Aflac (AFL) Daniel P. Amos on Q4 2015 Results - Earnings Call Transcript

| About: Aflac Incorporated (AFL)

Aflac, Inc. (NYSE:AFL)

Q4 2015 Earnings Call

February 02, 2016 9:00 am ET

Executives

Robin Y. Wilkey - Senior VP-Investor & Rating Agency Relations

Daniel P. Amos - Chairman & Chief Executive Officer

Frederick John Crawford - Chief Financial Officer & Executive Vice President

Eric M. Kirsch - Global Chief Investment Officer & Executive VP

Paul S. Amos II - President, Global Operations

Teresa L. White - President, Aflac U.S.

Kriss Cloninger III - President

Analysts

Randy Binner - FBR Capital Markets & Co.

Nigel P. Dally - Morgan Stanley & Co. LLC

Jamminder Singh Bhullar - JPMorgan Securities LLC

Seth M. Weiss - Bank of America Merrill Lynch

Yaron J. Kinar - Deutsche Bank Securities, Inc.

Erik J. Bass - Citigroup Global Markets, Inc. (Broker)

John M. Nadel - Piper Jaffray & Co (Broker)

Michael Kovac - Goldman Sachs & Co.

Steven D. Schwartz - Raymond James & Associates, Inc.

Thomas George Gallagher - Credit Suisse Securities (NYSE:USA) LLC (Broker)

Operator

Welcome to the Aflac Fourth Quarter Earnings Conference Call. Your lines have been placed on listen-only until the question and answer session. Please be advised, today's conference is being recorded. I would now like to turn the call over to Ms. Robin Wilkey, Senior Vice President of Aflac Investor and Rating Agency Relations. You may again.

Robin Y. Wilkey - Senior VP-Investor & Rating Agency Relations

Good morning and welcome to our fourth quarter call. Joining me this morning from the U.S. is Dan Amos, Chairman and CEO; Kriss Cloninger, President of Aflac Incorporated; Paul Amos, President of Aflac; Fred Crawford, Executive Vice President and CFO of Aflac Incorporated; Teresa White, President of Aflac U.S.; and Eric Kirsch, Executive Vice President and Global Chief Investment Officer. Also, joining us from Tokyo is Hiroshi Yamauchi, President and COO of Aflac Japan; Koji Ariyoshi, Executive Vice President and Director of Sales and Marketing.

Before we start, let me remind you that some of the statements in this teleconference are forward-looking within the meaning of federal securities laws, although we believe these statements are reasonable and we can give no assurances that they will prove to be accurate because they're prospective in nature. Actual results could differ materially from those we discuss today. We encourage you to look at our quarterly release for some of the various risk factors that can materially impact our results.

Now I'll turn the program over to Dan who will begin this morning with some comments about the quarter and the year as well as our operations in Japan and the U.S. Following Dan's comments, Fred will follow up with brief comments about our financial performance for the quarter and the year. Dan?

Daniel P. Amos - Chairman & Chief Executive Officer

Thank you, Robin. Good morning and thank you for joining us. As we look back on 2015, Aflac's 60th year of operations, let me start off by saying that the final quarter of 2015 concluded another great year for Aflac.

What's been true for these six decades, and what separates us from every other competitor, is our distinct product focus on voluntary and supplemental insurance in both the United States and in Japan. That kind of direct approach has been a major factor in our success and I believe it will continue to propel our leading position in the future.

I'm especially pleased that our operating earnings per share growth, before currency, exceeded our expectations for the year, rising 7.5%. I think this is especially notable given historically low interest rates, market volatility and economic uncertainty in the world.

I couldn't be more proud of the hard work and accomplishments of our management team, employees and sales distribution in Japan and the United States. It is an honor to work alongside our team who are dedicated to enhancing our long-term growth of the company and who represent all that Aflac stands for, The Aflac Way.

Now I'll provide you some highlights related to our Japanese operation, where I believe we set the standard in many ways for other insurance companies in Japan.

We're not only the pioneer and leading provider of cancer insurance, but we're also the number one seller of medical insurance too. This is particularly impressive given our increasing competitive medical market for insurance has become in Japan. But our relevant products, trusted brand and diverse distribution are a powerful combination that's very hard to compete with, and it propelled Aflac to insure one out of four households.

I'm thrilled with Aflac Japan's tremendous annual growth of 13.4% increase in sales for third sector products, which surpassed our original expectation considerably.

Not only were our 2015 results impressive across all channels, but we pointed out in our release last night the third sector sales increase for 2015 is particularly phenomenal because it marked the second highest annual third sector growth in 10 years.

On the product side, it's exciting that sales of our founding cancer insurance were up a tremendous 40.6% for the year. As the pioneer of cancer insurance, this remarkable result underscores the importance of Japanese consumers' place on selecting a brand they know and trust.

Turning to first sector products, the actions taken by the Bank of Japan on Friday resulted in JGB yields decline, as well as additional weakening of the yen to the dollar. As discussed on our December outlook call, we have taken steps to control the sale of first sector products as we enter 2016.

Managing through the low interest rate environment is nothing new to Aflac Japan. The actions of the Bank of Japan simply reinforce our strategy and we will continue to review potential and further actions as the rate environment plays out. Fred will touch on the financial considerations in his comments.

Looking at our distribution side, our traditional agencies had been and remain vital contributors to our success and this was certainly true throughout 2015. At the same time, I'm pleased with Aflac Japan's significant strides in further developing our alliance with Japan Post throughout the year.

We completed the expansion of the number of post offices and their agents selling their products to more than 20,000 outlets during 2015. With this expansion, we've continued to ramp up our training of Japan Post employees to ensure they have the knowledge and tools to sell Aflac products successfully.

The Catch-22 of tremendous sales results is the difficult comparisons they create. As we indicated, we believe that sales of third sector products in 2016 will be down mid-single digits following another year of outstanding sales in 2015. However, looking further out, we continue to view Aflac Japan's long-term compound annual growth rate as being in the range of 4% to 6%.

Now turning to Aflac U.S., 2015 was a year of building our business through our career and broker distribution channels. We not only enhanced our career sales management infrastructure over the last year and a half, but we also laid the foundation for greater opportunities within the broker market.

As you saw in the earnings release, Aflac U.S. hit an all-time record for the quarter with a premium amount of $497 million in new sales, which equated to a 9.6% increase. I'm especially happy with the fourth quarter given that it followed a 14.1% sales increase in the prior year. Our quarterly results exceeded our expectations and drove our total sales of $1.5 billion, which translates to a 3.7% increase for the year.

Our sales results for 2015 exemplify that we've been communicating; our sales are increasingly concentrated toward the end of the fourth quarter and we believe this will continue to be the case.

As you all well know, success and opportunity breeds competition. That, combined with a clear need for voluntary products, has resulted in a number of other companies entering the voluntary supplemental insurance market. These have included insurance carriers who sell voluntary insurance as well as companies involved in various aspects of healthcare management. But keep in mind, Aflac's singular focus on supplemental voluntary products has greatly contributed to our dominant position in the work-side insurance market, and I believe will continue to drive our competitive edge.

One Day Pay remains a differentiator for Aflac. We will continue our promotion of One Day Pay to consumers which we believe will help increase brand loyalty and account penetration. Here is an amazing statistic. In 2015, we paid 1.2 million claims. 100% of the eligible One Day Pay claims submitted were paid within one day.

I think we'll pay over 2 million One Day Pay claims in 2016. In the minds of consumers, our already high integrity jumped by 22%, the biggest move ever and we believe it's because of One Day Pay. Paying claims in just one day translates to this statement from consumers: If you're paying it in just one day, you must be a good company and with high integrity. Also, independent research continues to show that there is no doubt American consumers need cash quickly, and paying claims fast and fairly sets us apart from the competition.

Even further differentiating Aflac, I'm also proud that Aflac's contact center has been recognized by J.D. Powers for providing outstanding customer service experience. This recognition is based on successful completion of an audit and exceeding a customer satisfaction benchmark. It is these kinds of initiatives and feedback that demonstrates our commitment to delivering on our promise to our policyholders.

While 2015 was a year of building, we see 2016 as a year of stabilization and growth. We continue to believe that Aflac U.S. annualized premium sales growth in 2016 will be in the range of 3% to 5%.

Turning to capital deployment, Fred will provide more detail shortly, but let me just say that we view growing the cash dividend and purchasing our shares as the most attractive means of deploying capital, particularly in the absence of any compelling alternative. Our plan for 2016 is to repurchase $1.4 billion of our shares and we anticipate concentrating the majority in the first half of the year.

As we indicated last quarter, 2015 was the 33rd consecutive year in which we've increased the cash dividend. Our objective is to grow the dividend at a rate generally in line with the increases in operating earnings per diluted share before the impact of foreign currency translation.

I'll conclude by reiterating how proud I am of our teams in both the United States and in Japan as they've worked hard to generate our 2015 results. You know I've been in the business for more than 40 years now, and I'm truly excited today more than I've ever been about Aflac's future.

So now, let me turn the program over to Fred for financial results and outlook. Fred?

Frederick John Crawford - Chief Financial Officer & Executive Vice President

Thank you, Dan. You've all had a chance to review the details in our earnings release. As Dan noted in his comments, our fourth quarter and full year results exceeded the high end of our earnings guidance driven by strong overall margins in both the U.S. and Japan. The only notable item to call out in the quarter was a favorable adjustment to certain retirement benefit liabilities as a result of refining our assumptions. These adjustments impacted our parent company-only results and contributed approximately $13 million pre-tax or $0.02 per share to the quarter's earnings.

Our Japan segment margins came in strong, driven by continued favorable benefit ratios. We had a few adjustments to reserves in the quarter, a result of our year-end actuarial work. These adjustments were largely offsetting and on a net basis contributed modestly to the out-performance in the period.

Our expense ratio came in favorable to our expectations as we are balancing investment with continued focus on expense management.

We would expect both our benefit and expense ratios to normalize within our outlook call guidance range as we move into 2016.

In the U.S., benefit ratios were considerably better than last year's quarter, but fairly consistent with our strong performance throughout 2015 and at the favorable end of our outlook call guidance range. As with Japan, our quarterly and year-end actuarial work resulted in certain reserve adjustments that were largely offsetting.

Our expense ratio in the U.S. was elevated in the quarter. This is not unusual in the fourth quarter and roughly in line with last year's quarter and in part reflects the conscious decision to accelerate certain investments in our platform.

Turning to investments, throughout 2015, we were successful in defending net investment income, recognizing that as higher yielding securities mature, we are investing new money into a low rate environment and need to proceed with caution given market volatility.

As we noted during our outlook call, this dynamic represents a natural headwind to investment income in 2016. We continue our efforts to build a position in diversified asset classes, helping to support higher, long-term returns.

Our capital and liquidity position remains strong. As is typically the case, we have only estimates on SMR and RBC at this time, but expect both to remain strong and consistent with recent periods.

Between dividends and repurchase, we returned just over $400 million to our shareholders in the quarter and achieved our guidance of $1.3 billion in repurchase for the year. Before I turn the call back over to Robin for Q&A, I'd like to comment on recent market volatility, the relevant strength of our financial position and our outlook.

The month of January has certainly been extraordinary with the return of credit and equity market volatility, a continuation of the low rate environments in the U.S. and Japan and a concern over energy and commodity prices and related exposures. In the case of Aflac, recent Bank of Japan actions draw renewed focus on Japan rates and the yen.

I think the following considerations are important and support the investment thesis that Aflac is well positioned to perform in the face of market volatility.

First, our core franchise in Japan and the U.S. supplemental health markets remain strong with natural demographic and economic catalysts driving core underwriting margins and favorable trends. These core franchise growth and earnings drivers are largely unaffected by recent market volatility.

Second, as with the rest of the industry, we are carefully monitoring interest rates. As Dan mentioned in his comments and consistent with Paul's strategic outlook in December, the recent move in Japan rates simply reinforces our strategy to actively manage down the sale of lump sum first sector products, focusing on appropriately priced, level-premium product in support of our high-return, third sector business and our core agency distribution network.

From a financial impact standpoint, we've concluded all of our year-end actuary work, including review and testing of core assumptions and maintain very strong margins across all material blocks of business and have very little liability and balance sheet risk associated with very low, for very long, interest rates.

In terms of investment strategy, we are only in the beginning stages of building our growth asset portfolio, thus we have modest exposure to naturally volatile asset classes. In some cases, we now have an opportunity to enter these asset classes at better valuations.

With historically low JGB yields, the success of the dollar program and expansion into new asset classes, we have naturally lightened our new money allocation to JGB's and that will continue into 2016. In addition, we pre-bought approximately 60% of our JGB budget prior to the BOJ easing announcement of late last week.

In terms of the dollar program, we carefully watch our hedging costs, but have been proactive in modestly extending the duration of our hedge positions to reduce exposure to short-term spikes.

While our long-term view is for hedging costs to rise, we remain comfortably within our tolerances and continue to drive significant value over and above JGB rates.

Finally, in terms of credit exposure, like the rest of our peers, we're carefully monitoring our exposure to energy sector along with metals and mining. We have a $6.6 billion energy portfolio measured at book value that is well diversified and high-quality. Only 7% of the portfolio is below investment grade and effectively all in the BB category.

As of the end of January, our below-investment-grade energy holdings were in an unrealized loss position of only $140 million. As we analyze security-by-security holdings, we do not see acute default risk, but do note that downgrade risk is present and pricing is under significant pressure on select names which could result in accounting-driven impairments as securities trade at deep discount for prolonged periods.

In summary, core margins are expected to remain strong and largely resilient to market volatility. Balance sheet exposures to low-for-long rates in the U.S. and Japan are modest and our general account assets are defensively positioned with limited exposure to naturally volatile asset classes and we are well positioned in terms of our energy and energy-related exposures.

We therefore have made no adjustments to our earnings per share guidance of $6.17 to $6.41 assuming an average exchange rate of roughly 121 yen to the dollar. And capital deployment guidance provided in our December outlook call remains the same.

Based on our capital conditions, earnings and cash flow stability, we are maintaining our repurchase target for 2016 at $1.4 billion. Having repatriated additional excess capital in the fourth quarter, we are front-end loading approximately $1 billion of repurchase in the first half of the year. Our performance in the fourth quarter certainly bodes well for 2016, but it is obviously very early in the year and we will update accordingly.

Thank you and I'll now hand the call back to Robin to begin Q&A. Robin?

Robin Y. Wilkey - Senior VP-Investor & Rating Agency Relations

Thank you, Fred. Before I turn it over to Q&A, I wanted to mention that you will be receiving an e-mail soon regarding our May 25 Financial Analyst Briefing to be held in New York. And again, if you have questions, please give us a call on that. Now we're ready to take your questions. But first, let me remind you that to be fair to everybody, please limit yourself to one initial question and only one follow-up that relates to the initial question. We're now ready to take the first question, please.

Question-and-Answer Session

Operator

Thank you. Our first question is from Randy Binner from FBR. You may ask your question.

Randy Binner - FBR Capital Markets & Co.

Hi, good morning. Thanks. I just wanted to pick up on Fred's closing comments there on the front loading of the buyback in 2016 that relied on a reinsurance transaction from last year and there were some questions about kind of the outlook for further reinsurance deals on the December call. And it sounded like you were actively looking at different blocks and the market was active there. So, I'd like to get an update on what that outlook looks like because if we're going to continue to have high levels of buyback kind of looking forward in 2017, it seems there needs to be another material reinsurance transaction at some time this year.

Frederick John Crawford - Chief Financial Officer & Executive Vice President

So first of all, Randy, just a couple comments. You're correct. So, we repatriated an additional 60 billion yen, as you know, in the fourth quarter, roughly US$500 million. That has built up a liquidity position at the holding company which we're now spending down in the form of front-end loading the repurchase of approximately $1 billion of our $1.4 billion target in 2016. You're also correct to note that over the past few years, we have benefited somewhat from elevated repatriation and cash flow related to these reinsurance transactions.

I would note, however, that we've had a balanced approach to the use of proceeds, if you will, or freed up capital from reinsurance, roughly 40% or so dedicated to shoring up our SMR ratio and protecting the capital strength of our insurance franchise, the remaining 60% then repatriated only after being comfortable with our capital ratios. That is roughly the same type of approach that we would take going forward if we did, in fact, continue to entertain reinsurance transactions.

Right now, we're out there with a long-range guidance of 2015 to 2017 of excess capital of $6.3 billion to $7.5 billion. We remain consistent in that number. The difference between $6.3 billion and $7.5 billion is tied up in excess capital, some of which is in Japan and could be unlocked via reinsurance. Our basic approach to that, Randy, is to be opportunistic and defensive, meaning if there are compelling opportunities to unlock and go through the exercise of unlocking that excess capital for redeployment at higher returns, we'll entertain that. We also don't want to be defensive. As we make our way through market volatility and watch things unfold over the next year or two, we want to be equally careful to recognize that excess capital needs to be held and in some cases to defend the balance sheet.

So, it's a balanced approach. We don't have any reinsurance dialed into our estimates for 2016 as I mentioned on the outlook call, but we'll continue to watch markets unfold and look for opportunities.

Randy Binner - FBR Capital Markets & Co.

So just a couple follow- ups; one is, can you just characterize how good the conversations are with reinsurers? I mean, broadly speaking, the global reinsurance market is overcapitalized, so I'd be interested then to see your characterization of how that's going.

And then, I guess the capital absorption in a downside scenario, is that – are you thinking in like low – you're thinking further moves by the BOJ on Japanese interest rates? Is that the main shock you would be looking at, or are you thinking more on the credit side? What would that main concern be there?

Frederick John Crawford - Chief Financial Officer & Executive Vice President

Yeah. So, first part of your question, we continue to maintain healthy reinsurance relationships. And in fact, we've even got commitments, if you will, for unfunded reinsurance that allows us the flexibility to pull down reinsurance if necessary for either defensive or offensive moves.

And that's largely a healthy approach because we're talking about health businesses and morbidity risk, which is an attractive type of risk to take in the capital markets these days by reinsurers. And because it's unaffected by capital market volatility, it tends to be something we can count on with reliability. So I'm not at all concerned about the nature of the discussions with reinsurers and our access to reinsurance. The issue is more whether or not it makes sense from a capital strength standpoint or an opportunity standpoint to entertain any of those transactions.

And then in terms of the second part of your question, as I mentioned in my comments, we're very well positioned relative to low-for-long interest rates. And that is not my concern relative to balance sheet. It's an issue relative to watching our earnings trajectory going forward, as I've mentioned, but it's not a balance sheet issue as we have very little relative liabilities exposed to low-for-long rates.

The bigger issue is whether or not we're entering into the early stages of a credit cycle and being careful about that. All eyes are on, of course, the energy market and commodities. But more broadly, we need to be careful about whether or not a mild or moderate credit cycle is in front of us.

And so it's a good time to be careful. I think spreads have widened, which is usually a signal; downgrades are outpacing upgrades modestly right now, even beyond the energy sector.

So, we have to be careful to watch that. But as I said, we're particularly well positioned. And we naturally have a defensive general account because we haven't been as aggressive as many in the industry in terms of entering into more volatile asset classes. We're just starting to begin that.

Randy Binner - FBR Capital Markets & Co.

That's great. Thanks a lot, Fred.

Operator

Our next question is from Mr. Nigel Dally from Morgan Stanley. You may ask your question.

Nigel P. Dally - Morgan Stanley & Co. LLC

Great, thanks. Good morning, everyone. So, wanted to ask about the hedge portfolio. Given we've got higher short-term U.S. rates and lower Japan rates, can you discuss the impact that's going to have on your hedge costs? You mentioned it will be going up, but by how much?

Also provide some more details as to what's been done to mitigate those incremental costs. And also just discuss the logic behind putting the hedge cost below the line given that it's really an ongoing expense item.

Frederick John Crawford - Chief Financial Officer & Executive Vice President

In terms of the hedge program, maybe I'll ask Eric to make some comments on kind of where we stand relative to the cost structure.

Eric M. Kirsch - Global Chief Investment Officer & Executive VP

Sure. Thanks, Nigel. Well, as everybody knows, we have been expecting hedge costs to go up and in fact, that's the case. About a year or so ago, they were running about 60 basis points, now they're running about 130 basis points to 140 basis points and that's including the actions by the BOJ the other day, which increased the hedge costs around 10 basis points to 15 basis points.

Having said that, we were planning for hedge costs in 2016 to be upwards of 180 basis points, 190 basis points based on where our markets were back in the third quarter, meaning look at what the Fed was going to do for potential rate hikes, this new information from Japan.

And even at that level of 180 basis points to 200 basis points, we still deem our portfolio to be very profitable versus buying a portfolio of JGBs, which is what we measure it against.

And part of that is because new investments on the U.S. dollar program are going in at higher yields and higher spreads. We did take advantage through asset allocation of some of the dislocation in the high yield in the bank loan market, which get us higher yields, and we've continued to see JGB yields go down, so that creates a wider spread.

But importantly, relative to the program, the fact is that monetary policy around the globe continues to be easy, i.e., the Bank of Japan. But the Federal Reserve is unlikely to raise four times unless there's really strong economic growth in the U.S. So when you look at things like forward curves, the 180 basis points to 200 basis points that we thought it was going to go to is unlikely to be realized this year. It most likely will continue to be lower.

Nevertheless, we have programs and analysis that looks at this continually and the tools that we have are either find higher-yielding assets, and to Fred's point earlier, as we're starting to explore growth assets, those have higher yields and returns than fixed income, continue to modify the types of hedges we have.

Again, Fred mentioned that we went through the duration of some of our hedges which has helped us to lock in some lower costs. So, those are the parameters we continued to look at to improve the performance of the program, but it's holding up much better than we would have expected and monetary policy is in our favor right now. And, Fred, maybe you want to talk about below the line.

Frederick John Crawford - Chief Financial Officer & Executive Vice President

Yeah. I think the decisions around reporting hedge costs below the line were largely predicated on the notion of these costs being highly sensitive to short-term interest rate fluctuations as you pointed out, Nigel, in your comment. So, that sort of mark-to-market, if you will, fluctuations in costs we felt was better depicted below the line. But most importantly, we are transparent in it and have created a line item around it because we realized that in this particular case, we're making a judgment call as to the definition of our operating earnings and you're now free to model it and track how those costs are moving. So that's fundamentally our position as to why we treat it below the line.

Nigel P. Dally - Morgan Stanley & Co. LLC

Got it. Appreciate the color. Thanks.

Operator

Our next question is from Mr. Jimmy Bhullar from JPMorgan. Your line is open.

Jamminder Singh Bhullar - JPMorgan Securities LLC

Hi. Good morning. So I just had a question on Japan sales. Just your reasoning for the expected decline in sales, I realize comps were tough in the first half of the year, but I would have assumed that you'd have an ongoing tailwind from greater production through the post office, especially from recently added branches. And also, I think you're adding new products later this year. So just discuss what you think will drive the weakness or the decline in sales in Japan and also maybe give a few more details on the new product initiatives in Japan later this year.

Daniel P. Amos - Chairman & Chief Executive Officer

I'm going to let Paul take that. Paul?

Jamminder Singh Bhullar - JPMorgan Securities LLC

Sure.

Paul S. Amos II - President, Global Operations

Jimmy, let me begin by saying that the 13.4% increase in sales last year creates your first hurdle. You're correct we're up against very difficult comparisons and that's going to persist throughout the year. We do believe that we'll have a strong year, but without a product launch of one of our major core products, that being a complete revitalization of either our cancer or medical plans, we are in a year where we're going to have what we consider to be more moderate product launches and therefore, we believe that the sales comparisons, especially against such a large year, will be difficult.

We have some product launches, smaller in nature that we'll look forward in the first half of the year, and then as I mentioned on the outlook call, we'll be launching a completely new product line that we believe will enhance the second half of the year. That said, as is in the case in Japan, when you do things that are brand-new to the company, they tend to have a much slower adoption rate as well as a much slower rate of usage by different channels as we both negotiate with those channels as well as teach them the process for sales of that product. And so, we expect 2016 to be a year where we are enhancing our products and opening up new potential growth, but we expect the majority of that growth to happen beyond 2016.

Unfortunately, I can't go into the specifics about the products themselves, but we feel very comfortable with our plan and our plan for 2017 and 2018 beyond that.

Daniel P. Amos - Chairman & Chief Executive Officer

And Jimmy, I want to add one thing. This time last year, where we thought we would be in 2016 is actually going to be there or even a little higher because if you combine the 13% last year, and then the down this year, the combined is still higher than where we thought it would be. We just happen to being able to have enrolled and penetrated the market for Japan Post even faster than we thought we would, and so I think that's part of the reason.

Jamminder Singh Bhullar - JPMorgan Securities LLC

Okay. And just a follow-up on the previous question on hedging costs and, Fred, your answer makes sense. But I was just wondering how do you – your hedging costs most recent quarter, I think, were around 8% of your earnings. So how do you think about hedging costs in the context of your earnings power and your ROE as you look at results internally?

Frederick John Crawford - Chief Financial Officer & Executive Vice President

Well, the hedging costs obviously factor into what we would call the net yield on our dollar program as compared to investing in other alternatives, JGBs and the like. So those hedging costs factor into our thinking about the relative attractiveness of the dollar program. It also can factor into how much of the dollar investment program we want to leave unhedged at times based on our view of the market.

So, it factors into the investment strategy predominantly. I would also add that those hedging costs also play into even our actuarial testing work, and so we also embed, for example, hedge costs including the rising hedge costs into our long-term cash flow testing and gross premium valuation work. And as I mentioned earlier, we're quite comfortable in terms of margins. So, it does play in. But I think the way we look at it, Jimmy, is more from a net yield perspective. It is really sort of an NII-driven view of those costs as opposed to maybe a conventional operating cost.

Eric M. Kirsch - Global Chief Investment Officer & Executive VP

I might just add, you'll recollect at the last FAB, I put up a chart where we actually showed you the, to Fred's point, the gross performance of the program and the net performance of the program taking out the hedge costs as well as any opportunity costs from settlements, versus a portfolio of JGBs because remember our assets on behalf of Aflac Japan, the liabilities are in yen. So, that's our natural benchmark, and that program has been very, very profitable versus JGBs since inception. And we monitor that on a year-to-date basis, inception to-date basis, a monthly basis to continue to make those relative value decisions between dollars to the dollar program or investing in some other asset classes.

Jamminder Singh Bhullar - JPMorgan Securities LLC

No, I think that makes sense that you are – it's overall beneficial to invest more in dollars and hedges than just buying JGBs. The only point I was trying to make is that it seems like, if that is going to be the case going forward, your operating ROE and operating earnings would overstate the economics of the business to some extent, but that was the point I was trying to make. But thank you for your answers.

Operator

Thank you. Our next question is from Seth Weiss from Merrill Lynch. Your line is open.

Seth M. Weiss - Bank of America Merrill Lynch

Hi. Thank you. Fred, just curious if you could comment a little bit more on U.S. expenses. You mentioned investments and infrastructure. You had mentioned this on the December outlook call. Just curious if any of this is front loading of some of those investments you were planning on making in 2016, and if this at all changes the expense guidance you gave for the U.S. for this coming year?

Frederick John Crawford - Chief Financial Officer & Executive Vice President

Sure. Seth, just a couple comments. I would not over-read accelerated investment into the expense ratio in the fourth quarter, that there was some acceleration of expenses into the fourth quarter. But as my comments and my prepared remarks, we would expect our expense ratio in 2016 to fall back down within the guidance range that we provided for the year. You had a couple things going on expense-wise. You had some acceleration of expenses. You had some miscellaneous items running through the expense line, which will happen from quarter-to-quarter. It didn't naturally fluctuate.

One other item I would note is that we did have a bit more DAC amortization in the quarter. And in fact we believe this relates also to a modestly improved benefit ratio in the period, and that while lapse rates were not unusually outside our expectation, what lapsed in terms of the mix of business that lapsed, tended to be policies that were carrying higher reserves and higher DAC balances. As a result, it tended to push up a better benefit ratio, if you will, or improve our benefit ratio, I should say, and pushed up our expense ratio a little bit. Estimates, in and around 100 basis points, but I would certainly say approximately, just to give you an idea.

So, on the expense side, we would expect to settle back down into our guidance. I do think you should expect what has been a natural seasonal pattern here at the company that we tend to move through the year well within the ranges, but it's not uncommon for us to see a little bit of an elevated expense ratio in the fourth quarter.

Seth M. Weiss - Bank of America Merrill Lynch

Great. Thanks a lot.

Operator

Our next question is from Yaron Kinar from Deutsche Bank. Your line is open.

Yaron J. Kinar - Deutsche Bank Securities, Inc.

Good morning, everybody, and thanks for taking my questions. First, I want to go back to the BOJ action, and I think we talked about the investment impact. But can we also talk about the potential sales impact? I would think that not only could it impact first sector sales in Japan, but maybe it could also influence competitive pressures in third sector sales as maybe reserve rates come down and competition gravitates into the third sector products? So, we'd just like to hear your view on that.

Paul S. Amos II - President, Global Operations

Yeah, be glad, this is Paul, be glad to talk about that. When we think about first sector products, as we've mentioned in the past, we really divide it into two categories. First is a lump sum product, second area is more of the level-premium products. With those lump sum products, we believe that especially given the low interest rate environment, it is not in our best interest to focus on those products. And as a result, we've put strong pressure on those sales. We've put caps in place and we believe that the lump sum will be down as much as 50% or more in 2016.

As it relates to our level-premium products, however, we believe those still are a strong enhancement to our portfolio primarily because of the cross sale that we're getting with our traditional third sector products with cancer and medical, and those products continue to be an overall positive for us. We believe that the sales of those will remain relatively flat for the foreseeable future.

In terms of the BOJ impact to our third sector products, as this point, we don't expect it to have a significant impact. The level of overall competition in third sector products, especially in medical, remains high, but we don't expect there to be any short-term impact to expedite or make that much faster. Hope that answers it.

Yaron J. Kinar - Deutsche Bank Securities, Inc.

It does, thank you. And then, my follow-up question is on the Japanese incurred claims ratio, which was, I think, the lowest I've seen in many years. And was hoping to get a little more color on what drove that abnormally low number.

Frederick John Crawford - Chief Financial Officer & Executive Vice President

It's really predominantly just a continuation of favorable results. As you know, we have been traveling in and around that benefit ratio in Japan of just 60% to 61% for a while here, and so the fourth quarter was modestly favorable.

I would say outside of just trends continue to be generally favorable. I mentioned in my comments that we did have some actuarial adjustments in the period, which are quite normal, frankly, every quarter, but also included some year-end adjustments. On a net basis, that contributed a bit to the positive out-performance. We didn't spike it out in dollar terms or basis point terms because some of these adjustments are quite normal each quarter. But we did benefit a little bit from actuarial adjustments on a net basis.

As a result, I would expect that you should see our benefit ratios in Japan fall back into line with the benefit ratio guidance for 2016 we provided.

Yaron J. Kinar - Deutsche Bank Securities, Inc.

Thank you very much.

Operator

Thank you. Our next question is from Erik Bass from Citigroup. You may ask your question.

Erik J. Bass - Citigroup Global Markets, Inc. (Broker)

Hi. Thank you. Just one follow-up on Japan sales. I think the fourth quarter was the highest quarter for cancer sales in 2015. So can you just provide more details on what drove production this quarter? I guess there's a potential that sales could hold up better than implied in guidance in 2016.

Paul S. Amos II - President, Global Operations

Well, I believe that the execution of our cancer sales was really about the leader of our sales force, Koji Ariyoshi, who is here on the call, continuing to guide our sales force in our different channels to continue to sell our product, because of the launch of that product a little over year ago, a year and a quarter ago, has continued to maintain strong momentum. I get the competition, and overall there's a high demand both in our traditional channels as well as through Japan Post.

And so I believe that is a potential positive that we will see continuation; however, the difficult comparisons that you come up against throughout this year do make us believe that there will be a downward trend in the overall sales, but we do believe that the product remains highly demanded and is still the best product in the market today.

Erik J. Bass - Citigroup Global Markets, Inc. (Broker)

Thank you. And then if I could just ask one on the U.S., can you just talk about where you're seeing the most traction from a sales perspective, and where are the biggest opportunities where you remain underpenetrated?

Teresa L. White - President, Aflac U.S.

Well, certainly, the broker – this is Teresa. Certainly, the broker market, it continues to be a market where we have not seen the penetration that we'd like to see, but we are going in the right direction there. The individual, less than 100 case market as well continues to be a great opportunity for Aflac. It's pretty much our bread and butter and we continue to work in that market. But I think that the market growth is in the broker market and that's really how we are developing our strategies and plans.

Erik J. Bass - Citigroup Global Markets, Inc. (Broker)

Got it. Is there any way to quantify sort of penetration levels in the broker channel at this point?

Teresa L. White - President, Aflac U.S.

At this point, what we're doing is we're looking at the current brokers that we have and we're driving penetration with those brokers. We've seen a 27% increase in our top 100 brokers, but right now, I don't have specifics that I can give you as it relates to penetration. Once we gain a little bit more knowledge as to how we want to report that, we'll start reporting in our FAB, in the booklets.

Daniel P. Amos - Chairman & Chief Executive Officer

Let me just say one thing about sales and that is that if you go back in the past, there was a real conflict between the brokers and our individual agents. And we probably are the – of all the companies out there, with that strong distribution network we've got, they're very important and you can't just forget them. And the thing I liked about sales in 2015 is, we were able to keep our sales numbers for our core agents continue to grow. We had them concentrate more on less-than-100, and we were up about 3%, I think, or 2.5%...

Teresa L. White - President, Aflac U.S.

Actually, it's 5.3% in the less-than-99.

Daniel P. Amos - Chairman & Chief Executive Officer

A 5.3% increase in the less-than-99 sales and then overall, our individual agents were up about 2.5%. And then our brokers were up – the difference is broker isn't (45:15) bigger number as of yet. But being able to manipulate or maneuver I should say, is that maneuver in that space to where we can keep our agents happy and the brokers happy has been our challenge.

But we are accomplishing that. And it's slow and tedious because they were competitors at one time. Even though they weren't direct competitors, our agents were always calling on these big accounts even though they weren't landing them, and the brokers didn't like that. Now they're working together as a team and I think with time there's enormous potential for that market to continue to grow.

Erik J. Bass - Citigroup Global Markets, Inc. (Broker)

Great. Thank you.

Operator

Our next question is from John Nadel from Piper Jaffray. Your line is open.

John M. Nadel - Piper Jaffray & Co (Broker)

Hi. Excuse me. Good morning, everybody. I guess the question I have for you is can we think a little bit more about the composition of the $497 million of sales that were generated in the U.S. in the fourth quarter? Can you put some color as to how much of that came from the broker channel versus the agent channel? And if you have some sense for what the margin would look like for the broker sold business versus the more traditional sold business?

Frederick John Crawford - Chief Financial Officer & Executive Vice President

The profitability.

Daniel P. Amos - Chairman & Chief Executive Officer

Yeah. So on the profitability what I would say, John, is we have not really broken out at this point in time, sort of segmented profitability metrics on group versus individual, broker sold versus agent sold. So I'm not in a position to bust that out for you. What I would tell you is that we certainly priced the product with the notion of meeting our return expectations and obviously, more than and comfortably covering our cost of capital. So the returns are good in our view and priced appropriately. I think we're right in line with competitive pricing in the marketplace. I don't view ourselves as being priced to drive business growth. I think we're doing it the old-fashioned way.

What I would say is because we're in such a growth mode on the group side, we're obviously investing heavier in the group platform to absorb that growth and build for further growth. So because it's been a relatively recent pick up in broker group sales, we are heavily investing in that ways down on a reported, if you will, returns, but over long term, we would expect to achieve returns that are commensurate with what we've achieved individually.

Teresa L. White - President, Aflac U.S.

And I'll just mention one thing, one of the things that I'd like to make sure that we don't assume is that all brokers write group products. 60% of broker sales were individually written product, is our core individually written product. So just wanted to make that comment.

Daniel P. Amos - Chairman & Chief Executive Officer

And let me make one other comment about that. The reason it's skewed that way is not the major brokers. There's two forms of brokers, there's in Columbus a small regional broker that maybe I do buy my property-casualty insurance business from and then there is these massive enormous brokers. And the regional brokers perform more like our sales agents to some degree. And the big brokers, of course, are writing the big accounts and do it totally different. So that's why this skew is more towards 60%, 70%.

Teresa L. White - President, Aflac U.S.

That's correct.

John M. Nadel - Piper Jaffray & Co (Broker)

Okay. And I guess I'm trying to understand the seasonality, right? Because you've said for some time that fourth quarter will now be – or you expect it, anyway, to be the largest production quarter. I guess that has to really mean that we're looking at a much bigger proportion that is broker-sold, whether that's small regional types or the more national players. So as you think about that $497 million, how much of that would you say was broker sold? Is it 75%? Is it 50%? Is it something much bigger?

Teresa L. White - President, Aflac U.S.

So, when we look at the skewing of business through the fourth quarter, what we saw is that from a traditional side, we did see a small list, and I think that that was primarily based on the Affordable Care Act and the dates that enrollments needed to be in place for the Affordable Care Act, because remember they deal with small case brokers as well.

But we did see a large skew of volume, especially group, as Dan said, the larger brokerage houses basically will do group product. So from a group perspective, we saw 50% of the group business come in the fourth quarter, but 40% came in December. So we saw a huge shift of business, which had not been a shift that we'd had before from an Aflac perspective.

Daniel P. Amos - Chairman & Chief Executive Officer

Our Risk Officer and Chief Actuary just said that 40% of our business in the fourth quarter came from broker; is that correct? Okay. That's your answer.

John M. Nadel - Piper Jaffray & Co (Broker)

That's helpful. Thank you. And if I could ask one quick follow-up on the hedged portfolio. I think Eric had mentioned that the cost is running at about 130 basis points to 140 basis points and that's post (51:17). Can you just remind us how big the U.S. dollar portfolio is at this point that we should apply that cost against?

Daniel P. Amos - Chairman & Chief Executive Officer

Sure. The total dollar program is about $21 billion, but the hedges are on about $14 billion to $15 billion of that portfolio. Robin can follow-up with the very specific numbers, but that's approximately right because some of that portfolio we do leave unhedged. It's a hedge against our equity in the branch and about $14 billion-plus is hedged.

John M. Nadel - Piper Jaffray & Co (Broker)

Thank you very much.

Daniel P. Amos - Chairman & Chief Executive Officer

One last thing you might want to know. I just got this number from them. It's 33 (51:54) for the year for broker and it's 40 (51:57) for the fourth quarter. So you can figure it's 30 (51:59) for the first three quarters and 40 (52:03) for the fourth quarter.

John M. Nadel - Piper Jaffray & Co (Broker)

Thank you.

Operator

Thank you. Our next question is from Michael Kovac from Goldman Sachs. You may ask your question.

Michael Kovac - Goldman Sachs & Co.

Thanks. I'm wondering, in the U.S. can you dive in a little bit deeper into some of the underlying drivers of the lower benefit ratio, 2015 versus 2014? And then more specifically the even lower benefit ratio in the fourth quarter?

Daniel P. Amos - Chairman & Chief Executive Officer

Sure. A couple of things. One is really just favorable claims experience in general. And so that has been the case for a while. While I think that aspect of it is stabilizing, it's been favorable and remains favorable. The other dynamic that I mentioned is that, in this particular quarter, we also had lapse rates played in, meaning not so much how much lapsed, but the nature of the product that lapsed in the period.

The product tended to carry, on average, higher reserves, and so there was a greater release of reserves, if you will, related to the lapsation. This also, as I mentioned, played into accelerated DAC amortization and weighed on the expense ratio. As we look at the year-over-year trend, as I mentioned earlier, we would approximate the impact of that dynamic to be in and around 100 basis points related to benefit ratio improvements. Again, that's based on the actuarial information we have and analyzing the nature of products that lapsed. So I think that mix of business in lapsation that will go on from quarter-to-quarter. This is not an unusual quarter. The mix of business will be different from time to time. We'll monitor it going forward, but right now, we hold to the benefit ratio guidance that we've provided on the U.S.

Michael Kovac - Goldman Sachs & Co.

Makes sense. And then looking at recruiting in the U.S., it looked like not only was sales growth fairly strong in the fourth quarter, but we also saw some signs of agent recruiting picking up. Can you discuss some of the drivers there in terms of maybe the broader economy or maybe some more Aflac-specific comments?

Paul S. Amos II - President, Global Operations

I think the driver, quite frankly, is the compensation. We basically are paying for performance with regard to U.S. and part of the compensation drive is the recruiting fees. We are seeing that recruiting in many of our markets have been a struggle in the past, but has not been as much of a struggle right now and it's because, quite frankly, we focused on recruiting.

Michael Kovac - Goldman Sachs & Co.

Thanks.

Operator

Our next question is from Steven Schwartz from Raymond James & Associates. You may ask your question.

Steven D. Schwartz - Raymond James & Associates, Inc.

Thank you. Good morning, everybody. Just one more follow-up on group sales in the U.S. Teresa, would you happen to know how much the group sales were up year-over-year in the fourth quarter? Maybe that would give us a sense of what's going on with the alphabet houses.

Teresa L. White - President, Aflac U.S.

Just a second. Let me make sure I get that number from my actuary (55:20). 32% increase in the fourth quarter for group sales.

Steven D. Schwartz - Raymond James & Associates, Inc.

Okay. On the group sales. And then you said the 20%, so and just to be clear, you mentioned the 27% number. That's total broker sales up or the top 100 broker sales up?

Teresa L. White - President, Aflac U.S.

That is the top 100 broker sales. Absolutely.

Steven D. Schwartz - Raymond James & Associates, Inc.

Okay. Thank you.

Operator

Our next question is from Tom Gallagher from Credit Suisse. Your line is open.

Thomas George Gallagher - Credit Suisse Securities (USA) LLC (Broker)

Good morning. So first question just as a follow-up on these hedging costs, just to make sure I get what the punch line is here. So if we run the 130 basis points, 140 basis point hedge cost assumption through the 2016 P&L, assuming things remain roughly where they are today. Fred, the after-tax difference between operating and net income would be about $200 million. Is that directionally about right, meaning net income would be about $200 million lower than operating?

Frederick John Crawford - Chief Financial Officer & Executive Vice President

Boy, Tom, I'd be reluctant to kind of opine to a number at this point in time. I'd have to look at it, to be candid. So we'll take a look at it and maybe take that type of analysis offline. It strikes me that you're trying to reconcile a model to get to the right number to think about and maybe we can work on that internally.

Thomas George Gallagher - Credit Suisse Securities (USA) LLC (Broker)

Okay. But conceptually, there's going to be that 140 basis points would be applied to the total portfolio, I believe, because you're going to have to roll the whole hedge program. It's not just the new money that's being invested, right? It's the total dollar portfolio where you're rolling the hedges, is that conceptually the way to think about it?

Frederick John Crawford - Chief Financial Officer & Executive Vice President

Well, the reason I'm hesitating is you've got a portfolio of maturities related to those hedge instruments that range in tenure from short to longer as in 3 months to 18 months. We've been stringing it out, as I mentioned in my comments, which shelters us against sharp swings, if you will, in hedge costs in any given year. So I want to think about that (57:54).

Daniel P. Amos - Chairman & Chief Executive Officer

Yeah. I would add two comments, Tom. First, just to give some specific numbers to the question earlier, the dollar program in total is $21.6 billion. Of that, $14.2 billion is hedged. But it's also relevant to your question that ties into part to Fred's answer. Remember what I said earlier, we now have a portfolio of hedge instruments of different types and we stratify the maturities of those. So when I say hedge costs are 130 basis points to 140 basis points, those are current annualized hedge costs. Our realized hedge costs will most likely over time be lower than the annualized. So to Fred's point to answer your question specifically requires a little bit of putting it down on paper. But also not all of our hedges are forwards. So those hedge costs pertain to forward contracts.

Predominantly, we are in forwards, but we do use collar instruments as well. And collars could have a settlement, but that will be more dependent on the level of the yen where it settles versus how we strike the collars and currently, we have about $1.2 billion or so of collars and the rest are forwards. So it's a little bit more complex to answer your question. But I would say this for today, your $200 million number is overstating it.

Thomas George Gallagher - Credit Suisse Securities (USA) LLC (Broker)

Okay. So from a full year standpoint it would come in would you say meaningfully lower than the $200 million?

Daniel P. Amos - Chairman & Chief Executive Officer

It depends on the definition of meaningfully. But I suspect it's a number that's lower than $175 million off the top today.

Thomas George Gallagher - Credit Suisse Securities (USA) LLC (Broker)

(59:33).

Kriss Cloninger III - President

This is Kriss Cloninger. I haven't said anything, but I want to help put this in perspective. We wouldn't have $14 billion of dollar investments if they weren't hedged. And I don't think it's appropriate to say what the hedge costs are without looking at what the additional net investment income associated with the underlying dollar investments are relative to the yen investments. So taking it – I think conceptually you're probably correct in applying 140 basis points to $14 billion and saying, yeah, that's the annualized hedge costs. But keep in mind we wouldn't have $14 billion of unhedged dollar investments unless we had this hedge program. So I think you've got to consider the net investment income differential between dollar investments and yen investments when you're talking about an economic evaluation of the deal.

Frederick John Crawford - Chief Financial Officer & Executive Vice President

I would just, Tom, we were able to do some quick math here. Assuming 130 basis points to 140 basis points, which I think on realized for this year will be lower than that. On an after-tax basis, we are probably looking at about $110 million. And that's probably on the high side because I think our realized hedge costs this year will be lower than the annualized cost where it is now.

Thomas George Gallagher - Credit Suisse Securities (USA) LLC (Broker)

Okay. Thanks, guys. That's helpful.

Robin Y. Wilkey - Senior VP-Investor & Rating Agency Relations

Thank you. We have reached 10 o'clock. So I would like to thank everybody for joining us. And if you have any further questions, you can contact us in Investor Relations. And again, I would remind you about our Analyst Meeting coming up in May, and we hope to see you all then. Thank you very much. Bye-bye.

Operator

That concludes today's conference. Thank you for participating. You may now disconnect.

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