Christopher Neczypor
Executive Vice President and Chief Financial Officer at Lincoln National
Thank you, Ellen, and good morning, everyone. We appreciate everyone dialing in and listening to our call.
I'm going to discuss three things this morning. First, we will provide a recap of the quarter, including an update on capital. Second, we will go through the segment level financials. And lastly, we will finish with an update on our investment portfolio.
So let's start with a recap of the quarter. Last night, we reported second quarter adjusted operating income available to common stockholders of $343 million or $2.02 per diluted share. There were no notable items in the current or prior period. Alternative investments were in line with our targeted returns. Net income available to common stockholders was $502 million or $2.94 per diluted share.
The difference between net and adjusted operating income for the quarter is predominantly driven by three factors. First, higher equity markets in the second quarter, coupled with an increase in interest rates, favorably impacted market risk benefits, resulting in a non-operating increase to our net income. Second, and again driven by the increase in equity markets and interest rates during the quarter, our hedge instruments declined in value. As Ellen mentioned, our repositioned hedge program continues to work as intended with an explicit capital hedge supporting our objective of reducing capital sensitivity to market volatility.
And third, as a result of the reinsurance transaction we announced in May with Fortitude Re, we impaired securities down to fair market value as of June 30, resulting in an after-tax realized loss of $493 million. Note, pursuant to the applicable accounting guidance, those impairments only included assets that were in an unrealized loss position. The remaining assets associated with the transaction were in an unrealized gain position totaling $374 million after tax as of June 30. That gain along with any subsequent change in fair value of the assets included in the transaction will be realized at closing of the transaction. As Ellen mentioned, the timing dynamic of this impairment has no impact to statutory capital this quarter. Lastly, I want to convey our continued confidence in closing the transaction with Fortitude Re. Given the size of the transaction, regulatory approval takes time and we expect the deal to close in due course.
Before turning to capital, I want to highlight one housekeeping item regarding the quarterly pattern of the preferred stock dividend. For the second quarter, the dividend was roughly $11 million. This will increase to roughly $34 million in the third quarter, which reflects the timing of when the semi-annual portion of the dividend is payable. This decreases back down to roughly $11 million in the fourth quarter, before again increasing in the first quarter.
Let's now turn to capital. We ended the quarter with an estimated RBC ratio that was flat with our first quarter level of approximately 380%. As Ellen noted, we expect the RBC ratio to increase by approximately 15 points at the close of the Fortitude transaction. Like with every quarter, there are headwinds and tailwinds, with this quarter strength in Group helping to offset continued pressure in our Life business and the realization of modest credit losses related to the bankruptcy of First Republic Bank. Lastly, we are continuing to hold capital above our target level at LNBAR. We are pleased with the performance of our reposition hedge program with actual performance being better-than-expected so far this year. However, markets have been relatively calm year-to-date, and thus, we continue to believe it is prudent to allow more time to pass before resuming regular LNBAR dividend to the holding company.
Now turning to the segment results. Let's start with Group, which was once again the highlight in the quarter. Before we get into the numbers, I'd like to step back and say three things. First, the continued growth in this business and the team's focus on restoring the profitability of the platform is critical to the overall long-term strategy of Lincoln. Over the past year, you've heard Ellen talk about our strategic objectives: growing our free cash flow; decreasing our capital sensitivity to market volatility; and diversifying our earnings. At the risk of stating the obvious, a bigger, more profitable, well-run Group Protection business helps to accomplish each of these objectives.
Second, the margin this quarter was 8.6% or 450 basis points higher year-over-year. And while the earnings in this business are benefiting from very strong execution and the strategic steps we've taken over the last year with new management in place, there is also a favorable industry backdrop at the moment and the second quarter tends to be seasonally strong. So it's a good story, but we would not expect the margin this quarter to be reflective of the run rate.
Third, as we look out over the next few years, our Group business will continue to become a bigger part of our story. While there are obviously many moving pieces to the overall earnings profile, Group contributed almost a third of our operating earnings this quarter, not something we've experienced in recent history. We would expect that mix shift to continue over the long term as we execute on our strategic objectives.
Turning to the numbers. This quarter, Group reported operating income of $109 million compared to $49 million in the prior year quarter. The improvement was broad-based as both life and disability results continued to show progress. Our disability loss ratio was 71% in the second quarter, an improvement of 800 basis points year-over-year. These results are driven by strong execution of our Group strategy, including continued investments to support our claimants and their return to work journey, and a favorable economic environment resulting in lower new claims. We are also seeing improved results from our life product with a loss ratio of 72%, down from 81% the prior year. The lower loss ratio reflects lower mortality trends consistent with US working age population mortality.
Turning to expenses, the expense ratio increased over the prior year from 12.5% to 13.6%, a reflection of our investment in talent and focus on strengthening our operational organization. While expenses are higher, we are seeing strong returns on our investments, allowing us to provide optimal outcomes for our customers. Overall, we are very pleased with the progress we are making in the Group business, which is contributing in a meaningful way to both GAAP earnings and free cash flow. Going forward, growing the Group business will continue to be important as we remain focused on executing against our enterprise strategic objectives.
Now let's turn to Annuities. Annuities delivered another solid quarter with operating income of $271 million compared to $294 million in the prior year quarter. The decrease was primarily due to higher expenses and lower prepayment income, partially offset by higher spread income. Sequentially, earnings improved $8 million when excluding the $11 million favorable tax item from the prior quarter, primarily due to higher fee income. Of note, the year-over-year impact from lower prepayment income on earnings will mostly subside in the second half of the year as the decrease in prepayment income began in the third quarter of last year.
Turning to spreads, as I noted earlier, Annuities earnings benefited from higher spread income relative to the prior year quarter. But sequentially, we experienced some temporary headwinds driven by fluctuation in option costs impacting our interest credited line. Looking ahead, we expect annuity spreads to decline for one more quarter, before leveling in the fourth quarter and rebounding in 2024.
Lastly, as a reminder, fixed annuities make up less than 10% of our overall in-force annuities block. And while surrender rates have increased due to the higher interest rate environment, the results were generally in line with expectations for this type of rate environment. Additionally, to reiterate a comment I have made in the past, we have reinsurance in place, both for new business and on our in-force block. When you look at our reported numbers, it is important to remember that those numbers are on a gross basis, and then there's an offset as it relates to the ceded surrenders that flows through on the account value line.
So, while there's always some noise quarter-to-quarter in a block of our size, the Annuity business once again delivered a solid result and significant free cash flow for the company. We continue to see long-term upside and are excited about the growth in this business.
Let's now turn to Retirement Plan Services. Retirement reported operating income of $47 million compared to $55 million in the prior year quarter. The decline was largely due to lower prepayment income and higher expenses. As in the Annuities business, the year-over-year impacts on the Retirement business from lower prepayment income will mostly subside in the second half of the year. Two items partly offset the headwinds. The first is higher base spreads, which expanded by 24 basis points relative to a year ago. As I mentioned previously, spread expansion will not be linear. Our expectation is that we end the year with spread expansion in the mid-single-digits for Retirement. Second, positive net flows, combined with favorable equity markets, led to a 4% growth in average account values compared to the prior year. As we noted last quarter, while we continue to anticipate higher expenses for the remainder of the year, the tailwinds from higher account values, coupled with a stable spread environment, should result in continued strength for the Retirement business.
Lastly, let's discuss Life Insurance. Life Insurance reported operating income of $33 million compared to $63 million in the prior year quarter. The decrease was primarily driven by the run rate impact from last year's assumption reset, partially offset by higher alternative investment income. Additionally, seasonally improved mortality and better alternative investment income drove the sequential improvement in Life earnings.
Turning to mortality, our total underlying claims were mostly in line with expectations this quarter. However, the term block experienced lower frequency of claims, while universal life-type products experienced higher severity. Note that under LDTI, term products will see less net reported variability around mortality in any given quarter, given that the liability for future policyholder benefit reserve or LFPB, smooths the variability in over time. However, for universal life-type products, there could be higher volatility quarter-to-quarter as the reserving mechanism did not change, and yet there is no longer an offsetting change in DAC amortization tied to quarterly profits.
Shifting to spreads. Base spreads were 113 basis points in the quarter, down 12 basis points from the prior year quarter due to the continued impact of certain duration extension programs put in place during the low rate environment. This, coupled with the long duration nature of the block, has delayed the benefits of the higher rate environment. We continue to anticipate spreads to bottom slightly lower than current levels before expanding in 2024.
Overall, persistent headwinds remain for the Life business as we walked you through in the first quarter. The benefits of seasonal mortality supported the sequential improvement, coupled with alternative investments performing in line with expectations, but there is still more work ahead of us. We remain focused on improving the earnings power and free cash flow profile over time.
Turning briefly to company-wide expenses. Expenses remain elevated, and let me start by saying this is an area of focus for us as a management team. There are three key drivers to the increase. First is investment in our business. With new management over the last year, there has been a lot of diligence on what strategically we need to do to grow our businesses and really take a fresh look at the need for some strategic projects. And so part of this is non-recurring once you start looking after 2024 and beyond. But more importantly, some of that expense will be ongoing and will translate into better overall profitability.
The second thing to note is that there is some cost in the system as a result of the challenges we faced over the last year. Over time, these expenses will decline.
And then, the largest driver obviously is an increase in base expense and the impact of the current inflationary environment. Beyond these expense pressures, we remain committed to implementing the benefits of the Spark Initiative, which will support both our earnings growth and capital generation objectives. You will begin to see that spend dissipate next year coinciding with increasing benefits from the initiatives.
Moving to investments, where our credit performance was once again solid for the quarter. Our portfolio remains conservatively positioned and we experienced our eighth consecutive quarter of favorable net credit migrations, reflecting disciplined portfolio construction and proactive credit risk management. Our team regularly stress tests the portfolio by asset class and sector name by name, with input from our outside investment managers. We remain highly confident in our ability to navigate various economic environments and expect credit to have a manageable impact on our capital levels under stress scenarios.
Turning to an update on our commercial mortgage loan portfolio, which continues to perform very well representing 12% of total invested assets. Our CML strategy continues to be focused on 100% fixed rate senior loans on stabilized properties with weighted average loan-to-value and debt service coverage ratios of 46% and 2.4 times, respectively, and negligible exposure to CM3 or below. We maintained disciplined underwriting and rigorous ongoing monitoring processes with no material loan modifications and no forced extensions and we have no direct real estate equity or transitional loan exposure.
Within our CML portfolio, office represents 20% of the holdings, down 500 basis points from three years ago as we continue to proactively shift our portfolio away from office, both from a mix perspective and on an absolute basis. In total, office represents just 2.5% of our overall invested assets.
A key area of focus in office remains near-term maturities. In the second half of 2023, we've only only $17 million of remaining maturities. We have a further $163 million and $188 million of maturities coming due in 2024 and 2025, respectively. Office loans with near-term maturities are conservatively positioned and continue to perform well with an average debt-to-service coverage ratio of 3.3 times.
Now turning to our alternative investment performance. We generated a return of 2.5% this quarter on our alternative investment portfolio, in line with our long-term targeted return, reflecting the strength of our portfolio construction and diversification across investment strategies that can perform well in a wide variety of economic environments. Additionally, the portfolio is benefiting from having only small allocations to venture capital and real estate.
Lastly, on our investment portfolio more generally and to reiterate a point I made on our call last quarter, our total investment portfolio and the asset listings in our statutory filings include assets both for Lincoln as well as those from certain of our reinsurance agreements on which we do not have the economic risk. As a result, the information I just discussed relating to our investment portfolio excludes the assets related to those reinsurance agreements.
In closing, let me reiterate three points. First, we know we have more work to do, but we're pleased with the progress we're making, and this quarter was a step in the right direction. Second, our investment portfolio continues to perform well and our exposure to recent areas of market concern is very manageable. And third, rebuilding capital remains a top priority, and I'm confident in our teams as we execute on our plan and work to create long-term sustainable value for shareholders.
We appreciate everyone taking the time to listen today. Now, we look forward to taking your questions.
With that, let me turn the call back to Al.