Investment Thesis
Lincoln National Corporation (NYSE:LNC) deals in the insurance and investment management business. It has recently announced a reinsurance transaction of $28 billion with Fortitude Re, which I believe can act as a primary catalyst to strengthen its balance sheet and improve its performance by mitigating financial losses. It may also highly benefit the company to sustain its high dividend payout which makes it an attractive investment opportunity.
About LNC
LNC is a Fortune 200 American holding company that operates a variety of insurance and investment management businesses through several subsidiaries. The company conducts its business in four business segments: Life Insurance, Annuities, Group Protection, and Retirement Plan Services. The Life Insurance segment focuses on wealth creation and protection for its clients by providing life insurance products such as term insurance, single (including universal life insurance (“UL”), COLI, and BOLI), and survivorship versions of indexed universal life insurance (“IUL”) and variable universal life insurance (“VUL”) products, linked-benefit products (which are UL and VUL with riders providing for long-term care costs), and critical illness and life insurance products. Revenue streams for the Life Insurance segment include premium payments, cost of insurance assessments, expense and fee charges, and investment income. The Annuities segment provides variable annuities, fixed (including indexed) annuities, and indexed variable annuities. It distributes the products to a large number of financial intermediaries which include wire/regional firms, independent financial planners, financial institutions, registered investment advisers, and managing general agents. The Group Protection segment provides group non-medical insurance products and services to the employer marketplace, such as short- and long-term disability, statutory disability, paid family medical leave administration and absence management services, term life, dental, vision, and accident, critical illness, and hospital indemnity benefits and services, and services to the employee marketplace through various forms of employee-paid and employer-paid plans. It offers its products and services to enterprises of various sizes, from small businesses with fewer than 100 employees to major corporations with 10,000 or more employees. The Retirement Plan Services segment offers retirement plan products and services to employers, especially in the defined contribution retirement plan market. Defined contribution plans are a prominent employee benefit offered by both large and small businesses across a wide range of industries. It offers several plan investment vehicles, including individual and group variable annuities, group fixed annuities, and mutual fund-based programs. It also provides a wide range of plan services, such as plan recordkeeping, compliance testing, member education, and trust and custodial services through its affiliated trust company, Lincoln Financial Group Trust Company. Other Operations contain financial data for operations that are not directly tied to business segments.
Reinsurance Transaction with Fortitude Re
In the previous year, the insurance industry faced macroeconomic and geopolitical obstacles which hindered its growth and led to a negative downturn. However, the group insurance sector has managed to sustain its growth amid the economic pressures as life loss ratios are appearing to be less than during the pandemic period. It was observed that dental claims, which declined during COVID’s peak, are also returning to normal as people resume their pre-lockdown lives. In addition, the retirement plan segment also has significant growth potential as the country has a huge percentage of the aging population which reflects the potential market opportunities for retirement plans and investments. All these potential opportunities and the constant negative macroeconomic pressure has induced competition in the market. Though the demand is positive, however, risk management plays a crucial role in the industry as global economic uncertainty has affected the insurance businesses in the past despite the growth in income from investments. Identifying this need for risk mitigation needs, the company has recently announced that it has entered into a reinsurance agreement with Fortitude Reinsurance Company Ltd which is one of the leading multi-line reinsurance companies. As per this agreement, the company will cede approximately $28 billion to Fortitude Re for its ULSG, MoneyGuard, and fixed annuity statutory reserves. The reinsured block includes approximately $9 billion of ULSG statutory reserves, or approximately 40% of Lincoln’s total in-force ULSG, nearly $12 billion of MoneyGuard statutory reserves, or approximately 80% of Lincoln’s total in-force MoneyGuard, and nearly $8 billion of fixed annuities statutory reserves, or approximately 40% of Lincoln’s total in-force fixed annuities. This deal will reduce Lincoln’s exposure to life insurance in-force long-term assumption risk and can lower invested asset leverage. The company expects that this ceding transaction can potentially improve its risk-based capital ratio by roughly 15 points. It also estimates that it can also significantly raise its annual free cash flow by about $100 million. I believe this reinsurance transaction can act as a primary catalyst to strengthen the company’s balance sheet and improve its capital position. As per my analysis, it can also highly contribute to the company’s growth and help it to mitigate financial losses which can lead to higher profit margins. This may also help the company to maximize its distributable earnings and take advantage of growing demand opportunities.
Financials
The company has recently reported its first-quarter results. It has reported a revenue of $3.81 billion, down 19.9% compared to $4.72 billion in the previous year. The Life Insurance segment experienced a loss of $13 million, compared to an income of $23 million in the same quarter of the previous year. The drop was mostly driven by the run-rate impact of the company’s annual review of DAC and reserve assumptions in the third quarter of 2022, as well as reduced alternative investment income, prepayment revenue, and base spreads. Income from operations decreased 14% YoY to $274 million for the Annuities segment due to lower fee income. Group Protection segment reported $71 million in operating income for the quarter, compared to a loss of $46 million in the prior-year quarter. Improved disability underwriting results and decreased COVID-19 mortality claims fueled the increase. Operating income for Retirement Plan Services segment decreased by 26% to $43 million which was mainly driven by higher expenses and lower prepayment income. Other Operations reported a $87 million loss from operations, compared to a $78 million loss in the prior-year quarter. The company reported a net loss of $881 compared to net income of $1.48 billion in Q122. The loss was largely triggered by unfavorable effects from a portion of the MRB and changes in the fair value of the hedging instrument. The net loss resulted in a net loss per diluted share of $5.37, compared to a net income of $8.39 in Q122. It reported a book value per share of $33.89, compared to $82.93 in the previous year. Though the company experienced a financial downturn in the first quarter, I believe the recent reinsurance transaction can significantly help it to improve its performance in the coming years, and the management is also optimistic about the potential of improving its balance sheet.
Dividend Yield
The company has a long and impressive track record of consistent dividend growth which signals its good positioning in the market. In the previous year, the company distributed a cash dividend of $0.45 in each of the four quarters, which makes the annual dividend $1.8, representing a dividend yield of 8.61%. In the current year, it distributed a cash dividend of $0.45 in each of the first two quarters, and observing the current market trends, global market condition, and the potential cash flows from its recent reinsurance transaction with Fortitude Re, I believe it can sustain this quarterly dividend payout of $0.45 in the next two quarters as well. This high dividend yield makes the company an attractive investment option for investors who are looking for passive income sources along with capital appreciation.
What is the Main Risk Faced by LNC?
As part of the insurance practice known as ceding, the company reinsures a portion of the risks under the insurance policies written by its insurance subsidiaries with other insurance or reinsurance companies. For reinsurance protection, it ceded $831.5 billion of life insurance coverage to reinsurers as of December 31, 2022. Reinsurers could possibly attempt to raise rates concerning the company’s existing reinsurance arrangements. If the reinsurance rates increase, it can increase the company’s expenses and can further contract its profit margins.
Valuation
In 2022, a significant reserve unlocking charge was incurred following the company’s annual review of deferred acquisition costs and reserve assumptions which impacted its financial results negatively by contracting its profit margins. In addition, global economic conditions and market volatility worsened the financial impacts on the company. All these factors contributed to a 62% YoY decrease in the share price levels. However, I believe its recent reinsurance transaction with Fortitude Re can significantly help in recovery by improving its cash flows and we can expect an upside from current price levels. After considering all the above factors, I am estimating EPS of $6.80 for FY2023 which gives the forward P/E ratio of 3.07x. After comparing the forward P/E ratio of 3.07x with the sector median of 14.60x, we can say the company is undervalued. At current pricing, LNC stock is highly inexpensive, and shareholder returns are impressive in the form of dividend payouts. I believe total returns might be fairly attractive over the period of one year as a result of its recent transaction. In my opinion, the company might gain significant momentum due to positive growth factors and risk mitigation operations which can help it to increase its cash flows and help it to trade above its forward P/E Ratio. I estimate the company might trade at a P/E ratio of 4.00x, giving the target price of $27.2, which is a 30.14% upside compared to the current share price of $20.90. A rise in reinsurance rates can affect the financial performance of the company. As per my analysis, in that case, it can contract the profit margins and EPS of the company.
|
Scenario |
EPS Estimates |
P/E Ratio Estimates |
Target price |
|
Best case |
$6.80 |
4.00x |
$27.2 |
|
Bear case |
$6.71 |
3.93x |
$26.37 |
I believe in the bear-case scenario of increased reinsurance rates, the EPS of FY2023 might be $6.71 and estimate that the company might trade at a P/E ratio of 3.93x, which gives a target price of $26.37, representing an upside of 26.17%.
Conclusion
Lincoln has been previously affected by various factors, including adverse macroeconomic conditions. It has recently underperformed in its first quarter results which was triggered by unfavorable effects from a portion of the MRB and changes in the fair value of the hedging instrument. However, it has recently entered into a reinsurance transaction with Fortitude Re, which I believe can significantly strengthen its balance sheet and improve its financial position in the coming years. It is exposed to the risk of a rise in rates of reinsurance which can contract its profit margins. This reinsurance deal can help the company to improve its cash flows and maximize its high dividend payout. The company is currently undervalued and we can expect a decent growth of 26%-30% as a result of its recent reinsurance transaction. After analyzing all the above factors, I assign a buy rating to LNC.
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