Lincoln National (LNC) Q3 2017 Earnings Conference Call Transcript

  • Earnings
  • 03/11/2017
Lincoln National (LNC) Q3 2017 Earnings Conference Call Transcript
Good morning and thank you for joining Lincoln Financial Group's Third Quarter 2017 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 be given at that time. If you need assistance at any time during the call, please press * followed by the zero and someone will assist you. Now I'd like to turn the conference over to the Senior Vice President of Investor Relations, Chris Giovanni. Please go ahead.

Thank you, Crystal. 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 sales and deposits, expenses, income from operations, share repurchases and liquidity and capital resources 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 and 10-Q filed with the SEC. We appreciate your participation today and invite you to visit Lincoln's website,, 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 measure. Before beginning, I would like to also remind you that we will be hosting our Investor Day on November 16 at Lincoln Financial Field in Philadelphia.

I trust you received our invitation, and we hope most of you will be able to attend. Presenting on today's call are Dennis Glass, President and Chief Executive Officer; and Randy Freitag, Chief Financial Officer. After their prepared remarks, we will move to the question-and-answer portion of the call. I would now like to turn the call over to Dennis.

Thank you, Chris. Good morning, everyone. 2017 continues to be an outstanding year as third-quarter operating earnings and earnings per share were a record. Operating EPS increased 7% compared to the prior year and marked the first time quarterly EPS has exceeded $2 per share.

Book value per share increased 8% and ROE was 13.6%. As you know, during the quarter, we also completed our comprehensive annual assumption review, which had a small impact on our financials. Randy will provide you more detail in his remarks. This quarter's strong earnings were broad-based, as all four businesses posted high-quality results.

Group Protection and Life Insurance had strong underwriting results, while Annuity and Retirement Plan Services benefited from record account values. Variable investment income, which has been higher than expected in recent quarters, returned to more historical levels, further highlighting the underlying strength of earnings. These excellent results are supported by solid execution of strategies we implemented a few years back to further diversify our sales mix and source of earnings. This diversification provides stability during periods of capital market uncertainty, while still enabling us to capitalize on significant long-term growth opportunities and capital market tailwinds.

One can measure the success we're having with these strategies as the contribution for mortality and morbidity sources of earnings has increased a couple of percentage points year-to-date. The impact of low-interest rates on spread-based business continues to abate, and earnings-related to fees on AUM are benefiting from the strength in equity markets. The complementary nature of our businesses and source of earnings also enable us to consistently generate a significant amount of free cash flow supporting active capital management, which includes $264 million returned to shareholders in the quarter. Additionally, last night, we announced a 14% increase in the common stock dividend.

We will continue to look for opportunities to leverage the strength of the balance sheet and our steady capital generation. Now turning to our business segments, starting with Annuities. Results were strong as earnings are benefiting from our high-quality and predictable in-force business, combined with equity market tailwinds. Let me remind you, for years, we have demonstrated our annuity book of business is one of the best in the industry, highlighted by returns in excess of 20% and extremely favorable risk metrics.

Shifting to sales. We remain encouraged about our ability to grow. Variable annuity sales increased modestly compared to the prior year and mark the first year-over-year growth in over three years. Compared to the second quarter, sales decreased slightly, consistent with historical seasonality.

However, sales picked up post summer and continued to be quite strong in October. Product expansion is a key focus for the Annuity business, and we now have the broadest portfolio of customer solutions we have ever had. This has resulted in market share gains over the course of the year, as we are benefiting from products that provide more investment choice and flexibility, along with fee-based compensation options. To these points, Max six Select, a living benefit rider we introduced late in the second quarter, has added nearly $50 million to sales and is continuing to gain traction, while fee-based sales totaled $79 million in the quarter, nearly matching all of 2016.

VA sales without living benefits increased 23% year-over-year as the value propositions for tax deferral and legacy planning continue to resonate with consumers. Fixed annuity sales increased 2% sequentially through improved competitive positioning and distribution reach due in part to reinsurance arrangement with Athene. These benefits more than offset the effect of low-interest rates throughout most of the quarter. So a strong quarter for the Annuity business, and I am encouraged by year-over-year growth in VA sales and solid momentum in the past couple of months.

We clearly have more work to do to get back to positive net flows, but we remain confident in our ability to further build sales in the near term. Longer term, the value proposition of guaranteed lifetime income remains extremely important and investable retirement assets are projected to grow considerably, creating significant opportunities for the annuity marketplace. In Retirement Plan Services, the strategy and franchise continue to drive top and bottom line growth. Total deposits in the quarter of $1.9 billion were up 6% from a year ago, driven by first-year sales increasing 11% to $672 million as both small and mid- to large markets delivered strong results while recurring deposits increased 4%.

Net flows totaled $450 million compared to $97 million in the prior-year quarter. Over the past 12 months, flows have exceeded $1.3 billion, a record for the retirement business. Positive net flows for seven straight quarters are being driven by momentum in all three components of flows. First, sales are benefiting from the combination of a more productive wholesaling force and improved competitiveness in the marketplace, a result of product enhancement and digital innovations.

Next, employee contributions have shown steady growth as our high-touch, high-tech model is providing an improved customer experience, that is resulting in more employees participating and higher contribution rates. Lastly, retention remains strong as our expanded client-facing teams continue to drive better participant outcomes. Bottom line, I am as optimistic as I have ever been about the RPS business because of strong execution and competitive positioning in the marketplace with product and distribution. Turning to Life Insurance.

Earnings decreased from the impact of our annual assumption review and lower variable investment income, while driver growth remained strong. Total Life Insurance sales in the quarter of $178 million were down 8%, as the prior year benefited from strong sales ahead of pricing adjustments on the interest rate-sensitive products. To this point, GUL sales were down 63% in the quarter. Excluding GUL, total life sales were largely unchanged.

With the pricing changes, returns on new business actually exceeded our 12% to 15% targeted returns. For the full year, sales have increased 10% with the same strong returns as we're benefiting from a broad product portfolio and industry-leading distribution. MoneyGuard sales were solid, up 16% this quarter and returned to levels more consistent with prior periods after sales accelerated in the second quarter ahead of pricing adjustments. On term insurance, sales were near last year's record quarter and policy count increased 7% as we leverage digital technology to expand distribution and reach a new customer base through TermAccel, which targets a younger demographic.

We continue to focus on sales diversification, risk management, growth and appropriate returns on capital. With new business returns above the top end of our targeted range, a well-diversified product portfolio, and a more favorable macro backdrop, we see opportunities to improve our competitive position while maintaining target returns. Bottom line, the life business is well positioned in the marketplace. Turning to Group Protections.

Earnings increased significantly over the prior year, driven by favorable loss ratios. Premiums grew 3% in the quarter as sales and persistency continued to improve. During the quarter, sales increased 21% as all product lines in both employer and employee-paid sales grew. Year-to-date, sales had increased 15%, and we have good momentum entering the fourth quarter, which is historically our largest production quarter, as the pipeline and quote activity are strong in our target markets.

We are also encouraged by persistency trends, which are up four percentage points compared to prior year, driven by stronger renewal trends in core life and disability products. As you know, we established a target of achieving 5% to 7% margins in 2018. Given results year-to-date, we now expect we will reach the target this year. While volatility is expected quarter-to-quarter, the focus is now on sustaining and improving margins, over time.

The strong, positive momentum in group results over the last several quarters validates our continuing strategic investment in this business, which offers very good growth and earning diversification opportunities for Lincoln. Shifting to investment results. The alternative investment portfolio achieved an 11% pre-tax annualized return with solid results from both the private equity and hedge fund portfolios. During the quarter, we invested new money at an average yield of 4% compared to 4.1% in the second quarter.

The decline is primarily driven by tighter spreads and increased purchases of shorter-duration investments, which match our liabilities and reflects Lincoln's tilt away from products with long-term guarantees. The fixed income portfolio yield declined three basis points to 4.73%, consistent with expectations. Overall, the investment portfolio remains in extremely good shape, high quality and broadly diversified. Below investment-grade assets represent only 4% of the fixed income portfolio, down 1 percentage point from the prior year quarter, largely due to maturities.

So in closing, I'm very pleased with results year-to-date, including this quarter's record earnings. As I look forward, I remain confident that our strategic objectives and initiatives will drive long-term sustainable growth. As you know, and Chris mentioned, on November 16, we'll be holding our Investment -- Investor Day, and we look forward to providing you, even more, insight into our business and the key drivers that will enable us to sustain our strong track record of financial success and stability. With that, let me turn the call over to Randy.

Thank you, Dennis. Last night, we reported income from operations of $454 million or $2.03 per share for the third quarter. Excluding notable items, EPS increased 6% year-over-year. As we noted in the earnings release, the current quarter benefited $0.09 from tax adjustments.

This year's annual review of DAC and reserve assumptions had a series of pluses and minuses that netted to a negative $0.01 impact to EPS. Separate from the annual review, the Group Protection business benefited $0.01 from a reinsurance recapture. A few comments on the outcome of this year's review. Annuity earnings benefited $15 million, primarily from favorable policyholder behavior assumptions.

Earnings in the Life Insurance business were negatively affected by $16 million, with no one item standing out. It is also worth noting that we did not change our long-term earned rate assumption or unlock the reversion to the mean quarter, which still provides a cushion against declines in the equity markets. So the bottom line with the annual DAC and reserve review is that when viewed in total, the assumptions underlying our balance sheet continue to be sound. One other item of note before shifting to key performance metrics.

As Dennis noted, variable investment income returned to more normal levels, coming in $4 million or $0.02 per share ahead of our expectations. This compares to $18 million or $0.08 per share last year. Moving to the performance of key financial metrics. Book value per share, excluding AOCI, grew 8% to over $61, an all-time high.

Normalized ROE was strong at 13% and the year-to-date ROE of 12.6% is 60 basis points above 2016. Consolidated net flows were positive and end-of-period account values reached a record $246 billion. Balance sheet strength and solid capital generation enabled us to return $264 million to shareholders in the quarter. Lastly, net income of $418 million further highlights the strength of the quarter, as MPR, which is noneconomic, had the largest below-the-line impact.

Year-to-date net income represents 96% of operating earnings. Now we'll turn to segment results, starting with Annuities. Reported earnings for the quarter were $277 million, up 5% from last year when excluding notable items in both periods. Net favorable items this quarter included the $15 million I noted up front.

Earnings growth was driven by higher fee income from a 6% increase in average account values, as equity markets strength over the past year has more than offset negative net flows. The quality of our variable annuity book can be seen by looking at return metrics and net amount at risk. Normalized returns remained strong as ROE came in at 21%, while ROA was 79 basis points, both consistent with recent quarters. Net amount at risky improved to less than 0.6% of account value for both living and death benefits.

So minimal financial impacts from assumption changes, a superior risk profile of net amount at risk well below competitors and strong and consistent returns continue to differentiate us in the marketplace and highlight our prudent and disciplined approach to the annuity business. In Retirement Plan Services, we reported earnings of $35 million compared to $32 million in the prior-year quarter. Both periods included modest impacts from our annual assumption review. Excluding these items, earnings increased 6%, primarily due to growth in fee income from higher account values and expense management.

Positive net flows of $1.3 billion over the trailing 12 months, combined with favorable equity markets, drove average account values to $64 billion, a 13% increase. Revenues increased 3%, while G&A expenses, net of amounts capitalized were flat year-over-year. Base spreads, excluding variable investment income, compressed 13 basis points year-to-date compared to last year, consistent with expectations. For the quarter, ROA was 23 basis points, excluding notable items, in line with recent quarters.

The retirement business continues to deliver solid growth in deposits, net flows, and assets. And combined with good expense discipline, RPS is well positioned for future earnings growth. Turning to the Life Insurance segment. Earnings of $121 million included net unfavorable items of $16 million related to our annual review.

Excluding notable items, earnings decreased 9% as the prior year quarter benefited from strong variable investment income. Mortality experience was favorable, consistent with typical third quarter seasonality. Earnings drivers remained solid in the quarter, with Life Insurance in-force up 4% and average account values up 6%. Base spreads, excluding variable investment income, compressed 8 basis points year-to-date compared to last year, in line with expectations.

So a solid quarter for the Life business as mortality was right in line with expectations, and the financial impacts from the annual assumption review were modest. Strong sales results year-to-date and steady driver growth continue to support earnings momentum. Group Protection reported $41 million in earnings compared to $28 million in the prior-year quarter. The significant increase in earnings was primarily due to favorable risk experience.

A $3 million benefit from the recapture of previously reinsured business was included in the quarter's results. The prior year quarter included net favorable items of $5 million, primarily from a disability reserve refinement. The strong risk results experienced in the second quarter carried into the third quarter. The nonmedical loss ratio was 63.7% in the quarter, a 650 basis point improvement from the prior year, excluding the disability reserve refinement.

Favorable disability and group life incidents rates, combined with lower new claim severity, remain the primary drivers of favorable loss ratios. While we wouldn't expect loss ratios to consistently be this strong, results clearly reflect underwriting discipline, coupled with positive external economic factors. Premium growth is also aiding the group business as premiums increased 3% from the prior year quarter, with leading indicators, such as sales and persistency, trending in a positive direction. Bottom line, it was another very strong quarter for group, with year-to-date margins now exceeding the lower end of our 5% to 7% target range.

While volatility is expected quarter-to-quarter, we now expect margins to be consistently within our target range on a year-to-year basis, with gradual improvement over time. Before moving to Q&A, let me comment on a few other items of note. First, on capital. Both capital and capital generation remained strong, providing significant financial flexibility and an ability to commit capital to drive long-term earnings growth and also return capital to shareholders.

As I noted up front, this quarter, we returned $264 million, including $200 million others in share repurchases, with the remainder through shareholder dividends. We expect to remain active allocators of capital. An example of this can be seen by the announcement of a 14% increase in our shareholder dividend, which is consistent with our strong earnings growth. As we have noted in the past, we anticipate growing and maintaining a competitive dividend.

Statutory surplus stands at over $9 billion and estimate the RBC ratio end of the quarter at approximately 495%. Holding company cash remains above our $500 million target. So to conclude, another excellent quarter for Lincoln. We reported record operating earnings and EPS, underwriting results in Group Protection and Life Insurance were strong, while Annuity and Retirement Plan Services benefited from record account values.

This year's annual review once again confirmed the quality of the assumptions underlying our balance sheet as there was almost no impact on our operating earnings. We grew book value per share by 8% as below-the-line impacts were modest and normalized ROE was 13%, which supports another year of ROE expansion. With that, let me turn the call back over to Chris.

Thank you, Dennis and Randy. We will now begin the question-and-answer portion of the call. [Operator Instructions] With that, let me turn it over to Crystal to begin Q&A.

Thank you. Ladies and gentlemen, if you have a question at this time, please press the * and then the number 1 key on your touchtone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. And we do ask for optimal sound quality, please use your handset instead of your speakerphone.

And again ladies and gentlemen, that's *1. And our first question comes from Erik Bass from Autonomous Research. Your line is open.

Hi, thank you. I just wanted to start with Group, and Randy, I heard you update on the guidance there. But certainly, Lincoln and the industry are seeing some favorable underwriting trends. And do you think that based on, I guess, the trends we're seeing in the economy and the rate increases you've put into your book the last few years, the benefits ratio is going to remain near the level that's been the past two quarters?

Erik, thanks for your question. As I mentioned in my notes, clearly, we believe we have achieved the goal that we set forth and expected to achieve next year, which is we expect to be, on a quarterly basis, between that 5% to 7% margin. What's driven that growth up to those targets has been driven primarily by the price increases, claims management improvement that was made over the year. But clearly, additionally, the economy, we believe, is having some impact.

Items like consumer confidence, which I believe is at a 17-year high, items like below unemployment rate, which is at 4.2% is clearly the lowest it's been in some time. Those items are clearly having some favorable impact. As you can see during the quarter, we ended up a little bit about our target range. So while we wouldn't expect to travel above our target range forever, I think those items could be in place for a little bit.

But who knows? I think it's a solid quarter. We would expect all the items that drove this quarter to be in place as we move forward, and we'll see what will come on, Erik. But thanks for your question.

Yes. Thanks. Yes. And then, some retirement, you're seeing, obviously, nice growth inflows and assets, and again, you've said some very positive comments on the business momentum.

Can you just comment where you see this business going over the next couple of years? And are we at a point where you sort of start seeing more positive operating leverage and margin expansion so that earnings sort of break out at the mid-$30 million range would have been in recent quarters?

As I said in my remarks, the business is as in good of a shape and our expectation is that continued improvement is very strong. So how that translates directly into earnings, we'll see over time. But the -- all the changes to management, the product improvements, the processes that we have, are driving these outcomes. So the real consumer value and substantive and something that will continue.

So yes, we're pretty optimistic.

Thank you. Our next question comes from Jimmy Bhullar from JPMorgan. Your line is open.

Good morning. I thought, overall your results are obviously pretty strong. The one area that surprised was indexed annuity sales, which were weak, especially given the reinsurance contract with Athene. So could you give us just some color on what drove that? Did you see disruption because of DOL rule? Or are there any other factors? And what your expectations are for that business?

The indexed annuity sales will go up and down in any particular period, so I don't think there's anything different about the month or different about our competitive position. And again, as we moved into the late summer and October, in particular, was a very strong quarter for all individual annuity sales, very strong month, excuse me, for all individual annuity sales. We continue to see positive momentum and are pretty confident that -- because of all the things that we've talked about, we'll regain sales momentum across product lines.

And then, Randy, could you give us the numbers or the assumptions -- the interest rate and separate account return assumptions that are embedded in your reserves and debt balances?

Sure, Jimmy. The -- if you look at a J curve, our interest rate assumption, as we have called it, as you know, over the past six years, we've lowered that assumption three different times, 50 basis points each time. As we sit here today, what underlies our assumption is a 10-year treasury rate of about 3.75%, a little below 3.75%, but right about 3.75%. So that underlies the ultimate earned rate, new money index that we're moving toward.

In terms of the separate account, I believe we are at about 7.3% these days from a separate account return standpoint.

And then, the 75% tenure, by why are you assuming you'll get there?

Within five -- the sort of trend toward that rate?

Yes, linearly over five years.

And then obviously, the separate account, a big component of that is the fixed income, so we should assume that the equity assumption embedded in the 7.3% is closer to 9-ish, or right?

Yes, I'm not going to get into the details. You can remember, I guess it was three years ago, we brought our separate account return assumption down and that was driven by a reduction, in our view, on what the equity markets were going to do in future years. As I also mentioned, Jimmy, we have outperformed this assumption, and that leaves us in a positive position from a corridor standpoint. Currently, that cushion in our corridor stands a little over $200 million in the annuity business.

Got it. Thank you.

Thank you. You-our next question comes from Suneet Kamath from Citi. Your line is open.

Thanks. Good morning. I wanted to follow up on Jimmy's question about Annuities. And as you comment about October being particularly strong, can you just provide a little more color in terms of what products are really driving that?

Suneet, it really is across the board in all products, both fixed and variable annuities. And it reflects what I said in my remarks, particularly on the VA side, all the changes that we've been talking about the last six months, broadening the consumer value proposition, reaching into product areas that previously we had not offered. So it's a -- it's an overall increase in all of the product lines. And just to put a number, October was actually the highest aggregate sales month we've seen since 2015.

Now let me hasten to say that 1 month does not create a new level. It's -- but it's the best month that we've had. And again, I'm going to come back, broadly based across all of our products and due to good distribution and effective wholesaling, all the things that separate us in the marketplace.

Got it. And then is it fair to say that maybe some of the uncertainty or pressure from DOL is starting to abate? Or is that going too far?

At one point, the qualified sales growth -- the growth sales were drifting away going from the nonqualified sales that seems to have now be more in lockstep -- so that would be an indication that some of the DOL affect our less important -- I think it was reported this morning that the DOL has applied with the OMB for this extension of the second implementation of rules not occur until June 30, 2019. So that would help as well and give us more opportunity in the industry to shape this final DOL ruling, shape it in the context of both what's good for American savers and, in particular -- and of course, we'll continue to emphasize, as we move forward in our discussions with the DOL, both choice of compensation for the consumer and what's in the best interest from a compensation perspective. And oftentimes, the answer to the best interest is actually commissions. So a lot to see happen over the next 18 months.

But to answer your question specifically, I think this pause, plus the business from June 9 is beginning to ease the impact of the DOL from a sales standpoint.

Great. And then, you didn't mention in your comments, but are we still -- are you still expecting positive flows in Annuities by 2018?

I think that's going to be a little harder to get to because of the -- some of this is just fact-based. With the increase in account balances, the amount of outflow is a little higher than we expected when we're talking about that number. So a little tougher to get there, certainly, in the early part of 2018, but everything we're talking about, both in terms of our product and our distribution as well as demand for particularly guaranteed lifetime income, is going to drive us to a positive net flow period, over time.

Thank you. Our next question comes from Tom Gallagher from Evercore ISI. Your line is open.

Good morning. We've heard from some other insurers about the cost of life reinsurance rising. To what degree are you all seeing that? And did that influence your actuarial review at all on the Life Insurance side? And also -- and just relatedly, is that an issue we should be thinking about being a negative for future margins?

Tom, discussions with reinsurers have been going on for four to five years now. In the case of Lincoln, outcomes of those discussions have ranged from a bigger capture, like we did at the end of 2014 for a payment, to sometimes modest increases in rates we're paying for reinsurance. All those discussions that we've had over the past four to five years are embedded in our balance sheets and our income statements. And our expectations for any future discussions that we may have are also embedded in our assumptions, so they're in our balance sheet and our income statements.

So I feel really good about where we are from an assumption standpoint. That doesn't mean that actual outcomes couldn't differ from assumptions, but I think we've managed through this situation over the past years, and I expect us to continue to do that as we move forward.

Got it. Thank you. Thanks, Randy. So nothing like new, when you think about repricing of current contracts or coverage you have in place.

There's nothing new that's like meaningful, where you would see that as a new development?

No, I don't think there are any new developments. This has been going on, like I said, for four to five years and I think it will continue into the future for a little bit.

Got you. And then question on the reinsurance contract with Athene. If we do get corporate tax reform and corporate tax rate lowered to 20%, does that deal still make sense for you? Do you get enough of a benefit where it's positive IRR versus your cost of capital?

Tom, the -- let me talk about tax reform in general for the moment, and remind all of us, I guess, blindly obvious, which is that we're in the early stages of tax reform and it is going to change as it moves forward through the legislative process. So with this in mind, I just have made a couple of industry comments. The first one is that the industry already pays a little bit more than it earns as a percent of corporate profit. So roughly speaking, for Life Insurance industry, share of all U.S.

corporate profits is like 1.8%, yet our share of corporate income tax is more in the neighborhood of 2.2% or 2.3%. So going into all of this legislative process, we're pretty well positioned in not being at an undertaxed industry. I'll also say that the industry view is that if there is any reduction in expenses or tax items that sort of go along with rate reductions, our industry view for our industry is they should be spread across the major areas rather than a single item, so no business model is disproportionately helped or hurt. And so there's so much change that's going on -- or excuse me, so much potential for different outcomes that I think we should just wait until we have a little more confidence before commenting on any specific issue related to tax.

Thank you. Our next question comes from Alex Scott from Goldman Sachs. You line is open.

Hey, good morning. Thanks for taking the question. Just following up on Tom's question on reinsurance costs. Yes, I hear you on the impact of the balance sheet.

Would that extend to the intangible piece of the balance sheet? So like, would goodwill related to Life Insurance be impacted at all?

Yes, Alex. When you hear me say something like balance sheet, I didn't qualify that in any way. I mean, the entirety of our balance sheet. So embedded in -- our actual results over the past four years have been the impact of anything we've done with reinsurers, and we have assumptions for what may happen to reinsurance rates embedded in our assumptions going forward.

And that impacts the entirety of our balance sheet and our income statement.

Okay, all right, thanks. And I guess a couple of your peers have made tweaks to the CTE-95 levels that they're sort of managing to. So I was just interested if you guys made any adjustments and just an update on sort of where you stand relative to your CTE targeted level?

Okay, thanks for the question. Alex, yes, thanks for the question. So we price for and capitalize our annuity business, our variable annuity business using a -- what I call a greater of approach. It's the greater of CTE-98 and a percent of account value.

We use CTE-98 because I think that you really need to move deep into the tails to understand the risk profile on this business. So I don't necessarily believe that CTE-95 is deep enough into the tail for the true profile of this business to emerge. And we use the greater of approach bringing in the percentage of account values because this business is one of those ones that can be countercyclical as the account values and as the risk comes out of the business, you keep sucking capital out of it. Right before the capital markets decide to move against you, and then you need to shove capital back into it.

So I think that greater of approach, along with the deep in the tail CTE-98 measure is what is prudent approach to running this business, and that's what we do. It hasn't changed at all, Alex.

Got it. Okay. So no changes there. And so should I interpret that as you feel pretty good about where you're at relative to what the NAIC is doing and sort of some of the stuff that's come out of the quantitative impact study?

Yes, look, I feel great about our annuity business. I feel great about the products we've issued, feel great about the risk profile, feel great about how we capitalize it. Separate from that, there's a lot of work going on with the NAIC and all of our alignment around potentially changing how we reserve for these products going forward. I think that work is moving along nicely.

We're active participants. I think that in general, as I've said before, the approach the NAIC is taking, which is to make statutory reserves more economic in nature is a good thing. It reflects how we reserve for these products and capitalize these products on a GAAP basis. So I think that's a good thing.

That doesn't mean there aren't some bad parts about where they end up, but in total, it's a good thing for the industry, it's a good thing for Lincoln. We're participating and we're very happy with the way it's moving along.

All right, thank you.

Thank you. Our next question comes from Bob Glasspiegel from Janney. Your line is open.

Good morning, Lincoln. And congrats on the quarter. Just a quick question, pushing Tom's question in a different area. The Republican proposal is coming out, I guess, in the next hour, and I guess it's going to double your state tax and eliminate it in five years.

How sensitive would Life sales be to doubling of the state tax? Last time around, what did it do to production?

Bob, a couple of comments on that. I haven't seen those. When you say double the state tax, I'm not sure what that means, but...

You said that 5.6% and 11.2% double immediately to 11.2% and 22.4%?

Yes, that's not -- I'll have to understand that because the effective tax rate after the $10 billion individual -- $10 million individual exclusion is up in the 40s, so I'm not familiar with that. I'll look at it. But let me answer the question to the extent that I think about the state tax and Lincoln. Only about 10% to 12% of our sales are estate tax-driven at this point.

And so any changes in the estate tax that require more planning or less planning is not, on the negative side, going to hurt us too much and if it requires more planning, that would help. And I'd also point out from life sales, the most important issue, I think -- maybe not most important, but an important issue is this $10 million individual joint exclusion really eliminates estate taxes on a large amount of the American families. However, if that $10 million was to go away, then you have taxes on the step-up in basis. And that could actually provide an opportunity for life sales.

So a lot of moving parts, a lot of different outcomes. So let's just see where it goes. But again, I'll come back to, at this moment in time, we don't have significant sales related to estate tax planning. Well, $10 million...

That's helpful. That's helpful, Dennis. The Journal article does say that the step-up in basis did remain at the last minute, that was a surprise. But obviously, whatever they propose isn't going to be what happens.

Yes, we all know that, so let's just -- let's all keep watching it and, of course, Lincoln will be participating through the -- excuse me, the ACLI and trying to shape good tax policy for America and good tax policy for the Life Insurance industry as we move through this process.

Thank you. Our next question comes from Ryan Krueger from KBQ. Your line is open

Hi, thanks. Good morning. Just first, Randy, could you just remind us of the typical seasonal pattern of mortality that you'd expect in the Life Insurance business, I guess, particularly this thing about the fourth quarter and how that usually compares to your kind of baseline assumption?

Yes, Ryan. The first quarter of the year is typically seasonally high. I would say, somewhere between 8% and 10% above the average quarter. And then you get that back over the last two quarters of the year, pretty much evenly, so somewhere between 94% and 95% of an average quarter in the third and fourth quarter of the year.

That's what we've historically seen, and that's -- pretty specific, each company is based upon your mix of business.

Thanks. And then, we've seen a number of your peers take modeling-related charges in their SGUL blocks as they move to an individual policy modeling system. You obviously haven't seen that. Can you just give us an update on kind of how your approach has been at this point for modeling purposes?

Well, Ryan, I think we have a highly sophisticated approach to both valuing all of our business, including SGUL policies both from a reserve standpoint and a DAC standpoint. So I don't know what to tell you beyond that. We've had good experience on SGUL in terms of the assumptions playing out like we thought they would. The outside of the interest rates, obviously, we've talked about that, but in terms of policy or the behavior and things like lapse rates, how people pay premiums, I think we've had really good experience, any changes we've reflected in the model.

So we have a very sophisticated valuation system that projects these policies on a policy basis, and we feel good about where we are.

Okay, that's what I thought. Thanks .

Thank you. Our next question comes from Humphrey Lee from Dowling and partners. Your line is open.

Good morning and thank you for taking my question. Looking at Group Protection, I was just wondering, is there any pricing differences between how you kind of set your pricing for employee-paid versus employer-paid? In other words, do you target any different loss ratio between the two categories?

I think, in general, we see better margins not coming from any one particular part of pricing on the employee-paid than we do on the employer-paid side. And I think you'd have to peel back the onion on that because certain products, such as critical illness or accident, which is included in employee-paid, require different margins than sort of the core life business does. So yes, there are differences driven by the product mix.

Okay. Yes, I guess what I was trying to get to is, obviously, the loss ratios have increased good -- favorable in the past couple of quarters. And obviously, there's some favorable underwriting happening. But I was just trying to see how much of an impact is coming from the mix shift.

Yes, I don't think there's any difference in our expectations relative to the aggregate numbers inside your question.

Okay, got it. And then in terms of the annuity sales, you talked about some of the recent refinements or product launches have been seeing good momentum. But I think at the same time, there's also greater competition from your competitors launching similar fee-based products, enhancing their product suites. Can you talk about, in general, how the competitive environment in terms of VA product offering are we talking -- any potential risk to getting back into an arms race again?

My answer on that is no. I don't see us, the industry, getting back into an arms race. That doesn't mean that any particular competitor might not be emphasizing a product for a particular reason and intentionally make it more competitive than maybe the industry. But I just think it's a reasonably logical market from a pricing standpoint right now.

And most of our share increase, as I mentioned in the opening remarks, is not just their results or our historical products, but the addition of new products that have more investment flexibility. So we have an opportunity to improve sales across a broader portfolio than we have had ever in the past. And so that's how we're trying to increase sales as opposed to increasing sales on the basis of price.

Thank you. Our next question comes from John Barnett she from Sandler O'Neill. Your line is open. And It looks like they have disconnected.

Our next question will come from Randy Binner from FBR.

Thanks. Good morning. I had a question, and it's going to get to the like the spread guidance and Annuities and Retirement. And just looking at our model, the interest credited has been managed very effectively in both of those areas.

And so I guess my question is, is there -- how much more can you push that? And how -- is there kind of a stopping point where you kind of run out of room to kind of push the liability costs in both of those segments?

Thanks, Randy. I think your question was specific to Annuities and Retirement, and the answer is different for those. In the Annuity business, we feel very comfortable in our ability to manage credit rates consistent with changes in earned rates. A significant percentage of our policy still have room between current credit and rate in the guarantee.

So we feel very comfortable, and you've seen that over the last few quarters. On the retirement business, and this has been the case for some time now, our rates are pretty close to the guarantees. And so as the credit of rate movement's down, you've seen more of a function of the fact that the new business we've been bringing on comes on at a lower rate as opposed to us managing in-force credits rates. And that's why in that business, we expect over the near term, annual spread compression in the 10 to 15 basis point range.

As I mentioned, year-to-date, we've worked down 13 basis points in the Retirement business. So the answer is different for those two businesses.

But 10 to 15 would be the expectation for '18 and '19, all things being equal, is that -- in retirement?

I mean, we typically don't talk out a few years. But yes, that's what we've been saying is 10 to 15 basis point is our current expectation, and that's what we've been experiencing recently.

That's all I have. Thanks.

You bet. And I'll just jump up in on that. And when we get to the IRB, we're going to have some very, by business line, a demonstration of where there's earning headwinds and where there's earning growth opportunities. And so just to front-run that a little bit, in the RPS, there's a little more headwinds from spread compression, but much of that will be offset by expense management.

So I really encourage people to come to the IRB or check in somehow because we'll have a lot of good information around strategy and earnings around each business and what the important opportunities or challenges are.

Yes, well OK. So, I guess, I'd say what drives those expense initiatives? Is that the money you're spending for that strategic digitalization initiative? Or is it other kinds of changes you can make to the expense structure?

In RPS, it's a combination of digitization and lowering expenses that way. But we also have a very major sort of, aside from that initiative, a very major reengineering process going on. So it's a combination of those two things that will drive our expenses down and over time. And again, we'll get into that in the IRB, those kind of details for each of the business lines.

All right. Thank you.

Thank you. And I'm showing no further questions from our phone lines. I would now like to turn the conference back over to Chris Giovanni for any closing remarks.

Great. Thanks so much, Crystal. And thank you all for joining us. As Dennis mentioned, hopefully, we'll be able to see a lot of you on November 16 and as always, we will take your questions on our Investor Relations line at (800) 237-2920 or via email at

Thank you, and have a good day.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Please have a wonderful day.

This article is a transcript of this conference call produced for The Motley Fool. While we strive for our Foolish Best, there may be errors, omissions, or inaccuracies in this transcript. As with all our articles, The Motley Fool does not assume any responsibility for your use of this content, and we strongly encourage you to do your own research, including listening to the call yourself and reading the company's SEC filings. Please see our Terms and Conditions for additional details, including our Obligatory Capitalized Disclaimers of Liability.

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