Lincoln National Corp (LNC) 2005 Q2 法說會逐字稿

Good morning and thank you for joining us for Lincoln Financial Group's second quarter 2005 earnings conference call.

[OPERATOR INSTRUCTIONS] This call is being recorded and will be available for replay beginning today through August 9, 2005. The replay can be accessed by dialing 1-888-203-1112 and, when prompted enter the pass code 798-6247. Before we begin I have an important reminder for you about Lincoln's earnings release.

Any comments made regarding future expectations, trends and market conditions including premiums, cash flow, pricing and loss cost trends are forward-looking statements under the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from current expectations. These risks and uncertainties are described in the cautionary statement disclosures and Lincoln's most recent reports including the form 8-K filed yesterday.

At this time I would like to turn the conference over to the Vice President of. Investor relations Ms. Priscilla Brown. Ms.Brown, please go ahead, ma'am.

Thank you operator. Good morning and welcome to Lincoln's second quarter earnings call. We appreciate your participation today and invite you to visit Lincoln's website LFG.com, where a statistical supplement and other pertinent information can be found. A full reconciliation of the non-GAAP measures used in the call including income from operations and return on equity, to the most comparable GAAP measure, is provided in our press release and in the (staff) supplement posted on LFG.com.

Now I'd like to turn the call over to Jon Boscia, Lincoln's Chairman and CEO and Fred Crawford, Lincoln's Chief Financial Officer. Their brief comments will be followed by a question and answer period. Jon?

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

I'm very pleased to share results from another quarter where we not only established new record levels of deposits, flows and earnings but where we also saw our business growing across several product categories within and across the segments. It is becoming very clear that the markets we serve present similar but distinct needs as evidenced by our sales and flow results across the three areas of accumulation, protection and retirement income.

Let me start with some of the highlights from the quarter. In the quarter record aggregate gross deposits of $12.7 billion were up 60% over the prior year, driven by an unprecedented surge in institutional investment management deposits, along with record gross retail deposits. Net in-flows followed suit with all domestic segments recording increases over the prior year period in both the retirement and investment management segments reporting record net in-flows for the quarter.

Positive net flows across all domestic businesses were $7.6 billion, up over two times the prior year quarter. The retirement segment continued its track record of delivering strong diverse net in-flows from both the individual and employer sponsored markets.

Investment management produced record-breaking net in-flows in both the institutional and retail lines of business that underscore the value of Delaware's performance track record and the talents behind those numbers. All of these results have emerged from superior execution of focused strategies.

In the retail channels we are providing savings and retirement income solutions for boomers who are either planning for or entering into retirement. In the institutional markets we are providing superior investment and product performance. We are very excited about the magnitude and diversity of the deposits and flows we are seeing.

Let me provide some color on these results by segment, starting with retirement. In the second quarter we continue to post strong results in our retirement segment with total deposits up $2.5 billion exceeding the prior year quarter by almost 15%. SmartSecurity Advantage, our guaranteed minimum withdrawal benefit rider, remain popular with overall elections holding steady in the mid-50% range and elections of the annual reset slightly outpacing the five-year reset version.

This is in line with our product development research which indicated that a large part of the market is seeking additional downside protection in order to accelerate or perhaps catch up on saving for retirement. In similar to our long-term experience with individual annuities, there is also a segment of the market that is looking for a retirement income strain with guarantees that align with their needs.

This is evident in the success we are experiencing with i4LIFE, our annuitization option that provides a unique level of flexibility to the client. i4LIFE elections in the second quarter of $230 million were up 230% over the prior year quarter and elections in the first half of the year of 408 million are now at the level we recorded for the full year in 2004. Combine this with the fact that over 80% of this year's elections are new money, it's clear that Lincoln is not only capturing a significant share of the emerging market for annuitizaions, it is, in fact, creating the interest with a truly innovative solution to retirement income needs.

Retirement net in-flows in the quarter were a record $857 million, a 22% increase over the prior year quarter. The continued growth here is a good indicator that annuity solutions are a growing integral part of boomers' financial plans.

Now let's turn to the life insurance segment. Retail first year premiums of $198.1 million were flat relative to prior year levels with universal life and variable universal life sales off-setting weaker MoneyGuard and term sales. My comments from last quarter described a market that was irrationally competitive and distracted by investor-owned life insurance. We are guardedly optimistic that the negative pressure on sales we've been seeing is beginning to ease, but it is too early to declare victory.

Last quarter I also reinforced the importance of product diversity, the benefit of which this quarter clearly demonstrates. We are encouraged by the gains we are seeing in our variable life sales and continue to make some head way on our universal life with secondary guarantees, due to the refined underwriting classes implemented late last year. The recent actions by the NAIC related to AG38 should also begin to give rise to revised product offerings as companies navigate the new requirements and adjust their pricing and/or reserving practices.

Although the changes are not formerly adopted yet, we fully expect them to be and are preparing accordingly. We are glad to see this difficult issue put to rest so that progress can be made toward adopting a principles-based evaluation system which we believe will have benefits for industry, consumers and regulators.

During the quarter the estate tax continued to garner attention, although no vote occurred prior to the August recess. It appears that there is genuine desire on both sides of the Senate to negotiate a permanent reform proposal, but there is still a gap in terms of exemption amount and the tax rates. It is also not yet clear the House, which has voted numerous times for full repeal will be willing to agree to a reform alternative. We continue to monitor developments on the hill and believe it is impossible to speculate on what impact potential reform might ultimately have on sales since the key elements, that is, exemption levels and tax rates, cover a wide range.

Turning to investment management, deposits for the quarter were up significantly, driven by sustained performance metrics and the success we are experiencing with the talent acquisitions completed to date. We have, over recent years, attracted top talent in four critical asset classes including the addition this quarter of an experienced international value team led by Zoe Neil. Formerly together as Boston-based (Arbor Ray) Capital, this team brings its seven-year track record to Delaware and will focus on international equities. When combined with investment professionals already on staff, Delaware now possesses a world class team of investment professionals that is clearly performing across a broad spectrum of styles.

Second quarter retail and institutional deposits increased almost $9.9 billion, up over 81% over the prior year quarter and up 180% if you adjust for the sale of DIAL. Retail deposits were up $1.9 billion for 91% of the prior year quarter, driven by strong mutual fund and managed account sales. Institutional deposits of 5.9 billion were up almost 76% over the prior year and over four times greater if you adjust for DIAL.

Net in-flows for the quarter were a record $6.4 billion, a 142% increase over the prior year quarter, and over a six-fold increase if you exclude DIAL. While not every quarter will deliver record results of this magnitude, we are excited about the positive trend that has developed at Delaware and the prospects for growth now that all the new teams are in place and contributing to our success.

For quite some time now, our quarterly earnings calls have delivered a series of consistent and candid messages about Lincoln's strategic focus -- Operating performance and adherence to prudent risk management practices. We have been deliberate in our actions to build a company that is clearly seen as the partner of choice for accumulating, protecting and enjoying wealth.

Our success in the first two, accumulation and protection, is well established and they have been cornerstones since Lincoln was founded one hundred years ago. However the enjoyment of wealth has emerged as a key part of the financial life cycle, and companies are now positioning themselves to provide solutions. Lincoln is absolutely at the forefront of retirement income solutions and will continue to identify strategies that help individuals and their employers to address this critical issue.

With that, let me turn it over to Fred.

Thanks, Jon. Yesterday Lincoln reported second quarter net income of 197.9 million or $1.13 per diluted share, and income from operations of 218.6 million, or $1.25 per diluted share. Return on equity for the quarter was just over 16%.

The quarter's earnings benefited from better than expected returns on both limited partnership investments and returns generated from a specialized real estate investment class known as standby contingent equity commitments. We receive fees in exchange for a standby commitment to acquire commercial real estate. There is a variable and, often, sizable component to the fee structure should the property be sold to a third party at a significant gain. This was the case on two commercial properties located in Arizona.

Our alternative investments combined to contribute just over 30 million of earnings in the quarter, as compared to an expected quarterly contribution to earnings of approximately 5 million. In other words, adding roughly $0.14 a share to the quarter.

In addition we recorded an adjustment to a deferred tax asset valuation allowance set up against net operating losses in our captive reinsurance company, Lincoln Barbados. This is essentially the same tax adjustment we experienced in both the fourth quarter of 2004 and the first quarter of 2005. We are now at a level of confidence in the future earnings capacity of the subsidiary to release what remains of the valuation allowance. The release of the valuation allowance contributed 23.5 million of earnings to the quarter, or roughly $0.13 a share. We expect an additional 17.5 million will be released over the second half of 2005, at which time the valuation allowance will be fully eliminated.

We did have a few items that detracted from earnings in the period. The most significant being expenses associated with a liftout of our new large-cap growth team in Delaware Investments, netting to approximately $4 million after tax in the period. It is also important to note that when comparing results to the previous year's quarter, we did experience favorable investment results in the second quarter of 2004, namely significant prepayment income and an equally impressive showing on limited partnership income.

Now let's move into the segment results and our outlook for the remainder of 2005. The retirement (segment) reported income from operations for the quarter of 119.4 million including about 20 million of investment income detailed in my earlier comments. We continue to feel the impact of our record deposit and flow activity. When compared to the same period in 2004, earnings have benefited from over $3 billion in cumulative positive flows on a trailing 12 month basis.

The core growth rate in earnings becomes more pronounced after adjusting for respective periods earnings for favorable investment returns. The performance of our hedge program supporting the GMDB and GMWB riders, net of the reserve and fee components, was in line with our expectations.

Our inforce risk metrics continue to be within our pricing assumptions for rider elections and utilization rates. In terms of our outlook for the retirement segment we expect income from operations to benefit from sustained strength in deposits and flows. This after adjusting for the excess investment returns experienced in the quarter.

Spread compression remains a concern. However, spreads rose slightly in the quarter, due to lower than expected cash flows in the fixed block and better than expected investment results. This after adjusting for prepayment (inaudible) premiums. As I mentioned last quarter, our projections of spread compression include a multitude of moving parts and, despite this quarter's results, we would still expect to see 4 to 5 basis points of compression per quarter, absent a material change and interest rates.

In our life segment earnings of 75.8 million also benefited from the favorable returns on our alternative investments, generating better than 5 million in excess of our normalized returns which was similar to last year. Although we experienced modest improvement in spreads in the life segment we did have another weak mortality quarter coming in approximately $2 million worse than our expectations for the quarter.

After adjusting for investment income items and mortality, we would expect earnings to build modestly throughout the remainder of 2005. This assumes continued success in holding off spread compression, recognizing our guidance of one to two basis points per quarter.

We think the amended approach to reserving for universal life with secondary guarantees under AG38, will result in a period of transition for the leading UL manufacturers and distributors. I will address our views on capital in a moment, but for life earnings the additional reserves will result in added capital costs even when factoring in securitization strategies. We will be paying close attention to the market's reaction, both in terms of product development and pricing initiatives.

We remain guarded in our view of the earnings of this segment, however we are focussed on creating earnings lift through a combination of product development and expanded distribution in the wire house channel.

Turning to investment management we reported earnings of 3.9 million, roughly in line with guidance I provided last quarter. Higher expenses in the period, largely associated with our new large cap growth in California totaled roughly $4 million after tax and net of other off-setting items. Delaware second quarter results were, again, somewhat dampened by expensive acquisition costs when compared to a year ago quarter, driven by yet another period of record retail deposits.

Included in the prior years earnings was $4 million of income from our DIAL operations sold at the end of third quarter last year. Looking forward in the segment, we expect continued strength in deposits and flows, recognizing that this was a significant quarter on both fronts, and that institutional deposits are naturally more variable, quarter to quarter.

As noted in our first quarter call, we expect talent acquisition expenses of approximately $1 million in both the third and fourth quarter of this year. After adjusting for liftout expenses, we expect earnings to build, off levels experienced during 2004, when adjusted for the DIAL sale.

Looking at distribution within corporate and other, the combined loss for Lincoln financial advisors and Lincoln financial distributors in the second quarter totaled 9.8 million compared to 11.8 million in the prior year quarter. The reduction in distribution losses at LFD reflects gains in wholesale and productivity, together with holding the line on fixed expenses. This despite a nearly 20% increase in the number of wholesalers year over year. The improvement in operating income at LFA is attributable to reduced operating costs as a result of the consistency of excellence realignment. We remain optimistic that the value proposition presented by LFA's new affiliation model will continue to attract and to retain top planners by offering competitive compensation, strong planning support and the flexibility to cover over time -- change over time -- as planner's practices grow. Our outlook remains unchanged for the combined distribution operations of LFA and LFD, that is, we expect modest improvement over the significant progress made on reducing losses in 2004. Lincoln's U.K. operation -- operating earnings -- in the quarter of 10.3 million were slightly above expectations due to a higher than expected exchange rate. Lincoln U.K. also benefited from favorable equity markets and improved persistency.

As with distribution, our outlook remains unchanged for earnings expectations in the U.K., anticipating slightly less than 40 million for the year. In corporate, excluding distribution and our tax adjustment, results were in line with what we communicated to you last year. As discussed in my opening comments, we did have a pickup in earnings of 23.5 million associated with the reduction in the deferred tax asset valuation allowance. Again, we expect to record a similar reduction in the valuation allowance of 17.5 million in the second half of 2005.

Before I turn it back over to Jon, let me provide a brief update on capital and risk management issues. Based on our early analysis and normalized sales of universal life, we expect AG38 will result in up to 100 million of additional reserves for 2005. The increase will not have a material impact on cash flow or our holding company and life insurance capital ratios.

We will explore securitization options to reduce the negative impact to RBC, but our capital quality affords us patience in finding the most efficient structure. In terms of C3 Phase Two, it is important to note that this applies to all variable annuities with both death and living benefit designs.

The combination of Lincoln's large block of variable annuities with return-of-premium death benefits, together with our living benefit hedge program and our captive reinsurance structure, results in little impact from the adoption of C3 Phase Two.

During the quarter we repurchased $69 million in stock, at an average share price of just under $44 a share. Our previous guidance on stock repurchase for 2005 was in the 100-$200 million range and we now expect to end the year at the high end of that range. Despite more definitive action on AG38 (UL) reserving and C3 Phase Two variable annuity capital charges, we want to make sure to maintain comfortable capital levels as we look to implement the upcoming changes and explore alternatives, including securitization strategies. With that I'll hand it back over to Jon.

Thanks, Jon. Our reported results for the second quarter highlight several themes that have been part of the Lincoln story for the last several years. Our focus on building strong product, brand and distribution strength to drive new business and long-term shareholder value has been clear and consistent in everything in the second quarter's results supports that focus and reinforces our strategic commitments. We continue to be very pleased with the strong deposits and flows and, more importantly, the performance in our products that is driving the growth.

I'll now turn it over to Priscilla for the Q and A.

Thanks, Jon. We would like to now open up the call to your questions. In order to provide an opportunity for as many callers as possible, we will take one question and then one follow-up from each caller.

[OPERATOR INSTRUCTIONS]

As for our first question, we go to Nigel Bailey with Morgan Stanley.

Great. Thank you. Good morning. Seeing your results, you took 15 million in charges, restructuring charges. Hoping to get some color on what those charges are being taken for -- whether we should expect them to continue going forward and when we can expect to see some positive impact your efficiency ratios from those charges.

Nigel, this is Fred. In terms of detailing the restructuring charges, we had, as you noted, about $15 million or so restructuring charges in the period, up a bit over the previous period. Breaking that down in rough numbers, approximately $12 million of that was related to the realignment of life and retirement that we announced back a couple years ago.

More specifically, this had to do with write-off of certain software -- capitalized software-related items -- when we switched from a computer associates contract to an IBM contract, as part of the realignment. That shift or contract actually expired or was removed in the April time frame and as a result we took the write-down there.

Another $3 million of that restructuring charge was related to the LFA Phase Three realignment, the part of their Consistency of Excellence program and was largely related to severance. We don't have any forward comments relative to expectations on restructuring charges other than to say, when it comes to both the realignment as well as the movement of operations out of First Pen into the life business and a few of the other restructuring charge issues, we would expect the majority of these restructuring charges to be behind us as we move into 2006.

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

Good morning. Two questions.

First on the investment advantage area. One of the things weighing down your income is this commission and other volume related expenses, particularly as you have strong retail sales. Interestingly, that line item came in at slightly under 12 million versus about 14 million in the year ago. It waivers between that range. So my question is, thinking about income in that segment, should I expect a pretty constant missions and other volume related expense line item -- not that much of an uptick -- coupled with some very strong income pickup? Is that the way to think about it?

Andrew, this is Fred. A couple of clarification statements then I'll speak to the conversion of flows to earnings.

First of all, when you are looking at those line item expenses, those other volume-related expenses are primarily related to the Director Product, which is more of an annuity based employer sponsored type product sold within the Delaware operation. When it comes to the acquisition cost that we speak to, i.e., the transfer pricing related with, primarily, retail related products, that actually falls in the administrative and other operating administrative expense line -- is, I think, the category in title.

That is stepped up pretty considerably and that is where you will see the drag. I think, a couple comments I would make on Delaware, that I think are important is that -- is just to, sort of, recognize the stage and the (gain) that Delaware is doing, given the strong turn around that's taken place over the last five years. Just looking at the level of deposits and flows, for example, there's a few very interesting statistics.

If you go back a year ago and exclude the insurance-related assets under management, you'll notice about $48 billion worth of assets under management.

In the last trailing 12 months, Delaware has added $23 billion worth of deposits on top of that number, and net flows of just shy of $14 billion. And the point I want to make there is, think about that kind of growth on the base of assets under management and you can start to understand where, particularly on the retail side, where we have the expensing of acquisition costs, you'll see that overwhelms, in some ways, progress made on assets under management income, that is, off of assets under management.

Now obviously, we would expect these flows to transition into earnings over time, and when we look at the breakdown of the various product categories, institutional and retail, generally speaking, we expect payback periods in around the two-year type period, that is, the time in which it takes for the income loss of the assets under management to recover the acquisition expenses.

So again, given the acceleration and, again, acceleration primarily also on the retail side, more recently, you'll find us gradually climbing out of this environment and that gives rise to our outlook on the segment.

Great. Yes. It seems like you've got a dramatic pickup in earnings power in that business. Moving over to the spreads.

You had two factors impacting the spreads. I think you had prepayments and alternative investments affecting spreads. Could you isolate out, in probably the most important area, the annuity area, what the non-reoccurring impact on the 225 basis points of spread, might have been in that quarter?

A couple of clarification statements, Andrew, before we jump into spreads. One is the alternative investment income that I referenced earlier in the call and what gave rise to a sizable pop in earnings this quarter. Those investments, those alternative investments, are housed in the surplus account and so they don't get factored in to the actual spread calculation.

There's also the matter of an associated back factor with those earnings as a result, also. It tends to be just a tax affected outcome to earnings. So turning to spreads, the real adjustments you want to make in the spread numbers tend to revolve around prepayment and make whole activity, And in the quarter when looking at annuities, our adjusted spread, the 225 we reported -- 2.25% we reported -- if you were to adjust for nine basis points of prepayment activity in the quarter, which is about what we would expect in the way of prepayment activity, you get an adjusted spread of about 2.17%.

This compares favorably to the previous quarter of about 2.15% and versus last year's quarter -- that adjusted spread was about 2.05%.

Importantly in the second quarter of '04 we had a sizable jump in prepayment make wholes, roughly 38 basis points of added spread from prepays and make wholes.

On the life side, spreadwise, the story is substantially similar to what I just described. Life spreads adjusted were around 1.55% and have been fairly consistent over the quarters. There hasn't been a lot of movement. Once again this period did enjoy a benefit of about 12 basis points of prepayment activity as compared to last year's quarter, where we benefited once again for about 32 basis points of prepayment activity.

I think the second part of your question is, what is it we're doing to maintain spreads or how is it that we are able to fight what we have forecast in the way of spread compression. And, again, as we've mentioned, there's a lot of moving parts to contemplate, when you think about our spread compression guidance, we are holding a lot of these activities constant and just recognizing the reality of a dropping portfolio rate relative to bumping up against minimum guarantees.

Having said that, we do undertake an awful lot strategically to try to fight against that, and that includes aggressive crediting rate action, where,at times, we'll find a little bit more flexibility, a little bit more traction in the drop of crediting rates to our earnings, than we would have otherwise forecasted. I would say, this is largely the case on the lifeside.

A little bit the case on the annuities side. I mentioned fixed flows are down, which helps us to maintain the spread activity. Also we're not sitting around and watching spread compression happen. Obviously we are looking for ways in which we can enhance the yield to more efficiently managing our idle cash and that is proven to be beneficial on the margin with contributing basis points.

We go next to Colin Devine with Smith Barney.

Two questions.

One, just to expand on the universal life (inaudible) products and the extra reserve addition and how that impacts the return of the business you've sold? And what you expect that will have on pricing and rates of the business that you are selling, going forward?

And, then, secondly, if we could slip over to the folks at Delaware and of the new, very strong in-flows we saw this quarter, how much of that was attributable to the team you lifted up from Trans America -- if you could separate that out and give us a sense of how fast you're getting traction?

And then, strategically, with respect to Delaware, it would seem to me that the company is going to fall short of hitting Jude's EBITDA target. Perhaps you could talk about the strategic position of Delaware within Lincoln. And one of your competitor's son has talked about a possible spin-off of (MFS) to get it's value -- that company's value better realized in it's share price. Is that an option you had considered for Lincoln and a partial spin-off of Delaware?

Colin, it's Fred. I'll try to grab a couple of the questions. I might ask Mike Smith who is with me here today to also join in to the degree he wants to add color. In terms of our outlook for the impact of AG38 on margins. That's very difficult for us to estimate.

There's no question that the added capital carry and, again as I mentioned earlier, even one factoring in efficient securitization vehicles will indeed add to the cost i.e., narrow the margin on that product going forward. What's uncertain is whether or not there will be any commensurate pricing activity that takes place in the market on new flows, to compensate for some of that margin compression, and that is something that we'll have to just continue to watch in the marketplace and see what gives away. So, it's very difficult for us to estimate the impact of that.

Maybe then just to jump in. The 100 million reserve addition, what is that as a percentage or how does that relate to the existing in-force reserves you have on the UL no-loss part that you've written to date?

I think, Colin, we'll have to get back to you with some of those details. As we're sitting here looking at the data -- we don't have that immediately available. Obviously the cost of that extra $100 million can be thought of in a couple different ways.

One is, if you were to carry the actual reserves, the cost of that ends up being effectively the difference between your cost of capital which you can earn in the general account. If you were to securitize it, either through letters of credit, which tend to priced around 50 basis points or better, or a full-fledged securitization vehicle, which will likely be more in the 100-125 basis point category, you can start to do a little of the math associated with just the raw costs associated with that extra carry. That's the kind of cost we would be imputing into the returns. Colin -- Mike, were you going to add anything to that? Okay, Colin, on the two Delaware questions, the first one having to do with one of the talent liftouts.

We have not, and are not going to be disclosing specific asset flows relative to liftouts, for a variety of sensitive reasons that I'm sure you could understand. With regard to any interest in selling off all or parts of Delaware, it's been our long standing policy that we just don't comment on potential M&A activity and this would fall under that type of category. .

And for our next question we go to Eric Byrd with Lehman Brothers.

Yes, thanks very much. I just have one question regarding Delaware.

The cash flows as everyone has noted were so strikingly strong that I have to ask, what else were you doing in the quarter other than promoting your performance? Were there any commission specials? Were there any other promotional activity at all that would explain how, in one quarter, I think, net of outflows you brought in $6 billion. It's just a staggering number that borders on incredible.

No, there really wasn't any special activities or specials that were being run anywhere.

Eric, I think what we're seeing is, Delaware has been -- increasingly been -- recognized in the marketplace, both by the institutional consulting side of the business as well as increasingly, by the various retail distributors out there, and the breadth of the product strength that it has. And we have said before that flows coming in and out of Delaware on the institutional side and, I would say probably on the retail side as well, have some lumpiness associated with it.

And the second quarter probably had lumpiness in a positive way that went in our direction. But no specials, just good old-fashioned consistency of performance and good marketing out there.

Actually, one quick follow-up. What is the state of competition with respect to rivals for Smart Security Advantage? How quickly would you expect competitors to follow with this one year stepup? Thank you.

I'd ask Wes or Jon, would you have some thoughts on that?

My response would be -- this is Les.

There are several products that are similar in nature that are in the marketplace.

Internal operation of those product features are not exact to our Smart Security Advantage and we do believe that a big part of the driver has been the strategic partnerships that we have formed and also the investment of wholesaling that we have made that's been driving the differential there.

Yes, to add to some of Westley's comments, we've seen some competitors come into the marketplace, in effect, implementing that feature. We have not seen a lot of traction. One is around the complexity side and the other is, (once mentioned), I think we've got a lot better alignment with the product and our distributors in terms of pushing it, versus our competitors, at this point, but there is a lot of activity in the marketplace, that is correct.

If I could add one other thing to that, too, Eric.

One of the things that our research and marketplace intelligence is really bringing home to bear is that, particularly in the retail side of the house, as it relates to baby boomers and their retirement income needs. They are driving more and more for companies to be able to unbundle risk. At the same time, unbundling risk in communicating effectively is a significant challenge. I think what you are seeing here is, it's not just a Smart Security Advantage rider or any of the other things that we might have, it's the ability to use our risk management expertise to understand risk and to repackage it, rebundle it, and then it's the communication efficiency ineffectiveness that puts it in plain English for people to understand.

And then, lastly, the third piece is having the distribution power to deliver it in the marketplace. And it's those three things working in harmony that makes it very difficult for other companies to get the traction that we've been able to have by simply reverse engineering the product because it's so much more than that. .

And next to Vanessa Wilson with Deutsche Banc.

Thank you. Good morning. Back on the capital question, Fred, could you -- I wasn't really clear why the additional reserves in the second half of '05 don't affect your capital position?

It certainly effects our capital position but not to a point to where it would be disruptive to our core ratios, both RBC holding company leverage and any of the cash flow coming out. So, it's not disruptive to the core mechanics of our capital structure, but $100 million in reserves is $100 million in reserves.

Now, the important issue there is whether or not we were to entertain any form of securitization to move those reserves, in our particular case, off to Lincoln Barbados, which is what we'd likely do. As you may know, Vanessa, we have a $900 million letter of credit facility with amble capacity. I don't view that as a permanent approach to securitizing reserves. We'd obviously want to explore a longer term securitization vehicle.

If we were to entertain either of those options, then, of course, you effectively remove the $100 million obstacle. But again, as I look at our statutory earnings capacity within the Lincoln Life Insurance Company, our RBC of roughly 338% at year end, and holding steady, and our leverage of around 22% reported, I still feel pretty good about being able to move forward on the capital front without any disruption from this $100 million adjustment.

I might also make a point. I said up to $100 million and that's an important distinction.

We are doing the calculations, as you can imagine, and I wanted to be conservative to give you the high side of the number but importantly it's up to 100 million. It may indeed come in less than that.

Okay and just so I can be clear on this. Your hundred million really relates to new sales sold from July 1 through December 31?

That's correct.

So if you did nothing in 2006, it would be probably 200 million?

If you did nothing in 2006, in other words, if by do nothing, you mean you continue on the current glide path of sales, okay? -- you would expect reserves, obviously, to rise at roughly that doubling of the size. But that really assumes that you have made no changes to your products and that you have not entertained any securitization vehicle, so that's really what we mean by a transition period.

We think there will be a transition period in terms of product development, pricing and the like, with most companies, Lincoln including, looking at 2006 and understanding that the reserve load will be increasing because of AG38.

We go next to Jason Zucker with Fox-Pitt Kelton.

Good morning. Thanks. First just a clarification, Fred. When you talked about excess investment income in the press-release, did that include any prepayment?

No, it did not.

Okay, that's what I thought, from your comments.

Yes, the prepayment and make whole activity in the quarter was about what we would expect to have quarter to quarter.

Okay. And the next question I have -- if I focus in on variable annuity sales and variable annuity net flows, they were down slightly sequentially from last quarter.

And I was wondering if I can get your outlook as to whether or not you thought maybe they had peaked now that you've had some time for your guaranteed features to maybe mature in your distribution system and, looking ahead, you'd be growing on a sequential basis around market levels?

I think at this point in time we'd hold to our comments in the guidance which was, we expect strong deposits and flows to continue. The notion of it peaking is a difficult one for us to predict. I think, at this point in time what's important to note is, what we consider to be the runway left associated with continuing to penetrate some of the key distribution partners that we have, and so there's no question that our annual reset and five year options are very popular and are doing quite well on sales. We would expect to sustain these positive results whether or not we would achieve quarter to quarter sequential record results -- that's, of course somewhat variable.

But again, what we get encouraged about is when we look at the increased market share and penetration within our key distribution partners as a method of building upon the results we've currently put together. .

And we go next to Jimmy Bhullar with JP Morgan.

Just a numbers question on asset management and then the follow-up. Was there any cost associated in the second quarter with the liftout of the international team? And if not, what do you expect in terms of cost, in the second half, for that?

There was not much in the way of cost associated with the international team just by virtue of the timing of it. The cost of the liftout of the international team is embedded within my guided outlook for one-time expenses -- liftout expenses -- of $1 million in each of the third and fourth quarter.

Well, because when you gave that guidance, the liftout had not even occurred. I think you last gave that guidance after the first quarter or during the first quarter earnings (inaudible).

Yeah. I think, fundamentally, what you had is just different timing of expenses. Some of them accelerated further into this current period associated with the growth team, and the international team, of course, was in process, so you do have some movement in those numbers, but fundamentally the guidance remains the same.

We go next to Jeff Hopson with AG Edwards.

Thanks, good morning. Could you remind us of the profitability of income for life products relative to other annuity products, and also, you have mentioned expansion of life insurance sales through the wire houses, and I know you've been emphasizing that distribution channel for a while. So what will you be doing, new, in the wire house channel?

Jeff, profitability of the income for life features are consistent with our overall profitability for our annuity lines of business. We price at that 15% level. We expect -- thus far have been successful in being able to achieve that. We don't price it any differently.

There are different expense levels, different depending upon the particular form, different levels of capital that are required (inaudible) but that's all embedded into the pricing of the product itself. With regard to actions and success and the regional channel for life insurance, I'd like to turn that to Wes Thompson and have him comment on that?

I'll address that. We have, over the last four years, been making fairly steady investment in our resources and the (wire region) channel for life insurance.

In fact, probably about four years ago, we talked quite heavily around the program partnership that we had, for instance, at Smith Barney, where we had a dedicated group of wholesalers that were a start-up at that time. And we've been very successful with that group over the last four years. We've continued those same types of programs in several other firms and now continue to look for opportunities where they make sense and where there's significant opportunity in terms of scale, both in terms of the number of advisors in those firms and where those firms have a very strong commitment to making estate planning or life insurance business planning a part of their overall wealth management programs. And those are the areas we find the opportunities to be the greatest.

Very good. Thank you.

And we go next to Bob Glasspiegel with Langen Mcalenney.

Good morning. I didn't know whether I heard the answers to Collin's questions and what your EBITDA target is for investment management and when you think you are going to be there?

Thanks for the reminder on that. We actually noticed that, too. And we figured if it wasn't picked up by someone else we'd communicate it. Fred?

Our EBITDA expectations are roughly 30% and based on the type of business we are bringing in, we expect to be on track for that kind of margin.

That's (ex) the liftout cost?

That's right.

Okay. And going back to the 1.9 -- what's the quarter?

I think, in terms of stringing that out as to when we would record or report that kind of margin, we are looking (inaudible) at 2007. That would be the time period upon which we'd reach that 30% margin.

And we go next to Tom Gallagher with Credit Suisse First Boston

Just a question for Fred on the spread guidance. I knew you'd mentioned you're still looking at the 4 to 5 basis point per-quarter spread pressure from fixed annuities. One of the things I've been trying to figure out here. Given that the bottom line EPS impact is not as great as the actual spread number would imply, that infers slower DAC amortization right now.

Now, a related question is how should we think about DAC amortization patterns if interest rates remain low? From a timing standpoint, are you going to need to accelerate that potentially or -- how should we be thinking about that?

Right now, we have not started into our prospective (unlocking) reviews, where we would look at all things -- interest rates would simply be one component of it -- and so our ability to project out what interest rates may mean for potential DAC on locking in associated amortization is difficult.

What I would note that is, is last year in the third quarter in the life division we took a negative unlocking related, in part, to a reduction of our long-term interest rate expectations. That has also led to higher DAC amortization as we moved into 2005, and so you've got a move already that has taken place relative to our expectations on interest rates, but at this point in time I would not be able to comment on whether or not we see any, either unlocking or swinging amortization-related interest rate assumptions.

And, Fred, you mentioned that was on the life side, but it wasn't on the fixed annuity side last year?

Right.

Okay. Thanks.

And for our next question we go to Jeff Schumer with Keefe, Bruyette & Woods.

Good morning. I wanted to come back to the issue of the estate tax. I realize that you're not going to make any predictions about where this goes, but can you give us an update on the portion of your current life sales that you believe are probably funding estate tax needs, at this point?

That's hard to do, Jeff because, what it's funding in estate tax in terms of the shape of the product is also the type of product that funds business continuity and key person insurance. It's basically your multiple life, your survivorship products out there.

Survivorship products -- we have that amount, and as we're talking I can ask John and his -- Jon and his team to perhaps be looking at that level. But what we can't do is to say whether survivorship products are 50% estate tax, 50% business continuity or other reasons, or if they're 20% estate tax and 80% others, because, again, it's the same basic policy form that is used. Jon or Mike or someone, if you have that information on what percentage survivorship -- ?

It's roughly 26%, which has been pretty consistent over the last year or so.

The 26%, or survivorship?

26% of the cases are survivorship.

And generally for estate tax planning purposes, you're going to use a survivorship premium rather than a straight life premium, but you're also going to use that, as I indicated, for estate equalization, you're going to use it for business continuity -- so it's hard to say what portion of that fourth of our sales is directly related to estate tax planning.

We don't usually, as a manufacturer, have that level of knowledge of what's inside someone's plan.

The other thing that we're hearing a lot about anecdotally, in terms of survivorship sales are, (a lot of) the state inheritance tax are going up significantly in anticipation of some of the things that are going on with the state taxes and we've seen a pickup of sales in that area, as well, for survivorship products.

I think, Jon, your state of Connecticut is up to about 16% -- they've just raised it to now.

Yes, they've just raised it.

And for our final question we go to David Lewis with SunTrust Robinson Humphrey.

Thank you. I've got two questions. Outside of the life and the fixed annuities, sales have obviously been robust, but it doesn't appear over the last few quarters that run rate earnings have actually improved.

Does that reflect both the margin compression and the fact that the variable annuity doesn't produce as much earnings as a dollar deposit or fixed annuity?

And secondly, has there been any change in activities regarding sales practices or other inquiries from the regulators?

In terms of the first question, David, we have indeed seen fairly significant lift in earnings related to the flows in retirement.

If you were to look, for example, at this quarter versus the same period last year, and adjust for the investment-related gains -- in the case of the '04 quarter, if you were to adjust for roughly $6 million in excess partnership earnings and $7 million in prepays and make wholes, and then make the $20 million adjustment this quarter that I mentioned, you would see some pretty significant lift in those earnings after making those adjustments.

I think the lift around an $89 million level to $100 million level period over and if you drift up you'll see the expense assessments associated with driving better flows is really the major component to driving that lift on the earnings side so what's really important when looking particularly at 2004 and in the first couple periods this year is making all those adjustments to the number of adjustment oriented income items coming through the statement and you'll start to see a purer picture of the list coming from the flow activity so we continue tobe very positive on that piece of the earnings story.

I think the lift is somewhere around an 80, (inaudible), $89 to a 99, $100 million level, period over period, and if you drift on up the P&L, you'll see the expense assessments associated with driving better flows -- is really the major component to driving that kind of lift on the earnings side.

So what's really important when looking back, particularly at 2004 and in the first couple periods here this year, is making all of those adjustments to the number of investment-oriented income items coming through the statement, and, when doing so, you'll start to see a purer picture of the list coming from the flow activity.

So we continue to be very positive on that piece of the earnings story. In terms of sales practices, as far as I know, I am not aware of any change in sales practices that would give rise to any concern or any adjustment in our outlook for the business right now.

And, I think your question, actually, David, may have been on the inquiry side and there are no changes to our existing disclosures right now for any new information there. .

And with that, Ms. Brown, I'll turn the conference back over to you for any closing remarks.

Thank you all for your questions today.

We will be updating any guidance and changes on comments that have been made regarding legislation, regulation, any of those sorts of things, in the 10-Q which will be issued this week. We thank you again for your time and your questions and as always we will take your questions on our investor lines following the call. Thank you and have a great day.

And ladies and gentlemen, that does conclude today's Lincoln Financial Group second quarter 2005 earnings conference call.