Lincoln National Corp. Q3 2008 Earnings Conference Call Transcript

Oct.29.08 | About: Lincoln National (LNC)

Lincoln National Corporation (NYSE:LNC)

Q3 FY08 Earnings Call

October 29, 2008, 11:00 AM ET

Executives

Jim Sjoreen - VP of IR

Dennis R. Glass - President and CEO

Frederick J. Crawford - Sr. VP and CFO

Mark E. Konen - President, Individual Markets

Douglas N. Miller - VP and Chief Accounting Officer

Analysts

Andrew Kligerman - UBS

Jimmy Bhullar - JP Morgan

Edward Spehar - Merrill Lynch

Nigel Dally - Morgan Stanley

Steven Schwartz - Raymond James

Jeffrey Schuman - Keefe, Bruyette & Woods

John Nadel - Sterne, Agee & Leach, Inc.

Suneet Kamath - Sanford C. Bernstein & Co.

Eric Berg - Barclays Capital

Bob Glasspiegel - Langen McAlenney

Thomas Gallagher - Credit Suisse

Darin Arita - Deutsche Bank

Daniel Johnson - Citadel Investment

Operator

Good morning and thank you for joining the Lincoln Financial Group's Third Quarter 2008 Earnings Conference Call. Today's call is being recorded. At this time all lines are in listen-only mode. Later we will announce the opportunity for questions and instructions will be given at that time. [Operator Instructions].

At this time, I would like to turn the conference over to Vice President of Investor Relations, Mr. Jim Sjoreen. Please go ahead, sir

Jim Sjoreen - Vice President of Investor Relations

Thank you operator. Good morning and welcome to Lincoln Financial's third quarter earnings call. Before we begin, I have an important reminder.

Any comments made during the call regarding future expectation, trends, and market conditions, including comments about capital, liquidity, expenses, and income from operations are forward-looking statements under the Private Securities Litigation Reform Act of 1995.

These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from current expectations. These risks and uncertainties are described in the cautionary statement disclosures in our earnings release issued yesterday and our reports on Forms 8-K, 10-Q, and 10-K filed with the SEC.

We appreciate your participation today and invite you to visit Lincoln's website, www.lincolnfinancial.com where you can find our press release and statistical supplement, which include a full reconciliation of the non-GAAP measures used in the call, including income from operations and return on equity to the most comparable GAAP measures.

A general account supplement is again available on the website as well.

Presenting on today call are Dennis Glass, President and Chief Executive Officer and Fred Crawford, Chief Financial Officer. After their prepared remarks, we will move to question-and-answer portion of the call.

I would now like to turn the call over to Dennis Glass, Dennis?

Dennis R. Glass - President and Chief Executive Officer

Thanks Jim and good morning to all of you on the call. Overall our results in the third quarter was good when viewed against the backdrop of equity markets, credit conditions and slowing economic growth. Our capital and liquidity positions remain strong towards the end of the quarter augmented by our decision to reduce the dividend. The reduction while not an easy decision to make given the dividend history of the company was a prudent one and aimed at strengthening our capital overtime. The company has a strong and diverse liquidity position. We've increased our cash holdings and our general accounts as a precautionary measure and while this has a minor impact on margin, we view this as a temporary move.

The diversification and quality of our balance sheet mitigated the losses we reported in the quarter primarily in the financial and mortgage backed assets classes, a lack of liquidity and widening credit spreads drove the unrealized losses at higher levels.

We have no significant single security in an unrealized loss position expect for the credit link notes which we believe are manageable and we saw a $250 million reduction at par in the CLMs during the quarter.

It remains unclear at this point when the stimulus plan put in place by the government will restore same liquidity and confidence in the market. Until then it is difficult to predict what the implications are for other than temporary impairments or unrealized losses and prolonged economic weakness can create a difficult credit environment over time.

We remain confident in our approach and discipline surrounding the management and evaluation of our invested assets and we'll take appropriate actions to maintain the integrity of the balance sheet. Fred will go into detail on the VA hedge program but I would note that our hedge program has been effective in large part and that based on the third quarter market levels any projected actual claims paid on the guarantees would not begin until toward the end of the next decade.

Turning to the fundamentals, new business production was relatively strong in the insurance businesses. Again taking into consideration the economic environment, while the asset management business was hard hit by declining asset values and negative consumer sentiment.

Our reported earnings came in at the higher end of the guidance we shared in our prerelease and there were a number of notable items that surfaced as part of our annual review of models and assumptions.

Assets on our management in the aggregate decreased by 21% from the prior year quarter, putting pressure on earnings, but mitigated by the contribution of spread and mortality morbidity margins to the bottom line. These latter non equity sensitive normalized margins are approximately 70% of our total third quarter results.

Expense levels remain relatively flat and we are of course looking at discretionary spending as a means to compensate for declining revenue growth. We are moving ahead on our IT related merger integration because this is critical to effectively managing expenses over the longer term. As part of our annual planning process we are revisiting spending plans, which is prudent in today's environment.

Let me drop down to a few more headlines by area starting with retirement solutions and annuities. Total variable annuity deposits were down 14% from the prior year quarter and 13% sequentially. Sales did trend down somewhat as the third quarter progressed and are again trending down in October, a mid-way disruption particularly in the wire firms along with the obvious volatility in the equity markets. While we do expect consumer sentiment to weigh heavily on purchasing decision in the near term, we don't necessarily view the new emerging distribution channel landscape as a negative. Recent and and/or pending combinations among certain wire and bank distribution partners may present opportunities given the strength of our relationship.

Fixed index annuity deposits and flows were mixed and we remain cautious recognizing that these products are sensitive to the relative value proposition of other deposit-oriented products. Define contribution and our defined contribution business, deposits were down 13% and what is typically the slowest quarter of the year.

Deposits in the micro, the small market were essentially flat year-over-year and sequentially while deposits in the mid to large market was down 20% from 3Q07 which quarter benefited from a small number of high dollar cases.

In mid September, we launched our new Lincoln Director product that will now offer more than 80 investment options and will be positioned as our primary product in the micro to small market place. The new Director product includes fiduciary support, planned sponsors, accumulation strategies and tools for planned participants and will also offer our patented distribution option i4LIFE Advantage. We have a strong management in place and we are moving this business forward.

Life insurance. As part of creating the insurance solution division, life insurance results now include executive benefits, that is, Cowey Bowey [ph] previously reported on a standalone basis. Life insurance sales of $190 million in the quarter were down 4% from the prior year quarter, but were up 15% from the second quarter, which itself is sequential improvement in Universal life driven by prior initiatives to fine tune pricing and enhance our underwriting service.

Sales of MoneyGuard, our universal life product with long term care benefits were up 26% and continued to benefit from a focused and expanded distribution effort. Looking ahead, the fourth quarter is historically the best life insurance sales quarter for the year. However our expectations for this year are muted given current conditions.

Group Protection. The Group Protection business stood out in the quarter, not only because of its solid results but because of the natural hedge it provides through product and earnings diversification. Net earned premium was up 10% over the prior year quarter fueled by organic growth and favorable persistency. Sales increased 13% over prior year quarter as our distribution expansion and restructuring continued to yield results.

Let me turn to Delaware. The investment management Delaware has not been immune to the turbulence affecting the capital markets and the asset management business in general. However a deep product lineup supported by high quality investment teams has helped to mitigate the market impacts.

On a relative basis excluding the fixed income asset sale in October of last year, our assets under management fell 25 billion in the last 12 months. This is approximately a 16% drop and puts us in similar and sometimes favorable life versus our competitors some of whom have lost over 30% of their asset base.

Retail sales of 2.7 billion were relatively in line with last year and the third quarter. Institutional sales after adjusting for a CDO issuance in the third quarter of last year were also flat. A bright point in institutional client fundings in the quarter surpassed $700 million and includes mandates in our fixed income products and our large cap growth products.

Let me turn to distribution. In our distribution companies we have been focused on getting in front of client [ph] and conducting business as usual. Given that the head of LFC has left, I am spending time with our management team and wholesalers as I look to name new leadership in the organization.

LFC possesses deep bench strengthen in both internal and external interests and the leadership position has been strong again given the quality of the organization, it's reputation and it's people. 100% of our leadership team remains in place and we have had no related wholesaler departures. We have 844 wholesalers as of the end of the third quarter which was up 5% from the approximately 800 at the end of the second quarter. I would expect to name a new head of LFC shortly.

At Lincoln Financial Network, the delivery of high quality expert advice remains the top priority as individuals struggle with personal financial decision. While we may see a slowdown in absolute sales in the near term, LFM continued to manage the breakeven levels or better for the quarter and year-to-date. Clearly this is an effective retail organization particularly given the caliber of talent.

With that let me turn it over to Fred to discuss the financial highlights in the period. Fred?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

Thanks Dennis. Our reported income from operations in the quarter of $316 million or $1.23 per diluted share includes the number of offsetting items that combined to reduce the quarter's earnings by about $21 million or $0.08 per share. Our reported earnings also included merger expenses of $13 million pretax.

Notable items in the quarter included the results of our third quarter prospective DAC unlocking, related model refinements together with retrospective unlocking thus primarily impacting our life results.

Offsetting our DAC work were favorable tax adjustments, the result of filing our 2007 tax return.

Net income of 148 million or $0.58 a share was impacted by realized losses and impairments on general accounting assets as well as the net results of our variable annuity hedge program.

Turning to our business segments and starting with annuities, earnings in the quarter included negative retrospective unlocking related to the markets of roughly $12 million. This was more than offset by $21 million in favorable tax adjustments related to our separate accounts and other net positive items totaling roughly $4 million.

Average variable annuity account values decreased roughly $3 billion or a little over 5% as compared to the second quarter. The markets impact on account values was somewhat offset by roughly 1.2 billion of variable annuity positive flows in the quarter. Expense assessment revenue was down a little less than 5% sequentially supported somewhat by our practice of charging living benefit fees on the guarantee amount versus account values.

Fixed margin contribution together with reported spreads of a 189 basis points reflect a decrease in interest earned attributed to building more liquidity in the portfolio. In addition we had a classification item which impacted interest credited thus having no ultimate bottom-line impact. We estimate normalized spreads in the 200 to 210 basis points range going forward.

Our defined contribution earnings came in as expected recognizing the impact of fee income due to the equity markets, this offset by better than expected fixed margins. We recorded our third consecutive quarter of positive net flows helping to soften the impact from weak markets. Average variable account values were down by roughly $1.4 billion driven primarily by the market with overall expense assessment income down 8% sequentially.

Fixed margin contribution was strong, the result of a large net earned [ph] premium collected in the period. We would estimate normalized spreads to be roughly 220 basis points, more in line with our outlook going forward.

In our Life segment the results of unlocking model refinements and other items negatively impacted the quarter's earnings by a net $30 million. Model refinements resulted in an adjustment to universal life reserves offset by the net positive impact of overall DAC unlocking.

When looking at forward run rate earnings, the unlocking and model work in the quarter results in an ongoing $7 million negative quarterly impact to our Life earnings.

Fundamentals remains stable with average universal Life In-Force up 4% over the period prior year. Adjusting for the DAC and model work, mortality margins and expense assessment income follow the steadied increase in our book of business. Fixed margins in the quarter benefited from roughly 23 million pre-tax of alternative investment income, this somewhat offset by weaker than expected prepayment income.

Reported spreads came in at the high end of our expected range of 180 to 190 basis points. Our group protection business continued its record of strong quarterly performance. Loss ratios performed within our expected range both in Life and Disability lines with overall non-medical ratios coming in at just over 71%.

Solid revenue growth continued with net earned premium increasing 10% over the comparable 2007 quarter fueled by organic growth and better than expected persistency. Delaware's reported earnings were weaker than expected but not surprising given the markets. Seed capital returns negatively impacted earnings by $3 million along with another 3 million of after tax expense items that are not expected to repeat in the fourth quarter.

Third quarter market decline drove period ending assets under management down $6.5 billion sequentially which together with the impact of negative flows served to reduce revenue in the quarter by roughly $14 million. Expense initiatives launched earlier in the year continue to yield positive results in the quarter.

Consolidated general and administrative expenses are down sequentially and we continue to focus on defending overall expenses ratios despite weakness in revenues. We expect merger expenses to be in the range of $12 million pre-tax for the fourth quarter tailing off more dramatically as we enter 2009.

In the quarter we recorded gross losses and impairments on available for sale securities of $406 million. Of this amount roughly $43 million is attributed to securities where we may no longer have the intent to hold to recovery.

Approximately 50% of the true credit impairments and realized losses were concentrated financials along with impairments on RMBS totaling approximately $80 million pre-tax.

As we break down our $4.9 million of unrealized loss position at the end of the quarter, we have very little in the way of concentration among the top 20 physicians. Many of the larger physicians are with financials benefiting from a combination of the TARP and consolidation.

As Dennis mentioned we were able to reduce our exposure to credit link notes in the quarter by $250 million as one of our holdings paid off at par. We experienced elevated levels of breakage in our variable annuity hedge program due to the extreme conditions experienced in the quarter. Incorporating the equally volatile FAS 157 nonperformance risk adjustment, the hedge program contributed $58 million to the quarter's net income.

Before the effects of DAC, tax, model refinements and 157 nonperformance factor, gross breakage in the quarter was a negative $336 million or approximately $83 million net of DAC and tax.

The ineffectiveness was concentrated in a handful of extreme trading days, such as the Monday after the Lehman bankruptcy announcement and the day the house filled to pass the original TARP legislation. The breakage in the quarter can be attributed to a combination of basis risk, currency movements and the impact of an extreme, intraday volatility. These same conditions have continued into the month of October.

We remained focus on balancing GAAP net income volatility with the long-term performance of the hedge program recognizing any meaningful potential claims under the living benefits are several years into the future.

Turning to capital liquidity and as noted in our pre-release, we estimated our excess capital position at around $500 million as of the end of the third quarter. We did end up taking a slightly stronger RBC into the fourth quarter than indicated in our pre release. However we expect the combination of continued general account impairments and the market decline in October to negatively impact our statutory capital position. Obviously and as we learned yesterday much is dependent on the market's performance for the rest of the year.

We have suspended our repurchase activity and halved our dividend. The dividend action generating roughly $200 million a year in additional capital.

We believe both moves were well received by the rating agencies. We are being proactive with the agencies keeping the communication lines open and regular. We were pleased to have receive Standard & Poor's strong enterprise risk management rating this past quarter, which situates us well among our peers.

Our liquidity position remains strong and with diverse sources of contingent liquidity. As of the end of the quarter, we have not experienced any unusual activity in our product flows. We have only a modest amount securities out on loan, roughly $400 million and have joined the Federal home loan, Bank of Indianapolis, where we can borrow up to $1 billion at reasonable rates.

At the holding company, we have around $120 million outstanding under our commercial paper program and over $1 billion in unused and multiyear committed bank line. We are focused on building capital and liquidity through expense controls, exploring reinsurance strategies and recognizing a slowing of production tends to require less capital.

October markets have impacted our insurance separate account values down roughly $16 billion before the rebound in yesterday's performance. We ended the third quarter inside our variable annuity DAC unlocking corridor, requiring about a 5% market decline to pierce the inner corridor thus setting of analysis and potentially resetting the base amortization assumption.

Even with yesterday's performance, we have in fact pierced the inner and potentially the outer corridor levels. If conditions do not materially improve, we may unlock our DAC amortization, model for equity market performance.

We would estimate any fourth quarter unlocking in the range of $250 million after tax as of yesterdays close. While not a cash or statutory capital issue, the unlocking would reduce our reported earnings in the quarter. I would caution this is simply an estimate and could differ according to the markets and upon making a final decision regarding our best estimates.

Now let me turn it back over to Dennis for some closing comments.

Dennis R. Glass - President and Chief Executive Officer

Thank you Fred. Before we go to Q&A let me comment on capital. As we have said in our remarks, we entered the fourth quarter with somewhat stronger capital than indicated in our pre-release. We have a well diversified asset portfolio, no liquidity issues and well diversified profitable businesses.

Again within these businesses during the quarter close to 70% of the earnings were driven by margins that are not related to equity markets.

Capital raising activity if any will be related to unfolding events. Our objective remains to run our businesses, protect our franchise and take actions that are in the best long-term interest of our client and shareholders and now let's turn it... open it up for Q&A.

Question And Answer

Operator

Thank you sir. [Operator Instructions]. And we'll take our first question that will come from Andrew Kligerman with UBS. Please go ahead sir.

Andrew Kligerman - UBS

Okay. Good morning. The first question is around the hedging breakage of about $232 million. I think Fred you were saying basis risk, currency extreme, intraday volatility. Could you drill in deeper and give us a clearer sense of exactly why it cost so much? And what the impact might be to excess capital or RBC or as we look forward to the fourth quarter?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

Sure, Andrew. Thanks for the question. First of all, drilling deeper on the pre-tax and DAC breakage of roughly $330 million a little north of that 50% of that breakage was related to basis risk more specifically the underlying performance in the separate accounts versus the indices we used to hedge the liability.

It's very important, we use fairly sophisticated mapping processes to track or correlate the best we can the Indices to the potential performance estimates of the underlying separate accounts. And so we would expect to go through periods of time where basis risk will contribute to a particular quarter or take away.

Indeed, it was a particularly severe period for basis risk; I think the underlying separate accounts underperformed the indices by some 400 basis points in the quarter. And we wouldn't expect that kind of severity going forward. Most importantly Andrew, in that particular piece of it again representing 50% of the breakage, we would expect over the long run for basis risk to even out overtime, and in fact map our hedge process accordingly.

Another big component of the hedge breakage was really these... in particular these few days where you had intraday massive swings in not just the equity markets but also in other indices, interest rate swings with a flight to quality more crisis like condition. And it's very difficult for our hedge program. In fact the hedge program by and large is not designed to keep pace with those kinds of intraday moves. And so that contributed about 30% or so of the breakage when looking at it.

And then finally there was some currency movement. We had a situation where the dollar, I believe, strengthened roughly 700 basis points against most of the currencies in a fairly sudden fashion as currency changes go. And our program had a little bit of difficulty catching up with that. That was not a particularly large component of it I would say 10% to 15% of the breakage in the quarter. It's also something we can address going forward with strategies.

Importantly when looking at these intraday volatility we've had to make some I think prudent decisions over the long run to somewhat expose ourselves to more... to some of the volatility in our structure recognizing that the cost of purchasing hedges and the cost of benefit right now is not really rational given the pricing we're seeing. And so we end up being on the margin and I would emphasize only on the margin, a bit short volatility which will bring about greater breakage during these extreme periods but we would expect that gap to close over a longer period of time.

We think it's also prudent and more consistent with the longer-term view of the other aspect of the hedge program, which is delivering assets in time to pay claims over the long run.

Andrew Kligerman - UBS

So Fred that leads me to my follow up and so with the same type of basis risk issues volatility in quarter the fourth quarter, do we accept... can we expect a similar type charge in the fourth quarter and more importantly what kind of impact would it have on excess capital?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

Right.

Andrew Kligerman - UBS

Maybe, it's easier to look back at this third quarter, what kind of impact did that have on excess capital in the third quarter and then we can extrapolate the fourth?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

Yes let me address that. And I will address what we're seeing in October Andrew, I'm happy to talk about that because this is fairly real time we track it pretty closely.

In terms of capital, you don't see the same risk based capital impacts that you'd see from the GAAP breakage, there is a different accounting that's involved in it and so we see more of a muted impact if you will related to the performance of the hedge program. You have more of a cost of the program that will run through and weigh down your RBC over time. For Lincoln through the use of captive reinsurance this result in increasing the premiums we pay to settle or account for if you will be adding cost of the hedge program. Not unlike the valuation premium that we use in our GAAP results and have incorporated into our operating earnings in the period.

So you don't see quite as much an impact there on the capital side. Now what you do... and also by the way I should say you don't have the mark-to-market swings because of that captive reinsurance and that's important. That swing by the way can really add back to your RBC and at times as well as taken away.

When it comes to October, we are seeing the same conditions in October that we saw in the third quarter. That breakage right now... I should say actually as of the end of last week was hovering between $400 million and $500 million pretax and DAC. Importantly also offset by the same non-performance risk factor that served to soften and in fact end up contributing net income to the bottom-line.

In other words the same sort of irrational or crisis type marks that we're getting that are influencing liability namely implied volatility being off the chart. Those same sort of economic input are impacting the non-performance risk as well serving to largely offset it. So many of the themes that are running through our P&L this quarter you'll see run through as we go into October. And again October is October, we see this thing move around quite a bit and we have to watch for the rest of the quarter to see how it turns.

Andrew Kligerman - UBS

So as of now excess capital is similar to that $500 million number that you outlined despite even hearing rating agencies somewhat concerned about equity exposures on DAs excess capital is still in that $500 million.

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

Yes let's talk about... now let's talk about the separate question of where is your capital position as you stare at the month of October. So as Dennis mentioned in his comments and I mentioned we carried a slightly stronger risk base capital into the month of October than we had in our pre release. In our pre release we've said 385%, it's actually closer to 400% as we start to finalize more of the numbers off the quarter. Just by the way I should remind you as an estimate that you make mid quarter or ultimately you print your blue books and that dictates your final RBC.

But we have a pretty good read on it. So we carried a bit of a stronger RBC into the quarter and that's helped us. We would estimate we've done some sensitivity analysis around this. If you work to assume a 30% drop in the equity market, and again with the rebound yesterday we came up quite a bit from that. I think we are running at around 19%-ish or so down through the end of close yesterday.

If you assume the 30% down market, that would have roughly a 25 percentage point negative impact on our RBC. That's because, we as a variable annuity writer, we still have to do all the calculations related to AG34 and 39 which is the reserving guidelines as well as C3 phase II work. So, when you do have a severe market decline, it will weigh down on your RBC and that's about the sensitivity analysis I would give you.

Operator

And we'll move on to our next question sir; that will come from Jimmy Bhullar with JP Morgan. Your line is open sir.

Jimmy Bhullar - JP Morgan

Hi, thank you. Good morning. I had another question just on your hedge program and it's not on the numbers, it's more on like the severe breakage you have seen in this quarter. Weather you agree that the market is rational or irrational, has it made you either reevaluate or think about your strategy for the VA business.

This is a business you make roughly like a $120 million, $125 million on each quarter and you've mentioned that basis points or basis risk over time would even out. But, let's say the market remain all down for the long time, have you thought about either changing your strategy in the market in terms of offering... living benefit guarantees or maybe raising prices or looking at the broadest again and maybe pulling back a little bit from the market, would you discuss that?

Dennis R. Glass - President and Chief Executive Officer

Jimmy, it's Dennis. Let me just say that we continue to think it's a good business over the long-term and let me put some shape around that. We take a look at different pricing runs and so for example a pricing run that only has a 4.5% equity market depreciation would still provide us returns on an internal rate of return basis, ROE basis, and the 12% to 15% un-levered.

Now clearly we are in the tail and there's a lot of jumping around that's occurring. But again over the long-term we think this can be a good and... good business and a profitable business. The other thing that we need to step back from time-to-time, and the hedging program has a dual purpose of hedging the potential or excuse me creating assets for potential liability payments as well as the secondary issue of trying to calm down to get income result.

And let me just give you a number, our hedge asset target at the end of the third quarter which is roughly the present value of expected future claims on a GAAP basis, before the non-performance risk we take that out of there that was about $1 billion. The hedge asset number which would be the amount of money available to pay those future claims was also about $1 billion and that $1 billion had 70% to 80% backed by cash collateral.

So just on a GAAP perspective of trying to present value future claims and do you have assets available to pay those claims at the end of third quarter those two numbers were about equal and again runs at lower assumed equity growth rate in the 9% that's typically used produces pretty good internal rates of return.

Now on this issue of the target versus the asset as markets move around those numbers might pull apart may have in the quarter. But we would expect over time to be able to keep those pretty close to each other.

Jimmy Bhullar - JP Morgan

Now, I had another quick one on... you have lost a few people to some Sun Life after John Bosh has joined, have you... then obviously you've announced the main ones but have you seen any other like either distributor defections or any people in sales management that have left since, if you can comments on that?

Dennis R. Glass - President and Chief Executive Officer

Yes. Let me explain it in three categories. The management team that reported to Terry is 100% impact, the sales management team has seen no departures and the external wholesaling team has seen no departures.

Now I will tell you that in a market like we are in, there is plenty of demand from competitors for the talented people that we have. And there may from time to time be some changes. But the simple answer to your question right now is nothing has changed.

Jimmy Bhullar - JP Morgan

Thank you.

Operator

And we'll move to our next question that will come from Edward Spehar with Merrill Lynch.

Edward Spehar - Merrill Lynch

Thank you. Good morning. I guess Fred going back to the RBC and 30% equity drop that you suggested, first could you just repeat again what you said you think the RBC ended the 3Q and could you give us the dollar amount to that 30% drop would hurt your capital buy, and maybe just can you help us understand a little bit at least what the pieces... how much of it is just the... how much is sort of caravan [ph], how much is anything else that we need to know about?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

So assuming a 30% drop in the market, had about a 25 percentage point reduction in RBC and we entered the quarter at about 400% RBC, a little bit north of the 380 that we talked about, and as you know now this is the RBC for our principal life insurance subsidiary, this would be the more or less the consolidated RBC of Lincoln Life of Indiana, New York and one other small entity First Penn-Pacific.

And the impact of the markets, the way to think about it, as we entered into the fourth quarter with about total adjusted capital in and around $5.25 billion right in that range. And the impact when you stress the market and do the after-tax impact of the market on that capital, i.e., kicking up the reserves under AG34 and 39, it had about a $275 million to $300 million reduction or impact to that total adjusted capital, from which you then apply your RBC to it to come up with the impact.

And again I would reduce it by about 25 percentage points, if you assume a 30% drop in the market and as we've seen it's rebounded a little bit. That answer your question?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

Ed, we can't be comfortable that they will come down. But again we are in a period of time, so I guess just a follow up on... in terms of the comments Dennis that you made about 4% equity market returns providing 12% to 15% un-levered returns on capital, I'm assuming now that does not factor in the 37%, 38% kind of implied volatility that's in 5 and 10 year put options right now. And I guess the question is, given the fact that... I think it's a pretty concentrated market in terms of providing that type of cover, how do we know... how can we confidently say that those implied volatilities which we all know are double realized volumes overtime, how can we be comfortable that those are ever going to come down?

Dennis R. Glass - President and Chief Executive Officer

Ed we can't be comfortable but they won't come down, but again we are in a period of time that represents the worst capital markets in 70 years. And it's coming out of this these volatility leverage were as high as they are now, we would have to reprise the product.

Edward Spehar - Merrill Lynch

I guess what about if they are even low, I mean earlier this year I think they were in the high 20s, two years ago they were in the low 20s. I mean if we say we are just even in the high 20s, does that require product reprising?

Dennis R. Glass - President and Chief Executive Officer

Yeah, I'm going to turn that over to Mark because he's more familiar with that kind of a granular question. Mark Konen?

Mark E. Konen - President, Individual Markets

Yes Ed. If you just step back and you can't look at one piece of the pie, admittedly an important piece, but as look at and we currently are looking at whether or not to reprise or when, et cetera, and you make the point that it depends on what day you look at it.

So you don't want to reprise at the high point and then find yourself regretting that in the marketplace. But if they remained at those kinds of levels, you would look at that, but then in conjunction with that, you would look at the other what I'll call actuarial input policy holder behavior, et cetera, which have continued even in this market to be much better than what we priced for, things like actually take rates in absolutely dollar rates being coming out of these living benefit et cetera. So that's serves to mitigate it obviously there are other leverage you would call investment restrictions et cetera. So it's a complicated thing. We are looking at it. I can't definitively say if Bob we're at 25%, we'd definitely reprieve but if we came out of this and they were at that kind of level we'd have to take a hard look at it.

Edward Spehar - Merrill Lynch

Okay thank you.

Operator

And we'll take our next question that will come from Nigel Dally with Morgan Stanley.

Nigel Dally - Morgan Stanley

Great, thank you, good morning. On capital can you provide some commentary somewhere we expect the treasuries, capital purchase plan, fixed ended to the life insurer. And if it were would you be eligible and willing to participate?

Second on the investment portfolio, certain classifications such as CDOs and credit link notes which you are trading at $0.43 on the dollar. I know you don't use a bright line test, but it seems hard to justify not taking an impairment on those securities given where the product... the best you can comment on that as well. Thanks.

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

Yes, Nigel on the first question I think you asked if we thought that treasury would extend the tariff program to insurance companies and that is up to treasury. I know what I read in the papers, which is they are mauling it. Based on the current eligibility requirement, which would require some type of the specialty regulated holding company Lincoln would not be eligible. But again I... from what I read in the papers it seem to be an emerging issue.

Let me come back to the credit link notes then as second question. As I said, we had a $250 million repayment from $850 million now down to $600 million in total. The credit link notes although a single note, we have been able to swap out of individual credits to protect the cushion inside note. So, the reason that we don't see a need to take a write-down in that is that on a credit by credit basis as we anticipate problems if we decide to swap out we can. And secondly there remains quite a bit of cushion in the level below us.

Nigel Dally - Morgan Stanley

Right, thanks.

Operator

And we'll to our next question that will come from Steven Schwartz with Raymond James.

Steven Schwartz - Raymond James

Hi, good morning everybody. Let's follow up on a question of western TARY [ph] reading, is there some prohibition outstanding against them possibly poaching that may expire and then may lead to people living?

Dennis R. Glass - President and Chief Executive Officer

No.

Steven Schwartz - Raymond James

No, okay. And then Fred, can you just explain to me I'll be following up on Ed's question in the 30% decline in the equity market. The market goes down 30%, the reserve itself would obviously go up under actuary going on 35 and actually going on 39 presumably the hedge would have some effectiveness. Does that not get counted on a statutory basis?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

The reason... what we have done Steven is that on that basis, we have structured a captive reinsurance treaty where we reinsure the hedge program off, that allows us to get reinsurance treatment as it pertains to claims payment. Now there is an ongoing structure here where you pay the premium and exactly pay the entire writer charges over to the reinsurance vehicle. It didn't change then; it's in a position to pay claims when and if they come do and as you know it's for out into the future.

And what you have to do is a couple of things first of all those premium payments need to reflect the cost that are being taken on by the captive reinsure. So as hedging cost go up or as they need to retain more moneys as a result of hedge ineffectiveness or any other cost that are affecting the re-insurer. We need to kick those premiums up and that kicking of the premiums would weigh down on your stuttering and your RBC over time, but more in line with the notion of a net valuation premium and that we've talked about earlier on a GAAP basis.

The other thing I would note that's very important is you've appointed actuary who each year have to sign off on the reserves and any reserve relief received on the reinsurance basis. So if there are questions as to asset quality or your ability to recover then you would normally under cash flow testing need to kick up your reserves to account for that also.

So it's very important as a company that we make sure enough premium is going up over there and it's properly reflecting all the cost of the reinsured. The only other thing I would say is the rating agencies which often play a role in this as you know, they have their own capital models and they tend to look through this structures and really try to understand them for what they mean when comparing company to company and of course we spent quite a bit of time talking about these structures with the agencies, and they feed them into their models accordingly. So you can assume all of this is being fold together when we think about our excess capital position.

Jimmy Bhullar - JP Morgan

Okay. Thank you.

Dennis R. Glass - President and Chief Executive Officer

Yes.

Operator

And moving to our next question, that will come from Jeff Schuman with KBW.

Jeffrey Schuman - Keefe, Bruyette & Woods

Good morning. Fred I have a couple of questions related to the hedging numbers. First of all I need to help in reconciling between the 231.5 of hedge program effectiveness on page six in the supplement and the number that you cited I think which was 336 on a pretax basis. And then secondly I am wondering if this translation this quarter of 336 pre tax pre DAC to 83 after tax after DAC is in rough terms kind of normal and was -- it is the sort of mapping that we might do and might just be in the future.

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

The answer to your question in terms of the statistical supplement, we have a line item called hedge program effectiveness and that has $231.5 million as the breakage. But what I have done is added the unlocking of $79 million close to $80 million above into that number.

The other thing I've done is I pulled out the net valuation premium, where you can think about that as the portion of the fees we collect that are attributed to if you will, the hedge. So what I was doing was really grousing up the breakage for the sort of what I would call peer breakage that is purely how we look at the target liability and purely how the hedge assets had performed.

And that's how we got to the 336 that I quoted on my script. Then later on in conversation I talked about October and I talked about that we track this obviously 24/7 and that we're seeing gross breakage between $400 million and $500 million as of last week, very important as of last week because the change is daily and that is basically... that's equivalent to the $336 million that I mentioned in my script comments or my prepared remarks.

Jeffrey Schuman - Keefe, Bruyette & Woods

That's helpful. Actually the second part of the question was... I think in the third quarter, the 336 pretax, free debt maps to 83 after tax after debt. So I'm wondering if we could anticipate the same sort of offset, if in fact the fourth quarter number ended being 400 to 500 till we kind of ratio it down the same way?

Dennis R. Glass - President and Chief Executive Officer

Yes, the technicians around would sort of caution to be careful but directionally you wouldn't be far off by taking that relationship.

Jeffrey Schuman - Keefe, Bruyette & Woods

And lastly, the... what is the cumulative after tax after DAC impact of the FAS 157 adjustment? In other words if and when your credit worthiness is completely restored, what sort of maybe reverse out of book value?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

Right now, I like to give you an idea of that, Dennis mentioned earlier a target liability of about $1 billion, this would be without the non performances risk. When you incorporate the nonperformance risk, I believe that comes down into the $550 million range which you could assume that being effectively the cumulative impact of MPR when looking at that balance sheet item.

Jeffrey Schuman - Keefe, Bruyette & Woods

So the delta $1 billion minus $550 million equals $450milion, $450milion would be the impact?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

Excuse me; I am sorry, say it again.

Jeffrey Schuman - Keefe, Bruyette & Woods

So the delta, the impact will be $450 billion minus the $550 billion?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

Right, right, that's the way... the way I look at it is how has that balance sheet liability progressed and so, it's up around a billion dollars at end of the third quarter for when you account for the -- yes, when you account for the MPR then that brings around down by better than $400 million down to that mid $500 million.

Now as we go forward into the October month, you see sort of similar pattern and that is you have got this large growth unlocking I talked about You also have an equally large... potentially larger non performance risk offset with similar reasons.

Jeffrey Schuman - Keefe, Bruyette & Woods

Just to be in clear, in principal I assume it works the same in both directions and in the way if your credit measures improve than it goes the other way in just a similar fashion. Is that correct?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

That's right, and something you want to careful about is in all this conversation you could walk away with the just the blanket assumption that there is always going to move in time. And that's not necessarily how it work.

I think when we see extreme conditions like this, they tend to heavily correlate, that is very important. So we're seeing really out of the box tail as Dennis called it conditions in these assumptions. So you see higher correlation between a liability jumping substantially in a single day or in a month, and a similar reaction to the non-performance risk. But if were to revert back to more normal historical times, you would find these measures don't always coordinate with each other since of course the non performance risk is related more to our specific credit condition and market condition overall could be changing differently.

Jeffrey Schuman - Keefe, Bruyette & Woods

Very helpful, thanks a lot Fred.

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

Yes.

Operator

And moving to our next question that will come from John Nadel with Sterne Agee

John Nadel - Sterne, Agee & Leach, Inc.

Hi good morning. Couple of quick ones. Dennis if the TARP was actually offered to life insurers including Lincoln, but the caveat was that you needed to change your holding company to a bank holding company, is there any reason you'd be reluctant to do that?

Dennis R. Glass - President and Chief Executive Officer

I would have to understand what the business activity restrictions are but somewhat little I know about it; I doubt seriously that it will prevent us from doing any of the things that we are doing. So based on what I know the answer is, we would do that.

John Nadel - Sterne, Agee & Leach, Inc.

Okay Fred real quick one on risk base capital. So you are starting the fourth quarter at roughly 400%, could you just remind us for year current ratings, what the targets are with respect to the rating agencies so to understanding the caveat being obviously that they are changing the rules sort of it seems every day?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

I'm glad you ended your question with that comment that saves time in my answer. The historical view and I would also say that that we have in fact as it turns, we met with the rating agencies as part of annual review just in the last month and dialogue was very constructive and we remain in very close contact with them in what conditions are taking place and how we're positioned.

But conventional wisdom is that you have to be hovering around 350% RBC or better and that's normally where we want to target. In fact historically we've try to kind to keep ourselves within a zone of 350% to 400%.

Some of this also is just reflecting on the make up of your business, so that's an RBC that I believe situates Lincoln well for AA rating standards, so that's what I would normally like to do.

Now again you need to remain in close contact with the agencies after giving effect for the events of the market, their views of the world and what is appropriate or inappropriate RBC and how they're valuing in their particular models, and they all have their own model; it's something you have to stay very close to, but that's how I would size it.

John Nadel - Sterne, Agee & Leach, Inc.

Okay and final one quick for you is just I know you've had some plans and expectations for securitization before the end of this year, any changes in those plans or expectations given the state of the markets?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

First of all, all of my coding of RBC is without any credit given to a reserve securitization that remains something we hold in the bag if you will relative to managing our RBC over time. That by the way is what I mean when I talk among other things potential reinsurance solutions available to the company.

Now conventional securitization is clearly out of scope right now, with the markets the way they are and your rational conditions that we're facing to issue various securities out there. What we are doing however is looking for whether or not or exploring whether or not there are other forms of funding such a vehicle. And I'm not prepared at this point in time to give specifics around that but I can tell you both Lincoln as well as I know few of our peers are exploring those options and seeing whether they could make sense. It requires you also working of course with the various regulatory bodies that you run the securitization through and so we have to work in partnership with them.

So I'm not going to rule out the notion of getting a securitization done, what I would tell you is it would be done in a less conventional structure given the marketplace.

John Nadel - Sterne, Agee & Leach, Inc.

Okay. So the original expectations for something order of magnitude similar to last year's level of capital sort of relief if you would?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

Yes.

John Nadel - Sterne, Agee & Leach, Inc.

And is, I guess, still on the table but in a non-standard sort of structure or potential?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

Yeah. In fact we've actually got in lot a done on that project in terms of the work you need in terms of the work you need to do block, the structure of the captive reinsurance vehicle and this in our particular case down in South Carolina.

We've done a lot of the base work to be sort of ready set go, but we need a few things to happen, rating agency reviews that are required around the structure and now we've got to really change the game if you will and looking potential funding solutions given market condition and we are working actively on that. But I would size it around, always talk about historically.

John Nadel - Sterne, Agee & Leach, Inc.

Okay. So, it's safe to assume then just to close the loop on that that you mentioned the response to Ed earlier that the impact of the market is 30% drop $275 to $300 million after tax impact on your total adjusted capital; this is a potential opportunity to fill that all.

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

That's right.

John Nadel - Sterne, Agee & Leach, Inc.

Okay. Thank you

Mark E. Konen - President, Individual Markets

Something... something I should also note, I think you all understand this but obviously we've been isolating the equity market the one that we keep our eyes on and the one that you're most familiar with is of course the continuation of realized losses in general account. So we've commented on our unrealized position, we've commented on the fact that we would expect that it is in this quarter things to be elevated going forward. So we want to watch that very carefully and that... that's likely to be a, the more major driver thinking through capital conditions if you go forward.

Operator

And we will move to our next question that will come from Suneet Kamath with Sanford Bernstein.

Suneet Kamath - Sanford C. Bernstein & Co.

Hi, good morning, I just had two questions. I guess the first is a follow up to Nigel's question and some of the comments that Fred just made about. Being in touch with the rating agencies on a constant basis so just looking your general account supplement rough numbers you have something like $4.5 billion of securities that in the aggregate are below 80% of amortized cost and I understand how you manage the duration of the assets and liabilities and all that. But in your discussions with rating agencies, are you hearing anything in terms of them changing their views about how they either test or cash flow matching or view unrealized losses, based on any sort of a discount to amortized cost. Just any directional thoughts that you could provide on that. And sort of related if there was a situation where Lincoln financial was downgraded from AA to say A plus, which of your businesses do you think would be the most impacted by such a rating. Thanks.

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

In terms of the agency approach to the general account, this is the way I would describe it. As their approach to general account is substantially similar frankly to our dialog with the auditors and that is they understand out OTTI process, they want to challenge as our auditors would where we are not taking impairment particularly on those securities that have been underwater for a long duration or are deeply discounted the market.

And so we have to perform and supply all of the appropriate analysis to discern taking impairment if that's the decision and that of course is going to be driven off of to the fundamental in our views of the likelihood of that security paying off. It also of course is heavily influenced by our intent to hold that security until recovery. And so the rating agency dialog tends to be very similar. There is one difference with the rating agency that at least in Lincoln's case we have done proactively and that is we stress the unrealized loss position on a security by security basis using often times historical deep sort of assumptions, that are assumptions of hiking the default rate.

And we throw those stress conditions in the front of the rating agencies as part of talking about forward-looking capital and the kinds of steps managements will take in the space of either stress or not so stressed conditions in the general account. So we push the dialog further with the rating agencies and the reason for that is we want everything out on the table and everything open and transparent with them. So they understand how bad it could get under what conditions, what our point of view is, and most importantly what sort of steps would management take in the space with that. Otherwise there has been no what I'd call a bright line-ish type dialog they are simply reviewing that, and spending time with management as you would imagine, they would.

In terms of the ratings reduction issue, one comment I would make about Lincoln is very important, is that we are largely a retail almost exclusively a retail based insurance company, and whether it would be our individual businesses, or whether it be participants that are part of group businesses or a defined contribution, we have very little in the way of what I'd call more heavily ratings sensitive issues relative to our liabilities.

And as a result, we are not quite as severely hit or impacted with ratings issues. They'll typically find Cowey and Bowey [ph] are more sensitive to ratings, and so forth. Now, what I would say is we have for a long time talked about targeting and maintaining AA rated standards, remaining in the AA rated categories as being important to run our business and we would not at all pull off at that comment. That is our goal, that's what we wanted to design certainly over the long run and short run, our ratio is to look like and our dialog to look like.

We think that it's very important in dealing with the financial intermediaries that we sell through. And so I don't want to, I don't want to discount the importance of ratings but I would remind you that Lincoln is not in the large kick businesses. We're funding agreement businesses and large institutional businesses that could be much more sensitive to ratings issues.

Suneet Kamath - Sanford C. Bernstein & Co.

If I could just briefly follow-up on the auditors issues since you brought it up. Is it fair to say that the discussions with be auditors in the fourth quarter given a sign off on your financials will be much deeper than sort of your discussions with them on a non year-end, quarter-end?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

I think generically speaking, your dialog with the auditors at year end across the entirety of your financial statements tends to be deeper and more significant than it is during the quarter now having said that, the OTTI and impairment issue is so front and center, at companies, and at the auditor firms that frankly quarter-by-quarter its an intense and involved dialog period for our company and honestly talking with our piers for all companies right now.

So I do not expect that tone to materially change. I think it's going to be the same OTTI dialog and documentation effort that you would expect the company to go through.

Suneet Kamath - Sanford C. Bernstein & Co.

Thank you, very much.

Operator

Ladies and gentlemen. This is the scheduled end time to our conference today. However, we will stay on the line with you at this time in an attempt to answer all of your questions. Our next question will come from Eric Berg with Barclays Capital.

Dennis R. Glass - President and Chief Executive Officer

Thanks very much. Fred we have had today our very, very involved in practical and good conversation about the hedge program, discussion actual guidelines in Carbom and Stag [ph] in GAAP and all that in valuation premium. But in the end I'm still not clear on the question; did the hedge program work as intended?

Eric Berg - Barclays Capital

It's a simple question, I just want to ask that simple question did it work as intended?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

Yeah and it's a very good question and the answer is for the most part of yes, and the only reason I use for the most part is that when you go through these extreme condition you will uncover things that you want to true out.

So for example, can we dial in our mapping process a little bit more finally to attack more that basis risk. I mentioned Eric, that we had some currency separation in the quarter, wasn't particularly big in fact it was in and around $50 million pre-tax and DAC of that breakage to be more pointed.

There are things we can do to dial in the currency issue better to capture more of that risk going forward and we have that underway. So, when you go through these kinds of extreme periods it will in fact expose some area that you can dial in and do differently.

But, when I say for the most part of work it's not only comment relative to its effectiveness which was better than 80% effective over the course of the quarter which is good. But also that when you're going through these periods of irrational markets and when you have the dual track of protecting GAAP net income as well as positioning this to be reinsurance in the future, you will proactively pull off putting hedges on in irrational periods which brings on to yourself a level of breakage that you consciously know about.

In fact we knew this was going to happen and it would be times like this, it is actually underlined the rational and pulling the breakage out of our operating earnings because we wanted to be able to as a management team make good long-term economic decisions that don't have implications for our core operating earnings. What you do want in operating earnings is the fact that this double pack funding [ph] there's real cost related to hedging and you want that to run through your numbers,

So the answer is for the most part this hedge program performed as we designed it and intended it to do. It will uncover some weaknesses and we are dialing in changes accordingly.

Eric Berg - Barclays Capital

My other question related to one that I think if you need ask with respect to other than temporary impairment and that is my question is, do you think that by their very nature what the order is called level three assets, their assets that are valued using level three inputs will necessarily all of the same be more likely to be impaired than level two or level one. Is that just for sure or not necessarily?

Dennis R. Glass - President and Chief Executive Officer

I'm going to ask Doug Miller maybe to give his perspective on it.

Eric Berg - Barclays Capital

Remind me of Doug's, he's the Chief --

Dennis R. Glass - President and Chief Executive Officer

Doug is the Chief Accounting Officer of the company.

Eric Berg - Barclays Capital

Thank you.

Douglas N. Miller - Vice President and Chief Accounting Officer

Hey Eric, this is Doug, that's an interesting question. I think the... this is between level 2 and 3 I guess one could reach to that conclusion but not necessarily will you end up with more impairments in three or two, depends upon whether or not the model that you use, doing your level III and the inputs that you put into the model, so I would believe that different companies could come to different conclusions on those types of impairments. So I wouldn't want to put a broad brush across that.

Eric Berg - Barclays Capital

Okay, thank you.

Operator

And we'll move to our next question that will come from Bob Glasspiegel with Langen McAlenney.

Bob Glasspiegel - Langen McAlenney

Good afternoon. It appears you've been sort of thought for funding [ph] out mostly your debt longer-term but there's I guess $1 billion or so if I reading the SEC documents correctly, debt coming in the next couple of years. What should we think in terms of interest cost going forward assuming now sort of external increase financings?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

Yes, I think the more... the most immediate maturity we have coming up is I believe in April for about $500 million and clearly if we would have just flattened our refinance at a consistent or at a equal structure like that, while you may have favorable treasuries relative to historically, you got a fairly substantial gaping out of spreads.

Bob Glasspiegel - Langen McAlenney

What are the credit supports... I mean what does the market tell you that your debt would be today? I mean, I know its ridiculous and you probably won't do it and you hope it will come back.

Dennis R. Glass - President and Chief Executive Officer

I think it was about 5 or 6. The expense on the security credit flow loss [ph].

Bob Glasspiegel - Langen McAlenney

Yeah, what about the 600, 700 over.

Dennis R. Glass - President and Chief Executive Officer

6 to 700 over that was mainly pre-tax that was good.

Bob Glasspiegel - Langen McAlenney

Okay.

Dennis R. Glass - President and Chief Executive Officer

So --

Mark E. Konen - President, Individual Markets

That's consistent with rest of the insurance company.

Dennis R. Glass - President and Chief Executive Officer

All the peer group is up in and around that territory. So what you want to be doing is really as a company right now is starting the process of building alternatives relative to any maturities that are coming down the road and so keeping yourself with a lot of dry powder in your commercial paper program for example we got a $120 million out under CP and it's a billion dollar commercial paper program.

Bob Glasspiegel - Langen McAlenney

What rate is that?

Dennis R. Glass - President and Chief Executive Officer

Excuse me.

Bob Glasspiegel - Langen McAlenney

What rate is that?

Dennis R. Glass - President and Chief Executive Officer

That commercial paper.

Bob Glasspiegel - Langen McAlenney

Yes for new stuff, which you mentioned.

Dennis R. Glass - President and Chief Executive Officer

It changes daily but I would say we've quoted depending on the duration in and around 50, 75 basis points over LIBOR in some cases, sometimes down.

Bob Glasspiegel - Langen McAlenney

Yes, a little inside of that.

Dennis R. Glass - President and Chief Executive Officer

Little inside of that and being full. So not attractive but available. Also things like the federal home loan bank that we joined, that is now down at the life company, got through some mechanics, you can use it to move some money around on a temporary basis. That sounds to be actually very favorably priced and not nearly as sensitive to the sharp movements that are going on.

So I think you typically end up pricing there more like a LIBOR plus 10 to 15 maybe 20 over LIBOR right in that area. So what you want to do these days is have yourself multiple accesses to avenues to grab money such that you can wade out a storm and issue into the longer-term markets when ready to do and when more competitive.

Bob Glasspiegel - Langen McAlenney

Okay. And pension fund assumptions I can't remember what you have left... UK --

Dennis R. Glass - President and Chief Executive Officer

I'm sorry could you repeat again Bob, I didn't --

Bob Glasspiegel - Langen McAlenney

Pension fund assumptions perspective, I can't remember what you have left that might be sensitive to that?

Dennis R. Glass - President and Chief Executive Officer

Yes, we... from a pension funding perspective, we... as we entered into the third quarter and through the third quarter I think we remain pretty well in a funded position. I don't expect to many surprise there. What I would say is we do have more of an under-funded position in the UK which is a different sort of regime, as you know. There's third party trustees, there's different sorts of assumptions that are applied. And so I would expect overtime there will be some level of funding. This is not a particularly big exposure of the company on a relative basis, relative to our company. So I do anticipate overtime there to be some diversion of capital to showing up pension under the current market performance. So we entered into this storm in a very well funded position on the pension zone.

Bob Glasspiegel - Langen McAlenney

Your short assumptions aren't going to be tested severely, not to worry. I was going to --

Dennis R. Glass - President and Chief Executive Officer

We haven't revisited those and so I wouldn't comment on now. I know Lincoln historically has always been in and around sort of a normal range of long-term assumptions. We haven't been particularly aggressive on that front but we would have to revisit those assumption and I couldn't really give you a iron clad answer right now.

Bob Glasspiegel - Langen McAlenney

Okay, thank you.

Dennis R. Glass - President and Chief Executive Officer

Yes.

Operator

And moving to our next question that will come from Tom Gallagher with Credit Suisse.

Thomas Gallagher - Credit Suisse

Hi just a follow up on the captive reinsurance after the variable annuities. Fred the $275 million to $300 million stress test scenario... I presume the rating agencies actually unwind the captive re-benefit and look for sort of what the growth hit would be before you get that benefit. Is that the way they are looking at it, and if so when you do that same stress test would your capital still be in excess AA levels?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

Yes, the stress test I am doing during is a market drop not necessarily sort of a hedge effectiveness concept if you will recognizing that the reason you have the hedges on is to absorb in part of those markets drops and offset it. The stress I am doing is just really to the actuarial guidelines surrounding the liability on variable annuity period with the market drop. And so that roughly 25% point. When it comes to the reinsurance vehicle I'm looking through it, I believe the rating agencies particularly to their own capital models look through and treat that likely very similarly to stat accounting these days where you would effectively keep all of your rider fees, you would pay out hedge class, you would have a mark-to-market on hedge instruments versus the liability which were on different accounting basis, okay.

And then they give you credit for hedge effectiveness. You get a credit if you will from a C3 phase II perspective for having an effective hedge program in place. I believe that ends up covering you if you will in upwards of 70% of claim. That's kind of how the factor comes in.

Thomas Gallagher - Credit Suisse

Right.

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

So when you do a look through if you will that's more or less the look through treatment that I would expect the rating agency to go through. And so you could assume that when they are thinking about our ratings, and thinking about our capital structure, that's the type of work they are trying to do.

Thomas Gallagher - Credit Suisse

Sojust a follow-up on that. So I guess the $275 million to $300 million number seems more, just in proportion to bolt the way. Carbom [ph] gets marked in C3 phase 2, should play out?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

Its tax affected too, keep in mind.

Thomas Gallagher - Credit Suisse

Okay. So even tax affecting it seems somewhat more, that's just my judgment but the... I guess I just want to get a better sense from you. With conversations you're understanding in the various rating agency models, do you think that's kind of the impact that they think, capital is likely to absorb and it down thirty market? The comments that I've heard from some of them would suggest the impact's going to be substantially larger than that. Not for Lincoln specific but more an industry question?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

It would be a bit of speculation on my part to kind of dive back into their model. Some of which they publish ultimately, some of which are more internal and are changing quite often. In fact as, most of them have been trying to adapt sort of their version of VA Carbon and their version of C3 phase II. So, it's a little speculative for me to say but I would assume that they're taking into account the market drops and trying to stress their models and incorporating them and thinking about our rating. So... and again it's a little speculative on my part to kind of try to judge what the rating agencies might be doing. But we track those models relatively closely, we try to trap them and I would expect similar impact of the market being down to what I've talked about looking at IC, RBC model.

Thomas Gallagher - Credit Suisse

Okay. And sorry just one last follow-up. So with market down 30, your... their working assumption is you all had adequate capital levels to maintain the AA.

Dennis R. Glass - President and Chief Executive Officer

We have what we believe to be capital levels that are consistent with AA rating carriers. The only thing we have to caution is what's the changing landscape in the agencies. Something else that, Tom, worth mentioning just in terms of Lincoln because there is... when you look at AG34 and 39, VA Carbom on the reserving side in C3 Phase II as its being installed so I have some very company specific issues to be aware of. For example one of the bigger ones was your mix of variable business. And something to keep in mind about Lincoln is when you're staring at our $55 billion, $56 billion of variable account, recognize that only $26 billion of that if you will roughly have is... has a guarantee of cash to it.

And we benefit not only from that age of our business and the fact that much of it does not carry guarantees, but also we benefit from the defined contribution business which is quite old, quite stable and without guarantee. In my understanding of VA Carbom and C3 phase II is that those mix of business issues will tend to allow Lincoln dampen some of the impact that compares to a player that may be solely in VA would guarantee that its driving their license.

Thomas Gallagher - Credit Suisse

Understood, thank you.

Operator

And moving on to our next question that will come from Darin Arita with Deutsche Bank.

Darin Arita - Deutsche Bank

Thank you. Just wanted to go back to the number, Dennis and Fred, you brought up in terms of the billion dollar... $1 billion hedge target. Is that the amount of claims you'd expect on a present value basis. Is that what I understood?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

That's correct.

Darin Arita - Deutsche Bank

And what are the assumptions behind that and in particular, the benefit utilization rates and market appreciation assumptions.

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

There are a number of assumptions benefit in that calculation and in fact those assumptions tend to mirror the same assumptions that use when you are pricing out the products. So, it has positive where the behavior aspects to and how that would influence the potential for paying claims or not. Has of course capital market input involved in it. It has persistency related inputs involved in that calculation. Very, very importantly, it has product design assumptions involved in it. So in other words, what source of things have you done on the product side such as investment restrictions or therefore that impact to likelihood of paying claims. So it ends up being how all of those things incorporated and to then present valuing the likelihood of potential claims out into the future.

Darin Arita - Deutsche Bank

I know it's a pretty dynamic equation there but could you share some other number there in terms of utilization rates in market appreciation?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

We have historically talked about utilization rates, we have talked about basically the take rate that is how many of these things we sell, are they actually taking the guarantee. Then out of that how many of them are taking any level of income and how many individuals are taking the maximum income they can take and those are the parameters that we look at.

And I believe all of those parameters are... first of all the take rates are sort of are much higher that is as we have gone over the last several quarters more and more of the products have sold with the guarantee. But the underwriting... underlying utilization of the guarantees; those dynamics have not changed materially really over the last several quarters. And that's in fact the kind of policy or the behavior that we are paying very close attention to when we go to these markets, when we say we haven't seen as of the end of the third quarter and you found very unusual activity.

Something also worth noting on the topic of assumption is of course we try to input where we can provisions for adverse deviation if you will or cushions involved in some of the issues and what we are finding and continue to find is that while some of the capital market import... inputs our outside of our long-term expectations as you might well understand, the policyholder behavior assumptions that are embedded in the calculation, we tend to be better doing better than assumptions which helps to offset or soften some of the capital market input.

Darin Arita - Deutsche Bank

Okay. That's helpful. Can we turn to the debt benefits, and can you help me understand what happened in the income statement for annuity; is there a couple of pieces that were moving around?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

Yes, a couple of comments I would make on it. First of all understand that when there is more in the money-ness, if you will, of the difference between the debt benefit, guarantee minimal debt benefit due to account values being down, you will naturally suffer more mortality expense and you will see some of that running through and that will result in things like some associated negative back unlocking with it as well depending on if its outstripping what your long-term assumptions would be for if you see a bit of that sort of weighing down the results.

The other thing you see is that we have -- you will see a jump in the operating earnings component of the realized gain and loss and that jump is really the effect of the hedge assets if you will offset by an equally large jump in the benefits line item, which is the benefit ratio unlocking associated with the debt benefit.

So, those offset each other effectively when looking at the bottom line P&L. I don't know if that's the noise if you will in moving parts that you're looking at.

Darin Arita - Deutsche Bank

Right. But were they offset more or less one for one there, this quarter?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

You've got pre-imposed DAC issues and I don't know that goes as far as call one for one but highly correlated.

Darin Arita - Deutsche Bank

And if we think about the fourth quarter if the market ended at these levels, should we expect this sort of movement as well?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

I think if the markets remain low and you're in the money ness remains where it has, you'll see this elevated level of debt claims for a period of time, that would make sense to me. These are not items that move the total P&L for our variable immunity or immunity business particularly in a particularly large weight but it would weigh down on it.

One of the other headwinds you face in down market conditions.

Darin Arita - Deutsche Bank

Great, thank you.

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

Yes.

Operator

And ladies and gentlemen at this time we have time for one additional question, we will take that from Richard Wagner with Citadel Investment.

Daniel Johnson - Citadel Investment

Great thank you very much, it's Dan Johnson. Let's see, let's talk a bit about the DAC going back up on the balance sheet. I understand the accounting concepts on the realized, unrealized gains. Is there a limit to the amount of DAC that can be put back up on the balance sheet and what sort of test do we use to test that limit?

Dennis R. Glass - President and Chief Executive Officer

Well, I'm not quite sure of the direction of your question. What I would say is this is that our DAC buildup if you will is governed by our DAC policies, and that is paying particularly close attention to what we DAC and what we don't DAC and we tend to be... we believe we are conservative in tracking other volume related type expenses beyond commissions and so forth. I'm not sure if you're talking about this if what you're talking about this. If what you are talking about is retrospective and prospective on locking and that DAC being unlocked positively and negatively, that is...

Daniel Johnson - Citadel Investment

No, really I'm going in to...that of most life companies when they generate real... let's just say, unrealized losses, keep it simple. Is that a meaningful part of the unrealized loss gets moved from one asset meaning an investment to another asset called DAC and is there a limit to and I want to say that in couple of $100 million, I think in the quarter it was added up on the DAC balance, I just don't have that page in front of me?

Frederick J. Crawford - Senior Vice President and Chief Financial Officer

You know what I would recommend... just before we kind of get mired into this level of detail, what I would recommend is that maybe we take this off line and we can kind of with the statement in front of us walk you through that that question. If it's a valid question, I'm not suggesting it's not, but I think it's better handled off-line if we could.

Daniel Johnson - Citadel Investment

Okay great. Then I'll just jump to the other one. And that's in terms of the DAC breakage in a non performance risk, I understand why those are obviously netted together on an accounting point of view and you've been good enough to break them out for us but. But just going forward we shouldn't count on those actually being linked together that the credit markets could become a little more normal and your credit default swap numbers could look something more like history which would reverse the benefits but that doesn't necessarily mean that environment would create a positive hedge breakage. I just want to make sure I'm understanding I think is that hedge breakage is sort of money lost. I know and yeah... that's probably the way I'd put it, would you agree or disagree with that?

Dennis R. Glass - President and Chief Executive Officer

I would you disagree with the first part of your comment being that overtime when markets finally normalize you may have a different movement in the non-performance risk then you would in the liability. And what I commented coming on earlier and this tends to be almost the truism in capital markets is that when in a four and five standard deviations away from the mean type tail event you'll see a lot of thing more heavenly correlate and we're finding the extreme jumps in the liability be offset or more than offset by the extreme jumps in this particular assumption as a result.

What I wouldn't agree with is this idea that the brakeage is going to outright result in a loss because remember I've made a conscious decision to balance the issue of mark to market related issues on the GAAP net income and the long-term viability of these assets to pay out claims. So I'm going to absorb a level of breakage consciously realizing that as time goes forward and volatility and other capital markets assumption comes down, that liability will fall faster than the asset falls and thus closing some of that GAAP overtime.

Daniel Johnson - Citadel Investment

Understood. And finally with the realized gains or losses I guess in the quarter on a GAAP basis, what was the similar realized gains on a stat basis?

Dennis R. Glass - President and Chief Executive Officer

The way to think about it is your... the portion of... the $406 million I think it is of realized losses and impairments. Of that I said $43 million of it is really items that we move to the intent less list [ph] and that amount you tend not to take as statutory hit on. The other security that you take to the stat accounting, you will take the impairment to it and the only difference in the two is that there could be tax differences in a way it's done.

Daniel Johnson - Citadel Investment

So if we look it on... ignoring the tax, I'm confused, is that most of it went to the stat line as well or just a little bit went to the stat line?

Dennis R. Glass - President and Chief Executive Officer

Most of it went to the stat line. We also had I think probably an additional true-up for certain class of securities that have been deemed impaired for stat and we've taken that action. So you may see a little bit of separation between GAAP and stat on that.

Daniel Johnson - Citadel Investment

Understood. Thanks for holding me, call open for so long.

Dennis R. Glass - President and Chief Executive Officer

You should also note... that's okay. And you should also know all of my comments about third quarter RBC of course is incorporating this notion of forecasting the drop down if you will of the realized losses and impairments through the stat line.

Daniel Johnson - Citadel Investment

Great, thanks again.

Dennis R. Glass - President and Chief Executive Officer

Yes.

Operator

Ladies and gentlemen unfortunately we have no time to take any further questions. I would like to turn the conference back over to Mr. Jim Sjoreen for any additional or closing remarks.

Jim Sjoreen - Vice President of Investor Relations

Thank you operator. And we would like to thank everybody for joining us on the call this morning and for your patience as we work through some very good questions.

As always, we will take your questions on our Investor Relations line at 1-800-237-2920 or via e-mail at www.investorrelations@lfg.com. Also, as a reminder, we will be hosting our annual conference for investors and bankers on Wednesday, November 19th, in Philadelphia and it will also be available via webcast. Please contact Investor Relations for information.

Again, thank you for your participation today and have a good day.

Operator

Once again ladies and gentlemen, that does concludes today's conference. We'd like to thank you for your participation and have a wonderful day. .

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