Lincoln National Corporation (LNC) Earnings Call Transcript & Summary

Good morning, everyone. I am Ryan Krueger from KBW. Real pleased to have Lincoln Financial Group with us today. From Lincoln we have Randy Freitag, who is the Chief Financial Officer and Head of the individual life business. Just for housekeeping purposes for those listening in, there is a submit question function at the bottom of your screen. I have a number of questions, but I'll keep an eye on any questions from the audience.

All right. So Randy, I guess to start, can you discuss Lincoln's approach to managing the balance sheet in this current environment where we have a combination of economic and claims uncertainty as well as even lower interest rates than we've been dealing with before?

Sure, Ryan. First off, thanks for hosting us today in these very strange times. So I think, this is my first virtual fireside chat. So thank you for doing that. I think in terms of managing our balance sheet, it really starts with what we've done over the last 5 or 6 years, which has built a very strong balance sheet. So we came into this year with a 439% RBC ratio. And we've actually been able to grow that over the first half of the year. So we ended the second quarter at a 444% RBC ratio, $9.7 billion of capital. So that's the first step of how we've managed the balance sheet, which is make sure we're in a very strong position. Then when it comes to -- ultimately, I think what you're getting at is what are you doing with your capital then? And I think for the second -- third quarter, we made the decision not to do share buybacks. And ultimately, that comes down to what view are we taking of the economy. So I think given the evidence that existed when this whole thing started in March or whatever, and through the second and third quarter, I think it was the best -- assumption was to assume that the potential for a stressed environment had grown, had grown to a greater level, obviously, than when we started the year. So we made the decision consistent with that assumption to not do buybacks in the second and third quarter. It doesn't say anything about the strength of our balance sheet, which I mentioned at the beginning, it was very strong. Just as everything, I think, what is the prudent approach when a stressed environment is at a higher level from a potential standpoint than during a normal state of the world. It's just a fact that I don't get an e-mail that tells me recession coming in 3 months, right? So you have to make an assumption, and that's what we've done for the second and third quarter. And as we get ready and move into the fourth quarter, we'll make a decision about what the best assumption for the state of the world is at that point.

I guess, is there anything in particular that you're looking to see in the external environment before considering the resumption of buybacks, whether it'd be broader reopening of the economy, higher interest rates, I guess, credit experience, any kind of specific thoughts on what you're looking to see?

I get all of those things, and I think the fact of the matter is, is that the primary stress. And when we run a stress test, it's a very severe stress, significant drops in the equity markets, 1 in 100 credit event. When we run that, the primary stress that we experience as a company comes to credit. And so I think that's the big in terms of you had to rank order things that we look at. And so we'll be looking for evidence that the credit environment has improved. Obviously, back early in the second quarter, there was a lot of uncertainty on what was going to go on with credit. We were preparing for more downgrades potentially for credit losses. And that really hasn't happened yet, right? So we've had pretty favorable experience relative to our expectations early on in this thing. And so I think that's a bit of evidence. But I think it's the sum total of all these things, but credit is probably, first and foremost, the thing we look at.

Got it. One thing you did discuss earlier in the year when COVID started was actions to preserve about $400 million of capital allocated to new business. I was curious, to what extent is that just occurring naturally due to social distancing and lower interest rates and just a natural pullback in sales in this environment versus more specific actions like putting in sales caps or things more of that nature?

Yes. It's actually a very natural response to actions we've taken. And I don't think it has as much to do with the environment, the sales environment that had a small impact as everybody is adjusted to a virtual world. It never really had anything to do with inorganic sales caps. I think it has more to do with appropriate -- from our standpoint, pricing actions that we've taken on some of our bigger products. I think that's been the primary driver of why sales are down this year. And sales, in the case of Lincoln, is a significant place that we allocate capital. Last year, if you look at how we allocated the capital that we generate, last year, about 2/3 of it, about $1.07 billion went to support new business, about $950 million, we returned to shareholders through buybacks through dividends. So with $1.07 billion going to new business, that's obviously a significant allocation of capital. And as -- really, the environment has changed this year, especially rates. As rates have dropped, it's really required pricing actions across a number of products in our portfolio, MoneyGuard, which has seen its price increased 35%. VUL had to have some price increases. Fixed annuities obviously impacted variable annuities, which are -- where the cost of hedging is really driven by interest rates have seen their benefits cut. So with a lot of our products, the median pricing actions. I think that's been the primary driver of why sales are down and thus, the amount of capital we allocate to sales is down.

As you think beyond this year, would you anticipate some continued benefit to free cash flow from this shift you've seen in some of the products that you're selling in this type of interest rate environment, is that something you think could continue?

I think it's somewhat dependent upon how successful we are with what we've been successful at in the past, which is, in addition to repricing products that need it, adding new products or shifting to other products. So we're not -- we don't stop with MoneyGuard needs to be repriced. So we don't stop with fixed annuities need to have their rates cut. We are constantly innovating and trying to add new products that makes sense. So in the case of MoneyGuard, we're redesigning that product in a different way. In the case of the annuity business, we've been able to significantly shift sales to a new product that is not as impacted by interest rates, that being the buffered annuity or the index variable annuity, you'll hear it referred to in different terms. So anyway, I think, that's somewhat dependent upon how successful we are. As we have been successful in the past in responding to the environment and then shifting to other products that create a better value prop and a better return profile for Lincoln.

Thanks. On the first quarter call, you updated your sensitivity to statutory cash flow testing, you meaningfully lowered the impact or the estimated impact from a 50 basis point 10-year interest rate level. I believe this is based on rates and spreads from June to June of each year. So given we've already passed that, would you anticipate much impact at year-end 2020 from this? Or is this something that would be more of a 2021 impact, if rates remain at these levels?

Yes. No impact at the end of 2020. This is a 2021 event. As we talked about, as I talked about $100 million to $200 million at the end of 2021, that would be the peak and then it would grade down from there, just to scale that $100 million to $200 million of incremental reserves is 4 to 8 points of RBC. And as I mentioned, we're in a very strong ROI. So very comfortable in our ability to manage through that, should it come to pass.

Got it. And then shifting to variable annuities a bit. Can you discuss how the hedging results have performed in this type of environment so far this year as well as your just general comfort with the capital and reserves in that business?

Sure. I think this environment is a case study in what is different about the way we operate the variable annuity business. First, in our hedge program, which I think is industry-leading. And I think it's proved itself during this environment as the markets have moved, as rates have fallen, as equity markets fell, we saw the value of the assets that in our hedge program increased significantly. And obviously, as the markets have moved back up, they've come down a little bit. But that dynamic program focused on the economics has proved itself in what has been a very volatile environment. I think this year has been an affirmation of our approach to product design and the benefits we'll offer consumer where the benefit profile or the risk of the products we sell is so dramatically different and lower than our peer companies. If you look at risk as measured through the net amount of risk of the guarantees we offer, whether that's guaranteed minimum death benefits or the guaranteed minimum living benefits. If you look at the end of the second quarter, our net amount cost debt benefits was 0.8%, that's like 1/20 of the average of our industry peers, which I believe is in the range of 17% or living benefits were net amount of risk at the end of the second quarter, I believe, was at 1.8%, going a bit from memory there, which once again is about 1/10 of the average of our industry peers. So that profile, which is so significantly better than nearly anybody out there and definitively better than the average peer company. I think this environment affirms that approach to operating that business. And the other thing the year has really demonstrated and an affirmation for me and for Lincoln is how we capitalize the business. We did have some breakage in the first quarter when the markets just went -- had rapid, rapid movement. But with our approach to capitalizing this business, our approach to reserving this business, where we're using a greater or greater CTE-98 or a percentage of account value, we have the ability with that approach to capitalization to absorb that at a little bit of breakage we had in the -- not a little bit -- that breakage we had in the first quarter. So yes, I think this year has been, for me, an affirmation about everything that we do, how we operate that business, which has been so important. It's successful for Lincoln, and the business, by the way, which is significantly undervalued by investors.

From a hedging standpoint, the breakage that you experienced in the first quarter, I think, was at least partly attributable just to the extreme amount of volatility in trading that you needed to do. Is there anything you can do or change with the hedge program to protect against that type of, I guess, that type of experience, you could see in that type of volatility in the environment? Or is that just something you kind of have to be able to absorb if we get into unusual times?

I think there are -- as evidenced by our industry where almost every company has a little different approach to hedging. There are obviously a number of different approaches. I think when we weigh the pluses and minuses of what are more static programs versus our growth, which is more dynamic and does call for trading, and which gets a little more expensive when the markets are moving that rapidly. I think we still believe that the pluses of our approach outweigh the negatives of other approaches. Yes. I mean there are other ways you can hedge these risks. There are other targets you can go after some of our peer companies target statutory, for instance, whereas we focus on the economics and GAAP. So yes, I mean, there are different approaches. But when we weigh the positives and minuses, I think we are very confident that our approach is the winning approach.

Got it. And 1 more variable annuity question. That you use your LNBar entity in Barbados to manage the rider risks. I guess, how do changes in the NAIC's variable annuity capital rules or prospective changes in the interest rate generator actually affect the Lincoln, given that you are using that different entity to manage those risks?

Well, the impact on Lincoln is small. Now that being said, we've been very supportive of the NAIC. We've been a significant contributor to the studies they've done, the work they did with Oliver Wyman. I mean we were a primary contributor to that network, and we're a primary contributor to the work they're doing on the rate generator. So we're very supportive of the work they're doing. I think anything the NAIC can do to make statutory -- reserving statutory capitalization move towards the economics is a positive. And so generically, we've been very supportive of that. I think why we tend to do very good in -- as they've made these changes, has a lot more to do with, once again, our approach to business than it does with whether or not we operate the business in LNBar or not. Remember the risk profile I talked about our business which is so dramatically reduced compared to our peers, just does a lot better in their approach and a significant amount of hedging that we do of things like interest rates, the capitals, when it comes to changes the NAIC might make in the generator, so we'll continue to be supportive as the NAIC looks to continue to evolve in their approach to reserving the capitalization of that business.

And a related question from the audience, which was that, Randy, you mentioned that you believe the public market is meaningfully undervaluing your variable annuity business. I think the question was, do you think that the private market is also still undervaluing variable annuity businesses to a similar degree?

It's very hard to say. We've seen so few transactions in the private markets and the transactions you have seen have been a bit one-offs. There've been almost until -- and it's very hard to discern what the valuation embedded in the Athene-Jackson deal was. But until then, there really hadn't -- there aren't making any transaction of companies, are still actively in the business -- books of business. So it's tough for me to say, but I think there -- the fact that there haven't been many transactions, is probably an indicator that the private markets are not putting a great valuation on this either. I say that because for me, what the variable annuity business is? It's the highest quality asset management business in the world. I mean, it has great persistency and good fees. So -- and then you have the guarantee attached. So it's about can you manage the guarantee to quite a guarantee that doesn't create too much risk for a company, I think we've shown we can do that. We've done that over the years. And so that's why, i.e., the variable annuity business is not getting the valuation that deserves because all the focus goes to guarantee and there's a perception of the guarantees as being riskier and in the case of Lincoln they are, and there's less focus on what is at the core of this business, which is an extremely high-quality stream of asset management fees.

And then just 1 more from the audience. It's somewhat -- also, I guess, related to annuities, which is if there is a change in the political administration in an attempt to bring back the department of labor fiduciary rule, how do you feel that, that could impact Lincoln now? And there's been changes since then with an SEC rule now as well, so just any thoughts on how that might play out?

We were very supportive of Reg BI and the SEC work. So we've been very supportive of that. I think to the extent the department of labor comes back to make changes. I think a lot of the leg work was done by Lincoln with the last administration. So if you go back to the beginning, and we're talking years ago, the very first approach, there really wasn't an understanding of commission-based products. And Lincoln did a ton of work, which is something we've shown capacity to do over the years with regulators to help them understand that in the case of a product like variable annuities, commissions make sense for -- they are the lowest-cost approach for consumers. Once again, a product where the persistency is extremely high. You're much better off paying a 4% to 5% commission or whatever it is upfront than you are for paying 1% for the rest of time. So they understood that and they ultimately made changes to their ruling that we felt we could at least operate in. So I think if we get a new department, and we need to work with them to help them understand the products we sell, we'll do that. We've shown the ability to do that. And so yes, I mean, change is always, if you want to use the word scary, but change creates risks, but I think we've shown the ability to work with administrations of all stripes to help them understand the products we sell.

Thanks. The actuarial assumption review you conducted in the third quarter, I'm not going to ask you what you're going to do with your interest rate assumption. But I guess the focus has often been on interest rates, but there's also many other factors that are reviewed each year. So I was hoping you could just touch on how some of the other key factors have played out in recent years, such as policyholder behavior, mortality, those types of other impacts?

Ryan, if you look over a more extended period of time, a decade, the sum total of everything that isn't related to interest rates is very, very small, if not positive. So all of the other policyholder behavior, mortality -- now there have been years in there when there have been movements one way or the other. For instance, last year in the life business, I think, reinsurance was a bit of a negative, and I think there was a negative -- a bit from mortality is had to bring a small slice of our business in line with the rest of our business. But if you sum it up over a number of years, the impacts outside of interest rates have been de minimis at most.