AFLAC Incorporated (NYSE:AFL)
The Raymond James 9th Annual European Investors North American Equities Conference September 10, 2013 08:45 am ET
Kriss Cloninger - President, Chief Financial Officer, and Treasurer, Aflac Incorporated
Steven Schwartz - Raymond James
Steven Schwartz - Raymond James
Hi, there. We'll start a little early since we have got the timing for those coming. That's fine. For those of you, I haven't met, my name is Steven Schwartz and I follow life Insurance and Asset Managers for Raymond James at our Chicago office.
Today we have with us today a recurring guest, the management of Aflac. For those of you not totally familiar with the company, Aflac is the largest supplemental health insurer in the world, operating at a basically two markets, Japan and the United States. You see up here that the duck, the Aflac, which is an iconic symbol in the U.S. very, very, well known 95% type of recognition.
Today we have with us Kriss Cloninger. Kriss is CFO, President of Aflac, Vice Chairman as well. Did I get them all?
Steven Schwartz - Raymond James
He is on board and also with us we have the Director of Investor Relations, Robin Wilkey, and with that I will leave it to Kriss.
Okay. Thank you, Steven and good afternoon to all. It's a pleasure to join you this year's Raymond James North American Equities Conference.
Before we start, let me remind you that some statements in this presentation will be forward-looking within the meaning of U.S. 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. Please look at our annual report on Form 10-K, for some of the risk factors that could cause the actual results to differ materially from those we discuss today.
Our strategy for growth in the United States and Japan has remained straightforward and consistent for many years. Aflac develops relevant voluntary insurance products and sells them through expanded distribution channels, which yields new accounts and customers. Aflac does business in the two largest insurance markets in the world, the U.S. and Japan. Our policies cover more than 50 million people worldwide.
Aflac products provide a layer of financial protection against loss of income and assets by paying fixed cash benefits directly to an insured based on health of them or life situation. Aflac's operations in Japan account for about three-quarters of our pre-tax insurance earnings. Today, we insure about one out of four households in Japan and we are the number one life insurance company in Japan in terms of individual policies enforce.
Our third sector cancer medical products have been and continue to be our pillar products and the foundation of our portfolio. For 2013, we are refocusing our sales efforts on our traditional cancer and medical third sector products. In fact, we introduced a new medical product last month, which is an area where we are currently underpenetrated. Although it's too early to determine actual results, we expect this product to be very well received by consumers.
Aflac Japan was represented by more than 17,600 sales agencies at the end of the second quarter, equating to more than 84,000 licensed sales associates employed by those agencies. With continued distribution expansion [inland], we are very pleased with the new alliance agreement Aflac Japan signed with the Japan Post group in July.
As Dan Amos, our CEO indicated, we believe this alliance is a game changer for us. Japan Post intends to gradually expand the number of post offices for Aflac cancer protection from a 1,000 to 20,000 postal units. Also, pending regulatory approval, Japan Post Insurance, otherwise known as Kampo, will enter into an agency contract with Aflac Japan to begin distributing Aflac's cancer insurance products to all of Kampo's 79 sales offices.
In consultation with the Japan Post group, Aflac Japan will also consider developing an exclusive cancer product to be sold through Japan Post and Kampo. We believe Japan Post can and will be a meaningful contributor to our sales.
Let me update you on Aflac Japan's performance for the first half of the year. Overall sales for the first six months of the year were down 20.4% to JPY 84.1 billion.
For the first half of the year in yen terms, our premium income increased 9.2% and revenues grew by 9.8%. Pre-tax earnings were JPY 184 billion, or 15.3%. Keep in mind that in the second half of the year, we anticipate stepping up our spending on advertising and promotional expenditures along with other projects to improve our business over the long-term.
I also want to remind you that for this year, our sales target is based on Aflac Japan's third sector products, which includes cancer and medical insurance, remaining the leader of third sector products is important to us and continues to be the foundation of our product portfolio. Achieving this target is a top priority for our entire management team both, in U.S. and Japan. Taking into account the launch of our new medical product, we believe our 2013 objectives of a flat to 5% increase in third sector sales is reasonable and achievable.
We have experienced a tremendous amount of success leveraging our strong brand in our efforts to drive sales. For example, to promote our new medical product, we launched a campaign in Japan featuring what is known as the black swan, that's a dark new character that represents the arch nemesis of the Aflac duck.
Black swan's goal is actually to tempt consumers to make bad decisions about life and health, and insurance, but the Aflac duck saves the day by reminding consumers to make sound, positive and healthy choices in life, including the decisions to purchase medical insurance. Now let me just say, it's a Japanese team that comes up these ideas, not me, but they are pretty good ideas. They always work.
By leveraging the popularity of the Aflac duck through different characters over the years, 9 out of 10 people in Japan recognize the Aflac brand and we will continue to look for new ways to connect with consumers through innovative marketing campaigns for this product line.
Japan's population is covered by universal healthcare system, but its citizens still have significant out-of-pocket cost associated with healthcare. As such, we believe the need for Aflac products will only continue to grow. Given Japan's aging population and declining birth rate, this national healthcare system has been under great financial strain and copayments for salaried workers under age 70 have grown to 30% of the cost of medical treatment.
However, financial resources are tied in all areas, including medical nursing care, in pension benefits. It's clearly that the difficult fiscal situation will persist in Japan. As you can see, the growth of medical expenses is significant outpacing GDP growth there. Because of the rapidly aging population and higher copayments for medical expenses, the market for medical products has been steadily increasing and this trend is expected to continue. We believe, we can expand our leading position as the medical market continues to grow in the future.
Now, let me turn to Aflac's U.S. operations. As you may know, we primarily distribute our voluntary insurance products at the worksite on a payroll deduction basis in the U.S. The Aflac U.S. product portfolio includes a variety of voluntary insurance products, designed to pay cash directly to policyholders when a serious medical event presents financial challenges. These payments are made regardless of any other insurance the policyholder might have.
Our group products align well with our individual product line and gives us the ability to customize our product offerings for the brokers who typically sell to the larger accounts. This is especially relevant, because now more than half of voluntary insurance products sold in the United States come from group policies.
Aflac's strong brand and market-leading status broaden the appeal of our products to consumers throughout the United States. Our diverse, yet focused product line is sold through a broad distribution network of over 76,000 commissioned sales associates. Additionally, we continue to work on initiatives that expand our relationships with brokers to access the larger case market. We believe our distribution network is a competitive strength that no other company has been able to duplicate.
Our strategy and competitive strengths are all designed to leverage the brand while providing valuable products to consumers. For the first half of the year, total new annualized premium sales in the U.S. were down 1.9%. We believe the market for our products has been impacted to some extent by uncertainty and confusion caused by the pending implementation of the Affordable Care Act. However, I would note the premium income increased 3.8%, reflecting strong persistency.
While we are busy laying the groundwork for future growth, we are still working hard to achieve our annual sales target. Our goal for Aflac U.S. sales in 2013 through our traditional land broker channels is to be flat to 5%. With our strong brand, consumers are more receptive to hear how Aflac products can help them. This opens up greater possibilities for our traditional sales force and our broker channel alike. We continue to believe that the U.S. represents a vast opportunity for growth and we are building our business with that potential in mind.
This next slide shows the most recent data from the U.S. small business administration. The United States has more than 5.7 million businesses with fewer than 500 workers, and these small businesses employ about 55 million people. Although our traditional focus has been on smaller sized payroll accounts, we believe our strategy for reaching larger brokers will better position Aflac to the larger case market as well. Our portfolio of group and individual products provides consumers with outstanding value while giving employers the choices they demand.
We believe our strong brand will be even more important in this period of transition as businesses and consumers look to do business with a company that has a solid reputation. With our trusted and well recognized brand, we believe we can be there to protect those we insure against income and asset loss when a health event causes financial challenges. We also believe the coming years will provide great opportunity for growth in the United States.
Now let me turn to our investment portfolio. As we have stated for many years, our greatest investment challenge has been to invest Aflac significant cash flows and suitable investments that provide investments returns that meet or exceed our pricing and policy reserving assumptions. Foremost on our mind is to invest in a way that takes our policy liabilities into consideration.
Following four years of significant portfolio de-risking after the financial crisis, we have successfully reduced our exposure to perpetual securities and investments in the PIGS countries and financial institutions especially in Europe. We are very pleased with our progress and our focus remains on liquidity, flexibility and diversification.
Our investment strategies have evolved since the financial crisis and we manage each portfolio with specific objectives. Almost 12% of our portfolio is made up of liquid U.S. corporate bonds with their principle hedged into yen. Next year, we expect to enhance our diversification by including other asset classes.
Overall, we are pleased that the balance sheet has improved in quality, liquidity, return profile, and diversification. Our objective is to have a portfolio that's diversified by geography and industry while remaining focused on higher quality investments. The vast majority of our investments in Japan are JGBs that provide both, the measure of liquidity and stability.
Our ability to continue to implement new strategies is based on the evolving capabilities of the Aflac's global investment division. We have defined our investment objectives as maximizing risk adjusted performance, subject to our liability profile and capital requirements.
Now, we are pleased that our Japan new money yield for the first half of this year was 3.02%, which is considerably higher than the new money yield of 2% for the first half of 2012. In light of financial market volatility in both, the United States and Japan during the second quarter, our investment team has been carefully analyzing our asset allocation as well as strategies to help mitigate interest rate risk.
As such, we expect to allocate the majority of our third quarter cash flows to JGBs and to underweight the allocation to the U.S. corporate bond portfolio. We remain committed to further building out our investment functions and capabilities to enable us to respond to a challenging economic environment.
Now, let me spend the last portion of my discussion updating you on our consolidated financial performance and our capital management activity. Aflac Incorporated has a long history of delivering strong financial performance, although that performance has been periodically distorted by changes in the foreign exchange market. While the yen was little changed from 2011 to 2012, it has weakened dramatically during 2013.
Due to the significant contribution of Aflac Japan's operations to our overall earnings, a weaker yen suppresses our results as it's reported in dollars. However, our actual currency exposure is mostly transaction related or translation related as opposed to currency transactions that actually convert yen into dollars.
As such, we still believe that viewing our results excluding the impact from foreign currency is the most meaningful way of evaluate our financial performance and that's the basis we communicated as [free] for many, many years. We remain very focused on capital ratios, which demonstrate our commitment to maintaining financial strength on behalf of our policyholders, our shareholders and bondholders.
Through strong surplus growth and improved portfolio risk profile and a weaker yen, our capital ratios improved significantly in 2012. Our estimated risk-based capital ratio as of June 30th was 724%, which was higher than our 2012 year end ratio of 630%. Additionally, Aflac Japan's solvency margin ratio or SMR was 585% at the end of June, compared with 686% at the end of March this year.
The decline in Japan's SMR was primarily due to a spike in U.S. interest rates and increase in Japanese interest rates, which lowered the market values of our available-for-sale investment portfolio in Japan. I would point out that the second quarter SMR did remain at the high end of our targeted range of 500% to 600%.
As we think about capital levels and how they are tied to profit repatriation, our first consideration is the protection of policyholders as measured by the solvency margin ratio. Next, we give consideration to the needs of the parent company and consult with Japan management in making a determination.
In July of this year, we did repatriated JPY 76.8 billion. You will recall that we entered into hedging transactions for the vast majority of anticipated repatriation at weighted average exchange rate of JPY 96.4 to the $1. That ended up in $1 repatriation approximately $800 million. We believe that an analysis of operating earnings, which is a non-GAAP financial measure, is important to an understanding Aflac's underlying profitability drivers.
Aflac defines operating earnings as the profits derived from operations before realized investment gains and losses from securities transactions, the impact from derivative activities and hedging as well as non-recurring items.
On an operating basis, we have a long history of producing strong earnings growth. As this chart shows, the growth in operating earnings per diluted share was held back by the weakening of the yen for the first half of 2013. However, excluding that impact, growth in earnings per share was strong.
As we have said for many years, when it comes to deploying excess capital, we still believe that growing the cash dividend and repurchasing our shares are the most attractive means and those are the avenues we will continue to pursue.
Our objective remains to grow the dividend at a rate that's in line with the operating earnings per share before the impact of the yen. Aflac purchased approximately $129 million worth of shares of about 2.3 million shares of the common stock in the second quarter. For the first half of the year, the company had purchased $279 million, or 5.3 million shares. We have a lot of flexibility at the parent company in terms of liquidity and it's still our intention to purchase about $600 million worth of our shares in the full year 2013.
We continue to focus on maintaining strong fundamentals in our core business and building on our record of earnings growth. Our objective for 2013 is to increase operating earnings per diluted share by 4% to 7%, excluding the impact of the yen.. Although we are above that range in the first half of the year, we do plan on increasing spending during the second half of the year. In Japan, we will increase expenditures on advertising and promotion of our new product launch. In the U.S., we anticipate spending extra money on initiatives related to healthcare reform. As such, we expect operating earnings to increase approximately 5% for the full year before the impact of foreign currency.
Generating an industry-leading return on equity, excluding the yen impact has also been an important objective. On an operating basis, our second quarter annualized ROE was 22.1%. Had the yen remained unchanged since the end of March, operating ROE would have been 26.4% in the second quarter. Based on year-to-date returns, we expect to meet or exceed our ROE target of 20% to 25% excluding the impact of foreign currency for the full year.
This slide shows how our 2013 EPS might look both, with and without the impact of currency. On a constant currency basis, our expectation of the 5% increase equates to operating earnings per diluted share of $6.93. We estimate that a JPY 1 change on the average annual exchange rate will equal about $0.43 in per share earnings or in 2013. If the yen averages 100, yen to the dollar for the full year, we would expect reporting earnings to be approximately $6.06 per diluted share.
We remain focused on our vision to be the leading provider of voluntary insurance both, in the U.S. and the number one provider of supplemental insurance in Japan. We have confidence in our business model, the fundamental need for our products and most importantly, the future success of Aflac.
That concludes my presentation, Steve, I don't know if we got any time for questions, but I will be glad.
If we return the asset allocation back more to JGBs, is that what you are saying?
Well, as I said in the second quarter conference call when we talked about the solvency margin, I said we have got some levers we can use to manage the solvency margin. As you point out, we have got a number of JGBs or we had a number of JGBs on the books. At the end of the second quarter, they were carried, classified as available-for-sale, which requires marking to market both, in U.S. GAAP financials and in the Japan FSA reports.
We have taken steps to sell and repurchase significant portion of the JGBs that we held in available-for-sale. We did that during the third quarter without a material realized gain or loss and then we reclassified those or reclassified following the repurchase as securities held in the so called policy reserve matching asset account. When assets are classified as PRM, policy reserve matching, they can be carried at amortized cost on the FSA books and that's what we will do for the future, so that will mitigate the risk of future changes in JGB yields on SMR. Steven?
Steven Schwartz - Raymond James
Kriss, is there anything you can do on the U.S. corporate type performance?
We can engage in two types of hedging. One is currency hedging which we have already done on the principle of U.S. corporate bond portfolio, so that we get a match between our liabilities, currency and our assets currency and we can also engage in some interest rate hedging, which we have started doing during the third quarter to protect us against future changes in interest rates on the U.S. securities, so we haven't done that with the whole portfolio at all, but we have done it on a portion of the portfolio and we continue to investigate other alternatives on interest rate hedging on that particular portfolio.
Steven Schwartz - Raymond James
Any other questions?
Steven Schwartz - Raymond James
Thank you very much.
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