Lincoln National Corporation (LNC) Earnings Call Transcript & Summary

Hello, everyone. I'm Tracy Dolin-Benguigui, insurance analyst at Barclays. And I'm pleased to host this fireside chat with Lincoln National, with our speaker, Ellen Cooper, President, and CEO. Maybe just we could kick things off, Ellen, you could describe some big-picture thoughts on the current macro environment for Lincoln.

Absolutely. So I think, first of all, we all were reminded yesterday about the volatility that we continue to experience in the market. So I'll just spend a moment talking about the fact that we all know that we have continued to see, in particular, persistent inflation and that, that has driven a lot of market volatility and a fair amount of uncertainty in terms of the overall economic landscape. What it has meant for Lincoln this year in particular, is that through the second quarter, we had seen a significant amount of market volatility that really had affected, first of all, our risk-based capital. It also -- we have seen some impact just from equity markets being down. They were down year-to-date about 20% through the second quarter. So we see that show up in terms of impact as it relates to our fees on assets under management. As a reminder, in terms of our overall source of earnings mix, about 50% of our overall source of earnings comes from fees on assets under management. So we saw that as an overall negative impact. And then the third area is that we have some reserves, in particular, that are more sensitive to lower equity levels and also some level of market volatility. So we saw some pressure from that as well. Having said that, we also -- as we look at the broad economy, there continues to be really a lot of support. We continue to see strong labor markets, as you all know. We continue to see strong wage inflation and also interest rates are higher. And so these are all positive that we also think create a lot of opportunity as it relates to overall customer value proposition of product with those overall higher rates. Wage inflation puts more dollars in the pockets of consumers, and we're seeing that translate in our retirement business. And also just in terms of when we see this overall market volatility, we tend to see shifts away from some of the more traditional variable-based products. But because of the broad product diversification that we offer, we're able to see shifting sales in terms of customer preferences more into products like stable value on the retirement side, fixed indexed annuity. So clearly, there are pressures underway, but also some opportunities as we continue to work through this market landscape.

So given the current macro backdrop, what is your confidence level in achieving your 8% to 10% annual EPS growth? And what could be one of the -- some of the main drivers?

Great. So I continue -- even at the end of the second quarter, with equity markets down 20% year-to-date, I continue to have strong confidence that over the next couple of years, we will -- we expect to produce an 8% to 10% EPS growth. Now a couple of components here as it relates to why and how we will do that. The first is that a portion of that growth comes from pure organic growth. We've talked to all of you over the years about our product strategy, reprice shift and add new. We're seeing sales acceleration across all 4 of our businesses, and we expect that to continue. The second area that we have talked to all of you about is our Spark initiative. And so here, an enterprise-wide expense initiative, we expect with the 2024 run rate, and we'll be incrementally working on this over time that we'll be taking out about $260 million to $300 million of annual expense per year. That's about 15% of the overall G&A expense. We're making significant investments now to be able to take those expenses out later, but that's another place in terms of how we will achieve that. And then the third area that we've talked to you about is sustaining really restoring our group protection margins. And you saw in the second quarter, granted typically a good seasonality quarter in the second quarter for Group Protection. But our margin being really close to the upper end of that range. Now we need to support sustaining it. So that's the other place overall. Additionally, we have had over the past headwinds that have come from spread compression from lower interest rates over time. And even though -- although we saw equity markets down and that definitely puts some pressure on EPS growth, with interest rates being higher, we actually believe that over the near term that we'll start to move into spread expansion and that, that will also be another tailwind now, finally to be able to support EPS growth and gives us further confidence in how we will get to the 8% to 10%.

So you talked about some opportunities from higher interest rates, like spread expansion, if you have anything else to add there? And if you could also balance that with any challenges like liquidity or disintermediation risk. I'm just thinking about liabilities that might be rentable.

Absolutely. So higher interest rates are good for our customers. They're good for Lincoln. They're good for the industry. And when we have interest rates at the levels that we have them now, they're still, if you look historically, they're higher certainly than they were, but they're still low historically. However, a couple of things. We are able to really improve the value proposition to our customers of the products that we overall offer. We're able to think about the reduction in elimination, which we expect this year if rates continue at this level of spread compression and really move to spread expansion. And then some of the reserves that we set also have some sensitivity to rates, and so higher rates would support a lower reserve. So those are really some of the positive things. Some of the things that we manage just in terms of being an overall insurance company, we're always managing to various different stress scenarios that should occur. If we were to see some type of a stagflation scenario, a rapidly accelerating high hyperinflationary environment, we could be exposed to some level of disintermediation on some portion of our product portfolio, not significant. We spend a lot of time, first of all, thinking about product features in those businesses that have the potential to be disintermediated against. We also have some macro hedges in place for very rapidly high rising rates that could support if we were to see a situation like that, that ultimately and a number of different product features to support. So clearly, something that we look for in terms of overall stress scenario analysis, not something that we're expecting in the near term. But if there was, we have a number of risk management mitigations that are in place.

Great. Ellen, you previously shared your vision of improving Lincoln's free cash flow conversion. And one of the points I've heard you make is that maximizing your present value of distributable earnings from your in force including potentially a future transaction. So looking at your back book, which piece do you think is the most transactable? And which part would you love to offload but cannot reach the appropriate bid-ask spread?

Yes. Okay. So we started to talk in our last quarter analyst call about our longer-term strategy, and I mentioned a couple of things there. One was that, in addition to our long-standing focus on EPS growth and on strong ROEs that we also would be increasing our emphasis on free cash flow. And I talked about a couple of contributors to that. First of all, we are looking at ways that we can accelerate growth and enhance shareholder value. And as part of that, there are really 3 areas that we will be spending more time focusing on and emphasizing and communicating with all of you as we think about what is the question around our long-term optimized business mix. And the 3 areas are increased focus on free cash flow, reducing the capital volatility from capital markets. And the third area is further diversifying our sources of earnings and revenue. We have -- I have put a person in charge, a chief strategy officer that is quarterbacking the long-term strategy for Lincoln. And over time, we'll be able to communicate more of that to all of you. And we're looking at the actions that we can take that will meet these 3 objectives that I've just talked about. If there is an opportunity to transact with no time commitments at the appropriate price that would meet some of those objectives, that could improve overall free cash flow, that could reduce capital volatility, we would do it. And we have a team that is fully staffed up now that is working 24/7. We've never had a fully dedicated team that this was their role, but they're looking at whether or not there could be opportunities here. And presumably, to answer your question in terms of mix, presumably, we would look at a subset of across the organization because they have $300 billion of in force. So we really would be looking at perhaps a portion across various different types of products as we consider a potential block transaction. So more as we continue to move through all of this. If, by the way, we're not able to transact in an appropriate time at a price that meets our needs. The end objective here is to really maximize the value of our in force. So are there other levers that we could pull around maximizing the value of the in force? We think that there are one tool could be transaction, but other tools could be looking at potential structures, potential investment strategy, et cetera. So more to come.

Okay. Interesting. Maybe turning to capital management, your RBC. Can you just discuss the factors that led Lincoln's buffer to be depleted in the second quarter? I think your RBC now is at the 400% level, which is your target.

Yes. So first of all, as it relates to our target, importantly, we ended the quarter at 400 RBC. About a year ago, we had the C1 factor RBC change. And for us, although there was no impact to our overall credit risk, to our overall view of the investment portfolio, it was a 20-point impact for us. So we really view that the $400 million that we had at the end of the quarter was effectively $420 a year ago. So we believe that we still have some room in terms of our overall target is the first thing. The second thing is that we did experience 30 points of RBC impact in the first half of the year, exactly to your point. About 2/3 of that came from the equity market decline and the impact that it had in terms of some of our businesses and additional reserve requirements aligned with that lower equity market move. About 1/3 of it came from some deferred tax assets that basically there's a limitation in terms of the amount of overall deferred tax assets, and that will reverse itself over time. So those are the primary drivers. And again, getting back to one of the objectives that we're going to be further focused on is really reducing that capital volatility to capital markets over time.

Maybe I'm oversimplifying, but can I think then 380 RBC is your new 400 RBC?

Effectively, yes. We do really believe that there's also variability in terms of our RBC. So as we've looked at this further, we believe that when markets are -- when equity markets are high, and we're seeing a lot of equity market growth and low volatility that we would see in credit markets benign, we would see a buildup in RBC. And you saw us do that actually earlier in the year. And then when we're seeing more pressure, more equity market volatility that there would be room to go a little bit lower. So we believe that there's a range with which we would be comfortable in terms of our target RBC level.

Okay. Can you just put a little bit more context over the range and as well as discuss how important it is to Lincoln to have an RPC buffer?

Yes. So as I mentioned, we would be comfortable with the 400 RBC, which was -- which, in our eyes, was a 420 RBC, and going to the 380 RBC. And then we also do a lot of stress testing and stress scenario analysis to ensure that the target level has to be correlated and connected to being able to withstand a severe stress and maintaining lower RBC levels but lower RBC levels that support potential significant credit risk, equity market, additional equity market decline, et cetera, with an objective of not reducing shareholder dividends, with not needing to do any capital or equity raise of any sort and being able to continue to operate sales as we typically would. So if we are feeling -- and also maintaining, of course, strong financial strength ratings. So if we're able to maintain all of that from a severe stress perspective, we also are comfortable in terms of our overall targets.

Okay. Great. Maybe shifting gears to mortality risk. What are your latest thoughts on non-COVID mortality risk? Is the pandemic a pull forward? Are you worried about late medical treatment, diagnosis of care, just recognizing that we've seen some favorable non-COVID mortality experience lately?

So when we think about non-COVID, I think sometimes it's hard to separate, first of all, non-COVID from COVID. And one of the reasons that I say that is that some of the pull forward of mortality that we have seen, in particular in the individual business, which affected a lot of older age individuals, is that there was a lot of comorbidity there. And so it's hard to know while somebody may on a death statement, it might have said that they died from COVID, it might not happen. So it's really a little bit unclear. We do think, having said that, then in our individual business where we saw a lot of older aged claims that were either directly COVID or we believe COVID related, we do believe that there was a pull forward there. We also have a group protection business, as you all know. And there, the story is a little bit different. So particularly during, you probably all remember the Delta COVID. And that, for whatever reason, seem to afflict more working-age population than some of the other strains that we've seen of COVID. And so we had an elevated working age COVID mortality, in particular, during the whole Delta situation. That, we don't think is a pull forward. We think it's an unfortunate circumstance of COVID. Having said that, because the group book more or less prices again and renews about every 3 years, we've talked about the fact that we've been able to reflect in our pricing increases and we've had strong new sales, and we've also had strong retention there. Persistency that we've been able to have some level of the pricing of those COVID claims back into the overall Group Protection business. As it relates to non-COVID in particular, we also know and we are watching the fact that we definitely know that during the early days of COVID that people were delaying doctors' visits. And so in general, there's a little bit of -- we've seen some evidence of a little bit of elevated non-COVID mortality coming from people finding later-stage cancers or whatever it might be. It's just hard to know at this point. As you all know, mortality and really thinking about trends takes a long period of time to really study and understand we're only about 2 years into COVID, and we really firmly believe that it's shifting now from pandemic to endemic. So we're going to have to really watch this and see what implications it has longer term before we can actually really come out with any clear trends in terms of what it could mean for long-term expectations.

Great. Could you provide an outlook on pricing competition in the U.S. Life and Retirement base?

Yes. So first of all, as it relates to -- I talked about higher interest rates. And as it relates to higher interest rates and just in general in terms of pricing and competition, we, the entire industry can offer a stronger consumer value proposition with rates being at these levels, certainly than we could 2 years ago when the 10-year was below 1%. In general, when we think about overall competition where it is -- where we have some level of crediting rate inside of the pricing, we are seeing really the entire industry, while competitive has also remained very disciplined. We continue to have strong market share, and we ourselves when we're pricing, we ensure that we are meeting or exceeding our target returns. And by the way, when we are pricing new product, we are using the forward curve. We're not grading into any long-term expectations. We use the forward curve when we price. On the life insurance side, I want to also add that in the working through of COVID, we really have seen an increase in terms of demand in general across the industry of life insurance and protection product. It's not a surprise. We saw a real uptick of that in 2021, still elevated in 2022, although not quite as strong. So we expect that, that will continue. And then I talked earlier about the fact that when we see market volatility and equity markets down in particular, we tend to see a pullback from some of the traditional variable-based product and more into -- more, call it, safer guaranteed product. And so we have seen that in terms of in our retirement business, on the stable value side. We've seen more of a shift into on the annuity side into fixed indexed annuity away from VA traditional product. So those are some of the things that we're seeing out there. And again, the fact that we've got the broad product diversification is supporting us to be able to meet our customers in terms of their overall preferences.

Great. For group life insurance, do you feel like you have enough scale there and enough product offerings? Are there any capabilities you wish you had that you don't currently have? I'm just wondering if you could share views of your ultimate growth potential.

Yes. So the group business is a very important business to us. Back in 2018, we acquired -- we did an M&A transaction that really doubled the size of that business. And in addition to doubling the size of the business, part of what it did is that Lincoln had traditionally been in the small and mid-case sizes, but it really enabled us to expand into the large and even the mega overall case sizes. So it gave us broad scale, and it gave us more broad diversification. And so we have significant market shares and we feel very comfortable in terms of where we are in the overall life space and disability and leave, we've got very strong market share there. We also feel very good about the split between our employer and our employee paid, and we continue to see really good focus there. We think that with the scale that we have, and it really gets back to our ability to execute on our goal of getting to sustained 5% to 7% margin. We think that with the scale of the business that we have, we have every opportunity now to really maximize our operational efficiencies, to maximize our claims effectiveness. We've got strong distribution in stope. So using that strategically in terms of improving the overall organic growth around sales, but also strong persistency, which we've been seeing and getting those premium increases. So we've been seeing really positive around all of that. The other thing that I want to add is that we've also talked about the fact that we would like to in terms of where to grow, we would like to be doing more in the supplemental health space. And so in order to do that, we historically had 2 sub-health products. We had accidental death, and we had critical illness. Last year, we rolled out hospital indemnity. That was important because many brokers and employers really feel that in order to be credible in the sub-health space, you have to have 3 legs to the stool, and we were missing one. So the fact that we now have hospital indemnity puts us in the mix and the flow. And as you all know, the margins are very healthy on that business. And so we believe that we have opportunity to grow and do more there. And then the final point is that we've just brought in a fantastic new leader to run those businesses. So the head of our Workplace Solutions, that's group protection and retirement plan services, James Reid, who has just come to us with deep experience in the Group Protection business. And so we will be looking at all ways to really continue to grow the business over time. And as we continue to work through that, we'll be able to communicate more.

Got it. And one of the tools you're aiming to optimize your business mix is to increase your mortality morbidity source of earnings to 30%. Can you walk us through how you'd like to accomplish that?

Absolutely. So when we think about our overall source of earnings mix, we had communicated some time ago that our goal was to get to a 30% mortality morbidity in terms of the overall earnings mix and the acquisition of the Liberty Group Protection business that I just mentioned enabled us to get there. Unfortunately, soon after we acquired that business, we entered into a pandemic. And so we have been struggling through the pressures of working through the pandemic. When we look, for example, at the source of earnings, ex, the pandemic, what we can see is that, for example, in 2021, that mortality morbidity was in the mid-20% range. In the second quarter where we produced a strong margin for the Group Protection business, we were closer to that 30% area. So we believe that with sustained margin that we will be able to, over the near term, achieve that 30% mortality morbidity. We have about 50% of the overall source of earnings, as I mentioned upfront. It's coming from equities that's really fees on assets under management. And the remainder is predominantly coming from spread and interest rates. When we think about the overall optimization of the business mix going forward, and I talked about the factors that we're going to be looking at around improving cash generation, reducing capital volatility, and diversified sources of earnings and revenue, we will be asking ourselves the question around what that long-term mix ultimately should look like to really further enhance shareholder value. So more to come on that as we continue to work through it.

Okay. Great. Maybe we could touch on retirement plan services. Can you discuss trends in this business, including sales growth, net flows, margins, and earnings?

Absolutely. So our retirement plan services business, we're really very proud of it. It's performed very, very well. We've talked to all of you during analyst calls about the fact that our sales have been good and strong and have continued to accelerate. We've talked about the fact that for 7 straight years, we've had positive net flows in the business. And a big contributor to that is also our deposits. So deposits, although they were a bit lighter in the second quarter than they had been over the last couple of quarters. We generally have seen strong overall recurring deposits. And we think that there are a number of factors that are contributing to that. One is, I talked about increased wage inflation, and we think that, that it's getting everybody's salaries up. And therefore, they are putting more money to work in terms of long-term retirement savings. The second thing is that employers are actually increasing contributions to try to just improve their overall retention of employees. And the third thing is that we're continuing to see some rollover into the business as employees are being hired away from one employer and coming into our new plan. And so that's all very much supportive. We also feel really good about the fact that although our retirement business relative to a number of our competitors is fairly small, about $100 billion of assets under management. We're really able to compete. So our ROAs are right in line with the largest of the overall competitors. And we think that one of the reasons here is that we really, the RPS business gets to leverage the rest of the organization for expense efficiencies as an example, for IT. And it's one of the reasons why we hear over and over again, one of the reasons why we think our retention is so strong is that the customers that work with us really like the value proposition of high touch, high tech. And it's really that combination of knowing that they have a person that they can work with to support retirement plan services and also they have all of the technology capability as well. The earnings, I should also add, we expect that -- and we've talked about the fact that this business is starting to move into spread expansion that we think that we can see even further earnings acceleration coming from the retirement business in the future.

Excellent. And I come to appreciate that your Spark program is not just about cost savings. Can you discuss the innovation, agility piece that may dovetail into revenue synergies?

Yes. So I was actually -- for 18 months before we rolled out the Spark program and talked about the expense saves with all of you, I was one of the co-sponsors of the enterprise-wide initiative. And this is a very exciting internally at Lincoln overall project that we are working on. We've never done something at this scale. And a big part of what we did, first of all, is we had about 1,000 people inside of the organization that we're focused on idea generation around where there were opportunities to be more efficient, to innovate, to think about new strategies, to support modernization of technology, et cetera. And out of those 1,000 people came 150 initiatives that were all prioritized and aligned to the business strategy. A big portion of what we are doing, and we've talked about the cost saves is we're making a substantial direct investment in the business. And some of the goals are really to modernize technology. There is inside of these initiatives, we are really completely strategically revamping the overall strategic operational efficiency of our technology organization. And then there are a number of employee experience opportunities here as well. So an example of that is that we've just launched a firm-wide recognition program that we call shout-out, where employees when they have accomplished something and they've done well, they have a reward. They have opportunities to go to leadership development boot camps, mobility opportunities. And so all of that has a lot of excitement and momentum inside of the organization. And most importantly, one of the things that I've said is that I really think that Spark at the end of the day, it provides a framework for us to be able to execute more quickly. And so it is making us -- it's building a muscle for us so that we can develop products faster so that we can think about optimizing the in-force in a quicker way because the systems are able to ultimately respond faster. We've got more automated processes. We have people that have been trained with skill sets that we need for the future as well. So I couldn't be more excited about that. I spent the day yesterday with our technology leaders, and they really are right at the center of this and focused also on the long-term opportunities as it relates to innovation.

Excellent. Maybe it's a good time to pause and see if there are any questions in the room. We do have some mic runners. If anyone has a question, please raise your hand.

[ Al Grismer from Millennium ]. It's good to hear you reiterate your EPS growth target, and you mentioned some of the drivers. But I also think capital return is an element of that. And there -- on the last quarter call, there was some concern around an assumption review that you're doing this quarter. And so if you could just provide some insight into how the potential impact of that and what it could do for capital return next year? Or if you are confident in that guide that there's not going to be some drag or impact from the assumption review, if you could talk about that. I think it would be helpful.

So you all know that -- and you've heard us talk about this that we cannot speak to third quarter or third quarter unlocking inter-quarter. So what I can share with you is that just like we do every year, we're in the middle of our overall assumption review process. It's a process internally that starts with our actuaries. And part of what our actuaries are doing is they are reviewing our own experience. They also will look at any industry experience as well that could potentially be additive to that. And you have heard and you know that we did participate in the industry study that was cited on one of our competitors in terms of that negatively impacting their overall results. That would simply be an input for us as would many other factors as we look at overall experience. And we're looking at a broad range of as we do every year of our policyholder behavior, so that's our mortality, our morbidity, our lapse assumptions, our capital market assumptions. And we will look at that and determine whether or not based on the best estimate, there's a need to make any changes to the overall assumptions and whether or not that would impact us on the GAAP side. Now in particular, the place where we know that a competitor took a write-down in the second quarter because they do second quarter unlocking. And they talked about the fact that when they look from GAAP to STAT that they were expecting from a capital perspective to see a 1-for-1 impact. So for us, when we look -- first of all, when we translate assumptions from GAAP to STAT, the assumption STAT, if we believe that lapses and the experience go forward for lapses should change, it would be consistent. The assumption change in and of itself would be consistent from GAAP to STAT. GAAP reserves and the GAAP process is set based on best estimates, statutory reserve process is different. On STAT, first of all, there are base reserves, and those base reserves are basically set and they would not at all be altered by any assumption setting process. Additionally, there are a couple of tests that need to occur on the statutory side on an annual basis. One is adequacy testing, that's cash flow testing. And so that's an aggregate test. And then there are also specific tests for portions of the GUL business, and that's an 8C and an 8D test. For us, these particular subtest, 8C, and 8D, which would utilize assumptions and be projection based. Last year, when we looked at those tests, we had a cushion there. And with interest rates being higher than they were a year ago, we would expect that there would be even more of a cushion as a result of higher capital market environment. So I want to give that to you as a backdrop and then our expectation of what we believe at this point in terms of the overall capital return as it relates to that overall EPS growth. We'll be able to share more of that with you as well in our third quarter call. But we do have assumptions, of course, that are inside of that EPS growth that are getting us to that 8% to 10%.

Okay. Doesn't look like there's any other questions in the room, but I thought this might be a good time to pull up our audience response system. So we're going to pull up some questions. So the first question is, if you don't currently own chairs of Lincoln, what will cause you to change your mind? Would it be higher interest rates, steeper yield curve, greater diversification, sources of earnings, higher or more consistent free cash flow generation, reinsurance transaction or a lower valuation? Okay. So overwhelmingly, it is the third bucket, higher or more consistent free cash flow generation.

Good. So we know we're focused on the right thing.

Okay. Maybe we'll go on to the next question. My confidence that Lincoln's operating ROE, ex AOCI will be 10% or higher in 2023. Maybe the last questions. My confidence in Lincoln’s ability to graduate from spread compression to spread expansion is. Great.

Good.

All right. I guess with that, we should thank Ellen for this fireside chat, if one could give a round of applause.

Thank you. Thank you to all of you and more to come from Lincoln over time. So it's great to be in front of all of you today. Really appreciate it. Thank you, Tracy.