Lincoln National Corporation: Fighting Uncertainty

Summary

• Lincoln National Corporation has a strong balance sheet and business model, which has just gotten disrupted by COVID-19.
• The company has marshaled all its resources, cut down on expenses, and has decided to become lean and mean.
• It faces rough headwinds in 2020, which it estimates will blow away in 2021.
• I do much more than just articles at The Lead-Lag Report: Members get access to model portfolios, regular updates, a chat room, and more. Get started today »

Uncertainty about sales impedes business planning and could harm capital formation just as much as uncertainty about inflation can create uncertainty about relative prices and harm business planning. - Janet Yellen

It was a no-brainer that insurance companies' bottom-lines would be hit by a double whammy after the COVID-19 pandemic disruption got serious and the Fed slashed interest rate to near 0%. Lincoln National Corporation (NYSE:LNC) was no exception. The stock got hammered down from about $60 in late-Feb 2020 to $41 as of June 3, 2020.

Image Source: My tweet alerting about the impact of falling interest rates on insurers.

LNC is a 150-year-old company with a robust balance sheet. It had been doing good till Q1 2020, but all that is in the past. COVID-19 has changed the business dynamics and what matters now is how companies fight against the pandemic, near-zero interest rates, asset risk, equity market volatility, and hedging mortality risk.

Though I am neutral on the company because of the rocky road that lies ahead, it feels good to know that LNC is treading diligently and cautiously. Here's how it is fighting the uncertainty.

Stress Testing its Business Model

The company's stress-testing model takes hard landing into account. The model assumes that equity markets will drop by more than 40% and will not be able to retrace back to their old highs in the following 3 years. The model also has dropped interest rates to very low levels and treasury rates to 0.50% in 2020 against 1% in prior years. LNC has also checked the impact that a 0% treasury rate will have on its business. Plus, the stress test also builds in a credit shock.

The company has responded to the stress test by chopping and changing business and investment strategies. It has decided to reduce expenses and shuffle investments while extending grace periods to customers that have missed premiums or are waiting for 401(k) hardship withdrawals.

At a 0.5% interest rate, LNC estimates an impact of $100 to $200 million by 2021. The company's employees have pitched in and delivered a plan to reduce expenses by $100 million in 2020. It also will suspend buybacks in Q2 2020, and maybe beyond. Though the company anticipates an increase in ratings migration and credit losses, the impact will be below its financial plan that was developed after the stress tests.

COVID-19 Morbidity and Mortality Claims

As of June 3, 2020, the U.S. has 1.9 million COVID-19 cases and a death rate of 5.7%. Though LNC was not impacted much by COVID-19 morbidity and mortality in Q1 2020, it expects short-term disability and mortality claims to increase going forward in 2020, which will negatively impact its earnings.

According to Moody's, COVID-19-related life insurance death benefit claims will range between $8 billion and $160 billion. Estimates are not available for the short-term disability claims, but the claims are estimated to rise exponentially.

The company's management estimates that for every 10,000 deaths in the U.S., its earnings will take a $9 million hit. Currently, there's a lot of buzz that a second virus wave is on its way and, therefore, investors must watch this metric. LNC has $760 million cash and has pre-funded its 2021 debt maturity. It also has access to $7 billion of committed borrowing and an undrawn $2.25 billion line of credit.

De-risking Investment Portfolio in an era of Low-Interest Rates

Image Source: Seeking Alpha

As of March 31, 2020, LNC had $102.6 billion in investments in its consolidated balance sheet. Of these $85.8 billion, or 83%, were represented by corporate bonds. As the business environment has gotten riskier, LNC has started selling investments that have a higher element of risk and started shifting to investment-grade and AA-rated securities. As of March 31, 2020, the company's below-investment-grade holdings make up just 4% of its total portfolio.

The company also has responded to the economic disruption and low-interest rates by re-pricing life and annuity products that are impacted by the fall in interest rates.

Another thing that investors must factor in is that every 1% change in the equity markets impacts LNC's earnings by around $10 million. Also, the company reports private equity returns with a one-quarter lag - so, Q2 2020 profits will get hit because the equity markets witnessed a severe decline in Q1.

Summing Up

In Q1 2020, LNC had $655 million of downgrades, which hurt its Risk-Based Capital (RBC) by 5 points. However, the company made up by growing its overall RBC by 7 points.

But Q1 2020 was more of a normal quarter. Q2 and beyond are expected to be different animals.

Going forward, LNC expects lower sales, a hit on profits from volatile variables that cannot be controlled, credit downgrades and asset impairments - and above all, uncertainty. Though the company has been in existence for 150 years, the disruption is so severe that the management team admits that it cannot estimate what will happen in the next couple of years.

My rating for LNC is neutral because of all the headwinds you read about upstairs. It's a quality stock that is fighting hard, but I really cannot recommend it at this time because even the near-term is full of question marks. The stock has also participated in the COVID-19 bubble, which I had tweeted and reported in The Lead-Lag Report.

As I'm unsure of how COVID-19 events will unfold, my rating is neutral and my advice is to track how the stock reacts to the evolving situation. I'm almost certain that the company will emerge stronger after the disruption is over, and that investors too will get chances to buy LNC on a dip.

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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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