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Aflac, Inc. (AFL)

Q4 2008 Earnings Call

February 3, 2009 09:00 am ET

Executives

Kenneth S. Janke – Senior Vice President, Investor Relations

Daniel P. Amos – Chairman of the Board & Chief Executive Officer

Kriss Cloninger III – President, Chief Financial Officer, Treasurer & Director

William Jeremy Jeffery – Senior Vice President, Investments & Chief Investment Officer

Mary Chapman – Vice President of Investments

Tohru Tonoike – President & Chief Operating Officer, Aflac Japan

Paul S. Amos II – President, Aflac; Chief Operating Officer, Aflac U.S.

Analysts

Jimmy Bhullar – JPMorgan

Nigel Dally – Morgan Stanley

John Nadel – Sterne, Agee

Thomas Gallagher – Credit Suisse

Randy Binner – FBR Capital Markets

Suneet Kamath – Sanford Bernstein

Mark Hughes – SunTrust

Steven Schwartz – Raymond James & Associates.

Colin Devine – Devine

Eric Berg – Barclays Capital

Ed Spehar – Banc of America/Merrill Lynch

Dan Johnson – Citadel Investment Group

Operator

Hello and welcome to the fourth quarter earnings call. All line will be in listen-only until the question-and-answer portion. (Operator Instructions). Today's call is being recorded. If you have any objection, you may disconnect at this time. I’d like to introduce your host Ken Janke, Senior Vice President of Investor Relations. Sir, please begin.

Kenneth S. Janke, Jr.

Thank you, Audra. Good morning everybody. We are glad you could join us today. I’d like to start with just introductions of those that are joining me in the room this morning beginning with Dan Amos, Chairman and CEO; Kriss Cloninger, President and CFO; Paul Amos, President of Aflac and Chief Operating Officer of Aflac U.S.; Jerry Jeffery, Senior Vice President and Chief Investment Officer is also here, as is Mary Chapman, Vice President of Investments. Mary leads our Global Credit team. We are also joined from Tokyo by Tohru Tonoike, who is President and COO of Aflac Japan.

Let me remind you that some of the statements we make this morning may be forward-looking within the meaning of Federal Securities Laws and although we believe these statements are reasonable, we can give you no assurance they will prove to be accurate because they are prospective in nature. The actual results in the future could differ materially from those we discuss today. So, I would encourage you to look at our most recent quarterly press release for some of the various risk factors that could impact our results.

Now, I’d like to turn the program over to Dan, who has some brief comments on our perpetual debenture portfolio. And then we will be happy to take your questions.

Daniel P. Amos

All right. Thanks Ken and good morning and thank you for joining us. As you can imagine, we have received a tremendous amount of calls in the last week following the sharp decline in our stock price. All of those calls in one way or another related to the ownership of perpetual debentures or hybrid securities and our capital position. We will still be conducting our regularly scheduled web presentation this evening. However, we thought it would be a good idea to talk about the hybrid holdings in more detail this morning since there seems to be a lot of confusion in that area. Then we'll be happy to take your questions.

Let me begin with a couple of comments on our investment portfolio. I want to reiterate, what I've said previously. Overall, I am pleased with the quality of our assets and with good reason despite global credit downgrades over the last few months the credit profile of our holding is still very strong. More than 98% of our fixed maturities and perpetual debentures were investment grade at year-end. I know you realize that you can't run a company in hindsight, but if you could other than avoiding a few specific securities, I would not alter our overall investment approach. The reason is straightforward.

We purchase securities that best match the characteristics of our policy liabilities. That is especially true with our Japanese operation. For more than 15 years, our greatest challenge has been investing huge cash flows in appropriate securities. We need to buy long-duration, yen-denominated investment grade securities to fund our long-duration, yen-denominated policy liabilities. With that background I'd like to make specific comments on the perpetual debentures holdings.

At the end of December, we owned a total of 9.1 billion in perpetual debentures at an amortized cost. Of that amount 6.5 billion or 72%, were upper Tier II securities. Upper Tier II securities are more debt like than Tier I and are senior to Tier I securities, preferred shares and common equity. Tier I securities amounted to 2.6 billion at amortized cost at the year-end, have more equity characteristics, but are still senior to common equity. They are generally senior to preferred shares as well, but that depends on individual security, the insurers capital structure and the regulatory jurisdiction of the insurer.

It's very important for you to differentiate between upper Tier II and Tier I securities. They are not the same and they carry different risks. Most of the hybrids we own are yen- denominated and long-dated instruments that we purchased to support Aflac Japan's policy liabilities. At the end of the year, the unrealized loss on our perpetual debentures was $1 billion, compared to loss of $475 million at the end of September. About $760 million of that loss is at the end of December is attributable to the Tier I instruments.

However, the stronger yen also contributed to the unrealized losses on the hybrid holdings. Since the end of the year, pricing is lower for hybrids. However, upper Tier II securities have declined less than Tier I securities. Again, this illustrates why it's important to differentiate between the two categories since this is exactly what the market is doing. I should also note that in the last week pricing has actually improved somewhat for Tier I instruments.

On a GAAP basis, we hold the perpetual debentures in available-for-sale category. That means they are carried on the balance sheet at fair value and unrealized gains or losses are reflected in the equity. For statutory accounting purposes, these perpetual debentures are carried at amortized costs. As such, the changes in fair value of the hybrid securities are not included in, and therefore do not impact the risk-based capital ratio. Furthermore, many of you have asked what impairments we might have to take due to the current pricing of hybrid securities.

As we mentioned in our press release, we issued recently, we are using a debt impairment model for GAAP purposes. Our debt impairment approach is primarily based on a assessment of whether it is highly probably, we received timely payments of interest and principle. Under the FASB determines whether a debt or an equity impairment approach is mostly appropriate for hybrid instruments. We will continue to evaluate them using a debt impairment model. For statutory accounting purposes, we will continue to evaluate our perpetual debenture holdings using the debt impairment approach and we do not anticipate that approach changing. The credit profile of our perpetual debenture portfolio remains high, in fact more than 92% were rated A or higher at year end.

As a result this portfolio is not creating a disproportionately high regulatory capital charge, compared with the rest of the portfolio. With the exception of the Icelandic Banks, which we announced in the third quarter and wrote down to zero in the fourth quarter, all of our perpetual debentures are current on interest payments. Only two of the insurers are rated as below investment grade and they're both current on meeting their obligations. Further, we have no reason to believe that the perpetual debentures will not be redeemed at their effective maturity date. It's noteworthy, that we have three hybrids redeemed in the fourth quarter of last year. We have only $306 million in perpetuals scheduled for redemption in 2009 and a $110 million in 2010.

So, we do not believe there is a significant extension risk in the short term. It's clear that the heightened level of concern of the asset class relates to the recent developments at European banks specifically realize that investors are worried about the possibility that some banks may be nationalized as a result that certain securities may no longer be honored. I am not going to get into the business of trying to handicap which government, if any might nationalize which bank. But I want to make a couple of points.

First, nationalization is not a preferred solution for rescuing bank. Instead, it's basically a course of last resort. Second, based on the media reports it seems to risk of nationalization at least in the U.K. is subsided a bit. Further, three nationalizations have occurred to-date; The Irish Bank nationalized Anglo Irish Bank. The British government nationalized Northern Rock and Bradford & Bingley. In each instance, the governments are standing behind the classes of perpetual debentures that we own for those banks, who issued them.

I realize there is no guarantee that other banks won’t be nationalized, though there is any guarantee that future nationalizations will result in governments backing their securities we own. However, there are favorable precedents, just the same. Along those lines, our investments departments have undertaken a thorough have analysis of what we believe is a very pessimistic scenario of potential bank nationalization. This stress testing was conducted after discussions with the rating agencies, investment banks and issuing banks themselves.

Specifically, we reviewed all the bank average to determine what might happen if they were all nationalized, if nationalization precedent I referred to earlier those securities that had voting rights were more equity like and we are not honored. If we had to write-off all of the hybrids that we have actual voting rights under the nationalization scenario, we estimate that they incurred a pre-tax impairment charge of only $100 million. If we take a much more conservative view and dramatically expand the definition of voting rights, the number only increases to approximately $400 million before taxes. Given our strong capital position currently and our ability to generate statutory capital, we do not believe this unlikely scenario poses significant risk to Aflac.

During 2008, we earned $1.9 billion in operating earnings. However, we realized after-tax investment losses of $655 million. The vast majority, which occurred in the third and fourth quarter, those losses brought our net income down to 1.3 billion. As we discussed most of our losses were attributable to the sale of Lehman Brothers, the impairment of Icelandic Banks and Ford Motor Company. You will recall, we impaired some of the perpetual debentures retrospectively using an equity impairment model in the third quarter.

We also impaired some of CDO holdings in the fourth quarter. The impairment of those CDOs was based on our analysis that suggested there was a greater likelihood, that we would not receive full interest and principles on those CDOs. As such, we wrote them down to fair value in the quarter. However, I’d like to point out that with the exception of the CDOs that were ranged by Lehman Brothers, which are currently being unwound, all the CDOs are current on interest payments. Although, I am not happy with incurring $655 million of realized losses for the year, I am pleased that we are strong enough to absorb those losses during these tough economic times.

Finally, I want to comment once again on our capital position. As we mentioned in the last nights press release, we expect our year-end risk-based capital to exceed 450% that would equate to excess capital of approximately $600 million to 1.1 billion using minimum RBC ratios of 400 and 350 respectively. For 2009, we expect another strong year of capital generation. We currently estimate that our statutory earnings will be $1.9 billion assuming the year-end 2008 exchange rate.

Assuming that we only dividend to the parent company amounts needed to fund the shareholder dividend and corporate cash expenses, we would expect statutory capital to exceed $5.5 billion at the end of 2009. We continue to believe our strong capital position will enable us to weather these turbulent and challenging times. Ken?

Kenneth S. Janke, Jr.

Thank you, Dan. Before we take your questions. Let me just mention a couple more facts about perpetual debentures that we've been asked over the course of last several days and last nights.

Specifically, we own 38 different entities in the perpetual debenture area. They are spread among 15 countries, 65% are in Europe, 20% are related to United Kingdom, a 11% in Japan and the remainder in Australia. As you know, the stronger yen magnified all the amounts on our balance sheet including the book value, the fair value, and the unrealized gains or losses in the portfolio, and that was also true with the perpetuals.

In fact, about a $100 million of the increase in the unrealized loss was attributable to the change in the currency. As you heard these typically are very long dated instruments, 62% of our perpetual debentures mature after 2019, 96% of those in the perpetual area are yen denominated, and we've also been asked about whether any of these securities have a provision for cumulative coupons or not. All of upper Tier II securities are cumulative and none of the Tier I perpetuals are cumulative. So, that's just a brief recap of some of the facts related to the portfolio.

We'd be happy to take your questions now. We've got plenty of time, so please limit your questions to one. So, everyone has a chance to ask a question. And with that Audra, we'll turn it back to you and you can start the process.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Your first question comes from Jimmy Bhullar with JPMorgan.

Jimmy Bhullar – JPMorgan

Hi, thank you. I have a question on the FASB classification of the hybrid securities. Do you have a sense of the timing on when the FASB could announce decision? And then, if they do, in fact, ask companies who classify them as equities, obviously on a GAAP basis you'd impair them, but how would that impact statutory accounting. Do you think that the NAIC would file a suit if that happen?

Kriss Cloninger III

At present, Kriss Cloninger here. At present we doubt that the FASB is going to make a pronouncement probably until, second quarter or later. We have no indication to believe that it's going to be any sooner than that. So, we're waiting, along with others and we hope we get our chance to comment, because, if and when we do we'll make the case that we've made before, for the last 15 years, which is we believe that our hybrids are more debt-security oriented and we created them that way for 15 years because they are traded like debt, the interest is deductible like debt et cetera, et cetera and they have more debt like characteristics than equity-like characteristics. Not only that, but we view these hybrids as an excellent match to our unit liabilities in Japan. We have the ability and intent to hold them to maturity if we find that to be appropriate. So, we just don't expect any change in that status before the second part of 2009. If the FASB does pronounce that equity impairment model is necessary for hybrid accounting then we'll have to follow that, obviously. At present though, we do not believe that will carry over into statutory accounting, because that's controlled by the NAIC and the standard valuation office and they went through an extensive vetting process over the last several years to conclude that these securities are debt in nature and should be accounted for as debt in the statutory financial statements so we don't anticipate any change in statutory.

Jimmy Bhullar – JPMorgan

Thank you.

Operator

Nigel Dally with Morgan Stanley. You may ask your question.

Nigel Dally – Morgan Stanley

Great, thank you, good morning. With respect to the impact of the yen on your capital ratios we are now at 89 and there are certain investors that expect it to strengthen further, potentially down to 80. If we did continue to see yen strengthening can you comment on what action would to take? Does hedging or shifting some of your capital into yen denominated assets make sense at some stage to eliminate or at least reduce the vulnerability of your RBC ratios to the yen?

Kriss Cloninger III

Well, we have done some stress testing regarding what happens if the yen proceeds continues to strengthen to the neighborhood of 80. We've determined that if the yen had been at 80 at year-end ’08. We believe our risk-based capital ratio is still would have exceeded 400%. We expect the actual to be in excess of 450, we probably would have lost another 50 points going from 91 to 80 some like that. I will say that, we never have done the currency hedging so to speak, a great deal, but we would, we have had a tendency toward favoring an increase in our yen-denominated capital, though I don't think you would see any sudden moves to make that happen. That would just come about more over time.

Nigel Dally – Morgan Stanley

Great. Thank you.

Operator

John Nadel with Sterne, Agee. You may ask your question.

John Nadel – Sterne, Agee

Thank you. Good morning, everybody. Just a quick question on OTTI from the fourth quarter, I am not sure if you guys mentioned whether the impairments that you took in the quarter were similar on both a GAAP and statutory basis?

Kriss Cloninger III

Yes. The OTTI impairments related to the CDO securities. And those would impact stat and GAAP similarly.

John Nadel – Sterne, Agee

Okay. And then, the only other question I had for you is just the, real quick, the new money yield in the U.S. in the fourth quarter was extremely high over 9%. Can you give us a sense for just how much money you put to work and what kind of assets you are buying?

William Jeremy Jeffery

Sure. This is Jerry Jeffery. We have put approximately a $120 million to work. So, it's a very small statistical sample and all of the securities we purchased were investment grade A or better, primarily corporate bonds.

John Nadel – Sterne, Agee

Corporates, okay. Thank you.

Operator

Tom Gallagher

Kriss Cloninger III

Let me amplify one thing that actually the Iceland banks were also classified as an OTTI even though we had announced those would have been written down in the fourth quarter, we announced that, at the end of third so I just don’t see those, sorry.

John Nadel - Sterne, Agee

Okay. And Kriss similar those impacted stat and GAAP the same?

Kriss Cloninger III

Yes, that's correct.

John Nadel - Sterne, Agee

Thank you.

Kriss Cloninger III

Okay.

Operator

Tom Gallagher with Credit Suisse, you may ask your question.

Thomas Gallagher – Credit Suisse

Thanks Dan. I guess you have been flagged here by some of the rating agencies is having above average single-issuer concentration risk, just curious if that's something you're planning on changing? And on a related topic, with S&P having downgraded one notch and giving some parameters on what might lead to further downgrade, do you see it as a problem if you get downgraded below AA as it relates specifically to the Japanese business? And then just one other quick question on the numbers on the fair value versus amortized cost of the hybrids, $8 billion versus $9.1 billion would I guess give us an $0.88 mark, do we need to make a further adjustment to the yen appreciation to get more of an apples-to-apples mark on that? Thanks.

Daniel P. Amos

Okay. Let me go back, lets see the first question was…

Kriss Cloninger III

Investment concentration.

Daniel P. Amos

Okay I will let Jerry handle that, but we did invest much heavier 85% was outside the financial sector. So, Jerry go ahead and talk about that.

William Jeremy Jeffery

Yes, let me speak to the concentration issues you mentioned. It has been our commitment to reduce the size of the purchases we make and that we've got some pretty firm guidelines that have been in place for a couple of years. We do have some legacy large positions, but overtime they will be reduced and obviously anything that falls within our top 30 exposures, we are scrutinizing intensely. But we are very comfortable with all those. But going forward, we got two commitments. One, is to reduce the size of the average purchase and the other is to diversify and do as many industry groups as we can. Luckily, the market is reporting us that is affording us that opportunity right now. We are seeing a more diversified number of opportunities than I think we ever have. I would say, that it is unlikely given our duration needs that we will be reducing our purchase size as to the $5 to $10 million level on average, because the Japanese credit market is really not developed beyond five years. So, in order for us to achieve our duration needs, we need to buy long-dated security and those are typically private. As a result, when we are purchasing these products, there is tend to be larger sizes then what you would typically expect from others. One, other thing, I would mention about our largest exposures, we did have in the fourth quarter Toko Fuji, which is one of our largest exposures, repurchased from us 28% of our exposure to them. And it was done on their initiative not ours. They approached us, we have a very good relationship with them. And they approached us and….

Thomas Gallagher – Credit Suisse

Did they…

William Jeremy Jeffery

Sorry.

Thomas Gallagher – Credit Suisse

Sorry. Did they retire that debt or did they…

William Jeremy Jeffery

Yeah, they did retire the debt. Yes, they retired it.

Daniel P. Amos

Retired it.

William Jeremy Jeffery

They were interested in. It was $0.99 on the dollar.

Thomas Gallagher – Credit Suisse

Okay.

William Jeremy Jeffery

And they we are insisting on that for accounting purposes. They were trying to retire some of their higher-coupon debt.

Thomas Gallagher – Credit Suisse

Got it. And, Dan, any comments on the ratings front?

Daniel P. Amos

Well, right now, we've got the top insurance companies in Japan, we're within that framework of where they are. Most of them, as you know, are A or AA-, I believe, and we want to do everything we can to hold our rating as high as we can. But we can certainly handle the AA- with no problem, and we could even handle the A if we need to. And so we top that through, and we feel comfortable with that, but that's not, of course, what we want. But in this environment we just have to continue to work through it and see what happens.

Thomas Gallagher – Credit Suisse

Okay, and Dan just.

Daniel P. Amos

Yeah, go ahead.

Thomas Gallagher – Credit Suisse

Sorry, just one quick follow up on that.

Daniel P. Amos

All right.

Thomas Gallagher – Credit Suisse

So, the plan here would be that, if in fact S&P did carry through and you had that kind of loss estimate, the plan would be not to raise capital to preserve the rating, but rather to go forward with the current plan?

Daniel P. Amos

I think that's very right, yes, we've talked with all the rating agencies since we were downgraded by one that we didn't talk to, apparently in response to the precipitous decline in our stock price that one day, and we've discussed this with all the rating agencies regarding our security concentrations. That really became a point on discussion after the Parmalat fraud occurred, and at that point we took a hard look at our investment concentrations. We concluded at that time that we were satisfied that those holdings would be money good and that's proven to be the case over the last five years. We did take steps at that time to reduce and this was pre-Jerry Jeffery time. So, he didn't need to speak to it rather, but we did take steps to reduce our new issuance purchase size. Presently, we're observing a discipline in the neighborhood of 5% of total adjusted capital for any new concentration. And the like, so we've made gradual moves in that regard. But the fact of the matter is, we've benefited over time from having fairly large concentrations, because of favorable terms we've been able to negotiate in the securities we've acquired and, in fact, those conditions benefited us in a number of circumstances. So, we're managing to reduce risk, I will say that, over time and so we are observing risk management principles and managing our investment portfolio, but we're generally comfortable with our holdings, including our hybrid holdings at the moment.

Kriss Cloninger III

And from, but I'm mainly talking about from a sales perspective of dealing with our agents and in the U.S. I guess the thing that most, our agents ask about is AM Best and AM Best confirmed there are financial ratings last week. So, we got that as well.

Thomas Gallagher – Credit Suisse

Okay, thanks

Operator

Randy Binner with FBR Capital Markets. You may ask your question.

Randy Binner – FBR Capital Markets

Hi thanks. Could you please review the redemptions you laid out for hybrids in '09 and '10 and also do you have any update on I believe H Boss announced that they were going to do a redemption in late January, earlier February, and if you have color on H Boss, how much that was for?

Kriss Cloninger III

The redemptions in '09 were $306 million, and a $110 million scheduled for 2010. As Dan mentioned 62% of our hybrids are scheduled for redemption further than 10 years from now. And really the lion's share out closer to 20 to 30 year. Sorry, 20 and 25 years, I suspect.

Randy Binner – FBR Capital Markets

Okay.

Kriss Cloninger III

What was, you were talking about H Boss, I am going to let Mary Chapman, who is our Global Credit Chief comment on H Boss, but they did, you're correct they did announce a redemption of their hybrid securities.

Mary Chapman

We've benefited from several redemptions at the end of '08 and into '09, H Boss I think was responding to the situation in the U.K. where there were some confusion regarding the absorption part or the transfer of the preference share by the U.K. government into common shares. And H Boss wants to refuse that by announcing the redemption they have the ability and strength to do that and so they were going ahead and doing that. We've also participated in the change in the consolidation of the H Boss and Lloyds instruments, and that has gone forward as expected.

Randy Binner – FBR Capital Markets

I am sorry, so just to be clear so is that redemption going to occur and can you disclose how much of the H Boss exposure that dealt was?

Mary Chapman

We're not actually.

Daniel P. Amos

We're not exposed to that issue.

Mary Chapman

Right, and we're not actually talking on.

Randy Binner – FBR Capital Markets

Okay.

Mary Chapman

On specific securities, but let me also comment that H Boss also experienced an upgrade.

Randy Binner – FBR Capital Markets

Okay. Thank you.

Kriss Cloninger III

Thanks.

Daniel P. Amos

I would point out that to-date we have not yet had a hybrid security that has not been redeemed at the first redemption date, including three which occurred in the fourth quarter.

Operator

Suneet Kamath with Sanford Bernstein, You may ask your question.

Suneet Kamath – Sanford Bernstein

Thanks. One quick follow-up to one of Tom's questions about the 88% mark. Can you just talk about where you're getting the fair value for those hybrids, because it seems like something, I have read in the press, things have sold off quite a bit, so where are you getting those prices? And then secondly, could you just put a little bit more detail around those loss expectations that you gave, Dan? I think you said a $100 million under one scenario pretax and then $400 million under another scenario. Can you just talk a little bit more about how you arrived at those numbers?

Daniel P. Amos

Yeah, I am going to let Jerry go into detail. Jerry?

William Jeremy Jeffery

Yeah. Let me comment first on the pricing. For the vast majority of our hybrid securities and for most of our debt securities, in fact, that are in our yen portfolio we use model pricing. Now, that model pricing takes inputs from a number of broker-dealers, every pricing period. And we then apply those inputs in generating prices for the securities. We also check the validity of those prices by consulting with LehmanLive, we also look at JPMorgan's Global Index, and the final piece of the puzzle is we're able to, and you're able to, as well, to source the trace pricing fee that's found on Bloomberg. So, you can actually get live pricing to validate all these. Let me kind of fast forward because I guess the question that a lot of people are asking is, what has happened to our portfolio year-to-date in the perpetual debenture area. The answer is, on an overall basis when you look at both upper Tier II and Tier I securities in our yen portfolio. They are down approximately 9% year-to-date. I know the press has written a number of, sort of hysterical articles about pricing, but I can tell you we're looking at live prices and in fact there are a number of very specific price points and institutional trades that we are seeing in the securities that are being written up in the press, and I can tell you the press reports are highly exaggerated. Let me turn now to what you were talking about, which is the worst-case scenario that you mentioned. The stress analysis we ran was we assumed that every single bank that we own gets nationalized, which is a highly unrealistic scenario. But, if it were to happen we then looked at nationalizations that have occurred and we look at which securities have been honored and which securities have not been honored in those nationalizations. There is a one consistent pattern in those nationalizations, and that is that securities with equity characteristics, specifically shareholder rights among other things are securities that have not been honored or have not been assigned value by the nationalizing governments. And we then looked at our securities and said, okay, which ones would have shareholder rights in such scenario, and the number was only $100 million. There are other types of voting rights that some of our securities have I would not characterize my shareholders rights, but even if we do include those in the mix the number only grows to $400 million. And again remember that's every bank can nationalized.

Suneet Kamath - Sanford Bernstein

Thanks. Just to confirm those are all pre-tax numbers?

William Jeremy Jeffery

They are pre-tax numbers, that's correct.

Suneet Kamath - Sanford Bernstein

Thanks very much.

Operator

Mark Hughes with SunTrust, you may ask your question.

Mark Huges – SunTrust

Thank you very much. With respect to operations, could you just talk about the new sales environment, your degree of confidence that the outlook you've got for 0% to 5% growth that that's achievable for '09?

Daniel P. Amos

Yes I will talk about a little bit about Japan and Tohru you may want to jump in and then maybe Paul can talk a little bit about the U.S. I think that 0% to 5% in Japan is a reasonable target what is we know when a difficult environment in both the U.S. and Japan and made no doubt it, our bonuses are tied to us making these numbers. So, when we put out a number of number of 0% to 5% ahead analysts ask well, gosh, aren't you being too optimistic, shouldn't you actually have negative numbers in this environment, because so many companies are. My answer is I believe that it is a reasonable thing for us to at least be flat to up and we have some positive things going on that we can talk about. Now talking about Japan, the two obvious things that come to mind is first, the banks. We really didn't get started with the banks to any great degree until the third quarter. It was building, we've wrote some in the first quarter and then we doubled that small amount, and then we, I think, tripled it again in the third quarter. And then, of course, as you know, in the fourth quarter, because of the financial crisis all the banks kind of stopped selling and had to go back. And call on their existing customers because of the annuities and the other products that they were selling for other insurance companies, so it affected us in the fourth quarter. Saying that, I think now from that standpoint of the, there being a little bit better opportunity for us to go forward and the comparables for the first quarter, it should begin to improve. The first quarter, I think was our biggest increase in Japan last year I think we were up 5%. The second quarter was our easiest, will be our easiest comparison. So, we'll have to see. And then in addition to that, you've got the bank channel. We're still, I'm sorry, the post. We're still in the test for the post. It did a little bit better than we thought it would do. It has not been rolled out, we only did it to, what, 300 banks, but the possibility of taking it to more post offices than 300 is certainly an opportunity for us. We know that there is some balance that when we have higher enrollment from these new distribution channel, it does affect our existing distribution channels a small amount. But all in all, I think that the zero to five is a reasonable target, but it is not an easy target, but it is a reasonable one, and as I said our bonuses are tied to it. So, if we had negative sales, that portion of our bonus, we make nothing on. Tohru, you have any comments you would like to add to that.

Tohru Tonoike

Yes. In addition to what Dan has just described, I would rather point out that, besides the bank channel, our traditional distribution channel of agents, we have been working to make it more effective by organizing our own, organization and giving the differentiated treatment for the, according to the stages of our agents. So, it is, we expect that it will take time that the effect of those organization takes place, but that is, we hope that that will say improve our productivity particularly the rate of the year. So, all in all, I think 0% to 5% is a very achievable target. Even though, that all of our general economic condition gives us some challenge.

Daniel P. Amos

And I personally called on 13 of the 20 largest banks in January, met with the post office, met with the head of the Shinkin organization, which is the banks that have been producing the most for us. So, I am encouraged with the banks especially. So, I can answer that first and then of course the post office, I was encouraged by our meetings with them as well. Turning to the, does that answer your question about Japan.

Mark Huges – SunTrust

It does thank you. And the U.S?

Daniel P. Amos

And the U.S Paul.

Paul S. Amos II

Despite a difficult environment I think we have a lot of very positive things going on. I want to address the traditional kind of, looking at the business as well as looking at the consumer themselves. From a business standpoint, the fact the matter is that major medical continues to offer less benefits, putting more and more pressure and price on the business to cut costs and at the same time offer their employees benefits that will round out what they need to support their lives. As those costs go down and they continue to take more and more out of the coverages there the need for our products goes in, we have seen that throughout the last year and continuing into this year with strong account growth. Also while we are seeing strong account growth, we have continued to see some deterioration of the number of people purchasing within an account, but we have seen that the people who are purchasing are purchasing more. I believe that we've got a couple of things that would really benefit us this year. Number one is, we have three products; two product provisions, as well as one product new line. We didn't have a single revision or new product in 2008 and we know that was generally a strong driver of our sales activity. And then layered on top of everything that we're doing within our core business we've got some strong strategies, some of which I'll elaborate on in our Financial Analysts Briefing in May, about particularly the broker project. We know that 50% of all American employees work for the top 1% of businesses and as we target the broker market, and specifically the large case market, we believe it gives us an additional opportunity to layer on our traditional business and be able to hit within the target of 0 to 5.

Mark Huges – SunTrust

Okay, thank you.

Operator

Steven Schwartz with Raymond James & Associates. You may ask your question.

Steven Schwartz – Raymond James & Associates

Hi good morning. Jerry, I want to follow-up on the statement about the loss of the $100 million and the $400 million and I think involved with that was a statement that was made that Anglo Irish Bank, Bradford & Bingley and Northern Rock are guaranteed or making good. My understanding is that Northern Rock is making good. My understanding is that Bradford & Bingley have stated that they want to pay off their hybrids, but they are not making payments currently. I don't know what Anglo Irish Bank is doing, but my understanding is that the Irish government, and in fact, neither the U.K. government nor the Irish government are guaranteeing hybrids, and yet you say that nationalization, historically what you've seen, says that this stuff is money good. That was probably stream of consciousness, but can you explain what you're thinking here? I mean it doesn't, everything I've read would suggest that what you're saying is not showing, of course, everything I've read could be wrong.

William Jeremy Jeffery

Well, let me first speak to Bradford & Bingley, if there is a little bit of a, I guess a misunderstanding there. Bradford & Bingley continues to service their hybrid debt instruments. What they have said is that they have not, and the Anglo and the Irish government says something similar. The Bradford & Bingley case, I believe the decision has been made to continue to service those instruments, but they may defer the maturity on those instruments until the senior indebtedness is fully repaid. At that point they will use, they intend to use what remains to satisfy the obligations of the perpetual shares or the perpetual debentures. Anglo Irish, let me speak to that Anglo Irish, let me speak to that one very specifically, Aglo the Irish government put out an FAQ and in that FAQ one of the questions that they put out was I hold an Anglo Tier I hybrid instrument, how will the nationalization affect me? The answer they gave, there should be no impact on your Tier I I’m reading this hybrid instrument, Anglo will continue to service it's obligations to you under the instrument IE to make coupon payments and blah, blah, blah. It goes on, I can give you the whole speech if you would like.

Steven Schwartz – Raymond James & Associates

Okay Jerry, if I can interrupt so as long they are making the payments if they it doesn’t matter if they extend out the redemption vis-à-vis the OTTI process as long as they are making the payments that they are supposed to be making till that time.

William Jeremy Jeffery

Well I think that now you are really talking about a different question, which is how would we then react. If we thought there was a high likelihood that the final repayment would be extended. In the case of a Bradford & Bingley we haven’t.

Steven Schwartz – Raymond James & Associates

Yeah I know you don’t have any of these.

William Jeremy Jeffery

But we haven't had to do that analysis, but were we to have to do the analysis, we would then ask ourselves all right do we think it's likely that we won't get that principle back at maturity. If we think it is likely, then we would impair it. Even though we continue to be receiving this coupon stream. So, and that's consistent with how we look at all our securities.

Steven Schwartz – Raymond James & Associates

Okay. So, whether you get it at the initial redemption date or some later redemption date it doesn’t matter, maybe Kriss wants to talk to that as long as you think you are going to get it?

Kriss Cloninger III

Well as long as we know we are going to get or we have a degree of confidence we are going to get it. And that we can predict with some likelihood as when we will get it. Then the decision would be not to impair.

Steven Schwartz - Raymond James & Associates

Okay.

Jeff Jeffrey

As you know, there's -- there are several variables that go into our impairment.

Steven Schwartz – Raymond James & Associates

Right. And if I can ask a quick other question on just the operations, do you guys have any thoughts on persistency? That's an issue that's come up to me lately. People have been asking about persistency and thoughts on that if things get really bad in the economy both here and in Japan?

Kriss Cloninger III

We have seen some modest declines in persistency, both in the U.S. and Japan, in the second half of '08. Well, we measure it through the premiums and force. We see it through slightly increased amortization charges. I guess it is partly a function of the economy. As you say, we went through 2008 first part of the year with the higher gas prices and then that moderated some and moved into the financial crisis in the second or the fourth quarter anyway. So, we are seeing some effect on that. We do believe, we've been relatively recession-neutral in the past. But clearly this is a severe situation and we do know that people tend to want to keep insurance they have in this kind of environment particularly if it's not terribly expensive, which ours isn't. So, that’s what's benefited us in the past, and we believe that it will influence consumers when they evaluate whether or not to continue their insurance.

Daniel P. Amos

And let me make a comment about Japan. We have not really ratcheted it up talking to our existing policyholders about persistency. But we’re now going to investigate. There's been no major change. Remember, in Japan our policies in Japan our policies are age specific.

Steven Schwartz – Raymond James & Associates

Right.

Daniel P. Amos

So, if you buy it and then you lapse it, if you rebuy it it's a much higher price. So, there's a real incentive to keep the policy in force, and although we're age banded in the U.S. and you don't want to go into that next band, the age-specific really works through our advantage of trying to get them to keep it in force. And so I'll be real curious as we work on this, doing a few little things in Japan, to see if it levels out and my hope is that it will.

Steven Schwartz – Raymond James & Associates

Japan has moved from a model of I guess at least from sales, maybe not in force, I don’t remember the numbers from people buying at the employer, your large employers to people buying on their own, I guess. Does that change the dynamics of persistency in a bad economy one way or another?

Daniel P. Amos

The employer, the corporate agencies probably has the highest persistency, Kriss can answer to that a little bit more so but age affects it, several other things affect it, but it is not anything significant, but a little bit more so. Kriss?

Kriss Cloninger III

Well, to tell you the truth, Steve, I really thought persistency was not going to be as good with the non-corporate agency business, but it’s pretty darn close. It's ben surprisingly close to me I expected the people not paying on the corporate payroll plan to not persist, as well, but that's turned out not to be the case. Let me remind you that I think earlier in 2008 probably in the first or second quarter, we talked about the effect of having a high, well a relatively higher percent of our in force business in Japan move into the retirement ages of 55 to 59.

Steven Schwartz – Raymond James & Associates

Right.

Kriss Cloninger III

There and that caused a blip up in lapse rates during 2008. We expect it will continue about at that same level throughout 2009 in Japan, so that seems to be our major movement in Japan. U.S. we just saw a slight blip up, I think, so far in the fourth quarter of '08. And let me remind you, from a financial reporting point of view though that the impact of lapses on profitability is relatively neutral in Japan. We have deferred costs we write off, we have our policy reserves we release. We have in Japan some cases cash values we pay out, like modest cash surrender values on the Japanese business. That applies to our older business, not so much our newer business. For our newer business in Japan and our total business in the U.S., we don't have any cash values in the policy. So, when people leave us, it's like a windfall to us profitability wise in the sense that we release the full reserve with no payment of cash. We do have write off the deferred cost, but we tend to generate excess profits in the U.S., and again, neither poorish or profit or it's unusual, it's a loss, in Japan. So, increase in lapses slows long-term growth rates, but it tends to improve current period profitability is what I'll leave you with.

Steven Schwartz – Raymond James & Associates

Okay, thanks Kriss.

Kriss Cloninger III

Okay.

Operator

Colin Devine with Devine. You may ask your question.

Colin Devine – Devine

I guess I have a new firm I did not. A couple of clarification and then a question. First, Dan, I believe you said that AM Best affirmed the ratings and I'm looking at a press release from last night that said the financial strength ratings were affirmed, but the issuer credit ratings were downgraded, so perhaps you can just clarify that for everybody?

Daniel P. Amos

I said the financial ratings.

Kriss Cloninger III

Yes, that's correct.

Daniel P. Amos

That's good. That's correct. But the financial ratings is what I was talking about and that's what our agents look to and that is what I was going back.

Colin Devine – Devine

Okay. And then secondly on the value of the hybrid portfolio, that's clearly driven the decline in the stock. I just want to be clear on what you gave as the indication for the decline year-to-date. I thought I heard 9%, and I just want to check, is that on the $8 billion or the $9 billion, that it's down or a portion of its if we could get some clarification obviously, that's a key one for everybody. I'd also like on the Kriss, a little more explanation on the concentration issue. It's obviously driven a couple of downgrades here. I'm looking at page 13. You said it's 5% of statutory capital is the hard limit. You've had it for five years, and yet every one of those 30 positions is above it. In fact, number 30 is at about 80% above your limit. What's going to be done clearly to accelerate this situation since it's a ratings problem? And then, if we could come to the incurred premiums, or current claims to premium ratio, if we could just touch on that for both Aflac U.S. and Aflac Japan, since they both hit an all time record this quarter? Thanks.

Daniel P. Amos

Okay, well, let's try to take it one at a time. Let's see, what was first.

Kriss Cloninger III

It was so long ago I've forgotten, but I think it was to get a little more color behind the year-to-date valuation on the portfolio?

Colin Devine – Devine

Correct, I mean clearly that's driven a 50% drop in the stock, so how much is the hybrid portfolio down year-to-date? You said 9% on what?

Kriss Cloninger III

9% on the $8 billion of fair value.

Colin Devine – Devine

Prefect.

Kriss Cloninger III

Do your math of the $8 billion.

Colin Devine – Devine

Yes, just want to confirm.

Kriss Cloninger III

Yep.

Colin Devine – Devine

On the concentration change?

Kriss Cloninger III

Regarding concentration change, those are all legacy positions, Colin. Virtually, all the 5% of tax refers more to new positions over the last five years

William Jeremy Jeffery

Let me make one comment, too, Colin. Some of those top 30 exposures were the result of consolidation to, it was not as the result of an increase in purchases by us.

Colin Devine – Devine

I guess it's just that number 30's not even close for the limit, Jerry, that's kind of the point?

William Jeremy Jeffery

Well, it's magnified by the yen as well, Colin. The other thing, Colin, that I would remind you that we have not added to any of those positions for a considerable period of time and really don't intend to.

Colin Devine – Devine

Okay. Then if we can go to what's going on with the businesses, that's what you want to talk about, what happened with the incurred claims to premium ratios, for both Japan and the U.S. all-time record highs as far as I could trace it back?

Kriss Cloninger III

All right. Let me look at the facts here just to bring them back to my mind. There wasn't a lot going on, Colin. There was some true up. We always have fourth quarter true ups, both in Japan and the U.S., when we're trying to - I think historically or in Japan, let's okay we are looking at 63.6% of revenue.

Colin Devine – Devine

I'm focusing on premiums where we had about a 500, 600 point jump, but as I say, it's the highest it's ever been. Is something changing over there with what you're doing, because it's in both of them, but the fact is it's, as far as I can tell these are record numbers. What happened this quarter?

Kriss Cloninger III

All right. Basically, the answer is, no, nothing's going on, nothing's changed. I'll say in the U.S. that what's influencing us there is a block of business called a platinum plan that we've addressed before, that we have a big payout of cash at the end of 20 policy years. It's been a so-called building benefit. It's similar to a return premium policy, where you get a big cash payment at the end of 20 years, and we're starting to see the maturities of those 20-year policies in U.S. So, relative to cash, that's going to cause a big jump in incurred claims as we pay out that cash. Now, we have a commensurate release of policy reserve that should fully offset it. We've been a little bit short on our reserve versus our cash payouts and we've known that, but under our accounting rules they are being strictly enforced regarding lock in, we're not allowed to increase our policy reserves to reflect that increased estimate of claims that are going to be paid out in '08 and '09 and a little bit in '10. Now, it's not going to kill us as far as earnings. We've got favorable developments in some other blocks, but that caused the influence in the jump up of incurred claims to premiums in the U.S.. In Japan, I don't look at claims to premiums over there, Colin, because policy reserves are such are such a big element of our benefits there, we have got longer-term liabilities in Japan and we have stronger policy reserves and then aging business and the like, and really what caused the part of the or substantial part of the increase in the fourth quarter, benefit ratio to revenues was the effect of yen strengthening on dollar-denominated investment income suppressing our revenue number. We showed a ratio of benefits to revenues at 63.6 it would have been 62.7 on a constant currency basis, which was in line with the prior quarters, and overall we were in line with the benefit ratio improvement guidance for the year, both in the US and Japan.

Colin Devine - Devine

Okay and maybe I will come back with calendar that just says at one thought. Given the issue hybrids represent and the fact we are going to disclose every single one of them in the statutory blanks when they come out, would it be possible to get a list of those early so that everybody can value them, put their own number on it and you can get some rationality back in your stock price.

Kriss Cloninger III

Colin, I think if you look at the 2007 schedule.

Colin Devine - Devine

Well I have it.

Kriss Cloninger III

Okay you may refer that it really hasn’t changed.

Colin Devine - Devine

Well there were few in the fourth quarter that’s I think it might be handy to update it.

Kriss Cloninger III

Well, okay. The Iceland Banks, of course, would be scoped out. Beyond that I defer to Ralph as to what would you do.

Ralph A. Rogers Jr.

There haven’t been any additions in the portfolio.

Kriss Cloninger III

There have been no additions.

Colin Devine - Devine

Okay.

Ralph A. Rogers Jr.

We haven't bought any in three years.

Colin Devine - Devine

Thank you.

Ralph A. Rogers Jr.

Okay, that's. And by the way, Colin, that point to just, we will be elevating PDFs of our blue books, both historically and the ’08 book when its available just to make a little bit easier for those of you who want to review that information. And my understanding, is well, in working through our Chief Accounting Officer is that the perpetual debentures right now that are largely classified as preferred instruments on stat blank will be moving

to debt instruments in terms of categorization.

Colin Devine

Okay, thank you.

Kenneth S. Janke, Jr.

Audra, we're at the top of the hour, can you tell me – we are going to have a presentation tonight, so for those of you that are in New York. We hope you can you be there to ask more questions this evening, but can you tell me, out of how many more we have in the queue right now?

Operator

Currently there's nine

Kenneth S. Janke, Jr.

There's nine. Well, lets take a couple of more, we are at top of the hour. We'll take a couple more questions before we cut off because we actually have to travel ahead to New York very shortly.

Operator

Thank you, Eric Berg with Barclays Capital. You may ask your question.

Eric Berg – Barclays Capital

Thanks, a couple of real quick ones. You told us in this call that with respect to the debentures they're currently worth, I emphasize currently, taking into consideration year-to-date pricing, roughly, 80% of amortized cost. My question, if we were to look beneath the surface at your individual security-by-security pricing, what would we find in particular, are there any securities trading at less than 50%, and any securities trading at less than 30% of cost? And then I have one follow up.

William Jeremy Jeffery

The answer is yes to both questions I don’t have the specific percentages for those two questions, but we certainly have those numbers.

Eric Berg – Barclays Capital

Okay, my second and final, thank you I will follow up with Ken regarding additional detail. My second and final question relates to CDOs. There has been, as everyone knows, a broadly-based deterioration or widening of credit spreads, although admittedly credit spreads did narrow in the month of December after widening dramatically in the months of October and November, and my sense is that, credit spreads really across the spectrum ended the quarter significantly that may started the quarter. My question on the CDOs is, what is structurally different about the ones that you have not impaired from the CDO impairments that you took in the December quarter? Why do we have 500 hours of unrealized losses that you believe will remain temporary to a 77 million?

William Jeremy Jeffery

Well, I think that the most important variable that we look at and the thing we really focus on when we look at our CDO holdings, is, a) of course, how much subordination is in each CDO that we own and b) looking at each and every credit exposure underlying the CDOs, and aggregating those risks, what is the overall default expectation. In other words, how many default can should we expect from the portfolio given their current credit conditions. And if we find that the number of defaults that we would expect over the life of the instrument brings us close to our and I used to emphasize close to our subordination, not through it. We will then recommend impairment. As long as, but we do look at it from other aspects, as well. We do look at price and we do look at other data. But the real driver is our default expectation.

Eric Berg – Barclays Capital

So, the answer, in other words, what you are saying is, there is something structurally different about these CDOs that you have not impaired?

William Jeremy Jeffery

No there is nothing structurally different. Our CDOs are very uniform in how they are structured.

Unidentified Company Representative

It's the underlying reference are they.

William Jeremy Jeffery

We look at the underlying reference entities, and pre-determine that in the aggregate that those reference entities have deteriorated to the point where there is a significant risk that that we're going to loose principle then we will impair the CDO. So, it's a very the decision is made individually security-by-security.

Eric Berg – Barclays Capital

So you are saying in other words, that your position in the cost structure of the CDOs is fairly similar, what differs from CDO to CDO is, or from tranche to tranche that you own is the, your position is on the underlying referenced corporate debt?

William Jeremy Jeffery

Yeah I think that’s a very good way of putting it.

Eric Berg – Barclays Capital

Thank you, okay.

Daniel P. Amos

Just in layman's terms I think of actual defaults incurred in the reference names. Certain defaults and certain CDOs and we have had more and sound than others, and the ones we've had more defaults in are more likely to be written now.

Paul S. Amos II

Well it's Paul, Eric. And as there's more to it than that but that’s certainly an element.

Eric Berg – Barclays Capital

Thanks to both of you.

Operator

Ed Spehar with Banc of America/Merrill Lynch.

Ed Spehar - Banc of America/Merrill Lynch

Thank you good morning two quick questions. Jerry can you give me any – any indication of potential ratings changes on hybrids, what portion of yours are on negative watch or outlook or any color on that. And Kriss can you give us any sense for I mean I know this is going to be rough may be, but an expectation for what required capital might be at year-end ’09 at the company actual level assuming no material change and ratings on the fixed income portfolio because I know you did give us an outlook for year-end 09 stat capital thanks.

William Jeremy Jeffery

The first question I think is, has to do with ratings distribution what I can give you right now it is ratings distributions as of January 30 versus ratings distributions as of December 31 for the hybrid portfolio. We have had one name that has been downgraded from single A to BB. It's actually split rated, but we are carrying it at BB and that's Royal Bank of Scotland. Aside from that we've had a minimal number of ratings changes. So the ratios looked are as follows. Our the number of securities we have rated A or better is still over 92% our below investment grade exposure's risen from 1% to 4.75%. But aside from that there's been very little, I don't have at hand the watch list, but I will try to get that and have it for you by the time we will get to New York.

Kriss Cloninger III

Okay, Ed, regarding capital, we anticipate that at current exchange rates required capital will probably go up around 10% next year, and if we earn what we expect to on a statutory basis just from core operations, don't have any more investment realized losses, our RBC should be in excess of 500% clearly and probably 525% or better. So, that’s kind of where we are.

Ed Spehar - Banc of America/Merrill Lynch

Thank you very much.

Kenneth S. Janke, Jr.

Audra, again we are going to have to leave shortly so let's take one more question then for those of you again that are in New York please join us this evening and share those questions with us if you are not going to see, you please feel free to e-mail them to either Rob or myself. Audra lets take one more?

Operator

Thank you. Dan Johnson with Citadel, you may ask your question.

Dan Johnson – Citadel Investment Group

Great thank you very much, just a follow up on the last one. In terms of the downgrades for the month of January is it just RBC was the only one.

William Jeremy Jeffery

RBS

Dan Johnson – Citadel Investment Group

RBS, thank you. I thought we have seen some action on Dexia and maybe a few others out of.

William Jeremy Jeffery

I'm sorry. What I was referring to you was we only had one that was downgraded to below investment grade. Dexia did receive ratings action but it was, it is still, that is now carried at split rated, and we are still carrying that as an investment grade holding.

Dan Johnson – Citadel Investment Group

Okay but for S&P it was below investment grade?

William Jeremy Jeffery

Correct and in the case of RBS again that had two below investment grade and still and still carried a single A on by one of the rating agencies so but we elected to begin carrying that as below investment grade

Dan Johnson – Citadel Investment Group

And was there one other one that had been downgraded in January, or are those the two big ones, or is that something else caught my eyes?

William Jeremy Jeffery

Fortis was also had.

Dan Johnson – Citadel Investment Group

Fortis. Thank you, that was done.

William Jeremy Jeffery

Correct.

Dan Johnson – Citadel Investment Group

And how are you handling that?

William Jeremy Jeffery

At the moment we are carrying that as investment grade as a BBB investment grade.

Dan Johnson – Citadel Investment Group

All right okay. And then finally we have got debt coming due in the near term I believe. Can you just talk about when that is and what the plans are. Thank you very much.

William Jeremy Jeffery

Well, we originally issued $450 million of senior notes in U.S. dollars. We swapped them to yen. The yen equivalent's roughly 54 billion or 55 billion yen. We plan to refinance them, either with bank debt or with the public issue we were widening until we have the year-end results in hand and we will get to work on explicitly what we intend to do. In the event we couldn’t refinance them we could repay them with internal capital, but its our preference to refinance them using bank or public market debt primarily, hopefully yen dominated but dollar denominated is an alternative.

Dan Johnson – Citadel Investment Group

Would that internal capital include using existing lines of credit or more literally just cash?

William Jeremy Jeffery

Literally cash.

Dan Johnson – Citadel Investment Group

Great thanks very much I'll save the rest for tonight.

William Jeremy Jeffery

Okay.

Kenneth S. Janke, Jr.

Thank you again for joining us, again. If you want to send us an e-mail, if you have anything immediate, we'll return that as quickly as we can. Otherwise many of you, we'll see this evening. Thank you.

Operator

This concludes conference call. Please disconnect at this time.

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Source: Aflac, Inc. Q4 2008 Earnings Call Transcript
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