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Lincoln National Corp. (NYSE:LNC)

Q3 2010 Earnings Call

November 3, 2010 11:00 am ET

Executives

Jim Sjoreen - VP of IR

Dennis Glass - President and CEO

Fred Crawford - CFO

Analysts

Andrew Kligerman - UBS

Tom Gallagher - Credit Suisse

Ed Spehar - Bank of America

Randy Binner - FBR Capital Markets

Eric Berg - Barclays Capital

John Nadel - Sterne, Agee

Steven Schwartz - Raymond James

Bob Glasspiegel - Langen McAlenney

Mark Finkelstein - Macquarie

Darin Arita - Deutsche Bank

Operator

Good morning and thank you for joining Lincoln Financial Group's third quarter 2010 earnings conference call. (Operator Instructions)

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

Jim Sjoreen

Good morning and welcome to Lincoln Financial's third quarter earnings call. Before we begin, I have an important reminder. Any comments made during the call regarding future expectations, trends and market conditions, including comments about liquidity and capital resources, premiums, deposits, interest rates and income from operations are forward-looking statements under the Private Securities Litigation Reform Act of 1995.

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

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

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.

At this time, I would now like to turn the call over to Dennis.

Dennis Glass

Thanks, Jim, and good morning to all of you on the call. Our third quarter sales, net flows and operating results reflect the year's continuing positive trends and are attributable to our core franchise strength, including strong distribution, innovative and well-priced products, the consistent market presence, expense discipline and risk management.

As you have seen, the quarter's earnings had several assumptions and model related impacts which Fred will cover.

Looking at our operating performance, sales and net flows accounted for about half of the 10% increase in our record-setting ending account balances of $150 billion, again, reflecting the effectiveness of our franchise and our commitment to consistency, product distribution support and service over market cycles.

Consistency enhances profitability and distribution relationships. Our distribution system is among the largest and most diversified in the industry, and our ability to execute the model efficiently creates value to the enterprise across all three platforms, wholesale, retail and worksite.

At Lincoln Financial Distributors, we continue to focus on increasing productivity and reducing cost. We saw meaningful year-over-year growth in wholesaler productivity, up 11% and a growing number of advisors recommending our products, up 60% to more than 48,000 advisors in the first nine months of year.

In addition, strategic distribution expansion efforts, which include introducing new products to distribution partners and adding new partners like banks are responsible for 17% of sales over the past two years. This is a clear measure of how we are maximizing the size and scope LFD to spur top-line growth and drive a diverse mix of business efficiently.

Lincoln Financial Network continues to attract and retain seasoned advisors. The number of active LFN advisors is up again this quarter by almost 100 net new advisors to a total approaching 8,000. Our experience shows that consumers remain risk-averse, but are seeking professional advice and security in greater numbers as they rebuild their savings. And LFN is well positioned to take advantage of these trends.

Both LFN and LFD ran within pricing in the quarter. This reflects a significant improvement at LFD where we have evolved the model to focus on productivity rather than headcount increases over the past two years.

Finally, we are making good progress in our goal to increase productivity in our worksite sales and service organizations. During the quarter we updated enrolment capabilities in our group benefits business, and announced a new partnership to enhance our recordkeeping and web technology in our defined contribution business.

Life insurance sales were up 2% over the prior year quarter, fueled by a strong increase in our Lincoln MoneyGuard, UL long term care linked benefit product. We are the industry leader for hybrid solutions with Lincoln MoneyGuard, and expect our momentum to continue as a growing number of consumers look for more flexible ways to plan for and fund their retirement needs.

The introduction this quarter of DurationGuarantee UL, our new limited coverage guaranteed Universal Life product was well received by advisors and distribution partners. This was a product that combines the flexibility and guarantees of Universal Life with the affordability of term insurance, and we expect the product to make a meaningful contribution to Life sales in coming quarters.

In anticipation of the opportunities that will arise with the likelihood of more clarity around state taxes in 2011, we will introduce new pricing on our guaranteed survivorship UL product early next year, reflecting a lower interest rate environment while maintaining our historical value proposition that has made us an industry leader in this space.

Variable annuity sales were up 11%, while fixed annuity sales were dampened by the weak interest rate environment, thus driving our overall annuity sales down slightly from a year ago. As market conditions change, the versatility of our products and our distribution teams allow us to pit it to the right solution for our clients. Recognizing the need to continue to balance competitive positioning with sound financial and risk management discipline, we are launching refreshed versions of our patented i4LIFE Advantage immediate income solution, as well as our guaranteed withdrawal benefits lifetime income advantage in the fourth quarter.

We are increasing pricing on both solutions and making other changes to increase capital efficiency, while maintaining consistency for our distribution partners and value to the customer. Capitalizing on our leadership in designing hybrid product offerings, we expect that the rollout of our fixed annuity long-term care linked benefit products in November will further differentiate our annuity portfolio, much like Lincoln MoneyGuard's differentiated by life insurance portfolio. This will be followed by a variable offering in early 2011.

Total deposits in our defined contribution business were up 14% over the year-ago period, benefiting from both new case sales and renewal deposits. Helping drive our strength in renewal flow was an increase in average contributions for individual participants, possibly a sign of growing confidence after the disruption of the financial crisis.

The business is inherently lumpy and we lost a few large cases this quarter due to client consolidation as well as some competitive pressure. We are making significant investments in technology and intermediary and worksite distribution to continue to grow and retain the business.

Sales in our group benefit business were down from last year, although both traditional group and voluntary sales were up modestly over the second quarter. The team continues to position the company to take advantage of the growing trend toward voluntary benefits with the launch of a new accident product in August.

I'd like to pause here for a moment to address non-medical loss ratios, which remained elevated in the quarter, primarily due to higher disability incidents. We've been in this business for many years now, and we know that loss ratios fluctuate. The business has outperformed for most of the last decade, and the last two years have been particularly strong years with loss ratios well below our expectations. In short, we expect a recovery in profitability based on our experience.

At the same time, we are studying the situation closely to isolate any contributing factors and take action as needed. We see nothing in pricing or underwriting that is negatively affecting loss ratios and the elevated incidents was spread across all issue years, size (bands) and industries. We are experiencing elevated case flows, however, so we have brought in additional resources to manage the increased volume, rolling out more case management training and new tools to improve outcomes and support claimants as they return to work.

What isn't changing is our approach to the market, our risk management discipline to effectively balance both top-line and bottom line growth and our flexibility to adjust pricing as we monitor this elevation in incidents. This is a very good business for us, and again, we are confident that we can bring loss ratios back into line over the next several quarters.

Now a little bit about the balance sheet. We continue to hold significant levels of capital and liquidity with an estimated risk-based capital ratio in our Life subsidiaries above 500%, and nearly $800 million in cash at the holding company. I believe the 500% plus RBC is qualitatively somewhat stronger this quarter than in previous quarters based in part on a slowly improving economy, and an unrealized gain position in our investment portfolio of $5 billion, which should to some degree point toward lower credit loss expectations.

Low interest rates and our decision to invest cash in mid-2009 at good returns also explain the unrealized gain position. Our increased confidence in our excess capital position contributed to our decision to purchase $48 million of warrants this quarter.

Now, before I turn the call over to Fred, I do want to comment on macroeconomic factors very quickly. First and foremost, we believe that we are well positioned from an operational and capital position to sustain solid footing in almost any realistic economic scenario.

With respect to today's conditions, we took proactive steps to address the balance sheet headwinds of lower interest rates this quarter. Importantly, macroeconomic events are also creating tailwinds for us, witnessed our end of period or comp value growth this quarter.

Company wide gross operating revenues climbed 9% year-to-date compared to the year-ago period, reflecting both tailwinds and headwinds. Our job as always is to drive that number higher organically while bringing top-line success to the bottom line, and I am confident that we have the right tools to make meaningful progress on this front.

At our upcoming investment conference, we will focus on actions management will take to further drive top-line growth, strengthen an already strong franchise and improve earnings.

Now let me turn the call over to Fred.

Fred Crawford

We reported income from operations of $206 million or $0.63 per share for the third quarter. During the quarter, we completed our model review project and annual prospective assumption review. In addition, we booked estimates for the impact of our valuation system conversion in the retirement segments.

Focusing on the model review work, this was a significant undertaking launched late last year, and I am very pleased with the outcome. While resulting in the few line item adjustments, the overall impact on income from operations was negligible in the quarter.

The more significant impact came as a result of our annual review of long-term actuarial assumptions guiding DAC amortization and reserving. As is always the case, there were offsetting items. However, the most notable impact to the operating earnings was an adjustment to our long term portfolio yield assumption in the Life segment.

I'll spend more time on this specific assumption change in a moment. Looked at in total, the model work valuation systems conversion and change in actuarial assumptions had a negative $72 million or $0.22 per share impact on the quarter's operating income.

If you adjust for all the notable items in our press release, including tax benefits and negative mortality, our run rate earnings came in at around $0.86 a share. This makes no adjustment for unfavorable loss ratios, which we expect to recover somewhat in the fourth quarter.

Net income per share of $0.75 benefited from mark-to-market gains on investments. Gross losses and impairments on general account investments came in at $65 million pre-tax, offset to a small degree by realized gains in the quarter. Concentrations included RMBS and select corporate bond holdings.

Mark-to-market adjustments, which included our credit-linked notes, credit default swaps and certain training portfolios combined to generate a $106 million of pre-tax gains in the quarter. These gains were driven by spreads coming in on corporate CDS and declining interest rates.

The underlying hedge program performed as expected, generating gains as volatility recovered in the quarter. These gains were offset by the unhedged FAS 157 adjustment. There are other items that ran through our hedge results but have little impact on earnings. Hedge assets continue to track in excess of our GAAP liability, and comfortably above our statutory reserve needs.

Turning to the segment results, and starting with annuities, our results continued to benefit from increased average account values, up $1 billion from the second quarter. Market appreciation, together with $1.3 billion of positive flows resulted in ending account values exceeding $80 billion for the first time in our history.

The sharp increase in account values was the principle driver of improvement in segments' run rate earnings. In fact, October average separate account values are up 8% over third quarter levels.

We sit comfortably towards the favorable end of our DAC corridor, which guides our prospective account value assumptions. Unlocking our corridor assumption today would result in a $270 million pre-tax gain in our annuity business.

Another way to think about this is our current assumption calls for a roughly 15% immediate drop in separate account returns, followed by an annual recovery of 9% going forward. In short, we are comfortable with our current annuity DAC assumptions.

Fixed margins were stable during the quarter with normalized spreads of 200 basis points, consistent with the last several quarters. We do not see signs of spread compression in our annuity business.

Turning to our defined contribution business, a solid quarter overall with stable account values in the period. We booked an $11 million gain, reflecting the impact of converting to our new valuation system, a result of a more granular approach to estimating gross profits.

Fixed margins and spreads held up nicely in the quarter with normalized spreads approaching 230 basis points, a result of crediting rate actions taken in the third quarter with additional moves planned on the fourth quarter as a result of a low interest rate environment.

This is obviously a noisy quarter in our Life segment, a result of completing the bulk of our model work in this area and adjustment to our prospective assumptions. There were two overarching areas of adjustments we made during the quarter. First, we modeled refinements which had little net impact on our results, but more significant on a line item basis.

The second area of adjustment's focused on our annual prospective assumption review. We had adjustments related to surrender, mortality and premium persistency assumptions which taken together had a $33 million positive impact on the segments earnings. This was more than offset by a change to our new money investment yield assumptions which alone negatively impacted the segments results by $114 million. There were other less material adjustments, but these are the more significant ones.

Focusing on portfolio yields, the revised assumption embeds current new money investment yields, expected cash flows, and actions we have taken to defend portfolio yields. Portfolio yields are currently hovering around 6%. Our assumption shows results in those yields falling over the next five years and not recovering back to current levels until 2020. We assume new money rates will recover only gradually over several years, arguably a conservative position, but prudent given current markets. Recognizing this as an adjustment guided by our best estimates, we believe the move lowers the risk profile of our future Life earnings.

Turning to mortality, gross mortality was fairly stable and where we would expect in the quarter. The issue was where mortality occurred, namely on blocks of business with less reinsurance in place, recognizing our retention limits in reinsurance programs differ by block of business. This was an unusual outcome, and we don't believe it to be indicative of expected mortality margins looking forward.

Fixed margins remained steady, helped by investment strategies deployed last year to lock in higher yielding assets. Normalized spreads are running at around 190 basis points and have been fairly consistent over the last few quarters.

Before leaving the Life segment and understanding the challenge in modeling our results, our underlying earnings drivers remained healthy and we expect to return to historical run rate earnings levels in the fourth quarter in the $150 million range.

In Group Protection, our non-medical loss ratio came in at 79%; 78% when adjusting for the lowering of our reserve discount rate, but still up from the already elevated levels experienced in the second quarter. Dennis commented on our review of loss ratio developments, so I'll not add to his comments. Poor disability results were driven primarily by unfavorable incidents which also impacted life loss ratios.

We expect loss ratios to remain elevated relative to our long term expectations, but recovering in the fourth quarter to the 75% to 77% range. As a reminder, every one percentage point of loss ratio is about $2.5 million of earnings in a given quarter.

Net earned premium continues at strong trend, up about 9% over last year's quarter, with premium growth rates benefiting from improved retention.

I want to refresh last quarter's interest rate sensitivity analysis to reflect a more severe scenario of new money rates, which are currently running about 100 basis points to 125 basis points below portfolio yields, remaining in place through 2012, said differently, freezing the ten-year treasury at 2.5% for the next two years.

The earnings drag from spread compression in our retirement business is largely concentrated in defined contribution as well as impacting individual annuities. Looking at our defined contribution business, we would expect an annualized earnings impact in the range of $5 million in 2011 and $15 million in 2012, entirely spread compression driven.

In our Life segment we benefit in the short run by the proactive investment strategies we detailed last quarter. As noted in our comments, we do not need to purchase a single asset in support of our UL secondary guarantee portfolio until mid-2011.

Under our two-year low rate scenario, we estimate an impact of about $25 million in 2011, and $45 million in 2012. These numbers appear similar to what we disclosed last quarter, but are skewed towards pure spread compression as the quarterly DAC unlocking and reserved build is reduced by our prospective assumption change this quarter.

The Group business would be impacted to a lesser degree. We would expect an annualized impact to this segment's earnings up to $5 million a year.

Timing and capital; we continue to believe cash flow (capital) will result in no material impact to capital and reserve levels. We hold considerable excess capital in our insurance companies, should test and dictate modest reserve strengthening, and do view interest rates as a near term capital issue to manage.

Turning more specifically to overall capital conditions, our insurance subsidiaries remain in a strong position with an RBC ratio in excess of 500% and just under $800 million in net liquidity at the holding company.

We estimate our capital margin to be approximately $1.9 billion if serving for a 400% RBC at the insurance company level and approximately $250 million above our holding company idle liquidity target of $500 million. As a result of improved capital conditions, we repurchased $48 million of our warrants participating in the U.S. Treasury auction process in September.

The purchase had little impact on our diluted share count in the third quarter. We estimate the repurchase would have about a $1.5 million share equivalent impact next quarter. This, holding all else equal, namely share price.

General account conditions continue to improve. Our unrealized gain position increased over $5 billion pre-tax. Capital charges associated with our general account holdings have stabilized with positive trends and overall credit quality. Impairments, while improved from 2009 levels, ticked up a bit related to a few select securities, but we would expect this number to come back down in future quarters.

Overall, a strong capital position as we monitor market conditions for the remainder of 2010 and entering 2011.

Now let me turn it back to our Operator to start the Q&A session.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question in queue comes from Andrew Kligerman with UBS.

Andrew Kligerman - UBS

The primary question would be around the interest rate assumptions. And Fred, I think what I heard you say is, the portfolio yield is around 6% and you are moving it down over 5 years and then it won't recover until '20. Fred, can you provide the specifics on where that rate or yield goes?

And then secondly, in that same vein, can you give us some confidence that another unlocking such as this one will not occur over the next year or two, should interest rates remain exactly where they are, which is what you are saying is the case with the 10-year treasury?

Fred Crawford

Can we kind of make sure we leverage that here a bit. So the actual assumption we changed was our new money investment rate assumption and that new money rate assumption expectation over the next several years. And what we did is, we dialed that down to our current experience in investing new cash flows across our life insurance portfolios. And then we only gradually increased that over several years back up to approaching our current portfolio levels.

When taking that kind of a severely reduced new money rate assumption over time, that has the effect of dragging down our portfolio yields over the next 5 to 7 years then slowly recovering on back up around 2020. What ends up happening is you see a bleed down in portfolio yields of around 25 to 30 basis points over time and then a gradual recovery. Part of the reason for that relatively slow drop-down in portfolio yields and gradual rise is the fact that these are fairly long duration portfolios, so you only have so much rolling off each year into those new money assumptions.

Also recognize all of the actions we've taken to lock in our forward buy, much of that high yield environment which serves to moderate the near term reduction in portfolio yields over time. So overall, we think, and you can obviously argue on whether or not we're being overly conservative in our approach to the new money rate. But what we felt was prudent here was recognizing an additional 50 basis point drop in rates since the third quarter. We are viewing our reinvestment strategies in the portfolios throughout the quarter, and recognizing that conditions suggest there could be a more sustainable low rate environment, we simply felt it was prudent to go ahead and make this move.

And also note that the size of the impact was a bit larger than what we had talked about under our assumption of 50 basis points in the past quarter. Well what's very important to understand is, it's not so much that ultimate assumption, although that plays a role; it's really the path of your assumption over time and the fact that we really dropped that ultimate portfolio assumption fairly significantly by taking this low new money rate environment and stringing it out more slowly over time.

Andrew Kligerman - UBS

So that's the difference in what you were thinking 3 months ago is that you dropped it more and you held it down longer. Is that why last quarter you were much more comfortable that a DAC size like this would not be likely?

Fred Crawford

It was really a combination of rates down, a growing view that they may stay down for longer. And then as we got into the actual process of really dialing in the assumption, you have to pay as much attention to the path of portfolio yields as much as the ultimate yield itself that you expect in the portfolio. And that shape of our forward-looking portfolio yields is as important as the ultimate rate - and those had implications.

Andrew Kligerman - UBS

So the bottom line, confidence that over the next few years we don't need to expect another DAC here?

Fred Crawford

Yes, certainly the way I would phrase it Andrew is that we feel very good about having lowered the risk profile of interest rate related charges as we go forward. Obviously there still needs to be a level of cooperation in the capital markets. But we feel that we took a very prudent step here and as a result feel much more comfortable with the risk profile of our forward earnings.

Operator

Our next questioner in queue is Tom Gallagher with Credit Suisse.

Tom Gallagher - Credit Suisse

Fred, just back on that question, just so I understand it. So by 2020, you are assuming you'd backup to 6. And the starting point today, did you say is about 120 basis points below that? It's kind of where we level-set this and then move up just very gradually over the period. Is that the right way to think about it?

Fred Crawford

Yes, the 100 to 125 points below current portfolio yields, the new money yields, that's about on average as we look across our Life portfolios. Note that there will be some differences portfolio-by-portfolio.

So for example, on the longer duration portfolios which would contain the secondary guarantee product, because we're investing in longer duration securities, you'll tend to be able to achieve something a little better than that. In fact, we have achieved better than that, because we looked at our year-to-date purchases. But on a blended basis, looking across all portfolios, that's where we're now at.

Tom Gallagher - Credit Suisse

And Fred, was the old assumption that rates moved up now sharply within a year or two and now the changes may be just a little more granularity, is it 10, 20 basis points a year? I just want to understand what the slope of the recovery change was just to conceptualize this better.

Fred Crawford

Probably the biggest change was really just that new money assumption. You have to remember a year ago this time, we were actively investing at levels that were in excess of our portfolio yields. And a lot has changed in a year.

And so not surprisingly, the type of assumption we had while we believe to be conservative and prudent was that we were able to invest that new money rates approaching our portfolio yields and building out over time. What we've really done is adjusted that new money rate down much more severely to reflect actual current investments. And that's what's really changed the slope and the ultimate performance of the portfolio as it relates to our assumptions.

Tom Gallagher - Credit Suisse

Was there a statutory reserve impact to this or was this a GAAP-only issue?

Fred Crawford

This was GAAP only. And we have to be attentive to cash flow testing results on our block of business as we approach yearend. Typically, those are done around the yearend timeframe. And as I said however in my comments that at this juncture we don't see cash flow testing pressure as a result of the current low industry environment. That's in large part because we happen to carry a fair amount of excess reserving on those blocks of business, which provides a level of comfort that they can really absorb a level of strain for a period of time.

And so we haven't done that cash flow testing, or that's something we start into as we add into the yearend process. But we're obviously paying very close attention to rates and the effect that could have. And at this point in time, we don't see it as having reserve end or capital implication for the company. And we sit in a good position right now.

Operator

Our next questioner in queue is Ed Spehar with Bank of America.

Ed Spehar - Bank of America

Fred, just again on this interest rate issue, so we're starting at 6, we're assuming new money is 4.75 to 5 for the next five years. And then we assume a new money rate that's going to get you back to 6 by 2020. Is that correct?

Fred Crawford

A little bit different. As I mentioned, the 100 to 125 basis point new money is really when looking more broadly across our Life business. And so you really have to look at the specific portfolios. Our UL portfolio for example has about $22 billion of reserves behind it. The more newer age secondary guarantee products have another $3 billion or so reserves behind it.

And so when you look at those portfolios specifically for example and the longer duration of those portfolios as well as the pre-buying we've done, we've been able to actively invest at our new money rates that are more in the 75 basis points or so area in terms of lower than the portfolio yields.

So as a result, that's more or less what we have installed into our new money assumption. I'm giving you an aggregate point of view to just give you the information that's necessary to understand our results. But realize this was done in a more granular basis on a portfolio-by-portfolio basis, analyzing new money rates by portfolio duration, the roll-off of cash and reinvestment. And so it does differ by portfolio.

Ed Spehar - Bank of America

But just to be clear, you're saying that for the overall Life Insurance segment that the portfolio yield drops from about 6 to 5.70 to 5.75 over five years?

Fred Crawford

Right, the portfolio yield does. And that's being driven down by a new money investment assumption that is in the 75 basis points or better below portfolio yields currently and then a gradual recovery over time. This is really specific to UL portfolios in particular.

Ed Spehar - Bank of America

And then a question about statutory versus GAAP. Is there a scenario where you would see a statutory reserve increase before you would have a K factor at 100 on a GAAP basis?

Fred Crawford

I'd have to think about that. I haven't thought about a question posed in that way relating K factors to stack capital. I think what you're saying is if things get severe enough to where recovery of DAC becomes more of an issue, is it relating to the capital issue.

Ed Spehar - Bank of America

I guess what I'm trying to envision is I can't come up with an example over the past 20-plus years where there's been a statutory reserve increase for a life company before there was a GAAP reserve increase. So I don't think you would see a GAAP reserve increase until you had blown through all the DAC. Isn't that correct?

Fred Crawford

Keep in mind that our just our adjusting here the interest rates had implications for the SOP reserve in this business which is a GAAP reserve issue related to interest rates. So I guess you'll fairly recall that is our assumption change had implications for the reserving and DAC and came before the risk of any statutory reserve issue.

Operator

Our next questionnaire in queue is Randy Binner with FBR Capital Markets.

Randy Binner - FBR Capital Markets

I guess I'm trying to hit the goodwill angle of this. I mean obviously the goodwill review happens in the fourth quarter. And so I'd just be interested now that this set of assumptions that's been described for the Life businesses has been laid out, how is this kind of a magnitude at the impact or the result of the impact would potentially affect fact how the goodwill for the Life segment is reviewed in the fourth quarter?

Dennis Glass

It really doesn't have implications for the goodwill review. That asset review is largely tested around the franchise or new business generation, new business profitability environment of the Life business.

And our sales patterns, our market share, our mix of sales, the expected profitability on what we sell and very importantly our ability to adjust pricing, which we have a proven ability to do for either capital strain or interest rates and still maintain market share and drive product sales, all of those components allow us to feel very comfortable with the valuation of our Life business.

Now we have to go through the testing as any company does, and we have to incorporate all the assumptions including discount rate assumptions on the business and once you settle yourself that the cash flows are holding up nicely, which they are. And so we have to go through that review, but the condition of the franchise remains very strong.

What we're talking about here today in terms of earnings impact is more to do with in-force. And really what we have done is impacted the assets or the carrying value of the Life business where spread compression takes place. So in other words, back assets, VOBA, reserve increases; all effectively reduce the carrying value of the Life business, but more oriented around where spread compression has an impact, and that's on reserves and DAC and VOBA.

The goodwill asset is all about that franchise, that new business and your confidence in being able to maintain and improve profitability levels in what you sell on a daily basis.

Randy Binner - FBR Capital Markets

If there is a little bit of more subjectivity I guess (inaudible) what would that be based on? If I looked to what happened with DAC, there was a lot of assumptions that were kind of $33 million positive and $114 million negative. The business value, is that based on comps? And then why you wouldn't have kind of a similar disproportion ahead of interests rates lower versus everything else?

Dennis Glass

When looking at goodwill, the analysis we do is really when we think about the new business we're booking going forward and let's call the embedded value of that business or the value of the cash flows, and we look at our ability to price or re-price if given the change in economic conditions or policyholder behavior, et cetera.

When we look at the cost associated with securitizing or financing reserves on the business and how that plays into the future profitability or returns, we have pricing power in the marketplace which has a lot to do with your market share which is significant at Lincoln.

All those things play into your views of this cash flow. If any of those things wee to go negative on you, it becomes more expensive to reserve for the products, capital costs increase beyond your assumptions, sales fall off, if those things start to happen, that's where you'll see sensitivity around goodwill.

I guess I'd call it more subjective element is once you have isolated those cash flows which really need to be proven out in your experience, particularly your recent experience, once you've settled in on that, you need to go about the business of discounting those cash flows.

And as I mentioned last quarter, there is good news and bad news on that front. Certainly if the view of the risk profile of the business has increased, you'd suggest a higher risk premium and a higher discount rate applied to the business. However, given the risk free rate environment has dropped so significantly, that has a counterbalancing or offsetting pressure, lowering discount rates.

You're starting to see a little bit of that even in some of the transactions that have taken place in the industry, although there is not a lot of great examples. And so that will go back and forth, and it's not necessarily a bad thing in terms of the industry environment. But what we'll guide you there is a reasonable expectation for discount rates applied to your business. Comparables in the market will guide your thinking.

And as we mentioned before, the reason why you do additional testing on your goodwill when your stock is trading at a discounted book is because of suggestion in that is there is a higher discount rate being applied to certain businesses. And so you've got to go that extra step of really analyzing on a segment by segment basis.

Again, we feel comfortable with the overall conditions of the business, but we do have to go through the process of course.

Operator

Our next question in queue is Eric Berg with Barclays Capital.

Eric Berg - Barclays Capital

Not to minimize the importance of the DAC accounting change, but to make sure that I understand it for what I think it really is, am I right, Fred, when I say that it's accounting-only, meaning it will have the DAC adjustment and the change in your assumptions and not to change in your forecast? And it will have no economic effect on the company, or may be I'm missing something? It feels like an accounting issue only that will no bearing on what Lincoln earns in the bond market in the future.

Fred Crawford

I think that's right, because at the end of the day, what you're really doing is you're just accelerating or decelerating on the amortization of an intangible. You're not necessarily suggesting anything about the underlying cash flows or net present value of the business.

What I'd say however is what's driving your prudent moves to unlock DAC is the notion of the risk of spread compression going forward. That obliviously has economic implications for estimated gross profits and the net present value, if you will, of the business or the cash flows you sold.

So, Eric, there is an economic element to it that's driving you towards unlocking or accelerating the amortization of DAC or building an additional SOP reserve. But in terms of the actual DAC element of it, at the end of the day, it's a timing issue of when you recognize your earnings by and large.

Eric Berg - Barclays Capital

I guess my point was it feels like this is a change in your forecast for what the ultimate economics would look like. But you don't determine interest rates. Interest rates and therefore the spread compression, whatever it is, will be determined by market interest rates. That's all I am saying.

Fred Crawford

You're exactly right. I think we all understandably want to orient ourselves about understanding the assumption and understanding what the risk of future unlockings could be. And again, we feel pretty comfortable with what we've done.

But lost on that conversation is the other end of that coin, which is we very well could be in a position of outperforming these, in which case you'd start to take positive retrospective unlocking through your earnings.

What I look for when I am redialing these assumptions, what I believe to be best estimates, is where I have put the company's assumptions in a position where there is roughly equal opportunity for both outcomes, and you can look at it and say this is certainly prudent under almost any level of scrutiny.

Eric Berg - Barclays Capital

It's a little bit surprising that this is happening in the Life business, because after all this is the business that you work so hard to shield yourself from the effect of lower interest rates by pre-funding the purchase of assets.

Why haven't you been able to or did not choose to, whatever the case may be, pre-fund the purchase of assets in the defined contribution in annuity business and why aren't we seeing in general similar DAC activity in those two businesses?

Dennis Glass

The reason really is that we simply from a risk return trade-off perspective, the risk into our earnings and capital associated with spread compression in our retirement businesses overall was just simply less.

Honestly, Eric, where we've been really focusing frankly is making sure that in this period of time we actually are putting in place protection against the rising interest rate which would be more detrimental to those businesses. And we've been actively putting protection on in that regard.

But also importantly is to note that with on the defined contribution business, which is really where you find most of the spread compression, it's because of relatively older business with high interest rate guarantees. And that's really where we're seeing the spread compression still select lots of business.

It just so happens to be the case that because in part of the age of that business, we have very little back asset left on those businesses that are more susceptible to spread compression. So as a matter of mechanics, there simply was less DAC to impact. Otherwise, there would be a level of impact.

Operator

Our next question in queue is John Nadel with Sterne, Agee.

John Nadel - Sterne, Agee

Fred, I may as well beat the horse to death, right? The question I have for you guys though is along this line. I know anytime we invest in the stock, we're making certain assumptions about a macroenvironment by definition, whether we want to admit it or not. But I guess my question for you is this. It seems to me as someone by definition looking to buy your stock right now is making a bet on rising rates.

If you guys made the assumption of the new money yield forever as opposed to for the next four or five years or whatever the case may be and then that sort of modest increase back to the current portfolio yield by year '10, if we just kept it low, can you give us a sense for what the severity is of what the sensitivity is around that sort of assumption, so that folks can sort of take the risk of what if rates don't rise, (inaudible) your stock right now?

Fred Crawford

John, you can appreciate that if I attempt to run our block a business against every economic point of view that's out there, particularly, interestingly I just was looking at it, you've got many of your shops on this call have very sophisticated economic outlooks for interest rates. And I got to tell you that a 10-year outlook over the next year ranges in your own shops from about 2.75% of 3.75%.

And so there are wild ranges on what folks' point of view is around forward-looking interest rates. So there's a danger in dialing in one point of view in the world. Rather I'd like to settle with something that most observers would look at and say that was prudent, perhaps even conservative, in your approach to it.

But the other thing I would say about your opening comment is this. I think what we're really looking to drive here is retirement and protection assets under management, recognizing that while we may have an environment, as Dennis mentioned, where spreads are weighing down on our returns, that may also be an environment, this quarter being a good example, where markets are driving retirement-based asset returns significantly.

And so our mission is to build products and distribution that drive retirement and protection assets under management, put in protection against tail risk related to the markets, but we don't want you to necessarily have to be investing in our stock with some sort of debt added to it relative to a particular macro condition.

John Nadel - Sterne, Agee

My second question is can you give us an update on your CFO search?

Dennis Glass

We are working hard. It's a great opportunity for someone. We have a lot of interest in the position. And at the same time, it's a very, very important decision for me and the management team. And so we're making sure that we've explored all opportunities and would expect some reasonable period of time to have come to a conclusion.

I'd like to come back to the other issue about interest rates, which is an important issue, and I am glad we've had the time to talk about what we think is a pretty prudent decision this quarter. The other point I would make and this gets back to headwinds and tailwinds, only a third of the company's total earnings are driven by interest rate margins. The other parts of our earnings margins are made of, and at one point, it was about a third, a third, a third between equity-driven fees, and mortality, and morbidity.

So I understand again the importance and the significance of the focus on interest margins long term interest rates, but just to add to the conversation, there are tailwinds and headwinds and this represents only about a third of our earnings.

John Nadel - Sterne, Agee

And if I could sneak one more in. Just on the $1.9 billion of capital cushion above of 400% RBC, should we have any expectation of any portion of that being deployed? I mean, it feels to me like we are getting told by a lot of companies that we are sitting on a lot of excess capital. And yet stocks are very cheap by historical standards and there's little if anything being done by the companies, other than obviously your warrant repurchase this quarter. Can you give us a sense for deployable capital and expectations there?

Fred Crawford

Yes, couple of things; and you probably heard this from other management teams. And I'll just come back to a comment that I made and then you can qualify that. I do feel better about the quality of our excess capital position this quarter than I did a quarter ago, again for the reasons I've stated. At the same time, when I look forward, we're not completely out of the woods on a double dip recession. The rating agencies remain cautious about the industry.

Potentially although, I don't think so there's some regulatory issues that are floating around. So, yes, I am more comfortable; yes, we want to put this capital to work. We did a little bit this quarter, $48 million. We are very conscious of the concept of getting idle capital put to work, either returning it to the shareholders in some way or shape or investing it in the business.

I can just say that our confidence continues to improve, and we'll just continue to watch the environment and the opportunities that we might have.

John Nadel - Sterne, Agee

Are you pricing it at a risk-based capital ratio of 400%, new business, or is it still lower than that?

Fred Crawford

It's roughly in the same category.

Operator

Our next questioner in queue is Steven Schwartz with Raymond James.

Steven Schwartz - Raymond James

I just want to quickly follow up on the capital question. Dennis, you still have a lot of retail investors from the JP days that are on the stock. Can you talk to the dividend?

Dennis Glass

That would be one of the ways to return capital to the shareholders. That's a Board level decision, but certainly it's something that we think about.

Steven Schwartz - Raymond James

And then if I may, just what is the takeaway here on the group protection? You kind of sounded to me like you are all over the place. Maybe it was just one of those things; maybe it will come down, you know, but we've got higher caseloads, we're looking at re-pricing. I mean, what's the takeaway here?

Dennis Glass

I think the principal takeaway is that this has been a very profitable business for us for a decade. And there may be some of you that have been around long enough to know that we had this type of a discussion with the people who were following at the time Jefferson-Pilot because, I forget, in 2004 or 2005 we saw the same type of spike.

Now let me try to parse out some of your questions. With respect to the issue of bringing more resources, that's a responsive management action to deal with, frankly more claims coming in the door and having to be managed. And so that helps us get, if you will, the claims to the right position, either off the books or keep them on the books. But even if we keep them on the books, trying to work hard to get the people back to work with either long or short term disability. So put that in the bucket. We are taking actions to deal with a larger inflow of activity. And that will subside as we get the inventory claims down. So that's one issue.

The second issue is, where is it coming from? And what I've tried to explain is that it's coming from completely across the board. So it's not new business that might have somehow been mis-priced. Again, it's from all cohorts of sales, all industries. And so that would lead us to believe that in some way, shape or form this incident spike is externally driven. So that would be another issue.

Now just to put some perspective on our incidence ratios, historically around from 3.89 to 3.9 per thousand in '09 when we had a spectacular year they were at 3.7 per thousand, and the current quarter they're at 4.1.

So now let me come back to the pricing issue. If we think that there is something that's happening externally that causes us to raise pricing, we will do that. And in fact we probably raised pricing on some of the blocks and some of our new business already in the 3% to 4% range.

So to put in perspective, we think it's predominantly externally driven. We're working very hard and adding resources to deal with the increased activity. We were watching what has been a spike, we hope temporary in nature in incidence. But if it isn't temporary in incidence, then we will be more aggressive with our future pricing. And remember, this is by and large short term pricing business so that we can get out of bad blocks and re-price it pretty quickly.

Steven Schwartz - Raymond James

If there is a need to re-price this, can this be feathered in over a year or is there some guarantee periods and maybe it goes over two or three years?

Fred Crawford

Most of the business is priced in the one to three year range, and certainly the new business that we'd be putting on the books would be priced immediately if we thought it was appropriate to increase.

Operator

Our next questioner in queue is Bob Glasspiegel with Langen McAlenney.

Bob Glasspiegel - Langen McAlenney

Sticking with Steven's theme on protection, you did grow your sales 15%, 14% last year which is faster than some of the bigger competitors that were saying it was competition. So as you postmortem, you're still pretty sure it wasn't an under-priced sales effort from last year?

Dennis Glass

That's a great question. And what I look at and the team looks at over time as one indicator of our pricing is sales close ratios. So if I look back over the last 36 months, our sales close ratios ran in the first 24 months of those 36 months, roughly around 10% and now they are down to 9%. That being one pretty good indicator, there is nothing to suggest that we were taking market share disproportionately in this period of time.

Bob Glasspiegel - Langen McAlenney

As you guys do your modeling for the future, when does a more active, normal capital management dividend become part of your plan? Are we sort of three to six months away, a year to two and three years? And what sort of macro-variable would accelerate sort of buyback?

Dennis Glass

Although we have a longer-term view, we look at it to sort of in real time and make decisions as we go along.

Bob Glasspiegel - Langen McAlenney

So you can't envision buyback in the next year as being an important lever?

Dennis Glass

We've already bought some shares back. So there's evidence that we would do that, but we're not prepared to announce at any point any large share buyback even though that doesn't preclude something from happening.

Fred Crawford

We're watching lot of things evolve, Bob. And as Dennis mentioned, economic conditions have obviously evolved, which you've heard from most companies in the industry. There is still a little bit of evolving going on at the rating agency environment to a lots of degree, but some regulatory change taking place as well.

And I think many of the industry are trying to pause a little bit on their excess capital positions and watch a few of these things unfold and crystallize and then get about the business of utilizing the excess capital to build returns in the business.

So, I know it's frustrating period of time, and I know you're getting a very similar answer from many companies in the industry, but it's because we're all staring at the same set of dynamics. And so it's difficult to talk about the end point of that. But certainly we'd expect and hope a lot of that to clear up in 2011.

Operator

Our next questioner in queue is Mark Finkelstein with Macquarie.

Mark Finkelstein - Macquarie

I guess this is a follow-up to whole bunch of questions. I think I understand kind of the reserve estimate, what was done in the yield assumptions. I think, Fred, you mentioned that earnings in the Life business kind of should revert back to the $150 million range. But I guess theoretically in this change, we're adjusting our assumption around long-term earnings or EGPs.

And so I guess what I am confused about is why isn't there an ongoing earnings impact going forward, whether it's just narrower spreads, which maybe that's accounted for in the $27 million to $35 million you talked about earlier, but definitely a higher DAC amortization rate? So if I didn't understand this correctly, clarify it. What am I missing here?

Dennis Glass

First, there are some run rate adjustments related to the many changes we've put in place, but a number of them offsetting it as it pertains to DAC amortization levels going forward. So for example, the interest rate change in and of itself had both the DAC impact and an SOP impact. There are other positive adjustments that were made in the period, which is commonly the case when you're reviewing all your assumptions, adjustments around mortality. For example, based on the mortality studies we've done internally, a finer more exacting approach to surrender activity and how to model that from a profit perspective.

So on a net basis, you didn't have quite as dramatic a change in some of the DAC balance related issues. You had more of a dramatic change in the SOP reserve on a net basis. So there are some implications for forward-looking earnings, but on balance, not a material degradation in the run rate expectation for the company.

Operator

We have time for one final question, and it comes from Darin Arita of Deutsche Bank.

Darin Arita - Deutsche Bank

In respect with the low interest rate discussed in here, and I was wondering if you ran this analysis you did on the Life segment, if you ran it on the annuity business, how would that turn out as we think about both the fixed annuity side and also your VA guarantees?

Dennis Glass

As a matter of general practice, we don't pick and choose where we're going to have an outlook. It wouldn't make sense for us to have one interest rate outlook for one business and a different interest rate outlook for another. And so you can assume that we've applied this discipline across all our businesses. But that'll be very different impact based on the nature of the business.

And so as I mentioned earlier, on a fixed annuity basis, because we have ample room in our crediting rate structures and a bit more of a matched booked environment, plus obviously an ability to re-price or adjust our crediting rates very rapidly, or weekly as commonly done in the industry, we can really react quickly to low interest rates and mitigate the extent of pressure and the related DAC unlocking or assumption changes related to it.

On the variable annuity side, what's important to know, which I think is what's driving your question, is that when you're looking at separate account returns, you have both an equity return and a fixed return. And what allows us to be very comfortable is our corridor approach. You tend to want to think of that corridor as an equity market assumption, but it's really not. It's a separate account value assumption. It's what our expectations for growth in those separate account values.

And as I mentioned during my comments when I was talking about the corridor, we sit here today with an account value assumption going forward where the returns on those account values are going to drop immediately 15% and then recover very slowly at a 9% annualized rate, this is why I personally and we have grown fond of the corridor process. It does what you would expect it do.

After a series of quarter where the equity markets have been hot and rising, it would stand to reason that you would want to lower your forward-looking expectations in an environment where the markets had dropped significantly and would stand the reason that your forward expectation for market recovery will be more robust. The corridor process sort of encapsulates all of that and doesn't run our results up and down for those shorter-term movements.

And that's where it gets uncomfortable. So if your apply your low interest rate assumption to the fixed portion of the variable annuity business, that's really incorporated in the overall corridor account value approach. And we feel comfortable with it.

Darin Arita - Deutsche Bank

And as you were thinking about a lower interest rate environment for the annuities, what was the corresponding assumption on where lapse rates would go?

Dennis Glass

Lapse rates were of kind of a different story. We did adjust our lapse rate assumption on the business, predominantly on our variable annuity business. But it didn't actually have to do necessarily within the moneyness or what would more commonly be discussed related to lapse rates on annuities. This had more to do with just a pattern of better persistency over a number of years now that has led us to bring down particularly the lapse assumption once our product is outside the surrender charts period.

And so we brought that assumption down. That had a positive DAC impact in the quarter on our annuity business. You didn't see that in the results on a net basis, because it was offset by a negative impact from our valuation conversion estimate. And so it netted out to have very little impact in the quarter, a couple million dollars of negative impact in the quarter.

So we did make adjustments to the lapse assumption. That also carries through to some adjustments made related to the hedge program that will move that around and are embedded in our results this quarter. So that's really where we worked in the lapse rate. It wasn't so much of an impact item on the fixed side.

Operator

That concludes our time for Q&A. I'd now like to turn the program back over to Jim Sjoreen for any closing remarks.

Jim Sjoreen

Thank you, operator, and thank you all for joining us this morning. As always, we will take your questions on our Investor Relations line 1-800-237-2920 or via e-mail at www.investorrelations@LFG.com. And as a reminder we will be hosting our annual conference for investors, analysts and bankers on November 18 and that will be available via webcast. Again, thank you for your time today.

Operator

Ladies and gentlemen, this does conclude today's program. Thank you for your participation and have a wonderful day. Attendees, you may disconnect at this time.

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