Lincoln National Corporation (LNC) Earnings Call Transcript & Summary

Good afternoon, and thank you for joining Lincoln Financial Group's conference call. [Operator Instructions] Now I would like to turn the conference over to the Vice President of Investor Relations, Al Copersino. Please go ahead, sir.

Thank you, operator. Good afternoon, and thank you for joining us on short notice. This afternoon, we issued a release announcing our reinsurance transaction with Fortitude Re. Before we begin, I have an important reminder. Any comments made during the call regarding future actions, performance or financial results, including the expected timing and impacts of the reinsurance transaction and our expected estimated first quarter 2023 financial results are forward-looking statements under the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from current expectations. These risks and uncertainties include those described in the cautionary statement disclosures in our press release issued today as well as those detailed in our 2022 annual report on Form 10-K, most recent quarterly reports on Form 10-Q and from time to time in our other filings with the SEC. These forward-looking statements are made only as of today, and we undertake no obligation to update or revise any of them to reflect events or circumstances that occur after this date. Today's call may include a discussion of certain non-GAAP financial measures. Full reconciliations of such non-GAAP measures, including adjusted income from operations or adjusted operating income and their most comparable GAAP measures can be found in our press release issued today or the statistical supplement posted in the Investor Relations section of Lincoln's website, www.lincolnfinancial.com. Presenting on today's call are Ellen Cooper, President and Chief Executive Officer; and Chris Neczypor, Executive Vice President and Chief Financial Officer. After their prepared remarks, we will move to the question-and-answer portion of the call. I would now like to turn the call over to Ellen.

Thank you, Al. Good afternoon, everyone, and thank you for joining us on short notice. I am pleased to announce that we are partnering with Fortitude Re to reinsure approximately $28 billion of our in-force business, which includes blocks of universal life with secondary guarantees, MoneyGuard and fixed annuities. This transaction is squarely aligned with our enterprise strategic objectives and advances our goals of strengthening our balance sheet and enhancing our ongoing pace of capital generation. I have said that we will act if we find the right opportunity at the right price to create value for shareholders, and this transaction provides all the elements that we have been prioritizing in a deal. It improves the risk profile of the balance sheet. It frees up capital on day 1, and it increases ongoing free cash flow, particularly in the life insurance business. While there will be a dilutive impact on GAAP earnings, which Chris will elaborate on shortly, and benefits I just highlighted outweighed this impact, and this transaction is in alignment with our enterprise strategic objectives. The transaction will have no impact on our policyholders or our long-standing distribution relationships. Going forward, we remain fully committed to our MoneyGuard and fixed indexed annuity products and our dedicated employees will continue to provide customer service and policy administration on ceded blocks of business. As we look at our business overall, and as I have mentioned in the past, we are focused on growing profitably through leveraging our distribution leadership and broad product portfolio to deliver a more capital-efficient new business mix. While we are focusing on the block transaction on today's call, given the proximity to our earnings release date, we announced preliminary first quarter earnings results. We will be back to you next week to discuss our first quarter performance more fully. We expect total company adjusted operating income of between $1.47 and $1.56 per diluted share available to common stockholders. These results reflect the 2023 headwinds we have previously discussed, such as higher expenses and lower prepayment income and in life insurance specifically, also higher reinsurance costs and lower base spreads. We also expect to report a net loss in the first quarter, driven by the impact of new accounting for market risk benefits, which are subject to quarter-to-quarter fluctuations. And as we have discussed with you, will drive more noneconomic volatility. Chris will elaborate on these results in a moment, and we will go into more detail on our earnings call next week. Importantly, our first quarter earnings do not impact our 2023 free cash flow expectations as these headwinds were contemplated in that original commentary. We expect the earnings power of our business to come through more materially in 2024 and beyond as a number of these headwinds begin to dissipate or be offset by larger positives. In summary, this landmark risk transfer transaction aligns with our strategic objectives, brings us close to our near-term goal of an RBC ratio of 400% and reduces balance sheet risk. In the past few months, we have been moving rapidly and have already made substantial progress in strengthening Lincoln's position for long-term growth and success. We concluded the issuance of preferred stock and fully reposition the VA hedge program to provide explicit capital protection, we are also reducing our new business capital allocation by $300 million in 2023 while continuing to produce a robust level of sales across our 4 businesses. We are pleased with this transaction and the many benefits it provides and remain confident in our ability to execute on our priorities and position our business for profitable growth to create long-term sustainable value for our shareholders. I will now turn the call over to Chris, who led the team responsible for executing this transaction to take you through the financial highlights.

Thank you, Ellen, and good afternoon, everyone. Before discussing the financial impact of the transaction and our preliminary results in more detail, I'd like first to say how pleased I am to be speaking with you today in my new role. There's tremendous opportunity at Lincoln to drive long-term profitable growth across the enterprise, and I'm excited to be leading the finance organization during this critical time and to be partnering with the rest of Lincoln's leadership team. Turning to the transaction. The block reinsurance deal announced today marks meaningful strategic and financial progress and is the direct result of our work over the past year. After receiving strong interest and engaging with multiple parties, we conducted a comprehensive bidding process and are pleased to be partnering with Fortitude Re. The transaction represents a pivotal step in our journey to create value for shareholders. It significantly reduces our exposure to universal life with secondary guarantees and lowers our invested asset leverage. In addition, it builds on our efforts to enhance our capital position and increases ongoing free cash flow. Let me now walk you through the details. The $28 billion reinsured block is comprised of the following: $9 billion of universal life with secondary guarantee reserves, representing about 40% of Lincoln's ULSG in-force; nearly $12 billion of MoneyGuard reserves, representing about 80% of our MoneyGuard in-force; and nearly $8 billion of fixed annuity reserves, representing about 40% of our fixed annuities in-force. The transaction is structured as a coinsurance treaty for the universal life and fixed annuity blocks and as coinsurance with funds withheld for the MoneyGuard block. The agreement includes robust counterparty protections, including a comfort trust, over collateralization and investment guidelines to meet Lincoln's risk management objectives. And as I mentioned, a meaningful portion of the transaction is in funds withheld form whereby Lincoln will hold the assets on behalf of Fortitude associated with the reinsured liabilities. Lincoln will retain administration and recordkeeping of the policies as well as full ownership of our relationships with and commitments to our distribution partners and policyholders. We expect the transaction to close in the second quarter. Turning to the benefits of the transaction. First, the transaction reduces balance sheet risk by decreasing our in-force exposure to long-term assumption risk associated with ULSG and by lowering our asset leverage. Second, we expect the RBC ratio to benefit by 15 points at closing. This benefit consists of a release in required capital, offset by a negative ceding commission of $375 million and other tax implications. In addition to a near-term goal of returning to an RBC ratio of 400%, we have also discussed the importance of lowering our financial leverage, and this transaction will provide us with additional flexibility to strengthen our balance sheet. Finally, we expect the transaction to increase our free cash flow by over $100 million per year. In the past, Ellen has highlighted some of the headwinds to free cash flow generation from our life insurance business, and this transaction helps to mitigate those headwinds. Let me now turn to the financial impacts on a GAAP basis. We expect the transaction to impact adjusted operating income by approximately $150 million on an annual basis or a negative quarterly run rate impact of $30 million to $35 million in our Life Insurance business and $5 million in our annuities business. At current interest rates, we expect the deal to have an immaterial and initial impact on stockholders' equity ex-AOCI. Going forward, there could be volatility in the funds withheld portion of the portfolio as Fortitude repositions the assets. As I mentioned, the deal includes investment guidelines to meet our risk management objectives, including a limit on the amount of asset churn. Taking a step back and weighing the positive impact to free cash flow with the negative impact to GAAP earnings, this transaction aligns with our strategic objectives and creates long-term value for shareholders. In addition, as Ellen mentioned, we provided preliminary first quarter results this afternoon. We expect adjusted operating income available to common stockholders of between $250 million and $265 million or $1.47 to $1.56 per share. Included within these results in our Life business, we expect an operating loss of between $23 million and $8 million. The decline relative to the prior year period is a result of LDTI, the ongoing impact from the third quarter 2022 unlocking, higher expenses, lower [ alternate ] prepays and spread compression. On a GAAP net income basis, we estimate a net loss available to common stockholders of between $919 million and $904 million or $5.43 to $5.34 per share. This estimate includes unfavorable impacts from the new accounting for market risk benefits or MRBs, as a result of the recent adoption of LDTI, including a portion of the MRB and hedge instrument fair value changes, which sum to approximately $1 billion. The estimated net loss excludes a favorable MRB related item that flows through accumulated other comprehensive income of approximately $1 billion and which roughly offsets the combined MRB and hedge instrument fair value impacts on total stockholders' equity. We expect to end the first quarter with an estimated RBC ratio of between 377% and 380%. Despite credit market turmoil in the first quarter, our investment portfolio performance remained solid. Finally, we expect our financial leverage ratio to be about flat sequentially. Overall, we remain confident in our ability to drive profitable long-term growth, particularly as we look to 2024 and beyond. In summary, I am very pleased that we have reached an agreement with Fortitude Re that demonstrates our commitment to executing on our strategic objectives. This transaction helps further derisk our balance sheet, improves our RBC ratio and generates incremental ongoing free cash flow. It represents a significant step in our journey to address the pressures in life insurance as we look at further opportunities to enhance the capital generation of the business. I will now hand the call back to Al.

Thank you, Ellen and Chris. We will now begin the question-and-answer portion of the call. [Operator Instructions] With that, let me turn the call over to begin Q&A.

[Operator Instructions] Our first question comes from the line of Tom Gallagher with Evercore ISI.

First question is, Ellen, does this change the timing of when you would expect now to get to kind of a capital level at which you believe you'd be in a position to start to resume share repurchase. Maybe talk a little bit about, does this change your view on leverage at all? It sounded like it's not going to affect book value, but this quarter, there was a hit-to-book value based on the new accounting. But talk a little bit about the level of debt reduction that would still need to come and kind of maybe timing and whether this accelerates from your prior plan?

Sure. So Tom, thank you for the question. And just as we step back and set context, so we previously communicated, first of all, a focus on executing across our strategic objectives. And those were maximizing free cash flow reducing our capital sensitivity to capital markets and also further diversifying the business mix. And I'm so pleased, first of all, that we have taken swift action. We've made substantial progress as we have rebuilt capital and we've increased our ongoing pace of capital generation. One of the examples of the things that we said that we were going to do as we moved into 2023 was deliver a more capital-efficient product mix, and that's across our retail and our Workplace Solutions businesses while we're maintaining a robust level of sales. And that will also require $300 million less in new business capital. So we also said at the same time that we had a fully dedicated deal team and that they had been actively evaluating internal and external opportunities for our in-force. And that included possible block transactions to advance our strategic objectives and that we would transact if, in fact, there was the right opportunity at the right price to create value for shareholders. So we do believe that this deal accelerates our capital rebuild while also improving our ongoing pace of capital generation. So we're not in a position today where we're going to update our guidance as it relates to what we termed our near-term goal of 400% RBC. And I'm going to pass it over to Chris to talk about some of your additional points, Tom, around leverage and also around our long term -- our near-term goal of 400% RBC.

Tom, yes, so to follow up on Ellen's points, we're not in a position, as you said, to update guidance today. I do think that the transaction gets us closer to the near-term goal of 400% on RBC. I think there's 2 points worth noting. One, we've highlighted the goal of reducing our financial leverage, right, as you said. So we mentioned in the script, the transaction gives us more flexibility to strengthen our balance sheet. And so I would say with the increased free cash flow, we would certainly look to opportunistically address the leverage. So it's a big financial objective for us. The second thing worth noting, as Al mentioned, the 400% RBC is a near-term goal, right? So at the moment, we're fully focused on closing the transaction and bringing the balance sheet closer to that near-term goal. But I would say very simply is that we don't want to be in a position like 2022 again. And so we'll look to update you all with the longer-term view of targeted capital levels later this year. But at the moment, we're focused on closing the transaction and then looking at the financial leverage. I hope that helps.

That does. And just my follow-up is, is there something -- a little bit about the SGL block that's being transacted on the $9 billion. I thought if I remember correctly, that seems like it's less than 40% of your in-force and maybe it has to do with like the vintages that are being transferred. So anyway, is there something about the block that's actually being transferred, that has maybe different risk characteristics of the amount that you're going to retain? And also just to follow up on that is what is the pro forma amount of total stat reserves you'll have for ULSG. It didn't seem like the assets split exactly the 40%, but I might be wrong on that, but just wanted to check.

So, Tom, we can certainly follow up with you on the math. What I would say is the $9 billion that we're ceding is 40% of the net ULSG, which is about a $22 billion net reserve. So it's 40% in the assets as it relates to the different blocks wouldn't be that much different.

Yes. And in terms of the rate risk characteristics of the total universal life secondary guarantee block are pretty similar across the board. So as you can imagine, with a transaction like this, it's very complex. There are a lot of moving parts. And so the $9 billion right now is clearly what's part of this overall transaction, but know that the overall risk characteristics are really quite similar across this entire book.

Our next question comes from the line of Jimmy Bhullar with JPMorgan.

So first, just a question on the relief you mentioned on free cash flow from this deal. Can you detail what the mechanisms are, what is specifically helping free cash flow with this transaction?

So Jimmy, it's a good question. Thanks for the question. We're not going to get into the free cash flow characteristics by block. But I would -- what I would tell you is that Ellen has been discussing the negative free cash flow that we've been dealing with in our life business for the past couple of quarters, right? And so the main product there is the GUL block. Look, it's a challenging block for both us and the industry, as we've talked about at length, right? The cash flow strain is really due to a combination of low interest rates and with persistency and mortality pressures that have been building up over time, leading to additional reserve buildup. And so it's a very capital-intensive business with a negative cash flow outlook over the next few years. And so that's the main drag as it relates to the free cash flow. So by ceding that, you're removing a negative.

Okay. And that reserve build is obviously not through the maturity of the business because over time, it sort of eases. So it's more when you say it's free cash flow, it's not for the next 20 years or whatever for the next few years and then over time because the way the reserves would have built, there would have been more of a strain initially and then less of a strain going forward, right?