Lincoln National Corp (LNC) 2003 Q2 法說會逐字稿

Please stand by for the commencement of the Lincoln National Earnings Conference Call. [Operator Instructions]. At this time I would like to turn the conference over to the Vice President of Investor Relations of Lincoln Financial Group, Ms. Priscilla Brown. Ms. Brown, please go ahead now.

Thank you Rufus. Good morning and welcome to Lincoln’s second quarter earnings call. You heard the safe harbor cautions while you were in queue so I won’t repeat them. We appreciate your participation today and we invite you to visit Lincoln’s website LSG.com, for an updated equity market guidance spreadsheet will be posted in the next few days and where our statistical supplement and other pertinent information can be found. Lincoln also plans to file its 10Q within the next few days. [Indiscernible] reconciliation of income from operations to net income is provided in our press release and on the [indiscernible].com website. Now I’d like to turn the call over to Jon Boscia, Lincoln’s Chairman and CEO and Rich Vaughan Lincoln’s Chief Financial Officer. Their comments will be followed by a question and answer period. Jon.

Thanks Priscilla. And thanks to all of you for joining us this morning.

The market performance of the second quarter was a welcome change as all of our businesses benefited from the double-digit increases in the major indices. Top tier investment performance at Delaware, strong sales in Life and positive net flows in all of our domestic businesses characterize a quarter that produced solid earnings and further bolstered a balance sheet that we consider to be one of the strongest in the industry.

During the quarter we also launched our new guaranteed minimum withdrawal benefit principal security available as a rider on the American Legacy and Choice Plus variable annuity products, principal security was first introduced to some of our distribution partners on June 2nd. Despite the fact that we do not have a living benefit available in the market until then, we are very pleased that we were able to maintain positive flows through several difficult quarters and are excited and encouraged by how well the product is being received.

Another important event in the quarter was our announcement of the change in the management structure of our Life and Annuity businesses. We created a single senior management team under the direction of John Gotta as CEO to take our Life and Annuity manufacturing platforms to the next level of operating excellence.

Just this week we provided additional information with respect to planned actions that will impact all of Lincoln's domestic operations we told you that Lincoln is taking measures across the enterprise to position the organization for emerging opportunities in the long-term while prudently responding to environmental issues affecting profitability in the near term. Our market's appetite for solutions that address the full spectrum of wealth management, including income generation and wealth transfer, is increasing. The product development engines inside of our domestic manufacturers are moving at a brisk pace and our distribution efforts continue to evolve in a dynamic marketplace. We believe this pace of change will escalate and that the coordination across all products and services will increase in complexity. We need to build greater flexibility into what is already a high-performing manufacturing platform in order to respond to growth opportunities like these. We are realigning our manufacturing platforms to utilize scale to build even greater product development capability to align distribution needs with the manufacturer and to work directly with distribution to develop business growth plans. So, while it is certainly strategic to deliver expense saves that ultimately lead to improved return on equity, the driving force behind the realignment is building growth capability in the businesses. We firmly belief that the most successful providers will ultimately be the most efficient ones. Lincoln's new approach will position us well to capitalize on future growth opportunities.

Now let me give you the highlights from the quarter as it relates to cash flows and sales. We continue to be pleased with the track record of our businesses with respect to net flows. We recorded total net flows of $1 billion during the second quarter with all of our domestic businesses recording positive net flows for the sixth consecutive quarter. This is particularly note worthy when you consider the business and economic environment during those six quarters. The ability of our businesses to maintain positive net flows is not only attributable to product, distribution and risk balance. It is also the direct result of dedicated employees executing well-defined strategies to both grow the top line and insure we deliver world class performance and service to our clients.

Looking at the business segments, let's start with life insurance. Lincoln Life continues to be a source of steady and positive cash flows as a result of strong sales and good retention. Retail first year premiums were $173 million, up 11% from last year's second quarter, driven by strong sales in our fixed universal life products, which grew 44%. We saw sales increases in wire house and MGA channels, including the M group relationship, which is in its first full calendar year with LFG. Life insurance face amount in force excluding term insurance increased to 1.27 billion, up 2.9% from one year ago, and account values grew to 12.7 billion, up 7.7% versus a year ago. Term face amount in force increased to $1.39 billion, up 15% year-over-year.

In the retirement segment, total annuity deposits were 1.4 billion for the quarter, down 300 million from the second quarter of 2002 and slightly below the first quarter of 2003. In the first quarter call we mentioned the likelihood of depressed annuity sales in the second quarter due to the lack of a guaranteed minimum withdrawal benefit rider until the June launch of principal security. We were pleasantly surprised to see American Legacy sales jump in Edward Jones in June resulting from the quick and successful introduction of the rider into the firm's branches. While it is premature to predict the longer term sales trend that will emerge from the introduction of Principal Security, our distributors have expressed tremendous excitement over this feature. An early indication is that July sales of $245 million for American Legacy and Choice Plus increased 33% over the average monthly sales in the second quarter of 183 million.

Turning to fixed annuities, deposits, excluding the fixed portion of variable contracts, were 356 million for the quarter, a decrease of 17% for the same period in 2002. While the recent runup in interest rates is a positive development for fixed products, we have said we will continue to pursue only those opportunities that allow us to achieve our targeted spread.

Looking ahead to the second half of the year, we expect to gain market share in variable annuities with Principal Security with some of the best performing asset managers led by cap research's American funds and Delaware investments, we believe the American Legacy and Choice Plus products offer the consumer good investment performance and attractive product features.

Turning now to the investment management segment, we had positive net flows of $591 million for the second quarter. Delaware has produced positive net flows for the last six quarters in both retail and institutional despite the volatility in the equity markets. As you may recall, we started implementing a plan almost four years ago where achieving net positive flows was the fourth step in a five-step turnaround process.

Let me briefly review all five steps and how we have delivered against them. Step 1 was selecting the right people to run the business. An experienced investment professional was hired to run Delaware. He replaced the significant portion of the professional staff and brought in a new team, which included Jude Driscoll, now Delaware's CEO.

Step 2 was implementing the right process. This new top-graded team of investment professionals revamped our investment processes in each major asset class, placing greater emphasis on bottom up research.

Step 3 was to get improved investment results. First and foremost, the goal of the new management team was to achieve outperformance in all asset classes and to build an attractive track record. This continues to be accomplished. In the second quarter 21 of our 25 largest mutual funds, or 84%, are outperforming their Lipper peer average year to date, and 18 of the 25, or 72%, are doing so for the three years ending June 30th, 2003. We've had an additional three funds get either their fourth or fifth star from Morningstar. On the institutional side, six out of eight asset categories outperformed their respective benchmarks for the one-year period ending June 30, 2003 and seven out of eight outperformed their benchmarks for the three-year period ending June 30th.

Step 4 was to achieve positive client cash flow. Prior to 2000 Delaware had realized net negative cash flows both before and after its acquisition by Lincoln, which undermined earnings and investor confidence. Delaware just recorded its sixth consecutive quarter of positive net flows.

Sales in the quarter totalled $2.1 billion with 60% coming through retail and the balance in institutional with almost half of institutional sales during the quarter coming from new investment mandates.

Step 5 was to improve margins. Early on we acknowledged that a balanced portfolio of products and broad distribution were necessary components of long-term success, but they would be achieved at the expense of profitability in the near term. Delaware's management team has implemented several expense initiatives in recent quarters. And with this week's announcements, we are accelerating the process. We are confident that this last step of the plan will be achieved with the same level of commitment and success exhibited early on. Rigorous expense management and continued asset growth will lead to improved margins. All in all, we are very pleased with the progress Delaware has made and are confident that the fundamentals are in place to produce outstanding results.

Next let me share a few comments about our distribution results in the quarter. Lincoln Financial Distributors, or LFD, is the wholesale distribution arm of Lincoln. Second quarter sales through LFD were up in both Life and investments compared to the year ago quarter. However, annuity sales were down 21% over the same period due to market demand for living benefits on variable annuities and the continued impact of low interest rates on fixed annuities.

As I mentioned earlier, the rollout of our new Principal Security product in Edward Jones was very well received, and we are experiencing similar reactions as wholesaling gains momentum. Life insurance saw the greatest sales increase with retail up 18% through Lincoln Financial Distributors. Universal life sales have remained strong despite competitive pressures on pricing. Investment product sales were up 2% over the same period last year, including mutual fund sales that were down 9% from the second quarter of last year. However, if you exclude a $160 million mandate we received from a major wire house in the second quarter of 2002, then this quarter's mutual fund sales of $436 million were the highest for LFD since it was formed.

Going forward sales trends may shift from fixed products back to equity-based products, reflecting changes in buyer behavior. Regardless of how buyer behavior responds to the recent run-up in the market, we will maintain our pricing discipline and rely on the extensive breadth and balance in our product portfolio to drive sales under all market conditions.

I'll now turn it over to Rich so he can spend a few minutes reviewing the financial results of the quarter. Rich?

Thanks, Jon.

Today Lincoln reported second quarter net income of $142.7 million and income from operations of 153.3 million, or 86 cents per diluted share.

As I did last quarter, I'll start by discussing the impact that the equity markets had on our earnings. I will point out that it was one year ago that we first introduced the calculation for estimating the market's impact on the Company's quarterly earnings. And we have since continued to refine it in order to assist you in modeling and analysis. If you'll apply the market sensitivity guidance filed in our 10-Q or use the marked volatility spreadsheet provided on LFG.com, your calculations would show an estimated impact that was in line with the positive 31.3 million after tax that we experienced in the second quarter from the growth in the market. Each of the lines of business was very close with about a $1 million positive variance in the U.K. offset by about a $1 million negative variance in retirement.

What I suspect all of you are looking for is some guidance as to what the underlying run rate was in each of our segments. Let me address that by starting first with the retirement segment.

We reported earnings of 86.1 million in the second quarter. Included in that was a pickup from the GMDB and DAK adjustments as well as a fee income adjustment component of the GMDB, all of which netted to about $14 million that needs to come out to get to the underlying run rate. In addition, we had about $2 million over and above our normal expectation of expenses that would have to be added back. That would get me down to about a $74 million run rate for the retirement segment. In our life insurance segment, we reported earnings of 71.8 million. There are a couple items included in there, both positives and negatives. But underlying all that is a run rate of about 72 million. So, that needs little adjustment to get to a run rate. Investment management earnings were primarily affected by the impact of the equity markets. Based on second quarter asset levels, Delaware should produce earnings of approximately $3.9 million.

Looking at the U.K., we said in the fourth quarter of last year that the expectation for 2003 earnings was about $40 million. Based on year to date earnings and the impact to the markets we have seen, our expectation of 40 million remains unchanged.

Turning now to distribution, LFD had a loss of $10.7 million in the second quarter and LFA incurred a loss of 7.4 million. We told you last quarter that distribution losses would average approximately $14 million per quarter for the balance of the year. We now anticipate that the average of the remaining two quarters will be about 13 million with the fourth quarter likely to be better than the third quarter. In summary, the overall run rate underlying the results of the second quarter appears to be about 138 million or about 77 cents a share.

Going forward, you need to make adjustments for changes in distribution, as I would expect those losses, as I indicated earlier, to mitigate in the third and fourth quarters. On an enterprisewide basis, partnership earnings were 4.3 million below expectation for the quarter on an asset base of about $300 million. Retirement's portion of the negative variance was 3.5 million and the Life segment share was about $600,000. On Monday of this week, we announced actions that the Company would be undertaking to position our businesses for future growth, actions that will affect all of our domestic operations. Included in the second quarter results are charges related to the realignment of $15.2 million pretax that we recorded in the Life and Retirement segments' net income. Of that 15.2 million of pretax charges reported for the quarter, 1.6 million pretax or approximately 1 million after tax is included in operating income.

With respect to the general account, we saw market improvement in the gain and loss profiles of the portfolios. In the second quarter we had a net realized loss of $13.6 million before DAK and before tax. This included realized capital losses of 63.9 million on securities sold and impairments of $36.8 million. Realized capital gains preDAK and pretax were $87 million. These transactions were not focused on any one sector and were driven in part by favorable conditions in the capital markets. On a consolidated basis gross unrealized losses decreased 48% from the end of the prior quarter to $294 million as of June 30th. Gross unrealized gains increased to $3.4 billion, a 33% increase over the prior quarter's ending balance.

Shifting to capital management, we recently redeemed all $200 million of our outstanding 7.4% toppers. This is part of our ongoing capital management program designed to reduce our cost of capital and to improve upon our already strong financial strength ratios. While on the subject of capital, there is a great deal of interest and discussion surrounding the upcoming changes to reserves and risk-based capital as various bodies struggle to assess the risks inherent in our businesses. In all cases, whether we are talking about the rating agencies, the FASB, the S.E.C. or the NAIC, there is still a high degree of uncertainty as to what the final rules and regulations will ultimately look like. While we do not know the exact impact these changes will have on our capital structure, we are pleased to be in a position of strength due to the conservative approach we have taken to reserve setting and capital management.

Another issue receiving a great deal of attention is spread compression. Through the second quarter we've been able to maintain aggregate spreads in line with our pricing targets. Although comforted by recent interest rate increases, we could see spread compression occur barring another jump in interest rates. We had been proactive in terms of disclosing the performance of our blocks of business relative to the underlying guaranteed rates and will continue to update the table on actual versus guaranteed rates in our quarterly S.E.C. filings.

During the third quarter, we planned to undertake a comprehensive review of our DAK assumptions, a process we last undertook in the fourth quarter of last year. As you're well aware, Lincoln has always maintained a disciplined approach to monitoring our DAK asset and other intangibles. This approach centers around broad reviews of the reasonableness of assumptions used to amortize these intangibles that are on our balance sheet. As part of this review our businesses will be looking at the fundamental assumptions including lapses, mortality, expenses, reinsurance and spreads.

I would also like to bring to your attention two emerging accounting issues that we have commented on in our 10 Q to be filed later this week. The topics include accounting for variable interest entities and accounting for [modco] and funds withheld co-insurance. In the Q we explained the FASB's position and describe the implementation issues.

With that I'll turn it back over to Jon.

Thanks, Rich.

During the last year we have seen tremendous volatility in the equity markets, shifting consumer preferences, industry-changing laws and regulations and interest rates consistently hitting historical lows. Despite all of these environmental factors, Lincoln has also seen the risk in our businesses reduced considerably when looking at the results of the second quarter. To that point we have seen equity market improvement of 15% in the quarter, unrealized losses in our portfolio decrease about 50% from the March 31 level, year to date gross realized losses on sold and impaired securities decrease about 30% from prior year levels, the net amount at risk in our GMDB decrease from 5 billion to 3 billion dollars, the CDSC asset develop a cushion large enough to withstand a 25% market decline. We know that it is premature to call one quarter's performance a trend, but it does help to illustrate what can occur in a more normalized environment.

With that, Priscilla, let's move to Q&A.

Thank you, Jon. We're going to open up the lines now for questions. So that more of you have an opportunity to get your questions in, I'm going to ask that we limit them to just one follow-up to an original question.

Thank you, ma'am. Ladies and gentlemen, our question and answer session will be conducted electronically. If you would like to ask a question please firmly press the “star” key followed by the digit 1 on your touchtone telephone. We will come to you in the order that you signal and if you find that your question has been asked and answered before you could ask it and you would like to remove yourself from the question roster please firmly press the “pound” key. Also, if you’re on a speaker phone please make sure that your mute button is disengaged so that your signal can reach our equipment. Again if you would like to ask a question, please firmly press the “star” key followed by the digit one. For our fist question we go to Nancy Benacci with McDonald Investments.

Good morning. I wanted to ask a question about your new Principal product rolled out. You indicated you strong results in June and further strong results in July. Obviously the environment is quite competitive out there. Can you give us an indication of your expected profitability with that product and whether what you're seeing in July looks like it can be continued to ramp up month over month?

Todd, would you take that question, please?

Yes. This is Todd Stephenson. We obviously, as you indicated, were very gratified to see the sales levels for our Choice Plus and Legacy products increase significantly in the months of June and July. Like all of our variable annuity products, we have priced the Principal Security to provide and produce at least a 15% rate of return or return on equity. So, it is very consistent with our standard pricing assumptions.

Okay. And then just my follow-up, do you have hedging programs again involved with that?

We are hedging the market risk with a dynamic hedging program that we implemented July 1st. And we're very pleased with the mechanics, the execution and the effectiveness of that program.

Thank you very much.

For our next question we go to Andrew Kligerman with UBS.

Yes, good morning. My question involves the distribution arms. Rich, you mentioned that the average quarterly loss in the second half of the year would be around 13 million a quarter, down a little bit from 14 in the second quarter. But what I understand is that historically always the fourth quarter is a phenomenal uptick and you actually earn money. So, what is the message there that these two distribution arms, LFA and LFD, are in a money-losing mode much more than we had originally thought? And then I'll follow up in a sec.

Andrew, we're obviously spending money on distribution and trying to expand our wholesaling operation. That is, I think, the one operation where we really wouldn't expect to see a lot of pickup in the fourth quarter. Typically LFA, up until last year, anyway, produced very strong results in the fourth quarter. What we don't know, whether fourth quarter of last year was an anomaly or if it's something that may repeat. So, at this point we're not expecting to see the huge pickup that we've seen in years prior to 2002. So, our expectations are that fourth quarter will be better than the third quarter, but will not be as substantially better as we've seen in 2001 in prior years on the LFA side. LFD, as you know, is a relatively new organization. We are expanding distribution. We are getting the sales expansion with that organization, and we're currently making investments in that distribution.

Rich, just as a follow-up to that, you mentioned on Monday that I think 35 million in distribution initiatives would be put in place. Could you elaborate on that?

There's a number of things that we expect to do as far as investments in our business. Some of it is in marketing; some of it's branding; some of it's in wholesaling as well as other aspects. We haven't given out any more detail than that. But it is expected to continue to be an area where we will be making further investments.

And that's gonna be heavily involving LFD?

LFD, branding and other areas.

Okay. Thank you.

One moment, please. We go next to Michelle Giordano with J. P. Morgan.

Good morning. I was wondering if you could address the rise in interest rates this quarter and the impact it has on your business? At what point does it become a problem? And then secondly, can you give us the monthly sales of variable annuities throughout the second quarter?

On the rise in interest rates, actually that's a very positive for us relative to the existing block of business as well as our ability, I believe, to get more aggressive in the fixed annuity marketplace again. As you know, we've pretty much pulled back from fixed annuities because rates had gotten to a point where it just didn't make sense for us to be putting product out there. But with the rise I think things are looking better there. Obviously it does reduce the unrealized gain that we have in the portfolio. And to the extent that securities have been bought in this low interest rate environment will create unrealized losses on those securities. So, you will see it appear, assuming rates stay where they are by the time we get to the end of the quarter, in some changes in our unrealized gain and loss position. But from a business perspective the higher level of rates is a very strong positive for us, both on our existing block as it slows down the rate that we might get the spread compression, as well as makes new product more attractive in the marketplace.

And the second part of your question was again?

Monthly sales in variable annuities.

We haven't given out monthly sales. This is the first time we've even given in effect the average for variable products. But we felt it important to give you an idea as to what the Principal Security addition to our portfolio was doing, and effectively July being about the first full month that we've got more broad-based distribution, wholesaling and product acceptance more in the marketplace. June was obviously the first month that it was out there and wasn't fully rolled out. So, it wouldn't be a good indicator of where we're going. That's why I wanted to give July sales relative to the average of the second quarter, and as I indicated the average for just the Choice Plus and American Legacy products in the second quarter was about $183 million a month.

And July was 245.

Thank you.

Mm-hmm.

Next question, Rufus?

For our next question we go to Ed Spehar with Merrill Lynch.

Good morning. First, I was wondering, Rich, if you could talk a little bit more about this comprehensive review of DAK assumptions in the third quarter? I guess I'm just curious why -- is there some message there when you bring that up? Because typically when we have comprehensive reviews of things, it turns out to be, you know, a charge for a lot of companies in this industry. So, I'm wondering if you could talk a little bit about that. And then I have one follow-up.

We want to take a look at it because there's a number of things that are changing. Obviously spreads, which affect the fixed annuity business and the DAK assets associated with that have been getting more close to compression. And as we look out into the future, we have to take that into consideration. Reinsurance costs would be another aspect. Our assumptions relative to persistency on the business which, with the environment we've been in I think have been performing even better than typically assumed. So, what we want to do here is before we even get to the fourth quarter, do a comprehensive look at our DAK assumptions, PVIF assumptions and look at that across our business lines on both Retirement and Life. No expectations at this point as to which way it ultimately will go. We think there are some positives and some negatives in there. And I've learned over time that it is impossible to predict the direction without looking at it on a comprehensive basis.

Ed, we should also add this is something that we do annually. You'll recall that we did do it last year, as well.

Okay. And then my follow-up is I'm hoping that you can provide some clarity on what I think is gonna be a pretty confusing consensus view of earnings. And what I mean is just the split between expense saves and restructuring charges and how those restructuring -- how you're going to report them. And just specifically, does it maybe make sense at this point to start calling it all operating, as many of your peers have? I think it would help in terms of people understanding what the numbers mean out there for expectations.

We're trying to be very clear as to what is included in both net as well as operating. One of the things that I think we have to think about here is the magnitude of this restructuring. By the time we get to the end of 2003 we expect to have a rather large number in effect that's gone through results this year and to say this is sort of a normal situation where you've got 12, 15, 17% of your work force in effect being eliminated and seeing that's a normal part of operations just doesn't sit very well with me. We will be very clear as to what's included in operations that's related to the realignment, what we will have excluded as meeting the definition of restructuring asset out in FAS 146 and the difference, in effect the piece that's going through operating will be the piece that doesn't qualify as restructuring under 146, but that we will identify or have identified with the realignment. We'll be as clear as we can. We understand there will be some confusion if people don't pay attention to the details. But I'm sure most of you will pay very close attention to the details of this as it rolls out and as we report progress against our plans.

Thanks.

For our next question we go to Colin Devine with Smith Barney.

Good morning, folks. I was wondering if you could talk a little bit about life insurance sales. Unlike many, I guess, of your peer companies, I think of Hancock in particular, but Met Nationwide, [indiscernible] who have experienced quite significant sales declines, the trend at Lincoln has been completely the opposite. And what are you doing? Is it the no lapse guarantee products? What is it that's obviously been so successful for you when your competitors are experiencing such little success?

Colin, I think there's two aspects to that. And they're each contributing very significantly to it.

One is that we have developed, I think, a very strong, perhaps you could categorize it as industry-leading product development capability. And a big part of our product development capability involves working directly with our various distributors on a continuing basis so that we can understand what the emerging issues, what the challenges, the needs that they have are. And then, because of the way we have defined, or designed, I should say, our product development process, we can go from concept to street, we think, as fast, if not faster than anybody else in the industry. So, we get a lot of the first mover advantage in life insurance that continues to come our way.

The second aspect is the breadth of the distribution itself. We have through Lincoln Financial Distributors been very successful in penetrating virtually all channels of life insurance distribution. And then, having a concentrated focus and capability on the very high end of the life insurance marketplace really enables us to be a preferred provider, whether it's through independent firms, whether it's through the wirehouse, whether it's through large organizations like M Group or whatever it might be. So, that combination of product and distribution is what really has enabled us to really differentiate ourself.

And then a quick follow-up. In terms of some of the potential regulatory capital requirement changes on the no-lapse products and what you might have to put up, how have you priced for that, and are you gonna have to, I guess, redo your pricing going forward, and is this gonna result in any sort of reserve charges?

There's no expectation that there will be any, quote, unquote, reserve charges at this point in time. But obviously there's pricing decisions being made on a constant basis as to how the risk-based capital and the capital required under AXXX will be handled there. We are looking at how we'll structure that going forward. I believe it will have a minor impact, but not very significant, on the repricing of the product. But we are working on that and expect to in fact have some solutions in the fourth quarter of this year.

Okay. Thanks very much.

We go next to Mario Mendonca with CIBC World Markets.

Good morning, everyone. Rich, I want to go back to your segmented guidance where you gave us the run rates this quarter and what you'd provided in the past. It's fairly consistent their retirement is probably up a little bit, life insurance is down a little bit. But the bottom line is pretty much the same, about $138 million. As we think about this guidance going forward, where does just the simple growth in the business, these positive net flows that we've seen, how does that kick in? And why doesn't that cause an improvement in the -- sort of the run rate?

I didn't try to reconcile the run rate from first quarter to second quarter. What we typically do here is give you what we believe is sort of the underlying run rate of the existing quarter, the historical quarter here, the second quarter, and would expect the analyst community to apply their growth assumptions to that. In other words, we're trying to give you -- trying to take out the noise factors, the non-repetitive items that are in the quarter so that you get a feel for what's the underlying earnings that were produced by this quarter.

One of the things that is different about what I gave you as far as the underlying results this quarter and what I gave you in the first quarter is you may have noted I didn't add back in effect the underperformance in the partnership returns this quarter. That was about $4.3 million. Had I done that, we would have added another couple of cents a share, another 4.3 million in earnings. But I think the group that we talked to generally thinks that we shouldn't be adding that back, that whatever partnerships produce is sort of what they produce and you shouldn't be putting that in run rate. I'm not sure that I totally agree with that. But I just want to be clear with everybody that we haven't in effect added back. This was very poor quarter from the partnership's perspective. We had a loss on an after tax basis of just under a million dollars. So, that's in that run rate of the 137 million. You make your assumptions as to what the investments will do in the future. We've got about $300 million invested in those types of investments that we would assume over time would proceed a decent return.

My follow-up is I recognize that it's not possible to do a line by line reconciliation, and I wasn't asking that you due that. When we think then about the 138 you brought up before and maybe now on a market system basis it might be 142, the difference, when we want to sort of move that run rate around on our own, the things we would have to think about clearly would be equity market performance, but also the new business. And that's more what I'm getting at here. How can we look at the positive net flows and everything else and imply something about how that run rate changes?

I don't have good guidance for you on that, Mario. There's obviously a component to the net flows issue, whether that's in life insurance or retirements or in the investment management segment. They all do add positively to the results. Part of what obviously if you take a look at it on [probably the cleanest] operation [indiscernible] what drives earnings is our investment management operation. We saw obviously the growth in the business there add some earnings, probably about a million dollars. The equity markets took us up about two and a half million dollars. So, you see it underlying the results, but in any one quarter it doesn't have a major impact until you stretch it out over a year. You don't see very much as far as actual impact on earnings.

That was helpful. Thank you.

For our next question we go to Vanessa Wilson with Deutsche Banc.

Thank you very much. Rich, you alluded to having some comments in your queue about a change in the Modco reinsurance. Could you give us a little preview? Is that growing to be something important that we need to know about that you could give us some color on now?

I really do encourage all of you to take a look at the Q when we file it. We had some fairly extensive disclosure in there on both the accounting for Modco as well as the accounting for variable interest entities. The VIEs we have to adopt in the third quarter and the fourth quarter, we have to adopt the accounting for Modco. Both of these require in effect potential charges to income, and underlying that there is no economic risk that we are bearing. But the accounting is going to be forcing volatility in earnings that could be fairly substantial. On the VIEs it's related to the CDO pools that we manage at Delaware where the risk that we have is basically on the fee income side that we charge for managing those pools. No economic risk in the underlying assets and liabilities, but under FIN 46 we end up having to put those on our books and running impairments through net income and changes in unrealized through OCI. Not very attractive accounting.

And then, of course, as those CDOs in effect pay off and mature, we have to reverse those things because they didn't belong in our earnings to start with. Modco and co-insurance funds withheld is a similar animal where we've in effect passed all the risk on to another insurance company but are continuing to manage the assets. The unrealized ends up being charged to our equity, even though when it turns around there's in effect a complete offset. But we only have to account for the underlying imbedded derivative which in a situation where you've got unrealized gains in the portfolio creates an unrealized derivative loss that has to run through operations. This is the most bizarre accounting I've seen in 32 years in the industry, but that's what we're faced with. It's not unlike the FAS 115 accounting that we've had over the last eight or nine years now where we in effect exclude the impact because it's not something that's important to the business. And looking at the equity, this is going to be a situation where we'll be breaking out the impact if it ultimately ends up being as I describe it. And hopefully you'll be able to take that into consideration in your evaluation of the earnings.

Rich, thanks for that. And I just wanted to say that I echo Ed Spihar's comment about where we should be putting the severance costs. My concern is with respect to comparability to sorry companies because this quarter Hartford and Hancock and Met and Pru all put severance above the line. And we need some consistency across the industry.

Thank you for your input, Vanessa.

For our next question we go to Steven Schwartz with Raymond James.

Good morning, everybody. Rich, I'm a little bit confused here on kind of how you got to a market adjustment for the retirement segment. I think you were saying that the benefits were 14 million. Is that correct?

Steve, that's a net number. Kind of drilling down into the detail a little bit, the DAK and GMDB adjustment in effect that went through the quarter that's included in the 86 million was about 16.3. And then going in there also we had about $2.3 million of fee income that previously was in effect feeding the GMDB reserve. If you recall, the amount that didn't change in the past was 5.9 million. Now we're looking at 3.6 million. So, that additional 2.3 is a positive in effect that will be coming through in the future on a more permanent basis because the amount of the net amount at risk has gone down so much. So, the net of those two, 16.3 and 2.3, is the 14. And then the other $2 million is basically expenses. Part of that's realignment and part of it was an experience refund.

Okay. Just to follow up quickly on that one just so I understand it, and then I want to ask a question about the investment partnerships, the market volatility spreadsheet would have indicated that the GMBV market effect was 15.4 million. We should read that as 15.4 less the 2.3?

Let me take this one off-line with you after the call. We can get into the nitty-gritty detail.

Okay. Can we talk about the investment partnerships and what is in there? Performance has been lousy, but that's been understandable given where -- what the market has done. Now, you know, the stock market was up 15% I think 480 out of the 500 S&P stocks were actually up in the quarter. What's in those investment partnerships and why in the world in a quarter like this would the performance have been below expectations?

If I look at what's underlying that, we've talked in the past we've got a $300 million investment in these partnerships, about half of that investment or about $150 million of that is in hedge funds. And our hedge funds actually did fairly well this quarter. They produced about a $2 million positive variance to our expected returns. And when I say "expected returns," that's based on a 7% pretax return. So, the hedge funds, which are more market-sensitive, certainly did very well during the quarter. Our venture capital investments is where we ended up having in effect an underperformance this particular quarter. And they underperformed about $6 million. So, up the positive 2 million from the hedge funds offset by a negative 6 from the venture capital. And I think venture capital is still working its way out in effect. So, that's the underlying details. And when the venture capital starts producing and the hedge funds produce in a given quarter, we'll give you the details, as well.

All right. Thanks.

For our next question we go to Jason Zucker with Banc of America Securities.

Great, thank and good morning. I was hoping you could just give us some more detail on the dynamic hedging program that you’ve put in place behind the guaranteed withdrawal benefit.

Ron, you want to wade in on this one?

Sure Rich. I'm not sure you want to give me too much – I’m not sure you want me to give you to much detail on this in this forum, but since our dynamic hedge program is designed to evaluate on a daily basis the GAAP reserve that is appropriate for embedded guarantees, particularly the GMWB and we construct futures positions that will change in value with an offsetting direction with the market movement.

Anything more specific in terms of the futures positions, what -- you know, what kind of options?

We use three major indices and we break down – we do an analysis of every policy we have to model from past experience how those actual funds correlate to those indices. And then we use that in our hedge program to establish what number of contracts we need for each of those three major indices.

And what do you think -- what kind of market environment would present you with a risk where the hedging program wouldn't exactly work the way you planned? So, for example, if we had any kind of tail risk in one direction or the other.

The hedge program is really designed to cover the equity market component. So, there are still some risks on our assumptions for long-term performance of the underlying contract from which we construct the hedge. So, that's similar to our GAAP DAK assumption risk. The other thing I guess I would mention is if we had -- because it's a dynamic hedge program, if we had a nearly instantaneous drop of a sizeable amount, there'd be some tail risk there.

Okay. Great. Thank you.

We go next to Bob Glasspiegel with Langen McAlenney.

Good morning. I'd like to pile on Andrew's pursuit of LFA-LFD trends. It seems like a few years back these divisions were looked to be an opportunity for narrowing the losses substantially. Now I guess you're perhaps making more investments in these lines and also product disruptions have happened. But on balance it seems like these two areas are a bigger drain than maybe you had expected before. To what extent do you build that back into retirement and life insurance profit objectives if in fact these are gonna be bigger drains?

Bob, there are a couple of aspects with it. As Rich had indicated in his comments, LFD, the wholesaling operation, is a newer operation. It's only in, I think, its third year. So, back a couple of years ago when we were talking about narrowing the distribution losses, those comments were directed towards Lincoln Financial Advisors, our retail distribution arm, because we were just in the early stages of creating a wholesale distribution arm and we knew that we would have to invest in that up front in order to be able to grow sales through the various businesses. LFA has been, during this period of time of the last I'd say three years, undergoing a fairly significant shift in the type of business that its clients are wanting to utilize. As an example, there's more investment-oriented businesses and less insurance-oriented businesses, or business that takes place through it.

As a result of that type of a shift, the amount of revenue that comes into LFA through the sale of mutual funds is significantly less than the amount of revenue that comes in, as an example, through the sale of life insurance. So, part of the realignment that we are doing currently as it directs towards LFA is saying LFA needs to change itself now to be more reflective of where the 2,000-plus registered reps in LFA will be conducting their business on a going forward basis because our intent is still to change that gap from what it is now to where it needs to be out there. And there's fundamental changes in the nature of the business that had occurred that now have to be dealt with.

LFD, on the other hand, is an organization that went from a couple of dozen wholesalers to a couple of hundred wholesalers on an internal and external basis. But if you look at that wholesaling force, let's say relative to the number of wholesalers that represent a company like Hartford out there in the marketplace, we still have a fair amount of investing in that organization that we need to be doing. So, pulling LFA in so that we can reduce its loss but still investing on the LFD side.

So, you're saying the divisions do bare the current run rate properly of these start-up operations?

Well, what we wanted to do, Bob, is we have to have products that are appropriately priced for the capital charges and the GNA expenses inside of the manufacturing organization and that have an allowable for distribution that's inside of it that's a marketable or a market-based allowable. If we were to put the current distribution losses inside of the product side of it, then the product probably would not be near as competitive as it is in the market and, you know, would have certain significant ramifications that came from that. So, on the manufacturing side we are pricing for operating distribution, operating allowables, and we're telling LFA get inside of those allowables. And we're making a conscious effort to continue to invest in LFD for the future.

Okay. This is the last. Are you going to give the expense and savings by line for Retirement and Life?

We're not intending on doing that, Bob, only because of the way that we are now combining retirement and life in a lot of the infrastructure operations and everything will make it more difficult to be able to do that. It would be an internal allocation thing that just probably wouldn't have the degree of precision that you'd be looking for. So, that's why we'll give you information on how we're doing overall so that you can make sure that your total earnings numbers are going to be accurately reflecting things but real difficult to get it down into the line because of the blurring of those lines now.

Thank you very much.

We go next to Joan Zeith with Goldman sacks.

This is Steven [inaudible]. I just wand today follow up on Ed's question.

We cannot hear Joan.

Hello?

I'm sorry, operator. We cannot hear Joan.

We will go next to Tom Gallagher with Credit Suisse first Boston.

Good morning. Just a question on the spreads. When you look at where you were in 1Q, and based on the disclosure you put in your 10Q, it looked like the average room you had between current crediting rates and contractual minimums was about 40 basis points for fixed annuities. Is that really what's leading to what you would view as the potential for spread compression? That's the first question. And the second related to that is did you lower crediting rates for your fixed annuities this quarter and by how much? And then if you look at the 220 basis-point spread you had in the quarter, where would you see that trending over time if rates remain at about where they are now?

Todd, do you want to take that one?

Yes, sure. The 40 basis points you referred to, Tom, is the difference between our current crediting rates and the minimum guarantees. And both during the second quarter and also prospectively in the third quarter we've continued to drop our crediting rates. I believe in the second quarter, for example, we dropped crediting rates by 20 basis points. And we have on our major portfolio based products, we've taken another 15 basis point drop in crediting rates to be effective in the third quarter. So, one of the dynamics you get is that we will, as we've continued to drop portfolio crediting rates, it will naturally move that average dynamic as reported there closer to the contract minimums. We continue especially with this more stabilized interest rate environment to feel comfortable that our spreads can be generally maintained without much significant risk of spread compression. So, we would look to see, as you've seen, the annuity product spread be relatively stable over the last few years and quarters in the 210 to 220 range. You know, we have no reason to believe that anything is in the cards that would change that dynamic.

Ladies and gentlemen, we do apologize. However, due to the time constraints, we must stop our Q&A session at this point. Therefore, Ms. Brown, I'll turn the conference back over to you for any closing remarks.

Thank you and thank all of you for so many questions. I want to remind you while we have the opportunity to save the dates of November 19th and 20th. That's when Lincoln will be holding its annual conference for analysts and bankers here in Philadelphia. As an addition to the conference, we're considering a workshop to discuss emerging accounting issues.

And I'll be looking for indications of interest as we talk to you over the next few days. As always, we will take your questions on our Investor Relations line at 800-237-2920. And I'd like to mention that in addition to Erica and myself, Jim Shareen has recently joined IR. So, there are now three members of the team who are available to take your questions.

Also, we will again be updating our equity market impact guidance in an 8 K filing in a few days. The new guidance will reflect equity market variances from June 30th market levels. Thank you and have a good day.

Ladies and gentlemen, this does conclude today's second quarter 2003 Earnings Conference Call for Lincoln Financial Group. We do appreciate your participation and you may disconnect at this time.