Good afternoon, and thank you for joining Lincoln Financial Group's Second Quarter 2012 Earnings Conference Call. At this time, all lines are in a listen-only mode. Later, we'll 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 star then zero, and someone will assist you. At this time, I would like to turn the conference over to Senior Vice President of Investor Relations, Jim Sjoreen . Please go ahead, sir.
Thank you, operator, and good afternoon, and welcome to Lincoln Financial's second quarter earnings call. Before we begin, I have an important reminder. Any comments made during the call regarding future expectations, trends and market conditions, including comments about liquidity and capital resources, premiums, deposits, expenses, and income from operations, 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 are described in the cautionary statement disclosures in our earnings release issued yesterday and our reports on Forms 8-K, 10-Q, and 10-K filed with the SEC.
We appreciate your participation today and invite you to visit Lincoln's website, www.lincolnfinancial.com, where you can find our press release and statistical supplement, which include a full reconciliation of the non-GAAP measures used in the call, including income from operations and return on equity, to their most comparable GAAP measures. Also, presenting on today's call are Dennis Glass, President and Chief Executive Officer, and Randy Freitag, Chief Financial Officer. After their prepared remarks, we will move to the question and answer portion of the call. I would now like to turn the call over to Dennis.
Thank you, Jim, and good afternoon, everyone. Overall, it was another excellent quarter for us, with all of our businesses delivering solid results. Our strong performance underscored the strength of our franchise, the flexibility of our balance sheet, and the aggressive actions we continue to take in response to difficult macroeconomic trends. We expect that the tough macro conditions will continue, as will the deliberate steps we are taking to keep us on track for delivering on our long-term goals and objectives. Let me now share some highlights from the quarter. We ended the second quarter with operating return on equity at 12%, book value per share growth of 5%, income from operations per share up 8%, and operating revenue growth of 2%. All clear indicators that we are delivering on the strategies we have discussed with you in the past.
Increased deposits and positive net flows in retirement plan services, as well as strong top-line results in group protection, demonstrate that our investments in talent, technology, and distribution are yielding results. Although life sales were mixed, we did experience strong results in the higher-return products we have pivoted to the past several quarters. Our strong capital position enabled us to repurchase another $150 million in shares. With our current valuation inconsistent with the actions we have taken and the results we have achieved, buying our shares is one of our best capital management uses. Let me now comment on underlying businesses. Life insurance sales for the quarter were $128 million, down from a year ago. This decline was expected as we continue to be a leader in implementing pricing actions that respond to the low interest rate environment.
We are committed to taking additional action if conditions require us to do so. To making pricing adjustments, we also continued our pivot to higher return, less interest rate sensitive products. Second quarter sales of these products, which include Variable Universal Life, Indexed Universal Life, and Term, were up 20% from the prior year quarter. Moving forward, our ability to keep pivoting to these products will be driven by the breadth, depth, and capability of our distribution teams. Turning to the annuity business, we are also responding to low interest rates and market volatility by implementing product changes on our Variable Annuity platform, by expanding our Protected Fund solutions, and by adding new distribution partners and strengthening relations within existing networks. You have heard me say this before, we are pleased with where we are positioned in the industry.
We maintain a consistent market presence, we remain more interested in offering products on our terms than we are focused on taking market share. Positive net flows in the second quarter helped drive annuity account balances of $90 billion, up 2% from a year ago. We continue to see strong results from our Protected Fund Series, as evidenced by 65% of June Variable Annuity purchasers opting for this solution. Our Protected Funds remain a good solution for consumers because they can lower the volatility of their returns and a good offering for Lincoln because they reduce our hedging costs. Our strategic partnership with Primerica also continues to be a source of growth and diversification. Indexed Annuity sales in the second quarter via this network were $100 million, up from $25 million in the first quarter.
In our retirement plan services business, we delivered solid results in the quarter with the benefits of our strategic investments taking deeper hold. Total deposits of $1.3 billion in the second quarter were up nearly 8% versus the prior year. We were also encouraged by our small market segment results, which saw an 18% increase in total deposits. This segment is an area of focus for us, given its growth dynamics and favorable return profile. Net inflows in the quarter were $194 million compared to outflows of $178 million a year ago. This marked the fourth straight quarter of positive flows, driven by a combination of strong deposit growth and improved retention. In group protection, second quarter sales were $89 million, representing a 33% increase from the year ago quarter. Our sales continued to be broad-based, with employers of fewer than 1,000 employees remaining a source of strength for us.
Second quarter sales were also driven by the strategic actions we are taking in this business, including a 15% increase in Lincoln's feet on the street. This increase in sales reps contributed to a 20% increase in independent brokers selling the segment's products. Our deep distribution, combined with the product and service expertise we bring to market, continue to position us well for near and long-term opportunities in the group space. Staying on topic for a minute, distribution overall has long been a strength for Lincoln, one that we believe differentiates us from competitors. It remains core to driving our continued pivot to the higher return products that yielded good results this quarter, as well as enables us to continue to sell products on our terms.
Our more than 8,000 agents and reps in retail, 500 worksite producers, and almost 600 wholesalers in LFD have brought to Lincoln approximately 60,000 independent producers selling our products. We'll continue to tap this deep resource to deliver good solutions to our clients. Before I turn the call over to Randy, let me say once again that this was an excellent quarter. Our results were strong and we remain focused on all levers that will incrementally help us to build earnings growth and returns. As I mentioned, we have flexibility on our balance sheet to continue share repurchases, and we will continue to reshape our products as a means to generate strong new business returns. The credit profile in our investment portfolio is very strong, allowing us to take modest additional risk that will improve our investment yield.
While we will continue to make significant strategic investments across our business lines, we will also continue to take action to lower our baseline operating expenses. The results we have produced over the last several quarters are strong. They reflect an unwavering commitment to our shareholders that we will take action that helps to ensure sustained growth and continued profitability. With that, let me turn it over to Randy.
Thank you, Dennis. Last night, we reported income from operations of $322 million or $1.09 per share for the second quarter. It was an excellent quarter that again demonstrated our ability to generate strong and improving results in the face of a challenging environment. Strong results across all four businesses were boosted by our alternative investment portfolio, which added $20 million to the quarter's results. Adjusting for this, normalized earnings came in at $1.03 per share. Looking at key value drivers, normalized operating return on equity of 11.3% and book value per share growth of 5.3% continued to perform very nicely. Operating revenue growth of 1.5% was muted as the daily average S&P grew only 2.4% year-over-year, while net investment income growth was negatively impacted by the interest rate environment.
Normalized operating EPS growth of 12% was helped by credited rate actions in the life annuity and retirement businesses, which largely offset the decline in our earn rate, tight management of baseline expenses, that is expenses excluding strategic investments, which grew 3% year-over-year, and capital management, as we repurchased 6.5 million shares during the quarter for a total investment of $150 million. All in all, a very, very good quarter. Turning to net income, we reported income of $324 million or $1.10 per share. Net income benefited from a small net realized gain resulting from a positive NPR adjustment, which was offset by RMBS and CMBS related impairments, mark-to-market adjustments on trading securities, and VA hedge performance. After-tax impairment and other net realized losses of $33 million were consistent with the levels we've seen in preceding quarters.
The VA hedge program continued to perform very well, particularly in a volatile quarter, with assets associated with the hedge program exceeding the liability by $450 million at the end of the quarter. In my opinion, no single statistic better exemplifies why our program is uniformly recognized as a leader in the industry than its ability to continually develop and grow the assets required to fund the liability for the guaranteed benefits that we issue. Before turning to segment results, let me comment on a couple of items, starting with the impact of today's interest rate environment. Previous guidance, which assumed a 10-year Treasury rate of 2%, was for an earnings impact of $50 million, $100 million, and $150 million in 2012, 2013, and 2014, respectively.
Our revised guidance, which is based upon today's Treasury rate environment and which includes actions that we have taken on credited rates and new business pricing, and which incorporates our actual experience for the first half of 2012, is for a smaller impact over the same period of approximately $10 million for the remainder of 2012, $75 million in 2013, and $140 million in 2014, representing a 25% reduction from the $300 million three-year total of the previous guidance. I'd attribute most of the improvement in the projections to the actions that we've taken around credited rates and good performance in the investment portfolio.
Looking forward, while in the life and retirement businesses we are essentially out of room to cut credited rates further, I do anticipate that there is room for further management actions to mitigate the bottom-line impact, primarily through expense management and the investment portfolio, where we have capacity to take on more risk after an extended period of risk reduction. My previous guidance for no near to midterm impact on statutory capital remains unchanged by today's rate environment. As a reminder, we have estimated and continue to estimate an impact of up to $500 million in the second half of a 10-year period of low rates. Looking at expenses, G&A grew $28 million or 7.7% from the second quarter of 2012, with approximately 60% of the growth attributable to strategic investments that we are making across the company, with a focus on the group protection and retirement businesses.
The positive impacts of those investments can be seen in the results with strong sales growth in both businesses, driven by investments in distribution and technology. Moving forward, we will continue to manage baseline expenses very tightly, while growth in strategic spending will level off as we exit 2012. Turning to segment results and starting with annuities. Reported earnings for the quarter were $158 million or $146 million normalized due to better than expected alternative investment income and a favorable DAC adjustment. Returns in the annuity business were very strong, with an ROE of 20.4% and an ROA of 70 basis points. Interest spreads remained strong in the annuity business. Looking forward, the annuity business continues to have ample room for further credited rate cuts.
As a result, I expect little pressure on economic interest spreads with any decline due primarily to new business that will put on with lower required interest margins. I made this point last quarter, and I'll make it again. When operated in a responsible and disciplined way, which is our approach, the annuity business is a high return business, the value of which is not fully reflected in our share price. Retirement plan services produced another solid quarter with earnings of $38 million or $34 million normalized and strong returns with an ROE in excess of 15% and an ROA of 37 basis points. Interest spreads decreased in the quarter by approximately seven basis points relative to the first quarter as new investments brought down the earned rate. Looking forward, I'd expect to see spread compression of 20 to 25 basis points a year.
We, of course, will not be standing still, and I fully expect that the strategic investments that we're making in the retirement business will fuel the growth needed to overcome the headwind of spread compression. Turning to life insurance, we reported earnings of $138 million, or $132 million after normalizing for strong alternative investment results. As I noted in my remarks on the first quarter call, life earnings growth this year is affected by the multiple reserve financing transactions that we did last year. Adjusting out the reserve financing impact, the current quarter's earnings grew by 5% relative to the second quarter of 2011. Interest spreads were relatively flat with the first quarter as incremental relief on credited rates offset a small decline in yield. Looking forward, I'd expect to see 10 to 15 basis points of spread compression per year in today's rate environment.
Group Protection had a very good quarter, reporting income from operations of $27 million or $24 million normalized. Net earned premium benefited from several quarters of strong sales and was up 8%. The non-medical loss ratio of 72.7% returned to the midpoint of our expected range, with all product lines experiencing a good quarter. LTD incidence and severity continued to perform within our expectations, and life mortality returned to a more normal level when compared to the first quarter. Our discount rate for new LTD claims remained at 4.25% during the quarter. I note that we've lowered our rate to 4.25% back in the second quarter of 2011. This early movement on the discount rate should allow us to maintain this rate for the remainder of 2012.
Today's rate environment would likely lead us to lower our discount rate 25 to 50 basis points in 2013. We are taking this into consideration on the pricing of new and renewal business. Turning to the balance sheet and capital management. Life company capital remained level during the quarter at $7.6 billion. RBC came in at approximately 500%. Cash at the holding company was just north of $800 million, including $300 million of debt proceeds that we will use in August to fund a debt maturity. We repurchased six and a half million shares for a total cost of $150 million, bringing the year-to-date total to $300 million. As I noted during the first quarter call, I expect to exceed initial guidance for the year for $400 million of capital deployment.
Given our belief that our share price remains significantly undervalued, we have a bias to skew capital deployment towards share buybacks. We would note that we will also continue to take leverage over the organization when the opportunity arises. Let me wrap up what was a great quarter by noting that last week, Moody's affirmed our ratings and positive outlook, another indicator of both our positive past performance and the strength of our franchise as we move forward. With that, let me turn the call over to the operator for questions.
Certainly. Ladies and gentlemen, if you have a question at this time, please press star then one on your touchtone telephone. If your question has been answered or you wish to remove yourself from the queue at any time, please press the pound key. Once again, if you have a question, please press star then one. Our first question comes from Randy Binner from FBR. Your line is open.
Hey, thank you very much. Touching on the updated rate exposure. The numbers you gave relate to, I think, GAAP earnings or kind of earnings overall. Is there any update to the disclosure you had given before about how DAC may be affected by a lower rate environment?
Hi, Randy. Thanks for the question. You know, the DAC, which I think you're probably referring to the long-term earned rate assumption.
That is exactly what I'm referring to, yes. The 4.25 versus the 6.25.
Right. Randy, that'll be part of our third quarter unlocking process. I'm not going to front run that process. There's teams of people across the company working on that right now. Obviously, rates have come down, and so we'll take all of that information into account when we think about that long-term assumption. I would note, though, having been through more unlocking processes than I care to admit in my life, there are always pieces of the unlocking that go both ways. We will have positive impacts, and we will have negative impacts. I don't know what the individual pieces are. We will do a thorough job of reviewing all of them and report the results in the third quarter.
Okay, just on one other piece of the disclosure, and I think this goes back to the investor event in November. There's kind of a base case and a low-rate case scenario for cash flow adequacy, the $6 and the $8 billion redundancy disclosure that you gave. Would that be affected by this new disclosure as well?
Right. I didn't go to that piece of the disclosure. What I did say is that my previous guidance for no near to midterm impact on statutory capital is unchanged. When you go out into that second half of a 10-year period on a piece of our business, the SGUL business, we project that there could be up to a $500 million impact. That guidance is completely unchanged from where we were before by the level of interest rates today.
All right. Okay. We should infer from that then the six to eight would be kind of roughly intact still.
I think you can make that inference.
Okay. Thank you. I will. Thanks.
Thank you. Our next question comes from Jimmy Bhullar from JPMorgan. Your line is open.
Hi, thanks. Good morning. Just had a question on your plans for excess capital beyond buybacks. I think in the past, Dennis, you talked about potentially looking at deals. You've highlighted the group benefits space and also the pension market, if you're still doing that, what do you see as activity in the market? Then secondly, you reported very strong growth in your group benefits business in terms of sales. What's really driving that and what are you seeing in terms of pricing in the group benefits market?
Yeah, Jimmy, on the M&A front, we continue to be interested in deploying some of our capital towards strategic opportunities, particularly in the group and retirement businesses. That's unchanged. We probably today, with where our share price is, not make such a large investment that it would stop us from buying our shares back. We continue to look at this on a holistic basis and take into consideration everything that you should when looking at building a company strategically and appropriately managing to your best return opportunities. With respect to the group protection business, let me start by saying, unlike some of our competitors, we have a sweet spot in the small employer market. It's not without competition, but it's not as competitive, our belief, as the jumbo market is. A little bit less price pressure there.
As I said in my remarks, the strong sales relates primarily back to an increase in sale representatives, some 15% or 17%, and an increase in shelf space, if you will, because we have 20% more brokers who've never used us before selling the product. Now, let me give you one more statistic because there's a lot of discussion in the industry around pricing. I think we have continued to move prices up modestly where we can, both on new business and renewals. A metric that I pay very close attention to, one of many, in terms of trying to judge how competitive we are is our close rate, because we bid on large numbers of cases through the course of the year. That close ratio, the number of cases that we actually win has stayed pretty consistently in the 10% area.
I hope those are responsive to your two questions.
Thank you.
Thank you. Our next question comes from Suneet Kamath from UBS. Your line is open.
Thanks, good morning, or good afternoon. I guess I'm a little tired from the earnings late last night and the calls today. Can you just go over again, Randy, the changes in the underlying assumptions around the interest rate guidance that goes from 300 to, I think, 225? I think you said the primary driver was that you've made some investments at a better return than you originally projected, or something along those lines. Can you just kind of go over that again just so it's clear? Because I think that's a pretty important point.
Yeah, sure, Suneet. I mean, the primary change going forward is today's interest rate environment, right? The last guidance was with the 10-year Treasury at 2%. Today's guidance, looking forward, is for today's interest rate environment, where the 10-year Treasury is bouncing between 140 and 150. In terms of what's impacted the results that's made them better than before, it's the actions that we've taken as you look back, primarily better action on credited rates than we originally projected, better results in the investment portfolio than we originally thought we'd get, and the actions we've taken on new business pricing. In the near term, it's the first two items that are the primary contributors to that. When you look forward, the change is from 10-year Treasury at 2% to today's interest rate environment.
I guess why is the crediting rate better than you expected? Because I was always under the assumption that you have the flexibility to go to the floors. Why would that be better than you expected?
Yeah. I'm going to take this question, Suneet. When we provided these projections, the questions that we were getting was not, what are you going to do to change the glide path? The questions were, what if essentially you did nothing? What would happen to your margins? When we provided the projections, we knew that we were going to be able to take some actions to mitigate that. I'm quite sure we said it. That's the reason. That's an answer to your question. Let me go on to say that the second set of projections that we just provided are on that same basis, which is essentially everything else being equal, and the only variable that changed would be the 50 basis points or so roughly decline in yields. That would be the consequence.
As Randy and I have both said, management is not going to accept that. We're going to take actions on core expenses. We're taking actions to improve our investment yield. We're again repricing new business. I fully expect that like the 300 came down, the 225 will come down. Clearly, because much of the drift from 300 to 225 was related to crediting rates, and you can see that quite clearly, or some increase in investment yield. We're having to look elsewhere now that we're sort of at the floors on these crediting rates. Still adding a little bit of risk on the investment portfolio, which we'll pass through that incremental gain, we'll pass through to our shareholders, not to the products. Our core expense line, we're pretty good at managing expenses, but the environment is such that you have to get better.
The mitigation to the $225 million will occur elsewhere in the balance sheet and it will be more an overall net income number than you will see it in the actual interest margin.
Okay. That's helpful. I appreciate that. I guess my question for Randy, you sort of teased us again like you did last quarter in terms of the amount of capital that you would be willing to return in excess of the $400. Can you help us out with a little bit of order of magnitude? All of the data points you are pointing to in terms of RBC, in terms of hedge program, in terms of balance sheet, just continue to suggest that a lot of these risks are certainly manageable. Any incremental info or color on what the buyback could be this year would obviously be helpful too. Thanks.
Yeah, thanks, Suneet. I will answer your question, but let me broaden it out a little bit too. Let us look back first. We have done a significant amount of share repurchases over the last seven quarters, $900 million. That represents roughly 12% of the shares we had outstanding at the beginning of that period. What drove that $900 million was both the strong capital position that we had and the free cash flow that we generate on an ongoing basis. When you look forward, when I project forward at those levels of share buybacks at the dividend pace that we have at Life Company, I fully expect that my RBC trajectory would be down 15 to 20 points a year. What you have seen over the last few quarters especially, is that we have had sort of discrete events that have benefited the required capital.
For instance, last quarter, we had an upgrade on a big holding. Pretty much took required capital and made a change in that neutral for the quarter. We have had these discrete events. As we talked about, when you look forward and we think about adding a little more risk to the portfolio, when I look forward, when we are using capital in the way we are using it, I fully expect to see sort of our RBC trend can go down as you move forward. I think that is the appropriate way to manage the strong capital position that we have today. When you think about all of the constituencies, the environment that exists today, constituencies being shareholders, constituencies being rating agencies, et cetera. I think that is the appropriate way to manage the capital today. We are being as aggressive as we can.
I fully expect to be in the market over the remainder of the year. I'm not going to give you specific guidance on what that number will be, but we will be deploying capital. Given where our share price is today, we'll skew that deployment towards share buybacks. We're not coming out of the market. We're going to go above our original guidance for the year of $400 million. As a reminder, we're at $300 million through the first two quarters. We're going to be out there in the market being aggressive, recognizing where our share price is today.
Okay, thanks.
Thank you. Our next question comes from Edward Spehar from Bank of America. Your line is open.
Thank you. Good afternoon. Two questions. First, Randy, a follow-up on your comment about the progression of RBC. In your plan, where would you have thought the RBC ratio would be today, given the buyback that you've completed versus where it actually has turned out?
Yeah, Ed, when we look out and we project sort of the behaviors we've had, we'd expect to see 15-20 points of RBC decline a year. That's average. It jumps up and down, but over a three-year planning period, that'd give you roughly 50 points of decline. We started this period with roughly 500 points of RBC, so I'd expected us to be in the 480-475 range right now, and we're at 500. The reason we haven't gone down is because of some of these events, primarily continual improvement in the risk profile of the general account.
Okay. One follow-up. Just to clarify on the room that you have on crediting rates, did I hear you correctly that you say you still have good flexibility on the individual annuity block? That it was the retirement and life that you're pretty much at minimums?
Yeah, absolutely. That's exactly right. The annuity business, we have ample room to respond to the declining earned rate, we don't see any pressure on the economic interest spreads in that business. Absolutely, on the retirement and the life space, we're pretty much out of room to cut rates further. As Dennis mentioned, we do have other areas of the company we'll look at to manage the bottom-line impact of spread compression. The investment portfolio, expense management, we're not done managing that potential impact.
Okay. Thank you very much.
Thank you. Our next question comes from Chris Giovanni from Goldman Sachs. Your line is open.
Thank you. Good afternoon. The comments around the expense leverage and then the ability to take on more risk within the investment portfolio, can you kind of talk some about what those potential expense initiatives could be, and then what specific asset classes you guys see an opportunity to take on more risk?
Yeah, Chris, let me give you some specific examples, things that are in various stages of being applied, some of which are fully underway. Let's go to the asset portfolio first. We have a very small allocation in the alternative space, roughly 1% of our general account. I think we can very easily take that up a bit and be well within our risk appetite. We recently issued a $450 million mandate to a high-quality manager to go out and invest in alternatives, private equity, hedge funds, et cetera. Also on the asset side, we have a very favorable liquidity profile. We have the capacity to take on investments that are a little less liquid. We recently issued a mandate for $500 million a year of private placements. Private placements that we don't really have access to with our current private platform.
Once again, we're looking at our capacity and we're going out and finding the best manager out there to fill that need. That's just a couple examples on the asset side. On the expense side, I'm not going to get any more specific than Dennis has said. We're very good at managing expenses, and you can fully expect that we'll be looking at all areas of general expenses as we go forward.
Okay. Within the investment portfolio, by changing some of that asset mix, what type of capital absorption does that take up in terms of the RBC?
I think it's embedded in those numbers that I gave you before. I don't feel that we'll have any different glide path than I talked about, sort of that 15-20 points a year of decline in RBC.
Okay. Back in the November Investor Day, you guys gave an update sort of under a moderate and severe stress scenario. The biggest delta was the investment portfolio. I guess given your comments today around the investment portfolio continuing to be better than expected, what type of incremental capital are you guys picking up just based on the better performance within the investment portfolio?
Yeah, I don't have the specific numbers on me today, Chris. We haven't gone through the process in a couple of quarters, sort of that complete stress test. We'll do that again. I feel very good that when we go through that process, the results will be better or at worst the same as they were before. I feel very good about the things that have happened inside the general account and the position it's put us in today.
Lastly, just quickly on, can you just give us an update on where you guys stand within the DAC corridor?
Yeah, sure, Chris. We're well above the mean. A couple hundred million dollars if we unlocked down to the mean. I believe if you look at the actual projection going forward, I think the first year has roughly a 9% drop. It's sort of the way we project out. We have a lot of cushion. It represents roughly a couple hundred million dollars if we were to unlock back to that mean.
Okay. Thank you very much.
Thank you. Our next question comes from John Nadel from Sterne Agee. Your line is open.
Thank you. First, I did want to thank you for giving us a break for lunch today. Second, I'm happy to see that even Mario Draghi couldn't spoil the reaction to your results this quarter.
Thank you.
Just to follow up on the rates on the incremental or on the new sensitivity on the rates, Randy. Maybe this is tough to provide, but I was wondering whether you could help us understand just how much these management actions have impacted the outlook. I think in past conversations with you, it sounds like incremental move downward in rates is a linear sort of earnings drag. Under that assumption, with none of the management actions, I would have assumed that that $300 million of pressure at 2% would have gone up. I'm not sure exactly by how much, but would have gone up. I'm trying to get a better sense of trying to measure exactly how much the management actions brought that down. It seems to me that the net impact of management actions could be easily $200 million.
Well, John, mathematically, over the three-year period, right, those management actions represented $75 million.
I just mean versus where you would have been if we assume the 140, the 1.4% or 1.5% 10-year.
Right. John, let me go at your question in this way. The things we've done in the past have improved the results over that three-year period by $75 million. Obviously, that's a number that continues projecting out into the future, so it has a present value much bigger than that. Going forward, we have over that three-year period, a total impact of $225 million. Not ready to talk to you specifically about what we believe we can offset against that, but the items we talked about, we believe we can really chew into that number in a serious way. When you look forward, the impact continues to remain linear in nature, at least over this next three-year period, and even beyond that. The impacts remain spread compression and reduction in your earned rate on surplus. Those are very linear impacts when you move forward.
I wouldn't expect the impact to have big jumps or dips in it as you move forward.
Okay. That's helpful. Just turning specifically to group protection. I was just hoping you could remind us how to think about a 25 or 50 basis point discount rate cut. All by itself, what kind of an impact that might have on earnings? What does that translate into, all else equal, in terms of your pricing? You were talking about that as potentially a 2013 event, but if you've got a lot of new and renewal business coming up between now and, let's say, the beginning of the year, if you put into price, I'm just trying to get a sense of how much you have to raise prices to essentially offset most of that discount rate cut.
Well, let's just talk about the numbers. A 25-basis point reduction in discount rate translates into $2 million to $3 million of annual income. Okay?
Okay.
It also translates into roughly 2% to 3% on a premium, somewhere in that range. It is very hard to estimate. It is going to vary case to case. Let's call it that range. We are taking that sort of impact into account when we price cases today.
Very helpful. Thank you.
Thank you. Our next question comes from Steven Schwartz from Raymond James. Your line is open.
Hey, good afternoon, everybody. Randy, I want to start, I want to go again to the guidance, the $50, $100, $150, the $1,075, $140, and maybe you can help me with some math here. Prior, last year, you were looking at a $50 million linear increase. Now we're looking at a $65 million linear increase. Why does that go up? What's the math?
Well, because you have a little more incremental year-by-year spread compression, right? I mean, rates are a little lower. If we had spread compression of X before, we have annual spread compression of X plus something today, which translates into a $65 million annual growth in that number versus the $50 million we had before. It's nothing more than that. Well, also the impact on surplus is a little bigger with a little lower earned rate.
Okay. Basically, you're saying, look, the changes that we made took this $50 down to $10, and then we go on with our lives. Is that probably the best way to look at it?
We go along with our lives and we get very active on managing other pieces of the income statement to mitigate as much of this impact as possible.
John, that's right. If you lower your crediting rate on your liabilities, and let's just use an example, not a specific example, but if we lowered our crediting rates on all of our liabilities by $50 million this year, that would repeat next year and the year after that, and the year after that. Is that your question?
Yeah, I think Randy got to it, Dennis.
Sure.
You made a statement about, it sounded to me like you were saying if rates continue where they are, we could be looking at more price increases on the life insurance side come around year-end. If that's an accurate interpretation of what you were saying, any sense of what you could be looking at?
I think the best thing to say is that we have, as you all know, and we've said several times, we have kept up with what's been a pretty quick decline in interest rates over the last 18 months, we've made pricing changes which both balance our need to get very good ROEs on new business and protecting the franchise. In the broadest sense, we'll continue to make it in all of our portfolios, if pricing changes reflecting conditions in the marketplace. Back specifically to the life insurance business for a minute.
I would again repeat what we've been saying is that we're moving away from SGUL into products that already have returns that are at our targets. SGUL is already down to only 30% of our sales, SGUL is the product that's most sensitive to interest rates. There'll be a combination of pricing changes as needed, along with this continued pivot to products that are less affected by the movement in interest rates.
Okay. One more, Dennis. Could you give us an update where the industry is, where NAIC is right now on PBR?
PBR and AG 38 are, I think, at the moment, kind of in the same bucket. AG 38 and PBR are going to the process is coming to a close. By the way, I would say that in my experience, the regulators and the industry have been working as well together on this as they could have. No one's ceding, by the way, their own responsibilities at all, just good dialogue. On AG 38 specifically, and large parts of principle-based reserving, the process is nearing its end. There is still moving parts. We should have some specific knowledge in the next couple of weeks or so.
Okay, you're saying the summer meeting, the NAIC summer meeting?
Yep.
Okay, great. Thank you.
Thank you. Our next question comes from Tom Gallagher from Credit Suisse. Your line is open.
Hi. Question for Randy. You roll forward a little bit further in time, rates are lower, but actually the outlook gets slightly better due to interest rates and related pressure. Should we take that to mean that as we look to 3Q or 4Q, considering balance sheet-type reviews in terms of goodwill, reserves, DAC, VOBA, anything else you might think to add in there that you would also be in, I don't know if I would say better shape. Will that give you some cushion as you roll into sort of testing season to think about how things might pan out?
Well, thanks for the question, Tom. I talked about the unlocking process a little bit ago. I'm not going to get in front of that. We are definitely going to look at both the long-term interest rate assumption along with all the other assumptions that go into this process. I fully expect that there'll be pluses and minuses. I don't know what the answer is at this point in time. My experience tells me there will be pluses, there will be assumptions where we've done better than pricing. There will be assumptions where we've done worse than pricing. We'll see what the sum total is. As it relates to the goodwill analysis, I'll just remind everybody, I'll start out with the same comment. I'm not going to front-run a process that occurs in the last half of the year.
I remind everybody, we took a good hard run at the key components of this last year, the profitability of new business, the amount of new business, and the discount rate we apply for the goodwill analysis. We'll go through that same analysis this year, but I feel good about what we did last year.
Got it. I guess another way to ask it would be if things are panning out better than your stress test, are things also panning out better than your embedded accounting assumptions? Obviously the accounting assumptions are best estimates, and stress test is something worse than that. I guess I just want to try and get a sense for, are the two related, or should I think of them as completely unrelated? One was starting from a much more conservative place.
Yeah, Tom, I'm going to go back to some of my earlier assumptions. You're talking about GAAP accounting.
Right
Best estimate sort of assumptions. There is some of those assumptions that I think we're doing better than. For instance, mortality. In general, when I hear from my business and when we report to you, we generally do better than pricing. Do I know exactly how that will translate into the unlocking? No. Generally, we've done better than that relative to pricing. Interest rates have obviously been a little lower than the pricing assumption, and we'll look at that assumption. There will be some where we do better, there will be some when we do worse. It's always that way whenever you go through one of these unlocking processes. I don't know what the answer will be in the third quarter. I feel good about where we are, and I feel good coming into the process.
Okay, thanks.
Thank you. Our next question comes from Ryan Krueger from Dowling & Partners. Your line is open.
Thanks. Good afternoon. Randy, what's your outlook for XXX reserve solutions in the back half of the year? I think my understanding is that the supply is pretty strong and the price is pretty good right now. Is there any reason to think you wouldn't be able to complete something in the back half of the year?
Thanks for the question, Ryan. We did a number of transactions last year. I've talked about that and how it impacts the growth rate and the earnings, and you've seen it in the life earnings of life business, and you've seen it reflected in some of the share buyback activity we've had. I'm not giving pointed guidance. I mean, what we're going to do over the remainder of the year, we obviously look at these things regularly to see if we have both capacity and the ability to do more of those. You are right, the marketplace is open, there is capacity. It's at a reasonable price. I don't know if we'll complete any this year, remembering that we did three of these transactions last year. We'll see. We'll do our best, I'm not giving any pointed guidance yet.
Okay, just a quick follow-up on the interest rate discussion. The 1.5% or 1.4%-1.5% scenario, what does that correspond to for new money rates?
It varies by business, right?
Yeah.
What we would use as part of that process is more of a long-term average credit spread than, for instance, the credit spreads that were experienced in the first half of the year. It's those Treasury rates with more of a long-term look at what credit spreads typically are. It varies by business. It's going to be a little higher for a business like long-term universal life, where the investment strategy is more of a 30-year strategy than it would be for the annuity business. It varies.
Okay, last one on SGUL. Have you guys seen any changes in lapse rates to this point in the low interest rate environment?
No, we haven't. Actually, we've seen lapses in that business run a little above what we price for. I think we've said that in the past. We haven't seen an explicit response to rates being low.
Thank you.
Thank you. Our next question comes from Joanne Smith from Scotia Capital. Your line is open.
My question's about that answered. Thanks.
Thank you. Our next question comes from Mark Finkelstein from Evercore Partners. Your line is open.
Hi. Actually, just a follow-up to Ryan's question. What would be the impact of profitability if you did see a decline in the lapse rate? I think you gave some information at your investor day where you did see some declines in both SGUL and the non-SGUL books. I'm just curious if you had, say, 100 or 150 basis point change in the lapse rate, how would that impact profitability?
Mark, I don't have updated guidance relative to what you've seen before. Feel really good about both the lapse assumption that's in our current models and the lapse assumption we're actually experiencing.
Okay. Just thinking about rates on the VA business. I guess the first question is, are you fully hedging the product right now, or are you taking any kind of rate bets currently? Secondly, do you need to kind of make any further adjustments to the product given where we are today?
Mark, let me take the first half of that. It is a hedging program, so we continue to hedge the liability as we calculate it. Not taking any explicit bets with the hedge program right now. Let me turn the second part of the question over to Dennis.
Mark, as you know, we've moved to these protected funds.
Right.
The ROE on that business is pretty good because of the change in our hedge cost. We're seeing increasingly more of that selection being made, so that's a good direction. Another action that we took was on the non-protected fund asset on mix in the sub-accounts. We lowered the rates 50 basis points, the guarantee rate, the long-term guarantee rate, roughly 50 basis points. Back to my earlier comment, we have a rifle-like focus on getting the appropriate returns on our capital. A lot of moving parts in the economy and in the capital markets. As those become entrenched for any long period of time, we'll make the appropriate adjustments.
Okay. Thank you.
Thank you. I show no further questions at this time and would like to turn the conference back to the speakers for closing remarks.
Well, we want to thank you all for joining us this afternoon. As always, if you have any questions, please follow up with me at the investor relations line at 1-800-237-2920, or via email at investorrelations@lfg.com. Again, thanks for your time today and have a good afternoon.
Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program and you may all disconnect at this time. Speakers, please stand by.