__________________________________________________________________________________________________________

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

 

FORM 10-Q

 

 

 

(Mark One)

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

 

For the quarterly period ended September 30, 2013

 OR

 

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

 

For the transition period from              to              

 

Commission File Number:  1-6028

 

 

 

LINCOLN NATIONAL CORPORATION

(Exact name of registrant as specified in its charter)

 

 

 

 

(484) 583-1400

(Registrant’s telephone number, including area code)

 

Not Applicable

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

 

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x    No ¨

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x    No ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):

 

Large accelerated filer x   Accelerated filer ¨   Non-accelerated filer ¨  (Do not check if a smaller reporting company)

Smaller reporting company ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes ¨No x

 

As of October 28, 2013, there were 262,347,187 shares of the registrant’s common stock outstanding.

 

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Lincoln National Corporation

 

Table of Contents

 

 

 

 

 

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1.  Nature of Operations and Basis of Presentation

 

Nature of Operations 

 

Lincoln National Corporation and its majority-owned subsidiaries (“LNC” or the “Company,” which also may be referred to as “we,” “our” or “us”) operate multiple insurance businesses through four business segments.  See Note 14 for additional details.  The collective group of businesses uses “Lincoln Financial Group” as its marketing identity.  Through our business segments, we sell a wide range of wealth protection, accumulation and retirement income products and solutions.  These products include fixed and indexed annuities, variable annuities, universal life insurance (“UL”), variable universal life insurance (“VUL”), linked-benefit UL,  indexed UL, term life insurance, employer-sponsored retirement plans and services, and group life, disability and dental.

 

 

Basis of Presentation

 

The accompanying unaudited consolidated financial statements are prepared in accordance with United States of America generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions for the Securities and Exchange Commission (“SEC”) Quarterly Report on Form 10-Q, including Article 10 of Regulation S-X.  Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements.  Therefore, the information contained in the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012 (“2012 Form 10-K”), should be read in connection with the reading of these interim unaudited consolidated financial statements.

 

Certain GAAP policies, which significantly affect the determination of financial position, results of operations and cash flows, are summarized in our 2012 Form 10-K.

 

In the opinion of management, these statements include all normal recurring adjustments necessary for a fair presentation of the Company’s results.  Operating results for the nine month period ended September 30, 2013, are not necessarily indicative of the results that may be expected for the full year ending December 31, 2013.  All material inter-company accounts and transactions have been eliminated in consolidation. 

2.  New Accounting Standards

 

Adoption of New Accounting Standards

 

Balance Sheet Topic

 

In December 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-11, “Disclosures about Offsetting Assets and Liabilities” (“ASU 2011-11”), and in January 2013, the FASB issued ASU No. 2013-01, “Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities” (“ASU 2013-01”).  For a more detailed description of ASU 2011-11 and ASU 2013-01, see “Future Adoption of New Accounting Standards – Balance Sheet Topic” in Note 2 of our 2012 Form 10-K.  We adopted the disclosure requirements of ASU 2011-11, after considering the scope clarification in ASU 2013-01, as of January 1, 2013, and have included the required disclosures for all comparative periods in Note 6 of this quarterly report on Form 10-Q. 

 

Comprehensive Income Topic

 

In February 2013, the FASB issued ASU No. 2013-02, “Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income” (“ASU 2013-02”), which requires enhanced reporting of such amounts either on the face of the financial statements or in the notes to the financial statements.  For a more detailed description of ASU 2013-02, see “Future Adoption of New Accounting Standards – Comprehensive Income Topic” in Note 2 of our 2012 Form 10-K.  We adopted the disclosure requirements in ASU 2013-02 as of January 1, 2013, and have provided the required disclosure in the notes to our consolidated financial statements.  We have prospectively included the required disclosures in Note 10 of this quarterly report on Form 10-Q.

 

Derivatives and Hedging Topic

 

In July 2013, the FASB issued ASU No. 2013-10, “Inclusion of the Fed Funds Effective Swap Rate (or Overnight Index Swap Rate) as a Benchmark Interest Rate for Hedge Accounting Purposes” (“ASU 2013-10”), which permits the Fed Funds Effective Swap Rate to be used as a benchmark interest rate for hedge accounting purposes under the FASB Accounting Standards CodificationTM (“ASC”) in addition to interest rates on direct Treasury obligations of the U.S. government and the LIBOR swap rate.  We adopted the amendments in ASU 2013-10 prospectively for qualifying new or designated hedging relationships entered into on or after July 17, 2013.  The adoption of ASU 2013-10 did not have an effect on our consolidated financial condition and results of operation.

 

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Future Adoption of New Accounting Standards

 

Financial Services – Investment Companies Topic

 

In June 2013, the FASB issued ASU No. 2013-08, “Amendments to the Scope, Measurement, and Disclosure Requirements” (“ASU 2013-08”), which provides comprehensive accounting guidance for assessing whether an entity is an investment company.  ASU 2013-08 requires an assessment of all the characteristics of an investment company through the use of a new two-tiered approach, which considers the entity’s purpose and design to determine whether it is an investment company.  As a result of applying the new criteria in ASU 2013-08, an entity once considered an investment company may no longer meet the new criteria to be classified as such, and, conversely, an entity not classified as an investment company under current GAAP may satisfy the criteria to be classified as such upon the adoption of ASU 2013-08.  If an entity is no longer classified as an investment company, it must discontinue the application of investment company accounting guidance and present the change in status through a cumulative effect adjustment to the beginning balance of retained earnings in the period of adoption.  If an entity becomes classified as an investment company, ASU 2013-08 should be applied prospectively with the effect of adoption recognized as an adjustment to opening net assets for the period of adoption.  The amendments in ASU 2013-08 are effective for interim and annual reporting periods in fiscal years beginning after December 15, 2013, with early application prohibited.  We will adopt the requirements in ASU 2013-08 effective January 1, 2014, and are currently evaluating the impact of adoption on our consolidated financial condition and results of operations.       

 

Income Taxes Topic

 

In July 2013, the FASB issued ASU No. 2013-11, “Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists” (“ASU 2013-11”) in order to explicitly define the financial statement presentation requirements in GAAP.  ASU 2013-11 provides guidance on the presentation of unrecognized tax benefits when net operating loss carryforwards, similar tax losses, or tax credit carryforwards exist.  The amendments in ASU 2013-11 are effective prospectively for interim and annual reporting periods in fiscal years beginning after December 15, 2013, with early application permitted.  We will adopt the requirements of ASU 2013-11 effective January 1, 2014, and will include the new disclosure requirements in the notes to our consolidated financial statements upon adoption.

 

3.  Dispositions

 

Discontinued Investment Management Operations

 

On January 4, 2010, we closed on the stock sale of our subsidiary, Delaware Management Holdings, Inc. (“Delaware”), which provided investment products and services to individuals and institutions, to Macquarie Bank Limited. 

 

Amounts (in millions) reflected in income (loss) from discontinued operations on our Consolidated Statements of Comprehensive Income (Loss) were as follows:

 

 

 

 

 

The income from discontinued operations for the three and nine months ended September 30, 2012, related to the release of reserves associated with prior tax years that were closed out during the third quarter.  In addition, the nine months ended September 30, 2012, included a purchase price adjustment associated with the termination of a portion of the investment advisory agreement with Delaware.

 

4.  Variable Interest Entities (“VIEs”)

 

Consolidated VIEs

 

See Note 4 in our 2012 Form 10-K for a detailed discussion of our consolidated VIEs, which information is incorporated herein by reference.

 

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The following summarizes information regarding the credit-linked note (“CLN”) structures (dollars in millions) as of September 30, 2013:

 

 

The following summarizes the exposure of the CLN structures’ underlying collateral by industry and rating as of September 30, 2013:  

 

 

Asset and liability information (dollars in millions) for the consolidated VIEs included on our Consolidated Balance Sheets was as follows:

 

 

 

For details related to the fixed maturity available-for-sale (“AFS”) securities for these VIEs, see Note 5.

 

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As described more fully in Note 1 of our 2012 Form 10-K, we regularly review our investment holdings for other-than-temporary impairment (“OTTI”).  Based upon this review, we believe that the AFS fixed maturity securities were not other-than-temporarily impaired as of September 30, 2013.  

 

The gains (losses) for the consolidated VIEs (in millions) recorded on our Consolidated Statements of Comprehensive Income (Loss) were as follows:

 

 

 

Unconsolidated VIEs

 

See Note 4 in our 2012 Form 10-K for a detailed discussion of our unconsolidated VIEs, which information is incorporated herein by reference.

 

We invest in certain limited partnerships (“LPs”) that operate qualified affordable housing projects that we have concluded are VIEs.  We receive returns from the LPs in the form of income tax credits that are guaranteed by creditworthy third parties, and our exposure to loss is limited to the capital we invest in the LPs.  We are not the primary beneficiary of these VIEs as we do not have the power to direct the most significant activities of the LPs.  Our maximum exposure to loss was $89 million and $92 million as of September 30, 2013, and December 31, 2012, respectively.

 

5.  Investments

 

AFS Securities

 

See Note 1 in our 2012 Form 10-K for information regarding our accounting policy relating to AFS securities, which also includes additional disclosures regarding our fair value measurements.

 

The amortized cost, gross unrealized gains, losses and OTTI and fair value of AFS securities (in millions) were as follows:

 

 

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The amortized cost and fair value of fixed maturity AFS securities by contractual maturities (in millions) as of September 30, 2013, were as follows:

 

 

Actual maturities may differ from contractual maturities because issuers may have the right to call or pre-pay obligations.

 

The fair value and gross unrealized losses, including the portion of OTTI recognized in other comprehensive income (loss) (“OCI”), of AFS securities (dollars in millions), aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows:

 

 

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For information regarding our investments in VIEs, see Note 4.

 

We perform detailed analysis on the AFS securities backed by pools of residential and commercial mortgages that are most at risk of impairment based on factors discussed in Note 1 in our 2012 Form 10-K.  Selected information for these securities in a gross unrealized loss position (in millions) was as follows:

 

 

 

 

 

For the nine months ended September 30, 2013 and 2012, we recorded OTTI for AFS securities backed by pools of residential and commercial mortgages of $23 million and $6 million, pre-tax, respectively, and before associated amortization expense for deferred acquisition costs (“DAC”), value of business acquired (“VOBA”), deferred sales inducements (“DSI”) and deferred front-end loads (“DFEL”), of which $1 million and $(31) million, respectively, was recognized in OCI and $22 million and $37 million, respectively, was recognized in net income (loss). 

 

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The fair value, gross unrealized losses, the portion of OTTI recognized in OCI (in millions) and number of AFS securities where the fair value had declined and remained below amortized cost by greater than 20% were as follows:

 

 

 

 

 

 

We regularly review our investment holdings for OTTI.  Our gross unrealized losses, including the portion of OTTI recognized in OCI, on AFS securities increased by $799 million for the nine months ended September 30, 2013.  As discussed further below, we believe the unrealized loss position as of September 30, 2013, did not represent OTTI as (i) we did not intend to sell the fixed maturity AFS securities; (ii) it is not more likely than not that we will be required to sell the fixed maturity AFS securities before recovery of their amortized cost basis; (iii) the estimated future cash flows were equal to or greater than the amortized cost basis of the debt securities; and (iv) we had the ability and intent to hold the equity AFS securities for a period of time sufficient for recovery. 

 

Based upon this evaluation as of September 30, 2013, management believes we have the ability to generate adequate amounts of cash from our normal operations (e.g., insurance premiums and fees and investment income) to meet cash requirements with a prudent margin of safety without requiring the sale of our temporarily-impaired securities.

 

As of September 30, 2013, the unrealized losses associated with our corporate bond securities were attributable primarily to securities that were backed by commercial loans and individual issuer companies.  For our corporate bond securities with commercial loans as the underlying collateral, we evaluated the projected credit losses in the underlying collateral and concluded that we had sufficient subordination or other credit enhancement when compared with our estimate of credit losses for the individual security and we expected to recover the entire amortized cost for each security.  For individual issuers, we performed detailed analysis of the financial performance of the issuer and determined that we expected to recover the entire amortized cost for each security.

 

As of September 30, 2013, the unrealized losses associated with our MBS and CDOs were attributable primarily to collateral losses and credit spreads.  We assessed our MBS and CDOs for credit impairment using a cash flow model that incorporates key assumptions including default rates, severities and prepayment rates.  We estimated losses for a security by forecasting the underlying loans in each transaction.  The forecasted loan performance was used to project cash flows to the various tranches in the structure, as applicable.  Our forecasted cash flows also considered, as applicable, independent industry analyst reports and forecasts, sector credit ratings and other independent market data.  Based upon our assessment of the expected credit losses of the security given the performance of the underlying collateral compared to our subordination or other credit enhancement, we expected to recover the entire amortized cost basis of each temporarily-impaired security.

 

As of September 30, 2013, the unrealized losses associated with our hybrid and redeemable preferred securities were attributable primarily to wider credit spreads caused by illiquidity in the market and subordination within the capital structure, as well as credit risk of specific issuers.  For our hybrid and redeemable preferred securities, we evaluated the financial performance of the issuer based upon credit performance and investment ratings and determined that we expected to recover the entire amortized cost of each security.

 

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Changes in the amount of credit loss of OTTI recognized in net income (loss) where the portion related to other factors was recognized in OCI (in millions) on fixed maturity AFS securities were as follows:

 

 

 

During the nine months ended September 30, 2013 and 2012, we recorded credit losses on securities for which an OTTI was not previously recognized as we determined the cash flows expected to be collected would not be sufficient to recover the entire amortized cost basis of the debt security.  The credit losses we recorded on securities for which an OTTI was not previously recognized were attributable primarily to one or a combination of the following reasons:

 

 

We recognize the OTTI attributed to the noncredit portion as a separate component in OCI referred to as unrealized OTTI on AFS securities. 

 

Details of the amount of credit loss of OTTI recognized in net income (loss) for which a portion related to other factors was recognized in OCI (in millions), were as follows:

 

 

 

 

 

Mortgage Loans on Real Estate

 

See Note 1 in our 2012 Form 10-K for information regarding our accounting policy relating to mortgage loans on real estate.

 

Mortgage loans on real estate principally involve commercial real estate.  The commercial loans are geographically diversified throughout the U.S. with the largest concentrations in California and Texas, which accounted for 32% of mortgage loans on real estate as of September 30, 2013, and December 31, 2012.

 

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The following provides the current and past due composition of our mortgage loans on real estate (in millions):

 

 

The number of impaired mortgage loans on real estate, each of which had an associated specific valuation allowance, and the carrying value of impaired mortgage loans on real estate (dollars in millions) were as follows:

 

 

The changes in the valuation allowance associated with impaired mortgage loans on real estate (in millions) were as follows:

 

 

 

 

The average carrying value on the impaired mortgage loans on real estate (in millions) was as follows:

 

 

As described in Note 1 in our 2012 Form 10-K, we use the loan-to-value and debt-service coverage ratios as credit quality indicators for our mortgage loans, which were as follows (dollars in millions):

 

 

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Alternative Investments 

 

As of September 30, 2013, and December 31, 2012, alternative investments included investments in 108 and 98 different partnerships, respectively, and the portfolio represented approximately 1% of our overall invested assets.

 

Realized Gain (Loss) Related to Certain Investments

 

The detail of the realized gain (loss) related to certain investments (in millions) was as follows:

 

 

Details underlying write-downs taken as a result of OTTI (in millions) that were recognized in net income (loss) and included in realized gain (loss) on AFS securities above, and the portion of OTTI recognized in OCI (in millions) were as follows:

 

 

Determination of Credit Losses on Corporate Bonds and CDOs

 

As of September 30, 2013, and December 31, 2012, we reviewed our corporate bond and CDO portfolios for potential shortfall in contractual principal and interest based on numerous subjective and objective inputs.  The factors used to determine the amount of credit loss for each individual security, include, but are not limited to, near term risk, substantial discrepancy between book and market value, sector or company-specific volatility, negative operating trends and trading levels wider than peers. 

 

Credit ratings express opinions about the credit quality of a security.  Securities rated investment grade, that is those rated BBB- or higher by Standard & Poor’s (“S&P”) Rating Services or Baa3 or higher by Moody’s Investors Service (“Moody’s”), are generally considered by the rating agencies and market participants to be low credit risk.  As of September 30, 2013, and December 31, 2012,  96% of the fair value of our corporate bond portfolio was rated investment grade.  As of September 30, 2013, and December 31, 2012, the portion of our corporate bond portfolio rated below investment grade had an amortized cost of $3.1 billion and $3.0 billion, respectively, and a fair value of $3.0 billion and $2.9 billion, respectively.  As of September 30, 2013, and December 31, 2012,  94% and 93% respectively, of the fair value of our CDO portfolio was rated investment grade.  As of September 30, 2013, and December 31, 2012, the portion of our CDO

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portfolio rated below investment grade had an amortized cost of $18 million and $21 million, respectively, and fair value of $12 million and $13 million, respectively.  Based upon the analysis discussed above, we believe as of September 30, 2013, and December 31, 2012, that we would recover the amortized cost of each investment grade corporate bond and CDO security.

 

Determination of Credit Losses on MBS

 

As of September 30, 2013, and December 31, 2012, default rates were projected by considering underlying MBS loan performance and collateral type.  Projected default rates on existing delinquencies vary between approximately 10% to 100% depending on loan type and severity of delinquency status.  In addition, we estimate the potential contributions of currently performing loans that may become delinquent in the future based on the change in delinquencies and loan liquidations experienced in the recent history.  Finally, we develop a default rate timing curve by aggregating the defaults for all loans in the pool (delinquent loans, foreclosure and real estate owned and new delinquencies from currently performing loans) and the associated loan-level loss severities. 

 

We use certain available loan characteristics such as lien status, loan sizes and occupancy to estimate the loss severity of loans.  Second lien loans are assigned 100% severity, if defaulted.  For first lien loans, we assume a minimum of 30% severity with higher severity assumed for investor properties and further adjusted by housing price assumptions.  With the default rate timing curve and loan-level severity, we derive the future expected credit losses.

 

Payables for Collateral on Investments

 

The carrying value of the payables for collateral on investments (in millions) included on our Consolidated Balance Sheets and the fair value of the related investments or collateral consisted of the following:

 

 

 

For information related to balance sheet offsetting of our securities lending and reverse repurchase agreements, see Note 6.  

 

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Increase (decrease) in payables for collateral on investments (in millions) included on the Consolidated Statements of Cash Flows consisted of the following:

 

 

Investment Commitments

 

As of September 30, 2013, our investment commitments were $1.2 billion, which included $389 million of LPs, $517 million of private placement securities and $285 million of mortgage loans on real estate.

 

Concentrations of Financial Instruments

 

As of September 30, 2013, and December 31, 2012, our most significant investments in one issuer were our investments in securities issued by the Federal Home Loan Mortgage Corporation with a fair value of $2.8 billion and $3.8 billion, respectively, or 3% and 4% of our invested assets portfolio, respectively, and our investments in securities issued by Fannie Mae with a fair value of $1.8 billion and $2.2 billion, respectively, or 2% of our invested assets portfolio.  These investments are included in corporate bonds in the tables above.

 

As of September 30, 2013, and December 31, 2012, our most significant investments in one industry were our investment securities in the electric industry with a fair value of $8.7 billion, or 9% of our invested assets portfolio, and our investment securities in the banking industry with a fair value of $4.9 billion, or 5% of our invested assets portfolio.  We utilized the industry classifications to obtain the concentration of financial instruments amount; as such, this amount will not agree to the AFS securities table above.

 

6.  Derivative Instruments

 

We maintain an overall risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate risk, foreign currency exchange risk, equity market risk, default risk, basis risk and credit risk.  See Note 1 in our 2012 Form 10-K for a detailed discussion of the accounting treatment for derivative instruments.  See Note 6 in our 2012 Form 10-K for a detailed discussion of our derivative instruments and use of them in our overall risk management strategy, which information is incorporated herein by reference.  See Note 13 for additional disclosures related to the fair value of our derivative instruments and Note 4 for derivative instruments related to our consolidated VIEs.

 

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We have derivative instruments with off-balance-sheet risks whose notional or contract amounts exceed the credit exposure.  Outstanding derivative instruments with off-balance-sheet risks (in millions) were as follows:

 

 

 

The maturity of the notional amounts of derivative instruments (in millions) was as follows:

 

 

 

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The change in our unrealized gain (loss) on derivative instruments in accumulated OCI (in millions) was as follows:

 

 

 

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The gains (losses) on derivative instruments (in millions) recorded within income (loss) from continuing operations on our Consolidated Statements of Comprehensive Income (Loss) were as follows:

 

 

 

Gains (losses) (in millions) on derivative instruments designated and qualifying as cash flow hedges were as follows:

 

 

As of September 30, 2013, $25 million of the deferred net losses on derivative instruments in accumulated OCI were expected to be reclassified to earnings during the next 12 months.  This reclassification would be due primarily to the interest rate variances related to the interest rate swap agreements.

 

For the nine months ended September 30, 2013 and 2012, there were no material reclassifications to earnings due to hedged firm commitments no longer deemed probable or due to hedged forecasted transactions that had not occurred by the end of the originally specified time period.

 

Gains (losses) (in millions) on derivative instruments designated and qualifying as fair value hedges were as follows:

 

 

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Information related to our open credit default swap liabilities for which we are the seller (dollars in millions) was as follows:

 

 

 

 

Details underlying the associated collateral of our open credit default swaps for which we are the seller, if credit risk related contingent features were triggered (in millions), are as follows:

 

 

Certain of our credit default swap agreements contain contractual provisions that allow for the netting of collateral with our counterparties related to all of our collateralized financing transactions that we have outstanding.  If these netting agreements were not in place, we would have been required to post $5 million as of September 30, 2013, after considering the fair values of the associated investments counterparties’ credit ratings as compared to ours and specified thresholds that once exceeded result in the payment of cash. 

 

Credit Risk

 

We use various derivative counterparties in executing our derivative transactions, which exposes us to credit losses in the event the counterparties do not perform in accordance with the terms of our derivative transactions, or non-performance risk (“NPR”).  We reflect assumptions related to counterparty behavior and NPR in the fair values of our derivative instruments.  The NPR is based upon assumptions for each counterparty’s credit spread over the estimated weighted average life of the counterparty exposure less collateral held.  As of September 30, 2013, the NPR adjustment was $3 million.  The credit risk associated with such agreements is minimized by purchasing such agreements from financial institutions with long-standing, superior performance records.  Additionally, we maintain a policy of requiring all derivative contracts to be governed by an International Swaps and Derivatives Association (“ISDA”) Master Agreement.  We are required to maintain minimum ratings as a matter of routine practice in negotiating ISDA agreements.  Under some ISDA agreements, our insurance subsidiaries have agreed to maintain certain financial strength or claims-paying ratings.  A downgrade below these levels could result in termination of derivative contracts, at which time any amounts payable by us would be dependent on the market value of the underlying derivative contracts.  In certain transactions, we and the counterparty have entered into a credit support annex requiring either party to post collateral when net exposures exceed pre-determined thresholds.  These thresholds vary by counterparty and credit rating.  The amount of such exposure is essentially the net replacement cost or market value less collateral held for such agreements with each counterparty if the net market value is in our favor.  As of September 30, 2013, our exposure was $99 million. 

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The amounts recognized (in millions) by S&P credit rating of counterparty, for which we had the right to reclaim cash collateral or were obligated to return cash collateral, were as follows:

 

 

Balance Sheet Offsetting

 

Information related to our derivative instruments, securities lending transactions and reverse repurchase agreements and the effects of offsetting on our Consolidated Balance Sheets (in millions) were as follows:    

 

 

 

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7.  Federal Income Taxes

 

The effective tax rate is a ratio of tax expense over pre-tax income (loss).  The effective tax rate was 24% and 23% for the three and nine months ended September 30, 2013, respectively.  The effective tax rate was 4% and 17% for the three and nine months ended September 30, 2012, respectively.  The effective tax rate on pre-tax income from continuing operations was lower than the prevailing corporate U.S. federal income statutory rate of 35% as a result of certain tax preferred investment income, separate account dividends-received deduction, foreign tax credits and other tax preference items.    A benefit to the effective tax rate was recognized in 2012 from a release of liability for uncertain tax positions related to the lapse of statute of limitations for prior year tax returns.

 

8.  Guaranteed Benefit Features

 

Information on the guaranteed death benefit (“GDB”) features outstanding (dollars in millions) was as follows (our variable contracts with guarantees may offer more than one type of guarantee in each contract; therefore, the amounts listed are not mutually exclusive):

 

 

 

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The determination of GDB liabilities is based on models that involve a range of scenarios and assumptions, including those regarding expected market rates of return and volatility, contract surrender rates and mortality experience.  The following summarizes the balances of and changes in the liabilities for GDBs (in millions), which were recorded in future contract benefits on our Consolidated Balance Sheets:

 

 

Account balances of variable annuity contracts with guarantees (in millions) were invested in separate account investment options as follows:

 

 

Future contract benefits also includes reserves for our secondary guarantee products sold through our Life Insurance segment.  These UL and VUL products with secondary guarantees represented 28% of total life insurance in-force reserves as of September 30, 2013, and 32% of total sales for the nine months ended September 30, 2013.

 

9.  Contingencies and Commitments

 

Regulatory bodies, such as state insurance departments, the SEC, Financial Industry Regulatory Authority and other regulatory bodies regularly make inquiries and conduct examinations or investigations concerning our compliance with, among other things, insurance laws, securities laws, laws governing the activities of broker-dealers, registered investment advisors and unclaimed property laws.

 

LNC and its subsidiaries are involved in various pending or threatened legal or regulatory proceedings, including purported class actions, arising from the conduct of business both in the ordinary course and otherwise.  In some of the matters, very large and/or indeterminate amounts, including punitive and treble damages, are sought.  Modern pleading practice in the U.S. permits considerable variation in the assertion of monetary damages or other relief.  Jurisdictions may permit claimants not to specify the monetary damages sought or may permit claimants to state only that the amount sought is sufficient to invoke the jurisdiction of the trial court.  In addition, jurisdictions may permit plaintiffs to allege monetary damages in amounts well exceeding reasonably possible verdicts in the jurisdiction for similar matters.  This variability in pleadings, together with the actual experiences of LNC in litigating or resolving through settlement numerous claims over an extended period of time, demonstrates to management that the monetary relief which may be specified in a lawsuit or claim bears little relevance to its merits or disposition value.

 

Due to the unpredictable nature of litigation, the outcome of a litigation matter and the amount or range of potential loss at particular points in time is normally difficult to ascertain.  Uncertainties can include how fact finders will evaluate documentary evidence and the credibility and effectiveness of witness testimony, and how trial and appellate courts will apply the law in the context of the pleadings or evidence presented, whether by motion practice, or at trial or on appeal.  Disposition valuations are also subject to the uncertainty of how opposing parties and their counsel will themselves view the relevant evidence and applicable law.

 

We establish liabilities for litigation and regulatory loss contingencies when information related to the loss contingencies shows both that it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. It is possible that some matters could require us to pay damages or make other expenditures or establish accruals in amounts that could not be estimated as of September 30, 2013.  While the potential future charges could be material in the particular quarterly or annual periods in which they are recorded, based on information currently known by management, management does not believe any such charges are likely to have a material adverse effect on LNC’s financial position.

 

On June 13, 2009, a single named plaintiff filed a putative national class action in the Circuit Court of Allen County, Indiana, captioned Peter S. Bezich v. The Lincoln National Life Insurance Company (“LNL”), No. 02C01-0906-PL73, asserting he was charged a cost-of-

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insurance fee that exceeded the applicable mortality charge, and that this fee breached the terms of the insurance contract.  We dispute the allegations and are vigorously defending this matter.  Plaintiffs have filed a motion for class certification.  We expect a hearing on class certification in the first half of 2014.

 

On July 23, 2012, LNL was added as a noteholder defendant to a putative class action adversary proceeding (“adversary proceeding”) captioned Lehman Brothers Special Financing, Inc. v. Bank of America, N.A. et al., Adv. Pro. No. 10-03547 (JMP) and instituted under In re Lehman Brothers Holdings Inc. in the United States Bankruptcy Court in the Southern District of New York.  Plaintiff Lehman Brothers Special Financing Inc. seeks to (i) overturn the application of certain priority of payment provisions in 47 collateralized debt obligation transactions on the basis such provisions are unenforceable under the Bankruptcy Code; and (ii) recover funds paid out to noteholders in accordance with the note agreements.  The adversary proceeding is stayed through January 20, 2014, and LNL’s response is currently due by the middle of 2014.

 

See Note 13 to the consolidated financial statements in our 2012 Form 10-K for additional discussion of commitments and contingencies, which information is incorporated herein by reference.

 

10.  Shares and Stockholders’ Equity

 

Common and Preferred Shares

 

The changes in our preferred and common stock (number of shares) were as follows:

 

 

 

(1)    Represents the conversion of Series A preferred stock into common stock.

 

Our common and Series A preferred stocks are without par value.

 

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Average Shares

 

A reconciliation of the denominator (number of shares) in the calculations of basic and diluted earnings (loss) per common share was as follows:

 

 

In the event the average market price of LNC common stock exceeds the issue price of stock options and the options have a dilutive effect to our earnings per share (“EPS”), such options will be shown in the table above.

 

The income used in the calculation of our diluted EPS is our net income (loss) reduced by preferred stock dividends.

 

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Accumulated OCI (“AOCI”)

 

The following summarizes the components and changes in accumulated OCI (in millions):

 

 

 

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The following summarizes the reclassifications out of AOCI (in millions) for the nine months ended September 30, 2013, and the associated line item in the Consolidated Statements of Comprehensive Income (Loss):

 

 

 

 

11.  Realized Gain (Loss)

 

Details underlying realized gain (loss) (in millions) reported on our Consolidated Statements of Comprehensive Income (Loss) were as follows:

 

 

 

 

 

 

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12.  Stock-Based Incentive Compensation Plans

 

We sponsor two stock-based incentive plans for our employees and directors and for the employees and agents of our subsidiaries that provide for the issuance of stock options, performance shares (performance-vested shares as opposed to service-vested shares), stock appreciation rights (“SARs”) and restricted stock units (“RSUs”).  We issue new shares to satisfy option exercises.

 

LNC stock-based awards granted were as follows:

 

 

 

 

13.  Fair Value of Financial Instruments

 

The carrying values and estimated fair values of our financial instruments (in millions) were as follows:

 

 

 

 

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Valuation Methodologies and Associated Inputs for Financial Instruments Not Carried at Fair Value

 

The following discussion outlines the methodologies and assumptions used to determine the fair value of our financial instruments not carried at fair value on our Consolidated Balance Sheets.  Considerable judgment is required to develop these assumptions used to measure fair value.  Accordingly, the estimates shown are not necessarily indicative of the amounts that would be realized in a one-time, current market exchange of all of our financial instruments.

 

Mortgage Loans on Real Estate

 

The fair value of mortgage loans on real estate is established using a discounted cash flow method based on credit rating, maturity and future income.  The ratings for mortgages in good standing are based on property type, location, market conditions, occupancy, debt-service coverage, loan-to-value, quality of tenancy, borrower and payment record.  The fair value for impaired mortgage loans is based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s market price or the fair value of the collateral if the loan is collateral dependent.  The inputs used to measure the fair value of our mortgage loans on real estate are classified as Level 2 within the fair value hierarchy.

 

Other Investments

 

The carrying value of our assets classified as other investments approximates fair value.  Other investments include LPs and other privately held investments that are accounted for using the equity method of accounting and the carrying value is based on our proportional share of the net assets of the LPs.  The inputs used to measure the fair value of our other investments are classified as Level 3 within the fair value hierarchy.

 

Other Contract Holder Funds

 

Other contract holder funds include remaining guaranteed interest and similar contracts and account values of certain investment contracts.  The fair value for the remaining guaranteed interest and similar contracts is estimated using discounted cash flow calculations as of the balance sheet date.  These calculations are based on interest rates currently offered on similar contracts with maturities that are consistent with those remaining for the contracts being valued.  As of September 30, 2013, and December 31, 2012, the remaining guaranteed interest and similar contracts carrying value approximated fair value.  The fair value of the account values of certain investment contracts is based on their approximate surrender value as of the balance sheet date.  The inputs used to measure the fair value of our other contract holder funds are classified as Level 3 within the fair value hierarchy.

 

Short-Term and Long-Term Debt    

 

The fair value of long-term debt is based on quoted market prices.  For short-term debt, excluding current maturities of long-term debt, the carrying value approximates fair value.  The inputs used to measure the fair value of our short-term and long-term debt are classified as Level 2 within the fair value hierarchy.   

 

Financial Instruments Carried at Fair Value

 

We did not have any assets or liabilities measured at fair value on a nonrecurring basis as of September 30, 2013, or December 31, 2012, and we noted no changes in our valuation methodologies between these periods.

 

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The following summarizes our financial instruments carried at fair value (in millions) on a recurring basis by the fair value hierarchy levels described  in “Summary of Significant Accounting Policies” in Note 1 of our 2012 Form 10-K:

 

 

 

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The following summarizes changes to our financial instruments carried at fair value (in millions) and classified within Level 3 of the fair value hierarchy.  This summary excludes any effect of amortization of DAC, VOBA, DSI and DFEL.  The gains and losses below may include changes in fair value due in part to observable inputs that are a component of the valuation methodology.

 

 

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The following provides the components of the items included in issuances, sales, maturities, settlements and calls, net, excluding any effect of amortization of DAC, VOBA, DSI and DFEL and changes in future contract benefits, (in millions) as reported above:

 

 

 

 

 

 

 

 

 

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The following summarizes changes in unrealized gains (losses) included in net income, excluding any effect of amortization of DAC, VOBA, DSI and DFEL and changes in future contract benefits, related to financial instruments carried at fair value classified within Level 3 that we still held (in millions):

 

 

 

The following provides the components of the transfers in and out of Level 3 (in millions) as reported above:

 

 

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Transfers in and out of Level 3 are generally the result of observable market information on a security no longer being available or becoming available to our pricing vendors.  For the three and nine months ended September 30, 2013 and 2012, our corporate bonds and RMBS transfers in and out were attributable primarily to the securities’ observable market information no longer being available or becoming available.  Transfers in and out of Levels 1 and 2 are generally the result of a change in the type of input used to measure the fair value of an asset or liability at the end of the reporting period.  When quoted prices in active markets become available, transfers from Level 2 to Level 1 will result.  When quoted prices in active markets become unavailable, but we are able to employ a valuation methodology using significant observable inputs, transfers from Level 1 to Level 2 will result.  For the three and nine months ended September 30, 2013 and 2012, the transfers between Levels 1 and 2 of the fair value hierarchy were less than $1 million for our financial instruments carried at fair value.

 

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The following summarizes the fair value (in millions), valuation techniques and significant unobservable inputs of the Level 3 fair value measurements as of September 30, 2013:

 

 

 

From the table above, we have excluded Level 3 fair value measurements obtained from independent, third-party pricing sources.  We do not develop the significant inputs used to measure the fair value of these assets and liabilities, and the information regarding the significant inputs is not readily available to us.  Independent broker-quoted fair values are non-binding quotes developed by market makers or broker-dealers obtained from third-party sources recognized as market participants.  The fair value of a broker-quoted asset or liability is based solely on the receipt of an updated quote from a single market maker or a broker-dealer recognized as a market participant as we do not adjust broker quotes when used as the fair value measurement for an asset or liability.  Significant increases or decreases in any of the quotes received from a third-party broker-dealer may result in a significantly higher or lower fair value measurement. 

 

Changes in any of the significant inputs presented in the table above may result in a significant change in the fair value measurement of the asset or liability as follows:

 

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For each category discussed above, the unobservable inputs are not inter-related; therefore, a directional change in one input will not affect the other inputs. 

 

As part of our on-going valuation process, we assess the reasonableness of our valuation techniques or models and make adjustments as necessary.  For more information, see “Summary of Significant Accounting Policies” in Note 1 of our 2012 Form 10-K.

 

14.  Segment Information

 

We provide products and services and report results through our Annuities, Retirement Plan Services, Life Insurance and Group Protection segments.  We also have Other Operations, which includes the financial data for operations that are not directly related to the business segments.  Our reporting segments reflect the manner by which our chief operating decision makers view and manage the business.  See Note 22 of our 2012 Form 10-K for a brief description of these segments and Other Operations.

 

Segment operating revenues and income (loss) from operations are internal measures used by our management and Board of Directors to evaluate and assess the results of our segments.  Income (loss) from operations is GAAP net income excluding the after-tax effects of the following items, as applicable:

 

 

Operating revenues represent GAAP revenues excluding the pre-tax effects of the following items, as applicable:

 

 

We use our prevailing corporate federal income tax rate of 35% while taking into account any permanent differences for events recognized differently in our financial statements and federal income tax returns when reconciling our non-GAAP measures to the most comparable GAAP measure.  Operating revenues and income (loss) from operations do not replace revenues and net income as the GAAP measures of our consolidated results of operations.

 

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Segment information (in millions) was as follows:

 

 

 

 

 

 

 

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand the financial condition as of September 30, 2013, compared with December 31, 2012, and the results of operations for the three and nine months ended September 30, 2013, compared with the corresponding periods in 2012 of Lincoln National Corporation and its consolidated subsidiaries.  Unless otherwise stated or the context otherwise requires, “LNC,” “Lincoln,” “Company,” “we,” “our” or “us” refers to Lincoln National Corporation and its consolidated subsidiaries.  The MD&A is provided as a supplement to, and should be read in conjunction with our consolidated financial statements and the accompanying notes to the consolidated financial statements (“Notes”) presented in “Part I – Item 1. Financial Statements”; our Form 10-K for the year ended December 31, 2012 (“2012 Form 10-K”), including the sections entitled “Part I – Item 1A. Risk Factors,” “Part II – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Part II – Item 8. Financial Statements and Supplementary Data”; our quarterly reports on Form 10-Q filed in 2013; and our current reports on Form 8-K filed in 2013. 

 

In this report, in addition to providing consolidated revenues and net income (loss), we also provide segment operating revenues and income (loss) from operations because we believe they are meaningful measures of revenues and the profitability of our operating segments.  Financial information that follows is presented in conformity with accounting principles generally accepted in the United States of America (“GAAP”), unless otherwise indicated.  See Note 1 in our 2012 Form 10-K for a discussion of GAAP.

 

Operating revenues and income (loss) from operations are the financial performance measures we use to evaluate and assess the results of our segments.  Accordingly, we define and report operating revenues and income (loss) from operations by segment in Note 14.  Our management believes that operating revenues and income (loss) from operations explain the results of our ongoing businesses in a manner that allows for a better understanding of the underlying trends in our current businesses because the excluded items are unpredictable and not necessarily indicative of current operating fundamentals or future performance of the business segments, and, in many instances, decisions regarding these items do not necessarily relate to the operations of the individual segments.  In addition, we believe that our definitions of operating revenues and income (loss) from operations will provide investors with a more valuable measure of our performance because it better reveals trends in our business. 

 

FORWARD-LOOKING STATEMENTS –  CAUTIONARY LANGUAGE

 

Certain statements made in this report and in other written or oral statements made by us or on our behalf are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 (“PSLRA”).  A forward-looking statement is a statement that is not a historical fact and, without limitation, includes any statement that may predict, forecast, indicate or imply future results, performance or achievements, and may contain words like:  “believe,” “anticipate,” “expect,” “estimate,” “project,” “will,” “shall” and other words or phrases with similar meaning in connection with a discussion of future operating or financial performance.  In particular, these include statements relating to future actions, trends in our businesses, prospective services or products, future performance or financial results and the outcome of contingencies, such as legal proceedings.  We claim the protection afforded by the safe harbor for forward-looking statements provided by the PSLRA.

 

Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from the results contained in the forward-looking statements.  Risks and uncertainties that may cause actual results to vary materially, some of which are described within the forward-looking statements, include, among others: 

 

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The risks included here are not exhaustive.  Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and other documents filed with the Securities and Exchange Commission (“SEC”) include additional factors that could affect our businesses and financial performance.  Moreover, we operate in a rapidly changing and competitive environment.  New risk factors emerge from time to time, and it is not possible for management to predict all such risk factors.

 

Further, it is not possible to assess the effect of all risk factors on our businesses or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.  Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results.  In addition, we disclaim any obligation to update any forward-looking statements to reflect events or circumstances that occur after the date of this report. 

 

INTRODUCTION

 

Executive Summary

 

We are a holding company that operates multiple insurance and retirement businesses through subsidiary companies.  Through our business segments, we sell a wide range of wealth protection, accumulation and retirement income products and solutions.  These products include fixed and indexed annuities, variable annuities, universal life insurance (“UL”), variable universal life insurance (“VUL”), linked-benefit universal life, indexed UL, term life insurance, employer-sponsored retirement plans and services, and group life, disability and dental.

 

We provide products and services and report results through our Annuities, Retirement Plan Services, Life Insurance and Group Protection segments.  We also have Other Operations.  These segments and Other Operations are described in “Part I – Item 1. Business” of our 2012 Form 10-K. 

 

For information on how we derive our revenues, see the discussion in results of operations by segment below.

 

Our current market conditions, significant operational matters, industry trends, issues and outlook are described in “Introduction – Executive Summary” of our 2012 Form 10-K. 

 

For factors that could cause actual results to differ materially from those set forth in this section, see “Forward-Looking Statements – Cautionary Language” above and “Part I – Item 1A. Risk Factors” in our 2012 Form 10-K.

 

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Critical Accounting Policies and Estimates

 

The MD&A included in our 2012 Form 10-K contains a detailed discussion of our critical accounting policies and estimates.  The following information updates the “Critical Accounting Policies and Estimates” provided in our 2012 Form 10-K and, accordingly, should be read in conjunction with the “Critical Accounting Policies and Estimates” discussed in our 2012 Form 10-K.

 

DAC, VOBA, DSI and DFEL

 

Unlocking

 

As discussed in our 2012 Form 10-K, we conduct our annual comprehensive review of the assumptions and projection models underlying the amortization of DAC, VOBA, DSI, DFEL, embedded derivatives and reserves for life insurance and annuity products with living benefit and death benefit guarantees in the third quarter of each year.  As a result of this review, we recorded unlocking on an annual basis that resulted in increases or decreases to the carrying values of these items.  See “DAC, VOBA, DSI and DFEL” in Note 1 of our 2012 Form 10-K for a detailed discussion of our unlocking process.    

 

Details underlying the effect to income (loss) from continuing operations from our unlocking as a result of our annual comprehensive review (in millions) were as follows:

 

 

 

Unlocking was driven primarily by the following:

 

2013

 

 

2012

 

During the third quarter of 2012, we lowered our new money investment yield assumption to reflect the then current new money rates and to approximate the forward curve for interest rates.  This reduction in the interest rate assumption resulted in resetting the current new money investment rate followed by a gradual annual recovery over seven years to a rate 50 basis points below our previous ultimate long-term assumption.  As a result of this assumption revision, we recorded unfavorable unlocking of $110 million, after-tax, for Life Insurance, $4 million, after-tax, for Annuities, and $6 million, after-tax, for Retirement Plan Services. 

 

 

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Reversion to the Mean (“RTM”)

 

As equity markets do not move in a systematic manner, we reset the baseline of account values from which EGPs are projected, which we refer to as our RTM process, as discussed in our 2012 Form 10-K. 

 

Our long-term variable fund growth rate assumption, which is used in the determination of DAC, VOBA, DSI and DFEL amortization for the variable component of our variable annuity and VUL products, is an immediate drop of approximately 14% followed by growth going forward of 7% to 9% depending on the block of business and reflecting differences in contract holder fund allocations between fixed income and equity-type investments.  If we were to have unlocked our RTM assumption in the corridor as of September 30, 2013, we would have recorded a favorable unlocking of approximately $295 million, pre-tax, for Annuities, approximately $25 million, pre-tax, for Retirement Plan Services, and approximately $30 million, pre-tax, for Life Insurance.

 

Investments

 

Investment Valuation

 

The following summarizes our available-for-sale (“AFS”) and trading securities and derivative investments carried at fair value by pricing source and fair value hierarchy level (in millions) as of September 30, 2013:

 

 

 

 

For more information about the valuation of our financial instruments carried at fair value, see “Part II – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Introduction – Critical Accounting Policies and Estimates – Investments – Investment Valuation” in our 2012 Form 10-K and Note 13 herein.

 

As of September 30, 2013, we evaluated the markets that our securities trade in and concluded that none were inactive.  We will continue to re-evaluate this conclusion, as needed, based on market conditions.  We use unobservable inputs to measure the fair value of securities trading in less liquid or illiquid markets with limited or no pricing information.  We obtain broker quotes for securities such as synthetic convertibles, index-linked certificates of deposit and collateralized debt obligations (“CDOs”) when sufficient security structure or other market information is not available to produce an evaluation.  For broker-quoted only securities, non-binding quotes from market makers or broker-dealers are obtained from sources recognized as market participants.  Broker-quoted securities are based solely on receipt of updated quotes from a single market maker or a broker-dealer recognized as a market participant.  Our broker-quoted only securities are generally classified as Level 3 of the fair value hierarchy.  As of September 30, 2013,  we used broker quotes for 62 securities as our final price source, representing approximately 1% of total securities owned.

 

Derivatives

 

Our accounting policies for derivatives and the potential effect on interest spreads in a falling rate environment are discussed in Note 6 of this report and “Part II – Item 7A. Quantitative and Qualitative Disclosures About Market Risk” in our 2012 Form 10-K.

 

GLB

 

Within our individual annuity business, approximately 72% of our variable annuity account values contained GLB features as of September 30, 2013.  Declines in the equity markets increase our exposure to potential benefits with the GLB features, leading to an increase in our existing liability for those benefits.  For example, a contract with a GLB feature is “in the money” if the contract holder’s account balance falls below the present value of guaranteed withdrawal or income benefits, assuming no lapses.  As of September 30, 2013 and 2012,  5% and 9%, respectively, of all in-force contracts with a GLB feature were “in the money,” and our exposure, after reinsurance, as of September 30, 2013 and 2012, was $387 million and $559 million, respectively.  However, the only way the contract

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holder can realize the excess of the present value of benefits over the account value of the contract is through a series of withdrawals or income payments that do not exceed a maximum amount.  If, after the series of withdrawals or income payments, the account value is exhausted, the contract holder will receive a series of annuity payments.  The account value can also fluctuate with equity market returns on a daily basis resulting in increases or decreases in the excess of the present value of benefits over account value.

 

For information on our variable annuity hedge program performance, see our discussion in “Realized Gain (Loss) and Benefit Ratio Unlocking – Variable Annuity Net Derivatives Results” below.

 

 

The following table presents our estimates of the potential instantaneous effect to realized gain (loss), which could result from sudden changes that may occur in equity markets, interest rates and implied market volatilities (in millions) at the levels indicated in the table and excludes the net cost of operating the hedging program.  The amounts represent the estimated difference between the change in the portion of GLB reserves that is calculated on a fair value basis and the change in the value of the underlying hedge instruments after the amortization of DAC, VOBA, DSI and DFEL and taxes.  These effects do not include any estimate of unlocking that could occur, nor do they estimate any change in the NPR component of the GLB reserve or any estimate of effects to our GLB benefit ratio unlocking.  These estimates are based upon the recorded reserves as of September 30, 2013, and the related hedge instruments in place as of that date.  The effects presented in the table below are not representative of the aggregate impacts that could result if a combination of such changes to equity market returns, interest rates and implied volatilities occurred.   

 

 

 

The following table shows the effect (dollars in millions) of indicated changes in instantaneous shifts in equity market returns, interest rate scenarios and market implied volatilities:

 

The actual effects of the results illustrated in the two tables above could vary significantly depending on a variety of factors, many of which are out of our control, and consideration should be given to the following:

 

 

Acquisitions and Dispositions

 

For information about acquisitions and divestitures, see Note 3.

 

 

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RESULTS OF CONSOLIDATED OPERATIONS

 

Details underlying the consolidated results, deposits, net flows and account values (in millions) were as follows: 

 

 

 

 

 

 

 

 

 

 

 

Comparison of the Three and Nine Months Ended September 30, 2013 to 2012

 

Net income decreased due primarily to the following:

 

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The decrease in net income was partially offset by growth in account values, insurance in force and group earned premiums.  

 

RESULTS OF ANNUITIES

 

Income (Loss) from Operations

 

Details underlying the results for Annuities (in millions) were as follows:

 

 

 

Comparison of the Three Months Ended September 30, 2013 to 2012

 

Income from operations for this segment increased due primarily to the following:

 

 

The increase in income from operations was partially offset by the following:

 

partially offset by:

partially offset by:

 

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Comparison of the Nine Months Ended September 30, 2013 to 2012

 

Income from operations for this segment increased due primarily to the following:

 

 

The increase in income from operations was partially offset by the following:

 

partially offset by:

partially offset by:

 

See “Critical Accounting Policies and Estimates – DAC, VOBA, DSI and DFEL – Unlocking” for more information about unlocking.

 

Additional Information

 

New deposits are an important component of net flows and key to our efforts to grow our business.    Although deposits do not significantly affect current period income from operations, they are an important indicator of future profitability.  We continue to monitor the marketplace and economic environment and make changes to our product offerings as needed to sustain the future profitability of our segment.  In 2013, these changes included the introduction of additional risk-managed funds, reductions to withdrawal rates and guaranteed income benefits for several GLB riders, closure of post-issue election of guaranteed withdrawal benefit (“GWB”) riders on new sales, and implementation of a minimum age of 50 for GWB rider elections on new sales.  Also, The Lincoln National Life Insurance Company (“LNL”) entered into a reinsurance treaty covering the Lincoln Lifetime IncomeSM Advantage 2.0 Protected Funds living benefit rider on Lincoln ChoicePlus AssuranceSM variable annuities.  Under the terms of the treaty, the reinsurer will provide 50% coinsurance on new sales through December 31, 2014, on up to a total of $8 billion of new living benefit guarantee sales.  We will retain 100% of the product cash flows, excluding the living benefit guarantee.

 

The other component of net flows relates to the retention of the business.  An important measure of retention is the lapse rate, which compares the amount of withdrawals to the average account values.  The overall lapse rate for our annuity products was 7% for the three and nine months ended September 30, 2013, compared to 8% for the corresponding periods in 2012.  

 

Our fixed annuity business includes products with discretionary crediting rates that are reset on an annual basis and are not subject to surrender charges.  Our ability to retain annual reset annuities will be subject to current competitive conditions at the time interest rates for these products reset.  We expect to manage the effects of spreads on near-term income from operations through portfolio management and, to a lesser extent, crediting rate actions, which assumes no significant changes in net flows into or out of our fixed accounts or other changes that may cause interest rate spreads to differ from our expectations.  For information on interest rate spreads and interest rate risk, see “Part I – Item 3. Quantitative and Qualitative Disclosures About Market Risk – Interest Rate Risk – Interest Rate Risk on Fixed Insurance Businesses” herein.  For information on the interest rate risk due to falling interest rates, see “Part I – Item 1A. Risk Factors – Market Conditions – Changes in interest rates and sustained low interest rates may cause interest rate spreads to decrease and changes in interest rates may also result in increased contract withdrawals” in our 2012 Form 10-K.

 

We provide information about this segment’s operating revenue and operating expense line items, the period in which amounts are recognized, key drivers of changes and historical details underlying the line items and their associated drivers below.

 

For factors that could cause actual results to differ materially from those set forth in this section, see “Forward-Looking Statements – Cautionary Language” above and “Part I – Item 1A. Risk Factors” in our 2012 Form 10-K.

 

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Fee Income

 

Details underlying fee income, account values and net flows (in millions) were as follows:

 

 

 

 

 

 

 

We charge contract holders mortality and expense assessments on variable annuity accounts to cover insurance and administrative expenses.  These assessments are a function of the rates priced into the product and the average daily variable account values.  Average daily account values are driven by net flows and the equity markets.  In addition, for our fixed annuity contracts and for some variable contracts, we collect surrender charges when contract holders surrender their contracts during their surrender charge periods to protect us from premature withdrawals.  Fee income includes charges on both our variable and fixed annuity products, but excludes the attributed fees on our GLB products; see “Part II – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Realized Gain (Loss) and Benefit Ratio Unlocking – Operating Realized Gain (Loss)” in our 2012 Form 10-K for discussion of these attributed fees.

 

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Net Investment Income and Interest Credited

 

Details underlying net investment income, interest credited (in millions) and our interest rate spread were as follows:

 

 

 

 

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A portion of our investment income earned is credited to the contract holders of our fixed annuity products, including the fixed portion of variable annuity contracts.  We expect to earn a spread between what we earn on the underlying general account investments supporting the fixed annuity product line, including the fixed portion of variable annuity contracts, and what we credit to our fixed annuity contract holders’ accounts, including the fixed portion of variable annuity contracts.  Changes in commercial mortgage loan prepayments and bond make-whole premiums, investment income on alternative investments and surplus investment income can vary significantly from period to period due to a number of factors and, therefore, may contribute to investment income results that are not indicative of the underlying trends.

 

Benefits

 

Details underlying benefits (in millions) were as follows:

 

 

 

Benefits for this segment include changes in reserves of immediate annuity account values driven by premiums, changes in benefit reserves and our expected costs associated with purchases of derivatives used to hedge our benefit ratio unlocking.  In addition, see footnote 1 under the “Income (Loss) from Operations” table above for additional information on the change in benefits.

 

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Commissions and Other Expenses

 

Details underlying commissions and other expenses (in millions) were as follows:

 

 

 

Commissions and other costs that result directly from and are essential to the successful acquisition of new or renewal business are deferred to the extent recoverable and are amortized over the lives of the contracts in relation to EGPs.  Certain of our commissions, such as trail commissions that are based on account values, are expensed as incurred rather than deferred and amortized.

 

Broker-dealer expenses that vary with and are related to sales are expensed as incurred and not deferred and amortized.  Fluctuations in these expenses correspond with fluctuations in other revenues.

 

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RESULTS OF RETIREMENT PLAN SERVICES

 

Income (Loss) from Operations

 

Details underlying the results for Retirement Plan Services (in millions) were as follows:

 

 

 

Comparison of the Three and Nine Months Ended September 30, 2013 to 2012

 

Income from operations for this segment increased due primarily to the following:

 

partially offset by:

 

The increase in income from operations was partially offset by higher commissions and other expenses due to higher account values driving higher trail commissions and the effect of unlocking (see “Critical Accounting Policies and Estimates – DAC, VOBA, DSI and DFEL – Unlocking” for more information).

 

Additional Information

 

We expect to continue making strategic investments during the remainder of 2013 to improve our infrastructure and expand distribution that will result in higher expenses. 

 

Net flows in this business fluctuate based on the timing of larger plans being implemented on our platform and terminating over the course of the year, and we expect this trend will continue for the remainder of 2013.

 

New deposits are an important component of net flows and key to our efforts to grow our business.  Although deposits do not significantly affect current period income from operations, they are an important indicator of future profitability.  The other component of net flows relates to the retention of the business.  An important measure of retention is the lapse rate, which compares the amount of withdrawals to the average account values.  The overall lapse rate for our annuity and mutual fund products was 14% and 12% for the three and nine months ended September 30, 2013, respectively, compared to 14% and 12% for the corresponding periods in 2012. 

 

Our lapse rate is negatively affected by the continued net outflows from our oldest blocks of annuities business (as presented on our Account Value Roll Forward table below as “Total Multi-Fund® and Other Variable Annuities”), which are also our higher margin product lines in this segment, due to the fact that they are mature blocks with much of the account values out of their surrender charge

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period.  The proportion of these products to our total account values was 34% and 37% as of September 30, 2013 and 2012, respectively.  Due to this expected overall shift in business mix toward products with lower returns, a significant increase in new deposit production continues to be necessary to maintain earnings at current levels.

 

Our fixed annuity business includes products with discretionary and index-based crediting rates that are reset on a quarterly basis.  Our ability to retain quarterly reset annuities will be subject to current competitive conditions at the time interest rates for these products reset.  We expect to manage the effects of spreads on near-term income from operations through portfolio management and, to a lesser extent, crediting rate actions, which assumes no significant changes in net flows into or out of our fixed accounts or other changes that may cause interest rate spreads to differ from our expectations.  For information on interest rate spreads and interest rate risk, see “Part I – Item 3.  Quantitative and Qualitative Disclosures About Market Risk – Interest Rate Risk – Interest Rate Risk on Fixed Insurance Businesses” herein.  For information on the interest rate risk due to falling interest rates, see “Part I – Item 1A. Risk Factors – Market Conditions – Changes in interest rates and sustained low interest rates may cause interest rate spreads to decrease and changes in interest rates may also result in increased contract withdrawals” in our 2012 Form 10-K.

 

We provide information about this segment’s operating revenue and operating expense line items, the period in which amounts are recognized, key drivers of changes and historical details underlying the line items and their associated drivers below. 

 

For factors that could cause actual results to differ materially from those set forth in this section, see “Forward-Looking Statements – Cautionary Language” above and “Part I – Item 1A. Risk Factors” in our 2012 Form 10-K.

 

Fee Income

 

Details underlying fee income, account values and net flows (in millions) were as follows:

 

 

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We charge expense assessments to cover insurance and administrative expenses.  Expense assessments are generally equal to a percentage of the daily variable account values.  Average daily account values are driven by net flows and the equity markets.  Our expense assessments include fees we earn for the services that we provide to our mutual fund programs.  In addition, for both our fixed and variable annuity contracts, we collect surrender charges when contract holders surrender their contracts during the surrender charge periods to protect us from premature withdrawals.

 

Net Investment Income and Interest Credited

 

Details underlying net investment income, interest credited (in millions) and our interest rate spread were as follows:

 

 

 

 

 

 

 

 

A portion of our investment income earned is credited to the contract holders of our fixed annuity products, including the fixed portion of variable annuity contracts.  We expect to earn a spread between what we earn on the underlying general account investments supporting the fixed annuity product line, including the fixed portion of variable annuity contracts, and what we credit to our fixed annuity contract holders’ accounts, including the fixed portion of variable annuity contracts.  Commercial mortgage loan prepayments and bond make-whole premiums, investment income on alternative investments and surplus investment income can vary significantly from period to period due to a number of factors and, therefore, may contribute to investment income results that are not indicative of the underlying trends.

 

Benefits

 

Benefits for this segment include changes in benefit reserves and our expected costs associated with purchases of derivatives used to hedge our benefit ratio unlocking.

 

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Commissions and Other Expenses

 

Details underlying commissions and other expenses (in millions) were as follows:

 

 

Commissions and other costs that result directly from and are essential to the successful acquisition of new or renewal business are deferred to the extent recoverable and are amortized over the lives of the contracts in relation to EGPs.  Certain of our commissions, such as trail commissions that are based on account values, are expensed as incurred rather than deferred and amortized.  Distribution expenses associated with the sale of mutual fund products are expensed as incurred.  When comparing DAC and VOBA deferrals as a percentage of sales for the three and nine months ended September 30, 2013, to the corresponding periods in 2012, the decrease is primarily a result of incurred deferrable commissions declining at a rate higher than sales due to changes in sales mix to products with lower commission rates.

 

 

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RESULTS OF LIFE INSURANCE

 

Income (Loss) from Operations

 

Details underlying the results for Life Insurance (in millions) were as follows:

 

 

 

Comparison of the Three Months Ended September 30, 2013 to 2012

 

Income from operations for this segment decreased due primarily to the following:

 

 

The decrease in income from operations was partially offset by lower commissions and other expenses attributable to the effect of unlocking.

 

Comparison of the Nine Months Ended September 30, 2013 to 2012

 

Income from operations for this segment decreased due primarily to higher benefits due to the effect of unlocking and higher death claims, partially offset by lower commissions and other expenses attributable to the effect of unlocking.

 

See “Critical Accounting Policies and Estimates – DAC, VOBA, DSI and DFEL – Unlocking” for more information about unlocking.

 

Strategies to Address Statutory Reserve Strain

 

Our insurance subsidiaries have statutory surplus and risk-based capital (“RBC”) levels above current regulatory required levels.  Term products and UL products containing secondary guarantees require reserves calculated pursuant to the Valuation of Life Insurance Policies Model Regulation (“XXX”) and Actuarial Guideline 38 (“AG38”), respectively.  On September 12, 2012, the National Association of Insurance Commissioners (“NAIC”) adopted revisions to AG38.  Effective as of December 31, 2012, reserves on in-force business written between July 1, 2005, and December 31, 2012, are subject to a minimum floor calculation.  This floor calculation is based on assumptions that are generally consistent with the principles-based reserving framework developed by the NAIC.  The AG38 revisions did not have a material impact on our total in-force reserves as of adoption.  Reserves on new business written after December 31, 2012, are calculated using a modified formulaic approach.  This approach results in higher reserves that exceed expected economic levels, which increases the surplus strain related to new sales.  However, our insurance subsidiaries are employing strategies to reduce the surplus strain of holding the higher statutory reserves associated with term products and UL products containing secondary guarantees.  As noted below, we have been successful in executing reinsurance solutions to release surplus to Other Operations.  We will continue to manage our present reinsurance solutions and attempt to enter into new solutions to minimize the strain on our surplus.    During the third quarter of 2013, the New York Department of Financial Services (“NYDFS”) announced that it would not recognize the NAIC revisions to AG38 discussed above in applying the New York law governing the reserves to be held for term products and UL products containing

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secondary guarantees. The change, effective for year end 2013 financial reporting, impacts our New York-domiciled insurance subsidiary, the Lincoln Life & Annuity Company of New York (“LLANY”).  LLANY discontinued the sale of these products in New York in early 2013, but the NYDFS’s action is expected to increase the reserves to be held for in-force business.  However, the exact impact on LLANY is not yet known, but we do not expect it to have a material adverse effect on our financial condition. 

 

Included in the LOCs issued as of September 30, 2013, was approximately $2.8 billion of long-dated LOCs issued to support inter-company reinsurance arrangements.  Approximately $1.8 billion of such LOCs expiring in 2031 were issued for UL products containing secondary guarantees.  Approximately $1.0 billion of such LOCs were issued for term business solutions (approximately $175 million will expire in 2018, and approximately $830 million will expire in 2023).  We have also used the proceeds from senior note issuances of approximately $875 million to execute long-term structured solutions supporting UL products containing secondary guarantees.  LOCs and related capital market alternatives lower the capital effect of term and UL products containing secondary guarantees.  An inability to obtain the necessary LOC capacity or other capital market alternatives could affect our returns on our in-force term and UL products containing secondary guarantees.  However, we believe that our insurance subsidiaries have sufficient capital to support the increase in statutory reserves, based on our current reserve projections, if such structures are not available.  See “Part I – Item 1A. Risk Factors – Legislative, Regulatory and Tax – Attempts to mitigate the impact of Regulation XXX and Actuarial Guideline 38 may fail in whole or in part resulting in an adverse effect on our financial condition and results of operations” in our 2012 Form 10-K for further information on XXX and AG38 reserves.  See the table in “Commissions and Other Expenses” below for the presentation of our expenses associated with reserve financing.

 

Additional Information

 

We expect to manage the effects of spreads on near-term income from operations through portfolio management, which assumes no significant changes in net flows into or out of our fixed accounts or other changes that may cause interest rate spreads to differ from our expectations. 

 

For information on interest rate spreads and interest rate risk, see “Part I – Item 3. Quantitative and Qualitative Disclosures About Market Risk – Interest Rate Risk – Interest Rate Risk on Fixed Insurance Businesses” herein.  For information on the interest rate risk due to falling interest rates, see “Part I – Item 1A. Risk Factors – Market Conditions – Changes in interest rates and sustained low interest rates may cause interest rate spreads to decrease and changes in interest rates may also result in increased contract withdrawals” in our 2012 Form 10-K.

 

Sales are not recorded as a component of revenues (other than for traditional products) and do not have a significant effect on current quarter income from operations but are indicators of future profitability.  Generally, we have higher sales during the second half of the year with the fourth quarter being our strongest. 

 

We provide information about this segment’s operating revenue and operating expense line items, the period in which amounts are recognized, key drivers of changes and historical details underlying the line items and their associated drivers below. 

 

For factors that could cause actual results to differ materially from those set forth in this section, see “Forward-Looking Statements – Cautionary Language” above and “Part I – Item 1A. Risk Factors” in our 2012 Form 10-K.

 

Insurance Premiums

 

Insurance premiums relate to traditional products and are a function of the rates priced into the product and the level of insurance in force.  Insurance in force, in turn, is driven by sales, persistency and mortality experience.

 

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Fee Income

 

Details underlying fee income, sales, net flows, account values and in-force face amount (in millions) were as follows:

 

 

 

 

 

 

 

 

Fee income relates only to interest-sensitive products and includes mortality assessments, expense assessments (net of deferrals and amortization related to DFEL) and surrender charges.  Mortality and expense assessments are deducted from our contract holders’ account values.  These amounts are a function of the rates priced into the product and premiums received, face amount in force and account values.  Insurance in force, in turn, is driven by sales, persistency and mortality experience. 

 

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Sales in the table above and as discussed above were reported as follows:

 

 

UL products with secondary guarantees represented approximately 19% and 17% of sales for the three and nine months ended September 30, 2013, respectively, as compared to approximately 22% and 27% for the corresponding periods in 2012.  Changes in the marketplace and continuing efforts to increase sales of higher return products (i.e., “pivot” products) in a low interest rate environment are resulting in a shift in our business mix to products like VUL, indexed UL and term that are not primarily focused upon secondary guarantees. 

 

Net Investment Income and Interest Credited

 

Details underlying net investment income, interest credited (in millions) and our interest rate spread were as follows:

 

 

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A portion of the investment income earned for this segment is credited to contract holder accounts.  Statutory reserves will typically grow at a faster rate than account values because of the AG38 reserve requirements.  Invested assets are based upon the statutory reserve liabilities and are affected by various reserve adjustments, including financing transactions providing relief from AG38 reserve requirements. These financing transactions lead to a transfer of invested assets from this segment to Other Operations.  We expect to earn a spread between what we earn on the underlying general account investments and what we credit to our contract holders’ accounts.  We use our investment income to offset the earnings effect of the associated growth of our policy reserves for traditional products.  Commercial mortgage loan prepayments and bond make-whole premiums and investment income on alternative investments can vary significantly from period to period due to a number of factors, and, therefore, may contribute to investment income results that are not indicative of the underlying trends.

 

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Benefits

 

Details underlying benefits (dollars in millions) were as follows:

 

 

 

Benefits for this segment include claims incurred during the period in excess of the associated reserves for its interest-sensitive and traditional products.  In addition, benefits include the change in secondary guarantee life insurance product reserves.  The reserve for secondary guarantees is affected by changes in expected future trends of expense assessments causing unlocking adjustments to this liability similar to DAC, VOBA and DFEL.  See “Future Contract Benefits and Other Contract Holder Funds” in Note 1 of our 2012 Form 10-K for additional information.

 

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Commissions and Other Expenses

 

Details underlying commissions and other expenses (in millions) were as follows:

 

 

Commissions and costs that result directly from and are essential to successful acquisition of new or renewal business are deferred to the extent recoverable and for our interest-sensitive products are generally amortized over the life of the contracts in relation to EGPs.  For our traditional products, DAC and VOBA are amortized on either a straight-line basis or as a level percent of premium of the related contracts, depending on the block of business.  When comparing DAC and VOBA deferrals as a percentage of sales for the three and nine months ended September 30, 2013, to the corresponding periods in 2012, the decrease is primarily a result of incurred deferrable commissions declining at a rate higher than sales due to changes in sales mix to products with lower commission rates. 

 

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RESULTS OF GROUP PROTECTION

 

Income (Loss) from Operations

 

Details underlying the results for Group Protection (in millions) were as follows:

 

 

 

 

 

 

Comparison of the Three and Nine Months Ended September 30, 2013 to 2012

 

Income from operations for this segment increased due primarily to the following:

 

The increase in income from operations was partially offset by higher commissions and other expenses attributable to an increase in business and strategic investments in sales and distribution processes and technology platforms. 

 

Additional Information

 

Management compares trends in actual loss ratios to pricing expectations because group-underwriting risks change over time.  We expect normal fluctuations in our composite non-medical loss ratios of this segment, as claims experience is inherently uncertain.  For every one percent increase in the loss ratio above our expectation, we would expect an approximate annual $11 million to $13 million decrease to income from operations. 

 

We are evaluating the potential effects that health care reform may have on the value and profitability of this segment’s products and income from operations, including, but not limited to, potential changes to traditional sources of income for our brokers who may seek additional portfolio options and/or modification to compensation structures.

 

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For information on the effects of current interest rates on our long-term disability claim reserves, see “Part II – Item 7A. Quantitative and Qualitative Disclosures About Market Risk – Interest Rate Risk – Interest Rate Risk on Fixed Insurance Businesses – Falling Rates” in our 2012 Form 10-K.

 

Sales relate to long-duration contracts sold to new contract holders and new programs sold to existing contract holders.  We believe that the trend in sales is an important indicator of development of business in force over time.

 

We provide information about this segment’s operating revenue and operating expense line items, the period in which amounts are recognized, key drivers of changes and historical details underlying the line items and their associated drivers below.

 

For factors that could cause actual results to differ materially from those set forth in this section, see “Forward-Looking Statements – Cautionary Language” above and “Part I – Item 1A. Risk Factors” in our 2012 Form 10-K. 

 

Insurance Premiums

 

Details underlying insurance premiums (in millions) were as follows:

 

 

 

 

Our cost of insurance and policy administration charges are embedded in the premiums charged to our customers.  The premiums are a function of the rates priced into the product and our business in force.  Business in force, in turn, is driven by sales and persistency experience.  Sales in the table above are the combined annualized premiums for our life, disability and dental products. 

 

Net Investment Income

 

We use our investment income to offset the earnings effect of the associated build of our policy reserves, which are a function of our insurance premiums and the yields on our invested assets.

 

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Benefits and Interest Credited

 

Details underlying benefits and interest credited (in millions) and loss ratios by product line were as follows:

 

 

 

Commissions and Other Expenses

 

Details underlying commissions and other expenses (in millions) were as follows:

 

 

 

Commissions and other costs that result directly from and are essential to the successful acquisition of new or renewal business are deferred to the extent recoverable and are amortized in relation to the revenue of the related contracts.  Certain broker commissions that vary with and are related to paid premiums are expensed as incurred.  The level of expenses is an important driver of profitability for this segment as group insurance contracts are offered within an environment that competes on the basis of price and service. 

 

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RESULTS OF OTHER OPERATIONS

 

Income (Loss) from Operations

 

Details underlying the results for Other Operations (in millions) were as follows:

 

 

 

Comparison of the Three and Nine Months Ended September 30, 2013 to 2012

 

Loss from operations for Other Operations increased due primarily to higher favorable tax benefits during 2012 related to the release of reserves associated with prior tax years that were closed in the third quarter.

 

The increase in loss from operations was partially offset by the following: 

 

 

Additional Information

 

We provide information about Other Operations’ operating revenue and operating expense line items, the period in which amounts are recognized, key drivers of changes and historical details underlying the line items and their associated drivers below.

 

For factors that could cause actual results to differ materially from those set forth in this section, see “Forward-Looking Statements – Cautionary Language” above and “Part I – Item 1A. Risk Factors” in our 2012 Form 10-K. 

 

Net Investment Income and Interest Credited

 

We utilize an internal formula to determine the amount of capital that is allocated to our business segments.  Investment income on capital in excess of the calculated amounts is reported in Other Operations.  If regulations require increases in our insurance segments’ statutory reserves and surplus, the amount of capital retained by Other Operations would decrease and net investment income would be negatively affected.

   

Write-downs for other-than-temporary impairment (“OTTI”) decrease the recorded value of our invested assets owned by our business segments.  These write-downs are not included in the income from operations of our operating segments.  When impairment occurs, assets are transferred to the business segments’ portfolios and will reduce the future net investment income for Other Operations, but should not have an effect on a consolidated basis unless the impairments are related to defaulted securities.  Statutory reserve adjustments for our business segments can also cause allocations of invested assets between the affected segments and Other Operations.

 

The majority of our interest credited relates to our reinsurance operations sold to Swiss Re in 2001.  A substantial amount of the business

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was sold through indemnity reinsurance transactions, which is still recorded in our consolidated financial statements.  The interest credited corresponds to investment income earnings on the assets we continue to hold for this business.  There is no effect to income or loss in Other Operations or on a consolidated basis for these amounts because interest earned on the blocks that continue to be reinsured is passed through to Swiss Re in the form of interest credited.

 

Benefits

 

Benefits are recognized when incurred for Institutional Pension products and disability income business.

 

Other Expenses

 

 

Details underlying other expenses (in millions) were as follows:

 

 

 

 

Interest and Debt Expense

 

Our current level of interest expense may not be indicative of the future due to, among other things, the timing of the use of cash, the availability of funds from our inter-company cash management program and the future cost of capital.  For additional information on our financing activities, see “Review of Consolidated Financial Condition – Liquidity and Capital Resources – Sources of Liquidity and Cash Flow – Financing Activities” below.

 

 

 

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REALIZED GAIN (LOSS) AND BENEFIT RATIO UNLOCKING

 

Details underlying realized gain (loss), after-DAC (1) and benefit ratio unlocking (in millions) were as follows:

 

 

 

 

For factors that could cause actual results to differ materially from those set forth in this section, see “Forward-Looking Statements – Cautionary Language” above and “Part I – Item 1A. Risk Factors” in our 2012 Form 10-K. 

 

For information on our counterparty exposure, see “Part I – Item 3. Quantitative and Qualitative Disclosures About Market Risk.”

 

Comparison of the Three Months Ended September 30, 2013 to 2012 

 

We had realized losses during 2013 as compared to gains during 2012 driven primarily by the following components of excluded realized gain (loss), which we have described net of benefit ratio unlocking, after-tax:

 

partially offset by:

 

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The realized losses were partially offset by the following:

 

 

Comparison of the Nine Months Ended September 30, 2013 to 2012

 

We had realized losses during 2013 as compared to gains during 2012 driven primarily by the following components of excluded realized gain (loss), which we have described net of benefit ratio unlocking, after-tax:

 

 

The realized losses were partially offset by the following:

 

 

Operating Realized Gain (Loss)

 

See “Realized Gain (Loss) and Benefit Ratio Unlocking – Operating Realized Gain (Loss)” in our 2012 Form 10-K for a discussion of our operating realized gain (loss).

 

Realized Gain (Loss) Related to Certain Investments

 

See “Consolidated Investments – Realized Gain (Loss) Related to Certain Investments” below.

 

Gain (Loss) on the Mark-to-Market on Certain Instruments

 

See “Realized Gain (Loss) and Benefit Ratio Unlocking – Gain (Loss) on the Mark-to-Market on Certain Instruments” in our 2012 Form 10-K for a discussion of the mark-to-market on certain instruments and Note 4 for information about consolidated variable interest entities (“VIEs”). 

 

Variable Annuity Net Derivatives Results

 

See “Realized Gain (Loss) and Benefit Ratio Unlocking – Variable Annuity Net Derivatives Results” in our 2012 Form 10-K for a discussion of our variable annuity net derivatives results.

 

Details underlying our variable annuity hedging program (dollars in millions) were as follows:

 

 

 

Our embedded derivative reserves were in an asset position as of September 30, 2013, as we estimated the present value of future benefits to be less than the future net valuation premiums. 

 

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The following shows the approximate hypothetical effect to net income, pre-DAC (1), pre-tax (in millions) for changes in the NPR factor along all points on the spread curve as of September 30, 2013:

 

 

 

 

For additional information on our guaranteed benefits, see “Critical Accounting Policies and Estimates – Derivatives – Guaranteed Living Benefits” above. 

 

Indexed Annuity Forward-Starting Option

 

See “Realized Gain (Loss) and Benefit Ratio Unlocking – Indexed Annuity Forward-Starting Option” in our 2012 Form 10-K for a discussion of our indexed annuity forward-starting option. 

 

CONSOLIDATED INVESTMENTS

 

Details underlying our consolidated investment balances (in millions) were as follows:

 

 

Investment Objective

 

Invested assets are an integral part of our operations.  We follow a balanced approach to investing for both current income and prudent risk management, with an emphasis on generating sufficient current income, net of income tax, to meet our obligations to customers, as well as other general liabilities.  This balanced approach requires the evaluation of expected return and risk of each asset class utilized, while still meeting our income objectives.  This approach is important to our asset-liability management because decisions can be made based upon both the economic and current investment income considerations affecting assets and liabilities.  For a discussion of our risk management process, see “Part II – Item 7A. Quantitative and Qualitative Disclosures About Market Risk” in our 2012 Form 10-K.

 

Investment Portfolio Composition and Diversification

 

Fundamental to our investment policy is diversification across asset classes.  Our investment portfolio, excluding cash and invested cash, is composed of fixed maturity securities, mortgage loans on real estate, real estate (either wholly-owned or in joint ventures) and other long-term investments.  We purchase investments for our segmented portfolios that have yield, duration and other characteristics that take into account the liabilities of the products being supported. 

 

We have the ability to maintain our investment holdings throughout credit cycles because of our capital position, the long-term nature of our liabilities and the matching of our portfolios of investment assets with the liabilities of our various products.

 

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Fixed Maturity and Equity Securities Portfolios

 

Fixed maturity securities and equity securities consist of portfolios classified as AFS and trading.  Mortgage-backed and private securities are included in both of the AFS and trading portfolios.

 

Details underlying our fixed maturity and equity securities portfolios by industry classification (in millions) are presented in the tables below.  These tables agree in total with the presentation of AFS securities in Note 5; however, the categories below represent a more detailed breakout of the AFS portfolio.  Therefore, the investment classifications listed below do not agree to the investment categories provided in Note 5.

 

 

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AFS Securities

 

In accordance with the AFS accounting guidance, we reflect stockholders’ equity as if unrealized gains and losses were actually recognized, and consider all related accounting adjustments that would occur upon such a hypothetical recognition of unrealized gains and losses.  Such related balance sheet effects include adjustments to the balances of DAC, VOBA, DFEL, future contract benefits, other contract holder funds and deferred income taxes.  Adjustments to each of these balances are charged or credited to accumulated other comprehensive income (loss) (“AOCI”).  For instance, DAC is adjusted upon the recognition of unrealized gains or losses because the

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amortization of DAC is based upon an assumed emergence of gross profits on certain insurance business.  Deferred income tax balances are also adjusted because unrealized gains or losses do not affect actual taxes currently paid. 

 

The quality of our AFS fixed maturity securities portfolio, as measured at estimated fair value and by the percentage of fixed maturity AFS securities invested in various ratings categories, relative to the entire fixed maturity AFS security portfolio (in millions) was as follows:

 

 

 

Comparisons between the NAIC ratings and rating agency designations are published by the NAIC.  The NAIC assigns securities quality ratings and uniform valuations, which are used by insurers when preparing their annual statements.  The NAIC ratings are similar to the rating agency designations of the Nationally Recognized Statistical Rating Organizations for marketable bonds.  NAIC ratings 1 and 2 include bonds generally considered investment grade (rated Baa3 or higher by Moody’s, or rated BBB- or higher by S&P and Fitch), by such ratings organizations.  However, securities rated NAIC 1 and NAIC 2 could be deemed below investment grade by the rating agencies as a result of the current RBC rules for residential mortgage-backed securities (“RMBS”) and CMBS for statutory reporting.  NAIC ratings 3 through 6 include bonds generally considered below investment grade (rated Ba1 or lower by Moody’s, or rated BB+ or lower by S&P and Fitch).

 

We have identified select countries in Europe that are currently experiencing stress in the credit markets, notably Greece, Ireland, Italy, Portugal, Spain, Hungary, Cyprus and Slovenia.  These countries were identified due to high credit spreads and political and economic uncertainty.  Our exposure was determined by country of risk, defined as the country where the issuer primarily conducts business, unless another company is deemed to have control.  Our investments by country as of September 30, 2013, are presented below (in millions): 

 

 

 

We have no exposure to any issuers in Greece, Hungary, Cyprus or Slovenia.

 

We manage European and other investment risks through our internal investment department and outside asset managers.  The risk management is focused on monitoring spreads, pricing and monitoring of global economic developments. 

 

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As of September 30, 2013, and December 31, 2012,  89.4%  and 68.7%, respectively, of the total publicly traded and private securities in an unrealized loss status were rated as investment grade.  See Note 5 for maturity date information for our fixed maturity investment portfolio.  Our gross unrealized losses, including the portion of OTTI recognized in other comprehensive income (loss) (“OCI”), on AFS securities as of September 30, 2013,  increased by $799 million.  As more fully described in Note 1 in our 2012 Form 10-K, we regularly review our investment holdings for OTTI.  We believe the unrealized loss position as of September 30, 2013, does not represent OTTI as:  (i) we do not intend to sell the debt securities; (ii) it is not more likely than not that we will be required to sell the debt securities before recovery of their amortized cost basis; (iii) the estimated future cash flows are equal to or greater than the amortized cost basis of the debt securities; and (iv) we have the ability and intent to hold the equity securities for a period of time sufficient for recovery.  For further information on our unrealized losses on AFS securities, see “Composition by Industry Categories of our Unrealized Losses on AFS Securities” below.

 

Selected information for certain AFS securities in a gross unrealized loss position (dollars in millions) as of September 30, 2013, was as follows:

 

 

As provided in the table above, many of the securities in these categories are long-dated with some of the preferred securities being perpetual.  This is purposeful as it matches the long-term nature of our liabilities associated with our life insurance and annuity products.  See “Part II – Item 7A. Quantitative and Qualitative Disclosures About Market Risk” in our 2012 Form 10-K where we present information related to maturities of securities and the expected cash flows for rate sensitive liabilities and maturities of our holding company debt, which also demonstrates the long-term nature of the cash flows associated with these items.  Because of this relationship, we do not believe it will be necessary to sell these securities before they recover or mature.  For these securities, the estimated range and average period until recovery is the call or maturity period.  It is difficult to predict or project when the securities will recover as it is dependent upon a number of factors including the overall economic climate.  We do not believe it is necessary to impair these securities as long as the expected future cash flows are projected to be sufficient to recover the amortized cost of these securities.

 

The actual range and period until recovery could vary significantly depending on a variety of factors, many of which are out of our control.  There are several items that could affect the length of the period until recovery, such as the pace of economic recovery, level of delinquencies, performance of the underlying collateral, changes in market interest rates, exposures to various industry or geographic conditions, market behavior and other market conditions.

 

We concluded that it is not more likely than not that we will be required to sell the fixed maturity AFS securities before recovery of their amortized cost basis, that the estimated future cash flows are equal to or greater than the amortized cost basis of the debt securities, and that we have the ability to hold the equity AFS securities for a period of time sufficient for recovery.  This conclusion is consistent with our asset-liability management process.  Management considers the following as part of the evaluation:

 

 

To determine the recoverability of a debt security, we consider the facts and circumstances surrounding the underlying issuer including, but not limited to, the following:

 

 

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As reported on our Consolidated Balance Sheets, we had $98.2 billion of investments and cash, which exceeded the liabilities for our future obligations under insurance policies and contracts, net of amounts recoverable from reinsurers, which totaled $85.7 billion as of September 30, 2013.  If it were necessary to liquidate securities prior to maturity or call to meet cash flow needs, we would first look to those securities that are in an unrealized gain position, which had a fair value of $61.8 billion, excluding consolidated VIEs in the amount of $699 million, as of September 30, 2013, rather than selling securities in an unrealized loss position.  The amount of cash that we have on hand at any point of time takes into account our liquidity needs in the future, other sources of cash, such as the maturities of investments, interest and dividends we earn on our investments and the on-going cash flows from new and existing business. 

 

See “AFS Securities – Evaluation for Recovery of Amortized Cost” in Note 1 in our 2012 Form 10-K and Note 5 for additional discussion.

 

As of September 30, 2013, and December 31, 2012, the estimated fair value for all private placement securities was $12.8 billion and $12.0 billion, respectively, representing 13% of total invested assets.

 

For information regarding our VIEs’ fixed maturity securities, see Note 4 in this report and Note 4 in our 2012 Form 10-K.

 

Mortgage-Backed Securities (“MBS”) (Included in AFS and Trading Securities)

 

See “Consolidated Investments – Mortgage-Backed Securities” in our 2012 Form 10-K for a discussion of our MBS. 

 

Our RMBS had a market value of $4.8 billion and an unrealized gain of $264 million, or 6%, as of September 30, 2013.    

 

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The market value of AFS securities and trading securities backed by subprime loans was $456 million and represented less than 1% of our total investment portfolio as of September 30, 2013.  AFS securities represented $443 million, or 97%, and trading securities represented $13 million, or 3%, of the subprime exposure as of September 30, 2013.  The table below summarizes our investments in AFS securities backed by pools of residential mortgages (in millions) as of September 30, 2013:

 

 

 

None of these investments included any direct investments in subprime lenders or mortgages.  We are not aware of material exposure to subprime loans in our alternative asset portfolio.

 

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The following summarizes our investments in AFS securities backed by pools of commercial mortgages (in millions) as of September 30, 2013:

 

 

 

As of September 30, 2013, the amortized cost and fair value of our AFS exposure to Monoline insurers was $570 million and $583 million, respectively.    

 

Composition by Industry Categories of our Unrealized Losses on AFS Securities

 

When considering unrealized gain and loss information, it is important to recognize that the information relates to the status of securities at a particular point in time and may not be indicative of the status of our investment portfolios subsequent to the balance sheet date.  Further, because the timing of the recognition of realized investment gains and losses through the selection of which securities are sold is largely at management’s discretion, it is important to consider the information provided below within the context of the overall unrealized gain or loss position of our investment portfolios.  These are important considerations that should be included in any evaluation of the potential effect of unrealized loss securities on our future earnings. 

 

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The composition by industry categories of all securities in unrealized loss status (in millions) as of September 30, 2013, was as follows:

 

 

As of September 30, 2013, the amortized cost and fair value of securities subject to enhanced analysis and monitoring for potential changes in unrealized loss status was $726 million and $565 million, respectively. 

 

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Mortgage Loans on Real Estate

 

The following tables summarize key information on mortgage loans on real estate (in millions):

 

 

 

 

 

 

 

 

 

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The global financial markets and credit market conditions experienced a period of extreme volatility and disruption that began in the second half of 2007 and continued and substantially increased throughout 2008 that led to a decrease in the overall liquidity and availability of capital in the mortgage loan market, and in particular a decrease in activity by securitization lenders.  These conditions and the overall economic downturn put pressure on the fundamentals of mortgage loans through rising vacancies, falling rents and falling property values.

 

See Note 5 for information regarding our loan-to-value and debt-service coverage ratios and our allowance for loan losses.

 

As of September 30, 2013, and December 31, 2012, there were 4 and 10 impaired mortgage loans on real estate, respectively, or less than 1% of the total dollar amount of mortgage loans on real estate.  The carrying value on the mortgage loans on real estate that were two or more payments delinquent as of September 30, 2013, was $7 million, or less than 1% of total mortgage loans on real estate.  The total principal and interest past due on the mortgage loans on real estate that were two or more payments delinquent as of September 30, 2013, was $1 million.  The carrying value on the mortgage loans on real estate that were two or more payments delinquent as of December 31, 2012, was $20 million, or less than 1% of total mortgage loans on real estate.  The total principal and interest past due on the mortgage loans on real estate that were two or more payments delinquent as of December 31, 2012,  was $7 million.  See Note 1 in our 2012 Form 10-K for more information regarding our accounting policy relating to the impairment of mortgage loans on real estate.

 

Alternative Investments

 

Investment income (loss) on alternative investments by business segment (in millions) was as follows:

 

 

 

As of September 30, 2013, and December 31, 2012, alternative investments included investments in 108 and 98 different partnerships, respectively, and the portfolio represented approximately 1% of our overall invested assets.  The partnerships do not represent off-balance sheet financing and generally involve several third-party partners.  Some of our partnerships contain capital calls, which require us to contribute capital upon notification by the general partner.  These capital calls are contemplated during the initial investment decision and are planned for well in advance of the call date.  The capital calls are not material in size and are not material to our liquidity.  Alternative investments are accounted for using the equity method of accounting and are included in other investments on our Consolidated Balance Sheets.

 

As discussed in “Critical Accounting Policies and Estimates – Investments – Valuation of Alternative Investments” in our 2012 Form 10-K, we update the carrying value of our alternative investment portfolio whenever audited financial statements of the investees for the

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preceding year become available.  Net investment income (loss) derived from our consolidated alternative investments by segment (in millions) related to the effect of preceding year audit adjustments recorded during the indicated year at the investee was as follows:

 

 

Non-Income Producing Investments

 

As of September 30, 2013, and December 31, 2012, the carrying amount of fixed maturity securities, mortgage loans on real estate and real estate that were non-income producing was $11 million and $14 million, respectively.

 

Net Investment Income

 

Details underlying net investment income (in millions) and our investment yield were as follows:

 

 

 

 

 

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We earn investment income on our general account assets supporting fixed annuity, term life, whole life, UL, interest-sensitive whole life and fixed portion of retirement plan and VUL products.  The profitability of our fixed annuity and life insurance products is affected by our ability to achieve target spreads, or margins, between the interest income earned on the general account assets and the interest credited to the contract holder on our average fixed account values, including the fixed portion of variable.  Net investment income and the interest rate yield table each include commercial mortgage loan prepayments and bond make-whole premiums, alternative investments and contingent interest and standby real estate equity commitments.  These items can vary significantly from period to period due to a number of factors and, therefore, can provide results that are not indicative of the underlying trends.

 

Commercial Mortgage Loan Prepayment and Bond Make-Whole Premiums

 

Prepayment and make-whole premiums are collected when borrowers elect to call or prepay their debt prior to the stated maturity.  A prepayment or make-whole premium allows investors to attain the same yield as if the borrower made all scheduled interest payments until maturity.  These premiums are designed to make investors indifferent to prepayment.

 

The increase in prepayment and make-whole premiums when comparing 2013 to 2012 was attributable primarily to increased refinancing activity.

 

Realized Gain (Loss) Related to Certain Investments

 

Details of the realized gain (loss) related to certain investments (in millions) were as follows:

 

 

Amortization of DAC, VOBA, DSI and DFEL and changes in other contract holder funds reflect an assumption for an expected level of credit-related investment losses.  When actual credit-related investment losses are realized, we recognize a true-up to our DAC, VOBA, DSI and DFEL amortization and changes in other contract holder funds within realized loss reflecting the incremental effect of actual versus expected credit-related investment losses.  These actual to expected amortization adjustments could create volatility in net realized gains and losses.  The write-down for impairments includes both credit-related and interest rate-related impairments.

 

Realized gains and losses generally originate from asset sales to reposition the portfolio or to respond to product experience.  During the first nine months of 2013 and 2012, we sold securities for gains and losses.  In the process of evaluating whether a security with an unrealized loss reflects declines that are other-than-temporary, we consider our ability and intent to sell the security prior to a recovery of value.  However, subsequent decisions on securities sales are made within the context of overall risk monitoring, assessing value relative to other comparable securities and overall portfolio maintenance.  Although our portfolio managers may, at a given point in time, believe that the preferred course of action is to hold securities with unrealized losses that are considered temporary until such losses are recovered, the dynamic nature of portfolio management may result in a subsequent decision to sell.  These subsequent decisions are consistent with the classification of our investment portfolio as AFS.  We expect to continue to manage all non-trading invested assets within our portfolios in a manner that is consistent with the AFS classification.

 

We consider economic factors and circumstances within countries and industries where recent write-downs have occurred in our assessment of the status of securities we own of similarly situated issuers.  While it is possible for realized or unrealized losses on a

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particular investment to affect other investments, our risk management has been designed to identify correlation risks and other risks inherent in managing an investment portfolio.  Once identified, strategies and procedures are developed to effectively monitor and manage these risks.  The areas of risk correlation that we pay particular attention to are risks that may be correlated within specific financial and business markets, risks within specific industries and risks associated with related parties.

 

When the detailed analysis by our external asset managers and investment portfolio managers leads us to the conclusion that a security’s decline in fair value is other-than-temporary, the security is written down to estimated recovery value.  In instances where declines are considered temporary, the security will continue to be carefully monitored.  See “Critical Accounting Policies and Estimates” in our 2012 Form 10-K for additional information on our portfolio management strategy.

 

Details underlying write-downs taken as a result of OTTI (in millions) were as follows:

 

 

The decrease in write-downs for OTTI when comparing the first nine months of 2013 to the same period in 2012 was attributable to declines in write-downs for OTTI on corporate bonds and structured holdings.  The improvements of the write-downs for OTTI on our RMBS and CMBS holdings were primarily attributable to gradual recovery in both residential and commercial real estate markets. 

 

The $73 million of impairments taken during the first nine months of 2013 were split between $63 million of credit-related impairments and $10 million of noncredit-related impairments.  The credit-related impairments were largely attributable to our RMBS and CMBS holdings primarily as a result of weakness within select residential and commercial real estate securities.  The noncredit-related impairments were due to declines in values of securities for which we do not have an intent to sell or it is not more likely than not that we will be required to sell the securities before recovery.

 

REVIEW OF CONSOLIDATED FINANCIAL CONDITION

 

Liquidity and Capital Resources

 

Sources of Liquidity and Cash Flow

 

Liquidity refers to the ability of an enterprise to generate adequate amounts of cash from its normal operations to meet cash requirements with a prudent margin of safety.  Our principal sources of cash flow from operating activities are insurance premiums and fees and investment income, while sources of cash flows from investing activities result from maturities and sales of invested assets.  Our operating activities provided cash of $504 million and $666 million for the first nine months of 2013 and 2012, respectively.  When considering our liquidity and cash flow, it is important to distinguish between the needs of our insurance subsidiaries and the needs of the holding company, LNC.  As a holding company with no operations of its own, LNC derives its cash primarily from its operating subsidiaries. 

 

The sources of liquidity of the holding company are principally comprised of dividends and interest payments from subsidiaries, augmented by holding company short-term investments, bank lines of credit and the ongoing availability of long-term public financing

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under an SEC-filed shelf registration statement.  These sources of liquidity and cash flow support the general corporate needs of the holding company, including its common and preferred stock dividends, interest and debt service, funding of callable securities, securities repurchases, acquisitions and investment in core businesses.  Our cash flows associated with collateral received from and posted with counterparties change as the market value of the underlying derivative contract changes.  As the value of a derivative asset declines (or increases), the collateral required to be posted by our counterparties would also decline (or increase).  Likewise, when the value of a derivative liability declines (or increases), the collateral we are required to post for our counterparties’ benefit would also decline (or increase).  During the first nine months of 2013, our payables for collateral on derivative investments decreased by $1.6 billion as rising interest rates and equity markets and less volatility lowered the fair values of the associated derivative investments.  For additional information, see “Credit Risk” in Note 6.

 

Details underlying the primary sources of our holding company cash flows (in millions) were as follows:

 

 

The table above focuses on significant and recurring cash flow items and excludes the effects of certain financing activities, namely the periodic issuance and retirement of debt and cash flows related to our inter-company cash management program (discussed below).  Taxes have been eliminated from the analysis due to a tax sharing agreement among our primary subsidiaries resulting in a modest effect on net cash flows at the holding company.  Also excluded from this analysis is the modest amount of investment income on short-term investments of the holding company. 

 

Subsidiaries’ Statutory Reserving and Surplus

 

For discussion of our strategies to lessen the burden of increased AG38 and XXX statutory reserves associated with UL products containing secondary guarantees and certain other products on our insurance subsidiaries, see “Results of Life Insurance – Income (Loss) from Operations – Strategies to Address Statutory Reserve Strain.”

 

Financing Activities

 

Although our subsidiaries currently generate adequate cash flow to meet the needs of our normal operations, periodically we may issue debt or equity securities to maintain ratings and increase liquidity, as well as to fund internal growth, acquisitions and the retirement of our debt and equity securities. 

 

We currently have an effective shelf registration statement, which allows us to issue, in unlimited amounts, securities, including debt securities, preferred stock, common stock, warrants, stock purchase contracts, stock purchase units, depository shares and trust preferred securities of our affiliated trusts. 

 

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Details underlying debt and financing activities (in millions) were as follows:

 

 

 

On August 16, 2013, we completed the issuance and sale of $350 million aggregate principal amount of our 4.00% senior notes due 2023.  We expect to repay a substantial portion of the maturities mentioned above with these proceeds.  The specific resources or combination of resources that we will use to meet the remaining portion of the maturities will depend upon, among other things, the financial market conditions present at the time of maturity.  As of September 30, 2013, the holding company had available liquidity of $1.0 billion.  Available liquidity consists of cash and cash equivalents, excluding cash held as collateral, investments maturing in one year or less at origination and receivables under the inter-company cash management program, less payables under the inter-company cash management program, payables from purchases of securities not settled as of the balance sheet date and commercial paper outstanding.

 

Effective as of May 29, 2013, we entered into a credit agreement with a syndicate of banks.  This agreement (the “credit facility”) allows for the issuance of LOCs of up to $2.5 billion and borrowing of up to $2.5 billion, $1.75 billion of which is available only to reimburse the banks for drawn LOCs.  The credit facility is unsecured and has a commitment termination date of May 29, 2018.  The LOCs support inter-company reinsurance transactions and specific treaties associated with our business sold through reinsurance.  LOCs are used primarily to satisfy the U.S. regulatory requirements of our domestic insurance companies for which reserve credit is provided by our affiliated reinsurance companies, as discussed above in “Results of Life Insurance – Income (Loss) from Operations – Strategies to Address Statutory Reserve Strain,” and our domestic clients of the business sold through reinsurance.

 

The credit facility contains or includes:

 

 

Upon an event of default, the credit facility provides that, among other things, the commitments may be terminated and the loans then outstanding may be declared due and payable.  As of September 30, 2013, we were in compliance with all such covenants.

 

This credit facility replaced our previous four-year credit facility dated as of June 10, 2011, that was scheduled to expire on June 10, 2015.

 

For more information about our short-term and long-term debt and our credit facilities and LOCs, see Note 12 in our 2012 Form 10-K.

 

We have not accounted for repurchase agreements, securities lending transactions, or other transactions involving the transfer of financial assets with an obligation to repurchase the transferred assets as sales and do not have any other transactions involving the transfer of financial assets with an obligation to repurchase the transferred assets.  For information about our collateralized financing transactions on our investments, see “Payables for Collateral on Investments” in Note 5.

 

If current credit ratings and claims-paying ratings were downgraded in the future, terms in our derivative agreements may be triggered, which could negatively affect overall liquidity.  For the majority of our counterparties, there is a termination event should the long-term

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senior debt ratings of LNC drop below BBB-/Baa3 (S&P/Moody’s).  Our long-term senior debt held a rating of A-/Baa1 (S&P/Moody’s) as of September 30, 2013.  In addition, contractual selling agreements with intermediaries could be negatively affected, which could have an adverse effect on overall sales of annuities, life insurance and investment products.  During the second quarter of 2013, Moody’s upgraded the financial strength ratings of our principal insurance subsidiaries from A2 to A1. See “Part I – Item 1A. Risk Factors – Liquidity and Capital Position – A decrease in the capital and surplus of our insurance subsidiaries may result in a downgrade to our credit and insurer financial strength ratings” and “Part I – Item 1A. Risk Factors – Covenants and Ratings – A downgrade in our financial strength or credit ratings could limit our ability to market products, increase the number or value of policies being surrendered and/or hurt our relationships with creditors” in our 2012 Form 10-K for more information.  See “Part I – Item 1. Business – Financial Strength Ratings” in our 2012 Form 10-K for additional information on our financial strength ratings.

 

See “Part II – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Review of Consolidated Financial Condition – Liquidity and Capital Resources – Financing Activities” in our 2012 Form 10-K for information on our credit ratings.

 

Alternative Sources of Liquidity

 

In order to manage our capital more efficiently, we have an inter-company cash management program where certain subsidiaries can lend to or borrow from the holding company to meet short-term borrowing needs.  The cash management program is essentially a series of demand loans among LNC and its affiliates that reduces overall borrowing costs by allowing LNC and its subsidiaries to access internal resources instead of incurring third-party transaction costs.  The holding company had an outstanding payable of $54 million to certain subsidiaries resulting from amounts placed by the subsidiaries in the inter-company cash management account in excess of funds borrowed by those subsidiaries as of September 30, 2013.  Any change in holding company cash management program balances is offset by the immediate and equal change in holding company cash and cash equivalents.  Loans under the cash management program are permitted under applicable insurance laws subject to certain restrictions.  For our Indiana-domiciled insurance subsidiaries, the borrowing and lending limit is currently 3% of the insurance company’s admitted assets as of its most recent year end.  For our New York-domiciled insurance subsidiary, it may borrow from LNC less than 2% of its admitted assets as of the last year end but may not lend any amounts to LNC.

 

Our insurance subsidiaries, by virtue of their general account fixed income investment holdings, can access liquidity through securities lending programs and repurchase agreements.  As of September 30, 2013, our insurance subsidiaries had investments with a carrying value of $2.6 billion out on loan or subject to reverse-repurchase agreements.  The cash received in our securities lending programs and repurchase agreements is typically invested in cash equivalents, short-term investments or fixed maturity securities.  For additional details, see “Payables for Collateral on Investments” in Note 5.

 

For factors that could cause actual results to differ materially from those set forth in this section, see “Forward-Looking Statements – Cautionary Language” above and “Part I – Item 1A. Risk Factors” in our 2012 Form 10-K.

 

Divestitures

 

For a discussion of our divestitures, see Note 3.

 

Uses of Capital

 

Our principal uses of cash are to pay policy claims and benefits, operating expenses, commissions and taxes, to purchase new investments, to purchase reinsurance, to fund policy surrenders and withdrawals, to pay dividends to our stockholders and to repurchase our stock and debt securities.

 

Return of Capital to Common Stockholders

 

One of the Company’s primary goals is to provide a return to our common stockholders through share price accretion, dividends and stock repurchases.  In determining dividends, the Board of Directors takes into consideration items such as current and expected earnings, capital needs, rating agency considerations and requirements for financial flexibility.  The amount and timing of share repurchase depends on key capital ratios, rating agency expectations, the generation of free cash flow and an evaluation of the costs and benefits associated with alternative uses of capital.  Free cash flow for the holding company generally represents the amount of dividends and interest received from subsidiaries less interest paid on debt.

 

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Details underlying this activity (in millions, except per share data), were as follows:

 

 

On November 8, 2012, our Board of Directors approved an increase of the quarterly dividend on our common stock from $0.08 to $0.12 per share.  Additionally, we expect to repurchase additional shares of common stock during the remainder of 2013 depending on market conditions and alternative uses of capital.  For more information regarding share repurchases, see “Part II – Item 2(c)” below.

 

Other Uses of Capital

 

In addition to the amounts in the table above in “Return of Capital to Common Stockholders,” other uses of holding company cash flow (in millions) were as follows:

 

 

The above table focuses on significant and recurring cash flow items and excludes the effects of certain financing activities, namely the periodic retirement of debt and cash flows related to our inter-company cash management account.  Taxes have been eliminated from the analysis due to a tax sharing agreement among our primary subsidiaries resulting in a modest effect on net cash flows at the holding company.

 

Significant Trends in Sources and Uses of Cash Flow

 

As stated above, LNC’s cash flow, as a holding company, is largely dependent upon the dividend capacity of its insurance company subsidiaries as well as their ability to advance funds to it through inter-company borrowing arrangements, which may be affected by factors influencing the insurance subsidiaries’ RBC and statutory earnings performance.  We currently expect to be able to meet the holding company’s ongoing cash needs and to have sufficient capital to offer downside protection in the event that the capital and credit markets experience another period of extreme volatility and disruption.  A decline in capital market conditions, which reduces our insurance subsidiaries’ statutory surplus and RBC, may require them to retain more capital and may pressure our subsidiaries’ dividends to the holding company, which may lead us to take steps to preserve or raise additional capital.  For factors that could affect our expectations for liquidity and capital, see “Part I – Item 1A. Risk Factors” in our 2012 Form 10-K. 

 

OTHER MATTERS

 

Other Factors Affecting Our Business

 

In general, our businesses are subject to a changing social, economic, legal, legislative and regulatory environment.  Some of the changes include initiatives to require more reserves to be carried by our insurance subsidiaries.  Although the eventual effect on us of the changing environment in which we operate remains uncertain, these factors and others could have a material effect on our results of operations, liquidity and capital resources.  For factors that could cause actual results to differ materially from those set forth in this section, see “Part I – Item 1A. Risk Factors” in our 2012 Form 10-K and “Forward-Looking Statements – Cautionary Language” above.

 

Recent Accounting Pronouncements

 

See Note 2 for a discussion of recent accounting pronouncements that have been implemented during the periods presented or that have been issued and are to be implemented in the future.

 

Item 3.  Quantitative and Qualitative Disclosures About Market Risk

 

We analyze and manage the risks arising from market exposures of financial instruments, as well as other risks, in an integrated asset-liability management process that considers diversification.  By aggregating the potential effect of market and other risks on the entire enterprise, we estimate, review and in some cases manage the risk to our earnings and shareholder value.  We have exposures to several

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market risks including interest rate risk, equity market risk, default risk, credit related derivatives risk, credit risk and, to a lesser extent, foreign currency exchange risk.  The exposures of financial instruments to market risks, and the related risk management processes, are most important to our business where most of the invested assets support accumulation and investment-oriented insurance products.  As an important element of our integrated asset-liability management processes, we use derivatives to minimize the effects of changes in interest levels, the shape of the yield curve, currency movements and volatility.  In this context, derivatives are designated as a hedge and serve to minimize interest rate risk by mitigating the effect of significant increases in interest rates on our earnings.  Additional market exposures exist in our other general account insurance products and in our debt structure and derivatives positions.  Our primary sources of market risk are substantial, relatively rapid and sustained increases or decreases in interest rates or a sharp drop in equity market values.  These market risks are discussed in detail in the following pages and should be read in conjunction with our consolidated financial statements and the accompanying notes to the consolidated financial statements (“Notes”) presented in “Item 1. Financial Statements,” as well as “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” (“MD&A”).

 

Interest Rate Risk  

 

Interest Rate Risk on Fixed Insurance Businesses

 

In periods of low interest rates, we have to reinvest the cash we receive as interest or return of principal on our investments in lower yielding instruments.  Moreover, borrowers may prepay fixed income securities, commercial mortgages and mortgage-backed securities in our general accounts in order to borrow at lower market rates, which exacerbates this risk.  Because we are entitled to reset the interest rates on our fixed rate annuities only at limited, pre-established intervals, and because many of our contracts have guaranteed minimum interest or crediting rates, our spreads could decrease and potentially become negative. 

 

Prolonged historically low rates are not healthy for our business fundamentals.  However, we have recognized this risk and have been proactive in our investment strategies, product designs, crediting rate strategies and overall asset-liability practices to mitigate the risk of unfavorable consequences in this type of environment.  For some time now, new products have been sold with low minimum crediting floors, and we apply disciplined asset-liability management standards, such as locking in spreads on these products at the time of issue.

 

If we were to assume a hypothetical stress scenario where the 10-year U.S. Treasury rate remains at 2.50% through the end of 2014, the impact relative to 2013 would result in an approximate unfavorable earnings effect of $30 million in 2014.  The earnings drag from this scenario related to the effect of continued low new money rates is largely concentrated in our Life Insurance and Retirement Plan Services segments.

 

The estimate above was based upon a hypothetical scenario and is only representative of the effects of assumptions around rates through 2014 keeping all else equal and does not give consideration to the aggregate effect of other factors, including but not limited to:  contract holder activity; sales; hedge positions; changing equity markets; shifts in implied volatilities; and changes in other capital market sectors as well as actions we might take to mitigate the effect of the low rate environment.  In addition, the scenario only illustrates the effect to spreads and certain unlocking and reserve changes.  Other potential effects of the scenario were not considered in the analysis.  See “Part I – Item 1A. Risk Factors – Market Conditions – Changes in interest rates and sustained low interest rates may cause interest rate spreads to decrease and changes in interest rates may also result in increased contract withdrawals” in our 2012 Form 10-K for additional information on interest rates. 

 

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The following provides detail on the percentage differences between the September 30, 2013, interest rates being credited to contract holders based on the third quarter of 2013 declared rates and the respective minimum guaranteed policy rate (in millions), broken out by contract holder account values reported within our segments:

 

 

 

 

The maturity structure and call provisions of the related portfolios are structured to afford protection against erosion of investment portfolio yields during periods of declining interest rates.  We devote extensive effort to evaluating the risks associated with falling interest rates by simulating asset and liability cash flows for a wide range of interest rate scenarios.  We seek to manage these exposures by maintaining a suitable maturity structure and by limiting our exposure to call risk in each respective investment portfolio.

 

Derivatives

 

See Note 6 for information on our derivatives used to hedge our exposure to changes in interest rates.

 

Equity Market Risk

 

Our revenues, assets, liabilities and derivatives are exposed to equity market risk.  Due to the use of our reversion to the mean (“RTM”) process and our hedging strategies, we expect that, in general, short-term fluctuations in the equity markets should not have a significant effect on our quarterly earnings from unlocking of assumptions for deferred acquisition costs, value of business acquired, deferred sales inducements and deferred front-end loads.  However, earnings are affected by equity market movements on account values and assets under management and the related fees we earn on those assets.  Refer to “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Introduction – Critical Accounting Policies and Estimates – DAC, VOBA, DSI and DFEL”  in our 2012 Form 10-K for further discussion of the effects of equity markets on our RTM.

 

Effect of Equity Market Sensitivity

 

If the level of the Standard & Poor’s (“S&P”) 500 Index® (“S&P 500”) were to instantaneously increase or decrease by 1% immediately after September 30, 2013, we estimate the effect on income (loss) from operations (in millions) for the next 12 month period from the change in asset-based fees and related expenses would be approximately $7 million.  For purposes of this sensitivity, we used the S&P 500

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as a proxy for equity market performance.  This estimate excludes any effect related to sales, unlocking, persistency, hedge program performance or customer behavior caused by the equity market change. 

 

The effect of quarterly equity market changes upon fee revenues and asset-based expenses is generally not fully recognized in the first quarter of the change because fee revenues are earned and related expenses are incurred based upon daily variable account values.  The difference between the current period average daily variable account values compared to the end of period variable account values affects fee revenues in subsequent periods.  Additionally, the effect on earnings may not necessarily be symmetrical with comparable increases or decreases in the equity markets.  This discussion concerning the estimated effects of ongoing equity market volatility on the fees we earn from account values and assets under management is intended to be illustrative and is concentrated primarily in our Annuities and Retirement Plan Services segments.  Actual effects may vary depending on a variety of factors, many of which are outside of our control, such as changing customer behaviors that might result in changes in the mix of our business between variable and fixed annuity contracts, switching among investment alternatives available within variable products, changes in sales production levels or changes in policy persistency.  For purposes of this guidance, the change in account values is assumed to correlate with the change in the relevant index. 

 

Credit-Related Derivatives

 

We use credit-related derivatives to minimize our exposure to credit-related events and we also sell credit default swaps to offer credit protection to our contract holders and investors.  See Note 6 for additional information.

 

Credit Risk  

 

See Note 6 for information on our credit risk.

 

In addition to the information provided about our counterparty exposure in Note 6, the fair value of our exposure by rating (in millions) was as follows:

 

 

Item 4.  Controls and Procedures

 

Conclusions Regarding Disclosure Controls and Procedures

 

We maintain disclosure controls and procedures, which are designed to ensure that information required to be disclosed in the reports we file or submit under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. As of the end of the period required by this report, we, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Exchange Act).  Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to us and our consolidated subsidiaries required to be disclosed in our periodic reports under the Exchange Act.

 

Changes in Internal Control Over Financial Reporting

 

There was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that occurred during the quarter ended September 30, 2013, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

A control system, no matter how well designed and operated, can provide only reasonable assurance that the control system’s objectives will be met.  Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the company have been detected.  Projections of any evaluation of controls effectiveness to future periods are subject to risks.  Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.

 

 

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PART II – OTHER INFORMATION

 

Item 1.  Legal Proceedings

 

Information regarding reportable legal proceedings is contained in Note 9 to the consolidated financial statements in “Part I – Item 1.”

 

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds

 

(c)  The following table summarizes purchases of equity securities by the issuer during the quarter ended September 30, 2013 (dollars in millions, except per share data): 

 

 

 

(1)Includes the deemed surrender of 1,392 shares of common stock to pay the exercise price in connection with the exercise of stock options.  For the quarter ended September 30, 2013, there were 2,320,882 shares purchased as part of publicly announced plans or programs. 

(2)On August 8, 2012, our Board of Directors authorized an increase in our securities repurchase authorization, bringing the total aggregate repurchase authorization to $1.0 billion.  As of September 30, 2013, our remaining security repurchase authorization was $458 million.  The security repurchase authorization does not have an expiration date.  The amount and timing of share repurchase depends on key capital ratios, rating agency expectations, the generation of free cash flow and an evaluation of the costs and benefits associated with alternative uses of capital.  On May 23, 2013, we announced a redemption of all of our outstanding $3.00 Cumulative Convertible Preferred Stock, Series A (“Series A Preferred Stock”).  We redeemed 450 shares of Series A Preferred Stock, which were convertible into 16 shares of Common Stock, on July 2, 2013.  The table reflects the redemption in shares of Common Stock.

(3)As of the last day of the applicable month. 

 

Item 6.  Exhibits

 

The Exhibits included in this report are listed in the Exhibit Index beginning on page E-1, which is incorporated herein by reference.

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.