Lincoln National Corp (LNC) 2010 Q2 法說會逐字稿

Good morning, and thank you for joining Lincoln Financial Group's second-quarter 2010 earnings conference call. At this time, all lines are in listen-only mode. Later, we will announce the opportunity for questions, and instructions will be given at that time. (Operator Instructions). At this time, I would like to turn the conference over to the Vice President of Investor Relations, Jim Sjoreen. Please go ahead, sir.

Thank you, operator, and good morning and welcome to Lincoln Financial's second-quarter earnings call.

Before we begin, I have an important reminder. Many comments made during the call regarding future expectations, trends, and market conditions, including comments about liquidity and capital resources, premiums, deposits, expenses, 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 link 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.

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 the question-and-answer portion of the call. We would appreciate in the interest of time that people limit themselves to two questions in order to get as many people on the call today. I would now like to turn the call over to Dennis.

Thanks, Jim, and good morning to all of you on the call. We are very pleased with the quality and diversity of our earnings this quarter and particularly satisfied with the stability and consistency of our operating results, driven by productivity gains and reach in our distribution organizations and our comprehensive product lineup.

Continuing our momentum from recent quarters, our fundamentals were very good. Deposits were up year over year in each of our businesses and 10% overall. And, total net flows of $2 billion were up 8% year over year, extending our long and consistent trend of positive net flows in our insurance and retirement businesses.

A focus on distribution relationships and productivity is essential to achieving these performance levels. At Lincoln Financial Distributors, we continue to expand distribution shelf space, adding product at five new firms this quarter. Each of our top 20 distribution partners offers at least three Lincoln products, and half of those firms offer four or more products. Wholesaler productivity is up 13% year to date on top of impressive productivity gains made last year.

Lincoln Financial Network continues to attract and retain seasoned advisors who value our multiple affiliation models. The number of LFN advisors has now reached more than 7,800. And retention of our most productive advisors remains extremely high.

We are enhancing distribution productivity in our Defined Contribution and Group Benefit businesses by marrying our high touch service-oriented worksite models with more efficient enrollment and servicing platforms.

The combination of distribution heft and our comprehensive and innovative suite of products helped generate solid sales in each of our businesses. Life Insurance experienced modest year-over-year sales growth with high levels of sustainable sales in term life insurance and MoneyGuard, our linked benefit UL long-term care product.

MoneyGuard is producing double-digit sales increases and the number of advisors recommending this product to their clients is up more than 50%. Lincoln created the market for these flexible hybrid solutions more than 20 years ago, and we believe they are a compelling option that will continue to gain traction with advisors and consumers. With this kind of advantage, we are confident that Lincoln will continue to lead this market even as competitors begin to enter the space.

We are pleased with progress in deposits and flows in our variable annuities this quarter. And, with the strength of our fixed offerings. The individual annuity business continues to benefit from increased reach in the form of 25 new firms carrying our fixed and index products in the past year and our successful strategy of having wholesalers represent the full suite of solutions, allowing them to pivot as markets and consumer preferences require.

Defined Contribution results were helped by strong first-year sales in mid to large case 403(b) plans, and we are seeing progress in our strategy to more effectively leverage our LFD relationships to support small case 401(k) business.

Group Protection sales trends were positive as well, and current sales are driving premium growth rates to 8%. Loss ratios were elevated this quarter. We have seen this occur before, understand the cycles of the business and know what actions are needed to work through it.

We continue to refine our offerings to round out our product portfolio. With the launch in August of our duration guarantee UL term product to fill the gap between traditional term and lifetime guarantee UL, and which we believe will generate healthy sales in its first year and over time. A new accident product for the voluntary market is also slated for August and should also open additional distribution opportunities in our group benefits business.

We maintained our leading market positions in top eight or better sales ranking in each of our core businesses last quarter, and increased market share in certain key product. And although the data is not yet available, we expect to see product market share increases in the second quarter as well.

Our financial foundation was strengthened during the quarter with the completion of our broad capital plan. We executed on a number of capital actions, including raising debt and equity, redeeming the preferred shares issued under the Capital Purchase Program, refinancing outstanding letters of credit, and addressing life reserve financing needs. Life Company capital and Holding Company cash levels remained at historically high levels at the end of the second quarter, with an estimated risk-based capital ratio of around 500% and more than $800 million in cash at the Holding Company. All four major rating agencies have now moved to a stable outlook for Lincoln, reflecting the success of our capital plan and acknowledging the consistency of our execution and the resilience of our model through the crisis.

Asset quality remained strong in our investment portfolio with growth in our unrealized gain position. As we sit here today, we see no significant areas of credit concern for the balance of the year.

I recognize that the current interest-rate environment is on many investors' minds, and low rates are a concern for the industry. Fred will cover the impact of low rates on Lincoln in his remarks.

I personally share the view of many economists, who predict that we will see higher rates within two years due to monetary and fiscal stimulus as well as huge deficit finance needs. Nonetheless, we have and will take necessary steps to address the interest rate environment.

We are studying the implications of financial reform on our operations, and early analysis leads us to believe that there will not be any material impact on Lincoln. We will continue to follow developments and additional rule making over the coming months.

As we execute our strategies for growth, ROE expansion continues to be a focus for this management team. The levers for ROE improvement include, first, unleveraged double-digit returns on all new product sales. Importantly, we have and will continue to adjust pricing to respond to market realities. But at the same time, we have never missed the mark such that we had to pull back a product. VA and secondary guarantee UL pricing changes last year were good examples.

Second on the ROE front, our ability to effectively redeploy excess capital could add in the range of 75 basis points or more to our ROE.

Third, shifting the business mix towards group and DC.

And fourth, continued disciplined expense management.

With cooperative capital markets and capital redeployment, we believe we can make solid return on equity progress over the next two years. Overall, the outlook for Lincoln is very positive, even more so today given all that has been accomplished in the quality of our execution. This industry has an enormous opportunity to help consumers regain confidence in their financial security, and I firmly believe that companies like Lincoln that understand and align their resources for this opportunity will be the winners. Now let me turn the call over to Fred.

Thank you, Dennis. We reported income from operations of $290 million or $0.86 per share for the second quarter. The only notable items in the quarter were positive DAC amortization in the annuity business, which contributed about $15 million to the segment's earnings. This, offset by unfavorable loss ratios in our group business negatively impacting earnings by about $8 million relative to our plan expectations.

We also had a number of smaller items spread across our segments that, taken together, impacted the quarter's earnings negatively by about $7 million. Net income per share of $0.33 included the early retirement of the CPP funds and the associated write-off of the unamortized discount on the preferred stock of $131 million together with the quarterly carry on the securities of $18 million.

Market volatility returned this quarter and had some impact on our VA hedge program performance. We made a conscious decision to not chase implied volatility higher in recent quarters, which resulted in marked to market losses in the period. This entirely offset by movement in the nonperformance risk factor.

Overall, the hedge program was better than 90% effective and our hedge assets remain in excess of our actuarial calculation of the liabilities and well above the statutory reserves needed under the calculation according to VACARVM.

Gross losses and impairments on general account investments were down significantly, coming in around $37 million pretax, and entirely offset by realized gains in the quarter. As noted in our press release, we have a few asset categories subject to marked to market adjustments. These include our credit linked notes under recently adopted accounting rules, a modest amount of credit default swaps and other derivative positions, and certain trading portfolios. These marks resulted in a $30 million net loss in the quarter, driven primarily by spread widening on corporate CDS and its impact on our credit linked notes.

Turning to the segment results and starting with annuities, our results continue to benefit from increased average account values. While June markets drove down end-of-period account values, positive flows and stronger markets earlier in the quarter resulted in average account values increasing $1.2 billion in the quarter.

End-of-period account values were $73 billion, about $3 billion lower than the average in the second quarter. There has since been some market recovery, and we expect positive flows will mitigate some of the pressure on earnings as we look towards the third quarter. We currently sit comfortably in the center of our DAC corridor method, which guides our prospective account value assumptions. We estimate markets would have to fall by approximately 30% before contemplating a negative unlocking.

Fixed margins were stable during the quarter with normalized spreads in the 190 to 200 basis point range, consistent with the last several quarters.

Turning to our Defined Contribution business, a steady quarter overall with key earnings drivers of positive net flows, stable account values and spreads cooperating in the period. Average account values were up about $700 million sequentially despite the market declines in June. As with our annuity business, end-of-period account values were a little over $1 billion lower than the average in the quarter, at about $35 billion.

Fixed margins and spreads were both strong in the quarter with normalized spreads of approximately 225 basis points, a result of credit and rate actions taken in the second quarter.

In Individual Life, reported earnings were in line with our expectations and underlying trends we see in the core earnings drivers of the business. Mortality bounced back to normal in the quarter. We are seeing both mortality and lapse rates run favorable to our pricing assumptions.

Fixed margins remained steady, helped by investment strategies deployed last year to lock in higher-yielding assets.

Also contributing was a solid quarter of alternative investment returns. Normalized spreads are running at around 190 basis points and have been fairly consistent over the last few quarters.

In our Group Protection business, our non-medical loss ratio came in at 76%, about what we experienced last quarter and above our long-range expectations in the low 70% range. The increase was primarily due to elevated long-term disability loss ratios. Life ratios recovered as expected in the period.

Poor disability results were driven primarily by unfavorable incidents and to a lesser degree, claim termination experience. We believe economic conditions are playing a role and see no concentrations that suggest underwriting issues. We expect loss ratios to recover in time, but are likely to remain elevated for the remainder of the year.

Net earned premium continues its strong trend, up about 8% over last year's quarter. The premium growth rates benefiting from consecutive periods of strong sales results, and improved retention and persistency rates.

We expect year-over-year premium growth rates to remain in the high single-digit area.

I want to spend a few minutes to address some of the concerns over the current low interest rate environment and its impact on our core insurance businesses.

Let me be clear at the start. A prolonged period of historically low rates is not healthy for our business fundamentals in isolation. However, we long ago recognized this threat and have been proactive in our investment strategies; our product designs, including crediting rate actions; and overall asset liability practices to defend against this type of environment.

The bottom line is we see a prolonged low rate scenario as having a relatively modest drag to near-term earnings. We see little in the way of near-term capital implications, and we do not see interest rates in isolation as a driver of goodwill impairment across our businesses.

In time, there could be a one-time impact related to revising our prospective yield assumptions supporting intangibles, but again, at manageable levels.

To provide further detail, let's look at the estimated financial impact assuming new money rates, currently running about 75 basis points below our portfolio yields, remain in place through 2012.

The earnings drag from spread compression in our retirement business is modest and largely concentrated in Defined Contribution.

There is little impact expected on Individual Annuities. For some time now, new products have been sold with very low minimum crediting floors, and we apply disciplined ALM standards locking in spreads on these products at the time of issue.

The risk in the Individual Annuities business is more a sharp rise in rates. We manage this risk by selling market-value adjusted product and through the purchase of derivative protection.

Defined Contribution experiences more of an impact, a function of higher guaranteed crediting rates, and reoccurring premium.

Assuming our two-year low rate scenario and looking at our annuities and Defined Contribution business in total, we would expect very little earnings impact in 2011 and $10 million to $15 million of annualized earnings impact in 2012.

In our Group business, the impact is also not material. The combination of lower portfolio yields and adjustments to reserve discount rates having an estimated annualized earnings impact in the $5 million range.

In our Life segment, the stress on earnings is more pronounced, but has been reduced by proactive strategies to lock in long-dated and high-yielding assets. We moved quickly to put idle liquidity to work after last year's capital raising efforts, and executed on strategies that allowed us to effectively pre-buy attractive assets in anticipation of future flows and maturing securities. In fact, we do not need to purchase a single asset in support of universal life secondary guarantee portfolios until mid-2011.

Under our two-year low rate scenario, we estimate the combination of spread compression, DAC unlocking, and build in reserves would combine to impact annualized earnings by about $35 million in 2011, and $50 million in 2012.

As noted a few quarters ago and in our disclosures, we are currently reviewing all of our life models as part of converting to a new valuation system. Included in this work is a review and harmonization of methodologies across all blocks of our life business, along with our traditional prospective DAC assumption testing. Under our two-year low rate scenario, Life portfolio yields drop on average only 5 to 10 basis points per year, a result of our investments and ALM strategies.

If you assume, for example, a 50 basis point reduction in our long-term yield assumption, the expected earnings impact from unlocking at adoption would be in the $50 million range.

It's important to note that we are taking a level of DAC unlocking along the way, which helps to contain this number, and we look at all gross profit assumptions in our prospective reviews. It is often the case that we adjust multiple, and, at times, offsetting estimates such as lapse rates and mortality.

On goodwill assigned to the Life business, the valuation is more to core franchise issues, such as new business growth and returns, mix of business and distribution strength. Goodwill is also sensitive to discount rates applied to the new business.

While threats to future profitability can theoretically push up the discount rate, a drop in the risk-free rates will also lower the cost of capital applied to the business.

Our current disclosures, therefore, provide sensitivities to both discount rates and new business generation and do not isolate interest rates. We are pleased with the overall health of the franchise and our second-quarter results continue to prove that out.

It is, however, fair to say that while economic conditions remain fragile, we will need to monitor the health of the franchise, and potential movements in conventional discount rates apply to this business.

Finally, on capital, a review of our cash flow testing results could withstand a 50 basis point drop in portfolio yields and still be considered sufficient under both regulatory and our internal cash flow testing standards. We have cushioned to weather the current low-rate environment in both our aggregate life reserves and those reserves backing universal life with secondary guarantees.

So to wrap this up for you, should new money investment yields remain at their current low levels for two years, we would experience a moderate drag to earnings, more so in 2012 and mostly in our life segment. We see little risk to near-term capital dynamics, and in the event we believe it prudent to unlock our prospective yield assumptions on DAC and VOBA, the one-time impact is manageable.

Finally, we do not see interest rates in isolation as a driver of goodwill impairment and believe our life franchise to be solid and building.

Dennis touched on capital in his comments, and you are all well aware of the series of transactions that we undertook in the last quarter. Our insurance subsidiaries remain in a strong position with RBC ratio estimated in the 500% range. This, after sending a dividend of $275 million up to the holding company during the quarter.

We currently sit with about $800 million in net liquidity at the holding company, well above our stated policy of holding 12 to 18 months of cash flow needs.

The combination of our $550 million ten-year letter of credit executed in 2009, our new credit facility allowing for $1.5 billion of letters of credit out to 2016, and this quarter's $500 million 30-year Universal Life transaction, place our reserve funding needs in solid position.

General account conditions continue to improve. Impairments are down significantly. And our unrealized gain position increased to $3 billion pretax.

Capital charges associated with our general account holdings have stabilized, and with the average credit quality improving, we are seeing a modest reversal of the ratings migration impact experienced in 2008 and 2009. We continue to position our general account portfolio in a defensive mode, recognizing economic conditions remain volatile. Overall, strong capital position with significant financial flexibility as we monitor market conditions for the remainder of 2010.

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

Thank you, Fred. The realities of the external environment, including macroeconomic forces, demographics and consumer behavior, have and will create both headwinds and tailwinds for Lincoln and for our industry. And what's important is Lincoln's skill in navigating the environment. Our proven ability to react appropriately to external forces and to deliver good operating results reflects our deep knowledge of this business and the stability and resilience of our operating model. Given these strengths, I'm confident that Lincoln is well positioned for the future to manage effectively through the headwinds and take advantage of the tailwinds. With that, let me turn the call over to the operator for questions.

(Operator Instructions). Ed Spehar, Bank of America Merrill Lynch.

Thank you. Good morning. First, Fred, could you state one more time the comment you made about the amount of a market decline that you would need to see before there was a negative DAC unlocking in the VA business?

Yes, we would see -- Ed, we would need to see markets decline by better than 30% before we would be contemplating an unlocking -- prospective unlocking in DAC. What that 30% decline does is it really triggers an analysis inside the Company, and particularly focuses on well, where do we think markets are going to go going forward? If we think they're going to recover because there was a relatively acute short-term issue, then we may not unlock.

But if we think it's going to be persistently low markets, then we would likely unlock, as we did in the -- late in 2008. Interestingly, right now, if you were to unlock our corridor to the mean of the estimate, we would book a pretax gain of about $150 million. So that gives you a little bit of idea of where we are in terms of relative to the center of the corridor.

Okay. And then one more question on interest rates, if you took the analysis that you apply to your book and you said new money rates 100 basis points lower, again, not a forecast, but just so we can understand, how much different is it in terms of the outcome versus what you modeled?

Yes; not material, really. And in fact, there are some portfolios that are traveling closer to 100 basis points, and we used that kind of current analysis to model it out. So the 75 basis point new money below portfolio is really an average across the blocks. So, in other words, Ed, there is some situations where 100 basis point new money lower is actually factored into those estimates. So I wouldn't expect it to be materially different.

Okay, I'm sorry. I wasn't clear. I meant not going from 75 to 100. I'm saying from 75 to 175.

Oh, to 175?

Right.

Haven't modeled that. Other than I would tell you that that's nowhere near what we are currently experiencing in terms of new money rates relative to the portfolio yields. And, in some cases, particularly because we've locked in some good rates in the past year, we have really -- are able to be very particular in what we buy. That's probably one of the things that's worth mentioning.

I talked about being able to step out of the markets for a year or so to wait out better yields, but that's not really what we do. What we are really going to do is be particular in the assets that we buy, and particular meaning buying those assets that on a risk adjusted basis provide great yields and good, long duration to support those blocks. That's really what we've been doing here in recent quarters, and that's really benefited us on the new money side.

Okay. And I recall Mark Konen years ago talking about when there was the fear about the low rates earlier in the decade, about the ability to reprice in Universal Life that wasn't fully appreciated by the market back then. Is that -- am I remembering correctly? Or is there the potential to, in a very dire scenario, actually adjust, maybe not in the -- obviously not the minimum crediting rate, but in the mortality charges or other charges in the UL contracts?

Hey, Ed, it's Dennis. Mark is sitting on my right, and as long as you've referenced his name, we'll have him answer that question.

Hi, Ed. I don't remember that many years ago. I'm losing my memory, but what really happened, let me just readdress it; it depends on what kind of Universal Life product you are talking about. And in the current assumption type Universal Life that was sold and still is a huge part of our book of business, that kind of an analysis would be correct.

If you look at the secondary guarantee Universal Life block itself, that analysis really has more to do with the lock-in of that premium is locked in. The lock-in of that cost to the policyholder is locked in. And there is less for the Company to do about that.

But that also allows us, as Fred has mentioned, to design it in a way that allows us to invest very long because there's no optionality either in that policyholder's arsenal. And therefore, if we can lock in long rates, that mitigates the impact of the low interest rate environment for an acute period, say two years, as we've talked about.

And what's the split right now, roughly, between the current assumption and secondary guarantee in terms of your book?

I don't have that off the top of my head. I'm looking to (multiple speakers)

It would probably be -- in terms of the in force, maybe 15% secondary guarantee.

15% secondary guarantee.

Rough numbers.

Yes, maybe a quarter, if you want to get real rough.

Perfect. Thank you.

Randy Binner, FBR Capital Markets.

Thanks. Thank you to Fred for all the scenario analysis. I just wanted to clarify that those were all -- the EPS, the DAC sensitivities, those were all pretax numbers, right?

No, these numbers are all tax affected. They're really -- they're meant to be an earnings number.

So the 35 for '11, the 50 for '12, the 50 for the DAC, all those would be after tax?

That's right.

Okay. And then, I guess I jump into more of a hot topic, which is this retained asset account issue. Is that something that Lincoln has exposure to?

We have retained assets. I must say that it must have been a slow news day yesterday to focus on that issue. And I think that the ACLI's response captured very well the strength of that asset for the industry.

I would say particularly, in Lincoln's case, where we have such a -- a distribution system that's focused on financial planning, I can tell you that our planners would, in a heartbeat, move that money to the right place on behalf of their customers. So that's our response.

Is it -- do you -- could you approximate for us how many assets or how much assets are exposed in those accounts?

We have about $800 million.

$800 million.

$800 million? Okay, great. Thank you.

Nigel Dally, Morgan Stanley.

Great, thanks. First question, with a 500% risk-based capital ratio, and with TARP now out of the way, can you discuss potentially when you would begin to consider capital management?

Yes; I think we are very pleased obviously with the capital position, particularly as it relates to the Life Insurance subsidiaries. I think what we are doing is watching very carefully market conditions. They continue to kind of re-remind us of a level of instability, and we would like to see some of that stabilize a bit more.

We also just got through, really, a nice, solid period of dialogue with projections and so forth with our rating agency players. That resulted in stable outlooks and pretty good views of our capital position and how it's positioned to weather the storm.

And so the real answer to that question is we fully expect we will be in a position to redeploy that capital for better returns than today. That's not saying much, by the way, because idle capital doesn't earn you anything effectively. But, we've got to be patient in watching the markets, and we also have to be mindful of the momentum that we've created in our ratings and wanting to continue that.

And just so I follow on from there, when you're looking at capital redeployment, how does buybacks compare to the acquisition opportunities in the current environment? Are you still seeing opportunities out there in the market?

Nigel, it's Dennis. My view has always been that if you can find a thoughtful strategic acquisition, that's the best use of excess capital because it will continue to grow over time, whereas share returns have a short impact on -- share repurchases have a short impact on operating earnings per share.

So our first focus would be the right acquisition opportunity. But as you know, these things aren't -- you can't predict when that's going to happen, and so there may be a point where we begin to do some other capital management if we can't find the right acquisition opportunity.

Okay. And then just, last question, just going back to the interest rate issue. Just hoping to get some clarity on one component of that, being spread flexibility. Is it possible to get details on the total amount of client assets that have guaranteed minimum rate floors? And for those assets, what is the current -- how does the current crediting rate compare with the weighted average guaranteed minimum floor?

Yes, actually, where you can get a lot of that data is we spill it out in tables in the 10-Q and the K, but I can give you some color. And it really syncs up with my comments.

In the annuity business, for example, we are really in very good position. There's really only roughly 30%, 35% of our business is at the minimum guarantee levels, and we've got some 90 basis points or so of room between the average crediting rate and minimum crediting rate guarantees. And that's in part while we are able to more proactively manage the onset of spread compression in that business with little to no effect. There are other reasons too, namely ALM mechanics and so forth.

When you get to the DC business, that's a bit of a different story. You have upwards of 80% of the block of business traveling at the minimum guarantee rate and more like 20 to 25 basis points of room between crediting rate, average crediting rate and minimum guarantee. So you have less room, and that's in part why under a reducing portfolio yield environment, you will suffer a bit more spread compression in the out years in the DC business.

On the Life side, it's a very similar dynamic with better than 80% of the book traveling at minimum guarantees, so less flexibility to adjust crediting rates. And more like 15 to 20 basis points, maybe 17 or so basis points of room between crediting rates and minimum guarantees on average. And so that's in part why you see, under our two-year down interest rate scenario, more spread compression impact in both DC and of course on the Life side.

That's great. Thanks a lot.

Jimmy Bhullar, JPMorgan.

Thank you. I had a question on your disability claims, and if you could just elaborate on the spike in your loss ratio in the disability business? Your margins had been fairly stable for a while, so what's causing the decline in margin? Is it more of a -- obviously the economy is weak but is it a pricing issue as well? You have had pretty good sales for a while. And then I have a follow-up after that.

Jimmy, it's Fred, and I will ask our -- my partners here to weigh in if they want to provide more color.

Sure.

But, this is really -- we have broken down, as you can imagine, the disability loss ratio climb. It was running at about 76% or so, which is about 5 or so percentage points north of what we would otherwise plan on a stabilized basis.

We believe it's attributable largely to the economic cycle, and I say cycle because we believe some of the early shock to the economy was in part resulting in stronger loss ratios for a period of time as people resisted going out on disability out of fear of potential job loss or job eliminations.

As things stabilized and employment levels, albeit lower, stabilized, a move back to people maybe going on disability more proactively. In some respects, this could be viewed as a reversion to the mean, meaning that for several quarters, we were running below our plan loss ratio expectations in the high to -- mid to high 60% range, for example. And this to some degree is playing out, as you would expect over the long run, and now we're running a bit higher. But when looking back over the last couple of years, we've been running around our plan levels. That's in part why we believe we are confident that these ratios will come back in line in time, probably remain elevated for the remainder of the year, would be our expectation, but come back in line over time.

And then on your VA business, your sales obviously, like I think they were up about 17% sequentially, so a lot better than what we expect the industry to do this quarter. Anything special that you are doing there in terms of either, like distribution expansion or just -- like what the factors are that drove those fund results?

Jimmy, it's Dennis. It just really comes back to the strength of the model, the continued focus on improving the training of our wholesalers, increasing the quality of our wholesalers, adding shelf space. It's basic blocking and tackling that's producing these results.

Okay, thanks.

Thomas Gallagher, Credit Suisse.

Good morning. Fred, hey, first, just a quick follow-up on the interest rate discussion. The -- in your analysis, have you changed lapse rate assumptions at all when you contemplate the low rate environment?

And then just a follow-up, what -- can you give us an idea of what the weighted average lapse rate assumptions would be embedded in your UL reserves, both on a GAAP and a statutory basis?

We did not do any sensitivities or dynamic movement of lapse rates surrounding our blocks of business per se as it relates to interest rates in isolation.

On the life business in general, I would tell you that lapse rates have been running better than our pricing assumptions for a while now. And, in fact, particularly where they can be most sensitive is in the UL secondary guarantee business, where we've been running -- on the UL block in total, we've been running around 5%-ish or so type lapse rates. I think on those secondary guarantee businesses, maybe in the 4%, right around the 4% territory.

That is quite a bit higher than what we price at. As we've talked about before, we typically reduce substantially the secondary guarantee lapse rate assumptions in our pricing, oftentimes traveling between 1% and 2%, for example. And on those policies that are running out of account value and going into kind of a guarantee, if you will, we zeroed out completely when we were thinking about the pricing. So, it's -- so that gives you some color on the lapse rate experience. It's been going favorable.

And that's in part why I noted that when you look at long-term assumptions, and you think about intangibles and profitability, you have to be very, very careful about isolating one single margin contribution to assess the financials. It's not uncommon for other elements of the profit drivers to be cooperating and doing better than our pricing, and thus serving as an offset to the issues.

Got it. And then just a follow-up, if you -- the 4% to 5% lapse rates that you are seeing today, appreciating that your pricing new business at much lower lapse rates, what would the -- if we were to look at your entire book of business, where would the embedded lapse rate assumptions be set, on your total reserve?

Yes, I'm kind of looking over at my partners.

Tom, this is Mark. And on the secondary guarantee UL, it really is, for the majority of that block of business, around the kind of numbers Fred talked about, in that the lower lapse rate, maybe not the first versions the industry put out but as you begin to understand this product, you get better and better at how you understand the economics of a product always.

But, for the majority of the business, it really does come down to very, very low lapse rates. And in fact, we are experiencing higher lapse rates than that. So, from that, you can take that off.

From the rest of the book of business, Universal Life book, that's all over the board. This goes back to the 1980s with some of this business. So, there's a lot of different assumptions in there, but I would go back to also what Fred said, which is, in total, lapse rates continue to track better than expectations, and he quoted the 5% number.

That's helpful. Thanks. And then just one more follow-up if I could. EITF 09-G, I think there's a meeting today on that. Any -- have you guys done any work on this in terms of quantifying, if it does go through, what the expected impact would be?

You know, it's -- we certainly have been monitoring the progress of this work with the FASB. And we've taken some look at it in terms of its potential impact. But it's very difficult for us to kind of toss estimates and numbers out there because it's somewhat of a moving dialogue, and I think our preference would be to wait and understand what the full context of the adoption is -- the timing of it, to be able to better assess its impact on our business.

I think back in June, I was asked a question in general about this topic at the S&P conference, and I answered it honestly the same way I do here, and that is at the end of the day, we price our product and we think about the embedded value of the business that we are putting on in terms of the appropriate pricing of the cash flows in the future and the risk-adjusted pricing of those cash flows.

That's where we focus our attention. That's what we sell each and every day. And that's what has really the greatest impact on the degree to which we are adding value or not.

The accounting is something that's a reality, and we've got to deal with it, and it could give rise to some volatility upon adoption. But at the end of the day, the amortization of DAC, the DAC concept in general is an earnings recognition timing issue, in general.

And as long as we think we're putting good economic business on the books, which we do, we think it will work itself out. So that's a bit of an overarching comment, I realize, but we simply have to watch this work before we get into more specifics.

Understood. Thanks.

Eric Berg, Barclays Capital.

Thanks very much. I think that Mark just mentioned that sort of on an overall basis, your lapse rates are running I think he said better than expected. Does better mean that lapse rates are running lower or higher than expected?

On the secondary guarantee block, they are running higher than our expectations, even though, again, we had very low lapse rates. If someone was totally in the money and didn't have to do anything else, as Fred mentioned, we would assume zero. You can't get any lower than zero.

But, what we're actually finding is the people that have bought these policies are having the same economic issues that many of the rest of America is having, and so they may get that premium bill and decide not to pay that premium. Whereas perhaps, our assumptions would assume that in this kind of environment they would pay that premium. But they want to eat instead or whatever the, whatever the --

Right. And what about away from, outside of -- lapse experience outside of no lapse guarantee Universal Life?

Again, that's the one that really, to me, depends upon cohort to cohort. But I don't see anything as being a big issue there. Again, those are pretty seasoned blocks and are traveling at or near the assumption, one way or the other.

Okay. And then, a couple more, one with respect to interest rates, the other with respect to disability. Fred, while I certainly understand the point that you have emphasized that the value of intangibles is a function of many variables that can be moving in different directions and provide offsets, if we look at interest rates as a factor in isolation, wouldn't it be the case that all else the same, everything else the same, a decline in rates does pressure the recoverability of goodwill? Or would it be the other way around?

Well, it makes it kind of hard to say, Eric, because here's my view of just isolating interest rates. The bad news on isolating low interest rates is it brings about the prospects of weaker forward-looking earnings or volatility in earnings, which would suggest for any business, the need to apply a higher discount rate.

But, because we're talking largely about treasuries when we think about interest rates, we also see the risk-free rate dropping and the cost of capital assigned to that business dropping, and that provides a downward pressure to the discount rates. And so -- and I think it's been pointed out by a few in the analytical community that you may even need to start in time thinking about the it New World order of ROEs when assessing the lower cost of capital that comes with a persistently low risk-free rate of return.

That's a little bit of the dynamic that plays into the notion of discounting a business, particularly a business that's a low beta business and as stable as the Life operations; as opposed to a potentially more volatile returns scenario on the VA business or equity market driven businesses. So, it's a push and pull, is the answer, which may be more difficult to judge.

Last question is just I wanted to -- relates to the disability experience, and I just wanted to clarify one point made earlier. In the course of this earnings season so far, a couple of companies -- StanCorp and Delphi, have said that as best as they can tell, the economy doesn't affect their disability business. Are you saying something different?

Yes. And, let me just say at the onset that we have seen the same thing you are saying, that companies are assessing the typical quarterly ebbs and flows of loss ratios and trying the best they can when looking at their blocks of business to assess what's driving it. I would say that we all have, in some respects, slightly different blocks of business, which require a little deeper understanding, small case versus mid and large case, different industry concentrations.

For example, we have a fairly large educational concentration in our business, which is normally stable, but as we all know, reading the newspapers, we're seeing teachers being let go more and more, and so that all of a sudden has become a more riskier occupation as it relates to that.

So there are different dynamics as you really dig into the details of your block. And I think what companies are doing is they're trying to do the best they can to assess what's driving it.

In our case, we've seen incidents pop up which we believe to be kind of a combination of reverting back to the mean, having enjoyed unusually low loss ratios for a period of time, and the economy.

But we've also seen the termination rates on our business also slow down a bit, which has to do with really claims management and administration, and these types of issues. That's a lesser issue for us, but that's involving just good, stable claims management work, which we are going to look at, and we think we could make some improvements in that respect.

So, there are some actions you can take as a management team, but you are correct. You will see a different read from different companies, but I think that gets into diving a couple layers down on the block.

Eric, can I come back to -- we've owned this business and have watched it for a decade or more, and I had seen this type of loss ratio development and incidence rate development. And we've got a quality management team who has demonstrated in the past and will demonstrate again, that we can work through these issues in a period of time. So, it's happened. Management is working on it; it's happened before, and we've worked our way through it.

Thank you very much.

Mark Finkelstein, Macquarie.

A couple questions. I think just to talk about the VA business a little bit, this is really the first quarter in several where we've actually had equity markets on a point-to-point basis go down. You've had some statutory changes in reserve requirements. You've also had changes in hedge strategies. I'm actually curious, how did the required capital change from the first quarter to the second quarter with the decline in equity markets? And if you can kind of incorporate both the stat and the offshore capital, that would be helpful.

Yes, what's really interesting about the statutory capital dynamics this quarter is you got a little bit of a short-term replay of what we, and I suspect some in the industry, those that have fulsome hedge programs, experienced during the depths of the crisis, where because you had a pretty sharp movement in volatility and interest rates, you saw your hedge assets spike in valuation relative to even the stochastic elements of VACARVM on the statutory front.

So I mentioned in my comments that we are currently in a position where our actual asset values, derivative asset values, supporting the reserves on this business are pretty substantially in excess of the statutory capital requirement. In fact, north of $0.5 billion in excess of that statutory requirement.

For Lincoln, that doesn't come through in our risk-based capital because we effectively house those capital dynamics, as you've mentioned, in a captive reinsurance vehicle. For those companies that have it on their balance sheet, they may see some pumping up, if you will, of their statutory capital by virtue of that dynamic.

What it does provide me is a great deal of comfort that what we are very unlikely to see is any sort of capital call to our holding company in support of the VA business. In fact, quite the opposite if we remain in these low interest rate environments.

Something that relates to our interest-rate discussion that you should all be mindful of is that we have a substantial amount of floor protection on our balance sheet as it relates to just running our VA hedge program when thinking about statutory. And so, while the low interest rate environment creates some capital dynamics and earnings dynamics on the Life Insurance side, it can, when it's in the tail scenario, provide a real booster in terms of asset values relative to statutory capital needs for your VA business and provide somewhat of an offsetting level of comfort. So that would be kind of the statutory dynamic.

Now, what I would be careful about is, of course, this is a quarter's worth of experience in the capital markets, and those capital markets move around. And we are not "spending" that excess capital, right? It's there to support the economic view of the hedge program, not just the statutory view.

But what I'm pleased about is even on an economic basis, our hedge assets are traveling a couple hundred million dollars north of the actuarial calculation and liability, so we're simply in good shape on both fronts.

Okay. Thank you. And then one other question, just a theoretical question I guess. You hedge interest-rate risk on VAs. Most companies hedge at least some interest-rate risk on long-term care. If I look at your secondary guarantee UL business, very long-duration liabilities. I guess, why don't you have a hedge program in place on that, on the interest-rate risk? Or if you do, let me know.

This is Mark again. And in effect, we do because of both the combination of the design of the product, which, without getting into all the nuances, really takes all the optionality out of the product, which therefore allows us to invest very long. So think about investing in 30-year assets, as an example. And in effect, then, call it a hedge when you look at the combination of those, which, therefore, does not require us to hedge short-term movements in interest rates.

Okay. Thank you.

Colin Devine, Citi.

Just a couple of questions. Dennis, you mentioned you're looking for ROE to grow, and I'm not sure if you're ready yet to put up some targets. But I was wondering perhaps if you could walk me through just how we're going to see that happen. When the capital supporting your Life business I think represents about 57% of Lincoln's total capital right now, and yet the Life business is earning, for the second quarter, I guess a 7.2% ROE on it. And so, what opportunity is there really to grow that, because it seems to me that's the key to getting the overall Company up.

And then secondly for Fred, I appreciate the interest in DAC discussions. On the annuities, when you're talking about whether or not you would have to adjust DAC and how much the market could drop, I was wondering how lapses factored into that because if I'm thinking in my own VA contracts, I think they're about 35% on the money at the end of the second quarter. And it would seem to me when they are that deep, assumed lapses on your VA business are also essentially pretty much going to zero. How is that factored into what we're seeing right now? Thanks.

Colin, first let's get a starting point on the UL business, which, absent goodwill, is -- it has a 10% ROE on it to start with.

Okay.

Which is lower than I would like to see it. Now, moving to just a repeat of what I've said, maybe adding a little bit more color, there isn't a product that we are selling today that doesn't have a middle, or excuse me, a double-digit ROE on it. So, as those products become more of the mix of the enforce that will incrementally drive ROE improvement, and I would quickly say that that takes time.

But just to interrupt for a second, I think you have always told us that your products have been priced for the level you just gave. Mark said the secondary guarantee UL block is only 15% or 20% of the total; then why is this ROE still -- based on what you just said, so much below where it was priced. Sorry. I just want to make sure we understand that and so we are framing expectations as to the timeframe in which this ROE might grow.

Yes; let me ask Mark to help us with the 10% ROE and the past pricing.

Right. And remember, everything you said there is correct, Colin. And, the ability to perfectly hedge out or not hedge out, but do away with the excess reserves has not -- is not there. Now we've made a lot of progress, as we've talked about, but if you normalize to that, then you are probably in the 11s for the return. And then it's, again, back to the basic blocking and tackling on some of this stuff to try to push it into that 12 and better range, including proactive investment management, proactive management of all the elements -- of the policies.

While on the secondary guarantee UL we have with new products, taken care of the need to capital -- have a capital solution, the term insurance we sell still requires a capital solution. We believe we obviously have the ability to do that over time, but as you sell term insurance, until you warehouse enough of it to go out and get a capital solution, there's going to be a little bit of drag on ROE.

Okay.

So the second opportunity -- and with the -- the most significant and most opportunity for near impact is the redeployment of excess capital. And to put that into perspective a little bit, as I said, we would like to do that in strategic opportunities. And strategic opportunities present themselves when they present themselves. Some of the actions we've taken, particularly with Fred's job, is to really heighten our focus on that and try to turn up as much as we can as soon as we can if it's the right transaction. But the excess capital now is fairly significant.

If, over time, we are traveling down towards 400 basis points of RBC as a target, and I say over time in a sense that we, as well as people who look at us, such as the rating agencies, want to see a little more stability. And then with our guideline of holding 18 months of cash at the Holding Company -- if you take the 400 and you take that second criteria, we're $1.7 billion or so in capital above those levels. So we have ample capital to redeploy over time. And again, not immediately, but over time. So that can provide a good kick.

And then the third one, which is consistent with this, is just that we do want to diversity away from the Life business and add businesses that have higher ROEs. And over time, I think we can do that.

And then fourth, and this is more modest, but still, it's a factor, is the disciplined expense management that will drive some incremental ROE over time. So it's really those four things.

Okay, thank you.

In the money-ness of annuities and lapse rates and how we think about that, I will give some color. And if any of my partners here want to add more, they can.

But obviously the corridor, as you know, is really focused in on a prospective view of account value, so it's driven by the equity markets and it's driven by flows and performance in the underlying funds. Everything that drives an account value, we tend to think about it as being primarily an equity market type prospective view, but it's really an account value driven.

Fortunately, what's helped us out over the years, really, is we've been steadily producing positive flows. And actually the underlying performance of our separate account funds has really outperformed the market indices as well in recent years, which has helped as well.

Separate and apart from that are our lapse rate assumptions. And when you're thinking about the prospective work we do on the annuities, we also have to contemplate all drivers, as you point out, including the lapse rates.

In that particular case, we dynamically view the lapse rates similar to what we would do on a stochastic basis, such that if we believe there to be a risk of in the money-ness, as you've pointed out, then we would also expect just what you are saying, and that is lapse rates to drop significantly.

Looking at our lapse rates, it's kind of interesting. We've seen our lapse rates in the last year across our entire annuity block go from about a little over 8% to down around 7%. And at first blush, I would have thought that to be driven by just what you are saying -- the in the money-ness on these variable annuity guarantees, particularly death benefit guarantees and the like.

But actually, we've seen variable annuity lapse rates remain fairly steady year over year at about 7%. Where we're seeing improvement in lapse rates or retention is on our equity indexed annuities and fixed annuities, which is a good guy relative to our assumptions, keeping that on.

And, we've interestingly seen a level of lapsation of in-the-money death benefits, for example, or in-the-money guarantees, living benefits and death benefits. We think it's very low. It's in the couple percent range; but even that somewhat surprises us from what we would expect. But we think that's, again, driven by economic conditions. Where, if you have the wherewithal to wait it out, you're going to wait it out and take a look at that as an added benefit or guarantee that you would expect to capitalize on in the future.

But if you are in need of cash and capital now, we have people just as they tap their defined contribution plan unwisely, they're also needing to tap their annuities at times for cash flow. We think that's in part what's driving it.

So, overall we are comfortable with it, but, yes, to your point, we dynamically stress the lapse rates, just as you pointed out.

Okay. And just to clarify, when you are giving -- you are commenting on lapses, do you have the ability to distinguish between actual policy lapses and systematic withdrawals under your withdrawal benefit program?

Yes.

Okay. Thank you.

Suneet Kamath, Sanford Bernstein.

In the interest of time, I'll just do one quick one. I wanted to go back to the goodwill issue, which is one that keeps coming up in my conversations with folks. If I go through your 10-Q and your 10-K, and I think about some of the triggers around goodwill, one of them is actually the valuation of Lincoln's stock. And as I think about where your stock has been valued, I think you've been below book value now since September of 2008, something like that. Just wondering, as you think about testing your goodwill, to the extent that the stock remains below book value, it's not a projection, just a scenario, at what point does that factor, at what point does that trigger a goodwill impairment? Thanks.

Yes, you know, it's interesting. The SEC guidance on this, providing their point of view, for example, has been that this should be a factor; that's certainly contemplated, discussed, defended, if necessary, as part of thinking about the prospects of goodwill impairment. But they've also been careful to say stock prices move around in very volatile markets and may not be a longer-term indication of impairment to the business, so be careful in your views on that.

And, I think that's a good, rational statement. For example, just in the second quarter alone, we saw a period of time where the stock was trading up in the low 30's, and if you add a control premium to that, which any company would expect, you are all of a sudden at book value.

And it's really hard to kind of take a look at your stock price at any moment in time and render a long-term judgment about the valuation of your business.

It is true though, I would say, that if your stock price remains below book for a persistent period of time, what that will typically do is trigger the need to go ahead and do just what you are saying, which is a further analysis of your business, including outright appraisals.

In fact, we did do that back not this past year end, but previous year end, brought in, for example, I believe it was [Milliman], to assist management, and of course, working with our auditors on outright doing a full-fledged appraisal of our Life business, including stressing all of the mechanics associated with goodwill impairment on that business. And of course, we came out of that analysis feeling as if certainly the business and its franchise was every bit worth what was stated on our books. So, we will take it another step.

And part of what pushes you into that additional step is in fact your share price remaining low. But I would be very careful about that sort of marked to market environment as opposed to the long-term appraisal of the cash flows involved. And you also have to be very mindful of the mechanics of what's driving your stock price up and down, and whether or not that in fact relates to the long-term valuation you think you are driving in your business.

Got it. Makes sense. And can you just confirm, do you test the goodwill every single quarter? Or is this a once a year type of methodology? Thanks.

Yes; you know, what we do, and it's really proscribed, is we, no matter what, once a year, go through a goodwill testing and analysis process across all of our businesses, any business that has a goodwill asset associated with it. But also under the accounting rules, which we obviously agree with, is you need to take a deep dive if there is an event or something that's taken place that really acutely affects one of your businesses, whether or not it's on or off cycle. We typically, in the October time frame, start into a full-fledged review of goodwill across all of our businesses, somewhat in time for the annual audit process. But again, if we are traveling through a second quarter or a first quarter or a third quarter and we see something that has really acutely affected the business and its franchise, then we may be forced into looking at the valuation more specifically. A good example of that with Lincoln has been the media businesses over the last few years. It hasn't always followed a cycle. Sometimes we simply see things go on and we've got to take action.

Got it. Thank you.

Mr. Sjoreen, you may go ahead.

Thank you. And we want to thank everybody for joining us this morning. Unfortunately, we weren't able to get to everybody in the queue, but we will be happy to take your calls at 1-800-237-2920. And we will be around all afternoon. Thanks and have a great day.

Ladies and gentlemen, this does conclude today's conference. Thank you for your participation, and have a wonderful day. You may all disconnect.