Lincoln National Corporation--Form 10-K
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20549

 


FORM 10-K

 


(Mark One)

x Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2006

 

¨ Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from              to             .

Commission File Number 1-6028

 


LINCOLN NATIONAL CORPORATION

(Exact name of registrant as specified in its charter)

 


 

Indiana   35-1140070

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

 

1500 Market Street, Suite 3900, Philadelphia, Pennsylvania   19102-2112
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code: (215) 448-1400

 


Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class

 

Name of each exchange on which registered

Common Stock   New York and Chicago
$3.00 Cumulative Convertible Preferred Stock, Series A   New York and Chicago
6.75% Capital Securities   New York
6.75% Trust Preferred Securities, Series F*   New York

* Issued by Lincoln National Capital VI. Payments of distributions and payments on liquidation or redemption are guaranteed by Lincoln National Corporation.

Securities registered pursuant to Section 12(g) of the Act: None

 


Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  x    No  ¨

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer in Rule 12b-2 of the Exchange Act. (Check one) Large accelerated filer  x    Accelerated filer  ¨    Non-accelerated filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) Yes  ¨    No  x

The aggregate market value of the shares of the registrant’s common stock held by non-affiliates (based upon the closing price of these shares on the New York Stock Exchange) as of the last business day of the registrant’s most recently completed second fiscal quarter was $15.8 billion.

As of February 23, 2007, 276,809,426 shares of common stock of the registrant were outstanding.

Documents Incorporated by Reference:

Selected portions of the Proxy Statement for the Annual Meeting of Shareholders, scheduled for May 10, 2007 have been incorporated by reference into Part III of this Form 10-K.

 



Table of Contents

Lincoln National Corporation

Table of Contents

 

Item         Page
PART I
1.   

Business

   1
  

Overview

   1
  

Business Segments and Other Operations:

  
  

Individual Markets – Annuities

   3
  

Individual Markets – Life Insurance

   7
  

Employer Markets – Retirement Products

   11
  

Employer Markets – Group Protection

   12
  

Investment Management

   14
  

Lincoln UK

   16
  

Lincoln Financial Media

   17
  

Other Operations

   18
  

Reinsurance

   19
  

Reserves

   20
  

Investments

   20
  

Ratings

   20
  

Regulatory

   22
  

Employees

   26
  

Available Information

   26
1A.   

Risk Factors

   26
1B.   

Unresolved Staff Comments

   33
2.   

Properties

   33
3.   

Legal Proceedings

   33
4.   

Submission of Matters to a Vote of Security Holders

   34
  

Executive Officers of Registrant

   34
PART II
5.   

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   36
6.   

Selected Financial Data

   37
7.   

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   38
  

Forward-Looking Statements—Cautionary Language

   38
  

Introduction

   40
  

Executive Summary

   40
  

Recent Developments

   42
  

Critical Accounting Policies

   42
  

Equity Market Guidance

   50
  

Results of Consolidated Operations

   51
  

Results of Operations by Segment

   55
  

Individual Markets – Annuities

   55
  

Individual Markets – Life Insurance

   62
  

Employer Markets – Retirement Products

   67
  

Employer Markets – Group Protection

   75

 

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Item

        Page
  

Results of Operations by Segment - continued

  
  

Investment Management

   77
  

Lincoln UK

   80
  

Lincoln Financial Media

   83
  

Other Operations

   84
  

Consolidated Investments

   86
  

Reinsurance

   95
  

Review of Consolidated Financial Condition

   97
  

Liquidity and Capital Resources

   97
  

Shareholders’ Equity

   104
  

Other Matters

   104
  

Other Factors Affecting Our Business

   104
  

Recent Accounting Pronouncements

   104
  

Acquisitions and Divestitures

   104
  

Restructuring Activities

   104

7A.

  

Quantitative and Qualitative Disclosures About Market Risk

   106

8.

  

Financial Statements and Supplementary Data

   114

9.

  

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

   184

9A.

  

Controls and Procedures

   184

9B.

  

Other Information

   185
PART III

10.

  

Directors and Executive Officers of the Registrant

   186

11.

  

Executive Compensation

   186

12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   186

13.

  

Certain Relationships and Related Transactions

   187

14.

  

Principal Accountant Fees and Services

   187
PART IV

15.

  

Exhibits and Financial Statement Schedules

   188
  

Signatures

   189
  

Index to Financial Statement Schedules

   FS-1
  

Index to Exhibits

   E-1

 

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PART I

The “Business” section and other parts of this Form 10-K contain forward-looking statements that involve inherent risks and uncertainties. Statements that are not historical facts, including statements about our beliefs and expectations, and containing words such as “believes,” “estimates,” “anticipates,” “expects” or similar words are forward-looking statements. Our actual results may differ materially from the projected results discussed in the forward-looking statements. Factors that could cause such differences include, but are not limited to, those discussed in “Item 1A—Risk Factors” and in the “Cautionary Statements” in “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations” (“MD&A”).

Item 1. Business

OVERVIEW

Lincoln National Corporation (“LNC” which also may be referred to as “we”, “our” or “us”) is a holding company, which operates multiple insurance and investment management businesses as well as broadcasting and sports programming business through subsidiary companies. Through our business segments, we sell a wide range of wealth protection, accumulation and retirement income products and solutions. These products include institutional and/or retail fixed and indexed annuities, variable annuities, universal life insurance, variable universal life insurance, term life insurance, mutual funds and managed accounts. LNC was organized under the laws of the state of Indiana in 1968, and maintains its principal executive offices in Philadelphia, Pennsylvania. “Lincoln Financial Group” is the marketing name for LNC and its subsidiary companies. At December 31, 2006, LNC had consolidated assets of $178.5 billion and consolidated shareholders’ equity of $12.2 billion.

On April 3, 2006, Jefferson-Pilot Corporation, a financial services and broadcasting holding company, merged with and into one of our wholly owned subsidiaries. As a result of the merger with Jefferson-Pilot, we provide products and services in five operating businesses and report results through seven business segments, as follows:

(1) Individual Markets, which includes the Individual Annuities and Individual Life Insurance segments,

(2) Employer Markets, which includes the Retirement Products and Group Protection segments,

(3) Investment Management, which is an operating business and segment,

(4) Lincoln UK, which is an operating business and segment, and

(5) Lincoln Financial Media, which is an operating business and segment.

We also have “Other Operations,” which includes the financial data for operations that are not directly related to the business segments, unallocated corporate items (such as investment income on investments related to the amount of statutory surplus in our insurance subsidiaries that is not allocated to our business units and other corporate investments, interest expense on short-term and long-term borrowings, and certain expenses, including restructuring and merger-related expenses) and the historical results of the former reinsurance segment, which was sold to Swiss Re Life & Health America Inc. (“Swiss Re”) in the fourth quarter of 2001, along with the ongoing amortization of deferred gain on the indemnity reinsurance portion of the transaction with Swiss Re.

Prior to our merger with Jefferson-Pilot, we had four business segments: 1) Lincoln Retirement, 2) Life Insurance, 3) Investment Management and 4) Lincoln UK. We also had an “Other Operations” category that included the financial data for the operations of Lincoln Financial Network (“LFN”) and Lincoln Financial Distributors (“LFD”), our retail and wholesale distributors, and for operations that were not directly related to the business segments, unallocated corporate items (such as corporate investment income, interest expense on short-term and long-term borrowings and other expenses), and the historical results of the former reinsurance segment, which was sold to Swiss Re, along with the ongoing amortization of deferred gain on the indemnity reinsurance portion of the transaction with Swiss Re.

LFD distributes our individual products and services primarily through brokers, planners, agents and other intermediaries. Lincoln’s Employer Markets group and retirement sales specialists distribute our employer products and services primarily through financial advisors, employee benefit brokers, third party administrators, and other employee benefit firms. LFN offers LNC and non-proprietary products and advisory services through a national network of approximately 3,800 full-time financial planners and advisors, along with more than 11,000 general agents, all operating under multiple affiliation models and open architecture. Distribution results are now reflected in the individual business segments.

Financial information in the tables that follow is presented in conformity with accounting principles generally accepted in the United States of America (“GAAP”), unless otherwise indicated. Because we have changed the composition of our segments as a

 

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result of the Jefferson-Pilot merger, we have restated prior periods’ segment financial information to conform to the 2006 presentation. We provide revenues, income (loss) from operations and assets attributable to each of our business segments and Other Operations as well as revenues derived inside and outside the U.S. for the last three fiscal years in Note 12 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K.

Our revenues by segment for each of the last three fiscal years were as follows:

 

(in millions)

   2006     2005     2004

Revenue

      

Segment operating revenue

      

Individual Markets

      

Annuities

   $ 2,161     $ 1,422     $ 1,335

Life Insurance

     3,256       1,911       1,863
                      

Total Individual Markets

     5,417       3,333       3,198
                      

Employer Markets

      

Retirement Products

     1,360       1,175       1,133

Group Protection

     1,032       —         —  
                      

Total Employer Markets

     2,392       1,175       1,133
                      

Investment Management

     564       475       491

Lincoln UK

     308       318       342

Lincoln Financial Media

     188       —         —  

Other operations

     196       175       109

Net realized investment results

     (3 )     (3 )     77

Reserve development net of related amortization on business sold through reinsurance

     1       2       1
                      

Total

   $ 9,063     $ 5,475     $ 5,351
                      

Acquisitions and Divestitures

As stated above, on April 3, 2006, we completed our merger with Jefferson-Pilot, pursuant to which Jefferson-Pilot merged into one of our wholly owned subsidiaries. Jefferson-Pilot, through its subsidiaries, offered full lines of individual life, annuity and investment products, and group life insurance products, disability income and dental policies, and it operated television and radio stations.

In September 2004, we completed the sale of our London-based international investment unit, Delaware International Advisors Ltd. (“DIAL”), to a newly-formed company associated with DIAL’s management and a private-equity firm. At closing, we received $181 million in cash and relief of certain obligations of approximately $19 million. We had an after-tax gain from the transaction of $46 million. DIAL, which has since been renamed Mondrian, continues to provide sub-advisory services with respect to certain international asset classes for our Investment Management segment and LNC.

For further information about acquisitions and divestitures, see “Acquisitions and Divestitures” in the MD&A and Notes 3 and 14 to our Consolidated Financial Statements.

Branding

Branding is a key element of our strategy. Our branding efforts are focused on two primary target audiences: financial intermediaries where we work to build brand familiarity and affluent consumers (top 11% of the population) where we work to build name awareness.

In 2006, we continued to build our brand on a national basis through an integrated package of consumer print and television, trade print and Internet advertising; sponsorships; and marketing, public relations and promotional events. As a result, we believe that our awareness among our financial intermediary and targeted-consumer audiences remained strong.

We recognize that our brand embodies the experience our customers have with us. Steps were taken in 2006 to identify and closely link the various channels of brand including customer touchpoint areas, Marketing, Advertising, Public Affairs, Investor Relations, Government Relations, Community Relations, Corporate Communications and affiliated media companies. Major

 

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brand initiatives across these channels include a customer touchpoint audit, an internal brand campaign that targets customer-facing employees, and a media campaign. These efforts are focused on Retirement Income Security.

BUSINESS SEGMENTS AND OTHER OPERATIONS

INDIVIDUAL MARKETS

The Individual Markets business provides its products through two segments: Individual Annuities and Individual Life Insurance. The Individual Annuities segment provides tax-deferred investment growth and lifetime income opportunities for its clients by offering individual fixed annuities, including indexed annuities, and variable annuities. The Individual Annuities segment also offers broker-dealer services through our wholly-owned subsidiaries. The Individual Life Insurance segment offers wealth protection and transfer opportunities through both single and survivorship versions of universal life, variable universal life, and term insurance, as well as a linked-benefit product, which is a universal life insurance policy linked with riders that provide for long-term care costs.

Individual Annuities

The Individual Annuities segment, with principal operations in Fort Wayne, Indiana, and Hartford, Connecticut, and additional operations in Greensboro, North Carolina and Concord, New Hampshire, provides tax-deferred investment growth and lifetime income opportunities for its clients by offering fixed and variable annuities. As a result of a broad product portfolio and a strong and diverse distribution network, we ranked 7th in assets and 5th in individual contract variable annuity sales for the year ended December 31, 2006 in the United States, according to Variable Annuity Research and Data Services (“VARDS”).

The Individual Annuities segment offers non-qualified and qualified fixed and variable annuities to individuals. The “fixed” and “variable” classification describes whether we or the policyholders bear the investment risk of the assets supporting the contract. This also determines the manner in which we earn investment margin profits from these products, either as investment spreads for fixed products or as asset-based fees charged to variable products.

Annuities are attractive because they provide tax-deferred growth in the underlying principal, thereby deferring the tax consequences of the growth in value until withdrawals are made from the accumulation values, often at lower tax rates occurring during retirement. In addition to favorable tax treatment, annuities are unique in that contract holders can select a variety of payout alternatives to help provide an income flow for life. The individual annuities market has seen an increase in competition along with new product types and promotion. The guarantee features (living, income and death benefits) offered within an annuity are not found in any other investment vehicle, and, we believe, make annuities attractive even in times of economic uncertainty.

Products

In general, an annuity is a contract between an insurance company and an individual or group in which the insurance company, after receipt of one or more contributions, agrees to pay an amount of money either in one lump sum or on a periodic basis (i.e., annually, semi-annually, quarterly, or monthly), beginning on a certain date and continuing for a period of time as specified in the contract. Such payments can begin within twelve months after the contribution is received (referred to as an immediate annuity) or at a future date in time (referred to as a deferred annuity). This retirement vehicle helps protect an individual from outliving his or her money and can be either a fixed annuity or a variable annuity.

 

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The Individual Annuities segment’s deposits for the periods indicated were as follows:

 

Year Ended December 31 (in millions)

   2006    2005    2004

Individual Annuities:

        

Variable portion of variable annuity deposits

   $ 7,251    $  5,539    $  4,344

Fixed portion of variable annuity deposits

     2,090      1,871      1,656
                    

Total variable annuity deposits

     9,341      7,410      6,000
                    

Indexed annuity deposits

     717      —        —  

Fixed annuity deposits

     698      118      498
                    

Total annuity deposits

   $ 10,756    $ 7,528    $ 6,498
                    

Variable Annuities

A variable annuity provides the contract holder the ability to direct the investment of deposits into one or more sub-accounts offered through the product (“variable portion”) or into a fixed account with a guaranteed return (“fixed portion”). The value of the variable portion of the contract holder’s account varies with the performance of the underlying sub-accounts chosen by the contract holder. The underlying assets of the sub-accounts are managed within a special insurance series of funds, similar to mutual funds. The contract holder’s return is tied to the performance of the segregated assets underlying the variable annuity, i.e. the contract holder bears the investment risk associated with these investments, except for the impact of guaranteed benefit features. The value of the fixed portion is guaranteed by us and recorded in our general account liabilities. Account values of variable annuities for individual business were $51.8 billion, $41.6 billion and $34.8 billion for the years ended December 31, 2006, 2005 and 2004, including the fixed portions of variable accounts of $3.6 billion, $3.9 billion and $4.1 billion, respectively.

We charge mortality and expense assessments on variable annuity accounts to cover insurance and administrative charges. These assessments are built into accumulation unit values, which when multiplied by the number of units owned for any sub-account equals the contract holder’s account value for that sub-account. The fees that we earn from these policies are reported as insurance fees on the income statement. In addition, for some contracts, we collect surrender charges that range from 0% to 10% of withdrawals—generally higher during the early years of a contract—when contract holders surrender their contracts during the surrender charge period. Our individual variable annuity products have a maximum surrender charge period of ten years.

We offer A-share, B-share, C-share, L-share, and bonus variable annuities, although not with every annuity product. The differences in A, B, C, L, and bonus shares relate to the sales charge and fee structure associated with the contract.

 

   

An A-share has a front-end sales charge and no back-end contingent deferred sales charge, also known as a surrender charge. The net premium (premium less front-end charge) is invested in the contract, resulting in full liquidity and lower mortality and expense assessments over the long term than those in other share classes.

 

   

A B-share has a seven-year surrender charge that is only paid if the account is surrendered or withdrawals are in excess of contractual free withdrawals within the contract’s specified surrender charge period. The entire premium is invested in the contract, but it offers limited liquidity during the surrender charge period.

 

   

A C-share has no front-end sales charge or back-end surrender charge. Accordingly, it offers maximum liquidity but mortality and expense assessments are higher than those for A- or B-shares. It offers a persistency credit in year eight to revert pricing to B-share levels.

 

   

An L-share has a four to five year contingent deferred sales charge that is only paid if the account is surrendered or withdrawals are in excess of contractual free withdrawals within the contract’s specified surrender charge period. The differences between the L-share and the B-share are the length of the surrender charge period and the fee structure. L-shares have a shorter surrender charge period, so for the added liquidity, mortality and expense assessments are higher. We offer L-share annuity products with persistency credits beginning in years five or eight to revert pricing back to B-share levels.

 

   

A bonus annuity is a variable annuity contract that offers a bonus credit to a contract based on a specified percentage (typically ranging from 2% to 5%) of each deposit. The entire premium plus the bonus are invested in the sub-accounts supporting the contract. It has a seven to nine-year contingent deferred sales charge. The expenses are slightly more than those for a B-share. We also offer bonus annuity products with persistency credits beginning in years eight or fifteen to revert bonus pricing back to B-share pricing levels.

 

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Certain of our variable annuity products offer guaranteed benefit features, such as a guaranteed minimum death benefit (“GMDB”), a guaranteed minimum withdrawal benefit (“GMWB”), a guaranteed income benefit (“GIB”) and a combination of such benefits. Most of our variable annuity products also offer the choice of a fixed option that provides for guaranteed interest credited to the account value.

Approximately 91%, 90% and 96% of variable annuity separate account values had a GMDB feature at December 31, 2006, 2005 and 2004, respectively. The GMDB features include those where we contractually guarantee to the contract holder that upon death, we will return no less than (a) the total deposits made to the contract less any partial withdrawals, (b) the total deposits made to the contract less any partial withdrawals plus a minimum return, or (c) the highest contract value on a specified anniversary date minus any partial withdrawals following the contract anniversary.

The Lincoln Smart SecuritySM Advantage benefit is a GMWB feature that offers the contract holder a guarantee equal to the initial deposit (or contract value, if elected after issue), adjusted for any subsequent purchase payments or withdrawals. There are two elective step-up options: a one-year option and a five-year option. In general, the one-year option allows an owner to step up the guarantee automatically on the benefit anniversary, and the five-year option allows the owner to step up the guarantee amount on or after the fifth anniversary of the election or of the most recent step up. In each case, the contract value must be greater than the initial deposit at the time of step up. To receive the full amount of the guarantee, annual withdrawals are limited to either 5% of the guaranteed amount for the one-year option or 7% of the guaranteed amount for the five-year option. Withdrawals in excess of the applicable maximum in any contract year are assessed any applicable surrender charges, and the guaranteed amount is recalculated. Approximately 26%, 21% and 12% of variable annuity account values at the end of 2006, 2005 and 2004, respectively, had elected a GMWB feature.

We offer other product riders including i4LIFE® Advantage and 4LaterSM Advantage. The i4LIFE® feature, on which we have received a U.S. patent, allows variable annuity contract holders access and control during the income distribution phase of their contract. This added flexibility allows the contract holder to access the account value for transfers, additional withdrawals, and other service features like portfolio rebalancing. In general, GIB is an optional feature available with i4LIFE® Advantage that guarantees regular income payments will not fall below 75% of the highest income payment on a specified anniversary date (reduced for any subsequent withdrawals). Approximately 83%, 72% and 48% of i4LIFE® Advantage account values elected the GIB feature in 2006, 2005 and 2004, respectively. Approximately 6%, 4% and 2% of variable annuity account values at the end of 2006, 2005 and 2004, respectively, have elected an i4LIFE® feature. 4LaterSM Advantage provides a minimum income base used to determine the GIB floor when a client begins income payments under i4LIFE® Advantage. The income base is equal to the initial deposit (or contract value, if elected after issue) and increases by 15% every three years (subject to a 200% cap). The owner may step up the income base on or after the third anniversary of rider election or of the most recent step-up (which also resets the 200% cap).

To mitigate the increased risks associated with guaranteed benefits, we developed a dynamic hedging program. The customized dynamic hedging program uses equity and interest rate futures positions as well as equity-based options depending upon the risks underlying the guarantees. Our program is designed to offset both positive and negative changes in the carrying value of the guarantees. However, while we actively manage these hedge positions, the hedge positions may not be effective to exactly offset the changes in the carrying value of the guarantees due to, among other things, the time lag between changes in their values and corresponding changes in the hedge positions, extreme swings in the equity markets, contract holder behavior, and divergence between the performance of the underlying funds and hedging indices. For more information on our hedging program, see “Critical Accounting Policies—Insurance and Investment Contract Obligations” of the MD&A. For information regarding risks related to guaranteed benefits, see “Item 1A—Risk Factors” below.

Fixed Annuities

A fixed annuity preserves the principal value of the contract while guaranteeing a minimum interest rate to be credited to the accumulation value. We offer single and flexible premium fixed deferred annuities to the individual annuities market. Single premium fixed deferred annuities are contracts that allow only a single contribution to be made. Flexible premium fixed deferred annuities are contracts that allow multiple contributions on either a scheduled or non-scheduled basis. Our fixed annuities include both traditional fixed-rate and fixed indexed annuities. With fixed deferred annuities, the contract holder has the right to surrender the contract and receive the current accumulation value less any applicable surrender charge and, if applicable, a market value adjustment (MVA).

Fixed indexed annuities allow the contract holder to elect an interest rate linked to the performance of the S&P 500 Index. The indexed interest rate is guaranteed never to be less than zero. Our fixed indexed annuities provide contract holders a choice of a traditional fixed-rate account and one or more different indexed accounts. A contract holder may elect to change their

 

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allocations at renewal dates, either annually or biannually. At each renewal date, we have the opportunity to re-price the indexed component (i.e. reset the caps, spreads, or participation rates), subject to minimum guarantees.

Fixed annuity contracts are general account obligations. We bear the investment risk for fixed annuity contracts. To protect from premature withdrawals, we impose surrender charges. Surrender charges are typically applicable during the early years of the annuity contract, with a declining level of surrender charges over time. We expect to earn a spread between what we earn on the underlying general account investments supporting the fixed annuity product line and what we credit to our fixed annuity contract holders’ accounts. In addition, with respect to fixed indexed annuities, we purchase options that are highly correlated to the indexed account allocation decisions of our contract holders, such that we are closely hedged with respect to indexed interest for the current reset period. For more information on our hedging program for fixed indexed annuities, see “Critical Accounting Policies” of the MD&A.

Individual fixed annuity account values were $14.9 billion, $6.9 billion and $7.3 billion at December 31, 2006, 2005 and 2004. Approximately $11.2 billion, $4.6 billion and $4.8 billion of individual fixed annuity account values at December 31, 2006, 2005 and 2004, respectively, were still within the surrender charge period. However, certain fixed annuities allow window periods during which contract holders can withdraw their funds without incurring a surrender charge. For example, our Step Five® Fixed Annuity has a sixty-day window period following each five-year fixed guarantee period. Crediting rates for each subsequent five-year fixed guarantee period are set at the beginning of the window period. During the window period, account holders can withdraw their funds without incurring a surrender charge. Account values for this type of product were $3.6 billion, $2.8 billion and $2.8 billion at December 31, 2006, 2005 and 2004, with approximately $1.4 billion of account values entering the window period during 2007.

Our fixed annuity product offerings as of December 31, 2006 consist of traditional fixed-rate and fixed indexed deferred annuities. We also offer fixed-rate immediate annuities with various payment options, including lifetime incomes. The traditional fixed-rate deferred annuity products include the Lincoln Select and ChoicePlus Fixed and the Jefferson-Pilot Classic (Single and Flexible Premium) annuities. The fixed indexed deferred annuity products include the Jefferson-Pilot OptiPoint, OptiChoice, New Directions and FuturePoint annuities. The fixed indexed annuities offer one or more of the following indexed accounts:

 

   

The Performance Triggered Indexed Account pays a specified rate, declared at the beginning of the indexed term, if the S&P 500 value at the end of the indexed term is the same or greater than the S&P 500 value at the beginning of the indexed term.

 

   

The Point to Point Indexed Account compares the value of the S&P 500 at the end of the indexed term to the S&P 500 value at the beginning of the term. If the S&P 500 at the end of the indexed term is higher than the S&P 500 value at the beginning of the term, then the percentage change, up to the declared indexed interest cap, is credited to the indexed account.

 

   

The Monthly Cap Indexed Account reflects the monthly changes in the S&P 500 value over the course of the indexed term. Each month, the percentage change in the S&P 500 value is calculated, subject to a monthly indexed cap that is declared at the beginning of the indexed term. At the end of the indexed term, all of the monthly change percentages are summed to determine the rate of indexed interest that will be credited to the account.

 

   

The Monthly Average Indexed Account compares the average monthly value of the S&P 500 to the S&P 500 value at the beginning of the term. The average of the S&P 500 values at the end of each of the twelve months in the indexed term is calculated. The percentage change of the average S&P 500 value to the starting S&P 500 value is calculated. From that amount, the indexed interest spread, which is declared at the beginning of the indexed term, is subtracted. The resulting rate is used to calculate the indexed interest that will be credited to the account.

If the S&P 500 values produce a negative indexed interest rate, no indexed interest is credited to the indexed account.

Many of our fixed annuities have a market value adjustment (MVA). If a contract with an MVA is surrendered during the surrender charge period, both a surrender charge and an MVA may be applied. The MVA feature increases or decreases the contract value of the annuity based on a decrease or increase in interest rates. Individual fixed annuities with an MVA feature constituted 24%, 11% and 12% of total fixed annuity account values at the end of 2006, 2005 and 2004, respectively.

Distribution

The Individual Annuities segment distributes all its individual fixed and variable annuity products through LFD, our wholesaling distribution organization. LFD’s distribution channels give the Individual Annuities segment access to its target

 

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markets. LFD distributes the segment’s products to a large number of financial intermediaries, including LFN. The financial intermediaries include wire/regional firms, independent financial planners, financial institutions and managing general agents.

Competition

The annuities market is very competitive and consists of many companies, with no one company dominating the market for all products. The Individual Annuities segment competes with numerous other financial services companies. The main factors upon which entities in this market compete are distribution channel access and the quality of wholesalers, investment performance, cost, product features, speed to market, brand recognition, financial strength ratings, crediting rates, and client service.

We believe that the Individual Annuities segment’s high service levels help it to compete in the annuities market. It tracks the amount of time in which calls to the center are answered as well as the average response time to customer queries. Further, the segment tracks the turnaround time for various customer services such as processing of applications.

The Individual Annuities segment attempts to design products that meet the needs of clients in its markets. The speed in which the segment’s products reach the market is, from concept of the product to launch, six to nine months. Over the last five years, the segment has announced several new products and product features to market in response to the evolving nature of the annuities market.

Individual Life Insurance

The Individual Life Insurance segment, with principal operations in Greensboro, North Carolina, and Hartford, Connecticut, with additional operations in Concord, New Hampshire and Fort Wayne, Indiana, focuses on the creation and protection of wealth for its clients through the manufacturing of life insurance products. The Individual Life Insurance segment primarily offers both single and survivorship versions of universal life (“UL”), variable universal life (“VUL”), and term insurance. The segment also offers a linked-benefit product, MoneyGuard®, which is a universal life insurance policy linked with riders that provide reimbursement for long-term care costs.

The life insurance operation primarily targets the mass affluent to high net worth markets, defined as households with at least $2,000,000 of net worth or more. For those individual policies we sold in 2006, the average face amount (excluding term and MoneyGuard®) was $803,000 and average first year premiums paid were approximately $17,000.

Products

The Individual Life Insurance segment sells primarily interest/market-sensitive products (UL and VUL) and term products. The segment’s sales (as defined below) for the prior three years were as follows:

 

Year Ended December 31 (in millions)

   2006    2005    2004

Universal Life excluding MoneyGuard®

   $ 437    $ 192    $ 178

MoneyGuard®:

     31      34      37
                    

Total Universal Life

     468      226      215

Variable Universal Life

     61      42      34

Whole Life

     2      2      2

Term

     40      33      41
                    

Total

   $ 571    $ 303    $ 292
                    

UL, VUL, and MoneyGuard® sales represent target premium plus 5% of excess premium (including adjustments for internal replacements at 50%); whole life and term sales throughout the presentation represent 100% of first year paid premium.

Due to some seasonality, we generally have higher sales in the second half of the year than in the first half of the year. Approximately 41%, 46% and 48% of total sales were in the first half of 2006, 2005 and 2004, with the remainder occurring in the second half of the year for the same periods.

 

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In addition, the following table shows life policies’ face amount in-force.

 

     Face Amount In-force

At December 31 (in millions)

   2006    2005    2004

In Force-Face Amount

        

Universal Life and Other

   $ 267,228    $ 128,792    $ 125,043

Term Insurance

     234,148      187,849      172,459
                    

Total in-force

   $ 501,376    $ 316,641    $ 297,502
                    

Mortality margins, morbidity margins (for MoneyGuard®), investment margins (through spreads or fees), net expense charges (expense charges assessed to the policyholder less expenses incurred to manage the business) and surrender fees drive life insurance profits. Mortality margins represent the difference between amounts charged to the customer to cover the mortality risk and the actual cost of reinsurance and death benefits paid. Mortality charges are either specifically deducted from the contract holder’s policy account value (i.e. cost of insurance assessments or “COI’s”) or are embedded in the premiums charged to the customer. In either case, these amounts are a function of the rates priced into the product and level of insurance in-force (less reserves previously set aside to fund benefits). Insurance in-force, in turn, is driven by sales, persistency, and mortality experience.

Similar to the annuity product classifications described above, life products can be classified as “fixed” or “variable” contracts. This classification describes whether we or the policyholders bear the investment risk of the assets supporting the policy. This also determines the manner in which we earn investment margin profits from these products, either as investment spreads for fixed products or as asset-based fees charged to variable products.

We offer four categories of life insurance products consisting of:

Fixed Life Insurance (primarily UL): Fixed life insurance products provide life insurance with account (cash) values that earn rates of return based on company-declared interest rates. Policyholder account values are invested in our general account investment portfolio, so we bear the risk of investment performance. Some of our UL contracts include secondary guarantees, which are explained more fully later in the document.

In a UL contract, policyholders have flexibility in the timing and amount of premium payments and the amount of death benefit, provided there is sufficient account value to cover all policy charges for mortality and expenses for the coming period. Under certain policyholder options and market conditions, the death benefit amount may increase or decrease. Premiums received on a UL product, net of expense loads and charges, are added to the policyholder’s account value. The client has access to their account value (or a portion thereof) through contractual liquidity features such as loans, partial withdrawals, and full surrenders. Loans and withdrawals reduce the death benefit amount and are limited to certain contractual maximums (some of which are required under state law), and interest is charged on all loans. Our UL contracts assess surrender charges against the policies’ account values for full or partial face amount surrenders that occur during the contractual surrender charge period. Depending on the product selected, surrender charge periods can range from 0 to 20 years.

We manage investment margins (i.e. the difference between the rate the portfolio earns compared to the rate that is credited to the customer) by seeking to maximize current yields, in line with asset/liability and risk management targets, while crediting a competitive rate to the customer. Crediting rates are typically subject to guaranteed minimums specified in the underlying life insurance contract. Fixed life account values (excluding VUL) were $21.9 billion, $11.8 billion and $11.2 billion at December 31, 2006, 2005 and 2004, respectively.

Linked Benefit Life Products: Linked benefit products combine fixed life insurance with long-term care insurance through the use of riders. The first rider allows the policyholder to accelerate their death benefit on a tax-free basis in the event of a qualified long-term care need. The second rider extends the long-term care insurance benefits for an additional period of time if the death benefit is fully depleted for the purposes of long-term care. If the long-term care benefits are never used, the policy provides a tax-free death benefit to the policyholder’s heirs. Linked benefit products generate earnings through investment, mortality, and morbidity margins. Our linked benefit product is called MoneyGuard®.

Variable Universal Life Insurance (VUL): VUL products are UL products that provide a return on account values linked to an underlying investment portfolio of sub-accounts offered through the product. The value of the policyholder’s account varies with the performance of the sub-accounts chosen by the policyholder. The underlying assets of the sub-accounts are managed within a special insurance series of funds. Premiums, net of expense loads and charges for mortality and expenses, received on VUL products are invested according to the policyholder’s investment option selection. As the return on the investment portfolio increases or decreases, the account value of the variable universal life policy will increase or decrease. As with fixed UL products,

 

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policyholders have access, within contractual maximums, to account values through loans, withdrawals, and surrenders. Surrender charges are assessed during the surrender charge period, ranging from 0 to 20 years depending on the product. The investment choices we offer in VUL products are the same, in most cases, as the investment choices offered in our individual variable annuity contracts.

In addition, VUL products offer a fixed account option that is managed by us. Investment risk is borne by the customer on all but the fixed account option. We charge fees for mortality costs and administrative expenses as well as asset-based investment management fees. VUL account values were $4.6 billion, $2.2 billion and $2.0 billion at December 31, 2006, 2005 and 2004, respectively.

Term Life Insurance: Term life insurance provides a fixed death benefit for a scheduled period of time. It usually does not offer cash values. Scheduled policy premiums are required to be paid at least annually. Products offering a Return of Premium benefit payable at the end of a specified period have been offered since March 2005.

As mentioned previously, we offer survivorship versions of our individual UL and VUL products. These products insure two lives with a single policy and pay death benefits upon the second death.

Sales results continue to be heavily influenced by the series of universal life products with secondary guarantees. A UL policy with a secondary guarantee can stay in force, even if the base policy account value is zero, as long as secondary guarantee requirements have been met. The secondary guarantee requirement is based on the evaluation of a reference value within the policy, calculated in a manner similar to the base policy account value, but using different assumptions as to expense charges, COI charges, and credited interest. The assumptions for the secondary guarantee requirement are listed in the contract. As long as the policyholder funds the policy to a level that keeps this calculated reference value positive, the death benefit will be guaranteed. The reference value has no actual monetary value to the policyholder; it is only a calculated value used to determine whether or not the policy will lapse should the base policy account value be less than zero.

Unlike other guaranteed death benefit designs, our secondary guarantee benefits maintain the flexibility of a traditional UL policy, which allows a policyholder to take loans or withdrawals. Although loans and withdrawals are likely to shorten the time period of the guaranteed death benefit, the guarantee is not automatically or completely forfeited, as is sometimes the case with other death benefit guarantee designs. The length of the guarantee may be increased at any time through additional excess premium deposits.

During 2006, we continued to monitor the regulatory changes that impact reserving for these products as well as the competitive environment. Secondary guarantee UL face amount in-force was $65.5 billion, $30.9 billion and $25.0 billion as of December 31, 2006, 2005 and 2004, respectively.

During 2006 we expanded and enhanced our variable products by introducing a survivorship version of VULONE and enhancing our single life VULONE. These products combine the lapse protection elements of universal life with the upside potential of a traditional variable universal life product. VULONE gives clients the flexibility to choose the appropriate balance between protection and market risk that meets their individual needs. The combined single life and survivorship VULONE face amount in-force was $2.9 billion, $1.8 billion and $0.6 billion as of December 31, 2006, 2005 and 2004, respectively.

Distribution

The Individual Life Insurance segment’s products are sold through LFD. LFD provides the Life Insurance segment with access to financial intermediaries in the following primary distribution channels—wire/regional firms, independent planner firms (including LFN), financial institutions, and managing general agents.

Competition

The life insurance industry is very competitive and consists of many companies with no one company dominating the market for all products. At the end of 2005, the latest year for which data is available, there were approximately 1,119 life insurance companies in the United States, according to the American Council of Life Insurers.

The Individual Life Insurance segment designs products specifically for the high-net-worth and mass affluent markets. In addition to the growth opportunity offered by its target market, our product breadth, design innovation, competitiveness, speed to market, customer service, and extensive distribution network all contribute to the strength of the Individual Life Insurance segment. On average, the development of products takes approximately six months. The Individual Life Insurance segment announced several major product upgrades and/or new features, including important UL, VUL, MoneyGuard®, and term product

 

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enhancements in 2006. With respect to customer service, management tracks the speed, accuracy, and responsiveness of service to customers’ calls and transaction requests. Further, the Individual Life Insurance segment tracks the turnaround time and quality for various client services such as processing of applications.

Underwriting

In the context of life insurance, underwriting is the process of evaluating medical and non-medical information about an individual and determining the effect these factors statistically have on life expectancy or mortality. This process of evaluation is often referred to as risk classification. Of course, no one can accurately predict how long any individual will live, but certain risk factors can affect life expectancy and are evaluated during the underwriting process.

Claims Administration

Claims services are delivered to customers from the Greensboro and Concord home offices. Claims examiners are assigned to each claim notification based on coverage amount, type of claim, and the experience of the examiner. Claims meeting certain criteria are referred to senior claim examiners. A formal quality assurance program is carried out to ensure the consistency and effectiveness of claims examining activities. A network of in-house legal counsel, compliance officers, medical personnel, and an anti-fraud investigative unit also support claim examiners. A special team of claims examiners, in conjunction with claims management, focus on more complex claims matters such as MoneyGuard® long-term care claims, claims incurred during the contestable period, beneficiary disputes, litigated claims, and the few invalid claims that are encountered.

The Individual Life Insurance segment maintains a centralized claim service center in order to minimize the volume of clerical and repetitive administrative demands on its claims examiners while providing convenient service to policy owners and beneficiaries.

EMPLOYER MARKETS

Overview

Lincoln Employer Markets includes numerous employer-based businesses that were previously dispersed throughout the organization. Employer Markets offers a broad breadth of products focused on retirement income security through its Defined Contribution, Executive Benefits and Group Protection businesses. This is a newly formed business unit and was created to deliver retirement income security through products, distribution and services that are focused on the needs of employers and their employees.

While this is a new internal business unit for the company, Lincoln Employer Markets is well-established in this marketplace. At December 31, 2006, Lincoln Employer Markets served nearly 60,000 plan sponsors and approximately 5 million plan participants. For the period ending and at December 31, 2006, the division segment accounted for 27% of our income from operations and had approximately $38 billion in account values.

The Employer Markets business provides its products through two key segments—Retirement Products and Group Protection. The Retirement Products segment includes two major lines of business:

 

   

The Defined Contribution business provides employer-sponsored fixed and variable annuities, mutual fund-based programs in the 401(k), 403(b) and 457 plan marketplaces through a wide range of intermediaries including advisors, consultants, broker, banks, wirehouses, third-party administrators (TPAs), and individual planners.

 

   

The Executive Benefits business offers corporate-owned universal and variable universal life insurance (COLI) and bank-owned universal and variable universal life insurance (BOLI) to small to mid-sized banks and mid to large-sized corporations, mostly through executive benefit brokers.

The Group Protection segment focuses on offering group term life, disability income and dental insurance primarily in the small to mid-sized employer marketplace for their eligible employees.

 

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Retirement Products

The Defined Contribution business is the largest business in this segment and focuses on 403(b) plans and 401(k) plans. Lincoln has a strong historical presence in the 403(b) space where assets account for about 65% of total assets under management in this segment. The 401(k) business accounts for nearly two thirds of our new deposits. The Retirement Products segment’s deposits for the periods indicated were as follows:

 

Year Ended December 31 (in millions)

   2006    2005    2004

Defined Contributions:

        

Variable portion of variable annuity

   $ 2,525    $ 2,254    $ 2,199

Fixed portion of variable annuity

     441      520      575
                    

Total variable annuity deposits

     2,966      2,774      2,774

Fixed annuity deposits

     506      563      503

Alliance Mutual Funds

     1,113      1,066      828
                    

Total Annuity and Alliance Deposit

     4,585      4,403      4,105

COLI/BOLI deposits

     267      210      273
                    

Total

   $ 4,852    $ 4,613    $ 4,378
                    

Defined Contribution

Products

Employer Markets currently offers four primary products to the employer-sponsored market: Lincoln American Legacy RetirementSM, The Lincoln DirectorSM, Lincoln Alliance and Multi-Fund®. These products cover both the 403(b) and 401(k) marketplace. Both 403(b) and 401(k) plans are tax-deferred, Defined Contribution plans offered to employees of an entity to enable them to save for retirement. The 403(b) plans are available to employees of educational institutions and certain non-profit entities, while 401(k) plans are generally available to employees of for-profit entities. The investment options for our annuities encompass the spectrum of asset classes with varying levels of risk and include both equity and fixed income.

The Lincoln American Legacy RetirementSM variable annuity, launched September 5, 2006, offers 46 investment options, 20 of which are American Funds options.

The Lincoln DirectorSM is a defined contribution retirement plan solution available to businesses of all sizes, but focused on micro- to small-sized corporations, generally with five to 200 lives. Funded through a Lincoln National Life Insurance Company (“LNL”) group variable annuity contract, the DirectorSM product offers participants 57 investment options from 14 fund families. In New York, Lincoln Life & Annuity Company of New York underwrites the annuity contracts, and these contracts offer 54 investment options from 15 fund families. The DirectorSM product has the option of being serviced through a third-party administrator or fully serviced by Lincoln. The Employer Markets Defined Contribution segment earns advisory fees, investment income, surrender charges and recordkeeping fees from this product. Director account values were $7.5 billion, $6.5 billion and $5.6 billion at December 31, 2006, 2005 and 2004, respectively.

Our Alliance® program, with an open architecture platform, bundles our traditional fixed annuity products with the employer’s choice of retail mutual funds, along with recordkeeping and customized employee education components. We earn fees for the services we provide to mutual fund accounts and investment margins on fixed annuities of Alliance® program accounts. The retail mutual funds associated with the Alliance program are not included in the separate accounts reported on our Consolidated Balance Sheet. This program is customized for each employer. The target market is primarily education and healthcare. Alliance® program deposits represented 34%, 34% and 30% of the segment’s deposits in 2006, 2005 and 2004, respectively. Alliance® program account values were $7.0 billion, $5.3 billion and $4.0 billion at December 31, 2006, 2005 and 2004, respectively.

The Lincoln Multi-Fund® Variable Annuity is a defined contribution retirement plan solution with full-bundled administrative services, experienced retirement consultants, and high quality investment choices marketed to small- to mid-sized healthcare, education, governmental, and not-for-profit plans. The product can be sold either to the employer through the Multi-Fund® Group Variable Annuity contract, or directly to the individual through the Multi-Fund® Select Variable Annuity contract. Funded through a Lincoln National Life Insurance Company variable annuity contract, the Multi-Fund® Variable Annuity offers participants 34 investment options from 9 fund families across a variety of asset classes. Included in the product offering is Lincoln Financial’s LifeSpanSM learning program, which provides participants with educational materials and one-on-one guidance for retirement planning assistance. Lincoln earns advisory fees, investment income, surrender charges, and recordkeeping and

 

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administrative fees from this product. The Multi-Fund® Variable Annuity is currently not available in New York. Account values for the Multi-Fund® Variable Annuity were $13.5 billion, $12.9 billion and $12.6 billion at December 31, 2006, 2005 and 2004, respectively.

Executive Benefits

Products

Through the Executive Benefits business, we offer COLI and BOLI products. COLI and BOLI are typically purchased by corporations and banks on the lives of their employees, with the corporation or bank or a trust sponsored by the corporation or bank named as a beneficiary under the policy, for the purpose of funding various employee benefit plans, including non-qualified deferred compensation plans.

We offer a portfolio of both fixed UL and VUL COLI products sold primarily through specialty brokers. COLI and BOLI account values were $4.3 billion, $1.3 billion and $1.1 billion as of December 31, 2006, 2005 and 2004.

This segment also includes a closed-block of pension business that was sold on a Guaranteed Insurance Contract basis. This block, which represents $2.7 billion of assets under management, is currently in run off.

Distribution

Multi-Fund® is sold primarily through advisors to 403(b) plans in the healthcare and education markets. The Alliance Program is sold primarily through consultants and advisors to 403(b) and 401(k) plans in the mid to large healthcare and corporate markets. Lincoln American Legacy RetirementSM and DirectorSM are sold primarily through banks, wirehouses, third-party administrators (TPAs) and individual planners to 401(k) plans in the micro to small corporate market. In October 2006, Employer Markets terminated its contract with the primary third-party wholesaler of the DirectorSM product. This termination did not have a material adverse effect on the Retirement Products segment’s results of operations. The distribution of Executive Benefit products are dominated by 15 to 20 intermediaries who specialize in the executive benefits market. We serve this group through a network of internal and external sales professionals.

Competition

The Retirement Products marketplace is very competitive and is comprised of many providers, with no one company dominating the market for all products. The Retirement Products area competes with numerous other financial services companies. The main factors upon which entities in this market compete are wholesaling, investment performance, cost, product features, speed to market, brand recognition, financial strength ratings, distribution channel access, crediting rates and client service.

Group Protection

Overview

The Group Protection segment offers group non-medical insurance products, principally term life, disability and dental, to the employer marketplace through various forms of contributory and noncontributory plans. This segment also offers a specialty, non-core product called Exec-U-Care®, which is an insured medical expense reimbursement vehicle for executives that covers eligible health plan costs not covered by their base health plans. A discontinuation of Exec-U-Care® would have a significant impact on segment revenues, but only a limited effect on reportable segment income from operations. Most of the segment’s group contracts are sold to employers with fewer than 500 employees.

 

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The Group Protection segment was added as a result of the merger with Jefferson-Pilot and was previously known as Benefit Partners. Accordingly, the product line data for this segment provided in the following table are given for the nine months ended December 31, 2006.

 

(in millions)

   Earned
Premiums

Life

   $ 334

Disability

     407

Dental

     95
      

Total non-medical

     836
      

Other

     113
      

Total

   $ 949
      

Products

Group Life Insurance

We offer employer-sponsored group term life insurance products including basic, optional and voluntary term life insurance to employees and their dependents. Additional benefits may be provided in the event of a covered individual’s accidental death or dismemberment (AD&D coverage).

Group Disability Insurance

We offer short- and long-term employer-sponsored group disability insurance, which protects an employee against loss of wages due to illness or injury. Short-term disability generally provides benefits for up to 26 weeks following a short waiting period, ranging from one to 30 days. Long-term disability provides benefits following a longer waiting period, usually between 30 and 180 days and provides benefits for a longer period, at least two years and typically extending to normal (Social Security) retirement age.

Group Dental

We offer employer-sponsored group dental insurance, which covers a portion of the cost of eligible dental procedures for employees and their dependents. Products offered include indemnity coverage, which does not distinguish benefits based on a dental provider’s participation in a network arrangement, and a Preferred Provider Organization (PPO) product that does reflect the dental provider’s participation in the PPO network arrangement, including agreement with network fee schedules.

Distribution

The segment’s products are marketed primarily through a national distribution system of 27 regional group offices. These offices develop business through employee benefit brokers, third-party administrators and other employee benefit firms.

Competition

The Group Protection marketplace is very competitive. Principal competitive factors include particular product features, price, quality of customer service and claims management, technological capabilities, financial strength and claims-paying ratings. In the group insurance market, the Group Protection segment competes with a limited number of major companies and selected other companies that focus on these products.

Underwriting

The Group Protection segment’s underwriters evaluate the risk characteristics of each employee group. Generally, the relevant characteristics evaluated include employee census information (such as age, gender, income and occupation), employer industry classification, geographic location, benefit design elements and other factors. The segment employs detailed underwriting policies, guidelines and procedures designed to assist the underwriter to properly assess and quantify risks. The segment uses technology to efficiently review, price and issue smaller cases, utilizing its underwriting staff on larger, more complex cases. Individual underwriting techniques (including evaluation of individual medical history information) may be used on certain covered

 

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individuals selecting larger benefit amounts. For voluntary and other forms of employee paid coverages, minimum participation requirements are used to obtain a better spread of risk and minimize the risk of anti-selection.

Claims

Claims for the Group Protection segment are managed by a staff of experienced claim specialists. Disability claims management is especially important to segment results, as results depend on both the incidence and the length of approved disability claims. The segment employs nurses and rehabilitation specialists to help evaluate medical conditions and develop return to work plans. Independent medical reviews are routinely performed by external medical professionals to further evaluate conditions as part of the claim management process.

INVESTMENT MANAGEMENT

Overview

The Investment Management segment, with principal operations in Philadelphia, Pennsylvania, provides investment products and services to both individual and institutional investors through Delaware Management Holdings, Inc. and its affiliates, also referred to as “Delaware Investments.” Delaware Investments offers a broad line of mutual funds and other investment products to retail investors (including managed accounts).

Delaware Investments also offers investment advisory services and products to institutional clients, such as corporate and public retirement plans, endowments and foundations, nuclear decommissioning trusts, sub-advisory clients and Taft-Hartley plans, and includes mutual funds offered by non-Delaware Investments entities for which Delaware Investments acts as a sub-advisor. At December 31, 2006, Delaware Investments served as investment advisor to approximately 280 institutional accounts, acts as investment manager and performs additional services for approximately 87 open-end funds and for 6 closed-end funds. The Investment Management segment also provides investment advisory services for our corporate and general insurance portfolios, including separate accounts and mutual funds, and acts as investment advisor to collateralized debt obligations.

Products

Investment Management products include U.S. and international equity and fixed-income retail mutual funds, institutional separate accounts, institutional mutual funds, managed accounts, as well as administration services for some of these products.

The Investment Management segment’s assets under management (including assets under administration) were as follows:

 

     Assets Under Management

At December 31 (in millions)

   2006    2005    2004

Retail Products:

        

Equity

   $ 39,627    $ 32,732    $ 24,274

Fixed

     10,993      9,625      8,457

Institutional Products:

        

Equity

     23,845      20,577      12,849

Fixed

     22,841      14,699      11,547

Insurance-related assets

     67,067      43,086      42,791
                    

Total

   $ 164,373    $ 120,719    $ 99,918
                    

Total sub-advised, included in above amounts1

   $ 22,671    $ 20,503    $ 13,550
                    

1

In the third quarter of 2004, the segment sold our international investment management unit (“DIAL”) institutional business to Mondrian Investment Partners (“Mondrian”). Accordingly, $22.1 billion of assets were transferred to Mondrian at the time of the sale. Mondrian was retained as a sub-advisor on certain assets. At December 31, 2006, approximately $17.3 billion of the sub-advised assets are being advised on our behalf by Mondrian, the buyer.

 

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Retail Products and Services

The Investment Management segment offers various retail products including mutual funds to individual investors, as well as investment services to high net worth and small institutional investors through managed accounts. The retail assets under management were $50.6 billion, $42.3 billion and $32.8 billion, respectively at December 31, 2006, 2005 and 2004. These assets include $18.0 billion, $15.4 billion and $9.5 billion of sub-advised assets for 2006, 2005 and 2004, respectively. We pay fees to the third party sub-advisors to manage the assets.

As of December 31, 2006, the Investment Management segment, through Delaware Investments, offered 45 open-end retail mutual funds to suit an array of investment needs. Delaware Investments’ mutual funds are grouped by asset class, with each investment management team focused on a specific investment discipline. This structure of distinct investment teams allows for a style-specific research effort tailored for each asset class. The mutual funds are owned by the shareholders of those funds and not by Delaware Investments. Delaware Investments manages the funds pursuant to an agreement with the separate funds boards. Accordingly, the mutual fund assets and liabilities, as well as related investment returns, are not reflected in our Consolidated Financial Statements. Instead, Delaware Investments earns fees for providing the management and other services to the funds.

Delaware Investments manages both open-end and closed-end funds. An open-end mutual fund does not have a fixed number of shares and will normally offer as many shares as investors are willing to buy. Investors sell their shares by requesting the fund to redeem the shares. The open-end funds are available with various pricing structures, such as A-class with a front end sales charge, B-class and C-class with a contingent deferred sales charge as well as R-class and Institutional class, which are sold without a front end or contingent deferred sales charge and are designed for certain retirement plans and/or institutional investors. A, B, C and R classes are generally subject to Rule 12b-1 fees. A closed-end fund offers a fixed number of shares and is usually sold through a brokerage firm. After the initial offering, shares normally trade on a major stock exchange.

The Investment Management segment also provides investment advisory services to clients through separately managed accounts, commonly referred to as wrap accounts. These products are offered by a sponsor, typically a broker-dealer, to higher net worth individuals with a minimum investment of approximately $250,000. During 2006, the Investment Management segment closed the International American Depository Receipt (“ADR”) separately managed account product, which was sub-advised by Mondrian Investment Partners, and the Delaware Large Cap Growth Equity separately managed account to new investors. An ADR is a stock that trades in the U.S. but represents a specified number of shares in a foreign corporation. ADRs are bought and sold on U.S. markets just like traditional stocks and are issued or sponsored in the U.S. by a bank or brokerage firm.

Institutional Products and Services

For institutional clients, the Investment Management segment offers Delaware Pooled Trust and institutional separate accounts. Institutional assets under management were $46.7 billion, $35.3 billion and $24.3 billion, respectively at December 31, 2006, 2005 and 2004.

Delaware Pooled Trust is a registered investment company which offers a series of mutual funds managed in styles that are similar to institutional separate account offerings and are best suited for smaller to medium-sized institutional investment mandates. Delaware Pooled Trusts’ minimum initial investment is typically $1 million. The funds included in Delaware Pooled Trust are offered without a sales charge directly through Delaware Investments’ institutional marketing and client services group.

The Investment Management segment provides investment advisory services through individually managed accounts to a broad range of institutional clients, such as corporate and public retirement plans, endowments and foundations, nuclear decommissioning trusts, sub-advisory clients and Taft-Hartley plans, among others. Included among sub-advisory clients are mutual funds and other commingled vehicles offered by institutional parties. Most clients utilize individually managed separate accounts, which means clients have the opportunity to customize the management of their portfolio by including or excluding certain types of securities, sectors or segments within a given asset class. Because of their individually managed nature, these separate accounts are best suited for larger investment mandates. Currently, the minimum account size is typically $25 million for U.S. investments.

The Investment Management segment also provides investment management services for Lincoln’s general account assets for which it earns advisory revenue.

Distribution

The businesses in the Investment Management segment deliver their broad range of products through multiple distribution channels, enabling them to reach an expanding community of retail and institutional investors. Investment Management

 

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distributes retail mutual funds and managed accounts through intermediaries, including LFN, which are serviced by the LFD wholesaling distribution network. Delaware Distributors, L.P. is the principal underwriter for the Delaware Investments mutual funds and serves as a liaison between the funds and LFD.

Delaware Investments’ institutional marketing group, working closely with manager selection consultants, markets substantially all of the institutional products.

Competition

The Investment Management segment primarily competes with mutual fund complexes that are broker sold, and other asset managers offering managed accounts, institutional accounts and sub-advisory services. Competitive factors impacting the Investment Management segment include investment performance, breadth of investment styles offered, distribution capabilities and customer service.

Investment performance is a key driver of the Investment Management segment’s ability to attract new sales, retain existing assets and improve net flows. The following table summarizes the performance of institutional and managed accounts composites relative to their respective benchmarks for the one-, three- and five-year periods ended December 31, 2006.

 

      One Year    Three Year    Five Year

Number of institutional composites outperforming their respective benchmarks 1

   5 of 8    5 of 7    6 of 7

Number of managed account styles outperforming their respective benchmarks 2

   2 of 9    1 of 6    2 of 5

1

Represents the largest composites based on assets under management. The returns for these composites are GIPS (Global Investments Performance Standards) compliant and the benchmarks are industry standards.

2

Represents Delaware Investments’ managed account styles that have associated benchmarks for the respective length of time.

Delaware Investments closely monitors the relative performance of individual funds. Fund performance is compared to a benchmark group of peer funds that have similar investment characteristics and objectives. Performance in various key categories, as reported to Lipper, one of the leading providers of mutual fund research, is used by Delaware Investments in measuring its funds’ performance. The following table summarizes the performance for the 25 largest mutual funds and for all of the mutual funds in the Delaware Investments’ family of funds for the one-, three- and five-year periods ended December 31, 2006.

 

     One Year    Three Year    Five Year

Number of Funds out of Delaware’s top 25 retail mutual funds in top half of their Lipper category 1

   16 of 25    16 of 25    18 of 25

Number of all retail mutual funds in top half of their Lipper category 1

   29 of 44    31 of 43    33 of 43

1

For these purposes, Delaware Investments’ family of funds does not include variable insurance product funds, or mutual funds managed by Delaware Investments for certain of our affiliates or other third parties.

LINCOLN UK

Lincoln UK is headquartered in Barnwood, Gloucester, England, and is licensed to do business throughout the United Kingdom (“U.K.”). Lincoln UK is primarily focused on protecting and enhancing the value of its existing customer base. The segment accepts new deposits on the existing block of business and markets a limited range of new products.

Lincoln UK’s product portfolio principally consists of unit-linked life and pension products, which are similar to U.S. produced variable life and annuity products, where the risk associated with the underlying investments are borne by the policyholders. These products have largely been issued to individuals, and benefits, premium levels and charges can often be varied within limits. Certain policyholders have chosen to contract out of the State Second Pension through a Lincoln personal pension arrangement. Lincoln UK receives rebate premiums from the government for those policyholders. These rebates are reported as deposits and as such only the fees earned by Lincoln UK are reported as revenue.

 

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The Lincoln UK segment’s product revenues were as follows. Product revenues include premiums, fees and assessments for Lincoln UK’s products:

 

Year Ended December 31 (in millions)

   2006    2005    2004

Life Products

   $ 95    $ 142    $ 137

Pension Products

     131      88      121

Other Products

     11      9      8
                    

Total

   $ 237    $ 239    $ 266
                    

Our subsidiary in the U.K. has its balance sheets and income statements translated at the current spot exchange rate as of the year-end and average spot exchange rate for the year, respectively.

Lincoln UK has an evergreen agreement to outsource its customer service and policy administration functions to Capita Life & Pensions Services Limited, a subsidiary of Capita Group Plc (“Capita”). The purpose of the outsourcing is to reduce the operational risk and variability of future costs associated with administering the business by taking advantage of Capita’s proven expertise in providing outsourcing solutions to a variety of industries including insurance companies. To date, the relationship has provided the segment with results in line with expectations.

LINCOLN FINANCIAL MEDIA

The Lincoln Financial Media segment consists of 18 radio and 3 television broadcasting stations located in selected markets in the Southeastern and Western United States and also produces and distributes syndicated collegiate basketball and football sports programming.

Products

The primary source of revenue for our media properties is the sale of advertising time to local, regional and national advertisers. Our net revenues for Lincoln Financial Media’s television, radio and sports operations for the period from April 3, 2006 to December 31, 2006 were as follows:

 

(in millions)

    

Radio

   $ 101

Television

     66

Sports

     21
      

Total

   $ 188
      

Seasonal revenue fluctuations are common in the broadcasting industry and are primarily due to fluctuations in advertising expenditures by retailers and automobile manufacturers. Broadcast advertising is typically strongest in the second and fourth quarters of the year, which coincides with increased advertising around certain holidays. Historically, the second quarter tends to show an increase in automotive advertising as well as increases in tourism and travel advertising before the summer months. Because television and radio broadcasters rely upon advertising revenue, they are subject to cyclical changes in the economy, such as benefiting from political campaign advertising revenues in even-numbered years. The size of advertisers’ budgets, which are affected by broad economic trends, affects the broadcast industry in general and the revenue of individual television and radio stations. The stations and sports programming derived 21% of their advertising revenues from the automotive industry for the period April 3, 2006 through December 31, 2006. If automobile advertising is severely curtailed, it could have a negative impact on broadcasting revenues.

Lincoln Financial Sports generates most of its revenues during fourth quarter for football and first quarter for basketball.

Television Operations

WBTV, Channel 3, Charlotte, NC, is affiliated with CBS under a Network Affiliation Agreement expiring on May 31, 2011. WWBT, Channel 12, Richmond, VA, is affiliated with NBC under a Network Affiliation Agreement expiring December 31, 2011. WCSC, Channel 5, Charleston, SC, is affiliated with CBS under a Network Affiliation Agreement expiring on May 31, 2011. Absent cancellation by either party, each of these agreements is expected to be renewed for successive five-year periods. For 2006, 7% of television revenues came from a network agreement with the two CBS-affiliated stations that expires in 2011. The trend in

 

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the industry is away from the networks compensating affiliates for carrying their programming, and there is a possibility those revenues will be eliminated when the contract is renewed.

The primary source of revenue for our television stations is through the sale of time to local and national advertisers. Our television advertising revenues in even-numbered years benefit from political, issue, and Olympics-related advertising. In all our markets, we focus on developing leading news programming, which we believe is the optimal way to maximize revenues.

Radio Operations

Lincoln Financial Media owns and operates one AM and one FM station in Atlanta, GA, one AM and two FM stations in Charlotte, NC, two AM and three FM stations in Denver, CO and one AM and two FM stations in Miami, FL. In San Diego, CA, Lincoln Financial Media owns and operates four FM stations and owns one AM station now operated by a third party under a local marketing agreement (LMA). The third party operator of the San Diego AM station has declared its intention to exercise a purchase option on that station during 2007.

Most of our radio broadcasting revenue is generated from the sale of local and national advertising. Additional revenue is generated from event payments, barter and other miscellaneous transactions. Our radio stations employ various formats for their programming. A station’s format can be important in determining the size and characteristics of its listening audience. Advertising rates charged by a radio station are based primarily on the station’s ability to attract audiences having certain demographic characteristics in the market area that advertisers want to reach, as well as the number of stations and other advertising media competing in the market and the relative demand for radio in any given market.

Advertising rates generally are the highest during morning and evening drive-time hours. Depending on the format of a particular station, there are certain numbers of advertisements that are broadcast each hour. We determine the number of advertisements broadcast hourly that can maximize available revenue dollars without jeopardizing listening levels.

Sports Operations

Lincoln Financial Sports’ principal business is to produce and syndicate broadcasts of Atlantic Coast Conference and Southeastern Conference football and basketball events. The contracts with the leagues were renewed in 2001 and extend through the 2010-2011 seasons for the Atlantic Coast Conference and the 2008-2009 seasons for the Southeastern Conference. Raycom Sports is an equal partner in the contract for Atlantic Coast Conference football and basketball. Most of our sports broadcasting revenue is generated from the sale of advertising time. Additional revenue is generated from renting the trucks that we use to produce sporting events to third parties for both sporting and other event production.

Competition

Our radio and television stations compete for programming, talent and revenues with other radio and television stations as well as with other advertising and entertainment media, including direct distribution cable and satellite television and direct transmission and satellite radio. Lincoln Financial Sports competes with other vendors of similar products and services.

OTHER OPERATIONS

“Other Operations” includes the financial data for operations that are not directly related to the business segments, unallocated corporate items (such as investment income on investments related to the amount of statutory surplus in our insurance subsidiaries that is not allocated to our business units and other corporate investments, interest expense on short-term and long-term borrowings, and certain expenses, including restructuring and merger-related expenses), along with the ongoing amortization of deferred gain on the indemnity reinsurance portion of the transaction with Swiss Re. Other Operations also includes the eliminations of intercompany transactions and the inter-segment elimination of the investment advisory fees for asset management services the Investment Management segment provides to Individual Markets and Employer Markets.

 

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Revenues from Other Operations were as follows:

 

(in millions)

   2006     2005     2004  

Premiums

   $ 5     $ 1     $ 2  

Net investment income

     224       203       164  

Amortization of deferred gain on indemnity reinsurance

     75       76       87  

Other revenue and fees

     (11 )     (6 )     (38 )

Inter-segment elimination of investment advisory fees

     (97 )     (99 )     (106 )
                        

Total

   $ 196     $ 175     $ 109  
                        

REINSURANCE

We follow the industry practice of reinsuring a portion of our life insurance and annuity risks with unaffiliated reinsurers. In a reinsurance transaction, a reinsurer agrees to indemnify another insurer for part or all of its liability under a policy or policies it has issued for an agreed upon premium. We use reinsurance to protect our insurance subsidiaries against the severity of losses on individual claims and unusually serious occurrences in which a number of claims produce an aggregate extraordinary loss. We also use reinsurance to improve our results by leveraging favorable reinsurance pricing. Although reinsurance does not discharge the insurance subsidiaries from their primary liabilities to their policyholders for losses insured under the insurance policies, it does make the assuming reinsurer liable to the insurance subsidiaries for the reinsured portion of the risk.

As a result of the Jefferson-Pilot merger, we currently have two reinsurance programs - one for LNL and its insurance subsidiaries, Lincoln Life & Annuity Company of New York and First Penn-Pacific Life Insurance Company (the “LNL program”), and one for the Jefferson-Pilot insurance companies (the “JP program”). Under the LNL program, we reinsure approximately 85% to 90% of the mortality risk on newly issued non-term life insurance contracts and approximately 45% to 50% of total mortality risk including term insurance contracts. Our policy for this program is to retain no more than $5 million on a single insured life issued on fixed and variable universal life insurance contracts. Additionally, the retention per single insured life for term life insurance and for COLI is $1 million and $2 million, respectively.

Beginning in September 2005, we changed the LNL program for our primary term products from coinsurance to renewable term and from 90% to 80% on a first dollar quota share basis. In January 2006, we changed this program from 80% first dollar quota share to an excess of retention program. These changes have the effect of reducing premiums paid to reinsurers while increasing our exposure to mortality losses, and could result in more volatility in results for our Individual Markets Life Insurance segment. With respect to annuities, we had previously reinsured a portion of our fixed annuity business, but beginning in 2004, we have retained the full risk on newly issued contracts.

The insurance subsidiaries participating in the JP program are Jefferson Pilot Financial Insurance Company (“JPFIC”), Jefferson Pilot LifeAmerica Insurance Company (“JPLA”) and Jefferson-Pilot Life Insurance Company (“JP Life”). For the JP program, our policy is to reinsure risks in excess of retention, which ranges from less than $1 million to $2 million on a single insured life, depending on the retention limit set for various individual products. We also attempt to reduce exposure to losses that may result from unfavorable events or circumstances by reinsuring certain levels and types of accident and health insurance risks underwritten.

With the integration of the Lincoln and Jefferson-Pilot companies and their products, we completed a corporate-wide evaluation of retention levels for new products concerning any one individual life and in the aggregate. This evaluation, to maximize profitability while minimizing mortality risk, will include the impact of changes in mortality retention balanced with the impact of premiums paid to reinsurers for new business written starting in 2007.

Portions of our deferred annuity business have been reinsured on a modified coinsurance basis with other companies to limit our exposure to interest rate risks. To cover products other than life insurance, we acquire other insurance coverages with retentions and limits that management believes are appropriate for the circumstances.

In a coinsurance program, the reinsurer shares proportionately in all financial terms of the reinsured policies, i.e. premiums, expenses, claims, etc. based on their respective quota share of the risk. In a renewable term program, the reinsurer is paid a renewable term premium to cover the proportionate share of mortality risk assumed by the reinsurer. In a first dollar quota share program, the reinsurer receives a proportionate share of all risks issued based on their respective quota share of the risk. In an excess of retention program, the reinsurer assumes a proportionate share of risks that exceed our per life retention.

 

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For more information regarding reinsurance see, Note 6 to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K and “Reinsurance” in the MD&A. For risks involving reinsurance, see “Item 1A—Risk Factors” below.

RESERVES

The applicable insurance laws under which insurance companies operate require that they report, as liabilities, policy reserves to meet future obligations on their outstanding policies. These reserves are the amounts that, with the additional premiums to be received and interest thereon compounded annually at certain assumed rates, are calculated to be sufficient to meet the various policy and contract obligations as they mature. These laws specify that the reserves shall not be less than reserves calculated using certain specified mortality and morbidity tables, interest rates, and methods of valuation.

The reserves reported in our financial statements contained herein are calculated based on GAAP and differ from those specified by the laws of the various states and carried in the statutory financial statements of the life insurance subsidiaries. These differences arise from the use of mortality and morbidity tables, interest, persistency and other assumptions which are believed to be more representative of the expected experience for these policies than those required for statutory accounting purposes and from differences in actuarial reserving methods. See “Regulatory” below for information on proposed regulations that may impact the amount of statutory reserves necessary to support our current insurance liabilities.

The assumptions on which reserves are based are intended to represent an estimation of experience for the period that policy benefits are payable. If actual experience is not less favorable than the reserve assumptions, then reserves should be adequate to provide for future benefits and expenses. If experience is less favorable than the reserve assumptions, additional reserves may be required. The key experience assumptions include mortality rates, policy persistency and interest rates. We periodically review our experience and update our policy reserves for new issues and reserve for all claims incurred, as we believe appropriate.

For risks related to reserves, see “Risk Factors” below.

INVESTMENTS

An important component of our financial results is the return on invested assets. Our investment strategy is to balance the need for current income with prudent risk management, with an emphasis on generating sufficient current income to meet our obligations. This approach requires the evaluation of risk and expected return of each asset class utilized, while still meeting our income objectives. This approach also permits us to be more effective in our asset-liability management, since decisions can be made based upon both the economic and current investment income considerations affecting assets and liabilities. Investments by our insurance subsidiaries must comply with the insurance laws and regulations of the states of domicile.

We do not use derivatives for speculative purposes. Derivatives are used for hedging purposes and income generation. Hedging strategies are employed for a number of reasons including, but not limited to, hedging certain portions of our exposure to changes in our GMDB and GMWB liabilities, interest rate fluctuations, the widening of bond yield spreads over comparable maturity U.S. Government obligations, and credit, foreign exchange and equity risks. Income generation strategies include credit default swaps through replication synthetic asset transactions (RSATs). These derivatives synthetically create exposure in the general account to corporate debt, similar to investing in the credit markets. Our investment portfolio does not contain any significant concentrations in single issuers. In addition, we do not have a significant concentration of investments in any single industry segment; no single segment comprises more than 10% of invested assets at December 31, 2006.

For additional information on our investments, including carrying values by category, quality ratings and net investment income, see “Consolidated Investments” in the MD&A, as well as Notes 1 and 4 to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K.

RATINGS

Nationally Recognized Statistical Ratings Organization (“NRSROs”), rate the financial strength of our principal insurance subsidiaries and the debt of LNC. Ratings are not recommendations to buy our securities.

Rating agencies rate insurance companies based on financial strength and the ability to pay claims, factors more relevant to policyholders than investors. We believe that the ratings assigned by nationally recognized, independent rating agencies are material to our operations. There may be other rating agencies that also rate our securities, which we do not disclose in our reports.

 

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Insurer Financial Strength Ratings

The insurer financial strength rating scales of A.M. Best, Fitch Ratings (“Fitch”), Standard & Poor’s (“S&P”) and Moody’s Investors Service (“Moody’s”) are characterized as follows:

 

   

A.M. Best—A++ to S

 

   

Fitch—AAA to D

 

   

Moody’s—Aaa to C

 

   

S&P—AAA to R

As of January 31, 2007, the financial strength ratings of our principal insurance subsidiaries, as published by the principal rating agencies that rate our securities, or us, are as follows:

 

    

A. M. Best

  

Fitch

  

S&P

   Moody’s

Lincoln National Life Insurance Co.

   A+ (2nd of 16)    AA (3rd of 24)    AA (3rd of 21)    Aa3 (4th of 21)

Lincoln Life & Annuity Co. of New York

   A+ (2nd of 16)    AA (3rd of 24)    AA (3rd of 21)    Aa3 (4th of 21)

First Penn-Pacific Life Insurance Co.

   A+ (2nd of 16)    AA (3rd of 24)    AA-(4th of 21)    A1 (5th of 21)

Jefferson-Pilot Life Insurance Co.

   A+ (2nd of 16)    AA (3rd of 24)    AA (3rd of 21)    Aa3 (4th of 21)

Jefferson Pilot Financial Insurance Co.

   A+ (2nd of 16)    AA (3rd of 24)    AA (3rd of 21)    Aa3 (4th of 21)

The A.M. Best, Fitch and Moody’s ratings above have a stable outlook. The S&P ratings have a positive outlook.

A downgrade of the financial strength rating of one of our principal insurance subsidiaries could affect our competitive position in the insurance industry and make it more difficult for us to market our products as potential customers may select companies with higher financial strength ratings.

Debt Ratings

The long-term credit rating scales of A.M. Best, Fitch Ratings, S&P and Moody’s are characterized as follows:

 

   

A.M. Best—aaa to d

 

   

Fitch—AAA to D

 

   

Moody’s—Aaa to C

 

   

S&P—AAA to D

As of January 31, 2007, our long-term credit ratings, as published by the principal rating agencies that rate our long-term credit, are as follows:

 

     

A. M. Best

  

Fitch

  

S&P

  

Moody’s

LNC

  

a (6th of 22)

   A (6th of 24)    A+ (5th of 22)    A3 (7th of 21)

The short-term credit rating scales of A.M. Best, Fitch Ratings, S&P and Moody’s are characterized as follows:

 

   

A.M. Best—AMB-1+ to d

 

   

Fitch—F1 to D

 

   

Moody’s—P-1 to NP

 

   

S&P—A-1 to D

 

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As of January 31, 2007, our short-term credit ratings, as published by the principal rating agencies that rate our short-term credit, are as follows:

 

     A. M. Best   Fitch   S&P   Moody’s

LNC

  AMB-1 (2nd of 6)   F1 (1st of 6)   A-2 (2nd of 6)   P-2 (2nd of 4)

A downgrade of our debt ratings could affect our ability to raise additional debt with terms and conditions similar to our current debt, and accordingly, likely increase our cost of capital. In addition, a downgrade of these ratings could make it more difficult to raise capital to refinance any maturing debt obligations, to support business growth at our insurance subsidiaries and to maintain or improve the current financial strength ratings of our principal insurance subsidiaries described above.

All of our ratings are subject to revision or withdrawal at any time by the rating agencies, and therefore, no assurance can be given that our principal insurance subsidiaries or that LNC can maintain these ratings. Each rating should be evaluated independently of any other rating.

REGULATORY

General

Our insurance subsidiaries, like other insurance companies, are subject to regulation and supervision by the states, territories and countries in which they are licensed to do business. The extent of such regulation varies, but generally has its source in statutes that delegate regulatory, supervisory and administrative authority to supervisory agencies. In the United States, this power is vested in state insurance departments.

In supervising and regulating insurance companies, state insurance departments, charged primarily with protecting policyholders and the public rather than investors, enjoy broad authority and discretion in applying applicable insurance laws and regulation for that purpose. Our insurance subsidiaries are domiciled in the following states:

 

Insurance Subsidiary

  

State of Domicile

The Lincoln National Life Insurance Company (“LNL”)

   Indiana

Jefferson-Pilot Life Insurance Company (“JP Life”)

   North Carolina

First Penn-Pacific Life Insurance Company (“First Penn”)

   Indiana

Jefferson Pilot Financial Insurance Company (“JPFIC”)

   Nebraska

Jefferson Pilot LifeAmerica Insurance Company (“JPLA”)

   New Jersey

Lincoln Life & Annuity Company of New York (“LLANY”)

   New York

The insurance departments of those states exercise principal regulatory jurisdiction over them. The extent of regulation by the states varies, but in general, most jurisdictions have laws and regulations governing standards of solvency, adequacy of reserves, reinsurance, capital adequacy, licensing of companies and agents to transact business, prescribing and approving policy forms, regulating premium rates for some lines of business, prescribing the form and content of financial statements and reports, regulating the type and amount of investments permitted and standards of business conduct. Insurance company regulation is discussed further below under “Insurance Holding Company Regulation” and “Restrictions on Subsidiaries’ Dividends and Other Payments.”

A new statutory reserving standard (commonly called “VACARVM”) is being developed by the NAIC replacing current statutory reserve practices for variable annuities with guaranteed benefits such as GMWBs. The timing for adoption of VACARVM is not certain but we currently expect adoption in 2007. In its current draft form, VACARVM has the potential to require statutory reserves well in excess of current levels for certain variable annuity riders sold by us. We plan to utilize existing captive reinsurance structures to lessen any negative impact on statutory capital and dividend capacity in the life insurance subsidiaries. However, additional statutory reserves could lead to lower risk-based capital ratios and potentially reduce future dividend capacity from our insurance subsidiaries. For more information of the impact of VACARVM, see “Review of Financial Condition—Liquidity and Capital Resources.”

The U.S. federal government does not directly regulate the insurance industry; however, federal initiatives from time to time can impact the insurance industry. In June 2001, the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) was enacted. EGTRRA contains provisions that have and will continue, near term, to significantly lower individual tax rates. These may have the effect of reducing the benefits of tax deferral on the inside build-up of annuities and life insurance products. EGTRRA also includes provisions that will eliminate, over time, the estate, gift and generation-skipping taxes and partially

 

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eliminates the step-up in basis rule applicable to property held in a decedent’s estate. Some of these changes might hinder our sales and result in the increased surrender of insurance and annuity products. These provisions expire after 2010, unless extended.

In May 2003, the Jobs and Growth Tax Relief Reconciliation Act of 2003 (“JGTRRA”) was enacted. Individual taxpayers are the principal beneficiaries of JGTRRA, which includes an acceleration of certain of the income tax rate reductions enacted originally under EGTRRA, as well as capital gains and dividend tax rate reductions. On May 17, 2006, the Tax Increase Prevention and Reconciliation Act of 2006 (“TIPRA”) was signed into law. TIPRA extends the lower capital gains and dividends rates through the end of 2010. Although most of these rate reductions expire after 2010, these reductions have the effect of reducing the benefits of tax deferral on the build-up of value of annuities and life insurance products. Like the EGTRRA changes, the JGTRRA changes may hinder our sales and result in increased surrender of insurance and annuity products.

On October 22, 2004, President Bush signed into law the American Jobs Creation Act of 2004 (“AJCA”), which includes provisions affecting non-qualified deferred compensation plans that may make such plans more complicated for employers depending on final tax rules and regulations. Because our COLI products are often used to support such deferred compensation liabilities, the AJCA may constrain sales of our COLI products.

In February 2007, bills were introduced in Congress to provide tax incentives designed to encourage individuals to invest their after-tax income in retirement vehicles, such as annuities, that provide guaranteed lifetime income. Under the proposal, individuals would not pay federal taxes on one-half of the income generated by annuities that make lifetime payments up to an annual limit of $20,000. If this bill is enacted into law, we believe that it would have a favorable impact on our annuity business.

In February 2006, the Bush Administration proposed that many of the temporary rate reductions from EGTRRA and the 2003 Act be made permanent. The Administration also continues to propose tax-favored savings initiatives that, if enacted by Congress, could also adversely affect the sale of our annuity, life and tax-qualified retirement products and increase the surrender of such products. However, we expect that the income for life guarantee provided within an annuity and features like our GMWB will continue to be viewed as significant benefits and may offset the adverse effect of these proposals.

On August 17, 2006, the Pension Protection Act of 2006 (“PPA”) was signed into law. PPA makes numerous changes to pension and other tax laws including: permanence for the EGTRRA enacted pension provisions including higher annual contribution limits for defined contribution plans and IRAs as well as catch-up contributions for persons over age 50; clarification of the safest available annuity standard for the selection of an annuity as a distribution option for defined contribution plans; expansion of investment advice options for defined contribution plan participants and IRA owners; more stringent funding requirements for defined benefit pension plans and clarification of the legal status of hybrid (cash balance) pension plans; and non-pension related tax changes such as the codification of COLI best practices bringing more certainty to this market segment; permanence for EGTRRA enacted tax benefits for section 529 college savings plans; and favorable tax treatment for long-term care insurance included as a rider to or on annuity products.

We expect many of these changes to have a beneficial effect upon various segments of our business lines.

Some of our separate accounts as well as mutual funds that we sponsor, in addition to being registered under the Securities Act of 1933, are registered as investment companies under the Investment Company Act of 1940, and the shares of certain of these entities are qualified for sale in some or all states and the District of Columbia. We also have several subsidiaries that are registered as broker-dealers under the Securities Exchange Act of 1934 (“Exchange Act”) and are subject to federal and state regulation, including but not limited to the NASD’s net capital rules. In addition, we have several subsidiaries that are investment advisors registered under the Investment Advisers Act of 1940. LFN’s agents and our employees, insofar as they are involved in the sale or marketing of products that are securities, are subject to the Exchange Act and to examination requirements and regulation by the SEC, the NASD and state securities commissioners. Regulation also extends to various LNC entities that employ or control those individuals. The SEC and other governmental agencies and self-regulatory organizations, as well as state securities commissions in the United States, have the power to conduct administrative proceedings that can result in censure, fines, the issuance of cease-and-desist orders or suspension, termination or limitation of the activities of the regulated entity or its employees.

Federal and state regulators are devoting substantial attention to the mutual fund, indexed annuity and variable annuity businesses. As a result of publicity relating to widespread perceptions of industry abuses, there have been numerous regulatory reform, initiatives addressing issues which include, but are not limited to, mutual fund governance and compliance practices, late trading, suitability of indexed and variable annuity products, directed brokerage and soft dollars, and new disclosure requirements concerning commission breakpoints, revenue sharing, shelf space, advisory fees, market timing, portfolio pricing, information about portfolio managers and other issues. While we have made certain changes to our businesses in response to new regulations, they have not had a significant impact on our businesses. However, it is difficult to predict whether additional changes resulting from new regulations will materially affect our businesses, and, if so, to what degree.

 

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Television and radio broadcasting operations are subject to the jurisdiction of the Federal Communications Commission (“FCC”) under the Communications Act of 1934, as amended (the “Act”). The Act empowers the FCC to issue, renew, revoke or modify broadcasting licenses, assign frequencies, determine the locations of stations, regulate the equipment used by stations, establish areas to be served, adopt necessary regulations, and impose certain penalties for violation of the regulations. The Act and present regulations prohibit the transfer of a license or of control of a licensee without prior approval of the FCC; restrict in various ways the common and multiple ownership of broadcast facilities; restrict alien ownership of licenses; and impose various other strictures on ownership and operation.

Broadcasting licenses are granted for a period of eight years for both television and radio and, in the absence of adverse claims as to the licensee’s qualifications or performance, will normally be renewed by the FCC for an additional term.

Insurance Holding Company Regulation

LNC and its insurance subsidiaries are subject to regulation pursuant to the insurance holding company laws of the states of Indiana, Nebraska, North Carolina, New Jersey and New York. These insurance holding company laws generally require an insurance holding company and insurers that are members of such insurance holding company’s system to register with the insurance department authorities, to file with it certain reports disclosing information including their capital structure, ownership, management, financial condition, certain intercompany transactions, including material transfers of assets and intercompany business agreements, and to report material changes in that information. These laws also require that intercompany transactions be fair and reasonable and, under certain circumstances, prior approval of the insurance departments must be received before entering into an intercompany transaction. Further, these laws require that an insurer’s policyholders’ surplus following any dividends or distributions to shareholder affiliates is reasonable in relation to the insurer’s outstanding liabilities and adequate for its financial needs.

In general, under state holding company regulations, no person may acquire, directly or indirectly, a controlling interest in our capital stock unless such person, corporation or other entity has obtained prior approval from the applicable insurance commissioner for such acquisition of control. Pursuant to such laws, in general, any person acquiring, controlling or holding the power to vote, directly or indirectly, ten percent or more of the voting securities of an insurance company, is presumed to have “control” of such company. This presumption may be rebutted by a showing that control does not exist in fact. The insurance commissioner, however, may find that “control” exists in circumstances in which a person owns or controls a smaller amount of voting securities. To obtain approval from the insurance commissioner of any acquisition of control of an insurance company, the proposed acquirer must file with the applicable commissioner an application containing information regarding: the identity and background of the acquirer and its affiliates; the nature, source and amount of funds to be used to carry out the acquisition; the financial statements of the acquirer and its affiliates; any potential plans for disposition of the securities or business of the insurer; the number and type of securities to be acquired; any contracts with respect to the securities to be acquired; any agreements with broker-dealers; and other matters.

Other jurisdictions in which our insurance subsidiaries are licensed to transact business may have similar or additional requirements for prior approval of any acquisition of control of an insurance or reinsurance company licensed or authorized to transact business in those jurisdictions. Additional requirements in those jurisdictions may include re-licensing or subsequent approval for renewal of existing licenses upon an acquisition of control. As further described below, laws that govern the holding company structure also govern payment of dividends to us by our insurance subsidiaries.

Restrictions on Subsidiaries’ Dividends and Other Payments

We are a holding company that transacts substantially all of our business directly and indirectly through subsidiaries. Our primary assets are the stock of our operating subsidiaries. Our ability to meet our obligations on our outstanding debt and to pay dividends and our general and administrative expenses depends on the surplus and earnings of our subsidiaries and the ability of our subsidiaries to pay dividends or to advance or repay funds to us.

In addition, our insurance subsidiaries are subject to certain insurance department regulatory restrictions as to the transfer of funds and payment of dividends to the holding company. Under Indiana laws and regulations, our Indiana insurance subsidiaries, including our primary insurance subsidiary, LNL, may pay dividends to LNC only from unassigned surplus, without prior approval of the Indiana Insurance Commissioner (the “Commissioner”), or must receive prior approval of the Commissioner to pay a dividend if such dividend, along with all other dividends paid within the preceding twelve consecutive months, would exceed the statutory limitation. The current statutory limitation is the greater of (i) 10% of the insurer’s policyholders’ surplus, as shown on its last annual statement on file with the Commissioner or (ii) the insurer’s statutory net gain from operations for the previous twelve months, but in no event to exceed statutory unassigned surplus. Indiana law gives Commissioner broad discretion to disapprove

 

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requests for dividends in excess of these limits. The states of domicile of our other major insurance subsidiaries, JP Life, JPFIC and JPLA, have similar, but not identical, restrictions.

Indiana law also provides that following the payment of any dividend, the insurer’s policyholders’ surplus must be reasonable in relation to its outstanding liabilities and adequate for its financial needs, and permits the Indiana Insurance Commissioner to bring an action to rescind a dividend which violates these standards. In the event that the Indiana Insurance Commissioner determines that the policyholders’ surplus of one subsidiary is inadequate, the Commissioner could use his or her broad discretionary authority to seek to require us to apply payments received from another subsidiary for the benefit of that insurance subsidiary. For information regarding dividends paid to us during 2006 from our insurance subsidiaries, see “Review of Consolidated Financial Condition—Sources of Liquidity and Cash Flow” in our MD&A.

As stated above, LNL is also an accredited reinsurer in the state of New York. As a result, it is also subject to the certain regulatory requirements of the state of New York. These regulations include reserve requirements, which differ from Indiana’s requirements. The New York regulations require LNL to report more reserves to the state of New York. As a result, the level of statutory surplus that LNL reports to New York is less than the statutory surplus reported to Indiana and the National Association of Insurance Commissioners (“NAIC”). If New York requires us to maintain a higher level of capital to remain an accredited reinsurer in New York, LNL’s ability to pay dividends to LNC could be constrained. However, we do not expect the New York reserve requirements to constrain LNL’s ability to pay dividends during 2007. For further information on the ability of our subsidiaries to pay dividends to us, see “Review of Consolidated Financial Condition—Sources of Liquidity and Cash Flow” in the MD&A.

Lincoln UK’s insurance subsidiaries are regulated by the U.K. Financial Services Authority (“FSA”) and are subject to capital requirements as defined by the U.K. Capital Resources Requirement. Lincoln UK targets maintaining approximately 1.5 to 2.0 times the required capital as prescribed by the regulatory resource requirement. Effective January 1, 2005, all insurance companies operating in the U.K. also have to complete a risk-based capital (“RBC”) assessment to demonstrate to the FSA that they hold sufficient capital to cover their risks. RBC requirements in the U.K. are different than the NAIC requirements. In addition, the FSA imposes certain minimum capital requirements for the combined U.K. subsidiaries. As is the case with regulated insurance companies in the U.S., future changes to regulatory capital requirements could impact the dividend capacity of our U.K. insurance subsidiaries and cash flow to the holding company.

Risk-Based Capital

The NAIC has adopted risk-based capital requirements for life insurance companies to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks. The requirements provide a means of measuring the minimum amount of statutory surplus appropriate for an insurance company to support its overall business operations based on its size and risk profile. There are five major risks involved in determining the requirements.

 

Category

   Name   

Description

Asset Risk – Affiliates

   C-0    Risk of assets’ default for certain affiliated investments

Asset Risk – Other

   C-1    Risk of assets’ default of principal and interest or fluctuation in fair value

Insurance Risk

   C-2    Risk of underestimating liabilities from business already written or inadequately pricing business to be written in the future

Interest Rate Risk, Health

Credit Risk and Market Risk

   C-3    Risk of losses due to changes in interest rate levels, risk that health benefits prepaid to providers become the obligation of the health insurer once again and risk of loss due to changes in market levels associated with variable products with guarantees

Business Risk

   C-4    Risk of general business

A company’s risk-based statutory surplus is calculated by applying factors and performing calculations relating to various asset, premium, claim, expense and reserve items. Regulators can then measure adequacy of a company’s statutory surplus by comparing it to the risk-based capital determined by the formula. Under RBC requirements, regulatory compliance is determined by the ratio of a company’s total adjusted capital, as defined by the NAIC, to its company action level of RBC (known as the RBC ratio), also as defined by the NAIC.

 

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Four levels of regulatory attention may be triggered if the RBC ratio is insufficient:

 

   

“Company action level”—If the RBC ratio is between 75% and 100%, then the insurer must submit a plan to the regulator detailing corrective action it proposes to undertake.

 

   

“Regulatory action level”—If the RBC ratio is between 50% and 75%, then the insurer must submit a plan, but a regulator may also issue a corrective order requiring the insurer to comply within a specified period.

 

   

“Authorized control level”—If the RBC ratio is between 35% and 50%, then the regulatory response is the same as at the “Regulatory action level,” but in addition, the regulator may take action to rehabilitate or liquidate the insurer.

 

   

“Mandatory control level”—If the RBC ratio is less than 35%, then the regulator must rehabilitate or liquidate the insurer.

At December 31, 2006, the RBC ratios of LNL, JP Life, JPFIC, JPLA, First Penn and LLANY reported to their respective states of domicile and the NAIC all exceeded the “Company action level.” We believe that we will be able to maintain the RBC ratios of our insurance subsidiaries in excess of “Company action level” through prudent underwriting, claims handling, investing and capital management. However, no assurances can be given that developments affecting the insurance subsidiaries, many of which could be outside of our control, including but not limited to changes in the regulatory environment, including changes to the manner in which the RBC ratio is calculated, economic conditions and competitive conditions in the jurisdictions in which we write business, will not cause the RBC ratios to fall below required levels resulting in a corresponding regulatory response.

EMPLOYEES

As of December 31, 2006, we had a total of 10,744 employees. None of our employees are represented by a labor union, and we are not a party to any collective bargaining agreements. We consider our employee relations to be good.

AVAILABLE INFORMATION

We file annual, quarterly and current reports, proxy statements and other documents with the SEC under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The public may read and copy any materials that we file with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Also, the SEC maintains an Internet website that contains reports, proxy and information statements, and other information regarding issuers, including LNC, that file electronically with the SEC. The public can obtain any documents that we file with the SEC at http://www.sec.gov.

We also make available, free of charge, on or through our Internet website (http://www.lfg.com) our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.

 

Item 1A. Risk Factors

You should carefully consider the risks described below before investing in our securities. The risks and uncertainties described below are not the only ones facing our company. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations. If any of these risks actually occur, our business, financial condition and results of operations could be materially affected. In that case, the value of our securities could decline substantially.

Risk Factors in connection with Our Business

Our reserves for future policy benefits and claims related to our current and future business as well as businesses we may acquire in the future may prove to be inadequate.

Our reserves for future policy benefits and claims may prove to be inadequate. We establish and carry, as a liability, reserves based on estimates of how much we will need to pay for future benefits and claims. For our life insurance and annuity products, we calculate these reserves based on many assumptions and estimates, including estimated premiums we will receive over the assumed life of the policy, the timing of the event covered by the insurance policy, the lapse rate of the policies, the amount of benefits or claims to be paid and the investment returns on the assets we purchase with the premiums we receive. The assumptions and estimates we use in connection with establishing and carrying our reserves are inherently uncertain. Accordingly,

 

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we cannot determine with precision the ultimate amounts that we will pay, or the timing of payment of, actual benefits and claims or whether the assets supporting the policy liabilities will grow to the level we assume prior to payment of benefits or claims. If our actual experience is different from our assumptions or estimates, our reserves may prove to be inadequate in relation to our estimated future benefits and claims. As a result, we would incur a charge to our earnings in the quarter in which we increase our reserves.

Because the equity markets and other factors impact the profitability and expected profitability of many of our products, changes in equity markets and other factors may significantly affect our business and profitability.

The fee revenue that we earn on equity-based variable annuities, unit-linked accounts, variable universal life insurance policies and investment advisory business, is based upon account values. Because strong equity markets result in higher account values, strong equity markets positively affect our net income through increased fee revenue. Conversely, a weakening of the equity markets results in lower fee income and may have a material adverse effect on our results of operations and capital resources.

The increased fee revenue resulting from strong equity markets increases the expected gross profits (“EGPs”) from variable insurance products as do better than expected lapses, mortality rates and expenses. As a result, the higher EGPs may result in lower net amortized costs related to deferred acquisition costs (“DAC”), deferred sales inducements (“DSI”), value of business acquired (“VOBA”), and deferred front-end sales loads (“DFEL”). However, a decrease in the equity market as well as increases in lapses, mortality rates and expenses depending upon their significance, may result in higher net amortized costs associated with DAC, DSI, VOBA and DFEL and may have a material adverse effect on our results of operations and capital resources. For more information on DAC, DSI, VOBA and DFEL amortization, see “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies” below.

Changes in the equity markets, interest rates and/or volatility affects the profitability of our products with guaranteed benefits, therefore, such changes may have a material adverse effect on our business and profitability.

The amount of reserves related to the guaranteed minimum death benefits (“GMDB”) for variable annuities is tied to the difference between the value of the underlying accounts and the guaranteed death benefit, calculated using a benefit ratio approach. The GMDB reserves take into account the present value of total expected GMDB payments and the present value of total expected assessments over the life of the contract and claims and assessments to date. The amount of reserves related to the guaranteed minimum withdrawal benefits (“GMWB”) and guaranteed income benefits (“GIB”) for variable annuities is based on the fair value of the underlying benefit. Both the level of expected GMDB payments and expected total assessments used in calculating the benefit ratio are affected by the equity markets. The liabilities related to GMWB and GIB benefits valued at fair value are impacted by changes in equity markets, interest rates and volatility. Accordingly, strong equity markets will decrease the amount of GMDB reserves that we must carry, and strong equity markets, increases in interest rates and decreases in volatility will generally decrease the fair value of the liabilities underlying the GMWB and GIB benefits.

Conversely, a decrease in the equity markets will increase the net amount at risk under the GMDB benefits we offer as part of our variable annuity products, which has the effect of increasing the amount of GMDB reserves that we must carry. Also, a decrease in the equity market along with a decrease in interest rates and an increase in volatility will generally result in an increase in the fair value of the liabilities underlying GMWB and GIB benefits, which has the effect of increasing the amount of GMWB and GIB reserves that we must carry. Such an increase in reserves would result in a charge to our earnings in the quarter in which we increase our reserves. We maintain a customized dynamic hedge program that is designed to mitigate the risks associated with income volatility around the change in reserves on guaranteed benefits. However, the hedge positions may not be effective to exactly offset the changes in the carrying value of the guarantees due to, among other things, the time lag between changes in their values and corresponding changes in the hedge positions, extreme swings or liquidity in the equity and derivatives markets, contractholder behavior different than expected, and divergence between the performance of the underlying funds and hedging indices. For more information on our hedging program, see “Critical Accounting Policies—Insurance and Investment Contract Obligations” in the MD&A.

Changes in interest rates may cause interest rate spreads to decrease and may result in increased contract withdrawals.

Because the profitability of our fixed annuity and interest-sensitive whole life, universal life and fixed portion of variable universal life insurance business depends in part on interest rate spreads, interest rate fluctuations could negatively affect our profitability. Changes in interest rates may reduce both our profitability from spread businesses and our return on invested capital. Some of our products, principally fixed annuities and interest-sensitive whole life, universal life and the fixed portion of variable universal life insurance, have interest rate guarantees that expose us to the risk that changes in interest rates will reduce our “spread,” or the difference between the amounts that we are required to pay under the contracts and the amounts we are able to

 

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earn on our general account investments intended to support our obligations under the contracts. Declines in our spread or instances where the returns on our general account investments are not enough to support the interest rate guarantees on these products could have a material adverse effect on our businesses or results of operations.

In periods of increasing interest rates, we may not be able to replace the assets in our general account with higher yielding assets needed to fund the higher crediting rates necessary to keep our interest sensitive products competitive. We therefore may have to accept a lower spread and thus lower profitability or face a decline in sales and greater loss of existing contracts and related assets. In periods of declining interest rates, we have to reinvest the cash we receive as interest or return of principal on our investments in lower yielding instruments then available. Moreover, borrowers may prepay fixed-income securities, commercial mortgages and mortgage-backed securities in our general account in order to borrow at lower market rates, which exacerbates this risk. Because we are entitled to reset the interest rates on our fixed rate annuities only at limited, pre-established intervals, and since many of our policies have guaranteed minimum interest or crediting rates, our spreads could decrease and potentially become negative.

Increases in interest rates may cause increased surrenders and withdrawals of insurance products. In periods of increasing interest rates, policy loans and surrenders and withdrawals of life insurance policies and annuity contracts may increase as policyholders seek to buy products with perceived higher returns. This process may lead to a flow of cash out of our businesses. These outflows may require investment assets to be sold at a time when the prices of those assets are lower because of the increase in market interest rates, which may result in realized investment losses. A sudden demand among consumers to change product types or withdraw funds could lead us to sell assets at a loss to meet the demand for funds.

A downgrade in our financial strength or credit ratings could limit our ability to market products, increase the number or value of policies being surrendered and/or hurt our relationships with creditors.

Nationally recognized rating agencies rate the financial strength of our principal insurance subsidiaries and rate our debt. Ratings are not recommendations to buy our securities. Each of the rating agencies reviews its ratings periodically, and our current ratings may not be maintained in the future. Please see “Item 1. Business—Ratings” above for a complete description of our ratings.

Our financial strength ratings, which are intended to measure our ability to meet policyholder obligations, are an important factor affecting public confidence in most of our products and, as a result, our competitiveness. The interest rates we pay on our borrowings are largely dependent on our credit ratings. A downgrade of the financial strength rating of one of our principal insurance subsidiaries could affect our competitive position in the insurance industry and make it more difficult for us to market our products as potential customers may select companies with higher financial strength ratings. This could lead to a decrease in fees as outflows of assets increase, and therefore, result in lower fee income. Furthermore, sales of assets to meet customer withdrawal demands could also result in losses, depending on market conditions. A downgrade of our debt ratings could affect our ability to raise additional debt with terms and conditions similar to our current debt, and accordingly, likely increase our cost of capital. In addition, a downgrade of these ratings could make it more difficult to raise capital to refinance any maturing debt obligations, to support business growth at our insurance subsidiaries and to maintain or improve the current financial strength ratings of our principal insurance subsidiaries described above.

A drop in the rankings of the mutual funds that we manage as well as a loss of key portfolio managers could result in lower advisory fees.

While mutual funds are not rated, per se, many industry periodicals and services, such as Lipper, provide rankings of mutual fund performance. These rankings often have an impact on the decisions of customers regarding which mutual funds to invest in. If the rankings of the mutual funds for which we provide advisory services decrease materially, the funds’ assets may decrease as customers leave for funds with higher performance rankings. Similarly, a loss of our key portfolio managers who manage mutual fund investments could result in poorer fund performance, as well as customers leaving these mutual funds for new mutual funds managed by the portfolio managers. Any loss of fund assets would decrease the advisory fees that we earn from such mutual funds, which are generally tied to the amount of fund assets and performance. This would have an adverse effect on our results of operations.

 

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Our businesses are heavily regulated and changes in regulation may reduce our profitability.

Our insurance subsidiaries are subject to extensive supervision and regulation in the states in which we do business. The supervision and regulation relate to numerous aspects of our business and financial condition. The primary purpose of the supervision and regulation is the protection of our insurance policyholders, and not our investors. The extent of regulation varies, but generally is governed by state statutes. These statutes delegate regulatory, supervisory and administrative authority to state insurance departments. This system of supervision and regulation covers, among other things:

 

   

standards of minimum capital requirements and solvency, including risk-based capital measurements;

 

   

restrictions of certain transactions between our insurance subsidiaries and their affiliates;

 

   

restrictions on the nature, quality and concentration of investments;

 

   

restrictions on the types of terms and conditions that we can include in the insurance policies offered by our primary insurance operations;

 

   

limitations on the amount of dividends that insurance subsidiaries can pay;

 

   

the existence and licensing status of the company under circumstances where it is not writing new or renewal business;

 

   

certain required methods of accounting;

 

   

reserves for unearned premiums, losses and other purposes; and

 

   

assignment of residual market business and potential assessments for the provision of funds necessary for the settlement of covered claims under certain policies provided by impaired, insolvent or failed insurance companies.

We may be unable to maintain all required licenses and approvals and our business may not fully comply with the wide variety of applicable laws and regulations or the relevant authority’s interpretation of the laws and regulations, which may change from time to time. Also, regulatory authorities have relatively broad discretion to grant, renew or revoke licenses and approvals. If we do not have the requisite licenses and approvals or do not comply with applicable regulatory requirements, the insurance regulatory authorities could preclude or temporarily suspend us from carrying on some or all of our activities or impose substantial fines. Further, insurance regulatory authorities have relatively broad discretion to issue orders of supervision, which permit such authorities to supervise the business and operations of an insurance company. As of December 31, 2006, no state insurance regulatory authority had imposed on us any substantial fines or revoked or suspended any of our licenses to conduct insurance business in any state or issued an order of supervision with respect to our insurance subsidiaries, which would have a material adverse effect on our results of operations or financial condition.

In addition, LFN and LFD, as well as our variable annuities and variable life insurance products, are subject to regulation and supervision by the SEC and the National Association of Securities Dealers (“NASD”). Our Investment Management segment, like other investment management companies, is subject to regulation and supervision by the SEC, NASD, the Municipal Securities Rulemaking Board, the Pennsylvania Department of Banking and jurisdictions of the states, territories and foreign countries in which they are licensed to do business. Lincoln UK is subject to regulation by the Financial Services Authority in the U.K. These laws and regulations generally grant supervisory agencies and self-regulatory organizations broad administrative powers, including the power to limit or restrict the subsidiaries from carrying on their businesses in the event that they fail to comply with such laws and regulations. Finally, our television and radio operations require a license, subject to periodic renewal, from the FCC to operate. While management considers the likelihood of a failure to renew remote, any station that fails to receive renewal would be forced to cease operations.

Many of the foregoing regulatory or governmental bodies have the authority to review our products and business practices and those of our agents and employees. In recent years, there has been increased scrutiny of our businesses by these bodies, which has included more extensive examinations, regular “sweep” inquiries and more detailed review of disclosure documents. These regulatory or governmental bodies may bring regulatory or other legal actions against us if, in their view, our practices, or those of our agents or employees, are improper. These actions can result in substantial fines, penalties or prohibitions or restrictions on our business activities and could have a material adverse effect on our business, results of operations or financial condition.

For further information on regulatory matters relating to us, see “Item 1. Business—Regulatory” above.

Legal and regulatory actions are inherent in our businesses and could result in financial losses or harm our businesses.

There continues to be a significant amount of federal and state regulatory activity in the industry relating to numerous issues including, but not limited to, market timing and late trading of mutual fund and variable and indexed insurance products and broker-dealer access arrangements. Like others in the industry, we have received inquiries including requests for information

 

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and/or subpoenas from various authorities including the SEC, NASD and the New York Attorney General, as well as notices of potential proceedings from the SEC and NASD. We are in the process of responding to, and in some cases have settled or are in the process of settling, certain of these inquiries and potential proceedings. We continue to cooperate fully with such authorities. In addition, we are, and in the future may be, subject to legal actions in the ordinary course of our insurance and investment management operations, both domestically and internationally. Pending legal actions include proceedings relating to aspects of our businesses and operations that are specific to us and proceedings that are typical of the businesses in which we operate. Some of these proceedings have been brought on behalf of various alleged classes of complainants. In certain of these matters, the plaintiffs are seeking large and/or indeterminate amounts, including punitive or exemplary damages. Substantial legal liability in these or future legal or regulatory actions could have a material financial effect or cause significant harm to our reputation, which in turn could materially harm our business prospects.

Changes in U.S. federal income tax law could make some of our products less attractive to consumers and increase our tax costs.

The Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) as well as the Jobs and Growth Tax Relief Reconciliation Act of 2003 contain provisions that have and will continue, near term, to significantly lower individual tax rates. These may have the effect of reducing the benefits of deferral on the build-up of value of annuities and life insurance products. EGTRRA also includes provisions that will eliminate, over time, the estate, gift and generation-skipping taxes and partially eliminate the step-up in basis rule applicable to property held in a decedent’s estate. Many of these provisions expire in 2010, unless extended. The Bush Administration continues to propose that many of the foregoing rate reductions, as well as elimination of the estate tax, be made permanent, and continues to propose several tax-favored savings initiatives, that, if enacted by Congress, could also adversely affect the sale of our annuity, life and tax-qualified retirement products and increase the surrender of such products. Although we cannot predict the overall effect on the sales of our products of the tax law changes included in these Acts, some of these changes might hinder our sales and result in the increased surrender of insurance products.

Our risk management policies and procedures may leave us exposed to unidentified or unanticipated risk, which could negatively affect our businesses or result in losses.

We have devoted significant resources to develop our risk management policies and procedures and expect to continue to do so in the future. Nonetheless, our policies and procedures to identify, monitor and manage risks may not be fully effective. Many of our methods of managing risk and exposures are based upon our use of observed historical market behavior or statistics based on historical models. As a result, these methods may not predict future exposures, which could be significantly greater than the historical measures indicate, such as the risk of pandemics causing a large number of deaths. Other risk management methods depend upon the evaluation of information regarding markets, clients, catastrophe occurrence or other matters that is publicly available or otherwise accessible to us, which may not always be accurate, complete, up-to-date or properly evaluated. Management of operational, legal and regulatory risks requires, among other things, policies and procedures to record properly and verify a large number of transactions and events, and these policies and procedures may not be fully effective.

Because we are a holding company with no direct operations, the inability of our subsidiaries to pay dividends to us in sufficient amounts would harm our ability to meet our obligations.

We are a holding company, and we have no direct operations. Our principal asset is the capital stock of our insurance, investment management and communication company subsidiaries.

Our ability to meet our obligations for payment of interest and principal on outstanding debt obligations and to pay dividends to shareholders and corporate expenses depends upon the surplus and earnings of our subsidiaries and the ability of our subsidiaries to pay dividends or to advance or repay funds to us. Payments of dividends and advances or repayment of funds to us by our insurance subsidiaries are restricted by the applicable laws of their respective jurisdictions, including laws establishing minimum solvency and liquidity thresholds. Changes in these laws can constrain the ability of our subsidiaries to pay dividends or to advance or repay funds to us in sufficient amounts and at times necessary to meet our debt obligations and corporate expenses.

We face a risk of non-collectibility of reinsurance, which could materially affect our results of operations.

We follow the insurance practice of reinsuring with other insurance and reinsurance companies a portion of the risks under the policies written by our insurance subsidiaries (known as ceding). At the end of 2006, we have ceded approximately $334 billion of life insurance in-force to reinsurers for reinsurance protection. Although reinsurance does not discharge our subsidiaries from their primary obligation to pay policyholders for losses insured under the policies we issue, reinsurance does make the assuming reinsurer liable to the insurance subsidiaries for the reinsured portion of the risk. As of December 31, 2006, we had $7.9 billion of reinsurance receivables from reinsurers for paid and unpaid losses, for which they are obligated to reimburse us under our

 

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reinsurance contracts. Of this amount, $4.1 billion relates to the sale of our reinsurance business to Swiss Re in 2001 through an indemnity reinsurance agreement. During 2004, Swiss Re funded a trust to support this business. The balance in the trust changes as a result of ongoing reinsurance activity and was $1.9 billion at December 31, 2006. In addition, should Swiss Re’s financial strength ratings drop below either S&P AA- or AM Best A or their NAIC risk-based capital ratio fall below 250%, assets equal to the reserves supporting business reinsured must be placed into a trust according to pre-established asset quality guidelines. Furthermore, approximately $2.1 billion of the Swiss Re treaties are funds-withheld structures where we have a right of offset on assets backing the reinsurance receivables.

During the third quarter one of LNL’s reinsurers, Scottish Re Group Ltd (“Scottish Re”), received rating downgrades from various rating agencies. Of the $1.2 billion of fixed annuity business that LNL reinsures with Scottish Re, approximately 78% is reinsured through the use of modified coinsurance treaties, in which LNL possesses the investments that support the reserves ceded to Scottish Re. For its annuity business ceded on a coinsurance basis, Scottish Re had previously established an irrevocable investment trust for the benefit of LNL that supports the reserves. In addition to fixed annuities, LNL has approximately $84 million of policy liabilities on the life insurance business it reinsures with Scottish Re. Scottish Re continues to perform under its contractual responsibilities to LNL.

The balance of the reinsurance is due from a diverse group of reinsurers. The collectibility of reinsurance is largely a function of the solvency of the individual reinsurers. We perform annual credit reviews on our reinsurers, focusing on, among other things, financial capacity, stability, trends and commitment to the reinsurance business. We also require assets in trust, letters of credit or other acceptable collateral to support balances due from reinsurers not authorized to transact business in the applicable jurisdictions. Despite these measures, a reinsurer’s insolvency, inability or unwillingness to make payments under the terms of a reinsurance contract, especially Swiss Re, could have a material adverse effect on our results of operations and financial condition.

Significant adverse mortality experience may result in the loss of, or higher prices for, reinsurance.

We reinsure a significant amount of the mortality risk on fully underwritten newly issued, individual life insurance contracts. We regularly review retention limits for continued appropriateness and they may be changed in the future. If we were to experience adverse mortality or morbidity experience, a significant portion of that would be reimbursed by our reinsurers. Prolonged or severe adverse mortality or morbidity experience could result in increased reinsurance costs, and ultimately, reinsurers not willing to offer coverage. If we are unable to maintain our current level of reinsurance or purchase new reinsurance protection in amounts that we consider sufficient, we would either have to be willing to accept an increase in our net exposures or revise our pricing to reflect higher reinsurance premiums. If this were to occur, we may be exposed to reduced profitability and cash flow strain or we may not be able to price new business at competitive rates.

Catastrophes may adversely impact liabilities for policyholder claims and the availability of reinsurance.

Our insurance operations are exposed to the risk of catastrophic mortality, such as a pandemic, an act of terrorism or other event that causes a large number of deaths or injuries. Significant influenza pandemics have occurred three times in the last century, but the likelihood, timing, or the severity of a future pandemic cannot be predicted. In our group insurance operations, a localized event that affects the workplace of one or more of our group insurance customers could cause a significant loss due to mortality or morbidity claims. These events could cause a material adverse effect on our results of operations in any period and, depending on their severity, could also materially and adversely affect our financial condition.

The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. Pandemics, hurricanes, earthquakes and man-made, including terrorism, catastrophes may produce significant damage in larger areas, especially those that are heavily populated. Claims resulting from natural or man-made catastrophic events could cause substantial volatility in our financial results for any fiscal quarter or year and could materially reduce our profitability or harm our financial condition. Also, catastrophic events could harm the financial condition of our reinsurers and thereby increase the probability of default on reinsurance recoveries. Accordingly, our ability to write new business could also be affected.

Consistent with industry practice and accounting standards, we establish liabilities for claims arising from a catastrophe only after assessing the probable losses arising from the event. We cannot be certain that the liabilities we have established will be adequate to cover actual claim liabilities, and a catastrophic event or multiple catastrophic events could have a material adverse effect on our business, results of operations and financial condition.

 

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We may be unable to attract and retain sales representatives and other employees, particularly financial advisors.

We compete to attract and retain financial advisors, wholesalers, portfolio managers and other employees, as well as independent distributors of our products. Intense competition exists for persons and independent distributors with demonstrated ability. We compete with other financial institutions primarily on the basis of our products, compensation, support services and financial position. Sales in our businesses and our results of operations and financial condition could be materially adversely affected if we are unsuccessful in attracting and retaining financial advisors, wholesalers, portfolio managers and other employees, as well as independent distributors of our products.

Our sales representatives are not captive and may sell products of our competitors.

We sell our annuity and life insurance products through independent sales representatives. These representatives are not captive, which means they may also sell our competitors’ products. If our competitors offer products that are more attractive than ours, or pay higher commission rates to the sales representatives than we do, these representatives may concentrate their efforts in selling our competitors’ products instead of ours.

Intense competition could negatively affect our ability to maintain or increase our profitability.

Our businesses are intensely competitive. We compete based on a number of factors including name recognition, service, the quality of investment advice, investment performance, product features, price, perceived financial strength, and claims-paying and credit ratings. Our competitors include insurers, broker-dealers, financial advisors, asset managers and other financial institutions. A number of our business units face competitors that have greater market share, offer a broader range of products or have higher financial strength or credit ratings than we do.

In recent years, there has been substantial consolidation and convergence among companies in the financial services industry resulting in increased competition from large, well-capitalized financial services firms. Many of these firms also have been able to increase their distribution systems through mergers or contractual arrangements. Furthermore, larger competitors may have lower operating costs and an ability to absorb greater risk while maintaining their financial strength ratings, thereby allowing them to price their products more competitively. We expect consolidation to continue and perhaps accelerate in the future, thereby increasing competitive pressure on us.

Losses due to defaults by others could reduce our profitability or negatively affect the value of our investments.

Third parties that owe us money, securities or other assets may not pay or perform their obligations. These parties include the issuers whose securities we hold, borrowers under the mortgage loans we make, customers, trading counterparties, counterparties under swaps and other derivative contracts, reinsurers and other financial intermediaries. These parties may default on their obligations to us due to bankruptcy, lack of liquidity, downturns in the economy or real estate values, operational failure, corporate governance issues or other reasons. A downturn in the United States and other economies could result in increased impairments.

We may have difficulty integrating Jefferson-Pilot and may incur substantial unexpected costs in connection with the integration.

We may experience material unanticipated difficulties or expenses in connection with integrating Jefferson-Pilot, especially given the relatively large size of the merger. Integrating Jefferson-Pilot with us is a complex, time-consuming and expensive process. Before the merger, we and Jefferson-Pilot operated independently, each with its own business, products, customers, employees, culture and systems.

We may seek to combine certain operations, functions and legal entities using common information and communication systems, operating procedures, financial controls and human resource practices, including training, professional development and benefit programs. We may be unsuccessful or delayed in implementing the integration of these systems and processes, which may cause increased operating costs, worse than anticipated financial performance or the loss of clients, employees and agents. Many of these factors are outside our control.

Anti-takeover provisions could delay, deter or prevent our change in control even if the change in control would be beneficial to LNC shareholders.

We are an Indiana corporation subject to Indiana state law. Certain provisions of Indiana law could interfere with or restrict takeover bids or other change in control events affecting us. Also, provisions in our articles of incorporation, bylaws and other

 

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agreements to which we are a party could delay, deter or prevent our change in control, even if a change in control would be beneficial to shareholders. In addition, under Indiana law, directors may, in considering the best interests of a corporation, consider the effects of any action on stockholders, employees, suppliers and customers of the corporation and the communities in which offices and other facilities are located, and other factors the directors consider pertinent. One statutory provision prohibits, except under specified circumstances, LNC from engaging in any business combination with any shareholder who owns 10% or more of our common stock (which shareholder, under the statute, would be considered an “interested shareholder”) for a period of five years following the time that such shareholder became an interested shareholder, unless such business combination is approved by the board of directors prior to such person becoming an interested shareholder. In addition, our articles of incorporation contain a provision requiring holders of at least three-fourths of our voting shares then outstanding and entitled to vote at an election of directors, voting together, to approve a transaction with an interested shareholder rather than the simple majority required under Indiana law.

In addition to the anti-takeover provisions of Indiana law, there are other factors that may delay, deter or prevent our change in control. As an insurance holding company, we are regulated as an insurance holding company and are subject to the insurance holding company acts of the states in which our insurance company subsidiaries are domiciled. The insurance holding company acts and regulations restrict the ability of any person to obtain control of an insurance company without prior regulatory approval. Under those statutes and regulations, without such approval (or an exemption), no person may acquire any voting security of a domestic insurance company, or an insurance holding company which controls an insurance company, or merge with such a holding company, if as a result of such transaction such person would “control” the insurance holding company or insurance company. “Control” is generally defined as the direct or indirect power to direct or cause the direction of the management and policies of a person and is presumed to exist if a person directly or indirectly owns or controls 10% or more of the voting securities of another person.

 

Item 1B. Unresolved Staff Comments

None.

 

Item 2. Properties

LNC and the various operating businesses own or lease approximately 3.8 million square feet of office space. We lease 0.4 million square feet of office space in Philadelphia, Pennsylvania for our corporate center and for the Investment Management segment, LFD and LFN. The operating units in the Fort Wayne, Indiana and Greensboro, North Carolina areas own or lease 1.4 million square feet. Also, businesses operating in the Chicago, Illinois metro area, Atlanta, Georgia, Omaha, Nebraska, Concord, New Hampshire, Hartford, Connecticut and the United Kingdom own or lease another 0.9 million square feet of office space. An additional 1.1 million square feet of office space is owned or leased in other U.S. cities for branch offices and other operations. As provided in Note 10 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K, the rental expense on operating leases for office space and equipment totaled $66 million for 2006. This discussion regarding properties does not include information on investment properties.

 

Item 3. Legal Proceedings

For information regarding legal proceedings, see “Regulatory and Litigation Matters” in Note 10 to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K, which is incorporated herein by reference.

 

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Item 4. Submission of Matters to a Vote of Security Holders

During the fourth quarter of 2006, no matters were submitted to security holders for a vote.

Executive Officers of the Registrant

Executive Officers of the Registrant as of February 28, 2007 were as follows:

 

Name

   Age**   

Position with LNC and Business Experience During the Past Five Years

Jon A. Boscia

   54    Chairman, Chief Executive Officer and Director (since 2001). President and Director, The Lincoln National Life Insurance Company * (1998-2004).

Charles C. Cornelio

   47    Senior Vice President, Shared Services and Chief Information Officer (since April 2006). Executive Vice President, Technology and Insurance Services, Jefferson-Pilot (2004-April 2006). Senior Vice President, Jefferson-Pilot (1997-2004).

Patrick P. Coyne

   43    President of Lincoln National Investment Company, Inc.* and Delaware Management Holdings, Inc.* (since July 2006). Executive Vice President and Chief Investment Officer, Lincoln National Investment Company, Inc. and Delaware Management Holdings, Inc. (2003-July 2006). Senior Vice President and Deputy Chief Investment Officer, Lincoln National Investment Company, Inc. and Delaware Management Holdings, Inc. (2002-2003).

Frederick J. Crawford

   43    Senior Vice President and Chief Financial Officer (since 2005). Vice President and Treasurer (2001-2004).

Robert W. Dineen

   57    President, Lincoln Financial Advisors* (since 2002). Senior Vice President, Managed Asset Group, Merrill Lynch, a diversified financial services company (2001-2002).

Heather C. Dzielak

   38    Senior Vice President, Retirement Income Security Ventures* (since September 2006); Vice President, Lincoln National Life Insurance Company* (December 2003-September 2006); Vice President of Sales—Chief Administrative Officer, ING USA Annuity and Life Insurance Co. (May-November 2003); Vice President of Sales—Income Annuity Product Line Leader, ING USA Annuity and Life Insurance Co. (2001-2003).

Dennis R. Glass

   57    President, Chief Operating Officer and Director (since April 2006). President and Chief Executive Officer, Jefferson-Pilot (2004-April 2006). President and Chief Operating Officer, Jefferson-Pilot (2001-April 2006). Executive Vice President, Chief Financial Officer and Treasurer, Jefferson-Pilot (1993-2001).

Mark E. Konen

   47    President, Individual Markets* (since April 2006). Executive Vice President, Life and Annuity Manufacturing, Jefferson-Pilot (2004-April 2006). Executive Vice President, Product/Financial Management (2002-2004). Executive Vice President, Product Development, M&A (2000-2002).

Barbara S. Kowalczyk

   55    Senior Vice President, Corporate Planning and Development (since 1994).

Elizabeth L. Reeves

   53    Senior Vice President, Chief Human Resources Officer (since 2005). Senior Vice President, Human Resources, The ServiceMaster Company, a home services company (2002-2004). Executive Vice President, Human Resources, BCOM 3 Group (now Publicis), a communications company (2000-2002).

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Name

   Age**   

Position with LNC and Business Experience During the Past Five Years

Dennis L. Schoff

   47   

Senior Vice President, LNC and General Counsel (since 2002). Vice President and

Deputy General Counsel (2001-2002). Vice President and Associate General Counsel

(2000-2001).

Michael Tallett-Williams

   53   

President and Managing Director, Lincoln National (UK)* (since 2000). Chief

Financial Officer, Lincoln National (UK)* (1995-2000).

Westley V. Thompson

   52   

President, Employer Markets* (since April 2006). Chief Executive Officer and

President, Lincoln Financial Distributors (2000-April 2006). Senior Vice President,

Lincoln Life and Annuity Distributors (1998-2002).


* Denotes an affiliate of LNC.
** Age shown is based on the officer’s age as of February 28, 2007.

 

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PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

(a) Stock Market and Dividend Information

The dividend on our common stock is declared each quarter by our Board of Directors. In determining dividends, the Board takes into consideration items such as our financial condition, including current and expected earnings, projected cash flows and anticipated financing needs. For potential restrictions on our ability to pay dividends, see “Item 7—MD&A—Review of Consolidated Financial Condition” and Note 10 to the Consolidated Financial Statements. The range of market prices and cash dividends declared by calendar quarter for the past two years are as follows:

 

Common Stock Data: (per share)

   1st Qtr    2nd Qtr    3rd Qtr    4th Qtr

2006

           

High

   $ 57.97    $ 60.52    $ 63.47    $ 66.72

Low

     52.00      54.30      53.94      61.74

Dividend declared

     0.380      0.380      0.380      0.395

2005

           

High

   $ 49.42    $ 47.77    $ 52.42    $ 54.41

Low

     44.36      41.59      46.59      46.94

Dividend declared

     0.365      0.365      0.365      0.380

At December 31, 2006, the number of shareholders of record of LNC’s common stock was 12,256.

Exchanges: New York and Chicago.

Stock Exchange Symbol: LNC

 

(b) Not Applicable

 

(c) Issuer Purchases of Equity Securities

The following table summarizes purchases of equity securities by the issuer during the quarter ended December 31, 2006:

 

Period

   (a) Total
Number
of Shares
(or Units)
Purchased (1)
   (b) Average
Price Paid
per Share
(or Unit)
   (c) Total Number
of Shares (or Units)
Purchased as Part of
Publicly Announced
Plans or Programs (2)
   (d) Approximate Dollar
Value of Shares that
May Yet Be Purchased
Under the Plans or
Programs (in millions) (3)

10/1/06 - 10/31/06

   2,924    $ 63.69    —      $ 221.6

11/1/06 - 11/30/06

   150,050,317      63.39    150,000,000      221.6

12/1/06 - 12/31/06

   —        —      —        221.6

(1)

Of the total number of shares purchased, 37,014 shares were received in connection with the exercise of stock options and related taxes and 13,303 shares were withheld for taxes on the vesting of restricted stock. For the quarter ended December 31, 2006, there was 1.5 billion shares purchased as part of publicly announced plans or programs.

 

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(2)

In January 2006, our Board of Directors approved a $1.6 billion increase in share repurchase authorization, bringing the total authorization at the time to $1.8 billion. At December 31, 2006, our share repurchase authorization was $649 million. On February 23, 2007, we announced that our Board approved a $2 billion increase in the authorization, bringing the total current authorization to $2.6 billion. On February 6, 2007, we announced a $500 million accelerated share buyback program to be executed by the end of the first quarter of 2007. The amount and timing of share repurchase depends on key capital ratios, rating agency expectations, the generation of free cash flow and an evaluation of the costs and benefits associated with alternative uses of capital.

(3)

As of the last day of the applicable month.

 

(d) Information on Securities Authorized for Issuance Under Equity Compensation Plans is in Item 12.

 

Item 6. Selected Financial Data

 

     (millions of dollars, except per share data)

Year Ended December 31

   2006    2005    2004     2003     2002

Total revenue

   $ 9,063    $ 5,475    $ 5,351     $ 5,284     $ 4,636

Income before cumulative effect of accounting changes

     1,316      831      732       767       49

Cumulative effect of accounting changes

     —        —        (25 )     (255 )     —  
                                    

Net income

   $ 1,316    $ 831    $ 707     $ 512     $ 49
                                    

Per share data: (1)

            

Net income-diluted

   $ 5.13    $ 4.72    $ 3.95     $ 2.85     $ 0.26

Net income-basic

     5.21      4.80      4.01       2.89       0.27

Common stock dividends

     1.535      1.475      1.415       1.355       1.295
     (millions of dollars, except per share data)

At December 31

   2006    2005    2004     2003     2002

Assets

   $ 178,494    $ 124,860    $ 116,219     $ 106,745     $ 93,185

Senior notes

     2,231      999      1,049       1,118       1,119

Junior subordinated debentures issued to affiliated trusts

     155      334      340       341       393

Capital securities

     1,072      —        —         —         —  

Shareholders’ equity

     12,201      6,384      6,176       5,812       5,348

Per share data: (1)

            

Shareholders’ equity (including accumulated other comprehensive income)

   $ 44.21    $ 36.69    $ 35.53     $ 32.56     $ 30.10

Shareholders’ equity (excluding accumulated other comprehensive income)

     41.99      33.66      30.17       27.69       25.97

Market value of common stock

     66.40      53.03      46.68       40.37       31.58

(1) Per share amounts were affected by the issuance of 112.3 million shares for the acquisition of Jefferson-Pilot and the retirement of 16.9 million, 2.3 million, 7.6 million and 12.1 million shares of common stock in 2006, 2005, 2004 and 2002, respectively.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following is a discussion of the financial condition of Lincoln National Corporation and its consolidated subsidiaries (“LNC” or the “Company” which also may be referred to as “we” or “us”) as of December 31, 2006, compared with December 31, 2005, and the results of operations of LNC in 2006 and 2005, compared with the immediately preceding year. On April 3, 2006, LNC completed its merger with Jefferson-Pilot Corporation (Jefferson-Pilot). Beginning on April 3, 2006, the results of operations and financial condition of Jefferson-Pilot, after being adjusted for the effects of purchase accounting, were consolidated with LNC’s. As part of the merger, we realigned our businesses to conform to the way we intend to manage and assess our business going forward. Accordingly, all prior period segment results have been adjusted to reflect the new segmentation. The financial information presented herein for the year ended December 31, 2006, reflects the accounts of LNC for the three months ended March 31, 2006, and the consolidated accounts of LNC and Jefferson-Pilot for the remainder of 2006. The data presented herein for the 2005 and 2004 periods reflect the accounts of LNC. The balance sheet information presented below is as of December 31 for each respective year. The statement of operations information is for the year ended December 31 for each respective year.

For more information regarding the completion of the merger, including the calculation and allocation of the purchase price, see Note 3 to the Consolidated Financial Statements in this Form 10-K.

This discussion and analysis should be read in conjunction with our audited Consolidated Financial Statements and Notes thereto presented in Item 8 (“Financial Statements and Supplementary Data”). You should also read our discussion below of “Critical Accounting Policies” beginning on page 42 for an explanation of those accounting estimates that we believe are most important to the portrayal of our financial condition and results of operations and that require our most difficult, subjective and complex judgments. Financial information in the tables that follow is presented in conformity with accounting principles generally accepted in the United States of America (“GAAP”), unless otherwise indicated. Certain reclassifications have been made to prior periods’ financial information to conform to the 2006 presentation.

Forward-Looking Statements—Cautionary Language

Certain statements made in this report and in other written or oral statements made by LNC or on LNC’s behalf are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 (“PSLRA”). A forward-looking statement is a statement that is not a historical fact and, without limitation, includes any statement that may predict, forecast, indicate or imply future results, performance or achievements, and may contain words like: “believe”, “anticipate”, “expect”, “estimate”, “project”, “will”, “shall” and other words or phrases with similar meaning in connection with a discussion of future operating or financial performance. In particular, these include statements relating to future actions, prospective services or products, future performance or results of current and anticipated services or products, sales efforts, expenses, the outcome of contingencies such as legal proceedings, operations, trends or financial results. LNC claims the protection afforded by the safe harbor for forward-looking statements provided by the PSLRA.

Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from the results contained in the forward-looking statements. Risks and uncertainties that may cause actual results to vary materially, some of which are described within the forward-looking statements include, among others:

 

   

Problems arising with the ability to successfully integrate our and Jefferson-Pilot’s businesses, which may affect our ability to operate as effectively and efficiently as expected or to achieve the expected synergies from the merger or to achieve such synergies within our expected timeframe, and the application of purchase price accounting on results of operations;

 

   

Legislative, regulatory or tax changes, both domestic and foreign, that affect the cost of, or demand for, LNC’s products, the required amount of reserves and/or surplus, or otherwise affect our ability to conduct business, including changes to statutory reserves and/or risk-based capital requirements related to secondary guarantees under universal life and variable annuity products such as Actuarial Guideline VACARVM; restrictions on revenue sharing and 12b-1 payments; and the potential for U.S. Federal tax reform;

 

   

The initiation of legal or regulatory proceedings against LNC or its subsidiaries and the outcome of any legal or regulatory proceedings, such as: (a) adverse actions related to present or past business practices common in businesses in which LNC and its subsidiaries compete; (b) adverse decisions in significant actions including, but not limited to, actions brought by federal and state authorities, and extra-contractual and class action damage cases; (c) new decisions that result in changes in law; and (d) unexpected trial court rulings;

 

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Changes in interest rates causing a reduction of investment income, the margins of LNC’s fixed annuity and life insurance businesses and demand for LNC’s products;

 

   

A decline in the equity markets causing a reduction in the sales of LNC’s products, a reduction of asset fees that LNC charges on various investment and insurance products, an acceleration of amortization of deferred acquisition costs (“DAC”), value of business acquired (“VOBA”), deferred sales inducements (“DSI”) and deferred front-end loads (“DFEL”) and an increase in liabilities related to guaranteed benefit features of LNC’s variable annuity products;

 

   

Ineffectiveness of LNC’s various hedging strategies used to offset the impact of declines in and volatility of the equity markets;

 

   

A deviation in actual experience regarding future persistency, mortality, morbidity, interest rates or equity market returns from LNC’s assumptions used in pricing its products, in establishing related insurance reserves, and in the amortization of intangibles that may result in an increase in reserves and a decrease in net income;

 

   

Changes in accounting principles generally accepted in the United States (“GAAP”) that may result in unanticipated changes to LNC’s net income, including the impact of adopting Statement of Position 05-1;

 

   

Lowering of one or more of LNC’s debt ratings issued by nationally recognized statistical rating organizations, and the adverse impact such action may have on LNC’s ability to raise capital and on its liquidity and financial condition;

 

   

Lowering of one or more of the insurer financial strength ratings of LNC’s insurance subsidiaries and the adverse impact such action may have on the premium writings, policy retention, and profitability of its insurance subsidiaries;

 

   

Significant credit, accounting, fraud or corporate governance issues that may adversely affect the value of certain investments in the portfolios of LNC’s companies requiring that LNC realize losses on such investments;

 

   

The impact of acquisitions and divestitures, restructurings, product withdrawals and other unusual items, including LNC’s ability to integrate acquisitions and to obtain the anticipated results and synergies from acquisitions;

 

   

The adequacy and collectibility of reinsurance that LNC has purchased;

 

   

Acts of terrorism, war, or other man-made and natural catastrophes that may adversely affect LNC’s businesses and the cost and availability of reinsurance;

 

   

Competitive conditions, including pricing pressures, new product offerings and the emergence of new competitors, that may affect the level of premiums and fees that LNC can charge for its products;

 

   

The unknown impact on LNC’s business resulting from changes in the demographics of LNC’s client base, as aging baby-boomers move from the asset-accumulation stage to the asset-distribution stage of life;

 

   

Loss of key management, portfolio managers in the Investment Management segment, financial planners or wholesalers; and

 

   

Changes in general economic or business conditions, both domestic and foreign, that may be less favorable than expected and may affect foreign exchange rates, premium levels, claims experience, the level of pension benefit costs and funding, and investment results.

The risks included here are not exhaustive. Other sections of this report, including the “Risk Factors” beginning on page 26 and LNC’s quarterly reports on Form 10-Q, current reports on Form 8-K and other documents filed with the SEC include additional factors which could impact LNC’s business and financial performance. Moreover, LNC operates in a rapidly changing and competitive environment. New risk factors emerge from time to time and it is not possible for management to predict all such risk factors.

Further, it is not possible to assess the impact of all risk factors on LNC’s business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results. In addition, LNC disclaims any obligation to update any forward-looking statements to reflect events or circumstances that occur after the date of this report.

 

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INTRODUCTION

Executive Summary

We are a holding company that operates multiple insurance and investment management businesses as well as broadcasting and sports programming business through subsidiary companies. Through our business segments, we sell a wide range of wealth protection, accumulation and retirement income products and solutions. These products include institutional and/or retail fixed and indexed annuities, variable annuities, universal life insurance, variable universal life insurance, linked-benefit universal life, term life insurance, mutual funds and managed accounts.

Our individual products and services are distributed primarily through brokers, planners, agents and other intermediaries with sales and marketing support provided by the 479 wholesalers within Lincoln Financial Distributors (“LFD”), our wholesaling distributor. Our group products and services are distributed primarily through financial advisors, employee benefit brokers, third party administrators, and other employee benefit firms with sales support provided by Lincoln’s Employer Markets group and retirement sales specialists. Our retail distributor, Lincoln Financial Network, offers LNC and non-proprietary products and advisory services through a national network of approximately 4,100 full-time financial planners and advisors, along with more than 11,000 general agents, all operating under multiple affiliation models and open architecture.

On April 3, 2006, Jefferson-Pilot, a financial services and broadcasting holding company, merged with and into one of our wholly owned subsidiaries. Through its subsidiaries, Jefferson-Pilot provided products and services in four major businesses: (1) life insurance, (2) annuities and investment products, (3) group life, disability and dental insurance and (4) broadcasting and sports programming production and distribution.

As a result of the merger, we provide products and services in five operating businesses: (1) Individual Markets, (2) Employer Markets, (3) Investment Management, (4) Lincoln UK and (5) Lincoln Financial Media, and are reporting results through seven business segments. These operating businesses and their segments are described in “Part I, Item 1, Business” of this Form 10-K.

We view our business similar to a columned structure as presented below.

LOGO

The base of the structure is our employees. Overlaying the base is financial and risk management, and operating efficiency, which are the cornerstones of our management and business philosophy. Talented employees and strong financial and risk management provide the foundation from which we operate and grow our company. Our April 2006 combination with Jefferson-Pilot, well known within the industry for their operational effectiveness, further strengthens the foundation to deliver on our strategic intent. During 2006 and into 2007, we are making investments in operating efficiencies to integrate and consolidate administrative systems across the enterprise.

Solutions is one of the pillars of our business. We offer creative product solutions that focus on how each part of a person’s portfolio can provide either income, accumulation, protection or leverage appropriately during the different phases of the retirement wealth cycle. To that end, our strategic intent is to be “The Retirement Income Security Company”. Retirement income security represents all of the risks at various stages of the wealth management cycle, not just the risk of outliving income during retirement. According to industry studies, by 2012 it is estimated that there will be over $1 trillion of money in motion each and every year as retirees begin to withdraw funds from their retirement vehicles and the retirees will need a strategy to manage

 

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those funds. We expect that these retirees will also be looking for the ability to transfer risk of their financial retirement decisions from themselves to someone else and the insurance industry is uniquely positioned to transfer those risks. To help accelerate our preparation to seize this opportunity, we formed the Retirement Income Security Venture (“RISV”), which is a group of individuals from within our organization tasked with developing the plans and products for success in this strategy.

Our merger with Jefferson-Pilot has increased our distribution breadth through retail distribution channels. In addition, the merger has expanded the life and annuity product offerings available to our existing channels and increased our capital position to support growth. Growth remains our priority as we move into 2007. We participate in many markets with multiple products/services and our goal is to gain market share in every market we operate. During 2006 and into 2007, we are focused on making a larger, unified product suite available to our distribution force. To this end we expect to reorganize our insurance subsidiaries by merging the two primary Jefferson-Pilot insurance subsidiaries, JP Life and JPFIC into LNL and by merging LNY into JPLA during 2007.

Within the Individual Markets’ variable annuity business, our Lincoln Smart SecuritySM Advantage, with its one- and five-year reset feature, continued to experience growth with elections totaling 46% of deposits in 2006 for products which offer these features. In addition, we offer a patented annuity product feature, i4LIFE®, which we introduced a few years ago to meet the needs of baby boomers for retirement income as they enter the retirement phase of their life cycle. The i4LIFE® Advantage product offers a guaranteed minimum income benefit (“GIB”) rider, which can be elected to provide a floor to the amount of income available from the annuity during retirement. In 2006, elections of i4LIFE® were $1.7 billion, an increase of nearly $700 million over 2005. As a result of our merger with Jefferson-Pilot, we offer an indexed fixed annuity, which offers upside growth from equity markets with fixed return protection. We believe that the baby-boomer generation reaching retirement age will present an emerging opportunity for companies like ours that offer products allowing baby-boomers to better manage their wealth accumulation, retirement income and wealth transfer needs.

In our Individual Markets Life Insurance segment, we continue to face competitive pressures, especially related to life insurance products with secondary guarantees. For products with secondary guarantees, we remain committed to maintaining appropriate risk management and pricing discipline despite the competitive environment. Sales of insurance products with such guarantees comprised 69% of our life insurance sales in 2006. In addition, we are seeking capital market solutions in response to regulations requiring increases in statutory reserves for these products.

In conjunction with integrating LNC and Jefferson-Pilot, we created a new Employer Markets reporting segment. The creation of this segment should allow us to better capitalize on the success we have already had in this market place - more than $35 billion in assets under management and administration - and on trends in employer-sponsored benefit plans. These trends include a decline in defined benefit pension plans and an increase in voluntary defined contribution plans, such as 401(k)s / 403(b)s, and a similar trend towards voluntary group life and disability, giving way to a convergence of distribution strategies. We see opportunities to capitalize on revenue synergies by leveraging our Group Protection group business with Retirement Products’ defined contribution platform for a single employer solution. We also believe that the recently passed Pension Protection Act of 2006 will benefit the Employer Markets segment.

Our mutual fund offerings have had strong performance over the one-, three-, and five-year performance periods, resulting in strong deposits and net flows and adding to the assets under management for both the retail and institutional products lines in our Investment Management segment. Growth in deposits and net flows have also benefited from the changes we made during 2005 in the management of certain asset category offerings.

As our businesses and products are complex, so is the manner in which we derive income. We derive our revenues primarily from fees for asset management and mortality and expense charges on variable annuity and variable universal life insurance account values, cost of insurance (“COI”) charges on life insurance products, asset management fees on retail and institutional assets under management, premiums on whole life and term life insurance, and investment income on our general account assets supporting fixed annuity, term life, whole life, universal life and interest sensitive whole life insurance products. COI charges are assessed on the net amount at risk (“NAR”) for investment-oriented life insurance products. NAR represents the face amount of insurance in force less the account values to cover death benefits. Deposits and first year premiums in current quarters do not have a significant immediate impact on current period income from operations, but are an important indicator of future profitability.

The profitability of our variable annuity and investment management businesses is dependent upon the level of account values and assets under management from which fees are earned. Changes in account values and assets under management are the result of net flows, the amount of assets deposited with us, net of assets returned to or withdrawn by the account owner, and the effect of changes in the equity markets on the underlying funds. Variable annuity account values are calculated on a daily basis with fees earned on those daily balances, rather than end of period values. As a result, point to point changes in equity market indices do not affect variable annuity fee income in the immediate period as much as does the timing of when the changes in the

 

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equity markets occurred during the period. Changes in the equity markets also impact the amount of variable annuity payments for guaranteed benefits, such as GMDB, GMWB and GIB as well as the amortization of DAC, VOBA, DSI and DFEL.

The profitability of our fixed annuity and life insurance products is affected by our ability to achieve target spreads, or margins, between the interest income earned on the general account assets and the interest credited to the policyholder. The profitability of the life insurance business depends primarily on the size of the in-force block of business, product-pricing discipline and underwriting proficiency.

During 2007 we expect our major challenges to include:

 

   

The continued, successful integration of the Jefferson-Pilot businesses and the successful launch of our unified product portfolio.

 

   

While recent increases in long-term rates have eased pressure on spreads, a continuation of the low interest rate environment creates a challenge for our products that generate investment margin profits, such as fixed annuities and universal life insurance.

 

   

The ability to generate tangible results from RISV.

 

   

The continued, successful expansion of our wholesale distribution businesses.

 

   

The ability to improve financial results and sales growth in Employer Markets.

 

   

The continuation of competitive pressures in the life insurance marketplace, increased regulatory scrutiny of the life and annuity industry, which may lead to higher product costs and negative perceptions about the industry.

 

   

Continued focus by the government on tax reform, which may impact our products.

In the face of these challenges, there are three key themes that will influence our actions and decisions throughout 2007:

 

   

Taking market share. We are making sizeable investments in distribution throughout the organization, recognizing that sales growth is driven by our ability to maintain a strong presence in our key accounts and distribution channels.

 

   

Jumpstarting our RISV. The focus of this cadre of insurance professionals is to rethink the products, delivery systems and customer servicing that will address the emerging needs of the baby boomers.

 

   

Embedding financial and execution discipline in our operations. We are making significant investments in operating efficiencies while integrating and consolidating systems and processes across the organization. Investment decisions will be evaluated based on a comprehensive metrics-based approach.

Recent Developments

On November 3, 2006, we entered into an agreement to purchase approximately 2.3 million shares of our common stock from a third party broker-dealer, using an accelerated stock buyback program for an aggregate purchase price of $150 million. The program terminated on November 27, 2006. As a result of the aggregate initial purchase price being greater than the volume weighted average share price during the term of the program, 17,000 shares of common stock were delivered on December 1, 2006 in final settlement of the program. All shares were retired upon receipt.

During the fourth quarter of 2006 and first quarter of 2007, we called for redemption $485 million in long-term debt with interest rates ranging from 7.65% to 8.285%. For a description of the redemptions, see “Review of Consolidated Financial Condition – Liquidity and Capital Resources” below.

Critical Accounting Policies

We have identified the accounting policies below as critical to the understanding of our results of operations and our financial position. In applying these critical accounting policies in preparing our financial statements, management must use significant judgments and estimates concerning future results or other developments including the likelihood, timing or amount of one or more future events. Actual results may differ from these estimates under different assumptions or conditions. On an on-going basis, we evaluate our estimates, assumptions and judgments based upon historical experience and various other information

 

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that we believe to be reasonable under the circumstances. For a detailed discussion of other significant accounting policies, see Note 1 of our Consolidated Financial Statements.

Deferred Acquisition Costs, Value of Business Acquired, Deferred Sales Inducements and Deferred Front-end Loads

Accounting for intangible assets requires numerous assumptions, such as estimates of expected future profitability for our operations and our ability to retain existing blocks of life and annuity business in force. Our accounting policies for the deferred acquisition costs (“DAC”), value of business acquired (“VOBA”), deferred sales inducements (“DSI”) and the liability for deferred front-end loads (“DFEL”) impact Individual Markets Annuities, Individual Markets Life Insurance, Employer Markets Retirement Products and Other, Group Protection, and Lincoln UK segments.

Acquisition costs for variable annuity contracts, universal and variable universal life insurance policies are amortized over the lives of the contracts in relation to the incidence of estimated gross profits (“EGPs”) derived from the contracts. Acquisition costs are those costs that vary with and are primarily related to new or renewal business. These costs include commissions and other expenses that vary with new business volume. The costs that we defer are recorded as an asset on our balance sheet as DAC for products we sold or VOBA for books of business we acquired. In addition, we defer costs associated with DSI and revenues associated with DFEL. DFEL is a balance sheet liability, included within contract and policyholder funds, and when amortized, increases product expense charge revenues and income. DSI is a balance sheet asset, included within other assets, and when amortized, increases insurance benefits and reduces income.

During the third quarter of each year, we conduct our annual comprehensive review of the assumptions underlying the amortization of DAC, VOBA, DSI and DFEL. We review the various assumptions including investment margins, mortality and retention. These assumptions also impact the reserves for the guarantee features within our variable annuity and life insurance products. The combined effect of these changes resulted in a decrease to income from operations of $6 million after-tax in 2006, compared with a $41 million after-tax increase to income from operations in 2005. The effects varied by segment and are discussed further in the respective segment discussions below. Additionally, we harmonized several assumptions and related processes as a result of our merger with Jefferson-Pilot.

The table below presents the balances by business segment as of December 31, 2006.

 

December 31, 2006 (in millions)

   Individual Markets    Employer Markets    Lincoln
UK
   Other
Operations
   Total
   Annuities    Life
Insurance
   Retirement
Products
   Group
Protection
        

DAC and VOBA

   $ 2,050    $ 4,659    $ 763    $ 138    $ 809    $ 1    $ 8,420

DSI

     194      —        —        —        —        —        194
                                                

Total DAC, VOBA and DSI

     2,244      4,659      763      138      809      1      8,614

DFEL

     101      450      22      —        404      —        977
                                                

Net DAC, VOBA, DSI and DFEL

   $ 2,143    $ 4,209    $ 741    $ 138    $ 405    $ 1    $ 7,637
                                                

Note: The above table includes DAC and VOBA amortized in accordance with SFAS No. 60, “Accounting and Reporting by Insurance Enterprises.” Under SFAS No. 60, acquisition costs for traditional life insurance and Group Protection’s products, which include whole life and term life insurance contracts, and group life, dental and disability contracts, are amortized over periods of 10 to 30 years for life products and up to 15 years for group products, on either a straight-line basis or as a level percent of premium of the related policies depending on the block of business. No DAC is being amortized under SFAS No. 60 for fixed and variable payout annuities.

EGPs vary based on policy persistency, mortality, fee income, investment margins, expense margins and realized gains and losses on investments, including assumptions about the expected level of credit-related losses. Each of these sources of profit is, in turn, driven by other factors. For example, assets under management and the spread between earned and credited rates drive investment margins; net amount at risk drives the level of COI charges and reinsurance premiums. The level of separate account assets under management is driven by changes in the financial markets (equity and bond markets, hereafter referred to collectively as “equity markets”) and net flows. Realized gains and losses on investments include amounts resulting from differences in the actual level of impairments from the levels assumed in calculating EGPs.

Because equity market movements have a significant impact on the value of variable annuity and unit-linked accounts (contracts written in the U.K. similar to U.S. produced variable life and annuity products) and the fees earned on these accounts, EGPs could increase or decrease with movements in the equity markets. Significant and sustained changes in equity markets could therefore have an impact on DAC amortization for our variable annuity, annuity-based 401(k) business and unit-linked business, but have significantly less impact on DAC amortization for our life insurance business because approximately 83% of their account values pertain to interest sensitive products, such as universal life and interest sensitive whole life. Our assumption for the long-

 

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term annual gross growth rate of the equity markets used in the determination of DAC amortization is 9%, which is reduced by mortality and expense charges (“M&E”) and asset management charges.

On a quarterly basis, we review actual and estimates of future gross profits underlying the DAC amortization model and record a positive or negative retrospective adjustment to the amount expensed (i.e., unlock DAC, VOBA and DSI), or earned (i.e. unlock DFEL). On an annual basis, we review and adjust as necessary our assumptions for prospective amortization of DAC, VOBA, DSI and DFEL. As discussed further below, we completed our 2006 comprehensive review of assumptions during the quarter ended September 30, 2006.

As equity markets do not move in a systematic manner, we use a “reversion to the mean” (“RTM”) process to compute our best estimate long-term gross growth rate assumption. Prior to the fourth quarter of 2004, our application of RTM resulted in the use of a higher or lower future gross equity market growth assumption, which, together with actual historical gross equity market growth, was expected to produce a 9% gross return. The use of a higher or lower future equity market growth assumption under RTM tended to mitigate the impact that short-term fluctuations in the equity markets have on the estimated EGPs as compared to the process we followed prior to implementing the RTM process. Until the fourth quarter of 2004, our RTM process gave consideration to the effect of short-term fluctuations in the equity markets on projected future EGPs. A reversion to the mean to adjust for historical changes in the equity markets results in a positive or negative DAC unlocking.

Beginning in the fourth quarter of 2004, we enhanced our RTM process to evaluate the carrying value of DAC for our variable annuity, annuity-based 401(k) and unit-linked product blocks of business. We changed our RTM process because we do not believe that random and insignificant short-term fluctuations in equity market returns are reflective of the best estimate of future EGPs. We believe it is larger fluctuations or sustained trends in the equity markets that should change our best estimate of future EGPs for these products. This process is not applied to our life insurance and fixed annuity businesses, as equity market performance does not have a significant impact on these products. Under our current RTM process, on each valuation date, future EGPs are projected using stochastic modeling of a large number of future equity market scenarios in conjunction with best estimates of lapse rates, interest rate spreads and mortality to develop a statistical distribution of the present value of future EGPs for each of the blocks of business. Because future equity market returns are impossible to predict, the underlying premise of this process is that best estimate projections of future EGPs, as required by Statement of Financial Accounting Standards (“SFAS”) No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments”, need not be affected by random short-term and insignificant deviations from expectations in equity market returns. However, long-term or significant deviations from expected equity market returns require a change to best estimate projections of EGPs and prospective unlocking of DAC, VOBA, DSI and DFEL. The statistical distribution is designed to identify when the equity market return deviations from expected returns have become significant enough to warrant a change of the future equity return EGP assumption.

The stochastic modeling performed for our variable annuity blocks of business as described above is used to develop a range of reasonably possible future EGPs. We compare the range of the present value of the future EGPs from the stochastic modeling to that used in the DAC amortization model. A set of intervals around the mean of these scenarios is utilized to calculate two separate statistical ranges of reasonably possible EGPs. These intervals are compared to the present value of the EGPs used in the DAC, VOBA, DSI and DFEL amortization model. If the present value of EGP assumptions utilized for amortization were to exceed the margin of the reasonable range of statistically calculated EGPs, a revision of the EGPs used to calculate amortization would occur. If a revision is deemed necessary, future EGPs would be re-projected using the current account values at the end of the period during which the revision occurred along with a revised long-term annual equity market gross return assumption such that the re-projected EGPs would be our best estimate of EGPs.

Notwithstanding these intervals, if a severe decline or advance in equity markets were to occur or should other circumstances, including policyholder activity, suggest that the present value of future EGPs no longer represents our best estimate, we could determine that a revision of the EGPs is necessary. A severe decline or advance in equity markets would involve a sustained change from December 31, 2006 levels.

Our practice is not necessarily to unlock immediately after exceeding the first of the two statistical ranges, but rather if we stay between the first and second statistical range for several quarters, we would likely unlock. Additionally, if we exceed the ranges as a result of a short-term market reaction, such as we saw after the events of September 11, 2001, we would not necessarily unlock. However, if the second statistical range is exceeded for more than one quarter, it is likely that we would unlock. While this approach reduces adjustments to DAC, VOBA, DSI and DFEL due to short-term equity market fluctuations, significant changes in the equity markets that extend beyond one or two quarters could result in a significant positive or negative unlocking.

Our long-term equity market growth assumption rate is 9%, which is used in the determination of DAC amortization for the variable component of our variable annuity products, as this component is primarily equity related. This variable appreciation rate

 

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is before the deduction of our contract fees. Under our current RTM methodology, we take into account the market performance on the business that was in force when the enhanced RTM methodology was put in effect using the RTM process used prior to the fourth quarter of 2004. For business issued in years prior to 2005 for the Individual Markets Annuity—segment and a portion of the Employer Markets—Defined Contribution segment, the assumed annual variable appreciation rate is 5.11% as of December 31, 2006. It remains 5.11% for the subsequent 21-month period and is then 9% thereafter. For business issued subsequent to 2004, the assumed annual variable appreciation rate and the long-term growth rate are 9%. The actual variable appreciation rate since the date of enhanced RTM implementation has been better than the assumed rate. As a result, we are more likely to unlock DAC from positive variable performance rather than from negative returns from December 31, 2006. Given our position within the range around our best estimate of EGPs for the Individual Markets—Annuity and the Employer Markets—Defined Contribution segments at December 31, 2006, a one-quarter equity market movement of positive 10% would bring us to the first of the two statistical ranges while a one-quarter equity market movement of positive 35% would bring us to the second of the two ranges for these segments. Subsequent equity market performance that would keep us at or move us beyond the first statistical range would likely result in positive unlocking. Negative equity market performance would have to be significantly greater than the above percentages for us to exceed the lower end of the two statistical ranges. As an illustration of the potential impact, given where our best estimate of EGPs for the Individual Markets—Annuity and Employer Markets—Defined Contribution segments were positioned in the range at December 31, 2006, if we were to reset the RTM to a gross equity market growth assumption representing the midpoint between the first of the two statistical ranges and the mean of the projections from December 31, 2006 forward in determining revised EGPs, we estimate it would result in a cumulative decrease to DAC amortization (positive DAC unlocking) of approximately $104 million pre-tax ($67 million after-tax).

In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants (“AICPA”) issued Statement of Position (“SOP”) 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts” (“SOP 05-1”). SOP 05-1 addresses the accounting for DAC on internal replacements other than those described in SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments.” An internal replacement is defined by SOP 05-1 as a modification in product benefits, features, rights or coverages that occurs by (a) exchanging the contract for a new contract, (b) amending, endorsing or attaching a rider to the contract, or (c) electing a feature or coverage within a contract. Contract modifications that result in a substantially unchanged contract will be accounted for as a continuation of the replaced contract. Contract modifications that result in a substantially changed contract should be accounted for as an extinguishment of the replaced contract, and any unamortized DAC, unearned revenue and deferred sales charges must be written-off. SOP 05-1 is to be applied prospectively and is effective for internal replacements occurring in fiscal years beginning after December 15, 2006.

We will adopt this new accounting guidance effective January 1, 2007, primarily impacting both our Individual Markets Annuities and our Employer Markets Group Protection businesses. The adoption of this new guidance impacts our assumptions for lapsation used in the amortization of DAC and VOBA. We estimate that our adoption will result in a reduction to our DAC and VOBA balances between $75 million to $100 million pre-tax, which will be recorded as a reduction to retained earnings. SOP 05-1 is expected to prospectively increase DAC and VOBA amortization in 2007. Our preliminary estimates indicated a range of $15-20 million increase in DAC and VOBA amortization primarily for Individual Markets Annuities. Our preliminary estimates are based upon our interpretation of SOP 05-1 and the proposed implementation guidance. We continue to analyze the impact on DAC and VOBA amortization and are currently evaluating the effect of a Technical Practice Aide (“TPA”) issued in February 2007. As a result, the actual impact of the adoption of SOP 05-1 may differ significantly from our preliminary estimates as the issuance of new implementation guidance and evolving industry practice may affect our interpretation and implementation.

Goodwill and Other Intangible Assets

Under SFAS No. 142, “Goodwill and Other Intangible Assets”, goodwill and intangible assets with indefinite lives are not amortized, but are subject to impairment tests conducted at least annually. Intangibles that do not have indefinite lives are amortized over their estimated useful lives.

The valuation techniques we use to estimate the fair value of the group of assets comprising the different reporting units varies based on the characteristics of each reporting unit’s business and operations. A market-based valuation technique that focuses on price-to-earnings (“P/E”) multiplier and the segment-level operating income is used for the Individual Markets and Employer Markets operating business. For the Lincoln UK segment, a discounted cash flow model is utilized to determine the fair value. A valuation technique combining multiples of revenues, earnings before interest, taxes, depreciation and amortization and assets under management is used to assess the goodwill in our Investment Management segment. We use October 1 as the annual review date for impairment. The results of the tests performed as of October 1, 2006, 2005 and 2004 indicated that we did not have impaired goodwill. The valuation techniques used for the Lincoln UK and the Investment Management segments are consistent with the methods used in previous periods.

 

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The $3.3 billion of goodwill resulting from the merger with Jefferson-Pilot, which resulted from the excess of the purchase price over the fair value of the net assets acquired at the merger date, was not tested for impairment as we believe the fair market valuation performed as of the merger date continues to be a reasonable basis for market value for that portion of our business for purposes of evaluating the recoverability of goodwill. We are in the process of finalizing our internal studies of the fair value of the net assets acquired including investments, VOBA, intangible assets and certain liabilities. As such, the preliminary fair values are subject to adjustment as additional information is obtained, which may result in adjustments to goodwill, which we do not expect to be material. Since there were no events or circumstances to indicate that there may be any significant change in the fair value of net assets acquired, management did not update the estimated fair value or perform an October 1, 2006 impairment test for the acquired goodwill.

Investments

Our primary investments are in fixed maturity securities, including corporate and government bonds, asset and mortgage-backed securities and redeemable preferred stock, and equity securities, mortgage loans and policy loans. All our fixed maturity and equity securities are classified as available-for-sale as defined in SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” except for those securities supporting certain reinsurance transactions which are classified as trading securities. Available-for-sale securities are carried at fair value with the difference from amortized cost included in shareholders’ equity as a component of accumulated other comprehensive income. The difference is net of related DAC, VOBA, DSI and DFEL and amounts that would be credited to policyholders, if realized, and taxes.

Investment Valuation

Fair values for fixed maturity securities are based on quoted market prices, where available. For fixed maturity securities that are not actively traded, fair values are estimated using values obtained from independent pricing services. The fair values for equity securities are based on quoted market prices. Fair values for private securities are estimated by (1) a matrix process that employs discounting expected future cash flows using a current market rate applicable to the coupon rate, credit quality, industry sector and maturity of the investments; (2) third party-supplied prices or secondary market transactions; and (3) applying professional judgment to arrive at the fair value based upon prices of public or non-public securities of similarly situated issuers.

Write-Downs for Other-Than-Temporary Impairments and Allowance for Losses

Determining whether a decline in current fair values is other than a temporary decline in value for securities classified as available-for-sale and trading can frequently involve a variety of assumptions and estimates, particularly for investments that are not actively traded on established markets. For instance, assessing the value of some investments requires an analysis of expected future cash flows. Some investment structures, such as collateralized debt obligations, often represent selected levels, or tranches collateralized by underlying investments in a wide variety of underlying issuers and security types.

Factors we consider in determining whether declines in the fair value of fixed maturity securities are other-than-temporary include 1) the significance of the decline; 2) our ability and intent to retain the investment for a sufficient period of time for it to recover to an amount at least equal to its carrying value; 3) the time period during which there has been a significant decline in value; and 4) fundamental analysis of the liquidity, business prospects and overall financial condition of the issuer. Based upon these factors, securities that have indications of potential impairment are subject to intensive review. Where such analysis results in a conclusion that declines in fair values are other-than-temporary, the security is written down to fair value. The fixed maturity securities to which these write-downs apply were generally of investment grade at the time of purchase, but were subsequently downgraded by rating agencies to “below-investment grade.” See Note 11 to the Consolidated Financial Statements for a general discussion of the methodologies and assumptions used to determine estimated fair values.

For certain securitized fixed maturity securities with contractual cash flows, including asset-backed securities, we use our best estimate of cash flows for the life of the security to determine whether there is an other-than-temporary impairment of the security as required under Emerging Issues Task Force (“EITF”) Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets,” and we review for other indicators of impairment as required by FASB Staff Position (“FSP”) 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”.

Based on our evaluation of securities with an unrealized loss at December 31, 2006, we do not believe that any additional other-than-temporary-impairment losses, other than those already reflected in the financial statements, are necessary. At December 31, 2006, there were available-for-sale securities with unrealized losses totaling $373 million pre-tax, and prior to the impact on DAC, VOBA, DSI and DFEL.

 

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As the discussion above indicates, there are risks and uncertainties associated with determining whether declines in the fair value of investments are other–than-temporary. These include subsequent significant changes in general overall economic conditions, as well as specific business conditions affecting particular issuers, future financial market effects such as interest rate spreads, stability of foreign governments and economies, future rating agency actions and significant accounting, fraud or corporate governance issues that may adversely affect certain investments. In addition, there are often significant estimates and assumptions that we use to estimate the fair values of securities, including projections of expected future cash flows and pricing of private securities. We continually monitor developments and update underlying assumptions and financial models based upon new information.

Write-downs and allowances for losses on select mortgage loans on real estate, real estate and other investments are established when the underlying value of the property is deemed to be less than the carrying value. All mortgage loans that are impaired have an established allowance for credit loss. Changing economic conditions impact our valuation of mortgage loans. Increasing vacancies, declining rents and the like are incorporated into the discounted cash flow analysis that we perform for monitored loans and may contribute to the establishment of (or an increase in) an allowance for credit losses. In addition, we continue to monitor the entire commercial mortgage loan portfolio to identify risk. Areas of current emphasis are the hotel mortgage loan portfolio and retail, office and industrial properties that have deteriorating credits or have experienced debt coverage reduction. Where warranted, we have established or increased loss reserves based upon this analysis.

Derivatives

To protect us from a variety of equity market and interest rate risks that are inherent in many of our life insurance and annuity products, we use various derivative instruments. Assessing the effectiveness of these hedging programs and evaluating the carrying values of the related derivatives often involve a variety of assumptions and estimates. We use derivatives to hedge equity market risks, interest rate risk and foreign currency exposures that are embedded in our annuity and life insurance product liabilities or investment portfolios. Derivatives held at December 31, 2006 contain industry standard terms and are entered into with financial institutions with long-standing, superior performance records. Our accounting policies for derivatives and the potential impact on interest spreads in a falling rate environment are discussed in “Item 7A. Quantitative and Qualitative Disclosures About Market Risk.” See Note 10 to the Consolidated Financial Statements for additional information on our accounting for derivatives.

Guaranteed Minimum Withdrawal and Guaranteed Income Benefits

The Individual Markets Annuity segment has a hedging strategy designed to mitigate the risk and income statement volatility caused by changes in the equity markets, interest rates, and volatility associated with the Lincoln Smart SecuritySM Advantage GMWB feature and, beginning in the fourth quarter of 2006, our i4LIFE® Advantage GIB feature that is available in our variable annuity products. The hedging strategy is designed such that changes in the value of the hedge contracts move in the opposite direction of changes in the value of the embedded derivative of the GMWB and GIB. This dynamic hedging strategy utilizes U.S.-based and international equity futures and options as well as interest rate futures and swaps. The notional amounts of the underlying hedge instruments are such that the magnitude of the change in the value of the hedge instruments due to changes in equity markets, interest rates, and implied volatilities is designed to offset the magnitude of the change in the fair value of the GMWB and GIB guarantees caused by those same factors. At December 31, 2006, the embedded derivative for GMWB was an asset valued at $39 million and the embedded derivative for i4LIFE® Advantage GIB was an asset valued at $14 million.

As part of our current hedging program, policyholder behavior and equity, interest rate, and volatility market conditions are monitored on a daily basis. We rebalance our hedge positions based upon changes in these factors as needed. While we actively manage our hedge positions, our hedge positions may not be totally effective to offset changes in assets and liabilities caused by movements in these factors due to, among other things, differences in timing between when a market exposure changes and corresponding changes to the hedge positions, extreme swings in the equity markets and interest rates, market volatility, policyholder behavior, divergence between the performance of the underlying funds and the hedging indices, divergence between the actual and expected performance of the hedge instruments, or our ability to purchase hedging instruments at prices consistent with our desired risk and return trade-off.

The table below illustrates our estimates of the potential instantaneous impact to income from operations which could result from sudden changes in equity markets, interest rates and implied market volatilities at the levels indicated in the table and excludes the run rate impacts which may occur. The amounts represent the estimated difference between the change in GMWB reserves and the change in the value of the underlying hedge instruments on an after-DAC and after-tax basis resulting from such changes. These estimates are based upon the recorded reserves for GMWB at December 31, 2006 and the related hedge instruments in place as of that date.

 

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December 31, 2006 (in millions)

   Inforce Sensitivities  
     -20%       -10%       -5%       5%  
                                

Equity market return

   $ (11 )   $ (2 )   $ (1 )   $ —    
     -50 bps       -25 bps       +25 bps       +50 bps  
                                

Interest rates

   $ (2 )   $ (1 )   $ —       $ —    
     -4%       -2%       2%       4%  
                                

Implied volatilities

   $ —       $ —       $ (1 )   $ (3 )

S&P 500 Index® Benefits

We also have in place a hedging program for our indexed annuities we obtained through our merger with Jefferson-Pilot. These contracts permit the holder to elect an interest rate return or an equity market component, where interest credited to the contracts is linked to the performance of the S&P 500 Index®. Policyholders may elect to rebalance index options at renewal dates, either annually or biannually. At each renewal date, we have the opportunity to re-price the indexed component by establishing participation rates, subject to minimum guarantees. We purchase options that are highly correlated to the portfolio allocation decisions of our policyholders, such that we are economically hedged with respect to equity returns for the current reset period. The mark-to-market of the options held impacts net investment income and generally offsets the change in value of the embedded derivative within the indexed annuity, which is recorded as a component of interest credited to policyholders’ within insurance benefits. SFAS 133 requires that we calculate fair values of index options we may purchase in the future to hedge policyholder index allocations in future reset periods. These fair values represent an estimate of the cost of the options we will purchase in the future, discounted back to the date of the balance sheet, using current market indicators of volatility and interest rates. Changes in the fair values of these liabilities are included as a component of interest credited to policyholders’ within insurance benefits.

Insurance and Investment Contract Obligations

Reserves

These reserves are the amounts that, with the additional premiums to be received and interest thereon compounded annually at certain assumed rates, are calculated to be sufficient to meet the various policy and contract obligations as they mature. Establishing adequate reserves for our obligations to policyholders requires assumptions to be made regarding mortality and morbidity. The applicable insurance laws under which insurance companies operate require that they report, as liabilities, policy reserves to meet future obligations on their outstanding policies. These laws specify that the reserves shall not be less than reserves calculated using certain specified mortality and morbidity tables, interest rates, and methods of valuation.

The reserves reported in our financial statements contained herein are calculated in accordance with GAAP and differ from those specified by the laws of the various states and carried in the statutory financial statements of the life insurance subsidiaries. These differences arise from the use of mortality and morbidity tables, interest, persistency and other assumptions which we believe to be more representative of the expected experience for these policies than those required for statutory accounting purposes and from differences in actuarial reserving methods. For example, in October 2005, the National Association of Insurance Commissioners (“NAIC”) adopted a change to Actuarial Guideline 38 (also known as “AXXX”), the statutory reserve requirements for UL products with secondary guarantees, which impacts such business written after the effective date of July 1, 2005. There was no impact to GAAP reserves or results of operations as a result of Actuarial Guideline 38.

The assumptions on which reserves are based are intended to represent an estimation of experience for the period that policy benefits are payable. If actual experience is better than or equal to the assumptions, then reserves should be adequate to provide for future benefits and expenses. If experience is worse than the assumptions, additional reserves may be required. This would result in a charge to our net income during the period the increase in reserves occurred. The key experience assumptions include mortality rates, policy persistency and interest rates. We periodically review our experience and update our policy reserves for new issues and reserve for all claims incurred, as we believe appropriate.

 

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Guaranteed Minimum Death Benefits

The reserves related to the GMDB features available in our variable annuity products are based on the application of a benefit ratio to total assessments related to the variable annuities. The level and direction of the change in reserves will vary over time based on the emergence of the benefit ratio (which is based on both historical and projected future level of benefits) and the level of assessments (both historical and projected) associated with the variable annuity.

We utilize a delta hedging strategy for variable annuity products with a GMDB feature, which uses futures on U.S.-based equity market indices to hedge against movements in equity markets. The hedging strategy is designed such that changes in the value of the hedge contracts move in the opposite direction of equity market driven changes in the reserve for GMDB contracts subject to the hedging strategy. Because the GMDB reserves are based upon projected long-term equity market return assumptions, and since the value of the hedging contracts will reflect current capital market conditions, the quarterly changes in values for the GMDB reserves and the hedging contracts may not offset each other on an exact basis. Despite these short-term fluctuations in values, we intend to continue to hedge our long-term GMDB exposure in order to mitigate the risk associated with falling equity markets. Account balances covered in this hedging program combined with account balances for which there is no death benefit represent approximately 94% of total variable annuity account balances, which excludes the Alliance mutual fund business.

Deferred Gain on Sale of the Reinsurance Segment

In 2001, we sold our reinsurance operation to Swiss Re. The transaction involved a series of indemnity reinsurance transactions combined with the sale of certain stock companies that comprised our reinsurance operation. The gain related to the indemnity reinsurance transactions was recorded as deferred gain in the liability section of our Consolidated Balance Sheet in accordance with the requirements of SFAS No. 113, “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts” (“SFAS 113”). The deferred gain is being amortized into income at the rate that earnings on the reinsured business are expected to emerge, over a period of 15 years. In addition, because we have not been relieved of our legal liabilities to the underlying ceding companies with respect to the portion of the business indemnity reinsured by Swiss Re, under SFAS 113 the reserves for the underlying reinsurance contracts as well as a corresponding reinsurance recoverable from Swiss Re will continue to be carried on our Consolidated Balance Sheet during the run-off period of the underlying reinsurance business. This is particularly relevant in the case of the exited personal accident reinsurance lines of business where the underlying reserves are based upon various estimates that are subject to considerable uncertainty.

Because of ongoing uncertainty related to personal accident business, the reserves related to these exited business lines carried on our Consolidated Balance Sheet at December 31, 2006 may ultimately prove to be either excessive or deficient. For instance, in the event that future developments indicate that these reserves should be increased, we would record a current period non-cash charge to record the increase in reserves. Because Swiss Re is responsible for paying the underlying claims to the ceding companies, we would record a corresponding increase in reinsurance recoverable from Swiss Re. However, SFAS 113 does not permit us to take the full benefit in earnings for the recording of the increase in the reinsurance recoverable in the period of the change. Rather, we would increase the deferred gain recognized upon the closing of the indemnity reinsurance transaction with Swiss Re and would report a cumulative amortization “catch-up” adjustment to the deferred gain balance as increased earnings recognized in the period of change. Any amount of additional increase to the deferred gain above the cumulative amortization “catch-up” adjustment must continue to be deferred and will be amortized into income in future periods over the remaining period of expected run-off of the underlying business. No cash would be transferred between Swiss Re and us as a result of these developments.

Pension and Other Postretirement Benefit Plans

Pursuant to the accounting rules for our obligations to employees under our various pension and other postretirement benefit plans, we are required to make a number of assumptions to estimate related liabilities and expenses. We use assumptions for the weighted-average discount rate, expected return on plan assets and a salary increase assumption to estimate pension expense. The discount rate assumptions are determined using an analysis of current market information and the projected benefit flows associated with these plans. The expected long-term rate of return on plan assets is initially established at the beginning of the plan year based on historical and projected future rates of return and is the average rate of earnings expected on the funds invested or to be invested in the plan. The calculation of our accumulated postretirement benefit obligation also uses an assumption of weighted-average annual rate of increase in the per capita cost of covered benefits, which reflects a health care cost trend rate. See Note 8 for more information on our accounting for employee benefit plans.

 

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Equity Market Guidance

Due to the use of our RTM process and our hedging strategies as described in “Critical Accounting Policies” above, we expect that in general, short-term fluctuations in the equity markets should not have a significant impact on our quarterly earnings from unlocking of assumptions for DAC, VOBA, DSI and DFEL. However, there is an impact to earnings from the affects of equity market movements on account values and assets under management and the related fees we earn on those assets. The table below presents our estimate of the annual after-tax impact on fees on account values and assets under management, after the associated DAC amortization, from a 1% change in the equity markets.

 

Segment

  

Relevant Measure

  

Impact per 1%

(in millions)

Investment Management

   Composite of Equity Assets*    $ 2

Individual Markets-Annuities

   Average daily change in the S&P 500      3

Employer Markets-Defined Contribution

   Average daily change in the S&P 500      1

Lincoln UK

   Average daily change in the FTSE 100      —  

* The Investment Management segment manages equity-based assets of varying styles (growth, value, blend, and international) and underlying products (mutual funds, institutional accounts, insurance separate accounts, etc.). No single equity benchmark is an accurate predictor of the change in fee revenue for this segment. The estimated annual effect on fees noted above is based on a 1% increase in overall Investment Management equity-based assets.

The fee income factors represent an expected annual effect. The result of the above factor should be multiplied by 25% to arrive at an estimated quarterly effect. The effect of quarterly equity market changes upon fee revenues will not be fully recognized in the current quarter due to the fact that fee revenues are earned based upon daily variable account values. The difference between the current period average daily variable account values compared to the end of period variable account values impacts fee revenues in subsequent periods. This discussion concerning the estimated effects of ongoing equity market volatility on the fees we earn from account values and assets under management is intended to be illustrative. Actual effects may vary depending on a variety of factors, many of which are outside of our control, such as changing customer behaviors that might result in changes in the mix of our business between variable and fixed annuity contracts, switching between investment alternatives available within variable products, or changes in policy persistency. For purposes of this guidance, the change in account values is assumed to correlate with the change in the relevant index. See “Item 7A. Quantitative and Qualitative Disclosures About Market Risk—Market Risk Exposures of Financial Instruments—3) Equity Market Exposures—Fee Revenues” of this Form 10-K for additional information of the effect of equity markets on fee revenues.

 

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RESULTS OF CONSOLIDATED OPERATIONS

 

Year Ended December 31, (in millions)

   2006     2005     2004    

Increase (Decrease)

Over Prior Year

 
         2006     2005  

Insurance premiums

   $ 1,406     $ 308     $ 299     NM     3 %

Insurance fees

     2,604       1,752       1,600     49 %   10 %

Investment advisory fees

     328       256       239     28 %   7 %

Communications revenue (net)

     187       —         —       NM     NM  

Net investment income

     3,981       2,702       2,704     47 %   0 %

Amortization of deferred gain

     76       77       88     -1 %   -13 %

Other revenues and fees

     484       383       344     26 %   11 %

Net realized investment losses

     (3 )     (17 )     (58 )   82 %   71 %

Gain on sale of subsidiaries

     —         14       135     -100 %   -90 %
                            

Total revenue

     9,063       5,475       5,351     66 %   2 %
                            

Insurance benefits

     4,170       2,332       2,243     79 %   4 %

Underwriting, acquisition, insurance and other expenses

     2,759       1,981       1,972     39 %   0 %

Communications expenses

     98       —         —       NM     NM  

Interest and debt expenses

     225       87       100     159 %   -13 %
                            

Total benefits and expenses

     7,252       4,400       4,315     65 %   2 %
                            

Income before federal income taxes

     1,811       1,075       1,036     68 %   4 %

Federal income taxes

     495       244       304     103 %   -20 %
                            

Income before cumulative effect of accounting change

     1,316       831       732     58 %   14 %

Cumulative effect of accounting change

     —         —         (25 )   NM     100 %
                            

Net income

   $ 1,316     $ 831     $ 707     58 %   18 %
                            

Items included in net income (after-tax):

          

Realized loss on investments and derivative instruments

   $ (3 )   $ (14 )   $ (38 )    

Net gain on reinsurance embedded derivative/trading securities

     2       3       (1 )    

Gain on sale of subsidiaries

     —         9       62      

Restructuring charges

     (9 )     (19 )     (14 )    

Reserve development, net of related amortization on business sold through indemnity reinsurance

     1       —         —        

Loss on early retirement of debt

     (4 )     —         (4 )    

Cumulative effect of accounting change

     —         —         (25 )    

 

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The table below provides a detailed comparison of items included within net realized investment gains (losses).

 

Year Ended December 31, (in millions)

   2006     2005     2004    

Improvement (Worsening)

Over Prior Year

 
         2006     2005  

Realized gains on investments

   $ 155     $ 142     $ 141     9 %   1 %

Realized losses on investments

     (120 )     (102 )     (123 )   -18 %   17 %

Realized gain (loss) on derivative instruments

     1       (2 )     (16 )   150 %   88 %

Amounts amortized to balance sheet accounts

     (41 )     (50 )     (49 )   18 %   -2 %

Gain on reinsurance embedded derivative/trading securities

     4       5       (1 )   -20 %   NM  

Investment expenses

     (2 )     (10 )     (10 )   80 %   —    
                            

Net losses on investments and derivative instruments

   $ (3 )   $ (17 )   $ (58 )   82 %   71 %
                            

Write-downs for other-than-temporary impairments included in realized losses on investments above

   $ (64 )   $ (22 )   $ (73 )   NM     70 %

As previously discussed, key operational measures of our success are deposits, net flows and assets under management. The table below summarizes these key measures for our U.S. based business segments over the last three years. These operational measures provide information necessary in understanding changes in our revenues and related expenses. Deposits are the result of sales of our products and represent money put into our products each year. Net flows represent the deposits net of withdrawals, payments on death and surrenders. Assets under management include our investment securities as well as those assets belonging to third parties but managed by our businesses. Assets under management also include assets that are sub-advised by third parties. For additional detail of deposit and net flow information, see the discussion in “Results of Operations by Segment” below.

 

Year Ended December 31, (in millions)

   2006     2005     2004     Improvement (Worsening)
Over Prior Year
 
         2006     2005  

Deposits

          

Individual Markets:

          

Annuities

   $ 10,756     $ 7,528     $ 6,498     43 %   16 %

Life Insurance

     3,365       2,031       1,970     66 %   3 %

Employer Markets:

          

Defined Contribution

     4,585       4,403       4,105     4 %   7 %

Executive Benefits

     267       210       273     27 %   -23 %

Investment Management (1)

     28,094       31,404       22,459     -11 %   40 %

Consolidating adjustments (2)

     (3,838 )     (3,465 )     (3,674 )   -11 %   6 %
                            

Total Deposits

   $ 43,229     $ 42,111     $ 31,631     3 %   33 %
                            

Net Flows

          

Individual Markets:

          

Annuities

   $ 2,665     $ 2,879     $ 2,387     -7 %   21 %

Life Insurance

     2,023       1,195       1,136     69 %   5 %

Employer Markets:

          

Defined Contribution

     342       420       1,079     -19 %   -61 %

Executive Benefits

     57       162       112     -65 %   45 %

Investment Management (1)

     9,177       15,220       8,640     -40 %   76 %

Consolidating adjustments (2)

     114       174       (39 )   -34 %   NM  
                            

Total Net Flows

   $ 14,378     $ 20,050     $ 13,315     -28 %   51 %
                            

 

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(in millions)

   2006    2005    2004    Increase (Decrease)
Over Prior Year
 
            2006     2005  

Assets Under Management by Advisor (3)

             

Investment Management: (1)

             

External assets

   $ 97,306    $ 77,633    $ 57,127    25 %   36 %

Insurance-related assets

     67,067      43,086      42,791    56 %   1 %

Lincoln UK

     10,108      8,562      8,586    18 %   0 %

Within business units (policy loans)

     2,760      1,862      1,900    48 %   -2 %

By non-LNC entities

     56,282      40,612      33,900    39 %   20 %
                         
   $ 233,523    $ 171,755    $ 144,304    36 %   19 %
                         

(1)

In September 2004, we completed the sale of our London-based international investment management unit (“DIAL”), which had assets under management of $22.1 billion at the date of sale. For additional information see “Results of Operations—Investment Management.” Assets under management include assets sub-advised for us by unaffiliated parties. Sub-advised assets were $22.7 billion, or approximately 14%, of the Investment Management segment’s assets under management at December 31, 2006, compared to $20.5 billion, or approximately 17%, at December 31, 2005.

(2)

Consolidating adjustments represent the elimination of deposits and net flows on products affecting more than one segment.

(3)

Assets under management by advisor provides a breakdown of assets that we manage or administer either directly or through unaffiliated third parties. These assets represent our investments, assets held in separate accounts and assets that we manage or administer for individuals or other companies. We earn insurance fees, investment advisory fees or investment income on these assets.

NM - Not Meaningful

Comparison of 2006 to 2005

Net income increased $485 million, or 58%, in 2006 compared to the prior year. The merger with Jefferson-Pilot was the primary driver of the increase. Also included in the increase was the net effect of a favorable insurance recovery related to losses incurred in connection with U.K. sales practices partially offset by net unfavorable adjustments from the completion of the annual comprehensive review of assumptions underlying the amortization of DAC, VOBA, DSI and DFEL, higher incentive compensation expenses and reserves for annuity and life insurance products with secondary guarantees.

Revenues

The merger with Jefferson-Pilot was the primary driver for the increase in insurance premiums and fees in 2006 compared with the same 2005 period. In addition to the merger, the increase in insurance fees and investment advisory fees in 2006 reflects growth in deposits and assets under management, as well as, the effects of favorable equity market performance. Assets under management increased 36% as a result of the Jefferson-Pilot merger, positive net flows and equity market gains. The average level of the equity markets was higher in 2006 compared to 2005, resulting in higher fee income. Excluding the impact of dividends, the S&P 500 Index® increased 13.6% and the average daily S&P 500 Index® increased 8.5% in 2006, compared to 2005.

The increase in net investment income in 2006 compared to 2005 primarily reflects the addition of Jefferson-Pilot investment assets, higher portfolio yields and higher invested assets due to the favorable effect of asset growth from net flows and equity markets. Negative fixed annuity net flows of $2.4 billion offset growth in indexed and variable annuity net flows. Fixed annuity net flows in 2006 were unfavorably impacted by higher withdrawals driven by the expiration of multi-year crediting rate guarantees on certain products we sold three to five years ago.

Included in revenues were net realized losses on investments of $(3) million in 2006 compared to $(17) million in 2005. See “Consolidated Investments” below for additional information on our investment performance. Revenues from the sale of subsidiaries/businesses in 2005 included a pre-tax gain of $14 million from an agreement to settle in full the residual contingent payments resulting from the arrangement to outsource Lincoln UK’s back-office operations to Capita Life and Pension Services Limited, a subsidiary of Capita Group Plc (“Capita”) the outsourcing firm for Lincoln UK’s customer and policy administration functions.

 

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Benefits and Expenses

Consolidated benefits and expenses increased $2.9 billion, or 65%, in 2006 compared to 2005, primarily due to the merger with Jefferson-Pilot. See “Results of Operations by Segment” below for further discussion by segment. Growth in our business partially offset by the effect of spread management through lower crediting rates on interest sensitive business and movements from fixed to variable annuity products also contributed to the increase. Expenses in 2006 benefited from a $26 million ($17 million after-tax) insurance recovery related to losses incurred in connection with U.K. sales practices.

Consolidated expenses in 2006 include $49 million related to the merger with Jefferson-Pilot for integration costs, including restructuring charges that were the result of actions undertaken by us to eliminate duplicate operations and functions as a result of the Jefferson-Pilot merger. These actions will be ongoing and are expected to be substantially complete by late 2008, with a total estimated cost of $180 million pre-tax. Expenses in 2005 included pre-tax restructuring charges of $30 million and were the result of expense initiatives undertaken by us during 2003 to improve operational efficiencies. For additional information on restructuring charges, see Note 15 to our Consolidated Financial Statements.

Consolidated expenses in 2006 also include $9 million pre-tax of net expense for the effect of net unfavorable unlocking resulting from the annual comprehensive review of the assumptions underlying the amortization of DAC, VOBA, DSI and DFEL as well as the reserves related to GMDB and the embedded derivative related to GMWB and liabilities for life insurance products sold with secondary guarantees, which compares with a net reduction of $64 million pre-tax for the 2005 period. The impact of the adjustments from the prospective assumption review varied by segment. The factors impacting the adjustments are discussed further in the respective segment discussions below. Expenses in 2006 include an increase in net operating and administrative expenses of approximately $47 million pre-tax ($31 million, after-tax) caused by an increase in incentive compensation expenses to reflect actual performance in 2006.

Federal Income Taxes

Federal income tax expense in 2006 includes a reduction of $42 million related to a favorable true-up to the 2005 tax return primarily driven by the separate accounts dividends-received deduction (“DRD”) and, to a lesser extent, foreign tax credits and other tax preference items, and revised estimates of these items in 2006. Federal income tax expense included a benefit of $47 million in 2005 related to the release of the deferred tax valuation allowance in our Barbados reinsurance company, which was included in Other Operations. For additional information on our effective tax rates, see Note 5 to our Consolidated Financial Statements.

Comparison of 2005 to 2004

Revenues

The increase in insurance fees and investment advisory fees in 2005 primarily reflects growth in deposits and assets under management, and to a lesser extent, the effects of favorable equity market performance. Assets under management increased 19.0% at December 31, 2005 compared to December 31, 2004 as a result of positive net flows and increases in equity markets. The average level of the equity markets was higher in 2005, compared to 2004, resulting in higher fee income. Excluding the impact of dividends, the S&P 500 Index® increased 3.0% and the average daily S&P 500 Index® increased 6.8% in 2005, compared to 2004.

Net realized investment losses in 2005 declined $41 million compared to 2004 due to lower impairment losses. See the “Consolidated Investments” section below for additional information on our investment performance.

Revenues in 2005 include a gain on sale of subsidiaries of $14 million pre-tax ($9 million after-tax) from an agreement to settle in full the residual contingent payments resulting from the arrangement to outsource Lincoln UK’s policy and administration functions to Capita Life and Pensions Services Limited, a subsidiary of Capita Group Plc (“Capita”). Revenues for 2004 included a gain of $111 million pre-tax ($46 million after-tax) from the sale of DIAL. See “Investment Management” and “Liquidity and Capital Resources” below, and Note 14 to our Consolidated Financial Statements for additional information. The gain on the sale of subsidiaries for 2004 also included a $10 million pre-tax gain on the exercise of a put option arising from the Capita arrangement (see Note 7 to the Consolidated Financial Statements in our 2004 Form 10-K for additional information) and $14 million from the sale of one of our segments’ employee benefits marketing business.

Net investment income in 2005 was level with the same 2004 periods. A decrease in commercial mortgage loan prepayment and bond makewhole premiums of $44 million and declining portfolio yields substantially offset the favorable effects of asset growth from net flows.

 

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Expenses

Consolidated benefits and expenses increased 2% in 2005 compared to 2004, reflecting higher expenses in the Individual Markets operating businesses and the Investment Management segments. The increases resulted primarily from business growth partially offset by the effect of spread management through lower crediting rates on interest sensitive business and movements from fixed to variable annuity products. See “Results of Operations by Segment” below for further discussion by segment.

Consolidated expenses in 2005 included a net reduction of $64 million pre-tax for the effect of net positive unlocking resulting from the third quarter 2005 annual comprehensive review of the assumptions underlying the amortization of DAC, VOBA, DSI and DFEL as well as the reserves related to GMDB and the embedded derivative related to GMWB, which compares with a net reduction of $15 million pre-tax for 2004. The impact of unlocking varied by segment. The factors impacting the unlocking are discussed further in respective segment discussions below.

Restructuring charges were $30 million pre-tax ($19 million after-tax) in 2005 compared to $21 million pre-tax ($14 million after-tax) for 2004, resulting from expense initiatives undertaken by us during 2003 to improve operational efficiencies and costs associated with one of our segments’ 2005 plan to realign its field management and financial planning support areas. See Note 15 to our Consolidated Financial Statements for additional information on restructuring charges.

Federal income tax expense included a benefit of $47 million in 2005 compared to $4 million in 2004, related to the release of the deferred tax valuation allowance in our Barbados reinsurance company. This reduction is included in Other Operations.

RESULTS OF INDIVIDUAL MARKETS

The Individual Markets business provides its products through two segments—Individual Annuities and Individual Life Insurance. Through its Individual Annuities segment, Individual Markets provides tax-deferred investment growth and lifetime income opportunities for its clients by offering individual fixed annuities, including indexed annuities, and variable annuities. The Individual Life Insurance segment offers wealth protection and transfer opportunities through term insurance, a linked-benefit product, which is a universal life insurance policy linked with riders that provide for long-term care costs, and both single and survivorship versions of universal life and variable universal life.

For factors that could cause actual results to differ materially from those set forth in this section, see “Part I – Item 1 – Risk Factors” and “Forward-looking Statements – Cautionary Language” above.

Individual Markets – Annuities

 

Operating Summary (in millions)

   2006    2005    2004    Increase (Decrease)
Over Prior Year
 
            2006     2005  

Operating Revenues

             

Insurance premiums

   $ 47    $ 37    $ 32    27 %   16 %

Insurance fees

     790      579      445    36 %   30 %

Net investment income

     1,039      614      665    69 %   -8 %

Other revenues and fees

     285      192      193    48 %   -1 %
                         

Total operating revenues

     2,161      1,422      1,335    52 %   7 %
                         

Operating Expenses

             

Insurance benefits

     787      487      478    62 %   2 %

Underwriting, acquisition, insurance and other expenses

     870      614      595    42 %   3 %
                         

Total operating expenses

     1,657      1,101      1,073    50 %   3 %
                         

Income from operations before taxes

     504      321      262    57 %   23 %

Federal income taxes

     95      69      53    38 %   30 %
                         

Income from operations

   $ 409    $ 252    $ 209    62 %   21 %
                         

 

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Net Flows (in millions)

   2006     2005     2004    

Improvement (Worsening)

Over Prior Year

 
         2006     2005  

Variable portion of variable annuity deposits

   $ 7,251     $ 5,539     $ 4,344     31 %   28 %

Variable portion of variable annuity withdrawals

     (4,080 )     (3,240 )     (2,864 )   -26 %   -13 %
                            

Variable portion of variable annuity net flows

     3,171       2,299       1,480     38 %   55 %
                            

Fixed portion of variable annuity deposits

     2,090       1,871       1,656     12 %   13 %

Fixed portion of variable annuity withdrawals

     (697 )     (634 )     (506 )   -10 %   -25 %
                            

Fixed portion of variable annuity net flows

     1,393       1,237       1,150     13 %   8 %
                            

Total variable annuity deposits

     9,341       7,410       6,000     26 %   24 %

Total variable annuity withdrawals

     (4,777 )     (3,874 )     (3,370 )   -23 %   -15 %
                            

Total variable annuity net flows

     4,564       3,536       2,630     29 %   34 %
                            

Indexed annuity deposits

     717       —         —       NM     NM  

Indexed annuity withdrawals

     (175 )     —         —       NM     NM  
                            

Indexed annuity net flows

     542       —         —       NM     NM  
                            

Fixed annuity deposits

     698       118       498     NM     -76 %

Fixed annuity withdrawals

     (3,139 )     (775 )     (741 )   NM     -5 %
                            

Fixed annuity net flows

     (2,441 )     (657 )     (243 )   NM     NM  
                            

Total annuity deposits

     10,756       7,528       6,498     43 %   16 %

Total annuity withdrawals

     (8,091 )     (4,649 )     (4,111 )   -74 %   -13 %
                            

Total annuity net flows

   $ 2,665     $ 2,879     $ 2,387     -7 %   21 %
                            

Annuities incremental deposits

   $ 10,625     $ 7,347     $ 6,470     45 %   14 %
                            

 

December 31, (in millions)

   2006     2005     2004    

Increase (Decrease)

Over Prior Year

 
         2006     2005  

Account Values

          

Variable annuities

   $ 51,782     $ 41,576     $ 34,839     25 %   19 %

Fixed annuities (including indexed annuities)

     14,932       6,918       7,303     116 %   -5 %

Fixed annuities ceded to reinsurers

     (1,812 )     (2,232 )     (2,297 )   -19 %   -3 %
                            

Total fixed annuities

     13,120       4,686       5,006     180 %   -6 %
                            

Total annuities

   $ 64,902     $ 46,262     $ 39,845     40 %   16 %
                            

Fixed portion of variable annuities

   $ 3,613     $ 3,921     $ 4,148     -8 %   -5 %
                            

 

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Interest Rate Spreads

   2006     2005     2004     Change in Rate Over
Prior Year (basis points)
 
         2006     2005  

Net investment income yield

     5.80 %     5.74 %     6.19 %   6     (45 )

Interest rate credited to policyholders

     3.82 %     3.94 %     4.08 %   (12 )   (14 )
                            

Interest rate spread

     1.98 %     1.80 %     2.11 %   18     (31 )

Effect on yield and interest rate spread:

          

Commercial mortgage loan prepayment and bond makewhole premiums

     0.07 %     0.04 %     0.20 %   3     (16 )

Contingent interest

     0.00 %     0.00 %     0.04 %   —       (4 )
                            

Interest rate spread, excluding the above items

     1.91 %     1.76 %     1.87 %   15     (11 )
                            

Average fixed annuity account values (in millions)

   $ 16,475     $ 10,243     $ 10,557      

Effect on income from operations (after-tax, after DAC) (in millions):

          

Commercial mortgage loan prepayment and bond makewhole premiums

   $ 3     $ 1     $ 8      

Contingent interest

     —         —         2      
                            

Effect on income from operations

   $ 3     $ 1     $ 10      
                            

 

December 31, (in millions)

   2006    2005    2004   

Increase (Decrease)

Over Prior Year

 
            2006     2005  

Average Daily Variable Account Values

   $ 42,504    $ 33,255    $ 26,942    28 %   23 %
                         

Comparison of 2006 to 2005

Income from operations for this segment increased $157 million, or 62%, in 2006 compared to 2005. The increase is due primarily to growth in account values from positive net flows and favorable market conditions, the merger with Jefferson-Pilot and a favorable tax adjustment in 2006 related to the separate account DRD and foreign tax credits to true up the taxes for 2005 resulting from the filing of the 2005 tax return. The adoption of SOP 05-1 during 2007 is anticipated to result in a reduction to the segment’s DAC and VOBA balances which will be recorded as a reduction to retained earnings. The impact of SOP 05-1 is expected to prospectively increase DAC and VOBA amortization in 2007 assuming that replacement activity, as defined by SOP 05-1, is comparable to recent years. Our estimates are based upon our interpretation of SOP 05-1 and the proposed implementation guidance and does not consider our interpretations of final implementation guidance which could be issued in 2007. As a result, the actual impact of the adoption of SOP 05-1 may differ significantly from our estimates as the issuance of new implementation guidance and evolving industry practice may affect our interpretation and implementation.

Revenues

Insurance fees increased 36% in 2006 compared to 2005, due to increases in average daily variable annuity account values and an increase in expense assessment rates resulting primarily from increased sales of riders. The increase in account values reflects cumulative positive net flows and improvement in the equity markets between periods. Excluding the impact of dividends, the S&P 500 Index® increased 13.6% from December 31, 2005 and the average daily S&P 500 Index® was 8.5% higher in 2006, compared to 2005. The increase in fixed annuity deposits from the previous year includes $717 million of deposits into indexed annuity products, which were added to our product portfolio as a result of the merger with Jefferson-Pilot.

New deposits are an important component of our effort to grow the annuity business. Although deposits do not significantly impact current period income from operations, they are an important indicator of future profitability. In the past several years, we have concentrated our efforts on both product and distribution breadth. Annuity deposits increased 43% in 2006 compared to 2005, primarily due to growth in the variable annuity business. New deposits in 2006 include deposits in Jefferson-Pilot annuity products after the merger.

 

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The growth in individual variable annuity deposits was primarily a result of continued strong sales of products with the Lincoln Smart SecuritySM Advantage and i4LIFE® Advantage features and the expansion of the wholesaling force in LFD. Variable annuity gross deposits in our Lincoln ChoicePlusSM and American Legacy products were up 26% in 2006 compared to 2005.

The other component of net flows relates to the retention of the business. One of the key assumptions in pricing a product is the account persistency, which we refer to as the lapse rate. The lapse rate compares the amount of withdrawals to the retained account values. One way to measure a company’s success in retaining assets is to look at the overall level of withdrawals from period to period. Additionally, by comparing actual lapse rates to the rates assumed in designing the annuity product, it is possible to gauge the impact of persistency on profitability. The overall lapse rate in 2006 was 12%, compared to 9% in 2005. See the discussion below for the drivers of the increased lapse rates.

Included in our suite of fixed annuity products are several multi-year guarantee products. Our Step Five Fixed Annuity products have a 60 day window period following each five-year fixed guarantee period during which there is no surrender charge, and where crediting rates are reset at the beginning of the window period. Crediting rates for these products are either at or near minimum guaranteed crediting rates. As multi-year guarantees expire, policyholders have the opportunity to renew their annuities at rates in effect at that time. Account values for these products were $2.1 billion at December 31, 2006, with approximately $1 billion of account values entering the window period during 2007. Amounts after 2007 are not significant. During 2006, approximately $1.3 billion of account values entered the window period of which 56% lapsed. In connection with our annual comprehensive review of assumptions underlying DAC, VOBA, DFEL, and DSI amortization, we adjusted our lapse rate assumptions for these products to reflect actual experience to date. The after-DAC, after-tax effect to the earnings of the segment is mitigated in part by a 50% coinsurance arrangement on 90% of the account values. See “Reinsurance” for additional information on this arrangement. Included in the fixed annuity business acquired in the Jefferson-Pilot merger was approximately $2.5 billion of fixed annuity policyholder fund balances with multi-year guarantees, of which approximately $1.1 billion reset in 2006 with approximately 85% lapsing where the holder did not select another of our products. In 2007, approximately $370 million of fixed annuities with multi-year guarantees will reset, of which we expect approximately 65% will based upon emerging experience. In 2008, approximately $220 million will be entering reset periods. As multi-year guarantees expire, policyholders have the opportunity to renew their annuities at rates in effect at that time.

Also included in the fixed annuity business acquired in the merger was approximately $4.1 billion of fixed annuity policyholder fund balances with crediting rates that are reset on an annual basis and are not subject to surrender charges. Account values for these products were $3.8 billion at December 31, 2006 with 36% already at their minimum guaranteed rates. The average crediting rates for these products were approximately 38 basis points in excess of average minimum guaranteed rates. Our ability to retain the multi-year guarantee and annual reset annuities will be subject to current competitive conditions at the time interest rates for these products reset.

We acquired our indexed annuity business through the merger with Jefferson-Pilot. Profitability of indexed annuities is influenced by the management of derivatives to hedge the index performance of the policies. These contracts permit the holder to elect an interest rate return or an equity market component, where interest credited to the contracts is linked to the performance of the S&P 500 Index®. Policyholders may elect to rebalance index options at renewal dates, either annually or biannually. At each renewal date, we have the opportunity to re-price the equity-indexed component by establishing participation rates, subject to minimum guarantees. We purchase options that are highly correlated to the portfolio allocation decisions of our policyholders, such that we are economically hedged with respect to equity returns for the current reset period. The mark-to-market of the options we hold impacts investment income and interest credited in approximately equal and offsetting amounts. Additionally, we calculate the fair values of index options we will purchase in the future to hedge policyholder index allocations applicable to future reset periods. These fair values represent an estimate of the cost of the options we will purchase in the future less expected charges to policyholders, discounted back to the date of the balance sheet, using current market indicators of volatility and interest rates. Changes in the fair values of these liabilities result in volatility that is reported in interest credited. Interest credited was increased by $4 million ($1 million after-DAC, after-tax) in 2006 for this fair value adjustment. The notional amounts of policyholder fund balances allocated to the index options were $2.4 billion at December 31, 2006.

Net investment income increased $425 million, or 69%, in 2006 compared to 2005. The increase in net investment income is due to the merger. Overall growth in net investment income has been constrained due primarily to lower investment portfolio yields, lower average fixed annuity account values and net outflows. Net investment income included $10 million and $4 million (pre-DAC, pre-tax) from commercial mortgage loan prepayment and bond makewhole premiums in 2006 and 2005, respectively. Net investment income in 2006 also includes an increase of $62 million (pre-DAC, pre-tax) from the mark-to-market adjustment for S&P 500 Index® call options supporting the hedge program for the indexed annuity business acquired in the merger. This

 

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adjustment, which is largely offset by a related adjustment in interest credited is included within insurance benefits expense but is excluded from spread calculations.

When analyzing the impact of net investment income, it is important to understand that a portion of the investment income earned is credited to the policyholders of our fixed annuity products. The interest credited to policyholders is included in the segment’s insurance benefits. The annuity product interest rate spread represents the excess of the yield on earning assets over the average crediting rate. The yield on earning assets is calculated as net investment income on fixed product investment portfolios divided by average earning assets. The average crediting rate is calculated using interest credited on annuity products less the mark-to-market adjustment on the indexed annuity business, bonus credits and excess interest on policies with the dollar cost averaging feature, divided by the average fixed account values net of coinsured account values. Fixed account values reinsured under modified coinsurance agreements are included in account values for this calculation. Interest credited to policyholder balances increased in 2006 compared to 2005 as a result of the Jefferson-Pilot merger, partially offset by lower average fixed account values and lower average crediting rates.

The interest rate spread table above summarizes the effect of changes in the portfolio yield, the rate credited to policyholders, as well as the impact of prepayment premiums on results on an after-DAC, after-tax basis. The adjusted interest rate spread was 1.91% and 1.76% in 2006 and 2005, respectively. The improvement is primarily due to a reduction in crediting rates year over year, partially offset by the unfavorable impact of the fair value adjustment on our indexed annuity products discussed above. During the third quarter of 2006, we also harmonized our policy for accounting and reporting for investment defaults by discontinuing the historical practice followed by Jefferson-Pilot of business segments reimbursing Other Operations for actual default experience through an intra-company charge referred to as the default charge. Net investment income in 2006 was reduced by $4 million ($1 million after-DAC, after-tax) of default charges before the methodology was changed. This change did not have an effect on consolidated income from operations.

We expect to manage the effect of spreads for near-term operating income through a combination of rate actions and portfolio management. Our expectation includes the assumption that there are no significant changes in net flows in or out of our fixed accounts or other changes that may cause interest rate spreads to differ from our expectation. For information on interest rate spreads and the interest rate risk due to falling interest rates, see “Item 7A—Quantitative and Qualitative Disclosures About Market Risk” of this Form 10-K.

Benefits and Expenses

Insurance benefits include interest credited to policyholders of $748 million and $437 million in 2006 and 2005, respectively. Increases from the merger with Jefferson-Pilot were partially offset by past actions taken to lower crediting rates commensurate with the reduction in the overall investment yield over the last several years and lower fixed account values. See the table above for the interest rate credited to policyholders. Interest credited to policyholders in 2006 also includes an increase of $59 million from the mark-to-market adjustment for indexed annuity liabilities acquired in the merger with Jefferson-Pilot resulting from changes in equity markets. This adjustment, which is largely offset in net investment income by a corresponding change in the market value of S&P 500 Index® call options acquired to hedge the equity market exposure for these liabilities is not included in spread calculations. Interest credited increased $4 million from the unfavorable fair value adjustment on our indexed annuity product liabilities, as discussed above. This fair value adjustment, which is influenced by equity markets and interest rates used for discounting the calculation, can be volatile from period to period affecting the comparability of interest credited.

Also included in insurance benefits are the costs associated with guaranteed benefits included within variable annuities with the GMDB, GMWB or GIB riders. For 2006, favorable market conditions resulted in decreased insurance benefits for the GMDB, GMWB and GIB riders, which were offset by unfavorable hedge results compared to 2005. The effect of changes in net reserve and benefit payments and results of the hedge program attributable to these guaranteed benefits was such that the period over period variances was an increase to benefits and expenses of $15 million ($5 million after-DAC, after-tax).

In the fourth quarter of 2006, we implemented a new process to estimate the fair value of the embedded derivative for our i4LIFE® GIB riders and began hedging this rider with a new hedge program. The implementation of this new calculation for the embedded derivative resulted in a change in the value that decreased the amount included in insurance benefits by $23 million ($6 million after-DAC, after-tax) for 2006 and was partially offset by hedging losses of $6 million ($2 million after-DAC, after-tax).

In the third quarter of 2006, we completed our annual comprehensive review of the assumptions underlying the prospective amortization of DAC, VOBA, DFEL, and DSI and the calculations of the GMDB reserves and the embedded derivative related to GMWB. This review resulted in a net favorable unlocking adjustment due to a favorable net interest rate margin, maintenance expense and mortality assumptions, partially offset by unfavorable fixed annuity account value retention discussed above and growth in our GIB riders with higher partial withdrawals. The result of this prospective assumption adjustment was a reduction in

 

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benefits and expenses of $6 million pre-tax ($4 million after-tax) and a reduction in insurance fees of $3 million pre-tax ($2 million after-tax). The comprehensive review completed during the third quarter of 2006 is not expected to significantly affect future amortization expense.

Our annual comprehensive review of the assumptions underlying the prospective amortization of DAC, VOBA, DFEL, and DSI, and the calculations of the GMDB reserves and the embedded derivative related to GMWB in 2005 resulted in a favorable adjustment due to continued favorable account value retention partially offset by mortality. In 2005, the result of this adjustment was a reduction in benefits and expenses of $33 million pre-tax ($21 million after-tax).

At December 31, 2006, the segment’s net amount at risk (“NAR”) related to contracts with a GMDB feature was $0.3 billion. The related GAAP and statutory reserves were $23 million and $42 million, respectively. The comparable amounts at December 31, 2005, were a NAR of $0.5 billion, GAAP reserves of $15 million and statutory reserves of $42 million. At any point in time, the NAR is the difference between the potential death benefit payable and the total account value, with a floor of zero (when account values exceed the potential death benefit there is no amount at risk). Accordingly, the NAR represents the maximum amount we would have to pay if all policyholders died. In evaluating the GMDB exposures that exist within our variable annuity business relative to industry peers, it is important to distinguish between the various types of GMDB features, and other factors such as average account values, average amounts of NAR, and the age of contractholders. The following table and discussion provides this information for our variable annuity business as of December 31, 2006:

 

     Type of GMDB Feature  
   Return of
Premium
    High Water
Mark
    Roll-up     No GMDB     Total  

Variable Annuity Account Value (billions)

   $ 24.0     $ 22.5     $ 0.4     $ 4.9     $ 51.8  

% of Total Annuity Account Value

     46.4 %     43.4 %     0.8 %     9.4 %     100.0 %

Average Account Value (thousands)

   $ 106.4     $ 106.2     $ 81.0     $ 73.0     $ 101.8  

Average NAR (thousands)

     6.3       8.9       12.5       N/A       8.6  

NAR (billions)

     0.1       0.2       —         —         0.3  

Average Age of Contract Holder

     64       64       67       62       64  

% of Contract Holders > 70 Years of Age

     14.3 %     30.8 %     41.0 %     31.0 %     20.0 %

We have variable annuity contracts containing GMDBs that have a dollar for dollar withdrawal feature. Under such a feature, withdrawals reduce both current account value and the GMDB amount on a dollar for dollar basis. For contracts containing this dollar for dollar feature, the account holder could withdraw a substantial portion of their account value resulting in a GMDB that is multiples of the current account value. Our exposure to this dollar for dollar risk is somewhat mitigated by the fact that we do not allow for partial 1035 exchanges on non-qualified contracts. To take advantage of the dollar for dollar feature, the contractholder must take constructive receipt of the withdrawal and pay any applicable surrender charges. We report the appropriate amount of the withdrawal that is taxable to the Internal Revenue Service, as well as indicating whether or not tax penalties apply under the premature distribution tax rules. We closely monitor the dollar for dollar withdrawal GMDB exposure. Beginning in 2003, the GMDB feature offered on new contract sales is a pro-rata GMDB feature whereby each dollar of withdrawal reduces the GMDB benefit in proportion to the current GMDB to account value ratio. As of December 31, 2006, there were 813 contracts for which the death benefit to account value ratio was greater than ten to one. The NAR on these contracts was $52 million.

Underwriting, acquisition, insurance and other expenses increased $256 million, or 42%, in 2006 compared to 2005. The increases were driven by the merger with Jefferson-Pilot, higher incentive compensation expenses, and account value growth from sales and favorable equity markets, which resulted in higher commission expenses, net of deferrals and higher DAC amortization.

Federal Income Taxes

Federal income tax expense in 2006 included a reduction of $33 million related to a favorable true-up to the 2005 tax return primarily relating to the separate accounts DRD. For additional information see Note 5 to the consolidated financial statements.

 

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Comparison of 2005 to 2004

Income from operations for this segment increased $43 million, or 21%, in 2005 compared to 2004. The increase was due primarily to growth in variable account values from positive net flows and favorable market conditions, net of lower fixed spreads.

Revenues

Insurance fees increased 30% in 2005 compared to 2004, due to increases in average daily variable annuity account values and an increase in expense assessment rates resulting primarily from increased sales of riders. The increase in account values reflects cumulative positive net flows and improvement in the equity markets between periods.

Annuity deposits increased 16% in 2005 compared to 2004, primarily due to growth in the variable annuity business. The growth in individual variable annuity deposits was primarily a result of continued strong sales of products with the Lincoln SmartSecuritySM Advantage feature and the expansion of the wholesaling force in LFD. Variable annuity gross deposits in our Lincoln ChoicePlusSM and American Legacy products were up 25% in 2005 compared to 2004. Fixed annuities decreased due to a lower interest rate environment.

Overall lapse rates were 8.6% in 2005 compared to 8.7% in 2004 and were more favorable than the level of persistency expected in product pricing.

Net investment income declined 8% in 2005 compared with 2004. The decrease in net investment income in 2005 was due to lower fixed account values and lower investment portfolio rates in 2005, lower commercial mortgage loan prepayment and bond makewhole premiums, and $4 million of contingent interest income received in 2004.

Benefits and Expenses

Insurance benefits increased $9 million, or 2% in 2005 compared to 2004. Insurance benefits include interest credited to policyholders, which decreased to $393 million in 2005 compared to $413 million in 2004 as a result of actions taken to lower crediting rates commensurate with the reduction in the overall investment yield. Also included in insurance benefits are costs associated with guaranteed benefits included within variable annuities with GMDB, GMWB or GIB riders. The effect of changes in net reserves and benefit payments during 2005 attributable to these guaranteed benefits was partially offset by the favorable results of the expanded hedge program implemented in 2004 such that the period over period variances on an after-DAC and after-tax basis was $4 million.

Underwriting, acquisition, insurance and other expenses increased $19 million, or 3% in 2005 compared to 2004. The increase was driven principally by higher net DAC amortization from higher insurance fees net of lower fixed margins.

In the third quarter of 2005, we completed our annual comprehensive review of the assumptions underlying the prospective amortization of DAC, VOBA, DFEL, and DSI and the calculations of the GMDB reserves and the embedded derivative related to GMWB. This review resulted in a favorable unlocking adjustment due to favorable lapse rates offset by mortality. In 2005, the result of this prospective unlocking was a reduction in expenses of $33 million pre-tax ($22 million after-tax). The annual comprehensive review of assumptions completed in the third quarter of 2004 resulted in prospective unlocking of $32 million pre-tax ($20 million after-tax).

 

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Individual Markets – Life Insurance

 

Operating Summary (in millions)

   2006    2005    2004    Increase (Decrease)
Over Prior Year
 
            2006     2005  

Operating Revenues

             

Insurance premiums

   $ 322    $ 198    $ 194    63 %   2 %

Insurance fees

     1,380      759      748    82 %   1 %

Net investment income

     1,511      909      901    66 %   1 %

Other revenues and fees

     43      45      20    -4 %   125 %
                         

Total operating revenues

     3,256      1,911      1,863    70 %   3 %
                         

Operating Expenses

             

Insurance benefits

     1,769      1,021      993    73 %   3 %

Underwriting, acquisition, insurance and other expenses

     742      503      489    48 %   3 %
                         

Total operating expenses

     2,511      1,524      1,482    65 %   3 %
                         

Income from operations before taxes

     745      387      381    93 %   2 %

Federal income taxes

     249      127      124    96 %   2 %
                         

Income from operations

   $ 496    $ 260    $ 257    91 %   1 %
                         

 

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Interest Rate Spreads

   2006     2005     2004    

Change in Rate Over

Prior Year (basis points)

 
         2006     2005  

Interest Sensitive Products

          

Net investment income yield

     6.29 %     6.33 %     6.71 %   (4 )   (38 )

Interest rate credited to policyholders

     4.52 %     4.68 %     4.87 %   (16 )   (19 )
                            

Interest rate spread

     1.77 %     1.65 %     1.84 %   12     (19 )

Effect on yield and interest rate spreads:

          

Commercial mortgage loan prepayment and bond makewhole premiums

     0.14 %     0.06 %     0.20 %   8     (14 )

Contingent interest

     0.00 %     0.00 %     0.07 %   —       (7 )
                            

Interest rate spread, excluding the above items

     1.63 %     1.59 %     1.57 %   4     2  
                            

Effect on income from operations (after-tax,after DAC) (in millions):

          

Commercial mortgage loan prepayment and bond makewhole premiums

   $ 8     $ 2     $ 7      

Contingent interest

     —         —         2      
                            

Effect on income from operations

   $ 8     $ 2     $ 9      
                            

Traditional Products

          

Net investment income yield

     6.60 %     6.55 %     6.65 %   5     (10 )

Effect on yield:

          

Commercial mortgage loan prepayment and bond makewhole premiums

     0.12 %     0.16 %     0.12 %   (4 )   4  

Contingent interest

     0.00 %     0.00 %     0.08 %   —       (8 )
                            

Net investment income yield, excluding the above items

     6.48 %     6.39 %     6.45 %   9     (6 )
                            

Effect on income from operations (after-tax) (in millions)

          

Commercial mortgage loan prepayment and bond makewhole premiums

   $ 2     $ 1     $ 2      

Contingent interest

     —         —         1      
                            

Effect on income from operations

   $ 2     $ 1     $ 3      
                            

 

(in millions)

   2006     2005     2004     Increase (Decrease)
Over Prior Year
 
         2006     2005  

Sales by Product

          

Universal Life (“UL”)

          

Excluding MoneyGuard®

   $ 437     $ 192     $ 178     128 %   8 %

MoneyGuard®

     31       34       37     -9 %   -8 %
                            

Total Universal Life

     468       226       215     107 %   5 %

Variable Universal Life (“VUL”)

     61       42       34     45 %   24 %

Whole Life

     2       2       2     —       —    

Term

     40       33       41     21 %   -20 %
                            

Total

   $ 571     $ 303     $ 292     88 %   4 %
                            

Net Flows (in millions)

          

Deposits

   $ 3,365     $ 2,031     $ 1,970     66 %   3 %

Withdrawals and deaths

     (1,342 )     (836 )     (834 )   -61 %   0 %
                            

Net flows

   $ 2,023     $ 1,195     $ 1,136     69 %   5 %
                            

Policyholder assessments

   $ 1,992     $ 1,147     $ 1,066     74 %   8 %
                            

 

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(in millions)

   2006    2005    2004   

Increase (Decrease)

Over Prior Year

 
            2006     2005  

Account Values

             

Universal Life

   $ 19,633    $ 9,573    $ 9,018    105 %   6 %

Variable Universal Life

     4,600      2,242      2,027    105 %   11 %

Interest-Sensitive Whole Life (“ISWL”)

     2,257      2,236      2,214    1 %   1 %
                         

Total life insurance account values

   $ 26,490    $ 14,051    $ 13,259    89 %   6 %
                         

In-Force Face Amount

             

Universal Life and Other

   $ 267,228    $ 128,792    $ 125,043    107 %   3 %

Term Insurance

     234,148      187,849      172,459    25 %   9 %
                         

Total in-force

   $ 501,376    $ 316,641    $ 297,502    58 %   6 %
                         

Net Amount at Risk

             

Universal Life and Other

   $ 238,200    $ 112,300    $ 109,500    112 %   3 %

Term Insurance

     233,000      186,900      171,600    25 %   9 %
                         

Total net amount at risk

   $ 471,200    $ 299,200    $ 281,100    57 %   6 %
                         

Comparison of 2006 to 2005

Income from operations for this segment increased $236 million, or 91%, in 2006 compared to 2005. The increase was driven by the merger with Jefferson-Pilot. Excluding the increased operating results from the merger, income from operations in 2006 increased over 2005 due to favorable investment results and growth of business in force, partially offset by the unfavorable adjustments from the annual DAC, VOBA and DFEL comprehensive assumption review compared with the results of that review in 2005 and an increase in reserves for life insurance policies with secondary guarantees.

Revenues

Revenues in 2006 increased 70% compared to 2005 due to the inclusion of results from the Jefferson-Pilot companies beginning in April 2006. Revenues from insurance fees were up 82% in 2006 compared to 2005. Insurance fees include mortality assessments, expense assessments (net of DFEL deferrals and amortization) and surrender charges. In addition to the effects of the merger, growth in mortality and expense assessments in 2006 compared to 2005 was primarily related to increased business in force due to new sales, favorable persistency and the impact of DFEL unlocking, discussed in the Benefits and Expenses section below. The improved persistency results should positively affect future revenues.

In 2006, life insurance in-force grew, as a result of and in addition to the Jefferson-Pilot merger. In-force growth should be considered independently with regard to term products versus permanent products, as term products have a lower profitability in relation to face amount compared to permanent products. Insurance premium revenue relates primarily to whole life and term life insurance products. Excluding the impact of the Jefferson-Pilot companies, insurance premiums for term insurance increased 37% in 2006 compared to 2005, while insurance premiums for whole life decreased 8%. For term insurance, gross premiums grew 6% in 2006 from continued growth in the term insurance book of business. Also contributing to the growth in net term insurance premiums was a 4% reduction in premiums paid for reinsurance coverage in 2006 compared to 2005, primarily resulting from restructuring our reinsurance program in September 2005. Under the restructured program, we reduced the percentage of each new term policy reinsured and changed from using coinsurance to using renewable term reinsurance. See “Reinsurance” below for additional information regarding our reinsurance coverage.

In the second quarter of 2006, we changed our basis for reporting sales to one more consistent with industry sales reports. Previously, we reported sales as first year paid premium, excluding internal replacements, for all products.

 

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Sales in the table above and as discussed below are reported as follows:

 

   

UL, VUL, MoneyGuard® – 100% of annualized expected target premium plus 5% of paid excess premium, including an adjustment for internal replacements at approximately 50% of target.

 

   

Whole Life and Term – 100% of first year paid premiums.

Sales are not part of revenues (other than for term products) and do not have a significant impact on current quarter income from operations, but are an indicator of future profitability. Total sales in 2006 increased $268 million compared to 2005 as a result of the merger and strong performance by our distributors.

Net investment income increased $602 million, or 66%, in 2006 compared to 2005, with the increase being driven by the merger with Jefferson-Pilot. Excluding the effects of the merger, growth in investment income was due to growth in in-force, higher commercial mortgage loan prepayments, and bond makewhole premiums and investment income from alternative investments. Investment income on alternative investments in the fourth quarter of 2006 was positively affected by standby equity commitments of $10 million pre-tax ($5 million after-tax, after-DAC), which was offset by a loss in the third quarter of 2006 in an alternative investment of $14 million ($8 million after-tax, after-DAC.)

The interest rate spread on interest sensitive products is the difference between the interest to be credited to policyholder accounts and the interest income we earn on the assets supporting the policyholder accounts. Traditional products use interest income to build the policy reserves. At December 31, 2006 and 2005, interest sensitive products represented approximately 81% and 78%, respectively, of total invested assets. Interest rate spreads for interest sensitive products increased 12 basis points in 2006 compared to 2005. Excluding the effects of commercial mortgage loan prepayment and bond makewhole premiums, interest rate spreads for interest sensitive products increased 4 basis points in 2006, compared to 2005.

During the third quarter of 2006, we harmonized our accounting and reporting policy for investment defaults by discontinuing the historical practice followed by Jefferson-Pilot of business segments reimbursing Other Operations for actual default experience through an intra-company charge referred to as the default charge. Income from operations in 2006 includes $5 million ($2 million after-DAC, after-tax) of default charges recorded before the methodology was harmonized. This change did not have an effect on consolidated income.

In 2006, spreads between new money rates and general account yields remained steady. At December 31, 2006, 50% of interest sensitive account values have crediting rates at contract guaranteed levels, and 41% have crediting rates within 50 basis points of contractual guarantees. Going forward, we expect to be able to manage the effects of spreads on near-term income from operations through a combination of rate actions and portfolio management. This assumes no significant changes in net flows into or out of our fixed accounts or other changes that may cause interest rate spreads to differ from our expectations. For information on interest rate spreads and the interest rate risk due to falling interest rates, see “Item 7A - Quantitative and Qualitative Disclosures About Market Risk” of this Form 10-K.

Benefits and Expenses

Insurance benefits include interest credited to policyholders of $882 million and $560 million in 2006 and 2005, respectively, with the increase primarily attributable to the merger. Also contributing to the increase was growth in the book of business partially offset by actions taken by us to lower crediting rates commensurate with the reductions in the overall investment yield in 2005. Refer to the table above for the interest rate credited to policyholders.

During the third quarter, we reviewed the assumptions underlying the amortization of DAC, VOBA and DFEL. Insurance benefits in 2006 include an increase of $15 million pre-tax ($10 million after-tax) to the reserve for our products with secondary guarantees. The reserve increase resulted from updating long-term assumptions, primarily investment interest rates. The change in assumptions is estimated to result in an increase in reserves in future years of approximately $7 million ($4 million after-tax) per year.

The 2006 review also resulted in a negative net prospective unlocking adjustment of $14 million pre-tax ($9 million after-tax), comprised of $1 million DFEL and $13 million DAC and VOBA. The adjustments primarily reflect the impact of the increased reserves related to the sale of life insurance products sold with secondary guarantees, partially offset by improved mortality and expense assumptions. The 2006 review also resulted in an increase in the on-going amortization expense of approximately $12 million pre-tax ($8 million after-tax) per year.

 

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As a result of the 2005 review, the segment had a positive net prospective positive unlocking adjustment of $4 million pre-tax ($2 million after-tax), comprised of $(20) million DFEL and $24 million DAC and VOBA. The adjustments were the result of improved mortality assumptions, partially offset by less favorable retention and interest rate assumptions.

The segment had favorable retrospective DAC, VOBA and DFEL unlocking of $16 million pre-tax ($10 million after-tax) in 2006, primarily due to favorable persistency and favorable retrospective DAC, VOBA and DFEL unlocking of $4 million pre-tax ($2 million after-tax) in 2005.

UL and VUL products with secondary guarantees represented approximately 26% of permanent life insurance in-force at December 31, 2006 and approximately 73% of sales for these products in 2006. Actuarial Guideline 38 (“AXXX”) imposes additional reserve requirements for these products - See “Review of Consolidated Financial Condition – Sources of Liquidity and Cash Flow – Financing Activities” for further information on the manner in which we reinsure our AXXX reserves.

Underwriting, acquisition, insurance and other expenses increased $239 million in 2006 compared to 2005, with the increase being driven by the merger, higher incentive compensation expenses and the net impact of the DAC and VOBA unlocking discussed above.

Comparison of 2005 to 2004

Income from operations for this segment increased $3 million, or 1%, in 2005 compared to 2004. The increase in income from operations is due to the favorable adjustments from the annual DAC, VOBA and DFEL comprehensive assumption review compared with the results of that review for 2004, mostly offset by higher operating expenses and the increase in amortization expense arising from the 2004 review.

Revenues

Revenues in 2005 increased 3% compared to 2004. Revenues from insurance fees were up 1% in 2005 compared to 2004. Insurance fees include mortality assessments, expense assessments (net of DFEL deferrals and amortization) and surrender charges. The growth in mortality and expense assessments in 2005 compared to 2004 was primarily related to increased business in force due to new sales and favorable persistency, offset by the impact of DFEL unlocking discussed in the Benefits and Expenses section below.

In 2005, life insurance in force grew, driven by favorable persistency and increased business in force due to new sales. Insurance premiums for term insurance increased 24% in 2005 compared to 2004, while insurance premiums for whole life decreased 6%. For term insurance, gross premiums grew 9% in 2005 from continued growth in the term insurance book of business. Also contributing to the growth in net term insurance premiums was a 5% reduction in premiums paid for reinsurance coverage in 2005, primarily resulting from restructuring our reinsurance program in September 2005. Under the restructured program, we reduced the percentage of each new term policy reinsured and changed from using coinsurance to using renewable term reinsurance. See “Reinsurance” below for additional information regarding our reinsurance coverage.

Sales are not part of revenues (other than for term products) and do not have a significant impact on current quarter income from operations, but are indicative of future profitability. Total sales in 2005 increased 4% compared to 2004.

Net investment income increased $8 million, or 1%, in 2005 compared to 2004.

At December 31, 2005 and 2004, interest sensitive products represented approximately 78% and 76%, respectively, of total invested assets. Interest rate spreads on interest sensitive products declined 19 basis points in 2005 compared to 2004. Excluding the effects of commercial mortgage loan prepayment and bond makewhole premiums, interest rate spreads for interest sensitive products increased 2 basis points in 2005 compared to 2004.

Benefits and Expenses

Insurance benefits increased $28 million or 3% in 2005 compared to 2004. The increase resulted from growth in the book of business partially offset by actions taken by the segment to lower crediting rates commensurate with the reductions in the overall investment yield in 2005. Refer to table above for the interest rate credited to policyholders.

 

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The 2004 annual comprehensive review of assumptions resulted in a negative net prospective unlocking adjustment of $16 million pre-tax ($11 million after-tax), comprised of $(3) million DFEL and $19 million DAC and VOBA. The adjustments resulted primarily from a reduction in the assumption of future investment yields.

Underwriting, acquisition, insurance and other expenses increased $14 million in 2005 compared to 2004, driven primarily by increased operating expenses and increased amortization expense resulting from the 2004 review discussed above.

RESULTS OF EMPLOYER MARKETS

The Employer Markets business provides its products through two segments, Retirement Products and Group Protection, formerly known as Benefit Partners. The Retirement Products segment operates through two lines of business – Defined Contribution, which provides employer-sponsored variable and fixed annuities, mutual-fund based programs in the 401(k), 403(b), and 457 marketplaces; and Executive Benefits, which provides corporate-owned life insurance (“COLI”) and bank-owned life insurance (“BOLI”) and contains an Institutional Pension business. The Group Protection segment of Employer Markets offers group life, disability, and dental insurance to employers. For factors that could cause actual results to differ materially from those set forth in this section, see “Part I – Item 1 – Risk Factors” and “Forward-looking Statements – Cautionary Language” above.

Employer Markets – Retirement Products

 

Operating Summary (in millions)

   2006    2005    2004   

Increase (Decrease)

Over Prior Year

 
            2006     2005  

Operating Revenues

             

Insurance premiums

   $ 5    $ 9    $ 1    -44 %   NM  

Insurance fees

     275      238      212    16 %   12 %

Net investment income

     1,055      898      898    17 %   —    

Other revenues and fees

     25      30      22    -17 %   36 %
                         

Total operating revenues

     1,360      1,175      1,133    16 %   4 %
                         

Operating Expenses

             

Insurance benefits

     681      575      567    18 %   1 %

Underwriting, acquisition, insurance and other expenses

     330      313      308    5 %   2 %
                         

Total operating expenses

     1,011      888      875    14 %   1 %
                         

Income from operations before taxes

     349      287      258    22 %   11 %

Federal income taxes

     96      80      68    20 %   18 %
                         

Income from operations

   $ 253    $ 207    $ 190    22 %   9 %
                         

 

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Retirement Products—Defined Contribution

 

Operating Summary (in millions)

   2006    2005    2004   

Increase (Decrease)

Over Prior Year

 
            2006     2005  

Operating Revenues

             

Insurance fees

   $ 230    $ 211    $ 188    9 %   12 %

Net investment income

     738      711      714    4 %   0 %

Other revenues and fees

     20      25      16    -20 %   56 %
                         

Total operating revenues

     988      947      918    4 %   3 %
                         

Operating Expenses

             

Insurance benefits

     411      402      397    2 %   1 %

Underwriting, acquisition, insurance and other expenses

     297      284      275    5 %   3 %
                         

Total operating expenses

     708      686      672    3 %   2 %
                         

Income from operations before taxes

     280      261      246    7 %   6 %

Federal income taxes

     76      74      67    3 %   10 %
                         

Income from operations

   $ 204    $ 187    $ 179    9 %   4 %
                         

December 31, (in millions)

   2006    2005    2004   

Increase (Decrease)

Over Prior Year