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Lincoln National (NYSE:LNC)

Q2 2012 Earnings Call

August 02, 2012 1:00 pm ET

Executives

Jim Sjoreen - Investor Relations Professional

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

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

Analysts

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

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

Suneet L. Kamath - UBS Investment Bank, Research Division

Edward A. Spehar - BofA Merrill Lynch, Research Division

Christopher Giovanni - Goldman Sachs Group Inc., Research Division

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

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

Thomas G. Gallagher - Crédit Suisse AG, Research Division

Ryan Krueger - Dowling & Partners Securities, LLC

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

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

Operator

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

Jim Sjoreen

Thank you, operator, and good afternoon, and welcome to Lincoln Financial's second quarter Earnings call.

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

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

Also, 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 R. Glass

Thank you, Jim, and good afternoon, everyone. Overall, it was another excellent quarter for us with all of our businesses delivering solid results. Our strong performance underscored the strength of our franchise, flexibility of our balance sheet and the aggressive actions we continue to take in response to difficult macroeconomic trends. We expect that the tough macro conditions will continue as will the deliberate steps we are taking to keep us on track for delivering on our long-term goals and objectives.

Let me now share some highlights from the quarter. We ended the second quarter with operating return on equity at 12%, book value per share growth of 5%, income from operations per share of 8% and operating revenue growth of 2%, all clear indicators that we are delivering on the strategies we have discussed with you in the past.

Increased deposits and positive net flows in Retirement Plan Services, as well as strong top line results in Group Protection, demonstrate that our investments in talent, technology and distribution are yielding results.

In addition, although Life sales were mixed, we did experience strong results in the higher return products we had pivoted to the past several quarters. And finally, our strong capital position enabled us to repurchase another S150 million in shares. With our current valuation inconsistent with the actions we have taken and the results we have achieved, buying our shares is one of our best capital management uses.

Let me now comment on underlying businesses. Life Insurance sales for the quarter were $128 million, down from a year ago. This decline was expected as we've continued to be a leader in implementing pricing actions that respond to the low-interest rate environment. We are committed to taking additional action if conditions require us to do so.

In addition to making pricing adjustments, we've also continued our pivot to higher-return, less-interest-rate-sensitive products. Second quarter sales of these products, which include Variable Universal Life, Indexed Universal Life and Term, were up 20% from the prior year quarter.

Moving forward, our ability to keep pivoting to these products will be driven by the breadth, depth and capability of our distribution teams.

Turning to the annuity business. We are also responding to low interest rates and market volatility by implementing product changes on our variable annuity platform, by expanding our Protected Funds solutions and by adding new distribution partners and strengthening relations within existing networks. You have heard me say this before, but we are pleased with where we are positioned in the industry. We maintain a consistent market presence, and we remain more interested in offering products on our terms, and we are focused on taking market share.

Positive net flows from the second quarter helped drive annuity account balances of $90 billion, up 2% from a year ago. We continue to see strong results from our Protected Funds series, as evidenced by 65% of June variable annuity purchasers opting for this solution. Our Protected Funds remain a good solution for consumers because they can lower the volatility of their returns and a good offering for Lincoln because they reduce our hedging costs.

Our strategic partnership with Primerica also continues to be a source of growth and diversification. Indexed annuity sales in the second quarter via this network were $100 million, up from $25 million in the first quarter.

In our Retirement Plan Services business, we delivered solid results in the quarter with the benefits of our strategic investments taking deeper hold. Total deposits of 1.3 billion in the second quarter were up nearly 8% versus the prior year. We were also encouraged by our small market segment results, which saw an 18% increase in total deposits. This segment is an area of focus for us given its great growth dynamics and favorable return profile.

Net inflows in the quarter were $194 million compared to outflows of $178 million a year ago. This marked the fourth straight quarter of positive flows, driven by a combination of strong deposit growth and improved retention.

In Group Protection, second quarter sales were $89 million, representing a 33% increase from the year-ago quarter. Our sales continued to be broad-based with employers of fewer than 1,000 employees remaining a source of strength for us. Second quarter sales were also driven by the strategic actions we are taking in this business, including a 15% increase in Lincoln's feet on the street. This increase in sales reps contributed to a 20% increase in independent brokers selling the segment's products. Our deep distribution, combined with the product and service expertise we bring to market, continue to position us well to near and long-term opportunities in the Group space.

Staying on topic for a minute, distribution overall has long been a strength for Lincoln, one that we believe differentiates us from competitors. It remains core to driving our continued pivot to the higher-return products that yielded good results this quarter as well as enables us to continue to sell products on our terms. Our more than 8,000 agents and reps in retail, 500 worksite producers and almost 600 wholesalers in LFD have brought to Lincoln approximately 60,000 independent producers selling our products. We will continue to tap this deep resource to deliver good solutions to our clients.

Before I turn the call over to Randy, let me state once again that this was an excellent quarter. Our results were strong, and we remain focused on all levers that will incrementally help us to build earnings growth and return. As I mentioned, we have flexibility on our balance sheet to continue share repurchases, and we will continue to reshape our products as a means to generate strong new business returns. The credit profile in our investment portfolio is very strong, allowing us to take modest additional risk that will improve our investment yield. And while we will continue to make significant strategic investments across our business lines, we will also continue to take action to lower our baseline operating expenses.

The results we have produced over the last several quarters are strong. They reflect an unwavering commitment to our shareholders that we will take action that helps to ensure sustained growth and continued profitability.

With that, let me turn it over to Randy.

Randal J. Freitag

Thank you, Dennis. Last night, we reported income from operations of $322 million or $1.09 per share for the second quarter. It was an excellent quarter that again demonstrated our ability to generate strong and improving results in the face of a challenging environment. Strong results across all 4 businesses were boosted by our alternative investment portfolio, which added 20 million to the quarter's results. Adjusting for this, normalized earnings came in at $1.03 per share.

Looking at key value drivers. Normalized operating return on equity of 11.3% and book value per share growth of 5.3% continued to perform very nicely. Operating revenue growth of 1.5% was muted as the daily average S&P grew only 2.4% year-over-year, while net investment income growth was negatively impacted by the interest rate environment.

Normalized operating EPS growth of 12% was helped by crediting rate actions in the Life, Annuity and Retirement businesses, which largely offset the decline in our earn rates; tight management of baseline expenses, that is expenses excluding strategic investments, which grew 3% year-over-year; and capital management as we repurchased 6.5 million shares during the quarter for a total investment of $150 million. All in all, a very, very good quarter.

Turning to net income. We reported income of $324 million or $1.10 per share. Net income benefited from a small net realized gain resulting from a positive NPR adjustment, which was offset by RMBS and CMBS related impairments, mark-to-market adjustments on trading securities and VA hedge performance. After tax impairment and other net realized losses of $33 million were consistent with the levels we have seen in preceding quarters.

The VA hedge program continued to perform very well, particularly in a volatile quarter with assets associated with the hedge program exceeding the liability by $450 million at the end of the quarter.

In my opinion, no single statistic better exemplifies that our program is uniformly recognized as a leader in the industry and its ability to continually develop and grow the assets required to fund the liability for the guaranteed benefits that we issued.

Before turning to segment results, let me comment on a couple of items, starting with the impact of today's interest rate environment. Previous guidance, which assumed a 10-year treasury rate of 2% was for an earnings impact of $50 million, $100 million and $150 million in 2012, 2013 and 2014, respectively. Our revised guidance, which is based upon today's treasury rate environment and which includes actions that we have taken on credit rates, our new business pricing and which incorporates our actual experience for the first half of 2012 is for a smaller impact over the same period of approximately $10 million for the remainder of 2012, $75 million in 2013 and $140 million in 2014, representing a 25% reduction from the $300 million 3-year total of the previous guidance. I'd attribute most of the improvement in the projections to the actions that we've taken around credited rates and good performance in the investment portfolio.

Looking forward, while in the Life and Retirement business we are essentially out of room to cut crediting rates further, I do anticipate that there is room for further management actions to mitigate the bottom line impact primarily through expense management in the investment portfolio, where we have capacity to take on more risk after an extended period of risk reduction.

My previous guidance are no near to midterm impact on statutory capital remains unchanged by today's rate environment. As a reminder, we have estimated and continued to estimate an impact of up to $500 million in the second half of a 10-year period of low rates.

Looking at expenses. G&A grew $28 million or 7.7% from the second quarter of 2012 with approximately 60% of the growth attributable to strategic investments that we are making across the company, with a focus on the Group Protection and Retirement businesses. Of course, the positive impact of those investments can be seen in the results, with strong sales growth in both businesses driven by investments in distribution and technology. Moving forward, we will continue to manage baseline expenses very tightly, while growth at strategic spending will level off as we exit 2012.

Turning to segment results and starting with Annuities. Reported earnings for the quarter were $158 million or $146 million normalized due to better-than-expected alternative investment income and a favorable stack adjustment. Returns in the Annuity business were very strong, with an ROE of 20.4% and an ROA of 70 basis points. Interest spreads remain strong in the Annuity business. Looking forward, the Annuity business continues to have ample room for further crediting rate cuts. As a result, I expect little pressure on economic interest spreads with any decline due primarily to new business that we'll put on with lower required interest margins. I made this point last quarter, and I'll make it again: when operated in a responsible and disciplined way, which is our approach, the Annuity business is a high-return business, the value of which is not fully reflected in our share price.

Retirement Plan Services produced another solid quarter, with earnings of $38 million or $34 million normalized, and strong returns, with an ROE in excess of 15% and an ROA of 37 basis points. Interest spreads decreased in the quarter by approximately 7 basis points relative to the first quarter as new investments brought down the earned rate.

Looking forward, I'd expect to see spread compression of 20 to 25 basis points a year. We, of course, will not be standing still, and I fully expect that the strategic investments that we are making in the retirement business will fuel the growth needed to overcome the headwind of spread compression.

Turning to Life Insurance. We reported earnings of $138 million or $132 million after normalizing for strong alternative investment results. As I noted in my remarks on the first quarter call, Life earnings growth this year is affected by the multiple reserve financing transactions that we did last year. Adjusting out the reserve financing impact, the current quarter's earnings grew by 5% relative to the second quarter of 2011.

Interest spreads were relatively flat for the first quarter as incremental relief on credited rates offset a small decline in yield. Looking forward, I'd expect to see 10 to 15 basis points of spread compression per year in today's rate environment.

The Group Protection had a very good quarter, reporting income from operations of $27 million or $24 million normalized. Net earned premium benefited from several quarters of strong sales and was up 8%. Non-medical loss ratio of 72.7% returned to the midpoint of our expected range, with all product lines experiencing a good quarter. LTD incidents and severity continued to perform within our expectations, and life mortality returned to a more normal level when compared to the first quarter. Our discount rate for new LTD claims remained at 4.25% during the quarter. I'd note that we lowered our rate to 4.25% back in the second quarter of 2011. This early movement on the discount rate should allow us to maintain this rate for the remainder of 2012. Today's rate environment would likely lead us to lower our discount rate 25 to 50 basis points in 2013, and we are taking this into consideration on the pricing of new and renewal business.

Turning to the balance sheet and capital management. Life company capital remained level during the quarter at 7.6 billion, and RBC came in at approximately 500%. Cash at the holding company was just north of $800 million, including $300 million of debt proceeds that we will use in August to fund the debt maturity. We repurchased 6.5 million shares for a total cost of $150 million, bringing the year-to-date total to $300 million. As I noted during the first quarter call, I expect to exceed initial guidance for the year for $400 million of capital deployment. Given our belief that our share price remains significantly undervalued, we have a bias to skew capital deployment toward share buybacks. But we'd note that we will also can continue to take leverage over the organization when the opportunity arises.

Let me wrap up what was a great quarter by noting that last week, Moody's affirmed our ratings and positive outlook, another indicator of both our positive past performance and the strength of our franchise as we move forward.

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

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Randy Binner from FBR.

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

So touching on the updated rate exposure, so the numbers you gave relate to, I think, GAAP earnings or kind of earnings overall. Is there any update to the disclosures you had given before about how DAC may be affected by a lower rate environment?

Randal J. Freitag

Note that DAC, which I think you're probably referring to the long-term earned rate assumption.

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

That is exactly what I'm referring to, yes, the 4.25 versus the 6.25.

Randal J. Freitag

Right. Randy, that will be part of our third quarter unlocking process. I'm not going to front run that process. There's teams of people across the company working on that right now. Obviously, rates have come down, and so we'll take all of that information into account when we think about that long-term assumption. I would note, though, having been through more unlocking processes than I care to admit in my life, there are always pieces of the unlocking that go both ways. We will have positive impacts, and we will have negative impact. I don't know what the different -- the individual pieces are. We will do a thorough job of reviewing all of them and report the results through the third quarter.

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

Okay. And then just on one other piece of disclosure. I think this goes back to the investor event in November. There's kind of a base case and a low rate case scenario for cash flow adequacy, the $6 billion and $8 billion redundancy disclosure that you gave. Would that be affected by this new disclosure as well?

Randal J. Freitag

Right. I didn't go to that piece of the disclosure. What I did say is that my previous guidance for no near to midterm impact on statutory capital is unchanged. When you go out into that second half of a 10-year period on a piece of our business, the SGUL business, we projected there could be up to a $500 million impact. That guidance is completely unchanged from where we were before by the level of interest rates today.

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

All right. So, okay. So we should improve from that? Then the 6 to 8 would be kind of roughly intact still?

Randal J. Freitag

I think you can make that inference.

Operator

Our next question comes from Jimmy Bhullar from JPMorgan.

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

Just had a question on your plans for excess capital beyond the buybacks. I think in the past, Dennis, you'd talked about potentially looking at deals. You've highlighted the Group Benefits space and also the pension market. If you're still doing that, and what do you see as activity in the market? And then secondly, you reported very strong growth in your Group Benefits business in terms of sales. What's certainly driving that? And what are you seeing terms of pricing in the Groups Benefits market?

Dennis R. Glass

Jimmy, on the M&A front, we continue to be interested in deploying some of our capital towards strategic opportunities, particularly related -- particularly in the Group and Retirement businesses. And that's unchanged. We'd probably, today, with where our share price is, not make such a large investment that it would stop us from buying our shares buyback -- shares back, so we continue to look at this on a holistic basis and take into consideration everything that you should when looking at building the company strategically and appropriately managing to your best return opportunities. With respect to the Group Protection business, let me start by saying unlike some of our competitors, we have a sweet spot in the small employer market. It's not without competition, but it's not as competitive, our belief, the jumbo market is, so a little bit less price pressure there. As I said in my remarks, strong sales relates primarily back to an increase in sale representatives, some 15% or 17%, and an increase in shelf space, if you will, because we have 20% more brokers who've never used us before selling the product. But let me give you one more statistic because there's a lot of discussion in the industry around pricing. I think we have continued to move prices up modestly where we can both on new business and renewals. And the metric that I pay very close attention to, one of many, in terms of trying to judge how competitive we are is our close rate because we close, we bid on large numbers of cases through the course of the year. And that close ratio, the number of cases that we actually win, stays -- had stayed pretty consistently in the 10% area. So I hope those are responsive to your 2 questions.

Operator

Our next question comes from Suneet Kamath from UBS.

Suneet L. Kamath - UBS Investment Bank, Research Division

I guess I'm a little tired from the earnings late last night and the calls today. Can you just go over again, Randy, the changes in the underlying assumptions around the interest rate guidance that goes from 300 to, I think, 225, you said, I think the primary driver was that you've made some investments at a better return than you originally projected or something along those lines. Can you just kind of go over that again just so it's clear because I think that's a pretty important point?

Randal J. Freitag

Sure, Suneet. I mean, the primary change going forward is today's interest rate environment, right? So the last guidance was with a 10-year treasury of 2%. Today's guidance, looking forward, is for today's interest rate environment, where the 10-year treasury is bouncing between 140 and 150. In terms of what's impacted the results, what's made them better than before is the actions that we've taken as you look back, primarily better action on crediting rates than we originally projected, better results in the investment portfolio than we originally thought we'd get, and the actions we've taken on new business pricing. Now in the near term, it's the first 2 items that are the primary contributors there, but when you look forward, that changes from 10-year treasury of 2% to today's interest rate environment.

Suneet L. Kamath - UBS Investment Bank, Research Division

I guess why is that crediting rate better than you expected? Because I mean, I was always under the assumption that you have the flexibility to go to the floors. And so why would that be better than you expected?

Dennis R. Glass

If this gets in -- I'm going to take this question, Suneet. When we provided these projections, the questions that we were getting was not what are you going to do to change the life path? The questions were, what if you essentially did nothing, what would happen to your margins? And so when we provided the projections, we knew that we were going to be able to take some actions to mitigate that. I'm quite sure we said it. And so that's the reason -- that's an answer to your question. Let me go on to say that the second set of projections that we just provided are on that same basis, which is essentially everything else being equal and the only variable that changed would be the 50 basis points or so roughly decline in yields, that would be the consequence. But as Randy and I have both said, management is not going to accept that. We're going to take actions on core expenses. We're taking actions to improve our investment yield. We're again repricing new business. So I fully expect that like the 300 came down, now the 225 will come down. Now clearly, because much of the drift from 300 to 225 was related to crediting rates, you can see that quite clearly or some increase in investment yield. We're having a look elsewhere now that we've got floors on these crediting rates. But we're still adding a little bit of risk on the investment portfolio, which we'll pass through that incremental gain, we'll pass through to our shareholders, not to the products. Our core expense line, pretty good at managing expenses, but the environment is such that you have to get better. So the mitigation to the $225 million will occur elsewhere in the balance sheet, and I believe a lower overall net income number than you'll see it in the actual interest margin.

Suneet L. Kamath - UBS Investment Bank, Research Division

Okay, that's helpful. I appreciate that. And then I guess, my second question, for Randy, you sort of teased us again like you did last quarter in terms of the amount of capital that you'd be willing to return in excess of the 400. Can you help us out a little bit of order of magnitude? I mean, all of the data points you're pointing to in terms of RBC, in terms of hedge programs, in terms of balance sheet, just continue so suggest that a lot of these risks are certainly manageable. So any incremental info or color on what the buybacks could be this year would obviously be helpful, too.

Randal J. Freitag

Let me -- I'll answer your question, but let me broaden it out a little bit, too. Let's look back first. We've done a significant amount of share repurchases over the last several quarters, $900 million. That represents roughly 12% of the shares we had outstanding at the beginning of that period. Now what drove that $900 million was both the strong capital position that we had and the free cash flow that we generate on an ongoing basis. Now when you look forward and when I project forward at those level of share buybacks at the dividend pays that we have over the life of the company, I fully expect that my RBC trajectory would be down 15 to 20 points a year. What you've seen over the last few quarters especially is that we've had sort of discrete events that have benefited the required capital. For instance, last quarter, we had an upgrade on a big holding, pretty much took required capital and made a change in that neutral for the quarter. So we've had these discrete events. As we've talked about when you look forward and we think about adding a little more risk to the portfolio, I don't necessarily think that. So when I look forward, when we're using capital in the way we're using it, I fully expect to see sort of our RBC trend to go down as you move forward. And I think that's the appropriate way to manage the strong capital position that we have today. When you think about all of the constituencies, the environment that exists today, constituencies being shareholders, constituencies being rating agencies, et cetera, I think that's the appropriate way to manage the capital today. We're being as aggressive as we can. I fully expect to be in the market over the remainder of the year. I'm not going to give you a specific guidance on what that number will be, but we will be deploying capital. Given where our share price is today, we'll skew that deployment towards share buybacks. We're not coming out of the market. We're going to go above our original guidance for the year, $400 million, as a reminder, by $300 million through the first 2 quarters. But we're not going to look -- we're going to be out there in the market, being aggressive, recognizing our share prices today.

Operator

Our next question comes from Ed Spehar from Bank of America.

Edward A. Spehar - BofA Merrill Lynch, Research Division

Two questions. First, Randy, a follow-up on your comment about the progression of RBC. Where in your plan, where would you have thought the RBC ratio would be today given the buyback that you've completed versus where it actually has turned out?

Randal J. Freitag

When I -- when we look out and when we project sort of the behaviors we've had, we'd expect to see 15 to 20 points of RBC decline a year. That's the average. I mean, it jumps up and down, but over a 3-year planning period. And that gives you roughly 50 points of decline. We started this period with roughly 500 points of RBC, so I'd expected us to be in that 480, 475 range right now. And we're at 500. And the reason we haven't gone down is because of some of these events primarily continually improvement in the risk profile of the general account.

Edward A. Spehar - BofA Merrill Lynch, Research Division

Okay. And then one follow-up. Just to clarify on the room that you have on crediting rates. Did you -- did I hear you correctly that you still -- you say you still have good flexibility on the individual Annuity block? That it was the Retirement and Life that you're pretty much at minimums?

Randal J. Freitag

Yes, absolutely, that's exactly right. The Annuity business, we have ample room to respond to the declining earned rates, so we don't see any pressure on the economics per interest spread in that business. Absolutely on the Retirement and the Life space, were pretty much out of room to recover rates further. As Dennis mentioned, we do have other areas of the company. We'll look at to manage the bottom line impact of spread compression. The investment portfolio, expense management, we're not done managing that potential impact.

Operator

Our next question comes from Chris Giovanni from Goldman Sachs.

Christopher Giovanni - Goldman Sachs Group Inc., Research Division

The comments around the expense leverage and then the ability to take on more risk within the investment portfolio, can you kind of talk some about what those potential expense initiatives could be and then what specific asset classes you guys are seeing an opportunity to take on more risk?

Randal J. Freitag

Yes, Chris. Let me give you some specific examples, things that are in various stages of being in place, some of which are still under way. Let's go to the asset portfolio first. We have a very small allocation in the alternative space, roughly 1% of our general account. I think we can very easily take that up a bit and be well within the risk appetite. So we recently issued a $450 million mandate to a high-quality manager to go out and invest in alternatives, private equity, hedge funds, et cetera. Also in the asset side, we have a very favorable liquidity profile. We have the capacity to take on investments that are a little less liquid. So we recently issued a mandate for $500 million a year to private placements, private placements that we don't really have access to as our current private platform. Once again, we're looking at our capacity, and we're going out in finding the best manager out there to fill that need. That's just a couple examples on the asset side. On the expense side, I'm not going to get any more specific than Dennis has said. We're very good at managing expenses, and you can fully expect that we'll be looking at all areas of general expenses as we go forward.

Christopher Giovanni - Goldman Sachs Group Inc., Research Division

Okay. And then within the investment portfolio, by changing some of that asset mix, what type of capital absorption does that take you up in terms of the RBC?

Randal J. Freitag

I think it's embedded in those numbers that I gave you before. I don't feel that will have any different glide path than I talked to you about, sort of that 15 to 20 points a year of decline in RBC.

Christopher Giovanni - Goldman Sachs Group Inc., Research Division

Okay. And then back in the November investor, you guys gave an update sort of under a moderate and severe stress scenario. And the biggest delta was the investment portfolio. And I guess given your comments today around the investment portfolio continuing to be better than expected, what type of incremental capital are you guys picking up just based on the better performance within the investment portfolio?

Randal J. Freitag

Yes. I don't have the specific numbers on me today, Chris. And we haven't gone through the process in a couple of quarters, sort of that complete stress. But we'll do that again. I feel very good that when we go through that process, the results will be better or worse, the same as they were before. I feel very good about the things that have happened besides the general account and the position that's put us in today.

Christopher Giovanni - Goldman Sachs Group Inc., Research Division

And then lastly, just quickly on -- can you give us an update on where you guys stand within the DAC quarter?

Randal J. Freitag

Yes, sure, Chris. We're well above the mean, a couple hundred million dollars if we unlock down to the mean. I believe if you look at the actual projection going forward, I think first year has roughly a 9% drop in sort of that the way we project out. So we have a lot of cushion. It represents roughly a couple of hundred million dollars if we were to unlock back to that mean.

Operator

Our next question comes from John Nadel from Sterne Agee.

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

Just a follow-up on the rates on the incremental or on the new sensitivity on the rates, Randy. Maybe this is tough to provide, but I was wondering whether you could help us understand just how much these management actions have impacted the outlook? I think in past conversations with you, it sounds like incremental move downward in rates is a linear sort of earnings drag. So under that assumption with none of the management actions, I would've assumed that, that $300 million of pressure at 2% would've gone up. I'm not sure exactly by how much, but it would've gone up. So I'm trying to get a better sense of trying to measure exactly how much the management actions brought that down. It seems to me that the net impact of the management actions could be easily $200 million.

Dennis R. Glass

Well, John, mathematically over the 3-year period, right, those management actions represented $75 million. Now...

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

I just mean versus where you would've been if we assumed the 140 -- the 1.4%, 1.5% 10-year.

Randal J. Freitag

Right. The -- John, let me go about your question on this way. The things we've done in the past have improved the results over that 3-year period by $75 million. Obviously, that's a number that continues projecting out into the future, so that has a present value much bigger than that. Going forward, we have over that 3-year period a total impact of $225 million. Not ready to talk to you specifically about what we believe we can offset against that, but the items we talked about, we believe we can really chew into that number in a serious way. Now when you look forward, the impact continues to remain linear in nature, at least over this next 3-year period and even beyond that. The impacts remain spread compression and reduction in your earned rate on surplus. Those are very linear impacts when you look forward. So I wouldn't expect the impact to have big jumps or dips in it as you move forward.

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

Okay, that's helpful. And then just turning specifically to Group Protection. I just hope that you could remind us how to think about a 25 or 50-basis-point discount rate cut. What kind of sense -- all by itself, what kind of an impact that might have on earnings? And then what does that translate into, all else equal, in terms of your pricing? You were talking about that as potentially a 2013 event. But if you've got a lot of new and renewal business coming up between now and, let's say, the beginning of the year, if you put in to price -- I'm just trying to get a sense of how much have to raise prices to essentially offset most of that discount rate cut.

Randal J. Freitag

Yes. we'll, let's talk about the numbers. So a 25--basis-point reduction in discount rates translates into $2 million to $3 million of annual income, okay? It also translates into roughly 2% to 3% on premium, somewhere in that range. It's very hard to estimate. It's going to vary case to case to case. But let's call it that range. We are taking that sort of impact into account when we price cases today.

Operator

Our next question comes from Steven Schwartz from Raymond James.

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

Randy, I want to start and I want to go again to the guidance of $50 million, $100 million and $150 million, the $10 million, $75 million, $140 million, and maybe you can help me with some math here. Prior -- so last year, you were looking at a $50 million linear increase. Now, we're looking at a $65 million linear increase. Why does that go up? What's the math?

Randal J. Freitag

Well because you have a little more incremental year-by-year spread compression, right? I mean, rates are a little lower, so if we got spread compression of X before, there's annual spread compression of X plus something today, which translates into a $65 million annual growth in that number versus the $50 million we had before. So it's nothing more than that. Also, the impact of surplus is a little bigger but a little lower earned rate.

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

Okay. So basically you're saying, look, the changes that we made took us 50 down to 10, and then we go on with our lives. Is that probably the best way to look at it?

Randal J. Freitag

Well, we go along with our lives, and we are very active on managing other pieces of the income statement to mitigate as much of this impact as possible.

Dennis R. Glass

Yes, that's right. If you lower your crediting rate on your liabilities, let's just use an example, not a specific example, but if we lowered our crediting rates on all of our liabilities by $50 million this year, that would repeat next year and the year after that, and year after, year after that. Is that the question?

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

Yes, I think Randy got to it, Dennis. Can we look at -- you made a statement about, it sounded to me like you're saying if rates continue where they are, we could be looking at more price increases on the Life Insurance side from around year end. If that's an accurate interpretation of what you were saying, any sense of what you could be looking at?

Randal J. Freitag

I think the best thing to say is that we have, as you all know and we've said several times, we have kept up with what's been a pretty quick decline in interest rates over the last 18 months and we've made pricing changes which will balance our need to get very good ROEs on new business and for taking the franchise. So in the broadest sense, we continue to make it in all of our portfolios if pricing changes reflecting conditions in the marketplace. Back specifically to the Life Insurance business for a minute, I would again repeat what we've been saying is that we're moving away from SGUL into products that already have the turns that are at our targets. SGUL is already down to only 30% of our sales, and SGUL is the product that's most sensitive to interest rates. So there'd be a combination of pricing changes as needed along with this continued pivot to products that are less affected by the movement in interest rates.

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

And one more, Dennis. Could you give us an update where the industry is, where NEIC is right now on PBR?

Dennis R. Glass

PBR and AG 38 are I think at the moment kind of in the same bucket. AG 38 and PBR are going to -- the process is coming to a close. And by the way, I would say that in my experience, the regulators in the industry have been working as well together on this as they could have. And no one's ceding, by the way, their own responsibilities at all, just the dialogue. So on AG 38 specifically, and large parts of principle-based reserving, the process is nearing its end. There's still moving parts, but we should have some specific knowledge in the next couple of weeks or so.

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

Okay. So you're saying this summer, at the summer meeting, maybe actually the summer meeting?

Dennis R. Glass

Yes.

Operator

Our next question comes from Tom Gallagher from Crédit Suisse.

Thomas G. Gallagher - Crédit Suisse AG, Research Division

A quick question for Randy. So you roll forward a little bit further in time. Rates are lower but actually, the outlook gets slightly better due to interest rates and related pressure. Is that -- should we take that to mean that as we look to 3Q or 4Q considering balance sheet type reviews in terms of goodwill, reserves, DAC, VOBA what -- anything else you might think to add in there, that you would also in -- I don't know if I would say better shape, but will that give you some cushion as you roll into sort of the testing season to think about how things might pan out?

Randal J. Freitag

I talked about the unlocking process a little bit ago, right. I'm not going to get in front of that. We are definitely going to look at both the long-term interest rate assumptions along with all the other assumptions that go with this process. I fully expect that there will be pluses and minuses. I don't know what the answer is at this point in time, but my experience tells me that there will pluses. There will be assumptions where we've been better than pricing. There will be assumptions where we've done worse than the pricing. And we'll see what the subtotal of it is. As it relates to the goodwill analysis, I'll just to remind everybody. I started out with the same comment. I'm not going to front run our process that occurs in the last half of the year. But I'll remind everybody, we took a good hard run at the key components of this last year, the profitability of new business, the amount of new business and the discount rate we applied for the goodwill analysis. Now we'll go through that same analysis this year, but I feel good about what we did last year.

Thomas G. Gallagher - Crédit Suisse AG, Research Division

Got it. I guess another way to ask it would be if things are panning out better than your stress test, are things also panning out better than your embedded accounting assumptions? When I think -- because obviously, the accounting assumptions are best estimates, and stress test are something worse than that. But I guess I just want to try and get a sense for -- are the 2 related or should I think of them as completely unrelated? Because one was take -- starting from a much more conservative place.

Randal J. Freitag

Yes, Tom, I'm going to go back my early assumptions. You're talking about GAAP accounting?

Thomas G. Gallagher - Crédit Suisse AG, Research Division

Right.

Randal J. Freitag

Well, best estimate sort of assumptions. There are some of those assumptions that I think we're doing better at. For instance, mortality. In general, when I -- hear for my businesses and when we report it to, we generally do better than pricing. Do I know exactly how that will translate in the amount? No. But generally we've done been better in that assumption relative to pricing. Interest rates, we've obviously been a little lower than the pricing assumption, and we look at that assumption. There will be some more we do better. There will be some more we do worse. It's always that way whenever you go through one of these unlocking processes. I don't know what the answer will be in the third quarter. I feel good about where we are, and I feel good coming into the process.

Operator

Our next question comes from Ryan Krueger from Dowling & Partners.

Ryan Krueger - Dowling & Partners Securities, LLC

Randy, what's your outlook for AXXX reserve solutions in the back half of the year? I think my understanding is that the supply is pretty strong and the price is pretty good right now. So is there any reason to think you wouldn't be able to complete something in the back of the year?

Randal J. Freitag

We did a number of transactions last year. I've talked about that, and all that impacts growth in the earnings. You see it in the Life -- here in the Life business. And you've seen it reflected in some of the share buyback activity we've had. So I'm not giving point of guidance at what we're going to do over the remainder of the year. We obviously look at these things regularly to see if we have both capacity and the ability to do more of those. You are right. The marketplace is open. So there is capacity. It's at a reasonable price. I don't know if we'll complete any this year. Remember that we did 3 of these transactions last year. We'll see. We'll do our best, but I'm not giving any point of guidance yet.

Ryan Krueger - Dowling & Partners Securities, LLC

Okay. And then just a quick follow-up on the interest rate discussion. The 1.5% or 1.4% to 1.5% scenario, what does that correspond to for new money rates?

Randal J. Freitag

We would -- it varies by business, right? We would use as part of that process in more of a long-term average credit spread than, for instance, the credit spread that we experienced in the first half of the year. So if those treasury rates were more of a long-term look at what credit spreads typically are, it varies by business. It's going to be a little higher for a business like long-term Universal Life or the investment strategy is more of a 30-year strategy than it would be for the Annuity business. So it varies.

Ryan Krueger - Dowling & Partners Securities, LLC

Okay. And then last one on SGUL, have you guys seen any changes in lapse rates to this point in the low interest rate environment?

Randal J. Freitag

No, we haven't actually. We've seen lapses in that business run a little above what we've priced for. Frankly, we've said that in the past. So we haven't seen an explicit response to rates being low.

Operator

Our next question comes from Joanne Smith from Scotia Capital.

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

My questions have all been answered.

Operator

Our next question comes from Mark Finkelstein from Evercore Partners.

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

Actually, just a follow-up to Ryan's question. What would be the impact of profitability if you did see a decline in the lapse rate? I think you gave some information at your Investor Day where you did see some declines in both SGUL and the non-SGUL books. I'm just curious if you had, say, 100 or 150 basis points change in the lapse rate, how would that impact profitability?

Randal J. Freitag

Mark, I don't have updated guidance relative to what you've seen before. We feel really good about both the lapse assumption that's in our current models and the lapse assumption we're actually experiencing.

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

Okay. And then just thinking about rates on the VA business, I guess the first question is, are you fully hedging the product right now? Or are you taking any kind of rate that's currently? And then secondly, do you need to kind of make any further adjustments to the product given where we are today?

Randal J. Freitag

Mark, let me take the first half of that. We -- it is a hedging program, so we continue to hedge the liability as we calculate it. So I'm not taking any explicit bet with the hedge program right now. Let me turn the second part of the question over to Dennis.

Dennis R. Glass

Mark, we did -- as you know, we've moved to these Protected Funds, and the ROE on that business is pretty good because of the change in our hedge cost. We're seeing increasingly more of that selection being made so that's a good direction. Another action that we took was on the non-protected fund asset mix and the sub-accounts. We lowered the rates 50 basis points, the guarantee rate, the long-term guarantee rate, roughly 50 basis points. Back to my earlier comment, we have a like-for-like focus on getting the appropriate return on our capital. A lot of moving parts both in the economy and the capital markets, and as those become entrenched for any long period of time, we'll make the appropriate adjustments.

Operator

I show no further questions at this time and would like to turn the conference back to the speakers for closing remarks.

Jim Sjoreen

Well, we want to thank you all for joining us this afternoon. And as always, if you have any questions, please follow up with me at the Investor Relations line at 1 (800) 237-2920 or via e-mail at investorrelations@lfg.com. Again, thanks for your time today, and have a good afternoon.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program and you may all disconnect at this time. Speakers, please stand by.

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