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Lincoln National Corporation (NYSE:LNC)

Q2 2010 Earnings Call

July 29, 2010 11:00 am ET

Executives

Jim Sjoreen - VP, IR

Dennis Glass - President and CEO

Fred Crawford - CFO

Analysts

Ed Spehar - Bank of America/Merrill Lynch

Randy Binner - FBR Capital Markets

Nigel Dally - Morgan Stanley

Jimmy Bhullar - JP Morgan

Thomas Gallagher - Credit Suisse

Eric Berg - Barclays Capital

Mark Finkelstein - Macquarie

Colin Devine - Citi

Suneet Kamath - Sanford Bernstein

Operator

Good morning and thank you for joining Lincoln Financial Group's Second Quarter 2010 Earnings Call. 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 the Vice President of Investor Relations, Jim Sjoreen. Please go ahead sir.

Jim Sjoreen

Good morning and welcome to Lincoln Financial's second 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, deposits, expenses, income from operations are forward-looking statements under the Private Securities Litigation Reform Act of 1995.

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

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

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

We would appreciate in the interest of time, that people limit themselves to two questions in order to get as many people on the call today.

I would now like to turn the call over to Dennis.

Dennis Glass

We are very pleased with the quality and diversity of our earnings this quarter and particularly satisfied with the stability and consistency of our operating results, driven by productivity gains, and reach in our distribution organizations and our comprehensive product line up.

Continuing our momentum from recent quarters, our fundamentals were very good. Deposits were up year-over-year in each of our businesses and 10% overall, and total net flows of $2 billion were up 8% year-over-year extending our long and consistent trend of positive net flows in our insurance and retirement businesses.

A focus on distribution relationships and productivity is essential to achieving these performance levels. At Lincoln Financial Distributors, we continue to expand distribution shelf space, adding product at five new firms this quarter.

Each of our top 20 distribution partners offers at least three Lincoln products and half of those firms offer four or more products. Wholesaler productivity is up 13% year-to-date on top of impressive productivity gains made last year.

Lincoln Financial Network continues to attract and retain seasoned advisors, who value our multiple affiliation models. The number of LFN advisors has now reached more than 7,800 and retention of our most productive advisors remains extremely high.

We are enhancing distribution productivity in our defined contribution and group benefit businesses by marrying our high-touch service-oriented worksite models with more efficient enrollment and servicing platforms.

The combination of distribution heft and our comprehensive and innovative suite of products help generate solid sales in each of our businesses. Life insurance experienced modest year-over-year sales growth with high levels of sustainable sales in term life insurance and MoneyGuard are linked benefit UL long-term care product.

MoneyGuard is producing double-digit sales increases and the number of advisors recommending this product to their clients is up more than 50%. Lincoln created the market for these flexible, hybrid solutions more than 20 years ago, and we believe there are compelling option that will continue to gain traction with advisors and consumers. With this kind of advantage, we are confident that Lincoln will continue to lead this market even as competitors begin to enter the space.

We are pleased with progress and deposits inflows in our variable annuities this quarter, and with the strength of our fixed offerings. The individual annuity business continues to benefit from increased reach in the form of 25 new firms carrying our fixed and index products in the past year and our successful strategy of having wholesalers represent the full suite of solutions allowing them to pivot as markets and consumer preferences require.

Defined contribution results were held by strong first year sales in mid to large case 403(b) plans and we are seeing progress in our strategy to more effectively leverage our LFD relationships to support small case for a 1K business.

Group Protection sales trends were positive as well and current sales are driving premium growth rates to 8%. Loss ratios were elevated this quarter. We have seen this occur before. Understand the cycles of the business and know what actions are needed to work through it.

We continue to refine our offerings to around out our product portfolio. With the launch in August of our duration guarantee UL term product to fill the gap between traditional term and life time guarantee UL and which we believe will generate healthy sales in its first year and over time.

Our new accident product for the voluntary market is also slated for August and should also open additional distribution opportunities in our group benefits business.

We maintained our leading market positions in top eight or better sales ranking in each of our core businesses last quarter and increased market share in certain key products, and although the data is not yet available. We expect to see product market share increases in the second quarter as well.

Our financial foundation was strengthened during the quarter with the completion of our broad capital plan. We executed the number of capital actions including raising debt and equity, redeeming the preferred shares issued under the capital purchased program, refinancing outstanding letters of credit and addressing life reserve financing needs.

Life company capital and holding company cash levels remain at historically high levels at the end of the second quarter with an estimated risk based capital ratio of around 500% and more than $800 million in cash at the holding company.

All four major rating agencies have now moved to a stable outlook for Lincoln. Reflecting the success of our capital plan and acknowledging the consistency of our execution and the resilience of our model through the crisis.

Asset quality remains strong in our investment portfolio with growth in our unrealized gain position. As we sit here today, we see no significant areas of credit concern for the balance of the year.

I recognize that the current interest rate environment is on many investors' minds, and lower rates are a concerned for the industry. Fred will cover the impact of lower rate on Lincoln in his remarks.

I personally share the view of many economists, who predict that we will see higher rates within two years due to monitory and fiscal stimulus as well as huge deficit finance needs. Nonetheless, we have and we will take necessary steps to address the interest rate environment.

We are starting the implication of financial reform on our operations and early analysis leads us to believe that there will not be any material impact on Lincoln. We will continue to follow developments and additional rule making over the coming months.

As we execute our strategies for growth ROE expansion continues to be a focus for this management team. The leverage for ROE improvement includes, first, unleveraged double-digit returns on all new product sales. Importantly, we have and we will continue to adjust pricing to respond the market realities, but at the same time we have never miss the mark such that we had to pullback a product. VA and secondary guarantee UL pricing changes last year were good examples.

Second on the ROE front, our ability to effectively redeploy excess capital could add in the range of 75 basis points or more to our ROE. Third, shipping the business mix towards group in DC and fourth, continued disciplined expense management. With cooperative capital markets and capital redeployment, we believe we can make solid return on equity progress over the next two years.

Overall, the outlook for Lincoln is very positive, even more so today given all that have been accomplished and the quality of our execution. This industry has enormous opportunity to help consumers regain confidence in their financial security and I firmly believe that company is like Lincoln that understand and align their resources this opportunity will be the winners.

Now let me turn the call over to Fred.

Fred Crawford

We reported income from operations of $290 million or $0.86 share for the second quarter. The only notable items in the quarter were positive DAC amortization in the annuity business, which contributed about $15 million to the segment's earnings.

This offset by unfavorable loss ratios in our group business negatively impacting earnings by about $8 million relatively to plan expectations. We also had a number of smaller items spread across our segments that taken together impacted the quarter's earnings negatively by about $7 million.

Net income per share of $0.33 included the early retirement of the CPP funds and the associated write-off of the unamortized discount on the preferred stock of $131 million, together with the quarterly carry on the securities of $18 million.

Market volatility returned this quarter and had some impact on our VA hedge program performance. We made a conscious decision to not chase implied volatility higher in recent quarters, which resulted in mark-to-market losses in the period. This entirely offset by movement in the non-performance risk factor.

Overall the hedge program was better than 90% effective and our hedge assets remain in excess of our actuarial calculation of the liabilities and well above the statutory reserves needed under the calculation according to VA curve.

Gross losses and impairments on general account investments were down significantly coming in around $37 million pre-tax and entirely offset by realized gains in the quarter. As noted in our press release, we have a few asset categories subject to mark-to-market adjustments.

These include our credit linked notes under recently adopted accounting rules, a modest amount of credit defaults swaps and other derivative positions and certain trading portfolios. These marks resulted in the $30 million net loss in the quarter, driven primarily by spread widening on corporate CDS and its impact on our credit linked notes.

Turning to the segment results and starting with annuities, our results continued to benefit from increased average account values. While June markets drove down, end of period account values, positive flows and stronger markets earlier in the quarter resulted in average account values increasing $1.2 billion in the quarter.

End of period account values were $73 billion, about $3 billion lower than the average in the second quarter. There has since been some market recovery, and we expect positive flows will mitigate some of the pressure on earnings as we look towards the third quarter.

We currently sit comfortably in the center of our debt corridor method, which guides our prospective account value assumptions. We estimate markets would have to fall by approximately 30% before contemplating a negative unlocking.

Fixed margins were stable during the quarter with normalized spreads in the 190 to 200 basis point range consistent with the last several quarters.

Turning to our Defined Contribution business, a steady quarter overall with key earnings drivers of positive net flows, stable account values and spreads cooperating in the period.

Average account values were up about $700 million, sequentially, despite the market declines in June. As with our Annuity business, end of period account values were little over $1 billion lower than the average in the quarter at about $35 billion.

Fixed margins and spreads were both, strong in the quarter with normalized spreads of approximately 225 basis points, a result of credit and rate actions taken in the second quarter.

In Individual Life, reported earnings were inline with our expectations and underlying trends we see in the core earnings drivers of the business. Mortality bounced back to normal in the quarter. We are seeing both, mortality and lapse rates were unfavorable rates run favorable to our pricing assumptions.

Fixed margins remained steady helped by investment strategies deployed last year to lock in higher yielding assets. Also contributing, was a solid quarter of alternative investment returns.

Normalized spreads are running at around 190 basis points and have been fairly consistent over the last few quarters. In our Group Protection business, our non-medical loss ratio came in at 76%, above what we experienced last quarter, and above our long range expectations in the low 70% range.

The increase was primarily due to elevated long term disability lost ratios, life ratios recovered as expected in the period.

Poor disability results were driven primarily by unfavorable incidents into a lesser degree, claim termination experience. We believe economic conditions are playing a role and see no concentrations that suggest underwriting issues.

We expect ratios to recover in time, but are likely to remain elevated for the remainder of the year. Net earned premium continues its strong trend, up about 8% over last year's quarter. Premium growth rates benefiting from consecutive periods of strong sales results and improved retention and persistency rates. We expect year-over-year premium growth rates to remain the high single digit area.

I want to spend a few minutes to address some of the concerns over the current low interest rate environment and its impact on our core insurance businesses.

Let me be clear at the start. A prolonged period of historically low rates is not healthy for our business fundamentals in isolation. However, we long ago recognized this threat and have been proactive in our investment strategies, our product designs, including crediting rate actions and overall asset liability practices to defend against this type of environment.

The bottom line is, we see a prolonged low rates scenario is having a relatively modest drag to near-term earnings. We see little in the way of near-term capital implications and we do not see interest rates in isolation as a driver of goodwill impairment across our businesses.

In time, there could be a one-time impact related to revising our prospective yield assumption supporting intangibles, but again, at manageable levels.

To provide further detail, let's look at the estimated financial impact assuming new money rates, currently running about 75 basis points below our portfolio yields, remain in place through 2012.

The earnings drag from spread compression in our retirement business is modest and largely concentrated in Defined Contribution. There is little impact expected on individual annuities.

For some time now, new products have been sold with very low minimum crediting floors and we apply disciplined ALM standards locking in spreads on these products at the time of issue.

The risk in the individual annuities business is more sharp rising rates, we managed this risk by selling market value adjusted product and through the purchase of derivative protection.

Defined Contribution experiences more of an impact, a function of higher guarantee crediting rates and reoccurring premiums.

Assuming our two-year low rate scenario and looking at our annuities and Defined Contribution business in total, we would expect very little earnings impact in 2011 and $10 million to $15 million of annualized earnings impact in 2012.

In our Group business, the impact is also not material. The combination of lower portfolio yields and adjustments to reserve discount rates having an estimated annualized earnings impact in the $5 million range.

In our Life segment, the stress on earning is more pronounced, but has been reduced by proactive strategies to lock in long dated and high yielding assets. We moved quickly to put idle liquidity to work after last year's capital raising efforts and executed on strategies that allowed us to effectively pre-buy attractive assets in anticipation of future flows and maturing securities.

In fact, we do not need to purchase a single asset in support of universal life secondary guarantee portfolios until mid-2011.

Under our two-year low rate scenario, we estimate the combination of spread compression, DAC unlocking and building reserves would combine to impact annualized earnings by about $35 million in 2011 and $50 million in 2012.

As noted a few quarters ago and in our disclosures, we are currently reviewing all of our life models as part of converting to a new valuation system. Included in this work is a review and harmonization of methodologies across all blocks of our Life business along with our traditional prospective DAC assumption testing

Under our two-year low rate scenario, Life portfolio yields drop on average only 5 to 10 basis points per year, a result of our investments and ALM strategies. If you assume for example, a 50-basis point reduction in our long-term yield assumption, the expected earnings impact from unlocking at adoption would be in the $50 million range.

It's important to note, that we are taking a level of DAC unlocking along the way, which helps to contain this number and we look at all gross profit assumptions in our prospective reviews.

It is often the case that we adjust multiple and at times offsetting estimates such as lapse rates and mortality.

On goodwill assigned to the life business, the valuation is more to core franchise issues such as new business growth and returns, mix of business and distribution strength.

Goodwill is also sensitive to discount rates applied to the new business. While threats to future profitability can theoretically push up the discount rate, a drop in the risk free rates will also lower the cost of capital applied to the business.

Our current disclosures therefore provide sensitivities to both, discount rates and new business generation and do not isolate interest rates. We are pleased with the overall health of the franchise and our second quarter results continue to improve that out.

It is however; fair to say that while economic conditions remain fragile, we will need to monitor the health of the franchise and potential movements in conventional discount rates applied to this business.

Finally on capital, the review of our cash flow testing results could withstand a 50 basis point drop in portfolio yields and still be considered sufficient under both, regulatory and our internal cash flow testing standards.

We have cushion to weather the current low rate environment in both, our aggregate life reserves and those reserves backing universal life with secondary guarantees.

So to wrap this up for you, should new money investment yields remain at their current low levels for two years, we would experience a moderate drag to earnings more so in 2012, and mostly in our Life segment.

We see little risk to near-term capital dynamics and in the event we believe prudent to unlock our perspective yield assumptions on DAC and VOBA, the one-time impact is manageable.

Finally, we do not see interest rates in isolation as a driver of goodwill impairment and believe our Life franchise to be solid and building.

Dennis touched on capital in his comments, and you are all well aware of the series of transactions that we undertook in the last quarter. Our insurance subsidiaries remain in a strong position with RBC ratio estimated in the 500% range, this after sending a dividend of $275 million up to the holding company during the quarter.

We currently sit with about $800 million in net liquidity at the holding company, well above our stated policy of holding 12 to 18 months of cash flow needs.

The combination of our $550 million tenure letter of credit executed in 2009, our new credit facility allowing for $1.5 billion of letters of credit out to 2016 and this quarter's $500 million 30-year universal life transaction place our reserve funding needs in solid position.

General account conditions continue to improve. Impairments are down significantly and our unrealized gain position increased to $3 billion in pre-tax.

Capital charges associated with our general account holdings have stabilized and with the average and with the average credit quality improving, we are seeing a modest reversal of the ratings migration impact experienced in 2008 and 2009.

We continue to position our general account portfolio in a defensive mode recognizing economic conditions remain volatile.

Overall, strong capital position with significant financial flexibility as we monitor market conditions for the remainder of 2010.

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

Dennis Glass

Thank you, Fred. The realities of the external environment, including macroeconomic forces, demographics and consumer behavior have and will create both, headwind and tailwinds for Lincoln and for our industry.

What's important is Lincoln skill in navigating the environment. Our proven ability to react properly to external forces and delivered good operating results reflects a deep knowledge of this business and the stability and resilience of our operating model.

Given the strengths, I am confident that Lincoln is well positioned for the future to manage effectively through the headwinds and take advantage of the tailwinds.

With that, let me turn the call over to the operator for question.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Ed Spehar of Bank of America/ Merrill Lynch. Your line is open.

Ed Spehar - Bank of America/Merrill Lynch

First, Fred, could you state one more time the comment you made about the amount of the market decline that you would need to see before there was a negative DAC unlocking in the VA business?

Fred Crawford

Yes, we'd need to see markets decline by better than 30% before we would be contemplating on unlocking, prospect of unlocking in back. With that 34% decline does it really triggers an analysis inside the company and particularly focus is on where do we think markets are going forward

If we think they are going to recover, because there was a relatively acute short-term issue then we may not unlock. So if you think it's going to be persistently low markets then we would unlock as we did in the late in 2008. Interestingly, right now if you were to unlock our corridor to the mean of the estimate we would book a pre-tax gain in about a $150 million, so that gives you a little bit of idea of where we are in terms of relative to the center of the corridor.

Ed Spehar - Bank of America/ Merrill Lynch

Then one more question on interest rate. If you took the analysis that you apply to your book, and you said new money rates a 100 basis points lower. Again not a forecast, but just so we can understand. How much different is it in terms of the outcome versus what you modeled?

Fred Crawford

Yes, not material really. In fact, there are some portfolios that are travelling closer to a 100 basis points and we are used to that kind of current analysis to model that out. So the 75 basis point new money below portfolio is really an average across the blocks.

So in other words there is some situations where a 100 basis point new money lower is actually factored into those estimates. So I wouldn't expect it to be materially different.

Ed Spehar - Bank of America/ Merrill Lynch

Okay, I am sorry, I wasn't clear. I meant not going from 75 to 100, I'm saying from 75 to 175?

Fred Crawford

Okay, 175. I haven't modeled that. Other than I would tell you that, that's no where near what we're currently experiencing in terms of new money rates relative to portfolio yields, and in some cases, particularly because we have locked in some good rates in the past year. We have really are able to be very particular in what we buy. That's worth mentioning.

I talked about being able to step out of the markets for a year or so to weight out better yields. So that's not really what we do. What we are really going to do is be particular in the assets that we buy and particular meaning buying those assets on a risk adjusted basis, provide great year yields and good long duration to support those blocks. That's really what we've been doing here in recent quarters and that's really benefited us on the new money side.

Ed Spehar - Bank of America/ Merrill Lynch

Okay. I recall Mark Konen, years ago talking about when there is a fear about the low rates earlier in the decade about the ability to re-price in Universal Life that wasn't fully appreciated by the market back then. Am I remembering correctly or is there the potential to in a very dire scenario actually adjust, maybe obviously not the minimum crediting rate but in the mortality charges or other charges in the UL contracts.

Dennis Glass

Mark is sitting on my right and long as you've referenced his name, we'll have him answer that question.

Mark Konen

Hi, Ed, I don't remember that, many years ago. I am losing my memory, but what really happened, let me just readdress this, it depends on what kind of Universal Life products you are talking about and in the current assumption type, universal life that was sold, it's still the huge part of our book of business. That kind of analysis would be correct.

If you look at the secondary guarantee universal life block itself, that analysis really has more to do with the lock-in of that premium is locked in. The lock-in of that cost to the policyholder is locked in, and there's less for the company to do about that. That also allows us as Fred has mentioned, to design it in a way that allows us to invest very long because there is no optionality either in that policyholders [back arsenal] and therefore if we can lock-in long rate, that mitigates the impact of the low interest rate environment for acute period, say two years as we've talked about.

Ed Spehar - Bank of America/ Merrill Lynch

What's the split right now roughly between the current assumption and secondary guarantee in terms of your book?

Mark Konen

I don't have that at top of my head. I am looking to…

Ed Spehar - Bank of America/ Merrill Lynch

It was called the, in terms of the [enforcement] at 15% secondary guarantee.

Mark Konen

15% secondary guarantee.

Ed Spehar - Bank of America/ Merrill Lynch

Rough numbers.

Mark Konen

Yes, maybe a quarter if you want to get real rough.

Operator

Our next question comes from Randy Binner of FBR Capital Markets.

Randy Binner - FBR Capital Markets

I just want to clarify that those are all the EPS, the DAC sensitivities those were all pre-tax numbers right?

Fred Crawford

No, these numbers are all tax effected. They are really, they are meant to be in earnings number.

Randy Binner - FBR Capital Markets

So the 35 for '11, the 50 for '12, and the 50 for the DAC, all those would be after tax?

Fred Crawford

That's right.

Randy Binner - FBR Capital Markets

Okay, and then, I guess Ohio jumped in more of a high topic, which is this retained asset account issue, is that something that Lincoln has exposure to?

Dennis Glass

We have retained assets, I must say that, it must have been a slow news yesterday to focus on that issue, and I think that the ACIO's response captured very well, the strength of that asset for the industry. I would say particularly in Lincoln's case where we have such a distribution system that's focused on financial planning. I can tell you that our planners would in a heart beat move that money to the right place on behalf of their customers, so that's our response.

Randy Binner - FBR Capital Markets

Can you approximate for us, how many assets, or how much assets are exposed, in those accounts?

Dennis Glass

We have around 800 million.

Randy Binner - FBR Capital Markets

800 million.

Operator

Our next question comes from Nigel Dally of Morgan Stanley.

Nigel Dally - Morgan Stanley

First question, with a 500% risk based capital ratio, can you discuss potentially when you'd begin to consider capital management?

Fred Crawford

Yes, we were very pleased obviously with the capital position, particularly as it relates to the life insurance subsidiaries. What we are doing is watching very carefully market conditions, that continue to re-remind us of a level of instability, and we would like to see some of that stabilize a bit more.

We also discussed through a really a nice solid period of dialogue with projections and so forth with our rating agency players, that resulted in stable outlooks and pretty good views of our capital position and how it's positioned to weather the storm. The real answer to that question as we fully expect we'll be in a position to redeploy that capital for better returns than today, that's not saying much by the way because I don't capital doesn't earn you anything effectively. So we got to be patient in watching the markets, and we also have to be mindful of the momentum that we have created in our ratings and wanting to continue that.

Nigel Dally - Morgan Stanley

Just a follow-on from that, wouldn't you looking at capital rate deployment, how does buyback compared to the acquisition opportunities in the current environment, are you still seeing opportunities out there in the market?

Dennis Glass

My view is always been that if you can find a thoughtful of strategic acquisition that's the best use of excess capital because it will continue to grow overtime where share returns have a short impact on share, repurchases have the short impact on operating earnings per share. So our first focus would be the right acquisition opportunity, but as you know these things aren't, if you can't predict when that's going to happen and so there maybe a point where we began to do some other capital management if we can't find the right acquisition opportunity.

Nigel Dally - Morgan Stanley

Then just last question, just going back to the interest rate issue. Just hoping to some clarity on one component of that being spread flexibility]. Is it possible to get detail from the total amount of finances that have guaranteed minimum rate flows, and for those assets how is the current crediting rate compared with weighted average guaranteed minimum floor?

Fred Crawford

Yes, actually where you can get a lot of that data as we spill it out in tables in the 10-Q and the K, but I can give you some color, and it really syncs up with my comments. In the annuity business for example, we're really in very good position. There's really only roughly 30%, 35% of our business is at the minimum guarantee levels and we've got some 90 basis points or so of room between the average crediting rate and minimum crediting rate guarantees and that's impart while we are able to more proactively manage the onset of spread compression in that business with a little to no effect. There are other reasons too namely ALM, mechanics and so forth.

When you get the DC business, that's a bit of a different story. We have upwards of 80% of the block of business traveling at the minimum guarantee rate and more like 20 to 25 basis points of room between crediting rate, average crediting rate and minimum guarantee, so you have less room and that's impart why under a reducing portfolio yield environment you'll suffer a bit more spread compression in the out years in the DC business.

On the life side, it's a very similar dynamic with better than 80% of the book traveling at minimum guarantee, so lets flexibility to adjust crediting rates, and more like 15 to 20 basis points maybe 17 or so basis points of room between crediting rates and minimum guarantees on an average. So that's impart why you'd see under our two-year down interest rate scenario more spread compression impact in both DC and of course on the life side.

Operator

Our next question comes from Jimmy Bhullar of JPMorgan.

Jimmy Bhullar - JP Morgan

I had a question on your disability claims, and if you could just elaborate on the spike in your loss ratio in the disability business, your margins had been fairly stable for a while. So what's causing the decline in margins? Obviously the economy is weak, but it is at pricing issue as well, we have had pretty good sale for a while and then I have a follow-up after that.

Fred Crawford

I'll ask my partners here to weigh in if they want to provide more color. We have broken down as you can imagine the disability loss ratio climb, it was running at about 76% or so, which is about 5 or so percentage points north of what we would otherwise plan on a stabilize basis.

We believe it's attributable largely to the economic cycle and I'd say cycle because we believe some of the early shock to the economy wasn't part resulting in stronger loss ratios for a period of time as people resisted going out on disability out of fear of potential job loss or job elimination.

As things stabilized and employments levels albeit lower stabilize a move back to people maybe going on disability more proactively. In some respects this could be viewed as a reversion to the mean, meaning that for a several quarters we were running below our plan loss ratio expectations in the mid-to-high 60% range for example and this to some degree is playing out as you would expect over the long run and that now we're running a bit higher, but looking back over the last couple of years we have been running around our planned levels.

That's in part why we believe, we're confident that these ratios will come back in line in time, it probably remain elevated for the remainder of the year, would be our expectation, but come back in line over time.

Jimmy Bhullar - JP Morgan

Then on the VA business, your sales obviously, like I think they are up about 17% sequentially. So a lot better than what we expect the industry to do this quarter. Anything special that you are doing there in terms of either life distribution expansion or just like what the factors are that drill those fund results?

Dennis Glass

It just really comes back to the strength of the model to continue focus on improving the training of our wholesalers, increasing the quality of our wholesalers, adding shelf space, its basic blocking and tackling that's producing these results.

Operator

Our next question comes from Thomas Gallagher of Credit Suisse.

Thomas Gallagher - Credit Suisse

Good morning, Fred. First just a quick follow-up on the interest rate discussion. In your analysis have you changed the lapse rate assumptions at all, when you contemplate the low rate environment? Just a follow-up, can you give us an idea of what the weighted average lapse rate assumptions would be embedded in your UL reserves both on a GAAP and a statutory basis?

Fred Crawford

We did not do any sensitivity. The dynamic movement of lapse rates surrounding our block of business per se as it relates to interest rates and isolation. The life business in general I would tell you that lapse rates have been running better than our pricing assumptions for a while now.

In fact, particularly where they can be more sensitive is in the UL secondary guarantee business, where we have been running on the UL block in total we have been running around 5 or so percent type lapse rates. I think on those secondary guarantee businesses maybe in the 4%, right on the 4% territory, that is quite a bit higher than what we price that, as we have talked about before we typically reduced substantially the secondary guarantee lapse rate assumptions in our pricing often times traveling between 1% and 2%, for example on those policies that are running out of account value and going into guaranty if you will, we zero it out completely, when we are thinking about the pricing.

So, that gives you some color on the lapse rate experience. It's been going favorable and that's in part why I noted that when you look at long-term assumptions and you think about intangibles and profitability, you have to be very careful about isolating one single margin contribution to assess the financials. It's not uncommon for other elements of the profit drivers to be cooperating and doing better than our pricing and best serving as an offset to the issues.

Thomas Gallagher - Credit Suisse

Just a follow up, if the 4% to 5% lapse rates that you're seeing today, appreciating that your pricing new business at much lower lapse rate. What would be, if we were to look in at your entire book of business, where would be embedded lapse rate assumptions be set on your total reserve?

Fred Crawford

I'm kind of looking over it my partners.

Mark Konen

Tom, this is Mark. On the secondary guaranty UL it really is for the majority of that block of business around the numbers, Fred talked about. The lower lapse rate maybe not the first version to the industry put out, as you begin to understand this product you get better and better probably understand the economics of a product always, but for the majority of the business it really does come down to very low lapse rate and in fact, we are experiencing higher lapse rate than that.

So, from that you can take that up. From the rest of the book of business the universal life book and that's all over the board. This goes back to the 1980s, some of this business. So, there is a lot of different assumptions in there, but I go back also what Fred said, which is in total lapse rates continue to track better than expectation and each quarter to 5% number.

Thomas Gallagher - Credit Suisse

That's helpful, thanks and then just one more follow up if I could. EITF 09-G, I think there is a meeting today on that. Have you guys done any work on this in terms of quantifying if does go through what the expected impact would be?

Mark Konen

We certainly have been monitoring the progress of this work with the FASB and we've taken some look at it in terms of its potential impact, but it's very difficult for us to toss estimates and numbers out there because it's some of what of moving dialogue. I think our preference would be to wait and understand what the full context of the adoption is, the timing of it to be able to better assess its impact on our business.

I think back in June I was asked question in general about this topic at the S&P conference and I answered largely same way I do here and that is, at the end of the day we price our product and we think about the embedded value of the business that we are putting on in terms of the appropriate pricing of the cash flows in the future and the risk adjusted pricing of those cash flows. That's where we focus our attention. That's what we sell each and every day and that's what has really the greatest impact on the degree to which we are adding value or not.

The accounting is something that's a reality and we've got to deal with it, and it could give rise to some volatility upon adoption, but at the end of the day the amortization of DAC, the DAC concept in general is an earnings recognition timing issue in general and as long as we think we are putting good economic business on the books, which we do, we think it will work itself out. So, that's bit of an overarching comment I realize, but we simply have to watch this work before we get into more specifics.

Operator

Our next question comes from Eric Berg of Barclays Capital.

Eric Berg - Barclays Capital

I think that Mark just mentioned that sort of on an overall basis, your lapse rates are running, I think you said better than expected. Does better mean that lapse rates are running lower or higher than expected?

Mark Konen

On the secondary guarantee, they are running higher than our expectations. Even though, again, we had very low lapse rates. If someone was totally in the money and didn't have to do anything else as Fred mentioned, we've assumed zero. You can't get any lower than zero, but what we are actually finding is the people that have bought these policies, they are having the same economic issues that many of the rest of America is having, and so they may get that premium bill and decide not to pay that premium, whereas perhaps, our assumptions will assume that in this current environment, they would pay that premium, but they want to eat and stay or whatever that.

Eric Berg - Barclays Capital

What about out away from outside of, lapse experience outside of no-lapse guarantee universal life?

Mark Konen

Again, that's the one that really to me depends upon cohort to cohort, but I don't see anything as being a big issue there. Again, those are pretty season blocks and are traveling at or near the assumption, one way or the other.

Eric Berg - Barclays Capital

Okay and then couple more, one with respect to interest rates, the other with respect to disability. Fred, well I certainly understand the point that you have emphasized that the value of intangibles is a function of many variables that can be moving in different directions, and provide offsets.

If you look at interest rates as a factor here in isolation, wouldn't it be the case that everything else the same, a decline in rates, does pressure the recoverability of goodwill, or would it be the other way around?

Fred Crawford

Well, it makes it hard to say, Eric because here is my view of just isolating interest rates. The bad news on isolating lower interest rates is that, it brings about the prospects of weaker, forward looking earnings or volatility in earnings, which would suggest for any business of the need to apply higher discount rate, but because we are talking largely about treasuries, when we think about interest rates, we also see the risk free rate dropping and the cost of capital assign to that business dropping, and that provides a downward pressure to the discount rates.

I think it has been pointed out by a few in the analytical community you may even need to start in time, thinking about the new world order of ROEs, when assessing the lower cost of capital that comes with a persistently low risk free rate of return. That's a little bit of the dynamic that plays into the notion of discounting a business, particularly a business that's a low data business, and is stable as the life operations, does appears to potentially more volatile return scenario on the VA business or equity market driven businesses. So, it's a push and pull as the answer, which made me more difficult to judge.

Eric Berg - Barclays Capital

Last question is relates to the disability experience and I just wanted to clarify, one point made earlier. In the course of this earning season so far, a couple of companies, StanCorp Financial and Delphi have said that is best they can tell, the economy doesn't expect their disability business. Are you saying something different?

Fred Crawford

Yes and let me just say at the onset that we have seen the same thing, you are saying that companies are assessing the typical quarterly ebbs and flows of loss ratios and trying the best they can, when looking at the blocks of business to assess what's driving it. I'd say that we all having some respects slightly different blocks of business, which require a little deeper understanding small case versus middle and large case, different industry concentrations. For example, we have a fairly large educational concentration in our business, which is normally stable, but as we now all know reading a newspapers, we are seeing teachers being let go more and more and so that all the sudden is becoming a more riskier occupation as it relates to that.

So, there are different dynamics as you really dig into the details of your block, and I think what companies are doing as they are trying to do the best they can to assess what's driving it.

In our case, we've seen incidence pop-up, which we believe to be combination of reverting back to the mean having enjoyed unusually low loss ratios for period of time and the economy. We have also seen the termination rates on our business also slow down a bit, which has to do with really claims management and administration and these types of issues that's a lesser issue for us, but that's involving just good stable claims management work, which we are going to look at and we think we can make some improvements in that respect.

So, there are some actions you can take as a management team, but you are correct, you will see a different rate from different companies, but I think that gets into diving a couple of layers down in the block.

Dennis Glass

Eric, we have owned this business and I have watched it for a decade or more, and I have seen this type of loss ratio development, incidence rate development and we've got a quality management team, who has demonstrated in the past and we will demonstrate again that we can work through these issues in a period of time. So, it's happened, management is working on it. It's happened before and we worked our way through.

Operator

Our next question comes from Mark Finkelstein of Macquarie.

Mark Finkelstein - Macquarie

A couple of questions. I think just to talk about the VA business a little bit. This is really the first quarter in several, where we've actually had equity markets on a point-to-point basis go down.

You've had some statutory changes in reserve requirements, you've also had changes in hedge strategies. I'm actually curious, how did the required capital change from the first quarter to the second quarter with the decline in equity markets, and if you could kindly incorporate both the stat and the offshore cap that would be helpful.

Dennis Glass

What's really interesting about the statutory capital dynamics this quarter is, you got a little bit of a short-term replay of what we and I suspect some in the industry, those that have pulled some hedge programs experienced during the debts of the crisis, because you had a pretty sharp movement in volatility and interest rates, you saw your hedge assets spike in valuation relative to even though stochastic elements of VA carve them on the statutory front.

So, I mentioned in my comments that we are currently in a position, where our actual asset values, derivative asset value supporting the reserves on this business are pretty substantially in excess of the statutory capital requirement. In fact, north of $0.5 billion in excess of that statutory requirement.

For Lincoln, that doesn't come true in our risk-based capital, because we effectively house those capital dynamics as you've mentioned in a captive reinsurance vehicle. For those companies that have it on their balance sheet, they may see some pumping up, if you will, of their statutory capital by virtue of that dynamic.

What it does provide me is a great deal of comfort that what we are very unlikely to see is any sort of capital call to our holding company in support of the VA business. In fact quite the opposite if we remain in these low interest rate environment.

Something that relates to our interest rate discussion that you should all be mindful of is that we have a substantial amount of floor protection on your balance sheet as it relates to just running our VA hedge program, when thinking about statutory. So while the low interest rate environment creates some capital dynamics and earnings dynamics on the life insurance side, it can when it's in the tail scenario provide a real booster in terms of asset values relative to statutory capital needs for your VA business and provide somewhat of an offsetting level of comfort. So that would be kind of the statutory dynamic.

Now what I would be careful about this of course this is a quarter's worth of experience in the capital markets and those capital markets move around and we are not "spending that excess capital" right?

It's there to support the economic view of the hedge program not just the statutory view, but what I'm pleased about is, even on an economic basis, our hedge assets are traveling a $200 million north of the actuarial calculation liability, so we are simply in good shape on both fronts.

Mark Finkelstein - Macquarie

One of the question, it's theoretical question. I guess, you hedge interest rate risk VAs most companies hedge at least some interest rate risk on long-term care. I mean, if I look at your secondary guarantee UL business, very long duration liabilities. Why don't you have a hedge program in place on the interest rate risk? Or if you do, let me know.

Mark Konen

This is Mark again. In effect, we do because of both, the combination of the design of the product, which without getting in to all those new nuances really takes all the optionality out of the product, which therefore allows us to invest very long. So, think about investing in 30-year assets as an example.

In effect then call it a hedge when you look at the combination of those, which then therefore does not require us to hedge short-term movements in interest rate.

Operator

Our next question comes from Colin Devine of Citi.

Colin Devine - Citi

Dennis, you mentioned you are looking for a ROE grail, and I am not sure if you're ready yet to put up some targets, but it's so impressive you walk through just how we're going to see that happen when the capital supporting your Life business, I think represents about 57% of Lincoln's total capital right now and yet the light business is earnings for the second quarter 7.2% ROE, so what opportunities that really took to grow that, because it seems to me that's the key to give me royal company up.

Secondly for Fred, I appreciate the interest in DAC discussions. On annuities, when you're talking about whether or not you have to adjust DAC, and how much of the market could drop?

I was wondering how lapse has factored into that, because if I am thinking in my own VA contracts, I think they are about 35% of the money at the end of second quarter and it would seem to me when they are that deep assume lapse is on your VA business and are also essentially pretty much going to zero. How is that factored into what we're seeing right now? Thanks.

Dennis Glass

First let's to starting point on the UL business, which absent goodwill is, it has a 10% ROE on it to start with, which is lower than I'd like to see it. Now, moving to just a repeat of what I've said, maybe adding little bit more color.

There isn't a product that we're selling today that doesn't have a double-digit ROE on it. So, as those products become more of the mix of the in force that will incrementally drive ROE improvement and I would quickly say that that takes time.

Colin Devine - Citi

All right, but jump for a second, I think you all have told us that your products have been priced for the level that you just gave. Mark said the secondary guaranty UL block is only 15% or 20% of the total. Then why is this ROE is still, based on what you just said, so much below where it was priced? Sorry, I just want to make sure we understand that and so we are framing expectations as to the timeframe by which this ROE might grow.

Fred Crawford

Yes. Let me ask Mark to help us with the 10% ROE and the past pricing.

Mark Konen

Right, and remember, everything you said there is correct, Colin. The ability to perfectly hedge out or not hedge out, but do away with the excess reserves is not there. Now, we've made a lot of progress as we talked about, but if you normalize to that, then you are probably in the 11 for the return and then it's again back to basic blocking and tackling on some of that stuff to try to push it into that 12 and better range, including proactive investment management, proactive management of all the element of the policy.

While on the secondary guarantee UL, we have with new products taking care of the need to have a capital solution, the term insurance we sell still requires the capital solution. We believe we obviously have the ability to do that overtime, but as you sell term insurance until you warehouse enough of it to go out and get a capital solution, there's going to be little bit of drag on ROE.

Dennis Glass

So the second opportunity and the more significant most opportunity for near impact is the redeployment of excess capital. To put that in perspective little bit as I said, we'd like to do that in strategic opportunities and strategic opportunities present themselves when they present themselves some of the actions we've taken particularly with Fred's job is to really heighten our focus on that and try to turn up as much as we can, as soon as we can if it's the right transaction, but the excess capital right now is fairly significant.

If over time, we're traveling down towards 400 basis points of RBC as we targeted and I say over time in a sense that we as well as people who look at us such as the rating agencies want to see little more stability and then with our guideline of holding 18 months of cash at the holding company.

If you take the 400 and you take that second criteria, we're $1.7 billion or so in capital above those levels. So we have ample capital to redeploy over time and again, not immediately but over time. So that can provide a good kick. Then, the third one which is consistent with this is just that we do want to diversify away from the life business and businesses that have higher ROEs and over time I think we can do that. Then, fourth, and this is more modest but still, it's a factor, it's the disciplined expense management that will drive some incremental ROE over time. So it's really those four things.

Fred Crawford

In-the-moneyness of annuities and lapse rates and how we think about that, I will give some color and if any of my partners here want to add more, they can, but, obviously, the corridor as you know is really focused in on a prospective view of account value. So it's driven by the equity markets and it's driven by flows and performance in the underlying funds, everything that drives an account value, we tend to think about it as being primarily an equity market type prospective view, but it's really an account value driven.

Fortunately, what's helped us out over the years really is we have been steadily producing positive flows and actually the underlining performance of our separate account funds has really outperformed in market industries as well in recent years which has helped us well. Separate and apart from that are our lapse rate assumptions and when you are thinking about the prospective work we do on the annuities, we also have to contemplate all drivers as you point out including lapse rates.

In that particular case, we dynamically view the lapse rates similar to what we were doing on stochastic basis, such that if we believe there to be a risk in-the-moneyness as you've pointed out, then we would also expect just what you are saying and that is lapse rates to drop significantly.

Looking at our lapse rates, it is kind of interesting; we have seen our lapse rates in the last year, across our entire and annuity block go for about a little over 8%, to down around 7%, and at first blush I would have thought that to be driven by just what you are saying, in the moneyness, on these variable annuity guarantees particularly death benefit guarantees and the like, but actually we have seen variable annuity lapse rates remains fairly steady, year-over-year, at about 7% where we are seeing improvement in lapse rates over where retention is on our equity index annuities and fixed annuities which is a good guide, relative to our assumptions, keeping that on.

We have interestingly seen a level of lapsation of in the money death benefits for example, are in the money guarantees, living benefits and death benefits, we think it's very low, it's in the couple percent range, but even that some what surprises us, from what we would expect, but we think that is again driven by economic conditions, where you have the ware results to wait it out, you are going to wait it out, and take a look at that, as an added benefit or guarantee or rather you would expect to capitalize on that in the future, but if you are need of cash and capital now, we have people, just as they tap, they define contribution plan unwisely, they also need to tap their annuities at times for cash flow, we think that is in part, what is driving it.

So, overall, we are comfortable with it, but yes to your point, we dynamically stress the lapse rates just as you pointed out.

Thomas Gallagher - Credit Suisse

Okay, just to clarify when you are doing, you're commenting on lapse you have the ability to distinguish between actual policy lapses, and systematic withdrawals under your withdrawal benefit program?

Fred Crawford

Yes.

Operator

We have time for one further question from Suneet Kamath of Sanford Bernstein.

Suneet Kamath - Sanford Bernstein

In the interest of time, I'll just do one quick one. I wanted to go back to the goodwill issue, which is one that keeps coming up in my conversations with folks. If I go through your 10-Q and your 10-K, and I think about some of the triggers around goodwill, one of them is actually the valuation of Lincoln's stock. As I think about where your stock has been valued, I think you've been below book value now since September of 2008, something like that.

Just wondering, as you think about testing your goodwill, to the extent that the stock remains below book value, it's not a projection, just a scenario, at what point does that factor, at what point does that trigger a goodwill impairment? Thanks.

Fred Crawford

The SEC guidance on this providing their point of view, for example has been that this should be a factor that's certainly contemplated, discussed, descended if necessary as part of thinking about the prospectus goodwill impairment, but they've also been careful to say stock prices move around in very volatile markets and may not be a longer term indication of impairment to the business. So be careful in your views on that. I think that's a good rational statement.

For example, just in the second quarter alone, we saw a period of time where the stock was trading up in the low 30s and if you add a control premium to that which any company would expect, you're all of the sudden in that book value and it's really hard to kind of take a look at your stock price at any moment in time and render a long-term judgment about the valuation of your business.

It is true that I would say, that if your stock price remains below book for persistent period of time what that will typically do is trigger the need to go ahead and do just what you're saying which is a further analysis of your business including outright appraisals. In fact we did do that back not this past year but previous year and brought in for example, I believe it was [Milliman] to assist management and of course working with our auditors on outright doing a full fledged appraisal of our life business including stressing all of the mechanics associated with goodwill impairment on that business and of course we came out of that analysis feeling as if the certainly the business and its franchise was every bit worth what was stated on our books.

So, we will take it in another step, and part of what pushes you into that additional step is in fact your share price remaining low, but I'd be very careful about that sort of mark-to-market environment as opposed to the long-term appraisal of the cash flows involved and you also have to be very mindful of the mechanics of what's driving your stock price up and down and whether or not that in fact relates to the long-term valuation you think you are driving in your business.

Suneet Kamath - Sanford Bernstein

Can you just confirm, do you test the goodwill every single quarter? Or is this a once a year type of methodology? Thanks.

Fred Crawford

What we do, and it's really prescribed is we no matter what, once-a-year go through a goodwill testing and analysis process across all of our businesses. Any business that has a goodwill asset associated with it.

Also under the accounting rules, which we obviously agree with is you need to take a deep dive if there is an event or something that's taken place that really acutely affects one of your businesses whether or not it's on or off cycle.

We typically, in the October timeframe, start into a full fledge review of goodwill across all of our businesses, somewhat in time for the annual audit process. Again, if we are traveling through second quarter or first quarter or third quarter and we see something that has really acutely affected the business and its franchise then we may be forced into looking at the valuation more specifically.

Good example of that Lincoln has been in the media businesses over last few years, haven't always followed a cycle. Sometimes we simply see things go on and we've got to take action.

Operator

Mr. Sjoreen. You may go ahead.

Jim Sjoreen

Thank you. Everyone I thank every party for joining this morning. Unfortunately we weren't able to get everybody in the queue, but we will be happy to take your calls at 1800-237-2920 and we will be around all afternoon. Thanks and have a great day.

Operator

Ladies and gentlemen, this does conclude today's conference. Thank you for your participation and have a wonderful day. You may all disconnect.

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Source: Lincoln National Corporation Q2 2010 Earnings Call Transcript
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