485BPOS 1 a2178318z485bpos.txt 485BPOS As filed with the Securities and Exchange Commission on July 2, 2007 1933 Act Registration No. 333-04999 1940 Act Registration No. 811-07645 -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM N-4 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 / / POST-EFFECTIVE AMENDMENT NO. 17 /X/ and REGISTRATION STATEMENT UNDER THE INVESTMENT COMPANY ACT OF 1940 / / AMENDMENT NO. 27 /X/ Lincoln National Variable Annuity Account L (Exact Name of Registrant) Group Variable Annuity I, II & III THE LINCOLN NATIONAL LIFE INSURANCE COMPANY (Name of Depositor) 1300 South Clinton Street Post Office Box 1110 Fort Wayne, Indiana 46801 (Address of Depositor's Principal Executive Offices) Depositor's Telephone Number, Including Area Code: (260) 455-2000 Dennis L. Schoff, Esquire The Lincoln National Life Insurance Company 1300 South Clinton Street Post Office Box 1110 Fort Wayne, IN 46801 (Name and Address of Agent for Service) Copy to: Brian Burke, Esquire The Lincoln National Life Insurance Company 1300 South Clinton Street Post Office Box 1110 Fort Wayne, IN 46801 Approximate Date of Proposed Public Offering: Continuous It is proposed that this filing will become effective: /x/ immediately upon filing pursuant to paragraph (b) of Rule 485 / / on _______________, pursuant to paragraph (b) of Rule 485 / / 60 days after filing pursuant to paragraph (a)(1) of Rule 485 / / on ______________, pursuant to paragraph (a)(1) of Rule 485 Title of Securities being registered: Interests in a separate account under group flexible payment deferred variable annuity contracts. THE LINCOLN NATIONAL LIFE INSURANCE COMPANY Lincoln National Variable Annuity Account C Multi-Fund(R), Multi-Fund(R) 5, Multi-Fund(R) Select Lincoln National Variable Annuity Account E The American Legacy Lincoln National Variable Annuity Account H American Legacy Product Suite Lincoln National Variable Annuity Account L Group Variable Annuity Lincoln Life Variable Annuity Account N ChoicePlus Product Suite, ChoicePlus II Product Suite, ChoicePlus Assurance Product Suite, ChoicePlus Design Lincoln Life Variable Annuity Account Q Multi-Fund(R) Group Lincoln National Variable Annuity Fund A Group, Individual Supplement to the Prospectus dated May 1, 2007 On July 2, 2007, Jefferson Pilot Financial Insurance Company merged with and into The Lincoln National Life Insurance Company ("LNL"). Both companies are direct subsidiaries of Lincoln National Corporation ("LNC"). LNC is a publicly held insurance and financial services holding company incorporated in Indiana. The section in your prospectus entitled Financial Statements is replaced in its entirety with the following: The financial statements of the VAA, the consolidated financial statements of Jefferson Pilot Financial Insurance Company and Subsidiary, The Lincoln National Life Insurance Company and Jefferson Pilot Life Insurance Company and Subsidiary, as well as the supplemental consolidated financial statements for LNL are located in the SAI. If you would like a free copy of the SAI, complete and mail the request on the last page of the prospectus, or call the customer service number listed in your prospectus. Please retain this supplement for future reference. PART A The prospectus for the Group Variable Annuity contract is incorporated herein by reference to Post-Effective Amendment No. 16 (File No. 33-04999) filed on April 16, 2007. Supplement to the prospectus for the Group Variable Annuity contract is incorporated herein by reference to 497 Filing (File No. 33-04999) filed on June 6, 2007. Supplement to the prospectus for the Group Variable Annuity contract is incorporated herein by reference to 497 Filing (File No. 33-04999) filed on June 8, 2007. Group Variable Annuity Contracts I, II, & III Funded Through the SubAccounts of Lincoln National Variable Annuity Account L of The Lincoln National Life Insurance Company Statement of Additional Information (SAI) This SAI should be read in conjunction with the prospectus of the Group Variable Annuity Contracts (the ""Contracts""), dated May 1, 2007. You may obtain a copy of the prospectus to which this SAI relates without charge by writing to The Lincoln National Life Insurance Company, PO Box 2340, Fort Wayne, IN 46808, by calling Lincoln Life at 1-800-341-0441, or by visiting www.LFG.com. Table of Contents
Item Page Special Terms B-2 Services B-2 Principal Underwriter B-2 Purchase of Securities Being Offered B-2 Annuity Payouts B-2 Determination of Accumulation and Annuity Unit Value B-3
Item Page Advertising B-4 Additional Services B-5 Other Information B-5 Financial Statements B-6
This SAI is not a prospectus. The date of this SAI is May 1, 2007. Special Terms The special terms used in this SAI are the ones defined in the Prospectus. Services Independent Registered Public Accounting Firm The financial statements of the VAA, the consolidated financial statements of Jefferson Pilot Financial Insurance Company and Subsidiary, Jefferson-Pilot Life Insurance Company and Subsidiary and The Lincoln National Life Insurance Company, as well as the supplemental consolidated financial statements of The Lincoln National Life Insurance Company appearing in this SAI and Registration Statement have been audited by Ernst & Young LLP, independent registered public accounting firm, 2300 National City Center, 110 West Berry Street, Fort Wayne, Indiana 46802, as set forth in their reports, also appearing in this SAI and in the Registration Statement. The financial statements audited by Ernst & Young LLP have been included herein in reliance on their reports given on their authority as experts in accounting and auditing. Keeper of Records All accounts, books, records and other documents which are required to be maintained for the VAA are maintained by us or by third parties responsible to Lincoln Life. We have entered into an agreement with the Delaware Management Holdings, Inc. and Delaware Service Company, Inc., One Commerce Square, 2005 Market Street, Philadelphia, PA 19103, to provide accounting services to the VAA. No separate charge against the assets of the VAA is made by us for this service. Principal Underwriter Pending regulatory approval Lincoln Financial Distributors, Inc. ("LFD"), an affiliate of Lincoln Life, will serve as principal underwriter (the "Principal Underwriter") for the contracts, as described in the prospectus as of May 1, 2007. The Principal Underwriter offers the contracts to the public on a continuous basis and anticipates continuing to offer the contracts, but reserves the right to discontinue the offering. The Principal Underwriter offers the contracts through sales representatives, who are associated with Lincoln Financial Advisors Corporation, our affiliate. The Principal Underwriter also may enter into selling agreements with other broker-dealers ("Selling Firms") for the sale of the contracts. Sales representatives of Selling Firms are appointed as our insurance agents. Prior to September 15, 2005, LFA was the Principal Underwritier, and they paid $4,129,656 and $3,750,709 to Lincoln Sales Representatives and Selling Firms in 2004, and 2005, respectively, as sales compensation with respect to the contracts. LFA retained no underwriting commissions for the sale of the contracts. After September 15, 2005, Lincoln Life was the Principal Underwriter, and they paid $1,100,062 and $3,514,035 to LFA and Selling Firms in 2005 and 2006, respectively, as sales compensation with respect to the contracts. The Principal Underwriter retained no underwriting commissions for sale of the contracts. Purchase of Securities Being Offered The variable annuity contracts are offered to the public through licensed insurance agents who specialize in selling our products; through independent insurance brokers; and through certain securities brokers/dealers selected by us whose personnel are legally authorized to sell annuity products. There are no special purchase plans for any class of prospective buyers. However, under certain limited circumstances described in the prospectus under the section Charges and Other Deductions, any applicable account fee and/or surrender charge may be reduced or waived. Both before and after the annuity commencement date, there are exchange privileges between subaccounts, and from the VAA to the general account (if available) subject to restrictions set out in the prospectus. See The Contracts, in the prospectus. No exchanges are permitted between the VAA and other separate accounts. The offering of the contracts is continuous. Annuity Payouts Variable Annuity Payouts Variable annuity payouts will be determined on the basis of: o the dollar value of the contract on the annuity commencement date less any applicable premium tax; B-2 o the annuity tables contained in the contract; o the type of annuity option selected; and o the investment results of the fund(s) selected. In order to determine the amount of variable annuity payouts, we make the following calculation: o first, we determine the dollar amount of the first payout; o second, we credit the contract with a fixed number of annuity units based on the amount of the first payout; and o third, we calculate the value of the annuity units each period thereafter. These steps are explained below. The dollar amount of the first periodic variable annuity payout is determined by applying the total value of the accumulation units credited under the contract valued as of the annuity commencement date (less any premium taxes) to the annuity tables contained in the contract. The first variable annuity payout will be paid 14 days after the annuity commencement date. This day of the month will become the day on which all future annuity payouts will be paid. Amounts shown in the tables are based on the 1983 Table "a" Individual Annuity Mortality Table modified, with an assumed investment return at the rate of 1%, 2%, 3%, 4%, 5%, or 6% per annum, depending on the terms of your contract. The first annuity payout is determined by multiplying the benefit per $1,000 of value shown in the contract tables by the number of thousands of dollars of value accumulated under the contract. These annuity tables vary according to the form of annuity selected and the age of the annuitant at the annuity commencement date. The assumed interest rate is the measuring point for subsequent annuity payouts. If the actual net investment rate (annualized) exceeds the assumed interest rate, the payout will increase at a rate equal to the amount of such excess. Conversely, if the actual rate is less than the assumed interest rate, annuity payouts will decrease. If the assumed rate of interest were to be increased, annuity payouts would start at a higher level but would decrease more rapidly or increase more slowly. We may use sex-distinct annuity tables in contracts that are not associated with employer sponsored plans and where not prohibited by law. At an annuity commencement date, the contract is credited with annuity units for each subaccount on which variable annuity payouts are based. The number of annuity units to be credited is determined by dividing the amount of the first periodic payout by the value of an annuity unit in each subaccount selected. Although the number of annuity units is fixed by this process, the value of such units will vary with the value of the underlying fund. The amount of the second and subsequent periodic payouts is determined by multiplying the contractowner's fixed number of annuity units in each subaccount by the appropriate annuity unit value for the valuation date ending 14 days prior to the date that payout is due. The value of each subaccount's annuity unit will be set initially at $1.00. The annuity unit value for each subaccount at the end of any valuation date is determined by multiplying the subaccount annuity unit value for the immediately preceding valuation date by the product of: o The net investment factor of the subaccount for the valuation period for which the annuity unit value is being determined, and o A factor to neutralize the assumed investment return in the annuity table. The value of the annuity units is determined as of a valuation date 14 days prior to the payment date in order to permit calculation of amounts of annuity payouts and mailing of checks in advance of their due dates. Such checks will normally be issued and mailed at least three days before the due date. Proof of Age, Sex and Survival We may require proof of age, sex, or survival of any payee upon whose age, sex, or survival payments depend. Determination of Accumulation and Annuity Unit Value A description of the days on which accumulation and annuity units will be valued is given in the prospectus. The New York Stock Exchange's (NYSE) most recent announcement (which is subject to change) states that it will be closed on weekends and on these holidays: New Year's Day, Martin Luther King Day, President's Day, Good Friday, Memorial Day, Independence Day, Labor Day, Thanksgiving Day, and Christmas Day. If any of these holidays occurs on a weekend day, the Exchange may also be closed on the business day occurring just before or just after the holiday. It may also be closed on other days. Since the portfolios of some of the fund and series will consist of securities primarily listed on foreign exchanges or otherwise traded outside the United States, those securities may be traded (and the net asset value of those fund and series and of the variable account could therefore be significantly affected) on days when the investor has no access to those funds and series. B-3 Advertising The Lincoln National Life Insurance Company (Lincoln Life) is ranked and rated by independent financial rating services, including Moody's, Standard & Poor's, Duff & Phelps and A.M. Best Company. The purpose of these ratings is to reflect the financial strength or claims-paying ability of Lincoln Life. The ratings are not intended to reflect the investment experience or financial strength of the VAA. We may advertise these ratings from time to time. In addition, we may include in certain advertisements, endorsements in the form of a list of organizations, individuals or other parties which recommend Lincoln Life or the policies. Furthermore, we may occasionally include in advertisements comparisons of currently taxable and tax deferred investment programs, based on selected tax brackets, or discussions of alternative investment vehicles and general economic conditions. More About the S&P 500 Index. Investors look to indexes as a standard of market performance. Indexes are model portfolios, that is, groups of stocks or bonds selected to represent an entire market. The S&P 500 Index is a widely used measure of large US company stock performance. It consists of the common stocks of 500 major corporations selected according to size, frequency and ease by which their stocks trade, and range and diversity of the American economy. The fund seeks to approximate as closely as possible, before fees and expenses, the total return of the S&P 500 Index. To accomplish this objective the fund's sub-adviser, Mellon Capital Management Corporation (Mellon Capital), attempts to buy and sell all of the index's securities in the same proportion as they are reflected in the S&P 500 Index, although the fund reserves the right not to invest in every security in the S&P 500 Index if it is not practical to do so under the circumstances. Mellon Capital does not seek to beat the S&P 500 Index and does not seek temporary defensive positions when markets appear to be overvalued. Mellon Capital makes no attempt to apply economic, financial or market analysis when managing the fund. Including a security among the fund's holdings implies no opinion as to its attractiveness as an investment. The fund may invest in stock index futures and options on stock index futures as a substitute for a comparable market position in the underlying securities. A stock index future obligates one party to deliver (and the other party to take), effectively, an amount of cash equal to a specific dollar amount times the difference between the value of a specific stock index at the close of the last trading day of the contract and the price at which the agreement is made. No physical delivery of the underlying stocks in the index is made. Instead, the buyer and seller settle the difference in cash between the contract price and the market price on the agreed upon date. The buyer pays the difference if the actual price is lower than the contract price and the seller pays the difference if the actual price is higher. There can be no assurance that a liquid market will exist at the time when the fund seeks to close out a futures contract or a futures option position. Lack of a liquid market may prevent liquidation of an unfavorable position. The fund is not sponsored, endorsed, sold or promoted by Standard & Poor's, a division of The McGraw-Hill Companies, Inc. ("S&P"). S&P makes no representation or warranty, express or implied, to the owners of the fund or any member of the public regarding the advisability of investing in securities generally or in the fund particularly or the ability of the S&P 500 Index to track general stock market performance. S&P's only relationship to the fund is the licensing of certain trademarks and trade names of S&P and of the S&P 500 Index which is determined, composed and calculated by S&P without regard to the fund. S&P has no obligation to take the needs of the fund or its shareholders into consideration in determining, composing or calculating the S&P 500 Index. S&P is not responsible for and has not participated in the determination of the prices and amount of the fund or the timing of the issuance or sale of the fund or in the determination or calculation of the equation by which the fund is to be converted into cash. S&P has no obligation or liability in connection with the administration, marketing or trading of the fund. S&P DOES NOT GUARANTEE THE ACCURACY AND/OR THE COMPLETENESS OF THE S&P 500 INDEX OR ANY DATA INCLUDED THEREIN AND S&P SHALL HAVE NO LIABILITY FOR ANY ERRORS, OMISSIONS, OR INTERRUPTIONS THEREIN. S&P MAKES NO WARRANTY, EXPRESS OR IMPLIED, AS TO RESULTS TO BE OBTAINED BY THE FUND OR ITS SHAREHOLDERS, OR ANY OTHER PERSON OR ENTITY FROM THE USE OF THE S&P 500 INDEX OR ANY DATA INCLUDED THEREIN. S&P MAKES NO EXPRESS OR IMPLIED WARRANTIES, AND EXPRESSLY DISCLAIMS ALL WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE WITH RESPECT TO THE S&P 500 INDEX OR ANY DATA INCLUDED THEREIN. WITHOUT LIMITING ANY OF THE FOREGOING, IN NO EVENT SHALL S&P HAVE ANY LIABILITY FOR ANY SPECIAL, PUNITIVE, INDIRECT, OR CONSEQUENTIAL DAMAGES (INCLUDING LOST PROFITS), EVEN IF NOTIFIED OF THE POSSIBILITY OF SUCH DAMAGES. Compound Interest Illustrations - These will emphasize several advantages of the variable annuity contract. For example, but not by way of illustration, the literature may emphasize the potential tax savings through tax deferral; the potential advantage of the variable annuity account over the fixed account; and the compounding effect when a client makes regular deposits to his or her contract. Internet - An electronic communications network which may be used to provide information regarding Lincoln Life, performance of the subaccounts and advertisement literature. Annuity Payout Illustrations. These will provide an initial benefit payment based in part on the annuitant, the contract value and the fixed and/or variable annuity payout option elected. In addition, variable annuity payout illustrations may show the historical results of a variable payout in a subaccount of the VAA. B-4 Dollar-Cost Averaging Illustrations. These illustrations will generally discuss the price-leveling effect of making regular purchases in the same subaccounts over a period of time, to take advantage of the trends in market prices of the portfolio securities purchased for those subaccounts. Additional Services Dollar Cost Averaging (DCA) - You may systematically transfer, on a monthly basis, amounts from certain subaccounts, or the fixed side of the contract into the subaccounts over a period of 1, 2 or 3 years. The minimum amount to be dollar cost averaged is $10,000 for 1 year, and $25,000 for 2 years or 3 years. You may elect to participate in the DCA program at the time of application or at anytime before the annuity commencement date by completing an election form available from us. Once elected, the program will remain in effect until the earlier of: o the annuity commencement date; o the value of the amount being DCA'd is depleted; or o you cancel the program by written request or by telephone if we have your telephone authorization on file. We reserve the right to discontinue this program at any time. DCA does not assure a profit or protect against loss. GVA III fixed account restrictions may apply. Systematic Transfer - The systematic transfer service is only available to GVA III participants. This service allows you to fully liquidate your fixed account balance over four years in five annual installments and transfer the amounts into one or more of the subaccounts. You may change the receiving subaccount allocation at any time. A distribution or a non-scheduled transfer from the fixed account may cancel the systematic transfer program prematurely. The program will also be cancelled prematurely if the fixed account balance falls to $0. Account Sweep - The account sweep service allows you to keep a designated amount (the baseline amount) in one subaccount or the fixed account, and automatically transfer the excess to other variable subaccount(s) of your choice. The transfers may take place monthly, quarterly, semi-annually or annually. A $10,000 minimum balance in the holding account is required in order to begin this service. For account sweep to occur, the holding account balance must exceed the designated baseline amount by at least $50. You may change the receiving subaccount allocation at any time. Deposits to or distributions from the holding account will not adjust your baseline amount, but may affect the amount of money available to be transferred. A new account sweep program is required to change the designated baseline amount. GVA III fixed account restrictions may apply. Portfolio Rebalancing - Portfolio rebalancing is an option, which, if elected by the contractowner, restores to a pre-determined level the percentage of the contract value, allocated to each variable subaccount or the fixed account. This pre-determined level will be the allocation initially selected when the contract was purchased, unless subsequently changed. The portfolio rebalancing allocation may be changed at any time by submitting a written request to us. If portfolio rebalancing is elected, all purchase payments allocated to the variable subaccounts must be subject to portfolio rebalancing. Portfolio rebalancing may take place on either a quarterly, semi-annual or annual basis, as selected by the contractowner. You may choose to either rebalance within your designated investment accounts, or to rebalance your designated investment account based on your total account value within the group annuity contract. This second selection will move 100% of your balance based on your allocated percentages. For portfolio rebalancing to occur, the total transfer amount must be $50 or more. If this minimum transfer amount is not available, the transfer will not occur. You may change the designated investment accounts' allocations or percentages at any time. The portfolio rebalancing program will be cancelled prematurely if the selected rebalancing account balance falls to $0. GVA III fixed account restrictions may apply. Sales literature may reference the Group Variable Annuity newsletter which is a newsletter distributed quarterly to clients of the VAA. The contents of the newsletter will be a commentary on general economic conditions and, on some occasions, referencing matters in connection with the Group Variable Annuity. Sales literature and advertisements may reference these and other similar reports from Best's or other similar publications which report on the insurance and financial services industries. Other Information Due to differences in redemption rates, tax treatment or other considerations, the interests of contractowners under the variable life accounts could conflict with those of contractowners under the VAA. In those cases, where assets from variable life and variable annuity separate accounts are invested in the same fund(s) (i.e., where mixed funding occurs), the Boards of Directors of the fund involved will monitor for any material conflicts and determine what action, if any, should be taken. If it becomes necessary for any separate account to replace shares of any fund with another investment, that fund may have to liquidate securities on a disadvantageous basis. Refer to the prospectus for each fund for more information about mixed funding. B-5 Financial Statements Financial statements of the VAA, the consolidated financial statements of Jefferson Pilot Financial Insurance Company and Subsidiary, Jefferson-Pilot Life Insurance Company and Subsidiary and The Lincoln National Life Insurance Company, as well as the supplemental consolidated financial statements for Lincoln Life appear on the following pages. B-6 LINCOLN NATIONAL VARIABLE ANNUITY ACCOUNT L L-1 LINCOLN NATIONAL VARIABLE ANNUITY ACCOUNT L STATEMENT OF ASSETS AND LIABILITIES DECEMBER 31, 2006
MORTALITY & EXPENSE CONTRACT CONTRACT GUARANTEE PURCHASES REDEMPTIONS CHARGES DUE FROM DUE TO PAYABLE TO THE LINCOLN THE LINCOLN THE LINCOLN NATIONAL LIFE NATIONAL LIFE NATIONAL LIFE INSURANCE INSURANCE INSURANCE SUBACCOUNT INVESTMENTS COMPANY TOTAL ASSETS COMPANY COMPANY NET ASSETS ---------------------------------------------------------------------------------------------------------------------------------- ABVPSF Global Technology Class B $ 2,549,360 $ 1,812 $ 2,551,172 $ -- $ 208 $ 2,550,964 ABVPSF Growth Class B 1,414,032 1,893 1,415,925 -- 116 1,415,809 ABVPSF Growth and Income Class B 984,705 1,045 985,750 -- 81 985,669 American Century VP Balanced 27,132,371 -- 27,132,371 2,970 2,201 27,127,200 American Funds Global Growth Class 2 3,316,848 24,593 3,341,441 -- 272 3,341,169 American Funds Growth Class 2 30,344,313 13,661 30,357,974 -- 2,482 30,355,492 American Funds Growth-Income Class 2 8,864,559 -- 8,864,559 74,750 727 8,789,082 American Funds International Class 2 18,238,059 -- 18,238,059 26,607 1,490 18,209,962 Baron Capital Asset 24,541,587 19,508 24,561,095 -- 2,000 24,559,095 Delaware VIPT Diversified Income 1,835,344 -- 1,835,344 13,133 149 1,822,062 Delaware VIPT High Yield 1,330,082 728 1,330,810 -- 109 1,330,701 Delaware VIPT REIT Service Class 25,495,657 2,150 25,497,807 -- 2,069 25,495,738 Delaware VIPT Small Cap Value Service Class 9,547,965 28,749 9,576,714 -- 787 9,575,927 Delaware VIPT Trend Service Class 3,029,125 2,487 3,031,612 -- 249 3,031,363 Dreyfus Developing Leaders 62,093,941 -- 62,093,941 92,317 5,101 61,996,523 Dreyfus Stock Index 103,911,259 -- 103,911,259 56,546 8,468 103,846,245 DWS VIP Equity 500 Index 2,251,795 -- 2,251,795 10,512 185 2,241,098 DWS VIP Small Cap Index 2,371,869 24,055 2,395,924 -- 195 2,395,729 Fidelity VIP Asset Manager 60,262,875 -- 60,262,875 1,111 4,919 60,256,845 Fidelity VIP Contrafund Service Class 2 19,164,162 11,750 19,175,912 -- 1,568 19,174,344 Fidelity VIP Equity-Income 88,446,979 -- 88,446,979 164,013 7,242 88,275,724 Fidelity VIP Growth 114,650,218 -- 114,650,218 58,839 9,384 114,581,995 Fidelity VIP Money Market 45,949 -- 45,949 1,199 -- 44,750 Janus Aspen Series Worldwide Growth 18,855,811 -- 18,855,811 5,489 1,527 18,848,795 Lincoln VIPT Aggressive Growth 23,585,117 -- 23,585,117 6,953 1,919 23,576,245 Lincoln VIPT Aggressive Profile 1,072,327 4,928 1,077,255 -- 88 1,077,167 Lincoln VIPT Bond 3,668,517 -- 3,668,517 10,761 300 3,657,456 Lincoln VIPT Capital Appreciation 1,965,368 3,009 1,968,377 -- 159 1,968,218 Lincoln VIPT Conservative Profile 2,013,346 1,578 2,014,924 -- 165 2,014,759 Lincoln VIPT Growth and Income 6,735,843 7,855 6,743,698 -- 550 6,743,148 Lincoln VIPT International 7,512,332 41,192 7,553,524 -- 614 7,552,910 Lincoln VIPT Managed 988,926 2,025 990,951 -- 82 990,869 Lincoln VIPT Moderate Profile 2,512,896 9,377 2,522,273 -- 204 2,522,069 Lincoln VIPT Moderately Aggressive Profile 1,560,144 4,816 1,564,960 -- 128 1,564,832 Lincoln VIPT Social Awareness 21,582,665 -- 21,582,665 6,450 1,755 21,574,460 NB AMT Mid-Cap Growth 4,617,720 15,743 4,633,463 -- 379 4,633,084 NB AMT Partners 11,889,142 4,908 11,894,050 -- 967 11,893,083 T. Rowe Price International Stock 23,430,232 -- 23,430,232 999 1,900 23,427,333
See accompanying notes. L-2 [THIS PAGE INTENTIONALLY LEFT BLANK] STATEMENT OF OPERATIONS YEAR ENDED DECEMBER 31, 2006
DIVIDENDS FROM MORTALITY AND NET INVESTMENT EXPENSE INVESTMENT SUBACCOUNT INCOME GUARANTEE CHARGES INCOME (LOSS) ----------------------------------------------------------------------------------------- ABVPSF Global Technology Class B $ -- $ (24,828) $ (24,828) ABVPSF Growth Class B -- (14,003) (14,003) ABVPSF Growth and Income Class B 8,261 (7,306) 955 American Century VP Balanced 507,081 (260,070) 247,011 American Funds Global Growth Class 2 16,226 (19,950) (3,724) American Funds Growth Class 2 229,640 (274,384) (44,744) American Funds Growth-Income Class 2 126,378 (69,278) 57,100 American Funds International Class 2 274,841 (151,260) 123,581 Baron Capital Asset -- (237,408) (237,408) Delaware VIPT Diversified Income 22,024 (14,777) 7,247 Delaware VIPT High Yield 31,145 (7,222) 23,923 Delaware VIPT REIT Service Class 320,733 (202,893) 117,840 Delaware VIPT Small Cap Value Service Class 1,537 (74,390) (72,853) Delaware VIPT Trend Service Class -- (30,079) (30,079) Dreyfus Developing Leaders 266,228 (648,864) (382,636) Dreyfus Stock Index 1,645,353 (982,717) 662,636 DWS VIP Equity 500 Index 19,420 (17,857) 1,563 DWS VIP Small Cap Index 11,041 (17,422) (6,381) Fidelity VIP Asset Manager 1,668,575 (603,928) 1,064,647 Fidelity VIP Contrafund Service Class 2 166,081 (168,464) (2,383) Fidelity VIP Equity-Income 2,684,384 (791,071) 1,893,313 Fidelity VIP Growth 464,313 (1,161,072) (696,759) Fidelity VIP Money Market 1,501 -- 1,501 Janus Aspen Series Worldwide Growth 312,076 (176,528) 135,548 Lincoln VIPT Aggressive Growth -- (238,117) (238,117) Lincoln VIPT Aggressive Profile 7,358 (7,015) 343 Lincoln VIPT Bond 151,273 (30,214) 121,059 Lincoln VIPT Capital Appreciation 3,513 (17,874) (14,361) Lincoln VIPT Conservative Profile 5,520 (3,106) 2,414 Lincoln VIPT Growth and Income 79,396 (61,751) 17,645 Lincoln VIPT International 145,247 (34,163) 111,084 Lincoln VIPT Managed 22,028 (8,228) 13,800 Lincoln VIPT Moderate Profile 19,542 (12,288) 7,254 Lincoln VIPT Moderately Aggressive Profile 12,628 (8,765) 3,863 Lincoln VIPT Social Awareness 180,389 (200,256) (19,867) NB AMT Mid-Cap Growth -- (44,024) (44,024) NB AMT Partners 85,296 (119,074) (33,778) T. Rowe Price International Stock 257,178 (217,372) 39,806
See accompanying notes. L-4
DIVIDENDS NET CHANGE NET INCREASE FROM TOTAL IN UNREALIZED (DECREASE) IN NET REALIZED NET REALIZED NET REALIZED APPRECIATION NET ASSETS GAIN (LOSS) GAIN ON GAIN (LOSS) OR DEPRECIATION RESULTING FROM SUBACCOUNT ON INVESTMENTS INVESTMENTS ON INVESTMENTS ON INVESTMENTS OPERATIONS -------------------------------------------------------------------------------------------------------------------------- ABVPSF Global Technology Class B $ 85,104 $ -- $ 85,104 $ 108,575 $ 168,851 ABVPSF Growth Class B 46,855 -- 46,855 (72,749) (39,897) ABVPSF Growth and Income Class B 15,892 37,091 52,983 64,105 118,043 American Century VP Balanced 57,851 1,699,661 1,757,512 190,221 2,194,744 American Funds Global Growth Class 2 26,615 -- 26,615 346,232 369,123 American Funds Growth Class 2 407,044 171,044 578,088 1,898,786 2,432,130 American Funds Growth-Income Class 2 28,970 163,798 192,768 708,596 958,464 American Funds International Class 2 322,808 136,699 459,507 1,919,830 2,502,918 Baron Capital Asset 1,987,915 -- 1,987,915 1,529,473 3,279,980 Delaware VIPT Diversified Income 4,771 -- 4,771 92,749 104,767 Delaware VIPT High Yield 2,170 -- 2,170 60,499 86,592 Delaware VIPT REIT Service Class 554,059 1,206,872 1,760,931 3,738,574 5,617,345 Delaware VIPT Small Cap Value Service Class 34,310 418,233 452,543 576,269 955,959 Delaware VIPT Trend Service Class 121,701 -- 121,701 58,545 150,167 Dreyfus Developing Leaders (776,649) 5,505,593 4,728,944 (2,645,095) 1,701,213 Dreyfus Stock Index 2,325,778 -- 2,325,778 10,463,964 13,452,378 DWS VIP Equity 500 Index 27,725 -- 27,725 225,911 255,199 DWS VIP Small Cap Index 23,558 73,866 97,424 149,162 240,205 Fidelity VIP Asset Manager (373,906) -- (373,906) 3,002,056 3,692,797 Fidelity VIP Contrafund Service Class 2 348,997 1,505,871 1,854,868 (248,879) 1,603,606 Fidelity VIP Equity-Income 660,483 9,777,650 10,438,133 1,766,940 14,098,386 Fidelity VIP Growth (1,089,837) -- (1,089,837) 8,367,391 6,580,795 Fidelity VIP Money Market -- -- -- -- 1,501 Janus Aspen Series Worldwide Growth (958,058) -- (958,058) 3,686,144 2,863,634 Lincoln VIPT Aggressive Growth (891,555) -- (891,555) 3,039,267 1,909,595 Lincoln VIPT Aggressive Profile 21,957 25 21,982 93,747 116,072 Lincoln VIPT Bond (13,305) -- (13,305) 14,893 122,647 Lincoln VIPT Capital Appreciation 21,394 -- 21,394 146,132 153,165 Lincoln VIPT Conservative Profile 1,340 87 1,427 27,089 30,930 Lincoln VIPT Growth and Income 129,254 -- 129,254 533,862 680,761 Lincoln VIPT International 32,438 -- 32,438 784,334 927,856 Lincoln VIPT Managed 14,212 -- 14,212 52,777 80,789 Lincoln VIPT Moderate Profile 3,986 46 4,032 155,225 166,511 Lincoln VIPT Moderately Aggressive Profile 11,029 39 11,068 114,743 129,674 Lincoln VIPT Social Awareness 22,365 -- 22,365 2,182,469 2,184,967 NB AMT Mid-Cap Growth 146,851 -- 146,851 390,578 493,405 NB AMT Partners 572,677 1,313,748 1,886,425 (633,211) 1,219,436 T. Rowe Price International Stock 509,476 77,153 586,629 3,017,146 3,643,581
L-5 STATEMENTS OF CHANGES IN NET ASSETS YEARS ENDED DECEMBER 31, 2005 AND 2006
ABVPSF ABVPSF GLOBAL ABVPSF GROWTH AND AMERICAN TECHNOLOGY GROWTH INCOME CENTURY VP CLASS B CLASS B CLASS B BALANCED SUBACCOUNT SUBACCOUNT SUBACCOUNT SUBACCOUNT --------------------------------------------------------------------------------------------------- NET ASSETS AT JANUARY 1, 2005 $ 2,882,430 $1,424,210 $ 171,474 $27,133,446 Changes From Operations: - Net investment income (loss) (24,657) (13,799) 1,334 221,283 - Net realized gain (loss) on investments 71,123 60,673 7,625 65,912 - Net change in unrealized appreciation or depreciation on investments (13,232) 95,158 13,192 726,022 ----------- ---------- --------- ----------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM OPERATIONS 33,234 142,032 22,151 1,013,217 Changes From Unit Transactions: - Contract purchases 1,249,755 441,616 633,408 3,553,026 - Contract withdrawals (1,671,176) (583,944) (267,482) (5,041,900) ----------- ---------- --------- ----------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM UNIT TRANSACTIONS (421,421) (142,328) 365,926 (1,488,874) ----------- ---------- --------- ----------- TOTAL INCREASE (DECREASE) IN NET ASSETS (388,187) (296) 388,077 (475,657) ----------- ---------- --------- ----------- NET ASSETS AT DECEMBER 31, 2005 2,494,243 1,423,914 559,551 26,657,789 Changes From Operations: - Net investment income (loss) (24,828) (14,003) 955 247,011 - Net realized gain (loss) on investments 85,104 46,855 52,983 1,757,512 - Net change in unrealized appreciation or depreciation on investments 108,575 (72,749) 64,105 190,221 ----------- ---------- --------- ----------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM OPERATIONS 168,851 (39,897) 118,043 2,194,744 Changes From Unit Transactions: - Contract purchases 832,544 474,698 626,320 2,675,593 - Contract withdrawals (944,674) (442,906) (318,245) (4,400,926) ----------- ---------- --------- ----------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM UNIT TRANSACTIONS (112,130) 31,792 308,075 (1,725,333) ----------- ---------- --------- ----------- TOTAL INCREASE (DECREASE) IN NET ASSETS 56,721 (8,105) 426,118 469,411 ----------- ---------- --------- ----------- NET ASSETS AT DECEMBER 31, 2006 $ 2,550,964 $1,415,809 $ 985,669 $27,127,200 =========== ========== ========= ===========
See accompanying notes. L-6
AMERICAN AMERICAN AMERICAN AMERICAN FUNDS GLOBAL FUNDS FUNDS FUNDS BARON GROWTH GROWTH GROWTH-INCOME INTERNATIONAL CAPITAL CLASS 2 CLASS 2 CLASS 2 CLASS 2 ASSET SUBACCOUNT SUBACCOUNT SUBACCOUNT SUBACCOUNT SUBACCOUNT ------------------------------------------------------------------------------------------------------------------------ NET ASSETS AT JANUARY 1, 2005 $ 184,048 $16,680,604 $ 1,776,123 $ 6,324,952 $27,275,683 Changes From Operations: - Net investment income (loss) (2,326) (47,323) 26,341 70,881 (263,336) - Net realized gain (loss) on investments 7,412 190,996 22,611 97,413 1,578,842 - Net change in unrealized appreciation or depreciation on investments 95,145 2,878,487 189,035 1,587,879 (733,026) ---------- ----------- ----------- ----------- ----------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM OPERATIONS 100,231 3,022,160 237,987 1,756,173 582,480 Changes From Unit Transactions: - Contract purchases 1,002,233 8,908,820 3,660,369 5,169,624 5,254,144 - Contract withdrawals (197,075) (4,033,980) (469,019) (1,355,107) (8,035,310) ---------- ----------- ----------- ----------- ----------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM UNIT TRANSACTIONS 805,158 4,874,840 3,191,350 3,814,517 (2,781,166) ---------- ----------- ----------- ----------- ----------- TOTAL INCREASE (DECREASE) IN NET ASSETS 905,389 7,897,000 3,429,337 5,570,690 (2,198,686) ---------- ----------- ----------- ----------- ----------- NET ASSETS AT DECEMBER 31, 2005 1,089,437 24,577,604 5,205,460 11,895,642 25,076,997 Changes From Operations: - Net investment income (loss) (3,724) (44,744) 57,100 123,581 (237,408) - Net realized gain (loss) on investments 26,615 578,088 192,768 459,507 1,987,915 - Net change in unrealized appreciation or depreciation on investments 346,232 1,898,786 708,596 1,919,830 1,529,473 ---------- ----------- ----------- ----------- ----------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM OPERATIONS 369,123 2,432,130 958,464 2,502,918 3,279,980 Changes From Unit Transactions: - Contract purchases 2,374,113 8,985,789 3,672,574 7,732,352 3,827,248 - Contract withdrawals (491,504) (5,640,031) (1,047,416) (3,920,950) (7,625,130) ---------- ----------- ----------- ----------- ----------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM UNIT TRANSACTIONS 1,882,609 3,345,758 2,625,158 3,811,402 (3,797,882) ---------- ----------- ----------- ----------- ----------- TOTAL INCREASE (DECREASE) IN NET ASSETS 2,251,732 5,777,888 3,583,622 6,314,320 (517,902) ---------- ----------- ----------- ----------- ----------- NET ASSETS AT DECEMBER 31, 2006 $3,341,169 $30,355,492 $ 8,789,082 $18,209,962 $24,559,095 ========== =========== =========== =========== =========== DELAWARE DELAWARE VIPT DELAWARE DELAWARE VIPT DIVERSIFIED VIPT VIPT REIT SMALL CAP INCOME HIGH YIELD SERVICE CLASS VALUE SERVICE SUBACCOUNT SUBACCOUNT SUBACCOUNT CLASS SUBACCOUNT ----------------------------------------------------------------------------------------------------------- NET ASSETS AT JANUARY 1, 2005 $ 403,732 $ -- $17,252,300 $ 1,588,398 Changes From Operations: - Net investment income (loss) (784) (1,079) 117,169 (31,412) - Net realized gain (loss) on investments 2,943 (1) 1,726,551 214,391 - Net change in unrealized appreciation or depreciation on investments (13,806) 1,916 (944,024) 138,188 ---------- ---------- ----------- ----------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM OPERATIONS (11,647) 836 899,696 321,167 Changes From Unit Transactions: - Contract purchases 1,107,373 360,502 6,351,122 4,486,620 - Contract withdrawals (227,961) (1,433) (7,074,540) (1,064,564) ---------- ---------- ----------- ----------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM UNIT TRANSACTIONS 879,412 359,069 (723,418) 3,422,056 ---------- ---------- ----------- ----------- TOTAL INCREASE (DECREASE) IN NET ASSETS 867,765 359,905 176,278 3,743,223 ---------- ---------- ----------- ----------- NET ASSETS AT DECEMBER 31, 2005 1,271,497 359,905 17,428,578 5,331,621 Changes From Operations: - Net investment income (loss) 7,247 23,923 117,840 (72,853) - Net realized gain (loss) on investments 4,771 2,170 1,760,931 452,543 - Net change in unrealized appreciation or depreciation on investments 92,749 60,499 3,738,574 576,269 ---------- ---------- ----------- ----------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM OPERATIONS 104,767 86,592 5,617,345 955,959 Changes From Unit Transactions: - Contract purchases 1,064,225 1,209,888 7,541,433 4,670,027 - Contract withdrawals (618,427) (325,684) (5,091,618) (1,381,680) ---------- ---------- ----------- ----------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM UNIT TRANSACTIONS 445,798 884,204 2,449,815 3,288,347 ---------- ---------- ----------- ----------- TOTAL INCREASE (DECREASE) IN NET ASSETS 550,565 970,796 8,067,160 4,244,306 ---------- ---------- ----------- ----------- NET ASSETS AT DECEMBER 31, 2006 $1,822,062 $1,330,701 $25,495,738 $ 9,575,927 ========== ========== =========== ===========
L-7
DELAWARE DREYFUS DREYFUS DWS VIP VIPT TREND DEVELOPING STOCK EQUITY SERVICE CLASS LEADERS INDEX 500 INDEX SUBACCOUNT SUBACCOUNT SUBACCOUNT SUBACCOUNT ------------------------------------------------------------------------------------------------------ NET ASSETS AT JANUARY 1, 2005 $ 2,535,815 $ 75,870,480 $110,001,042 $ 768,623 Changes From Operations: - Net investment income (loss) (24,621) (692,071) 624,065 5,327 - Net realized gain (loss) on investments 46,408 (1,029,003) 2,350,310 15,821 - Net change in unrealized appreciation or depreciation on investments 91,174 4,708,137 486,908 37,558 ----------- ------------ ------------ ---------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM OPERATIONS 112,961 2,987,063 3,461,283 58,706 Changes From Unit Transactions: - Contract purchases 787,616 5,186,543 7,065,308 1,152,989 - Contract withdrawals (648,259) (14,386,315) (20,920,406) (424,301) ----------- ------------ ------------ ---------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM UNIT TRANSACTIONS 139,357 (9,199,772) (13,855,098) 728,688 ----------- ------------ ------------ ---------- TOTAL INCREASE (DECREASE) IN NET ASSETS 252,318 (6,212,709) (10,393,815) 787,394 ----------- ------------ ------------ ---------- NET ASSETS AT DECEMBER 31, 2005 2,788,133 69,657,771 99,607,227 1,556,017 Changes From Operations: - Net investment income (loss) (30,079) (382,636) 662,636 1,563 - Net realized gain (loss) on investments 121,701 4,728,944 2,325,778 27,725 - Net change in unrealized appreciation or depreciation on investments 58,545 (2,645,095) 10,463,964 225,911 ----------- ------------ ------------ ---------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM OPERATIONS 150,167 1,701,213 13,452,378 255,199 Changes From Unit Transactions: - Contract purchases 1,137,286 4,106,670 5,928,687 876,285 - Contract withdrawals (1,044,223) (13,469,131) (15,142,047) (446,403) ----------- ------------ ------------ ---------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM UNIT TRANSACTIONS 93,063 (9,362,461) (9,213,360) 429,882 ----------- ------------ ------------ ---------- TOTAL INCREASE (DECREASE) IN NET ASSETS 243,230 (7,661,248) 4,239,018 685,081 ----------- ------------ ------------ ---------- NET ASSETS AT DECEMBER 31, 2006 $ 3,031,363 $ 61,996,523 $103,846,245 $2,241,098 =========== ============ ============ ==========
See accompanying notes. L-8
DWS VIP FIDELITY FIDELITY VIP SMALL CAP VIP ASSET CONTRAFUND FIDELITY VIP FIDELITY VIP INDEX MANAGER SERVICE CLASS 2 EQUITY-INCOME GROWTH SUBACCOUNT SUBACCOUNT SUBACCOUNT SUBACCOUNT SUBACCOUNT ----------------------------------------------------------------------------------------------------------------------- NET ASSETS AT JANUARY 1, 2005 $ 430,699 $ 68,542,269 $ 5,237,198 $ 77,728,119 $138,318,758 Changes From Operations: - Net investment income (loss) (3,211) 1,122,946 (71,750) 482,686 (586,035) - Net realized gain (loss) on investments 35,045 (735,609) 112,637 3,313,461 (3,964,611) - Net change in unrealized appreciation or depreciation on investments 17,471 1,429,863 1,248,625 (334,870) 9,768,489 ---------- ------------ ----------- ------------ ------------ NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM OPERATIONS 49,305 1,817,200 1,289,512 3,461,277 5,217,843 Changes From Unit Transactions: - Contract purchases 1,166,492 4,056,440 7,614,262 7,286,984 8,489,615 - Contract withdrawals (562,720) (11,166,023) (1,831,414) (12,407,534) (29,915,996) ---------- ------------ ----------- ------------ ------------ NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM UNIT TRANSACTIONS 603,772 (7,109,583) 5,782,848 (5,120,550) (21,426,381) ---------- ------------ ----------- ------------ ------------ TOTAL INCREASE (DECREASE) IN NET ASSETS 653,077 (5,292,383) 7,072,360 (1,659,273) (16,208,538) ---------- ------------ ----------- ------------ ------------ NET ASSETS AT DECEMBER 31, 2005 1,083,776 63,249,886 12,309,558 76,068,846 122,110,220 Changes From Operations: - Net investment income (loss) (6,381) 1,064,647 (2,383) 1,893,313 (696,759) - Net realized gain (loss) on investments 97,424 (373,906) 1,854,868 10,438,133 (1,089,837) - Net change in unrealized appreciation or depreciation on investments 149,162 3,002,056 (248,879) 1,766,940 8,367,391 ---------- ------------ ----------- ------------ ------------ NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM OPERATIONS 240,205 3,692,797 1,603,606 14,098,386 6,580,795 Changes From Unit Transactions: - Contract purchases 1,810,896 3,183,247 10,034,888 8,446,040 6,758,836 - Contract withdrawals (739,148) (9,869,085) (4,773,708) (10,337,548) (20,867,856) ---------- ------------ ----------- ------------ ------------ NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM UNIT TRANSACTIONS 1,071,748 (6,685,838) 5,261,180 (1,891,508) (14,109,020) ---------- ------------ ----------- ------------ ------------ TOTAL INCREASE (DECREASE) IN NET ASSETS 1,311,953 (2,993,041) 6,864,786 12,206,878 (7,528,225) ---------- ------------ ----------- ------------ ------------ NET ASSETS AT DECEMBER 31, 2006 $2,395,729 $ 60,256,845 $19,174,344 $ 88,275,724 $114,581,995 ========== ============ =========== ============ ============ JANUS FIDELITY ASPEN SERIES LINCOLN VIPT LINCOLN VIPT VIP MONEY WORLDWIDE AGGRESSIVE AGGRESSIVE MARKET GROWTH GROWTH PROFILE SUBACCOUNT SUBACCOUNT SUBACCOUNT SUBACCOUNT ----------------------------------------------------------------------------------------------------- NET ASSETS AT JANUARY 1, 2005 $ 39,405 $21,898,470 $25,360,950 $ -- Changes From Operations: - Net investment income (loss) 1,110 69,109 (235,043) (587) - Net realized gain (loss) on investments -- (2,164,224) (1,479,875) 9 - Net change in unrealized appreciation or depreciation on investments -- 2,906,759 3,662,246 10,226 --------- ----------- ----------- ---------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM OPERATIONS 1,110 811,644 1,947,328 9,648 Changes From Unit Transactions: - Contract purchases 347,480 2,140,325 2,463,599 194,015 - Contract withdrawals (333,816) (6,139,986) (5,004,068) (884) --------- ----------- ----------- ---------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM UNIT TRANSACTIONS 13,664 (3,999,661) (2,540,469) 193,131 --------- ----------- ----------- ---------- TOTAL INCREASE (DECREASE) IN NET ASSETS 14,774 (3,188,017) (593,141) 202,779 --------- ----------- ----------- ---------- NET ASSETS AT DECEMBER 31, 2005 54,179 18,710,453 24,767,809 202,779 Changes From Operations: - Net investment income (loss) 1,501 135,548 (238,117) 343 - Net realized gain (loss) on investments -- (958,058) (891,555) 21,982 - Net change in unrealized appreciation or depreciation on investments -- 3,686,144 3,039,267 93,747 --------- ----------- ----------- ---------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM OPERATIONS 1,501 2,863,634 1,909,595 116,072 Changes From Unit Transactions: - Contract purchases 255,954 1,400,527 1,818,216 1,117,864 - Contract withdrawals (266,884) (4,125,819) (4,919,375) (359,548) --------- ----------- ----------- ---------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM UNIT TRANSACTIONS (10,930) (2,725,292) (3,101,159) 758,316 --------- ----------- ----------- ---------- TOTAL INCREASE (DECREASE) IN NET ASSETS (9,429) 138,342 (1,191,564) 874,388 --------- ----------- ----------- ---------- NET ASSETS AT DECEMBER 31, 2006 $ 44,750 $18,848,795 $23,576,245 $1,077,167 ========= =========== =========== ==========
L-9
LINCOLN VIPT LINCOLN VIPT LINCOLN VIPT LINCOLN VIPT CAPITAL CONSERVATIVE GROWTH BOND APPRECIATION PROFILE AND INCOME SUBACCOUNT SUBACCOUNT SUBACCOUNT SUBACCOUNT --------------------------------------------------------------------------------------------------------- NET ASSETS AT JANUARY 1, 2005 $ 663,873 $1,768,942 $ -- $ 5,089,902 Changes From Operations: - Net investment income (loss) 76,455 (12,106) (362) 22,873 - Net realized gain (loss) on investments 9,262 13,507 (483) 65,438 - Net change in unrealized appreciation or depreciation on investments (66,231) 48,220 1,508 162,514 ----------- ---------- ---------- ----------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM OPERATIONS 19,486 49,621 663 250,825 Changes From Unit Transactions: - Contract purchases 2,282,568 525,763 195,272 1,895,973 - Contract withdrawals (533,559) (634,251) (73,595) (1,167,112) ----------- ---------- ---------- ----------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM UNIT TRANSACTIONS 1,749,009 (108,488) 121,677 728,861 ----------- ---------- ---------- ----------- TOTAL INCREASE (DECREASE) IN NET ASSETS 1,768,495 (58,867) 122,340 979,686 ----------- ---------- ---------- ----------- NET ASSETS AT DECEMBER 31, 2005 2,432,368 1,710,075 122,340 6,069,588 Changes From Operations: - Net investment income (loss) 121,059 (14,361) 2,414 17,645 - Net realized gain (loss) on investments (13,305) 21,394 1,427 129,254 - Net change in unrealized appreciation or depreciation on investments 14,893 146,132 27,089 533,862 ----------- ---------- ---------- ----------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM OPERATIONS 122,647 153,165 30,930 680,761 Changes From Unit Transactions: - Contract purchases 2,114,937 444,455 2,031,714 1,278,386 - Contract withdrawals (1,012,496) (339,477) (170,225) (1,285,587) ----------- ---------- ---------- ----------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM UNIT TRANSACTIONS 1,102,441 104,978 1,861,489 (7,201) ----------- ---------- ---------- ----------- TOTAL INCREASE (DECREASE) IN NET ASSETS 1,225,088 258,143 1,892,419 673,560 ----------- ---------- ---------- ----------- NET ASSETS AT DECEMBER 31, 2006 $ 3,657,456 $1,968,218 $2,014,759 $ 6,743,148 =========== ========== ========== ===========
See accompanying notes. L-10
LINCOLN VIPT LINCOLN VIPT MODERATELY LINCOLN VIPT LINCOLN VIPT MODERATE AGGRESSIVE INTERNATIONAL MANAGED PROFILE PROFILE SUBACCOUNT SUBACCOUNT SUBACCOUNT SUBACCOUNT ---------------------------------------------------------------------------------------------------------- NET ASSETS AT JANUARY 1, 2005 $ 263,924 $ 325,853 $ -- $ -- Changes From Operations: - Net investment income (loss) 17,135 10,927 (946) (774) - Net realized gain (loss) on investments 10,492 5,307 76 (38) - Net change in unrealized appreciation or depreciation on investments 98,135 4,559 9,564 7,823 ---------- --------- ---------- ---------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM OPERATIONS 125,762 20,793 8,694 7,011 Changes From Unit Transactions: - Contract purchases 1,823,234 588,752 368,805 422,239 - Contract withdrawals (592,602) (159,633) (37,739) (8,654) ---------- --------- ---------- ---------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM UNIT TRANSACTIONS 1,230,632 429,119 331,066 413,585 ---------- --------- ---------- ---------- TOTAL INCREASE (DECREASE) IN NET ASSETS 1,356,394 449,912 339,760 420,596 ---------- --------- ---------- ---------- NET ASSETS AT DECEMBER 31, 2005 1,620,318 775,765 339,760 420,596 Changes From Operations: - Net investment income (loss) 111,084 13,800 7,254 3,863 - Net realized gain (loss) on investments 32,438 14,212 4,032 11,068 - Net change in unrealized appreciation or depreciation on investments 784,334 52,777 155,225 114,743 ---------- --------- ---------- ---------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM OPERATIONS 927,856 80,789 166,511 129,674 Changes From Unit Transactions: - Contract purchases 5,936,237 487,173 2,263,168 1,273,591 - Contract withdrawals (931,501) (352,858) (247,370) (259,029) ---------- --------- ---------- ---------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM UNIT TRANSACTIONS 5,004,736 134,315 2,015,798 1,014,562 ---------- --------- ---------- ---------- TOTAL INCREASE (DECREASE) IN NET ASSETS 5,932,592 215,104 2,182,309 1,144,236 ---------- --------- ---------- ---------- NET ASSETS AT DECEMBER 31, 2006 $7,552,910 $ 990,869 $2,522,069 $1,564,832 ========== ========= ========== ========== LINCOLN VIPT NB AMT T. ROWE PRICE SOCIAL MID-CAP NB AMT INTERNATIONAL AWARENESS GROWTH PARTNERS STOCK SUBACCOUNT SUBACCOUNT SUBACCOUNT SUBACCOUNT -------------------------------------------------------------------------------------------------------- NET ASSETS AT JANUARY 1, 2005 $ 18,372,102 $ 1,878,881 $ 8,945,159 $19,948,620 Changes From Operations: - Net investment income (loss) (22,345) (23,074) 2,008 122,667 - Net realized gain (loss) on investments (213,651) 23,567 294,085 187,847 - Net change in unrealized appreciation or depreciation on investments 2,176,222 306,661 1,335,310 2,478,983 ------------ ----------- ----------- ----------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM OPERATIONS 1,940,226 307,154 1,631,403 2,789,497 Changes From Unit Transactions: - Contract purchases 2,645,614 1,720,374 4,574,738 2,526,539 - Contract withdrawals (3,155,133) (483,109) (2,938,421) (3,836,163) ------------ ----------- ----------- ----------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM UNIT TRANSACTIONS (509,519) 1,237,265 1,636,317 (1,309,624) ------------ ----------- ----------- ----------- TOTAL INCREASE (DECREASE) IN NET ASSETS 1,430,707 1,544,419 3,267,720 1,479,873 ------------ ----------- ----------- ----------- NET ASSETS AT DECEMBER 31, 2005 19,802,809 3,423,300 12,212,879 21,428,493 Changes From Operations: - Net investment income (loss) (19,867) (44,024) (33,778) 39,806 - Net realized gain (loss) on investments 22,365 146,851 1,886,425 586,629 - Net change in unrealized appreciation or depreciation on investments 2,182,469 390,578 (633,211) 3,017,146 ------------ ----------- ----------- ----------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM OPERATIONS 2,184,967 493,405 1,219,436 3,643,581 Changes From Unit Transactions: - Contract purchases 2,247,054 2,271,352 2,240,885 2,204,556 - Contract withdrawals (2,660,370) (1,554,973) (3,780,117) (3,849,297) ------------ ----------- ----------- ----------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM UNIT TRANSACTIONS (413,316) 716,379 (1,539,232) (1,644,741) ------------ ----------- ----------- ----------- TOTAL INCREASE (DECREASE) IN NET ASSETS 1,771,651 1,209,784 (319,796) 1,998,840 ------------ ----------- ----------- ----------- NET ASSETS AT DECEMBER 31, 2006 $ 21,574,460 $ 4,633,084 $11,893,083 $23,427,333 ============ =========== =========== ===========
L-11 NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 2006 1. ACCOUNTING POLICIES AND ACCOUNT INFORMATION THE VARIABLE ACCOUNT: Lincoln National Variable Annuity Account L (Variable Account) is a segregated investment account of The Lincoln National Life Insurance Company (the Company) and is registered with the Securities and Exchange Commission under the Investment Company Act of 1940, as amended, as a unit investment trust. The contracts are eligible for the lower, or "Breakpoint", mortality and expense risk charge if criteria has been satisfied that the Company realizes lower issue and administrative costs. The assets of the Variable Account are owned by the Company. The Variable Account's assets supporting the annuity contracts may not be used to satisfy liabilities arising from any other business of the Company. During 2007, Jefferson Pilot Life Insurance Company and Jefferson Pilot Financial Insurance Company will merge into The Lincoln National Life Insurance Company. The merger will not affect the assets and liabilities of Lincoln National Variable Annuity Account L. BASIS OF PRESENTATION: The accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States for unit investment trusts. INVESTMENTS: The assets of the Variable Account are divided into variable subaccounts, each of which is invested in shares of thirty-eight mutual funds (the Funds) of twelve diversified open-end management investment companies, each Fund with its own investment objective. The Funds are: AllianceBernstein Variable Products Series Fund, Inc. (ABVPSF): ABVPSF Global Technology Class B Fund ABVPSF Growth Class B Fund ABVPSF Growth and Income Class B Fund American Century Variable Portfolios, Inc. (American Century VP): American Century VP Balanced Portfolio American Funds Insurance Series (American Funds): American Funds Global Growth Class 2 Fund American Funds Growth Class 2 Fund American Funds Growth-Income Class 2 Fund American Funds International Class 2 Fund Baron Capital Funds Trust (Baron Capital): Baron Capital Asset Fund Delaware VIP Trust (Delaware VIPT)*: Delaware VIPT Diversified Income Series Delaware VIPT High Yield Series Delaware VIPT REIT Service Class Series Delaware VIPT Small Cap Value Service Class Series Delaware VIPT Trend Service Class Series Dreyfus Variable Investment Fund (Dreyfus): Dreyfus Developing Leaders Portfolio Dreyfus Stock Index Fund DWS Scudder VIP Funds (DWS VIP): DWS VIP Equity 500 Index Fund DWS VIP Small Cap Index Fund Fidelity Variable Insurance Products Fund (Fidelity VIP): Fidelity VIP Asset Manager Portfolio Fidelity VIP Contrafund Service Class 2 Portfolio Fidelity VIP Equity-Income Portfolio Fidelity VIP Growth Portfolio Fidelity VIP Money Market Portfolio Janus Aspen Series: Janus Aspen Series Worldwide Growth Portfolio Lincoln Variable Insurance Products Trust (Lincoln VIPT)*: Lincoln VIPT Aggressive Growth Fund Lincoln VIPT Aggressive Profile Fund Lincoln VIPT Bond Fund Lincoln VIPT Capital Appreciation Fund Lincoln VIPT Conservative Profile Fund Lincoln VIPT Growth and Income Fund Lincoln VIPT International Fund Lincoln VIPT Managed Fund Lincoln VIPT Moderate Profile Fund Lincoln VIPT Moderately Aggressive Profile Fund Lincoln VIPT Social Awareness Fund Neuberger Berman Advisors Management Trust (NB AMT): NB AMT Mid-Cap Growth Fund NB AMT Partners Fund T. Rowe Price International Series, Inc. (T. Rowe Price): T. Rowe Price International Stock Portfolio * Denotes an affiliate of The Lincoln National Life Insurance Company. The Fidelity VIP Money Market Portfolio is used only for investments of initial contributions for which the Company has not received complete order instructions. Upon receipt of complete order instructions, the payments transferred to the Fidelity VIP Money Market Portfolio are allocated to purchase shares of one of the above Funds. Investments in the Funds are stated at the closing net asset value per share on December 31, 2006, which approximates fair value. The difference between cost and fair value is reflected as unrealized appreciation or depreciation of investments. Investment transactions are accounted for on a trade date basis. The cost of investments sold is determined by the average cost method. L-12 1. ACCOUNTING POLICIES AND ACCOUNT INFORMATION (CONTINUED) DIVIDENDS: Dividends paid to the Variable Account are automatically reinvested in shares of the Funds on the payable date with the exception of Fidelity VIP Money Market Portfolio, which is invested monthly. Dividend income is recorded on the ex-dividend date. FEDERAL INCOME TAXES: Operations of the Variable Account form a part of and are taxed with operations of the Company, which is taxed as a "life insurance company" under the Internal Revenue Code. The Variable Account will not be taxed as a regulated investment company under Subchapter M of the Internal Revenue Code, as amended. Under current federal income tax law, no federal income taxes are payable with respect to the Variable Account's net investment income and the net realized gain on investments. NEW INVESTMENT FUNDS AND FUND NAME CHANGES: During 2005, the Delaware VIPT High Yield Series, the Lincoln VIPT Aggressive Profile Fund, the Lincoln VIPT Conservative Profile Fund, the Lincoln VIPT Moderate Profile Fund and the Lincoln VIPT Moderately Aggressive Profile Fund became available as investment options for Variable Account contract owners. Accordingly, the 2005 statements of changes in net assets and total return and investment income ratios in note 3 for these subaccounts are for the period from the commencement of operations to December 31, 2005. Also during 2005, the ABVPSF Technology Class B Fund changed its name to the ABVPSF Global Technology Class B Fund. During 2006, the Scudder Investments VIT Funds (Scudder VIT) family of funds changed its name to DWS Scudder VIP Funds (DWS VIP). 2. MORTALITY AND EXPENSE GUARANTEES AND OTHER TRANSACTIONS WITH AFFILIATES Amounts are paid to the Company for mortality and expense guarantees at a percentage of the current value of the Variable Account each day with the exception of Fidelity VIP Money Market Portfolio, which does not have a mortality and expense charge. The rates are as follows: - Standard at a daily rate of .00273973 (1.00% on an annual basis) - Breakpoint at a daily rate of .00205479 (.75% on an annual basis) Accordingly, the Company is responsible for all sales, general and administrative expenses applicable to the Variable Account. 3. FINANCIAL HIGHLIGHTS A summary of the fee rates, unit values, units outstanding, net assets and total return and investment income ratios for variable annuity contracts as of and for each year or period in the five years ended December 31, 2006 follows.
MINIMUM MAXIMUM MINIMUM MAXIMUM MINIMUM MAXIMUM INVESTMENT COMMENCEMENT FEE FEE UNIT UNIT UNITS TOTAL TOTAL INCOME SUBACCOUNT YEAR DATE(1) RATE(2) RATE(2) VALUE(3) VALUE(3) OUTSTANDING NET ASSETS RETURN(4) RETURN(4) RATIO(5) -------------------------------------------------------------------------------------------------------------------------------- ABVPSF GLOBAL TECHNOLOGY CLASS B 2006 0.75% 1.00% $ 4.92 $ 5.00 518,348 $ 2,550,964 7.30% 7.57% 0.00% 2005 0.75% 1.00% 4.58 4.64 543,901 2,494,243 2.61% 2.87% 0.00% 2004 0.75% 1.00% 4.47 4.52 645,002 2,882,430 4.04% 4.30% 0.00% 2003 0.75% 1.00% 4.29 4.33 634,977 2,726,924 42.36% 42.72% 0.00% 2002 0.75% 1.00% 3.02 3.03 356,123 1,074,302 -42.39% -42.24% 0.00% ABVPSF GROWTH CLASS B 2006 0.75% 1.00% 7.67 7.79 184,496 1,415,809 -2.22% -1.98% 0.00% 2005 0.75% 1.00% 7.84 7.95 181,450 1,423,914 10.52% 10.80% 0.00% 2004 0.75% 1.00% 7.10 7.17 200,618 1,424,210 13.39% 13.67% 0.00% 2003 0.75% 1.00% 6.26 6.31 166,869 1,044,684 33.36% 33.70% 0.00% 2002 0.75% 1.00% 4.69 4.72 77,381 363,366 -28.98% -28.80% 0.00% ABVPSF GROWTH AND INCOME CLASS B 2006 0.75% 1.00% 13.35 13.44 73,807 985,669 15.82% 16.11% 1.12% 2005 0.75% 1.00% 11.53 11.57 48,528 559,551 3.56% 3.82% 1.28% 2004 6/2/04 0.75% 1.00% 11.13 11.15 15,401 171,474 6.52% 8.62% 0.00% AMERICAN CENTURY VP BALANCED 2006 0.75% 1.00% 27.68 28.20 978,891 27,127,200 8.53% 8.80% 1.92% 2005 0.75% 1.00% 25.50 25.92 1,044,194 26,657,789 3.89% 4.15% 1.82% 2004 0.75% 1.00% 24.55 24.89 1,104,388 27,133,446 8.69% 8.96% 1.62% 2003 0.75% 1.00% 22.59 22.84 1,099,205 24,843,084 18.27% 18.57% 2.57% 2002 0.75% 1.00% 19.10 19.26 1,086,014 20,752,198 -10.46% -10.23% 2.73%
L-13 3. FINANCIAL HIGHLIGHTS (CONTINUED)
MINIMUM MAXIMUM MINIMUM MAXIMUM MINIMUM MAXIMUM INVESTMENT COMMENCEMENT FEE FEE UNIT UNIT UNITS TOTAL TOTAL INCOME SUBACCOUNT YEAR DATE(1) RATE(2) RATE(2) VALUE(3) VALUE(3) OUTSTANDING NET ASSETS RETURN(4) RETURN(4) RATIO(5) -------------------------------------------------------------------------------------------------------------------------------- AMERICAN FUNDS GLOBAL GROWTH CLASS 2 2006 0.75% 1.00% $15.23 $15.33 219,365 $ 3,341,169 19.23% 19.53% 0.81% 2005 0.75% 1.00% 12.77 12.83 85,285 1,089,437 12.94% 13.23% 0.62% 2004 6/2/04 0.75% 1.00% 11.31 11.33 16,273 184,048 -0.18% 11.01% 0.00% AMERICAN FUNDS GROWTH CLASS 2 2006 0.75% 1.00% 10.32 10.48 2,940,200 30,355,492 9.12% 9.39% 0.83% 2005 0.75% 1.00% 9.46 9.58 2,598,102 24,577,604 15.04% 15.32% 0.75% 2004 0.75% 1.00% 8.22 8.31 2,028,674 16,680,604 11.38% 11.66% 0.19% 2003 0.75% 1.00% 7.38 7.44 1,490,461 11,001,230 35.45% 35.79% 0.14% 2002 0.75% 1.00% 5.45 5.48 920,362 5,015,649 -25.21% -25.02% 0.04% AMERICAN FUNDS GROWTH-INCOME CLASS 2 2006 0.75% 1.00% 13.12 13.20 669,845 8,789,082 14.06% 14.34% 1.82% 2005 0.75% 1.00% 11.50 11.55 452,521 5,205,460 4.78% 5.04% 1.75% 2004 6/1/04 0.75% 1.00% 10.98 10.99 161,789 1,776,123 7.21% 8.00% 1.68% AMERICAN FUNDS INTERNATIONAL CLASS 2 2006 0.75% 1.00% 12.83 13.03 1,419,434 18,209,962 17.79% 18.09% 1.81% 2005 0.75% 1.00% 10.89 11.03 1,092,363 11,895,642 20.29% 20.60% 1.87% 2004 0.75% 1.00% 9.05 9.15 698,684 6,324,952 18.13% 18.43% 1.66% 2003 0.75% 1.00% 7.66 7.72 392,222 3,005,680 33.51% 33.85% 2.16% 2002 0.75% 1.00% 5.74 5.77 171,254 983,054 -15.69% -15.48% 1.66% BARON CAPITAL ASSET 2006 0.75% 1.00% 30.33 30.91 808,702 24,559,095 14.37% 14.66% 0.00% 2005 0.75% 1.00% 26.52 26.96 944,820 25,076,997 2.34% 2.59% 0.00% 2004 0.75% 1.00% 25.92 26.28 1,051,968 27,275,683 24.39% 24.70% 0.00% 2003 0.75% 1.00% 20.83 21.07 951,461 19,828,408 28.72% 29.04% 0.00% 2002 0.75% 1.00% 16.19 16.33 938,804 15,199,665 -15.05% -14.84% 0.00% DELAWARE VIPT DIVERSIFIED INCOME 2006 0.75% 1.00% 11.52 11.59 158,190 1,822,062 6.85% 7.11% 1.49% 2005 0.75% 1.00% 10.78 10.82 117,970 1,271,497 -1.44% -1.20% 0.91% 2004 6/2/04 0.75% 1.00% 10.94 10.95 36,920 403,732 3.68% 8.87% 0.00% DELAWARE VIPT HIGH YIELD 2006 0.75% 1.00% 11.44 11.48 116,341 1,330,701 11.33% 11.61% 4.30% 2005 7/12/05 0.75% 1.00% 10.27 10.29 35,032 359,905 0.53% 0.90% 0.00% DELAWARE VIPT REIT SERVICE CLASS 2006 0.75% 1.00% 27.99 28.42 910,538 25,495,738 31.01% 31.33% 1.57% 2005 0.75% 1.00% 21.36 21.64 815,493 17,428,578 5.79% 6.06% 1.68% 2004 0.75% 1.00% 20.19 20.41 854,122 17,252,300 29.78% 30.11% 1.77% 2003 0.75% 1.00% 15.56 15.68 615,446 9,577,143 32.40% 32.73% 2.26% 2002 0.75% 1.00% 11.75 11.82 512,211 6,020,157 3.34% 3.60% 1.35% DELAWARE VIPT SMALL CAP VALUE SERVICE CLASS 2006 0.75% 1.00% 15.02 15.12 637,375 9,575,927 14.73% 15.02% 0.02% 2005 0.75% 1.00% 13.09 13.15 407,175 5,331,621 8.06% 8.33% 0.12% 2004 6/1/04 0.75% 1.00% 12.12 12.14 131,091 1,588,398 17.56% 18.16% 0.00% DELAWARE VIPT TREND SERVICE CLASS 2006 0.75% 1.00% 8.50 8.63 356,472 3,031,363 6.27% 6.53% 0.00% 2005 0.75% 1.00% 8.00 8.10 348,466 2,788,133 4.56% 4.83% 0.00% 2004 0.75% 1.00% 7.65 7.73 331,456 2,535,815 11.20% 11.48% 0.00% 2003 0.75% 1.00% 6.88 6.93 222,850 1,533,130 33.45% 33.79% 0.00% 2002 0.75% 1.00% 5.15 5.18 129,038 665,325 -20.86% -20.66% 0.00% DREYFUS DEVELOPING LEADERS 2006 0.75% 1.00% 26.54 27.04 2,334,223 61,996,523 2.74% 2.99% 0.41% 2005 0.75% 1.00% 25.83 26.26 2,694,886 69,657,771 4.75% 5.01% 0.00% 2004 0.75% 1.00% 24.66 25.00 3,074,985 75,870,480 10.23% 10.51% 0.20% 2003 0.75% 1.00% 22.37 22.63 3,208,955 71,810,565 30.38% 30.71% 0.03% 2002 0.75% 1.00% 17.16 17.31 3,243,293 55,666,049 -19.93% -19.73% 0.04%
L-14 3. FINANCIAL HIGHLIGHTS (CONTINUED)
MINIMUM MAXIMUM MINIMUM MAXIMUM MINIMUM MAXIMUM INVESTMENT COMMENCEMENT FEE FEE UNIT UNIT UNITS TOTAL TOTAL INCOME SUBACCOUNT YEAR DATE(1) RATE(2) RATE(2) VALUE(3) VALUE(3) OUTSTANDING NET ASSETS RETURN(4) RETURN(4) RATIO(5) ---------------------------------------------------------------------------------------------------------------------------------- DREYFUS STOCK INDEX 2006 0.75% 1.00% $44.77 $45.62 2,317,135 $103,846,245 14.35% 14.63% 1.65% 2005 0.75% 1.00% 39.15 39.80 2,541,797 99,607,227 3.65% 3.91% 1.60% 2004 0.75% 1.00% 37.78 38.30 2,909,931 110,001,042 9.54% 9.81% 1.81% 2003 0.75% 1.00% 34.49 34.88 3,013,626 103,979,670 27.09% 27.41% 1.50% 2002 0.75% 1.00% 27.14 27.37 3,082,208 83,676,695 -23.14% -22.94% 1.33% DWS VIP EQUITY 500 INDEX 2006 0.75% 1.00% 13.16 13.24 170,315 2,241,098 14.37% 14.66% 1.08% 2005 0.75% 1.00% 11.50 11.55 135,261 1,556,017 3.63% 3.89% 1.44% 2004 6/2/04 0.75% 1.00% 11.10 11.12 69,247 768,623 7.99% 10.41% 0.00% DWS VIP SMALL CAP INDEX 2006 0.75% 1.00% 14.15 14.25 169,218 2,395,729 16.32% 16.61% 0.63% 2005 0.75% 1.00% 12.17 12.22 89,056 1,083,776 3.22% 3.48% 0.58% 2004 6/4/04 0.75% 1.00% 11.79 11.81 36,535 430,699 14.60% 15.88% 0.00% FIDELITY VIP ASSET MANAGER 2006 0.75% 1.00% 28.09 28.62 2,143,508 60,256,845 6.25% 6.52% 2.74% 2005 0.75% 1.00% 26.44 26.87 2,390,790 63,249,886 3.01% 3.27% 2.73% 2004 0.75% 1.00% 25.67 26.02 2,669,058 68,542,269 4.42% 4.68% 2.73% 2003 0.75% 1.00% 24.58 24.86 2,874,822 70,688,251 16.80% 17.09% 3.57% 2002 0.75% 1.00% 21.05 21.23 3,132,093 65,932,059 -9.64% -9.41% 4.09% FIDELITY VIP CONTRAFUND SERVICE CLASS 2 2006 0.75% 1.00% 13.46 13.67 1,424,007 19,174,344 10.32% 10.60% 0.98% 2005 0.75% 1.00% 12.20 12.36 1,008,577 12,309,558 15.49% 15.78% 0.10% 2004 0.75% 1.00% 10.56 10.68 495,569 5,237,198 14.01% 14.30% 0.16% 2003 0.75% 1.00% 9.27 9.34 261,580 2,423,802 26.92% 27.24% 0.25% 2002 0.75% 1.00% 7.30 7.34 173,583 1,267,412 -10.50% -10.28% 0.47% FIDELITY VIP EQUITY-INCOME 2006 0.75% 1.00% 34.32 34.97 2,570,626 88,275,724 19.00% 19.30% 3.36% 2005 0.75% 1.00% 28.84 29.31 2,636,306 76,068,846 4.81% 5.07% 1.64% 2004 0.75% 1.00% 27.51 27.90 2,823,725 77,728,119 10.42% 10.70% 1.52% 2003 0.75% 1.00% 24.92 25.20 2,831,538 70,574,288 29.03% 29.36% 1.78% 2002 0.75% 1.00% 19.31 19.48 2,900,506 56,025,109 -17.77% -17.57% 1.81% FIDELITY VIP GROWTH 2006 0.75% 1.00% 39.48 40.23 2,900,026 114,581,995 5.79% 6.05% 0.40% 2005 0.75% 1.00% 37.32 37.94 3,269,686 122,110,220 4.75% 5.01% 0.52% 2004 0.75% 1.00% 35.63 36.13 3,879,966 138,318,758 2.35% 2.61% 0.27% 2003 0.75% 1.00% 34.81 35.21 4,271,497 148,743,129 31.53% 31.86% 0.27% 2002 0.75% 1.00% 26.47 26.70 4,544,049 120,301,371 -30.80% -30.63% 0.26% FIDELITY VIP MONEY MARKET 2006 0.00% 0.00% 16.41 16.44 2,727 44,749 4.87% 4.88% 4.70% 2005 0.00% 0.00% 15.65 15.67 3,462 54,179 3.01% 3.03% 2.86% 2004 0.00% 0.00% 15.19 15.21 2,594 39,405 1.21% 1.29% 1.13% 2003 0.00% 0.00% 15.01 15.02 2,512 37,695 1.00% 1.00% 1.04% 2002 0.00% 0.00% 14.86 14.87 5,186 77,056 1.63% 1.70% 1.73% JANUS ASPEN SERIES WORLDWIDE GROWTH 2006 0.75% 1.00% 15.06 15.34 1,250,294 18,848,795 17.03% 17.32% 1.74% 2005 0.75% 1.00% 12.87 13.08 1,452,801 18,710,453 4.81% 5.07% 1.34% 2004 0.75% 1.00% 12.28 12.45 1,782,575 21,898,470 3.74% 4.00% 1.00% 2003 0.75% 1.00% 11.83 11.97 1,997,597 23,648,472 22.76% 23.06% 1.11% 2002 0.75% 1.00% 9.64 9.72 2,202,281 21,238,076 -26.24% -26.06% 0.90% LINCOLN VIPT AGGRESSIVE GROWTH 2006 0.75% 1.00% 13.42 13.67 1,755,202 23,576,245 8.19% 8.46% 0.00% 2005 0.75% 1.00% 12.40 12.61 1,995,282 24,767,809 8.72% 8.99% 0.00% 2004 0.75% 1.00% 11.41 11.57 2,221,637 25,360,950 12.53% 12.82% 0.00% 2003 0.75% 1.00% 10.14 10.25 2,337,426 23,704,442 31.30% 31.63% 0.00% 2002 0.75% 1.00% 7.72 7.79 2,320,539 17,923,056 -30.92% -30.74% 0.00%
L-15 3. FINANCIAL HIGHLIGHTS (CONTINUED)
MINIMUM MAXIMUM MINIMUM MAXIMUM MINIMUM MAXIMUM INVESTMENT COMMENCEMENT FEE FEE UNIT UNIT UNITS TOTAL TOTAL INCOME SUBACCOUNT YEAR DATE(1) RATE(2) RATE(2) VALUE(3) VALUE(3) OUTSTANDING NET ASSETS RETURN(4) RETURN(4) RATIO(5) -------------------------------------------------------------------------------------------------------------------------------- LINCOLN VIPT AGGRESSIVE PROFILE 2006 0.75% 1.00% $12.62 $12.67 85,336 $ 1,077,167 15.39% 15.67% 1.05% 2005 6/7/05 0.75% 1.00% 10.94 10.95 18,537 202,779 8.10% 9.32% 0.00% LINCOLN VIPT BOND 2006 0.75% 1.00% 11.12 11.19 328,992 3,657,456 3.67% 3.93% 4.98% 2005 0.75% 1.00% 10.72 10.76 226,840 2,432,368 1.62% 1.87% 5.82% 2004 5/28/04 0.75% 1.00% 10.55 10.57 62,916 663,873 0.24% 4.97% 5.39% LINCOLN VIPT CAPITAL APPRECIATION 2006 0.75% 1.00% 6.70 6.80 293,578 1,968,218 8.58% 8.85% 0.19% 2005 0.75% 1.00% 6.17 6.25 276,982 1,710,075 3.17% 3.42% 0.26% 2004 0.75% 1.00% 5.98 6.04 295,673 1,768,942 4.23% 4.50% 0.00% 2003 0.75% 1.00% 5.74 5.78 256,029 1,469,023 31.14% 31.47% 0.00% 2002 0.75% 1.00% 4.37 4.40 178,153 779,521 -27.69% -27.51% 0.00% LINCOLN VIPT CONSERVATIVE PROFILE 2006 0.75% 1.00% 11.15 11.20 180,611 2,014,759 8.25% 8.52% 1.84% 2005 6/6/05 0.75% 1.00% 10.30 10.32 11,873 122,340 1.68% 3.04% 0.00% LINCOLN VIPT GROWTH AND INCOME 2006 0.75% 1.00% 10.16 10.32 663,117 6,743,148 11.24% 11.52% 1.27% 2005 0.75% 1.00% 9.13 9.25 664,088 6,069,588 4.49% 4.75% 1.41% 2004 0.75% 1.00% 8.74 8.84 581,984 5,089,902 10.88% 11.15% 1.50% 2003 0.75% 1.00% 7.88 7.95 386,289 3,046,056 28.42% 28.75% 1.45% 2002 0.75% 1.00% 6.14 6.17 218,753 1,343,791 -22.82% -22.63% 1.48% LINCOLN VIPT INTERNATIONAL 2006 0.75% 1.00% 17.58 17.69 429,665 7,552,910 28.71% 29.03% 4.22% 2005 0.75% 1.00% 13.65 13.71 118,640 1,620,318 11.42% 11.70% 2.67% 2004 5/24/04 0.75% 1.00% 12.25 12.27 21,536 263,924 18.67% 22.55% 1.63% LINCOLN VIPT MANAGED 2006 0.75% 1.00% 12.48 12.56 79,421 990,869 9.47% 9.75% 2.68% 2005 0.75% 1.00% 11.40 11.44 68,069 775,765 3.49% 3.75% 3.10% 2004 6/7/04 0.75% 1.00% 11.01 11.03 29,588 325,853 -0.05% 7.64% 3.44% LINCOLN VIPT MODERATE PROFILE 2006 0.75% 1.00% 11.67 11.72 216,008 2,522,069 10.92% 11.20% 1.58% 2005 6/24/05 0.75% 1.00% 10.52 10.54 32,283 339,760 1.20% 5.18% 0.00% LINCOLN VIPT MODERATELY AGGRESSIVE PROFILE 2006 0.75% 1.00% 12.09 12.14 129,388 1,564,832 13.01% 13.29% 1.43% 2005 7/7/05 0.75% 1.00% 10.70 10.71 39,304 420,596 3.96% 6.49% 0.00% LINCOLN VIPT SOCIAL AWARENESS 2006 0.75% 1.00% 16.46 16.77 1,308,991 21,574,460 11.19% 11.47% 0.89% 2005 0.75% 1.00% 14.81 15.05 1,336,207 19,802,809 10.91% 11.19% 0.86% 2004 0.75% 1.00% 13.35 13.53 1,375,179 18,372,102 11.58% 11.86% 0.97% 2003 0.75% 1.00% 11.96 12.10 1,355,859 16,230,913 30.55% 30.88% 0.89% 2002 0.75% 1.00% 9.16 9.24 1,309,142 12,004,399 -22.90% -22.70% 0.97% NB AMT MID-CAP GROWTH 2006 0.75% 1.00% 7.48 7.59 619,338 4,633,084 13.55% 13.84% 0.00% 2005 0.75% 1.00% 6.58 6.67 519,732 3,423,300 12.61% 12.89% 0.00% 2004 0.75% 1.00% 5.85 5.91 321,228 1,878,881 15.15% 15.44% 0.00% 2003 0.75% 1.00% 5.08 5.12 236,792 1,202,559 26.80% 27.12% 0.00% 2002 0.75% 1.00% 4.00 4.03 159,808 640,134 -30.04% -29.87% 0.00% NB AMT PARTNERS 2006 0.75% 1.00% 18.58 18.94 639,280 11,893,083 11.12% 11.40% 0.71% 2005 0.75% 1.00% 16.72 17.00 729,534 12,212,879 16.87% 17.16% 1.00% 2004 0.75% 1.00% 14.31 14.51 624,552 8,945,159 17.79% 18.09% 0.01% 2003 0.75% 1.00% 12.15 12.29 545,036 6,626,293 33.75% 34.08% 0.00% 2002 0.75% 1.00% 9.08 9.16 451,029 4,100,305 -24.90% -24.71% 0.50%
L-16 3. FINANCIAL HIGHLIGHTS (CONTINUED)
MINIMUM MAXIMUM MINIMUM MAXIMUM MINIMUM MAXIMUM INVESTMENT COMMENCEMENT FEE FEE UNIT UNIT UNITS TOTAL TOTAL INCOME SUBACCOUNT YEAR DATE(1) RATE(2) RATE(2) VALUE(3) VALUE(3) OUTSTANDING NET ASSETS RETURN(4) RETURN(4) RATIO(5) -------------------------------------------------------------------------------------------------------------------------------- T. ROWE PRICE INTERNATIONAL STOCK 2006 0.75% 1.00% $18.92 $19.27 1,237,640 $23,427,333 17.91% 18.20% 1.17% 2005 0.75% 1.00% 16.04 16.31 1,334,898 21,428,493 14.88% 15.17% 1.61% 2004 0.75% 1.00% 13.96 14.16 1,427,817 19,948,620 12.64% 12.92% 1.13% 2003 0.75% 1.00% 12.40 12.54 1,475,205 18,294,159 29.23% 29.55% 1.28% 2002 0.75% 1.00% 9.59 9.68 1,490,442 14,302,969 -19.11% -18.90% 0.93%
(1) Reflects less than a full year of activity. Funds were first received in this option on the commencement date noted or the option was inactive at the date funds were received. (2) These amounts represent the annualized minimum and maximum contract expenses of the separate account, consisting primarily of mortality and expense charges, for each period indicated. The ratios include only those expenses that result in a direct reduction to unit values. Charges made directly to contract owner accounts through the redemption of units and expenses of the underlying funds have been excluded. (3) As the unit value is presented as a range of minimum to maximum values for only those subaccounts which existed for the entire year, some individual contract unit values may not be within the ranges presented as a result of partial year activity. (4) These amounts represent the total return, including changes in value of mutual funds, and reflect deductions for all items included in the fee rate. The total return does not include contract charges deducted directly from policy account values. The total return is not annualized. As the total return is presented as a range of minimum to maximum values for only those subaccounts which existed for the entire year, some individual contract total returns may not be within the ranges presented as a result of partial year activity. (5) These amounts represent the dividends, excluding distributions of capital gains, received by the subaccount from the underlying mutual fund, net of management fees assessed by the fund manager, divided by the average net assets. These ratios exclude those expenses, such as mortality and expense guarantee charges, that result in direct reductions in the unit values. The recognition of investment income by the subaccount is affected by the timing of the declaration of dividends by the underlying fund in which the subaccounts invest. Investment income ratios are not annualized. Note: Fee rate, unit value and total return minimum and maximum are the same where there is only one active contract level charge for the subaccount. 4. PURCHASES AND SALES OF INVESTMENTS The aggregate cost of investments purchased and the aggregate proceeds from investments sold were as follows for 2006. AGGREGATE AGGREGATE COST OF PROCEEDS SUBACCOUNT PURCHASES FROM SALES -------------------------------------------------------------------------------- ABVPSF Global Technology Class B $ 585,234 $ 718,794 ABVPSF Growth Class B 353,614 352,630 ABVPSF Growth and Income Class B 633,185 287,319 American Century VP Balanced 3,297,736 3,063,989 American Funds Global Growth Class 2 2,130,792 271,798 American Funds Growth Class 2 5,646,333 2,130,795 American Funds Growth-Income Class 2 3,306,632 379,652 American Funds International Class 2 5,618,571 1,488,977 Baron Capital Asset 1,800,241 5,852,544 Delaware VIPT Diversified Income 943,135 472,932 Delaware VIPT High Yield 1,183,901 276,137 Delaware VIPT REIT Service Class 6,277,433 2,480,064 Delaware VIPT Small Cap Value Service Class 4,137,543 522,116 Delaware VIPT Trend Service Class 858,597 797,504 Dreyfus Developing Leaders 6,183,254 10,306,253 Dreyfus Stock Index 2,564,233 11,040,007 DWS VIP Equity 500 Index 799,986 348,893 DWS VIP Small Cap Index 1,646,514 528,337 L-17 4. PURCHASES AND SALES OF INVESTMENTS (CONTINUED) AGGREGATE AGGREGATE COST OF PROCEEDS SUBACCOUNT PURCHASES FROM SALES -------------------------------------------------------------------------------- Fidelity VIP Asset Manager $ 2,276,596 $ 7,870,197 Fidelity VIP Contrafund Service Class 2 9,180,087 2,375,625 Fidelity VIP Equity-Income 15,474,972 5,508,351 Fidelity VIP Growth 1,200,225 15,935,447 Fidelity VIP Money Market 262,669 243,859 Janus Aspen Series Worldwide Growth 598,996 3,175,773 Lincoln VIPT Aggressive Growth 459,876 3,784,594 Lincoln VIPT Aggressive Profile 1,051,615 297,782 Lincoln VIPT Bond 1,913,176 673,419 Lincoln VIPT Capital Appreciation 340,304 250,243 Lincoln VIPT Conservative Profile 2,023,895 161,319 Lincoln VIPT Growth and Income 871,267 853,103 Lincoln VIPT International 5,437,496 360,535 Lincoln VIPT Managed 465,332 316,650 Lincoln VIPT Moderate Profile 2,192,220 178,151 Lincoln VIPT Moderately Aggressive Profile 1,225,375 211,055 Lincoln VIPT Social Awareness 1,162,382 1,575,675 NB AMT Mid-Cap Growth 1,692,609 1,025,304 NB AMT Partners 2,428,733 2,679,414 T. Rowe Price International Stock 1,174,921 2,703,695 5. INVESTMENTS The following is a summary of investments owned at December 31, 2006.
NET SHARES ASSET FAIRVALUE SUBACCOUNT OWNED VALUE OF SHARES COST OF SHARES ------------------------------------------------------------------------------------------------ ABVPSF Global Technology Class B 150,494 $16.94 $ 2,549,360 $ 2,141,860 ABVPSF Growth Class B 71,057 19.90 1,414,032 1,206,547 ABVPSF Growth and Income Class B 36,565 26.93 984,705 894,653 American Century VP Balanced 3,603,237 7.53 27,132,371 25,675,257 American Funds Global Growth Class 2 142,415 23.29 3,316,848 2,862,337 American Funds Growth Class 2 473,538 64.08 30,344,313 23,512,770 American Funds Growth-Income Class 2 210,110 42.19 8,864,559 7,856,515 American Funds International Class 2 831,270 21.94 18,238,059 13,632,851 Baron Capital Asset 759,801 32.30 24,541,587 15,110,768 Delaware VIPT Diversified Income 186,708 9.83 1,835,344 1,746,022 Delaware VIPT High Yield 214,529 6.20 1,330,082 1,267,667 Delaware VIPT REIT Service Class 1,117,251 22.82 25,495,657 18,015,354 Delaware VIPT Small Cap Value Service Class 286,468 33.33 9,547,965 8,649,649 Delaware VIPT Trend Service Class 87,724 34.53 3,029,125 2,494,416 Dreyfus Developing Leaders 1,477,372 42.03 62,093,941 66,420,819 Dreyfus Stock Index 2,874,447 36.15 103,911,259 75,710,797 DWS VIP Equity 500 Index 150,420 14.97 2,251,795 1,936,228 DWS VIP Small Cap Index 147,138 16.12 2,371,869 2,166,538 Fidelity VIP Asset Manager 3,835,956 15.71 60,262,875 60,664,322 Fidelity VIP Contrafund Service Class 2 616,013 31.11 19,164,162 17,253,301 Fidelity VIP Equity-Income 3,375,839 26.20 88,446,979 77,151,166 Fidelity VIP Growth 3,196,270 35.87 114,650,218 117,823,332 Fidelity VIP Money Market 45,948 1.00 45,949 45,949 Janus Aspen Series Worldwide Growth 580,715 32.47 18,855,811 22,088,391 Lincoln VIPT Aggressive Growth 1,994,007 11.83 23,585,117 27,905,460 Lincoln VIPT Aggressive Profile 81,527 13.15 1,072,327 968,354 Lincoln VIPT Bond 290,231 12.64 3,668,517 3,721,253 Lincoln VIPT Capital Appreciation 97,702 20.12 1,965,368 1,699,087 Lincoln VIPT Conservative Profile 176,733 11.39 2,013,346 1,984,749 Lincoln VIPT Growth and Income 191,593 35.16 6,735,843 5,376,332 Lincoln VIPT International 330,896 22.70 7,512,332 6,611,148
L-18 5. INVESTMENTS (CONTINUED)
NET SHARES ASSET FAIRVALUE SUBACCOUNT OWNED VALUE OF SHARES COST OF SHARES ------------------------------------------------------------------------------------------------ Lincoln VIPT Managed 58,320 $16.96 $ 988,926 $ 917,446 Lincoln VIPT Moderate Profile 208,591 12.05 2,512,896 2,348,107 Lincoln VIPT Moderately Aggressive Profile 124,533 12.53 1,560,144 1,437,578 Lincoln VIPT Social Awareness 600,854 35.92 21,582,665 19,821,135 NB AMT Mid-Cap Growth 198,526 23.26 4,617,720 3,715,733 NB AMT Partners 561,869 21.16 11,889,142 9,663,346 T. Rowe Price International Stock 1,303,853 17.97 23,430,232 17,334,639
6. CHANGES IN UNITS OUTSTANDING The change in units outstanding for the year ended December 31, 2006 is as follows: UNITS UNITS NET INCREASE SUBACCOUNT ISSUED REDEEMED (DECREASE) ------------------------------------------------------------------------------ ABVPSF Global Technology Class B 179,776 (205,329) (25,553) ABVPSF Growth Class B 64,807 (61,761) 3,046 ABVPSF Growth and Income Class B 55,942 (30,663) 25,279 American Century VP Balanced 106,236 (171,539) (65,303) American Funds Global Growth Class 2 172,553 (38,473) 134,080 American Funds Growth Class 2 960,248 (618,150) 342,098 American Funds Growth-Income Class 2 313,316 (95,992) 217,324 American Funds International Class 2 690,727 (363,656) 327,071 Baron Capital Asset 149,366 (285,484) (136,118) Delaware VIPT Diversified Income 97,178 (56,958) 40,220 Delaware VIPT High Yield 112,091 (30,782) 81,309 Delaware VIPT REIT Service Class 312,335 (217,290) 95,045 Delaware VIPT Small Cap Value Service Class 340,354 (110,154) 230,200 Delaware VIPT Trend Service Class 137,429 (129,423) 8,006 Dreyfus Developing Leaders 166,707 (527,370) (360,663) Dreyfus Stock Index 160,227 (384,889) (224,662) DWS VIP Equity 500 Index 73,160 (38,106) 35,054 DWS VIP Small Cap Index 137,104 (56,942) 80,162 Fidelity VIP Asset Manager 130,860 (378,142) (247,282) Fidelity VIP Contrafund Service Class 2 823,152 (407,722) 415,430 Fidelity VIP Equity-Income 284,390 (350,070) (65,680) Fidelity VIP Growth 199,426 (569,086) (369,660) Fidelity VIP Money Market 18,787 (19,522) (735) Janus Aspen Series Worldwide Growth 112,717 (315,224) (202,507) Lincoln VIPT Aggressive Growth 151,367 (391,447) (240,080) Lincoln VIPT Aggressive Profile 97,142 (30,343) 66,799 Lincoln VIPT Bond 200,219 (98,067) 102,152 Lincoln VIPT Capital Appreciation 73,133 (56,537) 16,596 Lincoln VIPT Conservative Profile 185,332 (16,594) 168,738 Lincoln VIPT Growth and Income 141,028 (141,999) (971) Lincoln VIPT International 375,309 (64,284) 311,025 Lincoln VIPT Managed 42,238 (30,886) 11,352 Lincoln VIPT Moderate Profile 206,742 (23,017) 183,725 Lincoln VIPT Moderately Aggressive Profile 113,306 (23,222) 90,084 Lincoln VIPT Social Awareness 154,893 (182,109) (27,216) NB AMT Mid-Cap Growth 339,154 (239,548) 99,606 NB AMT Partners 141,292 (231,546) (90,254) T. Rowe Price International Stock 133,896 (231,154) (97,258) L-19 6. CHANGES IN UNITS OUTSTANDING (CONTINUED) The change in units outstanding for the year ended December 31, 2005 is as follows: UNITS UNITS NET INCREASE SUBACCOUNT ISSUED REDEEMED (DECREASE) ------------------------------------------------------------------------------ ABVPSF Global Technology Class B 295,631 (396,732) (101,101) ABVPSF Growth Class B 68,783 (87,951) (19,168) ABVPSF Growth and Income Class B 56,790 (23,663) 33,127 American Century VP Balanced 144,660 (204,854) (60,194) American Funds Global Growth Class 2 86,072 (17,060) 69,012 American Funds Growth Class 2 1,048,596 (479,168) 569,428 American Funds Growth-Income Class 2 337,184 (46,452) 290,732 American Funds International Class 2 539,604 (145,925) 393,679 Baron Capital Asset 206,441 (313,589) (107,148) Delaware VIPT Diversified Income 110,380 (29,330) 81,050 Delaware VIPT High Yield 39,541 (4,509) 35,032 Delaware VIPT REIT Service Class 318,321 (356,950) (38,629) Delaware VIPT Small Cap Value Service Class 363,094 (87,010) 276,084 Delaware VIPT Trend Service Class 111,161 (94,151) 17,010 Dreyfus Developing Leaders 215,288 (595,387) (380,099) Dreyfus Stock Index 189,353 (557,487) (368,134) Fidelity VIP Asset Manager 163,868 (442,136) (278,268) Fidelity VIP Contrafund Service Class 2 684,875 (171,867) 513,008 Fidelity VIP Equity-Income 269,988 (457,407) (187,419) Fidelity VIP Growth 247,000 (857,280) (610,280) Fidelity VIP Money Market 22,752 (21,884) 868 Janus Aspen Series Worldwide Growth 187,844 (517,618) (329,774) Lincoln VIPT Aggressive Growth 219,616 (445,971) (226,355) Lincoln VIPT Aggressive Profile 18,966 (429) 18,537 Lincoln VIPT Bond 218,349 (54,425) 163,924 Lincoln VIPT Capital Appreciation 90,272 (108,963) (18,691) Lincoln VIPT Conservative Profile 22,319 (10,446) 11,873 Lincoln VIPT Growth and Income 218,722 (136,618) 82,104 Lincoln VIPT International 145,359 (48,255) 97,104 Lincoln VIPT Managed 55,048 (16,567) 38,481 Lincoln VIPT Moderate Profile 37,263 (4,980) 32,283 Lincoln VIPT Moderately Aggressive Profile 40,144 (840) 39,304 Lincoln VIPT Social Awareness 193,987 (232,959) (38,972) NB AMT Mid-Cap Growth 283,779 (85,275) 198,504 NB AMT Partners 301,813 (196,831) 104,982 DWS VIP Equity 500 Index 104,158 (38,144) 66,014 DWS VIP Small Cap Index 100,618 (48,097) 52,521 T. Rowe Price International Stock 180,852 (273,771) (92,919) L-20 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors of The Lincoln National Life Insurance Company and Contract Owners of Lincoln National Variable Annuity Account L We have audited the accompanying statement of assets and liabilities of Lincoln National Variable Annuity Account L ("Variable Account"), comprised of the subaccounts described in Note 1, as of December 31, 2006, the related statement of operations for the year then ended, and the statements of changes in net assets for each of the two years in the period then ended. These financial statements are the responsibility of the Variable Account's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Variable Account's internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Variable Account's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our procedures included confirmation of investments owned as of December 31, 2006, by correspondence with the custodian. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of each of the respective subaccounts constituting Lincoln National Variable Annuity Account L at December 31, 2006, the results of their operations for the year then ended, and the changes in their net assets for each of the two years in the period then ended, in conformity with U.S. generally accepted accounting principles. /s/ Ernst & Young LLP Fort Wayne, Indiana March 7, 2007 L-21 THE LINCOLN NATIONAL LIFE INSURANCE COMPANY S-1 THE LINCOLN NATIONAL LIFE INSURANCE COMPANY CONSOLIDATED BALANCE SHEETS
2006 2005 -------- --------- (IN MILLIONS) -------------------- ASSETS Investments: Securities available-for-sale, at fair value: Fixed maturity (cost: 2006 -- $31,204; 2005 -- $31,267) $ 31,840 $ 32,245 Equity (cost: 2006 -- $191; 2005 -- $95) 203 101 Trading securities 2,820 2,985 Mortgage loans on real estate 3,571 3,662 Real estate 175 182 Policy loans 1,898 1,858 Derivative investments 49 41 Other investments 657 423 -------- -------- Total Investments 41,213 41,497 Cash and invested cash 1,308 1,962 Deferred acquisition costs and value of business acquired 4,859 4,418 Premiums and fees receivable 283 285 Accrued investment income 477 500 Amounts recoverable from reinsurers 6,798 6,955 Goodwill 919 919 Other assets 1,112 1,091 Assets held in separate accounts 69,099 56,427 -------- -------- Total Assets $126,068 $114,054 ======== ======== LIABILITIES AND SHAREHOLDER'S EQUITY LIABILITIES: Insurance and Investment Contract Liabilities: Insurance policy and claim reserves $ 10,350 $ 10,384 Investment contract and policyholder funds 34,753 35,273 -------- -------- Total Insurance and Investment Contract Liabilities 45,103 45,657 Short-term debt 21 34 Long-term debt 1,390 1,250 Reinsurance related derivative liability 218 278 Funds withheld reinsurance liabilities 1,816 1,711 Deferred gain on indemnity reinsurance 759 835 Other liabilities 2,069 2,536 Liabilities related to separate accounts 69,099 56,427 -------- -------- Total Liabilities 120,475 108,728 -------- -------- COMMITMENTS AND CONTINGENCIES (SEE NOTE 9) SHAREHOLDER'S EQUITY: Common stock -- 10,000,000 shares authorized 25 25 Retained earnings 5,268 4,848 Accumulated Other Comprehensive Income: Net unrealized gain on securities available-for-sale 315 452 Net unrealized gain/(loss) on derivative instruments (9) 7 Minimum pension liability adjustment -- (6) Adjustment to initially apply SFAS 158 (6) -- -------- -------- Total Accumulated Other Comprehensive Income 300 453 -------- -------- Total Shareholder's Equity 5,593 5,326 -------- -------- Total Liabilities and Shareholder's Equity $126,068 $114,054 ======== ========
See accompanying notes to the Consolidated Financial Statements S-2 CONSOLIDATED STATEMENTS OF INCOME
2006 2005 2004 ------ ------ ------ (IN MILLIONS) ------------------------ REVENUE: Insurance premiums $ 54 $ 67 $ 158 Insurance fees 1,841 1,575 1,405 Net investment income 2,594 2,592 2,593 Realized gain (loss) on investments 2 (16) (45) Amortization of deferred gain on indemnity reinsurance 76 77 87 Other revenue and fees 258 316 275 ------ ------ ------ Total Revenue 4,825 4,611 4,473 ------ ------ ------ BENEFITS AND EXPENSES: Benefits 2,178 2,122 2,143 Underwriting, acquisition, insurance and other expenses 1,577 1,544 1,475 Interest and debt expense 80 78 79 ------ ------ ------ Total Benefits and Expenses 3,835 3,744 3,697 ------ ------ ------ Income before Federal Income Taxes 990 867 776 Federal income taxes 247 223 193 ------ ------ ------ Income before Cumulative Effect of Accounting Changes 743 644 583 Cumulative Effect of Accounting Changes (net of Federal income taxes) -- -- (26) ------ ------ ------ Net Income $ 743 $ 644 $ 557 ====== ====== ======
See accompanying notes to the Consolidated Financial Statements S-3 CONSOLIDATED STATEMENTS OF SHAREHOLDER'S EQUITY
2006 2005 2004 ------ ------ ------ (IN MILLIONS) ------------------------ COMMON STOCK: Balance at beginning and end-of-year $ 25 $ 25 $ 25 RETAINED EARNINGS: Balance at beginning-of-year 4,848 4,385 3,856 Comprehensive income 596 315 566 Less other comprehensive income (loss) (net of federal income tax): Net unrealized gain (loss) on securities available-for-sale, net of reclassification adjustment (137) (329) 23 Net unrealized loss on derivative instruments (16) (7) (10) Minimum pension liability adjustment 6 7 (4) ------ ------ ------ Net Income 743 644 557 Additional investment by Lincoln National Corporation/Stock Compensation 27 19 122 Dividends declared (350) (200) (150) ------ ------ ------ Balance at End-of-Year 5,268 4,848 4,385 ------ ------ ------ NET UNREALIZED GAIN ON SECURITIES AVAILABLE-FOR-SALE: Balance at beginning-of-year 452 781 758 Change during the year (137) (329) 23 ------ ------ ------ Balance at End-of-Year 315 452 781 ------ ------ ------ NET UNREALIZED GAIN ON DERIVATIVE INSTRUMENTS: Balance at beginning-of-year 7 14 24 Change during the year (16) (7) (10) ------ ------ ------ Balance at End-of-Year (9) 7 14 ------ ------ ------ MINIMUM PENSION LIABILITY ADJUSTMENT: Balance at beginning-of-year (6) (13) (9) Change during the year 6 7 (4) ------ ------ ------ Balance at End-of-Year -- (6) (13) ------ ------ ------ ADJUSTMENT TO INITIALLY APPLY SFAS 158: (6) -- -- ------ ------ ------ Total Shareholder's Equity at End-of-Year $5,593 $5,326 $5,192 ====== ====== ======
See accompanying notes to the Consolidated Financial Statements S-4 CONSOLIDATED STATEMENTS OF CASH FLOWS
2006 2005 2004 ------- ------- ------- (IN MILLIONS) --------------------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 743 $ 644 $ 557 Adjustments to reconcile net income to net cash provided by operating activities: Deferred acquisition costs and value of business acquired (391) (430) (350) Premiums and fees receivable 2 54 112 Accrued investment income 23 (4) (5) Insurance policy and claim reserves (14) (1,082) (1,347) Net trading securities purchases, sales and maturities 165 (72) (99) Cumulative effect of accounting change -- -- 39 Investment contract and policyholder funds 778 1,893 1,536 Amounts recoverable from reinsurers 157 101 375 Federal income taxes 43 144 121 Stock-based compensation expense -- 18 19 Depreciation 27 64 48 Realized gain (loss) on investments and derivative instruments (2) 16 59 Gain on sale of subsidiaries/business -- -- (14) Amortization of deferred gain (76) (77) (87) Other (210) (607) (275) ------- ------- ------- Net Adjustments 502 18 132 ------- ------- ------- Net Cash Provided by Operating Activities 1,245 662 689 ------- ------- ------- CASH FLOWS FROM INVESTING ACTIVITIES: Securities available-for-sale: Purchases (6,487) (5,725) (9,001) Sales 4,181 3,767 4,740 Maturities 2,282 2,392 2,468 Purchase of other investments (408) (1,008) (1,938) Sale or maturity of other investments 104 1,151 2,187 Proceeds from disposition of business -- -- 10 Other (155) 9 146 ------- ------- ------- Net Cash Provided by (Used in) Investing Activities (483) 586 (1,388) ------- ------- ------- CASH FLOWS FROM FINANCING ACTIVITIES: Issuance of long-term debt 140 -- 47 Payment of long-term debt -- (47) -- Net decrease in short-term debt (13) 2 (10) Universal life and investment contract deposits 4,791 4,783 4,928 Universal life and investment contract withdrawals (4,268) (3,755) (3,353) Investment contract transfers (1,821) (1,483) (1,336) Increase in cash collateral on loaned securities -- 45 181 Increase in funds withheld liability 105 131 87 Capital contribution from shareholder -- -- 100 Dividends paid to shareholders (350) (200) (150) ------- ------- ------- Net Cash Provided by (Used in) Financing Activities (1,416) (524) 494 ------- ------- ------- Net Increase (Decrease) in Cash and Invested Cash (654) 724 (205) ------- ------- ------- Cash and Invested Cash at Beginning-of-Year 1,962 1,238 1,443 ------- ------- ------- Cash and Invested Cash at End-of-Year $ 1,308 $ 1,962 $ 1,238 ======= ======= =======
See accompanying notes to the Consolidated Financial Statements S-5 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION. The accompanying Consolidated Financial Statements include The Lincoln National Life Insurance Company ("the Company") and its majority-owned subsidiaries ("LNL" or the "Company" which may be referred to as "we" or "us"). The Company is domiciled in Indiana. Lincoln National Corporation ("LNC") owns 100% of the Company on a direct basis and its subsidiaries on an indirect basis. The Company owns 100% of the outstanding common stock of two insurance company subsidiaries: First Penn-Pacific Life Insurance Company ("First Penn") and Lincoln Life & Annuity Company New York ("Lincoln Life New York"). The Company also owns several non-insurance companies, including Lincoln Financial Distributors ("LFD") and Lincoln Financial Advisors ("LFA"), LNC's internally owned wholesaling and retailing business units, respectively. On April 3, 2006, LNC acquired the Jefferson-Pilot Corporation ("Jefferson-Pilot"). As a result of this transaction, the following affiliates of Jefferson-Pilot became affiliates of LNC: Jefferson Pilot Financial Insurance Company ("JPFIC"), which is domiciled in Nebraska; Jefferson-Pilot Life Insurance Company ("JPL"), which is domiciled in North Carolina; and JPFIC's wholly owned subsidiary Jefferson-Pilot LifeAmerica Insurance Company ("JP LifeAmerica"), which is domiciled in the state of New Jersey and commercially domiciled in New York. On January 17, 2007, The Nebraska Insurance Department approved the merger of JPFIC with and into LNL. The Indiana Department of Insurance has not yet issued its final approval due to a limitation in its laws regarding approval of a transaction in excess of 90 days before closing. The anticipated effective date of the proposed transaction is July 2, 2007. On February 15, 2007, the North Carolina Department of Insurance approved the merger of JPL, with and into LNL. The Indiana Department of Insurance approved the merger on February 15, 2007. The expected effective date of the merger is April 2, 2007. On February 22, 2007, the New Jersey Department of Banking and Insurance approved a request to redomicle JPLA from New Jersey to New York. The New York Insurance Department is reviewing for approval a request to redomicile JPLA to New York, and then merge Lincoln Life & Annuity Company of New York with and into JPLA. Subject to the New York Insurance Department approval, the effective date of these proposed transactions is April 2, 2007. The surviving merged company will adopt the name Lincoln Life & Annuity Company of New York. LNL's principal businesses consist of underwriting annuities, deposit-type contracts and life insurance through multiple distribution channels. LNL is licensed and sells its products throughout the United States and several U.S. territories. Operations are divided into two business segments: Individual Markets and Employer Markets (see Note 11). These Consolidated Financial Statements have been prepared in conformity with accounting principles generally accepted in the United States. ACCOUNTING ESTIMATES AND ASSUMPTIONS. The preparation of financial statements requires management to make estimates and assumptions affecting the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities as of the date of the financial statements, and the reported amounts of revenue and expenses for the reporting period. Those estimates are inherently subject to change and actual results could differ from those estimates. Included among the material (or potentially material) reported amounts and disclosures that require extensive use of estimates are: fair value of certain invested assets and derivatives, asset valuation allowances, deferred policy acquisition costs, goodwill, value of business acquired, deferred sales inducements, insurance and investment contract liabilities, deferred front end loads, pension plans, income taxes and the potential effects of resolving litigated matters. INVESTMENTS. Securities available-for-sale consist of fixed maturity and equity securities, which are stated at fair value with net unrealized gains and losses included in accumulated other comprehensive income, net of deferred income taxes and adjustments to deferred policy acquisition costs ("DAC") and value of business acquired ("VOBA"). Fair value is based on quoted market prices from observable market data or estimated using an internal pricing matrix for privately placed securities when quoted market prices are not available. This matrix relies on management's judgment concerning: 1) the discount rate used in calculating expected future cash flows; 2) credit quality; 3) industry sector performance; and 4) expected maturity. Under certain circumstances, we apply professional judgment and make adjustments based upon specific detailed information concerning the issuer. The cost of available-for-sale fixed maturity and equity securities is reduced to fair value with a corresponding charge to realized loss on investments for declines in value that are other-than-temporary. Dividend and investment income are recognized when earned. Amortization of premiums and accretion of discounts on investments in debt securities are reflected in earnings over the contractual terms of the investments in a manner that produces a constant effective yield. Investment securities are regularly reviewed for impairment based on criteria that include the extent to which cost exceeds market value, the duration of the market decline, and the financial health of and specific prospects for the issuer. Unrealized losses that are considered to be other-than-temporary are recognized in realized gains and losses with a corresponding reduction in the cost of available-for-sale fixed maturity and equity securities. See Note 3 for further discussion of the Company's policies regarding identification of other-than-temporary impairments. Trading securities consist of fixed maturity and equity securities in designated portfolios, which support modified coinsurance ("Modco") and coinsurance with funds withheld ("CFW") reinsurance arrangements. Investment results for these portfolios, including gains and losses from sales, are passed directly to the reinsurers through the contractual terms of the reinsurance arrangements. Trading securities are carried at fair value and S-6 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) changes in fair value are recorded in net income as they occur. Offsetting these amounts are corresponding changes in the fair value of embedded derivative liabilities associated with the underlying reinsurance arrangements. For the mortgage-backed securities portion of the trading and available-for-sale fixed maturity securities portfolios, we recognize investment income using a constant effective yield based on anticipated prepayments and the estimated economic life of the securities. When estimates of prepayments change, the effective yield is recalculated to reflect actual payments to date and anticipated future payments. When the effective yield changes, the carrying value of the security is adjusted prospectively. This adjustment is reflected in net investment income. Mortgage loans on real estate are carried at the outstanding principal balances adjusted for amortization of premiums and discounts and are net of valuation allowances. Valuation allowances are established for the excess carrying value of the mortgage loan over its estimated fair value 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, the cost is adjusted or a provision for loss is established equal to the difference between the amortized cost of the mortgage loan and the estimated value. Estimated value is based on: 1) the present value of expected future cash flows discounted at the loan's effective interest rate; 2) the loan's observable market price; 3) the fair value of the collateral. The provision for losses is reported as realized gain (loss) on investments. Mortgage loans deemed to be uncollectible are charged against the allowance for losses and subsequent recoveries, if any, are credited to the allowance for losses. Interest income on mortgage loans includes interest collected, the change in accrued interest, and amortization of premiums and discounts. Mortgage loan fees and costs are recorded in net investment income as they are incurred. Investment real estate is carried at cost less accumulated depreciation. Depreciation is provided on a straight-line basis over the estimated useful life of the asset. Cost is adjusted for impairment when the projected undiscounted cash flow from the investment is less than the carrying value. Impaired real estate is written down to the estimated fair value of the real estate, which is generally computed using the present value of expected future cash flows from the real estate discounted at a rate commensurate with the underlying risks. Also, valuation allowances for losses are established, as appropriate, for real estate holdings that are in the process of being sold. Real estate acquired through foreclosure proceedings is reclassified on the balance sheet from mortgage loans on real estate to real estate and is recorded at fair value at the settlement date, which establishes a new cost basis. If a subsequent periodic review of a foreclosed property indicates the fair value, less estimated costs to sell, is lower than the carrying value at settlement date, the carrying value is adjusted to the lower amount. Write-downs to real estate and any changes to the reserves on real estate are reported as realized gain (loss) on investments. Policy loans are carried at aggregate unpaid balances. Realized gain (loss) on investments includes realized gains and (losses) from the sale of investments, derivative gains (losses), gains on sale of subsidiaries/business, and net gain on reinsurance embedded derivative/trading securities. See Note 3 for additional detail. Realized gain (loss) on investments is recognized in net income, net of associated amortization of DAC and investment expenses, using the specific identification method. Changes in the fair values of available-for-sale securities carried at fair value are reported as a component of accumulated other comprehensive income, after deductions for related adjustments for DAC and amounts required to satisfy policyholder commitments that would have been recorded had these securities been sold at their fair value, and after deferred taxes or credits to the extent deemed recoverable. DERIVATIVE INSTRUMENTS. We hedge certain portions of our exposure to interest rate risk, credit risk, foreign exchange risk and equity fluctuation risk by entering into derivative transactions. We recognize all derivative instruments as either assets or liabilities in the consolidated Balance Sheets at fair value. The accounting for changes in the fair value of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship and further, on the type of hedging relationship. For those derivative instruments that are designated and qualify as hedging instruments, we must designate the hedging instrument based upon the exposure being hedged -- as a cash flow hedge, fair value hedge or a hedge of a net investment in a foreign operation. As of December 31, 2006 and 2005, we had derivative instruments that were designated and qualified as cash flow hedges and fair value hedges. In addition, we had derivative instruments that were economic hedges, but were not designated as hedging instruments under Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). For derivative instruments that are designated and qualify as a cash flow hedge, the effective portion of the gain or loss on the derivative instrument is reported as a component of other comprehensive income ("OCI") and reclassified into net income in the same period or periods during which the hedged transaction affects net income. The remaining gain or loss on the derivative instrument in excess of the cumulative change in the present value of designated future cash flows of the hedged item (hedge ineffectiveness), if any, is recognized in net income during the period of change. For derivative instruments that are designated and qualify as a fair value hedge, the gain or loss on the derivative instrument as well as the offsetting loss or gain in fair value on the hedged item attributable to the hedged risk are recognized in net income during the period of change in fair values. For derivative instruments not designated as hedging instruments but are economic hedges, the gain or loss is recognized in current income during the period of change in the corresponding income statement line as the transaction being hedged. We have certain Modco and CFW reinsurance arrangements with embedded derivatives related to the funds withheld assets. S-7 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) These derivatives are considered total return swaps with contractual returns that are attributable to various assets and liabilities associated with these reinsurance arrangements. Changes in the fair value of these derivatives are recorded in net income as they occur. Offsetting these amounts are corresponding changes in the fair value of trading securities in portfolios that support these arrangements. See Note 9 for further discussion of our accounting policy for derivative instruments. CASH AND INVESTED CASH. Cash and invested cash are carried at cost and include all highly liquid debt instruments purchased with a maturity of three months or less. DEFERRED ACQUISITION COSTS, VALUE OF BUSINESS ACQUIRED, DEFERRED FRONT END LOADS, DEFERRED SALES INDUCEMENTS. Commissions and other costs of acquiring universal life insurance, variable universal life insurance, traditional life insurance, annuities and other investment contracts, which vary with and are primarily related to the production of new business, have been deferred to the extent recoverable. The methodology for determining the amortization of acquisition costs varies by product type based on two different accounting pronouncements: SFAS No. 97, "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments" ("SFAS 97") and SFAS No. 60, "Accounting and Reporting by Insurance Enterprises" ("SFAS 60"). Under SFAS 97, acquisition costs for universal life, variable universal life insurance and investment-type products, which include fixed and variable deferred annuities, are amortized over the lives of the policies in relation to the incidence of estimated gross profits from surrender charges, investment, mortality net of reinsurance ceded and expense margins, and actual realized gain (loss) on investments. Past amortization amounts are adjusted when revisions are made to the estimates of current or future gross profits expected from a group of products. Policy lives for universal and variable universal life policies are estimated to be 30 years, based on the expected lives of the policies. Policy lives for fixed and variable deferred annuities are 14 to 20 years for the traditional, long surrender charge period products and 8 to 10 years for the more recent short-term, or no surrender charge variable products. The front-end load annuity product has an assumed life of 25 years. Longer lives are assigned to those blocks that have demonstrated favorable experience. Under SFAS 60, acquisition costs for traditional life insurance products, which include whole life and term life insurance contracts are amortized over periods of 10 to 30 years on either a straight-line basis or as a level percent of premium of the related policies depending on the block of business. There is currently no DAC being amortized under SFAS 60 for fixed and variable payout annuities. For all SFAS 97 and SFAS 60 policies, amortization is based on assumptions consistent with those used in the development of the underlying policy form adjusted for emerging experience and expected trends. VOBA is amortized over the expected lives of the block of insurance business in relation to the incidence of estimated profits expected to be generated on universal life, variable universal life and investment-type products acquired, (i.e., variable deferred annuities) and over the premium paying period for insurance products acquired, (i.e., traditional life insurance products). Amortization is based upon assumptions used in pricing the acquisition of the block of business and is adjusted for emerging experience. Accordingly, amortization periods and methods of amortization for VOBA vary depending upon the particular characteristics of the underlying blocks of acquired insurance business. VOBA is amortized in a manner consistent with DAC. The carrying amounts of DAC and VOBA are adjusted for the effect of realized gains and losses and the effects of unrealized gains and losses on debt securities classified as available-for-sale. Bonus credits and excess interest for dollar cost averaging ("DCA") contracts are considered sales inducements and are deferred as a sales inducement asset (referred to as "deferred sales inducements" or "DSI") and the unamortized balance is reported in other assets. DSI is amortized as a benefit expense over the expected life of the contract. Amortization is computed using the same methodology and assumptions used in amortizing DAC. DSI is reported within the other assets caption of the Consolidated Balance Sheets. Policy sales charges that are collected in the early years of an insurance policy have been deferred (referred to as "deferred front-end loads" or "DFEL") and are amortized into income over the life of the policy in a manner consistent with that used for DAC. DFEL is reported within the investment contract and policyholder funds caption of the Consolidated Balance Sheets. The deferral and amortization of DFEL is reported within insurance fees in the Consolidated Statements of Income. During the third quarter of each year, we conduct our annual comprehensive review of the assumptions underlying the amortization of DAC, VOBA, DSI and DFEL. We review the various assumptions including investment margins, mortality and retention. These assumptions also impact the reserves for the guarantee features within our variable annuity and life insurance products. In addition to the annual third quarter review of assumptions, if factors or trends indicate that actual experience varies significantly from these assumptions, adjustments are made in the quarter in which the evaluation of the respective blocks of business is completed. The effects of changes in estimated future gross profits on unamortized deferred policy acquisition costs and value of business acquired, referred to as prospective unlockings, are reflected in amortization expense within the Consolidated Statements of Income. Prospective unlockings affecting DSI are reflected in benefits expense and affecting DFEL are included in insurance fees within the Consolidated Statements of Income. DAC and VOBA are reviewed periodically to determine that the unamortized portion does not exceed the expected recoverable amounts. No significant impairments occurred during the three years ending December 31, 2006. S-8 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) REINSURANCE. We enter into reinsurance agreements with other companies in the normal course of our business. Assets/Liabilities and premiums/benefits from certain reinsurance contracts that grant statutory surplus relief to other insurance companies are netted on the balance sheets and income statements, respectively, since there is a right of offset. All other reinsurance agreements are reported on a gross basis in the balance sheets as an asset for amounts recoverable from reinsurers or as a component of other liabilities for amounts, such as premiums, owed to the reinsurers, with the exception of Modco agreements for which the right of offset also exists. GOODWILL AND OTHER INTANGIBLE ASSETS. We recognize the excess of the purchase price over the fair value of net assets acquired as goodwill. Goodwill is not amortized, but is reviewed at least annually for indications of value impairment, with consideration given to financial performance and other relevant factors. In addition, certain events including a significant adverse change in legal factors or the business climate, an adverse action or assessment by a regulator, or unanticipated competition would cause the Company to review carrying amounts of goodwill for impairment. When considered impaired, the carrying amounts are written down using a combination of fair value and discounted cash flows. No impairments occurred during the three years ending December 31, 2006. Other intangible assets, which consist of only of DSI as of December 31, 2006 and 2005, net of accumulated amortization are reported in other assets. DSI is amortized as discussed above, under the heading Deferred Acquisition Costs, Value of Business Acquired, Deferred Front End Loads, Deferred Sales Inducements. PROPERTY AND EQUIPMENT. Property and equipment owned for company use is included in other assets in our Consolidated Balance Sheets and is carried at cost less allowances for depreciation. Provisions for depreciation of investment real estate and property and equipment owned for company use are computed principally on the straight-line method over the estimated useful lives of the assets, which include buildings, computer hardware and software and other property and equipment. IMPAIRMENT OF LONG-LIVED ASSETS. We periodically review the carrying value of our long-lived assets, including property and equipment, for impairment whenever events or circumstances indicate that the carrying amount of such assets may not be fully recoverable. For long-lived assets to be held and used, impairments are recognized when the carrying amount of a long-lived asset is not recoverable and exceeds its fair value. The carrying amount of a long-lived asset is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. An impairment loss is measured as the amount by which the carrying amount of a long-lived asset exceeds its fair value. Long-lived assets to be disposed of by abandonment or in an exchange for a similar productive long-lived asset are classified as held and used until disposed of. Long-lived assets to be sold are classified as held for sale and are no longer depreciated. Certain criteria have to be met in order for the long-lived asset to be classified as held for sale, including that a sale is probable and expected to occur within one year. Long-lived assets classified as held for sale are recorded at the lower of their carrying amount or fair value less cost to sell. ASSETS HELD IN SEPARATE ACCOUNTS/LIABILITIES RELATED TO SEPARATE ACCOUNTS. These assets and liabilities related to separate accounts represent segregated funds administered and invested by us and our insurance subsidiaries for the exclusive benefit of pension and variable life and annuity contractholders. Both the assets and liabilities are carried at fair value. The fees earned by us and our insurance subsidiaries for administrative and contractholder maintenance services performed for these separate accounts are included in insurance fee revenue. Policyholder account deposits and withdrawals, investment income and realized investment gains and losses in the separate accounts are excluded from the amounts reported in the Consolidated Statements of Income. INSURANCE AND INVESTMENT CONTRACT LIABILITIES. The liabilities for future policy benefits and claim reserves for universal and variable universal life insurance policies consist of policy account balances that accrue to the benefit of the policyholders, excluding surrender charges. The liabilities for future insurance policy benefits and claim reserves for traditional life policies are computed using assumptions for investment yields, mortality and withdrawals based principally on generally accepted actuarial methods and assumptions at the time of policy issue. Interest assumptions for traditional direct individual life reserves for all policies range from 2.25% to 7.00% depending on the time of policy issue. The interest assumptions for immediate and deferred paid-up annuities range from 0.75% to 13.50%. These investment yield assumptions are intended to represent an estimation of the interest rate experience for the period that these policy benefits are payable. The liabilities for future claim reserves for variable annuity products containing guaranteed minimum death benefits ("GMDB") features are calculated by multiplying the benefit ratio (present value of total expected GMDB payments over the life of the contract divided by the present value of total expected assessments over the life of the contract) by the cumulative assessments recorded from the contract inception through the balance sheet date less the cumulative GMDB payments plus interest. The change in the reserve for a period is then the benefit ratio multiplied by the assessments recorded for the period less GMDB claims paid in the period plus interest. If experience or assumption changes result in a new benefit ratio, the reserves are unlocked to reflect the changes in a manner similar to DAC. S-9 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) With respect to its insurance and investment contract liabilities, we continually review our: 1) overall reserve position; 2) reserving techniques and 3) reinsurance arrangements. As experience develops and new information becomes known, liabilities are adjusted as deemed necessary. The effects of changes in estimates are included in the operating results for the period in which such changes occur. The business written or assumed by us includes participating life insurance contracts, under which the policyholder is entitled to share in the earnings of such contracts via receipt of dividends. The dividend scale for participating policies is reviewed annually and may be adjusted to reflect recent experience and future expectations. As of December 31, 2006 and 2005 participating policies comprised 1% of the face amount of insurance in-force, and dividend expenses were $70 million, $78 million, and $77 million for the years ended December 31, 2006, 2005 and 2004, respectively. Universal life and variable life products with secondary guarantees represent approximately 31% of permanent life insurance in-force at December 31, 2006 and approximately 67% of sales of these products in 2006. Liabilities for the secondary guarantees on universal life-type products are calculated by multiplying the benefit ratio (present value of total expected secondary guarantee benefits over the life of the contract divided by the present value of total expected assessments over the life of the contract) by the cumulative assessments recorded from contract inception through the balance sheet date less the cumulative secondary guarantee benefit payments plus interest. If experience or assumption changes result in a new benefit ratio, the reserves are unlocked to reflect the changes in a manner similar to DAC, VOBA, DFEL and DSI. The accounting for secondary guarantee benefits impacts, and is impacted by, EGPs used to calculate amortization of DAC, VOBA, DFEL and DSI. The risk for the secondary guarantee is ceded to an affiliate of the Company in an arrangement that does not qualify as reinsurance. If the Company incurs a claim under the secondary guarantee benefit, then the affiliate will reimburse the Company for the cost of insurance charges. The reinsurance of the secondary guarantee is considered a derivative as it does not meet the insurance risk transfer requirements of FAS 113. The fair value of the derivative is determined based on the fair value of the cash flows related to this agreement. LOANED SECURITIES. Securities loaned are treated as collateralized financing transactions and a liability is recorded equal to the cash collateral received which is typically greater than the market value of the related securities loaned. This liability is included within other liabilities in our Consolidated Balance Sheets. Our agreements with third parties generally contain contractual provisions to allow for additional collateral to be obtained when necessary. We value collateral daily and obtain additional collateral when deemed appropriate. BORROWED FUNDS. Short-term borrowings are defined as borrowings with contractual or expected maturities of one year or less. Long-term borrowings have contractual or expected maturities greater than one year. COMMITMENTS AND CONTINGENCIES. Contingencies arising from environmental remediation costs, regulatory judgments, claims, assessments, guarantees, litigation, recourse reserves, fines, penalties and other sources are recorded when deemed probable and estimable. PREMIUMS AND FEES ON INVESTMENT PRODUCTS AND UNIVERSAL LIFE INSURANCE PRODUCTS. Investment products consist primarily of individual and group variable and fixed deferred annuities. Universal life insurance products include universal life insurance, variable universal life insurance, and other interest-sensitive life insurance policies. These products include life insurance sold to individuals, corporate-owned life insurance and bank-owned life insurance. Revenues for investment products and universal life insurance products consist of net investment income, asset based fees, cost of insurance charges, percent of premium charges, policy administration charges and surrender charges that have been assessed and earned against policy account balances and premiums received during the period. The timing of revenue recognition as it relates to fees assessed on investment contracts is determined based on the nature of such fees. Asset based fees, cost of insurance and policy administration charges are assessed on a daily or monthly basis and recognized as revenue when assessed and earned. Percent of premium charges are assessed at the time of premium payment and recognized as revenue when assessed and earned. Certain amounts assessed that represent compensation for services to be provided in future periods are reported as unearned revenue and recognized in income over the periods benefited. Surrender charges are recognized upon surrender of a contract by the contractholder in accordance with contractual terms. PREMIUMS ON TRADITIONAL LIFE INSURANCE PRODUCTS. Traditional life insurance products include those products with fixed and guaranteed premiums and benefits and consist primarily of whole life insurance, limited-payment life insurance, term life insurance and certain annuities with life contingencies. Premiums for traditional life insurance products are recognized as revenue when due from the policyholder. OTHER REVENUES AND FEES. Other revenue and fees principally consists of amounts earned by LFA, our retail distribution arm, from sales of third party insurance and investment products. Such revenue is recorded as earned at the time of sale. BENEFITS AND EXPENSES. Benefits and expenses for universal life-type and other interest-sensitive life insurance products include interest credited to policy account balances and benefit claims incurred during the period in excess of policy account balances. Interest crediting rates associated with funds invested in our general account during 2004 through 2006 ranged from 4.0% to 7.0%. For traditional life, group health and disability income products, benefits and expenses, other than DAC, are recognized when incurred in a manner consistent with the related premium recognition policies. Benefits and expenses includes the change in reserves for annuity products with guaranteed benefits, such as GMDB, and the change in fair values of guarantees for annuity products with guaranteed income benefits ("GIB") or guaranteed minimum withdrawal benefits ("GMWB"). S-10 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS. Pursuant to the accounting rules for our obligations to employees under our various pension and other postretirement benefit plans, we are required to make a number of assumptions to estimate related liabilities and expenses. We use assumptions for the weighted-average discount rate, expected return on plan assets and a salary increase assumption to estimate pension expense. The discount rate assumptions are determined using an analysis of current market information and the projected benefit flows associated with these plans. The expected long-term rate of return on plan assets is initially established at the beginning of the plan year based on historical and projected future rates of return and is the average rate of earnings expected on the funds invested or to be invested in the plan. The calculation of our accumulated postretirement benefit obligation also uses an assumption of weighted-average annual rate of increase in the per capita cost of covered benefits, which reflects a health care cost trend rate. See Note 7 for more information on our accounting for employee benefit plans. STOCK-BASED COMPENSATION. We expense the fair value of stock awards included in LNC's incentive compensation plans. On the date LNC's Board of Directors approves stock awards, the fair value of stock options is determined using a Black-Scholes options valuation methodology. The fair value of other stock awards is based upon the market value of the stock. The fair value of the awards is expensed over the service period, which generally corresponds to the vesting period, and is recognized as an increase to shareholder's equity. For additional information on stock-based incentive compensation see Note 8. INCOME TAXES. We and our eligible subsidiaries have elected to file consolidated Federal and state income tax returns with LNC and certain LNC subsidiaries. Pursuant to an intercompany tax sharing agreement with LNC, we provide for income taxes on a separate return filing basis. The tax sharing agreement also provides that we will receive benefit for net operating losses, capital losses and tax credits which are not usable on a separate return basis to the extent such items may be utilized in the consolidated income tax returns of LNC. RECLASSIFICATIONS. Certain amounts reported in prior years' Consolidated Financial Statements have been reclassified to conform with the presentation adopted in the current year. These reclassifications have no effect on net income or shareholder's equity of the prior years. 2. CHANGES IN ACCOUNTING PRINCIPLES AND CHANGES IN ESTIMATES SFAS NO. 123(R) -- SHARE-BASED PAYMENT. In December 2004, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123(R)"), which is a revision of SFAS 123, "Accounting for Stock-based Compensation" ("SFAS 123"). SFAS 123(R) requires us to recognize at fair value all costs resulting from share-based payments to employees, except for equity instruments held by employee share ownership plans. Similar to SFAS 123 under SFAS 123(R), the fair value of share-based payments are recognized as a reduction to earnings over the period an employee is required to provide service in exchange for the award. Effective January 1, 2006, LNC adopted SFAS 123(R), using the modified prospective transition method. Under that transition method, compensation cost recognized in 2006 includes: (a) compensation cost for all share-based payments granted prior to but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). LNC's results from prior periods have not been restated. The effect of adopting SFAS 123(R) did not have a material effect on the amount of stock-based compensation expense allocated to the Company in 2006. See Note 8 for more information regarding our stock-based compensation plans. FSP 115-1 -- THE MEANING OF OTHER-THAN-TEMPORARY IMPAIRMENT AND ITS APPLICATION TO CERTAIN INVESTMENTS. In November 2005, the FASB issued FASB Staff Position ("FSP") FAS 115-1 and FAS 124-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" ("FSP 115-1"). The guidance in FSP 115-1 nullifies the accounting and measurement provisions of Emerging Issues Task Force No. 03-1 -- "The Meaning of Other Than Temporary Impairments and Its Application to Certain Investments" references existing guidance, and supersedes EITF Topic No. D-44 "Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value." FSP 115-1 was effective for reporting periods beginning after December 15, 2005, on a prospective basis. Our existing policy for recognizing other-than-temporary impairments is consistent with the guidance in FSP 115-1, and includes the recognition of other than temporary impairments of securities resulting from credit related issues as well as declines in fair value related to rising interest rates, where we do not have the intent to hold the securities until either maturity or recovery. We adopted FSP 115-1 effective January 1, 2006. The adoption of FSP 115-1 did not have a material effect on our consolidated financial condition or results of operations. S-11 2. CHANGES IN ACCOUNTING PRINCIPLES AND CHANGES IN ESTIMATES (CONTINUED) SFAS NO. 158 -- EMPLOYERS' ACCOUNTING FOR DEFINED BENEFIT PENSION AND OTHER POSTRETIREMENT PLANS -- AN AMENDMENT OF FASB STATEMENTS NO. 87, 88, 106, AND 132(R). In September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans -- an amendment of FASB Statements No. 87, 88, 106, and 132(R)" ("SFAS 158"). The guidance requires us to recognize on the balance sheet the funded status of our defined benefit postretirement plans as either an asset or liability, depending on the plans' funded status, with changes in the funded status recognized through other comprehensive income. The funded status is measured as the difference between the fair value of the plan assets and the projected benefit obligation, for pension plans, or the accumulated postretirement benefit obligation for postretirement benefit plans. Prior service costs or credits and net gains or losses which are not recognized in current net periodic benefit cost, pursuant to SFAS No. 87, "Employers' Account for Pensions" or SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," must be recognized in other comprehensive income, net of tax, in the period in which they occur. As these items are recognized in net periodic benefit cost, the amounts accumulated in other comprehensive income are adjusted. Under SFAS 158, disclosure requirements have also been expanded to separately provide information on the prior service costs or credits and net gains and losses recognized in other comprehensive income and their effects on net periodic benefit costs. Retroactive application of SFAS 158 is not permitted. We applied the recognition provisions of SFAS 158 as of December 31, 2006. The adoption of SFAS 158 resulted in a reduction to accumulated other comprehensive income of $6 million. See Note 7 for more information regarding our adoption of SFAS 158. SAB NO. 108 -- CONSIDERING THE EFFECTS OF PRIOR YEAR MISSTATEMENTS WHEN QUANTIFYING MISSTATEMENTS IN CURRENT YEAR FINANCIAL STATEMENTS. In September 2006, the Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 108, "Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements" ("SAB 108"). SAB 108 provides guidance for evaluating the effects of prior year uncorrected errors when quantifying misstatements in the current year financial statements. Under SAB 108, the impact of correcting misstatements occurring in the current period and those that have accumulated over prior periods must both be considered when quantifying the impact of misstatements in current period financial statements. SAB 108 is effective for fiscal years ending after November 15, 2006, and may be adopted by either restating prior financial statements or recording the cumulative effect of initially applying the approach as adjustments to the carrying values of assets and liabilities as of January 1, 2006 with an offsetting adjustment to retained earnings. We adopted the provisions of SAB 108 as of December 31, 2006. The adoption of SAB 108 did not have a material effect on our consolidated financial statements. STATEMENT OF POSITION 05-1. In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position ("SOP") 05-1, "Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts" ("SOP 05-1"). SOP 05-1 addresses the accounting for Deferred Acquisition Costs ("DAC") on internal replacements other than those described in SFAS No. 97, "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments." An internal replacement is defined by SOP 05-1 as a modification in product benefits, features, rights or coverages that occurs by (a) exchanging the contract for a new contract, (b) amending, endorsing or attaching a rider to the contract, or (c) electing a feature or coverage within a replaced contract. Contract modifications that result in a substantially unchanged contract will be accounted for as a continuation of the replaced contract. Contract modifications that result in a substantially changed contract should be accounted for as an extinguishment of the replaced contract, and any unamortized DAC, unearned revenue and deferred sales charges must be written-off. SOP 05-1 is to be applied prospectively and is effective for internal replacements occurring in fiscal years beginning after December 15, 2006. We will adopt this new accounting guidance effective January 1, 2007, primarily impacting our Individual Markets Annuities business. The adoption of this new guidance will impact our assumptions for lapsation used in the amortization of DAC and VOBA on certain blocks of our business. Our adoption will result in a reduction to our DAC and VOBA balances between $20 million to $50 million pre-tax, which will be recorded as a reduction to retained earnings with no impact on net income. The impact of SOP 05-1 is expected to prospectively increase DAC and VOBA amortization $3 million to $20 million, pre-tax, in 2007 assuming that replacement activity, as defined by SOP 05-1, is comparable to recent years. Our estimates are based upon our interpretation of SOP 05-1 and the proposed implementation guidance and do not consider our interpretations of final implementation guidance that could be issued in 2007. As a result, the actual impact of the adoption of SOP 05-1 may differ from our estimates as the issuance of new implementation guidance and evolving industry practice may affect our interpretation and implementation. SFAS NO. 155 -- ACCOUNTING FOR CERTAIN HYBRID FINANCIAL INSTRUMENTS -- AN AMENDMENT OF FASB STATEMENTS NO. 133 AND 140. In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments -- an amendment of FASB Statements No. 133 and 140" ("SFAS 155"), which permits fair value remeasurement for a hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. Under SFAS 155, an entity may S-12 2. CHANGES IN ACCOUNTING PRINCIPLES AND CHANGES IN ESTIMATES (CONTINUED) make an irrevocable election to measure a hybrid financial instrument at fair value, in its entirety, with changes in fair value recognized in earnings. SFAS 155 also: (a) clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"); (b) eliminates the interim guidance in SFAS 133 Implementation Issue No. D1, "Application of Statement 133 to Beneficial Interests in Securitized Financial Assets," and establishes a requirement to evaluate beneficial interests in securitized financial assets to identify interests that are either freestanding derivatives or hybrid financial instruments that contain an embedded derivative requiring bifurcation; (c) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and (d) eliminates restrictions on a qualifying special-purpose entity's ability to hold passive derivative financial instruments that pertain to beneficial interests that are or contain a derivative financial instrument. In December 2006, the FASB cleared Derivative Implementation Group Statement 133 Implementation Issue No. B40, "Embedded Derivatives: Application of Paragraph 13(b) to Securitized Interests in Prepayable Financial Assets" ("DIG B40"). Since SFAS 155 eliminated the interim guidance related to securitized financial assets, DIG B40 provides a narrow scope exception for securitized interests that contain only an embedded derivative related to prepayment risk. Under DIG B40, a securitized interest in prepayable financial assets would not be subject to bifurcation if: (a) the right to accelerate the settlement of the securitized interest cannot be controlled by the investor and (b) the securitized interest itself does not contain an embedded derivative for which bifurcation would be required other than an embedded derivative that results solely from the embedded call options in the underlying financial assets. Any other terms in the securitized financial asset that may affect cash flow in a manner similar to a derivative instrument would be subject to the requirements of paragraph 13(b) of SFAS 133. The guidance in DIG B40 is to be applied upon the adoption of SFAS 155. We will adopt the provisions SFAS 155 and DIG B40 on January 1, 2007, for all financial instruments acquired, issued, or subject to a remeasurement event occurring after that date. Prior period restatement is not permitted. The adoption of SFAS 155 will not have a material impact on our consolidated financial condition or results of operations. FASB INTERPRETATION NO. 48 -- ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES -- AN INTERPRETATION OF FASB STATEMENT NO. 109. In July 2006, the FASB issued FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes -- an interpretation of FASB Statement No. 109" ("FIN 48"). FIN 48 establishes criteria that an individual tax position must meet for any part of the benefit of the tax position to be recognized in the financial statements. These criteria include determining whether it is more-likely-than-not that a tax position will be sustained upon examination by the appropriate taxing authority. If the tax position meets the more-likely-than-not threshold, the position is measured as the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. If a tax position does not meet the more-likely-than-not recognition threshold, the benefit is not recognized in the financial statements. Upon adoption of FIN 48, the guidance will be applied to all tax positions, and only those tax positions meeting the more-likely-than-not threshold will be recognized or continue to be recognized in the financial statements. Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first subsequent financial reporting period in which that threshold is met. In addition, FIN 48 expands disclosure requirements to include additional information related to unrecognized tax benefits. FIN 48 is effective for fiscal years beginning after December 15, 2006. The cumulative effect adjustment upon the initial adoption of FIN 48 will be recorded as an adjustment to retained earnings with no impact on net income. We will adopt the provisions of FIN 48 on January 1, 2007. The adoption of FIN 48 is not expected to have a material effect on our consolidated financial condition or results of operations. SFAS NO. 157 -- FAIR VALUE MEASUREMENTS. In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements" ("SFAS 157"), which establishes a framework for measuring fair value under current accounting pronouncements that require or permit fair value measurement. SFAS 157 retains the exchange price notion, but clarifies that exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the most advantageous market for that asset or liability. Fair value measurement is based on assumptions used by market participants in pricing the asset or liability, which may include inherent risk, restrictions on the sale or use of an asset, or nonperformance risk which would include the reporting entity's own credit risk. SFAS 157 establishes a three-level fair value hierarchy, which prioritizes the inputs to valuation techniques used to measure fair value. The highest priority is given to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs in situations where there is little or no market activity for the asset or liability. In addition, SFAS 157 expands the disclosure requirements for annual and interim reporting to focus on the inputs used to measure fair value, including those measurements using significant unobservable inputs, and the effects of the measurements on earnings. SFAS 157 will be applied prospectively and is effective for fiscal years beginning after November 15, 2007. Retrospective application is required for certain financial instruments as a cumulative effect adjustment to the opening balance of retained earnings. We are currently evaluating the effects of SFAS 157 on our consolidated financial condition and results of operations. SOP 03-1. Effective January 1, 2004, we implemented the provisions of AICPA SOP 03-1, "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts" ("SOP 03-1"). Adjustments arising from implementation, as discussed below, were S-13 2. CHANGES IN ACCOUNTING PRINCIPLES AND CHANGES IN ESTIMATES (CONTINUED) recorded in net income as a cumulative effect of accounting change. GUARANTEED MINIMUM DEATH BENEFIT RESERVES. Although there was no method prescribed under GAAP for GMDB reserving until the issuance of SOP 03-1, our Individual Annuities segment had been recording a reserve for GMDBs. At December 31, 2003, our GMDB reserve was $46 million. Adoption of the GMDB reserving methodology under SOP 03-1 resulted in a decrease to reserves of $10 million pre-tax. GMDB reserves were $23 million and $15 million at December 31, 2006 and 2005, respectively, of which $21 and $15 million were ceded to an affiliated reinsurance company. Application of SOP 03-1 impacts EGPs used to calculate amortization of DAC, VOBA, DSI, and the liability for DFEL. The benefit ratio approach under SOP 03-1 results in a portion of future GMDB fees being accrued as a liability for future GMDB reserves. As a result, the EGPs used in our determination of DAC amortization are lower under SOP 03-1. Therefore upon adoption of SOP 03-1 we reported an unfavorable DAC/VOBA/DSI/DFEL unlocking as a negative cumulative effect adjustment of $43 million pre-tax in 2004. The combined effects of the GMDB reserve requirements and related unlocking adjustments from implementation of SOP 03-1 resulted in a charge to net income for the cumulative effect of accounting change of $35 million pre-tax ($23 million after-tax) in 2004. SALES INDUCEMENTS. Our Individual Markets -- Annuities segment variable annuity product offerings include contracts that offer a bonus credit, typically ranging from 2% to 5% of each deposit. We also offer enhanced interest rates to variable annuity contracts that are under DCA funding arrangements. Bonus credits and excess DCA interest are considered sales inducements under SOP 03-1 and, as such, are to be deferred as a sales inducement asset and amortized as a benefit expense over the expected life of the contract. Amortization is computed using the same methodology and assumptions used in amortizing DAC. UNIVERSAL LIFE CONTRACTS. Our Individual Markets -- Life Insurance segment offers an array of individual and survivor-life universal life insurance products that contain features for which SOP 03-1 might apply. A review of the products and their features for possible SOP implications concluded that no additional reserves were necessary with the exception of the MoneyGuard(R) product. MoneyGuard(R) is a universal life insurance product with an acceleration of death benefit feature that provides convalescent care benefit payments when the insured becomes chronically ill. There is an optional extension of benefit rider available that will provide continuation of the convalescent care benefit payments once the total benefits from the base policy have been exhausted. The optional extended benefit payments can be for 2 years, 4 years, or the remaining life of the insured. Charges for the extension rider are deducted from the base policy account value and vary by the length of extension period selected. The adoption of SOP 03-1 in 2004 resulted in a charge recorded as a cumulative effect of accounting change of $4 million pre-tax ($3 million after-tax) for the extension of benefit feature in MoneyGuard(R). SFAS NO. 159 -- THE FAIR VALUE OPTION FOR FINANCIAL ASSETS AND FINANCIAL LIABILITIES. In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" ("SFAS 159"), which allows an entity to make an irrevocable election, on specific election dates, to measure eligible items at fair value. The election to measure an item at fair value may be determined on an instrument by instrument basis, with certain exceptions. If the fair value option is elected, unrealized gains and losses will be recognized in earnings at each subsequent reporting date, and any upfront costs and fees related to the item will be recognized in earnings as incurred. In addition, the presentation and disclosure requirements of SFAS 159 are designed to assist in the comparison between entities that select different measurement attributes for similar types of assets and liabilities. SFAS 159 does not affect any existing accounting literature that requires certain assets and liabilities to be carried at fair value and does not eliminate disclosure requirements included in other accounting standards. SFAS 159 applies to fiscal years beginning after November 15, 2007, with early adoption permitted for an entity that has also elected to apply the provisions of SFAS 157. Retrospective application of SFAS 159 is not permitted unless early adoption is elected. At the effective date, the fair value option may be elected for eligible items that exist on that date. The effect of the first remeasurement to fair value shall be reported as a cumulative effect adjustment to the opening balance of retained earnings. We are currently evaluating the potential effects of SFAS 159 on our consolidated financial condition and results of operations. S-14 3. INVESTMENTS The amortized cost, gross unrealized gain and loss, and fair value of securities available-for-sale are as follows:
AMORTIZED COST GAINS LOSSES FAIR VALUE --------- ------ ------ ---------- (IN MILLIONS) ---------------------------------------- 2006: Corporate bonds $24,262 $ 807 $(238) $24,831 U.S. Government bonds 141 7 -- 148 Foreign government bonds 689 58 (2) 745 Asset and mortgage-backed securities: Mortgage pass-through securities 389 3 (5) 387 Collateralized mortgage obligations 3,156 18 (43) 3,131 Commercial Mortgage Backed Securities 2,235 37 (19) 2,253 Other asset-backed securities 130 3 -- 133 State and municipal bonds 113 2 (1) 114 Redeemable preferred stocks 89 9 -- 98 ------- ------ ----- ------- Total fixed maturity securities 31,204 944 (308) 31,840 Equity securities 191 14 (2) 203 ------- ------ ----- ------- Total $31,395 $ 958 $(310) $32,043 ======= ====== ===== ======= 2005: Corporate bonds $24,190 $1,106 $(241) $25,055 U.S. Government bonds 143 12 -- 155 Foreign government bonds 839 62 (3) 898 Asset and mortgage-backed securities: Mortgage pass-through securities 453 5 (6) 452 Collateralized mortgage obligations 2,982 25 (34) 2,973 Commercial Mortgage Backed Securities 2,350 52 (20) 2,382 Other asset-backed securities 99 3 -- 102 State and municipal bonds 123 4 (1) 126 Redeemable preferred stocks 88 14 -- 102 ------- ------ ----- ------- Total fixed maturity securities 31,267 1,283 (305) 32,245 Equity securities 95 6 -- 101 ------- ------ ----- ------- Total $31,362 $1,289 $(305) $32,346 ======= ====== ===== =======
Future maturities of fixed maturity securities available-for-sale are as follows:
AMORTIZED FAIR COST VALUE --------- -------- (IN MILLIONS) -------------------- Due in one year or less $ 1,052 $ 1,056 Due after one year through five years 6,605 6,759 Due after five years through ten years 8,538 8,630 Due after ten years 9,099 9,491 ------- ------- Subtotal 25,294 25,936 Asset and mortgage-backed securities 5,910 5,904 ------- ------- Total $31,204 $31,840 ======= =======
The foregoing data is based on stated maturities. Actual maturities will differ in some cases because borrowers may have the right to call or pre-pay obligations. The amortized cost and estimated fair value of investments in asset/mortgage-backed securities summarized by interest rates of the underlying collateral are as follows:
AMORTIZED FAIR COST VALUE --------- -------- (IN MILLIONS) -------------------- Below 5% $ 91 $ 91 5%-6% 2,458 2,419 6%-7% 2,179 2,178 Above 7% 1,182 1,216 ------ ------ Total $5,910 $5,904 ====== ======
S-15 3. INVESTMENTS (CONTINUED) The quality ratings of fixed maturity securities available-for-sale are as follows:
NAIC RATING AGENCY DESIGNATION EQUIVALENT DESIGNATION FAIR VALUE % OF TOTAL ----------- ---------------------- ---------- ---------- (IN MILLIONS) ----------------------- 1 AAA / AA / A $19,335 60.7% 2 BBB 10,147 31.9% 3 BB 1,420 4.5% 4 B 748 2.3% 5 CCC and lower 169 0.5% 6 In or near default 21 0.1% ------- ----- $31,840 100.0% ======= =====
The major categories of net investment income are as follows:
2006 2005 2004 ------ ------ ------ (IN MILLIONS) ------------------------ Fixed maturity securities available-for-sale $1,970 $1,959 $1,932 Equity securities available-for-sale 10 7 8 Trading securities 181 176 173 Mortgage loans on real estate 271 288 350 Real estate 37 48 25 Policy loans 120 118 119 Invested cash 53 46 21 Other investments 61 61 54 ------ ------ ------ Investment revenue 2,703 2,703 2,682 Investment expense 109 111 89 ------ ------ ------ Net investment income $2,594 $2,592 $2,593 ====== ====== ======
Trading securities at fair value retained in connection with Modco and CFW reinsurance arrangements, consisted of the following:
2006 2005 ------ ------ (IN MILLIONS) --------------- Corporate bonds $2,140 $2,282 U.S. Government bonds 331 322 Foreign government bonds 45 52 Asset and mortgage-backed securities: Mortgage pass-through securities 24 29 Collateralized mortgage obligations 111 113 Commercial Mortgage Backed Securities 133 149 Other asset-backed securities 8 9 State and municipal bonds 18 19 Redeemable preferred stocks 8 8 ------ ------ Total fixed maturity securities 2,818 2,983 Equity securities 2 2 ------ ------ Total $2,820 $2,985 ====== ======
The portion of the market adjustment for trading securities still held at December 31, 2006 and 2005 was a loss of $48 million and $70 million, respectively. The detail of the realized gain (loss) on investments is as follows:
2006 2005 2004 ---- ---- ----- (IN MILLIONS) -------------------- Realized loss on investments and derivative instruments $(2) $(21) $(58) Gain (loss) on reinsurance embedded derivative/trading securities 4 5 (1) Gain on sale of subsidiaries/business -- -- 14 --- ---- ---- Total realized gain (loss) on investments $ 2 $(16) $(45) === ==== ====
The detail of the realized loss on investments and derivative instruments is as follows:
2006 2005 2004 ----- ---- ----- (IN MILLIONS) -------------------- Fixed maturity securities available-for-sale Gross gain $103 $113 $ 107 Gross loss (82) (90) (115) Equity securities available-for-sale Gross gain 1 8 19 Gross loss -- -- (1) Other investments 9 10 4 Associated amortization of deferred acquisition costs and provision for policyholder commitments (31) (52) (51) Investment expenses (2) (9) (10) ----- ---- ----- Total Investments (2) (20) (47) Derivative instruments net of associated amortization of deferred acquisition costs -- (1) (11) ----- ---- ----- Total investments and derivative instruments $ (2) $(21) $ (58) ===== ==== =====
S-16 3. INVESTMENTS (CONTINUED) Provisions (credits) for write-downs and net changes in allowances for loss, which are included in the realized loss on investments and derivative instruments shown above, are as follows:
2006 2005 2004 ---- ---- ---- (IN MILLIONS) ------------------ Fixed maturity securities $56 $19 $67 available-for-sale Mortgage loans on real estate 1 (6) (2) --- --- --- Total $57 $13 $65 === === ===
The change in unrealized appreciation (depreciation) on investments in fixed maturity and equity securities available-for-sale is as follows:
2006 2005 2004 ----- ----- ---- (IN MILLIONS) -------------------- Fixed maturity securities $(342) $(839) $61 Equity securities 6 (6) (6) ----- ----- --- Total $(336) $(845) $55 ===== ===== ===
For securities available for sale held by us at December 31, 2006 and 2005 that are in unrealized loss status, the fair value, amortized cost, unrealized loss and total time period that the security has been in an unrealized loss position are presented in the table below.
FAIR % FAIR AMORTIZED % AMORTIZED UNREALIZED % UNREALIZED VALUE VALUE COST COST LOSS LOSS ------- ------ --------- ----------- ---------- ------------ (IN MILLIONS) ---------------------------------------------------------------------- 2006 less than or equal to 90 days $ 3,646 27.5% $ 3,672 27.0% $ (26) 8.4% greater than 90 days but less than or equal 180 days 112 0.8% 115 0.9% (3) 1.0% greater than 180 days but less than or equal 270 days 842 6.3% 861 6.3% (19) 6.1% greater than 270 days but less than or equal 1 year 1,456 11.0% 1,492 11.0% (36) 11.6% greater than 1 year 7,226 54.4% 7,452 54.8% (226) 72.9% ------- ----- ------- ----- ----- ----- Total $13,282 100.0% $13,592 100.0% $(310) 100.0% ======= ===== ======= ===== ===== ===== 2005 less than or equal to 90 days $ 3,006 27.6% $ 3,039 27.1% $ (33) 10.8% greater than 90 days but less than or equal 180 days 5,152 47.4% 5,258 47.1% (106) 34.8% greater than 180 days but less than or equal 270 days 374 3.4% 384 3.4% (10) 3.3% greater than 270 days but less than or equal 1 year 789 7.2% 822 7.3% (33) 10.8% greater than 1 year 1,570 14.4% 1,693 15.1% (123) 40.3% ------- ----- ------- ----- ----- ----- Total $10,891 100.0% $11,196 100.0% $(305) 100.0% ======= ===== ======= ===== ===== =====
S-17 3. INVESTMENTS (CONTINUED) For fixed maturity and equity securities available-for-sale with unrealized losses as of December 31, 2006 and 2005, the gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous loss position are summarized as follows:
LESS THAN OR EQUAL TO TWELVE GREATER THAN TWELVE MONTHS MONTHS TOTAL -------------------- -------------------- --------------------- GROSS GROSS GROSS FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED VALUE LOSSES VALUE LOSSES VALUE LOSSES ------- ---------- ------- ---------- -------- ---------- (IN MILLIONS) ------------------------------------------------------------------- 2006: Corporate bonds $ 4,527 $ (71) $ 4,892 $ (167) $ 9,419 $(238) U.S. Government bonds 3 -- -- -- 3 -- Foreign government bonds 56 (1) 62 (1) 118 (2) Asset and mortgage-backed securities: Mortgage pass-through securities 63 -- 223 (5) 286 (5) Collateralized mortgage obligations 890 (7) 1,320 (36) 2,210 (43) Commercial Mortgage Backed Securities 451 (3) 663 (16) 1,114 (19) Other asset-backed securities -- -- 21 -- 21 -- State and municipal bonds 16 -- 44 (1) 60 (1) Redeemable preferred stocks -- -- 1 -- 1 -- ------- ------- ------- ------- -------- ----- Total fixed maturity securities 6,006 (82) 7,226 (226) 13,232 (308) Equity securities 50 (2) -- -- 50 (2) ------- ------- ------- ------- -------- ----- Total $ 6,056 $ (84) $ 7,226 $ (226) $ 13,282 $(310) ======= ======= ======= ======= ======== ===== 2005: Corporate bonds $ 6,300 $ (132) $ 1,235 $ (109) $ 7,535 $(241) U.S. Government bonds -- -- -- -- -- -- Foreign government bonds 169 (3) 38 -- 207 (3) Asset and mortgage-backed securities: Mortgage pass-through securities 320 (4) 39 (2) 359 (6) Collateralized mortgage obligations 1,589 (27) 145 (7) 1,734 (34) Commercial Mortgage Backed Securities 888 (16) 100 (4) 988 (20) Other asset-backed securities 23 -- -- -- 23 -- State and municipal bonds 31 -- 13 (1) 44 (1) Redeemable preferred stocks 1 -- -- -- 1 -- ------- ------- ------- ------- -------- ----- Total fixed maturity securities 9,321 (182) 1,570 (123) 10,891 (305) Equity securities -- -- -- -- -- -- ------- ------- ------- ------- -------- ----- Total $ 9,321 $ (182) $ 1,570 $ (123) $ 10,891 $(305) ======= ======= ======= ======= ======== =====
S-18 3. INVESTMENTS (CONTINUED) Securities available-for-sale that were deemed to have declines in fair value that were other than temporary were written down to fair value. The fixed maturity securities to which these write-downs apply were generally of investment grade at the time of purchase, but were subsequently downgraded by rating agencies to "below-investment grade." Factors we considered in determining whether declines in the fair value of fixed maturity securities are other than temporary include 1) the significance of the decline, 2) our ability and intent to retain the investment for a sufficient period of time for it to recover, 3) the time period during which there has been a significant decline in value, and 4) fundamental analysis of the liquidity, business prospects and overall financial condition of the issuer. Based upon these factors, securities that have indications of potential impairment are subject to intensive review. Where such analysis results in a conclusion that declines in fair values are other than temporary, the security is written down to fair value. See Note 10 - Fair Value of Financial Instruments to the Consolidated Financial Statements for a general discussion of the methodologies and assumptions used to determine estimated fair values. The balance sheet captions, "Real estate" and "Other assets," which includes property and equipment, include accumulated depreciation as follows:
2006 2005 ---- ---- (IN MILLIONS) ------------- Real estate $ 25 $ 19 Property and equipment 240 255
Impaired mortgage loans along with the related allowance for losses are as follows:
2006 2005 ---- ---- (IN MILLIONS) ------------- Impaired loans with allowance for losses $27 $66 Allowance for losses (1) (9) --- --- Net impaired loans $26 $57 === ===
We believe the allowance for losses is maintained at a level adequate to absorb estimated probable credit losses. Our periodic evaluation of the adequacy of the allowance for losses is based on our past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay (including the timing of future payments), the estimated value of the underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors. This evaluation is inherently subjective as it requires estimating the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. A reconciliation of the mortgage loan allowance for losses for these impaired mortgage loans is as follows:
2006 2005 2004 ---- ---- ---- (IN MILLIONS) ------------------ Balance at beginning-of-year $ 9 $15 $17 Provisions for losses 1 2 5 Releases due to principal paydowns (9) (8) (7) --- --- --- Balance at end-of-year $ 1 $ 9 $15 === === ===
The average recorded investment in impaired mortgage loans and the interest income recognized on impaired mortgage loans were as follows:
2006 2005 2004 ---- ---- ---- (IN MILLIONS) ------------------ Average recorded investment in impaired loans $41 $62 $101 Interest income recognized on impaired loans 4 5 9
All interest income on impaired mortgage loans was recognized on the cash basis of income recognition. As of December 31, 2006 and 2005, we had no mortgage loans on non-accrual status. As of December 31, 2006 and 2005, we had no mortgage loans past due 90 days and still accruing. As of December 31, 2006 and 2005, we had restructured mortgage loans of $15 million and $45 million, respectively. We recorded $1 million and $2 million of interest income on these restructured mortgage loans in 2006 and 2005, respectively. Interest income in the amount of $1 million and $4 million would have been recorded on these mortgage loans according to their original terms in 2006 and 2005, respectively. As of December 31, 2006 and 2005, we had no outstanding commitments to lend funds on restructured mortgage loans. As of December 31, 2006, our investment commitments for fixed maturity securities (primarily private placements), mortgage loans on real estate and real estate were $1,072 million. This includes $283 million of standby commitments to purchase real estate upon completion and leasing. The carrying value of fixed maturity securities available-for-sale, mortgage loans on real estate and real estate investments which were non-income producing totaled $40 million and $67 million at December 31, 2006 and 2005, respectively. S-19 4. FEDERAL INCOME TAXES The Federal income tax expense is as follows:
2006 2005 2004 ---- ---- ---- (IN MILLIONS) ------------------ Current $148 $111 $ 98 Deferred 99 112 95 ---- ---- ---- Total tax expense $247 $223 $193 ==== ==== ====
The effective tax rate on pre-tax income from continuing operations is lower than the prevailing corporate Federal income tax rate. A reconciliation of this difference is as follows:
2006 2005 2004 ---- ---- ---- (IN MILLIONS) ------------------ Tax rate times pre-tax income $347 $303 $272 Effect of: Tax-preferred investment income (80) (63) (69) Tax credits (16) (14) (14) Other (4) (3) 4 ---- ---- ---- Provision for income taxes $247 $223 $193 ==== ==== ==== Effective tax rate 25% 26% 25%
The Federal income tax liability, included in other liabilities on the Consolidated Balance Sheets is as follows:
2006 2005 ---- ---- (IN MILLIONS) ----------- Current $20 $77 Deferred 28 24 --- ---- Total Federal income tax liability $48 $101 === ====
Significant components of our deferred tax assets and liabilities are as follows:
2006 2005 ------ ------ (IN MILLIONS) --------------- Deferred tax assets: Insurance and investment contract liabilities $1,275 $1,206 Reinsurance deferred gain 265 291 Modco embedded derivative 76 98 Postretirement benefits other than pension 14 15 Compensation related 111 100 Ceding commission asset 9 11 Other 89 53 ----- ----- Total deferred tax assets 1,839 1,774 ----- ----- Deferred tax liabilities: Deferred acquisition costs 1,208 998 Net unrealized gain on securities available-for-sale 230 351 Trading security gains 74 91 Present value of business in-force 238 260 Other 117 98 ----- ----- Total deferred tax liabilities 1,867 1,798 ----- ----- Net deferred tax liability $ 28 $ 24 ====== ======
We and our affiliates are part of a consolidated Federal income tax filing with LNC. Cash paid for Federal income taxes in 2006, 2005 and 2004 was $208 million, $75 million and $56 million, respectively. We are required to establish a valuation allowance for any gross deferred tax assets that are unlikely to reduce taxes payable in future years' tax returns. At December 31, 2006 and 2005, we concluded that it was more likely than not that all gross deferred tax assets will reduce taxes payable in future years. Accordingly, no valuation allowance was necessary at December 31, 2006 and 2005. Under prior Federal income tax law, one-half of the excess of a life insurance company's income from operations over its taxable investment income was not taxed, but was set aside in a special tax account designated as "Policyholders' Surplus." On October 23, 2004, President Bush signed into law the "American Jobs Creation Act of 2004." Beginning January 1, 2005 through December 31, 2006, the additional tax imposed on distributions from the special tax account, Policyholders' Surplus, was suspended. In addition, the statute provides that distributions made during the two-year suspension period will first reduce the Policyholders' Surplus account balance. Our 2005 dividend activity along with that of our insurance subsidiaries eliminated the account balance during the suspension period. The LNC consolidated group is subject to annual tax examinations from the Internal Revenue Service ("IRS"). During the first quarter of 2006, the IRS completed its examination for the tax years 1999 through 2002 with assessments resulting in a payment that was not material to our consolidated results of operations. In addition to taxes assessed and interest, the payment included a deposit relating to a portion of the assessment, which we continue to challenge. LNC believes this portion of the assessment is inconsistent with existing law, and is protesting it through the established IRS appeals process. We do not anticipate that any adjustments that might result from such audits would be material to the Company's results of operations or financial condition. The LNC consolidated group is currently under audit by the IRS for years 2003 and 2004. S-20 5. SUPPLEMENTAL FINANCIAL DATA Reinsurance transactions included in the income statement captions, "Insurance Premiums" and "Insurance Fees", excluding amounts attributable to the indemnity reinsurance transaction with Swiss Re, are as follows:
2006 2005 2004 ----- ----- ----- (IN MILLIONS) --------------------- Insurance assumed $ -- $ 1 $ -- Insurance ceded (827) (767) (640) ----- ----- ----- Net reinsurance premiums and fees $(827) $(766) $(640) ===== ===== =====
The 2005 and 2004 amounts reported above for insurance ceded to other companies have been adjusted to conform to the 2006 presentation. These adjustments had no effect on insurance premiums, fees or net income presented in the Consolidated Statements of Income as the gross premiums and fees were offset by equal amounts. The income statement caption, "Benefits," is net of reinsurance recoveries of $0.7 billion for 2006 and 2005 and $0.6 billion for 2004. A roll forward of DAC is as follows:
2006 2005 2004 ------ ------ ------ (IN MILLIONS) ------------------------ Balance at beginning-of-year $3,676 $2,904 $2,552 Deferral 1,062 934 868 Amortization (608) (427) (415) Adjustment related to realized gains on securities available-for-sale (39) (48) (46) Adjustment related to unrealized losses on securities available-for-sale 90 313 (16) Cumulative effect of accounting change -- -- (39) ------ ------ ------ Balance at end-of-year $4,181 $3,676 $2,904 ====== ====== ======
A roll forward of VOBA is as follows:
2006 2005 2004 ---- ---- ----- (IN MILLIONS) ------------------- Balance at beginning-of-year $742 $819 $ 922 Amortization, net (63) (77) (103) Adjustment related to realized gains on securities available-for-sale (1) -- -- ---- ---- ----- Balance at end-of-year $678 $742 $ 819 ==== ==== =====
Future estimated amortization of VOBA is as follows (in millions): 2007-$63 2008-$66 2009-$64 2010-$62 2011-$41 Thereafter-$382 Realized losses on investments and derivative instruments on the Consolidated Statements of Income for the year ended December 31, 2006, 2005 and 2004 are net of amounts amortized against DAC of $39 million, $48 million and $46 million, respectively. In addition, realized gains and losses for the year ended December 31, 2006, 2005 and 2004 are net of adjustments made to policyholder reserves of $9 million, $(2) million and $(2) million, respectively. We have either a contractual obligation or a consistent historical practice of making allocations of investment gains or losses to certain policyholders and to certain reinsurance arrangements. A rollforward of DSI, included in Other assets on the Consolidated Balance Sheets, is as follows:
2006 2005 2004 ---- ---- ---- (IN MILLIONS) ------------------ Balance at beginning-of-year $129 $ 85 $ 45 Capitalized 70 60 50 Amortization (21) (16) (10) ---- ---- ---- Balance at end-of-year $178 $129 $ 85 ==== ==== ====
Details underlying the income statement caption, "Underwriting, acquisition, insurance and other expenses," are as follows:
2006 2005 2004 ------ ------ ------ (IN MILLIONS) ------------------------ Commissions $1,043 $ 899 $1,208 General and administrative expenses 816 966 532 DAC and VOBA deferrals, net of amortization (391) (431) (350) Taxes, licenses and fees 96 81 85 Restructuring charges - includes merger-integration expenses 13 29 -- ------ ------ ------ Total $1,577 $1,544 $1,475 ====== ====== ======
The carrying amount of goodwill by reportable segment as of December 31, is as follows:
2006 2005 ---- ---- (IN MILLIONS) ----------- Individual Markets: Life Insurance $855 $855 Annuities 44 44 Employer Markets: Retirement Products 20 20 ---- ---- Total $919 $919 ==== ====
S-21 5. SUPPLEMENTAL FINANCIAL DATA (CONTINUED) Details underlying the balance sheet caption, "Insurance contract and policyholder funds," are as follows:
2006 2005 ------- ------- (IN MILLIONS) ----------------- Premium deposit funds $20,499 $21,755 Other policyholder funds 13,666 12,975 Deferred front end loads 486 432 Undistributed earnings on participating business 102 111 ------- ------- Total $34,753 $35,273 ======= =======
Details underlying the balance sheet captions related of short-term debt and long-term debt are as follows:
2006 2005 ------ ------ (IN MILLIONS) --------------- Short-term debt $ 21 $ 34 ====== ====== Long-term debt: Note due Lincoln National Corporation, due September 2008 $ 140 $ -- Surplus notes due Lincoln National Corporation: 6.56% surplus note, due 2028 500 500 6.03% surplus note, due 2028 750 750 ------ ------ Total Surplus Notes 1,250 1,250 ------ ------ Total long-term debt $1,390 $1,250 ====== ======
The short-term debt represents short-term notes payable to LNC. We issued a surplus note of $500 million to LNC in 1998. This note calls for us to pay the principal amount of the notes on or before March 31, 2028 and interest to be paid quarterly at an annual rate of 6.56%. Subject to approval by the Indiana Insurance Commissioner, LNC also has a right to redeem the note for immediate repayment in total or in part once per year on the anniversary date of the note. Any payment of interest or repayment of principal may be paid only out of our statutory earnings, only if our statutory capital surplus exceeds $2.3 billion, and subject to approval by the Indiana Insurance Commissioner. We issued a surplus note for $750 million to LNC in 1998. This note calls for us to pay the principal amount of the notes on or before December 31, 2028 and interest to be paid quarterly at an annual rate of 6.03%. Subject to approval by the Indiana Insurance Commissioner, LNC also has a right to redeem the note for immediate repayment in total or in part once per year on the anniversary date of the note. Any payment of interest or repayment of principal may be paid only out of our statutory earnings, only if our statutory capital surplus exceeds $2.4 billion, and subject to approval by the Indiana Insurance Commissioner. A consolidated subsidiary of LNL issued a note for an amount not to exceed $150 million to LNC in 2006. As of December 31, 2006, $140 million had been advanced to us. This note calls for us to pay the principal amount of the notes on or before September 30, 2008 and interest to be paid monthly at a rate equal to the Federal Reserve Board's 30 day AA- financial commercial paper rate plus ten basis points. Cash paid for interest on both the short-term debt and the surplus notes was $99 million, $59 million and $79 million for 2006, 2005 and 2004, respectively. 6. INSURANCE BENEFIT RESERVES We issue variable contracts through our separate accounts for which investment income and investment gains and losses accrue directly to, and investment risk is borne by, the contractholder (traditional variable annuities). We also issue variable annuity and life contracts through separate accounts that include various types of GMDB, GMWB and GIB. The GMDB features include those where we contractually guarantee to the contract holder either (a) return of no less than total deposits made to the contract less any partial withdrawals, (b) total deposits made to the contract less any partial withdrawals plus a minimum return, or (c) the highest contract value on a specified anniversary date minus any partial withdrawals following the contract anniversary. The following table provides information on the GMDB features outstanding at December 31, 2006 and 2005. (Note that our variable contracts with guarantees may offer more than one type of guarantee in each contract; therefore, the amounts listed are not mutually exclusive.) The net amount at risk is defined as the current guaranteed minimum death benefit in excess of the current account balance at the balance sheet date.
2006 2005 ----- ----- IN EVENT OF DEATH --------------------- (DOLLARS IN BILLIONS) --------------------- Return of net deposit Account value $38.3 $31.9 Net amount at risk 0.1 0.1 Average attained age of contractholders 54 53 Return of net deposits plus a minimum return Account value $ 0.4 $ 0.3 Net amount at risk -- -- Average attained age of contractholders 67 66 Guaranteed minimum return 5% 5% Highest specified anniversary account value minus withdrawals post anniversary Account value $22.5 $18.8 Net amount at risk 0.2 0.3 Average attained age of contractholders 64 63
S-22 6. INSURANCE BENEFIT RESERVES (CONTINUED) Approximately $13.2 billion and $8.2 billion of separate account values at December 31, 2006 and 2005 were attributable to variable annuities with a GMWB feature. This GMWB feature offers the contractholder a guarantee equal to the initial deposit adjusted for any subsequent purchase payments or withdrawals. There are one-year and five-year step-up options, which allow the contractholder to step up the guarantee. GMWB features are considered to be derivatives under SFAS 133 resulting in the related liabilities being recognized at fair value, with changes in fair value being reported in net income. At December 31, 2006 and 2005, we had approximately $2.7 billion and $1.2 billion of separate account values that were attributable to variable annuities with a GIB feature. All of the outstanding contracts with a GIB feature are still in the accumulation phase. Separate account balances attributable to variable annuity contracts with guarantees are as follows:
2006 2005 ----- ------ (IN BILLIONS) -------------- Asset Type Domestic equity $39.0 $32.2 International equity 5.9 4.2 Bonds 6.4 5.1 ----- ----- Total 51.3 41.5 ----- ----- Money market 5.6 4.0 ----- ----- Total $56.9 $45.5 ===== ===== Percent of total variable annuity separate account values 87% 87% ===== =====
The determination of the GMDB 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 table summarizes the liabilities for GMDB:
GMDB 2006 2005 ----- ------ (IN MILLIONS) -------------- Total: Balance at January 1 $ 15 $ 18 Changes in reserves 14 9 Benefits paid (6) $(12) ---- ---- Balance at December 31 $ 23 $ 15 ==== ==== Ceded: Balance at January 1 $(15) $(18) Changes in reserves (12) (9) Benefits paid 6 12 ---- ---- Balance at December 31 $(21) $(15) ==== ==== Net: Balance at January 1 $ -- $ -- Changes in reserves 2 -- Benefits paid -- -- ---- ---- Balance at December 31 $ 2 $ -- ==== ====
The offset to the benefit reserve amounts above are reflected in benefits in the Consolidated Statements of Income. We have an Automatic Indemnity Reinsurance Agreement with Lincoln National Reinsurance Company (Barbados) Limited ("LNR Barbados"), a wholly-owned subsidiary of LNC. Under this agreement, we cede a portion of our GMDB, GMWB and GIB risks to LNR Barbados. In connection with this reinsurance agreement, we paid premiums to LNR Barbados totaling $154 million and $109 million in 2006 and 2005, respectively, related to this agreement. These reinsurance premiums are reflected as an offset in insurance premiums in the Consolidated Statements of Income. 7. RETIREMENT BENEFIT PLANS The Company's employees, other than its insurance agents, are included in various benefit plans sponsored by LNC including pension and other postretirement benefit plans, 401(k) and profit sharing plans, and deferred compensation plans. The Company `s insurance agents are included in various benefit plans sponsored by either LNL or LNC including pension and other postretirement benefit plans, 401(k) and profit sharing plans, and deferred compensation plans. PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS LNC maintains a funded defined benefit pension plan for most of its U.S. employees (including those of LNL). Effective January 1, 2002, the employees' pension plan has a cash balance formula. Employees retiring before 2012 will have their benefits calculated under both the old and new formulas and will receive the greater of the two calculations. Employees retiring in 2012 or after will receive benefits under the amended plan. Benefits under the old employees' plan are based on total years of service and the highest 60 months of compensations during the last 10 years of employment. Under the amended plan, employees have guaranteed account balances that grow with pay and interest credits each year. LNL sponsors a defined benefit pension plan which, prior to January 1, 1995, covered most full-time insurance agents of the Company. All benefits applicable to this plan were frozen as of December 31, 1994. The plans are funded by contributions to tax-exempt trusts. The funding policy is consistent with the funding requirements of Federal law and regulations. Contributions are intended to provide not only the benefits attributed to service to date, but also those expected to be earned in the future. LNC sponsors three types of unfunded, nonqualified, defined benefit plans for certain U.S. employees and agents (including those of LNL): supplemental retirement plans, a salary continuation plan, and supplemental executive retirement plans. The supplemental retirement plans provide defined benefit pension benefits in excess of limits imposed by Federal tax law. S-23 7. RETIREMENT BENEFIT PLANS (CONTINUED) The salary continuation plan provides certain of our officers defined pension benefits based on years of service and final monthly salary upon death or retirement. The supplemental executive retirement plan provides defined pension benefits for certain executives who became our employees as a result of the acquisition of a block of individual life insurance and annuity business from CIGNA Corporation ("CIGNA"), and benefits under this plan were frozen effective January 1, 2000. A second supplemental executive retirement plan was established for this same group of executives to guarantee that the total benefit payable under the LNC employees' defined benefit pension plan benefit formula will be determined using an average compensation not less than the minimum three-year average compensation as of a certain period. All benefits payable from this plan are reduced by benefits payable from the LNC employees' defined benefit pension plan. LNC also sponsors an unfunded plan that provide postretirement medical, dental and life insurance benefits to full-time U.S. employees who have worked for LNC 10 years and attained age 55 (including those of LNL). LNL sponsors an unfunded plan that provide postretirement medical, dental and life insurance benefits to full-time agents who have worked for LNL 10 years and attained age 60. Medical and dental benefits are also available to spouses and other dependents of employees and agents. For medical and dental benefits, limited contributions are required from individuals who retired prior to November 1, 1988. Contributions for later retirees, which can be adjusted annually, are based on such items as years of service at retirement and age at retirement. Effective April 1, 2004, the employees' postretirement plan was changed such that employees and agents not attaining age 50 by that date will not be eligible to receive life insurance benefits when they retire. Life insurance benefits for retirees are noncontributory for employees and agents that attain the age of 50 by April 1, 2004 and meet the eligibility requirements at the time they retire; however, these participants can elect supplemental contributory life benefits up to age 70. Effective July 1, 1999, the agents' postretirement plan was changed to require agents retiring on or after that date to pay the full medical and dental premium costs. Beginning January 1, 2002, the employees' postretirement plan was changed to require employees not yet age 50 with five years of service by the end of 2001 to pay the full medical and dental premium cost when they retire. OBLIGATIONS, FUNDED STATUS AND ASSUMPTIONS Information with respect to plan asset activity and defined benefit plan obligations for the agent defined benefit and other postretirement benefit plans sponsored by LNL is as follows:
OTHER PENSION POSTRETIREMENT BENEFITS BENEFITS ------------- -------------- 2006 2005 2006 2005 ----- ----- ----- ------ (IN MILLIONS) ------------------------------ Change in plan assets: Fair value of plan assets at beginning-of-year $ 93 $ 82 $ -- $ -- Actual return on plan assets 12 6 -- -- Company contributions -- 10 2 2 Benefits paid (5) (5) (2) (2) ----- ----- ----- ----- Fair value of plan assets at end-of-year $ 100 $ 93 $ -- $ -- ===== ===== ===== ===== Change in benefit obligation: Benefit obligation at beginning-of-year $ 92 $ 87 $ 22 $ 19 Interest cost 5 5 1 1 Plan participants' contributions -- -- 1 1 Actuarial (gains)/ losses (2) 4 (3) 3 Benefits paid (5) (4) (2) (2) ----- ----- ----- ----- Benefit obligation at end-of-year $ 90 $ 92 $ 19 $ 22 ===== ===== ===== ===== Funded status of the plans $ 10 $ 1 $ (19) $ (22) Unrecognized net actuarial losses 20 (1) ----- ----- Prepaid (accrued) benefit cost 21 (23) Other assets 11 -- -- -- Other liabilities (1) -- (19) -- ----- ----- ----- ----- Amounts recognized in the Consolidated Balance Sheets $ 10 $ 21 $ (19) $ (23) ===== ===== ===== ===== Amounts recognized in accumulated other comprehensive income (net of tax): Net loss (gain) 8 (2) ----- ----- Total $ 8 $ (2) Weighted-average assumptions as of December 31: Weighted-average discount rate 5.75% 6.00% 5.75% 6.00% Expected return on plan assets 8.00% 8.25% -- -- Rate of increase in compensation 4.00% 4.00% 4.00% 4.00%
The Company uses December 31 as the measurement date for our pension and postretirement plans. S-24 7. RETIREMENT BENEFIT PLANS (CONTINUED) The expected return on plan assets was determined based on historical and expected future returns of the various asset classes, using the target plan allocations. This assumption is reevaluated at an interim date each plan year. The calculation of the accumulated postretirement benefits obligation assumes a weighted-average annual rate of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) of 12.0% for 2006. It further assumes the rate will gradually decrease to 5.0% by 2017 and remain at that level in future periods. The health care cost trend rate assumption has a significant effect on the amounts reported. A one-percentage point increase and decrease in assumed health care cost trend rates would have the following effects:
ONE-PERCENTAGE ONE-PERCENTAGE POINT INCREASE POINT DECREASE -------------- -------------- (IN MILLIONS) ------------------------------- Effect on accumulated postretirement benefit obligation $ 1 $(1) Effect on total service and interest cost components -- --
As discussed in Note 2, we applied the recognition provisions of SFAS 158 as of December 31, 2006. The incremental effect of applying SFAS 158 on our Consolidated Balance Sheets at December 31, 2006 is as follows:
BEFORE AFTER APPLICATION APPLICATION OF SFAS 158 OF SFAS 158 ADJUSTMENTS SFAS 158 ----------- ----------- ----------- (IN MILLIONS) ------------------------------------- Other assets $ 1,101 $11 $ 1,112 Total assets 126,057 11 126,068 Other liabilities 2,052 17 2,069 Total liabilities 120,458 17 120,475 Accumulated other comprehensive income 306 (6) 300 Total shareholder's equity 5,599 (6) 5,593
Information for the Company's agent pensi on plans with accumulated benefit obligations in excess of plan assets is as follows:
2006 2005 ----- ----- (IN MILLIONS) ------------- Accumulated benefit obligation $ 1 $ 1 Projected benefit obligation 1 1 Fair value of plan assets -- --
COMPONENTS OF NET PERIODIC PENSION COST The components of net defined benefit pension plan and postretirement benefit plan expense are as follows:
PENSION BENEFITS OTHER POSTRETIREMENT BENEFITS ------------------ ----------------------------- 2006 2005 2004 2006 2005 2004 ---- ---- ---- ---- ---- ---- (IN MILLIONS) -------------------------------------------------- Service cost $ 18 $ 17 $ 17 $ 1 $ 2 $ 2 Interest cost 29 29 28 5 5 5 Expected return on plan assets (38) (38) (35) -- -- -- Amortization of prior service cost (2) (2) (2) -- -- -- Recognized net actuarial (gains) losses 4 2 1 1 -- (1) Recognized actuarial (gain) loss due to special termination benefits 2 -- -- -- -- -- ---- ---- ---- --- --- --- Net periodic benefit expense $ 13 $ 8 $ 9 $ 7 $ 7 $ 6 ==== ==== ==== === === ===
We maintain a defined contribution plan for our insurance agents. Contributions to this plan are based on a percentage of the agents' annual compensation as defined in the plan. Effective January 1, 1998, we assumed the liabilities for a non-contributory defined contribution plan covering certain highly compensated former CIGNA agents and employees. Contributions for this plan are made annually based upon varying percentages of annual eligible earnings as defined in the plan. Contributions to this plan are in lieu of any contributions to the qualified agent defined contribution plan. Effective January 1, 2000, this plan was expanded to include certain of our highly compensated agents. The combined pre-tax expenses for these plans amounted to $3 million in 2006, 2005 and 2004, respectively. These expenses reflect both our contribution as well as changes in the measurement of our liabilities under these plans. PLAN ASSETS Defined benefit pension plan asset allocations for the Company's agent plan at December 31, 2006 and 2005, by asset category are as follows:
2006 2005 ---- ---- ASSET CATEGORY Equity securities 60% 64% Fixed income securities 40% 34% Real estate 0% 1% Cash and cash equivalents 0% 1% --- --- Total 100% 100% === ===
S-25 7. RETIREMENT BENEFIT PLANS (CONTINUED) The primary investment objective of the defined benefit pension plan is for capital appreciation and income growth, with an emphasis on avoiding undue risk. A secondary objective is for current income. Investments can be made using the following asset classes: both domestic and international equity and fixed income securities, real estate, guaranteed products, venture capital, oil and gas and other asset classes the investment managers deem prudent. A five-year time horizon is utilized, as there are inevitably short-run fluctuations, which will cause variations in investment performance. Each managed fund is expected to rank in the upper 50% of similar funds over the three and/or five year periods. Managers not meeting criteria will be subject to additional due diligence review and possible termination. The following short-term ranges have been established for weightings in the various asset categories:
WEIGHTING RANGE --------------- ASSET CATEGORY Cash 0-20% Guaranteed Products 0-20% Fixed Income 20-80% Long-term 0-10% High-Yield 0-10% International/Emerging Markets* 0-10% Real Estate 0-20% Equities 20-80% Small-cap 0-20% International* 0-20% Emerging Markets* 0-10% Other 0-20% Total International** 0-25%
---------- The total of domestic cash, domestic fixed income, and domestic equities shall not be less than 50%. * Currency exposure can be hedged up to 100% ** International/Emerging Markets-Fixed Income and Equities Within the broad ranges provided above, current target asset weightings are as follows: 64% equities, 35% fixed income, including real estate, and 1% cash. The performance of the plan and the managed funds are monitored on a quarterly basis relative to the plan's objectives. The performance of the managed fund is measured against the following indices: S&P 500, EAFE, Russell 2000, NAREIT, Lehman US Universal and Salomon (Citigroup) 90-day T-Bill. The investment policy is reviewed on an annual basis. The plan assets are principally managed by LNC's Investment Management segment. PLAN CASH FLOWS The Company does not expect to make a contribution to the defined benefit pension plans in 2007. The Company expects to fund approximately the following amounts for benefit payments for unfunded non-qualified defined benefit plans and postretirement benefit plans:
PENSION PLANS POSTRETIREMENT PLANS --------------- ---------------------------------------------- NON-QUALIFIED REFLECTING NOT REFLECTING DEFINED BENEFIT MEDICARE PART MEDICARE PART MEDICARE PART PENSION PLANS D SUBSIDY D SUBSIDY D SUBSIDY --------------- ------------- ------------- -------------- (IN MILLIONS) ---------------------------------------------------------------- Year 2007 $ 3 $ 5 $(1) $ 6 2008 3 5 (1) 6 2009 3 5 (1) 6 2010 4 5 (1) 6 2011 4 5 (1) 6 Thereafter 25 28 (4) 32
S-26 7. RETIREMENT BENEFIT PLANS (CONTINUED) 401(k). LNC sponsors a contributory defined contribution plan for eligible U.S. employees (including those of LNL) and LNL sponsors a contributory defined contribution plan for eligible insurance agents (401(k) plans). Our contributions to the 401(k) plans for our employees and agents are equal to a participant's pre-tax contribution, not to exceed 6% of base pay, multiplied by a percentage, ranging from 50% to 150%, which varies according to certain incentive criteria as determined by LNC's Board of Directors. Our expense for the 401(k) plan amounted to $22 million, $25 million, and $25 million in 2006, 2005 and 2004, respectively. DEFERRED COMPENSATION PLANS. LNC sponsors contributory deferred compensation plans for certain U.S. employees and agents including those of LNL who meet the established plan criteria. Plan participants may elect to defer payment of a portion of their compensation, as defined by the plans. At this point, these plans are not funded. Plan participants may select from a variety of alternative measures for purposes of calculating the investment return considered attributable to their deferral. Under the terms of these plans, we agree to pay out amounts based upon the alternative measure selected by the participant. Plan participants who are also participants in a LNC 401(k) plan and who have reached the contribution limit for that plan may also elect to defer the additional amounts into the deferred compensation plan. We make matching contributions to these plans for its participants based upon amounts placed into the deferred compensation plans by individuals who have reached the contribution limit under the 401(k) plan. The amount of our contribution is calculated in a manner similar to the employer match calculation described in the 401(k) plans section above. Expense for these plans amounted to $17 million, $11 million, and $7 million in 2006, 2005 and 2004, respectively. These expenses reflect both our employer matching contributions of $4 million, $3 million and $2 million, as well as changes in the measurement of our liabilities net of LNC's total return swap under these plans of $13 million, $8 million and $5 million for 2006, 2005 and 2004, respectively. Our total liabilities associated with these plans were $158 million and $138 million at December 31, 2006 and 2005, respectively. 8. STOCK-BASED COMPENSATION The Company's employees are included in LNC's various incentive plans that provide for the issuance of stock options, stock incentive awards, stock appreciation rights ("SARs"), restricted stock awards, restricted stock units ("performance shares"), and deferred stock units. LNC has a policy of issuing new shares to satisfy option exercises. LNC issues share-based compensation awards under an authorized plan, subject to specific vesting conditions. Generally, compensation expense is recognized ratably over a three-year vesting period, but recognition may be accelerated upon the occurrence of certain events. For awards that specify an employee will vest upon retirement and an employee is eligible to retire before the end of the normal vesting period, the Company would record compensation expense over the period from the grant date to the date of retirement eligibility. On January 1, 2006, the Company adopted SFAS 123-R under the modified prospective method. Accordingly, prior period amounts have not been restated. Under the modified prospective method, the fair value of all employee stock options vesting on or after the adoption date is generally included in the determination of net income as the options vest. The fair value of stock options granted has been estimated using the Black-Scholes option valuation model considering assumptions for dividend yield, expected volatility, risk-free interest rate and expected life of the option. The fair value of the option grants is amortized on a straight-line basis over the implicit service period of the employee, considering retirement eligibility. For those employees that will achieve retirement eligibility during the vesting period, the expense is recognized evenly up through the retirement eligibility date or immediately upon grant for participants already eligible for retirement. Total pre-tax compensation expense (income) for stock-based awards to employees of the company is as follows:
2006 2005 2004 ---- ---- ---- (IN MILLIONS) ------------------ Stock options $ 2 $-- $ 1 Shares 17 13 11 Cash awards 1 1 1 SARs (1) 2 4 Restricted stock 1 1 1 --- --- --- Total $20 $17 $18 === === === Recognized tax benefit $ 7 $ 6 $ 6
The compensation cost is included in the underwriting, acquisition, insurance, and other expenses line item on the Company's Consolidated Statements of Income. 9. RESTRICTIONS, COMMITMENTS AND CONTINGENCIES STATUTORY INFORMATION AND RESTRICTIONS Net income as determined in accordance with statutory accounting practices for us was $229 million, $544 million and $310 million for 2006, 2005 and 2004, respectively. Statutory surplus as determined in accordance with statutory accounting practices for us was $3.0 billion and $3.2 billion for December 31, 2006 and 2005, respectively. S-27 9. RESTRICTIONS, COMMITMENTS AND CONTINGENCIES (CONTINUED) The state of Indiana has adopted certain prescribed accounting practices that differ from those found in NAIC statutory accounting practices and affect our reported statutory surplus. We utilize the Indiana universal life method to calculate reserves for universal life policies, which increased statutory surplus by $227 million and $210 million at December 31, 2006 and 2005, respectively. We also use a permitted valuation interest rate on certain annuities, which decreased statutory surplus by $14 million and $15 million at December 31, 2006 and 2005, respectively. We are subject to certain insurance department regulatory restrictions as to the transfer of funds and payment of dividends to the holding company. Under Indiana laws and regulations, we may pay dividends to LNC only from unassigned surplus, without prior approval of the Indiana Insurance Commissioner (the "Commissioner"), or must receive prior approval of the Commissioner to pay a dividend if such dividend, along with all other dividends paid within the preceding twelve consecutive months, would exceed the statutory limitation. The current statutory limitation is the greater of (i) 10% of the insurer's policyholders' surplus, as shown on its last annual statement on file with the Commissioner or (ii) the insurer's statutory net gain from operations for the previous twelve months, but in no event to exceed statutory unassigned surplus. Indiana law gives Commissioner broad discretion to disapprove requests for dividends in excess of these limits. We paid dividends of $350 million, $200 million and $150 million to LNC during 2006, 2005 and 2004, respectively, which did not require prior approval of the Commissioner. Based upon anticipated on-going positive statutory earnings and favorable credit markets, we expect that we could pay dividends of $301 million in 2007 without prior approval from the Commissioner. LNL is recognized as an accredited reinsurer in the state of New York, which effectively enables it to conduct reinsurance business with unrelated insurance companies that are domiciled within the state of New York. As a result, in addition to regulatory restrictions imposed by the state of Indiana, LNL is also subject to the regulatory requirements that the state of New York imposes upon authorized insurers. These include reserve requirements, which differ from Indiana's requirements. The New York regulations require us to report more reserves to the state of New York. As a result, the level of statutory surplus that we report to New York is less than the statutory surplus reported to Indiana and the National Association of Insurance Commissioners. If New York requires us to maintain a higher level of capital to remain an accredited reinsurer in New York, our ability to pay dividends could be constrained. However, we do not expect that our ability to pay dividends during 2007 will be constrained as a result of our status in New York. REINSURANCE CONTINGENCIES Our amounts recoverable from reinsurers represent receivables from and reserves ceded to reinsurers. We obtain reinsurance from a diverse group of reinsurers and monitor concentration as well as financial strength ratings of our principal reinsurers. Swiss Re Life & Health America, Inc. ("Swiss Re") represents our largest reinsurance exposure. In 2001, Swiss Re acquired our reinsurance operation and personal accident business through indemnity reinsurance transactions. We recorded the gain related to the indemnity reinsurance transactions on the business sold to Swiss Re as deferred gain in the liability section of our Consolidated Balance Sheets in accordance with the requirements of SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts" ("SFAS 113"). The deferred gain is being amortized into income at the rate that earnings on the reinsured business are expected to emerge, over a period of 15 years. During 2006 and 2005 we amortized $49 million after-tax ($76 million pre-tax) per year and in 2004 we amortized $57 million after-tax ($87 million pre-tax) of deferred gain on the sale of the reinsurance operation. In the third quarter of 2004, we adjusted the deferred gain up by $77 million. As a result, the amortization of the deferred gain in 2004 included an adjustment upward of $9 million after-tax. Because of ongoing uncertainty related to personal accident business, the reserves related to these exited business lines carried on our balance sheet at December 31, 2006 may ultimately prove to be either excessive or deficient. For instance, in the event that future developments indicate that these reserves should be increased, under SFAS 113 we would record a current period non-cash charge to record the increase in reserves. Because Swiss Re is responsible for paying the underlying claims to the ceding companies, we would record a corresponding increase in reinsurance recoverable from Swiss Re. However, SFAS 113 does not permit us to take the full benefit in earnings for the recording of the increase in the reinsurance recoverable in the period of the change. Rather, we would increase the deferred gain recognized upon the closing of the indemnity reinsurance transaction with Swiss Re and would report a cumulative amortization "catch-up" adjustment to the deferred gain balance as increased earnings recognized in the period of change. Any amount of additional increase to the deferred gain above the cumulative amortization "catch-up" adjustment must continue to be deferred and will be amortized into income in future periods over the remaining period of expected run-off of the underlying business. We would transfer no cash to Swiss Re as a result of these developments. Accordingly, even though we have no continuing underwriting risk, and no cash would be transferred to Swiss Re, in the event that future developments indicate our December 31, 2006 personal accident reserves are deficient or redundant, SFAS 113 requires us to adjust earnings in the period of change, with only a partial offset to earnings for the cumulative deferred gain amortization adjustment in the period of change. The remaining amount of increased gain would be amortized into earnings over the remaining run-off period of the underlying business. Because we are not relieved of our liability to the ceding companies for this business, the liabilities and obligations associated S-28 9. RESTRICTIONS, COMMITMENTS AND CONTINGENCIES (CONTINUED) with the reinsured contracts remain on our Consolidated Balance Sheets with a corresponding reinsurance receivable from the business sold to Swiss Re, which totaled $3.8 billion at December 31, 2006, and is included in amounts recoverable from reinsurers. Swiss Re has funded a trust, with a balance of $1.9 billion at December 31, 2006, to support this business. In addition to various remedies that we would have in the event of a default by Swiss Re, we continue to hold assets in support of certain of the transferred reserves. These assets consist of those reported as trading securities and certain mortgage loans. Our liabilities for funds withheld and embedded derivative liabilities at December 31, 2006 included $1.8 billion and $0.2 billion, respectively, related to the business reinsured by Swiss Re. MARKETING AND COMPLIANCE ISSUES There continues to be a significant amount of federal and state regulatory activity in the industry relating to numerous issues including, but not limited to, market timing and late trading of mutual fund and variable insurance products and broker-dealer access arrangements. Like others in the industry, we have received inquiries including requests for information and/or subpoenas from various authorities including the SEC, National Association of Securities Dealers ("NASD"), and the New York Attorney General. We are in the process of responding to, and in some cases have settled or are in the process of settling, certain of these inquiries. We continue to cooperate fully with such authorities. Regulators also continue to focus on replacement and exchange issues. Under certain circumstances companies have been held responsible for replacing existing policies with policies that were less advantageous to the policyholder. Our management continues to monitor compliance procedures to minimize any potential liability. Due to the uncertainty surrounding all of these matters, it is not possible to provide a meaningful estimate of the range of potential outcomes; however it is management's opinion that future developments will not materially affect our consolidated financial position. LEASES We lease our Fort Wayne, Indiana home office properties through sale-leaseback agreements. The agreements provide for a 25-year lease period with options to renew for six additional terms of five years each. The agreements also provide us with the right of the first refusal to purchase the properties during the terms of the lease, including renewal periods, at a price defined in the agreements. We also have the option to purchase the leased properties at fair market value as defined in the agreements on the last day of the initial 25-year lease period ending in 2009 or the last day of any of the renewal periods. In 2006, we exercised the right and option to extend the lease for two extended terms such that the lease shall expire in 2019. We retain our right and option to exercise the remaining options for extended terms of five years each in accordance with the lease agreement. Total rental expense on operating leases in 2006, 2005 and 2004 was $47 million, $55 million and $55 million, respectively. Future minimum rental commitments are as follows (in millions): 2007-$45 2008-$40 2009-$28 2010-$17 2011-$13 Thereafter-$40 INFORMATION TECHNOLOGY COMMITMENT In February 1998, we signed a seven-year contract with IBM Global Services for information technology services for the Fort Wayne operations. In February 2004, we renegotiated and extended the contract through February 2010. Annual costs are dependent on usage but are expected to range from $45 million to $50 million. INSURANCE CEDED AND ASSUMED Our insurance companies cede insurance to other companies. The portion of risks exceeding each company's retention limit is reinsured with other insurers. We seek reinsurance coverage within the businesses that sell life insurance to limit its liabilities. We reinsure approximately 85% to 90% of the mortality risk on newly issued non-term life insurance contracts and approximately 45% to 50% of total mortality risk including term insurance contracts. Our policy is to retain no more than $5 million on a single insured life issued on fixed and variable universal life insurance contracts. Additionally, the retention per single insured life for term life insurance and for Corporate Owned Life Insurance (COLI) is $1 million and $2 million, respectively. Beginning in September 2005, we changed our reinsurance program for our primary term products from coinsurance to renewable term and from 90% to 80% on a first dollar quota share basis. In January 2006, we changed this program from 80% first dollar quota share to an excess of retention program. Portions of our deferred annuity business have been reinsured on a Modco basis with other companies to limit our exposure to interest rate risks. At December 31, 2006, the reserves associated with these reinsurance arrangements totaled $1.8 billion. To cover products other than life insurance, we acquire other insurance coverages with retentions and limits that management believes are appropriate for the circumstances. The accompanying financial statements reflect premiums, benefits and deferred acquisition costs, net of insurance ceded (see Note 5). Our insurance companies remain liable if their reinsurers are unable to meet contractual obligations under applicable reinsurance agreements. See "Reinsurance Contingencies" above for a discussion of our reinsurance business sold to Swiss Re. VULNERABILITY FROM CONCENTRATIONS At December 31, 2006, we did not have a material concentration of financial instruments in a single investee or industry. Our investments in mortgage loans principally involve commercial real estate. At December 31, 2006, 34% of such mortgages, or $1.2 billion, involved properties located in California, S-29 9. RESTRICTIONS, COMMITMENTS AND CONTINGENCIES (CONTINUED) Pennsylvania and Texas. Such investments consist of first mortgage liens on completed income-producing properties and the mortgage outstanding on any individual property does not exceed $28 million. Also at December 31, 2006, we did not have a concentration of: 1) business transactions with a particular customer or lender; 2) sources of supply of labor or services used in the business or; 3) a market or geographic area in which business is conducted that makes it vulnerable to an event that is at least reasonably possible to occur in the near term and which could cause a severe impact to our financial position. Although we do not have any significant concentration of customers, our American Legacy Variable Annuity product offered in our Individual Markets Annuities segment is significant to this segment. The American Legacy Variable Annuity product accounted for 49%, 48% and 45% of Individual Markets Annuities deposits in 2006, 2005 and 2004, respectively and represented approximately 67% of our total Individual Markets Annuities variable annuity product account values at December 31, 2006, 2005 and 2004. In addition, fund choices for certain of our other variable annuity products offered in our Individual Markets Individual Annuity segment include American Fund Insurance Seriessm ("AFIS") funds. For the Individual Markets Individual Annuity segment, AFIS funds accounted for 60%, 57% and 56% of variable annuity product deposits in 2006, 2005 and 2004 respectively and represented 57%, 52% and 51% of the segment's total variable annuity product account values at December 31, 2006, 2005 and 2004, respectively. OTHER CONTINGENCY MATTERS We are involved in various pending or threatened legal proceedings, including purported class actions, arising from the conduct of business. In some instances, these proceedings include claims for unspecified or substantial punitive damages and similar types of relief in addition to amounts for alleged contractual liability or requests for equitable relief. After consultation with legal counsel and a review of available facts, it is management's opinion that these proceedings ultimately will be resolved without materially affecting our consolidated financial position. We have pursued claims with our liability insurance carriers for reimbursement of certain costs incurred in connection with a class action settlement involving the sale of our non-variable universal life and participating whole life policies issued between January 1, 1981 and December 31, 1998, and the settlement of claims and litigation brought by owners that opted out of the class action settlement. During the fourth quarter of 2002, we settled our claims against three liability carriers on a favorable basis, and settled our claims against a fourth liability insurance carrier on a favorable basis in 2004. State guaranty funds assess insurance companies to cover losses to policyholders of insolvent or rehabilitated companies. Mandatory assessments may be partially recovered through a reduction in future premium taxes in some states. We have accrued for expected assessments net of estimated future premium tax deductions. GUARANTEES We have guarantees with off-balance-sheet risks having contractual values of $3 million and $4 million at December 31, 2006 and 2005, respectively, whose contractual amounts represent credit exposure. Certain of our subsidiaries have sold commercial mortgage loans through grantor trusts, which issued pass-through certificates. These subsidiaries have agreed to repurchase any mortgage loans which remain delinquent for 90 days at a repurchase price substantially equal to the outstanding principal balance plus accrued interest thereon to the date of repurchase. In case of default on the mortgage loans, we have recourse to underlying real estate. It is management's opinion that the value of the properties underlying these commitments is sufficient that in the event of default, the impact would not be material to us. These guarantees expire in 2009. 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 risk, equity risk, and credit risk. We assess these risks by continually identifying and monitoring changes in interest rate exposure, foreign currency exposure, equity market exposure, and credit exposure that may adversely impact expected future cash flows and by evaluating hedging opportunities. Derivative instruments that are currently used as part of our interest rate risk management strategy include interest rate swaps and interest rate caps. Derivative instruments that are used as part of our foreign currency risk management strategy include foreign currency swaps. Call options on LNC stock are used as part of our equity market risk management strategy. We also use credit default swaps as part of our credit risk management strategy. By using derivative instruments, we are exposed to credit risk (our counterparty fails to make payment) and market risk (the value of the instrument falls and we are required to make a payment). When the fair value of a derivative contract is positive, this generally indicates that the counterparty owes us and, therefore, creates a credit risk for us equal to the extent of the fair value gain in the derivative. When the fair value of a derivative contract is negative, this generally indicates we owe the counterparty and therefore we have no credit risk, but have been affected by market risk. We minimize the credit risk in derivative instruments by entering into transactions with high quality counterparties with minimum credit ratings that are reviewed regularly by us, by limiting the amount of credit exposure to any one counterparty, and by requiring certain counterparties to post collateral if our credit risk exceeds certain limits. We also maintain a policy of requiring all derivative contracts to be governed by an International Swaps and Derivatives Association ("ISDA") Master Agreement. We do not believe that the credit or market risks associated with derivative instruments are material to any insurance subsidiary or the Company. S-30 9. RESTRICTIONS, COMMITMENTS AND CONTINGENCIES (CONTINUED) We are required to maintain minimum ratings as a matter of routine practice in negotiating ISDA agreements. Under some ISDA agreements, we have agreed to maintain certain financial strength or claims-paying ratings of S&P BBB and Moody's Baa2. A downgrade below these levels would result in termination of the derivatives contract at which time any amounts payable by us would be dependent on the market value of the underlying derivative contract. In certain transactions, we and the counterparty have entered into a collateral support agreement requiring us to post collateral upon significant downgrade. We are required to maintain long-term senior debt ratings above S&P BBB and Moody's Baa3. We also require for our own protection minimum rating standards for counterparty credit protection. We are required to maintain financial strength or claims-paying ratings of S&P A- and Moody's A3 under certain ISDA agreements, which collectively do not represent material notional exposure. We do not believe the inclusion of termination or collateralization events pose any material threat to our liquidity position. Market risk is the adverse effect that a change in interest rates, currency rates, implied volatility rates, or a change in certain equity indexes or instruments has on the value of a financial instrument. We manage the market risk by establishing and monitoring limits as to the types and degree of risk that may be undertaken. Our derivative instruments are monitored by our risk management committee as part of that committee's oversight of our derivative activities. Our derivative instruments committee is responsible for implementing various hedging strategies that are developed through its analysis of financial simulation models and other internal and industry sources. The resulting hedging strategies are then incorporated into our overall risk management strategies. We have derivative instruments with off-balance-sheet risks whose notional or contract amounts exceed the credit exposure. Outstanding derivative instruments with off-balance-sheet risks, shown in notional or contract amounts along with their carrying value and estimated fair values, are as follows:
ASSETS (LIABILITIES) NOTIONAL OR CONTRACT AMOUNTS CARRYING VALUE/FAIR VALUE ---------------------------- ------------------------- 2006 2005 2006 2005 ------ ------ ----- ----- (IN MILLIONS) -------------------------------------------------------- Interest rate derivative instruments: Interest rate cap agreements $5,950 $5,450 $ 3 $ 5 Interest rate swap agreements 563 463 4 9 ------ ------ ----- ----- Total interest rate derivative instruments 6,513 5,913 7 14 ====== ====== ===== ===== Foreign currency derivative instruments: Foreign currency swaps 86 58 (7) (5) Credit derivative instruments: Credit default swaps 20 20 -- -- Equity indexed derivative instruments: Call options (based on LNC stock) 1 1 22 16 Embedded derivatives per SFAS 133 -- -- (139) (268) ------ ------ ----- ----- Total derivative instruments * $6,620 $5,992 $(117) $(243) ====== ====== ===== =====
---------- * Total derivative instruments for 2006 are composed of an asset of $49 million recorded in derivative investments, a $52 million contra-liability recorded in insurance policy and claim reserves and a liability of $218 million recorded in reinsurance related derivative liability. Total derivative instruments for 2005 are composed of an asset of $41 million in derivative investments, a $6 million liability in insurance policy and claim reserves and a liability of $278 million recorded in reinsurance related derivative liability. A reconciliation of the notional or contract amounts for the significant programs using derivative agreements and contracts is as follows:
INTEREST RATE INTEREST RATE FOREIGN CURRENCY CAP AGREEMENTS SWAP AGREEMENTS SWAP AGREEMENTS --------------- --------------- --------------- 2006 2005 2006 2005 2006 2005 ------ ------ ----- ---- ---- ---- (IN MILLIONS) --------------------------------------------------- Balance at beginning-of-year $5,450 $4,000 $ 463 $446 $58 $ 42 New contracts 750 1,450 130 37 30 30 Terminations and maturities (250) -- (30) (20) (2) (14) ------ ------ ----- ---- --- ---- Balance at end-of-year $5,950 $5,450 $ 563 $463 $86 $ 58 ====== ====== ===== ==== === ====
S-31 9. RESTRICTIONS, COMMITMENTS AND CONTINGENCIES (CONTINUED)
CREDIT DEFAULT CALL OPTIONS SWAPS (BASED ON LNC STOCK) -------------- -------------------- (IN MILLIONS) ------------------------------------- 2006 2005 2006 2005 ---- ---- ---- ---- Balance at beginning-of-year $ 20 $ 13 $ 1 $ 1 New contracts 10 20 -- -- Terminations and maturities (10) $(13) -- -- --- ---- --- --- Balance at end-of-year $ 20 $ 20 $ 1 $ 1 ==== ==== === ===
ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES As of December 31, 2006 and 2005, we had derivative instruments that were designated and qualified as cash flow hedges and derivative instruments that were not designated as hedging instruments. We did not have derivative instruments that were designated as fair value hedges or hedges of a net investment in a foreign operation. See Note 1 for a detailed discussion of the accounting treatment for derivative instruments. For the years ended December 31, 2006, 2005 and 2004, we recognized after tax after-DAC net losses of $1 million, $0 and $7 million, respectively, in net income as a component of realized investment gains and losses. These losses relate to the ineffective portion of cash flow hedges, the change in market value for derivative instruments not designated as hedging instruments, and the gain (loss) on swap terminations. For the years ended December 31, 2006, 2005 and 2004, we recognized after-tax after-DAC losses of $16 million, $7 million and $10 million, respectively, in OCI related to the change in market value on derivative instruments that are designated and qualify as cash flow hedges. DERIVATIVE INSTRUMENTS DESIGNATED IN CASH FLOW HEDGES INTEREST RATE SWAP AGREEMENTS. We use interest rate swap agreements to hedge our exposure to floating rate bond coupon payments, replicating a fixed rate bond. An interest rate swap is a contractual agreement to exchange payments at one or more times based on the actual or expected price level, performance or value of one or more underlying interest rates. We are required to pay the counterparty the stream of variable interest payments based on the coupon payments from the hedged bonds, and in turn, receives a fixed payment from the counterparty, at a predetermined interest rate. The net receipts/payments from these interest rate swaps are recorded in net investment income. Gains (losses) on interest rate swaps hedging interest rate exposure on floating rate bond coupon payments are reclassified from accumulated OCI to net income as bond interest is accrued. We also use interest rate swap agreements to hedge our exposure to interest rate fluctuations related to the forecasted purchase of assets for certain investment portfolios. The gains (losses) resulting from the swap agreements are recorded in OCI. The gains (losses) are reclassified from accumulated OCI to earnings over the life of the assets once the assets are purchased. As of December 31, 2006, there were no interest rate swaps hedging forecasted asset purchases. FOREIGN CURRENCY SWAPS. We use foreign currency swaps, which are traded over-the-counter, to hedge some of the foreign exchange risk of investments in fixed maturity securities denominated in foreign currencies. A foreign currency swap is a contractual agreement to exchange the currencies of two different countries at a specified rate of exchange in the future. Gains (losses) on foreign currency swaps hedging foreign exchange risk exposure on foreign currency bond coupon payments are reclassified from accumulated OCI to net income as bond interest is accrued. The foreign currency swaps expire in 2014 through 2016. CALL OPTIONS ON LNC STOCK. We use call options on LNC stock to hedge the expected increase in liabilities arising from stock appreciation rights ("SARs") granted to our agents on LNC stock. Upon option expiration, the payment, if any, is the increase in LNC's stock price over the strike price of the option applied to the number of contracts. Call options hedging vested SARs are not eligible for hedge accounting and both are marked to market through net income. Call options hedging nonvested SARs are eligible for hedge accounting and are accounted for as cash flow hedges of the forecasted vesting of SAR liabilities. To the extent that the cash flow hedges are effective, changes in the fair value of the call options are recorded in accumulated OCI. Amounts recorded in OCI are reclassified to net income upon vesting of SARs. Our call option positions will be maintained until such time the SARs are either exercised or expire and our SAR liabilities are extinguished. The SARs expire five years from the date of grant. ALL OTHER DERIVATIVE INSTRUMENTS We use various other derivative instruments for risk management and income generation purposes that either do not qualify for hedge accounting treatment or have not currently been qualified by us for hedge accounting treatment. The gain or loss related to the change in market value for these derivative instruments is recognized in net income during the period of change (reported as realized gain (loss) on investments in the Consolidated Statements of Income except where otherwise noted below). FORWARD STARTING INTEREST RATE SWAP AGREEMENTS. We used a forward starting interest rate swap agreement to hedge our exposure to the forecasted sale of mortgage loans. We were required to pay the counterparty a predetermined fixed stream of payments, and in return, received payments based on a floating rate from the counterparty. The net receipts/payments from these interest rate swaps were recorded in realized gain (loss) on investments and derivative instruments. As of December 31, 2006, there were no forward starting interest rate swap agreements. S-32 9. RESTRICTIONS, COMMITMENTS AND CONTINGENCIES (CONTINUED) INTEREST RATE CAP AGREEMENTS. The interest rate cap agreements, which expire in 2007 through 2011, entitle us to receive quarterly payments from the counterparties on specified future reset dates, contingent on future interest rates. For each cap, the amount of such quarterly payments, if any, is determined by the excess of a market interest rate over a specified cap rate multiplied by the notional amount divided by four. The purpose of our interest rate cap agreement program is to provide a level of protection for our annuity line of business from the effect of rising interest rates. The interest rate cap agreements provide an economic hedge of the annuity line of business. However, the interest rate cap agreements are not linked to assets and liabilities on the balance sheet that meet the significantly increased level of specificity required under SFAS 133. Therefore, the interest rate cap agreements do not qualify for hedge accounting under SFAS 133. SWAPTIONS. Swaptions entitled us to receive settlement payments from the counterparties on specified expiration dates, contingent on future interest rates. For each swaption, the amount of such settlement payments, if any, is determined by the present value of the difference between the fixed rate on a market rate swap and the strike rate multiplied by the notional amount. The purpose of our swaption program was to provide a level of protection for its annuity line of business from the effect of rising interest rates. The swaptions provided an economic hedge of the annuity line of business. However, the swaptions were not linked to specific assets and liabilities on the balance sheet that met the significantly increased level of specificity required under SFAS 133. Therefore, the swaptions did not qualify for hedge accounting under SFAS 133. At December 31, 2006, there were no outstanding swaptions. CREDIT DEFAULT SWAPS. We buy credit default swaps to hedge against a drop in bond prices due to credit concerns of certain bond issuers. A credit swap allows us to put the bond back to the counterparty at par upon a credit event by the bond issuer. A credit event is defined as bankruptcy, failure to pay, or obligation acceleration. We have no currently qualified credit default swaps for hedge accounting under SFAS 133, as amounts are insignificant. As of December 31, 2006, we had no outstanding purchased credit default swaps. We also sell credit default swaps to offer credit protection to investors. The credit default swaps hedge the investor against a drop in bond prices due to credit concerns of certain bond issuers. A credit swap allows the investor to put the bond back to us at par upon a credit event by the bond issuer. A credit event is defined as bankruptcy, failure to pay, or restructuring. As of December 31, 2006, we had credit swaps with a notional amount of $20 million, which expire in 2010. CALL OPTIONS ON LNC STOCK. As discussed previously in the Cash Flow Hedges section above, we use call options on LNC stock to hedge the expected increase in liabilities arising from SARs granted to our agents on LNC stock. Call options hedging vested SARs are not eligible for hedge accounting treatment under SFAS 133. Mark to market changes are recorded in net income in underwriting, acquisition, insurance and other expenses. DERIVATIVE INSTRUMENT EMBEDDED IN DEFERRED COMPENSATION PLAN. We have certain deferred compensation plans that have embedded derivative instruments. The liability related to these plans varies based on the investment options selected by the participants. The liability related to certain investment options selected by the participants is marked to market through net income in underwriting, acquisition, insurance and other expenses. DERIVATIVE INSTRUMENT EMBEDDED IN MODIFIED COINSURANCE AGREEMENTS WITH FUNDS WITHHELD ARRANGEMENTS. We are involved in various Modco and CFW reinsurance arrangements that have embedded derivatives. The change in fair value of the embedded derivative, as well as the gains or losses on trading securities supporting these arrangements, flows through net income. DERIVATIVE INSTRUMENT EMBEDDED IN VARIABLE ANNUITY PRODUCTS. We have certain variable annuity products with GMWB and GIB features that are embedded derivatives. The change in fair value of the embedded derivatives flows through net income through the benefits line in the Consolidated Statements of Income. DERIVATIVE INSTRUMENTS EMBEDDED IN AVAILABLE-FOR-SALE SECURITIES. We own various debt securities that (a) contain call options to exchange the debt security for other specified securities of the borrower, usually common stock, or (b) contain call options to receive the return on equity-like indexes. The change in fair value of the embedded derivatives flows through net income. These embedded derivatives have not been qualified for hedge accounting treatment under SFAS 133. We have used certain other derivative instruments in the past for hedging purposes. Although other derivative instruments may have been used in the past, derivative types that were not outstanding from January 1, 2005 through December 31, 2006 are not discussed in this disclosure. ADDITIONAL DERIVATIVE INFORMATION. Income other than realized gains and losses for the agreements and contracts described above amounted to $13 million, $14 million and $26 million in 2006, 2005 and 2004, respectively. The decrease in income from 2004 to 2005 was primarily because of decreased income on interest rate swaps. We are exposed to credit loss in the event of nonperformance by counterparties on various derivative contracts. However, we do not anticipate nonperformance by any of the counterparties. The credit risk associated with such agreements is minimized by purchasing such agreements from financial institutions with long-standing, superior performance records. 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. At December 31, 2006, the exposure was $24 million. S-33 10. FAIR VALUE OF FINANCIAL INSTRUMENTS The following discussion outlines the methodologies and assumptions used to determine the estimated fair value of our financial instruments. Considerable judgment is required to develop these fair values. 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. FIXED MATURITY AND EQUITY SECURITIES -- AVAILABLE-FOR-SALE AND TRADING SECURITIES. Fair values for fixed maturity securities are based on quoted market prices, where available. For fixed maturity securities not actively traded, fair values are estimated using values obtained from independent pricing services. In the case of private placements, fair values are estimated by discounting expected future cash flows using a current market rate applicable to the coupon rate, credit quality and maturity of the investments. The fair values for equity securities are based on quoted market prices. MORTGAGE LOANS ON REAL ESTATE. The estimated fair value of mortgage loans on real estate was 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, caliber of tenancy, borrower and payment record. Fair values for impaired mortgage loans are based on: 1) the present value of expected future cash flows discounted at the loan's effective interest rate; 2) the loan's market price or; 3) the fair value of the collateral if the loan is collateral dependent. POLICY LOANS. The estimated fair value of investments in policy loans was calculated on a composite discounted cash flow basis using Treasury interest rates consistent with the maturity durations assumed. These durations were based on historical experience. DERIVATIVE INSTRUMENTS. We employ several different methods for determining the fair value of our derivative instruments. Fair values for these contracts are based on current settlement values. These values are based on: 1) quoted market prices; 2) industry standard models that are commercially available; and 3) broker quotes. These techniques project cash flows of the derivatives using current and implied future market conditions. We calculate the present value of the cash flows to determine the derivatives' current fair market value. OTHER INVESTMENTS, AND CASH AND INVESTED CASH. The carrying value for assets classified as other investments, and cash and invested cash in the accompanying balance sheets approximates their fair value. Other investments include limited partnership investments which are accounted for using the equity method of accounting. INVESTMENT TYPE INSURANCE CONTRACTS. The balance sheet captions, "Insurance policy and claims reserves" and "Investment contract and policyholder funds," include investment type insurance contracts (i.e., deposit contracts and certain guaranteed interest contracts). The fair values for the deposit contracts and certain guaranteed interest contracts are based on their approximate surrender values. The fair values for the remaining guaranteed interest and similar contracts are estimated using discounted cash flow calculations. 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. The remainder of the balance sheet captions, "Insurance policy and claims reserves" and "Investment contract and policyholder funds" that do not fit the definition of "investment type insurance contracts" are considered insurance contracts. Fair value disclosures are not required for these insurance contracts, nor have we determined the fair value of such contracts. It is our position that not disclosing the fair value of these insurance contracts is important because readers of these financial statements could draw inappropriate conclusions about our shareholder's equity determined on a fair value basis. It could be misleading if only the fair value of assets and liabilities defined as financial instruments are disclosed. Along with other companies in the insurance industry, we are monitoring the related actions of the various rule-making bodies and attempting to determine an appropriate methodology for estimating and disclosing the "fair value" of their insurance contract liabilities. SHORT-TERM AND LONG-TERM DEBT. Fair values for long-term debt issues are estimated using discounted cash flow analysis based on our current incremental borrowing rate for similar types of borrowing arrangements. For short-term debt, the carrying value approximates fair value. GUARANTEES. Our guarantees relate to mortgage loan pass-through certificates. Based on historical performance where repurchases have been negligible and the current status of the debt, none of the loans are delinquent and the fair value liability for the guarantees related to mortgage loan pass-through certificates is insignificant. INVESTMENT COMMITMENTS. Fair values for commitments to make investments in fixed maturity securities (primarily private placements), mortgage loans on real estate and real estate are based on the difference between the value of the committed investments as of the date of the accompanying balance sheets and the commitment date. These estimates take into account changes in interest rates, the counterparties' credit standing and the remaining terms of the commitments. S-34 10. FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED) SEPARATE ACCOUNTS. We report assets held in separate accounts at fair value. The related liabilities are also reported at fair value in amounts equal to the separate account assets. The carrying values and estimated fair values of our financial instruments are as follows:
2006 2005 ------------------- -------------------- CARRYING FAIR CARRYING FAIR VALUE VALUE VALUE VALUE -------- -------- -------- --------- (IN MILLIONS) ------------------------------------------ Assets (liabilities): Securities available-for-sale Fixed maturities $ 31,840 $ 31,840 $ 32,245 $ 32,245 Equity 203 203 101 101 Trading securities 2,820 2,820 2,985 2,985 Mortgage loans on real estate 3,571 3,687 3,662 3,859 Policy loans 1,898 2,044 1,858 2,004 Derivatives Instruments * (117) (117) (243) (243) Other investments 657 657 423 423 Cash and invested cash 1,308 1,308 1,962 1,962 Investment type insurance contracts: Deposit contracts and certain guaranteed interest contracts (20,233) (20,235) (21,270) (21,273) Remaining guaranteed interest and similar contracts (12) (12) (13) (13) Short-term debt (21) (21) (34) (34) Long-term debt (1,390) (1,345) (1,250) (1,325) Guarantees -- -- -- -- Investment commitments -- (2) -- --
---------- * Total derivative instruments for 2006 are composed of an asset of $49 million recorded in derivative investments, a $52 million contra-liability recorded in insurance policy and claim reserves and a liability of $218 million recorded in reinsurance related derivative liability. Total derivative instruments for 2005 are composed of an asset of $41 million in derivative investments, a $6 million liability in insurance policy and claim reserves and a liability of $278 million recorded in reinsurance related derivative liability. As of December 31, 2006 and 2005, the carrying value of the deposit contracts and certain guaranteed contracts is net of DAC of $304 million and $383 million, respectively, excluding adjustments for DAC applicable to changes in fair value of securities. The carrying values of these contracts are stated net of DAC so that they are comparable with the fair value basis. 11. SEGMENT INFORMATION In the quarter ended June 30, 2006, LNC completed its merger with Jefferson-Pilot and changed its management organization. LNC also realigned its reporting segments, which included those of LNL to reflect the current manner by which its chief operating decision makers view and manage the business. All segment data for reporting periods have been adjusted to reflect the current segment reporting. As a result of these changes, we provide products and services in two operating businesses: (1) Individual Markets and (2) Employer Markets, and report results through three business segments. The following is a brief description of these segments. INDIVIDUAL MARKETS. The Individual Markets business provides its products through two segments, Individual Annuities and Individual Life Insurance. Various insurance and investment products are currently marketed to individuals and businesses in the United States. Through its Individual Annuities segment, Individual Markets provides tax-deferred investment growth and lifetime income opportunities for its clients by offering individual fixed annuities, including indexed annuities, and variable annuities. The Individual Life Insurance segment offers wealth protection and transfer opportunities through both single and survivorship versions of universal life, variable universal life, interest-sensitive whole life, term insurance, as well as a linked-benefit product, which is a universal life insurance policy linked with riders that provide for long-term care costs. EMPLOYER MARKETS. The Employer Markets business provides its products through the Retirement Products segment, which consists of its Defined Contribution business. Employer Markets provides employer-sponsored variable and fixed annuities, mutual-fund based programs in the 401(k), 403(b), and 457 marketplaces and corporate/bank owned life insurance. We also have Other Operations which includes the financial data for operations that are not directly related to the business segments, unallocated corporate items (such as investment income on investments related to the amount of statutory surplus in our insurance subsidiaries that is not allocated to our business units and other corporate investments, interest expense on short-term and long-term borrowings, and certain expenses, including restructuring and merger-related expenses) and the historical results of the former reinsurance segment, which was sold to Swiss Re in the fourth quarter of 2001, along with the ongoing amortization of deferred gain on the indemnity reinsurance portion of the transaction with Swiss Re. S-35 11. SEGMENT INFORMATION (CONTINUED) Financial data by segment for 2004 through 2006 is as follows:
2006 2005 2004 ------ ------ ------ (IN MILLIONS) ------------------------ REVENUE: Segment Operating Revenue: Individual Markets: Individual Annuities $1,428 $1,308 $1,278 Life Insurance 1,946 1,841 1,847 ------ ------ ------ Individual Markets Total 3,374 3,149 3,125 ------ ------ ------ Employer Markets: Retirement Products 1,212 1,168 1,125 ------ ------ ------ Employer Markets Total 1,212 1,168 1,125 ------ ------ ------ Other Operations 236 309 267 Net realized investment results(1) 2 (16) (45) Reserve development net of related amortization on business sold through reinsurance 1 1 1 ------ ------ ------ Total $4,825 $4,611 $4,473 ====== ====== ====== NET INCOME: Segment Operating Income: Individual Markets: Individual Annuities $ 265 $ 197 $ 169 Life Insurance 257 238 252 ------ ------ ------ Individual Markets Total 522 435 421 ------ ------ ------ Employer Markets: Retirement Products 226 206 181 ------ ------ ------ Employer Markets Total 226 206 181 ------ ------ ------ Other Operations (8) 12 9 Net realized investment results(2) 2 (10) (29) Reserve development net of related amortization on business sold through reinsurance 1 1 1 ------ ------ ------ Income before cumulative effect of accounting changes 743 644 583 Cumulative effect of accounting changes -- -- (26) ------ ------ ------ Net Income $ 743 $ 644 $ 557 ====== ====== ======
---------- (1) Includes realized losses on investments of $2 million, $20 million and $47 million for 2006, 2005 and 2004, respectively; realized gains (losses) on derivative instruments of less than $1 million, $(1) million and $(12) million for 2006, 2005 and 2004, respectively; gain (loss) on reinsurance embedded derivative/trading securities of $4 million, $5 million and $(1) million in 2006, 2005 and 2004, respectively; and gain on sale of subsidiaries/businesses of $14 million for 2004. (2) Includes realized losses on investments of less than $1 million, $13 million and $21 million for 2006, 2005 and 2004, respectively; realized gains (losses) on derivative instruments of $1 million, less than $(1) million and $(7) million for 2006, 2005 and 2004, respectively; gain (loss) on reinsurance embedded derivative/trading securities of $2 million, $3 million and $(1) million for 2006, 2005 and 2004, respectively.
2006 2005 -------- -------- (IN MILLIONS) ------------------- ASSETS: Individual Annuities $ 58,995 $ 48,250 Life Insurance 24,238 21,795 Retirement Products 34,218 33,478 Other Operations 6,685 6,649 Consolidating adjustments 1,932 3,882 -------- -------- Total $126,068 $114,054 ======== ========
S-36 12. SHAREHOLDER'S EQUITY All of the 10 million authorized, issues and outstanding shares of $2.50 par value common stock of LNL are owned by LNC. Details underlying the balance sheet caption "Net Unrealized Gain on Securities Available-for-Sale," are as follows:
2006 2005 ------- ------- (IN MILLIONS) ----------------- Fair value of securities available-for-sale $32,043 $32,346 Cost of securities available-for-sale 31,395 31,362 ------- ------- Unrealized gain 648 984 Adjustments to DAC and VOBA (175) (266) Amounts required to satisfy policyholder commitments (20) (31) Foreign currency exchange rate adjustment 28 16 Deferred income taxes (166) (251) ------- ------- Net unrealized gain on securities available-for-sale $ 315 $ 452 ======= =======
Adjustments to DAC and VOBA and amounts required to satisfy policyholder commitments are netted against the DAC and VOBA asset line and included within the insurance policy and claim reserve line on the Consolidated Balance Sheets, respectively. Details underlying the change in net unrealized gain (loss) on securities available-for-sale, net of reclassification adjustment shown on the Consolidated Statements of Shareholder's Equity are as follows:
2006 2005 2004 ----- ----- ---- (IN MILLIONS) -------------------- Unrealized gains (losses) on securities available-for-sale arising during the year $(157) $(479) $116 Less: Reclassification adjustment for gains on disposals of prior year inventory included in net income(1) 65 39 82 Less: Federal income tax expense (benefit) on reclassification (85) (189) 11 ----- ----- ---- Net unrealized gain (loss) on securities available-for-sale, net of reclassifications and federal income tax expense (benefit) $(137) $(329) $ 23 ===== ===== ====
(1) The reclassification adjustment for gains (losses) does not include the impact of associated adjustments to DAC and VOBA and amounts required to satisfy policyholder commitments. The net unrealized gain (loss) on derivative instruments component of other comprehensive income shown on the Consolidated Statements of Shareholder's Equity is net of Federal income tax expense (benefit) of $3 million, $5 million, $3 million for 2006, 2005, 2004 respectively, and net of adjustments to DAC and VOBA of less than $1 million, $(7) million, $(8) million for 2006, 2005, 2004 respectively. 13. RESTRUCTURING CHARGES The following provides details on our restructuring charges. All restructuring charges recorded by us are included in underwriting, acquisition, insurance and other expenses on the Consolidated Statements of IncomeConsolidated Statements of Income in the year incurred and are included in the Other Operations segment. 2006 RESTRUCTURING PLAN Upon completion of LNC's merger with Jefferson-Pilot, a restructuring plan was implemented relating to the integration of LNC's legacy operations with those of Jefferson-Pilot. The realignment will enhance productivity, efficiency and scalability while positioning LNC and its affiliates for future growth. The following details LNL's restructuring charges associated with this integration plan:
TOTAL ------------- (IN MILLIONS) ------------- Amounts incurred in 2006 Employee severance and termination benefits $12 Abandoned office space 1 --- Total 2006 restructuring charges 13 Amounts expended in 2006 Restructuring reserve at December 31, 2006 (6) --- $ 7 === Additional amounts expended that do not qualify as restructuring charges $14
Expected completion date 4th Quarter 2009 S-37 13. RESTRUCTURING CHARGES (CONTINUED) 2005 RESTRUCTURING PLAN During May 2005, LFA implemented a restructuring plan to realign its field management and financial planning support areas. Total pre-tax restructuring charges incurred during 2005 were $7 million. These charges, which are included in Other Operations, included employee severance and termination benefits of $4 million and rent on abandoned office space of $3 million. The remaining reserves totaled $1 million at December 31, 2006. The plan was completed by year end 2006, except for lease payments on vacated space which run through 2008. 2003 RESTRUCTURING PLANS In January 2003, we realigned the operations in Hartford, Connecticut and Schaumburg, Illinois to enhance productivity, efficiency and scalability while positioning us for future growth. In February 2003, we announced plans to consolidate our fixed annuity operations in Schaumburg, Illinois into Fort Wayne, Indiana. In June 2003, we announced that we were combining our retirement and life insurance businesses into a single operating unit focused on providing wealth accumulation and protection, income distribution and wealth transfer products. In August 2003, we announced additional realignment activities. The total pre-tax restructuring charges recorded in 2005 and 2004 were $23 million and $20 million, respectively. Pre-tax amounts reversed in restructuring charges in 2006 and 2004 were $1 million in each year. Additional pre-tax amounts expended that do not qualify as restructuring charges in 2005 and 2004 were $7 million and $15 million, respectively. These plans were completed in 2006. 14. TRANSACTIONS WITH AFFILIATES Cash and short-term investments at December 31, 2006 and 2005 include our participation in a cash management agreement with LNC of $389 million and $227 million, respectively. Related investment income was $14 million, $6 million and $3 million in 2006, 2005 and 2004, respectively. Short-term debt represents notes payable to LNC of $21 million and $34 million at December 31, 2006 and 2005, respectively. Total interest expense for this short-term debt was $1 million per year in 2006, 2005 and 2004. As shown in Note 5, LNC supplied funding to us totaling $1.390 billion in 2006 and $1.250 billion in 2005, in exchange for notes. The interest expense on these notes was $78 million per year in 2006, 2005 and 2004. A transfer pricing arrangement is in place between LFD and Delaware Management Holdings, Inc. ("DMH") related to the wholesaling of DMH's investment products. As a result, we received fees of $36 million, $41 million, and $32 million from DMH for transfer pricing in 2006, 2005, and 2004. We also received fees of $4 million in 2006, from the Jefferson-Pilot Companies, for distributing Variable Universal Life products. We paid fees of $57 million, $72 million and $79 million to DMH for investment management services in 2006, 2005 and 2004, respectively. We provide services to and receive services from affiliated companies plus we receive an allocation of corporate overhead from LNC. This allocation is based on a calculation that utilizes income and equity of the business units. These activities with affiliated companies resulted in net payments of $59 million, $122 million and $101 million in 2006, 2005 and 2004, respectively. We cede and accept reinsurance from affiliated companies. As discussed in Note 6, we cede certain Guaranteed Benefit risks (including certain GMDB and all GMWB benefits) to LNR Barbados. We also cede certain risks for certain UL policies, which resulted from recent actuarial reserving guidelines, to LNR Barbados. As of December 31, 2006, 2005 and 2004, all of these transactions are between us and LNR Barbados and us and Lincoln Assurance Limited, an affiliated life insurance company. Premiums in the accompanying Consolidated Statements of Income include premiums on insurance business accepted under reinsurance contracts and exclude premiums ceded to other affiliated companies, as follows:
2006 2005 2004 ----- ----- ----- (IN MILLIONS) --------------------- Insurance assumed $ 25 $ -- $ -- Insurance ceded (238) (219) (116) ----- ----- ----- Net reinsurance premiums and fees $(213) $(219) $(116) ===== ===== =====
The Consolidated Balance Sheets include reinsurance balances with affiliated companies as follows:
2006 2005 ---- ------ (IN MILLIONS) ------------- Future policy benefits and claims assumed $141 $ 3 Future policy benefits and claims ceded 951 1,052 Amounts recoverable from reinsurers on paid and unpaid losses 16 16 Reinsurance payable on paid losses 11 3 Funds held under reinsurance treaties-net liability 702 718
Substantially all reinsurance ceded to affiliated companies is with unauthorized companies. To take a reserve credit for such reinsurance, we hold assets from the reinsurer, including funds held under reinsurance treaties, and are the beneficiary on letters of credit aggregating $1,153 million and $751 million at December 31, 2006 and 2005, respectively. The letters of credit are issued by banks and represent guarantees of performance under the reinsurance agreement, and are guaranteed by LNC. S-38 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors The Lincoln National Life Insurance Company We have audited the accompanying consolidated balance sheets of The Lincoln National Life Insurance Company ("Company") as of December 31, 2006 and 2005, and the related consolidated statements of income, shareholder's equity and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company's internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of The Lincoln National Life Insurance Company at December 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. As discussed in Note 2 to the financial statements, in 2006 the Company changed its method of accounting for defined benefit pension and other postretirement plans. Also, as discussed in Note 2 to the financial statements, in 2004 the Corporation changed its method of accounting for certain non-traditional long-duration contracts and for separate accounts. /s/ Ernst & Young LLP Philadelphia, Pennsylvania March 19, 2007 S-39 AUDITED CONSOLIDATED FINANCIAL STATEMENTS Jefferson-Pilot Life Insurance Company and Subsidiary As of December 31, 2006 and 2005 and For the Periods April 3 Through December 31, 2006 and January 1 Through April 2, 2006 and For the Years Ended December 31, 2005 and 2004 [THIS PAGE INTENTIONALLY LEFT BLANK] JEFFERSON-PILOT LIFE INSURANCE COMPANY AND SUBSIDIARY AUDITED CONSOLIDATED FINANCIAL STATEMENTS AS OF DECEMBER 31, 2006 AND 2005 AND FOR THE PERIODS APRIL 3 THROUGH DECEMBER 31, 2006 AND JANUARY 1 THROUGH APRIL 2, 2006 AND FOR THE YEARS ENDED DECEMBER 31, 2005 AND 2004 CONTENTS Report of Independent Registered Public Accounting Firm F-1 Audited Consolidated Financial Statements Consolidated Balance Sheets as of December 31, 2006 and 2005 F-2 Consolidated Statements of Income for the periods April 3 through December 31, 2006 and January 1 through April 2, 2006 and the years ended December 31, 2005 and 2004 F-4 Consolidated Statements of Stockholder's Equity for the periods April 3 through December 31, 2006 and January 1 through April 2, 2006 and for the years ended December 31, 2005 and 2004 F-5 Consolidated Statements of Cash Flows for the periods April 3 through December 31, 2006 and January 1 through April 2, 2006 and for the years ended December 31, 2005 and 2004 F-6 Notes to Consolidated Financial Statements F-7 [THIS PAGE INTENTIONALLY LEFT BLANK] REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors Jefferson-Pilot Life Insurance Company and Subsidiary We have audited the consolidated balance sheets of Jefferson-Pilot Life Insurance Company and Subsidiary as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholder's equity, and cash flows for each of the periods April 3 through December 31, 2006 and January 1 through April 2, 2006 and for the years ended December 31, 2005 and 2004. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company's internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Jefferson-Pilot Life Insurance Company and Subsidiary at December 31, 2006 and 2005, and the consolidated results of their operations and their cash flows for each of the periods April 3 through December 31, 2006 and January 1 through April 2, 2006 and for the years ended December 31, 2005 and 2004 in conformity with U.S. generally accepted accounting principles. /s/ Ernst & Young LLP Greensboro, North Carolina March 19, 2007 F-1 JEFFERSON-PILOT LIFE INSURANCE COMPANY AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS (IN THOUSANDS)
DECEMBER 31, ------------------------- 2006 2005 ----------- ----------- ASSETS Investments: Debt securities available-for-sale, at fair value (amortized cost $13,115,270 and $11,163,632) $13,243,588 $11,340,518 Debt securities held-to-maturity, at amortized cost (fair value $0 and $1,378,716) -- 1,325,157 Equity securities available-for-sale, at fair value (cost $534 and $286) 549 427 Mortgage loans on real estate 2,376,014 2,417,618 Policy loans 279,686 258,362 Real estate 165,871 81,261 Other investments 341,981 242,024 ----------- ----------- Total investments 16,407,689 15,665,367 Cash and cash equivalents 359,425 41,392 Accrued investment income 210,965 195,845 Due from reinsurers 160,911 153,060 Deferred policy acquisition costs 306,873 1,671,492 Value of business acquired 1,363,401 -- Goodwill 1,358,027 -- Property and equipment, net of accumulated depreciation 118,022 79,585 Cash surrender value of life insurance 147,884 140,730 Assets held in separate accounts 510,411 491,697 Other assets 305,752 238,129 ----------- ----------- Total assets $21,249,360 $18,677,297 =========== ===========
See accompanying notes. F-2
DECEMBER 31, ------------------------- 2006 2005 ----------- ----------- LIABILITIES Policy liabilities: Future policy benefits $ 1,231,397 $ 1,244,257 Policyholder contract deposits 13,686,716 13,067,520 Policy and contract claims 41,981 46,425 Funding agreements 300,000 300,000 Other policy liabilities 560,144 773,986 ----------- ----------- Total policy liabilities 15,820,238 15,432,188 Deferred income tax liabilities 302,722 183,773 Currently payable (recoverable) income tax 193 (2,786) Securities sold under repurchase agreements -- 300,835 Accounts payable, accruals and other liabilities 915,218 237,604 Liabilities related to separate accounts 510,411 491,697 ----------- ----------- Total liabilities 17,548,782 16,643,311 Commitments and contingent liabilities (see Note 14) STOCKHOLDER'S EQUITY Common stock, par value $100 per share, 50,000 shares authorized, issued and outstanding 5,000 5,000 Paid in capital 3,428,755 31,570 Retained earnings 195,927 1,894,678 Accumulated other comprehensive income 70,896 102,738 ----------- ----------- Total stockholder's equity 3,700,578 2,033,986 ----------- ----------- Total liabilities and stockholder's equity $21,249,360 $18,677,297 =========== ===========
See accompanying notes. F-3 JEFFERSON-PILOT LIFE INSURANCE COMPANY AND SUBSIDIARY CONSOLIDATED STATEMENTS OF INCOME (IN THOUSANDS)
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, ----------------------- 2006 2006 2005 2004 ------------ ----------- ---------- ---------- REVENUE Premiums and other considerations $ 79,279 $ 25,426 $ 102,926 $ 105,084 Universal life and investment product charges 298,891 94,593 363,239 304,670 Net investment income 760,258 253,520 935,300 906,750 Realized investment losses (4,446) (4,046) (4,529) (12,218) ---------- -------- ---------- ---------- Total revenues 1,133,982 369,493 1,396,936 1,304,286 BENEFITS AND EXPENSES Insurance and annuity benefits 671,705 228,655 826,230 782,345 Insurance commissions, net of deferrals 8,139 1,844 9,230 15,422 General and administrative expenses, net of deferrals 24,845 16,705 17,597 27,519 Insurance taxes, licenses and fees 26,020 8,496 29,607 29,730 Amortization of policy acquisition costs and value of business acquired 110,901 38,620 162,403 130,022 Interest expense 28 1,121 3,173 1,413 ---------- -------- ---------- ---------- Total benefits and expenses 841,638 295,441 1,048,240 986,451 ---------- -------- ---------- ---------- Income before income taxes and cumulative effect of change in accounting principle 292,344 74,052 348,696 317,835 INCOME TAXES: Current 8,572 12,939 63,307 116,239 Deferred 85,645 1,833 48,565 (14,370) ---------- -------- ---------- ---------- Total income taxes 94,217 14,772 111,872 101,869 ---------- -------- ---------- ---------- Income before cumulative effect of change in accounting principle 198,127 59,280 236,824 215,966 Cumulative effect of change in accounting for long duration contracts, net of taxes -- -- -- (9,356) ---------- -------- ---------- ---------- Net income $ 198,127 $ 59,280 $ 236,824 $ 206,610 ========== ======== ========== ==========
See accompanying notes. F-4 JEFFERSON-PILOT LIFE INSURANCE COMPANY AND SUBSIDIARY CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY (IN THOUSANDS)
ACCUMULATED OTHER TOTAL COMMON PAID IN RETAINED COMPREHENSIVE STOCKHOLDER'S STOCK CAPITAL EARNINGS INCOME EQUITY -------- ---------- ----------- ------------- ------------- BALANCE, JANUARY 1, 2004 $ 5,000 $ 30,567 $ 1,550,244 $ 243,943 $ 1,829,754 Net income -- -- 206,610 -- 206,610 Change in fair value of derivative financial instruments, net of taxes -- -- -- (1,426) (1,426) Unrealized gain on available-for-sale securities, net of taxes -- -- -- 9,668 9,668 ----------- Comprehensive income -- -- -- -- 214,852 Dividends paid -- -- (10,000) -- (10,000) -------- ---------- ----------- --------- ----------- BALANCE, DECEMBER 31, 2004 5,000 30,567 1,746,854 252,185 2,034,606 ======== ========== =========== ========= =========== Net income -- -- 236,824 -- 236,824 Parent company capital contribution for stock option expense -- 1,003 -- -- 1,003 Change in fair value of derivative financial instruments, net of taxes -- -- -- (222) (222) Unrealized loss on available-for-sale securities, net of taxes -- -- -- (149,225) (149,225) ----------- Comprehensive income -- -- -- -- 88,380 Dividends paid -- -- (89,000) -- (89,000) -------- ---------- ----------- --------- ----------- BALANCE, DECEMBER 31, 2005 5,000 31,570 1,894,678 102,738 2,033,986 ======== ========== =========== ========= =========== Net income -- -- 59,280 -- 59,280 Parent company capital contribution for stock option expense -- 6,312 -- -- 6,312 Change in fair value of derivative financial instruments, net of taxes -- -- -- 1,116 1,116 Unrealized loss on available-for-sale securities, net of taxes -- -- -- (165,416) (165,416) ----------- Comprehensive loss (98,708) -------- ---------- ----------- --------- ----------- BALANCE, APRIL 2, 2006 5,000 37,882 1,953,958 (61,562) 1,935,278 ======== ========== =========== ========= =========== Acquisition by Lincoln National Corporation: Sale of stockholder's equity (5,000) (37,882) (1,953,958) 61,562 (1,935,278) Lincoln National Corporation purchase price 5,000 3,424,337 -- -- 3,429,337 -------- ---------- ----------- --------- ----------- BALANCE, APRIL 3, 2006 5,000 3,424,337 -- -- 3,429,337 ======== ========== =========== ========= =========== Net income -- -- 198,127 -- 198,127 Parent company capital contribution for stock option expense -- 4,418 -- -- 4,418 Change in fair value of derivative financial instruments, net of taxes -- -- -- (498) (498) Unrealized gain on available-for-sale securities, net of taxes -- -- -- 61,522 61,522 Adjustment to initially apply SFAS 158 -- -- -- 9,872 9,872 ----------- Comprehensive income -- -- -- -- 273,441 Dividends paid -- -- (2,200) -- (2,200) -------- ---------- ----------- --------- ----------- BALANCE, DECEMBER 31, 2006 $ 5,000 $3,428,755 $ 195,927 $ 70,896 $ 3,700,578 ======== ========== =========== ========= ===========
See accompanying notes. F-5 JEFFERSON-PILOT LIFE INSURANCE COMPANY AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, -------------------------- 2006 2006 2005 2004 ------------ ----------- ----------- ------------ OPERATING ACTIVITIES Net income $ 198,127 $ 59,280 $ 236,824 $ 206,610 Adjustments to reconcile net income to net cash provided by operating activities: Change in policy liabilities other than deposits 105,528 44,278 124,430 88,040 Credits to policyholder accounts, net 24,786 11,987 19,287 124,462 Deferral of policy acquisition costs and sales inducements, net of amortization (325,455) (57,454) (254,854) (204,708) Change in receivables and asset accruals (34,537) 1,546 (59,379) (7,712) Change in payables and expense accruals 248,905 12,170 29,919 6,707 Realized investment losses 4,446 4,046 4,529 12,218 Depreciation and amortization (accretion) 33,343 5,806 23,885 15,554 Amortization (accretions) and additions to value of business acquired, net 25,317 -- -- -- Stock compensation 4,418 6,312 -- -- Other (61,290) (53,438) (33,997) (52,507) ----------- --------- ----------- ------------ Net cash provided by operating activities 223,588 34,533 90,644 188,664 ----------- --------- ----------- ------------ INVESTING ACTIVITIES Securities available-for-sale: Sales 860,105 13,155 654,846 278,986 Maturities, calls and redemptions 444,018 79,191 685,550 890,400 Purchases (1,886,375) (312,008) (2,339,164) (2,602,618) Securities held-to-maturity: Sales -- -- 2,524 19,252 Maturities, calls and redemptions -- 81,971 250,224 239,750 Purchases -- (8,570) (127) (5) Repayments of mortgage loans 332,041 43,720 480,466 236,541 Mortgage loans originated (247,888) (30,025) (693,507) (321,250) Increase in policy loans, net (18,191) (3,133) (1,770) (12,683) Securities lending 166,080 -- -- -- Other investing activities, net (16,207) (4,196) (46,267) (110,740) ----------- --------- ----------- ------------ Net cash used in investing activities (366,417) (139,895) (1,007,225) (1,382,367) ----------- --------- ----------- ------------ FINANCING ACTIVITIES Policyholder contract deposits 2,034,751 508,510 2,130,934 2,146,513 Withdrawals of policyholder contract deposits (1,593,526) (411,286) (1,373,497) (1,025,468) Funding agreements issuance -- -- 300,000 -- Net proceeds (payments) from securities sold under repurchase agreements 49,447 (19,472) (16,905) 72,395 Cash dividends paid (2,200) -- (89,000) (10,000) ----------- --------- ----------- ------------ Net cash provided by financing activities 488,472 77,752 951,532 1,183,440 ----------- --------- ----------- ------------ Net increase (decrease) in cash and cash equivalents 345,643 (27,610) 34,951 (10,263) Cash and cash equivalents, beginning 13,782 41,392 6,441 16,704 ----------- --------- ----------- ------------ Cash and cash equivalents, ending $ 359,425 $ 13,782 $ 41,392 $ 6,441 =========== ========= =========== ============ SUPPLEMENTAL CASH FLOW INFORMATION Interest paid $ 1,211 $ 1,304 $ 8,028 $ 2,806 =========== ========= =========== ============
See accompanying notes. F-6 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JEFFERSON-PILOT LIFE INSURANCE COMPANY AND SUBSIDIARY (DOLLAR AMOUNTS IN THOUSANDS) DECEMBER 31, 2006 1. NATURE OF OPERATIONS Prior to April 3, 2006, Jefferson-Pilot Life Insurance Company (JP Life or the Company) was wholly-owned by Jefferson-Pilot Corporation (Jefferson-Pilot). JP Life and its subsidiary, Jefferson Standard Life Insurance Company (the subsidiary), collectively referred to as (the Company), are principally engaged in the sale of individual life insurance, annuity and investment products, and group non-medical products (primarily term life and disability). These products are marketed primarily through personal producing general agents throughout the United States. On April 3, 2006, Lincoln National Corporation (LNC or the Parent) completed its merger with Jefferson-Pilot by acquiring 100% of the outstanding shares of Jefferson-Pilot in a transaction accounted for under the purchase method of accounting prescribed by Statement of Financial Accounting Standard (SFAS) No. 141, "Business Combinations" (SFAS 141) and JP Life became wholly-owned by LNC. On February 15, 2007, the North Carolina Department of Insurance approved the merger of the Company into Lincoln National Life Insurance Company (LNL), an Indiana domiciled affiliate. The effective date of the merger will be April 2, 2007. LNL is a subsidiary of LNC. SFAS 141 requires that the total purchase price be allocated to the assets acquired and liabilities assumed based on their fair values at the merger date. As of April 3, 2006, the associated fair values of JP Life were "pushed down" to the Company's financial statements in accordance with push down accounting rules. LNC is in the process of finalizing its internal studies of the fair value of the net assets acquired including investments, value of business acquired (VOBA), intangible assets, and certain liabilities. As such, the preliminary fair values in the table below are subject to adjustment as additional information is obtained, which may result in adjustments to goodwill, which the Company does not expect to be material. The fair value of JP Life's net assets assumed in the merger was $3.4 billion. Goodwill of $1.4 billion resulted from the excess of purchase price over the fair value of JP Life's net assets. The parent paid a premium over the fair value of JP Life's net assets for a number of potential strategic and financial benefits that are expected to be realized as a result of the merger including, but not limited to, the following: - Greater size and scale with improved earnings diversification and strong financial flexibility; - Broader, more balanced product portfolio; - Larger distribution organization; and - Value creation opportunities through expense savings and revenue enhancements across business units. The following table summarizes the preliminary fair values of the net assets acquired as of the acquisition date along with the adjustments that were made to the Company's Balance Sheet to get to the fair value of net assets: PRELIMINARY FAIR VALUE FAIR VALUE ADJUSTMENTS (1) ------------ ----------- Investments $ 15,728,254 $ 203,199 Due from reinsurers 159,155 -- Deferred policy acquisition costs -- (1,767,553) Value of business acquired 1,422,208 1,422,208 Goodwill 1,358,027 1,358,027 Other assets 739,114 67,110 Assets held in separate accounts 500,016 -- Policy liabilities (15,254,983) 329,285 Income tax liabilities (161,413) (76,646) Accounts payable, accruals and other liabilities (561,025) (41,572) Liabilities related to separate accounts (500,016) -- ------------ ----------- Total net assets acquired $ 3,429,337 $ 1,494,058 ============ =========== (1) Premiums and discounts that resulted from recording the assets and liabilities at their respective fair values are being amortized and accreted using methods that approximate a constant effective yield over the expected life of the assets and liabilities. F-7 1. NATURE OF OPERATIONS--CONTINUED The goodwill resulting from the merger was allocated to the following segments: PRELIMINARY FAIR VALUE ----------- Individual Markets: Life Insurance $ 795,829 Annuities 562,198 ---------- Total Goodwill $1,358,027 ========== 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION The consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP). The Company also submits financial statements to insurance industry regulatory authorities. Those financial statements are prepared on the basis of statutory accounting principles (SAP) and are significantly different from financial statements prepared in accordance with GAAP. See Note 7. PRINCIPLES OF CONSOLIDATION The consolidated financial statements presented herein include the accounts of JP Life and Jefferson Standard Life Insurance Company. All material intercompany accounts and transactions have been eliminated. An affiliated trust, Jefferson-Pilot Life Funding Trust I, is a variable interest entity (VIE). VIEs are defined by the Financial Accounting Standards Board's Interpretation (FIN) No. 46 (Revised), "Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51", (FIN 46-R). The Company is not the primary beneficiary of this affiliated trust and does not have a controlling financial interest. Accordingly, under FIN 46-R, the accounts of this entity are not included in the Company's consolidated financial statements. ACCOUNTING ESTIMATES AND ASSUMPTIONS The preparation of financial statements requires management to make estimates and assumptions affecting the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities as of the date of the financial statements, and the reported amounts of revenue and expenses for the reporting period. Those estimates are inherently subject to change and actual results could differ from those estimates. Included among the material (or potentially material) reported amounts and disclosures that require extensive use of estimates are: fair value of certain invested assets, asset valuation allowances, deferred policy acquisition costs, policy liabilities, unearned revenue, pension plan and the potential effects of resolving litigated matters. DEBT AND EQUITY SECURITIES Debt and equity securities are classified as either securities held-to-maturity, which are stated at amortized cost and consist of securities the Company has the positive intent and ability to hold to maturity, or securities available-for-sale, which are stated at fair value with net unrealized gains and losses included in accumulated other comprehensive income, net of deferred income taxes and adjustments to deferred policy acquisition costs and value of business acquired. Fair value is based on quoted market prices from observable market data, or estimated using an internal pricing matrix for privately placed securities when quoted market prices are not available. This matrix relies on management's judgment concerning: 1) the discount rate used in calculating expected future cash flows; 2) credit quality; 3) industry sector performance; and 4) expected maturity. Under certain circumstances, the Company applies professional judgment and makes adjustments based upon specific detailed information concerning the issuer. The cost of available-for-sale fixed maturity and equity securities is reduced to fair value with a corresponding charge to realized loss on investments for declines in value that are other-than-temporary. Dividend and investment income are recognized when earned. Amortization of premiums and accrual of discounts on investments in debt securities are reflected in earnings over the contractual terms of the investments in a manner that produces a constant effective yield. Investment securities are regularly reviewed F-8 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--CONTINUED for impairment based on criteria that include the extent to which cost exceeds market value, the duration of the market decline, and the financial health of and specific prospects for the issuer. Unrealized losses that are considered to be other-than-temporary are recognized in realized gains and losses. See Note 3 for further discussion of the Company's policies regarding identification of other-than-temporary impairments. Realized gains and losses on dispositions of securities are determined by the specific-identification method. MORTGAGE AND POLICY LOANS Mortgage loans on real estate are stated at the unpaid balances adjusted for amortization of premiums and discounts, and are net of estimated unrecoverable amounts. An allowance for unrecoverable amounts is provided for when a mortgage loan becomes impaired. Changes in the allowance are reported as realized investment gains (losses) within the consolidated statements of income. Mortgage loans are considered impaired when it becomes probable the Company will be unable to collect the total amounts due, including principal and interest, according to the contractual terms of the loan. Such an impairment is measured based upon the present value of expected cash flows discounted at the effective interest rate on both a loan-by-loan basis and by measuring aggregated loans with similar risk characteristics. Interest on mortgage loans is recorded until collection is deemed improbable. Policy loans are stated at their unpaid balances. REAL ESTATE AND OTHER INVESTMENTS Real estate acquired by foreclosure is stated at the lower of depreciated cost or fair value less estimated costs to sell. Real estate not acquired by foreclosure is stated at cost less accumulated depreciation. Real estate, primarily buildings, is depreciated principally by the straight-line method over estimated useful lives generally ranging from 30 to 40 years. Accumulated depreciation was $2,131 and $31,115 at December 31, 2006 and 2005. Other investments, which consist primarily of S&P 500 Index(R) options and affordable housing tax credit investments, are stated at equity, fair value or the lower of cost or market, as appropriate. Cost of real estate is adjusted for impairment whenever events or changes in circumstances indicate the carrying amount of the asset may not be recoverable. Impaired real estate is written down to estimated fair value with the impairment loss being included in realized gains and losses. Impairment losses are based upon the estimated fair value of real estate, which is generally computed using the present value of expected future cash flows from the real estate discounted at a rate commensurate with the underlying risks. DERIVATIVE FINANCIAL INSTRUMENTS The Company uses derivatives to help manage exposure to certain equity and interest rate risks. Statement of Financial Accounting Standard (SFAS) No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES, (SFAS 133), requires companies to recognize all derivative instruments as either assets or liabilities in the balance sheet at fair value, which the Company classifies within its investments on its consolidated balance sheets. The accounting for changes in the fair value (i.e., gains or losses) of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship. For those derivative instruments that are designated and qualify as hedging instruments, the Company designates the hedging instrument, based upon the exposure being hedged, as a fair value hedge or cash flow hedge. The Company accounts for changes in fair values of derivatives that are not part of a hedge or do not qualify for hedge accounting through investment income during the period of the change. For derivatives that are designated and qualify as cash flow hedges, the effective portion of the gain or loss realized on the derivative instrument is reported as a component of other comprehensive income and reclassified into earnings in the same period during which the hedged transaction impacts earnings. The remaining gain or loss on these derivative instruments is recognized in investment income during the period of the change. Effectiveness of the Company's hedge relationships is assessed and measured on a quarterly basis. F-9 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--CONTINUED CASH AND CASH EQUIVALENTS Cash and invested cash are carried at cost and include all highly liquid debt instruments purchased with a maturity of three months or less. REINSURANCE BALANCES AND TRANSACTIONS Reinsurance receivables include amounts related to paid benefits and estimated amounts related to unpaid policy and contract claims, future policy benefits and policyholder contract deposits. The cost of reinsurance is accounted for over the terms of the underlying reinsured policies using assumptions consistent with those used to account for the policies. DEFERRED POLICY ACQUISITION COSTS AND VALUE OF BUSINESS ACQUIRED Costs related to obtaining new and renewal business, including commissions and incentive compensation, certain costs of underwriting and issuing policies, and certain agency office expenses, all of which vary with and are primarily related to the production of new and renewal business, are deferred. The Company's traditional individual and group insurance products are long-duration contracts. Deferred policy acquisition costs related to these products are amortized over the expected premium paying periods using the same assumptions for anticipated premium revenue that are used to compute liabilities for future policy benefits. For fixed universal life and annuity products, these costs are amortized at a constant rate based on the present value of the estimated future gross profits to be realized over the terms of the contracts. Estimates of future gross profits are determined based upon assumptions for mortality, interest spreads, lapse rates, and policy fees earned. Value of business acquired represents the actuarially determined present value of anticipated profits to be realized from life insurance and annuity business acquired in business combinations, using the same assumptions used to value the related liabilities. Amortization of the value of business acquired occurs over the related contract periods, using current crediting rates to accrete interest and a constant amortization rate based on the present value of expected future profits for fixed universal life and annuity products. Deferred policy acquisition costs and the value of business acquired for variable life and annuity products are amortized incorporating the assumptions listed above for fixed products, except for interest spreads. In calculating the estimated gross profits for these products, the Company utilizes a long-term total gross return on assets of 8.0%. The carrying amounts of deferred policy acquisition costs and value of business acquired are adjusted for the effect of credit and non-credit related realized gains and losses and the effects of unrealized gains and losses on debt securities classified as available-for-sale. At least annually, the assumptions used to estimate future gross profits in calculating the amortization of deferred policy acquisition costs are evaluated in relation to emerging experience. When actual experience varies from the assumptions, adjustments are made in the quarter in which the evaluation of the respective blocks of business is completed. The effects of changes in estimated future gross profits on unamortized deferred policy acquisition costs, referred to as unlockings, are reflected in amortization expense within the consolidated statements of income. Deferred policy acquisition costs are periodically reviewed to determine that the unamortized portion does not exceed expected recoverable amounts. No significant impairments occurred during the three years ending December 31, 2006. GOODWILL Goodwill (purchase price in excess of net assets acquired in a business combination) resulted from the merger with LNC on April 3, 2006 and will be regularly reviewed for indications of value impairment, with consideration given to financial performance and other relevant factors. In addition, certain events including a F-10 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--CONTINUED significant adverse change in legal factors or the business climate, an adverse action or assessment by a regulator, or unanticipated competition would cause the Company to review carrying amounts of goodwill for impairment. When considered impaired, the carrying amounts would be written down using a combination of fair value and discounted cash flows. No impairments occurred during the year ending December 31, 2006. SEPARATE ACCOUNTS Separate account assets and liabilities represent variable annuity and variable universal life funds segregated for the benefit of the related policyholders who bear the investment risk of their account balances. The separate account assets and liabilities, which are equal, are recorded at fair value. Policyholder account deposits and withdrawals, investment income and realized investment gains and losses in the separate accounts are excluded from the amounts reported in the consolidated statements of income. Fees charged on separate account policyholder account balances are included in universal life and investment product charges in the consolidated statements of income. The amounts of minimum guarantees or other similar benefits related to these policies are negligible. PROPERTY AND EQUIPMENT Property and equipment is stated at cost and depreciated principally by the straight-line method over estimated useful lives of 30 to 50 years for buildings, approximately 10 years for other property and equipment and 3 to 5 years for computer hardware and software. Accumulated depreciation was $13,873 and $105,185 at December 31, 2006 and 2005. Property and equipment is adjusted for impairment whenever events or changes in circumstances indicate the carrying amount of the asset may not be recoverable. In such cases, the cost basis of the property and equipment is reduced to fair value with the impairment loss being included in realized gains and losses. DEFERRED SALES INDUCEMENTS The Company has policies in force containing two primary types of sales inducements: 1) day-one bonuses on fixed annuities, which are in the form of either an increased interest rate for a stated period or an additional premium credit; and 2) persistency-related interest crediting bonuses. These bonuses are accrued over the period in which the policy must remain in force for the policyholder to qualify for the inducement. Capitalized sales inducements are amortized using the same methodology and assumptions used to amortize deferred policy acquisition costs. The unamortized balance of the Company's deferred sales inducement asset is reported in other assets within the consolidated balance sheets. FUTURE POLICY BENEFITS AND OTHER POLICY LIABILITIES Liabilities for future policy benefits on traditional life and disability insurance are computed by the net level premium valuation method based on assumptions about future investment yield, mortality, morbidity and persistency. Estimates about future circumstances are based principally on historical experience and provide for possible adverse deviations. Liabilities related to no-lapse guarantees (secondary guarantees) on universal life-type products are included in other policy liabilities within the consolidated balance sheets. These liabilities are calculated by multiplying the benefit ratio (present value of total expected secondary guarantee benefits over the life of the contract divided by the present value of total expected assessments over the life of the contract) by the cumulative profits recorded from purchase date for pre-merger issues and from contract inception for post merger issues through the balance sheet date less the cumulative secondary guarantee benefit payments plus interest. If experience or assumption changes result in a new benefit ratio, the reserves are unlocked to reflect the changes in a manner similar to deferred policy acquisition costs. The accounting for secondary guarantee benefits impacts, and is impacted by, estimated future gross profits used to calculate amortization of deferred policy acquisition costs, deferred sales inducements, and unearned revenue. F-11 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--CONTINUED POLICYHOLDER CONTRACT DEPOSITS Policyholder contract deposits consist of policy values that accrue to holders of universal life-type contracts and annuities other than portions carried in the separate account, discussed above. The liability is determined using the retrospective deposit method and is presented before deduction of potential surrender charges. POLICY AND CONTRACT CLAIMS The liability for policy and contract claims consists of the estimated amount payable for claims reported but not yet settled and an estimate of claims incurred but not reported, which are based on historical experience, adjusted for trends and circumstances. Management believes that the recorded liability is sufficient to provide for claims and the associated claims adjustment expenses incurred through the balance sheet date. FUNDING AGREEMENTS Funding agreements consist of investment contracts, which back medium term notes sold by the Company through investment banks to commercial investors. Accrued interest on the funding agreements is classified within other policy liabilities on the Company's consolidated balance sheets. RECOGNITION OF REVENUE Premiums on traditional life insurance products are reported as revenue when received unless received in advance of the due date. Premiums on traditional accident and health, disability income and dental insurance are reported as earned over the contract period. A reserve is provided for the portion of premiums written which relates to unexpired coverage terms. Revenue from universal life-type and annuity products includes charges for the cost of insurance, initiation and administration of the policy, and surrender of the policy. Revenue from these charges is recognized in the year assessed to the policyholder, except that any portion of an assessment that relates to services to be provided in future years is deferred as unearned revenue and is recognized as income over the period during which services are provided based upon estimates of future gross profits. The net of amounts deferred and amounts recognized is reflected in universal life and investment product charges in the consolidated statements of income. The effects of changes in estimates of future gross profits, referred to as unlockings, on unearned revenue are reflected in the consolidated statements of income within universal life and investment product charges in the period such revisions occur. Dividend and investment income are recognized when earned. RECOGNITION OF BENEFITS AND EXPENSES Benefits and expenses, other than deferred policy acquisition costs, related to traditional life, accident and health, disability income, and dental insurance products are recognized when incurred in a manner designed to match them with related premiums and to spread income recognition over expected policy lives (see preceding discussion of policy liabilities). For universal life-type and annuity products, benefits include interest credited to policyholders' accounts, which is recognized as it accrues. STOCK BASED COMPENSATION The Company and its subsidiary are included in LNC's consolidated incentive compensation plans. The Company expenses its portion of the fair value of stock awards included in LNC's incentive compensation plans. On the date LNC's Board of Directors approves stock awards, the fair value of stock options is determined using a Black-Scholes options valuation methodology. The fair value of other stock awards is based upon the market value of the stock. The fair value of the awards is expensed over the service period, which generally corresponds to the vesting period, and is recognized as an increase to paid-in capital in shareholder's equity. INCOME TAXES On April 3, 2006, the Company's ultimate parent company merged with and into a wholly owned acquisition subsidiary of LNC, a holding company with control over other insurance subsidiaries. As a result, LNC became F-12 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--CONTINUED the ultimate parent after completion of the merger. Prior to the merger, the Company's federal income tax return was consolidated with all companies, which were 80% or more owned by Jefferson-Pilot. Effective as of the merger date, the Company's federal income tax return is no longer consolidated with the other members of the holding company group. Instead the Company will file a separate federal income tax return. Deferred income taxes are recognized when assets and liabilities have different values for financial statement and tax reporting purposes. A valuation allowance is recorded to the extent required to reduce the deferred tax asset to an amount that the Company expects, more likely than not, will be realized. NEW ACCOUNTING PRONOUNCEMENTS THE FAIR VALUE OPTION FOR FINANCIAL ASSETS AND FINANCIAL LIABILITIES In February 2007, the Financial Accounting Standards Board (FASB) issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" (SFAS 159), which allows an entity to make an irrevocable election, on specific election dates, to measure eligible items at fair value. The election to measure an item at fair value may be determined on an instrument by instrument basis, with certain exceptions. If the fair value option is elected, unrealized gains and losses will be recognized in earnings at each subsequent reporting date, and any upfront costs and fees related to the item will be recognized in earnings as incurred. In addition, the presentation and disclosure requirements of SFAS 159 are designed to assist in the comparison between entities that select different measurement attributes for similar types of assets and liabilities. SFAS 159 does not affect any existing accounting literature that requires certain assets and liabilities to be carried at fair value and does not eliminate disclosure requirements included in other accounting standards. SFAS 159 applies to fiscal years beginning after November 15, 2007, with early adoption permitted for an entity that has also elected to apply the provisions of SFAS 157. Retrospective application of SFAS 159 is not permitted unless early adoption is elected. At the effective date, the fair value option may be elected for eligible items that exist on that date. The effect of the first re-measurement to fair value shall be reported as a cumulative effect adjustment to the opening balance of retained earnings. The Company is currently evaluating the potential effects of SFAS 159 on its consolidated financial condition and results of operations. CONSIDERING THE EFFECTS OF PRIOR YEAR MISSTATEMENTS WHEN QUANTIFYING MISSTATEMENTS IN CURRENT YEAR FINANCIAL STATEMENTS. In September 2006, the Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 108, "Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements" (SAB 108). SAB 108 provides guidance for evaluating the effects of prior year uncorrected errors when quantifying misstatements in the current year financial statements. Under SAB 108, the impact of correcting misstatements occurring in the current period and those that have accumulated over prior periods must both be considered when quantifying the impact of misstatements in current period financial statements. SAB 108 is effective for fiscal years ending after November 15, 2006, and may be adopted by either restating prior financial statements or recording the cumulative effect of initially applying the approach as adjustments to the carrying values of assets and liabilities as of January 1, 2006 with an offsetting adjustment to retained earnings. The Company adopted the provisions of SAB 108 as of December 31, 2006. The adoption of SAB 108 did not have a material effect on the Company's consolidated financial statements. FAIR VALUE MEASUREMENTS In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements" (SFAS 157), which establishes a framework for measuring fair value under current accounting pronouncements that require or permit fair value measurement. SFAS 157 retains the exchange price notion, but clarifies that exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the most advantageous market for that asset or liability. Fair value measurement is based on assumptions used by market participants in pricing the asset or liability, which may include F-13 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--CONTINUED inherent risk, restrictions on the sale or use of an asset, or nonperformance risk which would include the reporting entity's own credit risk. SFAS 157 establishes a three-level fair value hierarchy which prioritizes the inputs to valuation techniques used to measure fair value. The highest priority is given to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs in situations where there is little or no market activity for the asset or liability. In addition, SFAS 157 expands the disclosure requirements for annual and interim reporting to focus on the inputs used to measure fair value, including those measurements using significant unobservable inputs, and the effects of the measurements on earnings. SFAS 157 will be applied prospectively and is effective for fiscal years beginning after November 15, 2007. Retrospective application is required for certain financial instruments as a cumulative effect adjustment to the opening balance of retained earnings. The Company is currently evaluating the effects of SFAS 157 on its financial condition and results of operations. EMPLOYERS' ACCOUNTING FOR DEFINED BENEFIT PENSION AND OTHER POSTRETIREMENT PLANS In September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statements No. 87, 88, 106, and 132(R)" (SFAS 158). The guidance requires the Company to recognize on the balance sheet the funded status of its defined benefit postretirement plans as either an asset or liability, depending on the plans' funded status, with changes in the funded status recognized through other comprehensive income. The funded status is measured as the difference between the fair value of the plan assets and the projected benefit obligation, for pension plans, or the accumulated postretirement benefit obligation for postretirement benefit plans. Prior service costs or credits and net gains or losses which are not recognized in current net periodic benefit cost, pursuant to SFAS No. 87, "Employers' Account for Pensions" or SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," must be recognized in other comprehensive income, net of tax, in the period in which they occur. As these items are recognized in net periodic benefit cost, the amounts accumulated in other comprehensive income are adjusted. Under SFAS 158, disclosure requirements have also been expanded to separately provide information on the prior service costs or credits and net gains and losses recognized in other comprehensive income and their effects on net periodic benefit costs. The Company adopted the recognition and disclosure provisions of SFAS 158 as of December 31, 2006. The adoption of SFAS 158 resulted in an increase to accumulated other comprehensive income of $9,872. ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES In July 2006, the FASB issued FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109" (FIN 48). FIN 48 establishes criteria that an individual tax position must be met for any part of the benefit of the tax position to be recognized in the financial statements. These criteria include determining whether it is more-likely-than-not that a tax position will be sustained upon examination by the appropriate taxing authority. If the tax position meets the more-likely-than-not threshold, the position is measured as the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. If a tax position does not meet the more-likely-than-not recognition threshold, the benefit is not recognized in the financial statements. Upon adoption of FIN 48, the guidance will be applied to all tax positions, and only those tax positions meeting the more-likely-than-not threshold will be recognized or continue to be recognized in the financial statements. Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first subsequent financial reporting period in which that threshold is met. In addition, FIN 48 expands disclosure requirements to include additional information related to unrecognized tax benefits. FIN 48 is effective for fiscal years beginning after December 15, 2006. The cumulative effect adjustment upon the initial adoption of FIN 48 will be recorded as an adjustment to retained earnings with no impact on net income. The Company will adopt the provisions of FIN 48 on March 31, 2007 effective January 1, 2007. The adoption of FIN 48 is not expected to have a material effect on the Company's financial condition or results of operations. F-14 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--CONTINUED ACCOUNTING FOR CERTAIN HYBRID FINANCIAL INSTRUMENTS In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140" (SFAS 155), which permits fair value remeasurement for a hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. Under SFAS 155, an entity may make an irrevocable election to measure a hybrid financial instrument at fair value, in its entirety, with changes in fair value recognized in earnings. SFAS 155 also: (a) clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS 133; (b) eliminates the interim guidance in SFAS 133 Implementation Issue No. D1, "Application of Statement 133 to Beneficial Interests in Securitized Financial Assets," and establishes a requirement to evaluate beneficial interests in securitized financial assets to identify interests that are either freestanding derivatives or hybrid financial instruments that contain an embedded derivative requiring bifurcation; (c) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and (d) eliminates restrictions on a qualifying special-purpose entity's ability to hold passive derivative financial instruments that pertain to beneficial interests that are or contain a derivative financial instrument. In December 2006, the FASB issued Derivative Implementation Group Statement 133 Implementation Issue No. B40, "Embedded Derivatives: Application of Paragraph 13(b) to Securitized Interests in Prepayable Financial Assets" (DIG B40). Since SFAS 155 eliminated the interim guidance related to securitized financial assets, DIG B40 provides a narrow scope exception for securitized interests that contain only an embedded derivative related to prepayment risk. Under DIG B40, a securitized interest in prepayable financial assets would not be subject to bifurcation if: (a) the right to accelerate the settlement of the securitized interest cannot be controlled by the investor and (b) the securitized interest itself does not contain an embedded derivative for which bifurcation would be required other than an embedded derivative that results solely from the embedded call options in the underlying financial assets. Any other terms in the securitized financial asset that may affect cash flow in a manner similar to a derivative instrument would be subject to the requirements of paragraph 13(b) of SFAS 133. The guidance in DIG B40 is to be applied upon the adoption of SFAS 155. The Company will adopt the provisions SFAS 155 and DIG B40 on January 1, 2007, for all financial instruments acquired, issued, or subject to a remeasurement event occurring after that date. Prior period restatement is not permitted. The adoption of SFAS 155 is not expected to have a material impact on the Company's consolidated financial condition or results of operations. SHARE-BASED PAYMENT In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment" (SFAS 123(R)), which is a revision of SFAS 123, "Accounting for Stock-based Compensation" (SFAS 123). SFAS 123(R) requires recognition, at fair value, of all costs resulting from share-based payments to employees, except for equity instruments held by employee share ownership plans. Similar to SFAS 123 under SFAS 123(R), the fair value of share-based payments are recognized as a reduction to earnings over the period an employee is required to provide service in exchange for the award. Effective January 1, 2006, the Company adopted SFAS 123(R), using the modified prospective transition method. Under that transition method, compensation cost recognized in 2006 includes: (a) compensation cost for all share-based payments granted prior to but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). Results from prior periods have not been restated. Adopting SFAS 123(R) did not have a material effect on the Company's results of operations. Prior to January 1, 2006, the Company accounted for stock incentive awards in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25), and accordingly, F-15 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--CONTINUED recognized no compensation expense for stock option awards to employees when the option price was not less than the market value of the stock at the date of award. See Note 16 for more information regarding stock-based compensation plans. THE MEANING OF OTHER-THAN-TEMPORARY IMPAIRMENTS AND ITS APPLICATION TO CERTAIN INVESTMENTS In November 2005, the FASB issued FSP FAS 115-1 and FAS 124-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" (FSP 115-1). The guidance in FSP 115-1 nullifies the accounting and measurement provisions of Emerging Issues Task Force No. 03-1 - "The Meaning of Other Than Temporary Impairments and Its Application to Certain Investments" references existing guidance, and supersedes EITF Topic No. D-44 "Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value." FSP 115-1 was effective for reporting periods beginning after December 15, 2005, on a prospective basis. The Company's existing policy for recognizing other-than-temporary impairments is consistent with the guidance in FSP 115-1, and includes the recognition of other than temporary impairments of securities resulting from credit related issues as well as declines in fair value related to rising interest rates, where the Company does not have the intent to hold the securities until either maturity or recovery. The Company adopted FSP 115-1 effective January 1, 2006. The adoption of FSP 115-1 did not have a material effect on the Company's consolidated financial condition or results of operations. See Note 3 for discussion of investment impairments and related disclosures. ACCOUNTING BY INSURANCE ENTERPRISES FOR DEFERRED ACQUISITION COSTS IN CONNECTION WITH MODIFICATIONS OR EXCHANGES OF INSURANCE CONTRACTS In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants (AICPA) issued Statement of Position (SOP) 05-1, "Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts" (SOP 05-1). SOP 05-1 addresses the accounting for Deferred Acquisition Costs (DAC) on internal replacements other than those described in SFAS No. 97, "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments." An internal replacement is defined by SOP 05-1 as a modification in product benefits, features, rights or coverages that occurs by (a) exchanging the contract for a new contract, (b) amending, endorsing or attaching a rider to the contract, or (c) electing a feature or coverage within a replaced contract. Contract modifications that result in a substantially unchanged contract will be accounted for as a continuation of the replaced contract. Contract modifications that result in a substantially changed contract should be accounted for as an extinguishment of the replaced contract, and any unamortized DAC, unearned revenue and deferred sales charges must be written-off. SOP 05-1 is to be applied prospectively and is effective for internal replacements occurring in fiscal years beginning after December 15, 2006. The Company will adopt this new accounting guidance effective January 1, 2007. The adoption of this new guidance impacts the Company's assumptions for lapsation used in the amortization of DAC and Value of Business Acquired (VOBA). The Company estimates that its adoption will result in an immaterial adjustment to DAC and VOBA balances upon adoption and an immaterial increase to amortization in 2007. The Company's preliminary estimates are based upon its interpretation of SOP 05-1 and the proposed implementation guidance. The Company continues to analyze the impact on DAC and VOBA amortization and is currently evaluating the effect of a Technical Practice Aide (TPA) issued in February 2007. As a result, the actual impact of the adoption of SOP 05-1 may differ significantly from the Company's preliminary estimates as the issuance of new implementation guidance and evolving industry practice may affect its interpretation and implementation. F-16 3. INVESTMENTS SUMMARY COST AND FAIR VALUE INFORMATION Aggregate cost or amortized cost, aggregate fair value and gross unrealized gains and losses of debt and equity securities are as follows:
DECEMBER 31, 2006 --------------------------------------------------- COST OR GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS (LOSSES) VALUE ----------- ---------- ---------- ----------- AVAILABLE-FOR-SALE, CARRIED AT FAIR VALUE U.S. Treasury obligations and direct obligations of U.S. Government agencies $ 18,351 $ 15 $ (30) $ 18,336 Federal agency issued mortgage-backed securities (including collateralized mortgage obligations) 754,025 5,475 (620) 758,880 Obligations of states and political subdivisions 41,314 478 (7) 41,785 Corporate obligations 11,712,212 144,810 (29,434) 11,827,588 Corporate private-labeled mortgage-backed securities (including collateralized mortgage obligations) 485,516 8,054 (421) 493,149 Affiliate bonds 103,852 -- (2) 103,850 ----------- -------- -------- ----------- Subtotal, debt securities 13,115,270 158,832 (30,514) 13,243,588 Equity securities 534 16 (1) 549 ----------- -------- -------- ----------- Securities available-for-sale $13,115,804 $158,848 $(30,515) $13,244,137 =========== ======== ======== ===========
DECEMBER 31, 2005 ---------------------------------------------------- COST OR GROSS GROSS AMORTIZED UNREALIZED UNREALIZED COST GAINS (LOSSES) FAIR VALUE ----------- ----------- ---------- ----------- AVAILABLE-FOR-SALE, CARRIED AT FAIR VALUE U.S. Treasury obligations and direct obligations of U.S. Government agencies $ 137,433 $ 3,109 $ (187) $ 140,355 Federal agency issued mortgage-backed securities (including collateralized mortgage obligations) 664,964 17,347 (5,906) 676,405 Obligations of states and political subdivisions 42,232 3,485 (88) 45,629 Corporate obligations 9,752,029 280,720 (116,716) 9,916,033 Corporate private-labeled mortgage-backed securities (including collateralized mortgage obligations) 474,873 3,068 (6,959) 470,982 Affiliate bonds 92,000 -- (982) 91,018 Redeemable preferred stocks 101 -- (5) 96 ----------- -------- --------- ----------- Subtotal, debt securities 11,163,632 307,729 (130,843) 11,340,518 Equity securities 286 141 -- 427 ----------- -------- --------- ----------- Securities available-for-sale $11,163,918 $307,870 $(130,843) $11,340,945 =========== ======== ========= =========== HELD-TO-MATURITY, CARRIED AT AMORTIZED COST Obligations of states and political subdivisions $ 1,001 $ 59 $ -- $ 1,060 Corporate obligations 1,307,910 62,891 (8,949) 1,361,852 Affiliate bonds 16,246 98 (540) 15,804 ----------- -------- --------- ----------- Debt securities held-to-maturity $ 1,325,157 $ 63,048 $ (9,489) $ 1,378,716 =========== ======== ========= ===========
At December 31, 2006, affiliate bonds included in securities available-for-sale consist of securities issued by LNC and Lincoln Financial Media Company. At December 31, 2005, affiliate bonds included in securities available-for-sale consist of securities issued by LNC and affiliate bonds included in securities held-to-maturity consist of securities issued by Lincoln Financial Media Company. See further discussion in Note 12. F-17 3. INVESTMENTS--CONTINUED CONTRACTUAL MATURITIES Aggregate amortized cost and aggregate fair value of debt securities at December 31, 2006, according to maturity date, were as indicated below. Contractual maturity dates were utilized for all securities except for mortgage-backed securities which are based upon estimated maturity dates. Actual future maturities may differ from the contractual maturities shown because the issuers of certain debt securities have the right to call or prepay the amounts due to the Company, with or without penalty. AVAILABLE-FOR-SALE ------------------------- AMORTIZED FAIR COST VALUE ----------- ----------- Due in one year or less $ 397,476 $ 397,250 Due after one year through five years 2,725,267 2,738,543 Due after five years through ten years 5,626,007 5,674,666 Due after ten years 3,126,980 3,181,100 Amounts not due at a single maturity date 1,239,540 1,252,029 ----------- ----------- $13,115,270 $13,243,588 =========== =========== SECURITIES LENDING In its securities lending program, the Company generally receives cash collateral in an amount that is in excess of the market value of the securities loaned. Market values of securities loaned and collateral are monitored daily, and additional collateral is obtained as necessary. The market value of securities loaned and collateral received amounted to $159,351 and $166,080 at December 31, 2006, and $152,195 and $156,231 at December 31, 2005. F-18 3. INVESTMENTS--CONTINUED CHANGES IN NET UNREALIZED GAINS ON SECURITIES Changes in amounts affecting net unrealized gains included in other comprehensive income, reduced by deferred income taxes, were as follows:
NET UNREALIZED GAINS (LOSSES) ------------------------------------ DEBT EQUITY SECURITIES SECURITIES TOTAL ---------- ---------- ---------- Net unrealized gains on securities available-for-sale as of December 31, 2003 $ 243,204 $ 32 $ 243,236 Change during year ended December 31, 2004: Increase in stated amount of securities 15,663 52 15,715 Decrease in deferred policy acquisition costs (841) -- (841) Increase in deferred income tax liabilities (5,188) (18) (5,206) --------- ---- --------- Increase in net unrealized gains included in other comprehensive income 9,634 34 9,668 --------- ---- --------- Net unrealized gains on securities available-for-sale as of December 31, 2004 252,838 66 252,904 Change during year ended December 31, 2005: (Decrease) increase in stated amount of securities (287,631) 30 (287,601) Increase in deferred policy acquisition costs 58,024 -- 58,024 Decrease (increase) in deferred income tax liabilities 80,362 (10) 80,352 --------- ---- --------- (Decrease) increase in net unrealized gains included in other comprehensive income (149,245) 20 (149,225) --------- ---- --------- Net unrealized gains on securities available-for-sale as of December 31, 2005 103,593 86 103,679 Change during period January 1 through April 2, 2006: (Decrease) increase in stated amount of securities (294,722) 19 (294,703) Increase in deferred policy acquisition costs and value of business acquired 40,218 -- 40,218 Decrease (increase) in deferred income tax liabilities 89,076 (7) 89,069 --------- ---- --------- (Decrease) increase in net unrealized gains included in other comprehensive income (165,428) 12 (165,416) --------- ---- --------- Net unrealized gains (losses) on securities available-for-sale as of April 2, 2006 $ (61,835) $ 98 $ (61,737) ========= ==== =========
F-19 3. INVESTMENTS--CONTINUED
NET UNREALIZED GAINS (LOSSES) ---------------------------------- DEBT EQUITY SECURITIES SECURITIES TOTAL ---------- ---------- -------- Net unrealized gains (losses) on securities available-for-sale as of April 2, 2006 $(61,835) $ 98 $(61,737) Sale of stockholder's equity 61,835 (98) 61,737 -------- ---- -------- Net unrealized gains on securities available-for-sale as of April 3, 2006 -- -- -- Change during period April 3 through December 31, 2006: Increase in stated amount of securities 128,318 15 128,333 Decrease in deferred policy acquisition costs and value of business acquired (32,337) -- (32,337) Increase in deferred income tax liabilities (34,469) (5) (34,474) -------- ---- -------- Increase in net unrealized gains included in other comprehensive income 61,512 10 61,522 -------- ---- -------- Net unrealized gains on securities available-for-sale as of December 31, 2006 $ 61,512 $ 10 $ 61,522 ======== ==== ========
NET INVESTMENT INCOME The details of net investment income follow:
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, -------------------- 2006 2006 2005 2004 ------------ ----------- -------- --------- Interest on debt securities $579,054 $185,283 $737,935 $705,123 Investment income on equity securities 25 -- 25 19 Interest on mortgage loans 122,775 41,105 160,567 160,083 Interest on policy loans 12,723 4,013 16,676 16,437 Other investment income 79,406 28,570 44,437 45,201 -------- -------- -------- -------- Gross investment income 793,983 259,971 959,640 926,863 Investment expenses (33,725) (5,451) (24,340) (20,113) -------- -------- -------- -------- Net investment income $760,258 $253,520 $935,300 $906,750 ======== ======== ======== ========
Investment expenses include salaries, expenses of maintaining and operating investment real estate, real estate depreciation and other allocated costs of investment management and administration. REALIZED GAINS AND LOSSES The details of realized investment gains (losses), including other-than-temporary impairments, follow:
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, ------------------ 2006 2006 2005 2004 ------------ ----------- ------- -------- Debt securities $ 1,946 $(3,721) $(9,454) $(17,182) Other (1,633) (679) 5,275 6,407 Amortization of deferred policy acquisition costs, value of business acquired and deferred sales inducements (4,759) 354 (350) (1,443) ------- ------- ------- -------- Realized investment losses $(4,446) $(4,046) $(4,529) $(12,218) ======= ======= ======= ========
F-20 3. INVESTMENTS--CONTINUED See Note 5 for discussion of amortization of deferred policy acquisition costs, value of business acquired and deferred sales inducements. Information about total gross realized gains and losses on debt securities, including other-than- temporary impairments, follows:
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, ------------------- 2006 2006 2005 2004 ------------ ----------- -------- -------- Gross realized: Gains $ 9,598 $ 246 $ 13,424 $ 26,997 Losses (7,652) (3,967) (22,878) (44,179) ------- ------- -------- -------- Realized gains (losses) on total debt securities $ 1,946 $(3,721) $ (9,454) $(17,182) ======= ======= ======== ========
Information about gross realized gains and losses on available-for-sale securities, including other-than-temporary impairments, follows:
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, ------------------- 2006 2006 2005 2004 ------------ ----------- -------- -------- Gross realized: Gains $ 9,598 $ 212 $ 9,744 $ 24,211 Losses (7,652) (3,933) (22,623) (40,712) ------- ------- -------- -------- Realized losses on available-for-sale securities $ 1,946 $(3,721) $(12,879) $(16,501) ======= ======= ======== ========
INVESTMENT CONCENTRATION, RISK, AND IMPAIRMENT Investments in debt and equity securities include 980 issuers. Debt securities include investments in Jefferson-Pilot of $92,000 as of December 31, 2006 and 2005. No other corporate issuer represents more than 1% of investments. Debt securities considered less than investment grade approximated 5% of the total debt securities portfolio as of December 31, 2006 and 2005. The Company uses repurchase agreements to meet various cash requirements. At December 31, 2006 and 2005, the amounts held in debt securities available-for-sale pledged as collateral for these borrowings were $341,429 and $311,054. As of December 31, 2006, the Company's commercial mortgage loan portfolio was comprised of conventional real estate mortgages collateralized primarily by retail (31%), office (26%), industrial (21%), apartment (10%), hotel (11%), and other (1%) properties. Mortgage loan underwriting standards emphasize the credit status of a prospective borrower, quality of the underlying collateral and loan-to-value relationships. Approximately 30% of stated mortgage loan balances as of December 31, 2006 are for properties located in South Atlantic states, approximately 24% are for properties located in Pacific states, approximately 10% are for properties located in West South Central states and approximately 12% are for properties located in the Mountain states. No other geographic region represents as much as 10% of December 31, 2006 mortgage loans. At December 31, 2006 and 2005, the recorded investment in mortgage loans that were considered to be impaired was $597 and $2,313. There was one delinquent loan outstanding as of December 31, 2006 and none outstanding as of December 31, 2005. The related allowance for credit losses on all mortgage loans was $610 and $9,563 at December 31, 2006 and 2005. The average recorded investment in impaired loans was $599 from April 3 through December 31, 2006, $2,282 from January 1 through April 2, 2006, and $4,379 and $31,602 during the years ended December 31, 2005 and 2004, on which interest income of $0 from April 3 through F-21 3. INVESTMENTS--CONTINUED December 31, 2006, $73 from January 1 through April 2, 2006, and $198 and $223 during the years ended December 31, 2005 and 2004, was recognized. During 2005 and 2004 the Company sold certain securities that had been classified as held-to-maturity, due to significant declines in credit worthiness. The net amortized costs of sold securities were $891 and $12,090 for 2005 and 2004. The realized gains on the sales of these securities, some of which were previously impaired, were $0 and $416 for 2005 and 2004. The Company monitors its portfolio closely to ensure that all other-than-temporary impairments are identified and recognized in earnings as they occur. The tables below summarize unrealized losses on all securities held by both asset class and length of time that a security has been in an unrealized loss position:
DECEMBER 31, 2006 ----------------------------------------------------------------------- LESS THAN 12 MONTHS 12 MONTHS OR LONGER TOTAL ----------------------- ------------------- ----------------------- GROSS GROSS GROSS FAIR UNREALIZED FAIR UNREALIZED UNREALIZED VALUE LOSSES VALUE LOSSES FAIR VALUE LOSSES ---------- ---------- ------ ---------- ---------- ---------- U.S. Treasury obligations and direct obligations of U.S. government agencies $ 15,666 $ (30) $-- $-- $ 15,666 $ (30) Federal agency issued mortgage-backed securities (including collateralized mortgage obligations) 145,044 (620) -- -- 145,044 (620) Obligations of state and political subdivisions 4,023 (7) -- -- 4,023 (7) Corporate obligations 2,481,092 (29,434) -- -- 2,481,092 (29,434) Corporate private-labeled mortgage-backed securities (including collateralized mortgage obligations) 40,840 (421) -- -- 40,840 (421) Affiliated bonds 4,167 (2) -- -- 4,167 (2) Equity securities 83 (1) -- -- 83 (1) ---------- -------- --- --- ---------- -------- Total temporarily impaired securities $2,690,915 $(30,515) $-- $-- $2,690,915 $(30,515) ========== ======== === === ========== ========
DECEMBER 31, 2005 --------------------------------------------------------------------------- LESS THAN 12 MONTHS 12 MONTHS OR LONGER TOTAL ----------------------- ----------------------- ----------------------- GROSS GROSS GROSS FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED VALUE LOSSES VALUE LOSSES VALUE LOSSES ---------- ---------- ---------- ---------- ---------- ---------- U.S. Treasury obligations and direct obligations of U.S. government agencies $ 15,276 $ (187) $ -- $ -- $ 15,276 $ (187) Federal agency issued mortgage-backed securities (including collateralized mortgage obligations) 97,310 (1,502) 120,255 (4,404) 217,565 (5,906) Obligations of state and political subdivisions 4,964 (60) 1,404 (28) 6,368 (88) Corporate obligations 4,716,660 (87,389) 948,837 (38,276) 5,665,497 (125,665) Corporate private-labeled mortgage-backed securities (including collateralized mortgage obligations) 345,748 (6,457) 12,782 (502) 358,530 (6,959) Redeemable preferred stock -- -- 96 (5) 96 (5) Affiliated bonds 91,018 (982) 12,595 (540) 103,613 (1,522) ---------- -------- ---------- -------- ---------- --------- Total temporarily impaired securities $5,270,976 $(96,577) $1,095,969 $(43,755) $6,366,945 $(140,332) ========== ======== ========== ======== ========== =========
F-22 3. INVESTMENTS--CONTINUED One statistic to which the Company pays particular attention with respect to debt securities is the fair value to amortized cost ratio. Securities with a fair value to amortized cost ratio in the 90%-99% range are typically securities that have been impacted by increases in market interest rates or sector spreads. Securities in the 80%-89% range are typically securities that have been impacted by increased market yields, specific credit concerns or both. These securities are monitored to ensure that the impairment is not other-than-temporary. Securities with a fair value to amortized cost ratio less than 80% are considered to be "potentially distressed securities," and are subjected to rigorous review. The following factors are considered: the length of time a security's fair value has been below amortized cost, industry factors or conditions related to a geographic area that are negatively affecting the security, downgrades by rating agencies, the valuation of assets specifically pledged to support the credit, the overall financial condition of the insurer, past due interest or principal payments, and the Company's intent and ability to hold the security for a sufficient time to allow for recovery in value. The table below summarizes the securities with unrealized losses in the Company's debt portfolio as of December 31, 2006: AMORTIZED UNREALIZED COST FAIR VALUE LOSSES PERCENTAGE ---------- ---------- ---------- ---------- 90% - 99% $2,671,563 $2,647,612 $(23,951) 78% 80% - 89% 49,781 43,220 (6,561) 22 Below 80% 2 -- (2) -- ---------- ---------- -------- --- $2,721,346 $2,690,832 $(30,514) 100% ========== ========== ======== === As of December 31, 2006, the Company had one security that was "potentially distressed." 4. DERIVATIVE FINANCIAL INSTRUMENTS The fair values of the Company's derivative instruments were $190,140 and $111,550 at December 31, 2006 and 2005 and are included in other investments in the consolidated balance sheets. At December 31, 2006 and 2005, the Company had no fair value hedges or hedges of net investments in foreign operations. CASH FLOW HEDGING STRATEGY The Company uses interest rate swaps to convert floating rate investments to fixed rate investments. Interest is exchanged periodically on the notional value, with the Company receiving the fixed rate and paying various short-term LIBOR rates on a net exchange basis. For the periods ended April 3, 2006 through December 31, 2006 and January 1, 2006 through April 2, 2006, and for the years ended December 31, 2005 and 2004, the ineffective portion of the Company's cash flow hedging instruments, which is recognized in realized investment gains, was not significant. At December 31, 2006 and 2005, the maximum term of interest rate swaps that hedge floating rate investments was 20 years. The Company also converts its floating rate funding agreements to a fixed rate using interest rate swaps. Concurrent with the issuance of its floating rate funding agreements in June 2005, the Company executed an interest rate swap for a notional amount equal to the proceeds of the funding agreements. The swap qualifies for cash flow hedge accounting treatment and converts the variable rate of the funding agreements to a fixed rate of 4.28%. The Company recognized other comprehensive income related to cash flow hedges, net of taxes, of $(498) from April 3 through December 31, 2006, $1,116 from January 1 through April 2, 2006, and $(222) and $(1,426) for the years ended December 31, 2005 and 2004. The Company does not expect to reclassify a significant amount of net gains (losses) on derivative instruments from accumulated other comprehensive income to earnings during 2007. Certain swaps serve as economic hedges but do not qualify for hedge accounting under SFAS 133. These swaps are marked-to-market through realized gains. The Company realized investment gains (losses) from F-23 4. DERIVATIVE FINANCIAL INSTRUMENTS--CONTINUED these swaps of $386 from April 3 through December 31, 2006, $(198) from January 1 through April 2, 2006, and $(317) and $(382) for the years ended December 31, 2005 and 2004. The Company recognized gains (losses) of $0 from April 3 through December 31, 2006, $(321) from January 1 through April 2, 2006, and $205 and $362 for the years ended December 31, 2005 and 2004, as a result of the sale of securities purchased through the use of cash flow hedges. OTHER DERIVATIVES The Company markets indexed annuities. These 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(R) index. Policyholders may elect to rebalance index options at renewal dates, either annually or biannually. At each renewal date, the Company has the opportunity to re-price the equity-indexed component by establishing participation rates, subject to minimum guarantees. The Company purchases options that are highly correlated to the portfolio allocation decisions of its policyholders, such that the Company is economically hedged with respect to equity returns for the current reset period. The mark-to-market of the options held impacts net investment income and interest credited in equal and offsetting amounts. SFAS 133 requires that the Company calculates fair values of index options they will purchase in the future to hedge policyholder index allocations in future reset periods. These fair values represent an estimate of the cost of the options the Company will purchase in the future, discounted back to the date of the balance sheet, using current market indicators of volatility and interest rates. Changes in the fair values of these liabilities are reported in interest credited. Interest credited was decreased by $59,268, $22,700, $17,586 and $20,510 for the periods April 3, 2006 through December 31, 2006 and January 1, 2006 through April 2, 2006 and in 2005 and 2004 for the changes in fair value of these liabilities. In 2006 the Company invested in debt securities with embedded options, which are considered to be derivative instruments under SFAS 133, resulting in realized investment gains of $96. In 2005 and 2004 these derivatives were marked-to-market through realized investment gains, but had an insignificant effect for these years. Counterparties to derivative instruments expose the Company to credit risk in the event of non-performance. The Company limits this exposure by diversifying among counterparties with high credit ratings. The Company's credit risk exposure on swaps is limited to the fair value of swap agreements that it has recorded as an asset. The Company does not expect any counterparty to fail to meet its obligation. F-24 5. DEFERRED POLICY ACQUISITION COSTS, VALUE OF BUSINESS ACQUIRED AND DEFERRED SALES INDUCEMENT ASSET DEFERRED POLICY ACQUISITION COSTS The following table rolls forward the Company's deferred policy acquisition costs asset for the periods April 3 through December 31, 2006, January 1 through April 2, 2006, and the years ended December 31, 2005 and 2004:
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, ------------------------ 2006 2006 2005 2004 ------------ ----------- ----------- ---------- Beginning balance $ 1,767,553 $1,671,492 $1,370,443 $1,205,748 Purchase accounting fair value adjustment (1,767,553) -- -- -- Cumulative effect of change in accounting principle -- -- -- (25,296) Deferral: Commissions 225,712 69,567 324,639 256,344 Other 93,733 24,607 81,089 65,770 ----------- ---------- ---------- ---------- 319,445 94,174 405,728 322,114 Amortization (8,966) (38,620) (162,403) (130,022) Adjustment related to realized losses (gains) on debt securities 87 289 (300) (1,260) Adjustment related to unrealized losses (gains) on securities available-for-sale (3,693) 40,218 58,024 (841) ----------- ---------- ---------- ---------- Ending balance $ 306,873 $1,767,553 $1,671,492 $1,370,443 =========== ========== ========== ==========
VALUE OF BUSINESS ACQUIRED The following table rolls forward the Company's value of business acquired asset for the periods April 3 through December 31, 2006, and January 1 through April 2, 2006:
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 THROUGH THROUGH DECEMBER 31, APRIL 2, 2006 2006 ------------ ----------- Beginning balance $ -- $-- Purchase accounting fair value adjustment 1,422,208 -- Adjustments: Deferral of commissions and accretion of interest 76,618 Amortization (101,935) -- Adjustment related to realized gains on debt securities (4,846) -- Adjustment related to unrealized gains on debt securities available-for-sale (28,644) -- ---------- --- Total adjustments (58,807) -- ---------- --- Ending balance $1,363,401 $-- ========== ===
Expected approximate amortization percentages relating to the value of business acquired for the next five years are as follows: 2007 10.4% 2008 8.8% 2009 8.2% 2010 7.5% 2011 7.1% F-25 5. DEFERRED POLICY ACQUISITION COSTS, VALUE OF BUSINESS ACQUIRED AND DEFERRED SALES INDUCEMENT ASSET--CONTINUED DEFERRED SALES INDUCEMENT ASSET The deferred sales inducement asset is included within other assets in the consolidated balance sheets. The following table rolls forward the Company's deferred sales inducement asset for the periods April 3 through December 31, 2006, January 1 through April 2, 2006 and the years ended December 31, 2005 and 2004:
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, ----------------- 2006 2006 2005 2004 ------------ ----------- ------- ------- Beginning balance $ 51,173 $49,208 $37,729 $ -- Purchase accounting fair value adjustment (51,173) -- -- -- Cumulative impact of adoption, including $25,296 reclassified from deferred policy acquisition costs -- -- -- 25,296 Additional amounts deferred 15,644 3,700 17,683 14,748 Amortization (668) (1,800) (6,154) (2,132) Adjustment related to realized losses (gains) on debt securities -- 65 (50) (183) -------- ------- ------- ------- Ending balance $ 14,976 $51,173 $49,208 $37,729 ======== ======= ======= =======
6. POLICY LIABILITIES INFORMATION INTEREST RATE ASSUMPTIONS The liability for future policy benefits associated with ordinary life insurance policies was determined using initial interest rate assumptions ranging from 2.0% to 11.5% and, when applicable, uniform grading over 20 to 30 years to ultimate rates ranging from 2.0% to 6.0%. Interest rate assumptions for weekly premium, monthly debit and term life insurance products generally fall within the same ranges as those pertaining to ordinary life insurance policies. Credited interest rates for universal life-type products ranged from 3.0% to 5.75% in 2006, 3.0% to 6.3% in 2005, and 3.0% to 6.5% in 2004. The average credited interest rates for universal life-type products were 4.2%, 4.3% and 4.7% for 2006, 2005, and 2004. For annuity products, credited interest rates generally ranged from 3.0% to 9.4% in 2006, 2.8% to 8.8% in 2005, and 3.0% to 8.0% in 2004. The average credited interest rates for annuity products including the SFAS 133 impact were 3.9%, 4.1% and 4.4% for 2006, 2005, and 2004. MORTALITY AND WITHDRAWAL ASSUMPTIONS Assumed mortality rates are generally based on experience multiples applied to select and ultimate tables commonly used in the industry. Withdrawal assumptions for individual life insurance policies are based on historical company experience and vary by issue age, type of coverage and policy duration. F-26 6. POLICY LIABILITIES INFORMATION--CONTINUED ACCIDENT AND HEALTH AND DISABILITY INSURANCE LIABILITIES ACTIVITY Activity in the liabilities for accident and health and disability benefits, including reserves for future policy benefits and unpaid claims and claim adjustment expenses, was as follows:
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, ----------------------- 2006 2006 2005 2004 ------------ ----------- ---------- ---------- Beginning Balance $ 111,737 $ 113,027 $ 118,591 $ 123,006 Less reinsurance recoverables 42,266 42,277 40,771 35,959 ---------- ---------- ---------- ---------- Net balance as of beginning of period 69,471 70,750 77,820 87,047 ---------- ---------- ---------- ---------- Amount incurred: Current year 6,159 5,216 7,081 7,386 Prior years (1,712) (3,122) (480) (2,007) ---------- ---------- ---------- ---------- 4,447 2,094 6,601 5,379 ---------- ---------- ---------- ---------- Less amount paid: Current year 644 199 1,189 333 Prior years 8,132 3,174 12,482 14,273 ---------- ---------- ---------- ---------- 8,776 3,373 13,671 14,606 ---------- ---------- ---------- ---------- Net balance as of end of period 65,142 69,471 70,750 77,820 Plus reinsurance recoverables 43,936 42,266 42,277 40,771 ---------- ---------- ---------- ---------- Balance as of end of period $ 109,078 $ 111,737 $ 113,027 $ 118,591 ========== ========== ========== ========== Balance as of end of period included with: Total future policy benefits $1,231,397 $1,255,767 $1,244,257 $1,273,249 Less: Other future policy benefits 1,123,751 1,145,467 1,132,729 1,156,365 ---------- ---------- ---------- ---------- A&H future policy benefits 107,646 110,300 111,528 116,884 ---------- ---------- ---------- ---------- Total policy and contract claims 41,981 58,442 46,425 37,644 Less: Other policy and contract claims 40,549 57,005 44,926 35,937 ---------- ---------- ---------- ---------- A&H policy and contract claims 1,432 1,437 1,499 1,707 ---------- ---------- ---------- ---------- Total A&H reserves $ 109,078 $ 111,737 $ 113,027 $ 118,591 ========== ========== ========== ==========
The Company uses estimates for determining its liability for accident and health and disability benefits, which are based on historical claim payment patterns and attempt to provide for the inherent variability in claim patterns and severity. Lower than anticipated claims resulted in favorable adjustments to the liabilities in each year. In 2005, claims incurred increased due to a reduction in valuation interest rates and revision of termination factors which offset the normal decline in claims incurred for this closed block of business. In 2006, incurred and paid amounts have declined due to this being a closed block of business. SOP 03-1 POLICY LIABILITIES At December 31, 2006 and 2005, the amount of SOP 03-1 policy liabilities included within other policy liabilities on the consolidated balance sheets were $142,476 and $88,587. F-27 6. POLICY LIABILITIES INFORMATION--CONTINUED FUNDING AGREEMENTS In June 2005, the Company established a program for an unconsolidated special purpose entity, Jefferson Pilot Life Funding Trust I (the Trust), to sell medium-term notes through investment banks to commercial investors. The notes are backed by funding agreements issued by the Company. The funding agreements are investment contracts that do not subject the Company to mortality or morbidity risk. The medium-term notes issued by the Trust are exposed to all the risks and rewards of owning the funding agreements that collateralize them. The funding agreements issued to the Trust are classified as a component of policy liabilities within the consolidated balance sheets. As spread products, funding agreements generate profit to the extent that the rate of return on the investments earned exceeds the interest credited and other expenses. The Company issued $300,000 of funding agreements in June 2005. The initial funding agreements were issued at a variable rate and provide for quarterly interest payments, indexed to the 3-month LIBOR plus 7 basis points, with principal due at maturity on June 2, 2008. Concurrent with this issuance, the Company executed an interest rate swap for a notional amount equal to the proceeds of the funding agreements. The swap qualifies for cash flow hedge accounting treatment and converts the variable rate of the funding agreements to a fixed rate of 4.28%. 7. STATUTORY FINANCIAL INFORMATION The Company prepares financial statements on the basis of SAP prescribed or permitted by the North Carolina Department of Insurance. Prescribed SAP includes the Accounting Practices and Procedures Manual of the National Association of Insurance Commissioners (NAIC) as well as state laws, regulations and administrative rules. Permitted SAP encompasses all accounting practices not so prescribed. The Company does not utilize any permitted practices in the preparation of its statutory financial statements. The principal differences between SAP and GAAP are (1) policy acquisition costs are expensed as incurred under SAP, but are deferred and amortized under GAAP, (2) the value of business acquired is not capitalized under SAP, but is under GAAP, (3) amounts collected from holders of universal life-type and annuity products are recognized as premiums when collected under SAP, but are initially recorded as contract deposits under GAAP, with cost of insurance recognized as revenue when assessed and other contract charges recognized over the periods for which services are provided, (4) the classification and carrying amounts of investments in certain securities are different, (5) the criteria for providing asset valuation allowances, and the methodologies used to determine the amounts thereof, (6) the timing of establishing certain reserves, and the methodologies used to determine the amounts thereof, and (7) certain assets are not admitted for purposes of determining surplus under SAP. Reported capital and surplus on a statutory basis at December 31, 2006 and 2005 was $772,868 and $867,421. Reported statutory net income (loss) for the years ended December 31, 2006, 2005, and 2004 was $(109,001), $89,986 and $93,599. Risk-Based Capital (RBC) requirements promulgated by the NAIC require life insurers to maintain minimum capitalization levels that are determined based on formulas incorporating credit risk, insurance risk, interest rate risk and general business risk. As of December 31, 2006, the Company and its subsidiary's adjusted capital and surplus exceeded their authorized control level RBC. Some states require life insurers to maintain a certain value of securities on deposit with the state in order to conduct business in that state. The Company had securities totaling $6,773 and $6,924 on deposit with various states in 2006 and 2005. F-28 7. STATUTORY FINANCIAL INFORMATION--CONTINUED The General Statues of North Carolina require the Company to maintain capital of $1,200 and minimum unassigned surplus of $300. Additionally, North Carolina limits the amount of dividends that the Company and its insurance subsidiary may pay annually without first obtaining regulatory approval. Generally, the limitations are based on a combination of statutory net gain from operations for the preceding year, 10% of statutory surplus at the end of the preceding year, and dividends and distributions made within the preceding twelve months. Depending on the timing of payments, the Company could pay approximately $76,787 in dividends to the Parent in 2007 without approval by North Carolina. 8. FEDERAL INCOME TAXES The Federal income tax expense (benefit) is as follows: PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 THROUGH THROUGH YEAR ENDED DECEMBER 31, DECEMBER 31, APRIL 2, ----------------------- 2006 2006 2005 2004 ------------ ----------- -------- -------- Current $ 8,572 $12,939 $ 63,307 $116,239 Deferred 85,645 1,833 48,565 (14,370) ------- ------- -------- -------- Total tax expense $94,217 $14,772 $111,872 $101,869 ======= ======= ======== ======== The effective tax rate on pre-tax income from continuing operations is lower than the prevailing corporate Federal income tax rate. A reconciliation of this difference is as follows:
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, ------------------- 2006 2006 2005 2004 ------------ ----------- -------- -------- Tax rate of 35% times pre-tax income $102,320 $25,919 $122,044 $111,243 Effect of: Tax-preferred investment income (4,995) (2,878) (5,363) (6,289) Release of prior year overaccrual -- (6,546) -- -- Tax credits (5,025) (1,642) (5,375) (3,055) Other items 1,917 (81) 566 (30) -------- ------- -------- -------- Provision for income taxes $ 94,217 $14,772 $111,872 $101,869 ======== ======= ======== ======== Effective tax rate 32.2% 19.9% 32.1% 32.1% ======== ======= ======== ========
The Federal income tax asset (liability) is as follows: YEAR ENDED DECEMBER 31, ----------------------- 2006 2005 --------- --------- Current $ (193) $ 2,786 Deferred (302,722) (183,773) --------- --------- Total federal income tax liability $(302,915) $(180,987) ========= ========= F-29 8. FEDERAL INCOME TAXES--CONTINUED Significant components of the Company's deferred tax assets and liabilities are as follows: DECEMBER 31, --------------------- 2006 2005 --------- --------- Deferred income tax assets: Differences in policy liabilities $ 229,410 $ 377,924 Deferred compensation 21,811 17,438 Net operating loss carryforward 21,220 -- Affordable housing tax credit carryforward 17,730 -- Other deferred tax assets 12,086 7,350 --------- --------- Total deferred tax assets 302,257 402,712 Deferred income tax liabilities: Deferral of policy acquisition costs (447,770) (467,086) Present value in force (21,128) -- Net unrealized gains on securities (44,645) (55,320) Deferred gain recognition for income tax purposes (14,262) (32,268) Differences in investment basis (639) (1,110) Depreciation differences (59,367) (19,164) Pension costs (7,862) (9,029) Other deferred tax liabilities (9,306) (2,508) --------- --------- Total deferred tax liabilities (604,979) (586,485) --------- --------- Net deferred income tax liabilities $(302,722) $(183,773) ========= ========= Prior to April 3, 2006, the Company and its affiliates were part of a consolidated Federal income tax filing with Jefferson-Pilot. Effective April 3, 2006, as a result of the merger with LNC, the Company's federal income tax return is no longer consolidated with the other members of the holding company group. Instead, the Company will file a separate federal income tax return. Cash paid (received) for income taxes in 2006, 2005, and 2004 was ($14.7) million, $72.7 million, and $35.8 million, respectively. The Company is required to establish a valuation allowance for any gross deferred tax assets that are unlikely to reduce taxes payable in future years' tax returns. At December 31, 2006 and 2005, the Company concluded that it was more likely than not that all gross deferred tax assets will reduce taxes payable in future years. Accordingly, no valuation allowance was necessary at December 31, 2006 or 2005. Under prior Federal income tax law, one-half of the excess of a life insurance company's income from operations over its taxable investment income was not taxed, but was set aside in a special tax account designated as "Policyholders' Surplus." On October 23, 2004, President Bush signed into law the "American Jobs Creation Act of 2004." Beginning January 1, 2005 through December 31, 2006, the additional tax imposed on distributions from the special tax account, Policyholders' Surplus, is suspended. In addition, the statute provides that distributions made during the two-year suspension period will first reduce the Policyholders' Surplus account balance. The 2005 and 2006 dividend activity of the Company eliminated the account balance during the suspension period. The Jefferson-Pilot consolidated return group is subject to annual examinations from the Internal Revenue Service ("IRS"). The IRS has examined tax years 2000-2003, with assessments resulting in refunds that are not material to the consolidated results of operations. Jefferson-Pilot and its affiliates are currently under examination by the IRS for years 2004 and 2005. The Company does not anticipate that any adjustments which might result from such audits would be material to its consolidated results of operations or financial condition. F-30 9. RETIREMENT BENEFIT PLANS PENSIONS The Company's employees participate in the Parent's tax-qualified and nonqualified defined benefit pension plans, which provide benefits based on years of service and final average earnings. The tax-qualified plan is funded through group annuity contracts issued by the Company. The assets of the tax-qualified plan are those of the related contracts, and are primarily held in the separate accounts of the Company. The funding policy is to contribute annually no more than the maximum amount deductible for federal income tax purposes. The plans are administered by the Parent. Pension expense for all years presented was not significant. Additionally the Company sponsors a non-contributory defined benefit pension plan covering full-time agents. No participants are accruing defined benefits under the plan. All participants with a defined benefit are vested and are either in pay status or have a frozen accrued benefit. DEFINED BENEFIT PLAN Information regarding the Company's pension plans covering full-time agents is as follows:
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 THROUGH THROUGH YEAR ENDED DECEMBER 31, APRIL 2, DECEMBER 31, 2006 2006 2005 ------------ ----------- ------------ Change in projected benefit obligation: Projected benefit obligation at beginning of period $28,445 $28,067 $27,202 Interest cost 1,151 383 1,572 Actuarial loss 92 1,068 2,523 Benefits paid (2,144) (1,073) (3,230) ------- ------- ------- Projected benefit obligation at end of period 27,544 28,445 28,067 ======= ======= ======= Change in plan assets: Fair value of assets at beginning of period 39,570 39,485 40,630 Actual return on plan assets 3,763 1,418 1,871 Transfer in (out) and (expenses) 122 (260) 214 Benefits paid (2,144) (1,073) (3,230) ------- ------- ------- Fair value of assets at end of period 41,311 39,570 39,485 ======= ======= ======= Funded status of the plan 13,767 11,125 11,418 Unamortized prior service cost -- 15 16 Unrecognized net (gain) loss (1,786) 2,733 2,150 ------- ------- ------- Net amount recognized $11,981 $13,873 $13,584 ======= ======= ======= Amounts recognized consist of: Prepaid benefit cost $11,981 $13,873 $13,584 ======= ======= =======
The accumulated benefit obligation for the Company's defined benefit pension plan was $27,544 and $28,067 at December 31, 2006 and 2005. The Company uses a December 31 measurement date for its pension and post-retirement plans. Because no employees are accruing defined benefits under the pension plan, past service costs and unrecognized gains and losses are amortized over the average remaining life expectancy of plan participants. F-31 9. RETIREMENT BENEFIT PLANS--CONTINUED As discussed in Note 2, the Company applied the recognition provisions of SFAS 158 as of December 31, 2006. The incremental effect of applying SFAS 158 on the Company's Consolidated Balance Sheet at December 31, 2006 is as follows:
BEFORE AFTER APPLICATION SFAS 158 APPLICATION OF SFAS 158 ADJUSTMENTS OF SFAS 158 ----------- ----------- ----------- Other assets $ 278,531 $27,221 $ 305,752 Total assets 21,222,139 27,221 21,249,360 Accounts payable, accruals and other liabilities 897,869 17,349 915,218 Total liabilities 17,531,433 17,349 17,548,782 Accumulated other comprehensive income 61,024 9,872 70,896 Total stockholder's equity 3,690,706 9,872 3,700,578
COMPONENTS OF NET PERIODIC BENEFIT COST
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, ----------------- 2006 2006 2005 2004 ------------ ----------- ------- ------- Interest cost $ 1,151 $ 383 $ 1,572 $ 1,661 Expected return on plan assets (2,260) (757) (3,180) (3,331) Amortization of prior service cost -- -- 2 86 ------- ----- ------- ------- Net periodic benefit cost (benefit) $(1,109) $(374) $(1,606) $(1,584) ======= ===== ======= =======
ASSUMPTIONS
2006 2005 2004 ---- ---- ---- Weighted-average assumptions used to determine benefit obligations at December 31: Discount rate 5.75% 5.50% 6.00% Weighted-average assumptions used to determine net cost for years ended December 31: Discount rate, January 1 through April 2 5.50% N/A N/A Discount rate 5.69% 6.00% 6.25% Expected return on plan assets 8.00% 8.00% 8.00%
The assumption for long-term rate of return on assets is derived from historical returns on investments of the types in which pension assets are invested. A range of assumptions for long-term rate of return is projected for benchmarks representing each asset class. The upper and lower range limits are based on optimistic and pessimistic assumptions, respectively, and reflect historical returns that are adjusted to reflect factors that might cause future experience to differ from the past, differences between the benchmarks and the plan's assets, and the effects of asset smoothing. The adjusted rates of return are weighted by target allocations for each asset class to derive limits for a range of overall long-term gross rates of return. Within this range, one rate of return is selected as the best estimate. From that rate the Company subtracts an estimate of expenses, and the result is the basis for the assumed long-term rate of return on assets. The assumption for discount rate is based upon an evaluation of specific plan attributes using cash flow analysis. The weighted average duration of the projected cash flows for the plans was used to select an appropriate AA-rated bond interest rate for disclosure at year ends 2005 and 2006. Upon acquisition of the Company in April 2006, the discount rate assumption increased due to the secular increase in interest rates from year end 2005 through the date of acquisition. F-32 9. RETIREMENT BENEFIT PLANS--CONTINUED PLAN ASSETS The Company's pension plan weighted-average asset allocation by asset category was as follows based on fair value: DECEMBER 31, ------------ 2006 2005 ---- ---- Asset category Equity securities 75% 72% Debt securities 25 27 Other -- 1 --- --- Total 100% 100% === === The overall investment objective of the plan is to meet or exceed the actuarial assumptions. The plan is assumed to exist in perpetuity; therefore, the investment portfolio is managed to provide stable and growing income, as well as to achieve growth in principal equal to the rate of inflation. Allocation of plan assets is reviewed at least annually. Investment guidelines are: equity securities, a range of 35% to 75% of the total portfolio's value, with no more than 20% of the total equity exposure in non-U.S. equities; fixed income, a range of 25% to 65% of the total portfolio's value; cash, up to 5% of the portfolio's value. The portfolio may be invested in individual securities, mutual funds or co-mingled funds of various kinds. In order to achieve a prudent level of portfolio diversification, the securities of any one company or issuer, other than the U.S. Treasury, should not exceed 5% of the portfolio's value and no more than 20% of the fund should be invested in any one industry. Without specific written instructions from the Plan Administrator, the plan will not be invested in short sales of individual securities, put or call options on individual securities or commodities, or commodity futures. CONTRIBUTIONS The Company is not expected to make a contribution to the pension plan during 2007. BENEFIT PAYMENTS The expected benefit payments from the Company's pension plan for the years indicated are as follows: 2007 $ 3,136 2008 2,997 2009 2,880 2010 2,763 2011 2,635 2012 through 2016 11,040 OTHER POSTRETIREMENT BENEFITS The Parent sponsors contributory health care and life insurance benefit plans for eligible retired employees, qualifying retired agents and certain surviving spouses. The Company contributes to a welfare benefit trust from which future benefits will be paid. The Company accrues the cost of providing postretirement benefits other than pensions during the employees' active service period. Plan expense for all years presented was not significant. In accordance with FSP 106-2 "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003," the Company re-measured its plan assets and Accumulated Postretirement Benefit Obligation (APBO) as of July 1, 2004 to account for the subsidy and other effects of the Act, which resulted in an immaterial reduction in postretirement benefit cost. The reduction in the APBO for the subsidy related to past service was insignificant. F-33 9. RETIREMENT BENEFIT PLANS--CONTINUED DEFINED CONTRIBUTION PLANS Through May 31, 2006, the Company participated in Jefferson-Pilot's defined contribution retirement plan covering most employees and fulltime agents. The Company matched a portion of participant contributions and made profit sharing contributions to a fund that acquired and held Jefferson-Pilot shares through April 2, 2006 and as of April 3, 2006 those shares were converted to shares of the Parent's common stock and going forward shares of the Parent were acquired and held. Plan assets are invested in a trust and under a group variable annuity contract issued by the Company. Plan expense for all years presented was not significant. Effective June 1, 2006, the Jefferson-Pilot defined contribution retirement plan was merged into the LNC defined contribution retirement plan. The Company matches a portion of participant contributions. Plan assets are invested in a trust. 10. REINSURANCE The Company attempts to reduce its exposure to significant individual claims by reinsuring portions of certain individual life insurance policies and annuity contracts written. The Company reinsures a portion of individual life insurance risks in excess of its retention, which ranges from $400 to $2,100 for various individual life and annuity products. The Company also attempts to reduce exposure to losses that may result from unfavorable events or circumstances by reinsuring certain levels and types of accident and health insurance risks underwritten. Reinsurance contracts do not relieve an insurer from its primary obligation to policyholders. Therefore, the failure of a reinsurer to discharge its reinsurance obligations could result in a loss to the Company. The Company regularly evaluates the financial condition of its reinsurers and monitors concentrations of credit risk related to reinsurance activities. No credit losses have resulted from the Company's reinsurance activities for the periods April 3 through December 31, 2006, January 1 through April 2, 2006 and for the years ended December 31, 2005 and 2004. The effects of reinsurance on premiums and other considerations, universal life and investment product charges and total benefits were as follows:
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, ------------------- 2006 2006 2005 2004 ------------ ----------- -------- -------- Premiums and other considerations direct $ 84,920 $ 26,197 $118,353 $121,194 Premiums and other considerations assumed 27 7 (8) (8) Less premiums and other considerations ceded 5,668 778 15,419 16,102 -------- -------- -------- -------- Net premiums and other considerations $ 79,279 $ 25,426 $102,926 $105,084 ======== ======== ======== ======== Universal life and investment product charges, direct and assumed $393,232 $118,297 $441,894 $377,000 Less universal life and investment product charges ceded 94,341 23,704 78,655 72,330 -------- -------- -------- -------- Net universal life and investment product charges $298,891 $ 94,593 $363,239 $304,670 ======== ======== ======== ======== Benefits direct $752,376 $265,136 $908,226 $872,540 Benefits assumed 192 210 952 350 Less reinsurance recoveries 80,863 36,691 82,948 90,545 -------- -------- -------- -------- Net benefits $671,705 $228,655 $826,230 $782,345 ======== ======== ======== ========
F-34 11. OTHER COMPREHENSIVE INCOME The components of accumulated other comprehensive income, along with related tax effects, were as follows:
UNREALIZED GAINS ON DERIVATIVE ADJUSTMENT AVAILABLE- FINANCIAL TO INITIALLY FOR-SALE INSTRUMENTS APPLY SECURITIES GAINS/(LOSSES) SFAS 158 TOTAL ---------- -------------- ------------ --------- BALANCE AT JANUARY 1, 2004 $ 243,236 $ 707 $ -- $ 243,943 Unrealized holding losses arising during period, net of $568 tax benefit (1,058) -- -- (1,058) Change in fair value of derivatives, net of $768 tax benefit -- (1,426) -- (1,426) Less: reclassification adjustment Losses realized in net income, net of $5,775 tax benefit (10,726) -- -- (10,726) --------- ------- ------ --------- BALANCE AT DECEMBER 31, 2004 252,904 (719) -- 252,185 Unrealized holding losses arising during period, net of $84,860 tax benefit (157,596) -- -- (157,596) Change in fair value of derivatives, net of $120 tax benefit -- (222) -- (222) Less: reclassification adjustment Losses realized in net income, net of $4,508 tax benefit (8,371) -- -- (8,371) --------- ------- ------ --------- BALANCE AT DECEMBER 31, 2005 103,679 (941) -- 102,738 Unrealized holding losses arising during period, net of $90,373 tax benefit (167,835) -- -- (167,835) Change in fair value of derivatives, net of $600 tax benefit -- 1,116 -- 1,116 Less: reclassification adjustment Losses realized in net income, net of $1,302 tax benefit (2,419) -- -- (2,419) --------- ------- ------ --------- Balance at April 2, 2006 (61,737) 175 -- (61,562) Acquisition by Lincoln National Corporation: Purchase accounting elimination of AOCI 61,737 (175) -- 61,562 --------- ------- ------ --------- Balance at April 3, 2006 -- -- -- -- Unrealized holding gains arising during period, net of $33,808 tax benefit 62,787 -- -- 62,787 Change in fair value of derivatives, net of $273 tax benefit -- (498) -- (498) Less: Adjustment to initially apply SFAS 158 -- -- 9,872 9,872 Gains realized in net income, net of $681 tax 1,265 -- -- 1,265 --------- ------- ------ --------- BALANCE AT DECEMBER 31, 2006 $ 61,522 $ (498) $9,872 $ 70,896 ========= ======= ====== =========
F-35 12. TRANSACTIONS WITH AFFILIATED COMPANIES The Company has entered into service agreements with the Parent and other subsidiaries of the Parent for personnel and facilities usage, general management services and investment management services. The Company was reimbursed $199,010, $235,596 and $202,368 in 2006, 2005 and 2004, for general management and investment services provided by the Company, of which $45,885 and $24,911 remained receivable as of December 31, 2006 and 2005, related to these agreements. The Company also made various disbursements to its affiliates, of which $8,068 and $6,292 remained payable as of December 31, 2006 and 2005. These balances are included in other assets on the consolidated balance sheets. The Company owns no securities of the Parent or any affiliate of the Parent other than the following, reflected at the carrying amounts in the consolidated balance sheets as of December 31:
2006 2005 ------- ------- Lincoln Financial Media Company (affiliate) Senior Promissory Notes due 2005 through 2013, interest ranging from 4.2% to 7.7% $11,852 $16,246 Lincoln National Corporation (Parent) Senior Notes Series due 2008 interest 4.6% 92,000 92,000
The Company recognized interest income totaling $3,667 from April 3 through December 31, 2006, $1,317 from January 1 through April 2, 2006, and $5,117 and $5,601 for the years ended December 31, 2005 and 2004, related to the preceding assets. The Company has an agreement with its affiliate broker/dealer, Jefferson Pilot Variable Corporation (JPVC). The agreement calls for the Company to pay JPVC for sales of the Company's variable annuity contracts. The amount paid is based on sales during the period and contracts in force. The Company recorded expense of $11 from April 3 through December 31, 2006, $3 from January 1 through April 2, 2006, and $20 and $30 for the years ended December 31, 2005 and 2004, related to this agreement. During 1999, the Company paid an affiliate, Jefferson Pilot Financial Life Insurance Company (JPFIC) $100,000 in premiums for a company owned life insurance policy on certain of its employees. At December 31, 2006 and 2005, the cash surrender value of this policy totaled approximately $147,884 and $140,730. The Company paid dividends to the Parent of $2,200 from April 3 through December 31, 2006, $0 from January 1 through April 2, 2006, and $89,000 and $10,000 for the years ended December 31, 2005 and 2004. 13. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying values and fair values of financial instruments as of December 31 were as follows:
2006 2005 ------------------------- ------------------------- CARRYING FAIR CARRYING FAIR VALUE VALUE VALUE VALUE ----------- ----------- ----------- ----------- FINANCIAL ASSETS Debt securities available-for-sale $13,243,588 $13,243,588 $11,340,518 $11,340,518 Debt securities held-to-maturity -- -- 1,325,157 1,378,716 Equity securities available-for-sale 549 549 427 427 Mortgage loans on real estate 2,376,014 2,421,664 2,417,618 2,553,161 Policy loans 279,686 305,635 258,362 289,140 Derivative financial instruments 190,594 190,594 111,550 111,550 FINANCIAL LIABILITIES Annuity contract liabilities in accumulation phase 6,935,423 6,149,237 7,001,788 6,295,549 Funding agreements 301,405 301,405 301,157 301,157 Securities sold under repurchase agreements -- -- 300,835 300,835
F-36 13. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS--CONTINUED The fair values of cash, cash equivalents, balances due on account from agents, reinsurers and others, and accounts payable approximate their carrying amounts in the consolidated balance sheets due to their short-term maturity or availability. Assets and liabilities related to separate accounts are reported at fair value in the consolidated balance sheets. The fair values of debt and equity securities and derivative financial instruments have been determined from nationally quoted market prices and by using values supplied by independent pricing services and discounted cash flow techniques. The fair value of the mortgage loan portfolio has been estimated by discounting expected future cash flows using the interest rate currently offered for similar loans. The fair value of policy loans outstanding for traditional life products has been estimated using a current risk-free interest rate applied to expected future loan repayments projected based on historical repayment patterns. The fair values of policy loans on universal life-type and annuity products approximate carrying values due to the variable interest rates charged on those loans. Annuity contracts do not generally have defined maturities. Therefore, fair values of the liabilities under annuity contracts, the carrying amounts of which are included with policyholder contract deposits in the consolidated balance sheets, are estimated to equal the cash surrender values of the contracts. The fair value of the funding agreements approximates the carrying value since interest is based on a variable rate. The above carrying and fair value amounts at December 31, 2006 include $1,405 in accrued interest. The fair value of the liability for securities sold under repurchase agreements approximates its carrying amount, which includes accrued interest. 14. COMMITMENTS AND CONTINGENT LIABILITIES The Company routinely enters into commitments to extend credit in the form of mortgage loans and to purchase certain debt securities for its investment portfolio in private placement transactions. The fair value of outstanding commitments to fund mortgage loans and to acquire debt securities in private placement transactions, which are not reflected in the Company's consolidated balance sheets, approximated $203,570 as of December 31, 2006. The Company leases electronic data processing equipment and field office space under noncancelable operating lease agreements. The lease terms generally range from one to seven years. Neither annual rent nor future rental commitments are significant. In the normal course of business, the Company and its subsidiary are parties to various lawsuits. Because of the considerable uncertainties that exist, the Company cannot predict the outcome of pending or future litigation. However, management believes that the resolution of pending legal proceedings will not have a material adverse effect on the Company's financial position or liquidity, although it could have a material adverse effect on the results of operations for a specific period. F-37 15. SEGMENT INFORMATION The Company's reporting segments reflect the current manner by which its chief operating decision makers view and manage the business. All segment data for reporting periods have been adjusted to reflect the current segment reporting. The Company provides products and services in two operating businesses: (1) Individual Markets and (2) Employer Markets and report results through four business segments. The following is a brief description of these segments. INDIVIDUAL MARKETS. The Individual Markets business provides its products through two segments, Individual Annuities and Individual Life Insurance. Through its Individual Annuities segment, Individual Markets provides tax-deferred investment growth and lifetime income opportunities for its clients by offering individual fixed annuities, including indexed annuities, and variable annuities. The Individual Life Insurance segment offers wealth protection and transfer opportunities through both single and survivorship versions of universal life, variable universal life, interest-sensitive whole life, term insurance, as well as a linked-benefit product, which is a universal life insurance policy linked with riders that provide for long-term care costs. EMPLOYER MARKETS. The Employer Markets business provides its products through two segments, Retirement Products and Group Protection, formerly referred to as Benefit Partners. Through its Retirement Products segment, Employer Markets provides employer-sponsored corporate/bank owned life insurance. The Group Protection segment offers group non-medical insurance products, principally term life, disability and dental, to the employer marketplace through various forms of contributory and noncontributory plans. Most of the Company's group contracts are sold to employers with fewer than 500 employees. The Company also has "Other Operations", which includes the financial data for operations that are not directly related to the business segments, unallocated items (such as corporate investment income on assets not allocated to its business units, interest expense on short-term and long-term borrowings, and certain expenses, including restructuring and merger-related expenses). Segment operating revenue and income (loss) from operations are internal measures used by the Company's management and Board of Directors to evaluate and assess the results of its segments. Operating revenue is GAAP revenue excluding realized gains and losses on investments. Income (loss) from operations is GAAP net income excluding net realized investment gains and losses. The Company's management and Board of Directors believe that operating revenue and income (loss) from operations explain the results of its ongoing businesses in a manner that allows for a better understanding of the underlying trends in the Company's current businesses because net realized investment gains and losses 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. Operating revenue and income (loss) from operations do not replace revenues and net income as the GAAP measure of the Company' consolidated results of operations. F-38 15. SEGMENT INFORMATION--CONTINUED The following tables show financial data by segment:
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, ----------------------- 2006 2006 2005 2004 ------------ ----------- ---------- ---------- REVENUE: Segment Operating Revenue: Individual Markets: Individual Annuities $ 384,340 $134,073 $ 453,326 $ 440,099 Life Insurance 624,443 197,345 767,528 691,642 ---------- -------- ---------- ---------- Individual Markets Total 1,008,783 331,418 1,220,854 1,131,741 ---------- -------- ---------- ---------- Employer Markets: Retirement Products 77,804 25,935 103,581 106,806 Group Protection 8,089 3,069 9,919 11,774 ---------- -------- ---------- ---------- Employer Markets Total 85,893 29,004 113,500 118,580 ---------- -------- ---------- ---------- Other Operations 43,752 13,117 67,111 66,183 Net realized gain (loss) on investments (4,446) (4,046) (4,529) (12,218) ---------- -------- ---------- ---------- Total $1,133,982 $369,493 $1,396,936 $1,304,286 ========== ======== ========== ========== NET INCOME: Segment Operating Income: Individual Markets: Individual Annuities $ 45,787 $ 16,640 $ 56,758 $ 53,464 Life Insurance 122,583 32,792 136,346 124,656 ---------- -------- ---------- ---------- Individual Markets Total 168,370 49,432 193,104 178,120 ---------- -------- ---------- ---------- Employer Markets: Retirement Products 12,549 3,675 12,090 11,256 Group Protection 3,241 1,322 2,995 5,143 ---------- -------- ---------- ---------- Employer Markets Total 15,790 4,997 15,085 16,399 ---------- -------- ---------- ---------- Other Operations 16,857 7,481 31,579 29,389 Cumulative effect of change -- -- -- (9,356) Net realized gain (loss) on investments (2,890) (2,630) (2,944) (7,942) ---------- -------- ---------- ---------- NET INCOME $ 198,127 $ 59,280 $ 236,824 $ 206,610 ========== ======== ========== ==========
DECEMBER 31, ------------------------- 2006 2005 ----------- ----------- ASSETS: Individual Markets: Individual Annuities $ 8,612,968 $ 8,068,493 Life Insurance 9,146,659 9,126,790 Employer Markets: Retirement Products 1,683,445 1,660,498 Group Protection 134,449 150,219 Other Operations 1,671,839 (328,703) ----------- ----------- Total $21,249,360 $18,677,297 =========== =========== F-39 16. STOCK-BASED COMPENSATION The Company's employees are included in LNC's various incentive plans that provide for the issuance of stock options, stock incentive awards, stock appreciation rights ("SARs"), restricted stock awards, restricted stock units ("performance shares"), and deferred stock units. LNC has a policy of issuing new shares to satisfy option exercises. LNC issues share-based compensation awards under an authorized plan, subject to specific vesting conditions. Generally, compensation expense is recognized ratably over a three-year vesting period, but recognition may be accelerated upon the occurrence of certain events. For awards that specify an employee will vest upon retirement and an employee is eligible to retire before the end of the normal vesting period, the Company would record compensation expense over the period from the grant date to the date of retirement eligibility. On January 1, 2006, the Company adopted SFAS 123(R) under the modified prospective method. Accordingly, prior period amounts have not been restated. Under the modified prospective method, the fair value of all employee stock options vesting on or after the adoption date is generally included in the determination of net income as the options vest. The fair value of stock options granted has been estimated using the Black Scholes option valuation model considering assumptions for dividend yield, expected volatility, risk-free interest rate and expected life of the option. The fair value of the option grants is amortized on a straight-line basis over the implicit service period of the employee, considering retirement eligibility. For those employees that will achieve retirement eligibility during the vesting period, the expense is recognized evenly up through the retirement eligibility date or immediately upon grant for participants already eligible for retirement. Total stock-based compensation expense allocated to the Company for the period April 3 through December 31, 2006 was $4,418 related to the various LNC stock incentive plans. Total stock-based compensation expense allocated to the Company for the period January 1 through April 2, 2006 was $6,312. The compensation cost is included in the general and administrative expenses, net of deferrals, line item on the Company's consolidated statements of income. Excluding the option grants made in February 2006, outstanding options to acquire Jefferson-Pilot common stock that existed immediately prior to the date of the merger remain subject to the same terms and conditions that existed, except that each of these stock options is now exercisable for LNC common stock. Grants of Jefferson-Pilot stock options in February 2006 will generally continue to vest in one-third annual increments. All employee and director stock options outstanding as of December 31, 2005 vested and became exercisable upon closing the merger resulting in an expense of $3,401 on April 2, 2006. F-40 AUDITED CONSOLIDATED FINANCIAL STATEMENTS Jefferson Pilot Financial Insurance Company and Subsidiary As of December 31, 2006 and 2005, and for the Periods April 3 Through December 31, 2006 and January 1 Through April 2, 2006 and for the Years Ended December 31, 2005 and 2004 JEFFERSON PILOT FINANCIAL INSURANCE COMPANY AND SUBSIDIARY AUDITED CONSOLIDATED FINANCIAL STATEMENTS AS OF DECEMBER 31, 2006 AND 2005, AND FOR THE PERIODS APRIL 3 THROUGH DECEMBER 31, 2006 AND JANUARY 1 THROUGH APRIL 2, 2006 AND FOR THE YEARS ENDED DECEMBER 31, 2005 AND 2004 CONTENTS Report of Independent Registered Public Accounting Firm F-1 Audited Consolidated Financial Statements Consolidated Balance Sheets as of December 31, 2006 and 2005 F-2 Consolidated Statements of Income for the periods April 3 through December 31, 2006, and January 1 through April 2, 2006 and the years ended December 31, 2005 and 2004 F-4 Consolidated Statements of Stockholder's Equity for the periods April 3 through December 31, 2006 and January 1 through April 2, 2006 and for the years ended December 31, 2005 and 2004 F-5 Consolidated Statements of Cash Flows for the periods April 3 through December 31, 2006 and January 1 through April 2, 2006 and for the years ended December 31, 2005 and 2004 F-6 Notes to Consolidated Financial Statements F-7 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors Jefferson Pilot Financial Insurance Company and Subsidiary We have audited the accompanying consolidated balance sheets of Jefferson Pilot Financial Insurance Company (a wholly owned subsidiary of Jefferson-Pilot Corporation) and Subsidiary as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholder's equity, and cash flows for each of the periods April 3 through December 31, 2006, and January 1 through April 2, 2006, and for the years ended December 31, 2005 and 2004. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company's internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Jefferson Pilot Financial Insurance Company and Subsidiary at December 31, 2006 and 2005, and the consolidated results of their operations and their cash flows for each of the periods April 3 through December 31, 2006, and January 1 through April 2, 2006, and for the years ended December 31, 2005 and 2004, in conformity with U.S. generally accepted accounting principles. /s/ Ernst & Young LLP Greensboro, North Carolina April 23, 2007 F-1 JEFFERSON PILOT FINANCIAL INSURANCE COMPANY AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AMOUNTS) DECEMBER 31, ------------------------- 2006 2005 ----------- ----------- ASSETS Investments: Securities available-for-sale: Debt securities, at fair value (amortized cost $9,526,755 and $8,847,627) $ 9,613,191 $ 9,046,904 Equity securities, at fair value (cost $13,013 and $6,859) 14,730 10,323 Debt securities held-to-maturity, at amortized cost (fair value $0 and $724,370) -- 688,480 Mortgage loans on real estate 1,397,198 1,526,925 Policy loans 577,264 574,808 Real estate 67,889 32,302 Other investments 15,990 9,130 ----------- ----------- Total investments 11,686,262 11,888,872 Cash and cash equivalents 94,499 18,551 Accrued investment income 150,111 150,409 Due from reinsurers 990,459 1,164,864 Currently recoverable income taxes 7,906 7,874 Deferred policy acquisition costs 88,666 674,858 Value of business acquired 990,870 476,277 Goodwill 1,236,859 269,952 Property and equipment, net 44,031 33,409 Other assets 69,224 149,398 Assets held in separate accounts 2,167,375 1,975,863 ----------- ----------- Total assets $17,526,262 $16,810,327 =========== =========== See accompanying Notes to the Consolidated Financial Statements. F-2 DECEMBER 31, ------------------------- 2006 2005 ----------- ----------- LIABILITIES Policy liabilities: Future policy benefits $ 1,860,471 $ 1,909,441 Policyholder contract deposits 8,683,104 9,229,051 Policy and contract claims 166,288 176,282 Other 401,665 485,989 ----------- ----------- Total policy liabilities 11,111,528 11,800,763 Deferred income tax liabilities 284,226 213,007 Payable to affiliates 71,820 72,235 Accrued expenses and other liabilities 339,763 234,438 Liabilities related to separate accounts 2,167,375 1,975,863 ----------- ----------- Total liabilities 13,974,712 14,296,306 Commitments and contingent liabilities (see Note 14) STOCKHOLDER'S EQUITY Common stock, par value $5 per share, 600,000 shares authorized, issued and outstanding 3,000 3,000 Paid in capital 3,499,893 1,769,440 Retained earnings 3,660 665,299 Accumulated other comprehensive income 44,997 76,282 ----------- ----------- Total stockholder's equity 3,551,550 2,514,021 ----------- ----------- Total liabilities and stockholder's equity $17,526,262 $16,810,327 =========== =========== See accompanying Notes to the Consolidated Financial Statements. F-3 CONSOLIDATED STATEMENTS OF INCOME (IN THOUSANDS)
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 THROUGH THROUGH YEAR ENDED DECEMBER 31, DECEMBER 31, APRIL 2, ------------------------- 2006 2006 2005 2004 ------------ ----------- ----------- ----------- REVENUE Premiums and other considerations, net $1,015,959 $340,770 $1,260,259 $1,198,086 Universal life and investment product charges 299,564 102,849 428,417 422,021 Net investment income 514,256 178,006 728,487 742,382 Realized investment gains (losses) 497 (3,086) (6,266) (37,337) ---------- -------- ---------- ---------- Total revenues 1,830,276 618,539 2,410,897 2,325,152 BENEFITS AND EXPENSES Insurance and annuity benefits 1,146,908 386,367 1,506,418 1,506,099 Insurance commissions, net of deferrals 117,289 38,310 142,871 135,215 General and administrative expenses, net of deferrals 117,582 31,216 110,491 107,069 Insurance taxes, licenses and fees 35,971 14,158 49,271 42,365 Amortization of policy acquisition costs and value of business acquired 69,359 40,575 155,632 157,406 Interest expense 3,799 1,235 4,880 5,273 ---------- -------- ---------- ---------- Total benefits and expenses 1,490,908 511,861 1,969,563 1,953,427 ---------- -------- ---------- ---------- Income before income taxes and cumulative effect of change in accounting principle 339,368 106,678 441,334 371,725 INCOME TAXES: Current 87,787 44,558 113,282 27,701 Deferred 31,121 (2,531) 38,590 96,059 ---------- -------- ---------- ---------- Total income taxes 118,908 42,027 151,872 123,760 ---------- -------- ---------- ---------- Income before cumulative effect of change in accounting principle 220,460 64,651 289,462 247,965 Cumulative effect of change in accounting for long duration contracts, net of taxes -- -- -- (7,233) ---------- -------- ---------- ---------- Net income $ 220,460 $ 64,651 $ 289,462 $ 240,732 ========== ======== ========== ==========
See accompanying Notes to the Consolidated Financial Statements F-4 CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY (IN THOUSANDS)
TOTAL COMMON PAID IN RETAINED ACCUMULATED OTHER STOCKHOLDER'S STOCK CAPITAL EARNINGS COMPREHENSIVE INCOME EQUITY -------- ----------- --------- -------------------- ------------- BALANCE, JANUARY 1, 2004 $ 3,000 $ 1,714,440 $ 538,105 $ 158,421 $ 2,413,966 Net income -- -- 240,732 -- 240,732 Change in fair value of derivative financial instruments, net of taxes -- -- -- (1,823) (1,823) Unrealized gain on available-for-sale securities, net of taxes -- -- -- 2,751 2,751 ----------- Comprehensive income 241,660 Parent Company capital contribution -- 55,000 -- -- 55,000 Dividends paid -- -- (192,000) -- (192,000) ------------------------------------------------------------------------- BALANCE, DECEMBER 31, 2004 3,000 1,769,440 586,837 159,349 2,518,626 ========================================================================= Net income -- -- 289,462 -- 289,462 Change in fair value of derivative financial instruments, net of taxes -- -- -- (2,589) (2,589) Unrealized loss on available-for-sale securities, net of taxes -- -- -- (80,478) (80,478) ----------- Comprehensive income 206,395 Dividends paid -- (211,000) -- (211,000) ------------------------------------------------------------------------- BALANCE, DECEMBER 31, 2005 3,000 1,769,440 665,299 76,282 2,514,021 ========================================================================= Net income -- -- 64,651 -- 64,651 Parent company capital contribution for stock option expense -- 4,107 -- -- 4,107 Change in fair value of derivative financial instruments, net of taxes -- -- -- (1,099) (1,099) Unrealized loss on available-for-sale securities, net of taxes -- -- -- (70,503) (70,503) ----------- Comprehensive loss (2,844) Dividends paid -- -- (75,000) -- (75,000) ------------------------------------------------------------------------- BALANCE, APRIL 2, 2006 3,000 1,773,547 654,950 4,680 2,436,177 ========================================================================= Acquisition by Lincoln National Corporation: Sale of stockholder's equity (3,000) (1,773,547) (654,950) (4,680) (2,436,177) Lincoln National Corporation purchase price 3,000 3,499,893 -- -- 3,502,893 ------------------------------------------------------------------------- BALANCE, APRIL 3, 2006 3,000 3,499,893 -- -- 3,502,893 ========================================================================= Net income -- -- 220,460 -- 220,460 Change in fair value of derivative financial instruments, net of taxes -- -- -- 356 356 Unrealized gain on available-for-sale securities, net of taxes -- -- -- 44,641 44,641 ----------- Comprehensive income 265,457 Dividends paid -- -- (216,800) -- (216,800) ------------------------------------------------------------------------- BALANCE, DECEMBER 31, 2006 $ 3,000 $ 3,499,893 $ 3,660 $ 44,997 $ 3,551,550 =========================================================================
See accompanying Notes to the Consolidated Financial Statements. F-5 CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, ------------------------- 2006 2006 2005 2004 ------------ ----------- ----------- ----------- OPERATING ACTIVITIES Net income $ 220,460 $ 64,651 $ 289,462 $ 240,732 Adjustments to reconcile net income to net cash provided by operating activities: Change in policy liabilities other than deposits 67,904 (349) 43,926 156,380 Deductions from policyholder accounts, net (50,422) (18,641) (62,241) (46,100) Deferral of policy acquisition costs and sales inducements, net of amortization (89,340) (6,203) (15,205) (28,235) Change in receivables and asset accruals 20,633 13,052 (4,116) (3,407) Change in payables and expense accruals (2,503) 57,549 17,523 105,520 Realized investment losses (gains) (497) 3,086 6,266 37,337 Depreciation and amortization 20,739 2,033 7,333 1,165 Amortization (accretion) and additions to value of business acquired, net 42,222 11,540 51,697 (2,847) Group coinsurance assumed -- -- -- 328,875 Stock compensation -- 4,107 -- -- Other (3,022) 26,858 25,157 (12,213) --------- --------- ----------- ----------- Net cash provided by operating activities 226,174 157,683 359,802 777,207 --------- --------- ----------- ----------- INVESTING ACTIVITIES Securities available-for-sale: Sales 286,558 59,090 890,460 930,264 Maturities, calls and redemptions 599,775 163,813 722,075 825,884 Purchases (949,836) (187,613) (1,647,073) (2,384,201) Securities held-to-maturity: Sales -- 86 536 19,397 Maturities, calls and redemptions -- 64,372 151,711 145,013 Purchases -- -- (73) (7,193) Repayments of mortgage loans 149,359 58,025 209,972 164,990 Mortgage loans originated (40,120) (8,262) (306,557) (228,043) Decrease (increase) in policy loans, net (1,345) (1,111) 10,575 1,851 Securities lending 83,599 -- -- -- Other investing activities, net (2,040) (13,901) (2,452) 16,891 --------- --------- ----------- ----------- Net cash provided by (used in) investing activities 125,950 134,499 29,174 (515,147) --------- --------- ----------- ----------- FINANCING ACTIVITIES Policyholder contract deposits 617,891 179,689 718,947 758,817 Withdrawals of policyholder contract deposits (798,439) (275,838) (920,815) (858,674) Net proceeds (payments) from securities sold under repurchase agreements (103) 242 245 (4,698) Cash dividends paid (216,800) (75,000) (211,000) (192,000) Capital contribution from parent -- -- -- 55,000 --------- --------- ----------- ----------- Net cash used in financing activities (397,451) (170,907) (412,623) (241,555) --------- --------- ----------- ----------- Net increase (decrease) in cash and cash equivalents (45,327) 121,275 (23,647) 20,505 Cash and cash equivalents, beginning 139,826 18,551 42,198 21,693 --------- --------- ----------- ----------- Cash and cash equivalents, ending $ 94,499 $ 139,826 $ 18,551 $ 42,198 ========= ========= =========== =========== SUPPLEMENTAL CASH FLOW INFORMATION Interest paid $ 2,868 $ 1,328 $ 4,427 $ 2,310 ========= ========= =========== ===========
See accompanying Notes to the Consolidated Financial Statements. F-6 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JEFFERSON PILOT FINANCIAL INSURANCE COMPANY AND SUBSIDIARY (DOLLAR AMOUNTS IN THOUSANDS) DECEMBER 31, 2006 1. NATURE OF OPERATIONS Prior to April 3, 2006, Jefferson Pilot Financial Insurance Company ("JPFIC") was wholly owned by Jefferson-Pilot Corporation ("Jefferson-Pilot"). JPFIC and its subsidiary, Jefferson Pilot LifeAmerica Insurance Company ("JPLA"), (collectively referred to as the "Company"), are principally engaged in the sale of individual life insurance products, annuity and investment products, and group non-medical products (primarily term life and disability). These products are marketed primarily through personal producing general agents throughout the United States. On April 3, 2006, Lincoln National Corporation ("LNC" or the "Parent") completed its merger with Jefferson-Pilot by acquiring 100% of the outstanding shares of Jefferson-Pilot in a transaction accounted for under the purchase method of accounting prescribed by Statement of Financial Accounting Standard ("SFAS") No.141, "Business Combinations" ("SFAS 141") and JPFIC became wholly-owned by LNC. JPFIC is expected to merge into Lincoln National Life Company, an Indiana domiciled affiliate on July 1, 2007. This transaction is dependent on the approval by the Indiana Department of Insurance. LNL is a subsidiary of LNC. SFAS 141 requires that the total purchase price be allocated to the assets acquired and liabilities assumed based on their fair values at the merger date. As of April 3, 2006, the associated fair values of JPFIC were "pushed down" to the Company's financial statements in accordance with push down accounting rules. The Company is in the process of finalizing its internal studies of the fair value of the net assets acquired including investments, value of business acquired (VOBA), intangible assets, and certain liabilities. As such, the preliminary fair values in the table below are subject to adjustment as additional information is obtained, which may result in adjustments to goodwill, which the Company does not expect to be material. The fair value of JPFIC's net assets assumed in the merger was $3.5 billion. Goodwill of $1.2 billion resulted from the excess of purchase price over the fair value of JPFIC's net assets. The parent paid a premium over the fair value of JPFIC's net assets for a number of potential strategic and financial benefits that are expected to be realized as a result of the merger including, but not limited to, the following: - Greater size and scale with improved earnings diversification and strong financial flexibility; - Broader, more balanced product portfolio; - Larger distribution organization; and - Value creation opportunities through expense savings and revenue enhancements across business units. The following table summarizes the preliminary fair values of the net assets acquired as of the acquisition date along with the adjustments that were made to the Company's Balance Sheet to get to the fair value of net assets:
PRELIMINARY FAIR VALUE FAIR VALUE ADJUSTMENTS(1) ------------ -------------- Investments $ 11,649,995 $ 101,994 Due from reinsurers 1,034,439 -- Deferred acquisition costs and value of business acquired 1,055,891 (166,959) Goodwill 1,236,859 966,907 Other assets 398,798 (43,083) Assets held in separate accounts 2,073,659 -- Policy liabilities (11,307,163) 234,716 Income tax liabilities (279,053) (59,635) Accounts payable, accruals and other liabilities (286,873) 29,098 Liabilities related to separate accounts (2,073,659) -- ------------ ---------- Total net assets acquired $ 3,502,893 $1,063,038 ============ ==========
(1) Premiums and discounts that resulted from recording the assets and liabilities at their respective fair values are being amortized and accreted using methods that approximate a constant effective yield over the expected life of the assets and liabilities. F-7 1. NATURE OF OPERATIONS--CONTINUED The goodwill resulting from the merger was allocated to the following segments: PRELIMINARY FAIR VALUE ----------- Individual Markets: Life Insurance $ 530,421 Annuities 425,464 ---------- Total Individual Markets 955,885 Employer Markets: Group Protection 280,974 ---------- Total Goodwill $1,236,859 ========== 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION The consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles ("GAAP"). The Company also submits financial statements to insurance industry regulatory authorities. Those financial statements are prepared on the basis of statutory accounting principles ("SAP"), as adopted by the Insurance Department of the states of Nebraska (JPFIC) and New Jersey (JPLA), and are significantly different from financial statements prepared in accordance with GAAP. See Note 7. PRINCIPLES OF CONSOLIDATION The consolidated financial statements presented herein include the accounts of JPFIC and JPLA. All material intercompany accounts and transactions have been eliminated. USE OF ESTIMATES The preparation of financial statements requires management to make estimates and assumptions affecting the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities as of the date of the financial statements, and the reported amounts of revenue and expenses for the reporting period. Those estimates are inherently subject to change and actual results could differ from those estimates. Included among the material (or potentially material) reported amounts and disclosures that require extensive use of estimates are: fair value of certain invested assets, asset valuation allowances, deferred policy acquisition costs, goodwill, value of business acquired, policy liabilities, unearned revenue, and the potential effects of resolving litigated matters. DEBT AND EQUITY SECURITIES Debt and equity securities are classified as either securities available-for-sale, which are stated at fair value with net unrealized gains and losses included in accumulated other comprehensive income, net of deferred income taxes and adjustments to deferred policy acquisition costs and value of business acquired or, in 2005, securities held-to-maturity, which are stated at amortized cost and consist of securities the Company has the positive intent and ability to hold to maturity. Fair value is based on quoted market prices from observable market data or estimated using an internal pricing matrix for privately placed securities when quoted market prices are not available. This matrix relies on management's judgment concerning: 1) the discount rate used in calculating expected future cash flows; 2) credit quality; 3) industry sector performance; and 4) expected maturity. Under certain circumstances, the Company applies professional judgment and makes adjustments based upon specific detailed information concerning the issuer. Dividend and investment income are recognized when earned. Amortization of premiums and accrual of discounts on investments in debt securities are reflected in earnings over the contractual terms of the investments in a manner that produces a constant effective yield. Investment securities are regularly reviewed for impairment based on criteria that include the extent to which cost exceeds market value, the duration of the market decline, and the financial health of and specific prospects for the issuer. Unrealized losses that are considered to be other-than-temporary are recognized in realized gains and losses. See Note 3 for further discussion of the Company's policies regarding identification of other-than-temporary impairments. Realized gains and losses on dispositions of securities are determined by the specific identification method. F-8 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--CONTINUED MORTGAGE AND POLICY LOANS Mortgage loans on real estate are stated at the unpaid balances adjusted for amortization of premiums and discounts, and are net of estimated unrecoverable amounts. An allowance for unrecoverable amounts is provided for when a mortgage loan becomes impaired. Changes in the allowance are reported as realized investment gains (losses) within the consolidated statements of income. Mortgage loans are considered impaired when it becomes probable the Company will be unable to collect the total amounts due, including principal and interest, according to the contractual terms of the loan. Such an impairment is measured based upon the present value of expected cash flows discounted at the effective interest rate on both a loan-by-loan basis and by measuring aggregated loans with similar risk characteristics. Interest on mortgage loans is recorded until collection is deemed improbable. Policy loans are stated at their unpaid balances. REAL ESTATE AND OTHER INVESTMENTS Real estate acquired by foreclosure is stated at the lower of depreciated cost or fair value less estimated costs to sell. Real estate not acquired by foreclosure is stated at cost less accumulated depreciation. Real estate, primarily buildings, is depreciated principally by the straight-line method over estimated useful lives generally ranging from 30 to 40 years. Accumulated depreciation was $1,237 and $31,590 at December 31, 2006 and 2005. Other investments, which consist primarily of affordable housing tax credit investments, are stated at equity, fair value, or the lower of cost or market as appropriate. Cost of real estate is adjusted for impairment whenever events or changes in circumstances indicate the carrying amount of the asset may not be recoverable. Impaired real estate is written down to estimated fair value with the impairment loss being included in realized gains and losses. Impairment losses are based upon the estimated fair value of real estate, which is generally computed using the present value of expected future cash flows from the real estate discounted at a rate commensurate with the underlying risks. DERIVATIVE FINANCIAL INSTRUMENTS The Company uses derivatives to help manage exposure to certain equity and interest rate risks. SFAS No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES, ("SFAS 133") requires companies to recognize all derivative instruments as either assets or liabilities in the balance sheet at fair value, which we classify within other investments on our consolidated balance sheets. The accounting for changes in the fair value (i.e., gains or losses) of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship. For those derivative instruments that are designated and qualify as hedging instruments, we designate the hedging instrument, based upon the exposure being hedged, as a fair value hedge or cash flow hedge. The Company accounts for changes in fair values of derivatives that are not part of a hedge or do not qualify for hedge accounting through investment income during the period of the change. For derivatives that are designated and qualify as cash flow hedges, the effective portion of the gain or loss realized on the derivative instrument is reported as a component of other comprehensive income and reclassified into earnings in the same period during which the hedged transaction impacts earnings. The remaining gain or loss on these derivative instruments is recognized in investment income during the period of the change. The effectiveness of the Company's hedge relationships is assessed and measured on a quarterly basis. CASH AND CASH EQUIVALENTS Cash and invested cash are carried at cost and include all highly liquid debt instruments purchased with a maturity of three months or less. REINSURANCE BALANCES AND TRANSACTIONS Reinsurance receivables include amounts related to paid benefits and estimated amounts related to unpaid policy and contract claims, future policy benefits and policyholder contract deposits. The cost of reinsurance is accounted for over the terms of the underlying reinsured policies using assumptions consistent with those used to account for the policies. F-9 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--CONTINUED DEFERRED POLICY ACQUISITION COSTS AND VALUE OF BUSINESS ACQUIRED Costs related to obtaining new and renewal business, including commissions and incentive compensation, certain costs of underwriting and issuing policies, and certain agency office expenses, all of which vary with and are primarily related to the production of new and renewal business, are deferred. The Company's traditional individual and group insurance products are long-duration contracts. Deferred policy acquisition costs related to these products are amortized over the expected premium paying periods using the same assumptions for anticipated premium revenue that are used to compute liabilities for future policy benefits. For fixed universal life and annuity products, these costs are amortized at a constant rate based on the present value of the estimated future gross profits to be realized over the terms of the contracts. Estimates of future gross profits are determined based upon assumptions for mortality, interest spreads, lapse rates, and policy fees earned. Value of business acquired represents the actuarially determined present value of anticipated profits to be realized from life insurance and annuity business acquired in business combinations, applying the same assumptions used to value the related liabilities. Amortization of the value of business acquired occurs over the related contract periods, using current crediting rates to accrete interest and a constant amortization rate based on the present value of expected future profits for fixed universal life and annuity products. Deferred policy acquisition costs and the value of business acquired for variable life and annuity products are amortized incorporating the assumptions listed above for fixed products, except for interest spreads, but also incorporating mean reversion techniques. In calculating the estimated gross profits for these products, the Company utilizes a long-term total net return on assets of 8.0%. The carrying amounts of deferred policy acquisition costs and value of business acquired are adjusted for the effect of credit and non-credit related realized gains and losses, and the effects of unrealized gains and losses on debt securities classified as available-for-sale. At least annually, the assumptions used to estimate future gross profits in calculating the amortization of deferred policy acquisition costs are evaluated in relation to emerging experience. When actual experience varies from the assumptions, adjustments are made in the quarter in which the evaluation of the respective blocks of business is completed. The effects of changes in estimated future gross profits on unamortized deferred policy acquisition costs, referred to as unlockings, are reflected in amortization expense within the consolidated statements of income. Deferred policy acquisition costs are periodically reviewed to determine that the unamortized portion does not exceed expected recoverable amounts. No significant impairments occurred during the three years ending December 31, 2006 DEFERRED SALES INDUCEMENTS The Company has policies in force containing two primary types of sales inducements: 1) day-one bonuses on fixed annuities, which are in the form of either an increased interest rate for a stated period or an additional premium credit; and 2) persistency-related interest crediting bonuses. These bonuses are accrued over the period in which the policy must remain in force for the policyholder to qualify for the inducement. Capitalized sales inducements are amortized using the same methodology and assumptions used to amortize deferred policy acquisition costs. The unamortized balance of the deferred sales inducement asset is reported in other assets within the consolidated balance sheets. GOODWILL Goodwill (purchase price in excess of net assets acquired in a business combination) carrying amounts are reviewed at least annually for indications of value impairment, with consideration given to financial performance and other relevant factors. In addition, certain events including a significant adverse change in legal factors or the business climate, an adverse action or assessment by a regulator, or unanticipated competition would cause the Company to review carrying amounts of goodwill for impairment. When considered impaired, the carrying amounts are written down using a combination of fair value and discounted cash flows. No impairments occurred during the three years ending December 31, 2006. F-10 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--CONTINUED SEPARATE ACCOUNTS Separate account assets and liabilities represent variable annuity and variable universal life funds segregated for the benefit of the related policyholders who bear the investment risk of their account balances. The separate account assets and liabilities, which are equal, are recorded at fair value. Policyholder account deposits and withdrawals, investment income and realized investment gains and losses in the separate accounts are excluded from the amounts reported in the consolidated statements of income. Fees charged on separate account policyholder account balances are included in universal life and investment product charges in the Consolidated Statements of Income. The amounts of minimum guarantees or other similar benefits related to these policies are negligible. PROPERTY AND EQUIPMENT Property and equipment is stated at cost and depreciated principally by the straight-line method over estimated useful lives of 30 to 50 years for buildings, approximately 10 years for other property and equipment, and three to five years for computer hardware and software. Accumulated depreciation was $605 and $42,743 at December 31, 2006 and 2005. Property and equipment is adjusted for impairment whenever events or changes in circumstances indicate the carrying amount of the asset may not be recoverable. In such cases, the cost basis of the property and equipment is reduced to fair value with the impairment loss being included in realized gains and losses. FUTURE POLICY BENEFITS AND OTHER POLICY LIABILITIES Liabilities for future policy benefits on traditional life and disability insurance are computed by the net level premium valuation method based on assumptions about future investment yield, mortality, morbidity and persistency. Estimates about future circumstances are based principally on historical experience and provide for possible adverse deviations. Liabilities related to no-lapse guarantees (secondary guarantees) on universal life-type products are included in other policy liabilities within the consolidated balance sheets. These liabilities are calculated by multiplying the benefit ratio (present value of total expected secondary guarantee benefits over the life of the contract divided by the present value of total expected assessments over the life of the contract). by the cumulative profits recorded from purchase date for pre-merger issues and from contract inception for post merger issues through the balance sheet date less the cumulative secondary guarantee benefit payments plus interest. If experience or assumption changes result in a new benefit ratio, the reserves are unlocked to reflect the changes in a manner similar to deferred policy acquisition costs and value of business acquired. The accounting for secondary guarantee benefits impacts, and is impacted by, estimated future gross profits used to calculate amortization of deferred policy acquisition costs, value of business acquired, deferred sales inducements, and unearned revenue. POLICYHOLDER CONTRACT DEPOSITS Policyholder contract deposits consist of policy values that accrue to holders of universal life-type contracts and annuities other than portions carried in the separate account, discussed above. The liability is determined using the retrospective deposit method and is presented before deduction of potential surrender charges. POLICY AND CONTRACT CLAIMS The liability for policy and contract claims consists of the estimated amount payable for claims reported but not yet settled and an estimate of claims incurred but not reported, which are based on historical experience adjusted for trends and circumstances. Management believes that the recorded liability is sufficient to provide for claims and the associated adjustment expenses incurred through the balance sheet date. F-11 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--CONTINUED RECOGNITION OF REVENUE Premiums on traditional life insurance products are reported as revenue when received unless received in advance of the due date. Premiums on traditional accident and health, disability income and dental insurance are reported as earned over the contract period. A reserve is provided for the portion of premiums written which relates to unexpired coverage terms. Revenue from universal life-type and annuity products includes charges for the cost of insurance, initiation and administration of the policy and surrender of the policy. Revenue from these charges is recognized in the year assessed to the policyholder, except that any portion of an assessment that relates to services to be provided in future years is deferred as unearned revenue and is recognized as income over the period during which services are provided based upon estimates of future gross profits. The net of amounts deferred and amounts recognized is reflected in universal life and investment product charges in the consolidated statements of income. The effects of changes in estimates of future gross profits, referred to as unlockings, on unearned revenue are reflected in the consolidated statements of income within universal life and investment product charges in the period such revisions occur. RECOGNITION OF BENEFITS AND EXPENSES Benefits and expenses, other than deferred policy acquisition costs, related to traditional life, accident and health, disability and dental insurance products are recognized when incurred in a manner designed to match them with related premiums and to spread income recognition over expected policy lives (see preceding discussion of policy liabilities). For universal life-type and annuity products, benefits include interest credited to policyholders' accounts, which is recognized as it accrues. STOCK BASED COMPENSATION The Company and its subsidiary are included in LNC's consolidated incentive compensation plans. The Company expenses its portion of the fair value of stock awards included in LNC's incentive compensation plans. On the date LNC's Board of Directors approves stock awards, the fair value of stock options is determined using a Black-Scholes options valuation methodology. The fair value of other stock awards is based upon the market value of the stock. The fair value of the awards is expensed over the service period, which generally corresponds to the vesting period, and is recognized as an increase to paid in capital in shareholder's equity. INCOME TAXES On April 3, 2006, the Company's initial parent company, Jefferson-Pilot, merged with and into a wholly owned acquisition subsidiary of LNC, a holding company with control over other insurance subsidiaries, as discussed in Note 1. As a result, LNC became the ultimate parent after completion of the merger. Prior to the merger, the Company's federal income tax return was consolidated with all companies, which were 80% or more owned by Jefferson-Pilot. Effective as of the merger date, the Company's federal income tax return is no longer consolidated with the other members of the holding company group. Instead the Company will file a separate federal income tax return. Deferred income taxes are recognized when assets and liabilities have different values for financial statement and tax reporting purposes. A valuation allowance is recorded to the extent required to reduce the deferred tax asset to an amount that the Company expects, more likely than not, will be realized. RECLASSIFICATIONS Certain amounts reported in prior years' consolidated financial statements have been reclassified to conform to the presentation adopted in the current year. These reclassifications had no effect on net income or shareholders' equity of the prior years. F-12 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--CONTINUED NEW ACCOUNTING PRONOUNCEMENTS SFAS NO, 157--FAIR VALUE MEASUREMENTS In September 2006, the Financial Accounting Standards Board ("FASB") issued SFAS No. 157, "Fair Value Measurements" ("SFAS 157"), which establishes a framework for measuring fair value under current accounting pronouncements that require or permit fair value measurement. SFAS 157 retains the exchange price notion, but clarifies that exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the most advantageous market for that asset or liability. Fair value measurement is based on assumptions used by market participants in pricing the asset or liability, which may include inherent risk, restrictions on the sale or use of an asset, or nonperformance risk which would include the reporting entity's own credit risk. SFAS 157 establishes a three-level fair value hierarchy, which prioritizes the inputs to valuation techniques used to measure fair value. The highest priority is given to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs in situations where there is little or no market activity for the asset or liability. In addition, SFAS 157 expands the disclosure requirements for annual and interim reporting to focus on the inputs used to measure fair value, including those measurements using significant unobservable inputs, and the effects of the measurements on earnings. SFAS 157 will be applied prospectively and is effective for fiscal years beginning after November 15, 2007. Retrospective application is required for certain financial instruments as a cumulative effect adjustment to the opening balance of retained earnings. The Company is currently evaluating the effects of SFAS 157 on its consolidated financial condition and results of operations. FIN 48--ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES In July 2006, the FASB issued FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109" ("FIN 48"). FIN 48 establishes criteria that an individual tax position must meet for any part of the benefit of the tax position to be recognized in the financial statements. These criteria include determining whether it is more-likely-than-not that a tax position will be sustained upon examination by the appropriate taxing authority. If the tax position meets the more-likely-than-not threshold, the position is measured as the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. If a tax position does not meet the more-likely-than-not recognition threshold, the benefit is not recognized in the financial statements. Upon adoption of FIN 48, the guidance will be applied to all tax positions, and only those tax positions meeting the more-likely-than-not threshold will be recognized or continue to be recognized in the financial statements. Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first subsequent financial reporting period in which that threshold is met. In addition, FIN 48 expands disclosure requirements to include additional information related to unrecognized tax benefits. FIN 48 is effective for fiscal years beginning after December 15, 2006. The cumulative effect of adjustment upon initial adoption of FIN 48 will be recorded as an adjustment to retained earnings with no impact on net income. The Company will adopt the provisions of FIN 48 on March 31, 2007, effective January 1, 2007. The adoption of FIN 48 is not expected to have a material effect on the Company's financial condition or results of operations. SFAS NO. 155--ACCOUNTING FOR CERTAIN HYBRID FINANCIAL INSTRUMENTS In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140" (SFAS 155), which permits fair value remeasurement for a hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. Under SFAS 155, an entity may make an irrevocable election to measure a hybrid financial instrument at fair value, in its entirety, with changes in fair value recognized in earnings. SFAS 155 also: (a) clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS 133; (b) eliminates the interim guidance in SFAS 133 Implementation Issue No. D1, "Application of Statement 133 to Beneficial Interests in Securitized Financial Assets," and establishes a requirement to evaluate beneficial interests in F-13 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--CONTINUED securitized financial assets to identify interests that are either freestanding derivatives or hybrid financial instruments that contain an embedded derivative requiring bifurcation; (c) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and (d) eliminates restrictions on a qualifying special-purpose entity's ability to hold passive derivative financial instruments that pertain to beneficial interests that are or contain a derivative financial instrument. In December 2006, the FASB issued Derivative Implementation Group Statement 133 Implementation Issue No. B40, "Embedded Derivatives: Application of Paragraph 13(b) to Securitized Interests in Prepayable Financial Assets" (DIG B40). Since SFAS 155 eliminated the interim guidance related to securitized financial assets, DIG B40 provides a narrow scope exception for securitized interests that contain only an embedded derivative related to prepayment risk. Under DIG B40, a securitized interest in prepayable financial assets would not be subject to bifurcation if: (a) the right to accelerate the settlement of the securitized interest cannot be controlled by the investor and (b) the securitized interest itself does not contain an embedded derivative for which bifurcation would be required other than an embedded derivative that results solely from the embedded call options in the underlying financial assets. Any other terms in the securitized financial asset that may affect cash flow in a manner similar to a derivative instrument would be subject to the requirements of paragraph 13(b) of SFAS 133. The guidance in DIG B40 is to be applied upon the adoption of SFAS 155. The Company will adopt the provisions SFAS 155 and DIG B40 on January 1, 2007, for all financial instruments acquired, issued, or subject to a remeasurement event occurring after that date. Prior period restatement is not permitted. The adoption of SFAS 155 is not expected to have a material impact on the Company's consolidated financial condition or results of operations. SFAS NO. 123R--SHARE-BASED PAYMENT In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123(R)"), which is a revision of SFAS 123, "Accounting for Stock-based Compensation" ("SFAS 123"). SFAS 123(R) requires recognition, at fair value, of all costs resulting from share-based payments to employees, except for equity instruments held by employee share ownership plans. Similar to SFAS 123, under SFAS 123(R) the fair value of share-based payments are recognized as a reduction to earnings over the period an employee is required to provide service in exchange for the award. Effective January 1, 2006, the Company adopted SFAS 123(R), using the modified prospective transition method. Under that transition method, compensation cost recognized in 2006 includes: (a) compensation cost for all share-based payments granted prior to but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). Results from prior periods have not been restated. The effect of adopting SFAS 123(R) did not have a material effect on the Company's results of operations. Prior to January 1, 2006, the Company accounted for stock incentive awards in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") and accordingly recognized no compensation expense for stock option awards to employees when the option price was not less than the market value of the stock at the date of award. See Note 16 for more information regarding stock-based compensation plans. The Company does not invest in significant amounts of nontraditional loan products and FSP 94-6-1 will not have an immediate impact on our disclosures. F-14 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--CONTINUED SOP 05-1--ACCOUNTING BY INSURANCE ENTERPRISES FOR DEFERRED ACQUISITION COSTS IN CONNECTION WITH MODIFICATIONS OR EXCHANGES OF INSURANCE CONTRACTS. In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position (SOP) 05-1, "Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts" (SOP 05-1). SOP 05-1 addresses the accounting for Deferred Acquisition Costs (DAC) on internal replacements other than those described in SFAS No. 97, "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments." An internal replacement is defined by SOP 05-1 as a modification in product benefits, features, rights or coverages that occurs by (a) exchanging the contract for a new contract, (b) amending, endorsing or attaching a rider to the contract, or (c) electing a feature or coverage within a replaced contract. Contract modifications that result in a substantially unchanged contract will be accounted for as a continuation of the replaced contract. Contract modifications that result in a substantially changed contract should be accounted for as an extinguishment of the replaced contract, and any unamortized DAC, unearned revenue and deferred sales charges must be written-off. SOP 05-1 is to be applied prospectively and is effective for internal replacements occurring in fiscal years beginning after December 15, 2006. The Company adopted this new accounting guidance effective January 1, 2007. The adoption of this new guidance impacts the Company's assumptions for lapsation used in the amortization of DAC and Value of Business Acquired ("VOBA"). The Company's adoption resulted in a $36.9 million decrease to DAC and VOBA balances and approximately an $11 million increase to amortization in 2007. FSP 115-1--THE MEANING OF OTHER-THAN-TEMPORARY IMPAIRMENT AND ITS APPLICATION TO CERTAIN INVESTMENTS In November 2005, the FASB issued FSP FAS 115-1 and FAS 124-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" ("FSP 115-1"). The guidance in FSP 115-1 nullifies the accounting and measurement provisions of Emerging Issues Task Force No. 03-1 - "The Meaning of Other Than Temporary Impairments and Its Application to Certain Investments" references existing guidance, and supersedes EITF Topic No. D-44 "Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value." FSP 115-1 was effective for reporting periods beginning after December 15, 2005, on a prospective basis. The Company's existing policy for recognizing other-than-temporary impairments is consistent with the guidance in FSP 115-1, and includes the recognition of other than temporary impairments of securities resulting from credit related issues as well as declines in fair value related to rising interest rates, where the Company does not have the intent to hold the securities until either maturity or recovery. The Company adopted FSP 115-1 effective January 1, 2006. The adoption of FSP 115-1 did not have a material effect on the Company's consolidated financial condition or results of operations. F-15 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--CONTINUED NEW ACCOUNTING PRONOUNCEMENTS THE FAIR VALUE OPTION FOR FINANCIAL ASSETS AND FINANCIAL LIABILITIES In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" (SFAS 159), which allows an entity to make an irrevocable election, on specific election dates, to measure eligible items at fair value. The election to measure an item at fair value may be determined on an instrument by instrument basis, with certain exceptions. If the fair value option is elected, unrealized gains and losses will be recognized in earnings at each subsequent reporting date, and any upfront costs and fees related to the item will be recognized in earnings as incurred. In addition, the presentation and disclosure requirements of SFAS 159 are designed to assist in the comparison between entities that select different measurement attributes for similar types of assets and liabilities. SFAS 159 does not affect any existing accounting literature that requires certain assets and liabilities to be carried at fair value and does not eliminate disclosure requirements included in other accounting standards. SFAS 159 applies to fiscal years beginning after November 15, 2007, with early adoption permitted for an entity that has also elected to apply the provisions of SFAS 157. Retrospective application of SFAS 159 is not permitted unless early adoption is elected. At the effective date, the fair value option may be elected for eligible items that exist on that date. The effect of the first re-measurement to fair value shall be reported as a cumulative effect adjustment to the opening balance of retained earnings. The Company is currently evaluating the potential effects of SFAS 159 on its consolidated financial condition and results of operations. CONSIDERING THE EFFECTS OF PRIOR YEAR MISSTATEMENTS WHEN QUANTIFYING MISSTATEMENTS IN CURRENT YEAR FINANCIAL STATEMENTS In September 2006, the Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 108, "Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements" (SAB 108). SAB 108 provides guidance for evaluating the effects of prior year uncorrected errors when quantifying misstatements in the current year financial statements. Under SAB 108, the impact of correcting misstatements occurring in the current period and those that have accumulated over prior periods must both be considered when quantifying the impact of misstatements in current period financial statements. SAB 108 is effective for fiscal years ending after November 15, 2006, and may be adopted by either restating prior financial statements or recording the cumulative effect of initially applying the approach as adjustments to the carrying values of assets and liabilities as of January 1, 2006 with an offsetting adjustment to retained earnings. The Company adopted the provisions of SAB 108 as of December 31, 2006. The adoption of SAB 108 did not have a material effect on the Company's consolidated financial statements. F-16 3. INVESTMENTS SUMMARY COST AND FAIR VALUE INFORMATION Aggregate cost or amortized cost, aggregate fair value and gross unrealized gains and losses of debt and equity securities were as follows:
DECEMBER 31, 2006 ------------------------------------------------- COST OR GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE ---------- ---------- ---------- ---------- AVAILABLE-FOR-SALE, CARRIED AT FAIR VALUE U.S. Treasury obligations and direct obligations of U.S. Government agencies $ 59,365 $ 413 $ (514) $ 59,264 Federal agency issued mortgage-backed securities (including collateralized mortgage obligations) 925,981 6,108 (1,596) 930,493 Obligations of states and political subdivisions 38,552 313 (30) 38,835 Corporate obligations 7,840,700 90,283 (15,884) 7,915,099 Corporate private-labeled mortgage-backed securities (including collateralized mortgage obligations) 531,914 7,515 (168) 539,261 Affiliate bonds 130,243 -- (4) 130,239 ---------- -------- -------- ---------- Subtotal, debt securities 9,526,755 104,632 (18,196) 9,613,191 Equity securities 13,013 1,717 -- 14,730 ---------- -------- -------- ---------- Securities available-for-sale $9,539,768 $106,349 $(18,196) $9,627,921 ========== ======== ======== ==========
DECEMBER 31, 2005 ------------------------------------------------- COST OR GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS (LOSSES) VALUE ---------- ---------- ---------- ---------- AVAILABLE-FOR-SALE, CARRIED AT FAIR VALUE U.S. Treasury obligations and direct obligations of U.S. government agencies $ 101,616 $ 3,989 $ (1,090) $ 104,515 Federal agency issued mortgage-backed securities (including collateralized mortgage obligations) 561,469 15,806 (4,454) 572,821 Obligations of states and political subdivisions 20,111 1,077 (256) 20,932 Corporate obligations 7,225,546 262,389 (85,895) 7,402,040 Corporate private-labeled mortgage-backed securities (including collateralized mortgage obligations) 821,732 16,992 (9,589) 829,135 Affiliated bonds 108,000 -- (1,152) 106,848 Redeemable preferred stocks 9,153 1,839 (379) 10,613 ---------- -------- --------- ---------- Subtotal, debt securities 8,847,627 302,092 (102,815) 9,046,904 Equity securities 6,859 3,464 -- 10,323 ---------- -------- --------- ---------- Securities available-for-sale $8,854,486 $305,556 $(102,815) $9,057,227 ========== ======== ========= ========== HELD-TO-MATURITY, CARRIED AT AMORTIZED COST Obligations of states and political subdivisions $ 3,750 $ 603 $ -- $ 4,353 Corporate obligations 661,790 39,722 (4,059) 697,453 Affiliate bonds 22,940 262 (638) 22,564 ---------- -------- --------- ---------- Debt securities held-to-maturity $ 688,480 $ 40,587 $ (4,697) $ 724,370 ========== ======== ========= ==========
Affiliate bonds consist of securities issued by Lincoln JP Holdings L.P., Lincoln Financial Media Company and LNC. See further discussion in Note 12. F-17 3. INVESTMENTS--CONTINUED CONTRACTUAL MATURITIES Aggregate amortized cost and aggregate fair value of debt securities at December 31, 2006, according to maturity date, were as indicated below. Contractual maturity dates were utilized for all securities except for mortgage-backed securities, which are based upon estimated maturity dates. Actual future maturities will differ from the contractual maturities shown because the issuers of certain debt securities have the right to call or prepay the amounts due to the Company, with or without penalty. AVAILABLE-FOR-SALE ----------------------- AMORTIZED FAIR COST VALUE ---------- ---------- Due in one year or less $ 383,281 $ 383,101 Due after one year through five years 2,737,093 2,750,186 Due after five years through ten years 3,070,169 3,099,630 Due after ten years 1,878,317 1,910,520 Amounts not due at a single maturity date 1,457,895 1,469,754 ---------- ---------- $9,526,755 $9,613,191 ========== ========== SECURITIES LENDING In its securities lending program, the Company generally receives cash collateral in an amount that is in excess of the market value of the securities loaned. Market values of securities loaned and collateral are monitored daily, and additional collateral is obtained as necessary. The market value of securities loaned and collateral received amounted to $80,121 and $83,599 at December 31, 2006, and $106,495 and $110,635 at December 31, 2005. F-18 3. INVESTMENTS--CONTINUED CHANGES IN NET UNREALIZED GAINS ON SECURITIES Changes in amounts affecting net unrealized gains included in other comprehensive income, reduced by deferred income taxes, were as follows:
NET UNREALIZED GAINS (LOSSES) ----------------------------------- DEBT EQUITY SECURITIES SECURITIES TOTAL ---------- ---------- --------- Net unrealized gains on securities available-for-sale as of December 31, 2003 $ 152,455 $ 1,993 $ 154,448 Change during year ended December 31, 2004: Increase in stated amount of securities 797 949 1,746 Increase in value of business acquired and deferred policy acquisition costs 2,487 -- 2,487 Increase in deferred income tax liabilities (1,150) (332) (1,482) --------- ------- --------- Increase in net unrealized gains included in other comprehensive income 2,134 617 2,751 --------- ------- --------- Net unrealized gains on securities available-for-sale as of December 31, 2004 154,589 2,610 157,199 Change during year ended December 31, 2005: Decrease in stated amount of securities (249,997) (554) (250,551) Increase in value of business acquired and deferred policy acquisition costs 126,738 -- 126,738 Decrease in deferred income tax liabilities 43,141 194 43,335 --------- ------- --------- Decrease in net unrealized gains included in other comprehensive income (80,118) (360) (80,478) --------- ------- --------- Net unrealized gains on securities available-for-sale as of December 31, 2005 74,471 2,250 76,721 Change during period January 1 through April 2, 2006: Increase (decrease) in stated amount of securities (184,858) 150 (184,708) Increase in value of business acquired and deferred policy acquisition costs 76,242 76,242 Decrease (increase) in deferred income tax liabilities 38,015 (52) 37,963 --------- ------- --------- Increase (decrease) in net unrealized gains included in other comprehensive income (70,601) 98 (70,503) --------- ------- --------- Net unrealized gains on securities available-for-sale as of April 2, 2006 3,870 2,348 6,218 Sale of stockholder's equity (3,870) (2,348) (6,218) --------- ------- --------- Net unrealized gains on securities available-for-sale as of April 3, 2006 -- -- -- --------- ------- --------- Net unrealized gains on securities available-for-sale as of April 3, 2006 -- -- -- Change during period April 3 through December 31, 2006: Increase in stated amount of securities 86,436 1,717 88,153 Decrease in deferred policy acquisition costs and value of business acquired (19,557) -- (19,557) Increase in deferred income tax liabilities (23,354) (601) (23,955) --------- ------- --------- Increase in net unrealized gains included in other comprehensive income 43,525 1,116 44,641 --------- ------- --------- Net unrealized gains on securities available-for-sale as of December 31, 2006 $ 43,525 $ 1,116 $ 44,641 ========= ======= =========
F-19 3. INVESTMENTS--CONTINUED NET INVESTMENT INCOME The details of net investment income follow:
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, ------------------- 2006 2006 2005 2004 ------------ ----------- -------- -------- Interest on debt securities $429,573 $144,476 $598,307 $606,715 Investment income on equity securities 700 20 843 807 Interest on mortgage loans 72,385 25,475 102,480 101,865 Interest on policy loans 25,705 7,653 35,004 34,819 Other investment income 6,661 5,744 10,778 14,675 -------- -------- -------- -------- Gross investment income 535,024 183,368 747,412 758,881 Investment expenses (20,768) (5,362) (18,925) (16,499) -------- -------- -------- -------- Net investment income $514,256 $178,006 $728,487 $742,382 ======== ======== ======== ========
Investment expenses include salaries, expenses of maintaining and operating investment real estate, real estate depreciation and other allocated costs of investment management and administration. REALIZED GAINS AND LOSSES The details of realized investment gains (losses), including other-than-temporary impairments, follow:
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, ------------------ 2006 2006 2005 2004 ------------ ----------- ------- -------- Debt securities $ 2,035 $(3,357) $(9,903) $(40,111) Other 1,692 198 4,989 (374) Amortization of deferred policy acquisition costs, value of business acquired and deferred sales inducements (3,230) 73 (1,352) 3,148 ------- ------- ------- -------- Realized investment losses $ 497 $(3,086) $(6,266) $(37,337) ======= ======= ======= ========
See Note 5 for discussion of amortization of deferred policy acquisition costs, value of business acquired and deferred sales inducements. Information about total gross realized gains and losses on debt securities, including other-than-temporary impairments, follows:
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, ------------------- 2006 2006 2005 2004 ------------ ----------- -------- -------- Gross realized: Gains $11,492 $ 1,493 $ 25,332 $ 19,583 Losses (9,457) (4,850) (35,235) (59,694) ------- ------- -------- -------- Realized gains (losses) on total securities $ 2,035 $(3,357) $ (9,903) $(40,111) ======= ======= ======== ========
F-20 3. INVESTMENTS--CONTINUED Information about gross realized gains and losses on available-for-sale securities, including other-than-temporary impairments, follows:
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, ------------------- 2006 2006 2005 2004 ------------ ----------- -------- -------- Gross realized: Gains $11,492 $ 1,211 $ 23,795 $ 15,735 Losses (9,457) (4,827) (35,073) (59,186) ------- ------- -------- -------- Realized gains (losses) on available-for-sale securities $ 2,035 $(3,616) $(11,278) $(43,451) ======= ======= ======== ========
INVESTMENT CONCENTRATION RISK AND IMPAIRMENT Investments in debt and equity securities include 1,084 issuers. Debt securities include investments in Lincoln JP Holdings L.P. of $108,000 and $106,848 as of December 31, 2006 and 2005. At December 31, 2006, no other corporate issuer represents more than 1% of investments. At December 31, 2005, Wachovia Corporation represented more than 1% of debt and equity investments with a balance of $105,753. Debt securities considered less than investment grade approximated 8% and 7% of the total debt securities portfolio as of December 31, 2006 and 2005. The Company uses repurchase agreements to meet various cash requirements. At December 31, 2006 and 2005, the amounts held in debt securities available-for-sale pledged as collateral for these borrowings were $158,392 and $158,346. As of December 31, 2006, the Company's commercial mortgage loan portfolio was comprised of conventional real estate mortgages collateralized primarily by industrial (31%), retail (30%), office (25%), apartment (8%), hotel (5%), and other (1%) properties. Our mortgage loan underwriting standards emphasize the credit status of a prospective borrower, quality of the underlying collateral and loan-to-value relationships. Approximately 29% of stated mortgage loan balances as of December 31, 2006 are for properties located in South Atlantic states, approximately 20% are for properties located in Pacific states, approximately 12% are for properties located in the East North Central states, approximately 11% are for properties located in the West South Central states, and approximately 11% are for properties located in the West North Central states. No other geographic region represents greater than 10% of December 31, 2006 mortgage loans. At December 31, 2006 and 2005, the recorded investment in mortgage loans that were considered to be potentially impaired was $0 and $2,238. There were no delinquent loans outstanding as of December 31, 2006 and 2005. The related allowance for credit losses on all mortgage loans was $0 and $5,922 at December 31, 2006 and 2005. The average recorded investment in potentially impaired loans was $0 from April 3 through December 31, 2006, $2,225 from January 1 through April 2, 2006, and $3,799 and $5,225 during the years ended December 31, 2005 and 2004, on which interest income of $0 from April 3 through December 31, 2006, $14 from January 1 through April 2, 2006, and $177 and $235 during the years ended December 31, 2005 and 2004, was recognized. The Company sold certain securities that had been classified as held-to-maturity, due to significant declines in credit worthiness. The net amortized cost of securities sold were $0, $536 and $11,633 for 2006, 2005 and 2004. The realized gains on the sales of these securities, some of which were previously impaired, were $0, $0 and $421. F-21 3. INVESTMENTS--CONTINUED The Company monitors its portfolio closely to ensure that all other-than-temporary impairments are identified and recognized in earnings as they occur. The table below summarizes unrealized losses on all debt securities held by both asset class and length of time that a security has been in an unrealized loss position:
DECEMBER 31, 2006 --------------------------------------------------------------------------- LESS THAN 12 MONTHS 12 MONTHS OR LONGER TOTAL ----------------------- ----------------------- ----------------------- GROSS GROSS GROSS UNREALIZED UNREALIZED UNREALIZED FAIR VALUE LOSSES FAIR VALUE LOSSES FAIR VALUE LOSSES ---------- ---------- ---------- ---------- ---------- ---------- U.S. Treasury obligations and direct obligations of U.S. Government agencies $ 24,247 $ (514) $-- $-- $ 24,247 $ (514) Federal agency issued mortgage-backed securities (including collateralized mortgage obligations) 252,625 (1,596) -- -- 252,625 (1,596) Obligations of states and political subdivisions 6,757 (30) -- -- 6,757 (30) Corporate obligations 1,619,415 (15,884) -- -- 1,619,415 (15,884) Corporate private-labeled mortgage-backed securities (including collateralized mortgage obligations) 61,716 (168) -- -- 61,716 (168) Affiliate bonds 11,822 (4) -- -- 11,822 (4) ---------- -------- --- --- ---------- -------- Total temporarily impaired securities $1,976,582 $(18,196) $-- $-- $1,976,582 $(18,196) ========== ======== === === ========== ========
DECEMBER 31, 2005 --------------------------------------------------------------------------- LESS THAN 12 MONTHS 12 MONTHS OR LONGER TOTAL ----------------------- ----------------------- ----------------------- GROSS GROSS GROSS UNREALIZED UNREALIZED UNREALIZED FAIR VALUE LOSSES FAIR VALUE LOSSES FAIR VALUE LOSSES ---------- ---------- ---------- ---------- ---------- ---------- U.S. Treasury obligations and direct obligations of U.S. Government agencies $ 24,905 $ (521) $ 18,617 $ (569) $ 43,522 $ (1,090) Federal agency issued mortgage-backed securities (including collateralized mortgage obligations) 85,513 (2,599) 44,886 (1,855) 130,399 (4,454) Obligations of states and political subdivisions 8,700 (256) -- -- 8,700 (256) Corporate obligations 2,386,691 (53,987) 889,742 (35,967) 3,276,433 (89,954) Corporate private-labeled mortgage-backed securities (including collateralized mortgage obligations) 473,299 (7,111) 55,731 (2,478) 529,030 (9,589) Redeemable preferred stock 925 (126) 1,850 (253) 2,775 (379) Affiliate bonds 106,848 (1,152) 14,718 (638) 121,566 (1,790) ---------- -------- ---------- -------- ---------- --------- Total temporarily impaired securities $3,086,881 $(65,752) $1,025,544 $(41,760) $4,112,425 $(107,512) ========== ======== ========== ======== ========== =========
One statistic to which the Company pays particular attention with respect to debt securities is the fair value to amortized cost ratio. Securities with a fair value to amortized cost ratio in the 90%-99% range are typically securities that have been impacted by increases in market interest rates or sector spreads. Securities in the 80%-89% range are typically securities that have been impacted by increased market yields, specific credit concerns or both. These securities are monitored to ensure that the impairment is not other-than-temporary. Securities with a fair value to amortized cost ratio less then 80% are considered to be "potentially distressed F-22 3. INVESTMENTS--CONTINUED securities," and are subjected to rigorous review. The following factors are considered: the length of time a security's fair value has been below amortized cost, industry factors or conditions related to a geographic area that are negatively affecting the security, downgrades by rating agencies, the valuations of assets specifically pledged to support the credit, the overall financial condition of the issuer, past due interest or principal payments, and our intent and ability to hold the security for a sufficient time to allow for a recovery in value. The table below summarizes the securities with unrealized losses in our debt portfolio as of December 31, 2006: AMORTIZED FAIR UNREALIZED COST VALUE LOSSES PERCENTAGE ---------- ---------- ---------- ---------- 90% - 99% $1,973,261 $1,958,011 $(15,250) 84% 80% - 89% 21,403 18,487 (2,916) 16% Below 80% 114 84 (30) -- ---------- ---------- -------- --- $1,994,778 $1,976,582 $(18,196) 100% ========== ========== ======== === As of December 31, 2006, the Company held four securities that were "potentially distressed." 4. DERIVATIVE FINANCIAL INSTRUMENTS The fair values of the Company's derivative instruments were $(1,297) and $(1,083) at December 31, 2006 and 2005 and are included in other investments in the consolidated balance sheets. At December 31, 2006 and 2005, the Company had no fair value hedges or hedges of net investments in foreign operations. CASH FLOW HEDGING STRATEGY The Company uses interest rate swaps to convert floating rate investments to fixed rate investments. Interest is exchanged periodically on the notional value with the Company receiving the fixed rate and paying various short-term LIBOR rates on a net exchange basis. For the years ended December 31, 2006, 2005 and 2004, the ineffective portion of the Company's cash flow hedging instruments, which is recognized in realized investment gains, was not significant. At December 31, 2006 and 2005, the maximum term of interest rate swaps that hedged floating rate investments was twenty years and eight years, respectively. The Company also uses interest rate swaps to hedge anticipated purchases of assets that support the annuity line of business. As assets are purchased, the interest rate swap is unwound resulting in a realized gain (loss) which effectively offsets the change in the cost of the assets purchased to back annuities issued. The gain (loss) is amortized into income over time, resulting in an overall yield that is consistent with the Company's pricing assumptions. The Company recognized other comprehensive income related to cash flow hedges, net of taxes, of $356 from April 3 through December 31, 2006, $(1,099) from January 1 through April 2, 2006, and $(2,589) and $(1,823) for the years ended December 31, 2005 and 2004. During 2006, 2005 and 2004, the Company did not reclassify any gains (losses) into earnings as a result of the discontinuance of its cash flow hedges. Further, the Company does not expect to reclassify a significant amount of net gains (losses) on derivative instruments from accumulated other comprehensive income to earnings during the next twelve months. Certain swaps serve as economic hedges but do not qualify for hedge accounting under SFAS 133. These swaps are marked-to-market through realized gains. The Company's realized investment gains from these swaps were $509 from April 3 through December 31, 2006, $(307) from January 1 through April 2, 2006, and $421 and $514 for the years ended December 31, 2005 and 2004. OTHER DERIVATIVES The Company markets indexed annuities. These 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(R) index. Policyholders may elect to rebalance index options at renewal dates, either annually or biannually. At each renewal date, the Company has the opportunity to re-price the equity-indexed component by establishing participation rates, subject to minimum guarantees. The Company purchases options that are highly correlated to the portfolio allocation decisions of its policyholders, such that the Company is F-23 4. DERIVATIVE FINANCIAL INSTRUMENTS--CONTINUED economically hedged with respect to equity returns for the current reset period. The mark-to-market of the options held impacts net investment income and interest credited in equal and offsetting amounts. SFAS 133 requires that the Company calculates fair values of index options it will purchase in the future to hedge policyholder index allocations in future reset periods. These fair values represent an estimate of the cost of the options the Company will purchase in the future, discounted back to the date of the balance sheet, using current market indicators of volatility and interest rates. Changes in fair values of these liabilities are reported in interest credited. Interest credited was decreased by $137, $522 and $2,364 in 2006, 2005 and 2004 for the changes in fair value of these liabilities. The Company also invests in debt securities with embedded options, which are considered to be derivative instruments under SFAS 133. These derivatives are marked-to-market through realized investment gains, but were insignificant for the years ended December 31, 2006, 2005, and 2004. Counterparties to derivative instruments expose the Company to credit risk in the event of non-performance. The Company limits this exposure by diversifying among counterparties with high credit ratings. The Company's credit risk exposure on swaps is limited to the fair value of swap agreements that it has recorded as an asset. The Company does not expect any counterparty to fail to meet its obligation. 5. DEFERRED POLICY ACQUISITION COSTS, VALUE OF BUSINESS ACQUIRED AND DEFERRED SALES INDUCEMENT ASSET DEFERRED POLICY ACQUISITION COSTS The following table rolls forward the Company's deferred policy acquisition costs asset for the periods April 3 through December 31, 2006, January 1 through April 2, 2006, and the years ended December 31, 2005 and 2004:
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, --------------------- 2006 2006 2005 2004 ------------ ----------- --------- --------- Beginning balance $ 727,271 $674,858 $ 586,157 $ 564,152 Purchase accounting fair value adjustment (727,271) -- -- -- Cumulative effect of change in accounting principle -- -- -- (2,504) Group coinsurance assumed -- -- -- 37,447 --------- -------- --------- --------- -- 674,858 586,157 599,095 --------- -------- --------- --------- Deferrals: Commissions 38,618 16,176 59,551 62,102 Other 59,513 19,589 62,449 55,979 --------- -------- --------- --------- Total deferrals 98,131 35,765 122,000 118,081 --------- -------- --------- --------- Adjustments: Amortization (9,477) (28,825) (102,791) (125,614) Adjustment related to realized losses (gains) on debt securities 349 75 (113) 804 Adjustment related to unrealized losses (gains) on securities available-for-sale (337) 45,398 69,605 (6,209) --------- -------- --------- --------- Total adjustments 9,465 16,648 (33,299) (131,019) --------- -------- --------- --------- Ending balance $ 88,666 $727,271 $ 674,858 $ 586,157 ========= ======== ========= =========
See Note 10 for discussion of group coinsurance transaction. F-24 5. DEFERRED POLICY ACQUISITION COSTS, VALUE OF BUSINESS ACQUIRED AND DEFERRED SALES INDUCEMENT ASSET--CONTINUED VALUE OF BUSINESS ACQUIRED The following table rolls forward the Company's value of business acquired asset for the periods April 3 through December 31, 2006, January 1 through April 2, 2006, and the years ended December 31, 2005 and 2004:
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, --------------------- 2006 2006 2005 2004 ------------ ----------- --------- --------- Beginning balance $ 495,579 $476,277 $472,076 $458,189 Purchase accounting fair value adjustment 560,312 -- -- -- Cumulative effect of change in accounting principle -- -- -- 30,223 ---------- -------- -------- -------- 1,055,891 476,277 472,076 488,412 ---------- -------- -------- -------- Deferral of commissions and accretion of interest 17,660 209 1,144 4,416 ---------- -------- -------- -------- Adjustments: Amortization (59,882) (11,749) (52,841) (31,792) Adjustment related to realized losses (gains) on debt securities (3,579) (2) (1,235) 2,344 Adjustment related to unrealized losses on debt securities available-for-sale (19,220) 30,844 57,133 8,696 ---------- -------- -------- -------- Total adjustments (82,681) 19,093 3,057 (20,752) ---------- -------- -------- -------- Ending balance $ 990,870 $495,579 $476,277 $472,076 ========== ======== ======== ========
Expected approximate amortization percentages relating to the value of business acquired for the next five years are as follows: AMORTIZATION YEAR PERCENTAGE ---- ------------ 2007 6.3% 2008 7.7% 2009 6.6% 2010 6.3% 2011 5.7% DEFERRED SALES INDUCEMENT ASSET The deferred sales inducement asset is included within other assets in the consolidated balance sheets. The following table rolls forward the Company's deferred sales inducement asset for the periods April 3 through December 31, 2006, January 1 through April 2, 2006 and the years ended December 31, 2005 and 2004:
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, ----------------- 2006 2006 2005 2004 ------------ ----------- ------- ------- Beginning balance $ 33,527 $34,264 $38,272 $ -- Purchase accounting fair value adjustment (33,527) -- -- -- Cumulative effect of change in accounting principle -- -- -- 41,223 Deferral of bonus interest 693 120 912 468 Adjustments: Amortization (7) (857) (4,916) (3,419) Adjustment related to realized (gains) on debt securities available-for-sale -- -- (4) -- -------- ------- ------- ------- Total adjustments (7) (857) (4,920) (3,419) -------- ------- ------- ------- Ending balance $ 686 $33,527 $34,264 $38,272 ======== ======= ======= =======
F-25 6. POLICY LIABILITIES INFORMATION INTEREST RATE ASSUMPTIONS The liability for future policy benefits associated with ordinary life insurance policies was determined using initial interest rate assumptions ranging from 5.5% to 7.8% and, when applicable, uniform grading over 10 years to an ultimate rate of 6.5%. Interest rate assumptions for weekly premium, monthly debit and term life insurance products generally fall within the same ranges as those pertaining to ordinary life insurance policies. Credited interest rates for universal life-type products ranged from 3.0% to 9.0% in 2006 and 2005. The average credited interest rates for universal life-type products were 4.7% in 2006, 2005, and 2004. For annuity products, credited interest rates generally ranged from 3.0% to 7.4% in 2006, 3.0% to 6.4% in 2005, and 3.0% to 7.4% in 2004. The average credited interest rates for annuity products were 4.1% for 2006, 4.0% for 2005, and 4.3% for 2004. MORTALITY AND WITHDRAWAL ASSUMPTIONS Assumed mortality rates are generally based on experience multiples applied to select and ultimate tables commonly used in the industry. Withdrawal assumptions for individual life insurance policies are based on historical company experience and vary by issue age, type of coverage and policy duration. ACCIDENT AND HEALTH AND DISABILITY INSURANCE LIABILITIES ACTIVITY Activity in the liabilities for accident and health and disability benefits, including reserves for future policy benefits and unpaid claims and claim adjustment expenses was as follows:
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, ----------------------- 2006 2006 2005 2004 ------------ ----------- ---------- ---------- Balance at beginning of period $ 939,745 $ 929,307 $ 846,643 $ 507,238 Less reinsurance recoverables 103,930 96,958 84,346 94,381 ---------- ---------- ---------- ---------- Net balance at beginning of period 835,815 832,349 762,297 412,857 ---------- ---------- ---------- ---------- Reinsurance transaction (See Note 9) -- -- -- 253,348 Amount incurred: Current year 450,629 131,612 580,771 582,066 Prior year 3,037 5,157 10,072 (22,452) ---------- ---------- ---------- ---------- 453,666 136,769 590,843 559,614 ---------- ---------- ---------- ---------- Less amount paid: Current year 250,523 50,600 295,157 292,495 Prior year 164,767 82,703 225,634 171,027 ---------- ---------- ---------- ---------- 415,290 133,303 520,791 463,522 ---------- ---------- ---------- ---------- Net balance at end of period 874,191 835,815 832,349 762,297 Plus reinsurance recoverables 101,912 103,930 96,958 84,346 ---------- ---------- ---------- ---------- Balance at end of period $ 976,103 $ 939,745 $ 929,307 $ 846,643 ========== ========== ========== ========== Balance at end of period included with: Total future policy benefits $1,860,471 $1,850,780 $1,909,441 $1,822,837 Less: Other future policy benefits 926,302 956,539 1,024,166 1,030,211 ---------- ---------- ---------- ---------- A&H future benefits 934,169 894,241 885,275 792,626 ---------- ---------- ---------- ---------- Total policy and contract claims 166,288 167,573 176,282 194,330 Less: Other policy and contract claims 124,354 122,069 132,250 140,313 ---------- ---------- ---------- ---------- A&H policy and contract claims 41,934 45,504 44,032 54,017 ---------- ---------- ---------- ---------- Total A&H reserves $ 976,103 $ 939,745 $ 929,307 $ 846,643 ========== ========== ========== ==========
F-26 6. POLICY LIABILITIES INFORMATION--CONTINUED The Company uses estimates for determining its liability for accident and health and disability benefits, which are based on historical claim payment patterns and attempt to provide for the inherent variability in claim patterns and severity. In 2006 and 2005, the amount incurred for accident and health and disability benefits related to prior years was negatively impacted by claims termination experience in the Company's long-term disability business. SOP 03-1 POLICY LIABILITIES At December 31, 2006 and 2005, the amount of SOP 03-1 policy liabilities included in other policy liabilities on the consolidated balance sheets were $2,894 and $1,397, respectively. 7. STATUTORY FINANCIAL INFORMATION The Company prepares financial statements on the basis of SAP prescribed or permitted by the Nebraska Department of Insurance for JPFIC, and the New Jersey Department of Banking and Insurance for JPLA. Prescribed SAP includes the Accounting Practices and Procedures Manual of the National Association of Insurance Commissioners (NAIC) as well as state laws, regulations and administrative rules. Permitted SAP encompasses all accounting practices not so prescribed. The Company does not utilize any permitted practices in the preparation of the statutory financial statements. The principal differences between SAP and GAAP are (1) policy acquisition costs are expensed as incurred under SAP, but are deferred and amortized under GAAP, (2) the value of business acquired is not capitalized under SAP, but is under GAAP, (3) amounts collected from holders of universal life-type and annuity products are recognized as premiums when collected under SAP, but are initially recorded as contract deposits under GAAP, with cost of insurance recognized as revenue when assessed and other contract charges recognized over the periods for which services are provided, (4) the classification and carrying amounts of investments in certain securities are different, (5) the criteria for providing asset valuation allowances, and the methodologies used to determine the amounts thereof, (6) the timing of establishing certain reserves, and the methodologies used to determine the amounts thereof, and (7) certain assets are not admitted for purposes of determining surplus under SAP. Reported capital and surplus on a statutory basis at December 31, 2006 and 2005 was $1,140,379 and $1,220,460. Reported statutory net income for the years ended December 31, 2006, 2005 and 2004 was $262,015, $290,812 and $200,856. Prior to its acquisition, Guarantee Life Insurance Company ("GLIC", which was subsequently merged into JPFIC) converted from a mutual form to a stock life company. In connection with that conversion, GLIC agreed to segregate certain assets to provide for dividends on participating policies using dividend scales in effect at the time of the conversion, providing that the experience underlying such scales continued. The assets allocated to the participating policies, including revenue there from, will accrue solely to the benefit of those policies. The assets and liabilities relating to these participating policies amounted to $320,223 and $327,382 at December 31, 2006 and $321,193 and $332,819 at December 31, 2005. The excess of liabilities over the assets represents the total estimated future earnings expected to emerge from these participating policies. Risk-Based Capital ("RBC") requirements promulgated by the NAIC require life insurers to maintain minimum capitalization levels that are determined based on formulas incorporating credit risk, insurance risk, interest rate risk and general business risk. The NAIC and the Life and Health Actuarial Task Force recently approved statutory reserving practices under Actuarial Guideline 38 (referred to as AXXX or the Guideline) that will require the Company, and other companies, to record higher AXXX reserves on new sales during a 21-month period beginning July 1, 2005, followed by a long-term change to reserving methods for these products. As of December 31, 2006, the Company and its subsidiary's adjusted capital and surplus exceeded their authorized control level RBC. F-27 7. STATUTORY FINANCIAL INFORMATION--CONTINUED Some states require life insurers to maintain a certain value of securities on deposit with the state in order to conduct business in that state. The Company had securities totaling $17,290 and $17,960 on deposit with various states in 2006 and 2005, which are reported in debt securities within the Company's consolidated balance sheets. The General Statutes of Nebraska require JPFIC to maintain minimum capital of $1,000 and minimum surplus of $1,500 over and above capital. Additionally, the General Statutes of Nebraska limit the amount of dividends that JPFIC may pay annually without first obtaining regulatory approval. Generally, the limitations are based on a combination of statutory net gain from operations for the preceding year, 10% of statutory surplus at the end of the preceding year, and dividends and distributions made within the preceding twelve months. Depending on the timing of the payment, JPFIC could pay $288,378 in dividends in 2007 without prior approval of the Nebraska Commissioner of Insurance. The New Jersey Statutes require JPLA to maintain minimum capital of $1,530 and minimum unassigned surplus of $6,120. Additionally, the New Jersey Statutes limit the amount of dividends that JPLA may pay annually without first obtaining regulatory approval. Payments of dividends to the stockholder generally are restricted to the greater of 10% of policyholders' surplus of the previous year or the previous year's net income. Depending on the timing of payments, approximately $6,619 in dividends can be paid by JPLA in 2007 without prior approval of the New Jersey Commissioner of Banking and Insurance. 8. FEDERAL INCOME TAXES The Federal income tax expense (benefit) is as follows: PERIOD FROM PERIOD FROM APRIL 3 THROUGH JANUARY 1 YEAR ENDED DECEMBER 31, DECEMBER 31, THROUGH APRIL 2, ----------------------- 2006 2006 2005 2004 --------------- ---------------- ---------- ---------- Current $ 87,787 $44,558 $113,282 $ 27,701 Deferred 31,121 (2,531) 38,590 96,059 -------- ------- -------- -------- Total tax expense $118,908 $42,027 $151,872 $123,760 ======== ======= ======== ======== The effective tax rate on pre-tax income from continuing operations differs from the prevailing corporate Federal income tax rate. A reconciliation of this difference is as follows:
PERIOD FROM PERIOD FROM APRIL 3 THROUGH JANUARY 1 DECEMBER 31, DECEMBER 31, THROUGH APRIL 2, ----------------------- 2006 2006 2005 2004 --------------- ---------------- ---------- ---------- Tax rate of 35% times pre-tax income $118,779 $37,337 $154,467 $130,104 Effect of: Tax-preferred investment income (761) (642) (2,570) (1,855) Tax credits (80) -- (323) (452) Release of prior year overaccrual -- -- -- (4,235) IRS audit adjustments 767 5,326 126 -- Other items 203 6 172 198 -------- ------- -------- -------- Provision for income taxes $118,908 $42,027 $151,872 $123,760 ======== ======= ======== ======== Effective tax rate 35.0% 39.4% 34.4% 33.3% ======== ======= ======== ========
F-28 8. FEDERAL INCOME TAXES--CONTINUED The Federal income tax asset (liability) is as follows: YEAR ENDED DECEMBER 31, --------------------- 2006 2005 --------- --------- Current $ 7,906 $ 7,874 Deferred (284,226) (213,007) --------- --------- Total federal income tax liability $(276,320) $(205,133) ========= ========= Significant components of JPFIC's deferred tax assets and liabilities are as follows: DECEMBER 31, --------------------- 2006 2005 --------- --------- Deferred income tax assets: Insurance and investment contract liabilities $ 23,759 $ 130,860 Deferral of policy acquisition costs 85,109 -- Investments -- 6,071 Deferred compensation 21,862 21,862 Capital loss carryforward 1,611 1,393 Deferred gain recognition for income tax purposes 399 189 Unearned investment revenue 2,381 2,457 Other deferred tax assets 6,688 6,943 --------- --------- Total deferred tax assets 141,809 169,775 Deferred income tax liabilities: Deferral of policy acquisition costs -- (150,134) Present value in force (343,411) (176,878) Net unrealized gains on securities (31,047) (41,075) Investments (17,463) -- Property, plant, and equipment (28,597) (10,971) Obligation for postretirement benefits (4,065) (3,659) Other deferred tax liabilities (1,452) (65) --------- --------- Total deferred tax liabilities (426,035) (382,782) --------- --------- Net deferred income tax liabilities $(284,226) $(213,007) ========= ========= Prior to April 3, 2006, the Company and its affiliates were part of a consolidated Federal income tax filing with Jefferson-Pilot. Effective April 3, 2006, as a result of the merger with LNC, the Company's federal income tax return is no longer consolidated with the other members of the holding company group. Instead, the Company will file a separate federal income tax return with its wholly-owned subsidiary, JPLA. Cash paid for income taxes in 2006, 2005, and 2004 was $116.3 million, $136.2 million, and $24.9 million, respectively. JPFIC is required to establish a valuation allowance for any gross deferred tax assets that are unlikely to reduce taxes payable in future years' tax returns. At December 31, 2006 and 2005, JPFIC concluded that it was more likely than not that all gross deferred tax assets will reduce taxes payable in future years. Accordingly, no valuation allowance was necessary at December 31, 2006 or 2005. The JPFIC consolidated return group is subject to annual examinations from the Internal Revenue Service ("IRS"). The IRS has examined tax years 2000-2003, with assessments resulting in a payment that was not material to the consolidated results of operations. Jefferson-Pilot and its affiliates are currently under examination by the IRS for years 2004 and 2005. JPFIC does not anticipate that any adjustments, which might result from such audits, would be material to JPFIC's consolidated results of operations or financial condition. F-29 9. RETIREMENT BENEFIT PLANS PENSIONS The Company's employees participate in the Parent's tax-qualified and nonqualified defined benefit pension plans, which provide benefits based on years of service and final average earnings. The tax-qualified plan is funded through group annuity contracts issued by the Company. The assets of the tax-qualified plan are those of the related contracts, and are primarily held in the separate accounts of the Company. The funding policy is to contribute annually no more than the maximum amount deductible for federal income tax purposes. The plans are administered by the Parent. Pension expense for all years presented was not significant. OTHER POSTRETIREMENT BENEFITS The Parent sponsors contributory health care and life insurance benefit plans for eligible retired employees, qualifying retired agents and certain surviving spouses. The Company contributes to a welfare benefit trust from which future benefits will be paid. The Company accrues the cost of providing postretirement benefits other than pensions during the employees' active service period. Plan expense for all years presented was not significant. In accordance with FSP 106-2 "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003," the Company re-measured its plan assets and Accumulated Postretirement Benefit Obligation (APBO) as of July 1, 2004 to account for the subsidy and other effects of the Act, which resulted in an immaterial reduction in postretirement benefit cost. The reduction in the APBO for the subsidy related to past service was insignificant. DEFINED CONTRIBUTION PLANS The Company participates in the Parent's defined contribution retirement plan covering most employees and full time agents. The Company matches a portion of participant contributions and makes profit sharing contributions to a fund that acquires and holds shares of the Parent's common stock. Most plan assets are invested under a group variable annuity contract issued by Jefferson-Pilot Life Insurance Company. Plan expense for all years presented was not significant. 10. REINSURANCE The Company attempts to reduce its exposure to significant individual claims by reinsuring portions of certain individual life insurance policies and annuity contracts written. The Company reinsures a portion of individual life insurance risks in excess of its retention, which ranges from $400 to $2,100 for various individual life and annuity products. The Company also attempts to reduce exposure to losses that may result from unfavorable events or circumstances by reinsuring certain levels and types of accident and health insurance risks underwritten. The Company reinsures certain insurance business written prior to 1995 with affiliates of Household International, Inc. (Household) on a coinsurance basis. Balances are settled monthly, and the reinsurers compensate the Company for administrative services related to the reinsured business. The amount due from reinsurers in the consolidated balance sheets includes $647,783 and $783,708 due from the Household affiliates at December 31, 2006 and 2005. Assets related to the Household reinsured business have been placed in irrevocable trusts formed to hold the assets for the benefit of the Company and are subject to investment guidelines which identify (1) the types and quality standards of securities in which new investments are permitted, (2) prohibited new investments, (3) individual credit exposure limits and (4) portfolio characteristics. Household has unconditionally and irrevocably guaranteed, as primary obligor, full payment and performance by its affiliated reinsurers. The Company has the right to terminate the PPA and COLI reinsurance agreements by recapture of the related assets and liabilities if Household does not take a required action under the guarantee agreements within 90 days of a triggering event. As of December 31, 2006 and 2005, the Company also had a reinsurance recoverable of $65,125 and $70,377 from a single reinsurer, pursuant to a 50% coinsurance agreement. The Company and the reinsurer are joint F-30 10. REINSURANCE--CONTINUED and equal owners in $159,226 and $193,047 of securities and short-term investments as of December 31, 2006 and 2005, 50% of which is included in investments in the consolidated balance sheets. Reinsurance contracts do not relieve an insurer from its primary obligation to policyholders. Therefore, the failure of a reinsurer to discharge its reinsurance obligations could result in a loss to the Company. The Company regularly evaluates the financial condition of its reinsurers and monitors concentrations of credit risk related to reinsurance activities. No credit losses have resulted from the Company's reinsurance activities for the periods April 3 through December 31, 2006, January 1 through April 2, 2006 and for the years ended December 31, 2005 and 2004. The Company generally assumes portions of the life and accident and health risks underwritten by certain other insurers on a limited basis. In March 2004, the Company acquired (via a reinsurance transaction) substantially all of the in-force U.S. group life, disability and dental business of The Canada Life Assurance Company (Canada Life), an indirect subsidiary of Great-West Lifeco Inc. Upon closing, Canada Life ceded, and the Company assumed, approximately $400 million of policy liabilities. The Company also received assets, primarily comprised of cash, in support of those liabilities. The deferred policy acquisition costs recorded in the transaction are being amortized over 15 years, representing the expected premium-paying period of the blocks of policies acquired. An intangible asset of $25 million, attributable to the value of the distribution system acquired in the transaction, was recorded in other assets within the consolidated balance sheets and is being amortized over 30 years, representing the period over which the Company expects to earn premiums from new sales stemming from the added distribution capacity. The revenues and benefits and expenses associated with these blocks are presented in the Company's consolidated statements of income in a manner consistent with the Company's accounting policies. Most of the business assumed has subsequently been rewritten to the Company's own policy forms such that the Company is now the direct writer of this business. The effects of reinsurance on premiums and other considerations, universal life and investment product charges and total benefits were as follows:
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, ----------------------- 2006 2006 2005 2004 ------------ ----------- ---------- ---------- Premiums and other considerations direct $1,048,733 $349,123 $1,303,612 $1,089,822 Premiums and other considerations assumed 7,640 3,601 13,231 163,538 Less premiums and other considerations ceded 40,414 11,954 56,584 55,274 ---------- -------- ---------- ---------- Net premiums and other considerations $1,015,959 $340,770 $1,260,259 $1,198,086 ========== ======== ========== ========== Universal life and investment product charges, direct $ 345,993 $115,678 $ 483,710 $ 474,563 Universal life and investment product charges assumed 115 13 259 209 Less universal life and investment product charges ceded 46,544 12,842 55,552 52,751 ---------- -------- ---------- ---------- Net universal life and investment product charges $ 299,564 $102,849 $ 428,417 $ 422,021 ========== ======== ========== ========== Benefits direct $1,179,064 $410,974 $1,875,527 $1,506,077 Benefits assumed (20,759) (2,145) (224,520) 148,644 Less reinsurance recoveries 11,397 22,462 144,589 148,622 ---------- -------- ---------- ---------- Net benefits $1,146,908 $386,367 $1,506,418 $1,506,099 ========== ======== ========== ==========
The negative benefits assumed amount in 2006 and 2005 is a result of lapses within the Canada Life block. F-31 11. OTHER COMPREHENSIVE INCOME The components of other comprehensive income, along with related tax effects, are as follows:
UNREALIZED GAINS (LOSSES) DERIVATIVE ON AVAILABLE- FINANCIAL FOR-SALE INSTRUMENTS SECURITIES GAINS/(LOSSES) TOTAL -------------- -------------- -------- BALANCE AT DECEMBER 31, 2003 $154,448 $ 3,973 $158,421 Unrealized holding losses arising during period, net of $13,726 tax benefit (25,493) -- (25,493) Change in fair value of derivatives, net of $982 tax benefit -- (1,823) (1,823) Less: reclassification adjustment Losses realized in net income, net of $15,207 tax benefit (28,244) -- (28,244) -------- -------- -------- BALANCE AT DECEMBER 31, 2004 157,199 2,150 159,349 Unrealized holding losses arising during period, net of $47,282 tax benefit (87,809) -- (87,809) Change in fair value of derivatives, net of $1,393 tax benefit -- (2,589) (2,589) Less: reclassification adjustment Losses realized in net income, net of $3,947 tax benefit (7,331) -- (7,331) -------- -------- -------- BALANCE AT DECEMBER 31, 2005 76,721 (439) 76,282 Unrealized holding losses arising during period, net of $39,229 tax benefit (72,854) (72,854) Change in fair value of derivatives, net of $592 tax benefit (1,099) (1,099) Less: reclassification adjustment Losses realized in net income, net of $1,265 tax benefit (2,351) -- (2,351) -------- -------- -------- BALANCE AT APRIL 2, 2006 6,218 (1,538) 4,680 Acquisition by Lincoln National Corporation: Purchase accounting elimination of AOCI (6,218) 1,538 (4,680) -------- -------- -------- BALANCE AT APRIL 3, 2006 -- -- -- Unrealized holding losses arising during period, net of $23,325 taxes 43,318 -- 43,318 Change in fair value of derivatives, net of $197 taxes 356 356 Less: reclassification adjustment Gains realized in net income, net of $712 taxes 1,323 -- 1,323 -------- -------- -------- BALANCE AT DECEMBER 31, 2006 $ 44,641 $ 356 $ 44,997 ======== ======== ========
12. TRANSACTIONS WITH AFFILIATED COMPANIES The Company has entered into service agreements with LNC and other subsidiaries of LNC for personnel and facilities usage, general management services and investment management services. The Company expensed, prior to deferrals, $195,318 from April 3 through December 31, 2006, $49,747 from January 1 through April 2, 2006, and $191,370 and $182,425 for the years ended December 31, 2005 and 2004, for general management and investment services provided by Jefferson-Pilot Life Insurance Company, of which $20,541 and $21,015 remained payable as of December 31, 2006 and 2005. The remainder of the payable to affiliates at year-end was due to other affiliates. Included in the payable to affiliates is a $50,000 surplus note issued by the Company on September 24, 1994 that is held by HARCO Capital Corporation, an affiliate. The note bears interest at 9.76% and matures on September 30, 2024. The Company recognized interest expense of $3,660 from April 3 through December 31, 2006, $1,220 from January 1 through April 2, 2006, and $4,880 in 2005 and 2004. The Company has the right to repay the note on any March 31 or September 30 after September 30, 2005. The note calls for the Company to pay interest semiannually on March 31 and September 30. Any payment of interest or repayment of principal may be paid only if the Company has obtained the prior written approval of the Nebraska Department of F-32 12. TRANSACTIONS WITH AFFILIATED COMPANIES--CONTINUED Insurance, has adequate earned surplus funds for such payment, and if such payment would not cause the Company to violate the statutory capital requirements as set forth in the General Statutes of Nebraska. The Company owns no securities of the Parent or any affiliate of the Parent other than the following, reflected at the carrying amounts in the consolidated balance sheets as of December 31: 2006 2005 -------- -------- Lincoln JP Holdings L.P. Senior Promissory Notes due 2008, interest rate of 4.6% $107,507 $106,848 Lincoln Financial Media Senior Promissory Notes due 2006 through 2013, interest rates ranging from 4.2% to 7.7% $ 16,743 $ 22,940 Lincoln National Corporation Senior Promissory Notes due 2007, interest rate of 5.25% $ 5,989 $ -- The Company recognized interest income totaling $4,806 from April 3 through December 31, 2006, $1,551 from January 1 through April 2, 2006, and $6,347 and $6,931 for the years ended December 31, 2005 and 2004, related to the preceding assets. The Company has an agreement with its affiliate broker/dealer, Jefferson Pilot Variable Corporation (JPVC). The agreement calls for the Company to pay JPVC for sales of the Company's variable annuity and variable universal life contracts. The amount paid is based on sales during the period and contracts in force. The Company recorded expense of $21,425 from April 3 through December 31, 2006, $9,426 from January 1 through December 31, 2006, and $31,151 and $36,680 for the years ended December 31, 2005 and 2004, related to this agreement. 13. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying values and fair values of financial instruments as of December 31 are summarized as follows:
2006 2005 ------------------------ ----------------------- CARRYING FAIR CARRYING FAIR VALUE VALUE VALUE VALUE ----------- ---------- ---------- ---------- FINANCIAL ASSETS Debt securities available-for-sale $9,613,191 $9,613,191 $9,046,904 $9,046,904 Debt securities held-to-maturity -- -- 688,480 724,370 Equity securities available-for-sale 14,730 14,730 10,323 10,323 Mortgage loans on real estate 1,397,198 1,421,562 1,526,925 1,599,264 Policy loans 577,264 629,109 574,808 624,895 Derivative financial instruments (1,297) (1,297) (1,083) (1,083) FINANCIAL LIABILITIES Annuity contract liabilities in accumulation phase 1,850,915 1,826,295 2,037,294 2,010,853 Securities sold under repurchase agreements -- -- 150,792 150,792
The fair values of cash, cash equivalents, balances due on account from agents, reinsurers and others, and accounts payable approximate their carrying amounts in the Company's consolidated balance sheets due to their short-term maturity or availability. Assets and liabilities related to separate accounts are reported at fair value in the consolidated balance sheets. The fair values of debt and equity securities and derivative financial instruments have been determined from nationally quoted market prices and by using values supplied by independent pricing services and discounted cash flow techniques. The fair value of the mortgage loan portfolio has been estimated by discounting expected future cash flows using the interest rate currently offered for similar loans. F-33 13. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS--CONTINUED The fair value of policy loans outstanding for traditional life products has been estimated using a current risk-free interest rate applied to expected future loan repayments projected based on historical repayment patterns. The fair values of policy loans on universal life-type and annuity products approximate carrying values due to the variable interest rates charged on those loans. Annuity contracts do not generally have defined maturities. Therefore, fair values of the liabilities under annuity contracts, the carrying amounts of which are included with policyholder contract deposits in the Company's consolidated balance sheets, are estimated to equal the cash surrender values of the contracts. The fair value of the liability for securities sold under repurchase agreements approximates its carrying amount, which includes accrued interest. 14. COMMITMENTS AND CONTINGENT LIABILITIES The Company routinely enters into commitments to extend credit in the form of mortgage loans and to purchase certain debt securities for its investment portfolio in private placement transactions. The fair value of outstanding commitments to fund mortgage loans and to acquire debt securities in private placement transactions, which are not reflected in the Company's consolidated balance sheets, approximated $32,659 and $13,050 as of December 31, 2006 and 2005, respectively. The Company leases electronic data processing equipment and field office space under noncancelable operating lease agreements. The lease terms generally range from one to seven years. Neither annual rent nor future rental commitments are significant. In the normal course of business, the Company is involved in various lawsuits. Because of the considerable uncertainties that exist, the Company cannot predict the outcome of pending or future litigation. However, management believes that the resolution of pending legal proceedings will not have a material effect on the Company's financial position, liquidity, or results of operations. 15. SEGMENT INFORMATION The Company's reporting segments reflect the current manner by which our chief operating decision makers view and manage the business. All segment data for reporting periods have been adjusted to reflect the current segment reporting. The Company provides its products and services in two operating businesses: (1) Individual Markets and (2) Employer Markets and report results through four business segments. The following is a brief description of these segments. INDIVIDUAL MARKETS. The Individual Markets business provides its products through two segments, Individual Annuities and Individual Life Insurance. Through its Individual Annuities segment, Individual Markets provides tax-deferred investment growth and lifetime income opportunities for its clients by offering individual fixed annuities, including indexed annuities, and variable annuities. The Individual Life Insurance segment offers wealth protection and transfer opportunities through both single and survivorship versions of universal life, variable universal life, interest-sensitive whole life, term insurance, as well as a linked-benefit product, which is a universal life insurance policy linked with riders that provide for long-term care costs. EMPLOYER MARKETS. The Employer Markets business provides its products through two segments, Retirement Products and Group Protection, formerly referred to as Benefit Partners. Through its Retirement Products segment, Employer Markets provides employer-sponsored variable and fixed annuities, mutual fund based programs in the 401 (k), 403 (b), and 457 marketplaces and corporate/bank owned life insurance. The Group Protection segment offers group non-medical insurance products, principally term life, disability and dental, to the employer marketplace through various forms of contributory and noncontributory plans. Most of the Company's contracts are sold to employers with fewer than 500 employees. The Company also has "Other Operations", which includes the financial data for operations that are not directly related to the business segments and unallocated items (such as corporate investment income on assets F-34 15. SEGMENT INFORMATION--CONTINUED not allocated to its business units, interest expense on short-term and long-term borrowings, and certain expenses, including restructuring and merger-related expenses). Segment operating revenue and income (loss) from operations are internal measures used by the Company's management and Board of Directors to evaluate and assess the results of its segments. Operating revenue is GAAP revenue excluding realized gains and losses on investments. Income (loss) from operations is GAAP net income excluding net realized investment gains and losses. The Company's management and Board of Directors believe that operating revenue and income (loss) from operations explain the results of its ongoing businesses in a manner that allows for a better understanding of the underlying trends in the Company's current businesses because net realized investment gains and losses 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. Operating revenue and income (loss) from operations do not replace revenues and net income as the GAAP measure of the Company's consolidated results of operations. The following tables show financial data by segment:
PERIOD FROM PERIOD FROM APRIL 3 JANUARY 1 YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, APRIL 2, ----------------------- 2006 2006 2005 2004 ------------ ----------- ---------- ---------- REVENUE: Segment Operating Revenue: Individual Markets: Individual Annuities $ 102,085 $ 34,975 $ 152,604 $ 163,996 Life Insurance 607,760 211,437 854,907 873,203 ---------- -------- ---------- ---------- Individual Markets Total 709,845 246,412 1,007,511 1,037,199 ---------- -------- ---------- ---------- Employer Markets: Retirement & Other 65,873 23,374 93,117 93,932 Group Protection 1,023,726 342,086 1,268,892 1,190,342 ---------- -------- ---------- ---------- Employer Markets Total 1,089,599 365,460 1,362,009 1,284,274 ---------- -------- ---------- ---------- Other Operations 30,335 9,753 47,643 41,016 Net realized gain (loss) on investments 497 (3,086) (6,266) (37,337) ---------- -------- ---------- ---------- Total $1,830,276 $618,539 $2,410,897 $2,325,152 ========== ======== ========== ========== NET INCOME: Segment Operating Income: Individual Markets: Individual Annuities $ 12,388 $ 4,673 $ 21,508 $ 18,806 Life Insurance 91,141 32,670 151,225 149,675 ---------- -------- ---------- ---------- Individual Markets Total 103,529 37,343 172,733 168,481 ---------- -------- ---------- ---------- Employer Markets: Retirement & Other 10,945 3,741 15,400 14,541 Group Protection 95,787 23,912 83,727 65,593 ---------- -------- ---------- ---------- Employer Markets Total 106,732 27,653 99,127 80,134 ---------- -------- ---------- ---------- Other Operations 9,876 1,660 21,674 23,619 Cumulative Change -- -- (7,233) Net realized gain (loss) on investments 323 (2,005) (4,072) (24,269) ---------- -------- ---------- ---------- NET INCOME $ 220,460 $ 64,651 $ 289,462 $ 240,732 ========== ======== ========== ==========
F-35 15. SEGMENT INFORMATION--CONTINUED DECEMBER 31 ------------------------- 2006 2005 ----------- ----------- ASSETS: Individual Markets: Individual Life Insurance $ 9,305,892 $10,425,115 Individual Annuities 2,911,465 2,684,610 Employer Markets: Retirement Products 1,372,364 1,397,437 Group Protection 2,207,218 1,786,677 Other Operations 1,708,782 495,473 ----------- ----------- Total $17,505,721 $16,789,312 =========== =========== 16. STOCK-BASED COMPENSATION The Company's employees are included in LNC's various incentive plans that provide for the issuance of stock options, stock incentive awards, stock appreciation rights ("SARs"), restricted stock awards, restricted stock units ("performance shares"), and deferred stock units. LNC has a policy of issuing new shares to satisfy option exercises. LNC issues share-based compensation awards under an authorized plan, subject to specific vesting conditions. Generally, compensation expense is recognized ratably over a three-year vesting period, but recognition may be accelerated upon the occurrence of certain events. For awards that specify an employee will vest upon retirement and an employee is eligible to retire before the end of the normal vesting period, the Company would record compensation expense over the period from the grant date to the date of retirement eligibility. On January 1, 2006, the Company adopted SFAS 123-R under the modified prospective method. Accordingly, prior period amounts have not been restated. Under the modified prospective method, the fair value of all employee stock options vesting on or after the adoption date is generally included in the determination of net income as the options vest. The fair value of stock options granted has been estimated using the Black Scholes option valuation model considering assumptions for dividend yield, expected volatility, risk-free interest rate and expected life of the option. The fair value of the option grants is amortized on a straight-line basis over the implicit service period of the employee, considering retirement eligibility. For those employees that will achieve retirement eligibility during the vesting period, the expense is recognized evenly up through the retirement eligibility date or immediately upon grant for participants already eligible for retirement. Total stock-based compensation expense allocated to the Company for the periods April 3 through December 31, 2006 and January 1 through April 2, 2006 were $0 and $4,107 related to the various LNC stock incentive plans. The compensation cost is included in the general and administrative expenses, net of deferrals, line item on the Company's consolidated statements of income. Outstanding options to acquire Jefferson-Pilot common stock that existed immediately prior to the date of the merger remain subject to the same terms and conditions that existed, except that each of these stock options is now exercisable for LNC common stock. Grants of Jefferson-Pilot stock options in February 2006 will generally continue to vest in one-third annual increments. All employee and director stock options outstanding as of December 31, 2005 vested and became exercisable upon closing the merger resulting in an expense of $2,379 on April 2, 2006. F-36 THE LINCOLN NATIONAL LIFE INSURANCE COMPANY C-1 THE LINCOLN NATIONAL LIFE INSURANCE COMPANY SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2006 AND 2005 THE LINCOLN NATIONAL LIFE INSURANCE COMPANY SUPPLEMENTAL CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2006 DECEMBER 31, 2005 ----------------- ----------------- (IN MILLIONS) ------------------------------------- ASSETS Investments: Securities available-for sale, at fair value: Fixed maturity (cost: 2006 -- $53,846, 2005 -- $31,267) $ 54,697 $ 32,245 Equity (cost: 2006 -- $205, 2005 -- $95) 218 101 Trading securities 2,820 2,985 Mortgage loans on real estate 7,344 3,662 Real estate 409 182 Policy loans 2,755 1,858 Derivative investments 245 41 Other investments 819 423 -------- -------- Total Investments 69,307 41,497 Cash and invested cash 1,762 1,962 Deferred acquisition costs and value of business acquired 7,609 4,418 Premiums and fees receivable 331 285 Accrued investment income 838 500 Amounts recoverable from reinsurers 7,949 6,955 Goodwill 3,514 919 Other assets 1,729 1,091 Assets held in separate accounts 71,777 56,427 -------- -------- Total Assets $164,816 $114,054 ======== ======== LIABILITIES AND SHAREHOLDER'S EQUITY LIABILITIES: Insurance policy and claim reserves $ 13,650 $ 10,384 Investment contractholder and policyholder funds 58,385 35,273 -------- -------- Total Insurance and Investment Contract Liabilities 72,035 45,657 Short-term debt 21 34 Long-term debt and senior notes 1,440 1,250 Reinsurance related derivative liability 218 278 Funds withheld reinsurance liabilities 1,816 1,711 Deferred gain on indemnity reinsurance 759 835 Other liabilities 3,905 2,536 Liabilities related to separate accounts 71,777 56,427 -------- -------- Total Liabilities 151,971 108,728 -------- -------- Commitments and Contingencies (See Note 9) SHAREHOLDER'S EQUITY Common stock 6,961 25 Retained earnings 5,468 4,848 Accumulated other comprehensive income: Net unrealized gain on securities available-for-sale 421 452 Net unrealized (loss)gain on derivative instruments (9) 7 Minimum pension liability adjustment -- (6) -------- -------- Net other comprehensive income adjustments, net of tax 412 453 Adjustment to initially apply SFAS 158 4 -- -------- -------- Total accumulated other comprehensive income 416 453 -------- -------- Total Shareholder's Equity 12,845 5,326 -------- -------- Total Liabilities and Shareholder's Equity $164,816 $114,054 ======== ========
See accompanying notes to the Supplemental Consolidated Financial Statements. C-2 SUPPLEMENTAL CONSOLIDATED STATEMENTS OF INCOME
2006 2005 2004 ------ ------ ------ (IN MILLIONS) ------------------------ REVENUE: Insurance premiums $1,149 $ 67 $ 158 Insurance fees 2,439 1,575 1,405 Net investment income 3,869 2,592 2,593 Realized (loss) on investments (2) (16) (45) Amortization of deferred gain on indemnity insurance 76 77 87 Other revenue and fees 258 316 275 ------ ------ ------ Total Revenue 7,789 4,611 4,473 ------ ------ ------ BENEFITS AND EXPENSES: Benefits 3,998 2,122 2,143 Underwriting, acquisition, insurance and other expenses 2,086 1,544 1,475 Interest and debt expense 84 78 79 ------ ------ ------ Total Benefits and Expenses 6,168 3,744 3,697 ------ ------ ------ Income before Federal income taxes and cumulative effect of accounting changes 1,621 867 776 Federal income taxes 460 223 193 ------ ------ ------ Income before cumulative effect of accounting changes 1,161 644 583 Cumulative effect of accounting changes (net of Federal income taxes) -- -- (26) ------ ------ ------ Net Income $1,161 $ 644 $ 557 ====== ====== ======
See accompanying notes to the Supplemental Consolidated Financial Statements. C-3 SUPPLEMENTAL CONSOLIDATED STATEMENTS OF SHAREHOLDER'S EQUITY
2006 2005 2004 ------- ------ ------ (IN MILLIONS) ------------------------- COMMON STOCK: Balance at beginning of year $ 25 $ 25 $ 25 Merger: Jefferson-Pilot Life, Jefferson-Pilot LifeAmerica and Jefferson-Pilot Financial Insurance Company 6,936 -- -- ------- ------ ------ Balance at the end of year 6,961 25 25 ------- ------ ------ RETAINED EARNINGS: Balance at the beginning of the year 4,848 4,385 3,856 Comprehensive income 1,120 315 566 Less other comprehensive income (loss) (net of federal income tax): Net unrealized gain (loss) on securities available-for-sale, net of reclassification adjustment (31) (329) 23 Net unrealized loss on derivative instruments (16) (7) (10) Minimum pension liability adjustment 6 7 (4) ------- ------ ------ Net income 1,161 644 557 Additional investment by Lincoln National Corporation/Stock Compensation 27 19 122 Dividends declared (568) (200) (150) ------- ------ ------ Balance at the end of year 5,468 4,848 4,385 ------- ------ ------ NET UNREALIZED GAIN ON SECURITIES AVAILABLE-FOR-SALE: Balance at the beginning of the year 452 781 758 Change during the year (31) (329) 23 ------- ------ ------ Balance at the end of year 421 452 781 ------- ------ ------ NET UNREALIZED (LOSS) GAIN ON DERIVATIVE INSTRUMENTS: Balance at the beginning of the year 7 14 24 Change during the year (16) (7) (10) ------- ------ ------ Balance at the end of year (9) 7 14 ------- ------ ------ MINIMUM PENSION LIABILITY ADJUSTMENT: Balance at the beginning of the year (6) (13) (9) Change during the year 6 7 (4) ------- ------ ------ Balance at the end of year -- (6) (13) ------- ------ ------ ADJUSTMENT FOR ADOPTION OF SFAS 158 4 -- -- ------- ------ ------ Total Shareholder's Equity $12,845 $5,326 $5,192 ======= ====== ======
See accompanying notes to the Supplemental Consolidated Financial Statements. C-4 STATEMENTS OF CASH FLOW
2006 2005 2004 ------- ------- ------- (IN MILLIONS) --------------------------- OPERATING ACTIVITIES Net income $ 1,161 $ 644 $ 557 Adjustments to reconcile net income to net cash provided by operating activities: Deferred acquisition costs and value of business acquired (722) (430) (350) Premiums and fees receivable 16 54 112 Accrued investment income 21 (4) (5) Policy liabilities and accruals 170 (1,082) (1,347) Net trading securities, purchases, sales and maturities 165 (72) (99) Cumulative effect of accounting change -- -- 39 Contractholder funds 741 1,893 1,536 Amounts recoverable from reinsurers 199 101 375 Federal income taxes 121 144 121 Stock-based compensation expense 4 18 19 Depreciation 54 64 48 Realized loss on investments and derivative instruments 2 16 59 Gain on sale of subsidiaries/business -- -- (14) Amortization of deferred gain (76) (76) (87) Other (164) (608) (275) ------- ------- ------- Net adjustments 531 18 132 ------- ------- ------- Net cash provided by operating activities 1,692 662 689 ------- ------- ------- INVESTING ACTIVITIES Securities available-for-sale: Purchases (9,323) (5,725) (9,001) Sales 5,328 3,767 4,740 Maturities 3,326 2,392 2,468 Purchase of other investments (696) (1,008) (1,938) Sale or maturity of other investments 585 1,151 2,187 Proceeds from disposition of business -- -- 10 Cash acquired from merger of Jefferson-Pilot Life Insurance Company and Jefferson-Pilot LifeAmerica Insurance Company 154 -- -- Other 58 9 146 ------- ------- ------- Net cash provided by (used in) investing activities (568) 586 (1,388) ------- ------- ------- FINANCING ACTIVITIES Issuance of long-term debt 140 -- 47 Payment of long-term debt -- (47) -- Net decrease in short-term debt (13) 2 (10) Univeral life and investment contract deposits 7,444 4,783 4,928 Univeral life and investment contract withdrawals (6,660) (3,755) (3,353) Investment contract transfers (1,821) (1,483) (1,336) Increase in collateral on loaned securities -- 45 181 Increase in funds withheld liability 105 131 87 Net proceeds from securities sold under repurchase agreements 49 -- -- Capital contribution from shareholder -- -- 100 Dividends paid to shareholders (568) (200) (150) ------- ------- ------- Net cash provided by (used in) financing activities (1,324) (524) 494 ------- ------- ------- Net increase (decrease) in cash and invested cash (200) 724 (205) ------- ------- ------- Cash and invested cash at beginning of year 1,962 1,238 1,443 ------- ------- ------- Cash and invested cash at end of year $ 1,762 $ 1,962 $ 1,238 ======= ======= =======
See accompanying notes to the Supplemental Consolidated Financial Statements. C-5 NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION The accompanying Supplemental Consolidated Financial Statements include The Lincoln National Life Insurance Company and its majority-owned subsidiaries ("LNL" or the "Company", which may also be referred to in these Notes as "we" or "us"). The Company is domiciled in Indiana. Lincoln National Corporation ("LNC") owns 100% of the Company on a direct basis and its subsidiaries on an indirect basis. The Company owns 100% of the outstanding common stock of two insurance company subsidiaries: First Penn-Pacific Life Insurance Company ("First Penn") and Lincoln Life & Annuity Company of New York ("Lincoln Life New York"). The Company also owns several non-insurance companies, including Lincoln Financial Distributors ("LFD") and Lincoln Financial Advisors ("LFA"), LNC's internally owned wholesaling and retailing business units, respectively throughout business segments. LNL's principal businesses consist of underwriting annuities, deposit-type contracts and life insurance through multiple distribution channels. LNL is licensed and sells its products throughout the United States and several U.S. territories (see Note 11). These Supplemental Consolidated Financial Statements have been prepared in conformity with accounting principles generally accepted in the United States ("GAAP"). On April 3, 2006, LNC completed its merger with Jefferson-Pilot ("JP") by acquiring 100% of the outstanding shares of Jefferson-Pilot. On February 15, 2007, the North Carolina Department of Insurance approved the merger of the Jefferson Pilot Life Insurance Company ("JPL") and Jefferson-Pilot LifeAmerica Insurance Company ("JPLA"), both affiliates, into the Company with the Company being the survivor and the Parent Company, respectively. The effective date of these transactions was April 2, 2007. Jefferson Pilot Financial Insurance Company ("JPFIC") was wholly owned by JP. JPFIC is expected to merge into LNL on July 2, 2007. This transaction is dependent on the approval by the Nebraska Insurance Department. These financial statements are prepared as if on April 3, 2006, the Company completed the merger with Jefferson-Pilot Life Insurance Company, Jefferson-Pilot Financial Insurance Company and Jefferson-Pilot LifeAmerica Insurance Company, and has included the results of operations and financial condition of JPL, JPFIC and JPLA in our Supplemental Consolidated Financial Statements beginning on April 3, 2006. The Supplemental Consolidated Financial Statements for the years ended December 31, 2005 and 2004 exclude the results of operations and financial condition of JPL, JPFIC and JPLA. The insurance subsidiaries also submit financial statements to insurance industry regulatory authorities. Those financial statements are prepared on the basis of statutory accounting practices (SAP) and are significantly different from financial statements prepared in accordance with GAAP. See Note 9. Certain GAAP policies, which significantly affect the determination of financial position, results of operations and cash flows, are summarized below. BUSINESS COMBINATIONS On April 3, 2006, LNC completed its merger with JP by acquiring 100% of the outstanding shares of JP in a transaction accounted for under the purchase method of accounting prescribed by Statement of Financial Accounting Standard (SFAS) No. 141, "Business Combinations" ("SFAS 141") and JPL, JPFIC and JPLA became wholly-owned by LNC. SFAS 141 requires that the total purchase price be allocated to the assets acquired and liabilities assumed based on their fair values at the merger date. As of April 3, 2006, the associated fair values of JPL, JPFIC and JPLA were "pushed down" to the Company's financial statements in accordance with push down accounting rules. The fair value of net assets assumed in the mergers was $6.9 billion. Goodwill of $2.6 billion resulted from the excess of purchase price over the fair value of the net assets assumed. The parent paid a premium over the fair value of JP's net assets for a number of potential strategic and financial benefits that are expected to be realized as a result of the merger including, but not limited to, the following: - Greater size and scale with improved earnings diversification and strong financial flexibility; - Broader, more balanced product portfolio; - Larger distribution organization; and - Value creation opportunities through expense savings and revenue enhancements across business units. The following table summarizes the preliminary fair values of the net assets acquired as of the acquisition date along with adjustments that were made to the Balance Sheet to get to the fair value of net assets:
PRELIMINARY FAIR VALUE FAIR VALUE ADJUSTMENTS(1) ----------- -------------- (IN MILLIONS) ---------------------------- Investments $ 27,378 $ 305 Due from reinsurers 1,193 -- Deferred policy acquisition costs -- (2,494) Value of business acquired 2,478 1,983 Goodwill 2,595 2,325 Other assets 1,138 24 Assets held in separate accounts 2,574 -- Policy liabilities (26,562) 564 Income tax liabilities (440) (137) Accounts payable, accruals and other liabilities (848) (13) Liabilities related to separate accounts (2,574) -- -------- ------- Total net assets acquired $ 6,932 $ 2,557 ======== =======
(1) Premiums and discounts that resulted from recording the assets and liabilities at their respective fair values are being amortized and accreted using methods that approximate a constant effective yield over the expected life of the assets and liabilities. C-6 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) The goodwill resulting from the merger was allocated to the following segments:
PRELIMINARY FAIR VALUE ------------- (IN MILLIONS) ------------- Individual Markets: Life Insurance $1,326 Annuities 988 Employer Markets: Group Protection 281 ------ Total Goodwill $2,595 ======
ACCOUNTING ESTIMATES AND ASSUMPTIONS The preparation of financial statements requires management to make estimates and assumptions affecting the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities as of the date of the financial statements, and the reported amounts of revenue and expenses for the reporting period. Those estimates are inherently subject to change and actual results could differ from those estimates. Included among the material (or potentially material) reported amounts and disclosures that require extensive use of estimates are: fair value of certain invested assets, derivatives, asset valuation allowances, deferred policy acquisition costs, goodwill, value of business acquired, insurance and investment contract liabilities, deferred front end loads, pension plans and the potential effects of resolving litigated matters. INVESTMENTS Securities available-for-sale consist of fixed maturity and equity securities, which are stated at fair value with net unrealized gains and losses included in accumulated other comprehensive income, net of deferred income taxes and adjustments to deferred policy acquisition costs and value of business acquired. Fair value is based on quoted market prices from observable market data or estimated using an internal pricing matrix for privately placed securities when quoted market prices are not available. This matrix relies on management's judgment concerning: 1) the discount rate used in calculating expected future cash flows; 2) credit quality; 3) industry sector performance; and 4) expected maturity. Under certain circumstances, we apply professional judgment and make adjustments based upon specific detailed information concerning the issuer. The cost of available-for-sale fixed maturity and equity securities is reduced to fair value with a corresponding charge to realized loss on investments for declines in value that are other-than-temporary. Dividend and investment income are recognized when earned. Amortization of premiums and accretion of discounts on investments in debt securities are reflected in earnings over the contractual terms of the investments in a manner that produces a constant effective yield. Investment securities are regularly reviewed for impairment based on criteria that include the extent to which cost exceeds market value, the duration of the market decline, and the financial health of and specific prospects for the issuer. Unrealized losses that are considered to be other-than-temporary are recognized in realized gains and losses with a corresponding reduction in the cost of available-for-sale fixed maturity and equity securities. See Note 3 for further discussion of the Company's policies regarding identification of other-than-temporary impairments. Trading securities consist of fixed maturity and equity securities in designated portfolios, which support modified coinsurance ("Modco") and coinsurance with funds withheld ("CFW") reinsurance arrangements. Investment results for these portfolios, including gains and losses from sales, are passed directly to the reinsurers through the contractual terms of the reinsurance arrangements. Trading securities are carried at fair value and changes in fair value are recorded in net income as they occur. Offsetting these amounts are corresponding changes in the fair value of embedded derivative liabilities associated with the underlying reinsurance arrangements. For the mortgage-backed securities portion of the trading and available-for-sale fixed maturity securities portfolios, we recognize investment income using a constant effective yield based on anticipated prepayments and the estimated economic life of the securities. When estimates of prepayments change, the effective yield is recalculated to reflect actual payments to date and anticipated future payments. When the effective yield changes, the carrying value of the security is adjusted prospectively. This adjustment is reflected in net investment income. Mortgage loans on real estate are carried at the outstanding principal balances adjusted for amortization of premiums and discounts and are net of valuation allowances. Valuation allowances are established for the excess carrying value of the mortgage loan over its estimated fair value 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, the cost is adjusted or a provision for loss is established equal to the difference between the amortized cost of the mortgage loan and the estimated value. Estimated value is based on: 1) the present value of expected future cash flows discounted at the loan's effective interest rate; 2) the loan's observable market price; 3) the fair value of the collateral. The provision for losses is reported as realized gain (loss) on investments. Mortgage loans deemed to be uncollectible are charged against the allowance for losses and subsequent recoveries, if any, are credited to the allowance for losses. Interest income on mortgage loans includes interest collected, the change in accrued interest, and amortization of premiums and discounts. Mortgage loan fees and costs are recorded in net investment income as they are incurred. Investment real estate is carried at cost less accumulated depreciation. Depreciation is provided on a straight-line basis over the estimated useful life of the asset. Cost is adjusted for impairment when the projected undiscounted cash flow from the investment is less than the carrying value. Impaired real estate is written down to the estimated fair value of the real estate, which is generally computed using the present value of expected future cash flows from the real estate discounted at a rate commensurate with the underlying risks. Also, valuation allowances for losses are established, as appropriate, for real estate holdings that are in the process of being sold. Real estate C-7 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) acquired through foreclosure proceedings is reclassified on the balance sheet from mortgage loans on real estate to real estate and is recorded at fair value at the settlement date, which establishes a new cost basis. If a subsequent periodic review of a foreclosed property indicates the fair value, less estimated costs to sell, is lower than the carrying value at settlement date, the carrying value is adjusted to the lower amount. Write-downs to real estate and any changes to the reserves on real estate are reported as realized loss on investments. Policy loans are carried at aggregate unpaid balances. Realized gain (loss) on investments includes realized gains and (losses) from the sale of investments, derivative gains (losses), gains on sale of subsidiaries/business, and net gain (loss) on reinsurance embedded derivative/trading securities. See Note 3 for additional detail. Realized gain (loss) on investments is recognized in net income, net of associated amortization of deferred acquisition costs ("DAC") and investment expenses, using the specific identification method. Changes in the fair values of available-for-sale securities carried at fair value are reported as a component of accumulated other comprehensive income, after deductions for related adjustments for DAC and amounts required to satisfy policyholder commitments that would have been recorded had these securities been sold at their fair value, and after deferred taxes or credits to the extent deemed recoverable. DERIVATIVE INSTRUMENTS We hedge certain portions of our exposure to interest rate risk, credit risk, foreign exchange risk and equity fluctuation risk by entering into derivative transactions. We recognize all derivative instruments as either assets or liabilities in the Supplemental Consolidated Balance Sheets at fair value. The accounting for changes in the fair value of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship and further, on the type of hedging relationship. For those derivative instruments that are designated and qualify as hedging instruments, we must designate the hedging instrument based upon the exposure being hedged -- as a cash flow hedge, fair value hedge or a hedge of a net investment in a foreign operation. As of December 31, 2006 and 2005, we had derivative instruments that were designated and qualified as cash flow hedges and fair value hedges. In addition, we had derivative instruments that were economic hedges, but were not designated as hedging instruments under Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). For derivative instruments that are designated and qualify as a cash flow hedge, the effective portion of the gain or loss on the derivative instrument is reported as a component of other comprehensive income ("OCI") and reclassified into net income in the same period or periods during which the hedged transaction affects net income. The remaining gain or loss on the derivative instrument in excess of the cumulative change in the present value of designated future cash flows of the hedged item (hedge ineffectiveness), if any, is recognized in net income during the period of change. For derivative instruments that are designated and qualify as a fair value hedge, the gain or loss on the derivative instrument as well as the offsetting loss or gain in fair value on the hedged item attributable to the hedged risk are recognized in net income during the period of change in fair values. For derivative instruments that are not designated as hedging instruments but that are economic hedges, the gain or loss is recognized in current income during the period of change in the corresponding income statement line as the transaction being hedged. We have 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 the Lincoln Smart SecuritySM Advantage guaranteed minimum withdrawal benefits ("GMWB") feature and our i4LIFE(R) Advantage guaranteed income benefits ("GIB") feature that is available in our variable annuity products. This GMWB feature offers the contractholder a guarantee equal to the initial deposit adjusted for any subsequent purchase payments or withdrawals. There are one-year and five-year step-up options, which allow the contractholder to step up the guarantee. GMWB features are considered to be derivatives under SFAS 133, resulting in the guarantees being recognized at fair value, with changes in fair value being reported in net income. The hedging strategy is designed such that changes in the value of the hedge contracts move in the opposite direction of changes in the value of the embedded derivative of the GMWB and GIB. As part of our current hedging program, policyholder behavior and equity, interest rate, and volatility market conditions are monitored on a daily basis. We rebalance our hedge positions based upon changes in these factors as needed. While we actively manage our hedge positions, our hedge positions may not be totally effective to offset changes in assets and liabilities caused by movements in these factors 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, policyholder behavior, divergence between the performance of the underlying funds and the hedging indices, divergence between the actual and expected performance of the hedge instruments, or our ability to purchase hedging instruments at prices consistent with our desired risk and return trade-off. We have certain Modco and CFW reinsurance arrangements with embedded derivatives related to the funds withheld assets. These derivatives are considered total return swaps with contractual returns that are attributable to various assets and liabilities associated with these reinsurance arrangements. Changes in the fair value of these derivatives are recorded in net income as they occur. Offsetting these amounts are corresponding changes in the fair value of trading securities in portfolios that support these arrangements. See Note 9 for further discussion of our accounting policy for derivative instruments. CASH AND INVESTED CASH Cash and invested cash are carried at cost and include all highly liquid debt instruments purchased with a maturity of three months or less. C-8 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) DEFERRED ACQUISITION COSTS, VALUE OF BUSINESS ACQUIRED, DEFERRED FRONT END LOADS, DEFERRED SALES INDUCEMENTS Commissions and other costs of acquiring universal life insurance, variable universal life insurance, traditional life insurance, annuities and other investment contracts, which vary with and are primarily related to the production of new business, have been deferred to the extent recoverable. The methodology for determining the amortization of acquisition costs varies by product type based on two different accounting pronouncements: SFAS No. 97, "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments" ("SFAS 97") and SFAS No. 60, "Accounting and Reporting by Insurance Enterprises" ("SFAS 60"). Under SFAS 97, acquisition costs for universal life, variable universal life insurance and investment-type products, which include fixed and variable deferred annuities, are amortized over the lives of the policies in relation to the incidence of estimated gross profits from surrender charges, investment, mortality net of reinsurance ceded and expense margins, and actual realized gain (loss) on investments. Past amortization amounts are adjusted when revisions are made to the estimates of current or future gross profits expected from a group of products. Policy lives for universal and variable universal life policies are estimated to be 30 years, based on the expected lives of the policies. Policy lives for fixed and variable deferred annuities are 14 to 20 years for the traditional, long surrender charge period products and 8 to 10 years for the more recent short-term, or no surrender charge variable products. The front-end load annuity product has an assumed life of 25 years. Longer lives are assigned to those blocks that have demonstrated favorable experience. Under SFAS 60, acquisition costs for traditional life insurance products, which include whole life and term life insurance contracts are amortized over periods of 10 to 30 years on either a straight-line basis or as a level percent of premium of the related policies depending on the block of business. There is currently no DAC being amortized under SFAS 60 for fixed and variable payout annuities. For all SFAS 97 and SFAS 60 policies, amortization is based on assumptions consistent with those used in the development of the underlying policy form adjusted for emerging experience and expected trends. Value of business acquired ("VOBA") is amortized over the expected lives of the block of insurance business in relation to the incidence of estimated profits expected to be generated on universal life, variable universal life and investment-type products acquired, (i.e., unit-linked products and variable deferred annuities) and over the premium paying period for insurance products acquired, (i.e., traditional life insurance products). Amortization is based upon assumptions used in pricing the acquisition of the block of business and is adjusted for emerging experience. Accordingly, amortization periods and methods of amortization for VOBA vary depending upon the particular characteristics of the underlying blocks of acquired insurance business. VOBA is amortized in a manner consistent with DAC. The carrying amounts of deferred policy acquisition costs and value of business acquired are adjusted for the effects of realized gains and losses and the effects of unrealized gains and losses on debt securities classified as available-for-sale. Bonus credits and excess interest for dollar cost averaging ("DCA") contracts are considered sales inducements and are deferred as a sales inducement asset (referred to as "deferred sales inducements" or "DSI"). DSI is amortized as a benefit expense over the expected life of the contract. Amortization is computed using the same methodology and assumptions used in amortizing DAC. DSI is reported within the other assets caption of the Supplemental Consolidated Balance Sheets. Policy sales charges that are collected in the early years of an insurance policy have been deferred (referred to as "deferred front-end loads" or "DFEL") and are amortized into income over the life of the policy in a manner consistent with that used for DAC. DFEL is reported within the investment contract and policyholder funds caption of the Supplemental Consolidated Balance Sheets. The deferral and amortization of DFEL is reported within insurance fees in the Supplemental Consolidated Statements of Income. During the third quarter of each year, we conduct our annual comprehensive review of the assumptions underlying the amortization of DAC, VOBA, DSI and DFEL. We review the various assumptions including investment margins, mortality and retention. These assumptions also impact the reserves for the guarantee features within our variable annuity and life insurance products. In addition to the annual third quarter review of assumptions, if factors or trends indicate that actual experience varies significantly from these assumptions, adjustments are made in the quarter in which the evaluation of the respective blocks of business is completed. The effects of changes in estimated future gross profits on unamortized deferred policy acquisition costs and value of business acquired, referred to as prospective unlockings, are reflected in amortization expense within the Consolidated Statements of Income. Prospective unlockings affecting DSI are reflected in benefits expense and affecting DFEL are included in insurance fees within the Consolidated Statements of Income. DAC and VOBA are reviewed periodically to determine that the unamortized portion does not exceed the expected recoverable amounts. No significant impairments occurred during the three years ending December 31, 2006. REINSURANCE We enter into reinsurance agreements with other companies in the normal course of our business. Assets/Liabilities and premiums/benefits from certain reinsurance contracts that grant statutory surplus relief to other insurance companies are netted on the balance sheets and income statements, respectively, since there is a right of offset. All other reinsurance agreements are reported on a gross basis in the balance sheets as an asset for amounts recoverable from reinsurers or as a component of other liabilities for amounts, such as premiums, owed to the reinsurers, with the exception of Modco agreements for which the right of offset also exists. C-9 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) GOODWILL AND OTHER INTANGIBLE ASSETS We recognize the excess of the purchase price over the fair value of net assets acquired as goodwill. Goodwill is not amortized, but is reviewed at least annually for indications of value impairment, with consideration given to financial performance and other relevant factors. In addition, certain events including a significant adverse change in legal factors or the business climate, an adverse action or assessment by a regulator, or unanticipated competition would cause the Company to review the carrying amounts of goodwill for impairment. When considered impaired, the carrying amounts are written down using a combination of fair value and discounted cash flows. No impairments occurred during the three years ending December 31, 2006. Other intangible assets, which consist of DSI and sales force intangibles, as of December 31, 2006 and 2005, net of accumulated amortization are reported in other assets. DSI is amortized as discussed above, under the heading Deferred Acquisition Costs, Value of Business Acquired, Deferred Front End Loads, Deferred Sales Inducements. Sales force intangibles are attributable to the value of the distribution system acquired in the Individual Markets -- Life Insurance segment. These assets are amortized on a straight-line basis over their useful life of 25 years. PROPERTY AND EQUIPMENT Property and equipment owned for company use is included in other assets in our Supplemental Consolidated Balance Sheets and is carried at cost less allowances for depreciation. Provisions for depreciation of investment real estate and property and equipment owned for company use are computed principally on the straight-line method over the estimated useful lives of the assets, which include buildings, computer hardware and software and other property and equipment. IMPAIRMENT OF LONG-LIVED ASSETS We periodically review the carrying value of long-lived assets, including property and equipment, for impairment whenever events or circumstances indicate that the carrying amount of such assets may not be fully recoverable. For long-lived assets to be held and used, impairments are recognized when the carrying amount of a long-lived asset is not recoverable and exceeds its fair value. The carrying amount of a long-lived asset is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. An impairment loss is measured as the amount by which the carrying amount of a long-lived asset exceeds its fair value. Long-lived assets to be disposed of by abandonment or in an exchange for a similar productive long-lived asset are classified as held and used until disposed of. Long-lived assets to be sold are classified as held for sale and are no longer depreciated. Certain criteria have to be met in order for the long-lived asset to be classified as held for sale, including that a sale is probable and expected to occur within one year. Long-lived assets classified as held for sale are recorded at the lower of their carrying amount or fair value less cost to sell. ASSETS HELD IN SEPARATE ACCOUNTS/LIABILITIES RELATED TO SEPARATE ACCOUNTS These assets and liabilities related to separate accounts represent segregated funds administered and invested by us and our insurance subsidiaries for the exclusive benefit of pension and variable life and annuity contractholders. Both the assets and liabilities are carried at fair value. The fees earned by us for administrative and contractholder maintenance services performed for these separate accounts are included in insurance fee revenue. Policyholder account balances, withdrawals, investment income and realized investment gains and losses in the separate accounts are excluded from the amounts reported in the Supplemental Consolidated Statements of Income. INSURANCE AND INVESTMENT CONTRACT LIABILITIES The liabilities for future policy benefits and claim reserves for universal and variable universal life insurance policies consist of policy account balances that accrue to the benefit of the policyholders, excluding surrender charges. The liabilities for future insurance policy benefits and claim reserves for traditional life policies are computed using assumptions for investment yields, mortality and withdrawals based principally on generally accepted actuarial methods and assumptions at the time of policy issue. Interest assumptions for traditional direct individual life reserves for all policies range from 2.25% to 7.00% depending on the time of policy issue. The interest assumptions for immediate and deferred paid-up annuities range from 0.75% to 13.50%. The liabilities for future claim reserves for variable annuity products containing guaranteed minimum death benefits ("GMDB") features are calculated by multiplying the benefit ratio (present value of total expected GMDB payments over the life of the contract divided by the present value of total expected assessments over the life of the contract) by the cumulative assessments recorded from the contract inception through the balance sheet date, less the cumulative GMDB payments, plus interest. The change in the reserve for a period is then the benefit ratio multiplied by the assessments recorded for the period less GMDB claims paid in the period plus interest. If experience or assumption changes result in a new benefit ratio, the reserves are unlocked to reflect the changes in a manner similar to DAC. With respect to its insurance and investment contract liabilities, we continually review our: 1) overall reserve position; 2) reserving techniques, and; 3) reinsurance arrangements. As experience develops and new information becomes known, liabilities are adjusted as deemed necessary. The effects of changes in estimates are included in the operating results for the period in which such changes occur. The business written or assumed by us includes participating life insurance contracts, under which the policyholder is entitled to share in the earnings of such contracts via receipt of dividends. The dividend scale for participating policies is reviewed annually and may be adjusted to reflect recent C-10 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) experience and future expectations. As of December 31, 2006 and 2005 participating policies comprised 1.3% of the face amount of insurance in-force, and dividend expenses were $85 million, $78 million, and $77 million for the years ended December 31, 2006, 2005 and 2004, respectively. Universal life and variable life products with secondary guarantees represent approximately 34% of permanent life insurance in-force at December 31, 2006 and approximately 77% of sales of these products in 2006. Liabilities for the secondary guarantees on universal life-type products are calculated by multiplying the benefit ratio (present value of total expected secondary guarantee benefits over the life of the contract divided by the present value of total expected assessments over the life of the contract) by the cumulative assessments recorded from contract inception through the balance sheet date less the cumulative secondary guarantee benefit payments plus interest. If experience or assumption changes result in a new benefit ratio, the reserves are unlocked to reflect the changes in a manner similar to DAC, VOBA, DFEL and DSI. The accounting for secondary guarantee benefits impacts, and is impacted by, EGPs used to calculate amortization of DAC, VOBA, DFEL and DSI. The risk for the secondary guarantee is ceded to an affiliate of the Company in an arrangement that does not qualify as reinsurance. If the secondary guarantee is triggered, then the affiliate will reimburse the Company for the cost of insurance charges. The reinsurance of the secondary guarantee is considered a derivative as it does not meet the insurance risk transfer requirements of SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts" ("SFAS 113"). The fair value of the derivative is determined based on the fair value of the cash flows related to this agreement. LOANED SECURITIES Securities loaned are treated as collateralized financing transactions and a liability is recorded equal to the cash collateral received which is typically greater than the market value of the related securities loaned. This liability is included within other liabilities in our Supplemental Consolidated Balance Sheets. Our agreements with third parties generally contain contractual provisions to allow for additional collateral to be obtained when necessary. We value collateral daily and obtain additional collateral when deemed appropriate. BORROWED FUNDS Short-term borrowings are defined as borrowings with contractual or expected maturities of one year or less. Long-term borrowings have contractual or expected maturities greater than one year. COMMITMENTS AND CONTINGENCIES Contingencies arising from environmental remediation costs, regulatory judgments, claims, assessments, guarantees, litigation, recourse reserves, fines, penalties and other sources are recorded when deemed probable and estimable. PREMIUMS AND FEES ON INVESTMENT PRODUCTS AND UNIVERSAL LIFE INSURANCE PRODUCTS Investment products consist primarily of individual and group variable and fixed deferred annuities. Universal life insurance products include universal life insurance, variable universal life insurance, and other interest-sensitive life insurance policies. These products include life insurance sold to individuals, corporate-owned life insurance and bank-owned life insurance. Revenues for investment products and universal life insurance products consist of net investment income, asset based fees, cost of insurance charges, percent of premium charges, policy administration charges and surrender charges that have been assessed and earned against policy account balances and premiums received during the period. The timing of revenue recognition as it relates to fees assessed on investment contracts is determined based on the nature of such fees. Asset based fees, cost of insurance and policy administration charges are assessed on a daily or monthly basis and recognized as revenue when assessed and earned. Percent of premium charges are assessed at the time of premium payment and recognized as revenue when assessed and earned. Certain amounts assessed that represent compensation for services to be provided in future periods are reported as unearned revenue and recognized in income over the periods benefited. Surrender charges are recognized upon surrender of a contract by the contractholder in accordance with contractual terms. PREMIUMS ON TRADITIONAL LIFE INSURANCE PRODUCTS Traditional life insurance products include those products with fixed and guaranteed premiums and benefits and consist primarily of whole life insurance, limited-payment life insurance, term life insurance and certain annuities with life contingencies. Premiums for traditional life insurance products are recognized as revenue when due from the policyholder. OTHER REVENUES AND FEES Other revenue and fees principally consists of amounts earned by LFA, our retail distribution arm, from sales of third party insurance and investment products. Such revenue is recorded as earned at the time of sale. BENEFITS AND EXPENSES Benefits and expenses for universal life-type and other interest-sensitive life insurance products include interest credited to policy account balances and benefit claims incurred during the period in excess of policy account balances. Interest crediting rates associated with funds invested in our general account during 2004 through 2006 ranged from 4.0% to 7.0%. For traditional life, group health and disability income products, benefits and expenses, other than DAC, are recognized when incurred in a manner consistent with the related premium recognition policies. Benefits and expenses includes the change in reserves for annuity products with guaranteed benefits, such as GMDB, and the change in fair values of guarantees for annuity products with guaranteed income benefits ("GIB") or guaranteed minimum withdrawal benefits ("GMWB"). PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS Pursuant to the accounting rules for our obligations to employees under our various pension and other postretirement benefit plans, we are required to make a number of assumptions to estimate related liabilities and expenses. We use assumptions for the weighted-average discount rate, expected return on plan assets and a salary increase assumption to estimate C-11 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) pension expense. The discount rate assumptions are determined using an analysis of current market information and the projected benefit flows associated with these plans. The expected long-term rate of return on plan assets is initially established at the beginning of the plan year based on historical and projected future rates of return and is the average rate of earnings expected on the funds invested or to be invested in the plan. The calculation of our accumulated postretirement benefit obligation also uses an assumption of weighted-average annual rate of increase in the per capita cost of covered benefits, which reflects a health care cost trend rate. See Note 7 for more information on our accounting for employee benefit plans. STOCK BASED COMPENSATION We expense the fair value of stock awards included in LNC's incentive compensation plans. On the date LNC's Board of Directors approves stock awards, the fair value of stock options is determined using a Black-Scholes options valuation methodology. The fair value of other stock awards is based upon the market value of the stock. The fair value of the awards is expensed over the service period, which generally corresponds to the vesting period, and is recognized as an increase in shareholder's equity. For additional information on stock based incentive compensation see Note 8. INCOME TAXES We and our eligible subsidiaries, excluding JPL, JPFIC and JPLA, have elected to file consolidated Federal and state income tax returns with LNC and certain LNC subsidiaries. Pursuant to an intercompany tax sharing agreement with LNC, we provide for income taxes on a separate return filing basis. The tax sharing agreement also provides that we will receive benefit for net operating losses, capital losses and tax credits which are not usable on a separate return basis to the extent such items may be utilized in the consolidated income tax returns of LNC. JPL and JPFIC file separate Federal income tax returns. 2. CHANGES IN ACCOUNTING PRINCIPLES AND CHANGES IN ESTIMATES SFAS NO. 123(R) -- SHARE-BASED PAYMENT. In December 2004, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123(R)"), which is a revision of SFAS 123, "Accounting for Stock-based Compensation" ("SFAS 123"). SFAS 123(R) requires us to recognize at fair value all costs resulting from share-based payments to employees, except for equity instruments held by employee share ownership plans. Similar to SFAS 123 under SFAS 123(R), the fair value of share-based payments are recognized as a reduction to earnings over the period an employee is required to provide service in exchange for the award. Effective January 1, 2006, we adopted SFAS 123(R), using the modified prospective transition method. Under that transition method, compensation cost recognized in 2006 includes: (a) compensation cost for all share-based payments granted prior to but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). Results from prior periods have not been restated. The effect of adopting SFAS 123(R) did not have a material effect on the amount of stock-based compensation expense allocated to the Company in 2006. See Note 8 for more information regarding our stock-based compensation plans. FSP 115-1 -- THE MEANING OF OTHER-THAN-TEMPORARY IMPAIRMENT AND ITS APPLICATION TO CERTAIN INVESTMENTS. In November 2005, the FASB issued FASB Staff Position ("FSP") FAS 115-1 and FAS 124-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" ("FSP 115-1"). The guidance in FSP 115-1 nullifies the accounting and measurement provisions of Emerging Issues Task Force No. 03-1 "The Meaning of Other Than Temporary Impairments and Its Application to Certain Investments," references existing guidance, and supersedes EITF Topic No. D-44 "Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value." FSP 115-1 was effective for reporting periods beginning after December 15, 2005, on a prospective basis. Our existing policy for recognizing other-than-temporary impairments is consistent with the guidance in FSP 115-1, and includes the recognition of other than temporary impairments of securities resulting from credit related issues as well as declines in fair value related to rising interest rates, where we do not have the intent to hold the securities until either maturity or recovery. We adopted FSP 115-1 effective January 1, 2006. The adoption of FSP 115-1 did not have a material effect on our consolidated financial condition or results of operations. SFAS NO. 158 -- EMPLOYERS' ACCOUNTING FOR DEFINED BENEFIT PENSION AND OTHER POSTRETIREMENT PLANS -- AN AMENDMENT OF FASB STATEMENTS NO. 87, 88, 106, AND 132(R). In September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans -- an amendment of FASB Statements No. 87, 88, 106, and 132(R)" ("SFAS 158"). The guidance requires us to recognize on the balance sheet the funded status of our defined benefit pension and other postretirement plans as either an C-12 2. CHANGES IN ACCOUNTING PRINCIPLES AND CHANGES IN ESTIMATES (CONTINUED) asset or liability, depending on the plans' funded status, with changes in the funded status recognized through other comprehensive income. The funded status is measured as the difference between the fair value of the plan assets and the projected benefit obligation, for pension plans, or the accumulated postretirement benefit obligation for postretirement benefit plans. Prior service costs or credits and net gains or losses which are not recognized in current net periodic benefit cost, pursuant to SFAS No. 87, "Employers' Account for Pensions" or SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," must be recognized in other comprehensive income, net of tax, in the period in which they occur. As these items are recognized in net periodic benefit cost, the amounts accumulated in other comprehensive income are adjusted. Under SFAS 158, disclosure requirements have also been expanded to separately provide information on the prior service costs or credits and net gains and losses recognized in other comprehensive income and their effects on net periodic benefit costs. Retroactive application of SFAS 158 is not permitted. We applied the recognition provisions of SFAS 158 as of December 31, 2006. The adoption of SFAS 158 resulted in a increase to accumulated other comprehensive income of $4 million. See Note 7 for more information regarding our adoption of SFAS 158. SAB NO. 108 -- CONSIDERING THE EFFECTS OF PRIOR YEAR MISSTATEMENTS WHEN QUANTIFYING MISSTATEMENTS IN CURRENT YEAR FINANCIAL STATEMENTS. In September 2006, the Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 108, "Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements" ("SAB 108"). SAB 108 provides guidance for evaluating the effects of prior year uncorrected errors when quantifying misstatements in the current year financial statements. Under SAB 108, the impact of correcting misstatements occurring in the current period and those that have accumulated over prior periods must both be considered when quantifying the impact of misstatements in current period financial statements. SAB 108 is effective for fiscal years ending after November 15, 2006, and may be adopted by either restating prior financial statements or recording the cumulative effect of initially applying the approach as adjustments to the carrying values of assets and liabilities as of January 1, 2006 with an offsetting adjustment to retained earnings. We adopted the provisions of SAB 108 as of December 31, 2006. The adoption of SAB 108 did not have a material effect on our Supplemental Consolidated Financial Statements. STATEMENT OF POSITION 05-1. In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position ("SOP") 05-1, "Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts" ("SOP 05-1"). SOP 05-1 addresses the accounting for Deferred Acquisition Costs ("DAC") on internal replacements other than those described in SFAS No. 97, "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments." An internal replacement is defined by SOP 05-1 as a modification in product benefits, features, rights or coverages that occurs by (a) exchanging the contract for a new contract, (b) amending, endorsing or attaching a rider to the contract, or (c) electing a feature or coverage within a replaced contract. Contract modifications that result in a substantially unchanged contract will be accounted for as a continuation of the replaced contract. Contract modifications that result in a substantially changed contract should be accounted for as an extinguishment of the replaced contract, and any unamortized DAC, unearned revenue and deferred sales charges must be written-off. SOP 05-1 is to be applied prospectively and is effective for internal replacements occurring in fiscal years beginning after December 15, 2006. We adopted SOP 05-1 effective January 1, 2007 by recording decreases to the following categories in our Consolidated Balance Sheets:
(IN MILLIONS, UNAUDITED) ------------- ASSETS Deferred acquisition costs $31 Value of business acquired 35 Other assets -- deferred sales inducements 3 --- Total assets $69 === LIABILITIES AND SHAREHOLDER'S EQUITY Investment contract and policyholder funds -- deferred front end loads $ 2 Insurance policy and claims reserve -- guaranteed minimum death benefit annuity reserve 4 Other liabilities -- income tax liabilities 22 --- Total liabilities 28 --- Retained earnings 41 --- Total liabilities and shareholder's equity $69 ===
The adoption of this new guidance primarily impacts our Individual Markets Annuities and Employer Markets Group Protection businesses, and our accounting policies regarding the assumptions for lapsation used in the amortization of DAC and value of business acquired ("VOBA"). In addition, the adoption of SOP 05-1 resulted in a $6 million (unaudited) pre-tax increase to underwriting, acquisition, insurance and other expenses on our Consolidated Statements of Income in the first three months of 2007, which was attributable to changes in DAC and VOBA deferrals and amortization. SFAS NO. 155 -- ACCOUNTING FOR CERTAIN HYBRID FINANCIAL INSTRUMENTS -- AN AMENDMENT OF FASB STATEMENTS NO. 133 AND 140. In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments -- an amendment of C-13 2. CHANGES IN ACCOUNTING PRINCIPLES AND CHANGES IN ESTIMATES (CONTINUED) FASB Statements No. 133 and 140" ("SFAS 155"), which permits fair value remeasurement for a hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. Under SFAS 155, an entity may make an irrevocable election to measure a hybrid financial instrument at fair value, in its entirety, with changes in fair value recognized in earnings. SFAS 155 also: (a) clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"); (b) eliminates the interim guidance in SFAS 133 Implementation Issue No. D1, "Application of Statement 133 to Beneficial Interests in Securitized Financial Assets," and establishes a requirement to evaluate beneficial interests in securitized financial assets to identify interests that are either freestanding derivatives or hybrid financial instruments that contain an embedded derivative requiring bifurcation; (c) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and (d) eliminates restrictions on a qualifying special-purpose entity's ability to hold passive derivative financial instruments that pertain to beneficial interests that are or contain a derivative financial instrument. In December 2006, the FASB cleared Derivative Implementation Group Statement 133 Implementation Issue No. B40, "Embedded Derivatives: Application of Paragraph 13(b) to Securitized Interests in Prepayable Financial Assets" ("DIG B40"). Since SFAS 155 eliminated the interim guidance related to securitized financial assets, DIG B40 provides a narrow scope exception for securitized interests that contain only an embedded derivative related to prepayment risk. Under DIG B40, a securitized interest in prepayable financial assets would not be subject to bifurcation if: (a) the right to accelerate the settlement of the securitized interest cannot be controlled by the investor and (b) the securitized interest itself does not contain an embedded derivative for which bifurcation would be required other than an embedded derivative that results solely from the embedded call options in the underlying financial assets. Any other terms in the securitized financial asset that may affect cash flow in a manner similar to a derivative instrument would be subject to the requirements of paragraph 13(b) of SFAS 133. The guidance in DIG B40 is to be applied upon the adoption of SFAS 155. We will adopt the provisions SFAS 155 and DIG B40 on January 1, 2007, for all financial instruments acquired, issued, or subject to a remeasurement event occurring after that date. Prior period restatement is not permitted. The adoption of SFAS 155 will not have a material impact on our consolidated financial condition or results of operations. FASB INTERPRETATION NO. 48 -- ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES -- AN INTERPRETATION OF FASB STATEMENT NO. 109. In July 2006, the FASB issued FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes -- an interpretation of FASB Statement No. 109" ("FIN 48"). FIN 48 establishes criteria that an individual tax position must meet for any part of the benefit of the tax position to be recognized in the financial statements. These criteria include determining whether it is more-likely-than-not that a tax position will be sustained upon examination by the appropriate taxing authority. If the tax position meets the more-likely-than-not threshold, the position is measured as the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. If a tax position does not meet the more-likely-than-not recognition threshold, the benefit is not recognized in the financial statements. Upon adoption of FIN 48, the guidance will be applied to all tax positions, and only those tax positions meeting the more-likely-than-not threshold will be recognized or continue to be recognized in the financial statements. Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first subsequent financial reporting period in which that threshold is met. In addition, FIN 48 expands disclosure requirements to include additional information related to unrecognized tax benefits. FIN 48 is effective for fiscal years beginning after December 15, 2006. We adopted FIN 48 effective January 1, 2007 by recording an increase in the liability for unrecognized tax benefits of $14 million (unaudited) in our Consolidated Balance Sheets, offset by a reduction to the beginning balance of retained earnings. SFAS NO. 157 -- FAIR VALUE MEASUREMENTS. In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements" ("SFAS 157"), which establishes a framework for measuring fair value under current accounting pronouncements that require or permit fair value measurement. SFAS 157 retains the exchange price notion, but clarifies that exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the most advantageous market for that asset or liability. Fair value measurement is based on assumptions used by market participants in pricing the asset or liability, which may include inherent risk, restrictions on the sale or use of an asset, or nonperformance risk which would include the reporting entity's own credit risk. SFAS 157 establishes a three-level fair value hierarchy, which prioritizes the inputs to valuation techniques used to measure fair value. The highest priority is given to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs in situations where there is little or no market activity for the asset or liability. In addition, SFAS 157 expands the disclosure requirements for annual and interim reporting to focus on the inputs used to measure fair value, including those measurements using significant unobservable inputs, and the effects of the measurements on earnings. SFAS 157 will be applied prospectively and is effective for fiscal years beginning after November 15, 2007. Retrospective application is required for certain financial instruments as a cumulative effect adjustment to the opening balance of retained earnings. We are currently evaluating the effects of SFAS 157 on our consolidated financial condition and results of operations. SOP 03-1. Effective January 1, 2004, we implemented the provisions of AICPA SOP 03-1, "Accounting and Reporting by Insurance C-14 2. CHANGES IN ACCOUNTING PRINCIPLES AND CHANGES IN ESTIMATES (CONTINUED) Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts" ("SOP 03-1"). Adjustments arising from implementation, as discussed below, were recorded in net income as a cumulative effect of accounting change. GUARANTEED MINIMUM DEATH BENEFIT RESERVES. Although there was no method prescribed under GAAP for GMDB reserving until the issuance of SOP 03-1, our Individual Annuities segment had been recording a reserve for GMDBs. At December 31, 2003, our GMDB reserve was $46 million. Adoption of the GMDB reserving methodology under SOP 03-1 resulted in a decrease to reserves of $10 million pre-tax. GMDB reserves were $23 million and $15 million at December 31, 2006 and 2005, respectively, of which $21 and $15 million were ceded to an affiliated reinsurance company. Application of SOP 03-1 impacts EGPs used to calculate amortization of DAC, VOBA, DSI, and the liability for DFEL. The benefit ratio approach under SOP 03-1 results in a portion of future GMDB fees being accrued as a liability for future GMDB reserves. As a result, the EGPs used in our determination of DAC amortization are lower under SOP 03-1. Therefore upon adoption of SOP 03-1 we reported an unfavorable DAC/VOBA/DSI/DFEL unlocking as a negative cumulative effect adjustment of $43 million pre-tax in 2004. The combined effects of the GMDB reserve requirements and related unlocking adjustments from implementation of SOP 03-1 resulted in a charge to net income for the cumulative effect of accounting change of $35 million pre-tax ($23 million after-tax) in 2004. SALES INDUCEMENTS. Our Individual Markets -- Annuities segment variable annuity product offerings include contracts that offer a bonus credit, typically ranging from 2% to 5% of each deposit. We also offer enhanced interest rates to variable annuity contracts that are under DCA funding arrangements. Bonus credits and excess DCA interest are considered sales inducements under SOP 03-1 and, as such, are to be deferred as a sales inducement asset and amortized as a benefit expense over the expected life of the contract. Amortization is computed using the same methodology and assumptions used in amortizing DAC. UNIVERSAL LIFE CONTRACTS. Our Individual Markets -- Life Insurance segment offers an array of individual and survivor-life universal life insurance products that contain features for which SOP 03-1 might apply. A review of the products and their features for possible SOP implications concluded that no additional reserves were necessary with the exception of the MoneyGuard(R) product. MoneyGuard(R) is a universal life insurance product with an acceleration of death benefit feature that provides convalescent care benefit payments when the insured becomes chronically ill. There is an optional extension of benefit rider available that will provide continuation of the convalescent care benefit payments once the total benefits from the base policy have been exhausted. The optional extended benefit payments can be for 2 years, 4 years, or the remaining life of the insured. Charges for the extension rider are deducted from the base policy account value and vary by the length of extension period selected. The adoption of SOP 03-1 in 2004 resulted in a charge recorded as a cumulative effect of accounting change of $4 million pre-tax ($3 million after-tax) for the extension of benefit feature in MoneyGuard(R). SFAS NO. 159 -- THE FAIR VALUE OPTION FOR FINANCIAL ASSETS AND FINANCIAL LIABILITIES. In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" ("SFAS 159"), which allows an entity to make an irrevocable election, on specific election dates, to measure eligible items at fair value. The election to measure an item at fair value may be determined on an instrument by instrument basis, with certain exceptions. If the fair value option is elected, unrealized gains and losses will be recognized in earnings at each subsequent reporting date, and any upfront costs and fees related to the item will be recognized in earnings as incurred. In addition, the presentation and disclosure requirements of SFAS 159 are designed to assist in the comparison between entities that select different measurement attributes for similar types of assets and liabilities. SFAS 159 does not affect any existing accounting literature that requires certain assets and liabilities to be carried at fair value and does not eliminate disclosure requirements included in other accounting standards. SFAS 159 applies to fiscal years beginning after November 15, 2007, with early adoption permitted for an entity that has also elected to apply the provisions of SFAS 157. Retrospective application of SFAS 159 is not permitted unless early adoption is elected. At the effective date, the fair value option may be elected for eligible items that exist on that date. The effect of the first remeasurement to fair value shall be reported as a cumulative effect adjustment to the opening balance of retained earnings. We are currently evaluating the potential effects of SFAS 159 on our consolidated financial condition and results of operations. C-15 3. INVESTMENTS The amortized cost, gross unrealized gain and loss, and fair value of securities available-for-sale are as follows:
GROSS GROSS COST OR UNREALIZED UNREALIZED AMORTIZED COST GAINS (LOSSES) FAIR VALUE -------------- ---------- ---------- ---------- (IN MILLIONS) ----------------------------------------------------- 2006 AVAILABLE-FOR-SALE Corporate bonds $44,049 $1,043 $(283) $44,809 U.S. Government bonds 218 7 -- 225 Foreign government bonds 689 58 (2) 745 Asset and mortgage backed-securities 8,607 88 (69) 8,626 State and municipal bonds 194 2 (2) 194 Redeemable preferred stocks 89 9 -- 98 ------- ------ ----- ------- Total fixed maturities $53,846 $1,207 $(356) $54,697 Equity securities 205 15 (2) 218 ------- ------ ----- ------- Total securities available-for-sale $54,051 $1,222 $(358) $54,915 ======= ====== ===== ======= 2005 AVAILABLE-FOR-SALE Corporate bonds $24,190 $1,106 $(241) $25,055 U.S. Government bonds 143 12 -- 155 Foreign government bonds 839 62 (3) 898 Asset and mortgage backed-securities 5,884 85 (60) 5,909 State and municipal bonds 123 4 (1) 126 Redeemable preferred stocks 88 14 -- 102 ------- ------ ----- ------- Total fixed maturities $31,267 $1,283 $(305) $32,245 Equity securities 95 6 -- 101 ------- ------ ----- ------- Total securities available-for-sale $31,362 $1,289 $(305) $32,346 ======= ====== ===== =======
Future maturities of fixed maturity securities available-for-sale are as follows:
AMORTIZED COST FAIR VALUE -------------- ---------- (IN MILLIONS) --------------------------- Due in one year or less $ 1,833 $ 1,836 Due after one year through five years 12,068 12,248 Due after five years through ten years 17,234 17,404 Due after ten years 14,103 14,583 ------- ------- Subtotal 45,238 46,071 Asset and mortgage-backed securities 8,607 8,626 ------- ------- Total $53,846 $54,697 ======= =======
The foregoing data is based on stated maturities. Actual maturities will differ in some cases because borrowers may have the right to call or pre-pay obligations. The quality ratings of fixed maturity securities available-for-sale are as follows:
RATING AGENCY NAIC RATING EQUIVALENT DESIGNATION FAIR VALUE % OF TOTAL ----------- ---------------------- ---------- ---------- (IN MILLIONS) ----------------------- 1 AAA / AA / A $32,307 59.1% 2 BBB 18,698 34.2% 3 BBB 2,269 4.1% 4 BBB 1,202 2.2% 5 CCC and lower 198 0.4% 6 In or near default 23 0.0% ------- ----- $54,697 100.0% ======= =====
C-16 3. INVESTMENTS (CONTINUED) The major categories of net investment income are as follows:
2006 2005 2004 ------ ------ ------ (IN MILLIONS) ------------------------ Fixed maturity securities available-for-sale $2,979 $1,959 $1,932 Equity securities available-for-sale 11 7 8 Trading securities 181 176 173 Mortgage loans on real estate 466 288 350 Real estate 37 48 25 Policy loans 158 118 119 Invested cash 53 46 21 Other investments 147 61 54 ------ ------ ------ Investment revenue 4,032 2,703 2,682 Investment expense 163 111 89 ------ ------ ------ Net investment income $3,869 $2,592 $2,593 ====== ====== ======
Trading securities at fair value retained in connection with Modco and CFW reinsurance arrangements, consisted of the following:
2006 2005 ------ ------ (IN MILLIONS) --------------- Corporate bonds $2,140 $2,283 U.S. Government bonds 331 322 Foreign government bonds 45 52 Asset and mortgage backed-securities Mortgage pass-through securities 24 29 Commercial mortgage obligations 111 113 Collateralized Mortgage Backed Securities 133 148 Other-asset backed securities 8 9 State and municipal bonds 18 19 Redeemable preferred stocks 8 8 ------ ------ Total fixed maturities 2,818 2,983 Equity securities 2 2 ------ ------ Total trading securities $2,820 $2,985 ====== ======
The portion of the market adjustment for trading securities still held at December 31, 2006 and 2005 was a loss of $48 million and $70 million, respectively. The detail of the realized gain (loss) on investments is as follows
2006 2005 2004 ---- ---- ---- (IN MILLIONS) ------------------ Realized loss on investment and derivative instruments $(6) $(21) $(58) Gain (loss) on reinsurance embedded derivative/trading securities 4 5 (1) Gain on sale of subsidiaries/business -- -- 14 --- ---- ---- Net loss on investments $(2) $(16) $(45) === ==== ====
The detail of the realized gain and losses on investments and derivative instruments is as follows:
2006 2005 2004 ---- ---- ---- (IN MILLIONS) --------------------- Fixed maturity securities available-for-sale Gross gain $124 $113 $107 Gross loss (99) (90) (114) Equity securities available-for-sale -- Gross gain 1 8 18 Gross loss -- -- (1) Fixed maturity securities held-to-maturity -- Gross gain -- -- -- Gross loss -- -- -- Other investments 9 10 4 Associated amortization of deferred acquisition costs and provision for policyholder commitments (39) (52) (51) Investment expense (2) (9) (10) ---- ---- ---- Total investments (6) (20) (47) Derivative instruments of associated amortization of deferred acquisition costs -- (1) (11) ---- ---- ---- Total investments and derivative instruments $ (6) $(21) $(58) ==== ==== ====
Provisions (credits) for write-downs and net changes in allowances for loss, which are included in the realized loss on investments and derivative instruments shown above, are as follows:
2006 2005 2004 ---- ---- ---- (IN MILLIONS) ------------------ Fixed maturity securities available-for-sale $65 $19 $67 Equity securities available-for-sale -- -- -- Mortgage loans on real estate 1 (6) (2) Real estate -- -- -- Guarantees -- -- -- --- --- --- Total $66 $13 $65 === === ===
The change in unrealized appreciation (depreciation) on investments in fixed maturity and equity securities available-for-sale is as follows:
2006 2005 2004 ----- ----- ---- (IN MILLIONS) -------------------- Fixed maturity securities available-for-sale $(127) $(839) $61 Equity securities available-for-sale 7 (6) (6) ----- ----- --- Total $(120) $(845) $55 ===== ===== ===
C-17 3. INVESTMENTS (CONTINUED) For fixed maturity and equity securities held by us at December 31, 2006 and 2005 that are in unrealized loss status, the fair value, amortized cost, unrealized loss and total time period that the security has been in an unrealized loss position are presented in the table below.
% FAIR AMORTIZED % AMORTIZED UNREALIZED % UNREALIZED FAIR VALUE VALUE COST COST LOSS LOSS ---------- ------ --------- ----------- ---------- ------------ (IN MILLIONS) ------------------------------------------------------------------------- 2006 90 Days $ 7,030 39.1% $ 7,082 38.7% $ (52) 14.5% Greater than 90 days but less than or equal to 180 days 400 2.2% 413 2.3% (13) 3.6% Greater than 180 days but less than or equal to 270 days 1,451 8.1% 1,478 8.1% (27) 7.5% Greater than 270 days less than or equal to 1 year 1,842 10.3% 1,883 10.3% (41) 11.5% Greater than 1 year 7,226 40.3% 7,451 40.6% (225) 62.9% ------- ----- ------- ----- ----- ----- Total $17,949 100.0% $18,307 100.0% $(358) 100.0% ======= ===== ======= ===== ===== ===== 2005 90 Days $ 3,007 27.6% $ 3,039 27.2% $ (32) 10.5% Greater than 90 days but less than or equal to 180 days 5,152 47.3% 5,258 47.0% (106) 34.6% Greater than 180 days but less than or equal to 270 days 374 3.4% 384 3.4% (10) 3.3% Greater than 270 days less than or equal to 1 year 788 7.3% 822 7.3% (34) 11.1% Greater than 1 year 1,570 14.4% 1,693 15.1% (123) 40.5% ------- ----- ------- ----- ----- ----- Total $10,891 100.0% $11,196 100.0% $(305) 100.0% ======= ===== ======= ===== ===== =====
For fixed maturity and equity securities with unrealized losses as of December 31, 2006 and 2005, the gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous loss position are summarized as follows:
LESS THAN OR EQUAL GREATER THAN TO TWELVE MONTHS TWELVE MONTHS TOTAL --------------------- --------------------- --------------------- GROSS GROSS GROSS CARRYING UNREALIZED CARRYING UNREALIZED CARRYING UNREALIZED VALUE LOSSES VALUE LOSSES VALUE LOSSES -------- ---------- -------- ---------- -------- ---------- (IN MILLIONS) --------------------------------------------------------------------- 2006 Corporate bonds $ 8,643 $(115) $4,892 $(168) $13,535 $(283) U.S. Government bonds 43 -- -- -- 43 -- Foreign government bonds 56 (1) 62 (1) 118 (2) Asset and mortgage backed-securities 1,911 (13) 2,227 (56) 4,138 (69) State and municipal bonds 20 (1) 44 (1) 64 (2) Redeemable preferred stocks -- -- 1 -- 1 -- ------- ----- ------ ----- ------- ----- Total fixed maturities 10,673 (130) 7,226 (226) 17,899 (356) Equity securities 50 (2) -- -- 50 (2) ------- ----- ------ ----- ------- ----- Total securities $10,723 $(132) $7,226 $(226) $17,949 $(358) ======= ===== ====== ===== ======= ===== 2005 Corporate bonds $ 6,300 $(132) $1,235 $(109) $ 7,535 $(241) U.S. Government bonds -- -- -- -- -- -- Foreign government bonds 169 (3) 38 -- 207 (3) Asset and mortgage backed-securities 2,820 (47) 284 (13) 3,104 (60) State and municipal bonds 31 -- 13 (1) 44 (1) Redeemable preferred stocks 1 -- -- -- 1 -- ------- ----- ------ ----- ------- ----- Total fixed maturities 9,321 (182) 1,570 (123) 10,891 (305) Equity securities -- -- -- -- -- -- ------- ----- ------ ----- ------- ----- Total securities $ 9,321 $(182) $1,570 $(123) $10,891 $(305) ======= ===== ====== ===== ======= =====
C-18 3. INVESTMENTS (CONTINUED) Securities available-for-sale that were deemed to have declines in fair value that were other than temporary were written down to fair value. The fixed maturity securities to which these write-downs apply were generally of investment grade at the time of purchase, but were subsequently downgraded by rating agencies to "below-investment grade." Factors we considered in determining whether declines in the fair value of fixed maturity securities are other than temporary include 1) the significance of the decline, 2) our ability and intent to retain the investment for a sufficient period of time for it to recover, 3) the time period during which there has been a significant decline in value, and 4) fundamental analysis of the liquidity, business prospects and overall financial condition of the issuer. Based upon these factors, securities that have indications of potential impairment are subject to intensive review. Where such analysis results in a conclusion that declines in fair values are other than temporary, the security is written down to fair value. See Note 10 to the Supplemental Consolidated Financial Statements - Fair Value of Financial Instruments for a general discussion of the methodologies and assumptions used to determine estimated fair values. The balance sheet captions, "Real Estate" and "Other Assets," which includes property and equipment, include accumulated depreciation as follows:
2006 2005 ---- ------ (IN MILLIONS) ------------- Real estate $ 27 $ 19 Property and equipment 859 255
Impaired mortgage loans along with the related allowance for losses are as follows:
2006 2005 ---- ------ (IN MILLIONS) ------------- Impaired loans with allowance for losses $28 $66 Allowance for losses (2) (9) --- --- Net impaired loans $26 $57 === ===
We believe the allowance for losses is maintained at a level adequate to absorb estimated probable credit losses. Our periodic evaluation of the adequacy of the allowance for losses is based on our past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay (including the timing of future payments), the estimated value of the underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors. This evaluation is inherently subjective as it requires estimating the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. A reconciliation of the mortgage loan allowance for losses for these impaired mortgage loans is as follows:
2006 2005 2004 ---- ---- ---- (IN MILLIONS) ------------------ Balance at beginning of year $ 9 $16 $18 Provisions for losses 2 2 5 Release due to principal paydowns (9) (9) (7) --- --- --- Balance at end of year $ 2 $ 9 $16 === === ===
The average recorded investment in impaired mortgage loans and the interest income recognized on impaired mortgage loans were as follows:
2006 2005 2004 ---- ---- ---- (IN MILLIONS) ------------------ Average recorded investment in impaired loans $42 $62 $101 Interest income recognized on impaired loans 4 5 9
All interest income on impaired mortgage loans was recognized on the cash basis of income recognition. As of December 31, 2006 and December 31 2005, we had no mortgage loans on non-accrual status. As of December 31, 2006 and 2005, we had no mortgage loans past due 90 days and still accruing interest. As of December 31, 2006 and 2005, we had restructured mortgage loans of $19 million and $45 million, respectively. We recorded $1 million and $2 million of interest income on these restructured mortgage loans in 2006 and 2005, respectively. Interest income in the amount of $1 million and $4 million would have been recorded on these mortgage loans according to their original terms in 2006 and 2005, respectively. As of December 31, 2006 and 2005, we had no outstanding commitments to lend funds on restructured mortgage loans. As of December 31, 2006, our investment commitments for fixed maturity securities (primarily private placements), mortgage loans on real estate and real estate were $1,309 million. This includes $316 million of standby commitments to purchase real estate upon completion and leasing. The carrying value of fixed maturity securities available-for-sale, mortgage loans on real estate and real estate investments which were non-income producing totaled $40 million and $67 million at December 31, 2006 and 2005, respectively. C-19 4. FEDERAL INCOME TAXES Federal income tax expense is as follows:
2006 2005 2004 ---- ---- ---- (IN MILLIONS) ------------------ Current $244 $111 $ 98 Deferred 216 112 95 ---- ---- ---- Total tax expense $460 $223 $193 ==== ==== ====
The effective tax rate on pre-tax income (loss) from continuing operations is lower than the prevailing corporate Federal income tax rate. A reconciliation of this difference is as follows:
2006 2005 2004 ---- ---- ---- (IN MILLIONS) ------------------ Tax rate times pre-tax income $568 $303 $272 Effect of: Tax-preferred investment income (86) (63) (69) Tax credits (21) (14) (14) Other (1) (3) 4 ---- ---- ---- Provision for income taxes $460 $223 $193 ==== ==== ==== Effective tax rate 28% 26% 25%
The Federal income tax liability included in Other liabilities on the Supplemental Consolidated Balance Sheets is as follows:
2006 2005 ----- ----- (IN MILLIONS) ------------- Current $ 13 $ 77 Deferred 615 24 ---- ---- Total Federal income tax liability $628 $101 ==== ====
Significant components of our deferred tax assets and liabilities are as follows:
2006 2005 ------ ------ (IN MILLIONS) --------------- Deferred tax assets: Insurance and investment contract liabilities $1,528 $1,206 Deferred gain recognition for income tax purposes 350 291 Modco embedded derivative 76 98 Postretirement benefits other than pension 14 15 Compensation related 155 100 Ceding commission asset 9 11 Capital loss carryforward 2 -- Net operating loss carryforward 21 -- Affordable housing tax credit carryforward 18 -- Other deferred tax assets 110 53 ------ ------ Total deferred tax assets 2,283 1,774 ------ ------ Deferred tax liabilities: Deferred acquisition costs 1,656 998 Net unrealized gain on securities available-for-sale 306 351 Trading security gains 74 91 Present value of business in-force 602 260 Deferred gain recognition for income tax purposes 14 -- Depreciation differences 59 -- Other deferred tax liabilities 187 98 ------ ------ Total deferred tax liabilities 2,898 1,798 ------ ------ Net deferred tax liability $ 615 $ 24 ====== ======
We and our affiliates, with the exception of JPL, JPFIC and JPLA, are part of a consolidated Federal income tax filing with LNC. Cash paid relating to these consolidated Federal income taxes in 2006, 2005 and 2004 was $208 million, $75 million and $56 million, respectively. JPL files a separate Federal income tax return. Cash received for income taxes relating to JPL's return in 2006 was $15 million. JPFIC files a separate federal income tax return. JPLA is part of a consolidated Federal income tax filing with JPFIC. Cash paid for income taxes relating to the consolidated return in 2006 was $116.3 million. We are required to establish a valuation allowance for any gross deferred tax assets that are unlikely to reduce taxes payable in future years' tax returns. At December 31, 2006 and 2005, we concluded that it was more likely than not that all gross deferred tax assets will reduce taxes payable in future years. Accordingly, no valuation allowance was necessary at December 31, 2006 and 2005. Under prior Federal income tax law, one-half of the excess of a life insurance company's income from operations over its taxable investment income was not taxed, but was set aside C-20 4. FEDERAL INCOME TAXES (CONTINUED) in a special tax account designated as "Policyholders' Surplus." On October 23, 2004, President Bush signed into law the "American Jobs Creation Act of 2004." Beginning January 1, 2005 through December 31, 2006, the additional tax imposed on distributions from the special tax account, Policyholders' Surplus, was suspended. In addition, the statute provides that distributions made during the two-year suspension period will first reduce the Policyholders' Surplus account balance. Our 2005 dividend activity along with that of our insurance subsidiaries eliminated the account balance during the suspension period. The LNC consolidated group is subject to annual tax examinations from the Internal Revenue Service ("IRS"). During the first quarter of 2006, the IRS completed its examination for the tax years 1999 through 2002 with assessments resulting in a payment that was not material to our consolidated results of operations. In addition to taxes assessed and interest, the payment included a deposit relating to a portion of the assessment, which we continue to challenge. LNC believes this portion of the assessment is inconsistent with existing law, and is protesting it through the established IRS appeals process. We do not anticipate that any adjustments that might result from such audits would be material to the Company's results of operations or financial condition. The LNC consolidated group is currently under audit by the IRS for years 2003 and 2004. 5. SUPPLEMENTAL FINANCIAL DATA Reinsurance transactions included in the income statement captions, "Insurance Premiums" and "Insurance Fees", excluding amounts attributable to the indemnity reinsurance transaction with Swiss Re, are as follows:
2006 2005 2004 ------- ----- ----- (IN MILLIONS) ----------------------- Insurance assumed $ 8 $ 1 $ -- Insurance ceded (1,021) (767) (640) ------- ----- ----- Net reinsurance premiums and fees $(1,013) $(766) $(640) ======= ===== =====
The income statement caption, "Benefits," is net of reinsurance recoveries at December 31, 2006, 2005 and 2004 of $0.9 billion, $0.7 billion, and $0.6 billion, respectively. A roll forward of Deferred Acquisition Costs is as follows:
2006 2005 2004 ------ ------ ------ (IN MILLIONS) ------------------------ Balance at beginning of year $3,676 $2,904 $2,552 Deferral 1,479 934 868 Amortization (626) (427) (415) Adjustment related to realized gains on securities available-for-sale (38) (48) (46) Adjustment related to unrealized gains on securities available-for-sale 86 313 (16) Cumulative effect of accounting change -- -- (39) ------ ------ ------ Balance at end of year $4,577 $3,676 $2,904 ====== ====== ======
A roll forward of Value of Business Acquired is as follows:
2006 2005 2004 ------ ---- ---- (IN MILLIONS) --------------------- Balance at beginning of year $ 742 $819 $922 Merger accounting fair value adjustment 2,478 -- -- Deferral of commissions and accretion of interest 96 -- -- Amortization (227) (77) (103) Adjustment related to realized gains on securities available-for-sale (9) -- -- Adjustment related to unrealized gains on securities available-for-sale (48) -- -- ------ ---- ---- Balance at end of year $3,032 $742 $819 ====== ==== ====
Future estimated amortization of Value of Business Acquired is as follows: 2007-$267 2008-$262 2009-$241 2010-$227 2011-$194 Thereafter-$1,841 Realized losses on investments and derivative instruments on the Supplemental Consolidated Statements of Income for the year ended December 31, 2006, 2005 and 2004 are net of amounts amortized against DAC of $38 million, $48 million and $46 million, respectively. In addition, realized gains and losses for the year ended December 31, 2006, 2005 and 2004 are net of adjustments made to policyholder reserves of $9 million, $(2) million and $(2) million, respectively. We have either a contractual obligation or a consistent historical practice of making allocations of investment gains or losses to certain policyholders and to certain reinsurance arrangements. C-21 5. SUPPLEMENTAL FINANCIAL DATA (CONTINUED) A rollforward of deferred sales inducements, included in Other assets on the Supplemental Consolidated Balance Sheets, is as follows:
2006 2005 2004 ---- ---- ---- (IN MILLIONS) ------------------- Balance at beginning of year $129 $ 85 $ 45 Capitalized 86 60 50 Amortization (22) (16) (10) ---- ---- ---- Balance at end of year $193 $129 $ 85 ==== ==== ====
Details underlying the income statement caption, "Underwriting, Acquisition, Insurance and Other Expenses," are as follows:
2006 2005 2004 ------ ------ ------ (IN MILLIONS) ------------------------ Commissions $1,431 $ 899 $1,136 General and administrative expenses 1,206 966 604 Deferred acquisition costs and value of business acquired, net of amortization (722) (431) (350) Taxes, licenses and fees 158 81 85 Restructuring charges 13 29 -- ------ ------ ------ Total $2,086 $1,544 $1,475 ====== ====== ======
The carrying amount of goodwill by reportable segment is as follows:
2006 2005 ------ ---- (IN MILLIONS) ------------- Individual Markets Life Insurance $2,181 $855 Annuities 1,032 44 Employer Markets Retirement Products 20 20 Group Protection 281 -- ------ ---- Total $3,514 $919 ====== ====
Details underlying the balance sheet caption, "Investment contractholder and policyholder funds," are as follows:
2006 2005 ------- ------- (IN MILLIONS) ----------------- Premium deposits funds $20,509 $21,755 Other policyholder funds 37,202 12,975 Deferred front end loads 572 432 Undistributed earnings on participating business 102 111 ------- ------- Total $58,385 $35,273 ======= =======
Details underlying the balance sheet captions related of short-term debt and long-term debt are as follows:
2006 2005 ------ ------ (IN MILLIONS) --------------- Short-term debt: $ 21 $ 34 ====== ====== Long-term debt: Note due Lincoln National Corporation, due September 2008 140 -- Surplus Notes due Lincoln National Corporation: 6.56% surplus note, due 2028 500 500 6.03% surplus note, due 2028 750 750 Surplus Note due HARCO Capital Corporation: 9.76% surplus note, due 2024 50 -- ------ ------ Total Surplus Notes 1,300 1,250 ------ ------ Total long-term debt $1,440 $1,250 ====== ======
The short-term debt represents short-term notes payable to LNC. We issued a surplus note of $500 million to LNC in 1998. This note calls for us to pay the principal amount of the note on or before March 31, 2028 and interest to be paid quarterly at an annual rate of 6.56%. Subject to approval by the Indiana Insurance Commissioner, LNC also has a right to redeem the note for immediate repayment in total or in part once per year on the anniversary date of the note. Any payment of interest or repayment of principal may be paid only out of our statutory earnings, only if our statutory capital surplus exceeds $2.3 billion, and subject to approval by the Indiana Insurance Commissioner. We issued a surplus note for $750 million to LNC in 1998. This note calls for us to pay the principal amount of the note on or before December 31, 2028 and interest to be paid quarterly at an annual rate of 6.03%. Subject to approval by the Indiana Insurance Commissioner, LNC also has a right to redeem the note for immediate repayment in total or in part once per year on the anniversary date of the note. Any payment of interest or repayment of principal may be paid only out of our statutory earnings, only if our statutory capital surplus exceeds $2.4 billion, and subject to approval by the Indiana Insurance Commissioner. JPFIC issued a surplus note for $50 million to HARCO Capital Corporation, an affiliate, in 1994. This note calls for JPFIC to pay the principal amount of the note on or before September 30, 2024 and interest to be paid semiannually at an annual rate of 9.76%. Any payment of interest or repayment of principal may be paid only if JPFIC has obtained the prior written approval of the Nebraska Department of Insurance, has adequate earned surplus funds for such payment, and if such payment would not cause JPFIC to violate the statutory capital requirements as set forth in the General Statutes of Nebraska. A consolidated subsidiary of LNL issued a note for an amount not to exceed $150 million to LNC in 2006. As of December 31, 2006, $140 million had been advanced to us. This note calls for us to pay the principal amount of the notes on or before C-22 September 30, 2008 and interest to be paid monthly at a rate equal to the Federal Reserve Board's 30 day AA- financial commercial paper rate plus ten basis points. Cash paid for interest on both the short-term debt and the surplus notes was $103 million, $59 million and $79 million for 2006, 2005 and 2004, respectively. 6. INSURANCE BENEFIT RESERVES The Company issues variable contracts through its separate accounts for which investment income and investment gains and losses accrue directly to, and investment risk is borne by, the contractholder (traditional variable annuities). The Company also issues variable annuity and life contracts through separate accounts that include various types of GMDB, GMWB and GIB. The GMDB features include those where the Company contractually guarantees to the contract holder either (a) return of no less than total deposits made to the contract less any partial withdrawals, (b) total deposits made to the contract less any partial withdrawals plus a minimum return, or (c) the highest contract value on a specified anniversary date minus any partial withdrawals following the contract anniversary. The following table provides information on the GMDB features outstanding at December 31, 2006 and 2005. (Note that our variable contracts with guarantees may offer more than one type of guarantee in each contract; therefore, the amounts listed are not mutually exclusive.) The net amount at risk is defined as the current GMDB in excess of the current account balance at the balance sheet date.
IN EVENT OF DEATH ----------------- 2006 2005 ------- ------- (IN BILLIONS) ----------------- Return of net deposit Account value $38.3 $31.9 Net amount at risk 0.1 0.1 Average attained age of contractholders 54 53 Return of net deposits plus a minimum return Account value $ 0.4 $ 0.3 Net amount at risk -- -- Average attained age of contractholders 67 66 Guaranteed minimum return 5% 5% Return of net deposit Account value $22.5 $18.8 Net amount at risk 0.2 0.3 Average attained age of contractholders 64 63
Approximately $13.2 billion and $8.2 billion of separate account values at December 31, 2006 and 2005 were attributable to variable annuities with a GMWB feature. This GMWB feature offers the contractholder a guarantee equal to the initial deposit adjusted for any subsequent purchase payments or withdrawals. There are one-year and five-year step-up options, which allow the contractholder to step up the guarantee. GMWB features are considered to be derivatives under SFAS 133 resulting in the related liabilities being recognized at fair value, with changes in fair value being reported in net income. At December 31, 2006 and 2005, we had approximately $2.7 billion and $1.2 billion of separate account values that were attributable to variable annuities with a GIB feature. All of the outstanding contracts with a GIB feature are still in the accumulation phase. Separate account balances attributable to variable annuity contracts with guarantees are as follows:
2006 2005 ----- ----- (IN BILLIONS) ------------- Asset Type Domestic Equity $39 $32 International Equity 6 5 Bonds 6 5 --- --- Total 51 42 Money Market 6 4 --- --- Total $57 $46 === === Percent of total variable annuity separate account values 87% 87% === ===
The determination of the GMDB 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 table summarizes the liabilities for GMDB:
GMDB ----------- 2006 2005 ---- ---- Total: Beginning balance $ 15 $ 18 Changes in reserves 14 9 Benefits paid (6) (12) ---- ---- Ending balance $ 23 $ 15 ==== ==== Ceded: Beginning balance $(15) $(18) Changes in reserves (12) (9) Benefits paid 6 12 ---- ---- Ending balance $(21) $(15) ==== ==== Net: Beginning balance $ -- $ -- Changes in reserves 2 -- Benefits paid -- -- ---- ---- Ending balance $ 2 $ -- ==== ====
The changes to the benefit reserve amounts above are reflected in benefits in the Supplemental Consolidated Statements of Income. We have an Automatic Indemnity Reinsurance Agreement with Lincoln National Reinsurance Company (Barbados) Limited ("LNR Barbados"), a wholly-owned subsidiary of LNC. Under this agreement, we cede a portion of our GMDB, GMWB and GIB risks to LNR Barbados. In connection with this reinsurance agreement, we paid premiums to LNR Barbados totaling $154 million and $109 million in 2006 and 2005, respectively. These reinsurance premiums are reflected as an offset in insurance premiums in the Supplemental Consolidated Statements of Income. C-23 7. RETIREMENT BENEFIT PLANS The Company's employees, other than its U.S. insurance agents, are included in LNC's various benefit plans that provide for pension and other postretirement benefit plans, 401(k) and profit sharing plans, and deferred compensation plans. The Company's insurance agents are included in various benefit plans sponsored by either LNL or LNC including pension and other postretirement benefit plans, 401(k) and profit sharing plans, and deferred compensation plans. LNL PENSION AND OTHER POST-RETIREMENT BENEFIT PLANS LNC maintains funded defined benefit pension plans for most of its U.S. employees (including those of LNL), and prior to January 1, 1995, most full-time agents (including those of LNL). Effective January 1, 2002, the employees' pension plan has a cash balance formula. Employees retiring before 2012 will have their benefits calculated under both the old and new formulas and will receive the greater of the two calculations. Employees retiring in 2012 or after will receive benefits under the amended plan. Benefits under the old employees' plan are based on total years of service and the highest 60 months of compensations during the last 10 years of employment. Under the amended plan, employees have guaranteed account balances that grow with pay and interest credits each year. All benefits applicable to the defined benefit plan for agents were frozen as of December 31, 1994. The plans are funded by contributions to tax-exempt trusts. The funding policy is consistent with the funding requirements of Federal law and regulations. Contributions are intended to provide not only the benefits attributed to service to date, but also those expected to be earned in the future. LNC sponsors three types of unfunded, nonqualified, defined benefit plans for certain U.S. employees and agents (including those of LNL): supplemental retirement plans, a salary continuation plan, and supplemental executive retirement plans. The supplemental retirement plans provide defined benefit pension benefits in excess of limits imposed by Federal tax law. The salary continuation plan provides certain of our officers defined pension benefits based on years of service and final monthly salary upon death or retirement. The supplemental executive retirement plan provides defined pension benefits for certain executives who became our employees as a result of the acquisition of a block of individual life insurance and annuity business, and benefits under this plan were frozen effective January 1, 2000. A second supplemental executive retirement plan was established for this same group of executives to guarantee that the total benefit payable under the LNC employees' defined benefit pension plan benefit formula will be determined using an average compensation not less than the minimum three-year average compensation as of a certain period. All benefits payable from this plan are reduced by benefits payable from the LNC employees' defined benefit pension plan. LNC also sponsors an unfunded plan that provide postretirement medical, dental and life insurance benefits to full-time U.S. employees who have worked for LNC 10 years and attained age 55 (including those of LNL). LNL sponsors an unfunded plan that provide postretirement medical, dental and life insurance benefits to full-time agents who have worked for LNL 10 years and attained age 60. Medical and dental benefits are also available to spouses and other dependents of employees and agents. For medical and dental benefits, limited contributions are required from individuals who retired prior to November 1, 1988. Contributions for later retirees, which can be adjusted annually, are based on such items as years of service at retirement and age at retirement. Effective April 1, 2004, the employees' postretirement plan was changed such that employees and agents not attaining age 50 by that date will not be eligible to receive life insurance benefits when they retire. Life insurance benefits for retirees are noncontributory for employees and agents that attain the age of 50 by April 1, 2004 and meet the eligibility requirements at the time they retire; however, these participants can elect supplemental contributory life benefits up to age 70. Effective July 1, 1999, the agents' postretirement plan was changed to require agents retiring on or after that date to pay the full medical and dental premium costs. Beginning January 1, 2002, the employees' postretirement plan was changed to require employees not yet age 50 with five years of service by the end of 2001 to pay the full medical and dental premium cost when they retire. C-24 7. RETIREMENT BENEFIT PLANS (CONTINUED) OBLIGATIONS, FUNDED STATUS AND ASSUMPTIONS LNL DEFINED BENEFIT PLAN LNC sponsors a non-contributory defined benefit pension plan covering its agents. Information with respect to LNL's defined benefit plan asset activity and defined benefit plan obligations for the agent defined benefit and other postretirement benefit plans sponsored by LNL is as follows:
PENSION BENEFITS OTHER POST-RETIREMENT BENEFITS ---------------- ------------------------------ 2006 2005 2006 2005 ------- ------ ------------- -------------- (IN MILLIONS) ------------------------------------------------- Change in plan assets $ 93 $ 82 $ -- $ -- Fair value of plan assets at beginning of year 12 6 -- -- Company contributions -- 10 2 2 Benefits paid (5) (5) (2) (2) ----- ----- ----- ---- Fair value of plan assets at end-of-year $ 100 $ 93 $ -- $ -- ===== ===== ===== ==== Change in benefit obligation: Benefit obligation at beginning-of-year $ 92 87 22 19 Interest Cost 5 5 1 1 Plan participant's contributions -- -- 1 1 Actuarial (gains)/losses (2) 4 (3) 3 Benefits paid (5) (4) (2) (2) ----- ----- ----- ---- Benefits obligation at end -of-year $ 90 $ 92 $ 19 $ 22 ===== ===== ===== ==== Funded status of the plans $ 10 $ 1 $ (19) $ (22) Unrecognized net actuarial losses 20 (1) ----- ----- ----- ---- Prepaid (accrued) benefit cost 21 (23) Other Assets 11 Other Liabilities (1) ----- ----- ----- ---- Amounts recognized in the Supplemental Consolidated Balance Sheets $ 10 $ 21 $ (19) $ (23) ===== ===== ===== ==== Amounts recognized in accumulated other comprehensive income (net of tax): Net loss (gain) 8 (2) ----- ----- ----- ---- Total $ 8 $ (2) Weighted-average assumptions as of December 31: Weighted-average discount rate 5.75% 6.00% 5.75% 6.00% Expected return on plan assets 8.00% 8.25% -- -- Rate of increase in compensation: 4.00% 4.00% 4.00% 4.00%
LNC uses December 31 as the measurement date for our pension and postretirement plans. The expected return on plan assets was determined based on historical and expected future returns of the various asset classes, using the target plan allocations. This assumption is reevaluated at an interim date each plan year. The calculation of the accumulated post-retirement benefits obligation assumes a weighted-average annual rate of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) of 12.0% for 2006. It further assumes the rate will gradually decrease to 5.0% by 2017 and remain at that level in future periods. The health care cost trend rate assumption has a significant effect on the amounts reported. A one-percentage point increase and decrease in assumed health care cost trend rates would have the following effects:
ONE-PERCENTAGE ONE-PERCENTAGE POINT INCREASE POINT DECREASE -------------- -------------- (IN MILLIONS) ------------------------------- Effect on accumulated postretirement benefit obligation $ 1 $(1) Effect on total service and interest cost components -- --
C-25 7. RETIREMENT BENEFIT PLANS (CONTINUED) Information for pension plans with accumulated benefit obligations in excess of plan assets is as follows:
2006 2005 ----- ----- (IN MILLIONS) ------------- U.S. PLAN: Accumulated benefit obligation $ 1 $ 1 Projected benefit obligation 1 1 Fair value of plan assets -- --
COMPONENTS OF NET PERIODIC PENSION COST The components of net defined benefit pension plan and postretirement benefit plan expense are as follows:
PENSION BENEFITS OTHER POSTRETIREMENT BENEFITS ------------------ ----------------------------- 2006 2005 2004 2006 2005 2004 ---- ---- ---- -------- ------- -------- (IN MILLIONS) -------------------------------------------------- U.S. PLANS: Service cost $ 18 $ 17 $ 17 $ 1 $ 2 $ 2 Interest cost 29 29 28 5 5 5 Expected return on plan assets (38) (38) (35) -- -- -- Amortization of prior service cost (2) (2) (2) -- -- -- Recognized net actuarial (gains) losses 4 2 1 1 -- (1) Recognized actuarial loss due to special termination benefits 2 -- -- -- -- -- ---- ---- ---- --- --- --- Net periodic benefit expense $ 13 $ 8 $ 9 $ 7 $ 7 $ 6 ==== ==== ==== === === ===
We maintain a defined contribution plan for our U.S. insurance agents. Contributions to this plan are based on a percentage of the agents' annual compensation as defined in the plan. Effective January 1, 1998, we assumed the liabilities for a non-contributory defined contribution plan covering certain highly compensated former CIGNA agents and employees. Contributions for this plan are made annually based upon varying percentages of annual eligible earnings as defined in the plan. Contributions to this plan are in lieu of any contributions to the qualified agent defined contribution plan. Effective January 1, 2000, this plan was expanded to include certain of our highly compensated agents. The combined pre-tax expenses for these plans amounted to $3 million each in 2006, 2005 and 2004. These expenses reflect both our contribution as well as changes in the measurement of our liabilities under these plans. PLAN ASSETS Defined benefit pension plan assets allocations at December 31, 2006 and 2005, by asset category are as follows:
2006 2005 ---- ---- ASSET CATEGORY U.S. PLANS: Equity securities 60% 64% Fixed income securities 40% 34% Real Estate -- 1% Cash and cash equivalents -- 1% --- --- Total 100% 100% === ===
The primary investment objective of the defined benefit pension plan is for capital appreciation and income growth, with an emphasis on avoiding undue risk. A secondary objective is for current income. Investments can be made using the following asset classes: both domestic and international equity and fixed income securities, real estate, guaranteed products, venture capital, oil and gas and other asset classes the investment managers deem prudent. A five-year time horizon is utilized, as there are inevitably short-run fluctuations, which will cause variations in investment performance. Each managed fund is expected to rank in the upper 50% of similar funds over the three and/or five year periods. Managers not meeting criteria will be subject to additional due diligence review and possible termination. The following short-term ranges have been established for weightings in the various asset categories:
WEIGHTING RANGE --------------- ASSET CATEGORY Cash 0-20% Guaranteed Products 0-20% Fixed Income 20-80% Long-term 0-10% High-Yield 0-10% International/Emerging Markets* 0-10% Real Estate 0-20% Equities 20-80% Small-cap 0-20% International* 0-20% Emerging Markets* 0-10% Other 0-20% Total International** 0-25%
---------- The total of domestic cash, domestic fixed income, and domestic equities shall not be less than 50%. * Currency exposure can be hedged up to 100% ** International/Emerging Markets-Fixed Income and Equities C-26 7. RETIREMENT BENEFIT PLANS (CONTINUED) Within the broad ranges provided above, current target asset weightings are as follows: 64% equities, 35% fixed income, including real estate, and 1% cash. The performance of the plan and the managed funds are monitored on a quarterly basis relative to the plan's objectives. The performance of the managed fund is measured against the following indices: S&P 500, EAFE, Russell 2000, NAREIT, Lehman US Universal and Salomon (Citigroup) 90-day T-Bill. The investment policy is reviewed on an annual basis. The plan assets are principally managed by LNC's Investment Management segment. PLAN CASH FLOWS The Company does not expect to make a contribution to the defined benefit pension plans in 2007. The Company expects to fund approximately the following amounts for benefit payments for unfunded non-qualified defined benefit plans and postretirement benefit plans:
US POST RETIREMENT PLANS ---------------------------------------------------------------- NON-QUALIFIED U.S. DEFINED REFLECTING NOT REFLECTING BENEFIT PENSION MEDICARE PART MEDICARE PART MEDICARE PART PLANS D SUBSIDY D SUBSIDY D SUBSIDY --------------- ------------- ------------- -------------- (IN MILLIONS) ---------------------------------------------------------------- Year 2007 $ 3 $ 5 $(1) $ 6 2008 3 5 (1) 6 2009 3 5 (1) 6 2010 4 5 (1) 6 2011 4 5 (1) 6 Thereafter 25 28 (4) 32
JPL DEFINED BENEFIT PLAN JPL sponsors a non-contributory defined benefit pension plan covering full-time agents. No participants are accruing defined benefits under the plan. All participants with a defined benefit are vested and are either in pay status or have a frozen accrued benefit. Information for the Company's agent pension plans with accumulated benefit obligations in excess of plan assets is as follows:
2006 ------------- (IN MILLIONS) ------------- Change in projected benefit obligation: Projected benefit obligation at beginning of period $29 Interest cost 1 Actuarial loss -- Benefits paid (2) --- Projected benefit obligation at end of period $28 === Change in plan assets: 39 Fair value of assets at beginning of period 4 Actual return on plan assets -- Transfer out and expenses (2) --- Benefits paid $41 === Fair value of assets at end of period Funded status of the plan $14 Unamortized prior service cost -- Unrecognized net loss (2) --- Net amount recognized $12 ===
The accumulated benefit obligation for JPL's defined benefit pension plan was $28 million at December 31, 2006. JPL uses a December 31 measurement date for its pension and post-retirement plans. Because no employees are accruing defined benefits under the pension plan, past service costs and unrecognized gains and losses are amortized over the average remaining life expectancy of plan participants. COMPONENTS OF NET PERIODIC BENEFIT COST
2006 ------------- (IN MILLIONS) ------------- Interest cost 1 Expected return on plan assets (2) Amortization of prior service cost -- --- Net periodic benefit benefit (1) ===
ASSUMPTIONS
2006 ---- Weighted-average assumptions used to determine benefit obligations at December 31: Discount rate 5.75% Weighted-average assumptions used to determine net cost for years ended December 31: Discount rate 5.69% Expected return on plan assets 8.00%
The assumption for long-term rate of return on assets is derived from historical returns on investments of the types in which pension assets are invested. A range of assumptions for long-term rate of return is projected for benchmarks representing each asset class. The upper and lower range limits are based on optimistic and pessimistic assumptions, respectively, and reflect historical returns that are adjusted to reflect factors that might cause future experience to differ from the past, differences between the benchmarks and the plan's assets, and the effects of asset smoothing. The adjusted rates of return are weighted by target allocations for each asset class to derive limits for a range of overall long-term gross rates of return. Within this range, one rate of return is selected as the best estimate. From that rate JPL subtracts an estimate of expenses, and the result is the basis for the assumed long-term rate of return on assets. The assumption for discount rate is based upon an evaluation of specific plan attributes using cash flow analysis. The weighted average duration of the projected cash flows for the plans was used to select an appropriate AA-rated bond interest rate for disclosure at year end 2006. PLAN ASSETS JPL's pension plan weighted-average asset allocation by asset category was as follows based on fair value:
2006 ---- ASSET CATEGORY Equity securities 75% Debt securities 25% --- Total 100% ===
C-27 7. RETIREMENT BENEFIT PLANS (CONTINUED) The overall investment objective of the plan is to meet or exceed the actuarial assumptions. The plan is assumed to exist in perpetuity; therefore, the investment portfolio is managed to provide stable and growing income, as well as to achieve growth in principal equal to the rate of inflation. Allocation of plan assets is reviewed at least annually. Investment guidelines are: equity securities, a range of 35% to 75% of the total portfolio's value, with no more than 20% of the total equity exposure in non-U.S. equities; fixed income, a range of 25% to 65% of the total portfolio's value; cash, up to 5% of the portfolio's value. The portfolio may be invested in individual securities, mutual funds or co-mingled funds of various kinds. In order to achieve a prudent level of portfolio diversification, the securities of any one company or issuer, other than the U.S. Treasury, should not exceed 5% of the portfolio's value and no more than 20% of the fund should be invested in any one industry. Without specific written instructions from the Plan Administrator, the plan will not be invested in short sales of individual securities, put or call options on individual securities or commodities, or commodity futures. PLAN CASH FLOWS JPL is not expected to make a contribution to the pension plan during 2007. The expected benefit payments for JPL's pension plan for the years indicated are as follows: 2007 $ 3 2008 3 2009 3 2010 3 2011 3 2012 through 2016 11
APPLICATION OF SFAS 158 As discussed in Note 2, the Company applied the recognition provisions of SFAS 158 as of December 31, 2006. The incremental effect of applying SFAS 158 on our Supplemental Consolidated Balance Sheet at December 31, 2006 is as follows:
AFTER BEFORE APPLICATION SFAS 158 APPLICATION OF OF SFAS 158 ADJUSTMENT SFAS 158 ------------------ ---------- -------------- (IN MILLIONS) ------------------------------------------------ Other assets $ 1,691 $38 $ 1,729 Total assets 164,778 38 164,816 Other Liabilities 3,871 34 3,905 Total Liabilities 151,937 34 151,971 Accumulated other comprehensive income 412 4 416 Total shareholder's equity 12,841 4 12,845
401(k) LNC sponsors contributory defined contribution plans (401(k) plans) for eligible U.S. employees and agents (including those of LNL). Our contributions to the 401(k) plans for our employees and agents are equal to a participant's pre-tax contribution, not to exceed 6% of base pay, multiplied by a percentage, ranging from 50% to 150%, which varies according to certain incentive criteria as determined by LNC's Board of Directors. Our expense for the 401(k) plan amounted to $22 million, $25 million, and $25 million in 2006, 2005 and 2004, respectively. DEFERRED COMPENSATION PLANS LNC sponsors contributory deferred compensation plans for certain U.S. employees and agents including those of LNL who meet the established plan criteria. Plan participants may elect to defer payment of a portion of their compensation, as defined by the plans. At this point, these plans are not funded. Plan participants may select from a variety of alternative measures for purposes of calculating the investment return considered attributable to their deferral. Under the terms of these plans, we agree to pay out amounts based upon the alternative measure selected by the participant. Plan participants who are also participants in a LNC 401(k) plan and who have reached the contribution limit for that plan may also elect to defer the additional amounts into the deferred compensation plan. We make matching contributions to these plans for its participants based upon amounts placed into the deferred compensation plans by individuals who have reached the contribution limit under the 401(k) plan. The amount of our contribution is calculated in a manner similar to the employer match calculation described in the 401(k) plans section above. Expense for these plans amounted to $17 million, $11 million, and $7 million in 2006, 2005 and 2004, respectively. These expenses reflect both our employer matching contributions of $4 million, $3 million and $2 million, as well as changes in the measurement of our liabilities net of LNC's total return swap under these plans of $13 million, $8 million and $5 million for 2006, 2005 and 2004, respectively. Our total liabilities associated with these plans were $158 million and $138 million at December 31, 2006 and 2005, respectively. C-28 8. STOCK-BASED COMPENSATION The Company's employees are included in LNC's various incentive plans that provide for the issuance of stock options, stock incentive awards, stock appreciation rights ("SARs"), restricted stock awards, restricted stock units ("performance shares"), and deferred stock units. LNC has a policy of issuing new shares to satisfy option exercises. LNC issues share-based compensation awards under an authorized plan, subject to specific vesting conditions. Generally, compensation expense is recognized ratably over a three-year vesting period, but recognition may be accelerated upon the occurrence of certain events. For awards that specify an employee will vest upon retirement and an employee is eligible to retire before the end of the normal vesting period, the Company would record compensation expense over the period from the grant date to the date of retirement eligibility. On January 1, 2006, the Company adopted SFAS 123-R under the modified prospective method. Accordingly, prior period amounts have not been restated. Under the modified prospective method, the fair value of all employee stock options vesting on or after the adoption date is generally included in the determination of net income as the options vest. The fair value of stock options granted has been estimated using the Black-Scholes option valuation model considering assumptions for dividend yield, expected volatility, risk-free interest rate and expected life of the option. The fair value of the option grants is amortized on a straight-line basis over the implicit service period of the employee, considering retirement eligibility. For those employees that will achieve retirement eligibility during the vesting period, the expense is recognized evenly up through the retirement eligibility date or immediately upon grant for participants already eligible for retirement. Total pre-tax compensation expense (income) for stock-based awards to employees of the company is as follows:
2006 2005 2004 ---- ---- ---- (IN MILLIONS) ------------------ Stock options $ 3 $-- $ 1 Shares 19 14 11 Cash awards 1 1 1 SARs (1) 2 4 Restricted stock 1 1 1 --- --- --- Total $23 $18 $18 === === === Recognized tax benefit $ 8 $ 6 $ 6
The compensation cost is included in the underwriting, acquisition, insurance, and other expenses line item on the Company's Supplemental Consolidated Statements of Income. 9. RESTRICTIONS, COMMITMENTS AND CONTINGENCIES STATUTORY INFORMATION AND RESTRICTIONS -- LNL Net income as determined in accordance with statutory accounting practices for LNL was $229 million, $544 million and $310 million for 2006, 2005 and 2004, respectively. Statutory surplus as determined in accordance with statutory accounting practices for LNL was $3.0 billion and $3.2 billion for December 31, 2006 and 2005, respectively. The state of Indiana has adopted certain prescribed accounting practices that differ from those found in NAIC statutory accounting practices and affect LNL's reported statutory surplus. LNL utilizes the Indiana universal life method to calculate reserves for universal life policies, which increased statutory surplus by $227 million and $210 million at December 31, 2006 and 2005, respectively. LNL also use a permitted valuation interest rate on certain annuities, which decreased statutory surplus by $14 million and $15 million at December 31, 2006 and 2005, respectively. LNL is subject to certain insurance department regulatory restrictions as to the transfer of funds and payment of dividends to the holding company. Under Indiana laws and regulations, we may pay dividends to LNC only from unassigned surplus, without prior approval of the Indiana Insurance Commissioner (the "Commissioner"), or must receive prior approval of the Commissioner to pay a dividend if such dividend, along with all other dividends paid within the preceding twelve consecutive months, would exceed the statutory limitation. The current statutory limitation is the greater of (i) 10% of the insurer's policyholders' surplus, as shown on its last annual statement on file with the Commissioner or (ii) the insurer's statutory net gain from operations for the previous twelve months, but in no event to exceed statutory unassigned surplus. Indiana law gives Commissioner broad discretion to disapprove requests for dividends in excess of these limits. LNL paid dividends of $350 million, $200 million and $150 million to LNC during 2006, 2005 and 2004, respectively, which did not require prior approval of the Commissioner. Based upon anticipated on-going positive statutory earnings and favorable credit markets, LNL expects that we could pay dividends of $301 million in 2007 without prior approval from the Commissioner. LNL is recognized as an accredited reinsurer in the state of New York, which effectively enables it to conduct reinsurance business with unrelated insurance companies that are domiciled within the state of New York. As a result, in addition to regulatory restrictions imposed by the state of Indiana, LNL is also subject to the regulatory requirements that the state of New York imposes upon authorized insurers. These include reserve requirements, which differ from Indiana's requirements. The New York regulations require us to report more reserves to the state of New York. As a result, the level of statutory surplus that we report to New York is less than the statutory surplus reported to Indiana and the National Association of Insurance Commissioners. If New York requires us to maintain a higher level of capital to remain an accredited reinsurer in New York, our ability to pay dividends could be constrained. However, we do not expect that our ability to pay dividends during 2007 will be constrained as a result of our status in New York. C-29 9. RESTRICTIONS, COMMITMENTS AND CONTINGENCIES (CONTINUED) STATUTORY INFORMATION AND RESTRICTIONS -- JPL, JPFIC AND JPLA Net income for JPFIC for the nine months ending December 31, 2006 as determined in accordance with statutory accounting practices was $210 million and net loss for JPL and JPLA for the nine months ending December 31, 2006 as determined in accordance with statutory accounting practices was $114 million and $26 million, respectively. Statutory surplus as determined in accordance with statutory accounting practices for JPL, JPFIC and JPLA was $773 million, $1,140 million and $69 million at December 31, 2006, respectively. JPL prepares financial statements on the basis of SAP prescribed or permitted by the North Carolina Department of Insurance. Prescribed SAP includes the Accounting Practices and Procedures Manual of the National Association of Insurance Commissioners (NAIC) as well as state laws, regulations and administrative rules. Permitted SAP encompasses all accounting practices not so prescribed. JPL does not utilize any permitted practices in the preparation of its statutory financial statements. The General Statues of North Carolina require JPL to maintain capital of $1.2 million and minimum unassigned surplus of $.3 million. Additionally, North Carolina limits the amount of dividends that the Company and its insurance subsidiary may pay annually without first obtaining regulatory approval. Generally, the limitations are based on a combination of statutory net gain from operations for the preceding year, 10% of statutory surplus at the end of the preceding year, and dividends and distributions made within the preceding twelve months. JPL paid dividends of $2 million to LNC during 2006. JPL expects that we could pay dividends of $77 million in 2007 without prior approval from North Carolina. JPFIC prepares financial statements on the basis of SAP prescribed or permitted by the Nebraska Department of Insurance for JPFIC, and the New Jersey Department of Banking and Insurance for JPLA. Prescribed SAP includes the Accounting Practices and Procedures Manual of the National Association of Insurance Commissioners (NAIC) as well as state laws, regulations and administrative rules. Permitted SAP encompasses all accounting practices not so prescribed. JPFIC and JPL do not utilize any permitted practices in the preparation of the statutory financial statements. The General Statutes of Nebraska require JPFIC to maintain minimum capital of $1,000 and minimum surplus of $1,500 over and above capital. Additionally, the General Statutes of Nebraska limit the amount of dividends that JPFIC may pay annually without first obtaining regulatory approval. Generally, the limitations are based on a combination of statutory net gain from operations for the preceding year, 10% of statutory surplus at the end of the preceding year, and dividends and distributions made within the preceding twelve months. Depending on the timing of the payment, JPFIC could pay $288,378 in dividends in 2007 without prior approval of the Nebraska Commissioner of Insurance. The New Jersey statutes require JPLA to maintain minimum capital of $1.5 million and minimum unassigned surplus of $6.1 million. Additionally, the New Jersey statutes limit the amount of dividends that JPLA may pay annually without first obtaining regulatory approval. Payments of dividends to the stockholder generally are restricted to the greater of 10% of policyholders' surplus of the previous year or the previous year's net income. JPLA expects that we could pay dividends of $7 million in 2007 without prior approval from the New Jersey Commissioner of Banking and Insurance. REINSURANCE CONTINGENCIES Our amounts recoverable from reinsurers represent receivables from and reserves ceded to reinsurers. We obtain reinsurance from a diverse group of reinsurers and monitor concentration as well as financial strength ratings of our principal reinsurers. Swiss Re Life & Health America, Inc. ("Swiss Re") represents our largest reinsurance exposure. In 2001, Swiss Re acquired our reinsurance operation and personal accident business through indemnity reinsurance transactions. We recorded the gain related to the indemnity reinsurance transactions on the business sold to Swiss Re as deferred gain in the liability section of our Supplemental Consolidated Balance Sheets in accordance with the requirements of SFAS 113. The deferred gain is being amortized into income at the rate that earnings on the reinsured business are expected to emerge, over a period of 15 years. During 2006 and 2005 we amortized $49 million after-tax ($76 million pre-tax) per year and in 2004 we amortized $57 million after-tax ($87 million pre-tax) of deferred gain on the sale of the reinsurance operation. In the third quarter of 2004, we adjusted the deferred gain up by $77 million. As a result, the amortization of the deferred gain in 2004 included an adjustment upward of $9 million after-tax. Because of ongoing uncertainty related to personal accident business, the reserves related to these exited business lines carried on our balance sheet at December 31, 2006 may ultimately prove to be either excessive or deficient. For instance, in the event that future developments indicate that these reserves should be increased, under SFAS 113 we would record a current period non-cash charge to record the increase in reserves. Because Swiss Re is responsible for paying the underlying claims to the ceding companies, we would record a corresponding increase in reinsurance recoverable from Swiss Re. However, SFAS 113 does not permit us to take the full benefit in earnings for the recording of the increase in the reinsurance recoverable in the period of the change. Rather, we would increase the deferred gain recognized upon the closing of the indemnity reinsurance transaction with Swiss Re and would report a cumulative amortization "catch-up" adjustment to the deferred gain balance as increased earnings recognized in the period of change. Any amount of additional increase to the deferred gain above the cumulative amortization "catch-up" adjustment must continue to be deferred and will be amortized into income in future periods over the remaining period of expected run-off of the underlying business. We would transfer no cash to Swiss Re as a result of these developments. Accordingly, even though we have no continuing underwriting risk, and no cash would be transferred to Swiss Re, in the event that future developments indicate our December 31, 2006 C-30 9. RESTRICTIONS, COMMITMENTS AND CONTINGENCIES (CONTINUED) personal accident reserves are deficient or redundant, SFAS 113 requires us to adjust earnings in the period of change, with only a partial offset to earnings for the cumulative deferred gain amortization adjustment in the period of change. The remaining amount of increased gain would be amortized into earnings over the remaining run-off period of the underlying business. Because we are not relieved of our liability to the ceding companies for this business, the liabilities and obligations associated with the reinsured contracts remain on our Supplemental Consolidated Balance Sheets with a corresponding reinsurance receivable from the business sold to Swiss Re, which totaled $3.8 billion at December 31, 2006, and is included in amounts recoverable from reinsurers. Swiss Re has funded a trust, with a balance of $1.9 billion at December 31, 2006, to support this business. In addition to various remedies that we would have in the event of a default by Swiss Re, we continue to hold assets in support of certain of the transferred reserves. These assets consist of those reported as trading securities and certain mortgage loans. Our liabilities for funds withheld and embedded derivative liabilities at December 31, 2006 included $1.8 billion and $0.2 billion, respectively, related to the business reinsured by Swiss Re. MARKETING AND COMPLIANCE ISSUES There continues to be a significant amount of federal and state regulatory activity in the industry relating to numerous issues including, but not limited to, market timing and late trading of mutual fund and variable insurance products and broker-dealer access arrangements. Like others in the industry, we have received inquiries including requests for information and/or subpoenas from various authorities including the SEC, National Association of Securities Dealers ("NASD"), and the New York Attorney General. We are in the process of responding to, and in some cases have settled or are in the process of settling, certain of these inquiries. We continue to cooperate fully with such authorities. Regulators also continue to focus on replacement and exchange issues. Under certain circumstances companies have been held responsible for replacing existing policies with policies that were less advantageous to the policyholder. Our management continues to monitor compliance procedures to minimize any potential liability. Due to the uncertainty surrounding all of these matters, it is not possible to provide a meaningful estimate of the range of potential outcomes; however it is management's opinion that future developments will not materially affect our consolidated financial position. LEASES Significant leases include the lease for our Fort Wayne, Indiana home office properties through sale-leaseback agreements. The agreements provide for a 25-year lease period with options to renew for six additional terms of five years each. The agreements also provide us with the right of the first refusal to purchase the properties during the terms of the lease, including renewal periods, at a price defined in the agreements. We also have the option to purchase the leased properties at fair market value as defined in the agreements on the last day of the initial 25-year lease period ending in 2009 or the last day of any of the renewal periods. In 2006, we exercised the right and option to extend the lease for two extended terms such that the lease shall expire in 2019. We retain our right and option to exercise the remaining options for extended terms of five years each in accordance with the lease agreement. Total rental expense on operating leases in 2006, 2005 and 2004 was $47 million, $55 million and $55 million, respectively. Future minimum rental commitments are as follows (in millions): 2007-$45 2008-$40 2009-$28 2010-$17 2011-$13 Thereafter-$40 In addition, the Company leases electronic data processing equipment and field office space under noncancelable operating lease agreements. The lease terms generally range from one to seven years. Neither annual rent nor future rental commitments are significant. INFORMATION TECHNOLOGY COMMITMENT In February 1998, we signed a seven-year contract with IBM Global Services for information technology services for the Fort Wayne operations. In February 2004, we renegotiated and extended the contract through February 2010. Annual costs are dependent on usage but are expected to range from $45 million to $50 million. INSURANCE CEDED AND ASSUMED Our insurance companies cede insurance to other companies. The portion of risks exceeding each company's retention limit is reinsured with other insurers. We seek reinsurance coverage within the businesses that sell life insurance to limit its liabilities. We reinsure approximately 85% to 90% of the mortality risk on newly issued non-term life insurance contracts and approximately 45% to 50% of total mortality risk including term insurance contracts. Our policy is to retain no more than $5 million on a single insured life issued on fixed and variable universal life insurance contracts. Additionally, the retention per single insured life for term life insurance and for Corporate Owned Life Insurance ("COLI") is $1 million and $2 million, respectively. Portions of our deferred annuity business have been reinsured on a Modco basis with other companies to limit our exposure to interest rate risks. At December 31, 2006, the reserves associated with these reinsurance arrangements totaled $1.8 billion. To cover products other than life insurance, we acquire other insurance coverages with retentions and limits that management believes are appropriate for the circumstances. The accompanying financial statements reflect premiums, benefits and deferred acquisition costs, net of insurance ceded (see Note 5). Our insurance companies remain liable if their reinsurers are unable to meet contractual obligations under applicable reinsurance agreements. See "Reinsurance Contingencies" above for a discussion of our reinsurance business sold to Swiss Re. VULNERABILITY FROM CONCENTRATIONS At December 31, 2006, we did not have a material concentration of financial instruments in a single investee or industry. Our investments in mortgage loans principally involve commercial real C-31 9. RESTRICTIONS, COMMITMENTS AND CONTINGENCIES (CONTINUED) estate. At December 31, 2006, 31% of such mortgages, or $2.3 billion, involved properties located in California, Pennsylvania and Texas. Such investments consist of first mortgage liens on completed income-producing properties and the mortgage outstanding on any individual property does not exceed $28 million. Also at December 31, 2006, we did not have a concentration of: 1) business transactions with a particular customer or lender; 2) sources of supply of labor or services used in the business or; 3) a market or geographic area in which business is conducted that makes it vulnerable to an event that is at least reasonably possible to occur in the near term and which could cause a severe impact to our financial position. Although we do not have any significant concentration of customers, our American Legacy Variable Annuity product offered in our Individual Markets Annuities segment is significant to this segment. The American Legacy Variable Annuity product accounted for 49%, 48% and 45% of Individual Markets Annuities deposits in 2006, 2005 and 2004, respectively and represented approximately 67% of our total Individual Markets Annuities variable annuity product account values at December 31, 2006, 2005 and 2004. In addition, fund choices for certain of our other variable annuity products offered in our Individual Markets Individual Annuity segment include American Fund Insurance SeriesSM ("AFIS") funds. For the Individual Markets Individual Annuity segment, AFIS funds accounted for 60%, 57% and 56% of variable annuity product deposits in 2006, 2005 and 2004 respectively and represented 57%, 52% and 51% of the segment's total variable annuity product account values at December 31, 2006, 2005 and 2004, respectively. OTHER CONTINGENCY MATTERS We are involved in various pending or threatened legal proceedings, including purported class actions, arising from the conduct of business. In some instances, these proceedings include claims for unspecified or substantial punitive damages and similar types of relief in addition to amounts for alleged contractual liability or requests for equitable relief. After consultation with legal counsel and a review of available facts, it is management's opinion that these proceedings ultimately will be resolved without materially affecting our consolidated financial position. We have pursued claims with our liability insurance carriers for reimbursement of certain costs incurred in connection with a class action settlement involving the sale of our non-variable universal life and participating whole life policies issued between January 1, 1981 and December 31, 1998, and the settlement of claims and litigation brought by owners that opted out of the class action settlement. During the fourth quarter of 2002, we settled our claims against three liability carriers on a favorable basis, and settled our claims against a fourth liability insurance carrier on a favorable basis in 2004. State guaranty funds assess insurance companies to cover losses to policyholders of insolvent or rehabilitated companies. Mandatory assessments may be partially recovered through a reduction in future premium taxes in some states. We have accrued for expected assessments net of estimated future premium tax deductions. GUARANTEES We have guarantees with off-balance-sheet risks having contractual values of $3 million and $4 million at December 31, 2006 and 2005, respectively, whose contractual amounts represent credit exposure. Certain of our subsidiaries have sold commercial mortgage loans through grantor trusts, which issued pass-through certificates. These subsidiaries have agreed to repurchase any mortgage loans which remain delinquent for 90 days at a repurchase price substantially equal to the outstanding principal balance plus accrued interest thereon to the date of repurchase. In case of default on the mortgage loans, we have recourse to underlying real estate. It is management's opinion that the value of the properties underlying these commitments is sufficient that in the event of default, the impact would not be material to us. These guarantees expire in 2009. 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 risk, equity risk, and credit risk. We assess these risks by continually identifying and monitoring changes in interest rate exposure, foreign currency exposure, equity market exposure, and credit exposure that may adversely impact expected future cash flows and by evaluating hedging opportunities. Derivative instruments that are currently used as part of our interest rate risk management strategy include interest rate swaps and interest rate caps. Derivative instruments that are used as part of our foreign currency risk management strategy include foreign currency swaps. Call options on LNC stock are used as part of our equity market risk management strategy. We also use credit default swaps as part of our credit risk management strategy. As a result of our merger with JPL, we now distribute indexed annuity contracts. These 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(R) index. Policyholders may elect to rebalance index options at renewal dates, either annually or biannually. At each renewal date, we have the opportunity to re-price the indexed component by establishing participation rates, subject to minimum guarantees. We purchase S&P 500(R) index call options that are highly correlated to the portfolio allocation decisions of our policyholders, such that we are economically hedged with respect to equity returns for the current reset period. The mark-to-market of the options held impacts net investment income and generally offsets the change in value of the embedded derivative within the indexed annuity, which is recorded as a component of interest credited to policyholders' within insurance benefits. SFAS 133 requires that we calculate fair values of index options we may purchase in the future to hedge policyholder index allocations in future reset periods. These fair values represent an estimate of the cost of the options we will purchase in the future, discounted back to the date of the balance sheet, using current market indicators of volatility and interest rates. Changes in the fair values of these liabilities are included in C-32 9. RESTRICTIONS, COMMITMENTS AND CONTINGENCIES (CONTINUED) interest credited. Interest credited was decreased by $59 million in 2006 for the changes in the fair value of these liabilities. The notional amounts of policyholder fund balances allocated to the equity-index options were $2.4 billion at December 31, 2006. By using derivative instruments, we are exposed to credit risk (our counterparty fails to make payment) and market risk (the value of the instrument falls and we are required to make a payment). When the fair value of a derivative contract is positive, this generally indicates that the counterparty owes us and, therefore, creates a credit risk for us equal to the extent of the fair value gain in the derivative. When the fair value of a derivative contract is negative, this generally indicates we owe the counterparty and therefore we have no credit risk, but have been affected by market risk. We minimize the credit risk in derivative instruments by entering into transactions with high quality counterparties with minimum credit ratings that are reviewed regularly by us, by limiting the amount of credit exposure to any one counterparty, and by requiring certain counterparties to post collateral if our credit risk exceeds certain limits. We also maintain a policy of requiring all derivative contracts to be governed by an International Swaps and Derivatives Association ("ISDA") Master Agreement. We do not believe that the credit or market risks associated with derivative instruments are material to any insurance subsidiary or the Company. We are required to maintain minimum ratings as a matter of routine practice in negotiating ISDA agreements. Under some ISDA agreements, we have agreed to maintain certain financial strength or claims-paying ratings of S&P BBB and Moody's Baa2. A downgrade below these levels would result in termination of the derivatives contract at which time any amounts payable by us would be dependent on the market value of the underlying derivative contract. In certain transactions, we and the counterparty have entered into a collateral support agreement requiring us to post collateral upon significant downgrade. We are required to maintain long-term senior debt ratings above S&P BBB and Moody's Baa3. We also require for our own protection minimum rating standards for counterparty credit protection. We are required to maintain financial strength or claims-paying ratings of S&P A- and Moody's A3 under certain ISDA agreements, which collectively do not represent material notional exposure. We do not believe the inclusion of termination or collateralization events pose any material threat to our liquidity position. Market risk is the adverse effect that a change in interest rates, currency rates, implied volatility rates, or a change in certain equity indexes or instruments has on the value of a financial instrument. We manage the market risk by establishing and monitoring limits as to the types and degree of risk that may be undertaken. Our derivative instruments are monitored by our risk management committee as part of that committee's oversight of our derivative activities. Our derivative instruments committee is responsible for implementing various hedging strategies that are developed through its analysis of financial simulation models and other internal and industry sources. The resulting hedging strategies are then incorporated into our overall risk management strategies. We have derivative instruments with off-balance-sheet risks whose notional or contract amounts exceed the credit exposure. Outstanding derivative instruments with off-balance-sheet risks, shown in notional or contract amounts along with their carrying value and estimated fair values, are as follows:
ASSETS (LIABILITIES) NOTIONAL OR CONTRACT AMOUNTS CARRYING VALUE/FAIR VALUE ---------------------------- ------------------------- 2006 2005 2006 2005 ------------ ------------- ----------- ----------- (IN MILLIONS) -------------------------------------------------------- Interest rate derivative instruments: Interest rate cap agreements $5,950 $5,450 $ 3 $ 5 Interest rate swap agreements 1,188 462 8 9 ------ ------ ----- ----- Total interest rate derivative instruments 7,138 5,912 11 14 ====== ====== ===== ===== Foreign currency derivative instruments: Foreign currency swaps 86 58 (7) (5) Credit derivative instruments: Credit default swaps 20 20 -- -- Equity indexed derivative instruments: Call options (based on LNC stock) 1 1 22 17 Call options (based on SPX Index) 2,357 -- 185 -- Embedded derivatives per SFAS 133 -- -- (132) (268) ------ ------ ----- ----- Total derivative instruments* $9,602 $5,991 $ 79 $(242) ====== ====== ===== =====
---------- * Total derivative instruments for 2006 are composed of an asset of $245 million recorded in derivative investments, a $52 million contra-liability recorded in insurance policy and claim reserves and a liability of $218 million recorded in reinsurance related derivative liability on the Supplemental Consolidated Balance Sheet. Total derivative instruments for 2005 are composed of an asset of $41 and liabilities of $6 million and $278 million on the Supplemental Consolidated Balance Sheet in derivative instruments, insurance policy and claim reserves and reinsurance related derivative liability, respectively. C-33 9. RESTRICTIONS, COMMITMENTS AND CONTINGENCIES (CONTINUED) A reconciliation of the notional or contract amounts for the significant programs using derivative agreements and contracts is as follows:
INTEREST RATE INTEREST RATE FOREIGN CURRENCY CAP AGREEMENTS SWAP AGREEMENTS SWAP AGREEMENTS --------------- --------------- ---------------- 2006 2005 2006 2005 2006 2005 ------ ------ ------ ------ ------ ------- (IN MILLIONS) ---------------------------------------------------- Balance at beginning of year $5,450 $4,000 $ 462 $446 $ 58 $ 42 New contracts 750 1,450 789 36 30 30 Terminations and maturities (250) -- (63) (20) (2) (14) ------ ------ ------ ---- ---- ---- Balance at end of year $5,950 $5,450 $1,188 $462 $ 86 $ 58 ====== ====== ====== ==== ==== ====
CALL OPTIONS CALL OPTIONS CREDIT DEFAULT SWAPS (BASED ON LNC STOCK) (BASED ON SPX INDEX) -------------------- -------------------- -------------------- 2006 2005 2006 2005 2006 2005 -------- --------- -------- --------- -------- --------- (IN MILLIONS) ------------------------------------------------------------------ Balance at beginning of year $ 20 $ 13 $ 1 $ 1 $ -- $-- New contracts 10 20 -- -- 3,377 -- Terminations and maturities (10) (13) -- -- (1,020) -- ---- ---- --- --- ------- --- Balance at end of year $ 20 $ 20 $ 1 $ 1 $ 2,357 $-- ==== ==== === === ======= ===
ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES As of December 31, 2006 and 2005, we had derivative instruments that were designated and qualified as cash flow hedges and derivative instruments that were not designated as hedging instruments. We did not have derivative instruments that were designated as fair value hedges or hedges of a net investment in a foreign operation. See Note 1 for a detailed discussion of the accounting treatment for derivative instruments. For the years ended December 31, 2006, 2005 and 2004, we recognized after tax after-DAC net losses of $2 million, less than $1 million and $7 million, respectively, in net income as a component of realized investment gains and losses. These losses relate to the ineffective portion of cash flow hedges, the change in market value for derivative instruments not designated as hedging instruments, and the gain (loss) on swap terminations. For the years ended December 31, 2006, 2005 and 2004, we recognized after-tax after-DAC losses of $16 million, $7 million and $10 million, respectively, in OCI related to the change in market value on derivative instruments that are designated and qualify as cash flow hedges. DERIVATIVE INSTRUMENTS DESIGNATED IN CASH FLOW HEDGES INTEREST RATE SWAP AGREEMENTS We use interest rate swap agreements to hedge our exposure to floating rate bond coupon payments, replicating a fixed rate bond. An interest rate swap is a contractual agreement to exchange payments at one or more times based on the actual or expected price level, performance or value of one or more underlying interest rates. We are required to pay the counterparty the stream of variable interest payments based on the coupon payments from the hedged bonds, and in turn, receive a fixed payment from the counterparty, at a predetermined interest rate. The net receipts/payments from these interest rate swaps are recorded in net investment income. Gains (losses) on interest rate swaps hedging interest rate exposure on floating rate bond coupon payments are reclassified from accumulated OCI to net income as bond interest is accrued. The open positions at December 31, 2006, expire in 2007 through 2026. We also use interest rate swap agreements to hedge our exposure to interest rate fluctuations related to the forecasted purchase of assets for certain investment portfolios. The gains (losses) resulting from the swap agreements are recorded in OCI. The gains (losses) are reclassified from accumulated OCI to earnings over the life of the assets once the assets are purchased. As of December 31, 2006, there were no interest rate swaps hedging forecasted asset purchases. FOREIGN CURRENCY SWAPS We use foreign currency swaps, which are traded over-the-counter, to hedge some of the foreign exchange risk of investments in fixed maturity securities denominated in foreign currencies. A foreign currency swap is a contractual agreement to exchange the currencies of two different countries at a specified rate of exchange in the future. Gains (losses) on foreign currency swaps hedging foreign exchange risk exposure on foreign currency bond coupon payments are reclassified from accumulated OCI to net income as bond interest is accrued. The foreign currency swaps expire in 2014 through 2016. CALL OPTIONS ON LNC STOCK We use call options on LNC stock to hedge the expected increase in liabilities arising from stock appreciation rights ("SARs") granted to our agents on LNC stock. Upon option expiration, the payment, if any, is the increase in LNC's stock price over the strike price of the option applied to the number of contracts. Call options hedging vested SARs are not eligible for hedge accounting and both are marked to market through net income. Call options hedging nonvested SARs are eligible for hedge accounting and are accounted for as cash flow hedges of the forecasted vesting of SAR liabilities. To the extent that the cash flow hedges are effective, changes in the fair C-34 9. RESTRICTIONS, COMMITMENTS AND CONTINGENCIES (CONTINUED) value of the call options are recorded in accumulated OCI. Amounts recorded in OCI are reclassified to net income upon vesting of SARs. Our call option positions will be maintained until such time as the SARs are either exercised or expire and our SAR liabilities are extinguished. The SARs expire five years from the date of grant. ALL OTHER DERIVATIVE INSTRUMENTS We use various other derivative instruments for risk management and income generation purposes that either do not qualify for hedge accounting treatment or have not currently been qualified by us for hedge accounting treatment. The gain or loss related to the change in market value for these derivative instruments is recognized in net income during the period of change (reported as realized gain (loss) on investments in the Supplemental Consolidated Statements of Income except where otherwise noted below). FORWARD STARTING INTEREST RATE SWAP AGREEMENTS We used a forward starting interest rate swap agreement to hedge our exposure to the forecasted sale of mortgage loans. We were required to pay the counterparty a predetermined fixed stream of payments, and in return, received payments based on a floating rate from the counterparty. The net receipts/payments from these interest rate swaps were recorded in realized gain (loss) on investments and derivative instruments. As of December 31, 2006, there were no forward starting interest rate swap agreements. INTEREST RATE CAP AGREEMENTS The interest rate cap agreements, which expire in 2007 through 2011, entitle us to receive quarterly payments from the counterparties on specified future reset dates, contingent on future interest rates. For each cap, the amount of such quarterly payments, if any, is determined by the excess of a market interest rate over a specified cap rate multiplied by the notional amount divided by four. The purpose of our interest rate cap agreement program is to provide a level of protection for our annuity line of business from the effect of rising interest rates. The interest rate cap agreements provide an economic hedge of the annuity line of business. However, the interest rate cap agreements are not linked to assets and liabilities on the balance sheet that meet the significantly increased level of specificity required under SFAS 133. Therefore, the interest rate cap agreements do not qualify for hedge accounting under SFAS 133. SWAPTIONS Swaptions entitled us to receive settlement payments from the counterparties on specified expiration dates, contingent on future interest rates. For each swaption, the amount of such settlement payments, if any, is determined by the present value of the difference between the fixed rate on a market rate swap and the strike rate multiplied by the notional amount. The purpose of our swaption program was to provide a level of protection for its annuity line of business from the effect of rising interest rates. The swaptions provided an economic hedge of the annuity line of business. However, the swaptions were not linked to specific assets and liabilities on the balance sheet that met the significantly increased level of specificity required under SFAS 133. Therefore, the swaptions did not qualify for hedge accounting under SFAS 133. At December 31, 2006, there were no outstanding swaptions. CREDIT DEFAULT SWAPS We buy credit default swaps to hedge against a drop in bond prices due to credit concerns of certain bond issuers. A credit swap allows us to put the bond back to the counterparty at par upon a credit event by the bond issuer. A credit event is defined as bankruptcy, failure to pay, or obligation acceleration. We have no currently qualified credit default swaps for hedge accounting under SFAS 133, as amounts are insignificant. As of December 31, 2006, we had no outstanding purchased credit default swaps. We also sell credit default swaps to offer credit protection to investors. The credit default swaps hedge the investor against a drop in bond prices due to credit concerns of certain bond issuers. A credit swap allows the investor to put the bond back to us at par upon a credit event by the bond issuer. A credit event is defined as bankruptcy, failure to pay, or restructuring. As of December 31, 2006, we had credit swaps with a notional amount of $20 million, which expire in 2010. CALL OPTIONS ON LNC STOCK As discussed previously in the Cash Flow Hedges section above, we use call options on LNC stock to hedge the expected increase in liabilities arising from SARs granted to our agents on LNC stock. Call options hedging vested SARs are not eligible for hedge accounting treatment under SFAS 133. Mark to market changes are recorded in net income in underwriting, acquisition, insurance and other expenses. DERIVATIVE INSTRUMENT EMBEDDED IN DEFERRED COMPENSATION PLAN We have certain deferred compensation plans that have embedded derivative instruments. The liability related to these plans varies based on the investment options selected by the participants. The liability related to certain investment options selected by the participants is marked to market through net income in underwriting, acquisition, insurance and other expenses. DERIVATIVE INSTRUMENT EMBEDDED IN MODIFIED COINSURANCE AGREEMENTS WITH FUNDS WITHHELD ARRANGEMENTS We are involved in various Modco and CFW reinsurance arrangements that have embedded derivatives. The change in fair value of the embedded derivative, as well as the gains or losses on trading securities supporting these arrangements, flows through net income. DERIVATIVE INSTRUMENT EMBEDDED IN VARIABLE ANNUITY PRODUCTS We have certain variable annuity products with a GMWB feature that is an embedded derivative. The change in fair value of the embedded derivatives flows through net income through the benefits line in the Supplemental Consolidated Statements of Income. C-35 9. RESTRICTIONS, COMMITMENTS AND CONTINGENCIES (CONTINUED) DERIVATIVE INSTRUMENTS EMBEDDED IN AVAILABLE-FOR-SALE SECURITIES We own various debt securities that (a) contain call options to exchange the debt security for other specified securities of the borrower, usually common stock, or (b) contain call options to receive the return on equity-like indexes. The change in fair value of the embedded derivatives flows through net income. These embedded derivatives have not been qualified for hedge accounting treatment under SFAS 133. We have used certain other derivative instruments in the past for hedging purposes. Although other derivative instruments may have been used in the past, derivative types that were not outstanding from January 1, 2005 through December 31, 2006 are not discussed in this disclosure. ADDITIONAL DERIVATIVE INFORMATION Income other than realized gains and losses for the agreements and contracts described above amounted to $78 million, $14 million and $26 million in 2006, 2005 and 2004, respectively. The decrease in income from 2004 to 2005 was primarily because of decreased income on interest rate swaps. We are exposed to credit loss in the event of nonperformance by counterparties on various derivative contracts. However, we do not anticipate nonperformance by any of the counterparties. The credit risk associated with such agreements is minimized by purchasing such agreements from financial institutions with long-standing, superior performance records. 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. At December 31, 2006, the exposure was $176 million. 10. FAIR VALUE OF FINANCIAL INSTRUMENTS The following discussion outlines the methodologies and assumptions used to determine the estimated fair value of our financial instruments. Considerable judgment is required to develop these fair values. 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. FIXED MATURITY AND EQUITY SECURITIES -- AVAILABLE-FOR-SALE, HELD-TO-MATURITY AND TRADING SECURITIES Fair values for fixed maturity securities are based on quoted market prices, where available. For fixed maturity securities not actively traded, fair values are estimated using values obtained from independent pricing services. In the case of private placements, fair values are estimated by discounting expected future cash flows using a current market rate applicable to the coupon rate, credit quality and maturity of the investments. The fair values for equity securities are based on quoted market prices. MORTGAGE LOANS ON REAL ESTATE The estimated fair value of mortgage loans on real estate was 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, caliber of tenancy, borrower and payment record. Fair values for impaired mortgage loans are based on: 1) the present value of expected future cash flows discounted at the loan's effective interest rate; 2) the loan's market price or; 3) the fair value of the collateral if the loan is collateral dependent. POLICY LOANS The fair value of policy loans outstanding has been estimated using a current risk-free interest rate applied to expect future loan repayments projected based on historical repayment patterns. The fair values of policy loans on universal life-type and annuity products approximate carrying values due to the variable interest rates charged on those loans. DERIVATIVE INSTRUMENTS We employ several different methods for determining the fair value of our derivative instruments. Fair values for these contracts are based on current settlement values. These values are based on: 1) quoted market prices; 2) industry standard models that are commercially available; and 3) broker quotes. These techniques project cash flows of the derivatives using current and implied future market conditions. We calculate the present value of the cash flows to determine the derivatives' current fair market value. OTHER INVESTMENTS, AND CASH AND INVESTED CASH The carrying value for assets classified as other investments, and cash and invested cash in the accompanying balance sheets approximates their fair value. Other investments include limited partnership investments which are accounted for using the equity method of accounting. INVESTMENT TYPE INSURANCE CONTRACTS The balance sheet captions, "Insurance Policy and Claims Reserves" and "Investment Contractholder and Policyholder Funds," include investment type insurance contracts (i.e., deposit contracts and certain guaranteed interest contracts). The fair values for the deposit contracts and certain guaranteed interest contracts are based on their approximate surrender values. The fair values for the remaining guaranteed interest and similar contracts are estimated using discounted cash flow calculations. 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. C-36 10. FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED) The remainder of the balance sheet captions, "Insurance Policy and Claims Reserves" and "Investment Contractholder and Policyholder Funds" that do not fit the definition of "investment type insurance contracts" are considered insurance contracts. Fair value disclosures are not required for these insurance contracts, nor have we determined the fair value of such contracts. It is our position that not disclosing the fair value of these insurance contracts is important because readers of these financial statements could draw inappropriate conclusions about our shareholder's equity determined on a fair value basis. It could be misleading if only the fair value of assets and liabilities defined as financial instruments are disclosed. We and other companies in the insurance industry are monitoring the related actions of the various rule-making bodies and attempting to determine an appropriate methodology for estimating and disclosing the "fair value" of their insurance contract liabilities. SHORT-TERM AND LONG-TERM DEBT Fair values for long-term debt issues are estimated using discounted cash flow analysis based on our current incremental borrowing rate for similar types of borrowing arrangements. For short-term debt, the carrying value approximates fair value. GUARANTEES Our guarantees include guarantees related to mortgage loan pass-through certificates. Based on historical performance where repurchases have been negligible and the current status of the debt, none of the loans are delinquent and the fair value liability for the guarantees related to mortgage loan pass-through certificates is insignificant. INVESTMENT COMMITMENTS Fair values for commitments to make investments in fixed maturity securities (primarily private placements), mortgage loans on real estate and real estate are based on the difference between the value of the committed investments as of the date of the accompanying balance sheets and the commitment date. These estimates take into account changes in interest rates, the counterparties' credit standing and the remaining terms of the commitments. SEPARATE ACCOUNTS Assets held in separate accounts are reported at fair value. The related liabilities are also reported at fair value in amounts equal to the separate account assets. The carrying values and estimated fair values of our financial instruments are as follows:
2006 2005 --------------------------- --------------------------- CARRYING VALUE FAIR VALUE CARRYING VALUE FAIR VALUE -------------- ---------- -------------- ---------- (IN MILLIONS) --------------------------------------------------------- Assets (liabilities): Securities available-for-sale Fixed maturies $ 54,697 $ 54,697 $ 32,245 $ 32,245 Equity 218 218 101 101 Trading securities 2,820 2,820 2,985 2,985 Mortgage loans on real estate 7,344 7,530 3,662 3,859 Policy loans 2,755 2,979 1,858 2,003 Derivative instruments * 79 79 (243) (243) Other investments 819 819 423 423 Cash and invested cash 1,762 1,762 1,962 1,962 Investment type insurance contracts: Deposit contracts and certain guaranteed interest contracts (28,628) (28,605) (21,270) (21,273) Remaining guaranteed interest and similar contracts (245) (245) (13) (13) Short-term debt (21) (21) (34) (34) Long-term debt (1,440) (1,395) (1,250) (1,324) Guarantees -- -- -- -- Investment commitments -- (1,308) -- --
---------- * Total derivative instruments for 2006 are composed of an asset of $245 million recorded in derivative investments, a $52 million contra-liability recorded in insurance policy and claim reserves and a liability of $218 million recorded in reinsurance related derivative liability. Total derivative instruments for 2005 are composed of an asset of $41 million in derivative investments, a $6 million liability in insurance policy and claim reserves and a liability of $278 million recorded in reinsurance related derivative liability. As of December 31, 2006 and 2005, the carrying value of the deposit contracts and certain guaranteed contracts is net of DAC of $789 million and $383 million, respectively, excluding adjustments for DAC applicable to changes in fair value of securities. The carrying values of these contracts are stated net of DAC so that they are comparable with the fair value basis. C-37 11. SEGMENT INFORMATION In the quarter ended June 30, 2006, LNC completed its merger with Jefferson-Pilot and changed its management organization. LNC also realigned its reporting segments, which included those of LNL to reflect the current manner by which its chief operating decision makers view and manage the business. All segment data for reporting periods have been adjusted to reflect the current segment reporting. As a result of these changes, we provide products and services in two operating businesses: (1) Individual Markets and (2) Employer Markets, and report results through three business segments. The following is a brief description of these segments. INDIVIDUAL MARKETS. The Individual Markets business provides its products through two segments, Individual Annuities and Individual Life Insurance. Various insurance and investment products are currently marketed to individuals and businesses in the United States. Through its Individual Annuities segment, Individual Markets provides tax-deferred investment growth and lifetime income opportunities for its clients by offering individual fixed annuities, including indexed annuities, and variable annuities. The Individual Life Insurance segment offers wealth protection and transfer opportunities through both single and survivorship versions of universal life, variable universal life, interest-sensitive whole life, term insurance, as well as a linked-benefit product, which is a universal life insurance policy linked with riders that provide for long-term care costs. EMPLOYER MARKETS. The Employer Markets business provides its products through two segments, Retirement Products and Group Protection. The Retirement Products segment consists of its Defined Contribution business. Employer Markets also provides employer-sponsored variable and fixed annuities, mutual-fund based programs in the 401(k), 403(b), and 457 marketplaces and corporate/bank owned life insurance. The Group Protection segment offers group non-medical insurance products, principally term life, disability and dental, to the employer marketplace through various forms of contributory and noncontributory plans. We also have Other Operations which includes the financial data for operations that are not directly related to the business segments, unallocated corporate items (such as investment income on investments related to the amount of statutory surplus in our insurance subsidiaries that is not allocated to our business units and other corporate investments, interest expense on short-term and long-term borrowings, and certain expenses, including restructuring and merger-related expenses) and the historical results of the former reinsurance segment, which was sold to Swiss Re Life & Health America Inc. ("Swiss Re") in the fourth quarter of 2001, along with the ongoing amortization of deferred gain on the indemnity reinsurance portion of the transaction with Swiss Re. Financial data by segment is as follows:
2006 2005 2004 ------ ------ ------ (IN MILLIONS) ------------------------ REVENUE: Segment Operating Revenue: Individual Markets: Individual Annuities $1,914 $1,309 $1,278 Life Insurance 3,178 1,840 1,847 ------ ------ ------ Individual Markets Total 5,092 3,149 3,125 ------ ------ ------ Employer Markets: Retirement Products 1,355 1,168 1,125 Group Protection 1,033 -- -- ------ ------ ------ Employer Markets Total 2,388 1,168 1,125 ------ ------ ------ Other Operations 474 309 621 Consolidating adjustments (164) -- (354) Net realized investment results(1) (2) (16) (45) Reserve development net of related amortization on business sold through reinsurance 1 1 1 ------ ------ ------ Total $7,789 $4,611 $4,473 ====== ====== ====== NET INCOME: Segment net income: Individual Markets: Individual Annuities $ 323 $ 197 $ 169 Life Insurance 470 238 252 ------ ------ ------ Individual Markets Total 793 435 421 ------ ------ ------ Employer Markets: Retirement Products 249 206 181 Group Protection 99 -- -- ------ ------ ------ Employer Markets Total 348 206 181 ------ ------ ------ Other Operations 20 12 9 Net realized investment results(2) (1) (10) (29) Reserve development net of related amortization on business sold through reinsurance 1 1 1 ------ ------ ------ Income before cumulative effect of accounting changes 1,161 644 583 Cumulative effect of accounting changes -- -- (26) ------ ------ ------ Net Income $1,161 $ 644 $ 557 ====== ====== ======
---------- (1) Includes realized losses on investments of $6 million, $20 million and $47 million for 2006, 2005 and 2004, respectively; realized losses on derivative instruments of $(1) million and $(11) million for 2005 and 2004, respectively; gain (loss) on reinsurance embedded derivative/trading securities of $4 million, $5 million and $(1) million in 2006, 2005 and 2004, respectively; and gain on sale of subsidiaries/businesses of $14 million for 2004. C-38 11. SEGMENT INFORMATION (CONTINUED) (2) Includes realized losses on investments of $4 million $13 million and $21 million for 2006, 2005 and 2004, respectively; realized gains (losses) on derivative instruments of less than $1 million, less than $(1) million and $(7) million for 2006, 2005 and 2004, respectively; gain (loss) on reinsurance embedded derivative/trading securities of $2 million, $3 million and $(1) million for 2006, 2005 and 2004, respectively.
2006 2005 -------- -------- (IN MILLIONS) ------------------- ASSETS: Annuities $ 70,520 $ 48,250 Life Insurance 42,691 21,795 Retirement Products 37,274 33,478 Group Protection 2,341 -- Other Operations 10,058 6,649 Consolidating adjustments 1,932 3,882 -------- -------- Total $164,816 $114,054 ======== ========
12. SHAREHOLDER'S EQUITY All authorized and issued shares of LNL, JPL, JPFIC and JPLA are owned by LNC. Details underlying the supplemental consolidated balance sheet caption "Net Unrealized Gain on Securities Available-for-Sale," are as follows:
2006 2005 ------- ------- (IN MILLIONS) ------------------ Fair value of securities available-for-sale $54,915 $32,346 Cost of securities available-for-sale 54,051 31,362 ------- ------- Unrealized gain 864 984 Adjustments to deferred acquisition costs and value of business acquired (227) (266) Amounts required to satisfy policyholder commitments (20) (31) Foreign currency exchange rate adjustment 28 16 Deferred income taxes (224) (251) ------- ------- Net unrealized gain on securities available-for-sale $ 421 $ 452 ======= =======
Adjustments to DAC and amounts required to satisfy policyholder commitments are netted against the DAC asset line and included within the insurance policy and claim reserve line on the Supplemental Consolidated Balance Sheets, respectively. Details underlying the change in net unrealized gain (loss) on securities available-for-sale, net of reclassification adjustment shown on the Supplemental Consolidated Statements of Shareholder's Equity are as follows:
2006 2005 2004 ---- ----- ---- (IN MILLIONS) ------------------- Unrealized gains (losses) on securities available-for-sale arising during the year $ 7 $(479) $116 Less: Reclassification adjustment for gains on disposals of prior year inventory included in net income(1) 65 39 82 Less: Federal income tax expense (benefit) (27) (189) 11 ---- ----- ---- Net change in unrealized gain on securities available-for-sale, net of reclassifications and federal income tax expense $(31) $(329) $ 23 ==== ===== ====
---------- (1) The reclassification adjustment for gains (losses) does not include the impact of associated adjustments to DAC and amounts required to satisfy policyholder commitments. The net unrealized gain (loss) on derivative instruments component of other comprehensive income shown on the Supplemental Consolidated Statements of Shareholder's Equity is net of Federal income tax expense (benefit) of $3 million, $5 million and $3 million for 2006, 2005 and 2004, respectively, and net of adjustments to DAC of $1 million, $(7) million and $(8) million for 2006, 2005 and 2004, respectively. C-39 13. RESTRUCTURING CHARGES The following provides details on our restructuring charges. All restructuring charges recorded by us are included in underwriting, acquisition, insurance and other expenses on the Supplemental Consolidated Statements of Income in the year incurred and are included in the Other Operations segment. 2006 RESTRUCTURING PLAN Upon completion of LNC's merger with Jefferson-Pilot, a restructuring plan was implemented relating to the integration of LNC's legacy operations with those of Jefferson-Pilot. The realignment will enhance productivity, efficiency and scalability while positioning LNC and its affiliates for future growth. The following details LNL's restructuring charges associated with this integration plan:
TOTAL ---------------- (IN MILLIONS) ---------------- Amounts incurred in 2006 Employee severance and termination benefits $12 Abandoned office space 1 --- Total 2006 restructuring charges 13 Amounts expended in 2006 (6) --- Restructuring reserve at December 31, 2006 $ 7 === Additional amounts expended that do not qualify as restructuring charges $14 Expected completion date 4th Quarter 2009
2005 RESTRUCTURING PLAN During May 2005, LFA implemented a restructuring plan to realign its field management and financial planning support areas. Total pre-tax restructuring charges incurred during 2005 were $7 million. These charges, which are included in Other Operations, included employee severance and termination benefits of $4 million and rent on abandoned office space of $3 million. The remaining reserves totaled $1 million at December 31, 2006. The plan was completed by year end 2006, except for lease payments on vacated space which run through 2008. 2003 RESTRUCTURING PLANS In January 2003, the operations in Hartford, Connecticut and Schaumburg, Illinois to enhance productivity, efficiency and scalability while positioning the segment for future growth. In February 2003, we announced plans to consolidate its fixed annuity operations in Schaumburg, Illinois into Fort Wayne, Indiana. In June 2003, we announced that we were combining our retirement and life insurance businesses into a single operating unit focused on providing wealth accumulation and protection, income distribution and wealth transfer products. In August 2003, we announced additional realignment activities. The total pre-tax restructuring charges recorded in 2005 and 2004 were $23 million and $20 million, respectively. Pre-tax amounts reversed in restructuring charges in 2006 and 2004 were $1 million in each year. Additional pre-tax amounts expended that do not qualify as restructuring charges in 2005 and 2004 were $7 million and $15 million, respectively. These plans were completed in 2006. 14. TRANSACTIONS WITH AFFILIATES Cash and short-term investments at December 31, 2006 and 2005 include our participation in a cash management agreement with LNC of $389 million and $227 million, respectively. Related investment income was $14 million, $6 million and $3 million in 2006, 2005 and 2004, respectively. Short-term debt represents notes payable to LNC of $21 million and $34 million at December 31, 2006 and 2005, respectively. Total interest expense for this short-term debt was $1 million per year in 2006, 2005 and 2004. As shown in Note 5, LNC supplied funding to us totaling $1.390 billion in 2006 and $1.250 billion in 2005, in exchange for notes. The interest expense on these notes was $78 million per year in 2006, 2005 and 2004. HARCO supplied funding to JPFIC totaling $50 million in 1994, in exchange for Notes. A transfer pricing arrangement is in place between LFD and Delaware Management Holdings, Inc. ("DMH") related to the wholesaling of DMH's investment products. As a result, we received fees of $36 million, $41 million, and $32 million from DMH for transfer pricing in 2006, 2005, and 2004. We also received fees of $4 million in 2006, from the Jefferson-Pilot Companies, for distributing Variable Universal Life products. We paid fees of $57 million, $72 million and $79 million to DMH for investment management services in 2006, 2005 and 2004, respectively. We provide services to and receive services from affiliated companies plus we receive an allocation of corporate overhead from LNC. This allocation is based on a calculation that utilizes income and equity of the business units. These activities with affiliated companies resulted in net payments of $59 million, $122 million and $101 million in 2006, 2005 and 2004, respectively. We cede and accept reinsurance from affiliated companies. As discussed in Note 6, we cede certain Guaranteed Benefit risks (including certain GMDB and all GMWB benefits) to LNR Barbados. We also cede certain risks for certain UL policies, which resulted from recent actuarial reserving guidelines, to LNR Barbados. As of December 31, 2006, 2005 and 2004, all of these transactions are between us and LNR Barbados and us and Lincoln Assurance Limited, an affiliated life insurance company. Premiums in the accompanying Supplemental Consolidated Statements of Income include premiums on insurance business accepted under reinsurance contracts and exclude premiums ceded to other affiliated companies, as follows:
2006 2005 2004 ----- ----- ----- (IN MILLIONS) --------------------- Insurance assumed $ 25 $ -- $ -- Insurance ceded (238) (219) (116) ----- ----- ----- Net reinsurance premiums and fees $(213) $(219) $(116) ===== ===== =====
C-40 14. TRANSACTIONS WITH AFFILIATES (CONTINUED) The Supplemental Consolidated Balance Sheets include reinsurance balances with affiliated companies as follows:
2006 2005 ---- ---- (IN MILLIONS) ------------- Future policy benefits and claims assumed $141 $ 3 Future policy benefits and claims ceded 951 1,052 Amounts recoverable from reinsurers on paid and unpaid losses 16 16 Reinsurance payable on paid losses 11 3 Funds held under reinsurance treaties-net liability 702 718
Substantially all reinsurance ceded to affiliated companies is with unauthorized companies. To take a reserve credit for such reinsurance, we hold assets from the reinsurer, including funds held under reinsurance treaties, and are the beneficiary on letters of credit aggregating $1,149 million and $751 million at December 31, 2006 and 2005, respectively. The letters of credit are issued by banks and represent guarantees of performance under the reinsurance agreement, and are guaranteed by LNC. The Company has entered into service agreements with the Parent and other subsidiaries of the Parent for personnel and facilities usage, general management services and investment management services. The Company was reimbursed $199 million in for general management and investment services provided by the Company, of which $46 million remained receivable as of December 31, 2006, related to these agreements. The Company also made various disbursements to its affiliates, of which $8 million remained payable as of December 31, 2006. These balances are included in other assets on the Supplemental Consolidated Balance Sheets. The Company owns the following securities of Jefferson-Pilot affiliates. Amounts are reflected at the carrying amounts in the Supplemental Consolidated Balance Sheets as of December 31.
2006 2005 ---- ---- (IN MILLIONS) ------------- Lincoln Financial Media Company (affiliate) Senior Promissory Notes due 2006 through 2013, interest ranging from 4.2% to 7.7% $ 29 $-- Lincoln National Corporation (Parent) Senior Notes Series due 2008 interest 4.6% 200 -- Lincoln National Corporation Senior Promissory Notes due 2007, interest rate of 5.25% 6 --
The Company recognized interest income on these securities totaling $9 million as of December 31, 2006. The Company has an agreement with its affiliate broker/dealer, Jefferson Pilot Variable Corporation (JPVC). The agreement calls for the Company to pay JPVC for sales of the Company's variable annuity contracts. The amount paid is based on sales during the period and contracts in force. The Company recorded expenses of $21 million as of December 31, 2006 related to this agreement. During 1999, JPLA paid an affiliate, JPFIC $100 million in premiums for a company owned life insurance policy on certain of its employees. At December 31, 2006, the cash surrender value of this policy totaled approximately $148 million. 15. SUBSEQUENT EVENT On April 26, 2007, the Indiana Department of Insurance approved to move ownership of First Penn-Pacific Life Insurance Company, a wholly owned subsidiary of the Company to LNC, the parent of the Company. This move of ownership was made in the form of a dividend, effective May 2, 2007 in the amount of $492 million. C-41 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors The Lincoln National Life Insurance Company We have audited the accompanying supplemental consolidated balance sheets of The Lincoln National Life Insurance Company as of December 31, 2006 and 2005, and the related supplemental consolidated statements of income, shareholder's equity, and cash flows for each of the three years in the period ended December 31, 2006. These supplemental financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these supplemental financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company's internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. The supplemental consolidated financial statements give retroactive effect to the merger of the Company with Jefferson-Pilot Financial Insurance Company, which occurred on July 2, 2007, and to the merger of the Company with Jefferson-Pilot Life Insurance Company ("JPL"), which occurred on April 2, 2007. These mergers have been accounted for in a manner similar to a pooling-of-interests as described in Note 1 to the supplemental consolidated financial statements. Generally accepted accounting principles proscribe giving effect to a consummated acquisition accounted for by the pooling-of-interests method in the financial statements that do not include the date of consummation. These supplemental financial statements do not extend through the date of consummation. However, they will become the historical consolidated financial statements of The Lincoln National Life Insurance Company after financial statements covering the dates of consummation of the mergers are issued. In our opinion, the supplemental consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of The Lincoln National Life Insurance Company at December 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles applicable after financial statements are issued for a period which includes the dates of the consummation of the business combinations. As discussed in Note 2 to the supplemental consolidated financial statements, in 2006 the Company changed its method of accounting for defined benefit pension and other postretirement plans. Also, as discussed in Note 2 to the supplemental consolidated financial statements, in 2004 the Company changed its method of accounting for certain non-traditional long-duration contracts and for separate accounts. /s/ Ernst & Young LLP ----------------------- Ernst & Young LLP Philadelphia, PA July 2, 2007 C-42 Lincoln National Variable Annuity Account L PART C - OTHER INFORMATION Item 24. Financial Statements and Exhibits (a) List of Financial Statements 1. Part A The Table of Condensed Financial Information is included in Part A of this Registration Statement incorporated herein by reference to Post-Effective Amendment No. 16 (File No. 333-04999) filed on April 18, 2007. 2. Part B The following financial statements for the Variable Account are included in Part B of this Registration Statement: Statement of Assets and Liabilities - December 31, 2006 Statement of Operations - Year ended December 31, 2006 Statements of Changes in Net Assets - Years ended December 31, 2006 and 2005 Notes to Financial Statements - December 31, 2006 Report of Independent Registered Public Accounting Firm 3. Part B The following consolidated financial statements for The Lincoln National Life Insurance Company are included in Part B of this Registration Statement: Consolidated Balance Sheets - Years ended December 31, 2006 and 2005 ConsolidatedStatements of Income - Years ended December 31, 2006, 2005, and 2004 Consolidated Statements of Shareholder's Equity - Years ended December 31, 2006, 2005 and 2004 Consolidated Statements of Cash Flows - Years ended December 31, 2006, 2005, and 2004 Notes to Consolidated Financial Statements - December 31, 2006 Report of Independent Registered Public Accounting Firm The following consolidated financial statements for Jefferson-Pilot Life Insurance Company and Subsidiary are included in Part B of this Registration Statement: Consolidated Balance Sheets - Years ended December 31, 2006 and 2005 Consolidated Statements of Income - For the periods April 3 through December 31, 2006, and January 1 through April 2, 2006, and for the years ended December 31, 2005, and December 31, 2004 Consolidated Statements of Shareholder's Equity - For the periods April 3 through December 31, 2006, and January 1 through April 2, 2006, and for the years ended December 31, 2005, and December 31, 2004 Consolidated Statements of Cash Flows - For the periods April 3 through December 31, 2006, and January 1 through April 2, 2006, and for the years ended December 31, 2005, and December 31, 2004 Notes to Consolidated Financial Statements - December 31, 2006 Report of Independent Registered Public Accounting Firm The following consolidated financial statements for Jefferson Pilot Financial Insurance Company and Subsidiary are included in Part B of this Registration Statement: Consolidated Balance Sheets - Years ended December 31, 2006 and 2005 Consolidated Statements of Income - For the periods April 3 through December 31, 2006, and January 1 through April 2, 2006, and for the years ended December 31, 2005, and December 31, 2004 Consolidated Statements of Shareholder's Equity - For the periods April 3 through December 31, 2006, and January 1 through April 2, 2006, and for the years ended December 31, 2005, and December 31, 2004 Consolidated Statements of Cash Flows - For the periods April 3 through December 31, 2006, and January 1 through April 2, 2006, and for the years ended December 31, 2005, and December 31, 2004 Notes to Consolidated Financial Statements - December 31, 2006 Report of Independent Registered Public Accounting Firm The following supplemental consolidated financial statements for The Lincoln National Life Insurance Company are included in Part B of this Registration Statement: Supplemental Consolidated Balance Sheets - Years ended December 31, 2006 and 2005 Supplemental Consolidated Statements of Income - Years ended December 31, 2006, 2005, and 2004 Supplemental Consolidated Statements of Shareholder's Equity - Years ended December 31, 2006, 2005 and 2004 Supplemental Consolidated Statements of Cash Flows - Years ended December 31, 2006, 2005, and 2004 Notes to Supplemental Consolidated Financial Statements - December 31, 2006 Report of Independent Registered Public Accounting Firm (b) List of Exhibits (1)(a) Resolution of Board of Directors of The Lincoln National Life Insurance Company authorizing establishment of the Variable Account incorporated herein by reference to Pre-Effective Amendment No. 1 (File No. 333-04999) filed on September 26,1996. (b) Amendment dated December 2, 1996 to Resolution of Board of Directors of The Lincoln National Life Insurance Company authorizing establishment of the Variable Account incorporated herein by reference to Post-Effective Amendment No. 2 (File No. 333-04999) filed on April 30, 1998. (2) Not Applicable. (3) (a) Broker-Dealer Sales Agreement incorporated herein by reference to Pre-Effective Amendment No. 1 (File No. 333-04999) filed on September 26, 1996. (b) Form of Principal Underwriting Agreement between The Lincoln National Life Insurance Company and Lincoln Financial Distributors, Inc. incorporated herein by reference to Post-Effective Amendment No. 20 (File No. 333-35784) filed on April 10, 2007. (4)(a) Group Variable Annuity I Contract incorporated herein by reference to Post-Effective Amendment No. 7 (File No. 333-04999) filed on April 26, 2000. (b) Group Variable Annuity II Contract incorporated herein by reference to Post-Effective Amendment No. 7 (File No. 333-04999) filed on April 26, 2000. (c) Group Variable Annuity III Contract incorporated herein by reference to Post-Effective Amendment No. 7 (File No. 333-04999) filed on April 26, 2000. (d) Endorsement to Group Annuity Contracts incorporated herein by reference to Post-Effective Amendment No. 7 (File No. 333-04999) filed on April 26, 2000. (e) Group Annuity Amendment to Group Annuity Contracts incorporated herein by reference to Post-Effective Amendment No. 7 (File No. 333-04999) filed on April 26, 2000. (f) Endorsement to Certificate incorporated herein by reference to Post-Effective Amendment No. 7 (File No. 333-04999) filed on April 26, 2000. (g) Section 403(b) Annuity Amendment incorporated herein by reference to Post-Effective Amendment No. 10 (File No. 333-04999) filed on April 9, 2002. (h) Group Annuity Amendment incorporated herein by reference to Post-Effective Amendment No. 10 (File No. 333-04999) filed on April 9, 2002. (i) Qualified Individual Retirement Annuity Rider incorporated herein by reference to Post-Effective Amendment No. 12 (File No. 333-04999) filed on April 6, 2004. (5)(a) Application for Group Annuity Contract incorporated herein by reference to Post-Effective Amendment No. 7 (File No. 333-05827) filed on April 26, 2000. (b) Participant Enrollment Form incorporated herein by reference to Post-Effective Amendment No. 7 (File No. 333-04999) filed on April 26, 2000. (6)(a) Articles of Incorporation of The Lincoln National Life Insurance Company incorporated herein by reference to Registration Statement on Form S-6 (File No. 333-40745) filed on November 21, 1997. B-2 (b) By-Laws of The Lincoln National Life Insurance Company incorporated herein by reference to Post-Effective Amendment No. 1 (File No. 333-40937) filed on November 9, 1998. (7) Not Applicable. (8)(a)(i) Services Agreement between Delaware Management Holdings, Inc., Delaware Service Company, Inc. and The Lincoln National Life Insurance Company incorporated herein by reference to Post-Effective Amendment No. 21 on Form N-1A (File No. 2-80741) filed on April 10, 2000. (ii) Amendment to Services Agreement between Delaware Management Holdings, Inc., Delaware Service Company, Inc. and The Lincoln National Life Insurance Company incorporated herein by reference to Post-Effective Amendment No. 5 (File No. 333-43373) filed on April 4, 2002. (iii) Form of Amendment to Services Agreement between Delaware Management Holdings, Inc., Delaware Service Company, Inc. and The Lincoln National Life Insurance Company incorporated herein by reference to Post-Effective Amendment No. 15 (File No. 333-04999) filed on April 12, 2006. (b) Fund Participation Agreements and Amendments between The Lincoln National Life Insurance Company and: (i) American Century incorporated herein by reference to Post-Effective Amendment No. 16 (File No. 333-04999 ) filed on April 18, 2007. (ii) Baron Capital Trust incorporated herein by reference to Post-Effective Amendment No. 16 (File No. 333-04999 ) filed on April 18, 2007. (iii)(a) Dreyfus Variable Investment Fund and Dreyfus Life and Annuity Index Fund, Inc. incorporated herein by reference to Pre-Effective Amendment No. 1 (File No. 333-04999) filed September 26, 1996. (Fund Participation Agreement) (iii)(b) Dreyfus Variable Investment Fund, Dreyfus Socially Responsible Growth Fund, Inc. and Dreyfus Life and Annuity Index Fund, Inc. incorporated herein by reference to Post-Effective Amendment No. 11 (File No. 333-04999) filed on April 3, 2003. (Amendment) (iii)(c) Dreyfus Variable Investment Fund, Dreyfus Socially Responsible Growth Fund, Inc. and Dreyfus Life and Annuity Index Fund, Inc. incorporated herein by reference to Post-Effective Amendment No. 11 (File No. 333-04999) filed on April 3, 2003. (Amendment) (iii)(d) Dreyfus Variable Investment Fund, Dreyfus Socially Responsible Growth Fund, Inc. and Dreyfus Life and Annuity Index Fund, Inc. incorporated herein by reference to Post-Effective Amendment No. 12 (File No. 333-04999) filed on April 6, 2004. (Amendment) (iv) Fidelity Variable Insurance Products incorporated herein by reference to Post-Effective Amendment No. 16 (File No. 333-04999 ) filed on April 18, 2007. (v) Janus Aspen Series incorporated herein by reference to Post-Effective Amendment No. 16 (File No. 333-04999 ) filed on April 18, 2007. (vi) Lincoln Variable Insurance Products Trust incorporated herein by reference to Post-Effective Amendment No. 16 (File No. 333-04999 ) filed on April 18, 2007. (vii) Neuberger Berman Advisers Management Trust incorporated herein by reference to Post-Effective Amendment No. 16 (File No. 333-04999 ) filed on April 18, 2007. (viii)(a) T. Rowe Price International Services, Inc and T. Rowe Price Investment Services, Inc. incorporated herein by reference to Pre-Effective Amendment No. 1 (File No. 333-04999) filed on September 26, 1996. (Fund Participation Agreement) (viii)(b) T. Rowe Price International Services, Inc and T. Rowe Price Investment Services, Inc. incorporated herein by reference to Post-Effective Amendment No. 11 (File No. 333-04999) filed on April 3, 2003. (Amendment) (ix) Alliance Variable Products Series Fund incorporated herein by reference to Post-Effective Amendment No. 16 (File No. 333-04999 ) filed on April 18, 2007. B-3 (x) American Funds Insurance Series incorporated herein by reference to Post-Effective Amendment No. 16 (File No. 333-04999 ) filed on April 18, 2007. (xi) Delaware VIP Trust incorporated herein by reference to Post-Effective Amendment No. 16 (File No. 333-04999 ) filed on April 18, 2007. (xii) Scudder Investments VIT Funds Trust incorporated herein by reference to Post-Effective Amendment No. 16 (File No. 333-04999 ) filed on April 18, 2007. (9) Opinion and Consent of Jeremy Sachs, Senior Counsel of The Lincoln National Life Insurance Company as to the legality of securities being issued incorporated herein by reference to Pre-Effective Amendment No. 1 (File No. 333-05827) filed on September 26, 1996. (10) (a) Consent of Independent Registered Public Accounting Firm (b) Power of Attorney - Principal Officers and Directors of The Lincoln National Life Insurance Company incorporated herein by reference to Post-Effective Amendment No. 16 (File No. 333-04999 ) filed on April 18, 2007. (11) Not Applicable (12) Not Applicable (13) Not Applicable (14) Not Applicable (15) Organizational Chart of The Lincoln National Insurance Holding Company System Item 25. Directors and Officers of the Depositor The following list contains the officers and directors of The Lincoln National Life Insurance Company who are engaged directly or indirectly in activities relating to Lincoln National Variable Annuity Account L as well as the contracts. The list also shows The Lincoln National Life Insurance Company's executive officers.
Name Positions and Offices with Depositor --------------------------- ------------------------------------------------------------- Kelly D. Clevenger* Vice President Frederick J. Crawford** Chief Financial Officer and Director Christine S. Frederick*** Vice President and Chief Compliance Officer Dennis R. Glass** President and Director Mark E. Konen*** Senior Vice President and Director Barbara Kowalczyk** Director See Yeng Quek**** Senior Vice President, Chief Investment Officer and Director Dennis L. Schoff** Senior Vice President and General Counsel Rise' C.M. Taylor* Treasurer and Vice President Westley V. Thompson*** Senior Vice President and Director C. Suzanne Womack** Secretary and Second Vice President
* Principal business address is 1300 South Clinton Street, Fort Wayne, Indiana 46802 ** Principal business address is Center Square West Tower, 1500 Market Street-Suite 3900, Philadelphia, PA 19102-2112 *** Principal business address is 350 Church Street, Hartford, CT 06103 **** Principal business address is One Commerce Square, 2005 Market Street, 39th Floor, Philadelphia, PA 19103-3682 Item 26. Persons Controlled by or Under Common Control with the Depositor or Registrant See Exhibit 15: Organizational Chart of the Lincoln National Insurance Holding Company System. B-4 Item 27. Number of Contractowners As of May 31, 2007 there were68,251 participants in group contracts under Account L. Item 28. Indemnification (a) Brief description of indemnification provisions. In general, Article VII of the By-Laws of The Lincoln National Life Insurance Company (Lincoln Life) provides that Lincoln Life will indemnify certain persons against expenses, judgments and certain other specified costs incurred by any such person if he/she is made a party or is threatened to be made a party to a suit or proceeding because he/she was a director, officer, or employee of Lincoln Life, as long as he/she acted in good faith and in a manner he/she reasonably believed to be in the best interests of, or act opposed to the best interests of, Lincoln Life. Certain additional conditions apply to indemnification in criminal proceedings. In particular, separate conditions govern indemnification of directors, officers, and employees of Lincoln Life in connection with suits by, or in the right of, Lincoln Life. Please refer to Article VII of the By-Laws of Lincoln Life (Exhibit no. 6(b) hereto) for the full text of the indemnification provisions. Indemnification is permitted by, and is subject to the requirements of, Indiana law. (b) Undertaking pursuant to Rule 484 of Regulation C under the Securities Act of 1933: Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the Registrant pursuant to the provisions described in Item 28(a) above or otherwise, the Registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Registrant of expenses incurred or paid by a director, officer, or controlling person of the Registrant in the successful defense of any such action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. Item 29. Principal Underwriter Lincoln Financial Distributors, Inc. (LFD) currently serves as Principal Underwriter for: Lincoln National Variable Annuity Fund A (Group & Individual); Lincoln National Variable Annuity Account C; Lincoln National Flexible Premium Variable Life Account D; Lincoln National Variable Annuity Account E; Lincoln National Flexible Premium Variable Life Account F; Lincoln National Flexible Premium Variable Life Account G; Lincoln National Variable Annuity Account H; Lincoln Life Flexible Premium Variable Life Account J; Lincoln Life Flexible Premium Variable Life Account K; Lincoln National Variable Annuity Account L; Lincoln Life Flexible Premium Variable Life Account M; Lincoln Life Variable Annuity Account N; Lincoln Life Variable Annuity Account Q; Lincoln Life Flexible Premium Variable Life Account R; Lincoln Life Flexible Premium Variable Life Account S; Lincoln Life Variable Annuity Account T; Lincoln Life Variable Annuity Account W; and Lincoln Life Flexible Premium Variable Life Account Y.
Name Positions and Offices with Underwriter ------------------------- ------------------------------------------------ Terrence Mullen* Chief Executive Officer, President and Director David M. Kittredge* Senior Vice President Duane L. Bernt** Vice President and Treasurer Patrick J. Caulfield* Vice President and Chief Compliance Officer Frederick J. Crawford** Director Dennis R. Glass** Director Barbara S. Kowalczyk** Director Nancy A. Jordan*** Second Vice President, Chief Financial Officer and Controller Marilyn K. Ondecker*** Secretary
* Principal Business address is 2001 Market Street, 4th Floor, Philadelphia, PA 19103 ** Principal Business address is 1500 Market Street, Suite 3900, Philadelphia, PA 19102 *** Principal Business address is 1300 S. Clinton Street, Ft. Wayne, IN 46802 B-5 (c) N/A Item 30. Location of Accounts and Records All accounts, books, and other documents, except accounting records, required to be maintained by Section 31a of the 1940 Act and the Rules promulgated thereunder are maintained by The Lincoln National Life Insurance Company, 1300 South Clinton Street, Fort Wayne, Indiana 46802. The accounting records are maintained by Delaware Management Company, One Commerce Square, 2005 Market Street, Philadelphia, Pennsylvania 19103. Item 31. Management Services Not Applicable. Item 32. Undertakings (a) Registrant undertakes that it will file a post-effective amendment to this registration statement as frequently as necessary to ensure that the audited financial statements in the registration statement are never more than 16 months old for so long as payments under the variable annuity contracts may be accepted. (b) Registrant undertakes that it will include either (1) as part of any application to purchase a Certificate or an Individual Contract offered by the Prospectus, a space that an applicant can check to request a Statement of Additional Information, or (2) a post card or a similar written communication affixed to or included in the Prospectus that the applicant can remove to send for a Statement of Additional Information. (c) Registrant undertakes to deliver any Statement of Additional Information and any financial statements required to be made available under this Form promptly upon written or oral request to Lincoln Life at the address or phone number listed in the Prospectus. (d) Lincoln Life hereby represents that the fees and charges deducted under the contract, in the aggregate, are reasonable in relation to the services rendered, the expenses expected to be incurred, and the risks assumed by Lincoln Life. (e) Registrant hereby represents that it is relying on the American Council of Life Insurance (avail. Nov. 28, 1988) no-action letter with respect to Contracts used in connection with retirement plans meeting the requirements of Section 403(b) of the Internal Revenue Code, and represents further that it will comply with the provisions of paragraphs (1) through (4) set forth in that no-action letter. Item 33. For contracts sold in connection with the Texas Optional Retirement Program, Registrant is relying on Rule 6c-7 and represents that paragraphs (a) through (d) of that rule have been complied with. SIGNATURES a) As required by the Securities Act of 1933 and the Investment Company Act of 1940, the Registrant certifies that it meets the requirements of Securities Act Rule 485(b) for effectiveness of this Registration Statement and has caused this Post-Effective Amendment No. 17 to the Registration Statement to be signed on its behalf, in the City of Fort Wayne, and State of Indiana on this 2nd day of July, 2007. Lincoln National Variable Annuity Account L (Registrant) Group Variable Annuity I, II & III By: /s/ John D. Weber ------------------------------------ John D. Weber Second Vice President, The Lincoln National Life Insurance Company (Title) THE LINCOLN NATIONAL LIFE INSURANCE COMPANY (Depositor) By: /s/ Kelly D. Clevenger ------------------------------------ Kelly D. Clevenger (Signature-Officer of Depositor) Vice President, The Lincoln National Life Insurance Company (Title)
B-6 (b) As required by the Securities Act of 1933, this Amendment to the Registration Statement has been signed by the following persons in their capacities indicated on July 2, 2007. Signature Title * President and Director (Principal Executive Officer) ------------------------------ Dennis Glass * Chief Financial Officer and Director (Principal Financial ------------------------------ Officer/Principal Accounting Officer) Frederick J. Crawford * Senior Vice President and Director ------------------------------ Mark E. Konen * Director ------------------------------ Barbara S. Kowalczyk * Senior Vice President and Director ------------------------------ See Yeng Quek * Senior Vice President and Director ------------------------------ Westley V. Thompson *By:/s/ Kelly D. Clevenger Pursuant to a Power of Attorney --------------------------- Kelly D. Clevenger
B-7