Good morning, everyone. I'm Ryan Krueger from KBW. I'm really pleased to have Lincoln Financial Group with us today. From Lincoln, we have Randy Freitag, who is the Chief Financial Officer and head of the individual life business. Just for housekeeping purposes for those listening in, there is a submit question function at the bottom of your screen. I have a number of questions, but I'll keep an eye on any questions from the audience. All right, Randy, I guess to start, can you discuss Lincoln's approach to managing the balance sheet in this current environment where we have a combination of economic and claims uncertainty, as well as even lower interest rates than we've been dealing with before?
Sure, Ryan. First off, thanks for hosting us today in these very strange times. I think this is my first virtual fireside chat, thank you for doing that. I think in terms of managing our balance sheet, it really starts with what we've done over the last five, six years, which is build a very strong balance sheet. We came into this year with a 439% RBC ratio, and we've actually been able to grow that over the first half of the year. We ended the second quarter at a 444% RBC ratio, $9.7 billion of capital. That's the first step of how we've managed the balance sheet, which is to make sure we're in a very strong position. When it comes to, because ultimately, I think what you're getting at is what are you doing with your capital then?
I think for the second and third quarter, we made the decision not to do share buybacks. Ultimately, that comes down to what view are we taking of the economy. I think given the evidence that existed when this whole thing started in March or whatever, and through the second and third quarter, I think the best assumption was to assume that the potential for a stressed environment had grown to a greater level, obviously, than when we started the year. We made the decision consistent with that assumption to not do buybacks in the second and third quarter. Doesn't say anything about the strength of our balance sheet, which I mentioned at the beginning was very strong.
Just as everything, I think what is the prudent approach when a stressed environment is at a higher level from a potential standpoint than during a normal state of the world. It's just a fact that I don't get an email that tells me recession coming in three months, right? You have to make an assumption, and that's what we've done for the second and third quarter. As we get ready and move into the fourth quarter, we'll make a decision about what the best assumption for the state of the world is at that point.
I guess, is there anything in particular that you're looking to see in the external environment before considering the resumption of buybacks, whether it be broader reopening of the economy, higher interest rates, I guess credit experience? Any kind of specific thoughts on what you're looking to see?
I think if all of those things. I think the fact of the matter is that the primary stress, and when we run a stress test, it's a very severe stress, significant drops in the equity markets, a one in 100 credit event. When we run that, the primary stress that we experience as a company comes through credit. I think that's the biggie in terms of if you had to rank order things that we look at. We'll be looking for evidence that the credit environment has improved. Obviously back early in the second quarter, there was a lot of uncertainty around what was going to go on with credit. We were preparing for more downgrades, potentially for credit losses, and that really hasn't happened yet, right? We've had pretty favorable experience relative to our expectations early on in this thing.
I think that's a bit of evidence, but I think it's the sum total of all these things, but credit is probably first and foremost the thing we look at.
Got it. One thing you did discuss earlier in the year when COVID started was actions to preserve about $400 million of capital allocated to new business. I was curious, to what extent is that just occurring naturally due to social distancing and lower interest rates, and just a natural pullback in sales in this environment versus more specific actions like putting in sales caps or things more of that nature?
Yeah. It's actually a very natural response to actions we've taken. I don't think it has as much to do with the environment, the sales environment. That's had a small impact as everybody's adjusted to a virtual world. It didn't really have anything to do with inorganic sales caps. I think it has more to do with appropriate from our standpoint, pricing actions that we've taken on some of our bigger products. I think that's been the primary driver of why sales are down this year. Sales, in the case of Lincoln, is a significant place that we allocate capital. Last year, if you look at how we allocated the capital that we generate last year, about two-thirds of it, about $1.7 billion, went to support New Business, about $950 million we returned to shareholders through buybacks, through dividends.
With $1.7 billion going to New Business, that's obviously a significant allocation of capital, and as really the environment has changed this year, especially rates. As rates have dropped, it's really required pricing actions across a number of products in our portfolio. MoneyGuard, which has seen its price increase 35%. VUL had to have some price increases. Fixed annuities obviously impacted. Variable annuities with guarantees, which are where the cost of hedging is really driven by interest rates, have seen their benefits cut. With a lot of our products needing pricing actions, I think that's been the primary driver of why sales are down and thus the amount of capital we allocate to sales is down.
As you think beyond this year, would you anticipate some continued benefit to free cash flow from this shift you've seen in some of the products that you're selling in this type of interest rate environment? Is that something you think could continue?
I think it's somewhat dependent upon how successful we are with what we've been successful at in the past, which is in addition to repricing products that need it, adding new products or shifting to other products. We don't stop with MoneyGuard needs to be repriced, or we don't stop with fixed annuities need to have their rates cut. We are constantly innovating and trying to add new products that make sense. In the case of MoneyGuard, we're redesigning that product in a different way. In the case of the annuity business, we've been able to significantly shift sales to a new product that is not as impacted by interest rates, that being the buffered annuity or the indexed variable annuity. You'll hear it referred to in different terms.
Anyway, I think that's somewhat dependent upon how successful we are, as we have been successful in the past in responding to the environment and then shifting to other products that create a better value prop and a better return profile for Lincoln.
Thanks. On the first quarter call, you updated your sensitivity to statutory cash flow testing, meaningfully lowered the impact or the estimated impact from a 50 basis points 10-year interest rate level. I believe this is based on rates and spreads from June to June of each year. Given we've already passed that, would you anticipate much impact at year-end 2020 from this, or is this something that would be more of a 2021 impact if rates remain at these levels?
No impact at the end of 2020. This is a 2021 event. As we talked about, or as I talked about, $100 million-$200 million at the end of 2021, that would be the peak, and then it would grade down from there. Just to scale that, $100 million-$200 million of incremental reserves is four to eight points of RBC, and as I mentioned, we're in a very strong RBC position. Very comfortable in our ability to manage through that should it come to pass.
Got it, then shifting to variable annuities a bit. Can you discuss how the hedging results have performed in this type of environment so far this year? As well as your just general comfort with the capital and reserves in that business.
Sure. I think this environment is a case study in what is different about the way we operate the variable annuity business. First, in our hedge program, which I think is industry leading, it's proved itself during this environment as the markets have moved, as rates have fallen, as equity markets fell. We saw the value of the assets that in our hedge program increased significantly. Obviously, as the markets have moved back up, they've come down a little bit. That dynamic program focused on the economics has proved itself in what has been a very volatile environment. I think this year has been an affirmation of our approach to product design and the benefits we'll offer a consumer where the benefit profile or the risk of the products we sell is so dramatically different and lower than our peer companies.
If you look at risk as measured through the net amount at risk of the guarantees we offer, whether that's the Guaranteed Minimum Death Benefit or the Guaranteed Minimum Living Benefits. If you look at the end of the second quarter, our net amount at risk in death benefits was 0.8%. That's like one-twentieth of the average of our industry peers, which I believe is in the range of 17%, or living benefits where our net amount at risk at the end of the second quarter, I believe, was at 1.8%, going a bit from memory there. Once again is about one-tenth of the average of our industry peers. That profile, which is so significantly better than nearly anybody out there and definitively better than the average peer company, I think this environment affirms that approach to operating that business.
The other thing the year has really demonstrated, and an affirmation for me and for Lincoln, is how we capitalize the business. We did have some breakage in the first quarter when the markets just had rapid movement. With our approach to capitalizing this business, with our approach to reserving this business, where we're using a greater of CTE 98 or a percentage of account value, we had the ability with that approach to capitalization to absorb that breakage we had in the first quarter. I think this year has been, for me, an affirmation about everything that we do, how we operate that business, which has been so important and successful for Lincoln and the business, by the way, which is significantly undervalued by investors.
From a hedging standpoint, the breakage that you experienced in the first quarter, I think was at least partly attributable just to the extreme amount of volatility and trading that you needed to do. Is there anything you can do or change with the hedge program to protect against that type of experience you could see in that type of volatility in the environment, or is that just something you have to be able to absorb if we get into unusual times?
I think there are, as evidenced by our industry, where almost every company has a little different approach to hedging. There are obviously a number of different approaches. I think when we weigh the pluses and minuses of what are more static programs versus our approach, which is more dynamic and thus does call for trading, which gets a little more expensive when the markets are moving that rapidly. I think we still believe that the pluses of our approach outweigh the negatives of other approaches. Yeah, there are other ways you can hedge these risks. There are other targets you can go after. Some of our peer companies target statutory, for instance, whereas we focus on the economics and GAAP. Yeah, there are different approaches, but when we weigh the positives and minuses, I think we are very confident that our approach is the winning approach.
Got it. One more variable annuity question. That you use your Linbar entity in Barbados to manage the rider risks. I guess, how do changes in the NAIC's variable annuity capital rules or prospective changes in the interest rate generator actually affect the Lincoln, given that you are using that different entity to manage those risks?
Well, the impact on Lincoln is small. Now, that being said, we've been very supportive of the NAIC. We've been a significant contributor to the studies they've done, the work they did with Oliver Wyman. We were a primary contributor to that work, and we're a primary contributor to the work they're doing on the rate generator. We're very supportive of the work they're doing. I think anything the NAIC can do to make reserving statutory capitalization move towards the economics is a positive. Generically, we've been very supportive of that. I think why we tend to do very good as they've made these changes has a lot more to do with, once again, our approach to business than it does with whether or not we operate the business in Linbar or not.
Remember the risk profile I talked about with our business, which is so dramatically reduced compared to our peers, just us a lot better.
Yeah
in their approach and the significant amount of hedging that we do of things like interest rates protect us when it comes to changes the NAIC might make in the generator. We'll continue to be supportive as the NAIC looks to continue to evolve the approach to reserving and capitalization for that business.
Had a related question from the audience, which was that, Randy, you mentioned that you believe the public market is meaningfully undervaluing your variable annuity business. I think the question was, do you think that the private market is also still undervaluing variable annuity businesses to a similar degree?
It's very hard to say. You've seen so few transactions in the private markets, and the transactions you have seen have been a bit one-offs. There have been almost until, and it's very hard to discern what the valuation embedded in the Athene Jackson deal was. Until then, there really hadn't been any transaction of companies who are still actively in the business selling these books of business. It's tough for me to say, I think the very fact that there haven't been many transactions is probably an indicator that the private markets are not putting a great valuation on this either. I say that because, for me, what the variable annuity business is, it's the highest quality asset management business in the world.
Right.
It has great persistency and good fees. Then you have the guarantee you've had. It's about can you manage the guarantee? Can you provide a guarantee that doesn't create too much risk for the company? I think we've shown we can do that. We've done that over the years. That's why I believe the variable annuity business is not getting the valuation that it deserves, because all the focus goes to the guarantee, and there's a perception of the guarantees as being riskier than in the case of Lincoln they are, and there's less focus on what is at the core of this business, which is an extremely high-quality stream of asset management fees.
just one more from the audience. It's somewhat also, I guess, related to annuities, which is if there is a change in the political administration in an attempt to bring back the Department of Labor Fiduciary Rule, how do you feel that that could impact Lincoln? There's been changes since then with an SEC rule now as well. Just any thoughts on how that might play out?
We were very supportive of Reg BI and the SEC work, we're very supportive of that. I think to the extent the Department of Labor comes back to make changes, I think a lot of the legwork was done by Lincoln with the last administration. If you go back to the beginning, now we're talking years ago, the very first approach, there really wasn't an understanding of commission-based products, right? Lincoln did a ton of work, which is something we've shown a capacity to do over the years with regulators to help them understand that in the case of a product like variable annuities, commissions make sense. They are the lowest cost approach for consumers.
Once again, a product where the persistency is extremely high, you're much better off paying a 4%-5% commission or whatever it is upfront than you are for paying 1% for the rest of time. They understood that, and they ultimately made changes to their ruling that we felt we could at least operate in. I think if we get a new department and we need to work with them to help them understand the products we sell, we'll do that. We've shown the ability to do that. Change is always, I don't know if you want to use the word scary, but change always creates risks, but I think we've shown the ability to work with administrations of all stripes to help them understand the products we sell.
Thanks. The actuarial assumption review you conduct in the third quarter, I'm not going to ask you what you're going to do with your interest rate assumption, but I guess the focus has often been on interest rates, but there's also many other factors that are reviewed each year. I was hoping you could just touch on how some of the other key factors have played out in recent years, such as policyholder behavior, mortality, those types of other impacts.
Ryan, if you look over a more extended period of time, a decade, the sum total of everything that isn't related to interest rates is very, very small, if not positive. All of the other policyholder behavior, mortality. Now, there have been years in there when there have been movements one way or the other. For instance, last year in the life business, I think reinsurance was a bit of a negative, and I think there was a negative a bit from mortality as we had to bring a small slice of our business in line with the rest of our business. If you sum it up over a number of years, the impacts outside of interest rates have been de minimis at most.
Thanks. Shifting more to earnings. You had previously guided to interest rate headwinds of about 2%-3% per year. Rates have come down since you had given that guidance. We've had spreads widen a lot, and now they've narrowed again. What's your view of the interest rate headwind for Lincoln from an earnings standpoint at this point?
I think as we were towards last year around this time, we were sort of coming down to the bottom end of the 2%-3% range, right? The headwind was around 2%. As rates started to travel down, we've moved up to the upper end of that 2%-3% range. I think we've gone above that. We're probably in the 4% headwind looking forward for the next few years. Once again, it'll continue to grade down over time. That's lower than it was if you go back five or six years when we were in the 5% range. Don't like the fact that it's went up, we have shown the ability to grow our earnings, even with greater levels of spread compression than we're at today.
You have a few different expense initiatives that are currently ongoing. Could you review these? Also just discuss what type of actions are you taking to achieve these type of expense efficiencies?
There's really three buckets. First is the integration savings associated with the group acquisition, which are really completing this year. We've got about $25 million of incremental savings coming from that integration savings program. Then you have the original digitization effort, which involved investments and ultimately is going to yield $90 million-$150 million of savings. That's growing at about $40 million of net benefit a year. Last year it was relatively neutral. Investments about equaled savings, and this year it's growing by roughly $40 million, and then it will continue to grow over the next couple of years into that $90 million-$150 million range. You have that program. The third is, this year, early on, we took $100 million out of our budgets in March in response to the environment. Some of that was stuff you might expect.
People aren't traveling as much, et cetera. As we look out into the out years, we have had an opportunity over the course of this year to continue to use modern business practices or more investments in technology to lock in those $100 million of savings looking forward. We've been able to permanently take $100 million out of our expense base, and we're actively looking to continue that sort of progress, Ryan. There's three big buckets. You have our normal ongoing budgets. We'll enter the budget season, where as part of the annual process, we expect savings across the organization as we link expense growth to a fraction of revenue growth. There's some big buckets, and continue to deliver on that.
I think it's something we've shown a capacity to do, is actually deliver in a way that you can see in our actual results, the savings that we announce. I'm always a bit perplexed by some programs I see announced and then you can't really see. I think definitively, you can see the savings that have come out of Lincoln. This year alone, our G&A is down what? 7% year-over-year.
In the group benefits business, you have a 5%-7% margin target. You had certainly at one point talked about the upper end of that potentially being achievable. I'm curious, do you still believe that's the case once we get beyond this COVID environment? Or has COVID caused some longer, or at least intermediate term negative impacts, do you think?
Yeah, I think absolutely. I think the upper end of that 5%-7% is a reasonable target for the business. I say that because that's a number that delivers somewhere in that 5%-7% is a number that delivers returns on capital that I think are appropriate for that sort of business on that 12% range. Yeah, absolutely. I think also if you look across our peer companies, I think that leading companies are earning margins in that range. Yeah, absolutely. We still target 5%-7%. There's going to be noise here for a period. We still have to figure out. Historically, recessions would cause a period of negative results in the disability business. This is a recession that we're already out of so this is a recession like no others before.
We'll have to see ultimately what the impact of what's gone on in the economy is on the disability business, and we'll see how that happens, and that may take a little time, of course. Yeah, over a period of years, yeah absolutely, upper end of 5%-7% makes a lot of sense for that business.
Similar question for the annuity business. It's pretty consistently generated after-tax return on assets in kind of the 75-80 basis point range in recent years. There was some volatility in the first quarter that dropped it to 71 basis points. Do you see it reverting back more to that prior ROA range going forward from here?
Ryan, now you're testing my memory. I think it was actually 76 in the first quarter. It was 71 in the second quarter.
I meant second quarter. I apologize.
I think you're just testing me.
Could be.
Yeah, the second quarter for the annuity business was more about what went on in our alternative investment results. That knocked the returns in that business down four to five points in that quarter. Yeah, absolutely. We expect it to go back to that 75-80 basis point range, especially as you've seen some recovery in the equity markets also, and we fully expect that the alternative results will return to more normal levels. In fact, we'd expect to have a very strong third quarter.
Got it. Another question from the audience. You did a fixed annuity reinsurance transaction in late 2018-
to take advantage of different pricing dynamics in the reinsurance market relative to your own stock price. Is that something for either fixed annuities or life insurance or other businesses that you'd think about doing again?
Look, we're always thinking about what's the best approach to allocating capital, and should we allocate capital to supporting an in-force book, or does it make more sense to do something? I think the reality of the environment today is that our share price is lower, but at the time we did that deal, the share price was pretty low also. We were in the 50 range. Even then, the price we got, I mean, it was a good deal, but it was 2%-3% accretive, I think. It wasn't hugely accretive, and I think the reality is with rates where they are today, that the purchase price on those books of business has come down also. Yeah, we're constantly looking at it, but I think both sides of the equation have come down.
Our share price is a little lower than it was at that point in time, I think also the price we could get from a willing buyer is not as attractive as it was then either.
Got it. Thanks. Wanted to come back to the new business pricing environment. You've mentioned that you've taken many actions. Wanted to delve into that a bit more on some of the particular actions you've taken from both pricing and product standpoint, given the low interest rate environment.
Sure. It's primarily been in the life and the annuity business. In the annuity business, there's been two products that have been impacted, at least in the way we operate the businesses. First, the VA with guarantee business, what drives the cost of hedging? The primary driver of the cost of hedging on a day-to-day basis can be the level of interest rates. As rates have come down, cost of hedging has gone up, and we've had to cut benefits multiple times this year. There's fixed annuities, where if you think about a 10-year treasury at 70 basis points, if you think about the way Lincoln invests is a reasonable spread above that, you're just not able to offer enough value to the consumer to make it attractive.
Now I know there are some companies out there who are talking about the ability to earn 3%, 4% on investments. I'm not really sure how you do that at scale, at least. We would not be comfortable saying that there's ability to do that at scale, fixed annuities have been impacted. On the other hand, indexed variable annuities, buffered annuities they actually benefit in some ways from this environment. That risk that the consumer accepts actually has a lot of value, which allows you to offer a much better upside value prop. We've seen sales of that product grow dramatically. That's the annuity business. On the life side, first it's products that have a connection to, once again, general account investing and the investment in corporate bonds. MoneyGuard historically has been that type of product.
As rates come down, you just can't offer the same benefits at the same price. The price of that product has gone up 35%. I think ultimately that product, at least in a lower environment, is going to have to shift to a different way to generate value for the consumer. I would think like that. Additionally we've got a product, a VUL product some level of guarantees, and that product really got impacted by principles-based reserving and the impact of low interest rates on principles-based reserving. That product saw its go up also. Pretty much universally, we've seen our competition respond generally a little after us. On the life business, I joke that we change price and then about two months later, I see everybody else change their price by pretty much the same amount, we've seen that.
We just saw our biggest competitor in the VUL guarantee space announce a price increase, for instance. That also happens on the annuity side. Yeah, those have been the products primarily impacted.
To what extent does this change your outlook for growth over the next few years in the life insurance business? Do you think you can offset some of this with different products?
Yeah, I think if you look historically, how does Lincoln generate earnings growth? About half of our earnings growth historically has come from the component that is new business net of outflows, right? That's been about a 4% piece of our growth over the years. I think over the next few years, we can overcome that number, which is going to go down a bit with expense savings. As I talked about locking in $100 million of savings, continued focus on expense savings. I think over the next few years, we have the ability to overcome the fact that at this red hot moment, we're not selling as much product, and then it's incumbent upon us to, using our distribution, using our innovation to create products that ultimately move sales levels back up to higher levels.
Coming back to the investment portfolio, one, can you discuss some of the de-risking actions that Lincoln has taken over the past few years? If you've done any additional de-risking this year. Secondly, I guess, does the amount of government stimulus and Fed liquidity ultimately make it more difficult for you to really assess the underlying credit risk at this point?
To the last part, I don't think it makes it more difficult in this regard. The more stimulus, the more support the Fed gives, the better it is for credit markets, right? That's, I think, the simple math. The difficult part is judging the duration of it, right? Is it a permanent thing? Is it here for six months? I think that's the more difficult thing. I think if it went away, then you would go back to an environment where there would be a higher level of expected credit losses. There would be a higher level of expected downgrade. I think that's the tricky component there.
In terms of what we've done, if you look over the last five years or so, coming into this year, we had de-risked or sold off about $5 billion of investments that we felt were at a higher level of risk to default or to downgrade. This is primarily in the energy and the consumer cyclical space. In the second quarter, as you started to see the benefit of the support from the government, we were able to continue that, and we actually did another $1 billion of de-risking. Once again, focused primarily in the energy and the consumer cyclical space. That's given us the ability to bring down our below investment-grade holdings for instance, down to 4.2%. That was down from where they were at the end of the first quarter. It's been allowed us to bring down our holdings of lower-rated BBB securities.
BBB minus securities dropped from 7.9% at the end of the first quarter to 7.4% at the end of the second quarter. Yeah, I think that's been our focus. It's a result of a disciplined process. Ellen and her team, they work daily with our managers. They model out different potential stressful environments. They look at securities in those environments that have a likelihood of downgrade or default. They assess how that potential loss or incremental capital from downgrade compares to the price of the security today. If it makes sense, we've done trading, and that's totaled up to roughly $6 billion of securities that we've de-risked over the last five years.
Got it. We are at the end of our time. I want to thank you again, Randy, for participating with us again this year, virtually this time. Hopefully, next year we will be back in person. Appreciate it, and, everyone stay safe.
Thanks, Ryan. Thanks, everybody.
All right. Take care.