Lincoln National Corp (LNC) 2009 Q3 法說會逐字稿

Good morning, everyone, and thank you for joining the Lincoln Financial Group's third quarter 2009 earnings conference call. At this time all lines are in a listen-only mode. Later we will announce the opportunity for questions, and instructions will begin at that time. (Operator instructions). Today's conference is being recorded, and at this time I'd like to turn the conference over to Mr. Jim Sjoreen. Please go ahead, sir.

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

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

Presenting on today's call are Dennis Glass, President and Chief Executive Officer; and Fred Crawford, Chief Financial Officer. After their prepared remarks we will move to a question-and-answer portion of the call. As reminder, there are a lot of companies reporting today, and we want to make sure we get as many questions on the call today. So please limit yourself to one question and one follow-up. With that I'd like to turn it over to Dennis.

Thanks, Jim, and good morning to everyone on the call. There's no question that the past year has been a tumultuous one for our industry. Lincoln was not immune to these pressures nor immobilized by them. We reassessed our strengths and sharpened our focus on our core insurance and retirement businesses, and as result we are emerging from this period in a favorable competitive position.

Importantly, we remain fully engaged in all of our businesses throughout the crisis, delivering valuable advice and a consistent product and service experience at a time when they were most needed by our customers. Our healthy third quarter operating results reflect the effects of the significant steps we took to fortify the Company during the financial crisis as well as the stabilizing external environment.

I want to touch on three themes that, together, create a substantial advantage for Lincoln. First, we have an even stronger financial foundation to support our growth as advisor, consumer and employer confidence improves. We completed our capital plan actions to since our last call, closing on the CPP funding and finalizing the sale of our UK operations. Over the past year our comprehensive capital plant allowed us to raise or retain close to $3 billion in capital, which gives us enough financial flexibility to invest in growth activities as well as to help protect the Company in the event that the fragile recovery falters.

Our continued strong sales, deposits and net flows in the quarter are positive signs that CPP has not disrupted our ability to distribute our products and attract new clients or our ability to attract and retain talent.

We also announced the sale of Delaware this quarter, which was a strategic move that allows us to focus our capital and management resources on our insurance and retirement businesses. We will, however, maintain a close relationship with the team at Delaware through a long-term contract to manage the general account assets.

The second theme is that we have scale and leading positions in several of our core businesses. In fact, we are in the top five by sales in our most established product lines, including universal life, variable annuities, health care 403(b) plans and the under 500 employee group protection market. We are gaining ground in solutions that resonate with consumers today, such as fixed annuities and term life insurance, and we are studying trends in consumer behavior post-crisis to ensure that our products remain at the forefront of demand.

The benefit of having a focused approach to our insurance and retirement businesses is evident in our third-quarter results. Our balanced portfolio of fixed indexed and variable annuities recorded strong deposits and an increase in total net flows of 54% sequentially. Aggregate deposits in our Defined Contribution business were flat in the quarter as the uncertain economy continues to pressure retirement plans and participants. But we continue to see good persistency.

In our individual life business sales were up 18% sequentially with double-digit increases in MoneyGuard and term life. While the trend continues to favor term and lower face amounts on permanent insurance, we have seen an increase of 45% in the number of UL policies sold this quarter over the prior-year period.

Group Protection had another outstanding quarter across all measures despite the contraction in employment, sales of 34% versus second quarter, and we continue to see an increase in voluntary business, which now represents 37% of sales year-to-date.

The third major theme is that we have solid, competitive advantage in our distribution platforms, wholesale distribution through Lincoln Financial Distributors, retail distribution through Lincoln Financial Network and our worksite sales and service organizations, found in both our Group Protection and Defined Contribution businesses. LFD remains a key differentiator for Lincoln in the industry, and we see a clear opportunity to increase advisor loyalty and firm partnerships by evolving the distribution model to create a more strategic and targeted client focus, increase productivity levels within the sales force and drive a more diverse mix of sales.

We are already seeing the results in many key metrics. In the third quarter, for example, wholesaler productivity increased 16% over the second quarter and 36% over the third quarter of 2008. Year to date, we have grown our advisor base by 6% over the same period last year, increased the number of advisors recommending multiple Lincoln solutions, and we've continued to add distribution relationships such as 14 new partners for our fixed and indexed annuities.

Having a strong base of tenured wholesalers is an important component of our ability to evolve LFD. We continued to maintain top wholesalers, and the percentage of wholesalers with more than two years of experience at the end of the third quarter has increased by 24 percentage points over the year-ago quarter.

Turning to Lincoln Financial Network, our recruiting efforts of seasoned advisors have continued to be very successful and retention of existing advisors has also been excellent. During the year we increased our advisor base from 7300 to more than 7500 today, an increase of 200 net new advisors.

From a growth perspective I'm confident that we have the right model and we are executing well in businesses that enjoy strong consumer preference and demand. We expect to maintain our category leadership in those product lines where we have scale and leading market positions. In addition, I expect to see meaningful contributions from a couple specific areas; for example, timely product solutions such as MoneyGuard with its unique value proposition for consumers who need flexible benefits; voluntary group sales in Defined Contribution, where we plan to make significant investments in technology and customer service. And we also expect to increase our penetration of the independent planner channel, which we see evolving significantly as the industry settles into a new competitive reality.

Finally, I see distribution, talent and risk management as major drivers of our ability to continue to expand our opportunities in today's environment, three areas where we have attracted key talent over the past several months.

In summary, during this critical period, we remain focused on execution and believe that the Company has made significant progress. Our assets under management are up 9% over the last quarter. At roughly $39 per share, our book value has increased 28% over the last quarter. Throughout the crisis our hedge program continued to maintain asset levels equal to or exceeding our estimates of future claims, and over the past year we've posted positive quarterly net flows in our core insurance and retirement businesses, and our net flows are up by 25% this quarter.

Now let me turn the call over to Fred for his comments.

Thank you, Dennis. We recorded income from operations of $276 million or $0.84 a share in the quarter. A few items worth noting -- with the announcement of the sale of Delaware Investments and our UK operations, both segments' results are now reported as discontinued operations. Their combined income of $17 million in the quarter is not included in our reported income from operations.

We closed on the CPP funding July 10 and recorded preferred stock dividends and related accretion of the preferred stock discount totaling $16 million in the quarter. This cost to our shareholders does not run through income from operations but does impact the calculation of earnings available to common shareholders for EPS purposes. The dividend and accretion is expected to be about $18 million for the fourth quarter.

The impact of the warrants added approximately 6 million shares to the quarter's average diluted share count and about 7.5 million shares to the end-of-period calculation.

We concluded our annual prospective DAC unlocking and model review work in the quarter. There was little net impact to our retirement businesses overall, but the unlocking did modestly impact life earnings negatively, which I'll touch on in a moment.

We continued to experience weak results in our alternative investment portfolio. We recorded a pre-tax and DAC loss of $11 million, much improved from the second quarter but down from the earnings experienced in the comparable 2008 quarter.

Overall, operating earnings reflect the strength of our underlying business model. Improved markets and continued positive flows drove about an 8% sequential improvement in overall operating earnings when normalized for notable items in the comparable quarters. We recorded net income of $153 million or $0.44 per share, impacted by net realized investment losses, the negative impact of the non-performance risk factor under FAS 157, partially offset by a positive adjustment to the estimated loss on the sale of our UK operations.

Net losses on invested assets were $42 million after tax. This number helped by mark to market gains on portfolios classified as trading accounts along with a modest amount of realized gains. Gross realized losses and impairments on general account investments were $174 million pre-tax. The most notable concentration was RMBS, which represents about $94 million of the impairments. We recorded a loss in our VA hedge program of $151 million after-tax, primarily attributed to the nonperformance risk factor, which amounted to $138 million of the loss, and driven by narrowing credit spreads.

Excluding the effect of the nonperformance factor, our hedge program performed as expected. Results in the quarter were impacted by the combination of prospective unlocking and a strategic decision to modestly reduce our interest rate coverage as we prepare for the adoption of VACARVM. We are exposed to about $1 million of GAAP income for every basis point move in interest rates. For example, we have recovered most of the quarter's rate-driven loss in the month of October.

Finally, we closed on the sale of our UK operation October 1 and recorded a $55 million positive adjustment to the estimated loss on sale we booked in the second quarter. This is the result of finalizing treatment of the UK pension, refining certain tax estimates and closing out various hedges put in place at the time of the announcement. These adjustments had little net impact on total consideration or the cash proceeds.

Turning to capital, this was a quarter of settling into our new capital structure after an active period for the Company. As does everyone in the industry, we officially calculate our RBC once a year as part of our year-end regulatory reporting. Recognizing there are a number of moving parts, we estimate our RBC at the end of the third quarter to be approximately 400%.

Realized losses and impairments have gradually moderated, but ratings migration has trended negative to our earlier expectations. On a net basis our year-to-date risk-based capital in dollar terms increased by roughly $200 million in support of overall general account assets, this driven primarily by sharp ratings actions on non-agency RMBS.

We currently have approximately $900 million of short-term investments at the holding company after giving effect for closing on the UK transaction and reducing our commercial paper outstanding to $150 million. We remain on track to close on the Delaware transaction around year end and expect after-tax proceeds of roughly $400 million. We have a $250 million debt maturity in March of 2010 and are currently considering refinancing alternatives.

We are well-positioned but recognize there are a number of moving parts as we proceed towards year end. As previously detailed in our capital plans, we would anticipate using a portion of the capital held at the holding company in support of our life subsidiaries, particularly with respect to managing VACARVM. The amount and the timing will be dictated by market conditions and our desire to maintain strong insurance company capital ratios.

We are being patient when it comes to life reserve securitization efforts, given volatile market conditions and because we currently have an ability to absorb the strain of new business and natural growth in reserves.

Before concluding, a few comments on our business segments. Earnings were solid in our retirement businesses, fueled by positive flows and improved markets. Annuity results had about $15 million of net positive items impacting the quarter, the primary contributor being positive retrospective DAC unlocking. We use a corridor process around the equity market returns, so while a significant cushion has built up in our account values against the negative DAC unlocking, we would only experience a material positive unlocking under a sustained increase in the markets.

Average account values in our variable Annuity business increased over $6 billion in the quarter, driving expense assessment revenue up 14% sequentially. We have long discussed the power of combining positive flows with positive markets. We ended the quarter with total annuity account values of $71 billion, up nearly $5 billion from the third quarter of 2008 ending levels and up $8 billion over the second quarter's ending values. Remarkable that our end-of-period account values are actually up over last year this time, when considering the events of the past year.

Consequently, when looking at our annuity risk characteristics, the net amount at risk, or death and living benefit in the money is -- at quarter end, is roughly equal to last year's level. Selling VA product throughout the up and down cycles of the markets creates a healthy mix of cohorts when considering both net amount at risk and returns across the block of business as a whole. We maintained throughout the crisis a comprehensive hedging strategy for all our VA guarantees covering all the Greeks, that is, rates, markets and volatility, and exposure to changing account values and guarantees.

Turning to our Defined Contribution business, this segment also performed well with average account values up about $2.5 billion sequentially, driving overall expense assessment revenue up 7%. Contributing to the effects of the markets was another positive flow quarter for this segment. We ended the third quarter with total DC account values of $34 billion, up $3 billion over the second quarter's ending values.

Earnings in this segment did benefit from prospective DAC unlocking of about $5 million after-tax, driven primarily by a modest change in our expense assumptions.

In our Life business fundamentals remained stable. Average account values and in-force were up modestly from the second quarter, down year-over-year as a result of our first-quarter reinsurance capital transaction. We experienced negative DAC unlocking in the period, which included the results of our annual review having about an $11 million impact on the quarter's results. This was offset by a favorable $5 million tax true-up in the quarter.

Our Life segment absorbs most of the results of our alternative investment portfolio, having about a $5 million negative impact on the quarter's earnings if you assume a zero expected return on the portfolio.

Turning to our Group business, another strong earnings performance with favorable loss ratios coming in at roughly 68%. We experienced strong loss ratios in both our life and disability lines. While we have enjoyed a consistent string of favorable quarters, we continued to hold to our long-term view of loss ratios in the low 70% range. Every 1% movement in loss ratios accounts for about $2.5 million in earnings for the quarter.

Net earned premium increased 2% over the comparable 2008 quarter. This is where we are experiencing the impact of current economic conditions, namely lower premium persistency due to overall employment and salary levels.

So we entered the fourth quarter on solid financial footing. Core earnings drivers include positive flows, account value growth and improved fixed margins as we return to being more fully invested. On the capital front, we have significantly improved our financial flexibility, and our insurance company capitalization is positioned to absorb weak market conditions. Gross unrealized losses came down again this quarter by roughly $2 billion, and we witnessed a similar-magnitude jump in unrealized gains. This resulted in a full recovery of OCI and related book value. However, we remain cautious when it comes to asset impairments overall, given the fragile nature of the recovery.

Our annual meetings with the respective agencies have been positive in tone, encouraged by the health and resiliency of our business model and the capital actions we've executed on. AM Best affirmed our insurance ratings last week at A+. The other agencies have not completed their respective processes.

I would also characterize the agencies as cautious in terms of their views on the broader economic recovery, and you can see that coming through in their industry and company outlooks.

Now let me turn it back to Dennis with some closing comments.

As you can see, we think today Lincoln is on a solid forward-looking path. We have the financial strength to support our growth, we have a full suite of relevant products and significant market share in key lines. We have powerful distribution platforms and robust client relationships. And, as this quarter's progress demonstrates, we have the ability to deliver stronger results.

Now let me turn it over to the operator for questions.

(Operator instructions) Andrew Kligerman, UBS.

A lot of good color around RBC and cash at the holdco. Could you put that in the context of what you deem to be excess capital at this point in time and what your plans would be with respect to paying down TARP, maybe a time line?

Let me take the second one first. As a matter of practice, we don't discuss the specifics on capital-raising events, so we can't give you a time line. What I can tell you, as we have been saying all along, is that the milestones repayment that we need to see achieved are a clear, sustainable recovery and normally functioning capital markets, and that our goal is to repay in as cost-effective a manner as we can and as soon as we can.

But I don't think, at this moment in time, we are convinced of the milestones. And so we're going to continue to pay attention to what's going on in the economy and capital markets and continue to plan accordingly. I'm going to turn over the excess capital question to Fred.

Sure. Andrew, first, in terms of the notion of excess capital, my general philosophy on that is there's a difference between excess capital and capital cushion. Excess capital is capital that you have available to return at any point in time or use in a strategic manner at any point in time. Capital cushion is where you're holding a level of additional capital in anticipation or at least in defense of what maybe weak conditions in the economy or so forth. What we try to do is target in and around 350% or better risk-based capital. And as I mentioned, we're traveling around 400%. The numerator and denominator in that calculation would be, rough [justice], a little north of $6 billion of total adjusted capital and a little north of $1.5 billion of risk-based capital in the denominator. So you can assess from that a level of capital cushion, if you will, in our RBC versus our targets.

At the holding company level we are obviously in a strong net liquidity position, which is going to be our matter of practice going forward. We're going to carry a level of excess liquidity at the holding company for financial flexibility going forward. The notion of how much of that represents excess will be very dependent upon capital conditions and market conditions as we go forward. And so we'll continue to assess that, in particular adopting some of the provisions around VACARVM, most notably. But we will just have to continue to monitor that going forward.

On the Retirement solutions segment, you got a nice sequential pickup in earnings from $28 million to $43 million. And we saw nice growth in account values. We also saw the spread go from 2.05% to 2.3%. So it would seem to me that this number could make a similar move into the next quarter. Could you give a little color around where you see Retirement solutions' earnings?

If you are talking specifically to defined contribution within our retirement segment, the comment I would make to start with is, first, reconcile to a $5 million positive on the perspective unlocking. But then, once reconciling for that, what you really see coming through in that business is, again, similar to Annuities, the combination of positive flows and positive markets combining to push that forward.

Now, you are seeing a little more energy around net investment income and spreads because, as you may recall, we've been gradually putting to work more and more of idle liquidity that we were holding through much of the latter part of 2008 and into the first half of 2009. So you are starting to see that come through.

The other thing I would note, and it's somewhat of a minor issue but it does wobble around, and that is we do have a level of alternative investment impact that comes through this particular segment as well that will ebb and flow. As I mentioned in my opening remarks, it was, again, another weak period for that.

Recognize some of those results lag, so I think we're still effectively experiencing some of the results that were really generated in the early part of the year coming through that portfolio. So we have no way of absolutely predicting, but we would certainly hope for improved conditions going forward in that regard.

But the underlying business, I think, is really responding to putting to work idle liquidity, positive flows and positive markets increasing the overall average account values as we go forward.

Very important on both Retirement businesses is recognizing the end-of- period gains and account value. So we carry reasonably strong account values into the fourth quarter, which should bode well for average account values, again, recognizing we have gone through a little bit of a weak patch here the last four or five days.

Suneet Kamath, Sanford Bernstein.

I just had a question about your variable annuity business. If I think back to some of the better equity market periods in the past, it looks like you guys were doing deposits on a quarterly basis somewhere in the $2 billion to $2.5 billion range. And now, as we think about Lincoln being, I guess, a less diversified company, less -- you lost the UK -- you don't have the UK business anymore. And obviously the asset management business provided some unregulated sources of capital. My question is really, what's the capacity or appetite for the variable annuity business going forward? If market conditions improve, do you think that you could get back to something like $2 billion, $2.5 billion per quarter? Or has the structural change in Lincoln in terms of business mix really put a ceiling on how much capacity you have to write VA's?

I think we have quite significant runway the way we manage the variable annuity business. And without getting into absolute dollars, at this point, absolute dollar deposit limits, to repeat what I just said, we have some continued runway in the VA business, again based on the fact that we have an excellent hedging program, based on the fact that we have increased pricing and de-risked the product. And as I said earlier, we continue to do this as a product that is going to be in demand, given the demographics and income guarantees and the like. So we are very positive on the product.

The other thing I'd mention is that the industry, just like Lincoln, has de-risked the product and increased pricing. And importantly, we are seeing new and innovative product solutions emerging across the industry. So I think all these things are very healthy. We are comfortable with the amount of business that we're generating. As I said in my remarks, we are investing in technology in our Defined Contribution businesses, investing in technology in our Group Protection businesses and particularly on the voluntary side. So we are hoping to accelerate the growth of those businesses and maintain a good overall business mix for the Company.

Again, going back to the Annuity business, can you just discuss what the returns you are getting on the product that you are selling today, VA's versus the FA's that you added in the quarter?

Mark Konen, who runs all these businesses with us -- let me say that I pretty much demand that our pricing returns on an underleveraged basis across all of our products run in the 12% to 15% neighborhood. And we continue to adhere to those standards. And, Mark, maybe I will just ask you to comment more specifically.

Suneet, if you look at the quarterly sales and if you combine our fixed sales and our variable sales because we look at it on a more holistic basis, you can see we would expect returns in the 12%-plus range. Now, in some quarters you probably recall that the VA expected returns were higher and the fixed expected returns might have been lower. I would say in second quarter that the reverse was true, as we continue to see a little head wind on the cost of hedges, etc. You saw a VA return probably somewhere in the 11% range on new business, and the fixed annuities well above 12% because of the strong corporate spreads, etc., that we were able to get in the marketplace for our investments.

Now we've made product changes, some more product changes on the VA side coming in as we begin October. So we would see those VA returns going back into that 15% expected range.

Jimmy Bhullar, JP Morgan.

I had a couple of questions, both on the variable annuities base. The first one is, if you could give us some idea on where you stand in terms of your DAC or in terms of potential DAC release, if the market keeps running up. And, to the extent you could quantify, that would be good.

Secondly, if you could just talk about your comfort with your variable annuity fees that you are charging in futures. It seems like everybody has raised fees a decent amount. You are at the low end on what you are charging for your GMWB, but just wanted to see do you anticipate further rate and price increases, or do you feel that your terms and conditions are more stringent than other companies, where you can actually offer or charge a lower price and generate a decent return?

I'll take the first one, on the DAC corridor. As you know, we do have a corridor in place for equity market returns as it relates to DAC unlocking. Right now, to give you an idea of order of magnitude, our account values are running about $8 billion north of the baseline assumption for the purposes of amortizing DAC. So we have built up, as I mentioned in my prepared remarks, quite a bit of a cushion against negative unlocking.

To give you an idea, had we abandoned, for example, the DAC corridor process this quarter, we would have recorded something along the lines of a pre-tax gain or profit related to DAC unlocking of nearly $200 million. But we think it's more prudent to run the corridor so that we are not whipsawing our results or writing up DAC inappropriately if the market is recovering on a more fragile basis, and it has served us well in the past.

Right now, in terms of where we are in the corridor is a 10% movement north in the market would touch the inner part of the corridor which starts the process of discussing where we think DAC is, where we think our assumptions are and whether we ought to be contemplated a move. The market would have to go up by roughly 20% to pierce the outer portion of that corridor, which makes a positive unlocking more likely.

Again, very important is recognizing, it's not just market increases and, more notably, account value increases; it's also sustainability. And that is a judgment call as to how sustainable the market trends are and whether or not it's a prudent decision to be unlocking your DAC positively. So that should give you some boundaries there.

And these numbers are all as of 9/30?

Yes.

Jimmy, I'm going to have Mark help me again with this, but I want to repeat that I think we manage the VA business extremely well. I'm quite comfortable with the relationship between customer pricing and the features and risks that we have in the product right now. And we continue to, again, manage the risk in the hedge program, I think, as well as anyone does in the industry. So I'm comfortable with that business, where we stand today.

I think, in terms of features from a competitive standpoint, we are in the middle of the pack with what we have. So we're not, as we have not ever been, way aggressive as compared to the competition.

But Mark, you may have a few more comments.

Just to put a fine point on a couple of things that Dennis just said, first I would remind everyone that Lincoln has a number of product solutions in the guaranteed income space. So what I think you are referring to is the more common GMWB, of which, of course, we have one. And if you step back and think about the cost of a GMWB rider, having a high fee is not the end all because it begins to eat into your expected return because it makes it more likely that it will be in the money some day because account values have to grow to overcome those fees. So, there is a balancing act.

I can tell you, with our changes that we have been to this WB product over the last months, the most notable or the most recent here in October, we've really increased the spread on the fee part, on the WB part, about 30 basis points with all those changes, about 12 coming from our 15-basis-point increase in fee to 90 basis points, as you referenced.

So, again, you don't get all of it down to the bottom line, if you will. So 12 of the 30 coming from that 15-basis-point increase, the rest of it coming from the benefit and investment restriction changes we made. But I go back to the question I answered earlier. All of that is with an expectation of a 15%-plus return, and we'll continue to look at it to make sure that's what we deliver to the bottom line.

And just following up on that, have you seen any change in the competitive dynamics in the sense that a lot of the Europeans had actually been backing away from the business. Are those companies back in the market, specifically in the VA space, as the equity markets come back or do you think that they have sort of permanently retrenched?

I think what we're seeing is quite a bit of shifting in terms of the competitors in the marketplace, and shifting in the sense that some people withdrew from the market and took a long time to redesign the products and they are now coming back into the marketplace, some people that may be leaving permanently.

I continue to believe that the industry in total is managed by pretty smart people, and I'm encouraged by the collective actions that have been taken and I'm hopeful that we don't find anyone coming back into the market with too rich of features to take market share.

Randy Binner, FBR Capital Markets.

I just wanted to drill down a little bit more on Defined Contribution segment. Flows have been, I guess, a little bit choppy. And I just wanted to try and get color on, is it mutual funds that might have the better chance of seeing an improvement in flows, or did you see more opportunity on the annuity side? And also I would just be interested in any commentary there on the impact of lower employment levels, and if you've seen any sign that there's more or less shifting going on by companies shopping these plans around.

Over the last couple of quarters we have seen our Alliance product taking market share, and that's our mutual fund product. So that has been gaining share. We saw a little less success on the small-case market, which is our annuity product, the Director, that sort of reversed itself this quarter, with the Director showing a little bit more progress and the Alliance product, the mutual fund product, showing a little less [product].

I think we don't look at it in terms of -- or we don't look at it in terms of mutual fund product or annuity product. We look at in terms of market segment. As I mentioned earlier, we have a very strong position in the 403(b) health care market, in other segments of the 403(b) business, and we expect to continue to see progress there.

On the 401(k) side, small-case is what we're focusing on. We are focusing on that because about a third of the volume of that business is driven through the wires or at least historically had been driven through the wires, where we have good relationships and good wholesaling capabilities.

So we are going to continue to balance our efforts on both sides of this or, excuse me, in both markets, the middle-market with 403(b) in health care and the adjacent markets, and in the small employer market with our 401(k) offerings.

Is there any commentary just on employer behavior in adding or drawing back on plans, or to the extent that they are shopping different plans around, and if there were any big transfers in the quarter?

I think, in the large-case market and probably even in the lower-case market, people are a little less quick to be changing providers. And so, in this past period, there has been less activity with movement. People are just sitting back and asking themselves, what's going to happen over the next six months? And until we see it in evolve, maybe we ought to just stay with whom we are with. So we've seen a little bit of that activity in the marketplace.

One of the things we see from a financial perspective is that the cases and the actual participants that we have continued to build, but the amount of asset values coming with those cases is less because of the obvious economic and market conditions. So there's sort of an embedded value view of, are you bringing in more business, are you adding to your participants? Are things like auto-enrolling and just a conscious effort to save for retirement building? And then that should position you well, should the markets continue to return. And so that's also what we focus on.

Darin Arita, Deutsche Bank.

Just turning back to the Annuity segment, I was wondering if you could give some color on the decline in the average equities in that segment. It seems it declined by about $1 billion during the quarter.

Yes. What you are seeing -- this is our GAAP-allocated equity methodology and what you see here are some of the mechanics of, really, a few things. One is, over the course of the last year we did take goodwill impairment to that business. We also did take a DAC unlocking early in the year to reset, essentially, our reversion to the mean and our baseline DAC assumptions.

We also, though, have had substantial changes, if you will, in the value of reserves and assets backing those reserves. This is related to the hedge program and hedge values. That gives rise to movements in your tax position, which also runs through that equity calculation. So that's primarily what you are seeing through the reduced GAAP capital allocation as we do our stat-to-GAAP conversions.

Is that return there of 13.9% for the quarter indicative of your expected return on the existing block of business?

It's -- yes. I think, just a couple things to sort of recognize that when we price and think about the returns we expect on the product, we tend to do it on an unlevered and prior-to-goodwill basis. So you will need to make, sort of, those adjustments in your head. They tend to, generally speaking, offset each other from a return perspective.

The other thing is obviously it's more of a period of time-ish type measurement, and it will ebb and flow over time. But yes, we go through a fairly disciplined approach of allocating GAAP equity to the business line, and the returns are what they are.

Mark Finkelstein, F-PK.

I actually have a broader question generally, just on life insurance returns. Using your numbers, the return on equity has migrated, call it from the 9-ish-plus range down to the high 6% range. And you are obviously mainly more of a fixed UL shop. I understand there's a lot of moving parts, whether it's DAC, alternative returns, but it has come in quite a bit over time. And I guess what I'm trying to get at is, how much of that is from having to hold a lot more capital due to lack of a securitization market? But are there other things that's kind of going on, underlying the returns, that we should be thinking about and maybe more of a permanent pretty low return on the in-force block?

I think, just a couple things, from my standpoint, to think through. One is that you are right; to be mindful of when looking at just the numerator, that the capital actions we've taken, whether it be reserve securitization at the end of 2008 or the first quarter reinsurance deal we did on Commonwealth, that that will pull earnings out of the numerator. I would wager and estimate that to be right around, period-over-period, $11 million in the quarter effect versus the third quarter of last year, to give you an idea of order of magnitude.

And, to the degree that freed-up capital is used to be sent back to the shareholders in the form of dividend and share repurchase, you end up improving the returns, net-net. But if you're holding onto that excess capital for just a defensive mechanism as you watch the economy, it will weigh down on your returns. So what you're seeing across the industry, of course, is a view of returns being weighed down in part by placing the capital structure in a defensive position. And that's a good example of what you would see on the Life side.

The only other thing I would point out is, yes, alternative investment income does move this number around quite a bit. We have had periods of time -- as you know, our long-term expected returns are hovering around 10%, is what we would expect over the long-term, on a portfolio of about $700 million. And I would say about $0.5 billion of that portfolio is attributed to the Life segment.

So that's a pretty good after-tax, after DAC return give-up, if your expectation is for a period of time here, a short period of time, we hope, is to have near zero returns on it. So we would expect that to contribute more going forward.

And then you just have the ebbs and flows of new production versus in-force, natural in-force lapsation and we've seen a little bit more slower growth and account values in in-force, but we would hope that to stabilize and pick up going forward.

Those are some observations I have on the Life side. I don't know if anybody else from the business unit wants to add any color to that?

The way I would think about it is, I would start with what our return would be without goodwill, which would be more in the 9% type range, currently. And then, if I think about in terms of the two major drags, the capital solutions that Fred talked about and the alternative investment income, if not for those drags I think you would get up, certainly, to double-digit range, 10% to 11% type returns on the business. So that's how I would think about it.

Maybe this is a follow-up on the TARP question, but one of the options is to get your TARP warrants cut in half if you raise enough equity capital by that calendar year. I know, Fred, you and I have talked about this. But is there any update in terms of conversations with the Treasury or anybody on whether the existing equity raise would count towards that and, equally, whether some of the asset sales would as well?

I think you are right with the question, but it's something that we are not going to discuss on the phone.

Colin Devine, Citi -- John Nadel, Sterne Agee.

Fred, maybe you could give us an update on what your statutory operating earnings and net income was in the quarter and on a year-to-date basis?

Maybe I'll just ask my second one while I've got you. So my second question is, just thinking about goodwill and as we approach year end, the impairment testing process. Obviously, we've seen an awful lot of recovery in market conditions and various other things that I think would probably be major inputs to that goodwill testing. But can you give us a sense for what are one or two or three of the key variables we should be keeping an eye on as it relates to that process?

Sure, let me address those, John. On the statutory income side, we generated net income in the quarter -- this is after realized gains and losses -- of right around $40 million, a little north of $40 million. Before losses essentially taking through the quarter, that was closer to $220 million and change.

Year-to-date, the net income -- again, net income as defined in the statutory world after realized gains and losses -- was about $176 million year-to-date, $175 million. Prior to the actual losses taking through and impairments taking through, that number would be about $750 million year-to-date.

What we've seen is we've seen a very strong stat earnings environment year-to-date, primarily because of a restoration of CARVM allowances and favorable annuity guaranteed benefit reserve adjustments, as we've seen the recovery in both the second and the third quarter. There still is a level of strain that comes through the Life segment. We are profitable even after giving effect for that strain; but you have, of course, new business strain as well as the drag of any reserve buildup that you otherwise have not found a financing solution for.

So pretty pleased with stat earnings. I think what is really working against stat earnings environment has been the ratings migration issue that I've talked about. That's the animal that has really been a mover in the denominator. And it's a type of capital use that, as we all know, it takes away but can also give back. I think it's important not to lose sight of the fact that, for the industry and for Lincoln from 2003 through 2007, ratings migration was something that was really delivering a lot of capital, and it can deliver again.

Right now our view is we would expect it to continue for a period of time but certainly start to moderate, we would hope, from what we've experienced year-to-date. So stat income, I think, is a good story so far.

In terms of goodwill, we do go through our normal fourth-quarter goodwill impairment process. We really are not into the depths of that process to where I could -- I'd be pinpointing anything more specifically. Obviously, we've seen conditions improved. We've already taken some steps on goodwill as it relates to our annuity business. But I just really wouldn't be able to try to size or comment on things. I think, if there's a business that I'm watching more carefully as we go forward, is while we have seen recovery in our major businesses, our core businesses, we continue to see weakness in our radio and media properties and have to be mindful and watchful of that operation, which we would hope to recover as economic conditions recover. That is typically the case; but thus far, that industry, that entire industry, has remained weak.

Steven Schwartz, Raymond James & Associates.

A couple on the RBC ratio, Fred, if you would. First, just so I'm clear here, the 400 -- is that based on a VACARVM regime, or is that based on the old AG 34/AG 39 regime?

That is before any VACARVM adoption, so that's really AG 34/AG 39.

The other question I have is, could you tie -- I'm trying to remember here. You had -- and the throes of the crisis, you reinsured the hedging. You had again in that subsidiary. I can't remember where that subsidiary was, but it was definitely offshore. Could you give an update on that?

Well, yes. We had -- as we were in the depths of the crisis, what we found is that we had really built up almost shadow RBC in our offshore captive, meaning the assets in that captive, the derivative assets in that captive had grown in excess of the statutory reserving requirements. Thus, we had pent-up excess risk-based capital housed in our offshore subsidiary.

I think, during the depths of the crisis, we were typically sizing that in the range of 20 to 25 points of RBC that was pent-up. As you will recall, we took some of that excess capital out as part of managing holding company liquidity events. But nevertheless, still we're running a nice excess.

I think I might also editorially comment that I think that's part of the power of having a more fulsome hedge program covering all the Greeks. It brings you a level of what we would call macro hedging that is significant bounce in asset values when you're actually in a crisis mentality and volatility is up and interest rates are down and markets are down. So it's served its purpose very well in that regard.

As we sit here today, on a pre-VACARVM basis, we are more in an assets equal to liabilities mode. That is, I don't believe that there's any hidden or excess risk-based capital out in our captive. And what we're going to have to monitor here as we adopt VACARVM is what, if any, capital we may need to put into either that vehicle or into our core life company to adopt VACARVM. And that, again, is driven by the markets.

Early in the process we put a placeholder for VACARVM at around $500 million. We have obviously, in the third quarter, seen conditions, market conditions, trend positive to that environment. But it's very volatile and it moves around daily, and so we think it's prudent to be cautious.

Tom Gallagher, Credit Suisse.

Just two quick ones for me. Fred, in terms of the LOC that you have outstanding and maturing 2011, I think, option [to] go out to 2012, can you just comment on where you stand to potentially refine that? And have you looked at what the cost would be to refi that now? And is the issue still too high a cost to come up with the near-term solution?

Second question is, can you comment on room to lower crediting rates on both Universal Life and Fixed Annuities, if we do get into a deflationary type environment?

In terms of the letter of credit environment and reserve securitization, I think what may be important and helpful is to size the entirety of the situation for you. So we have about $25 billion of UL reserves on our books. And of those Universal Life reserves, we would calculate about $2.7 billion or so of those reserves that could be subject to or benefit from financing, this determined through cash flow testing and actuarial work.

What our strategy all along has been is to use a mix of simply holding excess reserves and not financing them in any way, plus term solutions and letters of credit. And so we currently have been holding already in our numbers, already in our RBC about $500 million or so of excess or reserves that we would deem subject to financing. We've termed out about or done term structures on about $400 million worth and have letters of credit of about $1.8 billion associated with these reserves.

As you mentioned, they go out to 2012 and it would be our plan to look to term out roughly half of that position over time. And that's what we are actively looking to pursue. We think it's probably the prudent approach. You always want to have some level of letters of credit because they are easy to strip off if you were able to find other solutions or if there were to be regulatory changes relative to the reserving standards.

So we are actively looking to do that. In terms of pricing, we would expect the pricing to be up fairly considerably from what we've been enjoying, certainly in letters of credit. We've always anticipated a larger expense related to the pricing of the product. But we would estimate, rough justice, overall returns for our Life segment to be impacted by maybe 0.5% if we were to find renewed solutions in the marketplace that would more likely be between 200 and 300 basis points of costs is what we would estimate at this time.

So hopefully, that gives you an idea of some of the sizing about it. But we've got a very disciplined plan around it. We're being patient because, as market conditions improve, the alternatives improve. And of course, it's important to note that we have, all along, been absorbing a level of excess reserves just in our normal statutory income generation, and that would continue.

With the question with respect to the room in the crediting rates on the Life, in particular, we have some room to go down. But I would focus also on the fact that the duration of that portfolio is quite long. And so it would take some time for the yield on the portfolio to decline. So it's a combination of those two things. I think perhaps maybe at the IRB we could sharpen our pencils and give you a more precise answer to it.

Colin Devine, Citi.

Fred, I was just wondering if you could re-clarify your hedging program. Is that primarily targeted as hedging the economics of the VA exposure? Or, is it on the GAAP results?

And then, second, if you could just give us a couple thoughts on what the current interest rate environment means for the Life block, particularly I'm thinking of the no-lapse UL portion, which I believe represents a substantial amount of the in-force and has somewhat limited ability to be repriced.

In terms of the hedge program, we dialed the hedge program in as an economic hedging, not to the GAAP, reported GAAP, the most notable difference, of course, being the nonperformance risk factor. So we've always targeted the hedge program around that, that being if the NPR were to have reduced the GAAP reserve, which it had been during the crisis, we weren't dialing in a hedge program to that level. So, whether it's calculated under FAS-133 or SOP 03-1, depending on the mortality element, that's what we dial our hedge program in to cover. And as you know and many know, that includes -- when we say economic, we mean coverage on interest rates, volatility and capital market movements themselves.

When it comes to the interest rate, what I would say in general about interest rates is that we do monitor our assumptions as it relates to, for example, things like DAC. So notably in this quarter, we did go through a full review again of portfolio yields as compared to our long-term DAC assumptions. We did make a modest adjustment to those interest rate assumptions that resulted in a bit of a negative DAC unlocking, but not too significant. I think the actual interest rate component of it was maybe, pre-tax, something around $7 million of that unlocking. So we do monitor that regularly, as it relates to expected gross profits.

And, fortunately, we've done a fair amount of long-term investing, particularly around our secondary guaranteed products, did that quite a while ago, which helps with, obviously, ALM, but also with managing portfolio deals for that long-duration liability.

If Mark or team have anything they want to add, though, to interest rates -- I'm not sure if that addressed your question or not.

Let me just finish off by saying, Colin, that the portfolio yields on our secondary guarantee assets are higher than the required pricing. And as Fred just mentioned, they have longer durations than the typical UL portfolio would have. So again, for the foreseeable future we are in a position to continue to achieve our pricing returns on that business.

With no further questions in the queue, I would like to turn the program back over to Mr. Sjoreen for any additional or closing comments.

Thanks to all of you for joining us this morning. As always, we will take your questions on our investor relations line at 1-800-237-2920, or via e-mail at our website.

As a reminder, we will be hosting our annual conference for investors and bankers on November 17 in New York, and it will be available via webcast. Details will be available on our website prior to the conference. Again, thank you for joining us today, and have a good day.

That does conclude today's conference. Thank you for your participation.