LNC and the various operating businesses own or lease approximately 2.9 million square feet of office space. The governance group for LNC and the Investment Management segment lease 0.4 million square feet of office space in Philadelphia, Pennsylvania. The operating units in the Fort Wayne, Indiana area own or lease 1.0 million square feet. Also, businesses operating in the Chicago, Illinois metro area; Hartford, Connecticut and the United Kingdom own or lease another 0.6 million square feet of office space. An additional 0.9 million square feet of office space is owned or leased in other U.S. cities and foreign countries for branch offices and other operations. As shown in the notes to the consolidated financial statements (see Note 7 to the consolidated financial statements), the rental expense on operating leases for office space and equipment totaled $67.0 million for 2002. Office space rent expense accounts for $56.6 million of this total. This discussion regarding properties does not include information on investment properties.
Lincoln National Corporation (“LNC”) is a holding company. Through subsidiary companies, LNC operates multiple insurance and investment management businesses. The collective group of companies uses, “Lincoln Financial Group” as its marketing identity. LNC is the 39th largest (based on assets) United States Corporation (2001 Fortune 500, Largest U.S. Corporations, April 2002). Operations are divided into four business segments: 1) Lincoln Retirement (formerly known as the Annuities segment), 2) Life Insurance, 3) Investment Management and 4) Lincoln UK. LNC reports operations not directly related to the business segments and unallocated corporate items (i.e., corporate investment income, interest expense on corporate debt, unallocated overhead expenses, and the operations of Lincoln Financial Advisors (“LFA”) and Lincoln Financial Distributors (“LFD”) and the amortization of the deferred gain on the sale of Lincoln Re) in “Other Operations”. Prior to the fourth quarter of 2001, LNC had a Reinsurance segment. Total employment of LNC at December 31, 2002 on a consolidated basis was 5,830.
The pages that follow review 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. 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 (the “Act”). Forward-looking statements include, without limitation, 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.
Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from the results contained in the forward-looking statements. These risks and uncertainties include, among others, subsequent significant changes in: the Company (e.g., acquisitions and divestitures of legal
To provide an overall perspective on these critical accounting policies, and guidance as to the specific areas within Management’s Discussion and Analysis where these critical accounting policies are discussed in detail, a summary of critical accounting policies and the disclosure location is presented below.
Determining whether a decline in current fair values for invested assets is other than a temporary decline in value can frequently involve a variety of assumptions and estimates, particularly for investments that are not actively traded on established markets. For instance, assessing the value of some investments requires an analysis of expected future cash flows. Some investment structures, such as collateralized debt obligations, often represent selected levels, or tranches of underlying investments in a wide variety of underlying issuers. LNC’s accounting policies for its invested assets are discussed within Results of Consolidated Operations and Consolidated Investments. Specific discussion of LNC’s accounting policy for write-downs for securities that were determined to have declines in fair value that were other than temporary along with analysis of securities available-for-sale in an unrealized loss position can be found within Consolidated Investments.
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 2003 Guidance for the Effects of Equity Market Volatility” found within LNC’s discussion of Quantitative and Qualitative Disclosures About Market Risk.
Establishing reserves for litigation and compliance-related regulatory actions inherently involve a variety of estimates of potential future outcomes. These matters are discussed within Results of Consolidated Operations and in the Lincoln UK segment, with additional detail provided within Note 7 Restrictions, Commitments and Contingencies, 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 discussed 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.
On pages 19 through 56, the results of operations of LNC consolidated, LNC’s four business segments and “Other Operations” are presented and discussed. Pages 56 through 68 discuss LNC’s consolidated investments. Pages 68 through 73 discuss LNC’s consolidated financial condition including liquidity and cash flow, and capital resources. Pages 73 through 81 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.
This “Management’s Discussion and Analysis” should be read in conjunction with the audited consolidated financial statements and accompanying notes presented on pages 83 through 147.
A significant contributor to the decrease in net income was the poor performance of the equity markets impact on fee income, DAC and PVIF amortization and GMDB reserves and benefits. The equity market impact is discussed in more detail within the discussion of results of operations by segment.
Consolidated expenses (excluding goodwill amortization, restructuring charges, reserve increases on business sold through reinsurance and federal income taxes) decreased by $1,202.0 million or 22% 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, and increased reserves and payments for GMDB in the Lincoln Retirement segment.
Net income for 2001 was $590.2 million compared to $621.4 million for 2000, a $31.2 million or 5% decrease. Restructuring charges, net of the release of liabilities, included in net income in 2001 and 2000 were $24.7 million and $80.2 million, respectively. Contributing to the decrease in 2001 were realized losses on investments and derivative instruments of $73.6 million in 2001 compared to $17.5 million in 2000. These investment losses were due primarily to losses of $41.8 million (pre-tax) taken on Enron and Argentina securities in the fourth quarter of 2001 in addition to increased write-downs of other securities throughout 2001 due to credit deterioration. Partially offsetting the additional losses in 2001 was the gain on sale of certain reinsurance stock companies to Swiss Re of $15.0 million. The remaining $30.1 million decrease in Net Income between years was primarily the result of decreased earnings from the Lincoln Retirement and Investment Management segments, as well as LNC’s distributors, LFA and LFD, which are reported in Other Operations. These negative variances were partially offset by improved earnings from the Life Insurance segment and the former Reinsurance segment, included within Other Operations. In addition, included in net income for 2001 was one month’s amortization of the deferred gain on the business transferred to Swiss Re via indemnity reinsurance. There was also a decrease in the net loss from LNC Financing and Other Corporate within Other Operations.
LNC’s domestic consolidated product deposits and net flows were as follows:
Consolidating adjustments represent the elimination of deposits and net flows on products affecting more than one segment.
First Quarter 2003 Guidance for the Estimated Effect of Equity Market Volatility
In prior periods, Lincoln National Corporation (“LNC”) provided guidance on the estimated effect of equity market volatility on its 2002 results. The following guidance is being provided for purposes of modeling the expected effects of equity market volatility for the first quarter of 2003. As will be explained in greater
This guidance is intended to provide a general indication of the expected effect of equity market volatility on LNC’s fee income; deferred acquisition costs (“DAC”) and present value of in-force (“PVIF”) intangible assets; and guaranteed minimum death benefit (“GMDB”) reserves. Excluded from this guidance is the effect that equity market changes may have upon LNC’s realized and unrealized gains and losses on investments and intangible assets, other than DAC and PVIF. For example, write-downs for impairment of goodwill and deferred dealer commission assets may be necessary under certain market conditions. These matters are not included within the guidance provided in this document.
In measuring the estimated effects of changes in equity markets on its Retirement segment, LNC uses the S&P 500 index. LNC has generally found that the S&P 500 index is reasonably correlated to the effect of overall equity markets performance on this segment’s account values. Because LNC’s fee income earned on its variable annuity business is determined daily, the change in the S&P 500 on a daily average basis relative to the level of the S&P 500 at the beginning of each quarter provides a reasonable indication of the impact quarterly changes in equity markets have on the Retirement segment’s fee income. Because end of period account values are used for computing DAC unlocking and for incurred GMDB costs, the end of period change in the S&P 500 is used in measuring the estimated market impact of DAC unlocking and for the impact associated with incurred GMDB costs. In addition, because DAC and GMDB calculations have an assumed 9% positive annual equity market return, or a 2.25% quarterly assumption, variances in actual market performance relative to these calculation assumptions will generate positive or negative DAC unlocking and GMDB adjustments.
LNC also uses the S&P 500 index when describing the general effects of changes in equity markets for the Life Insurance segment. For the Lincoln UK segment, the FTSE 100 index provides a reasonable measure for approximating the effect of equity markets performance on earnings. LNC estimates that the lagging effect for the fourth quarter 2002 equity markets change will create a decrease of $0.1 million in fee income for Lincoln UK in the first quarter of 2003, because average account values for the fourth quarter of 2002 exceeded the level of ending account values at December 31, 2002.
The following discussion concerning the estimated effects of ongoing equity market volatility on LNC’s earnings is intended to be illustrative. Actual effects may vary depending on a variety of factors, many of which
are outside of LNC’s control, such as changing customer behaviors that might result in changes in the mix of LNC’s business between variable or fixed annuity contracts, switching between investment alternatives available within variable products, or changes in policy lapsation rates. The relative effects shown in the illustrative scenarios presented below should not be considered to be indicative of the proportional effects on earnings that more significant changes in equity markets may generate. Such non-proportional effects include those discussed earlier, such as incurred GMDB costs and DAC unlocking.
Since the effect of continued equity market volatility is complex and subject to a variety of estimates and assumptions, such as assumed rates of long-term equity market performance, it is difficult to provide information that can be reliably applied to predict earnings effects over a broad range of equity markets performance alternatives. But in an effort to provide some insight into these matters, LNC has provided below illustrative examples of the effects that equity market volatility might be expected to have on LNC’s earnings. The underlying assumptions regarding these illustrations are as follows:
The first scenario assumes that equity markets remain unchanged from their respective levels at December 31, 2002 through the first quarter of 2003.
The second scenario assumes that from December 31, 2002 through the end of the first quarter of 2003 equity markets increase smoothly by 2.5%.
As the above assumptions indicate, actual equity market changes that may have occurred since December 31, 2002 up to the date of issuance of this guidance are not being considered; rather, the examples that follow are provided to illustrate the effects of a hypothetical change in equity markets from December 31, 2002. The following tables are examples of the estimated effects on earnings that might be expected for each of these scenarios.
Differences exist in the market change effect on fee income for the current quarter, as compared to the ongoing quarterly effect, because the change in fee income in the immediate quarter is determined by the change in beginning variable account balances to average variable account balances for the current quarter. The change in fee income in the next subsequent quarter is determined by the change in average account values to ending variable account values that occurred due to the market changing in the preceding quarter.
2.5% increase in equity markets from December 31, 2002 to March 31, 2003
effects are subject to ongoing modification, as they are particularly sensitive to the mix of business and to the actual level of variable account balances.
In compliance with the transition provision of FAS 142, LNC completed the first step of the transitional goodwill impairment test during the second quarter of 2002. The valuation techniques used by LNC to estimate the fair value of the group of assets comprising the different reporting units varied based on the characteristics of each reporting unit’s business and operations. A number of valuation approaches, including discounted cash flow modeling, were used to assess the goodwill of the reporting units within LNC’s Lincoln Retirement, Life Insurance and Lincoln UK segments. Valuation approaches combining multiples of revenues, earnings before interest, taxes, depreciation and amortization (“EBITDA”) and assets under management were used to estimate the fair value of the reporting units within LNC’s Investment Manage-
Accounting for Stock-Based Compensation - Transition and Disclosure. On December 31, 2002, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure” (“FAS 148”), which provides alternative methods of transition for entities that change to the fair value method of accounting for stock-based employee compensation. In addition, FAS 148 amends the disclosure provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” to require expanded and more prominent disclosure of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements.
performance measures for the initial grant under the new plan will be calculated over a three-year period from grant date and will compare LNC’s performance relative to a selected group of peer companies. Comparative performance measures will include relative growth in earnings per share, return on equity and total share performance. Certain participants in the new plans will select from seven different combinations of stock options, performance shares and cash in determining the form of their award. Other participants will have their award paid in performance shares. This plan will replace the current LNC stock option plan; however, the separate stock option incentive plans established by Delaware Investments U.S., Inc. (“DIUS”) and DIAL Holding Company, Inc. (“DIAL”), both wholly-owned subsidiaries of Delaware Management Holdings, Inc., will continue. The revised long-term incentive plan for 2003 is expected to result in about the same amount of total expense as would have been reported in 2002 for the stock option employee compensation plan, if stock options had been expensed, combined with previously expensed accrual for the long-term cash incentive plan. This estimated 2003 expense is subject to uncertainty given that several assumptions are required to be made regarding LNC’s performance.
Among the matters that LNC is currently reviewing in connection with the third quarter 2003 effective date of Interpretation No. 46 to existing VIEs is the potential application to Collateralized Debt Obligation (CDO) pools that are managed by LNC. If the fees earned by LNC for managing these CDOs are required to be included in the analysis of expected residual returns, it is possible that such CDO pools would fall under the consolidation requirements of Interpretation No. 46. While LNC does not currently have access to all information necessary to determine the ultimate effects of such a required consolidation (because LNC is not the trustee or the administrator to the CDOs), based upon currently available information LNC estimates that the effect of consolidation would result in recording additional assets and liabilities on LNC’s consolidated balance sheet of about $1.3 billion. If such liabilities are required to be recorded, LNC would disclose that such liabilities are without recourse to LNC, as LNC’s role of investment manager for such CDO pools does not expose LNC to risk of loss.
Currently, there are ongoing discussions surrounding the implementation and interpretation of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities”, by the Financial Accounting Standards Board’s (“FASB”) Derivative Implementation Group regarding receivables and payables that are indexed to a pool of assets; and specific to LNC, modified coinsurance agreements and coinsurance with funds withheld reinsurance agreements that reference a pool of securities. An exposure draft for this issue has been issued by the FASB. It is not expected to be finalized by the FASB until sometime in the second quarter of
2003. If the definition of derivative instruments is altered, this may impact LNC’s prospective reported consolidated net income and consolidated financial position. Until the FASB finalizes the Statement 133 Implementation Issue, LNC is unable to determine what, if any, impact it will have on LNC’s consolidated financial statements.
During 1998, LNC implemented a restructuring plan relating to the integration of existing life and annuity operations with the new business operations acquired from CIGNA Corporation (“CIGNA”) and a second restructuring plan relating to the streamlining of LNC’s corporate center operations. The aggregate charges associated with these two unrelated restructuring plans totaled $34.3 million after-tax ($52.8 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, 1998. These aggregate pre-tax costs include $19.6 million for employee severance and termination benefits, $9.9 million for asset impairments and $23.3 million for costs relating to exiting business activities. The CIGNA restructuring plan was completed in the first quarter of 2000. During the fourth quarter of 2000, $0.5 million (pre-tax) of the original charge to downsize LNC’s corporate center operations was reversed. This plan was completed in the third quarter of 2002 due to the termination of the lease, which resulted from LNC’s purchase and ultimate sale of the abandoned building. The remaining $0.2 million related to the terminated lease was reversed as a reduction in restructuring costs during the third quarter of 2002. Total pre-tax costs of $56.2 million were expended or written-off under these restructuring plans.
During 1999, LNC implemented restructuring plans relating to 1) the downsizing and consolidation of the operations of Lynch & Mayer, Inc. (“Lynch & Mayer”); 2) the discontinuance of HMO excess-of-loss reinsurance programs and 3) the streamlining of Lincoln UK’s operations. The aggregate charges associated with these three unrelated restructuring plans totaled $21.8 million after-tax ($31.8 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. During the fourth quarter of 1999, $3.0 million (pre-tax) of the original charge recorded for the Lynch & Mayer restructuring plan was reversed as a reduction of restructuring costs due primarily to a change in estimate for space costs. In addition, during the fourth quarter of 1999, $1.5 million (pre-tax) associated with lease terminations was released into income. During the fourth quarter of 2000, the Lynch & Mayer restructuring plan was completed and $0.3 million (pre-tax) of the original charge recorded was reversed as Lynch & Mayer was able to successfully exit certain contracts without any further obligations or penalties. Also, during the fourth quarter of 2000, $1.0 million (pre-tax) of the original charge for the discontinuance of HMO excess-of-loss reinsurance programs 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. Actual pre-tax costs totaling $24.8 million have been expended or written-off for all three plans through December 31, 2002. As of December 31, 2002, a balance of $2.5 million remains in the restructuring reserve for the Lincoln UK plan and is expected to be utilized in the completion of this plan. Additional details of each of the three restructuring plans are discussed in Note 12 to the consolidated financial statements.
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. The Vantage restructuring charge was recorded in the second quarter, the Lincoln UK restructuring charge was recorded in the third and fourth quarters, and the Lincoln Investment Management restructuring was recorded in the fourth quarter of 2000. The aggregate charges associated with all restructuring plans entered into during 2000 totaled $81.8 million after-tax ($107.4 million pre-tax). These charges were included in Underwriting, Acquisition, Insurance and Other Expenses on the Consolidated Statement of Income for the year ended December 31, 2000. The component elements of these aggregate pre-tax costs include employee severance and termination benefits of $33.8 million, write-off of impaired assets of $40.9 million and other exit costs of $32.7 million. During the fourth quarter of 2000, $0.6 million (pre-tax) of
In February 2003, Lincoln Retirement announced plans to consolidate its fixed annuity operations in Schaumburg, Illinois into Fort Wayne, Indiana. Restructuring costs under the plan are expected to be $3-$5 million after-tax and are expected to be incurred during 2003. The consolidation is expected to result in pre-tax savings of approximately $4-$6 million annually beginning in the third quarter of 2003.
On August 30, 2002, LNC acquired The Administrative Management Group, Inc. (“AMG”), an employee benefits record keeping firm for $21.6 million in cash. Contingent payments up to an additional $14 million will be paid over a period of 4 years (2003-2006) if certain criteria are met. Any such contingent payments will be expensed as incurred. AMG, a strategic partner of the Lincoln Retirement segment for several years, provides record keeping services for the Lincoln Alliance Program along with approximately 400 other clients nationwide. As of December 31, 2002, the application of purchase accounting to this acquisition resulted in goodwill of $20.2 million.
The transaction structure involved a series of indemnity reinsurance transactions combined with the sale of certain stock companies that comprised LNC’s reinsurance operation. At closing, an immediate gain of $15.0 million after-tax was recognized on the sale of the stock companies. A gain of $723.1 million after-tax ($1.1 billion pre-tax) relating to the indemnity reinsurance agreements was reported at the time of closing. This gain was recorded as a deferred gain on LNC’s consolidated balance sheet, in accordance with the requirements of FAS 113, and is being amortized into earnings at the rate that earnings on the reinsured business are expected to emerge, over a period of 15 years.
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.
Through December 31, 2002, of the original $2 billion in proceeds received by LNC, approximately $0.56 billion 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 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
Cumulative Effect of Accounting Changes relates 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.
Net income decreased $211.4 million or 79% in 2002. The decrease in net income between periods was primarily the result of the decline in the equity markets and an increase in realized losses on investments of $86.2 million, resulting from the decline in value and the sale and write-downs of fixed maturity securities.
Average daily variable annuity account values decreased $4.8 billion or 13% and variable annuity account values at December 31, 2002 were $7.2 billion or 21% lower than at December 31, 2001. The decrease in variable annuity account values was caused primarily by the overall decline in the equity markets in 2002. This decrease reduced fees and lowered net income by $29.9 million. The effect of equity market impact on DAC and PVIF from retrospective unlocking and net changes in amortization decreased net income by $18.4 million. The current year negative unlocking was due to actual equity market performance lagging the expected market performance used in LNC’s DAC assumptions. Increases in GMDB reserves and benefit payments decreased net income by $40.4 million from 2001. In addition, in the fourth quarter of 2002 the segment had reduced net income of $30.3 million due to prospective unlocking of various assumptions underlying DAC, PVIF and GMDB calculations, including the reversion to the mean net growth assumption. The tax benefit from the Separate Account Dividend Received Deduction (“DRD”) was $17.7 million lower in 2002 than in 2001 due to lower fees, primarily resulting from the decline in the equity markets.
Average fixed annuity account values increased $2.1 billion in 2002 resulting in an increase in income of $17.7 million. 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. (See below for further discussion of net flows.) These strong sales increases could be interrupted if the interest rates decrease significantly and remain lower. In the event that LNC is not able to achieve spread targets, sales of fixed annuities could be significantly reduced.
The amortization of the Lincoln Retirement segment’s deferred acquisition costs is impacted by the change in market value of variable annuity accounts. 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 unlocking) when estimates of current or future gross profits to be realized from variable annuity contracts are revised. Because equity market movements have a significant impact on the value of variable annuity accounts and the fees earned on these accounts, estimated future profits increase or decrease with movements in the equity markets. Movements in equity markets also have an impact on reserves and payments for the guaranteed minimum death benefit feature within certain annuity contracts. The Lincoln Retirement segment’s assumption for the long-term
As discussed above, the decline of the equity markets effect has resulted in increased GMDB reserves and benefit payments which negatively effected Lincoln Retirement’s income. Although there is no method currently prescribed under generally accepted accounting principles for GMDB reserving, LNC uses 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 is expected to cover future GMDB payments, net of future GMDB fee income. Currently, there are few companies that reserve for the liability caused by the decline in the equity markets with some companies recognizing the cost on a pay as you go basis. At December 31, 2002, LNC’s net amount at risk (“NAR”) was $4.6 billion and the GAAP reserve was $84.5 million. The reserve for statutory accounting was $144.1 million, reflecting the more conservative market performance and mortality assumptions required under statutory accounting.
In evaluating the relative GMBD exposures that exist within LNC’s variable annuity business relative to industry peers, it is important to distinguish between the various types of GMDB structures, and other factors
At December 31, 2002 LNC had $19.2 billion of variable annuity account value, about 52% of LNC’s total, that was subject to a return of premium type GMDB benefit. LNC’s average variable annuity with a return of premium feature has an average account value of $32,000 and an average remaining premium base of $26,300 resulting in an average NAR of $5,700. The average attained age of these contract holders is just over 50 with less than 9% over age 70. The GAAP GMDB reserve on these accounts was $27.2 million on a total NAR of $1.8 billion.
LNC’s average non-qualified contract holder’s attained age is just under 64 with 35% over age 72 compared to the industry average attained age of 65 with 35% over age 72.
As illustrated in the discussion of Lincoln Retirement’s results of operations above, the segment’s income is extremely sensitive to swings in the equity markets. Refer to the First Quarter 2003 Guidance for Estimated Effect of Equity Market Volatility section for estimates of the effect of movements in the equity markets on Lincoln Retirement’s earnings.
taken on Enron and Argentina securities in the fourth quarter of 2001 in addition to increased write-downs of other securities throughout 2001 due to credit deterioration.
Increased operating and administrative expenses of $16.2 million also contributed to the decrease in net income between years. This increase was due primarily to higher information technology costs including computer software write-offs and equipment amortization, as well as increased severance and relocation costs related to LNC’s initiative to build a high performance culture.
Although American Legacy Variable Annuity gross deposits were down 14%, its incremental deposits decreased only 2% in 2002. In addition, Lincoln ChoicePlusSM with its multi-manager variable annuity experienced a $302 million or 40% increase in gross deposits in 2002. In the first quarter of 2002, LFD launched Lincoln ChoicePlus in UBS PaineWebber, one of the largest distributors of variable annuity products in the country. Also, in April 2002, LFD launched Lincoln ChoicePlus in Salomon Smith Barney, another key distributor of variable annuity products. Sales of the SEI Variable Annuity product line, distributed through SEI, declined 30% to $57 million in 2002. Effective February 28, 2003, SEI Investments will no longer take applications for new contract sales in the SEI Variable Annuity Program. Total fixed annuity gross deposits (excluding the fixed portion of variable annuity gross deposits) were $1.9 billion in 2002, a $0.2 billion or 12% increase. The increase was reflective of the strong sales of the StepFive, Lincoln Select Fixed Annuity and the Alliance Program Fixed Annuities.
LNC has been focused over the last several years on growing new deposits. This effort has been concentrated on both product and distribution breadth. As a result of the continued volatility of the equity markets, sales of fixed annuities have increased in spite of the historically low interest rate environment. 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 include AccelaRate and ChoiceGuarantee. The market value adjusted (“MVA”) feature of the Lincoln Select Fixed Annuity is expected to be more attractive in the Wirehouse/ Regional channel during a volatile interest rate environment. This feature increases or decreases the cash surrender value of the annuity based on a decrease or increase in interest rates. Contractholders participate in gains when the contract is surrendered in a falling interest rate market, and LNC is protected from losses up to a cap when the contract is surrendered in a rising interest rate market. A new version of Lincoln Select that provides the individual with a higher interest rate but a larger potential penalty for early withdrawal or surrender is being developed. LNC continues to approach the fixed annuity marketplace opportunistically and only offer rates that are consistent with LNC’s required spreads. If interest rates drop further, it may result in reduced product offerings and could impact net flows.
In 2002, an enhanced low cost variable annuity product, Multi-Fund 5 was launched. In addition, LNC expanded the ChoicePlus and American Legacy product offerings in New York to include Bonus, L-share and A-share (American Legacy only) contracts. Annuities with living benefit riders, that provide equity market performance guarantees, are becoming much more prevalent in the industry. LNC is evaluating various product approaches and designs in this area that will provide a competitive benefit while still falling within LNC’s risk tolerance levels for such guarantees.
LFD, LNC’s wholesaling distribution arm and internal partner of Lincoln Retirement, provides a wholesaling unit for the distribution of the Lincoln ChoicePlus variable annuity, Lincoln ChoicePlus fixed annuity and StepFive fixed annuity product lines. In 2002, LFD contributed significantly to the level of ChoicePlusSM Variable Annuity sales which reached $1.0 billion, an increase of 40% from 2001. LFD has also been a driver of fixed annuity products with $1.2 billion of sales in 2002. LNC is continuing to build and reinvent its strategic partnerships as part of its ongoing marketing strategy, while selectively working on other alliances that will provide increased access for LNC annuity products through various distribution channels. American Legacy variable annuity gross deposits were $1.7 billion in 2002, a decrease of 14% from 2001. One means for improving American Legacy annuity sales would be the use of a dedicated wholesaling team of Lincoln Insurance Planning Consultants focused strictly on American Legacy Variable Annuity products. Recently, LNC and American Funds Distributors (“AFD”) have agreed to transition the wholesaling of American Legacy to LFD. Currently, AFD uses wholesalers who focus on both American Funds mutual funds as well as the American Legacy Variable Annuity products. Segment management believes that this change to a dedicated team focused on key broker/dealer relationships developed in conjunction with AFD, has the potential to renew growth in American Legacy VA sales. The transitioning of wholesaling and distribution responsibility for the American Legacy variable annuities from AFD to LFD will provide LFD with two distinct annuity product areas: The single-manager (American Legacy) and the multi-manager (ChoicePlusSM and Multi-Fund®).
President Bush’s proposed 2003 budget legislation contains a variety of changes to the taxation of corporations and shareholders. Of particular importance to the Lincoln Retirement segment are proposed
The Life Insurance segment, headquartered in Hartford, Connecticut, 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 term life, universal life, variable universal life, interest-sensitive whole life and corporate owned life insurance. A majority of the Life Insurance segment’s products are currently distributed through LFD and LFA. In the third quarter 2002, the Life Insurance segment entered into a marketing agreement to distribute life insurance products through the M Financial Group, a well-respected and successful nationwide organization of independent firms serving the needs of affluent individuals and corporations. In addition to the marketing agreement, most business sold through M Financial Group will be subject to a 50% modified coinsurance arrangement.
In addition to the items noted above, other factors contributing to the decline in net income in 2002 compared to 2001 were less favorable mortality, declining investment margins, poor results in investment partnerships and declines in the equity markets.
FAS 97 requires that acquisition costs for universal life insurance (“UL”) policies and variable universal life insurance (“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 surrender charges; investment, mortality net of reinsurance ceded and expense margins; and realized gains/losses on investments. For VUL policies, estimated gross profits are affected by fee income as well. 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 (net of reinsurance) and interest margins. 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. The Life Insurance segment earns fee income on its VUL product line based on the ending daily VUL account values. This product only makes up 14% of the segment’s total account values at December 31, 2002.
On a quarterly basis, LNC reviews the assumptions of its DAC amortization model and records a retrospective adjustment to the amount expensed, (i.e. unlocks the DAC). On an annual basis, LNC reviews and adjusts as necessary its assumptions for prospective amortization of DAC, as well as its other intangible asset, PVIF. Although the Life Insurance segment is not as sensitive to the performance of the equity markets as the Lincoln Retirement segment, the negative performance of the equity markets resulted in negative retrospective DAC unlocking in 2002 of $2.4 million. In addition, negative DAC unlocking of $3.9 million related to changes in various prospective assumptions occurred in 2002.
As illustrated in the discussion of the Life Insurance segment’s results of operations above, the segment earnings are not particularly sensitive to swings in the equity markets. Refer to the First Quarter 2003 Guidance for Estimated Effect of Equity Market Volatility section for estimates of the effect of movements in the equity markets on Life Insurance’s earnings.
The $16.2 million or 6% decrease in net income in 2001 was due primarily to increased realized losses on investments and derivative instruments of $26.3 million. The Life Insurance segment also incurred two restructuring charges in the second and fourth quarters of 2001 of $2.0 million and $1.5 million, respectively. The $2.0 million charge recorded in the second quarter of 2001 related to a restructuring plan with the objective of eliminating duplicative staff functions in the Schaumburg, Illinois operations of First Penn-Pacific by transitioning them into the Annuities and Life Insurance segment operations in Fort Wayne, Indiana and Hartford, Connecticut, respectively, in order to reduce ongoing operating costs. The $1.5 million charge recorded in the fourth quarter of 2001 was for 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.
Life Insurance experienced less favorable mortality throughout 2001 after having a favorable year in 2000. Partially contributing to the downturn in mortality experience were the losses of $1.1 million recorded for the September 11 terrorist attacks. The Life Insurance segment also experienced lower earnings on investment partnerships. The Life Insurance segment’s 2001 income was positively impacted by growth in life insurance in-force from sales, favorable persistency and lower general and administrative expenses. General and administrative expenses decreased due to expense reduction initiatives implemented in the second half of 2001. In 2000 and 2001, the Life Insurance segment did not experience DAC unlocking that resulted in a significant impact on earnings.
Sales as measured by first year premiums were down overall in 2001 by $33.7 million or 5%. This decline was due to a $39.8 million decrease in Corporate Owned Life Insurance (“COLI”) sales. COLI sales, which
consist of very large cases, decreased from the prior year due to two large cases accounting for $42.5 million in first year premiums recorded in the fourth quarter of 2000.
First year premiums on retail products increased by $6.1 million or 1% between years. UL sales increased $3.4 million or 1% between years. Although this overall increase is modest, sales in the fourth quarter of 2001 were $98 million, a 20% increase over the prior year quarter. Sales rebounded nicely in the fourth quarter after a volatile year for UL sales. VUL sales were up $9.8 million or 4% between years. These results were encouraging given the performance of the equity markets in 2001.
Account values increased $0.6 billion or 6% to $11.4 billion at December 31, 2001 from $10.8 billion at the prior year-end. Positive cash flows for the year of $1.2 billion were the main contributor to the increase between years. Cash flows in 2001 were flat compared to the prior year. VUL account values were down between years by $62 million due to market depreciation.
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 and long-term care benefit provisions are available with certain products. .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.
Given the economic environment of the recent past, portfolio breadth has proven its value. The industry has experienced a dramatic shift from variable to fixed products over the last year, driven primarily by the equity market decline and a flight to conservatism exacerbated by the events of September 11, 2001. Over the last 12 months, the Life segment’s mix of business has shifted dramatically from VUL to UL, but the dollar decline in VUL sales has been more than offset by the dollar increase in UL sales. Universal Life accounted for 79% of total retail UL/ VUL sales in 2002 versus 56% of those sales in 2001. In times like these, when clients have less tolerance for market risk, it is important to have a competitive fixed Universal Life portfolio.
The Life Insurance segment has continued to develop products that meet the changing needs of its target affluent market. Throughout 2002, the segment revamped its entire retail UL portfolio. In March 2002, it introduced a new single life series of products with Lincoln ULLPR and Lincoln ULDB. The Lapse Protection Rider (“LPR”) product is an upgrade to the product introduced in 2001 which offers the innovative lapse protection rider, designed to provide flexibility and guaranteed death benefit coverage - important features in today’s market. The Death Benefit (“DB”) product is designed to offer cost-efficient coverage for people less interested in guarantees. In August of 2002, new survivorship versions of both the LPR and DB products were also introduced. Overall, the response to these new products has been very positive. In 2003, the segment plans to continue to be aggressive in product development.
Estate tax reform was a major legislative debate in 2002, which is expected to continue. Among a variety of alternatives being considered is a temporary extension of the one-year estate tax repeal that will occur in 2010 under current law. If this occurs, inheritance taxes on a state-by-state basis may be increased to offset the projected reduction in revenues to state governments. More costly to both federal and state governments would be a permanent repeal of estate taxes. The outlook for permanent repeal remains highly uncertain, particularly in light of increasing federal and state budgetary concerns.
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 Policies Model Regulation (“Regulation XXX”). AXXX will increase statutory reserves for universal life policies sold beginning in 2003 with secondary guarantees using shadow accounts and for specified premium guarantees that are prefunded. The secondary guarantee promises to keep a policy in force as long as certain conditions are met, regardless of whether the policy has any cash value.
Regardless of the value in the actual account value, the policy will not lapse as long as the shadow account is positive. A shadow account is a hypothetical account that accumulates actual premium payments and interest less fees based on the secondary guarantee assumptions. However, the shadow account does not provide any cash value to the policyholder. All companies offering secondary guarantees that allow prefunding will be impacted to a greater or lesser degree depending on product design. A prefunded policy is one where premiums are paid earlier than is necessary to maintain the policy’s benefits.
New regulations have set forth the IRS’ views regarding the tax treatment of split dollar funding arrangements. Split dollar is a premium funding mechanism that has been used for many years, with IRS approval, to provide life insurance benefits to a firm’s key executives, or to provide life insurance benefits to family members of closely held firms, etc. In some cases, split dollar funding may not be as attractive under the new IRS rules.
Net income for 2002 increased $13.8 million or 117% over 2001. Excluding the effect of goodwill amortization in 2001, net income decreased $2.4 million or 9% in 2002. The decrease in income is primarily a result of declines in the equity markets reducing retail and institutional assets under management and revenues. Offsetting the negative effect of the markets on revenues has been a reduction in expenses of $19.2 million, excluding the reduction in expenses from the change in accounting for goodwill amortization and restructuring charges. This improvement in expenses is a result of cost containment efforts, the effect of the equity market decline on variable expenses, $1.7 million reduction in amortization of other intangible assets resulting from certain intangibles being fully amortized in the second quarter of 2001 and $4.2 million for the release of accrued compensation resulting from the fourth quarter 2002 resignation of the segment’s CEO. In addition to lower expenses, positive net cash flows in 2002 partially offset the negative effect of the equity markets on assets under management and revenues.
As illustrated in the discussion of the Investment Management segment’s results of operations above, the segment’s earnings are sensitive to swings in the equity markets. Refer to the First Quarter 2003 Guidance for Estimated Effect of Equity Market Volatility section for estimates of the effect of movements in the equity markets on Investment Management’s earnings.
The Investment Management segment has a deferred dealer commission asset of approximately $53 million as of December 31, 2002 relating to upfront sales commissions paid to brokers for the sale of “Class B” shares of Delaware Investments 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 has been negatively impacted by the continued declines in the equity markets.
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, 2002, the estimated undiscounted future 12b-1 and CDSC cash flows exceeded the carrying value of the deferred dealer commission asset.
The decreases in net income of $25.2 million or 68% in 2001 were primarily attributable to lower investment advisory fees and to a lesser extent lower other revenue partially offset by lower expenses. Revenue decreased as a result of a decrease in external assets under management, reduced distribution, shareholder servicing and investment accounting revenue associated with lower retail mutual fund sales and lower assets under management.
The Investment Management segment made significant investments in 2000 and 2001 in upgrading talent and revamping investment processes; however, effective expense management resulted in an overall decrease in expenses. Expenses decreased by $10.9 million (pre-tax) or 3% in 2001. This decrease was primarily due to the absence of significant severance expenses incurred during 2000, lower amortization expense associated with other intangible assets and effective management of other expenses. Certain other intangible assets capitalized as part of LNC’s acquisition of Delaware Management Holdings, Inc. in 1995 had six-year lives and were fully amortized in April of 2001. In addition, the segment had lower incentive compensation expense accruals due primarily to the declining financial results between years. Partially offsetting the decreased expenses noted above was higher amortization of deferred broker commissions due to an increase in the deferred broker commission asset and expenses incurred during 2001 to close and/or merge a number of mutual funds.
Vantage into Delaware, in order to reduce ongoing operating costs and to eliminate redundant facilities within this business segment. The objectives of the $2.5 million charge recorded in the fourth quarter of 2000 were to combine the investment management operations for fixed income products of Lincoln Investment Management and Delaware in Philadelphia, in order to reduce ongoing operating costs and eliminate redundant facilities within this business segment. In addition, in 2000 there were reversals totaling $0.6 million related to the Lynch & Mayer restructuring charge originally recorded in 1999 and the Vantage restructuring charge recorded in 2000. For further discussion of these restructuring plans refer to Note 12 to the consolidated financial statements.
Retail assets under management and net flows for 2000 and 2001 have been restated to include assets under administration by the segment. Previously, these assets were excluded as the investments are managed by third parties. Assets under administration are now included so that assets under management includes all assets for which the segment receives asset based revenues. The restatements increased assets under management by $0.5 billion at both December 31, 2001 and December 31, 2000 and net retail flows increased by $81 million and $18 million for the year ended December 31, 2001 and 2000, respectively.
Retail sales for 2002 were a record $5.7 billion, up $2.0 billion or 54% over 2001. The growth in retail sales was driven by increased sales of managed account business. Managed account deposits in 2002 more than doubled deposits in 2001, with deposits of $1.2 billion in 2002 compared to $0.5 billion in 2001. A portion of the sales increase in managed accounts was a result of events affecting key competitors (a group departure of investment professionals from one firm and a second firm temporarily closing for new business).
Sales of Delaware’s mutual funds by LFA continued to decline during 2002 as sales through LFA represented approximately 4% and 5% of LFA’s total mutual fund sales in 2002 and 2001, respectively. Sales of mutual funds, managed accounts, 401(k) products and “529” plans through LFD, the internal wholesaling arm for distribution of Delaware’s investment products increased 32% in 2002 relative to 2001. LFD was organized at the end of 2000 and was in the ramp up stage throughout 2001. Delaware is working closely with both LFA and LFD to increase sales through improved communication, focusing on selected funds and working with the newly formed research teams to ensure optimum positioning of competitive Delaware products. Delaware was awarded program management and certain investment advisory services for the “529” college savings plans for the state of Hawaii and the Commonwealth of Pennsylvania during 2001. Services commenced in mid-2002 for the “529” plans. The persistence of poor equity markets, combined with a more crowded “529” marketplace, has resulted in lower than anticipated sales; however, these programs provide Delaware with an opportunity to attract significant long-term assets under management. Although “529”
In October 2002, the President and CEO of Delaware, Charles E. Haldeman, Jr. announced his resignation. In January 2003, Jude T. Driscoll, Executive Vice-President and Head of Fixed Income for Delaware, was named President and CEO. LNC believes that a strong team of investment and research professionals exists at Delaware that continues to be committed to a team approach to research and investment management. Delaware continues to focus on improving investment performance, attracting and retaining client assets and/or funds, managing expenses and ultimately improving profitability. The Investment Management segment has made progress on these initiatives, and will continue to focus on sustaining and improving those results.
The $28.9 million or 42% decrease in net income in 2002 was primarily due to the decline in the UK equity markets. The FSTE 100 index declined 24% in 2002 compared to a 16% decline in 2001. The decline in the equity markets reduced assets in equity-linked accounts resulting in lower fee income. The equity market
As illustrated in the discussion of the Lincoln UK segment’s results of operations above, the segment earnings are sensitive to swings in the equity markets. Refer to the First Quarter 2003 Guidance for Estimated Effect of Equity Market Volatility on Fee Income, DAC and GMDB section for estimates of the effect of movements in the equity markets on Lincoln UK’s earnings.
LNC’s subsidiary in the UK has its balance sheets and income statements translated at the current spot exchange rate as of the year end and average spot exchange rate for the year, respectively. From time to time, LNC will hedge its exposure to foreign currency as it relates to its net investment in Lincoln UK.
Activity that is not included in the major business segments is reported in “Other Operations.” “Other Operations” includes operations not directly related to the business segments and unallocated corporate items (i.e., corporate investment income, interest expense on corporate debt, unallocated overhead expenses, and the operations of LFA and LFD.
Net income for 2001, included $128.8 million of income from the former Reinsurance segment. In 2002, LNC reported a gain of $21.7 million on the sale of its investment (included in realized gains on investments) in an international marketing company associated with LNC’s former Reinsurance segment. Offsetting this gain was an adjustment in 2002 of $9.4 million to the gain on sale of reinsurance subsidiaries sold in 2001. The adjustment related primarily to the true-up of estimated taxes associated with the sale.
LNC Financing had a positive variance of $34.9 million from 2001. In 2002, LNC Financing included investment income of $19.6 million from the proceeds of the sale of LNC’s reinsurance business to Swiss Re.
In addition to the investment income, there was a decrease in long-term debt expense associated with various long-term financing activities that occurred in the second half of 2001 and third quarter of 2002 as described in the Liquidity and Cash Flow section within Review of Consolidated Financial Conditions. In addition, short-term borrowing costs were lower due to lower interest rates and lower daily average borrowings under the commercial paper program in the U.K. The Lincoln UK segment has experienced increased cash flow from operations over the last year, which was used in part to eliminate its outstanding commercial paper balance during 2002.
Other Corporate had income of $5.8 million in 2002, an improvement of $24.0 million compared to 2001. Included in the 2001 loss was a restructuring charge of $15.8 million to consolidate operations and reduce excess space in LNC’s Fort Wayne, Indiana operations resulting from LNC’s divestiture of its reinsurance operations.
Net income increased $17.4 million to $7.2 million in 2002. Net income for 2001 included the impact of three restructuring charges totaling $19.5 million: two charges were recorded related to LFD totaling $3.7 million and the other charge was for $15.8 million noted above in Other Corporate. Net income for 2001 also included the impact of a $15.0 million gain on sale of reinsurance subsidiaries.
The Reinsurance line, which includes the historical earnings of the former Reinsurance segment had an increase in income of $5.6 million in 2001. The 2001 results, however, only represents eleven months of earnings through November 30, 2001.
LFD had an increased loss of $15.9 million between years due to decreased sales revenue and increased expenses, including the restructuring charge in 2001 noted above. LFD experienced slightly lower retail sales in 2001, and revenue decreased as a result of changes in the mix of business. In addition, LFD had lower sales of corporate owned life insurance as previously discussed in the Life Insurance segment’s result of operations. Retail sales were bolstered by strong second half sales of the StepFive® Fixed Annuity, Lincoln ChoicePlussm Variable Annuity product line and the MoneyGuard universal life product which includes a long-term care benefit. Mutual fund sales, however, were weak throughout the year due primarily to the poor performance of the equity markets. In addition, LFD’s wholesaling force was not at full strength until the end of 2001. LFD had higher expenses primarily as a result of its investment in new wholesalers during 2001 partially offset by the positive impact on expenses of the two restructuring plans implemented in 2001, as well as other targeted expense reduction activities. LFD started with 221 wholesalers at the beginning of 2001 and had 241 at December 31, 2001.
In 2001, Lincoln National Life Insurance Company (“LNL’) concluded the settlement of all class action lawsuits alleging fraud in the sale of LNL non-variable universal life and participating whole life policies issued between January 1, 1981 and December 31, 1998. Since 2001, LNL has reached settlements with a substantial number of the owners of policies that opted out of the class action settlement. LNL continues to defend a small number of opt out claims and lawsuits. While there is continuing uncertainty about the ultimate costs of settling the remaining opt out cases, it is management’s opinion that established reserves are adequate and future developments will not materially affect the consolidated financial position of LNC.
The consolidated assets under management including consolidated investments and assets held in separate accounts on the balance sheet, and external assets under management classified by investment advisor, mean invested assets, net investment income and investment yield are as follows:
institutional assets, see the Investment Management segment discussion. LNC follows a balanced approach of investment for both current income and prudent risk management, with an emphasis on generating sufficient current income to meet LNC’s obligations. This approach requires the evaluation of risk and expected return of each asset class utilized, while still meeting the income objectives of LNC. This approach also permits LNC to be more effective in its asset-liability management, since decisions can be made based upon both the economic and current investment income considerations affecting assets and liabilities.
Investment Portfolio Composition and Diversification: Fundamental to LNC’s investment policy is diversification across asset classes. LNC’s investment portfolio, excluding cash and invested cash, is composed of fixed maturity securities; mortgage loans on real estate; real estate either wholly owned or in joint ventures and other long-term investments. LNC purchases investments for its segmented portfolios that have yield, duration and other characteristics that take into account the liabilities of the products being supported. The dominant investments held are fixed maturity securities, which represent approximately 82% the investment portfolio. The total investment portfolio increased $3.9 billion in 2002 and $744 million in 2001. The increase in 2002 was due to the purchase of investments from cash flow generated by the business units, positive net flows for fixed annuity portfolios and market appreciation of fixed maturity securities. The increase in 2001 was due to the purchase of investments from cash flow generated by the business units, positive net flows for fixed annuity portfolios and market appreciation of fixed maturity securities due to the significant decline in interest rates during 2001.
Securities Available-for-Sale: LNC’s entire fixed maturity and equity securities portfolio is classified as “available-for-sale” and is carried at fair value on its 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 based upon an assumed emergence of gross profits on certain insurance business. In a similar manner, adjustments to the balances of policyholder reserves or commitments are made because LNC has either a contractual obligation or has a consistent historical practice of making allocations of investment gains or losses to certain policyholders. Deferred income tax balances are also adjusted, since unrealized gains or losses do not affect actual taxes currently paid. See Note 3 to the consolidated financial statements for details of the gross unrealized gains and losses as of December 31, 2002.
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, 2002, 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.
LNC completed securitizations of commercial mortgage loans in both the fourth quarter of 2000 and the fourth quarter of 2001. In each securitization, the loans were transferred to a trust held in a “qualified” special purpose entity (“SPE”), which is therefore not consolidated into LNC. In the first securitization, the loans had a fair value of $186.0 million and a carrying value of $185.7 million. LNC retained a 6.3% interest in the securitized assets. LNC received $172.7 million from the trust for the sale of the senior trust certificates representing the other 93.7% beneficial interest. A realized gain of $0.4 million pre-tax was recorded on this sale. A recourse liability was not recorded since LNC is not obligated to repurchase any loans from the trust that may later become delinquent. Cash flows received during 2002, 2001 and 2000 from interests retained in the trust were $2.6 million, $2.6 million and $0.4, respectively.
In the second securitization completed in 2001, 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 $0.03 million were received in 2001 and $0.2 million were received in 2002. 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. LNC did not initially retain an interest in the securitized assets; however, LNC later invested $14.3 million of its general account assets in the certificates issued by the trust. This investment is included in fixed maturity securities on the balance sheet.
The losses in the telecommunications sector were largely due to sales and impairment write-downs of Worldcom bonds, although there were other telecommunications issuers that were sold at losses throughout the year. Similar to the telecommunication sector, LNC also experienced realized losses in the airline sector due to the bankruptcies of US Airways and United Airlines. LNC’s exposure to the airline sector is primarily equipment trust certificates and enhanced equipment trust certificates. Airplanes collateralize these investments, but the declines in underlying valuations of airplanes have resulted in the impairment of LNC’s holdings.
3. Small proportions of the LNC portfolio are allocated to high-risk asset classes such as emerging markets. Given the volatile markets in 2002, the turnover was higher on this sub-segment of the portfolio than in previous years. This resulted in realized gains as well as realized losses.
Significant circumstances that contributed to realized losses on investments in 2001 included the Enron bankruptcy, the defaults by Kmart and Argentina, as well as rapid declines in credit ratings and deterioration of expected cash flows on various collateralized debt obligation investments. The loss in 2000 was primarily the result of the sale of investments, and to a lesser extent the write-down and provision for losses on investments.
Critical Accounting Policy - Write-Downs and Allowance for Losses: 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 quality at the time of purchase, but were subsequently down graded 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.
may adversely affect certain investments. In addition, there are often significant estimates and assumptions required by LNC to estimate the fair values of securities, including projections of expected future cash flows and pricing of private securities. LNC is continuously monitoring developments and updating underlying assumptions and financial models based upon new information. Provided below are additional facts concerning the potential affect upon LNC’s future earnings and financial position should management later conclude that some of the current declines in fair value of securities are other than temporary declines.
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 write-downs of fixed maturity and equity securities are disclosed within the notes to the accompanying consolidated financial statements (see Note 3 to the consolidated financial statements).
Where detailed analysis by LNC credit analysts and investment portfolio managers leads to the conclusion that a security’s decline in fair value is other than temporary, the security is written down to fair value. In instances where declines are considered temporary, the security will continue to be carefully monitored.
The following information is applicable to unrealized loss securities that were subject to these enhanced analysis and monitoring processes as of the relevant balance sheet date. In viewing this information, it is important to realize that LNC is continuously reviewing and updating the status of its investment portfolios. Accordingly, the information presented below relates to the status of securities that were being monitored at a particular point in time, and may not be indicative of the status of LNC’s investment portfolios subsequent to the balance sheet date. Further, since the timing of the recognition of realized investment gains and losses through the selection of which securities are sold is largely at management’s discretion, it is important to consider the information provided below within the context of the overall unrealized gain or loss position of LNC’s investment portfolios. These are important considerations that should be included in any evaluation of the potential impact of unrealized loss securities upon LNC’s future earnings. LNC had an overall net unrealized gain (after the amortization of acquisition costs, provision for policyholder commitments, investment expenses and taxes) on securities available-for-sale under FAS 115 of $753.3 million and $195.7 million at December 31, 2002 and 2001, respectively.
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, 2002 is presented in the table below.
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, 2001 is presented in the table below.
At December 31, 2002 and 2001, less than 9% and 5%, respectively, of the traded and private securities held that were subject to enhanced analysis and monitoring for potential changes in unrealized loss status were rated as investment grade. The range of maturity dates for these securities varies, with about 57% of these securities maturing between 5 and 10 years, about 20% maturing in greater than 10 years and the remaining maturity dates maturing in less than 5 years. At December 31, 2002 and 2001, 65.3% and 84.7%, respectively of total traded and private securities in unrealized loss status were rated as investment grade. At December 31, 2002, the range of maturity dates for total traded and private securities in unrealized loss status varies, with about 22% maturing between 5 and 10 years, 46% maturing after 10 years and the remaining securities maturing in less than 5 years. At December 31, 2001, the range of maturity dates for these securities varies, with about 39% maturing between 5 and 10 years, 37% maturing after 10 years and the remaining securities maturing in less than 5 years. See Note 3 to the consolidated financial statements for ratings and maturity date information for LNC’s fixed maturity investment portfolio.
During the year ended December 31, 2002 and 2001, LNC sold securities at gains and at losses. As discussed earlier, in the process of evaluating whether a security with an unrealized loss reflects an other than temporary decline, LNC considers its ability and intent to hold the security until its value recovers. However, subsequent decisions on securities sales are made within the context of overall risk monitoring, assessing value relative to other comparable securities and overall portfolio maintenance. Although LNC’s portfolio managers may, at a given point in time, believe that the preferred course of action is to hold securities with unrealized losses that are considered temporary until such losses are recovered, the dynamic nature of portfolio management may result in a subsequent decision to sell. These subsequent decisions are consistent with the classification of LNC’s investment portfolio as available-for-sale. In the future, LNC expects to continue to
manage all invested assets within its portfolios in a manner that is consistent with the available-for-sale classification.
Use of Derivatives: The primary use of derivatives at LNC is to hedge interest rate risk that is embedded in either life insurance and annuity product liabilities or investment portfolios. To a lesser extent, derivatives are also used to hedge exposures to foreign currency and equity market risks. Derivatives held at December 31, 2002 contain industry standard terms and are entered into with financial institutions with long-standing, superior performance records.
Liquidity refers to the ability of an enterprise to generate adequate amounts of cash from its normal operations to meet cash requirements with a prudent margin of safety. Because of the interval of time from receipt of deposit or premium until payment of benefits or claims, LNC and other insurers employ investment portfolios as an integral element of operations. By segmenting its investment portfolios along product lines, LNC enhances the focus and discipline it can apply to managing the liquidity, as well as the interest rate and credit risk of each portfolio commensurate with the profile of the liabilities. For example, portfolios backing products with less certain cash flows and/or withdrawal provisions are kept more liquid than portfolios backing products with more predictable cash flows.
The consolidated statements of cash flows indicate that operating activities provided cash of $0.5 billion, $1.3 billion and $2.0 billion in 2002, 2001 and 2000, respectively. This statement also classifies the other sources and uses of cash by investing activities and financing activities and discloses the amount of cash available at the end of the year to meet LNC’s obligations.
Although LNC generates adequate cash flow to meet the needs of its normal operations, periodically LNC may issue debt or equity securities to fund internal expansion, acquisitions, investment opportunities and the retirement of LNC’s debt and equity. In April 2002, a new shelf registration statement was declared effective by the Securities and Exchange Commission. The new shelf registration totaled $1.2 billion (including $402.5 million of registered but unissued securities from previous registration statements). After giving consideration to the $250 million 5.25% five-year senior notes issued in June 2002, LNC has $950 million remaining under the shelf registration to issue debt securities, preferred stock, common stock, warrants, stock purchase contracts and stock purchase units of LNC and trust preferred securities of four subsidiary trusts. The net proceeds from the sale of the securities offered by this shelf registration and the applicable prospectus supplement(s) are expected to be used by LNC for general corporate purposes, including repurchases of outstanding common stock, repayment or redemption of outstanding debt or preferred stock, the possible acquisition of financial services businesses or assets thereof, investment in portfolio assets and working capital needs. Cash funds are also available from LNC’s revolving credit agreements. In June 2002, LNC reduced its revolving bank lines of credit from $700 million to $500 million when LNC suspended its commercial paper issuance under its European Commercial Paper program (see Note 5 to the consolidated financial statements).
LNC purchased and retired 12,088,100; 11,278,022; and 6,222,581 shares of common stock at a cost of $474.5 million, $503.7 million and $210.0 million in 2002, 2001 and 2000, respectively. In November 2000, the LNC board authorized $500 million to repurchase LNC securities. At the time of this authorization, there was $99.7 million remaining under a $500 million May 1999 board authorization. All of the shares repurchased in 2000 came under the May 1999 board authorization. In July 2001, the LNC board authorized an additional $500 million to repurchase LNC securities. In 2001, the remaining amount ($53.4 million) under the May 1999 board authorization was used and $450.4 million under the November 2000 board authorization was used. On August 8, 2002, the LNC Board authorized the repurchase of up to an additional $600 million of LNC securities. In 2002, the remaining amount ($49.6 million) under the November 2000 board authorization was used and $424.9 million under the July 2001 board authorization was used. The remaining amount under the combined repurchase authorization at December 31, 2002 was $675.1 million.
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 has 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 $0.56 billion 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 approximately $0.3 billion to pay the fourth quarter 2002 settlement with Swiss Re (see the Acquisition and Divestiture section for regarding the settlement with Swiss Re). Any remaining proceeds will be dedicated to the ongoing capital needs of LNL.
In order to maximize the use of available cash, the holding company (LNC) 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. In addition to facilitating the management of cash, the holding company receives dividends from its subsidiaries, invests in operating companies, maintains an investment portfolio and pays shareholder dividends and certain corporate expenses.
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.
The tables below summarize LNC’s obligations and commitments to make future payments under contracts in place at December 31, 2002, as well as contingent commitments in place at December 31, 2002.
The amount includes a maximum annual increase related to the CPI.
The contract is for a term of 10 years and 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.
Total includes $72.0 million of capital calls on limited partnership investments, $182.9 million of real estate pre-buys and $49.7 million and $86.2 million of commitments for mortgage loans and private placement securities, respectively.
At December 31, 2002 LNC maintained three revolving credit agreements with a group of domestic and foreign banks totaling $580 million. LNC’s commercial paper is supported by these facilities, a $200 million 364-day revolving credit facility maturing in December 2003 and a $300 million revolving credit facility maturing in December 2005 and a $80 million revolving credit facility, maintained by Lincoln UK, which matured in January 2003. The UK facility was renewed in January 2003 for $48 million maturing in January 2004. At December 31, 2002, LNC had $12 million in outstanding borrowings under the Lincoln UK agreement. 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. LNC’s 364-day revolving credit contains a one-year term-out feature which allows LNC to convert any loans outstanding on the maturity date of the credit facility into a one-year term loan subject to a floating interest rate.
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.
Total shareholders’ equity increased $32.8 million during the year ended December 31, 2002. Accumulated other comprehensive income increased shareholders’ equity by $561.4 million. The components of the changes to accumulated other comprehensive income were: $564.5 million related to the increase in the unrealized gain on securities available-for-sale and derivative instruments, $58.8 million related to an increase in the accumulated foreign exchange gain and a decrease of $61.9 million for minimum pension liability adjustments. Excluding changes due to other comprehensive income, shareholders’ equity decreased $528.6 million. This decrease is the net of increases due to $91.6 million of net income and $93.6 million from the issuance of common stock related to benefit plans and decreases due to $234.3 million from the declaration of dividends to shareholders, $474.5 million for the retirement of common stock, $4.5 million for the forfeiture of shares under benefit plans and $0.5 million for the cancellation of shares related to the acquisition of subsidiaries
Capital adequacy is a primary measure used by insurance regulators to determine the financial stability of an insurance company. In the U.S., risk-based capital guidelines are used by the National Association of Insurance Commissioners to determine the amount of capital that represents minimum acceptable operating amounts related to insurance and investment risks. Regulatory action is triggered when an insurer’s statutory-basis capital falls below the formula-produced capital level. At December 31, 2002, statutory-basis capital for each of LNC’s U.S. insurance subsidiaries was in excess of regulatory action levels of risk-based capital required by the jurisdiction of domicile.
See notes to the consolidated financial statements on pages 87 through 147.
Basis of Presentation. The accompanying consolidated financial statements include Lincoln National Corporation (“LNC”) and its majority-owned subsidiaries. Through subsidiary companies, LNC operates multiple insurance and investment management businesses divided into four business segments (see Note 9). The collective group of companies uses “Lincoln Financial Group” as its marketing identity. Less than majority-owned entities in which LNC has at least a 20% interest are reported on the equity basis. These consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States.
For the mortgage-backed securities portion of the fixed maturity securities portfolio, LNC recognizes income using a constant effective yield based on anticipated prepayments and the estimated economic life of the securities. When estimates of prepayments change, the effective yield is recalculated to reflect the revised anticipated future payments. The new effective yield is used to recognize income on the security prospectively. This adjustment is reflected in net investment income.
Cash and invested cash are carried at cost and include all highly liquid debt instruments purchased with a maturity of three months or less.
Realized gain (loss) on investments is recognized in net income, net of associated amortization of deferred acquisition costs and investment expenses, using the specific identification method. Changes in the fair values of securities carried at fair value are reflected directly in shareholders’ equity, after deductions for related adjustments for deferred acquisition costs and amounts required to satisfy policyholder commitments that would have been recorded had these securities been sold at their fair value, and after deferred taxes or credits to the extent deemed recoverable.
Derivative Instruments. For the years ended December 31, 2002, 2001 and 2000, LNC hedged certain portions of its exposure to interest rate fluctuations, the widening of bond yield spreads over comparable maturity U.S. Government obligations, credit risk, foreign exchange risk and equity risk fluctuations by entering into derivative transactions. A description of LNC’s accounting for its hedging of such risks is discussed in the following paragraphs.
Over-the-counter call options which hedged liabilities tied to the S&P stock index were carried at fair value. The change in fair value was reflected directly in net income. Gain (loss) realized upon termination of these call options was included in net income. Over-the-counter call options which hedge stock appreciation rights were carried at fair value when hedging vested stock appreciation rights and at cost when hedging unvested stock appreciation rights. The change in fair value of call options hedging vested stock appreciation rights was included in net income. Gain (loss) upon termination was reported in net income.
Loaned Securities. Securities loaned are treated as collateralized financing transactions and a liability is recorded equal to the cash collateral received which is typically greater than the market value of the related securities loaned. In other instances, LNC will hold as collateral securities with a market value at least equal to the securities loaned. Securities held as collateral are not recorded in LNC’s consolidated balance sheet in accordance with accounting guidance for secured borrowings and collateral. LNC’s agreements with third parties generally contain contractual provisions to allow for additional collateral to be obtained when necessary. LNC values collateral daily and obtains additional collateral when deemed appropriate.
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 by Insurance Companies For Certain Long-Duration Contracts & Realized Gains and Losses on Investment Sales” (“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.
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.
Under FAS 60, acquisition costs for traditional life insurance products, which include whole life and term life insurance contracts, are amortized over periods of 10 to 30 years on either a straight-line basis or as a level percent of premium of the related policies depending on the block of business. There are currently no deferred acquisition costs being amortized under FAS 60 for fixed and variable payout annuities.
Benefits and Expenses. Benefits and expenses for universal life-type and other interest-sensitive life insurance products include interest credited to policy account balances and benefit claims incurred during the period in excess of policy account balances. Interest crediting rates associated with funds invested in the general account of LNC’s insurance subsidiaries during 2000 through 2002 ranged from 4.00% to 10.00%. 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.
Interest and debt expense includes interest on company-obligated mandatorily redeemable preferred securities of subsidiary trusts holding solely junior subordinated debentures.
Insurance businesses typically produce ongoing profit streams from expected new business generation that extend significantly beyond the maximum 40-year period allowed for goodwill amortization. Accordingly, for acquired insurance businesses where financial modeling indicated that anticipated new business benefits would extend for 40 years or longer, goodwill was amortized over a 40-year period.
Prior to January 1, 2002, goodwill relating to acquisitions of investment management subsidiaries was amortized using the straight-line method, over a 25-year period. Effective January 1, 2002, goodwill is not amortized, but is subject to impairment tests conducted at least annually. Other intangible assets relating to these acquisitions 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.
Insurance and Investment Contract Liabilities. The liabilities for future policy benefits and claim reserves for universal and variable universal life insurance policies consist of policy account balances that accrue to the benefit of the policyholders, excluding surrender charges. The liabilities for future insurance policy benefits and claim reserves for traditional life policies are computed using assumptions for investment yields, mortality and withdrawals based principally on generally accepted actuarial methods and assumptions at the time of policy issue. Interest assumptions for traditional direct individual life reserves for all policies range from 2.25% to 6.75% depending on the time of policy issue. The interest assumptions for immediate and deferred paid-up annuities range from 1.50% to 13.55%.
announced plans to expense the fair value of employee stock options beginning in 2003 under Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“FAS 123”). On December 31, 2002, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure” (“FAS 148”), which provides alternative methods of transition for entities that change to the fair value method of accounting for stock-based employee compensation. In addition, FAS 148 amends the disclosure provisions of FAS 123 to require expanded and more prominent disclosure of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements.
The following table illustrates the effect on net income and earnings per share for 2002, 2001 and 2000 if LNC had applied the fair value recognition provisions of FAS 123.
Accounting for Derivative Instruments and Hedging Activities. In June 1998, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”). In July 1999, the FASB issued Statement of Financial Accounting Standards No. 137, “Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133” (“FAS 137”), which delayed the effective date of FAS 133 one year (i.e., adoption required no later than the first quarter of 2001). In June 2000, the FASB issued Statement of Financial Accounting Standards No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities” (“FAS 138”), which addresses a limited number of implementation issues arising from FAS 133.
LNC adopted FAS 133, as amended, on January 1, 2001. Upon adoption, the provisions of FAS 133 were applied prospectively. 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.
Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets. On April 1, 2001, LNC adopted Emerging Issues Task Force Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets” (“EITF 99-20”). EITF 99-20 was effective for fiscal quarters beginning after March 15, 2001. EITF 99-20 changed the manner in which LNC determined impairment of certain investments including collateralized bond obligations. Upon the adoption of EITF 99-20, LNC recognized a net realized loss on investments of $11.3 million after-tax or $0.06 per share ($17.3 million pre-tax) reported as a cumulative effect of change in accounting principle. In arriving at this amount, deferred acquisition costs of $12.2 million were restored and netted against net realized loss on investments.
Accounting for Business Combinations and Goodwill and Other Intangible Assets. In June 2001, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards No. 141, “Business Combinations” (“FAS 141”), and No. 142, “Goodwill and Other Intangible Assets” (“FAS 142”). FAS 141 is effective for all business combinations initiated after June 30, 2001, and FAS 142 is effective for fiscal years beginning after December 15, 2001. Under the new rules, goodwill is no longer amortized, but is subject to impairment tests conducted at least annually in accordance with the new standards. Intangible assets that do not have indefinite lives continue to be amortized over their estimated useful lives. LNC
adopted FAS 142 on January 1, 2002. After consideration of the provisions of the new standards regarding proper classification of goodwill and other intangible assets on the consolidated balance sheet, LNC did not reclassify any goodwill or other intangible balances held as of January 1, 2002.
During 2002, the consolidated carrying value of goodwill changed as a result of changes to the goodwill balances in the Lincoln UK and Retirement segments. The Lincoln UK segment’s carrying value changed as a result of the translation of the Lincoln UK balance from British pounds to U.S. dollars based on the prevailing exchange rate as of the balance sheet date. The adjustment to the Retirement segment carrying value was a result of the acquisition of The Administrative Management Group, Inc. (“AMG”). Total purchased goodwill in 2002 was $20.2 million (see Note 11).
The non-compete agreements included in the Investment Management segment as of December 31, 2001 were fully amortized during the first quarter of 2002 resulting in a net carrying value of zero at December 31, 2002.
The gross carrying amount and accumulated amortization of the present value of in-force for the Lincoln UK segment changed from December 31, 2001 to December 31, 2002 due to the translation of the balances from British pounds to U.S. dollars based on the prevailing exchange rate as of the balance sheet dates.
Accounting for the Impairment or Disposal of Long-lived Assets. In August 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“FAS 144”), which addresses financial accounting and reporting for the impairment or disposal of long-lived assets and supersedes Statement of Financial Accounting Standards No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,” and the accounting and reporting provisions of APB Opinion No. 30, “Reporting the Results of Operations” for a disposal of a segment of a business. FAS 144 is effective for fiscal years beginning after December 15, 2001. LNC adopted FAS 144 on January 1, 2002 and the adoption of the Statement did not have a material impact on the consolidated financial position and results of operations of LNC.
Accounting for Costs Associated with Exit or Disposal Activities. In June 2002, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“FAS 146”), which addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Action (including Certain Costs Incurred in a Restructuring)” (“Issue 94-3”). The principal difference between FAS 146 and Issue 94-3 is that FAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred, rather than at the date of an entity’s commitment to an exit plan. FAS 146 is effective for exit or disposal activities after December 31, 2002. Adoption of FAS 146 by LNC will result in a change in timing of when expense is recognized for restructuring activities after December 31, 2002.
Among the matters that LNC is currently reviewing in connection with the third quarter 2003 effective date of Interpretation No. 46 to existing VIEs is the potential application to Collateralized Debt Obligation (CDO) pools that are managed by LNC. If the fees earned by LNC for managing these CDOs are required to be included in the analysis of expected residual returns, it is possible that such CDO pools would fall under the consolidation requirements of Interpretation No. 46. While LNC does not currently have access to all information necessary to determine the ultimate effects of such a required consolidation (because LNC is not the trustee or administrator to the CDOs), based upon currently available information, LNC estimates that the effect of consolidation would result in recording additional assets and liabilities on LNC’s consolidated balance sheet of about $1.3 billion. If such liabilities are required to be recorded, LNC would disclose that such liabilities are without recourse to LNC, as LNC’s role of investment manager for such CDO pools does not expose LNC to risk of loss.
The detail of the net realized loss on investments and derivative instruments is as follows:
The allowance for losses is maintained at a level believed adequate by management to absorb estimated probable credit losses. Management’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, 2002 and 2001, LNC had mortgage loans on non-accrual status of $1.8 million and $0.0 million, respectively. As of December 31, 2002 and 2001, LNC had no mortgage loans past due 90 days and still accruing.
As of December 31, 2002 and 2001, LNC had restructured mortgage loans of $4.6 million and $5.2 million, respectively. LNC recorded $0.4 million and $0.5 million of interest income on these restructured mortgage loans in 2002 and 2001, respectively. Interest income in the amount of $0.4 million and $0.5 million would have been recorded on these mortgage loans according to their original terms in 2002 and 2001, respectively. As of December 31, 2002 and 2001, LNC had no outstanding commitments to lend funds on restructured mortgage loans.
As of December 31, 2002, LNC’s investment commitments for fixed maturity securities (primarily private placements), mortgage loans on real estate and real estate were $558.9 million. This includes $168.1 million of standby commitments to purchase real estate upon completion and leasing.
The balance sheet account for other liabilities includes a reserve for guarantees of third-party debt in the amount of $0.4 million and $0.3 million at December 31, 2002 and 2001, respectively.
During the fourth quarter of 2000, LNC completed a securitization of commercial mortgage loans. In the aggregate, the loans had a fair value of $186.0 million and carrying value of $185.7 million. LNC retained a 6.3% beneficial interest in the securitized assets. LNC received $172.7 million from the trust for the sale of the senior trust certificates representing the other 93.7% beneficial interest. A realized gain of $0.4 million pre-tax was recorded on this sale. A recourse liability was not recorded since LNC is not obligated to repurchase any loans from the trust that may later become delinquent. Cash flows received during 2002, 2001 and 2000 from interests retained in the trust were $2.6 million, $2.6 million and $0.4 million, respectively. The fair values of the mortgage loans were based on a discounted cash flow method based on credit rating, maturity and future income. Prepayments are expected to be less than 1% with an expected weighted-average life of 6.4 years. Credit losses are anticipated to be minimal over the life of the trust.
The effective tax rate on pre-tax income is lower than the prevailing corporate Federal Income tax rate. A reconciliation of this difference is as follows:
LNC is required to establish a valuation allowance for any gross deferred tax assets that are unlikely to reduce taxes payable in future years’ tax returns. At December 31, 2002, LNC believes that it is more likely than not that all gross deferred tax assets will reduce taxes payable in future years except for the amount of the valuation allowance established in 2001. In 2001, LNC established a valuation allowance of $51.2 million for the gross deferred tax assets relating to net operating losses of its remaining foreign life reinsurance subsidiary, Lincoln National Reinsurance Company (Barbados) (“LNR Barbados”). The net operating losses of LNR Barbados are subject to Federal income tax limitations that only allow the net operating losses to be used to offset future taxable income of the subsidiary. Due to the disposition of its reinsurance operations, LNC believes that it is more likely than not that LNC will not realize all of the tax benefits associated with LNR Barbados’ net operating losses. Because LNC has been required to defer recognition of the gain on the portion of the disposition of its reinsurance operation that was structured as indemnity reinsurance, the establishment of this valuation allowance was recorded as a decrease in the after-tax amount of the reinsurance deferred gain carried on LNC’s consolidated balance sheet.
At December 31, 2002, LNC had net operating loss carryforwards for Federal income tax purposes of: $290.0 million for LNR Barbados that expire in the years 2014, 2016 and 2017 and $31.7 million for Lincoln Life & Annuity Company of New York that expire in the year 2013. LNC also had net capital loss carryforwards of $156.2 million for The Lincoln National Life Insurance Company and $7.4 million for First Penn-Pacific Life Insurance Company that expire in the year 2007. Net capital losses of $33.5 million for
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 2002 includes activity related to the indemnity reinsurance transaction with Swiss Re.
The income statement caption, “Benefits,” is net of reinsurance recoveries of $1,165 million, $637 million and $448 million for the years ended December 31, 2002, 2001 and 2000, respectively.
Realized gains and losses on investments and derivative instruments on the Statements of Income for the year ended December 31, 2002, 2001 and 2000 are net of amounts restored or (amortized) against deferred acquisition costs of $115.0 million, $112.9 million and $38.5 million, respectively. In addition, realized gains and losses for the years ended December 31, 2002, 2001 and 2000 are net of adjustments made to policyholder reserves of $27.3 million, $10.5 million and $(3.2) 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.
Future estimated amortization of insurance business acquired net of interest on unamortized balance for LNC’s insurance subsidiaries is as follows (in millions):
The U.S. commercial paper outstanding at December 31, 2002 had a weighted average interest rate of 1.59%. There was no U.K. commercial paper outstanding at December 31, 2002. The final Lincoln UK commercial paper retirement was in May 2002. The combined U.S. and U.K. commercial paper outstanding at December 31, 2001 had a blended weighted average interest rate of approximately 3.10%.
In August 1998, Lincoln National Capital IV issued 9,200,000 shares or $230 million of 7.75% FELINE PRIDES (service mark of Merrill Lynch & Co. Inc.). The purchasers of such securities were also provided stock purchase contract agreements that indicated they would receive a specified amount of LNC common stock on or before the August 2001 maturity date of the FELINE PRIDES. A portion of the issuance costs associated with this offering along with the present value of the payments associated with the stock purchase agreements were charged to the common stock line within shareholders’ equity.
On August 16, 2001, LNC settled mandatory stock purchase contracts issued in conjunction with the FELINE PRIDES financing. This action resulted in the issuance of 4,630,318 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. In the case of investors who held the Trust Originated Preferred Securities (“TOPrS”) as collateral for the purchase contracts, they were permitted to enter into a remarketing process with proceeds used to settle the contracts. On August 13, 2001, the remarketing failed resulting in the retirement of $225 million TOPrS. A total of $5 million of two-year TOPrS remain outstanding which represents investors who chose to settle with separate cash and hold onto their TOPrS until maturity.
In December 2001, LNC issued $250 million 6.20% ten-year senior notes. In January 2002, LNC redeemed $100 million 8.35% TOPrS which were issued by Lincoln Capital II in August 1996. In June 2002, LNC issued $250 million 5.25% five-year senior notes. In conjunction with the $250 million debt issue, LNC executed an interest rate swap in the amount of 100 million notional that effectively converted the 5.25% fixed rate coupon on that portion of the bond into LIBOR-based floating rate debt.
Finally, LNC maintains three revolving credit agreements with a group of domestic and foreign banks totaling $580 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 December 2003. The third agreement, in the amount of $80 million, is maintained by Lincoln UK and expired in January 2003. The Lincoln UK agreement was renewed in January 2003 for $48 million maturing in January 2004. 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, 2002, LNC had $11.9 million in outstanding borrowings under the Lincoln UK agreement. During 2002, 2001 and 2000, fees paid for maintaining revolving credit agreements amounted to $0.55 million, $0.65 million and $0.64 million, respectively.
Cash paid for interest for 2002, 2001 and 2000 was $96.6 million, $123.1 million and $145.4 million million, respectively.
The supplemental retirement plans provide defined benefit pension benefits in excess of limits imposed by Federal tax law. Effective January 1, 2000, one of these plans was amended to limit the maximum compensation recognized for benefit payment calculation purposes. The effect of this amendment was to reduce the pension benefit obligation by $5.4 million.
LNC also sponsors unfunded plans that provide postretirement medical, dental and life insurance benefits to full-time U.S. employees and agents who, depending on the plan, have worked for LNC 10 years and attained age 55 (60 for agents). Medical and dental benefits are also available to spouses and other dependents of employees and agents. For medical and dental benefits, limited contributions are required from individuals who retired prior to November 1, 1988. Contributions for later retirees, which can be adjusted annually, are based on such items as years of service at retirement and age at retirement. Life insurance benefits are noncontributory; however, participants can elect supplemental contributory life benefits up to age 70. Effective July 1, 1999, the agents’ postretirement plan was changed to require agents retiring on or after that date to pay the full medical and dental premium costs. This change in the plan resulted in a one-time curtailment gain of $10.2 million pre-tax. Beginning January 1, 2002, the employees’ postretirement plan was changed to require employees not yet age 50 with five years of service by year end 2001 to pay the full medical and dental
premium cost when they retire. This change in the plan resulted in the immediate recognition at the end of 2001 of a one-time curtailment gain of $11.3 million pre-tax.
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.
The calculation of the accumulated postretirement benefits obligation assumes a weighted-average annual rate of increase in the per capita cost of covered benefits (i.e. health care cost trend rate) of 10.0% for 2002. It further assumes the rate will gradually decrease to 5.0% by 2014 and remain at that level. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, increasing the assumed health care cost trend rates by one percentage point each year would increase the accumulated postretirement benefits obligation as of December 31, 2002 and 2001 by $7.5 million and $6.8 million, respectively. The aggregate of the estimated service and interest cost components of net periodic postretirement benefits cost for the year ended December 31, 2002 and 2001 would increase by $0.6 million and $0.8 million, respectively.
LNC maintains a defined contribution plan for its U.S. insurance agents. Contributions to this plan are based on a percentage of the agents’ annual compensation as defined in the plan. Effective January 1, 1998, LNC assumed the liabilities for a non-contributory defined contribution plan covering certain highly compensated former CIGNA agents and employees. Contributions for this plan are made annually based upon varying percentages of annual eligible earnings as defined in the plan. Contributions to this plan are in lieu of any contributions to the qualified agent defined contribution plan. Effective January 1, 2000, this plan was expanded to include certain highly compensated Lincoln agents. The combined pre-tax expenses for these plans amounted to $1.0 million, $2.8 million and $4.2 million in 2002, 2001 and 2000, respectively. These expenses reflect both LNC’s contribution as well as changes in the measurement of LNC’s liabilities under these plans.
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 Holdings 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 2002 and 2001, the contribution to the defined contribution money purchase plan was based on 7.5% of the eligible compensation for the year ended December 31, 2002 and for the nine-month period ended December 31, 2001, respectively. For the profit sharing plan’s fiscal years ended March 31, 2001 and 2000, 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 $22.6 million, $27.0 million and $43.5 million in 2002, 2001 and 2000, 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.
The total liabilities associated with these plans were $161.3 million and $149.5 million at December 31, 2002 and 2001, respectively.
In 2001, Holdings, through its wholly-owned subsidiaries Delaware Investments U.S., Inc. (“DIUS”) and DIAL Holding Company, Inc. (“DIAL”), established separate stock option incentive plans for its domestic and international personnel, respectively. Stock options awarded under the plans are granted with an exercise price equal to the estimated fair market value per share at the date of the grant, as determined by an
Through 2002, LNC recognized compensation expense for its stock option incentive plans using the intrinsic value method of accounting and provides the required pro forma information for stock options granted after December 31, 1994. Accordingly, no compensation expense has been recognized for stock option incentive plans. LNC’s pro forma net income and earnings per diluted share for the last three years (2002, 2001 and 2000) would have been $56.6 million ($0.31 per diluted share); $549.2 million ($2.84 per diluted share) and $588.3 million ($3.02 per diluted share), respectively (a decrease of $35.0 million or $0.19 per diluted share; $41.0 million or $0.21 per diluted share and $33.1 million or $0.17 per diluted share, respectively). Included in this pro forma information is the following effect of the DIUS and DIAL stock option incentive plans.
These effects on pro forma net income and earnings per share of expensing the estimated fair value of stock options are not necessarily representative of the effects on reported net income for future years due to factors such as the vesting period of the stock options and the potential for issuance of additional stock options in future years.
On August 8, 2002, LNC announced plans to expense the fair value of employee stock options beginning in 2003 under FAS 123. FAS 148, issued on December 31, 2002, provides for alternative methods of transition for entities that change to the fair value method of accounting for stock-based compensation. On January 1, 2003, LNC will adopt the retroactive restatement method under FAS 148, which requires that companies restate all periods presented to reflect stock-based employee compensation cost under the fair value accounting method in FAS 123 for all employee awards granted, modified or settled in fiscal years beginning after December 15, 1994. LNC will present restated financial statements for the years 2002, 2001 and 2000 in its first quarter 2003 filing on Form 10-Q
The option price assumptions used for the LNC stock option incentive plans were as follows:
The option price assumptions used for the DIUS and DIAL stock option incentive plans were as follows:
At December 31, 2002, DIAL had 10,000,000 shares of common stock outstanding. Information with respect to the DIAL incentive plan involving stock options is as follows:
Net income (loss) as determined in accordance with statutory accounting practices for LNC’s insurance subsidiaries excluding the insurance subsidiaries sold to Swiss Re in 2001 was $(0.159) billion, $0.268 billion and $0.547 billion for 2002, 2001 and 2000, respectively. On December 7, 2001, Swiss Re acquired LNC’s reinsurance operations. The transaction structure involved a series of indemnity reinsurance transactions combined with the sale of certain stock companies that comprised LNC’s reinsurance operation. See Note 11 for further discussion of Swiss Re’s acquisition of LNC’s reinsurance operations. All of LNC’s foreign life reinsurance companies were sold to Swiss Re on December 7, 2001 except Lincoln National Reinsurance Company (Barbados) and Lincoln Re (Ireland) Limited. In the second quarter of 2002, LNC exercised a contractual right to “put” its interest in Lincoln Re (Ireland) Limited to Swiss Re.
Shareholders’ equity as determined in accordance with statutory accounting practices for LNC’s insurance subsidiaries was $3.0 billion and $3.8 billion for December 31, 2002 and 2001, respectively.
In general, dividends are not subject to prior approval from the Commissioner provided LNL’s statutory earned surplus is positive and such dividends do not exceed the standard limitation of the greater of 10% of total statutory earned surplus or the amount of statutory earnings in the prior calendar year. Dividends of $710 million were paid by LNL to LNC in the second quarter of 2002. These distributions were made in two installments. The first installment of $60 million was paid in April. The second installment of $650 million was paid in June. As both installments exceeded the standard limitation noted above, a special request was made for each payment and each was approved by the Commissioner. Both distributions represented a portion of the proceeds received from the indemnity reinsurance transaction with Swiss Re. As a result of the payment of dividends plus the statutory loss in 2002, LNL’s statutory earned surplus is 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 will be subject to prior approval from the Commissioner. As occurred in 2001, dividends approved and paid while statutory earned surplus is negative are expected to be classified as a reduction to paid-in-capital.
With regard to mortgage endowments, on November 30, 2000, U.K. regulators issued a paper containing draft guidelines explaining how mortgage endowment policyholders would be compensated in instances where it is determined that mis-selling occurred. This release also indicated that an extensive analysis is underway of mortgage endowment products offered by insurance companies in the U.K. marketplace since 1988. Where the results of this analysis indicate that products are designed in a way that could lead to potential mis-selling, U.K. regulators are contacting companies to review sales practices. Subsequently, further guidance has been issued by the U.K. regulators to clarify the treatment of complaints concerning the sale of these products.
Lincoln UK received a letter from U.K. regulators on February 8, 2001, raising concerns with certain mortgage endowment products sold by British National Life Assurance Company (“BNLA”). The specific policies at issue were sold between the period of July 1988 through March 1994. Lincoln UK acquired BNLA from Citibank in August of 1993. Less than 6,000 of these BNLA policies remain in force.
In their letter and in subsequent discussions, U.K. regulators are contending that BNLA’s sales literature was written in a manner that provides a contractual warranty that, if certain assumptions are achieved, the mortgage endowment would grow to a balance sufficient to repay the contractholder’s mortgage. LNC strongly disagrees that any contractual warranties were made in the sale of these mortgage endowment policies. In August of 2001, LNC reaffirmed its position in a letter to the UK regulators.
In March of 2002, LNC received a letter saying that the U.K. regulators had appointed enforcement investigators to review BNLA’s charging structure. This change was not a result of anything LNC had done to resolve this matter, but was a formality according to the U.K. regulators, reflecting how they wish to proceed with these matters across the entire industry. They want to obtain more information to be able to understand the background of the arguments. Accordingly, LNC has provided a significant amount of data about BNLA mortgage endowments and their charging structure. On May 31, 2002, the U.K. regulator wrote to LNC informing them that enforcement investigations had been completed and suggesting a meeting between the parties’ leading counsel to try to resolve the issues. This meeting has taken place but agreement was not reached. LNC is prepared to proceed with all available means of resolution, including pursuing regulatory, administrative and legal means of concluding this matter.
Following allegations made by the U.K. Consumers’ Association (an organization which acts on behalf of consumers of goods and services provided in the U.K.) concerning various selling practices of CFPL, LNC
conducted an internal review of 5,000 ten-year savings plans sold by CFPL during the period September 1, 1998 to August 31, 2000 and, following discussions with the U.K. regulator, LNC wrote to all customers with a ten-year savings plan sold by CFPL to determine whether the sales of those policies were appropriate. As of December 31, 2002, the mailings were substantially complete.
Regulators continue to focus on market conduct and compliance issues. Under certain circumstances, companies operating in the insurance and financial services markets have been held responsible for providing incomplete or misleading sales materials and for replacing existing policies with policies that were less advantageous to the policyholder. LNC’s management continues to monitor the company’s sales materials and compliance procedures and is making an extensive effort to minimize any potential liability. Due to the uncertainty surrounding such matters, it is not possible to provide a meaningful estimate of the range of potential outcomes at this time; however, it is management’s opinion that such future developments will not materially affect the consolidated financial position of LNC.
LNC owns operating companies in the U.K. and previously conducted business with companies located within Europe. LNC has modified its systems, financial activities and currency risk exposures to align with the first phase of the European Union’s conversion to a new common currency (the Euro) that was adopted January 1, 1999. On January 1, 2002, the Euro banknotes and coins were put into circulation. It is management’s opinion that the additional phases of this conversion, which will be implemented during the next few years, will not materially affect the consolidated financial position of LNC.
Certain of LNC’s subsidiaries lease their home office properties through sale-leaseback agreements. The agreements provide for a 25-year lease period with options to renew for six additional terms of five years each. The agreements also provide LNC with the right of the first refusal to purchase the properties during the terms of the lease, including renewal periods, at a price defined in the agreements. LNC also has the option to purchase the leased properties at fair market value as defined in the agreements on the last day of the initial 25-year lease period ending in 2009 or the last day of any of the renewal periods.
Lincoln UK agreed to outsource its customer and policy administration functions to the Capita Group Plc (“Capita”) on August 1, 2002. The contract is for a term of 10 years and the annual cost is based on a per policy charge plus an amount for other services provided. The total costs over the life of the contract are estimated to be $259.2 million and annual costs over the next five years are estimated to decline from $33.3 million to $26.7 million. The amounts quoted are estimates as the actual cost will depend on the number of policies in force and the applicable inflation rate for the period concerned. Lincoln UK or Capita may terminate the contract, subject to the necessary conditions being satisfied, by serving six and 12 months notice, respectively.
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 will be accounted for in a manner consistent with the accounting for operating leases under Statement of Financial Accounting Standards No. 13, “Accounting for Leases.”
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 was 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 also been co-insured with other companies to limit LNC’s exposure to interest rate risks. At December 31, 2002, the reserves associated with these reinsurance arrangements totaled $2,009.0 million. 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.
LNC maintains $450 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, 2002, there was a total of $223.8 million in outstanding bank letters of credit supporting six separate reinsurance treaties. In exchange for the letters of credit, LNC paid the banks approximately $3.8 million in fees in 2002.
At December 31, 2002, LNC did not have a material concentration of financial instruments in a single investee or industry. LNC’s investments in mortgage loans principally involve commercial real estate. At December 31, 2002, 28% of such mortgages, or $1.2 billion, involved properties located in California and Texas. Such investments consist of first mortgage liens on completed income-producing properties and the mortgage outstanding on any individual property does not exceed $38.2 million. Also at December 31, 2002, LNC did not have a concentration of: 1) business transactions with a particular customer or lender; 2) sources of supply of labor or services used in the business or; 3) a market or geographic area in which business is conducted that makes it vulnerable to an event that is at least reasonably possible to occur in the near term and which could cause a severe impact to LNC’s financial position. Although LNC does not have any significant concentration of customers, LNC’s Retirement segment has a long-standing distribution relationship with American Funds Distributors (“AFD”) that is significant to this segment. In 2002, the American Legacy Variable Annuity product line sold through AFD accounted for about 15% of LNC’s total gross annuity deposits. In addition, the American Legacy Variable Annuity product line represents approximately 31% of LNC’s total gross annuity account values at December 31, 2002. Recently, LNC and AFD have agreed to transition the wholesaling of American Legacy to LFD. Currently, AFD uses wholesalers who focus on both American Funds mutual funds as well as the American Legacy Variable Annuity products. Segment management believes that this change to a dedicated team focused on key broker/ dealer relationships developed in conjunction with AFD, should lead to renewed growth in American Legacy Variable Annuity sales.
In 2001, LNL concluded the settlement of all class action lawsuits alleging fraud in the sale of LNL non-variable universal life and participating whole life policies issued between January 1, 1981 and December 31, 1998. Since 2001, LNL has reached settlements with a substantial number of the owners of policies that opted out of the class action settlement. LNL continues to defend a small number of opt out claims and lawsuits. While there is continuing uncertainty about the ultimate costs of settling the remaining opt out cases, it is management’s opinion that established reserves are adequate and future developments will not materially affect the consolidated financial position of LNC.
Certain subsidiaries of LNC have invested in real estate partnerships that use industrial revenue bonds to finance their projects. LNC has guaranteed the repayment of principal and interest on these bonds. Certain subsidiaries of LNC are also involved in other real estate partnerships that use conventional mortgage loans. In case of default by the partnerships, LNC has recourse to the underlying real estate.
LNC. LNC also maintains a policy of requiring that all derivative contracts be governed by an International Swaps and Derivatives Association (“ISDA”) Master Agreement.
return equal to interest plus capital gains or losses on a referenced asset and receives a floating rate of interest. As of December 31, 2002, LNC did not have any open total return swaps.
Foreign Currency Forward Contract. LNC uses foreign currency forward contracts to hedge a portion of its net investment in its foreign subsidiary, Lincoln National (UK) PLC. 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 National (UK) PLC is sold or liquidated. The foreign currency forward contracts outstanding at December 31, 2002 terminate in 2003.
Interest Rate Cap Agreements. The interest rate cap agreements, which expire in 2003 through 2007, 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.
Call Options on LNC Stock. As discussed previously in the Cash Flow Hedges section, LNC uses call options on LNC stock to hedge the expected increase in liabilities arising from SARs granted on LNC stock. Call options hedging vested SARs are not eligible for hedge accounting treatment under FAS 133.
Additional Derivative Information. Income and (expenses) for the agreements and contracts described above amounted to $23.0 million, $3.5 million and $(7.3) million in 2002, 2001 and 2000, respectively. The increase in income for 2002 was primarily because of payments received on interest rate swaps. The increase in 2001 was primarily because under FAS 133 premiums for caps and swaptions are no longer amortized.
Fixed Maturity and Equity Securities. Fair values for fixed maturity securities are based on quoted market prices, where available. For fixed maturity securities not actively traded, fair values are estimated using values obtained from independent pricing services. In the case of private placements, fair values are estimated by discounting expected future cash flows using a current market rate applicable to the coupon rate, credit quality and maturity of the investments. The fair values for equity securities are based on quoted market prices.
Investment Type Insurance Contracts. The balance sheet captions, “Insurance Policy and Claims Reserves” and “Contractholder Funds,” include investment type insurance contracts (i.e. deposit contracts and certain guaranteed interest contracts). The fair values for the deposit contracts and certain guaranteed interest contracts are based on their approximate surrender values. The fair values for the remaining guaranteed interest and similar contracts are estimated using discounted cash flow calculations. These calculations are based on interest rates currently offered on similar contracts with maturities that are consistent with those remaining for the contracts being valued.
Company-Obligated Mandatorily Redeemable Preferred Securities of Subsidiary Trusts Holding Solely Junior Subordinated Debentures. Fair values for company-obligated mandatorily redeemable preferred securities of subsidiary trusts holding solely junior subordinated debentures are based on quoted market prices.
Total derivative instruments for 2001 are composed of $46.4 million and $(0.3) million on the consolidated balance sheet in Derivative Instruments and Other Liabilities, respectively.
The Life Insurance segment, headquartered in Hartford, Connecticut, focuses on the creation and protection of wealth for its clients through the manufacture and sale of life insurance products throughout the United States. The Life Insurance segment offers universal life, variable universal life, interest-sensitive whole life, term life and corporate owned life insurance. The segment also offers linked-benefit life insurance (a universal life product with a long-term care benefit). A majority of the Life Insurance segment’s products are currently distributed through LFD and LFA. In the third quarter 2002, the Life Insurance segment entered into a marketing agreement to distribute life insurance products through the M Financial Group, a well-respected and successful nationwide organization of independent firms serving the needs of affluent individuals and corporations.
Lincoln UK is headquartered in Barnwood, Gloucester, England, and is licensed to do business throughout the United Kingdom (“UK”). Although Lincoln UK transferred its sales force to Inter-Alliance Group PLC in the third quarter of 2000, it continues to manage, administer and accept new deposits on its current block of business and, as required by UK regulation, accept 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 2000 through 2002 is as follows:
During 2000, management initiated a plan to change the operational and management reporting structure of LNC’s wholesale distribution organization. Beginning with the quarter ended March 31, 2001, LFD, the wholesaling arm of LNC’s distribution network, was reported within Other Operations. Previously, LNC’s wholesaling efforts were conducted separately within the Lincoln Retirement, Life Insurance and Investment
Management segments. Earlier periods were restated to aid comparability of segment reporting between periods.
Also, in the fourth quarter of 2000, a decision was made to change the management reporting and operational responsibilities for First Penn-Pacific’s Schaumburg, Illinois annuities business. Beginning with the quarter ended March 31, 2001, the financial reporting for First Penn-Pacific’s annuities business was included in the Lincoln Retirement segment. This business was previously managed and reported in the Life Insurance segment. Earlier periods were restated to aid the comparability of segment reporting between periods.
Most of LNC’s foreign operations are conducted by Lincoln UK, a UK company. The data for this company is shown above under the Lincoln UK segment heading. In addition, the Investment Management segment has non-U.S. operations. Foreign intracompany revenues are not significant. Financial data for Lincoln UK and the other non-U.S. units* is as follows:
The financial data for other non-U.S. units includes the activity of several former reinsurance subsidiaries for the year ended December 31, 2000 and for the eleven months ended November 30, 2001. These entities were sold to Swiss Re in December 2001.
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, 2002, there were 177,307,999 Rights outstanding.
During 2002, 2001 and 2000, LNC purchased and retired 12,088,100; 11,278,022 and 6,222,581 shares, respectively, of its common stock at a total cost of $474.5 million, $503.7 million and $210.0 million, respectively. The common stock account was reduced for these purchases in proportion to the percentage of shares acquired. The remainder of the purchase price was charged to retained earnings.
Per share amounts for net income are shown on the income statement using 1) an earnings per common share basic calculation and 2) an earnings per common share-assuming dilution calculation. A reconciliation of the factors used in the two calculations are as follows:
LNC has stock options outstanding which were issued at prices that are above the current average market price of LNC common stock. In the event the average market price of LNC’s common stock exceeds the issue price of stock options, such options would be dilutive to LNC’s earnings per share and will be shown in the table above. During 1999, LNC changed its deferred compensation plans so that participants selecting LNC
Details underlying the balance sheet caption “Net Unrealized Gain (Loss) on Securities Available-for-sale,” are as follows:
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 effect to the increased levels of capital needed within the Life Insurance and Lincoln Retirement segments that result 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 retained 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. At the time of closing, an immediate gain of $15.0 million after-tax was recognized on the sale of the stock companies. A gain of $723.1 million after-tax ($1.1 billion pre-tax) relating to the indemnity reinsurance agreements was reported at the time of closing. This gain was recorded as a deferred gain on LNC’s consolidated balance sheet, in accordance with the requirements of FAS 113, and is being amortized into earnings at the rate that earnings on the reinsured business are expected to emerge, over a period of 15 years.
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 its legal liabilities to the underlying ceding companies with respect to the portion of the business reinsured by Swiss Re, under FAS 113 the reserves for the underlying reinsurance contracts as well as a corresponding reinsurance recoverable from Swiss Re will continue to be carried on LNC’s balance sheet during the run-off period of the underlying reinsurance business. This is particularly relevant in the case of the exited personal accident and disability income reinsurance lines of business where the underlying reserves are based upon various estimates that are subject to considerable uncertainty.
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 ($72.4 million pre-tax) of
Through December 31, 2002, of the original $2 billion in proceeds received by LNC, approximately $0.56 billion 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.
Because of ongoing uncertainty related to personal accident and disability income businesses, the reserves related to these exited business lines carried on LNC’s balance sheet at December 31, 2002 may ultimately prove to be either excessive or deficient. For instance, in the event that future developments indicate that these reserves should be increased, under FAS 113 LNC would record a current period non-cash charge to record the increase in reserves. Because Swiss Re is responsible for paying the underlying claims to the ceding companies, LNC would record a corresponding increase in reinsurance recoverable from Swiss Re. However, FAS 113 does not permit LNC to take the full benefit in earnings for the recording of the increase in the reinsurance recoverable in the period of the change. Rather, LNC would increase the deferred gain recognized upon the closing of the indemnity reinsurance transaction with Swiss Re and would report a cumulative amortization “catch-up” adjustment to the deferred gain balance as increased earnings recognized in the period of change. Any amount of additional increase to the deferred gain above the cumulative amortization “catch-up” adjustment must continue to be deferred and will be amortized into income in future periods over the remaining period of expected run-off of the underlying business. No cash would be transferred between LNC and Swiss Re as a result of these developments.
During 1998, LNC implemented a restructuring plan relating to the integration of existing life and annuity operations with the new business operations acquired from CIGNA, and a second restructuring plan related to downsizing LNC’s corporate center operations. The aggregate charges associated with these two unrelated restructuring plans totaled $34.3 million after-tax ($52.8 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, 1998. These aggregate pre-tax costs include $19.6 million for employee severance and termination benefits, $9.9 million for asset impairments and $23.3 million for costs relating to exiting business activities. The CIGNA restructuring plan was completed in the first quarter of 2000. During the fourth quarter of 2000, $0.5 million (pre-tax) of the original charge to downsize LNC’s corporate center operations was reversed. This plan was completed in the third quarter of 2002 due to the termination of the lease which resulted from LNC’s purchase and ultimate sale of the abandoned building. The remaining $0.2 million related to the terminated lease was reversed as a reduction in restructuring costs during the third quarter of 2002. Total pre-tax costs of $56.2 million were expended or written-off under these restructuring plans.
During the fourth quarter of 1999, LNC recorded a restructuring charge in its Lincoln UK segment of $6.5 million after-tax ($10.0 million pre-tax). The objective of this restructuring plan was to reduce operating costs by consolidating and eliminating redundant staff functions and facilities. The restructuring plan identified the following activities and associated costs to achieve the objectives of the restructuring plan: (1) severance and termination benefits of $3.9 million related to the elimination of 119 positions, and (2) other costs of $6.1 million primarily related to the remaining lease payments on closed facilities. Expenditures and write-offs under the restructuring plan began in the fourth quarter of 1999 and were completed in the 3rd quarter of 2001 except for lease payments on closed facilities which will continue until 2016. Through December 31, 2002, $7.5 million (pre-tax) has been expended or written-off under this restructuring plan and 112 positions have been eliminated.
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. The Vantage restructuring charge was recorded in the second quarter, the Lincoln UK restructuring was recorded in the third and fourth quarters, and the Lincoln Investment Management restructuring charge was recorded in the fourth quarter of 2000. The aggregate charges associated with all of these restructuring plans entered into during 2000 totaled $81.8 million after-tax ($107.4 million pre-tax). These charges were included in Underwriting, Acquisition, Insurance and Other Expenses on the Consolidated Statement of Income for the year ended December 31, 2000. The component elements of these aggregate pre-tax costs include employee severance and termination benefits of $33.8 million, write-off of impaired assets of $40.9 million and other exit costs of $32.7 million. During the fourth quarter of 2000, $0.6 million (pre-tax) of the original charge recorded for the Vantage restructuring plan was reversed as a reduction of restructuring costs. The Vantage restructuring plan was completed in the fourth quarter of 2001 and total expenditures and write-offs under this plan totaled $3.5 million pre-tax and 13 positions were eliminated under this plan. Expenditures and write-offs for the Lincoln UK restructuring plan were completed in the fourth quarter of 2001 except for lease payments on abandoned office facilities, which will continue until 2015. In the fourth quarter of 2002, $1.7 million of the Lincoln UK restructuring reserve was released as a result of new tenants being contracted for several of the abandoned office facilities on terms that were better than originally expected. 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. Actual pre-tax costs totaling $3.5 million were expended or written-off and 19 positions were eliminated. Details of the Lincoln UK restructuring plan are provided below.
The charges recorded in the third and fourth quarters of 2000 related to this restructuring plan were $40.5 million after-tax ($53.5 million pre-tax) and $36.1 million after-tax ($45.9 million pre-tax), respectively. The components of the pre-tax costs include employee severance and termination benefits of $29.8 million related to the elimination of 671 positions, write-off of impaired assets of $39.2 million and other costs to exit of $30.4 million. All expenditures under this plan except for those related to abandoned office facilities were completed by the end of 2001. Expenditures for rents on abandoned office facilities are expected to be complete by 2015. In the fourth quarter of 2002, $1.7 million of the Lincoln UK restructuring reserve was released as a result of new tenants being contracted for several of the abandoned office facilities on terms that were better than originally expected. Through December 31, 2002, $88.0 million (pre-tax) has been expended or written-off under this restructuring plan and 671 positions have been eliminated. As of December 31, 2002, a balance of $9.7 million remains in the restructuring reserve for this plan.
The Syracuse restructuring charge was recorded in the first quarter of 2001 and was completed in the first quarter of 2002. The Schaumburg, Illinois restructuring charge was recorded in the second quarter of 2001, the LFD restructuring charges were recorded in the second and fourth quarters of 2001, and the remaining restructuring charges were all recorded in the fourth quarter of 2001. The LFD restructuring plan that was initiated in the second quarter of 2001 was completed in the fourth quarter of 2002. The Life Insurance segment restructuring plan that was initiated in the fourth quarter of 2001 was completed in the fourth quarter of 2002.
During the second quarter of 2001, LNC recorded restructuring charges in its Lincoln Retirement and Life Insurance segments of $0.63 million ($0.97 million pre-tax) and $2.03 million ($3.12 million pre-tax), respectively, related to a restructuring plan for the Schaumburg, Illinois operations of First Penn-Pacific. The objective of this plan was to eliminate duplicative functions in Schaumburg, Illinois by transitioning them into the Lincoln Retirement and Life Insurance segment operations in Fort Wayne, Indiana and Hartford, Connecticut, respectively, in order to reduce on-going operating costs. The restructuring plan identified the following activities and associated pre-tax costs to achieve the objectives of the plan: (1) severance and termination benefits of $3.19 million related to the elimination of 27 positions and (2) other costs of $0.9 million. In the second quarter of 2002, $0.1 million of the restructuring reserve was released. Actual pre-tax costs totaling $3.7 million have been expended or written-off and 26 positions have been eliminated under this plan through December 31, 2002. As of December 31, 2002, a balance of $0.3 million remains in the restructuring reserve for this plan. Expenditures under this plan are expected to be completed in the first quarter of 2004.
During the fourth quarter of 2001, LNC recorded a restructuring charge in its Investment Management segment of $0.4 million ($0.6 million pre-tax). The objectives of this restructuring plan were to consolidate 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 segment. The restructuring plan identified the following activities and associated pre-tax costs to achieve the objectives of the plan: (1) write-off of impaired assets of $0.1 million and (2) other costs of $0.5 million primarily related to lease payments on abandoned office space. Actual pre-tax costs totaling $0.2 million have been expended or written-off through December 31, 2002. As of December 31, 2002, a balance of $0.4 million remains in the restructuring reserve for this plan. Expenditures under this plan are expected to be completed by the fourth quarter of 2005 consistent with the lease term.
During the fourth quarter of 2001, LNC recorded a restructuring charge for LFD in “Other Operations” of $2.5 million ($3.8 million pre-tax). The objectives of this restructuring plan were to combine channel oversight, position LFD to take better advantage of ongoing “marketplace consolidation” and to expand the customer base of wholesalers in certain territories. The restructuring plan identified severance and termination benefits of $3.8 million (pre-tax) related to the elimination of 63 positions. Actual pre-tax costs totaling $3.8 million have been expended and 62 positions have been eliminated under this plan through December 31, 2002. As of December 31, 2002, less than $0.1 million remains in the restructuring reserve for this plan. Expenditures under this restructuring plan are expected to be completed in the first quarter of 2003.
During the fourth quarter of 2001, LNC recorded a restructuring charge in “Other Operations” of $15.8 million ($24.4 million pre-tax). The objectives of this restructuring plan were to consolidate operations and reduce excess space in LNC’s Fort Wayne, Indiana operations. In light of LNC’s divestiture of its reinsurance operations, which were headquartered in Fort Wayne, excess space and printing capacity will not be used. The restructuring plan identified the following activities and associated pre-tax costs to achieve the
objectives of the plan: (1) severance and termination benefits of $0.3 million related to the elimination of 9 positions; (2) write-off of leasehold improvements of $3.2 million and (2) other costs of $20.9 million primarily related to termination of equipment leases ($1.4 million) and rent on abandoned office space ($19.5 million). In the third quarter of 2002, $1.5 million of the restructuring reserve related to rent was released. The release was due to LNC’s purchase and ultimate sale of the vacant building on terms which were favorable to what was included in the original restructuring plan for rent on this abandoned office space. Actual pre-tax costs totaling $22.3 million have been expended and 19 positions have been eliminated under this plan through December 31, 2002. As of December 31, 2002, a balance of $0.6 million remains in the restructuring reserve for this plan. Expenditures under this restructuring plan are expected to be completed in 2004. LNC estimates an annual reduction in future operating expenses of $4.6 million (pre-tax) after the plan is fully implemented.
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 segment recorded a restructuring charge of $1.0 million ($1.6 million pre-tax). The restructuring plan identified the following activities and associated pre-tax costs to achieve the objectives of the plan: $1.4 million for employee severance and $0.2 million for employee outplacement relative to 49 eliminated positions. Actual pre-tax costs totaling $0.9 million have been expended and 49 positions have been eliminated under this plan through December 31, 2002. As of December 31, 2002, a balance of $0.7 million remains in the restructuring reserve for this plan. The plan is expected to be completed in the third quarter of 2003.
We have audited the accompanying consolidated balance sheets of Lincoln National Corporation as of December 31, 2002 and 2001, and the related consolidated statements of income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2002. Our audits also included the financial statement schedules listed in the Index at Item 15(a)(2). These financial statements and schedules are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.