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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT UNDER SECTION 13 or 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For quarter ended September 30, 2003 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.)
1500 Market Street, Suite 3900,
Philadelphia, Pennsylvania 19102-2112
(Address of principal executive offices)
Registrant's telephone number (215) 448-1400
Indicate the number of shares outstanding for each issuer's classes of
common stock, as of the last applicable date:
As of October 31, 2003 LNC had 177,985,844 shares of Common Stock
outstanding.
Indicate by check mark whether 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 for such shorter periods 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 whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). Yes [ x ] No [ ]
The exhibit index to this report is located on page 66.
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
- ------------------------------------------------------------------------
LINCOLN NATIONAL CORPORATION
CONSOLIDATED BALANCE SHEETS
September 30 December 31
(000s omitted) 2003 2002
-------------- ---- ----
ASSETS (Unaudited)
Investments:
Securities available-for-sale, at fair value:
Fixed maturity (cost 2003 - $32,896,159;
2002 - $31,103,146) $35,383,944 $32,767,465
Equity (cost 2003 - $223,286;
2002 - $334,493) 242,953 337,216
Mortgage loans on real estate 4,151,542 4,205,470
Real estate 249,754 279,702
Policy loans 1,910,467 1,945,626
Derivative instruments 84,671 86,236
Other investments 400,014 378,136
----------- -----------
Total Investments 42,423,345 39,999,851
Cash and invested cash 1,960,591 1,690,534
Property and equipment 237,258 242,135
Deferred acquisition costs 2,919,363 2,970,866
Premiums and fees receivable 306,483 212,942
Accrued investment income 560,228 536,720
Assets held in separate accounts 41,283,406 36,178,336
Federal income taxes -- 317,726
Amounts recoverable from reinsurers 7,537,869 7,280,014
Goodwill 1,233,685 1,233,232
Other intangible assets 1,228,360 1,291,973
Other assets 1,134,874 1,230,316
----------- -----------
Total Assets $100,825,462 $93,184,645
See notes to consolidated financial statements.
LINCOLN NATIONAL CORPORATION
CONSOLIDATED BALANCE SHEETS
- -CONTINUED-
September 30 December 31
(000s omitted) 2003 2002
-------------- ---- ----
(Unaudited)
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Insurance and Investment Contract Liabilities:
Insurance policy and claim reserves $24,185,291 $23,558,874
Contractholder funds 22,530,863 21,286,396
Liabilities related to separate accounts 41,283,406 36,178,336
----------- -----------
Total Insurance and Investment Contract Liabilities 87,999,560 81,023,606
Federal income taxes 37,097 --
Short-term debt 76,500 153,045
Long-term debt 1,118,489 1,119,245
Junior subordinated debentures issued to
affiliated trusts 333,597 392,658
Other liabilities 4,724,825 4,171,452
Deferred gain on indemnity reinsurance 949,032 977,149
----------- -----------
Total Liabilities 95,239,100 87,837,155
Shareholders' Equity:
Series A preferred stock - 10,000,000 shares authorized
(9/30/03 liquidation value - $1,484) 634 666
Common stock - 800,000,000 shares authorized 1,508,056 1,467,439
Retained earnings 3,281,987 3,144,831
Accumulated Other Comprehensive Income (Loss):
Foreign currency translation adjustment 66,989 50,780
Net unrealized gain on securities available-for-sale 804,454 753,272
Net unrealized gain on derivative instruments 23,211 28,349
Minimum pension liability adjustment (98,969) (97,847)
----------- -----------
Total Accumulated Other Comprehensive Income 795,685 734,554
----------- -----------
Total Shareholders' Equity 5,586,362 5,347,490
----------- -----------
Total Liabilities and Shareholders' Equity $100,825,462 $93,184,645
See notes to consolidated financial statements.
LINCOLN NATIONAL CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
Nine Months Ended Three Months Ended
September 30 September 30
(000s omitted, except per share amounts) 2003 2002* 2003 2002*
- ---------------------------------------- ---- ---- ---- ----
(Unaudited) (Unaudited)
Revenue:
Insurance premiums $203,785 $216,112 $69,500 $61,993
Insurance fees 1,040,552 1,064,423 357,902 350,178
Investment advisory fees 146,755 138,660 53,218 42,893
Net investment income 1,979,302 1,964,568 664,435 652,363
Realized gain (loss) on investments
and derivative instruments (net of
amounts restored/(amortized) against
balance sheet accounts, Note 5) (75,211) (221,208) 18,917 (36,805)
Amortization of deferred gain on
Indemnity reinsurance 58,217 66,924 22,006 20,723
Other revenue and fees 227,928 217,381 82,871 72,085
----------- ----------- ----------- -----------
Total Revenue 3,581,328 3,446,860 1,268,849 1,163,430
Benefits and Expenses:
Benefits 1,845,421 2,193,340 639,202 941,617
Underwriting, acquisition,
insurance and other expenses 1,261,170 1,278,638 424,338 438,835
Interest and debt expense 72,922 73,143 26,621 23,688
----------- ----------- ----------- -----------
Total Benefits and Expenses 3,179,513 3,545,121 1,090,161 1,404,140
----------- ----------- ----------- -----------
Income (loss) before federal income taxes 401,815 (98,261) 178,688 (240,710)
Federal income taxes (tax benefits) 84,211 (96,026) 45,375 (104,321)
Net Income (Loss) $317,604 $(2,235) $133,313 $(136,389)
Net Income (Loss) Per Common Share - Basic $1.79 $(0.01) $0.75 $(0.75)
Net Income (Loss) Per Common Share - Diluted $1.77 $(0.01) $0.74 $(0.74)
* Restated, see Note 2 - Change in Accounting Principle for more information.
See notes to consolidated financial statements.
LINCOLN NATIONAL CORPORATION
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
Nine Months Ended September 30
Number of Shares Amounts
(000s omitted from dollar amounts) 2003 2002 2003 2002*
------------------------------------------ ---- ---- ---- ----
(Unaudited) (Unaudited)
Series A Preferred Stock:
Balance at beginning-of-year 20,118 23,034 $666 $762
Conversion into common stock 1,566 (2,766) (32) (91)
----------- ----------- ----------- -----------
Balance at September 30 18,552 20,268 634 671
Common Stock:
Balance at beginning-of-year 177,307,999 186,943,738 1,467,439 1,376,098
Conversion of series A preferred stock 25,056 44,256 32 91
Issued/forfeited under benefit plans 627,668 2,248,218 10,138 70,143
Additional paid-in capital - vesting of
stock options granted 38,269 42,910
Additional paid-in capital - tax benefit on
stock options (7,822) 3,729
Cancelled for acquisition of subsidiaries -- (11,246) -- (474)
Retirement of common stock -- (12,088,100) -- (51,064)
----------- ----------- ----------- -----------
Balance at September 30 177,960,723 177,136,866 1,508,056 1,441,434
Retained Earnings:
Balance at beginning-of-year 3,144,831 3,753,774
Comprehensive income 378,735 669,539
Less other comprehensive income (loss):
Foreign currency translation adjustment 16,209 43,410
Net unrealized gain on securities available-for-sale 51,182 621,856
Net unrealized gain on derivative instruments (5,138) 5,799
Minimum pension liability adjustment (1,122) 709
----------- -----------
Net Income 317,604 (2,235)
Retirement of common stock -- (423,422)
Dividends declared:
Series A preferred ($1.50 per share) (44) (36)
Common stock (2003-$1.00; 2002-$0.96) (180,404) (178,383)
----------- -----------
Balance at September 30 $3,281,987 $3,149,698
* Restated, see Note 2 - Change in Accounting Principle for more information.
See notes to consolidated financial statements.
LINCOLN NATIONAL CORPORATION
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (Continued)
Nine Months Ended
September 30
Amounts
(000s omitted from dollar amounts) 2003 2002*
---------------------------------------- ---- ----
(Unaudited)
Foreign Currency Translation Adjustment:
Accumulated adjustment at beginning-of-year $50,780 $(8,062)
Change during the period 16,209 43,410
----------- -----------
Balance at September 30 66,989 35,348
----------- -----------
Net Unrealized Gain (Loss) on
Securities Available-for-Sale:
Balance at beginning-of-year 753,272 195,681
Change during the period 51,182 621,856
----------- -----------
Balance at September 30 804,454 817,537
----------- -----------
Net Unrealized Gain (Loss) on Derivative Instruments:
Balance at beginning-of-year 28,349 21,523
Change during the period (5,138) 5,799
----------- -----------
Balance at September 30 23,211 27,322
----------- -----------
Minimum Pension Liability Adjustment:
Balance at beginning-of-year (97,847) (35,959)
Change during the period (1,122) 709
----------- -----------
Balance at September 30 (98,969) (35,250)
----------- -----------
Total Shareholders' Equity at
September 30 $5,586,362 $5,436,759
Common Stock at End of Quarter:
Assuming conversion of preferred stock 178,257,555 177,461,154
Diluted basis 179,883,423 178,238,520
* Restated, see Note 2 - Change in Accounting Principle for more information.
See notes to consolidated financial statements.
LINCOLN NATIONAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine Months Ended
September 30
(000s omitted) 2003 2002*
---------------------------------------- ---- ----
(Unaudited)
Cash Flows from Operating Activities:
Net income (loss) $317,604 $(2,235)
Adjustments to reconcile net income to net cash
(used in) provided by operating activities:
Deferred acquisition costs (222,734) (210,029)
Premiums and fees receivable (93,541) (177,159)
Accrued investment income (23,508) (4,700)
Policy liabilities and accruals (158,846) 582,757
Contractholder funds 892,360 802,456
Amounts recoverable from reinsurers (225,755) (794,083)
Federal income taxes 145,318 (44,682)
Federal income taxes paid from proceeds of disposition -- (516,152)
Stock-based compensation expense 38,637 42,700
Provisions for depreciation 59,021 37,801
Amortization of other intangible assets 71,797 99,713
Amortization of deferred gain (58,217) (68,284)
Realized loss on investments and derivative instruments 75,211 221,208
Other (208,198) 332,988
----------- -----------
Net Adjustments 291,545 304,534
----------- -----------
Net Cash Provided by Operating Activities 609,149 302,299
Cash Flows from Investing Activities:
Securities-available-for-sale:
Purchases (9,394,021) (10,277,941)
Sales 5,318,434 5,752,146
Maturities 2,347,790 1,859,780
Purchase of other investments (1,306,984) (817,819)
Sale or maturity of other investments 1,407,235 1,337,630
Increase (Decrease) in cash collateral on loaned securities 216,680 (193,152)
Property and equipment purchases (90,472) (101,696)
Property and equipment sales 43,463 77,859
Other 271,350 (66,733)
----------- -----------
Net Cash Used in Investing Activities (1,186,525) (2,429,926)
Cash Flows from Financing Activities:
Retirement/call of junior subordinated debentures (204,962) (84,068)
Issuance of junior subordinated debentures (net of issuance costs) 145,275 --
Issuance of long-term debt -- 248,990
Net decrease in short-term debt (76,545) (230,203)
Universal life and investment contract deposits 3,605,972 4,031,974
Universal life and investment contract withdrawals (2,004,801) (2,753,554)
Investment contract transfers (447,554) 115,000
Common stock issued for benefit plans 10,138 73,370
Retirement of common stock -- (457,591)
Other liabilities - retirement of common stock -- (131,890)
Dividends paid to shareholders (180,090) (180,017)
----------- -----------
Net Cash Provided by Financing Activities 847,433 632,011
----------- -----------
Net Increase (Decrease) in Cash and Invested Cash 270,057 (1,495,616)
Cash and Invested Cash at Beginning-of-Year 1,690,534 3,095,480
----------- -----------
Cash and Invested Cash at September 30 $1,960,591 $1,599,864
* Restated, see Note 2 - Change in Accounting Principle for more information.
See notes to consolidated financial statements.
LINCOLN NATIONAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
1. 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. The collective group of companies uses
"Lincoln Financial Group" as its marketing identity. Operations are
divided into four business segments. Less than majority-owned entities
in which LNC has at least a 20% interest are reported on the equity
basis. These unaudited consolidated statements have been prepared in
conformity with accounting principles generally accepted in the United
States, except that they do not contain complete notes. However, in the
opinion of management, these statements include all normal recurring
adjustments necessary for a fair presentation of the results. These
financial statements should be read in conjunction with the audited
consolidated financial statements and the accompanying notes
incorporated by reference into LNC's latest annual report on Form 10-K
for the year ended December 31, 2002 and the current report on Form 8-K
voluntary filing of certain sections of the Annual Report filed on
August 29, 2003 to reflect LNC's retroactive application of the fair
value expense recognition provisions of Statement of Financial
Accounting Standards No. 123, "Accounting for Stock Based Compensation"
("FAS 123").
Operating results for the nine months ended September 30, 2003 are not
necessarily indicative of the results that may be expected for the full
year ending December 31, 2003.
2. Change in Accounting Principle and New Accounting Pronouncements
Accounting for Stock Compensation. Effective January 1, 2003, LNC
adopted the fair value recognition method of accounting for its stock
option incentive plans under FAS 123. On December 31, 2002, the
Financial Accounting Standards Board ("FASB") issued Statement of Financial
Accounting Standards No. 148, "Accounting for Stock-Based Compensation
- -Transition and Disclosure" ("FAS 148"), which provides alternative
methods of transition for entities that change to the fair value method
of accounting for stock-based employee compensation. In addition, FAS
148 amends the disclosure provisions of FAS 123 to require expanded and
more prominent disclosure of the effects of an entity's accounting
policy with respect to stock-based employee compensation on reported net
income and earnings per share in annual and interim financial
statements. LNC adopted the retroactive restatement method under FAS 148
which requires LNC to restate all prior periods presented to reflect
stock-based employee compensation cost under the fair value accounting
method in FAS 123 for all employee awards granted, modified or settled
in fiscal years beginning after December 15, 1994. See LNC's Form 8-K
"Voluntary filing of certain sections of the Annual Report on Form 10-K
for the year ended December 31, 2002," filed on August 29, 2003 to
reflect LNC's retroactive application of the fair value expense
recognition provisions of FAS 123. Prior to January 1, 2003, LNC
accounted for its stock option incentive plans using the intrinsic value
method of accounting under the recognition and measurement provisions of
Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued
to Employees" ("APB 25"), and related Interpretations. No stock-based
compensation cost for stock options was reflected in previously reported
results.
The effect of the accounting change on net income for 2002 is as
follows:
Nine Months Ended Three Months Ended
September 30, September 30,
(in millions except per share amounts) 2002 2002
---- ----
Net income (loss) as previously reported $28.4 $(125.5)
Adjustment for effect of change in accounting principle
that is applied retroactively, net of tax effects (30.6) (10.9)
-------- ------
Net income (loss) as adjusted $(2.2) $(136.4)
Per share amounts:
Earnings (loss) per common share - Basic:
Net income (loss) as previously reported $0.15 $(0.69)
Adjustment for effect of change in accounting principle
that is applied retroactively, net of tax effects (0.16) (0.06)
Net income (loss) as adjusted $(0.01) $(0.75)
Earnings (loss) per common share - Diluted:
Net income (loss) as previously reported $0.15 $(0.68)
Adjustment for effect of change in accounting principle
that is applied retroactively, net of tax effects (0.16) (0.06)
-------- ------
Net income (loss) as adjusted $(0.01) $(0.74)
Retained earnings at September 30, 2002:
Retained earnings as previously reported $3,261.0
Cumulative adjustment for effect of change in accounting principle
that is applied retroactively, net of tax effects (111.3)
--------
Retained earnings as adjusted $3,149.7
Although LNC did not recognize compensation expense for stock options
under the intrinsic value method of accounting in accordance with APB
25, a tax benefit was recognized in additional paid-in capital for stock
options that were exercised through December 31, 2002. Because LNC
elected not to restate periods prior to 2000 in the adoption of FAS 123,
the tax benefit for options granted after December 31, 1994 and
exercised prior to January 1, 2000 had to be determined under the fair
value method and then compared to the tax benefit that was previously
recorded in additional paid-in capital upon exercise. As of January 1,
2000, a tax benefit was calculated under the fair value method for
outstanding stock options granted after December 31, 1994 that vested
prior to January 1, 2000. An adjustment of $13.7 million was made to
increase additional paid-in capital and the deferred tax asset as of
January 1, 2000 for the adoption of FAS 123.
Accounting for Costs Associated with Exit or Disposal Activities. In
June 2002, the FASB issued Statement of Financial Accounting Standards
No. 146, "Accounting for Costs Associated with Exit or Disposal
Activities" ("FAS 146"), which addresses financial accounting and
reporting for costs associated with exit or disposal activities and
nullifies Emerging Issues Task Force Issue No. 94-3, "Liability
Recognition for Certain Employee Termination Benefits and Other Costs to
Exit an Action (including Certain Costs Incurred in a Restructuring)"
("Issue 94-3"). The principal difference between FAS 146 and Issue 94-3
is that FAS 146 requires that a liability for a cost associated with an
exit or disposal activity be recognized when the liability is incurred,
rather than at the date of an entity's commitment to an exit plan. FAS
146 is effective for exit or disposal activities after December 31,
2002. LNC adopted FAS 146 on January 1, 2003 and the adoption of the
Statement will affect the timing of when an expense is recognized for
restructuring activities.
Accounting for Variable Interest Entities. In January 2003, the FASB
issued Interpretation No. 46, "Consolidation of Variable Interest
Entities" ("Interpretation 46"), which requires the consolidation of
variable interest entities ("VIE") by an enterprise if that enterprise
has a variable interest that will absorb a majority of the VIE's
expected losses if they occur, receive a majority of the entity's
expected residual returns if they occur, or both. If one enterprise will
absorb a majority of a VIE's expected losses and another enterprise will
receive a majority of that VIE's expected residual returns, the
enterprise absorbing a majority of the losses shall consolidate the VIE.
VIE refers to an entity in which equity investors do not have the
characteristics of a controlling financial interest or do not have
sufficient equity at risk for the entity to finance its activities
without additional subordinated financial support from other parties. In
October 2003, the FASB delayed the effective date of this Interpretation
until the fourth quarter of 2003 for VIEs in which an enterprise holds a
variable interest acquired before February 1, 2003. LNC expects to adopt
this Interpretation prospectively with a cumulative-effect adjustment as
of the end of the period ending December 31, 2003. As key guidance with
respect to certain aspects of the new Interpretation is still emerging,
LNC has not been able to finalize the expected effect of adoption.
Among the matters that LNC is reviewing in connection with the fourth
quarter 2003 effective date is the potential application to
Collateralized Debt Obligation (CDO) pools that are managed by LNC.
Because the fees earned by LNC for managing these CDOs are required to
be included in the analysis of expected residual returns, it is likely
that such CDO pools may fall under the consolidation requirements of
Interpretation 46. If the invested assets within the CDO pools and the
liabilities owed by the CDO pools to the third party investors are
required to be brought onto LNC's consolidated balance sheet, LNC would
disclose that the CDO pool liabilities are nonrecourse to LNC.
Because the fair value of the underlying invested assets in the CDO
pools is currently below amortized cost basis, if LNC is required to
consolidate the CDO pools, the value of the assets recorded upon initial
adoption of the new Interpretation is expected to be less than the
amount of nonrecourse debt. Based upon information currently available,
LNC estimates that the fair value of the CDO pool assets is about $1.2
billion and that the nonrecourse debt would be recorded at about $1.5
billion. LNC has an investment of about $22.0 million in certain of the
CDO pools that it manages; at September 30, 2003 these investments had a
fair value of $21.2 million. LNC does not bear the economic risk of the
loss represented by the approximate $300 million difference between the
value of all of the CDO pool assets and the total amount of CDO pool
nonrecourse debt. Yet under this emerging guidance, at the time of
adopting these new rules LNC's financial statements would not reflect
the fact that it is the third party investor group, and not LNC, that
bears the economic risk of these losses.
To record the difference between the value of the CDO pool assets and
the CDO pool nonrecourse debt on LNC's balance sheet upon the adoption
of Interpretation 46, LNC would record a charge to equity through Other
Comprehensive Income for the cumulative temporary declines in underlying
investment asset values and LNC would record a charge to net income
equal to the declines in value of the underlying investment assets that
are considered other than temporary. At December 31, LNC will complete
the analysis of all of the underlying investment assets held within
these CDO pools in order to determine which of these investments have
experienced declines in fair value that are other than temporary.
In subsequent periods, when the underlying invested assets are sold and
the proceeds are distributed to the investors, LNC would record gains
associated with the extinguishment of nonrecourse debt. This reversal of
the losses recorded upon the initial adoption of Interpretation 46 as
the CDO pools liquidate reflects the fact that it is the third party
investors, and not LNC, that ultimately bears the risk of loss from
these CDO pools.
The FASB is still considering important guidance relating to these types
of investment pools. Until final guidance is issued, LNC is unable to
finalize its review of these matters. In addition, LNC does not
currently have access to all information necessary to determine the
ultimate effects of such a required consolidation, because LNC is not
the trustee or the administrator of the CDO pools. Accordingly, the
estimated effects of the adoption of Interpretation 46 that are
discussed in the preceding paragraphs are subject to change, pending the
issuance of final guidance by the FASB and LNC's obtaining the necessary
information from the CDO pool trustees and administrators.
Since LNC's role of investment manager for the CDO pools does not expose
LNC to risk of loss on the underlying invested assets, LNC management
does not believe the accounting model imposed under Interpretation 46 is
reflective of the true underlying economics for the investment manager
of these types of CDO pool arrangements. However, based upon the current
status of this emerging guidance, it appears that LNC will be required
to apply this accounting model in order to comply with generally
accepted accounting principles.
Although LNC and the industry continue to review the new rules, at the
present time LNC does not believe there are other significant VIEs that
would result in consolidation with LNC, beyond the managed CDO pools
discussed above.
Accounting for Modified Coinsurance. In April 2003, the FASB's
Derivative Implementation Group issued Statement 133 Implementation
Issue No. B36 ("DIG B36") addressing the accounting for modified
coinsurance agreements ("Modco") and coinsurance with funds withheld
("CFW") reinsurance agreements. This implementation guidance concluded
that Modco and CFW agreements contain embedded derivatives that must be
accounted for separately from the underlying reinsurance agreements. In
conjunction with the initial application of these new rules, companies
that have ceded business and are holding invested assets under these
types of reinsurance arrangements may reclassify available for sale
invested assets to trading account classification, where such securities
relate to the embedded derivatives in the reinsurance agreements.
The effective date for implementation of DIG B36 for LNC is the October
1, 2003 start date of the fourth quarter. Upon adoption, LNC will record
the fair value of the applicable embedded derivatives in net income as a
cumulative effect of a change in accounting. The new rules do not
provide guidance with respect to a number of key implementation matters,
presenting LNC and the life insurance industry with several challenging
decisions and numerous alterative interpretations as to the application
of the new rules. Accordingly, LNC is currently evaluating alternative
interpretations that could affect the amounts recorded at the time of
adoption as well as the way changes in the fair values of invested
assets and embedded derivatives associated with these reinsurance
agreements will be reflected within LNC's financial statements on an
ongoing basis.
Among the matters LNC is currently evaluating is how to characterize the
embedded derivatives in various Modco and CFW reinsurance agreements.
Alternatives under consideration include viewing the embedded
derivatives as total return swaps or credit default derivatives. Once
the characterizations of the various embedded derivatives are decided
upon, LNC must then determine what methodologies to use to measure the
fair value of the embedded derivatives. For instance, if LNC determines
that characterization of an embedded derivative as a total return swap
is appropriate for a particular agreement, LNC might look to the
unrealized gains and losses included within the invested assets
supporting the agreement as a means of measuring the fair value of the
embedded derivative. In such circumstances, upon adoption of the new
rules LNC may decide to reclassify that portion of the underlying
invested assets that are currently classified as available for sale
securities to trading account assets.
To illustrate the potential effect that the initial adoption of these
rules could have on LNC's financial statements, information relating to
invested assets held by LNC at September 30, 2003 under Modco and CFW
agreements is provided below. The actual effect of adoption will vary
depending upon a number of factors, such as how the embedded derivatives
are characterized, the valuation methodologies selected, whether the
terms of the reinsurance agreements provide for a pass through of the
total return of an identified investment portfolio or some other
measure, whether or not invested assets within such reinsurance
investment portfolios are reclassified from available for sale to
trading account and the amount of unrealized gains or losses of the
relevant invested assets at the adoption date.
At September 30, 2003, the fair value of LNC invested assets associated
with Modco and CFW agreements totaled about $3.3 billion. The net
unrealized pre-tax gain associated with these assets at September 30,
2003 was about $394 million. Included within that total net gain is
about $372 million of net gain related to available for sale securities
and $22 million of net gain related to other invested assets. If LNC
should determine that the best characterization of the embedded
derivatives associated with these various agreements is that of total
return swaps, and if LNC determines that the unrealized gains and losses
of the underlying invested asset portfolios can be used to measure the
value of the embedded derivative, then LNC would record a $394 million
pre-tax loss in net income upon the initial adoption of the new rules to
record the various embedded derivatives. LNC would also record a pre-tax
increase in equity of $372 million to reverse the adjustments previously
recorded due to the fact that unrealized gains or losses on the
reinsurance portfolios generally inure to the benefit or detriment of
the assuming reinsurance company. The $22 million pre-tax net effect on
LNC's equity of the initial adoption adjustments would reverse over the
term of the reinsurance agreements, as the net unrealized gains
associated with invested assets that are not classified as
available-for-sale securities are realized in future periods.
If LNC decided to concurrently reclassify all relevant
available-for-sale invested assets as trading account assets upon the
initial adoption of these new rules, LNC would record a pre-tax gain in
net income of $372 million. However, LNC's equity would not be affected
by this reclassification accounting, as the previously recorded
increases to shareholder's equity booked in Other Comprehensive Income
as a result of the available-for-sale classification of these
investments would be reversed upon the reclassification of these
invested assets from available-for-sale to trading account.
On an ongoing basis, changes in the fair value of the embedded
derivative would flow through net income, as would changes in the fair
value of trading account assets. Changes in the fair value of other
invested assets supporting these agreements would flow through net
income as unrealized gains or losses on these assets are realized.
Because the recognition of the fair value of embedded derivatives does
not affect either the cash flows or the economic profits to be
recognized over the life of the reinsurance agreement, it is expected
that these new rules will only change the pattern of earnings associated
with these reinsurance agreements. Importantly, it is expected that the
new rules will not change the ultimate profit or loss that will be
reported over the entire term of the reinsurance agreement.
Not included in the above discussion are a number of reinsurance
agreements where LNC accepts business as a reinsurer on a Modco basis
and then cedes the business off on a Modco basis to Swiss Re. LNC does
not hold the underlying invested assets under these agreements, and LNC
has effectively transferred all underwriting and investment risks
associated with these agreements. LNC is a party to a number of such
reinsurance agreements, which at September 30, 2003 aggregated about
$1.7 billion of business. While LNC continues to review the treatment of
these Modco agreements under these new rules, it appears that the
embedded derivatives associated with these agreements will be
characterized as total return swaps. Based upon information available at
this time and the preliminary conclusion that these embedded derivatives
should be characterized as total return swaps, LNC expects that its
position as an accepting reinsurer and a ceding company on the same
business should result in equal and offsetting changes in the value of
the embedded derivatives associated with these agreements. Accordingly,
LNC would not expect that the embedded derivatives associated with these
reinsurance agreements would create significant volatility in reported
net income in future periods.
In addition, LNC has acquired certain blocks of variable annuity and
life business using Modco reinsurance structures. At September 30, 2003
there was about $330 million of business acquired in this manner. LNC
continues to review whether the accounting for these agreements will
change under the new rules; based upon information available at this
time LNC does not believe there will be any new effects on net income
created by the adoption of the new embedded derivative accounting rules
for these agreements, given the fact that the assets and liabilities
associated with these variable blocks of business are already reflected
at fair value within LNC's financial statements.
Statement of Accounting Position 03-01. In July 2003, the American
Institute of Certified Public Accountants issued Statement of Position
03-1, "Accounting and Reporting by Insurance Enterprises for Certain
Nontraditional Long-Duration Contracts and for Separate Accounts" ("SOP
03-1"). SOP 03-1 provides guidance related to the reporting and
disclosure of certain insurance contracts and separate accounts,
including guidance for computing reserves for products with guaranteed
benefits, such as guaranteed minimum death benefits ("GMDB"), and for
products with annuitization benefits such as guaranteed minimum income
benefits. In addition, SOP 03-1 addresses the presentation and reporting
of separate accounts, as well as rules concerning the capitalization and
amortization of sales inducements.
Based upon a preliminary comparison of the requirements of SOP 03-1 to
LNC's established practice of reserving for GMDB, the adoption of the
GMDB reserving methodology under SOP 03-1 is not expected to have
a material effect on LNC's financial statements.
In addition to GMDB reserving matters, LNC is also assessing the other
requirements included in SOP 03-1. At this point, LNC has not completed
an estimate of the expected effect of these other SOP 03-01
requirements; however, based upon a preliminary review, LNC does not
currently expect that the adoption of these new rules should have a
material effect on LNC's financial statements. LNC expects to adopt SOP
03-1 in the first quarter of 2004.
3. Federal Income Taxes.
The effective tax rate on net income is lower than the prevailing
corporate federal income tax rate principally from tax-preferred
investment income. LNC recorded a tax benefit on the loss before federal
income taxes for the nine and three month periods ended September 30,
2002 greater than the prevailing corporate federal income tax rate due
to the fact that LNC earns tax-preferred investment income that does not
change proportionately with the overall change in earnings or losses
before federal income taxes.
4. Junior Subordinated Debentures Issued to Affiliated Trusts.
In July 2003 LNC redeemed the $200 million 7.40% TOPr'S issued by
Lincoln Capital III and guaranteed by LNC. A loss of $3.7 million
related to unamortized issuance costs is reported in the third quarter
of 2003 related to the redemption. In September, Lincoln Capital VI, a
wholly-owned affiliated trust of LNC, issued $150 million of 6.75% Junior
Subordinated Debentures, Series F guaranteed by LNC. The debentures
mature September 11, 2052 and can be redeemed for principal plus accrued
interest beginning September 11, 2008. Proceeds from the offering will
be used for general corporate purposes.
5. Supplemental Financial Data
A roll forward of the balance sheet account, "Deferred Acquisition
Costs," is as follows:
Nine Months Ended
September 30
(in millions) 2003 2002
---- ----
Balance at beginning-of-period $2,970.9 $2,885.3
Deferral 454.8 459.5
Amortization (232.0) (283.9)
Adjustments related to net realized losses
on securities available-for-sale (22.3) 97.3
Adjustments related to net unrealized gains
on securities available-for-sale (271.2) (304.3)
Foreign currency translation adjustment 19.2 43.2
Other -- (28.3)
-------- --------
Balance at end-of-period $2,919.4 $2,868.8
Realized gains and losses on investments and derivative instruments on
the Statements of Income for the nine months ended September 30, 2003
and 2002 are net of amounts restored or (amortized) against deferred
acquisition costs of $(22.3) million and $97.3 million, respectively. In
addition, realized gains and losses for the nine months ended September
30, 2003 and 2002 are net of adjustments made to policyholder reserves
of $46.9 million and $23.1 million, respectively. LNC has either a
contractual obligation or has a consistent historical practice of making
allocations of investment gains or losses to certain policyholders.
Details underlying the income statement caption, "Underwriting,
Acquisition, Insurance and Other Expenses," are as follows:
Nine Months Ended Three Months Ended
September 30 September 30
(in millions) 2003 2002* 2003 2002*
- ------------- ----- ----- ----- -----
Commissions $402.7 $417.4 $144.1 $124.6
Other volume related expenses 227.5 184.1 90.5 63.9
Operating and administrative expenses 663.0 668.3 209.8 228.1
Deferral of acquisition costs (454.8) (459.5) (165.7) (155.5)
Amortization of deferred acquisition costs 232.0 283.9 67.9 113.0
Other intangibles amortization 5.9 6.2 2.0 2.0
Restructuring charges 38.8 (0.5) 19.8 (2.1)
Other 146.1 178.8 55.9 64.8
-------- ------- -------- -------
Total $1,261.2 $1,278.7 $424.3 $438.8
* 2002 amounts have been restated for the retroactive adoption of FAS 123. See Note 2 for additional information.
The carrying amount of goodwill by reportable segment as of September
30, 2003 and December 31, 2002 was as follows:
(in millions) September 30, December 31,
2003 2002
---- ----
Lincoln Retirement $64.1 $64.1
Life Insurance 855.1 855.1
Investment Management 300.7 300.7
Lincoln UK* 13.8 13.3
-------- -------
Total $1,233.7 $1,233.2
* The consolidated carrying value of goodwill as of September 30, 2003
changed from the balance as of December 31, 2002 as a result of the
translation of the Lincoln UK balance from British pounds to U.S.
dollars based on the prevailing exchange rate as of the balance sheet
date.
For intangible assets subject to amortization, the total gross carrying
amount and accumulated amortization in total and for each major
intangible asset class by segment are as follows:
As of September 30, 2003 As of December 31, 2002
------------------------ -----------------------
(in millions) Gross Carrying Accumulated Gross Carrying Accumulated
Amount Amortization Amount Amortization
------ ------------ ------ ------------
Amortized Intangible Assets:
Lincoln Retirement Segment:
Present value of in-force $225.0 $110.0 $225.0 $102.3
Life Insurance Segment:
Present value of in-force 1,254.2 425.7 1,254.2 364.1
Investment Management Segment:
Client lists 103.6 67.7 103.6 61.8
Lincoln UK Segment:
Present value of in-force* 354.2 105.2 344.2 106.8
-------- -------- -------- --------
Total $1,937.0 $708.6 $1,927.0 $635.0
* The gross carrying amount of the present value of in-force for the
Lincoln UK segment changed from December 31, 2002 to September 30, 2003
due to the translation of the balances from British pounds to U.S.
dollars based on the prevailing exchange rate as of the balance sheet
dates.
The aggregate amortization expense for other intangible assets for the
nine months ended September 30, 2003 and 2002 was $71.8 million and
$99.7 million, respectively. The aggregate amortization expense for
other intangible assets for the three months ended September 30, 2003
and 2002 was $31.6 million and $42.2 million, respectively.
Future estimated amortization of other intangible assets is as follows
(in millions):
2003 - $21.2 2004 - $82.8 2005 - $80.8
2006 - $81.2 2007 - $81.0 Thereafter - $881.4
The 2003 amount shown above is the amortization expected for the
remaining three months of 2003.
6. Restrictions, Commitments and Contingencies
Statutory Restriction. 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, the acquisition of two blocks of business in 1998
resulted in negative statutory earned surplus for The Lincoln National
Life Insurance Company ("LNL") which triggered certain approval
requirements in order for LNL to declare and pay dividends to LNC. As a
result of negative earned surplus, LNL was required to obtain the prior
approval of the Indiana Insurance Commissioner ("Commissioner") before
paying any dividends to LNC until its statutory earned surplus became
positive. During the first quarter 2002, LNL received approval from the
Commissioner to reclassify total dividends of $495 million paid to LNC
in 2001 from LNL's earned surplus to paid-in-capital. This change plus
the increase in statutory earned surplus from the indemnity reinsurance
transaction with Swiss Re resulted in positive statutory earned surplus
for LNL at December 31, 2001.
In general, dividends are not subject to prior approval from the
Commissioner provided LNL's statutory earned surplus is positive and
such dividends do not exceed the standard limitation of the greater of
10% of total statutory earned surplus or the amount of statutory
earnings in the prior calendar year. As a result of the payment of
dividends and statutory losses in 2002, LNL's statutory earned surplus
was negative as of December 31, 2002. The statutory losses resulted from
realized losses on investments, the effect of the equity markets and the
reserve strengthening in 2002 related to the reinsurance business sold
to Swiss Re. Due to the negative statutory earned surplus as of December
31, 2002, any dividend(s) paid by LNL in 2003 will be subject to prior
approval from the Commissioner. During the first nine months of 2003,
LNL received approval from the Commissioner and paid dividends of $134
million to LNC. As occurred in 2001, dividends approved and paid while
statutory earned surplus is negative have been classified as a reduction
to paid-in-capital.
LNL is recognized as an accredited reinsurer in the state of New York,
which effectively enables it to conduct reinsurance business with
unrelated insurance companies that are domiciled in the state of New
York. As a result, in addition to regulatory restrictions imposed by the
state of Indiana, LNL is also subject to the regulatory requirements
that the state of New York imposes upon accredited reinsurers.
Reinsurance Contingencies. On December 7, 2001, Swiss Re acquired LNC's
reinsurance operation. The transaction structure involved a series of
indemnity reinsurance transactions combined with the sale of certain
stock companies that comprised LNC's reinsurance operation.
On October 29, 2002 LNC and Swiss Re settled disputed matters totaling
about $770 million that had arisen in connection with the final closing
balance sheets associated with Swiss Re's acquisition of LNC's
reinsurance operations. The settlement provided for a payment by LNC of
$195 million to Swiss Re, which was recorded by LNC as a reduction in
deferred gain. As a result of additional information made available to
LNC following the settlement with Swiss Re in the fourth quarter of
2002, LNC recorded a further reduction in the deferred gain of $51.6
million after-tax ($79.4 million pre-tax), as well as a $9.4 million
after-tax ($8.3 million pre-tax) reduction in the gain on the sale of
subsidiaries.
As part of the dispute settlement, LNC also paid $100 million to Swiss
Re in satisfaction of LNC's $100 million indemnification obligation with
respect to personal accident business. As a result of this payment, LNC
has no further underwriting risk with respect to the reinsurance
business sold. However, because LNC has not been relieved of its legal
liabilities to the underlying ceding companies with respect to the
portion of the business reinsured by Swiss Re, under FAS 113, the
reserves for the underlying reinsurance contracts as well as a
corresponding reinsurance recoverable from Swiss Re will continue to be
carried on LNC's balance sheet during the run-off period of the
underlying reinsurance business. This is particularly relevant in the
case of the exited personal accident and disability income reinsurance
lines of business where the underlying reserves are based upon various
estimates that are subject to considerable uncertainty.
As a result of developments and information obtained during 2002
relating to personal accident and disability income matters, LNC
increased these exited business reserves by $198.5 million after-tax
($305.4 million pre-tax). After giving effect to LNC's $100 million
indemnification obligation, LNC recorded a $133.5 million after-tax
($205.4 million pre-tax) increase in reinsurance recoverable from Swiss
Re with a corresponding increase in the deferred gain. As a result of
developments and information received in the third quarter of 2003
relating to personal accident matters, LNC increased reserves on this
exited business by $20.9 million after-tax ($32.1 million pre-tax) with
a corresponding increase in reinsurance recoverable from Swiss Re and in
the deferred gain.
Because of ongoing uncertainty related to personal accident and
disability income businesses, the reserves related to these exited
business lines carried on LNC's balance sheet at September 30, 2003 may
ultimately prove to be either excessive or deficient. For instance, in
the event that future developments indicate that these reserves should
be increased, under FAS 113, LNC would record a current period non-cash
charge to record the increase in reserves. Because Swiss Re is
responsible for paying the underlying claims to the ceding companies,
LNC would record a corresponding increase in reinsurance recoverable
from Swiss Re. However, FAS 113 does not permit LNC to take the full
benefit in earnings for the recording of the increase in the reinsurance
recoverable in the period of the change. Rather, LNC would increase the
deferred gain recognized upon the closing of the indemnity reinsurance
transaction with Swiss Re and would report a cumulative amortization
"catch-up" adjustment to the deferred gain balance as increased earnings
recognized in the period of change. Any amount of additional increase to
the deferred gain above the cumulative amortization "catch-up"
adjustment must continue to be deferred and will be amortized into
income in future periods over the remaining period of expected run-off
of the underlying business. No cash would be transferred between LNC and
Swiss Re as a result of these developments.
Accordingly, even though LNC has no continuing underwriting risk, and no
cash would be transferred between LNC and Swiss Re, in the event that
future developments indicate LNC's September 30, 2003 personal accident
or disability income reserves are deficient or redundant, FAS 113
requires LNC to adjust earnings in the period of change, with only a
partial offset to earnings for the cumulative deferred gain amortization
adjustment in the period of change. The remaining amount of increased
gain would be amortized into earnings over the remaining run-off period
of the underlying business.
United Kingdom Selling Practices. Various selling practices of the
Lincoln UK operations have come under scrutiny by the U.K. regulators.
These include the sale and administration of individual pension
products, mortgage endowments and the selling practices of City
Financial Partners Limited ("CFPL"), a subsidiary company purchased in
December 1997. Regarding the sale and administration of pension products
to individuals, regulatory agencies have raised questions as to what
constitutes appropriate advice to individuals who bought pension
products as an alternative to participation in an employer-sponsored
plan. In cases of alleged inappropriate advice, an extensive
investigation has been or is being carried out and the individual put in
a position similar to what would have been attained if the individual
had remained in an employer-sponsored plan.
Following allegations made by the U.K. Consumers' Association (an
organization which acts on behalf of consumers of goods and services
provided in the U.K.) concerning various selling practices of CFPL, LNC
conducted an internal review of 5,000 ten-year savings plans sold by
CFPL during the period September 1, 1998 to August 31, 2000 and,
following discussions with the U.K. regulator, LNC extended this review
to all customers with a ten-year savings plan sold by CFPL to determine
whether the sales of those policies were appropriate. On April 16, 2003,
the Financial Services Authority ("FSA") fined Lincoln UK $762,600
related to the ten-year savings plans sold by CFPL. This concluded the
FSA investigation on this matter.
At September 30, 2003 and December 31, 2002, the aggregate liability
associated with Lincoln UK selling practices was $34.3 million and $82.2
million, respectively. The decrease in the aggregate liability was a
result of redress payments and expenditures partially offset by exchange
rate fluctuation. The level of customer complaints associated with
mortgage endowments has recently been in excess of expectations,
apparently due to increased levels of industry-wide publicity
surrounding these matters. On an ongoing basis, Lincoln UK evaluates
various assumptions underlying these estimated liabilities, including
the expected levels of future complaints, and the potential implications
with respect to the adequacy of the aggregate liability associated with
UK selling practice matters. A continuation of higher than expected
levels of complaints may result in Lincoln UK revising its current
estimate of the required level of these liabilities. See discussion in
LNC's Form 10-K for the year ended December 31, 2002 for background on
these matters including pension mis-selling, mortgage endowment and
other Lincoln UK selling practice issues. The reserves for these issues
are based on various estimates that are subject to considerable
uncertainty. Accordingly, the aggregate liability may prove to be
deficient or excessive. However, it is management's opinion that future
developments regarding Lincoln UK selling practices will not materially
affect the consolidated financial position of LNC.
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 developments will
not materially affect the consolidated financial position of LNC.
LFG has been contacted by various regulatory bodies for information
relating to various industry-wide matters including the market timing and
late trading of mutual fund and variable insurance products and
broker-dealer access arrangements. LNC is in the process of responding to
these information requests. At the present time, LNC is unaware of any
matters that may be expected to result in a material accrual for potential
liabilities associated with the resolution of these inquiries.
Other Contingency Matters. LNC and its subsidiaries are involved in
various pending or threatened legal proceedings, including purported
class actions, 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.
In 2001, LNL concluded the settlement of all class action lawsuits
alleging fraud in the sale of LNL non-variable universal life and
participating whole life policies issued between January 1, 1981 and
December 31, 1998. Since 2001, LNL has reached settlements with a
substantial number of the owners of policies that opted out of the class
action settlement. LNL continues to defend a small number of opt out
claims and lawsuits. While there is continuing uncertainty about the
ultimate costs of settling the remaining opt out cases, it is
management's opinion that established reserves are adequate and future
developments will not materially affect the consolidated financial
position of LNC.
LNC and LNL have pursued claims with their liability insurance carriers
for reimbursement of certain costs incurred in connection with the class
action settlement and the settlement of claims and litigation brought by
owners that opted out of the class action settlement. During the fourth
quarter of 2002, LNC and LNL settled their claims against three
liability carriers on a favorable basis. LNC and LNL continue to pursue
similar claims against a fourth liability insurance carrier.
State guaranty funds assess insurance companies to cover losses to
policyholders of insolvent or 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 had contractual values of $16.1 million and
$22.4 million at September 30, 2003 and December 31, 2002, respectively.
Certain subsidiaries of LNC have invested in real estate partnerships
that use industrial revenue bonds to finance their projects. LNC has
guaranteed the repayment of principal and interest on these bonds.
Certain subsidiaries of LNC are also involved in other real estate
partnerships that use conventional mortgage loans. In case of default by
the partnerships, LNC has recourse to the underlying real estate. 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. These guarantees
expire in 2005 through 2008.
In addition, certain subsidiaries of LNC have sold commercial mortgage
loans through grantor trusts, which issued pass-through certificates.
These subsidiaries have agreed to repurchase any mortgage loans which
remain delinquent for 90 days at a repurchase price substantially equal
to the outstanding principal balance plus accrued interest thereon to
the date of repurchase. In case of default on the mortgage loans, LNC
has recourse to the underlying real estate. It is management's opinion
that the value of the properties underlying these commitments is
sufficient that in the event of default, the impact would not be
material to LNC. These guarantees expire in 2004 through 2009.
Derivative Instruments. LNC maintains an overall risk management
strategy that incorporates the use of derivative instruments to minimize
significant unplanned fluctuations in earnings that are caused by
interest rate risk, foreign currency risk, equity risk, and credit risk.
LNC assesses these risks by continually identifying and monitoring
changes in interest rate exposure, foreign currency exposure, equity
market exposure, and credit exposure that may adversely impact expected
future cash flows and by evaluating hedging opportunities. Derivative
instruments that are currently used as part of LNC's interest rate risk
management strategy include interest rate swaps, interest rate caps and
swaptions. Derivative instruments that are used as part of LNC's foreign
currency risk management strategy include foreign currency swaps and
foreign exchange forwards. Call options on LNC stock, equity index
options and futures contracts are used as part of LNC's equity market
risk management strategy. LNC also uses credit default swaps as part of
its credit risk management strategy.
By using derivative instruments, LNC is exposed to credit and market
risk. If the counterparty fails to perform, credit risk is equal to the
extent of the fair value gain in the derivative. When the fair value of
a derivative contract is positive, this generally indicates that the
counterparty owes LNC and, therefore, creates a payment risk for LNC.
When the fair value of a derivative contract is negative, LNC owes the
counterparty and therefore LNC has no payment risk. LNC minimizes the
credit (or payment) risk in derivative instruments by entering into
transactions with high quality counterparties that are reviewed
periodically by LNC. LNC also maintains a policy of requiring that all
derivative contracts be governed by an International Swaps and
Derivatives Association ("ISDA") Master Agreement.
LNC and LNL are required to maintain minimum ratings as a matter of
routine practice in negotiating ISDA agreements. Under the majority of
ISDA agreements and as a matter of policy, LNL has agreed to maintain
financial strength or claims-paying ratings above S&P BBB and Moody's
Baa2. LNC is required to maintain long-term senior debt ratings above
S&P BBB and Moody's Baa2. A downgrade below these levels would result in
termination of the derivatives contract at which time any amounts
payable by LNC would be dependent on the market value of the underlying
derivative contract. In certain transactions, LNC and the counterparty
have entered into a collateral support agreement requiring LNC to post
collateral upon significant downgrade. LNC also requires for its own
protection minimum rating standards for counterparty credit protection.
LNL is required to maintain financial strength or claims-paying ratings
above S&P A- and Moody's A3 under certain ISDA agreements, which
collectively do not represent material notional exposure. LNC does not
believe the inclusion of termination or collateralization events pose
any material threat to its liquidity position.
Market risk is the adverse effect that a change in interest rates,
currency rates, implied volatility rates, or a change in certain equity
indexes or instruments has on the value of a financial instrument. LNC
manages the market risk by establishing and monitoring limits as to the
types and degree of risk that may be undertaken.
LNC's derivative instruments are monitored by its risk management
committee as part of that committee's oversight of LNC's derivative
activities. LNC's derivative instruments committee is responsible for
implementing various hedging strategies that are developed through its
analysis of financial simulation models and other internal and industry
sources. The resulting hedging strategies are then incorporated into
LNC's overall risk management strategies.
7. Segment Disclosures
LNC has four business segments: Lincoln Retirement (formerly known as
the Annuities segment), Life Insurance, Investment Management and
Lincoln UK.
The following tables show financial data by segment:
Nine Months Three Months
Ended September 30 Ended September 30
(in millions) 2003 2002 (1) 2003 2002 (1)
------------- ---- ---- ---- ----
Revenue:
Lincoln Retirement $1,420.5 $1,336.3 $536.3 $440.7
Life Insurance 1,400.5 1,305.4 468.9 441.6
Investment Management (2) 340.2 310.9 121.7 97.5
Lincoln UK 196.3 225.4 67.3 91.8
Other operations 480.5 513.0 164.2 174.9
Consolidating adjustments (256.7) (244.2) (89.6) (83.1)
-------- -------- -------- --------
Total $3,581.3 $3,446.9 $1,268.8 $1,163.4
Income (Loss) before Federal Income Taxes
(Tax Benefits):
Lincoln Retirement $221.7 $7.9 $135.9 $(35.1)
Life Insurance 245.2 208.2 80.8 66.1
Investment Management 19.4 (2.9) 10.3 (5.4)
Lincoln UK 47.2 19.2 17.6 0.4
Other operations (includes interest expense) (131.7) (330.7) (65.9) (266.7)
Consolidating adjustments -- -- -- --
-------- -------- -------- --------
Total $401.8 ($98.3) $178.7 $(240.7)
Federal Income Taxes (Tax Benefits):
Lincoln Retirement $31.1 $(40.9) $33.9 $(28.0)
Life Insurance 75.3 61.6 24.9 19.7
Investment Management 7.5 (0.4) 4.0 (1.5)
Lincoln UK 16.5 (0.6) 6.1 0.2
Other operations (46.2) (115.7) (23.5) (94.7)
Consolidating adjustments -- -- -- --
-------- -------- -------- --------
Total $84.2 $(96.0) $45.4 $(104.3)
Net Income (Loss):
Lincoln Retirement $190.6 $48.7 $102.0 $(7.0)
Life Insurance 169.9 146.6 55.8 46.4
Investment Management 12.0 (2.5) 6.3 (3.9)
Lincoln UK 30.7 19.8 11.5 0.2
Other operations (includes interest expense) (85.6) (214.8) (42.3) (172.1)
Consolidating adjustments -- -- -- --
-------- -------- -------- --------
Total $317.6 $(2.2) $133.3 $(136.4)
September 30 December 31
(in millions) 2003 2002 (1)
------------- ---- ----
Assets:
Lincoln Retirement $57,636.8 $52,896.4
Life Insurance 20,753.5 19,591.6
Investment Management 1,525.1 1,461.4
Lincoln UK 7,866.3 7,327.1
Other operations 15,034.1 13,951.5
Consolidating adjustments (1,990.2) (2,043.4)
-------- ---------
Total $100,825.6 $93,184.6
(1) 2002 amounts have been restated for the retroactive adoption of FAS
123. See Note 2 for additional information.
(2) Revenues for the Investment Management segment include inter-segment
revenues for asset management services provided to the other segments of
LNC. These inter-segment revenues totaled $75.0 million and $73.5
million for the nine months ended September 30, 2003 and 2002,
respectively, and $25.5 million and $24.1 million for the three months
ended September 30, 2003 and 2002, respectively.
8. Earnings Per Share
Per share amounts for net income (loss) 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.
Reconciliations of the factors used in the two calculations are as
follows:
Nine Months Three Months
Ended September 30 Ended September 30
2003 2002 (1) 2003 2002 (1)
---- ---- ---- ----
Numerator: [in millions]
Net income (loss), as used in basic calculation (1) $317.6 $(2.2) $133.3 $(136.4)
Dividends on convertible preferred stock
and adjustments for minority interests * * * *
------------ ------------ ------------ ------------
Net income (loss), as used in diluted calculation $317.6 $(2.2) $133.3 $(136.4)
* Less than $100,000.
Denominator: [number of shares]
Weighted-average shares, as used
in basic calculation 177,238,951 184,658,447 177,483,351 181,295,515
Shares to cover conversion of
preferred stock 307,267 341,347 299,165 327,311
Shares to cover non-vested stock 101,057 66,965 156,837 118,397
Average stock options outstanding
during the period 7,018,859 13,857,354 8,291,043 8,657,366
Assumed acquisition of shares
with assumed proceeds and
benefits from exercising stock options
(at average market price during
the period) (6,055,635) (11,617,750) (6,937,116) (7,369,919)
Shares repurchaseable from measured
but unrecognized stock option expense (444,220) (1,179,784) (434,970) (655,066)
Average deferred compensation shares 944,810 847,321 965,827 868,435
------------ ------------ ------------ ------------
Weighted-average shares, as
used in diluted calculation 179,122,313 186,973,901 179,857,804 183,242,039
(1) 2002 net income amounts have been restated for the retroactive
adoption of FAS 123. See Note 2 for additional information.
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. Participants in
LNC's deferred compensation plans, who select LNC stock for measuring
the investment return attributable to their deferral amounts, will be
paid out in LNC stock. The obligation to satisfy these deferred
compensation plan liabilities is dilutive and is shown in the table
above.
9. Employee Benefit Plans
Stock Compensation. Refer to Note 6 to the audited financial statements
in LNC's annual report on Form 10-K for the year ended December 31,
2002, for a detailed discussion of this matter.
LNC Stock Options
Information with respect to the LNC incentive plans involving stock
options is as follows:
Options Outstanding Options Exercisable
------------------- -------------------
Weighted-Average Weighted-Average
Shares Exercise Price Shares Exercise Price
- -----------------------------------------------------------------------------------------------------------------
Balance at December 31, 2002 18,608,009 $38.89 10,883,053 $38.87
Granted-original 413,937 25.49
Granted-reloads 100,136 31.61
Exercised (includes shares tendered) (758,770) 25.77
Forfeited (691,466) 39.49
----------------------------------------------------------------------------
Balance at September 30, 2003 17,671,846 $39.07 13,445,318 $39.22
Total compensation expense for LNC incentive plans involving stock
options for the nine months ended September 30, 2003 and 2002 was $19.2
million after-tax ($27.1 million pre-tax) and $24.1 million after-tax
($33.7 million pre-tax), respectively. Total compensation expense for
LNC incentive plans involving stock options for the three months ended
September 30, 2003 and 2002 was $6.5 million after-tax ($9.1 million
pre-tax) and $8.6 million after-tax ($12.0 million pre-tax),
respectively. Included in the above compensation is the acceleration of
expense resulting from the 2003 realignment activities.
Performance Vesting Awards
Effective January 1, 2003, LNC's employee stock option compensation plan
and long-term cash incentive compensation plan were revised and combined
to provide for performance vesting, and to provide for awards that may
be paid out in a combination of LNC stock options, performance shares of
LNC stock and cash. The performance measures for the initial grant under
the new plan will compare LNC's performance relative to a selected group
of peer companies, over a three-year performance measurement period.
Comparative performance measures for these initial awards are: relative
growth in earnings per share, return on equity and total share
performance. Certain participants in the new plans selected from various
combinations of stock options, performance shares and cash in
determining the form of their award. Other participants will have their
award paid in performance shares.
New grants of LNC option awards are expected to be made under the
general terms of this new performance-vesting plan. However, the
separate stock option incentive plans previously established by Delaware
Investments U.S., Inc. ("DIUS") and DIAL Holding Company, Inc. ("DIAL"),
both wholly-owned subsidiaries of Delaware Management Holdings, Inc.,
are expected to continue under their existing plan designs. See the
information provided below under the caption "Delaware Investments U.S.,
Inc. ("DIUS") and DIAL Holding Company, Inc. ("DIAL") Plans."
In the first nine months of 2003, LNC granted a combination of
performance vesting stock options, performance share units and
performance vesting cash awards under the new plan. These awards
consisted of 322,827 10-year LNC stock options, 780,174 performance
share units that could result in the issuance of LNC shares, and cash
awards. As of September 30, 2003, 204,316 stock options and 721,034
performance share units were outstanding. The ultimate amount of stock
to be issued for either the stock option or performance share awards, or
cash to be paid for the cash awards will be determined by the level of
achievement on LNC's three performance measures over the three-year
performance measurement period. Information with respect to the expenses
recorded for awards under these programs is as follows:
Periods Ended September 30, 2003
-----------------------------------------------
Nine Months Three Months
After-Tax Pre-Tax After-Tax Pre-Tax
-----------------------------------------------
Stock Options $0.2 $0.3 $0.1 $0.1
Performance Shares 3.1 4.7 1.0 1.6
Cash Awards 0.4 0.7 0.1 0.2
The amount of stock option expense for the performance vesting awards is
included in the total LNC stock option expense as discussed above under
the caption "LNC Stock Options."
All expense calculations for performance vesting stock options,
performance shares, and performance vesting cash awards that were
granted in 2003 have been based upon the current assumption that the
actual performance achievement over the three-year performance
measurement period will result in target levels of long-term incentive
compensation payouts. As the three-year performance period progresses,
LNC will continue to refine its estimate of the expense associated with
these awards so that by the end of the three-year performance period,
LNC's cumulative expense will reflect the actual level of awards that
vest.
Stock Appreciation Rights ("SARs")
Information with respect to the LNC incentive plan involving SARs is as
follows:
SARs Outstanding SARs Exercisable
---------------- ----------------
Weighted- Weighted-
Average Average
Shares Exercise Price Shares Exercise Price
- ----------------------------------------------------------------------------------------------------------------
Balance at December 31, 2002 1,382,248 $39.20 301,108 $32.06
Granted-original 326,650 25.28
Exercised (includes shares tendered) (44,887) 24.72
Forfeited (38,350) 39.41
----------------------------------------------------------------------------
Balance at September 30, 2003 1,625,661 $36.80 619,406 $36.11
Net compensation expense for the LNC incentive plan involving SARs for
the nine months ended September 30, 2003 and 2002 was $3.0 million
after-tax ($4.7 million pre-tax). Net compensation expense for the LNC
incentive plan involving SARs for the three months ended September 30,
2003 and 2002 was $1.1 million after-tax ($1.8 million pre-tax) and
$0.9 million after-tax ($1.5 million pre-tax), respectively. As
discussed in Note 6 to the audited financial statements in LNC's annual
report on Form 10K, compensation expense (income) for the LNC incentive
plan involving SARs represents the net amount of the mark-to-market
adjustment for options to acquire LNC shares purchased at the time of
the grants, combined with the change in LNC's stock price compared to
the SAR's grant price.
Delaware Investment U.S. Inc. ("DIUS") and DIAL Holding Company, Inc.
("DIAL") Plans
At September 30, 2003, DIUS had 10,000,000 shares of common stock
outstanding. Information with respect to the DIUS incentive plan
involving stock options is as follows:
Options Options
Outstanding Exercisable
------------------- -------------------
Weighted- Weighted-
Average Average
Shares Exercise Price Shares Exercise Price
- ----------------------------------------------------------------------------------------------------------------
Balance at December 31, 2002 1,087,996 $104.31 280,877 $103.61
Granted-original 277,200 98.71
Exercised (includes shares tendered) -- --
Forfeited (161,256) 104.68
----------------------------------------------------------------------------
Balance at September 30, 2003 1,203,940 $102.97 407,945 $103.80
At September 30, 2003, DIAL had 10,000,000 shares of common stock
outstanding. Information with respect to the DIAL incentive plan
involving stock options is as follows:
Options Options
Outstanding Exercisable
------------------- -------------------
Weighted- Weighted-
Average Average
Shares Exercise Price Shares Exercise Price
- ----------------------------------------------------------------------------------------------------------------
Balance at December 31, 2002 1,088,010 $25.76 202,703 $25.47
Granted-original 583,579 26.79
Exercised (includes shares tendered) -- --
Forfeited (45,686) 25.76
----------------------------------------------------------------------------
Balance at September 30, 2003 1,625,903 $26.13 454,750 $25.64
Compensation expense for the DIUS and DIAL incentive plans involving
stock options for the nine months ended September 30, 2003 and 2002
totaled $7.2 million after-tax ($10.0 million pre-tax) and $6.5 million
after-tax ($9.2 million pre-tax), respectively. Compensation expense for
the DIUS and DIAL incentive plans involving stock options for the three
months ended September 30, 2003 and 2002 totaled $2.6 million after-tax
($3.6 million pre-tax) and $2.4 million after-tax ($3.3 million
pre-tax), respectively.
10. Restructuring Charges
Included in the discussion below are restructuring plans that were
implemented during the years 1999 through 2003 that were not yet
completed as of December 31, 2002. Any restructuring plans that were
implemented during the years 1999 through 2001 that were completed as of
December 31, 2002 are not included in the discussion below. For
discussion of these completed plans, see Note 12 to the audited
financial statements of LNC's annual report on Form 10-K for the year
ended December 31, 2002. The aggregate charges associated with the
restructuring plans were included in Underwriting, Acquisition,
Insurance and Other Expenses on the Consolidated Statements of Income in
the period incurred.
1999 Restructuring Plan
During 1999, LNC implemented a restructuring plan relating to the
streamlining of Lincoln UK's operations. The following table provides
information about this restructuring plan.
Lincoln UK
(in millions) Plan
------------- -------
Employee severance and termination benefits $3.9
Other costs - rent on abandoned office space 6.1
-------
1999 Restructuring Charge (pre-tax) 10.0
Amounts expended through December 31, 2002 7.5
Amounts reversed through December 31, 2002 --
-------
Restructuring reserve at December 31, 2002 2.5
Amounts expended in the first nine months of 2003 1.1
Amounts reversed in the first nine months of 2003 --
-------
Restructuring reserve at September 30, 2003 $1.4
=======
Positions to be eliminated under original plan 119
Actual positions eliminated through September 30, 2003 112
Substantially completed with lease payments on vacated
space through 2016
2000 Restructuring Plan
During 2000, LNC implemented a restructuring plan relating to the exit
of all direct sales and sales support operations of Lincoln UK and the
consolidation of its Uxbridge home office with its Barnwood home office.
The following table provides information about this restructuring plan.
Lincoln UK
(in millions) Plan
------------- -------
Employee severance and termination benefits $29.8
Write-off of impaired assets 39.2
Other costs 30.4
-------
2000 Restructuring Charge (pre-tax) 99.4
Amounts expended and written-off through
December 31, 2002 88.0
Amounts reversed through December 31, 2002 1.7
-------
Restructuring reserve at December 31, 2002 9.7
Amounts expended in the first nine months of 2003 1.3
Amounts reversed in the first nine months of 2003 --
-------
Restructuring reserve at September 30, 2003 $8.4
=======
Positions to be eliminated under original plan 671
Actual positions eliminated through
September 30, 2003 671
Substantially completed with lease payments on
vacated space through 2015
2001 Restructuring Plan
During 2001, LNC implemented restructuring plans relating to 1) the
elimination of duplicative functions in the Schaumburg, Illinois
operations of First Penn-Pacific (FPP), and the absorption of these
functions into the Lincoln Retirement and Life Insurance segment
operations in Fort Wayne, Indiana and Hartford, Connecticut,
respectively; 2) the planned consolidation of the Boston, Massachusetts
investment and marketing office with the Philadelphia, Pennsylvania
investment and marketing operations in order to eliminate redundant
facilities and functions within the Investment Management segment; 3)
the combination of LFD channel oversight, positioning of LFD to take
better advantage of ongoing "marketplace consolidation" and expansion of
the customer base of wholesalers in certain non-productive territories,
recorded in "Other Operations"; and 4) the consolidation of operations
and space in LNC's Fort Wayne, Indiana operations, recorded in "Other
Operations". The following table provides information about these
restructuring plans.
Schaumburg Boston Office LFD Plan- Fort Wayne
(in millions) Plan Consolidation 4th Quarter Operations Total
------------- ---------- ------------- ----------- ---------- -----
Employee severance and termination benefits $3.2 $-- $3.8 $0.3 $7.3
Write-off of impaired assets -- 0.1 -- 3.2 3.3
Other costs:
Termination of equipment leases -- -- -- 1.4 1.4
Rent on abandoned office space 0.9 0.5 -- 19.5 20.9
------- ------- ------- ------- ------
Total 2001 Restructuring Charges (pre-tax) $4.1 $0.6 $3.8 $24.4 $32.9
Amounts expended and written-off through Dec. 31, 2002 3.7 0.2 3.8 22.3 30.0
Amounts reversed through December 31, 2002 0.1 -- -- 1.5 1.6
------- ------- ------- ------- ------
Restructuring reserve at December 31, 2002 0.3 0.4 -- 0.6 1.3
Amounts expended in the first nine months of 2003 0.1 -- -- 0.5 0.6
Amounts reversed in the first nine months of 2003 -- -- -- -- --
------- ------- ------- ------- ------
Restructuring reserve at September 30, 2003 $0.2 $0.4 $-- $0.1 $0.7
======= ======= ======= ======= ======
Positions to be eliminated under original plan 27 -- 63 9 99
Actual positions eliminated through September 30, 2003 26 -- 62 19 107
Expected completion date 1st Quarter 4th Quarter Completed 2nd Quarter
2004 2005 2004
2002 Restructuring Plan
During the second quarter of 2002, Lincoln Retirement completed a review
of its entire internal information technology organization. As a result
of that review, Lincoln Retirement decided in the second quarter of 2002
to reorganize its IT organization in order to better align the
activities and functions conducted within its own organization and its
IT service providers. This change was made in order to focus Lincoln
Retirement on its goal of achieving a common administrative platform for
its annuities products, to better position the organization and its
service providers to respond to changing market conditions, and to
reduce overall costs in response to increased competitive pressures. The
following table provides information about this restructuring plan.
Lincoln
Retirement
(in millions) Plan
------------- -------
Employee severance and termination benefits $1.6
-------
2002 Restructuring Charge (pre-tax) 1.6
Amounts expended through December 31, 2002 0.9
Amounts reversed through December 31, 2002 --
-------
Restructuring reserve at December 31, 2002 0.7
Amounts expended in the first nine months of 2003 0.7
Amounts reversed in the first nine months of 2003 --
-------
Restructuring reserve at September 30, 2003 $--
=======
Positions to be eliminated under original plan 49
Actual positions eliminated through September 30, 2003 49
Expected completion date Completed
2003 Restructuring Plan
In January 2003, the Life Insurance segment announced that it was
realigning its operations in Hartford, Connecticut and Schaumburg,
Illinois to enhance productivity, efficiency and scalability while
positioning the segment for future growth. In February 2003, Lincoln
Retirement announced plans to consolidate its fixed annuity operations
in Schaumburg, Illinois into Fort Wayne, Indiana. In June 2003, LNC
announced that it was combining its retirement and life insurance
businesses into a single operating unit focused on providing wealth
accumulation and protection, income distribution and wealth transfer
products. The realigned organization is expected to significantly reduce
operating expenses while positioning LNC for future growth and to take
advantage of the recent market recovery. In August 2003, LNC announced
additional realignment activities. The following table provides
information about the 2003 restructuring plans.
Life Insurance Fixed Annuity Realignment
Realignment Consolidation June/August
(in millions) Jan 2003 Feb 2003 2003 Total
------------- ---------- ------------- ----------- ----------
Total expected charges $20.0 $5.6 $109.4 135.0
Amounts incurred through September 30
Employee severance and termination benefits $4.2 $1.1 $19.0 $24.3
Write-off of impaired assets 1.9 -- 1.2 3.1
Other Costs:
Rent on abandoned office space 6.0 2.2 -- 8.2
Other 2.1 0.2 0.9 3.2
------- ------- ------- -------
Total 2003 Restructuring Charges (pre-tax) 14.2 3.5 21.1 38.8
Amounts expended in the first nine months of 2003 11.6 3.5 6.0 21.1
Amounts reversed in the first nine months of 2003 -- -- -- --
------- ------- ------- -------
Restructuring reserve at September 30, 2003 $2.6 $-- $15.1 $17.7
======= ======= ======= =======
Additional amounts expended that do not qualify as
restructuring charges $2.0 -- $1.5 $3.5
Expected completion date Second Quarter Second First
2006 Quarter 2006 Quarter 2006
Restructuring charges for the nine-month period ended September 30, 2003 were
reported as follows: Life Insurance Realignment - Life Insurance, Fixed
Annuity Consolidation - Retirement, Realignment June/August - Retirement
($11.1 million), Life Insurance ($1.1 million), Investment Management
($5.3 million), and Other Operations ($3.6 million).
Item 2. Management's Discussion and Analysis of Financial Information
Forward Looking Statements -- Cautionary Language
This report, among other things, reviews the results of operations of
LNC Consolidated, LNC's four business segments and "Other Operations";
LNC's consolidated investments; and consolidated financial condition
including liquidity, cash flows and capital resources. Historical
financial information is presented and analyzed. This report and other
written or oral statements made by LNC or on LNC's behalf may contain
forward-looking statements. Where appropriate, factors that may affect
future financial performance are identified and discussed. Certain
statements made in this report are "forward-looking statements" within
the meaning of the Securities Litigation Reform Act of 1995 (the "Act").
A forward-looking statement is any statement that is not a historical
fact and, without limitation, includes any statement that may predict,
forecast, indicate or imply future results, performance or achievements,
and may contain words like: "believe", "anticipate", "expect",
"estimate", "project", "will", "shall" and other words or phrases with
similar meaning. LNC claims the protection afforded by the safe harbor
for forward-looking statements provided by the Act.
Forward-looking statements involve risks and uncertainties that may
cause actual results to differ materially from the results contained in
the forward-looking statements. These risks and uncertainties include,
among others, subsequent significant changes in:
* the Company (e.g., acquisitions and divestitures of legal entities and
blocks of business -- directly or by means of reinsurance transactions);
* financial markets (e.g., interest rates and securities markets and
stock and bond market performance);
* the performance of the investment portfolios of LNC's subsidiaries and
of the portfolios which they manage (both internal and external);
* competitors and competing products and services;
* LNC's ability to operate its businesses in a relatively normal manner;
* legislation (e.g., corporate, individual, estate and product taxation)
* the price of LNC's stock;
* accounting principles generally accepted in the United States;
* regulations (e.g., insurance and securities regulations);
* debt and claims-paying ratings issued by nationally recognized
statistical rating organizations; and
* the National Association of Insurance Commissioners' ("NAIC") capital
requirements.
* future interpretations of NAIC Actuarial Guidelines may require LNC to
establish additional statutory reserves for guaranteed minimum death
benefits under variable annuity contracts.
Other risks and uncertainties include:
* the risk that significant accounting, fraud or corporate governance
issues may adversely affect the value of certain investments in the
portfolios of LNC's companies;
* the risk that the LNC could have to accelerate amortization of
deferred policy acquisition costs if the market deteriorates;
* the risk that the LNC could have to write off investments in certain
securities if the issuers' financial condition deteriorates;
* the risks associated with having products with guaranteed benefits;
* whether necessary regulatory approvals are obtained (e.g., insurance
department, Hart-Scott-Rodino, etc.) and, if obtained, whether they are
obtained on a timely basis;
* whether proceeds from divestitures of legal entities and blocks of
business can be used as planned;
* risks associated with litigation, arbitration and other actions such
as: (a) adverse decisions in significant actions including, but not
limited to extra-contractual and class action damage cases; (b) new
decisions which change the law; (c) unexpected trial court rulings; (d)
unavailability of witnesses; (e) newly discovered evidence and (f) acts
of God (e.g., hurricanes, earthquakes and storms);
* whether there will be significant charges or benefits resulting from
the contingencies described in the footnotes to LNC's consolidated
financial statements;
* risks associated with acts of terrorism or war;
* other insurance risks (e.g., policyholder mortality and morbidity).
The risks included here are not exhaustive. Other sections of this
report, and LNC's annual reports on Form 10-K, quarterly reports on Form
10-Q, current reports on Form 8-K and other documents filed with the
Securities and Exchange Commission include additional factors which
could impact LNC's business and financial performance. Moreover, LNC
operates in a rapidly changing and competitive environment. New risk
factors emerge from time to time and it is not possible for management
to predict all such risk factors.
Further, it is not possible to assess the impact of all risk factors on
LNC's business or the extent to which any factor, or combination of
factors, may cause actual results to differ materially from those
contained in any forward-looking statements. Given these risks and
uncertainties, investors should not place undo reliance on
forward-looking statements as a prediction of actual results. In
addition, LNC disclaims any obligation to update any forward-looking
statements to reflect events or circumstances that occur after the date
of this report.
Critical Accounting Policies
Refer to Management's Discussion and Analysis of LNC's annual report on
Form 10-K for the year ended December 31, 2002, for a detailed
discussion of LNC's critical accounting policies. Refer to the various
sections captioned Critical Accounting Policy within the discussion that
follows for updates to the information provided in the Form 10-K.
All amounts stated in this "Management's Discussion and Analysis" are on
an after-tax basis except where specifically noted as pre-tax.
RESULTS OF CONSOLIDATED OPERATIONS
Summary Financial Results
Nine Months Ended Three Months Ended
September 30, September 30,
(in millions) 2003 2002 2003 2002
- -------------------------------------------------------------------------------------------------------------------
Life insurance and annuity premiums $1,244.3 $1,280.5 $427.4 $412.2
Investment advisory fees 146.8 138.7 53.2 42.9
Net investment income 1,979.3 1,964.6 664.4 652.4
Realized gain (loss) on investments
and derivative instruments (75.2) (221.2) 18.9 (36.8)
Other revenue and fees 286.1 284.3 104.9 92.7
------- ------- ------- -------
Total Revenue 3,581.3 3,446.9 1,268.8 1,163.4
Insurance Benefits 1,845.4 2,193.3 639.2 941.6
Underwriting, acquisition, insurance and
other expenses 1,261.2 1,278.7 424.3 438.8
Interest and debt expenses 72.9 73.2 26.6 23.7
------- ------- ------- -------
Total Benefits and Expenses 3,179.5 3,545.1 1,090.1 1,404.1
Income Before Federal Income Taxes 401.8 (98.3) 178.7 (240.7)
Federal income taxes 84.2 (96.1) 45.4 (104.3)
------- ------- ------- -------
Net Income $317.6 $(2.2) $133.3 $(136.4)
Items Included in Net Income:
Realized gain (loss) on investments and
derivative instruments (after tax) $(48.9) $(143.4) $12.3 $(23.5)
Restructuring Charges (after tax) (25.3) 0.3 (12.9) 1.3
Reserve Development on Business Sold
through Indemnity Reinsurance and Related
Amortization of
Deferred Gain (after tax) (18.7) (190.8) (18.5) (176.4)
Loss on Early Retirement of Subordinated
Debt (after tax) (3.7) -- (3.7) --
LNC has the following business segments: Lincoln Retirement, Life
Insurance, Investment Management and Lincoln UK. Operations not directly
related to the business segments and unallocated corporate items (i.e.,
corporate investment income, interest expense on corporate debt,
unallocated overhead expenses, the operations of Lincoln Financial
Advisors ("LFA") and Lincoln Financial Distributors ("LFD"), reserve
developments on business sold through indemnity reinsurance and the
amortization of the deferred gain on the sale of Lincoln Re) are
reported in "Other Operations".
Stock-Based Compensation
The periods presented for 2002 have been restated for the adoption of
FAS 148. See the discussion under the topic "Accounting for Stock-Based
Compensation" presented in the Consolidated Results of Operations for
further discussion of this matter. The effect of the adoption was a
decrease in net income of $30.6 million for the nine months ended
September 30, 2002 and $10.9 million for the three months ended
September 30, 2002 from previously reported amounts.
Net Income
Net income for the nine months ended September 30, 2003 increased $319.8
million compared to the same period in 2002. For the three months ended
September 30, 2003 net income was $269.7 million higher than the same
period in 2002.
Critical Accounting Policy -- Personal Accident and Disability Income
Reserves
In 2003 and 2002 LNC recorded charges for reserve increases on the
business sold to Swiss Re. Net income for the first nine months and
third quarter of 2003 includes a loss of $18.5 million (net of related
deferred gain amortization) related to charges required by FAS 113 on
increases in reserves for business sold through indemnity reinsurance to
Swiss Re. Net losses for the corresponding periods of 2002 included
similar charges (net of related deferred gain amortization) of $182.9
million and $168.5 million, respectively.
Critical Accounting Policy -- Deferred Acquisition Costs ("DAC"), Present
Value of In-Force ("PVIF") and Deferred Front-End Loads ("DFEL")
During the third quarter of 2003, LNC completed a comprehensive review of
the assumptions underlying the amortization of DAC, PVIF and DFEL. This
review encompassed the Lincoln Retirement, Life Insurance and Investment
Management segments. As a result of this review, Underwriting, Acquisition,
Insurance and Other Expenses includes an adjustment of $9.8 million
pre-tax for the effect of negative unlocking resulting from modeling
refinements relating to reinsurance premiums within the Life Insurance
segment, and adjustments to assumptions and refinement of the amortization
methodology within all three segments. In addition, Realized Gains (Losses)
on Investments and Derivative Investments includes negative adjustments
toalling $36.3 million pre-tax within the Lincoln Retirement and Life
Insurance segments. This adjustment resulted from a refinement in the
methodology related to the assumption for credit defaults and realized
losses from sales and other than temporary impairments of
available-for-sale securities. Refer to the segment discussions under
Realized Gains and Losses on Investments and Derivative Instruments and
Critical Accounting Policy - DAC, PVIF, and DFEL for the respective
adjustments.
Realized Gains (Losses) on Investments and Derivative Instruments
Net realized gains (losses) were $(48.9) million and $12.3 million for
the nine and three months ended September 30, 2003, respectively, an
improvement of $94.5 million and $35.8 million compared to the same
periods of 2002. See the discussion above under the caption Critical
Accounting Policy - DAC, PVIF and DFEL for details of the impact of
LNC's third quarter of 2003 DAC review on LNC realized gains (losses).
Write-downs for impairments were required for the nine months ended
September 30, 2003 for securities held primarily within the airline
industry, electric utilities and asset-backed securities. Net realized
investment losses for the first nine months of 2002 were largely due to
sales and write-downs of investments in Worldcom, other
telecommunications issuers and collateralized debt obligations. For
additional detail on realized losses see the discussion in the
Consolidated Investment section.
Revenue
Consolidated revenue increased primarily due to improvements in net
realized investment gains (losses) for both the nine-month and
three-month periods ended September 30, 2003 compared to the same
periods last year. Strong sales in the Life Insurance segment combined
with growth in the Investment Management segment in retail and
institutional assets under management resulting from favorable net flows
and the effects of the equity markets also contributed to these
increases. For the nine-month period, the revenue increase was partially
offset by lower fee income in the Lincoln Retirement and Lincoln UK
segments due to declines in the average balances of variable annuities
and unit linked account values, respectively, from the impact of lower
average equity markets. The average level of the equity markets was
higher for the third quarter of 2003 compared to the same period in
2002, resulting in higher fee income for the Lincoln Retirement and
Lincoln UK segments.
Expenses
Consolidated expenses were favorably affected by the improvement in the
equity markets in the first nine months of 2003, which resulted in
positive unlocking of "DAC and PVIF" in the Lincoln Retirement and
Lincoln UK business segments, and decreased reserves and payments for
guaranteed minimum death benefits in the Lincoln Retirement segment.
Somewhat offsetting this improvement was the effect of the unlocking
resulting from the review of DAC assumptions in the third quarter of
2003. See above under Critical Accounting Policy - DAC, PVIF and DFEL
for further discussion of this issue. Additionally, the impact of
charges for certain reserves for the business sold to Swiss Re was less
in 2003 than in 2002 as described above. For further discussion of the
results of operations see the discussion of the results of operations by
segment.
Consolidated Deposits and Net Flows
LNC's domestic consolidated product deposits and net cash flows were as
follows:
Periods ended September 30, Nine Months Three Months
(in billions) 2003 2002 2003 2002
- -----------------------------------------------------------------------------------------------------
Deposits (1):
Lincoln Retirement Segment $4.4 $5.0 $1.6 $1.7
Life Insurance Segment 1.6 1.5 0.6 0.5
Investment Management Segment (including
both retail and institutional deposits) 7.8 7.9 3.4 2.6
Consolidating Adjustments (2) (0.7) (1.1) (0.3) (0.4)
----------------------------------------------------
Total Deposits $13.1 $13.3 $5.3 $4.2
Net Flows (1):
Lincoln Retirement Segment $0.5 $0.4 $0.3 $0.1
Life Insurance Segment 1.0 0.9 0.3 0.3
Investment Management Segment (including
both retail and institutional net flows) 2.1 1.8 1.2 0.4
Consolidating Adjustments (2) 0.1 0.1 -- 0.1
----------------------------------------------------
Total Net Flows $3.7 $3.2 $1.8 $0.9
(1) For additional detail of deposit and net flow information see the
discussion of the Results of Operations by Segment.
(2) Consolidating adjustments represent the elimination of deposits and
net cash flows on products affecting more than one segment.
Equity Market Impact
For the nine months ended September 30, 2003, the equity markets
experienced overall improvement as the S&P index at September 30, 2003
was 13.2% higher than December 31, 2002, with all of the improvement
occurring in the second and third quarters of 2003. The S&P index gained
2.2% in the third quarter of 2003, and ended the period 22.2% higher
than September 30, 2002. The equity market improvement from December 31,
2002 increased LNC's overall results by $9.5 million in the first nine
months of 2003, and $6.0 million in the third quarter of 2003, primarily
within the Lincoln Retirement segment. Excluding the $(3.6) million
impact of the No Change Effect on GMDB, the equity market impact in the
third quarter of 2003 relative to the second quarter of 2003 was $9.6
million. The following table displays the impact of the improvement in
the equity markets by segment for the first nine months of 2003.
Impact of the Equity Markets by Segment ($ Millions) - Nine Months Ended September 30, 2003
Segment
---------------------------------------------------------
Lincoln Life Investment
Retirement Insurance Management Lincoln UK LNC Total
---------------------------------------------------------
Fee Income:
Lagging Effect of 4Q02
Market Changes on 1Q03 $(0.5) $-- $0.1 $(0.1) $(0.5)
Lagging Effect of 1Q03
Market Changes on 2Q03 (0.8) -- (0.1) (0.1) (1.0)
Lagging Effect of 2Q03
Market Changes on 3Q03 2.2 -- 0.6 0.1 2.9
Current Effects in 1Q03 (1.0) -- (0.5) (0.5) (2.0)
Current Effects in 2Q03 6.0 0.3 2.7 0.4 9.4
Current Effects in 3Q03 1.8 -- 0.9 0.2 2.9
---------------------------------------------------------
Total Fee Income 7.7 0.3 3.7 -- 11.7
Other 1.5 -- -- -- 1.5
GMDB:
No Change Effect 1Q03 (5.9) -- -- -- (5.9)
Market Change Effect 1Q03 (7.5) -- -- -- (7.5)
No Change Effect 2Q03 (5.9) -- -- -- (5.9)
Market Change Effect 2Q03 13.6 -- -- -- 13.6
No Change Effect 3Q03 (3.6) -- -- -- (3.6)
Market Change Effect 3Q03 4.0 -- -- -- 4.0
---------------------------------------------------------
Total GMDB (5.3) -- -- -- (5.3)
DAC/DFEL:
1Q03 (1.8) (0.6) -- (3.6) (6.0)
2Q03 2.7 1.3 -- 3.8 7.8
3Q03 (0.7) 0.1 -- 0.4 (0.2)
---------------------------------------------------------
Total DAC/DFEL 0.2 0.8 -- 0.6 1.6
Total Effect $4.1 $1.1 $3.7 $0.6 $9.5
The following table displays the impact of the improvement in the equity
markets by segment for the third quarter of 2003.
Impact of the Equity Markets by Segment ($ Millions) - Three Months Ended September 30, 2003
Segment
---------------------------------------------------------
Lincoln Life Investment
Retirement Insurance Management Lincoln UK LNC Total
---------------------------------------------------------
Fee Income:
Lagging Effect of 2Q03
Market Changes on 3Q03 $2.2 $-- $0.6 $0.1 $2.9
Current Effects in 3Q03 1.8 -- 0.9 0.2 2.9
---------------------------------------------------------
Total Fee Income 4.0 -- 1.5 0.3 5.8
Other -- -- -- -- --
GMDB:
No Change Effect 3Q03 (3.6) -- -- -- (3.6)
Market Change Effect 3Q03 4.0 -- -- -- 4.0
---------------------------------------------------------
Total GMDB 0.4 -- -- -- 0.4
DAC/DFEL 3Q03 (0.7) 0.1 -- 0.4 (0.2)
---------------------------------------------------------
Total Effect $3.7 $0.1 $1.5 $0.7 $6.0
See the discussion of results of operations for each business segment
for additional details on the impact of the equity markets for the nine
and three months ended September 30, 2003. See the discussion presented
below under the topic "Fourth Quarter 2003 Guidance for the Estimated
Effect of Equity Market Volatility" for information regarding the
factors that LNC uses to estimate the expected effect of equity market
volatility for the upcoming quarter.
Fourth Quarter 2003 Guidance for the Estimated Effect of Equity Market
Volatility
After the second quarter of 2003, LNC provided guidance on the estimated
effect of equity market volatility on its third quarter of 2003 results.
The following guidance is being provided for purposes of modeling the
expected effects of equity market volatility for the fourth quarter of
2003. As will be explained in greater detail below, the effects on LNC's
results of significant volatility in equity markets are complex and are
not expected to be proportional for market increases and market
decreases. The fourth quarter of 2003 information provided below is
based upon market conditions and LNC's mix of business as of the end of
the third quarter of 2003. All amounts provided in this guidance are on
an after-tax basis. This guidance can be expected to change as actual
circumstances change. Although LNC believes this guidance provides
reasonable estimates based upon conditions as of October 1, 2003, actual
results may differ materially from those projected and LNC claims no
responsibility for updating this forward-looking information (see
Forward-Looking Statements -- Cautionary Language at the beginning of
Item 2).
This guidance is intended to provide a general indication of the
expected effect of equity market volatility on LNC's fee income;
deferred acquisition costs ("DAC") and present value of in-force ("PVIF")
intangible assets; deferred front-end load revenue ("DFEL") and
guaranteed minimum death benefit ("GMDB") reserves. Excluded from this
guidance is the effect that equity market changes may have upon LNC's
realized and unrealized gains and losses on investments and intangible
assets, other than DAC and PVIF. For example, write-downs for impairment
of goodwill and deferred dealer commission assets may be necessary under
certain market conditions. These matters are not included within the
guidance provided in this document.
Market Indices Used For Modeling LNC's Various Operating Segments
In measuring the estimated effects of changes in equity markets on its
Lincoln Retirement segment, LNC uses the S&P 500 index. LNC has
generally found that the S&P 500 index is reasonably correlated to the
effect of overall equity markets performance on this segment's account
values. Because LNC's fee income earned on its variable annuity business
is determined daily, the change in the S&P 500 on a daily average basis
relative to the level of the S&P 500 at the beginning of each quarter
provides a reasonable indication of the impact quarterly changes in
equity markets have on Lincoln Retirement's fee income. Because end of
period account values are used for computing DAC unlocking and for
incurred GMDB costs, the end of period change in the S&P 500 is used in
measuring the estimated market impact of DAC unlocking and for the
impact associated with incurred GMDB costs. In addition, because DAC and
GMDB calculations have an assumed 9% positive annual equity market
return, or a 2.25% quarterly assumption, variances in actual market
performance relative to these calculation assumptions will generate
positive or negative DAC unlocking and GMDB adjustments. Further, the
GMDB reserve adjustment results in an increase or decrease to actual
gross profits and therefore has an inverse impact on DAC amortization.
The interplay of GMDB reserve changes on DAC unlocking and DAC
amortization is taken into consideration in the model.
It is important to understand that the actual effect on fee income of
market changes in the current quarter of an equity market change and the
effect in the immediately following quarter will not be equal to a
pro-rata 25% of the estimated annualized effect of the market change.
This is due to the fact that the actual change in fee income in the
immediate quarter during which the market changes is measured by the
change in actual variable account values from the beginning of the
quarter compared to the average balance of variable account values for
the quarter. The change in fee income due to the change from average
account values to ending account values does not occur in the immediate
quarter of the market change; rather, that change in fee income will
occur in the quarter following the market change. LNC estimates that
this lagging effect for the third quarter of 2003 equity markets change
will not be significant in the fourth quarter of 2003 for the Lincoln
Retirement segment, because average account values for the third quarter
of 2003 were only slightly greater than the level of ending account
values at September 30, 2003.
LNC also uses the S&P 500 index when describing the general effects of
changes in equity markets for the Life Insurance segment. For the
Lincoln UK segment, the FTSE 100 index provides a reasonable measure for
approximating the effect of equity markets performance on earnings. LNC
estimates that the lagging effect for the third quarter of 2003 equity
markets change will create a decrease of $0.1 million in fee income for
Lincoln UK in the fourth quarter of 2003, because average account values
for the third quarter of 2003 were greater than the level of ending
account values at September 30, 2003.
Additional market indices are used in measuring the effects of the
market on the results of LNC's Investment Management segment. All of the
relevant equity market indices (S&P, NASDAQ and MSCI EAFE) increased
during the third quarter of 2003, ranging from a 2.2% increase in the
S&P 500 to an 8.2% increase in the MSCI EAFE to a 10.1% NASDAQ increase.
The lagging effect of the third quarter equity markets change is
expected to be a $0.2 million increase in the fourth quarter of 2003 fee
income.
Illustrative Scenarios
The following discussion concerning the estimated effects of ongoing
equity market volatility on LNC's earnings is intended to be
illustrative. Actual effects may vary depending on a variety of factors,
many of which are outside of LNC's control, such as changing customer
behaviors that might result in changes in the mix of LNC's business
between variable or fixed annuity contracts, switching between
investment alternatives available within variable products, or changes
in policy lapsation rates. The relative effects shown in the
illustrative scenarios presented below should not be considered to be
indicative of the proportional effects on earnings that more significant
changes in equity markets may generate. Such non-proportional effects
include those discussed earlier, such as incurred GMDB costs and DAC
unlocking.
Since the effects of continued equity market volatility are complex and
subject to a variety of estimates and assumptions, such as assumed rates
of long-term equity market performance, it is difficult to provide
information that can be reliably applied to predict earnings effects
over a broad range of equity markets performance alternatives. But in an
effort to provide some insight into these matters, LNC has provided
below illustrative examples of the effects that equity market volatility
might be expected to have on LNC's earnings. The underlying assumptions
regarding these illustrations are as follows:
1) The first scenario assumes that equity markets remain unchanged from
their respective levels at September 30, 2003 through the fourth quarter
of 2003.
2) The second scenario assumes that from September 30, 2003 through the
end of the fourth quarter of 2003 equity markets increase smoothly by
2.5%.
3) The third scenario assumes that from September 30, 2003 through the
end of the fourth quarter of 2003 equity markets decline smoothly by
2.5%.
As the above assumptions indicate, actual equity market changes that may
have occurred since September 30, 2003 up to the date of issuance of
this guidance are not being considered; rather, the examples that follow
are provided to illustrate the effects of a hypothetical change in
equity markets from September 30, 2003. The following tables are
examples of the estimated effects on earnings that might be expected for
each of these scenarios.
Scenario #1:
No change in equity markets from September 30, 2003 through December 31,
2003.
Estimated After-tax Effect on Fourth Quarter of 2003 Results (in millions):
Segment
---------------------------------------------------------
Lincoln Life Investment
Retirement Insurance Management Lincoln UK LNC Total
---------------------------------------------------------
Fees - Lagging Effect of 3Q03
Market Changes on 4Q03* $-- $-- $0.2 $(0.1) $0.1
Fees - Current Effects in
Fourth Quarter -- -- -- -- --
---------------------------------------------------------
Total Fee Income -- -- 0.2 (0.1) 0.1
Other (0.2) -- -- -- (0.2)
GMDB-No Change Effect (2.3) -- -- -- (2.3)
GMDB-Market Change Effect -- -- -- -- --
---------------------------------------------------------
Total GMDB (2.3) -- -- -- (2.3)
DAC/DFEL** -- (0.3) -- (0.9) (1.2)
---------------------------------------------------------
Total Effect $(2.5) $(0.3) $0.2 $(1.0) $(3.6)
* Differences exist in the market change effect on fee income for the
current quarter, as compared to the ongoing quarterly effect, because
the change in fee income in the immediate quarter is determined by the
change in beginning variable account balances to average variable
account balances for the current quarter. The change in fee income in
the next subsequent quarter is determined by the change in average
account values to ending variable account values that occurred due to
the market changing in the preceding quarter. However, in all following
quarters, the ongoing effect of changes in the market occurring in the
current quarter will be determined by the difference in beginning of
quarter to end of quarter variable account balances. For purposes of
this guidance, the change in account values is assumed to correlate with
the change in the relevant index.
** This amount includes the impact on DAC, DFEL and PVIF for the Life
Insurance and Lincoln UK segments.
Scenario #2:
2.5% increase in equity markets from September 30, 2003 to December 31,
2003 occurs smoothly during the quarter.
Estimated After-tax Effect on Fourth Quarter of 2003 Results (in millions):
Segment
---------------------------------------------------------
Lincoln Life Investment
Retirement Insurance Management Lincoln UK LNC Total
---------------------------------------------------------
Fees - Lagging Effect of 3Q03
Market Changes on 4Q03* $-- $-- $0.2 $(0.1) $0.1
Fees - Current Effects in
Fourth Quarter 0.7 -- 0.4 0.1 1.2
---------------------------------------------------------
Total Fee Income 0.7 -- 0.6 -- 1.3
Other -- -- -- -- --
GMDB-No Change Effect (2.3) -- -- -- (2.3)
GMDB-Market Change Effect 1.5 -- -- -- 1.5
---------------------------------------------------------
Total GMDB (0.8) -- -- -- (0.8)
DAC/DFEL** -- -- -- 0.1 0.1
---------------------------------------------------------
Total Effect $(0.1) $-- $0.6 $0.1 $0.6
* See * under Scenario #1 for explanation.
** See ** under Scenario #1 for explanation.
Scenario #3:
2.5% decline in equity markets from September 30, 2003 to December 31,
2003 occurs smoothly during the quarter.
Estimated After-tax Effect on Fourth Quarter of 2003 Results (in millions):
Segment
---------------------------------------------------------
Lincoln Life Investment
Retirement Insurance Management Lincoln UK LNC Total
---------------------------------------------------------
Fees - Lagging Effect of 3Q03
Market Changes on 4Q03* $-- $-- $0.2 $(0.1) $0.1
Fees -- Current Effects in
Fourth Quarter (0.7) -- (0.4) (0.1) (1.2)
---------------------------------------------------------
Total Fee Income (0.7) -- (0.2) (0.2) (1.1)
Other (0.4) -- -- -- (0.4)
GMDB-No Change Effect (2.3) -- -- -- (2.3)
GMDB-Market Change Effect (3.5) -- -- -- (3.5)
---------------------------------------------------------
Total GMDB (5.8) -- -- -- (5.8)
DAC/DFEL** (1.4) (0.5) -- (1.9) (3.8)
---------------------------------------------------------
Total Effect $(8.3) $(0.5) $(0.2) $(2.1) $(11.1)
* See * under Scenario #1 for explanation.
** See ** under Scenario #1 for explanation.
Estimated Effect of Each One-Percent Change in Equity Markets
The above examples are based upon the estimated annual after-tax effect
on earnings for each one-percentage point change in relevant equity
market indices. Taking one-fourth of this annual estimate will generate
the expected effect of the equity market change on quarterly results,
with the exception of DAC unlocking and GMDB incurred cost calculations
where the effect is fully reflected in one quarter. The estimated annual
effect in millions of dollars per one-percentage change and the changes
in each of the relevant market indices used in the above examples, are
listed in the following table.
- -----------------------------------------------------------------------------------------------------------------------
2.50% increase 2.50% decline
No Change in Fourth in Fourth
Segment and Effect* Relevant Measure in Market Quarter 2003 Quarter 2003
- -----------------------------------------------------------------------------------------------------------------------
Lincoln Retirement - Ave Daily Change
Fee Income in S&P 500 $0.0 M x 0.0 $2.3 M x 1.25 $2.3 M x (1.25)
- -----------------------------------------------------------------------------------------------------------------------
Actual Change
Lincoln Retirement - in S&P 500 $0.3 M x (2.25) $0.3 M x 0.25 $0.3 M x (4.75)
Other Items vs. Expected
- -----------------------------------------------------------------------------------------------------------------------
Lincoln Retirement - Actual Change ($2.3 M) + ($2.3 M) +
GMDB Incurred Costs in S&P 500 ($2.3M) $0.6 M x 2.5 $1.4 M x (2.5)
- -----------------------------------------------------------------------------------------------------------------------
Actual Change
Lincoln Retirement - in S&P 500 vs. $0.0 M* x (2.25) $0.1 M x 0.25 $0.3 M x (4.75)
DAC/DFEL Expected
- -----------------------------------------------------------------------------------------------------------------------
Actual Change
Life Insurance - in S&P 500 vs. $0.11 M x (2.25) $0.11 M x 0.25 $0.11 M x (4.75)
DAC/DFEL/PVIF Expected
- -----------------------------------------------------------------------------------------------------------------------
Investment
Management - Blend of
Fee Income Market Indices $0.6 M x 0.0 $0.6 M x 2.5 $0.6 M x (2.5)
- -----------------------------------------------------------------------------------------------------------------------
Investment Blend of
Management - DAC** Market Indices $0.0 M x (2.25) $0.0 M x 0.25 $0.0 M x (4.75)
- -----------------------------------------------------------------------------------------------------------------------
Lincoln UK - Ave Daily Change
Fee Income in FTSE 100 $0.2 M x 0.0 $0.2 M x 1.25 $0.2 M x (1.25)
- -----------------------------------------------------------------------------------------------------------------------
Actual Change in
Lincoln UK - FTSE 100 vs. $0.4 M x (2.25) $0.4 M x 0.25 $0.4 M x (4.75)
DAC/DFEL/PVIF Expected Change
- -----------------------------------------------------------------------------------------------------------------------
* The factor for no change in market for Lincoln Retirement DAC is $0.0
M. This is because the GMDB reserve adjustment results in an increase or
decrease to actual gross profits and therefore has an inverse impact on
DAC amortization. The interplay of GMDB reserve changes on DAC unlocking
and DAC amortization is taken into consideration in the model.
** The factors for a 1% change in the equity markets for the Investment
Management segment DAC are noted as approximately $0.0 M on the above
chart. This is because the trigger points for unlocking are beyond the
percentage changes noted in the above scenarios. The trigger point for
negative DAC unlocking in the fourth quarter of 2003 is an approximate
21% decline in the equity markets and the trigger point for positive
unlocking in the fourth quarter is an approximate 23% increase in the
equity markets.
Sensitivity Factors for Retirement Segment
As the above table indicates, the annual effect of a one percent change
in equity markets varies depending upon the severity of the change.
Presented below are estimated one million dollar effects for various
market changes that are currently used by LNC in modeling the Lincoln
Retirement segment. These estimated effects are subject to ongoing
modification, as they are particularly sensitive to the mix of business
and to the actual level of variable account balances.
The following table provides the annual after-tax effect for changes in
equity markets for the Lincoln Retirement segment related to fee income
and other:
($Millions for each 1% Change in Relevant Market Index)
- --------------------------------------------------------------------------------------
20% + 11 - 20% 6 - 10% 1 to 5% No 1 to 5% 6 - 10%
Decline Decline Decline Decline Change Increase Increase 10%+
- --------------------------------------------------------------------------------------
Fee Income (1.9) (2.1) (2.2) (2.3) -- 2.3 2.4 2.5
- --------------------------------------------------------------------------------------
Other (0.3) (0.3) (0.3) (0.3) -- 0.3 0.3 0.3
- --------------------------------------------------------------------------------------
The estimated annual effects indicated in the table above are applicable
for the fourth quarter of 2003. For example, assume an estimate is being
computed for the quarterly effect on Lincoln Retirement fee income due
to a 2.5% increase in the markets occurring in the fourth quarter of
2003. In this example, the expected quarterly effect of a fourth quarter
2.5% increase is estimated as: ($2.3 x 1.25/4) = $0.72 million.
The table provided below contains information for use in estimating the
fourth quarter 2003 after-tax effect for changes in equity markets for
the Lincoln Retirement segment related to GMDB and DAC. For GMDB,
quarterly results will include a reserve adjustment. This is due to the
fact that LNC has established the GMDB reserves net of anticipated
future GMDB fee revenues. As a result, an adjustment will be required to
increase GMDB reserves during periods where a GMDB Net Amount At Risk
exists.
Based upon the Net Amount At Risk for GMDB at September 30, 2003, the
fourth quarter 2003 GMDB reserve adjustment is estimated at $2.3 million
(included in the no change column in the table below).
($Millions for each 1% Change in Relevant Market Index)
- --------------------------------------------------------------------------------------
20% + 11 - 20% 6 - 10% 1 to 5% No 1 to 5% 6 - 10%
Decline Decline Decline Decline Change Increase Increase 10%+
- --------------------------------------------------------------------------------------
GMDB (2.0) (1.6) (1.4) (1.4) (2.3) 0.6 0.9 1.1
- --------------------------------------------------------------------------------------
DAC (1.0) (0.6) (0.5) (0.3) -- 0.1 0.1 0.2
- --------------------------------------------------------------------------------------
The estimated quarterly effects indicated in the table above are
applicable for the fourth quarter of 2003. For example, assume an
estimate is being computed for the quarterly effect on Lincoln
Retirement's GMDB reserve due to a 2.5% increase in the equity markets
occurring in the fourth quarter of 2003. The estimated quarterly effect
is calculated as follows: $(2.3) + $0.6 x 2.5 = $(0.8) million.
Accounting for Costs Associated with Exit or Disposal Activities. In
June 2002, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 146, "Accounting for
Costs Associated with Exit or Disposal Activities" ("FAS 146"), which
addresses financial accounting and reporting for costs associated with
exit or disposal activities and nullifies Emerging Issues Task Force
Issue No. 94-3, "Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (including Certain Costs
Incurred in a Restructuring)" ("Issue 94-3"). The principal difference
between FAS 146 and Issue 94-3 is that FAS 146 requires that a liability
for a cost associated with an exit or disposal activity be recognized
when the liability is incurred, rather than at the date of an entity's
commitment to an exit plan. FAS 146 is effective for exit or disposal
activities after December 31, 2002. LNC adopted FAS 146 on January 1,
2003 and the adoption of the Statement affects the timing of when an
expense is recognized for restructuring activities.
Accounting for Stock-Based Compensation. On December 31, 2002, the FASB
issued Statement of Financial Accounting Standards No. 148, "Accounting
for Stock-Based Compensation- Transition and Disclosure" ("FAS 148"),
which provides alternative methods of transition for entities that
change to the fair value method of accounting for stock-based employee
compensation.
The three transition methods provided under FAS 148 are the prospective,
the modified prospective and the retroactive restatement methods. LNC
adopted the retroactive restatement method, which requires that
companies restate all periods presented to reflect stock-based employee
compensation cost under the fair value accounting method in FAS 123 for
all employee awards granted, modified or settled in fiscal years
beginning after December 15, 1994. LNC adopted the fair value method of
accounting under FAS 123, as amended by FAS 148, as of January 1, 2003
and has restated financial statements for the years 2002, 2001, and
2000.
Effective January 1, 2003, under LNC's Incentive Compensation Plan,
LNC's employee stock option compensation program and long-term cash
incentive compensation program were revised and combined to provide for
performance vesting, and to provide for awards that may be paid out in a
combination of stock options, performance shares of LNC stock and cash.
The performance measures for the initial grant under the new plan will
be calculated over a three-year period from grant date and will compare
LNC's performance relative to a selected group of peer companies.
Comparative performance measures will include relative growth in
earnings per share, return on equity and total share performance.
Certain participants in the new plans selected from various combinations
of stock options, performance shares and cash in determining the form of
their award. Other participants will have their award paid in
performance shares. This plan replaces the current LNC stock option
plan; however, the separate stock option incentive programs established
by Delaware Investments U.S., Inc. ("DIUS") and DIAL Holding Company,
Inc. ("DIAL"), both wholly-owned subsidiaries of Delaware Management
Holdings, Inc., will continue.
The following table provides the impact of the restatement for
stock-based compensation for the years ended December 31, 2002 and 2001.
For the effect of the restatement on the nine and three months ended
September 30, 2002, refer to Note 2 to the September 30, 2003 unaudited
consolidated financial statements and the discussion of results of
operations for each business segment.
After-tax effect of the retroactive adoption of FAS 123 fair value
method of accounting for stock options on previously reported Net Income
for LNC's segments:
Year Ended December 31,
(in millions) 2002 2001
-------------------------------
Lincoln Retirement $(4.1) $(4.1)
Life Insurance (2.9) (3.8)
Investment Management (27.1) (20.7)
Lincoln UK (2.3) (2.1)
Other Operations (6.4) (13.9)
------- -------
Total $(42.8) $(44.6)
======= =======
Accounting for Variable Interest Entities. In January 2003, the FASB
issued Interpretation No. 46, "Consolidation of Variable Interest
Entities" ("Interpretation 46"), which requires the consolidation of
variable interest entities ("VIE") by an enterprise if that enterprise
has a variable interest that will absorb a majority of the VIE's
expected losses if they occur, receive a majority of the entity's
expected residual returns if they occur, or both. If one enterprise will
absorb a majority of a VIE's expected losses and another enterprise will
receive a majority of that VIE's expected residual returns, the
enterprise absorbing a majority of the losses shall consolidate the VIE.
VIE refers to an entity in which equity investors do not have the
characteristics of a controlling financial interest or do not have
sufficient equity at risk for the entity to finance its activities
without additional subordinated financial support from other parties. In
October 2003, the FASB delayed the effective date of this Interpretation
until the fourth quarter of 2003 for VIEs in which an enterprise holds a
variable interest acquired before February 1, 2003. LNC expects to adopt
this Interpretation prospectively with a cumulative-effect adjustment as
of the end of the period ending December 31, 2003. As key guidance
with respect to certain aspects of the new Interpretation is still
emerging, LNC has not been able to finalize the expected effect of
adoption.
Among the matters that LNC is reviewing in connection with the fourth
quarter 2003 effective date is the potential application to
Collateralized Debt Obligation (CDO) pools that are managed by LNC.
Because the fees earned by LNC for managing these CDOs are required to
be included in the analysis of expected residual returns, it is likely
that such CDO pools may fall under the consolidation requirements of
Interpretation 46. If the invested assets within the CDO pools and the
liabilities owed by the CDO pools to the third party investors are
required to be brought onto LNC's consolidated balance sheet, LNC would
disclose that the CDO pool liabilities are nonrecourse to LNC.
Because the fair value of the underlying invested assets in the CDO
pools is currently below amortized cost basis, if LNC is required to
consolidate the CDO pools, the value of the assets recorded upon initial
adoption of the new Interpretation is expected to be less than the amount of
nonrecourse debt. Based upon information currently available, LNC
estimates that the fair value of the CDO pool assets is about $1.2
billion and that the nonrecourse debt would be recorded at about $1.5
billion. LNC has an investment of about $22.0 million in certain of the
CDO pools that it manages; at September 30, 2003 these investments had a
fair value of $21.2 million. LNC does not bear the economic risk of the
loss represented by the approximate $300 million difference between the
value of all of the CDO pool assets and the total amount of CDO pool
nonrecourse debt. Yet under this emerging guidance, at the time of
adopting these new rules LNC's financial statements would not reflect
the fact that it is the third party investor group, and not LNC, that
bears the economic risk of these losses.
To record the difference between the value of the CDO pool assets and
the CDO pool nonrecourse debt on LNC's balance sheet upon the adoption
of Interpretation 46, LNC would record a charge to equity through Other
Comprehensive Income for the cumulative temporary declines in underlying
investment asset values and LNC would record a charge to net income
equal to the declines in value of the underlying investment assets that
are considered other than temporary. At December 31, LNC will complete
the analysis of all of the underlying investment assets held within
these CDO pools in order to determine which of these investments have
experienced declines in fair value that are other than temporary.
In subsequent periods, when the underlying invested assets are sold and
the proceeds are distributed to the investors, LNC would record gains
associated with the extinguishment of nonrecourse debt. This reversal of
the losses recorded upon the initial adoption of Interpretation 46 as
the CDO pools liquidate reflects the fact that it is the third party
investors, and not LNC, that ultimately bears the risk of loss from
these CDO pools.
The FASB is still considering important guidance relating to these types
of investment pools. Until final guidance is issued, LNC is unable to
finalize its review of these matters. In addition, LNC does not
currently have access to all information necessary to determine the
ultimate effects of such a required consolidation, because LNC is not
the trustee or the administrator of the CDO pools. Accordingly, the
estimated effects of the adoption of Interpretation 46 that are
discussed in the preceding paragraphs are subject to change, pending the
issuance of final guidance by the FASB and LNC's obtaining the necessary
information from the CDO pool trustees and administrators.
Since LNC's role of investment manager for the CDO pools does not expose
LNC to risk of loss on the underlying invested assets, LNC management
does not believe the accounting model imposed under Interpretation 46 is
reflective of the true underlying economics for the investment manager
of these types of CDO pool arrangements. However, based upon the current
status of this emerging guidance, it appears that LNC will be required
to apply this accounting model in order to comply with generally
accepted accounting principles.
Although LNC and the industry continue to review the new rules, at the
present time LNC does not believe there are other significant VIEs that
would result in consolidation with LNC, beyond the managed CDO pools
discussed above.
Accounting for Modified Coinsurance. In April 2003, the FASB's
Derivative Implementation Group issued Statement 133 Implementation
Issue No. B36 ("DIG B36") addressing the accounting for modified
coinsurance agreements ("Modco") and coinsurance with funds withheld
("CFW") reinsurance agreements. This implementation guidance concluded
that Modco and CFW agreements contain embedded derivatives that must be
accounted for separately from the underlying reinsurance agreements. In
conjunction with the initial application of these new rules, companies
that have ceded business and are holding invested assets under these
types of reinsurance arrangements may reclassify available for sale
invested assets to trading account classification, where such securities
relate to the embedded derivatives in the reinsurance agreements.
The effective date for implementation of DIG B36 for LNC is the October
1, 2003 start date of the fourth quarter. Upon adoption, LNC will record
the fair value of the applicable embedded derivatives in net income as a
cumulative effect of a change in accounting. The new rules do not
provide guidance with respect to a number of key implementation matters,
presenting LNC and the life insurance industry with several challenging
decisions and numerous alterative interpretations as to the application
of the new rules. Accordingly, LNC is currently evaluating alternative
interpretations that could affect the amounts recorded at the time of
adoption as well as the way changes in the fair values of invested
assets and embedded derivatives associated with these reinsurance
agreements will be reflected within LNC's financial statements on an
ongoing basis.
Among the matters LNC is currently evaluating is how to characterize the
embedded derivatives in various Modco and CFW reinsurance agreements.
Alternatives under consideration include viewing the embedded
derivatives as total return swaps or credit default derivatives. Once
the characterizations of the various embedded derivatives are decided
upon, LNC must then determine what methodologies to use to measure the
fair value of the embedded derivatives. For instance, if LNC determines
that characterization of an embedded derivative as a total return swap
is appropriate for a particular agreement, LNC might look to the
unrealized gains and losses included within the invested assets
supporting the agreement as a means of measuring the fair value of the
embedded derivative. In such circumstances, upon adoption of the new
rules LNC may decide to reclassify that portion of the underlying
invested assets that are currently classified as available for sale
securities to trading account assets.
To illustrate the potential effect that the initial adoption of these
rules could have on LNC's financial statements, information relating to
invested assets held by LNC at September 30, 2003 under Modco and CFW
agreements is provided below. The actual effect of adoption will vary
depending upon a number of factors, such as how the embedded derivatives
are characterized, the valuation methodologies selected, whether the
terms of the reinsurance agreements provide for a pass through of the
total return of an identified investment portfolio or some other
measure, whether or not invested assets within such reinsurance
investment portfolios are reclassified from available for sale to
trading account and the amount of unrealized gains or losses of the
relevant invested assets at the adoption date.
At September 30, 2003, the fair value of LNC invested assets associated
with Modco and CFW agreements totaled about $3.3 billion. The net
unrealized pre-tax gain associated with these assets at September 30, 2003
was about $394 million. Included within that total net gain is about $372
million of net gain related to available for sale securities and $22
million of net gain related to other invested assets. If LNC should
determine that the best characterization of the embedded derivatives
associated with these various agreements is that of total return swaps, and
if LNC determines that the unrealized gains and losses of the underlying
invested asset portfolios can be used to measure the value of the embedded
derivative, then LNC would record a $394 million pre-tax loss in net income
upon the initial adoption of the new rules to record the various embedded
derivatives. LNC would also record a pre-tax increase in equity of $372
million to reverse adjustments previously recorded due to the fact that
unrealized gains or losses on the reinsurance portfolios generally inure to
the benefit or detriment of the assuming reinsurance company. The $22
million pre-tax net effect on LNC's equity of the initial adoption
adjustments would reverse over the term of the reinsurance agreements, as
the net unrealized gains associated with invested assets that are not
classified as available-for-sale securities are realized in future periods.
If LNC decided to concurrently reclassify all relevant
available-for-sale invested assets as trading account assets upon the
initial adoption of these new rules, LNC would record a pre-tax gain in
net income of $372 million. However, LNC's equity would not be affected
by this reclassification accounting, as the previously recorded
increases to shareholder's equity booked in Other Comprehensive Income
as a result of the available-for-sale classification of these
investments would be reversed upon the reclassification of these
invested assets from available-for-sale to trading account.
On an ongoing basis, changes in the fair value of the embedded
derivative would flow through net income, as would changes in the fair
value of trading account assets. Changes in the fair value of other
invested assets supporting these agreements would flow through net
income as unrealized gains or losses on these assets are realized.
Because the recognition of the fair value of embedded derivatives does
not affect either the cash flows or the economic profits to be
recognized over the life of the reinsurance agreement, it is expected
that these new rules will only change the pattern of earnings associated
with these reinsurance agreements. Importantly, it is expected that the
new rules will not change the ultimate profit or loss that will be
reported over the entire term of the reinsurance agreement.
Not included in the above discussion are a number of reinsurance
agreements where LNC accepts business as a reinsurer on a Modco basis
and then cedes the business off on a Modco basis to Swiss Re. LNC does
not hold the underlying invested assets under these agreements, and LNC
has effectively transferred all underwriting and investment risks
associated with these agreements. LNC is a party to a number of such
reinsurance agreements, which at September 30, 2003 aggregated about
$1.7 billion of business. While LNC continues to review the treatment of
these Modco agreements under these new rules, it appears that the
embedded derivatives associated with these agreements will be
characterized as total return swaps. Based upon information available at
this time and the preliminary conclusion that these embedded derivatives
should be characterized as total return swaps, LNC expects that its
position as an accepting reinsurer and a ceding company on the same
business should result in equal and offsetting changes in the value of
the embedded derivatives associated with these agreements. Accordingly,
LNC would not expect that the embedded derivatives associated with these
reinsurance agreements would create significant volatility in reported
net income in future periods.
In addition, LNC has acquired certain blocks of variable annuity and
life business using Modco reinsurance structures. At September 30, 2003
there was about $330 million of business acquired in this manner. LNC
continues to review whether the accounting for these agreements will
change under the new rules; based upon information available at this
time LNC does not believe there will be any new effects on net income
created by the adoption of the new embedded derivative accounting rules
for these agreements, given the fact that the assets and liabilities
associated with these variable blocks of business are already reflected
at fair value within LNC's financial statements.
Restructuring Charges
In June 2003, LNC announced the realignment of its life insurance and
annuity businesses into a single operating unit focused on providing
wealth accumulation and protection; income distribution and wealth
transfer products.
On August 4, 2003, LNC announced that in addition to the previously
announced realignment of LNC's life and annuity businesses it is taking
further action to position LNC for future growth. The actions are
expected to impact all domestic operations. In total, the planned
actions, including the previously announced realignments, are expected
to result in pre-tax savings of $30 million in 2003, $80 million in 2004
and $105 million in 2005. Offsetting these savings are related pre-tax
charges estimated to be $135 million which are expected to occur over a
three year period, with an estimated $75 million in 2003, $55 million in
2004 and $5 million in 2005. Also, offsetting the savings are pre-tax
investments in business growth initiatives of which $15 million are
expected to be recognized in 2003, $30 million in 2004 and $35 million
in 2005. The after-tax impact to net income from the investments in
business growth initiatives, expense savings and charges is estimated to
result in a net charge of $39 million in 2003, net charge of $3 million
in 2004 and net savings of $42 million in 2005. The number of job
eliminations is expected to range between 800 and 1,000, including
approximately 500 that have occurred in the nine-month period ended
September 30, 2003.
For an update on the status of restructuring plans implemented from 1999
through September 30, 2003, refer to Note 10 to the September 30, 2003
unaudited consolidated financial statements.
RESULTS OF OPERATIONS BY SEGMENT
Lincoln Retirement
Results of Operations
Nine Months Ended Three Months Ended
September 30, September 30,
2003 2002 2003 2002
- --------------------------------------------------------------------------------------------
Net Income (Loss) (in millions) $190.6 $48.7 $102.0 $(7.0)
Items Included in Net Income (Loss):
Realized Gain (Loss) on Investments
and Derivative Instruments (after-tax) $(37.7) $(98.2) $13.2 $(28.8)
Restructuring Charge (after-tax) (9.5) (1.0) (5.5) --
Average Daily Variable Account Values
(in billions) $29.2 $32.0 $31.5 $28.0
September 30 (in billions) 2003 2002
- --------------------------------------------------------------------------------------------
Account Values
Variable Annuities $31.7 $25.9
Fixed Annuities $21.1 $19.6
Reinsurance Ceded (2.2) (1.9)
----------------------
Total Fixed Annuities $18.9 $17.7
Total Account Values $50.6 $43.6
Net income increased $141.9 million and $109.0 million for the nine and
three months ended September 30, 2003, respectively, compared with the
same periods in 2002. Included within net income for the nine and three
month periods ended September 30, 2003 are $2.8 million and $6.5 million
of increased earnings, relative to prior year periods, due to
adjustments associated with certain annuity reinsurance recoverables.
Stock-Based Compensation
The periods presented for 2002 have been restated for the adoption of
FAS 123 and FAS 148. See the discussion under the topic "Accounting for
Stock-Based Compensation" presented in the Consolidated Results of
Operations for further discussion of this matter. The effect of adoption
was a decrease of $3.0 million and $1.0 million in net income in the
nine and three months ended September 30, 2002, respectively, from
previously reported amounts.
Realized Gains (Losses) on Investments and Derivative Instruments
Realized losses on investments and derivative instruments for the
Lincoln Retirement segment decreased $60.5 million for the nine months
ended September 30, 2003 compared with the same period in 2002. For the
three months ended September 30, 2003 realized gains on investments and
derivatives were $13.2 million, compared with realized losses on
investments and derivatives of $28.8 million for the same period in
2002. Realized investment gains for the third quarter 2003 include a
$10.9 million unfavorable adjustment resulting from the completion of
the third quarter 2003 DAC assumption review discussed previously. For
additional detail on realized losses see the discussion in the
Consolidated Investments section.
Equity Market Impact
The improvement in the equity markets favorably affected the segment's
earnings through positive unlocking of deferred acquisition costs
("DAC") and the present value of in-force intangible ("PVIF"), a
decrease in reserves and benefit payments for guaranteed minimum death
benefits ("GMDB"), partially offset by lower fees resulting from lower
average variable account values compared with the first nine months of
2002. The increase in the equity markets positively affected earnings by
$57.7 million in the nine months ended September 30, 2003 and $51.8
million in the three months ended September 30, 2003 compared with the
same periods in 2002.
Average variable annuity account values were $2.8 billion lower for the
nine-month period, and $3.5 billion higher for the three-month period
ended September 30, 2003, respectively, compared with the same periods
in 2002. The lower average account balance for the nine months resulted
in a reduction of fees lowering earnings by $15.2 million compared with
the same period in 2002. The higher average account values for the
three-month period resulted in higher fees and increased earnings $6.5
million compared with the same period in 2002.
Due to the improvement in the equity markets, variable annuity account
values at September 30, 2003 were $5.8 billion higher than September 30,
2002. The positive effect of equity markets on DAC and PVIF unlocking
and net changes in amortization increased earnings by $25.0 million and
$11.4 million in the nine and three-month periods ended September
30, 2003, respectively, compared with the same periods of 2002.
Decreases in GMDB reserves and benefit payments resulted in a positive
variance of $45.0 million and $34.6 million for the nine and
three-month periods ended September 30, 2003, respectively, compared
with 2002 periods. (See the section captioned "Critical Accounting
Policy -- Guaranteed Minimum Death Benefit Reserving" for additional
details). In addition, there were variances of $2.9 million and $(0.7)
million for the nine and three month 2003 periods, respectively related
Lincoln Retirement's Separate Account Dividends Received Deduction
("DRD") tax benefit.
Refer to the Fourth Quarter 2003 Guidance for Estimated Effect of Equity
Market Volatility section for estimates of the effect of movements in
the equity markets on Lincoln Retirement's earnings.
Investment Margins
Investment margins on fixed annuities were $24.3 million and $6.5
million higher in the nine-month and three-month periods ended September
30, 2003, respectively, compared with the same periods of 2002. The
increase in margins resulted from reductions in crediting rates and
increased levels of mortgage loan prepayments, which exceeded the
effects of overall declines in yields on related investment assets
during the periods ended September 30, 2003. (See further discussion on
investment margins and the interest rate risk due to falling interest
rates in Item 3, Quantitative and Qualitative Disclosures About Market
Risk.)
Net Flows -- Fixed Annuities
Average gross fixed annuity account values for the nine and three-
months ended September 30, 2003 were $2.0 billion and $1.7 billion
higher, respectively, than the same periods in 2002. This increase
contributed additional earnings of $9.2 million and $4.7 million in the
first nine months and third quarter of 2003 compared with the same
periods in 2002. The increase in fixed annuity account values was due to
the positive net flows for fixed annuities. (See below for further
discussion of net flows.)
Restructuring Charges
Restructuring charges for the Lincoln Retirement segment were $9.5
million and $5.5 million for the nine and three month periods ended
September 30, 2003, respectively. Included in these amounts are $7.2
million and $5.3 million for the comparable periods related to the
combining of the Lincoln Retirement and Life Insurance operations
announced in June of 2003. The remaining amounts, $2.3 million and $0.2
million, related to the consolidation of the fixed annuity operations in
Schaumburg, Illinois into Fort Wayne, Indiana. For further details refer
to Note 10 to the September 30, 2003 unaudited consolidated financial
statements.
Critical Accounting Policy -- Deferred Acquisition Costs and Present
Value of In-Force
Refer to Management's Discussion and Analysis of LNC's annual report on
Form 10-K for the year ended December 31, 2002, for a detailed
discussion of this critical accounting policy. At September 30, 2003,
Lincoln Retirement's reversion to the mean gross growth rate assumption
for the equity markets was 6.45%, which compares to the assumption of 9%
at December 31, 2002. The decrease in the growth rate was due to the
increase in the equity markets since December 31, 2002.
As discussed in the Results of Consolidated Operations - Critical
Accounting Policy - DAC, PVIF and DFEL, a comprehensive review of the
assumptions underlying the amortization of the DAC and PVIF assets was
completed during the third quarter of 2003. Excluding amounts included
in Realized Gains (Losses) on Investments and Derivative Instruments
discussed above, net income for the Lincoln Retirement segment for the
third quarter includes a $1.5 million favorable adjustment resulting
from the completion of this review.
Critical Accounting Policy -- Guarantee Minimum Death Benefit Reserving
Refer to Management's Discussion and Analysis of LNC's annual report on
Form 10-K for the year ended December 31, 2002, for a detailed
discussion of this critical accounting policy. At September 30, 2003,
Lincoln Retirement's net amount at risk ("NAR") was $2.6 billion and the
GAAP reserve was $63.7 million. The reserve for statutory accounting was
$87.5 million. The comparable amounts at December 31, 2002 were a NAR of
$4.6 billion, GAAP reserves of $84.5 million and statutory reserves of
$144.1 million. See the table below for additional statistics related to
GMDB as of September 30, 2003:
Return of High Water
Premium Mark Roll-Up No GMDB Total
--------- ---------- ------- -------- --------
Variable Annuity Account
Value (billions) $23.2 $11.0 $0.3 $7.1 $41.6
% of Total Annuity Account Value 55.7% 26.5% 0.7% 17.1% 100.0%
Average Account Value $33,496 $66,963 $98,616 $48,874 $42,873
Average NAR $9,083 $8,638 $16,445 N/A $8,964
GAAP Reserve (millions) $17.2 $44.8 $1.7 N/A $63.7
NAR (billions) $0.9 $1.7 $-- N/A $2.6
Average Age of Contract Holder 51 61 64 59 54
% of Contract Holders
> 70 Years of Age 9.7% 26.2% 30.4% 21.9% 14.5%
As described in LNC's annual report on Form 10-K for the year ended
December 31, 2002, LNC has variable annuity contracts containing GMDB's
which have a dollar for dollar withdrawal feature. As of September 30,
2003, there were 557 contracts for which the death benefit to account
value ratio was greater than ten to one. The NAR on these contracts was
$40.9 million. Effective May of 2003, the GMDB feature offered on new
sales was a pro-rata GMDB feature whereby each dollar of withdrawal will
reduce the GMDB benefit in proportion to the current GMDB to account
value ratio.
The IRS recently issued guidance permitting tax-free treatment for
partial exchanges of non-qualified contracts. LNC does not permit
partial exchanges on its non-qualified contracts. To take advantage
of the dollar for dollar feature, the contract holder must take a
taxable withdrawal, and pay any applicable surrender charges. Such
withdrawals would not qualify for tax-free partial exchange treatment
under the current published guidelines from the IRS. LNC reports the
appropriate amount of any withdrawals as taxable income to the IRS, and
indicates whether or not tax penalties apply under the premature
distribution rules.
Net Flows
Nine Months Ended Three Months Ended
September 30, September 30,
- ---------------------------------------------------------------------------------------------------
(in billions) 2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------------
Variable Portion of Annuity Deposits $2.0 $2.2 $0.8 $0.6
Variable Portion of Annuity Withdrawals (2.3) (2.6) (0.8) (0.8)
------- ------- ------- -------
Variable Portion of Variable Annuity Net Flows (0.3) (0.4) -- (0.2)
Fixed Portion of Variable Annuity Deposits 1.2 1.4 0.4 0.5
Fixed Portion of Variable Annuity Withdrawals (0.8) (0.9) (0.2) (0.3)
------- ------- ------- -------
Fixed Portion of Variable Annuity Net Flows 0.4 0.5 0.2 0.2
Fixed Annuity Deposits 1.1 1.5 0.3 0.6
Fixed Annuity Withdrawals (0.7) (1.2) (0.2) (0.5)
------- ------- ------- -------
Fixed Annuity Net Flows 0.4 0.3 0.1 0.1
Total Annuity Net Flows $0.5 $0.4 $0.3 $0.1
Incremental Deposits(1) $4.3 $4.8 $1.5 $1.6
(1) Incremental Deposits represent gross deposits reduced by transfers
from other Lincoln annuity products.
Net Flows and Product Sales
With positive net flows in the third quarter of 2003, the Lincoln
Retirement segment experienced positive net flows for the ninth
consecutive quarter. Net flows for the first nine months and third
quarter of 2003 were $93 million and $209 million higher, respectively,
compared with the same periods in 2002. Although gross annuity deposits
were down, the Lincoln Retirement segment experienced an improvement in
persistency, as evidenced by lower withdrawals. Overall gross annuity
deposits declined $683 million, or 13.5%, and $116 million, or 6.8%, in
the first nine months and third quarter of 2003, respectively, compared
with the same periods in 2002. The decline occurred in sales of both
individual variable and fixed annuities for the nine months of 2003
compared with the same period of 2002, while individual variable annuity
deposits increased $86 million in the third quarter of 2003 compared
with the same period last year. American Legacy Variable Annuity, and
Lincoln ChoicePlusSM variable and fixed annuity gross deposits were down
$254 million, or 19%, and $59 million, or 7%, respectively, for the
nine-month period. For the three-month period, American Legacy Variable
Annuity and Lincoln ChoicePlusSM variable and fixed annuity gross
deposits increased $59 million, or 15%, and $34 million, or 12%,
respectively.
The favorable third quarter variable annuities sales experience was due
in part to the June 2003 introduction by the Lincoln Retirement segment
of the Lincoln Principal SecuritySM feature, which provides the
contractholder with a guaranteed living benefit. Approximately 27% of
American Legacy Variable Annuity and 42% of Lincoln ChoicePlusSM
variable annuity sales for the third quarter selected this feature. The
feature is available for an additional fee and provides a guarantee
equal to the initial purchase payment (or contract value if elected
after issue) as adjusted for subsequent purchase payments and
withdrawals. It also allows investors to make annual withdrawals up to
the amount of their original deposit, provided each annual withdrawal is
less than seven percent of the initial deposit. LNC will waive fees for
this feature after year five as long as withdrawal activity has been and
remains minimal and the benefit has not been reset, an innovative
element in the Guaranteed Minimum Withdrawal Benefit ("GMWB") market. As
of September 30, 2003, less than 10% of deposits that selected this
feature have elected automatic withdrawals at the seven percent level.
In order to manage the equity market risk associated with this feature,
the Lincoln Retirement segment implemented a hedging strategy. During
the third quarter, the hedging program was broadened to also mitigate
the risk associated with variable annuity embedded minimum death benefit
guarantees. At September 30,2003, account balances covered in this
hedging program combined with account balances for which there is no
death benefit represent approximately 45% of total variable annuity
account balances.
In addition to the introduction of the Lincoln Principal SecuritySM
feature, Lincoln Financial Distributors ("LFD") had several new wholesalers
in place during the third quarter of 2003, and more are expected to
be in place in the near future. The increase in wholesalers is expected
to strengthen LNC's penetration in the variable annuity market.
Partially offsetting the decline in individual annuities product sales
was an increase in employer-sponsored annuity product sales, which were
up $153 million, or 10%, in the nine months ended September 30, 2003 and
were flat for the third quarter of 2003 compared with the same periods
in 2002. The strong sales performance in 2003 within employer-sponsored
annuities is a result of increased deposits in the Alliance program.
Sales of the Alliance program were $741 million in the first nine months
of 2003, up from $433 million in the first nine months of 2002. Alliance
sales are expected to moderate over the remainder of 2003 as first
quarter 2003 sales of $337 million benefited from the large number of
enrollments from employer-sponsored plans.
Life Insurance
Results of Operations
Nine Months Ended Three Months Ended
September 30, September 30,
(in millions) 2003 2002 2003 2002
- --------------------------------------------------------------------------------------------
Net Income $169.9 $146.6 $55.8 $46.4
Items Included in Net Income:
Realized Loss on Investments and
Derivative Instruments (after-tax) $(11.3) $(59.3) $(1.3) $(16.3)
Restructuring Charge (after-tax) (10.0) -- (1.6) --
First Year Premiums (by Product)
Universal Life $445.8 $318.2 $172.3 $132.9
Variable Universal Life 55.0 107.5 16.6 26.1
Whole Life 22.0 19.3 8.5 7.7
Term 29.3 24.2 10.5 7.3
---------------------------------------------------
Total Retail 552.1 469.2 207.9 174.0
Corporate Owned Life Insurance ("COLI") 96.1 61.3 23.8 7.8
---------------------------------------------------
Total First Year Premiums $648.2 $530.5 $231.7 $181.8
September 30 (in billions) 2003 2002
- --------------------------------------------------------------------------------------------
Account Values
Universal Life $8.8 $8.0
Variable Universal Life 2.0 1.6
Interest-Sensitive Whole Life 2.2 2.2
-------------------
Total Life Insurance Account Values $13.0 $11.8
In Force - Face Amount
Universal Life and Other $127.8 $124.1
Term Insurance 145.5 123.9
-------------------
Total In-Force $273.3 $248.0
Net income increased $23.3 million, or 16%, and $9.4 million, or 20%,
for the nine-month and three-month periods ended September 30, 2003,
respectively, compared with the same periods in 2002.
Stock-Based Compensation
The 2002 periods have been restated for the adoption of FAS 123 and FAS
148. See the discussion under the topic "Accounting for Stock-Based
Compensation" presented in the Consolidated Results of Operations for
further discussion of this matter. The effect of adoption was a decrease
of $2.1 million and $0.7 million to net income in the nine-month and
three-month periods ended September 30, 2002, respectively, from
previously reported amounts.
Realized Losses on Investments and Derivative Instruments
The Life Insurance segment had an improvement of $48.0 million and $15.0
million in realized investment losses for the nine-month and three-month
periods ended September 30, 2003, respectively, relative to the same
periods of 2002. Realized investment gains for the third quarter 2003
include a $12.7 million unfavorable adjustment resulting from the
completion of the third quarter 2003 DAC assumption review discussed
previously. For additional detail on realized losses see the discussion
in the Consolidated Investments section.
Mortality
Improved mortality margin (mortality assessments less net death
benefits, net of DAC unlocking) resulted in a $7.8 million increase in
earnings in the nine months ended September 30, 2003 and a $3.2 million
increase in the three months ended September 30, 2003 over the same
periods in 2002.
Investment Margins
Lower investment margins reduced income by $1.2 million in the nine
months ended September 30, 2003 compared with the same period in 2002,
primarily due to lower investment yields. This unfavorable variance is
primarily related to traditional whole life insurance products and
corporate account investments where LNC bears the risk for falling
interest rates. For the three months ended September 30, 2003 investment
margins improved $1.3 million compared with the same 2002 period, as the
impact of lower yields was offset by lowering credited rates to the
customers of universal life and interest sensitive whole life insurance
products, (except for policies which were already at their guaranteed
minimum interest rate). (See discussion on investment margins and the
interest rate risk due to falling interest rates in Item 3, Quantitative
and Qualitative Disclosures About Market Risk.)
Equity Market Impact
The overall positive performance of the equity markets resulted in
positive DAC unlocking of $0.8 million in the nine months ended
September 30, 2003 and $0.1 million in the three months ended September
30, 2003 compared with negative DAC unlocking of $3.2 million and $1.8
million, respectively, for the nine and three month periods in 2002. In
addition to the unlocking impact, the favorable market performance in
the second and third quarters of 2003 has offset the negative impact of
market declines in 2002 on the Life Insurance segment's asset-based fee
revenue on variable universal life ("VUL") insurance products (less than
16% of account values are VUL). Refer to the Fourth Quarter 2003
Guidance for Estimated Effect of Equity Market Volatility section for
estimates of the effect of movements in the equity markets on the Life
Insurance segment's earnings.
Critical Accounting Policy -- DAC and PVIF
Refer to Management's Discussion and Analysis of LNC's annual report on
Form 10-K for the year ended December 31, 2002, for a detailed
discussion of this critical accounting policy. In 2003, the Life
Insurance segment experienced negative DAC unlocking of $20.4 million
and $11.5 million in the first nine months and third quarter,
respectively, compared with positive unlocking of $0.3 million in the
nine months and negative unlocking of $1.0 million for the third quarter
of 2002. Included in these amounts for 2003 is $10.5 million resulting
from the completion of a third quarter comprehensive review of the
assumptions underlying the amortization of the DAC and PVIF assets. The
DAC unlocking for the first nine months of 2003 also includes $7.2
million related to a second quarter change in future assumptions
regarding face amount reductions (i.e. prospective unlocking). The 2003
assumption change relating to face amount reductions is expected to
lower future gross profits resulting in an increase in DAC amortization.
In the nine-month and three-month periods ended September 30, 2003,
there was an increase of $6.1 million and $2.5 million, respectively, in
the rate of amortization of the DAC asset compared with the same periods
in 2002. For additional information, refer to the discussion in Results
of Consolidated Operations - Critical Accounting Policy - DAC, PVIF and
DFEL.
Restructuring Charges
In the first quarter of 2003, the Life Insurance segment announced it is
realigning operations in Hartford, Connecticut and Schaumburg, Illinois
to enhance productivity, efficiency and scalability while positioning
the segment for future growth. In the first nine months of 2003, the
Life Insurance segment incurred restructuring charges of $9.3 million
and other realignment related expenses of $1.3 million. In the third
quarter of 2003, the Life Insurance segment incurred restructuring
charges of $0.9 million and other realignment related expenses of $0.1
million. Restructuring charges related to the combining of the Lincoln
Retirement and Life Insurance operations announced in June 2003 were
$0.7 million for the nine-month and three-month periods ended September
30, 2003. For further details refer to Note 10 to the September 30, 2003
unaudited consolidated financial statements.
In-force and Product Sales
As measured by life insurance in-force, the Life Insurance segment
increased 10% from September 30, 2002 primarily due to strong growth in
term life insurance in-force (up 17%). Account values increased $1.2
billion, or 10%, from September 30, 2002. The drivers of this increase
were positive net flows, net of policyholder assessments, of
approximately $1.4 billion across all products during the twelve months
ended September 30, 2003, and interest earned on the fixed products.
Total sales of retail and corporate owned life insurance products, as
measured by first year premiums, were up $117.7 million, or 22%, and
$49.9 million, or 27%, for the first nine months and third quarter of
2003 compared with the same periods last year. Sales of retail life
insurance products were up $83.0 million, or 18%, in the first nine
months of 2003 and $34.0 million, or 20%, in the third quarter of 2003.
Sales of retail life insurance products through both LNC distribution
organizations were strong as sales through LNC's financial planning
organization, Lincoln Financial Advisors ("LFA") were up 15% for the
first nine months of 2003 relative to the same period in 2002 driven by
a third quarter 2003 increase of 43% compared with the third quarter of
2002. Excluding $11.2 million of incremental first year premium
related to a large Universal Life replacement case, LFA sales were up 7%
and 19% for the nine-month and three-month periods. Sales through
Lincoln Financial Distributors ("LFD") were up 13% and 18% for the nine
months and third quarter of 2003, respectively, compared with the same
periods of 2002.
Within retail, sales of universal life ("UL") insurance products
improved by $127.6 million, or 40%, in the first nine months of 2003,
and $39.4 million, or 30%, for the third quarter of 2003 compared with
prior year periods. The increase in UL product sales reflect consumers'
concerns with volatile equity markets, which is reflected in continued
movement from variable life insurance products to interest-sensitive
products. In contrast to the growth in UL sales, sales of variable
universal life insurance ("VUL") were down $52.5 million, or 49%, during
the first nine months of 2003 from the prior year period. The decrease
was $9.5 million, or 36%, for the third quarter of 2003 compared with
the same period of 2002.
Sales of Corporate Owned Life Insurance ("COLI") were up $34.7 million,
or 57%, and $15.9 million, or 204%, in the nine and three month periods
ended September 30, 2003 compared with the same periods in 2002. Sales
of COLI products consist of large cases resulting in fluctuations in
first year premium from period to period. One such case, which
contributed $33.2 million of premium in the second quarter of 2003, was
sold through the M-Group Financial ("M-Group") relationship. This case
is subject to a modified coinsurance arrangement and as such, results
will be shared 50/50 with M-Group Life Insurance Company.
Investment Management
Results of Operations
Nine Months Ended Three Months Ended
September 30, September 30,
(in millions) 2003 2002 2003 2002
- --------------------------------------------------------------------------------------------
Total Revenue $340.2 $310.9 $121.7 $97.5
Total Investment Advisory Fees
(Included in Total Revenue) 221.8 212.2 78.7 67.0
Net Income (Loss) $12.0 $(2.5) $6.3 $(3.9)
Items Included in Net Income (Loss):
Realized Gain (Loss) on Investments
(after-tax) $(0.1) $(2.6) $0.1 $(1.2)
Restructuring Charge (after-tax) (3.5) 0.3 (3.5) 0.3
Income Statement Reclassifications
In 2003, certain reclassifications have been made in the prior periods
to conform to the current year presentation. As a result, Investment
Advisory fees for the nine and three month periods ended September 30,
2002 were increased by $10.8 million, and $3.2 million, respectively,
with corresponding increases in expenses for the same periods. In
addition, foreign taxes of $3.8 million and $1.0 million for the
nine and three-month periods ended September 30, 2002,
respectively, were reclassified from operating expenses to the federal
income tax line.
Net Income
Net income increased $14.5 million and $10.2 million in the nine and
three-month periods ended September 30, 2003, respectively, from the
same periods in 2002.
Stock-Based Compensation
The 2002 periods have been restated for the adoption of FAS 123 and FAS
148. See the discussion under the topic "Accounting for Stock-Based
Compensation" presented in the Consolidated Results of Operations for
further discussion of this matter. The effect of adoption was a decrease
of $18.9 million and $7.0 million in net income for the nine-month and
three-month periods ended September 30, 2002, respectively, from
previously reported amounts.
Realized Losses on Investments and Derivative Instruments
The Investment Management segment reported realized investment losses of
$0.1 million and $2.6 million, respectively, for the nine months period
ended September 30, 2003 and 2002. For the three-month period ended
September 30, 2003, the Investment Management segment reported realized
investment gains of $0.1 million, compared with a realized investment
loss of $1.2 million for the same period in 2002.
Equity Market Impact
Institutional and Retail assets under management increased $11.7 billion
from September 30, 2002 to September 30, 2003, with $8.5 billion of the
increase due to increases in the equity markets. Of this increase, $1.5
billion occurred in the third quarter of 2003. The market appreciation
combined with positive net flows resulted in increased revenues
partially offset by increased variable expenses. These items combined
to increase earnings by $6.3 million and $7.2 million for the nine-month
and three-month periods ended September 30, 2003 compared with the same
periods in 2002.
Refer to the Fourth Quarter 2003 Guidance for Estimated Effect of Equity
Market Volatility section for estimates of the effect of movements in
the equity markets on the Investment Management segment's earnings.
Critical Accounting Policy -- Deferred Acquisition Costs
In the first quarter of 2003, the Investment Management segment
implemented a new system for calculating the amortization of deferred
acquisition costs consistent with the system and methodology utilized by
the Lincoln Retirement and Life Insurance segments. As a result, lower
net DAC amortization increased earnings by $4.9 million and $1.4 million
in the nine-month and three-month periods ended September 30, 2003,
respectively, compared with the same periods in 2002. As discussed in
the Results of Consolidated Operations - Critical Accounting Policy -
DAC, PVIF and DFEL, net income for the Investment Management segment for
the third quarter of 2003 includes a $2.6 million favorable adjustment.
Investment Management -- Assets Under Management and Net Flows
The Investment Management segment's assets under management were as
follows:
September 30 (in billions) 2003 2002
- -------------------------------------------------------------------
Assets Under Management
Regular Operations:
Retail-Equity $18.0 $13.7
Retail-Fixed 8.0 7.5
------- -------
Total Retail $26.0 $21.2
Institutional-Equity $21.0 $15.0
Institutional-Fixed 8.1 7.2
------- -------
Total Institutional $29.1 $22.2
Insurance Assets $43.0 $40.4
------- -------
Total Assets Under Management $98.1 $83.8
The Investment Management segment's net flows were as follows:
Nine Months Ended Three Months Ended
September 30, September 30,
(in billions) 2003 2002 2003 2002
- -------------------------------------------------------------------------------------------
Retail:
Equity Sales $2.6 $3.1 $1.1 $1.1
Equity Redemptions and Transfers (2.1) (2.9) (0.6) (1.2)
------- ------- ------- -------
Net Flows 0.5 0.2 0.5 (0.1)
Fixed Sales 1.3 0.9 0.4 0.3
Fixed Redemptions and Transfers (1.1) (0.8) (0.5) (0.1)
------- ------- ------- -------
Net Flows 0.2 0.1 (0.1) 0.2
Total Retail Net Flows $0.7 $0.3 $0.4 $0.1
------- ------- ------- -------
Institutional:
Equity Inflows $2.6 $1.9 $1.4 $0.6
Equity Withdrawals and Transfers (1.7) (1.7) (0.9) (0.5)
------- ------- ------- -------
Net Flows 0.9 0.2 0.5 0.1
Fixed Inflows 1.3 2.0 0.6 0.5
Fixed Withdrawals and Transfers (0.8) (0.7) (0.3) (0.3)
------- ------- ------- -------
Net Flows 0.5 1.3 0.3 0.2
------- ------- ------- -------
Total Institutional Net Flows $1.4 $1.5 $0.8 $0.3
------- ------- ------- -------
Total Retail and Institutional Net Flows $2.1 $1.8 $1.2 $0.4
Assets Under Management and Net Flows
Assets under management increased $14.3 billion to $98.1 billion at
September 30, 2003 compared with September 30, 2002. The increase was
primarily the result of $8.5 billion in market appreciation and net
flows of $3.2 billion in Institutional and Retail assets under
management. In addition, insurance assets (i.e. primarily general
account assets of LNC's insurance subsidiaries) increased $2.6 billion
during the same period. Institutional assets under management increased
$6.9 billion as a result of market appreciation of $4.9 billion and
positive net inflows of $2.0 billion. Retail assets under management
increased $4.8 billion as a result of market appreciation of $3.6
billion and positive net flows of $1.2 billion.
The Investment Management segment's net flows remained positive in the
first nine months and third quarter of 2003. Total net flows for the
nine-month period increased $0.3 billion, and increased $0.8 billion for
the three-month periods of 2003 compared with the same periods in 2002.
These improvements reflect a 67% increase in third quarter 2003
institutional inflows and favorable retention of retail accounts as
evidenced by a significant reduction in redemptions compared with the
same period in 2002. The decline in the institutional net flows for the
first nine months ending September 30, 2003 compared with the same
period in 2002 was due to a large funding of approximately $0.7 billion
in March 2002. Sales in the institutional business tend to fluctuate
from period to period depending upon when large institutional mandates
are received.
Retail sales declined 2.6% for the nine months of 2003 compared with the
same period in 2002, and increased 2.0% for the three-month period. The
third quarter growth was concentrated in mutual funds and for the nine
months, the decline in sales was concentrated within the annuities
products managed by the Investment Management segment. Sales of managed
account products for the first nine months of 2003 were up 5.5% over the
same period of 2002, with substantially all the increase occurring in
the first quarter of 2003 compared with the first quarter of 2002.
However, full year 2003 managed account sales are expected to be lower
than the full year of 2002 as sales in the third and fourth quarters of
2002 were higher than the previous quarters of the year as a result of
events affecting key competitors (a group departure of investment
professionals from one firm and a second firm temporarily closing for
new business).
Investment Performance
Positive investment performance has been a key driver of the improvement
in net flows. On the institutional side, for the twelve months ended
September 30, 2003, 5 of the 8 largest product composites met or
outperformed their respective indices and these 5 composites accounted
for approximately 76% of institutional assets under management. This
relative performance is above the results experienced for the year ended
December 31, 2002, in which 4 of the 8 largest composites outperformed
their respective indices. On the retail side, for the twelve months
ended September 30, 2003, 76% of the 25 largest retail funds in the
Delaware Investments Family of Funds (the Delaware Investments Family of
Funds does not include mutual funds managed by Delaware for certain LNC
affiliates) performed in the top half of their respective Lipper
universes. These 19 funds represented 84% of assets under management of
the largest 25 retail funds at September 30, 2003. At September 30,
2003, of the funds rated by Lipper, Delaware had 39 of its 50 retail
funds labeled as a Lipper Leader in at least one category and 22 funds
were selected in multiple categories. For the managed accounts, 1 of the
6 largest product composites outperformed its respective index for the
one-year period ending September 30, 2003, while 4 of the largest 6
outperformed their respective indices for the corresponding three-year
period.
Lincoln UK
Results of Operations
Nine Months Ended Three Months Ended
September 30, September 30,
(in millions) 2003 2002 2003 2002
- ----------------------------------------------------------------------------------------
Net Income $30.7 $19.8 $11.5 $0.2
Items Included in Net Income:
Realized Gain on Investments (after-tax) $0.2 $0.5 $0.2 $0.9
September 30 (in billions) 2003 2002
- ----------------------------------------------------------------------------------------
Unit-Linked Assets $5.7 $4.8
Individual Life Insurance In-Force $19.3 $19.8
Exchange Rate Ratio -- U.S. Dollars to Pounds Sterling
Average for the Period 1.615 1.555
End of Period 1.664 1.569
Net income increased $10.9 million and $11.3 million for the nine and
three-month periods ended September 30, 2003, respectively.
Stock-Based Compensation
The 2002 periods have been restated for the adoption of FAS 123 and FAS
148. See the discussion under the topic "Accounting for Stock-Based
Compensation" presented in the Consolidated Results of Operations for
further discussion of this matter. The effect of adoption was a decrease
in net income for the nine-month and three-month periods ended September
30, 2002 of $1.7 million and $0.6 million, respectively, from previously
reported amounts.
Realized Gain on Investments
Realized investment gains were $0.2 million for the nine-month and
three-month periods ended September 30, 2003, compared with realized
investment gains of $0.5 million for the nine months and of $0.9 million
for the three months ended September 30, 2002.
Critical Accounting Policy -- Equity Market Sensitivity
The FTSE 100 index at September 30, 2003 increased 3.8% from December
31, 2002 and 9.9% from September 30, 2002. However, the 28.7% decline in
the FTSE 100 index during 2002 resulted in lower fee income from
unit-linked accounts of $3.4 million for the nine months ended September
30, 2003. The increase for the three months ended September 30, 2003
resulted in higher fee income of $0.8 million compared with the same
period in 2002. The increase in the FTSE 100 for both the nine and three
month periods ended September 30, 2003 compared to the same periods in
2002, resulted in positive net unlocking of $25.1 million and $13.0
million, respectively, for DAC and PVIF assets and deferred front end
load revenue ("DFEL") compared with the nine-month and three-month
periods ending September 30, 2002.
Refer to the Fourth Quarter 2003 Guidance for Estimated Effect of Equity
Market Volatility section for estimates of the effect of movements in
the equity markets on the segment's earnings.
Taxes
The Lincoln UK segment's effective tax rate increased in the nine month
and three month periods ended September 30, 2003 compared with the same
periods in 2002. In 2002, the effective tax rate was lower than 35% due
to the existence of excess foreign tax credits from years prior to 2002.
Now that the foreign tax credits have been fully utilized, the effective
tax rate is expected to be approximately 35%. The performance of the
equity markets could result in future changes to the Lincoln UK
segment's effective tax rate. The increase in the effective tax rate
reduced earnings in the nine-month and three-month periods ended
September 30, 2003 by $10.6 million and $1.7 million, respectively,
compared with the same periods in 2002.
United Kingdom Selling Practices
The level of customer complaints associated with mortgage endowments has
recently been in excess of expectations, apparently due to increased levels
of industry-wide publicity surrounding these matters. On an ongoing basis,
Lincoln UK evaluates various assumptions underlying these estimated
liabilities, including the expected levels of future complaints, and the
potential implications with respect to the adequacy of the aggregate
liability associated with UK selling practice matters. A continuation of
higher than expected levels of complaints may result in Lincoln UK revising
its current estimate of the required level of these liabilities. See Note 6
to the September 30, 2003 unaudited consolidated financial statements for
further discussion of this matter.
Other Operations
Results of Operations
Nine Months Ended Three Months Ended
September 30, September 30,
(in millions) 2003 2002 2003 2002
- ----------------------------------------------------------------------------------------
Net Income (Loss) by Source:
LFA $(27.6) $(27.7) $(9.8) $(8.9)
LFD (26.3) (27.2) (7.5) (13.1)
LNC Financing (43.1) (29.4) (13.3) (11.0)
Other Corporate (2.0) (0.4) (1.5) 0.9
Amortization of Deferred Gain
on Indemnity Reinsurance 35.7 44.4 11.9 14.4
Reserve Development on Business
Sold Through Indemnity Reinsurance
and Related Amortization of
Deferred Gain (18.7) (190.8) (18.5) (176.4)
Realized Loss on Investments
and Derivatives 0.1 16.3 0.1 22.0
Loss on retirement of Junior
Subordinated Debentures (3.7) -- (3.7) --
------- ------- ------- -------
Net Loss $(85.6) $(214.8) $(42.3) $(172.1)
Items Included in Net Income:
Restructuring Charges $(2.4) $1.1 $(2.4) $1.1
The net loss reported within Other Operations for the nine-month and
three-month periods ended September 30, 2003 decreased $129.1 million
and $129.8 million, respectively, compared with same periods of 2002.
Net losses for the nine months and third quarters of 2003 and 2002
include charges required by FAS 113 on increases in reserves for the
business sold through indemnity reinsurance to Swiss Re. See the
discussion below in Critical Accounting Policy -- Personal Accident and
Disability Income Reserves.
Stock-Based Compensation
The 2002 periods have been restated for the adoption of FAS 123 and FAS
148. See the discussion under the topic "Accounting for Stock-Based
Compensation" presented in the Consolidated Results of Operations for
further discussion of this matter. The effect of adoption was a decrease
in net income of $2.9 million for LFA and $1.0 million for LFD in the
first nine months of 2002 and a decrease in net income of $1.0 million
for LFA and $0.3 million for LFD in the third quarter of 2002 from
previously reported amounts.
Lincoln Financial Advisors ("LFA")
LFA net losses for the nine-month and three-month periods ended
September 30, 2003 includes $2.4 million of realignment related to
restructuring costs. Excluding these costs, net losses for the nine and
three-month periods decreased $2.5 million and $1.5 million,
respectively, compared with the same periods in 2002. LFA's net revenues
(gross revenues net of commissions) increased $2.5 millon for the third
quarter of 2003 compared with the same period last year, reflecting
favorable sales in the period. LFA's net revenues were down $3.8
million for the nine months of 2003 compared with the same period last
year, generally driven by decreased sales of variable products. Sales by
LFA of LNC's life insurance products, as measured by first year
premiums, were $157.4 million and $66.9 million for the first nine
months and third quarter of 2003, respectively, increases of 15% and 43%
compared with the same periods in 2002, as increased sales of universal
life insurance products were partially offset by lower sales of variable
universal life insurance products. Sales by LFA of LNC's individual
annuity products, as measured by deposits, increased $29.3 million, or
22% in the third quarter, but were down $23.0 million, or 6%, for the
first nine months of 2003, respectively, compared with the same periods
in 2002. Sales by LFA of Delaware retail mutual funds increased 17% and
59% for the first nine months and third quarter of 2003 compared with
the same periods in 2002. Overall fees received for financial plans
increased 10% in the first nine months of 2003 and 9% in the third
quarter of 2003 compared with the same periods of the prior year. The
average fees per plan as calculated on a rolling twelve month average
increased 3% for the twelve month period ending September 30, 2003
compared with the same period ending September 30, 2002.
Lincoln Financial Distributors ("LFD")
LFD net losses for the nine months and third quarter of 2002 included an
adjustment to expense previously deferred costs of $5.0 million and $6.3
million, respectively, related to specific initiatives to expand life
insurance sales. Excluding this item, LFD net losses increased $4.1
million for the nine months and $0.7 million for the three months ended
September 30, 2003 compared with the same periods in 2002. LFD's net
loss increased as lower sales reduced net revenues (gross revenues net
of variable expenses) for the nine months of 2003. Sales of Life
Insurance, Investment and Annuity product lines increased 6% for the
third quarter compared with the same period last year. Although sales
of Life Insurance and Investment products through LFD were up 12% for
the first nine months of 2003, sales of annuity products were down 23%
for the nine months of 2003 compared with 2002.
LNC Financing
LNC Financing costs were $13.7 million higher in the nine months ended
September 30, 2003 and $2.3 million higher in the three months ended
September 30, 2003 compared with the same periods in 2002. LNC Financing
for the nine and three month periods of 2002 included investment income
of $17.9 million and $3.8 million, respectively, from the proceeds of
the sale of LNC's reinsurance business to Swiss Re. During 2002, the
proceeds were reduced by the repurchase of LNC stock and various
financing activities. In December of 2002, the remaining proceeds were
allocated to LNC's business units, primarily the Lincoln Retirement and
Life Insurance segments. Excluding the investment income from the Swiss
Re proceeds, LNC's financing costs declined due to lower interest rates
and changes in LNC's debt structure, including the elimination of the
outstanding commercial paper balance in the U.K. in the second quarter
of 2002.
Other Corporate
Other Corporate's net loss increased $0.6 million in the first nine
months of 2003 and $1.3 million in the third quarter of 2003 compared
with the same periods in 2002.
Amortization of Deferred Gain
The amortization of the deferred gain on the indemnity reinsurance
transfer of LNC's reinsurance business to Swiss Re was lower for the
nine and three month periods ended September 30, 2003 compared with the
same periods in 2002 due primarily to adjustments during 2002 relating
to the settlement of disputed matters with Swiss Re.
Critical Accounting Policy -- Personal Accident and Disability Income
Reserves
During the nine-month and three-month periods ended September 30, 2003,
LNC recognized a loss of $20.9 million from charges required by FAS 113
on increases in certain reserves for personal accident business sold
through indemnity reinsurance to Swiss Re. Net losses for the same
periods of 2002 include adjustments for personal accident and disability
income reserves of $189.9 million and $175.5 million, respectively. As
a result of these charges and their effects on the deferred gain,
cumulative favorable catch-up adjustments of $2.2 million and $6.1
million, respectively, to the deferred gain amortization were recognized
in the third quarters of 2003 and 2002, respectively. See Note 6 to the
September 30, 2003 unaudited consolidated financial statements for
further discussion of this matter.
CONSOLIDATED INVESTMENTS
Sept 30, Dec 31, Sept 30,
(in billions) 2003 2002 2002
- ----------------------------------------------------------------------------
Assets Managed by Advisor
Investment Management Segment (1):
External Assets $55.1 $46.5 $43.4
Insurance Assets 43.0 41.1 40.4
Lincoln UK 6.9 6.4 6.1
Within Business Units (Policy Loans) 1.9 1.9 1.9
By Non-LNC Entities 23.9 20.0 18.9
------- ------- -------
Total Assets Managed $130.8 $115.9 $110.7
Total Invested Assets $42.4 $40.0 $39.4
Nine Months Ended Three Months Ended
September 30, September 30,
(in millions) 2003 2002 2003 2002
- ------------------------------------------------------------------------------------
Net Investment Income (pre-tax) $1,979.3 $1,964.6 $664.4 $652.4
Adjusted Net Investment Income
(pre-tax) (2) 1,985.2 1,969.6 666.8 653.9
Mean Invested Assets (cost basis, in
billions) 40,969.0 38,527.0 41,597.9 $39,175.8
Investment Yield (ratio of adjusted net
investment income to mean invested
assets) 6.46% 6.82% 6.41% 6.68%
(1) See Investment Management segment data for additional detail.
(2) Includes tax-exempt income on a tax equivalent basis.
The total investment portfolio increased $2.4 billion in the first nine
months of 2003 from December 31, 2002, resulting from purchases of
investments from cash flow generated by the business segments and an
increase in the fair value of securities available-for-sale.
LNC's insurance assets are invested primarily in high quality fixed
maturity securities that are expected to generate cash flows that will
enable LNC to meet the liability funding requirements of LNC's life
insurance and annuity businesses. LNC has the ability to maintain its
investment holdings throughout credit cycles because of its capital
position, the long-term nature of its liabilities and matching of LNC's
portfolios of investment assets with the liabilities of LNC's various
products.
The quality of LNC's fixed maturity securities portfolio, as measured at
fair value and by the percentage of fixed maturity securities invested
in various ratings categories relative to the entire fixed maturity
security portfolio, as of September 30, 2003 was as follows:
Treasuries and AAA 20.4% BBB 35.0%
AA 6.0% BB 4.3%
A 31.7% Less than BB 2.6%
The ratings data listed above have been determined by using the lowest
of all publicly available ratings assigned to a particular fixed
maturity security. If no public ratings exist, a rating is assigned
based upon LNC's analysis of the inherent risks of the individual
security.
As of September 30, 2003 and December 31, 2002, $2.4 billion, or 6.9%,
and $2.1 billion, or 6.6%, respectively, of all fixed maturity
securities were invested in below investment grade securities (less than
BBB). This represents 5.7% and 5.3% of the total investment portfolio at
September 30, 2003 and December 31, 2002, respectively. When viewed on a
cost basis, below investment grade securities held at September 30, 2003
and December 31, 2002 represented 7.6% and 8.4%, respectively, of fixed
maturity securities. When measured on cost basis, below investment
grade securities showed a decrease from December 31, 2002 levels which
resulted from asset sales, impairments and maturities.
LNC's fixed maturity securities include residential and commercial
mortgage-backed securities. Given that LNC's current product mix
reflects an emphasis on fixed products, LNC has been relatively
conservative in its asset allocation to residential mortgage-backed
securities. LNC manages its prepayment risk on residential
mortgage-backed securities by prudently limiting the portion of its
fixed maturity portfolio that is invested in the asset class, by
generally avoiding the purchase of securities with a cost that
significantly exceeds par and by purchasing securities with no more
prepayment sensitivity than the underlying collateral. LNC's investments
in residential mortgage-backed securities at September 30, 2003 and
December 31, 2002 totaled $2.7 billion and $3.1 billion, respectively,
representing 6.4% and 7.8% of total invested assets, respectively.
Investments in commercial mortgage-backed securities at September 30,
2003 and December 31, 2002 totaled $2.2 billion and $1.8 billion,
respectively, representing 5.2% and 4.5%, of total invested assets,
respectively.
The fair value of all private securities was $4.8 billion and $4.6
billion at September 30, 2003 and December 31, 2002, respectively,
representing 11.3% and 11.5% of total invested assets, respectively.
This excludes section 144 registered securities, which have fair values
that are readily available for these publicly-traded securities.
LNC's entire fixed maturity and equity securities portfolio is
classified as "available-for-sale" and is carried at fair value. Changes
in fair value, net of related deferred acquisition costs, amounts
required to satisfy policyholder commitments and taxes, are charged or
credited directly to shareholders' equity. Other than temporary declines
in fair value are recorded as realized losses in the income statement.
During the nine-month and three-month periods ended September 30, 2003,
LNC sold securities at gains and at losses. In the process of evaluating
whether a security with an unrealized loss reflects an other than
temporary decline, LNC considers its ability and intent to hold the
security until its value recovers. However, subsequent decisions on
securities sales are made within the context of overall risk monitoring,
assessing value relative to other comparable securities and overall
portfolio maintenance. Although LNC's portfolio managers may, at a given
point in time, believe that the preferred course of action is to hold
securities with unrealized losses that are considered temporary until
such losses are recovered, the dynamic nature of portfolio management
may result in a subsequent decision to sell. These subsequent decisions
are consistent with the classification of LNC's investment portfolio as
available-for-sale. LNC expects to continue to manage all invested
assets within its portfolios in a manner that is consistent with the
available-for-sale classification, except for certain invested assets
associated with reinsurance agreements that may be reclassified as
trading account assets. See discussion under "Accounting for Modified
Coinsurance" for more information.
Critical Accounting Policy -- Realized Gain (Loss) on Investments Sales
and Write-downs: LNC had net pre-tax realized losses on investments and
derivatives of $75.2 million and $221.2 million for the nine months
ended September 30, 2003 and 2002, respectively, and gains of $18.9
million and losses of $36.8 million for the three months ended September
30, 2003 and 2002, respectively.
Prior to the amortization of acquisition costs, provision for
policyholder commitments and investment expenses, net pre-tax realized
losses were $92.4 million and $331.6 million for the nine months ended
September 30, 2003 and 2002, respectively, while net pre-tax realized
gains were $79.9 million and net pre-tax losses were $62.0 million for
the three months ended September 30, 2003 and 2002, respectively.
Gross realized gains on fixed maturity and equity securities were $226.1
million and $101.2 million, and gross realized losses on fixed maturity
and equity securities were $305.9 million and $49.0 million for the
nine-month and three-month periods ended September 30, 2003,
respectively. The realized gains and losses exclude realized gains and
losses on equity securities related to participating policies in the
Lincoln UK segment. These realized gains and losses were credited to the
policyholder and did not affect LNC's net income. Included within losses
are write-downs for impairments of $209.4 million and $35.4 million in
the nine-month and three-month periods ended September 30, 2003,
respectively.
While realized losses from sales and write-downs occurred in a number of
sectors, approximately 60% of gross losses for the nine months ended
September 30, 2003, excluding the losses on equity securities in the
Lincoln UK segment described above, were attributed to losses on sales
and write-downs in airlines, electric utilities and asset-backed
securities ("ABS") including ABS investments collateralized by
manufactured housing receivables, as well as Collateralized Debt
Obligations (CDOs). In the third quarter of 2003, approximately 50% of
the gross losses were attributed to losses on sales and write-downs in
ABS, mainly from CDOs, and electric utilities. While both ABS and
electric utilities have continued to be the sectors with the largest
realized losses, 45% of total gross losses realized in the third quarter
2003 resulted from losses realized on two securities, one ABS and issued
by a recently bankrupt electric utility provider. The remaining gross
realized losses were distributed among several sectors and industries,
none of which represented more than 15% of total gross realized losses.
The following discussion provides details relating to gross realized
losses taken during the first nine months and third quarter of 2003 in
these sectors.
LNC's exposure to the airline sector is primarily equipment trust
certificates (ETCs) and enhanced equipment trust certificates (EETCs).
Aircraft owned or operated by domestic air carriers collateralize these
securities. The war in Iraq, continued weak economic data, intense
competition in the industry and the sale of several aircraft by one
domestic carrier all put downward pressure during the first half of 2003
on valuations of securities issued by domestic carriers. The sale of
aircraft in the first half of 2003 provided a market-clearing price for
used aircraft at levels lower than what the market had previously
anticipated. This resulted in a re-evaluation of the underlying
collateral in ETC and EETC structures. The combination of these factors,
along with increased concerns reflected in the market relating to the
potential bankruptcy filing for AMR Corporation, resulted in a $48.6
million write-down on AMR Corporation's ETCs to current market fair
value in the first quarter of 2003. There were no further losses
reported on AMR in the second or third quarter of 2003. The change in
valuation of the underlying aircraft and continued economic pressures on
the sector also led to additional write-downs of ETCs/EETCs for the nine
and three-month periods ended September 30, 2003 of $10.0 million and
$1.1 million, respectively.
Electric utility sector losses were taken on selected issuers whose
securities had not recovered with the rest of the electric utility
issues in the market. The deterioration of these securities, along with
a lack of improvement of the underlying credit, led to the determination
that the declines in value of these securities were other than
temporary. Losses taken in this sector totaled $57.1 million in the
first nine months of 2003 and $16.6 million in the third quarter of
2003.
ABS secured by manufactured housing receivables have experienced
deterioration in value, following the bankruptcy filing of a major
servicer in the industry. This servicer was granted changes to the
existing servicing agreements by the bankruptcy court. Servicing fees
were increased and were moved to a more senior position in the capital
structure. For those securities where the subordination was not at
levels high enough to withstand this increase in fees without impairing
value, write-downs of $14.1 million were recorded during the nine months
ended September 30, 2003, all of which occurred in the first quarter of
2003.
Deterioration in the underlying collateral pools of other ABS
investments during the first nine months of 2003 led to decreased
expectations of future cash flows. As a result, additional losses of
$51.4 million and $7.9 million, respectively, on various ABS holdings,
including CDOs, were also recorded during the nine-month and three-month
periods ended September 30, 2003. Sales, write-downs and amortization
have reduced LNC's CDO exposure from 1.6% of invested assets at December
31, 2002 to 1.4% of LNC's invested assets at September 30, 2003 as
measured on a cost basis, with over 90% of the CDOs remaining investment
grade. The unrealized loss position on the CDO portfolio has been
reduced to approximately $18.5 million. Any further deterioration or
additional realized losses in the CDO portfolio will depend on economic
factors such as economic growth, corporate profitability and future
asset default rates. Cash flow testing of the CDO portfolio as required
under EITF 99-20 supports the conclusion that these unrealized losses
are temporary. A full recovery of principal and interest is expected
under the current economic environment.
Following the strong rally in the credit markets that extended through
the third quarter 2003, especially in the higher risks sectors of the
market, several securities were liquidated in order to reposition the
below investment grade and investment grade investments. The
repositioning focused on securities whose risk profile was no longer
consistent with LNC's long-term investment strategy. This repositioning
resulted in realization of both gains and losses. The securities that
were liquidated during the third quarter were a diversified pool of
assets with no industry concentrations.
For additional information regarding LNC's process for determining
whether declines in fair value of securities available-for-sale are
other than temporary, see the discussion in LNC's Form 10-K for the year
ended December 31, 2002 under "Critical Accounting Policy Write-Downs
and Allowances for Losses."
Unrealized Gains and Losses: When considering unrealized gain and loss
information, it is important to realize that the information relates to
the status of securities at a particular point in time, and may not be
indicative of the status of LNC's investment portfolios subsequent to
the balance sheet date. Further, since the timing of the recognition of
realized investment gains and losses through the selection of which
securities are sold is largely at management's discretion, it is
important to consider the information provided below within the context
of the overall unrealized gain or loss position of LNC's investment
portfolios. These are important considerations that should be included
in any evaluation of the potential impact of unrealized loss securities
upon LNC's future earnings. LNC had an overall net unrealized gain
(after the amortization of acquisition costs, provision for policyholder
commitments, investment expenses and taxes) on securities
available-for-sale under FAS 115 of $804.5 million and $753.3 million at
September 30, 2003 and December 31, 2002, respectively.
At September 30, 2003 and December 31, 2002, gross unrealized gains on
securities available-for-sale were $2,789.3 million and $2,402.4
million, respectively, and gross unrealized losses on securities
available-for-sale were $281.9 million and $735.4 million, respectively.
At September 30, 2003, gross unrealized gains and gross unrealized
losses on fixed maturity securities available-for-sale were $2,761.5
million and $273.7 million, respectively, and gross unrealized gains and
losses on equity securities available-for-sale were $27.9 million and
$8.2 million, respectively. At December 31, 2002, gross unrealized gains
and gross unrealized losses on fixed maturity securities
available-for-sale were $2,355.2 million and $690.9 million,
respectively, and gross unrealized gains and losses on equity securities
available-for-sale were $47.2 million and $44.5 million, respectively.
Unrealized Losses on Securities Subject to Enhanced Analysis and
Monitoring: Within the portfolio of securities with unrealized losses
are certain securities that LNC has identified as exhibiting indications
that the decline in fair value may be other than a temporary decline in
value. Where detailed analysis by LNC credit analysts and investment
portfolio managers leads to the conclusion that a security's decline in
fair value is other than temporary, the security is written down to fair
value. In instances where declines are considered temporary, the
security will continue to be carefully monitored. The following
information is applicable to unrealized loss securities that were
subject to these enhanced analysis and monitoring processes.
For traded and private securities held by LNC at September 30, 2003 that
were subject to enhanced analysis and monitoring for potential changes
in unrealized loss status, the fair value, amortized cost, unrealized
loss and total time period that the security has been in an unrealized
loss position are presented in the table below.
Unrealized Losses -- Available-for-Sale Securities
Subject to Enhanced Analysis and Monitoring
September 30, 2003
% %
Fair % Fair Amortized Amortized Unrealized Unrealized
(000s omitted) Value Value Cost Cost Loss Loss
- --------------------------------------------------------------------------------------------------
<=90 days $45,470 15.1% $49,625 13.7% $(4,155) 6.6%
> 90 days but < =180 days 17,240 5.7% 19,091 5.2% (1,851) 3.0%
> 180 days but <= 270 days 17,647 5.8% 20,787 5.7% (3,140) 5.0%
> 270 days but <= 1 year 87,763 29.1% 105,786 29.0% (18,023) 28.9%
> 1 year 133,752 44.3% 169,051 46.4% (35,299) 56.5%
---------------------------------------------------------------------
Total $301,872 100% $364,340 100% $(62,468) 100%
=====================================================================
LNC has no concentrations of issuers or guarantors of fixed maturity and
equity securities. The composition by industry categories of securities
subject to enhanced analysis and monitoring for potential changes in
unrealized loss status held by LNC at September 30, 2003 is presented in
the table below.
Unrealized Losses by Industry Sector -- Available-for-Sale Securities
Subject to Enhanced Analysis and Monitoring
September 30, 2003
% %
% Fair Amortized Amortized Unrealized Unrealized
(000s omitted) Fair Value Value Cost Cost Loss Loss
- --------------------------------------------------------------------------------------------------
Electric $135,341 44.8% $159,029 43.6% $(23,688) 37.9%
Asset-Backed Securities 59,386 19.7% 72,396 19.9% (13,010) 20.8%
Airlines 30,354 10.1% 39,963 11.0% (9,609) 15.4%
Chemicals 21,000 7.0% 30,000 8.2% (9,000) 14.4%
Media Cable 16,000 5.3% 19,937 5.5% (3,937) 6.3%
CMBS 6,997 2.3% 9,479 2.6% (2,482) 4.0%
Financial Companies 4,384 1.5% 4,690 1.3% (306) 0.5%
Industrial Other 6,464 2.1% 6,716 1.8% (252) 0.4%
Consumer Cyclical 640 0.2% 769 0.2% (129) 0.2%
Textile 8,617 2.9% 8,672 2.4% (55) 0.1%
Pipeline 12,689 4.2% 12,689 3.5% -- 0.0%
---------------------------------------------------------------------
Total $301,872 100.0% $364,340 100.0% $(62,468) 100.0%
=====================================================================
At September 30, 2003 and December 31, 2002, about 23.1% and 9%,
respectively, of the traded and private securities held that were
subject to enhanced analysis and monitoring for potential changes in
unrealized loss status were rated as investment grade. The range of
maturity dates for these securities varies, with about 35% of these
securities maturing between 5 and 10 years, about 50% maturing in
greater than 10 years and the remaining securities maturing in less than
5 years.
Unrealized Loss on All Below-Investment-Grade Fixed Maturity Securities:
Gross unrealized losses on all below-investment-grade securities were
$149.1 million at September 30, 2003, representing 52.9% of total gross
unrealized losses on all available-for-sale securities, excluding the
available-for-sale securities in the Lincoln UK segment. Generally,
below-investment-grade fixed maturity securities are more likely than
investment-grade securities to develop credit concerns. The remaining
$132.8 million or 47.1% of the gross unrealized losses relates to
investment grade available-for-sale securities. The ratios of market
value to amortized cost reflected in the table below are not necessarily
indicative of the market value to amortized cost relationships for the
securities throughout the entire time that the securities have been in
an unrealized loss position nor are they necessarily indicative of these
ratios subsequent to September 30, 2003.
Unrealized Losses
Below-Investment-Grade Fixed Maturity Securities
September 30, 2003
Aging Category Amortized Unrealized
(000s omitted) Bk Mkt Ratio Fair Value Cost Loss
- -----------------------------------------------------------------------------
<=90 days 70% to 100% $272,351 $281,541 $(9,190)
40% to 70% -- -- --
Below 40% -- -- --
---------------------------------
<=90 days Total 272,351 281,541 (9,190)
>90 days but <=180 days 70% to 100% 158,467 165,067 (6,600)
40% to 70% 1,275 3,006 (1,731)
Below 40% -- 173 (173)
---------------------------------
>90 days but <=180 days Total 159,742 168,246 (8,504)
>180 days but <=270 days 70% to 100% 61,951 65,380 (3,429)
40% to 70% 300 500 (200)
Below 40% -- -- --
---------------------------------
>180 days but <=270 days Total 62,251 65,880 (3,629)
>270 days but <=1 year 7 0% to 100% 214,386 233,980 (19,594)
40% to 70% 14,682 21,297 (6,616)
Below 40% 454 1,168 (714)
---------------------------------
>270 days but <=1 year Total 229,522 256,445 (26,923)
>1 year 70% to 100% 481,191 560,599 (79,408)
40% to 70% 37,191 58,596 (21,405)
Below 40% -- -- --
---------------------------------
>1 year Total 518,382 619,195 (100,813)
Total Below-Investment-Grade $1,242,248 $1,391,307 $(149,059)
=================================
Unrealized Losses on All Securities: For total traded and private
available-for-sale securities held by LNC at September 30, 2003 that are
in unrealized loss status, the amortized cost, fair value, unrealized
loss and total time period that the security has been in an unrealized
loss position are presented in the table below.
Unrealized Losses -- All Available-for-Sale Securities
September 30, 2003
% %
% Fair Amortized Amortized Unrealized Unrealized
(000s omitted) Fair Value Value Cost Cost Loss Loss
- -------------------------------------------------------------------------------------------------
< 90 days 1,995,758 46.1% 2,032,415 44.0% (36,657) 13.0%
> 90 days but < 180 days 698,566 16.1% 726,809 15.8% (28,243) 10.0%
> 180 days but < 270 days 168,256 3.9% 178,140 3.9% (9,884) 3.5%
> 270 days but < 1 year 432,991 10.0% 479,481 10.4% (46,490) 16.5%
> 1 year 1,036,537 23.9% 1,197,154 25.9% (160,617) 57.0%
----------------------------------------------------------------------
Total 4,332,108 100.0% 4,613,999 100.0% (281,891) 100.0%
======================================================================
The composition by industry categories of total securities
available-for-sale in unrealized loss status, held by LNC at September
30, 2003 is presented in the table below.
Unrealized Losses by Industry Sector -- All Available-for-Sale Securities
September 30, 2003
% %
% Fair Amortized Amortized Unrealized Unrealized
(000s omitted) Fair Value Value Cost Cost Loss Loss
- ----------------------------------------------------------------------------------------------
Airlines $181,661 4.2% $231,375 5.0% $(49,714) 17.6%
Electric 511,925 11.8% 555,224 12.0% (43,299) 15.4%
Asset-backed securities 669,834 15.5% 707,391 15.3% (37,557) 13.3%
Banking 440,587 10.2% 463,925 10.1% (23,338) 8.3%
CMBS 119,846 2.8% 132,895 2.9% (13,049) 4.6%
Chemicals 57,813 1.3% 69,954 1.5% (12,141) 4.3%
Sovereigns 299,938 6.9% 312,042 6.8% (12,104) 4.3%
Automotive 92,306 2.1% 102,383 2.2% (10,077) 3.6%
Retailers 84,945 2.0% 92,455 2.0% (7,510) 2.7%
Refining 16,719 0.4% 23,400 0.5% (6,681) 2.4%
Pipelines 91,162 2.1% 97,630 2.1% (6,468) 2.3%
Industrial other 93,259 2.2% 98,533 2.1% (5,274) 1.9%
Metals and mining 77,412 1.8% 82,086 1.8% (4,674) 1.7%
Media cable 31,509 0.7% 35,854 0.8% (4,345) 1.5%
Consumer products 115,937 2.7% 120,238 2.6% (4,301) 1.5%
Wirelines 68,528 1.6% 72,390 1.6% (3,862) 1.4%
CMO 160,656 3.7% 164,389 3.6% (3,733) 1.3%
Transportation services 47,251 1.1% 49,669 1.1% (2,418) 0.9%
Food and beverage 90,388 2.1% 92,793 2.0% (2,405) 0.9%
Technology 65,409 1.5% 67,499 1.5% (2,090) 0.7%
Media Noncable 26,668 0.6% 28,468 0.6% (1,800) 0.6%
P&C 70,263 1.6% 71,927 1.6% (1,664) 0.6%
Municipal 83,519 1.9% 84,883 1.8% (1,364) 0.5%
Non captive consumer 29,128 0.7% 30,364 0.7% (1,236) 0.4%
Mortgage 15,082 0.3% 16,145 0.3% (1,063) 0.4%
Supermarkets 32,446 0.7% 33,471 0.7% (1,025) 0.4%
Industries with U/R
losses < $1mm 445,307 10.3% 454,110 9.8% (8,803) 3.1%
Lincoln UK fixed
maturity securities 290,177 6.7% 296,963 6.4% (6,786) 2.4%
Lincoln UK equity
securities 22,433 0.5% 25,543 0.6% (3,110) 1.1%
----------------------------------------------------------------------
Grand Total $4,332,108 100.0% $4,613,999 100.0% $(281,891) 100.0%
======================================================================
At September 30, 2003, the range of maturity dates for total traded and
private securities available-for-sale in unrealized loss status varies,
with about 29% maturing between 5 and 10 years, 50% maturing after 10
years and the remaining securities maturing in less than 5 years.
As of September 30, 2003, gross unrealized losses including assets held
at Lincoln UK totaled $281.9 million, a 4% improvement over gross
unrealized losses of $294.4 million at June 30, 2003. This improvement
occurred, despite a rise in interest rates during the quarter, as a
result of the continued rally in credit spreads during the third
quarter. As of September 30, 2003 there were unrealized losses of $153.9
million in the airline, electrical, ABS and banking sectors,
representing 54.6% of total unrealized losses. LNC's view of risk
factors at September 30, 2003 with respect to these industries is
presented below.
Airline holdings ended the third quarter 2003 with an unrealized loss of
$49.7 million, an improvement of $49.6 million over December 31, 2002.
In contrast to the airline securities that were written down, the
securities of relatively stronger carriers improved in market value
significantly during the third quarter. For these relatively stronger
airlines, LNC believes that the unrealized loss positions at September
30, 2003 are temporary, and LNC expects an ultimate recovery of full
principal and interest as these securities mature. All of LNC's airline
holdings in an unrealized loss position are secured as either ETC or
EETC structures. For the portion of the airline sector exposure that is
invested in EETC structures, LNC holds securities that are enhanced
through the liquidity facilities present in these securities and their
relatively higher quality aircraft collateral pools.
The electric utility sector had $43.3 million of unrealized losses at
September 30, 2003. During the first half of 2003, several utilities
were able to complete asset sales and secure the financing needed in
order to weather the trough in the energy cycle. The market is now
expecting those yet to secure financing will be able to do so at terms
that are palatable. The announcement in the first quarter of 2003 of the
settlement between the FERC and a large energy provider relieved some of
the concerns regarding the future litigation risks of all energy
providers in California. With the overhang of litigation and potentially
debilitating settlements mitigated, valuations of utility paper are
improving. LNC believes that as the over-capacity in the market for
electricity is rectified by increased economic activity and as old,
inefficient power plants are taken off-line, margins should begin to
revert to mid-cycle valuations. As this cycle progresses, LNC expects to
see further improvement in this sector and believes that the unrealized
losses in this sector are temporary.
The asset-backed securities (ABS) exposure of the LNC portfolio ended
the third quarter of 2003 with an unrealized loss of $37.6 million. Of
this amount, $18.5 million relates to CDOs and $11.3 million relates to
ABS secured by manufactured housing receivables. CDOs have experienced
pressure due to the nature of the assets, poor collateral experience and
the specific risk of downgrade for individual tranches held by LNC. LNC
has performed the cash flow testing required by EITF 99-20 and, based on
that analysis, anticipates full recovery of principal and interest. As a
result, these unrealized losses are considered temporary.
ABSs secured by manufactured housing receivables have experienced
deterioration in value following the bankruptcy filing of a major
servicer in the industry. This servicer was granted changes to the
existing servicing agreements by the bankruptcy court. Servicing fees
were increased and were moved to a more senior position in the capital
structure. For those securities that were adversely affected by this
change, LNC recorded write-downs in the first three months of 2003. No
additional losses were recorded on ABS secured by manufactured housing
receivables in the second or third quarters of 2003. Where LNC held
positions that are not believed to be affected by the change in fee
structure, LNC expects to fully recover principal and interest.
The majority of unrealized loss in the banking sector is economically
offset by unrealized gains in the derivative portfolio for hedging that
is related to these securities. Of the $23.3 million of unrealized loss
in the banking industry, $12.7 million is related to securities with
offsetting derivative gains. The unrealized gain on the derivative
positions relating to these securities was $25.6 million at the end of
the third quarter 2003. All the underlying credits that have been
swapped have an average rating of A+ and LNC does not anticipate any
credit-related losses on these securities.
Unrealized Loss on Fixed Maturity Securities Available-for-Sale in
Excess of $10 million: As of September 30, 2003, LNC held fixed maturity
securities available-for-sale with gross unrealized losses of $10
million, or greater, as discussed below:
Fixed Maturity Securities
Unrealized Losses Greater Than $10 million
September 30, 2003
Fair Amortized Unrealized Length of Time
(000s omitted) Value Cost Loss in a Loss Position
- -------------------------------------------------------------------------------------
Investment Grade
ABS secured by Manufactured >270 days but <=1
Housing Receivables $46,904 $57,850 $(10,946) year
--------------------------------
Total Investment Grade $46,904 $57,850 $(10,946)
Non-Invest Grade
U.S. Based International
Airline $51,519 $71,503 $(19,984) >1 year
U.S. Based Utility Company 36,685 46,997 (10,312) >1 year
--------------------------------
Total Non-Investment Grade $88,204 $118,500 $(30,296)
================================
The information presented above is subject to rapidly changing
conditions. As such, LNC expects that the level of securities with
overall unrealized gains and losses will fluctuate, as will the level of
unrealized loss securities that are subject to enhanced analysis and
monitoring.
Mortgage Loans on Real Estate: As of September 30, 2003, mortgage loans
on real estate and investments in real estate represented 9.8% and 0.6%
of LNC's total investment portfolio, respectively. As of September 30,
2003, the underlying properties supporting the mortgage loans on real
estate consisted of 38.3% in commercial office buildings, 23.1% in
retail stores, 17.6% in industrial buildings, 9.8% in apartments, 7.6%
in hotels/motels and 3.6% in other. In addition to the dispersion by
property type, the mortgage loan portfolio is geographically diversified
throughout the United States.
The following summarizes key information on mortgage loans:
September 30, December 31,
(in millions) 2003 2002
--------------------------------
Total Portfolio (net of reserves) $4,151.5 $4,205.5
Impaired mortgage loans $89.6 $72.3
Impaired mortgage loans as a percentage of
total mortgage loans 2.2% 1.7%
Mortgage loans two or more payments
delinquent (including in process of foreclosure) -- $1.9
Restructured loans in good standing $34.3 $4.6
Reserve for mortgage loans $13.9 $11.9
All mortgage loans that are impaired have an established allowance for
credit loss. Changing economic conditions impact LNC's valuation of
mortgage loans. Current market data, such as local vacancy, rental,
discount and capitalization rates, are incorporated into the discounted
cash flow analysis that LNC performs for monitored loans and may
contribute to the establishment of (or an increase in) an allowance for
credit losses. In addition, LNC continues to monitor its entire
commercial mortgage portfolio to identify risks. Areas of current
emphasis are the hotel mortgage loan portfolio and retail, office and
industrial properties anchored by deteriorating credits or experiencing
debt coverage reduction. Where warranted, LNC has established or
increased loss reserves based upon this analysis. Impaired mortgage
loans as a percentage of total mortgage loans at September 30, 2003 have
increased over the last year as a result of increased credit losses in
the sectors noted above, but have remained at a level consistent with
December 31, 2002. This percentage was 2.2%, 1.7%, 0.6%, 0.5%, 0.6%,
0.8%, 1.1%, 1.9% and 3.9% as of September, 30, 2003, December 31, 2002,
2001, 2000, 1999, 1998, 1997, 1996 and 1995, respectively.
As of September 30, 2003 and December 31, 2002, the fair value of fixed
maturity securities available-for-sale, mortgage loans on real estate and
real estate which were non-income producing for the nine-month and twelve
month periods was $60.4 million and $37.3 million, respectively.
Net Investment Income
Net investment income was flat in the nine-month and three-month periods
ended September 30, 2003 when compared with the same periods of 2002.
The overall yield on investments decreased to 6.46% from 6.82% for the
nine months ended September 30, 2003 compared to the same period in
2002. The decrease in the yield was primarily due to lower interest
rates on new securities purchased along with additional security
defaults during the last year. The mean invested assets increased 6.3%
for the nine months ended September 30, 2003 compared to the first nine
months of 2002. This increase was due primarily to positive fixed
annuity flows and new life insurance business generated over the last
year.
REVIEW OF CONSOLIDATED FINANCIAL CONDITION
Liquidity, Cash Flow and Capital Resources
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 in the September 30, 2003
unaudited consolidated financial statements indicates that operating
activities provided cash of $609.2 million during the first nine months
of 2003. This statement also classifies the other sources and uses of
cash by investing activities and financing activities and discloses the
total amount of cash available 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 July 2001, the LNC Board authorized the repurchase of $500 million of
LNC's securities. On August 8, 2002, the LNC Board authorized the
repurchase of up to an additional $600 million of LNC securities. The
remaining amount under the combined repurchase authorization at
September 30, 2003 was $675.1 million.
In July 2003 LNC redeemed the $200 million 7.40% TOPr'S issued by
Lincoln Capital III and guaranteed by LNC. A loss of $3.7 million
related to unamortized issuance costs is reported in the third quarter
of 2003 related to the redemption. In September, LNC issued $150
million of 6.75% Junior Subordinated Debentures, Series F. The
debentures mature September 11, 2052 and can be redeemed for principal
plus accrued interest beginning September 11, 2008. Proceeds from the
offering will be used for general corporate purposes.
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, the
acquisition of two blocks of business in 1998 resulted in negative
statutory earned surplus for LNL which triggered certain approval
requirements in order for LNL to declare and pay dividends to LNC. As a
result of negative earned surplus, LNL was required to obtain the prior
approval of the Indiana Insurance Commissioner ("Commissioner") before
paying any dividends to LNC until its statutory earned surplus became
positive. During the first quarter 2002, LNL received approval from the
Commissioner to reclassify total dividends of $495 million paid to LNC
in 2001 from LNL's earned surplus to paid-in-capital. This change plus
the increase in statutory earned surplus from the indemnity reinsurance
transaction with Swiss Re resulted in positive statutory earned surplus
for LNL at December 31, 2001.
In general, dividends are not subject to prior approval from the
Commissioner provided LNL's statutory earned surplus is positive and
such dividends do not exceed the standard limitation of the greater of
10% of total statutory earned surplus or the amount of statutory
earnings in the prior calendar year. As a result of the payment of
dividends and statutory losses in 2002, LNL's statutory earned surplus
was negative as of December 31, 2002. The statutory losses resulted from
realized losses on investments, the effect of the equity markets and the
reserve strengthening in 2002 related to the reinsurance business sold
to Swiss Re. Due to the negative statutory earned surplus as of December
31, 2002, any dividend(s) paid by LNL in 2003 will be subject to prior
approval from the Commissioner. During the first nine months of 2003,
LNL received approval from the Commissioner and paid dividends of $134
million to LNC. As occurred in 2001, dividends approved and paid while
statutory earned surplus is negative have been classified as a reduction
to paid-in-capital.
LNL is recognized as an accredited reinsurer in the state of New York,
which effectively enables it to conduct reinsurance business with
unrelated insurance companies that are domiciled within the state of New
York. As a result, in addition to regulatory restrictions imposed by the
state of Indiana, LNL is also subject to the regulatory requirements
that the state of New York imposes upon accredited reinsurers.
A key component of managing LNC's overall liquidity and capital position
is managing the capital of LNC's insurance subsidiaries. The level of
capital maintained in the domestic insurance subsidiaries is subject to
the requirements of the NAIC's risk based capital ("RBC"). While
maintaining capital within the requirements of the NAIC RBC formula is a
primary focus, LNC actively monitors similar capital quality measures
produced by the rating agencies. These models are subject to adjustment
from time-to-time and, together with potential NAIC RBC adjustments,
could impact LNC's ongoing capital and liquidity management.
As of September 30, 2003, LNC's senior debt ratings were Moody's at A3
("Upper Medium Grade"), Standard and Poor's at A- ("Strong"), Fitch at A
("Strong") and A.M. Best at "a" ("Strong"), and LNC's commercial paper
ratings included Moody's at P-2 ("Strong"), Standard and Poor's at A-2
("Satisfactory") and Fitch at F-1 ("Very Strong"). Although there are
fewer investors for A-2/P-2 commercial paper and there are periods when
there is weak investor interest in A-2/P-2 commercial paper, through
September 30, 2003, LNC's liquidity has not been adversely impacted by
the A-2/P-2 ratings. LNC can draw upon alternative short-term borrowing
facilities such as revolving bank lines of credit to meet its liquidity
needs.
On the average, LNC's commercial paper borrowing rates have increased
0.20% per annum since LNC was downgraded to an A-2/P-2 issuer. However,
historically there have been times of greater volatility in commercial
paper borrowing rates for an A-2/P-2 issuer with the spread above
A-1/P-1 rates ranging from 0.10% to 0.50%. During such times of greater
volatility, LNC may experience difficulty in placing longer-term
commercial paper (defined as 30-90 day maturities), and as a result,
experience increased short-term financing costs.
Total shareholders' equity increased $238.9 million during the nine
months ended September 30, 2003. Accumulated other comprehensive income
increased shareholders' equity by $61.1 million. The components of the
changes to accumulated other comprehensive income were: $46.0 million
related to the increase in the net unrealized gain on securities
available-for-sale and derivative instruments, $16.2 million related to
a change in the accumulated foreign exchange adjustment, and a decrease
of $1.1 million related to the effect of foreign currency changes on the
minimum pension liability adjustment. Excluding changes due to other
comprehensive income, shareholders' equity increased $177.8 million.
This increase is due to $317.6 million of net income, $10.1 million from
the issuance/forfeiture of common stock under benefit plans and a $30.4
million net increase to additional paid-in to record stock-based
compensation and decreases due to $180.4 million from the declaration of
dividends to shareholders.
Contingencies
Refer to Note 5 to the September 30, 2003 unaudited consolidated
financial statements for information regarding contingencies.
Item 3. Quantitative and Qualitative Disclosure of Market Risk
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LNC provided a discussion of its market risk in Item 7A of its 2002
Annual Report on Form 10-K for the year ended December 31, 2002. During
the first nine months of 2003, there was no substantive change to LNC's
market risk except for the items noted below:
Interest Rate Risk -- Falling Rates.
As discussed in the Quantitative and Qualitative Disclosures About
Market Risk section of LNC's annual report on Form 10-K for the year
ended December 31, 2002, interest spreads would be at risk on LNC's
fixed annuity and interest-sensitive whole life, universal life and
fixed portion of variable universal life insurance policies if interest
rates continued to fall and remained lower for a period of time. The
following table provides detail on the difference between interest
crediting rates and minimum guaranteed rates as of September 30, 2003.
For example, at September 30, 2003, there are $2,392.9 billion of
combined Retirement and Life Insurance account values where the excess
of the crediting rate over contract minimums is between 1.01% and 1.50%.
The analysis presented below ignores any non-guaranteed elements within
the life insurance products such as cost of insurance or expense loads
which, for many products, may be redetermined in the event that interest
margins deteriorate below the level that would cause the credited rate
to equal the minimum guaranteed rate.
Excess of Crediting Rates over Contract Minimums
------------------------------------------------
As of September 30, Retirement Life Total %
2003 (in millions) Account Values Account Values Account Values Account Values
- ---------------------------------------------------------------------------------------
CD and On-Benefit
type annuities $4,859.0 $-- $4,859.0 15.2%
Discretionary rate
setting products
No difference 6,862.0 2,725.4 9,587.4 29.9%
up to .1% 55.0 -- 55.0 0.2%
..11% to .20% 139.0 16.4 155.4 0.5%
..21% to .30% 204.0 632.9 836.9 2.6%
..31% to .40% 5,519.0 114.6 5,633.6 17.6%
..41% to .50% 251.0 342.3 593.3 1.9%
..51% to .60% 65.0 333.9 398.9 1.2%
..61% to .70% 76.0 1,401.8 1,477.8 4.6%
..71% to .80% 249.0 209.1 458.1 1.4%
..81% to .90% 865.0 130.9 995.9 3.1%
..91% to 1.0% 965.0 2,712.4 3,677.4 11.5%
1.01% to 1.50% 559.0 1,833.9 2,392.9 7.5%
1.51% to 2.00% 401.0 286.2 687.2 2.1%
2.01% to 2.50% 59.0 148.1 207.1 0.6%
2.51% to 3.00% 2.0 4.1 6.1 0.0%
3.01% and above 2.0 -- 2.0 0.0%
Total Discretionary
rate setting products 16,273.0 10,892.0 27,165.0 84.8%
Grand Total $21,132.0 $10,892.0 $32,023.9 100.0%
* For purposes of this exhibit, contracts currently within new money
rate bands are grouped according to the corresponding portfolio rate
band in which they will fall upon their first anniversary.
Equity Market Exposures.
See the discussion captioned Fourth Quarter 2003 Guidance for the
Estimated Effect of Equity Market Volatility for updated guidance for
the estimated effect of equity market volatility.
The following is a discussion of changes to LNC's derivative positions.
Derivatives
As discussed in Note 7 to the consolidated financial statements for the
year ended December 31, 2002, LNC has entered into derivative
transactions to reduce its exposure to fluctuations in interest rates,
the risk of changes in liabilities indexed to LNC stock, credit risk and
foreign exchange risk. In addition, LNC is subject to risks associated
with changes in the value of its derivatives; however, such changes in
value are generally offset by changes in the value of the items being
hedged by such contracts. Modifications to LNC's derivative strategy
are initiated periodically upon review of the Company's overall risk
assessment. During the first nine months of 2003, the more significant
changes in LNC's derivative positions are as follows:
1. Entered into 1.3 billion notional of interest rate cap agreements
that are used to hedge its annuity business against the negative impact
of a significant and sustained rise in interest rates. A total of 0.2
billion notional expired resulting in a total remaining 2.4 billion
notional. The expiration in notional resulted in no gain or loss.
2. Allowed its use of swaptions that are used to hedge its annuity
business against the negative impact of a significant and sustained rise
in interest rates to decrease from 180.0 million notional to 0.0 million
notional. The decrease in notional is a result of expirations and resulted
in no gain or loss.
3. Entered into interest rate swap agreements hedging floating rate bond
coupon payments in the amount of 40.0 million notional. A total of 15.3
million notional expired resulting in a total remaining 453.8 million
notional. These interest rate swap agreements convert floating rate
bond coupon payments into a fixed rate of return. No gain or loss was
recognized as a result of the expirations. In addition, entered into a
forward starting interest rate swap in the amount of 220.0 million
notional that was hedging the forecasted sale of commercial mortgage
loans. The sale occurred during the third quarter and the entire swap
was terminated resulting in a gain of $7.8 million.
4. Entered into foreign exchange forward contracts in the amount of 53.0
million notional that are hedging the foreign currency exposure of a
portion of LNC's investment in its Lincoln UK subsidiary. A total of
71.9 million notional expired resulting in a total remaining 24.0
million notional. No gain or loss was recognized as a result of the
expirations.
5. Decreased its use of credit default swaps from 26.0 million notional
to 8.0 million notional. The decrease in notional is a result of
expirations and resulted in no gain or loss. LNC uses credit default
swaps to hedge against a drop in bond prices due to credit concerns of
certain bond issuers.
6. Entered into 0.3 million call options on an equal number of shares of
LNC stock, resulting in a total of 1.5 million call options on an equal
number of shares of LNC stock. A total of 0.1 million call options were
terminated, resulting in a gain of $0.1 million. These call options are
hedging the increase in liabilities arising from stock appreciation
rights granted on LNC stock. Additional stock appreciation rights were
granted to LNC agents during the first quarter of 2003.
7. Entered into financial future contracts in the amount of 59.3 million
notional. These futures are hedging the liability exposure on certain
options in variable annuity products. A total of 39.5 million notional
expired or was closed resulting in a total remaining 19.8 million notional.
No gain or loss was recognized as a result of the expirations or
terminations.
8. Decreased its use of foreign currency swaps from 61.4 million
notional to 60.9 million notional. This reduction in notional resulted
in a gain of $0.1 million. These foreign currency swap agreements are
part of a hedging strategy. LNC owns various foreign issue securities.
Interest payments from these securities are received in a foreign
currency and then swapped into U.S. dollars.
LNC is exposed to credit loss in the event of non-performance by
counterparties on various derivative contracts. However, LNC does not
anticipate non-performance 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.
Item 4 -- Controls and Procedures
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LNC maintains disclosure controls and procedures, which are designed to
ensure that information required to be disclosed in the reports it files
or submits under the Securities Exchange Act of 1934, as amended (the
"Exchange Act"), is recorded, processed, summarized and reported within
the time periods specified in the Securities and Exchange Commission's
rules and forms, and that such information is accumulated and
communicated to the Company's management, including its Chief Executive
Officer and Chief Financial Officer, as appropriate to allow timely
decisions regarding required disclosure.
An evaluation of the effectiveness of LNC's disclosure controls and
procedures as of September 30, 2003 was conducted under the supervision
and with the participation of LNC's Chief Executive Officer and Chief
Financial Officer. Based on that evaluation, the LNC's Chief Executive
Officer and Chief Financial Officer have concluded that LNC's disclosure
controls and procedures were adequate and designed to ensure that
material information relating to LNC and its consolidated subsidiaries
would be made known to the Chief Executive Officer and Chief Financial
Officer by others within those entities, particularly during the periods
when periodic reports under the Exchange Act are being prepared.
Furthermore, there has been no change in the LNC's internal control over
financial reporting, identified in connection with the evaluation of
such control, that occurred during LNC's last fiscal quarter that has
materially affected, or is reasonably likely to materially affect, LNC's
internal control over financial reporting. Refer to the Certifications
by the Company's Chief Executive Officer and Chief Financial Officer
filed as exhibits to this report.
PART II -- OTHER INFORMATION AND EXHIBITS
Items 1, 2, 3, 4 and 5 of this Part II are either inapplicable or are
answered in the negative and are omitted pursuant to the instructions to
Part II.
Item 6. Exhibits and Reports on Form 8-K
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(a) The following Exhibits of the Registrant are included in this
report.
Note: The number preceding the exhibit corresponds to the specific
number within Item 601 of Regulation S-K.)
4.1 Amended and Restated Trust Agreement dated September 11, 2003, between
Lincoln, as Depositor, and Bank One Trust Company, National Association, as
Property Trustee, Bank One Delaware, Inc., as Delaware Trustee, and the
Administrative Trustees named therein. (incorporated by reference to
Exhibit 4.1 of the Corporation's current report on Form 8-K filed on
September 16, 2003).
4.2 Form of 6.75% Trust Preferred Security certificate. (incorporated by
reference to Exhibit 4.2 of the Corporation's current report on Form 8-K
filed on September 16, 2003).
4.3 Form of 6.75% Junior Subordinated Deferrable Interest Debentures, Series
F (incorporated by reference to Exhibit 4.3 of the Corporation's current
report on Form 8-K filed on September 16, 2003).
4.4 Guarantee Agreement dated September 11, 2003, between Lincoln, as
Guarantor, and Bank One Trust Company, National Association, as Guarantee
Trustee (incorporated by reference to Exhibit 4.4 of the Corporation's
current report on Form 8-K filed on September 16, 2003).
12 Historical Ratio of Earnings to Fixed Charges
21 List of Subsidiaries of LNC
31 Certifications of the Chief Executive Officer and the Chief Financial
Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32 Certifications of the Chief Executive Officer and the Chief Financial
Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
(b) Reports on Form 8-K
During the three months ended September 30, 2003, the following Current
Reports on Form 8-K were filed with or furnished to the SEC by LNC:
1. Form 8-K furnished to the SEC on August 7, 2003 under Item 9
containing the Statistical Supplement for the quarter ended June 30,
2003.
2. Form 8-K furnished to the SEC on August 7, 2003 under Item 12
containing: (1) Lincoln Financial Group press release dated August 4,
2003, announcing actions Lincoln will be taking to position its
businesses for emerging opportunities and providing details on a
previously announced realignment and (2) Lincoln Financial Group press
release dated August 7, 2003, announcing Lincoln National Corporation's
2003 2nd quarter earnings.
3. Form 8-K filed with the SEC on August 29, 2003 under Item 5
containing a Restatement (reflecting the expensing of options) of the
various Items and Schedules from Annual Report on Form 10-K for the year
ended December 31, 2002, originally filed March 13, 2003 and a related
Consent of Ernst & Young LLP, Independent Auditors.
4. Form 8-K filed with the SEC on September 16, 2003 under Item 5
containing an underwriting agreement and various other documents related to
an offering of Trust Preferred Securities, Series F.
SIGNATURE PAGE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
LINCOLN NATIONAL CORPORATION
By /S/ Richard C. Vaughan
----------------------
Richard C. Vaughan,
Executive Vice President and
Chief Financial Officer
By /S/ Casey J. Trumble
----------------------
Casey J. Trumble,
Senior Vice President and Chief
Accounting Officer
Date November 4, 2003
- -------------------------
LINCOLN NATIONAL CORPORATION
Exhibit Index for the Report on Form 10-Q
for the Quarter Ended September 30, 2003
Exhibit Number Description Page Number
- -------------- ----------- -----------
12 Historical Ratio of Earnings to
Fixed Charges 69
21 List of Subsidiaries of LNC 72-93
31 Additional Exhibit -- Section 302
Certifications 70
32 Additional Exhibit -- Section 906
Certifications 71
Note: This is an abbreviated version of the Lincoln National Corporation
Form 10-Q. Copies of the exhibits (pages 67-99) are not attached. Copies
of these exhibits are available electronically at www.sec.gov or by
writing to the Corporate Secretary at Lincoln National Corporation,
Centre Square, 1500 Market Street, Suite 3900, Philadelphia,
Pennsylvania 19102-2112