LINCOLN NATIONAL CORP
Item 1. Business
OVERVIEW
Lincoln National Corporation (“LNC,” which also may be referred to as “Lincoln,” “we,” “our” or “us”) is a holding company, which operates multiple insurance and retirement businesses through subsidiary companies. Through our business segments, we sell a wide range of wealth protection, accumulation and retirement income products and solutions. These products include fixed and indexed annuities, variable annuities, universal life insurance (“UL”), variable universal life insurance (“VUL”), linked-benefit UL, term life insurance, employer-sponsored retirement plans and services, and group life, disability and dental. LNC was organized under the laws of the state of Indiana in 1968. We currently maintain our principal executive offices in Radnor, Pennsylvania. “Lincoln Financial Group” is the marketing name for LNC and its subsidiary companies. As of December 31, 2011, LNC had consolidated assets of $202.9 billion and consolidated stockholders’ equity of $14.2 billion.
We provide products and services and report results through four segments as follows:
Business Segments
Annuities
Retirement Plan Services (formerly known as the “Defined Contribution Segment”)
Life Insurance
Group Protection
We also have Other Operations, which includes the financial data for operations that are not directly related to the business segments.
As a result of entering agreements of sale for Lincoln National (UK) plc (“Lincoln UK”) and Delaware Management Holdings, Inc. (“Delaware”) during 2009, we have reported the results of these businesses as discontinued operations on our Consolidated Statements of Income (Loss) for all periods presented and the assets and liabilities, prior to the sale, as held for sale on our Consolidated Balance Sheets. For further information, see “Acquisitions and Dispositions” below.
The results of Lincoln Financial Network (“LFN”) and Lincoln Financial Distributors (“LFD”), our retail and wholesale distributors, respectively, are included in the segments for which they distribute products. LFD distributes our individual products and services, defined contribution plans and corporate-owned UL and VUL (“COLI”) and bank-owned UL and VUL (“BOLI”) products and services. The distribution occurs primarily through consultants, brokers, planners, agents, financial advisors, third-party administrators (“TPAs”) and other intermediaries. Group Protection distributes its products and services primarily through employee benefit brokers, TPAs and other employee benefit firms. As of December 31, 2011, LFD had approximately 560 internal and external wholesalers (including sales managers). As of December 31, 2011, LFN offered LNC and non-proprietary products and advisory services through a national network of approximately 8,150 active producers who placed business with us within the last 12 months.
Financial information in the tables that follow is presented in conformity with accounting principles generally accepted in the United States of America (“GAAP”), unless otherwise indicated. We provide revenues, income (loss) from operations and assets attributable to each of our business segments and Other Operations in Note 22. Assets, revenues and earnings attributable to foreign activities were not material in the periods presented.
Acquisitions and Dispositions
On January 8, 2009, the Office of Thrift Supervision approved our application to become a savings and loan holding company and our acquisition of Newton County Loan & Savings, FSB (“NCLS”), a federally regulated savings bank located in Indiana. We closed on our purchase of NCLS on January 15, 2009. On July 25, 2011, NCLS submitted a voluntary plan of dissolution with the Officer of the Comptroller of the Currency (“OCC”). The OCC approved NCLS’s voluntary dissolution effective November 30, 2011.
On August 18, 2009, we entered into a purchase and sale agreement with Macquarie Bank Limited (“MBL”), pursuant to which we agreed to sell to MBL all of the outstanding capital stock of Delaware, our former subsidiary, which provided investment products and services to individuals and institutions. This transaction closed on January 4, 2010, with net of tax proceeds of approximately $405 million.
In addition, certain of our subsidiaries, including The Lincoln National Life Insurance Company (“LNL”), our primary insurance subsidiary, entered into investment advisory agreements with Delaware dated January 4, 2010, pursuant to which Delaware will continue to manage the majority of the general account insurance assets of the subsidiaries. The investment advisory agreements will have 10-year terms, and we may terminate them without cause, subject to a purchase price adjustment of up to $67 million in the event that all of the agreements with our subsidiaries are terminated. The amount of the potential adjustment declines on a pro rata basis over the 10-year term of the advisory agreements.
On October 1, 2009, we completed the sale of the capital stock of Lincoln UK to SLF of Canada UK Limited for net of tax proceeds of $325 million. We retained Lincoln UK’s pension plan assets and liabilities. The former Lincoln UK segment primarily focused on providing life and retirement income products in the United Kingdom.
On November 12, 2007, Lincoln Financial Media Company (“LFMC”), our wholly-owned subsidiary, entered into two stock purchase agreements with Raycom Holdings, LLC (“Raycom”). Pursuant to one of the agreements, LFMC agreed to sell to Raycom all of the outstanding capital stock of three of LFMC’s wholly-owned subsidiaries: WBTV, Inc., the owner and operator of television station WBTV, Charlotte, North Carolina; WCSC, Inc., the owner and operator of television station WCSC, Charleston, South Carolina; and WWBT, Inc., the owner and operator of television station WWBT, Richmond, Virginia. The transaction closed on March 31, 2008, and LFMC received proceeds of $546 million. Pursuant to the other agreement, LFMC agreed to sell to Raycom all of the outstanding capital stock of Lincoln Financial Sports, Inc., a wholly-owned subsidiary of LFMC. This transaction closed on November 30, 2007, and LFMC received $42 million of proceeds.
On November 12, 2007, LFMC also entered into a stock purchase agreement with Greater Media, Inc., to sell all of the outstanding capital stock of LFMC of North Carolina, the owner and operator of radio stations WBT(AM), Charlotte, North Carolina; WBT-FM, Chester, South Carolina; and WLNK(FM), Charlotte, North Carolina. This transaction closed on January 31, 2008, and LFMC received proceeds of $100 million. More information on these LFMC transactions can be found in our Form 8-K filed on November 14, 2007.
On April 3, 2006, we completed our merger with Jefferson-Pilot Corporation (“Jefferson-Pilot”), pursuant to which Jefferson-Pilot merged into one of our wholly-owned subsidiaries. Prior to the merger, Jefferson-Pilot, through its subsidiaries, offered full lines of individual life, annuity and investment products, and group life insurance products, disability income and dental contracts, and it operated television and radio stations and a sports broadcasting network.
For further information about acquisitions and divestitures, see Note 3.
BUSINESS SEGMENTS AND OTHER OPERATIONS
ANNUITIES
Overview
The Annuities segment provides tax-deferred investment growth and lifetime income opportunities for its clients by offering fixed (including indexed) and variable annuities. The “fixed” and “variable” classifications describe whether we or the contract holders bear the investment risk of the assets supporting the contract. This also determines the manner in which we earn investment margin profits from these products, either as investment spreads for fixed products or as asset-based fees charged to variable products.
Annuities have several features that are attractive to customers. First, they provide tax-deferred growth on the underlying principal, thereby deferring the tax consequences of the growth in value until withdrawals are made from the accumulation values, often at lower tax rates occurring during retirement. Second, annuities are unique in that contract holders can select a variety of payout alternatives to help provide an income flow for life. Many annuity contracts include guarantee features (living and death benefits) that are not found in any other investment vehicle and, we believe, make annuities attractive especially in times of economic uncertainty.
Products
In general, an annuity is a contract between an insurance company and an individual or group in which the insurance company, after receipt of one or more premium payments, agrees to pay an amount of money either in one lump sum or on a periodic basis (i.e., annually, semi-annually, quarterly or monthly), beginning on a certain date and continuing for a period of time as specified in
the contract or as requested. Periodic payments can begin within 12 months after the premium is received (referred to as an immediate annuity) or at a future date in time (referred to as a deferred annuity). This retirement vehicle helps protect an individual from outliving his or her money.
Variable Annuities
A variable annuity provides the contract holder the ability to direct the investment of premium deposits into one or more sub-accounts offered through the product (“variable portion”) or into a fixed account with a guaranteed return (“fixed portion”). The value of the variable portion of the contract holder’s account varies with the performance of the underlying sub-accounts chosen by the contract holder.
We charge mortality and expense assessments and administrative fees on variable annuity accounts to cover insurance and administrative expenses. These assessments are built into accumulation unit values, which when multiplied by the number of units owned for any sub-account equals the contract holder’s account value for that sub-account. The fees that we earn from these contracts are reported as insurance fees on our Consolidated Statements of Income (Loss). In addition, for some contracts, we collect surrender charges that range from 0% to 10% of withdrawals when contract holders surrender their contracts during the surrender charge period, which is generally higher during the early years of a contract.
We offer guaranteed benefit riders with certain of our variable annuity products, such as a guaranteed death benefit (“GDB”), a guaranteed withdrawal benefit (“GWB”), a guaranteed income benefit (“GIB”) and a combination of such benefits. Most of our variable annuity products also offer the choice of a fixed option that provides for guaranteed interest credited to the account value.
The GDB features offered in 2011 included those where we contractually guarantee to the contract holder that upon death, depending on the particular product, we will return no less than: the current contract value; the total deposits made to the contract, adjusted to reflect any partial withdrawals; the highest contract value on a specified anniversary date adjusted to reflect any partial withdrawals following the contract anniversary; or the current contract value plus a specified percentage of contract earnings, not to exceed a covered earnings limit.
In 2011, we offered product riders including the Lincoln Lifetime IncomeSM Advantage, Lincoln Lifetime IncomeSM Advantage 2.0 and Lincoln Lifetime IncomeSM Advantage Plus, which are hybrid benefit riders combining aspects of GWB and GIB. These benefit riders allow the contract holder the ability to take income at a maximum rate of 4% or 5% of the guaranteed amount when they are above the lifetime income age or income through i4LIFE® Advantage with the GIB. Lincoln Lifetime IncomeSM Advantage, Lincoln Lifetime IncomeSM Advantage 2.0 and Lincoln Lifetime IncomeSM Advantage Plus provide higher income if the contract holder delays withdrawals, including both a 5% enhancement to the guaranteed amount each year a withdrawal is not taken for a specified period of time and an annual step-up of the guaranteed amount to the current contract value. The Lincoln Lifetime IncomeSM Advantage Plus provides an additional benefit, which is a return of principal at the end of the seventh year if the customer has not taken any withdrawals. Contract holders under Lincoln Lifetime IncomeSM Advantage, Lincoln Lifetime IncomeSM Advantage 2.0 and Lincoln Lifetime IncomeSM Advantage Plus are subject to restrictions on the allocation of their account value within the various investment choices.
We also offered the i4LIFE® Advantage and 4LATER® Advantage. The i4LIFE® Advantage rider, on which we have received a U.S. patent, allows variable annuity contract holders access and control during the income distribution phase of their contract. This added flexibility allows the contract holder to access the account value for transfers, additional withdrawals and other service features like portfolio rebalancing. In general, GIB is an optional feature available with i4LIFE® Advantage that guarantees regular income payments will not fall below the greater of a minimum income floor set at benefit issue, or 75% of the highest income payment on a specified anniversary date (reduced for any subsequent withdrawals). 4LATER® Advantage provides a minimum income base used to determine the GIB floor when a client begins income payments under i4LIFE® Advantage. The income base is equal to the initial deposit, or contract value, if elected after issue, and increases by 15% every three years, subject to a 200% cap. The owner may step up the income base to the current contract value on or after the third anniversary of rider election or of the most recent step-up, which also resets the 200% cap.
The Lincoln SmartSecurity® Advantage one-year benefit is a GWB rider that offers the contract holder a guarantee equal to the initial deposit (or contract value, if elected after issue), adjusted for any subsequent purchase payments or withdrawals. Lincoln SmartSecurity® Advantage one-year allows an owner to step up the guarantee amount automatically on the benefit anniversary to the current contract value if the contract value is greater than the guarantee amount at the time of step up. To receive the full amount of the guarantee, annual withdrawals are limited to 5% of the guaranteed amount. Withdrawals will continue until the longer of when the guarantee is equal to zero or for the rest of the owner’s life (“single life version”) or the life of the owner or owner’s spouse (“joint life version”) as long as withdrawals begin after attained age 65 and are limited to 5% of the guaranteed amount. Withdrawals in excess of the applicable maximum in any contract year are assessed any applicable surrender charges, and the guaranteed amount is recalculated.
We design and actively manage the features and structure of our guaranteed benefit riders to maintain a competitive suite of products consistent with profitability and risk management goals. To mitigate the increased risks associated with guaranteed
benefits, we developed a dynamic hedging program. The customized dynamic hedging program uses equity and interest rate futures positions, interest rate and variance swaps, as well as equity-based options depending upon the risks underlying the guarantees. For more information on our hedging program, see “Critical Accounting Policies and Estimates - Derivatives” and “Realized Gain (Loss) and Benefit Ratio Unlocking” in the MD&A. For information regarding risks related to guaranteed benefits, see “
Item 1A. Risk Factors
You should carefully consider the risks described below before investing in our securities. The risks and uncertainties described below are not the only ones facing our company. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations. If any of these risks actually occur, our business, financial condition and results of operations could be materially affected. In that case, the value of our securities could decline substantially.
Legislative, Regulatory and Tax
Our businesses are heavily regulated and changes in regulation may affect our insurance subsidiary capital requirements or reduce our profitability.
Our insurance subsidiaries are subject to extensive supervision and regulation in the states in which we do business. The supervision and regulation relate to numerous aspects of our business and financial condition. The primary purpose of the supervision and regulation is the protection of our insurance contract holders, and not our investors. The extent of regulation varies, but generally is governed by state statutes. These statutes delegate regulatory, supervisory and administrative authority to state insurance departments. This system of supervision and regulation covers, among other things:
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Standards of minimum capital requirements and solvency, including RBC measurements;
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Restrictions of certain transactions between our insurance subsidiaries and their affiliates;
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Restrictions on the nature, quality and concentration of investments;
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Restrictions on the types of terms and conditions that we can include in the insurance policies offered by our primary insurance operations;
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Limitations on the amount of dividends that insurance subsidiaries can pay;
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The licensing status of the company;
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Certain required methods of accounting;
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Reserves for unearned premiums, losses and other purposes; and
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Assignment of residual market business and potential assessments for the provision of funds necessary for the settlement of covered claims under certain policies provided by impaired, insolvent or failed insurance companies.
Although we endeavor to maintain all required licenses and approvals, our businesses may not fully comply with the wide variety of applicable laws and regulations or the relevant authority’s interpretation of the laws and regulations, which may change from time to time. Also, regulatory authorities have relatively broad discretion to grant, renew or revoke licenses and approvals. If we do not have the requisite licenses and approvals or do not comply with applicable regulatory requirements, the insurance regulatory authorities could preclude or temporarily suspend us from carrying on some or all of our activities or impose substantial fines. Further, insurance regulatory authorities have relatively broad discretion to issue orders of supervision, which permit such authorities to supervise the business and operations of an insurance company. As of December 31, 2011, no state insurance regulatory authority had imposed on us any substantial fines or revoked or suspended any of our licenses to conduct insurance business in any state or issued an order of supervision with respect to our insurance subsidiaries, which would have a material adverse effect on our results of operations or financial condition.
In addition, Lincoln Financial Advisors, Lincoln Financial Securities and LFD, as well as our variable annuities and variable life insurance products, are subject to regulation and supervision by the SEC and FINRA. These laws and regulations generally grant supervisory agencies and self-regulatory organizations broad administrative powers, including the power to limit or restrict the subsidiaries from carrying on their businesses in the event that they fail to comply with such laws and regulations.
Recently, there has been an increase in potential federal initiatives that would affect the financial services industry. On July 21, 2010, President Obama signed into law the Dodd-Frank Act, a wide-ranging Act that includes a number of reforms of the financial services industry and financial products. The Dodd-Frank Act includes, among other things, changes to the rules governing derivatives; restrictions on proprietary trading by certain entities; the imposition of capital and leverage requirements on bank and
savings and loan holding companies; a study by the SEC of the rules governing broker-dealers and investment advisers with respect to individual investors and investment advice, followed potentially by rulemaking; the creation of a new Federal Insurance Office within the U.S. Treasury to gather information regarding the insurance industry; the creation of a resolution authority to unwind failing institutions, funded on a post-event basis; the creation of a new Consumer Financial Protection Bureau to protect consumers of certain financial products; and changes to executive compensation and certain corporate governance rules, among other things. The Dodd-Frank Act requires significant rulemaking across numerous agencies within the federal government. Although the rulemaking process began in the second half of 2010, it is proceeding substantially slower than the aggressive schedule contemplated at the time of enactment. Consequently, the ultimate impact of these provisions on our businesses (including product offerings), results of operations, liquidity or capital resources is currently indeterminable.
Many of the foregoing regulatory or governmental bodies have the authority to review our products and business practices and those of our agents and employees. In recent years, there has been increased scrutiny of our businesses by these bodies, which has included more extensive examinations, regular sweep inquiries and more detailed review of disclosure documents. These regulatory or governmental bodies may bring regulatory or other legal actions against us if, in their view, our practices, or those of our agents or employees, are improper. These actions can result in substantial fines, penalties or prohibitions or restrictions on our business activities and could have a material adverse effect on our business, results of operations or financial condition.
Changes to the calculation of reserves and attempts to mitigate the impact of Regulation XXX and Actuarial Guideline 38 may fail in whole or in part resulting in an adverse effect on our financial condition and results of operations.
The Valuation of Life Insurance Policies Model Regulation (“XXX”) requires insurers to establish additional statutory reserves for term life insurance policies with long-term premium guarantees and UL policies with secondary guarantees. In addition, Actuarial Guideline 38 (“AG38”), commonly known as “AXXX,” clarifies the application of XXX with respect to certain UL insurance policies with secondary guarantees. Virtually all of our newly issued term and the majority of our newly issued UL insurance products are now affected by XXX and AG38. The application of both AG38 and XXX involve numerous interpretations. In the fourth quarter of 2011, the Life Actuarial Task Force, an advisory group to the Life Insurance and Annuities (A) Committee of the NAIC, submitted a draft statement on the application of AG38 (the “Statement”) to the Committee. The NAIC’s Executive Committee set up a joint working group (the “Joint Working Group”) comprised of members of the Life Insurance and Annuities (A) Committee and the Financial Condition (E) Committee to review the Statement and the current application of AG38 to determine whether new interim guidelines should be developed for the products within the scope of AG38. The Joint Working Group has developed a draft framework that proposes to evaluate in-force reserves based on an asset adequacy analysis incorporating moderately adverse scenarios. New business written after a certain date, yet to be specified, would be reserved using a formulaic approach consistent with the Statement, as modified or clarified by the NAIC. Any interim guidelines would be in place only until principles-based reserving is implemented. Because the draft framework contains many open issues, we cannot predict its impact on our statutory reserves. However, a change to the method for calculating reserves may require us to significantly increase our statutory reserves for UL policies with secondary guarantees. Further, changes in the method of calculating reserves may also impact the future profitability and sales of our UL insurance policies with secondary guarantees.
We have implemented reinsurance and capital management actions to mitigate the capital impact of XXX and AG38, including the use of letters of credit to support the reinsurance provided by captive reinsurance subsidiaries. Although formal details have not been provided, we anticipate the rating agencies may require a portion of these letters of credit to be included in our leverage calculations, which would pressure our leverage ratios and potentially our ratings. Therefore, we cannot provide assurance that there will not be regulatory, rating agency or other challenges to the actions we have taken to date. The result of those potential challenges could require us to increase statutory reserves or incur higher operating and/or tax costs.
We also cannot provide assurance that we will be able to continue to implement actions to mitigate the impact of XXX or AG38 on future sales of term and UL insurance products. If we are unable to continue to implement those actions, we may have lower returns on such products sold than we currently anticipate and/or reduce our sales of these products.
Changes in U.S. federal income tax law could increase our tax costs and make the products that we sell less desirable.
Changes to the Internal Revenue Code, administrative rulings or court decisions could increase our effective tax rate, make our products less desirable and lower our net income. For example, on February 14, 2011, the Obama Administration released its fiscal year 2012 budget proposal including proposals which, if enacted, would affect the taxation of life insurance companies and certain life insurance products. If enacted into law, the statutory changes contemplated by the Administration’s revenue proposals would, among other things, change the method used to determine the amount of dividend income received by a life insurance company on assets held in separate accounts used to support products, including variable life insurance and variable annuity contracts, that are eligible for the dividend received deduction. The dividend received deduction reduces the amount of dividend income subject to tax and is a significant component of the difference between our actual tax expense and expected amount determined using the federal statutory tax rate of 35%. Our income tax provision for the year ended December 31, 2011, included a separate account dividend received deduction benefit of $112 million. In addition, the proposals would affect the treatment of COLI policies by limiting the availability of certain interest deductions for companies that purchase those policies. If proposals of this type were
enacted, our sale of COLI, variable annuities and variable life products could be adversely affected and our actual tax expense could increase, reducing earnings.
Legal and regulatory actions are inherent in our businesses and could result in financial losses or harm our businesses.
We are, and in the future may be, subject to legal and regulatory actions in the ordinary course of our insurance and retirement operations. Pending legal actions include proceedings relating to aspects of our businesses and operations that are specific to us and proceedings that are typical of the businesses in which we operate. Some of these proceedings have been brought on behalf of various alleged classes of complainants. In certain of these matters, the plaintiffs are seeking large and/or indeterminate amounts, including punitive or exemplary damages. Substantial legal liability in these or future legal or regulatory actions could have a material financial effect or cause significant harm to our reputation, which in turn could materially harm our business prospects. See Note 13 for a description of legal and regulatory proceedings and actions. These actions include ongoing audits on behalf of multiple states’ treasury and controllers’ offices for compliance with laws and regulations concerning the identification, reporting and escheatment of unclaimed contract benefits or abandoned funds.
Changes in accounting standards issued by the Financial Accounting Standards Board or other standard-setting bodies may adversely affect our financial statements.
Our financial statements are prepared in accordance with GAAP as identified in the Financial Accounting Standards Board (“FASB”) Accounting Standards CodificationTM (“ASC”). From time to time, we are required to adopt new or revised accounting standards or guidance that are incorporated into the FASB ASC. It is possible that future accounting standards we are required to adopt could change the current accounting treatment that we apply to our consolidated financial statements and that such changes could have a material adverse effect on our financial condition and results of operations.
For example, the FASB issued Accounting Standards Update (“ASU”) No. 2010-26, “Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts” (“ASU 2010-26”), which clarifies the types of costs that insurance companies may capitalize and amortize over the life of the business. ASU 2010-26 significantly reduces the amount of acquisition cost that we will be able to defer in connection with sales of our insurance products. Although this will not affect the ultimate profitability of our products, we expect it could materially alter the pattern of our earnings. For further information, see “Part II - Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies - DAC, VOBA, DSI and DFEL - New DAC Methodology.”
In addition, the FASB is working on several projects with the International Accounting Standards Board, which could result in significant changes as GAAP and International Financial Reporting Standards (“IFRS”) attempt to converge, including how we account for our insurance contracts and financial instruments and how our financial statements are presented. Furthermore, the SEC is considering whether and how to incorporate IFRS into the U.S. financial reporting system. The accounting changes being proposed by the FASB may result in a complete change to how we account for and report significant areas of our business, such as insurance contracts and deferred acquisition costs (“DAC”). The effective dates and transition methods are not known; however, issuers may be required to or may choose to adopt the new standards retrospectively. In this case, the issuer will report results under the new accounting method as of the effective date, as well as for all periods presented. The changes to GAAP and potential incorporation of IFRS into the U.S. financial reporting system will impose special demands on issuers in the areas of governance, employee training, internal controls, contract fulfillment and disclosure and will likely affect how we manage our business, as it will likely affect other business processes such as design of compensation plans, product design, etc.
Anti-takeover provisions could delay, deter or prevent our change in control, even if the change in control would be beneficial to LNC shareholders.
We are an Indiana corporation subject to Indiana state law. Certain provisions of Indiana law could interfere with or restrict takeover bids or other change in control events affecting us. Also, provisions in our articles of incorporation, bylaws and other agreements to which we are a party could delay, deter or prevent our change in control, even if a change in control would be beneficial to shareholders. In addition, under Indiana law, directors may, in considering the best interests of a corporation, consider the effects of any action on shareholders, employees, suppliers and customers of the corporation and the communities in which offices and other facilities are located, and other factors the directors consider pertinent. One statutory provision prohibits, except under specified circumstances, LNC from engaging in any business combination with any shareholder who owns 10% or more of our common stock (which shareholder, under the statute, would be considered an “interested shareholder”) for a period of five years following the time that such shareholder became an interested shareholder, unless such business combination is approved by the board of directors prior to such person becoming an interested shareholder. In addition, our articles of incorporation contain a provision requiring holders of at least three-fourths of our voting shares then outstanding and entitled to vote at an election of directors, voting together, to approve a transaction with an interested shareholder rather than the simple majority required under Indiana law.
In addition to the anti-takeover provisions of Indiana law, there are other factors that may delay, deter or prevent our change in control. As an insurance holding company, we are regulated as an insurance holding company and are subject to the insurance
holding company acts of the states in which our insurance company subsidiaries are domiciled. The insurance holding company acts and regulations restrict the ability of any person to obtain control of an insurance company without prior regulatory approval. Under those statutes and regulations, without such approval (or an exemption), no person may acquire any voting security of a domestic insurance company, or an insurance holding company which controls an insurance company, or merge with such a holding company, if as a result of such transaction such person would “control” the insurance holding company or insurance company. “Control” is generally defined as the direct or indirect power to direct or cause the direction of the management and policies of a person and is presumed to exist if a person directly or indirectly owns or controls 10% or more of the voting securities of another person.
Market Conditions
Difficult conditions in the global capital markets and the economy generally may materially adversely affect our business and results of operations.
Our results of operations are materially affected by conditions in the global capital markets and the economy generally, both in the U.S. and elsewhere around the world. Concerns over the viability of the European Union and its ability to resolve the European debt crisis, the ability of the U.S. government to reign in the U.S. deficit, continued high unemployment and a stagnant real estate market in the U.S. have contributed to increased volatility and diminished expectations for the economy and the markets going forward. These events may have an adverse effect on us given our credit and equity market exposure. Our revenues are likely to decline in such circumstances and our profit margins could erode. In addition, in the event of extreme prolonged market events, such as the global credit crisis and recession that occurred during 2008 and 2009, we could incur significant losses. Even in the absence of a market downturn, we are exposed to substantial risk of loss due to market volatility.
Factors such as consumer spending, business investment, domestic and foreign government spending, the volatility and strength of the capital markets, the potential for inflation or deflation and uncertainty over domestic and foreign government actions all affect the business and economic environment and, ultimately, the amount and profitability of our business. In an economic downturn characterized by higher unemployment, lower family income, lower corporate earnings, lower business investment and lower consumer spending, the demand for our financial and insurance products could be adversely affected. In addition, we may experience an elevated incidence of claims and lapses or surrenders of policies. Our contract holders may choose to defer paying insurance premiums or stop paying insurance premiums altogether. Adverse changes in the economy could affect earnings negatively and could have a material adverse effect on our business, results of operations and financial condition.
Changes in interest rates and sustained low interest rates may cause interest rate spreads to decrease and changes in interest rates may also result in increased contract withdrawals.
Interest rate fluctuations and/or a sustained period of low interest rates could negatively affect our profitability. Some of our products, principally fixed annuities, interest-sensitive whole life, UL and the fixed portion of VUL, have interest rate guarantees that expose us to the risk that changes in interest rates will reduce our spread, or the difference between the amounts that we are required to pay under the contracts and the amounts we are able to earn on our general account investments intended to support our obligations under the contracts. Spreads are an important component of our net income. Declines in our spread or instances where the returns on our general account investments are not enough to support the interest rate guarantees on these products could have a material adverse effect on our businesses or results of operations.
In periods when interest rates are declining or remain at low levels, we may have to reinvest the cash we receive as interest or return of principal on our investments in lower yielding instruments reducing our spread. Moreover, borrowers may prepay fixed-income securities, commercial mortgages and mortgage-backed securities in our general account in order to borrow at lower market rates, which exacerbates this risk. Lowering interest crediting rates helps to mitigate the effect of spread compression on some of our products. However, because we are entitled to reset the interest rates on our fixed rate annuities only at limited, pre-established intervals, and since many of our contracts have guaranteed minimum interest or crediting rates, our spreads could still decrease. As of December 31, 2011, 85% of our annuities business, 93% of our retirement plan services business and 92% of our life insurance business with guaranteed minimum interest or crediting rates are at their guaranteed minimums.
Our expectation for future spreads is an important component in the amortization of DAC and value of business acquired (“VOBA”) as it affects the future profitability of the business. Currently, new money rates continue to be at historically low levels. The Federal Reserve Board recently announced that it will keep rates low until at least late 2014. If interest rates were to remain low over a sustained period of time, this will put additional pressure on our spreads, potentially resulting in unlocking of our DAC and VOBA assets, thereby reducing net income in the affected reporting period. We would expect the effect to be most pronounced in our Life Insurance segment. For additional information on interest rate risks, see “Part II - Item 7A. Quantitative and Qualitative Disclosures About Market Risk - Interest Rate Risk.”
A decline in market interest rates could also reduce our return on investments that do not support particular policy obligations. During periods of sustained lower interest rates, our recorded policy liabilities may not be sufficient to meet future policy obligations and may need to be strengthened, thereby reducing net income in the affected reporting period. Accordingly, declining
interest rates may materially affect our results of operations, financial position and cash flows and significantly reduce our profitability.
Increases in market interest rates may also negatively affect our profitability. In periods of rapidly increasing interest rates, we may not be able to replace the assets in our general account with higher yielding assets needed to fund the higher crediting rates necessary to keep our interest-sensitive products competitive. We therefore may have to accept a lower spread and thus lower profitability or face a decline in sales and greater loss of existing contracts and related assets. Increases in interest rates may cause increased surrenders and withdrawals of insurance products. In periods of increasing interest rates, policy loans and surrenders and withdrawals of life insurance policies and annuity contracts may increase as contract holders seek to buy products with perceived higher returns. This process may lead to a flow of cash out of our businesses. These outflows may require investment assets to be sold at a time when the prices of those assets are lower because of the increase in market interest rates, which may result in realized investment losses. A sudden demand among consumers to change product types or withdraw funds could lead us to sell assets at a loss to meet the demand for funds. Furthermore, unanticipated increases in withdrawals and termination may cause us to unlock our DAC and VOBA assets, which would reduce net income. An increase in market interest rates could also have a material adverse effect on the value of our investment portfolio, for example, by decreasing the estimated fair values of the fixed income securities that comprise a substantial portion of our investment portfolio. An increase in interest rates could also result in decreased fee income associated with a decline in the value of variable annuity account balances invested in fixed income funds.
Because the equity markets and other factors impact the profitability and expected profitability of many of our products, changes in equity markets and other factors may significantly affect our business and profitability.
The fee revenue that we earn on equity-based variable annuities and VUL insurance policies is based primarily upon account values. Because strong equity markets result in higher account values, strong equity markets positively affect our net income through increased fee revenue. Conversely, a weakening of the equity markets results in lower fee income and may have a material adverse effect on our results of operations and capital resources.
The increased fee revenue resulting from strong equity markets increases the expected gross profits (“EGPs) from variable insurance products as do better than expected lapses, mortality rates and expenses. As a result, higher EGPs may result in lower net amortized costs related to DAC, deferred sales inducements (“DSI”), VOBA, deferred front-end loads (“DFEL”) and changes in future contract benefits. However, a decrease in the equity markets, as well as worse than expected increases in lapses, mortality rates and expenses, depending upon their significance, may result in higher net amortized costs associated with DAC, DSI, VOBA, DFEL and changes in future contract benefits and may have a material adverse effect on our results of operations and capital resources. If we were to have unlocked our reversion to the mean (“RTM”) assumption in the corridor as of December 31, 2011, we would have recorded a favorable prospective unlocking of approximately $175 million, pre-tax, for our Annuities segment, approximately $20 million, pre-tax for our Retirement Plan Services segment and approximately $15 million, pre-tax, for our Life Insurance segment. For further information about our RTM process, see “Critical Accounting Policies and Estimates - DAC, VOBA, DSI and DFEL - Reversion to the Mean” in the MD&A.
Changes in the equity markets, interest rates and/or volatility affect the profitability of our products with guaranteed benefits; therefore, such changes may have a material adverse effect on our business and profitability.
Certain of our variable annuity products include guaranteed benefit riders. These include GDB, GWB and GIB riders. Our GWB, GIB and 4LATER® (a form of GIB rider) features have elements of both insurance benefits accounted for under the Financial Services - Insurance - Claim Costs and Liabilities for Future Policy Benefits Subtopic of the FASB ASC (“benefit reserves”) and embedded derivatives accounted for under the Derivatives and Hedging and the Fair Value Measurements and Disclosures Topics of the FASB ASC (“embedded derivative reserves”). We calculate the value of the embedded derivative reserve and the benefit reserves based on the specific characteristics of each guaranteed living benefit feature. The amount of reserves related to GDB for variable annuities is tied to the difference between the value of the underlying accounts and the GDB, calculated using a benefit ratio approach. The GDB reserves take into account the present value of total expected GDB payments, the present value of total expected GDB assessments over the life of the contract, claims paid to date and assessments to date. Reserves for our GIB and certain GWB with lifetime benefits are based on a combination of fair value of the underlying benefit and a benefit ratio approach that is based on the projected future payments in excess of projected future account values. The benefit ratio approach takes into account the present value of total expected GIB payments, the present value of total expected GIB assessments over the life of the contract, claims paid to date and assessments to date. The amount of reserves related to those GWB that do not have lifetime benefits is based on the fair value of the underlying benefit.
Both the level of expected payments and expected total assessments used in calculating the reserves not carried at fair value are affected by the equity markets. The liabilities related to fair value are impacted by changes in equity markets, interest rates and volatility. Accordingly, strong equity markets, increases in interest rates and decreases in volatility will generally decrease the reserves calculated using fair value. Conversely, a decrease in the equity markets along with a decrease in interest rates and an increase in volatility will generally result in an increase in the reserves calculated using fair value.
Increases in reserves would result in a charge to our earnings in the quarter in which the increase occurs. Therefore, we maintain a customized dynamic hedge program that is designed to mitigate the risks associated with income volatility around the change in reserves on guaranteed benefits. However, the hedge positions may not be effective to exactly offset the changes in the carrying value of the guarantees due to, among other things, the time lag between changes in their values and corresponding changes in the hedge positions, high levels of volatility in the equity markets and derivatives markets, extreme swings in interest rates, contract holder behavior different than expected, a strategic decision to under- or over-hedge in reaction to extreme market conditions or inconsistencies between economic and statutory reserving guidelines and divergence between the performance of the underlying funds and hedging indices. For example, for the years ended December 31, 2011, 2010 and 2009, we experienced a breakage on our variable annuity net derivatives results of $(106) million, $(27) million and $103 million, respectively, pre-tax and before the associated amortization of DAC, VOBA, DSI and DFEL and changes in other contract holder funds and funds withheld reinsurance liabilities. Breakage is defined as the difference between the change in the value of the liabilities, excluding the amount related to the non-performance risk component, and the change in the fair value of the derivatives. Breakage can be positive or negative. The non-performance risk factor is required under the Fair Value Measurements and Disclosures Topic of the FASB ASC, which requires us to consider our own credit standing, which is not hedged, in the valuation of certain of these liabilities. A decrease in our own credit spread could cause the value of these liabilities to increase, resulting in a reduction to net income. Conversely, an increase in our own credit spread could cause the value of these liabilities to decrease, resulting in an increase to net income.
In addition, we remain liable for the guaranteed benefits in the event that derivative counterparties are unable or unwilling to pay, and we are also subject to the risk that the cost of hedging these guaranteed benefits increases, resulting in a reduction to net income. These, individually or collectively, may have a material adverse effect on net income, financial condition or liquidity.
Liquidity and Capital Position
Adverse capital and credit market conditions may affect our ability to meet liquidity needs, access to capital and cost of capital.
We need liquidity to pay our operating expenses, interest on our debt and dividends on our capital stock, to maintain our securities lending activities and to replace certain maturing liabilities. Without sufficient liquidity, we will be forced to curtail our operations, and our business will suffer. When considering our liquidity and capital position, it is important to distinguish between the needs of our insurance subsidiaries and the needs of the holding company.
For our insurance and other subsidiaries, the principal sources of liquidity are insurance premiums and fees, annuity considerations and cash flow from our investment portfolio and assets, consisting mainly of cash or assets that are readily convertible into cash.
In the event that current resources do not satisfy our needs, we may have to seek additional financing. The availability of additional financing will depend on a variety of factors such as market conditions, the general availability of credit, the volume of trading activities, the overall availability of credit to the financial services industry, our credit ratings and credit capacity, as well as the possibility that customers or lenders could develop a negative perception of our long- or short-term financial prospects if we incur large investment losses or if the level of our business activity decreases due to a market downturn. Similarly, our access to funds may be impaired if regulatory authorities or rating agencies take negative actions against us. See “Item 7. MD&A - Review of Consolidated Financial Condition - Liquidity and Capital Resources - Sources of Liquidity and Cash Flows” for a description of our credit ratings. Our internal sources of liquidity may prove to be insufficient, and in such case, we may not be able to successfully obtain additional financing on favorable terms, or at all.
Disruptions, uncertainty or volatility in the capital and credit markets may also limit our access to capital required to operate our business, most significantly our insurance operations. Such market conditions may limit our ability to replace, in a timely manner, maturing liabilities; satisfy statutory capital requirements; generate fee income and market-related revenue to meet liquidity needs; and access the capital necessary to grow our business. As such, we may be forced to delay raising capital, issue shorter term securities than we prefer or bear an unattractive cost of capital which could decrease our profitability and significantly reduce our financial flexibility. Our results of operations, financial condition, cash flows and statutory capital position could be materially adversely affected by disruptions in the financial markets.
Because we are a holding company with no direct operations, the inability of our subsidiaries to pay dividends to us in sufficient amounts would harm our ability to meet our obligations.
We are a holding company and we have no direct operations. Our principal asset is the capital stock of our insurance subsidiaries. Our ability to meet our obligations for payment of interest and principal on outstanding debt obligations and to pay dividends to shareholders, repurchase our securities and pay corporate expenses depends primarily on the ability of our subsidiaries to pay dividends or to advance or repay funds to us. Under Indiana laws and regulations, our Indiana insurance subsidiaries, including LNL, our primary insurance subsidiary, may pay dividends to us without prior approval of the Commissioner up to a certain threshold, or must receive prior approval of the Commissioner to pay a dividend if such dividend, along with all other dividends paid within the preceding 12 consecutive months exceed the statutory limitation. The current Indiana statutory limitation is the
greater of 10% of the insurer’s contract holders’ surplus, as shown on its last annual statement on file with the Commissioner or the insurer’s statutory net gain from operations for the prior calendar year.
In addition, payments of dividends and advances or repayment of funds to us by our insurance subsidiaries are restricted by the applicable laws of their respective jurisdictions requiring that our insurance subsidiaries hold a specified amount of minimum reserves in order to meet future obligations on their outstanding policies. These regulations specify that the minimum reserves shall be calculated to be sufficient to meet future obligations, after giving consideration to future required premiums to be received, and are based on certain specified mortality and morbidity tables, interest rates and methods of valuation, which are subject to change. In order to meet their claims-paying obligations, our insurance subsidiaries regularly monitor their reserves to ensure we hold sufficient amounts to cover actual or expected contract and claims payments. At times, we may determine that reserves in excess of the minimum may be needed to ensure sufficiency.
Changes in, or reinterpretations of, these laws can constrain the ability of our subsidiaries to pay dividends or to advance or repay funds to us in sufficient amounts and at times necessary to meet our debt obligations and corporate expenses. Requiring our insurance subsidiaries to hold additional reserves has the potential to constrain their ability to pay dividends to the holding company. See “Legislative, Regulatory and Tax - Changes to the calculation of reserves and attempts to mitigate the impact of Regulation XXX and Actuarial Guideline 38 may fail in whole or in part resulting in an adverse effect on our financial condition and results of operations” above for additional information on potential changes in these laws.
The earnings of our insurance subsidiaries impact contract holders’ surplus. Lower earnings constrain the growth in our insurance subsidiaries’ capital, and therefore, can constrain the payment of dividends and advances or repayment of funds to us.
In addition, the amount of surplus that our insurance subsidiaries could pay as dividends is constrained by the amount of surplus they hold to maintain their financial strength ratings, to provide an additional layer of margin for risk protection and for future investment in our businesses. Notwithstanding the foregoing, we believe that our insurance subsidiaries have sufficient liquidity to meet their contract holder obligations and maintain their operations.
A decrease in the capital and surplus of our insurance subsidiaries may result in a downgrade to our credit and insurer financial strength ratings.
In any particular year, statutory surplus amounts and RBC ratios may increase or decrease depending on a variety of factors, including the amount of statutory income or losses generated by our insurance subsidiaries (which itself is sensitive to equity market and credit market conditions), the amount of additional capital our insurance subsidiaries must hold to support business growth, changes in reserving requirements, such as AG38 and principles-based reserving, our inability to secure capital market solutions to provide reserve relief, such as issuing letters of credit to support captive reinsurance structures, changes in equity market levels, the value of certain fixed-income and equity securities in our investment portfolio, the value of certain derivative instruments that do not get hedge accounting, changes in interest rates and foreign currency exchange rates, as well as changes to the NAIC RBC formulas. The RBC ratio is also affected by the product mix of the in-force book of business (i.e., the amount of business without guarantees is not subject to the same level of reserves as the business with guarantees). Most of these factors are outside of our control. Our credit and insurer financial strength ratings are significantly influenced by the statutory surplus amounts and RBC ratios of our insurance company subsidiaries. The RBC ratio of LNL is an important factor in the determination of the credit and financial strength ratings of LNC and its subsidiaries. In addition, rating agencies may implement changes to their internal models that have the effect of increasing or decreasing the amount of statutory capital we must hold in order to maintain our current ratings. In addition, in extreme scenarios of equity market declines, the amount of additional statutory reserves that we are required to hold for our variable annuity guarantees may increase at a rate greater than the rate of change of the markets. Increases in reserves reduce the statutory surplus used in calculating our RBC ratios. To the extent that our statutory capital resources are deemed to be insufficient to maintain a particular rating by one or more rating agencies, we may seek to raise additional capital through public or private equity or debt financing, which may be on terms not as favorable as in the past. Alternatively, if we were not to raise additional capital in such a scenario, either at our discretion or because we were unable to do so, our financial strength and credit ratings might be downgraded by one or more rating agencies. For more information on risks regarding our ratings, see “Covenants and Ratings - A downgrade in our financial strength or credit ratings could limit our ability to market products, increase the number or value of policies being surrendered and/or hurt our relationships with creditors” below.
Assumptions and Estimates
Our reserves for future policy benefits and claims related to our current and future business as well as businesses we may acquire in the future may prove to be inadequate.
We establish and carry, as a liability, reserves based on estimates of how much we will need to pay for future benefits and claims. For our insurance products, we calculate these reserves based on many assumptions and estimates, including, but not limited to, estimated premiums we will receive over the assumed life of the policies, the timing of the events covered by the insurance policies,
the lapse rate of the policies, the amount of benefits or claims to be paid and the investment returns on the assets we purchase with the premiums we receive.
The sensitivity of our statutory reserves and surplus established for our variable annuity base contracts and riders to changes in the equity markets will vary depending on the magnitude of the decline. The sensitivity will be affected by the level of account values relative to the level of guaranteed amounts, product design and reinsurance. Statutory reserves for variable annuities depend upon the cumulative equity market impacts on the business in force, and therefore, result in non-linear relationships with respect to the level of equity market performance within any reporting period.
The assumptions and estimates we use in connection with establishing and carrying our reserves are inherently uncertain. Accordingly, we cannot determine with precision the ultimate amount or the timing of the payment of actual benefits and claims or whether the assets supporting the policy liabilities will grow to the level we assume prior to payment of benefits or claims. If our actual experience is different from our assumptions or estimates, our reserves may prove to be inadequate in relation to our estimated future benefits and claims. Increases in reserves have a negative effect on income from operations in the quarter incurred.
If our businesses do not perform well and/or their estimated fair values decline or the price of our common stock does not increase, we may be required to recognize an impairment of our goodwill or to establish a valuation allowance against the deferred income tax asset, which could have a material adverse effect on our results of operations and financial condition.
Goodwill represents the excess of the acquisition price incurred to acquire subsidiaries and other businesses over the fair value of their net assets as of the date of acquisition. As of December 31, 2011, we had a total of $2.3 billion of goodwill on our Consolidated Balance Sheets, of which $1.5 billion related to our Life Insurance segment and $440 million related to our Annuities segment. We test goodwill at least annually for indications of value impairment with consideration given to financial performance, merger and acquisitions and other relevant factors. In addition, certain events, including a significant and adverse change in legal factors, accounting standards or the business climate, an adverse action or assessment by a regulator or unanticipated competition, would cause us to review the carrying amounts of goodwill for impairment. Impairment testing is performed based upon estimates of the fair value of the “reporting unit” to which the goodwill relates. As of December 31, 2011, we recorded a goodwill impairment of $747 million, primarily related to our Life Insurance segment. Subsequent reviews of goodwill could result in impairment of goodwill, and such write downs could have a material adverse effect on our net income and book value, but will not affect the statutory capital of our insurance subsidiaries. For more information on goodwill, see Note 10 and “Critical Accounting Policies and Estimates - Goodwill and Other Intangible Assets” in the MD&A.
Deferred income tax represents the tax effect of the differences between the book and tax basis of assets and liabilities. Deferred tax assets are assessed periodically by management to determine if they are realizable. As of December 31, 2011, we had a deferred tax asset of $2.5 billion. Factors in management’s determination include the performance of the business, including the ability to generate capital gains from a variety of sources and tax planning strategies. If, based on available information, it is more likely than not that the deferred income tax asset will not be realized, then a valuation allowance must be established with a corresponding charge to net income. Such valuation allowance could have a material adverse effect on our results of operations and financial position.
The determination of the amount of allowances and impairments taken on our investments is highly subjective and could materially impact our results of operations or financial position.
The determination of the amount of allowances and impairments varies by investment type and is based upon our periodic evaluation and assessment of known and inherent risks associated with the respective asset class. Such evaluations and assessments are revised as conditions change and new information becomes available. Management updates its evaluations regularly and reflects changes in allowances and impairments in operations as such evaluations are revised. There can be no assurance that our management has accurately assessed the level of impairments taken and allowances reflected in our financial statements. Furthermore, additional impairments may need to be taken or allowances provided for in the future. Historical trends may not be indicative of future impairments or allowances.
We regularly review our available-for-sale (“AFS”) securities for declines in fair value that we determine to be other-than-temporary. For an equity security, if we do not have the ability and intent to hold the security for a sufficient period of time to allow for a recovery in value, we conclude that an other-than-temporary impairment (“OTTI”) has occurred, and the amortized cost of the equity security is written down to the current fair value, with a corresponding change to realized gain (loss) on our Consolidated Statements of Income (Loss). When assessing our ability and intent to hold the equity security to recovery, we consider, among other things, the severity and duration of the decline in fair value of the equity security as well as the cause of decline, a fundamental analysis of the liquidity, business prospects and overall financial condition of the issuer.
For a debt security, if we intend to sell a security or it is more likely than not we will be required to sell a debt security before recovery of its amortized cost basis and the fair value of the debt security is below amortized cost, we conclude than an OTTI has
occurred and the amortized cost is written down to current fair value, with a corresponding charge to realized loss on our Consolidated Statements of Income. If we do not intend to sell a debt security or it is not more likely than not we will be required to sell a debt security before recovery of its amortized cost basis but the present value of the cash flows expected to be collected is less than the amortized cost of the debt security (referred to as the credit loss), we conclude that an OTTI has occurred and the amortized cost is written down to the estimated recovery value with a corresponding charge to realized loss on our Consolidated Statements of Income (Loss), as this is also deemed the credit portion of the OTTI. The remainder of the decline to fair value is recorded in other comprehensive income (loss) (“OCI”) to unrealized OTTI on AFS securities on our Consolidated Statements of Stockholders’ Equity, as this is considered a noncredit (i.e., recoverable) impairment. Net OTTI recognized in net income (loss) was $118 million, $152 million and $392 million, pre-tax, for the years ended December 31, 2011, 2010 and 2009, respectively. The portion of OTTI recognized in OCI for the years ended December 31, 2011 and 2010, was $47 million and $88 million, pre-tax, respectively.
Related to our unrealized losses, we establish deferred tax assets for the tax benefit we may receive in the event that losses are realized. The realization of significant realized losses could result in an inability to recover the tax benefits and may result in the establishment of valuation allowances against our deferred tax assets. Realized losses or impairments may have a material adverse impact on our results of operations and financial position.
Our valuation of fixed maturity, equity and trading securities may include methodologies, estimations and assumptions which are subject to differing interpretations and could result in changes to investment valuations that may materially adversely affect our results of operations or financial condition.
Fixed maturity, equity and trading securities and short-term investments, which are reported at fair value on our Consolidated Balance Sheets, represented the majority of our total cash and invested assets. Pursuant to the Fair Value Measurements and Disclosures Topics of the FASB ASC, we have categorized these securities into a three-level hierarchy, based on the priority of the inputs to the respective valuation technique. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3).
The determination of fair values in the absence of quoted market prices is based on valuation methodologies, securities we deem to be comparable and assumptions deemed appropriate given the circumstances. The fair value estimates are made at a specific point in time, based on available market information and judgments about financial instruments, including estimates of the timing and amounts of expected future cash flows and the credit standing of the issuer or counterparty. Factors considered in estimating fair value include coupon rate, maturity, estimated duration, call provisions, sinking fund requirements, credit rating, industry sector of the issuer and quoted market prices of comparable securities. The use of different methodologies and assumptions may have a material effect on the estimated fair value amounts.
During periods of market disruption, including periods of significantly increasing/decreasing or high/low interest rates, rapidly widening credit spreads or illiquidity, it may be difficult to value certain securities if trading becomes less frequent and/or market data becomes less observable. There may be certain asset classes that were in active markets with significant observable data that become illiquid due to the current financial environment. In such cases, more securities may fall to Level 3 and thus require more subjectivity and management judgment. As such, valuations may include inputs and assumptions that are less observable or require greater estimation, as well as valuation methods which are more sophisticated or require greater estimation, thereby resulting in values which may be less than the value at which the investments may be ultimately sold. Further, rapidly changing and unprecedented credit and equity market conditions could materially impact the valuation of securities as reported within our consolidated financial statements and the period-to-period changes in value could vary significantly. Decreases in value may have a material adverse effect on our results of operations or financial condition.
Significant adverse mortality experience may result in the loss of, or higher prices for, reinsurance.
We reinsure a significant amount of the mortality risk on fully underwritten, newly issued, individual life insurance contracts. We regularly review retention limits for continued appropriateness and they may be changed in the future. If we were to experience adverse mortality or morbidity experience, a significant portion of that would be reimbursed by our reinsurers. Prolonged or severe adverse mortality or morbidity experience could result in increased reinsurance costs, and ultimately, reinsurers not willing to offer coverage. If we are unable to maintain our current level of reinsurance or purchase new reinsurance protection in amounts that we consider sufficient, we would either have to be willing to accept an increase in our net exposures or revise our pricing to reflect higher reinsurance premiums. If this were to occur, we may be exposed to reduced profitability and cash flow strain or we may not be able to price new business at competitive rates.
Catastrophes may adversely impact liabilities for contract holder claims and the availability of reinsurance.
Our insurance operations are exposed to the risk of catastrophic mortality, such as a pandemic, an act of terrorism, natural disaster or other event that causes a large number of deaths or injuries. Significant influenza pandemics have occurred three times in the last century, but the likelihood, timing or severity of a future pandemic cannot be predicted. Additionally, the impact of climate change could cause changes in weather patterns, resulting in more severe and more frequent natural disasters such as forest fires,
hurricanes, tornados, floods and storm surges. In our group insurance operations, a localized event that affects the workplace of one or more of our group insurance customers could cause a significant loss due to mortality or morbidity claims. These events could cause a material adverse effect on our results of operations in any period and, depending on their severity, could also materially and adversely affect our financial condition.
The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. Pandemics, natural disasters and man-made catastrophes, including terrorism, may produce significant damage in larger areas, especially those that are heavily populated. Claims resulting from natural or man-made catastrophic events could cause substantial volatility in our financial results for any fiscal quarter or year and could materially reduce our profitability or harm our financial condition. Also, catastrophic events could harm the financial condition of our reinsurers and thereby increase the probability of default on reinsurance recoveries. Accordingly, our ability to write new business could also be affected.
Consistent with industry practice and accounting standards, we establish liabilities for claims arising from a catastrophe only after assessing the probable losses arising from the event. We cannot be certain that the liabilities we have established or applicable reinsurance will be adequate to cover actual claim liabilities, and a catastrophic event or multiple catastrophic events could have a material adverse effect on our business, results of operations and financial condition.
Operational Matters
Our enterprise risk management policies and procedures may leave us exposed to unidentified or unanticipated risk, which could negatively affect our businesses or result in losses.
We have devoted significant resources to develop our enterprise risk management policies and procedures and expect to continue to do so in the future. Nonetheless, our policies and procedures to identify, monitor and manage risks may not be fully effective. Many of our methods of managing risk and exposures are based upon our use of observed historical market behavior or statistics based on historical models. As a result, these methods may not predict future exposures, which could be significantly greater than the historical measures indicate, such as the risk of pandemics causing a large number of deaths. Other risk management methods depend upon the evaluation of information regarding markets, clients, catastrophe occurrence or other matters that is publicly available or otherwise accessible to us, which may not always be accurate, complete, up-to-date or properly evaluated. Management of operational, legal and regulatory risks requires, among other things, policies and procedures to record properly and verify a large number of transactions and events, and these policies and procedures may not be fully effective.
We face a risk of non-collectibility of reinsurance, which could materially affect our results of operations.
We follow the insurance practice of reinsuring with other insurance and reinsurance companies a portion of the risks under the policies written by our insurance subsidiaries (known as “ceding”). As of December 31, 2011, we ceded $331.7 billion of life insurance in force to reinsurers for reinsurance protection. Although reinsurance does not discharge our subsidiaries from their primary obligation to pay contract holders for losses insured under the policies we issue, reinsurance does make the assuming reinsurer liable to the insurance subsidiaries for the reinsured portion of the risk. As of December 31, 2011, we had $6.5 billion of reinsurance receivables from reinsurers for paid and unpaid losses, for which they are obligated to reimburse us under our reinsurance contracts. Of this amount, $2.8 billion related to the sale of our reinsurance business to Swiss Re in 2001 through an indemnity reinsurance agreement. Swiss Re has funded a trust to support this business. The balance in the trust changes as a result of ongoing reinsurance activity and was $2.2 billion as of December 31, 2011. Furthermore, approximately $1.0 billion of the Swiss Re treaties are funds withheld structures where we have a right of offset on assets backing the reinsurance receivables.
The balance of the reinsurance is due from a diverse group of reinsurers. The collectibility of reinsurance is largely a function of the solvency of the individual reinsurers. We perform annual credit reviews on our reinsurers, focusing on, among other things, financial capacity, stability, trends and commitment to the reinsurance business. We also require assets in trust, letters of credit or other acceptable collateral to support balances due from reinsurers not authorized to transact business in the applicable jurisdictions. Despite these measures, a reinsurer’s insolvency, inability or unwillingness to make payments under the terms of a reinsurance contract, especially Swiss Re, could have a material adverse effect on our results of operations and financial condition.
Competition for our employees is intense, and we may not be able to attract and retain the highly skilled people we need to support our business.
Our success depends, in large part, on our ability to attract and retain key people. Intense competition exists for the key employees with demonstrated ability, and we may be unable to hire or retain such employees. The unexpected loss of services of one or more of our key personnel could have a material adverse effect on our operations due to their skills, knowledge of our business, their years of industry experience and the potential difficulty of promptly finding qualified replacement employees. We compete with other financial institutions primarily on the basis of our products, compensation, support services and financial position. Sales in our businesses and our results of operations and financial condition could be materially adversely affected if we are unsuccessful in
attracting and retaining key employees, including financial advisors, wholesalers and other employees, as well as independent distributors of our products.
We may not be able to protect our intellectual property and may be subject to infringement claims.
We rely on a combination of contractual rights and copyright, trademark, patent and trade secret laws to establish and protect our intellectual property. Although we use a broad range of measures to protect our intellectual property rights, third parties may infringe or misappropriate our intellectual property. We may have to litigate to enforce and protect our copyrights, trademarks, patents, trade secrets and know-how or to determine their scope, validity or enforceability, which represents a diversion of resources that may be significant in amount and may not prove successful. Additionally, complex legal and factual determinations and evolving laws and court interpretations make the scope of protection afforded our intellectual property uncertain, particularly in relation to our patents. While we believe our patents provide us with a competitive advantage, we cannot be certain that any issued patents will be interpreted with sufficient breadth to offer meaningful protection. In addition, our issued patents may be successfully challenged, invalidated, circumvented or found unenforceable so that our patent rights would not create an effective competitive barrier. The loss of intellectual property protection or the inability to secure or enforce the protection of our intellectual property assets could have a material adverse effect on our business and our ability to compete.
We also may be subject to costly litigation in the event that another party alleges our operations or activities infringe upon another party’s intellectual property rights. Third parties may have, or may eventually be issued, patents that could be infringed by our products, methods, processes or services. Any party that holds such a patent could make a claim of infringement against us. We may also be subject to claims by third parties for breach of copyright, trademark, trade secret or license usage rights. Any such claims and any resulting litigation could result in significant liability for damages. If we were found to have infringed a third-party patent or other intellectual property rights, we could incur substantial liability, and in some circumstances could be enjoined from providing certain products or services to our customers or utilizing and benefiting from certain methods, processes, copyrights, trademarks, trade secrets or licenses, or alternatively could be required to enter into costly licensing arrangements with third parties, all of which could have a material adverse effect on our business, results of operations and financial condition.
Our information systems may experience interruptions or breaches in security.
Our information systems are critical to the operation of our business. We collect, process, maintain, retain and distribute large amounts of personal financial and health information and other confidential and sensitive data about our customers in the ordinary course of our business. Our business therefore depends on our customers’ willingness to entrust us with their personal information. Any failure, interruption or breach in security could result in disruptions to our critical systems and adversely affect our customer relationships. While we employ a robust and tested information security program, there can be no assurance that any such failure, interruption or security breach will not occur or, if any does occur, that it can be sufficiently remediated. The occurrence of any such failure, interruption or security breach of our systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and financial liability.
Covenants and Ratings
A downgrade in our financial strength or credit ratings could limit our ability to market products, increase the number or value of policies being surrendered and/or hurt our relationships with creditors.
Nationally recognized rating agencies rate the financial strength of our principal insurance subsidiaries and rate our debt. Ratings are not recommendations to buy our securities. Each of the rating agencies reviews its ratings periodically, and our current ratings may not be maintained in the future.
Our financial strength ratings, which are intended to measure our ability to meet contract holder obligations, are an important factor affecting public confidence in most of our products and, as a result, our competitiveness. A downgrade of the financial strength rating of one of our principal insurance subsidiaries could affect our competitive position in the insurance industry by making it more difficult for us to market our products as potential customers may select companies with higher financial strength ratings and by leading to increased withdrawals by current customers seeking companies with higher financial strength ratings. This could lead to a decrease in fees as net outflows of assets increase, and therefore, result in lower fee income. Furthermore, sales of assets to meet customer withdrawal demands could also result in losses, depending on market conditions. The interest rates we pay on our borrowings are largely dependent on our credit ratings. A downgrade of our debt ratings could affect our ability to raise additional debt, including bank lines of credit, with terms and conditions similar to our current debt, and accordingly, likely increase our cost of capital.
All of our ratings and ratings of our principal insurance subsidiaries are subject to revision or withdrawal at any time by the rating agencies, and therefore, no assurance can be given that our principal insurance subsidiaries or we can maintain these ratings. See “Item 1. Business - Financial Strength Ratings” and "Item 7. MD&A - Review of Consolidated Financial Condition - Liquidity and Capital Resources - Sources of Liquidity and Cash Flows” for a description of our ratings.
We will be required to pay interest on our capital securities with proceeds from the issuance of qualifying securities if we fail to achieve capital adequacy or net income and stockholders’ equity levels.
As of December 31, 2011, we had approximately $1.2 billion in principal amount of capital securities outstanding. All of the capital securities contain covenants that require us to make interest payments in accordance with an alternative coupon satisfaction mechanism (“ACSM”) if we determine that one of the following triggers exists as of the 30th day prior to an interest payment date, or the “determination date”:
1. LNL’s RBC ratio is less than 175% (based on the most recent annual financial statement filed with the State of Indiana); or
2. (i) The sum of our consolidated net income for the four trailing fiscal quarters ending on the quarter that is two quarters prior to the most recently completed quarter prior to the determination date is zero or negative, and (ii) our consolidated stockholders’ equity (excluding accumulated OCI and any increase in stockholders’ equity resulting from the issuance of preferred stock during a quarter), or “adjusted stockholders’ equity,” as of (x) the most recently completed quarter and (y) the end of the quarter that is two quarters before the most recently completed quarter, has declined by 10% or more as compared to the quarter that is ten fiscal quarters prior to the last completed quarter, or the “benchmark quarter.”
The ACSM would generally require us to use commercially reasonable efforts to satisfy our obligation to pay interest in full on the capital securities with the net proceeds from sales of our common stock and warrants to purchase our common stock with an exercise price greater than the market price. We would have to utilize the ACSM until the trigger events above no longer existed, and, in the case of test 2 above, until our adjusted stockholders’ equity amount increased or declined by less than 10% as compared to the adjusted stockholders’ equity at the end of the benchmark quarter for each interest payment date as to which interest payment restrictions were imposed by test 2 above.
If we were required to utilize the ACSM and were successful in selling sufficient shares of common stock or warrants to satisfy the interest payment, we would dilute the current holders of our common stock. Furthermore, while a trigger event is occurring and if we do not pay accrued interest in full, we may not, among other things, pay dividends on or repurchase our capital stock. Our failure to pay interest pursuant to the ACSM will not result in an event of default with respect to the capital securities, nor will a nonpayment of interest, unless it lasts for ten consecutive years, although such breaches may result in monetary damages to the holders of the capital securities.
The calculations of RBC, net income (loss) and adjusted stockholders’ equity are subject to adjustments and the capital securities are subject to additional terms and conditions as further described in supplemental indentures filed as exhibits to our Forms 8-K filed on March 13, 2007, May 17, 2006, and April 20, 2006.
Certain blocks of our insurance business purchased from third-party insurers under indemnity reinsurance agreements may require us to place assets in trust, secure letters of credit or return the business, if the financial strength ratings and/or capital ratios of certain insurance subsidiaries are not maintained at specified levels.
Under certain indemnity reinsurance agreements, one of our insurance subsidiaries, LLANY, provides 100% indemnity reinsurance for the business assumed, however, the third-party insurer, or the “cedent,” remains primarily liable on the underlying insurance business. Under these types of agreements, as of December 31, 2011, we held statutory reserves of $3.1 billion. These indemnity reinsurance arrangements require that our subsidiary, as the reinsurer, maintain certain insurer financial strength ratings and capital ratios. If these ratings or capital ratios are not maintained, depending upon the reinsurance agreement, the cedent may recapture the business, or require us to place assets in trust or provide letters of credit at least equal to the relevant statutory reserves. Under the largest indemnity reinsurance arrangement, we held $2.1 billion of statutory reserves as of December 31, 2011. LLANY must maintain an A.M. Best financial strength rating of at least B+, an S&P financial strength rating of at least BB+ and a Moody’s financial strength rating of at least Ba1, as well as maintain an RBC ratio of at least 160% or an S&P capital adequacy ratio of 100%, or the cedent may recapture the business. Under two other arrangements, by which we established approximately $875 million of statutory reserves, LLANY must maintain an A.M. Best financial strength rating of at least B++, an S&P financial strength rating of at least BBB- and a Moody’s financial strength rating of at least Baa3. One of these arrangements also requires LLANY to maintain an RBC ratio of at least 185% or an S&P capital adequacy ratio of 115%. Each of these arrangements may require LLANY to place assets in trust equal to the relevant statutory reserves. As of December 31, 2011, LLANY’s RBC ratio exceeded the required ratio. See “Item 1. Business - Financial Strength Ratings” for a description of our financial strength ratings.
If the cedent recaptured the business, LLANY would be required to release reserves and transfer assets to the cedent. Such a recapture could adversely impact our future profits. Alternatively, if LLANY established a security trust for the cedent, the ability to transfer assets out of the trust could be severely restricted, thus negatively impacting our liquidity.
Investments
Some of our investments are relatively illiquid and are in asset classes that have been experiencing significant market valuation fluctuations.
We hold certain investments that may lack liquidity, such as privately placed fixed maturity securities, mortgage loans, policy loans and other limited partnership interests. These asset classes represented 21% of the carrying value of our total cash and invested assets as of December 31, 2011.
If we require significant amounts of cash on short notice in excess of normal cash requirements or are required to post or return collateral in connection with our investment portfolio, derivatives transactions or securities lending activities, we may have difficulty selling these investments in a timely manner, be forced to sell them for less than we otherwise would have been able to realize, or both.
The reported value of our relatively illiquid types of investments, our investments in the asset classes described in the paragraph above and, at times, our high quality, generally liquid asset classes, do not necessarily reflect the lowest current market price for the asset. If we were forced to sell certain of our assets in the current market, there can be no assurance that we would be able to sell them for the prices at which we have recorded them and we might be forced to sell them at significantly lower prices.
We invest a portion of our invested assets in investment funds, many of which make private equity investments. The amount and timing of income from such investment funds tends to be uneven as a result of the performance of the underlying investments, including private equity investments. The timing of distributions from the funds, which depends on particular events relating to the underlying investments, as well as the funds’ schedules for making distributions and their needs for cash, can be difficult to predict. As a result, the amount of income that we record from these investments can vary substantially from quarter to quarter. Recent equity and credit market volatility may reduce investment income for these types of investments.
Defaults on our mortgage loans and write downs of mortgage equity may adversely affect our profitability.
Our mortgage loans face default risk and are principally collateralized by commercial properties. The performance of our mortgage loan investments may fluctuate in the future. In addition, some of our mortgage loan investments have balloon payment maturities. An increase in the default rate of our mortgage loan investments could have a material adverse effect on our business, results of operations and financial condition.
Further, any geographic or sector exposure in our mortgage loans may have adverse effects on our investment portfolios and consequently on our consolidated results of operations or financial condition. While we seek to mitigate this risk by having a broadly diversified portfolio, events or developments that have a negative effect on any particular geographic region or sector may have a greater adverse effect on the investment portfolios to the extent that the portfolios are exposed.
The difficulties faced by other financial institutions could adversely affect us.
We have exposure to many different industries and counterparties, and routinely execute transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, investment banks and other institutions. Many of these transactions expose us to credit risk in the event of default of our counterparty. In addition, with respect to secured transactions, our credit risk may be exacerbated when the collateral held by us cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the loan or derivative exposure due to it. We also may have exposure to these financial institutions in the form of unsecured debt instruments, derivative transactions and/or equity investments. These parties may default on their obligations to us due to bankruptcy, lack of liquidity, downturns in the economy or real estate values, operational failure, corporate governance issues or other reasons. A further downturn in the U.S. and other economies could result in increased impairments. There can be no assurance that any such losses or impairments to the carrying value of these assets would not materially and adversely affect our business and results of operations.
Our requirements to post collateral or make payments related to declines in market value of specified assets may adversely affect our liquidity and expose us to counterparty credit risk.
Many of our transactions with financial and other institutions, including settling futures positions, specify the circumstances under which the parties are required to post collateral. The amount of collateral we may be required to post under these agreements may increase under certain circumstances, which could adversely affect our liquidity. In addition, under the terms of some of our transactions, we may be required to make payments to our counterparties related to any decline in the market value of the specified assets.
Our investments are reflected within our consolidated financial statements utilizing different accounting bases, and, accordingly, there may be significant differences between cost and fair value that are not recorded in our consolidated financial statements.
Our principal investments are in fixed maturity and equity securities, mortgage loans on real estate, policy loans, short-term investments, derivative instruments, limited partnerships and other invested assets. The carrying value of such investments is as follows:
·
Fixed maturity and equity securities are classified as AFS, except for those designated as trading securities, and are reported at their estimated fair value. The difference between the estimated fair value and amortized cost of AFS securities (i.e., unrealized investment gains and losses) is recorded as a separate component of OCI, net of adjustments to DAC, contract holder related amounts and deferred income taxes;
·
Fixed maturity and equity securities designated as trading securities are recorded at fair value with subsequent changes in fair value recognized in realized gain (loss). However, in certain cases, the trading securities support reinsurance arrangements. In those cases, offsetting the changes to fair value of the trading securities are corresponding changes in the fair value of the embedded derivative liability associated with the underlying reinsurance arrangement. In other words, the investment results for the trading securities, including gains and losses from sales, are passed directly to the reinsurers through the contractual terms of the reinsurance arrangements. These types of securities represent 60% of our trading securities;
·
Short-term investments include investments with remaining maturities of one year or less, but greater than three months, at the time of acquisition and are stated at amortized cost, which approximates fair value;
·
Also, mortgage loans on real estate are carried at unpaid principal balances, adjusted for any unamortized premiums or discounts and deferred fees or expenses, net of valuation allowances;
·
Policy loans are carried at unpaid principal balances;
·
Real estate joint ventures and other limited partnership interests are carried using the equity method of accounting; and
·
Other invested assets consist principally of derivatives with positive fair values. Derivatives are carried at fair value with changes in fair value reflected in income from non-qualifying derivatives and derivatives in fair value hedging relationships. Derivatives in cash flow hedging relationships are reflected as a separate component of other comprehensive income or loss.
Investments not carried at fair value on our consolidated financial statements, principally, mortgage loans, policy loans and real estate, may have fair values which are substantially higher or lower than the carrying value reflected on our consolidated financial statements. In addition, unrealized losses are not reflected in net income unless we realize the losses by either selling the security at below amortized cost or determine that the decline in fair value is deemed to be other-than-temporary (i.e., impaired). Each of such asset classes is regularly evaluated for impairment under the accounting guidance appropriate to the respective asset class.
Competition
Intense competition could negatively affect our ability to maintain or increase our profitability.
Our businesses are intensely competitive. We compete based on a number of factors, including name recognition, service, the quality of investment advice, investment performance, product features, price, perceived financial strength and claims-paying and credit ratings. Our competitors include insurers, broker-dealers, financial advisors, asset managers and other financial institutions. A number of our business units face competitors that have greater market share, offer a broader range of products or have higher financial strength or credit ratings than we do.
In recent years, there has been substantial consolidation and convergence among companies in the financial services industry resulting in increased competition from large, well-capitalized financial services firms. Many of these firms also have been able to increase their distribution systems through mergers or contractual arrangements. Furthermore, larger competitors may have lower operating costs and an ability to absorb greater risk while maintaining their financial strength ratings, thereby allowing them to price their products more competitively. We expect consolidation to continue and perhaps accelerate in the future, thereby increasing competitive pressure on us.
Our sales representatives are not captive and may sell products of our competitors.
We sell our annuity and life insurance products through independent sales representatives. These representatives are not captive, which means they may also sell our competitors’ products. If our competitors offer products that are more attractive than ours, or pay higher commission rates to the sales representatives than we do, these representatives may concentrate their efforts in selling our competitors’ products instead of ours.
Item 1B. Unresolved Staff Comments
None.
Item 2. Properties
As of December 31, 2011, LNC and our subsidiaries owned or leased approximately 3.5 million square feet of office space. We leased 0.1 million square feet of office space in Philadelphia, Pennsylvania for LFN. We leased 0.2 million square feet of office space in Radnor, Pennsylvania for our corporate center and for LFD. We owned or leased 0.8 million square feet of office space in Fort Wayne, Indiana, primarily for our Annuities and Retirement Plan Services segments. We owned or leased 0.8 million square feet of office space in Greensboro, North Carolina, primarily for our Life Insurance segment. We owned or leased 0.3 million square feet of office space in Omaha, Nebraska, primarily for our Group Protection segment. An additional 1.3 million square feet of office space is owned or leased in other U.S. cities for branch offices. As provided in Note 13, the rental expense on operating leases for office space and equipment was $42 million for 2011. This discussion regarding properties does not include information on investment properties.
Item 3. Legal Proceedings
For information regarding legal proceedings, see “Regulatory and Litigation Matters” in Note 13, which is incorporated herein by reference.
Item 4. Mine Safety Disclosures
Not applicable.
Executive Officers of the Registrant
Executive Officers of the Registrant as of February 17, 2012, were as follows:
Name
Age (1)
Position with LNC and Business Experience During the Past Five Years
Dennis R. Glass
President, Chief Executive Officer and Director (since July 2007). President, Chief Operating Officer and Director (April 2006 - July 2007). President and Chief Executive Officer, Jefferson-Pilot (2004 - April 2006). President and Chief Operating Officer, Jefferson-Pilot (2001 - April 2006).
Lisa M. Buckingham
Executive Vice President, Chief Human Resources Officer (since March 2011) Senior Vice President, Chief Human Resources Officer (December 2008 - March 2011). Senior Vice President, Global Talent, Thomson Reuters, a provider of information and services for businesses and professionals (April 2008 - November 2008). Senior Vice President, Human Resources, Thomson Corporation (2002 - April 2008).
Charles C. Cornelio
President, Retirement Plan Services (since December 2009). Executive Vice President, Chief Administrative Officer (November 2008 - December 2009). Senior Vice President, Shared Services and Chief Information Officer (April 2006 - November 2008). Executive Vice President, Technology and Insurance Services, Jefferson-Pilot (2004 - April 2006). Senior Vice President, Jefferson-Pilot (1997 - 2004).
Robert W. Dineen
President, Lincoln Financial Network, and CEO, Lincoln Financial Advisors (2) (since 2002). Senior Vice President, Managed Asset Group, Merrill Lynch & Co., a diversified financial services company (2001 - 2002).
Randal J. Freitag
Executive Vice President and Chief Financial Officer (since January 2011). Senior Vice President, Chief Risk Officer (2007 - December 2010). Senior Vice President, Chief Risk Officer and Treasurer (2007 - October 2009). Senior Vice President, Product Risk and Profitability and Actuary (2004 - 2007).
Wilford H. Fuller
President and CEO, Lincoln Financial Distributors (2) (since February 2009). Head, Distribution, Global Wealth Management, Merrill Lynch & Co., a diversified financial services company (2007 - 2009). Head, Distribution, Managed Solutions Group, Merrill Lynch & Co. (2005 - 2007). National Sales Manager, Merrill Lynch & Co. (2000 - 2005).
Mark E. Konen
President, Insurance Solutions and Annuities (since July 2008 and February 2009 respectively). President, Individual Markets (April 2006 - July 2008). Executive Vice President, Life and Annuity Manufacturing, Jefferson-Pilot (2004 - April 2006). Executive Vice President, Product/Financial Management, Jefferson-Pilot (2002 - 2004).
(1)
Age shown is based on the officer’s age as of February 17, 2012.
(2)
Denotes an affiliate of LNC.
PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
(a) Stock Market and Dividend Information
Our common stock is traded on the New York stock exchange under the symbol LNC. As of January 27, 2012, the number of shareholders of record of our common stock was 10,053. The dividend on our common stock is declared each quarter by our Board of Directors if we are eligible to pay dividends and the Board determines that we will pay dividends. In determining dividends, the Board takes into consideration items such as our financial condition, including current and expected earnings, projected cash flows and anticipated financing needs. For potential restrictions on our ability to pay dividends, see “Review of Consolidated Financial Condition - Liquidity and Capital Resources” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 20 in the accompanying notes to the consolidated financial statements presented in “Item 8. Financial Statements and Supplementary Data,” as well as in “Part I - Item 1. Business - Regulatory - Insurance Regulation - Restriction on Subsidiaries’ Dividends and Other Payments.” The following presents the high and low prices for our common stock on the New York Stock Exchange during the periods indicated and the dividends declared per share during such periods:
1st Qtr
2nd Qtr
3rd Qtr
4th Qtr
High
$ 32.68
$ 32.39
$ 29.67
$ 21.88
Low
28.00
25.97
15.00
13.75
Dividend declared
0.050
0.050
0.050
0.080
High
$ 30.74
$ 33.55
$ 26.83
$ 29.12
Low
22.52
23.86
20.65
23.17
Dividend declared
0.010
0.010
0.010
0.050
For information on securities authorized for issuance under equity compensation plans, see “Part III - Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters,” which is incorporated herein by reference.
(b) Not Applicable
(c) Issuer Purchases of Equity Securities
The following summarizes purchases of equity securities by the issuer during the quarter ended December 31, 2011 (dollars in millions, except per share data):
(a) Total
(c) Total Number
(d) Approximate Dollar
Number
(b) Average
of Shares (or Units)
Value of Shares (or
of Shares
Price Paid
Purchased as Part of
Units) that May Yet Be
(or Units)
per Share
Publicly Announced
Purchased Under the
Period
Purchased (1)
(or Unit)
Plans or Programs (2)
Plans or Programs (3)
10/1/11 - 10/31/11
2,378
$
16.27
-
$
11/1/11 - 11/30/11
7,572,969
19.01
7,572,600
12/1/11 - 12/31/11
2,822,964
19.78
2,812,800
(1)
Of the total number of shares purchased, no shares were received in connection with the exercise of stock options and related taxes and 12,911 shares were withheld for taxes on the vesting of restricted stock. For the quarter ended December 31, 2011, there were 10,385,400 shares purchased as part of publicly announced plans or programs.
(2)
On February 23, 2007, our Board approved a $2.0 billion increase to our securities repurchase authorization, bringing the total authorization at that time to $2.6 billion. As of December 31, 2011, our security repurchase authorization was $540 million. The security repurchase authorization does not have an expiration date. The amount and timing of share repurchase depends on key capital ratios, rating agency expectations, the generation of free cash flow and an evaluation of the costs and benefits associated with alternative uses of capital. The shares repurchased in connection with the awards described in Note 19 in the
accompanying notes to the consolidated financial statements presented in “Item 8. Financial Statements and Supplementary Data” do not reduce our security repurchase authorization.
(3)
As of the last day of the applicable month.
Item 6. Selected Financial Data
The following selected financial data (in millions, except per share data) should be read in conjunction with “
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand the financial condition as of December 31, 2011, compared with December 31, 2010, and the results of operations in 2011 and 2010, compared with the immediately preceding year of Lincoln National Corporation and its consolidated subsidiaries. Unless otherwise stated or the context otherwise requires, “LNC,” “Lincoln,” “Company,” “we,” “our” or “us” refers to Lincoln National Corporation and its consolidated subsidiaries. The MD&A is provided as a supplement to, and should be read in conjunction with our consolidated financial statements and the accompanying notes to the consolidated financial statements (“Notes”) presented in “Part II - Item 8. Financial Statements and Supplementary Data,” as well as “Part I - Item 1A. Risk Factors” above.
In this report, in addition to providing consolidated revenues and net income (loss), we also provide segment operating revenues and income (loss) from operations because we believe they are meaningful measures of revenues and the profitability of our operating segments. Financial information that follows is presented in conformity with accounting principles generally accepted in the United States of America (“GAAP”), unless otherwise indicated. See Note 1 for a discussion of GAAP.
Operating revenues and income (loss) from operations are the financial performance measures we use to evaluate and assess the results of our segments. Accordingly, we define and report operating revenues and income (loss) from operations by segment in Note 22. Our management believes that operating revenues and income (loss) from operations explain the results of our ongoing businesses in a manner that allows for a better understanding of the underlying trends in our current businesses because the excluded items are unpredictable and not necessarily indicative of current operating fundamentals or future performance of the business segments, and, in many instances, decisions regarding these items do not necessarily relate to the operations of the individual segments. In addition, we believe that our definitions of operating revenues and income (loss) from operations will provide investors with a more valuable measure of our performance because it better reveals trends in our business.
Certain reclassifications have been made to prior periods’ financial information.
FORWARD-LOOKING STATEMENTS - CAUTIONARY LANGUAGE
Certain statements made in this report and in other written or oral statements made by us or on our behalf are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 (“PSLRA”). A forward-looking statement is a 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 in connection with a discussion of future operating or financial performance. In particular, these include statements relating to future actions, trends in our businesses, prospective services or products, future performance or financial results and the outcome of contingencies, such as legal proceedings. We claim the protection afforded by the safe harbor for forward-looking statements provided by the PSLRA.
Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from the results contained in the forward-looking statements. Risks and uncertainties that may cause actual results to vary materially, some of which are described within the forward-looking statements, include, among others:
·
Deterioration in general economic and business conditions that may affect account values, investment results, guaranteed benefit liabilities, premium levels, claims experience and the level of pension benefit costs, funding and investment results;
·
Adverse global capital and credit market conditions could affect our ability to raise capital, if necessary, and may cause us to realize impairments on investments and certain intangible assets, including goodwill and a valuation allowance against deferred tax assets, which may reduce future earnings and/or affect our financial condition and ability to raise additional capital or refinance existing debt as it matures;
·
Because of our holding company structure, the inability of our subsidiaries to pay dividends to the holding company in sufficient amounts could harm the holding company’s ability to meet its obligations;
·
Legislative, regulatory or tax changes, both domestic and foreign, that affect the cost of, or demand for, our subsidiaries’ products, the required amount of reserves and/or surplus, or otherwise affect our ability to conduct business, including changes to statutory reserve requirements related to secondary guarantees under universal life, such as a change to reserve calculations under Actuarial Guideline 38 (also known as The Application of the Valuation of Life Insurance Policies Model Regulation, or “AG38”), and variable annuity products under Actuarial Guideline 43 (also known as Commissioners Annuity Reserve Valuation Method for Variable Annuities, or “AG43”); restrictions on revenue sharing and 12b-1 payments; and the potential for U.S. federal tax reform;
·
Uncertainty about the effect of rules and regulations to be promulgated under the Dodd-Frank Wall Street Reform and Consumer Protection Act on us and the economy and the financial services sector in particular;
·
The initiation of legal or regulatory proceedings against us, and the outcome of any legal or regulatory proceedings, such as: adverse actions related to present or past business practices common in businesses in which we compete; adverse decisions in
significant actions including, but not limited to, actions brought by federal and state authorities and class action cases; new decisions that result in changes in law; and unexpected trial court rulings;
·
Changes in or sustained low interest rates causing a reduction in investment income, the interest margins of our businesses, estimated gross profits and demand for our products;
·
A decline in the equity markets causing a reduction in the sales of our subsidiaries’ products, a reduction of asset-based fees that our subsidiaries charge on various investment and insurance products, an acceleration of the net amortization of deferred acquisition costs (“DAC”), value of business acquired (“VOBA”), deferred sales inducements (“DSI”) and deferred front-end loads (“DFEL”) and an increase in liabilities related to guaranteed benefit features of our subsidiaries’ variable annuity products;
·
Ineffectiveness of our risk management policies and procedures, including various hedging strategies used to offset the effect of changes in the value of liabilities due to changes in the level and volatility of the equity markets and interest rates;
·
A deviation in actual experience regarding future persistency, mortality, morbidity, interest rates or equity market returns from the assumptions used in pricing our subsidiaries’ products, in establishing related insurance reserves and in the net amortization of DAC, VOBA, DSI and DFEL, which may reduce future earnings;
·
Changes in GAAP, including the potential incorporation of International Financial Reporting Standards (“IFRS”) into the U.S. financial reporting system, that may result in unanticipated changes to our net income;
·
Lowering of one or more of our debt ratings issued by nationally recognized statistical rating organizations and the adverse effect such action may have on our ability to raise capital and on our liquidity and financial condition;
·
Lowering of one or more of the insurer financial strength ratings of our insurance subsidiaries and the adverse effect such action may have on the premium writings, policy retention, profitability of our insurance subsidiaries and liquidity;
·
Significant credit, accounting, fraud, corporate governance or other issues that may adversely affect the value of certain investments in our portfolios, as well as counterparties to which we are exposed to credit risk, requiring that we realize losses on investments;
·
The effect of acquisitions and divestitures, restructurings, product withdrawals and other unusual items;
·
The adequacy and collectibility of reinsurance that we have purchased;
·
Acts of terrorism, a pandemic, war or other man-made and natural catastrophes that may adversely affect our businesses and the cost and availability of reinsurance;
·
Competitive conditions, including pricing pressures, new product offerings and the emergence of new competitors, that may affect the level of premiums and fees that our subsidiaries can charge for their products;
·
The unknown effect on our subsidiaries’ businesses resulting from changes in the demographics of their client base, as aging baby-boomers move from the asset-accumulation stage to the asset-distribution stage of life; and
·
Loss of key management, financial planners or wholesalers.
The risks included here are not exhaustive. Other sections of this report, our quarterly reports on Form 10-Q, current reports on Form 8-K and other documents filed with the Securities and Exchange Commission (“SEC”) include additional factors that could affect our businesses and financial performance, including “Part I - Item 1A. Risk Factors,” “Part II -
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
We analyze and manage the risks arising from market exposures of financial instruments, as well as other risks, in an integrated asset-liability management process that takes diversification into account. By aggregating the potential effect of market and other risks on the entire enterprise, we estimate, review and in some cases manage the risk to our earnings and shareholder value. We have exposures to several market risks including interest rate risk, equity market risk, default risk, basis risk, credit risk and, to a lesser extent, foreign currency exchange risk. The exposures of financial instruments to market risks, and the related risk management processes, are most important to our business where most of the invested assets support accumulation and investment-oriented insurance products. As an important element of our integrated asset-liability management processes, we use derivatives to minimize the effects of changes in interest levels, the shape of the yield curve, currency movements and volatility. In this context, derivatives are designated as a hedge and serve to minimize interest rate risk by mitigating the effect of significant increases in interest rates on our earnings. Additional market exposures exist in our other general account insurance products and in our debt structure and derivatives positions. Our primary sources of market risk are: substantial, relatively rapid and sustained increases or decreases in interest rates or a sharp drop in equity market values. These market risks are discussed in detail in the following pages and should be read in conjunction with our consolidated financial statements and the accompanying notes to the consolidated financial statements (“Notes”) presented in “Part II -
Item 8. Financial Statements and Supplementary Data
MANAGEMENT REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management is responsible for establishing and maintaining adequate internal control over financial reporting for Lincoln National Corporation to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that: (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with United States of America generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of internal control over financial reporting effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.
Management assessed our internal control over financial reporting as of December 31, 2011, the end of our fiscal year. Management based its assessment on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Management’s assessment included evaluation of such elements as the design and operating effectiveness of key financial reporting controls, process documentation, accounting policies, and our overall control environment.
Based on the assessment, management has concluded that our internal control over financial reporting was effective as of the end of the fiscal year to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with United States of America generally accepted accounting principles.
The effectiveness of our internal control over financial reporting as of December 31, 2011, has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report which is included immediately below.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders of
Lincoln National Corporation
We have audited Lincoln National Corporation’s (the “Corporation”) internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The Corporation’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Corporation’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Lincoln National Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Lincoln National Corporation as of December 31, 2011 and 2010, and the related consolidated statements of income (loss), stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2011 and our report dated February 23, 2012 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Philadelphia, Pennsylvania
February 23, 2012
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders of
Lincoln National Corporation
We have audited the accompanying consolidated balance sheets of Lincoln National Corporation (the “Corporation”) as of December 31, 2011 and 2010, and the related consolidated statements of income (loss), stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2011. Our audits also included the financial statement schedules listed in the Index at Item 15(a)(2). These financial statements and schedules are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Lincoln National Corporation at December 31, 2011 and 2010, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2011, in conformity with United States of America generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
As discussed in Note 2 to the consolidated financial statements, in 2010 the Corporation changed its method of accounting for the consolidation of variable interest entities. Also, as discussed in Note 2 to the consolidated financial statements, in 2009 the Corporation changed its method of accounting for the recognition and presentation of other-than-temporary impairments.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Lincoln National Corporation's internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 23, 2012 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Philadelphia, Pennsylvania
February 23, 2012
LINCOLN NATIONAL CORPORATION
CONSOLIDATED BALANCE SHEETS
(in millions, except share data)
As of December 31,
ASSETS
Investments:
Available-for-sale securities, at fair value:
Fixed maturity securities (amortized cost: 2011 - $68,988; 2010 - $65,175)
$
75,433
$
68,030
Variable interest entities' fixed maturity securities (amortized cost: 2011 - $673; 2010 - $570)
Equity securities (cost: 2011 - $135; 2010 - $179)
Trading securities
2,675
2,596
Mortgage loans on real estate
6,942
6,752
Real estate
Policy loans
2,884
2,865
Derivative investments
3,151
1,076
Other investments
1,069
1,038
Total investments
93,130
83,340
Cash and invested cash
4,510
2,741
Deferred acquisition costs and value of business acquired
8,191
8,930
Premiums and fees receivable
Accrued investment income
Reinsurance recoverables
6,526
6,527
Funds withheld reinsurance assets
Goodwill
2,273
3,019
Other assets
2,536
2,458
Separate account assets
83,477
84,630
Total assets
$
202,906
$
193,824
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities
Future contract benefits
$
19,813
$
17,527
Other contract holder funds
69,466
66,407
Short-term debt
Long-term debt
5,391
5,399
Reinsurance related embedded derivatives
Funds withheld reinsurance liabilities
1,045
1,149
Deferred gain on business sold through reinsurance
Payables for collateral on investments
3,733
1,659
Variable interest entities' liabilities
Other liabilities
4,762
3,194
Separate account liabilities
83,477
84,630
Total liabilities
188,742
181,018
Contingencies and Commitments (See Note 13)
Stockholders' Equity
Preferred stock - 10,000,000 shares authorized; Series A - 10,072 and 10,914 shares issued and outstanding as of December 31, 2011, and December 31, 2010, respectively
-
-
Common stock - 800,000,000 shares authorized; 291,319,222 and 315,718,554 shares issued and outstanding as of December 31, 2011, and December 31, 2010, respectively
7,590
8,124
Retained earnings
4,126
3,934
Accumulated other comprehensive income (loss)
2,448
Total stockholders' equity
14,164
12,806
Total liabilities and stockholders' equity
$
202,906
$
193,824
See accompanying Notes to Consolidated Financial Statements
LINCOLN NATIONAL CORPORATION
CONSOLIDATED STATEMENTS OF INCOME (LOSS)
(in millions, except per share data)
For the Years Ended December 31,
Revenues
Insurance premiums
$
2,294
$
2,176
$
2,064
Insurance fees
3,437
3,234
2,922
Net investment income
4,652
4,541
4,178
Realized gain (loss):
Total other-than-temporary impairment losses on securities
(165
)
(240
)
(667
)
Portion of loss recognized in other comprehensive income
Net other-than-temporary impairment losses on securities
recognized in earnings
(118
)
(152
)
(392
)
Realized gain (loss), excluding other-than-temporary
impairment losses on securities
(181
)
(754
)
Total realized gain (loss)
(299
)
(77
)
(1,146
)
Amortization of deferred gain on business sold through reinsurance
Other revenues and fees
Total revenues
10,636
10,407
8,499
Benefits and Expenses
Interest credited
2,488
2,488
2,465
Benefits
3,345
3,327
2,834
Underwriting, acquisition, insurance and other expenses
3,163
3,067
2,794
Interest and debt expense
Impairment of intangibles
-
Total benefits and expenses
10,037
9,173
9,020
Income (loss) from continuing operations before taxes
1,234
(521
)
Federal income tax expense (benefit)
(106
)
Income (loss) from continuing operations
(415
)
Income (loss) from discontinued operations, net of federal
income taxes
(8
)
(70
)
Net income (loss)
(485
)
Preferred stock dividends and accretion of discount
-
(167
)
(35
)
Net income (loss) available to common stockholders
$
$
$
(520
)
Earnings (Loss) Per Common Share - Basic
Income (loss) from continuing operations
$
0.99
$
2.53
$
(1.60
)
Income (loss) from discontinued operations
(0.03
)
0.09
(0.25
)
Net income (loss)
$
0.96
$
2.62
$
(1.85
)
Earnings (Loss) Per Common Share - Diluted
Income (loss) from continuing operations
$
0.95
$
2.45
$
(1.60
)
Income (loss) from discontinued operations
(0.03
)
0.09
(0.25
)
Net income (loss)
$
0.92
$
2.54
$
(1.85
)
See accompanying Notes to Consolidated Financial Statements
LINCOLN NATIONAL CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in millions, except per share data)
For the Years Ended December 31,
Preferred Stock
Balance as of beginning-of-year
$ -
$
$ -
Issuance (redemption) of Series B preferred stock
-
(950 )
Accretion of discount on Series B preferred stock
-
Balance as of end-of-year
-
-
Common Stock
Balance as of beginning-of-year
8,124
7,840
7,035
Issuance of common stock
-
Issuance (repurchase and cancellation) of common stock warrants
-
(48 )
Stock compensation/issued for benefit plans
(8 )
Deferred compensation payable in stock
-
-
Effect of amendment to deferred compensation plans
(6 )
(29 )
-
Retirement of common stock/cancellation of shares
(545 )
(25 )
-
Balance as of end-of-year
7,590
8,124
7,840
Retained Earnings
Balance as of beginning-of-year
3,934
3,316
3,745
Cumulative effect from adoption of new accounting standards
-
(169 )
Comprehensive income (loss)
1,994
1,809
2,158
Less other comprehensive income (loss), net of tax
1,700
2,643
Net income (loss)
(485 )
Retirement of common stock
(31 )
-
-
Dividends declared: Common (2011 - $0.230; 2010 - $0.080; 2009 - $0.040)
(71 )
(26 )
(11 )
Dividends on preferred stock
-
(23 )
(23 )
Accretion of discount on Series B preferred stock
-
(144 )
(12 )
Balance as of end-of-year
4,126
3,934
3,316
Accumulated Other Comprehensive Income (Loss)
Balance as of beginning-of-year
(262 )
(2,803 )
Cumulative effect from adoption of new accounting standards
-
(102 )
Other comprehensive income (loss), net of tax
1,700
2,643
Balance as of end-of-year
2,448
(262 )
Total stockholders' equity as of end-of-year
$ 14,164
$ 12,806
$ 11,700
See accompanying Notes to Consolidated Financial Statements
LINCOLN NATIONAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions)
For the Years Ended December 31,
Cash Flows from Operating Activities
Net income (loss)
$
$
$ (485 )
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Deferred acquisition costs, value of business acquired, deferred sales inducements and deferred front-end loads deferrals and interest, net of amortization
(252 )
(246 )
(316 )
Trading securities purchases, sales and maturities, net
(3 )
Change in premiums and fees receivable
(73 )
(14 )
Change in accrued investment income
(48 )
(44 )
(75 )
Change in future contract benefits and other contract holder funds
(463 )
Change in reinsurance related assets and liabilities
(66 )
Change in federal income tax accruals
Realized (gain) loss
1,146
(Income) loss attributable to equity method investments
(90 )
(93 )
(Gain) loss on early extinguishment of debt
(64 )
Amortization of deferred gain on business sold through reinsurance
(75 )
(75 )
(76 )
Impairment of intangibles
-
(Gain) loss on disposal of discontinued operations
(66 )
Other
(21 )
Net cash provided by (used in) operating activities
1,277
1,720
Cash Flows from Investing Activities
Purchases of available-for-sale securities
(10,702 )
(13,057 )
(13,532 )
Sales of available-for-sale securities
1,497
3,118
3,818
Maturities of available-for-sale securities
5,324
4,652
3,330
Purchases of other investments
(3,282 )
(3,581 )
(4,261 )
Sales or maturities of other investments
3,094
3,239
4,340
Increase (decrease) in payables for collateral on investments
2,074
(248 )
(1,799 )
Proceeds from sale of subsidiaries/businesses, net of cash disposed
-
Other
(130 )
(74 )
(75 )
Net cash provided by (used in) investing activities
(2,125 )
(5,630 )
(7,852 )
Cash Flows from Financing Activities
Payment of long-term debt, including current maturities
(525 )
(405 )
(522 )
Issuance of long-term debt, net of issuance costs
Increase (decrease) in commercial paper, net
(100 )
(216 )
Deposits of fixed account values, including the fixed portion of variable
10,953
11,080
11,378
Withdrawals of fixed account values, including the fixed portion of variable
(5,050 )
(5,305 )
(5,530 )
Transfers to and from separate accounts, net
(2,325 )
(2,957 )
(2,248 )
Common stock issued for benefit plans and excess tax benefits
-
Issuance (redemption) of Series B preferred stock and issuance (repurchase and cancellation) of associated common stock warrants
-
(998 )
Issuance of common stock
-
Repurchase of common stock
(576 )
(25 )
-
Dividends paid to common and preferred stockholders
(61 )
(42 )
(79 )
Net cash provided by (used in) financing activities
2,617
2,467
5,173
Net increase (decrease) in cash and invested cash, including discontinued operations
1,769
(1,443 )
(1,742 )
Cash and invested cash, including discontinued operations, as of beginning-of-year
2,741
4,184
5,926
Cash and invested cash, including discontinued operations, as of end-of-year
$ 4,510
$ 2,741
$ 4,184
See accompanying Notes to Consolidated Financial Statements
LINCOLN NATIONAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Nature of Operations, Basis of Presentation and Summary of Significant Accounting Policies
Nature of Operations
Lincoln National Corporation and its majority-owned subsidiaries (“LNC” or the “Company,” which also may be referred to as “we,” “our” or “us”) operate multiple insurance businesses through four business segments. See Note 22 for additional details. The collective group of businesses uses “Lincoln Financial Group” as its marketing identity. Through our business segments, we sell a wide range of wealth protection, accumulation and retirement income products. These products include institutional and/or retail fixed and indexed annuities, variable annuities, universal life insurance (“UL”), variable universal life insurance (“VUL”), linked-benefit UL, term life insurance, mutual funds and group life, disability and dental.
Basis of Presentation
The accompanying consolidated financial statements are prepared in accordance with United States of America generally accepted accounting principles (“GAAP”). Certain GAAP policies, which significantly affect the determination of financial position, results of operations and cash flows, are summarized below.
Certain amounts reported in prior years’ consolidated financial statements have been reclassified to conform to the presentation adopted in the current year. These reclassifications had no effect on net income or stockholders’ equity of the prior years.
Summary of Significant Accounting Policies
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of LNC and all other entities in which we have a controlling financial interest and any variable interest entities (“VIEs”) in which we are the primary beneficiary. Entities in which we do not have a controlling financial interest and do not exercise significant management influence over the operating and financing decisions are reported using the equity method. The carrying value of our investments that we account for using the equity method on our Consolidated Balance Sheets and equity in earnings on our Consolidated Statements of Income (Loss) is not material. All material inter-company accounts and transactions have been eliminated in consolidation.
Our involvement with VIEs is primarily to invest in assets that allow us to gain exposure to a broadly diversified portfolio of asset classes. A VIE is an entity which does not have sufficient equity to finance its own activities without additional financial support or where investors lack certain characteristics of a controlling financial interest. We assess our contractual, ownership or other interests in a VIE to determine if our interest participates in the variability the VIE was designed to absorb and pass onto variable interest holders. We perform an ongoing qualitative assessment of our variable interests in VIEs to determine whether we have a controlling financial interest and would therefore be considered the primary beneficiary of the VIE. If we determine we are the primary beneficiary of a VIE, we consolidate the assets and liabilities of the VIE in our consolidated financial statements.
Accounting Estimates and Assumptions
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions affecting the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses for the reporting period. Those estimates are inherently subject to change and actual results could differ from those estimates. Included among the material (or potentially material) reported amounts and disclosures that require extensive use of estimates are: fair value of certain invested assets and derivatives, asset valuation allowances, deferred acquisition costs (“DAC”), value of business acquired (“VOBA”), deferred sales inducements (“DSI”), goodwill, future contract benefits, other contract holder funds which includes deferred front-end loads (“DFEL”), pension plans, income taxes and the potential effects of resolving litigated matters.
Business Combinations
We use the acquisition method of accounting for all business combination transactions, and accordingly, recognize the fair values of assets acquired, liabilities assumed and any noncontrolling interests in our consolidated financial statements. The allocation of fair values may be subject to adjustment after the initial allocation for up to a one-year period as more information relative to the fair values as of the acquisition date becomes available. The consolidated financial statements include the results of operations of any acquired company since the acquisition date.
Fair Value Measurement
Our measurement of fair value is based on assumptions used by market participants in pricing the asset or liability, which may include inherent risk, restrictions on the sale or use of an asset or non-performance risk, which would include our own credit risk. Our estimate of an exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability (“exit price”) in the principal market, or the most advantageous market in the absence of a principal market, for that asset or liability, as opposed to the price that would be paid to acquire the asset or receive a liability (“entry price”). Pursuant to the Fair Value Measurements and Disclosures Topic of the Financial Accounting Standards Board (“FASB”) Accounting Standards CodificationTM (“ASC”), we categorize our financial instruments carried at fair value into a three-level fair value hierarchy, based on the priority of inputs to the respective valuation technique. The three-level hierarchy for fair value measurement is defined as follows:
·
Level 1 - inputs to the valuation methodology are quoted prices available in active markets for identical investments as of the reporting date, except for large holdings subject to “blockage discounts” that are excluded;
·
Level 2 - inputs to the valuation methodology are other than quoted prices in active markets, that are either directly or indirectly observable as of the reporting date, and fair value can be determined through the use of models or other valuation methodologies; and
·
Level 3 - inputs to the valuation methodology are unobservable inputs in situations where there is little or no market activity for the asset or liability, and we make estimates and assumptions related to the pricing of the asset or liability, including assumptions regarding risk.
In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the investment.
When a determination is made to classify an asset or liability within Level 3 of the fair value hierarchy, the determination is based upon the significance of the unobservable inputs to the overall fair value measurement. Because certain securities trade in less liquid or illiquid markets with limited or no pricing information, the determination of fair value for these securities is inherently more difficult. However, Level 3 fair value investments may include, in addition to the unobservable or Level 3 inputs, observable components, which are components that are actively quoted or can be validated to market-based sources.
Available-For-Sale Securities - Fair Valuation Methodologies and Associated Inputs
Securities classified as available-for-sale (“AFS”) consist of fixed maturity and equity securities and are stated at fair value with unrealized gains and losses included within accumulated other comprehensive income (loss) (“AOCI”), net of associated DAC, VOBA, DSI, other contract holder funds and deferred income taxes.
We measure the fair value of our securities classified as AFS based on assumptions used by market participants in pricing the security. The most appropriate valuation methodology is selected based on the specific characteristics of the fixed maturity or equity security, and we consistently apply the valuation methodology to measure the security’s fair value. Our fair value measurement is based on a market approach that utilizes prices and other relevant information generated by market transactions involving identical or comparable securities. Sources of inputs to the market approach primarily include third-party pricing services, independent broker quotations or pricing matrices. We do not adjust prices received from third parties; however, we do analyze the third-party pricing services’ valuation methodologies and related inputs and perform additional evaluation to determine the appropriate level within the fair value hierarchy.
The observable and unobservable inputs to our valuation methodologies are based on a set of standard inputs that we generally use to evaluate all of our AFS securities. Observable inputs include benchmark yields, reported trades, broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and reference data. In addition, market indicators, industry and economic events are monitored, and further market data is acquired if certain triggers are met. For certain security types, additional inputs may be used, or some of the inputs described above may not be applicable. For private placement securities, we use pricing matrices that utilize observable pricing inputs of similar public securities and Treasury yields as inputs to the fair value measurement. Depending on the type of security or the daily market activity, standard inputs may be prioritized differently or may not be available for all AFS securities on any given day. For broker-quoted only securities, non-binding quotes from market makers or broker-dealers are obtained from sources recognized as market participants. For securities trading in less liquid or illiquid markets with limited or no pricing information, we use unobservable inputs to measure fair value.
The following summarizes our fair valuation methodologies and associated inputs, which are particular to the specified security type and are in addition to the defined standard inputs to our valuation methodologies for all of our AFS securities discussed above:
·
Corporate bonds and U.S. Government bonds - We also use Trade Reporting and Compliance EngineTM reported tables for our corporate bonds and vendor trading platform data for our U.S. Government bonds.
·
Mortgage- and asset-backed securities - We also utilize additional inputs which include new issues data, monthly payment information and monthly collateral performance, including prepayments, severity, delinquencies, step-down features and over collateralization features for each of our mortgage-backed securities (“MBS”), which include collateralized mortgage obligations and mortgage pass through securities backed by residential mortgages (“RMBS”), commercial mortgage-backed securities (“CMBS”) and collateralized debt obligations (“CDOs”).
·
State and municipal bonds - We also use additional inputs that include information from the Municipal Securities Rule Making Board, as well as material event notices, new issue data, issuer financial statements and Municipal Market Data benchmark yields for our state and municipal bonds.
·
Hybrid and redeemable preferred and equity securities - We also utilize additional inputs of exchange prices (underlying and common stock of the same issuer) for our hybrid and redeemable preferred and equity securities, including banking, insurance, other financial services and other securities.
In order to validate the pricing information and broker-dealer quotes, we employ, where possible, procedures that include comparisons with similar observable positions, comparisons with subsequent sales and observations of general market movements for those security classes. We have policies and procedures in place to review the process that is utilized by our third-party pricing service and the output that is provided to us by the pricing service. On a periodic basis, we test the pricing for a sample of securities to evaluate the inputs and assumptions used by the pricing service, and we perform a comparison of the pricing service output to an alternative pricing source. We also evaluate prices provided by our primary pricing service to ensure that they are not stale or unreasonable by reviewing the prices for unusual changes from period to period based on certain parameters or for lack of change from one period to the next.
AFS Securities - Evaluation for Recovery of Amortized Cost
We regularly review our AFS securities for declines in fair value that we determine to be other-than-temporary. For an equity security, if we do not have the ability and intent to hold the security for a sufficient period of time to allow for a recovery in value, we conclude that an other-than-temporary impairment (“OTTI”) has occurred and the amortized cost of the equity security is written down to the current fair value, with a corresponding charge to realized gain (loss) on our Consolidated Statements of Income (Loss). When assessing our ability and intent to hold the equity security to recovery, we consider, among other things, the severity and duration of the decline in fair value of the equity security as well as the cause of the decline, a fundamental analysis of the liquidity, and business prospects and overall financial condition of the issuer.
For our fixed maturity AFS securities, we generally consider the following to determine whether our unrealized losses are OTTI:
·
The estimated range and average period until recovery;
·
The estimated range and average holding period to maturity;
·
Remaining payment terms of the security;
·
Current delinquencies and nonperforming assets of underlying collateral;
·
Expected future default rates;
·
Collateral value by vintage, geographic region, industry concentration or property type;
·
Subordination levels or other credit enhancements as of the balance sheet date as compared to origination; and
·
Contractual and regulatory cash obligations.
For a debt security, if we intend to sell a security or it is more likely than not we will be required to sell a debt security before recovery of its amortized cost basis and the fair value of the debt security is below amortized cost, we conclude that an OTTI has occurred and the amortized cost is written down to current fair value, with a corresponding charge to realized gain (loss) on our Consolidated Statements of Income (Loss). If we do not intend to sell a debt security or it is not more likely than not we will be required to sell a debt security before recovery of its amortized cost basis but the present value of the cash flows expected to be collected is less than the amortized cost of the debt security (referred to as the credit loss), we conclude that an OTTI has occurred and the amortized cost is written down to the estimated recovery value with a corresponding charge to realized gain (loss) on our Consolidated Statements of Income (Loss), as this amount is deemed the credit portion of the OTTI. The remainder of the decline to fair value is recorded in OCI to unrealized OTTI on AFS securities on our Consolidated Statements of Stockholders’ Equity, as this amount is considered a noncredit (i.e., recoverable) impairment.
When assessing our intent to sell a debt security or if it is more likely than not we will be required to sell a debt security before recovery of its cost basis, we evaluate facts and circumstances such as, but not limited to, decisions to reposition our security portfolio, sale of securities to meet cash flow needs and sales of securities to capitalize on favorable pricing. In order to determine the amount of the credit loss for a debt security, we calculate the recovery value by performing a discounted cash flow analysis based on the current cash flows and future cash flows we expect to recover. The discount rate is the effective interest rate implicit in the underlying debt security. The effective interest rate is the original yield or the coupon if the debt security was previously impaired. See the discussion below for additional information on the methodology and significant inputs, by security type, which we use to determine the amount of a credit loss.
Our conclusion that it is not more likely than not that we will be required to sell the fixed maturity AFS securities before recovery of their amortized cost basis, the estimated future cash flows are equal to or greater than the amortized cost basis of the debt securities, or we have the ability to hold the equity AFS securities for a period of time sufficient for recovery is based upon our asset-liability management process. Management considers the following as part of the evaluation:
·
The current economic environment and market conditions;
·
Our business strategy and current business plans;
·
The nature and type of security, including expected maturities and exposure to general credit, liquidity, market and interest rate risk;
·
Our analysis of data from financial models and other internal and industry sources to evaluate the current effectiveness of our hedging and overall risk management strategies;
·
The current and expected timing of contractual maturities of our assets and liabilities, expectations of prepayments on investments and expectations for surrenders and withdrawals of life insurance policies and annuity contracts;
·
The capital risk limits approved by management; and
·
Our current financial condition and liquidity demands.
To determine the recovery period of a debt security, we consider the facts and circumstances surrounding the underlying issuer including, but not limited to, the following:
·
Historic and implied volatility of the security;
·
Length of time and extent to which the fair value has been less than amortized cost;
·
Adverse conditions specifically related to the security or to specific conditions in an industry or geographic area;
·
Failure, if any, of the issuer of the security to make scheduled payments; and
·
Recoveries or additional declines in fair value subsequent to the balance sheet date.
In periods subsequent to the recognition of an OTTI, the AFS security is accounted for as if it had been purchased on the measurement date of the OTTI. Therefore, for the fixed maturity AFS security, the original discount or reduced premium is reflected in net investment income over the contractual term of the investment in a manner that produces a constant effective yield.
To determine recovery value of a corporate bond or CDO, we perform additional analysis related to the underlying issuer including, but not limited to, the following:
·
Fundamentals of the issuer to determine what we would recover if they were to file bankruptcy versus the price at which the market is trading;
·
Fundamentals of the industry in which the issuer operates;
·
Earnings multiples for the given industry or sector of an industry that the underlying issuer operates within, divided by the outstanding debt to determine an expected recovery value of the security in the case of a liquidation;
·
Expected cash flows of the issuer (e.g., whether the issuer has cash flows in excess of what is required to fund its operations);
·
Expectations regarding defaults and recovery rates;
·
Changes to the rating of the security by a rating agency; and
·
Additional market information (e.g., if there has been a replacement of the corporate debt security).
Each quarter we review the cash flows for the MBS to determine whether or not they are sufficient to provide for the recovery of our amortized cost. We revise our cash flow projections only for those securities that are at most risk for impairment based on current credit enhancement and trends in the underlying collateral performance. To determine recovery value of a MBS, we perform additional analysis related to the underlying issuer including, but not limited to, the following:
·
Discounted cash flow analysis based on the current cash flows and future cash flows we expect to recover;
·
Level of creditworthiness of the home equity loans or residential mortgages that back an RMBS or commercial mortgages that back a CMBS;
·
Susceptibility to fair value fluctuations for changes in the interest rate environment;
·
Susceptibility to reinvestment risks, in cases where market yields are lower than the securities’ book yield earned;
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Susceptibility to reinvestment risks, in cases where market yields are higher than the book yields earned on a security;
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Expectations of sale of such a security where market yields are higher than the book yields earned on a security; and
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Susceptibility to variability of prepayments.
When evaluating MBS and mortgage-related asset-backed securities (“ABS”), we consider a number of pool-specific factors as well as market level factors when determining whether or not the impairment on the security is temporary or other-than-temporary. The most important factor is the performance of the underlying collateral in the security and the trends of that performance in the prior periods. We use this information about the collateral to forecast the timing and rate of mortgage loan defaults, including making projections for loans that are already delinquent and for those loans that are currently performing but may become delinquent in the future. Other factors used in this analysis include type of underlying collateral (e.g., prime, Alt-A or subprime), geographic distribution of underlying loans and timing of liquidations by state. Once default rates and timing assumptions are determined, we then make assumptions regarding the severity of a default if it were to occur. Factors that impact the severity assumption include expectations for future home price appreciation or depreciation, loan size, first lien versus second lien, existence of loan level private mortgage insurance, type of occupancy and geographic distribution of loans. Once default and severity assumptions are determined for the security in question, cash flows for the underlying collateral are projected including expected defaults and prepayments. These cash flows on the collateral are then translated to cash flows on our tranche based on the cash flow waterfall of the entire capital security structure. If this analysis indicates the entire principal on a particular security will not be returned, the security is reviewed for OTTI by comparing the expected cash flows to amortized cost. To the extent that the security has already been impaired or was purchased at a discount, such that the amortized cost of the security is less than or equal to the present value of cash flows expected to be collected, no impairment is required.
Otherwise, if the amortized cost of the security is greater than the present value of the cash flows expected to be collected, and the security was not purchased at a discount greater than the expected principal loss, then impairment is recognized.
We further monitor the cash flows of all of our AFS securities backed by pools on an ongoing basis. We also perform detailed analysis on all of our subprime, Alt-A, non-agency residential MBS and on a significant percentage of our AFS securities backed by pools of commercial mortgages. The detailed analysis includes revising projected cash flows by updating the cash flows for actual cash received and applying assumptions with respect to expected defaults, foreclosures and recoveries in the future. These revised projected cash flows are then compared to the amount of credit enhancement (subordination) in the structure to determine whether the amortized cost of the security is recoverable. If it is not recoverable, we record an impairment of the security.
Trading Securities
Trading securities consist of fixed maturity and equity securities in designated portfolios, some of which support modified coinsurance (“Modco”) and coinsurance with funds withheld (“CFW”) reinsurance arrangements. Investment results for the portfolios that support Modco and CFW reinsurance arrangements, including gains and losses from sales, are passed directly to the reinsurers pursuant to contractual terms of the reinsurance arrangements. Trading securities are carried at fair value and changes in fair value and changes in the fair value of embedded derivative liabilities associated with the underlying reinsurance arrangements, are recorded in realized gain (loss) on our Consolidated Statements of Income (Loss) as they occur.
Alternative Investments
Alternative investments, which consist primarily of investments in Limited Partnerships (“LPs”), are included in other investments on our Consolidated Balance Sheets. We account for our investments in LPs using the equity method to determine the carrying value. Recognition of alternative investment income is delayed due to the availability of the related financial statements, which are generally obtained from the partnerships’ general partners. As a result, our venture capital, real estate and oil and gas portfolios are generally on a three-month delay and our hedge funds are on a one-month delay. In addition, the impact of audit adjustments related to completion of calendar-year financial statement audits of the investees are typically received during the second quarter of each calendar year. Accordingly, our investment income from alternative investments for any calendar-year period may not include the complete impact of the change in the underlying net assets for the partnership for that calendar-year period.
Payables for Collateral on Investments
When we enter into collateralized financing transactions on our investments, a liability is recorded equal to the cash collateral received. This liability is included within payables for collateral on investments on our Consolidated Balance Sheets. Income and expenses associated with these transactions are recorded as investment income and investment expenses within net investment income on our Consolidated Statements of Income (Loss). Changes in payables for collateral on investments are reflected within cash flows from investing activities on our Consolidated Statements of Cash Flows.
Mortgage Loans on Real Estate
Mortgage loans on real estate are carried at unpaid principal balances adjusted for amortization of premiums and accretion of discounts and are net of valuation allowances. Interest income is accrued on the principal balance of the loan based on the loan’s contractual interest rate. Premiums and discounts are amortized using the effective yield method over the life of the loan. Interest income and amortization of premiums and discounts are reported in net investment income on our Consolidated Statements of Income (Loss) along with mortgage loan fees, which are recorded as they are incurred.
Our commercial loan portfolio is comprised of long-term loans secured by existing commercial real estate. As such, it does not exhibit risk characteristics unique to mezzanine, construction, residential, agricultural, land or other types of real estate loans. We believe all of the loans in our portfolio share three primary risks: borrower creditworthiness; sustainability of the cash flow of the property; and market risk; therefore, our methods for monitoring and assessing credit risk are consistent for our entire portfolio. Loans are considered impaired when it is probable that, based upon current information and events, we will be unable to collect all amounts due under the contractual terms of the loan agreement. When we determine that a loan is impaired, a valuation allowance is established for the excess carrying value of the loan over its estimated value. The loan’s estimated value is based on: the present value of expected future cash flows discounted at the loan’s effective interest rate; the loan’s observable market price; or the fair value of the loan’s collateral. Valuation allowances are maintained at a level we believe is adequate to absorb estimated probable credit losses of each specific loan. Our periodic evaluation of the adequacy of the allowance for losses is based on our past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay (including the timing of future payments), the estimated value of the underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors. Trends in market vacancy and rental rates are incorporated into the analysis that we perform for monitored loans and may contribute to the establishment of (or an increase or decrease in) an allowance for credit losses. In addition, we review each loan individually in our commercial mortgage loan portfolio on an annual basis to identify emerging risks. We focus on properties that experienced a reduction in debt-service coverage or that have significant exposure to tenants with deteriorating credit profiles. Where warranted, we establish or increase loss reserves for a specific loan based upon this analysis. Our process for determining past due or delinquency status begins when a payment date is missed, at which time the borrower is contacted. After the grace period expiration that may last up to 10 days, we send a default notice. The default notice generally provides a short time period to cure the default. Our policy is to report loans that are 60 or more days past due, which equates to two or more payments missed, as delinquent. We do not accrue interest on loans 90 days past due, and any interest received on these loans is either applied to the principal or recorded in net investment income on our Consolidated Statements of Income (Loss) when received, depending on the assessment of the collectibility of the loan. We resume accruing interest once a loan complies with all of its original terms or restructured terms. Mortgage loans deemed uncollectible are charged against the allowance for losses, and subsequent recoveries, if any, are credited to the allowance for losses. All mortgage loans that are impaired have an established allowance for credit losses. Changes in valuation allowances are reported in realized gain (loss) on our Consolidated Statements of Income (Loss).
We measure and assess the credit quality of our mortgage loans by using loan-to-value and debt-service coverage ratios. The loan-to-value ratio compares the principal amount of the loan to the fair value at origination of the underlying property collateralizing the loan and is commonly expressed as a percentage. Loan-to-value ratios greater than 100% indicate that the principal amount is greater than the collateral value. Therefore, all else being equal, a lower loan-to-value ratio generally indicates a higher quality loan. The debt-service coverage ratio compares a property’s net operating income to its debt-service payments. Debt-service coverage ratios of less than 1.0 indicate that property operations do not generate enough income to cover its current debt payments. Therefore, all else being equal, a higher debt-service coverage ratio generally indicates a higher quality loan.
Policy Loans
Policy loans represent loans we issue to contract holders that use the cash surrender value of their life insurance policy as collateral. Policy loans are carried at unpaid principal balances.
Real Estate
Real estate includes both real estate held for the production of income and real estate held-for-sale. Real estate held for the production of income is carried at cost less accumulated depreciation. Depreciation is calculated on a straight-line basis over the
estimated useful life of the asset. We periodically review properties held for the production of income for impairment. Properties whose carrying values are greater than their projected undiscounted cash flows are written down to estimated fair value, with impairment losses reported in realized gain (loss) on our Consolidated Statements of Income (Loss). The estimated fair value of real estate is generally computed using the present value of expected future cash flows from the real estate discounted at a rate commensurate with the underlying risks. Real estate classified as held-for-sale is stated at the lower of depreciated cost or fair value less expected disposition costs at the time classified as held-for-sale. Real estate is not depreciated while it is classified as held-for-sale. Also, valuation allowances for losses are established, as appropriate, for real estate held-for-sale and any changes to the valuation allowances are reported in realized gain (loss) on our Consolidated Statements of Income (Loss). Real estate acquired through foreclosure proceedings is recorded at fair value at the settlement date.
Derivative Instruments
We hedge certain portions of our exposure to interest rate risk, foreign currency exchange risk, equity market risk and credit risk by entering into derivative transactions. All of our derivative instruments are recognized as either assets or liabilities on our Consolidated Balance Sheets at estimated fair value. We categorized derivatives into a three-level hierarchy, based on the priority of the inputs to the respective valuation technique as discussed above in “Fair Value Measurement.” The accounting for changes in the estimated fair value of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship, and further, on the type of hedging relationship. For those derivative instruments that are designated and qualify as hedging instruments, we must designate the hedging instrument based upon the exposure being hedged: as a cash flow hedge, a fair value hedge or a hedge of a net investment in a foreign subsidiary.
For derivative instruments that are designated and qualify as a cash flow hedge, the effective portion of the gain or loss on the derivative instrument is reported as a component of accumulated OCI and reclassified into net income in the same period or periods during which the hedged transaction affects net income. The remaining gain or loss on the derivative instrument in excess of the cumulative change in the present value of designated future cash flows of the hedged item (hedge ineffectiveness), if any, is recognized in net income during the period of change. For derivative instruments that are designated and qualify as a fair value hedge, the gain or loss on the derivative instrument, as well as the offsetting gain or loss on the hedged item attributable to the hedged risk are recognized in net income during the period of change in estimated fair values. For derivative instruments that are designated and qualify as a hedge of a net investment in a foreign subsidiary, the gain or loss on the derivative instrument is reported as a component of accumulated OCI and reclassified into net income at the time of the sale of the foreign subsidiary. For derivative instruments not designated as hedging instruments but that are economic hedges, the gain or loss is recognized in net income.
We purchase and issue financial instruments and products that contain embedded derivative instruments. When it is determined that the embedded derivative possesses economic characteristics that are not clearly and closely related to the economic characteristics of the host contract, and a separate instrument with the same terms would qualify as a derivative instrument, the embedded derivative is bifurcated from the host for measurement purposes. The embedded derivative, which is reported with the host instrument in the Consolidated Balance Sheets, is carried at fair value with changes in fair value recognized in net income during the period of change.
We employ several different methods for determining the fair value of our derivative instruments. The fair value of our derivative contracts are measured based on current settlement values, which are based on quoted market prices, industry standard models that are commercially available and broker quotes. These techniques project cash flows of the derivatives using current and implied future market conditions. We calculate the present value of the cash flows to measure the current fair market value of the derivative.
Cash and Cash Equivalents
Cash and invested cash is carried at cost and includes all highly liquid debt instruments purchased with an original maturity of three months or less.
DAC, VOBA, DSI and DFEL
Commissions and other costs of acquiring UL insurance, VUL insurance, traditional life insurance, annuities and other investment contracts, which vary with and are related primarily to the production of new business, have been deferred (i.e., DAC) to the extent recoverable. VOBA is an intangible asset that reflects the estimated fair value of in-force contracts in a life insurance company acquisition and represents the portion of the purchase price that is allocated to the value of the right to receive future cash flows from the business in force at the acquisition date. Bonus credits and excess interest for dollar cost averaging contracts are considered DSI. Contract sales charges that are collected in the early years of an insurance contract are deferred (i.e., DFEL), and the unamortized balance is reported in other contract holder funds on our Consolidated Balance Sheets.
Both DAC and VOBA amortization, excluding amounts reported in realized gain (loss), is reported within underwriting, acquisition, insurance and other expenses on our Consolidated Statements of Income (Loss). DSI amortization, excluding amounts reported in realized gain (loss), is reported in interest credited on our Consolidated Statements of Income (Loss). The amortization of DFEL, excluding amounts reported in realized gain (loss), is reported within insurance fees on our Consolidated Statements of Income (Loss). The methodology for determining the amortization of DAC, VOBA, DSI and DFEL varies by product type. For all insurance contracts, amortization is based on assumptions consistent with those used in the development of the underlying contract adjusted for emerging experience and expected trends.
Acquisition costs for UL and VUL insurance and investment-type products, which include fixed and variable deferred annuities, are generally amortized over the lives of the policies in relation to the incidence of estimated gross profits (“EGPs”) from surrender charges, investment, mortality net of reinsurance ceded and expense margins and actual realized gain (loss) on investments. Contract lives for UL and VUL policies are estimated to be 40 years and 30 years, respectively, based on the expected lives of the contracts. Contract lives for fixed and variable deferred annuities are generally between 12 and 30 years, while some of our fixed multi-year guarantee products have amortization periods equal to the guarantee period. The front-end load annuity product has an assumed life of 25 years. Longer lives are assigned to those blocks that have demonstrated favorable lapse experience.
Acquisition costs for all traditional contracts, including traditional life insurance, which include individual whole life, group business and term life insurance contracts, are amortized over periods of 7 to 30 years on either a straight-line basis or as a level percent of premium of the related policies depending on the block of business. There is currently no DAC, VOBA, DSI or DFEL balance or related amortization for fixed and variable payout annuities.
We account for modifications of insurance contracts that result in a substantially unchanged contract as a continuation of the replaced contract. We account for modifications of insurance contracts that result in a substantially changed contract as an extinguishment of the replaced contract.
The carrying amounts of DAC, VOBA, DSI and DFEL are adjusted for the effects of realized and unrealized gains and losses on securities classified as AFS and certain derivatives and embedded derivatives. Amortization expense of DAC, VOBA, DSI and DFEL reflects an assumption for an expected level of credit-related investment losses. When actual credit-related investment losses are realized, we recognize a true-up to our DAC, VOBA, DSI and DFEL amortization within realized gain (loss) on our Consolidated Statements of Income (Loss) reflecting the incremental effect of actual versus expected credit-related investment losses. These actual to expected amortization adjustments can create volatility from period to period in realized gain (loss).
On a quarterly basis, we may record an adjustment to the amounts included within our Consolidated Balance Sheets for DAC, VOBA, DSI and DFEL with an offsetting benefit or charge to revenue or expense for the effect of the difference between future EGPs used in the prior quarter and the emergence of actual and updated future EGPs in the current quarter (“retrospective unlocking”). In addition, in the third quarter of each year, we conduct our annual comprehensive review of the assumptions and the projection models used for our estimates of future gross profits underlying the amortization of DAC, VOBA, DSI and DFEL and the calculations of the embedded derivatives and reserves for life insurance and annuity products with living benefit and death benefit guarantees. These assumptions include investment margins, mortality, retention, rider utilization and maintenance expenses (costs associated with maintaining records relating to insurance and individual and group annuity contracts and with the processing of premium collections, deposits, withdrawals and commissions). Based on our review, the cumulative balances of DAC, VOBA, DSI and DFEL, included on our Consolidated Balance Sheets, are adjusted with an offsetting benefit or charge to revenue or amortization expense to reflect such change (“prospective unlocking - assumption changes”). We may have prospective unlocking in other quarters as we become aware of information that warrants updating prospective assumptions outside of our annual comprehensive review. We may also identify and implement actuarial modeling refinements (“prospective unlocking - model refinements”) that result in increases or decreases to the carrying values of DAC, VOBA, DSI, DFEL, embedded derivatives and reserves for life insurance and annuity products with living benefit and death benefit guarantees. The primary distinction between retrospective and prospective unlocking is that retrospective unlocking is driven by the difference between actual gross profits compared to EGPs each period, while prospective unlocking is driven by changes in assumptions or projection models related to our expectations of future EGPs.
DAC, VOBA, DSI and DFEL are reviewed periodically to ensure that the unamortized portion does not exceed the expected recoverable amounts.
Reinsurance
Our insurance companies enter into reinsurance agreements with other companies in the normal course of business. Assets and liabilities and premiums and benefits from certain reinsurance contracts that grant statutory surplus relief to other insurance companies are netted on our Consolidated Balance Sheets and Consolidated Statements of Income (Loss), respectively, because there is a right of offset. All other reinsurance agreements are reported on a gross basis on our Consolidated Balance Sheets as an
asset for amounts recoverable from reinsurers or as a component of other liabilities for amounts, such as premiums, owed to the reinsurers, with the exception of Modco agreements for which the right of offset also exists. Reinsurance premiums and benefits paid or provided are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Premiums, benefits and DAC are reported net of insurance ceded.
Goodwill
We recognize the excess of the purchase price, plus the fair value of any noncontrolling interest in the acquiree, over the fair value of identifiable net assets acquired as goodwill. Goodwill is not amortized, but is reviewed at least annually for indications of value impairment, with consideration given to financial performance and other relevant factors. In addition, certain events, including a significant adverse change in legal factors or the business climate, an adverse action or assessment by a regulator or unanticipated competition, would cause us to review the carrying amounts of goodwill for impairment. We are required to perform a two-step test in our evaluation of the carrying value of goodwill for impairment. In Step 1 of the evaluation, the fair value of each reporting unit is determined and compared to the carrying value of the reporting unit. If the fair value is greater than the carrying value, then the carrying value is deemed to be sufficient and Step 2 is not required. If the fair value estimate is less than the carrying value, it is an indicator that impairment may exist and Step 2 is required to be performed. In Step 2, the implied fair value of the reporting unit’s goodwill is determined by assigning the reporting unit’s fair value as determined in Step 1 to all of its net assets (recognized and unrecognized) as if the reporting unit had been acquired in a business combination at the date of the impairment test. If the implied fair value of the reporting unit’s goodwill is lower than its carrying amount, goodwill is impaired and written down to its fair value, and a charge is reported in impairment of intangibles on our Consolidated Statements of Income (Loss).
Other Assets and Other Liabilities
Other assets consist primarily of DSI, specifically identifiable intangible assets, property and equipment owned by the company, balances associated with corporate-owned and bank-owned life insurance, certain reinsurance assets, receivables resulting from sales of securities that had not yet settled as of the balance sheet date, debt issue costs and other prepaid expenses. Other liabilities consist primarily of current and deferred taxes, pension and other employee benefit liabilities, certain reinsurance payables, payables resulting from purchases of securities that had not yet settled as of the balance sheet date, interest on borrowed funds and other accrued expenses.
The carrying values of specifically identifiable intangible assets are reviewed at least annually for indicators of impairment in value that are other-than-temporary, including unexpected or adverse changes in the following: the economic or competitive environments in which the company operates; profitability analyses; cash flow analyses; and the fair value of the relevant business operation. If there was an indication of impairment, then the discounted cash flow method would be used to measure the impairment, and the carrying value would be adjusted as necessary and reported in impairment of intangibles on our Consolidated Statements of Income (Loss). Sales force intangibles are attributable to the value of the new business distribution system acquired through business combinations. These assets are amortized on a straight-line basis over their useful life of 25 years. Federal Communications Commission (“FCC”) licenses also acquired through business combinations are not amortized.
Property and equipment owned for company use is carried at cost less allowances for depreciation. Provisions for depreciation of investment real estate and property and equipment owned for company use are computed principally on the straight-line method over the estimated useful lives of the assets, which include buildings, computer hardware and software and other property and equipment. We periodically review the carrying value of our long-lived assets, including property and equipment, for impairment whenever events or circumstances indicate that the carrying amount of such assets may not be fully recoverable. For long-lived assets to be held and used, impairments are recognized when the carrying amount of a long-lived asset is not recoverable and exceeds its fair value. The carrying amount of a long-lived asset is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. An impairment loss is measured as the amount by which the carrying amount of a long-lived asset exceeds its fair value.
Long-lived assets to be disposed of by abandonment or in an exchange for a similar productive long-lived asset are classified as held-for-use until they are disposed. Long-lived assets to be sold are classified as held-for-sale and are no longer depreciated. Certain criteria have to be met in order for the long-lived asset to be classified as held-for-sale, including that a sale is probable and expected to occur within one year. Long-lived assets classified as held-for-sale are recorded at the lower of their carrying amount or fair value less cost to sell.
Separate Account Assets and Liabilities
We maintain separate account assets, which are reported at fair value. The related liabilities are reported at an amount equivalent to the separate account assets. Investment risks associated with market value changes are borne by the contract holders, except to the extent of minimum guarantees made by the Company with respect to certain accounts.
We issue variable annuity contracts through our separate accounts for which investment income and investment gains and losses accrue directly to, and investment risk is borne by, the contract holder (traditional variable annuities). We also issue variable annuity and life contracts through separate accounts that include various types of guaranteed death benefit (“GDB”), guaranteed withdrawal benefit (“GWB”) and guaranteed income benefit (“GIB”) features. The GDB features include those where we contractually guarantee to the contract holder either: return of no less than total deposits made to the contract less any partial withdrawals (“return of net deposits”); total deposits made to the contract less any partial withdrawals plus a minimum return (“minimum return”); or the highest contract value on any contract anniversary date through age 80 minus any payments or withdrawals following the contract anniversary (“anniversary contract value”).
As discussed in Note 6, certain features of these guarantees are accounted for as embedded derivative reserves, whereas other guarantees are accounted for as benefit reserves. Other guarantees contain characteristics of both and are accounted for under an approach that calculates the value of the embedded derivative reserve and the benefit reserve based on the specific characteristics of each guaranteed living benefit (“GLB”) feature. We use derivative instruments to hedge our exposure to the risks and earnings volatility that result from the embedded derivatives for living benefits in certain of our variable annuity products. The change in fair value of these instruments tends to move in the opposite direction of the change in the value of the associated reserves. The net impact of these changes is reported as a component of realized gain (loss) on our Consolidated Statements of Income (Loss).
The “market consistent scenarios” used in the determination of the fair value of the GWB liability are similar to those used by an investment bank to value derivatives for which the pricing is not transparent and the aftermarket is nonexistent or illiquid. In our calculation, risk-neutral Monte-Carlo simulations resulting in over 35 million scenarios are utilized to value the entire block of guarantees. The market consistent scenario assumptions, as of each valuation date, are those we view to be appropriate for a hypothetical market participant. The market consistent inputs include assumptions for the capital markets (e.g., implied volatilities, correlation among indices, risk-free swap curve, etc.), policyholder behavior (e.g., policy lapse, benefit utilization, mortality, etc.), risk margins, administrative expenses and a margin for profit. We believe these assumptions are consistent with those that would be used by a market participant; however, as the related markets develop we will continue to reassess our assumptions. It is possible that different valuation techniques and assumptions could produce a materially different estimate of fair value.
Future Contract Benefits and Other Contract Holder Funds
Future contract benefits represent liability reserves that we have established and carry based on estimates of how much we will need to pay for future benefits and claims. Other contract holder funds represent liabilities for fixed account values, including the fixed portion of variable, dividends payable, premium deposit funds, undistributed earnings on participating business and other contract holder funds as well the carrying value of DFEL discussed above.
The liabilities for future contract benefits and claim reserves for UL and VUL insurance policies consist of contract account balances that accrue to the benefit of the contract holders, excluding surrender charges. The liabilities for future insurance contract benefits and claim reserves for traditional life policies are computed using assumptions for investment yields, mortality and withdrawals based principally on generally accepted actuarial methods and assumptions at the time of contract issue. Investment yield assumptions for traditional direct individual life reserves for all contracts range from 2.25% to 7.75% depending on the time of contract issue. The investment yield assumptions for immediate and deferred paid-up annuities range from 1.00% to 13.50%. These investment yield assumptions are intended to represent an estimation of the interest rate experience for the period that these contract benefits are payable.
The liabilities for future claim reserves for variable annuity products containing GDB features are calculated by estimating the present value of total expected benefit payments over the life of the contract divided by the present value of total expected assessments over the life of the contract (“benefit ratio”) multiplied by the cumulative assessments recorded from the contract inception through the balance sheet date less the cumulative GDB payments plus interest on the reserves. The change in the reserve for a period is the benefit ratio multiplied by the assessments recorded for the period less GDB claims paid in the period plus interest. If experience or assumption changes result in a new benefit ratio, the reserves are adjusted to reflect the changes in a manner similar to the unlocking of DAC, VOBA, DFEL and DSI.
With respect to our future contract benefits and other contract holder funds, we continually review: overall reserve position, reserving techniques and reinsurance arrangements. As experience develops and new information becomes known, liabilities are adjusted as deemed necessary. The effects of changes in estimates are included in the operating results for the period in which such changes occur.
The business written or assumed by us includes participating life insurance contracts, under which the contract holder is entitled to share in the earnings of such contracts via receipt of dividends. The dividend scale for participating policies is reviewed annually and may be adjusted to reflect recent experience and future expectations. As of December 31, 2011 and 2010, participating policies
comprised approximately 1% of the face amount of insurance in force, and dividend expenses were $79 million, $82 million and $89 million for the years ended December 31, 2011, 2010 and 2009, respectively.
Liabilities for the secondary guarantees on UL-type products are calculated by multiplying the benefit ratio by the cumulative assessments recorded from contract inception through the balance sheet date less the cumulative secondary guarantee benefit payments plus interest. If experience or assumption changes result in a new benefit ratio, the reserves are adjusted to reflect the changes in a manner similar to the unlocking of DAC, VOBA, DFEL and DSI. The accounting for secondary guarantee benefits impacts, and is impacted by, EGPs used to calculate amortization of DAC, VOBA, DFEL and DSI.
Future contract benefits on our Consolidated Balance Sheets include GLB features and remaining guaranteed interest and similar contracts that are carried at fair value, which represents approximate surrender value including an estimate for our nonperformance risk. Certain of these features have elements of both insurance benefits and embedded derivatives. We weight these features and their associated reserves accordingly based on their hybrid nature. We classify these items in Level 3 within the hierarchy levels described above in “Fair Value Measurement.”
The fair value of our indexed annuity contracts is based on their approximate surrender values.
Borrowed Funds
LNC’s short-term borrowings are defined as borrowings with contractual or expected maturities of one year or less. Long-term borrowings have contractual or expected maturities greater than one year.
Deferred Gain on Business Sold Through Reinsurance
Our reinsurance operations were acquired by Swiss Re Life & Health America, Inc. (“Swiss Re”) in December 2001 through a series of indemnity reinsurance transactions. We are recognizing the gain related to these transactions at the rate that earnings on the reinsured business are expected to emerge, over a period of 15 years from the date of sale.
Commitments and Contingencies
Contingencies arising from environmental remediation costs, regulatory judgments, claims, assessments, guarantees, litigation, recourse reserves, fines, penalties and other sources are recorded when deemed probable and reasonably estimable.
Insurance Fees
Insurance fees for investment and interest-sensitive life insurance contracts consist of asset-based fees, cost of insurance charges, percent of premium charges, contract administration charges and surrender charges that are assessed against contract holder account balances. Investment products consist primarily of individual and group variable and fixed deferred annuities. Interest-sensitive life insurance products include UL insurance, VUL insurance and other interest-sensitive life insurance policies. These products include life insurance sold to individuals, corporate-owned life insurance and bank-owned life insurance.
In bifurcating the embedded derivative of our GLB features on our variable annuity products, we attribute to the embedded derivative the portion of total fees collected from the contract holder that relate to the GLB riders (the “attributed fees”), which are not reported within insurance fees on our Consolidated Statements of Income (Loss). These attributed fees represent the present value of future claims expected to be paid for the GLB at the inception of the contract plus a margin that a theoretical market participant would include for risk/profit and are reported within realized gain (loss) on our Consolidated Statements of Income (Loss).
The timing of revenue recognition as it relates to fees assessed on investment contracts is determined based on the nature of such fees. Asset-based fees, cost of insurance and contract administration charges are assessed on a daily or monthly basis and recognized as revenue when assessed and earned. Percent of premium charges are assessed at the time of premium payment and recognized as revenue when assessed and earned. Certain amounts assessed that represent compensation for services to be provided in future periods are reported as unearned revenue and recognized in income over the periods benefited. Surrender charges are recognized upon surrender of a contract by the contract holder in accordance with contractual terms.
For investment and interest-sensitive life insurance contracts, the amounts collected from contract holders are considered deposits and are not included in revenue.
Insurance Premiums
Our insurance premiums for traditional life insurance and group insurance products are recognized as revenue when due from the contract holder. Our traditional life insurance products include those products with fixed and guaranteed premiums and benefits and consist primarily of whole life insurance, limited-payment life insurance, term life insurance and certain annuities with life contingencies. Our group non-medical insurance products consist primarily of term life, disability and dental.
Net Investment Income
Dividends and interest income, recorded in net investment income, are recognized when earned. Amortization of premiums and accretion of discounts on investments in debt securities are reflected in net investment income over the contractual terms of the investments in a manner that produces a constant effective yield.
For CDOs and MBS, included in the trading and AFS fixed maturity securities portfolios, we recognize income using a constant effective yield based on anticipated prepayments and the estimated economic life of the securities. When actual prepayments differ significantly from originally anticipated prepayments, the retrospective effective yield is recalculated to reflect actual payments to date and a catch up adjustment is recorded in the current period. In addition, the new effective yield, which reflects anticipated future payments, is used prospectively. Any adjustments resulting from changes in effective yield are reflected in net investment income on our Consolidated Statements of Income (Loss).
Realized Gain (Loss)
Realized gain (loss) on our Consolidated Statements of Income (Loss) includes realized gains and losses from the sale of investments, write-downs for other-than-temporary impairments of investments, certain derivative and embedded derivative gains and losses, gains and losses on the sale of subsidiaries and businesses and net gains and losses on reinsurance embedded derivative and trading securities. Realized gains and losses on the sale of investments are determined using the specific identification method. Realized gain (loss) is recognized in net income, net of associated amortization of DAC, VOBA, DSI and DFEL. Realized gain (loss) is also net of allocations of investment gains and losses to certain contract holders and certain funds withheld on reinsurance arrangements for which we have a contractual obligation.
Other Revenues and Fees
Other revenues and fees consists primarily of fees attributable to broker-dealer services recorded as earned at the time of sale, changes in the market value of our seed capital investments and communications sales recognized as earned, net of agency and representative commissions.
Interest Credited
Interest credited includes interest credited to contract holder account balances. Interest crediting rates associated with funds invested in the general account of LNC’s insurance subsidiaries during 2009 through 2011 ranged from 3.00% to 9.00%.
Benefits
Benefits for UL and other interest-sensitive life insurance products include benefit claims incurred during the period in excess of contract account balances. Benefits also include the change in reserves for life insurance products with secondary guarantee benefits and annuity products with guaranteed death benefits. For traditional life, group health and disability income products, benefits are recognized when incurred in a manner consistent with the related premium recognition policies.
Pension and Other Postretirement Benefit Plans
Pursuant to the accounting rules for our obligations to employees and agents under our various pension and other postretirement benefit plans, we are required to make a number of assumptions to estimate related liabilities and expenses. We use assumptions for the weighted-average discount rate and expected return on plan assets to estimate pension expense. The discount rate assumptions are determined using an analysis of current market information and the projected benefit flows associated with these plans. The expected long-term rate of return on plan assets is based on historical and projected future rates of return on the funds invested in the plan. The calculation of our accumulated postretirement benefit obligation also uses an assumption of weighted-average annual rate of increase in the per capita cost of covered benefits, which reflects a health care cost trend rate.
Stock-Based Compensation
In general, we expense the fair value of stock awards included in our incentive compensation plans. As of the date our stock awards are approved, the fair value of stock options is determined using a Black-Scholes options valuation methodology, and the fair value of other stock awards is based upon the market value of the stock. The fair value of the awards is expensed over the performance or service period, which generally corresponds to the vesting period, and is recognized as an increase to common stock in stockholders’ equity. We classify certain stock awards as liabilities. For these awards, the settlement value is classified as a liability on our consolidated balance sheet and the liability is marked-to-market through net income at the end of each reporting period. Stock-based compensation expense is reflected in underwriting, acquisition, insurance and other expenses on our Consolidated Statements of Income (Loss).
Interest and Debt Expenses
Interest expense on our short-term and long-term debt is recognized as due and any associated premiums, discounts, and costs are amortized (accreted) over the term of the related borrowing utilizing the effective interest method. In addition, gains or losses related to certain derivative instruments associated with debt are recognized in interest expense during the period of the change.
Income Taxes
We file a U.S. consolidated income tax return that includes all of our eligible subsidiaries. Ineligible subsidiaries file separate individual corporate tax returns. Subsidiaries operating outside of the U.S. are taxed, and income tax expense is recorded based on applicable foreign statutes. Deferred income taxes are recognized, based on enacted rates, when assets and liabilities have different values for financial statement and tax reporting purposes. A valuation allowance is recorded to the extent required. Considerable judgment and the use of estimates are required in determining whether a valuation allowance is necessary and, if so, the amount of such valuation allowance. In evaluating the need for a valuation allowance, we consider many factors, including: the nature and character of the deferred tax assets and liabilities; taxable income in prior carryback years; future reversals of temporary differences; the length of time carryovers can be utilized; and any tax planning strategies we would employ to avoid a tax benefit from expiring unused.
Discontinued Operations
The results of operations of a component of the Company that either has been disposed of or is classified as held-for-sale are reported in income (loss) from discontinued operations, net of federal income taxes, for all periods presented if the operations and cash flows of the component have been or will be eliminated from our ongoing operations as a result of the disposal transaction and we will not have any significant continuing involvement in the operations.
Foreign Currency Translation
The balance sheet accounts and income statement items of foreign subsidiaries, reported in functional currencies other than the U.S. dollar are translated at the current and average exchange rates for the year, respectively. Resulting translation adjustments and other translation adjustments for foreign currency transactions that affect cash flows are reported in accumulated OCI, a component of stockholders’ equity.
Earnings Per Share
Basic earnings per share (“EPS”) is computed by dividing earnings available to common shareholders by the average common shares outstanding. Diluted EPS is computed assuming the conversion or exercise of dilutive convertible preferred securities, nonvested stock, stock options, performance share units, warrants and non-employee directors’ deferred compensation shares outstanding during the year.
Our deferred compensation plans allow participants the option to diversify from LNC stock to other investment alternatives. When calculating our weighted-average dilutive shares, we presume the investment option will be settled in cash and exclude these shares from our calculation, unless the effect of settlement in shares would be more dilutive to our diluted EPS calculation.
For any period where a loss from continuing operations is experienced, shares used in the diluted EPS calculation represent basic shares because using diluted shares would be anti-dilutive to the calculation.
2. New Accounting Standards
Adoption of New Accounting Standards
Consolidations Topic
In June 2009, the FASB issued Accounting Standards Update (“ASU”) No. 2009-17, “Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities” (“ASU 2009-17”), which amended the consolidation guidance for VIEs. The Consolidations Topic of the FASB ASC was amended to require a qualitative approach for identifying the variable interest required to consolidate the VIE based on the entity that has the power to direct the activities that most significantly impact the economic performance of the VIE and the obligation to absorb losses or the right to receive returns that could potentially be significant to the VIE. In February 2010, the FASB issued ASU No. 2010-10, “Amendments for Certain Investment Funds” (“ASU 2010-10”), which deferred application of the guidance in ASU 2009-17 for reporting entities with interests in an entity that applies the specialized accounting guidance for investment companies.
Effective January 1, 2010, we adopted the amendments in ASU 2009-17 and ASU 2010-10, and accordingly reconsidered our involvement with all our VIEs and the primary beneficiary of the VIEs. We concluded we are the primary beneficiary of the VIEs associated with our investments in credit-linked notes (“CLNs”), and as such, consolidated all of the assets and liabilities of these VIEs and recorded a cumulative effect adjustment of $169 million, after-tax, to the beginning balance of retained earnings as of January 1, 2010. In addition, we considered our investments in LPs and other alternative investments, and concluded these investments are within the scope of the deferral in ASU 2010-10, and as such they are not currently subject to the amended consolidation guidance in ASU 2009-17. As a result, we will continue to account for our alternative investments consistent with the accounting policy in Note 1. See Note 4 for more detail regarding the consolidation of our VIEs.
Fair Value Measurements and Disclosures Topic
In January 2010, the FASB issued ASU No. 2010-06, “Improving Disclosures about Fair Value Measurements” (“ASU 2010-06”), which required additional disclosure related to the three-level fair value hierarchy. We adopted the disclosure requirements related to significant transfers in and out of Levels 1 and 2 of the fair value hierarchy, and fair value disclosures related to pension and postretirement benefit plan assets effective January 1, 2010. Effective January 1, 2011, we adopted the remaining disclosure amendments in ASU 2010-06 requiring us to separately present information related to purchases, sales, issuances and settlements in the reconciliation of fair value measurements classified as Level 3, and have included the disclosure in Note 21 for the year ended December 31, 2011.
Financial Services - Insurance Industry Topic
In April 2010, the FASB issued ASU No. 2010-15, “How Investments Held through Separate Accounts Affect an Insurer’s Consolidation Analysis of Those Investments” (“ASU 2010-15”), to clarify a consolidation issue for insurance entities that hold a controlling interest in an investment fund either partially or completely through separate accounts. ASU 2010-15 concludes that an insurance entity would not be required to consider interests held in separate accounts when determining whether or not to consolidate an investment fund, unless the separate account interest is held for the benefit of a related party. If an investment fund is consolidated, the portion of the assets representing interests held in separate accounts would be recorded as a separate account asset with a corresponding separate account liability. The remaining investment fund assets would be consolidated in the insurance entity’s general accounts. We adopted the accounting guidance in ASU 2010-15 effective January 1, 2011, and applied the accounting guidance retrospectively to our separate accounts. The adoption did not have a material effect on our consolidated financial condition and results of operations.
Intangibles - Goodwill and Other Topic
In December 2010, the FASB issued ASU No. 2010-28, “When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts” (“ASU 2010-28”). Generally, reporting units with zero or negative carrying amounts will pass Step 1 of the goodwill impairment test as the fair value will exceed carrying value; therefore, goodwill impairment would not be assessed under Step 2. ASU 2010-28 modifies Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts, and requires these reporting units perform Step 2 of the impairment test to determine if it is more likely than not that goodwill impairment exists. We adopted ASU 2010-28 effective January 1, 2011, and the adoption did not have a material effect on our consolidated financial condition and results of operations.
Investments - Debt and Equity Securities Topic
In April 2009, the FASB replaced the guidance in the Investments - Debt and Equity Securities Topic of the FASB ASC related to OTTI. Our accounting policy for OTTI, included in Note 1, reflects these changes adopted by the FASB. As a result of adopting this accounting guidance, effective January 1, 2009, we recorded an increase of $102 million to the opening balance of retained earnings with a corresponding decrease to accumulated OCI on our Consolidated Statements of Stockholders’ Equity to reclassify the noncredit portion of previously other-than-temporarily impaired debt securities held as of January 1, 2009. The cumulative effect adjustment was calculated for all debt securities held as of January 1, 2009, for which an OTTI was previously recognized, and for which we did not intend to sell the security and it was not more likely than not that we would be required to sell the security before recovery of its amortized cost, by comparing the present value of cash flows expected to be received as of January 1, 2009, to the amortized cost basis of the debt securities. In addition, because the carrying amounts of DAC, VOBA, DSI and DFEL are adjusted for the effects of realized and unrealized gains and losses on fixed maturity AFS securities, we recognized a true-up to our DAC, VOBA, DSI and DFEL balances for this cumulative effect adjustment. The impact of this adoption to both basic and diluted per share amounts for the year ended December 31, 2009, was an increase of $0.98 per share.
Information regarding our calculation of OTTI is included in Note 5, and the amount of OTTI recognized in accumulated OCI is provided in Note 14.
Receivables Topic
In July 2010, the FASB issued ASU No. 2010-20, “Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses” (“ASU 2010-20”) to provide more information regarding the nature of the risk associated with financing receivables and how the assessment of the risk is used to estimate the allowance for credit losses. ASU 2010-20 was adopted over two reporting periods, and comparative disclosures were not required for earlier reporting periods ending prior to the initial adoption date. The remaining disclosure requirement related to the activity in our allowance for mortgage loans on real estate losses was effective January 1, 2011, and is provided in Note 5.
Future Adoption of New Accounting Standards
Balance Sheet Topic
In December 2011, the FASB issued ASU No. 2011-11, “Disclosures about Offsetting Assets and Liabilities” (“ASU 2011-11”), to address certain comparability issues between financial statements prepared in accordance with GAAP and those prepared in accordance with International Financial Reporting Standards. ASU 2011-11 will require an entity to provide enhanced disclosures about financial instruments and derivative instruments to enable users to understand the effects of offsetting in the financial statements as well as the effects of master netting arrangements on an entity’s financial position. The disclosures required by ASU 2011-11 are effective for annual and interim reporting periods beginning on or after January 1, 2013, with respective disclosures required for all comparative periods presented. We will adopt the disclosure requirements in ASU 2011-11 beginning with our first quarter 2013 financial statements, and are currently evaluating the appropriate location for these disclosures in the notes to our financial statements.
Comprehensive Income Topic
In June 2011, the FASB issued ASU No. 2011-05, “Presentation of Comprehensive Income” (“ASU 2011-05”), with an objective of increasing the prominence of items reported in other comprehensive income (“OCI”). The amendments in ASU 2011-05 provide entities with the option to present the total of comprehensive income, the components of net income and the components of OCI in either a single continuous statement of comprehensive income or in two separate but consecutive statements. In addition, ASU 2011-05 requires entities to present reclassification adjustments for each component of AOCI in both net income and OCI on the face of the financial statements; however, in December 2011, the FASB deferred this presentation requirement by issuing ASU No. 2011-12, “Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05” (“ASU 2011-12”). The FASB is considering operational concerns about the presentation requirements and the needs of financial statement users for additional information about reclassification adjustments. As noted in ASU 2011-12, the deferral does not affect the requirements in ASU 2011-5 to present the items of net income, OCI and total comprehensive income in a single continuous or two consecutive statements. In addition, entities will still be required to present amounts reclassified out of AOCI on the face of the financial statements or in the notes to the financial statements. ASU 2011-05 and ASU 2011-12 are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011. Early adoption is permitted, and the accounting guidance in ASU 2011-05 not subject to the deferral in ASU 2011-12 must be applied retrospectively. We will adopt the provisions of ASU 2011-05 and ASU 2011-12 with our first quarter 2012 financial statements and are currently evaluating our options for the presentation of comprehensive income.
Fair Value Measurements and Disclosures Topic
In May 2011, the FASB issued ASU No. 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards” (“ASU 2011-04”), which was issued to create a consistent framework for the application of fair value measurement across jurisdictions. The amendments include wording changes to GAAP in order to clarify the FASB’s intent about the application of existing fair value measurements and disclosure requirements, as well as to change a particular principle or existing requirement for measuring fair value or disclosing information about fair value measurements. There are no additional fair value measurements required upon the adoption of ASU 2011-04. The amendments are effective, prospectively, for interim and annual reporting periods beginning after December 15, 2011. Early adoption is prohibited. We will adopt the provisions of ASU 2011-04 effective January 1, 2012, and do not expect the adoption will have a material effect on our consolidated financial condition and results of operations.
Financial Services - Insurance Industry Topic
In October 2010, the FASB issued ASU No. 2010-26, “Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts” (“ASU 2010-26”), which clarifies the types of costs incurred by an insurance entity that can be capitalized in the acquisition of insurance contracts. Only those costs incurred which result directly from and are essential to the successful acquisition of new or renewal insurance contracts may be capitalized. Incremental costs related to unsuccessful attempts to acquire insurance contracts must be expensed as incurred. Under ASU 2010-26, the capitalization criteria in the direct-response advertising
guidance of the Other Assets and Deferred Costs Topic of the FASB ASC must be met in order to capitalize advertising costs. The amendments are effective for fiscal years and interim periods beginning after December 15, 2011. Early adoption is permitted and an entity may elect to apply the guidance prospectively or retrospectively. We will adopt the provisions of ASU 2010-26 effective January 1, 2012, and currently estimate that retrospective adoption will result in the restatement of all years presented with a cumulative effect adjustment to the opening balance of retained earnings for the earliest period presented of approximately $950 million to $1.15 billion. In addition, the adoption of this accounting guidance will result in a lower DAC adjustment associated with unrealized gains and losses on AFS securities and certain derivatives; therefore, we will also adjust these DAC balances through a cumulative effect adjustment to the opening balance of AOCI. This adjustment is dependent on our unrealized position as of the date of adoption.
Intangibles - Goodwill and Other Topic
In September 2011, the FASB issued ASU No. 2011-08, “Testing Goodwill for Impairment” (“ASU 2011-08”), which provides an option to first assess qualitative factors to determine if it is necessary to complete the two-step goodwill impairment test. If an assessment of the relevant events and circumstances leads to a conclusion that it is not more likely than not that the fair value of a reporting unit is less than its carrying value, then performing the two-step impairment test is unnecessary. However, if a conclusion is reached otherwise, the two-step impairment test, that is currently required under the FASB ASC, must be completed. An entity has an unconditional option to bypass the qualitative assessment for any reporting unit and proceed directly to the two-step goodwill impairment test, and resume qualitative assessment for the same reporting unit in a subsequent reporting period. The amendments in ASU 2011-08 will be effective for interim and annual goodwill impairment tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted. We will adopt the provisions of ASU 2011-08 effective January 1, 2012, and do not expect the adoption will have a material effect on our consolidated financial condition and results of operations.
Transfers and Servicing Topic
In April 2011, the FASB issued ASU No. 2011-03, “Reconsideration of Effective Control for Repurchase Agreements” (“ASU 2011-03”), which revises the criteria for assessing effective control for repurchase agreements and other agreements that both entitle and obligate a transferor to repurchase or redeem financial assets before their maturity. The determination of whether the transfer of a financial asset subject to a repurchase agreement is a sale is based, in part, on whether the entity maintains effective control over the financial asset. ASU 2011-03 removes the following from the assessment of effective control: the criterion requiring the transferor to have the ability to repurchase or redeem the financial asset on substantially the agreed terms, even in the event of default by the transferee, and the related requirement to demonstrate that the transferor possesses adequate collateral to fund substantially all the cost of purchasing replacement financial assets. The amendments in ASU 2011-03 will be effective for interim and annual reporting periods beginning on or after December 15, 2011, early adoption is prohibited and the amendments will be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. We will adopt the provisions of ASU 2011-03 effective January 1, 2012, and do not expect the adoption will have a material effect on our consolidated financial condition and results of operations.
3. Dispositions
Newton County Loan & Savings, FSB (“NCLS”)
On January 8, 2009, the Office of Thrift Supervision approved our application to become a savings and loan holding company and our acquisition of NCLS, a federally regulated savings bank located in Indiana. On November 30, 2011, we completed the liquidation of NCLS, which did not have a material effect on our consolidated financial condition or results of operations.
Discontinued Investment Management Operations
On January 4, 2010, we closed on the stock sale of our subsidiary Delaware Management Holdings, Inc. (“Delaware”), which provided investment products and services to individuals and institutions, to Macquarie Bank Limited.
In addition, certain of our subsidiaries, including The Lincoln National Life Insurance Company (“LNL”), our primary insurance subsidiary, entered into investment advisory agreements with Delaware, pursuant to which Delaware will continue to manage the majority of the general account insurance assets of the subsidiaries. The investment advisory agreements have 10-year terms, and we may terminate them without cause, subject to a purchase price adjustment of up to $67 million, the amount of which is dependent on the timing of any termination and which agreements are terminated. The amount of the potential adjustment will decline on a pro rata basis over the 10-year term of the advisory agreements.
We reclassified the results of operations of Delaware into income (loss) from discontinued operations, net of federal income taxes, for all periods presented on our Consolidated Statements of Income (Loss), and selected amounts (in millions) were as follows:
For the Years Ended December 31,
Revenues
Investment advisory fees - external
$ -
$ -
$
Investment advisory fees - internal
-
-
Other revenues and fees
-
-
Gain (loss) on sale of business
-
Total revenues $ -
$
$
Discontinued Operations Before Disposal
Income (loss) from discontinued operations before disposal, before federal income taxes
$ -
$ (13 ) $
Federal income tax expense (benefit)
-
(2 )
Income (loss) from discontinued operations before disposal
-
(11 )
Disposal
Gain (loss) on disposal, before federal income taxes
(3 )
-
Federal income tax expense (benefit)
(13 )
-
Gain (loss) on disposal
(8 )
-
Income (loss) from discontinued operations $ (8 ) $
$
The loss from discontinued operations for the year ended December 31, 2011, related to an unfavorable tax return true-up from the prior year. The income from discontinued operations for the year ended December 31, 2010, included final cash received toward the purchase price for certain institutional taxable fixed income business sold during the fourth quarter 2007, and also reflected stock compensation expense attributable to the acceleration of vesting of equity awards for certain Delaware employees upon the sale of Delaware.
Discontinued Lincoln UK Operations
On October 1, 2009, we closed on the stock sale of Lincoln National (UK) plc (“Lincoln UK”), our subsidiary, which focused primarily on providing life and retirement income products in the United Kingdom to SLF of Canada UK Limited, and we retained Lincoln UK’s pension plan assets and liabilities.
We have reclassified the results of operations of Lincoln UK into income (loss) from discontinued operations, net of federal income taxes, for all periods presented on our Consolidated Statements of Income (Loss), and selected amounts (in millions) were as follows:
For the Years Ended
December 31,
Revenues
Insurance premiums
$ -
$
Insurance fees
-
Net investment income
-
Realized gain (loss)
-
(1 )
Total revenues $ -
$
Discontinued Operations Before Disposal
Income (loss) from discontinued operations before disposal, before federal income taxes
$ -
$
Federal income tax expense (benefit)
-
Income (loss) from discontinued operations before disposal
-
Disposal
Gain (loss) on disposal, before federal income taxes
(219 )
Federal income tax expense (benefit)
(105 )
Gain (loss) on disposal
(114 )
Income (loss) from discontinued operations $
$ (89 )
The income from discontinued operations for the year ended December 31, 2010, related to an unfavorable tax return true-up from the prior year, partially offset by the estimated transaction cost being lower than anticipated. In addition, the income from discontinued operations for the year ended December 31, 2010, included additional consideration received attributable to a post-closing adjustment of the purchase price based upon a final actuarial appraisal of the value of the business as set forth in the share purchase agreement, partially offset by the items mentioned above.
4. Variable Interest Entities
Consolidated VIEs
CLNs
We have invested in the Class 1 notes of two CLN structures, which represent special purpose trusts combining asset-backed securities with credit default swaps to produce multi-class structured securities. The CLN structures also include subordinated Class 2 notes, which are held by third parties, and, together with the Class 1 notes, represent 100% of the outstanding notes of the CLN structures. The entities that issued the CLNs are financed by the note holders, and, as such, the note holders participate in the expected losses and residual returns of the entities.
Because the note holders do not have voting rights or similar rights, we determined the entities issuing the CLNs are VIEs, and as a note holder, our interest represented a variable interest. We have the power to direct the most significant activity affecting the performance of both CLN structures, as we have the ability to actively manage the reference portfolio underlying the credit default swaps. In addition, we receive returns from the CLN structures and may absorb losses that could potentially be significant to the CLN structures. As such, we concluded that we are the primary beneficiary of the VIEs associated with the CLNs. We reflected the assets and liabilities on our Consolidated Balance Sheets and recognized the results of operations of these VIEs on our Consolidated Statements of Income since adopting new accounting guidance in the first quarter of 2010. See “Consolidations Topic” in Note 2 for more detail regarding the effect of the adoption.
As a result of consolidating the CLNs, we also consolidate the derivative instruments in the CLN structures. The credit default swaps create variability in the CLN structures and expose the note holders to the credit risk of the referenced portfolio. The contingent forwards transfer a portion of the loss in the underlying fixed maturity corporate asset-backed credit card loan securities back to the counterparty after credit losses reach our attachment point.
The following summarizes information regarding the CLN structures (dollars in millions) as of December 31, 2011:
Amount and Date of Issuance
$400
$200
December
April
Original attachment point (subordination)
5.50
%
2.05
%
Current attachment point (subordination)
4.17
%
1.48
%
Maturity
12/20/2016
3/20/2017
Current rating of tranche
B+
Ba2
Current rating of underlying collateral pool
Aa1-B3
Aaa-Caa1
Number of defaults in underlying collateral pool
Number of entities
Number of countries
There has been no event of default on the CLNs themselves. Based upon our analysis, the remaining subordination as represented by the attachment point should be sufficient to absorb future credit losses, subject to changing market conditions. Similar to other debt market instruments, our maximum principal loss is limited to our original investment.
The following summarizes the exposure of the CLN structures’ underlying collateral by industry and rating as of December 31, 2011:
AAA
AA
A
BBB
BB
B
CCC
Total
Industry
Telecommunications
-
%
-
%
5.5
%
4.8
%
0.4
%
0.5
%
-
%
11.2
%
Financial intermediaries
0.3
%
3.3
%
6.4
%
0.5
%
-
%
-
%
-
%
10.5
%
Oil and gas
-
%
0.7
%
1.0
%
4.6
%
-
%
-
%
-
%
6.3
%
Utilities
-
%
-
%
3.1
%
1.4
%
-
%
-
%
-
%
4.5
%
Chemicals and plastics
-
%
-
%
2.3
%
1.2
%
0.4
%
-
%
-
%
3.9
%
Drugs
0.3
%
2.2
%
1.2
%
-
%
-
%
-
%
-
%
3.7
%
Retailers (except food and drug)
-
%
-
%
2.1
%
0.9
%
0.5
%
-
%
-
%
3.5
%
Industrial equipment
-
%
-
%
3.0
%
0.3
%
-
%
-
%
-
%
3.3
%
Sovereign
-
%
0.7
%
1.6
%
1.0
%
-
%
-
%
-
%
3.3
%
Food products
-
%
0.3
%
1.8
%
1.1
%
-
%
-
%
-
%
3.2
%
Conglomerates
-
%
2.6
%
0.5
%
-
%
-
%
-
%
-
%
3.1
%
Forest products
-
%
-
%
-
%
1.6
%
1.4
%
-
%
-
%
3.0
%
Other
-
%
3.0
%
14.9
%
17.3
%
3.5
%
1.5
%
0.3
%
40.5
%
Total
0.6
%
12.8
%
43.4
%
34.7
%
6.2
%
2.0
%
0.3
%
100.0
%
Statutory Trust Note
In August 2011, we purchased a $100 million note issued by a statutory trust (“Issuer”) in a private placement offering. The proceeds were used by the Issuer to purchase U.S. Treasury securities to be held as collateral assets supporting an excess mortality swap. Our maximum exposure to loss is limited to our original investment in the notes. We have concluded that the Issuer of the note is a VIE as the entity does not have sufficient equity to support its activities without additional financial support, and as a note holder, our interest represents a variable interest. In our evaluation of the primary beneficiary, we concluded that our economic interest was greater than our stated power. As a result, we concluded that we are the primary beneficiary of the VIE and consolidated all of the assets and liabilities of the Issuer on our Consolidated Balance Sheets as of August 1, 2011.
Asset and liability information (dollars in millions) for these consolidated VIEs included on our Consolidated Balance Sheets was as follows:
As of December 31, 2011
As of December 31, 2010
Number
Number
of
Notional
Carrying
of
Notional
Carrying
Instruments
Amounts
Value
Instruments
Amounts
Value
Assets
Fixed maturity securities:
Asset-backed credit card loan
N/A
$
-
$
N/A
$
-
$
U.S. Government bonds
N/A
-
N/A
-
-
Excess mortality swap
-
-
-
-
Total assets (1)
$
$
-
$
-
$
Liabilities
Non-qualifying hedges:
Credit default swaps
$
$
$
$
Contingent forwards
-
(4
)
-
(6
)
Total non-qualifying hedges
Federal income tax
N/A
-
(98
)
N/A
-
(77
)
Total liabilities (2)
$
$
$
$
(1)
Reported in VIEs' fixed maturity securities on our Consolidated Balance Sheets.
(2)
Reported in VIEs' liabilities on our Consolidated Balance Sheets.
For details related to the fixed maturity AFS securities for these VIEs, see Note 5.
As described more fully in Note 1, we regularly review our investment holdings for OTTI. Based upon this review, we believe that the fixed maturity securities were not other-than-temporarily impaired as of December 31, 2011.
The gains (losses) for these consolidated VIEs (in millions) recorded on our Consolidated Statements of Income (Loss) were as follows:
For the Years Ended
December 31,
Non-Qualifying Hedges
Credit default swaps
$ (80 ) $
Contingent forwards
(2 )
(9 )
Total non-qualifying hedges (1) $ (82 ) $
(1)
Reported in realized gain (loss) on our Consolidated Statements of Income (Loss).
Unconsolidated VIEs
Effective December 31, 2010, we issued a $500 million long-term senior note in exchange for a corporate bond AFS security of like principal and duration from a non-affiliated VIE whose primary activities are to acquire, hold and issue notes and loans, as well as pay and collect interest on the notes and loans. We have concluded that we are not the primary beneficiary of this VIE because we do not have power over the activities that most significantly affect its economic performance. In addition, the terms of the senior note provide us with a set-off right to the corporate bond AFS security we purchased from the VIE; therefore, neither appears on our Consolidated Balance Sheets. We assigned the corporate bond AFS security to one of our subsidiaries and issued a guarantee to our subsidiary for the timely payment of the corporate bond’s principal.
Through our investment activities, we make passive investments in structured securities issued by VIEs for which we are not the manager. These structured securities include our RMBS, CMBS and CDOs. We have not provided financial or other support with
respect to these VIEs other than our original investment. We have determined that we are not the primary beneficiary of these VIEs due to the relative size of our investment in comparison to the principal amount of the structured securities issued by the VIEs and the level of credit subordination that reduces our obligation to absorb losses or right to receive benefits. Our maximum exposure to loss on these structured securities is limited to the amortized cost for these investments. We recognize our variable interest in these VIEs at fair value on our Consolidated Balance Sheets. For information about these structured securities, see Note 5.
5. Investments
AFS Securities
Pursuant to the Fair Value Measurements and Disclosures Topic of the FASB ASC, we have categorized AFS securities into a three-level hierarchy, based on the priority of the inputs to the respective valuation technique. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3), as described in Note 1, which also includes additional disclosures regarding our fair value measurements.
The amortized cost, gross unrealized gains, losses and OTTI and fair value of AFS securities (in millions) were as follows:
As of December 31, 2011
Amortized
Gross Unrealized
Fair
Cost
Gains
Losses
OTTI
Value
Fixed maturity securities:
Corporate bonds
$ 53,661
$ 6,185
$
$
$ 59,261
U.S. Government bonds
-
-
Foreign government bonds
-
-
RMBS
7,690
8,039
CMBS
1,642
1,600
CDOs
-
-
State and municipal bonds
3,490
-
4,047
Hybrid and redeemable preferred securities
1,277
-
1,157
VIEs' fixed maturity securities
-
-
Total fixed maturity securities
69,661
7,569
76,133
Equity securities
-
Total AFS securities
$ 69,796
$ 7,585
$
$
$ 76,272
As of December 31, 2010
Amortized
Gross Unrealized
Fair
Cost
Gains
Losses
OTTI
Value
Fixed maturity securities:
Corporate bonds
$ 48,863
$ 3,571
$
$
$ 51,740
U.S. Government bonds
-
Foreign government bonds
-
RMBS
8,673
8,838
CMBS
2,144
2,053
CDOs
State and municipal bonds
3,222
-
3,155
Hybrid and redeemable preferred securities
1,476
-
1,397
VIEs' fixed maturity securities
-
-
Total fixed maturity securities
65,745
4,270
1,153
68,614
Equity securities
-
Total AFS securities
$ 65,924
$ 4,295
$ 1,160
$
$ 68,811
The amortized cost and fair value of fixed maturity AFS securities by contractual maturities (in millions) were as follows:
As of December 31, 2011
Amortized
Fair
Cost
Value
Due in one year or less
$ 2,342
$ 2,378
Due after one year through five years
12,418
13,288
Due after five years through ten years
22,456
24,593
Due after ten years
22,992
26,133
Subtotal
60,208
66,392
MBS
9,332
9,639
CDOs
Total fixed maturity AFS securities
$ 69,661
$ 76,133
Actual maturities may differ from contractual maturities because issuers may have the right to call or pre-pay obligations.
The fair value and gross unrealized losses, including the portion of OTTI recognized in OCI, of AFS securities (dollars in millions), aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows:
As of December 31, 2011
Less Than or Equal
Greater Than
to Twelve Months
Twelve Months
Total
Gross
Gross
Gross
Unrealized
Unrealized
Unrealized
Fair
Losses and
Fair
Losses and
Fair
Losses and
Value
OTTI
Value
OTTI
Value
OTTI
Fixed maturity securities:
Corporate bonds
$ 2,848
$
$ 1,452
$
$ 4,300
$
RMBS
CMBS
CDOs
State and municipal bonds
-
Hybrid and redeemable preferred securities
Total fixed maturity securities
3,955
2,490
6,445
1,097
Equity securities
-
-
Total AFS securities
$ 3,993
$
$ 2,490
$
$ 6,483
$ 1,109
Total number of AFS securities in an unrealized loss position
As of December 31, 2010
Less Than or Equal
Greater Than
to Twelve Months
Twelve Months
Total
Gross
Gross
Gross
Unrealized
Unrealized
Unrealized
Fair
Losses and
Fair
Losses and
Fair
Losses and
Value
OTTI
Value
OTTI
Value
OTTI
Fixed maturity securities:
Corporate bonds
$ 5,271
$
$ 2,007
$
$ 7,278
$
U.S. Government bonds
-
Foreign government bonds
-
RMBS
1,405
CMBS
CDOs
-
-
State and municipal bonds
1,889
1,916
Hybrid and redeemable preferred securities
Total fixed maturity securities
8,140
3,814
11,954
1,401
Equity securities
-
-
Total AFS securities
$ 8,200
$
$ 3,814
$
$ 12,014
$ 1,408
Total number of AFS securities in an unrealized loss position
1,237
For information regarding our investments in VIEs, see Note 4.
We perform detailed analysis on the AFS securities backed by pools of residential and commercial mortgages that are most at risk of impairment based on factors discussed in Note 1. Selected information for these securities in a gross unrealized loss position (in millions) was as follows:
As of December 31, 2011
Amortized
Fair
Unrealized
Cost
Value
Loss
Total
AFS securities backed by pools of residential mortgages
$ 2,023
$ 1,553
$
AFS securities backed by pools of commercial mortgages
Total
$ 2,495
$ 1,897
$
Subject to Detailed Analysis
AFS securities backed by pools of residential mortgages
$ 2,015
$ 1,545
$
AFS securities backed by pools of commercial mortgages
Total
$ 2,141
$ 1,606
$
As of December 31, 2010
Amortized
Fair
Unrealized
Cost
Value
Loss
Total
AFS securities backed by pools of residential mortgages
$ 2,539
$ 2,006
$
AFS securities backed by pools of commercial mortgages
Total
$ 3,150
$ 2,416
$
Subject to Detailed Analysis
AFS securities backed by pools of residential mortgages
$ 2,303
$ 1,776
$
AFS securities backed by pools of commercial mortgages
Total
$ 2,488
$ 1,852
$
For the years ended December 31, 2011 and 2010, we recorded OTTI for AFS securities backed by pools of residential and commercial mortgages of $135 million and $163 million, pre-tax, respectively, and before associated amortization expense for DAC, VOBA, DSI and DFEL, of which $(15) million and $19 million, respectively, was recognized in OCI and $150 million and $144 million, respectively, was recognized in net income (loss).
The fair value, gross unrealized losses, the portion of OTTI recognized in OCI (in millions) and number of AFS securities where the fair value had declined and remained below amortized cost by greater than 20% were as follows:
As of December 31, 2011
Number
Fair
Gross Unrealized
of
Value
Losses
OTTI
Securities(1)
Less than six months
$
$
$
Six months or greater, but less than nine months
Nine months or greater, but less than twelve months
-
Twelve months or greater
Total
$ 1,055
$
$
As of December 31, 2010
Number
Fair
Gross Unrealized
of
Value
Losses
OTTI
Securities(1)
Less than six months
$
$
$
Six months or greater, but less than nine months
-
Nine months or greater, but less than twelve months
Twelve months or greater
Total
$ 1,201
$
$
(1)
We may reflect a security in more than one aging category based on various purchase dates.
We regularly review our investment holdings for OTTI. Our gross unrealized losses on AFS securities as of December 31, 2011, decreased $299 million in comparison to December 31, 2010. This change was attributable primarily to a decline in overall market yields, which was driven by market uncertainty and weakening economic activity. As discussed further below, we believe the unrealized loss position as of December 31, 2011, does not represent OTTI as we did not intend to sell these fixed maturity AFS securities, it is not more likely than not that we will be required to sell the fixed maturity AFS securities before recovery of their amortized cost basis, the estimated future cash flows were equal to or greater than the amortized cost basis of the debt securities, or we had the ability and intent to hold the equity AFS securities for a period of time sufficient for recovery.
Based upon this evaluation as of December 31, 2011, management believed we had the ability to generate adequate amounts of cash from our normal operations (e.g., insurance premiums and fees and investment income) to meet cash requirements with a prudent margin of safety without requiring the sale of our temporarily-impaired securities.
As of December 31, 2011, the unrealized losses associated with our corporate bond securities were attributable primarily to securities that were backed by commercial loans and individual issuer companies. For our corporate bond securities with commercial loans as the underlying collateral, we evaluated the projected credit losses in the underlying collateral and concluded that we had sufficient subordination or other credit enhancement when compared with our estimate of credit losses for the individual security and we expected to recover the entire amortized cost for each security. For individual issuers, we performed detailed analysis of the financial performance of the issuer and determined that we expected to recover the entire amortized cost for each security.
As of December 31, 2011, the unrealized losses associated with our MBS and CDOs were attributable primarily to collateral losses and credit spreads. We assessed for credit impairment using a cash flow model as discussed above. The key assumptions included default rates, severities and prepayment rates. We estimated losses for a security by forecasting the underlying loans in each transaction. The forecasted loan performance was used to project cash flows to the various tranches in the structure, as applicable. Our forecasted cash flows also considered, as applicable, independent industry analyst reports and forecasts, sector credit ratings and other independent market data. Based upon our assessment of the expected credit losses of the security given the performance of the underlying collateral compared to our subordination or other credit enhancement, we expected to recover the entire amortized cost basis of each security.
As of December 31, 2011, the unrealized losses associated with our hybrid and redeemable preferred securities were attributable primarily to wider credit spreads caused by illiquidity in the market and subordination within the capital structure, as well as credit risk of specific issuers. For our hybrid and redeemable preferred securities, we evaluated the financial performance of the issuer based upon credit performance and investment ratings and determined we expected to recover the entire amortized cost of each security.
Changes in the amount of credit loss of OTTI recognized in net income (loss) where the portion related to other factors was recognized in OCI (in millions) on fixed maturity AFS securities were as follows:
For the Years Ended December 31,
Balance as of beginning-of-year
$
$
$ -
Cumulative effect from adoption of new accounting standard
-
-
Increases attributable to:
Credit losses on securities for which an OTTI was not previously recognized
Credit losses on securities for which an OTTI was previously recognized
-
Decreases attributable to:
Securities sold
(55 )
(28 )
(30 )
Balance as of end-of-year
$
$
$
During the years ended December 31, 2011, 2010 and 2009, we recorded credit losses on securities for which an OTTI was not previously recognized as we determined the cash flows expected to be collected would not be sufficient to recover the entire amortized cost basis of the debt security. The credit losses we recorded on securities for which an OTTI was not previously recognized were attributable primarily to one or a combination of the following reasons:
·
Failure of the issuer of the security to make scheduled payments;
·
Deterioration of creditworthiness of the issuer;
·
Deterioration of conditions specifically related to the security;
·
Deterioration of fundamentals of the industry in which the issuer operates;
·
Deterioration of fundamentals in the economy including, but not limited to, higher unemployment and lower housing prices; and
·
Deterioration of the rating of the security by a rating agency.
We recognize the OTTI attributed to the noncredit portion as a separate component in OCI referred to as unrealized OTTI on AFS securities.
Details of the amount of credit loss of OTTI recognized in net income (loss) where the portion related to other factors was recognized in OCI (in millions), were as follows:
As of December 31, 2011
Gross Unrealized
OTTI in
Amortized
Losses and
Fair
Credit
Cost
Gains
OTTI
Value
Losses
Corporate bonds
$
$
$
$
$
RMBS
CMBS
-
Total
$
$
$
$
$
Trading Securities
Trading securities at fair value (in millions) consisted of the following:
As of December 31,
Fixed maturity securities:
Corporate bonds
$ 1,908
$ 1,801
U.S. Government bonds
Foreign government bonds
RMBS
CMBS
CDOs
State and municipal bonds
Hybrid and redeemable preferred securities
Total fixed maturity securities
2,673
2,594
Equity securities
Total trading securities
$ 2,675
$ 2,596
The portion of the market adjustment for losses that relate to trading securities still held as of December 31, 2011, 2010 and 2009, was $118 million, $93 million and $137 million, respectively.
Mortgage Loans on Real Estate
Mortgage loans on real estate principally involve commercial real estate. The commercial loans are geographically diversified throughout the U.S. with the largest concentrations in California and Texas, which accounted for approximately 32% and 30% of mortgage loans on real estate as of December 31, 2011 and 2010, respectively.
The following provides the current and past due composition of our mortgage loans on real estate (in millions):
As of December 31,
Current
$ 6,858
$ 6,697
60 to 90 days past due
Greater than 90 days past due
Valuation allowance associated with impaired mortgage loans on real estate
(31 )
(13 )
Unamortized premium (discount)
Total carrying value
$ 6,942
$ 6,752
The number of impaired mortgage loans on real estate, each of which had an associated specific valuation allowance, and the carrying value of impaired mortgage loans on real estate (dollars in millions) were as follows:
As of December 31,
Number of impaired mortgage loans on real estate
Principal balance of impaired mortgage loans on real estate
$
$
Valuation allowance associated with impaired mortgage loans on real estate
(31 )
(13 )
Carrying value of impaired mortgage loans on real estate
$
$
The average carrying value on the impaired mortgage loans on real estate (in millions) was as follows:
For the Years Ended December 31,
Average carrying value for impaired mortgage loans on real estate
$
$
$
Interest income recognized on impaired mortgage loans on real estate
Interest income collected on impaired mortgage loans on real estate
As described in Note 1, we use the loan-to-value and debt-service coverage ratios as credit quality indicators for our mortgage loans, which were as follows (dollars in millions):
As of December 31, 2011
As of December 31, 2010
Debt-
Debt-
Service
Service
Principal
% of
Coverage
Principal
% of
Coverage
Loan-to-Value
Amount
Total
Ratio
Amount
Total
Ratio
Less than 65%
$ 5,338
76.7 %
1.61
4,863
72.1 %
1.62
65% to 74%
1,198
17.2 %
1.37
1,484
22.0 %
1.40
75% to 100%
4.4 %
0.92
2.7 %
0.85
Greater than 100%
1.7 %
0.36
3.2 %
1.06
Total mortgage loans on real estate
$ 6,960
100.0 %
6,745
100.0 %
Alternative Investments
As of December 31, 2011 and 2010, alternative investments included investments in approximately 96 and 95 different partnerships, respectively, and the portfolio represented less than 1% of our overall invested assets.
Net Investment Income
The major categories of net investment income (in millions) on our Consolidated Statements of Income (Loss) were as follows:
For the Years Ended December 31,
Fixed maturity AFS securities
$ 3,842
$ 3,694
$ 3,474
VIEs' fixed maturity AFS securities
-
Equity AFS securities
Trading securities
Mortgage loans on real estate
Real estate
Standby real estate equity commitments
Policy loans
Invested cash
Commercial mortgage loan prepayment and bond makewhole premiums
Alternative investments
(55 )
Consent fees
Other investments
(27 )
(3 )
Investment income
4,763
4,661
4,292
Investment expense
(111 )
(120 )
(114 )
Net investment income
$ 4,652
$ 4,541
$ 4,178
Realized Gain (Loss) Related to Certain Investments
The detail of the realized gain (loss) related to certain investments (in millions) was as follows:
For the Years Ended December 31,
Fixed maturity AFS securities:
Gross gains
$
$
$
Gross losses
(227 )
(248 )
(709 )
Equity AFS securities:
Gross gains
Gross losses
-
(3 )
(27 )
Gain (loss) on other investments
(9 )
(53 )
(130 )
Associated amortization of DAC, VOBA, DSI and DFEL and changes in other contract holder funds
(13 )
Total realized gain (loss) related to certain investments
$ (151 ) $ (180 ) $ (538 )
Details underlying write-downs taken as a result of OTTI (in millions) that were recognized in net income (loss) and included in realized gain (loss) on AFS securities above, and the portion of OTTI recognized in OCI (in millions) were as follows:
For the Years Ended December 31,
OTTI Recognized in Net Income (Loss)
Fixed maturity securities:
Corporate bonds
$ (14 ) $ (90 ) $ (214 )
RMBS
(79 )
(65 )
(250 )
CMBS
(57 )
(41 )
-
CDOs
(1 )
(1 )
(39 )
Hybrid and redeemable preferred securities
(2 )
(5 )
(67 )
Total fixed maturity securities
(153 )
(202 )
(570 )
Equity securities
-
(3 )
(27 )
Gross OTTI recognized in net income (loss)
(153 )
(205 )
(597 )
Associated amortization of DAC, VOBA, DSI and DFEL
Net OTTI recognized in net income (loss), pre-tax
$ (118 ) $ (152 ) $ (392 )
Portion of OTTI Recognized in OCI
Gross OTTI recognized in OCI $
$
$
Change in DAC, VOBA, DSI and DFEL
(11 )
(10 )
(82 )
Net portion of OTTI recognized in OCI, pre-tax $
$
$
Determination of Credit Losses on Corporate Bonds and CDOs
As of December 31, 2011 and 2010, we reviewed our corporate bond and CDO portfolios for potential shortfall in contractual principal and interest based on numerous subjective and objective inputs. The factors used to determine the amount of credit loss for each individual security, include, but are not limited to, near term risk, substantial discrepancy between book and market value, sector or company-specific volatility, negative operating trends and trading levels wider than peers.
Credit ratings express opinions about the credit quality of a security. Securities rated investment grade, that is those rated BBB- or higher by Standard & Poor’s (“S&P”) Rating Services or Baa3 or higher by Moody’s Investors Service (“Moody’s”), are generally considered by the rating agencies and market participants to be low credit risk. As of December 31, 2011 and 2010, 96% and 95%, respectively, of the fair value of our corporate bond portfolio was rated investment grade. As of December 31, 2011 and 2010, the portion of our corporate bond portfolio rated below investment grade had an amortized cost of $2.6 billion and a fair value of $2.4 billion. As of December 31, 2011 and 2010, 97% and 91%, respectively, of the fair value of our CDO portfolio was rated investment grade. As of December 31, 2011 and 2010, the portion of our CDO portfolio rated below investment grade had an
amortized cost of $3 million and $24 million and fair value of $3 million and $16 million, respectively. Based upon the analysis discussed above, we believed as of December 31, 2011 and 2010, that we would recover the amortized cost of each investment grade corporate bond and CDO security.
For securities where we recorded an OTTI recognized in net income (loss) for the years ended December 31, 2011 and 2010, the recovery as a percentage of amortized cost was 98% and 80% for corporate bonds, respectively, and 0% for CDOs.
Determination of Credit Losses on MBS
As of December 31, 2011 and 2010, default rates were projected by considering underlying MBS loan performance and collateral type. Projected default rates on existing delinquencies vary between 25% to 100% depending on loan type and severity of delinquency status. In addition, we estimate the potential contributions of currently performing loans that may become delinquent in the future based on the change in delinquencies and loan liquidations experienced in the recent history. Finally, we develop a default rate timing curve by aggregating the defaults for all loans (delinquent loans, foreclosure and real estate owned and new delinquencies from currently performing loans) in the pool to project the future expected cash flows.
We use certain available loan characteristics such as lien status, loan sizes and occupancy to estimate the loss severity of loans. Second lien loans are assigned 100% severity, if defaulted. For first lien loans, we assume a minimum of 30% severity with higher severity assumed for investor properties and further housing price depreciation.
Payables for Collateral on Investments
The carrying values of the payables for collateral on investments (in millions) included on our Consolidated Balance Sheets and the fair value of the related investments or collateral consisted of the following:
As of December 31, 2011
As of December 31, 2010
Carrying
Fair
Carrying
Fair
Value
Value
Value
Value
Collateral payable held for derivative investments (1)
$ 2,980
$ 2,980
$
$
Securities pledged under securities lending agreements (2)
Securities pledged under reverse repurchase agreements (3)
Securities pledged for Term Asset-Backed Securities
Loan Facility ("TALF") (4)
Securities pledged for Federal Home Loan Bank of
Indianapolis Securities ("FHLBI") (5)
Total payables for collateral on investments
$ 3,733
$ 3,808
$ 1,659
$ 1,714
(1)
We obtain collateral based upon contractual provisions with our counterparties. These agreements take into consideration the counterparties’ credit rating as compared to ours, the fair value of the derivative investments and specified thresholds that once exceeded result in the receipt of cash that is typically invested in cash and invested cash. See Note 6 for details about maximum collateral potentially required to post on our credit default swaps.
(2)
Our pledged securities under securities lending agreements are included in fixed maturity AFS securities on our Consolidated Balance Sheets. We generally obtain collateral in an amount equal to 102% and 105% of the fair value of the domestic and foreign securities, respectively. We value collateral daily and obtain additional collateral when deemed appropriate. The cash received in our securities lending program is typically invested in cash and invested cash or fixed maturity AFS securities.
(3)
Our pledged securities under reverse repurchase agreements are included in fixed maturity AFS securities on our Consolidated Balance Sheets. We obtain collateral in an amount equal to 95% of the fair value of the securities, and our agreements with third parties contain contractual provisions to allow for additional collateral to be obtained when necessary. The cash received in our reverse repurchase program is typically invested in fixed maturity AFS securities.
(4)
Our pledged securities for TALF are included in fixed maturity AFS securities on our Consolidated Balance Sheets. We obtain collateral in an amount that has typically averaged 90% of the fair value of the TALF securities. The cash received in these transactions is invested in fixed maturity AFS securities.
(5)
Our pledged securities for FHLBI are included in fixed maturity AFS securities on our Consolidated Balance Sheets. We generally obtain collateral in an amount equal to 85% to 95% of the fair value of the FHLBI securities. The cash received in these transactions is typically invested in cash and invested cash or fixed maturity AFS securities.
Increase (decrease) in payables for collateral on investments (in millions) included on the Consolidated Statements of Cash Flows consisted of the following:
For the Years Ended December 31,
Collateral payable held for derivative investments
$ 2,180
$
$ (2,192 )
Securities pledged under securities lending agreements
(302 )
Securities pledged under reverse repurchase agreements
-
(64 )
(126 )
Securities pledged for TALF
(107 )
(65 )
Securities pledged for FHLBI
-
-
Total increase (decrease) in payables for collateral on investments
$ 2,074
$ (248 ) $ (1,799 )
Investment Commitments
As of December 31, 2011, our investment commitments were $541 million, which included $233 million of LPs, $191 million of private placements and $117 million of mortgage loans on real estate.
Concentrations of Financial Instruments
As of December 31, 2011 and 2010, our most significant investments in one issuer were our investments in securities issued by the Federal Home Loan Mortgage Corporation with a fair value of $5.0 billion, or 5% and 6% of our invested assets portfolio, respectively, and our investments in securities issued by Fannie Mae with a fair value of $2.6 billion and $2.9 billion, or 3% of our invested assets portfolio, respectively. These investments are included in corporate bonds in the tables above.
As of December 31, 2011, and December 31, 2010, our most significant investments in one industry were our investment securities in the electric industry with a fair value of $7.7 billion and $6.7 billion, or 8% of our invested assets portfolio, respectively, and our investment securities in the CMO industry with a fair value of $5.6 billion and $6.5 billion, or 6% and 8% of our invested assets portfolio, respectively. We utilized the industry classifications to obtain the concentration of financial instruments amount; as such, this amount will not agree to the AFS securities table above.
6. Derivative Instruments
We maintain 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 exchange risk, equity market risk, default risk, basis risk and credit risk. We assess these risks by continually identifying and monitoring changes in our exposures that may adversely affect expected future cash flows and by evaluating hedging opportunities.
Our derivative instruments are monitored by our Asset Liability Management Committee and our Equity Risk Management Committee as part of those committees’ oversight of our derivative activities. Our committees are responsible for implementing various hedging strategies that are developed through their analysis of financial simulation models and other internal and industry sources. The resulting hedging strategies are incorporated into our overall risk management strategies.
See Note 1 for a detailed discussion of the accounting treatment for derivative instruments. See Note 21 for additional disclosures related to the fair value of our financial instruments and see Note 4 for derivative instruments related to our consolidated VIEs.
Interest Rate Contracts
We use derivative instruments as part of our interest rate risk management strategy. These instruments are economic hedges unless otherwise noted and include:
Consumer Price Index Swaps
We use consumer price index swaps to hedge the liability exposure on certain options in fixed/indexed annuity products. Consumer price index swaps are contracts entered into at no cost and whose payoff is the difference between the consumer price index inflation rate and the fixed rate determined as of inception.
Forward-Starting Interest Rate Swaps
We use forward-starting interest rate swaps designated and qualifying as cash flow hedges to hedge our exposure to interest rate fluctuations related to the forecasted purchase of certain assets and liabilities.
Interest Rate Cap Agreements
We use interest rate cap agreements to provide a level of protection from the effect of rising interest rates to economically hedge our annuity business. Interest rate cap agreements entitle us to receive quarterly payments from the counterparties on specified future reset dates, contingent on future interest rates. For each cap, the amount of such quarterly payments, if any, is determined by the excess of a market interest rate over a specified cap rate, multiplied by the notional amount divided by four.
Interest Rate Cap Corridors
We use interest rate cap corridors to provide a level of protection from the effect of rising interest rates for our annuity business. Interest rate cap corridors involve purchasing an interest rate cap at a specific cap rate and selling an interest rate cap with a higher cap rate. For each corridor, the amount of quarterly payments, if any, is determined by the rate at which the underlying index rate resets above the original capped rate. The corridor limits the benefit the purchaser can receive as the related interest rate index rises above the higher capped rate. There is no additional liability to us other than the purchase price associated with the interest rate cap corridor. Our interest rate cap corridors provide an economic hedge of our annuity business.
Interest Rate Futures
We use interest rate futures contracts to hedge the liability exposure on certain options in variable annuity products. These futures contracts require payment between our counterparty and us on a daily basis for changes in the futures index price.
Interest Rate Swap Agreements
We use interest rate swap agreements to hedge the liability exposure on certain options in variable annuity products.
We also use interest rate swap agreements designated and qualifying as cash flow hedges. These instruments either hedge the interest rate risk of floating rate bond coupon payments by replicating a fixed rate bond, or hedge our exposure to fixed rate bond coupon payments and the change in the underlying asset values as interest rates fluctuate.
Finally, we use interest rate swap agreements designated and qualifying as fair value hedges to hedge against changes in the value of anticipated transactions and commitments as interest rate fluctuate.
Treasury and Reverse Treasury Locks
We use treasury locks designated and qualifying as cash flow hedges to hedge the interest rate exposure related to our issuance of fixed rate securities or the anticipated future cash flows of floating rate fixed maturity securities due to changes in interest rates. In addition, we use reverse treasury locks designated and qualifying as cash flow hedges to hedge the interest rate exposure related to the purchase of fixed rate securities or the anticipated future cash flows of floating rate fixed maturity securities due to changes in interest rates. These derivatives are primarily structured to hedge interest rate risk inherent in the assumptions used to price certain liabilities.
Foreign Currency Contracts
We use derivative instruments as part of our foreign currency risk management strategy. These instruments are economic hedges unless otherwise noted and include:
Currency Futures
We use currency futures to hedge foreign exchange risk associated with certain options in variable annuity products. Currency futures exchange one currency for another at a specified date in the future at a specified exchange rate.
Foreign Currency Forwards
We used foreign currency forward contracts to hedge the liability exposure on certain options in the variable annuity products. The foreign currency forward contracts obligated us to deliver a specified amount of currency at a future date and a specified exchange rate.
Foreign Currency Swaps
We use foreign currency swaps designated and qualifying as cash flow hedges, which are traded over-the-counter, to hedge some of the foreign exchange risk of investments in fixed maturity securities denominated in foreign currencies. A foreign currency swap is a contractual agreement to exchange the currencies of two different countries at a specified rate of exchange in the future.
Equity Market Contracts
We use derivative instruments as part of our equity market risk management strategy that are economic hedges and include:
Call Options Based on the S&P 500 Index® (“S&P 500”)
We use indexed annuity contracts to permit the holder to elect an interest rate return or an equity market component, where interest credited to the contracts is linked to the performance of the S&P 500. Contract holders may elect to rebalance index options at renewal dates, either annually or biannually. As of each renewal date, we have the opportunity to re-price the indexed component by establishing participation rates, subject to minimum guarantees. We purchase call options that are highly correlated to the portfolio allocation decisions of our contract holders, such that we are economically hedged with respect to equity returns for the current reset period.
Equity Futures
We use equity futures contracts to hedge the liability exposure on certain options in variable annuity products. These futures contracts require payment between our counterparty and us on a daily basis for changes in the futures index price.
Put Options
We use put options to hedge the liability exposure on certain options in variable annuity products. Put options are contracts that require counterparties to pay us at a specified future date the amount, if any, by which a specified equity index is less than the strike rate stated in the agreement, applied to a notional amount.
Total Return Swaps
We use total return swaps to hedge a portion of the liability related to our deferred compensation plans. We receive the total return on a portfolio of indexes and pay a floating rate of interest.
In addition, we use total return swaps to hedge the liability exposure on certain options in variable annuity products. We receive the total return on a portfolio of indexes and pay a floating rate of interest.
Variance Swaps
We use variance swaps to hedge the liability exposure on certain options in variable annuity products. Variance swaps are contracts entered into at no cost and whose payoff is the difference between the realized variance rate of an underlying index and the fixed variance rate determined as of inception.
Credit Contracts
We use derivative instruments as part of our credit risk management strategy that are economic hedges and include:
Credit Default Swaps - Buying Protection
We buy credit default swaps to hedge against a drop in bond prices due to credit concerns of certain bond issuers. A credit default swap allows us to put the bond back to the counterparty at par upon a default event by the bond issuer. A default event is defined as bankruptcy, failure to pay, obligation acceleration or restructuring.
Credit Default Swaps - Selling Protection
We sell credit default swaps to offer credit protection to contract holders and investors. The credit default swaps hedge the contract holders and investors against a drop in bond prices due to credit concerns of certain bond issuers. A credit default swap allows the investor to put the bond back to us at par upon a default event by the bond issuer. A default event is defined as bankruptcy, failure to pay, obligation acceleration or restructuring.
Embedded Derivatives
We use embedded derivatives that are economic hedges that include:
Deferred Compensation Plans Embedded Derivatives
We have certain deferred compensation plans that have embedded derivative instruments. The liability related to these plans varies based on the investment options selected by the participants.
GLB Reserves Embedded Derivatives
We use a hedging strategy designed to mitigate the risk and income statement volatility caused by changes in the equity markets, interest rates and volatility associated with GLBs offered in our variable annuity products, including products with GWB and GIB features. The hedging strategy is designed such that changes in the value of the hedge contracts due to changes in equity markets, interest rates and implied volatilities move in the opposite direction of changes in embedded derivative GLB reserves caused by those same factors. We rebalance our hedge positions based upon changes in these factors as needed. While we actively manage our hedge positions, these hedge positions may not be totally effective in offsetting changes in the embedded derivative reserve due to, among other things, differences in timing between when a market exposure changes and corresponding changes to the hedge positions, extreme swings in the equity markets and interest rates, market volatility, contract holder behavior, divergence between the performance of the underlying funds and the hedging indices, divergence between the actual and expected performance of the hedge instruments and our ability to purchase hedging instruments at prices consistent with our desired risk and return trade-off.
Certain features of these guarantees have elements of both insurance benefits accounted for under the Financial Services - Insurance - Claim Costs and Liabilities for Future Policy Benefits Subtopic of the FASB ASC (“benefit reserves”) and embedded derivatives accounted for under the Derivatives and Hedging and the Fair Value Measurements and Disclosures Topics of the FASB ASC (“embedded derivative reserves”). We calculate the value of the embedded derivative reserve and the benefit reserve based on the specific characteristics of each GLB feature.
Indexed Annuity Contracts Embedded Derivatives
We distribute indexed annuity contracts that permit the holder to elect an interest rate return or an equity market component, where interest credited to the contracts is linked to the performance of the S&P 500. Contract holders may elect to rebalance index options at renewal dates, either annually or biannually. As of each renewal date, we have the opportunity to re-price the indexed component by establishing participation rates, subject to minimum guarantees. We purchase S&P 500 call options that are highly correlated to the portfolio allocation decisions of our contract holders, such that we are economically hedged with respect to equity returns for the current reset period.
Reinsurance Related Embedded Derivatives
We have certain modified coinsurance arrangements and coinsurance with funds withheld reinsurance arrangements with embedded derivatives related to the withheld assets of the related funds. These derivatives are considered total return swaps with contractual returns that are attributable to various assets and liabilities associated with these reinsurance arrangements.
We have derivative instruments with off-balance-sheet risks whose notional or contract amounts exceed the credit exposure. Outstanding derivative instruments with off-balance-sheet risks (in millions) were as follows:
As of December 31, 2011
As of December 31, 2010
Notional
Fair Value
Notional
Fair Value
Amounts
Asset
Liability
Amounts
Asset
Liability
Qualifying Hedges
Cash flow hedges:
Interest rate contracts (1)
$ 2,512
$
$ -
$ 2,076
$ (40 ) $ -
Foreign currency contracts (1)
-
-
Total cash flow hedges
2,852
-
2,416
(10 )
-
Fair value hedges:
Interest rate contracts (2)
1,675
1,675
Non-Qualifying Hedges
Interest rate contracts (1)
30,232
-
18,406
(426 )
-
Foreign currency contracts (1)
-
-
-
-
Equity market contracts (1)
16,401
2,096
-
11,577
1,442
-
Credit contracts (1)
-
-
-
-
-
Credit contracts (3)
-
-
Embedded derivatives:
Deferred compensation plans (3)
-
-
-
-
Indexed annuity contracts (4)
-
-
-
-
GLB reserves (4)
-
-
2,217
-
-
Reinsurance related (5)
-
-
-
-
AFS securities (1)
-
-
-
-
-
Total derivative instruments
$ 51,360
$ 3,151
$ 3,473
$ 34,438
$ 1,076
$ 1,441
(1)
Reported in derivative investments on our Consolidated Balance Sheets.
(2)
The asset is reported in derivative investments and the liability in long-term debt on our Consolidated Balance Sheets.
(3)
Reported in other liabilities on our Consolidated Balance Sheets.
(4)
Reported in future contract benefits on our Consolidated Balance Sheets.
(5)
Reported in reinsurance related embedded derivatives on our Consolidated Balance Sheets.
The maturity of the notional amounts of derivative instruments (in millions) was as follows:
Remaining Life as of December 31, 2011
Less Than
1 - 5
6 - 10
11 - 30
Over 30
1 Year
Years
Years
Years
Years
Total
Interest rate contracts (1)
$ 2,154
$ 11,353
$ 11,349
$ 9,556
$
$ 34,419
Foreign currency contracts (2)
-
Equity market contracts
8,638
3,155
4,589
16,401
Credit contracts
-
-
Total derivative instruments with notional amounts $ 10,836
$ 14,778
$ 16,083
$ 9,654
$
$ 51,360
(1)
As of December 31, 2011, the latest maturity date for which we were hedging our exposure to the variability in future cash flows for these instruments was June 2042.
(2)
As of December 31, 2011, the latest maturity date for which we were hedging our exposure to the variability in future cash flows for these instruments was July 2022.
The change in our unrealized gain (loss) on derivative instruments in accumulated OCI (in millions) was as follows:
For the Years Ended December 31,
Unrealized Gain (Loss) on Derivative Instruments
Balance as of beginning-of-year
$ (15 ) $
$
Other comprehensive income (loss):
Unrealized holding gains (losses) arising during the year:
Cash flow hedges:
Interest rate contracts
(47 )
Foreign currency contracts
(52 )
Fair value hedges:
Interest rate contracts
Equity market contracts
-
-
(28 )
Net investment in a foreign subsidiary
-
-
(74 )
AFS securities embedded derivatives
-
-
Change in foreign currency exchange rate adjustment
-
Change in DAC, VOBA, DSI and DFEL
(1 )
(4 )
Income tax benefit (expense)
(66 )
(13 )
Less:
Reclassification adjustment for gains (losses) included in net income (loss):
Cash flow hedges:
Interest rate contracts (1)
(15 )
Interest rate contracts (2)
(1 )
-
Foreign currency contracts (1)
-
Fair value hedges:
Interest rate contracts (2)
Associated amortization of DAC, VOBA, DSI and DFEL
-
(1 )
-
Income tax benefit (expense)
(5 )
(3 )
Balance as of end-of-year
$
$ (15 ) $
(1)
The OCI offset is reported within net investment income on our Consolidated Statements of Income (Loss).
(2)
The OCI offset is reported within interest and debt expense on our Consolidated Statements of Income (Loss).
The gains (losses) on derivative instruments (in millions) recorded within income (loss) from continuing operations on our Consolidated Statements of Income (Loss) were as follows:
For the Years Ended December 31,
Qualifying Hedges
Cash flow hedges:
Interest rate contracts (1)
$ (15 ) $
$
Foreign currency contracts (1)
Total cash flow hedges
(13 )
Fair value hedges:
Interest rate contracts (2)
Equity market contracts (3)
-
Total fair value hedges
Non-Qualifying Hedges
Interest rate contracts (1)
(44 )
-
Interest rate contracts (3)
1,144
(1,553 )
Foreign currency contracts (1)
-
(98 )
Foreign currency contracts (3)
(12 )
(13 )
(7 )
Equity market contracts (3)
(386 )
(1,379 )
Equity market contracts (4)
(118 )
Credit contracts (1)
-
Credit contracts (3)
(7 )
(37 )
Embedded derivatives:
Deferred compensation plans (4)
(11 )
(34 )
(63 )
Indexed annuity contracts (3)
(81 )
(75 )
GLB reserves (3)
(1,809 )
2,228
Reinsurance related (3)
(66 )
(71 )
(62 )
AFS securities (1)
-
-
Total derivative instruments
$ (426 ) $ (140 ) $ (988 )
(1)
Reported in net investment income on our Consolidated Statements of Income (Loss).
(2)
Reported in interest and debt expense on our Consolidated Statements of Income (Loss).
(3)
Reported in realized gain (loss) on our Consolidated Statements of Income (Loss).
(4)
Reported in underwriting, acquisition, insurance and other expenses on our Consolidated Statements of Income (Loss).
Gains (losses) (in millions) on derivative instruments designated and qualifying as cash flow hedges were as follows:
For the Years Ended December 31,
Ineffective portion recognized in realized gain (loss)
$ -
$ -
$ (1 )
Gain (loss) recognized as a component of OCI with the offset to net investment income
(13 )
As of December 31, 2011, $20 million of the deferred net losses on derivative instruments in accumulated OCI were expected to be reclassified to earnings during the next 12 months. This reclassification would be due primarily to the interest rate variances related to the interest rate swap agreements.
For the years ended December 31, 2011 and 2010, there were no material reclassifications to earnings due to hedged firm commitments no longer deemed probable or due to hedged forecasted transactions that had not occurred by the end of the originally specified time period.
Gains (losses) (in millions) on derivative instruments designated and qualifying as fair value hedges were as follows:
For the Years Ended December 31,
Ineffective portion recognized in realized gain (loss)
$ -
$
$
Gain (loss) recognized as a component of OCI with the offset to interest expense
Information related to our open credit default swap liabilities for which we are the seller (dollars in millions) was as follows:
As of December 31, 2011
Credit
Reason
Nature
Rating of
Number
Maximum
for
of
Underlying
of
Fair
Potential
Maturity
Entering
Recourse
Obligation (1)
Instruments
Value (2)
Payout
12/20/2012 (3)
(5)
(6)
BBB+
$ -
$
12/20/2016 (4)
(5)
(6)
BBB+
(12 )
03/20/2017 (4)
(5)
(6)
BBB
(4 )
$ (16 ) $
As of December 31, 2010
Credit
Reason
Nature
Rating of
Number
Maximum
for
of
Underlying
of
Fair
Potential
Maturity
Entering
Recourse
Obligation (1)
Instruments
Value (2)
Payout
12/20/2012 (3)
(5)
(6)
BBB+
$ -
$
12/20/2016 (4)
(5)
(6)
BBB
(12 )
03/20/2017 (4)
(5)
(6)
BBB-
(4 )
$ (16 ) $
(1)
Represents average credit ratings based on the midpoint of the applicable ratings among Moody’s, S&P and Fitch Ratings, as scaled to the corresponding S&P ratings.
(2)
Broker quotes are used to determine the market value of credit default swaps.
(3)
These credit default swaps were sold to our contract holders, prior to 2007, where we determined there was a spread versus premium mismatch.
(4)
These credit default swaps were sold to a counter-party of the consolidated VIEs discussed in Note 4.
(5)
Credit default swap was entered into in order to generate income by providing default protection in return for a quarterly payment.
(6)
Seller does not have the right to demand indemnification or compensation from third parties in case of a loss (payment) on the contract.
Details underlying the associated collateral of our open credit default swaps for which we are the seller, if credit risk related contingent features were triggered (in millions) are as follows:
As of December 31,
Maximum potential payout
$
$
Less:
Counterparty thresholds
-
Maximum collateral potentially required to post
$
$
Certain of our credit default swap agreements contain contractual provisions that allow for the netting of collateral with our counterparties related to all of our collateralized financing transactions that we have outstanding. If these netting agreements were not in place, we would have been required to post approximately $16 million as of December 31, 2011, after considering the fair values of the associated investments counterparties’ credit ratings as compared to ours and specified thresholds that once exceeded result in the payment of cash.
Credit Risk
We are exposed to credit loss in the event of nonperformance by our counterparties on various derivative contracts and reflect assumptions regarding the credit or nonperformance risk. The nonperformance risk is based upon assumptions for each counterparty’s credit spread over the estimated weighted average life of the counterparty exposure less collateral held. As of December 31, 2011, the nonperformance risk adjustment was $16 million. The credit risk associated with such agreements is minimized by purchasing such agreements from financial institutions with long-standing, superior performance records. Additionally, we maintain a policy of requiring all derivative contracts to be governed by an International Swaps and Derivatives Association (“ISDA”) Master Agreement. We are required to maintain minimum ratings as a matter of routine practice in negotiating ISDA agreements. Under some ISDA agreements, our insurance subsidiaries have agreed to maintain certain financial strength or claims-paying ratings. A downgrade below these levels could result in termination of the derivatives contract, at which time any amounts payable by us would be dependent on the market value of the underlying derivative contract. In certain transactions, we and the counterparty have entered into a collateral support agreement requiring either party to post collateral when net exposures exceed pre-determined thresholds. These thresholds vary by counterparty and credit rating. The amount of such exposure is essentially the net replacement cost or market value less collateral held for such agreements with each counterparty if the net market value is in our favor. As of December 31, 2011, the exposure was $81 million.
The amounts recognized (in millions) by S&P credit rating of counterparty, for which we had the right to reclaim cash collateral or were obligated to return cash collateral, were as follows:
As of December 31, 2011
As of December 31, 2010
Collateral
Collateral
Collateral
Collateral
Posted by
Posted by
Posted by
Posted by
S&P
Counter-
LNC
Counter-
LNC
Credit
Party
(Held by
Party
(Held by
Rating of
(Held by
Counter-
(Held by
Counter-
Counterparty
LNC)
Party)
LNC)
Party)
AAA
$ -
$ -
$
$ -
AA
-
-
AA-
-
-
A+
-
(76 )
A
1,681
(120 )
(223 )
A-
-
-
-
$ 3,170
$ (120 ) $ 1,149
$ (299 )
7. Federal Income Taxes
The federal income tax expense (benefit) on continuing operations (in millions) was as follows:
For the Years Ended December 31,
Current
$
$ (138 ) $ (751 )
Deferred
Federal income tax expense (benefit)
$
$
$ (106 )
A reconciliation of the effective tax rate differences (in millions) was as follows:
For the Years Ended December 31,
Tax rate times pre-tax income
$
$
$ (182 )
Effect of:
Tax-preferred investment income
(122 )
(105 )
(92 )
Tax credits
(42 )
(42 )
(46 )
Goodwill
-
Prior year tax return adjustment
(28 )
(12 )
(60 )
Other items
Federal income tax expense (benefit)
$
$
$ (106 )
Effective tax rate
%
%
%
Included in tax-preferred investment income was a separate account dividends-received deduction benefit of $112 million, $94 million and $77 million for the years ended December 31, 2011, 2010 and 2009, respectively, exclusive of any prior years’ tax return adjustment.
The federal income tax asset (liability) (in millions) was as follows:
As of December 31,
Current
$ (241 ) $ (182 )
Deferred
(2,432 )
(1,221 )
Total federal income tax asset (liability)
$ (2,673 ) $ (1,403 )
Significant components of our deferred tax assets and liabilities (in millions) were as follows:
As of December 31,
Deferred Tax Assets
Future contract benefits and other contract holder funds
$
$ 1,400
Deferred gain on business sold through reinsurance
Reinsurance related embedded derivative asset
Investments
Compensation and benefit plans
Net operating loss
-
Net capital loss
Tax credits
VIE
Other
Total deferred tax assets
2,473
2,642
Deferred Tax Liabilities
DAC
1,823
1,977
VOBA
Net unrealized gain on AFS securities
2,259
1,014
Net unrealized gain on trading securities
Intangibles
Other
Total deferred tax liabilities
4,905
3,863
Net deferred tax asset (liability)
$ (2,432 ) $ (1,221 )
Although realization is not assured, management believes as of December 31, 2011 and 2010, it is more likely than not that the deferred tax assets, including our capital loss deferred tax asset, will be realized.
As of December 31, 2011, LNC had net capital loss carryforwards of $93 million and $77 million which will expire in 2014 and 2015, respectively. LNC believes that it is more likely than not that the capital losses will be fully utilized within the allowable carryforward period.
As of December 31, 2011, LNC had net operating loss carryforwards of $66 million which will expire in 2031. LNC believes that it is more likely than not that the operating losses will be fully utilized within the allowable carryforward period.
As of December 31, 2011 and 2010, $234 million and $223 million of our unrecognized tax benefits presented below, if recognized, would have affected our income tax expense and our effective tax rate. We anticipate a change to our unrecognized tax benefits during 2012 in the range of zero to $131 million. A reconciliation of the unrecognized tax benefits (in millions) was as follows:
For the
Years Ended
December 31,
Balance as of beginning-of-year $
$
Increases for prior year tax positions
Decreases for prior year tax positions
(10 )
(7 )
Increases for current year tax positions
Decreases for current year tax positions
(6 )
(8 )
Decreases for settlements with taxing authorities
-
(10 )
Decreases for lapse of statute of limitations
-
(4 )
Balance as of end-of-year
$
$
We recognize interest and penalties accrued, if any, related to unrecognized tax benefits as a component of tax expense. For the years ended December 31, 2011, 2010 and 2009, we recognized interest and penalty expense related to uncertain tax positions of $10 million, $7 million and $12 million, respectively. We had accrued interest and penalty expense related to the unrecognized tax benefits of $103 million and $93 million as of December 31, 2011 and 2010, respectively.
In the normal course of business, we are subject to examination by taxing authorities throughout the U.S. and the U.K. At any given time, we may be under examination by state, local or non-U.S. income tax authorities. During the second quarter of 2010, the IRS completed its examination for tax years 2005 and 2006 resulting in a proposed assessment. Also, during the second quarter of 2010, the IRS completed its examination of tax year 2006 for the former Jefferson-Pilot Corporation (“JP”) and its subsidiaries. We believe a portion of the assessments is inconsistent with the existing law and are protesting it through the established IRS appeals process. We do not anticipate that any adjustments that might result from such audits would be material to our consolidated results of operations or financial condition. We are currently under audit by the IRS for years 2007 and 2008. The JP subsidiaries acquired in the April 2006 merger are subject to a separate IRS examination cycle. For the former JP subsidiaries, JP Life Insurance Company and JP Financial Insurance Company, the IRS is examining the tax years ended April 1, 2007, and July 1, 2007, respectively.
8. DAC, VOBA, DSI and DFEL
Changes in DAC (in millions) were as follows:
For the Years Ended December 31,
Balance as of beginning-of-year $ 7,552
$ 7,424
$ 7,640
Business acquired (sold) through reinsurance
-
-
(37 )
Deferrals
1,681
1,641
1,621
Amortization, net of interest:
Prospective unlocking - assumption changes
(274 )
(31 )
(15 )
Prospective unlocking - model refinements
-
Retrospective unlocking
Other amortization
(959 )
(930 )
(746 )
Adjustment related to realized (gains) losses
(23 )
(50 )
Adjustment related to unrealized (gains) losses
(1,051 )
(688 )
(1,206 )
Balance as of end-of-year
$ 7,136
$ 7,552
$ 7,424
Changes in VOBA (in millions) were as follows:
For the Years Ended December 31,
Balance as of beginning-of-year $ 1,378
$ 2,086
$ 3,762
Business acquired (sold) through reinsurance
-
(255 )
Deferrals
Amortization:
Prospective unlocking - assumption changes
(41 )
(20 )
Prospective unlocking - model refinements
(7 )
-
Retrospective unlocking
(44 )
Other amortization
(300 )
(361 )
(349 )
Accretion of interest (1)
Adjustment related to realized (gains) losses
(6 )
(8 )
Adjustment related to unrealized (gains) losses
(322 )
(417 )
(1,183 )
Balance as of end-of-year
$ 1,055
$ 1,378
$ 2,086
(1)
The interest accrual rates utilized to calculate the accretion of interest ranged from 3.40% to 7.25%.
Estimated future amortization of VOBA, net of interest (in millions), as of December 31, 2011, was as follows:
$
Changes in DSI (in millions) were as follows:
For the Years Ended December 31,
Balance as of beginning-of-year $
$
$
Deferrals
Amortization, net of interest:
Prospective unlocking - assumption changes
(2 )
(3 )
-
Retrospective unlocking
Other amortization
(55 )
(58 )
(33 )
Adjustment related to realized (gains) losses
(1 )
(8 )
Adjustment related to unrealized (gains) losses
(13 )
(41 )
(1 )
Balance as of end-of-year
$
$
$
Changes in DFEL (in millions) were as follows:
For the Years Ended December 31,
Balance as of beginning-of-year $ 1,502
$ 1,338
$ 1,019
Business acquired (sold) through reinsurance
-
-
(11 )
Deferrals
Amortization, net of interest:
Prospective unlocking - assumption changes
(57 )
(22 )
Prospective unlocking - model refinements
-
Retrospective unlocking
(23 )
(16 )
Other amortization
(180 )
(173 )
(129 )
Adjustment related to realized (gains) losses
(9 )
(8 )
(1 )
Adjustment related to unrealized (gains) losses
(534 )
(177 )
Balance as of end-of-year
$ 1,369
$ 1,502
$ 1,338
9. Reinsurance
The following summarizes reinsurance amounts (in millions) recorded on our Consolidated Statements of Income (Loss), excluding amounts attributable to the indemnity reinsurance transaction with Swiss Re:
For the Years Ended December 31,
Direct insurance premiums and fees
$ 6,997
$ 6,599
$ 6,124
Reinsurance assumed
Reinsurance ceded
(1,276 )
(1,202 )
(1,148 )
Total insurance premiums and fees
$ 5,731
$ 5,410
$ 4,986
Direct insurance benefits
$ 4,897
$ 4,547
$ 3,891
Reinsurance recoveries netted against benefits
(1,552 )
(1,220 )
(1,057 )
Total benefits
$ 3,345
$ 3,327
$ 2,834
Our insurance companies cede insurance to other companies. The portion of risks exceeding each company’s retention limit is reinsured with other insurers. We seek reinsurance coverage within the businesses that sell life insurance and annuities in order to limit our exposure to mortality losses and enhance our capital management.
Under our reinsurance program, we reinsure approximately 25% to 30% of the mortality risk on newly issued non-term life insurance contracts and approximately 30% to 35% of total mortality risk including term insurance contracts. Our policy for this program is to retain no more than $11 million on a single insured life issued on fixed, VUL and term life insurance contracts. The
retention per single insured life for corporate-owned life insurance is less than $1 million. Portions of our deferred annuity business have been reinsured on a Modco basis with other companies to limit our exposure to interest rate risks. As of December 31, 2011, the reserves associated with these reinsurance arrangements totaled $878 million. To cover products other than life insurance, we acquire other reinsurance coverages with retentions and limits.
We obtain reinsurance from a diverse group of reinsurers, and we monitor concentration as well as financial strength ratings of our principal reinsurers. Our reinsurance operations were acquired by Swiss Re in December 2001, through a series of indemnity reinsurance transactions. Swiss Re represents our largest reinsurance exposure. Under the indemnity reinsurance agreements, Swiss Re reinsured certain of our liabilities and obligations. As we are not relieved of our legal liability to the ceding companies, the liabilities and obligations associated with the reinsured contracts remain on our Consolidated Balance Sheets with a corresponding reinsurance receivable from Swiss Re, which totaled $2.8 billion and $3.0 billion as of December 31, 2011 and 2010, respectively. Swiss Re has funded a trust, with a balance of $2.2 billion as of December 31, 2011, to support this business. In addition to various remedies that we would have in the event of a default by Swiss Re, we continue to hold assets in support of certain of the transferred reserves. These assets are reported within trading securities or mortgage loans on real estate on our Consolidated Balance Sheets. Our liabilities for funds withheld and embedded derivatives as of December 31, 2011, included $1.0 billion and $142 million, respectively, related to the business reinsured by Swiss Re.
We recorded the gain related to the indemnity reinsurance transactions on the business sold to Swiss Re as a deferred gain on business sold through reinsurance on our Consolidated Balance Sheets. The deferred gain is being amortized into income at the rate that earnings on the reinsured business are expected to emerge, over a period of 15 years from the date of sale. During 2011, 2010 and 2009, we amortized $49 million, $49 million and $50 million, after-tax, respectively, of deferred gain on business sold through reinsurance.
See Note 13 for discussion of the rescission of indemnity reinsurance for disability income business that occurred during the year ended December 31, 2009.
10. Goodwill and Specifically Identifiable Intangible Assets
The changes in the carrying amount of goodwill (in millions) by reportable segment were as follows:
For the Year Ended December 31, 2011
Acquisition
Cumulative
Balance
Impairment
as of
as of
Acquisition
Balance
Beginning-
Beginning-
Accounting
as of End-
of-Year
of-Year
Adjustments
Impairment
Other
of-Year
Annuities
$ 1,040
$ (600 ) $ -
$ -
$ -
$
Retirement Plan Services
-
-
-
-
Life Insurance
2,188
-
-
(650 )
1,539
Group Protection
-
-
-
-
Other Operations - Media
(244 )
-
(97 )
-
-
Total goodwill
$ 3,863
$ (844 ) $ -
$ (747 ) $
$ 2,273
For the Year Ended December 31, 2010
Acquisition
Cumulative
Balance
Impairment
as of
as of
Acquisition
Balance
Beginning-
Beginning-
Accounting
as of End-
of-Year
of-Year
Adjustments
Impairment
Other
of-Year
Annuities
$ 1,040
$ (600 ) $ -
$ -
$ -
$
Retirement Plan Services
-
-
-
-
Life Insurance
2,188
-
-
-
-
2,188
Group Protection
-
-
-
-
Other Operations - Media
(244 )
-
-
Total goodwill
$ 3,857
$ (844 ) $
$ -
$ -
$ 3,019
Included in the other above were adjustments related to income tax deductions recognized when stock options attributable to mergers were exercised or the release of unrecognized tax benefits acquired through mergers.
We perform a Step 1 goodwill impairment analysis on all of our reporting units at least annually on October 1. To determine the implied fair value for our reporting units, we utilize primarily a discounted cash flow valuation technique (“income approach”), although limited available market data is also considered. In determining the estimated fair value, we consider discounted cash flow calculations, the level of our own share price and assumptions that market participants would make in valuing the reporting unit. This analysis requires us to make judgments about revenues, earnings projections, capital market assumptions and discount rates.
As of October 1, 2011, our Annuities, Retirement Plan Services and Group Protection reporting units passed the Step 1 analysis, and although the carrying value of the net assets for Group Protection was within the estimated fair value range, we deemed it prudent to validate the carrying value of goodwill through a Step 2 analysis. Given the Step 1 results, we also performed a Step 2 analysis for our Life Insurance and Media reporting units. Based upon our Step 2 analysis for Life Insurance, we recorded a goodwill impairment that was attributable primarily to marketplace dynamics and lower expectations associated with product changes that we have implemented or will implement shortly that we believe will have an unfavorable effect on our sales levels for a period of time. Based upon our Step 2 analysis for Group Protection, we determined that there was no impairment due to the implied fair value of goodwill being in excess of the carrying value of goodwill. Based upon our Step 2 analysis for Media, we recorded a goodwill impairment that was primarily a result of the deterioration in operating environment and outlook for the business.
As of October 1, 2010, all of our reporting units passed the Step 1 analysis, and although the carrying value of the net assets was within the estimated fair value range for our Life Insurance reporting unit, we deemed it prudent to validate the carrying value of goodwill through a Step 2 analysis. In our Step 2 analysis of the Life Insurance reporting unit, we determined there was no impairment due to the implied fair value of goodwill being in excess of the carrying value of goodwill.
As of October 1, 2009, all of our reporting units passed the Step 1 analysis, except for our Media reporting unit, which required a Step 2 analysis to be completed. As a result of this Step 2 analysis for our Media reporting unit, we recorded an $80 million impairment of goodwill attributable primarily to declines in current and forecasted advertising revenue for the entire radio market. We also recorded a $50 million impairment of our FCC license.
As of March 31, 2009, we performed a Step 1 goodwill impairment analysis on all of our reporting units as a result of our performing an interim test due to volatile capital markets that provided indicators that a potential impairment could be present. All of our reporting units passed the Step 1 analysis, except for our Annuities reporting unit, which required a Step 2 analysis to be completed. Based upon our Step 2 analysis, we recorded goodwill impairment for the Annuities reporting unit in the first quarter of 2009 for $600 million, which was attributable primarily to higher discount rates driven by higher debt costs and equity market volatility, deterioration in sales and declines in equity markets.
For our acquisition of NCLS, during 2009, we impaired the estimated goodwill that arose from the acquisition after considering the expected financial performance and other relevant factors of this business.
The gross carrying amounts and accumulated amortization (in millions) for each major specifically identifiable intangible asset class by reportable segment were as follows:
As of December 31,
Gross
Gross
Carrying
Accumulated
Carrying
Accumulated
Amount
Amortization
Amount
Amortization
Life Insurance:
Sales force
$
$
$
$
Retirement Plan Services:
Mutual fund contract rights (1)
-
-
Other Operations:
FCC licenses (1)
-
-
Other
Total
$
$
$
$
(1)
No amortization recorded as the intangible asset has indefinite life.
Future estimated amortization of specifically identifiable intangible assets (in millions) as of December 31, 2011, was as follows:
$
11. Guaranteed Benefit Features
Information on the GDB features outstanding (dollars in millions) was as follows (our variable contracts with guarantees may offer more than one type of guarantee in each contract; therefore, the amounts listed are not mutually exclusive):
As of December 31,
Return of Net Deposits
Total account value
$
54,004
$
52,211
Net amount at risk (1)
1,379
Average attained age of contract holders
59 years
58 years
Minimum Return
Total account value
$
$
Net amount at risk (1)
Average attained age of contract holders
72 years
70 years
Guaranteed minimum return
%
%
Anniversary Contract Value
Total account value
$
21,648
$
23,483
Net amount at risk (1)
2,939
2,183
Average attained age of contract holders
67 years
66 years
(1)
Represents the amount of death benefit in excess of the account balance. The increase in net amount at risk when comparing December 31, 2011, to December 31, 2010, was attributable primarily to the decline in international equity markets during 2011.
The determination of GDB liabilities is based on models that involve a range of scenarios and assumptions, including those regarding expected market rates of return and volatility, contract surrender rates and mortality experience. The following summarizes the balances of and changes in the liabilities for GDB (in millions), which were recorded in future contract benefits on our Consolidated Balance Sheets:
For the Years Ended December 31,
Balance as of beginning-of-year
$
$
$
Changes in reserves
(33 )
Benefits paid
(53 )
(84 )
(173 )
Balance as of end-of-year
$
$
$
Account balances of variable annuity contracts with guarantees (in millions) were invested in separate account investment options as follows:
As of December 31,
Asset Type
Domestic equity
$ 34,286
$ 35,659
International equity
13,095
14,172
Bonds
17,735
15,913
Money market
5,892
5,725
Total
$ 71,008
$ 71,469
Percent of total variable annuity separate account values
%
%
Future contract benefits also includes reserves for our products with secondary guarantees for our products sold through our Life Insurance segment. These UL and VUL products with secondary guarantees represented approximately 38% of permanent life insurance in force as of December 31, 2011, and approximately 43% of total sales for these products for the year ended December 31, 2011.
12. Short-Term and Long-Term Debt
Details underlying short-term and long-term debt (in millions) were as follows:
As of December 31,
Short-Term Debt
Commercial paper (1)
$ -
$
Current maturities of long-term debt
Other short-term debt
-
Total short-term debt
$
$
Long-Term Debt, Excluding Current Portion
Senior notes:
5.65% notes, due 2012
$ -
$
LIBOR + 175 bps loan, due 2013
4.75% notes, due 2014
4.75% notes, due 2014
4.30% notes, due 2015 (2)
LIBOR + 3 bps notes, due 2017
7.00% notes, due 2018
8.75% notes, due 2019 (2)
6.25% notes, due 2020 (2)
4.85% notes, due 2021 (2)
-
6.15% notes, due 2036
6.30% notes, due 2037
7.00% notes, due 2040 (2)
Total senior notes
3,875
3,875
Capital securities:
6.75%, due 2066 (3)
-
7.00%, due 2066
6.05%, due 2067
Total capital securities
1,213
1,488
Unamortized premiums (discounts)
(16 )
(19 )
Fair value hedge on interest rate swap agreements
Total unamortized premiums (discounts) and fair value hedge on interest rate swap agreements
Total long-term debt
$ 5,391
$ 5,399
(1)
The weighted-average interest rate of commercial paper was 0.20% and 0.41% as of December 31, 2011 and 2010, respectively.
(2)
We have the option to repurchase the outstanding notes by paying the greater of 100% of the principal amount of the notes to be redeemed or the make-whole amount (as defined in each note agreement), plus in each case any accrued and unpaid interest as of the date of redemption.
(3)
During the third quarter of 2011, we redeemed all of our 6.75% capital securities due 2066. See below for the details of the loss on extinguishment of debt.
Details underlying the recognition of a gain (loss) on the extinguishment of debt (in millions) reported within interest and debt expense on our Consolidated Statements of Income (Loss) were as follows:
For the Years Ended December 31,
Principal balance outstanding prior to payoff
$
$
$
Unamortized debt issuance costs and discounts prior to payoff
(8 )
(5 )
(1 )
Amount paid to retire
(275 )
(155 )
(22 )
Gain (loss) on extinguishment of debt, pre-tax
$ (8 ) $ (5 ) $
Future principal payments due on long-term debt (in millions) as of December 31, 2011, were as follows:
$
-
Thereafter
4,138
Total
$
5,388
For our long-term debt outstanding, unsecured senior debt, which consists of senior notes, fixed rate notes and other notes with varying interest rates, ranks highest in priority, followed by capital securities.
Credit Facilities and Letters of Credit (“LOCs”)
Credit facilities, which allow for borrowing or issuances of LOCs, and LOCs (in millions) were as follows:
As of December 31, 2011
Expiration
Maximum
LOCs
Date
Available
Issued
Credit Facilities
Four-year revolving credit facility
Jun-2015
$
2,000
$
LOC facility
Mar-2023
LOC facility
Aug-2031
LOC facility
Oct-2031
Total
$
3,821
$
2,040
Effective as of June 10, 2011, we entered into a credit agreement with a syndicate of banks. This agreement (the “credit facility”) allows for any combination of issuance of LOCs and borrowing of up to $2.0 billion; however, only $1.0 billion of the borrowing is available to reimburse the banks for drawn LOCs. The credit facility is unsecured and has a commitment termination date of June 10, 2015. LOCs issued under the credit facility may remain outstanding for one year following the applicable commitment termination date of the agreement. The LOCs support inter-company reinsurance transactions and specific treaties associated with our business sold through reinsurance. LOCs are used primarily to satisfy the U.S. regulatory requirements of our domestic insurance companies for which reserve credit is provided by our affiliated reinsurance companies, as discussed above in “Results of Life Insurance - Income (Loss) from Operations - Strategies to Address Statutory Reserve Strain,” and our domestic clients of the business sold through reinsurance.
The credit facility contains customary terms and conditions, including covenants restricting our ability to incur liens, merge or consolidate with another entity where we are not the surviving entity and dispose of all or substantially all of our assets. The credit facility also includes financial covenants including: maintenance of a minimum consolidated net worth (as defined in the facility) equal to the sum of $9.2 billion plus fifty percent (50%) of the aggregate net proceeds of equity issuances received by us in accordance with the terms of the credit facility; and a debt-to-capital ratio as defined in accordance with the credit facility not to exceed 0.35 to 1.00. Further, the credit facility contains customary events of default, subject to certain materiality thresholds and grace periods for certain of those events of default. The events of default include payment defaults, covenant defaults, material
inaccuracies in representations and warranties, certain cross-defaults, bankruptcy and liquidation proceedings and other customary defaults. Upon an event of default, the credit facility provides that, among other things, the commitments may be terminated and the loans then outstanding may be declared due and payable. As of December 31, 2011, we were in compliance with all such covenants.
This credit facility replaced our existing four-year credit facility dated as of June 9, 2010, and set to expire June 9, 2014, and the commitments under the existing credit facility have been terminated. Our 364-day credit facility expired June 8, 2011, prior to entering into the new credit agreement.
On November 1, 2011, one of our wholly-owned subsidiaries entered into a credit facility agreement with a third-party lender. Under the agreement, the lender issued an irrevocable LOC effective November 1, 2011, with a maximum scheduled LOC amount of up to approximately $690 million. The LOC supports an inter-company reinsurance agreement and expires October 1, 2031. On August 26, 2011, one of our wholly-owned subsidiaries entered into a credit facility agreement with a third-party lender. Under the agreement, the lender issued an irrevocable LOC effective August 26, 2011, with a maximum scheduled LOC amount of up to approximately $520 million. The LOC supports an inter-company reinsurance agreement and expires August 26, 2031. On April 28, 2011, certain of our wholly-owned subsidiaries amended and restated the reimbursement agreement entered into on December 31, 2009, with a third-party lender. Under the amended agreement, the lender issued an irrevocable LOC effective April 1, 2011, with a maximum scheduled LOC amount of up to approximately $925 million. The LOC supports an inter-company reinsurance agreement and expires March 31, 2023.
These agreements each contain customary terms and conditions, including covenants restricting the ability of the subsidiaries to incur liens, merge or consolidate with another entity and dispose of all or substantially all of their assets. Further, the agreements contain customary events of default, subject to certain materiality thresholds and grace periods for certain of those events of default. The events of default include payment defaults, covenant defaults, material inaccuracies in representations and warranties, bankruptcy and liquidation proceedings and other customary defaults. Upon an event of default, the agreements provide that, among other things, obligations to issue, amend or increase the amount of any LOC shall be terminated and any obligations shall become immediately due and payable. As of December 31, 2011, we were in compliance with all such covenants.
Shelf Registration
We currently have an effective shelf registration statement, which allows us to issue, in unlimited amounts, securities, including debt securities, preferred stock, common stock, warrants, stock purchase contracts, stock purchase units and trust preferred securities of our affiliated trusts.
Certain Debt Covenants on Capital Securities
Our $1.2 billion in principal amount of capital securities outstanding contain certain covenants that require us to make interest payments in accordance with an alternative coupon satisfaction mechanism (“ACSM”) if we determine that one of the following trigger events exists as of the 30th day prior to an interest payment date (“determination date”):
·
LNL’s risk-based capital ratio is less than 175% (based on the most recent annual financial statement filed with the State of Indiana); or
·
(i) The sum of our consolidated net income for the four trailing fiscal quarters ending on the quarter that is two quarters prior to the most recently completed quarter prior to the determination date is zero or negative; and (ii) our consolidated stockholders’ equity (excluding accumulated other comprehensive income and any increase in stockholders’ equity resulting from the issuance of preferred stock during a quarter), or “adjusted stockholders’ equity,” as of (x) the most recently completed quarter and (y) the end of the quarter that is two quarters before the most recently completed quarter, has declined by 10% or more as compared to the quarter that is 10 fiscal quarters prior to the last completed quarter, or the “benchmark quarter.”
The ACSM would generally require us to use commercially reasonable efforts to satisfy our obligation to pay interest in full on the capital securities with the net proceeds from sales of our common stock and warrants to purchase our common stock with an exercise price greater than the market price. We would have to utilize the ACSM until the trigger events no longer existed. Our failure to pay interest pursuant to the ACSM will not result in an event of default with respect to the capital securities nor will a nonpayment of interest unless it lasts for 10 consecutive years, although such breaches may result in monetary damages to the holders of the capital securities.
13. Contingencies and Commitments
Contingencies
Regulatory and Litigation Matters
Regulatory bodies, such as state insurance departments, the SEC, Financial Industry Regulatory Authority and other regulatory bodies regularly make inquiries and conduct examinations or investigations concerning our compliance with, among other things, insurance laws, securities laws, laws governing the activities of broker-dealers and unclaimed property laws.
LNC and its subsidiaries are involved in various pending or threatened legal proceedings, including purported class actions, arising from the conduct of business both in the ordinary course and otherwise. In some of the matters, very large and/or indeterminate amounts, including punitive and treble damages, are sought. Modern pleading practice in the U.S. permits considerable variation in the assertion of monetary damages or other relief. Jurisdictions may permit claimants not to specify the monetary damages sought or may permit claimants to state only that the amount sought is sufficient to invoke the jurisdiction of the trial court. In addition, jurisdictions may permit plaintiffs to allege monetary damages in amounts well exceeding reasonably possible verdicts in the jurisdiction for similar matters. This variability in pleadings, together with the actual experiences of LNC in litigating or resolving through settlement numerous claims over an extended period of time, demonstrates to management that the monetary relief which may be specified in a lawsuit or claim bears little relevance to its merits or disposition value.
Due to the unpredictable nature of litigation, the outcome of a litigation matter and the amount or range of potential loss at particular points in time is normally difficult to ascertain. Uncertainties can include how fact finders will evaluate documentary evidence and the credibility and effectiveness of witness testimony, and how trial and appellate courts will apply the law in the context of the pleadings or evidence presented, whether by motion practice, or at trial or on appeal. Disposition valuations are also subject to the uncertainty of how opposing parties and their counsel will themselves view the relevant evidence and applicable law.
We establish liabilities for litigation and regulatory loss contingencies when information related to the loss contingencies shows both that it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. It is possible that some matters could require us to pay damages or make other expenditures or establish accruals in amounts that could not be estimated as of December 31, 2011. While the potential future charges could be material in the particular quarterly or annual periods in which they are recorded, based on information currently known by management, management does not believe any such charges are likely to have a material adverse effect on LNC’s financial position.
For some matters, the Company is able to estimate a reasonably possible range of loss. For such matters in which a loss is probable, an accrual has been made. For such matters where a loss is believed to be reasonably possible, but not probable, no accrual has been made. Accordingly, the estimate contained in this paragraph reflects two types of matters. For some matters included within this estimate, an accrual has been made, but there is a reasonable possibility that an exposure exists in excess of the amount accrued. In these cases, the estimate reflects the reasonably possible range of loss in excess of the accrued amount. For other matters included within this estimation, no accrual has been made because a loss, while potentially estimable, is believed to be reasonably possible but not probable. In these cases, the estimate reflects the reasonably possible loss or range of loss. As of December 31, 2011, we estimate the aggregate range of reasonably possible losses, including amounts in excess of amounts accrued for these matters as of such date, to be up to approximately $100 million.
For other matters, we are not currently able to estimate the reasonably possible loss or range of loss. We are often unable to estimate the possible loss or range of loss until developments in such matters have provided sufficient information to support an assessment of the range of possible loss, such as quantification of a damage demand from plaintiffs, discovery from other parties and investigation of factual allegations, rulings by the court on motions or appeals, analysis by experts, and the progress of settlement negotiations. On a quarterly and annual basis, we review relevant information with respect to litigation contingencies and update our accruals, disclosures and estimates of reasonably possible losses or ranges of loss based on such reviews.
Our life insurance subsidiaries are currently being audited on behalf of multiple states’ treasury and controllers’ offices for compliance with laws and regulations concerning the identification, reporting and escheatment of unclaimed contract benefits or abandoned funds. The audits focus on insurance company processes and procedures for identifying unreported death claims, and their use of the Social Security Master Death File to identify deceased policy and contract holders. In addition, our life insurance subsidiaries are the subject of multiple state Insurance Department inquiries and market conduct examinations with a similar focus on the handling of unreported claims and abandoned property. The audits and related examination activity may result in additional payments to beneficiaries, escheatment of funds deemed abandoned under state laws, administrative penalties and changes in our procedures for the identification of unreported claims and handling of escheatable property.
On June 13, 2009, a single named plaintiff filed a putative national class action in the Circuit Court of Allen County, Indiana, captioned Peter S. Bezich v. LNL, No. 02C01-0906-PL73, asserting he was charged a cost-of-insurance fee that exceeded the
applicable mortality charge, and that this fee breached the terms of the insurance contract. The parties are conducting fact discovery, and no class certification motion has yet been filed. We dispute the allegations and are vigorously defending this matter.
Commitments
Rescission of Indemnity Reinsurance for Disability Income Business
Included in the business sold to Swiss Re through indemnity reinsurance in 2001 was disability income business. In response to the rescission award of a panel of arbitrators on January 24, 2009, of the underlying reinsurance agreement with Swiss Re, we recorded an adjustment to write down our reinsurance recoverable and the corresponding funds withheld liability, and we released the embedded derivative liability related to the funds withheld nature of the reinsurance agreement, as discussed below. The rescission resulted in our being responsible for paying claims on the business and maintaining sufficient reserves to support the liabilities.
For the year ended December 31, 2009, an unfavorable adjustment of $97 million, after-tax, was reflected in segment income from operations within Other Operations, comprised of increases of $129 million to benefits, $15 million to interest credited and $5 million to underwriting, acquisition, insurance and other expenses, partially offset by a tax benefit of $52 million. In addition, during 2009 the embedded derivative liability release discussed above increased net income by approximately $31 million. The combined adjustments reduced net income by approximately $66 million, after-tax. As a result of the rescission, we reduced our reinsurance recoverables by approximately $900 million related to the reserves for the disability income business and reduced our funds withheld liability by approximately $840 million.
Leases
Certain subsidiaries of ours lease their home office properties. In 2006, we exercised the right and option to extend the Fort Wayne lease for two extended terms such that the lease shall expire in 2019. We retain our right and option to exercise the remaining four extended terms of five years each in accordance with the lease agreement. These agreements also provide us with the right of first refusal to purchase the properties at a price defined in the agreements and the option to purchase the leased properties at fair market value on the last day of any renewal period. In 2007, we exercised the right and option to extend the Hartford lease for one extended term such that the lease shall expire in 2013. During 2007, we moved our corporate headquarters to Radnor, Pennsylvania from Philadelphia, Pennsylvania and entered into a new 13-year lease for office space.
Total rental expense on operating leases for the years ended December 31, 2011, 2010 and 2009, was $42 million, $46 million and $55 million, respectively. Future minimum rental commitments (in millions) as of December 31, 2011, were as follows:
$
Information Technology Commitment
Effective January 1, 2012, we renewed our contract with IBM Global Services for information technology services. Annual costs are dependent on usage but are expected to be approximately $9 million for this new five-year commitment.
Football Stadium Naming Rights Commitment
In 2002, we entered into an agreement with the Philadelphia Eagles to name the Eagles’ new stadium Lincoln Financial Field. In exchange for the naming rights, we agreed to pay $140 million over a 20-year period through annual payments to the Philadelphia Eagles, which average approximately $7 million per year. The total amount includes a maximum annual increase related to the Consumer Price Index. This future commitment has not been recorded as a liability on our Consolidated Balance Sheets as it is being accounted for in a manner consistent with the accounting for operating leases under the Leases Topic of the FASB ASC.
Vulnerability from Concentrations
As of December 31, 2011, we did not have a concentration of: business transactions with a particular customer or lender; sources of supply of labor or services used in the business; or a market or geographic area in which business is conducted that makes us vulnerable to an event that is at least reasonably possible to occur in the near term and which could cause a severe impact to our financial position.
Although we do not have any significant concentration of customers, our American Legacy Variable Annuity (“ALVA”) product offered in our Annuities segment is significant to this segment. The ALVA product accounted for 22%, 25% and 28% of Annuities’ variable annuity product deposits in 2011, 2010 and 2009, respectively, and represented approximately 54%, 58% and 61% of the segment’s total variable annuity product account values as of December 31, 2011, 2010 and 2009, respectively. In addition, fund choices for certain of our other variable annuity products offered in our Annuities segment include American Fund Insurance SeriesSM (“AFIS”) funds. For the Annuities segment, AFIS funds accounted for 27%, 29% and 33% of variable annuity product deposits in 2011, 2010 and 2009, respectively, and represented 63%, 66% and 69% of the segment’s total variable annuity product account values as of December 31, 2011, 2010 and 2009, respectively.
Other Contingency Matters
State guaranty funds assess insurance companies to cover losses to contract holders of insolvent or rehabilitated companies. Mandatory assessments may be partially recovered through a reduction in future premium taxes in some states. We have accrued for expected assessments net of estimated future premium tax deductions of $31 million and $10 million as of December 31, 2011 and 2010, respectively.
14. Shares and Stockholders’ Equity
Common and Preferred Shares
The changes in our preferred and common stock (number of shares) were as follows:
For the Years Ended December 31,
Series A Preferred Stock
Balance as of beginning-of-year
10,914
11,497
11,565
Conversion of convertible preferred stock (1)
(842 )
(583 )
(68 )
Balance as of end-of-year
10,072
10,914
11,497
Series B Preferred Stock
Balance as of beginning-of-year
-
950,000
-
Issuance (redemption) of Series B preferred stock
-
(950,000 )
950,000
Balance as of end-of-year
-
-
950,000
Common Stock
Balance as of beginning-of-year
315,718,554
302,223,281
255,869,859
Stock issued
-
14,137,615
46,000,000
Conversion of convertible preferred stock (1)
13,472
9,328
1,088
Stock compensation/issued for benefit plans
248,553
414,712
436,100
Retirement/cancellation of shares
(24,661,357 )
(1,066,382 )
(83,766 )
Balance as of end-of-year
291,319,222
315,718,554
302,223,281
Common Stock as of End-of-Year
Assuming conversion of preferred stock
291,480,374
315,893,178
302,407,233
Diluted basis
298,225,244
324,043,137
311,846,021
(1)
Represents the conversion of Series A preferred stock into common stock.
Our common, Series A and Series B preferred stocks are without par value.
Average Shares
A reconciliation of the denominator (number of shares) in the calculations of basic and diluted earnings (loss) per common share was as follows:
For the Years Ended December 31,
Weighted-average shares, as used in basic calculation
307,216,181
310,005,264
280,031,363
Shares to cover exercise of outstanding warrants
10,150,292
12,260,236
6,209,013
Shares to cover conversion of preferred stock
173,289
178,720
184,687
Shares to cover non-vested stock
813,905
616,314
550,700
Average stock options outstanding during the year
636,989
707,704
401,369
Assumed acquisition of shares with assumed proceeds from exercising outstanding warrants
(4,658,020 )
(5,148,473 )
(2,945,429 )
Assumed acquisition of shares with assumed proceeds and benefits from exercising stock options (at average market price for the year)
(427,425 )
(464,813 )
(275,543 )
Shares repurchaseable from measured but unrecognized stock option expense
(65,882 )
(139,673 )
(85,511 )
Average deferred compensation shares
1,110,722
1,198,468
1,564,954
Weighted-average shares, as used in diluted calculation
314,950,051
319,213,747
285,635,603
In the event the average market price of LNC common stock exceeds the issue price of stock options and the options have a dilutive effect to our EPS, such options will be shown in the table above. As a result of a loss from continuing operations for the year ended December 31, 2009, shares used in the EPS calculation represent basic shares, since using diluted shares would have been anti-dilutive to the calculation.
The income used in the calculation of our diluted EPS is our net income (loss), reduced by preferred stock dividends and accretion of discount. These amounts are presented on our Consolidated Statements of Income (Loss).
We have participants in our deferred compensation plans who selected LNC stock as the measure for the investment return attributable to their deferral amounts. For the years ended December 31, 2011 and 2010, the effect of settling this obligation in LNC stock (“equity classification”) was more dilutive than the scenario of settling it in cash (“liability classification”). Therefore, for our EPS calculation for these periods, we added these shares to the denominator and adjusted the numerator to present net income as if the shares had been accounted for under equity classification by removing the mark-to-market adjustment included in net income attributable to these deferred units of LNC stock. The amount of this adjustment was $4 million and $1 million for the years ended December 31, 2011 and 2010, respectively.
As of December 31, 2011, we had 10,150,292 outstanding warrants. The warrants, each representing the right to purchase one share of our common stock, no par value per share, have an exercise price of $10.85, and expire on July 10, 2019, and are listed on the New York Stock Exchange under the symbol “LNC WS.”
Accumulated OCI
The following summarizes the components and changes in accumulated OCI (in millions):
For the Years Ended December 31,
Unrealized Gain (Loss) on AFS Securities
Balance as of beginning-of-year $ 1,072
$
$ (2,654 )
Cumulative effect from adoption of new accounting standards
-
(84 )
Unrealized holding gains (losses) arising during the year
3,414
2,528
6,204
Change in foreign currency exchange rate adjustment
(5 )
(6 )
Change in DAC, VOBA, DSI and other contract holder funds
(993 )
(1,196 )
(2,371 )
Income tax benefit (expense)
(864 )
(478 )
(1,366 )
Less:
Reclassification adjustment for gains (losses) included in net income (loss)
(129 )
(135 )
(569 )
Reclassification adjustment for gains (losses) on derivatives included in net income (loss)
-
(45 )
Associated amortization of DAC, VOBA, DSI and DFEL
(13 )
Income tax benefit (expense)
(3 )
Balance as of end-of-year
$ 2,716
$ 1,072
$
Unrealized OTTI on AFS Securities
Balance as of beginning-of-year $ (129 ) $ (115 ) $ -
(Increases) attributable to:
Cumulative effect from adoption of new accounting standards
-
-
(18 )
Gross OTTI recognized in OCI during the year
(58 )
(98 )
(357 )
Change in DAC, VOBA, DSI and DFEL
Income tax benefit (expense)
Decreases attributable to:
Sales, maturities or other settlements of AFS securities
Change in DAC, VOBA, DSI and DFEL
(22 )
(20 )
(29 )
Income tax benefit (expense)
(28 )
(23 )
(43 )
Balance as of end-of-year
$ (107 ) $ (129 ) $ (115 )
Unrealized Gain (Loss) on Derivative Instruments
Balance as of beginning-of-year $ (15 ) $
$
Unrealized holding gains (losses) arising during the year
(27 )
(89 )
Change in foreign currency exchange rate adjustment
(31 )
Change in DAC, VOBA, DSI and DFEL
(1 )
(4 )
Income tax benefit (expense)
(66 )
(13 )
Less:
Reclassification adjustment for gains (losses) included in net income (loss)
(10 )
Associated amortization of DAC, VOBA, DSI and DFEL
-
(1 )
-
Income tax benefit (expense)
(5 )
(3 )
Balance as of end-of-year
$
$ (15 ) $
Foreign Currency Translation Adjustment
Balance as of beginning-of-year $
$
$
Foreign currency translation adjustment arising during the year
-
(3 )
(2 )
Income tax benefit (expense)
-
(1 )
Balance as of end-of-year
$
$
$
Funded Status of Employee Benefit Plans
Balance as of beginning-of-year $ (181 ) $ (210 ) $ (282 )
Adjustment arising during the year
(149 )
Income tax benefit (expense)
(16 )
(39 )
Balance as of end-of-year
$ (278 ) $ (181 ) $ (210 )
15. Realized (Gain) Loss
Details underlying realized gain (loss) (in millions) reported on our Consolidated Statements of Income (Loss) were as follows:
For the Years Ended December 31,
Total realized gain (loss) related to certain investments (1)
$ (151 ) $ (180 ) $ (538 )
Realized gain (loss) on the mark-to-market on certain instruments (2)
(83 )
Indexed annuity net derivative results: (3)
Gross gain (loss)
Associated amortization of DAC, VOBA, DSI and DFEL
(2 )
(15 )
(4 )
Variable annuity net derivatives results: (4)
Gross gain (loss)
(60 )
(710 )
Associated amortization of DAC, VOBA, DSI and DFEL
(5 )
(47 )
Realized gain (loss) on sale of subsidiaries/businesses
-
-
Total realized gain (loss)
$ (299 ) $ (77 ) $ (1,146 )
(1)
See “Realized Gain (Loss) Related to Certain Investments” section in Note 5.
(2)
Represents changes in the fair values of certain derivative investments (including those associated with our consolidated VIEs), total return swaps (embedded derivatives that are theoretically included in our various modified coinsurance and coinsurance with funds withheld reinsurance arrangements that have contractual returns related to various assets and liabilities associated with these arrangements) and trading securities.
(3)
Represents the net difference between the change in the fair value of the S&P 500 call options that we hold and the change in the fair value of the embedded derivative liabilities of our indexed annuity products along with changes in the fair value of embedded derivative liabilities related to index call options we may purchase in the future to hedge contract holder index allocations applicable to future reset periods for our indexed annuity products.
(4)
Includes the net difference in the change in embedded derivative reserves of our GLB products and the change in the fair value of the derivative instruments we own to hedge GDB and GLB products, including the cost of purchasing the hedging instruments.
16. Underwriting, Acquisition, Insurance, Restructuring and Other Expenses
Details underlying underwriting, acquisition, insurance and other expenses (in millions) were as follows:
For the Years Ended December 31,
Commissions
$ 1,672
$ 1,616
$ 1,543
General and administrative expenses
1,422
1,412
1,284
Expenses associated with reserve financing and unrelated LOCs
DAC and VOBA deferrals and interest, net of amortization
(651 )
(583 )
(598 )
Broker-dealer expenses
Other intangibles amortization
Media expenses
Taxes, licenses and fees
Merger-related expenses
-
Restructuring charges (recoveries) for expense initiatives
-
(1 )
Total
$ 3,163
$ 3,067
$ 2,794
17. Pension, Postretirement Health Care and Life Insurance Benefit Plans
We maintain U.S. qualified funded defined benefit pension plans in which many of our U.S. employees and agents are participants, and we retained the Lincoln UK pension plan after the sale of this business. We also maintain non-qualified, unfunded defined benefit pension plans for certain employees and agents. In addition, for certain former employees we have supplemental retirement plans that provide defined benefit pension benefits in excess of limits imposed by federal tax law. All of our defined benefit pension plans are frozen, including the defined benefit pension plan that was retained after the sale of Lincoln UK, and there are no new participants and no future accruals of benefits from the date of the freeze.
The eligibility requirements for each plan are described in each plan document and vary for each plan based on completion of a specified period of continuous service and date of hire, subject to age limitations. The frozen pension plan benefits are calculated either on a traditional or cash balance formula. Those formulas are based upon years of credited service and eligible earnings as defined in each plan document. The traditional formula provides benefits stated in terms of a single life annuity payable at age 65. The cash balance formula provides benefits stated as a lump sum hypothetical account balance. That account balance equals the sum of the employee’s accumulated annual benefit credits plus interest credits. Benefit credits, which are based on years of service and base salary plus bonus, ceased as of the date the plan was frozen. Interest credits continue until the participant’s benefit is paid.
We also sponsor a voluntary employees’ beneficiary association (“VEBA”) trust that provides postretirement medical, dental and life insurance benefits to retired full-time U.S. employees and agents who, depending on the plan, have worked for us for 10 years and attained age 55 (age 60 for agents). VEBAs are a special type of tax-exempt trust used to provide benefits that are subject to preferential tax treatment under the Internal Revenue Code. Medical and dental benefits are available to spouses and other eligible dependents of retired employees and agents. Retirees may be required to contribute toward the cost of these benefits. Eligibility and the amount of required contribution for these benefits varies based upon a variety of factors including years of service and year of retirement.
Obligations, Funded Status and Assumptions
Information (in millions) with respect to our benefit plans’ assets and obligations was as follows:
As of or for the Years Ended December 31,
U.S.
Non-U.S.
Other
Pension Benefits
Pension Benefits
Postretirement Benefits
Change in Plan Assets
Fair value as of beginning-of-year
$
$
$
$
$
$
Actual return on plan assets
Company and participant contributions
-
Benefits paid
(70 )
(73 )
(12 )
(12 )
(17 )
(15 )
Medicare Part D subsidy
-
-
-
-
Foreign exchange translation
-
-
(2 )
(10 )
-
-
Fair value as of end-of-year
Change in Benefit Obligation
Balance as of beginning-of-year
1,093
1,050
Service cost (1)
-
-
Interest cost
Company and participant contributions
-
-
-
-
Curtailments
-
-
-
-
-
-
Actuarial (gains) losses
(12 )
-
Benefits paid
(70 )
(73 )
(12 )
(12 )
(17 )
(15 )
Medicare Part D subsidy
-
-
-
-
Foreign exchange translation
-
-
(1 )
(10 )
-
-
Balance as of end-of-year
1,238
1,093
Funded status of the plans
$ (282 ) $ (175 ) $
$
$ (122 ) $ (118 )
Amounts Recognized on the Consolidated Balance Sheets
Other assets
$
$
$
$
$ -
$ -
Other liabilities
(300 )
(190 )
-
-
(122 )
(118 )
Net amount recognized
$ (282 ) $ (175 ) $
$
$ (122 ) $ (118 )
Amounts Recognized in Accumulated OCI, Net of Tax
Net (gain) loss
$
$
$
$
$
$
Prior service credit
-
-
-
-
(3 )
(4 )
Net amount recognized
$
$
$
$
$
$ (2 )
Rate of Increase in Compensation
Retiree Life Insurance Plan
N/A
N/A
N/A
N/A
4.00 %
4.00 %
All other plans
N/A
N/A
N/A
N/A
N/A
N/A
Weighted-Average Assumptions
Benefit obligations:
Weighted-average discount rate
4.45 %
5.50 %
5.00 %
5.70 %
4.25 %
5.00 %
Expected return on plan assets
7.78 %
8.00 %
5.40 %
5.40 %
6.50 %
6.50 %
Net periodic benefit cost:
Weighted-average discount rate
5.45 %
6.00 %
5.70 %
5.80 %
5.00 %
6.00 %
Expected return on plan assets
7.78 %
8.00 %
5.40 %
5.80 %
6.50 %
6.50 %
(1)
Amounts for our U.S. pension plans represent general and administrative expenses.
Consistent with our benefit plans’ year end, we use December 31 as the measurement date.
The discount rate was determined based on a corporate yield curve as of December 31, 2011, and projected benefit obligation cash flows for the U.S. pension plans. We reevaluate this assumption each plan year. For 2012, our discount rate for the U.S. pension plans will be 4.45%, and 5.00% for the non-U.S. plan.
The expected return on plan assets was determined based on historical and expected future returns of the various asset categories, using the plans’ target plan allocation. We reevaluate this assumption each plan year. For 2012, our expected return on plan assets is 7.78% for the U.S. plans and 5.40% for the non-U.S. plan.
The calculation of the accumulated other postretirement benefit obligation assumes a weighted-average annual rate of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) as follows:
As of or for the
Years Ended December 31,
Pre-65 health care cost trend rate
8.50
%
9.50
%
10.00
%
Post-65 health care cost trend rate
8.50
%
9.50
%
13.00
%
Ultimate trend rate
4.50
%
5.00
%
5.00
%
Year that the rate reaches the ultimate trend rate
We expect the health care cost trend rate for 2012 to be 8.50% for both the pre-65 and the post-65 population. A one-percentage point increase in assumed health care cost trend rates would have increased the accumulated postretirement benefit obligation by $5 million and total service and interest cost components by $1 million. A one-percentage point decrease in assumed health care cost trend rates would have decreased the accumulated postretirement benefit obligation by $8 million and total service and interest cost components by $1 million.
Information for our pension plans with an accumulated benefit obligation in excess of plan assets (in millions) was as follows:
As of December 31,
U.S. Plan
Accumulated benefit obligation
$ 1,118
$ 1,072
Projected benefit obligation
1,118
1,072
Fair value of plan assets
Components of Net Periodic Benefit Cost
The components of net periodic benefit cost for our pension plans’ and other postretirement plans’ expense (recovery) (in millions) were as follows:
For the Years Ended December 31,
Pension Benefits
Other Postretirement Benefits
U.S. Plans
Service cost (1)
$
$
$
$
$
$
Interest cost
Expected return on plan assets
(71 )
(65 )
(55 )
(2 )
(2 )
(2 )
Amortization of prior service cost
-
-
-
(1 )
(1 )
(1 )
Recognized net actuarial loss (gain)
(2 )
Net periodic benefit expense (recovery)
$
$
$
$
$
$
Non-U.S. Plans
Service cost
$ -
$ -
$
Interest cost
Expected return on plan assets
(16 )
(16 )
(15 )
Amortization of prior service cost
-
-
Recognized net actuarial loss (gain)
-
Net periodic benefit expense (recovery)
$ (1 ) $
$
(1)
Amounts for our pension plans represent general and administrative expenses.
We expect our 2012 U.S. pension plans’ expense to be approximately $13 million. In addition, we expect our non-U.S. pension plan income for 2012 to be approximately $2 million when assuming an average exchange rate of 1.56 pounds sterling to U.S. dollars.
For 2012, the estimated amount of amortization from accumulated OCI into net periodic benefit expense related to net actuarial loss or gain is expected to be an approximate $26 million loss for our pension plans and less than $1 million loss for our other postretirement plans.
Plan Assets
Our pension plans’ asset target allocations by asset category based on estimated fair values were as follows:
For the Years Ended December 31,
U.S. Plan - Employees
U.S. Plan - Agents
Non-U.S. Plan
Asset Class
Fixed maturity securities
%
%
%
%
%
%
Common stock:
Domestic equity
%
%
%
%
- %
- %
International equity
%
%
%
%
- %
- %
Equity securities
- %
- %
- %
- %
%
%
Cash and invested cash
- %
- %
- %
- %
%
%
The investment objectives for the assets related to our pension plans are to:
·
Maintain sufficient liquidity to pay obligations of the plans as they come due;
·
Minimize the effect of a single investment loss and large losses to the plans through prudent risk/reward diversification consistent with sound fiduciary standards;
·
Maintain an appropriate asset allocation policy;
·
Earn a return commensurate with the level of risk assumed through the asset allocation policy; and
·
Control costs of administering and managing the plans' investment operations.
Investments can be made in various asset classes and styles, including, but not limited to: domestic and international equity, fixed income securities, derivatives and other asset classes the investment managers deem prudent. Our plans follow a strategic asset allocation policy that strives to systemically increase the percentage of assets in liability-matching fixed income investments as funding levels increase.
We currently target asset weightings as follows: for the U.S. Plan - Employees, domestic equity allocations (35%) are split into large cap (25%), small cap (5%) and hedge funds (5%), and for the U.S. Plan - Agents, domestic equity allocations (14%) are split into large cap (10%), small cap (2%) and hedge funds (2%). Fixed maturity securities represent core fixed income investments. The performance of the pension trust assets are monitored on a quarterly basis relative to the plans’ objectives.
Our U.S. pension plans’ assets have been combined into a master retirement trust where a variety of qualified managers, including manager of managers, are expected to have returns that exceed the median of similar funds over three-year periods, above an appropriate index over five-year periods and meet real return standards over ten-year periods. Managers are monitored for adherence to approved investment policy guidelines and managers not meeting these criteria are subject to additional due diligence review, corrective action or possible termination.
Fair Value of Plan Assets
See “Fair Value Measurement” in Note 1 for discussion of how we categorize our pension plans’ assets into the three-level fair value hierarchy. See “Financial Instruments Carried at Fair Value” in Note 21 for a summary of our fair value measurements of our pension plans’ assets by the three-level fair value hierarchy.
The following summarizes our fair value measurements of benefit plans’ assets (in millions) on a recurring basis by asset category:
As of December 31,
U.S.
Non-U.S.
Other
Pension Plans
Pension Plans
Postretirement Benefits
Fixed maturity securities:
Corporate bonds
$
$
$
$
$ -
$ -
U.S. Government bonds
-
-
Foreign government bonds
-
-
RMBS
-
-
-
-
CMBS
-
-
-
-
CDOs
-
-
Common stock
-
-
Cash and invested cash
Total
$
$
$
$
$
$
Valuation Methodologies and Associated Inputs for Pension Plans’ Assets
The fair value measurements of our pension plans’ assets are based on assumptions used by market participants in pricing the security. The most appropriate valuation methodology is selected based on the specific characteristics of the security, and the valuation methodology is consistently applied to measure the security’s fair value. The fair value measurement is based on a market approach, which utilizes prices and other relevant information generated by market transactions involving identical or comparable securities. Sources of inputs to the market approach include third-party pricing services, independent broker quotations or pricing matrices. Both observable and unobservable inputs are used in the valuation methodologies. Observable inputs include benchmark yields, reported trades, broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and reference data. In addition, market indicators, industry and economic events are monitored and further market data is acquired if certain triggers are met. For certain security types, additional inputs may be used, or some of the inputs described above may not be applicable. For broker-quoted only securities, quotes from market makers or broker-dealers are obtained from sources recognized to be market participants. In order to validate the pricing information and broker-dealer quotes, procedures are
employed, where possible, that include comparisons with similar observable positions, comparisons with subsequent sales, discussions with brokers and observations of general market movements for those security classes. For those securities trading in less liquid or illiquid markets with limited or no pricing information, unobservable inputs are used in order to measure the fair value of these securities. In cases where this information is not available, such as for privately placed securities, fair value is estimated using an internal pricing matrix. This matrix relies on judgment concerning the discount rate used in calculating expected future cash flows, credit quality, industry sector performance and expected maturity.
Prices received from third parties are not adjusted; however, the third-party pricing services’ valuation methodologies and related inputs are evaluated and additional evaluation is performed to determine the appropriate level within the fair value hierarchy.
The observable and unobservable inputs to the valuation methodologies are based on general standard inputs. The standard inputs used in order of priority are benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and reference data. Depending on the type of security or the daily market activity, standard inputs may be prioritized differently or may not be available for all securities on any given day.
Cash and invested cash is carried at cost, which approximates fair value. This category includes highly liquid debt instruments purchased with a maturity of three months or less. Due to the nature of these assets, we believe these assets should be classified as Level 2.
Plan Cash Flows
It is our practice to make contributions to the qualified pension plans to comply with minimum funding requirements of the Employee Retirement Income Security Act of 1974, as amended and with guidance issued there under. In accordance with such practice, no contributions were required for the years ended December 31, 2011 or 2010; however, we elected to contribute $25 million on December 1, 2011. Based on our calculations, we do not expect to be required to make any contributions to our qualified pension plans in 2012 under applicable pension law.
For our nonqualified pension plans, we fund the benefits as they become due to retirees. The amount expected to be contributed to the nonqualified pension plans during 2012 is approximately $10 million.
We expect the following benefit payments (in millions):
Pension Plans
U.S. Other Postretirement Plans
Qualified
Nonqualified
Qualified
U.S.
U.S.
Non-U.S.
Not
Defined
Defined
Defined
Reflecting
Reflecting
Benefit
Benefit
Benefit
Medicare
Medicare
Medicare
Pension
Pension
Pension
Part D
Part D
Part D
Plans
Plans
Plans
Subsidy
Subsidy
Subsidy
$
$
$
$
$ (2 ) $
(2 )
(2 )
(2 )
(2 )
Following five years thereafter
(12 )
18. Defined Contribution and Deferred Compensation Plans
Defined Contribution Plans
We sponsor defined contribution plans, which include money purchase plans, for eligible employees and agents. We make contributions and matching contributions to each of the active plans in accordance with the plan documents and various limitations under Section 401(a) of the Internal Revenue Code of 1986, as amended. For the years ended December 31, 2011, 2010 and 2009, expenses (income) for these plans were $67 million, $62 million and $63 million, respectively.
Deferred Compensation Plans
We sponsor six separate non-qualified, unfunded, deferred compensation plans for employees, agents and non-employee directors.
The results for certain investment options within the plans are hedged by total return swaps. Participants’ account values change due primarily to investment earnings driven by market fluctuations. Our expenses increase or decrease in direct proportion to the change in market value of the participants’ investment options. Participants are able to select our stock as an investment option; however, it is not hedged by the total return swaps and is a primary source of expense volatility related to these plans. For further discussion of total return swaps related to our deferred compensation plans, see Note 6.
Information (in millions) with respect to these plans was as follows:
As of December 31,
Total liabilities (1)
$
$
Investments held to fund liabilities (2)
(1)
Reported in other liabilities on our Consolidated Balance Sheets.
(2)
Reported in other assets on our Consolidated Balance Sheets.
Deferred Compensation Plan for Employees
Participants may elect to defer a portion of their compensation as defined by the plan. Participants may select from prescribed “phantom” investment options that are used as measures for calculating the returns that are notionally credited to their accounts. Under the terms of the plan, we agree to pay out amounts based upon the aggregate performance of the investment measures selected by the participants. We make matching contributions based upon amounts placed into the plan by individuals after participants have exceeded applicable limits of the Internal Revenue Code. The amount of our contribution is calculated in accordance with the plan document. Expenses (income) (in millions) for this plan were as follows:
For the Years Ended December 31,
Employer matching contributions
$
$
$
Increase (decrease) in measurement of liabilities, net of total return swap
(5 )
Total plan expenses (income)
$
$
$ (1 )
Deferred Compensation Plans for Agents
We sponsor three deferred compensation plans for certain eligible agents. Participants may elect to defer a portion of their compensation as defined by the respective plan. Participants may select from prescribed “phantom” investment options that are used as measures for calculating the returns that are notionally credited to their accounts. Under the terms of these plans, we agree to pay out amounts based upon the aggregate performance of the investment measures selected by the participants. We make matching contributions based upon amounts placed into the plans by individuals after participants have exceeded applicable limits of the Internal Revenue Code. The amounts of our contributions are calculated in accordance with the plans’ documents. Expenses (income) (in millions) for these plans were as follows:
For the Years Ended December 31,
Employer matching contributions
$
$
$
Increase (decrease) in measurement of liabilities, net of total return swap
-
Total plan expenses (income)
$
$
$
Deferred Compensation Plan for Non-Employee Directors
Non-employee directors may defer a portion of their annual retainers, and we credit deferred stock units annually to their accounts. The prescribed “phantom” investment options are identical to those offered in the employees’ plan. For the years ended December 31, 2011, 2010 and 2009, expenses (income) for this plan were less than ($1) million, $2 million and $1 million, respectively.
Deferred Compensation Plan for Former JP Agents
Eligible former agents of JP may participate in this deferred compensation plan. Participants may elect to defer commissions and bonuses and specify where this deferred compensation will be invested in selected notional mutual funds. Participants may not receive the returns on these funds until attaining a specified age or in the event of a significant lifestyle change. The funded amount is rebalanced to match the funds that have been elected under the deferred compensation plan. The plan obligation increases with contributions, deferrals and investment gains, and decreases with withdrawals and investment losses. The plan assets increase with investment gains and decrease with investment losses and payouts of benefits. For the years ended December 31, 2011, 2010 and 2009, expenses (income) for this plan were $4 million, $2 million and $1 million, respectively.
19. Stock-Based Incentive Compensation Plans
LNC Stock-Based Incentive Plans
We sponsor various incentive plans for our employees and directors, and for the employees and agents of our subsidiaries that provide for the issuance of stock options, performance shares (performance-vested shares as opposed to time-vested shares), stock appreciation rights (“SARs”), restricted stock units, and restricted stock awards (“nonvested stock”). We have a policy of issuing new shares to satisfy option exercises.
Total compensation expense (in millions) for all of our stock-based incentive compensation plans was as follows:
For the Years Ended December 31,
Stock options
$
$
$
Performance shares
(1 )
(2 )
Restricted stock units and nonvested stock
Total
$
$
$
Recognized tax benefit
$
$
$
Total unrecognized compensation expense (in millions) for all of our stock-based incentive compensation plans was as follows:
For the Years Ended December 31,
Weighted-
Weighted-
Weighted-
Average
Average
Average
Expense
Period
Expense
Period
Expense
Period
Stock options
$
1.7
$
1.8
$
1.7
Performance shares
2.0
-
-
-
1.0
SARs
3.4
3.7
4.1
Restricted stock units and nonvested stock
1.7
1.9
2.2
Total unrecognized stock-based incentive compensation expense
$
$
$
In the first quarter of 2011, a performance period from 2011-2013 was approved for certain of our executive officers by the Compensation Committee. The award for executive officers participating in this performance period consisted of LNC restricted stock units representing approximately 34%, LNC stock options representing approximately 33% and LNC performance shares representing approximately 33% of the total award. LNC stock options granted for this performance period vest ratably over the three-year period, based solely on a service condition. Depending on the performance results for this period, the ultimate payout of performance shares could range from zero to 200% of the target award. Under the 2011-2013 plan, a total of 221,813 LNC restricted stock units, 459,093 LNC stock options and 215,137 LNC performance shares were granted.
In the first quarter of 2010, a performance period from 2010-2012 was approved for certain of our executive officers by the Compensation Committee. The award for executive officers participating in this performance period consisted of LNC stock options representing approximately 34% and LNC restricted stock units representing approximately 66% of the total award. LNC
stock options granted for this performance period vest ratably over the three-year period, based solely on a service condition. Under the 2010-2012 plan, a total of 301,524 LNC stock options and 575,353 LNC restricted stock units were granted.
In the first quarter of 2009, a performance period from 2009-2011 was approved for our executive officers by the Compensation Committee. The award for executive officers participating in this performance period consisted of LNC restricted stock units representing approximately 27%, LNC stock options representing approximately 40% and performance cash awards representing approximately 33% of the total award. LNC stock options granted for this performance period vest ratably over the three-year period, based solely on a service condition. Under the 2009-2011 plan, a total of 609,175 LNC stock options and 902,269 LNC restricted stock units were granted.
The option price assumptions used for our stock option incentive plans were as follows:
For the Years Ended December 31,
Weighted-average fair value per option granted
$
13.88
$
16.91
$
9.47
Assumptions:
Dividend yield
1.2
%
1.3
%
1.8 %
Expected volatility
48.5
%
72.5
%
78.7 %
Risk-free interest rate
1.4-2.9
%
2.7-3.3
%
1.5-3.2 %
Expected life (in years)
6.7
6.3
5.8
The fair value of options is determined using a Black-Scholes options valuation model with the assumptions disclosed in the table above. The dividend yield is based on the expected dividend rate during the expected life of the option. Expected volatility is based on the implied volatility of exchange-traded securities and the historical volatility of the LNC stock price. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of the grant. The expected life of the options granted represents the weighted-average period of time from the grant date to the date of exercise, forfeiture or cancellation based upon historical behavior.
Information with respect to our incentive plans involving stock options with performance conditions (aggregate intrinsic value shown in millions) was as follows:
Weighted-
Weighted-
Average
Average
Remaining
Aggregate
Exercise
Contractual
Intrinsic
Shares
Price
Term
Value
Outstanding as of December 31, 2010
1,948,923
$
49.03
Granted - original
95,516
29.97
Exercised (includes shares tendered)
(7,662
)
24.15
Forfeited or expired
(187,329
)
48.60
Outstanding as of December 31, 2011
1,849,448
$
48.19
1.09
$
-
Vested or expected to vest as of December 31, 2011 (1)
1,236,345
$
51.01
1.26
$
-
Exercisable as of December 31, 2011
1,734,930
$
49.46
0.94
$
-
(1)
Includes estimated forfeitures.
The total fair value of options vested during the years ended December 31, 2011, 2010 and 2009, was $2 million, $9 million and $1 million, respectively. The total intrinsic value of options exercised during the years ended December 31, 2011, 2010 and 2009, was zero.
Information with respect to our incentive plans involving stock options with service conditions (aggregate intrinsic value shown in millions) was as follows:
Weighted-
Weighted-
Average
Average
Remaining
Aggregate
Exercise
Contractual
Intrinsic
Shares
Price
Term
Value
Outstanding as of December 31, 2010
7,755,483
$
47.20
Granted - original
491,653
30.65
Exercised (includes shares tendered)
(24,096
)
17.62
Forfeited or expired
(1,572,482
)
44.47
Outstanding as of December 31, 2011
6,650,558
$
46.73
3.66
$
Vested or expected to vest as of December 31, 2011 (1)
6,384,696
$
47.59
3.48
$
Exercisable as of December 31, 2011
5,969,616
$
48.95
3.08
$
(1)
Includes estimated forfeitures.
The total fair value of options vested during the years ended December 31, 2011, 2010 and 2009, was $7 million, $4 million and $8 million, respectively. The total intrinsic value of options exercised during the years ended December 31, 2011, 2010 and 2009, was zero.
Information with respect to our performance shares was as follows:
Weighted-
Average
Grant-Date
Shares
Fair Value
Nonvested as of December 31, 2010
210,695
$
42.28
Granted
215,137
31.03
Forfeited
(228,383
)
41.41
Nonvested as of December 31, 2011
197,449
$
31.02
Stock Appreciation Rights
Under our incentive compensation plan, we issue SARs to certain planners and advisors who have full-time contracts with us. The SARs under this program are rights on our stock that are cash settled and become exercisable in increments of 25% over the four-year period following the SARs grant date. SARs are granted with an exercise price equal to the fair market value of our stock at the date of grant and, unless cancelled earlier due to certain terminations of employment, expire five years from the date of grant. Generally, such SARs are transferable only upon death.
We recognize compensation expense for SARs based on the fair value method using the Black-Scholes option-pricing model. Compensation expense and the related liability are recognized on a straight-line basis over the vesting period of the SARs. The SARs liability is marked-to-market through net income, which causes volatility in net income (loss) as a result of changes in the market value of our stock and reported within underwriting, acquisition, insurance and other expenses on our Consolidated Statements of Income (Loss). We have hedged a portion of this volatility by purchasing call options on LNC stock. Call options hedging vested SARs are also marked-to-market through net income. See Note 6 for further information on our call options on LNC stock. The SARs liability as of December 31, 2011, 2010 and 2009, was $1 million and reported within other liabilities on our Consolidated Balance Sheets.
The option price assumptions used for our SARs plan were as follows:
For the Years Ended December 31,
Weighted-average fair value per SAR granted
$
9.41
$
7.81
$
12.47
Assumptions:
Dividend yield
1.9
%
2.4
%
0.2
%
Expected volatility
39.1
%
38.2
%
106.0
%
Risk-free interest rate
2.2
%
1.8
%
2.4
%
Expected life (in years)
5.0
5.0
5.0
The assumptions above are the same as those discussed for options above, except expected volatility is based on the implied volatility of exchange-traded securities and the expected life represents the contractual term.
Information with respect to our SARs plan (aggregate intrinsic value shown in millions) was as follows:
Weighted-
Weighted-
Average
Average
Remaining
Aggregate
Exercise
Contractual
Intrinsic
Shares
Price
Term
Value
Outstanding as of December 31, 2010
715,631
$
47.02
Granted - original
106,950
29.97
Exercised (includes shares tendered)
(8,818
)
16.53
Forfeited or expired
(142,438
)
54.14
Outstanding as of December 31, 2011
671,325
$
43.26
1.89
$
-
Vested or expected to vest as of December 31, 2011 (1)
648,545
$
43.78
1.84
$
-
Exercisable as of December 31, 2011
480,041
$
49.44
1.30
$
-
(1)
Includes estimated forfeitures.
The payment for SARs exercised during the years ended December 31, 2011, 2010 and 2009, was zero.
Restricted Stock Units
We award restricted stock units under the incentive compensation plan, generally subject to a three-year vesting period. Information with respect to our restricted stock units was as follows:
Weighted-
Average
Grant-Date
Shares
Fair Value
Outstanding as of December 31, 2010
1,563,928
$
23.38
Granted
540,394
30.20
Vested
(206,294
)
33.36
Forfeited
(118,675
)
25.09
Outstanding as of December 31, 2011
1,779,353
$
23.94
20. Statutory Information and Restrictions
The Company’s domestic life insurance subsidiaries prepare financial statements in accordance with statutory accounting principles (“SAP”) prescribed or permitted by the insurance departments of their states of domicile, which may vary materially from GAAP. Prescribed SAP includes the Accounting Practices and Procedures Manual of the National Association of Insurance
Commissioners (“NAIC”) as well as state laws, regulations and administrative rules. Permitted SAP encompasses all accounting practices not so prescribed. The principal differences between statutory financial statements and financial statements prepared in accordance with GAAP are that statutory financial statements do not reflect DAC, some bond portfolios may be carried at amortized cost, assets and liabilities are presented net of reinsurance, contract holder liabilities are generally valued using more conservative assumptions and certain assets are non-admitted.
Our insurance subsidiaries are subject to the applicable laws and regulations of their respective states. Changes in these laws and regulations could change capital levels or capital requirements for our insurance subsidiaries.
Statutory capital and surplus, net gain (loss) from operations, after-tax, net income (loss) and dividends to LNC Parent Company amounts (in millions) below consists of all or a combination of the following entities: LNL, First Penn-Pacific Life Insurance Company, Lincoln Reinsurance Company of South Carolina, Lincoln Reinsurance Company of South Carolina II, Lincoln Life & Annuity Company of New York (“LLANY”), Lincoln Financial Group South Carolina Reinsurance Company, Lincoln Reinsurance Company of Vermont I, Lincoln Reinsurance Company of Vermont II, Lincoln Reinsurance Company of Vermont III and Lincoln Reinsurance Company of Vermont IV.
As of December 31,
U.S. capital and surplus
$
7,264
$
6,955
For the Years Ended December 31,
U.S. net gain (loss) from operations, after-tax
$
$
$
U.S. net income (loss)
(4
)
U.S. dividends to LNC Parent Company
The decrease in statutory net income (loss) for the year ended December 31, 2011, from that of 2010, was primarily due to increased realized losses in invested assets, an increase in reserves on UL secondary guarantee products and prior year favorable tax items that did not repeat in the current year.
The increase in statutory net income (loss) for the year ended December 31, 2010, from that of 2009, was primarily due to a significant decrease in realized losses on investments due to improving market conditions throughout 2010.
The states of domicile of the Company’s insurance subsidiaries have adopted certain prescribed accounting practices that differ from those found in NAIC SAP. These prescribed practices are the use of continuous Commissioners Annuity Reserve Valuation Method (“CARVM”) in the calculation of reserves as prescribed by the state of New York and the calculation of reserves on universal life policies based on the Indiana universal life method as prescribed by the state of Indiana. The insurance subsidiaries also have several accounting practices permitted by the states of domicile that differ from those found in NAIC SAP. Specifically, these are accounting for the lesser of the face amount of all amounts outstanding under an LOC and the value of the Valuation of Life Insurance Policies Model Regulation (“XXX”) additional statutory reserves as an admitted asset and a form of surplus and the use of a more conservative valuation interest rate on certain annuities as of December 31, 2011 and 2010.
The favorable (unfavorable) effects on statutory surplus compared to NAIC statutory surplus from the use of these prescribed and permitted practices (in millions) were as follows:
As of December 31,
Calculation of reserves using the Indiana universal life method
$
$
Calculation of reserves using continuous CARVM
(2
)
(5
)
Conservative valuation rate on certain annuities
(20
)
(15
)
Lesser of LOC and XXX additional reserve as surplus
1,731
Our insurance subsidiaries are subject to certain insurance department regulatory restrictions as to the transfer of funds and payment of dividends to the holding company. Under Indiana laws and regulations, our Indiana insurance subsidiaries, including our primary insurance subsidiary, LNL, may pay dividends to LNC without prior approval of the Indiana Insurance Commissioner (the “Commissioner”), only from unassigned surplus and must receive prior approval of the Commissioner to pay a dividend if such dividend, along with all other dividends paid within the preceding 12 consecutive months, would exceed the statutory limitation. The current statutory limitation is the greater of 10% of the insurer’s contract holders’ surplus, as shown on its last
annual statement on file with the Commissioner or the insurer’s statutory net gain from operations for the previous 12 months, but in no event to exceed statutory unassigned surplus. As discussed above, we may not consider the benefit from the statutory accounting principles relating to our insurance subsidiaries’ deferred tax assets in calculating available dividends. Indiana law gives the Commissioner broad discretion to disapprove requests for dividends in excess of these limits. New York, the state of domicile of our other major insurance subsidiary, LLANY, has similar restrictions, except that in New York it is the lesser of 10% of surplus to contract holders as of the immediately preceding calendar year-end or net gain from operations for the immediately preceding calendar year, not including realized capital gains. We expect our domestic insurance subsidiaries could pay dividends of approximately $675 million in 2012 without prior approval from the respective state commissioners.
All payments of principal and interest on the surplus notes must be approved by the respective Commissioner of Insurance.
21. Fair Value of Financial Instruments
The carrying values and estimated fair values of our financial instruments (in millions) were as follows:
As of December 31,
Carrying
Fair
Carrying
Fair
Value
Value
Value
Value
Assets
AFS securities:
Fixed maturity securities
$ 75,433
$ 75,433
$ 68,030
$ 68,030
VIEs' fixed maturity securities
Equity securities
Trading securities
2,675
2,675
2,596
2,596
Mortgage loans on real estate
6,942
7,608
6,752
7,183
Derivative investments
3,151
3,151
1,076
1,076
Other investments
1,069
1,069
1,038
1,038
Cash and invested cash
4,510
4,510
2,741
2,741
Separate account assets
83,477
83,477
84,630
84,630
Liabilities
Future contract benefits:
Indexed annuity contracts embedded derivatives
(399 )
(399 )
(497 )
(497 )
GLB reserves embedded derivatives
(2,217 )
(2,217 )
(408 )
(408 )
Other contract holder funds:
Remaining guaranteed interest and similar contracts
(1,114 )
(1,114 )
(1,108 )
(1,108 )
Account values of certain investment contracts
(27,468 )
(30,812 )
(26,130 )
(27,142 )
Short-term debt (1)
(300 )
(309 )
(351 )
(364 )
Long-term debt
(5,391 )
(5,025 )
(5,399 )
(5,512 )
Reinsurance related embedded derivatives
(168 )
(168 )
(102 )
(102 )
VIEs' liabilities - derivative instruments
(291 )
(291 )
(209 )
(209 )
Other liabilities:
Deferred compensation plans embedded derivatives
(354 )
(354 )
(363 )
(363 )
Credit default swaps
(16 )
(16 )
(16 )
(16 )
Benefit Plans' Assets (2)
1,345
1,345
1,269
1,269
(1)
The difference between the carrying value and fair value of short-term debt as of December 31, 2011 and 2010, related to current maturities of long-term debt.
(2)
Included in the funded statuses of the benefit plans, which is reported in other liabilities on our Consolidated Balance Sheets. Refer to Note 17 for additional detail.
Valuation Methodologies and Associated Inputs for Financial Instruments Not Carried at Fair Value
The following discussion outlines the methodologies and assumptions used to determine the fair value of our financial instruments not carried at fair value on our Consolidated Balance Sheets. Considerable judgment is required to develop these assumptions used to measure fair value. Accordingly, the estimates shown are not necessarily indicative of the amounts that would be realized in a one-time, current market exchange of all of our financial instruments.
Mortgage Loans on Real Estate
The fair value of mortgage loans on real estate is established using a discounted cash flow method based on credit rating, maturity and future income. The ratings for mortgages in good standing are based on property type, location, market conditions, occupancy, debt-service coverage, loan-to-value, quality of tenancy, borrower and payment record. The fair value for impaired mortgage loans is based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s market price or the fair value of the collateral if the loan is collateral dependent.
Other Investments
The carrying value of our assets classified as other investments approximates their fair value. Other investments include LPs and other privately held investments that are accounted for using the equity method of accounting.
Other Contract Holder Funds
Other contract holder funds include remaining guaranteed interest and similar contracts and account values of certain investment contracts. The fair value for the remaining guaranteed interest and similar contracts is estimated using discounted cash flow calculations as of the balance sheet date. These calculations are based on interest rates currently offered on similar contracts with maturities that are consistent with those remaining for the contracts being valued. As of December 31, 2011 and 2010, the remaining guaranteed interest and similar contracts carrying value approximates fair value. The fair value of the account values of certain investment contracts is based on their approximate surrender value as of the balance sheet date.
Short-Term and Long-Term Debt
The fair value of long-term debt is based on quoted market prices or estimated using discounted cash flow analysis determined in conjunction with our incremental borrowing rate as of the balance sheet date for similar types of borrowing arrangements where quoted prices are not available. For short-term debt, excluding current maturities of long-term debt, the carrying value approximates fair value.
Financial Instruments Carried at Fair Value
We did not have any assets or liabilities measured at fair value on a nonrecurring basis as of December 31, 2011, or December 31, 2010, and we noted no changes in our valuation methodologies between these periods.
The following summarizes our financial instruments carried at fair value (in millions) on a recurring basis by the fair value hierarchy levels described above:
As of December 31, 2011
Quoted
Prices
in Active
Markets for
Significant
Significant
Identical
Observable
Unobservable
Total
Assets
Inputs
Inputs
Fair
(Level 1)
(Level 2)
(Level 3)
Value
Assets
Investments:
Fixed maturity AFS securities:
Corporate bonds
$
$ 57,310
$ 1,888
$ 59,261
U.S. Government bonds
Foreign government bonds
-
RMBS
-
7,881
8,039
CMBS
-
1,566
1,600
CDOs
-
-
State and municipal bonds
-
4,047
-
4,047
Hybrid and redeemable preferred securities
1,042
1,157
VIEs' fixed maturity securities
-
Equity AFS securities
Trading securities
2,605
2,675
Derivative investments
-
2,470
3,151
Cash and invested cash
-
4,510
-
4,510
Separate account assets
-
83,477
-
83,477
Total assets
$
$ 164,411
$ 4,974
$ 170,085
Liabilities
Future contract benefits:
Indexed annuity contracts embedded derivatives
$ -
$ -
$ (399 ) $ (399 )
GLB reserves embedded derivatives
-
-
(2,217 )
(2,217 )
Long-term debt - interest rate swap agreements
-
(319 )
-
(319 )
Reinsurance related embedded derivatives
-
(168 )
-
(168 )
VIEs' liabilities - derivative instruments
-
-
(291 )
(291 )
Other liabilities:
Deferred compensation plans embedded derivatives
-
-
(354 )
(354 )
Credit default swaps
-
-
(16 )
(16 )
Total liabilities
$ -
$ (487 ) $ (3,277 ) $ (3,764 )
Benefit Plans' Assets $
$ 1,246
$ -
$ 1,345
As of December 31, 2010
Quoted
Prices
in Active
Markets for
Significant
Significant
Identical
Observable
Unobservable
Total
Assets
Inputs
Inputs
Fair
(Level 1)
(Level 2)
(Level 3)
Value
Assets
Investments:
Fixed maturity AFS securities:
Corporate bonds
$
$ 49,864
$ 1,816
$ 51,740
U.S. Government bonds
Foreign government bonds
-
RMBS
-
8,719
8,838
CMBS
-
1,944
2,053
CDOs
-
State and municipal bonds
-
3,155
-
3,155
Hybrid and redeemable preferred securities
1,260
1,397
VIEs' fixed maturity securities
-
-
Equity AFS securities
Trading securities
2,518
2,596
Derivative investments
-
(419 )
1,495
1,076
Cash and invested cash
-
2,741
-
2,741
Separate account assets
-
84,630
-
84,630
Total assets
$
$ 155,464
$ 4,113
$ 159,854
Liabilities
Future contract benefits:
Indexed annuity contracts embedded derivatives $ -
$ -
$ (497 ) $ (497 )
GLB reserves embedded derivatives
-
-
(408 )
(408 )
Long-term debt - interest rate swap agreements
-
(55 )
-
(55 )
Reinsurance related embedded derivatives
-
(102 )
-
(102 )
VIEs' liabilities - derivative instruments
-
-
(209 )
(209 )
Other liabilities:
Deferred compensation plans embedded derivatives
-
-
(363 )
(363 )
Credit default swaps
-
-
(16 )
(16 )
Total liabilities
$ -
$ (157 ) $ (1,493 ) $ (1,650 )
Benefit Plans' Assets $
$ 1,113
$
$ 1,269
The following summarizes changes to our financial instruments carried at fair value (in millions) and classified within Level 3 of the fair value hierarchy. This summary excludes any impact of amortization of DAC, VOBA, DSI and DFEL. The gains and losses below may include changes in fair value due in part to observable inputs that are a component of the valuation methodology.
For the Year Ended December 31, 2011
Purchases,
Gains
Issuances,
Transfers
Items
(Losses)
Sales,
In or
Included
in
Maturities,
Out
Beginning
in
OCI
Settlements,
of
Ending
Fair
Net
and
Calls,
Level 3,
Fair
Value
Income
Other (1)
Net
Net (2)
Value
Investments: (3)
Fixed maturity AFS securities:
Corporate bonds
$ 1,816
$
$
$ (138 ) $
$ 1,888
U.S. Government bonds
-
-
(1 )
-
Foreign government bonds
-
(3 )
(17 )
RMBS
(3 )
-
CMBS
(62 )
(78 )
CDOs
(17 )
(72 )
-
Hybrid and redeemable preferred securities
(1 )
(6 )
(9 )
(3 )
Equity AFS securities
(12 )
(33 )
Trading securities
(8 )
(4 )
Derivative investments
1,495
-
2,470
Future contract benefits: (4)
Indexed annuity contracts embedded derivatives
(497 )
-
-
(399 )
GLB reserves embedded derivatives
(408 )
(1,809 )
-
-
-
(2,217 )
VIEs' liabilities - derivative instruments (5)
(209 )
(82 )
-
-
-
(291 )
Other liabilities:
Deferred compensation plans embedded derivatives (6)
(363 )
(11 )
-
-
(354 )
Credit default swaps (7)
(16 )
(7 )
-
-
(16 )
Total, net
$ 2,620
$ (1,445 ) $
$ (36 ) $
$ 1,697
Benefit plans' assets (8) $
$
$ (3 ) $ (39 ) $ -
$ -
For the Year Ended December 31, 2010
Purchases,
Gains
Issuances,
Transfers
Items
(Losses)
Sales,
In or
Included
in
Maturities,
Out
Beginning
in
OCI
Settlements,
of
Ending
Fair
Net
and
Calls,
Level 3,
Fair
Value
Income
Other (1)
Net
Net (2)
Value
Investments: (3)
Fixed maturity AFS securities:
Corporate bonds
$ 2,070
$ (42 ) $
$ (218 ) $ (50 ) $ 1,816
U.S. Government bonds
-
-
(4 )
Foreign government bonds
-
(4 )
RMBS
(5 )
(17 )
(4 )
CMBS
(47 )
(72 )
(118 )
CDOs
(12 )
-
CLNs
-
-
(600 )
-
Hybrid and redeemable preferred securities
(26 )
(14 )
-
Equity AFS securities
-
(4 )
-
Trading securities
(10 )
(7 )
(1 )
Derivative investments
1,368
(151 )
-
1,495
Future contract benefits: (4)
Indexed annuity contracts embedded derivatives
(419 )
(81 )
-
-
(497 )
GLB reserves embedded derivatives
(676 )
-
-
-
(408 )
VIEs' liabilities - derivativeinstruments (5)
-
-
-
(225 )
(209 )
Other liabilities:
Deferred compensation plans embedded derivatives (6)
(332 )
(34 )
-
-
(363 )
Credit default swaps (7)
(65 )
-
-
(16 )
Total, net
$ 3,246
$ (62 ) $
$ (33 ) $ (978 ) $ 2,620
Benefit plans' assets (8) $
$ -
$
$
$ -
$
For the Year Ended December 31, 2009
Purchases,
Gains
Issuances,
Transfers
Items
(Losses)
Sales,
In or
Included
in
Maturities,
Out
Beginning
in
OCI
Settlements,
of
Ending
Fair
Net
and
Calls,
Level 3,
Fair
Value
Income
Other (1)
Net
Net (2)
Value
Investments: (3)
Fixed maturity AFS securities:
Corporate bonds
$ 2,335
$ (46 ) $
$ (239 ) $ (301 ) $ 2,070
U.S. Government bonds
-
-
-
-
Foreign government bonds
RMBS
(8 )
(156 )
CMBS
(45 )
-
CDOs
(35 )
(22 )
(2 )
CLNs
-
-
-
State and municipal bonds
-
-
(194 )
-
Hybrid and redeemable preferred securities
(21 )
Equity AFS securities
(8 )
(24 )
-
Trading securities
-
(7 )
(17 )
Derivative investments
2,147
(712 )
(135 )
-
1,368
Future contract benefits: (4)
Indexed annuity contracts embedded derivatives
(252 )
(75 )
-
(92 )
-
(419 )
GLB reserves embedded derivatives
(2,904 )
2,228
-
-
-
(676 )
Other liabilities:
Deferred compensation plans embedded derivatives (6)
(336 )
(63 )
-
-
(332 )
Credit default swaps (7)
(51 )
(37 )
-
-
(65 )
Total, net
$ 2,043
$ 1,259
$
$ (105 ) $ (642 ) $ 3,246
Benefit plans' assets (8) $
$ -
$ -
$ (2 ) $ (7 ) $
(1)
The changes in fair value of the interest rate swaps are offset by an adjustment to derivative investments (see Note 6).
(2)
Transfers in or out of Level 3 for AFS and trading securities are displayed at amortized cost as of the beginning-of-period. For AFS and trading securities, the difference between beginning-of-year amortized cost and beginning-of-year fair value was included in OCI and earnings, respectively, in prior years.
(3)
Amortization and accretion of premiums and discounts are included in net investment income on our Consolidated Statements of Income (Loss). Gains (losses) from sales, maturities, settlements and calls and OTTI are included in realized gain (loss) on our Consolidated Statements of Income (Loss).
(4)
Gains (losses) from sales, maturities, settlements and calls are included in realized gain (loss) on our Consolidated Statements of Income (Loss).
(5)
The changes in fair value of the credit default swaps and contingency forwards are included in realized gain (loss) on our Consolidated Statements of Income (Loss).
(6)
Deferrals and subsequent changes in fair value for the participants’ investment options are reported in underwriting, acquisition, insurance and other expenses on our Consolidated Statements of Income (Loss).
(7)
Gains (losses) from sales, maturities, settlements and calls are included in net investment income on our Consolidated Statements of Income (Loss).
(8)
The expected return on plan assets is reported in underwriting, acquisition, insurance and other expenses on our Consolidated Statements of Income (Loss).
The following provides the components of the items included in issuances, sales, maturities, settlements, calls, net, excluding any effect of amortization of DAC, VOBA, DSI and DFEL and changes in future contract benefits (in millions) as reported above:
For the Year Ended December 31, 2011
Issuances
Sales
Maturities
Settlements
Calls
Total
Investments:
Fixed maturity AFS securities:
Corporate bonds
$
$ (216 ) $ (16 ) $ (54 ) $ (89 ) $ (138 )
U.S. Government bonds
-
-
-
(1 )
-
(1 )
Foreign government bonds
-
(2 )
-
-
(1 )
(3 )
RMBS
(1 )
-
(15 )
-
CMBS
-
(53 )
-
(24 )
(1 )
(78 )
CDOs
-
(33 )
-
(39 )
-
(72 )
Hybrid and redeemable preferred securities
(18 )
-
-
-
(9 )
Equity AFS securities
(18 )
-
-
-
Trading securities
-
(3 )
-
(5 )
-
(8 )
Derivative investments
(2 )
(277 )
-
-
Future contract benefits:
Indexed annuity contracts embedded derivatives
(59 )
-
-
-
Other liabilities:
Deferred compensation plans embedded derivatives
-
-
-
-
Credit default swaps
-
-
-
-
Total, net
$
$ (339 ) $ (293 ) $
$ (91 ) $ (36 )
Benefit plans' assets $ -
$ (22 ) $ (17 ) $ -
$ -
$ (39 )
The following summarizes changes in unrealized gains (losses) included in net income, excluding any impact of amortization of DAC, VOBA, DSI and DFEL and changes in future contract benefits, related to financial instruments carried at fair value classified within Level 3 that we still held (in millions):
For the Years Ended December 31,
Investments: (1)
Trading securities
$ -
$ -
$
Derivative investments
(162 )
(486 )
Future contract benefits: (1)
Indexed annuity contracts embedded derivatives
(1 )
(17 )
GLB reserves embedded derivatives
(1,615 )
2,405
VIEs' liabilities - derivative instruments (1)
(82 )
-
Other liabilities:
Deferred compensation plans embedded derivatives (2)
(11 )
(34 )
(63 )
Credit default swaps (3)
(8 )
(12 )
(14 )
Total, net
$ (1,245 ) $
$ 1,857
(1)
Included in realized gain (loss) on our Consolidated Statements of Income (Loss).
(2)
Included in underwriting, acquisition, insurance and other expenses on our Consolidated Statements of Income (Loss).
(3)
Included in net investment income on our Consolidated Statements of Income (Loss).
The following provides the components of the transfers in and out of Level 3 (in millions) as reported above:
For the Years Ended December 31,
Transfers
Transfers
Transfers
Transfers
In to
Out of
In to
Out of
Level 3
Level 3
Total
Level 3
Level 3
Total
Investments:
Fixed maturity AFS securities:
Corporate bonds
$
$ (83 ) $
$
$ (197 ) $ (50 )
U.S. Government bonds
-
-
-
-
Foreign government bonds
-
(17 )
(17 )
-
RMBS
-
-
-
-
(4 )
(4 )
CMBS
(1 )
(121 )
(118 )
CLNs
-
-
-
-
(600 )
(600 )
Hybrid and redeemable preferred securities
(21 )
(3 )
-
-
-
Equity AFS securities
(35 )
(33 )
-
-
-
Trading securities
(5 )
(4 )
-
(1 )
(1 )
Future contract benefits:
VIEs' liabilities - derivative instruments
-
-
-
(225 )
-
(225 )
Total, net
$
$ (162 ) $
$ (55 ) $ (923 ) $ (978 )
Transfers in and out of Level 3 are generally the result of observable market information on a security no longer being available or becoming available to our pricing vendors. For the years ended December 31, 2011 and 2010, our corporate bonds and CMBS transfers in and out were attributable primarily to the securities’ observable market information being available or no longer being available, respectively. For the year ended December 31, 2010, the CLNs transfer out of Level 3 and VIEs’ liabilities - derivative instruments transfer into Level 3 were related to new accounting guidance that is discussed in Note 2. For the years ended December 31, 2011 and 2010, there were no significant transfers between Level 1 and 2 of the fair value hierarchy.
22. Segment Information
We provide products and services and report results through our Annuities, Retirement Plan Services, Life Insurance and Group Protection segments. We also have Other Operations, which includes the financial data for operations that are not directly related to the business segments. Our reporting segments reflect the manner by which our chief operating decision makers view and manage the business. The following is a brief description of these segments and Other Operations.
The Annuities segment provides tax-deferred investment growth and lifetime income opportunities for its clients by offering individual fixed annuities, including indexed annuities and variable annuities. The Retirement Plan Services segment provides employer-sponsored variable and fixed annuities, defined benefit, individual retirement accounts and mutual-fund based programs in the retirement plan marketplaces.
The Life Insurance segment offers wealth protection and transfer opportunities through term insurance, a linked-benefit product (which is a UL policy linked with riders that provide for long-term care costs) and both single and survivorship versions of UL and VUL, including corporate-owned UL and VUL insurance and bank-owned UL and VUL insurance products. The Group Protection segment offers group life, disability and dental insurance to employers, and its products are marketed primarily through a national distribution system of regional group offices. These offices develop business through employee benefit brokers, third-party administrators and other employee benefit firms.
Other Operations includes investments related to the excess capital in our insurance subsidiaries; investments in media properties and other corporate investments; benefit plan net liability; the unamortized deferred gain on indemnity reinsurance related to the sale of reinsurance; the results of certain disability income business; a closed-block of pension business, the majority of which was sold on a group annuity basis, and is currently in run-off; and debt costs.
Segment operating revenues and income (loss) from operations are internal measures used by our management and Board of Directors to evaluate and assess the results of our segments. Income (loss) from operations is GAAP net income excluding the after-tax effects of the following items, as applicable:
·
Realized gains and losses associated with the following (“excluded realized gain (loss)”):
§
Sale or disposal of securities;
§
Impairments of securities;
§
Change in the fair value of derivative instruments, embedded derivatives within certain reinsurance arrangements and our trading securities;
§
Change in the fair value of the derivatives we own to hedge our GDB riders within our variable annuities;
§
Change in the GLB embedded derivative reserves, net of the change in the fair value of the derivatives we own to hedge the changes in the embedded derivative reserves; and
§
Changes in the fair value of the embedded derivative liabilities related to index call options we may purchase in the future to hedge contract holder index allocations applicable to future reset periods for our indexed annuity products accounted for under the Derivatives and Hedging and the Fair Value Measurements and Disclosures Topics of the FASB ASC.
·
Change in reserves accounted for under the Financial Services - Insurance - Claim Costs and Liabilities for Future Policy Benefits Subtopic of the FASB ASC resulting from benefit ratio unlocking on our GDB and GLB riders (“benefit ratio unlocking”);
·
Income (loss) from the initial adoption of new accounting standards;
·
Income (loss) from reserve changes (net of related amortization) on business sold through reinsurance;
·
Gain (loss) on early extinguishment of debt;
·
Losses from the impairment of intangible assets; and
·
Income (loss) from discontinued operations.
Operating revenues represent GAAP revenues excluding the pre-tax effects of the following items, as applicable:
·
Excluded realized gain (loss);
·
Amortization of DFEL arising from changes in GDB and GLB benefit ratio unlocking;
·
Amortization of deferred gains arising from the reserve changes on business sold through reinsurance; and
·
Revenue adjustments from the initial adoption of new accounting standards.
We use our prevailing corporate federal income tax rate of 35% while taking into account any permanent differences for events recognized differently in our financial statements and federal income tax returns when reconciling our non-GAAP measures to the most comparable GAAP measure. Operating revenues and income (loss) from operations do not replace revenues and net income as the GAAP measures of our consolidated results of operations.
Segment information (in millions) was as follows:
For the Years Ended December 31,
Revenues
Operating revenues:
Annuities
$ 2,865
$ 2,654
$ 2,301
Retirement Plan Services
1,017
Life Insurance
4,739
4,590
4,295
Group Protection
1,939
1,831
1,713
Other Operations
Excluded realized gain (loss), pre-tax
(388 )
(146 )
(1,200 )
Amortization of deferred gain arising from reserve changes on business sold through reinsurance, pre-tax
Amortization of DFEL associated with benefit ratio unlocking, pre-tax
-
-
(4 )
Total revenues
$ 10,636
$ 10,407
$ 8,499
For the Years Ended December 31,
Net Income (Loss)
Income (loss) from operations:
Annuities
$
$
$
Retirement Plan Services
Life Insurance
Group Protection
Other Operations
(146 )
(186 )
(237 )
Excluded realized gain (loss), after-tax
(252 )
(95 )
(780 )
Gain (loss) on early extinguishment of debt, after-tax
(5 )
(3 )
Income (expense) from reserve changes (net of related amortization) on business sold through reinsurance, after-tax
Impairment of intangibles, after-tax
(747 )
-
(710 )
Benefit ratio unlocking, after-tax
(14 )
Income (loss) from continuing operations, after-tax
(415 )
Income (loss) from discontinued operations, after-tax
(8 )
(70 )
Net income (loss)
$
$
$ (485 )
For the Years Ended December 31,
Net Investment Income
Annuities
$ 1,106
$ 1,119
$ 1,037
Retirement Plan Services
Life Insurance
2,294
2,186
1,975
Group Protection
Other Operations
Total net investment income
$ 4,652
$ 4,541
$ 4,178
For the Years Ended December 31,
Amortization of DAC and VOBA, Net of Interest
Annuities
$
$
$
Retirement Plan Services
Life Insurance
Group Protection
Total amortization of DAC and VOBA, net of interest
$ 1,050
$ 1,084
$ 1,053
For the Years Ended December 31,
Federal Income Tax Expense (Benefit)
Annuities
$
$
$
Retirement Plan Services
Life Insurance
Group Protection
Other Operations
(76 )
(107 )
(143 )
Excluded realized gain (loss)
(136 )
(51 )
(420 )
Gain (loss) on early extinguishment of debt
(3 )
(2 )
Reserve changes (net of related amortization) on business sold through reinsurance
Impairment of intangibles
-
-
(16 )
Benefit ratio unlocking
(7 )
Total federal income tax expense (benefit)
$
$
$ (106 )
As of December 31,
Assets
Annuities
$ 97,272
$ 91,435
Retirement Plan Services
28,774
28,562
Life Insurance
60,544
56,713
Group Protection
3,458
3,254
Other Operations
12,858
13,860
Total assets
$ 202,906
$ 193,824
23. Supplemental Disclosures of Cash Flow Data
The following summarizes our supplemental cash flow data (in millions):
For the Years Ended December 31,
Interest paid $
$
$
Income taxes paid (received)
(36 )
(107 )
(189 )
Significant non-cash investing and financing transactions:
Business combinations:
Fair value of assets acquired (includes cash and invested cash)
$ -
$ -
$
Liabilities assumed
$ -
$ -
$
Business dispositions:
Assets disposed (includes cash and invested cash)
$ -
$ (509 ) $ (8,044 )
Liabilities disposed
(3 )
7,457
Foreign currency awards released
-
-
Cash received
-
Gain (loss) on dispositions
$ (3 ) $
$ (219 )
Sale of subsidiaries/businesses:
Proceeds from sale of subsidiaries/businesses
$ -
$
$
Assets disposed (includes cash and invested cash)
-
-
(5 )
Gain (loss) on sale of subsidiaries/businesses
$ -
$
$
24. Quarterly Results of Operations (Unaudited)
The unaudited quarterly results of operations (in millions, except per share data) were as follows:
For the Three Months Ended
March 31,
June 30,
September 30,
December 31,
Total revenues
$ 2,714
$ 2,804
$ 2,548
$ 2,570
Total benefits and expenses
2,246
2,363
2,409
3,019
Income (loss) from continuing operations
(513 )
Income (loss) from discontinued operations, net of federal income taxes
-
-
(8 )
-
Net income (loss)
(513 )
Earnings (loss) per common share - basic:
Income (loss) from continuing operations
1.08
1.04
0.50
(1.73 )
Income (loss) from discontinued operations
-
-
(0.03 )
-
Net income (loss)
1.08
1.04
0.47
(1.73 )
Earnings (loss) per common share - diluted:
Income (loss) from continuing operations
1.05
1.01
0.47
(1.73 )
Income (loss) from discontinued operations
-
-
(0.03 )
-
Net income (loss)
1.05
1.01
0.44
(1.73 )
Total revenues
$ 2,527
$ 2,605
$ 2,613
$ 2,662
Total benefits and expenses
2,179
2,275
2,310
2,409
Income (loss) from continuing operations
Income (loss) from discontinued operations, net of federal income taxes
(2 )
-
Net income (loss)
Earnings (loss) per common share - basic:
Income (loss) from continuing operations
0.79
0.34
0.79
0.62
Income (loss) from discontinued operations
0.09
0.01
(0.01 )
-
Net income (loss)
0.88
0.35
0.78
0.62
Earnings (loss) per common share - diluted:
Income (loss) from continuing operations
0.76
0.32
0.76
0.60
Income (loss) from discontinued operations
0.09
0.01
(0.01 )
-
Net income (loss)
0.85
0.33
0.75
0.60
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A. Controls and Procedures
(a)
Conclusions Regarding Disclosure Controls and Procedures
We maintain disclosure controls and procedures, which are designed to ensure that information required to be disclosed in the reports we file or submit 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 our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. As of the end of the period required by this report, we, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Exchange Act). Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to us and our consolidated subsidiaries required to be disclosed in our periodic reports under the Exchange Act.
(b)
Management’s Report on Internal Control Over Financial Reporting
Management’s Report on Internal Control Over Financial Reporting is included on page 119 of “Item 8. Financial Statements and Supplementary Data” and is incorporated herein by reference.
A control system, no matter how well designed and operated, can provide only reasonable assurance that the control system’s objectives will be met. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the company have been detected. Projections of any evaluation of controls’ effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.
(c)
Changes in Internal Control Over Financial Reporting
There was no change in our internal control over financial reporting (as that term is defined in rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the quarter ended December 31, 2011, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Item 9B. Other Information
None.
PART III
Item 10. Directors, Executive Officers and Corporate Governance
Information for this item relating to officers of LNC is incorporated by reference to “Part I - Executive Officers of the Registrant.” Information for this item relating to directors of LNC is incorporated by reference to the sections captioned “GOVERNANCE OF THE COMPANY - Our Corporate Governance Guidelines,” “GOVERNANCE OF THE COMPANY - Director Nomination Process,” “THE BOARD OF DIRECTORS AND COMMITTEES - Current Committee Membership and Meetings Held During 2012,” “THE BOARD OF DIRECTORS AND COMMITTEES - Audit Committee,” “ITEM 1 - Election of Directors,” “SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE” and “GENERAL - Shareholder Proposals” of LNC’s Proxy Statement for the Annual Meeting scheduled for May 24, 2012.
We have adopted a code of ethics, which we refer to as our “Code of Conduct,” that applies, among others, to our principal executive officer, principal financial officer, principal accounting officer or controller and other persons performing similar functions. The Code of Conduct is posted on our Internet website (www.lincolnfinancial.com). LNC will provide to any person without charge, upon request, a copy of such code. Requests for the Code of Conduct should be directed to: Corporate Secretary, Lincoln National Corporation, 150 N. Radnor Chester Road, Suite A305, Radnor, PA 19087. We intend to disclose any amendment to or waiver from the provisions of our Code of Conduct that applies to our directors and executive officers on our website, www.lincolnfinancial.com.
Item 11. Executive Compensation
Information for this item is incorporated by reference to the sections captioned “EXECUTIVE COMPENSATION,” “COMPENSATION OF DIRECTORS” and “COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION” of LNC’s Proxy Statement for the Annual Meeting scheduled for May 24, 2012.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Information for this item is incorporated by reference to the section captioned “SECURITY OWNERSHIP” of LNC’s Proxy Statement for the Annual Meeting scheduled for May 24, 2012.
Securities Authorized for Issuance Under Equity Compensation Plans
The table below provides information as of December 31, 2011, regarding securities authorized for issuance under LNC’s equity compensation plans. See Note 19 to the consolidated financial statements included in “Part II - Item 8. Financial Statements and Supplementary Data” of this Form 10-K for a brief description of our equity compensation plans.
Number of
Weighted-
Number of
securities to be
average
securities remaining
issued upon
exercise
available for future
exercise of
price of
issuance under
outstanding
outstanding
equity compensation
options,
options,
plans (excluding
warrants
warrants
securities reflected
and rights
and rights
in column (a))
(a)
(b)
(c)
Plan Category
Equity compensation plans approved by shareholders
7,183,136 (1)(2) $ 40.32
11,190,459 (3)
Equity compensation plans not approved by shareholders
-
-
-
Total
7,183,136
$ 40.32
11,190,459
(1)
This amount excludes outstanding stock options assumed in connection with our acquisition of Jefferson-Pilot Corporation (“JP”) as follows:
·
3,804,009 shares to be issued upon exercise of outstanding options as of December 31, 2011, under the JP Long-Term Stock Incentive Plan with a weighted-average exercise price of $46.87; and
·
73,712 shares to be issued upon exercise of outstanding options as of December 31, 2011, under the JP Non-Employee Directors Stock Option Plan with a weighted-average exercise price of $65.74.
(2)
This amount includes the following:
·
Outstanding options of 2,580,687;
·
Outstanding long-term incentive awards of 1,557,531, of which 1,162,633 represent options with performance conditions and 394,898 represent the number of performance shares based on the maximum amounts potentially payable under the awards in stock options and shares (including potential dividend equivalents). The long-term incentive awards have not been earned as of December 31, 2011. The number of options and shares, if any, to be issued pursuant to such awards will be determined based on our, and in some cases, our subsidiaries performance over the applicable three-year performance period (target amounts are set forth in Note 19 to the consolidated financial statements, included in Part II - Item 8 of the Form 10-K for the year ended December 31, 2011. Since the shares that may be received in payment of the awards have no exercise price, they are not included in the weighted-average exercise price calculation in column (b) above. The long-term incentive awards are all issued under the LNC 2009 Amended and Restated Incentive Compensation Plan (“ICP”);
·
Outstanding restricted stock units of 1,779,353; and
·
Outstanding deferred stock units of 1,265,565, which are not included in Note 19 to the consolidated financial statements, included in Part II - Item 8 of the Form 10-K for the year ended December 31, 2011.
(3)
Includes up to 10,920,004 securities available for issuance in connection with restricted stock, restricted stock units, performance stock units, deferred stock, and deferred stock unit awards under the ICP. Shares that may be issued in payment of awards, other than options and stock appreciation rights, granted between May 12, 2005, and May 13, 2009, reduce the
number of securities remaining available for future issuance under equity compensation plans at a ratio of 3.25-to-1. Shares that may be issued in payment of awards, other than options and stock appreciation rights, granted after May 13, 2009, reduce the number of securities remaining available for future issuance under equity compensation plans at a ratio of 1.63-to-1. Shares that may be issued in payment of awards granted prior to May 12, 2005, and grants for options and stock appreciation rights, reduce the number of securities remaining available for future issuance under equity compensation plans on a 1-for-1 basis. Also includes up to 270,455 securities available for issuance in connection with deferred stock units under the Deferred Compensation Plan for Non-Employee Directors.
Item 13. Certain Relationships and Related Transactions, and Director Independence
Information for this item is incorporated by reference to the sections captioned “RELATED PARTY TRANSACTIONS” and “GOVERNANCE OF THE COMPANY - Director Independence” of LNC’s Proxy Statement for the Annual Meeting scheduled for May 24, 2012.
Item 14. Principal Accounting Fees and Services
Information for this item is incorporated by reference to the sections captioned “ITEM 2 - RATIFICATION OF THE APPOINTMENT OF THE INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM - Independent Registered Public Accounting Firm Fees and Services” and “ITEM 2 - RATIFICATION OF THE APPOINTMENT OF THE INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM - Audit Committee Pre-Approval Policy” of LNC’s Proxy Statement for the Annual Meeting scheduled for May 24, 2012.
PART IV
Item 15. Exhibits, Financial Statement Schedules
(a) (1) Financial Statements
The following Consolidated Financial Statements of Lincoln National Corporation are included in Part II - Item 8:
Management Report on Internal Control Over Financial Reporting
Reports of Independent Registered Public Accounting Firm
Consolidated Balance Sheets - December 31, 2011 and 2010
Consolidated Statements of Income (Loss) - Years ended December 31, 2011, 2010 and 2009
Consolidated Statements of Stockholders’ Equity - Years ended December 31, 2011, 2010 and 2009
Consolidated Statements of Cash Flows - Years ended December 31, 2011, 2010 and 2009
Notes to Consolidated Financial Statements
(a) (2) Financial Statement Schedules
The Financial Statement Schedules are listed in the Index to Financial Statement Schedules on page FS-1, which is incorporated herein by reference.
(a) (3) Listing of Exhibits
The Exhibits are listed in the Index to Exhibits beginning on page E-1, which is incorporated herein by reference.
(c) The Financial Statement Schedules for Lincoln National Corporation begin on page FS-2, which are incorporated herein by reference.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, LNC has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
LINCOLN NATIONAL CORPORATION
Date: February 23, 2012
By:
­ /s/ Randal J. Freitag­­­­­­­­
Randal J. Freitag
Executive Vice President and Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on February 23, 2012.
Signature
Title
/s/ Dennis R. Glass
Dennis R. Glass
President, Chief Executive Officer and Director
(Principal Executive Officer)
/s/ Randal J. Freitag
Randal J. Freitag
Executive Vice President and Chief Financial Officer
(Principal Financial Officer)
/s/ Douglas N. Miller
Douglas N. Miller
Senior Vice President and Chief Accounting Officer
(Principal Accounting Officer)
/s/ William J. Avery
William J. Avery
Director
/s/ William H. Cunningham
William H. Cunningham
Director
/s/ George W. Henderson, III
George W. Henderson, III
Director
/s/ Eric G. Johnson
Eric G. Johnson
Director
/s/ Gary C. Kelly
Gary C. Kelly
Director
/s/ M. Leanne Lachman
M. Leanne Lachman
Director
/s/ Michael F. Mee
Michael F. Mee
Director
/s/ William Porter Payne
William Porter Payne
Director
/s/ Patrick S. Pittard
Patrick S. Pittard
Director
/s/ Isaiah Tidwell
Isaiah Tidwell
Director
Index to Financial Statement Schedules
I
-
Summary of Investments - Other than Investments in Related Parties
FS-2
II
-
Condensed Financial Information of Registrant
FS-3
III
-
Supplementary Insurance Information
FS-6
IV
-
Reinsurance
FS-8
V
-
Valuation and Qualifying Accounts
FS-9
All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions, are inapplicable, or the required information is included in the consolidated financial statements, and therefore omitted. See “Part II - Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates” on page 40 for more detail on items contained within these schedules.
FS-1
LINCOLN NATIONAL CORPORATION
SCHEDULE I - CONSOLIDATED SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS IN
RELATED PARTIES
(in millions)
Column A
Column B
Column C
Column D
As of December 31, 2011
Fair
Carrying
Type of Investment
Cost
Value
Value
Available-For-Sale Fixed Maturity Securities (1)
Bonds:
U.S. government and government agencies and authorities
$
$
$
States, municipalities and political subdivisions
3,490
4,047
4,047
Mortgage-backed securities
9,332
9,639
9,639
Foreign governments
Public utilities
10,644
12,074
12,074
Convertibles and bonds with warrants attached
All other corporate bonds
43,133
47,288
47,288
Hybrid and redeemable preferred securities
1,277
1,157
1,157
Variable interest entities
Total available-for-sale fixed maturity securities
69,661
76,133
76,133
Available-For-Sale Equity Securities (1)
Common stocks:
Banks, trusts and insurance companies
Industrial, miscellaneous and all other
Nonredeemable preferred securities
Total available-for-sale equity securities
Trading securities
2,301
2,67
2,675
Mortgage loans on real estate
6,942
7,608
6,942
Real estate
N/A
Policy loans
2,884
N/A
2,884
Derivative instruments
1,668
3,151
3,151
Other investments
1,069
1,069
1,069
Total investments
$
84,797
$
93,130
(1)
Investments deemed to have declines in value that are other-than-temporary are written down or reserved for to reduce the carrying value to their estimated realizable value.
FS-2
LINCOLN NATIONAL CORPORATION
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
BALANCE SHEETS
(Parent Company Only) (in millions, except share data)
As of December 31,
ASSETS
Investments in subsidiaries (1)
$
16,818
$
15,485
Derivative investments
Other investments
Cash and invested cash
Loans and accrued interest to subsidiaries (1)
2,605
2,759
Other assets
Total assets
$
20,665
$
19,273
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities
Common and preferred dividends payable
$
$
Short-term debt
Long-term debt
5,641
5,649
Loans from subsidiaries (1)
-
Other liabilities
Total liabilities
6,501
6,467
Contingencies and Commitments
Stockholders' Equity
Preferred stock - 10,000,000 shares authorized; Series A
-
-
Common stock - 800,000,000 shares authorized
7,590
8,124
Retained earnings
4,126
3,934
Accumulated other comprehensive income (loss)
2,448
Total stockholders' equity
14,164
12,806
Total liabilities and stockholders' equity
$
20,665
$
19,273
(1)
Eliminated in consolidation.
FS-3
LINCOLN NATIONAL CORPORATION
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued)
STATEMENTS OF INCOME
(Parent Company Only) (in millions)
For the Years December 31,
Revenues
Dividends from subsidiaries (1)
$
$
$
Interest from subsidiaries (1)
Net investment income
-
(5
)
Realized gain (loss)
(3
)
(4
)
Other revenue
-
Total revenues
Expenses
Operating and administrative
Interest - subsidiaries (1)
Interest - other
Total expenses
Income (loss) before federal income taxes, equity in income (loss) of
subsidiaries, less dividends
Federal income tax expense (benefit)
(68
)
(106
)
(50
)
Income (loss) before equity in income (loss) of subsidiaries, less dividends
Equity in income (loss) of subsidiaries, less dividends
(456
)
(1,164
)
Net income (loss)
$
$
$
(485
)
(1)
Eliminated in consolidation.
FS-4
LINCOLN NATIONAL CORPORATION
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued)
STATEMENTS OF CASH FLOWS
(Parent Company Only) (in millions)
For the Years December 31,
Cash Flows from Operating Activities
Net income (loss)
$
$
$
(485
)
Adjustments to reconcile net income (loss) to net cash provided by
operating activities:
Equity in (income) loss of subsidiaries greater than distributions (1)
(457
)
1,164
Realized (gain) loss
(1
)
Change in fair value of equity collar
-
-
Change in legal accruals
(70
)
-
Change in federal income tax accruals
(190
)
(69
)
(Gain) loss on early extinguishment of debt
(64
)
Other
(22
)
(22
)
(4
)
Net cash provided by (used in) operating activities
Cash Flows from Investing Activities
Purchases of investments
-
-
(50
)
Sales or maturities of investments
-
Capital contribution to subsidiaries (1)
(17
)
(125
)
(1,260
)
Proceeds from sale of subsidiaries/businesses, net of cash disposed
-
Net cash provided by (used in) investing activities
(953
)
Cash Flows from Financing Activities
Payment of long-term debt, including current maturities
(525
)
(405
)
(522
)
Issuance of long-term debt, net of issuance costs
Increase (decrease) in commercial paper, net
(100
)
(216
)
Increase (decrease) in loans from subsidiaries, net (1)
(97
)
(291
)
Increase (decrease) in loans to subsidiaries, net (1)
(683
)
-
Common stock issued for benefit plans and excess tax benefits
-
-
Issuance (redemption) of Series B preferred stock and issuance (repurchase
and cancellation) of associated common stock warrants
-
(998
Issuance of common stock
-
Repurchase of common stock
(575
)
(25
)
-
Dividends paid to common and preferred stockholders
(62
)
(42
)
(79
)
Net cash provided by (used in) financing activities
(749
)
(1,132
)
1,282
Net increase (decrease) in cash and invested cash
(408
)
Cash and invested cash as of beginning-of-year
Cash and invested cash as of end-of-year
$
$
$
(1)
Eliminated in consolidation.
FS-5
LINCOLN NATIONAL CORPORATION
SCHEDULE III - CONSOLIDATED SUPPLEMENTARY INSURANCE INFORMATION
(in millions)
Column A
Column B
Column C
Column D
Column E
Column F
Other
Future
Contract
DAC and
Contract
Unearned
Holder
Insurance
Segment
VOBA
Benefits
Premiums (1)
Funds
Premiums
As of or for the Year Ended December 31, 2011
Annuities
$
2,318
$
3,642
$
-
$
20,701
$
Retirement Plan Services
-
13,624
-
Life Insurance
5,348
7,984
-
34,066
Group Protection
1,742
-
1,778
Other Operations
-
6,438
-
Total
$
8,191
$
19,813
$
-
$
69,466
$
2,294
As of or for the Year Ended December 31, 2010
Annuities
$
2,250
$
1,707
$
-
$
20,135
$
Retirement Plan Services
-
12,773
-
Life Insurance
6,145
7,606
-
32,386
Group Protection
1,620
-
1,682
Other Operations
-
6,592
-
Total
$
8,930
$
17,527
$
-
$
66,407
$
2,176
As of or for the Year Ended December 31, 2009
Annuities
$
2,381
$
1,991
$
-
$
19,014
$
Retirement Plan Services
-
12,240
-
Life Insurance
6,432
7,108
-
30,616
Group Protection
1,459
-
1,579
Other Operations
-
6,584
-
Total
$
9,510
$
17,145
$
-
$
62,964
$
2,064
(1)
Unearned premiums are included in Column E, other contract holder funds.
FS-6
LINCOLN NATIONAL CORPORATION
SCHEDULE III - CONSOLIDATED SUPPLEMENTARY INSURANCE INFORMATION (Continued)
(in millions)
Column A
Column G
Column H
Column I
Column J
Column K
Benefits
Amortization
Net
and
of DAC
Other
Investment
Interest
and
Operating
Premiums
Segment
Income
Credited
VOBA
Expenses (2)
Written
As of or for the Year Ended December 31, 2011
Annuities
$
1,106
$
$
$
$
-
Retirement Plan Services
-
Life Insurance
2,294
2,904
-
Group Protection
1,317
-
Other Operations
-
-
Total
$
4,652
$
5,833
$
1,050
$
2,407
$
-
As of or for the Year Ended December 31, 2010
Annuities
$
1,119
$
$
$
$
-
Retirement Plan Services
-
Life Insurance
2,186
2,933
-
Group Protection
1,300
-
Other Operations
-
-
Total
$
4,541
$
5,815
$
1,084
$
2,274
$
-
As of or for the Year Ended December 31, 2009
Annuities
$
1,037
$
$
$
$
-
Retirement Plan Services
-
Life Insurance
1,975
2,558
-
Group Protection
1,120
-
Other Operations
-
-
Total
$
4,178
$
5,299
$
1,053
$
1,938
$
-
(2)
Excludes impairment of intangibles of $747 million and $730 million for the years ended December 31, 2011 and 2009, respectively. The allocation of expenses between investments and other operations is based on a number of assumptions and estimates. Results would change if different methods were applied.
FS-7
LINCOLN NATIONAL CORPORATION
SCHEDULE IV - CONSOLIDATED REINSURANCE
(in millions)
Column A
Column B
Column C
Column D
Column E
Column F
Ceded
Assumed
Percentage
to
from
of Amount
Gross
Other
Other
Net
Assumed
Description
Amount
Companies
Companies
Amount
to Net
As of or for the Year Ended December 31, 2011
Individual life insurance in force (1)
$
881,100
$
331,700
$
2,800
$
552,200
0.5
%
Premiums:
Life insurance and annuities (2)
5,811
1,252
4,569
0.2
%
Accident and health insurance
1,186
-
1,162
-
%
Total premiums
$
6,997
$
1,276
$
$
5,731
As of or for the Year Ended December 31, 2010
Individual life insurance in force (1)
$
842,300
$
337,800
$
3,000
$
507,500
0.6
%
Premiums:
Life insurance and annuities (2)
5,458
1,170
4,301
0.3
%
Accident and health insurance
1,141
-
1,109
-
%
Total premiums
$
6,599
$
1,202
$
$
5,410
As of or for the Year Ended December 31, 2009
Individual life insurance in force (1)
$
799,900
$
342,600
$
3,000
$
460,300
0.7
%
Premiums:
Life insurance and annuities (2)
5,025
1,126
3,909
0.3
%
Accident and health insurance
1,099
-
1,077
-
%
Total premiums
$
6,124
$
1,148
$
$
4,986
(1)
Includes Group Protection segment and Other Operations in force amounts.
(2)
Includes insurance fees on universal life and other interest-sensitive products.
FS-8
LINCOLN NATIONAL CORPORATION
SCHEDULE V - CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS
(in millions)
Column A
Column B
Column C
Additions
Column D
Column E
Charged
Balance at
Charged to
to Other
Balance
Beginning-
Costs
Accounts -
Deductions -
at End-
Description
of-Year
Expenses (1)
Describe
Describe (2)
of-Year
For the Year Ended December 31, 2011
Deducted from asset accounts:
Reserve for mortgage loans on real estate
$
$
$ -
$ (6 ) $
For the Year Ended December 31, 2010
Deducted from asset accounts:
Reserve for mortgage loans on real estate
$
$
$ -
$ (27 ) $
For the Year Ended December 31, 2009
Deducted from asset accounts:
Reserve for mortgage loans on real estate
$ -
$
$ -
$ (13 ) $
(1)
Excludes charges for the direct write-off assets.
(2)
Deductions reflect sales, foreclosures of the underlying holdings or change in reserves.
FS-9
INDEX TO EXHIBITS
2.1
Stock Purchase Agreement between Lincoln Financial Media Company and Raycom Holdings, LLC is incorporated by reference to Exhibit 2.3 to LNC’s Form 10-K (File No. 1-6028) for the year ended December 31, 2007.***
2.2
Purchase and Sale Agreement By and Among LNC, Lincoln National Investment Companies, Inc. and Macquarie Bank Limited, dated as of August 18, 2009 is incorporated by reference to Exhibit 2.1 to LNC’s Quarterly Report on Form 10-Q (File No. 1-6028) for the quarter ended September 30, 2009.***
3.1
LNC Restated Articles of Incorporation are incorporated by reference to Exhibit 3.1 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on August 17, 2010.
3.2
Articles of Amendment to the Restated Articles of Incorporation of LNC dated May 26, 2011 are incorporated by reference to Exhibit 3.1 of LNC’s Form 8-K (File No. 1-6028) filed with the SEC on May 31, 2011.
3.3
Amended and Restated Bylaws of LNC (effective May 31, 2011) are incorporated by reference to Exhibit 3.3 to LNC’s Form 10-Q (File No. 1-6028) for the quarter ended June 30, 2011.
4.1
Indenture of LNC, dated as of September 15, 1994, between LNC and The Bank of New York, as trustee, is incorporated by reference to Exhibit 4(c) to LNC’s Registration Statement on Form S-3/A (File No. 33-55379) filed with the SEC on September 15, 1994.
4.2
First Supplemental Indenture, dated as of November 1, 2006, to Indenture dated as of September 15, 1994 is incorporated by reference to Exhibit 4.4 to LNC’s Form 10-K (File No. 1-6028) for the year ended December 31, 2006.
4.3
Junior Subordinated Indenture, dated as of May 1, 1996, between LNC and The Bank of New York Trust Company, N.A. (successor in interest to J.P. Morgan Trust Company and The First National Bank of Chicago) is incorporated by reference to Exhibit 4(j) to LNC’s Form 10-K (File No. 1-6028) for the year ended December 31, 2001.
4.4
First Supplemental Indenture, dated as of August 14, 1998, to Junior Subordinated Indenture dated as of May 1, 1996 is incorporated by reference to Exhibit 4.3 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on August 27, 1998.
4.5
Second Supplemental Junior Subordinated Indenture, dated April 20, 2006, to Junior Subordinated Indenture, dated as of May 1, 1996, is incorporated by reference to Exhibit 4.1 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on April 20, 2006.
4.6
Third Supplemental Junior Subordinated Indenture dated May 17, 2006, to Junior Subordinated Indenture, dated as of May 1, 1996, is incorporated by reference to Exhibit 4.1 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on May 17, 2006.
4.7
Fourth Supplemental Junior Subordinated Indenture, dated as of November 1, 2006, to Junior Subordinated Indenture, dated May 1, 1996, is incorporated by reference to Exhibit 4.9 to LNC’s Form 10-K (File No. 1-6028) for the year ended December 31, 2006.
4.8
Fifth Supplemental Junior Subordinated Indenture, dated as of March 13, 2007, to Junior Subordinated Indenture, dated May 1, 1996, is incorporated by reference to Exhibit 4.1 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on March 13, 2007.
4.9
Senior Indenture, dated as of March 10, 2009, between LNC and the Bank of New York Mellon, is incorporated by reference to LNC’s Form S-3ASR (File No. 333-157822) filed with the SEC on March 10, 2009.
4.10
Junior Subordinated Indenture, dated as of March 10, 2009, between LNC and the Bank of New York Mellon, is incorporated by reference to LNC’s Form S-3ASR (File No. 333-157822) filed with the SEC on March 10, 2009.
4.11
Indenture, dated as of November 21, 1995, between Jefferson-Pilot Corporation and U.S. National Bank Association (as successor in interest to Wachovia Bank, National Association), is incorporated by reference to Exhibit 4.7 to LNC’s Form 10-Q (File No. 1-6028) for the quarter ended June 30, 2006.
4.12
Third Supplemental Indenture, dated as of January 27, 2004, to Indenture dated as of November 21, 1995, is incorporated by reference to Exhibit 4.8 to LNC’s Form 10-Q (File No. 1-6028) for the quarter ended June 30, 2006.
E-1
4.13
Fourth Supplemental Indenture, dated as of January 27, 2004, to Indenture dated as of November 21, 1995, is incorporated by reference to Exhibit 4.9 to LNC’s Form 10-Q (File No. 1-6028) for the quarter ended June 30, 2006.
4.14
Fifth Supplemental Indenture, dated as of April 3, 2006, to Indenture, dated as of November 21, 1995, incorporated by reference to Exhibit 10.1 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on April 3, 2006.
4.15
Sixth Supplemental Indenture, dated as of March 1, 2007, to Indenture dated as of November 21, 1995, is incorporated by reference to Exhibit 4.4 to LNC’s Form 10-Q (File No. 1-6028) for the quarter ended March 31, 2007.
4.16
Form of 7% Notes due March 15, 2018 incorporated by reference to Exhibit 4.2 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on March 24, 1998.
4.17
Form of 6.20% Note dated December 7, 2001 is incorporated by reference to Exhibit 4.1 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on December 11, 2001.
4.18
Form of 6.75% Trust Preferred Security Certificate is incorporated by reference to Exhibit 4.2 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on September 16, 2003.
4.19
Form of 6.75% Junior Subordinated Deferrable Interest Debentures, Series F is incorporated by reference to Exhibit 4.3 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on September 16, 2003.
4.20
Form of 4.75% Note due February 15, 2014 is incorporated by reference to Exhibit 4.1 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on February 4, 2004.
4.21
Form of 7% Capital Securities due 2066 of LNC is incorporated by reference to Exhibit 4.2 to LNC’s Form 8-K (File NO. 1-6028) filed with the SEC on May 17, 2006.
4.22
Form of 6.75% Capital Securities due 2066 of Lincoln Financial Corporation is incorporated by reference to Exhibit 4.2 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on April 20, 2006.
4.23
Form of Floating Rate Senior Note due April 6, 2009 is incorporated by reference to Exhibit 4.1 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on April 7, 2006.
4.24
Form of 6.15% Senior Note due April 6, 2036 is incorporated by reference to Exhibit 4.2 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on April 7, 2006.
4.25
Amended and Restated Trust Agreement dated September 11, 2003, among LNC, as Depositor, Bank One Trust Company, National Association, as Property Trustee, Bank One Delaware, Inc., as Delaware Trustee, and the Administrative Trustees named therein is incorporated by reference to Exhibit 4.1 of Form 8-K (File No. 1-6028) filed with the SEC on September 16, 2003.
4.26
Guarantee Agreement, dated September 11, 2003, between LNC, as Guarantor, and Bank One Trust Company, National Association, as Guarantee Trustee is incorporated by reference to Exhibit 4.4 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on September 16, 2003.
4.27
Form of 6.05% Capital Securities due 2067 is incorporated by reference to Exhibit 4.2 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on March 13, 2007.
4.28
Form of Floating Rate Senior Notes due 2010 is incorporated by reference to Exhibit 4.3 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on March 13, 2007.
4.29
Form of 5.65% Senior Notes due 2012 is incorporated by reference to Exhibit 4.1 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on August 27, 2007.
4.30
Form of 6.30% Senior Notes due 2037 is incorporated by reference to Exhibit 4.1 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on October 9, 2007.
4.31
Form of 8.75% Senior Notes due 2019 is incorporated by reference to Exhibit 4.1 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on June 22, 2009.
E-2
4.32
Form of 6.25% Senior Notes due 2020 is incorporated by reference to Exhibit 4.1 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on December 11, 2009.
4.33
Form of 4.30% Senior Notes due 2015 incorporated by reference to Exhibit 4.1 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on June 18, 2010.
4.34
Form of 7.00% Senior Notes due 2040 incorporated by reference to Exhibit 4.1 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on June 18, 2010.
4.35
Form of 4.85% Senior Notes due 2021 incorporated by reference to Exhibit 4.1 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on June 24, 2011.
4.36
First Supplemental Indenture, dated as of April 3, 2006, among Lincoln JP Holdings, L.P. and JPMorgan Chase Bank, N.A., as trustee, to the Indenture, dated as of January 15, 1997, among Jefferson-Pilot and JPMorgan Chase Bank, N.A., as trustee, is incorporated by reference to Exhibit 10.2 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on April 3, 2006.
10.1
LNC 2009 Amended and Restated Incentive Compensation Plan (as amended and restated on May 14, 2009) is incorporated by reference to Exhibit 4 to LNC’s Proxy Statement (File No. 1-6028) filed with the SEC on April 9, 2009.*
10.2
Form of Restricted Stock Unit Award Agreement under the LNC Amended and Restated Incentive Compensation Plan, adopted February 7, 2008 is incorporated by reference to Exhibit 10.6 to LNC’s Form 10-Q (File No. 1-6028) for the quarter ended March 31, 2008.*
10.3
Form of Restricted Stock Award Agreement is incorporated by reference to Exhibit 10.7 to LNC’s Form 10-Q (File No. 1-6028) for the quarter ended March 31, 2008.*
10.4
Form of Restricted Stock Unit Award Agreement under the LNC Amended and Restated Incentive Compensation Plan, adopted May 2008, is incorporated by reference to Exhibit 10.1 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on May 6, 2008.*
10.5
Form of Restricted Stock Unit Award Agreement under the LNC 2009 Amended and Restated Incentive Compensation Plan, adopted November 2009, is incorporated by reference to Exhibit 99.1 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on November 6, 2009.*
10.6
LNC Stock Option Plan for Non-Employee Directors is incorporated by reference to Exhibit 5 to LNC’s Proxy Statement (File No. 1-6028) filed with the SEC on April 4, 2007.*
10.7
Non-Qualified Stock Option Agreement for the LNC Stock Option Plan for Non-Employee Directors is incorporated by reference to Exhibit 10.3 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on May 10, 2007.*
10.8
2007 Non-Employee Director Fees (revised to include fee for non-Executive Chairman) (unchanged for 2010) is incorporated by reference to Exhibit 10.3 to LNC’s Form 10-Q (File No. 1-6028) for the quarter ended September 30, 2007.*
10.9
2011 Non-Employee Director Fees (revised to include fee for non-Executive Chairman) is incorporated by reference to Exhibit 10.1 to LNC’s Form 10-Q (File No. 1-6028) for the quarter ended September 30, 2010.*
10.10
Form of Restricted Stock Award Agreement (2007) is incorporated by reference to Exhibit 10.1 to LNC’s Form 10-Q (File No. 1-6028) for the quarter ended September 30, 2007.*
10.11
Amended and Restated LNC Supplemental Retirement Plan is incorporated by reference to Exhibit 10.10 to LNC’s Form 10-K (File No. 1-6028) for the year ended December 31, 2007.*
10.12
2009 Severance Plan for Officers of LNC is incorporated by reference to Exhibit 99.1 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on March 19, 2009.*
10.13
Severance Plan for Officers of LNC is incorporated by reference to Exhibit 99.1 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on November 6, 2009.*
E-3
10.14
Amended and Restated Salary Continuation Plan for Executives of LNC and Affiliates is incorporated by reference to Exhibit 10.13 to LNC’s Form 10-K (File No. 1-6028) for the year ended December 31, 2007.*
10.15
The LNC Outside Directors’ Value Sharing Plan, last amended March 8, 2001, is incorporated by reference to Exhibit 10(e) to LNC’s Form 10-K (File No. 1-6028) for the year ended December 31, 2001.*
10.16
LNC Deferred Compensation and Supplemental/Excess Retirement Plan, as amended and restated effective December 31, 2010, is incorporated by reference to Exhibit 10.16 to LNC’s Form 10-K (File No. 1-6028) for the year ended December 31, 2010.*
10.17
LNC 1993 Stock Plan for Non-Employee Directors, as last amended May 10, 2001, is incorporated by reference to Exhibit 10(g), to LNC’s Form 10-K (File No. 1-6028) for the year ended December 31, 2001.*
10.18
Amendment No. 2 to the LNC 1993 Stock Plan for Non-Employee Directors (effective February 1, 2006) is incorporated by reference to Exhibit 10.1 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on January 13, 2006.*
10.19
Non-Qualified Stock Option Agreement (For Non-Employee Directors) under the LNC 1993 Stock Plan for Non-Employee Directors is incorporated by reference to Exhibit 10(z) to LNC’s Form 10-K (File No. 1-6028) for the year ended December 31, 2004.*
10.20
Amendment of outstanding Non-Qualified Option Agreements (for Non-Employee Directors) under the LNC 1993 Stock Plan for Non-Employee Directors is incorporated by reference to Exhibit 10.2 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on January 12, 2006.*
10.21
LNC Executives’ Severance Benefit Plan (effective August 7, 2008) is incorporated by reference to Exhibit 10.3 to LNC’s Form 10-Q (File No. 1-6028) for the quarter ended June 30, 2008.*
10.22
Amendment No. 1 to the LNC Executives’ Severance Benefit Plan (effective November 9, 2011) is filed herewith.*
10.23
Amended and Restated LNC Excess Retirement Plan is incorporated by reference to Exhibit 10.26 to LNC’s Form 10-K (File No. 1-6028) for the year ended December 31, 2007.*
10.24
LNC Deferred Compensation Plan for Non-Employee Directors, as amended and restated November 5, 2008 is incorporated by reference to Exhibit 10.23 to LNC’s Form 10-K (File NO. 1-6028) for the year ended December 31, 2008.*
10.25
Form of LNC Restricted Stock Agreement is incorporated by reference to Exhibit 10(b) to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on January 20, 2005.*
10.26
Form of LNC Stock Option Agreement is incorporated by reference to Exhibit 10(c) to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on January 20, 2005.*
10.27
Form of 2008-2010 Performance Cycle Agreement under the LNC Amended and Restated Incentive Compensation Plan, is incorporated by reference to Exhibit 10.1 of LNC’s Form 8-K (File No. 1-6028) filed with the SEC on February 13, 2008.*
10.28
Description of Special 2008 Annual Incentive Payout Arrangement with Terrance J. Mullen, Former President of Lincoln Financial Distributors, is incorporated by reference to Exhibit 10.4 to LNC’s Form 10-Q (File No. 1-6028) for the quarter ended March 31, 2008.*
10.29
2009 Executive compensation Matters dated March 30, 2009 is incorporated by reference to Exhibit 10.2 to LNC’s Form 10-Q (File No. 1-6028) for the quarter ended March 31, 2009.*
10.30
Agreement, Waiver and General Release between Elizabeth L. Reeves and LNC is incorporated by reference to Exhibit 10.2 to LNC’s Form 10-Q (File No. 1-6028) for the quarter ended June 30, 2008.*
10.31
Form of 2008 Non-Qualified Stock Option Agreement under the LNC Amended and Restated Incentive Compensation Plan is incorporated by reference to Exhibit 10.2 of LNC’s Form 8-K (File No. 1-6028) filed with the SEC on February 13, 2008.*
E-4
10.32
LNC Employees’ Supplemental Pension Benefit Plan is incorporated by reference to Exhibit 10(e) to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on January 20, 2005.*
10.33
Description of resolution dated January 13, 2005 amending the LNC Employees’ Supplemental Pension benefit Plan incorporated by reference to Exhibit 10(d) to LNC’s Form 10-Q (File No 1-6028) for the quarter ended March 31, 2005.*
10.34
Form of Indemnification between LNC and each director incorporated by reference to Exhibit 10.1 to LNC’s Form 10-Q (File No. 1-6028) for the quarter ended September 30, 2009.*
10.35
Form of Stock Option Agreement is incorporated by reference to Exhibit 10.3 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on April 18, 2006.*
10.36
Form of nonqualified LNC restricted stock award agreement is incorporated by reference to Exhibit 10.15 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on April 7, 2006.*
10.37
LNC Domestic Relocation Policy Home Sale Assistance Plan, effective as of September 6, 2007, is incorporated by reference to Exhibit 10.35 to LNC’s Form 10-K (File No. 1-6028) for the year ended December 31, 2009.*
10.38
Jefferson Pilot Corporation Long Term Stock Incentive Plan, as amended in February 2005, is incorporated by reference to Exhibit 10(iii) of Jefferson-Pilot’s Form 10-K (File No. 1-5955) for the year ended December 31, 2004.*
10.39
Jefferson Pilot Corporation Non-Employee Directors’ Stock Option Plan, as amended in February 2005, is incorporated by reference to Exhibit 10(iv) of Jefferson-Pilot’s Form 10-K (File No. 1-5955) for the year ended December 31, 2004.*
10.40
Jefferson Pilot Corporation Non-Employee Directors’ Stock Option Plan, as last amended in 1999, is incorporated by reference to Exhibit 10(vii) of Jefferson-Pilot’s Form 10-K (File No. 1-5955) for the year ended December 31, 1998.*
10.41
Jefferson Pilot Corporation forms of stock option terms for non-employee directors are incorporated by reference to Exhibit 10(xi) of Jefferson-Pilot’s Form 10-K (File No. 1-5955) for the year ended December 31, 2004 and to Exhibit 10.2 of Jefferson-Pilot’s Form 8-K filed with the SEC on February 17, 2006.*
10.42
Jefferson Pilot Corporation forms of stock option terms for officers are incorporated by reference to Exhibit 10(xi) of Jefferson-Pilot’s Form 10-K (File No. 1-5955) for the year ended December 31, 2004 and to Exhibit 10.1 of Jefferson-Pilot’s Form 8-K filed with the SEC on February 17, 2006.*
10.43
Jefferson-Pilot Deferred Fee Plan for Non-Employee Directors, as amended and restated November 5, 2008 is incorporated by reference to Exhibit 10.55 to LNC’s Form 10-K (File No. 1-6028) for the year ended December 31, 2008.*
10.44
Lease and Agreement dated August 1, 1984, with respect to LNL’s offices located at Clinton Street and Harrison Street, Fort Wayne, Indiana is incorporated by reference to Exhibit 10(n) to LNC’s Form 10-K (File No. 1-6028) for the year ended December 31, 1995.
10.45
First Amendment of Lease, dated as of June 16, 2006, between Trona Cogeneration Corporation and The Lincoln National Life Insurance Company, is incorporated by reference to Exhibit 10.22 to LNC’s Form 10-Q (File No. 1-6028) for the quarter ended June 30, 2006.
10.46
Agreement of Lease dated February 17, 1998, with respect to LNL’s offices located at 350 Church Street, Hartford, Connecticut is incorporated by reference to Exhibit 10(q) to LNC’s Form 10-K (File No. 1-6028) for the year ended December 31, 1997.
10.47
Stock and Asset Purchase Agreement by and among LNC, The Lincoln National Life Insurance Company, Lincoln National Reinsurance Company (Barbados) Limited and Swiss Re Life & Health America Inc. dated July 27, 2001 is incorporated by reference to Exhibit 99.1 to LNC’s Form 8-K (File No. 1-6028) filed with the Commission on August 1, 2001. Omitted schedules and exhibits listed in the Agreement will be furnished to the Commission upon request.
10.48
Credit Agreement, dated as of June 10, 2010, among Lincoln National Corporation, as an Account Party and Guarantor, the Subsidiary Account Parties, as additional Account Parties, JPMorgan Chase Bank, N.A. as administrative agent, and the other lenders named therein, incorporated by reference to Exhibit 10.1 to LNC’s Form 8-K (File No. 1-6028) filed with the SEC on June 15, 2011.
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10.49
Master Confirmation Agreement and related Supplemental Confirmation, dated March 14, 2007, and Trade Notification, dated March 16, 2007, relating to LNC’s Accelerated Stock Repurchase with Citibank, N.A. is incorporated by reference to Exhibit 10.2 to LNC’s Form 10-Q (File No. 1-6028) for the quarter ended March 31, 2007.**
10.50
Indemnity Reinsurance Agreement, dated as of January 1, 1998, between Connecticut General Life Insurance Company and Lincoln Life & Annuity Company of New York is incorporated by reference to Exhibit 10.67 to LNC’s Form 10-K (File No. 1-6028) for the year ended December 31, 2008.***
10.51
Coinsurance Agreement, dated as of October 1, 1998, AETNA Life Insurance and Annuity Company and Lincoln Life & Annuity Company of New York is incorporated by reference to Exhibit 10.68 to LNC’s Form 10-K (File No. 1-6028) for the year ended December 31, 2008.***
10.52
Investment Advisory Agreement, dated as of January 4, 2010, between The Lincoln National Life Insurance Company and Delaware Investment Advisers is incorporated by reference to Exhibit 10.58 to LNC’s for 10-K (File No. 1-6028) for the year ended December 31, 2009.**
10.53
Investment Advisory Agreement, dated as of January 4, 2010, between Lincoln Life & Annuity Company of New York and Delaware Investment Advisers is incorporated by reference to Exhibit 10.59 to LNC’s for 10-K (File No. 1-6028) for the year ended December 31, 2009.**
10.54
Reimbursement Agreement, dated December 31, 2009, between Lincoln Reinsurance Company of Vermont I, Lincoln Financial Holdings, LLC II and Credit Suisse AG is incorporated by reference to Exhibit 10.60 to LNC’s for 10-K (File No. 1-6028) for the year ended December 31, 2009.**
Historical Ratio of Earnings to Fixed Charges.
Subsidiaries List.
Consent of Independent Registered Public Accounting Firm.
31.1
Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2
Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1
Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2
Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
Attached as Exhibit 101 to this report are the following Interactive Data Files formatted in XBRL (Extensible Business Reporting Language): (i) Consolidated Balance Sheets as of December 31, 2011 and 2010; (ii) Consolidated Statements of Income (Loss) for the years ended December 31, 2011, 2010 and 2009; (iii) Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2011, 2010 and 2009; (iv) Consolidated Statements of Cash Flows for the years ended December 31, 2011, 2010 and 2009; (v) Notes to the Consolidated Financial Statements; and (vi) Financial Statement Schedules. Users of this data are advised pursuant to Rule 401 of Regulation S-T that the information contained in the XBRL documents is unaudited and these are not the official publicly filed financial statements of Lincoln National Corporation.
In accordance with Rule 402 of Regulation S-T, the XBRL related information in this report shall not be deemed filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to the liability of that section, and shall not be incorporated by reference into any registration statement or other document filed under the Securities Act of 1933, as amended, except as shall be expressly set forth by specific reference in such filing.
* This exhibit is a management contract or compensatory plan or arrangement.
** Portions of the exhibit have been redacted and are subject to a confidential treatment request filed with the Secretary of the Securities and Exchange Commission (“SEC”) pursuant to Rule 24b-2 under the Securities Exchange Act of 1934, as amended.
*** Schedules to the agreement have been omitted pursuant to Item 601(b)(2) of Regulation S-K. LNC will furnish supplementally a copy of the schedule to the SEC, upon request.
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We will furnish to the SEC, upon request, a copy of any of our long-term debt agreements not otherwise filed with the SEC.
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