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Aflac Incorporated (AFL)

Q1 2009 Earnings Call Transcript

April 30, 2009 9:00 am ET

Executives

Ken Janke – SVP, IR

Dan Amos – Chairman and CEO

Kriss Cloninger – President and CFO

Jerry Jeffery – SVP and Chief Investment Officer

Paul Amos – President and COO

Analysts

Jimmy Bhullar – J.P. Morgan

Steven Schwartz – Raymond James and Associates

Suneet Kamath – Sanford Bernstein

Colin Devine – Citigroup

Andrew Kligerman – UBS

Darin Arita – Deutsche Bank

Randy Binner – FBR Capital Markets

Jeff Schuman – KBW

Operator

Good morning and thank you for standing by. At this time, all participants are in a listen only mode. After the presentation, we will conduct a question-and-answer session. (Operator instructions). Today's conference is being recorded. If you have any objections, you may wish to disconnect at this time. I'll now turn the meeting over to Mr. Ken Janke, Senior Vice President of Investor Relations. Mr. Jenke, you may begin.

Ken Janke

Thank you, Susan, and good morning everybody, and thanks for joining us today for our first quarter conference call. With me this morning is Dan Amos, Chairman and CEO; Kriss Cloninger, President and CFO; Paul Amos, President of Aflac and Chief Operating Officer of our US operations joins us from a national sales convention; Jerry Jeffery, Senior Vice President and Chief Investment Officer, and Tohru Tonoike, who is President and COO of Aflac Japan joins us from Tokyo.

Before we begin, let me mention the safe harbor. I would like to point out that some of the statements in this conference call are forward-looking within the meaning of Federal Securities Laws. Although we believe these statements are reasonable, we can give no assurance they will prove to be accurate because they are prospective in nature. Actual results could differ materially from those we discuss today. I would encourage you to look at our recent quarterly press release for some of the various risk factors that could materially impact our future results.

Now, I’ll like to turn the program over to Dan to comment on the quarter and also the balance sheet and the outlook for the United States and Japanese operations. I will follow up with a few financial highlights, and then we'd be happy to take your questions. Dan?

Dan Amos

Thank you, Ken. Good morning and thank you for joining us. Hope you had a chance to review our first quarter press release. I will comment on our operations in Japan and the United States but first I would like to discuss our balance sheet and capital position at the end of the quarter. As we mentioned in our press release yesterday, we elected to early adopt the new mark to market accounting. Although we did not get any relief on the pricing site, we believe the changes regarding impairment charges supports the long view of price recovery that we have held for many years.

We believe analyzing Alfac's investment portfolio and potential other than temporary impairment for the long-term perspective makes sense. This long-term view reflects the way we approach and manage the investments supporting our policy liabilities. Our policyholder liabilities have long durations, particularly in Japan. As such we purchased long-duration assets to support those liabilities. Due to our asset liability matching approach and very strong predictable operating cash flows, we have the ability and intent to hold the securities until they recover in value, which may be at their maturity. As a result, our approach has always been to take impairment charges for debt securities only when our credit analysis indicate we are unlikely to receive contractual interest and principal payments. We believe the robust accounting guidance supports that view.

We did incur some credit losses in the first quarter. However at 152 million, they were manageable given the strong capital generation of our business. I do want to point out that 42 million of the charges on perpetual securities resulted from the application of equity impairment approach, because they were downgraded to below investment grade. The impairment of perpetuals did not affect our statutory financial statements, as we continue to believe we will receive interest and principal payments that are contractually due. If the pricing of the perpetuals remain unchanged as of March 31 levels, and there are no additional downgrades to below investment grade, we would expect to book 295 million of impairments during the remainder of the year under the equity impairment method.

I want to emphasize two points. First, these charges would not impact GAAP shareholder equity. And second and most important, we would not record impairment charges for statutory accounting purposes. Overall, I remain pleased with the quality of our balance sheet. As you're well aware, the pricing for fixed maturities have deteriorated significantly since year-end. That resulted in a sharp increase in unrealized losses in our portfolio and a decline in the shareholder equity. However, because we hold our investments until maturity, the unrealized losses will not be realized if our credit analysis is correct, which we conclude the investment is good money.

Again, we believe this view is fully supported by the recent changes in the mark to market accounting. Despite the ongoing decline in the global credit quality, the credit profile of our investments remain high. I'm sure you're not surprised that we experienced credit downgrades in our holdings in the first quarter. However, at the end of March, 95% of our fixed maturities in perpetual securities were investment grade compared to 98.2% at year-end. At the end of March, 86% of the perpetuals securities were investment grade.

In addition to monitoring the overall credit quality of perpetuals securities in our portfolio, we are continually assessing deferral and risk extensions. Other than the securities of the Icelandic banks that we wrote off in the fourth quarter, everyone of the perpetuals securities we own is current on interest. We do own 102 million of fixed maturity upper tier 2 securities of an Austrian bank that deferred its coupon in the first quarter. That bank, Communal Credit, was contractually required to defer payment due to profitability test. The coupons on the securities are cumulative and additionally they provide interest on top of the coupon. Based on our extensive work on this credit, we continue to believe we will receive all interest payments and principals, and as a result we did not impair these bonds.

I would also like to point out that we have not experienced any extension of principal at this point. You will recall that in the fourth quarter of 2008, we had three separate hybrid securities redeemed. On April 22 of this year, KBC Bank redeemed its upper tier 2 securities we own. For the balance of the year, we have four perpetuals securities totaling 235 million that are expected to be redeemed. As you're aware, the senior notes issued in 1999 matured earlier this month. It has always been our preference to refinance the notes in the debt market to preferably the Samurai market in Japan. However, due to the financial crisis, debt markets have been effectively closed to financial names, especially those without government guarantees.

In addition, we are sensitive to the current interest rate costs and we are not willing to issue debt with excessive coupons. As a result, we elected to repay our maturing obligations using internally generated funds. We accomplished this through a loan from our principal life insurance subsidiary American Family Life Assurance Company to the parent Aflac Inc. It is important to note that the loan is an admitted asset on the insurance subsidiary's booked under statutory accounting principles. As a result, it does not negatively impact our RBC ratio. The loan has an annual interest of 7.13% and a term of three years with a provision for early repayment.

Although the loan has a three-year term, we view it as short-term financing until the credit markets improve. At the time, our preference remains exploring the debt markets for longer-term financing. I would like to point out that the senior notes that matured were originally issued with a notion of about 450 million at 6.5% annual interest rate. We entered into a cross currency interest rates swap to convert dollar obligations into yen denominated notes at 55.6 billion yen at a 1.67 annual rate. By doing so, we estimated that we saved more than 200 million in interest payments over the life of the senior notes, which is almost twice the cost of the foreign exchange portion of the swap contract. The total cost of the swaps was 106 million. Our debt issue to mature occurs in July of 2010. Although that is more than a year away, we are already exploring options to satisfy the 40 billion in obligation.

I continue to believe our regulatory capital position remains very strong. Our risk-based capital was 477% at the end of the year and I consider that number to be very impressive in light of the negative effect of the 25% strengthening of the yen dollar in 2008, as well as elevated credit losses for last year. Although we have not yet completed our statutory accounting for the first quarter, we believe the capital position remains very strong. We estimate that the RBC ratio was 479% at the end of March.

I would like to assure you that our primary focus remains on Alfac's capital position. In fact every officer's incentive compensation for 2009 has a component link to maintaining the target of RBC ratio of 375. We recognize that shareholders are laser focused on capital adequacy and I believe it is important for our officer group to be aligned with those interests. At the same time, I want to ensure that we continue to concentrate on the business of running Aflac's core operations. Therefore, we are still using other important incentive compensation methods, such as traditional premium, sales, expense growth. Additionally, we used the RBC ratio as the only measure for our performance based restricted stock that were granted to the section 16 insiders this year. To earn these equity awards when they best in three years, we will have to maintain a targeted RBC level.

Maintaining our shareholder dividend is also directly related to the statutory capital position and our ability to upstream funds the parent company. Based on the current results and expectations for capital generated in 2009, we do not expect any change to this year's dividend. Our statutory capital generation in the first quarter was strong. We estimate first quarter's statutory operating income exceeded $500 million. We believe it is important to many of our owners that we continue to pay the dividend. However, if deterioration in investment portfolio produces stress on our statutory capital position, we will certainly look to a modified dividend as a means of conserving capital.

Now let me turn to a brief review of the operations beginning with Aflac Japan. Aflac Japan performed very well both from an operation and a financial perspective in the first quarter 2009. Although sales are basically flat in the quarter, we were encouraged by our results in the first quarter. In the first quarter of 2008, we produced strong sequential sales growth from the new bank channels. In the fourth quarter, sales of all insurance and investment products at banks fell sharply with the emergence of the financial crisis. And bank third sector products including Aflac's were not immune. However in the first quarter of 2009, sales through the bank channels recovered some of the pricing, 5.2% on a sequential basis. Compared with the start of the banks channel sales in the first quarter of last year, sales were up 265%. At the end of March, we had selling agreements with 250 banks, which is significantly greater than the next closest company selling through banks. We continue to believe that the bank channel is a great opportunity for distribution of our product and we expect further improvement in this channel as the year progresses.

We were also pleased with the sale of cancer insurance, which was up 7.4% for the quarter. Cancer insurance sales benefited from the new sales channel or the bank channel and Cancer Forte upgrade products we began offering last year. While medical sales were down 5.4% in the quarter, ordinary products 1% [ph]. We introduced two new life products in the first quarter. We think consumers will find these new first actor policies appealing. We also believe it will better position us to offer our primary third sector products in the future.

In addition to launching new products, we expanded our reach through the recruitment of new agencies. In the first quarter, recruitment was up 35% over last year. We believe this increase reflected improved recruiting techniques as well as weak labor market in Japan. More importantly, we believe we can provide appropriate training that will turn recruits into producers. We continue to view Japan as a very good market for the types of products we offer. Although Japan's weak economic will certainly pose challenges, we still think the sales range of flat to 5% increase for the year is reasonable.

Not surprising, Aflac US also faced challenges selling insurance in a weak economic environment. During the first quarter, total new annualized sales were down 6/10 of a percent. As we pointed out in the press release, we had six additional production days in the first quarter due to the moment in the production calendar. With the benefit of the extra days, sales would have been down approximately 6.5%. Despite the weak sales environment, we still produced premium income of 1.1 billion in the first quarter, an increase of 5%.

As we assumed in our financial projections for this year, the persistency rate for the US business declined. Our first quarter persistency rate was about 98% of our planned assumption. Virtually all product lines and various policy durations showed higher lapses. That tells us higher lapses rates are directly linked to the recessionary environment. We believe our coverage is affordable for the average American family, yet we realized in these times and hardships, families have difficult choices to make. I would like to point out that the lapsation did not hurt Aflac US earnings. However, the lapse rates this year do put pressure on US premium and earnings growth in 2010.

Like last year, we remain encouraged with the basic sales related activities of the US operations. The current labor market has provided good opportunities for expanding our commission sales force based on salaried jobs being on the comeback. In the first quarter, recruitment of new agents was up 25% to 8,100 new sales associates. The average number of weekly producing associates increased by 2.4% in the quarter and the average number of new weekly producers rose 12.1%.

New payroll account growth was also up solid 9.9% over the first quarter of 2008 and payroll accounts opened by new agents was up 18.1%. We remain convinced that we have strong business model in the United States and we believe there are tremendous opportunities for our product line. We expect the US sales and persistency will continue to be influenced by the weak economic conditions. And although a challenge, we currently believe it is possible to produce flat sales to a 5% increase this year.

From an earnings perspective, our objective remains 13% to 15% increase in operating earnings per diluted share in 2009 excluding the impact of the yen. But I want to remind you that my number one priority is capital position. Our capital position remains strong yet with credit markets remaining distressed, I think it is unlikely that we will purchase shares in 2009 even though we finds the valuations very attractive. With no share repurchase, we would expect earnings growth to be at the low end of the 13% to 15% range, which is consistent with the comments on the fourth quarter conference call.

Overall I believe we remain well positioned in the two best insurance markets in the world from a competitive standpoint. Our operations are performing well and our balance sheet is strong. Although we remain in very challenging times, I have great confidence in the future of Aflac. Ken?

Ken Janke

Thank you Dan. Before we get to your questions, let me briefly go through some of the first quarter numbers starting with Aflac Japan. Total revenues rose 3.3% in the quarter ending in yen terms. Investment income was up 0.5%, which was held back due to the impact of the stronger yen and Aflac Japan's dollar-denominated portfolio. Excluding the effect of the stronger yen, investment income was up 4.6%.

The annualized persistency rate excluding annuities in the first quarter was 93.9% compared with 94.4% in the first quarter of 2008. As we previously discussed, we believe the persistency was impacted by a higher proportion of the population and our customer base reaching retirement age. In addition however it is clear that the weak Japanese economy has also influenced policy retention.

In terms of quarterly operations ratios, the benefit ratio continued to improve as we had expected. It was 61.5% in the quarter compared with 62.4% a year ago. Excluding the impact from the stronger yen investment income, the benefit pressure would have been 61.3%. The expense ratio for the quarter was 19.5 compared with 19.6% in 2008. Expenses overall were in line with our plan and debt amortization was higher due in part to lower persistency.

Reflecting the lower benefit in expense ratios, the margin improved from 18% to 19% in the quarter and with the expansion of the margin, pretax earnings were up 9.3% in yen. Again, excluding the impact of the stronger yen on the dollar-denominated portfolio, pretax earnings were up 11.2% in the quarter. For the first quarter, we invested our cash flows in yen securities at 4.13% and including dollars, the blended rate was 4.57. The portfolio yield at the end of March was 3.87 which was down three basis points from December and 12 basis points lower than a year ago.

Turning to Aflac US, revenues rose 4.7% for the quarter. The annualized persistency rate for the three months was 66.9% compared with 71.9. As Dan mentioned, the economy has undoubtedly influenced our lapse rates. I would like to remind you that was an annualized rate and our first quarter is generally the lowest quarter in terms of persistency. On a rolling 12 month average basis, the rate was 71.9 versus 73.6% for the prior period. For Aflac US operating ratios, the benefit ratio was 49.5%, down from 52.4% in the first quarter of 2008. The decline in the benefit ratio reflected the release of reserves related to the higher lapsation.

Higher lapse rates also increased DAC amortization which rose 32.8% in the quarter and that was largely responsible for the increase in the operating expense ratio rising from 31.4% to 33.9%. The margin expanded and was 16.6% in the quarter compared with 16.2% a year ago. And as a result, pretax earnings rose 7.2%. Although we did not have a lot of cash flow go into new Aflac US investments, the new money yield for the quarter was 8.67, up from 7.03 a year ago. And the yield on the portfolio at the end of March was 7.18 which is up eight basis points from the fourth quarter and 17 basis points higher than a year ago.

Looking at some other items, non-insurance interest expense was unchanged at $7 million in the quarter. Parent company and other expenses were $8 million, down from $10 million a year ago. Total operating profit margins rose, reflecting the improved profitability of Aflac Japan and US. The pretax margin rose from 17% to 18.1% and on an after-tax basis the margin 11.8 up from 11.1. The tax rate was unchanged at 34.7%.

We did generate $0.32 per share in operating or realized gains in the quarter, which is we said we trigger to offset tax losses we had previously booked. We also had $0.33 per share of realized losses which combined with those gains resulted in a net realized loss of a penny in the quarter.

We also purchased some of our yen denominated corporate debt in the quarter. We brought back 5.4 billion yen of bonds at a purchase price of 3.86 billion yen or about 71% at par. The extinguishments of this debt resulted in a $10 million gain in the quarter or $0.02 per diluted share. As we reported, operating earnings on a per diluted share basis rose 24.5% to $1.22. The stronger yen in the quarter increased operating earnings by $0.09 cents per share. And excluding the yen's impact, operating earnings per share increased 15.3% for the first quarter.

I would like to comment on the outlook for operating earnings. As Dan mentioned, our objective is 13% to 15% excluding the impact of the yen on a per diluted share basis. However, as you heard, it is more likely it would be toward the lower end of the range this year as we do not anticipate purchasing any shares in 2009. A 13% increase would translate into $4.51 in operating earnings per share for 2009, assuming the same exchange rate. And although the yen has weakened to the dollar since last year, the average so far this year which is about 95 yen is still stronger than it was a year ago.

If we assume the yen averages 100 to 105 for the full year, we would expect to report operating earnings of $4.47 to $4.59 per diluted share for 2009. And under that same currency scenario, we would expect second-quarter operating earnings per share to be $1.11 to $1.14. The current first call estimate for the second quarter is $1.15. I hope you will all attend or listen to our 2009 analyst meeting which will be coming up in just a couple of weeks. At that time, we will discuss our outlook for 2010 earnings targets.

We would like to take your questions now. We have about 35 minutes to do so. I would hope you would just ask one question so we can make sure we get to everybody. Susan, with that I'll turn it back to you for the Q&A.

Question-and-Answer Session

Operator

Thank you sir. We will now begin the question and answer session. (Operator instructions). Our first question comes from Jimmy Bhullar, J.P. Morgan. You may ask a question.

Jimmy Bhullar – J.P. Morgan

Hi, thanks. Good morning. I had a question on your persistency in both the Japan and US businesses, obviously it declined a decent amount in the US. It seemed like it was lower in Japan also. What do you attribute this to? You mentioned the weak economy in the US, but what do you attribute the Japanese decline to? And if in fact you do expect a further decline, how does that impact your view of your growth rate longer term?

Kriss Cloninger

This is Kriss Cloninger. In Japan, I think Ken mentioned that we're experiencing slightly higher lapses due to some demographics that are going on in Japan. We have a high concentration of old business that is going through the typical retirement ages in Japan between attained ages 55 and 60 and we had an extraordinarily high amount of business start to impact in this last year, went up – the lapse rate went up about 0.5% last year and it continued to go up a little bit this year. We expect to stay at that elevated level throughout 2009 and then to gradually decline in 2010 and later.

That doesn't have a really material impact on our Japanese growth rate longer term. So I don't – there is some impact of the economy on Japanese persistency but I don't think it is significant. I think the impact to the economy is much more significant in the US where we saw a more uniformly distributed increase in lapses across the entire spectrum of our business. Be it by issue age or product category and the like, we just had increases in lapses at all policy issue ages and the duration and categories of business. So that was more pervasive and related to the general economy.

Jimmy Bhullar – J.P. Morgan

And do you think this is a representative quarter in terms of the rest of the year or are you seeing – do you expect to see a further increase in lapses as the year goes on in the US?

Kriss Cloninger

Well you tell me what the economy is going to do and I will tell you what I expect. You know I think the first quarter was very bad from my perspective. I will tell you that Aflac's lapses tend to be higher in the first quarter than any other quarter for the year and the way we annualize quarterly number tends to magnify extremes. When you look at persistency measures in the second, third and fourth quarter, it is going to be cumulative, based on what's has happened so far. But the first quarter get to annualize based on the first quarter numbers. So you know it is really hard to tell whether the economic conditions are going to moderate or improve at all in the US for the next couple of quarters. So you it is not beyond belief that we would continue at this level for another couple of quarters in 2009.

Ken Janke

And again I want to remind you that when we discussed our outlook for 2009 and our modeling assumptions, we had assumed declines in persistency for both the US and Japanese segments.

Jimmy Bhullar – J.P. Morgan

Thank you.

Operator

Our next question comes from Steven Schwartz, Raymond James and Associates. You may ask your question.

Steven Schwartz – Raymond James and Associates

Hi. Good morning everybody. Kind of related here, Dan, I think it was 295 million numbers that you put out there for perpetual GAAP impairments, it has been staying the same. Was that pre or post tax or the same – is there a tax offset there?

Dan Amos

That is after tax, Steve.

Steven Schwartz – Raymond James and Associates

Okay. So the pretax would be 295 divided by 0.65?

Dan Amos

Right.

Steven Schwartz – Raymond James and Associates

Okay. And is there still on a, Kriss, on a statutory basis, there is still tax credits to be had to offset any losses there?

Kriss Cloninger

Tax credits…

Steven Schwartz – Raymond James and Associates

No, I'm not saying it right, but there is going to be a tax – some companies run out of the potential for tax options?

Dan Amos

We are not one of those.

Kriss Cloninger

No, we haven't. We – the gains that we recognized, that we have realized gains on for GAAP purposes, we generated those games to make sure that we covered unrealized tax credits that would expire within five years. We want to be sure we take advantage of those. We would like to match up realized gains with realized losses for tax purposes.

Let we point out though Steven that for statutory purposes, that 146 million of realized gains, that is an after-tax number for GAAP and needs to be grossed out to the pretax number for stat. Those aren't allowed to be recognized in stat income or stat equity. You have to put those gains into the so-called interest maintenance reserve or the IMR for statutory. So that then increased statutory equity until they are amortized to income. But they would be utilized for tax purposes to offset realized losses, particularly things like the Icelandic banks when we generate the real tax losses, and Lehman Brothers and some of the others.

Steven Schwartz – Raymond James and Associates

Okay great. That was my question.

Kriss Cloninger

Okay.

Operator

Our next question comes from Suneet Kamath, Sanford Bernstein. You may ask your question.

Suneet Kamath – Sanford Bernstein

Thanks. Just a follow up on the 295 million equity impairment charge, what is the base of perpetuals that that applies to? And sort of related to that, what has been the trend since the end of the first quarter in terms of downgrades of perpetuals? I think you said 14% as of March was below investment grade, so maybe that is 1.2 billion? How significantly has that changed since March? Thanks.

Jerry Jeffery

It is Jeffrey speaking. Your first question was the 294 million, what base of, those reflect the below investment grade ratings that have been applied to the Lloyds Banking Group which includes HBAS and Bank of Scotland and it also includes Royal Bank of Scotland. And the assumption is that assuming the price and rating remains the same going forward for the balance of the year that we would impair these under the equity impairment model during the third and fourth quarters of 2009. I think your other question pertains to ratings actions. Since March 31, none of our securities have migrated to below investment grade since March 31 and I should say in the perpetual security sector.

Operator

Our next question comes from Colin Devine, Citigroup. You may ask your question.

Colin Devine – Citigroup

Okay. I have two. First, with respect to the lapse rates, I guess that the record lapse rates in both Japan and in particularly in the US, you mentioned that impacted earnings favorably, I was wondering if you could quantify that? And then if I could turn to the investment portfolio, Jerry, I guess I'm puzzled given Dan's commitment to maintaining the RBC, when we're looking at things like Lloyds which are going to impair, when do you begin to bring into question Aflac intent to hold to maturity and then specifically then why haven't you impaired it now? I'm just looking at how much these unrealized losses are up and also I guess on the Ford credit position and now the debt is being sold back at $0.38 on the dollar, how can you not impair that right now?

Kriss Cloninger

Let me talk first Colin – Kriss here, about quantifying the effect of persistency. Really in the US, it was pretty much an offset. We had – we measure offset by comparing say amortization versus plan and then total benefits versus plan and benefits were higher than planned by about – they were less than planned by about $24 million. And amortization was higher than planned by about $22 million. So…

Colin Devine – Citigroup

Do you mean DAC amortization versus the increase in future policy benefits because it is just going to be very helpful to be very specific here?

Kriss Cloninger

Okay. That is correct Colin. I thought I said that but anyway the amortization was 22 million higher than planned in the US. And the total incurred benefits, to be actually explicit, was $24 million less than planned. So we don't know that all of that was attributable to persistency, but the greatest part of it was in terms of the planned variants. So we said maybe there was a modest, there was a net $2 million benefit to the US earnings there which we consider immaterial. So we essentially said, it was either a modest benefit or it was neutral on US earnings. And then in Japan I think it was pretty neutral to, I don't have a plan variance numbers on my mind, but benefit were pretty much right on plan in Japan. Amortization was slightly higher in Japan at 4.1% of premium, but that was compared to 4.0% in the fourth quarter. So I didn't consider that a material change between the fourth quarter and the first quarter.

Colin Devine – Citigroup

Okay. And these lapses are why we're seeing the slowest growth in premiums in force…

Kriss Cloninger

That is correct. Well that combined with basically flat sales. I mean sales increase, premiums in force, lapses decrease premium in force, and so you are right. Relatively flat sales and relatively higher lapses tend to lower the increases in premium in force.

Colin Devine – Citigroup

Okay.

Jerry Jeffery

Colin, it is Jerry. Let me answer your question. First, let us start with your second part of your question which refers to Ford credit. And I think what you said was that you referred to Ford at $0.38 a dollars. I think you are referring to Ford company. We in fact did further impair Ford company to reflect that pricing in the first quarter. Turning to forward credit, as I'm sure you're aware of the new accounting guidance and we're early adopters of them, I'm sure you know, speaks to the fact that we are not held to any right line standard about time to recovery. We still firmly believe that forward credit will pay us in full and on time and that it will recover. So therefore under the accounting guidance we are mandated not to impair it and that has been a position and continues to be our position. Now I didn't really quite understand your question about the hybrids? Do you want to rephrase that maybe?

Colin Devine – Citigroup

I guess given the steep increase in unrealized losses, for the quarter, how are we not seeing more impairments? And specifically on the Lloyds piece, it is very unclear to me why you haven't impaired it this quarter?

Jerry Jeffery

Well, that's a good question. We impaired – we did impair Lloyds this quarter in fact under the equity impairment model. And the equity impairment model speaks to an amount of price decline and the time that the security has been below carrying value. Some of our Lloyds exposure was mandated to be impaired under the equity impairment model in the first quarter and we did so. Some of the other Lloyds and RBS exposure that we hold – by the way RBS we also impaired some of our holdings there in the first quarter…

Colin Devine – Citigroup

Can you be specific with the amounts?

Jerry Jeffery

Sure. The total amounts I believe were in the press release, were they not, Ken?

Ken Janke

42 million.

Jerry Jeffery

$42 million, that was all Lloyds and RBS. And the amounts that were reported earlier on this call, 294 million, net of tax, also speaks to the same credit. All our other – in fact all of our perpetual securities continue to pay us in full. In fact, KBC Bank, and this should be public knowledge I think, redeemed their upper tier 2 securities that we hold on April 22. That was a 5 billion yen exposure. So again when we think that we're not going to get paid in full and on time, we will aggressively impair and/or sell any of those holdings.

Colin Devine – Citigroup

Okay. And the to 295 number that you provided, is just on the proposal preferreds, that doesn't include the other fixed maturity holdings in terms of projected losses there?

Jerry Jeffery

That is correct. I think that is correct.

Colin Devine – Citigroup

Okay, thank you.

Ken Janke

Those are – Colin, those are the below investment grade rated perpetuals that we account for impairments on those according to the equity method. The new accounting pronouncements basically verified that other than temporary impairments can be assessed with respect to credit expectations over the period in which you believe you will hold security and it is not price driven. In the past, the impairments were more price driven in terms of will the security recover in price within some period of time, and the auditors liked a one you period of time. And so we were really under the gun. And particularly given the long-term nature of our securities that we hold to match the longer duration nature of our liabilities. So we have always had long-duration securities to match our liabilities and we have always had an affinity or a tendency toward looking to the long-term rather than the short-term, because we don't we are not subjected to liquidity problems that some others have to have a shorter term view might be.

Jerry Jeffery

The one thing I would add is that we have held below investment grade securities through credit cycles before and we felt we would get paid for instance KLM and Ahold and in other cases where we became uncomfortable with the credit Lévi-Strauss we sold them.

Colin Devine – Citigroup

Or Parmalat. But just did you say the 295 projected losses is just on the below investment grade perpetual preferreds?

Jerry Jeffery

Correct.

Colin Devine – Citigroup

So that then doesn't include Lloyds, because you have got that rated as an A?

Jerry Jeffery

Colin, once again let me answer that, that does include Lloyds. That does HBAS, and that does Royal Bank of Scotland and that does include Bank of Scotland.

Colin Devine – Citigroup

Okay. Well that this is just not what Kris said. So – all right.

Kriss Cloninger

Not what I said?

Colin Devine – Citigroup

You said 295 in below investment grade, and you have got Lloyds rated investment grade and unless I can't read page 13 here which says it is rated A. I'm just trying to clarify what the likely realized losses number is for the year that you're projecting.

Kriss Cloninger

Wait, just to be clear, we rate Lloyds internally as below investment grade. And therefore, they are part of our projected impairments for the year.

Colin Devine – Citigroup

But maybe what you could put in this will be helpful is your ratings, what you think you have is below investment grade, and what is on the stats up…

Kriss Cloninger

I think Colin we also own some senior debt of Lloyds which is rated A.

Dan Amos

Well Colin what I would point you to is page 15 of the supplement which shows Lloyds is the first below investment grade holding.

Colin Devine – Citigroup

I am just trying to reconcile between page 13 and page 15, Ken.

Ken Janke

Susan, do we have another question?

Operator

Our next question comes from Andrew Kligerman, UBS. Your line is open. Please ask your question.

Andrew Kligerman – UBS

Yes. Good morning. Quickly just on the sales, you had upgraded to the newer cancer insurance product, how much would sales be down in lieu of that 0.6%?

Dan Amos

I don't know how to answer that.

Kriss Cloninger

I couldn't tell you that Andrew.

Dan Amos

I just can tell you Andrew that we expect to make the sales number for the year I think the bank channel is what driving it more so than the upgrade of that and we hope to have another new policy approved and ready to go in the end of the second quarter. But I can't go into the details of that because we haven't gotten the FSA approval.

Andrew Kligerman – UBS

Got it.

Ken Janke

Andrew, let me comment real briefly on the upgrade policy. Now this is a regular activity for us to upgrade our customers and when we come out with something new. We did it before with the product called a Rider Pack. There are about 13.6 million cancer policyholders in Japan that are eligible for an upgrade to the levels of Cancer Forte and we only have a little less than 400,000 of the upgrade policies in force. So this is a campaign that will likely continue for some time and continue to influence the cancer sales category.

Andrew Kligerman – UBS

Got it. Ken, I mean just in my view though, it might make sales look – new sales look significantly better than they actually would be just given that these are people that are existing and it is renewal business, but I understand your point. Now, the other thing is just following on from what Colin had been talking about, I'm quite perplexed myself, and let me just give a little backdrop and see if you could help me. It is my understanding that a number of hybrids were downgraded in 1Q 2009 particularly by the Standard & Poor's. However, in your supplement, only three perpetual issuers, Lloyd, RBS and (inaudible) show up in the below investment grade holdings listed on page 15. So I'm looking at be 8.4 billion in perpetuals. And my first question is how much of this exposure is split rated, and of these split rated securities, what portion is classified as investment grade? And then lastly if there is a fair amount of that, you know, when you decide it is investment grade or below investment grade? What is going into this decision-making, because I see a number of names that you hold that S&P has downgraded to BB range and those still appear to be investment grade with Aflac?

Ken Janke

The answer to that question is there are approximately booked value about just looking at the numbers here, somewhere – I have to get back to you on the precise numbers, but the precise number will fall between 1.5 billion and 2 billion in book value that are split rated. When we look at split rated securities, we do a case-by-case credit analysis, and it is a determination of our credit group as to whether or not to impair these securities. In fact, when we look at and we use a debt impairment analysis for all these. In other words, our debt impairment policy is, will we continue to receive our interest and principal, in full and on time?

And in every case, we have determined that we will. And by the way, that includes Lloyds and Royal Bank of Scotland who continue to pay and continue to honor all coupons. So where these securities are split rated to have a majority of ratings below investment grade, so if there are three ratings, and two of them go below investment grade, than we really are mandated whether or not we believe them to be money good, we will then mandatorily impair them.

Andrew Kligerman – UBS

So just S&P did it, that may not be…

Ken Janke

Not necessarily a precondition to our impairing. It may be, depending on what our credit view is.

Dan Amos

But again remember when he is talking about impairments, he is talking about under the equity impairment method which is simply an analysis of an aging of unrealized losses and has no bearing whatsoever on the issuers ability to satisfy the obligation.

Andrew Kligerman – UBS

And Ken did the adoption this quarter of FAS 115-2 and 157-4, did that have any benefit to not having to take impairments and is – I know you mentioned immaterial in the release but how much benefit might that have provided?

Ken Janke

Well we are convinced that the changes to 115 support the view that we have held for many years and that is when you have the ability and tend to hold the securities to maturity, meaning they haven't the probability of recovery in value and that the cash flow testing and credit analysis suggests that the issuer will meet its contractual obligations for interest and principal on a timely basis, then regardless of what happens to the price in the short term, OTTI isn't warranted.

Andrew Kligerman – UBS

So you're view really didn't change with that?

Ken Janke

Our view did not change. The accounting view supports our view and our long-held view.

Andrew Kligerman – UBS

Got it. And then just lastly, my estimate on the perpetual portfolio is that you have kind of on an unrealized basis marked it to $0.65, $0.70 on the dollar on average, does that sound right to you?

Ken Janke

I would have to look at it on upper tier 2 versus tier 1. But I think combined the perpetuals were about $0.74 on the dollar at the end of March.

Andrew Kligerman – UBS

I mean the one thing I mean a lot of the securities are trading way below $0.50 and I would just on where they are trading, the average is so much lower. I mean is there a fair amount of discretion being used?

Ken Janke

I don't think it is discretion. But I'm not sure you are pricing the very securities that we own. We get a lot of comments that the securities, perpetual securities have much lower marks than we are carrying, while I would suggest that they are probably not looking to comparable securities to what we own which are long dated, privately issued, yen denominated securities that have been swapped by the issuer back into their local currency.

Andrew Kligerman – UBS

All right.

Dan Amos

There is an embedded value in the currency swap that really doesn't show up on the publicly traded perpetual securities people tend to look at.

Andrew Kligerman – UBS

All right, thank you very much.

Operator

Darin Arita, Deutsche Bank, your line is open. Please ask your question.

Darin Arita – Deutsche Bank

Thank you. With respect to the perpetual securities, at the start of the year, could you talk about what changes you have made to monitor these exposures and proactive measures you have taken or are thinking about taking to mitigate potential losses?

Ken Janke

Hi, Darin. I am not sure we have made any specific changes to how we are monitoring them. I would say that you have to understand our investment style which is we do tend to have bespoke issuance offered to us and in so doing and structuring these deals, we develop pretty close relationships with a lot of these issuers. Therefore, our credit analyst here and in Japan are in constant contact with the treasurers of a lot of these financial institutions and really probably all of them sit on at least once a week talking to guys depending on the institutions, maybe more frequent than that.

We visit them and recently visited – our credit analyst here recently did a visit of several banks in Europe, attended conferences in Europe. But those are ongoing activities that we have always done and nothing has changed there. To your question about mitigating potential losses, it is still our contention that these securities offer value. We have obviously been shown a number of tender opportunities from banks and at this point although we will evaluate them on a case by case basis, we've turned them all down because the banks were taking are, A, liquid enough to be able to tender for these bonds. And B, we view as a tremendous arbitrage opportunity for them that is improving their balance sheet. So we want to be investors in a bank whose balance sheet is getting improved.

Darin Arita – Deutsche Bank

All right. Thank you.

Operator

Randy Binner, FBR Capital Markets, your line is open, please ask your question.

Randy Binner – FBR Capital Markets

Hi, thank you. A couple of quick ones on RBC, with the RBC neutral loan that came up to the parent, the 450 million, was that something that needed to be requested from the regulator?

Ken Janke

Actually, it was a $500 million loan to assist us in retiring the 450 million of senior notes. So that is provided for under the Nebraska statute as a permitted practice and then it was subsequently received approval by the Nebraska Commissioner so that it could be treated as an admitted asset. But it was in the normal course of business and the 500 million amount of the loan was significantly less than the amount permitted under the statue which would have been an excess of $1 billion.

Randy Binner – FBR Capital Markets

Okay. Do you have any color on how the rating agencies may view that?

Ken Janke

Well, we were affirmed – our rating was affirmed and taken off negative credit watch by Standard & Poor's subsequent to the time we did that and we fully discussed the process we would use to extinguish the senior debt with S&P during our review. So I can only infer that they didn't have any problem with it.

Randy Binner – FBR Capital Markets

I guess just more technically when we are trying to forecast RBC, that is what I am thinking about from a– if the rating agency shared the same view as the regulator?

Ken Janke

I think you can assume they would.

Randy Binner – FBR Capital Markets

Okay. And just one last thing, Dan's comment, was that RBC target, was that 375?

Ken Janke

That is not our target per se. That is kind of a – well, I don't know if it is –

Dan Amos

It is the middle of…

Ken Janke

Yes. It is kind of – where we start valuating everything we are doing in a much was studious manner.

Kriss Cloninger

Right. I think it is fair to say that our target is higher than that more in terms of – that is kind of the threshold at which we start to be concerned about you know the impact on the ratings and things like that. It is just kind of our comfort zone, though it is way in excess of where the regulators would get concerned.

Randy Binner – FBR Capital Markets

Okay. But in the context of the compensation package, would it – if it was 374 at the end of 2009, would that impact the discretionary compensation?

Dan Amos

Yes.

Ken Janke

The compensation would be less than targeted, 374, yes.

Randy Binner – FBR Capital Markets

Perfect, thank you very much.

Operator

Ed Spehar, Merrill Lynch, you may ask your question. Mr. Spehar, check your mute button please. Ed Spehar, your line is open. I will go to the next question. Jeff Schuman, KBW, your line is open, please ask your question.

Jeff Schuman – KBW

Good morning. A couple of quick ones. First of all, in the US, how many sales days are there in the second quarter and how should that shade our expectations for sales production? Secondly what are new investment cash flows going into US and Japan? And lastly for than given that without share repurchases you are headed more towards 13% EPS growth rather than your personal goal of 15%, is there any contemplation of any other possible levers of adjustments that could be used to get your back towards your personal 15% target?

Dan Amos

I will answer the first one, this is Dan. I'm certainly disappointed to even think that ball was in the bag because I think we would be doing the share repurchase. I never say never because we have got things can change tomorrow, capital can continue to improve, and we would just have to watch it accordingly. But I would think it behooves us to pay much more attention to the capital position than the EPS and so at this particular point I'm giving up something personally I wanted to achieve to ultimately protect our shareholders and to make the analysts feel more comfortable. And that is really all it is about. It is really not about the 20 years, it is really about making our share value go back up and that is what I'm trying to do.

Ken Janke

Paul, you want to take the one about the production days?

Paul Amos

Absolutely. The second quarter is a difficult comp for a couple of reasons. One we do lose a day, one of the day that we mentioned before was the movement of the Good Friday holiday back and forth depending on when the calendar is. Obviously the second quarter of last year were our largest comparables of any the quarter as well as the majority of things that we just rolled out with our new wingspan initiative around products, marketing, as well as sales techniques, have all been rolled out in the last week. The product rollout will continue to happen through the remainder of this quarter, really take full effect in the third quarter. So I expect the second half of the year hopefully to show stronger promise than the first half and second quarter continuing to be a difficult comparison.

Ken Janke

Were those all your questions?

Dan Amos

There was a question for you that came here while we're on.

Jeff Schuman – KBW

The question for Jerry which is where investment cash flows are being directed now in US and Japan?

Jerry Jeffery

Okay. We expect cash flow for investments in Japan in yen to be approximately 450 billion yen this year. That is very similar to the amount that we had targeted for investments last year. In the US, the cash flow is de minimus for a couple of reasons. It has been – there are some policies that were written in the 90s that required payouts, and last year and this year, I think, are the big payout years. So that is redirected that cash flow. So it is difficult to project the US cash flow, but it'll be a very minimal number.

Jeff Schuman – KBW

No – but I mean what are you buying…

Jerry Jeffery

Different question. We are – in Japan, our purchases have really centered around purchases of A, we have done some very attractive opportunities in sovereign and state guaranteed debt, not US state guaranteed, these are foreign states. And we have also found some great opportunities in the central services, really globally, and by central services, I'm referring to water and power provider, transmission companies, companies that we view as essential to the infrastructure of countries. We haven't made any bank investments in the first quarter of 2009, have no immediate plans to increase our exposure, which is already at a pretty lofty level. In the US, since cash flow is quite minimal, the investments there has basically been as a result of bonds swaps and again the strategy is the same.

Jeff Schuman – KBW

Great, thank you very much.

Ken Janke

Susan, my watch is telling me we are at the top of the hour and that is the terminating point for the call. I hope we were able to answer everyone's questions. If there were some that were still in the queue, I apologize we didn't get to you. I hope that you will take the time today to call either Robin Wilkey or myself and we would be happy to discuss the quarter with you and any questions you might have. Again, thanks for joining us.

Operator

This concludes today's conference. Thank you for joining. You may disconnect at this time.

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Source: Aflac Incorporated Q1 2009 Earnings Call Transcript
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