AFLAC's Hybrid Securities Are a Cause for Concern

The problems in the British banking sector have spread back across the Atlantic to strike our very own AFLAC (AFL). The stock got crushed yesterday on concerns about its losses in U.K. bank investments. Like a lot of insurance companies, AFLAC invests in perpetual debenture investments or “hybrid securities,” and an analyst is worried about the losses they’ve taken in banks like Royal Bank of Scotland (RBS), HBOS or Barclays (BCS).

Morgan Stanley said, ”If even a small portion of these losses are realized, the hit to Aflac’s capital ratios could be substantial, and their overall capital adequacy could be significantly less than most investors believe.”

Barron's notes:

According to Morgan, Aflac has nearly $8 billion exposure to hybrid securities, with as much as 80% of this exposure to European financial services companies, including Royal Bank of Scotland (RBS) and Barclays (BCS), both of whose solvency has become a subject of open conjecture amid talk that the British Treasury might nationalize some of its financial institutions.

Some of the hybrid securities products have declined as much as 30% in just the past week, so that many have traded at less than 50 cents on the dollar. It’s these losses, that, if realized, would hurt Aflac’s capital adequacy.

The stock opened down 11% but it’s slid all morning. At one point, AFL was down 39% for the day. In the most recent 10-Q, AFLAC discussed some of the accounting issues involved in their hybrids:

Securities and Exchange Commission Guidance: On October 14, 2008, the Securities and Exchange Commission [SEC issued a letter to the FASB addressing recent questions raised by various interested parties regarding declines in the fair value of perpetual preferred securities, or so-called “hybrid securities,” which have both debt and equity characteristics and the assessment of those declines under existing accounting guidelines for other-than-temporary impairments.

In its letter, the SEC recognized that hybrid securities are often structured in equity form but generally possess significant debt-like characteristics. The SEC also recognized that existing accounting guidance does not specifically address the impact, if any, of the debt-like characteristics of these hybrid securities on the assessment of other-than-temporary impairments.

After consultation with and concurrence of the FASB staff, the SEC concluded that it will not object to the use of an other-than-temporary impairment model that considers the debt-like characteristics of hybrid securities (including the anticipated recovery period), provided there has been no evidence of a deterioration in credit of the issuer (for example, a decline in the cash flows from holding the investment or a downgrade of the rating of the security below investment grade), in filings after the date of its letter until the matter can be addressed further by the FASB.

As more fully discussed in Note 3 of the Notes to the Consolidated Financial Statements, in light of the recent unprecedented volatility in the debt and equity markets, we have concluded that all of our investments in perpetual debentures, or hybrid securities, should be classified as available-for-sale securities. We have also concluded that our perpetual debentures should be evaluated for other-than-temporary impairments using an equity security impairment model as opposed to our previous policy of using a debt security impairment model until further guidance is provided by the SEC and the FASB.

We recognized realized investment losses of $294 million ($191 million after tax) in the third quarter of 2008 as a result of applying our equity impairment model to this class of securities. The impact of classifying all of our perpetual debentures as available for sale and assessing them for other-than-temporary impairments under our equity impairment model was determined to be immaterial to our results of operations and financial position for any previously reported period.

AFLAC has said that it's "comfortable" with its capital position. Earnings are due on Monday, February 4.

Comments

[livesinhiscar:]

In the worst case scenario for AFL, they nationalize the institutions and the British government will stand behind the troubled hybrid securities.

Jan 23 08:12 AM

[notsosmart:]

that duck could be soup soon.

Jan 23 11:29 AM

[Guero:]

Looks like they better crack the whip on the sales force! "Get out there boys, and sell some of that quality, affordable gap insurance! Seems the smart guys running our money have put us in a hole!"

Jan 23 05:36 PM