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 44th largest (based on assets) United States corporation (2002 Fortune 500, Largest U.S. Corporations, April 2003). Operations are divided into four business segments: 1) Lincoln Retirement, 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, 2003 on a consolidated basis was 5,644.
To protect itself from a variety of equity market and interest rate risks that are inherent in many of LNC’s life insurance and annuity products, LNC uses various derivative instruments. Assessing the effectiveness of these hedging programs and evaluating the carrying values of the related derivatives often involves a variety of assumptions and estimates. LNC’s accounting policies for derivatives are discussed within Results of Consolidated Operations, Consolidated Investments and within the discussion of Quantitative and Qualitative Disclosures About Market Risk. In addition, the potential impact on interest spreads in a falling rate environment is presented in the “Interest Rate Risk - Falling Rates” section within LNC’s Quantitative and Qualitative Disclosures About Market Risk.
This “Management’s Discussion and Analysis” should be read in conjunction with the audited consolidated financial statements and accompanying notes presented on pages 91 through 158.
The decrease in net income in 2002 from 2001 included an increase in realized losses on investments and derivatives and expenses recorded in 2002 related to increases in reserves for the business sold through indemnity reinsurance to Swiss Re. The realized losses on investments resulted from declines in value and the sale and write-downs of fixed maturity securities. See the Consolidated Investments section on page 58 for further discussion of this matter.
(2) Consolidating adjustments represent the elimination of deposits and net flows on products affecting more than one segment.
LNC currently manages seven 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 VIEs. LNC’s maximum exposure to loss in these five CDOs is an investment in a small portion of the senior debt issued by one of these CDO pools, which had a carrying and estimated fair value of approximately $3 million, at December 31, 2003.
These adjustments do not net to zero in any one particular accounting period because not all of the invested assets supporting these Modco and CFW reinsurance agreements were available-for-sale securities that could be reclassified to trading account securities and not all Modco and CFW reinsurance agreements have segregated portfolios of securities that can be classified as trading account securities. However, it is important to note that these differences in net income will reverse over the term of the underlying Modco and CFW reinsurance agreements, reflecting the fact that the new accounting for the embedded derivatives prescribed in DIG B36 changes the timing of the recognition of income under these Modco and CFW reinsurance agreements but does not change the total amount of earnings that will ultimately be reported over the life of these agreements.
LNC currently reports excess DCA interest as benefit expense when the excess interest is earned under the contract. Upon adoption of the SOP, LNC will begin deferring excess DCA interest as deferred sales inducements and amortizing these deferred sales inducements as benefit expense over the expected life of the contract. Amortization will be calculated using the same methodology and assumptions used in amortizing DAC. While over the long run the same amount of excess DCA interest expense will emerge under the SOP as under LNC’s current accounting method, because of the prospective treatment of new deferred sales inducements, LNC expects earnings to be slightly higher under the SOP, relative to LNC’s current approach, for near term financial reporting periods. For instance, had the rules for excess DCA interest expense under the SOP been in effect for 2003, LNC estimates that Lincoln Retirement would have reported increased earnings of about $6 million. The actual effect on LNC’s results in future periods will depend upon the volume of business written with excess DCA interest.
As a result of the application of the non-amortization provisions of the new standards, LNC had an increase in net income of $41.7 million ($0.22 per common share on a fully diluted basis) for the year ended December 31, 2002.
Below is a summary of the restructuring charges initiated by year. Additional details of each of these restructuring plans are discussed in Note 12 to the consolidated financial statements.
As disclosed in the “Restructuring Charges” section, LNC initiated realignment activities during 2003, which included combining the retirement and life insurance businesses into a single unit for operating purposes. Although these operations are now under common management, the results of these businesses are required to be reported as separate reporting segments for financial statement purposes.
LFD is the primary wholesale distributor of LNC’s individual annuity products. During 2003, LNC worked with American Funds Distributors (“AFD”) to transition the wholesaling of the American Legacy variable annuity to LFD. With this change, LFD has a dedicated team focused on key broker/dealer relationships developed in conjunction with AFD, which is expected to continue to renew growth in American Legacy variable annuity sales. Also as a result of this change, LFD now has two distinct annuity product wholesaling groups: the single-manager (American Legacy) and the multi-manager (ChoicePlusSM and Multi-Fund®).
(1) Cumulative Effect of Accounting Changes for 2003 results from the recording in the fourth quarter of 2003 the embedded derivative for Modco reinsurance arrangements resulting from implementation of DIG B36. The 2001 changes relate to the transition adjustment of $(0.2) million recorded in the first quarter of 2001 upon adoption of FAS 133 and the adjustment of $(5.3) million recorded in the second quarter of 2001 upon adoption of EITF 99-20. (Refer to New Accounting Pronouncements section beginning on page 23 for further discussion of these items.)
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. The final IRS regulations issued in 2003 are effective for arrangements entered into or materially modified after September 17, 2003. The new regulations do not eliminate split dollar arrangements, but clarify certain issues. As a result of the final regulation, some split dollar plans may not be as attractive as before, but some plans may be better.
During 2002, Lincoln UK entered into an agreement to outsource its customer service and policy administration functions to the Capita Group Plc. The agreement involved the transfer of approximately 500 employees to Capita. The purpose of the outsourcing was to reduce the operational risk and variability of future costs associated with administering the business by taking advantage of Capita’s proven expertise in providing outsourcing solutions to a variety of industries including general insurance companies. The relationship through 2003 has provided the segment with results in line with expectations. During 2003, the initial 10 year contract with Capita was converted to an arrangement that automatically renews.
The banking sector had $16.1 million in unrealized losses at December 31, 2003. The majority of this unrealized loss is economically offset by unrealized gains in the derivative portfolio for hedging that is related to these securities. Although $2.9 million of the unrealized losses relates to securities with offsetting derivative gains, the unrealized gains on the derivative position was $16.7 million at December 31, 2003. All the underlying credits that have been swapped have an average rating of A+ and LNC does not anticipate any credit related losses on these securities.
At December 31, 2003 LNL’s reported NAIC RBC was 323% of Company Action Level.
In addition, LNC’s insurance subsidiaries are subject to certain insurance department regulatory restrictions as to the transfer of funds and payment of dividends to the holding company. In general, dividends are not subject to prior approval from the Indiana Insurance Commissioner (“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. Generally, these restrictions pose no short-term liquidity concerns for the holding company. However, as discussed in detail within Note 7 to the consolidated financial statements, the acquisition of two blocks of business in 1998 resulted in negative statutory earned surplus for LNL, which triggered certain approval requirements in order for LNL to declare and pay dividends to LNC. As a result of negative earned surplus, LNL was required to obtain the prior approval of the Commissioner before paying any dividends to LNC until its statutory earned surplus became positive.
• On September 13, 2001, LNC redeemed all 8.6 million shares of the $215 million 8.75% Cumulative Quarterly Income Preferred Securities issued by Lincoln National Capital I and guaranteed by LNC.
(3) LNC’s information technology contract with IBM was renegotiated and expires on February 8, 2010. The future minimum annual costs range from $40.5 million - $53.3 million per year. However, based upon usage, the fees are estimated to be $60.0 million per year
As a result of increased cash flow from operations, Lincoln National (UK) PLC was able to retire its remaining outstanding commercial paper in the second quarter of 2002 and LNC eliminated the bank lines and ratings associated with this program.
Investment Advisory Fees. As specified in the investment advisory agreements with the mutual funds, fees are determined and recognized as revenues monthly, based on the average daily net assets of the mutual funds
Under prior Federal income tax law, one-half of the excess of a life insurance company’s income from operations over its taxable investment income was not taxed, but was set aside in a special tax account designated as “Policyholders’ Surplus.” At December 31, 2003, LNC has approximately $196.0 million of untaxed “Policyholders’ Surplus” on which no payment of Federal income taxes will be required unless it is distributed as a dividend, or under other specified conditions. Barring the passage of unfavorable tax legislation, LNC does not believe that any significant portion of the account will be taxed in the foreseeable future. Accordingly, no deferred tax liability has been recognized relating to LNC’s Policyholders’ Surplus balance. If the entire Policyholders’ Surplus balance became taxable at the current Federal rate, the tax would be approximately $68.6 million.
Within the broad ranges provided above, LNC currently targets asset weightings as follows: 64% equities, 35% fixed income, including real estate, and 1% cash. The performance of the plan and the managed funds are monitored on a quarterly basis to relative to the plan’s objectives. The performance of the managed fund is measured against the following indices: S&P 500, EAFE, Russell 2000, NAREIT, Lehman US Universal and Salomon (Citigroup) 90-day T-Bill. LNC reviews this investment policy on an annual basis.
Shares acquired upon exercise, provided they have been held for more than six months and are vested, may be “put” to Holdings at the most recent determined fair market value per share, subject to the specific terms of
At December 31, 2003, the range of exercise prices for options outstanding under the DIUS incentive plan involving stock options was $98.71 to $107.45, with a weighted-average remaining contractual life of 8.1 years.
Various selling practices of the Lincoln UK segment have come under scrutiny by the U.K. regulators in the last 10 years. These selling practices include the sale and administration of individual pension products, mortgage endowments and the selling practices of City Financial Partners Limited (“CFPL”), a subsidiary company purchased in December 1997. Regarding the sale and administration of pension products to individuals, regulatory agencies have raised questions as to what constitutes appropriate advice to individuals who bought pension products as an alternative to participation in an employer-sponsored plan. In cases of inappropriate advice, an extensive investigation may have to be done and the individual put in a position similar to what would have been attained if the individual had remained in the employer-sponsored plan.
For discussion of the resolution of legal proceedings related to LNC’s sale of its former reinsurance business to Swiss Re, refer to the discussion of Reinsurance Contingencies above.