Lincoln National Corp Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20549

 


FORM 10-Q

 


(Mark One)

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

For the quarterly period ended September 30, 2007.

 

¨ 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)

(215) 448-1400

Registrant’s telephone number, including area code

Not Applicable

Former name, former address and former fiscal year, if changed since last report

 


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 whether the registrant is a large accelerated filer, an accelerated filer, or a non- accelerated filer. See definition of “accelerated filer” and “large 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

As of November 1, 2007, there were 269,227,387 shares of the registrant’s common stock outstanding.

 



PART I – FINANCIAL INFORMATION

 

Item 1. Financial Statements

LINCOLN NATIONAL CORPORATION

CONSOLIDATED BALANCE SHEETS

 

     

September 30,

2007

  

December 31,

2006

     (Unaudited)     
     (in millions)

ASSETS

     

Investments:

     

Securities available-for-sale, at fair value:

     

Fixed maturity (cost: 2007-$56,063; 2006-$54,960)

   $ 56,086    $ 55,853

Equity (cost: 2007-$669; 2006-$681)

     670      701

Trading securities

     2,717      3,036

Mortgage loans on real estate

     7,281      7,384

Real estate

     385      421

Policy loans

     2,790      2,760

Derivative investments

     554      415

Other investments

     1,065      918
             

Total investments

     71,548      71,488

Cash and invested cash

     1,326      1,621

Deferred acquisition costs and value of business acquired

     9,337      8,420

Premiums and fees receivable

     401      356

Accrued investment income

     916      866

Amounts recoverable from reinsurers

     8,227      7,939

Goodwill

     4,522      4,500

Other assets

     3,037      2,770

Assets held in separate accounts

     92,903      80,534
             

Total assets

   $ 192,217    $ 178,494
             

LIABILITIES AND SHAREHOLDERS’ EQUITY

     

Liabilities

     

Insurance and investment contract liabilities:

     

Insurance policy and claim reserves

   $ 15,093    $ 14,771

Investment contract and policyholder funds

     59,797      59,145
             

Total insurance and investment contract liabilities

     74,890      73,916

Short-term debt

     326      658

Long-term debt:

     

Senior notes

     2,682      2,231

Junior subordinated debentures issued to affiliated trusts

     155      155

Capital securities

     1,571      1,072

Reinsurance related derivative liability

     192      229

Funds withheld reinsurance liabilities

     2,137      2,094

Deferred gain on indemnity reinsurance

     715      760

Other liabilities

     4,683      4,644

Liabilities related to separate accounts

     92,903      80,534
             

Total liabilities

     180,254      166,293
             

Commitments and Contingencies (See Note 9)

     

Shareholders’ Equity

     

Series A preferred stock-10,000,000 shares authorized (2007 liquidation value-$1)

     1      1

Common stock-800,000,000 shares authorized (shares issued and outstanding: 2007- 269,158,104; 2006- 275,752,668)

     7,309      7,449

Retained earnings

     4,456      4,138

Accumulated other comprehensive income

     197      613
             

Total shareholders’ equity

     11,963      12,201
             

Total liabilities and shareholders’ equity

   $ 192,217    $ 178,494
             

See accompanying Notes to Consolidated Financial Statements

 

1


LINCOLN NATIONAL CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

 

     

Three Months Ended

September 30,

   

Nine Months Ended

September 30,

 
     2007     2006     2007     2006  
     (Unaudited)  
     (in millions, except per share amounts)  

Revenue

        

Insurance premiums

   $ 489     $ 426     $ 1,437     $ 958  

Insurance fees

     852       679       2,389       1,846  

Investment advisory fees

     89       83       272       242  

Communications revenue (net)

     60       60       184       117  

Net investment income

     1,067       1,108       3,326       2,854  

Realized loss

     (37 )     (11 )     (15 )     (17 )

Amortization of deferred gain on indemnity reinsurance

     19       19       65       57  

Other revenue and fees

     142       123       434       348  
                                

Total revenue

     2,681       2,487       8,092       6,405  
                                

Benefits and Expenses

        

Insurance benefits

     1,301       1,201       3,781       2,962  

Underwriting, acquisition, insurance and other expenses

     819       728       2,438       1,948  

Communications expense

     33       31       106       61  

Interest and debt expense

     69       67       204       154  
                                

Total benefits and expenses

     2,222       2,027       6,529       5,125  
                                

Income before taxes

     459       460       1,563       1,280  

Federal income taxes

     129       96       461       346  
                                

Net income

   $ 330     $ 364     $ 1,102     $ 934  
                                

Net Income Per Common Share

        

Basic

   $ 1.22     $ 1.31     $ 4.06     $ 3.82  
                                

Diluted

   $ 1.21     $ 1.29     $ 4.00     $ 3.76  
                                

See accompanying Notes to Consolidated Financial Statements

 

2


LINCOLN NATIONAL CORPORATION

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

 

      Nine Months Ended September 30,  
     2007     2006  
     (Unaudited)  
     (in millions, except for share amounts)  

Series A Preferred Stock

    

Balance at beginning-of-year

   $ 1     $ 1  
                

Balance at end-of-period

     1       1  
                

Common Stock

    

Balance at beginning-of-year

     7,449       1,775  

Issued for acquisition

     20       5,632  

Stock compensation/issued for benefit plans

     113       179  

Deferred compensation payable in stock

     5       9  

Retirement of common stock

     (278 )     (147 )
                

Balance at end-of-period

     7,309       7,448  
                

Retained Earnings

    

Balance at beginning-of-year

     4,138       4,081  

Cumulative effect of adoption of SOP 05-1

     (41 )     —    

Cumulative effect of adoption of FIN 48

     (15 )     —    

Comprehensive income

     686       1,015  

Less other comprehensive income (loss) (net of Federal income tax):

    

Net unrealized loss on securities available-for-sale, net of reclassification adjustment

     (475 )     (19 )

Net unrealized gain on derivative instruments

     31       49  

Foreign currency translation adjustment

     29       54  

Amortization of actuarial net loss

     (1 )     (3 )
                

Net income

     1,102       934  

Retirement of common stock

     (408 )     (709 )

Dividends declared: Common (2007-$1.185; 2006-$1.14)

     (320 )     (320 )
                

Balance at end-of-period

     4,456       3,986  
                

Net Unrealized Gain on Securities Available-for-Sale

    

Balance at beginning-of-year

     493       497  

Change during the period

     (475 )     (19 )
                

Balance at end-of-period

     18       478  
                

Net Unrealized Gain on Derivative Instruments

    

Balance at beginning-of-year

     39       7  

Change during the period

     31       49  
                

Balance at end-of-period

     70       56  
                

Foreign Currency Translation Adjustment

    

Balance at beginning-of-year

     165       83  

Change during the period

     29       54  
                

Balance at end-of-period

     194       137  
                

Minimum Pension Liability Adjustment

    

Balance at beginning-of-year

     —         (60 )

Change during the period

     —         (3 )
                

Balance at end-of-period

     —         (63 )
                

Funded Status of Employee Benefit Plans

    

Balance at beginning-of-year

     (84 )     —    

Change during the period

     (1 )     —    
                

Balance at end-of-period

     (85 )     —    
                

Total shareholders’ equity at end-of-period

   $ 11,963     $ 12,043  
                

See accompanying Notes to Consolidated Financial Statements

 

3


LINCOLN NATIONAL CORPORATION

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

-CONTINUED-

 

      Nine Months Ended September 30,  
     2007     2006  
     (Unaudited)  
     (Number of Shares)  

Series A Preferred Stock

    

Balance at beginning-of-year

   12,706     15,515  

Conversion into common stock

   (500 )   (1,602 )
            

Balance at end-of-period

   12,206     13,913  
            

Common Stock

    

Balance at beginning-of-year

   275,752,668     173,768,078  

Issued for acquisition

   —       112,301,906  

Conversion of Series A preferred stock

   8,000     25,632  

Stock compensation/issued for benefit plans

   3,600,543     5,456,670  

Deferred compensation payable in stock

   104,310     161,715  

Retirement of common stock

   (10,307,417 )   (14,373,938 )
            

Balance issued and outstanding at end-of-period

   269,158,104     277,340,063  
            

Common stock at end-of-period:

    

Assuming conversion of preferred stock

   269,353,400     277,571,615  

Diluted basis

   271,722,491     281,348,962  

See accompanying Notes to Consolidated Financial Statements

 

4


LINCOLN NATIONAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

     

Nine Months Ended

September 30,

 
     2007     2006  
     (Unaudited)  
     (in millions)  

Cash Flows from Operating Activities

    

Net income

   $ 1,102     $ 934  

Adjustments to reconcile net income to net cash provided by operating activities:

    

Deferred acquisition costs and value of business acquired

     (715 )     (447 )

Premiums and fees receivable

     (45 )     59  

Accrued investment income

     (50 )     (47 )

Policy liabilities and accruals

     194       (315 )

Net trading securities purchases, sales and maturities

     319       56  

Gain on reinsurance embedded derivative/trading securities

     (3 )     (3 )

Contractholder funds

     1,043       992  

Pension plan contribution

     (9 )     —    

Amounts recoverable from reinsurers

     (168 )     215  

Federal income taxes

     360       73  

Stock-based compensation expense

     39       35  

Depreciation

     28       44  

Increase in funds withheld liability

     43       73  

Realized loss on investments and derivative instruments

     18       20  

Amortization of deferred gain on indemnity reinsurance

     (65 )     (57 )

Other

     39       312  
                

Net adjustments

     1,028       1,010  
                

Net cash provided by operating activities

     2,130       1,944  
                

Cash Flows from Investing Activities

    

Securities-available-for-sale:

    

Purchases

     (10,740 )     (7,165 )

Sales

     6,456       4,557  

Maturities

     3,162       2,250  

Purchase of other investments

     (1,849 )     (352 )

Sale or maturity of other investments

     1,617       63  

Increase in cash collateral on loaned securities

     (184 )     (55 )

Purchase of Jefferson-Pilot stock, net of cash acquired of $39

     —         (1,826 )

Other

     (75 )     134  
                

Net cash used in investing activities

     (1,613 )     (2,394 )
                

Cash Flows from Financing Activities

    

Payment of long-term debt

     (653 )     —    

Issuance of long-term debt

     1,050       2,045  

Net increase (decrease) in short-term debt

     226       (564 )

Universal life and investment contract deposits

     7,030       5,398  

Universal life and investment contract withdrawals

     (5,805 )     (5,397 )

Investment contract transfers

     (1,732 )     (1,257 )

Common stock issued for benefit plans and excess tax benefits

     81       153  

Retirement of common stock

     (686 )     (852 )

Dividends paid to shareholders

     (323 )     (280 )
                

Net cash used in financing activities

     (812 )     (754 )
                

Net decrease in cash and invested cash

     (295 )     (1,204 )

Cash and invested cash at beginning-of-year

     1,621       2,312  
                

Cash and invested cash at end-of-period

   $ 1,326     $ 1,108  
                

See accompanying Notes to Consolidated Financial Statements

 

5


LINCOLN NATIONAL CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Basis of Presentation

Lincoln National Corporation and its majority-owned subsidiaries (“LNC” or the “Company,” which also may be referred to as “we”, “our” or “us”) operate multiple insurance and investment management businesses as well as a broadcasting and sports programming business through seven business segments (see Note 10). The collective group of businesses uses “Lincoln Financial Group” as its marketing identity. 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.

The accompanying unaudited consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the instructions for the Securities and Exchange Commission Quarterly Report on Form 10-Q, including Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. Therefore, the information contained in the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 (“2006 Form 10-K”) should be referred to in connection with the reading of these interim unaudited consolidated financial statements.

On April 3, 2006, we completed our merger with Jefferson-Pilot Corporation (“Jefferson-Pilot”), and have included the results of operations and financial condition of Jefferson-Pilot in our consolidated financial statements beginning on April 3, 2006.

On June 7, 2007, we announced plans to explore strategic options for Lincoln Financial Media. We are evaluating a range of options including, but not limited to, divestiture strategies.

In the opinion of management, these statements include all normal recurring adjustments necessary for a fair presentation of the results. Operating results for the three and nine month periods ended September 30, 2007 are not necessarily indicative of the results that may be expected for the full year ending December 31, 2007. All material intercompany accounts and transactions have been eliminated in consolidation.

Certain amounts reported in prior periods’ unaudited consolidated financial statements have been reclassified to conform to the 2007 presentation. These reclassifications have no effect on net income or shareholders’ equity of the prior periods.

2. Changes in Accounting Principles and Changes in Estimates

Statement of Position 05-1 – Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts. In September 2005, 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 provides guidance on accounting for deferred acquisition costs (“DAC”) on internal replacements of insurance and investment contracts. An internal replacement, defined by SOP 05-1, is a modification in product benefits, features, rights or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement or rider to a contract, or by the election of 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. Unamortized DAC, unearned revenue and deferred sales inducements (“DSI”) from the replaced contract must be written-off. SOP 05-1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006.

 

6


We adopted SOP 05-1 effective January 1, 2007 by recording decreases to the following categories in our Consolidated Balance Sheets:

 

(in millions)

    

Assets

  

Deferred acquisition costs

   $ 31

Value of business acquired

     35

Other assets - deferred sales inducements

     3
      

Total assets

   $ 69
      

Liabilities and Shareholders’ Equity

  

Investment contract and policyholder funds - deferred front end loads

   $ 2

Insurance policy and claim reserves - guaranteed minimum death benefit annuity reserves

     4

Other liabilities - income tax liabilities

     22
      

Total liabilities

     28
      

Shareholders’ Equity

  

Retained earnings

     41
      

Total liabilities and shareholders’ equity

   $ 69
      

The adoption of this new guidance primarily impacts our Individual Markets Annuities and Employer Markets Group Protection businesses, and our accounting policies regarding the assumptions for lapsation used in the amortization of DAC and value of business acquired (“VOBA”). In addition, the adoption of SOP 05-1 resulted in a $4 million and $14 million, pre-tax, increase to underwriting, acquisition, insurance and other expenses on our Consolidated Statements of Income in the three and nine month periods ended September 30, 2007, which was attributable to changes in DAC and VOBA deferrals and amortization.

Financial Accounting Standards Board Interpretation No. 48 – Accounting for Uncertainty in Income Taxes – an interpretation of Financial Accounting Standards Board Statement No. 109. In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 requires an entity to determine whether it is “more likely than not” that an individual tax position will be sustained upon examination by the appropriate taxing authority prior to any part of the benefit being recognized in the financial statements. The amount recognized would be the largest amount of tax benefit that is greater than fifty percent likely of being realized upon ultimate settlement, along with any related interest and penalties (if applicable). Upon adoption of FIN 48, the guidance will be applied to all tax positions, and only those tax positions meeting the “more likely than not” threshold will be recognized or continue to be recognized in the financial statements. In addition, FIN 48 expands disclosure requirements to include additional information related to unrecognized tax benefits, including accrued interest and penalties, and uncertain tax positions where the estimate of the tax benefit may change significantly in the next twelve months. FIN 48 is effective for fiscal years beginning after December 15, 2006. We adopted FIN 48 effective January 1, 2007 by recording an increase in the liability for unrecognized tax benefits of $15 million in our Consolidated Balance Sheets, offset by a reduction to the beginning balance of retained earnings. See Note 4 for more information regarding our adoption of FIN 48.

Statement of Financial Accounting Standards No. 155 – Accounting for Certain Hybrid Financial Instruments – an amendment of FASB Statements No. 133 and 140. In February 2006, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 155, “Accounting for Certain Hybrid Financial Instruments – an amendment of FASB Statements No. 133 and 140” (“SFAS 155”), which permits fair value remeasurement for a hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. Under SFAS 155, an entity may make an irrevocable election to measure a hybrid financial instrument at fair value, in its entirety, with changes in fair value recognized in earnings. SFAS 155 also: (a) clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”); (b) eliminates the interim guidance in SFAS 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets,” and establishes a requirement to evaluate beneficial interests in securitized financial assets to identify interests that are either freestanding derivatives or hybrid financial instruments that contain an embedded derivative requiring bifurcation; (c) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and (d) eliminates restrictions on a qualifying special-purpose entity’s ability to hold passive derivative financial instruments that pertain to beneficial interests that are or contain a derivative financial instrument.

 

7


In December 2006, the FASB issued Derivative Implementation Group Statement 133 Implementation Issue No. B40, “Embedded Derivatives: Application of Paragraph 13(b) to Securitized Interests in Prepayable Financial Assets” (“DIG B40”). Since SFAS 155 eliminated the interim guidance related to securitized financial assets, DIG B40 provides a narrow scope exception for securitized interests that contain only an embedded derivative related to prepayment risk. Under DIG B40, a securitized interest in prepayable financial assets would not be subject to bifurcation if: (a) the right to accelerate the settlement of the securitized interest cannot be controlled by the investor and (b) the securitized interest itself does not contain an embedded derivative for which bifurcation would be required other than an embedded derivative that results solely from the embedded call options in the underlying financial assets. Any other terms in the securitized financial asset that may affect cash flow in a manner similar to a derivative instrument would be subject to the requirements of paragraph 13(b) of SFAS 133. The guidance in DIG B40 is to be applied upon the adoption of SFAS 155.

We adopted the provisions SFAS 155 and DIG B40 on January 1, 2007. Prior period restatement was not permitted. The adoption of SFAS 155 did not have a material impact on our consolidated financial condition or results of operations.

SFAS No. 157 – Fair Value Measurements. In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value under current accounting pronouncements that require or permit fair value measurement and enhances disclosures about fair value instruments. SFAS 157 retains the exchange price notion, but clarifies that exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability (exit price) in the most advantageous market for that asset or liability, as opposed to the price that would be paid to acquire the asset or receive a liability (entry price). Fair value measurement is based on assumptions used by market participants in pricing the asset or liability, which may include inherent risk, restrictions on the sale or use of an asset, or nonperformance risk which would include the reporting entity’s own credit risk. SFAS 157 establishes a three-level fair value hierarchy, which prioritizes the inputs to valuation techniques used to measure fair value. The highest priority, Level 1, is given to quoted prices in active markets for identical assets or liabilities. Level 2 inputs are observable inputs, other than quoted prices included in Level 1, for the asset or liability or prices for similar assets and liabilities. Level 3 inputs, the lowest priority, include unobservable inputs in situations where there is little or no market activity for the asset or liability and the reporting entity makes estimates and assumptions related to the pricing of the asset or liability, including assumptions regarding risk. We have certain Guaranteed Benefit features that are currently recorded using fair value pricing. Prior to SFAS 157, when a fair value estimate was made on a liability and there were no observable inputs (classified as Level 1 or 2 under SFAS 157) for that liability or similar liabilities, market risk margins could only be included in said estimate when the margin was identifiable, measurable and significant. In which case, the present value of expected cash flows, discounted at the risk free rate of interest, may be the best available estimate of fair value. Under SFAS 157, many Level 3 inputs may be necessary to include in order to account for the market risk margins which are required to be used in the fair value measurement. In addition, SFAS 157 expands the disclosure requirements for annual and interim reporting to focus on the inputs used to measure fair value, including those measurements using significant unobservable inputs, and the effects of the measurements on earnings. SFAS 157 will be applied prospectively and is effective for fiscal years beginning after November 15, 2007. Retrospective application is required for certain financial instruments as a cumulative effect adjustment to the opening balance of retained earnings. We expect to adopt SFAS 157 effective January 1, 2008, and are currently evaluating the effects of SFAS 157 on our consolidated financial condition and results of operations.

SFAS No. 159 – The Fair Value Option for Financial Assets and Financial Liabilities. In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”), which allows an entity to make an irrevocable election, on specific election dates, to measure eligible items at fair value. The election to measure an item at fair value may be determined on an instrument by instrument basis, with certain exceptions. If the fair value option is elected, unrealized gains and losses will be recognized in earnings at each subsequent reporting date, and any upfront costs and fees related to the item will be recognized in earnings as incurred. In addition, the presentation and disclosure requirements of SFAS 159 are designed to assist in the comparison between entities that select different measurement attributes for similar types of assets and liabilities. SFAS 159 applies to fiscal years beginning after November 15, 2007, with early adoption permitted for an entity that has also elected to apply the provisions of SFAS 157. At the effective date, the fair value option may be elected for eligible items that exist on that date. The effect of the first remeasurement to fair value shall be reported as a cumulative effect adjustment to the opening balance of retained earnings. We expect to adopt SFAS 159 effective January 1, 2008, and are currently evaluating the items to which we may apply the fair value option and the effect on our consolidated financial condition and results of operations.

SOP 07-1 – Clarification of the Scope of the Audit and Accounting Guide Investment Companies and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies. In June 2007, the AICPA issued SOP 07-1, “Clarification of the Scope of the Audit and Accounting Guide Investment Companies and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies” (“SOP 07-1”). SOP 07-1 provides guidance for determining whether an entity is within the scope of the AICPA Audit and Accounting Guide, Investment Companies (“the Guide”). For those entities that are deemed to be investment companies, this SOP also addresses whether the specialized

 

8


industry accounting principles of the Guide (“investment company accounting”) should be retained by a parent company in consolidation or by an investor that has the ability to exercise significant influence over the investment company and applies the equity method of accounting to its investment in the entity (“equity method investor”). In addition, this SOP includes certain disclosure requirements for parent companies and equity method investors in investment companies that retain investment company accounting in the parent company’s consolidated financial statements or the financial statements of an equity method investor. This SOP may cause companies to no longer be considered investment companies or investors in investment companies to no longer be able to retain the specialized industry accounting of an investee in their own financial statements. However, it may be possible for these entities or investors to elect, upon transition, to report certain noncontrolling investments at fair value under SFAS 159. SOP 07-1 applies to fiscal years beginning on or after December 15, 2007; however, on October 17, 2007, the FASB agreed to propose an indefinite delay of the effective date of SOP 07-1.

Staff Accounting Bulletin No. 109 – Written Loan Commitments Recorded at Fair Value through Earnings. In November 2007, the Securities and Exchange Commission staff issued Staff Accounting Bulletin (“SAB”) No. 109, “Written Loan Commitments Recorded at Fair Value through Earnings” (“SAB 109”). SAB 109 supersedes the guidance provided in SAB No. 105, “Application of Accounting Principles to Loan Commitments” (“SAB 105”), which stated that in measuring the fair value of a derivative loan commitment, it was inappropriate to incorporate the expected net future cash flows related to the associated servicing of the loan. Under SAB 109, the expected net future cash flows related to the associated servicing of the loan should be included in the measurement of all written loan commitments that are accounted for at fair value through earnings. SAB 105 also indicated that internally-developed intangible assets (such as customer relationship intangible assets) should not be recorded as part of the fair value of a derivative loan commitment. SAB 109 retains that staff view and broadens its application to all written loan commitments that are accounted for at fair value through earnings. SAB 109 is effective on a prospective basis to derivative loan commitments issued or modified in fiscal years quarters beginning after December 15, 2007. We expect to adopt SAB 109 effective January 1, 2008, and are currently evaluating the effects of SAB 109 on our consolidated financial condition and results of operations.

3. Business Combination

On April 3, 2006, we completed our merger with Jefferson-Pilot by acquiring 100% of the outstanding shares of Jefferson-Pilot in a transaction accounted for under the purchase method of accounting prescribed by SFAS No. 141, “Business Combinations” (“SFAS 141”). Jefferson-Pilot’s results of operations are included in our results of operations beginning April 3, 2006. As a result of the merger, our product portfolio was expanded, and we now offer fixed and variable universal life, fixed annuities, including indexed annuities, variable annuities, mutual funds and institutional accounts, 401(k) and 403(b) offerings, and group life, disability and dental insurance products. We also own and operate television and radio stations in selected markets in the Southeastern and Western United States and produce and distribute sports programming.

SFAS 141 requires that the total purchase price be allocated to the assets acquired and liabilities assumed based on their fair values at the merger date.

The aggregate consideration paid for the merger was as follows:

 

(in millions, except share data)

  

Share

Amounts

    

LNC common shares issued

     112,301,906   

Purchase price per share of LNC common share (1)

   $ 48.98   

Fair value of common shares issued

      $ 5,501

Cash paid to Jefferson-Pilot shareholders

        1,800

Fair value of Jefferson-Pilot stock options (2)

        151

Transaction costs

        66
         

Total purchase price

      $ 7,518
         

(1)

The value of the shares of LNC common stock exchanged with Jefferson-Pilot shareholders was based upon the average of the closing prices of LNC common stock for the five day trading period ranging from two days before, to two days after, October 10, 2005, the date the merger was announced.

(2)

Includes certain stock options that vested immediately upon the consummation of the merger. Any future income tax deduction related to these vested stock options will be recognized on the option exercise date as an adjustment to the purchase price and recorded to goodwill.

 

9


The fair value of Jefferson-Pilot’s specifically identifiable net assets acquired in the merger was $4.2 billion. Goodwill of $3.3 billion resulted from the excess of purchase price over the fair value of Jefferson-Pilot’s net assets. The amount of goodwill that is expected to be deductible for tax purposes is approximately $24 million. We paid a premium over the fair value of Jefferson-Pilot’s net assets for a number of potential strategic and financial benefits that are expected to be realized as a result of the merger including, but not limited to, the following:

 

   

Greater size and scale with improved earnings diversification and strong financial flexibility;

 

   

Broader, more balanced product portfolio;

 

   

Larger distribution organization; and

 

   

Value creation opportunities through expense savings and revenue enhancements across business units.

The following table summarizes the fair values of the net assets acquired as of the acquisition date:

 

(in millions)

   Fair Value  

Investments

   $ 27,910  

Due from reinsurers

     1,296  

Value of business acquired

     2,486  

Goodwill

     3,324  

Other assets

     1,693  

Assets held in separate accounts

     2,574  

Insurance and investment contract liabilities

     (26,641 )

Long-term debt

     (905 )

Income tax liabilities

     (782 )

Accounts payable, accruals and other liabilities

     (863 )

Liabilities related to separate accounts

     (2,574 )
        

Total purchase price

   $ 7,518  
        

The goodwill resulting from the merger was allocated to the following segments:

 

(in millions)

    

Individual Markets:

  

Life Insurance

   $ 1,346

Annuities

     1,002
      

Total Individual Markets

     2,348
      

Employer Markets: Group Protection

     274

Lincoln Financial Media

     702
      

Total goodwill

   $ 3,324
      

 

10


The following table summarizes the fair value of identifiable intangible assets acquired in the merger and reported in other assets.

 

(in millions)

       

Weighted

Average

Amortization

Period

Lincoln Financial Media:

     

FCC licenses

   $ 638    N/A

Sports production rights

     11    5 years

Network affiliation agreements

     10    21 years

Other

     11    16 years
         

Total Lincoln Financial Media

     670   
         

Individual Markets - Life Insurance:

     

Sales force

     100    25 years
         

Total indentifiable intangibles

   $ 770   
         

Identifiable intangibles not subject to amortization

   $ 638    N/A

Identifiable intangibles subject to amortization

     132    22 years
         

Total identifiable intangibles

   $ 770   
         

4. Federal Income Taxes

The effective tax rate was 28% and 21% for the three months ended September 30, 2007 and 2006, respectively. The effective tax rate for the nine months ended September 30, 2007 and 2006 was 29% and 27%, respectively. Differences in the effective rates and the U.S. statutory rate of 35% are the result of certain tax preferred investment income including separate account dividends-received deduction (“DRD”) and foreign tax credits, and other tax preference items.

Federal income tax expense for the third quarter and first nine months of 2007 included a reduction of $13 million related to favorable adjustments from the 2006 tax return, filed in the third quarter of 2007, relating to the separate account DRD, foreign tax credits and other tax preference items. Federal income tax expense for the third quarter and first nine months of 2006 included a reduction of $39 million related to favorable adjustments from the 2005 tax return, filed in the third quarter of 2006, relating primarily to the separate account DRD and, to a lesser extent, foreign tax credits and other tax preference items, and revised estimates of these items for 2006.

We are required to establish a valuation allowance for any gross deferred tax assets that are unlikely to reduce taxes payable in future years’ tax returns. At September 30, 2007, we believe that it is more likely than not that all gross deferred tax assets will reduce taxes payable in future years.

As discussed in Note 2, we adopted FIN 48 on January 1, 2007 and had unrecognized tax benefits of $349 million of which $143 million, if recognized, would impact the effective tax rate. Also, as of the adoption date, we had accrued interest expense related to the unrecognized tax benefits of $51 million. We recognize interest and penalties, if any, accrued related to unrecognized tax benefits as a component of tax expense.

In the normal course of business we are subject to examination by taxing authorities throughout the United States and the United Kingdom. At any given time, we may be under examination by state, local or non-U.S. income tax authorities. It is reasonably possible that a reduction in the unrecognized tax benefits may occur; however, quantification of an estimated range cannot be made at this time.

5. Supplemental Financial Data

During the third quarter of each year, we conduct our annual comprehensive review of the assumptions underlying the amortization of DAC, VOBA, DSI and deferred front end loads (“DFEL”) as well as our reserves for our guaranteed benefit features. The cumulative balances of these items, included within our Consolidated Balance Sheets, are adjusted with an offsetting benefit or charge to income to reflect such changes. The various assumptions that are reviewed include investment margins,

mortality and retention. This process is described as a “prospective unlocking”. In addition, as part of our annual comprehensive review, we make corrections and modifications to our amortization models.

 

11


In addition, on a quarterly basis, we review actual and estimates of future gross profits underlying our models and record a positive or negative retrospective adjustment to the amortization of DAC, VOBA, DSI and DFEL, as well as the reserves for our guaranteed benefit features. If our models fall outside a reasonable range, revisions to best estimate assumptions used to estimate future gross profits are necessary and a “retrospective unlocking” is recorded, which revises future gross profits to reflect our best estimate of assumptions.

Our unlocking process is described more fully in “Part II – Item 7 – Management’s Discussion and Analysis of Financial Condition, Results of Operations – Critical Accounting Policies” of our 2006 Form 10-K.

A rollforward of DAC is as follows:

 

     

Nine Months Ended

September 30,

 

(in millions)

   2007     2006  

Balance at beginning-of-year

   $ 5,116     $ 4,164  

Cumulative effect of adoption of SOP 05-1

     (31 )     —    

Deferral

     1,469       986  

Amortization net of interest:

    

Unlocking

     23       35  

Other amortization

     (596 )     (476 )

Adjustment related to realized gains on securities available-for-sale and derivatives

     (13 )     (35 )

Adjustment related to unrealized losses on securities available-for-sale and derivatives

     185       106  

Foreign currency translation adjustment

     23       43  
                

Balance at end-of-period

   $ 6,176     $ 4,823  
                

For the nine months ended September 30, 2007, the unlocking total includes $34 million in prospective unlocking from updates to assumptions for experience, $(56) million in model changes and $45 million in retrospective unlocking. For the nine months ended September 30, 2006, the unlocking total includes $8 million in prospective unlocking from updates to assumption for experience, $(6) million in model changes and $33 million in retrospective unlocking.

 

12


A rollforward of VOBA is as follows:

 

     

Nine Months Ended

September 30,

 

(in millions)

   2007     2006  

Balance at beginning-of-year

   $ 3,304     $ 999  

Cumulative effect of adoption of SOP 05-1

     (35 )     —    

Business acquired

     14       2,478  

Deferral of commissions

     35       74  

Amortization:

    

Unlocking

     23       (7 )

Other amortization

     (347 )     (257 )

Accretion of interest

     108       92  

Adjustment related to realized gains on securities available-for-sale and derivatives

     (7 )     (4 )

Adjustment related to unrealized (gains) losses on securities available-for-sale and derivatives

     53       (49 )

Foreign currency translation adjustment

     13       23  
                

Balance at end-of-period

   $ 3,161     $ 3,349  
                

For the nine months ended September 30, 2007, the unlocking total includes $15 million in prospective unlocking from updates to assumptions for experience, $(7) million in model changes and $15 million in retrospective unlocking. For the nine months ended September 30, 2006, the unlocking total includes $(5) million in prospective unlocking from updates to assumption for experience and $(2) million in retrospective unlocking.

Realized gains and losses on investments and derivative instruments on the Consolidated Statements of Income for the nine months ended September 30, 2007 and 2006 are net of amounts amortized against DAC and VOBA of $20 million and $39 million, respectively. In addition, realized gains and losses for the nine months ended September 30, 2007 and 2006 are net of adjustments made to policyholder reserves of $(16) million and $(1) million, respectively. We have either a contractual obligation or a consistent historical practice of making allocations of investment gains or losses to certain policyholders and to certain reinsurance arrangements.

A rollforward of DSI, which is included in other assets on the Consolidated Balance Sheets, is as follows:

 

     

Nine Months Ended

September 30,

 

(in millions)

   2007     2006  

Balance at beginning-of-year

   $ 194     $ 129  

Cumulative effect of adoption of SOP 05-1

     (3 )     —    

Deferral

     81       58  

Amortization net of interest:

    

Unlocking

     3       3  

Other amortization

     (26 )     (17 )
                

Balance at end-of-period

   $ 249     $ 173  
                

For the nine months ended September 30, 2007, the unlocking total includes $2 million in prospective unlocking from updates to assumptions for experience, $(1) million model changes and $2 million in retrospective unlocking. For the nine months ended September 30, 2006, the unlocking total includes $1 million in prospective unlocking from updates to assumption for experience and $2 million in retrospective unlocking.

 

13


Details underlying underwriting, acquisition, insurance and other expenses on the Consolidated Statements of Income are as follows:

 

     

Three Months Ended

September 30,

   

Nine Months Ended

September 30,

 

(in millions)

   2007     2006     2007     2006  

Commissions

   $ 542     $ 437     $ 1,592     $ 1,100  

General and administrative expenses

     441       423       1,306       1,122  

DAC and VOBA deferrals and interest, net of amortization

     (249 )     (198 )     (715 )     (447 )

Other intangibles amortization

     3       3       10       12  

Taxes, licenses and fees

     53       50       172       131  

Merger-related expenses

     29       13       73       30  
                                

Total

   $ 819     $ 728     $ 2,438     $ 1,948  
                                

As discussed in Note 3, the excess of the purchase price for the Jefferson-Pilot merger over the fair value of net assets acquired totaled $3.3 billion.

The following summarizes the changes in the carrying amount of goodwill by reportable segment for the nine months ended September 30, 2007:

 

(in millions)

  

Balance at

December 31, 2006

  

Purchase

Accounting and

Other Adjustments

   

Balance at

September 30, 2007

Individual Markets:

       

Life Insurance

   $ 2,181    $ 20     $ 2,201

Annuities

     1,032      13       1,045

Employer Markets:

       

Retirement Products

     20      —         20

Group Protection

     281      (7 )     274

Investment Management

     262      1       263

Lincoln Financial Media

     707      (5 )     702

Lincoln UK

     17      —         17
                     

Total

   $ 4,500    $ 22     $ 4,522
                     

Details of investment contract and policyholder funds on the Consolidated Balance Sheets are as follows:

 

(in millions)

  

September 30,

2007

  

December 31,

2006

Account values and other policyholder funds

   $ 58,430    $ 57,904

Deferred front end loads

     1,128      977

Premium deposit funds

     146      162

Undistributed earnings on participating business

     93      102
             

Total

   $ 59,797    $ 59,145
             

The following summarizes debt and financing activity during the nine months ended September 30, 2007:

 

   

On January 11, 2007, we redeemed all of the outstanding 8.14% Junior Subordinated Deferrable Interest Debentures, Series A due 2046, which were held by Jefferson-Pilot Capital Trust A. The redemption price for the Capital Securities, Series A was $1,040.70 per security, for a total principal amount of $206 million, plus $16 million for accrued interest through the redemption date.

 

   

On March 1, 2007, we redeemed all of the outstanding 8.285% Junior Subordinated Deferrable Interest Debentures, Series B due 2046, which were held by Jefferson-Pilot Capital Trust B. The redemption price for the Capital Securities, Series B was $1,041.43 per security, for a total principal amount of $103 million, plus $8 million for accrued interest through the redemption date.

 

14


   

In March 2007, LNC issued $500 million of 6.05% Capital Securities (callable in year 10 at par) due April 20, 2067 and $250 million 3-year floating rate senior notes at LIBOR plus 8 basis points due April 20, 2010.

 

   

On June 15, 2007, LNC repaid $244 million ($6 million was owed to a non-regulated subsidiary and eliminated in consolidation) of 5.25% senior notes that matured.

 

   

On August 17, 2007, we repaid $100 million of floating rate extendible notes whose maturity had not been extended beyond the August 17, 2007 interim maturity date.

 

   

On August 22, 2007, we issued $300 million aggregate principal amount of our 5.65% Senior Notes due August 27, 2012 pursuant to the Prospectus, dated March 14, 2006.

 

   

Long-term debt decreased by $5 million for the accretion of a discount.

 

   

Our commercial paper increased by $226 million.

6. Insurance Benefit Reserves

We issue variable contracts through our separate accounts for which investment income and investment gains and losses accrue directly to, and investment risk is borne by, the contractholder (traditional variable annuities). We also issue variable annuity and life contracts through separate accounts that include various types of guaranteed minimum death benefit (“GMDB”), guaranteed minimum withdrawal benefit and guaranteed income benefit features. The GMDB features include those where we contractually guarantee to the contractholder either (a) return of no less than total deposits made to the contract less any partial withdrawals, (b) total deposits made to the contract less any partial withdrawals plus a minimum return, or (c) the highest contract value on any contract anniversary date through age 80 minus any payments or withdrawals following the contract anniversary.

The following table provides information on the GMDB features outstanding at September 30, 2007 and December 31, 2006. (Note that our variable contracts with guarantees may offer more than one type of guarantee in each contract; therefore, the amounts listed are not mutually exclusive). The net amount at risk is defined as the current guaranteed minimum death benefit in excess of the current account balance at the balance sheet date.

 

      In Event of Death  

(dollars in billions)

  

September 30,

2007

   

December 31,

2006

 

Return of Net Deposit

    

Account value

   $ 44.6     $ 38.3  

Net amount at risk

     —         0.1  

Average attained age of contractholders

     55       54  

Return of Net Deposits Plus a Minimum Return

    

Account value

   $ 0.4     $ 0.4  

Net amount at risk

     —         —    

Average attained age of contractholders

     67       67  

Guaranteed minimum return

     5 %     5 %

Highest Specified Anniversary Account Value Minus Withdrawals Post Anniversary

    

Account value

   $ 25.8     $ 22.5  

Net amount at risk

     0.1       0.2  

Average attained age of contractholders

     64       64  

The determination of the GMDB liabilities is based on models that involve a range of scenarios and assumptions, including those regarding expected market rates of return and volatility, contract surrender rates and mortality experience.

 

15


The following summarizes the liabilities for GMDB, which is recorded in insurance policy and claim reserves on our Consolidated Balance Sheets:

 

     

Nine Months Ended

September 30,

 

(in millions)

   2007     2006  

Balance at beginning-of-year

   $ 23     $ 15  

Cumulative effect of adoption of SOP 05-1

     (4 )     —    

Changes in reserves

     17       11  

Benefits paid

     (4 )     (5 )
                

Balance at end-of-period

   $ 32     $ 21  
                

The changes to the benefit reserves amounts above are reflected in benefits in the Consolidated Statements of Income.

Also included in benefits are the results of the hedging program, which included losses of $2 million and $3 million for GMDB for the three and nine months ended September 30, 2007, respectively, and losses of $1 million and $3 million for the three and nine months ended September 30, 2006, respectively.

Separate account balances attributable to variable annuity contracts with guarantees are as follows:

 

(in billions)

  

September 30,

2007

   

December 31,

2006

 

Asset Type

    

Domestic equity

   $ 45.7     $ 39.3  

International equity

     7.7       5.9  

Bonds

     7.7       6.4  
                

Total

     61.1       51.6  

Money market

     6.6       5.6  
                

Total

   $ 67.7     $ 57.2  
                

Percent of total variable annuity separate account values

     88 %     87 %
                

Credit-Linked Notes

As of September 30, 2007 and December 31, 2006, investment contract and policyholder funds on our Consolidated Balance Sheets included $1.2 billion and $700 million outstanding in funding agreements issued by the Lincoln National Life Insurance Company (“LNL”). We invested proceeds of $850 million received for issuing three funding agreements in 2006 and 2007 into three separate credit-linked notes originated by third-party companies. We earn a spread between the coupon received on the credit-linked notes and the interest credited on the funding agreements. Our credit-linked notes were created using a trust that combined a high quality asset with a credit default swap to produce multi-class structured securities. Consistent with other debt market instruments, we are exposed to credit losses within the structure of the credit-linked notes, which could result in principal losses to our investments. However, we have attempted to protect our investments from credit losses through the multi-tiered class structure of the credit-linked note, which requires the subordinated classes of the investment pool to absorb all of the initial credit losses. Our affiliate, Delaware Investments, manages the investments in the underlying portfolio. We will not incur credit losses unless the subordinated classes are retired and unless additional credit losses are incurred in the underlying credit-linked note structure. Similar to other debt market instruments, our maximum principal loss is limited to our original investment of $850 million as of September 30, 2007.

The statutory surplus of our insurance subsidiaries is impacted by changes in the market value of these investments. The market values of these investments are sensitive to credit spreads. Sustained declines in the market value of these investments, such as widening credit spreads, would reduce the surplus and may negatively impact the dividend capacity of our insurance subsidiaries.

 

16


The table below summarizes information regarding our investments in these securities:

 

      Amount and Date of Issuance

(dollars in millions)

  

$400 million

December 2006

  

$200 million

April 2007

  

$250 million

April 2007

Amount of subordination (1)

   $ 2,184    $ 410    $ 1,167

Total amount of pool

     40,000      20,000      25,000

Maturity

     12/20/16      3/20/17      6/20/17

Current rating of tranche (1)

     AA      Aa2      AA

Current rating of underlying collateral pool (1) (2)

     Aaa-Ba2      Aaa-Ba1      Aaa-Ba1

Number of entities (1)

     125      100      102

Number of countries (1)

     20      21      14

Number of industries (1)

     36      27      30

(1)

As of October 25, 2007

(2)

Represents the range of ratings assigned to individual investments. For each respective security, the percentage of investments at investment grade is 97%, 99% and 99%.

We are not aware of any significant realized credit losses in the above investments as of September 30, 2007. We have determined that we are not the primary beneficiary, as we do not hold the majority of the risk of loss.

7. Employee Benefit Plans

Pension and Other Postretirement Benefit Plans

As a result of our merger with Jefferson-Pilot, we maintain funded defined benefit pension plans for the former U.S. employees and agents of Jefferson-Pilot. The components of net defined benefit pension plan and postretirement benefit plan expense are as follows:

 

      Pension Benefits     Other Postretirement Benefits
     

Three Months Ended

September 30,

   

Three Months Ended

September 30,

(in millions)

   2007     2006     2007     2006

U.S. Plans

        

Service cost

   $ 9     $ 9     $ —       $ 1

Interest cost

     14       15       2       2

Expected return on plan assets

     (19 )     (19 )     (1 )     —  

Amortization of prior service cost

     1       —         —         —  

Recognized net actuarial losses

     —         1       —         —  
                              

Net periodic benefit expense

   $ 5     $ 6     $ 1     $ 3
                              

Non-U.S. Plans

        

Interest cost

   $ 5     $ 4      

Expected return on plan assets

     (5 )     (4 )    

Recognized net actuarial losses

     1       1      
                    

Net periodic benefit expense

   $ 1     $ 1      
                    

 

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      Pension Benefits     Other Postretirement Benefits  
     

Nine Months Ended

September 30,

   

Nine Months Ended

September 30,

 

(in millions)

   2007     2006     2007     2006  

U.S. Plans

        

Service cost

   $ 25     $ 23     $ 2     $ 2  

Interest cost

     44       38       6       6  

Expected return on plan assets

     (59 )     (48 )     (2 )     (1 )

Recognized net actuarial (gains) losses

     —         2       (1 )     —    
                                

Net periodic benefit expense

   $ 10     $ 15     $ 5     $ 7  
                                

Non-U.S. Plans

        

Service cost

   $ 1     $ 1      

Interest cost

     14       12      

Expected return on plan assets

     (15 )     (13 )    

Recognized net actuarial losses

     3       3      
                    

Net periodic benefit expense

   $ 3     $ 3      
                    

On May 1, 2007, we announced plans to change the retirement benefits provided to employees, which include replacing our traditional pension retirement benefits with a new defined contribution plan beginning January 1, 2008. This prospective change in benefits will not impact any of the pension retirement benefits that have already accrued to employees. On January 1, 2008, retirement benefits for employees will begin accruing through the new defined contribution plan. This change is not expected to be material to our future earnings, but resulted in a one-time curtailment gain of $9 million ($6 million after-tax) in the second quarter of 2007, which was reported within Other Operations.

See Note 8 to the consolidated financial statements in our 2006 Form 10-K for a detailed discussion of our other benefit plans.

8. Stock-Based Incentive Compensation Plans

See Note 9 to the consolidated financial statements in our 2006 Form 10-K for a detailed discussion of stock and incentive compensation.

We have various incentive plans for our employees, agents and directors and our subsidiaries that provide for the issuance of stock options, stock incentive awards, stock appreciation rights, restricted stock awards, restricted stock units (“performance shares”), and deferred stock units. Delaware Investments U.S., Inc. (“DIUS”) has a separate stock option incentive plan.

In the first quarter of 2007, a performance period from 2007-2009 was approved for our executive officers by the Compensation Committee. Executive officers participating in this performance period received one-half of their award in 10-year LNC or DIUS stock options, with the remainder of the award in a combination of either: 100% performance shares or 75% performance shares and 25% cash. LNC stock options granted for this performance period vest ratably over the three-year period, based solely on a service condition. DIUS stock options granted for this performance period vest ratably over a four-year period, based solely on a service condition and were granted only to employees of DIUS. Depending on the performance, the actual amount of performance shares could range from zero to 200% of the granted amount. Under the 2007-2009 plan, a total of 725,721 LNC stock options were granted; 12,237 DIUS stock options were granted; and 126,879 LNC performance shares were granted during the three months ended March 31, 2007. Additionally, 217,771 LNC stock options were granted during the three months ended September 30, 2007.

 

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In addition to the stock-based grants noted above, various other LNC stock-based awards were granted in the three and nine months ended September 30, 2007, which are summarized in the table below:

 

     

Three Months Ended

September 30, 2007

  

Nine Months Ended

September 30, 2007

Awards

     

10-year LNC stock options

   25,129    446,456

Non-employee director stock options

   —      30,070

Non-employee agent stock options

   —      158,526

Restricted stock

   170,809    404,054

Stock appreciation rights

   —      187,750

9. Restrictions, Commitments and Contingencies

See “Restrictions, Commitments and Contingencies” in Note 10 to the consolidated financial statements in our 2006 Form 10-K for a discussion of restrictions, commitments and contingencies, which information is incorporated herein by reference.

Regulatory and Litigation Matters

Federal and state regulators continue to focus on issues relating to variable insurance products, including suitability and replacements and sales to seniors. Like others in the industry, we have received inquiries including requests for information regarding sales to senior from the Financial Industry Regulation Authority. We are in the process of responding to these inquiries. We continue to cooperate fully with such authority.

In the ordinary course of its business, LNC and its subsidiaries are involved in various pending or threatened legal proceedings, including purported class actions, arising from the conduct of business. In some instances, these proceedings include claims for unspecified or substantial punitive damages and similar types of relief in addition to amounts for alleged contractual liability or requests for equitable relief. After consultation with legal counsel and a review of available facts, it is management’s opinion that these proceedings, after consideration of any reserves and rights to indemnification, ultimately will be resolved without materially affecting the consolidated financial position of LNC. However, given the large and indeterminate amounts sought in certain of these proceedings and the inherent difficulty in predicting the outcome of such legal proceedings, including the proceeding described below, it is possible that an adverse outcome in certain matters could be material to our operating results for any particular reporting period.

Transamerica Investment Management, LLC and Transamerica Investments Services, Inc. v. Delaware Management Holdings, Inc. (dba Delaware Investments), Delaware Investment Advisers and certain individuals, was filed in the San Francisco County Superior Court on April 28, 2005. The plaintiffs are seeking substantial compensatory and punitive damages. The complaint alleges breach of fiduciary duty, breach of duty of loyalty, breach of contract, breach of the implied covenant of good faith and fair dealing, unfair competition, interference with prospective economic advantage, conversion, unjust enrichment, and conspiracy. We and the individual defendants dispute the allegations and intend to defend these actions vigorously.

Statutory Information and Restrictions

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. Generally, these restrictions pose no short-term liquidity concerns for the holding company. For example, under Indiana laws and regulations, our Indiana insurance subsidiaries, including one of our major insurance subsidiaries, 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 the Commissioner broad discretion to disapprove requests for dividends in excess of these limits. Our Jefferson-Pilot Life Insurance Company subsidiary, domiciled in North Carolina, and our Jefferson Pilot Financial Insurance Company subsidiary, domiciled in Nebraska, were merged with and into LNL, our Indiana domiciled subsidiary in April and July 2007, respectively. Our Jefferson Pilot LifeAmerica Insurance Company subsidiary was redomiciled from New Jersey to New York, and our New York domiciled company subsidiary, Lincoln Life & Annuity Company of New York, was subsequently merged with and into it in April 2007. The merged company retains the name Lincoln Life & Annuity Company of New York (“LLANY”). LLANY is a wholly owned subsidiary of LNL. LLANY is

 

19


subject to similar, but not identical, regulatory restrictions with regard to the transfer of funds and payment of dividends as our Indiana domiciled subsidiaries. Ownership of our other Indiana domiciled subsidiary, First Penn Pacific Life Insurance Company, was transferred by extraordinary dividend payment from LNL to LNC. As a result of that transfer, any transfer of funds and payment of dividends from our Indiana domiciled insurance companies are subject to the prior approval of the Indiana Insurance Commissioner for the remainder of 2007.

Reinsurance Contingencies

Our amounts recoverable from reinsurers represent receivables from and reserves ceded to reinsurers. We obtain reinsurance from a diverse group of reinsurers, and we monitor concentration as well as financial strength ratings of our principal reinsurers. Swiss Re Life & Health America, Inc. (“Swiss Re”) represents our largest reinsurance exposure. In the second quarter of 2007, we recognized a reserve increase on the personal accident business that was sold to Swiss Re through an indemnity reinsurance transaction in 2001, at which time we recognized a deferred gain that is being amortized into income at the rate that earnings are expected to emerge within a 15 year period. This adjustment resulted in a non-cash charge of $13 million, after-tax, to increase reserves, which was partially offset by a cumulative “catch-up” adjustment to the deferred gain amortization of $5 million, after-tax, for a total decrease to net income of $8 million. The impact of the accounting for reserve adjustments related to this reinsurance treaty is excluded from our definition of income from operations. Because Swiss Re is responsible for paying the underlying claims to the ceding companies corresponding to the reserve increase, we record an increase in the reinsurance recoverable in the period of the change. The amount of the additional increase to the deferred gain above the cumulative amortization “catch-up” adjustment will be amortized into income in future periods over the remaining period of expected run-off of the underlying business.

10. Segment Information

In the quarter ended June 30, 2006, we completed our merger with Jefferson-Pilot and realigned our reporting segments to reflect the current manner by which our chief operating decision makers view and manage the business. 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 report results through seven business segments.

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), 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.

Segment operating revenue and income (loss) from operations are internal measures used by our management and Board of Directors to evaluate and assess the results of our segments. Operating revenue is GAAP revenue excluding realized gains and losses on investments and derivative instruments, gains and losses on reinsurance embedded derivative/trading securities, gains and losses on sale of subsidiaries/businesses and the amortization of deferred gain arising from reserve development on business sold through reinsurance. Income (loss) from operations is GAAP net income excluding net realized investment gains and losses, losses on early retirement of debt, reserve development net of related amortization on business sold through reinsurance and cumulative effect of accounting changes. Our management and Board of Directors believe that operating revenue and income (loss) from operations explain the results of our ongoing businesses in a manner that allows for a better understanding of the underlying trends in our current businesses because net realized investment gains and losses, reserve development net of related amortization on business sold through reinsurance and cumulative effect of accounting changes are unpredictable and not necessarily indicative of current operating fundamentals or future performance of the business segments, and in many instances, decisions regarding these items do not necessarily relate to the operations of the individual segments. Operating revenue and income (loss) from operations do not replace revenues and net income as the GAAP measures of our consolidated results of operations.

 

20


The following tables show financial data by segment:

 

     

Three Months Ended

September 30,

   

Nine Months Ended

September 30,

 

(in millions)

   2007     2006     2007     2006  

Revenue

        

Segment operating revenue

        

Individual Markets:

        

Annuities

   $ 666     $ 597     $ 1,947     $ 1,524  

Life Insurance

     990       895       2,919       2,297  
                                

Total Individual Markets

     1,656       1,492       4,866       3,821  
                                

Employer Markets:

        

Retirement Products

     357       349       1,082       1,006  

Group Protection

     368       332       1,119       687  
                                

Total Employer Markets

     725       681       2,201       1,693  
                                

Investment Management (1)

     150       140       451       415  

Lincoln UK

     89       72       272       223  

Lincoln Financial Media (2)

     60       60       185       117  

Other Operations

     65       87       220       244  

Consolidating adjustments

     (28 )     (34 )     (97 )     (92 )

Net realized investment results (3)

     (37 )     (11 )     (15 )     (17 )

Amortization of deferred gain on indemnity reinsurance related to reserve developments

     1       —         9       1  
                                

Total revenue

   $ 2,681     $ 2,487     $ 8,092     $ 6,405  
                                

Net Income

        

Segment operating income

        

Individual Markets:

        

Annuities

   $ 107     $ 129     $ 358     $ 285  

Life Insurance

     174       123       517       339  
                                

Total Individual Markets

     281       252       875       624  
                                

Employer Markets:

        

Retirement Products

     52       65       177       195  

Group Protection

     33       29       85       66  
                                

Total Employer Markets

     85       94       262       261  
                                

Investment Management (5)

     22       13       49       41  

Lincoln UK

     10       8       33       29  

Lincoln Financial Media

     14       15       40       27  

Other Operations

     (59 )     (11 )     (141 )     (38 )

Net realized investment results (4)

     (23 )     (7 )     (9 )     (11 )

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

     —         —         (7 )     1  
                                

Net income

   $ 330     $ 364     $ 1,102     $ 934  
                                

(1)

Revenues for the Investment Management segment include inter-segment revenues for asset management services provided to our other segments. These inter-segment revenues totaled $20 million and $24 million for the three months ended September 30, 2007 and 2006, respectively, and $67 million and $72 million for the nine months ended September 30, 2007 and 2006, respectively.

 

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(2)

Lincoln Financial Media revenues are net of $8 million of commissions paid to agencies for the three months ended September 30, 2007 and 2006, and $25 million and $17 million for the nine months ended September 30, 2007 and 2006, respectively.

(3)

Includes realized losses on investments of $26 million and $1 million for the three months ended September 30, 2007 and 2006, respectively; realized losses on derivative instruments of $10 million and $5 million for the three months ended September 30, 2007 and 2006, respectively; and losses on reinsurance embedded derivative/trading securities of $1 million and $5 million for the three months ended September 30, 2007 and 2006, respectively. Includes realized losses on investments of $11 million and $19 million for the nine months ended September 30, 2007 and 2006, respectively; realized losses on derivative instruments of $7 million and $1 million for the nine months ended September 30, 2007 and 2006; and gains on reinsurance embedded derivative/trading securities of $3 million for the nine months ended September 30, 2007 and 2006.

(4)

Includes realized losses on investments of $16 million and $1 million for the three months ended September 30, 2007 and 2006, respectively; realized losses on derivative instruments of $7 million and $3 million for the three months ended September 30, 2007 and 2006, respectively; and losses on reinsurance embedded derivative/trading securities of $3 million for the three months ended September 30, 2006. Includes realized losses on investments of $7 million and $11 million for the nine months ended September 30, 2007 and 2006, respectively; realized losses on derivative instruments of $4 million and $1 million for the nine months ended September 30, 2007 and 2006, respectively; and gains on reinsurance embedded derivative/trading securities of $2 million for the nine months ended September 30, 2007 and 2006.

(5)

On October 31, 2007, we reached an agreement with an unaffiliated investment management company involving certain members of our fixed income team and related institutional taxable fixed income business. We expect this transaction to decrease income from operations by approximately $3 million, after-tax, per quarter, in 2008.

11. Earnings Per Share

The income used in the calculation of our diluted earnings per share is our income before cumulative effect of accounting change and net income, reduced by minority interest adjustments related to outstanding stock options under the DIUS stock option incentive plan of $1 million for the nine months ended September 30, 2007 and less than $1 million for all other periods presented.

A reconciliation of the denominator in the calculations of basic and diluted net income and income before cumulative effect of accounting change per share is as follows:

 

     

Three Months Ended

September 30,

   

Nine Months Ended

September 30,

 
     2007     2006     2007     2006  

Denominator: [number of shares]

        

Weighted-average shares, as used in basic calculation

   269,395,799     278,472,606     271,597,197     244,436,546  

Shares to cover conversion of preferred stock

   196,509     229,398     198,811     236,090  

Shares to cover non-vested stock

   361,084     1,215,886     621,802     1,296,788  

Average stock options outstanding during the period

   12,182,185     17,027,119     13,270,967     14,198,174  

Assumed acquisition of shares with assumed proceeds and benefits from exercising stock options (at average market price for the year)

   (10,811,052 )   (14,296,624 )   (11,352,163 )   (12,150,774 )

Shares repurchaseable from measured but unrecognized stock option expense

   (168,157 )   (1,532,286 )   (227,169 )   (1,303,201 )

Average deferred compensation shares

   1,331,319     1,301,204     1,328,341     1,281,868  
                        

Weighted-average shares, as used in diluted calculation

   272,487,687     282,417,303     275,437,786     247,995,491  
                        

In the event the average market price of LNC common stock exceeds the issue price of stock options, such options would be dilutive to our earnings per share and will be shown in the table above. Participants in our deferred compensation plans that select LNC stock for measuring the investment return attributable to their deferral amounts will be paid out in LNC stock. The obligation to satisfy these deferred compensation plan liabilities is dilutive and is shown in the table above.

 

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12. Restructuring Charges

2006 Restructuring Plan

Upon completion of the merger with Jefferson-Pilot, we implemented a restructuring plan relating to the integration of our legacy operations with those of Jefferson-Pilot. The realignment will enhance productivity, efficiency and scalability while positioning us for future growth.

The following is the detail of the reserve for restructuring charges:

 

(in millions)

   Total  

Restructuring reserve at December 31, 2006

   $ 8  

Amounts incurred in the first nine months of 2007

  

Employee severance and termination benefits

     6  

Other

     11  
        

Total 2007 restructuring charges

     17  

Amounts expended in the first nine months of 2007

     (22 )
        

Restructuring reserve at September 30, 2007

   $ 3  
        

Additional amounts expended in the first nine months of 2007 that do not qualify as restructuring charges

   $ 56  

Total expected costs

     205 - 215  

Expected completion date

     4th Quarter 2009  

The total expected costs include both restructuring charges and additional expenses that do not qualify as restructuring charges that are associated with the integration activities. In addition, involuntary employee termination benefits were recorded in goodwill as part of the purchase price allocation (see Note 3). Merger integration costs relating to employee severance and termination benefits of $13 million were included in other liabilities in the purchase price allocation in 2006. The remaining liability balance at December 31, 2006 was $3 million. In the first quarter of 2007, an additional $8 million was recorded to goodwill and other liabilities as part of the final adjustment to the purchase price allocation related to employee severance and termination benefits. Through September 30, 2007 approximately $14 million of these costs were incurred and the remaining liability balance at September 30, 2007 was $7 million.

Restructuring charges for this plan in the first nine months of 2007 were included in underwriting, acquisition, insurance and other expenses within Other Operations on the Consolidated Statements of Income.

13. Subsequent Event

On October 9, 2007, we issued $375 million aggregate principal amount of our 6.30% Senior Notes due October 9, 2037. See “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Introduction – Recent Developments” for more details.

 

23


Item 2. 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 September 30, 2007, compared with December 31, 2006, and the results of operations of LNC for the three and nine months ended September 30, 2007 and 2006. 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. Accordingly, the financial information presented herein for the nine months ended September 30, 2006, reflects the accounts of Jefferson-Pilot for only the six months ended September 30, 2006. The balance sheet information presented below is as of September 30, 2007 and December 31, 2006. The statement of operations information is for the three and nine months ended September 30, 2007 and 2006.

For more information regarding the completion of the merger, including the calculation and allocation of the purchase price, see, “Part I – Item 1 – Financial Statements – Note 3 to the Consolidated Financial Statements” (the “consolidated financial statements”).

This discussion and analysis should be read in conjunction with our consolidated financial statements and notes thereto, and in conjunction with “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations” (“MD&A”), “Item 1A – Risk Factors” and “Item 8 – Consolidated Financial Statements” of our latest annual report on Form 10-K for the year ended December 31, 2006 (“2006 Form 10-K”), as well as “Part II – Item 1A – Risk Factors.”

In this report, in addition to providing consolidated revenues and net income (loss), we also provide segment operating revenue and income (loss) from operations because we believe they are meaningful measures of revenues and the profit or loss generated by our operating segments. Operating revenue is GAAP revenue excluding realized gains and losses on investments and derivative instruments, gains and losses on reinsurance embedded derivative/trading securities, gains and losses on sale of subsidiaries/businesses and the amortization of deferred gains arising from reserve development on business sold through reinsurance. Income (loss) from operations is GAAP net income excluding net realized investment gains and losses, losses on early retirement of debt, reserve development net of related amortization on business sold through reinsurance and cumulative effect of accounting changes. Operating revenue and income (loss) from operations are the financial performance measures we use to evaluate and assess the results of our segments. Accordingly, we report operating revenue and income (loss) from operations by segment in Note 10 to our unaudited consolidated financial statements. Our management and Board of Directors believe that operating revenue and income (loss) from operations explain the results of our ongoing businesses in a manner that allows for a better understanding of the underlying trends in our current businesses because net realized investment gains and losses, reserve development net of related amortization on business sold through reinsurance and cumulative effect of accounting changes are unpredictable and not necessarily indicative of current operating fundamentals or future performance of the business segments, and in many instances, decisions regarding these items do not necessarily relate to the operations of the individual segments. Operating revenue and income (loss) from operations do not replace revenues and net income as the GAAP measures of our consolidated results of operations.

Certain reclassifications have been made to prior periods’ financial information to conform to the 2007 presentation.

Forward-Looking Statements—Cautionary Language

Certain statements made in this report and in other written or oral statements made by Lincoln or on Lincoln’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, trends in our business, prospective services or products, future performance or financial results and the outcome of contingencies, such as legal proceedings. Lincoln 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 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;

 

24


   

Legislative, regulatory or tax changes, both domestic and foreign, that affect the cost of, or demand for, Lincoln’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 Lincoln 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 Lincoln 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;

 

   

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

 

   

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

 

   

Ineffectiveness of Lincoln’s various hedging strategies used to offset the impact of changes in the value of liabilities due to changes in the level and volatility of the equity markets and interest rates;

 

   

A deviation in actual experience regarding future persistency, mortality, morbidity, interest rates or equity market returns from Lincoln’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, including as a result of investor-owned life insurance business;

 

   

Changes in accounting principles generally accepted in the United States that may result in unanticipated changes to Lincoln’s net income, including the impact of Statements of Financial Accounting Standards 157 and 159;

 

   

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

 

   

Lowering of one or more of the insurer financial strength ratings of Lincoln’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 Lincoln’s companies requiring that Lincoln realize losses on such investments;

 

   

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

 

   

The adequacy and collectibility of reinsurance that Lincoln has purchased;

 

   

Acts of terrorism, war, or other man-made and natural catastrophes that may adversely affect Lincoln’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 Lincoln can charge for its products;

 

   

The unknown impact on Lincoln’s business resulting from changes in the demographics of Lincoln’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

 

25


   

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. Lincoln’s annual report on Form 10-K, current reports on Form 8-K and other documents filed with the SEC include additional factors which could impact Lincoln’s business and financial performance. Moreover, Lincoln 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 Lincoln’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, Lincoln disclaims any obligation to update any forward-looking statements to reflect events or circumstances that occur after the date of this report.

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.

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 the 2006 Form 10-K.

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. 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.

On April 2, 2007, we launched a broader, fixed life insurance and fixed/indexed annuity unified product suite available to our distribution force. On May 21, 2007, we launched a unified fund line-up in our variable life insurance products, and on June 4, 2007, we launched a unified fund line-up in our variable annuity products. On July 9, 2007, we launched our unified term life insurance products and on August 20, 2007, we launched the first of three unified variable life insurance products. On October 15, 2007, we launched our second unified variable life insurance product and we have plans in place to launch the final unified variable life insurance product in the fourth quarter of 2007 after receiving appropriate regulatory approvals.

During the remainder of 2007 and throughout 2008, we expect our major challenges to include:

 

   

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

 

   

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 Retirement Income Security Ventures (“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.

 

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

 

   

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. At September 30, 2007, we had 588 wholesalers in Lincoln Financial Distributors (“LFD”) compared to 529 at December 31, 2006.

 

   

Jumpstarting our RISV. The focus of these 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 October 31, 2007, we reached an agreement with an unaffiliated investment management company involving certain members of our fixed income team and related institutional taxable fixed income business. The purchase price is up to $48 million, which included a $25 million payment at closing with additional annual payments to be received over the next three years. The transaction did not impact the fixed income team that manages our fixed income mutual funds or general account assets. Investment Management was able to retain approximately 15% of the roughly $14 billion of assets involved in this transaction. We expect this transaction to decrease income from operations by approximately $3 million, after-tax, per quarter in 2008. Following the transaction, Investment Management will manage nearly $93 billion of fixed income assets with a team of 100 fixed income investment professionals.

On October 9, 2007, we issued $375 million aggregate principal amount of our 6.30% Senior Notes due October 9, 2037. We contributed the net proceeds of approximately $370 million from the offering to a new wholly-owned insurance subsidiary. This new subsidiary was created for the purpose of reinsuring the policy liabilities of our existing insurance affiliates, primarily related to statutory reserves on universal life products with secondary guarantees. These reserves are calculated under prevailing statutory reserving requirements as promulgated under Actuarial Guideline 38 (also known as “AXXX”). The transaction released approximately $300 million of capital previously supporting our universal life products with secondary guarantees. We intend to use the released capital for general corporate purposes, including for share repurchase and to support future business growth.

On September 7, 2007, we entered into a 36-month variable forward contract with Wachovia Bank, National Association with respect to approximately four million shares of our Bank of America (“BAC”) common stock and received approximately $145 million in proceeds. The contract included an equity collar derivative related to the changes in the fair value of the BAC common stock over the 36-month period. The proceeds we received were based upon the fair value of 4 million shares of BAC common stock at the inception of the contract net of the cost of the equity collar. The amount to be settled with Wachovia at the end of the contract period is approximately $196 million in either cash or BAC common stock. We are retaining the ordinary dividends in connection with the four million shares, which currently amount to $10 million annually. Approximately $74 million of the proceeds of this transaction were used to repurchase shares of our common stock during the third quarter of 2007. See “Item 3 – Quantitative and Qualitative Disclosures About Market Risk” for further discussion on the equity collar.

On August 22, 2007, we issued $300 million aggregate principal amount of our 5.65% Senior Notes due August 27, 2012.

On July 6, 2007, our Chairman of the Board of Directors and Chief Executive Officer, Jon A. Boscia, announced his plans to retire effective September 1, 2007. Dennis R. Glass, our President and Chief Operating Officer, was appointed Chief Executive Officer and J. Patrick Barrett, a long-time board member, was appointed as non-executive Chairman of the Board of Directors.

On June 7, 2007, we announced plans to explore strategic options for Lincoln Financial Media. We are continuing to evaluate a range of options including, but not limited to, divestiture strategies. We do not intend to provide updates to the strategic review process or disclose developments or potential outcomes until and unless a definitive course of action is reached. For additional details, see Note 1 of our consolidated financial statements.

 

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Critical Accounting Policies

The MD&A included in our 2006 Form 10-K contains a detailed discussion of our critical accounting policies. The following information updates the critical accounting policies provided in the 2006 Form 10-K and accordingly should be read in conjunction with the critical accounting policies discussed in the 2006 Form 10-K.

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

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 Statement of Financial Accounting Standards No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments” (“SFAS 97”). 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 are accounted for as a continuation of the replaced contract. Contract modifications that result in a substantially changed contract are accounted for as an extinguishment of the replaced contract, and any unamortized DAC, unearned revenue and deferred sales charges are written-off. SOP 05-1 was applied prospectively on January 1, 2007.

For a detailed discussion of the cumulative effect of adoption of SOP 05-1 recorded to our January 1, 2007 Consolidated Balance Sheets, see Note 2 of our consolidated financial statements. The adoption of this new guidance primarily impacted and continues to impact our Individual Markets-Annuities and Employer Markets-Group Protection businesses, and our related accounting policies regarding the assumptions for lapsation used in the amortization of DAC and VOBA. In addition, we estimate that the adoption of SOP 05-1 resulted in a $4 million and $14 million, pre-tax, increase to underwriting, acquisition, insurance and other expenses for the three and nine months ended September 30, 2007, which were attributable to changes in DAC and VOBA deferrals and amortization. The impact is expected to be approximately $19 million, pre-tax, for the full year 2007. In addition, due to the changes in our Guaranteed Minimum Death Benefit (“GMDB”) annuity reserves and DSI, we expect benefits to increase by approximately $2 million, pre-tax, for 2007. The impact on the amortization of DFEL is expected to be less than $1 million.

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. 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 unpredictable, the underlying premise of this process is that best estimate projections of future EGPs, as required by SFAS 97, 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. 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 September 30, 2007, if we were to reset the RTM to a gross variable account growth assumption representing the midpoint between the first of the two statistical ranges and the mean of the projections from September 30, 2007 forward in determining revised EGPs, we estimate it would result in a cumulative decrease to DAC amortization (positive DAC unlocking) of approximately $161 million, pre-tax ($105 million, after-tax). For more information about the implications of declines and advances in equity markets and our RTM process, see “Part II – Item 7 – Critical Accounting Policies” in our 2006 Form 10-K.

In the third quarter of each year, we complete our annual comprehensive review of the assumptions underlying the amortization of DAC, VOBA, DSI and DFEL and the embedded derivative and reserves for annuity and life insurance products with certain guarantees. We review the various assumptions including investment margins, mortality and retention. As part of our annual review we also make corrections and modifications to our amortization models. As a result, the net effect of our annual review resulted in a $12 million, after-tax, increase ($28 million increase from assumption changes net of $16 million decrease from model changes) to income from operations for the three and nine months ended September 30, 2007 and a $20 million, after-tax, decrease ($18 million decrease from assumption changes and an $2 million decrease from model changes) for the corresponding periods in 2006. The 2006 amounts also reflect our harmonization of several assumptions and related processes as a result of our merger with Jefferson-Pilot. The effects varied by segment and are discussed further in the respective segment discussions below.

 

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The table below presents the after-tax increase (decrease) to income from operations by business segment for our prospective unlocking for the three and nine months ended September 30 for the years indicated:

 

(in millions)

   DFEL(1)    

DAC

and
VOBA(2)

    DSI(3)   

GMDB

and Life
Reserves(3)

   

Guarantee

Embedded
Derivative(3)

   Total  

2007

              

Individual Markets - Annuities

   $ (1 )   $ 8     $ 1    $ (1 )   $ 1    $ 8  

Individual Markets - Life Insurance

     18       (13 )     —        —         —        5  

Employer Markets - Defined Contribution

     —         (2 )     —        —         —        (2 )

Employer Markets - COLI/BOLI

     —         (1 )     —        —         —        (1 )

Lincoln UK

     3       (1 )     —        —         —        2  
                                              

Total

   $ 20     $ (9 )   $ 1    $ (1 )   $ 1    $ 12  
                                              

2006

              

Individual Markets - Annuities

   $ (2 )   $ 1     $ 1    $ 2     $ —      $ 2  

Individual Markets - Life Insurance

     (1 )     (9 )     —        (10 )     —        (20 )

Employer Markets - Defined Contribution

     —         5       —        —         —        5  

Employer Markets - COLI/BOLI

     —         (1 )     —        —         —        (1 )

Lincoln UK

     (8 )     2       —        —         —        (6 )
                                              

Total

   $ (11 )   $ (2 )   $ 1    $ (8 )   $ —      $ (20 )
                                              

(1)

Reported in insurance fees within our Consolidated Statements of Income.

(2)

Reported in underwriting, acquisition, insurance and other expenses within our Consolidated Statements of Income.

(3)

Reported in insurance benefits within our Consolidated Statements of Income.

The table below presents the balances by business segment as of September 30, 2007:

 

      Individual Markets    Employer Markets               

(in millions)

   Annuities   

Life

Insurance

  

Retirement

Products

  

Group

Protection

  

Lincoln

UK

  

Other

Operations

   Total

DAC and VOBA

   $ 2,347    $ 5,261    $ 805    $ 116    $ 807    $ 1    $ 9,337

DSI

     249      —        —        —        —        —        249
                                                

Total DAC, VOBA and DSI

     2,596      5,261      805      116      807      1      9,586

DFEL

     122      586      22      —        398      —        1,128
                                                

Net DAC, VOBA, DSI and DFEL

   $ 2,474    $ 4,675    $ 783    $ 116    $ 409    $ 1    $ 8,458
                                                

Derivatives

Guaranteed Minimum Withdrawal and Guaranteed Income Benefits

The Individual Markets-Annuities segment has a hedging strategy designed to mitigate the risk and statement of income volatility caused by changes in the equity markets, interest rates, and volatility associated with the Lincoln Smart SecuritySM Advantage Guaranteed Minimum Withdrawal Benefit (“GMWB”) feature and, beginning in the fourth quarter of 2006, our i4LIFE® Advantage Guaranteed Income Benefit (“GIB”) feature that is available in our variable annuity products. In the second quarter of 2007, we also began hedging our 4LATER® Advantage GIB feature 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 features. 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 September 30, 2007, the embedded derivatives for GMWB, i4LIFE® Advantage GIB, and the 4LATER® Advantage GIB were assets valued at $6 million and $13 million and a liability valued at $14 million, respectively.

 

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Annuity Hedge Performance by Benefit Feature

The table below provides a comparison of our hedge performance (earnings impact) by benefit feature on an after-DAC, after-tax, basis:

 

     

Three Months Ended

September

         

Nine Months Ended

September

       

(in millions)

   2007     2006     Change     2007     2006     Change  

GMWB

   $ (11 )   $ —       NM     $ (10 )   $ (2 )   NM  

GIB

     (3 )     (1 )   NM       (4 )     (2 )   -100 %

GMDB(1)

     —         1     -100 %     1       1     —    
                                    

Total

   $ (14 )   $ —       NM     $ (13 )   $ (3 )   NM  
                                    

(1)

Our reserves related to our GMDB features are based upon projected long-term equity market return assumptions, and we utilize a delta hedging strategy using futures on U.S.-based equity market indices to hedge around the movements in equity markets. Because of this, the quarterly changes in values for our GMDB reserves and the hedging contracts may not offset each other.

For additional information on our hedging results see “Individual Markets – Annuities – Benefits and Expenses”

Income Taxes

Management uses certain assumptions and estimates in determining income taxes payable or refundable for the current year, deferred income tax liabilities and assets for events recognized differently in its financial statements and income tax returns, and federal income tax expense. Determining these amounts requires analysis of certain transactions and interpretation of tax laws and regulations. Management exercises considerable judgment in evaluating the amount and timing of recognition of the resulting income tax liabilities and assets. These judgments and estimates are re-evaluated on a continual basis as regulatory and business factors change.

We adopted FASB Interpretation No. 48, – “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement 109” (“FIN 48”) effective January 1, 2007 and recorded an increase in the liability for unrecognized tax benefits of $15 million in our Consolidated Balance Sheets, offset by a reduction to the beginning balance of retained earnings with no impact on net income. FIN 48 established criteria for recognizing or continuing to recognize only more-likely-than tax positions, which may result in federal income tax expense volatility in future periods. While we believe we have adequately provided for all tax positions, amounts asserted by taxing authorities could be greater than our accrued position. Accordingly, additional provisions on federal and foreign tax-related matters could be recorded in the future as revised estimates are made or the underlying matters are settled or otherwise resolved. For a detailed discussion of FIN 48, see Note 2 and Note 4 of our consolidated financial statements.

 

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RESULTS OF CONSOLIDATED OPERATIONS

 

     

Three Months Ended

September 30,

         

Nine Months Ended

September 30,

       

(in millions)

   2007     2006     Change     2007     2006     Change  

Insurance premiums

   $ 489     $ 426     15 %   $ 1,437     $ 958     50 %

Insurance fees

     852       679     25 %     2,389       1,846     29 %

Investment advisory fees

     89       83     7 %     272       242     12 %

Communications revenue (net)

     60       60     0 %     184       117     57 %

Net investment income

     1,067       1,108     -4 %     3,326       2,854     17 %

Amortization of deferred gain on indemnity reinsurance

     19       19     0 %     65       57     14 %

Other revenues and fees

     142       123     15 %     434       348     25 %

Realized loss

     (37 )     (11 )   NM       (15 )     (17 )   12 %
                                    

Total revenue

     2,681       2,487     8 %     8,092       6,405     26 %
                                    

Insurance benefits

     1,301       1,201     8 %     3,781       2,962     28 %

Underwriting, acquisition, insurance and other expenses

     819       728     13 %     2,438       1,948     25 %

Communications expenses

     33       31     6 %     106       61     74 %

Interest and debt expenses

     69       67     3 %     204       154     32 %
                                    

Total benefits and expenses

     2,222       2,027     10 %     6,529       5,125     27 %
                                    

Income before taxes

     459       460     0 %     1,563       1,280     22 %

Federal income taxes

     129       96     34 %     461       346     33 %
                                    

Net income

   $ 330     $ 364     -9 %   $ 1,102     $ 934     18 %
                                    

Items included in net income (after-tax):

            

Realized loss on investments and derivative instruments

   $ (23 )   $ (4 )     $ (11 )   $ (12 )  

Net gain (loss) on reinsurance embedded derivative/trading securities

     —         (3 )       2       2    

Restructuring charges

     (5 )     (1 )       (11 )     (7 )  

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

     —         —           (7 )     1    

 

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The table below provides a detailed comparison of items included within net realized losses:

 

     

Three Months Ended

September 30,

         

Nine Months Ended

September 30,

       

(in millions)

   2007     2006     Change     2007     2006     Change  

Fixed maturity securities available-for-sale:

            

Gross gains

   $ 26     $ 52     -50 %   $ 108     $ 97     11 %

Gross losses

     (44 )     (47 )   6 %     (97 )     (80 )   -21 %

Equity securities available-for-sale:

            

Gross gains

     1       —       NM       7       (1 )   NM  

Gross losses

     —         —       NM       —         —       NM  

Gain on other investments

     5       1     NM       7       5     40 %

Associated amortization of DAC, VOBA, DSI, DFEL and changes in policy loans and insurance liabilities

     (14 )     (7 )   -100 %     (36 )     (40 )   10 %
                                    

Total realized loss on investments

     (26 )     (1 )   NM       (11 )     (19 )   42 %

Loss on derivative instruments

     (11 )     (5 )   NM       (7 )     (1 )   NM  

Associated amortization of DAC, VOBA, DSI, DFEL and changes in policy loans and insurance liabilities

     1       —       NM       —         —       NM  
                                    

Loss on investments and derivative instruments

     (36 )     (6 )   NM       (18 )     (20 )   10 %

Gain (loss) on reinsurance embedded derivative/trading securities

     (1 )     (5 )   80 %     3       3     0 %
                                    

Total realized loss

   $ (37 )   $ (11 )   NM     $ (15 )   $ (17 )   12 %
                                    

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

   $ (34 )   $ (39 )   13 %   $ (68 )   $ (43 )   -58 %

 

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Following are deposits and net flows by business segment. For additional detail of deposit and net flow information, see the discussion in “Results of Operations by Segment” below.

 

     

Three Months Ended

September 30,

         

Nine Months Ended

September 30,

       

(in millions)

   2007     2006     Change     2007     2006     Change  

Deposits

            

Individual Markets:

            

Annuities

   $ 3,478     $ 2,720     28 %   $ 9,577     $ 7,596     26 %

Life Insurance

     980       753     30 %     3,024       2,264     34 %

Employer Markets:

            

Retirement Products - Defined Contribution

     1,525       1,086     40 %     4,285       3,486     23 %

Retirement Products - Executive Benefits

     52       58     -10 %     196       182     8 %

Investment Management

     5,745       4,904     17 %     17,930       20,013     -10 %

Consolidating adjustments (1)

     (907 )     (1,020 )   11 %     (2,898 )     (2,896 )   0 %
                                    

Total Deposits

   $ 10,873     $ 8,501     28 %   $ 32,114     $ 30,645     5 %
                                    

Net Flows

            

Individual Markets:

            

Annuities

   $ 1,291     $ 304     NM     $ 3,185     $ 1,773     80 %

Life Insurance

     635       491     29 %     1,918       1,296     48 %

Employer Markets:

            

Retirement Products - Defined Contribution

     133       37     259 %     428       331     29 %

Retirement Products - Executive Benefits

     (5 )     (11 )   55 %     (54 )     64     NM  

Investment Management

     91       746     -88 %     (422 )     6,651     NM  

Consolidating adjustments (1)

     198       150     32 %     545       139     292 %
                                    

Total Net Flows

   $ 2,343     $ 1,717     36 %   $ 5,600     $ 10,254     -45 %
                                    

 

        
      As of September 30,   

As of

December 31,

   Change Over     Change Over  

(in millions)

   2007    2006    2006    Prior Year     Prior Quarter  

Assets Under Management by Advisor (2)

             

Investment Management:

             

External assets

   $ 99,716    $ 89,511    $ 97,307    11 %   2 %

Insurance-related assets

     67,324      67,410      67,437    0 %   0 %

Lincoln UK

     10,589      9,440      10,108    12 %   5 %

Within business units (policy loans)

     2,790      2,725      2,389    2 %   17 %

By non-LNC entities

     71,042      51,214      56,282    39 %   26 %
                         
   $ 251,461    $ 220,300    $ 233,523    14 %   8 %
                         

(1)

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

(2)

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 the Three and Nine Months Ended September 30, 2007 to 2006

Net income decreased $34 million, or 9%, and increased $168 million, or 18%, for the three and nine months ended September 30, 2007 compared to the same periods in 2006. The decrease in net income for the three months ended September 30, 2007 was primarily driven favorable items in the third quarter of 2006 which included an insurance recovery related to losses

 

33


incurred in connection with U.K. sales practices and a positive income tax adjustment primarily related to the separate accounts dividends-received deduction (“DRD”). These items more than offset the current period’s growth of business in-force, account value growth from favorable equity markets, positive net flows and net favorable adjustments from the completion of our annual comprehensive review, which are discussed below. The increase in net income for the nine months ended September 30, 2007, primarily reflects the April 2006 merger with Jefferson-Pilot, stronger results from our alternative investments, growth of business in-force, account value growth from growth in the equity markets, positive net flows, and net favorable adjustments from the completion of our annual comprehensive review compared to the prior year period. The nine-month period of 2006 also includes the net effect of the insurance recovery and DRD adjustment discussed above.

In the third quarter of each year, we complete our annual comprehensive review of the assumptions underlying the amortization of DAC, VOBA, DSI, DFEL and the embedded derivative and reserves for annuity and life insurance products with certain guarantees. As part of our annual review we also make corrections and modifications to our amortization models. As a result, the net effect of our annual review resulted in a $12 million, after-tax, increase ($28 million increase from assumption changes net of $16 million decrease from model changes) to income from operations for the three and nine months ended September 30, 2007 and a $20 million, after-tax, decrease ($18 million decrease from assumption changes and a $2 million decrease from model changes) for the corresponding periods in 2006. See “Revenues” and “Benefits and Expenses” below for further discussion.

Net income for the nine months ended September 30, 2007, was negatively affected by a correction to account values for certain of our life insurance policies, a modification of the accounting for one of our UL products with secondary guarantees related to its product features, both occurring during the second quarter of 2007. See “Individual Markets-Life Insurance” below for a further discussion of the correction to account values and accounting modification.

Revenues

Total revenue for the three and nine months ended September 30, 2007 was $2.7 billion and $8.1 billion compared to $2.5 billion and $6.4 billion for the same periods in 2006. The increase in insurance premiums for the three months ended September 30, 2007, primarily reflects organic growth in the non-medical portion of our Employer Markets-Group Protection segment. In addition, the increase in insurance fees and investment advisory fees for the three months ended September 30, 2007 reflects growth in assets under management, positive net flows, and the effects of favorable equity market performance. Included in the increase in insurance fees was growth in cost-of-insurance charges and in expense assessments in connection with our individual variable annuities. Higher expense assessments from individual variable annuities resulted from higher average daily variable account values for the three and nine months ended September 30, 2007 compared to the same period in 2006, resulting from favorable equity markets and sales growth. Average daily variable account values for our Individual Markets-Annuities segment increased 32% and 29% for the three and nine months ended September 30, 2007 compared to the same periods in 2006. The increase in insurance premiums and fees for the nine months ended September 30, 2007 primarily reflects the April 2006 merger with Jefferson-Pilot, 14% growth in assets under management, positive net flows, the impact of favorable equity market performance on our variable account values, and the favorable impact of our prospective unlocking adjustments, discussed below, partially offset by the impact of the correction to account values and modification of the accounting within the Individual Markets-Life Insurance segment in the second quarter of 2007, which reduced insurance fees by $41 million, pre-DAC and pre-tax. Additionally, retrospective DFEL unlocking negatively impacted insurance fees for nine months ended September 30, 2007 by $10 million, pre-tax ($7 million, after-tax), for the Individual Markets-Life Insurance segment, primarily due to favorable mortality and persistency. Excluding the impact of dividends, the S&P 500 Index® at September 30, 2007 was 14.3% higher than at September 30, 2006 and the average daily S&P 500 Index® for the three and nine months ended September 30, 2007 was 15.7% and 14.5% higher than the comparable 2006 periods.

The net effect of our annual comprehensive review of DFEL resulted in a $31 million increase ($34 million increase from model changes net of $3 million decrease from assumption changes) to insurance fees for the three and nine months ended September 30, 2007 and a $16 million decrease ($20 million decrease from assumption changes net of $4 million increase from model changes) for the corresponding periods in 2006. The 2007 model changes are primarily related to account values in model projections for certain of our life insurance policies that were identified and corrected in the second quarter of 2007.

Net investment income decreased $41 million, or 4%, and increased $472 million, or 17%, for the three and nine months ended September 30, 2007 compared to the same periods in 2006. The decrease in net investment income for the three months ended September 30, 2007 is primarily the result of lower commercial mortgage loan prepayments and bond makewhole premiums, decreased investment income from alternative investments, and a $28 million decrease in the change in the market value of S&P 500 Index® call options used to hedge our indexed annuity product. See “Consolidated Investments – Alternative Investments” below for additional information. The increase in net investment income for the nine months ended September 30, 2007 primarily reflects the addition of Jefferson-Pilot investment assets, higher alternative investment income, a $23 million increase in the change in the market value of S&P 500 Index® call options used to hedge our indexed annuity product and higher invested assets due to the

 

34


favorable effect of asset growth from net flows. Investment income from alternative investments, increased $68 million, pre-DAC, pre-tax, in the nine months ended September 30, 2007 compared to the same period in 2006 due to favorable performance in alternative investments. Negative fixed annuity net flows partially offset growth in our indexed and variable annuity net flows for both the three and nine months ended September 30, 2007, as higher withdrawals were 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 $37 million and $15 million for the three and nine months ended September 30, 2007 compared to losses of $11 million and $17 million for the comparable 2006 periods. See “Consolidated Investments” below for additional information on our investment performance.

Benefits and Expenses

Consolidated insurance benefits increased $100 million, or 8%, and $819 million, or 28%, for the three and nine months ended September 30, 2007, compared to the same periods in 2006. The increase in insurance benefits for the three months ended September 30, 2007, is primarily due to growth of business in-force, the impact of our hedge effectiveness, an unfavorable increase in the change in the fair value of the Statement of Financial Accounting Standards No. 133 “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) forward-starting option liability related to our indexed annuity contracts of $6 million and interest credited on the secured limited recourse notes issued in December 2006 and April 2007, partially offset by a $26 million favorable decrease in the change in the indexed annuity options mark-to-market adjustment. For additional detail on the secured limited recourse notes, see “Consolidated Investments – Credit-Linked Notes” below and Note 6 to our consolidated financial statements. The increase in benefits for the nine months ended September 30, 2007 is primarily driven by the merger with Jefferson-Pilot, the $20 million increase in the change in the indexed annuity options mark-to-market adjustment, and the impact attributable to variable annuities with guaranteed benefits, as discussed above. Additionally, in the second quarter 2007, we recognized a $20 million reserve increase on the personal accident business that was sold to Swiss Re through an indemnity transaction in 2001. Higher benefits related to growth in our business were partially offset by effective spread management through lower crediting rates on interest sensitive business; the lower interest credited from lower fixed annuity account values resulting from net outflows on fixed annuities and movements from fixed to variable annuity products. The impact of our annual comprehensive review was not significant to insurance benefits for the three and nine months ended September 30, 2007, while insurance benefits were increased by $11 million, pre-tax ($7 million, after-tax), for the same periods in 2006, due to net unfavorable prospective assumption adjustments surrounding the reserves for the guarantee features within our variable annuity and life insurance products. For additional detail on hedge performance by benefit feature, see “Critical Accounting Policies – Derivatives” and “Individual Markets – Annuities.”

Consolidated underwriting, acquisition, insurance and other expenses increased $91 million, or 13%, and $490 million, or 25% for the three and nine months ended September 30, 2007 compared to the same periods in 2006. The increase in acquisition, insurance and other expenses increased primarily due to higher DAC and VOBA amortization, integration expenses and due to a benefit from an insurance recovery recognized in the prior year quarter that reduced expenses in that period. Integration expenses in the third quarter and first nine months of 2007 increased $16 million and $43 million compared to the same periods in 2006, 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 the first half of 2009. Our current estimate of integration expenses is approximately $205 million to $215 million, pre-tax (excludes amounts capitalized or recorded to goodwill), which represents an increase of approximately $25 million to $35 million, pre-tax, for certain internal costs (which are expected to be eliminated once integration efforts are completed), costs related to the implementation of our new unified product portfolio and other initiatives. We have incurred approximately $123 million, pre-tax, and expect approximately $82 million to $92 million will be incurred over the remainder of the integration period. In the third quarter and first nine months of 2007, broker-dealer commissions and expenses increased $15 million and $69 million as a result of higher sales and the impact of the merger on the first nine months comparison. Consolidated underwriting, acquisition, insurance and other expenses for the third quarter and first nine months of 2006 benefited from a $26 million ($17 million, after-tax) insurance recovery related to losses incurred in connection with U.K. sales practices. A $9 million increase in legal expenses and $5 million of expenses related to the launch of a new closed-end mutual fund also contributed to an increase in expenses in the first nine months of 2007. The remainder of the increase in underwriting, acquisition, insurance and other expenses for the three and nine months ended September 30, 2007, is attributable to higher taxes, licenses and fees and an increase in DAC and VOBA amortization, which is discussed below. The increase in underwriting, acquisition, insurance and other expenses for the three and nine months ended September 30, 2007, was partially offset by $35 million and $12 million, pre-DAC, pre-tax, lower incentive compensation expenses compared to the same periods of 2006 as a result of actual performance exceeding our expectations in the prior year. In 2007, the true-up of incentive compensation accruals was recognized in the second quarter rather than the third quarter, as it occurred in 2006. Additionally, in the second quarter of 2007, we recorded a one-time curtailment gain of $9 million ($6 million, after-tax) related to a change in our employee benefit plans that will go into effect on January 1, 2008. See below for discussion surrounding the impact of our prospective unlocking adjustments on underwriting, acquisition, insurance and other expenses as a result of our annual comprehensive review. For additional information on the change in our employee benefit plans, see “Other Operations” and Note 7 to our consolidated financial statements.

 

35


DAC and VOBA amortization, which is included within underwriting, acquisition, insurance and other expenses, increased $37 million and $175 million for the three and nine months ended September 30, 2007, with the year-to-date increase primarily driven by the merger with Jefferson-Pilot. In addition to continued growth in our insurance and annuity blocks, the change in DAC and VOBA amortization was impacted by several other items. Favorable retrospective DAC and VOBA unlocking for the three and nine months ended September 30, 2007, decreased DAC and VOBA amortization by $12 million, pre-tax ($8 million, after-tax), and $60 million, pre-tax ($39 million, after-tax), primarily due to favorable investment, mortality, and persistency results. The adjustments in the second quarter of 2007 related to the Individual Markets-Life Insurance segment discussed above, reduced DAC amortization by $23 million, pre-tax, for the nine months ended September 30, 2007. Additionally, DAC and VOBA amortization for the nine months ended September 30, 2007 for the Individual Markets-Life Insurance segment was increased by $10 million ($6 million, after-tax) related to adjustments to the opening balance sheet of Jefferson-Pilot finalized in the first quarter of 2007. The adoption of SOP 05-1 on January 1, 2007 resulted in a $4 million, pre-tax ($3 million, after-tax), and $14 million, pre-tax ($9 million, after-tax), increase to DAC and VOBA amortization for the three and nine months ended September 30, 2007.

The net effect of our annual comprehensive review of DAC and VOBA resulted in a $14 million increase ($63 million increase from model changes net of $49 million decrease from assumption changes) to underwriting, acquisition, insurance and other expenses for the three and nine months ended September 30, 2007 and a $3 million increase ($6 million increase from model changes net of $3 million decrease from assumption changes) for the corresponding periods in 2006. The impact of the adjustments from this review varied by segment and are discussed further in the respective segment discussions below.

Federal Income Taxes

The effective tax rate was 28% and 21% for the three months ended September 30, 2007 and 2006, respectively. The effective tax rate for the nine months ended September 30, 2007 and 2006 was 29% and 27%, respectively. For additional information on our effective tax rates, see Note 4 to our consolidated financial statements.

 

36


RESULTS OF OPERATIONS BY SEGMENT

Following is a reconciliation of our revenue and our income from operations to our consolidated revenue and net income:

 

              
     

Three Months Ended

September 30,

   

Nine Months Ended

September 30,

 

(in millions)

   2007     2006     2007     2006  

Revenue

        

Segment operating revenue

        

Individual Markets:

        

Annuities

   $ 666     $ 597     $ 1,947     $ 1,524  

Life Insurance

     990       895       2,919       2,297  
                                

Total Individual Markets

     1,656       1,492       4,866       3,821  
                                

Employer Markets:

        

Retirement Products

     357       349       1,082       1,006  

Group Protection

     368       332       1,119       687  
                                

Total Employer Markets

     725       681       2,201       1,693  
                                

Investment Management (1)

     150       140       451       415  

Lincoln UK

     89       72       272       223  

Lincoln Financial Media (2)

     60       60       185       117  

Other Operations

     65       87       220       244  

Consolidating adjustments

     (28 )     (34 )     (97 )     (92 )

Net realized investment results (3)

     (37 )     (11 )     (15 )     (17 )

Amortization of deferred gain on indemnity reinsurance related to reserve developments

     1       —         9       1  
                                

Total revenue

   $ 2,681     $ 2,487     $ 8,092     $ 6,405  
                                

Net Income

        

Segment operating income

        

Individual Markets:

        

Annuities

   $ 107     $ 129     $ 358     $ 285  

Life Insurance

     174       123       517       339  
                                

Total Individual Markets

     281       252       875       624  
                                

Employer Markets:

        

Retirement Products

     52       65       177       195  

Group Protection

     33       29       85       66  
                                

Total Employer Markets

     85       94       262       261  
                                

Investment Management

     22       13       49       41  

Lincoln UK

     10       8       33       29  

Lincoln Financial Media

     14       15       40       27  

Other Operations

     (59 )     (11 )     (141 )     (38 )

Net realized investment results (4)

     (23 )     (7 )     (9 )     (11 )

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

     —         —         (7 )     1  
                                

Net income

   $ 330     $ 364     $ 1,102     $ 934  
                                

(1)

Revenues for the Investment Management segment include inter-segment revenues for asset management services provided to our other segments. These inter-segment revenues totaled $20 million and $24 million for the three months ended September 30, 2007 and 2006, respectively, and $67 million and $72 million for the nine months ended September 30, 2007 and 2006, respectively.

 

37


(2)

Lincoln Financial Media revenues are net of $8 million of commissions paid to agencies for the three months ended September 30, 2007 and 2006, and $25 million and $17 million for the nine months ended September 30, 2007 and 2006, respectively.

(3)

Includes realized losses on investments of $26 million and $1 million for the three months ended September 30, 2007 and 2006, respectively; realized losses on derivative instruments of $10 million and $5 million for the three months ended September 30, 2007 and 2006, respectively; and losses on reinsurance embedded derivative/trading securities of $1 million and $5 million for the three months ended September 30, 2007 and 2006, respectively. Includes realized losses on investments of $11 million and $19 million for the nine months ended September 30, 2007 and 2006, respectively; realized losses on derivative instruments of $7 million and $1 million for the nine months ended September 30, 2007 and 2006; and gains on reinsurance embedded derivative/trading securities of $3 million for the nine months ended September 30, 2007 and 2006.

(4)

Includes realized losses on investments of $16 million and $1 million for the three months ended September 30, 2007 and 2006, respectively; realized losses on derivative instruments of $7 million and $3 million for the three months ended September 30, 2007 and 2006, respectively; and losses on reinsurance embedded derivative/trading securities of $3 million for the three months ended September 30, 2006. Includes realized losses on investments of $7 million and $11 million for the nine months ended September 30, 2007 and 2006, respectively; realized losses on derivative instruments of $4 million and $1 million for the nine months ended September 30, 2007 and 2006, respectively; and gains on reinsurance embedded derivative/trading securities of $2 million for the nine months ended September 30, 2007 and 2006.

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 1A – Risk Factors” in our 2006 Form 10-K as updated by “Part II – Item 1A – Risk Factors” and “Forward-looking Statements – Cautionary Language” in this report.

Individual Markets – Annuities

 

     

Three Months Ended

September 30,

        

Nine Months Ended

September 30,

      

Operating Summary (in millions)

   2007    2006    Change     2007    2006    Change  

Operating Revenues

                

Insurance premiums

   $ 43    $ 12    258 %   $ 72    $ 37    95 %

Insurance fees

     274      196    40 %     770      562    37 %

Net investment income

     254      313    -19 %     823      724    14 %

Other revenues and fees

     95      76    25 %     282      201    40 %
                                

Total operating revenues

     666      597    12 %     1,947      1,524    28 %
                                

Operating Expenses

                

Insurance benefits

     290      236    23 %     700      565    24 %

Underwriting, acquisition, insurance and other expenses

     235      228    3 %     770      617    25 %
                                

Total operating expenses

     525      464    13 %     1,470      1,182    24 %
                                

Income from operations before taxes

     141      133    6 %     477      342    39 %

Federal income taxes

     34      4    NM       119      57    109 %
                                

Income from operations

   $ 107    $ 129    -17 %   $ 358    $ 285    26 %
                                

 

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Three Months Ended

September 30,

         

Nine Months Ended

September 30,

       

Net Flows (in millions)

   2007     2006     Change     2007     2006     Change  

Variable portion of variable annuity deposits

   $ 2,247     $ 1,658     36 %   $ 6,543     $ 5,191     26 %

Variable portion of variable annuity withdrawals

     (1,296 )     (1,011 )   -28 %     (3,722 )     (2,973 )   -25 %
                                    

Variable portion of variable annuity net flows

     951       647     47 %     2,821       2,218     27 %
                                    

Fixed portion of variable annuity deposits

     746       560     33 %     1,943       1,516     28 %

Fixed portion of variable annuity withdrawals

     (181 )     (189 )   4 %     (486 )     (539 )   10 %
                                    

Fixed portion of variable annuity net flows

     565       371     52 %     1,457       977     49 %
                                    

Total variable annuity deposits

     2,993       2,218     35 %     8,486       6,707     27 %

Total variable annuity withdrawals

     (1,477 )     (1,200 )   -23 %     (4,208 )     (3,512 )   -20 %
                                    

Total variable annuity net flows

     1,516       1,018     49 %     4,278       3,195     34 %
                                    

Indexed annuity deposits

     199       244     -18 %     550       472     17 %

Indexed annuity withdrawals

     (59 )     (68 )   13 %     (182 )     (114 )   -60 %
                                    

Indexed annuity net flows

     140       176     -20 %     368       358     3 %
                                    

Fixed annuity deposits

     286       258     11 %     541       417     30 %

Fixed annuity withdrawals

     (651 )     (1,148 )   43 %     (2,002 )     (2,197 )   9 %
                                    

Fixed annuity net flows

     (365 )     (890 )   59 %     (1,461 )     (1,780 )   18 %
                                    

Total annuity deposits

     3,478       2,720     28 %     9,577       7,596     26 %

Total annuity withdrawals

     (2,187 )     (2,416 )   9 %     (6,392 )     (5,823 )   -10 %
                                    

Total annuity net flows

   $ 1,291     $ 304     NM     $ 3,185     $ 1,773     80 %
                                    

Annuities incremental deposits

   $ 3,441     $ 2,681     28 %   $ 9,476     $ 7,504     26 %
                                    

 

      As of September 30,        

Account Values (in millions)

   2007     2006     Change  

Variable annuities

   $ 58,293     $ 43,977     33 %

Fixed annuities (including indexed annuities)

     17,813       18,939     -6 %

Fixed annuities ceded to reinsurers

     (1,430 )     (2,045 )   30 %
                  

Total fixed annuities

     16,383       16,894     -3 %
                  

Total annuities

   $ 74,676     $ 60,871     23 %
                  

Fixed portion of variable annuities

   $ 3,470     $ 3,719     -7 %
                  

 

     

Three Months Ended

September 30,

        

Nine Months Ended

September 30,

      
     2007    2006    Change     2007    2006    Change  

Average daily S&P 500 Index®

   1,489.60    1,287.50    15.7 %   1,470.65    1,284.18    14.5 %
                        

 

39


     

Three Months Ended

September 30,

   

Basis

Points

   

Nine Months Ended

September 30,

   

Basis

Points

 

Interest Rate Spreads

   2007     2006     Change     2007     2006     Change  

Net investment income yield on reserves, excluding below items

     5.73 %     5.84 %   (11 )     5.78 %     5.77 %   1  

Default charges

     0.00 %     0.00 %   —         0.00 %     -0.04 %   4  

Commercial mortgage loan prepayment and bond makewhole premiums

     0.03 %     0.06 %   (3 )     0.05 %     0.05 %   —    
                                    

Net investment income yield

     5.76 %     5.90 %   (14 )     5.83 %     5.78 %   5  
                                    

Interest rate credited to policyholders, excluding below item

     3.76 %     3.84 %   (8 )     3.71 %     3.86 %   (15 )

SFAS 133 forward-starting option

     0.31 %     0.16 %   15       0.05 %     0.07 %   (2 )
                                    

Interest rate credited to policyholders

     4.07 %     4.00 %   7       3.76 %     3.93 %   (17 )
                                    

Interest rate spread

     1.69 %     1.90 %   (21 )     2.07 %     1.85 %   22  
                                    

Average fixed annuity account values (in millions)

   $ 17,358     $ 18,723       $ 17,589     $ 15,933    

 

     

Three Months Ended

September 30,

        

Nine Months Ended

September 30,

      

(in millions)

   2007    2006    Change     2007    2006    Change  

Average daily variable account values

   $ 55,827    $ 42,342    32 %   $ 52,922    $ 40,968    29 %
                                

Comparison of the Three and Nine Months Ended September 30, 2007 to 2006

Income from operations for this segment decreased $22 million, or 17%, and increased $73 million, or 26% for the three and nine months ended September 30, 2007, compared to the same periods in 2006. We have a hedge program that is designed to mitigate risk and income statement volatility caused by changes in equity markets, interest rates and volatility associated with our guaranteed benefit features of our variable annuity products. In third quarter of 2007, hedge effectiveness negatively impacted our quarterly earnings, as a result of the change in reserves and other benefits exceeding the impact from our hedge program. The decrease for the three months ended September 30, 2007 was primarily due to the impact of our hedge effectiveness, discussed in “Benefits and Expenses” below, and due to a favorable tax adjustment that was recognized during the third quarter of 2006 related to the separate account DRD from the filing of the 2005 tax return. The increase for the nine months ended September 30, 2007 was due primarily to growth in account values from favorable equity markets and positive net flows, higher investment income on surplus and the impact of the merger with Jefferson-Pilot, partially offset by the impact of our hedge effectiveness, higher incentive compensation and broker-dealer expenses and the favorable tax adjustment during the third quarter of 2006.

The adoption of SOP 05-1 on January 1, 2007, resulted in a cumulative effect reduction of $28 million in the segment’s DAC and VOBA balances. The adoption of SOP 05-1 also increased DAC and VOBA amortization by $2 million and $7 million for the three and nine months ended September 30, 2007, compared to the same periods in 2006. The impact is expected to be approximately $2 million, pre-tax, for the fourth quarter of 2007.

In the third quarter of each year, we complete our annual comprehensive review of the assumptions underlying the amortization of DAC, VOBA, DSI and DFEL, as well as the calculations of the GMDB reserves and the embedded derivative related to GMWB and GIB. As part of our annual review we also make corrections and modifications to our amortization models. The net effect of our annual review resulted in an $8 million, after-tax, increase ($14 million increase from assumption changes net of $6 million decrease from model changes) to income from operations for the three and nine months ended September 30, 2007 and a $2 million, after-tax, increase from assumption changes for the corresponding periods in 2006. See “Revenues” and “Benefits and Expenses” below for further discussion.

On August 15, 2007, we entered into a reinsurance arrangement with Swiss Re covering Lincoln SmartSecurity Advantage, our GMWB rider related to our variable annuity products. For additional information about this agreement, refer to “Reinsurance” in this report.

 

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Revenues

Insurance fees increased 40% and 37% for the three and nine months ended September 30, 2007, compared to the same periods in 2006. The increases were primarily due to increases in average daily variable account values of 32% and 29% for the three and nine months ended September 30, 2007, compared to the same periods in 2006. Additionally, the average expense assessment rates increased over these same periods contributing to the increase in insurance fees. The increase in expense assessment rates is driven primarily by an increase in account values with elective riders for guarantees that we offer such as GMDB, GMWB and GIB which have additional expense assessment charges associated with them. The increase in account values reflects cumulative positive net flows and improvement in the equity markets between periods.

The net effect of our annual comprehensive review of DFEL resulted in a $1 million decrease to insurance fees from assumption changes for the three and nine months ended September 30, 2007 and a $3 million decrease from assumption changes for the corresponding periods in 2006.

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 28% and 26% for the three and nine months ended September 30, 2007, compared to the same periods in 2006, primarily due to growth in the variable annuity business. Indexed annuity deposits increased $78 million for the nine months ended September 30, 2007 compared to the same period in 2006, due to nine months of activity being included in net flows in 2007 compared to only six months of activity included in net flows in 2006, as this product was added to our product portfolio as a result of the merger with Jefferson-Pilot.

The growth in individual variable annuity deposits was primarily a result of continued strong sales of products with the Lincoln SmartSecuritySM Advantage, 4Later® Advantage and i4Life® Advantage elective riders and the expansion of the wholesaling force in LFD. Variable annuity gross deposits in our Lincoln ChoicePlusSM and American Legacy products were up 35% and 27% for the three and nine months ended September 30, 2007, compared to the same periods in 2006.

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. Overall lapse rates for the nine months ended September 30, 2007 were 10.3% compared to 12.3% for the same period in 2006.

Our lapse rates have been impacted by multi-year guarantee fixed annuity products, which have fixed credited rates for a defined guarantee period before resetting to new rates. 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. Account values for these products were $1.5 billion at September 30, 2007, with approximately $0.1 billion of account values entering the window period throughout the remainder of 2007. Amounts entering window periods after 2007 are not significant. Through the nine months ended September 30, 2007, approximately $0.4 billion of account values entered the window period. Based on our emerging experience with this block of business, we expect lapse rates of approximately 50% on the Step Five Fixed Annuity products. The after-DAC, after-tax effect to the earnings of the segment is mitigated in part by a 50% coinsurance arrangement on 87% of the account values. See “Reinsurance” for additional information on this arrangement. Account values for our other multi-year guaranteed products were $1.8 billion at September 30, 2007, with an insignificant amount of the account value entering the window period throughout the remainder of 2007. During the first nine months of 2007, approximately $335 million of these multi-year guarantee products reset with approximately 62% lapsing where the holder did not select another of our products. As multi-year guarantees expire, policyholders have the opportunity to renew their annuities at rates in effect at that time.

Net investment income decreased $59 million, or 19%, and increased $99 million, or 14%, for the three and nine months ended September 30, 2007 compared to the same periods in 2006. Overall growth in net investment income has been constrained due primarily to lower average fixed annuity account values and net outflows. The decrease in net investment income for the three months ended September 30, 2007 is also attributable to a $28 million decrease in the change in the market value of S&P 500 Index® call options that we use to hedge our indexed annuity products. This change in the call option market value largely offsets the change in interest credited (included within insurance benefits expense) caused by fluctuations in the value of our indexed annuity contract liabilities. These impacts of the indexed annuity hedge program, related to both net investment income and interest credited, are excluded from our spread calculations. The decrease in net investment income for the three months ended September 30, 2007 also includes a $2 million (pre-DAC, pre-tax) decrease related to commercial mortgage loan prepayment and bond makewhole premiums compared to the same period in 2006. The increase in net investment income for the nine months

 

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ended September 30, 2007 is primarily due to the increase in fixed account values which were acquired in the Jefferson-Pilot merger, the impact of changes in the market value of S&P Index® call options used to hedge our indexed annuity products and higher investment income on surplus, partially offset by a change in methodology surrounding default charges. The change in the market value of S&P 500 Index® call options for the nine months ended September 30, 2007 was an increase of $23 million compared to the same period in 2006. Net investment income in the second quarter of 2006 was reduced by $4 million ($1 million after-DAC, after-tax) for internal default charges before the methodology was discontinued in the third quarter of 2006. See “Other Operations” below for additional information.

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 annuity product interest rate spread represents the excess of the yield on earning assets over the average crediting rate. We exclude the impact of investment income from statutory surplus investment portfolios from our spread calculations. 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. For further explanation of interest credited to policyholders, see “Benefits and Expenses” below.

The interest rate spread table above summarizes the effect of changes in the portfolio yield and the rate credited to policyholders, as well as certain significant items causing volatility in the periods presented. We include fixed account values reinsured under modified coinsurance agreements in our interest rate credited to policyholders, which is included in our interest rate spread calculation. For the three months ended September 30, 2007, in addition to the significant items identified, the interest spreads for this segment have declined primarily due to a decrease in the earned rate on invested assets partially offset by a reduction in average crediting rates year over year driven by the lapses of higher multi-year products as described above. For the nine months ended September 30, 2007, in addition to the significant items identified, the interest spreads for this segment have improved primarily due to an increase in earned rates on invested assets, a reduction in average crediting rates year over year driven by the lapses of higher rate multi-year products as described above, and the 3 basis point increase attributable to the opening balance sheet adjustment, discussed below.

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 3—Quantitative and Qualitative Disclosures About Market Risk” of this Form 10-Q.

Benefits and Expenses

Insurance benefits increased $54 million, or 23%, and $135 million, or 24% for the three and nine months ended September 30, 2007, compared to the same periods in 2006. The increase for the three months ended September 30, 2007 is primarily due to growth in our business and the impact of our hedge effectiveness, partially offset by a decrease in interest credited to policyholders. Our hedge effectiveness in the third quarter of 2007 was negatively impacted by a significant and sudden increase in market implied volatility coupled with a drop in interest rates, which resulted in a net increase in insurance benefits of $53 million ($14 million, after-DAC, after-tax), which was comprised of an increase in reserves and benefits payments totaling $117 million and $33 million for the three months ended September 30, 2007 and 2006, respectively, partially offset by favorable results in our hedge program totaling $62 million and $31 million for these same periods. In addition, during the third quarter there were certain unhedged items, such as those related to products we sell in New York, for which we did not have sufficient size to hedge. Although these items are not a significant component of our account value, movements in the related reserves during the quarter contributed to the negative impact. These increases were partially offset by a decrease in interest credited of $31 million attributable to a decline in average fixed annuity account values, the impact of lapsation of products with higher crediting rates and a $26 million decrease in the change in the indexed annuity options mark-to-market adjustment. This decrease in interest credited was partially offset by a $6 million increase in the change in the fair value of the SFAS 133 forward-starting option liability related to our indexed annuity contracts. SFAS 133 requires that we calculate the fair values of index call options we may purchase in the future to hedge policyholder index allocations applicable to future reset periods, which we refer to as the SFAS 133 forward-starting option liability. This liability represents an estimate of the cost of the options we may 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 this liability result in volatility in interest credited. The interest rate assumption used in discounting this liability within the fair value calculation is the primary driver of the change in value.

The increase in insurance benefits for the nine months ended September 30, 2007 is primarily due to growth in our business, the merger with Jefferson-Pilot, the impact of the change in reserves and other benefits exceeding the impact from our hedge program of $37 million ($10 million, after-DAC, after-tax) and a $20 million increase in the change in the indexed annuity options

 

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mark-to-market adjustment. These increases were partially offset by lower average fixed account values, lower average crediting rates and a $4 million ($3 million, after-tax) adjustment to the opening balance sheet of Jefferson-Pilot finalized in the first quarter of 2007. This opening balance sheet adjustment increased our interest rate spread by 3 basis points in the first nine months of 2007. See the table above for the interest rate credited to policyholders.

Our fixed annuity business includes products with crediting rates that are reset on an annual basis and are not subject to surrender charges. Account values for these products were $3.5 billion at September 30, 2007 with 32% already at their minimum guaranteed rates. The average crediting rates for these products were approximately 48 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.

At September 30, 2007, the segment’s net amount at risk (“NAR”) related to contracts with a GMDB feature was $0.2 billion. The related GAAP and statutory reserves were $31 million and $41 million, respectively. The comparable amounts at December 31, 2006, were a NAR of $0.3 billion, GAAP reserves of $23 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 consider 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 September 30, 2007:

 

      Type of GMDB Feature  
    

Return of

Premium

   

High Water

Mark

    Roll-up     No GMDB     Total  

Variable annuity account value (billions)

   $ 29.9     $ 25.8     $ 0.4     $ 5.7     $ 61.8  

% of total annuity account value

     48.4 %     41.8 %     0.6 %     9.2 %     100.0 %

Average account value (thousands)

   $ 121.1     $ 119.2     $ 88.4     $ 85.1     $ 115.8  

Average NAR (thousands)

     5.7       9.9       11.7       N/A       8.9  

NAR (billions)

     —         0.2       —         —         0.2  

Average age of contractholder

     65       64       67       63       64  

% of contractholders > 70 years of age

     35.0 %     31.5 %     43.1 %     32.7 %     33.3 %

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 September 30, 2007, there were 772 contracts for which the death benefit to account value ratio was greater than ten to one. The NAR on these contracts was $50 million.

Underwriting, acquisition, insurance and other expenses increased $7 million, or 3%, and $153 million, or 25%, for the three and nine months ended September 30, 2007 compared to the same periods in 2006. The increases for both periods were driven primarily by account value growth from sales and favorable equity markets, which resulted in higher commission expenses, net of deferrals and lower DAC amortization. DAC and VOBA amortization decreased $12 million and increased $53 million for the three and nine months ended September 30, 2007 compared to the same periods in 2006. See below for discussion surrounding the impact of our prospective unlocking adjustments on underwriting, acquisition, insurance and other expenses as a result of our annual comprehensive review. Broker-dealer commissions and operating expenses increased $15 million and $69 million in the third quarter and first nine months of 2007 as a result of higher sales. Higher incentive compensation expenses due to favorable performance also contributed to the increase in expenses for the three and nine month periods of 2007. The merger with Jefferson-Pilot also contributed to the increase for the nine months ended September 30, 2007. Underwriting, acquisition, insurance and other expenses for nine months ended September 30, 2007 were increased by $2 million ($1 million, after-tax) related to adjustments to the opening balance sheet of Jefferson-Pilot finalized in the first quarter of 2007.

 

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The net effect of our annual comprehensive review of DAC and VOBA resulted in a $12 million decrease ($28 million decrease from assumption changes net of $16 million increase from model changes) to underwriting, acquisition, insurance and other expenses for the three and nine months ended September 30, 2007 and a $1 million decrease from assumption changes for the corresponding periods in 2006. The 2007 assumption changes were the result of favorable interest rates, maintenance expense and account retention assumptions partially offset by unfavorable asset-based commission assumptions. The 2006 assumption changes were the result of unfavorable fixed annuity account retention and unfavorable mortality, partially offset by lowering our long-term interest assumption.

The net effect of our annual comprehensive review of DSI resulted in a $1 million decrease ($2 million decrease from assumption changes net of $1 million increase from model changes) to insurance benefits for the three and nine months ended September 30, 2007 and a $1 million decrease from assumption changes for the corresponding periods in 2006. In addition, the net effect of our annual comprehensive review of the revised calculations of the reserves related to GMDB resulted in a $3 million decrease to insurance benefits from assumption changes for the three and nine months ended September 30, 2006. The comprehensive review during the third quarter of 2007 is not expected to significantly affect future amortization expense.

Federal Income Taxes

Federal income tax expense for the third quarter and first nine months of 2007 included a reduction of $2 million related to a favorable true-up to the 2006 tax return relating primarily to the separate account DRD, compared to a $33 million favorable true-up to the 2005 tax return for the same periods in 2006. For additional information on our effective tax rates, see Note 4 to our consolidated financial statements.

Individual Markets – Life Insurance

 

     

Three Months Ended

September 30,

        

Nine Months Ended

September 30,

      

Operating Summary (in millions)

   2007    2006    Change     2007    2006    Change  

Operating Revenues

                

Insurance premiums

   $ 83    $ 87    -5 %   $ 258    $ 228    13 %

Insurance fees

     457      383    19 %     1,244      969    28 %

Net investment income

     444      414    7 %     1,392      1,070    30 %

Other revenues and fees

     6      11    -45 %     25      30    -17 %
                                

Total operating revenues

     990      895    11 %     2,919      2,297    27 %
                                

Operating Expenses

                

Insurance benefits

     514      508    1 %     1,528      1,268    21 %

Underwriting, acquisition, insurance and other expenses

     218      207    5 %     611      523    17 %
                                

Total operating expenses

     732      715    2 %     2,139      1,791    19 %
                                

Income from operations before taxes

     258      180    43 %     780      506    54 %

Federal income taxes

     84      57    47 %     263      167    57 %
                                

Income from operations

   $ 174    $ 123    41 %   $ 517    $ 339    53 %
                                

 

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Three Months Ended

September 30,

   

Basis

Points

   

Nine Months Ended

September 30,

   

Basis

Points

 

Interest Rate Spreads

   2007     2006