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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1998
Commission File Number 1-6028
LINCOLN NATIONAL CORPORATION
(Exact name of registrant as specified in its charter)
Indiana 35-1140070
(State of incorporation) (I.R.S. Employer Identification No.)
200 East Berry Street, Fort Wayne, Indiana 46802-2706
(Address of principal executive offices)
Registrant's telephone number (219) 455-2000
Securities registered pursuant to Section 12(b) of
the Act:
Title of each class Exchanges on which registered
- ------------------- -----------------------------
Common Stock New York, Chicago and Pacific
Common Share Purchase Rights New York, Chicago and Pacific
$3.00 Cumulative Convertible Preferred Stock, Series A New York and Chicago
8.75% Cumulative Quarterly Income Preferred Securities, Series A* New York
8.35% Trust Originated Preferred Securities, Series B* New York
7.40% Trust Originated Preferred Securities, Series C* New York
7.75% FELINE PRIDES, Series D* New York, Chicago and Pacific
* Issued by Lincoln National Capital I, Lincoln National Capital II, Lincoln
National Capital III and Lincoln National Capital IV, respectively. Payments
of distributions and payments on liquidation or redemption are guaranteed by
Lincoln National Corporation.
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934
during the preceding 12 months (or such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [ x ] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ x ]
As of February 26, 1999, 101,245,205 shares of common stock were outstanding.
The aggregate market value of such shares (based upon the closing price of these
shares on the New York Stock Exchange) held by nonaffiliates was approximately
$9,586,700,000.
Select materials from the Proxy Statement for the Annual Meeting of
Shareholders, scheduled for May 13, 1999 have been incorporated by reference
into Part III of this Form 10-K.
The exhibit index to this report is located on page 80.
Page 1 of 218
2
Lincoln National Corporation
Table of Contents
Item Page
PART I
1. Business
A. General Description.......................................... 3
B. Description of Business Segments:
Life Insurance and Annuities.............................. 3
Lincoln UK................................................ 4
Reinsurance .............................................. 4
Investment Management..................................... 4
C. Other Matters:
Regulation................................................ 5
Miscellaneous............................................. 5
2. Properties....................................................... 5
3. Legal Proceedings................................................ 6
4. Submission of Matters to a Vote of Security Holders.............. 6
PART II
5. Market for Registrant's Common Equity and Related Stockholder Matters 6
6. Selected Financial Data.......................................... 7
7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 8
7A. Quantitative and Qualitative Disclosures About Market Risk....... 28
8. Financial Statements and Supplementary Data...................... 35
9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosures.................................... 67
PART III
10. Directors and Executive Officers of the Registrant............... 68
11. Executive Compensation........................................... 69
12. Security Ownership of Certain Beneficial Owners and Management... 69
13. Certain Relationships and Related Transactions................... 69
PART IV
14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.. 69
Index to Exhibits............................................... 80
Signatures...................................................... 81
3
PART I
Item 1. Business
Lincoln National Corporation ("LNC") is a holding company. Through subsidiary
companies, LNC operates multiple insurance and investment management businesses.
During 1998, the collective group of companies adopted "Lincoln Financial Group"
as its marketing identity. LNC is the 39th largest (based on assets) U.S.
corporation (1997 Fortune 500, Largest U.S. Corporations, April 1998).
Operations are divided into four business segments: 1) Life Insurance and
Annuities, 2) Lincoln UK, 3) Reinsurance and 4) Investment Management. Over the
past five years, segments have been redefined as noted below. Prior to 1997, LNC
had a Property-Casualty segment. This segment was sold in 1997 and the related
segment information was reclassified to discontinued operations (see note 11 to
the consolidated financial statements on page 65). The Lincoln UK segment, which
was added in 1997, was included in the Life Insurance and Annuities segment
prior to the adoption of Financial Accounting Standard No. 131. The Investment
Management segment was added in April of 1995 following the acquisition of
Delaware Management Holdings, Inc. Prior to the sale of 71% of its direct writer
of employee life-health coverages in the first quarter of 1994, LNC operated a
business segment entitled Employee Life-Health Benefits. After the sale, the
earnings from the 29% minority interest retained were included in "Other
Operations" as described below. Although one of the subsidiaries held by LNC was
formed as early as 1905, LNC itself was formed in 1968. LNC is an Indiana
corporation with its principal office at 200 East Berry Street, Fort Wayne,
Indiana 46802-2706. As of December 31, 1998, there were 210 persons on the staff
of the LNC holding company. Once the organizational/expense review discussed in
note 11 to the consolidated financial statements on page 67 is fully
implemented, the governance of the holding company will be under the direction
of a staff of approximately 65 persons. Total employment of Lincoln National
Corporation at December 31, 1998 on a consolidated basis was 8,015.
Revenues, pre-tax income and assets for LNC's major business segments and other
operations are shown in this Form 10-K report as part of the consolidated
financial statements (see note 9 to the consolidated financial statements on
page 62). The LNC "Other Operations" category includes the financial data for an
unconsolidated affiliate (subsequent to the first quarter of 1994 and prior to
the sale of this unit in October of 1995) engaged in the employee life-health
benefits business, an investment management company that services LNC's business
segments, certain other operations that are not directly related to the business
segments and unallocated corporate items (i.e., corporate investment income,
interest expense on short-term and long-term borrowings and unallocated
corporate overhead expenses).
Following is a brief description of the four business segments:
1. Life Insurance and Annuities
The primary companies within this business segment are Lincoln National Life
Insurance Company ("Lincoln Life"); First Penn-Pacific Life Insurance Company
("First Penn"); Lincoln Life & Annuity Company of New York ("LLANY") and Lincoln
Financial Advisors ("LFA").
Lincoln Life, an Indiana corporation headquartered in Fort Wayne, Indiana with
significant operations in Hartford, Connecticut, is the 10th largest U.S.
stockholder-owned life insurance company, based on revenues (1997 Fortune
Rankings of Largest Life Insurance Companies by Revenues, April 1998) and the
13th largest, based on assets (Best's Review Life-Health Edition, July 1998). A
network of 58 life insurance agencies, independent life insurance brokers,
insurance agencies located within financial institutions and specifically
trained employees sell fixed annuities, variable annuities, pension products,
universal life insurance, variable universal life insurance, term insurance and
other individual insurance coverages in most states of the United States. The
distribution network includes approximately 2,050 career agents, 34,500 brokers,
4,500 bank agents and access to 75,000 stockbrokers and financial planners.
First Penn is an Indiana Corporation headquartered in Oakbrook Terrace,
Illinois. Its universal life, term life and deferred annuity products are
distributed through stockbrokers, financial planners, banks and personal
producing general agents. It also manufactures universal life, term life and
deferred annuity products for Lincoln Life for distribution through its career
agents and banks. These products are marketed in most states of the United
States.
LLANY is a New York company, headquartered in Syracuse, New York. This company
was formed in connection with the acquisition of the tax-qualified annuity
business from UNUM Corporation's affiliates in 1996 (see note 11 to the
consolidated financial statements on page 65). LLANY also offers other types of
annuities, pension and life insurance products within the state of New York.
4
LFA is a securities broker/dealer and a registered investment advisor that
offers a full range of financial and estate planning. LFA also offers access to
annuities, 401(k) plans, pensions, universal life insurance and other wealth
accumulation and protection products and services.
Other companies within this segment include various general business
corporations that support the segment's sales, service and administrative
efforts.
Approximately 4,285 employees are involved in this business segment.
2. Lincoln UK
Business in this segment is conducted through a series of operating companies
owned by Lincoln National (UK) plc. Lincoln UK is headquartered in Gloucester,
England, and is licensed to do business throughout the United Kingdom. The
principal products produced by this operation, unit-linked life and pension
products, are similar to U.S. produced variable life and annuity products. The
distribution network includes approximately 1,630 sales representatives and tied
agents. Lincoln National (UK) was the 12th largest writer of unit-linked new
business premiums in the UK for 1997 (Money Management Magazine-New Business
Trends, June 1998).
Approximately 1,400 employees are involved in this business segment.
3. Reinsurance
The primary companies within this business segment are Lincoln National
Reassurance Company ("LNRAC"), Lincoln National Health & Casualty Insurance
Company ("LNH&C"), Lincoln Life, Lincoln National Reinsurance Company Ltd
(Bermuda), Old Fort Insurance Company Ltd (Bermuda) and Lincoln National
Reinsurance Company Ltd (Barbados). LNRAC and Lincoln Life offer reinsurance
programs for individual life, group life, group medical, disability income,
personal accident and annuity products to U.S. and international clients. LNH&C
offers group medical products and services on both a direct and reinsurance
basis as well as personal accident reinsurance. The insurance companies in
Bermuda and Barbados offer specialized reinsurance programs for life, health and
annuity business. They also offer funded cover programs to property-casualty
carriers in the U.S. and select international markets.
This segment provides a broad range of risk management products and services to
insurance companies, Health Maintenance Organizations, self-funded employers and
other primary market risk accepting organizations throughout the United States
and economically attractive international markets. Marketing efforts are
conducted primarily through the efforts of a reinsurance sales staff. Some
business is generated through reinsurance intermediaries and brokers. The
reinsurance organization is one of the leading life-health reinsurers worldwide
measured on gross premiums, net of ceded (Business Insurance, August 1998).
Other companies in this business segment include various general business
corporations that support the segment's sales, service and administration
efforts.
Approximately 840 employees are involved in this business segment.
4. Investment Management
The primary companies within this business segment include Lincoln National
Investments, Inc. ("LNI"), Lincoln National Investment Companies, Inc. ("LNIC"),
Delaware Management Holdings, Inc. ("Delaware"), Lynch & Mayer, Inc. ("L&M") and
Vantage Investment Advisors ("Vantage"). LNI and LNIC are intermediate level
holding companies that own the operating companies within this segment. The
operating companies provide a variety of asset management services to
institutional and retail customers including pension plans, endowment funds,
individuals and trusts. These companies serve as investment advisor to
approximately 455 pension funds and other institutional accounts; act as
investment manager/national distributor and/or shareholder services agent for
114 open-end funds; and serve as investment manager for 10 closed-end funds.
Approximately 1,045 employees are involved in this business segment.
5
LNC's insurance subsidiaries protect themselves against losses greater than the
amount they are willing to retain on any one risk or event by purchasing
reinsurance from unaffiliated insurance companies (see note 7 to the
consolidated financial statements on page 55.
All businesses LNC is involved in are highly competitive due to the market
structure and the large number of competitors. At the end of 1997, the latest
year for which data is available, there were more than 1,700 life insurance
companies in the United States. Lincoln Life is the 10 largest stock and mutual
life insurance company in the United States based on revenues (1997 Fortune
Ranking of Largest Life Insurance Companies by Revenues, April 1998). LNC's
investment management companies were the 35th largest U.S. investment management
group at the end of 1997 (1997 Institutional Investor 300 Money Managers, July
1998).
LNC's Life Insurance & Annuities, Lincoln UK and Reinsurance business segments,
in common with those of other insurance companies, are subject to regulation and
supervision by the states, territories and countries in which they are licensed
to do business. The laws of these jurisdictions generally establish supervisory
agencies with broad administrative powers relative to granting and revoking
licenses to transact business, regulating trade practices, licensing agents,
prescribing and approving policy forms, regulating premium rates for some lines
of business, establishing reserve requirements, regulating competitive matters,
prescribing the form and content of financial statements and reports, regulating
the type and amount of investments permitted and prescribing minimum levels of
capital. The ability to continue an insurance business is dependent upon the
maintenance of the licenses in the various jurisdictions.
LNC's Investment Management segment, in common with other investment management
groups, is subject to regulation and supervision by the Securities and Exchange
Commission, National Association of Securities Dealers, the Investment
Management Regulatory Organization ("IMRO"), the Pennsylvania Department of
Banking and jurisdictions of the states, territories and foreign countries in
which they are licensed to do business.
Because of the nature of the insurance and investment management businesses,
there is no single customer or group of customers upon whom the business is
dependent. Factors such as backlog, raw materials, seasonality, patents
(including trademarks, licenses, franchises and any other concessions held) or
environmental impact do not have a material effect upon such businesses.
However, within LNC's Reinsurance segment, Lincoln National Risk Management,
Inc. ("LNRM") does hold patents for "The Method and Apparatus for Evaluating a
Potentially Insurable Risk," and "Automated Decision-making Arrangements." LNRM
markets multiple knowledge-based underwriting products that rely on these
products. LNC does not have a separate unit that conducts market research.
Research activities related to new products or services, or the improvement of
existing products or services, are conducted within the business segments.
Expenses related to such activities are not material. Also, sales are not
dependent upon select geographic areas. LNC has foreign operations that are
significant in relationship to the consolidated group (see note 9 to the
consolidated financial statements on page 63).
Item 2. Properties
LNC and the various Fort Wayne operating businesses own or lease approximately
1.6 million square feet of office space in the Fort Wayne area. Businesses
operating in suburban Chicago, Illinois; Philadelphia, Pennsylvania; Hartford,
Connecticut and the United Kingdom own or lease another 1.2 million square feet
of office space. An additional 1.1 million square feet of office space is owned
or leased in other U.S. cities and foreign countries for branch offices and
other smaller operations. LNC expects to move its corporate headquarters from
Fort Wayne to Philadelphia in mid-1999. The future lease commitments shown
within note 7 includes a commitment for 30,000 square feet in Philadelphia for
LNC's headquarters. As shown in the notes to the consolidated financial
statements (see note 7 to the consolidated financial statements on page 55), the
rental expense on operating leases for office space and equipment for continuing
operations totaled $81.3 million for 1998. Office space rent expense accounts
for $63.2 million of this total. This discussion regarding properties does not
include information on investment properties.
6
Item 3. Legal Proceedings
LNC and its subsidiaries are involved in various pending or threatened legal
proceedings arising from the conduct of business. In some instances, these
proceedings include claims for unspecified or substantial punitive damages and
similar types of relief in addition to amounts for alleged contractual liability
or requests for equitable relief. After consultation with legal counsel and a
review of available facts, it is management's opinion that these proceedings
ultimately will be resolved without materially affecting the consolidated
financial position of LNC.
Item 4. Submission of Matters to a Vote of Security Holders
During the fourth quarter of 1998, no matters were submitted to securityholders
for a vote.
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
Stock Market and Dividend Information
The dividend on LNC's common stock is declared each quarter by LNC's Board of
Directors. In determining dividends, the Board takes into consideration items
such as LNC's financial condition, including current and expected earnings,
projected cash flows and anticipated financing needs. The range of market prices
and cash dividends declared by calendar quarter for the past two years are as
follows:
Common Stock Data: (per share) 1st Qtr 2nd Qtr 3rd Qtr 4th Qtr
- ------------------------------------------------------------------------------------------------------------------
1998
High...................................................... $86.500 $94.125 $98.875 $86.688
Low....................................................... 72.250 83.688 82.250 67.000
Dividend declared......................................... $.52 $.52 $.52 $.55
1997
High...................................................... $61.625 $68.625 $73.000 $78.125
Low....................................................... 51.375 49.000 63.813 64.625
Dividend declared......................................... $.49 $.49 $.49 $.52
Notes:
(1) At December 31, 1998, the number of shareholders of record of LNC's common
stock was 12,025.
(2) The payment of dividends to shareholders is subject to the restrictions
described in note 7 to the consolidated financial statements (see page 54)
and is discussed in the Management's Discussion and Analysis of Financial
Condition (see page 28).
Exchanges: New York, Chicago and Pacific.
Stock Exchange Symbol: LNC
7
Item 6. Selected Financial Data
(millions of dollars, except per share data)
Year Ended December 31 1998 1997 1996 1995 1994
- ----------------------------------------------------------------------------------------------------------------
Total revenue.................................... 6,087.1 4,898.5 4,733.6 4,586.5 3,932.7
Net income from continuing operations (1)........ 509.8 22.2 356.4 301.4 165.5
Net income from discontinued operations.......... -- 134.9 157.2 180.8 184.4
Gain on sale of discontinued operations.......... -- 776.9 -- -- --
-------- ----- -------- -------- --------
Net Income (1)............................... 509.8 934.0 513.6 482.2 349.9
Per Share Data: (2)
Net income from continuing operations............ $5.02 $ .21 $3.38 $2.88 $1.59
Net income from discontinued operations.......... -- 1.30 1.49 1.72 1.76
Gain on sale of discontinued operations.......... -- 7.47 -- -- --
-------- ---- ----- ------ -------
Net Income-Diluted........................... $5.02 $8.98 $4.87 $4.60 $3.35
Net Income-Basic............................. $5.08 $9.11 $4.95 $4.78 $3.52
Common stock dividends........................... $2.11 $1.99 $1.87 $1.75 $1.66
(millions of dollars, except per share data)
December 31 1998 1997 1996 1995 1994
- ----------------------------------------------------------------------------------------------------------------
Assets........................................... 93,836.3 77,174.7 71,713.4 63,257.7 48,864.8
Long-term debt................................... 712.2 511.0 626.3 659.3 474.2
Minority interest-preferred securities of
subsidiary companies............................ 745.0 315.0 315.0 -- --
Shareholders' equity............................. 5,387.9 4,982.9 4,470.0 4,378.1 3,042.1
Per Share Data: (2)
Shareholders' equity (Securities at market)...... $53.18 $49.27 $43.00 $41.89 $29.35
Shareholders' equity (Securities at cost)........ 47.73 44.96 39.03 35.21 32.35
Market value of common stock..................... 81.81 78.13 52.50 53.75 35.00
(1) Factors affecting the comparability of net income from continuing operations
and net income from continuing operations for the 1994- 1998 period are
shown on page 8 (see "Supplemental Data"). Other factors affecting
comparability are shown within the review of operations for each segment
(see pages 9-18).
(2) Per share amounts were also affected by the issuance of 9,200,000 and
1,398,112 shares of common stock in 1993 and 1997, respectively, and the
retirement of 500,000; 694,582; 4,948,900 and 623,281 shares of common stock
in 1994, 1996; 1997 and 1998 respectively.
8
Supplemental Data
The following table presents a reconciliation of "Income (Loss) from Continuing
Operations" to "Net Income (Loss) from Continuing Operations" determined in
accordance with generally accepted accounting principles. Income (Loss) from
Continuing Operations is LNC's alternative measure of operating performance
which excludes the after-tax realized gain (loss) on investments and associated
items, gain (loss) on sale of subsidiaries and restructuring charges.
Year Ended December 31 (in millions) 1998 1997 1996 1995 1994
- ----------------------------------------------------------------------------------------------------------------
Income (loss) from continuing operations (1)......... $530.4 $(50.7) $298.8 $140.9 $218.6
Realized gain (loss) on investments, net of
associated amortization of deferred policy
acquisition costs, investment expenses
and income taxes.................................... 13.7 72.9 57.6 102.2 (101.9)
Gain (loss) on sale of subsidiary, net of taxes...... -- -- -- 58.3 48.8
Restructuring charges................................ (34.3) -- -- -- --
------- -------- -------- --------- --------
Net Income from Continuing Operations............. $509.8 $ 22.2 $356.4 $301.4 $165.5
(1) Income (loss) from continuing operations for 1997 and 1995 includes the
impact of the changes in estimate of the reserve level needed for LNC's
disability income business ($130.0 million and $121.6 million, after-tax,
respectively). Also 1997 includes a change in estimate for reserves for 1)
Lincoln UK's pension business of $174.9 million after-tax and 2)
Reinsurance's personal accident programs of $113.7 million after-tax.
Item 7. Management's Discussion and Analysis of Results of Operations and
Financial Condition
The pages to follow review LNC's results of operations and financial condition.
Historical financial information is presented and analyzed. Where appropriate,
factors that may affect future financial performance are identified and
discussed. Actual results could differ materially from those indicated in
forward-looking statements due to, among other specific changes currently not
known, subsequent significant changes in: the company (e.g., acquisitions and
divestitures), financial markets (e.g., interest rates and securities markets),
legislation (e.g., taxes and product taxation), regulations (e.g., insurance and
securities regulations), acts of God (e.g., hurricanes, earthquakes and storms),
other insurance risks (e.g., policyholder mortality and morbidity) and
competition.
On pages 9 through 18, the financial results of LNC's four business segments and
other operations are presented and discussed. Within these business segment
discussions, reference is made to "Income from Operations". This alternative
measure of earnings is defined as "Net income less realized gain (loss) on sale
of investments, gain (loss) on sale of subsidiaries and restructuring charges,
all net of taxes." Page 19 discusses factors affecting LNC's consolidated
investment performance. Pages 20 through 34 discuss factors that have affected
specific elements of the consolidated financial statements as well as
information pertaining to LNC as a whole.
This "Management's Discussion and Analysis of Results of Operations and
Financial Condition" should be read in conjunction with the audited consolidated
financial statements and accompanying notes presented on pages 36 through 67.
9
Review of Operations: Life Insurance and Annuities
Year Ended December 31 1998 1997 1996 1995 1994
- ----------------------------------------------------------------------------------------------------------------
Financial Results by Source (in millions)
Annuities......................................... $257.6 $203.0 $165.0 $149.3 $120.0
Insurance......................................... 147.0 36.1 36.4 31.1 34.2
Pensions.......................................... 10.4 6.3 2.9 22.1 22.4
Disability Income (1)............................. -- -- -- (18.3) (14.9)
Other............................................. (10.4) 10.4 8.2 8.5 (5.5)
----- ---- ---- ----- -----
Income from Operations......................... 404.6 255.8 212.5 192.7 156.2
Realized Gain (Loss) on Investments............... 2.9 47.5 38.5 81.3 (93.4)
Restructuring charge.............................. (20.0) -- --- -- --
----- ------ ------ ------ -------
Net Income..................................... $387.5 $303.3 $251.0 $274.0 $ 62.8
Sales - Face Amount (in billions)
Term Insurance.................................... $27.6 $16.2 $13.3 $2.2 $ .3
Universal Life and Other.......................... 9.0 2.2 2.9 2.8 3.2
December 31 (in billions) 1998 1997 1996 1995 1994
- -----------------------------------------------------------------------------------------------------------------------------------
Account Values
Annuities........................................ $51.5 $44.6 $38.0 $30.3 $24.6
Reinsurance Ceded - Annuities..................... (1.6) (1.8) (1.8) (1.7) (1.5)
Universal and Variable Life Insurance............. 7.4 3.0 2.9 2.6 2.4
Interest Sensitive Whole Life..................... 1.8 -- -- -- --
401(k) Retirement Plans........................... 3.7 3.4 2.9 2.4 1.9
Other Pensions.................................... 3.6 4.5 4.9 5.6 5.5
----- --- ---- ---- ----
Total Account Values........................... $66.4 $53.7 $46.9 $39.2 $32.9
In Force - Face Amount
Universal Life and Others......................... $107.6 $32.8 $32.9 $32.2 $32.1
Term Insurance.................................... 54.3 30.3 16.3 3.8 1.9
(1) Lincoln stopped writing disability income coverages on a direct basis at the
end of March 1996. The administration of this business was moved to the
Reinsurance segment at the end of September 1995.
The Life Insurance and Annuities segment reported record income from operations
of $404.6 million in 1998, a 58% increase over the $255.8 million reported in
1997. Continuing double-digit growth in the annuity business, plus the added
earnings from the blocks of business acquired from CIGNA and Aetna during 1998
(see note 11 to the consolidated financial statements on page 66), were the
primary factors in this segment's earnings performance.
Profile: LNC's Insurance and Annuities segment is composed of Lincoln National
Life Insurance Company ("Lincoln Life"), First Penn-Pacific Life Insurance
Company ("First Penn"), Lincoln Life & Annuity Company of New York ("LLANY") and
Lincoln Financial Advisors Corporation ("LFA"). As shown above, account values
for this segment's annuities, life insurance, 401(k) retirement plans and other
pensions totaled $66.4 billion as of December 31, 1998. Life insurance in force
for these companies as of December 31,1998, totaled $161.9 billion, an increase
of 157% in comparison with $63.1 billion as of December 31, 1997.
Lincoln Life, which is based in Fort Wayne, Indiana, is the 13th largest life
insurer in the United States when measured by assets (Best's Review, Life/Health
Edition, July 1998). First Penn, which is headquartered in Oakbrook Terrace,
Illinois, is recognized for product innovations. One unique product is
MoneyGuard (Registered Trade Mark), a policy that links the benefits of
universal life and long-term care insurance in one. LLANY, which is based in
Syracuse, New York, provides group tax-qualified annuities and other insurance
products in the state of New York.
Lincoln Life, First Penn and LLANY earned charter memberships in the Insurance
Marketplace Standards Association ("IMSA"), an independent, voluntary
organization created by the American Council of Life Insurance. IMSA membership
demonstrates a company's commitment to honesty, fairness and integrity in all
customer contacts involving sales and service of individual life and annuity
products.
10
National Branding Campaign: As part of our strategy to gain name recognition on
a national level, we kicked off an aggressive branding campaign where we
introduced our new marketing name, Lincoln Financial Group. Print ads
emphasizing our ability to provide "clear and understandable solutions in a
complex world," appeared in high profile business and lifestyle publications.
Also, part of our strategic targeting was our participation with other
nationally branded companies in an ESPN cable "Sports Century" sponsorship, an
18-month long special series of programs commemorating highlights in sports
during the past century.
Acquisitions/Divestitures: LNC completed the acquisition of a block of
individual life insurance and annuities business on January 2, 1998, from CIGNA
Corporation, adding a career agency system of 600 producers; a life brokerage
operation; an annuity distribution system; and $37 billion of individual life
insurance in force. The acquisition of another block of individual life
insurance business on October 1, 1998, from Aetna, Inc. added 30 life brokerage
managers, 30 managing general agent relationships, a corporate-owned life
insurance sales force, access to more than 30,000 independent agents and a total
of $42 billion of individual life insurance in force. A block of
employer-sponsored life insurance business acquired in connection with the Aetna
businesses was sold to Protective Life Corp. In addition, an agreement was
reached with Allstate Life under which they would reinsure and administer a
variable annuity portfolio acquired in connection with the CIGNA business.
In order to eliminate redundancies and capitalize on newly acquired competencies
and existing efficiencies, Hartford, Connecticut, became the platform for
operating the segment's life insurance business, while the annuities operation
remained in Fort Wayne, Indiana.
Varied Distribution: Products from the companies in this segment are sold
through multiple distribution channels, reflecting a marketplace where consumers
increasingly want to do business on their own terms. These channels are career
agents, independent agencies, insurance brokers, banks, stockbrokers, financial
planners and the Internet.
Lincoln Life's and LLANY's wealth accumulation and wealth protection products
include: fixed, variable and tax-deferred annuities; term, whole life, universal
and variable universal life insurance; and employer sponsored retirement plans.
These products are sold in 50 states through the 58 regional offices of LFA, a
broker/dealer that serves approximately 2,050 career agents, 34,500 brokers and
4,500 bank agents as well as through 75,000 stockbrokers and financial planners.
LFA includes a network of regional financial planning offices that serve as the
preferred distributor of Lincoln Life products. LFA offers a full range of
financial planning services and investments and is a securities broker/dealer
and registered investment advisor.
Lincoln Life formed a strategic alliance with BDO Seidman, LLP, one of the top
10 accounting and consulting firms serving the dynamic entrepreneurial business
market. Through this alliance, LFA planners will offer estate planning, business
continuity planning, investment management services and financial planning to
BDO Seidman's client base at more than 40 offices across the country.
First Penn offers linked benefit, universal and term life insurance and fixed
annuities through stockbrokers, financial planners, banks, independent agents
and LFA. Life products are available for individual and worksite markets. First
Penn designs, managers distribution and administers fixed annuities sold through
banks for Lincoln Life.
Annuities: Lincoln Life is a leading writer of annuities in the United States
(National Underwriter, August 1998). Annuity earnings in this segment increased
27% in 1998, reaching a record $257.6 million. As of December 31, 1998, annuity
account values were $51.5 billion, up from $44.6 billion the year before.
Variable annuity account values at year-end were $33.4 billion, while fixed
annuities represented $18.1 billion.
Annuity deposits in 1998 were $3.9 billion. Annuity deposits sold through
producers were $2.0 billion, while annuity deposits sold through stockbrokers
were $1.4 billion.
11
Lincoln is working with American Funds Distributors ("AFD") on a number of
initiatives aimed at further strengthening sales. The American Legacy variable
annuity products are marketed to stockbrokers by AFD and to banks through
Lincoln Financial Institutions Group, a strategic business unit of First Penn.
As a result of restructuring its wholesaler network, AFD has broadened its
distribution capabilities and its wholesalers now market both mutual funds and
annuities. Today, the American Legacy product has the potential of being
marketed by three times as many wholesalers as in the past. Lincoln also is
supporting the wholesaler network by providing its own American Legacy sales
support team to assist in sales promotion and stockbroker training programs.
Product improvements, including the expansion of fund offerings, are being made
to American Legacy.
In response to the increased demand for multi-manager products, Lincoln
introduced the Delaware Lincoln ChoicePlus (Service Mark) variable annuity in
the fourth quarter of 1998. This new product contains 30 variable investment
options in addition to a number of fixed account options. Delaware Distributors
LP wholesales the Delaware Lincoln ChoicePlus variable annuity.
During 1998, Lincoln also introduced two new multi-manager products in the
employer-sponsored market. Lincoln Alliance gives an employer more choices by
offering a solid, fixed annuity foundation, combined with a vast array of mutual
funds. In addition, the Lincoln/Delaware Advantage product offers the investment
stability of a Lincoln Life fixed annuity and the investment performance and
diversity available through the Delaware family of funds. The product is
targeted at the mid- to large-size employer in the health care industry.
Finally, eAnnuity (Trade Mark), the first variable annuity targeted to the
self-directed investor and sold completely online, was also launched.
Life Insurance: In 1998, Lincoln began building a life insurance platform that
allowed the company to quickly achieve scale, deliver higher growth and better
financial performance, as well as leverage its expertise in serving the super
affluent market. Operating income from life insurance was $147.0 million as of
December 31, 1998, four times higher than 1997, as a result of the businesses
acquired from CIGNA and Aetna. Combined universal life, whole life, variable
life and interest sensitive whole life insurance account values tripled in 1998
to $9.2 billion. Individual life insurance sales, as measured by face amount of
in force, nearly doubled for the year to $36.6 billion.
All CIGNA products were duplicated within Lincoln Life within four months after
the transaction closed. In addition, Lincoln introduced three new universal life
products, two of which provide second-to-die coverage, for estate protection.
One also offers the opportunity for equity returns on account values. All three
offer lifetime death benefit guarantees, including a Survivor Variable Universal
Life I and a Survivor Universal Life II product in 1998.
Pensions: This segment's pension business is focused on 401(k) retirement plans
for businesses with fewer than 200 employees. Account values for these plans
were $3.7 billion as of December 31, 1998, a 9% increase over 1997. To better
service the retirement services market and to achieve economies of scale,
Lincoln Life's 401(k) retirement plans were combined with the Investment
Management segment's defined contributions effective January 1999.
Outlook: The Life Insurance and Annuities segment has laid the foundation for
increased sales in the future. With the kickoff of an aggressive national
branding campaign, were moving forward to build national brand recognition. In
addition, a well-balanced distribution system, coupled with product
improvements, new product introductions and strategic partnerships will help in
strengthening our market presence and will be the driving forces in placing our
annuities and life insurance operations among the top five.
12
Review of Operations: Lincoln UK (1)
Year Ended December 31 (in millions) 1998 1997 1996 1995 1994
- --------------------------------------------------------------------------------------------------------------
Financial Results
Income (Loss) from Operations (1)..................... $70.9 $(108.3) $66.1 $45.9 $17.2
Realized Gain (Loss) on Investments................... .8 1.5 (.1) (.2) 1.3
----- ------ ----- ----- -----
Net Income (Loss) (1)............................. $71.7 $(106.8) $66.0 $45.7 $18.5
Net Initial Commission Value (2)....................... $54.9 $55.4 $47.2 $39.4 $32.1
December 31 (in billions) 1998 1997 1996 1995 1994
- ---------------------------------------------------------------------------------------------------------------
Unit-Linked Assets..................................... $6.265 $5.643 $5.074 $4.307 $1.320
Individual Life Insurance
In Force - Face Amount................................ $25.002 $25.026 $23.835 $23.509 $9.412
Exchange Rate Ratio - U.S. Dollars to Pounds Sterling
Average for the Year................................... 1.658 1.644 1.567 1.582 1.536
End of Year............................................ 1.660 1.651 1.713 1.553 1.565
(1) Income (loss) from operations and net income (loss) for 1997 include a
charge of $174.9 million ($199.4 million pre-tax) for a change in estimate
of the cost of settling pension mis-selling liabilities (see note 2 to the
consolidated financial statements on page 45).
(2) Net Initial Commissions is a measure used by Lincoln UK to measure sales
progress and future profitability.
LNC's Lincoln UK segment, conducted through Lincoln National (UK) plc and its
operating subsidiaries reported record income from operations of $70.9 million
in 1998 compared with $66.6 million in 1997, excluding a special charge noted
above.
Profile: Lincoln UK offers life, investment, protection and retirement planning
products primarily through 1,630 direct sales representatives and tied agents.
Lincoln UK sells predominantly unit-linked products where the investment risk is
borne by the policyholder. These products are similar to the variable life
products sold in the United States. Home office operations are divided between
Uxbridge, Middlesex, and Barnwood, Gloucester, England.
Product Development: Lincoln UK relaunched Financial Foundations, its flagship
unit-linked life insurance product with improved features allowing it to be much
more competitive in the marketplace. Since its relaunch in mid-1998, sales are
20% ahead of the same period last year, and now represent over 25% of new
business. In response to a UK government promotional program on individual
savings, plans also are under way to relaunch a wide range of medium- to
long-term savings products this year, including a new tax preferred Individual
Savings Account (ISA) product.
National Branding Campaign: During 1998, Lincoln UK took major steps to develop
its brand awareness in the UK with two key initiatives - the Company's first
ever integrated television and print advertising campaign, as well as
participation in top level sports sponsorship.
The advertising campaign was held during April and May in Scotland, using
creative concepts adapted from Lincoln's corporate campaign in the U.S.
Subsequent research indicated that awareness was raised throughout Scotland and
that the campaign had a positive effect on product sales.
Lincoln UK also participated in the sponsorship of the Rugby League Test Series
between Great Britain and New Zealand, two of the top three leaders in Rugby
League football in the world. The three matches were played during October and
November 1998 and received wide media coverage, on television and radio, and in
the national and local press.
The sponsorship was widely acclaimed by the public, sales advisors and members
of staff as one of the most positive name awareness promotions ever to have been
undertaken by Lincoln UK.
13
City Financial Partners Ltd ("CFPL"): Lincoln UK's largest tied agent, CFPL, was
acquired at the end of 1997 and is now a wholly-owned subsidiary. Its
integration into the organization was successfully completed in 1998, a year in
which CFPL agents produced 45% of Lincoln UK's new business.
Markets: Account values in the unit-linked asset business were $6.3 billion as
of December 31, 1998, an increase of 11% over the year before. Net initial
commission values were $54.9 million, slightly lower than the $55.4 million in
1997. Individual life insurance in force as of December 31, 1998, was $25.0
billion.
Exchange Rates: LNC's subsidiary in the United Kingdom, as with subsidiaries in
other foreign countries, has its balance sheet accounts and income statements
translated at the current exchange and average exchange rates for the year,
respectively. The average exchange rate for 1998 was $1.658 per British pound
sterling. This was 1% higher than the 1997 average exchange rate of $1.644 per
British pound.
Pension Product Mis-selling: A charge of $174.9 million after-tax was taken in
the fourth quarter of 1997 to increase reserves for liabilities in the so-called
"pension mis-selling" situation in the United Kingdom. Regulatory agencies
raised questions as to whether individuals who bought pensions in the UK and
exited employer plans were given appropriate advice by insurance agents and
brokers. The regulatory agencies asked the insurance companies to review their
cases and to provide redress to those individuals harmed by the activities of
agents or brokers. As a result of what the government viewed as a slow response
by the insurance industry, regulators have set targets, publicly named companies
that it sees as tardy in their resolution of cases and taken disciplinary
actions.
Lincoln UK is committed to completing its review as quickly as possible so that
appropriate action can be taken. The regulatory agency deadline for Lincoln UK
to complete phase one of its review was December 31, 1998. The achievement of
this target was a critical milestone for the company. Lincoln has made offers of
redress, or provided reassurance that redress is not required to all its
priority policyholders. The segment has also obtained acceptance of offers or,
in accordance with the regulatory agency requirements, believe they can
demonstrate that every effort to obtain their acceptance has been made. Nearly
11,000 cases have been assessed by a dedicated team of 170 full-time staff at
four locations. The company is well positioned to deal with phase two of the
review, which began on January 4, 1999. This will entail the review of the
balance of policyholders who took out personal pensions between April 1988 and
June 1994 and have not had their cases reviewed under phase one.
As of December 31, 1998 and December 31, 1997, the balance in the liability
account established for this matter was $202.1 million and $291.0 million,
respectively. These liabilities, which are net of expected recoveries, were
established for the estimated cost of this issue following regulatory guidance
as to activities to be undertaken. These liabilities are net of expected
recoveries of $84.9 million and $113.0 million, respectively, from previous
owners of companies acquired over the last few years as specified in the
indemnification clauses of the purchase agreements.
Outlook: By the end of 1999, Lincoln UK will have made substantial progress in
the pensions review and expects a stable earnings picture with some growth going
forward. Lincoln UK anticipates growing faster than the rest of the U.K. life
insurance industry through increased distribution, a superior trained sales
force, improved products and investment performance.
14
Review of Operations: Reinsurance
Year Ended December 31 1998 1997 1996 1995 1994
- ------------------------------------------------------------------------------------------------------------------
Financial Results by Source (in millions)
Individual Markets................................... $ 83.5 $ 71.9 $49.9 $43.4 $41.4
Group Markets (1).................................... 2.7 (103.3) 19.0 25.2 21.6
Financial Reinsurance................................ 15.2 14.4 16.4 10.2 5.5
Other................................................ (1.3) (.3) (.2) .7 (1.9)
---- ------ ----- ------ ---
Income (Loss) from Operations,
excluding Disability Income..................... 100.1 (17.3) 85.1 79.5 76.6
Disability Income (1)................................ 1.4 (134.3) (11.1) (132.2) (10.0)
------ ----- ----- ----- ----
Income (Loss) from Operations (1)................ 101.5 (151.6) 74.0 (52.7) 66.6
Realized Gain on Investments......................... .7 15.2 11.7 10.7 .5
------- ----- ----- ---- ----
Net Income (Loss) (1)............................ $102.2 $(136.4) $85.7 $(42.0) $67.1
Individual Life Sales -
Face Amount (in billions)............................ $78.1 $39.5 $26.6 $22.7 $19.9
December 31 (in billions) 1998 1997 1996 1995 1994
- ----------------------------------------------------------------------------------------------------------------
Individual and Group Life Insurance
In Force Face Amount................................ $250.3 $183.5 $160.9 $142.8 $125.6
(1) Income (loss) from operations and net income (loss) for 1997 and 1995
include the impact of a change in estimate of the reserve level needed for
LNC's disability income business ($130.0 million, and $121.6 million
after-tax, respectively). Also, income (loss) from operations and net income
(loss) for 1997 include a charge of $113.7 million after-tax for the impact
of a change in estimate of the reserve level needed for personal accident
programs.
LNC's Reinsurance segment ("Lincoln Re"), reported record income from operations
of $101.5 million in 1998, exceeding its $100 million target established a few
years ago. This compares with $92.1 million in 1997, excluding special charges.
As of December 31, 1998, Lincoln Re's individual and group life business in
force was $250.3 billion, an increase of 36% over the prior year.
Profile: One of the leading life-health reinsurers in the world, Lincoln Re
reported consolidated, worldwide net premium income of $2.1 billion in 1998.
This compares with $1.7 billion net premium income reported in 1997. Lincoln Re
maintains offices in a number of U.S. cities and has offices in Toronto,
Brussels, Buenos Aires, London, Mexico City, Manila and Singapore.
Lincoln Re also is charged with managing LNC's activities in several emerging
markets, including LNC's joint venture, Seguros Serfin Lincoln, which sells
insurance products through Banca Serfin, Mexico's oldest and third largest bank.
Lincoln Re also maintains representative offices in China (Beijing, Shanghai,
Guangzhou) and, in 1998, signed a letter of intent with Ping An, the largest
private insurance company in the People's Republic of China with a national
charter, to work toward creating a joint venture that will sell life insurance.
Lincoln Re's approach is that the traditional risk-transfer commodity business
is in decline and that today's reinsurer must provide innovative, tailored
programs. As a result, Lincoln Re uses a mass customization approach. This
involves packaging and distributing modular pricing, underwriting, systems,
alliance resources, marketing consultation, product development and claims
management components to meet the needs of client companies. It has a current
client base of more than 1,700 U.S. and 350 international companies, and a
client retention rate of more than 95%.
Lincoln Re's intellectual capital is critical to its success and its systems are
used throughout the insurance industry. Its knowledge-based approach to
reinsurance continues to distinguish itself as a leader in an increasingly
competitive marketplace, allowing for customer retention and to build new
relationships on a global basis.
15
Foremost among these systems is Lincoln National Risk Management's ("LNRM")
patented Life Underwriting System, a state-of-the-art risk management technology
now licensed to more than 50 insurers. Further, nearly 30 % of new life business
written during 1998 can be attributed to companies that have utilized the
Lincoln Mortality System (Trade Mark), a system which helps design new preferred
term insurance products. In 1998, Lincoln Re was granted a second patent to
protect its Lincoln Mortality System and other automated decision-making
systems. Other proprietary systems assist health insurers, claims processors and
agents. Datalliance (Registered Trade Mark), is an electronic data interchange
that can link agents, insurers, information sources, medical labs and
reinsurers.
In 1998, Lincoln Re introduced the industry's first browser-based life
underwriting manual on CD-ROM to its reinsurance clients, enabling faster, more
efficient underwriting of life insurance policies. Lincoln Re also entered into
a strategic alliance with Cybertek, a major developer of administrative
solutions in the life insurance business. Cybertek is working to incorporate the
Lincoln Underwriting System into its base product.
Lincoln Re's approach also involves the capabilities of more than 40 alliance
partners. These include direct marketers, medical equipment suppliers,
electronic information providers, specialized legal firms, accountants, variable
life and annuity administrators, all ready to form a "virtual organization" to
help Lincoln Re clients do business.
Individual Markets: Strong sales in recent years contributed to record income
from operations for individual markets in 1998. Income from operations was $83.5
million, a 16% increase over 1997. Very favorable life mortality throughout the
year was an integral factor in the strong performance. Sales volume, measured by
face amount of new business, was a record $78.1 billion in 1998, nearly double
the amount of last year.
Group Markets: Income from operations in 1998 in group markets was $2.7 million.
This compares with $10.4 million in 1997, excluding the special charge for
personal accident programs. Total annualized premium of $248.4 million
represents an increase of 23% over the $202.2 million in 1997.
Financial Reinsurance: Income from operations was $15.2 million, slightly higher
than income from operations of $14.4 million in 1997.
Disability Income: The disability income business has proved to be one of the
most difficult for the industry in this decade. Lincoln Life, the largest
company in LNC's Life Insurance and Annuities segment, withdrew from the
disability income market in 1996 and its block of business was transferred to
Lincoln Re where it has been managed along with a block of reinsurance
disability income business.
In the fourth quarter of 1995, LNC took a $121.6 million after-tax charge
against earnings to strengthen reserves for the direct and reinsurance
disability income business. These reserves were established assuming that the
current experience would continue. In the second quarter of 1997, LNC took an
additional after-tax charge of $130 million against earnings when it obtained
new information indicating that experience had deteriorated further.
Outlook: Lincoln Re continues to enhance its reputation as a leading life-health
reinsurer in the world with the development of new knowledge-based tools and
marketing methods. It continues to build partnerships inside and outside the
traditional insurance marketplace.
16
Review of Operations: Investment Management (1)
Year Ended December 31 (in millions) 1998 1997 1996 1995
- -----------------------------------------------------------------------------------------------------------------
Financial Results
Fees:
Investment Advisory Fees........................................... $244.2 $219.6 $190.4 $130.1
Other Revenue and Fees............................................. 57.1 38.1 24.6 18.7
Income:
Income from Operations............................................. $20.8 $4.5 $10.2 $13.3
Realized Gain on Investments....................................... .7 3.3 5.2 4.3
----- --- ---- -----
Net Income..................................................... $21.5 $7.8 $15.4 $17.6
Income from Operations-Excluding
Amortization of Intangibles....................................... $49.6 $31.6 $34.1 $28.1
December 31 (in billions) 1998 1997 1996 1995
- -----------------------------------------------------------------------------------------------------------------
Assets Under Management
Retail-Fixed....................................................... $ 7.1 $ 6.9 $ 4.6 $ 4.8
Retail-Equity...................................................... 19.5 15.6 11.5 8.8
---- ---- ---- ---
Total Retail.................................................. 26.6 22.5 16.1 13.6
Institutional-Fixed................................................ 6.9 5.7 3.6 3.0
Institutional-Equity............................................... 25.3 25.8 23.5 22.1
---- ---- ---- ----
Total Institutional............................................ 32.2 31.5 27.1 25.1
Total Assets Under Management.................................. $58.8 $54.0 $43.2 $38.7
(1) Data shown in the 1995 column is for a partial year, as this segment was
added in April 1995 following the acquisition of Delaware Management Holdings,
Inc.
LNC's Investment Management segment reported record income from operations of
$20.8 million in 1998, compared with $4.5 million in 1997. The segment's 1998
operating income, excluding amortization of goodwill and other intangible
assets, was $49.6 million. The improvement was driven by increased revenues due
to record levels of inflows, higher net sales and the impact of the market
levels during the year.
LNIC's assets under management at December 31, 1998 were $58.8 billion, an
increase of $4.8 billion or 9% from December 31, 1997 assets of $54.0 billion,
primarily due to the upward trend of the market during the year. LNIC had record
levels of retail sales ($4.2 billion for 1998) and institutional inflows ($6.2
billion for 1998). In addition, LNIC's net retail cash flows were $2.0 billion
for the year versus $0.6 billion for 1997.
Domestic institutional assets represent $21.5 billion of the Investment
Management segment's total assets under management, while domestic retail assets
were $25.2 billion. International equity and global bond assets managed by
Delaware International Advisers, Ltd. account for $12.1 billion ($10.7 billion
institutional, $1.4 billion retail).
Profile: The companies that comprise this segment are: Delaware Management
Holdings, Inc.; Lynch & Mayer, Inc.; and Vantage Investment Advisors. Delaware
has its headquarters in Philadelphia, with affiliates in London, Denver and
Minneapolis. Lynch & Mayer and Vantage each maintain separate headquarters in
New York.
Although investment management has long been an area of expertise within LNC,
the addition of Delaware in 1995 signaled LNC's intention to expand its role as
a money manager and meet its objective of becoming a force in the financial
services industry.
During 1998, two external transactions positively affected the retail business
of LNIC: the acquisition of CIGNA's ACCRU business and the sale of Delaware's
Unit Investment Trust business to Nike Securities. These transactions reinforced
Delaware's market focus on core retail products, (i.e., mutual funds, variable
annuities and participant directed retirement plans) and strengthened Delaware's
retail distribution by the addition of the former CIGNA ACCRU wholesalers.
17
Delaware Investments' defined contribution area performed well in 1998, growing
to $5.9 billion in assets under management as of December 31, 1998. In the first
quarter of 1999, Lincoln Life's retirement area was combined under Delaware,
resulting in an organization with $9.6 billion in retirement assets. This
combination should result in a broader product range that is better serviced and
more profitable over the long term, with consistent asset growth because
retirement plans tend to be long-term relationships with continuing cash flow.
Complementary Approaches: Delaware, Lynch & Mayer and Vantage are encouraged to
preserve their complementary and distinctive investment styles. Diversity of
investment styles, as well as diversity of clients served, are prudent ways to
diversify risk in varying market environments.
Delaware is best known for a conservative, "value" equity investment style that
focuses on stocks with above average dividend yields. It is also recognized for
expertise in the small-cap and mid-cap growth styles and in municipal and
high-yield bonds. Delaware International Advisers, Ltd. in London provides
global and international equity and fixed income investment expertise.
Lynch & Mayer pursues a "growth" investment style and specializes in mid-cap and
large-cap equities. Vantage invests in undervalued companies that have strong
potential for above-average growth. It employs a disciplined, systematic,
risk-controlled investment approach, which delivers growth at a reasonable price
(GARP). Vantage is especially well known for its socially responsible investing
expertise, the practice of aligning investment objectives with social concerns
in one investment portfolio.
Distribution: Multiple distribution channels enable the businesses in the
Investment Management segment to deliver their broad range of products to an
expanding community of retail and institutional investors. Delaware markets its
mutual funds through regional and national broker/dealers, financial planners,
banks, and insurance agents, including those associated with the regional
marketing offices of Lincoln Life. Institutional products are marketed primarily
by each company's sales force through pension consultants and directly to
defined benefit and defined contribution plan sponsors, endowments, foundations
and insurance companies.
Retail Mutual Funds: The Investment Management segment's retail mutual fund and
wrap fee assets totaled $26.6 billion at December 31, 1998, an 18% increase from
$22.5 billion at December 31, 1997. Delaware offers 74 open-end retail mutual
funds and 8 closed-end funds with assets under management of $13.2 billion, an
increase of 7% over the $12.3 billion at December 31, 1997. The remaining $13.4
billion was from wrap-fee business and retail mutual funds managed by Lynch &
Mayer and Vantage.
The acquisition and integration of CIGNA's ACCRU business increased the number
of retail wholesalers to 51 as of December 31, 1998 from 37 as of December 31,
1997, strengthening Delaware's retail sales presence. The multi-manager ACCRU
variable annuity product, which was re-launched in the 4th quarter of 1998 under
the name Delaware-Lincoln ChoicePlus (Service Mark), has further broadened and
diversified Delaware's product line.
Delaware received excellent ratings in the 1998 Dalbar Broker/Dealer Survey that
rates the quality of marketing and service of approximately 25 large mutual fund
complexes. Delaware is the 4th highest ranked firm in the Main Office Operations
category, up from 8th last year. In addition, financial advisors ranked Delaware
2nd in Wholesaler Support and 1st in Dedicated Marketing Support. High ratings
are important because quality service is a key factor in growing and retaining
assets.
Improved performance and service contributed to Delaware increasing its retail
non-money market sales to $3.1 billion in 1998, up 55% in comparison with $2.0
billion for 1997. In addition, Delaware's net retail cash flows were $1.5
billion for 1998 versus $0.1 billion for 1997.
Institutional Investments: The institutional investment management business had
assets under management of $32.2 billion as of December 31, 1998, compared with
$31.5 billion at December 31, 1997. LNIC's institutional inflows of $6.2 billion
for 1998, were 22% higher than the $5.1 billion in 1997. Institutional net cash
flows, however, declined slightly to ($2.2) billion for 1998 versus ($2.0)
billion for 1997, largely due to client losses resulting from underperformance
in Lynch & Mayer's mid- and large-cap growth products.
Investment Performance: As of December 31, 1998, Delaware had 16 funds,
representing 28% of the company's mutual fund assets under management, ranked as
four- and five-star funds by Morningstar, Inc., a service that assigns
risk-adjusted performance ratings to mutual funds. One star is the lowest
rating; five
18
is the highest. High Morningstar ratings are significant because virtually all
equity net inflows are directed into funds with high risk-adjusted ratings.
Vantage manages the Lincoln Life MultiFund (Registered Trade Mark) Social
Awareness subaccount. The Fund has performed exceptionally well over the long
term. For the five years ended December 31, 1998, the Fund's annualized return
earned Vantage 30th place among 572 variable annuity funds.
Among U.S. institutional investment managers, Delaware produced strong results
in the value equity category, with a return of 11.19% for the year ended
December 31, 1998 that qualified as second quartile performance as measured by
Callan's Yield Universe.
Underperformance in Lynch & Mayer's mid-cap growth product resulted in the loss
of clients and a decline in institutional assets under management from $4.5
billion at December 31, 1997 to $2.8 billion at December 31, 1998. This issue
was addressed during 1998 and a restructured investment team is in place with a
mandate to improve performance.
Outlook: The rapid growth of Delaware's retail mutual fund business, both
through internal efforts and selective acquisitions, continues to be an
essential component of LNC's long-term strategy. Given the improvements realized
in 1998, LNC is well positioned for accelerating this growth.
Review of Other Operations:
Year Ended December 31 (in millions) 1998 1997 1996 1995 1994
- -------------------------------------------------------------------------------------------------------------------
Financial Results by Source
Lincoln Investment Management............................. $ .7 $ 1.4 $ 1.5 $ 1.7 $ 7.1
LNC Financing............................................. (52.5) (31.9) (49.7) (52.7) (31.7)
LNC Operations............................................ (18.5) (18.4) (14.8) (19.5) (21.8)
Other Corporate........................................... 2.9 (2.2) (.9) (1.5) (3.9)
Earnings from Unconsolidated Affiliate.................... -- -- -- 13.7 14.8
----- ------ ----- ----- -----
Income (Loss) from Operations......................... (67.4) (51.1) (63.9) (58.3) (35.5)
Realized Gain (Loss) on Investments....................... 8.6 5.4 2.2 6.1 (10.6)
Gain (Loss) on Sale of Subsidiaries....................... -- -- -- 58.3 48.8
Restructuring Charge...................................... (14.3) -- -- -- --
----- ------ ------ ------ ------
Net Income (Loss)..................................... $(73.1) $(45.7) $(61.7) $ 6.1 $ 2.7
The income (loss) from operations shown above includes the earnings from Lincoln
Investment Management, certain other operations that are not directly related to
the business segments and unallocated corporate revenues and expenses, such as
corporate investment income, interest expense on short-term and long-term
borrowings, and corporate overhead expenses. Prior to the date of sale in
October 1995, Other Operations also include LNC's investment in an
unconsolidated affiliate engaged in the employee life-health benefits business.
Lincoln Investment Management provides investment advisory services and asset
management services for LNC's Corporate portfolios as well as entities not owned
by LNC.
Corporate interest expense reported within the LNC financing line above was
greater for 1995 and 1996 than years prior to 1995 as the result of additions to
long-term debt and minority interest-preferred securities of subsidiary
companies. The 1997 amount was less than 1995 and 1996 due to reduced interest
expense and investment earnings in the fourth quarter of 1997 that resulted from
the use of proceeds from the sale of discontinued operations (see liquidity and
cash flow discussion on page 34). This benefit did not continue into 1998 as
most of these funds were used to purchase blocks of individual life insurance
and annuity business in January and October of 1998 (see note 11 to the
consolidated financial statements on page 66).
Net income (loss) shown above for "Other Operations" includes the items
described above under loss from operations plus the realized gain (loss) on sale
of certain investments, the gain (loss) on sale of subsidiaries (see note 11 to
the consolidated financial statements on page 65) and a restructuring charge.
The 1998 restructuring charge is the result of an organizational/expense review
and represents severance pay and space abandonment charges because of staff
reductions in the parent and other select companies.
19
Discussion and Analysis of Consolidated Investments
December 31 (in billions) 1998 1997 1996 1995 1994
- --------------------------------------------------------------------------------------------------------------------
Assets Managed (by advisor)
Investment Management Segment (1)......................... $ 58.8 $ 54.0 $ 43.2 $38.7 $ --
Lincoln Investment Management:
Regular Fees............................................ 1.9 2.9 8.2 4.2 11.8
At Cost For Business Units.............................. 38.7 33.9 30.6 33.3 36.3
Lincoln UK................................................ 7.6 6.8 6.1 5.3 1.0
Within Business Units (Policy Loans)...................... 1.8 .8 .8 .6 .6
Non-LNC Affiliates........................................ 25.2 20.7 16.2 12.7 9.4
----- ----- ----- ---- ----
Total Assets Managed.................................. $134.0 $119.1 $105.1 $94.8 $59.1
(1) See Investment Management segment data on page 16 for additional detail.
The following discussion covers select general investment matters. The review of
consolidated operations, which begins on page 20, includes the fact that LNC's
net investment income for the year ended December 31, 1998 was $2.7 billion, an
increase of 17% over 1997. Also, this discussion indicates that during 1998 net
gains on investments totaling $19 million were realized. The review of
consolidated financial condition begins on page 24 and discusses the composition
and quality of the LNC portfolio.
Investment Objective: LNC follows a balanced approach of investing for both
current income and total return, 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.
Asset 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; equities; mortgage loans on real
estate; real estate either wholly owned or in joint ventures and other long-term
investments. LNC purchases investments that have yield, duration and other
characteristics which take into account the liabilities of the products being
supported. The dominant investment held is fixed maturity securities, which
represent approximately 80% of the investment portfolio.
Fixed Maturity Performance: In 1998, the LNC fixed maturity portfolio produced a
return of 7.57%, compared to the Lehman Brothers Government/Corporate index (68%
government bonds, 32% corporate bonds) which produced 9.47%. The
underperformance relative to the index during 1998 is due to the investment
strategy of investing in bonds with sufficient spread to support long-term
insurance liabilities. During 1998, LNC experienced extreme spread widening in
all sectors which had the effect of reducing returns. The spread widening was
caused by the Emerging Markets crisis and the subsequent flight to high quality
U.S. treasury bonds by global investors. The government bond component of the
index performed very well relative to corporate bonds.
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.
20
REVIEW OF CONSOLIDATED OPERATIONS AND FINANCIAL CONDITION
Summary Information Increase
(Decrease)
Year Ended December 31 (in millions) 1998 1997 1996 1998 1997
- ----------------------------------------------------------------------------------------------------------------------
Continuing Operations:
Life insurance and annuity premiums.................... $ 985.6 $ 756.2 $ 728.7 30% 4%
Health premiums........................................ 635.1 572.5 790.5 11% (28%)
Insurance fees......................................... 1,274.6 832.2 713.5 53% 17%
Investment advisory fees............................... 227.1 204.9 180.8 11% 13%
Net investment income.................................. 2,681.4 2,250.8 2,087.9 19% 8%
Equity in earnings of
unconsolidated affiliates............................. 3.3 2.1 1.4
Realized gain (loss) on investments.................... 19.0 122.6 92.5
Other revenue and fees................................. 261.0 157.2 138.3 14%
Life insurance and annuity benefits ................... 2,762.0 2,358.7 2,036.3 17% 16%
Health benefits........................................ 566.9 833.1 673.6 (32%) 24%
Underwriting, acquisition, insurance
and other expenses.................................... 1,943.7 1,579.3 1,434.9 23% 10%
Interest and debt expenses............................. 117.1 92.5 84.7 27% 9%
Federal income taxes................................... 187.6 12.7 147.7
------- ------- ------
Net Income from Continuing Operations............. 509.8 22.2 356.4
Discontinued Operations:
Income prior to disposal............................... -- 134.9 157.2
Gain on disposal....................................... -- 776.9 --
------- ----- -------
Net Income....................................... $ 509.8 $ 934.0 $ 513.6
REVIEW OF CONSOLIDATED OPERATIONS
Some of the increases shown above are the result of the purchase of two blocks
of individual life insurance and annuity business in January and October of 1998
(see note 11 to the consolidated financial statements on page 66).
Life Insurance and Annuity Premiums
Life insurance and annuity premiums increased $229.4 million or 30% in 1998 and
$27.5 million or 4% in 1997 as the result of increases in volumes of business in
the Life Insurance & Annuities and Reinsurance segments. A portion of the
increase from the Life Insurance and Annuities segment in 1998 is the result of
the acquisition of the blocks of business. Barring the passage of unfavorable
tax legislation that would eliminate the tax-advantages for some of LNC's life
and annuity products, LNC expects growth in life insurance and annuity premiums
in 1999.
Health Premiums
Health premiums within the Reinsurance segment increased $62.6 million or 11% in
1998 after decreasing $218.0 million or 28% in 1997. The 1997 reduction included
planned cut backs in the level of business.
Insurance Fees
Insurance fees from universal life, other interest-sensitive life insurance
contracts and variable life insurance contracts increased $442.4 million or 53%
in 1998 and $118.7 million or 17% in 1997. These increases are the result of an
increase in the volume of transactions (including the addition of two blocks of
business in 1998 as described in note 11 to the consolidated financial
statements on page 66) and a market-driven increase in the value of existing
customer accounts upon which some of the fees are based in the Life Insurance &
Annuities and Lincoln UK segments. The growth in fees from this business is
expected to continue in 1999.
Investment Advisory Fees
Investment advisory fees increased $22.2 million or 11 % in 1998 and $24.1
million or 13% in 1997. These increases were the result of increased volumes of
business and an increase in the market value of customer accounts. The increased
volumes were the result of increasing the number of wholesalers and products,
including the addition of wholesalers in the bank market.
21
Net Investment Income
Net investment income increased $430.6 million or 19% in 1998 as the net result
of a 21% increase in mean invested assets, a decrease in the yield on
investments from 7.46% to 7.36% (all calculations on a cost basis). This
increase in mean invested assets is the result of increased volumes of business
in all the business segments and funds held in Other Operations that were
applied toward the purchase of a block of business in October of 1998 (see note
11 to the consolidated financial statements on page 66). The increase in the
Life Insurance and Annuities segment includes the impact of the acquisition of
the blocks of business in 1998 (see note 11 to the consolidated financial
statements on page 66). Net investment income increased $162.9 million or 8% in
1997 as a net result of a 9% increase in mean invested assets, a decrease in the
yield on investments from 7.52% to 7.46% (all calculations on a cost basis) and
a benefit of a reduction in the recurring adjustment of discount on
mortgage-backed securities. In 1997, this adjustment was a charge of $.4 million
versus a charge of $7.6 million in 1996. The increase in mean invested assets in
1997 was the result of increased volumes of business in the Life Insurance and
Annuities segment.
Realized Gain on Investments
The pre-tax realized gain on investments, net of related amortization and
expenses, was $19.0 million, $122.6 million and $92.5 million in 1998, 1997 and
1996, respectively. The after-tax gain in 1998, 1997 and 1996 was $13.7 million,
$72.9 million and $57.6 million, respectively. These gains were primarily the
result of the sale of investments. Write-downs and provisions for losses offset
a portion of the realized gains. During 1996, LNC completed a bulk sale of
performing and non-performing mortgage loans and real estate holdings through a
sealed bid process. The selling price for these holdings was $6.1 million in
excess of the carrying value, resulting in a gain on sale.
Securities available-for-sale, mortgage loans on real estate and real estate
that were deemed to have declines in fair value that were other than temporary
were written down. The fixed maturity securities to which these write-downs
apply were generally of investment grade quality at the time of purchase but
were classified as "below-investment-grade" at the time of the write-downs.
Also, 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 are disclosed within the notes to the
accompanying financial statements (see note 3 to the consolidated financial
statements on page 46).
Other Revenue and Fees
Other revenue and fees increased $103.8 million in 1998 and $18.9 million in
1997 as the result of increases in the volume of transactions in each of the
business segments.
Total Revenue
The level of revenue produced for select revenues listed above, primarily the
fee based revenues, such as insurance fees and investment advisory fees,
fluctuates from year to year because of changes in the equity investment
markets. For example, a 1% change in the equity investment market, as
represented by a measure such as the S&P 500, increases or decreases total
revenue by approximately $4.5 million based on the business currently managed.
Although the impact is not dollar for dollar because of the impact of Federal
income taxes, such changes in revenues also increases or decreases LNC's
earnings. Barring a major drop in the equity markets, LNC expects to produce
revenues in future years in excess of the revenues produced for the year ended
December 31, 1998.
Life Insurance and Annuity Benefits
Life insurance and annuity benefits increased $403.3 million or 17% in 1998 as
compared to 1997. This increase was the net result of increases of $470.8
million in the Life Insurance and Annuities segment (includes the addition of
two blocks of individual life insurance and annuity business as described in
note 11 to the consolidated financial statements on page 66) and increases in
the Reinsurance segment of $122.5 million being partially offset by a decrease
in the Lincoln UK segment of $190.0 million due to the absence of special
charges in 1998. Life insurance and annuity benefits in 1997 increased $322.4
million or 16% as compared to 1996. This increase was the result of increases of
$89.4 million or 6% from the Life Insurance and Annuities segment, $25.6 million
or 7% from the Reinsurance segment and $207.1 million from the Lincoln UK
segment. The Lincoln UK increase includes a change in estimate for its pension
mis-selling liability (see note 2 to the consolidated financial statements on
page 45).
Health Benefits
Health benefits increased $108.8 million or 24% in 1998 compared to 1997 health
benefits, excluding the 1997 special additions to the disability income and
personal accident programs reserves ($130.0 million and $113.7 million,
respectively) as the result of increased volumes of business. See note 2 to the
consolidated financial
22
statements on page 45. Health benefits increased $159.5 million in 1997 as the
net result of decreased volumes of business being more than offset by additions
to the reserves for disability income business and personal accident programs
within the Reinsurance segment.
Underwriting, Acquisition, Insurance and Other Expenses
These expenses increased $364.4 million or 23% in 1998 as the result of
increased business volumes in all business segments, the addition of the
operating costs associated with the block of business acquired in January 1998
and increased expenditures related to Year 2000 issues. Underwriting,
Acquisition, Insurance and other expenses increased $144.4 million or 10% in
1997. The primary drivers behind this increase beyond the general inflation rate
was increased business volumes in the various segments due to general growth and
the one-time and on-going costs associated with the acquisition of the two
blocks of business (see note 11 to the consolidated financial statements on page
66) and the write-off of deferred acquisition costs associated with the
disability income business (see note 2 to the consolidated financial statements
on page 45). In 1999, all business segments will continue to adjust staff levels
as appropriate to match business volumes.
Due to LNC's change in its business focus during the last few years (i.e.,
exited property-casualty business, added emphasis on annuities, life insurance
and investment management) as well as the on-going and increasing competitive
pressures within the business LNC operates in, the decision was made in 1998 to
initiate an organizational/expense review. This review, which was completed in
the fourth quarter of 1998, resulted in a one-time restructuring charge to
earnings. The amount of the pre-tax charge was $22.0 million and the estimate of
the reduction in future expenses once implementation is complete is $15-$20
million per year.
Interest and Debt Expense
Interest and debt expense increased $24.6 million or 27% in 1998 and $7.8
million or 9% in 1997. These increases were the result of increases in the
average debt outstanding and the impact of changes in the composition of debt
outstanding (see page 32). During 1998, Moody's re-affirmed LNC's debt ratings
as A2 ("Very Good, Strong or High"), Standard and Poor's changed its rating from
A to A- ("both Very Good, Strong or High") and Duff & Phelps changed its rating
from AA- ("Excellent") to A+ ("Very Good, Strong or High").
Federal Income Taxes
Federal income taxes increased $174.9 million in 1998 as the result of an
increase in the pre-tax earnings. Federal income taxes decreased from $147.7
million in 1996 to $12.7 million in 1997 as the result of a decrease in pre-tax
earnings.
Discontinued Operations
In 1997, lines were added to the income statement to accommodate the operating
activity and gain on sale associated with LNC's decision to sell its 83.3%
ownership in American States Financial Corporation (see note 11 to the
consolidated financial statements on page 65.
Summary
Net income for 1998 was $509.8 million compared with $934.0 million in 1997.
Excluding realized gain (loss) on investments, gain (loss) on sale of
subsidiaries, restructuring charges, discontinued operations and the 1997
special additions to the disability income, personal accident programs and UK
pension product reserves, all net of taxes, LNC earned $530.4 million for 1998
compared to $368.0 million in 1997. This increase is the result of increased
earnings from each of the business segments. In the fourth quarter of 1997 Other
Operations benefited from earnings on proceeds from discontinued operations.
This benefit did not continue into 1998 as most of these funds were used to
purchase a block of individual life and annuity business on January 2, 1998 (see
note 11 to the consolidated financial statements on page 66). Net income for
1997 was $934.0 million compared with $513.6 million in 1996. Excluding realized
gain (loss) on investments, gain on sale of subsidiaries, discontinued
operations and the 1997 special additions to reserves, LNC earned $368.0 million
for 1997 compared to $298.8 million in 1996. This increase is the result of
increased earnings in the Life Insurance & Annuities, Lincoln UK and Reinsurance
segments.
Century Compliance
The Year 2000 issue is pervasive and complex and affects virtually every aspect
of LNC's businesses. LNC's computer systems and interfaces with the computer
systems of vendors, suppliers, customers and business partners are particularly
vulnerable. LNC and its operating subsidiaries have been redirecting a large
portion of internal Information Technology ("IT") efforts and contracting with
outside consultants to update systems to address Year 2000 issues. Experts have
been engaged to assist in developing work plans and cost estimates and to
complete remediation activities.
23
For the year ended December 31, 1998, LNC identified expenditures of $37.5
million ($24.4 million after-tax) to address this issue. This brings the
expenditures for 1996-1998 to $48.5 million ($31.5 million after-tax). LNC's
financial plans for 1999-2000 include expected expenditures of an additional
$44.4 million ($28.9 million after-tax) bringing estimated overall Year 2000
expenditures to $92.9 million ($60.4 million after-tax). Because updating
systems and procedures is an integral part of LNC's on-going operations,
approximately 50% of expenditures shown above are expected to continue after all
Year 2000 issues have been resolved. Actual Year 2000 expenditures through
December 31, 1998 and future Year 2000 expenditures are expected to be funded
from operating cash flows. The anticipated cost of addressing Year 2000 issues
is based on management's current best estimates which were derived utilizing
numerous assumptions of future events, including the continued availability of
certain resources, third party modification plans and other factors. Such costs
will be monitored closely by management. Nevertheless, there can be no guarantee
that actual costs will not be higher than these estimated costs. Specific
factors that might cause such differences include, but are not limited to, the
availability and cost of personnel trained in this area, the ability to locate
and correct all relevant computer problems and other uncertainties.
The current scope of the overall Year 2000 program includes the following four
major project areas: 1) addressing the readiness of business applications,
operating systems and hardware on mainframe, personal computer and Local Area
Network platforms (IT); 2) addressing the readiness of non-IT embedded software
and equipment (non-IT); 3) addressing the readiness of key business partners and
4) establishing year 2000 contingency plans.
The projects to address IT and non-IT readiness have four major phases. Phase
one involves raising awareness and creating an inventory of all IT and non-IT
assets. The second phase consists of assessing all items inventoried to
initially determine whether they are affected by the Year 2000 issue and
preparing general plans and strategies. The third phase entails the detailed
planning and remediation of affected systems and equipment. The last phase
consists of testing to verify Year 2000 readiness.
LNC has completed these four phases for over two-thirds of its high priority IT
systems, including those provided by software vendors. While LNC's year 2000
program for nearly all high priority IT systems is expected to be completed in
the first quarter of 1999, phase four, for a small but important subset of these
systems, will continue through the end of the second quarter 1999. As of
December 31, 1998 the status of projects addressing readiness of IT assets is:
100% of IT assets have been inventoried (Phase 1) and assessed (Phase 2); 97% of
IT projects have been through the remediation phase (Phase 3) with the last
project scheduled for completion by the end of March 1999; and 71% of IT
projects have completed the testing phase (Phase 4) with the last project
scheduled to finish testing by the end of June 1999. A portion of the effort
that extends into 1999 is dependent on outside third parties and is behind the
original schedule. LNC is working with these parties to modify the completion
schedule.
As of December 31, 1998 the status of projects that address readiness of high
priority non-IT assets, is:100% of non-IT assets have been inventoried (Phase 1)
and assessed (Phase 2); 72% of non-IT projects addressing remediation (Phase 3)
have been completed and 23% of non-IT projects have completed the testing phase
(Phase 4). LNC expects to have all phases related to high priority non-IT
completed by the end of October 1999.
Concurrent with the IT and non-IT projects, the readiness of key business
partners is being reviewed and Year 2000 contingency plans are being developed.
The most significant categories of key business partners are financial
institutions, software vendors, and utility providers (gas, electric and
telecommunications). Surveys have been mailed to these key business partners.
Based on responses received, current levels of readiness are being assessed,
follow-up contacts are underway, alternative strategies are being developed and
testing is being scheduled where feasible. This effort is expected to continue
well into 1999. As noted above, software vendor assessments are considered part
of the IT projects and, therefore, would follow the schedule shown above for
such projects.
While LNC is working to meet the schedules outlined above, some uncertainty
remains. Specific factors that give rise to this uncertainty include a possible
loss of technical resources to perform the work, failure to identify all
susceptible systems, non-compliance by third parties whose systems and
operations impact LNC and other similar uncertainties.
A worst case scenario might include LNC's inability to achieve Year 2000
readiness with respect to one or more of LNC's significant policyholder systems,
resulting in a material disruption to LNC's operations. Specifically, LNC could
experience an interruption in its ability to collect and process premiums or
deposits,
24
process claim payments, accurately maintain policyholder information, accurately
maintain accounting records, and/or perform adequate customer service. Should
the worst case scenario occur, it could, depending on its duration, have a
material impact on LNC's results of operations and financial position. Simple
failures can be repaired and returned to production within a matter of hours
with no material impact. Unanticipated failures with a longer service disruption
period would have a more serious impact. For this reason, LNC is placing
significant emphasis on risk management and Year 2000 contingency planning. LNC
is in the process of modifying its contingency plans to address potential year
2000 issues. Where these efforts identify high risks due either to unacceptable
work around procedures or significant readiness risks, appropriate risk
management techniques are being defined. These techniques, such as resource
shifting or use of alternate providers, will be employed to provide stronger
assurances of readiness. LNC has gone through exercises to identify worst case
scenario failures. At this time, LNC believes its plans are sufficient to
mitigate identified worst case scenarios.
REVIEW OF CONSOLIDATED FINANCIAL CONDITION
Some of the increases in the balance sheet accounts described below are a result
of the purchase of two blocks of individual life insurance and annuity business
in January and October of 1998 (see note 11 to the consolidated financial
statements on page 66).
Investments
The investment portfolio, excluding cash and invested cash, is comprised of
fixed maturity and equity securities; mortgage loans on real estate; real
estate, either wholly owned or joint ventures; and other long-term investments.
LNC purchases investments for its segmented portfolios with yield, duration and
other characteristics that take into account the liabilities of the products
being supported. The total investment portfolio increased $8.1 billion in 1998.
This increase was the net result of increases from 1) the addition of $7.7
billion in invested assets related to the two blocks of business acquired in
1998, 2) the increase in fair value of securities available-for-sale and 3) the
new purchases of investments from cash flow generated by the business units
being partially offset by the continuation of fixed annuity contractholders
opting to transfer funds to variable annuity contracts.
LNC maintains a high-quality fixed maturity securities portfolio. As of December
31, 1998, $9.9 billion or 32.7% of its fixed maturity securities portfolio had
ratings of AA or better. Fixed maturity securities with below- investment-grade
ratings (BB or less) were $2.1 billion or 7.0% of the total fixed maturity
securities portfolio (see note 3 to the consolidated financial statements on
page 47). The below-investment-grade fixed maturity securities represent 5.6% of
LNC's total investment portfolio. The interest rates available on these below-
investment-grade securities are significantly higher than are available on other
corporate debt securities. Also, the risk of loss due to default by the borrower
is significantly greater with respect to such below investment grade securities
because these securities are generally unsecured, often subordinated to other
creditors of the issuer and issued by companies that usually have high levels of
indebtedness. LNC attempts to minimize the risks associated with these below
investment grade securities by limiting the exposure to any one issuer and by
closely monitoring the credit worthiness of such issuers. For the year ended
December 31, 1998, the aggregate cost of below investment grade securities
purchased was $1.6 billion. Aggregate proceeds from such investments sold were
$1.1 billion, resulting in a realized pre-tax loss at the time of sale of $55.2
million.
LNC's entire fixed maturity and equity securities portfolio is classified as
"available-for-sale" and is carried at fair value. Changes in fair values, net
of related deferred acquisition costs, amounts required to satisfy policyholder
commitments and taxes are charged or credited directly to shareholders' equity.
Note 3 to the consolidated financial statements on page 46 shows the gross
unrealized gains and losses as of December 31, 1998.
LNC's fixed maturity securities available-for-sale include mortgage-backed
securities. The mortgage-backed securities included in LNC's investment
portfolio are subject to risks associated with variable prepayments. This may
result in these securities having a different actual cash flow and maturity than
planned at the time of purchase. Securities that have an amortized cost greater
than par and backed by mortgages that prepay faster than expected will incur a
reduction in yield or a loss. Those securities with an amortized cost lower than
par that prepay faster than expected will generate an increase in yield or a
gain. In addition, LNC may incur reinvestment risks if market yields are lower
than the book yields earned on the securities. Prepayments occurring slower than
expected have the opposite impact. LNC may incur disinvestment risks if market
yields are higher than the book yields earned on the securities and LNC is
forced to sell the securities. The degree to which a security is susceptible to
either gains or losses is influenced by 1) the difference between its amortized
cost and par, 2) the relative sensitivity of the underlying mortgages backing
the assets to
25
prepayment in a changing interest rate environment and 3) the repayment priority
of the securities in the overall securitization structure.
LNC limits the extent of its risk on mortgage-backed securities by prudently
limiting exposure to the asset class, by generally avoiding the purchase of
securities with a cost that significantly exceeds par, by purchasing securities
backed by stable collateral, and by concentrating on securities with enhanced
priority in their trust structure. Such securities with reduced risk typically
have a lower yield (but higher liquidity) than higher-risk mortgage-backed
securities. At selected times, higher-risk securities may be purchased if they
do not compromise the safety of the general portfolio. At December 31, 1998, 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. Note 3 to the consolidated financial statements on page 48 shows
additional detail about the underlying collateral.
As of December 31, 1998, mortgage loans on real estate and investments in real
estate represented 11.5% and 1.3% of the total investment portfolio. As of
December 31, 1998, the underlying properties supporting the mortgage loans on
real estate consisted of 25.4% in commercial office buildings, 33.5% in retail
stores, 18.8% in apartments, 12.6% in industrial buildings, 4.0% in
hotels/motels and 5.7% in other. In addition to the dispersion by type of
property, the mortgage loan portfolio is geographically diversified throughout
the United States.
Cash and Invested Cash
Cash and invested cash decreased by $1.4 billion in 1998. This decrease is the
result of paying out the funds that had been accumulated at the end of 1997 in
anticipation of the purchase of a block of individual life and annuity business
on January 2, 1998 (see note 11 to the consolidated financial statements on page
66).
Deferred Acquisition Costs
Deferred acquisition costs increased $340.6 million in 1998. This increase was
the net result of an increase related to the growth in business being partially
offset by reductions related to the increase in unrealized gain on securities
available-for-sale.
Premiums and Fees Receivable
Premiums and fees receivable increased $48.7 million in 1998 as the result of
increased volumes of business in the Life Insurance & Annuities and Reinsurance
segments.
Assets Held in Separate Accounts
This asset account, as well as the corresponding liability account, increased by
$6.3 billion in 1998 as a result of increases in annuity and pension funds under
management. This increase resulted from new deposits, market appreciation and
the continuation of fixed annuity contractholders opting to transfer funds to
variable annuity contracts.
Amounts Recoverable from Reinsurers
The increase of $776.3 million in amounts recoverable from reinsurers was the
result of an increased volume of business ceded in the Life Insurance and
Annuities segment.
Goodwill and Other Intangible Assets
The increase of $1.0 billion and $1.2 billion, respectively, is the net result
of additions related to business acquired (see note 11 to the consolidated
financial statements on page 66) being more than the on-going amortization.
Other Assets
The decrease in other assets of $76.8 million is the result of having a lower
receivable related to investment securities sold in the last few days of 1998
versus the end of 1997.
Total Liabilities
Total liabilities increased by $16.3 billion in 1998. The primary item
underlying this increase is the addition of the blocks of individual life and
annuity business described above. Insurance policy reserves increased $8.9
billion as a result of the new blocks of business and increased levels of
business in the Life Insurance and Annuities segment. Contractholder funds
increased $689.7 million which is the net result of additions related to the
block of business acquired and new deposits being partially offset by the
withdrawal upon maturity of guaranteed interest contracts. Liabilities related
to separate accounts increased $6.3 billion (see discussion of Assets Held in
Separate Accounts above). Total debt increased $648.5 million as the result of
26
issuing new debt in the first and third quarters of 1998 (see note 5 to the
consolidated financial statements on page 51). The decrease in the remaining
liabilities of $225.4 is the net amount from an increase in the expected payouts
for securities purchased in the last few days of 1998 versus a lower volume of
such transactions late in 1997 being more than offset by the Federal income tax
decrease.
While it is management's judgement that, based on available information, the
appropriate level of liabilities have been recorded, LNC has areas where changes
in estimates of related liabilities required could occur in the near term. These
areas include claims for disability income coverages, liabilities and recoveries
related to inappropriate selling of products in the United Kingdom, liabilities
for personal accident programs, liabilities for marketing and compliance issues
and the reserve for the run-off of group pension annuities (see note 7 to the
consolidated financial statements on page 54).
Shareholders' Equity
Total shareholders' equity increased $405.0 million during the year ended
December 31, 1998. Excluding the increase of $116.4 million related to an
increase in the unrealized gain (loss) on securities available-for- sale,
shareholders' equity increased $288.6 million. This increase in shareholders'
equity was the net result of increases due to $509.8 million of net income,
$48.7 million from the issuance of common stock related to benefit plans and
$3.8 million related to an increase in the accumulated foreign exchange gain
being offset by $211.8 million related to the declaration of dividends to
shareholders, $14.8 million of issuance costs related to an offering of FELINE
PRIDES and $46.9 million for the retirement of common stock.
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, 1998, statutory-basis capital
for each of LNC's U.S. insurance subsidiaries was substantially in excess of
regulatory action levels of risk- based capital required by the jurisdiction of
domicile.
As noted above, shareholders' equity includes net unrealized gain (loss) on
securities available-for-sale. At December 31, 1998, the book value of $53.18
per share included $5.45 of unrealized gains on securities and at December 31,
1997, the book value of $49.27 per share included $4.31 of unrealized gains on
securities.
A significant portion of both realized and unrealized gains or losses on
investments that support long-term life insurance, pension and annuity contracts
are expected to be applied to contract benefits. These realized and unrealized
gains or losses are included in net income and shareholders' equity,
respectively. Current accounting standards do not require or permit adjustment
of policyholder reserves to recognize the full effect of these realized and
unrealized gains or losses on future benefit payments in the absence of a
contractual obligation requiring their attribution to policyholders.
LIQUIDITY AND CASH FLOW
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 a 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 on page 39 indicate that operating
activities provided cash of $1.3 billion, $1.1 billion and $1.4 billion in 1998,
1997 and 1996, 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 1998, LNC filed a shelf registration for $1.3
billion which included the right to offer regular debt, preferred stock, common
stock or various forms of hybrid securities. This $1.3 billion filing included
an aggregate of $300 million that had not been utilized from a previously filed
shelf registration. In December, 1998 LNC combined the unused portion of another
previously filed shelf
27
registration. The combination of these two filings, less securities offered in
1998 (see below), resulted in an unused balance as of December 31, 1998 of $825
million that would allow LNC to issue various securities. The hybrid securities
offerings utilize six subsidiaries (Lincoln National Capital I, II, III, IV, V
and VI) which were formed for the specific purpose of issuing such securities.
All of these subsidiaries' common securities are owned by LNC. Cash funds are
also available from LNC's revolving credit agreement, which provides for
borrowing up to $750 million (see note 5 to the consolidated financial
statements on page 52).
In 1998, LNC issued $300 million of long-term debt, $200 million of Series C
Trust Originated Preferred Securities and $230 million of FELINE PRIDES. Also
LNC purchased and retired; 623,281; 4,948,900 and 694,582 shares of common stock
at a cost of $46.9 million; $325.3 million and $35.0 million in 1998, 1997 and
1996, respectively. The 5,572,181 shares purchased in 1997 - 1998 includes
4,993,281 shares at a cost of $341.8 million that have been purchased since the
June 1997 board authorization to repurchase up to $500 million of common stock.
This leaves a Board authorization to repurchase an additional $158.2 million of
LNC's common stock as of December 31, 1998. Also LNC issued 1,323,144 shares of
LNC common stock in 1997 to purchase subsidiary companies.
Another transaction that occurred in 1997 that had a major impact on LNC's cash
flow was the sale of a subsidiary for $2.65 billion (see note 11 to the
consolidated financial statements on page 65). LNC used these proceeds to 1)
repurchase $341.8 million of its own common stock, 2) retire $86.7 million in
long-term debt, 3) fund the purchase of a 49% interest in Seguros Serfin Lincoln
for $85.0 million, 4) pay the $447.6 million of taxes related to the gain on
sale of discontinued operations and 5) purchase a block of individual life
insurance and annuity business for $1.4 billion (see note 11 to the consolidated
financial statements on page 66). The remaining balance was initially applied to
pay off a portion of LNC's short-term debt and invested for general corporate
purposes, then later used to fund a portion of the purchase of another block of
individual life insurance business.
In order to maximize the use of available cash, the holding company (Lincoln
National Corporation) 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.
Holding Company Cash Flow
Year Ended December 31 (in millions) 1998 1997 1996
- ------------------------------------------------------------------------------------------------------------------
Dividends from subsidiaries:
Lincoln Life.................................................. $ 220.0 $ 150.0 $ 135.0
American States (subsidiary subsequently
transferred to discontinued operations ).................... -- 24.7 74.7
Other......................................................... 54.8 63.2 96.4
Net investment income........................................... 7.0 10.7 4.3
Operating expenses.............................................. (25.7) (36.9) (44.6)
Interest........................................................ (95.1) (84.1) (67.8)
Net sales (purchases) of investments............................ 188.9 4.2 91.2
Increase (decrease) in cash collateral on
loaned securities.............................................. (73.1) (21.9) (53.4)
Decrease (increase) in investment in subsidiaries............... (159.5) (116.8) 217.8
Sale of subsidiary (discontinued operations).................... (124.2) 822.5 --
(Investment in) sale of unconsolidated affiliates............... -- (69.0) (16.0)
Net increase (decrease) in debt................................. 268.6 (72.7) (178.5)
Decrease (increase) in receivables from subsidiaries............ 280.3 (23.0) (36.0)
Increase in loans from subsidiaries............................. 251.3 454.3 28.2
Decrease (increase) in loans to subsidiaries.................... (1,272.7) 414.7 (303.5)
Federal income taxes paid....................................... (374.3) (158.0) (143.8)
Net tax receipts from subsidiaries.............................. 354.7 206.8 122.3
Dividends paid to shareholders.................................. (209.0) (201.9) (191.2)
Common stock issued for benefit plans........................... 48.7 33.2 (0.2)
Retirement of common stock...................................... (46.9) (327.6) (32.7)
Other........................................................... (28.4) 24.0 (35.2)
The table above shows the cash flow activity for the holding company from 1996
through 1998. The line, "net tax receipts from (payments to) subsidiaries",
recognizes that the holding company receives tax payments from subsidiaries,
pays the consolidated tax liability and reimburses subsidiaries for the tax
effect of any taxable operating and capital losses.
28
LNC's insurance subsidiaries are subject to certain insurance department
regulatory restrictions as to the transfer of funds and payment of dividends to
the holding company. Generally, these restrictions pose no short-term liquidity
concerns for the holding company. However, as discussed in detail within note 7
on page 54, the acquisition of two blocks of business in 1998 will place further
restrictions on the ability of LNC's primary insurance subsidiary, Lincoln
National Life Insurance Company ("Lincoln Life"), to declare and pay dividends.
As a result of these acquisitions, Lincoln Life's statutory earned surplus will
be negative and it will be necessary for Lincoln Life to obtain the prior
approval of the Indiana Insurance Commissioner before paying any dividends to
LNC until such time its statutory earned surplus is positive. It is expected
that statutory earned surplus will return to a positive position within two to
three years from the closing of the Aetna transaction assuming a level of
statutory earnings coinciding with recent earnings patterns. If statutory
earnings are less than recent patterns due, for example, to adverse operating
conditions or further indemnity reinsurance transactions of this nature, the
statutory earned surplus may not return to a positive position as soon as
expected. Although no assurance can be given, management believes that the
approvals for the payment of dividends in amounts consistent with those paid in
the past can be obtained. In the event such approvals are not obtained,
management believes that LNC can obtain the funds required to satisfy its
obligations from its existing credit facilities and other sources.
Effect of Inflation
LNC's insurance affiliates, as well as other companies in the insurance
industry, attempt to minimize the effect of inflation on their revenues and
expenses by anticipating inflationary trends in the pricing of their products.
Inflation, except for changes in interest rates, does not have a significant
effect on LNC's balance sheet due to the minimal amount of dollars invested in
property, plant and equipment and the absence of inventories.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Market Risk Exposures of Financial Instruments
LNC analyzes and manages the risks arising from market exposures of financial
instruments, as well as other risks, in an integrated asset-liability management
process that takes diversification into account. By aggregating the potential
effect of market and other risks of the entire enterprise, LNC estimates,
reviews and in some cases manages the risk to its earnings and shareholder
value. LNC has material exposures to several market risks including interest
rate, default risk, foreign currency exchange and equity price risks.
The exposures of financial instruments to market risks, and the related risk
management processes, are most important in the Life Insurance and Annuities
segment. This segment is where most of the invested assets support accumulation
and investment oriented insurance products. As an important element of its
integrated asset-liability management process, LNC uses derivatives to minimize
the effects of changes in interest rate levels and the shape of the yield curve.
In this context, derivatives are designated as a hedge and serve to reduce
interest rate risk by mitigating the effect of large rises in interest rates on
LNC's stream of earnings. Additional market exposures exist in LNC's other
general account insurance products and in its debt structure and derivatives
positions. The primary sources of market risk are: 1) substantial, relatively
rapid and sustained increases or decreases in interest rates, 2) fluctuations in
currency exchange rates 3) a sharp drop in equity market values. Each of these
market risks are discussed in detail in the following pages.
1) Interest Rate Risk
Accumulation and Investment Oriented Insurance Products. General account assets
supporting accumulation and investment oriented insurance products total $26.0
billion or 69% and $22.4 billion or 75% of total invested assets at December 31,
1998 and 1997, respectively. Fixed maturity and equity securities are held at
fair value on the balance sheet, mortgage loans on real estate are held at
amortized cost and real estate is held at cost less depreciation while
liabilities are generally held at account values less surrender charges (see
note 1 to the consolidated financial statements on page 42). The fair values for
mortgage loans on real estate and guaranteed interest rate contracts are
calculated on a discounted cash flow basis while fixed annuities and other
deposit liabilities are at policy cash surrender value (see note 8 to the
consolidated financial statements on page 60).
With respect to these products, LNC seeks to earn a stable and profitable spread
between investment income and interest credited to account values. If LNC has
adverse experience on investments that cannot be passed onto customers, its
spreads are reduced. Alternatively, LNC may seek to maintain spreads and this
may result in crediting rates that are not competitive in the market place. This
strategy could result in adverse surrender experience on policies and could
force LNC to liquidate a portion of its portfolio to fund excess cash surrender
value benefits.
29
LNC does not view the near term risk to spreads over the next twelve months to
be material. The combination of a probable range of interest rate changes over
the next twelve months, asset-liability management strategies, flexibility in
adjusting crediting rate levels and protection afforded by policy surrender
charges and other switching costs all work together to minimize this risk. The
interest rate scenarios of concern are those in which there is a substantial,
relatively rapid increase or decrease in interest rates that is then sustained
over a long period.
Fixed Deferred Annuities. Assets of $17.2 billion and $15.6 billion at December
31, 1998 and 1997, respectively, supports the biggest category of accumulation
and investment oriented insurance products, fixed deferred annuities. For these
products, LNC may adjust renewal crediting rates monthly or annually, subject to
guaranteed minimums ranging from 3% to 5%. The higher minimums apply to in-force
blocks of older products that no longer are sold. Annuity insurance customers
have the right to surrender their policies at account value less a surrender
charge that grades to zero over periods ranging from 5 to 10 years from policy
issue date or, in some cases, the date of each premium received. Due to LNC's
ability to change crediting rates to reflect investment experience, the
underlying assets are assumed to be a good proxy for the interest rate risk
inherent in these liabilities. This assumption is appropriate for probable
movements in interest rates over the next 12 months. This assumption may not be
appropriate for a substantial, relatively rapid increase or decrease in interest
rates that is then sustained over a long period.
Universal Life. LNC had $6.1 billion and $3.4 billion in assets at December 31,
1998 and 1997, respectively, supporting universal life insurance on which it has
the right to adjust renewal crediting rates subject to guaranteed minimums
ranging from 4% to 6% at December 31, 1998. Similar to annuities, universal life
insurance customers have the right to surrender their policies at account value
less a surrender charge that grades to zero over periods ranging from 10 to 20
years from policy issue date or, in some cases, the date of each premium
received.
Guaranteed Interest Contracts and Group Pension Annuities. LNC had assets
totaling $2.7 billion and $3.4 billion at December 31, 1998 and 1997,
respectively, that support guaranteed interest contracts, group pension
annuities and immediate annuities. Generally, the cash flows expected on these
liabilities do not vary with fluctuations in market interest rates and are not
adjustable by LNC. Accordingly, if experience on the assets supporting these
products is more adverse than the assumptions used in pricing the products,
spreads will tend to be below expectations. LNC limits exposure to interest rate
risk by managing the duration and maturity structure of each investment
portfolio in relation to the liabilities it supports.
Other General Account Insurance Products. LNC had $11.9 billion and $7.4 billion
of assets at December 31, 1998 and 1997, respectively, supporting general
account products, including disability income and term life insurance. For these
products, the liability cash flows may have actuarial uncertainty. However,
their amounts and timing do not vary significantly with interest rates. LNC
limits interest rate risk by analyzing the duration of the projected cash flows
and structuring investment portfolios with similar durations.
Interest Rate Risk--Falling Rates. Interest rates fell in 1995, rose again in
1996 and declined in 1997 and 1998. For example, the five-year Treasury yield
declined from 7.8% in 1994 to 5.4% at the end of 1995, increased to 6.2% by the
end of 1996, decreased to 5.7% by the end of 1997 and decreased to 4.5% by the
end of 1998. Under scenarios in which interest rates fall and remain at levels
significantly lower than those prevailing at December 31, 1998, minimum
guarantees on annuity and universal life insurance policies (generally 3% to 5%
or an average of approximately 4%) could cause the spread between the yield on
the portfolio and the interest rate credited to policyholders to deteriorate.
Select contracts that specify these minimum guarantees can be amended
periodically to reflect current interest rate conditions. The earned rate on the
annuity and universal life insurance portfolios averaged 8% and 7.7%,
respectively, for the year ended December 31, 1998, providing a cushion for
further decline before the earned rates would be insufficient to cover minimum
guaranteed rates plus the target spread. The maturity structure and call
provisions of the related portfolios are structured to afford protection against
erosion of this cushion for a period of time. However, spreads would be at risk
if interest rates continued to fall and remained lower for a long period. LNC
manages these exposures by maintaining a suitable maturity structure and by
limiting its exposure to call risk in each respective investment portfolio.
LNC believes that the portfolios supporting its accumulation and investment
oriented insurance products have a prudent degree of call protection
individually and on a consolidated basis. As of December 31, 1998 the
mortgage-backed securities ("MBS") and asset-backed securities ("ABS") portion
of the portfolio represented a total of $5.1 billion or 20% of the $26.0 billion
of general account assets supporting such products. Of this
30
portfolio, 15% of general account assets or $4.0 billion is subject to
residential prepayment risk from investments made in Collateralized Mortgage
Obligations ("CMOs"), mortgage pass-throughs, manufactured housing and home
equity loans. As of December 31, 1997 the MBS and ABS portion of the portfolio
represented a total of $4.5 billion or 20% of the $22.4 billion of general
account assets supporting such products. LNC's MBS portfolio has equal to or
slightly less prepayment risk than the MBS pass-through market in general
primarily due to holding more seasoned securities in the portfolio. Due to the
combination of recent lower interest rates and increased efficiency by
mortgage-holders in exercising their prepayment options, the riskiness of these
securities has increased over the last few years without a compensating
adjustment to risk premiums. This trend has also reduced the degree of
protection provided by the purchase of protected amortization class CMOs. As a
result, LNC has reduced its exposure to the MBS asset class in recent years.
Interest Rate Risk--Rising Rates. For both annuities and universal life
insurance, a rapid and sustained rise in interest rates poses risks of
deteriorating spreads and high surrenders. The portfolios supporting these
products have fixed-rate assets laddered over maturities generally ranging from
one to ten years or more. Accordingly, the earned rate on each portfolio lags
behind changes in market yields. As rates rise, the lag may be increased by
slowing MBS prepayments. The greater and faster the rise in interest rates, the
more the earned rate will tend to lag behind market rates. If LNC sets renewal
crediting rates to earn the desired spread, the gap between its renewal
crediting rates and competitors' new money rates may be wide enough to cause
increased surrenders. If LNC credits more competitive renewal rates to limit
surrenders, its spreads will narrow. LNC devotes extensive effort to evaluating
these risks by simulating asset and liability cash flows for a wide range of
interest rate scenarios. Such analysis has led to adjustments in the target
maturity structure and to hedging the risk of rising rates by buying
out-of-the-money interest rate cap agreements and swaptions (see discussion
below). With this hedge, the potential adverse impact of a rapid and sustained
rise in rates is kept within corporate risk tolerances. LNC believes that the
risks of rising interest rates are also mitigated by its emphasis on periodic
premium products.
Debt. As of December 31, 1998, LNC had short-term debt, long-term debt and
minority interest-preferred securities of subsidiary companies totaling $1.8
billion ($1.6 billion with fixed rates and $214.4 million with floating rates).
As of December 31, 1997, LNC had short-term debt, long-term debt and minority,
interest- preferred securities of subsidiary companies totaling $1.1 billion
($835.6 million with fixed rates and $287.6 million with floating rates). LNC
manages the timing of maturities and the mixture of fixed-rate and floating-rate
debt as part of the process of integrated management of interest rate risk for
the entire enterprise.
Derivatives. As indicated in note 7 to the consolidated financial statements on
page 57, LNC has entered into derivative transactions to reduce its exposure to
rapid rises in interest rates. The four programs discussed below are used to
help LNC achieve more stable margins while providing competitive crediting rates
to policyholders during periods when interest rates are rising. Failure to
maintain competitive crediting rates could cause policyholders to withdraw their
funds and place them in more competitive products.
LNC uses interest rate cap agreements to hedge against the negative impact of a
significant and sustained rise in interest rates. Interest rate caps are
contracts that require counterparties to pay LNC at specified future dates the
amount, if any, by which a specified market interest rate exceeds the cap rate
stated in the agreements, applied to a notional amount. As of December 31, 1998,
LNC had agreements with notional amounts of $4.1 billion with cap rates ranging
from 250 to 800 basis points above prevailing interest rates. The cap rates in
some contracts increase over time. These agreements expire in 1999 through 2006.
LNC also uses swaptions to hedge against the negative impact of a significant
and sustained rise in interest rates. Swaptions are options to enter into a swap
at a specified future date. If the option is exercised at expiration, the option
is either settled in cash or exercised into a swap agreement. LNC purchases
swaptions to be settled in cash. At expiration, the counterparty is required to
pay LNC the amount, if any, of the present value of the difference between the
fixed rate on a market rate swap and the strike rate stated in the agreement,
applied to a notional amount. As of December 31, 1998, LNC had agreements with
notional amounts of $1.9 billion with strike rates ranging from 350 to 900 basis
points above prevailing interest rates. These agreements expire in 1999 through
2003.
For future periods, the fair value of LNC's interest rate caps and swaptions
depends on the levels of interest rates on U.S. Treasury securities with
maturities of two, five, seven and ten years and U.S. dollar swap rates with
five, seven and ten year maturities. The table below analyzes fair value levels
at December 31, 1998 and for the next five years if the rates were 2%, 4%, 6%,
8%,10% or 12% higher than they were at December
31
31, 1998. In relation to the level of these rates at December 31, 1998, the cap
and swaption rates were from 2.5% to 9.0% out-of-the-money, i.e., higher. The
table below shows the fair value levels of interest rate caps and swaptions
under these scenarios.
Year Ended December 31, 1998 (in millions) 1998 1999 2000 2001 2002 2003
- -------------------------------------------------------------------------------------------------------------------
No change........................................ 3.4 1.6 .5 .1 -- --
Up 2%.......................................... 30.1 20.4 9.4 3.4 1.1 0.5
Up 4%.......................................... 111.3 93.1 62.9 38.6 15.1 4.6
Up 6%.......................................... 267.1 286.9 249.6 137.8 86.8 47.3
Up 8%.......................................... 466.0 412.2 346.8 278.7 203.8 130.7
Up 10%........................................... 666.5 592.6 513.7 429.0 330.0 239.6
Up 12%........................................... 856.5 770.7 683.6 587.4 474.8 367.4
LNC uses exchange-traded financial futures contracts and options on financial
futures to hedge against interest rate risks and to manage duration of a portion
of its fixed maturity securities. Financial futures contracts obligate LNC to
buy or sell a financial instrument at a specified future date for a specified
price. They may be settled in cash or through delivery of the financial
instrument. Cash settlements on the change in market values of financial futures
contracts are made daily. Put options on a financial futures contract give LNC
the right, but not the obligation, to assume a long or short position in the
underlying futures contract at a specified price during a specified time period.
As of December 31, 1998, LNC did not have any open futures or options on
futures.
LNC uses interest rate swap agreements to hedge its exposure to floating rate
bond coupon payments, replicating a fixed rate bond. An interest rate swap is a
contractual agreement to exchange payments at one or more times based on the
actual or expected price, level, performance or value of one or more underlying
interests. LNC is required to pay the counterparty the stream of variable coupon
payments generated from the bonds, and in turn, receives a fixed payment from
the counterparty, at a predetermined interest rate. LNC also uses interest rate
swap agreements to hedge its exposure to interest rate fluctuations related to
the anticipated purchase of assets that support newly acquired blocks of
business. As of December 31, 1998, LNC had swap agreements with a notional
amount of $258.3 million that expires in 2000 through 2009.
In addition to continuing existing programs, LNC may use derivative products in
other strategies to limit risk and enhance returns, particularly in the
management of investment spread businesses. LNC has established policies,
guidelines and internal control procedures for the use of derivatives as tools
to enhance management of the overall portfolio of risks assumed in LNC's
operations.
The table below provides a general measure of LNC's significant interest rate
risk (principal amounts are shown by year of maturity and include amortization
of premiums and discounts) as of December 31, 1998.
There- Fair
(in millions of dollars) 1999 2000 2001 2002 2003 after Total Value
- --------------------------------------------------------------------------------------------------------------------
Rate Sensitive Assets:
Fixed maturity securities....... 915 975 1,308 1,309 1,752 25,543 31,802 30,233
Average interest rate............ 7.48% 7.21% 7.43% 7.95% 7.32% 7.65% 7.61%
Mortgage loans................... 246.4 316.9 221.5 590.4 250.8 2,752.1 4,378.1 4,580.4
Average interest rate............ 8.91% 9.04% 8.62% 8.44% 8.35% 8.30% 8.41%
Rate Sensitive Liabilities:
Guaranteed Interest Contracts:
Interest paid out annually....... 133.0 103.0 236.0 247.0
Average interest rate............ 7.23% 6.96% 7.11%
Interest paid at maturity........ 133.0 132.0 38.0 1.0 16.0 39.0 359.0 375.0
Average interest rate............ 6.93% 7.18% 8.15% 6.18% 10.67% 10.71% 7.72%
Investment type insurance
contracts, excluding
guaranteed interest
contracts (1)................... 731 820 1,066 1,135 1,134 13,755 18,641 19,232
Average interest rate............ 7.62% 7.66% 7.44% 7.83% 7.47% 7.88% 7.81%
Debt (2)......................... 314.6 .1 230.4 100.0 -- 1,128.3 1,773.4 1,807.7
Average interest rate............ 6.81% 7.75% 7.63% 7.75% 7.58%
32
There- Fair
(in millions of dollars) 1999 2000 2001 2002 2003 after Total Value
- -------------------------------------------------------------------------------------------------------------------
Rate Sensitive Derivative
Financial Instruments:
Interest Rate and Foreign
Currency Swaps:
Pay variable/receive fixed....... 2.4 10.0 49.6 26.2 50.1 167.2 305.5 10.2
Average pay rate................. 4.79% 5.11% 5.14% 5.12% 5.28% 5.37% 5.29%
Average receive rate............. 8.13% 6.36% 6.00% 6.97% 5.32% 6.51% 6.28%
Interest Rate Caps and
Swaptions: (3)
Outstanding cap notional.........2,511.1 2,741.5 3,216.3 2,542.3 659.3 613.7 3.4
Average strike rate (4).......... 9.3% 9.0% 8.9% 8.9% 8.4% 8.4%
Forward CMT curve (5)............ 4.6% 4.7% 4.6% 4.6% 4.8% 5.1%
The table below shows the principal amount and fair value for LNC's significant
interest rate risks as of December 31, 1997.
Principal
(in millions of dollars) Amount Fair Value
- ---------------------------------------------------------------------------------------------------------------
Fixed maturity securities............................................. 25,373.0 24,066.4
Mortgage loans........................................................ 3,294.8 3,473.5
Guaranteed interest contracts......................................... 1,139.0 1,169.9
Investment type insurance contracts (1)............................... 17,632.7 18,329.8
Debt.................................................................. 1,126.2 1,161.8
Interest rate caps and swaptions (notional) (3)....................... 7.8
(1) The information shown is for the fixed maturity securities and mortgage
loans that support these insurance contracts.
(2) Includes minority
interest - preferred securities of subsidiary companies.
(3) Swaptions notional is shown converted to cap equivalent.
(4) The indexes are a mixture of five-year and ten-year Constant Maturity
Treasury ("CMT") and Constant Maturity Swap ("CMS").
(5) The CMT curve is
the five-year constant maturity treasury forward curve.
2) Foreign Currency Risk
Foreign Currency Denominated Investments. LNC invests in foreign currency
securities for incremental return and risk diversification relative to United
States Dollar-Denominated ("USD") securities. The fair value of foreign
securities, which are denominated in six different foreign currencies, totaled
$166.8 million as of December 31, 1998. LNC periodically uses a combination of
foreign exchange forward contracts, foreign currency options, and foreign
currency swaps to hedge some of the foreign exchange risk related to its
investments in securities denominated in foreign currencies. The currency risk
is hedged using foreign currency derivatives of the same currency as the bonds.
Unhedged, a 10% adverse move in the currency would create a $16.7 million
pre-tax loss. The aggregate USD equivalent of forward currency positions hedging
the portfolio was $47.4 million; the unhedged amount of the portfolio was $119.4
million. A 10% adverse currency move has thus been reduced to $11.9 million
pre-tax through hedging. This number is approximate because not all foreign
currency derivatives are struck at the current spot rate. The table below shows
LNC's exposure to foreign currency securities. Also included is the relevant
information relating the foreign currency derivatives that are hedging the
currency risk of these securities. The table below presents the principal
(notional) amount in U.S. dollar equivalents by expected maturity for LNC's
foreign currency denominated investments as of December 31, 1998.
There- Fair
(in millions of dollars) 1999 2000 2001 2002 2003 after Total Value
- ---------------------------------------------------------------------------------------------------------------
Currencies
Canadian Dollar............ 16.3 .6 9.4 10.6 9.8 59.2 105.9 114.0
Interest Rate............ 9.50% 5.57% 8.29% 7.67% 7.15% 6.22% 7.13%
British Pound.............. 6.5 15.6 22.1 25.9
Interest Rate............ 5.07% 10.07% 8.54%
Argentine Peso............. 10.0 7.0 17.0 14.0
Interest Rate............ 11.54% 11.70% 11.61%
All Other Currencies....... 8.1 .5 5.2 13.8 12.9
Interest Rate............ 19.54% 14.73% 12.40% 16.94%
------ ------ ----- ------ ----- ------ ------ -----
Total Currencies.... 24.4 1.1 15.9 20.6 9.8 87.0 158.8 166.8
Derivatives
Forwards................. 1.5 -- -- -- -- -- 1.5 .004
Swaps.................... 2.4 -- 9.6 8.3 -- 26.9 47.2 .4
33
The table below presents the principal (notional) amount in U.S. dollar
equivalents as of December 31, 1997.
Fair
(in millions) Principal Value
- -------------------------------------------------------------------------------------------------------------------
Currencies:
Canadian Dollar............................................................... $ 83.5 $ 91.2
British Pound................................................................. 78.3 90.0
Japanese Yen.................................................................. 65.1 73.6
German Mark................................................................... 62.1 67.3
Italian Lira.................................................................. 44.9 54.8
All other currencies.......................................................... 134.9 142.9
----- -----
Total Currencies........................................................ $468.8 $519.8
Derivatives:
Forwards...................................................................... $163.1 $ 5.4
Swaps......................................................................... 15.0 (2.1)
Foreign Currency Forward Contracts. LNC uses foreign currency forward contracts
to hedge some of the foreign exchange risk related to its investments in fixed
maturity securities denominated in foreign currencies. LNC typically engages in
short-term currency forward contracts of less than six months and actively
monitors currency markets in determining those currencies to hedge, the duration
of the hedge and the nominal amount to hedge. A foreign currency forward
contract obligates LNC to deliver a specified amount of currency at a future
date at a specified exchange rate. The value of the foreign exchange forward
contracts at any given point fluctuates according to the underlying level of
exchange rate and interest rate differentials. LNC periodically uses foreign
exchange forward contracts to hedge against foreign exchange risk related to
LNC's investment in its British subsidiary, Lincoln National (UK). As of
December 31, 1998, LNC did not have any open foreign exchange forward contracts
related to its investment in Lincoln National (UK).
Foreign Currency Options. A foreign currency option gives LNC the right, but not
the obligation, to buy or sell a foreign currency at a specific exchange rate
during a specified time period. LNC has historically used options that were
slightly "out-of-the-money" resulting in a "corridor" of currency risk assumed,
but limited the risk above the strike price. At December 31, 1998, LNC did not
have any open positions in foreign currency options.
Foreign Currency Swaps. A foreign currency swap is a contractual agreement to
exchange the currencies of two different countries pursuant to an agreement to
re-exchange the two currencies at the same rate of exchange at a specified
future date. LNC uses foreign currency swaps to convert the cash flow of foreign
currency securities to U.S. dollars. LNC had foreign currency swaps with a total
notional amount of $47.2 million and $15.0 million for December 31, 1998 and
1997, respectively.
3) Equity Market Exposures
LNC's revenues, assets, liabilities and derivatives are exposed to equity market
risk.
Fee Revenues. The fee revenues of LNC's Investment Management segment and fees
earned from variable annuities are exposed to the risk of a decline in equity
market values. These fees are generally a fixed percentage of the market value
of assets under management. In a severe equity market decline, fee income could
be reduced by not only reduced market valuations but also by customer
withdrawals. Such withdrawals from equity funds and accounts might be partially
offset by transfers to LNC's fixed-income accounts and the transfer of funds to
LNC by its competitors' customers.
Assets. While LNC invests in equity assets with the expectation of achieving
higher returns than would be available in its core fixed-income investments, the
returns on, and values of, these equity investments are subject to somewhat
greater market risk than its fixed income investments. These investments,
however, add diversification benefits to LNC's fixed income investments. The
table below shows the sensitivity of price changes to LNC's equity assets owned.
------------ December 31, 1998 --------------- --December 31, 1997--
10% Fair 10% Fair
Carrying Fair Value Value Carrying Fair
(in millions) Value Value Increase Decrease Value Value
- ------------------------------------------------------------------------------------------------------------------
U.S. Equities....................... 231.3 231.3 254.4 208.2 498.1 498.1
Foreign Equities..................... 276.5 276.5 304.2 248.8 157.7 157.7
Emerging Market Equities............. 35.0 35.0 38.5 31.5 4.6 4.6
------ ------ ------ ------ ------- -------
Sub-Total....................... 542.8 542.8 597.1 488.5 660.4 660.4
Real Estate.......................... 488.7 536.0 589.6 482.4 576.0 621.3
Other Equity Interests............... 312.5 356.9 392.6 321.2 202.1 245.5
------- ------- ------- ------- ------- --------
Total........................... $1,344.0 $1,435.7 $1,579.3 $1,292.1 $1,438.5 $1,527.2
34
Liabilities. LNC has an exposure to foreign currency equity risk with respect to
unit-linked annuity policies issued in the UK. The aggregate U.S. dollar
equivalent amount of account value was $11.1 million and $14.1 million at
December 31, 1998 and 1997, respectively. LNC also has exposure to U.S. equity
markets through reinsurance contracts that reinsure equity-indexed annuities.
The aggregate amount of account value of these annuities is $89.4 million and
$6.6 million at December 31, 1998 and 1997, respectively. These risks are being
hedged with equity derivatives as discussed below.
Derivatives Hedging Equity Risks. LNC has two programs hedging equity market
risk in annuities issued in the U.K. and U.S. that contain equity features.
LNC uses Over-the-Counter ("OTC") foreign currency equity call options to hedge
against the foreign equity market risk component contained in its U.K.
unit-linked annuities which are a function of the Financial Times Stock Exchange
("FTSE") index. These call options require the counterparties to pay LNC at
specified future expiration dates the amount, if any, of the percentage increase
in the FTSE index over the strike price defined in the contract, applied to a
notional amount. LNC had agreements with notional amounts of $11.1 million and
$14.1 million at December 31, 1998 and 1997, respectively. The call options
expirations are matched to the liabilities and expire in 1999 through 2001.
LNC uses OTC equity call options on the S&P 500 index to hedge against the
increase in its liabilities resulting from certain reinsurance agreements which
guarantee payment of the appreciation of the S&P 500 index on certain underlying
annuity products. These call options require the counterparty to pay LNC at
specified future expiration dates the amount, if any, of the percentage increase
in the S&P 500 index over the strike price defined in the contract, applied to
the notional amount. The reinsurance agreement then requires LNC to pay any
appreciation on the S&P 500 index to the reinsurance client. LNC had agreements
with notional amounts of $79.9 million and $5.3 million for December 31, 1998
and 1997, respectively. The call options expirations are matched to the
liabilities and expire in 1999 through 2006.
Default Risk. In assessing the risk that the rate of default losses for each
category of asset may be higher than the rates assumed in pricing its products,
LNC considers the entire $37.9 billion portfolio of invested assets as of
December 31, 1998, taking diversification into account. Of this total, $22.5
billion consists of corporate bonds and $4.4 billion consists of commercial
mortgages. LNC manages the risk of adverse default experience on these
investments by applying disciplined credit evaluation and underwriting
standards, prudently limiting allocations to lower-quality, higher-yielding
investments, and diversifying exposures by issuer, industry, region and property
type. For each counterparty or borrowing entity and its affiliates, LNC's
exposures from all transactions are aggregated and managed in relation to formal
limits set by rating quality and industry group. LNC remains exposed to
occasional adverse cyclical economic downturns during which default rates may be
significantly higher than the long-term historical average used in pricing. As
of December 31, 1997, LNC had a portfolio of invested assets of $29.8 billion.
LNC is depending on the ability of derivative product dealers and their
guarantors to honor their obligations to pay the contract amounts under interest
rate cap agreements, swaptions, spread-lock agreements, interest rate swaps,
commodity swaps, call options, put options foreign currency exchange contracts,
foreign currency options and foreign currency swaps. In order to minimize the
risk of default losses, LNC diversifies its exposures among several dealers and
limits the amount of exposure to each in accordance with the credit rating of
each dealer or its guarantor. LNC generally limits its selection of
counterparties that are obligated under these derivative contracts to those with
an A credit rating or above.
Credit-Related Derivatives. LNC periodically uses spread-lock agreements to
hedge a portion of the value of its fixed maturity securities against the risk
of widening in the spreads between their yields and the yields of comparable
maturity U.S. or other Government obligations. As of December 31, 1998, LNC did
not have any open spread-lock agreements. LNC uses put options, combined with
various perpetual fixed-income securities and interest rate swaps to replicate
fixed-income, fixed-maturity investments. The risk being hedged is a drop in
bond prices due to credit concerns with the international bond issuers. The put
options allow LNC to put the bonds back to the counterparties at original par.
As of December 31, 1998, LNC had put options with a notional amount of $21.3
million that expire in 2007.
35
Item 8. Financial Statements and Supplementary Data
(in millions, except per share)
Operating Results by Quarter 1st Qtr 2nd Qtr 3rd Qtr 4th Qtr
- -------------------------------------------------------------------------------------------------------------
1998 Data
Premiums and other considerations .................. $765.7 $823.3 $794.7 $1,003.0
Net investment income................................ 658.4 658.7 649.6 714.7
Realized gain (loss) on investments.................. 23.9 25.5 (26.7) (3.7)
Net income........................................... $122.0 $ 148.7 $113.5 $ 125.6
Net income per diluted share......................... $ 1.20 $ 1.46 $ 1.11 $ 1.24
1997 Data
Premiums and other considerations.................... $626.6 $567.8 $661.5 $ 669.2
Net investment income................................ 559.4 557.8 548.5 585.1
Realized gain on investments......................... 12.1 2.5 57.0 51.0
Net income (loss) from continuing operations (1)..... $ 83.0 $(48.0) $124.9 $ (137.7)
Discontinued operations (1).......................... 48.3 40.2 46.4 776.9
----- ----- ----- ------
Net Income (Loss)................................. $131.3 $ (7.8) $171.3 $ 639.2
Net income from continuing
operations per diluted share........................ $ .79 $ (.46) $ 1.20 $ (1.34)
Discontinued operations per share.................... .47 .39 .45 7.55
----- --- ---- -----
Net Income (Loss) Per Diluted Share.............. $ 1.26 $ (.07) $ 1.65 $ 6.21
(1)Net income (loss) from continuing operations for the second and fourth
quarters of 1997 include special charges for changes in estimates on
reserves. The discontinued operations amount for the fourth quarter of 1997
includes the gain on sale of the discontinued operations. See notes 2 and 11
to the consolidated financial statements on pages 45 and 65, respectively.
Consolidated Financial Statements
The consolidated financial statements of Lincoln National Corporation and
Subsidiaries follow on pages 36 through 67.
36
LINCOLN NATIONAL CORPORATION
CONSOLIDATED BALANCE SHEETS
December 31 (000s omitted) 1998 1997
- ----------------------------------------------------------------------------------------------------------
ASSETS
Investments:
Securities available-for-sale, at fair value:
Fixed maturity
(cost: 1998-$28,639,558; 1997-$22,626,036)............. $30,232,892 $24,066,376
Equity
(cost: 1998-$436,718; 1997-$517,156)................... 542,843 660,428
Mortgage loans on real estate............................ 4,393,082 3,288,112
Real estate.............................................. 488,722 575,956
Policy loans............................................. 1,839,970 763,148
Other investments........................................ 431,964 464,826
----------- -----------
Total Investments..................................... 37,929,473 29,818,846
Investment in unconsolidated affiliates................... 18,811 20,975
Cash and invested cash.................................... 2,433,350 3,794,706
Property and equipment.................................... 174,762 189,811
Deferred acquisition costs................................ 1,964,366 1,623,845
Premiums and fees receivable.............................. 246,203 197,509
Accrued investment income................................. 528,500 423,008
Assets held in separate accounts.......................... 43,408,858 37,138,845
Federal income taxes...................................... 204,075 --
Amounts recoverable from reinsurers....................... 3,127,093 2,350,766
Goodwill.................................................. 1,484,343 457,729
Other intangible assets................................... 1,848,442 613,909
Other assets.............................................. 467,984 544,759
----------- ------------
Total Assets.......................................... $93,836,260 $77,174,708
37
December 31 (000s omitted) 1998 1997
- --------------------------------------------------------------------------------------------------------------
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Insurance and Investment Contract Liabilities:
Insurance policy and claim reserves................................ $20,139,982 $11,266,272
Contractholder funds............................................... 20,753,064 20,063,393
Liabilities related to separate accounts........................... 43,408,858 37,138,845
---------- ----------
Total Insurance and Investment Contract Liabilities............. 84,301,904 68,468,510
Federal income taxes............................................... -- 487,805
Short-term debt.................................................... 314,610 297,208
Long-term debt..................................................... 712,171 511,037
Minority interest - preferred securities of
subsidiary companies.............................................. 745,000 315,000
Other liabilities.................................................. 2,374,634 2,112,233
---------- ----------
Total Liabilities............................................. 88,448,319 72,191,793
Shareholders' Equity:
Series A preferred stock - 10,000,000 shares authorized
(1998 liquidation value - $2,637)................................. 1,083 1,153
Common stock - 800,000,000 shares authorized...................... 994,472 966,461
Retained earnings.................................................. 3,790,038 3,533,105
Accumulated Other Comprehensive Income:
Foreign currency translation adjustment............................ 49,979 46,204
Net unrealized gain (loss) on securities available-for-sale........ 552,369 435,992
---------- ----------
Total Accumulated Other Comprehensive Income................... 602,348 482,196
---------- ----------
Total Shareholders' Equity..................................... 5,387,941 4,982,915
---------- ----------
Total Liabilities and Shareholders' Equity..................... $93,836,260 $77,174,708
See notes to the consolidated financial statements on pages 42-67.
38
LINCOLN NATIONAL CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
Year Ended December 31 (000s omitted) 1998 1997 1996
- ----------------------------------------------------------------------------------------------------------------
Revenue:
Insurance premiums..................................... $1,620,629 $1,328,735 $1,519,169
Insurance fees......................................... 1,274,569 832,153 713,519
Investment advisory fees............................... 227,059 204,926 180,792
Net investment income.................................. 2,681,406 2,250,764 2,087,946
Equity in earnings of unconsolidated affiliates....... 3,336 2,081 1,416
Realized gain (loss) on investments.................... 19,034 122,570 92,520
Other revenue and fees................................. 261,030 157,250 138,246
--------- --------- ---------
Total Revenue....................................... 6,087,063 4,898,479 4,733,608
Benefits and Expenses:
Benefits............................................... 3,328,865 3,191,733 2,709,881
Underwriting, acquisition,
insurance and other expenses......................... 1,943,749 1,579,341 1,434,948
Interest and debt expense.............................. 117,051 92,524 84,721
--------- ---------- ----------
Total Benefits and Expenses.......................... 5,389,665 4,863,598 4,229,550
--------- --------- ---------
Net Income from Continuing Operations
Before Federal Income Taxes......................... 697,398 34,881 504,058
Federal income tax expense............................... 187,623 12,651 147,669
--------- -------- ---------
Net Income from Continuing Operations................ 509,775 22,230 356,389
Discontinued Operations (Net of income taxes):
Income prior to disposal .............................. -- 134,886 157,169
Gain on disposal ...................................... -- 776,872 --
------------- --------- --------------
Net Income........................................... $ 509,775 $ 933,988 $ 513,558
Earnings Per Common Share-Basic:
Net Income from Continuing Operations.................. $5.08 $ .22 $3.43
Discontinued Operations................................ -- 8.89 1.52
------- ---- ----
Net Income.......................................... $5.08 $9.11 $4.95
Earnings Per Common Share-Diluted:
Net Income from Continuing Operations.................. $5.02 $ .21 $3.38
Discontinued Operations................................ -- 8.77 1.49
------- ---- ----
Net Income........................................... $5.02 $8.98 $4.87
See notes to the consolidated financial statements on pages 42-67.
39
LINCOLN NATIONAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year Ended December 31 (000s omitted) 1998 1997 1996
- ----------------------------------------------------------------------------------------------------------------
Cash Flows from Operating Activities:
Net income.................................................... $ 509,775 $ 933,988 $ 513,558
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Deferred acquisition costs................................. (226,253) (23,519) 34,471
Premiums and fees receivable............................... 3,151 39,836 (77,379)
Accrued investment income.................................. (101,555) (5,426) (22,079)
Policy liabilities and accruals............................ 1,055,277 540,676 71,471
Contractholder funds....................................... 800,678 636,600 1,280,205
Amounts recoverable from reinsurers........................ (775,064) (22,252) (128,538)
Federal income taxes....................................... (205,198) 255,105 30,418
Equity in undistributed earnings of
unconsolidated affiliates................................. (1,636) (2,081) (1,428)
Provisions for depreciation................................ 58,070 58,136 51,328
Amortization of goodwill and other intangible assets....... 183,756 82,396 70,748
Realized (gain) loss on investments........................ (19,034) (122,570) (92,520)
Gain on sale of subsidiaries/discontinued operations....... -- (1,192,226) --
Other...................................................... 47,905 (65,857) (356,819)
--------- ----------- --------
Net Adjustments......................................... 820,097 178,818 859,878
--------- ---------- ---------
Net Cash Provided by Operating Activities............... 1,329,872 1,112,806 1,373,436
Cash Flows from Investing Activities:
Securities available-for-sale:
Purchases................................................... (11,780,821) (10,740,292) (15,661,295)
Sales....................................................... 9,278,969 10,098,697 12,135,338
Maturities.................................................. 1,987,506 1,461,390 981,264
Purchase of other investments................................. (2,922,984) (2,128,852) (2,450,400)
Sale or maturity of other investments......................... 1,831,412 1,961,551 2,187,615
Sale of subsidiary/discontinued operations.................... -- 2,650,000 --
Purchase of affiliates/business............................... (2,285,081) (11,847) (71,593)
Cash acquired from purchase of affiliates/business............ 2,323,220 -- 2,650,733
Increase (decrease) in cash collateral on
loaned securities............................................ 274,426 353,550 (97,257)
Other......................................................... (481,137) 121,065 (146,768)
--------- --------- --------
Net Cash Provided by (Used in) Investing Activities....... (1,774,490) 3,765,262 (472,363)
Cash Flows from Financing Activities:
Decrease in long-term debt (includes payments and
transfers to short-term debt)................................ (99,977) (116,942) (35,074)
Issuance of long-term debt.................................... 299,198 -- --
Net increase (decrease) in short-term debt.................... 17,402 108,248 (237,888)
Issuance of preferred securities of subsidiary companies...... 430,000 -- 315,000
Issuance costs related to FELINE PRIDES....................... (14,834) -- --
Universal life and investment contract deposits............... 1,314,301 986,541 1,125,532
Universal life and investment contract withdrawals............ (2,655,688) (2,709,662) (2,366,725)
Common stock issued for benefit plans......................... 48,747 33,199 (565)
Retirement of common stock.................................... (46,871) (327,585) (32,716)
Proceeds from sale of minority interest in subsidiary......... -- -- 215,182
Dividends paid to shareholders................................ (209,016) (201,927) (191,223)
------- -------- --------
Net Cash Provided by (Used in) Financing Activities........ (916,738) (2,228,128) (1,208,477)
----------- ----------- ---------
Net Increase (Decrease) in Cash............................ (1,361,356) 2,649,940 (307,404)
Cash and Invested Cash at Beginning-of-Year................... 3,794,706 1,144,766 1,452,170
--------- --------- ---------
Cash and Invested Cash at End-of-Year...................... $2,433,350 $3,794,706 $1,144,766
See notes to the consolidated financial statements on pages 42-67.
40
. LINCOLN NATIONAL CORPORATION
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
Year Ended December 31 (000s omitted) 1998 1997 1996
--------------------------------------------------------------------------------------------------------------
Series A Preferred Stock:
Balance at beginning-of-year................................ $ 1,153 $ 1,212 $ 1,335
Conversion into common stock................................ (70) (59) (123)
----- ----- ----
Balance at End-of-Year................................... 1,083 1,153 1,212
Common Stock:
Balance at beginning-of-year................................ 966,461 904,331 907,432
Conversion of series A preferred stock...................... 70 59 123
Issued for benefit plans.................................... 50,666 34,592 7,597
Shares forfeited under benefit plans........................ (1,919) (1,393) (4,771)
Issued for purchase of subsidiaries......................... -- 74,390 --
Retirement of common stock.................................. (5,972) (45,518) (6,050)
Issuance costs related to FELINE PRIDES .................... (14,834) -- --
------- ------- -------
Balance at End-of-Year.................................... 994,472 966,461 904,331
Retained Earnings:
Balance at beginning-of-year................................ 3,533,105 3,082,368 2,757,762
Comprehensive income........................................ 629,927 934,139 284,010
Less other comprehensive income (loss):
Foreign currency translation............................... 3,775 (20,250) 53,041
Net unrealized gain (loss) on securities
available-for-sale....................................... 116,377 20,401 (282,589)
------- ------- -------
Net Income........................................... 509,775 933,988 513,558
Realized gain (loss) on sale of minority
interest in subsidiary..................................... -- -- 34,121
Retirement of common stock.................................. (40,899) (279,808) (28,925)
Dividends declared:
Series A Preferred ($3.00 per share)........................ (100) (106) (112)
Common stock (1998 - $2.11;
1997 - $1.99; 1996 - $1.87)................................ (211,823) (203,337) (194,036)
------- ------- -------
Balance at End-of-Year.................................. 3,790,038 3,533,105 3,082,368
Foreign Currency Translation Adjustment:
Accumulated adjustment at beginning-of-year................. 46,204 66,454 13,413
Change during the year...................................... 3,775 (20,250) 53,041
------- ------- -------
Balance at End-of-Year.................................. 49,979 46,204 66,454
Net Unrealized Gain (Loss) on Securities
Available-for-sale:
Balance at beginning-of-year................................ 435,992 415,591 698,180
Realized gain (loss) on sale of
minority interest in subsidiary............................ -- -- (19,101)
Removal of discontinued operations.......................... -- (176,603) --
Other change during the year................................ 116,377 197,004 (263,488)
--------- --------- ---------
Balance at End-of-Year.................................. 552,369 435,992 415,591
--------- --------- ---------
Total Shareholders' Equity at End-of-Year............... $5,387,941 $4,982,915 $4,469,956
41
Year Ended December 31 (Number of Shares) 1998 1997 1996
- ---------------------------------------------------------------------------------------------------------------
Series A Preferred Stock:
Balance at beginning-of-year................................. 35,091 36,885 40,646
Conversion into common stock................................. (2,132) (1,794) (3,761)
------ ----- ------
Balance Issued and Outstanding at End-of-Year............. 32,959 35,091 36,885
Common Stock:
Balance at beginning-of-year................................ 100,859,478 103,658,575 104,185,117
Conversion of series A preferred stock...................... 17,056 14,352 30,088
Issued for benefit plans.................................... 825,777 759,330 250,072
Shares forfeited under benefit plans........................ (23,443) (21,991) (112,120)
Issued for purchase of subsidiaries......................... -- 1,398,112 --
Retirement of common stock.................................. (623,281) (4,948,900) (694,582)
----------- ----------- ------------
Balance Issued and Outstanding at End-of-Year............. 101,055,587 100,859,478 103,658,575
Common Stock at End-of-Year:
Assuming conversion of preferred stock.................... 101,319,259 101,140,206 103,953,655
Diluted basis............................................. 101,697,717 102,363,115 104,766,000
See notes to the consolidated financial statements on pages 42-67.
42
LINCOLN NATIONAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Summary of Significant Accounting Policies
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. During 1998, the collective group of companies
adopted "Lincoln Financial Group" as its marketing identity. Operations are
divided into four business segments (see note 9 on page 62). 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 generally accepted accounting principles.
Use of Estimates. The nature of the insurance and investment management
businesses requires management to make estimates and assumptions that affect the
amounts reported in the consolidated financial statements and accompanying
notes. Actual results could differ from those estimates.
Investments. LNC classifies its fixed maturity and equity securities as
available-for-sale and, accordingly, such securities are carried at fair value.
The cost of fixed maturity securities is adjusted for amortization of premiums
and discounts. The cost of fixed maturity and equity securities is adjusted for
declines in value that are other than temporary.
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
actual payments to date and anticipated future payments. The net investment in
the securities is adjusted to the amount that would have existed had the new
effective yield been applied at the time of acquisition. This adjustment is
reflected in net investment income.
Mortgage loans on real estate are carried at the outstanding principal balances
less unaccrued discounts. Investment real estate is carried at cost less
allowances for depreciation. The cost for both mortgage loans and real estate
and investment real estate is adjusted for declines in value that are other than
temporary. Also, allowances for losses are established, as appropriate, for real
estate holdings that are in the process of being sold. Real estate acquired
through foreclosure proceedings is recorded at fair value on the settlement date
which establishes a new cost basis. If a subsequent periodic review of a
foreclosed property indicates the fair value, less estimated costs to sell, is
lower than the carrying value at the settlement date, the carrying value is
adjusted to the lower amount. Any changes to the reserves for mortgage loans on
real estate and real estate are reported as realized gain (loss) on investments.
Policy loans are carried at aggregate unpaid balances.
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 capital gains
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.
Realized gain (loss) on sale of subsidiaries, net of taxes, is recognized in net
income. Realized gain (loss) on sale of minority interests in subsidiaries is
reflected directly in shareholders' equity net of deferred taxes, if any.
Derivatives. LNC hedges certain portions of its exposure to interest rate
fluctuations, the widening of bond yield spreads over comparable maturity U.S.
Government obligations, commodity risk, credit risk, fluctuations in certain
stock indices, increased liabilities associated with certain reinsurance
agreements and foreign exchange risk by entering into derivative transactions. A
description of LNC's accounting for its hedging of such risks is discussed in
the following two paragraphs.
43
The premiums paid for interest rate caps, swaptions, put options and S&P call
options are deferred and amortized to net investment income on a straight-line
basis over the term of the respective derivative. Any settlement received in
accordance with the terms of the interest rate caps is also recorded as net
investment income. Realized gain (loss) from the termination of the interest
rate caps is included in net income. Settlements received on swaptions are
deferred and amortized over the life of the hedged assets as an adjustment to
yield. Swaptions, put options, spread-lock agreements, interest rate swaps,
commodity swaps and financial futures that hedge fixed maturity securities
available-for-sale are carried at fair value. The change in fair value is
reflected directly in shareholders' equity. Realized gain (loss) from the
settlement of such derivatives is deferred and amortized over the life of the
hedged assets as an adjustment to the yield. Over-the-counter call options are
carried at fair value. The change in fair value is reflected directly in
shareholders' equity. Any gain (loss) realized upon termination of these call
options is included in net income. Foreign exchange forward contracts, which
hedge LNC's investment in its British subsidiary, Lincoln National (UK), are
carried at fair value. The change in fair value and realized gain (loss) on such
contracts is reflected directly in the foreign currency translation adjustment
component of shareholders' equity. Foreign exchange forward contracts, foreign
currency options and foreign currency swaps, which hedge some of the foreign
exchange risk of investments in fixed maturity securities denominated in foreign
currencies, are carried at fair value. The change in fair value is included in
shareholders' equity. Realized gain (loss) from the settlement of such
derivatives is included in net income.
Hedge accounting is applied as indicated above after LNC determines that the
items to be hedged expose LNC to interest rate fluctuations, the widening of
bond yield spreads over comparable maturity U.S. Government obligations,
fluctuations in certain stock indices, increased liabilities associated with
certain reinsurance agreements and foreign exchange risk. Moreover, the
derivatives used are designated as a hedge and reduce the indicated risk by
having a high correlation between changes in the value of the derivatives and
the items being hedged at both the inception of the hedge and throughout the
hedge period. Should such criteria not be met or if the hedged items have been
sold, terminated or matured, the change in value of the derivatives is included
in net income.
Loaned Securities. Securities loaned are treated as collateralized financing
transactions and a liability is recorded equal to the repurchase price. It is
LNC's policy to take possession of securities with a market value at least equal
to the securities loaned. Securities loaned are recorded at fair value as long
as the value of the related collateral is sufficient. 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.
Property and Equipment. Property and equipment owned for company use is carried
at cost less allowances for depreciation.
Premiums and Fees. Revenue for universal life and other interest-sensitive
insurance policies consists of policy charges for the cost of insurance, policy
initiation and administration, and surrender charges that have been assessed.
Traditional individual life-health and annuity premiums are recognized as
revenue over the premium-paying period of the policies. Group health premiums
are prorated over the contract term of the policies.
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 managed. Investment
advisory contracts generally provide for the determination and payment of
advisory fees based on market values of managed portfolios at the end of a
calendar month or quarter. Investment management and advisory contracts are
renewable annually with cancellation clauses ranging from 30 to 90 days.
Assets Held in Separate Accounts/Liabilities Related to Separate Accounts. These
assets and liabilities represent segregated funds administered and invested by
LNC's insurance subsidiaries for the exclusive benefit of pension and variable
life and annuity contractholders. Both the assets and liabilities are carried at
fair value. The fees earned by LNC's insurance subsidiaries for administrative
and contractholder maintenance services performed for these separate accounts
are included in insurance fee revenue.
Deferred Acquisition Costs. Commissions and other costs of acquiring universal
life insurance, variable universal life insurance, unit-linked products,
traditional life insurance, annuities and group health insurance which vary with
and are primarily related to the production of new business, have been deferred
to the extent recoverable. Acquisition costs for universal and variable
universal life insurance policies and unit-linked products are being amortized
over the lives of the policies in relation to the incidence of estimated gross
profits from surrender charges and investment, mortality, and expense margins,
and actual realized gain
44
(loss) on investments. That amortization is adjusted retrospectively when
estimates of current or future gross profits to be realized from a group of
products are revised. Traditional life acquisition costs are being 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.
Annuity acquisition costs are amortized over a period of 15 years for more
recently issued policies, and over the surrender charge period for all other
policies. For all policies, amortization is based on assumptions consistent with
those used in the development of the underlying policy form adjusted for
emerging experience.
Benefits and Expenses. Benefits for universal and variable universal life
insurance policies 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 insurance
company's general account during 1996 through 1998 ranged from 5.80% to 7.05%.
Interest and debt expense includes interest on Minority Interest-Preferred
Securities of Subsidiary Companies.
Goodwill and Other Intangible Assets. The cost of acquired insurance
subsidiaries or blocks of business in excess of the fair value of net assets
(goodwill) is amortized using the straight-line method over periods of 20 to 40
years which corresponds with the benefits expected to be derived from the
acquisitions.
Other intangible assets for the non-insurance subsidiaries (i.e., institutional
customer relationships, covenants not to compete and mutual fund customer
relationships) have been recorded in connection with the acquisition of asset
management services companies. These assets are amortized on a straight-line
basis over 6 to 15 years.
The carrying value of goodwill and other intangible assets is reviewed
periodically for indicators of impairment in value.
Insurance and Investment Contract Liabilities. The liabilities for future policy
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 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 2.5% to 7.0% depending on the time of policy issue.
Interest rate assumptions for reinsurance reserves range from 5.0% to 11.0%
graded to 8.0% after 20 years. The interest assumptions for immediate and
deferred paid-up annuities range from 4.5% to 7.75%.
With respect to its insurance and investment contract liabilities, LNC
continually reviews its: 1) overall reserve position; 2) reserving techniques
and 3) reinsurance arrangements. As experience develops and new information
becomes known, liabilities are adjusted as deemed necessary. The effects of
changes in estimates are included in the operating results for the period in
which such changes occur.
Reinsurance. LNC's insurance companies enter into reinsurance agreements with
other companies in the normal course of their business. LNC's insurance
subsidiaries may assume reinsurance from unaffiliated companies and/or cede
reinsurance to such companies. Assets/liabilities and premiums/benefits from
certain reinsurance contracts that grant statutory surplus to other insurance
companies have been netted on the balance sheets and income statements,
respectively, since there is a right of offset. All other reinsurance agreements
are reported on a gross basis.
Depreciation. Provisions for depreciation of investment real estate and property
and equipment owned for company use are computed principally on the
straight-line method over the estimated useful lives of the assets.
Postretirement Medical and Life Insurance Benefits. LNC accounts for its
postretirement medical and life insurance benefits using the full accrual
method.
Stock Options. LNC recognizes compensation expense for its stock option
incentive plans using the intrinsic value method of accounting. Under the terms
of the intrinsic value method, compensation cost is the excess, if any, of the
quoted market price of the stock at the grant date, or other measurement date,
over the amount an employee must pay to acquire the stock.
Foreign Exchange. LNC's foreign subsidiaries' balance sheet accounts and income
statement items are translated at the current exchange and average exchange
rates for the year, respectively. Resulting translation adjustments are reported
as a component of shareholders' equity. Other translation adjustments for
foreign currency transactions that affect cash flows are reported in earnings.
45
2. Changes in Accounting Principles and Change in Estimates
Change in Estimate for Disability Income Reserve. During the second quarter of
1997, LNC conducted an additional in-depth review of loss experience on its
disability income business. As a result of this study, the reserve level was
deemed to be inadequate to meet future obligations if current incidence levels
were to continue in the future. In order to address this situation, LNC's
Reinsurance segment strengthened its disability income reserve by $92,800,000,
wrote-off deferred acquisition costs of $71,100,000 and reduced related assets
by $36,100,000. Combined these actions reduced net income in the second quarter
of 1997 by $130,000,000 or $1.23 per share ($200,000,000 pre-tax).
Change in Estimate for United Kingdom Pension Mis-selling. During the fourth
quarter of 1997, an in-depth review was completed of the United Kingdom
regulatory environment, settlements to date and the remaining liability
established to settle claims associated with this business. As a result of this
study, the Lincoln UK segment strengthened its liability by $199,400,000
reducing net income in the fourth quarter of 1997 by $174,900,000 after-tax or
$1.70 per share.
Change in Estimate for Personal Accident Programs. During the fourth quarter of
1997, an in-depth review was completed of certain excess-of-loss personal
accident reinsurance programs written by LNC's Reinsurance segment. Based on a
concern that these programs were generating claims substantially in excess of
expectations, an investigation and audit was conducted covering all such
programs. While LNC continues to investigate the manner in which these programs
were designed and all legal remedies available, it has been determined that the
incurred but not reported reserve liability related to this business should be
strengthened. Accordingly, a charge of $175,000,000 ($113,700,000 after-tax or
$1.11 per share) was taken in the fourth quarter of 1997.
Accounting for Derivative Instruments and Hedging Activities. In June 1998, the
Financial Accounting Standards Board issued an accounting standard entitled
"Accounting for Derivative Instruments and Hedging Activities" ("FAS 133"). This
standard indicates that adoption may occur at the beginning of any fiscal
quarter but no later than the first quarter of 2000. LNC has not completed the
analysis necessary to provide a precise estimate of the effect of this statement
or to specify the quarter in which it plans to adopt the standard.
3. Investments
The major categories of net investment income are as follows:
Year Ended December 31 (in millions) 1998 1997 1996
- ---------------------------------------------------------------------------------------------------------------
Fixed maturity securities...................................... $2,065.8 $1,832.1 $1,690.1
Equity securities.............................................. 22.9 19.2 14.4
Mortgage loans on real estate ................................. 383.6 279.2 292.7
Real estate.................................................... 86.8 99.4 125.4
Policy loans . . . . . . . . . . . . . . . . . . . . . . . .... 99.5 44.5 40.7
Invested cash.................................................. 156.7 102.4 69.2
Other investments.............................................. 88.4 20.6 14.7
-------- -------- --------
Investment revenue.......................................... 2,903.7 2,397.4 2,247.2
Investment expense............................................. 222.3 146.6 159.3
------- ------- --------
Net investment income....................................... $2,681.4 $2,250.8 $2,087.9
The realized gain (loss) on investments is as follows:
Year Ended December 31 (in millions) 1998 1997 1996
- -------------------------------------------------------------------------------------------------------------
Fixed maturity securities available-for-sale:
Gross gain.................................................... $211.7 $240.0 $209.5
Gross loss.................................................... (211.2) (91.5) (202.6)
Equity securities available-for-sale:
Gross gain.................................................... 107.8 136.8 152.7
Gross loss.................................................... (50.4) (41.8) (37.8)
Other investments.............................................. 11.9 (32.3) 40.4
Amortization of deferred acquisition costs,
provision for policyholder commitments and
capital gains expenses........................................ (50.8) (88.6) (69.7)
------ ------ -----
Total....................................................... $ 19.0 $122.6 $ 92.5
46
Provisions (credits) for write-downs and net changes in allowances for loss,
which are included in the realized gain (loss) on investments shown above, are
as follows:
Year Ended December 31 (in millions) 1998 1997 1996
- ---------------------------------------------------------------------------------------------------------------
Fixed maturity securities..................................... $60.0 $13.1 $12.3
Equity securities............................................. 3.4 .3 3.2
Mortgage loans on real estate................................. (.2) (8.9) 3.1
Real estate................................................... (7.2) (13.6) 4.6
Other long-term investments................................... 5.4 (6.5) (.8)
Guarantees.................................................... (.5) -- .2
------- ----- ----
Total...................................................... $60.9 $(15.6) $22.6
The change in unrealized appreciation (depreciation) on investments in fixed
maturity and equity securities is as follows:
Year Ended December 31 (in millions) 1998 1997 1996
- --------------------------------------------------------------------------------------------------------------
Fixed maturity securities available-for-sale.................. $152.9 $549.0 $(735.5)
Equity securities available-for-sale.......................... (37.1) 20.2 (42.1)
------ ------ -------
Total..................................................... $115.8 $569.2 $(777.6)
The amortized cost, gross unrealized gain and loss, and fair value of securities
available-for-sale are as follows:
Amortized Fair
December 31 (in millions) Cost Gain Loss Value
- --------------------------------------------------------------------------------------------------------------
1998:
Corporate bonds............................ $21,289.6 $1,350.2 $134.6 $22,505.2
U.S. Government bonds...................... 1,043.9 94.3 3.6 1,134.6
Foreign governments bonds.................. 1,240.1 127.5 46.4 1,321.2
Asset/mortgage-backed securities:
Mortgage pass-through securities......... 1,176.6 34.6 .9 1,210.3
Collateralized mortgage obligations...... 2,532.9 120.7 5.4 2,648.2
Asset-backed securities.................. 1,170.0 54.1 2.1 1,222.0
State and municipal bonds.................. 15.9 .9 -- 16.8
Redeemable preferred stocks................ 170.6 7.4 3.4 174.6
--------- --------- ------ ---------
Total fixed maturity securities........ 28,639.6 1,789.7 196.4 30,232.9
Equity securities.......................... 436.7 141.2 35.1 542.8
--------- -------- ------ ---------
Total.................................. $29,076.3 $1,930.9 $231.5 $30,775.7
1997:
Corporate bonds............................ $15,622.9 $ 1,077.2 $ 66.8 $16,633.3
U.S. Government bonds...................... 591.9 70.7 .2 662.4
Foreign governments bonds.................. 1,683.4 129.0 7.9 1,804.5
Asset/mortgage-backed securities:
Mortgage pass-through securities......... 952.5 34.8 2.6 984.7
Collateralized mortgage obligations...... 2,522.0 170.9 3.4 2,689.5
Asset-backed securities.................. 818.0 26.9 .9 844.0
Other mortgage-backed securities......... 11.1 -- -- 11.1
State and municipal bonds.................. 236.1 5.3 -- 241.4
Redeemable preferred stocks................ 188.1 8.0 .6 195.5
--------- --------- ------ --------
Total fixed maturity securities........ 22,626.0 1,522.8 82.4 24,066.4
Equity securities.......................... 517.2 163.9 20.7 660.4
--------- ------- ----- ---------
Total.................................. $23,143.2 $1,686.7 $103.1 $24,726.8
Future maturities of fixed maturity securities available-for-sale are as
follows:
Amortized Fair
December 31, 1998 (in millions) Cost Value
- ---------------------------------------------------------------------------------------------------------------
Due in one year or less....................................................... $ 909.8 $ 916.7
Due after one year through five years......................................... 5,112.4 5,283.7
Due after five years through ten years........................................ 7,989.4 8,274.7
Due after ten years........................................................... 9,748.5 10,677.3
-------- --------
Subtotal.................................................................. 23,760.1 25,152.4
Asset/mortgage-backed securities.............................................. 4,879.5 5,080.5
-------- ---------
Total..................................................................... $28,639.6 $30,232.9
47
The foregoing data is based on stated maturities. Actual maturities will differ
in some cases because borrowers may have the right to call or pre-pay
obligations.
Par value, amortized cost and estimated fair value of investments in
asset/mortgage-backed securities summarized by interest rates of the underlying
collateral are as follows:
Par Amortized Fair
December 31, 1998 (in millions) Value Cost Value
- --------------------------------------------------------------------------------------------------------------
Below 7%....................................................... $ 594.2 $ 318.1 $ 339.8
7% - 8%........................................................ 2,450.5 2,430.8 2,492.6
8% - 9%........................................................ 1,241.3 1,198.7 1,255.7
Above 9%....................................................... 950.2 931.9 992.4
------- ------- -------
Total...................................................... $5,236.2 $4,879.5 $5,080.5
The quality ratings of fixed maturity securities available-for-sale are as
follows:
December 31 1998
- --------------------------------------------------------------------------------
Treasuries and AAA............................................. 25.6%
AA............................................................. 7.0
A.............................................................. 27.5
BBB............................................................ 32.9
BB............................................................. 4.3
Less than BB................................................... 2.7
-----
100.0%
During the second quarter of 1998, LNC purchased two bonds issued with
offsetting interest rate characteristics. Subsequent to the purchase of these
bonds, interest rates increased and the value of one of these bonds decreased.
This bond was sold at the end of the second quarter 1998 and a realized loss of
$20.0 million ($13.0 million after-tax) was recorded. The other bond is still
owned by LNC and is producing net investment income on an annual basis of $10.0
million ($6.5 million after-tax). Subsequent to these transactions being
recorded, the Emerging Issues Task Force of the Financial Accounting Standards
Board reached consensus with regard to accounting for this type of investment
strategy. LNC is not required to apply the new accounting rules, however, if
such rules were applied, the realized loss on the sale of $20.0 million ($13.0
million after-tax) on one of these bonds recorded at the end of the second
quarter of 1998 would be reversed and the amount would be applied as a change in
the carrying amount of the bond that remains in LNC's portfolio. Also, net
investment income for the year ended December 31, 1998 would be less than
reported by $5.0 million ($3.3 million after-tax).
The balance sheet captions, "Real Estate" and "Property and Equipment," are
shown net of allowances for depreciation as follows:
December 31 (in millions) 1998 1997
- --------------------------------------------------------------------------------
Real estate......................................... $ 51.0 $ 50.2
Property and equipment.............................. 222.1 155.9
Mortgage loans on real estate which are primarily held in the Life Insurance and
Annuities segment are considered impaired when, based on current information and
events, it is probable that LNC will be unable to collect all amounts due
according to the contractual terms of the loan agreement. When LNC determines
that a loan is impaired, the cost is adjusted or a provision for loss is
established equal to the difference between the initial cost of the mortgage
loan and the estimated value. Estimated value is based on: 1) the present value
of expected future cash flows discounted at the loan's effective interest rate;
2) the loan's observable market price or; 3) the fair value of the collateral.
The provision for losses is reported as realized gain (loss) on investments.
Mortgage loans deemed to be uncollectible are charged against the allowance for
losses and subsequent recoveries, if any, are credited to the allowance for
losses.
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.
48
Impaired mortgage loans along with the related allowance for losses are as
follows:
December 31 (in millions) 1998 1997
- --------------------------------------------------------------------------------
Impaired loans with allowance for losses......... $37.0 $41.2
Allowance for losses............................. (4.8) (5.0)
Impaired loans with no allowance for losses...... 2.2 --
------ ------
Net impaired loans............................... $34.4 $36.2
Impaired mortgage loans with no allowance for losses are a result of: 1) direct
write-downs or; 2) collateral dependent loans where the fair value of the
collateral is greater than the recorded investment in the loan.
A reconciliation of the mortgage loan allowance for losses for these impaired
mortgage loans is as follows:
Year Ended December 31 (in millions) 1998 1997 1996
- -------------------------------------------------------------------------------
Balance at beginning-of-year............ $5.0 $12.4 $29.6
Provisions for losses................... .7 .8 3.1
Releases due to write-downs............. -- -- --
Releases due to sales................... (.9) (4.8) (19.9)
Releases due to foreclosures............ -- (3.4) (.4)
---- ----- -----
Balance at end-of-year.............. $4.8 $ 5.0 $12.4
The average recorded investment in impaired mortgage loans and the interest
income recognized on impaired mortgage loans were as follows:
Year Ended December 31 (in millions) 1998 1997 1996
- --------------------------------------------------------------------------------
Average recorded investment in impaired loans..$33.4 $74.9 $139.6
Interest income recognized on impaired loans... 3.5 7.0 12.7
All interest income on impaired mortgage loans was recognized on the cash basis
of income recognition.
As of December 31, 1998 and 1997, LNC had restructured mortgage loans of
$32,000,000 and $38,500,000, respectively. LNC recorded $3,100,000 and
$3,800,000 of interest income on these restructured mortgage loans in 1998 and
1997, respectively. Interest income in the amount of $3,200,000 and $3,900,000
would have been recorded on these mortgage loans according to their original
terms in 1998 and 1997, respectively. As of December 31, 1998 and December 31,
1997, LNC had no outstanding commitments to lend funds on restructured mortgage
loans.
An investment in real estate is considered impaired when the projected
undiscounted cash flow from the investment is less than the carrying value. When
LNC determines that an investment in real estate is impaired, it is written-down
to reduce the carrying value to the estimated value.
As of December 31, 1998, LNC's investment commitments for fixed maturity
securities (primarily private placements), mortgage loans on real estate and
real estate were $487,800,000.
For the year ended December 31, 1998, fixed maturity securities
available-for-sale, mortgage loans on real estate and real estate investments
which were non-income producing were not significant.
The cost information for mortgage loans on real estate, real estate and other
long-term investments are net of allowances for losses. The balance sheet
account for other liabilities includes a reserve for guarantees of third-party
debt. The amount of allowances and reserves for such items is as follows:
December 31 (in millions) 1998 1997
- --------------------------------------------------------------------------------
Mortgage loans on real estate....................... $4.8 $ 5.0
Real estate......................................... -- 1.5
Guarantees.......................................... .3 .8
49
4. Federal Income Taxes
The Federal income tax expense (benefit) is as follows:
Year Ended December 31 (in millions) 1998 1997 1996
- ---------------------------------------------------------------------------------------------------------------
Current........................................................... $(37.0) $137.4 $129.8
Deferred.......................................................... 224.6 (124.7) 17.9
----- ------ -----
Total for continuing operations............................... $187.6 $ 12.7 $147.7
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:
Year Ended December 31 (in millions) 1998 1997 1996
- ---------------------------------------------------------------------------------------------------------------
Tax rate times pre-tax income from continuing operations.......... $244.1 $12.2 $176.4
Effect of:
Tax-preferred investment income................................... (51.1) (34.8) (25.6)
Change in valuation allowance..................................... (5.3) 43.5 --
Other items....................................................... (.1) (8.2) (3.1)
------ ----- -----
Provision for income taxes.................................... $187.6 $12.7 $147.7
----- ---- -----
Effective tax rate............................................ 27% 36% 29%
The Federal income tax recoverable (liability) is as follows:
December 31 (in millions) 1998 1997
- -----------------------------------------------------------------------------------------------------------------
Current.......................................................................... $ (6.3) $(431.8)
Deferred......................................................................... 210.4 (56.0)
------ -----
Total Federal income tax recoverable (liability)............................. $204.1 $(487.8)
Significant components of LNC's net deferred tax asset (liability) for
continuing operations are as follows:
December 31 (in millions) 1998 1997
- ----------------------------------------------------------------------------------------------------------------
Deferred tax assets:
Insurance and investment contract liabilities.................................... $1,386.3 $ 914.3
Net operating loss............................................................... 103.1 66.3
Postretirement benefits other than pensions...................................... 39.9 39.4
Other............................................................................ 147.3 102.9
-------- --------
Total deferred tax assets.................................................... 1,676.6 1,122.9
Valuation allowance for deferred tax assets...................................... 38.2 43.5
-------- --------
Net deferred tax asset....................................................... 1,638.4 1,079.4
Deferred tax liabilities:
Deferred acquisition costs....................................................... 214.9 271.2
Premiums and fees receivable..................................................... 11.6 3.9
Net unrealized gain on securities available-for-sale............................. 542.0 520.0
Present value of business in-force............................................... 625.9 211.2
Other............................................................................ 33.6 129.1
-------- --------
Total deferred tax liabilities................................................ 1,428.0 1,135.4
------- -------
Net deferred tax asset (liability)............................................ $ 210.4 $ (56.0)
LNC's Lincoln UK segment has incurred losses in its pension business which under
United Kingdom tax law can only be utilized against its future pension business
earnings. At December 31, 1998 and 1997 the deferred tax asset related to these
pension business losses was $86,700,000 and $92,000,000, respectively. The
valuation allowances shown in the table above reflect managements assessment,
based upon all available information, that it is more likely than not that a
portion of this deferred tax asset will not be realized. Adjustment to the
valuation allowance will be made if there is a change in management's assessment
of the amount of the deferred tax asset that is realizable.
Cash paid for Federal income taxes in 1998, 1997 and 1996 was $379,600,000,
$158,000,000 and $143,800,000 respectively.
At December 31, 1998, LNC had net operating loss carryforwards of $257,000,000
for Federal income tax purposes related to its foreign life reinsurance
companies that expire in years 2006 through 2018. Delaware Management Holdings,
Inc. ("Delaware"), acquired in 1995, has net operating loss carryforwards for
Federal
50
income tax purposes of $79,100,000 at December 31, 1998, which expire in the
years 2003 through 2008. These carryforwards will only be available to reduce
the respective taxable income of the foreign life reinsurance companies and
Delaware.
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." LNC has approximately $196,000,000 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 and
no related deferred tax liability has been recognized. If the entire balance of
account became taxable under the current Federal rate, the tax would be
approximately $68,600,000.
LNC has declared its intention to reinvest the undistributed earnings of Lincoln
UK and will not provide U.S. income tax on these undistributed earnings. At
December 31, 1998, for the years covered by this declaration there was a deficit
in earnings for Lincoln UK.
5. Supplemental Financial Data
Reinsurance transactions included in the income statement captions, "Insurance
Premiums" and "Insurance Fees," are as follows:
Year Ended December 31 (in millions) 1998 1997 1996
- ----------------------------------------------------------------------------------------------------------------
Insurance assumed................................................. $1,259.8 $1,079.1 $1,201.0
Insurance ceded................................................... 695.4 315.0 168.6
--------- ----- -----
Net reinsurance premiums....................................... $ 564.4 $ 764.1 $1,032.4
The income statement caption, "Benefits," is net of reinsurance recoveries of
$1,056,800,000; $393,000,000 and $250,100,000 for the years ended December 31,
1998, 1997 and 1996, respectively.
The income statement caption, "Underwriting, Acquisition, Insurance and Other
Expenses," includes amortization of deferred acquisition costs of $440,000,000;
$468,000,000 and $428,500,000 for the years ended December 31, 1998, 1997 and
1996, respectively. An additional $(34,500,000); $(78,200,000) and $(65,200,000)
of deferred acquisition costs was restored (amortized) and netted against
"Realized Gain (Loss) on Investments" for the years ended December 31, 1998,
1997 and 1996, respectively.
A reconciliation of the present value of business in-force for LNC's insurance
subsidiaries included in other intangible assets is as follows:
December 31 (in millions) 1998 1997 1996
- -------------------------------------------------------------------------------------------------------------
Balance at beginning-of-year..................................... $ 501.3 $602.4 $407.4
Acquisitions of insurance companies/business..................... 1,323.2 22.0 163.5
Interest accrued on unamortized balance.......................... 44.4 36.9 37.9
(Interest rates range from 5% to 7%)
Balance sheet reclassification related to Lincoln UK............. -- (94.8) --
Amortization..................................................... (117.4) (48.1) (47.6)
Foreign exchange adjustment...................................... 1.8 (17.1) 41.2
--------- ----- -----
Balance at end-of-year........................................ 1,753.3 501.3 602.4
Other intangible assets (non-insurance).......................... 95.1 112.6 106.0
-------- ----- -----
Total other intangible assets at end-of-year.................. $1,848.4 $613.9 $708.4
Future estimated amortization of the present value of business in-force net of
interest on unamortized balance for LNC's insurance subsidiaries is as follows
(in millions):
1999 - $112.2 2001 - $115.1 2003 - $ 109.7
2000 - 113.0 2002 - 112.4 Thereafter - 1,190.9
Details underlying the balance sheet caption, "Contractholder Funds," are as
follows:
December 31 (in millions) 1998 1997
- --------------------------------------------------------------------------------
Premium deposit funds.................................. $20,171.9 $19,803.0
Undistributed earnings on participating business....... 142.8 79.8
Other.................................................. 438.4 180.6
--------- ---------
Total............................................... $20,753.1 $20,063.4
51
Details underlying the balance sheet captions related to total debt are as
follows:
December 31 (in millions) 1998 1997
- -----------------------------------------------------------------------------------------------------------------
Short-term debt:
Commercial paper.................................................................... $ 214.4 $ 286.3
Other short-term notes.............................................................. -- 1.3
Current portion of long-term debt................................................... 100.2 9.6
----- -------
Total short-term debt........................................................... 314.6 297.2
Long-term debt less current portion:
7.125% notes payable, due 1999...................................................... -- 99.7
7.625% notes payable, due 2002...................................................... 99.8 99.4
7.250% notes payable, due 2005...................................................... 191.6 191.4
6.500% notes payable, due 2008...................................................... 100.2 --
7% notes payable, due 2018.......................................................... 200.3 --
9.125% notes payable, due 2024...................................................... 119.8 119.8
Mortgages and other notes payable................................................... .5 .7
------- -------
Total long-term debt............................................................ 712.2 511.0
Minority interest - preferred securities of subsidiary companies:
8.75% Quarterly Income Preferred Securities......................................... 215.0 215.0
8.35% Trust Originated Preferred Securities......................................... 100.0 100.0
7.40% Trust Originated Preferred Securities......................................... 200.0 --
7.75% FELINE PRIDES................................................................. 230.0 --
------- --------
Total.......................................................................... 745.0 315.0
Total debt..................................................................... $1,771.8 $1,123.2
The combined U.S. and U.K. commercial paper outstanding at December 31, 1998 and
1997, had a blended weighted average interest rate of approximately 6.67% and
7.03%, respectively.
Future maturities of long-term debt are as follows (in millions):
1999 - $100.2 2001 - $ .4 2003 - $ --
2000 - .1 2002 - 100.0 Thereafter - 613.3
LNC also has access to capital from minority interest in preferred securities of
subsidiary companies. In May 1996, LNC filed a shelf registration with the
Securities and Exchange Commission that would allow LNC to offer and sell up to
$500,000,000 of various forms of hybrid securities. These securities, which
combine debt and equity characteristics, are offered through a series of three
subsidiaries (Lincoln National Capital I, II and III). These subsidiaries were
formed solely for the purpose of issuing preferred securities and lending the
proceeds to LNC. The common securities of these subsidiaries are owned by LNC.
The only assets of Lincoln National Capital I, II and III are the notes
receivable from LNC for such loans. Distributions are paid by these subsidiaries
to the preferred securityholders on a quarterly basis. The principal obligations
of these subsidiaries are irrevocably guaranteed by LNC. Upon liquidation of
these subsidiaries, the holders of the preferred securities would be entitled to
a fixed amount per share plus accumulated and unpaid distributions. LNC reserves
the right to: 1) redeem the preferred securities at a fixed price plus
accumulated and unpaid distributions and; 2) extend the stated redemption date
up to 19 years if certain conditions are met.
In April 1998, LNC filed a shelf registration with the Securities and Exchange
Commission, that would allow LNC to offer and sell up to $1,300,000,000 of
various securities, including regular debt, preferred stock, common stock or
hybrid securities. This filing included an aggregate of $300,000,000 from a
previous filing that had not been utilized. In conjunction with this shelf
registration, three additional subsidiaries were added (Lincoln National Capital
IV, V and VI) to accommodate the issuance of additional preferred securities.
The purpose and terms of these new subsidiaries essentially parallel Lincoln
National Capital I, II and III.
In July 1996, Lincoln National Capital I issued 8,600,000 shares or
$215,000,000, 8.75% Quarterly Income Preferred Securities ("QUIPS"). In August
1996, Lincoln National Capital II issued 4,000,000 shares or $100,000,000, 8.35%
Trust Originated Preferred Securities ("TOPrS"). Both issues mature in 2026 at
$25 per share and are redeemable in whole or in part at LNC's option any time
after 2001. In March 1998, LNC issued notes of 1) $100,000,000, 6.5% due 2008
and 2) $200,000,000, 7% due 2018. In July 1998, Lincoln National Capital III
issued 8,000,000 shares or $200,000,000 of 7.4% TOPrS which mature in 2028 at
$25 per share and are redeemable in whole or in part at LNC's option anytime
after July 2003. In August 1998, Lincoln National Capital IV issued 9,200,000
shares or $230,000,000 of 7.75% FELINE PRIDES (service
52
mark of Merrill Lynch & Co. Inc.). The purchasers of such securities were also
provided stock purchase contract agreements that indicate they will 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. In December 1998, LNC filed a shelf registration with the Securities
Exchange Commission that combines unused portions of the April 1998 registration
($640,000,000) and the May 1996 registration ($185,000,000) resulting in an
active shelf registration allowing LNC to sell up to an additional $825,000,000
of securities.
The funds raised in 1998 from the various public offerings of securities
described above were used to acquire a block of individual life insurance
business from Aetna (see note 11 on page 66).
Finally, LNC maintains a revolving credit agreement with a group of domestic and
foreign banks in the aggregate amount of $750,000,000. This agreement, which
expires in October 2001, provides for interest on borrowings based on various
money market indices. Under the terms of this agreement, LNC must maintain a
prescribed level of adjusted consolidated net worth. At December 31, 1998, LNC
had no outstanding borrowings under this agreement. During 1998, 1997 and 1996,
fees paid for maintaining revolving credit agreements amounted to $662,000;
$670,000 and $715,000, respectively.
Cash paid for interest for 1998, 1997 and 1996 was $108,300,000; $96,000,000 and
$83,200,000, respectively.
6. Employee Benefit Plans
Incentive Plans. LNC has various incentive plans for key employees, agents and
directors of LNC and its subsidiaries that provide for the issuance of stock
options, stock appreciation rights, restricted stock awards and stock incentive
awards. These plans are comprised primarily of stock option incentive plans.
Stock options granted under the stock option incentive plans are at the market
value at the date of grant and, subject to termination of employment, expire 10
years from the date of grant. Such options are transferable only upon death and
are exercisable one year from date of grant for options issued prior to 1992.
Options issued subsequent to 1991 are exercisable in 25% increments on the
option issuance anniversary in the four years following issuance. A "reload
option" feature was added on May 14, 1997. In most cases, persons exercising an
option after that date have been granted new options in an amount equal to the
number of matured shares tendered. The reload options are granted for the
remaining term of the related original option and can be exercised two years
after the grant date if the value of the new option has appreciated by 25%.
Information with respect to incentive plan stock options outstanding at December
31, 1998 is as follows:
Options Outstanding Options Exercisable
Weighted-
Average Weighted- Number Weighted-
Range of Number Out- Remaining Average Exercisable Average
Exercise standing at Contractual Exercise at Exercise
Prices Dec 31, 1998 Life (Years) Price Dec 31, 1998 Price
- -------------------------------------------------------------------------------------------------------------------
$21 - $ 35 388,895 2.65 $26.53 387,645 $26.50
36 - 50 1,360,963 6.18 42.64 1,037,211 41.96
51 - 65 979,856 8.35 58.84 278,569 58.54
66 - 80 359,279 9.04 78.14 69,772 77.49
81 - 95 2,303,372 9.37 90.45 25,276 89.86
96 - 110 61 9.59 96.41 --
--------- ---------
$21 - $110 5,392,426 1,798,473
LNC recognizes compensation expense for its stock option incentive plans using
the intrinsic value based method of accounting (see note 1 on page 44) 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. Had compensation expense for LNC's stock option
incentive plans for options granted after December 31, 1994 been determined
based on the estimated fair value at the grant dates for awards under those
plans, LNC's pro forma net income and earnings per share for the last three
years (1998, 1997 and 1996) would have been $500,984,000 ($4.93 per diluted
share); $930,538,000 ($8.95 per diluted share) and $511,253,000 ($4.85 per
diluted share), respectively (a decrease of $8,791,000 or $.09 per diluted
share; $3,450,000 or $.03 per diluted share and $2,305,000 or $.02 per diluted
share, respectively). 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.
53
The fair value of options granted after December 31, 1994, used as a basis for
the pro forma disclosures, shown above, was estimated as of the date of grant
using a Black-Scholes option pricing model.
The option price assumptions used were as follows:
Year Ended December 31 1998 1997 1996
- ---------------------------------------------------------------------------------------------------------------
Dividend yield.................................................... 3.6% 3.8% 4.1%
Expected volatility............................................... 20.4% 19.0% 18.0%
Risk-free interest rate........................................... 5.6% 6.6% 6.5%
Expected life (in years).......................................... 6 6 5
Weighted-average fair values per option granted................... $18.15 $11.24 $7.35
Restricted stock (non-vested stock) awarded from 1996 through 1998 was as
follows:
Year Ended December 31 1998 1997 1996
- ------------------------------------------------------------------------------------------------------------------
Restricted stock (number of shares)................................... 438,003 118,836 55,538
Weighted-average price per share at time of grant..................... $ 82.50 $61.98 $46.16
Information with respect to the incentive plans involving stock options is as
follows:
Options Outstanding Options Exercisable
Weighted- Weighted-
Shares Average Average
Available Exercise Exercise
for Grant Shares Price Shares Price
____________________________________________________________________________________________________________________
Balance at January 31, 1996................ 7,747,911 2,832,280 $33.21 1,647,872 $28.56
Granted.................................... (636,500) 636,500 45.69
Exercised.................................. -- (273,967) 26.68
Expired.................................... (1,600) (1,000) 27.75
Forfeited.................................. 151,818 (38,650) 36.03
Restricted stock awarded........................ (55,538)
--------- ---------
Balance at December 31, 1996................ 7,206,091 3,155,163 36.29 1,833,269 31.22
Additional authorized. . . . . . . . . . . ..... 5,493,909
Granted-original. . . . . . . . .. . . . . . ... (1,047,200) 1,047,200 60.05
Granted-reloads................................. (47,029) 47,029 68.41
Exercised (includes shares tendered)............ 149,139 (903,407) 31.67
Expired......................................... -- (783) 71.07
Forfeited....................................... 60,797 (44,316) 46.43
Restricted stock awarded........................ (118,836)
------- ---------
Balance at December 31, 1997................. 11,696,871 3,300,886 45.08 1,601,972 35.81
Granted-original................................ (2,605,875) 2,605,875 89.19
Granted-reloads................................. (43,725) 43,725 89.41
Exercised (includes shares tendered)............ 97,862 (488,441) 36.22
Forfeited....................................... 71,287 (69,619) 71.89
Restricted stock awarded........................ (438,003)
-------- ----------
Balance at December 31, 1998................. 8,778,417 5,392,426 67.21 1,798,473 43.25
Other Benefit Plans. LNC maintains defined benefit pension plans for its U.S.
and U.K. employees and a defined contribution plan for its U.S. agents. LNC
also maintains 401(k) Plans, deferred compensation plans and postretirement
medical and life insurance plans for its U.S. employees and agents. The
aggregate expenses and accumulated obligations for these plans are not material
to LNC's consolidated statements of income or financial position for any of the
periods shown in the accompanying consolidated financial statements.
7. Restrictions, Commitments and Contingencies
Statutory Information and Restrictions
Net income (loss) as determined in accordance with statutory accounting
practices for LNC's insurance subsidiaries was $(1,452,400,000); $345,200,000
and $384,600,000 for 1998, 1997 and 1996, respectively. The 1998 amounts
includes the statutory ceding commissions associated with the acquisition of two
blocks
54
of business as described below. Excluding the impact of these acquisitions, net
income for 1998 would have been $545,900,000. Statutory net income (loss) for
1998, 1997 and 1996, excluding LNC's foreign life reinsurance companies, was
$(1,397,600,000); $299,100,000 and $342,700,000, respectively.
Shareholders' equity as determined in accordance with statutory accounting
practices for LNC's insurance subsidiaries was $2,952,500,000 and $2,660,900,000
for December 31, 1998 and 1997, respectively.
The National Association of Insurance Commissioners is involved in a multi-year
project to examine and challenge the appropriateness of current statutory
accounting practices. This project could result in changes to statutory
accounting practices that could cause changes to the statutory net income and
shareholders' equity data shown above.
LNC's insurance subsidiaries are subject to certain insurance department
regulatory restrictions as to the transfer of funds and payments of dividends to
LNC. Based upon these regulations, and without giving effect to the 1998
acquisitions, (see note 11 on page 66), LNC's insurance subsidiaries would have
been able to pay dividends to LNC in 1999 of approximately $603,400,000 without
obtaining specific approval from the insurance commissioners. LNC's primary
insurance subsidiary, Lincoln National Life Insurance Company ("Lincoln Life")
acquired a block of individual life insurance and annuity business from CIGNA in
January 1998 and a block of individual life insurance from Aetna in October
1998. These acquisitions were structured as indemnity reinsurance transactions.
The statutory accounting regulations do not allow goodwill to be recognized on
indemnity reinsurance transactions and therefore, the related statutory ceding
commission flows through the statement of operations as an expense resulting in
a reduction of earned surplus. As a result of these acquisitions, Lincoln Life's
statutory earned surplus is negative and it is necessary for Lincoln Life to
obtain the prior approval of the Indiana Insurance Commissioner before paying
any dividends to LNC until such time as statutory earned surplus is positive. It
is expected that statutory earned surplus will return to a positive position
within two-three years from the closing of the Aetna transaction described above
assuming a level of statutory earnings coinciding with recent earnings patterns.
If statutory earnings are less than recent patterns due, for example, to adverse
operating conditions or further indemnity reinsurance transactions of this
nature or if dividends are approved or paid at amounts higher than recent
history, the statutory earned surplus may not return to a positive position as
soon as expected. Although no assurance can be given, management believes that
the approvals for the payment of dividends in amounts consistent with those paid
in the past can be obtained. In the event such approvals are not obtained,
management believes that LNC can obtain the funds required to satisfy its
obligations from its existing credit facilities and other sources.
Disability Income Claims
The liability for disability income claims net of the related asset for amounts
recoverable from reinsurers at December 31, 1998 and 1997 is a net liability of
$1,813,400,000 and $1,654,000,000, respectively, excluding deferred acquisition
costs. This liability is based on the assumption that recent experience will
continue in the future. If incidence levels and/or claim termination rates
fluctuate significantly from the assumptions underlying the reserves,
adjustments to reserves could be required in the future. Accordingly, this
liability may prove to be deficient or excessive. However, it is management's
opinion that such future development will not materially affect the consolidated
financial position of LNC. LNC reviews reserve levels on an on-going basis.
United Kingdom Pension Products
Operations in the U.K. include the sale 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 has 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. At December 31, 1998 and 1997, liabilities of
$202,100,000, and $291,000,000, respectively, had been established for this
issue. The decrease in the level of the reserve reflects the settlement payouts
that occurred during 1998. These liabilities, which are net of expected
recoveries, have been established for the estimated cost of this issue following
regulatory guidance as to activities to be undertaken. The expected recoveries
from previous owners of companies acquired over the last few years as specified
in the indemnification clauses of the purchase agreements at December 31, 1998
and 1997 were $84,900,000 and $113,000,000, respectively . These liabilities and
recoveries are based on various estimates that are subject to considerable
uncertainty. Also, there is further uncertainty from the regulator perspective
as additional guidelines were issued in December of 1998 that extended the
review to a wider range client population. These guidelines specify actions
expected from the companies that issued such products. Accordingly, these
liabilities may prove to be deficient or excessive. However, it is management's
opinion that such future development will not materially affect the consolidated
financial position of LNC.
55
Personal Accident Programs
LNC's Reinsurance segment accepts personal accident reinsurance programs from
other insurance companies. Most of these programs are presented to the
Reinsurance segment by independent brokers who represent the ceding companies.
Certain excess of loss personal accident reinsurance programs created in the
London market during 1993-1996 have produced and have potential to produce
significant losses. At December 31, 1998 and 1997, liabilities of $177,400,000
and $186,300,000, respectively had been established for such programs. This
reserve is based on various estimates that are subject to considerable
uncertainty. Accordingly, this reserve may prove to be deficient or excessive.
However, it is management's opinion that such future development will not
materially affect the consolidated financial position of LNC.
LNC continues to investigate its personal accident reinsurance programs to
determine if there are additional programs including certain workers
compensation programs which may produce losses. At this time LNC 1) does not
have sufficient information to determine whether or not it is probable that
additional losses have been incurred and 2) can not accurately estimate the
ultimate cost or timing of the outcome on these programs.
Marketing and Compliance Issues
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 development will not materially affect the consolidated
financial position of LNC.
Group Pension Annuities
The liabilities for guaranteed interest and group pension annuity contracts are
supported by a single portfolio of assets that attempts to match the duration of
these liabilities. Due to the long-term nature of group pension annuities and
the resulting inability to exactly match cash flows, a risk exists that future
cash flows from investments will not be reinvested at rates as high as currently
earned by the portfolio. Accordingly, these liabilities may prove to be
deficient or excessive. However, it is management's opinion that such future
development will not materially affect the consolidated financial position of
LNC.
Euro Conversion
LNC owns operating companies in Europe and conducts 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.
It is management's opinion the additional phases of this conversion, which will
be implemented during the next few years, will not materially affect the
consolidated financial condition of LNC.
Leases
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 first refusal to purchase the
properties during the term 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.
Total rental expense on operating leases in 1998, 1997 and 1996 was $81,300,000,
$62,500,000 and $54,500,000, respectively. Future minimum rental commitments are
as follows (in millions):
1999 - $55.0 2001 - $48.2 2003 - $ 36.1
2000 - 51.6 2002 - 41.9 Thereafter - 217.1
Information Technology Commitment
In February 1998, Lincoln Life signed a seven-year contract with IBM Global
Services for information technology services for the Fort Wayne operations.
Annual costs are dependent on usage but are expected to range from $33,600,000
to $56,800,000.
Insurance Ceded and Assumed
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
56
business segments that sell life insurance to limit its liabilities. As of
December 31, 1998, LNC's maximum retention was $10,000,000 on a single insured.
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, 1998,
the reserves associated with these reinsurance arrangements totaled
$1,608,500,000. 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 on page 49). LNC's insurance companies remain liable if their reinsurers
are unable to meet contractual obligations under applicable reinsurance
agreements.
Certain LNC insurance companies assume insurance from other companies. At
December 31, 1998, LNC's insurance companies have provided $228,800,000 of
statutory surplus relief to other insurance companies under reinsurance
transactions. Generally, such amounts are offset by corresponding receivables
from the ceding company, which are secured by future profits on the reinsured
business. However, LNC's insurance companies are subject to the risk that the
ceding company may become insolvent and the right of offset would not be
permitted.
Associated with these transactions, LNC's insurance companies have obtained
letters of credit in favor of various insurance companies. This allows the
ceding companies to take statutory reserve credit. The letters of credit
issued by the banks represent a guarantee of performance under the reinsurance
agreements. At December 31, 1998, there was a total of $656,200,000 in
outstanding bank letters of credit. In exchange for the letters of credit, LNC
paid the banks approximately $1,637,000 in fees in 1998.
Vulnerability from Concentrations
At December 31, 1998, LNC did not have a material concentration of financial
instruments in a single investee, industry or geographic location. Also at
December 31, 1998, LNC did not have a concentration of: 1) business transactions
with a particular customer, lender or distributor; 2) revenues from a particular
product or service; 3) sources of supply of labor or services used in the
business or; 4) 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
condition.
Other Contingency Matters
LNC and its subsidiaries are involved in various pending or threatened legal
proceedings arising from the conduct of business. Most of these proceedings are
routine in the ordinary course of business. LNC maintains professional liability
insurance coverage for claims in excess of $5 million. The degree of
applicability of this coverage will depend on the specific facts of each
proceeding. In some instances, these proceedings include claims for compensatory
and punitive damages and similar types of relief in addition to amounts for
alleged contractual liability or requests for equitable relief. After
consultation with legal counsel and a review of available facts, it is
management's opinion that the ultimate liability, if any, under these suits will
not have a material adverse effect on the consolidated financial condition of
LNC.
Four lawsuits involving alleged fraud in the sale of interest sensitive
universal life and whole life insurance have been filed as class actions against
Lincoln Life, although the court has not certified a class in any of these
cases. Plaintiffs seek unspecified damages and penalties for themselves and on
behalf of the putative class. While the relief sought in these cases is
substantial, it is premature to make assessments about the potential loss, if
any, because the status of the cases ranges from the early stages of litigation
to the dismissal and appeals stage. Management intends to defend these suits
vigorously. The amount of liability, if any, which may arise as a result of
these suits cannot be reasonably estimated at this time.
UK regulatory authorities have completed a review of Lincoln UK selling
practices. This review does not include matters related to the pension product
mis-selling investigations. Management is currently working with the regulators
to address compliance issues that have been raised in the course of this review.
The extent of corrective measures and potential disciplinary actions, if any,
that may result from this review are actively being discussed with the
regulatory authorities. It is not possible to provide a meaningful estimate of
the potential outcome of this matter at the present time. However, it is
management's opinion that the resolution of these matters will not materially
affect the consolidated financial position of LNC.
The number of insurance companies that are under regulatory supervision has
resulted, and is expected to continue to result, in assessments by state
guaranty funds to cover losses to policyholders of insolvent or
57
rehabilitated companies. Mandatory assessments may be partially recovered
through a reduction in future premium taxes in some states. LNC has accrued for
expected assessments net of estimated future premium tax deductions.
Guarantees
LNC has guarantees with off-balance-sheet risks whose contractual amounts
represent credit exposure. Outstanding guarantees with off-balance-sheet risks,
shown in notional or contract amounts along with their carrying value and
estimated fair values, are as follows:
Assets (Liabilities)
Notional or Carrying Fair Carrying Fair
Contract Amounts Value Value Value Value
December 31 (in millions) 1998 1997 1998 1998 1997 1997
- ------------------------------------------------------------------------------------------------------------------
Industrial revenue bonds.......................... $27.1 $27.9 -- -- $(.8) $ --
Real estate partnerships.......................... -- 2.9 -- -- -- --
Mortgage loan pass-through certificates........... 30.9 41.6 -- -- -- --
---- ---- ------ ------ --- -----
Total guarantees............................. $58.0 $72.4 -- -- $(.8) $ --
Certain subsidiaries of LNC have invested in real estate partnerships which 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 some cases, the terms of these arrangements involve
guarantees by each of the partners to indemnify the mortgagor in the event a
partner is unable to pay its principal and interest payments. 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. 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.
Derivatives
LNC has derivatives with off-balance-sheet risks whose notional or contract
amounts exceed the credit exposure. LNC has entered into derivative transactions
to reduce its exposure to fluctuations in interest rates, the widening of bond
yield spreads over comparable maturity U.S. Government obligations, Commodity
risk, credit risk, increased liabilities associated with certain reinsurance
agreements, foreign exchange risks and fluctuations in the FTSE and S&P indexes.
In addition, LNC is subject to the risks associated with changes in the value of
its derivatives; however, such changes in value generally are offset by changes
in the value of the items being hedged by such contracts. Outstanding
derivatives with off- balance-sheet risks, shown in notional or contract amounts
along with their carrying value and estimated fair values, are as follows:
Assets (Liabilities)
Notional or Carrying Fair Carrying Fair
Contract Amounts Value Value Value Value
December 31 (in millions) 1998 1997 1998 1998 1997 1997
- ------------------------------------------------------------------------------------------------------------------
Interest rate derivatives:
Interest rate cap agreements.............. $4,108.8 $4,900.0 $ 9.3 $ .9 $13.9 $ .9
Swaptions................................. 1,899.5 1,752.0 2.5 2.5 6.9 6.9
Interest rate swap agreements............. 258.3 10.0 9.9 9.9 .2 .2
Put options............................... 21.3 -- 2.2 2.2 -- --
--------- -------- ----- ----- ----- -----
Total interest rate derivatives........ 6,287.9 6,662.0 23.9 15.5 21.0 8.0
Foreign currency derivatives:
Forward exchange forward contracts:
Foreign investments..................... 1.5 163.1 * * 5.4 5.4
Foreign currency swaps.................... 47.2 15.0 .3 .3 (2.1) (2.1)
---- ------ ----- ----- --- ---
Total foreign currency derivatives..... 48.7 178.1 .3 .3 3.3 3.3
Commodity derivatives:
Commodity swap............................ 8.1 -- 2.4 2.4 -- --
Equity indexed derivatives:
Call options (based on FTSE).............. 11.1 14.1 11.7 11.7 13.5 13.5
Call options (based on S&P)............... 79.9 5.3 23.1 23.1 1.1 1.1
Total derivatives...................... $6,435.7 $6,859.5 $61.4 $53.0 $38.9 $25.9
*Less than $100,000.
58
A reconciliation of the notional or contract amounts for the significant
programs using derivative agreements and contracts is as follows:
Interest Rate Spread-Lock
Cap Agreements Swaptions Agreements
December 31 (in millions) 1998 1997 1998 1997 1998 1997
- ------------------------------------------------------------------------------------------------------------------
Balance at beginning-of-year............ $4,900.0 $5,500.0 $1,752.0 $ 672.0 $ -- $ --
New contracts........................... 708.8 -- 218.3 1,080.0 -- 50.0
Terminations and maturities............. (1,500.0) (600.0) (70.8) -- -- (50.0)
------- -------- ------ -------- --- ----
Balance at end-of-year............... $4,108.8 $4,900.0 $1,899.5 $1,752.0 $ -- $ --
Financial
Futures Interest Rate
Contracts Swap Agreements Put Options
December 31 (in millions) 1998 1997 1998 1997 1998 1997
- -----------------------------------------------------------------------------------------------------------------
Balance at beginning-of-year............ $ -- $ 147.7 $ 10.0 $ -- $ -- $ --
New contracts........................... -- 88.3 2,226.6 10.0 21.3 --
Terminations and maturities............. -- (236.0) (1,978.3) -- -- --
--- ------ ------- ----- ----- ---
Balance at end-of-year................ $ -- $ -- $ 258.3 $10.0 $21.3 $ --
Foreign Currency Derivatives (Foreign Investments)
Foreign Exchange Foreign Foreign
Forward Currency Currency
Contracts Options Swaps
December 31 (in millions) 1998 1997 1998 1997 1998 1997
- ------------------------------------------------------------------------------------------------------------------
Balance at beginning-of-year............ $ 163.1 $ 251.6 $ -- $ 50.2 $15.0 $15.0
New contracts........................... 419.8 833.1 -- -- 39.2 --
Terminations and maturities............. (581.4) (921.6) -- (50.2) (7.0) --
----- ------- ---- ----- ---- ------
Balance at end-of-year............... $ 1.5 $ 163.1 $ -- $ -- $47.2 $15.0
Commodity Call Options Call Options
Swap (Based on FSTE) (Based on S&P)
December 31 (in millions) 1998 1997 1998 1997 1998 1997
- ----------------------------------------------------------------------------------------------------------------
Balance at beginning-of-year............ $ -- $ -- $14.1 $14.7 $ 5.3 $ --
New contracts........................... 8.1 -- -- -- 74.6 5.3
Terminations and maturities............. -- -- (3.1) -- -- --
Foreign exchange adjustment............. -- -- .1 (.6) -- --
---- --- ----- ---- ----- ----
Balance at end-of-year............... $8.1 $ -- $11.1 $14.1 $79.9 $5.3
Interest Rate Cap Agreements. the interest rate cap agreements, which expire in
1999 through 2006, 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 protect its annuity line of business from the
effect of rising interest rates. The premium paid for the interest rate caps is
included in other investments ($9,300,000 as of December 31, 1998) and is being
amortized over the terms of the agreements. This amortization is included in net
investment income.
Swaptions. Swaptions, which expire in 1999 through 2003, entitle LNC to receive
settlement payments from the counterparties on specified expiration dates,
contingent on future interest rates. For each swaption, the amount of such
settlement payments, if any, is determined by the present value of the
difference between the fixed rate on a market rate swap and the strike rate
multiplied by the notional amount. The purpose of LNC's swaption program is to
protect its annuity line of business from the effect of rising interest rates.
The premium paid for the swaptions is included in other investments (amortized
cost of $16,200,000 as of December 31, 1998) and is being amortized over the
terms of the agreements. This amortization is included in net investment income.
Spread-Lock Agreements. Spread-lock agreements provide for a lump sum payment to
or by LNC, depending on whether the spread between the swap rate and a specified
Government note is larger or smaller than a contractually specified spread. Cash
payments are based on the product of the notional amount, the spread between the
swap rate and the yield of an equivalent maturity Government security, and the
price sensitivity of the swap at that time. The purpose of LNC's spread-lock
program is to protect a portion of its fixed maturity securities against
widening spreads.
59
Financial Futures Contracts. LNC uses exchange-traded financial futures
contracts to hedge against interest rate risks and to manage duration of a
portion of its fixed maturity securities. Financial futures contracts obligate
LNC to buy or sell a financial instrument at a specified future date for a
specified price. They may be settled in cash or through delivery of the
financial instrument. Cash settlements on the change in market values of
financial futures contracts are made daily.
Interest Rate Swap Agreements. LNC uses interest rate swap agreements to hedge
its exposure to floating rate bond coupon payments, replicating a fixed rate
bond. An interest rate swap is a contractual agreement to exchange payments at
one or more times based on the actual or expected price, level, performance or
value of one or more underlying interests rates. LNC is required to pay the
counterparty to the agreements the stream of variable coupon payments generated
from the bonds, and in turn, receives a fixed payment from the counterpart, at a
predetermined interest rate. The net receipts/payments from interest rate swaps
are recorded in net investment income. LNC also uses interest rate swap
agreements to hedge its exposure to interest rate fluctuations related to the
anticipated purchase of assets to support newly acquired blocks of business.
Once the assets are purchased the gains resulting from the termination of the
swap agreements will be applied to the basis of the assets. The gains will be
recognized in earnings over the life of the assets.
Put Options. LNC uses put options, combined with various perpetual fixed income
securities, and interest rate swaps to replicate a fixed income, fixed maturity
investment. The put options give LNC the right, but not the obligation, to sell
to the counterparty of the agreement the specified securities on a specified
date at a fixed price.
Foreign Currency Derivatives (Foreign Investments). LNC uses a combination of
foreign exchange forward contracts, foreign currency options and foreign
currency swaps, all of which are traded over-the-counter, to hedge some of the
foreign exchange risk of investments in fixed maturity securities denominated in
foreign currencies. The foreign currency forward contracts obligate LNC to
deliver a specified amount of currency at a future date at a specified exchange
rate. Foreign currency options give LNC the right, but not the obligation, to
buy or sell a foreign currency at a specified exchange rate during a specified
time period. A foreign currency swap is a contractual agreement to exchange the
currencies of two different countries pursuant to an agreement to re-exchange
the two currencies at the same rate of exchange at a specified future date.
Foreign Exchange Forward Contracts (Foreign Subsidiary). LNC has used foreign
exchange forward contracts, which are traded over-the-counter, to hedge the
foreign exchange risk assumed with its investment in its U.K. subsidiary,
Lincoln National (UK). The foreign exchange forward contracts obligated LNC to
deliver a specified amount of currency at a future date at a specified exchange
rate.
Commodity Swap. LNC uses a commodity swap to hedge its exposure to fluctuations
in the price of gold, which is the underlying variable in determining the
periodic interest payments associated with a fixed income security. A commodity
swap is a contractual agreement to exchange a certain amount of a particular
commodity for a fixed amount of cash. LNC owns a fixed income security that
meets its coupon payment obligations in gold bullion. LNC is obligated to pay to
the counterparty the gold bullion, and in return receives from the counterparty
a stream of fixed income payments. The fixed income payments are the product of
the swap notional multiplied by the fixed rate stated in the swap agreement. The
net receipts/payments from commodity swaps are recorded in net investment
income.
Call Options. LNC uses both FTSE index and S&P 500 index call options. Call
options which expire in 1999 through 2006, provide LNC with settlement payments
from the counterparties on specified expiration dates. The payment, if any, is
the percentage increase in the index, over the strike price defined in the
contract, applied to the notional amount. The purpose of LNC's FTSE call option
program is to offset the cost of increases in the liabilities of certain single
premium investment contracts which are tied to the FTSE index. The purpose of
LNC's S&P 500 call option program is to offset the increase in its liabilities
resulting from certain reinsurance agreements which guarantee payment of the
appreciation of the S&P 500 index on certain underlying annuity products. The
premium paid for the S&P 500 index call options is included in other assets
($16,800,000 as of December 31, 1998) and is being amortized over the terms of
the agreements. This amortization is included in net investment income.
Additional Derivative Information. Expenses for the agreements and contracts
described above amounted to $11,600,000 and $10,000,000 in 1998 and 1997,
respectively. Deferred gains of $64,800,000 as of December 31, 1998, were the
result of: 1) terminated and expired spread-lock agreements and; 2) terminated
60
interest rate swaps. These gains are included with the related fixed maturity
securities to which the hedge applied or as deferred liabilities and are being
amortized over the life of such securities.
LNC is exposed to credit loss in the event of nonperformance by counterparties
on interest rate cap agreements, swaptions, spread-lock agreements, interest
rate swaps, commodity swaps, call options, put options, foreign exchange forward
contracts, foreign currency options and foreign currency swaps. However, LNC
does not anticipate nonperformance by any of the counterparties. The credit risk
associated with such agreements is minimized by purchasing such agreements from
financial institutions with long-standing, superior performance records. The
amount of such exposure is essentially the net replacement cost or market value
for such agreements with each counterparty if the net market value is in LNC's
favor. At December 31, 1998, the exposure was $53,000,000.
8. Fair Value of Financial Instruments
The following discussion outlines the methodologies and assumptions used to
determine the estimated fair value of LNC's financial instruments. Considerable
judgment is required to develop these fair values. Accordingly, the estimates
shown are not necessarily indicative of the amounts that would be realized in a
one-time, current market exchange of all of LNC's financial instruments.
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.
Mortgage Loans on Real Estate. The estimated fair value of mortgage loans on
real estate was established using a discounted cash flow method based on credit
rating, maturity and future income. The ratings for mortgages in good standing
are based on property type, location, market conditions, occupancy, debt service
coverage, loan to value, caliber of tenancy, borrower and payment record. Fair
values for impaired mortgage loans are based on: 1) the present value of
expected future cash flows discounted at the loan's effective interest rate; 2)
the loan's market price or; 3) the fair value of the collateral if the loan is
collateral dependent.
Policy Loans. The estimated fair value of investments in policy loans was
calculated on a composite discounted cash flow basis using Treasury interest
rates consistent with the maturity durations assumed.
These durations were based on historical experience.
Other Investments, and Cash and Invested Cash. The carrying value for assets
classified as other investments, and cash and invested cash in the accompanying
balance sheets approximates their fair value.
Investment Type Insurance Contracts. The balance sheet captions, "Future Policy
Benefits, Claims and Claim Expenses" and "Contractholder Funds," include
investment type insurance contracts (i.e. deposit contracts and 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.
The remainder of the balance sheet captions "Future Policy Benefits, Claims and
Claim Expenses" and "Contractholder Funds" that do not fit the definition of
"investment type insurance contracts" are considered insurance contracts. Fair
value disclosures are not required for these insurance contracts and have not
been determined by LNC. It is LNC's position that the disclosure of the fair
value of these insurance contracts is important because readers of these
financial statements could draw inappropriate conclusions about LNC's
shareholders' equity determined on a fair value basis. It could be misleading if
only the fair value of assets and liabilities defined as financial instruments
are disclosed. LNC and other companies in the insurance industry are monitoring
the related actions of the various rule-making bodies and attempting to
determine an appropriate methodology for estimating and disclosing the "fair
value" of their insurance contract liabilities.
Short-term and Long-term Debt. Fair values for long-term debt issues are based
on quoted market prices or estimated using discounted cash flow analysis based
on LNC's current incremental borrowing rate for
61
similar types of borrowing arrangements where quoted prices are not available.
For short-term debt, the carrying value approximates fair value.
Minority Interest - Preferred Securities of Subsidiary Companies. Fair values
for minority interest- preferred securities of subsidiary companies are based on
quoted market prices less the unamortized cost of issue.
Guarantees. LNC's guarantees include guarantees related to industrial revenue
bonds, real estate partnerships and mortgage loan pass-through certificates.
Based on historical performance where repurchases have been negligible and the
current status, which indicates none of the loans are delinquent, the fair value
liability for the guarantees related to the mortgage loan pass-through
certificates is insignificant.
Derivatives. LNC employs several different methods for determining the fair
value of its derivative instruments. Fair values for these contracts are based
on current settlement values. These values are based on: 1) quoted market prices
for foreign currency exchange contracts and financial futures contracts 2)
industry standard models that are commercially available for interest rate cap
agreements, swaptions, spread-lock agreements, interest rate swaps, commodity
swaps and put options. 3) Monte Carlo techniques are used for the exotic equity
call options. These techniques project cash flows of the derivatives using
current and implied future market conditions. The cash flows are then present
valued to arrive at the derivatives current fair market value. 4) Black-Scholes
pricing methodology for standard European equity call options.
Investment Commitments. Fair values for commitments to make investments in fixed
maturity securities (primarily private placements), mortgage loans on real
estate and real estate are based on the difference between the value of the
committed investments as of the date of the accompanying balance sheets and the
commitment date. These estimates would take into account changes in interest
rates, the counterparties' credit standing and the remaining terms of the
commitments.
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.
The carrying values and estimated fair values of LNC's financial instruments are
as follows:
Carrying Fair Carrying Fair
Value Value Value Value
December 31 (in millions) 1998 1998 1997 1997
- -------------------------------------------------------------------------------------------------------------------
Assets (liabilities):
Fixed maturities securities........................ $30,232.9 $30,232.9 $24,066.4 $24,066.4
Equity securities.................................. 542.8 542.8 660.4 660.4
Mortgage loans on real estate...................... 4,393.1 4,580.4 3,288.1 3,473.5
Policy loans....................................... 1,840.0 1,938.4 763.1 754.4
Other investments.................................. 432.0 432.0 464.8 464.8
Cash and invested cash............................. 2,433.4 2,433.4 3,794.7 3,794.7
Investment type insurance contracts:
Deposit contracts and certain
guaranteed interest contracts.................. (18,746.3) (18,419.8) (17,844.6) (17,489.1)
Remaining guaranteed interest
and similar contracts........................... (1,444.9) (1,433.8) (2,032.0) (2,010.0)
Short-term debt.................................... (314.6) (314.6) (297.2) (297.2)
Long-term debt..................................... (712.2) (748.7) (511.0) (541.7)
Minority interest-preferred
securities of subsidiary companies................ (745.0) (744.4) (315.0) (322.9)
Guarantees......................................... -- -- (.8) --
Derivatives........................................ 61.4 53.0 38.9 25.9
Investment commitments............................. -- .1 -- .3
As of December 31, 1998 and 1997, the carrying value of the deposit contracts
and certain guaranteed contracts is net of deferred acquisition costs of
$52,600,000 and $96,400,000, respectively, excluding adjustments for deferred
acquisition costs applicable to changes in fair value of securities. The
carrying values of these contracts are stated net of deferred acquisition costs
so that they are comparable with the fair value basis.
62
9. Segment Information
LNC has four business segments: Life Insurance and Annuities, Lincoln UK,
Reinsurance and Investment Management. The Life Insurance and Annuities segment
offers annuities, universal life, pension products and other individual
coverages through a network of career agents, independent general agencies, and
insurance agencies located within a variety of financial institutions. These
products are sold throughout the United States. The Lincoln UK segment offers
similar products within the United Kingdom through sales representatives.
Reinsurance sells reinsurance products and services to insurance companies,
HMOs, self-funded employers and other primary risk accepting organizations in
the U.S. and economically attractive international markets. The Investment
Management segment offers a variety of asset management services to
institutional and retail customers primarily throughout the United States.
Activity which is not included in the major business segments is shown as "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 and unallocated overhead expenses). LNC's
other operations also includes data for its investment management company that
services LNC's business segments.
Financial data by segment for 1996 through 1998 is as follows:
Year Ended December 31 (in millions) 1998 1997 1996
- -----------------------------------------------------------------------------------------------------------------
Revenue, Excluding Net Investment Income and Realized
Gain (Loss) on Investments and Subsidiaries:
Life Insurance and Annuities..................................... $1,495.6 $ 867.0 $ 755.9
Lincoln UK....................................................... 350.8 340.1 311.4
Reinsurance...................................................... 1,267.5 1,073.7 1,279.2
Investment Management............................................ 301.3 257.7 215.0
Other Operations (includes consolidating adjustments)............ (28.5) (13.4) (8.3)
-------- -------- -------
Total........................................................ $3,386.7 $2,525.1 $2,553.2
Net Investment Income:
Life Insurance and Annuities..................................... $2,249.0 $1,842.4 $1,741.7
Lincoln UK....................................................... 87.9 85.1 82.0
Reinsurance...................................................... 307.8 284.4 263.7
Investment Management............................................ .2 .5 .7
Other Operations................................................. 36.5 38.4 (.2)
-------- -------- -------
Total........................................................ $2,681.4 $2,250.8 $2,087.9
Realized Gain (Loss) on Investments and Subsidiaries:
Life Insurance and Annuities..................................... $ 6.7 $ 82.1 $65.5
Lincoln UK....................................................... 1.1 2.1 (.2)
Reinsurance...................................................... 1.5 23.6 18.1
Investment Management............................................ 1.2 5.9 8.1
Other Operations................................................. 8.5 8.9 1.0
----- ------ -----
Total........................................................ $19.0 $122.6 $92.5
Net Income (Loss) from Continuing Operations
before Federal Income Taxes:
Life Insurance and Annuities..................................... $518.9 $397.3 $346.7
Lincoln UK....................................................... 106.9 (96.8) 101.5
Reinsurance...................................................... 156.7 (210.2) 131.1
Investment Management............................................ 39.4 20.9 32.4
Other Operations (includes interest expense)..................... (124.5) (76.3) (107.6)
----- ------- ------
Total........................................................ $697.4 $ 34.9 $504.1
63
Year Ended December 31 (in millions) 1998 1997 1996
- ------------------------------------------------------------------------------------------------------------------
Income Tax Expense (Benefit):
Life Insurance and Annuities..................................... $131.4 $ 94.0 $ 95.7
Lincoln UK....................................................... 35.2 10.0 35.5
Reinsurance...................................................... 54.5 (73.8) 45.4
Investment Management............................................ 17.9 13.1 17.0
Other Operations................................................. (51.4) (30.6) (45.9)
----- ---- -----
Total........................................................ $187.6 $ 12.7 $147.7
Net Income (Loss) from Continuing Operations:
Life Insurance and Annuities..................................... $387.5 $303.3 $251.0
Lincoln UK....................................................... 71.7 (106.8) 66.0
Reinsurance...................................................... 102.2 (136.4) 85.7
Investment Management............................................ 21.5 7.8 15.4
Other Operations (includes interest expense)..................... (73.1) (45.7) (61.7)
----- ------- ------
Total Net Income from Continuing Operations.................. 509.8 22.2 356.4
Discontinued Operations.......................................... -- 911.8 157.2
------ ------- ------
Total Net Income............................................. $509.8 $934.0 $513.6
December 31 (in millions) 1998 1997 1996
- ------------------------------------------------------------------------------------------------------------------
Assets:
Life Insurance and Annuities..................................... $77,797.9 $60,604.4 $53,089.3
Lincoln UK....................................................... 8,757.3 7,923.8 7,331.8
Reinsurance...................................................... 6,408.0 5,540.2 5,196.1
Investment Management............................................ 698.3 697.4 623.4
Other Operations................................................. 174.8 2,408.9 (9.9)
--------- --------- ---------
Sub-total..................................................... 93,836.3 77,174.7 66,230.7
Discontinued Operations.......................................... -- -- 5,482.7
--------- ---------- ---------
Total......................................................... $93,836.3 $77,174.7 $71,713.4
Substantially all of LNC's foreign operations are conducted by Lincoln National
(UK) plc, a United Kingdom company. The data for this company is shown above
under the Lincoln UK segment heading. Foreign intracompany revenue is not
significant. All earnings from LNC's U.K. operations have been retained in the
U.K.
10. Shareholders' Equity
LNC's common and preferred stock is without par value.
All of the issued and outstanding series A preferred stock is $3 Cumulative
Convertible and is convertible at any time into shares of common stock. The
conversion rate is eight shares of common stock for each share of series A
preferred stock, subject to adjustment for certain events. The series A
preferred stock is redeemable at the option of LNC at $80 per share plus accrued
and unpaid dividends. Outstanding series A preferred stock has full voting
rights, subject to adjustment if LNC is in default as to the payment of
dividends. If LNC is liquidated or dissolved, holders of series A preferred
stock will be entitled to payments of $80.00 per share. The difference between
the aggregate preference on liquidation value and the financial statement
balance for the series A preferred stock was $1,554,000 at December 31, 1998.
LNC has outstanding one common share purchase right ("Right") on each
outstanding share of LNC's common stock. A Right will also be issued with each
share of LNC's common stock that is issued before the Rights become exercisable
or expire. If a person or group announces an offer that would result in
beneficial ownership of 15% or more of LNC's common stock, the Rights will
become exercisable and each Right will entitle its holder to purchase one share
of LNC's common stock for $200. 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,
1998, there were 101,055,587 Rights outstanding.
64
During 1998, 1997 and 1996, LNC purchased and retired 623,281; 4,948,900 and
694,582 shares, respectively, of its common stock at a total cost of
$46,900,000; $325,300,000 and $35,000,000, respectively. The common stock
account was reduced for these purchases in proportion to the percentage of share
acquired. The remainder of the purchase price was charged to retained earnings.
Per share amounts for net income from continuing operations 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:
Year Ended December 31 1998 1997 1996
- ----------------------------------------------------------------------------------------------------------------
Numerator: [in millions]
Net income from continuing operations,
as used in basic calculation................................. $509.7 $22.1 $356.3
Dividends on convertible preferred stock...................... .1 .1 .1
----- ---- -----
Net income from continuing operations,
as used in diluted calculation......................... $509.8 $22.2 $356.4
Denominator: [number of shares]
Weighted average shares, as used in basic calculation......... 100,357,079 102,495,557 103,828,451
Shares to cover conversion of preferred stock................. 271,019 287,077 307,784
Shares to cover restricted stock.............................. 228,288 208,664 423,112
Average stock options outstanding during the year............. 3,195,155 3,199,539 2,979,244
Assumed acquisition of shares with assumed proceeds
and tax benefits from exercising stock options
(at average market price during the year).................... (2,420,314) (2,194,950) (2,167,199)
--------- --------- ---------
Weighted-average shares, as used
in diluted calculation.................................. 101,631,227 103,995,887 105,371,392
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. Also, LNC has purchase contracts outstanding which require the
holder to purchase LNC common stock by August 16, 2001. These purchase contracts
were issued in conjunction with the FELINE PRIDES financing. The common shares
involved are not currently dilutive to LNC's earnings per share and will not be
dilutive in the future except during periods when the average market price of
LNC's common stock exceeds a stated threshold price of $111.45 per share.
Details underlying the balance sheet caption "Net Unrealized Gain (Loss) on
Securities Available-for-Sale," are as follows:
December 31 (in millions) 1998 1997
- -----------------------------------------------------------------------------------------------------------------
Fair value of securities available-for-sale............................. $30,775.7 $24,726.8
Cost of securities available-for-sale................................... 29,076.3 23,143.2
-------- ----------
Unrealized gain.................................................... 1,699.4 1,583.6
Adjustments to deferred acquisition costs............................... (244.6) (355.9)
Amounts required to satisfy policyholder commitments.................... (665.0) (571.1)
Deferred income credits (taxes).......................................... (251.1) (207.6)
----- ---------
Net unrealized gain on securities
available-for-sale for continuing operations...................... 538.7 449.0
Change in fair value of derivatives designated as a hedge
(classified as other investment)....................................... 13.7 (13.0)
-------- ----------
Net unrealized gain on securities available for sale............... $ 552.4 $ 436.0
Adjustments to deferred acquisition costs and amounts required to satisfy
policyholder commitments are netted against the Deferred Acquisition Costs asset
line and included within the Insurance Policy and Claim Reserves line on the
balance sheet, respectively.
65
The "Net Unrealized Gain (Loss) on Securities Available-for-Sale" shown above is
net of realized gain (loss) on investments. Following is the detail of the
realized gain (loss) on investments and gross unrealized gain (loss) on
securities available-for-sale:
Year Ended December 31 (in millions) 1998 1997
- --------------------------------------------------------------------------------------------------------------------
Continuing operations:
Pre-tax realized gain (loss) on securities available-for-sale................ $ 19.0 $112.2
Federal income taxes @ 35%................................................... 6.7 39.3
---- -----
Realized gain (loss) on securities available-for-sale................... $ 12.3 $ 72.9
Discontinued operations:
Pre-tax realized gain (loss) on securities available-for-sale................ $ -- $ 38.2
Federal income taxes @ 35%................................................... -- 13.4
------ ----
Realized gain (loss) on securities available-for-sale.................... $ -- $ 24.8
Previously unrealized gains on securities that became realized at time of sale
of discontinued operations:
Pre-tax...................................................................... $ -- $271.7
After-tax.................................................................... -- 176.6
Gross unrealized gain (loss) on securities available- for-sale arising during
the year:
Pre-tax...................................................................... $179.1 $256.9
After-tax.................................................................... 116.4 197.0
11. Acquisitions/Sales of Subsidiaries, Discontinued Operations and
Organizational Review
In May 1996, 16.7% of American States Financial Corporation ("ASFC"), the
holding company of LNC's principal property-casualty subsidiary, was sold to the
public in the form of an initial public offering of its common stock. ASFC
received net proceeds of $215,200,000 from the sale of this 16.7% minority
interest and LNC recorded a non-taxable realized gain, net of expenses, directly
in shareholders' equity of $15,000,000. LNC continued to fully consolidate this
operation within its financial statements and tax reporting until the sale of
the remaining 83.3% (see below).
In October 1996, LNC purchased a block of group tax-qualified annuity business
from UNUM Corporation's affiliates. The bulk of the transaction was completed in
the form of a reinsurance transaction, which resulted in a ceding commission of
$71,800,000. The ceding commission, along with $67,000,000 to cover expenses
associated with the purchase, represents the present value of business in-force
and accordingly has been classified as an intangible asset. LNC's assets and
liabilities increased $3,200,000,000 as a result of this transaction.
In April 1997, LNC completed the acquisition of Voyageur Fund Managers, Inc.
("Voyageur") for $74,000,000. While this includes cash paid out for expenses
associated with the purchase, the bulk of the purchase price was covered by the
issuance of 1,323,144 shares of LNC common stock to the previous owners of
Voyageur. Purchase accounting has been applied to this acquisition resulting in
intangible assets of $78,900,000. Voyageur's operating results are included in
LNC's consolidated financial statements from the closing date.
On June 9, 1997, LNC announced that it agreed to sell its 83.3% ownership in
American States Financial Corporation for $2,650,000,000. As this sale resulted
in an exit from the property-casualty business (previously a business segment),
the financial data from the units being sold are shown as discontinued
operations in the accompanying financial statements. June 9, 1997, is the
measurement date for purposes of discontinued operations. Following the closing
of this transaction on October 1, 1997, the gain on sale of $776,900,000
($1,224,500,000 pre-tax) was recorded within discontinued operations. LNC used
these proceeds to repurchase $341,800,000, (4,993,281 shares) of its own common
stock, retire $86,700,000 of long-term debt, purchase a 49% ownership in Seguros
Serfin Lincoln for $85,000,000 pay income taxes of $447,600,000 related to the
sale of discontinued operations and purchase a block of individual life
insurance and annuity business for $1,642,500,000 (see below). The remainder was
used to pay off a portion of LNC's short-term debt and to invest for general
corporate purposes, then later used to fund a portion of the purchase of another
block of individual life insurance business.
66
Net Income from discontinued operations was as follows:
Nine Months Year Ended
Ended September December 31
(in millions) 30, 1997 1996
- --------------------------------------------------------------------------------
Revenue . . . . . . . . . . . . . . . . . $1,538.5 $1,987.7
Benefits and expenses.................... 1,363.6 1,799.0
------- -------
Pre-tax net income.................... 174.9 188.7
Federal income taxes...................... 40.0 31.5
-------- --------
Net income............................ $ 134.9 $ 157.2
On January 2, 1998, LNC acquired of a block of individual life insurance and
annuity business from CIGNA Corporation for $1,414,000,000. Additional funds
($228,500,000) were required to provide additional capital for the Life
Insurance and Annuities segment to support this business and to cover expenses
associated with the purchase. Funding used to complete this acquisition was from
the proceeds of the sale of the property-casualty business in 1997 (see note 11
on page 65). This transaction was accounted for using purchase accounting and,
accordingly, operating results generated by this block of business after the
closing date are included in LNC's consolidated financial statements. At the
time of closing, this block of business had liabilities, measured on a statutory
basis, of $5,500,000,000 that became LNC's obligation. LNC also received assets
measured on a historical statutory basis, equal to the liabilities. Subsequent
to this acquisition, LNC announced that it had reached an agreement to sell the
administration rights to a variable annuity portfolio that had been acquired as
part of the block of business acquired January 2, 1998. This sale closed on
October 12, 1998 with an effective date of August 1, 1998. The application of
purchase accounting to this block of business, net of the administration rights
sold, resulted in goodwill and other intangible assets of $807,000,000 and
$464,000,000, respectively. Pursuant to the terms of the acquisition agreement
LNC and CIGNA are in the final stages of agreeing to the value of these assets
and liabilities. Any changes to these values that may occur in future periods
will not be material to LNC's financial position. In connection with the
completion of this acquisition, LNC recorded a charge to its Life Insurance and
Annuities segment during the first quarter of 1998 of $20,000,000 ($31,000,000
pre-tax). This restructuring charge covered certain costs of integrating the
existing operations with the new block of business.
On October 1, 1998, LNC acquired a block of individual life insurance from
Aetna, Inc for $1,000,000,000. Funding used to complete this acquisition was
primarily from public securities offered in 1998 (see note 5 on page 51). This
transaction was accounted for using purchase accounting and, accordingly, the
operating results generated by this block of business after the closing date are
included in LNC's consolidated financial statements. At the time of closing this
block of business had liabilities measured on a statutory basis, of
$3,300,000,000 that became LNC's obligation. LNC also received assets, measured
on a historical statutory basis, equal to the liabilities. In August of 1998,
LNC announced that it had reached an agreement to sell the sponsored life
business acquired as part of the Aetna block of business. This sale closed on
October 14, 1998 with an effective date of October 1, 1998 at a sales price of
$99,500,000. During 1997, after deducting the sponsored life income statement
amounts, the Aetna block produced premiums and fees of $227,800,000 and earnings
of $65,000,000 on a basis of generally accepted accounting principles (prior to
adjustments required by purchase accounting). The initial application of
purchase accounting to this block of business, net of the sponsored life
business resulted in goodwill and other intangibles of $220,000,000 and
$871,000,000, respectively. Additional analysis of this block of business may
result in a change in the amounts or the shifting of amounts between goodwill
and other intangible assets.
The consolidated proforma results of operations shown below assumes that the two
blocks of business described in the preceding paragraphs were purchased on
January 1, 1997.
(unaudited)
Year Ended December 31 (in millions, except per share data) 1998 1997
- --------------------------------------------------------------------------------------------------------------------
Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .... $6,469.4 $6,366.4
Net income from continuing operations........................................... 547.3 145.5
Net income...................................................................... 547.3 1,057.3
Net income from continuing operation per diluted share.......................... $ 5.38 $ 1.40
Net income per diluted share.................................................... 5.38 10.17
This proforma financial information is not necessarily indicative of the actual
results that would have occurred had the purchases been made on January 1, 1997
or of the results which may occur in the future.
67
As noted above, LNC has been involved in a series of divestitures and
acquisitions during the last few years. These changes, along with on-going and
increasing competitive pressures within the business LNC operates in, led to a
decision to initiate an organizational/expense review. This review, which
centered around the size and make-up of the parent company, was completed in the
fourth quarter of 1998. As a result, LNC recorded a restructuring charge of
$14,300,000 ($22,000,000 pre-tax) in the fourth quarter of 1998 to provide
severance for the personnel that were eliminated and to cover costs associated
with the resulting excess office space and equipment.
Report of Ernst & Young LLP, Independent Auditors
Board of Directors
Lincoln National Corporation
We have audited the accompanying consolidated balance sheets of Lincoln National
Corporation as of December 31, 1998 and 1997, and the related consolidated
statements of income, shareholders' equity, and cash flows for each of the three
years in the period ended December 31, 1998. Our audits also included the
financial statement schedules listed in the Index at Item 14(a). 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.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
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, 1998 and 1997, and the consolidated results of its
operations and its cash flows for each of the three years in the period ended
December 31, 1998, in conformity with 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.
Ernst & Young LLP
Fort Wayne, Indiana
February 1, 1999
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosures
There have been no disagreements with LNC's independent auditors which are
reportable pursuant to Item 304 of Regulation S-K.
68
PART III
Item 10. Directors and Executive Officers of the Registrant
Information for this item relating to directors of LNC is incorporated by
reference to the sections captioned "NOMINEES FOR DIRECTOR", "DIRECTORS
CONTINUING IN OFFICE" and "COMPLIANCE WITH SECTION 16(a) OF THE SECURITIES AND
EXCHANGE ACT OF 1934", of LNC's Proxy Statement for the Annual Meeting scheduled
for May 13, 1999.
Executive Officers of the Registrant as of March 1, 1999 were as follows:
Name Age** Position with LNC and Business Experience During the Past Five Years
Jon A. Boscia, 47 President, Chief Executive Officer and Director, LNC (since November
1998). President and Director, LNC (since January 1998). Chief
Executive Officer, Lincoln Life* (1996 - January, 1998). President, Chief
Operating Officer, Lincoln Life* (1994-1996). Executive Vice President,
LNC (1991-1994). President, Lincoln National Investment Companies
("LNIC")* (1991-1994).
Bernard G. Brown 48 Managing Director, Lincoln National (UK)* (since January 1998).
Operations Director, Lincoln National (UK)* (1995 - January 1998).
Managing Director, Liberty Life Assurance Company, Ltd. (1992- 1995).
George E. Davis 56 Senior Vice President, LNC (since 1993).
Jack D. Hunter 62 Executive Vice President, LNC (since 1986). General Counsel (since
1971).
Barbara S. Kowalczyk 48 Senior Vice President, LNC (since 1994). Senior Vice President,
LNIC* (1992-1994).
H. Thomas McMeekin 46 Executive Vice President, LNC (since 1994). President, LNIC* (1994-
1996). Senior Vice President, LNC (1992-1994).
Jeffrey J. Nick 46 President and Chief Executive Officer, LNI* (since 1996). Managing
Director, Lincoln National (UK)* (1992-1996).
Lawrence T. Rowland 47 President and Chief Executive Officer, Lincoln National Reassurance
Company* and other Lincoln Re affiliates* (since 1996). Senior Vice
President, LNRC* (1995-1996). Vice President, Lincoln Re* (1991-
1994).
Gabriel L. Shaheen 45 President and Chief Executive Officer, Lincoln Life* (since January 1998).
Managing Director, Lincoln National (UK)* (1996 - January 1998).
President and Chief Executive Officer, Lincoln Re* (1994-1996). Senior
Vice President, Lincoln Life* (1991-1994).
Donald L. Van Wyngarden 59 Second Vice President and Controller, LNC (since 1975).
Richard C. Vaughan 49 Executive Vice President and Chief Financial Officer, LNC (since 1995).
Senior Vice President and Chief Financial Officer, LNC (1992-1994).
* Denotes a subsidiary of LNC
** Age shown is based on nearest birthdate to March 1, 1999.
There is no family relationship between any of the foregoing executive officers,
all of whom are elected annually.
69
Item 11. Executive Compensation
Information for this item is incorporated by reference to the section captioned
"EXECUTIVE COMPENSATION" of LNC's Proxy Statement for the Annual Meeting
scheduled for May 13, 1999.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Information for this item is incorporated by reference to the sections captioned
"SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS" and "SECURITY OWNERSHIP OF
DIRECTORS, NOMINEES AND EXECUTIVE OFFICERS" of LNC's Proxy Statement for the
Annual Meeting scheduled for May 13, 1999.
Item 13. Certain Relationships and Related Transactions
Information for this item is incorporated by reference to the section captioned
"TERMINATION OF EMPLOYMENT ARRANGEMENT" of LNC's Proxy Statement for the Annual
Meeting scheduled for May 13, 1999.
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
Item 14(a)(1) Financial Statements
The following consolidated financial statements of Lincoln National Corporation
are included in Item 8:
Consolidated Balance Sheets - December 31, 1998 and 1997
Consolidated Statements of Income - Years ended December 31, 1998, 1997 and
1996
Consolidated Statements of Shareholders' Equity - Years ended December 31,
1998, 1997 and 1996
Consolidated Statements of Cash Flows - Years ended December 31, 1998, 1997
and 1996
Notes to Consolidated Financial Statements
Report of Ernst & Young LLP, Independent Auditors
Item 14(a)(2) Financial Statement Schedules
The following consolidated financial statement schedules of Lincoln National
Corporation are included in Item 14(d):
I - Summary of Investments - Other than Investments in Related Parties
II - Condensed Financial Information of Registrant
III - Supplementary Insurance Information
IV - Reinsurance
V - Valuation and Qualifying Accounts
All other schedules for which provision is made in the applicable accounting
regulation of the Securities and Exchange Commission are not required under the
related instructions, are inapplicable, or the required information is included
in the consolidated financial statements, and therefore omitted.
70
Item 14(a)(3) Listing of Exhibits
The following exhibits of Lincoln National Corporation are included in Item 14 -
Note: The numbers preceding the exhibits correspond to the specific numbers
within Item 601 of Regulation S-K.):
3(a) The Articles of Incorporation of LNC as last amended effective May
12, 1994.
3(b) The Bylaws of LNC as last amended January 14, 1998 is incorporated by
reference to Exhibit 3(b) of LNC's Form 10-K for the year ended
December 31, 1997, filed with the Commission on March 18, 1998.
4(a) Indenture of LNC dated as of January 15, 1987 is incorporated by
reference to Exhibit 4(a) of LNC's Form 10-K for the year ended
December 31, 1994, filed with the Commission on March 27, 1995.
4(b) First Supplemental Indenture dated as of July 1, 1992, to Indenture
of LNC dated as of January 15, 1987 is incorporated by reference to
Exhibit 4(b) of LNC's Form 10-K for the year ended December 31, 1996,
filed with the Commission on March 13, 1997.
4(c) Specimen Notes for 7 1/8% Notes due July 15, 1999 and for 7 5/8%
Notes due July 15, 2002 are incorporated by reference to Exhibit 4(c)
of LNC's Form 10-K for the year ended December 31, 1996, filed with
the Commission on March 13, 1997.
4(d) Rights Agreement of LNC as last amended November 14, 1996 is
incorporated by reference to LNC's Form 8-K filed with the Commission
on November 22, 1996.
4(e) Indenture of LNC dated as of September 15, 1994, between LNC and The
Bank of New York, as Trustee.
4(f) Form of Note is incorporated by reference to Exhibit No.4(d) to LNC's
Registration Statement on Form S-3/A (Commission File No. 33-55379),
filed with the Commission on September 15, 1994.
4(g) Form of Zero Coupon Security is incorporated by reference to Exhibit
No. 4(f) of LNC's Registration Statement on Form S-3/A (Commission
File No. 33-55379), filed with the Commission on September 15, 1994.
4(h) Specimen of LNC's 9 1/8% Debentures due October 1, 2024 is
incorporated by reference to Schedule I of LNC's Form 8-K filed with
the Commission on September 29, 1994.
4(I) Specimen of LNC's 7 1/4% Debenture due May 15, 2005 is incorporated
by reference to Schedule III of LNC's Form 8-K filed with the
Commission on May 17, 1995.
4(j) Junior Subordinated Indenture dated as of May 1, 1996 between LNC and
The First National Bank of Chicago is incorporated by reference to
Exhibit 4(j) of LNC's Form 10-K for the year ended December 31, 1996,
filed with the Commission on March 13, 1997.
4(k) Guarantee Agreement for Lincoln National Capital I is incorporated by
reference to Exhibit 4(k) of LNC's Form 10-K for the year ended
December 31, 1996, filed with the Commission on March 13, 1997.
4(l) Guarantee Agreement for Lincoln National Capital II is incorporated
by reference to Exhibit 4(l) of LNC's form 10-K for the year ended
December 31, 1996, filed with the Commission on March 13, 1997.
4(m) Form of Lincoln National Capital I 8.75% Cumulative Quarterly Income
Preferred Securities, Series A (Commission File No. 333-04133) is
incorporated by reference to Exhibit 4(m) to LNC's Form 10- K for the
year ended December 31, 1996, filed with the Commission on March 13,
1997.
4(n) Form of Lincoln National Capital II 8.35% Trust Originated Preferred
Securities, Series B (Commission File No. 333-04133) is incorporated
by reference to Exhibit 4(n) to LNC's Form 10-K for the year ended
December 31, 1996, filed with the Commission on March 13, 1997.
71
4(o) Form of Amended and Restated Declaration of Trust for Lincoln
National Capital I and Lincoln National Capital II between LNC, as
depositor, The First National Bank of Chicago, as property trustee,
First Chicago Delaware, Inc., as Delaware trustee, and certain
administrative trustees is incorporated by reference to Exhibit 4(o)
of LNC's Registration Statement (Commission File No.
333-4133) filed with the commission on May 21, 1996.
4(p) Specimen of 6 1/2% Notes due March 15, 2008 incorporated by reference
to Exhibit 4.1 LNC's Form 8-K filed with the commission on March 24,
1998.
4(q) Specimen of 7% Notes due March 15, 2018 incorporated by reference to
Exhibit 4.2 of LNC's Form 8-K filed with the Commission on March 24,
1998.
4(r) Amended and Restated Trust Agreement for Lincoln National Capital III
between LNC, as depositor, The First National Bank of Chicago, as
property trustee, First Chicago Delaware, Inc. as Delaware trustee,
and the administrative trustees is incorporated by reference to
Exhibit 4.1 of LNC's Form 8-K filed with the Commission on July 30,
1998.
4(s) Form of 7.40% Trust Originated Preferred Securities, Series C, of
Lincoln National Capital III is incorporated by reference to Exhibit
4.2 of LNC's Form 8-K filed with the Commission on July 30, 1998.
4(t) Guarantee Agreement for Lincoln National Capital III is incorporated
by reference to Exhibit 4.4 of LNC's Form 8-K filed with the
Commission on July 30, 1998.
4(u) Amended and Restated Trust Agreement for Lincoln National Capital IV
between LNC, as depositor, The First National Bank of Chicago, a
property trustee, First Chicago Delaware Inc., as Delaware trustee,
and the administrative trustees is incorporated by reference to
Exhibit 4.1 of LNC's Form 8-K filed with the Commission on August 27,
1998.
4(v) Form of Income Prides Certificate of Lincoln National Capital IV is
incorporated by reference to Exhibit 4.7 of LNC's Form 8-K filed with
the Commission on August 27, 1998.
4(w) Form of Growth Prides Certificates of Lincoln National Capital IV is
incorporated by reference to Exhibit 4.8 of LNC's Form 8-K filed with
the Commission on August 27, 1998.
4(x) Guarantee Agreement for Lincoln National Capital IV is incorporated
by reference to Exhibit 4.5 of LNC's Form 8-K filed with the
Commission on August 27, 1998.
4(y) Purchase Contract Agreement between LNC and The First National Bank
of Chicago, as Purchase Contract Agent, relating to Lincoln National
Capital IV is incorporated by reference to Exhibit 4.6 of LNC's Form
8-K filed with the Commission on August 27, 1998.
4(z) Pledge Agreement among LNC, The Chase Manhattan Bank, as agent, and
The First National Bank of Chicago, as Purchase Agent, relating to
Lincoln National Capital IV is incorporated by reference to Exhibit
4.9 of LNC's Form 8-K filed with the Commission on August 27, 1998.
10(a)* The Lincoln National Corporation 1986 Stock Option Incentive Plan.
10(b)* The Lincoln National Corporation Executives' Salary Continuation Plan
as last amended January 1, 1992 is incorporated by reference to
Exhibit 10(c) LNC's Form 10-K for the year ended December 31, 1997,
filed with the Commission on March 18, 1998.
10(c)* The Lincoln National Corporation Executive Value Sharing Plan as
Amended and Restated effective January 1, 1994.
10(d)* Lincoln National Corporation Executives' Severance Benefit Plan as
Amended and Restated effective November 9, 1995 is incorporated by
reference to Exhibit 10(e) of LNC's Form 10-K for the year ended
December 31, 1995, filed with the Commission on March 27, 1996.
10(e)* The Lincoln National Corporation Outside Directors Retirement Plan as
last amended effective March 15, 1990 is incorporated by reference to
Exhibit 10(f) of LNC's Form 10-K for the year ended December 31,
1995, filed with the Commission on March 27, 1996.
10(f)* The Lincoln National Corporation Outside Directors Benefits Plan is
incorporated by reference to Exhibit 10(g) of LNC's Form 10-K for the
year ended December 31, 1997, filed with the Commission on March 18,
1998.
72
10(g)* Lincoln National Corporation Directors' Value Sharing Plan as last
amended effective May 14, 1998 is incorporated by reference to
Exhibit 10(6) of LNC's Form 10-Q for the quarter ended June 30, 1998,
filed with the Commission on July 27, 1998.
10(h)* Lincoln National Corporation Executive Deferred Compensation Plan for
Employees (Commission File No. 33-51721) as last amended effective
February 16, 1998 is incorporated by reference to Exhibit 10(I) of
LNC's Form 10-K for the year ended December 31, 1997, filed with the
Commission on March 18, 1998.
10(I)* Lincoln National Corporation 1993 Stock Plan for Non-Employee
Directors (Commission File No.33-58113) as last amended effective
November 11, 1998.
10(j)* Lincoln National Corporation Executives' Excess Compensation Benefit
Plan.
10(k)* Lincoln National Corporation 1997 Incentive Compensation Plan as last
amended effective May 14, 1998 is incorporated by reference to
Exhibit 10(a) of LNC's Form 10-Q for the quarter ended June 30, 1998,
filed with the Commission on July 27, 1998.
10(l)* Descriptions of compensation arrangements with Executive Officers.
10(m) Lease and Agreement dated August 1, 1984, with respect to LNL's Home
Office property located at Magnavox Way, Fort Wayne, Indiana are
incorporated by reference to Exhibit 10(m) of LNC's Form 10-K for the
year ended December 31, 1995, filed with the Commission on March 27,
1996.
10(n) Lease and Agreement dated August 1, 1984, with respect to LNL's Home
Office properties located at Clinton Street and Harrison Street, Fort
Wayne, Indiana are incorporated by reference to Exhibit 10(n) of
LNC's Form 10-K for the year ended December 31, 1995, filed with the
Commission on March 27, 1996.
10(o) Lease and Agreement dated December 1, 1994, with respect to LNC's
Corporate Office located at 200 East Berry Street, Fort Wayne,
Indiana, are incorporated by reference to Exhibit 10(p) of LNC's Form
10-K for the year ended December 31, 1994, filed with the Commission
on March 27, 1995.
10(p) Agreement of Lease dated February 17, 1998, with respect to Lincoln
Life's life products headquarters located at 350 Church Street,
Hartford, Connecticut is incorporated by reference to Exhibit 10(q)
of LNC's Form 10-K for the year ended December 31, 1997, filed with
the Commission on March 18, 1998.
*This exhibit is a management contract or compensatory plan or
arrangement required to be filed as an exhibit to this form
pursuant to Item 14 of this report.
12 Historical Ratio of Earnings to Fixed Charges.
21 List of Subsidiaries of LNC.
23 Consent of Ernst & Young LLP, Independent Auditors.
27 Financial Data Schedule.
Item 14(b)
During the fourth quarter of 1998, LNC filed a Form 8-K and Form 8-K/A with the
Commission regarding LNC's acquisition of a block of individual life insurance
from Aetna, Inc. These filings which were dated October 14, 1998 and December
14, 1998 include pro forma information and audited statements covering the
business acquired.
Item 14(c)
The exhibits of Lincoln National Corporation are listed in Item 14(a)(3) above.
Item 14(d)
The financial statement schedules for Lincoln National Corporation follow on
pages 73 through 79.
73
LINCOLN NATIONAL CORPORATION
SCHEDULE I - SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS
IN RELATED PARTIES
December 31, 1998 (000s omitted)
Column A Column B Column C Column D
Amount
at Which
Shown in the
Type of Investment Cost Value Balance Sheet
Fixed maturity securities available-for-sale:
Bonds:
United States Government and government
agencies and authorities.............................. $1,043,850 $1,134,614 $1,134,614
States, municipalities and political subdivisions....... 15,871 16,738 16,738
Asset/Mortgage-backed securities........................ 4,879,524 5,080,535 5,080,535
Foreign governments..................................... 1,240,113 1,321,175 1,321,175
Public utilities........................................ 3,130,998 3,325,448 3,325,448
Convertibles and bonds with warrants attached........... 25,214 24,325 24,325
All other corporate bonds............................... 18,133,334 19,155,425 19,155,425
Redeemable preferred stocks............................... 170,654 174,632 174,632
----------- ----------- -----------
Total................................................. 28,639,558 30,232,892 30,232,892
Equity securities available-for-sale:
Common stocks:
Public utilities........................................ 20,913 24,466 24,466
Banks, trusts and insurance companies................... 37,777 41,990 41,990
Industrial, miscellaneous and all other................. 296,287 396,614 396,614
Nonredeemable preferred stocks.......................... 81,741 79,773 79,773
----------- ---------- ----------
Total Equity Securities................................ 436,718 542,843 542,843
Mortgage loans on real estate............................... 4,397,876 4,393,082(1)
Real estate:
Investment properties................................... 470,095 470,095
Acquired in satisfaction of debt........................ 18,627 18,627
Policy loans................................................ 1,839,970 1,839,970
Other investments........................................... 431,964 431,964
----------- -----------
Total Investments...................................... $36,234,808 $37,929,473
(1) Investments deemed to have declines in value that are other than temporary
are written down or reserved for to reduce their carrying value to their
estimated realizable value.
74
LINCOLN NATIONAL CORPORATION
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
BALANCE SHEETS
Lincoln National Corporation (Parent Company Only)
December 31 (000s omitted) 1998 1997
- ----------------------------------------------------------------------------------------------------------------
Assets:
Investments in subsidiaries*........................................... $5,642,793 $5,341,786
Investments........................................................... 35,717 231,931
Investment in unconsolidated affiliate................................ 18,811 18,500
Cash and invested cash**.............................................. 495,612 1,230,180
Property and equipment................................................ 4,437 10,316
Accrued investment income............................................. 1,774 4,071
Receivable from subsidiaries*......................................... 153,300 433,580
Dividends receivable from subsidiaries*............................... 6,500 12,875
Loans to subsidiaries*................................................ 1,305,028 32,299
Goodwill.............................................................. 65,217 66,500
Federal income taxes recoverable...................................... 31,365 --
Other assets.......................................................... 80,079 48,470
---------- --------
Total Assets........................................................ $7,840,633 $7,430,508
Liabilities and Shareholders' Equity
Liabilities:
Cash collateral on loaned securities.................................. $50,625 $ 123,688
Dividends payable..................................................... 55,074 52,167
Short-term debt....................................................... 149,956 82,767
Long-term debt........................................................ 711,671 510,301
Loans from subsidiaries*.............................................. 1,291,714 1,040,431
Federal income taxes payable ......................................... -- 418,783
Accrued expenses and other liabilities................................ 193,652 219,456
--------- ---------
Total Liabilities................................................... 2,452,692 2,447,593
Shareholders' Equity
Series A preferred stock.............................................. 1,083 1,153
Common stock.......................................................... 994,472 966,461
Retained earnings..................................................... 3,790,038 3,533,105
Foreign currency translation adjustment............................... 49,979 46,204
Net unrealized gain on securities available-for-sale
[including unrealized gain of subsidiaries and
discontinued operations: 1998 - $531,138; 1997 - $410,281]........... 552,369 435,992
---------- ----------
Total Shareholders' Equity......................................... 5,387,941 4,982,915
--------- ---------
Total Liabilities and Shareholders' Equity......................... $7,840,633 $7,430,508
*Eliminated in consolidation.
**Includes short-term funds invested in behalf of LNC's subsidiaries.
These condensed financial statements should be read in conjunction with the
consolidated financial statements and accompanying footnotes of Lincoln National
Corporation (see pages 36 through 67).
75
LINCOLN NATIONAL
Lincoln National Corporation (Parent Company Only)
Year Ended December 31 (000s omitted) 1998 1997 1996
- -------------------------------------------------------------------------------------------------------------------
Revenue:
Dividends from subsidiaries*.................................. $268,454 $ 250,725 $601,701
Interest from subsidiaries*................................... 44,068 22,807 18,945
Equity in earnings of unconsolidated affiliate................ 1,636 -- 1,428
Net investment income......................................... 48,597 38,108 21,790
Realized gain (loss) on investments........................... 1,001 (1,403) (432)
Gain on sale of subsidiaries and
discontinued operations..................................... -- 1,192,226 --
Other......................................................... 2,202 1,180 1,127
-------- ----------- --------
Total Revenue............................................... 365,958 1,503,643 644,559
Expenses:
Operating and administrative.................................. 41,922 36,540 36,275
Interest-subsidiaries*........................................ 32,251 25,703 23,529
Interest-other................................................ 106,059 85,512 72,086
-------- -------- --------
Total Expenses.............................................. 180,232 147,755 131,890
------- ------- -------
Income before Federal Income Tax Expense
(Benefit), Equity in Income of Subsidiaries
and Discontinued Operations, Less Dividends................ 185,726 1,355,888 512,669
Federal income tax expense (benefit)............................ (28,891) 389,791 (34,157)
------- --------- -------
Income Before Equity in Income of Subsidiaries
and Discontinued Operations, Less Dividends................ 214,617 966,097 546,826
Equity in income of subsidiaries and
discontinued operations, less dividends....................... 295,158 (32,109) (33,268)
------- --------- --------
Net Income.................................................. $509,775 $ 933,988 $513,558
*Eliminated in consolidation.
These condensed financial statements should be read in conjunction with the
consolidated financial statements and accompanying footnotes of Lincoln National
Corporation (see pages 36 through 67).
76
LINCOLN NATIONAL CORPORATION
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued)
STATEMENTS OF CASH FLOWS
Lincoln National Corporation (Parent Company Only)
Year Ended December 31 (000's omitted) 1998 1997 1996
- ----------------------------------------------------------------------------------------------------------------
Cash Flows from Operating Activities:
Net income........................................................ $ 509,775 $ 933,988 $ 513,558
Adjustments to reconcile net income to net cash provided by
(used in) operating
activities:
Equity in income of subsidiaries and discontinued
operations less than (greater than) distributions*............ (288,784) 18,950 (262,268)
Equity in undistributed earnings of unconsolidated affiliate... (1,636) -- (1,428)
Realized (gain) loss on investments............................ (1,001) 1,403 432
Gain on sale of subsidiaries and discontinued operations....... -- (1,192,226) --
Tax on sale of discontinued operations......................... -- 415,354 --
Other.......................................................... (66,445) 26,038 (80,715)
-------- ------- -------
Net Adjustments.............................................. (357,866) (730,481) (343,979)
------- --------- -------
Net Cash Provided by Operating Activities.................... 151,909 203,507 169,579
Cash Flows from Investing Activities:
Net sales (purchases) of investments............................ 188,938 4,157 91,161
Cash collateral on loaned securities............................ (73,063) (21,906) (53,406)
Decrease (increase) in investment in subsidiaries*.............. (159,458) (116,824) 217,844
Sale of (investment in) unconsolidated affiliate................ -- (68,959) (16,041)
Sale of discontinued operations................................. (124,151) 822,500 --
Net (purchase) sale of property and equipment................... (256) (1,417) (790)
Other........................................................... (36,831) (1,096) (26,883)
------- -------- -------
Net Cash Provided by (Used in) Investing Activities........... (204,821) 616,455 211,885
Cash Flows from Financing Activities:
Decrease in long-term debt (includes payments and
transfers to short-term debt).................................. (99,737) (86,338) --
Issuance of long-term debt...................................... 299,198 -- --
Net increase (decrease) in short-term debt...................... 67,189 13,056 (179,033)
Increase in loans from subsidiaries*............................ 251,283 454,311 28,224
Decrease (increase) in loans to subsidiaries*................... (1,272,729) 414,669 (303,506)
Decrease (increase) in receivables from subsidiaries*........... 280,280 (23,000) (36,000)
Common stock issued for benefit plans........................... 48,747 33,199 (153)
Retirement of common stock...................................... (46,871) (327,585) (32,716)
Dividends paid to shareholders.................................. (209,016) (201,927) (191,223)
-------- --------- -------
Net Cash Provided by (Used in) Financing Activities........... (681,656) 276,385 (714,407)
-------- ------- -------
Net Increase (Decrease) in Cash............................... (734,568) 1,096,347 (332,943)
Cash and invested cash at beginning-of-year....................... 1,230,180 133,833 466,776
--------- ------- --------
Cash and Invested Cash at End-of-Year......................... $ 495,612 $1,230,180 $ 133,833
*Eliminated in consolidation.
These condensed financial statements should be read in conjunction with the
consolidated financial statements and accompanying footnotes of Lincoln National
Corporation (see pages 36 through 67).
77
LINCOLN NATIONAL CORPORATION
SCHEDULE III - SUPPLEMENTARY INSURANCE INFORMATION
Column A Column B Column C Column D Column E Column F
-------- ---------- ---------- ---------- ---------- --------
Insurance Other Policy
Deferred Policy and Claims and
Acquisition Claim Unearned Benefits Premium
Segment Costs Reserves Premiums Payable Revenue(1)
Year Ended December 31, 1998 ------------------------------------(000s Omitted)-------------------------
Life Insurance and Annuities......... $1,012,635 $14,511,012 $ $ $ 1,330,793
Lincoln UK........................... 636,254 1,498,820 339,518
Reinsurance.......................... 315,477 4,238,609 1,224,887
Investment Management................
Other (incl. consol. adj's.)......... (108,459)
---------- ----------- --------- ----------- ----------
Total.............................. $1,964,366 $20,139,982 $ -- $ -- $ 2,895,198
Year Ended December 31, 1997
Life Insurance and Annuities......... $ 779,703 $ 6,418,417 $ $ $ 788,040
Lincoln UK........................... 563,080 1,442,768 336,721
Reinsurance.......................... 281,062 3,513,311 1,036,127
Investment Management................
Other (incl. consol. adj's.)......... (108,224)
--------- --------- -------- -------- -----------
Total.............................. $1,623,845 $11,266,272 $ -- $ -- $ 2,160,888
Year Ended December 31, 1996
Life Insurance and Annuities......... $ 926,593 $ 6,180,970 $ $ $ 676,047
Lincoln UK........................... 440,414 1,252,276 306,238
Reinsurance.......................... 322,709 3,144,785 1,250,403
Investment Management................
Other (incl. consol. adj's.)......... (120,135)
---------- ---------- -------- -------- -----------
Total.............................. $1,689,716 $10,457,896 $ -- $ -- $ 2,232,688
Column A Column G Column H Column I Column J Column K
-------- -------- -------- --------- ---------- --------
Amortization of
Net Deferred Policy Other
Investment Acquisition Operating Premiums
Segment Income (2) Benefits Costs Expenses( 2) Written
Year Ended December 31, 1998 --------------------------------------(000s Omitted)---------------------
Life Insurance and Annuities......... $2,248,946 $2,118,107 $368,290 $ 746,104 $
Lincoln UK........................... 87,930 150,962 26,252 155,651
Reinsurance.......................... 307,784 1,059,796 45,477 314,903
Investment Management................ 232 263,275
Other (incl. consol. adj's.)......... 36,514 140,848
---------- ----------- -------- --------- -------
Total.............................. $2,681,406 $3,328,865 $440,019 $1,620,781 $ --
Year Ended December 31, 1997
Life Insurance and Annuities......... $1,842,351 $1,646,581 $316,346 $ 431,301 $
Lincoln UK........................... 85,132 339,637 4,342 180,132
Reinsurance.......................... 284,430 1,205,515 147,300 239,135
Investment Management................ 457 243,206
Other (incl. consol. adj's.)......... 38,394 110,103
---------- ----------- -------- -------- ------
Total.............................. $2,250,764 $3,191,733 $467,988 $1,203,877 $ --
Year Ended December 31, 1996
Life Insurance and Annuities......... $1,741,649 $1,562,087 $266,343 $ 388,020 $
Lincoln UK........................... 81,955 133,927 157,732
Reinsurance.......................... 263,870 1,013,867 162,150 253,880
Investment Management................ 701 191,416
Other (incl. consol. adj's).......... (229) 100,128
---------- ---------- ---------- ---------- ------
Total.............................. $2,087,946 $2,709,881 $428,493 $1,091,176 $ --
(1) Includes insurance fees on universal life and other interest sensitive
products.
(2) The allocation of expenses between investments and other operations are
based on a number of assumptions and estimates. Results would change if
different methods were applied.
78
LINCOLN NATIONAL CORPORATION
SCHEDULE IV - REINSURANCE
Column A Column B Column C Column D Column E Column F
-------- -------- -------- -------- -------- --------
Percentage
Ceded Assumed of Amount
Gross to Other from Other Net Assumed
Amount Companies Companies Amount to Net
--------------------------(000s Omitted)----------------------------------
Year Ended December 31, 1998
Individual life insurance in force... $187,100,000 $108,100,000 $213,700,000 $292,700,000 73.0%
Premiums:
Life insurance and annuities (1)... $ 2,182,847 $ 573,532 $ 650,807 $ 2,260,122 28.8%
Health insurance................... 147,940 121,848 608,984 635,076 95.9%
--------- ------- --------- ----------
Total............................ $ 2,330,787 $ 695,380 $ 1,259,791 $ 2,895,198
Year Ended December 31, 1997
Individual life insurance in force .. $125,800,000 $ 37,300,000 $124,000,000 $212,500,000 58.4%
Premiums:
Life insurance and annuities (1)... $ 1,235,085 $196,929 $ 550,173 $ 1,588,329 34.6%
Health insurance................... 161,693 118,083 528,949 572,559 92.4%
------- ---------- ------- --------
Total............................ $ 1,396,778 $ 315,012 $ 1,079,122 $ 2,160,888
Year Ended December 31, 1996
Individual life insurance in force... $110,700,000 $37,600,000 $130,400,000 $203,500,000 64.0%
Premiums:
Life insurance and annuities (1).... $ 1,031,740 $ 96,999 $ 507,512 $1,442,253 35.2%
Health insurance................... 168,545 71,636 693,526 790,435 87.7%
--------- ------ -------- --------
Total............................ $ 1,200,285 $168,635 $1,201,038 $2,232,688
(1) Includes insurance fees on universal life and other interest sensitive
products.
79
LINCOLN NATIONAL CORPORATION
SCHEDULE V - VALUATION AND QUALIFYING ACCOUNTS
Column A Column B Column C Column D Column E
----------- ---------- ---------------- --------- --------
Additions
Charged
Balance at Charged to Other Balance at
Description Beginning to Costs Accounts- Deductions- End of
of Period Expenses(1) Describe Describe(2) Period
---------------------------(000's Omitted)----------------------
Year Ended December 31, 1998
Deducted from Asset Accounts:
Reserve for Mortgage Loans
on Real Estate.............................. $5,019 $ 675 $(900) $4,794
Reserve for Real Estate...................... 1,500 (1,500) --
Included in Other Liabilities:
Investment Guarantees........................ 790 (467) 323
Year Ended December 31, 1997
Deducted from Asset Accounts:
Reserve for Mortgage Loans
on Real Estate.............................. $12,385 $1,778 $(9,144) $5,019
Reserve for Real Estate...................... 3,000 (1,500) 1,500
Included in Other Liabilities:
Investment Guarantees........................ 1,775 (985) 790
Year Ended December 31, 1996
Deducted from Asset Accounts:
Reserve for Mortgage Loans
on Real Estate.............................. $29,592 $3,136 $(20,343) $12,385
Reserve for Real Estate...................... 58,029 3,000 $(51,517) (6,512) 3,000
Reserve for Other Long-term,
Investments................................. 13,644 (388) (12,971) (285) --
Included in Other Liabilities:
Investment Guarantees........................ 7,099 (886) (4,438) 1,775
(1) Excludes charges for the direct write-offs of assets. The negative amounts
shown in the additions columns represent improvement in the underlying
assets and guarantees for which valuation accounts had previously been
established.
(2) Deductions reflect sales or foreclosures of the underlying holdings.
80
LINCOLN NATIONAL CORPORATION
EXHIBIT INDEX FOR THE ANNUAL REPORT ON FORM 10-K
For the Year Ended December 31, 1998
Exhibit
Number Page
3(a) Articles of Incorporation dated as of May 12, 1994. 82
3(b) Bylaws of LNC as last amended May 15, 1997.*
4(a) Indenture of LNC dated as of January 15, 1987.*
4(b) LNC First Supplemental Indenture dated July 1, 1992, to
Indenture of LNC dated as of January 15, 1987.*
4(c) Specimen Notes for 7 1/8% Notes due July 15, 1999 and
7 5/8% Notes due July 15, 2002.*
4(d) Rights Agreement dated November 14, 1996.*
4(e) Indenture of LNC dated as of September 15, 1994. 120
4(f) Form of Note dated as of September 15, 1994.*
4(g) Form of Zero Coupon Security dated as of September 15, 1994.*
4(h) Specimen Debenture for 9 1/8% Notes due October 1, 2024.*
4(I) Specimen of 7 1/4% Debenture due May 15, 2005.*
4(j) Junior Subordinated Indenture of LNC as of May 1, 1996.*
4(k) Guarantee Agreement for Lincoln National Capital I.*
4(l) Guarantee Agreement for Lincoln National Capital II.*
4(m) Form of Lincoln National Capital I Preferred Securities, Series A.*
4(n) Form of Lincoln National Capital II Preferred Securities, Series B.*
4(o) Declaration of Trust for Lincoln National Capital I.*
4(p) Specimen Notes for 6 1/2% Notes due March 15, 2008.*
4(q) Specimen Notes for 7% Notes due March 15, 2018.*
4(r) Trust Agreement for Lincoln National Capital III.*
4(s) Form of Lincoln National Capital III Preferred Securities, Series C.*
4(t) Guarantee Agreement for Lincoln National Capital III.*
4(u) Trust Agreement for Lincoln National Capital IV.*
4(v) Form of Lincoln National Capital IV Income Prides Certificates.*
4(w) Form of Lincoln National Capital IV Growth Pride Certificates.*
4(x) Guarantee Agreement for Lincoln National Capital IV.*
4(y) Purchase Contract Agreement for Lincoln National Capital IV.*
4(z) Pledge Agreement for Lincoln National Capital IV.*
10(a) LNC 1986 Stock Option Plan. 150
10(b) The LNC Executives' Salary Continuation Plan.*
10(c) LNC Executive Value Sharing Plan 165
10(d) LNC Executives' Severance Benefit Plan.*
10(e) The LNC Outside Directors Retirement Plan.*
10(f) The LNC Outside Directors Benefits Plan.*
10(g) LNC Directors' Value Sharing Plan.*
10(h) The LNC Executive Deferred Compensation Plan for Employees.*
10(i) LNC 1993 Stock Plan for Non-Employee Directors. 171
10(j) LNC Executives' Excess Compensation Benefit Plan. 177
10(k) LNC 1997 Incentive Compensation Plan.*
10(l) Description of compensation arrangements with Executive Officers. 181
10(m) Lease and Agreement-Lincoln Life's home office property.*
10(n) Lease and Agreement-additional Lincoln Life home office property.*
10(o) Lease-LNC's Corporate Offices.*
10(p) Lease and Agreement-additional Lincoln Life headquarter property.*
12 Historical Ratio of Earnings to Fixed Charges. 205
21 List of Subsidiaries of LNC. 206
23 Consent of Ernst & Young LLP, Independent Auditors. 217
27 Financial Data Schedule. 218
*Incorporated by Reference
81
Signature Page
LINCOLN NATIONAL CORPORATION
Pursuant to the requirements
of Section 13 or 15(d) of
the Securities Exchange Act By /s/ Jon A. Boscia March 11, 1999
-------------------------------------------------
of 1934, LNC has duly caused Jon A. Boscia
this report to be signed on (President, Chief Executive Officer and
its behalf by the under- Director)
signed, thereunto duly
authorized. By /s/ Richard C. Vaughan March 11, 1999
-------------------------------------------------
Richard C. Vaughan
(Executive Vice President and Chief
Financial Officer)
By /s/ Donald L. Van Wyngarden March 11, 1999
-------------------------------------------------
Donald L. Van Wyngarden
(Second Vice President and Controller)
Pursuant to the requirements By /s/ J. Patrick Barrett March 11, 1999
-------------------------------------------------
of the Securities Exchange J. Patrick Barrett
Act of 1934, this report
has been signed below by By /s/ Thomas D. Bell, Jr. March 11, 1999
-------------------------------------------------
the following Directors Thomas D. Bell, Jr
of LNC on the date indicated.
By /s/ Daniel R. Efroymson March 11, 1999
-------------------------------------------------
Daniel R. Efroymson
By /s/ Eric G. Johnson March 11, 1999
-------------------------------------------------
Eric G. Johnson
By /s/ Harry L. Kavetas March 11, 1999
-------------------------------------------------
Harry L. Kavetas
By /s/ M. Leanne Lachman March 11, 1999
-------------------------------------------------
M. Leanne Lachman
By /s/ Roel Pieper March 11, 1999
-------------------------------------------------
Roel Pieper
By /s/ John M. Pietruski March 11, 1999
-------------------------------------------------
John M. Pietruski
By /s/ Ian M. Rolland March 11, 1999
-------------------------------------------------
Ian M. Rolland
By /s/ Jill S. Ruckelshaus March 11, 1999
-------------------------------------------------
Jill S. Ruckelshaus
By /s/ Gilbert R. Whitaker,Jr. March 11, 1999
-------------------------------------------------
Gilbert R. Whitaker,Jr.