A deviation in actual experience regarding future persistency, mortality, morbidity, interest rates and equity market returns from LNC’s assumptions used in pricing its products, in establishing related insurance reserves, and in the amortization of intangibles that may result in an increase in reserves and a decrease in net income;
Loss of key portfolio managers in the Investment Management segment, financial planners in LFA or wholesalers in LFD; and
In our Life Insurance operation, in late 2004, we introduced a new universal life product with an updated lapse protection rider. This was in response to a major challenge that we face from continued competitive pressures, especially related to life insurance products with secondary guarantees. We remain committed to maintaining appropriate risk management and pricing discipline despite the competitive environment. Our universal life product with a long-term care benefit rider, MoneyGuardSM, continued to show strong first year premium growth in 2004.
Factors we consider in determining whether declines in the fair value of fixed maturity securities are other than temporary include 1) the significance of the decline; 2) our ability and intent to retain the investment for a sufficient period of time for it to recover to an amount at least equal to its carrying value; 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. Securities available-for-sale that are deemed to have declines in fair value that were other than temporary are written down to fair value. The fixed maturity securities to which these write-downs apply were generally of investment grade at the time of purchase, but were subsequently downgraded by rating agencies to “below-investment grade.” See Note 9 to the Consolidated Financial Statements for a general discussion of the methodologies and assumptions used to determine estimated fair values.
See “Accounting Pronouncements-EITF 03-1-The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” for a discussion of potential changes to the requirements for other-than-temporary impairments.
Management assessed our internal control over financial reporting as of December 31, 2004, the end of our fiscal year. Management based its assessment on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Management’s assessment included evaluation of such elements as the design and operating effectiveness of key financial reporting controls, process documentation, accounting policies, and our overall control environment.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Lincoln National Corporation at December 31, 2004 and 2003, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
Consolidated Statements of Cash Flows-Years Ended December 31, 2004, 2003 and 2002
Other intangible assets for acquired Investment Management subsidiaries include institutional customer relationships, covenants not to compete and mutual fund customer relationships. These assets are still required to be amortized on a straight-line basis over their useful life for periods ranging from 14 to 15 years depending upon the characteristics of the particular underlying relationships for the intangible asset.
LNC adopted the retroactive restatement method under FAS148 and restated 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 currently manages eight Collateralized Debt Obligation pools (“CDOs”), and of these, there are five where the asset management fees paid to LNC no longer contain performance-based incentives. As a result, LNC is not considered the primary beneficiary of these VIE’s. LNC’s maximum exposure to loss in these five CDOs is an investment in a small portion of the senior debt issued by one of these CDO pools, which had a carrying and estimated fair value of approximately $0.1 million, at December 31, 2004.
As of December 31, 2004 and 2003, LNC had no mortgage loans on non-accrual status and no mortgage loans past due 90 days and still accruing interest.
During the third quarter of 2003, LNC completed a securitization of commercial mortgage loans. In the aggregate, the loans had a fair value of $182.2 million and a carrying value of $167.3 million. LNC received $182.2 million from the trust for the sale of the loans. A recourse liability was not recorded since LNC is not obligated to repurchase any loans from the trust that may later become delinquent. The transaction was hedged with interest rate swaps to lock in the value of the loans. LNC recorded a gain on the hedge of $7.8 million pre-tax and realized a gain on the sale of $14.9 million pre-tax resulting in a total net gain of $22.7 million pre-tax. LNC did not retain an interest in the securitized assets.
The effective tax rate on pre-tax income from continuing operations is lower than the prevailing corporate Federal income tax rate. A reconciliation of this difference is as follows:
LNC’s contribution to Delaware’s defined contribution money purchase plan is equal to 7.5% per annum of each participant’s eligible compensation. For any plan year, eligible compensation is defined as 100% of an eligible participant’s base salary, plus bonus. The amount of bonus is capped such that only 50% of the bonus amounts over $100,000 are considered eligible compensation. Eligible compensation is also subject to various limitations under Section 401(a) of the Internal Revenue Code of 1986, as amended. Expense for the 401(k) and profit sharing plans amounted to $38.5 million, $36.1 million and $22.6 million in 2004, 2003 and 2002, respectively.
In general, a dividend is not subject to prior approval from the Commissioner provided LNL’s statutory earned surplus is positive and the proposed dividend, plus all other dividends made within the twelve consecutive months prior to the date of the proposed dividend, does not exceed the standard limitation of the greater of 10% of total statutory earned surplus or the amount of statutory earnings in the prior calendar year. Dividends of $710 million were paid by LNL to LNC in the second quarter of 2002. These distributions were made in two installments. The first installment of $60 million was paid in April. The second installment of $650 million was paid in June. As both installments exceeded the standard limitation noted above, a special request was made for each payment and each was approved by the Commissioner. Both distributions represented a portion of the proceeds received from the indemnity reinsurance transaction with Swiss Re. As a result of the payment of dividends plus earnings in 2002, LNL’s statutory earned surplus was negative as of December 31, 2002. Due to the negative statutory earned surplus as of December 31, 2002, dividends paid by LNL in 2003 were subject to prior approval from the Commissioner.
received an offer from Capita to settle in full the residual contingent payments under these options. We are evaluating the full settlement offer. We estimate that based on the current offer it would result in a gain of approximately $14.3 million, pre-tax ($9.3 million, after-tax). This would be reported as a realized gain and would not be included in the segment’s income from operations.
In addition, certain subsidiaries of LNC have sold commercial mortgage loans through grantor trusts, which issued pass-through certificates. These subsidiaries have agreed to repurchase any mortgage loans which remain delinquent for 90 days at a repurchase price substantially equal to the outstanding principal balance plus accrued interest thereon to the date of repurchase. In case of default by the partnerships, LNC has recourse to the underlying real estate. It is management’s opinion that the value of the properties underlying these commitments is sufficient that in the event of default, the impact would not be material to LNC. These guarantees expire in 2009.
Credit Default Swaps. LNC buys credit default swaps, which expire in 2006, to hedge against a drop in bond prices due to credit concerns of certain bond issuers. A credit swap allows LNC to put the bond back to the counterparty at par upon a credit event by the bond issuer. A credit event is defined as bankruptcy, failure to pay, or obligation acceleration. LNC has not currently qualified credit default swaps for hedge accounting under FAS 133 as amounts are insignificant. As of December 31, 2004, LNC had bought credit swaps with a notional amount of $8.0 million. The credit default swaps expire in 2006.
Separate Accounts. Assets held in separate accounts are reported in the accompanying Consolidated Balance Sheets at fair value. The related liabilities are also reported at fair value in amounts equal to the separate account assets.
(1) The reclassification adjustment for gains (losses) does not include the impact of associated adjustments to deferred acquisition costs and amounts required to satisfy policyholder commitments.
Pre-tax restructuring charges for the June/August realignment activities for the year ended December 31, 2004 occurred in the following segments: Retirement ($6.2 million), Life Insurance ($0.6 million), Investment Management ($1.6 million), and Other Operations ($9.9 million).
The aggregate charges associated with all restructuring plans entered into during 2001 totaled $24.6 million after-tax ($38.0 million pre-tax) for the year ended December 31, 2001. The component elements of these aggregate pre-tax costs include employee severance and termination benefits of $12.2 million, write-off of impaired assets of $3.3 million and other exit costs of $22.5 million primarily related to the termination of equipment leases ($1.4 million) and rent on abandoned office space ($20.0 million). Actual pre-tax costs totaling $1.3 million were expended or written-off and 30 positions were eliminated under the Syracuse restructuring plan, which was completed in the first quarter of 2002. The total amount expended for this plan exceeded the original restructuring reserve by $0.3 million. Actual pre-tax costs totaling $1.8 million were expended or written-off and 26 positions were eliminated under the second quarter of 2001 LFD restructuring plan, which was completed in the fourth quarter of 2002. The amount expended for this plan was equal to the original reserve. Actual pre-tax costs totaling $2.3 million were expended or written-off and 36 positions were eliminated under the restructuring plan for the reorganization and consolidation of life insurance operations, which was completed