Lincoln National Corp Q3 FY2022 Earnings Call

Good morning, and thank you for joining Lincoln Financial Group's Third Quarter 2022 Earnings Conference Call. Now I would like to turn the conference over to the Vice President of Investor Relations, Al Copersino. Please go ahead, sir.

Thank you. Good morning, and welcome to Lincoln Financial's third quarter earnings call. Before we begin, I have an important reminder. Any comments made during the call regarding future expectations, including those regarding deposits, expenses, income from operations, share repurchases and liquidity and capital resources are forward-looking statements under the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from current expectations. These risks and uncertainties include those described in the cautionary statement disclosures in our press release issued yesterday as well as those detailed in our 2021 annual report on Form 10-K, most recent quarterly reports on Form 10-Q and from time to time in our other filings with the SEC. These forward-looking statements are made only as of today, and we undertake no obligation to update or revise any of them to reflect events or circumstances that occur after this date. We appreciate your participation today and invite you to visit Lincoln's website, www.lincolnfinancial.com, where you can find our press release and statistical supplement, which include the full reconciliations of the non-GAAP measures used on the call, including adjusted return on equity and adjusted income from operations or adjusted operating income to the most comparable GAAP measures. A slide presentation containing supplemental third quarter 2022 information related to our annual assumption review is also posted on our website in the Investor Relations section. Presenting on today's call are Ellen Cooper, President and CEO; and Randy Freitag, Chief Financial Officer. After their prepared remarks, we will move to the question-and-answer portion of the call. I would now like to turn the call over to Ellen.

Thank you, Al, and good morning, everyone. Before we discuss the details of our third quarter performance, I want to step back and speak to the magnitude of the unlocking charge resulting from our annual assumption review. I'll also address the decline in our risk-based capital ratio, the recent performance of our Life business, provide a quick review of our other businesses, the multiple levers available to improve our capital position, and how we are changing the strategic approach to our business in key areas. First, I will address the unlocking at a high level, and Randy will provide more details. The $2.1 billion total unlocking includes a $2.3 billion charge in our Life business, driven by $1.8 billion related to policyholder lapse behavior within the Guaranteed Universal Life or GUL block. This charge was primarily due to updated lapse assumptions where emerging Lincoln GUL experience was validated this year by new industry perspectives. As a result, we expect a $180 million decline in GAAP annual run rate life operating earnings. On a statutory basis, the updated lapse assumptions also produced a $550 million charge related to the AD GUL subtest to be booked in the fourth quarter, which translates to about 22 points of RBC. The unlocking has no impact on run rate statutory earnings. As a reminder, GUL is a type of permanent life policy that guarantees insurance will stay in force if the policyholder continues to pay a certain minimum premium. Because of this guarantee, GUL is subject to long-term assumption risk. Interest rates have been lower than assumed in pricing and were a significant driver of our decision some years ago to reduce sales dramatically and ultimately exit the GUL market. Additionally, over the years, mortality and reinsurance costs have seen unfavorable adjustments. Lapse is the other key assumption. Over the last several years, as Lincoln's GUL policy experience has materialized, it has provided deeper insights into anticipated behavior patterns in later policy durations, which were subsequently supplemented with the recent industry experience study. As a result, we have reset our assumptions to reflect lower lapsation going forward. In addition, we separately incurred a $634 million GAAP goodwill impairment charge in our life business, primarily driven by variable universal life or VUL equity market impacts and the use of a higher discount rate. Before I discuss the other topics, I will briefly touch on the operating highlights of our businesses this quarter. We delivered strong sales growth in all four of our businesses reflecting our continued focus on expanding and diversifying the product portfolio. We saw a sales rebound in annuities, up 21% from the prior year quarter as growth in indexed variable annuities and fixed annuities more than offset a decline in traditional variable annuities. Net flows were positive in the quarter for the first time since mid-2020 driven by sales growth. Total Life Insurance sales were up 3% from the prior year quarter, driven primarily by an increase in indexed Universal Life sales. And in Retirement Plan Services, or RPS, total deposits of $2.8 billion were up 16% from the prior year quarter reflecting a 33% increase in first year sales and a 9% increase in recurring deposits. Year-to-date, positive net flows rose to $2.7 billion. In Group Protection, sales were up 83% from the prior year quarter, reflecting strong results across all products and market segments. Premiums of $1.2 billion were up 8% compared to the prior year quarter. And finally, our high-quality investment portfolio continues to perform well and higher interest rates have led to spread expansion following years of spread compression. Now turning to the RBC ratio. We started the year at approximately 430% risk-based capital and are projected to end the year with our RBC at approximately 360%. The year-end projection includes the expected fourth quarter statutory charge as well as other factors. Before I elaborate on those factors and importantly, our actions underway to replenish capital back to our target, I want to emphasize the following: while we are not satisfied with our projected RBC ratio, we are taking swift and targeted actions to rebuild to our 400% target. We are confident we have ample capital to effectively operate the business as we get back to our targeted level. We have a clear understanding of the issues and have a plan in place to address them as you'll hear this morning. Effective execution starts with leadership and our new experienced and talented senior leaders will execute on the strategic objectives I introduced last quarter, which are: first, maximizing distributable earnings and improving capital generation. Second, reducing capital sensitivity to market volatility and improving capital efficiency; and third, further diversifying our earnings mix with durable cash-generative income streams. Continuing this discussion on capital. Our life business has been the source of three-quarters of our RBC ratio decline this year, with the three main contributors as follows: as I mentioned, the assumption review will increase our statutory reserves, which will reduce statutory capital and is included in the projected year-end RBC ratio I referenced above. However, the statutory AD test utilizes prescribed trailing interest rates. And if rates stay at current levels, we would expect to release a portion of these reserves over time. Second, while smaller than the impacts of the prior two years, we continue to experience pandemic claims this year, particularly in the first quarter. We expect these impacts to continue to moderate over time. Third, setting aside the impact of the AD test and pandemic claims, the life insurance business is a negative contributor to cash flow generation. A portion of this negative contribution is attributable to increased reserves in our VUL portfolio due to this year's equity market decline. However, there are other factors weighing on the life insurance business's ability to generate distributable earnings, including negative statutory earnings producing negative cash flow from our GUL block which are not affected by the assumption change, an increase in recurring reinsurance costs, the loss of ongoing free cash flow from previous block transactions and the transition to principal-based reserving, which has changed the pattern of distributable earnings and capital intensity for certain products, notably term life. The remaining 25% of this year's projected RBC decline is attributable to a variety of factors, including higher capital allocation to fixed annuity sales and stable value offerings within our retirement business as well as the impact of group's pandemic claims and lower fees in our annuity business. Our annuity business has always been and remains highly cash generative and well risk managed. However, this year's market movements, specifically the declines in equity markets and the increase in interest rates had negatively impacted both equity and bond fund returns, resulting in lower fees on assets under management and consequently reduced capital generation. Additionally, we hedge our variable annuity guaranteed benefits out of LNBar. The current hedge program has been highly effective and has focused on generating sufficient assets to fund future claims by minimizing GAAP net income volatility. This year's capital market environment has led to market volatility and increased hedge breakage that has resulted in reduced capital within LNBar. We intend to organically rebuild the LNBar capital position over time. And while we have taken an average of about $120 million of dividends per year out of LNBar, we do not expect to take the dividend for some time. In September, we announced enhancements to our VA hedging program that focus on maximizing distributable earnings and explicitly protecting statutory capital. The updated VA hedge program aligns with our increased strategic focus on capital generation. Additionally, I note that our two workplace businesses; group protection and retirement plan services are well positioned to deliver strong distributable earnings and contribute to the rebuilding of capital. I will now discuss the actions that the leadership team and I are taking to enhance the distributable earnings and capital generation of our business where a number of the initiatives underway will support improvements in our life business, rebuild our RBC ratio to our 400% target and strengthen our balance sheet. First, while we prioritize balance sheet resilience to replenish our capital, we are pausing share repurchases. We remain committed to returning capital to shareholders; we will be maintaining the dividend and expect to return to dividend growth and share repurchases over time. Second, we have capacity in our capital structure beyond today's mix of primarily common equity and senior debt and are evaluating alternatives such as preferred or additional hybrid securities to provide additional margin given the uncertain macroeconomic environment and risk of potential headwinds from that environment beyond what we see today. And third, we are considering strategic alternatives for our in-force business, including potential block reinsurance transactions with a wider lens that incorporates our new strategic objectives. As I have mentioned previously, we have a fully dedicated and staffed up team. While there are no commitments, if we find the right opportunity at the right price, we will look to execute. In addition to these three actions, we have several initiatives already underway to advance our strategic objectives that will have a favorable impact on our balance sheet longer term. In particular, a number of the measures we are taking are designed to improve the distributable earnings profile of the Life business. The three new leaders I introduced last quarter, Matt Grove, Head of Individual Life, Annuity and Lincoln Financial Network, James Reid, Head of Workplace Solutions; and Chris Neczypor, our Chief Strategy Officer, are charged with implementing our strategic actions. As a team, we are keenly focused on our reprice, shift and add new product strategy. In recent years, we have been focused on shifting the product mix to a diversified set of solutions with lower guarantees, more sharing with the customer, and improved capital efficiency. As we move forward, consistent with our strategy to maximize distributable earnings, we are refocusing our new business capital allocation process. We've previously focused on growing sales while exceeding our return thresholds. Going forward, we expect to allocate a targeted amount of capital to new business and will focus on maximizing our return on this capital. We expect this approach to allow us to allocate less capital to new business in 2023 than we did in 2022 while delivering a robust level of sales and more distributable earnings. This focus on the efficiency of our capital allocation is an important part of our go-forward strategy. Spark. We are ahead of schedule and making substantial progress in the implementation of this enterprise-wide expense initiative to deliver run rate savings of $260 million to $300 million by late 2024. We have achieved approximately 45% of the planned expense savings to date. We are also working on reducing the market sensitivity of our BUL product to mitigate the capital impact of potential further market declines and are exploring multiple avenues to accomplish this including both hedge and structural solutions. And as I previously mentioned, our Workplace Solutions businesses comprised of group protection and retirement plan services continue to be critically important to our long-term strategy. Both businesses are focused on the customer, driving differentiation in the market and delivering results. We have spoken with you about our goal of reaching and then sustaining the high end of our 5% to 7% target margins for Group Protection, which will have a positive impact on our capital generation. We continue to execute our group protection margin enhancement strategy of pricing and product discipline, improved claims effectiveness such as by helping our customers return to the workforce and driving expense efficiencies through Spark. And finally, higher interest rates, enabling a shift from spread compression to spread expansion. In closing, we are laser-focused on advancing our strategic objectives as we increase capital and strengthen our balance sheet, delivering long-term value for our stakeholders. With a talented leadership team in place, a strong franchise and a long-standing track record of disciplined execution, we have a clear strategy that we will be executing on in the months ahead, and I look forward to updating you on our progress.

Thank you, Ellen, and good morning to everyone on the call. Before discussing our earnings results today, I will comment on three topics: the results of this year's assumption review, our expected year-end position from an RBC perspective, and the write-off of the remaining goodwill related to our Life business. Starting with the assumption review, the total impact reduced our earnings by $2.1 billion, with $2 billion affecting adjusted operating income. In terms of adjusted operating income by business unit, retirement and group saw negligible impacts at $6 million and $1 million, respectively, while the annuity business had a favorable impact of $217 million due to higher interest rates on projected profitability. In contrast, the Life business faced a negative impact of $2.2 billion from four main factors: first, settlements from rate increases with two reinsurance partners in 2022, resulting in an unfavorable $81 million impact; second, a negative $106 million impact from updates to our underlying morbidity assumptions; third, a $223 million unfavorable impact from mortality assumption updates, roughly two-thirds of which relates to aligning our mortality improvement expectations with industry standards and one-third from changes in older age mortality assumptions. Lastly, we saw an unfavorable impact of $1.8 billion stemming from updated policyholder behavior assumptions in our guaranteed Universal Life book. About 70% of that impact relates to our adjusted long-term expectations for lapses, as we have combined our data with industry studies to support significantly higher persistency assumptions. For the remaining 30%, we noticed a decrease in lapse and surrender rates during the pandemic, which we do not expect to return to pre-pandemic levels for GUL. Our GUL book consists of 128,000 policies, and including the assumption review effects, our net GAAP reserves stand at $20.7 billion compared to $23.1 billion in net statutory reserves, which will incorporate a $550 million statutory reserve charge anticipated next quarter. If interest rates remain stable, we estimate recovering about half of that statutory capital impact by year-end 2023. Alongside the previously mentioned one-time impacts, we foresee a $180 million reduction in our after-tax life GAAP operating earnings, although statutory results should remain unaffected. Focusing on our risk-based capital ratio, we started 2022 at 427% and expect to finish around 360%. This projected 67-point decline mainly hinges on life insurance, which accounts for 75% of this drop, including the anticipated fourth-quarter statutory charge, ongoing pandemic-related claims, and negative cash flow generative trends. Prioritizing the rebuilding of RBC is essential, with a target RBC ratio of 400%. Additionally, our leverage ratio has taken a hit from this quarter's goodwill and unlocking charges, exceeding our long-term target of 25%. We plan to manage this over time through organic equity growth, aided by pausing our buyback program. As previously communicated regarding LNBar, we will forgo a dividend from this entity while we rebuild capital following elevated hedge breakage this year. As discussed on our LDTI call, our hedge program will be refocused to emphasize capital protection. Moving to the $634 million write-off of the remaining life goodwill balance, this decision resulted from several factors, notably an increase in the discount rate due to rising interest rates and a downturn in equity markets affecting our VUL business. Now, let me address our quarterly results. Last night, we reported a third-quarter adjusted operating loss of $1.7 billion, equivalent to $10.23 per share, which includes a $11.62 per share impact from this year's assumption review. Excluding this effect, adjusted operating earnings would have been $237 million or $1.39 per share for the quarter. Pandemic-related claims reduced operating earnings by $48 million or $0.28 per share, while alternative investment returns lagged long-term expectations by $93 million or $0.55 per share. Regarding our balance sheet, book value per share, excluding AOCI, arrived at $64.09, while cash at the holding company totaled $756 million. The VA hedge program performed 99% effectively this quarter, resulting in improved breakage of $82 million compared to recent periods. Excluding the previous year's notable legal expenses of $94 million, G&A expenses, net of capitalized amounts, increased by 11%, primarily due to one-time expenses totaling around $30 million this quarter. Additionally, robust sales contributed to the growth in G&A. Now shifting to segment results, starting with Annuities, operating income excluding the annual assumption review stood at $232 million, down from $343 million in the same quarter last year. After adjusting for notable items in both years, operating income fell 32% year-over-year due to a 19% drop in average separate account values and alternative investment results being $18 million less favorable than last year. The decline in equity markets this quarter increased our risk amount for living and death benefits to 9% and 6% of account values, respectively. As we diversify our annuity business, VAs with living benefit guarantees now make up 46% of total annuity account values. Without the annual review, return on assets and return on equity were 63 basis points and 15%, respectively. Looking ahead, we believe our diverse product portfolio, revised VA hedge program, and the advantage of higher interest rates will enhance future earnings and cash flow generation. Retirement Plan Services reported operating income of $52 million, including a $6 million favorable impact from DAC. Excluding notable items, operating earnings decreased to $46 million from $60 million in the prior year quarter, driven by a $10 million drop in alternative investment income and a 9% decline in average account values due to lower equity markets, despite positive net flows. These challenges were somewhat mitigated by a 14 basis point increase in base spreads and solid organic growth. In Life insurance, we reported an operating loss of $2.2 billion, or operating income of $37 million, excluding the adverse impact from our annual assumption review. Last year, we marked $93 million in operating income, which included a $26 million negative impact from our annual assumption review and $19 million in legal expenses. This quarter's results also featured alternative investment returns that were $131 million less favorable than the previous year and included $22 million in pandemic-related claims, showing a $38 million improvement in pandemic claims. Beginning in the fourth quarter, we will start reflecting a $45 million unfavorable quarterly run rate impact from the annual review in life operating earnings. Average in-force policies grew by 11% compared to the previous year, while average account values, net of reinsurance, dropped by 20% due to equity market declines and impacts from the resolution transaction. Despite this challenging quarter, we are optimistic about growth, bolstered by our updated GUL assumptions, higher interest rates, and a revamped product portfolio aimed at enhancing cash flow. In Group Protection, we logged an operating income of $37 million, compared to an operating loss of $32 million in the same quarter last year, which benefited from a $16 million favorable impact from the previous year's assumption review. The current quarter's results factored in $26 million in pandemic-related claims and alternative investment income that fell $5 million short of target returns. Pandemic-related claims showed an improvement of $94 million year-over-year. After adjusting for pandemic claims and alternative investment income, the group margin stood at 5.5%, within our 5% to 7% target range. When excluding pandemic-related claims and the previous year’s assumption review impact, the loss ratio improved by 20 basis points year-over-year, thanks to fewer new group disability claims, despite a slight uptick in group life mortality. We are pleased with the progress of the Group Protection business and remain hopeful about sustaining margins at the higher end of our targeted range through our ongoing margin enhancement strategy. Lastly, regarding investment results, we continue to see strong credit performance and increasing new money yields. Our investment portfolio maintained a net positive credit migration for the fifth straight quarter, while below-investment-grade fixed income assets remain at a historic low of 3%. We acknowledge the growing risk of a recession and are vigilant in managing credit risk. As part of our regular assessments, we utilized our extensive multi-manager platform to conduct scenario analyses across all asset classes in our portfolio, positioning ourselves well for a potential economic downturn. New money yield rose by 80 basis points sequentially to 5%, now standing 90 basis points above the current yield of 4.1% on the fixed income portfolio, signaling a transition from years of spread compression to spread expansion, which bodes well for earnings and cash flow. Moreover, higher interest rates will ultimately support reserve levels. Our alternatives return this quarter was negative at 2.1%, falling short of our targeted 2.5% quarterly return but still outperforming the double-digit negative returns of major equity indices in the prior quarter. Now let me turn the call back over to Al.

Before we move into the question-and-answer portion of the call, I'd like to turn it back to Ellen for additional comments.

Thank you, Al. Before opening it up to Q&A, as you may have seen, S&P has revised our rating from AA- with a negative outlook to A+ with a stable outlook. In addition, Moody's has affirmed our A1 rating and has revised our outlook from stable to negative. We are confident that we can effectively operate the business with these ratings. We have opened ongoing conversations with our rating agencies, and we'll continue to update them on our progress. With that, let me turn the call back over to the operator to begin the Q&A.

Your first question today comes from the line of Ryan Krueger with KBW.

My first question is, can you give some perspective on how long you think it may take to rebuild the RBC ratio back to the 400% target?

Yes, thank you for the question, Ryan. We understand that rebuilding will take time. However, we are confident in our plan to achieve this. While we cannot provide a specific timeline due to various factors, many of the actions we've discussed are already in progress. Specifically, we are focusing on our organic capital generation, which has historically been strong. Current initiatives include our new business capital allocation, which is crucial for immediate support, as well as exploring options related to our VUL portfolio and overall VA strategies. We're also looking into additional external capital generation opportunities. We will keep you updated on our progress.

Can you help by quantifying where you have set your ultimate lapse rate on GUL? Now that you've made that move, how realistic do you think it is to explore opportunities for third-party reinsurance?

Thank you for your question. This year, we made significant changes to our underwriting practices regarding lapses. Our process involves a deep dive into our experience, acknowledging that our experience declined during the pandemic. We expect that behavior to persist. We have gathered extensive data not just from our own experiences but also through an industry study with nine participants, which provided insights into how policyholders might behave in the future regarding additional premiums. To give you an overview of our current situation, over the past couple of years, our total lapsing surrender rate has been about 1.2%, with 40% of that attributed to surrenders. Surrenders occur when policyholders with account value choose to cash out their policies. The remaining 60% comes from lapses, which happen when individuals run out of account value and decide not to pay more premiums, resulting in their policies lapsing. So, we have approximately 50 basis points from surrenders and 70 basis points from lapses. We've projected this experience into the future. For surrenders, the design of these policies means that account values diminish over time, leading surrender rates to eventually reach zero over the next 20 to 25 years. Lapses are forecasted based on behavioral data aligned with our current experience, accounting for future policyholders that will face decisions about funding. We are confident in our assumptions about the future. However, there is always some inherent risk, but we believe it reflects a significant reduction and gives us a solid understanding of likely behavior. Compared to last year, our model suggests that we will retain about 8% more policies in force over the next decade. With around 128,000 policies, this translates to an additional 10,000 policies relative to last year. The financial impact of changes in lapse and surrender assumptions is estimated at $1.8 billion, resulting in a continued impact of $180 million. Essentially, we are establishing reserves to cover claims for these additional policyholders we expect to remain active. While there's always some residual risk, we feel very positive about our current strategies and insights.

Ryan, to clarify the last part of your question and to summarize Randy's comments, we believe that we have completely reset our GUL assumptions with total confidence. You also brought up reinsurance of SGUL, which I want to address. As I mentioned earlier, we are considering all alternatives and assessing various transactions. We will only pursue a potential transaction if it presents an opportunity at the right price and time that truly enhances value. Ideally, if we proceed with a transaction, it would align with our objectives of increasing capital generation and distributable earnings while reducing capital volatility. If an opportunity arises involving reinsurance of SGUL that meets these criteria, we would definitely want to follow through. Additionally, I want to note that we are encouraged by the expanding buyer universe. Buyers are increasingly interested in more complex liabilities compared to their previous focus on straightforward ones. So, everything is open for consideration. If the right opportunity comes along at the right price and time, our dedicated team is fully engaged in examining these chances, and we will provide updates as we move forward.

Your next question comes from the line of Suneet Kamath with Jefferies.

So first question, just on the common stock dividend. I think that's running around $300 million a year or so. Can you just talk about given all the changes, kind of how you feel confident in being able to fund that on an ongoing basis as you build back RBC?

Yes, we are very confident in continuing to maintain the shareholder dividend. We generate significant capital and have a strong in-force that produces distributable earnings. Each year, we also have considerable sales where we allocate new business, providing us with various options to manage our priorities, including maintaining the dividend. While focusing on that, we will manage other factors to improve the overall quality of distributable earnings and optimize capital allocation for new business. Additionally, we have faced notable impacts on our capital position due to market conditions this year, and we believe we can implement hedging strategies and structural solutions to mitigate these effects in the short term. Our goal is to enhance the quality of our core earnings, optimize new business capital allocation, and maintain the shareholder dividend.

Got it. Okay. And then I guess if I take a step back and think about Lincoln over time, one of the hallmarks of your company has been the strength of your distribution relationships and always being present in the market, always providing product for them to sell. And just based on what you're saying, it sounds like there's such a significant amount of change going on at Lincoln around risk management, around product or on capital. I guess how do you balance preserving the strength of those distribution relationships and always being in the market with all of the changes that you're making, just to make sure that you're not disrupting that distribution franchise that has been so important to the company in the past.

Yes, Suneet, this is a great question. And I think from our perspective, I think this really goes to a couple of things. The power of our distribution organization and our relationships, coupled with all the work that we've done around reprice, shift and add new as it relates to product strategy. So when we look across the four businesses right now, part of what we are seeing is we have a broad diversified set of product solutions that are really meeting a variety of different customer preferences and really strong, deep distribution relationships. And so you put those things together and when we were talking about things like now really shifting and further emphasizing as it relates to new business capital allocation, the idea of having a set amount of capital and then really optimizing the overall new business relative to that. I want to be clear that that's within the current product suite. So we really believe that the reprice shift in add new and all of those actions have given us the broad product portfolio that we need to be able to deliver on our commitment to all of you. But what we're going to be doing is being further laser-focused on how we take the overall products that we're offering and utilize them to really be able to optimize the overall distributable earnings profile at the same time. And so this is work that's well underway already in partnership inside of the organization with the business, with the product manufacturing teams and with distribution. And we really are confident that we can really step into this shift without disruption.

Your next question comes from the line of Alex Scott with Goldman Sachs.

First, I'd like to follow up on the cash flow impact from the life insurance review. Can you discuss the reinsurance of SGUL to the Barbados legal entity? It seems that the adjustments you're making on GAAP would influence how you account for this business in LNBar, which I believe is under GAAP accounting. Since you're currently shifting to statutory accounting, I'm trying to understand whether $550 million is the correct figure for that entity. We can observe the RBC moving in the U.S. operating company, but given your remarks about cash flow from LNBar likely being halted for a while, should we consider any impacts related to that? Can you provide any details about the capitalization of LNBar to help us assess the adequacy of capital there, particularly concerning the seeding between UL and variable annuities, as a significant portion of your tail risk is being ceded?

Yes, Alex, regarding LNBar, I'll begin and then pass it to Randy for details on SGUL. We have certainly seen our overall capital position affected this year due to market declines and volatility causing hedge breakage. However, we are confident in our ability to rebuild our capital position organically related to LNBar. Additionally, as announced in September, we are moving towards a hedge strategy with an explicit stat capital hedge. This aims to ensure that in the event of another equity market downturn, our risk management will effectively mitigate that impact. Currently, we are focused on replenishing our capital, which means we will not be taking dividends from LNBar for a while. Importantly, we believe that going forward, with future equity market volatility, we will be better positioned. Now, I will turn it over to Randy to discuss the SGUL impact in relation to LNBar.

Thank you for your question, Alex. Regarding the business outside of variable annuity within LNBar, your inquiry is specifically about SGUL. What it involves are some financing arrangements with external entities, which we host in LNBar. It's important to note that this does not represent the entire contract. All the base reserves are allocated within LNL; it's just the financed portion that is recorded in LNBar. The financed reserves in LNBar are based on long-term financing agreements. The first agreement is set to renew in the middle of the 2030s, which is more than ten years away. When we consider these financing relationships, one aspect to keep in mind is that financing arrangements typically include provisions for adverse deviations, providing some support. However, with new assumptions emerging as we approach renewals in over a decade, there may be some pressure on the financing amounts. As we discussed, with current rates, we expect to release around half of the AD reserve we are setting aside this year. The remaining half will essentially be available to support these financing relationships. Therefore, I believe LNBar is well-capitalized and effectively managed, consistent with how we manage the capitalization of LNL and our broader life insurance companies.

Got it. And I think you got to touch on it a little bit there, but I wanted to also ask about the subtest and the impact of interest rates. I know this is sort of one of those weird backward-looking discount rate calculation that goes into it. And I think there's a little commentary provided in the opening comments, but could you give us a sensitivity around for every, however many basis points of movement in interest rates, how much that would benefit the SubD test reserves?

So Alex, the comments that we made, which are that the AD subtest uses 12 months of trailing interest rates for the test. And so I believe it goes from July 1 to July 1. So if you think about where we were a year ago as it relates to rates through July 1 of this year. And when we look forward, if we look at rates at this level, we see pretty significant impact reducing that overall statutory impact as we move into 2023. And Randy, do you have any additional color?

Yes, Alex, let me give you some specific details. The index rate we used at the end of 2021 was 2.96%. For the end of 2022, the index rate will be 3.5%. The average index rate for the end of 2023 is currently being calculated, starting from July 1 of this year and concluding on June 30 next year. It currently sits at about 5% on average, and the most recent actual index I checked on November 1 was roughly 5.70%. Comparing that average of 5% to the 3.5% we're using this year shows a difference of 150 basis points. We expect this difference to result in a release of roughly half, so 150 basis points translates to $275 million. This should provide a clear perspective on the situation.

Your next question comes from the line of Tom Gallagher with Evercore.

First question, just you plan to issue hybrids. Should we assume the proceeds will be immediately injected into LNL to bolster the RBC? Or would you expect to keep that at the holding company?

If we were to issue hybrid securities, we would likely allocate a couple of hundred million to the holding company. We have a debt maturity coming in 2023, so we would set some funds aside for that. The remainder would be directed towards the life companies.

As a reminder, we have a little over $750 million of cash at the holding company. About $300 million of that has already been earmarked for the upcoming debt maturity, which is roughly $500 million. The first $200 million is probably there in the balance with downstream.

In terms of the strategic options, what do you think is the most likely from a risk transfer perspective? Life insurance may not be the top option considering recent events, but how do you see the prospects for variable annuities and fixed annuities? Is life insurance still a possibility? Also, can we expect any developments on this front within a year, or is it more likely to take longer? Additionally, will the slowdown in sales or changes in sales strategy significantly affect capital generation, or will the impact be more modest?

Regarding the first question, I wish I could provide a specific answer. However, I can share that we are exploring all options, and there is a vast array of potential buyers available. We have never seen such a large number of buyers interested in various transactions. Everything is under consideration. Ideally, we're looking for a situation where the timing and price align with our objectives to enhance cash generation, but it must be at the right price. We are diligently examining this and will provide updates as we progress. On the second point, I want to clarify that we anticipate a strong level of sales as we approach new business capital allocation. While I expect sales to be slightly lower than in 2022, this decline will be marginal. Our extensive product portfolio across all our businesses positions us well to optimize capital and maximize distributable earnings. Our distribution organization and product offerings are robust, allowing us to navigate changes without significant disruption. We believe this will positively impact capital generation, and you will see results as we move into 2023.

Got you. And if I could sneak in one more. When you add all that up, Ellen or Randy, and you think about coming out the other side of this, should we expect the amount of free cash flow to be significantly lower when considering the likely high-cost, high-coupon hybrids that you're probably going to be issuing? Plus, you're going to be potentially shrinking the in-force earnings from an in-force deal, trading earnings or cash flow for capital? Or do you think, and maybe you're not far along in the process to really opine on that, but I just want any kind of sense you can provide from start to finish here after you resolve the capital issue about whether there could be a significant reduction in the free cash flow levels?

Yes. We will provide ongoing updates on this matter. As we look ahead to this year, we expect our RBC ratio to decrease by 67 points. Given the current market conditions, we anticipate lower cash generation and capital generation compared to previous years, which is not ideal. All our actions are aimed at improving this situation. Additionally, regarding hybrids, while there is indeed a cost involved, a significant portion of that will benefit the life companies. We plan to invest the proceeds, which means the overall financing cost will be lessened by our ability to invest a large majority of those funds at attractive new money yields.

The last thing I mentioned just broader, not specifically on this question, but there are some levers that we are retaining. And there is an uncertain work. For instance, I mentioned that we still have, even after the $300 million we allocated to the debt maturity, $450 million of cash holding company, we're probably on maintaining that. We also, Tom, retain access to a $500 million contingent capital facility, which we're not drawing down. So we've got a significant plan, a lot of internal and external levers, but there are some that we are retaining for the uncertain world that exists today.

Tom, one other point to your question about Block deal also impacting cash generation. Ideally, if we could have our pick in terms of what kinds of transactions would we want, the transactions would improve cash generation as opposed to actually further reducing, so that's the holy grail. It has to be at the right price, of course. We're not going to do something that doesn't make sense. But ideally, that's what we would be focused on.

Your next question comes from the line of John Barnidge with Piper Sandler.

If I heard you correct in the prepared remarks, you had mentioned if rates are at current levels, you'll recover about half of the statutory hit by year-end 2023. Appreciate that rate comment, but can you maybe talk about how we should be thinking about the assumptions embedded in that on equity and VII between now and that period?

John, the AD test itself is a test with a fair amount of prescription. So for instance, I'll use like we made some tweaks to our mortality assumption that had about a $223 million impact. That doesn't really have an impact on the AD subtest because the mortality assumption is already prescribed with provisions for adverse deviations. So I think the big impact on the AD test was the change we made to lapse and surrenders. That is pretty much that entire $1.8 billion impact, transports over to the subtest. In terms of the other assumptions, once again, I think with the level of prescription, I don't think of the sort of risks that you might be implied by your question.

This concludes today's Q&A. If we were unable to get to your question this morning, the team will follow up with you this afternoon. I now would like to turn the call back over to Al Copersino for closing remarks.

Thank you for joining us this morning. We're happy to take any follow-up questions that you have. You can e-mail us at investorrelations@lfg.com. Thank you, and have a good day.

This concludes today's conference call. Thank you for attending. You may now disconnect.