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Lincoln National (NYSE:LNC)

Q4 2012 Earnings Call

February 07, 2013 9:00 am ET

Executives

Jim Sjoreen - Executive Officer of Investor Relations

Dennis R. Glass - Chief Executive Officer, President, Director, Chairman of Committee On Corporate Action and Member of Executive Committee

Randal J. Freitag - Chief Financial Officer and Executive Vice President

Analysts

Randy Binner - FBR Capital Markets & Co., Research Division

John A. Hall - Wells Fargo Securities, LLC, Research Division

Steven D. Schwartz - Raymond James & Associates, Inc., Research Division

Suneet L. Kamath - UBS Investment Bank, Research Division

Christopher Giovanni - Goldman Sachs Group Inc., Research Division

Jamminder S. Bhullar - JP Morgan Chase & Co, Research Division

John M. Nadel - Sterne Agee & Leach Inc., Research Division

Ryan Krueger - Dowling & Partners Securities, LLC

A. Mark Finkelstein - Evercore Partners Inc., Research Division

Thomas G. Gallagher - Crédit Suisse AG, Research Division

Joanne A. Smith - Scotiabank Global Banking and Markets, Research Division

Operator

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

Jim Sjoreen

Thank you, operator, and good morning to all, and welcome to Lincoln Financial's fourth quarter earnings call.

Before we begin, I have an important reminder. Any comments made during the call regarding future expectations, trends and market conditions, including comments about liquidity and capital resources, premiums, 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 the soon to be filed 10-K.

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

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

With that, I would now like to turn the call over to Dennis.

Dennis R. Glass

Thank you, Jim, and good morning, everyone. As you've already seen, we had a strong fourth quarter contributing to a very good year. Operating earnings per share was up 13%, operating return on equity was 12% and book value per share growth was up 15%. Recapping for a moment some of the actions and strategies implemented in 2012 that contributed to the strong results for the year: Reshaping and repricing products combined with our agile and capable distribution system allowed us to pivot away from low-return products and transition to higher return products; we introduced new solutions that have bolstered our overall product offerings to better meet customer needs; we repurchased almost $500 million in shares for the full year and effective use of capital given the current stock price; our strategic investments in technology and distribution, notably in Retirement Plan Services and Group Protection, laid the foundation for ongoing organic growth.

Let me now share results from our underlying businesses. Individual Life had a very good year, offering new solutions and executing on the pivot strategy to shift the sales mix. Pivot strategy gained momentum throughout the year and fourth quarter sales reached the same level as last year's fourth quarter, an excellent result. The sales mix reflected the successful transition to solutions that not only meet customer needs but also achieve higher returns in a low-rate environment. Our pivot products include variable UL, indexed UL and term insurance. Collectively, these products represented about half of our Life sales in 2012 and almost 2/3 of our sales in the fourth quarter. [indiscernible] through our early implementers of pricing changes in the GUL space, which accounted for just 23% of 2012 sales, down from 40% a year ago. We are seeing more companies now taking similar action and we will continue to take the steps necessary to improve the risk return profiles of our offerings.

Further enhancements to our Life portfolio will include the first quarter launch of an innovative Indexed Universal Life solution, as well as the repricing and relaunching of Term products.

Our Annuity business also had a very good year with distribution product and an effective hedge program contributing to our strong results. Annuity deposits of $11.6 billion drove positive net flows of $2.5 billion. Account values of $97 billion were up 13% from the year-ago quarter.

On the product side, our Protected Strategies, which we introduced in late 2011, accounted for more than 75% of the $3 billion in fourth quarter variable Annuity deposits. In addition, as of the end of the year, 11% of separate account funds were in Protected Strategy funds. I have said this before, but these risk-managed funds are good client solutions effectively embedding volatility management inside accounts and lowering our hedging costs.

During the quarter, we expanded our Protected offerings and made changes to our variable and fixed indexed products that will improve margins as we move through 2013. We remain pleased with our approach to the Annuity business. As we look at the market, there is a lot of activity on the supply side. We view this as an opportunity to improve returns rather than capture more market share. We will maintain our consistent presence in the Annuity space selling solutions that help Lincoln continue to achieve its strong results.

Turning to Group Protection. Full-year sales were approximately $460 million. Our sales remain driven by the strategic actions we are taking in this business, including adding Group reps, which enables us to add and effectively serve more brokers. Full-year net premium growth of 9% was about half attributable to net sales growth and the balance to in-force premium growth, which includes renewal pricing and in plan premium growth derived mostly from our clients adding employees. Our strategic investment in the Group business will continue with a focus on talent, technology and distribution. We are investing, for the long-term, in areas that offer high growth potential in the Group space, including businesses with fewer than 1,000 employees and the voluntary market.

As in our other businesses, we see opportunities for price increases during 2013. Our expectation is that all of the steps we are taking will lead to significant profitable growth in this business 2 to 3 years from now.

In Retirement Plan Services, our results continue to benefit from strong sales and positive net flows. The 12% growth in account balances for the year was aided by the combination of market appreciation, solid retention across all markets and record deposits in the small-case market, where first-year sales were up 66%. 66% was related to a new product introduction and seasoning of our expanded wholesaler force. Total deposits for the year were up 15%. Net flows for 2012 were approximately $1 billion, almost doubling the amount we saw last year. Investments we are making in RPS, notably to enhance our recordkeeping platform and to expand wholesale distribution, helped us increase deposits and net flows. We will continue to take strategic steps in this business that yield both near-term returns and long-term growth.

Turning to distribution. Our retail, wholesale and work-site teams continue to deliver outstanding results. All 3 systems are key strengths for Lincoln. Central to our advantage is the depth and breadth of the strategic partnership we have with advisors, agents, brokers and consultants. Approximately 65,000 producers chose to sell Lincoln Solutions last year. Distribution effectiveness has also enabled us to consistently sell products on our terms as evidenced by our pivot strategy in Life, Protected Strategy in Annuities and by accelerated sales growth in RPS and Group. We ended the year with 8,300 advisors affiliated through LFN, more than 600 wholesalers in LFD and 500 representatives within our work-site teams. We will continue to tap into these powerful resources, which are important pieces of how we run our businesses, how we create value for Lincoln and how we continue to deliver a distinct client experience.

Spending a minute on the investments. Our net unrealized gain in our investment portfolio has increased to $9.4 billion or 13% of assets. We continue to have a record level of net unrealized gains, the amount reflecting the long duration of our invested assets, which is driven by our asset liability management practices. We also continue to pursue incremental yield opportunities that provide attractive risk-adjusted returns such as expanding our sourcing for private placements, taking advantage of additional supply in middle-market loans and improving the overall strategy and commitment to our alternatives hedge fund and private equity program.

To date, we have put approximately $600 million to work in these opportunities with an expected incremental net yield of greater than 200 basis points over investment grade corporates. We do remain cautiously optimistic that macroeconomic conditions are improving and we are taking prudent, proactive investment actions to meet all of our goals.

Let me close my comments today by looking ahead. Lincoln will build on its strong performance in 2012 by continuing to expand and deliver on the core strategies in place for our 4 lines of business. We'll keep investing in these areas with an emphasis on greater organic growth in Retirement Plan Services and Group Protection. We will also maintain our focus on new business returns across all business lines, just as we did in 2012 by reshaping and repricing our solutions when needed. Underpinning and driving all of this will be a powerful distribution franchise, one that enables us to deliver to clients the solutions that are best suited to their diverse financial needs.

With that, I will turn the call over to Randy.

Randal J. Freitag

Thank you, Dennis. Last night, we reported income from operations of $310 million or $1.10 per share for the fourth quarter, up 21% from 2011. The quarter's earnings serve as a high-quality ending to 2012, which saw full-year EPS of $4.47, up 13% from the previous year. Return on equity of 11.2% for the fourth quarter and 12% for the full year were both up from the comparable periods of 2011, continuing a pattern of steady improvement, while book value per share excluding AOCI was up 15% for the year. We also saw strong top line performance as operating revenue increased 8.5% for the quarter and 4.9% for the full year, as growth across the businesses offset the drag on investment income caused by low interest rates.

Normalized expense growth came in at 4% to 5%. Reported growth of 14.5% in expenses was due to a number of items, including: investments made across the company focused in the Group and Retirement businesses; strong production at the end of the year that drove increases in some non-deferrable expenses; an additional $6 million accrual for the restructuring launched in the third quarter, that I discussed on last quarter's call; and the reimbursement on a previously-settled legal case that lowered 2011 expenses by $11 million.

The quarter's results included a few items that on a net basis benefited consolidated earnings by $8 million or $0.03 per share, which I'll cover in the respective sections.

Also note that net income of $320 million for the quarter and $1.3 billion for the full year both exceeded operating income. I believe that speaks to the overall quality of our earnings and our balance sheet. All in, it was a great year from a top and bottom line standpoint that positions us nicely as we move into 2013.

Before I turn to discussing business results, let me discuss an adjustment to our prior-period results that we undertook in the quarter. Review of our tax accounting, primarily how we were accounting for affordable housing tax credits, led us to lower 2010 and 2011 earnings by approximately $3 million per quarter while increasing 2012 earnings by $20 million, while equity at the beginning of 2010 was reduced by $113 million.

Going forward, I expect the quarterly impact to be about negative $3 million, which is fully reflected in our fourth quarter results. Our stat supp provides detail on the few line items that were impacted and the Form 10-K will provide some additional information.

Turning to segment results and starting with Annuities. Reported earnings for the quarter were $162 million or $154 million normalized. Revenues increased nearly 11% from the fourth quarter of 2011, primarily on higher fees driven by a 12% increase in average account values. Interest spreads continued to perform nicely in the Annuity business. As a reminder, we expect little economic spread compression in the Annuity business as we continue to be in a position to manage in-force Annuity spreads. Returns in the Annuity business continue to be very strong with ROE coming in at 21.2% for the quarter and 19.5% for the year. The hedge program had excellent performance in both the quarter and for the year as the hedge liability tracked very closely with the hedge assets for both periods. Hedge assets exceeded the hedge target by $760 million at the end of the year.

In Retirement Plan Services, we reported earnings of $28 million or $32 million on a normalized basis. Revenue growth of 5% was held back by lower investment income. However, average account values were up 12% driven by a combination of market appreciation, strong deposits and net flows. Interest spreads came down 7 basis points from the third quarter, at the high end of our guidance. Spreads can be influenced by the timing and magnitude of cash flows, but in general with interest rates at their current level, we expect spreads to decline by 20 to 25 basis points on an annual basis in the Retirement business. Normalized ROA in Retirement of 29 basis points has been negatively impacted by the interest-rate environment. As we look forward, while we may see some modest erosion in this measure, I would expect that the rate of decline should slow, as strong net flows continue to fuel account value growth. Ultimately I see the Retirement business returning 25 to 30 basis points from a ROA standpoint.

Turning to our Life Insurance segment. Earnings of $147 million or $138 million normalized remained relatively stable compared to prior quarters after giving effect for notable items. Our earnings drivers performed as expected during the quarter, with average account balances up 6% and Life Insurance in-force up 2% quarter-over-quarter. Interest spreads continue to perform in the Life business coming in at 203 basis points for the quarter. Looking forward, I continue to see 10 to 15 basis points of annual spread compression in Life Insurance.

Group Protection earned $13 million for the fourth quarter -- below our expectations. There's a way of understanding what you should expect in the Group business. I think it's best to focus on everything that went on in 2012. For 2012, we earned $72 million with the year impacted by 3 main themes.

Life mortality, which negatively impacted 2012 by approximately $7 million. After analyzing the year's mortality experience, which during the fourth quarter was very strong, we do expect 2013 to return to historical levels.

Elevated loss ratios in the Disability business that impacted 2012 by approximately $20 million. The increase in loss ratio has been driven by an increase in severity focused in our higher salary bands. We've been tracking this issue for a time and have started to reflect it in pricing in the last half of the year. But while we should see Disability results improve as we move forward, I believe that it will be 12 to 24 months before we fully put this issue behind us.

And lastly, continuing investments in distribution and technology that will continue in 2013. As we see things today, and when we wrap all of these items together, we expect to see a recovery in earnings to the $80 million to $90 million range in 2013 for the Group business.

Before moving to Q&A, let me do an overview of 2012 and what I see as we move forward. 2012 was a year of active capital management focused on improving performance. Highlights include $1 billion of capital upstream to the holding company, which allowed us to deploy over $500 million in 2012, largely in share buybacks, while still holding $700 million of cash at the holding company at the end of 2012. Looking forward, we enter 2013 expecting to upstream $800 million to the holding company, which should allow us to deploy $400 million with the majority going into share buybacks. Life company capital of $7.6 billion and an RBC ratio of approximately 490% both came right in line with expectations. RBC came down approximately 15 percentage points this year as we manage down our excess RBC position. A 50% increase in our shareholder dividend of $0.48 per share on an annual basis, early pricing actions in the Life Insurance business that both helped returns and freed up capital to deploy elsewhere, disciplined pricing actions in the Annuity business as we reported our third straight year of ROEs in excess of 19% in this business, a third-quarter assumption unlocking process that saw us adjust both policyholder behavior and our long-term earned rate assumption but essentially no financial impact, a fourth quarter goodwill review that validated our current balances and actions including a restructuring that took approximately $30 million out of annual expense, crediting rate cuts, prudent actions in the investment portfolio and strong share repurchases that when looked at in total allowed us to mitigate much of the negative impact caused by the interest rate environment in 2012.

Taken all together, it is safe to say that 2012 was a year of excellent financial performance that exceeded the investment community's expectations for the year, but was consistent with our view on the strength of our franchise. With that, let me turn the call over to the operator for questions.

Question-and-Answer Session

Operator

[Operator Instructions] The first question is from Randy Binner of FBR.

Randy Binner - FBR Capital Markets & Co., Research Division

Hard to know where to start, but I guess I'll address the lack of the goodwill charge. Just wondering if you could give any color on kind of how that process worked in determining the fair value versus the carrying value and if it's still the same kind of evaluation of new business and value of business in-force? But any color on the lack of development there would be helpful.

Dennis R. Glass

Yes, Randy. As always, every year, we do a real thorough analysis on goodwill. It includes both internal and external resources. We bring in a lot of opinions into the process. And last year when we did that analysis, that led us to impairment of $750 million. I think what I said coming out of that, that I felt really good about the goodwill balance. And when we did the analysis this year, it led to no impairment. I feel real good about those results and we'll provide some more details in the 10-K. But outside of that, we feel real good about where we ended up.

Operator

The next question is from John Hall of Wells Fargo Securities.

John A. Hall - Wells Fargo Securities, LLC, Research Division

I was going to ask a question about the variable Annuities. And Dennis, you mentioned, I guess, managing the process of not getting too much market share, which based on the competitive environment out there, there could be a fair amount of market share available. How do you do that?

Dennis R. Glass

Well, first let me say, I'll repeat what I said in my remarks, John, we repriced in December and we've already seen a decline in AB count as a result of that repricing. We do expect growth but not outsize growth in 2013. I'd also point out that 5 years running, we have maintained the same market share and we prefer to modulate demand by pricing adjustments. I don't like to take artificial actions like pulling a hot product for a short process, for a short period. And so, if somebody does something like that or somebody changes their supply in the marketplace and we start getting a little bit more share, we'll move our pricing up. So in a quarter, you could see some adjustments for increased market share because of actions other people have taken. But we've been very successful. Again, I'll repeat it, our market share has been consistent at 5 for the last 5 or 6 years despite the fact that number 1, 2, 3 and 4, some of them aren't in the market anymore, some of them have moved around. So pricing adjustments is the way we want to modulate demand or -- excuse me, temper demand. And as to supply in the marketplace, actually it's not as clear to me that it's going to decrease. I think that was the point of your question. There's actually a lot of people who are coming back into the market. So we'll have to see what the supply-demand situation is in 2013. I'd also comment, you didn't ask this question, but I think it's very encouraging to see smart money coming back into the variable Annuity space. We've seen some acquisitions of blocks and some reinsurance transactions, one just announced yesterday, which I think are -- well, not I think, but the people who are doing this are pretty smart people. And so I think that will be helpful to people better understanding this marketplace over time.

John A. Hall - Wells Fargo Securities, LLC, Research Division

Great. And then I just have a second question on leverage. Your debt capital ratio for the supplement is now below 20%. Is there a thought process around leverage, capital management, buybacks that you could talk about?

Randal J. Freitag

Yes, John, this is Randy. I think as I said in my comments, we expect to continue as we come into the year to deploy roughly $400 million of capital with the majority of that going into buyback, share buybacks. I do expect that when given the opportunity, we may do some modest amount of deleveraging. We feel pretty good about where we are from a leverage standpoint, but we'll continue to allocate small amounts. To give you an example, I think early in 2014, we have $500 million of debt coming due or so. So that's really the next big opportunity we would have to do anything. But for the near term, over the next year, I'd say most of the capital will be allocated to share buybacks.

Operator

The next question is from Steven Schwartz of Raymond James.

Steven D. Schwartz - Raymond James & Associates, Inc., Research Division

Just a follow-up on the VA discussion. Dennis, could you give us the parameters of what you did in December?

Dennis R. Glass

Yes. We lowered the payouts on age bands under 65 so that the income benefit on the withdrawal product is lower than it was in the past. And I believe we dropped 50 basis points on those age bands.

Steven D. Schwartz - Raymond James & Associates, Inc., Research Division

Okay. And then if I could, I guess, follow-up on the goodwill issue. I believe in the fourth quarter you also do your asset adequacy testing, Randy. I was wondering how that came out?

Randal J. Freitag

Yes. We're still going through the work. But I continue to be very encouraged. And I think the guidance that I've given in the past, is that I expect no increase in in-force reserves and I continue to have that same opinion. We do anticipate that with the new AG 38 you'll see an increase on new business reserves and -- but we had anticipated some of that in our pricing of our GUL product. I think that's probably one of the reasons we were so far off the marketplace in 2012.

Steven D. Schwartz - Raymond James & Associates, Inc., Research Division

Okay. And then just on employee benefits -- this is kind of off-the-wall. But the EBSA recently put out an FAQ where it addressed some indemnity products sold through a -- sold through on a Group platform. And whether or not those products would be ACAA exempt. I'm wondering if you're familiar with that and have any thoughts about it if it might affect you?

Dennis R. Glass

I think we'll have to dig into that a little bit. We'll be glad to get back to you on the answer. Steven, just one other quick point in the VA space, we also lowered commissions, so that'll help temper down demand.

Operator

The next question is from Suneet Kamath of UBS.

Suneet L. Kamath - UBS Investment Bank, Research Division

Just a first question on capital. Just in terms of your prepared remarks, Randy, I think at the end, I missed what you said about share repurchase. It sounded like maybe you were guiding us to $400 million of dividends or free cash flow and then -- and some of that would be used for buyback. Is that what you had said?

Randal J. Freitag

Yes. I'll just walk you through the math. I expect to upstream to the holding company $800 million in 2013. From that $800 million, we have interest expense and other uses at the holding company of roughly $250 million, $260 million. And then we have our shareholder dividends that will be roughly $130 million. So at $400 million between debt interest expense and shareholder dividends, that will leave us $400 million for other capital deployment with the majority of that $400 million going into share buybacks.

Suneet L. Kamath - UBS Investment Bank, Research Division

Got it. And is the dividend, I think it's lower -- the expectation it's going to be lower in '13 versus '12. Is that because of the -- to Dennis' comments about the sales level in the Life business sort of being in line fourth quarter of '12 versus fourth quarter of '11? And so, that's creating some strain?

Randal J. Freitag

No. I don't really anticipate a lot of incremental strain from the Life business as we move into 2013. I think it has more just to do with the fact that we had a very good 2012 from a capital generation standpoint. And so, we continue to have very strong performance from the RBC denominator, for instance. So going forward, I expect $800 million, which is sort of what I expect coming into any given year. We just outperformed a little bit this year.

Suneet L. Kamath - UBS Investment Bank, Research Division

Got it. And then just lastly, on the RBC ratio, if you were to include -- I'm assuming that's just for your primary writing entities combined. So if you were to include your offshore captives into that calculation, how much would the RBC change, if at all?

Randal J. Freitag

Yes, it's really -- I'll break it up into 2 components. You have the onshore captives, which are fully capitalized just like any Life Insurance company. And our RBC ratio is very comparable, if not a little above the main insurance entities. Then you have the offshore captive where you have primarily the hedge program. I talked about the amount of hedge assets in excess of our liability, so that entity remains very well capitalized from that standpoint. Where if you were to fold all of those entities back in, you would actually see an increase in the RBC ratio.

Operator

The next question is from Chris Giovanni of Goldman Sachs.

Christopher Giovanni - Goldman Sachs Group Inc., Research Division

Dennis, I wanted to follow up on your comment about the transactions we've seen in the VA space, so if you could expand a little bit on that? And curious if there's a role that you think Lincoln can play within the consolidation?

Dennis R. Glass

Chris, it was a very general comment, which is you haven't seen private equity money or a big insurance company like Berkshire Hathaway, which is public knowledge, come into the market in an announcement yesterday in a reinsurance transaction. So generally speaking, I think when you see smart money moving into a market, there's opportunity. And I think insofar as Lincoln is concerned, we're getting 19% to 20% returns on this business. We're doing it the right way, as we've said. So I don't see any specific implications for us, just a general observation that when money starts moving into a marketplace, that's generally a good sign in terms of the economics of the business.

Christopher Giovanni - Goldman Sachs Group Inc., Research Division

Okay. And then in terms of those 19% to 20% returns that you're generating, there is the carrier kind of retrenchment that we can debate whether that's occurring or not. But you made the comment around a focus for improving returns versus growing volumes. So can you comment what is kind of the targeted returns you're shooting for now with the new product? And if we're generating 20%, why shouldn't we be comfortable with you guys maybe gaining a bit of market share here as we move into 2013?

Dennis R. Glass

Again, I guess I'd come back to -- our market intelligence suggests that there's as many companies wanting to come back into the marketplace. So anecdotally, some people saying, some producers saying double the business that they've been doing in the previous year. So some players are going out, some players are coming in. But I'll fall back to what I said, we haven't -- the fourth quarter was a little bit different because people pulled out of the market and we got some of that share. But we've been very effective in keeping demand or sales at the levels that we're comfortable with, by changing pricing or reducing commissions, as I've said. So that you can't turn it on and turn it off in a particular quarter. But over time, we can do that.

Christopher Giovanni - Goldman Sachs Group Inc., Research Division

Okay. And then just the targeted returns on the new product?

Dennis R. Glass

Yes, we're still in that high-teens range. And when we have strong markets, as you saw, the returns might show up a little bit better on the GAAP balance sheets.

Operator

The next question is from Jimmy Bhullar of JPMorgan.

Jamminder S. Bhullar - JP Morgan Chase & Co, Research Division

I had a question first on your Disability business, and I think you mentioned that -- and you were seeing some higher severity. But I was wondering how much of the problem is potentially just underpricing in the past few years? And you are in the process of repricing the block and just some details on how much you've repriced already and by when do you expect it to be fully priced? I'm assuming there, most of the book has 2- to 3-year guarantees? And then on Variable Annuities, even if you maintain the same market share, yours -- flows are positives so the business is growing and it's actually growing faster than some of your other businesses. So at what point would you say that it's just too big of a part of your business mix given the nature of this product even if the returns are good or -- and are you at that point already because it's -- that's I would argue one of the main things that's been weighing on your valuation and one of the main reasons you're not trading at a multiple that you should trade at is purely on your ROEs?

Dennis R. Glass

So let me speak to the Group question first. As you would expect, all of us in the Group business have very precise analysis of where the claim increase or -- excuse me, where the -- what's causing the increases in the claim ratios. So what's caused it at Lincoln over the past -- in this year, is an unusual cell and that is, we're seeing a little bit more increase in loss ratio related to severity. And the severity is related to the fact that more people in the 8 -- excuse me, in the salary band, over $56,000, are putting in claims. The point is that there's nothing coming specifically from the new business or the old block that's too different. It's just we're seeing something that we've never seen before. So to answer your question, and that might be related to just the post-crises and the long-term higher unemployment. It's hard to figure out. Other carriers are having that same result. So a way to resolve that is to increase prices. We did do that last year and we think the market is going to receive or be such that we could increase prices again. And I think the timing of the recovering earnings is what Randy's related to. So very specific severity issue where we haven't seen it before and over time, we'll cover that with pricing if it persists. With respect to VA, at the level of sales and that we're getting right now and the proportion of earnings that we have, we're not uncomfortable. And as I've said, we're going to modulate our sales through pricing increases so I don't expect that we will see dramatic moves in Group -- excuse me, in the earnings coming from our Annuity business over the foreseeable future. Now let me also add that I think sometimes people look at the Annuity earnings and think all Variable Annuity earnings. I'd like to remind you that included, and we don't publish it this way, but there's a lot of fixed Annuity earnings in that segment. So when you look at just Variable Annuity earnings, it's significantly smaller than what you see in our reported results for the same -- for the whole line. And maybe we'll, in the next analyst presentation, we'll break that out a little bit more.

Operator

The next question is from John Nadel of Sterne Agee.

John M. Nadel - Sterne Agee & Leach Inc., Research Division

I just wanted to revisit. Randy, could you just remind us, it sounds like $700 million holding company sort of ongoing cash position or buffer cushion, or whatever you want to call it, is about right? Is that accurate?

Randal J. Freitag

Yes, John. Our target is $500 million so we ended up the year a little above our target.

John M. Nadel - Sterne Agee & Leach Inc., Research Division

Okay. And then a second question is just any outlook or any -- what does the outlook look like for potential reserve financings?

Randal J. Freitag

I think entering any given year, we expect to generate roughly $200 million from reserve financings. We did that again in 2012. We did a little more than that in 2011, if you remember. So I come into the year expecting to do a couple hundred million dollars again and the marketplace looks very amenable to that sort of level.

John M. Nadel - Sterne Agee & Leach Inc., Research Division

And is that included as part of the $800 million or would that be separate?

Randal J. Freitag

Yes, that's all part of the $800 million of cash going to the holding company.

John M. Nadel - Sterne Agee & Leach Inc., Research Division

Okay. Last question is just on DAC, specifically around the VA business. Given continued market strengths, it seems like that cushion that has built up reflecting the reset that you did on equity markets back in, I don't recall if it's exactly late '08 or early '09, but it seems like that cushion, that buffer is probably getting pretty significant. Is there any expectation for actually a favorable unlocking around equity market assumptions?

Randal J. Freitag

Of course, we look at those things, primarily during the big third quarter on lock interviews [ph] . But I think we're still very comfortably within our range. We ended the year with a couple hundred million dollars of cushion on a pretax basis. So we're still comfortably within our range.

Operator

The next question is from Ryan Krueger of Dowling & Partners.

Ryan Krueger - Dowling & Partners Securities, LLC

First question is do you guys expect any impact from the change in Dodd-Frank collateral requirements on derivatives set to go in place in 2013?

Dennis R. Glass

You broke up a little bit on that. Could you repeat the question, please?

Ryan Krueger - Dowling & Partners Securities, LLC

Sorry about that. We're just wondering if you expected any impact from the change in collateral posting requirements on derivatives that Dodd-Frank requires in 2013?

Dennis R. Glass

Ryan, no, no appreciable impact with the implementation of the Dodd-Frank rules as we understand them around the initial margin requirements, so nothing of note that I would point out.

Ryan Krueger - Dowling & Partners Securities, LLC

Okay. And then you gave a bunch of segment expectations. But just in total, is the prior guidance for a $65 million headwind from low interest rates on earnings still a good guide for '13?

Dennis R. Glass

Yes, Ryan. No update to that guidance at this time. I think that guidance was given with the 10-year a little lower than it is today. So that would have an effect. I don't have an update for the number right now. I would note that we've had an extended period now where we've been beating the Street by a little bit. And I think one of the things is that, that's a gross number that I think people are modeling. And what's not getting fully reflected I think is that there are a number of actions that we take as a company outside of that, that handwit [ph] of interest rates like expense initiatives, like some prudent things we've done in the investment portfolio, like the strong capital management that we've been able to do that are offsetting some of that negative impact. So I would just point that out for you.

Ryan Krueger - Dowling & Partners Securities, LLC

All right. And then the last one is on statutory cash flow testing. I understand your comment that you don't expect much of an increase in stat reserves from that over the next few years. But I guess I'm -- what I'm curious is, I think you've said after a 5-year period, there could be an impact. I'm wondering what causes it to be cliff-type of event because a lot of your peers have suggested that they would just gradually build statutory reserves because of low interest rates, where I think you differently are suggesting that there wouldn't be any impact but then there would be a larger impact that would occur all at once?

Dennis R. Glass

Well, let's talk about this in total. One, we've said it's $500 million towards the end of the decade and $500 million relative to the size of our company, especially when you move out a decade, is a relatively small number. So I wouldn't describe $500 million as a cliff in any sort of way, more of a bump. And by saying that, I'm not necessarily saying that would all happen at one point out of that point in time. So I don't describe the number or the way the impact may occur as anything that I would describe as a cliff, Ryan.

Ryan Krueger - Dowling & Partners Securities, LLC

All right. So we should just think about it as no impact for a while, and then if rates stay low, there could be some impact over time that could reach $500 million?

Dennis R. Glass

And that's why we spike out this unrealized gain. Now we all know the unrealized gain is because interest rates have gotten lower. But when you relate the size of ours to the general account at 13%, I think if you sort of did that across the industry, you'd see that ours is higher, that is our unrealized gain as a percentage of the general account is probably higher than the majority of our competitors, and naturally so because we have a little -- well, I don't know that for sure. But that $9.5 million -- $9.5 billion is why Randy can be so confident about reserve, confident in our reserve levels for a long period of time.

Operator

The next question is from Mark Finkelstein of Evercore Partners.

A. Mark Finkelstein - Evercore Partners Inc., Research Division

My first question, just back to the VA business. A number of your competitors have taken DAC revisions related to policyholder behavior assumptions, largely around lapse. I'm just curious how your experience is trending relative to the expectations on policyholder behavior and whether there's any issues that you see on the horizon?

Dennis R. Glass

Well, Mark, I'd point out that we went through, in the third quarter, a complete review of all of our policyholder behavior assumptions in the VA business, and the net impact of that was essentially 0. So we adjusted our lapses. We adjusted our utilization. We adjusted all of those assumptions to be consistent with the experience that we've seen over the last 5, 6 years. So experience that reflects the crisis and all the changes in behavior that, that caused. So feel really good about our policyholder behavior assumptions, feel really good that we're able to go through that process with essentially 0 impact, which once again, in the Variable Annuity business, differentiates Lincoln from almost any other company I can think of.

A. Mark Finkelstein - Evercore Partners Inc., Research Division

Okay, that's helpful. And then just back to the Life business, I guess it sounds like you in your comments, and you said this over several quarters, that the pricing largely reflects the implementation of more stringent rules around the reserving for AG 38 into '13. I guess, how meaningful is any further changes that you have to make, number one? And then secondly, as the competition comes down or up towards your pricing, do you expect to see a meaningful ramp up in UL or guaranteed UL production?

Dennis R. Glass

Yes, the -- I was listening. I sort of forgot the first part of the question. But on the second part of the question, pricing has come back on GUL for both periodic pay, as well as short pay. We still don't want short pay business. And so effectively, you can prevent that from coming in by putting some rules into your systems. And so we're not accepting very significant amount of short pay business. I'd also point out that with respect to GUL in general, it's now down to, I don't know, it'll probably even get lower -- it's now down to 23% or 24%, I forget what the number is, of our fourth quarter sales. So it's not as significant an issue for us as it was in the past. And the first part of the question was?

A. Mark Finkelstein - Evercore Partners Inc., Research Division

It was around the pricing. I think what you'd said was that you're largely there in terms of the pricing on AG 38 for '13, and I was just curious what further revisions, if any, you need to make and how meaningful those are to get the pricing appropriate for the new reserving standards?

Dennis R. Glass

Yes. I'm being corrected, the SGUL sales were only 15% of fourth quarter. And we anticipated the increasing reserves associated with the changes in AG 38. And so we took action last year. We price for the overall portfolio in any particular year. We're taking another look at the entire portfolio to see if we need to change prices to increase returns. And as I've said in my closing remarks, we're doing this in each of our businesses. There's a stronger push this year to get higher returns in general on our new proffers. So the AG 38 issue, on a prospective basis, is an issue, but it's one of many, as we look at how we want to price business in 2013.

Operator

The next question is from Tom Gallagher of Credit Suisse.

Thomas G. Gallagher - Crédit Suisse AG, Research Division

Randy, I just wanted to circle back to the cash flow to the holdco and the building blocks of that. The $800 million that you expect to dividend up, I got the $200 million was related to securitizations. Can you just remind me what the components of the $600 million are? Because I know there's a surplus debenture or I believe there is one that funds part of that. And so what would that imply your level of stat earnings for the year that you're expecting?

Randal J. Freitag

Yes. Well, let's talk about this year. We had statutory operating income of high 7s. We're still nailing down the final stat, but the number will come in a little below $800 million. So when you come to the $800 million that goes to the holding company, as you were right to point out, about $100 million of interest, between $80 million and $100 million of interest on some surplus note debentures and the balance comes from the Life companies, including the $200 million that you mentioned from reserve financings. So that's what I expect in total for any given year. Of course, we have increasing capital requirements in our Life companies we continue to grow. And so that reduces your distributable earnings a little bit. But to the answer of statutory earnings, we made roughly $800 million this year. I don't anticipate huge changes in that number next year.

Thomas G. Gallagher - Crédit Suisse AG, Research Division

So Randy, as a good rule of thumb then -- so that would be of your Life earnings, you expect to earn $800 million, retain about $300 million, take about $500 million, then you get $200 million of securitizations and $100 million of surplus debentures. Is that the rough math?

Randal J. Freitag

Yes, I think your math, Tom, was pretty good.

Thomas G. Gallagher - Crédit Suisse AG, Research Division

Okay. And I guess my question, if that all stays the same next year and VA sales momentum remains strong, is that going to -- would that mean you need to hold less to support that growth or do you expect sales to -- the inflows to decelerate so that won't be an issue?

Dennis R. Glass

All of the sales for all of the products next year, Tom, are embedded in that number, sort of that guidance I gave you. And they reflect all of the comments that Dennis has made on what we expect from market share, what we expect from new business returns. So everything is reflected in the numbers I gave you.

Thomas G. Gallagher - Crédit Suisse AG, Research Division

Got it. And then my other question is just on can you give any color on what's going on with use of captives in the industry? Is that something that you anticipate you'll be able to still utilize in the future? Do you think there's going to be restrictions on that, whether that would be just new sales or in-force? Any color you can give would be helpful.

Dennis R. Glass

Look, Tom, this is a pretty -- the issue is being discussed in the industry right now. As a matter of fact, I represented the industry in -- with the commissioners in St. Thomas over the weekend and we talked about this issue. I think it's safe to say that both the regulators and companies in the industry want to make sure that these structures are appropriate. I think we'll find a good answer. But it's very early to say what changes, if any, will be made. But there's a confluence of interest again between the regulators and the industry to make sure that the structures are -- transfer the risk appropriately and the assets are good assets. So I'm reasonably confident we'll come to a good guiebing [ph] -- the regulators and companies come to a good solution here that's good for the industry and good for the companies. But it's hard at this point to give any guidance about what changes, if any, will be made.

Thomas G. Gallagher - Crédit Suisse AG, Research Division

Got it. And Dennis, just my last follow-up. So just as you think about things that are being discussed related to use of captives, is there an outcome that would make you feel differently about either your Annuity or Life Insurance business as a result? Or do you feel like pretty much most -- any plausible outcomes you see wouldn't meaningfully change your view?

Dennis R. Glass

Well, Tom, again not knowing at all how this might evolve and what changes, if any, are made, I can't really comment on if it would affect our businesses. I would say that from Lincoln's standpoint, the large majority of the captive structures that we have on the books have maturities that extend out 15 and 20 years. And so far, no one's talking about anything retroactive. Again, so far no one's talking about anything retroactive. So the large majority of what Lincoln has is in place and doesn't -- it goes out decades in its term. And then we had what Randy's referred to as a small amount each year. So I feel pretty comfortable overall that there's not much that, assuming there is no retroactive look at things, with which no one is talking about to my knowledge, I feel pretty good with the way we've structured our deals, particularly the term of 15 to 20 years on most of them. I'd feel a little bit differently if we had a lot of stuff coming due in the next 12 months. There is some uncertainty, but we're really in good shape. And so, I don't see this. Again, I can't predict what's going to happen. It's very topical. It's an important issue for the regulators. We're engaged as an industry with them. But because of the way we're positioned, it doesn't seem, at the moment, to change anything that we're doing or raise concerns.

Operator

The question is from Joanne Smith of Scotia Capital.

Joanne A. Smith - Scotiabank Global Banking and Markets, Research Division

I just wanted to follow up on the alternatives investment strategy and if you could just elaborate a little bit more on where you're putting money to work and what the opportunities are in that asset class?

Randal J. Freitag

Yes. We -- we're going to commit around $400 million more to our alternatives book, which I think is about $900 million today. We've engaged some very good outside help. We're looking at clear strategies, both at a deal level and an overall portfolio level. And we'll just -- add over time. We're not jumping to this -- into this in a sense that we've got to do $400 million in the next 30 days. We're going to put it out over time and be cautious. More exciting are -- and well, that's exciting, but as interesting to me is having this additional sourcing of private placements. And here, we're going to ask for 30 basis points of yield. We have access to product we didn't have before and the credit quality is similar to what we have on our books today. So there, you get 30 basis points of yield just by adding distribution opportunities. Similarly, in the middle markets, we're adding specific advisors that can help us structure good portfolios. The advisors have very good track records. And all of this over time will add incrementally to yield. And we're pretty excited about and comfortable with the strategy. There is no significant right turn in terms of credit risk or volatility in the overall $80 billion portfolio as we move forward with this program.

Joanne A. Smith - Scotiabank Global Banking and Markets, Research Division

Okay, that's great. And just on the Group Protection business, you had very strong sales there in the quarter, and I was just wondering if you could -- so obviously, the poor Disability experience has been pretty much across the space, and so I'm just wondering what you're seeing from a competitive perspective there and just talk about how you achieved the type of growth in sales that you did?

Dennis R. Glass

Yes. The -- I'm going to connect a couple of thoughts here. But in direct response to your question, the increase in sales comes mostly from the fact that we've expanded our distribution by roughly 8% -- 18% year-over-year, which gives us 2 things, access to -- it gives us more reps, but access to brokers that we haven't used before. So a lot of the growth is coming from new sources of business. And expansion of distribution and additional shelf space is something we do all the time across our businesses. It's the best way to drive growth over the long term. And I want to connect the question about the Annuity earnings growth rate with this strategy. We are willing in the short run because we're investing so heavily in the Group business to take a little bit lower earnings, while overall, Lincoln Financial Group is growing at a good pace. But we expect more growth and more profitable growth and a bigger percentage of earnings 2 to 3 years out coming from the Group business and the DC business. So everything is going well from a growth perspective right now. We want to get these 2 businesses to be a bigger part of our overall earnings mix. But it takes investment to begin to do that organically. And so for a little while here, maybe the earnings mix will shift slightly away from those 2 businesses. But 2 or 3 years out from now, we're expecting it to increase -- those earnings to increase dramatically. It's a very clear strategy on our part to invest and sacrifice short-term earnings in those 2 businesses in order for the benefit of the long-term growth rate of them.

Joanne A. Smith - Scotiabank Global Banking and Markets, Research Division

Dennis, is that -- is there like a fine line in terms of pricing where you make a mistake in terms of sacrificing a bit of profit for the growth? I mean, I just -- seeing these numbers turn on a dime for so many players so quickly in the past?

Dennis R. Glass

Yes, I understand that question, but let me come back to -- we're not talking about getting growth by pricing actions. We're talking about getting growth by investment in technology and investment in distribution. So let me be absolutely clear, there is no strategy to gain market share by aggressive pricing, none whatsoever. Now back to your question about can things turn quickly, in the last decade at Lincoln, we've seen quarters where typically following a recession, where long-term disability rates move very quickly, and then you've got to change your pricing. So that can happen. Our business has a net income margin of 4%. And so, you have some room in the loss ratio and some room in revenue growth, where you're not going to see, for small changes, a movement from profit to loss. But it's a business that has volatility in it.

Operator

There are no further questions at this time. I would like to turn the call back over to Jim Sjoreen for closing remarks.

Jim Sjoreen

Okay. I want to thank, everybody, for joining us this morning. As always, we will take your calls and your emails at Investor Relations. So with that, we're going to conclude the call, and thank you, again, for participating. Have a good day.

Operator

Ladies and gentlemen, this concludes today's conference. You may now disconnect. Good day.

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