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Lincoln National Corp. (NYSE:LNC)

Q4 FY07 Earnings Call

February 05, 2008, 11:00 AM ET

Executives

Jim Sjoreen - VP, IR

Dennis R. Glass - President and CEO

Frederick J. Crawford - CFO

David Bulin - Hedging Program

Analysts

Andrew Kligerman - UBS Securities

Steven Schwartz - Raymond James & Associates

Edward Spehar - Merrill Lynch

Jamminder Bhullar - JP Morgan

Darin Arita - Deutsche Bank

Nigel Dally - Morgan Stanley

Thomas Gallagher - Credit Suisse

Mark Finkelstein - Fox-Pitt Kelton

Eric Berg - Lehman Brothers

Jeffrey Schuman - Keefe, Bruyette & Woods

Operator

Please standby. We are about to being. Good morning everyone and thank you for joining Lincoln Financial Group’s Fourth Quarter 2007 Earnings Conference Call. At this time, all lines are in a listen-only mode. Later, we will announce the opportunity for questions and instructions will be given at that time. [Operator Instructions].

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

Jim Sjoreen - Vice President, Investor Relations

Thank you, Dana. Good morning and welcome to Lincoln Financials fourth quarter earnings call.

Before we begin, I have an important reminder. Any comments made during the call regarding future expectation, trends, and market conditions, including comments about premiums, deposits, expenses, and income from operations, are forward-looking statements under the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from current expectations. These risks and uncertainties are described in the cautionary statement disclosures in our earnings release issued yesterday and our reports a Form 8-K, 10-Q, and 10-K filed with the SEC. We appreciate you 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 for their most comparable GAAP measures.

In addition, you will also find a general accounts supplement posted in our website that includes additional information and expanded profiles of certain asset classes held in our general account.

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 Q&A portion of the call.

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

Dennis R. Glass - President and Chief Executive Officer

Thanks Jim and good morning to everyone on the call. 2007 was a good year, reflecting the strong fundamentals in our underlining businesses and operations, even as we face headwinds in the capital markets that intensify in the fourth quarter. The fourth quarter capped a solid year productions results from Lincoln. Sales in the quarter and for the year were strong overall with record annual results established in core businesses, including variable annuities, life insurance, and group protection.

Year-over-year, we saw sales grow rate at or above 20% in each of these businesses, as well as 20% sales growth in our defined contribution business, and 32% growth our retail mutual funds. These results reflect our substantial investment during 2007 to expand our world class distribution platforms in the individual and employer markets, as well as a robust product portfolio. Along with this strong production, we also reached merger integration cost save targets, and we are making significant progress on consolidating multiple systems, which will improve productivity and enable easier access to customer information. As you saw in yesterday’s press release, the volatile capital markets lowered fourth quarter’s net income, we believe well below the aggregate underlying earnings strength of our businesses. Fred will dive into this in his remarks.

Despite the challenges presented by the economy, I am very pleased that our enterprise risk management including credit risk management, in fact, worked well. We made solid decisions in regard to our exposure to volatility in the variable annuity hedge program and are seeing the benefits of this emerge in the first quarter. Overall, Delaware has skillfully managed the general account assets. Evolving economic and capital market conditions can not be predicted and we are seeing conditions could have future impact on the portfolio. But in general, we have a strong portfolio and currently do not anticipate credit losses that would materially affect our future investment income or significantly erode our capital position. Our capital position at year-end was strong, and after financing our expected strong growth in 2008, we will capital available for share repurchase acquisitions and for other business development purposes.

Let me move to distribution. Lincoln National distributors, the wholesaling group supporting our individual retail products had a very significant year, reaching a record $20 billion and total sales up 14% over the prior year. Supporting these results was a wholesale of course have 654 at year-end, representing roughly a 25% increase over the prior year. Average VA productive… productivity increased in ’07 LFD’s revenues exceeded expenses. Our ’08 expansion plan call for increasing wholesaler count by another 20%, focusing on the independent Planner and Bank channels where we have the greatest opportunity for growth and taking market share. More specifically, a portion of this expansion will support two recent significant shelf space additions, the first, SunTrust Bank, a large generator of variable annuity sales, and second, placing our ChoicePlus VA product in the Edward Jones independent Planner system.

Lincoln Financial Network, our retail distribution group, also had a significant year, with product sale increases in life, variable annuity, and retail mutual funds, while growing the number of advisors. LF revenues also exceeded expenses for the first time a significant accomplishment. LFN expects to further expand its 7,000 strong advisor group in ’08 with a targeted focus and growing the population of advisors, delivering top tier production amount.

From our manufacturing perspective, Lincoln has clearly become an industry leader in annuities. Fourth quarter total annuity deposits were up 23% over the prior year quarter, driven by record variable annuity deposits in both ChoicePlus and American Legacy. When the industry data is published, we expect to have meaningfully increased our market share during the year. Our i4LIFE rider remains a compelling option for retirement income, and it continues to gain momentum. i4LIFE elections in the fourth quarter set another record with a 54% increase over last year’s fourth quarter. In fact, in the seven years, we have been offering to i4LIFE rider, elections have exceeded $5.5 billion and over 80% of those elections have been new money.

Leading edge product development along side shelf space additions and wholesaler expansion will support continued good growth in ’08. Product development in ’08 is focusing on a February launch of enhancements to our income and withdrawal benefits. The enhancements both address the competitive environment and achieve our objective of high teens ROE development. We will also add new investment fund options, improving both our VA and VUL products.

In our life business, Lincoln strategy is to leverage scale and cost advantage, strong underwriting capability, competitive products, and distribution breadth to drive growth and to develop low to middle teen ROEs. For 2007, we delivered a 20% annual increase in sales, even while launching our unified product portfolio and beginning the implementation of our industry leading underwriting initiative.

In the fourth quarter, we were at the tail end of the transition to the new unified product portfolio. As a result, sales for the quarter were down about 17% from the prior year and flat with prior quarter. Product introductions of this magnitude had a learning curve associated with them, as client and distribution partner familiarize themselves with the products and the relative competitiveness. We will continue to see tough comps in the few quarters of ’08, but we expect to achieve above industry year-over-year sales growth in 2008.

2007 was a very aggressive year of product development work in the life area, that produced a robust and competitive product portfolio. Our product people will be spending time early in the year helping distribution market for new portfolio. In addition, in the first half of the year, we are launching updated VUL and term products, and later in the year, further enhancing the UL secondary guarantee products

In our employer market segment, 20007 wraps up a rebuilding year in which we made significant progress in positioning our define contribution business. We identified the markets offering the strongest growth opportunities mid to large healthcare markets and the small to mid corporate markets. We launched new or updated products, specifically design for these markets. We invested in distribution more than doubling the wholesalers from 37 to 80. We began the consolidation of our service operations and made progress in enhancing our customer facing capabilities. But this is still a work in progress.

Sales in the mid to large case market continued to produce excellent results, with deposits increasing 33% over the prior year quarter. Sales in the small case market on the other hand were down 4%, mostly due to the transition of replacing a third party wholesaler organization with our own internal wholesaling group. We did see an appreciable pickup in proposal activity during the fourth quarter in the small case market, which can be a leading indicator of sales. In fact, January sales are up significantly over last year in this area. I want to be cautious about allowing one quarter’s data to signal a turnaround, but these are the results expected as we build out the wholesaler team.

Looking forward to 2008, we will be increasing the wholesaling force by 40%, focusing product development on increasing our competitive position in the small to mid corporate 401(k) markets, capitalizing on the opportunities provided by the new 403(b) regulatory changes, enhancing our delivery of education, invite [ph] plan participants and we also will increase service capabilities to intermediaries, employers, and plan participants.

In group protection, the fourth quarter capped one of its stronger years. Annualized sales and earned premiums on our key businesses for the quarter were over 25% and 10% respectively. Annualized sales for ’07 were a record $326 million, up 20%. We encouraged by the fact that this sales strength occurred in our core small case market and that loss ratios were favorable throughout 2007. All in all, a very good year group protection. 2008, we will see focus on voluntary product development and targeted wholesaler expansion.

Delaware's financial performance this year was exceptional, as we posted record earnings, record revenues, and record pretax operating margins. On the production side, we saw very strong gross sales in net mutual funds flows, driven in part by the success of our four star rated diversified income fund. We also launched our first close end fund in over a decade. Total retail sales were up 2% for the year as managed account sales were down, reflecting capacity constraints and equity market weakness in the fourth quarter.

The institutional fixed income business was disrupted by the Logan Circle transaction. However, we hired talented people to replace the group that left, and expect to see progress and proposal activity and mandates as we move through 2008. In 2008, at Delaware, we will be focusing on the following. Leveraging Delaware fund inside our VA, VUL, and DC variable products, which is a significant growth opportunity given the growth in these products. We are making a significant investment to provide a chassis for managing international funds, continuing to build performance track record, increasing the exposure of our new fixed income team already known and highly regarded by many institutional clients. At the margin we are reopening our emerging market equity fund in 2007, and are proposing to reopen our small cap value fund next year. A lot of activity on the way at Delaware.

Let me wrap up on Lincoln to you by saying that we have a strong overall business platform with significant momentum as we move through 2008. To reiterate, in 2008 we expect to complete the cost save program and focus on continued unit cost improvements, continue to expand aggressively, wholesale distribution support for both the individual and employer markets and grow our retail planner base, successively roll out our new variable product enhancements and execute on our product development plans throughout the organization.

See the results of our investments that we have been making in the DC business and stronger sales and we will rebuild Delaware’s fixed income institutional business and put more resources behind product development.

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

Frederick J. Crawford - Chief Financial Officer

Thanks Dennis. Our reported income from operations in the quarter, of $312 million or $1.16 per diluted share excludes approximately $9 million of media income, moved to discontinued operations or $0.03 per share in addition to a number of items noted in our release that reduced earnings by about $ 48 million or $0.17 per share. Reported earnings also included merger expenses of $28 million pretax, coming in as we guided in the third quarter. Notable items in the quarter included volatility in our hedge program, related DAC unlocking, FAS 133 adjustments on index annuities and various expense items running largely through our other operations line. In addition we had a higher than expected mortality in our individual Life business, largely offset by another favorable period for loss ratios in our Group Protection business. Normalizing both quarters for the items identified in our press release and excluding merger expenses, EPS grew by about 10% over the same period in 2006.

This is an important quarter to look carefully at the health of the underlying fundamentals, fundamentals that shape our outlook for 2008. Individual annuity fundamentals are very strong with positive net flows in the quarter of $1.8 billion, a combination of continued momentum in the VA deposits and a slowing of six annuity outflows.

The markets, together with over $6 billion of positive variable flows for the year contributed to a 32% increase in expense assessment revenue over the comparable quarter in 2006. Removing the impact of FAS 133, six margins and spreads came in as expected, recognizing year-over-year fixed account values were down 4% due to negative flows.

These underlying fundamentals were masked by volatile hedge program results which I will touch on in a moment. Our individual Life business continues to deliver consistent results with average UL in-force and account values up 7% respectively over the comparable quarter in 2006. Normalized mortality assessment continued to reflect the steady build in in-force, growing by 7% over last year. However we did experience a higher than expected mortality quarter and expect this to normalize heading into 2008.

Six margins and spreads came in as expected with weakness in alternative investment income offset by strength in prepayment income. Our defined contribution business performed as expected in the quarter. For the year, positive net flows together with market appreciation, drove average variable account values up over $3 billion and fee income up 11% in the quarter. We continue to experience headwinds in terms of negative flows in our director 401(k) product and fixed margins, but we see both trends slowing as we move to 2008. Progress on flows will be a critical success factor in 2008, as we have invested heavily in product and distribution to support our market strategy.

In Group Protection business, loss ratios both in the quarter and for the full year performed favorably across all major lines. We experienced strong revenue growth again in the quarter with net earned premium increasing 11% over the comparable 2006 quarter. This is a strong business across the board with solid production, underwriting and earnings lift. For the year, and as Dennis noted, Delaware Investments posted record revenues and earnings with expanding margins, as asset growth together with restructuring efforts emerged throughout 2007. As we looked towards 2008, our quarter’s earnings result needs to be adjusted, not only for favorable expense items in the quarter but for the transition of our fixed income assets.

Recognizing the impact of January equity market, Delaware earnings should be in the range of $13 million to $15 million for the first quarter. In terms of overall expenses, we continue to make consistent progress on our goal of taking approximately $200 million out of our gross expenses. Through the end of the fourth quarter we have achieved roughly $175 million of annualized savings. After giving effect for strategic investments and increased business activity overall, we continue to see improvement in our enterprise wide expense ratios.

In the quarter we recorded gross impairments of approximately $193 million. As detailed in our release the majority of impairments was taken on financials, subprime and Alt-A, RMBS and structured credit notes where the underlying collateral is preferred stock issued by financials. We believe there is an opportunity to recover a portion of the non-credit related impairment in these securities. This quarter we provided supplemental information on our general account. Overall I will simply highlight the following. Over 90% of our $9 billion in exposure to residential mortgages is rated AAA with about 60% of the portfolio agency backed. Of the non-agency backed holdings approximately 97% of our holdings are rated AA or better. Our CNBS portfolio totals $2.7 billion with over 86% rated AA or better. Our holdings are predominantly 2005 and earlier vintages. As disclosed previously our subprime and Alt-A exposures totaled $2.1 billion, with 95% rated AA or better. Our direct exposure to monolines and assured bonds is relatively modest at just over $500 million, as is our exposure to consumer loan backed securities of only $160 million. We do have some indirect exposure to both classes of securities and credit linked note structures referenced in our supplemental. Our $7 billion direct commercial mortgage loan portfolio is well diversified, both in terms of property type and geography. It has overall strong loan to value metrics and little to no delinquency issues.

We are monitoring credit market conditions closely, but feel good about our overall general accounts position.

Turning to capital and risk management, let me first make a few comments on our VA hedge program. At our Investor Conference we noted that through October, we experienced similar conditions to that in the third quarter. The drivers of the hedge breakage in the fourth quarter included a combination of items, including a decision to purchase longer dated volatility protection to better match liability calculations under FAS 157. We were also exposed on our New York variable annuity business since January now captured under our hedge program. These two items alone accounted for fully half of the $20 million earnings impact in the quarter. We also were modestly short volatility closing that gap gradually throughout the quarter. These efforts have thus far proven beneficial in the month of January with only modest breakage despite volatile conditions.

We repurchased $300 million of stock in the fourth quarter, a bit more than the $200 million we guided to, essentially accelerating our planned repurchase for 2008 in anticipation of receiving our media proceeds. We are carrying a strong risk based capital in 2008 ending the year in excess of 425%. Including proceeds from our media company sale we expect to repurchase from $500 million to $600 million of stock throughout 2008.

In summary we are pleased with the overall quality of our hedge program and our capital position is very strong. We have provided in both our comments this morning, and our press release, an outlook for the business as we enter 2008. I would like to comment on a few items. Excluding any impact from the hedge program and DAC unlocking we believe our annual earnings to be impacted approximately $7 million for every one percentage point moved in the equity markets. This guidance involves a complicated interplay of estimates beyond simple impact of fee income, so I caution that this guidance is directional in nature.

We ended the year with just under $800 million of alternative investments namely hedge funds, private equity and partnerships. We expect long-term returns of roughly 10% to 12%, last year earning 15% on this portfolio albeit with significant quarterly volatility. As we sit here today we expect alternative investment income in the first half of 2008 to come under pressure, falling before our longer term expectations. We have moved a portion of our media earnings into discontinued operations and out of operating earnings. We also recorded a loss on the sale as a result of the low tax basis of the properties currently under agreement for sale. We have officially ended the media process and will manage the remaining radio properties as part of other operations, no longer identified as a specific business segment.

Finally we will be adopting FAS 157 in the first quarter and expect to take a charge of between $25 million and $75 million. The accounting adoption will impact net income but will not be included in our definition of operating earnings for the period.

Now let me turn it over to the operator to start us in Q&A.

Question and Answer

Operator

Thank you sir. [Operator Instructions]. And we will take our first question today from Andrew Kligerman of UBS.

Andrew Kligerman - UBS Securities

Okay. The initial question is with regard to the diskette in front of me. Your $193 million pretax, pre-DAC, gross losses from right down to impairment. I am not a 100% clear on pieces of this, so you designed one piece as financial institution, another as structured products with exposures to financial spreads, I think you were referring something equity related. Could you break out each of those three pieces spread specified in your press release and maybe even give us a sense of the magnitude of the losses there.

Frederick J. Crawford - Chief Financial Officer

Absolutely Andrew. Let me break apart the $193 million as follows. First of all, we did take impairment on what I would call pure financial… exposures to pure financials, meaning direct holdings in financial institutions of about, just shy of $36 million pretax and DAC. Those… that included names like Northern Rock where we had some exposure, Res Cap or Residential Capital Corp., just to name a couple of the more significant in that pool securities.

Andrew Kligerman - UBS Securities

These are equity holdings or…

Frederick J. Crawford - Chief Financial Officer

No, no. no. These are the debt holdings direct to institutions so…

Andrew Kligerman - UBS Securities

Okay. Got it.

Frederick J. Crawford - Chief Financial Officer

So this is just direct debt exposure to financials. The second major category which also was around $35 million pretax would be exposure to subprime and Alt-A related collateral, securities backed by subprime and Alt-A related collateral. And it was a mixture of facilities, no particular piece of it significant and tended to be of the lower rated tranches, where we had holdings and some CDO holdings albeit very, very small. By lower rating, meaning more on that BBB to single A category, that is lower than the AA, AAA type holdings that makes up the predominant amount of our holdings, again about $35 million.

The biggest piece of it and where you may have some level of confusion in understanding what it is… our structured securities that were the underlying collateral is essentially preferred stock issued by financials. That was about $110 million pretax and what these are. This is a conduit that essentially holds preferred stock issued by large and typically highly rated financial institutions that includes for example, names like Freddie and Fannie as well as Goldman, Merrill Lynch and some others. These preferred stock holdings issue certificates out to investors, both A certificates and B certificates. The A certificate are issued into the asset backed commercial paper market, and the B certificates are what we hold as an investor. What has impaired these securities effectively is the liquidity issues involved in the asset backed commercial paper market, because our cash flows on these securities come after payment to the asset backed security holders. Any lack of liquidity and increased pricing of roll over, impacts our coupons, impacts the dividends we receive on these securities, and that has lowered the underlying pricing of these structured products to a point to where we felt it necessary to take impairment. When I talk about there being an opportunity to recover, economically some of these holdings, it is these securities that I am predominantly focused on, because the pricing is a bit more severely impaired and predominantly due to liquidity conditions which we expect to improve over time. And so that is the color if you will Andrew on our realized losses. Hopefully that helps.

Andrew Kligerman - UBS Securities

And definitely helps and then just sort of looking at your portfolio into the first quarter. Do you expect any further write downs?

Frederick J. Crawford - Chief Financial Officer

Yes, right now as you probably know and probably traditional with most companies, we go through a pretty exhaustive, other than temporary impairment process or write down process each quarter, and so we will wait and see how that quarterly process works. As we sit here today looking at the portfolio we feel as if it’s in good position, but we are watching those securities that are particularly exposed to either illiquid conditions, or exposed to financials or other forms of collateral where the pricing is depressed, and we are in a non-realized loss position, so we are watching those more carefully, but again overall Andrew as we step back from the general count, and particularly as we step back relative to our capital position, we feel very comfortable in the general account portfolio and the overall quality of the balance sheet.

Andrew Kligerman - UBS Securities

And then just one last quick follow up on the alternative investment income. I calculated about a 6.5% yield, less of course the intent to 12% that you are… you are saying it’s going to be 10% to 12% long-term. You are forecasting less than 10% to 12% in the percent. What’s kind of holding down the return there? Where is the weight on these returns coming from in alternative investment income?

Frederick J. Crawford - Chief Financial Officer

No one category is completely weighing them down. I think our holdings as you may know are largely made up of hedge fund investments and private equity, and we expect there to be dampened returns in both those categories. As you probably know and certainly realize from time to time there can be one or two partnerships in either category, that can pop and have a very strong quarter and help with the returns. But, our general view is we expect weakness across those two categories. You are right, we did about $12 million or so pretax in the quarter representing an annualized return of roughly 6%. It’s frankly that fourth quarter result, that we are staring at if you will, when we look at rolling forward into 2008 and therein lies my comment relative to falling below our longer term expectations. Again it is very important to note though Andrew that the reason why we have longer term expectations that are up around 10% to 12%, is because over time as we look back historically that’s in fact what this portfolio securities has yielded, if not slightly better and so it would be our hope certainly in our intention in making these investments that we find a way back to those longer term returns, but with some quarterly volatility.

Andrew Kligerman - UBS Securities

Thanks. Most appreciated.

Operator

And we’ll take our next question from Steven Schwartz of Raymond James.

Steven Schwartz - Raymond James & Associates

Hey, good morning guys. Andrew, I just have a question. I’m going to ask on alternative investments. I did want to touch though Fred, if you can go back over the structured securities that you just talked about, the link notes. I’m afraid I didn’t understand the last part with regard to liquidity and how that affects the price of these things. Are you still getting the cash flows that you expected to get all along? I’m really confused.

Frederick J. Crawford - Chief Financial Officer

Yes. To clarify again, the underlying collateral for the securities we hold is perpetual preferred essentially, mostly preferred stock issued by financials, and the first… the water flow, if you will of cash flows coming off those securities goes first to service the asset backed paper holders on the A certificates.

Steven Schwartz - Raymond James & Associates

Okay. Sure.

Frederick J. Crawford - Chief Financial Officer

Then the residual, in fact some term these residual interest trusts. The residual cash flow then comes to the B certificate holders. Because of the ill liquidity in the marketplace on the asset backed commercial paper side and the increased costs associated with rollovers, they’re absorbing more of the perpetual preferred dividend than they have before, which has impacted negatively our cash flows on the securities and thus depressing the pricing.

Steven Schwartz - Raymond James & Associates

Okay. So, what your saying here is that the A certificate holders are getting more of the flow because of the liquidity or what?

Frederick J. Crawford - Chief Financial Officer

Because generally ill liquidity in the market, and the fact that the borrowing cost if you will, are going up, because of the ill liquidity.

Steven Schwartz - Raymond James & Associates

Okay. All right. I think I get that. And then quickly the assets transfers to Logan, when did that occur?

Frederick J. Crawford - Chief Financial Officer

That occurred at, in the October time frame and was roughly $14 billion.

Steven Schwartz - Raymond James & Associates

All right. Thanks.

Frederick J. Crawford - Chief Financial Officer

Okay. Sorry $12.3 billion.

Steven Schwartz - Raymond James & Associates

Okay.

Operator

And we’ll take our next question from Ed Spehar of Merrill Lynch.

Edward Spehar - Merrill Lynch

Thank you, good morning. Fred I have questions I have on hedging. I guess a few. First, could you tell us, are you sort of, caught up on volatility now, in terms of hedging for the in force book because I think from your comments it suggests that you perhaps, didn’t hedge as much vol as what you now are hedging. So, I want to know if you've sort of caught up on the in force. If you could talk a little about equity market sensitivity, potential breakage if we had long-term implied volatilities stay near what I think is 27 right now. And finally on FAS 157. I guess it’s a little bid troubling when we hear companies talk about changing economic behavior based on accounting. So, I’m wondering if you can help us understand a little bit more why we buy more options because of a FAS B change. Thanks.

Frederick J. Crawford - Chief Financial Officer

No problem Ed, I’ll kind of hit them in order. In terms of how we caught up on the in force. Yes, when we entered into frankly the third quarter and the fourth quarter, we had an intentionally short position volatility, which means we had not covered 100% of our vol exposure. And over the course of the tail-end of the third quarter, and throughout the fourth quarter, we went about the business of gradually, I would characterize it as almost dollar cost averaging our way into closing that gap on volatility so that as we head into the first quarter, while there is maybe a bit of a shortage in volatility it is largely closed and relatively minor. I would also note that from just a practical standpoint, we didn’t have our New York variable annuity business under the hedge program. That’s about $1.3 billion of variable account value not under the hedge program. About 5% of our total balance is under the hedge program. While seemingly small, obviously in dramatic changes in volatility, it’s still going to have an impact. As of January, we now have the New York business installed in the hedge program and don’t expect that to be an area where were short vol if you will or exposed to volatility.

So, we think we’ve made a lot of progress on that front and as a result would expect exposure to volatility from that position to be calmed down quite a bit. In terms of the equity market, sensitivity with volatility being up… yes, I would say because of the actions we've taken in the quarter we would expect to be able to keep pace with the change in volatility, better than what we have in the past couple of quarters. But also particular to what I call the shape of volatility, meaning that we have been buying longer dated volatility in our hedge program which better marries up to the new accounting related to 157 as we just moved into the first quarter. That had a negative effect in the fourth quarter, because we were essentially dialing in our hedge program a little bit differently, than the accounting on the liability side. That will close up a bit as we move through the first quarter. In that, in lies your third question essentially. Let me just say it this way.

We have always intended the hedge program to have, certainly one of it’s primary mission to quiet down the earnings volatility associated with a dramatic movements on the liability side if volatility were to change. And that remains a fundamental of the program. But it’s always had a dual role in our thinking and that’s included the economic benefits that the hedge program provides in covering us in the case of cash outflows related to the guarantees we offer. And while we have dialed-in or adjusted our hedge program, according to157, it still is the case that we have moved the dime forward so as to speak on covering as much or more economic risk than we have going forward. So, I do want to caution, Ed, that while it does provide reduction of earnings volatility, it also very much provides us an economic support as well, and we’re quite focused on that.

Edward Spehar - Merrill Lynch

And Fred, just one quick follow-up. Can you give us some sense for sort of what the range of expectations we should have in terms of this breakage number? We had $20 million this quarter. I think it was $13 million this quarter, and there has been I think a couple of million plus or minus previously. Is there any way you can help us understand that two-thirds of the time we’re going to see it between plus or minus 20 or is there something you can do to help us in terms of our estimates going forward.

Frederick J. Crawford - Chief Financial Officer

I realize, particularly because we have to find our operating earnings as including the effects of the hedge program. It is of a greater focus when you are looking to dial-in. even though all companies I believe account for it the same way when it comes to net income and book value. Unfortunately, Ed, I do want to be careful in suggesting that no matter what the capital markets tosses at us, we somehow have it covered, no problem. What we’ve learnt in the couple of quarters is that the capital markets, whether it would be the equity market movement, interest rate movement, volatility or the combination of all of the above, can toss curveballs at you. That in some cases, your hedge program can’t catch up to in time. Now we’ve taken great strides to try to calm down particularly the after tax and the after DAC implications on the hedge program, and we would expect that to pay dividends going forward. But I want to be careful in sort of predicting for you a range of hedge breakage going forward, other than the goal of the Company’s is to certainly to keep it to a minimum.

Edward Spehar - Merrill Lynch

Thank you.

Operator

And we’ll take our next question from Jimmy Bhullar of JP Morgan. :

Jamminder Bhullar - JP Morgan

Hi, thank you. I just had a question on your capital situation. If you can talk about what your excess capital is right… excess that capital position is right now? And secondly on your progress on selling the remaining media business and also your intention for the Banc of America stock, the 4 million shares you have.

Frederick J. Crawford - Chief Financial Officer

Jimmy, let me answer your first two questions. But I didn’t hear your third question.

Jamminder Bhullar - JP Morgan

The third one was just your intention with the Banc of America stock that you own.

Frederick J. Crawford - Chief Financial Officer

Okay. In term of excess capital, as I mentioned on the… early part of the call, we’re carrying a very strong risk base capital into 2008, which I think is very good, obviously given market conditions and alike. I am quite comfortable with our stock repurchase estimate for the year. And I would suggest to you that after giving effect for the share repurchase that we’ve dialed in 2008, that we will very likely retain around $0.5 billion of excess capital through out 2008. That excess capital position housed in our regulatory entities, that is, part of that excess right based capital I mentioned.

It terms of the remaining media assets we have, we own radio clusters now, in four major cities, San Diego, Atlanta, Denver, and Miami. And our intention now is that we have ended the process. I am looking to sell those properties and we are going to manage those properties into the future. The way I would characterize it, is we are not all that dissimilar than a private equity owner. Where we’re going to look to make investments, where it makes sense and drives good valuation in these properties. At the same time, like any private equity owner, we’re also going to keep one eye on understanding the excess strategy, when it’s appropriate and when we can maximize the value for our shareholders.

Jamminder Bhullar - JP Morgan

So, some attractive offer comes along, you would consider it, but your not actively shopping them right now.

Frederick J. Crawford - Chief Financial Officer

Right now, very importantly, the market conditions are such that it’s not in the best interest in our view of our shareholders to move forward without right sale. And so, it’s very important for us to work with the general managers in our radio stations to concentrate on running the business the best we can and improving the value of it. So, I don’t want to want to leave the impression that we are going sort of perpetually having for sale sign out there. We have also to pay very careful attention to running the business property… properly, like any other private equity owner would do.

In terms of the BofA stock, right now, the BofA stock represents the utility value to us, meaning it’s access capital if you will, held at the holding company. I think the market value now is in and around $110 million and it’s serves a liquidity backstop for us. It serves a excess capital if necessary and as it’s always been the case, we’ll see what the appropriate use of those proceeds will be depending on our needs as a company, and depending on what opportunities the marketplace offers us in terms of the values of those securities and the use of the proceeds.

Jamminder Bhullar - JP Morgan

Okay. Thank you.

Operator

And we’ll take our next question from Darin Arita of Deutsche Bank.

Darin Arita - Deutsche Bank

Thank you. Fred, can you share with us additional metrics, and the approach… underwriting approach on the commercial mortgage loan portfolio. I know, you talked about how it’s diversified. You’ve been very little or no delinquency thus far. But is there any thing else you can share to make us feel more comfortable on the portfolio

Frederick J. Crawford - Chief Financial Officer

Sure. I’ve got with me a few members of our asset management team. But as I mentioned earlier on call, we have a very diversified portfolio, both geography, as well as property type. And we’ve experienced little to know delinquencies of any note. And we’ve also taken a very conservative, in general, loan to value approach. We tend to underwrite to about a 75% loan to value. And that has allowed us to maintain the quality of the portfolio during this period of time. We have a very, I call it, fragmented portfolio. The average loan size of our commercial loan portfolio is about $5.5 million. So, we have terrific diversity in that respect. And again, as we look at all of the metrics in terms of the percentage of the loans where we have either weak loan metrics is very, very low, less than 3% of our portfolio. We characterize this having some either low loan to value or low occupancy or weakness in terms of a major credit tenant what have you. So, those securities tend to be on our watch list, we watch them very carefully, but again, a very small proportion of loans and very high quality. So, that would be some of the highlights I would give you. I don’t know if there’s any additional color your want Darin.

Darin Arita - Deutsche Bank

I guess, that’s pretty helpful Fred. And just turning towards the variable annuity headwind, can you give us a sense of what the incremental cost would be in 2008 for, a, hedging the New York business also FAS 157?

Frederick J. Crawford - Chief Financial Officer

Yes. On a quarterly basis, I would give you an idea, just to get your bearings on it. This quarter, for example, we brought in about $37 million pretax of revenue associated with these riders. And of that, we have been amortizing the cost of the puts through the options that we buy as well as carrying costs on the futures. That tends to run pretax and pre-DAC about $8 million a quarter. After taxing, after DAC, there’s a pretty large DAC to offset to these costs. That will run around $3 million to maybe $4 million. That incorporates having bought a fair amount of long dated volatility to close the gap through the fourth quarter as I mentioned earlier. And obviously, as volatility remains high, you will find that cost creeping up over time, but still manageable from a total return perspective. In fact, even after giving effect for the higher hedge cost, we still enjoy un-levered returns in the mid teens for that product, still quite comfortable. So, the New York business will have some impact on the cost of hedging, but I wouldn’t characterize it particularly after tax and DAC as material.

Darin Arita - Deutsche Bank

So, knowing in that $3 million number you gave includes the effective FAS 157 going forward?

Frederick J. Crawford - Chief Financial Officer

Yes, we started to bleed our way into FAS 157 throughout the quarter and so I would it may pickup a little bit, but not in the material way.

Darin Arita - Deutsche Bank

Okay. Thank You.

Operator

And we’ll take our next question from Nigel Dally of Morgan Stanley.

Nigel Dally - Morgan Stanley

Great. Thank you. Good morning. First with the capital, can you discuss the sensitivity of your excess capital to change in the equity market? I know you talked the $600 million of buyback the next year. Are you likely to make those repurchases through a accelerated repurchase plan or a regular way? Thanks.

Frederick J. Crawford - Chief Financial Officer

Sure. I think… I definitely… you were breaking up a little bit Nigel. So, I apologize. But I think your second question, I you wanted two questions. Your second question was a little bit of color around share repurchase, and whether or not we would do an accelerated share repurchase.

Nigel Dally - Morgan Stanley

Yes. The first part was just the sensitivity of your capital to changes in the equity market.

Frederick J. Crawford - Chief Financial Officer

Got you. The… I would say our sensitivity to capital on the equity market is really not the issue. Meaning that even though we do have our earning sensitivity to the equity market, in the grand scheme of things, a company that’s just using 2007 as an example, doing in and around $350 million plus of operating earnings a quarter, it would pay $7 million up or down with the market up or down 1%, while definitely having a dampening effect headwind if the markets are down considerably as they were in January, is not really what I would view as a capital item. In other words, I don’t necessarily redial or recalibrate my capital plans for that environment.

And in terms of share repurchase, I would say that we have dialed-in about $500 million to $600 million for 2008, that includes the proceeds of the media company and recognize that also has imbedded in it that we accelerated about $100 million of repurchase into the fourth quarter that otherwise wouldn’t have been done in 2008. I am not going to do an ASR on that. We will basically buy in the open market. Throughout the year, we have plenty of volume in our stock to be able to do that and do that quickly if necessary. So, we won’t be executing an ASR. I would say this though Nigel, I would probably front-end, a bit of the repurchase. I would expect to do in the first quarter between $200 million to $300 million of repurchase.

Nigel Dally - Morgan Stanley

Very helpful. Thanks.

Operator

And we’ll take our next question from Tom Gallagher of Credit Suisse.

Thomas Gallagher - Credit Suisse

Hi. Can you talk a little bit about the way you’re evaluating risk as you move forward here on the credit side. Have you formed the watch list? Maybe if you could give a little bit of color for the total amount of securities that are now trailing below 80% a par. And I guess, as I think about the main areas concerned here, if I just look at your disclosure over unrealized loss as a percent of par, it looks like the biggest unrealized loss position is the CDOs and credit link notes, which has a little over $200 million. Is that fair to say that that we should be focused on in terms of near-term loss expectations. Anyway, anything you can give us on kind of the way you are evaluating there?

Frederick J. Crawford - Chief Financial Officer

Yes, in terms of pricing, I might just… I think the question you had Tom, the first question you had was really related to pricing across the Board and how it’s holding up. Obviously, the report we gave last night shows that for the most part as of year-end, with very few exceptions. We don’t have a sizable unrealized loss positions which obviously suggest that our book and market are tracking reasonably well. I’m not aware as I sit here today, albeit I’m not on the trading floor. I am not aware of any material swings in that pricing in terms of pricing quotes we’re getting from the pricing services and so forth.

What I would say is your second observation is correct, that we have an unrealized loss position in the so called CRE [ph] or credit link note exposures. And these are highly structured instruments that we’re essentially, we own a AA rated tranche that is backed by a collateral. That collateral is essentially highly rated for investment grade is probably the best description, corporate. Where we have CDO… essentially credit default swaps with investment grade players coupled with a cash bond instrument, held in a… affectively a trust. And we own a AA rated security that’s issued out of that trust.

We have a subordinated position below us that helps shelter us against first losses. We also are junior to a tranche that’s above us as well. And we’re watching those securities carefully because the pricing of those securities are indeed below book value where that is we’re carrying an unrealized loss position. So, you’re right in saying that those are among the securities that we’re watching carefully. I should say that we have experienced no defaults in the underlying collateral. There have been a few downgrades but no defaults. We currently feel comfortable with these securities. That is we don’t believe them to be impaired. But if you're familiar with the accounting rules of the road if you will. As time goes on, if the pricing remains depressed on these securities and I would say on average, we're talking about $0.70 on the dollar give or take. That moves around but if the pricing on these securities remains depressed for an extended period of time and there’s not some level of recovery. Then impairment starts to come into play and you have to give some thought to that. So, those are among the securities that we're watching carefully.

Thomas Gallagher - Credit Suisse

Okay. And Fred, just on, I understand kind of the overall methodology that you're using to record impairment. Is the key determinant here from this point forward evaluating securities that are trading below some percent of par, is it 80%, is it 70% and do you have any number depending on whatever that bright line test is. Can you give us any metrics with the overall portfolio? Are there $1 billion or are there $2 billion that are trading low, whatever that level of par is that you're using of the test? Thanks.

Frederick J. Crawford - Chief Financial Officer

I think, the securities that I've identified with you plus a few others probably fall in the category of where we have our eyes on. The unrealized loss position and the pricing. I think the numbers you're quoting are quite large. I would not put it in that kind of a category. We don’t have what I would call a strict bright line test. What we do have is thresholds where we start to drop these securities on to a watch or concerned list and we watch it more carefully for potential impairment and one of the triggers that will do that is where the security is in fact being priced below book and particularly materially below book. That is approaching sub $0.80 on the dollar or $0.70 on the dollar is where we’ll start to pay a lot more attention.

The other element of it, Tom, that we look at is how long it stays priced at that level. So, if we're talking about depressed pricing level for several quarters for example. Even if we believe there to basically a level of recovery, you start to have to spend more time focusing on whether or not we're talking about and other than temporary impairment to the security in which case, we’ll take impairment. What is often the case as well is when you do decide you're going to take impairment. You take it down to that market and as a result we may not always agree with the mark provided on that bond depending on circumstances and that’s where you can have a situation or even though there hasn't been a credit related impairment, there’s more of a liquidity pricing issue and we would expect there to be some level of recovery going forward.

Thomas Gallagher - Credit Suisse

Okay. Thanks.

Operator

And we’ll take our next question from Mark Finkelstein of FPK.

Mark Finkelstein - Fox-Pitt Kelton

I've got a few detailed questions. I guess Fred firstly, with F&P down about 5% year-to-date and assuming you kind of grew in line with your own expectations from here. Should we expect a first quarter retrospective DAC unlocking the annuity business and do you have any assumptions about what that would be or how we should think about modeling that?

Frederick J. Crawford - Chief Financial Officer

The answer is, I don’t have any gauge to give you on the possibility nor the magnitude of the retrospective DAC unlocking related to the market mark. I would say this, that our… we do have a weapon available to us when it comes to the equity markets being down and that weapon is just what you alluded to and that is generating our positive flows in our core businesses. Of the $7 million for example of equity market exposure, that I mentioned. $5 million… $45 million of that is in our VA business and that also happens to be the business where we're generating significant strong positive flows, which helps us fight that battle. But I would not want to wager a guess or an estimate on what could be a retrospective DAC unlocking, that as you know, a very complicated process.

Mark Finkelstein - Fox-Pitt Kelton

Right. Okay. And then just on the annuity hedging. We talked a lot about kind of changes implied volatility. Do we need to at all be worried about kind of further declines of long-term interest rates and how that’s going to affect the hedge program. I guess specifically are we fully hedged on Row and how should we think about that?

Frederick J. Crawford - Chief Financial Officer

I have my friend Dave Bulin here with me who runs our hedge program and I'm, honestly Mark, glancing his direction, what I would tell you is row can have distinctly large impact on your hedge program. It tends to be the case that we all focus on vol and we all naturally focus on just movements in the equity markets or delta. But Row has proven to be as big an element in the last year, last several quarters. In particular, the interplay between ROE and the other factors as well. Dave, I don’t know if you have any color on that as an input?

David Bulin - Hedging Program

I guess, directly to your question, is yes. We're definitely fully hedged on Row. That’s one of the things that we're… that we pay a lot of attention to. Not only hedged from a sensitivity, but also from a term structure perspective. But as Fred said as and traits move around that also has an interplay with some of your other sensitivity so as interest rates move up or down that’s also going to affect how sensitive you are to both the equity markets and to implied volatilities. But it may not be as straight forward but I would say that, that’s interest rates is definitely one piece that we keep a very, very close eye onto both the first order effects and any secondary effects.

Mark Finkelstein - Fox-Pitt Kelton

Okay. And then I guess just moving to the, I guess the small case 401(k) business kind of the director. Are we past or are we kind of getting past the point where the impact of terminations of third party distributor has flowed through? And do you still feel good that you should start to see that turn into positive net flows at some point in 2008 in that business?

Dennis R. Glass - President and Chief Executive Officer

This is Dennis. There may be some residual impact left. It’s affected us in two ways. One, the sales team has been building and so we've had to replace the sales team. That third party organization was able to grab a few dollars of account balances and customers. We think most of that is over, that is grabbing the account balances. So, we are expecting, because of the increased size of that force, the fact that a good number of them have been with us now for quite some time. That we’ll begin to see, positive sales development in the small case market next year.

Mark Finkelstein - Fox-Pitt Kelton

Okay. Thank you.

Operator

And we’ll take our next question from Eric Berg of Lehman Brothers.

Eric Berg - Lehman Brothers

Thanks and good morning. So, good morning to everyone. My first question regards to how to think about, what the right measure of stock market performance is in terms of thinking about the impact on Lincoln? There’s been a lot of talk about on this call and indeed on the principal call preceding this one about the stock market. But I think, the fact is that in the month of January between the first trading day and the last trading day, it looks like, I'm thinking it was only about 2% or 3% so. My question is, when we talk about how tough January was and we're already off to a bad start. What exactly do we mean by that? Are we talking about the average level of the S&P or are we talking about another index, are we talking about the average level of the S&P versus the average in a previous quarter, point-to-point. Exactly how do you arrive at this conclusion numerically that it was a tough… we're already off to a tough start?

Frederick J. Crawford - Chief Financial Officer

You raised very good observations. Eric, it's important to focus on the following. I’ll tell you what I focus on. I focus on the average-to-average change in markets and I do that because the vast majority of our business is priced on a daily basis, if you will and that is we get our fees calculated off of a daily account value balance. So, point-to-point can move around on you dramatically. It's important to focus in on the average reduction in the stock market when thinking about the relative impact to your financials. There us a piece of our business that is an exception to that rule. We have some elements of the institutional asset management business that ends up priced if you will, or fees are charged off of a quarter-end type balance. But it's a relatively small element, if not a very small element, when considering… stepping back and considering Lincoln’s overall exposure to the equity markets. So, that is in fact what I look at. I look at the averages because that’s ultimately what's driving that assessment revenue.

Eric Berg - Lehman Brothers

I take it this type of question relates, actually relates back to an earlier question about excess capital and the stock market. I was a little surprised Fred, to hear your response, simply, because in the Hartford call, and I realize the situation may be different at Lincoln, I think it was said that, if the stock market were to perform poorly ion 2008, that that would effect your would affect your risk-based capital score of your insurance company under the so called C3 Phase II rules of the NAIC that some of your capital would be, sort of be tagged or needed to meet this increased capital requirement for variable annuities. Thus reducing the amount of excess capital. So, I would have thought, based on that observation that in fact there is a link between excess capital and the stock market.

Frederick J. Crawford - Chief Financial Officer

What we have done Eric, is we have effectively reinsured our hedge program riders to a captive reinsurance entity in the Company, such that movements in the equity markets do not have as dramatic an impact on our risk-based capital and so we don’t have that same potential significant sharp move in RBC calculation that you might find under the VA carve-in type rules that are out there in calculating it. It doesn’t mean though, that we don’t understand the look through implications of the stock market on what it may mean to the generating of earnings of the accounts and what it may mean in the potential payment out to the captive reinsurer under the hedge programs; That is the economic impacts of the program. If those were to deteriorate, then we would have to think about capital. But that would be quite a significant and really long lasting move in the equity markets, in my view to cause that to be a problem.

Eric Berg - Lehman Brothers

And so, even though. Just as a final question, just to make sure I'm clear on this. Even though this reinsurance, reinsurer pardon me, is captively owned, this still dampens under regulations the under state regulatory rules, let's say the capital requirements associated with a declining stock market even though you own the reinsurer?

Frederick J. Crawford - Chief Financial Officer

Yes. It has the effect of not causing us as dramatic a movement on our underlying principal insurance company Lincoln National corp. of Indiana, which is what drives the RBC and drives our cash flows out.

Eric Berg - Lehman Brothers

Thank you very much.

Operator

And we have time for one final question today. We will go to Jeff Schumann of KBW.

Jeffrey Schuman - Keefe, Bruyette & Woods

Good afternoon. Fred I want you to talk a little bit more about the credit outlook and sort of relate that to your comments about excess capital. If we do see, I guess a continued difficult credit markets from here as an additional impairments of as we roll through '08. To what extent would those be funded from the $500 million of sort of residual excess capital you talked about versus at some point sort of going against mix funded from your intended $500 million or $600 million of share repurchases?

Frederick J. Crawford - Chief Financial Officer

Yes. I think, a way to think about Jeff is this; First and foremost, just from a very practical standpoint, if we suffer significant… as with any insurance company, significant impairments, gross impairments. That will have implications for how you think about it. How you manage your capital going forward If they were to be severe enough then we would potentially find ourselves in a position of having to retain more of the capital to support our ratings. Let me be very, very clear. We're not going to sacrifice our ratings or put ourselves in a position of having difficult balance sheet conversations with the rating agencies. Having said that, as I mentioned, we're carrying a very strong risk-based capital into 2008 and we're doing that because we have been somewhat defensive in our management of capital recognizing the poor credit conditions were brewing in the marketplace and this didn’t happen just all of a sudden. We have for quite a while as a company been viewing the credit markets as eventually reverting to the mean if you will after several years of very strong conditions. So we've positioned our risk-based capital in to account for heightened levels of realized losses throughout 2008 while still maintaining our share repurchases estimates.

So, I would first let it bleed through in the form of risk-based capital, looking to defend our share repurchases activity and again for a AA rated company that’s traditional to dial in something around the 375% to 400% risk-based capital or carrying north of 425% into the year-end that allows us some cushion if you will or capital, excess capital position to weather our realized losses and so, I feel reasonably good sitting here today. But we're watching very, very carefully, obviously, the credit markets as we've mentioned earlier.

Jeffrey Schuman - Keefe, Bruyette & Woods

Okay. I think you've drawn the distinction I was looking for. So the cushion really is a cushion? It can be used to some extent to fund a little bit of rate in ’08?

Frederick J. Crawford - Chief Financial Officer

Very practically I wouldn’t do that right now. I think, right now as an insurance company with a $70 billion general account you’re wise to be watching your excess capital position and retaining it while the capital markets particularly credit markets look to calm down.

Jeffrey Schuman - Keefe, Bruyette & Woods

Thank you.

Operator

And Mr. Sjoreen, I’d like to turn the call back over to you for any additional or closing remarks.

Jim Sjoreen - Vice President, Investor Relations

At this time, I’d just like to turn it over to Dennis to wrap up the call.

Dennis R. Glass - President and Chief Executive Officer

Well again. Thank you for your participation and interest today. All of the questions are appropriately around some of the volatility of the capital markets and how that’s reflected in our hedge program and what impact if any will it have on our credit loss position. I think Fred has summarized it up very well in his comments. I would tell you as we sit here today that we remain very confident in the underlying fundamentals of Lincoln with respect to all of the investments in the operating businesses that we've talked about expanding distribution additional product development and the like. There is certainly nothing that I see in the capital markets, which will prevent us from doing any of those things. So, we think 2008 will be a continuation of the building and strategy that we did in 2007.

And again thank you very much for your interest today. Thank you operator and thanks to all for joining us today.

Operator

Thank you, sir. And that does conclude today’s conference call. Thank you for your participation. You may disconnect at this time.

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Source: Lincoln National Corp. Q4 2007 Earnings Call Transcript

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