Good morning, thank you for joining Lincoln Financial Group's second quarter 2011 earnings 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 should need assistance at any time during the call, please press the star key followed by the zero and someone will assist you. At this time, I would like to turn the conference over to the Senior Vice President of Investor Relations, Jim Sjoreen. Please go ahead, sir.
Thank you, operator, good morning, 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, in our reports on Forms 8-K, 10-Q, and 10-K filed with the SEC.
We appreciate your participation today excuse me, 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. 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.
Thanks, Jim, good morning. Our solid results this quarter and last quarter add up to a strong first half of the year, reflecting successive quarters of good sales, positive net flows, distribution productivity and expansion, and consistent presence in the market with good quality, profitable retail products. Highlights in the quarter include sales increases in nearly every business, which, combined with higher equity markets, resulted in $5.4 billion of deposits, $164 billion of account balances, and $1.4 billion of net flows. The acceleration of our capital management activities to take advantage of our share price, an improvement of 70 basis points in consolidated return on equity year to date on a normalized basis, an 8% increase in revenues, 20% increase in income from operations, and a 28% increase in net income.
Given these strong results, let's take a moment to look at a couple of highlights from our underlying businesses. Sales in our individual life business were up 12%, driven by continuing strength in MoneyGuard, which benefited from new distribution relationships and a 61% jump in the number of advisors recommending the product to their clients. We continue to improve our product offerings. Earlier this year, we raised prices on our survivorship product to reflect the low interest rate environment and added a new flex pay funding option for consumers. We plan to introduce similar enhancements to our secondary guarantee UL product and further enhancements to our indexed UL products in the third quarter. Our value proposition of consistency in the market, maintaining a full lineup of products and experienced wholesaling support allows us to capture and retain significant market share with major distribution partners.
For the first six months of the year, Lincoln is the number one life provider in each of our top 10 strategic partner firms. In our annuity business, individual annuity sales were up 4%, with variable annuity sales growing by 8%. Our value proposition with VAs is to offer good value, but not the most aggressive features, and to continue to mitigate basis risk and hedge breakage while supporting consumer choice. For example, over the past several years, we have evolved our investment options to include more passively managed funds and asset allocation models, which improves our risk profile at the margin. This year, 39% of all flows into VAs has been into these kinds of investment selections. They are now available in every wirehouse.
We also recently introduced a guaranteed lifetime withdrawal benefit rider. These changes will provide a lift to sales as the environment for these products improve. We had a solid quarter in defined contribution as we see the benefit of our investments in distribution, marketing, and technology, expect deposits to improve and flows to turn positive in the second half as new plans currently in the pipeline come on board. We are gaining momentum in the small case market, where we have grown our wholesaling group from 30 to 46, we are pleased to see a double-digit increase this quarter in small case deposits. We expect similar momentum in the mid large segment over the coming quarters.
We have added senior level talent to propel our distribution strategies, in November, we will have achieved a significant milestone in our technology transformation in this segment as we begin to add new clients to our enhanced record-keeping platform. In our group business, we have been focused on managing through elevated loss ratios we're pleased to see some improvement there as actions we instituted took hold. New business proposals and sales in the quarter were both up single digits, we plan to launch a critical illness product in the third quarter to further round out our portfolio and position this business for the trend toward voluntary benefits. Taken together, these measures give us confidence that the foundation is in place for increased sales momentum in the second half of the year. We continue to successfully leverage the strength and reach of Lincoln Financial Distributors.
As I mentioned, we've increased shelf space for MoneyGuard and fixed annuities and have completed our planned expansion of the small case DC team and continue to build our team supporting mid to large planned sales. We once again saw an increase in the number of advisors who recommended Lincoln solutions already at over 40,000 through the first six months of the year. We also saw increases in wholesaler productivity across most products. Lincoln Financial Network continues to execute on its growth strategy by retaining top-level financial planners and attracting experienced recruits. LFN has increased net active producers by 125 from last year, which helped LFN to meaningfully contribute to Lincoln's growth in the quarter, including sales of Lincoln Life up 12%, Lincoln variable annuities up 13%, and first year small case DC deposits up 16%.
Turning to the balance sheet, we remain well-positioned from a capital and cash standpoint. We continue to maintain holding company cash in excess of our target, continue to generate healthy RBC ratios at our insurance subsidiaries, and have undertaken meaningful capital management actions in the quarter. Over the past two years, we have taken steps to place our investment portfolio in a more defensive position, reducing our exposure to below investment-grade securities and more volatile investments as we ride out the slow economic recovery. Before I turn the call over to Randy to add his comments on the quarter, let me say there has obviously been a lot of focus lately on global economic uncertainty with the debt ceiling negotiations, evolving conditions in Europe, and recent weakness in U.S. economic indicators.
It's important to recognize that the policy and strategy actions we took over the past few years position us to compete in an increasingly volatile environment without sacrificing the product and distribution consistency that our partners expect of Lincoln. Some of these actions include raising prices and reducing tail risk in our product designs, deleveraging the holding company balance sheet, reducing credit risk in the investment portfolio, and importantly, moving from a net borrowed position to a strong net cash position at the holding company. Individually, these are all important and prudent steps. Collectively, they represent significant and long-lasting improvement for the company and its ability to perform more consistently in the future and in volatile markets. We have already seen this in our first half results. With that, let me turn it over to Randy.
Thank you, Dennis. Last night, we reported income from operations of $349 million or $1.09 per share for the second quarter. Our second quarter results closely mirror those of the first. Overall, strong top and bottom line performance across the businesses, with operating revenues up over 8% and normalized earnings of $0.98 per share, up 15% from last year. A very strong capital position and continued improvement in our risk profile. Consolidated return on equity for the quarter was 11.3% or 10.2% when looking at normalized earnings, continuing a trend of improvement in this key valuation metric. Return on equity growth has been driven primarily by strong earnings results with a lesser impact from accelerated share buybacks.
Operating earnings benefited from strong margin performance across the businesses, most notably interest margin, where strong income from alternative investments and prepayment fees added to interest spreads. Base spreads, that is excluding excess alternative and prepayment fee income, remained steady when compared to the second quarter of 2010, despite the persistent low interest rate environment that has existed over that period. During the quarter, we entered into $300 million of interest rate locks, increasing our total to $1.3 billion. Rate locks, which were entered into at interest rate levels that will help to support current interest spreads, will mature over the next five years. As you know, we have previously disclosed the potential implications to earnings if prevailing interest rates are to remain at depressed levels for a few more years.
Based on an update as of June 30th and assuming the 10-year treasury stays at 3%, earnings were declined by approximately $20 million in 2012 and $40 million in 2013. It's worth noting that this is an exercise that runs counter to what the forward curve indicates and what we believe will happen to rates over the next few years. Nonetheless, you can see that the projections represent a relatively small percentage of total annual earnings. Turning to segment results and starting with annuities. Positive flows in markets produced another strong quarter, driving a 21% increase in total account balances to a record $89 billion. Earnings during the quarter of $150 million were up 29% over the prior year quarter as growth in the equity markets led to improved mortality results, positive retrospective unlocking, and a 14% increase in revenues.
In our defined contribution business, account values were up 15% to $40 billion. Revenues grew 6%, leading to an 18% increase in earnings to $42 million. Pre-tax margin in the quarter came in at a strong 23% compared to 20% in the second quarter of 2010. Turning to our life insurance segment. Earnings drivers performed as expected, with life insurance in force up 3%. Account balances up 8% quarter-over-quarter. Normalized interest spreads remained strong in the 190-basis-point range, having increased modestly from the year ago level, supported by the long-duration nature of the assets and liabilities in our life business. Life earnings of $152 million were essentially flat with the prior year. As a reminder, we have executed reserve financings over the past year, which, while benefiting the enterprise in total, have pulled income out of the life segment.
In the group protection segment, non-medical net earned premium grew 7%, which despite a soft sales environment, continues to benefit from good persistency and pricing increases. Non-medical loss ratio for the quarter came in at 73.4%, continuing the trend of improvement seen in the first quarter. Embedded in this quarter's number is a 50-basis-point reduction in the discount rate to 4.25% for 2011 new claim incurrals. This increased the loss ratio by about 1% for the quarter. Premium growth, improving loss ratios. Strong investment income drove earnings of $26 million, up 15% from the second quarter of 2010. I think that we still need to be somewhat cautious in this business as unemployment levels in the economy pressure incidents. It continues to run above our long-term expectations, although down from the high seen at the end of 2010.
While some caution is still called for, it is an encouraging development to see loss ratios responding to the actions that we've taken, including premium increases and additional resources applied to claims management. Turning to expenses. Expense management was strong during the quarter, with expense ratios declining on both a sequential and a quarter-over-quarter basis. Realize that while G&A was up 4% over 2010 levels, this was due primarily to sales growth and targeted strategic investment-related spends. As we move through the remainder of the year, I do expect expenses to increase, primarily the result of growth in strategic investment-related spends across the company. I size this at $0.01-$0.02 per share per quarter relative to second quarter expense levels. Finally, let me provide some comments on capital, risk management, and related activities.
The credit profile of our invested assets continues to improve with below-investment-grade assets declining to just over 6% of the portfolio, down over 3% from the peak. Recently, we have seen limited value in the high yield space and thus have been following a higher quality investment strategy, primarily investment-grade bonds and commercial mortgages. Additionally, we have been selectively de-risking the portfolio of assets that are more sensitive to the economy. Looking forward, if and when value comes back into more credit-sensitive assets, I would anticipate that we would allocate more of these asset classes. The variable annuity hedge program continued its history of strong performance and end of the quarter with hedge assets of $1 billion, well in excess of the hedge liability of $350 million. Estimated RBC is unchanged from first quarter levels at approximately 500%.
Total adjusted capital of $7.3 billion was up approximately $100 million for the quarter after taking dividends to the holding company of $150 million. During the quarter, we continued our capital redeployment activities with the repurchase of $150 million of common stock. It was an opportune time given weakness in our share price, and if you recall, this represents the balance of the buyback guidance provided on last quarter's call. Looking ahead, we generate $350 million-$400 million of free cash flow at the holding company each year and have $1.6 billion of capital in excess of targeted levels, positioning us to continue capital deployment activities such as share buybacks. I'm going to move away from specific guidance but anticipate that share buybacks will continue in coming quarters.
To wrap up and expand on Dennis' comments, it's important to note some of the important actions we have taken to improve both the balance sheet and consistency of quarterly results. As equity markets and interest rates struggled, we reset our long-term earned rate for both, reducing the risk of volatility from unfavorable movements in DAC and VOLA. We put lingering issues such as the Transamerica and Swiss Re litigation behind us. On the capital leverage and liquidity front, over the last few years, we have grown insurance company capital by over $2 billion, executed on numerous reserve financings, so that today nearly 80% of our financed reserves are covered by long-term solutions that are matched to the duration of the liabilities.
Reduced long-term financial leverage by over five percentage points to 20%. We went from a net short-term borrowed position at our holding company to today, where we hold net cash of $700 million. Sometimes it's important to step back and look at the totality of what we've done, because it is actions like these that have positioned us to report consistent, high-quality earnings as we move forward. With that, let me turn the call over to the operator for questions.
Thank you. Ladies and gentlemen, if you have a question at this time, please press star then one on your touchtone telephone. Due to time constraints, we ask that you limit yourself to one question and one follow-up. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. One moment for our first question. Our first question comes from Suneet Kamath of Sanford Bernstein. Your line is open.
Thanks. A question about the interest rate guidance, just to make sure that I have the numbers correct. You said, assuming a 3% 10-year, you said $20 million in 2012 and $40 million in 2013. Is that correct?
Yes, Suneet, that's correct.
Okay. If I go back to earlier this year, I think in some of your conference presentations, you provided some data on this, I think the 2012 estimate at that time was something, again, I think the assumptions were the same, was something like $71 million hit. If that's correct, what specifically has changed in terms of dropping that impact? Thanks.
Suneet, we've given impacts of low interest rates three different times. One time with the 10-year Treasury at 2.5%. At that time, the year one impact was approximately $30 million. We gave the impact when the 10-year Treasury was closer to approximately 335. At that time, the year one impact was in the range of $20 million. I think where we sit today, with the guidance using the 10-year Treasury of 3%, we're very consistent with those results with the year one impact, as I mentioned, of $20 million. If you think about sensitivity around that, I'd really go back to that earliest guidance where the 10-year Treasury was at 2.5% and look at that year one impact of $30 million. That should give you a good range for potential impacts of low interest rates.
Got it. Just a quick follow-up. This is all just operating earnings drags as opposed to anything in terms of DAC or reserve builds that could happen. Is that correct? Can you provide any sensitivities around or thoughts around the potential for something other than just kind of normal earnings drag?
Yes, Suneet. By giving these impacts for the next few years, I'm really giving you the impacts that I believe could happen. Other issues, I really don't see happening over the next few years.
Yes, Suneet, let me just reemphasize that. When we give this guidance, we're inclusive of both operating income and balance sheet implications. To be quite clear, the operating earnings impact from reduced margins to declining interest rates over the next couple of years is the only impact that we see from low interest rates.
Okay. Thank you.
Thank you. Our next question comes from Nigel Dally of Morgan Stanley. Your line is open.
Great. Thanks. Good morning. With capital, encouraging to hear plans for continued buybacks over the course of the year. Can you provide us an update with other capital management alternatives such as your plans for leverage reduction, how you're viewing the dividend and anything on the consolidation front? Thanks.
Yeah. Let me tackle those in order. Looking at share buybacks. We're generating cash flow at the holding company, as I mentioned, $350 million to $400 million. It'll be right around $400 million this year. That really provides the pool that I would look to for share buyback potential for the year. As you're aware, we've done $225 million through the first half of the year. We'll look to that number when thinking about share buybacks. Dividends, we'll discuss that with the board in the fourth quarter, so no further guidance right now on that. On the deleveraging front, we have a fourth quarter maturity of $250 million. I'd look to excess cash at the holding company right now. As I mentioned, we have $700 million of excess cash, which is a couple hundred million in excess of our targeted level of $500 million.
Current plans are to pay that fourth quarter maturity with excess cash.
Nigel, the only thing I would add to that, and you've heard me say this before, specifically with respect to dividends, it's our intention and hope that over time we can increase the level meaningfully from where it is today. When that happens, is, as Randy says, a board decision. Certainly the board and I are consistent in our desire to see the dividend rate get higher.
Okay. Any comments on the consolidation front?
On the what front?
Consolidation. Any acquisition opportunities?
M&A in the-
Yep
M&A in business. I think M&A has been slowed down, certainly in the life industry, and probably more widely because of the economic uncertainty. There may be deals done in the industry, but it seems quite quiet right now. From our perspective, specifically, we continue to look for opportunities to strategically improve the business. We've said, and continue to be consistent, that if we were to do something, if we were to be able to find something, and that's not sure, our priorities would be to expand the group protection and DC business.
Okay. Very helpful. Thank you.
Thank you. Our next question comes from Jay Gelb of Barclays Capital. Your line is open.
Thanks. Could you remind us how you calculate the $1.6 billion of excess capital? With a 500% risk-based capital ratio, that seems awfully high. I'm trying to get a sense of what a realistic target is.
Yeah, Jay, when we calculate the $1.6 billion, we're using a 400% RBC ratio and $500 million of cash at the holding company. Mathematically, $1.6 billion is the numbers in excess of that. When you look at the life company capital, I'd go back to my earlier discussion. We're looking at the free cash flow as the cash we have available, really, for capital deployment. With some usage of the excess capital that we have at the holding company. In terms of life company capital, when you look at the environment today, it's obviously volatile. I think we're going to continue to be somewhat cautious with the usage of that life company capital.
I see. On a separate issue, you gave us the sensitivity of interest rates stay lower for longer. What if the yield curve flattens? How should we be thinking about the potential impact there?
Hey, Jay. I think I'm going to stick to the guidance we've given on interest rates, which is with the 10-year at 3% and the previous guidance we've given, and a yield curve that is shaped somewhat like it is today. When you think about the flattening of the yield curve, the impacts on that we really haven't contemplated in terms of guidance. I don't think we would see large negative impacts from the flattening of the yield curve. It's tough to say what the other macroeconomic factors that would be in place if that were to happen.
Just to add to Randy's comments, most of what we're talking about in terms of the impact on earnings comes from the in-force business. Some of this question, in particular, a flattening of the yield curve probably doesn't change that much, that being the impact from the in-force business. It does open questions about, not just for Lincoln, but for everybody else, product development and product changes, and other bigger, not in-force, but new business issues. Again, even if that were to happen, pretty confident that we can maintain good quality retail products in the marketplace across the board, that we could change pricing, and that the products would still be viewed by the consumer as high quality and meeting needs.
Jay, I would add, just the overall position of the balance sheet and liquidity at the holding company, feel very comfortable from a balance sheet and a capital standpoint that we're well-positioned to handle any environment that comes our way for the next few years.
Right. It just feels that you have an added potential lever there for ROE enhancement. I understand your position.
Thank you. Our next question comes from Randy Binner of FBR Capital Markets. Your line is open.
Hi. Thanks. The question on a lot of people's minds, this is kind of picking up on where Suneet left off, is just I think it'd be helpful to just to review what the DAC charge that was taken in the third quarter of last year as well as the goodwill test of last year. Just my recollection is that both of those tests were kind of meant to be for a 10-year yield environment where the 10-year was at 250. I think it'd be helpful for myself and others just to hear a quick review of where that DAC test was done relative to the 10-year. With goodwill in particular, I think the discount rate and new business quality also played in. If you could elaborate on those two items, that'd be great.
Sure, Randy. Start with goodwill. The goodwill is first and foremost a test of the life production. Life production continues to run strong. That is a good indicator of where we stand on life goodwill. On the interest rate side, I'd say the impacts are somewhat neutral to relative to last year's tests, in that rates that come down tend to pull the discount rate down, while at the same time putting some pressure on margins. I would describe interest rates as neutral, while the main driver, the life production, continues to run strong. On the J Curve front, if you remember, we set that last year in the third quarter with the 10-year right at about 2.5%. Right in the range of where we are today. What happened then was then that the new money rate graded up over an eight-year period.
We're running pretty close to the J Curve at that time, I'd say we're a couple, two, three basis points behind, but a relatively small impact, a real small impact relative to the assumption change that we made last year.
By and large on the DAC front, that set of assumptions has already been kind of reset for these low yield environments that we're finding now.
Absolutely, Randy. I'd say we feel real good about where we are from a DAC standpoint relative to our interest rate assumption.
All right. Very good. Thank you.
Thank you. Our next question comes from Chris Giovanni of Goldman Sachs. Your line is open.
Thanks so much. Just a couple questions. One for Randy. I wanted to see if you could provide an update on your sensitivity to moves in the equity markets on your earnings, and then sort of a rough justice impact to RBC, assuming maybe 100-point decline in the S&P.
The impact on the earnings of movements to of a certain percentage in the equity markets is primarily an item that occurs obviously in the VA and the annuity business. I would say, roughly speaking, that growth in the equity markets is pretty closely linked to the growth in the earnings. If you saw equity markets move up, pick a number, 2% or 3%, you see earnings move up a like amount across the whole business. I would say it's fairly similar in the VA space. Those are the two primary areas where I'd look to an impact from any movement in the equity markets. Chris, could you repeat your last question?
Just in terms of maybe 100-point decline in the S&P, what does that do to your RBC ratio?
The impact of a movement in the S&P and RBC ratio would be relatively small. Remembering that, as I mentioned in my comments, we're sitting here today with a hedge program with assets that exceed liabilities, and that includes the statutory liabilities by $650 million. We have a significant amount of cushion against any impact on the RBC from movements in the equity markets. Very well-positioned from that standpoint.
What level of S&P then would we need to see to sort of absorb that cushion?
It is impacted by movements in factors outside of just movements in the equity markets. I would roughly estimate that you'd be at S&P levels in the 800-900 range.
That's helpful. Just one for Dennis. If you can maybe give us sort of a bit of an update in the VA space in terms of what you're seeing in terms of maybe a pickup in competition, and then maybe any changes sort of in guarantee features or pricing.
Competition in any particular quarter, I've heard that some companies have reported some pretty big swings. It can result from any number of things, including moving from a higher or more rich product to a less rich product. It's hard really to judge in any particular quarter what the competition is doing. I would come back to what I've said in previous analyst calls that to a large extent, we're trying to sell products on our terms and in amounts that we feel good with respect to our overall business mix. What we're focusing on is the continuation of our value proposition, distribution productivity. As I mentioned already today, we obviously keep an eye on hedge risk and continue to try to make asset improvements that help on that front.
From Lincoln's perspective, irrespective of what others may be doing, we continue to sell in good volumes with good increases and on our terms. I feel pretty good about what we're doing, and I'll come back to and say, at some level, the competition is important. Just to repeat, market share is not, I think, a good place to focus on because you can get market share by cranking up products that are good for the consumers but not for the shareholders.
Okay, thanks. If I can sneak just one last one in. Just in terms of, you mentioned the comment in terms of increase in global uncertainty. Can you maybe provide a bit of an update in terms of what Fred's looking at, what you guys are seeing and thinking about in terms of long-term strategic planning and M&A strategies?
Yes, I can. It starts with we strongly believe in the fundamental business model that we have right now across all of our businesses. Our distribution strength, the pricing of our products, and of course, that will change as need be. The balance sheet, all the things that we've been saying now for quite a while, the fundamentals of distribution, product, balance sheet strength are as strong now as they have been for years. It's continuing to execute by and large on the strategy that's in place. On top of that, we would, at some point, if the right opportunity comes along, like to move our DC and group protection business to a little bit larger percentage of our overall earnings mix and capital allocation. Been in the business for a long time.
Opportunities for strategic and sound acquisitions come and go, but you can't count on it. We continue to focus on the fundamentals of the businesses that we're in and growing on an organic basis.
Great. Thanks so much.
Before we move to the next question, I wanted to go back to the earlier question on the impact of the movement in the S&P for earnings. I talked about the impact on the annuity and the DC business. When you bring it all together and you look in total across the company, what we find is that about 1% movement in the S&P currently has an impact of about $3 million-$5 million of earnings on the total organization.
Thank you. Our next question comes from Andrew Kligerman of UBS Securities. Your line is open.
Hey, Ray. Good morning. Just sort of staying on the S&P issue. Where might your DAC get impacted? Where would the S&P have to hit? At which point would you have to take a DAC charge?
Yeah, Andrew, as we've talked about in the past, we're very well-positioned in our corridor with an assumption, effective long-term earn rate assumption in our DAC models that assumes an immediate drop in account values of 15%, which equates to a drop in the equity markets of between 20% and 25%. Before we would have to consider an unlocking, we would even have to move through that, a negative unlocking through that. It's probably in that same range that I talked about earlier for capital impact. It's in the S&P 800 range, S&P 500 operating at about 800, somewhere in that 8-900 range.
Any sense, Randy, of what kind of impact hopefully it won't happen again. I'd hate to see the S&P there, any sense of the kind of impact or the range of impact that we might see there?
Andrew, it all depends on the level it would go to, right? As we sit here today, on the positive side, we're between $350 million and $400 million of positive good guy as of the end of the second quarter.
Perfect. Just maybe a little color on the group business. I mean, the loss ratios look at least stable to modestly improved. You mentioned, I think, some increased pricing. Could I get a little color around what type of pricing increases we're seeing in dental and long-term disability?
Andrew, Dennis. First, I'd hoped you'd ask the question, when we'd have to release, at what level of the S&Ps we'd have to release this built-up cushion.
I hope that's the case. Yeah.
Now to your specific question. We've taken two actions to help improve the loss ratios or two principal actions. One was to raise pricing, and the second one was to increase resources in our claims management area. Let me speak to your specific question first, which is pricing. It's a little bit easier to measure pricing increases on renewals because you know exactly what you had and exactly what you're getting. There, on the non-dental business, we're getting about a 3% pop in pricing on the non-dental business. On the dental business, we're a little bit north of 9%. We're getting the targeted price increases that we had hoped to achieve. On new business, across the board on the non-dental products, we've raised prices about 3%, in that same range. On dental, similarly.
At the moment, we're not having to discount too much in terms of pricing on a case. That low single digit is what we're achieving. Again, we're pretty happy to be able to do that. On the claim resources, or excuse me, on claims management, we are making good strides, particularly helped by some new sophisticated programming that we use to identify claims that have the most likelihood and opportunity to be managed. Across the board, good price increases and a lot more investment in technology to improve our claim management capability.
Perfect. Thanks.
Thank you. Our next question comes from Jimmy Bhullar of J.P. Morgan. Your line is open.
Hi, thanks. I just had a question on DC flows. They were actually negative this quarter. It looks like the withdrawal rate ticked up. I was just wondering what's going on there and maybe if you're seeing any disruption related to the new record-keeping system that you're going onto in the fourth quarter. If that is the case, then why wouldn't you see high withdrawals for the next couple of quarters?
Yeah. What we've said is that the negative flows this quarter were predominantly related to our mid to large case segment. That, just by its nature, is lumpy. I think in fact, there was two cases that surrendered, they added up to $250 million. Both of them were competitive situations, we just couldn't match the pricing. Let me come back to some of the more positive pieces of it, both in the small case as well as the mid to large case market. In the small cases, I've said we've finished our expansion of wholesalers, we're seeing double-digit increases in deposits in the small case market. We have a fairly significant, for us, pipeline of opportunity in the mid to large case market, we typically convert that pipeline at 10% to 15% of that.
It's the 10% to 15% of that pipeline that is giving us confidence that we'll see good results in the third quarter and the fourth quarter. I would add to this change in technology. In fact, particularly in the consultant marketplace, there's one or two consultants that I would say put us in the penalty box. Not everyone did, a couple did. Hopefully by being in the position to put the new business on the new platform in the third quarter, we'll be out of the penalty box, that should help us as well. Probably more so in 2012 than in 2011, because these cases take time. The sales cycle is more than a couple of months on these cases. Okay.
Just one more on the share buybacks. I think you mentioned in your comments that you are going to continue buying back stock. You also said you've got about $1.6 billion of excess capital. The question was, on the one hand, you've got a ton of capital, on the other side, the economy's actually not that great. The market's pulled back. Rates are low. How should we think about buybacks? Would they remain at this type of a pace, or would they slow down until the economy improves? Do you see signs of the market coming back?
Right now, let me just repeat a couple of things that Randy said. Again, this is the way he and I are thinking about it right now. We're generating and have continually generated free cash at the holding company in the neighborhood of $400 million. There's capital coming up from our subsidiaries to the holding company, roughly $700 million, reduced by $250 million-$260 million of that interest expense. It's in that $350 million-$400 million category. Right now, in terms of share repurchases and increases in the dividend, that's the pool that we're looking at. I think it'll be pretty similar in 2012 to the experience we're having in 2011. Again, to repeat what Randy said, we've used about $250 million of that, if we went to the full amount, that would suggest a $150 million more capability.
We're not saying we're going to do that. To your point, I think it's a very volatile time right now. Hopefully, there's been a little bit of an overreaction to some of the events or some of the reported data over the last couple of weeks. To summarize, we're thinking about $350 million-$400 million as kind of an ongoing pool of money available for share repurchases and dividend increases. We are going to further reduce leverage. That's coming out of cash, so that doesn't affect that number. That leaves the $1.6 billion. Right now, we're not thinking about using any significant amount of that for share repurchases. As we've said in the past, when things improve, and of course they haven't in the last 30-60 days, we'd be more willing to use that money for capital management activities.
Hopefully, as we talked earlier, there might be some acquisition opportunity that would strategically move us forward and use some of that $1.6 billion. Okay?
Okay. Thank you.
Yeah. Okay.
Thank you. Your next question comes from Ed Spehar of Bank of America Merrill Lynch. Your line is open.
Thank you. Good morning. First of all, I hope you don't take the questions on M&A as any indication that any of us want to see a deal with the stock at less than 65% of book value.
I think using equity right now is not a very good idea, Ed.
Well, yeah, using any capacity, whether that's cash or equity, either way, it's using equity. I guess my question is on the buyback is, you've talked about a very substantial cushion. S&P 800, 900, both a stat and GAAP basis. You've talked about no material impact, really, from a 10-year treasury at really a 2.5%. You look at an opportunity here for permanent value creation with your stock with a 15% earnings yield. I'm wondering why, I understand that it's an uncertain world, uncertain worlds are the ones that create big opportunities if you're confident in the actual fundamental numbers you're talking about. What would it take for you to think about working down excess capital to buy the stock?
Let me just state, restate what we just said. We said that we were going to buy shares back maybe up to $400 million this year, some question around that. We're going to take $250 million of cash out of the holding company position. We're already, if we do more share repurchase, we're already removing $650 million of capital from the company. I think that's a pretty strong statement.
Yeah, I just would reiterate, Ed, in terms of the movement you've seen from us, if we go back to the end of last year, we were talking about share buybacks this year of about $100 million. As we have seen some stability lately, some of that stability's gone away, as we've seen the profile of the company continue to improve, as we've seen that capital continue to remain strong, we have moved up the capital we're deploying into share buybacks from, as I mentioned, about $100 million estimated just as recently as the end of last year to what Dennis talked about and I talked about a little earlier, which is in the range of $400 million potentially this year.
No, I think it's great the level this year versus last. I don't mean to say it isn't. When you look at where the stock is now, I'm just wondering if it doesn't make sense to be even more aggressive. Just one other question, Dennis, on VA. I think that you've got the big three. I think there's some indication that MET might reduce the attractiveness at least somewhat of this new product that they've come out with when they refile the next version. Pru has reduced the guarantee percentage, or sorry, the roll-up percentage. Jackson National has said publicly that they're going to be less aggressive with product in the second half of the year versus the first. If all that stuff is true, how much of an appetite do you have?
I think it's good to hear market share isn't what drives you, but it sounds like there might be an opportunity to write more business as you head into the second half of the year. Do you have the appetite for it?
We're not going to make any product feature change to drive sales. We keep pretty close attention to what the competition is doing, and although I can't comment specifically on any of the three that you've mentioned, it does seem like people are coming back to where we are or have been on roll-up rates and other features. We will just add, I'm happy with what we're doing, and I mean that in the perspective of volume of sales, and selling on our terms. We could see that improve a little bit. We'd still be comfortable. The kind of sales growth that you've seen over the last couple of quarters is, we're pretty comfortable with that level and somewhat higher than that level if the competitive situation changes.
Thank you very much.
Thank you. Our next question comes from Colin Devine of Citi. Your line is open.
Good morning. I had one question, if we could talk about the no-lapse guarantee reserves and what you're holding on a GAAP level relative to what you hold on a stat under the XXX.
Colin. Remember that stat and GAAP accounting does some significant differences, not just in the reserve levels, but in the assets you hold, including DAC assets that you hold on a GAAP basis. The net balance sheet of the two items is much closer than the reserve levels I think would indicate. On a GAAP basis, we're building up SOP reserves. We have been building up SOP reserves for some time now to the point now where we have built SOP reserves in the range of a billion and a half dollars behind that book of business. On the stat basis, we have total stat reserves in the range of $14 billion or so, and we have total GAAP reserves of $11 billion. When you take that GAAP reserve of $11 billion and you add in the SOP reserve to that number-
you can see that you have a difference in that $2 to $3 billion range. Let me restate that, Colin. I believe that the $11 billion includes the billion and a half of SOP reserves. You have about a $3 billion difference. Remember that we have been doing successive reserve financings of statutory reserves with this business. We've continued those over the last year, and we anticipate we'll be able to continue to do those as we move forward. I would anticipate that that difference would come down as we move forward.
Okay. If I hear that, are you saying that you think on a GAAP basis that you are going to get your no-lapse guarantee reserve level up to somewhere close to what it is on a stat?
No, the stat reserve number of $14 billion-
is a gross number. Remember that we have, as I mentioned earlier, financed reserves in the range right now of $2.5 billion. When you net out that $2.5 billion number, what you see is that the GAAP and stat reserves are very much in alignment. I don't anticipate any negative impact on GAAP reserves from SGUL.
Okay. Just to clarify what you financed, did you fully finance it or did you reinsure part of the mortality exposure only?
No. Let's separate the issues. We obviously have reinsurance on all of our products on exposures above our retained amount. Our financings are discrete transactions we enter into on specific books of business. We've done a number of those that have added up to the $2.5 billion that I talked about.
Okay. Thank you.
Thank you. Our next question comes from Thomas Gallagher of Credit Suisse. Your line is open.
Hi. One follow-up on reserves. If I look at page 24, there was an increase in life insurance reserves in the quarter, but it was offset by a DAC reduction. My understanding is that it was related to the systems conversion that's going on. My question is, can you give us a little bit of color what exactly is going on there? Also, is that systems conversion occurring for both GAAP and statutory?
Yeah, the conversion is occurring for both. We've been going through this process for over a year now, and we probably have about that time left, even though I'd anticipate that we would complete the majority of this work, hopefully, by the end of the year or early into next year. I would say that the impact we took this quarter, I believe, hopefully represents the bulk of any sort of noise that you'll see around that item. Looking at the specific adjustments, what you find inside these models is that these numbers do move together. If one goes up, for instance, the liability goes up, DAC will move down. The models are not independent, but they're related. I'm not surprised at all that the fact that one went up caused the other one to go down.
As we estimated earlier in the year, the impacts almost perfectly offset each other. The noise I think that you saw this quarter, while some may continue as we go forward, I think you've sort of seen the peak of this quarter, and the noise offset each other in the two lines as you had mentioned.
Got it. Okay. Randy, given that it's being done for both GAAP and stat, for GAAP you have the DAC offset. Is it fair to assume on stat you got the $150 million reserve increase, but no offsetting DAC impact? Was there a statutory charge this quarter related to this, or can you help me?
There was no stat-related impact. Remember that the statutory assumptions, which are really set at issue and locked in. You don't have that perspective nature that you see inside of the GAAP, which is really what drives some of the calculational differences inside the GAAP reserves and DAC balances.
Got it. Okay. Just one question on EITF 09-G. Can you give us an update on where you stand there, any quantification of it? A related question, is it both DAC and VOBA that are potentially falling under the scope here, or is VOBA excluded?
Yeah. The VOBA does not get impacted by EITF 09-G. It's just DAC balances. The VOBA we established back at the time of the merger will not be adjusted as we look to do our retrospective adjustment. In terms of where we are today, really say the first half of this year has been about interpreting the rules. We've gone through the rules, we've come up with our interpretations. We've pretty much completed our review with our auditors, so we have them on board with our interpretations. Last half of the year, and I would really say the next quarter, will be about determining the specific impacts. We do anticipate that we will do the retrospective adjustment that is allowed as part of the process.
Uncertain what the net impact is going to be, but we should be on track to provide a pretty good guidance as we move into the third quarter call, I would imagine.
Okay. Just how much of your $9.3 billion of DAC and VOBA is VOBA?
The VOBA balance, I don't have that number right on me.
I'll get it for you, Randy.
Jim can provide that number offline.
Okay, great. Thanks.
Thank you. Our next question comes from Steven Schwartz of Raymond James. Line is open.
Hey, good afternoon, everybody.
Yes.
A couple questions on annuities. Something that has caught me by surprise, you mentioned, I think, that you had introduced a GLWB. I mean, you've had income for life for quite a while, which could be used like a GLWB. I think you've had lifetime income advantage for a long time now. What is it that you did?
I made that comment in reference to adding it to our fixed products.
Okay. All right, I didn't get that. Another one if I may. What is today the reliance sensitivity, however you want to put it, to American Funds?
I'd have to find the breakout, which I don't have right in front of me, of the balances in our VAs between the two products. Why don't I ask Jim to get back to you on that?
Okay. I would appreciate that.
Okay. Thank you.
Okay, thanks.
Thank you. Our next question comes from John Nadel of Sterne Agee. Your line is open.
Hi, good morning. Maybe good afternoon, everybody. If the 10-year sits at 3%, you've got about 3% pressure on earnings two years out. If we're at 2.5% on the 10-year, you've got maybe 5% pressure, again, two years out. To be frank, that seems pretty trivial when you put it in that kind of context, and yet it seems to be low interest rates remains the single biggest reason your stock continues to trade at this consistent discount versus the group. I can see how the market would be wrong on a given stock or even on a given issue like this for a relatively short period of time, but this discount remains intact now for a long period of time. What is it that we're all missing? I mean, in terms of the risk to the balance sheet or the risk to reserves or capital.
I mean, this discount versus the group can't simply be because of 3%-5% earnings risk.
I think it's a very good question because what you say is accurate. I guess possibly because there's been more volatility in our balance sheet, such as the $130 million hit to DAC, I guess, third quarter of 2010, that it's left an impression that that might happen again.
I don't know. Manulife has more volatility than that, and they traded a premium to you.
Well, let me say this. We think that the premium isn't warranted by the facts or the discount isn't warranted by the facts.
Yeah, I'd echo Dennis's comments. I think you saw that in the quarter when we accelerated our share buybacks that we'd announced earlier and did $150 million share buybacks. We don't agree with the marketplace that the share price should be priced like this. Let me kind of just respond to an earlier question. We have $9.3 billion balances. $1.3 billion is our total VOBA.
Just following up on that leaves $8 billion of DAC, just to be clear?
Yes.
Okay. I'm not sure exactly what to ask you for to help us get more comfortable with the risk that perhaps the difference between your UL statutory and GAAP reserves, that difference between the two needs to close over time and that that's a charge to equity. You know what I'm getting at? I clearly understood Colin's line of questioning. I guess that difference between those two reserve levels, I think that probably at the end of the day is the weight on your stock. Randy, maybe you can go through that a bit one more time for us.
Yeah. Let me go back to that because I think I fumbled that question a little bit. We have net statutory reserves, that is reserves after financings that we've put in place, in the range of $11.5 billion. We have GAAP reserves of about $11 billion. The numbers are relatively close. Let me be clear. I see no additional reserves that we need to put up on either a GAAP or a STAT basis on our SGUL for the foreseeable future.
That's pretty-
Those differences in reserves are solely due to the different calculational techniques.
Okay. That was pretty clear. Thank you.
Maybe I'll expand a little bit on the question of the valuation. We've worked hard since the crisis to make changes, fundamental changes, so that the volatility that we saw during the crisis, dominantly driven by balance sheet issues, don't reoccur. Just go back in time. We've had good sales, positive net flows because of the strength of our products, the strength of our distribution in every quarter with the exception of one, I think over the last 36 months for sure, and probably even before that. The fundamentals of the business model continue and did continue right through the crisis. The crisis hurt us a little bit for 2 reasons. 1, asset losses, and 2, at a moment in time, we had a net borrowed position and $500 million worth of debt maturing, and it spooked the market. We've resolved those problems.
lowered the risk of our overall investment portfolio and now have about 18 months to 24 months of cash on the balance sheet, so we can finance ourselves over that period of time if the world ever gets back to where it was a short 24 to 30 months ago. This is why we keep reiterating the fact that the fundamental operating platform of the company has worked throughout the last 3 years, and we've made significant changes on the balance sheet, cash and investment risk. I'll also add to that, repriced our products, reduced the tail risk, took the charges that we need to take related to low interest rates. We think we're in a very solid position to move forward and continue to kind of demonstrate good results.
Dennis, if I can just follow up on all of that. Clearly, so much progress. The world is a volatile place, but certainly better than it was a couple of years ago.
Right.
Your capital position is strong, your risk-based capital ratio is strong. If I look at a shorter period of time, just let's call it the second quarter. From the beginning of the second quarter to the end of the second quarter, your excess capital is unchanged. In essence, you bought back stock to the tune of your free cash flow during the quarter.
Yep.
With all of this confidence, with your own understanding of your earnings risk to low rates to equity markets. If there's this big of a disconnect between your understanding of that risk and the market's understanding of that risk, to Ed's point earlier, why not spend some of the on-balance sheet excess capital, work that down in addition to spending your free cash flow, buying back your stock at what at least I would expect in your view, is an extraordinarily attractive price, even if the market doesn't recognize it.
Yeah. Again, let me repeat what I said and what Randy said. Progress that we've made and improvements that we've seen cause us to dramatically increase our actions in and around share repurchases. I think in contemplating in a 12-month period, removing $650 million of capital from this company in a combination of share repurchases and debt reductions is a very strong statement by management on the confidence that we have going forward. Now, with respect to dipping into the $1.6 billion, that is something we're more cautious about. Not because we don't have strong belief about the strength of the company, because we do, obviously, we keep saying it. Because the rating agencies haven't come along quite as quickly. Again, we're only two years away from the biggest calamity in recent history, economically and in capital markets.
Those two things, and quite candidly the results that we've seen or not the results, but the reports that we've seen in the last 24 months, excuse me, 24-48 hours, I guess, have suggested that the economy is still fairly tepid. We're just perhaps abundantly cautious, but cautious. Again, I'll come back to removing $650 million of capital from the company, permanent capital from the company in a six-month period is a fairly strong statement by management.
Thank you. I appreciate the commentary and the extra time. Thanks.
Okay.
Thank you. We have time for one further question from Joanne Smith of Scotia Capital. Your line is open.
Hi. Maybe I'll approach it in a little bit different way on what the market's missing. If I go back to 2008, 2009, it was the investment portfolio that really got you into trouble and the lack of available cash on the balance sheet. I guess part of the reasons that you were holding a lot of commercial-backed mortgage CMBS and RMBS on your balance sheet was because you didn't have the large in-house capability to underwrite your own commercial loans. You had this dependency on packaged securities. I'm looking at the disclosures as of March 31st, and there's still $9.3 billion of RMBS on your balance sheet at fair value. Do you think that there is something in the market that still has that fear that there could be significant asset losses? We all know that the residential real estate market still is very bad.
Maybe you could give us a little bit more color on where you stand in terms of the quality of that portfolio and any potential impairments.
Right. Joanne, let me unwind a few of those comments. First, on the commercial mortgage loan front. We originate many commercial mortgage loans. We have a $7 billion book of commercial mortgage loans and believe we have one of the best underwriting platforms in the industry. I think that's been borne out by the experience, which has been stellar even through the credit crisis that we've been through over the last couple of years. On the CMBS side, relatively speaking, we have had actually a lower exposure than our peer companies at about $2.5 billion. We've had pretty good experience in that CMBS book also. Some losses recently coming from some of the lower rate of collateral. All in very good performance from what is a relatively smaller piece of the book. On the RMBS side, which is where we experienced
Our losses by and large in the last two years. I'd say that today we sit in a very good position, that I think we've been through the worst of the worst. You've really started to see if you break that book up into its component parts, what you really see is subprime metrics really stabilizing across that book. Alt-A metrics getting very close to stabilizing. Really the prime book really where you're experiencing any losses that you experience today, which have been relatively modest in recent quarters. In terms of those asset classes, feel very good about where we are today.
The broader issue of the general account over the last two years, Fred and team I think have done an amazing amount of work to clear out issues, holdings that we believe are potentially subjected to more stress in an economically stressed environment. Feel very good about where we are. You've heard us say this in the past. It is credit at the end of the day, that is the only item that has generated any capital losses for Lincoln over the years. Not the hedge program. It's not interest rates. It's been credit is the only area. Feel very good about where we are. That's the one area, that's an area where we continue to be very focused on remaining cautious.
Randy, just, you know, I'm just going to use the example of Aflac, for example. You know, there was a period of time where they, you know, they tried to argue to the market that the European financial institution holdings that they had in their investment portfolio were money good, that's all they preached for a really long time. It didn't matter whether they were money good. What mattered was the fact that the market wanted them to get rid of them, they did or largely did. Maybe the market's telling you that you need to reconsider the RMBS portfolio.
Yeah. Joanne, let me, because you did quote, there's one point I didn't speak to that you made on the RMBS side. Of that $9 billion exposure, fully $7 billion is agency RMBS. Is actually, in terms of what the market thinks, it's trading at a pretty significant premium to its amortized cost. Feel very good, once again, Joanne, just to reiterate, very good about the things we've done inside the general account. We continue to invest what I would describe cautiously, very highly rated investment-grade corporates, commercial mortgage loans. As I mentioned in my comments, we really haven't seen value recently in the high yield space. We continue to selectively de-risk where we see issues.
Yeah, you know, you've already won me over, Randy. You know, I'm just trying to figure out why the market has your stock trading at 65% above. Just about one last question, and that is going back to the 09-G. I thought that in the first quarter you gave an estimate of the impact of that was going to be about $200 million-$250 million. Are you saying that that estimate is no longer accurate?
Joanne, I don't remember what you're referring to, but we have not given any guidance on what the impact on results is going to be for 09-G because we simply don't know yet. As I mentioned, first half of the year was really about interpreting rules and sitting down with our auditors and getting them on board with our interpretation. It's really in the next quarter when we'll be determining what the impacts of those interpretations are.
Okay. Perhaps we could take that offline. Thank you.
Thank you. I'd like to turn the conference back over to Mr. Sjoreen.
Well, I want to thank everybody for taking the time to join us on our call this morning. As always, we'll take your questions on our investor relations line at 1-800-237-2920 or via email on our investor relations website. Again, thank you, and have a good day.
Ladies and gentlemen, this does conclude today's conference. Thank you for your participation and have a wonderful day. You may disconnect.