Lincoln National Corporation (LNC) Q3 2012 Earnings Report, Transcript and Summary

Good morning, and thank you for joining Lincoln Financials Group Third Quarter 2012 Earnings Conference Call. [Operator Instructions] At this time, I would like to turn the conference over to Senior Vice President of Investor Relations, Jim Sjoreen. Please go ahead, sir.

Thank you, operator, and good morning, and welcome to Lincoln's third quarter earnings call. Before we begin, I have an important reminder. Any comments made during the call regarding future expectations, trends and market conditions, including comments about liquidity and capital resources and income from operations are forward-looking statements under the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from current expectations. These risks and uncertainties are described in the cautionary statement disclosures in our earnings release issued yesterday and our reports on Forms 8-K, 10-Q and 10-K filed with the SEC. We appreciate your participation today and invite you to visit Lincoln's website, www.lincolnfinancial.com, where you can find our press release and statistical supplement, which include a full reconciliation of the non-GAAP measures used in the call, including income from operations and return on equity, to their most comparable GAAP measures. Presenting on today's call are Dennis Glass, President and Chief Executive Officer; and Randy Freitag, Chief Financial Officer. After their prepared remarks, we will move to the question-and-answer portion of the call. So at this time, I would like to turn the call over to Dennis.

Thank you, Jim. Good morning, everyone. Knowing many of you on the phone live or work in the Northeast, let me first say Lincoln hopes your families, friends and colleagues are safe following the storm. Now turning to our results. Lincoln had another overall good quarter with our performance driven by many of the actions we have talked about during the course of the year. On a normalized basis, we ended the third quarter with operating return on equity at 11%. And compared to the prior year quarter, income from operations per share is up 14%, operating revenue growth a little better -- up a little better than 3.5%. Actions that contributed to these results include: Significant sharebacks -- buybacks driven by strong earnings, redundant reserve financings and the allocation of capital from the Lifeline as we raised prices and saw somewhat lower sales; distribution expansion and reorganization that resulted in improved sales in Group and Retirement Plan Services; product repricing that help maintain a good return on capital associated with new sales, as well as a pivot to products that are good consumer solutions and priced better given low interest rates and finally, crediting rate actions that help mitigate the interest margin impact of low investment yields. Our investment portfolio maintains an overall A- rating, and we continue to invest in high-quality fixed income securities. Our net unrealized gain on our investment portfolio has increased to $9.4 billion or 13% of assets. This is a record level of unrealized gains, the amount reflecting a long duration of our invested assets, which is driven by our asset liability management practices. We also continue to pursue incremental yield opportunities that provide attractive risk-adjusted returns such as expanding our sourcing for private placements, middle-market loans and increasing the overall commitment to our…

Thank you, Dennis. Last night, we reported income from operations of $335 million or $1.18 per share for the third quarter, while normalized operating EPS grew 14% to $1.06 per share. I'll get to the buy segment results in a bit, but let me start by talking about some of the larger items that impacted the quarter's results starting with the annual review of actuarial assumptions, which we completed during the quarter. The net impact of the assumption review on operating income was a small positive, an additional positive impact on net income. Notable assumption changes included: A reduction in our interest rate assumption or what we refer to as the J curve. The change included resetting the new money rate to current levels and then grading to the ultimate new money rate, which was reduced by 50 basis points over a period of 7 years. Well that's a perfectly good description of what went into the change. It might be more illuminating to talk about the outcome, which is that for the first 3 to 4 years, new money rates essentially follow the forward curve. After that, the forward curve flattens out a bit relative to our assumption. We will obviously continue to assess and review this assumption. But for now, I feel very good about where we are. The total impact of this change was negative $120 million with the majority of the impact in the Life business. A change in our life mortality assumption to reflect mortality performing better than that assumed in our DAC models. This had a positive impact of $105 million. And finally, refinements through variable annuity policyholder behavior assumptions that had a small impact on the annuity results accounted for all of the positive net income impact. Additionally, during the quarter, we had…

[Operator Instructions] Our first question comes from Suneet Kamath from UBS.

First question is on the DAC review. I guess, Randy, you didn't unlock for the positive equity markets, I'm assuming giving your commentary so that sort of remains, I'll call it a cushion out there. So first, is that correct? And then second, if you did unlock that mean reversion, how much of a positive unlock would that have been?

Yes, Suneet, you're absolutely correct. We did not unlock that assumption. It remains in the -- that range of $200 million to $250 million.

And is that pretax or after tax?

That's a pretax number.

Okay. And then, I guess, my second question is just on the interest rate sensitivity. Almost a year ago, I think you gave us your reserve redundancy of like $8 billion and then moving to $6 billion if we stayed in a 2% 10-year treasury world for 10 years. And I guess since then, a couple of things have changed. Obviously, yields have come in a little bit. I think corporate spreads are a little tighter and then you have AG38 get some clarity. So sort of factoring in those 3 things and anything else that will influence that, how are you thinking about that $6 billion number now?

Well, Suneet, first, it's a fourth quarter analysis, the appointed actuary and the team are focused on doing that work as we approach the end of the year. As we sit here today based upon the environment that existed over the last year, I think we've performed pretty much in line with our expectations. I don't expect material changes, but work's being done here in the fourth quarter.

So we'll get an update on that analysis when you guys report fourth quarter earnings?

I would assume we'll eventually give an update on that.

Our next question comes from Chris Giovanni from Goldman Sachs.

Can you maybe just provide an update in terms of kind of continued philosophy around capital management actions related to buybacks, the dividends, as well as well as further debt paydown?

Sure, Chris. Well, as always, it is the -- we're approaching our November Board meeting which typically when we discuss dividends with the Board. So I'll hold off on that assumption. At a macro level, we remain very well-capitalized. We have a very strong capital position, strong cash flow, strong ability to push cash to the holding company. So the number, on a normalized basis, continues in that $400 million range. Obviously, we're leveraging a bit. Our strong capital position this year, as I mentioned in my notes, expect to go over that $400 million number this year. So we're not going to give you a specific guidance, but we're not done for the year. We remain well-capitalized. We have a lot of cash at the holding company, strong position in life companies and we'll remain very proactive.

Okay. And then you made some additional comments in terms of asset classes you're expanding to within the investment portfolio. I think last quarter, you talked about maybe 15 to 20 point of RBC drag from taking on incremental risk. I guess, has that changed? And then as you increase exposure to alternatives, just managing kind of the volatility within the investment income line.

Well, Chris, let me first say that broadly speaking, our program, which includes increasing alternatives, sourcing additional private placements, sourcing additional middle-market loans, not all of those activities are a call on RBC. We did about 425 million of that so far this year, and we expect that the return on it would be 250 basis points above over time what we'd get on investment grade corporates. So we are pushing that as one of our yield enhancement strategies. Again, very cautious about getting the right risk-adjusted returns. I don't think that we see this as a dramatic change in our RBC, but Randy may want to expand on that.

Dennis, I'd absolutely agree. Chris, as I said in the past, when we look forward distributing capital the way we're distributing, we expect RBC ratio to drift down 10 to 15, 20 points a year, so just as we project forward and the risk in the organization grows, et cetera. So we'll look at these programs. They do use a little more incremental capital, but I don't expect that they'll fundamentally change that analysis, Chris.

Our next question comes from Ryan Krueger from Dowling. Ryan Krueger - Dowling & Partners Securities, LLC: How should we think about the impact of the mortality adjustments to the Life DAC assumptions? And I guess my question relates to the go-forward operating earnings impact. Should we think about getting some negative go-forward implications since you've now assumed a better mortality assumption that's already baked in?

Ryan, no, looking forward, I would expect no negative impact relative to the assumption. How I'd think of the assumption change is no different than I think of any other assumption change. Ryan, as with all these things, when we get credible information, we reflect it in our models. We did that on the J curve side and that was also the case in the mortality side. We had a lot of credible information. Obviously, we're a large player in the Life Insurance business. We have a lot of data that we can use. We were running better than our DAC models, and so we reflected that in the models net of positive benefit, but no impact on go-forward earnings. Ryan Krueger - Dowling & Partners Securities, LLC: Okay. And then a broader question. It's pretty clear that you guys have been frustrated with your stocks valuation. And over the last year, I guess, we've seen Genworth monetize a couple of Life Insurance blocks that's freed up capital at 20x the lost cap earnings. You also have seen Hartford of their individual Life business that freed up capital at 12x GAAP earnings. You're structured at 6x earnings, and I think it's fair to assume that a lot of that relates to the individual Life business. So I understand there's differences between the businesses, but why not look to monetize at least some portion of your individual Life block to capitalize on the apparent valuation discrepancy? Any thoughts there would be appreciated.

Yes, this is Dennis. Let me say, like you, we're very aware of all of the capital management opportunities that are in the marketplace, and we'll select the ones that we think translate into best shareholder value over the long term. So right now, share buybacks is the best place to put excess capital, but we'll continue to look at the trade-offs.

Ryan, let me also mention that every time we do a reserve financing, we're generating capital from the Life business. So I can't think of anybody in the industry who's done more reserved financings than us. So we have capability there. We've used that capability in the past. It helped us do things like accelerate share buybacks. So we're not standing still. We're generating capital. We've talked about -- very openly about the price increases we've put through on the Life side which lowers sales, which frees up capital. So I think we are being very proactive on that front.

Our next question comes from Steven Schwartz from Raymond James & Associates. Steven D. Schwartz - Raymond James & Associates, Inc., Research Division: A couple here. First, I think for Randy, the discussion of the J curve, if I understood you correctly, tell me if I'm wrong, that you're assuming that for 3 to 5 years, rates kind of follow the yield curve -- the forward yield curve and then you move from there to assuming some type of parallel shift in the curve. Is that the way to think about this?

So let me go through this again. First off, you mentioned that the absolute -- the key point, which is that for the next 3 to 4 years, we're very tight with the forward curve. Just factually, if you look at the forward curve after that, it flat -- it really does sort of flattened out. Even though I think it's really -- it's anybody's guess what rates will be 5 years from now, but just the forward curve itself flattens out after the 3- to 4-year period. While our assumption continues to move up. We moved down that ultimate rate by 50 basis points, but we go from current rates to that ultimate rate over a period of 7 years. So in the last half or so of that 7-year period, we're going to deviate a little. I feel very good about where we are today. We'll obviously, we'll continue to assess this. We've done this a couple times. Very proactive, I think we get in front of these assumptions as good as anybody, so we'll continue to assess, but we're happy where we are today. Steven D. Schwartz - Raymond James & Associates, Inc., Research Division: Okay. Relative to AG38, how are you feeling about the reserves on the in-force block?

Yes, I'll handle that. Let me first say that the resolution that was approved, I guess, in last 60 days, was a very satisfactory one for the regulators, for the companies. We know it has 2 pieces, 1 is retroactive and 1 is new business. To specifically answer your question, although we have a little more work to do as we get toward the year end, we don't expect any significant increase in our aggregate reserves as a result of the adoption of the retroactive change. On a new money -- new business basis, reserves are a little higher, we've anticipated that in some of our repricings that we've already done. And as we get into the new year, whether or not we'll have to take further action, will depend on all of the considerations that go into pricing new business. Steven D. Schwartz - Raymond James & Associates, Inc., Research Division: Okay, that was actually going to be my next question. So new business, it's -- you're basically using, at least right now, you're basically using the same types of products, the same design of products, just lifting rate a little bit?

Yes. But there -- my point was that independent of the design, the new AG38 requirements across different designs for new business reserve requirements are higher. My point was that we anticipated some of that in the pricings that we did this year, and that next year, we'll look at if we have to do more.

Our next question comes from Mark Finkelstein from Evercore Partners.

I guess my first question, just going back to the DAC division is if you were to actually go down to the curve in terms of the long-term assumptions, the forward curve, what would the DAC impact have been on that basis?

Mark, let me take [ph] you back to the sensitivities we've been giving for a long, long time because they don't changed, which is each 50 basis points is roughly $125 million. I think our curve relative to that flattening in the forward curve roughly 80 to 85 basis points of difference,I think, out there at the ultimate point. So you can do the interpolation. But once again, key point for those first 3 to 4 years, tight of that forward curve. We feel very good about where we are today.

I would just add to that, on a present value basis, if would be hard for you actually do that calculation because on a present value basis, it's the early years that make the big difference just to -- as we all know that what happens when you're doing discounted flows.

It's a fair point.

Okay. I guess in the fourth quarter, you'll kind of go through your goodwill review and share that with us. And I guess I'm just -- theoretically, do you go through that study any differently this year than you did in the past? And I guess I'm thinking about Met a little bit in terms of that charge that they took yesterday, which was very much related to a fair value test. You guys historically have kind of used that as a first step and then kind of in step two, did the -- kind of looked at the future value of new business, et cetera, to justify that goodwill. I'm just curious if you look at the study any differently this year, just kind of knowing how valuations have continued to be very depressed.

Well, Mark, first off, it's an accounting-based test, it's a 2-step test, so I don't think the way one company does it is any different than another company. But let's talk about us specifically. You're right, absolutely right. We do this analysis in the fourth quarter, so I'm not going to get in front of that analysis. But let's talk a little bit about the facts that we do know. It's about 4 years ago when we got ahead of this issue and wrote down our annuity goodwill by $600 million. I would note that, that impact was driven by an increase in the discount rate to the Annuity business. Over the last 4 years, we've written-off 100% of the goodwill behind our media business. And last year end, I think we got in front of the Life issue with a $650 million write-down. So we're doing the analysis as we speak, but we have been very proactive. I think we've been out in front of these issues for the last 4 to 5 years, and I feel very good about where we are today.

Our next question comes from Jeff Schuman from KBW. Jeffrey R. Schuman - Keefe, Bruyette, & Woods, Inc., Research Division: I was wondering if we could talk a bit more about mortality. It was just a few years ago there was a lot of concerns about industry pricing and underwriting for higher ages and big-face amounts and concerns about life settlement folks kind of picking off the industry. Now we see you making a favorable adjustment to your mortality assumptions behind DAC. I mean, can we interpret from that, that you feel pretty good about how that older age underwriting and pricing is holding up?

Jeff, we have always felt good about our underwriting and our mortality experience. Mortality, for as long as I've been alive has been getting better and our underwriters have done a great job of reflecting these trends and changes over time. So we have always felt good. I feel great that this quarter, we had the credibility, enough information to reflect that in the models, but we're in a great place and we've never really had a hiccup in mortality if you go back over the decades.

Jeff, I'll just add the -- just stepping back and looking at the overall DAC adjustments, but we've talked about all the issues in the Variable Annuity business as to why we're getting good results. We talked about the Life business. But a part of all of this is that as we're pricing products and this is inside baseball and hard to compare to other companies, we simply just don't push every one of the assumptions to the corner of the envelope. We try to take a very practical and reasonable approach to what might evolve over time, and here's an example of where it's actually -- even though we -- mortality's improving, it's still better than we had anticipated.. Jeffrey R. Schuman - Keefe, Bruyette, & Woods, Inc., Research Division: That's very helpful there. And if I can ask one other area, I haven't looked at for a while. I'm just surprised that the media revenues don't seem to be up that much this year. I would have thought with some of the heavy political advertising in some of your markets in Florida and Colorado, et cetera, that we'd see more lift there. Should we look forward to a little more pick up in the fourth quarter?

Jeff, I can't speak to specifics there. I think the political advertising has been a little late to the game this year. So I think you're probably right. We haven't seen much in the third quarter. Now we'll see if any comes in the fourth quarter. But remember that not all of our stations are in what are called the "swing states" where all the advertising is going on.

And a lot of it, Jeff, as we all have seen on TV rather than radio. But the last point Randy made is the best point, which is it's very location-specific. Jeffrey R. Schuman - Keefe, Bruyette, & Woods, Inc., Research Division: Yes, [indiscernible] thought. I think you're in Florida and Colorado still, which I think are pretty active but maybe it varies within those markets as well.

Our next question comes from Eric Berg from RBC Capital Markets.

In any case, I wanted to get a sense for sort of where you stand in terms of the competitiveness of your variable annuity. Dennis, in your prepared remarks, you rightly indicated that many companies have been pulling back. Historically Lincoln has been a follower, probably a good thing rather than the leader in terms of offering rich guarantees. As the landscape has shifted, where do you now stand?

Well, Eric, I think I'm going to stick with the general comment that we both in the Life and Annuity line, we're seeing competitors announce changes. You'd have to get into a lot of detail to say where in each product line and what sell, for example, in Life where we stand. But generally, in the Lifeline, prices are going up on GUL, people are making changes that haven't made changes in the early part of the year. And in the Annuity business, we're seeing people lower payout benefits, seeing them increase premiums. At this point in time, although the competitors have come closer to where we are already, the combination of the strength of our distribution and the overall positioning that we have is still pretty good. We picked up a little bit of market share, might pick up a little bit more. But as you know, we don't look at market share as a driver here. We look at putting well-priced products, well-hedged products into the market that are good consumer values and good return and risk profile for our shareholders.

My second question relates to what would appear to be a growing, maybe a trend. It's not clear whether it's a trend, but developments in the marketplace regarding some of your competitors, Principal, Prudential, entering into these pension closeout transactions. My question is one that I haven't had a chance to ask before of others, so I'd like to ask it of you and your colleagues at Lincoln. It's my sense that from talking to the consulting actuaries that everybody, not just the insurance industry, but pension plan sponsors have sort of not gotten it right with respect to longevity risk, have repeatedly underestimated the pace of progress in lifespans, and that therefore, we should have some concerns perhaps about the ability of life insurance companies such as your competitors and Lincoln -- should it pursue this business -- to price these pension closeouts correctly because of the risk of getting longevity risk wrong given the industry's history. Is that -- is my assessment of the history correct that there has been a problem in pricing longevity risk? And what is Lincoln's appetite for this business? That's it for today.

Eric, I'm going to leave the specifics of the answer to that question to the people who are in the business because we're not in the business. Let me tell you why we're not in the business. We're not in the business because we are almost 100% focused on the manufacture and distribution of retail products, which requires a distribution network. It requires product manufacturing capability. It requires good service across the board. It's a holistic view as to how to get good returns on your money. We've never been in wholesale businesses where somebody's on the phone calling up for funding dollars overnight and then trying to take some type of either ALM risk or credit risk, I mean, that's not anything that we've ever been in or do we plan to go into. So we like what we do, which is building a holistic approach to making money on real retail product.

[Operator Instructions] Our next question comes from Jimmy Bhullar from JPMorgan. Jamminder S. Bhullar - JP Morgan Chase & Co, Research Division: I had a question first on, just your Disability business. And overall, obviously, pretty strong results this quarter, but the Disability margins did weaken a lot. And I remember a couple of years ago, you had an issue where margins compressed; they had been improving. So just wondering what drove the uptick in loss ratios in both the Disability and maybe to a lesser extent, the Group Life business. And then secondly, just on capital deployment, you've been buying back stock at a steady pace. I just wanted to see what your appetite would be for acquisitions or block transactions because there are certainly several of them in the market. And if you are interested in those, what areas would you be interested in, in terms of the businesses?

Jimmy, let me take the first one and Dennis will take the second one. First off, back to my remarks, I do believe that the economic environment we're in is giving you a little more quarter-to-quarter volatility that we're used to. But when you look at it over time, I think you're seeing results that, on average, are within our targeted range. Factually this quarter, but if the Group business was severity that was a little higher than we probably [indiscernible] expect. So we dug through the business. We've done a ton of analysis and don't see anything systemic about that other than sort of an ordinary blip. In fact, I think if you look at the LTD loss ratios, this quarter really stands out compared to the 4 or 5 before it which were all very reasonable loss ratios. So we don't see a systemic nature in what occurred this quarter but it was little bit a severity.

With respect to M&A, we've been straightforward with, I think, our comments on this, which is one, we've got a very good history with this team of pricing and integrating acquisitions and have used that as a tool to grow shareholder value for a long time. So we're quite comfortable trying to find deals that do that. The areas that we're most interested are the Group Protection business and Retirement Plan Services. And as opportunities in those areas come along, we will be taking a look at them. As we've also said, at least for the capital that could otherwise -- our excess capital that could otherwise be used for share repurchases, the litmus test for return on those acquisitions is higher than it's been in the past. That would capture... Jamminder S. Bhullar - JP Morgan Chase & Co, Research Division: That's given the lower stock price and then user buybacks as an alternative?

Excuse me? Jamminder S. Bhullar - JP Morgan Chase & Co, Research Division: That's just the hurdle rate's higher just because the stock price is lower and you could use the money for buybacks otherwise?

Well, let me say it the way we think about it which is we look at what we think we can get on as a return on buying our stock and that becomes sort of best indicator of what we would expect from an investment return perspective. I think we... Jamminder S. Bhullar - JP Morgan Chase & Co, Research Division: And overall, it seems like in the benefits and the pension market, there are actually more interested buyers than there are sellers, at least that's been my impression, what's your view?

Again, we've been doing this for 10 years and there's always some company that has more enthusiasm for a property than another company has or, at a moment in time, a particular business. So maybe right now, there's a little more interest in one business versus the other. These things change over time, and I think it persists consistent approach to sourcing, pricing deals and eventually, something will happen.

And I'm showing no further questions at this time. I will turn the call back over to Jim Sjoreen for closing comments.

Thank you, operator, and we want to thank all of you for joining us this morning. As always, if you have any additional questions, you can contact me directly at (484)583-1420, or via our Investor Relations line at 1 (800) 237-2920. Again, thank you for your time this morning, and have a good weekend.

Thank you, ladies and gentlemen. That does conclude today's conference. You may all disconnect, and have a wonderful day.