Good morning, and thank you for joining Lincoln Financial Group's LDTI Investor Disclosure conference call. At this time, all lines are in a listen-only mode. Later, we will announce the opportunity for questions, and instructions will be given at that time. If you need assistance at any time during the call, please press the star key followed by zero, and someone will assist you. Now, I would like to turn the conference over to the Vice President of Investor Relations, Al Copersino. Please go ahead, sir.
Thank you. Good morning, and welcome to Lincoln Financial LDTI Initial Disclosure conference call. Before we begin, I have an important reminder. Any comments made during the call regarding future expectations, including those regarding the expected impacts of the adoption of LDTI on book value earnings, hedge costs, and capital generation, as well as any other future expectations regarding deposits, expenses, income from operations, share repurchases, and liquidity and capital resources are forward-looking statements under the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from current expectations. These risks and uncertainties include those described in the cautionary statement disclosures in our LDTI initial disclosure presentation posted on our website and furnished on Form 8-K this morning.
As well as those detailed in our 2021 annual report on Form 10-K, most recent quarterly reports on Form 10-Q, and from time to time in our other filings with the SEC. These forward-looking statements are made only as of today, and we undertake no obligation to update or revise any of them to reflect events or circumstances that occur after this date. We appreciate your participation today and invite you to visit Lincoln's website, www.lfg.com, where you can find the slide presentation we will be discussing today, which includes reconciliations of the non-GAAP measures used on this call, including book value per share excluding AOCI, adjusted return on equity and adjusted income from operations or adjusted operating income to the most comparable GAAP measures. Presenting on today's call are Ellen Cooper, President and CEO, and Randy Freitag, Chief Financial Officer.
After their prepared comments, we will move to a question-and-answer portion of the call. We expect the call to take about 30 minutes. As a reminder, on today's call, we will not be discussing upcoming third quarter earnings nor our ongoing annual assumption review. I would now like to turn the call over to Ellen.
Thank you, Al, and good afternoon, everyone, and welcome. On today's call, you will hear about the expected impacts from our adoption of LDTI. We expect minimal impact to adjusted operating income, though there will be some additional net income volatility. I also want to highlight what is not changing. Importantly, LDTI will have no impact on cash flow generation, capital return, new business return targets, sales or our business mix. Lastly, we are making enhancements to our VA hedge program to maximize distributable earnings under a range of economic scenarios with an explicit capital hedge. These enhancements are aligned with our increased strategic emphasis on free cash flow generation, as discussed on our last earnings call. We look forward to providing more detail as we further build out our long-term strategic framework. With that, I will turn the call over to Randy.
Thank you, Ellen. Earlier today, we shared our LDTI initial disclosure presentation, which illustrates the impact on our reported financial results versus current GAAP and highlights important updates to our hedge program. The figures we will discuss today reflect our current expectations and are our best estimates. I would like to highlight a few key messages before going into some detail. First, as of June 30, we estimate LDTI would have an immaterial impact to total book value and a very moderate impact on book value ex-AOCI. Second, adjusted operating income will be minimally impacted and will continue to reflect the expected cost of hedging. Third, net income volatility will increase, driven by the impact of capital market movements on market risk benefits or MRBs.
Fourth, in alignment with our increased strategic focus on cash flow generation, our hedge program will now have a goal of maximizing the present value of distributable earnings. The program will continue to focus on generating sufficient assets to fund future claims at the same level of cost as the existing program. Lastly, LDTI is an accounting change. It does not change economics such as cash flows, capital requirements, or new business target returns. Turning to book value on slide five. Three shifts that have occurred since 12/31/2020, driven primarily by the rise in rates and spreads. First, the impact of the LFPB component changed from a negative to a slight positive. Second, our investment portfolio has moved to an unrealized loss position. Generally, shadow DAC adjustments move in the opposite direction of unrealized gains and losses, so the removal of shadow DAC moves to a small negative.
Finally, we have witnessed a significant reduction in the impact of MRBs on book value and book value ex-AOCI. Diving further into MRBs on slide six, we estimate that as of 6/30/2022, MRBs will sit on our balance sheet as a net liability of roughly $1 billion. Unchanged from our current accounting, leading to an immaterial impact on book value. This includes a negative impact on book value ex-AOCI, offset by a positive impact on AOCI. These two countervailing impacts are driven by the geographic move under LDTI of the change in the credit spread component of shareholders' equity from retained earnings to AOCI. Given this treatment of the credit spread component, we view total book value as the appropriate measure. At the bottom of page six are the estimated sensitivities of the MRB reserve impacts to changes in the capital markets. Turning to slide seven.
We expect an immaterial impact on adjusted operating income. There are some moving pieces, including a negative impact from back amortization on life insurance earnings. In total, we expect only a small impact on operating income. We expect net income volatility to rise primarily as the result of quarterly fair value changes in MRBs, which we will exclude from our definition of adjusted operating income. As a reminder, each year, we will take $800 million of hedge costs directly out of adjusted operating income. Lastly, turning to page eight. I would like to provide an update on our hedge program. The program will continue to focus on generating sufficient assets from future claims using similar instruments as our current program and at a similar cost. The past program focused on matching movements in the GAAP liability.
The new program will focus on capital protection and on maximizing statutory distributable earnings under a broad range of modeled scenarios. The shift in focus is aligned with our increased strategic emphasis on capital generation. Finally, Linbar will continue to host our VA hedge program. Additionally, with the shift in focus of our hedge program, Linbar's regulatory accounting framework for VA reserves will change from GAAP to statutory. In closing, we see little impact on our adjusted operating income or balance sheet, and we'll be making adjustments to our hedge program, which will continue to be industry-leading, aligned with our strategic focus on cash flow generation, and with, as Ellen said, no impact to our products, distribution, or business mix. With that, let me turn the call back over to Al.
Thank you, Ellen and Randy. We will now begin the question and answer portion of the call. As a reminder, we ask that you please limit yourself to one question and one follow-up, and then if you have additional questions. With that, let me turn the call over to the operator to begin Q&A.
At this time, if you would like to ask a question, simply press star, then the number one on your telephone keypad. If you would like to withdraw your question, press star one again. For optimal sound quality, please do not use a speakerphone. Please speak directly into your receiver or use a wired headset with a microphone. Our first question will come from the line of Ryan Krueger with KBW. Please go ahead.
Hi. Thanks. I had a question on your updated VA hedging. Given the change in the MRB calculation, can you give us any rough sense of what percentage of the equity market risk and interest rate risk under the new fair value regime that your hedge target would be hedging? Maybe excluding the death benefits. I'm really focused on the living benefit guarantees.
Ryan, thanks for the question. I think without getting into too much specifics, and as I mentioned in my script, I think the levels and type of coverage we're gonna get in the new program are very similar to what we got in the old program. One way to think about the shift to a program that's more focused on capital protection, one way I think about it, essentially, we're tightening the range around the level of CTE we manage to. In the old program, we would benefit when the markets rallied, but we would have a little more downside when you saw the markets go down in relation to CTE. Basically, what we're doing is we're selling away some of that upside benefit to get more downside protection. You know, as we said, the program is gonna continue to be very robust.
It's gonna have significant amount of coverage against movement in equity markets, interest rates, volatility, all the various Greeks we had. I feel very good about the program. We'll have a similar cost. A cost, as just as we've done in the past, we'll continue to pull out of operating income, not trying to hide the cost of running a program like this. But, you know, I think, Ryan, when you think about that cost, it's a good indication of the quality, and the level of hedging we will be doing.
Ryan, I will also add, as we have talked about our increased emphasis on cash flow generation, we have also talked about this notion that Randy mentioned around less capital volatility from capital markets. The hedge strategy of the future is really focused exactly on that as its objective.
Thanks. Since you're shifting to a stat regime in Linbar, I think there's some optionality right now with how companies reflect hedging within their reserves, whether you use mean reversion or you use, you know, more of an implicit CDHS approach. Can you give any color on how you're thinking about that?
Yeah, Ryan, without getting into the specifics of exactly, you know, how we'll adopt statutory, we will follow all the rules. We've run this by, and it's already been approved, by the way, by the Barbados Financial Services Commission, by our Indiana regulators. We'll be following all the appropriate rules and regulations surrounding how you account for these things under statutory.
All right, great. Thank you.
Our next question will come from the line of Suneet Kamath with Jefferies. Please go ahead.
Yeah, thanks. Just on your comment about distributable earnings equal to or above the current level, can you just remind us where are we in terms of the current level of distributable earnings? You're using this sort of present value concept. I just wanna make sure there's not a issue from a timing perspective where some of the distributable earnings might be out into the future, where there's some sort of near term reduction in it. Just curious about that.
Yeah. See, really keeping this call focused on LDTI, I think a very easy way to think about the impact of the new program versus the old program is the fact that they have the same expected costs, right? That's the real cost, going against distributable earnings, and they're not changing, from the old program to the new program. No impact on cash flow generation from this switch. Exactly as Ellen said, and as I said, what you do get is an increased focus on that capital protection aspect, and thus maximizing those distributable earnings over time from a present value standpoint. In terms of the immediate impact, no impact reflected by this, those, the same costs in the current, and the new program.
Got it.
Yeah. Additionally, we do see, as we have talked about the fact that we have an explicit capital hedge, which means that we will see some favorability in adverse capital market scenarios in the new hedge strategy.
Got it. Then some of these market risk benefit impacts are pretty sizable when you start to think about kind of the environment that we're in right now. Have you confirmed with the rating agencies that there won't be any sort of changes to views on your leverage, debt to capital, that kind of thing?
Suneet, we've had discussions with the agencies. I would tell you, I think the agencies are still trying to figure out what their approach is gonna be. You know, as we noted, there's gonna be more volatility in net income, for instance. I think the agencies are still deciding or defining how exactly they're gonna think about this new approach to LDTI. I don't see it as an issue. Once again, it doesn't change cash flow, which ultimately is what matters, I think, most to the rating agencies. While I can't tell you definitively because they're still working on their answer, I don't see it as an issue.
Okay, thanks.
Your next question comes from the line of Tom Gallagher with Evercore. Please go ahead.
Hi. The first question I had is there any consideration being given to collapsing Linbar back into the OpCo since you're now shifting back to a stat accounting framework? I thought the whole, you know, the kind of rationale for having that to begin with was the differences in accounting regime. Is that something you're contemplating?
Not out of the gate, Tom. You know, I think there still are some advantages. You know, there are some aspects of statutory, for instance, the reserve can't go below zero, where I think you still get some benefits from Linbar. I do agree with you that as we move more in alignment with statutory that it is something we will continue to assess. I think we feel good about operating the program in Linbar. It's gonna continue to remain a well-capitalized entity. But we'll operate the program for a while, and I think it's something we'll continually assess over time whether it eventually makes sense to bring it back into our own.
Gotcha. Just a related question. Randy, I think historically you had evaluated capital adequacy at Linbar looking at a two-tiered test. One was on GAAP accounting metrics, and then the other one was on CTE 98. I assume since you're shifting to stat, you're no longer gonna look at GAAP as an appropriate parameter. If that's true, does that mean does your starting point when you evaluate capital adequacy there, is there any excess there? Or maybe you could just comment at all about the approach to the capital adequacy and how you're gonna manage it going forward.
Tom, there are really two lenses we need to bring to Linbar when we think about capital. There's the management view, a CTE economic-focused approach to capitalizing the entity, and then there's a regulatory view. There's a regulatory minimum amount of capital, which is simply the assets minus liabilities inside of the entity. That last one was really highlighted by the importance of shifting the underlying way we value the liabilities from GAAP to stat. As we shifted the program more in alignment with stat, it became very important to change the underlying way we value the liabilities. That sort of, you know, supports that regulatory view of capital. In terms of the economic view of capital, the same way we've always managed, I don't see any change.
As we talked about similar costs, so I don't see any change to what we talked about on last quarter's call in terms of dividends out of Linbar, which I don't see any for the remainder of this year. We did take one earlier in the year. I think the entity remains well capitalized. I don't see this change in how we hedge the liability is having really any significant impact on the capital we may or may not distribute out of Linbar.
Okay, thanks.
Mm-hmm.
Your next question comes from the line of Alex Scott with Goldman Sachs. Please go ahead.
Hi. The first question I had is just related to some of the net income volatility. I mean, if I look at slide five, it looks like probably over $4 billion is kinda flowed positively through net income from a combination of markets up and rates up and so forth. I guess, you know, I saw elsewhere in the deck, you know, where, you know, some of that volatility was sort of referenced as being noneconomic. What I wanted to understand was sort of what are the key reasons that you view that as being noneconomic?
I mean, you know, the reason I ask is, you know, I think there's another company out there that maybe views, you know, the new framework as a little bit more economic than the one we've had in the past. You know, and I think away from variable annuities in general, you know, market neutral approach is generally, you know, the way people value derivatives. You know, what is it that's more unique about, you know, this kind of liability and, you know, the derivative you've written as part of your book that causes you to call that noneconomic?
I think fundamentally, Alex, we don't think that a pure risk-free rate is the appropriate way to value this liability. By the way, I don't think anybody in our industry does that or truly manages or hedges that way, regardless of what you've heard. I'm pretty sure that nobody is actually running a program that way. Why do we believe that? There are a number of ways to think about it. There's no liability on our balance sheet that we manage without thinking about the concept of credit. When we think specifically about a VA liability here, comparing it, I think in your question to something like a put option. When you think about a put option which has immediate liquidity, it's very economic and sensible to use risk-free rates, right?
If you, as a counterparty, need to be there whenever asked to provide the funds, the value of that particular liability, it makes all the sense in the world that you can't take credit risk, and thus you should value it that way. Contrast that with the nature of these liabilities, which don't have what you would call liquidity, right? Think about what creates the event, in the case of our liabilities. One is death for the guaranteed minimum death benefit. The other is typically some sort of retirement-linked event. Right? I mean, that's oftentimes what the living benefit liabilities are used for. It's not something where, you know, the day the markets move, somebody's calling you up and saying, "I want my money today." In that framework, it doesn't make sense to use purely a risk-free rate.
You can take credit risk to manage that sort of liability. It's very economic, it's very appropriate, and I think that's pretty much how everybody in our industry thinks about these liabilities, Alex.
Yes. Alex, I'll also add that one of the objectives of the current hedge program and also the future hedge program is around generating sufficient assets to fund the future claims, while we're also trying to maximize the earnings profile of the block. You know, to address the question around economics also, just recognizing the period-to-period volatility, and you can see it on this page in terms of, you know, with the rate move and a little bit of an equity move, how much that has moved the MRB liability over that period of time.
Well, if we were period to period looking at hedging that particular piece, that would be extremely expensive, and it really would not maximize the overall earnings of the block, nor would it meet the objective of really, at the end of the day, generating sufficient assets to fund future claims. We have looked at this and really optimized it and then ultimately come to the decision that in order to meet those objectives, that the best way to do it is exactly, you know, what we are defining for you today as our future hedging program.
The other thing I'd say, Alex, is we're not trying to hide the fact that it does cost money to provide these guarantees. As I mentioned, we, as we always have, we'll be pulling $800 million out of our view of earnings. You know, think about that over a five-year period of time. That's roughly $4 billion of costs. Over that period, I think what you would see is you'll see the MRB move up and down. Over time, this cost, as we believe, represents a very good levelized version of the real economics of providing these guarantees for all the reasons Ellen and I both just talked about.
Got it. A follow-up on the last piece. You're putting $800 million of costs. I guess I'd be interested in. I assume you're also including the rider fees themselves, so is that still a net positive? That's sort of one piece of the question. Then, the other thing I wanted to understand is, in addition to the volatility, I guess this attributed fee that's being calculated is also based on a market-neutral approach and sort of, I guess, is an indication of, like, my understanding of it anyway is it's an indication of how much it would roughly cost to maybe offset the liability if you were trying to market-neutral hedge.
You know, is that attributed fee gonna be higher than, you know, the fees you're actually getting on the rider. You know, if that's the case, is there a more ongoing, even in a normal market, like where the volatility from like just, you know, changes in equities and rates isn't coming through. Is there still sort of a drag below the line because of that attributed fee dynamic that would, you know, impact your compounded book value on a GAAP basis? Sorry for the detailed question.
Yeah, obviously, Alex, that'll be all part of our disclosures under LDTI. Yeah, to confirm your question, the attributed fees will be higher than our overall charges. $800 million, the costs of our program is slightly below the actual fees we collect. I think, you know, the attributed fees is a good example of why sort of a market neutral or risk-free doesn't make sense. I don't have the exact numbers, but the attributed fees for just one of our benefits, the guaranteed minimum death benefits. I've heard this factoid. For one year, the attributed fees that will appear in our 10-K is greater than the guaranteed minimum death benefits we've paid out over the past 20 years. That should give you an example of why market neutral just.
That's a real tangible factor on how, you know, the nature of these sorts of liabilities just doesn't make sense.
Got it. Maybe one more really quick one for me. When you're changing over to statutory and Linbar, you know, I heard your response to Ryan's question. I guess, you know, the scenario generator that you're using in there, I mean, my understanding is this American Academy scenario generator is, you know, not particularly useful these days and that they're switching to a new one. I mean, when you guys make that switch, are you gonna be switching to like that old triple A model, or is there something more modern that you're contemplating there?
It works a little different. I think the generator they have today is very useful. It's used as part of the calculation. The NAIC is currently investigating whether they wanna switch generators. You know, if they switch generators, and that's what we need to use as part of the calculation, that's what we'll use, and we'll adopt that, if and when they do that. We're part of that process. We're very involved, as we always are with any change with the regulators. I'm sure we'll adopt it and we'll manage it going forward that way.
Got it. Thanks for the answers. We'll try to be thoughtful about all this.
Thanks, Alex.
Our next question will come from the line of Erik Bass with Autonomous Research. Please go ahead.
Thank you. It doesn't look like there are any material updates to existing reserves in the life business. So I just wanted to confirm that's the case. Also, how will the pattern of earnings in the life business be affected? Should we see less quarter-to-quarter volatility from mortality fluctuations than we would have historically?
In the life business does not have any MRB impact, right? It's only impacted by the other two components, the liability for future policyholder benefits and then the shadow DAC, right? There's a very small and immaterial impact in the life business. As I mentioned, as part of our earnings, which in total we have an immaterial impact inside of life. The earnings impact in the first year will be a modest negative. That negative will decline over time. I think the very fact that DAC amortization is now going to a levelized approach should give you more ability to project the next quarter's amortization and then presumably the overall earnings. You know, I think one thing you are gonna lose with this levelized approach to amortization is the offset to movements in other financial statement items.
For instance, if mortality is better or worse than expected, in the old world, you would've had a buffer or an offset in DAC amortization, and you won't have that in the future. You're gonna have a little less buffering in the future world on items that move period to period, but you are gonna have an amount of DAC amortization that should be pretty predictable.
Got it. I guess I was thinking more of the benefits kind of each quarter where I think you're setting more of a, call it, I guess, a smoother.
Immaterial. Yeah.
Expectations pattern.
An immaterial impact on the emergence of earnings . I think what you're talking about is Liability for Future Policyholder Benefits. An immaterial impact as we look at it.
Got it. I think you mentioned you're considering the use of an adjusted book value measure given the MRB impacts. I guess, how are you thinking about setting the initial valuation level for the market risk benefits given how sensitive they are to market inputs?
Yeah. Erik, I think as I said in my script, we view when you think about the MRBs, the impact on total book value, which at 6/30 was roughly zero, that would be how we would set sort of the time zero number. What we'd be adjusting out of this measure looking forward would be the period-to-period movement in the MRB value. What will be coming out of that adjusted book value measure, though, just as a reminder, would be those $800 million of cost, right? Sort of that levelized version of period-to-period volatility you'll see in the MRB calculation.
Got it. Okay. You view the 630 numbers as a reasonable starting point.
That methodology, that looking at the total impact on book value, whatever that is on 12/31 of the end of this year of 2022.
Got it. Okay. Thank you.
Mm-hmm.
That is all the time we have for questions today. Management will be following up on the remaining questions later this afternoon. I'll turn the call back over to Al for any closing remarks.
Well, thank you all for joining us, and have a great day.
Ladies and gentlemen, that will conclude today's meeting. Thank you all for joining. You may now disconnect.