UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
_________________
FORM 10-Q
_________________
(Mark One)
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended September 30, 2020
OR
Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the transition period from ____________ to____________
Commission File Number: 000-55871
_________________
THE LINCOLN NATIONAL LIFE INSURANCE COMPANY
(Exact name of registrant as specified in its charter)
_________________
Indiana | 35-0472300 |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) |
1300 South Clinton Street, Fort Wayne, Indiana | 46802 |
(Address of principal executive offices) | (Zip Code) |
(260) 455-2000
(Registrant’s telephone number, including area code)
_________________
Securities registered pursuant to Section 12(b) of the Act: None
Indicate by check mark whether the 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 No
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large Accelerated Filer | | Accelerated Filer | | ||
Non-accelerated Filer | | Smaller Reporting Company | | ||
Emerging Growth Company | |
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section13(a) of the Exchange Act. ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No
As of November 5, 2020, 10,000,000 shares of common stock of the registrant ($2.50 par value) were outstanding, all of which were directly owned by Lincoln National Corporation.
THE REGISTRANT MEETS THE CONDITIONS SET FORTH IN GENERAL INSTRUCTIONS H(1)(a) AND (b) OF
FORM 10-Q AND IS THEREFORE FILING THIS FORM 10-Q WITH THE REDUCED DISCLOSURE FORMAT.
The Lincoln National Life Insurance Company
Table of Contents
Item | Page | ||||
PART I | |||||
1. | 1 | ||||
2. | Management’s Narrative Analysis of the Results of Operations | 54 | |||
54 | |||||
55 | |||||
56 | |||||
58 | |||||
59 | |||||
60 | |||||
62 | |||||
64 | |||||
66 | |||||
68 | |||||
69 | |||||
70 | |||||
70 | |||||
3. | 72 | ||||
4. | 72 | ||||
PART II | |||||
1. | 73 | ||||
1A. | 73 | ||||
2. | 73 | ||||
6. | 73 | ||||
| 74 | ||||
75 | |||||
PART I – FINANCIAL INFORMATION
Item 1. Financial Statements
THE LINCOLN NATIONAL LIFE INSURANCE COMPANY
CONSOLIDATED BALANCE SHEETS
(in millions, except share data)
As of | As of | |||||||
September 30, | December 31, | |||||||
2020 | 2019 | |||||||
(Unaudited) | ||||||||
ASSETS | ||||||||
Investments: | ||||||||
Fixed maturity available-for-sale securities, at fair value | ||||||||
(amortized cost: 2020 – $100,682; 2019 – $93,307; allowance for credit losses: 2020 – $12; 2019 – $0) | $ | 116,372 | $ | 103,773 | ||||
Trading securities | 4,574 | 4,602 | ||||||
Equity securities | 120 | 103 | ||||||
Mortgage loans on real estate, net of allowance for credit losses | ||||||||
(portion at fair value: 2020 – $794; 2019 – $0) | 16,458 | 16,244 | ||||||
Policy loans | 2,511 | 2,460 | ||||||
Derivative investments | 3,235 | 1,911 | ||||||
Other investments | 2,986 | 2,565 | ||||||
Total investments | 146,256 | 131,658 | ||||||
Cash and invested cash | 1,711 | 1,879 | ||||||
Deferred acquisition costs and value of business acquired | 6,073 | 7,745 | ||||||
Premiums and fees receivable | 497 | 464 | ||||||
Accrued investment income | 1,273 | 1,109 | ||||||
Reinsurance recoverables, net of allowance for credit losses | 19,015 | 19,164 | ||||||
Funds withheld reinsurance assets | 539 | 542 | ||||||
Goodwill | 1,778 | 1,778 | ||||||
Other assets | 20,196 | 18,106 | ||||||
Separate account assets | 152,975 | 153,571 | ||||||
Total assets | $ | 350,313 | $ | 336,016 | ||||
LIABILITIES AND STOCKHOLDER’S EQUITY | ||||||||
Liabilities | ||||||||
Future contract benefits | $ | 39,415 | $ | 35,717 | ||||
Other contract holder funds | 101,972 | 97,422 | ||||||
Short-term debt | 466 | 609 | ||||||
Long-term debt | 2,409 | 2,414 | ||||||
Reinsurance related embedded derivatives | 476 | 375 | ||||||
Funds withheld reinsurance liabilities | 8,184 | 5,566 | ||||||
Payables for collateral on investments | 6,433 | 5,077 | ||||||
Other liabilities | 14,218 | 13,680 | ||||||
Separate account liabilities | 152,975 | 153,571 | ||||||
Total liabilities | 326,548 | 314,431 | ||||||
Contingencies and Commitments (See Note 10) |
|
| ||||||
Stockholder’s Equity | ||||||||
Common stock – 10,000,000 shares authorized, issued and outstanding | 11,809 | 11,312 | ||||||
Retained earnings | 3,781 | 4,437 | ||||||
Accumulated other comprehensive income (loss) | 8,175 | 5,836 | ||||||
Total stockholder’s equity | 23,765 | 21,585 | ||||||
Total liabilities and stockholder’s equity | $ | 350,313 | $ | 336,016 |
THE LINCOLN NATIONAL LIFE INSURANCE COMPANY
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Unaudited, in millions)
For the Three | For the Nine | |||||||||||
Months Ended | Months Ended | |||||||||||
September 30, | September 30, | |||||||||||
2020 | 2019 | 2020 | 2019 | |||||||||
Revenues | ||||||||||||
Insurance premiums | $ | 1,241 | $ | 1,276 | $ | 3,844 | $ | 3,989 | ||||
Fee income | 1,799 | 1,868 | 4,676 | 4,735 | ||||||||
Net investment income | 1,404 | 1,167 | 3,834 | 3,645 | ||||||||
Realized gain (loss): | ||||||||||||
Total other-than-temporary impairment losses on securities | - | (2 | ) | - | (26 | ) | ||||||
Portion of loss recognized in other comprehensive income | - | - | - | 13 | ||||||||
Net other-than-temporary impairment losses on securities | ||||||||||||
recognized in earnings | - | (2 | ) | - | (13 | ) | ||||||
Realized gain (loss), excluding other-than-temporary | ||||||||||||
impairment losses on securities | (13 | ) | (214 | ) | (448 | ) | (831 | ) | ||||
Total realized gain (loss) | (13 | ) | (216 | ) | (448 | ) | (844 | ) | ||||
Amortization of deferred gain on business sold through reinsurance | 9 | 7 | 27 | 20 | ||||||||
Other revenues | 131 | 125 | 410 | 373 | ||||||||
Total revenues | 4,571 | 4,227 | 12,343 | 11,918 | ||||||||
Expenses | ||||||||||||
Interest credited | 737 | 699 | 2,184 | 2,043 | ||||||||
Benefits | 2,350 | 2,282 | 6,042 | 5,826 | ||||||||
Commissions and other expenses | 1,899 | 1,493 | 4,065 | 3,833 | ||||||||
Interest and debt expense | 29 | 36 | 96 | 110 | ||||||||
Strategic digitization expense | 14 | 16 | 39 | 47 | ||||||||
Total expenses | 5,029 | 4,526 | 12,426 | 11,859 | ||||||||
Income (loss) before taxes | (458 | ) | (299 | ) | (83 | ) | 59 | |||||
Federal income tax expense (benefit) | (131 | ) | (98 | ) | (114 | ) | (96 | ) | ||||
Net income (loss) | (327 | ) | (201 | ) | 31 | 155 | ||||||
Other comprehensive income (loss), net of tax | 360 | 1,972 | 2,339 | 5,838 | ||||||||
Comprehensive income (loss) | $ | 33 | $ | 1,771 | $ | 2,370 | $ | 5,993 | ||||
THE LINCOLN NATIONAL LIFE INSURANCE COMPANY
CONSOLIDATED STATEMENTS OF STOCKHOLDER’S EQUITY
(Unaudited, in millions)
For the Three | For the Nine | |||||||||||
Months Ended | Months Ended | |||||||||||
September 30, | September 30, | |||||||||||
2020 | 2019 | 2020 | 2019 | |||||||||
Common Stock | ||||||||||||
Balance as of beginning-of-period | $ | 11,799 | $ | 11,241 | $ | 11,312 | $ | 11,237 | ||||
Capital contribution from Lincoln National Corporation | - | - | 475 | - | ||||||||
Stock compensation/issued for benefit plans | 10 | 10 | 22 | 14 | ||||||||
Balance as of end-of-period | 11,809 | 11,251 | 11,809 | 11,251 | ||||||||
Retained Earnings | ||||||||||||
Balance as of beginning-of-period | 4,188 | 4,378 | 4,437 | 4,423 | ||||||||
Cumulative effect from adoption of new accounting standards | - | - | (201 | ) | - | |||||||
Net income (loss) | (327 | ) | (201 | ) | 31 | 155 | ||||||
Dividends paid to Lincoln National Corporation | (80 | ) | (149 | ) | (486 | ) | (550 | ) | ||||
Balance as of end-of-period | 3,781 | 4,028 | 3,781 | 4,028 | ||||||||
Accumulated Other Comprehensive Income (Loss) | ||||||||||||
Balance as of beginning-of-period | 7,815 | 4,525 | 5,836 | 659 | ||||||||
Other comprehensive income (loss), net of tax | 360 | 1,972 | 2,339 | 5,838 | ||||||||
Balance as of end-of-period | 8,175 | 6,497 | 8,175 | 6,497 | ||||||||
Total stockholder’s equity as of end-of-period | $ | 23,765 | $ | 21,776 | $ | 23,765 | $ | 21,776 |
THE LINCOLN NATIONAL LIFE INSURANCE COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in millions)
For the Nine | ||||||
Months Ended | ||||||
September 30, | ||||||
2020 | 2019 | |||||
Cash Flows from Operating Activities | ||||||
Net income (loss) | $ | 31 | $ | 155 | ||
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: | ||||||
Realized (gain) loss | 448 | 844 | ||||
Trading securities purchases, sales and maturities, net | 24 | (2,552 | ) | |||
Amortization of deferred gain on business sold through reinsurance | (27 | ) | (20 | ) | ||
Change in: | ||||||
Deferred acquisition costs, value of business acquired, deferred sales inducements | ||||||
and deferred front-end loads deferrals and interest, net of amortization | 355 | (281 | ) | |||
Premiums and fees receivable | (33 | ) | 129 | |||
Accrued investment income | (157 | ) | (61 | ) | ||
Future contract benefits and other contract holder funds | (239 | ) | 727 | |||
Reinsurance related assets and liabilities | 873 | (1,765 | ) | |||
Accrued expenses | (188 | ) | (24 | ) | ||
Federal income tax accruals | (236 | ) | (305 | ) | ||
Cash management agreement | (1,694 | ) | (775 | ) | ||
Other | 50 | 236 | ||||
Net cash provided by (used in) operating activities | (793 | ) | (3,692 | ) | ||
Cash Flows from Investing Activities | ||||||
Purchases of available-for-sale securities and equity securities | (12,107 | ) | (11,074 | ) | ||
Sales of available-for-sale securities and equity securities | 1,354 | 6,454 | ||||
Maturities of available-for-sale securities | 3,581 | 4,932 | ||||
Purchases of alternative investments | (265 | ) | (344 | ) | ||
Sales and repayments of alternative investments | 116 | 104 | ||||
Issuance of mortgage loans on real estate | (1,221 | ) | (3,430 | ) | ||
Repayment and maturities of mortgage loans on real estate | 835 | 747 | ||||
Issuance (repayment) of policy loans, net | (51 | ) | 33 | |||
Net change in collateral on investments, derivatives and related settlements | 2,207 | 1,047 | ||||
Other | (113 | ) | (194 | ) | ||
Net cash provided by (used in) investing activities | (5,664 | ) | (1,725 | ) | ||
Cash Flows from Financing Activities | ||||||
Capital contribution from Lincoln National Corporation | 475 | - | ||||
Payment of long-term debt, including current maturities | (30 | ) | (28 | ) | ||
Issuance of long-term debt, net of issuance costs | 30 | 28 | ||||
Issuance (payment) of short-term debt | (142 | ) | 281 | |||
Proceeds from certain financing arrangements | 69 | 50 | ||||
Deposits of fixed account values, including the fixed portion of variable | 10,544 | 11,549 | ||||
Withdrawals of fixed account values, including the fixed portion of variable | (4,590 | ) | (4,349 | ) | ||
Transfers to and from separate accounts, net | 427 | (1,142 | ) | |||
Common stock issued for benefit plans | (8 | ) | (32 | ) | ||
Dividends paid to Lincoln National Corporation | (486 | ) | (550 | ) | ||
Net cash provided by (used in) financing activities | 6,289 | 5,807 | ||||
Net increase (decrease) in cash, invested cash and restricted cash | (168 | ) | 390 | |||
Cash, invested cash and restricted cash as of beginning-of-year | 1,879 | 1,848 | ||||
Cash, invested cash and restricted cash as of end-of-period | $ | 1,711 | $ | 2,238 |
THE LINCOLN NATIONAL LIFE INSURANCE COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. Nature of Operations and Basis of Presentation
Nature of Operations
The Lincoln National Life Insurance Company (“LNL” or the “Company,” which also may be referred to as “we,” “our” or “us”), a wholly-owned subsidiary of Lincoln National Corporation (“LNC” or the “Parent Company”), is domiciled in the state of Indiana. We own 100% of the outstanding common stock of 2 insurance company subsidiaries, Lincoln Life & Annuity Company of New York (“LLANY”) and Lincoln Life Assurance Company of Boston. We also own several non-insurance companies, including Lincoln Financial Distributors, our wholesale distributor, and Lincoln Financial Advisors Corporation, part of LNC’s retail distributor, Lincoln Financial Network. Through our business segments, we sell a wide range of wealth protection, accumulation, retirement income and group protection products and solutions. These products primarily include fixed and indexed annuities, variable annuities, universal life insurance (“UL”), variable universal life insurance (“VUL”), linked-benefit UL, indexed universal life insurance (“IUL”), term life insurance, employer-sponsored retirement plans and services, and group life, disability and dental. LNL is licensed and sells its products throughout the U.S. and several U.S. territories. See Note 14 for additional information.
Basis of Presentation
The accompanying unaudited consolidated financial statements are prepared in accordance with United States of America generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions for the Securities and Exchange Commission (“SEC”) Quarterly Report on Form 10-Q, including Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. The information contained in the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019 (‘‘2019 Form 10-K’’), should be read in connection with the reading of these interim unaudited consolidated financial statements.
Certain GAAP policies, which significantly affect the determination of financial condition, results of operations and cash flows, are summarized in our 2019 Form 10-K.
In the opinion of management, these statements include all normal recurring adjustments necessary for a fair presentation of the Company’s results. Operating results for the nine months ended September 30, 2020, are not necessarily indicative of the results that may be expected for the full year ending December 31, 2020, especially when considering the risks and uncertainties associated with the coronavirus, or COVID-19, pandemic and the future impacts of the pandemic on our business, results of operations and financial condition. All material inter-company accounts and transactions have been eliminated in consolidation.
2. New Accounting Standards
Adoption of New Accounting Standards
The following table provides a description of our adoption of new Accounting Standards Updates (“ASUs”) issued by the Financial Accounting Standards Board (“FASB”) and the impact of the adoption on our financial statements. ASUs not listed below were assessed and determined to be either not applicable or insignificant in presentation or amount.
Standard | Description | Effective Date | Effect on Financial Statements or Other Significant Matters |
ASU 2016-13, Measurement of Credit Losses on Financial Instruments and related amendments | These amendments adopt a new model in Accounting Standards CodificationTM (“ASC”) Topic 326 to measure and recognize credit losses for most financial assets. The ASU requires a financial asset measured at amortized cost to be presented at the net amount expected to be collected over the life of the asset using an allowance for credit losses. Changes in the allowance are charged to earnings. The measurement of expected credit losses is based on relevant information about past events, including historical experience, as well as current economic conditions and reasonable and supportable forecasts that affect the collectability of the financial asset. The method used to measure estimated credit losses for fixed maturity available-for-sale (“AFS”) securities will be unchanged from current GAAP; however, the amendments require credit losses to be recognized through an allowance rather than as a reduction to the amortized cost of those securities. The amendments permit entities to recognize improvements in credit loss estimates on fixed maturity AFS securities by reducing the allowance account immediately through earnings. The amendments are adopted through a cumulative effect adjustment to the beginning balance of retained earnings as of the first reporting period in which the amendments are effective. Early adoption is permitted for annual periods beginning after December 15, 2018, and interim periods therein. | January 1, 2020 | The adoption of this standard and related amendments resulted in the recognition of a cumulative effect decrease of $216 million, net of deferred acquisition costs (“DAC”), value of business acquired (“VOBA”), deferred sales inducements (“DSI”), deferred front-end loads (“DFEL”) and changes in other contract holder funds, after-tax, to retained earnings. The overall adjustment recorded our allowance for credit losses as of the date of adoption, primarily related to commercial and residential mortgage loans, as well as reinsurance recoverables. Upon adoption of the standard, the concept of other-than-temporary impairment (“OTTI”) no longer exists; however, our prior period presentation herein is reflective of OTTI recorded in those periods. |
ASU 2019-04, Codification Improvements to Topic 326, Financial Instruments – Credit Losses, Topic 815, Derivatives and Hedging and Topic 825, Financial Instruments | These amendments clarify the measurement, recognition and presentation of the allowance for credit losses on accrued interest receivable balances; the inclusion of recoveries when estimating the allowance for credit losses; the inclusion of all ASC Topic 944 – Financial Services – Insurance reinsurance recoverables within the scope of ASC 326-20; and provide additional targeted clarifications on the calculation of the allowance for credit losses. | January 1, 2020 | Our adoption of ASU 2016-13 and related amendments is discussed above. The adoption of the remainder of this guidance did not have a material impact on our consolidated financial condition and results of operations. |
Standard | Description | Effective Date | Effect on Financial Statements or Other Significant Matters |
ASU 2019-05, Financial Instruments – Credit Losses (Topic 326): Targeted Transition Relief | The amendments provide entities that have certain instruments within the scope of Subtopic 326-20, Financial Instruments – Credit Losses – Measured at Amortized Cost, with an option to irrevocably elect the fair value option in Subtopic 825-10, Financial Instruments – Overall, applied on an instrument-by-instrument basis for eligible instruments, upon adoption of ASC Topic 326. | January 1, 2020 | We recognized a cumulative effect increase to retained earnings of $15 million, after-tax, by electing the fair value option for certain mortgage loans in connection with our adoption of ASC Topic 326. |
ASU 2020-04, Reference Rate Reform (Topic 848) | The amendments in this update provide optional guidance for a limited period of time to ease the potential burden in accounting for (or recognizing the effects of) reference rate reform on financial reporting. The amendments provide optional expedients and exceptions for applying GAAP to contracts, hedging relationships and other transactions impacted by reference rate reform. If certain criteria are met, an entity will not be required to remeasure or reassess contracts impacted by reference rate reform. Additionally, changes to the critical terms of a hedging relationship affected by reference rate reform will not require entities to de-designate the relationship if certain requirements are met. The expedients and exceptions provided by the amendments do not apply to contract modifications made and hedging relationships entered into or evaluated after December 31, 2022, with certain exceptions. The amendments are effective for contract modifications made between March 12, 2020, and December 31, 2022. | March 12, 2020 through December 31, 2022 | This standard may be elected and applied prospectively as reference rate reform unfolds. We have begun our implementation and are currently evaluating the impact of this ASU on our consolidated financial condition and results of operations. |
ASU 2018-12, Targeted Improvements to the Accounting for Long-Duration Contracts and related amendments | These amendments make changes to the accounting and reporting for long-duration contracts issued by an insurance entity that will significantly change how insurers account for long-duration contracts, including how they measure, recognize and make disclosures about insurance liabilities and DAC. Under this ASU, insurers will be required to review cash flow assumptions at least annually and update them if necessary. They also will have to make quarterly updates to the discount rate assumptions they use to measure the liability for future policyholder benefits. The ASU creates a new category of market risk benefits (i.e., features that protect the contract holder from capital market risk and expose the insurer to that risk) that insurers will have to measure at fair value. The ASU provides various transition methods by topic that entities may elect upon adoption. On November 5, 2020, the FASB issued ASU 2020-11, which amends the ASU to defer the effective date for large public SEC filers to January 1, 2023, with early adoption permitted. | January 1, 2023 | We are currently evaluating the impact of adopting this ASU on our consolidated financial condition and results of operations. |
3. Variable Interest Entities
Unconsolidated Variable Interest Entities
Structured Securities
Through our investment activities, we make passive investments in structured securities issued by variable interest entities (“VIEs”) for which we are not the manager. These structured securities include our asset-backed securities (“ABS”), residential mortgage-backed securities (“RMBS”), commercial mortgage-backed securities (“CMBS”) and collateralized loan obligations (“CLOs”). We have not provided financial or other support with respect to these VIEs other than our original investment. We have determined that we are not the primary beneficiary of these VIEs due to the relative size of our investment in comparison to the principal amount of the structured securities issued by the VIEs and the level of credit subordination that reduces our obligation to absorb losses or right to receive benefits. Our maximum exposure to loss on these structured securities is limited to the amortized cost for these investments. We recognize our variable interest in these VIEs at fair value on our Consolidated Balance Sheets. For information about these structured securities, see Note 4.
Limited Partnerships and Limited Liability Companies
We invest in certain limited partnerships (“LPs”) and limited liability companies (“LLCs”), including qualified affordable housing projects, that we have concluded are VIEs. We do not hold any substantive kick-out or participation rights in the LPs and LLCs, and we do not receive any performance fees or decision maker fees from the LPs and LLCs. Based on our analysis of the LPs and LLCs, we are not the primary beneficiary of the VIEs as we do not have the power to direct the most significant activities of the LPs and LLCs.
The carrying amounts of our investments in the LPs and LLCs are recognized in other investments on our Consolidated Balance Sheets and were $1.9 billion as of September 30, 2020, and December 31, 2019. Included in these carrying amounts are our investments in qualified affordable housing projects, which were $8 million and $13 million as of September 30, 2020, and December 31, 2019, respectively. We do not have any contingent commitments to provide additional capital funding to these qualified affordable housing projects. We received returns from these qualified affordable housing projects in the form of income tax credits and other tax benefits of $1 million for the nine months ended September 30, 2020 and 2019, which were recognized in federal income tax expense (benefit) on our Consolidated Statements of Comprehensive Income (Loss).
Our exposure to loss is limited to the capital we invest in the LPs and LLCs, and there have been 0 indicators of impairment that would require us to recognize an impairment loss related to the LPs and LLCs as of September 30, 2020.
4. Investments
Fixed Maturity AFS Securities
In 2020, we adopted ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which resulted in a new recognition and measurement of credit losses on most financial assets. See Note 2 for additional information.
The amortized cost, gross unrealized gains, losses, allowance for credit losses and fair value of fixed maturity AFS securities (in millions) were as follows:
As of September 30, 2020 | |||||||||||||||
Allowance | |||||||||||||||
Amortized | Gross Unrealized | for Credit | Fair | ||||||||||||
Cost | Gains | Losses | Losses | Value | |||||||||||
Fixed maturity AFS securities: | |||||||||||||||
Corporate bonds | $ | 83,945 | $ | 13,813 | $ | 341 | $ | 11 | $ | 97,406 | |||||
U.S. government bonds | 369 | 91 | - | - | 460 | ||||||||||
State and municipal bonds | 5,043 | 1,477 | 3 | - | 6,517 | ||||||||||
Foreign government bonds | 353 | 81 | 3 | - | 431 | ||||||||||
RMBS | 2,654 | 310 | - | 1 | 2,963 | ||||||||||
CMBS | 1,308 | 114 | 1 | - | 1,421 | ||||||||||
ABS | 6,465 | 140 | 22 | - | 6,583 | ||||||||||
Hybrid and redeemable preferred securities | 545 | 88 | 42 | - | 591 | ||||||||||
Total fixed maturity AFS securities | $ | 100,682 | $ | 16,114 | $ | 412 | $ | 12 | $ | 116,372 |
The amortized cost, gross unrealized gains, losses, OTTI and fair value of fixed maturity AFS securities (in millions) were as follows:
As of December 31, 2019 | |||||||||||||||
Amortized | Gross Unrealized | Fair | |||||||||||||
Cost | Gains | Losses | OTTI (1) | Value | |||||||||||
Fixed maturity AFS securities: | |||||||||||||||
Corporate bonds | $ | 78,875 | $ | 9,071 | $ | 172 | $ | (5 | ) | $ | 87,779 | ||||
U.S. government bonds | 355 | 48 | - | - | 403 | ||||||||||
State and municipal bonds | 4,605 | 1,087 | 7 | - | 5,685 | ||||||||||
Foreign government bonds | 326 | 62 | - | - | 388 | ||||||||||
RMBS | 2,820 | 179 | 9 | (18 | ) | 3,008 | |||||||||
CMBS | 1,038 | 45 | 1 | (1 | ) | 1,083 | |||||||||
ABS | 4,803 | 62 | 17 | (35 | ) | 4,883 | |||||||||
Hybrid and redeemable preferred securities | 485 | 79 | 20 | - | 544 | ||||||||||
Total fixed maturity AFS securities | $ | 93,307 | $ | 10,633 | $ | 226 | $ | (59 | ) | $ | 103,773 |
(1)Prior to the adoption of ASU 2016-13, we recognized the OTTI attributed to noncredit factors as a separate component in other comprehensive income (loss) (“OCI”) referred to as unrealized OTTI on fixed maturity AFS securities. This includes unrealized (gains) and losses on credit-impaired securities related to changes in the fair value of such securities subsequent to the impairment measurement date.
The amortized cost and fair value of fixed maturity AFS securities by contractual maturities (in millions) as of September 30, 2020, were as follows:
Amortized | Fair | |||||
Cost | Value | |||||
Due in one year or less | $ | 3,435 | $ | 3,468 | ||
Due after one year through five years | 14,463 | 15,292 | ||||
Due after five years through ten years | 19,302 | 21,510 | ||||
Due after ten years | 53,055 | 65,135 | ||||
Subtotal | 90,255 | 105,405 | ||||
Structured securities (RMBS, CMBS, ABS) | 10,427 | 10,967 | ||||
Total fixed maturity AFS securities | $ | 100,682 | $ | 116,372 |
Actual maturities may differ from contractual maturities because issuers may have the right to call or pre-pay obligations.
The fair value and gross unrealized losses of fixed maturity AFS securities (dollars in millions) for which an allowance for credit losses has not been recorded, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows:
As of September 30, 2020 | |||||||||||||||||||
Less Than or Equal | Greater Than | ||||||||||||||||||
to Twelve Months | Twelve Months | Total | |||||||||||||||||
Gross | Gross | Gross | |||||||||||||||||
Fair | Unrealized | Fair | Unrealized | Fair | Unrealized | ||||||||||||||
Value | Losses | Value | Losses | Value | Losses (1) | ||||||||||||||
Fixed maturity AFS securities: | |||||||||||||||||||
Corporate bonds | $ | 5,323 | $ | 246 | $ | 648 | $ | 95 | $ | 5,971 | $ | 341 | |||||||
State and municipal bonds | 183 | 3 | - | - | 183 | 3 | |||||||||||||
Foreign government bonds | 49 | 3 | - | - | 49 | 3 | |||||||||||||
CMBS | 53 | 1 | 1 | - | 54 | 1 | |||||||||||||
ABS | 3,327 | 13 | 369 | 9 | 3,696 | 22 | |||||||||||||
Hybrid and redeemable | |||||||||||||||||||
preferred securities | 111 | 20 | 92 | 22 | 203 | 42 | |||||||||||||
Total fixed maturity AFS securities | $ | 9,046 | $ | 286 | $ | 1,110 | $ | 126 | $ | 10,156 | $ | 412 | |||||||
Total number of fixed maturity AFS securities in an unrealized loss position | 1,191 |
(1)We recognized $3 million of gross unrealized losses in OCI for fixed maturity AFS securities for which an allowance for credit losses has been recorded.
The fair value and gross unrealized losses, including the portion of OTTI recognized in OCI, of fixed maturity AFS securities (dollars in millions), aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows:
As of December 31, 2019 | |||||||||||||||||||
Less Than or Equal | Greater Than | ||||||||||||||||||
to Twelve Months | Twelve Months | Total | |||||||||||||||||
Gross | Gross | Gross | |||||||||||||||||
Unrealized | Unrealized | Unrealized | |||||||||||||||||
Fair | Losses and | Fair | Losses and | Fair | Losses and | ||||||||||||||
Value | OTTI | Value | OTTI | Value | OTTI | ||||||||||||||
Fixed maturity AFS securities: | |||||||||||||||||||
Corporate bonds | $ | 2,827 | $ | 44 | $ | 1,381 | $ | 131 | $ | 4,208 | $ | 175 | |||||||
State and municipal bonds | 316 | 7 | 18 | - | 334 | 7 | |||||||||||||
RMBS | 471 | 9 | 15 | - | 486 | 9 | |||||||||||||
CMBS | 48 | 1 | 4 | - | 52 | 1 | |||||||||||||
ABS | 1,791 | 8 | 300 | 9 | 2,091 | 17 | |||||||||||||
Hybrid and redeemable | |||||||||||||||||||
preferred securities | 29 | 1 | 102 | 19 | 131 | 20 | |||||||||||||
Total fixed maturity AFS securities | $ | 5,482 | $ | 70 | $ | 1,820 | $ | 159 | $ | 7,302 | $ | 229 | |||||||
Total number of fixed maturity AFS securities in an unrealized loss position | 882 |
The fair value, gross unrealized losses (in millions) and number of fixed maturity AFS securities where the fair value had declined and remained below amortized cost by greater than 20% were as follows:
As of September 30, 2020 | |||||||||||||
Gross | Number | ||||||||||||
Fair | Unrealized | of | |||||||||||
Value | Losses | Securities (1) | |||||||||||
Less than six months | $ | 171 | $ | 62 | 27 | ||||||||
Six months or greater, but less than nine months | 126 | 54 | 21 | ||||||||||
Twelve months or greater | 30 | 13 | 22 | ||||||||||
Total | $ | 327 | $ | 129 | 70 |
(1)We may reflect a security in more than one aging category based on various purchase dates.
The fair value, gross unrealized losses, the portion of OTTI recognized in OCI (in millions) and number of fixed maturity AFS securities where the fair value had declined and remained below amortized cost by greater than 20% were as follows:
As of December 31, 2019 | |||||||||||||
Number | |||||||||||||
Fair | Gross Unrealized | of | |||||||||||
Value | Losses | OTTI | Securities (1) | ||||||||||
Less than six months | $ | 15 | $ | 5 | $ | - | 7 | ||||||
Six months or greater, but less than nine months | 10 | 3 | - | 4 | |||||||||
Twelve months or greater | 130 | 74 | - | 31 | |||||||||
Total | $ | 155 | $ | 82 | $ | - | 42 | ||||||
(1)We may reflect a security in more than one aging category based on various purchase dates.
Our gross unrealized losses on fixed maturity AFS securities increased by $183 million for the nine months ended September 30, 2020. As discussed further below, we believe the unrealized loss position as of September 30, 2020, did not require an impairment recognized in earnings as (i) we did not intend to sell these fixed maturity AFS securities; (ii) it is not more likely than not that we will be required to sell the fixed maturity AFS securities before recovery of their amortized cost basis; and (iii) the difference in the fair value compared to the amortized cost was due to factors other than credit loss. Based upon this evaluation as of September 30, 2020, management believes we have the ability to generate adequate amounts of cash from our normal operations (e.g., insurance premiums, fee income and investment income) to meet cash requirements with a prudent margin of safety without requiring the sale of our impaired securities.
As of September 30, 2020, the unrealized losses associated with our corporate, state and municipal and foreign government bond securities were attributable primarily to widening credit spreads and rising interest rates since purchase. We performed a detailed analysis of the financial performance of the underlying issuers and determined that we expected to recover the entire amortized cost of each impaired security.
As of September 30, 2020, the unrealized losses associated with our mortgage-backed securities (“MBS”) and ABS were attributable primarily to widening credit spreads and rising interest rates since purchase. We assessed for credit impairment using a cash flow model that incorporates key assumptions including default rates, severities and prepayment rates. We estimated losses for a security by forecasting the underlying loans in each transaction. The forecasted loan performance was used to project cash flows to the various tranches in the structure, as applicable. Our forecasted cash flows also considered, as applicable, independent industry analyst reports and forecasts and other independent market data. Based upon our assessment of the expected credit losses of the security given the performance of the underlying collateral compared to our subordination or other credit enhancement, we expected to recover the entire amortized cost of each impaired security.
As of September 30, 2020, the unrealized losses associated with our hybrid and redeemable preferred securities were attributable primarily to wider credit spreads caused by illiquidity in the market and subordination within the capital structure, as well as credit risk of underlying issuers. For our hybrid and redeemable preferred securities, we evaluated the financial performance of the underlying issuers based upon credit performance and investment ratings and determined that we expected to recover the entire amortized cost of each impaired security.
Evaluation for Credit Loss Impairment
We regularly review our fixed maturity AFS securities (also referred to as “debt securities”) for declines in fair value that we determine to be impairment-related, including those attributable to credit risk factors that may require an allowance for credit losses.
For our fixed maturity AFS securities, we generally consider the following to determine whether our debt securities with unrealized losses are credit impaired:
The estimated range and average period until recovery;
The estimated range and average holding period to maturity;
Remaining payment terms of the security;
Current delinquencies and nonperforming assets of underlying collateral;
Expected future default rates;
Collateral value by vintage, geographic region, industry concentration or property type;
Subordination levels or other credit enhancements as of the balance sheet date as compared to origination; and
Contractual and regulatory cash obligations.
For a debt security, if we intend to sell a security, or it is more likely than not we will be required to sell a debt security before recovery of its amortized cost basis and the fair value of the debt security is below amortized cost, we conclude that an impairment has occurred and the amortized cost is written down to current fair value with a corresponding charge to realized gain (loss) on our Consolidated Statements of Comprehensive Income (Loss). If we do not intend to sell a debt security, or it is not more likely than not we will be required to sell a debt security before recovery of its amortized cost basis but the present value of the cash flows expected to be collected is less than the amortized cost of the debt security (referred to as the credit loss), we conclude that an impairment has occurred, and an allowance for credit losses is recorded, with a corresponding charge to realized gain (loss) on our Consolidated Statements of Comprehensive Income (Loss). The remainder of the decline to fair value related to factors other than credit loss is recorded in OCI to unrealized losses on fixed maturity AFS securities on our Consolidated Statements of Stockholders’ Equity, as this amount is considered a non-credit impairment.
When assessing our intent to sell a debt security, or if it is more likely than not we will be required to sell a debt security before recovery of its cost basis, we evaluate facts and circumstances such as, but not limited to, decisions to reposition our security portfolio, sales of securities to meet cash flow needs and sales of securities to capitalize on favorable pricing. Management considers the following as part of the evaluation:
The current economic environment and market conditions;
Our business strategy and current business plans;
The nature and type of security, including expected maturities and exposure to general credit, liquidity, market and interest rate risk;
Our analysis of data from financial models and other internal and industry sources to evaluate the current effectiveness of our hedging and overall risk management strategies;
The current and expected timing of contractual maturities of our assets and liabilities, expectations of prepayments on investments and expectations for surrenders and withdrawals of life insurance policies and annuity contracts;
The capital risk limits approved by management; and
Our current financial condition and liquidity demands.
Calculation of Credit Impairment
In order to determine the amount of the credit loss for a debt security, we calculate the recovery value by performing a discounted cash flow analysis based on the current cash flows and future cash flows we expect to recover. The discount rate is the effective interest rate implicit in the underlying debt security. The effective interest rate is the original yield, or the coupon if the debt security was previously impaired. See the discussion below for additional information on the methodology and significant inputs, by security type, that we use to determine the amount of a credit loss.
To determine the recovery period of a debt security, we consider the facts and circumstances surrounding the underlying issuer including, but not limited to, the following:
Historical and implied volatility of the security;
The extent to which the fair value has been less than amortized cost;
Adverse conditions specifically related to the security or to specific conditions in an industry or geographic area;
Failure, if any, of the issuer of the security to make scheduled payments; and
Recoveries or additional declines in fair value subsequent to the balance sheet date.
In periods subsequent to the recognition of a credit loss impairment through an allowance, we continue to reassess the expected cash flows of the fixed maturity AFS security at each subsequent measurement date as necessary. If the measurement of credit loss changes, we recognize a provision for (or reversal of) credit loss expense through realized gain (loss) on our Consolidated Statements of Comprehensive Income (Loss), limited by the amount that amortized cost exceeds fair value. Losses are charged against the allowance when management believes the uncollectibility of a fixed maturity AFS security is confirmed or when either of the criteria regarding intent or requirement to sell is met. Accrued interest on fixed maturity AFS securities is written off when deemed uncollectible.
Determination of Credit Losses on Corporate Bonds
To determine the recovery value of a corporate bond, CLO or collateralized debt obligation (“CDO”), we perform additional analysis related to the underlying issuer including, but not limited to, the following:
Fundamentals of the issuer to determine what we would recover if they were to file bankruptcy versus the price at which the market is trading;
Fundamentals of the industry in which the issuer operates;
Earnings multiples for the given industry or sector of an industry that the underlying issuer operates within, divided by the outstanding debt to determine an expected recovery value of the security in the case of a liquidation;
Expected cash flows of the issuer (e.g., whether the issuer has cash flows in excess of what is required to fund its operations);
Expectations regarding defaults and recovery rates;
Changes to the rating of the security by a rating agency; and
Additional market information (e.g., if there has been a replacement of the corporate debt security).
Credit ratings express opinions about the credit quality of a security. Securities rated investment grade (those rated BBB- or higher by Standard & Poor’s (“S&P”) Rating Services or Baa3 or higher by Moody’s Investors Service (“Moody’s”)) are generally considered by the rating agencies and market participants to be low credit risk. As of September 30, 2020, and December 31, 2019, 96% of the fair value of our corporate bond portfolio was rated investment grade. As of September 30, 2020, and December 31, 2019, the portion of our corporate bond portfolio rated below investment grade had an amortized cost of $3.7 billion and $3.1 billion, respectively, and a fair value of $3.7 billion and $3.1 billion, respectively. Based upon the analysis discussed above, we believe that as of September 30, 2020, and December 31, 2019, we would have recovered the amortized cost of each corporate bond.
Determination of Credit Losses on MBS and ABS
Each quarter, we review the cash flows for the MBS portfolio, including current credit enhancements and trends in the underlying collateral performance, to determine whether or not they are sufficient to provide for the recovery of our amortized cost. To determine recovery value of a MBS, we perform additional analysis related to the underlying issuer including, but not limited to, the following:
Discounted cash flow analysis based on the current cash flows and future cash flows we expect to recover;
Level of borrower creditworthiness of the home equity loans or residential mortgages that back an RMBS or commercial mortgages that back a CMBS;
Susceptibility to fair value fluctuations for changes in the interest rate environment;
Susceptibility to reinvestment risks, in cases where market yields are lower than the securities’ book yield earned;
Susceptibility to reinvestment risks, in cases where market yields are higher than the book yields earned on a security;
Expectations of sale of such a security where market yields are higher than the book yields earned on a security; and
Susceptibility to variability of prepayments.
When evaluating MBS and mortgage-related ABS, we consider a number of pool-specific factors as well as market level factors when determining whether or not the impairment on the security requires an allowance for credit losses. The most important factor is the performance of the underlying collateral in the security and the trends of that performance in the prior periods. We use this information about the collateral to forecast the timing and rate of mortgage loan defaults, including making projections for loans that are already delinquent and for those loans that are currently performing but may become delinquent in the future. Other factors used in this analysis include the credit characteristics of borrowers, geographic distribution of underlying loans and timing of liquidations by state. Once default rates and timing assumptions are determined, we then make assumptions regarding the severity of a default if it were to occur. Factors that impact the severity assumption include expectations for future home price appreciation or depreciation, loan size, first lien versus second lien, existence of loan level private mortgage insurance, type of occupancy and geographic distribution of loans. Second lien loans are assigned 100% severity, if defaulted. For first lien loans, we assume a minimum of 30% severity, with higher severity assumed for investor properties and further adjusted by housing price assumptions. Once default and severity assumptions are determined for the security in question, cash flows for the underlying collateral are projected including expected defaults and prepayments. These cash flows on the collateral are then translated to cash flows on our tranche based on the cash flow waterfall of the entire capital security structure. If this analysis indicates the entire principal on a particular security will not be returned, the security is reviewed for a credit loss by comparing the expected cash flows to amortized cost. To the extent that the security has already been impaired through a recognized credit loss allowance or was purchased at a discount, such that the amortized cost of the security is less than or equal to the present value of cash flows expected to be collected, no allowance is required. Otherwise, if the amortized cost of the security is greater than the present value of the cash flows expected to be collected, and the security was not purchased at a discount greater than the expected principal loss, then an impairment through a credit loss allowance is recognized.
We further monitor the cash flows of all of our fixed maturity AFS securities backed by mortgages on an ongoing basis. We also perform detailed analysis on all of our subprime, Alt-A, non-agency residential MBS and on a significant percentage of our fixed maturity AFS securities backed by pools of commercial mortgages. The detailed analysis includes revising projected cash flows by updating the cash flows for actual cash received and applying assumptions with respect to expected defaults, foreclosures and recoveries in the future.
These revised projected cash flows are then compared to the amount of credit enhancement (subordination) in the structure to determine whether the amortized cost of the security is recoverable. If it is not recoverable, we record an impairment through a credit loss allowance for the security.
Changes in the allowance for credit losses on fixed maturity AFS securities (in millions), aggregated by investment category, were as follows:
For the Three | ||||||||||||
Months Ended | ||||||||||||
September 30, 2020 | ||||||||||||
Corporate | ||||||||||||
Bonds | RMBS | ABS | Total | |||||||||
Balance as of beginning-of-period | $ | 19 | $ | 1 | $ | 1 | $ | 21 | ||||
Additions for securities for which credit losses were not | ||||||||||||
previously recognized | 5 | - | - | 5 | ||||||||
Additions from purchases of PCD debt securities (1) | - | - | - | - | ||||||||
Additions (reductions) for securities for which credit losses | ||||||||||||
were previously recognized | (3 | ) | - | (1 | ) | (4 | ) | |||||
Reductions for securities charged-off | (10 | ) | - | - | (10 | ) | ||||||
Balance as of end-of-period (2) | $ | 11 | $ | 1 | $ | - | $ | 12 |
For the Nine | ||||||||||||
Months Ended | ||||||||||||
September 30, 2020 | ||||||||||||
Corporate | ||||||||||||
Bonds | RMBS | ABS | Total | |||||||||
Balance as of beginning-of-period | $ | - | $ | - | $ | - | $ | - | ||||
Additions for securities for which credit losses were not | ||||||||||||
previously recognized | 39 | 1 | 1 | 41 | ||||||||
Additions from purchases of PCD debt securities (1) | - | - | - | - | ||||||||
Additions (reductions) for securities for which credit losses | ||||||||||||
were previously recognized | (3 | ) | - | (1 | ) | (4 | ) | |||||
Reductions for securities disposed | (15 | ) | - | - | (15 | ) | ||||||
Reductions for securities charged-off | (10 | ) | - | - | (10 | ) | ||||||
Balance as of end-of-period (2) | $ | 11 | $ | 1 | $ | - | $ | 12 |
(1)Represents purchased credit-deteriorated (“PCD”) fixed maturity AFS securities.
(2)Accrued interest receivable on fixed maturity AFS securities totaled $1.0 billion as of September 30, 2020, and was excluded from the estimate of credit losses.
Changes in the amount of credit loss of OTTI recognized in net income (loss) where the portion related to other factors was recognized in OCI (in millions) on fixed maturity AFS securities were as follows:
For the | For the | ||||||||
Three | Nine | ||||||||
Months | Months | ||||||||
Ended | Ended | ||||||||
September 30, | September 30, | ||||||||
2019 | 2019 | ||||||||
Balance as of beginning-of-period | $ | 244 | $ | 337 | |||||
Increases attributable to: | |||||||||
Credit losses on securities for which an | |||||||||
OTTI was not previously recognized | 1 | 11 | |||||||
Credit losses on securities for which an | |||||||||
OTTI was previously recognized | 1 | 3 | |||||||
Decreases attributable to: | |||||||||
Securities sold, paid down or matured | (37 | ) | (142 | ) | |||||
Balance as of end-of-period | $ | 209 | $ | 209 |
Mortgage Loans on Real Estate
Mortgage loans on real estate consist of commercial and residential mortgage loans and are generally carried at unpaid principal balances adjusted for amortization of premiums and accretion of discounts and are net of allowances for credit losses. We carry certain commercial mortgage loans at fair value where the fair value option has been elected. Interest income is accrued on the principal balance of the loan based on the loan’s contractual interest rate. Premiums and discounts are amortized using the effective yield method over the life of the loan. Interest income and amortization of premiums and discounts are reported in net investment income on our Consolidated Statements of Comprehensive Income (Loss) along with mortgage loan fees, which are recorded as they are incurred.
Our policy for commercial mortgage loans is to report loans that are 60 or more days past due, which equates to two or more payments missed, as delinquent. Our policy for residential mortgage loans is to report loans that are 90 or more days past due, which equates to three or more payments missed, as delinquent. We do not accrue interest on loans 90 days past due, and any interest received on these loans is either applied to the principal or recorded in net investment income on our Consolidated Statements of Comprehensive Income (Loss) when received, depending on the assessment of the collectability of the loan. We resume accruing interest once a loan complies with all of its original terms or restructured terms. Mortgage loans deemed uncollectible are charged against the allowance for credit losses, and subsequent recoveries, if any, are likewise credited to the allowance for credit losses. Accrued interest on mortgage loans is written off when deemed uncollectible.
The following provides the current and past due composition of our mortgage loans on real estate (in millions):
As of September 30, 2020 | As of December 31, 2019 | |||||||||||||||||
Commercial | Residential | Total | Commercial | Residential | Total | |||||||||||||
Current | $ | 15,918 | $ | 589 | $ | 16,507 | $ | 15,525 | $ | 659 | $ | 16,184 | ||||||
30 to 59 days past due | - | 26 | 26 | 3 | 27 | 30 | ||||||||||||
60 to 89 days past due | - | 13 | 13 | - | 10 | 10 | ||||||||||||
90 or more days past due | - | 79 | 79 | - | 16 | 16 | ||||||||||||
Allowance for credit losses | (171 | ) | (30 | ) | (201 | ) | - | (2 | ) | (2 | ) | |||||||
Unamortized premium (discount) | (15 | ) | 23 | 8 | - | - | - | |||||||||||
Mark-to-market gains (losses) (1) | 26 | - | 26 | (17 | ) | 23 | 6 | |||||||||||
Total carrying value | $ | 15,758 | $ | 700 | $ | 16,458 | $ | 15,511 | $ | 733 | $ | 16,244 |
(1)Represents the mark-to-market on certain commercial mortgage loans on real estate for which we have elected the fair value option. See Note 13 for additional information.
Our commercial mortgage loan portfolio has the largest concentrations in California, which accounted for 24% of commercial mortgage loans on real estate as of September 30, 2020, and December 31, 2019, and Texas, which accounted for 11% of commercial mortgage loans on real estate as of September 30, 2020, and December 31, 2019.
Our residential mortgage loan portfolio has the largest concentrations in California, which accounted for 33% and 34% of residential mortgage loans on real estate as of September 30, 2020, and December 31, 2019, respectively, and Florida, which accounted for 19% and 20% of residential mortgage loans on real estate as of September 30, 2020, and December 31, 2019, respectively.
As of September 30, 2020, and December 31, 2019, we had 160 and 38 residential mortgage loans, respectively, that were either delinquent or in foreclosure.
Evaluation for Credit Losses on Mortgage Loans on Real Estate
In connection with our recognition of an allowance for credit losses for mortgage loans on real estate, we perform a quantitative analysis using a probability of default/loss given default/exposure at default approach to estimate expected credit losses in our mortgage loan portfolio as well as unfunded commitments related to commercial mortgage loans, exclusive of certain mortgage loans held at fair value. Our model estimates expected credit losses over the contractual terms of the loans, which are the periods over which we are exposed to credit risk, adjusted for expected prepayments. Credit loss estimates are segmented by commercial mortgage loans, residential mortgage loans, and unfunded commitments related to commercial mortgage loans.
The allowance for credit losses for pooled loans of similar risk (i.e., commercial and residential mortgage loans) is estimated using relevant historical credit loss information adjusted for current conditions and reasonable and supportable forecasts of future conditions. Historical credit loss experience provides the basis for the estimation of expected credit losses with adjustments for differences in current loan-specific risk characteristics, such as differences in underwriting standards, portfolio mix, delinquency level, or term lengths as well as adjustments for changes in environmental conditions, such as unemployment rates, property values, or other factors that management deems relevant. We apply probability weights to the positive, base and adverse scenarios we use. For periods beyond our reasonable and supportable forecast, we use implicit mean reversion over the remaining life of the recoverable, meaning our model will inherently revert to the baseline scenario as the baseline is representative of the historical average over a longer period of time.
Allowances for credit losses are maintained at a level we believe is adequate to absorb current expected lifetime credit losses. Our periodic evaluation of the adequacy of the allowances for credit losses is based on historical 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, reasonable and supportable forecasts about the future and other relevant factors.
Loans are considered impaired when it is probable that, based upon current information and events, we will be unable to collect all amounts due under the contractual terms of the loan agreement. When we determine that a loan is impaired, a specific allowance for credit losses is established for the excess carrying value of the loan over its estimated value. The loan’s estimated value is based on: 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 loan’s collateral.
Mortgage loans on real estate are presented net of the allowance for credit losses on our Consolidated Balance Sheets. Changes in the allowance are reported in realized gain (loss) on our Consolidated Statements of Comprehensive Income (Loss). Mortgage loans on real estate deemed uncollectible are charged against the allowance, and subsequent recoveries, if any, are credited to the allowance, limited to the aggregate of amounts previously charged-off and expected to be charged-off.
Determination of Credit Losses on Commercial Mortgage Loans on Real Estate
Our commercial loan portfolio is primarily comprised of long-term loans secured by existing commercial real estate. We believe all of the commercial loans in our portfolio share three primary risks: borrower credit worthiness; sustainability of the cash flow of the property; and market risk; therefore, our methods of monitoring and assessing credit risk are consistent for our entire portfolio.
For our commercial mortgage loan portfolio, trends in market vacancy and rental rates are incorporated into the analysis that we perform for monitored loans and may contribute to the establishment of (or an increase or decrease in) an allowance for credit losses. In addition, we review each loan individually in our commercial mortgage loan portfolio on an annual basis to identify emerging risks. We focus on properties that experienced a reduction in debt-service coverage or that have significant exposure to tenants with deteriorating credit profiles. Where warranted, we establish or increase an allowance for credit losses for a specific loan based upon this analysis.
We measure and assess the credit quality of our commercial mortgage loans by using loan-to-value and debt-service coverage ratios. The loan-to-value ratio compares the principal amount of the loan to the fair value at origination of the underlying property collateralizing the loan and is commonly expressed as a percentage. Loan-to-value ratios greater than 100% indicate that the principal amount is greater than the collateral value. Therefore, all else being equal, a lower loan-to-value ratio generally indicates a higher quality loan. The debt-service coverage ratio compares a property’s net operating income to its debt-service payments. Debt-service coverage ratios of less than 1.0 indicate that property operations do not generate enough income to cover its current debt payments. Therefore, all else being equal, a higher debt-service coverage ratio generally indicates a higher quality loan. These credit quality metrics are monitored and reviewed at least annually.
For our commercial mortgage loans, there was one specifically identified impaired loan with a carrying value of less than $1 million as of September 30, 2020, and December 31, 2019.
Most of our off-balance sheet commitments relate to commercial mortgage loans. As such, the estimate is developed based on the commercial mortgage loan process outlined above, along with an internally developed conversion factor.
Determination of Credit Losses on Residential Mortgage Loans on Real Estate
Our residential loan portfolio is primarily comprised of first lien mortgages secured by existing residential real estate. Residential mortgage loans are primarily smaller-balance homogenous loans that share similar risk characteristics. Therefore, these pools of loans are collectively evaluated for inherent credit losses. Such evaluations consider numerous factors, including, but not limited to borrower credit scores, collateral values, loss forecasts, geographic location, delinquency rates and economic trends. These evaluations and assessments are revised as conditions change and new information becomes available, including updated forecasts, which can cause the allowances for credit losses to increase or decrease over time as such evaluations are revised. Generally, residential mortgage loan pools exclude loans that are nonperforming as those loans are evaluated individually using the evaluation framework for specific allowances for credit losses described above.
For residential mortgage loans, our primary credit quality indicator is whether the loan is performing or nonperforming. We generally define nonperforming residential mortgage loans as those that are 90 or more days past due and/or in nonaccrual status. There is generally a higher risk of experiencing credit losses when a residential mortgage loan is nonperforming. We monitor and update aging schedules and nonaccrual status on a monthly basis.
For our residential mortgage loans, there were 74 specifically identified impaired loans with an aggregate carrying value of $35 million as of September 30, 2020. There were 4 specifically identified impaired loans with an aggregate carrying value of $1 million as of December 31, 2019.
Additional information related to impaired mortgage loans on real estate (in millions) was as follows:
For the Three | For the Nine | |||||||||||
Months Ended | Months Ended | |||||||||||
September 30, | September 30, | |||||||||||
2020 | 2019 | 2020 | 2019 | |||||||||
Average carrying value for impaired mortgage loans on real estate | $ | 31 | $ | - | $ | 17 | $ | - | ||||
Interest income recognized on impaired mortgage loans on real estate | - | - | - | - | ||||||||
Interest income collected on impaired mortgage loans on real estate | - | - | - | - | ||||||||
The amortized cost of mortgage loans on real estate on nonaccrual status (in millions) was as follows:
As of September 30, 2020 | As of January 1, 2020 | |||||||||||
Nonaccrual | Nonaccrual | |||||||||||
with no | with no | |||||||||||
Allowance | Allowance | |||||||||||
for Credit | for Credit | |||||||||||
Losses | Nonaccrual | Losses | Nonaccrual | |||||||||
Commercial mortgage loans on real estate | $ | - | $ | - | $ | - | $ | - | ||||
Residential mortgage loans on real estate | - | 82 | - | 17 | ||||||||
Total | $ | - | $ | 82 | $ | - | $ | 17 |
We use loan-to-value and debt-service coverage ratios as credit quality indicators for our commercial mortgage loans on real estate (dollars in millions) as follows:
As of September 30, 2020 | As of December 31, 2019 | |||||||||||||
Debt- | Debt- | |||||||||||||
Service | Service | |||||||||||||
Amortized | % of | Coverage | Amortized | % of | Coverage | |||||||||
Loan-to-Value Ratio | Cost | Total | Ratio | Cost | Total | Ratio | ||||||||
Less than 65% | $ | 14,599 | 91.8% | 2.43 | $ | 14,121 | 91.0% | 2.35 | ||||||
65% to 74% | 1,268 | 8.0% | 1.82 | 1,389 | 9.0% | 1.88 | ||||||||
75% to 100% | 36 | 0.2% | 1.24 | 1 | 0.0% | 1.09 | ||||||||
Total | $ | 15,903 | 100.0% | $ | 15,511 | 100.0% |
The amortized cost of commercial mortgage loans on real estate (in millions) by year of origination and credit quality indicator was as follows:
As of September 30, 2020 | ||||||||||||||||||
Debt- | Debt- | Debt- | ||||||||||||||||
Service | Service | Service | ||||||||||||||||
Less | Coverage | 65% | Coverage | 75% | Coverage | |||||||||||||
than 65% | Ratio | to 74% | Ratio | to 100% | Ratio | Total | ||||||||||||
Origination Year | ||||||||||||||||||
2020 | $ | 951 | 3.29 | $ | 85 | 1.67 | $ | - | - | $ | 1,036 | |||||||
2019 | 2,933 | 2.30 | 448 | 1.74 | - | - | 3,381 | |||||||||||
2018 | 2,368 | 2.22 | 221 | 1.53 | - | - | 2,589 | |||||||||||
2017 | 1,797 | 2.33 | 170 | 2.62 | - | - | 1,967 | |||||||||||
2016 | 1,689 | 2.44 | 204 | 1.62 | 28 | 1.30 | 1,921 | |||||||||||
2015 and prior | 4,861 | 2.47 | 140 | 1.89 | 8 | 1.03 | 5,009 | |||||||||||
Total | $ | 14,599 | $ | 1,268 | $ | 36 | $ | 15,903 |
We use loan performance status as the primary credit quality indicator for our residential mortgage loans on real estate (dollars in millions) as follows:
As of September 30, 2020 | As of December 31, 2019 | |||||||||
Amortized | % of | Amortized | % of | |||||||
Performance Indicator | Cost | Total | Cost (1) | Total | ||||||
Performing | $ | 648 | 88.8% | $ | 718 | 97.7% | ||||
Nonperforming | 82 | 11.2% | 17 | 2.3% | ||||||
Total | $ | 730 | 100.0% | $ | 735 | 100.0% | ||||
(1)A valuation allowance of $2 million was established on residential mortgage loans on real estate as of December 31, 2019.
The amortized cost of residential mortgage loans on real estate (in millions) by year of origination and credit quality indicator was as follows:
As of September 30, 2020 | |||||||||||
Performing | Nonperforming | Total | |||||||||
Origination Year | |||||||||||
2020 | $ | 125 | $ | 8 | $ | 133 | |||||
2019 | 338 | 58 | 396 | ||||||||
2018 | 185 | 16 | 201 | ||||||||
2017 | - | - | - | ||||||||
2016 | - | - | - | ||||||||
2015 and prior | - | - | - | ||||||||
Total | $ | 648 | $ | 82 | $ | 730 |
Changes in the allowance for credit losses on mortgage loans on real estate (in millions) were as follows:
For the Three | For the Nine | |||||||||||||||||
Months Ended | Months Ended | |||||||||||||||||
September 30, 2020 | September 30, 2020 | |||||||||||||||||
Commercial | Residential | Total | Commercial | Residential | Total | |||||||||||||
Balance as of beginning-of-period | $ | 234 | $ | 37 | $ | 271 | $ | - | $ | 2 | $ | 2 | ||||||
Impact of adopting ASU 2016-13 | - | - | - | 61 | 26 | 87 | ||||||||||||
Additions from provision for credit | ||||||||||||||||||
loss expense (1) | - | - | - | 173 | 9 | 182 | ||||||||||||
Additions from purchases of PCD | ||||||||||||||||||
mortgage loans on real estate | - | - | - | - | - | - | ||||||||||||
Additions (reductions) for mortgage | ||||||||||||||||||
loans on real estate for which credit | ||||||||||||||||||
losses were previously recognized | (63 | ) | (7 | ) | (70 | ) | (63 | ) | (7 | ) | (70 | ) | ||||||
Balance as of end-of-period (2) | $ | 171 | $ | 30 | $ | 201 | $ | 171 | $ | 30 | $ | 201 |
(1)Due to recent improving economic projections, the provision for credit loss expense decreased by $70 million for the three months ended September 30, 2020. Due to changes in economic projections driven by the impact of the COVID-19 pandemic, the provision for credit loss expense increased by $112 million for the nine months ended September 30, 2020. For the three months ended September 30, 2020, we recognized 0 credit loss expense related to unfunded commitments for mortgage loans on real estate, and we had 0 realized losses for disposals of mortgage loans on real estate. For the nine months ended September 30, 2020, we recognized $1 million of credit loss benefit related to unfunded commitments for mortgage loans on real estate, and we had $1 million of realized losses for disposals of mortgage loans on real estate.
(2)Accrued interest receivable on mortgage loans on real estate totaled $50 million as of September 30, 2020, and was excluded from the estimate of credit losses.
There were 0 changes in the allowance for credit losses associated with impaired commercial mortgage loans on real estate for the three and nine months ended September 30, 2019.
Alternative Investments
As of September 30, 2020, and December 31, 2019, alternative investments included investments in 270 and 256 different partnerships, respectively, and represented approximately 1% of our total investments.
Impairments on Fixed Maturity AFS Securities
Details underlying credit loss expense incurred as a result of impairments that were recognized in net income (loss) and included in realized gain (loss) on fixed maturity AFS securities (in millions) were as follows:
For the Three | For the Nine | |||||||||||
Months Ended | Months Ended | |||||||||||
September 30, | September 30, | |||||||||||
2020 | 2019 | 2020 | 2019 | |||||||||
Credit Loss Expense Recognized in Net Income (Loss) (1) | ||||||||||||
Fixed maturity AFS securities: | ||||||||||||
Corporate bonds | $ | (2 | ) | $ | (2 | ) | $ | (21 | ) | $ | (12 | ) |
RMBS | - | - | (1 | ) | (1 | ) | ||||||
ABS | 1 | - | - | (1 | ) | |||||||
Gross credit loss expense recognized in net income (loss) | (1 | ) | (2 | ) | (22 | ) | (14 | ) | ||||
Associated amortization of DAC, VOBA, DSI and DFEL | - | - | 1 | 1 | ||||||||
Net credit loss expense recognized in net income (loss) | $ | (1 | ) | $ | (2 | ) | $ | (21 | ) | $ | (13 | ) |
(1) For the three and nine months ended September 30, 2020, we recognized credit loss expense incurred and write-downs taken as a result of impairments through net income (loss), pursuant to ASU 2016-13. For the three and nine months ended September 30, 2019, prior to the adoption of ASU 2016-13, we recognized write-downs taken as a result of OTTI through net income (loss).
During the three months ended September 30, 2019, we recorded no OTTI recognized in OCI. During the nine months ended September 30, 2019, we recorded $13 million of OTTI recognized in OCI.
Payables for Collateral on Investments
The carrying value of the payables for collateral on investments included on our Consolidated Balance Sheets and the fair value of the related investments or collateral (in millions) consisted of the following:
As of September 30, 2020 | As of December 31, 2019 | ||||||||||
Carrying | Fair | Carrying | Fair | ||||||||
Value | Value | Value | Value | ||||||||
Collateral payable for derivative investments (1) | $ | 3,172 | $ | 3,172 | $ | 1,383 | $ | 1,383 | |||
Securities pledged under securities lending agreements (2) | 131 | 127 | 114 | 110 | |||||||
Investments pledged for Federal Home Loan Bank of | |||||||||||
Indianapolis (“FHLBI”) (3) | 3,130 | 5,029 | 3,580 | 5,480 | |||||||
Total payables for collateral on investments | $ | 6,433 | $ | 8,328 | $ | 5,077 | $ | 6,973 |
(1)We obtain collateral based upon contractual provisions with our counterparties. These agreements take into consideration the counterparties’ credit rating as compared to ours, the fair value of the derivative investments and specified thresholds that if exceeded result in the receipt of cash that is typically invested in cash and invested cash. See Note 5 for additional information.
(2)Our pledged securities under securities lending agreements are included in fixed maturity AFS securities on our Consolidated Balance Sheets. We generally obtain collateral in an amount equal to 102% and 105% of the fair value of the domestic and foreign securities, respectively. We value collateral daily and obtain additional collateral when deemed appropriate. The cash received in our securities lending program is typically invested in cash and invested cash or fixed maturity AFS securities.
(3)Our pledged investments for FHLBI are included in fixed maturity AFS securities and mortgage loans on real estate on our Consolidated Balance Sheets. The collateral requirements are generally 105% to 115% of the fair value for fixed maturity AFS securities and 155% to 175% of the fair value for mortgage loans on real estate. The cash received in these transactions is primarily invested in cash and invested cash or fixed maturity AFS securities.
Increase (decrease) in payables for collateral on investments (in millions) consisted of the following:
For the Nine | |||||||
Months Ended | |||||||
September 30, | |||||||
2020 | 2019 | ||||||
Collateral payable for derivative investments | $ | 1,789 | $ | 1,072 | |||
Securities pledged under securities lending agreements | 17 | 19 | |||||
Securities pledged under repurchase agreements | - | (2 | ) | ||||
Investments pledged for FHLBI | (450 | ) | (350 | ) | |||
Total increase (decrease) in payables for collateral on investments | $ | 1,356 | $ | 739 |
We have elected not to offset our securities lending transactions in our financial statements. The remaining contractual maturities of securities lending transactions accounted for as secured borrowings (in millions) were as follows:
As of September 30, 2020 | |||||||||||||||
Overnight and Continuous | Up to 30 Days | 30 - 90 Days | Greater Than 90 Days | Total | |||||||||||
Securities Lending | |||||||||||||||
Corporate bonds | $ | 127 | $ | - | $ | - | $ | - | $ | 127 | |||||
Foreign government bonds | 4 | - | - | - | 4 | ||||||||||
Total gross secured borrowings | $ | 131 | $ | - | $ | - | $ | - | $ | 131 |
As of December 31, 2019 | |||||||||||||||
Overnight and Continuous | Up to 30 Days | 30 - 90 Days | Greater Than 90 Days | Total | |||||||||||
Securities Lending | |||||||||||||||
Corporate bonds | $ | 114 | $ | - | $ | - | $ | - | $ | 114 | |||||
Total gross secured borrowings | $ | 114 | $ | - | $ | - | $ | - | $ | 114 |
We accept collateral in the form of securities in connection with repurchase agreements. In instances where we are permitted to sell or re-pledge the securities received, we report the fair value of the collateral received and a related obligation to return the collateral in the financial statements. In addition, we receive securities in connection with securities borrowing agreements that we are permitted to sell or re-pledge. As of September 30, 2020, the fair value of all collateral received that we are permitted to sell or re-pledge was $26 million. As of September 30, 2020, we have re-pledged none of this collateral to cover initial margin and over-the-counter collateral requirements on certain derivative investments.
Investment Commitments
As of September 30, 2020, our investment commitments were $1.6 billion, which included $1.1 billion of LPs, $343 million of private placement securities and $159 million of mortgage loans on real estate.
Concentrations of Financial Instruments
As of September 30, 2020, and December 31, 2019, our most significant investments in one issuer were our investments in securities issued by the Federal Home Loan Mortgage Corporation with a fair value of $1.2 and $1.3 billion, respectively, or 1% of total investments, and our investments in securities issued by the Federal National Mortgage Association with a fair value of $1.0 billion, or 1% of total investments. These concentrations include fixed maturity AFS, trading and equity securities.
As of September 30, 2020, and December 31, 2019, our most significant investments in one industry were our investments in securities in the financial services industry with a fair value of $20.8 billion and $18.2 billion, respectively, or 14% of total investments, and our investments in securities in the consumer non-cyclical industry with a fair value of $18.1 billion and $15.4 billion, respectively, or 12% of total investments. These concentrations include fixed maturity AFS, trading and equity securities.
5. Derivative Instruments
We maintain an overall risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate risk, foreign currency exchange risk, equity market risk, basis risk and credit risk. We assess these risks by continually identifying and monitoring changes in our exposures that may adversely affect expected future cash flows and by evaluating hedging opportunities.
Derivative activities are monitored by various management committees. The committees are responsible for overseeing the implementation of various hedging strategies that are developed through the analysis of financial simulation models and other internal and industry sources. The resulting hedging strategies are incorporated into our overall risk management strategies.
See Note 13 for additional disclosures related to the fair value of our derivative instruments.
Interest Rate Contracts
We use derivative instruments as part of our interest rate risk management strategy. These instruments are economic hedges unless otherwise noted and include:
Forward-Starting Interest Rate Swaps
We use forward-starting interest rate swaps designated and qualifying as cash flow hedges to hedge our exposure to interest rate fluctuations related to the forecasted purchases of certain assets.
We also use forward-starting interest rate swaps to hedge the interest rate exposure within our life products related to the forecasted purchases of certain assets.
Interest Rate Cap Corridors
We use interest rate cap corridors to provide a level of protection from the effect of rising interest rates for certain life insurance products and annuity contracts. Interest rate cap corridors involve purchasing an interest rate cap at a specific cap rate and selling an interest rate cap with a higher cap rate. For each corridor, the amount of quarterly payments, if any, is determined by the rate at which the underlying index rate resets above the original capped rate. The corridor limits the benefit the purchaser can receive as the related interest rate index rises above the higher capped rate. There is no additional liability to us other than the purchase price associated with the interest rate cap corridor.
Interest Rate Futures
We use interest rate futures contracts to hedge the liability exposure on certain options in variable annuity products. These futures contracts require payment between our counterparty and us on a daily basis for changes in the futures index price.
Interest Rate Swap Agreements
We use interest rate swap agreements to hedge the liability exposure on certain options in variable annuity products.
We also use interest rate swap agreements designated and qualifying as cash flow hedges to hedge the interest rate risk of floating-rate bond coupon payments by replicating a fixed-rate bond.
Finally, we use interest rate swap agreements designated and qualifying as fair value hedges to hedge against changes in the fair value of certain fixed maturity securities due to interest rate risks.
Reverse Treasury Locks
We use reverse treasury locks designated and qualifying as cash flow hedges to hedge the interest rate exposure related to the anticipated purchase of fixed-rate securities or the anticipated future cash flows of floating-rate fixed maturity securities due to changes in interest rates. These derivatives are primarily structured to hedge interest rate risk inherent in the assumptions used to price certain liabilities.
Foreign Currency Contracts
We use derivative instruments as part of our foreign currency risk management strategy. These instruments are economic hedges unless otherwise noted and include:
Currency Futures
We use currency futures to hedge foreign exchange risk associated with certain options in variable annuity products. Currency futures exchange one currency for another at a specified date in the future at a specified exchange rate.
Foreign Currency Swaps
We use foreign currency swaps to hedge foreign exchange risk of investments in fixed maturity securities denominated in foreign currencies. A foreign currency swap is a contractual agreement to exchange one currency for another at specified dates in the future at a specified exchange rate.
We also use foreign currency swaps designated and qualifying as cash flow hedges to hedge foreign exchange risk of investments in fixed maturity securities denominated in foreign currencies.
Foreign Currency Forwards
We use foreign currency forwards to hedge foreign exchange risk of investments in fixed maturity securities denominated in foreign currencies. A foreign currency forward is a contractual agreement to exchange one currency for another at specified dates in the future at a specified current exchange rate.
Equity Market Contracts
We use derivative instruments as part of our equity market risk management strategy that are economic hedges and include:
Call Options Based on the S&P 500 Index and Other Indices
We use call options to hedge the liability exposure on certain options in variable annuity products.
Our indexed annuity and IUL contracts permit the holder to elect an interest rate return or an equity market component, where interest credited to the contracts is linked to the performance of the S&P 500 Index or other indices. Contract holders may elect to rebalance index options at renewal dates. At the end of each indexed term, which can be up to six years, we have the opportunity to re-price the indexed component by establishing participation rates, caps, spreads and specified rates, subject to contractual guarantees. We use call options that are highly correlated to the portfolio allocation decisions of our contract holders, such that we are economically hedged with respect to equity returns for the current reset period.
Consumer Price Index Swaps
We use consumer price index swaps to hedge the liability exposure on certain options in fixed annuity products. Consumer price index swaps are contracts entered into at no cost and whose payoff is the difference between the consumer price index inflation rate and the fixed-rate determined as of inception.
Equity Futures
We use equity futures contracts to hedge the liability exposure on certain options in variable annuity products. These futures contracts require payment between our counterparty and us on a daily basis for changes in the futures index price.
Put Options
We use put options to hedge the liability exposure on certain options in variable annuity products. Put options are contracts that require counterparties to pay us at a specified future date the amount, if any, by which a specified equity index is less than the strike rate stated in the agreement, applied to a notional amount.
Total Return Swaps
We use total return swaps to hedge the liability exposure on certain options in variable annuity products.
In addition, we use total return swaps to hedge a portion of the liability related to our deferred compensation plans. We receive the total return on a portfolio of indexes and pay a floating-rate of interest.
Credit Contracts
We use derivative instruments as part of our credit risk management strategy that are economic hedges and include:
Credit Default Swaps – Buying Protection
We use credit default swaps to hedge the liability exposure on certain options in variable annuity products.
We buy credit default swaps to hedge against a drop in bond prices due to credit concerns of certain bond issuers. A credit default swap allows us to put the bond back to the counterparty at par upon a default event by the bond issuer. A default event is defined as bankruptcy, failure to pay, obligation acceleration or restructuring.
Credit Default Swaps – Selling Protection
We use credit default swaps to hedge the liability exposure on certain options in variable annuity products.
We sell credit default swaps to offer credit protection to contract holders and investors. The credit default swaps hedge the contract holders and investors against a drop in bond prices due to credit concerns of certain bond issuers. A credit default swap allows the investor to put the bond back to us at par upon a default event by the bond issuer. A default event is defined as bankruptcy, failure to pay, obligation acceleration or restructuring.
Embedded Derivatives
We have embedded derivatives that include:
GLB Reserves Embedded Derivatives
Certain features of these guarantees have elements of both insurance benefits accounted for under the Financial Services – Insurance – Claim Costs and Liabilities for Future Policy Benefits Subtopic of the FASB ASC (“benefit reserves”) and embedded derivatives accounted for under the Derivatives and Hedging and the Fair Value Measurements and Disclosures Topics of the FASB ASC (“embedded derivative reserves”). We calculate the value of the benefit reserves and the embedded derivative reserves based on the specific characteristics of each guaranteed living benefit (“GLB”) feature.
We use a hedging strategy designed to mitigate the risk and income statement volatility caused by changes in the equity markets, interest rates and volatility associated with GLBs offered in our variable annuity products, including products with guaranteed withdrawal benefit (“GWB”) and guaranteed income benefit (“GIB”) features. These GLB features are reinsured among various reinsurance counterparties on a coinsurance basis. We cede a portion of the GLB features to Lincoln National Reinsurance Company (Barbados) Limited (“LNBAR”), a wholly-owned subsidiary of LNC, on a funds withheld coinsurance basis. The funds withheld arrangement includes a dynamic hedging strategy designed to mitigate selected risks. Changes in the value of the hedge contracts due to changes in equity markets, interest rates and implied volatilities hedge the income statement effect of changes in embedded derivative GLB reserves assumed by LNBAR caused by those same factors. We rebalance our hedge positions based upon changes in these factors as needed. While we actively manage our hedge positions, these hedge positions may not be totally effective in offsetting changes in the embedded derivative reserve assumed by LNBAR due to, among other things, differences in timing between when a market exposure changes and corresponding changes to the hedge positions, extreme swings in the equity markets and interest rates, market volatility, contract holder behavior, divergence between the performance of the underlying funds and the hedging indices, divergence between the actual and expected performance of the hedge instruments and our ability to purchase hedging instruments at prices consistent with our desired risk and return trade-off. However, the hedging results do not impact LNL due to a funds withheld agreement with LNBAR, which causes the financial impact of the derivatives, as well as the cash flow activity, to be reflected on LNBAR.
Indexed Annuity and IUL Contracts Embedded Derivatives
Our indexed annuity and IUL contracts permit the holder to elect an interest rate return or an equity market component, where interest credited to the contracts is linked to the performance of the S&P 500 Index or other indices. Contract holders may elect to rebalance index options at renewal dates. At the end of each indexed term, we have the opportunity to re-price the indexed component by establishing participation rates, caps, spreads and specified rates, subject to contractual guarantees. We use options that are highly correlated to the portfolio allocation decisions of our contract holders, such that we are economically hedged with respect to equity returns for the current reset period.
Reinsurance Related Embedded Derivatives
We have certain modified coinsurance (“Modco”) and coinsurance with funds withheld reinsurance agreements with embedded derivatives related to the withheld assets of the related funds. These derivatives are considered total return swaps with contractual returns that are attributable to various assets and liabilities associated with these reinsurance agreements.
We have derivative instruments with off-balance-sheet risks whose notional or contract amounts exceed the related credit exposure. Outstanding derivative instruments with off-balance-sheet risks (in millions) were as follows:
As of September 30, 2020 | As of December 31, 2019 | |||||||||||||||||
Notional | Fair Value | Notional | Fair Value | |||||||||||||||
Amounts | Asset | Liability | Amounts | Asset | Liability | |||||||||||||
Qualifying Hedges | ||||||||||||||||||
Cash flow hedges: | ||||||||||||||||||
Interest rate contracts (1) | $ | 1,234 | $ | 169 | $ | 2 | $ | 1,174 | $ | 108 | $ | 12 | ||||||
Foreign currency contracts (1) | 2,871 | 320 | 36 | 2,874 | 191 | 51 | ||||||||||||
Total cash flow hedges | 4,105 | 489 | 38 | 4,048 | 299 | 63 | ||||||||||||
Fair value hedges: | ||||||||||||||||||
Interest rate contracts (1) | 530 | - | 301 | 546 | - | 202 | ||||||||||||
Non-Qualifying Hedges | ||||||||||||||||||
Interest rate contracts (1) | 131,973 | 1,752 | 142 | 112,921 | 1,082 | 219 | ||||||||||||
Foreign currency contracts (1) | 239 | 3 | - | 262 | 1 | 3 | ||||||||||||
Equity market contracts (1) | 68,727 | 2,211 | 1,070 | 43,283 | 1,442 | 664 | ||||||||||||
Credit contracts (1) | 54 | - | - | 55 | - | - | ||||||||||||
Embedded derivatives: | ||||||||||||||||||
GLB direct (2) | - | - | 1,106 | - | 450 | - | ||||||||||||
GLB ceded (2) | - | 1,105 | - | - | 60 | 510 | ||||||||||||
Reinsurance related (3) | - | - | 476 | - | - | 375 | ||||||||||||
Indexed annuity and IUL contracts (2) (4) | - | 536 | 2,688 | - | 927 | 2,585 | ||||||||||||
Total derivative instruments | $ | 205,628 | $ | 6,096 | $ | 5,821 | $ | 161,115 | $ | 4,261 | $ | 4,621 |
(1)Reported in derivative investments and other liabilities on our Consolidated Balance Sheets.
(2)Reported in other assets and other liabilities on our Consolidated Balance Sheets.
(3)Reported in reinsurance related embedded derivatives on our Consolidated Balance Sheets.
(4)Reported in future contract benefits on our Consolidated Balance Sheets.
The maturity of the notional amounts of derivative instruments (in millions) was as follows:
Remaining Life as of September 30, 2020 | ||||||||||||||||||
Less Than | 1 – 5 | 6 – 10 | 11 – 30 | Over 30 | ||||||||||||||
1 Year | Years | Years | Years | Years | Total | |||||||||||||
Interest rate contracts (1) | $ | 14,583 | $ | 55,297 | $ | 27,601 | $ | 35,879 | $ | 377 | $ | 133,737 | ||||||
Foreign currency contracts (2) | 176 | 387 | 967 | 1,580 | - | 3,110 | ||||||||||||
Equity market contracts | 34,706 | 20,651 | 5,504 | 12 | 7,854 | 68,727 | ||||||||||||
Credit contracts | - | - | 54 | - | - | 54 | ||||||||||||
Total derivative instruments | ||||||||||||||||||
with notional amounts | $ | 49,465 | $ | 76,335 | $ | 34,126 | $ | 37,471 | $ | 8,231 | $ | 205,628 |
(1)As of September 30, 2020, the latest maturity date for which we were hedging our exposure to the variability in future cash flows for these instruments was July 1, 2022.
(2)As of September 30, 2020, the latest maturity date for which we were hedging our exposure to the variability in future cash flows for these instruments was June 17, 2050.
The following amounts (in millions) were recorded on the Consolidated Balance Sheets related to cumulative basis adjustments for fair
value hedges:
Cumulative Fair Value | ||||||||||||||||
Hedging Adjustment | ||||||||||||||||
Included in the | ||||||||||||||||
Amortized Cost of the | Amortized Cost of the | |||||||||||||||
Hedged | Hedged | |||||||||||||||
Assets / (Liabilities) | Assets / (Liabilities) | |||||||||||||||
As of | As of | As of | As of | |||||||||||||
September 30, | December 31, | September 30, | December 31, | |||||||||||||
2020 | 2019 | 2020 | 2019 | |||||||||||||
Line Item in the Consolidated Balance Sheets in | ||||||||||||||||
which the Hedged Item is Included | ||||||||||||||||
AFS fixed maturity securities, at fair value | $ | 854 | $ | 776 | $ | 302 | $ | 202 |
The change in our unrealized gain (loss) on derivative instruments within accumulated other comprehensive income (loss) (“AOCI”) (in millions) was as follows:
For the Nine | ||||||
Months Ended | ||||||
September 30, | ||||||
2020 | 2019 | |||||
Unrealized Gain (Loss) on Derivative Instruments | ||||||
Balance as of beginning-of-year | $ | 181 | $ | 119 | ||
Other comprehensive income (loss): | ||||||
Unrealized holding gains (losses) arising during the period: | ||||||
Cash flow hedges: | ||||||
Interest rate contracts | 75 | 173 | ||||
Foreign currency contracts | 213 | 114 | ||||
Change in foreign currency exchange rate adjustment | (16 | ) | 80 | |||
Change in DAC, VOBA, DSI and DFEL | (70 | ) | (3 | ) | ||
Income tax benefit (expense) | (43 | ) | (77 | ) | ||
Less: | ||||||
Reclassification adjustment for gains (losses) | ||||||
included in net income (loss): | ||||||
Cash flow hedges: | ||||||
Interest rate contracts (1) | 2 | 2 | ||||
Foreign currency contracts (1) | 46 | 25 | ||||
Foreign currency contracts (2) | 6 | 9 | ||||
Associated amortization of DAC, VOBA, DSI and DFEL | (14 | ) | (1 | ) | ||
Income tax benefit (expense) | (8 | ) | (7 | ) | ||
Balance as of end-of-period | $ | 308 | $ | 378 |
(1)The OCI offset is reported within net investment income on our Consolidated Statements of Comprehensive Income (Loss).
(2)The OCI offset is reported within realized gain (loss) on our Consolidated Statements of Comprehensive Income (Loss).
The effects of qualifying and non-qualifying hedges (in millions) on the Consolidated Statements of Comprehensive Income (Loss) were as follows:
Gain (Loss) Recognized in Income | |||||||||||||
For the Three Months Ended September 30, | |||||||||||||
2020 | 2019 | ||||||||||||
Realized | Net | Realized | Net | ||||||||||
Gain | Investment | Gain | Investment | ||||||||||
(Loss) | Income | (Loss) | Income | ||||||||||
Total Line Items in which the Effects of | |||||||||||||
Fair Value or Cash Flow Hedges are Recorded | $ | (13 | ) | $ | 1,404 | (216 | ) | $ | 1,167 | ||||
Qualifying Hedges | |||||||||||||
Gain or (loss) on fair value hedging relationships: | |||||||||||||
Interest rate contracts: | |||||||||||||
Hedged items | - | (21 | ) | - | 44 | ||||||||
Derivatives designated as hedging instruments | - | 21 | - | (44 | ) | ||||||||
Gain or (loss) on cash flow hedging relationships: | |||||||||||||
Interest rate contracts: | |||||||||||||
Amount of gain or (loss) reclassified from AOCI into income | - | 1 | - | - | |||||||||
Foreign currency contracts: | |||||||||||||
Amount of gain or (loss) reclassified from AOCI into income | (2 | ) | 24 | 5 | 10 | ||||||||
Non-Qualifying Hedges | |||||||||||||
Interest rate contracts | (374 | ) | - | 698 | - | ||||||||
Equity market contracts | 949 | - | 172 | - | |||||||||
Credit contracts | 1 | - | - | - | |||||||||
Embedded derivatives: | |||||||||||||
GLB | 4 | - | (1 | ) | - | ||||||||
Reinsurance related | (127 | ) | - | (156 | ) | - | |||||||
Indexed annuity and IUL contracts | (105 | ) | - | (23 | ) | - |
Gain (Loss) Recognized in Income | |||||||||||||
For the Nine Months Ended September 30, | |||||||||||||
2020 | 2019 | ||||||||||||
Realized | Net | Realized | Net | ||||||||||
Gain | Investment | Gain | Investment | ||||||||||
(Loss) | Income | (Loss) | Income | ||||||||||
Total Line Items in which the Effects of | |||||||||||||
Fair Value or Cash Flow Hedges are Recorded | $ | (448 | ) | $ | 3,834 | $ | (844 | ) | $ | 3,645 | |||
Qualifying Hedges | |||||||||||||
Gain or (loss) on fair value hedging relationships: | |||||||||||||
Interest rate contracts: | |||||||||||||
Hedged items | - | 100 | - | 101 | |||||||||
Derivatives designated as hedging instruments | - | (100 | ) | - | (101 | ) | |||||||
Gain or (loss) on cash flow hedging relationships: | |||||||||||||
Interest rate contracts: | |||||||||||||
Amount of gain or (loss) reclassified from AOCI into income | - | 2 | - | 2 | |||||||||
Foreign currency contracts: | |||||||||||||
Amount of gain or (loss) reclassified from AOCI into income | 6 | 46 | 9 | 25 | |||||||||
Non-Qualifying Hedges | |||||||||||||
Interest rate contracts | 1,795 | - | 1,624 | - | |||||||||
Equity market contracts | 565 | - | (241 | ) | - | ||||||||
Credit contracts | (4 | ) | - | - | - | ||||||||
Embedded derivatives: | |||||||||||||
GLB | (1 | ) | - | (1 | ) | - | |||||||
Reinsurance related | (141 | ) | - | (716 | ) | - | |||||||
Indexed annuity and IUL contracts | 396 | - | (372 | ) | - | ||||||||
As of September 30, 2020, $48 million of the deferred net gains (losses) on derivative instruments in AOCI were expected to be reclassified to earnings during the next 12 months. This reclassification would be due primarily to interest rate variances related to our interest rate swap agreements.
For the nine months ended September 30, 2020 and 2019, there were 0 material reclassifications to earnings due to hedged firm commitments no longer deemed probable or due to hedged forecasted transactions that had not occurred by the end of the originally specified time period.
As of September 30, 2020, we did not have any exposure related to credit default swaps for which we are the seller.
Information related to our credit default swaps for which we are the seller (dollars in millions) was as follows:
As of December 31, 2019 | ||||||||||||||||
Credit | ||||||||||||||||
Reason | Nature | Rating of | Number | Maximum | ||||||||||||
for | of | Underlying | of | Fair | Potential | |||||||||||
Credit Contract Type | Maturity | Entering | Recourse | Obligation (1) | Instruments | Value (2) | Payout | |||||||||
Basket credit default swaps | 12/20/2024 | (3) | (4) | BBB+ | 1 | $ | 1 | $ | 55 |
(1)Represents average credit ratings based on the midpoint of the applicable ratings among Moody’s, S&P and Fitch Ratings, as scaled to the corresponding S&P ratings.
(2)Broker quotes are used to determine the market value of our credit default swaps.
(3)Credit default swaps were entered into in order to hedge the liability exposure on certain variable annuity products.
(4)Sellers do not have the right to demand indemnification or compensation from third parties in case of a loss (payment) on the contract.
Details underlying the associated collateral of our credit default swaps for which we are the seller if credit risk-related contingent features were triggered (in millions) were as follows:
As of | As of | |||||||
September 30, | December 31, | |||||||
2020 | 2019 | |||||||
Maximum potential payout | $ | - | $ | 55 | ||||
Less: Counterparty thresholds | - | - | ||||||
Maximum collateral potentially required to post | $ | - | $ | 55 |
Certain of our credit default swap agreements contain contractual provisions that allow for the netting of collateral with our counterparties related to all of our collateralized financing transactions that we have outstanding. If these netting agreements were not in place, we would have been required to post collateral if the market value was less than zero.
Credit Risk
We are exposed to credit losses in the event of non-performance by our counterparties on various derivative contracts and reflect assumptions regarding the credit or non-performance risk (“NPR”). The NPR is based upon assumptions for each counterparty’s credit spread over the estimated weighted average life of the counterparty exposure, less collateral held. As of September 30, 2020, the NPR adjustment was 0. The credit risk associated with such agreements is minimized by entering into agreements with financial institutions with long-standing, superior performance records. Additionally, we maintain a policy of requiring derivative contracts to be governed by an International Swaps and Derivatives Association (“ISDA”) Master Agreement. We are required to maintain minimum ratings as a matter of routine practice in negotiating ISDA agreements. Under some ISDA agreements, we and LLANY have agreed to maintain certain financial strength or claims-paying ratings. A downgrade below these levels could result in termination of derivative contracts, at which time any amounts payable by us would be dependent on the market value of the underlying derivative contracts. In certain transactions, we and the counterparty have entered into a credit support annex requiring either party to post collateral when net exposures exceed pre-determined thresholds. These thresholds vary by counterparty and credit rating. The amount of such exposure is essentially the net replacement cost or market value less collateral held for such agreements with each counterparty if the net market value is in our favor. We did 0t have any exposure as of September 30, 2020, or December 31, 2019.
The amounts recognized (in millions) by S&P credit rating of counterparty, for which we had the right to reclaim cash collateral or were obligated to return cash collateral, were as follows:
As of September 30, 2020 | As of December 31, 2019 | ||||||||||||
Collateral | Collateral | Collateral | Collateral | ||||||||||
Posted by | Posted by | Posted by | Posted by | ||||||||||
S&P | Counter- | LNL | Counter- | LNL | |||||||||
Credit | Party | (Held by | Party | (Held by | |||||||||
Rating of | (Held by | Counter- | (Held by | Counter- | |||||||||
Counterparty | LNL) | Party) | LNL) | Party) | |||||||||
AA- | $ | 818 | $ | (1 | ) | $ | 441 | $ | (22 | ) | |||
A+ | 1,648 | (98 | ) | 549 | (168 | ) | |||||||
A | 45 | - | 36 | - | |||||||||
A- | 661 | - | 355 | - | |||||||||
$ | 3,172 | $ | (99 | ) | $ | 1,381 | $ | (190 | ) |
Balance Sheet Offsetting
Information related to the effects of offsetting (in millions) was as follows:
As of September 30, 2020 | ||||||||||||
Embedded | ||||||||||||
Derivative | Derivative | |||||||||||
Instruments | Instruments | Total | ||||||||||
Financial Assets | ||||||||||||
Gross amount of recognized assets | $ | 4,455 | $ | 1,641 | $ | 6,096 | ||||||
Gross amounts offset | (1,220 | ) | - | (1,220 | ) | |||||||
Net amount of assets | 3,235 | 1,641 | 4,876 | |||||||||
Gross amounts not offset: | ||||||||||||
Cash collateral | (3,172 | ) | - | (3,172 | ) | |||||||
Non-cash collateral | (48 | ) | - | (48 | ) | |||||||
Net amount | $ | 15 | $ | 1,641 | $ | 1,656 | ||||||
Financial Liabilities | ||||||||||||
Gross amount of recognized liabilities | $ | 592 | $ | 4,270 | $ | 4,862 | ||||||
Gross amounts offset | - | - | - | |||||||||
Net amount of liabilities | 592 | 4,270 | 4,862 | |||||||||
Gross amounts not offset: | ||||||||||||
Cash collateral | (99 | ) | - | (99 | ) | |||||||
Non-cash collateral | - | - | - | |||||||||
Net amount | $ | 493 | $ | 4,270 | $ | 4,763 |
As of December 31, 2019 | ||||||||||||
Embedded | ||||||||||||
Derivative | Derivative | |||||||||||
Instruments | Instruments | Total | ||||||||||
Financial Assets | ||||||||||||
Gross amount of recognized assets | $ | 2,619 | $ | 1,437 | $ | 4,056 | ||||||
Gross amounts offset | (708 | ) | - | (708 | ) | |||||||
Net amount of assets | 1,911 | 1,437 | 3,348 | |||||||||
Gross amounts not offset: | ||||||||||||
Cash collateral | (1,381 | ) | - | (1,381 | ) | |||||||
Non-cash collateral | (242 | ) | - | (242 | ) | |||||||
Net amount | $ | 288 | $ | 1,437 | $ | 1,725 | ||||||
Financial Liabilities | ||||||||||||
Gross amount of recognized liabilities | $ | 771 | $ | 3,470 | $ | 4,241 | ||||||
Gross amounts offset | (15 | ) | - | (15 | ) | |||||||
Net amount of liabilities | 756 | 3,470 | 4,226 | |||||||||
Gross amounts not offset: | ||||||||||||
Cash collateral | (190 | ) | - | (190 | ) | |||||||
Non-cash collateral | - | - | - | |||||||||
Net amount | $ | 566 | $ | 3,470 | $ | 4,036 |
6. Federal Income Taxes
The effective tax rate is the ratio of tax expense (benefit) over pre-tax income (loss). The effective tax rate was 29% and 137% for the three and nine months ended September 30, 2020, respectively. The effective tax rate was 33% for the three months ended September 30, 2019, and was not considered meaningful for the nine months ended September 30, 2019. The effective tax rate on pre-tax income is typically lower than the prevailing corporate federal income tax rate of 21% due to benefits from preferential tax items including the separate accounts dividends-received deduction (“DRD”) and tax credits.
For the three and nine months ended September 30, 2020, the effective tax rate differed from the prevailing corporate federal income tax rate due primarily to the effects of preferential tax items being additive to the tax benefit at 21% on pre-tax losses.
For the three months ended September 30, 2019, the effective tax rate differed from the prevailing corporate federal income tax rate due primarily to the effects of preferential tax items being additive to the tax benefit at 21% on pre-tax losses. For the nine months ended September 30, 2019, losses reduced pre-tax income to a level that, when computing tax expense at the prevailing corporate federal income tax rate of 21% and then adding the effects of preferential tax items, produced a tax benefit that then resulted in a non-meaningful negative effective tax rate based on the relationship between tax benefit and pre-tax income.
7. Reinsurance
Adoption of ASU 2016-13
In 2020, we adopted ASU 2016-13, which resulted in a new recognition and measurement of credit losses on most financial assets. See Note 2 for additional information. We established an allowance for credit losses of $190 million as of January 1, 2020, for reinsurance-related assets for the risk of credit losses inherent in reinsurance transactions. We estimated an allowance for credit losses for all reinsurance recoverables and related reinsurance deposit assets held by our subsidiaries. As such, we performed a quantitative analysis using a probability of loss approach to estimate expected credit losses for reinsurance recoverables, inclusive of similar assets recognized using the deposit method of accounting. The allowance for credit losses is a general allowance for pools of receivables with similar risk characteristics segmented by credit risk ratings and receivables assessed on an individual basis that do not share similar risk characteristics where we anticipate a credit loss over the life of reinsurance-related assets.
Our model uses relevant internal or external historical loss information adjusted for current conditions and reasonable and supportable forecasts of future events and conditions in developing our loss estimate. We utilized historical credit rating data to form an estimation of probability of default of counterparties by means of a transition matrix that provides the rates of credit migration for credit ratings transitioning to impairment. We updated reinsurer credit ratings during the quarter to incorporate the most up-to-date information on the current state of the financial stability of our reinsurers. To simulate changes in economic conditions, we used positive, base and adverse scenarios that include varying levels of loss given default assumptions to reflect the impact of changes in severity of losses. We applied probability weights to the positive, base and adverse scenarios. For periods beyond our reasonable and supportable forecasts, we used implicit mean reversion over the remaining life of the recoverable. Additionally, we considered factors that impact our exposure at default
that are driven by actuarial expectations around term and mortality assumptions rather than being directly driven by market or economic environment.
Our model estimates the expected credit losses over the life of the reinsurance asset. Credit loss estimates are segmented based on counterparty credit risk. Our modeling process utilizes counterparty credit ratings, collateral types and amounts, and term and run-off assumptions. For reinsurance recoverables that do not share similar risk characteristics, we assessed on an individual basis to determine a specific allowance for credit losses.
We estimated expected credit losses over the contractual term of the recoverable, which is the period during which we are exposed to the credit risk. Reinsurance recoverables may not have explicit contractual lives, but are tied to the underlying insurance products; as a result, we estimated the contractual life by utilizing actuarial estimates of the timing of payouts related to those underlying products.
Reinsurance treaties often require the reinsurer to collateralize the recoverable with funds in a trust account for the benefit of the ceding insurance entity that can reduce the expected credit losses on a given treaty. As such, we review reinsurance collateral by individual treaty to sensitize risk of loss based on level of collateralization. This review is driven by the assumption that non-collateralized reinsurance recoverables would have materially higher losses in time of default. Therefore, reinsurance recoverables are pooled as either fully-collateralized or non-collateralized.
Reinsurance recoverables are presented net of the allowance for credit losses on our Consolidated Balance Sheets. Changes in the allowance for credit losses are reported in realized gain (loss) on our Consolidated Statements of Comprehensive Income (Loss). Reinsurance recoverables deemed uncollectible are charged against the allowance for credit losses, and subsequent recoveries, if any, are credited to the allowance for credit losses, limited to the aggregate of amounts previously charged-off and expected to be charged-off.
Modco Agreements
Some portions of our annuity business have been reinsured on a Modco basis with other companies. In a Modco agreement, we as the ceding company retain the reserves, as well as the assets backing those reserves, and the reinsurer shares proportionally in all financial terms of the reinsured policies based on their respective percentage of the risk. Effective October 1, 2018, we entered into one such Modco agreement with Athene Holding Ltd. (“Athene”) to reinsure fixed and fixed indexed annuity products, which resulted in a deposit asset of $5.9 billion and $6.6 billion as of September 30, 2020, and December 31, 2019, respectively, within other assets on our Consolidated Balance Sheets. We held assets in support of reserves associated with the transaction in a Modco investment portfolio, which consisted of the following (in millions):
As of | As of | ||||||||
September 30, | December 31, | ||||||||
2020 | 2019 | ||||||||
Fixed maturity AFS securities | $ | 1,630 | $ | 2,308 | |||||
Trading securities | 3,488 | 3,534 | |||||||
Equity securities | 17 | 14 | |||||||
Commercial mortgage loans | 794 | 698 | |||||||
Derivative investments | 95 | 130 | |||||||
Other investments | 116 | 94 | |||||||
Cash and invested cash | 117 | 62 | |||||||
Accrued investment income | 43 | 57 | |||||||
Other assets | 3 | - | |||||||
Total | $ | 6,303 | $ | 6,897 | |||||
In addition, the portfolio was supported by $186 million of over-collateralization and a $175 million letter of credit as of September 30, 2020.
8. Guaranteed Benefit Features
Information on the guaranteed death benefit (“GDB”) features outstanding (dollars in millions) was as follows:
As of | As of | ||||||||
September 30, | December 31, | ||||||||
2020 (1) | 2019 (1) | ||||||||
Return of Net Deposits | |||||||||
Total account value | $ | 101,215 | $ | 101,601 | |||||
Net amount at risk (2) | 156 | 71 | |||||||
Average attained age of contract holders | 66 years | 65 years | |||||||
Minimum Return | |||||||||
Total account value | $ | 91 | $ | 92 | |||||
Net amount at risk (2) | 13 | 13 | |||||||
Average attained age of contract holders | 78 years | 77 years | |||||||
Guaranteed minimum return | 5% | 5% | |||||||
Anniversary Contract Value | |||||||||
Total account value | $ | 25,348 | $ | 25,763 | |||||
Net amount at risk (2) | 497 | 384 | |||||||
Average attained age of contract holders | 72 years | 71 years |
(1)Our variable contracts with guarantees may offer more than one type of guarantee in each contract; therefore, the amounts listed are not mutually exclusive.
(2)Represents the amount of death benefit in excess of the account balance that is subject to market fluctuations.
The determination of GDB liabilities is based on models that involve a range of scenarios and assumptions, including those regarding expected market rates of return and volatility, contract surrender rates and mortality experience. The following summarizes the balances of and changes in the liabilities for GDBs (in millions), which were recorded in future contract benefits on our Consolidated Balance Sheets:
For the Nine | |||||||
Months Ended | |||||||
September 30, | |||||||
2020 | 2019 | ||||||
Balance as of beginning-of-year | $ | 117 | $ | 161 | |||
Changes in reserves | 46 | (16 | ) | ||||
Benefits paid | (21 | ) | (15 | ) | |||
Balance as of end-of-period | $ | 142 | $ | 130 | |||
Variable Annuity Contracts
Account balances of variable annuity contracts, including those with guarantees, (in millions) were invested in separate account investment options as follows:
As of | As of | ||||||||
September 30, | December 31, | ||||||||
2020 | 2019 | ||||||||
Asset Type | |||||||||
Domestic equity | $ | 63,423 | $ | 64,093 | |||||
International equity | 18,871 | 19,852 | |||||||
Fixed income | 41,175 | 41,405 | |||||||
Total | $ | 123,469 | $ | 125,350 | |||||
Percent of total variable annuity separate account values | 98% | 98% |
Secondary Guarantee Products
Future contract benefits and other contract holder funds include reserves for our secondary guarantee products sold through our Life Insurance segment. Reserves on UL and VUL products with secondary guarantees represented 36% and 35% of total life insurance in-force reserves as of September 30, 2020, and December 31, 2019, respectively. UL and VUL products with secondary guarantees represented 32% of total life insurance sales for the three and nine months ended September 30, 2020, compared to 25% and 28%, respectively, for the corresponding periods in 2019.
9. Liability for Unpaid Claims
The liability for unpaid claims consists primarily of long-term disability claims and is reported in future contract benefits on our Consolidated Balance Sheets. Changes in the liability for unpaid claims (in millions) were as follows:
For the Nine | ||||||
Months Ended | ||||||
September 30, | ||||||
2020 | 2019 | |||||
Balance as of beginning-of-year | $ | 5,552 | $ | 5,335 | ||
Reinsurance recoverable | 152 | 143 | ||||
Net balance as of beginning-of-year | 5,400 | 5,192 | ||||
Incurred related to: | ||||||
Current year | 2,615 | 2,370 | ||||
Prior years: | ||||||
Interest | 116 | 117 | ||||
All other incurred (1) | (157 | ) | (203 | ) | ||
Total incurred | 2,574 | 2,284 | ||||
Paid related to: | ||||||
Current year | (1,184 | ) | (1,046 | ) | ||
Prior years | (1,118 | ) | (1,091 | ) | ||
Total paid | (2,302 | ) | (2,137 | ) | ||
Net balance as of end-of-period | 5,672 | 5,339 | ||||
Reinsurance recoverable | 149 | 148 | ||||
Balance as of end-of-period | $ | 5,821 | $ | 5,487 |
(1)All other incurred is primarily impacted by the level of claim resolutions in the period compared to that which is expected by the reserve assumption. A negative number implies a favorable result where claim resolutions were more favorable than assumed. Our claim resolution rate assumption used in determining reserves is our expectation of the resolution rate we will experience over the long-term life of the block of claims. It will vary from actual experience in any one period, both favorably and unfavorably.
The interest rate assumption used for discounting long-term claim reserves is an important part of the reserving process due to the long benefit period for these claims. Interest accrued on prior years’ reserves has been calculated on the opening reserve balance less one-half of the prior years’ incurred claim payments at our average reserve discount rate.
Long-term disability benefits may extend for many years, and claim development schedules do not reflect these longer benefit periods. As a result, we use longer term retrospective runoff studies, experience studies and prospective studies to develop our liability estimates.
10. Contingencies and Commitments
Contingencies
Regulatory and Litigation Matters
Regulatory bodies, such as state insurance departments, the SEC, Financial Industry Regulatory Authority and other regulatory bodies regularly make inquiries and conduct examinations or investigations concerning our compliance with, among other things, insurance laws, securities laws, laws governing the activities of broker-dealers, registered investment advisers and unclaimed property laws.
LNL and its affiliates are involved in various pending or threatened legal or regulatory proceedings, including purported class actions, arising from the conduct of business both in the ordinary course and otherwise. In some of the matters, very large and/or indeterminate amounts, including punitive and treble damages, are sought. Modern pleading practice in the U.S. permits considerable variation in the assertion of monetary damages or other relief. Jurisdictions may permit claimants not to specify the monetary damages sought or may permit claimants to state only that the amount sought is sufficient to invoke the jurisdiction of the trial court. In addition, jurisdictions
may permit plaintiffs to allege monetary damages in amounts well exceeding verdicts obtained in the jurisdiction for similar matters. This variability in pleadings, together with the actual experiences of LNL in litigating or resolving through settlement numerous claims over an extended period of time, demonstrates to management that the monetary relief which may be specified in a lawsuit or claim bears little relevance to its merits or disposition value.
Due to the unpredictable nature of litigation, the outcome of a litigation matter and the amount or range of potential loss at particular points in time is normally difficult to ascertain. Uncertainties can include how fact finders will evaluate documentary evidence and the credibility and effectiveness of witness testimony, and how trial and appellate courts will apply the law in the context of the pleadings or evidence presented, whether by motion practice, or at trial or on appeal. Disposition valuations are also subject to the uncertainty of how opposing parties and their counsel will themselves view the relevant evidence and applicable law.
We establish liabilities for litigation and regulatory loss contingencies when information related to the loss contingencies shows both that it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. It is possible that some matters could require us to pay damages or make other expenditures or establish accruals in amounts that could not be estimated as of September 30, 2020. While the potential future charges could be material in the particular quarterly or annual periods in which they are recorded, based on information currently known by management, management does not believe any such charges are likely to have a material adverse effect on LNL’s financial condition.
For some matters, the Company is able to estimate a reasonably possible range of loss. For such matters in which a loss is probable, an accrual has been made. For such matters where a loss is believed to be reasonably possible, but not probable, no accrual has been made. Accordingly, the estimate contained in this paragraph reflects two types of matters. For some matters included within this estimate, an accrual has been made, but there is a reasonable possibility that an exposure exists in excess of the amount accrued. In these cases, the estimate reflects the reasonably possible range of loss in excess of the accrued amount. For other matters included within this estimation, no accrual has been made because a loss, while potentially estimable, is believed to be reasonably possible but not probable. In these cases, the estimate reflects the reasonably possible loss or range of loss. As of September 30, 2020, we estimate the aggregate range of reasonably possible losses, including amounts in excess of amounts accrued for these matters as of such date, to be up to approximately $90 million. Any estimate is not an indication of expected loss, if any, or of the Company’s maximum possible loss exposure on such matters.
For other matters, we are not currently able to estimate the reasonably possible loss or range of loss. We are often unable to estimate the possible loss or range of loss until developments in such matters have provided sufficient information to support an assessment of the range of possible loss, such as quantification of a damage demand from plaintiffs, discovery from other parties and investigation of factual allegations, rulings by the court on motions or appeals, analysis by experts and the progress of settlement negotiations. On a quarterly and annual basis, we review relevant information with respect to litigation contingencies and update our accruals, disclosures and estimates of reasonably possible losses or ranges of loss based on such reviews.
Certain reinsurers have sought rate increases on certain yearly renewable term treaties. We are disputing the requested rate increases under these treaties. We have initiated and will initiate arbitration proceedings, as necessary, under these treaties in order to protect our contractual rights. Additionally, reinsurers may initiate arbitration proceedings against us. We believe it is unlikely the outcome of these disputes will have a material adverse effect on our financial condition.
Cost of Insurance Litigation
Glover v. Connecticut General Life Insurance Company and The Lincoln National Life Insurance Company, filed in the U.S. District Court for the District of Connecticut, No. 3:16-cv-00827, is a putative class action that was served on LNL on June 8, 2016. Plaintiff is the owner of a universal life insurance policy who alleges that LNL charged more for non-guaranteed cost of insurance than permitted by the policy. Plaintiff seeks to represent all universal life and variable universal life policyholders who owned policies containing non-guaranteed cost of insurance provisions that are similar to those of Plaintiff’s policy and seeks damages on behalf of all such policyholders. On January 11, 2019, the court dismissed Plaintiff’s complaint in its entirety. In response, Plaintiff filed a motion for leave to amend the complaint, which we have opposed.
Hanks v. Lincoln Life & Annuity Company of New York (“LLANY”) and Voya Retirement Insurance and Annuity Company (“Voya”), filed in the U.S. District Court for the Southern District of New York, No. 1:16-cv-6399, is a putative class action that was served on LLANY on August 12, 2016. Plaintiff owns a universal life policy originally issued by Aetna (now Voya) and alleges that (i) Voya breached the terms of the policy when it increased non-guaranteed cost of insurance rates on Plaintiff’s policy; and (ii) LLANY, as reinsurer and administrator of Plaintiff’s policy, engaged in wrongful conduct related to the cost of insurance increase and was unjustly enriched as a result. Plaintiff seeks to represent all owners of Aetna life insurance policies that were subject to non-guaranteed cost of insurance rate increases in 2016 and seeks damages on their behalf. On March 13, 2019, the court issued an order granting plaintiff’s motion for class certification for the breach of contract claim and denying such motion with respect to the unjust enrichment claim against LLANY, and, on September 12, 2019, the court issued an order approving the parties’ joint stipulation of dismissal with respect to the unjust enrichment claim and dismissed LLANY as a defendant in the case. In light of LLANY’s role as reinsurer and administrator under the 1998 coinsurance agreement with Aetna (now Voya), and of the parties’ rights and obligations thereunder, LLANY continues to be actively engaged in the defense of this case. On September 30, 2020, the court denied plaintiff’s motion for summary judgment and
granted in part Voya’s motion for summary judgment. The court has not yet set a trial date, and we continue to vigorously defend this action.
EFG Bank AG, Cayman Branch, et al. v. The Lincoln National Life Insurance Company, pending in the U.S. District Court for the Eastern District of Pennsylvania, No. 2:17-cv-02592, is a civil action filed on February 1, 2017. Plaintiffs own Legend Series universal life insurance policies originally issued by Jefferson-Pilot (now LNL). Plaintiffs allege that LNL breached the terms of policyholders’ contracts when it increased non-guaranteed cost of insurance rates beginning in 2016. We are vigorously defending this matter.
In re: Lincoln National COI Litigation, pending in the U.S. District Court for the Eastern District of Pennsylvania, Master File No. 2:16-cv-06605-GJP, is a consolidated litigation matter related to multiple putative class action filings that were consolidated by an order dated March 20, 2017. In addition to consolidating a number of existing matters, the order also covers any future cases filed in the same district related to the same subject matter. Plaintiffs own universal life insurance policies originally issued by Jefferson-Pilot (now LNL). Plaintiffs allege that LNL and LNC breached the terms of policyholders’ contracts by increasing non-guaranteed cost of insurance rates beginning in 2016. Plaintiffs seek to represent classes of policyowners and seek damages on their behalf. We are vigorously defending this matter.
In re: Lincoln National 2017 COI Rate Litigation, Master File No. 2:17-cv-04150 is a consolidated litigation matter related to multiple putative class action filings that were consolidated by an order of the court in March 2018. Plaintiffs own universal life insurance policies originally issued by former Jefferson-Pilot (now LNL). Plaintiffs allege that LNL and LNC breached the terms of policyholders’ contracts by increasing non-guaranteed cost of insurance rates beginning in 2017. Plaintiffs seek to represent classes of policyholders and seek damages on their behalf. We are vigorously defending this matter.
TVPX ARS INC., as Securities Intermediary for Consolidated Wealth Management, LTD. v. The Lincoln National Life Insurance Company, filed in the U.S. District Court for the Eastern District of Pennsylvania, No. 2:18-cv-02989, is a putative class action that was filed on July 17, 2018. Plaintiff alleges that LNL charged more for non-guaranteed cost of insurance than permitted by the policy. Plaintiff seeks to represent all universal life and variable universal life policyholders who own policies issued by LNL or its predecessors containing non-guaranteed cost of insurance provisions that are similar to those of Plaintiff’s policy and seeks damages on behalf of all such policyholders. We are vigorously defending this matter.
LSH Co. and Wells Fargo Bank, National Association, as securities intermediary for LSH Co. v. Lincoln National Corporation and The Lincoln National Life Insurance Company, pending in the U.S. District Court for the Eastern District of Pennsylvania, No. 2:18-cv-05529, is a civil action filed on December 21, 2018. Plaintiffs own universal life insurance policies originally issued by Jefferson-Pilot (now LNL). Plaintiffs allege that LNL breached the terms of policyholders’ contracts when it increased non-guaranteed cost of insurance rates in 2016 and 2017. We are vigorously defending this matter.
Vida Longevity Fund, LP v. Lincoln Life & Annuity Company of New York, pending in the U.S. District Court for the Southern District of New York, No. 1:19-cv-06004, is a putative class action that was filed on June 27, 2019. Plaintiff alleges that LLANY charged more for non-guaranteed cost of insurance than was permitted by the policies. Plaintiff seeks to represent all current and former owners of universal life (including variable universal life) policies who own or owned policies issued by LLANY and its predecessors in interest that were in force at any time on or after June 27, 2013, and which contain non-guaranteed cost of insurance provisions that are similar to those of Plaintiff’s policies. Plaintiff also seeks to represent a sub-class of such policyholders who own or owned “life insurance policies issued in the State of New York.” Plaintiff seeks damages on behalf of the policyholder class and sub-class. We are vigorously defending this matter.
Other Litigation
Andrew Nitkewicz v. Lincoln Life & Annuity Company of New York, pending in the U.S. District Court for the Southern District of New York, No. 1:20-cv-06805, is a putative class action that was filed on August 24, 2020. Plaintiff Andrew Nitkewicz, as trustee of the Joan C. Lupe Trust, seeks to represent all current and former owners of universal life (including variable universal life) policies who own or owned policies issued by LLANY and its predecessors in interest that were in force at any time on or after June 27, 2013, and for which planned annual, semi-annual, or quarterly premiums were paid for any period beyond the end of the policy month of the insured’s death. Plaintiff alleges LLANY failed to refund unearned premium in violation of New York Insurance Law Section 3203(a)(2) in connection with the payment of death benefit claims for certain insurance policies. Plaintiff seeks compensatory damages and pre-judgment interest on behalf of the various classes and sub-class. We are vigorously defending this matter.
11. Shares and Stockholder’s Equity
All authorized and issued shares of LNL are owned by LNC.
AOCI
The following summarizes the components and changes in AOCI (in millions):
For the Nine | ||||||
Months Ended | ||||||
September 30, | ||||||
2020 | 2019 | |||||
Unrealized Gain (Loss) on AFS Securities | ||||||
Balance as of beginning-of-year | $ | 5,637 | $ | 536 | ||
Cumulative effect from adoption of new accounting standard | 40 | - | ||||
Unrealized holding gains (losses) arising during the period | 5,190 | 9,407 | ||||
Change in foreign currency exchange rate adjustment | 19 | (80 | ) | |||
Change in DAC, VOBA, DSI, future contract benefits and other contract holder funds | (2,392 | ) | (2,271 | ) | ||
Income tax benefit (expense) | (603 | ) | (1,502 | ) | ||
Less: | ||||||
Reclassification adjustment for gains (losses) included in net income (loss) | (46 | ) | (16 | ) | ||
Associated amortization of DAC, VOBA, DSI and DFEL | 48 | (11 | ) | |||
Income tax benefit (expense) | - | 6 | ||||
Balance as of end-of-period | $ | 7,889 | $ | 6,111 | ||
Unrealized OTTI on AFS Securities | ||||||
Balance as of beginning-of-year | $ | 40 | $ | 29 | ||
(Increases) attributable to: | ||||||
Cumulative effect from adoption of new accounting standard | (40 | ) | - | |||
Gross OTTI recognized in OCI during the period | - | (14 | ) | |||
Change in DAC, VOBA, DSI and DFEL | - | 1 | ||||
Income tax benefit (expense) | - | 4 | ||||
Decreases attributable to: | ||||||
Changes in fair value, sales, maturities or other settlements of AFS securities | - | 20 | ||||
Change in DAC, VOBA, DSI and DFEL | - | (3 | ) | |||
Income tax benefit (expense) | - | (4 | ) | |||
Balance as of end-of-period | $ | - | $ | 33 | ||
Unrealized Gain (Loss) on Derivative Instruments | ||||||
Balance as of beginning-of-year | $ | 181 | $ | 119 | ||
Unrealized holding gains (losses) arising during the period | 288 | 287 | ||||
Change in foreign currency exchange rate adjustment | (16 | ) | 80 | |||
Change in DAC, VOBA, DSI and DFEL | (70 | ) | (3 | ) | ||
Income tax benefit (expense) | (43 | ) | (77 | ) | ||
Less: | ||||||
Reclassification adjustment for gains (losses) included in net income (loss) | 54 | 36 | ||||
Associated amortization of DAC, VOBA, DSI and DFEL | (14 | ) | (1 | ) | ||
Income tax benefit (expense) | (8 | ) | (7 | ) | ||
Balance as of end-of-period | $ | 308 | $ | 378 | ||
Funded Status of Employee Benefit Plans | ||||||
Balance as of beginning-of-year | $ | (22 | ) | $ | (25 | ) |
Adjustment arising during the period | - | - | ||||
Balance as of end-of-period | $ | (22 | ) | $ | (25 | ) |
The following summarizes the reclassifications out of AOCI (in millions) and the associated line item in the Consolidated Statements of Comprehensive Income (Loss):
For the Nine | ||||||||
Months Ended | ||||||||
September 30, | ||||||||
2020 | 2019 | |||||||
Unrealized Gain (Loss) on AFS Securities | ||||||||
Gross reclassification | $ | (46 | ) | $ | (16 | ) | Total realized gain (loss) | |
Associated amortization of DAC, | ||||||||
VOBA, DSI and DFEL | 48 | (11 | ) | Total realized gain (loss) | ||||
Reclassification before income | Income (loss) from continuing | |||||||
tax benefit (expense) | 2 | (27 | ) | operations before taxes | ||||
Income tax benefit (expense) | - | 6 | Federal income tax expense (benefit) | |||||
Reclassification, net of income tax | $ | 2 | $ | (21 | ) | Net income (loss) | ||
Unrealized OTTI on AFS Securities | ||||||||
Gross reclassification | $ | - | $ | 4 | Total realized gain (loss) | |||
Change in DAC, VOBA, DSI and DFEL | - | - | Total realized gain (loss) | |||||
Reclassification before income | Income (loss) from continuing | |||||||
tax benefit (expense) | - | 4 | operations before taxes | |||||
Income tax benefit (expense) | - | (1 | ) | Federal income tax expense (benefit) | ||||
Reclassification, net of income tax | $ | - | $ | 3 | Net income (loss) | |||
Unrealized Gain (Loss) on Derivative Instruments | ||||||||
Gross reclassifications: | ||||||||
Interest rate contracts | $ | 2 | $ | 2 | Net investment income | |||
Foreign currency contracts | 46 | 25 | Net investment income | |||||
Foreign currency contracts | 6 | 9 | Total realized gain (loss) | |||||
Total gross reclassifications | 54 | 36 | ||||||
Associated amortization of DAC, | ||||||||
VOBA, DSI and DFEL | (14 | ) | (1 | ) | Commissions and other expenses | |||
Reclassifications before income | Income (loss) from continuing | |||||||
tax benefit (expense) | 40 | 35 | operations before taxes | |||||
Income tax benefit (expense) | (8 | ) | (7 | ) | Federal income tax expense (benefit) | |||
Reclassifications, net of income tax | $ | 32 | $ | 28 | Net income (loss) |
12. Realized Gain (Loss)
Realized gain (loss) on our Consolidated Statements of Comprehensive Income (Loss) includes realized gains and losses from the sale of investments, write-downs for impairments of investments and changes in the allowance for credit losses for financial assets, changes in fair value for mortgage loans on real estate accounted for under the fair value option, changes in fair value of equity securities, certain derivative and embedded derivative gains and losses, gains and losses on the sale of subsidiaries and businesses and net gains and losses on reinsurance embedded derivatives and trading securities. Realized gains and losses on the sale of investments are determined using the specific identification method. Realized gain (loss) is recognized in net income, net of associated amortization of DAC, VOBA, DSI and DFEL. Realized gain (loss) is also net of allocations of investment gains and losses to certain contract holders and certain funds withheld on reinsurance arrangements for which we have a contractual obligation. Details underlying realized gain (loss) (in millions) were as follows:
For the Three | For the Nine | ||||||||||||
Months Ended | Months Ended | ||||||||||||
September 30, | September 30, | ||||||||||||
2020 | 2019 | 2020 | 2019 | ||||||||||
Fixed maturity AFS securities: | |||||||||||||
Gross gains | $ | - | $ | 7 | $ | 26 | $ | 39 | |||||
Gross losses | (6 | ) | (12 | ) | (72 | ) | (55 | ) | |||||
Credit loss benefit (expense) (1) | (1 | ) | - | (21 | ) | - | |||||||
Gross OTTI | - | (2 | ) | - | (14 | ) | |||||||
Realized gain (loss) on equity securities (2) | 5 | (17 | ) | (9 | ) | (10 | ) | ||||||
Credit loss benefit (expense) on mortgage loans on real estate | 70 | (1 | ) | (111 | ) | (2 | ) | ||||||
Other gain (loss) on investments | 2 | (4 | ) | (7 | ) | (9 | ) | ||||||
Associated amortization of DAC, VOBA, DSI and DFEL | |||||||||||||
and changes in other contract holder funds | (8 | ) | (5 | ) | 34 | (12 | ) | ||||||
Total realized gain (loss) related to certain financial assets | 62 | (34 | ) | (160 | ) | (63 | ) | ||||||
Realized gain (loss) on the mark-to-market on certain instruments (3)(4) | (51 | ) | (104 | ) | (102 | ) | (515 | ) | |||||
Indexed annuity and IUL contracts net derivatives results: (5) | |||||||||||||
Gross gain (loss) | 47 | (21 | ) | (2 | ) | (97 | ) | ||||||
Associated amortization of DAC, VOBA, DSI and DFEL | (20 | ) | (2 | ) | (5 | ) | 7 | ||||||
GLB fees ceded to LNBAR and attributed fees: | |||||||||||||
Gross gain (loss) | (46 | ) | (47 | ) | (157 | ) | (153 | ) | |||||
Associated amortization of DAC, VOBA, DSI and DFEL | (5 | ) | (8 | ) | (22 | ) | (23 | ) | |||||
Total realized gain (loss) | $ | (13 | ) | $ | (216 | ) | $ | (448 | ) | $ | (844 | ) |
(1)Includes changes in the allowance for credit losses as well as direct write-downs to amortized cost as a result of negative credit events.
(2)Includes market adjustments on equity securities still held of $5 million and $(17) million for the three months ended September 30, 2020 and 2019, respectively, and $(8) million and $(11) million for the nine months ended September 30, 2020 and 2019, respectively.
(3)Represents changes in the fair values of certain derivative investments (not including those associated with our variable and indexed annuity and IUL contracts net derivative results), reinsurance related embedded derivatives, mortgage loans on real estate accounted for under the fair value option and trading securities. See Note 7 for information regarding Modco.
(4)Includes gains and losses from fair value changes on mortgage loans on real estate accounted for under the fair value option of $3 million for the three months ended September 30, 2020 and $8 million for the nine months ended September 30, 2020.
(5)Represents the net difference between the change in fair value of the index options that we hold and the change in the fair value of the embedded derivative liabilities of our indexed annuity and IUL contracts along with changes in the fair value of embedded derivative liabilities related to index options we may purchase or sell in the future to hedge contract holder index allocations applicable to future reset periods for our indexed annuity products.
13. Fair Value of Financial Instruments
The carrying values and estimated fair values of our financial instruments (in millions) were as follows:
As of September 30, 2020 | As of December 31, 2019 | |||||||||||
Carrying | Fair | Carrying | Fair | |||||||||
Value | Value | Value | Value | |||||||||
Assets | ||||||||||||
Fixed maturity AFS securities | $ | 116,372 | $ | 116,372 | $ | 103,773 | $ | 103,773 | ||||
Trading securities | 4,574 | 4,574 | 4,602 | 4,602 | ||||||||
Equity securities | 120 | 120 | 103 | 103 | ||||||||
Mortgage loans on real estate | 16,458 | 18,145 | 16,244 | 16,774 | ||||||||
Derivative investments (1) | 3,235 | 3,235 | 1,911 | 1,911 | ||||||||
Other investments | 2,976 | 2,976 | 2,554 | 2,554 | ||||||||
Cash and invested cash | 1,711 | 1,711 | 1,879 | 1,879 | ||||||||
Other assets: | ||||||||||||
GLB direct embedded derivatives | - | - | 450 | 450 | ||||||||
GLB ceded embedded derivatives | 1,105 | 1,105 | 60 | 60 | ||||||||
Indexed annuity ceded embedded derivatives | 536 | 536 | 927 | 927 | ||||||||
Separate account assets | 152,975 | 152,975 | 153,571 | 153,571 | ||||||||
Liabilities | ||||||||||||
Future contract benefits – indexed annuity | ||||||||||||
and IUL contracts embedded derivatives | (2,688 | ) | (2,688 | ) | (2,585 | ) | (2,585 | ) | ||||
Other contract holder funds: | ||||||||||||
Remaining guaranteed interest and similar contracts | (1,860 | ) | (1,860 | ) | (1,900 | ) | (1,900 | ) | ||||
Account values of certain investment contracts | (40,437 | ) | (56,321 | ) | (38,606 | ) | (46,781 | ) | ||||
Short-term debt | (466 | ) | (466 | ) | (609 | ) | (609 | ) | ||||
Long-term debt | (2,409 | ) | (2,736 | ) | (2,414 | ) | (2,714 | ) | ||||
Reinsurance related embedded derivatives | (476 | ) | (476 | ) | (375 | ) | (375 | ) | ||||
Other liabilities: | ||||||||||||
Derivative liabilities (1) | (331 | ) | (331 | ) | (238 | ) | (238 | ) | ||||
GLB direct embedded derivatives | (1,106 | ) | (1,106 | ) | - | - | ||||||
GLB ceded embedded derivatives | - | - | (510 | ) | (510 | ) |
(1)We have master netting agreements with each of our derivative counterparties, which allow for the netting of our derivative asset and liability positions by counterparty.
Valuation Methodologies and Associated Inputs for Financial Instruments Not Carried at Fair Value
The following discussion outlines the methodologies and assumptions used to determine the fair value of our financial instruments not carried at fair value on our Consolidated Balance Sheets. Considerable judgment is required to develop these assumptions used to measure fair value. Accordingly, the estimates shown are not necessarily indicative of the amounts that would be realized in a one-time, current market exchange of all of our financial instruments.
Mortgage Loans on Real Estate
The fair value of mortgage loans on real estate, including mortgage loans accounted for using the fair value option, is established using a discounted cash flow method based on credit rating, maturity and future income. The ratings for mortgages in good standing are based on property type, location, market conditions, occupancy, debt-service coverage, loan-to-value, quality of tenancy, borrower and payment record. The fair value for impaired mortgage loans is based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s market price or the fair value of the collateral if the loan is collateral dependent. The inputs used to measure the fair value of our mortgage loans on real estate are classified as Level 2 within the fair value hierarchy.
Other Investments
The carrying value of our assets classified as other investments approximates fair value. Other investments includes primarily LPs and other privately held investments that are accounted for using the equity method of accounting and the carrying value is based on our proportional share of the net assets of the LPs. Other investments also includes Federal Home Loan Bank (“FHLB”) stock carried at cost and periodically evaluated for impairment based on ultimate recovery of par value. The inputs used to measure the fair value of our LPs, other privately held investments and FHLB stock are classified as Level 3 within the fair value hierarchy. The remaining assets in other investments include cash collateral receivables and securities that are not LPs or other privately held investments. The inputs used to measure the fair value of these assets are classified as Level 1 within the fair value hierarchy.
Separate Account Assets
Separate account assets are primarily carried at fair value. A portion of our separate account assets includes LPs, which are accounted for using the equity method of accounting. The carrying value is based on our proportional share of the net assets of the LPs and approximates fair value. The inputs used to measure the fair value of the separate account asset LPs are classified as Level 3 within the fair value hierarchy.
Other Contract Holder Funds
Other contract holder funds include remaining guaranteed interest and similar contracts and account values of certain investment contracts. The fair value for the remaining guaranteed interest and similar contracts is estimated using discounted cash flow calculations as of the balance sheet date. These calculations are based on interest rates currently offered on similar contracts with maturities that are consistent with those remaining for the contracts being valued. As of September 30, 2020, and December 31, 2019, the remaining guaranteed interest and similar contracts carrying value approximated fair value. The fair value of the account values of certain investment contracts is based on their approximate surrender value as of the balance sheet date. The inputs used to measure the fair value of our other contract holder funds are classified as Level 3 within the fair value hierarchy.
Short-Term and Long-Term Debt
The fair value of short-term and long-term debt is based on quoted market prices. The inputs used to measure the fair value of our short-term and long-term debt are classified as Level 2 within the fair value hierarchy.
Fair Value Option
Mortgage loans on real estate, net of allowance for credit losses, as reported on our Consolidated Balance Sheets, includes commercial mortgage loans for which the fair value option was elected. The fair value option allows us to elect fair value as an alternative measurement for mortgage loans not otherwise reported at fair value. We have made these elections for certain mortgage loans associated with Modco arrangements to help mitigate the inconsistency in earnings that would otherwise result from the use of embedded derivatives included with these loans. Changes in fair value are reflected in realized gain (loss) on our Consolidated Statement of Comprehensive Income (Loss) for commercial mortgage loans. Changes in fair value due to instrument-specific credit risk are estimated using changes in credit spreads and quality ratings for the period reported.
The fair value and aggregate contractual principal for mortgage loans where the fair value option was elected (in millions) was as follows:
As of | |||
September 30, | |||
2020 | |||
Commercial mortgage loans: (1) | |||
Fair value | $ | 794 | |
Aggregate contractual principal | 770 | ||
- |
(1)As of September 30, 2020, 0 loans for which the fair value option has been elected were in non-accrual status and NaN were more than 90 days past due and still accruing interest.
Financial Instruments Carried at Fair Value
We did 0t have any assets or liabilities measured at fair value on a nonrecurring basis as of September 30, 2020, or December 31, 2019, and we noted no changes in our valuation methodologies between these periods.
The following summarizes our financial instruments carried at fair value (in millions) on a recurring basis by the fair value hierarchy levels:
As of September 30, 2020 | ||||||||||||||||
Quoted | ||||||||||||||||
Prices | ||||||||||||||||
in Active | ||||||||||||||||
Markets for | Significant | Significant | ||||||||||||||
Identical | Observable | Unobservable | Total | |||||||||||||
Assets | Inputs | Inputs | Fair | |||||||||||||
(Level 1) | (Level 2) | (Level 3) | Value | |||||||||||||
Assets | ||||||||||||||||
Investments: | ||||||||||||||||
Fixed maturity AFS securities: | ||||||||||||||||
Corporate bonds | $ | - | $ | 90,199 | $ | 7,207 | $ | 97,406 | ||||||||
U.S. government bonds | 423 | 37 | - | 460 | ||||||||||||
State and municipal bonds | - | 6,517 | - | 6,517 | ||||||||||||
Foreign government bonds | - | 365 | 66 | 431 | ||||||||||||
RMBS | - | 2,961 | 2 | 2,963 | ||||||||||||
CMBS | - | 1,420 | 1 | 1,421 | ||||||||||||
ABS | - | 6,170 | 413 | 6,583 | ||||||||||||
Hybrid and redeemable preferred securities | 61 | 426 | 104 | 591 | ||||||||||||
Mortgage loans on real estate | - | 794 | - | 794 | ||||||||||||
Trading securities | 5 | 4,034 | 535 | 4,574 | ||||||||||||
Equity securities | 22 | 49 | 49 | 120 | ||||||||||||
Derivative investments (1) | - | 2,176 | 2,279 | 4,455 | ||||||||||||
Cash and invested cash | - | 1,711 | - | 1,711 | ||||||||||||
Other assets: | ||||||||||||||||
GLB ceded embedded derivatives | - | - | 1,105 | 1,105 | ||||||||||||
Indexed annuity ceded embedded derivatives | - | - | 536 | 536 | ||||||||||||
Separate account assets | 720 | 152,246 | - | 152,966 | ||||||||||||
Total assets | $ | 1,231 | $ | 269,105 | $ | 12,297 | $ | 282,633 | ||||||||
Liabilities | ||||||||||||||||
Future contract benefits – indexed annuity | ||||||||||||||||
and IUL contracts embedded derivatives | $ | - | $ | - | $ | (2,688 | ) | $ | (2,688 | ) | ||||||
Reinsurance related embedded derivatives | - | (476 | ) | - | (476 | ) | ||||||||||
Other liabilities: | ||||||||||||||||
Derivative liabilities (1) | - | (420 | ) | (1,131 | ) | (1,551 | ) | |||||||||
GLB direct embedded derivatives | - | - | (1,106 | ) | (1,106 | ) | ||||||||||
Total liabilities | $ | - | $ | (896 | ) | $ | (4,925 | ) | $ | (5,821 | ) |
As of December 31, 2019 | ||||||||||||||||
Quoted | ||||||||||||||||
Prices | ||||||||||||||||
in Active | ||||||||||||||||
Markets for | Significant | Significant | ||||||||||||||
Identical | Observable | Unobservable | Total | |||||||||||||
Assets | Inputs | Inputs | Fair | |||||||||||||
(Level 1) | (Level 2) | (Level 3) | Value | |||||||||||||
Assets | ||||||||||||||||
Investments: | ||||||||||||||||
Fixed maturity AFS securities: | ||||||||||||||||
Corporate bonds | $ | - | $ | 80,801 | $ | 6,978 | $ | 87,779 | ||||||||
U.S. government bonds | 391 | 7 | 5 | 403 | ||||||||||||
State and municipal bonds | - | 5,685 | - | 5,685 | ||||||||||||
Foreign government bonds | - | 298 | 90 | 388 | ||||||||||||
RMBS | - | 2,997 | 11 | 3,008 | ||||||||||||
CMBS | - | 1,082 | 1 | 1,083 | ||||||||||||
ABS | - | 4,615 | 268 | 4,883 | ||||||||||||
Hybrid and redeemable preferred securities | 77 | 389 | 78 | 544 | ||||||||||||
Trading securities | 50 | 3,886 | 666 | 4,602 | ||||||||||||
Equity securities | 25 | 48 | 30 | 103 | ||||||||||||
Derivative investments (1) | - | 1,089 | 1,735 | 2,824 | ||||||||||||
Cash and invested cash | - | 1,879 | - | 1,879 | ||||||||||||
Other assets: | ||||||||||||||||
GLB direct embedded derivatives | - | - | 450 | 450 | ||||||||||||
GLB ceded embedded derivatives | - | - | 60 | 60 | ||||||||||||
Indexed annuity ceded embedded derivatives | - | - | 927 | 927 | ||||||||||||
Separate account assets | 644 | 152,916 | - | 153,560 | ||||||||||||
Total assets | $ | 1,187 | $ | 255,692 | $ | 11,299 | $ | 268,178 | ||||||||
Liabilities | ||||||||||||||||
Future contract benefits – indexed annuity | ||||||||||||||||
and IUL contracts embedded derivatives | $ | - | $ | - | $ | (2,585 | ) | $ | (2,585 | ) | ||||||
Reinsurance related embedded derivatives | - | (375 | ) | - | (375 | ) | ||||||||||
Other liabilities: | ||||||||||||||||
Derivative liabilities (1) | - | (284 | ) | (867 | ) | (1,151 | ) | |||||||||
GLB ceded embedded derivatives | - | - | (510 | ) | (510 | ) | ||||||||||
Total liabilities | $ | - | $ | (659 | ) | $ | (3,962 | ) | $ | (4,621 | ) |
(1)Derivative investment assets and liabilities are presented within the fair value hierarchy on a gross basis by derivative type and not on a master netting basis by counterparty.
The following summarizes changes to our financial instruments carried at fair value (in millions) and classified within Level 3 of the fair value hierarchy. This summary excludes any effect of amortization of DAC, VOBA, DSI and DFEL. The gains and losses below may include changes in fair value due in part to observable inputs that are a component of the valuation methodology.
For the Three Months Ended September 30, 2020 | ||||||||||||||||||
Gains | Issuances, | Transfers | ||||||||||||||||
Items | (Losses) | Sales, | Into or | |||||||||||||||
Included | in | Maturities, | Out | |||||||||||||||
Beginning | in | OCI | Settlements, | of | Ending | |||||||||||||
Fair | Net | and | Calls, | Level 3, | Fair | |||||||||||||
Value | Income | Other (1) | Net | Net (2) | Value | |||||||||||||
Investments: (3) | ||||||||||||||||||
Fixed maturity AFS securities: | ||||||||||||||||||
Corporate bonds | $ | 6,975 | $ | (7 | ) | $ | 191 | $ | 64 | $ | (16 | ) | $ | 7,207 | ||||
U.S. government bonds | 5 | - | - | - | (5 | ) | - | |||||||||||
Foreign government bonds | 86 | - | - | (20 | ) | - | 66 | |||||||||||
RMBS | 2 | - | - | - | - | 2 | ||||||||||||
CMBS | 1 | - | - | - | - | 1 | ||||||||||||
ABS | 424 | - | 3 | 60 | (74 | ) | 413 | |||||||||||
Hybrid and redeemable | ||||||||||||||||||
preferred securities | 90 | - | 1 | 13 | - | 104 | ||||||||||||
Trading securities | 673 | 2 | - | (119 | ) | (21 | ) | 535 | ||||||||||
Equity securities | 29 | 2 | - | 18 | - | 49 | ||||||||||||
Derivative investments | 595 | 958 | - | (189 | ) | (216 | ) | 1,148 | ||||||||||
Other assets: (4) | ||||||||||||||||||
GLB ceded embedded derivatives | 3,081 | (1,976 | ) | - | - | - | 1,105 | |||||||||||
Indexed annuity ceded embedded derivatives | 664 | 295 | - | (423 | ) | - | 536 | |||||||||||
Future contract benefits – indexed annuity | ||||||||||||||||||
and IUL contracts embedded derivatives (4) | (2,272 | ) | (400 | ) | - | (16 | ) | - | (2,688 | ) | ||||||||
Other liabilities – GLB direct embedded | ||||||||||||||||||
derivatives (4) | (3,086 | ) | 1,980 | - | - | - | (1,106 | ) | ||||||||||
Total, net | $ | 7,267 | $ | 854 | $ | 195 | $ | (612 | ) | $ | (332 | ) | $ | 7,372 |
For the Three Months Ended September 30, 2019 | ||||||||||||||||||
Gains | Issuances, | Transfers | ||||||||||||||||
Items | (Losses) | Sales, | Into or | |||||||||||||||
Included | in | Maturities, | Out | |||||||||||||||
Beginning | in | OCI | Settlements, | of | Ending | |||||||||||||
Fair | Net | and | Calls, | Level 3, | Fair | |||||||||||||
Value | Income | Other (1) | Net | Net (2) | Value | |||||||||||||
Investments: (3) | ||||||||||||||||||
Fixed maturity AFS securities: | ||||||||||||||||||
Corporate bonds | $ | 6,061 | $ | 3 | $ | (49 | ) | $ | 239 | $ | 51 | $ | 6,305 | |||||
Foreign government bonds | 113 | - | 2 | - | - | 115 | ||||||||||||
RMBS | - | - | - | 10 | - | 10 | ||||||||||||
CMBS | 2 | - | - | 7 | - | 9 | ||||||||||||
ABS | 320 | - | 1 | 69 | (173 | ) | 217 | |||||||||||
Hybrid and redeemable | ||||||||||||||||||
preferred securities | 78 | - | - | - | - | 78 | ||||||||||||
Trading securities | 523 | 10 | - | 146 | (113 | ) | 566 | |||||||||||
Equity securities | 68 | (11 | ) | - | (3 | ) | - | 54 | ||||||||||
Derivative investments | 466 | 183 | 119 | 23 | - | 791 | ||||||||||||
Other assets: (4) | ||||||||||||||||||
GLB ceded embedded derivatives | 111 | 733 | - | - | - | 844 | ||||||||||||
Indexed annuity ceded embedded derivatives | 903 | 7 | - | (19 | ) | - | 891 | |||||||||||
Future contract benefits – indexed annuity | ||||||||||||||||||
and IUL contracts embedded derivatives (4) | (1,973 | ) | (30 | ) | - | (95 | ) | - | (2,098 | ) | ||||||||
Other liabilities: (4) | ||||||||||||||||||
GLB direct embedded derivatives | (1 | ) | (845 | ) | - | - | - | (846 | ) | |||||||||
GLB ceded embedded derivatives | (111 | ) | 111 | - | - | - | - | |||||||||||
Total, net | $ | 6,560 | $ | 161 | $ | 73 | $ | 377 | $ | (235 | ) | $ | 6,936 |
For the Nine Months Ended September 30, 2020 | ||||||||||||||||||
Gains | Issuances, | Transfers | ||||||||||||||||
Items | (Losses) | Sales, | Into or | |||||||||||||||
Included | in | Maturities, | Out | |||||||||||||||
Beginning | in | OCI | Settlements, | of | Ending | |||||||||||||
Fair | Net | and | Calls, | Level 3, | Fair | |||||||||||||
Value | Income | Other (1) | Net | Net (2) | Value | |||||||||||||
Investments: (3) | ||||||||||||||||||
Fixed maturity AFS securities: | ||||||||||||||||||
Corporate bonds | $ | 6,978 | $ | (6 | ) | $ | 17 | $ | 146 | $ | 72 | $ | 7,207 | |||||
U.S. government bonds | 5 | - | - | - | (5 | ) | - | |||||||||||
Foreign government bonds | 90 | - | (4 | ) | (20 | ) | - | 66 | ||||||||||
RMBS | 11 | - | - | - | (9 | ) | 2 | |||||||||||
CMBS | 1 | - | - | - | - | 1 | ||||||||||||
ABS | 268 | - | 5 | 317 | (177 | ) | 413 | |||||||||||
Hybrid and redeemable | ||||||||||||||||||
preferred securities | 78 | - | (1 | ) | 9 | 18 | 104 | |||||||||||
Trading securities | 666 | (2 | ) | - | (139 | ) | 10 | 535 | ||||||||||
Equity securities | 30 | 1 | - | 18 | - | 49 | ||||||||||||
Derivative investments | 868 | 555 | 267 | (326 | ) | (216 | ) | 1,148 | ||||||||||
Other assets: (4) | ||||||||||||||||||
GLB direct embedded derivatives | 450 | (450 | ) | - | - | - | - | |||||||||||
GLB ceded embedded derivatives | 60 | 1,045 | - | - | - | 1,105 | ||||||||||||
Indexed annuity ceded embedded derivatives | 927 | 484 | - | (875 | ) | - | 536 | |||||||||||
Future contract benefits – indexed annuity | ||||||||||||||||||
and IUL contracts embedded derivatives (4) | (2,585 | ) | (88 | ) | - | (15 | ) | - | (2,688 | ) | ||||||||
Other liabilities: (4) | ||||||||||||||||||
GLB direct embedded derivatives | - | (1,106 | ) | - | - | - | (1,106 | ) | ||||||||||
GLB ceded embedded derivatives | (510 | ) | 510 | - | - | - | - | |||||||||||
Total, net | $ | 7,337 | $ | 943 | $ | 284 | $ | (885 | ) | $ | (307 | ) | $ | 7,372 |
For the Nine Months Ended September 30, 2019 | ||||||||||||||||||
Gains | Issuances, | Transfers | ||||||||||||||||
Items | (Losses) | Sales, | Into or | |||||||||||||||
Included | in | Maturities, | Out | |||||||||||||||
Beginning | in | OCI | Settlements, | of | Ending | |||||||||||||
Fair | Net | and | Calls, | Level 3, | Fair | |||||||||||||
Value | Income | Other (1) | Net | Net (2) | Value | |||||||||||||
Investments: (3) | ||||||||||||||||||
Fixed maturity AFS securities: | ||||||||||||||||||
Corporate bonds | $ | 5,652 | $ | 3 | $ | 44 | $ | 641 | $ | (35 | ) | $ | 6,305 | |||||
Foreign government bonds | 109 | - | 6 | - | - | 115 | ||||||||||||
RMBS | 7 | - | - | 10 | (7 | ) | 10 | |||||||||||
CMBS | 2 | - | - | 7 | - | 9 | ||||||||||||
ABS | 134 | - | 2 | 477 | (396 | ) | 217 | |||||||||||
Hybrid and redeemable | ||||||||||||||||||
preferred securities | 75 | - | 3 | - | - | 78 | ||||||||||||
Trading securities | 67 | 12 | - | 723 | (236 | ) | 566 | |||||||||||
Equity securities | 25 | (11 | ) | - | 40 | - | 54 | |||||||||||
Derivative investments | 533 | (129 | ) | 235 | 152 | - | 791 | |||||||||||
Other assets: (4) | ||||||||||||||||||
GLB direct embedded derivatives | 123 | (123 | ) | - | - | - | - | |||||||||||
GLB ceded embedded derivatives | 72 | 772 | - | - | - | 844 | ||||||||||||
Indexed annuity ceded embedded derivatives | 902 | 128 | - | (139 | ) | - | 891 | |||||||||||
Future contract benefits – indexed annuity | ||||||||||||||||||
and IUL contracts embedded derivatives (4) | (1,305 | ) | (500 | ) | - | (293 | ) | - | (2,098 | ) | ||||||||
Other liabilities: (4) | ||||||||||||||||||
GLB direct embedded derivatives | - | (846 | ) | - | - | - | (846 | ) | ||||||||||
GLB ceded embedded derivatives | (196 | ) | 196 | - | - | - | - | |||||||||||
Total, net | $ | 6,200 | $ | (498 | ) | $ | 290 | $ | 1,618 | $ | (674 | ) | $ | 6,936 |
(1)The changes in fair value of the interest rate swaps are offset by an adjustment to derivative investments (see Note 5).
(2)Transfers into or out of Level 3 for fixed maturity AFS and trading securities are reported at amortized cost as of the beginning-of-period. For fixed maturity AFS and trading securities, the difference between beginning-of-period amortized cost and beginning-of-period fair value was included in OCI and earnings, respectively, in the prior period.
(3)Amortization and accretion of premiums and discounts are included in net investment income on our Consolidated Statements of Comprehensive Income (Loss). Gains (losses) from sales, maturities, settlements and calls and credit loss expense are included in realized gain (loss) on our Consolidated Statements of Comprehensive Income (Loss).
(4)Gains (losses) from the changes in fair value are included in realized gain (loss) on our Consolidated Statements of Comprehensive Income (Loss).
The following provides the components of the items included in issuances, sales, maturities, settlements and calls, net, excluding any effect of amortization of DAC, VOBA, DSI and DFEL and changes in future contract benefits, (in millions) as reported above:
For the Three Months Ended September 30, 2020 | ||||||||||||||||||
Issuances | Sales | Maturities | Settlements | Calls | Total | |||||||||||||
Investments: | ||||||||||||||||||
Fixed maturity AFS securities: | ||||||||||||||||||
Corporate bonds | $ | 182 | $ | (53 | ) | $ | (3 | ) | $ | (17 | ) | $ | (45 | ) | $ | 64 | ||
Foreign government bonds | - | - | (20 | ) | - | - | (20 | ) | ||||||||||
ABS | 74 | - | - | (14 | ) | - | 60 | |||||||||||
Hybrid and redeemable | ||||||||||||||||||
preferred securities | 13 | - | - | - | - | 13 | ||||||||||||
Trading securities | 15 | - | (20 | ) | (114 | ) | - | (119 | ) | |||||||||
Equity securities | 18 | - | - | - | - | 18 | ||||||||||||
Derivative investments | 126 | (177 | ) | (138 | ) | - | - | (189 | ) | |||||||||
Other assets – indexed annuity ceded | ||||||||||||||||||
embedded derivatives | 4 | - | - | (427 | ) | - | (423 | ) | ||||||||||
Future contract benefits – indexed annuity | ||||||||||||||||||
and IUL contracts embedded derivatives | (88 | ) | - | - | 72 | - | (16 | ) | ||||||||||
Total, net | $ | 344 | $ | (230 | ) | $ | (181 | ) | $ | (500 | ) | $ | (45 | ) | $ | (612 | ) |
For the Three Months Ended September 30, 2019 | ||||||||||||||||||
Issuances | Sales | Maturities | Settlements | Calls | Total | |||||||||||||
Investments: | ||||||||||||||||||
Fixed maturity AFS securities: | ||||||||||||||||||
Corporate bonds | $ | 323 | $ | (4 | ) | $ | (21 | ) | $ | (43 | ) | $ | (16 | ) | $ | 239 | ||
RMBS | 10 | - | - | - | - | 10 | ||||||||||||
CMBS | 7 | - | - | - | - | 7 | ||||||||||||
ABS | 79 | - | - | (10 | ) | - | 69 | |||||||||||
Trading securities | 150 | - | - | (4 | ) | - | 146 | |||||||||||
Equity securities | - | (3 | ) | - | - | - | (3 | ) | ||||||||||
Derivative investments | 131 | (34 | ) | (74 | ) | - | - | 23 | ||||||||||
Other assets – indexed annuity ceded | ||||||||||||||||||
embedded derivatives | 9 | - | - | (28 | ) | - | (19 | ) | ||||||||||
Future contract benefits – indexed annuity | ||||||||||||||||||
and IUL contracts embedded derivatives | (124 | ) | - | - | 29 | - | (95 | ) | ||||||||||
Total, net | $ | 585 | $ | (41 | ) | $ | (95 | ) | $ | (56 | ) | $ | (16 | ) | $ | 377 |
For the Nine Months Ended September 30, 2020 | ||||||||||||||||||
Issuances | Sales | Maturities | Settlements | Calls | Total | |||||||||||||
Investments: | ||||||||||||||||||
Fixed maturity AFS securities: | ||||||||||||||||||
Corporate bonds | $ | 665 | $ | (250 | ) | $ | (37 | ) | $ | (109 | ) | $ | (123 | ) | $ | 146 | ||
Foreign government bonds | - | - | (20 | ) | - | - | (20 | ) | ||||||||||
ABS | 352 | - | - | (35 | ) | - | 317 | |||||||||||
Hybrid and redeemable | ||||||||||||||||||
preferred securities | 13 | (4 | ) | - | - | - | 9 | |||||||||||
Trading securities | 53 | (25 | ) | (20 | ) | (147 | ) | - | (139 | ) | ||||||||
Equity securities | 19 | (1 | ) | - | - | - | 18 | |||||||||||
Derivative investments | 374 | (395 | ) | (305 | ) | - | - | (326 | ) | |||||||||
Other assets – indexed annuity ceded | ||||||||||||||||||
embedded derivatives | 21 | - | - | (896 | ) | - | (875 | ) | ||||||||||
Future contract benefits – indexed annuity | ||||||||||||||||||
and IUL contracts embedded derivatives | (170 | ) | - | - | 155 | - | (15 | ) | ||||||||||
Total, net | $ | 1,327 | $ | (675 | ) | $ | (382 | ) | $ | (1,032 | ) | $ | (123 | ) | $ | (885 | ) |
For the Nine Months Ended September 30, 2019 | ||||||||||||||||||
Issuances | Sales | Maturities | Settlements | Calls | Total | |||||||||||||
Investments: | ||||||||||||||||||
Fixed maturity AFS securities: | ||||||||||||||||||
Corporate bonds | $ | 901 | $ | (35 | ) | $ | (75 | ) | $ | (127 | ) | $ | (23 | ) | $ | 641 | ||
RMBS | 10 | - | - | - | - | 10 | ||||||||||||
CMBS | 7 | - | - | - | - | 7 | ||||||||||||
ABS | 489 | - | - | (12 | ) | - | 477 | |||||||||||
Trading securities | 728 | - | - | (5 | ) | - | 723 | |||||||||||
Equity securities | 43 | (3 | ) | - | - | - | 40 | |||||||||||
Derivative investments | 403 | (46 | ) | (205 | ) | - | - | 152 | ||||||||||
Other assets – indexed annuity ceded | ||||||||||||||||||
embedded derivatives | 50 | - | - | (189 | ) | - | (139 | ) | ||||||||||
Future contract benefits – indexed annuity | ||||||||||||||||||
and IUL contracts embedded derivatives | (420 | ) | - | - | 127 | - | (293 | ) | ||||||||||
Total, net | $ | 2,211 | $ | (84 | ) | $ | (280 | ) | $ | (206 | ) | $ | (23 | ) | $ | 1,618 | ||
The following summarizes changes in unrealized gains (losses) included in net income, excluding any effect of amortization of DAC, VOBA, DSI and DFEL and changes in future contract benefits, related to financial instruments carried at fair value classified within Level 3 that we still held (in millions):
For the Three | For the Nine | ||||||||||||
Months Ended | Months Ended | ||||||||||||
September 30, | September 30, | ||||||||||||
2020 | 2019 | 2020 | 2019 | ||||||||||
Derivative investments | $ | 731 | $ | 204 | $ | 265 | $ | (65 | ) | ||||
Embedded derivatives: | |||||||||||||
Indexed annuity and IUL contracts | 340 | (11 | ) | 582 | (87 | ) | |||||||
Other assets – GLB direct and ceded | 2,143 | (665 | ) | (1,062 | ) | (452 | ) | ||||||
Other liabilities – GLB direct and ceded | (2,143 | ) | 665 | 1,062 | 452 | ||||||||
Total, net (1) | $ | 1,071 | $ | 193 | $ | 847 | $ | (152 | ) |
(1)Included in realized gain (loss) on our Consolidated Statements of Comprehensive Income (Loss).
The following summarizes changes in unrealized gains (losses) included in OCI, net of tax, excluding any effect of amortization of DAC, VOBA, DSI and DFEL and changes in future contract benefits, related to financial instruments carried at fair value classified within Level 3 that we still held (in millions):
For the Three | For the Nine | ||||||||
Months Ended | Months Ended | ||||||||
September 30, | September 30, | ||||||||
2020 | 2020 | ||||||||
Fixed maturity AFS securities: | |||||||||
Corporate bonds | $ | 139 | $ | (154 | ) | ||||
Foreign government bonds | - | (2 | ) | ||||||
ABS | 3 | - | |||||||
Hybrid and redeemable preferred securities | 1 | (4 | ) | ||||||
Total, net | $ | 143 | $ | (160 | ) | ||||
The following provides the components of the transfers into and out of Level 3 (in millions) as reported above:
For the Three | For the Three | |||||||||||||||||
Months Ended | Months Ended | |||||||||||||||||
September 30, 2020 | September 30, 2019 | |||||||||||||||||
Transfers | Transfers | Transfers | Transfers | |||||||||||||||
Into | Out of | Into | Out of | |||||||||||||||
Level 3 | Level 3 | Total | Level 3 | Level 3 | Total | |||||||||||||
Investments: | ||||||||||||||||||
Fixed maturity AFS securities: | ||||||||||||||||||
Corporate bonds | $ | 38 | $ | (54 | ) | $ | (16 | ) | $ | 51 | $ | - | $ | 51 | ||||
U.S. government bonds | - | (5 | ) | (5 | ) | - | - | - | ||||||||||
ABS | - | (74 | ) | (74 | ) | - | (173 | ) | (173 | ) | ||||||||
Trading securities | - | (21 | ) | (21 | ) | - | (113 | ) | (113 | ) | ||||||||
Derivative investments | - | (216 | ) | (216 | ) | - | - | - | ||||||||||
Total, net | $ | 38 | $ | (370 | ) | $ | (332 | ) | $ | 51 | $ | (286 | ) | $ | (235 | ) |
1 | ||||||||||||||||||
For the Nine | For the Nine | |||||||||||||||||
Months Ended | Months Ended | |||||||||||||||||
September 30, 2020 | September 30, 2019 | |||||||||||||||||
Transfers | Transfers | Transfers | Transfers | |||||||||||||||
Into | Out of | Into | Out of | |||||||||||||||
Level 3 | Level 3 | Total | Level 3 | Level 3 | Total | |||||||||||||
Investments: | ||||||||||||||||||
Fixed maturity AFS securities: | ||||||||||||||||||
Corporate bonds | $ | 288 | $ | (216 | ) | $ | 72 | $ | 136 | $ | (171 | ) | $ | (35 | ) | |||
U.S. government bonds | (5 | ) | - | (5 | ) | - | - | - | ||||||||||
RMBS | 1 | (10 | ) | (9 | ) | - | (7 | ) | (7 | ) | ||||||||
ABS | 18 | (195 | ) | (177 | ) | - | (396 | ) | (396 | ) | ||||||||
Hybrid and redeemable preferred | ||||||||||||||||||
securities | 18 | - | 18 | - | - | - | ||||||||||||
Trading securities | 12 | (2 | ) | 10 | 5 | (241 | ) | (236 | ) | |||||||||
Derivative investments | - | (216 | ) | (216 | ) | - | - | - | ||||||||||
Total, net | $ | 332 | $ | (639 | ) | $ | (307 | ) | $ | 141 | $ | (815 | ) | $ | (674 | ) |
Transfers into and out of Level 3 are generally the result of observable market information on a security no longer being available or becoming available to our pricing vendors. For the three and nine months ended September 30, 2020 and 2019, transfers in and out of Level 3 were attributable primarily to the securities’ observable market information no longer being available or becoming available.
The following summarizes the fair value (in millions), valuation techniques and significant unobservable inputs of the Level 3 fair value measurements as of September 30, 2020:
Weighted | |||||||||||||||||||
Average | |||||||||||||||||||
Fair | Valuation | Significant | Assumption or | Input | |||||||||||||||
Value | Technique | Unobservable Inputs | Input Ranges | Range (1) | |||||||||||||||
Assets | |||||||||||||||||||
Investments: | |||||||||||||||||||
Fixed maturity AFS and | |||||||||||||||||||
trading securities: | |||||||||||||||||||
Corporate bonds | $ | 3,009 | Discounted cash flow | Liquidity/duration adjustment (2) | 0.1 | % | - | 15.8 | % | 2.1 | % | ||||||||
Foreign government | |||||||||||||||||||
bonds | 27 | Discounted cash flow | Liquidity/duration adjustment (2) | 9.3 | % | - | 9.3 | % | 9.3 | % | |||||||||
ABS | 21 | Discounted cash flow | Liquidity/duration adjustment (2) | 4.3 | % | - | 4.3 | % | 4.3 | % | |||||||||
Equity securities | 22 | Discounted cash flow | Liquidity/duration adjustment (2) | 4.5 | % | - | 6.3 | % | 5.9 | % | |||||||||
Other assets – GLB ceded | |||||||||||||||||||
embedded derivatives | 1,105 | Discounted cash flow | Long-term lapse rate (3) | 1 | % | - | 30 | % | (10) | ||||||||||
Utilization of guaranteed withdrawals (4) | 85 | % | - | 100 | % | 94 | % | ||||||||||||
Claims utilization factor (5) | 60 | % | - | 100 | % | (10) | |||||||||||||
Premiums utilization factor (5) | 80 | % | - | 115 | % | (10) | |||||||||||||
NPR (6) | 0.13 | % | - | 1.62 | % | 1.13 | % | ||||||||||||
Mortality rate (7) | (9) | (10) | |||||||||||||||||
Volatility (8) | 1 | % | - | 28 | % | 14.28 | % | ||||||||||||
Indexed annuity ceded | |||||||||||||||||||
embedded derivatives | 536 | Discounted cash flow | Lapse rate (3) | 0 | % | - | 9 | % | (10) | ||||||||||
Mortality rate (7) | (9) | (10) | |||||||||||||||||
Liabilities | |||||||||||||||||||
Future contract benefits – | |||||||||||||||||||
indexed annuity and IUL | |||||||||||||||||||
contracts embedded | |||||||||||||||||||
derivatives | $ | (2,688 | ) | Discounted cash flow | Lapse rate (3) | 0 | % | - | 9 | % | (10) | ||||||||
Mortality rate (7) | (9) | (10) | |||||||||||||||||
Other liabilities – | |||||||||||||||||||
GLB direct embedded | |||||||||||||||||||
derivatives | (1,106 | ) | Discounted cash flow | Long-term lapse rate (3) | 1 | % | - | 30 | % | (10) | |||||||||
Utilization of guaranteed withdrawals (4) | 85 | % | - | 100 | % | 94 | % | ||||||||||||
Claims utilization factor (5) | 60 | % | - | 100 | % | (10) | |||||||||||||
Premiums utilization factor (5) | 80 | % | - | 115 | % | (10) | |||||||||||||
NPR (6) | 0.13 | % | - | 1.62 | % | 1.13 | % | ||||||||||||
Mortality rate (7) | (9) | (10) | |||||||||||||||||
Volatility (8) | 1 | % | - | 28 | % | 14.28 | % |
(1)Unobservable inputs were weighted by the relative fair value of the instruments, unless otherwise noted.
(2)The liquidity/duration adjustment input represents an estimated market participant composite of adjustments attributable to liquidity premiums, expected durations, structures and credit quality that would be applied to the market observable information of an investment.
(3)The lapse rate input represents the estimated probability of a contract surrendering during a year, and thereby forgoing any future benefits. The range for indexed annuity and IUL contracts represents the lapse rates during the surrender charge period.
(4)The utilization of guaranteed withdrawals input represents the estimated percentage of contract holders that utilize the guaranteed withdrawal feature.
(5)The utilization factors are applied to the present value of claims or premiums, as appropriate, in the GLB reserve calculation to estimate the impact of inefficient withdrawal behavior, including taking less than or more than the maximum guaranteed withdrawal.
(6)The NPR input represents the estimated additional credit spread that market participants would apply to the market observable discount rate when pricing a contract. The NPR input was weighted by the absolute value of the sensitivity of the reserve to the NPR assumption.
(7)The mortality rate input represents the estimated probability of when an individual belonging to a particular group, categorized according to age or some other factor such as gender, will die.
(8)The volatility input represents overall volatilities assumed for the underlying variable annuity funds, which include a mixture of equity and fixed-income assets. Fair value of the variable annuity GLB embedded derivatives would increase if higher volatilities were used for valuation. Volatility assumptions vary by fund due to the benchmarking of different indices. The volatility input was weighted by the relative account value assigned to each index.
(9)The mortality rate is based on a combination of company and industry experience, adjusted for improvement factors.
(10)A weighted average input range is not a meaningful measurement for lapse rate, utilization factors or mortality rate.
From the table above, we have excluded Level 3 fair value measurements obtained from independent, third-party pricing sources. We do not develop the significant inputs used to measure the fair value of these assets and liabilities, and the information regarding the significant inputs is not readily available to us. Independent broker-quoted fair values are non-binding quotes developed by market makers or broker-dealers obtained from third-party sources recognized as market participants. The fair value of a broker-quoted asset or liability is based solely on the receipt of an updated quote from a single market maker or a broker-dealer recognized as a market participant as we do not adjust broker quotes when used as the fair value measurement for an asset or liability. Significant increases or decreases in any of the quotes received from a third-party broker-dealer may result in a significantly higher or lower fair value measurement.
Changes in any of the significant inputs presented in the table above would have resulted in a significant change in the fair value measurement of the asset or liability as follows:
Investments – An increase in the liquidity/duration adjustment input would have resulted in a decrease in the fair value measurement.
Indexed annuity and IUL contracts embedded derivatives – For direct embedded derivatives, an increase in the lapse rate or mortality rate inputs would have resulted in a decrease in the fair value measurement.
GLB embedded derivatives – Assuming our GLB direct embedded derivatives are in a liability position: an increase in our lapse rate, NPR or mortality rate inputs would have resulted in a decrease in the fair value measurement; and an increase in the utilization of guaranteed withdrawal or volatility inputs would have resulted in an increase in the fair value measurement.
For each category discussed above, the unobservable inputs are not inter-related; therefore, a directional change in one input would not have affected the other inputs.
As part of our ongoing valuation process, we assess the reasonableness of our valuation techniques or models and make adjustments as necessary.
14. Segment Information
We provide products and services and report results through our Annuities, Retirement Plan Services, Life Insurance and Group Protection segments. We also have Other Operations, which includes the financial data for operations that are not directly related to the business segments. Our reporting segments reflect the manner by which our chief operating decision makers view and manage the business. A discussion of these segments and Other Operations is found in Note 21 of our 2019 Form 10-K.
Segment operating revenues and income (loss) from operations are internal measures used by our management and Board of Directors to evaluate and assess the results of our segments. Income (loss) from operations is GAAP net income excluding the after-tax effects of the following items, as applicable:
Realized gains and losses associated with the following (“excluded realized gain (loss)”):
Sales or disposals and impairments of financial assets;
Changes in the fair value of equity securities;
Changes in the fair value of derivatives, embedded derivatives within certain reinsurance arrangements and trading securities (“gain (loss) on the mark-to-market on certain instruments”);
GLB rider fees ceded to LNBAR;
The net valuation premium of the GLB attributed rider fees; and
Changes in the fair value of the embedded derivative liabilities related to index options we may purchase or sell in the future to hedge contract holder index allocations applicable to future reset periods for our indexed annuity products accounted for at fair value (“indexed annuity forward-starting option”);
Changes in reserves resulting from benefit ratio unlocking on our GLB riders;
Income (loss) from reserve changes, net of related amortization, on business sold through reinsurance;
Gains (losses) on early extinguishment of debt;
Losses from the impairment of intangible assets;
Income (loss) from discontinued operations;
Acquisition and integration costs related to mergers and acquisitions; and
Income (loss) from the initial adoption of new accounting standards, regulations, and policy changes including the net impact from the Tax Cuts and Jobs Act.
Operating revenues represent GAAP revenues excluding the pre-tax effects of the following items, as applicable:
Excluded realized gain (loss);
Revenue adjustments from the initial adoption of new accounting standards;
Amortization of DFEL arising from changes in GDB and GLB benefit ratio unlocking; and
Amortization of deferred gains arising from reserve changes on business sold through reinsurance.
The tables below reconcile our segment measures of performance to the GAAP measures presented in our Consolidated Statements of Comprehensive Income (Loss) (in millions):
For the Three | For the Nine | |||||||||||
Months Ended | Months Ended | |||||||||||
September 30, | September 30, | |||||||||||
2020 | 2019 | 2020 | 2019 | |||||||||
Revenues | ||||||||||||
Operating revenues: | ||||||||||||
Annuities | $ | 1,082 | $ | 1,024 | $ | 3,055 | $ | 3,177 | ||||
Retirement Plan Services | 307 | 293 | 878 | 877 | ||||||||
Life Insurance | 2,032 | 1,995 | 5,297 | 5,264 | ||||||||
Group Protection | 1,184 | 1,136 | 3,607 | 3,429 | ||||||||
Other Operations | 37 | 47 | 115 | 152 | ||||||||
Excluded realized gain (loss), pre-tax | (71 | ) | (268 | ) | (609 | ) | (981 | ) | ||||
Total revenues | $ | 4,571 | $ | 4,227 | $ | 12,343 | $ | 11,918 |
For the Three | For the Nine | |||||||||||
Months Ended | Months Ended | |||||||||||
September 30, | September 30, | |||||||||||
2020 | 2019 | 2020 | 2019 | |||||||||
Net Income (Loss) | ||||||||||||
Income (loss) from operations: | ||||||||||||
Annuities | $ | 32 | $ | 216 | $ | 589 | $ | 723 | ||||
Retirement Plan Services | 47 | 41 | 111 | 117 | ||||||||
Life Insurance | (318 | ) | (227 | ) | (149 | ) | 103 | |||||
Group Protection | 6 | 61 | 85 | 184 | ||||||||
Other Operations | (34 | ) | (50 | ) | (109 | ) | (119 | ) | ||||
Excluded realized gain (loss), after-tax | (56 | ) | (212 | ) | (480 | ) | (775 | ) | ||||
Benefit ratio unlocking, after-tax | - | - | (4 | ) | - | |||||||
Acquisition and integration costs related to mergers | ||||||||||||
and acquisitions, after-tax | (4 | ) | (30 | ) | (12 | ) | (78 | ) | ||||
Net income (loss) | $ | (327 | ) | $ | (201 | ) | $ | 31 | $ | 155 |
Item 2. Management’s Narrative Analysis of the Results of Operations
Management’s narrative analysis (“MNA”) of the results of operations for the three and nine months ended September 30, 2020, compared with the corresponding periods in 2019 of The Lincoln National Life Insurance Company (“LNL”) and its consolidated subsidiaries should be read in conjunction with our consolidated financial statements and the accompanying notes to the consolidated financial statements (“Notes”) presented in “Part I – Item 1. Financial Statements,” our Form 10-K for the year ended December 31, 2019 (“2019 Form 10-K”) and other reports filed with the Securities and Exchange Commission (“SEC”). Unless otherwise stated or the context otherwise requires, “LNL,” “Company,” “we,” “our” or “us” refers to The Lincoln National Life Insurance Company and its consolidated subsidiaries. LNL is a wholly-owned subsidiary of Lincoln National Corporation (“LNC”).
See “Part I – Item 1. Business” and Note 1 in our 2019 Form 10-K for a description of the business.
In this report, in addition to providing consolidated revenues and net income (loss), we also provide segment operating revenues and income (loss) from operations because we believe they are meaningful measures of revenues and the profitability of our operating segments. Operating revenues and income (loss) from operations are the financial performance measures we use to evaluate and assess the results of our segments. Accordingly, we define and report operating revenues and income (loss) from operations by segment in Note 14. Our management believes that operating revenues and income (loss) from operations explain the results of our ongoing businesses in a manner that allows for a better understanding of the underlying trends in our current businesses. Certain items are excluded from operating revenue and income (loss) from operations because they are unpredictable and not necessarily indicative of current operating fundamentals or future performance of the business segments, and, in many instances, decisions regarding these items do not necessarily relate to the operations of the individual segments. In addition, we believe that our definitions of operating revenues and income (loss) from operations will provide readers with a more valuable measure of our performance because it better reveals trends in our business.
Management’s narrative analysis is presented pursuant to General Instructions H(2)(a) of Form 10-Q in lieu of Management’s Discussion and Analysis of Financial Condition and Results of Operations.
FORWARD-LOOKING STATEMENTS – CAUTIONARY LANGUAGE
This Quarterly Report on Form 10-Q, including “Risk Factors” and “Management’s Narrative Analysis of the Results of Operations,” contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 (“PSLRA”). A forward-looking statement is a statement that is not a historical fact and, without limitation, includes any statement that may predict, forecast, indicate or imply future results, performance or achievements. Forward-looking statements may contain words like: “anticipate,” “believe,” “estimate,” “expect,” “project,” “shall,” “will” and other words or phrases with similar meaning in connection with a discussion of future operating or financial performance. In particular, these include statements relating to future actions, trends in our businesses, prospective services or products, future performance or financial results and the outcome of contingencies, such as legal proceedings. We claim the protection afforded by the safe harbor for forward-looking statements provided by the PSLRA.
Forward-looking statements are subject to risks and uncertainties. Actual results could differ materially from those expressed in or implied by such forward-looking statements due to a variety of factors, including:
The continuation of the coronavirus, or COVID-19, pandemic, or future outbreaks of COVID-19, and uncertainty surrounding the length and severity of future impacts on the global economy and on our business, results of operations and financial condition;
Further deterioration in general economic and business conditions that may affect account values, investment results and claims experience;
Adverse global capital and credit market conditions could affect our ability to raise capital, if necessary, and may cause us to realize impairments on investments;
Legislative, regulatory or tax changes that affect: the cost of, or demand for, our products; our ability to conduct business; the impact of U.S. federal tax reform legislation on our business, earnings and capital; and the impact of any “best interest” standards of care adopted by the SEC or other regulations adopted by federal or state regulators or self-regulatory organizations relating to the standard of care owed by investment advisers and/or broker-dealers;
Actions taken by reinsurers to raise rates on in-force business;
Further declines in or sustained low interest rates causing a reduction in investment income, the interest margins of our businesses, and demand for our products;
Rapidly increasing interest rates causing contract holders to surrender life insurance and annuity policies, thereby causing realized investment losses, and reduced hedge performance related to variable annuities;
The initiation of legal or regulatory proceedings against us, and the outcome of any legal or regulatory proceedings, such as: adverse actions related to present or past business practices common in businesses in which we compete; adverse decisions in significant actions including, but not limited to, actions brought by federal and state authorities and class action cases; new decisions that result in changes in law; and unexpected trial court rulings;
A decline or continued volatility in the equity markets causing a reduction in the sales of our products; a reduction of asset-based fees that we charge on various investment and insurance products; and an increase in liabilities related to guaranteed benefit features of our variable annuity products;
Changes in our assumptions related to deferred acquisition costs (“DAC”) or value of business acquired (“VOBA”);
Ineffectiveness of our risk management policies and procedures;
A deviation in actual experience regarding future persistency, mortality, morbidity, interest rates or equity market returns from the assumptions used in pricing our products;
Changes in accounting principles that may affect our financial statements;
Lowering of one or more of our financial strength ratings;
Inability to protect our intellectual property rights or claims of infringement of the intellectual property rights of others;
Interruption in telecommunication, information technology or other operational systems or failure to safeguard the confidentiality or privacy of sensitive data on such systems from cyberattacks or other breaches of our data security systems;
The adequacy and collectability of reinsurance that we have purchased;
The continuation of the COVID-19 pandemic, or future outbreaks of COVID-19 or other pandemics, acts of terrorism, war or other man-made and natural catastrophes that may adversely affect our businesses and the cost and availability of reinsurance;
Competitive conditions, including pricing pressures, new product offerings and the emergence of new competitors, that may affect the level of premiums and fees that our subsidiaries can charge for their products;
The unknown effect on our businesses resulting from evolving market preferences and the changing demographics of our client base;
Possible difficulties in executing, integrating and realizing projected results of acquisitions, divestitures and restructurings; and
The unanticipated loss of key management, financial planners or wholesalers.
The risks and uncertainties included here are not exhaustive. Our most recent Form 10-K and our Form 10-Q for the quarter ended March 31, 2020, as well as other reports that we file with the SEC, include additional factors that could affect our businesses and financial performance. Moreover, we operate in a rapidly changing and competitive environment. New risk factors emerge from time to time, and it is not possible for management to predict all such risk factors.
We do not intend, and are under no obligation, to update any particular forward-looking statement included in this document. See “Risk Factors” included in “Part I – Item 1A. Risk Factors” in our 2019 Form 10-K and “Part II – Item 1A. Risk Factors” in our Form 10-Q for the quarter ended March 31, 2020, for a discussion of certain risks relating to our business.
INTRODUCTION
Impact of COVID-19
The COVID-19 pandemic emerged in the United States in the first quarter of 2020 and led to an extreme downturn in and volatility of the capital markets, record-low interest rates and wide-ranging changes in consumer behavior, including as a result of quarantines, shelter-in-place orders and limitations on business activity. The severe restriction in economic activity caused by the COVID-19 pandemic and increased level of unemployment in the United States have contributed to increased volatility and uncertainty regarding expectations for the economy and markets going forward. The National Bureau of Economic Research, a panel of economists charged with officially designating business cycles, announced in June 2020 that a recession began in March 2020, ending the longest expansion period in United States history. Although states have eased restrictions and the capital markets have started to recover, it is unclear when the economy and capital markets will operate under normal or near-normal conditions. The economy has begun to recover from what has been deemed the shortest recession on record in the United States, with recent annualized quarter over quarter gross domestic product reported at 33.1% in the third quarter. However, as the economic and regulatory environment continues to react and evolve, we cannot predict the full impact of the pandemic and ensuing conditions on our business and financial condition. For more information on the expected and potential impacts of the COVID-19 pandemic on our business and financial condition, see “Forward-Looking Statements – Cautionary Language” above and “Part II – Item 1A. Risk Factors” in our Form 10-Q for the quarter ended March 31, 2020. For more information on the unfavorable impacts we continue to expect for the remainder of 2020 related to our business segments, see the “Additional Information” section within the results of operations for each of those segments below.
Actions in Response to COVID-19
We have taken several actions during 2020 to preserve our liquidity and capital position in response to the COVID-19 pandemic and ensuing economic and market conditions.
While the COVID-19 pandemic caused distribution disruption, we efficiently moved to a virtual sales environment across all of our distribution channels beginning in mid-March 2020. In addition, during 2020, we accelerated a plan already in place, in light of the low interest rate environment, to re-price certain products to achieve appropriate returns, shift our sales mix toward shorter-duration products that are less sensitive to interest rates, and add new products that are more capital efficient while increasing consumer choice and expanding customer value propositions.
We also continue to focus on expense discipline. During the second quarter of 2020, we implemented a plan to significantly reduce expenses in 2020, and we expect to continue to manage expenses aggressively going forward.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The MNA included in our 2019 Form 10-K contains a detailed discussion of our critical accounting policies and estimates. The following information updates the “Critical Accounting Policies and Estimates” provided in our 2019 Form 10-K, and therefore, should be read in conjunction with that disclosure.
DAC, VOBA, DSI and DFEL
Unlocking
As stated in “Part II – Item 7. Management’s Narrative Analysis of the Results of Operations – Critical Accounting Policies and Estimates – Unlocking” in our 2019 Form 10-K, we conduct our annual comprehensive review of the assumptions and projection models underlying the amortization of DAC, VOBA, deferred sales inducements (“DSI”), deferred front-end loads (“DFEL”), embedded derivatives and reserves for life insurance and annuity products in the third quarter of each year. As a result of this review, we recorded unlocking that resulted in increases and decreases to the carrying values of these items. See “DAC, VOBA, DSI and DFEL” in Note 1 of our 2019 Form 10-K for a detailed discussion of our unlocking process.
Details underlying the effect to net income (loss) from our unlocking as a result of our annual comprehensive review (in millions) were as follows:
For the Three | |||||||
Months Ended | |||||||
September 30, | |||||||
2020 | 2019 | ||||||
Income (loss) from operations: | |||||||
Annuities | $ | (10 | ) | $ | (54 | ) | |
Retirement Plan Services | (3 | ) | - | ||||
Life Insurance | (426 | ) | (299 | ) | |||
Excluded realized gain (loss) | 21 | - | |||||
Net income (loss) | $ | (418 | ) | $ | (353 | ) |
Unlocking was driven primarily by the following:
2020
As part of our annual comprehensive review in the third quarter, we updated our interest rate assumptions. These updates included lowering starting new money rates to reflect the current interest rate environment and reducing our long-term new money investment yield assumption by 50 basis points, resulting in an ultimate long-term assumption of 3.0% for a 10-year U.S. Treasury. As a result of these updates, we recorded unfavorable after-tax unlocking of $351 million for Life Insurance, $46 million for Annuities and $7 million for Retirement Plan Services.
For Annuities, unfavorable unlocking was driven by updates to interest rate assumptions, partially offset by favorable updates to policyholder behavior assumptions and other items.
For Retirement Plan Services, unfavorable unlocking was driven by updates to interest rate assumptions, partially offset by favorable updates to maintenance expense and other items.
For Life Insurance, unfavorable unlocking was driven by updates to interest rate and policyholder behavior assumptions.
For excluded realized gain (loss), favorable unlocking was driven by updates to reserves for fixed and indexed annuities, partially offset by unfavorable updates to policyholder behavior assumptions.
2019
As part of our annual comprehensive review in the third quarter, we updated our interest rate assumptions. These updates included lowering starting new money rates to reflect the current interest rate environment; reducing our long-term new money investment yield assumption by 25 basis points, resulting in an ultimate long-term assumption of 3.5% for a 10-year U.S. Treasury; and extending the grade-in period from current rates to long-term rates from five years to seven years. As a result of these updates, we recorded unfavorable after-tax unlocking of $215 million for Life Insurance, $23 million for Annuities and $3 million for Retirement Plan Services.
For Annuities, unfavorable unlocking was driven by updates to interest rate assumptions and other items, partially offset by favorable updates to policyholder behavior and separate account fee assumptions.
For Retirement Plan Services, unfavorable unlocking impact from updates to interest rate assumptions was entirely offset by favorable updates to separate account fee, maintenance expense and policyholder behavior assumptions.
For Life Insurance, unfavorable unlocking was driven by updates to mortality margin, interest rate and reinsurance assumptions, partially offset by favorable updates to investment allocation and reserve discount rate assumptions and other items.
Reversion to the Mean
As variable fund returns do not move in a systematic manner, we reset the baseline of account values from which EGPs are projected, which we refer to as our reversion to the mean (“RTM”) process, as discussed in our 2019 Form 10-K.
If we had unlocked our RTM assumption as of September 30, 2020, we would have recorded favorable unlocking of approximately $140 million, pre-tax, for our Annuities segment and approximately $20 million, pre-tax, for our Retirement Plan Services segment and unfavorable unlocking of approximately $5 million, pre-tax, for our Life Insurance segment.
Investments
Investment Valuation
For more information about the valuation of our financial instruments carried at fair value, see “Part II – Item 7. Management’s Narrative Analysis of the Results of Operations – Critical Accounting Policies and Estimates – Investments – Investment Valuation” in our 2019 Form 10-K and Note 13 herein.
Write-Downs for Impairment and Allowance for Credit Losses
As of January 1, 2020, we adopted ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which replaced the historical incurred credit loss methodology with an expected credit loss methodology and impacts the way we recognize and measure impairment. See Note 2 for additional information.
We regularly review our fixed maturity available-for-sale (“AFS”) securities for declines in fair value that we determine to be an indication of impairment. Realized gains and losses generally originate from asset sales to reposition the portfolio or to respond to product experience. In the process of evaluating whether a security with an unrealized loss reflects declines that are related to credit losses, we consider our ability and intent to sell the security prior to a recovery of value. However, subsequent decisions on securities sales are made within the context of overall risk monitoring, assessing value relative to other comparable securities and overall portfolio maintenance. Although our portfolio managers may, at a given point in time, believe that the preferred course of action is to hold securities with unrealized losses that are considered temporary until such losses are recovered, the dynamic nature of portfolio management may result in a subsequent decision to sell. These subsequent decisions are consistent with the classification of our investment portfolio as AFS. We expect to continue to manage all non-trading investments within our portfolios in a manner that is consistent with the AFS classification.
We consider economic factors and circumstances within industries and countries where recent write-downs have occurred in our assessment of the position of securities we own of similarly situated issuers. While it is possible for realized or unrealized losses on a particular investment to affect other investments, our risk management strategy has been designed to identify correlation risks and other risks inherent in managing an investment portfolio. Once identified, strategies and procedures are developed to effectively monitor and manage these risks. The areas of risk correlation that we pay particular attention to are risks that may be correlated within specific financial and business markets, risks within specific industries and risks associated with related parties. When the detailed analysis by our external asset managers and investment portfolio managers leads us to the conclusion that a security’s decline in fair value is other-than-temporary indicative of an impairment, the security is written down to estimated recovery value. In instances where declines are considered temporary, the security will continue to be carefully monitored.
There are risks and uncertainties associated with determining whether an investment shows indications of impairment. These include subsequent significant changes in general overall economic conditions, as well as specific business conditions affecting particular issuers, future financial market effects such as interest rate spreads, stability of foreign governments and economies, future rating agency actions and significant accounting, fraud or corporate governance issues that may adversely affect certain investments. In addition, there are often significant estimates and assumptions that we use to estimate the fair values of securities as described in “Investment Valuation” above. We continually monitor developments and update underlying assumptions and financial models based upon new information.
For certain securitized fixed maturity AFS securities with contractual cash flows, including asset-backed securities (“ABS”), we use our best estimate of cash flows for the life of the security to determine whether there is an impairment of the security. In addition, we review for other indicators of impairment as required by the Investments – Debt and Equity Securities Topic of the Financial Accounting Standards Board Accounting Standards CodificationTM (“ASC”).
Write-downs and allowances on commercial mortgage loans, real estate and other investments are established when the underlying value of the property is deemed to be less than the carrying value. All commercial mortgage loans that are impaired are individually reviewed to determine an appropriate allowance for credit losses. Changing economic conditions affect our valuation of commercial mortgage loans.
Increasing vacancies, declining rents and the like are incorporated into the allowance for credit losses analysis that we perform for monitored loans and may contribute to an increase in the allowance for credit losses. In addition, we continue to monitor the entire commercial mortgage loan portfolio to identify both current and projected future risk based on reasonable and supportable forecasts. Areas of emphasis include properties that have deteriorating credits or have experienced debt-service coverage and/or loan-to-value reduction. Where warranted, we have increased our allowance for credit losses based upon this analysis.
We have also established an allowance for credit losses on our residential mortgage loan portfolio that includes a specific allowance for credit losses for loans that are deemed to be impaired as well as a general allowance for credit losses for pools of loans with similar risk characteristics. The allowance for credit losses for the performing population of loans is based on historical performance for similar loans, as well as projected future losses based on modeling, which includes reasonable and supportable forecasts. The historical data utilized in the allowance for credit losses calculation process is adjusted for current economic conditions.
Amortization of DAC, VOBA, DSI and DFEL and changes in other contract holder funds reflect an assumption for an expected level of credit-related investment losses. When actual credit-related investment losses are realized, we recognize a true-up to our DAC, VOBA, DSI and DFEL amortization and changes in other contract holder funds within realized losses reflecting the incremental effect of actual versus expected credit-related investment losses. These actual to expected amortization adjustments could create volatility in net realized gains and losses.
Derivatives
Our accounting policies for derivatives and the potential effect on interest spreads in a falling rate environment are discussed in Note 5 of this report and “Part II – Item 7A. Quantitative and Qualitative Disclosures About Market Risk” in our 2019 Form 10-K.
ACQUISITIONS AND DISPOSITIONS
For information about acquisitions and dispositions, see Note 3 in our 2019 Form 10-K.
RESULTS OF CONSOLIDATED OPERATIONS
Details underlying the consolidated results (in millions) were as follows:
For the Three | For the Nine | |||||||||||
Months Ended | Months Ended | |||||||||||
September 30, | September 30, | |||||||||||
2020 | 2019 | 2020 | 2019 | |||||||||
Net Income (Loss) | ||||||||||||
Income (loss) from operations: | ||||||||||||
Annuities | $ | 32 | $ | 216 | $ | 589 | $ | 723 | ||||
Retirement Plan Services | 47 | 41 | 111 | 117 | ||||||||
Life Insurance | (318 | ) | (227 | ) | (149 | ) | 103 | |||||
Group Protection | 6 | 61 | 85 | 184 | ||||||||
Other Operations | (34 | ) | (50 | ) | (109 | ) | (119 | ) | ||||
Excluded realized gain (loss), after-tax | (56 | ) | (212 | ) | (480 | ) | (775 | ) | ||||
Benefit ratio unlocking, after-tax | - | - | (4 | ) | - | |||||||
Acquisition and integration costs related to mergers | ||||||||||||
and acquisitions, after-tax | (4 | ) | (30 | ) | (12 | ) | (78 | ) | ||||
Net income (loss) | $ | (327 | ) | $ | (201 | ) | $ | 31 | $ | 155 |
Comparison of the Three and Nine Months Ended September 30, 2020 to 2019
Net loss for the three month period increased and net income for the nine month period decreased due primarily to the following:
Higher benefits driven by unfavorable mortality in our Life Insurance segment and unfavorable experience in our Group Protection segment.
The effect of unlocking.
Spread compression due to average new money rates trailing our current portfolio yields, partially offset by actions implemented to reduce interest crediting rates.
The increase in net loss for the three month period and the decrease in net income for the nine month period were partially offset by the following:
Lower realized losses.
Investment income on alternative investments in 2020 as compared to investment losses in 2019.
Lower acquisition and integration costs incurred associated with our 2018 acquisition.
Aggressively managing expenses in response to the COVID-19 pandemic.
Growth in average account values and business in force.
We provide information about our segments’ and Other Operations’ operating revenue and expense line items and realized gain (loss), key drivers of changes and historical details underlying the line items below. For factors that could cause actual results to differ materially from those set forth, see “Forward-Looking Statements – Cautionary Language” above, “Part I – Item 1A. Risk Factors” in our 2019 Form 10-K and “Part II – Item 1A. Risk Factors” in our Form 10-Q for the quarter ended March 31, 2020.
RESULTS OF ANNUITIES
Details underlying the results for Annuities (in millions) were as follows:
For the Three | For the Nine | |||||||||||
Months Ended | Months Ended | |||||||||||
September 30, | September 30, | |||||||||||
2020 | 2019 | 2020 | 2019 | |||||||||
Operating Revenues | ||||||||||||
Insurance premiums (1) | $ | 17 | $ | 79 | $ | 92 | $ | 424 | ||||
Fee income | 613 | 549 | 1,678 | 1,614 | ||||||||
Net investment income | 312 | 270 | 871 | 776 | ||||||||
Operating realized gain (loss) (2) | 57 | 51 | 160 | 137 | ||||||||
Amortization of deferred gain on | ||||||||||||
business sold through reinsurance | 8 | 8 | 24 | 23 | ||||||||
Other revenues (3) | 75 | 67 | 230 | 203 | ||||||||
Total operating revenues | 1,082 | 1,024 | 3,055 | 3,177 | ||||||||
Operating Expenses | ||||||||||||
Interest credited | 209 | 182 | 592 | 507 | ||||||||
Benefits (1) | 69 | 159 | 202 | 534 | ||||||||
Commissions and other expenses | 791 | 438 | 1,599 | 1,308 | ||||||||
Total operating expenses | 1,069 | 779 | 2,393 | 2,349 | ||||||||
Income (loss) from operations before taxes | 13 | 245 | 662 | 828 | ||||||||
Federal income tax expense (benefit) | (19 | ) | 29 | 73 | 105 | |||||||
Income (loss) from operations | $ | 32 | $ | 216 | $ | 589 | $ | 723 |
(1)Insurance premiums include primarily our income annuities that have a corresponding offset in benefits. Benefits include changes in income annuity reserves driven by premiums.
(2)See “Realized Gain (Loss)” below.
(3)Consists primarily of revenues attributable to broker-dealer services that are subject to market volatility and the net settlement related to a modified coinsurance (“Modco”) reinsurance transaction.
Comparison of the Three and Nine Months Ended September 30, 2020 to 2019
Income from operations for this segment decreased due primarily to higher commissions and other expenses driven by an increase in amortization expense and higher average account values resulting in trail commissions, partially offset by the effect of unlocking, expense management and incentive compensation as a result of production performance.
The decrease in income from operations was partially offset by the following:
Higher fee income driven by higher average daily variable account values.
Lower benefits, net of changes in income annuity reserves, due to the effect of unlocking, partially offset by an increase in the growth in benefit reserves driven primarily by equity market performance.
Higher net investment income, net of interest credited, driven by investment income on alternative investments within our surplus portfolio in 2020 and higher average gross fixed account values.
See “Critical Accounting Policies and Estimates – DAC, VOBA, DSI and DFEL – Unlocking” above for information about unlocking.
Additional Information
Strategic near-term actions to re-price certain products and to shift sales from fixed annuity products to respond to the low interest rate environment have contributed to lower deposits in 2020 and negative net flows for the three months ended September 30, 2020. We expect this trend to continue for the remainder of 2020. For more information on the impacts of COVID-19 and the actions management is taking to address COVID-19 impacts, see “Introduction” above.
New deposits are an important component of net flows and key to our efforts to grow our business. Although deposits do not significantly affect current period income from operations, they can significantly impact future income from operations.
The other component of net flows relates to the retention of the business. An important measure of retention is the reduction in account values caused by full surrenders, deaths and other contract benefits. These outflows as a percentage of average gross account values were 7% for the three and nine months ended September 30, 2020, compared to 9% for the corresponding periods in 2019.
Our fixed annuity business includes products with discretionary crediting rates that are reset on an annual basis and are not subject to surrender charges. Our ability to retain annual reset annuities will be subject to current competitive conditions at the time interest rates for these products reset. We expect to manage the effects of spreads on near-term income from operations through portfolio management and, to a lesser extent, crediting rate actions, which assumes no significant changes in net flows into or out of our fixed accounts or other changes that may cause interest rate spreads to differ from our expectations. For information on interest rate spreads and interest rate risk, see “Part II – Item 7A. Quantitative and Qualitative Disclosures About Market Risk – Interest Rate Risk – Interest Rate Risk on Fixed Insurance Businesses – Falling Rates” and “Part I – Item 1A. Risk Factors – Market Conditions – Changes in interest rates and sustained low interest rates may cause interest rate spreads to decrease and make it more challenging to meet certain statutory requirements and changes in interest rates may also result in increased contract withdrawals” in our 2019 Form 10-K.
RESULTS OF RETIREMENT PLAN SERVICES
Details underlying the results for Retirement Plan Services (in millions) were as follows:
For the Three | For the Nine | |||||||||||
Months Ended | Months Ended | |||||||||||
September 30, | September 30, | |||||||||||
2020 | 2019 | 2020 | 2019 | |||||||||
Operating Revenues | ||||||||||||
Insurance premiums and fee income (1) | $ | 63 | $ | 61 | $ | 179 | $ | 181 | ||||
Net investment income | 238 | 226 | 680 | 679 | ||||||||
Other revenues (2) | 6 | 6 | 19 | 17 | ||||||||
Total operating revenues | 307 | 293 | 878 | 877 | ||||||||
Operating Expenses | ||||||||||||
Interest credited | 155 | 147 | 458 | 437 | ||||||||
Benefits | - | 1 | 1 | 1 | ||||||||
Commissions and other expenses | 98 | 100 | 294 | 309 | ||||||||
Total operating expenses | 253 | 248 | 753 | 747 | ||||||||
Income (loss) from operations before taxes | 54 | 45 | 125 | 130 | ||||||||
Federal income tax expense (benefit) | 7 | 4 | 14 | 13 | ||||||||
Income (loss) from operations | $ | 47 | $ | 41 | $ | 111 | $ | 117 |
(1)Includes amounts ceded to Lincoln National Reinsurance Company (Barbados) Limited (“LNBAR”).
(2)Consists primarily of mutual fund account program revenues from mid to large employers.
Comparison of the Three Months Ended September 30, 2020 to 2019
Income from operations for this segment increased due primarily to the following:
Higher net investment income, net of interest credited, driven by investment income on alternative investments within our surplus portfolio in 2020, partially offset by spread compression due to average new money rates trailing our current portfolio yields.
Higher insurance premiums and fee income driven by higher average variable account values.
Lower commissions and other expenses driven by expense management and incentive compensation as a result of production performance, partially offset by the effect of unlocking.
Comparison of the Nine Months Ended September 30, 2020 to 2019
Income from operations for this segment decreased due primarily to lower net investment income, net of interest credited, driven by spread compression due to average new money rates trailing our current portfolio yields, partially offset by investment income on alternative investments within our surplus portfolio in 2020. The decrease in income from operations was partially offset by lower commissions and other expenses driven by expense management and incentive compensation as a result of production performance, partially offset by the effect of unlocking.
See “Critical Accounting Policies and Estimates – DAC, VOBA, DSI and DFEL – Unlocking” above for information about unlocking.
Additional Information
For more information on the impacts of COVID-19 and the actions management is taking to address COVID-19 impacts, see “Introduction” above.
Net flows in this business fluctuate based on the timing of larger plans being implemented and terminating over the course of the year.
New deposits are an important component of net flows and key to our efforts to grow our business. Although deposits do not significantly affect current period income from operations, they can significantly impact future income from operations. The other component of net flows relates to the retention of the business. An important measure of retention is the reduction in account values caused by plan sponsor terminations and participant withdrawals. These outflows as a percentage of average account values were 10% and 13% for the three and nine months ended September 30, 2020, respectively, compared to 11% and 12%, respectively, for the corresponding periods in 2019. During the second quarter of 2020, account values were negatively impacted by two large case terminations in the mid to large market.
Our net flows are negatively affected by the continued net outflows from our oldest blocks of annuities business which are among our higher margin product lines in this segment, due to the fact that they are mature blocks with low distribution and servicing costs. The
proportion of these products to our total account values was 20% and 22% as of September 30, 2020 and 2019, respectively. Due to this expected overall shift in business mix toward products with lower returns, new deposit production continues to be necessary to maintain earnings at current levels.
Our fixed annuity business includes products with discretionary and index-based crediting rates that are reset on either a quarterly or semi-annual basis. Our ability to retain quarterly or semi-annual reset annuities will be subject to current competitive conditions at the time interest rates for these products reset. We expect to manage the effects of spreads on near-term income from operations through portfolio management and, to a lesser extent, crediting rate actions, which assumes no significant changes in net flows into or out of our fixed accounts or other changes that may cause interest rate spreads to differ from our expectations. For information on interest rate spreads and interest rate risk, see “Item 7A. Quantitative and Qualitative Disclosures About Market Risk – Interest Rate Risk – Interest Rate Risk on Fixed Insurance Businesses – Falling Rates” and “Part I – Item 1A. Risk Factors – Market Conditions – Changes in interest rates and sustained low interest rates may cause interest rate spreads to decrease and make it more challenging to meet certain statutory requirements and changes in interest rates may also result in increased contract withdrawals” in our 2019 Form 10-K.
RESULTS OF LIFE INSURANCE
Details underlying the results for Life Insurance (in millions) were as follows:
For the Three | For the Nine | |||||||||||
Months Ended | Months Ended | |||||||||||
September 30, | September 30, | |||||||||||
2020 | 2019 | 2020 | 2019 | |||||||||
Operating Revenues | ||||||||||||
Insurance premiums (1) | $ | 172 | $ | 173 | $ | 520 | $ | 485 | ||||
Fee income | 1,122 | 1,258 | 2,819 | 2,941 | ||||||||
Net investment income | 737 | 559 | 1,947 | 1,829 | ||||||||
Operating realized gain (loss) (2) | 1 | 1 | 1 | - | ||||||||
Amortization of deferred gain (loss) on | ||||||||||||
business sold through reinsurance | 1 | (1 | ) | 3 | (4 | ) | ||||||
Other revenues | (1 | ) | 5 | 7 | 13 | |||||||
Total operating revenues | 2,032 | 1,995 | 5,297 | 5,264 | ||||||||
Operating Expenses | ||||||||||||
Interest credited | 363 | 354 | 1,099 | 1,051 | ||||||||
Benefits | 1,378 | 1,330 | 3,187 | 2,948 | ||||||||
Commissions and other expenses | 701 | 605 | 1,219 | 1,150 | ||||||||
Total operating expenses | 2,442 | 2,289 | 5,505 | 5,149 | ||||||||
Income (loss) from operations before taxes | (410 | ) | (294 | ) | (208 | ) | 115 | |||||
Federal income tax expense (benefit) | (92 | ) | (67 | ) | (59 | ) | 12 | |||||
Income (loss) from operations | $ | (318 | ) | $ | (227 | ) | $ | (149 | ) | $ | 103 |
(1)Includes term insurance premiums, which have a corresponding partial offset in benefits for changes in reserves.
(2)See “Realized Gain (Loss)” below.
Comparison of the Three Months Ended September 30, 2020 to 2019
Loss from operations for this segment increased due primarily to the following:
Lower fee income due to the effect of unlocking, partially offset by growth in business in force.
Higher commissions and other expenses due to the effect of unlocking, partially offset by lower amortization rates and expense management.
Higher benefits due to unfavorable mortality as a result of impacts of the COVID-19 pandemic and growth in business in force, partially offset by the effect of unlocking.
The increase in loss from operations was partially offset by higher net investment income, net of interest credited, driven by investment income on alternative investments in 2020, partially offset by spread compression due to average new money rates trailing our current portfolio yields.
Comparison of the Nine Months Ended September 30, 2020 to 2019
Income from operations for this segment decreased due primarily to the following:
Higher benefits due to unfavorable mortality as a result of impacts of the COVID-19 pandemic and growth in business in force, partially offset by the effect of unlocking.
Lower fee income due to the effect of unlocking, partially offset by growth in business in force.
Higher commissions and other expenses due to the effect of unlocking, partially offset by lower amortization rates and expense management.
The decrease in income from operations was partially offset by higher net investment income, net of interest credited, driven by investment income on alternative investments in 2020, partially offset by spread compression due to average new money rates trailing our current portfolio yields.
See “Critical Accounting Policies and Estimates – DAC, VOBA, DSI and DFEL – Unlocking” above for more information about unlocking.
Strategies to Address Statutory Reserve Strain
We and our insurance subsidiaries have statutory surplus and risk-based capital (“RBC”) levels above current regulatory required levels. Term products and other products containing secondary guarantees require reserves calculated pursuant to the Valuation of Life Insurance Policies Model Regulation (“XXX”), Actuarial Guideline 38 (“AG38”) and the principles-based reserving framework. For information on strategies we use to reduce the statutory reserve strain, see “Review of Consolidated Financial Condition – Liquidity and Capital Resources – Sources of Liquidity and Cash Flow – Statutory Capital and Surplus” below.
Additional Information
Strategic repricing actions to respond to the low interest rate environment have contributed to lower sales for the three and nine months ended September 30, 2020, compared to the three and nine months ended September 30, 2019, and we expect this trend to continue for the remainder of 2020. We also continue to expect elevated mortality during the remainder of 2020 as a result of the impacts of the COVID-19 pandemic. For more information on the impacts of COVID-19 and the actions management is taking to address COVID-19 impacts, see “Introduction” above.
Generally, we have higher mortality in the first quarter of the year due to the seasonality of claims.
For information on interest rate spreads and interest rate risk, see “Part II – Item 7A. Quantitative and Qualitative Disclosures About Market Risk – Interest Rate Risk – Interest Rate Risk on Fixed Insurance Businesses – Falling Rates” and “Part I – Item 1A. Risk Factors – Market Conditions – Changes in interest rates and sustained low interest rates may cause interest rate spreads to decrease and make it more challenging to meet certain statutory requirements and changes in interest rates may also result in increased contract withdrawals” in our 2019 Form 10-K.
RESULTS OF GROUP PROTECTION
Details underlying the results for Group Protection (in millions) were as follows:
For the Three | For the Nine | ||||||||||||
Months Ended | Months Ended | ||||||||||||
September 30, | September 30, | ||||||||||||
2020 | 2019 | 2020 | 2019 | ||||||||||
Operating Revenues | |||||||||||||
Insurance premiums | $ | 1,052 | $ | 1,024 | $ | 3,231 | $ | 3,079 | |||||
Net investment income | 88 | 71 | 238 | 225 | |||||||||
Other revenues (1) | 44 | 41 | 138 | 125 | |||||||||
Total operating revenues | 1,184 | 1,136 | 3,607 | 3,429 | |||||||||
Operating Expenses | |||||||||||||
Interest credited | 1 | 2 | 4 | 4 | |||||||||
Benefits | 875 | 756 | 2,580 | 2,267 | |||||||||
Commissions and other expenses | 300 | 301 | 916 | 926 | |||||||||
Total operating expenses | 1,176 | 1,059 | 3,500 | 3,197 | |||||||||
Income (loss) from operations before taxes | 8 | 77 | 107 | 232 | |||||||||
Federal income tax expense (benefit) | 2 | 16 | 22 | 48 | |||||||||
Income (loss) from operations | $ | 6 | $ | 61 | $ | 85 | $ | 184 |
(1)Consists of revenue from third parties for administrative services performed, which has a corresponding partial offset in commissions and other expenses. In the first quarter of 2020, we recaptured certain disability business that was originally ceded to a third-party reinsurer, which has a corresponding offset in benefits.
Comparison of the Three Months Ended September 30, 2020 to 2019
Income from operations for this segment decreased due primarily to higher benefits driven by unfavorable experience in our life business and unfavorable reserve adjustments in 2020 as compared to favorable reserve adjustments in 2019 due to modifying certain assumptions on the reserves in these businesses.
The decrease in income from operations was partially offset by the following:
Higher insurance premiums due to favorable persistency.
Higher net investment income, net of interest credited, driven by investment income on alternative investments within our surplus portfolio in 2020.
Comparison of the Nine Months Ended September 30, 2020 to 2019
Income from operations for this segment decreased due primarily to higher benefits driven by unfavorable experience in our life and disability businesses and unfavorable reserve adjustments in 2020 as compared to favorable reserve adjustments in 2019 due to modifying certain assumptions on the reserves in these businesses, partially offset by lower incidence in our dental business.
The decrease in income from operations was partially offset by the following:
Higher insurance premiums due to favorable persistency.
Higher net investment income, net of interest credited, driven by investment income on alternative investments within our surplus portfolio in 2020.
Lower commissions and other expenses driven by expense management and incentive compensation as a result of production performance.
Additional Information
Our total loss ratio for the three and nine months ended September 30, 2020, was 83.2% and 79.8%, respectively, compared to 74.1% and 73.8% for the corresponding periods in 2019. The total loss ratio for the three and nine months ended September 30, 2020, was driven primarily by unfavorable mortality in our life business due primarily to the impacts of the COVID-19 pandemic. In addition, for the nine months ended September 30, 2020, the total loss ratio was unfavorably impacted by higher incidence and new claims severity in our disability business, partially offset by lower incidence in our dental business due to COVID-19. We continue to expect an unfavorable loss ratio in our life business for the remainder of 2020 as a result of the impacts of the COVID-19 pandemic. In addition,
we anticipate morbidity headwinds in our disability business related to the economic environment. For more information on the impacts of COVID-19 and the actions management is taking to address COVID-19 impacts, see “Introduction” above.
Generally, we experience higher mortality in the first quarter of the year and higher disability claims in the fourth quarter of the year due to the seasonality of claims. Also, we generally have higher DAC and VOBA amortization in the first quarter of the year due to a significant number of policies renewing in the quarter.
For information about the effect of the loss ratio sensitivity on our income (loss) from operations, see “Part II – Item 7. Management’s Narrative Analysis of the Results of Operations – Results of Group Protection – Additional Information” in our 2019 Form 10-K. For information on the effects of current interest rates on our long-term disability claim reserves, see “Item 7A. Quantitative and Qualitative Disclosures About Market Risk – Interest Rate Risk – Effect of Interest Rate Sensitivity” in our 2019 Form 10-K.
RESULTS OF OTHER OPERATIONS
Details underlying the results for Other Operations (in millions) were as follows:
For the Three | For the Nine | |||||||||||
Months Ended | Months Ended | |||||||||||
September 30, | September 30, | |||||||||||
2020 | 2019 | 2020 | 2019 | |||||||||
Operating Revenues | ||||||||||||
Insurance premiums | $ | 1 | $ | - | $ | 1 | $ | - | ||||
Net investment income | 29 | 41 | 98 | 136 | ||||||||
Other revenues | 7 | 6 | 16 | 16 | ||||||||
Total operating revenues | 37 | 47 | 115 | 152 | ||||||||
Operating Expenses | ||||||||||||
Interest credited | 9 | 14 | 31 | 44 | ||||||||
Benefits | 28 | 36 | 67 | 76 | ||||||||
Other expenses | 3 | 10 | 22 | 40 | ||||||||
Interest and debt expense | 29 | 36 | 96 | 110 | ||||||||
Strategic digitization expense | 14 | 16 | 39 | 47 | ||||||||
Total operating expenses | 83 | 112 | 255 | 317 | ||||||||
Income (loss) from operations before taxes | (46 | ) | (65 | ) | (140 | ) | (165 | ) | ||||
Federal income tax expense (benefit) | (12 | ) | (15 | ) | (31 | ) | (46 | ) | ||||
Income (loss) from operations | $ | (34 | ) | $ | (50 | ) | $ | (109 | ) | $ | (119 | ) |
Comparison of the Three Months Ended September 30, 2020 to 2019
Loss from operations for Other Operations decreased due primarily to the following:
Lower other expenses attributable to the effect of changes in LNC’s stock price on liabilities related to our deferred compensation plans, as LNC’s stock price decreased during the third quarter of 2020, compared to a less significant decrease during the third quarter of 2019.
Lower benefits attributable to favorable experience and reserve adjustments in our run-off institutional pension business.
Lower interest and debt expense driven by a decline in average interest rates.
The decrease in loss from operations was partially offset by lower net investment income, net of interest credited, related to lower allocated investments driven by a decrease in excess capital retained by Other Operations, partially offset by investment income on alternative investments in 2020.
Comparison of the Nine Months Ended September 30, 2020 to 2019
Loss from operations for Other Operations decreased due primarily to the following:
Lower other expenses attributable to the effect of changes in LNC’s stock price on liabilities related to our deferred compensation plans, as LNC’s stock price decreased significantly during the nine months ended September 30, 2020, compared to an increase during the nine months ended September 30, 2019.
Lower interest and debt expense driven by a decline in average interest rates.
Lower benefits attributable to favorable experience and reserve adjustments in our run-off institutional pension business.
The decrease in loss from operations was partially offset by the following:
Lower net investment income, net of interest credited, related to lower allocated investments driven by a decline in excess capital retained by Other Operations, partially offset by investment income on alternative investments in 2020.
Less favorable income tax benefits driven by lower excess tax benefits associated with stock-based compensation and unfavorable market impacts on tax preferred investment income.
Additional Information
For information on our strategic digitization initiative, see “Part II – Item 7. Management’s Narrative Analysis of the Results of Operations – Results of Consolidated Operations – Additional Information” in our 2019 Form 10-K.
REALIZED GAIN (LOSS)
Details underlying realized gain (loss), after-DAC (1) (in millions) were as follows:
For the Three | For the Nine | |||||||||||
Months Ended | Months Ended | |||||||||||
September 30, | September 30, | |||||||||||
2020 | 2019 | 2020 | 2019 | |||||||||
Components of Realized Gain (Loss), Pre-Tax | ||||||||||||
Total operating realized gain (loss) | $ | 58 | $ | 52 | $ | 161 | $ | 137 | ||||
Total excluded realized gain (loss) | (71 | ) | (268 | ) | (609 | ) | (981 | ) | ||||
Total realized gain (loss), pre-tax | $ | (13 | ) | $ | (216 | ) | $ | (448 | ) | $ | (844 | ) |
Components of Excluded Realized Gain (Loss), | ||||||||||||
After-Tax | ||||||||||||
Realized gain (loss) related to certain financial assets | $ | 49 | $ | (27 | ) | $ | (126 | ) | $ | (50 | ) | |
Realized gain (loss) on the mark-to-market on | (40 | ) | (82 | ) | (80 | ) | (406 | ) | ||||
certain instruments (2) | ||||||||||||
GLB fees ceded to LNBAR and attributed fees | (83 | ) | (83 | ) | (260 | ) | (253 | ) | ||||
Indexed annuity forward-starting option | 18 | (20 | ) | (14 | ) | (66 | ) | |||||
Excluded realized gain (loss), after-tax | $ | (56 | ) | $ | (212 | ) | $ | (480 | ) | $ | (775 | ) |
(1)DAC refers to the associated amortization of DAC, VOBA, DSI and DFEL and changes in other contract holder funds and funds withheld reinsurance assets and liabilities.
(2)Includes activity with LNBAR. The Modco investment portfolio includes fixed maturity securities classified as AFS with changes in fair value recorded in other comprehensive income (loss) (“OCI”). Since the corresponding and offsetting changes in fair value of the embedded derivatives related to the Modco investment portfolio are recorded in realized gain (loss), volatility can occur within net income (loss). See Note 7 for more information.
Comparison of the Three Months Ended September 30, 2020 to 2019
We had lower realized losses due primarily to a decrease in our allowance for credit losses, favorable changes in the fair value of embedded derivatives related to certain Modco arrangements and the effect of unlocking.
Comparison of the Nine Months Ended September 30, 2020 to 2019
We had lower realized losses due primarily to favorable changes in the fair value of embedded derivatives related to certain Modco arrangements and the effect of unlocking, partially offset by an increase in our allowance for credit losses.
See “Critical Accounting Policies and Estimates – DAC, VOBA, DSI and DFEL – Unlocking” above for more information about unlocking.
Operating Realized Gain (Loss)
See “Part II – Item 7. Management’s Narrative Analysis of the Results of Operations – Realized Gain (Loss) – Operating Realized Gain (Loss)” in our 2019 Form 10-K for a discussion of our operating realized gain (loss).
Realized Gain (Loss) Related to Certain Financial Assets
See “Part II – Item 7. Management’s Narrative Analysis of the Results of Operations – Realized Gain (Loss) – Realized Gain (Loss) Related to Certain Investments” in our 2019 Form 10-K for a discussion of our realized gain (loss) related to certain financial assets. For additional information on realized gain (loss) related to certain financial assets, see Note 12.
Realized Gain (Loss) on the Mark-to-Market on Certain Instruments
See “Part II – Item 7. Management’s Narrative Analysis of the Results of Operations – Realized Gain (Loss) – Gain (Loss) on the Mark-to-Market on Certain Instruments” in our 2019 Form 10-K for a discussion of the mark-to-market on certain instruments. We also recognize the mark-to-market on certain commercial mortgage loans on real estate for which we have elected the fair value option. See Note 13 for additional information.
Guaranteed Living Benefit Fees Ceded to LNBAR and Attributed Fees
See “Part II – Item 7. Management’s Narrative Analysis of the Results of Operations – Realized Gain (Loss) – GLB Fees Ceded to LNBAR and Attributed Fees” in our 2019 Form 10-K for a discussion of our guaranteed living benefit (“GLB”) fees ceded to LNBAR and attributed fees.
Indexed Annuity Forward-Starting Option
See “Part II – Item 7. Management’s Narrative Analysis of the Results of Operations – Realized Gain (Loss) – Indexed Annuity Forward-Starting Option” in our 2019 Form 10-K for a discussion of our indexed annuity forward-starting option.
REVIEW OF CONSOLIDATED FINANCIAL CONDITION
Liquidity and Capital Resources
Sources of Liquidity and Cash Flow
Liquidity refers to the ability of an enterprise to generate adequate amounts of cash from its normal operations to meet cash requirements with a prudent margin of safety. Our principal sources of cash flow from operating activities are insurance premiums and fees and investment income, while sources of cash flows from investing activities result from maturities and sales of investments. Our operating activities provided (used) cash of $(793) million and $(3.7) billion for the nine months ended September 30, 2020 and 2019, respectively. In addition, during the first quarter of 2020, we received a capital contribution from LNC in the amount of $475 million. When considering our liquidity and cash flow, it is important to distinguish between our needs, the needs of our insurance subsidiaries and the needs of the holding company, LNC. As a holding company with no operations of its own, LNC derives its cash primarily from its operating subsidiaries.
Statutory Capital and Surplus
Our regulatory capital levels are also affected by statutory accounting rules, which are subject to change by each applicable insurance regulator. Our term products and UL products containing secondary guarantees require reserves calculated pursuant to XXX and AG38, respectively. As discussed in “Part I – Item 1A. Risk Factors – Legislative, Regulatory, and Tax – Attempts to mitigate the impact of Regulation XXX and Actuarial Guideline 38 may fail in whole or in part resulting in an adverse effect on our financial condition and result of operations” in our 2019 Form 10-K, we employ strategies to reduce the strain caused by XXX and AG38 by reinsuring the business to reinsurance captives. Our captive reinsurance subsidiaries and LNBAR provide a mechanism for financing a portion of the excess reserve amounts in a more efficient manner. We use long-dated letters of credit (“LOCs”) and debt financing as well as other financing strategies to finance those reserves. LOCs and related capital market solutions lower the capital effect of term products and UL products containing secondary guarantees. For information on the LOCs, see the credit facilities table in Note 13 in our 2019 Form 10-K. Our captive reinsurance subsidiaries and LNBAR have also issued long-term notes to finance a portion of the excess reserves. For information on long-term notes issued by our captive reinsurance subsidiaries, see Note 4 in our 2019 Form 10-K. We have also used the proceeds from certain senior note issuances to execute long-term structured solutions primarily supporting reinsurance of UL products containing secondary guarantees.
Our captive reinsurance subsidiaries and LNBAR free up capital we can use for any number of purposes, including paying dividends to LNC, our parent company. The National Association of Insurance Commissioners’ (“NAIC”) adoption of the Valuation Manual that defines a principles-based reserving framework for newly issued life insurance policies was effective January 1, 2017. We adopted the framework for our newly issued term business in 2017 and phased in the framework through January 1, 2020, for all other newly issued life insurance products. We continue to analyze the effects of principles-based reserving on the use of captive reinsurance subsidiaries, LNBAR and third-party reinsurance for reserve financing transactions for our life insurance business. For more information on the NAIC’s adoption of principles-based reserving, see “Part I – Item 1. Business – Regulatory – Insurance Regulation” in our 2019 Form 10-K.
Statutory reserves established for variable annuity contracts and riders are sensitive to changes in the equity markets and interest rates, and are affected by the level of account values relative to the level of any guarantees, product design and reinsurance arrangements. As a result, the relationship between reserve changes and equity market performance is non-linear during any given reporting period. Market conditions greatly influence the ultimate capital required due to its effect on the valuation of reserves and derivative assets hedging these reserves. We also utilize inter-company reinsurance arrangements to manage our hedge program for variable annuity guarantees. We implemented the NAIC’s changes to the statutory reserving, capital and accounting framework for variable annuities as of January 1, 2020, which did not have a material impact on our statutory capital position or RBC ratios. The NAIC is also considering modifications to the NAIC RBC C-1 capital charges for bonds, which may impact the level of the C-1 related RBC we are required to hold. For more information, see “Part I – Item 1A. Risk Factors – Federal Regulation – Changes in accounting standards issued by the Financial Accounting Standards Board or other standard-setting bodies may adversely affect our financial statements” in our 2019 Form 10-K.
We continue to analyze the use of our existing captive reinsurance structures, as well as additional third-party reinsurance arrangements, and our current hedging strategies relative to managing the effects of equity markets and interest rates on the statutory reserves, statutory capital and the dividend capacity of LNL and Lincoln Life & Annuity Company of New York (“LLANY”).
Financing Activities
For information about our short-term and long-term debt and our credit facilities and LOCs, see Note 13 in our 2019 Form 10-K.
We have not accounted for securities lending transactions or other transactions involving the transfer of financial assets with an obligation to repurchase the transferred assets as sales. For information about our collateralized financing transactions on our investments, see “Payables for Collateral on Investments” in Note 4.
If current claims-paying ratings were downgraded in the future, terms in our derivative agreements may be triggered, which could negatively affect overall liquidity. For the majority of our derivative counterparties, there is a termination event if our financial strength ratings drop below BBB-/Baa3 (Standard & Poor (“S&P”)/Moody’s). In addition, contractual selling agreements with intermediaries could be negatively affected, which could have an adverse effect on overall sales of annuities, life insurance and investment products. See “Part I – Item 1A. Risk Factors – Liquidity and Capital Position – A decrease in our capital and surplus may result in a downgrade to our insurer financial strength ratings” and “Part I – Item 1A. Risk Factors – Covenants and Ratings – A downgrade in our financial strength ratings could limit our ability to market products, increase the number or value of policies being surrendered and/or hurt our relationships with creditors” in our 2019 Form 10-K for more information. See “Part I – Item 1. Business – Financial Strength Ratings” in our 2019 Form 10-K for additional information on our current financial strength ratings.
Alternative Sources of Liquidity
In order to manage our capital more efficiently, we participate in an inter-company cash management program where LNL, and certain of our subsidiaries and certain affiliates, can lend to or borrow from the holding company to meet short-term borrowing needs. The cash management program is essentially a series of demand loans between LNC and participating subsidiaries that reduces overall borrowing costs by allowing LNC and its subsidiaries to access internal resources instead of incurring third-party transaction costs. As of September 30, 2020, we had a net outstanding receivable (payable) of $2.5 billion from (to) certain subsidiaries and affiliates in the inter-company cash management program. Loans under the cash management program are permitted under applicable insurance laws subject to certain restrictions. LNL and our New Hampshire-domiciled insurance subsidiary are subject to a borrowing and lending limit of, currently, 3% of the insurance company’s admitted assets as of its most recent year end. For our New York-domiciled insurance subsidiary, it may borrow from LNC less than 2% of its admitted assets as of its most recent year end but may not lend any amounts to LNC.
We, by virtue of our general account fixed-income investment holdings, can access liquidity through securities lending programs and repurchase agreements. We are a member of the Federal Home Loan Bank of Indianapolis (“FHLBI”). Membership allows us access to the FHLBI’s financial services, including the ability to obtain loans and to issue funding agreements as an alternative source of liquidity that are collateralized by qualifying mortgage-related assets, agency securities or U.S. Treasury securities. Borrowings under this facility are subject to the FHLBI’s discretion and require the availability of qualifying assets at LNL. As of September 30, 2020, we had an estimated maximum borrowing capacity of $7.0 billion under the FHLBI facility and maximum available borrowing based on qualifying assets of $4.3 billion. In October 2020, LLANY became a member of the Federal Home Loan Bank of New York (“FHLBNY”) with an estimated maximum borrowing capacity of $750 million. Borrowings under this facility are subject to the FHLBNY’s discretion and require the availability of qualifying assets at LLANY. As of September 30, 2020, we had investments with a carrying value of $3.3 billion out on loan. The cash received in our securities lending programs and repurchase agreements is typically invested in cash and invested cash, short-term investments or fixed maturity AFS securities. For additional details, see “Payables for Collateral on Investments” in Note 4.
Cash Flows from Collateral on Derivatives
Our cash flows associated with collateral received from and posted with counterparties change as the market value of the underlying derivative contract changes. As the value of a derivative asset decreases (or increases), the collateral required to be posted by our counterparties would also decrease (or increase). Likewise, when the value of a derivative liability decreases (or increases), the collateral we are required to post to our counterparties would also decrease (or increase). For the nine months ended September 30, 2020, our collateral payable for derivative investments increased due primarily to decreasing interest rates that increased the fair values of our associated over-the-counter derivative investments. In the event of adverse changes in fair value of our derivative instruments, we may need to post collateral with a counterparty if our net derivative liability position reaches certain contractual levels. If we do not have sufficient high quality securities or cash and invested cash to provide as collateral, we have committed liquidity sources, in addition to those discussed above, of approximately $2.0 billion to leverage that would be eligible for collateral posting. For additional information, see “Credit Risk” in Note 5.
Uses of Capital
Our principal uses of cash are to pay policy claims and benefits, operating expenses, commissions and taxes, to purchase new investments, to purchase reinsurance, to fund policy surrenders and withdrawals, to pay dividends to LNC and to repay debt.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
We analyze and manage the risks arising from market exposures of financial instruments, as well as other risks, in an integrated asset-liability management process that considers diversification. We have exposures to several market risks including interest rate risk, equity market risk, credit risk and, to a lesser extent, foreign currency exchange risk. For information on these market risks, see “Item 7A. Quantitative and Qualitative Disclosures About Market Risk” in our 2019 Form 10-K. See also “Part I – Item 2. Management’s Narrative Analysis of the Results of Operations – Introduction” herein.
Item 4. Controls and Procedures
Conclusions Regarding Disclosure Controls and Procedures
We maintain disclosure controls and procedures, which are designed to ensure that information required to be disclosed in the reports we file or submit under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including our President (the principal executive officer) and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. As of the end of the period required by this report, we, under the supervision and with the participation of our President and Chief Financial Officer, conducted an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Exchange Act). Based on that evaluation, our President and Chief Financial Officer have concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to us and our consolidated subsidiaries required to be disclosed in our periodic reports under the Exchange Act.
Changes in Internal Control Over Financial Reporting
There was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that occurred during the quarter ended September 30, 2020, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
A control system, no matter how well designed and operated, can provide only reasonable assurance that the control system’s objectives will be met. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the Company have been detected. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.
PART II – OTHER INFORMATION
Item 1. Legal Proceedings
Reference is made to Hanks v. Lincoln Life & Annuity Company of New York (“LLANY”) and Voya Retirement Insurance and Annuity Company (“Voya”), previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2019. On September 30, 2020, the court denied plaintiff’s motion for summary judgment and granted in part Voya’s motion for summary judgment. The court has not yet set a trial date, and we continue to vigorously defend this action.
Andrew Nitkewicz v. Lincoln Life & Annuity Company of New York, pending in the U.S. District Court for the Southern District of New York, No. 1:20-cv-06805, is a putative class action that was filed on August 24, 2020. Plaintiff Andrew Nitkewicz, as trustee of the Joan C. Lupe Trust, seeks to represent all current and former owners of universal life (including variable universal life) policies who own or owned policies issued by LLANY and its predecessors in interest that were in force at any time on or after June 27, 2013, and for which planned annual, semi-annual, or quarterly premiums were paid for any period beyond the end of the policy month of the insured’s death. Plaintiff alleges LLANY failed to refund unearned premium in violation of New York Insurance Law Section 3203(a)(2) in connection with the payment of death benefit claims for certain insurance policies. Plaintiff seeks compensatory damages and pre-judgment interest on behalf of the various classes and sub-class. We are vigorously defending this matter.
See Note 10 in “Part I – Item 1” above for further discussion regarding these and other contingencies.
Item 1A. Risk Factors
In addition to the factors set forth in “Part I – Item 2. Management’s Narrative Analysis of the Results of Operations – Forward-Looking Statements – Cautionary Language” above, you should carefully consider the risks described under “Part I – Item 1A. Risk Factors” in our Form 10-K for the year ended December 31, 2019, and “Part II – Item 1A. Risk Factors” in our Form 10-Q for the quarter ended March 31, 2020. Such risks and uncertainties are not the only ones facing our Company. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations. If any of these risks actually occur, our business, financial condition and results of operations could be materially affected. In that case, the value of our securities could decline substantially.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None.
Item 6. Exhibits
The Exhibits included in this report are listed in the Exhibit Index beginning on page 74, which is incorporated herein by reference.
THE LINCOLN NATIONAL LIFE INSURANCE COMPANY
Exhibit Index for the Report on Form 10-Q
For the Quarter Ended September 30, 2020
Certification of the President pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |
101.INS | XBRL Instance Document – the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. |
101.SCH | XBRL Taxonomy Extension Schema Document. |
101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document. |
101.LAB | XBRL Taxonomy Extension Label Linkbase Document. |
101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document. |
101.DEF | XBRL Taxonomy Extension Definition Linkbase Document. |
104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101). |
SIGNATURES
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.
THE LINCOLN NATIONAL LIFE INSURANCE COMPANY | |||
Dated: November 9, 2020 | By: | /s/ Christine A. Janofsky | |
Christine A. Janofsky | |||
Senior Vice President and Controller | |||
(Authorized Signatory and Principal Accounting Officer) |