Lincoln National Corp (LNC) 2003 Q1 法說會逐字稿

Good morning, everyone, and welcome to the first quarter 2003 earnings conference call for Lincoln Financial Group. 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. If you should need technical assistance during the call, please press star 0 and someone will help you.

This call is being recorded and will be available for replay beginning today through Monday, May 5 by dialing 888-203-1112. And please enter access code 207499. Once again the replay is available by dialing 888-203-1112 and enter access code 207449. Or you can access the replay at www.lfg.com./webcast. At this time, I would like to turn the call over to the Vice President of Investor Relations for Lincoln Financial Group, Ms. Priscilla Brown. Please go ahead.

Thank you, Jessica. Good morning, and welcome to Lincoln's first quarter earnings call for investors and analysts. You heard the safe harbor cautions while you were in cue. I won't repeat them. We appreciate your participation today and invite you to visit Lincoln's website, LFG.com where an updated equity market guidance spread sheet will be posted will posted in the coming days. Lincoln also plans to release its 10Q within the next week.

A full reconciliation of income from operations to net income is provided in our press release and on the LFG.com web site. Now I would like to turn the call over to Jon Boscia, and Richard Vaughan. Their comments will be followed by a Q and A period. Jon?

Thanks Priscilla and thanks to all of you for joining us this morning. Fundamentally, our businesses are performing well and we are maintaining positive net flows an important factor in creating long term shareholder value. That said, as you well know, our businesses are impacted, especially in the short-term by a number of variables. Economic factors like declining financial markets, partnership earnings and interest rates, to name a few, as well as industry dynamics such as pricing and other product design issues.

While these types of variables generally work independent of one another, in recent quarters they have converged to weaken results. We saw this play again in the first quarter. Yet despite these forces working against us, we continue to record positive cash flows in each of our domestic retail businesses, representing the fifth quarter in a row.

We believe this trend of positive cash flows in an extremely difficult environment reflects the fact that Lincoln has compelling markets in the marketplace and a strong distribution system behind it and that we are positioned to weather the storm and come out strong on the other end. We believe the key to maintaining positive flows and one of the keys to our long term success is the balance Lincoln has across products, across distribution channels, and across the risk spectrum.

Looking at the business segments, let's start with life insurance. Lincoln Life continues to be a source of steady positive cash flows as a result of strong sales. With more than 86% of life account values in fixed products, this business has been largely immune to the effects of the market and the strong sales results of fixed UL bode well for maintaining this immunity. Moreover, while the poor equity markets continue to depress variable universal life sales the overall breadth in balance of our life insurance product portfolio more than offset any negative impact.

For the first quarter, life retail first-year premiums were $171 million, up over 22% from last year's first quarter, driven by strong sales in our fixed universal life products, which grew 51%. Life insurance face amount in force increased $260 billion, up 8.2% from one year ago. And account values grew to $12.2 billion, up 4.9% versus a year ago.

Turning to the retirement segment, total annuity deposits were $1.4 billion for the quarter, down from the very strong $1.7 billion we saw in the first quarter of 2002 and holding steady with the fourth quarter of 2002. As discussed in previous earnings calls and analyst meetings, Lincoln currently offers only guaranteed death benefits, not guaranteed returns during the accumulation period or guaranteed income on variable products.

During the past few years, people have watched their equity portfolios lose value. Consequently, while they continue to turn to investments that have the potential for delivering strong equity returns, they demand guarantees that protect against erosion of savings over the long term if the market continues its slide. Banks have not been able to construct certificates of deposit that guarantee equity market performance. Securities firms have not been able to construct portfolios that guarantee equity market performance and Lincoln has not been able to do so either. Yet some insurance companies offer products that do just that, and their growth in sales reflect the consumer demand for those products. Lincoln has and continues to pass on these short-term sales gains for one very important reason.

We take the promise we make every time we sell a financial commitment that extends for 50 or more years very seriously. We want to be around to honor that guarantee. Providing financial guarantees of stock market performance is not the way to assure long term solvency. We did, however, recently announce that in June we are launching the Lincoln Principal Security Benefit, which is a withdrawal benefit that guarantees the customer will receive their original investment through withdrawals of 7% or less in a given year. This is an excellent investment vehicle in these uncertain times. And we have differentiated our product by adding benefits that will make it very competitive in the marketplace.

Two industry dynamics impacted our decision to enter this part of the market. The first is that primary competitors have slowed the practice of underpricing or in some cases have even suspended new sales of the most risky type of living benefits. Reinsurers have backed away completely from these benefits. A few large distributors have also either discouraged or outright prohibited their producers from engaging in sales of benefits that seem rich but could be costly to the client and risky for both the manufacturer and distributor in the long run. In short, the market has become more rational.

The second dynamic is that more robust hedging strategies are now available to help mitigate the risk. We've analyzed and extensively modeled this product carefully and to have in place a hedging program that protects both our quality of earnings and capital against significant moves in the market while achieving a return on equities on the product. By not offering this benefit in the first quarter, Lincoln Retirement had lower variable annuity deposits than the year ago period. Also, there is the likelihood that by preannouncing the June launch of this new benefit we depress sales in the interim. But we expect this to turn around beginning as early as midsummer. Although variable annuity deposits were lower, we had strong performance on the employer sponsored side due to record enrollments in the fourth quarter.

A multimanager product called the Lincoln Alliance Program saw deposits grow 126%, helping Lincoln Retirement reach its 7th consecutive quarter of positive cash flows. In the employer sponsored business, deposits are normally strong during the quarter after enrollment of new plans as rollovers come in from existing plans. However, future quarterly deposits are typically lower but more predictable as they occur primarily through payroll deductions. This is an area where we continue to see growth. And while plan participants are certainly aware of capital market issues, this business overall is fairly resilient during these times.

The employer sponsored business is also GMDB friendly given the natural dollar cost averaging which takes place which reduces the net amount at risk during chopping markets. What this also demonstrates is the importance of balance from the perspective of distribution.

Turning to fixed annuities, deposits, excluding the sixth portion of variable contracts were $408 million for the quarter, a decrease of 19% from the same period in 2002. We continue to approach this marketplace opportunistically and only offer rates that are consistent with our required spreads. The surrender rate in our retirement segment was about 10%. We remain better than both pricing and our DAC assumptions. We feel good about the quality of business we are putting on the books. Clearly, with sales and annuity product today are three things. Great wholesaling, product excellence, and relative investment performance.

Lincoln has distribution access across key channels and we are strengthening our wholesaling force. Principal securities should bring our VA product suite to the head of the pact and we have some of the best performing asset managers led by our two largest, Cap Research's American Funds and Delaware Investments.

Turning now to the investment management segment, Delaware's strong investment performance and once again the power of balanced distribution contributed to positive net flows of $344 million in the first quarter. This is the 5th consecutive quarter of positive net flows for both Delaware's retail and institutional businesses illustrating the breadth of our capabilities on both the retail and institutional side.

The institutional business won 14 new institutional mandates across 12 different asset classes during the quarter. Approximately 90% of the new assets came into the fixed income group. And the most recent mutual fund redemption data provided by the Investment Company Institute, the ICI, through February showed that Delaware's mutual fund redemptions continued to be significantly better than industry averages. Not surprising considering the outstanding investment results Delaware continues to deliver.

With respect to investment performance in the first quarter, 17, or 68% of the 25 largest funds in the Delaware investments family earned the top half of the LIBOR universe for one year and 19 of 76 percent for the three years ending March 31st. Barron's annual mutual fund ranking published during the quarter now ranks Delaware as a top. quartile fund family. Quite a move for the company named one of the ten most disfunctional complexes in year's past. Also for the year ending March 31st, 39, or 75% of Delaware's 52 retail funds have been labeled a LIBOR leader in at least one category. And 19 funds have been selected in multiple categories.

Managed account performance continues to be strong as five out of six asset classes beat their respective indexes for one year ending March 31st, and six out of six for both three and five-year periods. We believe that it is important to build performance records that are lasting. Our goal is not to design funds that shoot to the top decile of one-year performance only to land at the bottom of the pack in the next year.

Now I'd like to say a few words about distribution results in the first quarter. Lincoln Financial distributors or LFD is the wholesale distribution arm of Lincoln. LFD first quarter sales were up in both life and investments. However, annuity sales were down 35%, due to the market demand for living benefits and our disciplined approach to fixed annuities. Needless to say, LFD is planning an aggressive rollout of the principal security benefit for both Choice Plus and American Legacy, emphasizing the strong investment performance of stellar managers. Life insurance (INAUDIBLE) increased with retail sales seeing a 32% increase through LFD.

We are also pleased to see that we are gaining traction across all of our new distribution alliances. We were once again the number one nonproprietary life company within Smith Barney with a 20% market share as measured by first-year premiums. Investment product sales were up 11% over the same period last year, reflecting buyer interest in managed accounts and mutual funds. Mutual fund sales were up 4% from the first quarter last year.

Managed account sales in the second half of 2002 were extraordinarily strong due to the exit of two major competitors from the marketplace. Even so, in the first quarter of this year we had sales of $208 million, up 25% from the same quarter in 2002. This strong performance is contrary to the industry. According to the ICI, the industry was down 13% through March.

These statistics show why we remain committed to sales growth through LFD with a focus on even further developing our strategic alliances. As recently as 1998, LFG had no third party distribution outside of American Legacy. Since that time, LFD has dominated industry growth rates. I'll now turn it over to Rich so he can spend a few minutes on the major drivers of earnings. Rich?

Thanks, Jon. Today Lincoln reported first quarter net income of $41.6 million, and income from operations of $104.8 million or 59 cents per diluted share.

Let's begin by discussing the item that significantly impacts results, equity markets. If you applied the market sensitivity guidance filed in our 10K or used the market volatility spreadsheet provided on LFG.com, your calculations would show an estimated impact which was generally in line with the negative $21.9 million after tax that we experienced in the first quarter from declines in the market since year-end.

I will also describe the impact to specific segments as compared to year-end 2002. In the U.K., the footsy underperformed the assumptions underlying present value of future profits and DAC by 10.5% during the first quarter. And that had a negative impact on earnings of $3.6 million after tax. The weak footsy also impacted fees by $600,000. The life segment had $600,000 of negative DAC unlocking due to the equity markets and Delaware had reduced fees of $400,000. Lincoln's retirement segment was most affected by equity market changes. And first quarter operating earnings were $16.7 million lower than the fourth quarter of 2002 due to the equity markets decrease with about $15.2 million of that coming from movements in DAC and GMDB balances.

This is a little better than the spreadsheet would have indicated due to the slight outperformance of our funds versus the S&P index used in the model. Plus the impact of continued movement of investment allocations to bond funds and fixed accounts.

I'll briefly cover data related to DAC assumptions and GMDB that many of you ask about. At March 31st, our retirement DAC asset, including PBIS but excluding the FAS 115 impact was about $1.3 billion and represented 2.5% of annuity account values. This ratio of DAC asset to account values remains one of the lowest in the industry. You might recall from previous quarters' conference calls that there is no method prescribed under DAC for guaranteed minimum death benefit reserving. Some companies recognize the cost of GMDB's on pay-as-you go basis.

We use a more conservative method that recognizes that there is an amount at risk that will result in future payments and that over time the market growth will reduce the payment stream. Our GMDB gap reserves were $91.7 million on a net amount of risk of just under $5 billion at March 31st, 2003. The industry may be required to establish reserves on a GAAP basis by the first quarter of 2004. For some, this will result in significant charges.

Based on what we see in the proposed new rule, Lincoln would expect a very small charge to move to the proposed new requirement. At quarter end, roughly 23% of variable annuity account values had no GMDB guarantees of any type. 51% of Lincoln's variable annuity account balances had the most conservative type of GMDB called the return of premium.

As you are aware, there are two other primary types of GMDB's in the industry. The high water mark type, which represents 25% of our variable annuity account balances and the more aggressive guaranteed return features, including those that ratchet up each year. The 5% step-up product accounts for less than 1% of our variable account values and results in a nominal GMDB exposure. Last quarter we announced the suspension of sales of this and all ratchet products.

I'd now like to discuss the non-market related issues that affect earnings. In the life segment, the realignment of operations that was previously announced is underway and resulted in a $3.6 million aftertax restructuring charge in the quarter. Operating income in the segment was reduced by $6.9 million for unlocking DAC to recognize both current reductions in face amount of in force policies and in order to put this issue behind us from a DAC perspective we thought it was appropriate to unlock DAC prospectively for future face reductions as well.

We also had a $1million unlocking charge as a result is of a COLI surrender. These charges for unlocking in the first quarter should not be expected to recur. The retirement segments results were favorly affected in relation to DAC assumptions announcements in the fourth quarter. As expected our quarterly run rate of DAC amortization expense was reduced by $1.5 million after tax, as expected.

First quarter also saw some positive unlocking due to net favorable persistency which we estimate to be also be about $1.5 million after tax. We saw improvements in persistentsy occur for those product types and share classes for which we either maintained or extended our amortization periods while deteriorating for those which we increased our lapse assumptions and shortened the amortization periods. Fortunately our business mix includes much more of the former than latter. This also affirms the appropriateness of the DAC lapse and amortization code assumption changes we made in the fourth quarter.

As previously announced, we started expensing stock options in 2003. Lincoln adopted the retroactive restatement method and have restated previous quarters income statements. Consolidated aftertax stock option expense was $9 million in the first quarter of 2003. This is comparable with the expense in the first quarter of last year. Based upon current investing assumptions, we expect the expense to increase to about $9.7 million for each of the remaining quarters in the year or about $38 million for the full year. The impact of Delaware's earnings for its share of this expense was $5.4 million in the first quarter.

For the balance of the year, using current investing assumptions we expect Delaware's share of the expense to be about $6 million in each of the remaining quarters of 2003. However, assuming no unusual new grants or forfeitures we expect a drop-off of over $5 million in Delaware's option expense for the full year in 2004 as a large grant made in 2000 runs off. On an enterprisewide basis, partnership earnings were about $1.7 million below expectations.

Many of you have focused, and rightly so, on the investment quality of Lincoln's general account and that of others in our industry. This is to be expected coming through the record default environment of 2002. We do not believe investment quality is a negotiatible item at Lincoln and are both satisfied with our current general account investment quality and our rigorous internal processes for judging asset impairment.

A few points worth noting when considering Lincoln's current investment portfolio quality. Credit quality in the portfolio is as strong as ever as we have maintained our A rated average credit standards throughout this period and reduced both our below investment grade and CDO exposures to industry or below industry levels. At Lincoln, we do not harvest gains embedded in the bond portfolio to mask realized losses. We believe that harvesting gains to mask losses leverages future profitability and quite simply puts future product flows at risk as your ability to hold crediting rates and spreads diminishes. You can see evidence of this in our above average unrealized gain position.

Because of the nature our products, we side towards taking credit risk over interest rate risk in the portfolio and have invested in significant research capabilities at Delaware to support this activity. We have below average exposure to structured product and prepayment and extension risk that accompanies mortgage backed securities. And finally our approach to other than temporary product process or OTTI is rigorous. It involves several constituencies across the company including senior management, internal audit and our audit team at Ernst & Young. We believe our practice is to be conservative.

Turning now to distribution, LFD had a loss of $8.1 million for the first quarter, and LFA incurred a loss of $10.4 million. Both were affected by lower sales, primarily in annuity products. We expect distribution to have losses averaging $14 million per quarter for the next three quarters unless market conditions improve. This projection recognizes that the business runs in cycles with the first quarter being the weakest, building to the fourth quarter, typically being the strongest. In the first quarter, the amortization of the deferred gain was $11.9 million in aftertax operating earnings. This is consistent with previously announced expectations.

During our fourth quarter earnings call, we noted management's commitment to a strong capital position. Lincoln's strong risk-based capital at 318% of company action leveled at the end of the year, both safeguards our ratings and positions the company for growth. We did not repurchase shares during the first quarter. We would except to resume share repurchases activity only after we have strong evidence that market conditions have improved. We told you last year that pension expense for the enterprise would go up. For the first quarter our costs were $8.5 million, and we expect it to be about $34 million for the year. These are pretax numbers and consistent with the numbers I released back in November. I'm turn it back over to Jon.

Thanks, Rich. For the last three years we have reminded you of the impact markets have on our businesses we said we were doing all we could to ensure that business fundamentals remain strong. As you well know, the S&P 500 fell another 3.6% in the first quarter. Also several companies in the S&P 500 continue to impact both credit and equity markets and extremely low interest rates cause spread compression. However, we look back over the six-month period ending March 31st and note that S&P returns are very close to expectations used in pricing and DAC.

It's too early to call that a trend, but repeated periods of this will certainly help. I would add that we would expect continued volatility, but improvement nonetheless. You have the tough task of analyzing all of these environmental and business issues and forecasting results. We recognize the enormity of this task, so we remain engaged in practices that will provide you as much clarity as we can.

Things like diligent and dynamic resetting of deferred acquisition cost assumptions, accompanied by industry-leading disclosures. Setting up GAAP reserves for guaranteed minimum death benefits long before being required to do so. Offering guidance on earnings in closed and runoff businesses and providing guidance on the equity markets impact to earnings. Expanding disclosure on our general account investments which we will continue to modify as necessary. Disclosure on spreads between current crediting rates and contractual minimums, and expensing stock options using the most conservative methodology in advance of regulatory or legislative requirements.

In today's environment, it's important to recognize both the changing short-term dynamics as well as the important longer term metrics that will ultimately drive growth. Some of the particular areas that we have fiercely focused on in how we measure our progress over time include: producing positive net flows in all business lines by growing sales and reducing surrenders and redemptions. Enforcing rigorous expense controls. Maintaining our strong capital position. Maintaining high asset quality in our investment portfolios. Managing crediting rates to maintain acceptable spreads. Developing and distributing state-of-the-art products consistent with our stringent profitability and risk management disciplines. A willingness to forego short-term sales bragging rights when they are contrary to long-term viability.

Investing in Lincoln's (INAUDIBLE) Talon, and remembering that we make promises to our policy holders that extend for 50 years and longer and refusing to yield to short-term product features that bear unacceptable long-term risk. In these uncertain times, financial discipline, as it relates to product profitability or risk factors is critical. Utilizing sound risk practices will lead to long-term quality in both our product offerings and our earnings. With that, Priscilla, let's move to Q and A.

Thank you. We'll now open the call for questions. In order to give everyone an opportunity to talk today, we would ask that you ask only one follow-up question to an initial question. Jessica, with that, we can open the line.

Thank you. To ask a question, please press the star key followed by the digit 1 on your touch tone telephone. Also, if you are listening on a speaker phone you may want to disengage your mute button to allow your signal to reach our equipment. Once again, that's star 1 to ask a question. Our first question comes from Andrew Klingerman with USB Warburg. Please go ahead.

Good morning. I guess -- just one question, huh? All right. With regard to the life DAC number, just a yes or a no, reaffirm that that's a nonrecurring item. And secondly, I see you cut spreads that, you know, by -- it appears more than 25 basis points. Can you get me down to what your minimum crediting rate is and whether you have the flexibility to continue to cut if rates come down? And I see expenses as well were pretty flat in the annuity area. Is that sustainable?

Andrew you said cut spreads. I assume you meant cut crediting rates.

Crediting rates. It looks like you cut them by about 25+ basis points.

We maintained spreads on the fixed business, as you said.

Andrew, let's turn the life DAC question over to John Gotta and then we will go to Lorry Stensrud or Todd to talk about the annuity business.

Some background on the DAC. The.

The DAC unlocking is a nonrecurring item. We attempted to project the future face reductions that we expect to see going forward and recalculated our DAC and unlocked our DAC for that. We don't expect to see that recurring in the future.

And the same is true on the COLI. Unlocking. We had a large case or a case that was a single cell that surrendered. So it went out. But unless you have an unusual activity on COLI, we wouldn't expect that to recur. Let me then move to Todd and or Lorry.

Rich, this is Todd Stevenson, CFO of Retirement. Yes, we have continued to be very proactive about cutting our crediting rates on our portfolio type business in fact, in the first quarter of this year, we cut on the majority of our fixed business crediting rates by 45 basis points effective in the second quarter we have cut those by an additional 20 basis points. If you look at our fixed portfolio in that portion of which we are not set rates but rather have discretionary portfolio crediting capabilities that would leave us at March 31st with an average crediting rate about 70 basis points above the contractual minimum. And with 74% roughly of that group that is more than 50 basis points above the minimum. In terms of expense within the retirement segment. We have been successful in managing our expenses to at least maintain flat, and it would be our expectations that we could continue if not, in fact, be able to improve upon our expense margins going forward.

How can you improve those expense margins? What might be accessible to do that?

, For example, in the first quarter we announced the consolidation of our fixed bank channel annuity product group in Schaumburg, consolidating that with our Fort Wayne based operation. So that would be an example of the activity that has occurred to allow us to continue to manage expenses.

Continue to -- you think there are opportunities out there like that further?

Well, we've been constantly looking at our organization and structure, improving prophecies and so forth over the last couple of years. We would anticipate continuing that, yes.

Thank you, Andrew.

Our next question comes from Nigel Dali with Morgan Stanley. Please go ahead.

Question on the investment portfolio. Losses seemed quite high. I just wanted to get some color behind the losses that you incurred this quarter including the also the amount of gross gains and gross losses. And also an update on the amount of gross losses currently embedded in your portfolio. Thanks.

The losses were unusually high in my opinion in this quarter driven by airlines. We did take a fairly significant writedown on American airlines, which was the largest single loss that we had that was recognized this quarter. It was a writedown as opposed to a sale. It was about $49 million. We also had writedowns on -- some additional writedown on United airlines. Basically, these related to ETC securities where we looked at the underlying collateral and wrote it down to what is basically fire sale levels at this point. But we believe it to be appropriate considering the circumstances. We also had some charges related to electric utilities that came through. The gross realized losses for the quarter, pretax, pre-DAC, were $163.5 million. The realized capital gains were about $37.5 million. And then then there is about $7.2 million of investment expenses and adjustments for policy holder interest that come through, effectively increasing the offset. So it is equivalent to a capital gain or reduces the capital losses for the net pretax of $118.8 million. And do we have anything available here on the unrealized at the end of the quarter? What do we have there. The unrealized loses for the end of the quarter is $565 million.

That's great. Thank you.

We have a question from Ed Spehar with Merrill Lynch. Please go ahead.

Thank you. I was wondering if you could talk about the expected profitability of your new guaranteed minimum withdrawal benefit product. You know, you talked about hedging and I'm wondering, is there reinsurance involved? And then as the follow-up, could you just talk about generally how the returns on the new variable business you are writing today would compare to what your expectations for returns would have been a few years ago. Thank you.

Todd, would you take that one? Lorry?

In term of the pricing on the GMWB, as Jon mentioned we've been very cautious about getting into this business. There is no reinsurance available. And we have been working with outside actuarial consulting firms to come up with hedging models that would get us to a return parameter that is very, very close to traditional B share pricing on variable annuities. So we don't expect the returns to be impacted on this business. In terms of how we look at variable annuity pricing, that's somewhat of a complicated answer because if you look at the business that we are writing today, so many of the companies are writing a lot of fixed business inside of their VA's and we are not doing that. As an example, on our Choice Plus, the only fixed bucket that we have is a ten-year MBA which really isn't even available on C shares. In our legacy contract we have some fixed business that has a one-year reset to it. If you take all in, our multifund, our Choice Plus, and Legacy, only 30% -- only 36% goes into the fixed bucket and only 17% of that is non-DCA. In that portion that's in our multifund employer sponsored business is payroll business. So we have very consciously stayed away from a lot of fixed business inside of our VA contracts which protects the return on our variable business.

And if I were to comment -- if I were to comment on how we look at pricing today versus in past years, we have always I think been pretty consistent in looking at the 15% return on equity level. But when we had 11 plus years of bull market, strong bull markets, it pushed return on equities up in excess of 20%. But our pricing assumption still assumed the 15% level. No different than what we are doing today. Over the last three years, with the decline in equity markets, obviously, you weren't having that 15% come through. But the discipline that Lorry and his group have used have been consistent.

Thank you.

Our next question comes from Collin Divine with Smith Barney. Please go ahead.

Good morning. For Jon and Rich. We looked at the earnings this quarter down about 27% year-over-year. They are back to pretty much on the run rate, 98, 99 level. How much longer can you continue to sustain dividend where it is? I know you take great pride that it's continually going up. But given the strong sales that you are putting up that dividend is starting to eat into the cash flow. How sustainable is it?

This is Rich. The -- based on all the projections that we've done -- we've done both sort of worst case and strong case kind of projections as well as most likely projections and in all of those cases we believe we are able to maintain the dividend going forward. Obviously it's always ultimately the decision of the Board. But at this point I see no risk in the dividend. And unless we would have severe market declines continue for a very long period of time it shouldn't be at risk. Keep in mind a lot of what's going on from an earnings perspective is writing adjustments to DAC which is noncash and doesn't affect statutory itself. Obviously as the equity markets stay depressed the impact on fee income certainly does depress the ultimate earnings coming through on a statutory basis. That's where long term, if things stayed very poor you would have the pressure. The spread compression issue is one that I think over the long term, if we don't see rates rise becomes the more pressure point. And obviously the write-offs that we have experienced over the last six quarters have put a lot of pressure on statutory results but we do believe that will mitigate in the not too distant future.

(INAUDIBLE) power ratio getting up to 50% you are comfortable you can commit to maintaining that through the end of the year?

Yes.

Thank you.

We have a question from Vanessa Wilson with Deutsche Bank Securities. Go ahead, please.

Thank you. Could you give us a little more color on the DAC adjustment in the life segment? You are saying it relates to your face amount. It relates to face amount changes on in force business? Could you explain how that happened? And does this say anything about the long term profitability of the business?

Jon, do you want to take that one? that one?

Yeah Vanessa. Let me give you a bit of a background. The face amount reductions were largely attributable to sales and buyings that were used in our well transfer market. And these types of sales became pretty popular between 2000 and 2002. What we had done within Lincoln is identified some issues with our contract features, how our contracts were written as well as our field compensation policy. If you look prospectively we have already taken the corrective action to eliminate future occurrences. In terms of the things that we ran into with our policy contracts and our compensation, our policy contracts until 2002 didn't charge a fee for face amount reductions so we had no income coming back in. And also on the comp side up until a year ago we didn't provide for commission recapture when we had face amount reductions once the policy had been in force for two years. So what we did in 2002 is adjusted our compensation schedule and all our new products which now include surrender charges for partial surrenders. Looking prospectively, as Pete had mentioned, in terms of the profitability of the business, we did conduct a study to determine which policies would have prospective face amount reductions. And again, that's policies that have already been written. And this quarter we unlocked our DAC accordingly.

So this is just a products feature that you wish you had written a little differently and you have gone back in and trued everything up?

Right, exactly.

Good.

We'll take our next question from Jason Zucker from Bank of America Securities.

This is actually David Haas. I wanted to drill down a little bit more on the unrealized losses. In U.K., you gave a breakdown of unrealized losses greater than 180 days as well as greater than one year. Do you have a breakout of those numbers as of the end of the first quarter?

We will when we file our Q. That detail will be in there. But we don't -- I don't have it here, nor do I want to get into that level of detail on this call.

Okay, thank you.

It will be in the Q though.

David, you will have that within the week.

Great.

We'll now go to Steven Schwartz with Raymond James. Please go ahead.

Good morning, everybody. I wanted to follow-up Vanessa's question on the -- question being this -- I wasn't -- is this -- the decline in face value, is this somehow being driven by the equity markets within some type of VUL policy or are we dealing with more traditional fixed universal life policies and these are people lapsing or partially lapsing?

John, do you want to take that?

Yeah, it relates to both UL and VUL. And basically a portion of it is attributable to what has been going on in the economy with the stock market. But the major portion of it is attributable to a sales design. I don't want to go into -- it's pretty technical. I don't want to go into the intricacies now. We'll happy to discuss it with you off line but it related to a sales design based on a specific need that was identified in the marketplace. And because the sales design was fine, what wasn't fine was our compensation policy or the fact that we didn't have partial surrenders in our policies which, again, we've now correct.

That leads to the natural question to my one follow-up, what happened to -- or did this need go away? What happened to cause the lapsation?

Again, I don't want to go into the detail, given it is a pretty complex design, particularly for the affluent marketplace. But it did relate to a design. The need is still there. But now we've got our policies and our compensation policies such that if that design continued we wouldn't have any profitability issues.

I understand that it's not nonrecurring. What was -- are you willing to say just what the need was.

Steven?

Without being too complicate.

Steven, why don't I talk with you about that in a follow-up call?

All right.

And it's only because it will take a while to go through the complexities of it. But I think the point is that the initial financial plan that these individuals put together included the provision for this -- for a face amount reduction to occur. So we will talk about that a little bit offline if you want to get into the detail. We have to go through a couple of tables.

Okay. I'm more than willing to do that. Thanks.

Thank you.

Our next question comes from Jeff Shoeman with KBW. Please go ahead.

Good morning. I was wondering if you could talk a little bit about interspreads on universal life. What the spread was in the quarter, how it's been trending and indicate whether you are able to cut credited rates there also, please.

Pete, would you take that, please?

Sure. Our spreads are on the universal life block, are in line with our target spreads. And we have been doing rate cuts over the last seven months or so. We do have a piece of that block at 3/31 -- March 31st, it was about 7% of the combined universal life and intrasensitive whole life block that was at minimum guarantees. But the other 93% was above guarantee. I think there is a chart available in the 10K or will be available in the 10Q that shows how much of our business is at guarantees and how much is above guarantees by what amount. We are managing to our target spreads. We are slightly above that today and will believe we will be able to maintain that throughout the year.

What is (INAUDIBLE) and what is the target.

Our spreads range by product they could be anywhere from 100 basis points to 250 basis points, it is a pretty wide range. On average, it is about 150. It's about 150 basis points. And we are slightly better than that.

We have a question from Joan Zeiss with Goldman Sachs. Please go ahead.

Thank you, good morning. My question relates to the ongoing equity sensitivity of the company. So for instance what percentage of your variable annuity sales went into the fixed bucket? If you gave us that, I'm sorry I wasn't able to remember it. And how do you see the equity sensitivity of the company? Do you see it growing? Do you see it shrinking? Am I right when I look at the in force business and it looks to me like about, you know, 35% or so of your total business relates to equity market sensitivity?

Let me answer a little bit on the market sensitivity piece and I'll turn it over to Todd on the percentages of business on the fixed and variable. The sensitivity of our earnings, as the market goes up, will decline. But it is a very, very gradual decline. The major cause of sensitivity right now has been the GMDB reserve and reserve changes that are taking place. So as the market increases and the net amount at risk decreases, that big driver of market sensitivity will decline and ultimately disappear. Once that takes place, the remaining piece that we have is the DAC unlocking, which is not as big typically from a market sensitivity perspective once we get closer to, in effect, our expected returns. So that should improve. Todd, do you want to touch the other piece?

Yes, Jon. The distribution in the first quarter of the fixed portion of variable product deposits was right at about 36%. That's only up slightly from the first quarter of last year, which was at 33%. And actually down from the levels that we experienced in the last half of '02. Those deposit levels and fixed options being at about 45% of total variable product flows.

Thank you.

We'll now go to Michele Giordano with J.P. Morgan.

I was hoping that Lorry could give us more details about the competitive climate in the variable annuity market. Is it getting worse or has it peaked in terms of how bad it can be? It would seem to me a lot of midsized players that benefited from generating scale very quickly during the hot equity market must be markedly losing scale and their competitive position deteriorating. Secondly to Rich, on the LFA and LFD I think you said in your comments that the loss would be about $14 million for the remaining quarters of the year. Does that imply that we are not going to get that seasonal pickup in earnings in this segment in the fourth quarter of the year? Or is this just an average and it will gradually improve throughout the year.

Let me go ahead and take the last part of that and then we'll turn it over to Lorry on the competitive piece. I tried to indicate that the 14 is an average and we would expect the improvement to take place as the year goes on which implies that the second quarter is likely to be close to what we experienced in the first quarter and then I would expect to see improvement as we get in the third and fourth quarters. So I'm still expecting to see some of that seasonality and the typical improvement we get from larger sales in effect in the fourth quarter of the year coming through. It drives actually the profitability of the sales side. One of the things that's predicated on obviously is that the markets continue the do a little bit of improvement. Right now the markets are very difficult to generate sales. And that's really being felt in LFA where we have all types of products sold through LFA to generate revenues to offset revenues of a fairly large block of fixed cost. So we are expecting to see volume pick up in order to see the losses come down there. Lorry, would you take the competitive environment question?

Sure. Michele, I think some of your comments are right on the money about some of the players that are -- that got into the marketplace with features and benefits and compensation. And those things just aren't working today. If you look at the marketplace today, the companies that have some form of a rational living benefit that have rational compensation and performance are the companies that are going to win over the long period of time. We're starting to see more and more of that. We are also seeing companies that are selling a fair amount of fixed business inside of their VA's and they are calling it variable business. I'm not convinced it is variable business. We have really stayed away from that. A, the returns aren't there. B, we don't think it's going to be very sticky. And C, we just don't they it's real variable business. So, on the variable business side, again, I think it gets back to performance compensation and some form of living benefit. And even the distributors today are saying you don't need the most exotic kinds. We understand why companies came to the marketplace with those, but we also see the companies leaving. So we want to sell a benefit that's going to be sustainable until the marketplace for a long period of time. From that perspective we see some rationality coming back into the marketplace.

Thank you.

Joan, I'd like to follow back up on your question that you had asked about the -- I understood your question to be the percentage of money -- new money that's going into the fixed bucket of variable annuities. And right now that's at 20%. I think Todd's 36% amount was the total fixed that was in there, not the fixed bucket of variables which I think you may have asked about.

Yeah, with the difference being the amount that goes into DCA specials.

Yeah.

DCA monies that are then pretty quickly allocated out to the variable subaccounts.

And Joan, I wasn't sure which one you were asking so we wanted to make sure you had both numbers there.

We'll take our next question from David Lewis with SunTrust Robinson Humphrey. Please go ahead.

Good morning. Can you give us an idea on maybe what you think your excess capital levels are today and whether the rating agencies have had any questions about your investment portfolio or capital position or looking more closely at your ratings?

That's a pretty broad three questions in one isn't it? I don't know what our capital position from a risk based capital percentage is as of the first quarter. I haven't seen those calculations but I have no reason to expect to see much change in that. We are at 318% RBC at the end of the year. That's quite a bit stronger than we would typically operate. But these are not typical times. And until we get to some typical times, we plan on maintaining that strong capital position. So at this point in time with the economy and credit and other things that are going on from an economy perspective, I don't consider us to be sitting on excess capital given the current circumstances. When the circumstances change, we could probably drop back to something in the 275 or 285 RBC range which would free up substantial capital. Right now, the risk profile in the market place is such that additional capital is required both from our view and I believe the view of the rating agencies. They have taken a look at our portfolios and have not expressed any concern, in fact, both -- I know Moody's has put out a comment relative to the strength of our investment portfolio and at this point don't see any significant pressures or concerns although all the agencies have the rating industry in a negative position right now so I don't think you can ever see, quote, unquote, comfortable but relative to that we are in a strong position relative to the product risk we have taken on as well as our capital position.

Can you comment about your original assumption that quarterly earnings in a normal market should hover in the 75% area, we had that discussion last quarter. And if the markets are up now, is that a reasonable assumption starting in the second quarter if we remain flat for the rest of the quarter?

The quarter has so far, through yesterday, increased substantially. In fact,, if you look back over the last seven months we have got a return from the market of about 12%. Obviously, that's not reflected in the last six months' earnings because most that is turned around here in the last 29 days. So if the markets would stay where they were when they closed yesterday, we would have turned around almost all of the unlocking that took place in the second quarter. The only thing that remained was a little piece of GMDB, obviously, and that didn't even factor in the pressure effect on the quarter, that 20-some million dollars that we took from an impact on the market. The lower account values that now are higher and generating higher fees which would probably have take$3 million or so that wasn't turned around by the market. If you just put the ending market in there in place what have the actual was at 3/31. A lot of that turns around and it would generate higher run rates. So this quarter has been depressed by lower average account balances as well as the unlocking. And those obviously do turn around with the market. So from an ongoing perspective, we would think that the base is still fairly solid. And with the market improvements that have taken place, if they stick and or continue, they should be positives to the earnings spread.

Thank you.

Due to time constraints, that was our final question. I'll now turn the call over to Priscilla Brown for additional or closing remarks.

Thank you all for listening to today's call. We will be giving you instructions for listening to the recall if you would like. If you have other questions, We would be happy to take them, as usual, on the IR line. Thank you, and have a good day.

Thank you, once again a replay of today's conference call will be available today through Monday, May 5th. To access the replay, dial 888-203-1112, and enter confirmation code 207499. You can also access the replay by going to www.lfg.com/webcast. Thank you for your participation. This does conclude today's conference call.