SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT UNDER SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For quarter ended September 30, 1995 Commission file number 1-6028 LINCOLN NATIONAL CORPORATION (Exact name of registrant as specified in its charter) Indiana 35-1140070 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 200 East Berry Street, Fort Wayne, Indiana 46802-2706 (Address of Principal Executive Offices) Registrant's telephone number (219) 455-2000 Common stock outstanding September 30, 1995 103,961,313 Indicate by check mark whether registrant (1) has filed all reports required to be filed by Section 13 or 15(d)of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes [ X ] No [ ] The exhibit index to this report is located on page 19. Page 1 of 20 -2- <TABLE> PART I - FINANCIAL INFORMATION Item 1 Financial Statements LINCOLN NATIONAL CORPORATION CONSOLIDATED BALANCE SHEETS September 30 December 31 (000'S omitted) 1995 1994 ASSETS <S> <C> <C> Investments: Securities available-for-sale, at fair value: Fixed maturity (cost 1995 - $24,005,053; 1994 - $21,438,155) ------------------ $25,233,712 $21,644,154 Equity (cost 1995 - $887,029; 1994 - $913,442) --------------------- 1,116,366 1,038,617 Mortgage loans on real estate ------------ 2,907,756 2,853,083 Real estate ------------------------------ 753,680 706,854 Policy loans ----------------------------- 598,352 550,672 Other investments ------------------------ 252,803 175,121 Total Investments ---------------------- 30,862,669 26,968,501 Investment in unconsolidated affiliates ---- 114,247 97,054 Cash and invested cash --------------------- 1,339,707 1,041,583 Property and equipment --------------------- 277,338 185,471 Deferred acquisition costs ----------------- 1,599,860 2,069,975 Premiums and fees receivable --------------- 665,956 551,679 Accrued investment income ------------------ 458,216 428,959 Assets held in separate accounts ----------- 21,474,760 14,301,684 Federal income taxes ----------------------- 11,287 396,888 Amounts recoverable from reinsurers -------- 2,394,518 2,152,327 Goodwill ----------------------------------- 467,919 145,844 Other intangible assets--------------------- 397,508 42,773 Other assets ------------------------------- 613,542 482,022 Total Assets ----------------------------- $60,677,527 $48,864,760 <FN> See notes to consolidated financial statements on page 7. </FN> </TABLE> -3- <TABLE> LINCOLN NATIONAL CORPORATION CONSOLIDATED BALANCE SHEETS -CONTINUED- September 30 December 31 (000's omitted) 1995 1994 LIABILITIES AND SHAREHOLDERS' EQUITY <S> <C> <C> Liabilities: Policy liabilities and accruals: Future policy benefits, claims and claim expenses -------------------- $12,281,658 $10,536,512 Unearned premiums ----------------------- 867,379 804,987 Total Policy Liabilities and Accruals - 13,149,037 11,341,499 Contractholder funds ---------------------- 18,201,503 17,250,423 Liabilities related to separate accounts -- 21,474,760 14,301,684 Short-term debt --------------------------- 323,443 275,310 Long-term debt ---------------------------- 621,997 419,607 Other liabilities ------------------------- 2,557,499 2,234,177 Total Liabilities ----------------------- 56,328,239 45,822,700 Shareholders' Equity: Series A preferred stock (9/30/95 liquidation value - $3,292) ----- 1,352 1,420 Series E preferred stock ------------------ -- 151,206 Series F preferred stock ------------------ -- 158,707 Common stock ------------------------------ 886,294 555,382 Earned surplus ---------------------------- 2,748,315 2,479,532 Foreign currency translation adjustment --- 16,583 6,890 Net unrealized gain (loss) on securities available-for-sale ----------------------- 696,744 (311,077) Total Shareholders' Equity -------------- 4,349,288 3,042,060 Total Liabilities and Shareholders' Equity -------------- $60,677,527 $48,864,760 <FN> See notes to consolidated financial statements on page 7. </FN> </TABLE> -4- <TABLE> LINCOLN NATIONAL CORPORATION CONSOLIDATED STATEMENTS OF INCOME Nine Months Ended Three Months Ended September 30 September 30 (000's omitted) 1995 1994 1995 1994 Revenue: <S> <C> <C> <C> <C> Insurance premiums -----------$2,325,231 $2,623,127 $ 800,342 $ 778,091 Insurance fees --------------- 387,062 329,799 135,153 112,933 Net investment income -------- 1,681,555 1,499,498 567,700 510,045 Investment advisory fees ----- 90,277 -- 47,697 -- Equity in earnings of unconsolidated affiliates -- 13,455 10,585 4,656 4,993 Realized gain (loss) on investments ---------------- 174,473 (102,375) 68,062 (74,140) Gain on sale of subsidiary/ unconsolidated affiliate --- -- 48,842 -- -- Other ------------------------ 126,326 110,593 44,848 34,680 Total Revenue ------------ 4,798,379 4,520,069 1,668,458 1,366,602 Benefits and Expenses: Benefits and settlement expenses ------------------- 2,892,186 3,058,335 987,906 941,095 Underwriting, acquisition, insurance and other expenses 1,314,851 1,144,278 457,653 354,447 Interest expense ------------- 53,441 34,878 19,493 12,148 Total Benefits and Expenses ----------- 4,260,478 4,237,491 1,465,052 1,307,690 Net Income Before Federal Income Taxes 537,901 282,578 203,406 58,912 Federal Income Taxes ----------- 130,851 26,409 49,081 530 Net Income $ 407,050 $ 256,169 $ 154,325 $ 58,382 Net Income Per Share ----------- $3.91 $2.47 $1.48 $ .56 Cash Dividends Per Share Common Stock ----------------- $1.29 $1.23 $ .43 $ .41 <FN> See notes to consolidated financial statements on page 7. </FN> </TABLE> -5- <TABLE> LINCOLN NATIONAL CORPORATION CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Nine Months Ended September 30 Number of Shares Issued Amounts (000's omitted from dollar amounts) 1995 1994 1995 1994 <S> <C> <C> <C> <C> Preferred Stock: (Shares authorized: 10,000,000) Series A Preferred Stock: Balance at beginning of year -------- 43,218 47,289 $ 1,420 $ 1,553 Conversion into common stock ------------- (2,072) (3,388) (68) (111) Balance at September 30 - 41,146 43,901 1,352 1,442 Series E and F Preferred Stock: Balance at beginning of year 4,417,897 4,417,897 309,913 309,913 Conversion into common stock ------------- (4,417,897) -- (309,913) -- Balance at September 30 - -- 4,417,897 -- 309,913 Common Stock: (Shares authorized: 800,000,000) Balance at beginning of year - 94,477,942 94,183,190 555,382 543,659 Conversion of series A preferred stock ------------ 16,576 27,104 68 111 Conversion of series E and F preferred stock ------------ 8,835,794 -- 309,913 -- Issued for benefit plans ----- 631,001 758,732 20,931 22,577 Balance at September 30 -103,961,313 94,969,026 886,294 566,347 Earned Surplus: Balance at beginning of year - 2,479,532 2,303,731 Net income ------------------- 407,050 256,169 Cash dividends declared ------ (138,267) (129,299) Balance at September 30 - 2,748,315 2,430,601 Foreign Currency Translation Adjustment: Accumulated adjustment at beginning of year ---------- 6,890 (1,214) Change during period --------- 9,693 8,602 Balance at September 30 - 16,583 7,388 Net Unrealized Gain (Loss) on Securities Available-for-Sale: Balance at beginning of year - (311,077) 914,679 Change during period --------- 1,007,821 (908,380) Balance at September 30 - 696,744 6,299 Total Shareholders' Equity at September 30 ------- $4,349,288 $3,321,990 Common Stock (assuming conversion of series A, E & F preferred stock): End of Period ----------- 104,290,481 104,156,028 Average for the Period -- 103,986,236 103,840,927 <FN> See notes to consolidated financial statements on page 7. </FN> </TABLE> -6- <TABLE> LINCOLN NATIONAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS Nine Months Ended September 30 (000's omitted) 1995 1994 Operating Activities: <S> <C> <C> Net income ---------------------------------------- $ 407,050 $ 256,169 Adjustments to reconcile net income to net cash provided by operating activities: Deferred acquisition costs -------------------- 6,409 (156,229) Premiums and fees receivable ------------------ (143,065) (132,693) Accrued investment income --------------------- (36,746) (40,455) Policy liabilities and accruals --------------- 904,160 57,042 Contractholder funds -------------------------- 751,652 1,360,747 Amounts recoverable from reinsurers ----------- (335,104) (752,037) Federal income taxes -------------------------- 133,580 (50,534) Equity in undistributed earnings of unconsolidated affiliates ------------------- (11,493) (9,183) Provisions for depreciation ------------------- 46,365 43,036 Realized (gain) loss on investments ----------- (225,340) 179,568 Gain on sale of subsidiary/unconsolidated affiliate ----------------------------------- -- (48,842) Other ----------------------------------------- 128,949 151,890 Net Adjustments ----------------------------- 1,219,367 602,310 Net Cash Provided by Operating Activities --- 1,626,417 858,479 Investing Activities: Securities-available-for-sale: Purchases -------------------------------------- (12,647,232)(10,612,797) Sales ------------------------------------------ 10,913,583 8,028,171 Maturities ------------------------------------- 688,757 973,118 Purchase of other investments -------------------- (1,072,918) (938,318) Sale or maturity of other investments ------------ 952,208 1,263,557 Sale (purchase) of subsidiaries/ unconsolidated affiliate ----------------------- (772,000) 417,367 Increase (decrease) in cash collateral on loan securities ----------------------------- 132,016 (176,789) Other -------------------------------------------- 26,193 (93,070) Net Cash Used in Investing Activities ------ (1,779,393) (1,138,761) Financing Activities: Principal payments on long-term debt ------------- (399) (9,535) Issuance of long-term debt ----------------------- 202,790 341 Net increase in short-term debt ------------------ 85,019 118,079 Universal life and investment contract deposits -- 1,854,514 1,982,388 Universal life and investment contract withdrawals --------------------------- (1,578,373) (1,348,563) Common stock issued for benefit plans ------------ 21,756 22,578 Dividends paid to shareholders ------------------- (134,207) (129,047) Net Cash Provided by Financing Activities -- 451,100 636,241 Net Increase in Cash ----------------------- 298,124 355,959 Cash at Beginning of Year -------------------------- 1,041,583 709,664 Cash at September 30 ----------------------- $1,339,707 $1,065,623 <FN> See notes to consolidated financial statements on page 7. </FN> </TABLE> -7- LINCOLN NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Basis of Presentation The accompanying consolidated financial statements include Lincoln National Corporation ("LNC") and its majority-owned subsidiaries. Less than majority- owned entities in which LNC has at least a 20% interest are reported on the equity basis. These unaudited consolidated statements have been prepared in conformity with generally accepted accounting principles,except that they do not contain complete notes. However, in the opinion of management, these statements include all normal recurring adjustments necessary for a fair presentation of the results. These financial statements should be read in conjunction with the financial statements and the related notes included in LNC's latest annual report on Form 10-K for the year ended December 31, 1994. Operating results for the nine months ended September 30, 1995 are not necessarily indicative of the results that may be expected for the full year ending December 31, 1995. 2. Federal Income Taxes The effective tax rate on net income is lower than the prevailing corporate federal income tax rate. The difference for 1995 resulted principally from tax-exempt investment income, less the effect of the non-deductible amortization of goodwill. The difference for the nine months ended September 30, 1994 was also affected by tax-exempt investment income and by the fact that no income taxes were payable on the gain on sale of a subsidiary. 3. Earnings Per Share Earnings per share are computed based on the average number of common shares outstanding (103,986,236 and 103,840,927 for the first nine months of 1995 and 1994, respectively) after assuming conversion of the series A, E and F preferred stock. 4. Purchase of Subsidiaries On April 3, 1995, LNC completed the acquisition of Delaware Management Holdings, Inc. ("Delaware") as described in note 12 to LNC's financial statements for the year ended December 31, 1994. Delaware provides a variety of asset management services through its operating companies. This acquisition resulted in goodwill of $339.9 million and other intangible assets of $131.5 million. Goodwill and the other intangible assets are being amortized on a straight-line basis over 25 years and 5 to 14 years, respectively. The results of Delaware's operations are included in LNC's consolidated financial statements from April 3, 1995. On April 25, 1995, LNC completed the acquisition of Laurentian Financial Group plc ("Laurentian"). Laurentian is a United Kingdom company that provides unit-linked life and pension products. This acquisition involved a purchase price of $237 million including assumption of $44 million of debt. This acquisition resulted in other intangible assets of $218.4 million which are being written-off in proportion to the present value of gross profits that are expected to emerge from the business acquired. It is expected that most of this asset will be written-off over a three to five year period. The results of Laurentian's operations are included in LNC's consolidated financial statements from April 25, 1995. 5. Subsequent Event As a result of a public tender after offer by Humana on October 11, 1995, LNC completed the sale of its 29% ownership in EMPHESYS Financial Group Inc. This transaction resulted in cash of $187.0 million and produced a fourth quarter gain on sale of subsidiaries/unconsolidated affiliate of $58.4 million after tax. -8- LINCOLN NATIONAL CORPORATION Item 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION During the nine months ended September 30, 1994, LNC completed the sale of 71% of its subsidiary involved in the writing of life-health benefit coverages on a direct basis. As noted in the following "Review of Consolidated Operations," this sale has affected the comparability of select line items within the Consolidated Statements of Income. REVIEW OF CONSOLIDATED OPERATIONS The discussion that follows focuses on the results for the nine months ended September 30, 1995 compared to the results for the nine months ended September 30, 1994. The factors affecting the current quarter to prior year quarter comparisons are essentially the same as the year-to-date factors, except as noted. Insurance Premiums Life and annuity premiums for the first nine months of 1995 were $528.8 million which is $64.7 or 10.9% less than the first nine months of 1994. This decrease is the net result of increases in business volume from the Life-Health Reinsurance segment being more than offset by decreases from the United Kingdom component of the Life Insurance and Annuities segment. This decrease in the United Kingdom component was the net result of 1)decreases due to modifying the classification of premiums associated with unit-linked transactions within Lincoln National (UK) on a prospective basis to more closely conform to the classification used for universal life transactions within the U.S. operations and 2)increases from the premiums generated by the sales personnel associated with the newly acquired U.K. company (see note 4 on page 7). As noted below, there is a corresponding decrease in life and annuity benefits. Prior period data was not reclassified due to the amounts involved not being material to consolidated revenue. Excluding the impact of the subsidiary sold in 1994, health premiums increased $81.4 million or 18% for the first nine months of 1995 compared with the first nine months of 1994 as a result of increased volumes of business in the Life-Health Reinsurance segment. Property-casualty premiums decreased by $21.9 million or 2% compared with the nine months ended September 30, 1994 primarily as the result of reevaluating underwriting actions, focusing on account selection, risk evaluation and the establishment of appropriate premiums. Property-casualty premiums for the third quarter of 1995 increased $10.0 million or 2% versus the comparable quarter in the 1994 and are also expected to increase slightly in the fourth quarter. Insurance Fees Insurance fees from universal life and other interest sensitive insurance contracts increased $57.2 million or 17% compared to the first nine months of 1994 as the result of increases in the volume of transactions and a market-driven increase in the value of existing customer accounts upon which some of the fees are based in the Life Insurance and Annuities segment. Investment Advisory Fees This line was added to the statement of income in the second quarter of 1995 following LNC's purchase of Delaware Management Holdings, Inc. (see note 4 on page 7). Net Investment Income Net investment income increased $182.1 million or 12% when compared with the first nine months of 1994. This increase is the result of a 17% increase in mean invested assets and an overall yield on investments that was 7.14% for both 1995 and 1994. Net investment income for the nine months ended September 30, 1995 include a benefit of $11.4 million from the recurring adjustment of discount on mortgage-backed securities that was triggered by significant declines in interest rates during the period. The mortgage-backed adjustment for the nine -9- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED OPERATIONS (continued) months ended September 30, 1994 was a charge of $9.0 million. The increase in mean invested assets is the net result of increased volumes of business in the Life Insurance and Annuity and Life-Health Reinsurance segment being partially offset by decreases due to the sale of a subsidiary in 1994. Equity in Earnings of Unconsolidated Affiliates This line was added to the statement of income in 1994 following LNC's sale of 71% of its direct writer of health coverages. The amounts shown represent LNC's share of the total earnings of this company after the closing of the sale on March 21, 1994. Due to the October 11, 1995 sale of the remaining 29% ownership in this company, no significant further activity is expected in this account in 1995 (see note 5 on page 7). Gain on Sale of Subsidiary/Unconsolidated Affiliates In the first nine months of 1994, LNC recorded the gain on sale of 71% of its direct writer of health coverages. The fourth quarter of 1995 will include the gain on sale of the remaining 29% ownership in this company (see note 5 on page 7). The proceeds from this sale will be invested in securities available-for-sale. Realized Gain (Loss) on Investments The first nine months of 1995 and 1994 had pre-tax realized gain (loss) on investments of $174.4 million and $(102.4) million, respectively. The gains for 1995 were the result of net gains on sale of investments, less some modest writedowns and provisions for losses. The losses for 1994 were the result of net losses on sale of investments and some modest writedowns and provisions for losses. Fixed maturity and equity securities that were deemed to have declines in fair value that were other than temporary were written down. Provision for losses on mortgage loans on real estate, real estate investments and other investments were established to the extent the carrying value was determined not to be recoverable. The pre-tax writedown of fixed maturity and equity securities for the first nine months of 1995 and 1994 were $17.3 million and $18.3 million, respectively. With the exception of interest only mortgage-backed securities, the fixed maturity securities to which these writedowns apply were generally of investment grade quality at the time of purchase, but were classified as "below investment grade" at the time of the writedowns. The net pre-tax additions to provision for losses on real estate and mortgage loans on real estate for the first nine months of 1995 and 1994 were $5.2 million and $38.4 million, respectively. The pre-tax addition (reduction) to the provision for losses for other investments for the first nine months of 1995 and 1994 were $(4.1) million and $2.6 million, respectively. Other Revenue Other revenue increased $15.7 million or 14% when compared to the first nine months of 1994 as the result of an increase in the volume of transactions within each of the business segments. Insurance Benefits and Settlement Expenses Life and annuity benefits and settlement expenses decreased $15.7 million or 1% when compared to the first nine months of 1994. This decrease is the net result of increases from the Life-Health Reinsurance segment and the U.S. portion of the Life Insurance and Annuity segment being more than offset by a decrease from the United Kingdom component of the Life Insurance and Annuities segment. This decrease in the United Kingdom component relates to the decrease in life and annuity premiums noted above. Excluding the impact of the subsidiary sold in 1994, health benefits increased by $80.3 million or 23% when compared to the first nine months of 1994 as a result of increased volumes of business in the Life-Health Reinsurance segment and increased -10- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED OPERATIONS (continued) claims in the Life Insurance and Annuity and Life-Health Reinsurance segments. Property-casualty benefits decreased by $18.6 million or 2% when compared with the first nine months of 1994 as a result of reductions in the volume of insurance written. Although the quarterly pattern for Catastrophe losses and weather related claims has differed for the 1995 and 1994 quarters, the total for the nine months for both years is essentially the same. The weather related claims were significantly larger in the second quarter of 1995 than a normal quarter due to wind, hail and tornado losses in Texas, Oklahoma, Kansas, Missouri and Arkansas. Catastrophe losses and weather related claims will be higher in the fourth quarter of 1995 versus the fourth quarter of 1994 due to losses of approximately $20.0 million from Hurricane Opal in October of 1995. Underwriting, Acquisition, Insurance and Other Expenses Excluding the impact of the subsidiary sold in 1994, this expense increased $243.9 million or 23% for the nine months ended September 30, 1995 compared to the first nine months of 1994. The primary driver behind this increase beyond the general inflation rate was the higher volume related expenses in the Life Insurance and Annuity and Life-Health Reinsurance segments due to the increase in business volumes and the addition of the companies acquired (see note 4 or page 7). These expenses for the Property- Casualty segment only increased 3% compared with a year ago as staff levels were adjusted to the current level of business. Interest Expense Interest expense increased $18.5 million when compared with the first nine months of 1994. This was the result of increases in the average debt outstanding and increases in short-term interest rates less the impact of changes in the composition of debt outstanding. Interest expense was higher in the second and third quarter of 1995 ($19.9 million and $19.5 million, respectively) than in the first quarter of 1995 ($14.0 million) due to an increase in debt related to the acquisitions of additional companies (see note 4 on page 7). While a portion of the interest expense is dependent upon future short-term borrowing rates, in the near term the total interest expense per quarter is expected to somewhat parallel the interest expense for the second and third quarter of 1995. Federal Income Taxes Federal income taxes increased $104.5 million when compared to the first nine months of 1994. This is the net result of an increase in pre-tax earnings and the lack of any tax expense on the 1994 gain on sale of subsidiary. Summary Net income for the first nine months of 1995 was $407.1 million or $3.91 per share compared with $256.2 million or $2.47 per share in the first nine months of 1994. Excluding realized gain (loss) on investments and gain on sale of subsidiary, LNC earned $297.1 million for the first nine months of 1995 compared with $278.6 million for the first nine months of 1994. This increase was net the result of the impact of the loss of earnings from a subsidiary sold in 1994, net of investment income earned on the proceeds from the sale, being more than offset by increases in earnings from the Life Insurance and Annuities and Investment Management business segments. -11- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED FINANCIAL CONDITION Investments The total investment portfolio increased $3.9 billion in the first nine months of 1995. This increase is the result of increases in the fair value of securities available-for-sale during the first nine months of 1995 and new purchases of investments from cash flow generated by the business segments. The quality of LNC's fixed maturity securities portfolio as of September 30, 1995 was as follows: Treasuries and AAA 36.6% BBB 22.2% AA 10.6% BB 3.0% A 24.8% Less than BB 2.8% As of September 30, 1995, $1.5 billion or 5.8% of fixed maturity securities was invested in below investment grade securities (less than BBB). This represents 4.7% of the total investment portfolio. The interest rates available on these below investment grade securities are significantly higher than are available on other corporate debt securities. Also, the risk of loss due to default by the borrower is significantly greater with respect to such below investment grade securities, because these securities are generally unsecured, often subordinated to other creditors of the issuer and issued by companies that usually have high levels of indebtedness. LNC attempts to minimize the risks associated with these below investment grade securities by limiting the exposure to any one issuer and by closely monitoring the credit worthiness of such issuers. During the nine months ended September 30, 1995, the aggregate cost of such investments purchased was $717.6 million. Aggregate proceeds from such investments sold were $576.5 million, resulting in a net realized pre-tax loss of $12.5 million. LNC's entire fixed maturity securities portfolio is classified as "available-for-sale" and is carried at fair value. Equity securities available-for-sale are also carried at fair value. Changes in fair value, net of related deferred acquisition costs, and amounts required to satisfy policyholder commitments and taxes, are charged or credited directly to shareholders' equity. As of September 30, 1995, mortgage loans on real estate and real estate represented 9.4% and 2.4% of LNC's total investment portfolio. As of September 30, 1995, the underlying properties supporting the mortgage loans on real estate consisted of 22.7% in commercial office buildings, 28.1% in retail stores, 20.0% in apartments, 15.2% in industrial buildings, 3.3% in hotels/motels and 10.7% in other. In addition to the dispersion by property type, the mortgage loan portfolio is geographically diversified throughout the United States. Mortgage loans on real estate are actively monitored to identify impaired loans. Mortgage loans on real estate are considered impaired when, based on current information and events, it is probable that LNC will be unable to collect all amounts due according to the contractual terms of the loan agreement. When LNC determines that a loan is impaired a provision for loss is established for the difference between the carrying value of the mortgage loan and the estimated value. Estimated value is based on either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's observable market price or the fair value of the collateral. The provision for losses is reported as realized gain (loss) on investments. Mortgage loans deemed to be uncollectible are charged against the provision for losses and subsequent recoveries, if any, are credited to the provision for losses. -12- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED FINANCIAL CONDITION (continued) The provision for losses is maintained at a level believed adequate by management to absorb estimated probable credit losses. Management's periodic evaluation of the adequacy of the provision for losses is based on LNC's past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay (including the timing of future payments), the estimated value of the underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors. This evaluation is inherently subjective as it requires estimating the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. Impaired loans included along with the related provision for losses are as follows: September 30 December 31 (in millions) 1995 1994 Impaired loans with provision for losses --------- $158.7 $275.8 Provision for losses ----------------------------- (43.3) (62.7) Impaired loans with no provision for losses ------ -- 2.3 Net Impaired Loans ----------------------------- $115.4 $215.4 Impaired loans with no provision for losses are a result of 1)direct write-downs or 2)collateral dependent loans where the fair value of the collateral is greater than the recorded investment in loans. A reconciliation of the mortgage loan provision for losses for these impaired mortgage loans is as follows: Nine Months Ended September 30 (in millions) 1995 1994 Balance at beginning of year --------------------- $62.7 $226.6 Provisions for losses ---------------------------- 12.9 22.7 Releases due to sales ---------------------------- (24.0) (102.6) Releases due to foreclosures --------------------- (8.3) (13.7) Balance at End of Quarter ---------------------- $43.3 $133.0 The average recorded investment in impaired loans and the interest income recognized on impaired loans were as follows: Nine Months Ended September 30 (in millions) 1995 1994 Average recorded investment in impaired loans ---- $201.9 $571.5 Interest income recognized on impaired loans ----- 12.8 32.3 All interest income on impaired loans was recognized on the cash basis of income recognition. As of September 30, 1995 and 1994, LNC had restructured loans of $61.9 million and $39.1 million, respectively. LNC recorded $4.4 million (including $1.0 million in interest income that was due LNC prior to January 1, 1995) and $2.4 million interest income on these restructured loans for the nine months ended September 30, 1995 and 1994, respectively, as compared to interest income of $4.9 million and $3.2 million that would have been recorded according to their original terms. -13- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED FINANCIAL CONDITION (continued) Mortgage loans on real estate with a combined carrying value at September 30, 1995 of $32.8 million were non-income producing for the nine months ended September 30, 1995. In the first nine months of 1995, LNC continued to add to its provision for losses for mortgage loans on real estate. The amount of such provisions for losses were lower in this first nine months of 1995 as compared to the previous year because of bulk sale transactions in 1994 of performing and non-performing properties. These bulk sales also caused a decrease in the ratio of reserves to impaired loans at December 31, 1994 and thereafter, as compared to quarters ended prior to December 31, 1994. As of September 30, 1995, LNC did not have any future commitments to lend funds for non-accrual, restructured or other problem loans. Cash and Invested Cash Cash and invested cash increased by $298.1 million in the first nine months of 1995. This increase is the result of a portion of the operating cash flow being invested temporarily in short-term investments pending the placement of funds in longer term investments. Deferred Acquisition Costs The decrease in deferred acquisition costs of $470.1 million is the net result of the growth in business being more than offset by a reduction in deferred acquisition costs related to realized gain on investments and the change in unrealized gain on securities available-for-sale. Premiums and Fee Receivable Premiums and fees receivable increased $114.3 million in the first nine months of 1995 as the result of increased volumes of business in the Life-Health Reinsurance segments. Assets Held in Separate Accounts This asset account as well as the corresponding liability account increased by $7.2 billion in the first nine months of 1995, reflecting an increase in annuity and pension funds under management. Federal Income Taxes Federal income taxes recoverable decreased $385.6 million in the first nine months of 1995. This decrease is the net result of 1)an increase in deferred tax related to the increase in unrealized gains on available-for-sale securities and 2)a tax refund of approximately $150 million in the first quarter of 1995, which resulted from the realization of capital losses in 1994 to recover capital gains taxes paid in prior years, being partially offset by increases related to recoverable deferred taxes from life insurance reserve differences, discounting of unpaid losses and additions to the investment reserves. Amounts Recoverable from Reinsurers The increase in amounts recoverable from reinsurers of $242.2 million was the result of increased volumes of business ceded in the Life Insurance and Annuities segment. -14- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED FINANCIAL CONDITION (continued) Goodwill Goodwill increased in the second quarter of 1995 due to the acquisition of an investment management company (see note 4 on page 7). Other Intangible Assets This line was added to the balance sheet in the second quarter of 1995 to accommodate the amounts related to LNC's purchase of additional subsidiaries (see note 4 on page 7). The prior period amount was previously included in other assets. Other Assets The increase in other assets of $131.5 million is the result of having a higher receivable related to investment securities sold in the last few days of the third quarter of 1995 versus the end of 1994. Total Liabilities Total liabilities increased by $10.5 billion in the first nine months of 1995. This increase reflects 1) an increased level of business as evidenced by an increase in policy liabilities and accruals of $1.8 billion, an increase of $1.0 billion in contractholder funds, an increase of $7.2 billion in the liabilities related to separate accounts, 2) an increase in debt of $250.5 million and 3) an increase in other liabilities of $323.3 million. Policyholder liabilities as of September 30, 1995 and December 31, 1994 included liabilities for environmental losses of $201.5. million and $201.0 million respectively. Because of the limited coverages that have been written by LNC, these reserves represent only 8% of LNC's total property-casualty reserves for both periods. On a claims count basis these environmental losses represent only 3% and 4%, respectively, of the direct business written. These percentages and amounts are at these levels due to LNC's concentration on writing coverages for small to medium size companies rather than the larger companies that tend to incur most of the environmental and product liability claims. LNC's management challenges environmental claims in cases of questionable liability and reviews the level of environmental liability on an on-going basis to help insure that the liability maintained is adequate. Nonetheless, establishing reserves for environmental losses is subject to significant uncertainties because of the long reporting delays, lack of historical data and the unresolved complex legal and regulatory issues that are involved. However, based on available information, it is management's judgement that the appropriate level of reserves have been recorded and that any unrecorded liability would not be material to LNC's future results of operations, liquidity or financial condition. As indicated in note 7 to the consolidated financial statements for the year ended December 31, 1994 (see page 46 of LNC's 10-K), LNC's December 31, 1994 balance sheet included a liability for future policy benefits, claims and claim expenses and an asset for amounts recoverable from reinsurers for its disability income business that netted to a liability of $815.8 million as of December 31, 1994. Principally due to the assumption of a large block of disability claim reserves and related assets through a reinsurance contract during the first nine months of 1995, the comparable net liability as of September 30, 1995 is $1.4 billion. -15- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED FINANCIAL CONDITION (continued) If recent disability income incidence levels do not improve or if claim termination rates deteriorate on existing contracts, substantial reserve additions and/or accelerated amortization or write-off of existing deferred acquisition costs may be required. Another in-depth review of the experience of the existing direct and reinsurance books of disability income business is expected to be completed in the fourth quarter of 1995 and deferred acquisition costs and reserve levels will be adjusted, if appropriate. Tax authorities continue to focus on compliance of qualified annuity plans marketed by insurance companies. If sponsoring employers cannot demonstrate compliance and the insurance company is held responsible due to its marketing efforts, LNC and other insurers may be subject to potential liability. It is not possible to provide a meaningful estimate of the range of possible liability at this time. Management continues to monitor this matter and to take steps to minimize any potential liability. The increase in other liabilities relates to an increase in the expected payouts for securities purchased in the last few days of the third quarter of 1995 versus a lower volume of such transactions at the end of 1994. Shareholders' Equity Total shareholders' equity increased $1.3 billion in the first nine months of 1995. Excluding the increase of $1.0 billion related to unrealized gains on securities available-for-sale, shareholders' equity increased $299.4 million. This increase was the net result of $407.1 million from net income, $20.9 million from the issuance of common stock related to benefit plans, $9.7 million related to an increase in the accumulated foreign exchange gain, and a decrease of $138.3 million related to the declaration of dividends to shareholders. Liquidity and Cash Flow In the businesses in which LNC operates, liquidity generally refers to the ability of an enterprise to generate adequate amounts of cash from its normal operations, including activities in its investment portfolio, to meet its financial commitments. LNC manages its operations, including prudent investment portfolio structuring, to provide for appropriate liquidity levels. The portfolio structuring involves segregating LNC's investments by segments, sub-segments or type of product. The investments selected for each segregated portfolio are based on LNC's desire to match characteristics (e.g., duration and yield) of the underlying liabilities. As indicated by the Consolidated Statements of Cash Flows on page 6, LNC's business operations generated $1.6 billion of cash during the first nine months of 1995. This amount includes a federal tax refund of approximately $150 million in the first quarter of 1995 which resulted from the realization of capital losses in 1994 to recover capital gains taxes paid in prior years. Although LNC generates adequate cash flow to meet the needs of its normal operations, periodically LNC may issue debt or equity securities to fund internal expansion, acquisitions, investment opportunities and the retirement of LNC's debt and equity. Such a transaction occurred in May 1995 when LNC issued $200 million of 7 1/4% debt securities payable in 2005 from its previously filed shelf registration. This issuance left LNC with remaining authority from the existing shelf registration to issue $100 million in debt securities, preferred stock, common stock or any combination thereof. On June 1, 1995 LNC filed a shelf registration statement with the Securities and Exchange Commission ("SEC") for potential public offerings of an additional $500 million of debt securities, preferred stock, common stock or combination thereof. This registration went effective on June 30, 1995. -16- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED FINANCIAL CONDITION (continued) As indicated in note 7 to the consolidated financial statements for the year ended December 31, 1994 (see page 53 of LNC's Form 10-K), LNC has entered into derivative transactions to reduce its exposure to fluctuations in interest rates and foreign exchange risks. During the first nine months of 1995, LNC has made changes to its derivative exposures as follows: 1. Added $700 million notional amount of interest rate caps, increasing the notional amount of interest rate cap agreements to $5.1 billion from $4.4 billion. 2. Terminated $700 million of maturing spread-lock agreements and added $500 million of new agreements. These transactions resulted in a net reduction in the outstanding contract amounts from $1.3 billion to $1.1 billion. 3. In the first quarter, removed the $354.3 million face amount of short financial futures that were being used at December 31, 1994 to hedge interest rate risks and to manage duration of a portion of the fixed maturity securities. During the third quarter, added $66.9 million face amount of long futures to hedge these same risks. 4. Used $200 million face amount of financial futures within the second quarter to hedge against adverse interest rate movements in connection with the 7 1/4%, $200 million debt offering referenced above. 5. Terminated the $28.2 million face amount of financial futures for hedging pension commitments. 6. Increased the use of foreign exchange forward contracts to hedge the currency risk of foreign bonds to $41.3 million from $21.5 million. 7. Increased the use of foreign exchange futures contracts to hedge the currency risk of additional funds invested in a UK subsidiary to $358.3 million from $138.2 million. 8. Established $142.1 million notional of foreign currency options as an additional hedge of the currency risk of foreign bonds. 9. Added $15 million notional of a foreign currency swap to convert the foreign currency cash flows associated with a foreign bond into U.S. dollars. During the second quarter, a major rating agency downgraded the debt rating of a cap agreement counterparty to Baa1 from A3; that counterparty continues to hold an A rating from another major rating agency. As of September 30, 1995, LNC's cap agreements with that counterparty have an aggregate notional amount of $500 million and an aggregate replacement value of approximately $200,000. The remaining $4.6 billion notional amount of caps are with counterparties rated A3/A- or better by two major rating agencies. -17- PART II - OTHER INFORMATION AND EXHIBITS Items 1, 2, 3, 4 and 5 of this Part II are either inapplicable or are answered in the negative and are omitted pursuant to the instructions to Part II. Item 6. Exhibits and Reports on Form 8-K (a) The following Exhibits of the Registrant are included in this report. (Note: The number preceding the exhibit corresponds to the specific number within Item 601 of Regulation S-K.) 11 Computation of Per Share Earnings 27 Financial Data Schedule (b) No reports on Form 8-K were filed during the quarter ended September 30, 1995. 18 SIGNATURE PAGE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. LINCOLN NATIONAL CORPORATION By /S/ Richard C. Vaughan Richard C. Vaughan, Executive Vice President and Chief Financial Officer /S/ Donald L. Van Wyngarden Donald L. Van Wyngarden, Second Vice President and Controller Date October 26, 1995 -19- LINCOLN NATIONAL CORPORATION Exhibit Index for the Report on Form 10-Q for the Quarter Ended September 30, 1995 Exhibit Number Description Page Number 11 Computation of Per Share Earnings 20 27 Financial Data Schedule 21