Lincoln National's (LNC) CEO Dennis Glass on Q2 2014 Results - Earnings Call Transcript

Aug. 3.14 | About: Lincoln National (LNC)

Lincoln National Corporation (NYSE:LNC)

Q2 2014 Earnings Conference Call

July 31, 2014 10:00 a.m. ET

Executives

Dennis R. Glass – President and Chief Executive Officer

Randal Freitag – Chief Financial Officer

Jim Sjoreen – Senior Vice President, Investor Relations

Analysts

Suneet Kamath – UBS

Seth Weiss – Bank of America Merrill Lynch

Jamminder Bhullar – JPMorgan Chase & Co.

Nigel Dally – Morgan Stanley

Randy Binner – FBR & Co.

Tom Gallagher – Credit Suisse

Eric Berg – RBC Capital Markets

John Nadel – Sterne, Agee & Leach, Inc.

Steven Schwartz – Raymond James & Associates

Colin Devine – Jefferies & Co.

Operator

Good morning, and thank you for joining Lincoln Financial Group's Second Quarter 2014 Earnings Conference Call. (Operator Instructions).

At this time, I would like to turn the conference over to the Senior Vice President of Investors Relations, Jim Sjoreen. Mr. Sjoreen, please go ahead.

Jim Sjoreen

Thank you, operator. And 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 sales and deposits, income from operations and liquidity and capital resources are forward-looking statements under the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve risks and uncertainties that could cause the 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 Randy Freitag, Chief Financial Officer. After their prepared remarks, we will move to the question-and-answer portion of the call.

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

Dennis Glass

Thank you, Jim, and good morning everyone. Lincoln reported another quarter outstanding results, including a 13% return on equity and record levels of operating revenue, operating earnings per share and efforts on their management. Our strong performance is a continuation of good results, generally driven by strong sales with attractive returns, positive net flows, equity markets driving higher AUM and related fees, disciplined expense management, favorable alternative investment income and pre-pays and active capital management including $150 million of share repurchases in the last quarter.

We also continued to make progress on our strategy to lean a little more towards the sales of products without long-term guarantees. 68% of total sales in the quarter were in products without long-term guarantees, up from 59% a year ago and against a target of 70%. We also upsized our VA reinsurance deal with Union Hamilton by an additional $4 billion, covering sales through the end of 2015. We did miss expectations this quarter in Group Protection. Randy and I will touch on group results in more detail in a moment. However, I'd like to emphasize that we have the right strategy in place. We’re taking necessary pricing actions, and with new and strengthened leadership in place to address the issues, I am confident that we’ll get back on track.

Let me turn now to the business lines, starting with the Life segment. Sales of our individual life products grew by 7% from a year ago excluding COLI. These results benefited from continued strong sales of Indexed Universal Life, Variable Universal Life and Term, offsetting weaker MoneyGuard sales related to the rollout of the new product. We expect MoneyGuard sales to pick up in the second half.

The diversification of sales by product and the returns on new business in the 13% to 15% range provides us with among the best risk return positions we have seen for the Life business. Also, our portfolio solutions, is as broad and competitive as it's ever been. We will take further steps to enhance our offerings to maintain our position as a leader in this phase. In the next quarter, we will introduce a survivorship version of our Indexed Universal Life solution. Other product development activities include a new retail COLI product, along with enhancements to our term portfolio later this year. Based on market demand in our enhanced product portfolio, we expect to see strong sales results in the Individual Life business for the remainder of the year.

Switching to our individual annuity business, it was another quarter of great results. Total annuity sales of $3.6 billion drove positive net flows of $800,000 plus. Sales were down 15% from the prior year quarter. However, you may recall in the second quarter of last year, we experienced an outsized lift to our variable annuity sales resulting from competitor dynamics. We maintained our emphasis on increasing variable annuity sales without living benefits. 23% of the quarter’s VA sales had no living benefits, up from 9% a year ago, and a change made possible by the size and quality of our wholesaling force. We supported this key strategy further in the second quarter with the launch of investor advantage, our new investment focused VA product that provides an efficient platform for account value performance. These actions continue to advance us towards achieving our organic goal of 30% of VA sales without a living benefit. When factoring in the benefit of the reinsurance transaction, 42% of VA sales in the quarter had no living benefits.

Also supplementing our sales mix strategy, fixed annuity sales carried the momentum from the first quarter into the second quarter, with sales up 49% from the prior year. As we move forward, our view of the annuity business remains unchanged. The right volume of sales and the profitability and risk profile of new business continues to make the annuity business very attractive.

In Group Protection, we continued to address our profitability challenges. As I have pointed out before, we started implementing pricing actions in mid-2013 aimed primarily at our employee-paid life and disability business. These pricing actions are achieving mid to upper single-digit increases in both new sales and renewals. We will continue to make pricing changes as needed in order to restore profitability. Given the rate increases, new business levels were off in the second quarter.

We continued to make inroads on our target strategy to further expand the employee-paid voluntary market. In the quarter, 43% of our sales were employee-paid, up from 39% in prior quarter. This is an important element in our overall strategy to achieve and sustain profitable growth in this business. Achieving this shift in sales mix, combined with ongoing pricing actions and strengthening our management team notably with the recent appointment of Dick Mucci as president, have us on the right path to achieve our strategic and earnings objectives over time.

Moving to Retirement Plan Services, it was a strong quarter with improved improvements in both sales and retention, leading to positive net flows of $366 million. Second quarter deposits of $1.8 billion, were up 12% from a year ago, driven by a 27% increase in first year sales. Increased sales momentum is a direct result of the investments we are making in distribution and technology. We are expanding our small market sales force, now 25% larger than one year ago.

Tapping into strategic relationships with leading distributors like Merrill Lynch, Wells Fargo and Ameriprise where sales have more than doubled from the last year, increasing our competitiveness through an enhanced service offering enabled by our new platform. These efforts, along with the broader and deeper relationships are affording us new opportunities with more consultants. Year to date, 44% of our mid to large market opportunities are from consultants who previously did not give us a look.

Overall retention improved compared to the first quarter, the result of focused retention efforts including dedicated retention teams and enhanced risk reporting. We’re happy with the progress we’ve made and expect to see continued growth from our retirement business.

In distribution we had another strong quarters well. Our broader and deep distribution franchise continues to be a differentiator, enabling us to grow sales and shift our mix when necessary. Our wholesale franchise, Lincoln Financial Distributors reaches more than 65,000 producers annually, a 3% increase from a year ago. In addition to growing, they were more productive, evidenced by repeat producers growing 4% over last year and a 12% jump in the number producers selling multiple Lincoln products.

Moving to our retail franchise, Investment News ranked Lincoln Financial Network as the second largest independent producer sales force in 2013. We continued to grow our affiliated advisor base up 2% from a year now reaching over 8,500. LFN drives more of Lincoln sales than any other firm currently at 13% share and we are committed to making investments to deepen this retail franchise. You’ve heard me say this before, distribution is a competitive advantage for Lincoln and we’ll continue to invest in and tap into the strength of our nearly 1,400 wholesale, retail and work side professional across Lincoln who are telling our compelling story.

And on investment managements, we continued to drive strong results while maintaining our portfolio’s high investment grade quality. Our fixed income portfolio yield stands at 5.14% and our net unrealized gain is $7.5 billion or 9.5 % of assets, which the long duration of our invested assets is driving our increase in that dollar amount.

Despite a persistently low yield environment, our new money purchases of $2.4 billion were invested at an average yield of 4.5%, 30 basis points over our average new money rate in 2013 with our yield enhancing debt program contributing 18 basis points to our new money yields this quarter. Our approach to the yield enhancing debt has focused on less liquid asset classes where yields and the quality of underwriting remain attractive. We also continued to commit capital to our alternatives program as we expand this strategy. We maintained the flexibility for further growth as well as benefit from its portfolio diversification and higher income yields.

Let me close my comments by saying once again that we had a very good second quarter. I’m confident that all the actions we are taking will enable us to achieve our long terms earnings growth, ROE and diversification objectives.

And with that I will now turn the call over to Randy.

Randal Freitag

Thank you, Dennis. Last night we reported income from operations of $394 million or $1.47 per share for the second quarter, up 16% from the prior year period. The quarter demonstrates the strength of a diversified set of earnings drivers as account value growth in the Annuity, Retirement and Life segments drove stronger earnings than more than offset weak results in our group business. The quarter’s earnings benefited from $11 million or $0.04 per share of normalized items, including $6 million in the other operation segment and $5 million in the life segment.

In addition to record operating earnings, the quarter featured strong performance across most financial measures, including topline line growth with operating revenues up 8%, continued expense discipline with G&A net of capitalized expenses remaining flat with the prior year. Coupled with a strong revenue growth we saw G&A as a percent of revenue decline 90 basis points from the prior year. And book value per share, excluding AOCI, grew 9% to $46.97, while return on equity increased to 13%.

Turning to the investment portfolio, income from alternative investments was in line with our expectations, while income from bond and mortgage prepayments remained elevated during the quarter, primarily benefiting the individual Life segment. Strong prepayment income has been a recurring theme for the past few years, which seems to be related to the environment that exists today. While it is a difficult number to project, we will not be at all surprised and in fact would expect to see elevated levels of prepayment income should the current environment persist.

Realized gain and loss performance was a net positive this quarter with $5 million of realized gains on investments, while the hedge program had another great quarter of performance. And the unrealized gain on our investment portfolio increased to $7.5 billion pretax or over $12 of book value per share.

Turning to segment results and starting with annuities. Reported earnings for the quarter were $227 million, a 16% increase over the prior year. Operating revenue growth of 13% was driven by fee income which grew 24% as average account values grew 14% and the average fee assessment rate increased by 8 basis points.

Negatively impacting revenue growth was net investment income which declined 5.5% as prepayment income decreased from an elevated level in the second quarter of 2013.

Consistent with recent quarters, the ROE and the annuity business came in at 26.7% for the second quarter. The combination of strong equity markets, positive net flows and strong new business returns provide an excellent back drop for the annuity business. The benefits of that environment are evident in what was another outstanding quarter of results.

In Retirement Plan Services, we reported earnings of $39 million consistent with both the prior year and previous quarters. Revenues were flat year over year on lower net investment income while fee revenue increased 7% on higher assets under management. Average account values increased 12% from the prior year period and ended the quarter at a record $54 billion. Spread compression in the retirement segment remained fairly constant with normalized spreads coming in 9 basis points lower compared to a year ago and 3 basis points lower than the prior quarter. Management actions to alleviate the effects of spread compressions are helping to partially offset the impact of current interest rate environment. Efforts to lower guaranteed minimum interest rates over the last year have lowered the credit and interest rate by 4 basis points.

Return on assets for the quarter of 30 basis points and a pretax net margin of 35% were again at the high end of our expectations, another strong quarter for the retirement business as asset growth driven by the strength of the equity markets offset the drag that spread compression is having on the business.

The Life Insurance segment reported earnings in the quarter of $148 million compared to $135 million in the prior year. Earnings drivers were strong in the quarter, with average account balances up 7% to $41 billion while Life insurance in force increased 5% to $629 billion. It was a very good quarter for the Life business, with several items contributing to the results, including mortality returned to expected levels after negatively impacting the first quarter by $18 million. As noted in the press release, earnings were positively impacted by $5 million primarily related to expenses. And the Life segment was the primary beneficiary of the prepayment income that I noted earlier. It benefited the segment by approximately $6 million.

The Group Protection segment reported earnings of $2 million in the quarter, down from $22 million in the year ago quarter and $20 million in the first quarter of this year. Relative to the first quarter, earnings were negatively impacted by two items. Mortality was elevated due to the cleanup of claims related to unclaimed property. This one time item impacted the quarter by $4 million and LTD claim experience which impacted the quarter $13 million. LTD metrics were mixed in the quarter with elevated incidents, while severity and recoveries were in line with expectations. LTD incidents was driven primarily by more serious complex disabilities and more subjective medical conditions such as musculoskeletal and psychiatric issues.

We continue to investigate the quarter’s experience and as we learn more, we will appropriately enhance administrative capacity to deal with any elevated level of these types of claim. Our analysis also leads us to believe that the LTD claim experience is driven more by volatility than any trend downward in morbidity experience. For example, when we examined our incidents over the past few years, we did not see evidence of deteriorating morbidity trends and incidence patterns.

Importantly, as Dennis mentioned, we are making progress on our plan pricing actions. That, combined with managing premium persistency to reasonable levels, and at the same time driving our business mix to the higher profit margin employee-paid and voluntary segments, are the right steps to restore profitability.

Regarding our earnings guidance for the year, the quarter’s results increased the likelihood that we will be at or below $60 million of earnings for the year, the low end of our guidance range.

Turning to capital activities. We repurchased $150 million of our shares during the quarter, moving us to $300 million for the first half of the year, while statutory capital grew approximately $80 million over the quarter to $8.25 billion, with RBC coming in at 503%.

During the quarter, we sent $210 million of dividends to the holding company, where we ended the quarter with $573 million of cash. The strong statutory performance and the balance sheet, coupled with the cash position at the holding company, put us in a very good position to meet or exceed our full year guidance for $500 million to $550 million of share buybacks.

To summarize, three of our businesses had excellent quarters that overcame weak performance in the group business. And when you wrap it all together, it was another strong quarter for Lincoln, with topline growth of 8%, disciplined expense management with solid improvement expense ratios, continued capital deployment through share buybacks, consistent growth and strength in the balance sheet with book value per share up 9% and a return on equity of 13%.

With that, let’s move to Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Suneet Kamath with UBS. Please go ahead. Your line is now open.

Suneet Kamath – UBS

I just wanted to start with group protection if I could. Dennis. In your prepared remarks, you said that some of the changes that you have made give you some confidence that you are going to get back on track. How long do you think it will take you to get back on track? Clearly the year-to-date earnings annualized is going to come in well below that 60 to 80 and Randy made some comments about that. So what sort of time frame are we talking about here?

Dennis Glass

Suneet, great question. Candidly not entirely easy to answer, but let me give you some facts. As we talked about last quarter and I guess even in the quarter before that, we really have to re-price about $1 billion worth of employer-paid premium. And it's going to take somewhere in the neighborhood or through the early part of 2015 to get that all re-priced. And so the impact on earnings of that re-pricing will show up in the latter part of 2014 to some extent, and then into 2015. So it will take through the end of 2015 for us to get back on plan, or excuse me, back up to higher levels of earnings. It could be a bumpy road in between now and then because we’re seeing some volatility as we’ve reported. So I think it's 2015, sometime in 2015 when we’ll begin to see some back to more normal levels.

Suneet Kamath – UBS

All right. And then you talked about the mid to high single digit rate increases that you have been implementing since the middle part of last year, I think. Just based on what you know now, in the quarter's experience, do you think that rate that you took is enough? Or could we be looking at another round of increases that is required?

Dennis Glass

We’re going to monitor that, Suneet. And we’re going to continue to make adjustments as needed. So it's hard to say exactly how much more we’ll need. We just have to see how the earnings continue to improve, how our lost ratios change. So we’re -- let me just say it this way. We obviously have a rightful focus on getting the right ROEs on this business. It's a function of premium increases. It's a function of incidence changes. And we’re working very hard at adding the staff that’s necessary to get that done.

Suneet Kamath – UBS

I got it. And then just one other one for Randy, I think when you originally did the VA reinsurance deal, either you or Dennis gave us some high level comments about the economics of that transaction. Should we think about this new deal that you just announced, or that you're pursuing to be roughly similar with that original transaction?

Randal Freitag

The economics of the two tranches are roughly the same. And as in the past, we’re not going to get into the details of what those economics are other than say that, as compared to a fully living benefit sale without the benefit of reinsurance, maybe it's with the benefit of the reinsurance. Maybe it's 1% or 2% off our internal rates of return.

Suneet Kamath – UBS

All right. So about in line with what did you before?

Randal Freitag

Yes.

Operator

Thank you and our next question comes from the line of Seth Weiss with Bank of America. Your line is open. Please go ahead.

Seth Weiss – Bank of America Merrill Lynch

I had a question about the annuity segment and the market leverage within there. Randy, last quarter, you gave us sort of a rule of thumb, 1% increase in the S&P provides about $7 million in annual earnings, and I think the results this quarter are very much in line with that kind of market growth. My question is, if we see the market come down, is the leverage on the way down the same as the way up? And the reason I ask because I believe you earn fees on guaranteed levels, not asset levels. So I would expect the leverage to maybe not be as much on the way down, or the sensitivity to not be as much as the way down. I’d appreciate your comments. Thanks.

Randal Freitag

Sure Weiss. Yeah, you’re absolutely correct. It's little less on the way down. That sensitivity to movements is going to increase as the overall account balances in the annuity segment go up. So our latest analysis would have a 1% movement, now having about $8 million positive increase on the segment as opposed to a 1% decrease having roughly a $6 million to $7 million negative impact. So there is a little more leverage going up, given where we are in the quarter, which is the primary driver of that.

Seth Weiss – Bank of America Merrill Lynch

Okay, that's helpful. And just in terms of sensitivity to hygiene costs, hygiene costs have stayed low for some time and I believe that has a little bit of a positive bleed through on operating earnings. Is that something that we should think of as maybe a potential pressure if we see hygiene costs increase, volatility increase in the market? Or is the role on the hedge so it’s not all that, you’re not going to see that impact sharply in any given quarter?

Randal Freitag

Yeah. What you would see if the hedging costs go up is that the extraordinary profitability that we even experienced in our new sales and we’ve talked about, returns on new sales have been in the 20s would come down. Now we don’t expect to be in the 20s forever I would say. So I wouldn’t be surprised to see the margin you’re getting on that guarantee rider come down over time. But we’re currently experiencing strong returns, and we expect to see that for the foreseeable future I should say. So, yeah, over the long term I wouldn’t be surprised to see that margin earning come down. But for right now, it's very strong and we continue to get those same excess returns.

Operator

Thank you, and our next question comes from the line of Jimmy Bhullar with JP Morgan. Your line is open. Please go ahead.

Jamminder Bhullar – JPMorgan Chase & Co.

Hi, good morning. First, on the disability business, if you just talk about the success you're having in raising prices in the business. How is it impacting persistency and a couple of years from now, when are you done re-pricing the book, how much of the book do you expect to lose? And then secondly, just a comment on initial traction of the VA product without living benefit guarantees.

Dennis Glass

Let me ask Randy to talk about in a little bit more detail than I did about the timing of the repricing and then when that repricing flows into earnings. My comment was about in 2015 was more about timing of the repricing. Randy, why don’t you talk how that affects earnings?

Randal Freitag

Sure. So the total amount of premium that we expect to be re-priced in this employer-paid segment is $1.1 billion. Through the second quarter of this year we’ve actually repriced $300 million of that. Now in terms of the earn to premium we’ve experienced in the first half of the year, roughly $130 million of that premium has been at this increased level. Of the $1.1 billion, about $130 million of that we experienced in the first half of the year. As we move throughout this year, over the course of this year we will reprice in total $500 million of that $1.1 billion. And about $300 million of that premium will come through in this year. That’s how you should experience. Then as you move into 2015, we’ll pretty much complete the repricing as we hit the 1/1 2016 renewals. So you should see about $800 million to 900 million of that premium effectively repriced inside of our 2015 earned premium and then it would all be repriced in 2016 effectively. Now in terms of the persistency on that, our historic persistency is roughly 80%. We’ve continued to experience persistence roughly in that range and I wouldn’t expect it to change in a material way from that.

Jamminder Bhullar – JPMorgan Chase & Co.

And then on the VA

Dennis Glass

I’m sorry. Could you repeat the VA question?

Jamminder Bhullar – JPMorgan Chase & Co.

On the variable annuity product, just an initial attraction of the new product without living benefits, because other companies have tried to do that and they haven't had a lot of success. So just wondering what you've seen so far.

Dennis Glass

We’ve built the -- first of all we introduced it in June so we don’t have any -- we saw a little bit of it, but not a lot of it. But we are very excited about it as a great mutual fund lineup. It has asset allocations imbedded in it. An important distinction from our competition is that it has an exit strategy, which is not a guaranteed exit strategy, but it’s our eye for Life pattern which permits distributions first to be in the nature of principal and then cumulated interest income. Great lineup, good asset allocation tools inside the product and an exit strategy which differentiates us from the competition. And I’ll come back to it again. The strength of our distribution is really powerful and it lets us make changes that maybe, well just that we can make changes. And let me come back to what I said a moment ago. Without any new product, we’ve moved the mix to 23% on guarantee. I think we can get -- with a good product we can achieve over the next couple of years 30% on an organic basis. And as you know, in the meantime we have the benefit of the reinsurance deal to keep the -- we are actually ahead of our objectives on non-guaranteed VA business.

Operator

Thank you and our next question comes from the line of Nigel Dally with Morgan Stanley. Your line is open. Please go ahead.

Nigel Dally – Morgan Stanley

Good morning. I have a question on interest rates and the sharp reduction we have seen this year. Randy, I know you're comfortable in being able to maintain your returns despite the low rate environment. In fact this quarter we saw some sold improvements. But perhaps you can also touch on how we should be thinking about interest rates given your upcoming actuarial review in the third quarter.

Randal Freitag

Nigel, you were breaking up a little bit so I’m going to have to fill in the blanks on a couple of the words. But as you mentioned, we will be doing our third quarter actuarial study in the third quarter. As part of that we’ll update our J curve. I don’t expect a huge impact. Rates are relatively similar to where they were, but of course we’ll update that as appropriate as we get there. But I don’t expect a huge impact from interest rates or a large impact from interest rates this year. In terms of how interest rates at current levels are hitting our statements, it continues to primarily be an issue for the Life and the retirement segment. The Life segment is seeing its spread decline roughly 8 to 12 basis points or so on annual basis at current level. And the retirement business is seeing its spread go down about 10 to 15 basis points on an Annual basis. If you look at those numbers and what does that mean from a quarterly standpoint, it’s roughly a $3 million or so headwind against earning with rates at this level.

Operator

Thank you and our next question comes from the line of Randy Binner with FBR & Co. Your line is open. Please go ahead.

Randy Binner – FBR & Co.

Thank you. I want to ask a question about capital and liquidity and how that’s related to buybacks, because so $150 million in each of the first two quarters has been good. And I guess the first question is just to clarify the $573 million of hold-co liquidity. Is that total or is that above your buffer that you like to keep?

Randal Freitag

No, that’s the total. The targeted amount is 500 and we’re at 553 as we sit here today.

Randy Binner – FBR & Co.

So I guess, and you said you had $210 million of dividends that came up. So is that almost all of the statutory earnings in the quarter?

Randal Freitag

No. As I mentioned in my script, the stat capital grew by about $80 million during the quarter. Total stat earnings were roughly $290 million in the quarter.

Randy Binner – FBR & Co.

Okay. And so that’s a good level, I think. Was there anything unusual in that stat earnings in the quarter?

Randal Freitag

No. As I mentioned we had a really strong first quarter. I didn’t expect that level at the first quarter to repeat where it was roughly $370 million. But I think that $290 million number is a reasonable number. I think what you are seeing in there are a couple of items. You’re seeing the growth in earnings, right? So you are seeing our GAAP earning grow and some of that should transfer through to statutory also. And then you are also seeing, and this is especially on the Life side, less strain given that the mix of sales has changed. If you go back two years we’ve talked about a dollar of strain for each dollar of life sales. And that number is roughly $0.80 per dollar of sales right now. You’re seeing the benefit of the mix change and part of that is flowing in to earnings also.

Randy Binner – FBR & Co.

Okay. And then just kind of a final piece of that is the -- I think your commentary earlier in the year was that you were not planning on doing a reserve financing this year. I guess I’d ask, is that still the case? Because previously it seemed like at least to me that you kind of needed to do reserve financing to get the full buyback, and maybe for the reasons you just explained, you have a little bit cleaner kind of cash flow coming up to the insurance -- up to the holding company. And so is that the right take-away and can we kind of hit the high end of that buy back without a reserve financing this year?

Randal Freitag

You answered the question for me. Yes, I’m very comfortable with the earnings we experienced in the second quarter which support the share buybacks and everything else that we’ve done. Now in terms of reserve financings, I don’t expected that we will do one this year. The sales mix given its change with GUA sales coming down quite a bit, means that it’s roughly in other year sort of thing for us from a reserve financing standpoint.

Operator

Thank you and our next question comes from the line of Tom Gallagher with Credit Suisse. Your line is open. Please go ahead.

Tom Gallagher – Credit Suisse

Good morning. Just first question for Randy, any geography changes we should be thinking about as an area of focus into balance sheet review for 3Q related to either DAC or reserves, whether it’s the equity cushion in DAC or interest rate assumptions? Anything we should be aware of?

Randal Freitag

No big things that I would caution or alert you to as we go into the process. We made substantial changes on the annuity side to the underlying assumptions around lapse and utilization last year and the year before. I wouldn’t expect huge changes in those assumptions this year. The corridor we are still inside the corridor or the area where we would look at it. So I feel comfortable where we are there. So there’s nothing in particular that I would alert you to as we go into the process.

Tom Gallagher – Credit Suisse

Okay. And then a follow-up on the disability claims issue. So Randy, you had mentioned you all had seen some more, what you described as subjective claims in disability. Can I take that commentary to mean that you are going to start emphasizing more claims adjudication and recovery, and focus more on sort of the scrutiny of the legitimacy and ability to get claims off the books? Is that going to be an area of focus going forward?

Dennis Glass

Let me try to answer that. Claims management is a big part of the Group Protection business. And as I’ve watched it over the years, you see patterns. For example if incidents starts rising, the claims get higher, it may take a little while to increase the staff and train the staff in such a way that the amount of claims that are being approved or disapproved get back to where they should be. And this year Randy has mentioned that we’ve had more complex claims. And sort of the same idea is that we’ll have to upgrade our staff and move people into the areas that are dealing with these more sophisticated claims. So I can’t tell you whether it’s going to increase or decrease claims, but over time these things will even themselves out whereas in a particular quarter you could see more less claims than you might over a longer period of time. Hopefully that’s responsive to your question.

Tom Gallagher – Credit Suisse

Yes, it is, Dennis. And then my final question is, just in lieu of what's happening to your own group benefits results and I would say several peers in terms of seeing some pressure on loss ratios, do you still have the same level of interest in the M&A? I know you've talked about group benefits being an area of potential focus. Can you give us an update whether this has any bearing in terms of reducing your level of interest in M&A in that area?

Dennis Glass

It doesn’t reduce our long term interest in M&A in the Group area. This gets back to some of these strategies that we’ve been talking about. Business with shorter term guarantees increase the amount of earnings derived from mortality and morbidity. Of course the Group business is right in the sweet spot of that strategy. I think when you are going through the amount of change that we are going through and by that I don’t just mean the pricing issues we’ve been talking about, but the shift in strategy, new systems, new people, building a stronger management team to deal with what has become for us at Lincoln a little bit more complex business, it’s employee paid directions. So I think when you have all that going on you might be a little bit more reluctant to add on top of it an M&A integration. So long term I’m still as excited of the business and the opportunity to grow it both organically and with M&A. Right now I think I’d be a little bit more cautious about trying to add more complexity to something that is already complex.

Operator

Thank you and our next question comes from Eric Berg with RBC Capital Markets. Your line is open. Please go ahead.

Eric Berg – RBC Capital Markets

Thanks very much and good morning to everyone. Randy, towards the ends of one of your answers to a prior question, you mentioned an $800 million to $900 million figure. Would that be the amount of premium that was earning at the higher rate or that had been subjected to the higher rate but not yet earned?

Randal Freitag

That would be the amount of our earned premium that we experienced for 2015 that would have been experienced at the higher level of pricing. So it would be the actual earned premium that had been repriced. Now, when you think about that $800 million of premium, you would lose some of that to persistency. So you lose roughly 20% of that to persistency. And then the remainder comes through at the higher rate.

Eric Berg – RBC Capital Markets

Okay. Now, the other thing I wanted to ask about was to try to reconcile your comments. Maybe they don't need to be reconciled. Maybe they were consistent, but I need some help about the disability business in the following sense. You’ve talked at length in this call about how you have been and will be raising prices. That's typically done when ab insurance company expects morbidity to deteriorate or morbidity is proving to be worse than you thought and the business needs to be repriced. It’s underpriced. But then -- and then around the same time you're talking about your pricing, you're saying that you're not seeing a downward -- I'm paraphrasing now. I don't remember exactly you what said, but what I recall is that you said something along the lines of you are not seeing a deterioration in incidents, a sort of deterioration in incidents. I'm not quite sure I understand the point you're trying to make. It's kind of nuanced I think. I would think if you're raising prices, it would be because you're seeing deteriorating morbidity including a deterioration in incidents. Can you clarify how these two issues, pricing and deterioration and the absence of a deterioration in incidents could be going on concurrently? In other words, how could you be raising prices if you're not seeing a deterioration in incidents?

Dennis Glass

Eric, it’s Dennis. That’s a great question and I’m going to put it into longer time frames than a quarter. In the 2009, 2010 period, incidents was running lower in aggregate than it has since then. And so Randy’s comments are more relevant to say the last couple of years. But we were pricing based on a lower expectation that we had seen for a longer period of time, 2009, 2010, 2011 and 2012. They seem to have stabilized over the last 24 months, incident has. Again on a longer term basis we still see volatility quarter to quarter, but we priced to a expected lower level of incidents and so we have to reprice to this new higher level of incident. Does that help?

Eric Berg – RBC Capital Markets

It does. What I'm hearing is that things are worse than you thought. Why else would you be raising prices? But incident levels are stable now at a higher level than you anticipated, but at a stable level nonetheless. That's sort of what I am taking away.

Dennis Glass

Yes, that’s right.

Eric Berg – RBC Capital Markets

Okay, thank you very much. That’s helpful clarification.

Operator

Thank you and our next question comes from the line of John Nadel with Sterne, Agee. Your line is open. Please go ahead.

John Nadel – Sterne, Agee & Leach, Inc.

Hey, good morning, everybody. Just a couple of quick ones and then maybe a slightly bigger picture one. One, Randy, I think you mentioned that alternatives were in line with your expectations. Could you just quickly remind us what that was?

Randal Freitag

We have a alternatives portfolio of about $1.1 billion right now. And we expect roughly to get a 10% return on that and our returns in the quarter were right in line with that.

John Nadel – Sterne, Agee & Leach, Inc.

Got it. Thank you. And then with the new $4 billion of capacity, what's the -- I guess at the end of June anyway, what's the total capacity remaining through the year -- through year end 2015 on the reinsurance program?

Randal Freitag

$6 billion plus.

John Nadel – Sterne, Agee & Leach, Inc.

Got it. And then the last question is this. I'm just wondering how should we -- how should I think about the excess returns on your new VA sales? You had mentioned consistently at least for the first half of this year, maybe a bit longer, that you are running in the low 20% range. How does that compare with the level, I guess you're actually baking into your pricing, if we assumed hedging costs do over time in fact normalize. I guess I'm trying to ask, how much is lower hedging costs contributing to the higher return?

Dennis Glass

Let me clarify the question about lower hedging cost. Actually the hedging costs that we are experiencing today are closer to what we’ve seen over a long period of time with the exception of 2009, 2010, 2011 when volatility spiked up. There is no way for me to be able to predict if the current level -- the historical level of volatility which matches what we are pricing today is going to be future level of volatility. But that puts that into perspective I think.

John Nadel – Sterne, Agee & Leach, Inc.

Okay. So I mean -- so I guess then, are you pricing overall to a 20% plus-type of ROE on this business? Or is there something else that's in at least the current environment favorable relative to pricing such that it's giving you some kind of boost?

Dennis Glass

No. The pricing today on our variable annuity product fully loaded with the living benefits products --- actually the total portfolio is at about 20% for the new business.

John Nadel – Sterne, Agee & Leach, Inc.

And that's the target?

Dennis Glass

Yeah. John, nothing has changed in our approach to pricing the variable annuity business. You’re not going to see us as the best product out there. You’re not going to see us as the worst product out there. It's a good product that our top shelf distribution channel can sell in the marketplace today. So nothing has changed about how we’re pricing variable annuities. So the returns we’re able to get today are reflective of the same approach to this business that we’ve always had.

John Nadel – Sterne, Agee & Leach, Inc.

Okay, got it. I just wasn't aware that the market was bearing overall that kind of return hurdle for new business, but perhaps I was wrong. Thank you.

Operator

Thank you, and our next question comes from the line of Steven Schwartz with Raymond James & Associates. Your line is open sir. Please go ahead.

Steven Schwartz – Raymond James & Associates

On the subject of variable annuity profitability, first I just want to make sure I understand something. On the new VA, there is i4LIFE but there is no GIB floor. Is that correct?

Dennis Glass

Yes.

Steven Schwartz – Raymond James & Associates

Good. So then how do we think about the profitability of the new annuity versus the profitability of, I don't know, maybe what you sold last year that had guarantees on it? Obviously it is very profitable because the market went up, but just thinking about, it I would think more risk, more return, less risk, less return.

Randal Freitag

Yeah. Great return up into two areas. First year, return on equity. I don’t expect to see a materially different return on equity between the non-guaranteed VA and the living benefit guarantee VA. Now what you will see a lower return on is a lower return on assets on the non-guaranteed VA because you’re not getting that return on assets that you get from the guarantees. So that’s what we would see with the non-guaranteed product is a lower ROA.

Steven Schwartz – Raymond James & Associates

And then I don't know if you said this or not, the operator came in and asked me my name or something like that while you were talking for some reason. On the employee, on the retirement plan side, Randy, did you talk about where gains were in terms of products, sales, sales growth in 401K or 403B, or 457? Did you touch on that at all?

Randal Freitag

We didn’t, but we’d have to get the detail on that for you.

Steven Schwartz – Raymond James & Associates

Okay. All right. I think that would be interesting. Okay. Thanks, guys.

Operator

Thank you, and our next question comes from the line of Colin Devine with Jefferies. Your line is open. Please go ahead.

Colin Devine – Jefferies & Co.

Good morning, gentlemen. I had a question on the VA business. Dennis, you've executed very strongly in sort of growing out of some of the older more generous living benefit products a few years back. And part of that, you know, Lincoln very quickly adopted the managed risk funds and they have been a big part of your story. (Inaudible) Ameriprise commented, they had about, I think about $1.5 billion voluntarily move into their funds this quarter. Perhaps you can give us an update as to how you have been able to change the risk composition of your block. By how much you've seen moving in to the managed risk funds and if that's had a benefit on earnings. And I assume it’s also materially lowering your hedge costs.

Dennis Glass

That’s a big question. My recollection is that – and you were fading out a little bit there. Is this Colin?

Colin Devine – Jefferies & Co.

Yes, it is.

Dennis Glass

Yeah. Colin, welcome back to the business. We’re happy to have you back on our phone calls. I think in terms of the risk protected funds, we probably have AUM in the $4 billion range. Excuse me.

Randal Freitag

It's roughly -- the risk managed fund AUM is $20 billion to $25 billion.

Colin Devine – Jefferies & Co.

That's what I thought.

Dennis Glass

And what was the question though, Colin more specifically?

Colin Devine – Jefferies & Co.

Okay. In their earnings release, Ameriprise mentioned they'd had about $1.5 billion five moved over into those this quarter and it popped earnings about $10 million. My impression has been that Lincoln has seen the same very strong voluntary adoption of those types of investments by their policy holders. And I guess if you could clarify, is that the case and is that helping your earnings? And I assume that’s also starting to make a meaningful reduction to your overall hedging costs.

Dennis Glass

The majority of our risk managed funds are coming from new sales. We did have some move over. We don’t see a pop to earnings when that money moves over. But any incremental growth you’re getting today is pretty much from new sales.

Colin Devine – Jefferies & Co.

Okay. And then one other follow-up, just Dennis, perhaps you could just clarify for this, for me, when you talk about the new products, and I guess from a competitive perspective, I assume you're referring to Elite Access and Jackson's product which really opened up the old annuity business that we maybe knew from pre-2002.

Dennis Glass

Yes.

Colin Devine – Jefferies & Co.

Can you just clarify about what’s different with your product versus Elite?

Dennis Glass

You’d have to – that would be a complex analysis. You’d have to go mutual fund by mutual fund, asset allocation models. We do have protected fund capacity or options inside of it. So the underlying investments that are going to generate the opportunity, Colin, will take a lot of work.

Colin Devine – Jefferies & Co.

Okay. I just think it’s a non-guaranteed product. So I just wanted to understand what the difference was.

Dennis Glass

Yeah. The big difference is the – we think that our underlying neutral funds and all of the different asset allocations, to repeat what I said, are an improvement over what's in the market today. Obviously people could catch up with us on those issues. But we do have, to repeat what I said earlier, the exit strategy i4LIFE again, non-guaranteed but are patented, and Colin here is familiar with that as anyone on the phone on Lincoln for a while. So that’s differentiator for us. Again, if I can come back to – we’ve already moved the dial without a product that’s specifically designed for accumulation from 9% of sales to 23% of sales. We’re only trying to get to 30% of variable annuity sales on a non-guaranteed basis. So we don’t need a lot more lift to get to 30% because we’re already at 23%. So it's not just the product, but we think the product is great. It's the strength of our distribution force.

Operator

Thank you. I’m showing no further questions, and I would like to turn the call back over to Mr. Jim Sjoreen for any closing remarks.

Jim Sjoreen

Thank you, Operator. And I want to thank everybody for joining us on the call this morning. And as always, if you have any follow-up questions, please contact Investor Relations at our hotline number or Investor Relations at lfg.com. Have a good day, and we’ll talk to you next quarter.

Operator

Ladies and gentlemen, this does conclude today's program and you may all disconnect. Everyone have a great day. Speakers, please standby.

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