Lincoln National Corporation (LNC) Earnings Call Transcript & Summary

All right. I think we're good to go. So for our next session, I've got Ellen Cooper, President and CEO of Lincoln Financial Group. So first, I'd like to just say thank you for being here. Very much appreciate it. And I think we'll start with me opening it up to Ellen to make some introductory comments, and then the session will be Q&A. I'll run through a series of questions. So with that, I will open it up to you.

Great. So thank you, Alex. And I want to start, first of all with acknowledging the fact as you all know, that the third quarter was a difficult quarter for Lincoln, and it has been a challenging year in general. And we are really focused on targeted actions to repair the balance sheet, and it's going to take some time. So, most importantly we have a team of leaders, a number of new leaders, and we are fully focused on execution and execution of the strategic objectives as I have outlined them. So that includes improving capital generation and distributable earnings, reducing our capital volatility to capital markets and further optimizing the business mix. We outlined a number of strategic actions in our third quarter earnings call, and I am pleased that we have had a successful preferred equity issuance of $1 billion. And additionally, in the last couple of weeks, we have put on a partial tactical hedge on the in-force VUL that has caused us to have some RBC negative impact to mitigate some potential additional impact if there was to be some equity market decline. We still have more work to do. And in particular, we have more work to do as it relates to the in-force life insurance business. But as I put this all together, I just want to remind all of you, and I think that the preferred equity issuance really goes to the fact that we have a strong business model. We have strong distribution. We're known for our overall strong product manufacturing. We've got a really high-quality investment portfolio. We have ways to organically generate capital and do it effectively and we're going to continue to do all those things as we focus on the overall repair of balance sheet and the overall situation as it relates to Lincoln. And with that, Alex, I'll turn it back to you.

Okay. So maybe we could start with something you touched on briefly there. Could you provide more details around the RBC rebuild? Where you are today after the preferred issuance? And how does it ultimately impact the timing of being able to return to share repurchases?

Absolutely. So we raised $1 billion of preferred equity and again, we were very pleased with that and the overall demand. And as we had mentioned, $200 million of the $1 billion will be held up at the holdco and will be put aside with an additional $300 million that already sits there to be able to cover a debt maturity that we have in the third quarter. The additional $800 million will be pushed into the life companies and will effectively add an additional 30 points of risk-based capital to the earlier projection that we had provided to you to end where we were expecting to end the year with RBC of 360. While we know that we said that we were raising this preferred equity to be able to provide an additional cushion as we know that we've got uncertain macro headwinds. And in the event that there are really potential additional macroeconomic headwinds that impact us that are beyond what we can perceive today. So, while we do that, we also are going to focus on improving the overall risk-based capital, continuing to do all the things that we talked about around capital generation and improving the overall distributable earnings. And as part of that also, we also are going to focus on reducing the overall financial leverage ratio. So, you put that all together, and we expect that we will be pausing share buybacks through the end of 2023. And in due course, as we continue to execute on all of the items that we talked about, we will be able to provide more around how we think about restarting our overall repurchase program at the end of that rebuild period.

Got it. Can you explain what's been happening with capital distribution, distributable earnings in 2022?

Yes. So, as I mentioned upfront, 2022 has been a really particularly challenging year for us. Before 2022, we had communicated to all of you that we were generating capital around the $2.4 billion level. And additionally, we were taking about $1.5 billion of that capital, and we were allocating it to new business. Now obviously, this year, we have been very pressured, and we have talked about the fact that our risk-based capital has been reduced by 67 points. So for us, a reduction of 67 points equates to about a minus $1.6 billion. So you can effectively think of that as the distributable earnings projected for 2022. So obviously, significant pressure. And so why? Well, we outlined a number of these things in our third quarter earnings call, and I'm just going to highlight them again now. The primary drivers of the pressure that we experienced in 2022 are coming from the in-force of the Individual Life business. And there are a number of areas there. The first one, as we all know, is the impact of the unlocking and the lapse assumption impact to our statutory reserves and in particular, the AC reserve that increased our statutory reserves by 550 points. That obviously was very significant. The second is that we continue to experience some level of COVID claims in 2022. But the third area is really around a negative distributable earnings profile in the life business. And it really is -- there are a number of drivers in here. One is that with the equity market declines that we experienced in 2022, we saw a pretty significant increase in reserve accruals in our in-force VUL portfolio. The second is around negative cash flow from the VUL in force that was not impacted at all by the Stat reserve impact. And then a number of other things, increased reinsurance costs, decline in overall statutory earnings as a result of previous block transactions. And then also some of the in-force products that are in the portfolio as a result of principal-based reserving, we're also in a negative distributable earnings, namely Term Life. And so those are really some of the primary factors that drove us to this overall negative result. And I also want to highlight that in 2022, with the strong sales that we've seen across the businesses that we have allocated about $1.4 billion, so pretty close to what we have done in the past to new business capital allocation.

Got it. And as we look forward to 2023, how do you see capital generation to distributable earnings developing over the next year?

So, as we look to 2023, we believe that the picture will be significantly improved from 2022, but will still be under a fair amount of pressure relative to the previous numbers that I just outlined. Some of the primary drivers of that pressure, again, are coming from the individual life business. And so, within the Individual Life business, all of the items that I just highlighted will continue to provide pressure as we move into 2023. We expect to see even a further pressure from increase in reinsurance cost. And the other thing that we also will see as we move into 2023 is that some of the duration extension programs, in particular, that we put in place in the life business as in the low interest rate environment, will have some level of spread compression, additional pressure in 2023 that will further highlight that. Some additional pressures across the org outside of individual life, there really are 2. One is we told you we will pause any dividends coming from LNBAR, and so that's the pressure. And the second thing is that we do expect as we move into 2023, that we're going to see some increased pressure as it relates to expenses and some -- particularly tied to inflation. And so a couple of examples of that are some pressures around pension and benefit costs. So you put all that together, those are the pressures. We also have some positives. So we talked about the fact that we are fully focused on improving how we think about allocating capital to new business. And remember, recall, I said $1.4 billion that we allocated this year. So we believe that optimizing the present value of distributable earnings per unit of capital that we can free up next year about $200 million to $300 million of capital. And while we do that, we can maintain a very robust amount of sales, and we'll talk a little bit more about this later in further detail. But additional places where we see some real improvement. So we talked about the fact that with interest rates higher as we move into next year, we would expect to see a pretty substantial amount of that $80 million reserve released in 2023. So potentially, maybe about half would be another example. We've been talking to you all about the Spark initiative. We're about 18 months into it. We haven't seen any run rate savings yet because we've been investing in that. But next year, we expect to see about $60 million to $80 million of the run rate savings in 2023, and we are on target to produce run rate savings by the end of 2024 in the $260 to $300 million range. And we are very much on track and very encouraged in terms of our Group Protection margin and really moving to the 5% to 7% range and really being able to stabilize at those levels. And as you all know, we have a new leader there that has deep group protection experience, and I'm really encouraged in terms of the future trajectory there. So you put all those pressures and all of the positives together, and here's how it is adding up. We expect, as we move into 2023, assuming some level of stable market conditions that our capital generation will be in the range of $1.7 billion to $1.9 billion as we move into next year. We also believe that our distributable earnings will be somewhere in the range of $600 million to $800 million. as we move into 2023. Out of that distributable earnings, we do have a couple of capital needs. One is the shareholder dividend and the other is our debt interest cost, which will include the preferred equity coupon on the preferred that we just raised. So again, a better picture. We've got work to do to get back to the levels that we were in prior to 2022.

That was really helpful. As we think about the GAAP operating impacts of the Life business, would any of that be consistent with what you're seeing on the statutory side.

So Alex, yes, it would be. So we do -- we are in the process right now of working through our overall 2023 financial process, and we'll have more to be able to communicate to all of you in our fourth quarter earnings call. But as we are working through some of the pressures that I just highlighted, we'll be consistent in terms of the impact to GAAP operating results, namely the further increase in reinsurance cost, the further pressure on the life business as it relates to the spread compression that I just mentioned. And then, of course, the overall increase in expenses that we're seeing as we move into 2023. So the bottom line is that some overall pressure to the overall headline GAAP operating earnings too early to be able to provide a range. And as soon as we have our arms around that, we'll be able to communicate that.

So what does lower new business capital imply for sales growth and distributable earnings. As you shift to a more capital-efficient product strategy, how are you ensuring that you're maintaining your competitive edge and distribution?

We pride ourselves on the strong distribution franchise that we have and also our competitive positioning, which we have in all 4 of our businesses. We have built a range of diversified products, and it is really the distribution leadership that supports the overall success in terms of sales. We believe that we can optimize to present value distributable earnings per unit of capital, and I'll describe to you what this means in terms of changes without any disruption and that we can maintain a robust level of sales across all 4 of our businesses. So if I step back for a minute, several years ago in the very low interest rate environment, we moved to overall product strategy where we were focused on repricing to make sure that we were meeting or exceeding all of our target returns. We shifted into customer value propositions that had more risk sharing that had lower guarantees, and we also added a variety of new products. This was clearly all the right idea, and we have improved our capital efficiency along the way while maintaining sales. We're looking to take that to its next level by really maximizing, by really focusing on those products that are maximizing present value of distributable earnings per unit of capital. And so when we look across the businesses and all the products, first of all, we are going to maintain the complete diversification that we have. There will be no product in any one of our businesses that will be pulled from a shelf, for example. What we will be doing is we will be tilting into places where we have proprietary products, proprietary options or features inside of the product. And in those particular cases, those products are simply less price sensitive. And so those are examples, and we will be stepping away from places where we are simply more price competitive. So an example of that would be in certain pockets of term life, in particular, those that are more digitally enabled that are not really using the power of our distribution to be able to support really the more complex protection products that we offer. And so those will be places where we will be stepping back somewhat, but not at all away from the overall distribution franchise. Other places where we will be stepping in is we expect to be doing more, for example, in the group protection space, where we have been focused on employee paid, where we have been focused on supplemental health and also where we have been focused more on continuing to grow down market. So those are some of the examples of places. So you put it all together, and we firmly believe, as I mentioned in an earlier question that we can free up in the range of $200 million to $300 million of new business capital we can -- and while we're doing that, improve the distributable earnings profile for '23 and also going forward.

Could you talk about the outlook for block reinsurance deals? How could that potentially impact your strategy?

Yes. So, we are fully focused on solutions to maximize the value of the in-force business. And one of those potential solutions is to look at possible block transactions. And so, we have talked in the past that we have staffed a team that is fully dedicated 24/7 to looking at potential opportunities. If we were to find an opportunity, we would be looking for an opportunity with a much wider lens than transactions that we have done in the past. And when we say that, what we mean is that we will be looking for risk transfer opportunities that would really support the goals that I outlined above. So something that could improve capital generation, distributable earnings, something that could reduce potentially capital volatility to capital markets and further diversify the overall earnings mix. We are very encouraged by the fact that there are more potential buyers out there and more potential buyers out there that are potentially looking at transactions that involve complex liabilities. If there was an opportunity at the right price and it involved some portion of SGUL for us, that would be a home run. But again, if it's not at the right price and there's no timing associated with any of this if it's not at the right price and it doesn't meet those overall objectives, then obviously, we wouldn't transact.

Got it. So you talked some about hedging both variable annuities and life products. Could you give us a summary of some of the changes you've made there and some of the changes that you're planning to make each program?

Absolutely. So when we think about hedging, first of all, I want to come back to the strategic objectives that I've outlined. And so one of the overall objectives as we think about our overall hedge programs going forward is the notion that we're going to utilize them to reduce capital volatility to capital markets going forward. So the first and most significant example is in our variable annuity with guaranteed benefits. So here, we announced a couple of months ago that we are shifting to a program where we will be hedging that will maximize the present value of distributable earnings for the overall VA block and will have an explicit statutory capital hedge. We are in the early stages of beginning the transition to this hedge program, and we expect in the first quarter that we will be fully completed in terms of the overall transition. And part of what it will do is that at the same relative hedge cost as the current program, -- what it will do is it will -- when markets are down, it will provide support, particularly to capital. And we will essentially really experience -- expected experience less capital volatility in an equity market downturn as a result of having this explicit hedge and really more levelized distributable earnings across a range of economic scenarios going forward. The second area is that I highlighted the fact that in our in-force guaranteed VUL portfolio that we experienced some pretty significant reserve accruals this year as a result of the equity market decline. What we have done there is we have put in an initial tactical partial hedge that will mitigate potential capital volatility for a relative market move. We still have more work to do. And part of what we will be looking at as we go forward is a solution that will do the same thing on the VUL side as what we've done on the VA side, and that is to maximize the present value of distributable earnings with an explicit capital hedge. So more work to do. Again, both of these programs will really serve to support the strategic objectives as we've outlined them.

So on the earnings call, you described the update to the GUL lapse assumption is a reset. Can you give us a bit more color around why we should have confidence there's not more to come on the assumption front? And maybe more broadly, are there other areas where you have high sensitivity to assumptions?

Absolutely. So when we think about assumptions, first of all, we have a robust process that occurs in the third quarter every year where we evaluate across all 4 businesses across life, annuity, retirement and group protection, all assumptions in all in-force products. That includes capital markets, and it includes all policyholder behavior assumptions as well. So that would be mortality, it would be morbidity. It would be lapsed as examples. Over the years, our focus by the way, and the objective of the assumption setting is to set assumptions based on best estimates go forward. And the process is very robust. It uses our own internal experience. There are times when we will lean into industry studies that will further support an assumption. Sometimes they do, sometimes they don't. It depends on the overall product level and the overall relevance to our particular product portfolio. I would really highlight that there are 2 products in particular that have longer duration and really more variability as it relates to overall policyholder assumptions. The first one we just talked about, and that's VA with guaranteed living benefits. Here, we have been in this particular product for decades. The overall performance of the VA portfolio has been excellent. Over the years, as we have evaluated the best estimate of all of the assumptions associated with VA, there have been some minor experience adjustments as it relates to policyholder behavior, but nothing that has been material. And the other area, as you all know, where there is really longer duration, material assumption risk is in the VUL portfolio. And so you all know that as we evaluated that this particular year and as it relates to best estimate, a couple of points that I will draw you to. One is that in 2022, in terms of our own internal experience around older ages and longer policy durations, our experience in the last couple of years had more than doubled to support what we were seeing. And additionally, with the industry study, we then had 7x the amount of information than what we had had just a couple of years prior. And so, you can see from the magnitude of the charge, $1.8 billion for the lapse assumption that clearly that was a sizable impact. We feel that this is our best estimate go forward and that it very much supports again the overall process as it relates to the assumption setting and the governance and oversight that we have.

So the next question I had was on the LNBAR subsidiary. I was hoping you could help us get a better understanding of what the subsidiary is and help us with how much confidence we should have in it. Sure.

So our LNBAR subsidiary, houses, first of all, our variable annuity guarantees. So all of our hedging occurs there. We've had LNBAR in place now for decades and really part of what it has done is it has supported capital volatility through time. To give you a sense and to help you get comfortable when the rating agencies are reviewing our overall capital position, they are looking on an overall consolidated level at all of our business, including LNBAR. And we had messaged to you in the third quarter that because of the significant capital volatility, we had experienced this year a fair amount of hedge breakage. And that, that hedge breakage had us in LNBAR below our overall target level. And so we believe, first of all, that we can rebuild this capital organically. Our action here is that we are going to pause our dividends in LNBAR, and we will do that through 2023, and we will take a look at what we do go forward as we rebuild that capital through time. And additionally, we are putting the new hedge program in place so that the next time we see an equity market downturn, we do not expect to be in this position again.

Can you talk about the ratings action we talk about third quarter and any implications that has your ability to do business?

Yes. So the rating agencies had a holistic view of our capital position of our action plan of our intention and plan to raise the preferred as well as they evaluated. And as you all know, we had 2 agencies, S&P and A.M. Best, where we received a one notch downgrade with a stable outlook. And we had 2 rating agencies, Fitch and Moody's, that affirmed our ratings, but put us on negative outlook and really highlighted that the reason for the negative outlook was as a result of our capital position. And we've spent the entire morning talking about all the things that we're focused on there. We recognize that we are fully focused on the replenishing of our overall capital. While we are with these ratings and these outlooks at this particular time, we firmly believe that we can continue to maintain our competitive positioning. We've got strong distribution franchise. We've got solid products, and we're going to continue to execute effectively as we are working through all of these challenges and as we are working through with the implications from the rating agencies.

Next, can you talk about your positioning for a potential recession, particularly as it relates to the credit portfolio.

Yes. So I want to highlight also that when we mentioned the preferred equity that we specifically said that this for us was to be thought of as an additional cushion in the event of macroeconomic environment, headwinds beyond what we can see today, and that's important. Additionally, when we start thinking about the probability of a recession, the first thing that we think about there is that in a recession, we typically will experience credit losses and overall deterioration in the credit portfolio that will put further stress on our capital position. So a couple of points to highlight there as it relates to credit for Lincoln. Number one is that the investment portfolio is the highest quality that it's ever been. 97% of the overall portfolio is investment grade. Over the last 6 plus years, we have been focused on name-by-name de-risking of individual securities that had the potential to have some type of meaningful credit deterioration in the event of a downgrade. And so we feel very good about that. Additionally, we utilize external managers and our external managers support us in regular name-by-name stress and scenario analysis across the entire portfolio. We have looked at a range of potential scenarios of what this recession could look like. Of course, we don't exactly know, but a range. And based on the portfolio and based on that range, we believe that any recessionary environment for us in terms of the credit implications would be manageable. And then I just want to remind you that in the event that we do find ourselves in a recession that we do have contingent capital, that we do have ample liquidity up at holdco, should we need those levers, hopefully not, but should we need they are there.

Next on Group Protection. I think you mentioned that you have an expectation to get back to the high end of the margins. Can you talk about some of the drivers of what you get you there?

Absolutely. So as we think about the Group Protection business, first of all, we have been very focused on really building our GP margins into the 5% to 7% range and stabilizing them. There really are 3 areas that we're focused on here. One is around product and pricing actions, and we have been well on our way. As you all know, the cases, the in-force in Group Protection book are repriced about once every 3 years. So we have the opportunity to reprice the book to reprice the book, including what we expect in terms of go-forward COVID and additional margin. Secondly, we are very focused on the effectiveness of claims management, and there are a number of actions that we're taking here. Number one is working with employers to get employees back to work more quickly. And there are lots of ways, especially now in a hybrid work-from-home environment that we expect to see increased success here. Improving the transition from STD to LTD from short-term disability to long-term disability, we believe that there's effectiveness there. And also, our model in terms of staffing up and down based on the demand required in claims would be another place to improve the effectiveness. And the third area is around Spark and expense efficiencies. And we have a number of areas in place where we are building out self-service capabilities, improving places where we have manual processes and operating processes to really lower the overall expense base. Put all that together, and additionally, what I highlighted earlier around continued focus on the employee-paid market on supplemental health and also continuing to increase our focus on the smaller end of the market, those are areas that we believe will really ensure us in terms of growing and stabilizing the GP margin.

So you mentioned the Spark initiative earlier in the conversation. So I think you touched on this a little bit already, but could you help us think through how that looks in terms of contribution and distributable earnings over the next couple of years?

Yes. So the Spark initiative is a firm-wide expense initiative is really focused on technology modernization. It's focused on streamlining and automating processes, improving the customer experience, improving the overall employee experience as well. And so we put all that together and in terms of its overall expense contribution, we have achieved, by the way, about 45% already in the last 18 months of our goal of a run rate of $260 million to $300 million of expenses by the end of 2024. And as I mentioned upfront, $60 million to $80 million expectations in 2023. We have about another $120 million to $150 million in addition to the $60 million to $80 million that will come into play in 2024 and then the bulk of it through the end of '24. And not only will we have the expense saves, but we also really believe that this will enable us to be more agile, more technologically efficient. Some of the very much necessary skill sets that we need as we think about our future and really continuing growth.

So, we've got a little bit of time left. Is there anything else that we haven't covered that you'd like to speak to?

So I do think that we've covered quite a lot. I want to reinforce a couple of points for all of you. We do believe that we have a solid business model. Yes, we have our challenges in the life insurance business. I want to reiterate the fact that we have a number of new leaders in place. We are fully executed on our -- we are fully focused on executing in terms of our overall goals. We are really focused on everything that we need to do right now to improve the overall distributable earnings and capital generation, and we will continue to communicate to all of you as we are continuing to make progress and also as we can provide more guidance to all of you to really better understand us.

Great. Well, I think we're just out of time. So I will leave it there. Thank you very much for joining us.

Thank you, Alex.

I appreciate it. Thanks.