Changes in general economic or business conditions, both domestic and foreign, that may be less favorable than expected and may affect foreign exchange rates, premium levels, claims experience, the level of pension benefit costs and funding, and investment results.
In conjunction with integrating LNC and Jefferson-Pilot, we created a new Employer Markets reporting segment. The creation of this segment should allow us to better capitalize on the success we have already had in this market place - more than $35 billion in assets under management and administration - and on trends in employer-sponsored benefit plans. These trends include a decline in defined benefit pension plans and an increase in voluntary defined contribution plans, such as 401(k)s / 403(b)s, and a similar trend towards voluntary group life and disability, giving way to a convergence of distribution strategies. We see opportunities to capitalize on revenue synergies by leveraging our Group Protection group business with Retirement Products’ defined contribution platform for a single employer solution. We also believe that the recently passed Pension Protection Act of 2006 will benefit the Employer Markets segment.
Our mutual fund offerings have had strong performance over the one-, three-, and five-year performance periods, resulting in strong deposits and net flows and adding to the assets under management for both the retail and institutional products lines in our Investment Management segment. Growth in deposits and net flows have also benefited from the changes we made during 2005 in the management of certain asset category offerings.
Because equity market movements have a significant impact on the value of variable annuity and unit-linked accounts (contracts written in the U.K. similar to U.S. produced variable life and annuity products) and the fees earned on these accounts, EGPs could increase or decrease with movements in the equity markets. Significant and sustained changes in equity markets could therefore have an impact on DAC amortization for our variable annuity, annuity-based 401(k) business and unit-linked business, but have significantly less impact on DAC amortization for our life insurance business because approximately 83% of their account values pertain to interest sensitive products, such as universal life and interest sensitive whole life. Our assumption for the long-
The accompanying consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). On April 3, 2006, we completed our merger with Jefferson-Pilot Corporation (“Jefferson-Pilot”), and have included the results of operations and financial condition of Jefferson-Pilot in our consolidated financial statements beginning on April 3, 2006 (see Note 3). The consolidated financial statements for the years ended December 31, 2005 and 2004 exclude the results of operations and financial condition of Jefferson-Pilot. The insurance subsidiaries also submit financial statements to insurance industry regulatory authorities. Those financial statements are prepared on the basis of statutory accounting practices (SAP) and are significantly different from financial statements prepared in accordance with GAAP. See Note 10. Certain GAAP policies, which significantly affect the determination of financial position, results of operations and cash flows, are summarized below.
Premiums on Traditional Life Insurance Products. Traditional life insurance products include those products with fixed and guaranteed premiums and benefits and consist primarily of whole life insurance, limited-payment life insurance, term life insurance and certain annuities with life contingencies. Premiums for traditional life insurance products are recognized as revenue when due from the policyholder.
Other Revenue and Fees. Other revenue and fees primarily consist of amounts earned by our retail distributor, Lincoln Financial Advisors (“LFA”), from sales of third party insurance and investment products. Such revenue is recorded as earned at the time of sale. Other revenues and fees also include revenues from our Individual Markets - Life Insurance, Investment Management and Lincoln UK segments not captured in other components of revenue.
The goodwill resulting from the merger was allocated to the following segments:
The balance sheet captions, real estate and other assets, which includes property and equipment, include accumulated depreciation as follows:
We are 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, 2006 and 2005, we concluded that it was more likely than not that all gross deferred tax assets will reduce taxes payable in future years. Our Federal income tax liability at December 31, 2004 included a valuation allowance of $47 million attributable to the net operating losses of our foreign life reinsurance subsidiary domiciled in Barbados. This valuation allowance was reduced to zero as of December 31, 2005.
In December 2005, we entered into a new credit agreement (the “Bridge Facility”) with a group of banks to provide for borrowings of up to $2.3 billion in connection with our merger with Jefferson-Pilot. The Bridge Facility was a 364-day facility. We made a drawdown under the Bridge Facility and used the proceeds of the loan to pay $1.8 billion to shareholders of Jefferson-Pilot in connection with our merger with Jefferson-Pilot, which represented the aggregate cash portion of the merger consideration. During the second quarter of 2006, we issued $2.1 billion of debt securities and acquired debt securities with a fair value of $905 million previously issued by Jefferson-Pilot. As discussed in Note 3, we used the proceeds from debt securities issued during the second quarter of 2006 and other cash to repay the outstanding loan balance under the Bridge Facility.
We also have access to capital from junior subordinated debentures issued to affiliated trusts. These trusts were formed solely for the purpose of issuing preferred securities and lending the proceeds to us. Securities currently outstanding were offered through a series of trusts (Lincoln National Capital V and VI, Jefferson-Pilot Capital Trust A and Jefferson-Pilot Capital Trust B). We own the common securities of these trusts. As discussed above, we redeemed the junior subordinated debentures issued by Lincoln Capital Trust V, and the trust redeemed its Trust Preferred Securities.
Jefferson-Pilot Capital Trusts A and B issued redeemable preferred securities in private placement transactions in 1997, and the debt securities previously issued by Jefferson-Pilot were included within our Consolidated Balance Sheets at the time of the merger. As of December 31, 2006, the carrying value of these junior subordinated debentures was $208 million at an interest rate of 8.14% and $104 million at an interest rate of 8.285%. Interest is paid semi-annually. We have redeemed or will redeem these debentures in the first quarter of 2007. See Note 16 for more information.
The changes to the benefit reserves amounts above are reflected in benefits in the Consolidated Statements of Income.
Pension and Other Postretirement Benefit Plans-U.S. We maintain funded defined benefit pension plans for most of our U.S. employees and, prior to January 1, 1995, most full-time agents. Effective January 1, 2002, the employees’ pension plan was converted to a cash balance formula. Eligible employees retiring before 2012 will have their benefits calculated under both the old final average pay formula and the cash balance formula and will receive the greater of the two calculations. Employees retiring in 2012 or after will receive benefits under the cash balance formula. Benefits under the final average pay formula are based on total years of service and the highest 60 months of compensation during the last 10 years of employment. Under the cash balance formula, employees have guaranteed account balances that earn annual benefit credits and interest credits each year. Annual benefit credits are based on years of service and base salary plus bonus. All benefits accruing under the defined benefit plan for agents were frozen as of December 31, 1994. The plans are funded by contributions to tax-exempt trusts. Our funding policy is consistent with the funding requirements of Federal law and regulations. Contributions are intended to provide not only the benefits attributed to service to date, but also those expected to be earned in the future. Effective January 1, 2005, we amended the employees’ pension plan to include 100% of eligible bonus amounts as compensation under the cash balance formula only.
Information with respect to our defined benefit plan asset activity and defined benefit plan obligations subsequent to the adoption of SFAS 158 is as follows:
Our U.S. pension plan asset allocations at December 31, 2006 and 2005, by asset category are as follows:
The option price assumptions used for our SAR plan were as follows:
In July 2006, we negotiated a memorandum of understanding with certain of our liability carriers, from whom we received a reimbursement during the third quarter of 2006 of $26 million for certain losses incurred in connection with certain United Kingdom selling practices. The reimbursement was included in net income for the third quarter in Other Operations. We continue to pursue claims with other liability carriers, and we cannot reasonably predict either the timing or the amount of any future reimbursements.
At December 31, 2006 and 2005, the aggregate liability associated with Lincoln UK selling practices was $7 million and $13 million, respectively. On an ongoing basis, Lincoln UK evaluates various assumptions underlying these estimated liabilities, including the expected levels of future complaints and the potential implications with respect to the adequacy of the aggregate liability associated with U.K. selling practice matters. Any changes in the regulatory position on time limits for making a complaint regarding the sale of mortgage endowment contracts or higher than expected levels of complaints may result in Lincoln UK revising its estimate of the required level of these liabilities. The reserves for these issues are based on various estimates that are subject to considerable uncertainty. Future changes in complaint levels could effect Lincoln UK’s ultimate exposure to mis-selling issues, although we believe that any future change would not materially affect our consolidated financial position.
Our derivative instruments are monitored by our risk management committee as part of that committee’s oversight of our derivative activities. Our derivative instruments committee is responsible for implementing various hedging strategies that are developed through its analysis of financial simulation models and other internal and industry sources. The resulting hedging strategies are incorporated into our overall risk management strategies.
Policy Loans. The estimated fair value of investments in policy loans are calculated on a composite discounted cash flow basis using Treasury interest rates consistent with the maturity durations assumed. These durations are based on historical experience.
During 1999 and 2000, we implemented restructuring plans relating to Lincoln UK’s operations. In addition to various other activities, these plans involved vacating leased facilities. All other plan activities have been completed and the remaining reserves relate to future lease payments on exited properties, which run through 2016. The remaining reserves for these plans totaled $6 million at December 31, 2006.