Hedging Variable Annuity Guarantees August 7, 2010

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1 Hedging Variable Annuity Guarantees August 7, 2010 Jeff Coutts Vice President, Head of Profitability, Risk & Implementation Management Lincoln Financial Group

2 Lincoln s Actuarial Presence 150 actuaries 60 students Hartford, CT Life/Annuity Product Management Executive Benefits Product Management Radnor & PHL, PA Corporate Center Equity Risk Management Greensboro, NC Life/Annuity Product Management Product Risk and Liability Valuation Omaha, NE Group Protection Fort Wayne, IN Valuation Management Reporting Defined Contribution Product Management 2

Management Greensboro, NC Life/Annuity Product Management Product Risk and Liability Valuation

3 Agenda Hedge program basics Performance throughout crisis Current issues 3

4 Hedge Program Basics Variable Annuity Overview Variable annuity industry sales of $125B in 2009* Base contract provides tax preferred investment vehicle and annuitization option Majority of sales include additional benefit riders: Guaranteed Minimum Death Benefits (GMDBs) Guaranteed Living Benefits (GLBs) - Guaranteed Minimum Withdrawal Benefit (GMWB) - Guaranteed Minimum Income Benefit (GIB) - Guaranteed Minimum Accumulation Benefit (GMAB) GLBs and GMDBs guarantee certain performance or level of income regardless of market conditions *Source: Morningstar MARC data as of Dec 31,

Benefits (GLBs) - Guaranteed Minimum Withdrawal Benefit (GMWB) - Guaranteed Minimum Income Benefit (GIB) - Guaranteed Minimum Accumulation Benefit

5 Hedge Program Basics What Are We Hedging? Historically only hedge guarantees, not the base contract Liability changes as market inputs change Hedge programs limit financial impact of higher reserves/claims due to declining market conditions 5

Liability changes as market inputs change Hedge programs

6 Hedge Program Basics VA Risk Management Spectrum Full Reinsurance 3 Greek Hedging Cost Delta Hedging Static Hedging No Protection Effectiveness Managing VA guarantees requires balancing cost and effectiveness 6

Static Hedging No Protection Effectiveness Managing

7 Hedge Program Basics 3 Greek Hedging Greeks measure sensitivity of liability to a given market condition Lincoln actively manages impact of 3 market measures Market Measure Delta Vega Rho Market Condition Market Drop Volatility Increase Interest rate Decrease Liability Impact 7

of 3 market measures Market Measure Delta Vega Rho Market Condition

8 Hedge Program Basics Types of Hedge Instruments Derivative instruments are purchased to match the liability exposure to each of the Greeks Greek Exposure Instrument Delta Rho Vega Put Options Interest Rate Swaps - - Variance Swaps - - Interest Rate futures - - Equity Futures - - 8

Greek Exposure Instrument Delta Rho Vega Put Options Interest Rate

9 Performance Throughout Crisis Impact of the Crisis Financial crisis put unprecedented stress on hedge programs: Huge daily market swings Extreme volatility = Higher Cost Interaction of market forces So how did we do? 9

programs: Huge daily market swings Extreme volatility

10 Performance Throughout Crisis Financial Impact Hedge Target/Hedge Assets (in billions) Mar 2008 Hedge Target Hedge Asset Average S&P 500 Jun 2008 Sep 2008 Dec 2008 Mar 2009 Jun 2009 Sep 2009 Dec ,500 1,400 1,300 1,200 1,100 1, Average S&P 500 Not Perfect, but overall we did quite well Hedge assets accumulated to offset our growing liability 10

0 Mar 2008 Hedge Target Hedge Asset Average S&P 500 Jun 2008 Sep 2008 Dec 2008 Mar 2009 Jun 2009 Sep

11 Performance Throughout Crisis Hedge Effectiveness 3,000 2,000 1,000 (in millions) - (1,000) (2,000) (3,000) 1q08 2q08 3q08 4q08 1q09 2q09 3q09 4q09 GLB Hedge Breakage GLB Change in Reserves Program was very effective but crisis highlighted weaknesses 11

4q08 1q09 2q09 3q09 4q09 GLB Hedge Breakage GLB Change in

12 Current Issues Reducing Breakage Capital Market Conditions/Hedging Cost Accounting Considerations 12

13 Current Issues Second Order and Interaction Breakage Impact/Concerns Largest source of breakage Only explicitly hedge first order market movements Difficult to capture the interdependency of the Greeks Preventative Actions Exploring different hedge instruments Consider macro hedge 13

movements Difficult to capture the interdependency of the Greeks

14 Current Issues Policyholder Behavior Breakage Impact/Concerns Withdrawal and investment activity not tracked in real time May cause over or underhedged position Preventative Actions Product design- restrictions on policyholder behavior Building experience to improve tracking and forecasting 14

underhedged position Preventative Actions Product design- restrictions on

15 Current Issues Basis Risk Breakage Impact/Concerns Has produced favorable breakage due to fund outperformance Derivative assets based on indices that try to mimic underlying policyholder investments Preventative Actions Continue improving fund mapping Carefully evaluate funds in VA lineup Avoid funds that are difficult to hedge 15

underlying policyholder investments Preventative Actions Continue improving fund

16 Current Issues Capital Market Conditions 10 the Money S&P Put Cost 35.00% 30.00% 25.00% % of Premium 20.00% 15.00% 10.00% 5.00% 0.00% Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Put options are very expensive in current environment May choose to not fully hedge liability Greeks Tradeoff between risk and profitability 16

00% Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Put options are very expensive in

17 Current Issues Accounting Considerations Economic/capital markets view (i.e FAS 133) Pure market consistent vs other approaches? What is the impact of illiquidity? GAAP Non performance risk (FAS 157) reduces liability. GMDB and portion of GLB liability not market consistent (valued under SOP 03-1) Statutory (i.e VACARVM) Measures tail risk via stochastic modeling Stat liability behaves differently from GAAP or economic 17

GAAP Non performance risk (FAS 157) reduces liability.

18 Current Issues Accounting Considerations Cannot simultaneously hedge to Economic vs GAAP vs STAT Lincoln s primary focus is economic liability We are mindful of GAAP and STAT impacts STAT reserves have higher market sensitivity but low rate and volatility sensitivity Macro hedges could limit statutory capital impacts from falling markets but are expensive to implement 18

STAT reserves have higher market sensitivity but low rate and volatility sensitivity Macro

19 Summary Hedge Program Manages Impact of Guaranteed Benefits Program Performed Well During Crisis Refining Program to Meet Challenges 19

20 Opportunities at LFG Please go to the LFG home page for additional career opportunities Lincoln Financial Development Programs: Actuarial Development Program - Contact: Actuarial@LFG.com Leadership Preparation Program - Contact: LPP@LFG.com 20

com/careers Lincoln Financial Development Programs: Actuarial

21 Questions? 2010 Lincoln National Corporation Lincoln Financial Group is the marketing name for Lincoln National Corporation and its affiliates. Affiliates are separately responsible for their own financial and contractual obligations. 21

Variable Annuities. Society of Actuaries in Ireland Evening Meeting September 17, 2008

Variable Annuities. Society of Actuaries in Ireland Evening Meeting September 17, 2008 Variable Annuities Society of Actuaries in Ireland Evening Meeting September 17, 2008 Variable Annuities Working Party Presented paper to Faculty and Institute in March 2008 Working Party members Colin