Description

Lincoln National Corporation (LNC) is a life insurance company with competitive advantages related both to products and distribution. The combination allows LNC to benefit from secular trends (i.e. aging baby boomers and growing demand for long-term care insurance). Additionally, the position of both the bond market (yields near record lows) creates an opportunity to safely bet on interest rate normalization.

Payoff summary: 1) Interest rate upside; 2) Secular growth tailwind; 3) Company outperformance potential. One or more of these dynamics paying off in the next 10 years will result in outsized returns.  

Interest rate upside: Based on the below long-term chart (via Barry Ritholtz's blog from Bianco Research LLC) of interest rates, it is possible we are at the end of a bull market in bonds. In the past, the end of interest rate bull markets has led to a long-term bear market in bonds.

I want to clarify: I would not be surprised if rates stay at these levels or lower for 10+ years (i.e. the Japan scenario where shorting bonds is known as the “widow-maker” trade). However, I think that at these levels, betting on rate increases makes some sense provided that you taking timing out of the equation. In other words, I don’t think it makes sense to bet that rates will increase in the near term. However, the odds of success go up as your time frame increases.

Based on this logic, LNC is a safe way to bet on interest rate normalization. If interest rates normalize, industry asset growth will accelerate and spreads will widen, resulting in outsized returns for most life insurance companies. If rates fail to normalize, LNC is still generating 3-5% in dividends/buybacks. As a result, unlike a short position in the bond market, LNC has a positive carry which removes the time pressure.  

Credit spreads could be another tail-wind. Currently, credit spreads are at/near record lows. As a result, new money rates are exceptionally low (i.e. low rates and low spreads). I have no reason to predict normalization other than long-term charts that show “what goes down, might come up” trends in credit spreads over the years.  

The numbers: Lincoln’s investments yield 5.27%, down from 5.51% in 2012. Currently, the company’s new money yield is only 4.3%. As bonds mature, the portfolio yield will gradually drop toward whatever the new money yield is. Based on the company’s recent statements, a flat interest rate environment over the long-run would result in a $375 million or 20-30% hit to earnings (lower than many of its peers).

In the extreme downside scenario where U.S. rates end up below 1% for an extended period of time (Germany and Japan) LNC can survive and remand profitable. Only 34% of the company’s earnings come directly from spread related products, down from 42% in 2012. The rest comes from mortality/morbidity (23%), fees on AUM (37%) and VA riders (7%). It is worth noting that the actual exposure to interest rates is greater than the 34% would suggest as lower rates reduce the overall demand for life insurance products in general (i.e. they will sell fewer riders).  

Currently, the company is making changes to increase the mortality/morbidity mix via improvements in group protection and decreased utilization of reinsurance.  Even if the spread component stays high in the <1% 10 year scenario insurance companies can generally survive by lowering rates paid to policyholders. It turns out that in developed countries there is a fairly high minimum level of demand for most insurance products regardless of how low crediting rates are.

With respect to spreads in general, LNC does have an advantage when it comes to investing because its retail focused product mix results in very long-duration liabilities with predictable payment patterns. The predictable nature of the cash flows allows the company to invest in less liquid assets with higher returns. 

The second source of upside comes in the form of demographic trends in the United States (massive asset accumulation happening). This trend would accelerate if interest rates normalized because company’s like LNC would have the opportunity to offer more attractive guarantees (i.e. assets would shift from mutual funds to annuities, etc.).

Demand for guarantees set to grow: financial advisors have attacked insurance products for years because of the “high fees” and relatively low returns. There is an element of truth to the criticism in some specific cases. However, financial advisors who offer merely a “high probability” of good outcomes don’t fully appreciate the value of a guarantee.

Most wealth management firms use Monte Carlo type simulations to show what mix investors should have between stocks and bonds. Advisors usually don’t mention to clients: a) the original Monte Carlo simulation was used and developed by gamblers; b) The simulation’s methods does not have any advice for the 5-10% who fall outside of the expected value range; c) The simulation generally assumes the past represents the future yet the future regularly deviates from the past. All this to say is that someone in their mid-50s with $400k in assets can reasonable chose the safety of an insurance product with a lower total return over the uncertain prospects of a stock/bond portfolio. Who, after all, wants to run out of money in their 80s?

With respect to fees, asset management firms don’t necessary have the high moral ground. A 1% asset management fee is really just a large commission spread out over a long period of time especially if the market is appreciating. Insurance company fees are high but mostly because it is necessary to buy the guarantee. For people at a certain age and net worth, the extra fees for protection is money well spent.

Both asset management firms and life insurance companies will do well. However, as massive numbers of people get closer and closer to retirement (baby boomers) I expect the demand for guarantees to increase, creating a secular tailwind for the life insurance industry.

The expanding pie is a critical component to the thesis because it keeps price competition under control. At times, small insurance company’s try to grab market share in various parts of the market by offering unrealistic rates. However, the bulk of the market (larger insurance companies) have no incentive to engage in this behavior. Evidence for favorable competitive dynamics include the relatively high ROEs earned by most major insurance companies. LNC’s ROE in particular was 13% in 2014. And, if you adjust for spread compression, LNC and other top life insurance companies are generating >15% ROEs.  

With respect to LNC’s unique position several things are worth noting. Lincoln has an unusually strong distribution network. Distribution functions much like shelf space in the retail world. A strong distribution network generally results in a strong insurance company. For example, one third of LNC’s small market retirement plan sales (RPS) and MoneyGuard (a combo long-term care product which I will discuss later) are driven by partners where LNC has multiple products on their platform and cross sell programs in place.

Near-term trend: according to the company, “client-facing distribution headcount increased 6% at both LFD (Lincoln Financial Distributors) and across LFG (Lincoln Financial Group). Importantly, headcount grew even faster in key growth areas. Notably, small-market RPS was up 29%, and Individual Life increased 10%.” An expanding distribution network is one of the key leading indicators of a company’s future growth.

Lincoln also has a key product advantage in the long-term care space. Currently, there are 150 million Americans between the ages of 40 and 75. 78 million baby boomers are between the ages of 50 and 68. Despite these demographics, only 7.4 million Americans are covered by LTC insurance.

As most baby boomers have saved significantly less than $100,000, 70% of Americans reaching the age of 65 will need LTC services and 10,000 Americans are turning 65 every day between now and 2030. Summary: LTC insurance demand will be growing for a very long time.

LNC has uniquely positive LTC prospects: traditional long-term care products are, more than likely, set to decline as the demand for LTC insurance grows. Why? Traditional LTC is more like health insurance where you pay a premium for the right to have your LTC needs covered. It turns out that this model is very expensive to offer as evidenced by Genworth’s current financial troubles. Long-term, rates for this category of product are set to spike which will create significant room in the market for LNC’s combo LTC alternative (MoneyGuard, 25% of life insurance product sales).

Apart from rates, combo LTC is better for both the policyholder and the insurance company: 1) Because any LTC usage is funded initially by the policyholder’s assets with combo, usage is more rational; 2) Policyholders still get the benefit of their financial product even if they never use LTC. Traditional LTC insurance is a “use it or lose it” system; 3) Traditional LTC policies have variable fees (Genworth is working hard now to get large fee increases passed through as mentioned). As a result, policyholders are forced to either let the policy lapse (losing all value of premiums paid) or pay a much higher premium (not always affordable). 4) Self-selection bias is a huge pricing problem for traditional LTC relative to combo products.  Summary: LTC is going to grow and combo LTC growth will take share from traditional LTC.

The combo product has been slow to catch on primarily because LNC and a few other smaller insurance companies have been the only companies willing to take on the “long-term care stigma.” That dynamic is changing however as several of the largest insurance companies are now entering the market. In terms of the risk of losing market share, Genworth does not have much to worry about. It takes years to build out an effective distribution system and LNC’s distribution network is built around, to a degree, combo LTC (wholesalers selling to banks, wealth management, brokerages, etc. it is not a simple product to sell). Furthermore, the market is expanding long-term and there will be plenty of market share the top companies.

Risk assessment: the one factor that has always bothered me about owning stock in a life insurance company is the massive amount of credit risk these companies take. Credit risk is an important issue because LNC is in the process of adding duration and credit risk to slow the decline in its portfolio yield. Note that LNC’s RBC ratio (risk based capital measure) of 540% is very strong which probably explains why management is trying to take more credit and duration risk.

Even at LNC’s RBC ratio, the company can only lose so much capital before its credit ratings drop below what most distributors are willing to accept. If, for example, the company lost half of its $16b in equity, the company would be a serious trouble. Yet, half of its capital is only 6% of its assets (less separate accounts). Most risk models assume that a 6% loss could never occur ironically because credit risk is assumed to have a low level of correlation. Yet, when a crisis develops, correlations spike and a 2% credit loss is only somewhat less likely as say a 6% loss. In other words, if a BBB rated bond in the energy sector defaults, the odds of another BBB rated bond in the energy also defaulting is elevated. At some point the insurance industry is going get shocked into managing credit risk more realistically.  

Consider the most recent financial crisis. In 2008, realized credit losses were relatively modest given the circumstances. Had the recession lasted another 6-12 months, losses would have escalated. Yet the industry assumes that the 2008 financial crisis proves credit risk is almost zero. Furthermore, the world is now more interconnected which creates an increased joint probability of a financial crisis. Summary: life insurance companies in general have a substantial amount of credit risk. Any credit market problems would immediately put the life insurance industry at risk of mass defaults.  

Fortunately, this risk can be avoided by using LNC’s dividend yield to purchase deep out of the money puts on stocks where the company’s credit is rated at or below CCC. Purchasing puts on CCC or lower stocks is an ideal way to hedge the inherent credit risk associated with a company like LNC. The vast majority of credit risk LNC has is B or better. As a result, LNC will have no problems unless CCC or lower bonds start to run into trouble. 50% of the hedging budget could also go towards puts on some of the lower rated life insurance companies.

Valuation: Lincoln has a fairly good track record of returning capital to shareholders. From 2011-2014, about half of its capital generated was returned to shareholders (most in the form of buybacks). Keep in mind that LNC trades at only 9.3x 2015E earnings and is targeting EPS growth of 8-10%. The relatively low PE combined with the growth potential implies that the market isn’t pricing in much help from interest rates long-term which is key because I am expecting rates to be incremental upside. I do not have a price target although I expect LNC stock to at least double if rates normalize (some multiple expansion plus meaningful earnings growth). If rates do not normalize I expect 5-10% annual returns mostly from dividends and buybacks.   

There are several long-term risks Lincoln faces:

-       Rates could go below 1%. The result would be meaningfully lower earnings and a lower stock price;

-       LNC’s group protection business is doing poorly. If the company fails to turn the business around, a big opportunity is missed. Group protection gives LNC access to the worksite which may become a bigger factor in the overall insurance sales process.

-       LNC’s retirement services business is doing well from a financial standpoint. However, the industry is extremely competitive especially in the large case market. The competition has steadily reduced fees over the past 10 years and the reductions are likely to continue. If LNC losses key individuals and/or develops a reputation problem (cyber-attack, market share loss, etc.) large competitors such as Principal (great with large plans) and/or Fidelity (low cost competitor) could quickly reduce LNC’s market share.

-       Interest rate spikes could in theory cause a large number of insurance companies serious liquidity problems. If people wake up one day to see that rates are now 500 basis points higher, assets will be walking/running out the door to find higher yields.

-       If the stock market drops, LNC’s earnings will take a big hit (separate account revenue and other product riders). As this is a 10+ year investment I am willing to ride the investment through a bear market.

Insurance is a great way to make money because large distribution networks function as massive barriers to entry. LNC’s is among the bests. From a timing standpoint, the insurance industry is very well positioned to benefit from the demographic trends. If interest rates cooperate by normalizing, LNC’s stock over the next 5-10 years will do extremely well (more volume at higher margins = substantial profit growth). However, if rates stay low, the company still has ways to drive profit growth via volume growth (more assets) or more non-spread based earnings. All these factors combine to make LNC a great compounder to hold for the long-run with meaningful upside.

Catalyst

Interest rates.