All right. We are going to get going. Happy to have Lincoln Financial with us again this year. Up with me is Randy Freitag, who is the CFO, and also recently took over responsibility for running the insurance operations as well, the life insurance operation at Lincoln. In the front row, we have Chris Giovanni from Investor Relations. To kick it off, Lincoln announced the digitization initiative about a year ago. I was hoping you could provide some examples of the type of things you're working on with that initiative, as well as the projected benefits going forward. Along those lines, are these more back office focused initiatives or are they also things that could lead to a revenue opportunity?
Sure. First, Ryan, thanks for having us. We always appreciate coming up and spending time.
Thank you.
You put on a great conference. Those of you here just holding your seat for Evan Greenberg, welcome to Lincoln Financial. We're a great core holding if you're looking for a company. Yeah, we announced this initiative a bit ago. It's very exciting. Obviously, as any company, we focus very intently on managing expenses. If you look at Lincoln over the last six, seven years, you've seen just our core expense ratios come down about 100 basis points. It seems that every five or 10 years something comes along which allows you to really take more of a jump as opposed to sort of that steady improvement. I think that the technologies that are enabling the digital revolution are an example of that.
The reality is that the benefits are both on the expense side, and I believe there will be some on the revenue side, even though in terms of what we've highlighted for investors, we're really just focused ultimately on the expense savings we would expect from this particular initiative. At Lincoln, what really drove us into this initiative, I would say, is really a few different things. First, customer expectations. As we look out 5 to 10 years and you look at our typical consumer, I think it's fair to say that their expectations, which are really being driven by companies like Uber and Amazon, are really going to start being reflected in their expectations for what they get from providers of other products like Lincoln. It isn't a huge thing for them today. I would say our typical consumer, which is a little older.
I think you'll see it growing. You've got this consumer expectation aspect. You have the fact that we're a leader in these four businesses we're in, life, annuities, retirement, and group. As a leader, we expect to lead from all aspects, including the implementation of technologies. You've got that aspect. You also have the fact that as we looked around, as we go through strategic planning processes and sit through quarterly business reviews, we really started to see a lot of these digital initiatives going on across the company. For example, in our retirement business, they implemented something called Click to Contribute, which is a very digital automated way to increase your contributions to your retirement plan. We saw that in the first 18 months or so, that generated $150 million of additional deposits.
We started to see these things and started to easily understand what this could mean for the rest of the organization. We set about this process of really taking a holistic look across the company and brought in some outside expertise to really kickstart us. We ultimately hired the outside expert we brought in. He's now our Chief Digital Officer at the company, Raj Chakraborty. He's heading this up across the enterprise. Our expectation is that ultimately we can deliver roughly $90 million to $150 million of expense savings, which is 6%-10% of our G&A. A pretty significant event over the next four years or so. How that's going to roll out this year, it's primarily about investing, spending money, about $40 million. Next year you'll actually see our expense ramp up, but you'll start to see benefits flow through.
I expect the same next year, roughly a net of $40 million. By the time you get to the third year, the benefits continue to grow. I would expect more of a neutral outcome. As you get into the fourth and fifth year, you'll get to that ultimate run rate, which I talked about. I think it's both. It'll happen over four to five years. Yeah, it's a significant event which I think can significantly improve the bottom line.
Thanks.
I guess a little bit with annuities within the businesses. I was hoping you could review some of the recent variable annuity product enhancements you've made, like the MAX 6 Select and the iShares product, tying into that, where you see new business returns in VA at this point.
Yeah. We have a goal of reinvigorating our annuity business back to the point of positive net flows. We've targeted 2018 as the point when we do this. This is a business that for forever had generated strong positive flows. Due to really changes in the marketplace, you've seen that change. We're currently in a negative flow situation. Part of that has been focused on the product portfolio. That is a mixture of tweaks to all of our existing products then the addition of some new products. A product like MAX 6 Select , which is a product that has a benefit structure which features a higher upfront benefit, but with the risk that benefit can get cut in half. You start out with a 6% payout.
That's why it's MAX 6 , which can get cut to 3% if and when your account value runs out. That's a product that seems to have a lot of current attraction in the marketplace, it's had a good rollout, we're seeing good, strong uptake of that product. iShares is an example of a product which I would say is more focused on the long-term trends we see in the annuity business, that is trends towards passive and fee-based products. I think that the annuity business will always be dominated by actively managed commission-based products, there are trends towards these fee-based passive products, iShares is an example of that. I would expect that to be a slower uptake.
Then in terms of new business returns, where do you see that for VA at this point, how does it compare to maybe the last few years?
Yeah. The returns are in the mid-teens. They're right in line with our targets. If you think about the returns in the annuity business, we expect and we price for returns in the mid-teens. Coming out of the financial crisis for a few years, returns went into la-la land, and they were very, very high.
Okay.
Well into the 20s for a period of time, and that was a reflection of the fact that a lot of supply left the marketplace. Yeah, I think we're right in line with our pricing targets right now from the VA side.
Okay. On the in-force, the annuity ROA is-
You've been pretty much in the 75 to 80 basis point range roughly for a while now, and you've been producing 20% plus ROEs. Is it a reasonable expectation for that kind of level of profitability to continue, or are there any other factors we should consider?
Yeah, I think that definitely our expectations are that we can continue returns of that level. You really have to construct what's gotten us to this point. If you think about why we report such strong returns on both an absolute and a relative basis, that's really driven by a few things. It's the quality of the portfolio. I think that we have the highest quality variable annuity portfolio in the business. That's most easily reflected when you look at the risk metrics, the net amount at risk that sit in our products. I guess the most recent data point I would have as a comparison is if you look at the end of 2016, which was when I could see all the peer group.
Yeah.
Our net amount at risk on our guaranteed living benefits was around 1%, and a peer group of companies, the rest of the companies in the industry, was at about 7.5%. You have a similar difference on the guaranteed minimum death benefit. That's a reflection of the fact that we have a very high-quality book of business. You've got that. Our approach to hedging. We've had a philosophy from day one in this business. No product hits the street without being brought into our hedge program, where we focus our hedging on the economics. That means that when we entered the financial crisis, we didn't have to, like a lot of companies did have to. We didn't have to go out and buy a lot of very expensive hedges.
Yeah
The cost of hedging pre-financial crisis, which was in the 50 basis points range, was suddenly three to four times that. A lot of companies who didn't have complete hedge programs had to go out and create their hedge programs in that environment. Obviously, if I had spent three to four times as much for all those hedges, I wouldn't have a very strong return in my annuity business. That's the second factor. The third factor is, as I mentioned, for a period of years coming out of the financial crisis, the returns available on new business were just tremendous and well above our longer-term expectations. It's put us in this situation where at about 20% ROE, 75 to 80 basis points ROA. I think it's reasonable to expect that to continue for an extended period of time.
New business, I just mentioned, is more in the mid-teens.
Okay.
Over time, you would expect that to bring it down. It's very slow in terms of its impact. At the same time, that new business may be coming on at a little lower rate. We're doing things like the digitization initiative I talked about. Yeah, I think it's a reasonable expectation.
Okay. I guess touching a little bit more on the VA rider fees and the hedge costs. You break out that the VA riders are about, I think, 5%-6% of your earnings-
on a net basis. I was hoping you could help us dig into the pieces of that and kind of where your rider fees are at versus the hedge costs at this point. I guess, how does that compare to your pricing? Do you price expecting to make a profit on those, or how to think about that?
Yeah. Well, the last part of that, yes. When we price to get so that the returns are not negatively impacted. That means you should get some profit out of the fact that we provide a guarantee on these products. Mathematically, what that is, that's the difference between what we charge the consumers for the guarantee and our cost of hedging that guarantee. Every week, our hedge program, which is focused on the economics of these products, we go into capital markets. We look at the interest rates and volatility levels and everything else, all the things that we hedge, and we economically price the cost of hedging. We assign to that week's group of issues something called a valuation premium. That is the expected cost of hedging. You have how much we actually charge the consumer, and the difference-
is what flows through above-the-line. Separate from that, you have what I call hedge breakage, which is the difference between the amount that our assets, the derivative assets that we hold move, and the liability moves in any particular quarter. That, what I call hedge breakage, flows below the line. For us, due to the things I've talked about, the fact that we have a high-quality book of business, which makes it easier to hedge, the fact that we've had this economically-focused hedge program, the fact that we're really, really good at running this hedge program, means that we haven't had much breakage over the years. In fact, if you look at that 20% operating ROE, and if you actually factored in all of the hedge breakage over history, it would change it from 20 to 19, I believe.
It's actually been a very small impact on the overall returns in this business.
Got it. One more question on hedging. We've seen some players in the industry make some changes to their hedging programs where they're using more of a combination of fixed assets and out-of-the-money derivatives. I think you pretty much exclusively focus on derivatives, but if you can give us an update on how you hedge the product and if you've made any changes in recent years.
No. I think what you're seeing is you have a mixture of companies that are active in the market and some companies that are not active in the market, and some companies who are actively trying to just ignore the fact that they have books of business, so they give them other names and they put them in other entities, and they try to make everybody forget about the fact that they exist. Those companies tend to be more focused on the protection of statutory capital, which is a different animal.
Yes.
That's not an economically focused way of accounting for these things. Those companies tend to have a different approach, and it sometimes is what you describe. It's about putting more capital against the product and then hedging tail events. That's not our focus. I continue to believe, or we continue to believe, that there's only one asset that can move on a daily basis like the liability, and that is a derivative asset matched-
Yeah
to those liabilities. That's what we do each and every day. We focus on the economics. It's a dynamic program, every single day, multiple times all throughout the day, we're doing hedging as the nature of those liabilities changes as the capital markets move. That's what our program has been. That's what our program continues to be.
Moving to life insurance. At least at your Investor Day a year and a half ago or so, you talked about some in-force actions you were working on.
Can you review what those are and then how far along in the process you are with those actions at this point?
For a long time, for decades, in-force actions in the life insurance business were just adjusting credit rates.
Got it.
We didn't really have teams of people who really focused on in-force management. As we and other companies essentially ran out of room on the credit rate side, I would think there was an impetus to get more focused on a broader definition. A lot of things. That, the ability, the technologies we have today, I think allowed companies, including Lincoln, to get more focused on optimizing the performance of their entire book of business. For us, that's taken a number of different avenues. For instance, we focused on the retention of our life insurance business. You've seen a lot of that in the term insurance space. This is really work we've done with our big reinsurance partners, where when you get to the end of a guarantee period on a term insurance product, there historically has been a very, very large increase-
Yeah
in the premium. Everybody would lapse. The very few people who retained had very high mortality. Well, I think it was Swiss and some of the others really started focusing on more optimizing patterns for those premium increases post the guarantee period. We've implemented some of that. It's had really great results. We focused on really working with the in-force to be more proactive in generating ongoing premium flows. You've seen a lot of work there. We've also taken some action on non-guaranteed elements, which is really driven by our expectation for what the future holds. We've done a few of those things. We continue to focus on all those aspects of in-force management, I would say, today. I'm sure there will be other aspects of in-force management in the future.
Within life, MoneyGuard has been a combination product with a long-term care rider, has been a big seller for you over a number of years. Can you talk about how the profitability of that product has performed relative to your expectations over time? I guess curious why you don't see more peers offering a product like that at this point.
It's a great product. It's a product that speaks directly to the needs of consumers. I think you've really seen a shift in what we sell away from a portfolio that was very focused on high net worth estate planning. You've really seen more of a shift into this consumer needs space. A product like MoneyGuard, which offers you some limited period of long-term care along with a death benefit should you need it. It's just a great product. I think it speaks to consumer needs. It's also a great product for us because when you put these benefits together, what you get is a favorable risk profile. You can only get one of those benefits, and you use up-
Yeah
each of them. If you die, obviously, that's what you get. But when you're getting your long-term care benefit, you're using up your death benefit first. It's a great product. There are a number of competitors in that space, and it's a space that is growing tremendously. I would say in total, this marketplace has grown about 20% a year. There aren't really any places in the life insurance business are growing at that rate. But this particular product is. Now there are a smaller set of companies who come at it with this targeted design product, MoneyGuard, and we are undoubtedly a leader in that space.
Pac Life, Nationwide, State Life, which is OneAmerica, they all sell MoneyGuard type products and typically when they come into the space, they try to emulate what we do, if not directly copy or get our people or whatever approach they can get to get in. They haven't been successful. We've been keeping ahead of the pack on this product. We continue to have very dominant market share. If you look at that slice of the marketplace. Now there's a whole other area in this marketplace which is companies selling universal life contracts where they attach an accelerated benefit rider to that product. That's how other companies are going at it. They're going at it that way because I believe getting a MoneyGuard product filed and approved takes a lot of expertise because it gets filed as a health product.
Okay.
It's a very different animal. Some companies just don't have that expertise. Actually, this is a very big marketplace that's growing. A smaller set of companies come at it like we do with a product specifically focused on this.
Has the profitability of that product been consistent with your expectations?
Yeah. It's been right in line with our expectations. Just like anything, you set your expectations for experience at time zero, and on none of them are you exactly perfect, but yet when you look at the totality, morbidity, lapses, all those things, yeah, they're largely running in line with our expectations. Like all products, interest rates being low has negatively impacted that just as it has our entire life insurance business, which has really caused us to reprice our entire book of business.
On the second quarter call, you talked about achieving new business returns on the life sales at the high end of your 12%-15% IRR. Can you talk about how you're achieving that given the competitiveness in the market? Then how sensitive that would be to different interest rate assumptions?
It's actually a return to normalcy. There are two ways you can acquire life insurance. You can sell it or you can buy it in the M&A marketplace. The more complex of those is selling it. It takes more to establish a distribution network. You create products. From an economic standpoint, you should get better returns for selling it than for buying it. Coming out of the financial crisis, it was exactly reversed because companies hadn't repriced their portfolios of new business, whereas the M&A marketplace tends to adjust very quickly.
Yeah.
You saw M&A returns move above new business returns, but that was an abnormal environment. Over the subsequent six, seven years, you've seen us go back to a state of normalcy, which is we and really everybody have repriced their products reflecting a lower rate environment, all the experience factors we had, whereas the M&A marketplace has started to drift down from a return standpoint. We're back to where we should be, which is new business is above M&A. M&A is in the high single, low double-digit returns right now, whereas new business, as we mentioned, 12%-15%, and in the second quarter we were at the high end of that. It is a return that can be impacted by the absolute level of interest rates.
When you look at that return, if you just use the forward curve, for instance, I think it lowers it by a couple of points.
Okay. Just the last question on the life insurance business. The secondary guarantee UL block that you have. We've seen some of your competitors have had specific headline issues with their blocks of SGUL business. Can you talk about how yours has performed?
I think like everybody, it's a long duration product and so it's impacted by low interest rates. What we have done with that product is reflect the environment that exists today. You've seen the prices of guaranteed universal life go up tremendously to the point where that product, which was 65% of our sales, is now somewhere between 5% and 10% of our sales. We're really not selling much of it anymore because of the fact that the price we're charging is very high. I would say the other factors, premium flows, lapse rates, have run right in line with our expectations.
Okay.
Rates have been lower than we would expect, and that's part of the headwind that we face in this particular business. As we've said, we have two businesses that are impacted by low interest rates, and that's the life insurance business and the retirement business.
Moving to group protection. You laid out a 5%-7% margin target a couple of years ago. In the second quarter, you hit that target and you're at the high end. Do you feel like you're already at the point where you can sustain margins within that target earlier than you had originally planned?
We said 2018.
Yeah
I think that's still our expectation. We can safely say that we're through the repricing process.
Okay.
That's behind us. As we've talked about, we need to get the premium growth along with expenses not growing as fast to really get our expense ratio down a little bit for the final piece of that puzzle. If you look at last year, we had a little over a 3% margin. This year, if you look year to date, we're a little over 4%. I think we're right on track for-
Yeah
2018 being that year when we regularly hit the 5%-7%. That being said, the second quarter was just tremendous. Every now and then you're going to get a quarter where pretty much everything goes your way.
Yeah.
Severity was great, incidence was great. It doesn't typically happen like that.
Yeah. I guess, where are you in terms of growth? Growth is definitely starting to pick up. Do you feel like you're on track to get the premium growth that you need to see operating leverage on the expenses?
Yeah, we're not there yet, but I think we're on track. We've started to see sales growth again. Our sales went down as we went through the repricing process, but we've started to grow again. Premiums, what's really flattened out, has started to grow modestly. We have a little more work to do there.
In retirement, you've had good momentum on flows. Recently, you've been generating expense leverage. Even though interest rates have been a headwind, you've seen pretty good re-emergence of earnings growth this year. Can you talk about some of the underlying dynamics you're seeing in that business, and how to think about the earnings potential?
I think that business, like any business that faces a headwind. In the case of the retirement business, it is impacted by low interest rates. It has a component of its earnings that come from spreads. It faces this headwind. The leadership in that business needed to figure out a way to overcome that. We can't change the fact that we have it, but that doesn't mean we can't do everything we can to overcome it. I'd say that's really twofold. Two avenues that they really focused on in that business is growing the assets and managing expenses. On the expense side, if you look at that business, they really had flat expenses for a couple of years now while the top line's been growing. They're doing what they can on the expense side.
Separate from that, they have been really, really focused on growing the deposits and working on the persistency of what we have on the books, which has led to steady, consistent, positive flows in that business. We've had 6 quarters in a row of positive flows, and you've seen deposits grow tremendously. Really driven by both new products and by our ability to grow and manage distribution. In the small market side of the retirement business, we've been able to leverage LFD, our wholesale distribution group, to just tremendous results. We've seen great growth in what we sell through our strategic partners that LFD has. That's really what has allowed that business to get back to growing.
You've guided to a 2%-3% earnings headwind on a consolidated basis from low interest rates. I think new money rates were about 65 basis points below your portfolio yield in the second quarter. Should we think about that level as being more towards the lower end of the headwind?
I think we've been traveling in the lower end. Of course, it changes day to day.
Yeah.
If you want to measure it today, it might have moved up a little.
Yeah
as rates came down. Even though you can't just look at treasuries. I think when I was talking to Ellen Cooper, our CIO, the other day, treasury rates were down, but I guess credit spreads have widened out a little bit also, you've had some offset. It isn't as simple as just looking at treasuries. Yeah, it moves around every day, but we're in that 2%-3%, closer to the lower end, I would say. It's something that continues to decline over time. Ellen, I think at the last investors conference we had, showed a chart that I think the five years 2011-2015, our decline in our portfolio was about 20 basis points. Our expectations 2016-2020 was more like 10 basis points, and then when you get up past 2020, it was more like three basis points a year.
Yeah, those two numbers are coming together.
Then on cash flow, you've guided to 60%-65% capital deployment as a percent of GAAP earnings this year. That's been more of the range you've often been in.
You always guide to a starting point of 50%-55%. Are we to the point where maybe the 50%-55%, you can sustainably exceed that, or have there been other key factors that have been going on that have driven you to exceed it?
If you go back a few years, we were 45%-50%. As our mix of business changed, as the strength of our balance sheet continued to grow, we were able to up that 50%-55%. No matter what our target has been, our stated goal has been to underpromise and overdeliver. That's what we've done for the last six and a half years. I think 50%-55% is still the number
Okay
That we feel comfortable guiding to. We're going to do everything we can to underpromise and overdeliver. When we know that we're going to be higher than that, we'll let you know. For instance, we told you this year that we would be 60%-65%, and I think for the first half of the year, we're at 63%. We'll let you know when we think there's specific things going on, like the fact that annuity sales have come down, which has lowered the capital we're allocating to that business, and that's why we're up a little higher this year.
We'll pause and see if there's any audience questions. All right, I'll continue. I'm sure one of them is probably variable annuities, but what are some of the key NAIC initiatives that are kind of in the works that you're paying attention to that you think are more meaningful?
I think there are two big ones. You've got the Oliver Wyman work to create a new reserving framework for variable annuities. There's a lot of work going into that, and there's a core group of companies that are providing just reams of data to Oliver Wyman. We are allocating a lot of resources to supporting the NAIC, as we do whenever they go about these initiatives. Separate from that, Ellen and her team spent a lot of time working as the NAIC looks to potentially change the way they charge for credit risk. They're looking at changing the factors, and Ellen has been actively focused on that particular project.
On the capital charges, I hear different opinions on this from different companies. Curious on your updated opinion. I think one of the reasons companies have higher RBC ratios are because the rating agencies have higher requirements to begin with.
Do you think the RBC factors changing actually impacts your view of capital adequacy, or does it just bring the RBC a little bit closer to the rating agency models?
Yeah, it's the latter. As I've said all along, whatever the C1 factors are, I don't see it changing.
Yeah
The amount of capital we distribute. We've been operating with five times our.
Yeah
regulatory requirement. There's no magic to that, and I've said all along that RBC, I think, is a decent relative measure. But obviously, as just an absolute measure, when you have to hold five times the required amount, it's not a perfect reflection of risk. The factors changing, while it's a bit of a pain, and it causes us to have to communicate clearly about the impacts, I don't see it changing the way we distribute capital.
Okay. On the fixed annuity reinsurance agreement you announced with Athene, can you help us think about the benefits to Lincoln from doing that? It sounds like it's a combination of maybe can produce better growth and better returns, but how do you think about it?
Athene has something we don't. That has allowed them to be more competitive in the index annuity space. We have something that they don't, which is this distribution network. In a situation where two companies have something that the other doesn't, you oftentimes have the seeds for a relationship, and that's what you saw here. It allows them to access some of our distribution, and it allows us to access some of their benefit, which is really a favorable tax situation that they have that we can't replicate. I think that was the drivers of that particular relationship, and we are very excited about it. I think Athene's a good company. We obviously have a great distribution network, and I think both companies can benefit.
All right. If there's no questions, I think we'll wrap it up there. Thank you very much for attending.
Thank you