Aflac, Inc. (NYSE:AFL) 2019 Outlook Conference Call December 3, 2018 9:00 AM ET
David Young - VP, Investor and Rating Agency Relations
Dan Amos - Chairman and CEO
Fred Crawford - CFO
Eric Kirsch - Global Chief Investment Officer
Koji Ariyoshi - Director and Head, Sales & Marketing
Humphrey Lee - Dowling & Partners
Suneet Kamath - Citi
Jimmy Bhullar - JP Morgan
Erik Bass - Autonomous Research
John Nadel - UBS
Tom Gallagher - Evercore
Welcome to the Aflac 2019 Outlook 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 Mr. David Young, Vice President of Aflac Investor and Rating Agency Relations.
Good morning and welcome to our 2019 outlook call.
Joining us this morning during the Q&A portion are members of our executive management team in the U.S. Dan Amos, Chairman and CEO; Fred Crawford, CFO of Aflac Incorporated; Teresa White, President of Aflac U.S.; Eric Kirsch, Global Chief Investment Officer; Rich Williams, Chief Distribution Officer; Al Riggieri, Global Chief Risk Officer and Chief Actuary; and Max Brodén, Treasurer.
We are also joined by members of our executive management team in Tokyo at Aflac Life Insurance Japan, Charles Lake, Chairman, Representative Director and President of Aflac International; Masatoshi Koide, President and Representative Director; Todd Daniels, Director and Principal Financial Officer; Koji Ariyoshi, Director and Head of Sales & Marketing.
Before we start, let me remind you that some statements in this teleconference are forward-looking within the meaning of federal security laws. Although we believe these statements are reasonable, we can give no assurance 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 Annual Report on Form 10-K for some of the various risk factors that could materially impact our results. The earnings release is available on the Investors page of Aflac’s website at investors.aflac.com as well as slides for today’s presentations and includes reconciliations of certain non-GAAP measures.
Now, I’ll turn the program over to Dan, who will begin this morning with some high-level comments and outline the Company’s strategic focus, value creation and operational outlook. Fred will follow with comments about our 2019 financial outlook and capital management. Dan?
Thank you, David, and good morning. Thank you for joining us today.
At Aflac, we’ve always managed our business for the long-term while remaining laser-focused on meeting our financial objectives. At the same time, we continue to work on enhancing our customer service and growing our book of business. Over time, our approach has led to the development of our strategic strengths in both Japan and the U.S. that we have leveraged to grow and drive shareholder value.
One of the more evident strengths is Aflac’s well-recognized and strong brand, which many people most commonly associate with the Aflac Duck. While about 9 out of 10 people in both the United States and Japan recognize the Aflac brand, it’s also a name that people have come to trust over the decades. As such, individuals and businesses are more receptive to hearing about Aflac’s innovative products can do to provide value to them.
And our well-established brand continues to serve as a very effective door opener. Along with Aflac’s strong brand, we look to leverage our diverse and productive distribution channels. In Japan and the U.S., we’ve focused a great deal of our efforts on having a presence where consumers want to make their insurance purchasing decisions. We will continue to enhance the productivity of our current channels, while exploring distribution expansion opportunities.
We offer innovative products and high-quality, customized service to provide our customers and affordable solutions that help protect their financial will be. It was our innovative spirit that led to the groundbreaking One Day Pay initiative in the U.S. to process approve and pay eligible claims in just one-day, gets cash in the hands of the policy holders fast. One Day Pay stands out as an example how we place the customer first and it benefited customers’ satisfaction, increased referral opportunities, and differentiated us from our competitors. Most importantly, One Day Pay symbolizes how we look to transform not only our Company but the industry.
Over the past two months, I’ve spent quality time at innovative hubs Charlotte, North Carolina and Shibuya, [ph] Japan. At both locations, I received a comprehensive update and engaged with members of our innovation and digital team. I’m energized about the initiatives we have underdevelopment. I’m also realistic that not all the initiatives will be commercially successful, but that is part of the process of developing the exciting new paths of growth. At the same, I want to make sure that we’re driving digital innovation in the market we dominate and keeping pace with the evolving customer expectations and rapidly industry changes. All of these strengths have combined to our industry-leading market share and scale in both Japan and the U.S., which allows us to offer affordable value coverage to our customers and competitive compensation to our distributors.
We are very proud to be the leaders in voluntary insurance sales at the work site in the U.S. and to insure one out of four households in Japan. Thus, we look to build upon our legal position in both countries. Ultimately these strengths have allowed us to establish a perfectly strong capital positions and consistently deliver stable earnings and strong cash flows to drive value for our shareholders. These points of leverage are the product of years of disciplined approach.
To be clear, our mission and management challenge is to further these core franchise strengths to grow the business and our enterprise value in 2019 and beyond.
For 2019, we continue to focus on delivering profitable growth in both Japan and the United States through our core products by enhancing our distribution, including digital direct initiatives. As such, we continue to evaluate and invest in digital applications and ventures with the aim of improving customer experience and seeing new growth opportunities.
We will continue to focus on maximizing efficiencies through the investments in our IT infrastructure with the goal of enhancing productivity and improving long-term expense ratios. As always, we remain committed to maintaining stable margins and allocating our capital to drive our returns. We will continue to see this in both in our investments strategy and our decisions to emphasize third sector and first sector protection rather than saving products in Japan. We remain committed to returning capital to our shareholders in the form of dividends and share repurchase. We also recognize the smart investment in our platform is critical to grow earned premium and drive efficiencies while ultimately will impact the bottom line. That investment will continue into 2019 and beyond. These areas of focus are steered by strong leadership and governance. I believe we have the right leaders in place who will continue to guide and propel our operations moving forward.
Looking at the near-term growth initiatives, we are pushing sales growth by focusing on three key market opportunities in the U.S. First, for the small business market, we continue to focus on growing the underpenetrated market with the strength of our agency distribution team. Second, we’re expanding our reach into the broker market, especially through local and regional brokers. And third, we will improve the servicing of our existing accounts to drive increased participation and persistency. We’re also investing in digital transformation of our current platform to improve our customer experience. To that, we’re leveraging our U.S. venture investments for commercial partnerships to accelerate our digital innovation.
In 2019, we will consider installing a new platform that supports our strategy to drive agent-assisted sales and digital distribution. This platform will enhance the overall customer experience and make it easier for our distribution teams to sell. We will leverage this platform with our current product fit and innovative new-to-markets products to meet challenging customer needs.
As we look to 2019, we anticipate growth in new sales premium to be stable within the range of the 3% to 5% increase. We continue to expect sales to be skewed towards the fourth quarter, influenced by increased distribution of broker sales. As we execute on our strategy, we anticipate stable premium persistency to lead the earned premium growth of 2% to 3%. We have initiatives underway to address persistency, and we believe there is opportunity over the long run.
Turning to Aflac Japan, we continue to focus on enhancing the value of our core third sector franchise through the following initiatives: Refreshing our existing product to keep pace with medical advancements; utilizing riders of our core medical products that recognize Japan’s aging population, like [indiscernible] nursing care coverage, launching innovative products like our recent health promotion medical insurance that underwrites to your health age and offers recovery of premium when you maintain certain health biometrics. This product is digitally distributed and administered.
Finally, being patient as new products like our income protection product, take hold as one of the few high-quality disability products in the market in Japan.
Our third sector franchise is complemented by the sales of our first sector protection products. While we don’t lead with first sector protection sales, they complement our third sector line of products very well and have similar profitability. From that profitability perspective, we tend to be agnostic when it comes to selling cancer medical or first sector protection insurance.
In 2019, we have initiatives in place to work toward higher policy retention, which allows profitability to emerge as we maintain the business. Long-term, we will continue to leverage our innovative labs in Shibuya, [ph] our strategic partnership and Aflac digital health platforms to develop new, innovative products, solutions that appeal to customers, and revolve around Aflac’s cancer and medical.
Turning to Aflac Japan sales, Aflac Japan’s new marketing campaign will focus on first sector protection products and drive us to attach to medical policies. However, Aflac Japan sales face challenging comparisons given the success of our new cancer product launch in 2018. This launch was supported by the alliance partners who sale only Aflac’s cancer insurance. As a result, we expect third sector and first sector protection sales combined to decline in the low single-digit range. Recognizing the impact of medical and cancer new product launches on a given year sales results, it’s important to focus on the long-term growth. Over the past five years and in the face of competition, we’ve grown our third sector annual sales platform from the mid ¥60 billion range to nearly ¥90 billion annually.
With respect to earned premium, we believe -- or we expect to see a slight decrease in Japan’s total earned premium, mainly due to first sector savings products reaching paid us stats. But most importantly, we expect to see growth of combined net earned premium of third sector and first sector protection products continue to grow in the 2% range, which will be driven by the third sector policies.
Before turning the call over to Fred, it goes without saying that we treasure our 36 years of consecutive dividend growth. I continue to believe that the absence of more compelling alternatives, dividend and share repurchase are the most attractive means of deploying excess capital, and those are the primary avenues we will continue to pursue. At the same time, we will reinvest in our business to enhance organic growth. Ultimately, we believe, this is more sustainable approach to business that will continue to increase shareholder value. By staying disciplined and focused on what we do best, I believe we will continue to generate results to build long-term shareholder value.
Now, I turn the program over to Fred. Fred?
Thank you, Dan.
Let me start by highlighting the key drivers of our 2019 financial outlook. Overall margins in both our Japan and U.S. segments remain strong as we continue to experience favorable benefit ratios and underlying claims trends. Consistent with Dan’s comments, digital growth and IT initiatives are expected to elevate expenses in the near-term, but we are confident will result in improved operating efficiencies and future growth opportunities.
Our investment strategy is designed to drive stable returns while managing capital volatility. We continue to navigate a challenging rate environment in Japan by evolving the U.S. dollar portfolio, asset mix and associated hedging to achieve consistent results. Having completed a year of significant legal structure transition in Japan, we continue to make progress on our capital optimization efforts and anticipate a step up in deployable capital, fuelling our dividend growth and a build in repurchase capacity and opportunistic capital.
A common theme running throughout our business strategy and investment decisions is a focus on defending and building economic value while being mindful that we have experienced several years of favorable market conditions which will ultimately slow and reinforce the benefits of our defensive business model.
Now, I would like to provide greater detail on the assumptions underlying our 2019 core insurance earnings drivers in Japan and the U.S. Focusing first on Japan, while overall premium continues to decline, largely due to first sector policies becoming paid up, we expect third sector earned premium to grow at a steady rate in the 2% range. The distribution of earned premium continues to shift towards third sector, which will lower our reported benefit ratio as compared to 2018. We expect benefit ratios in our core lines of cancer and medical to remain strong with claims trends benefiting from fundamental changes in Japan's healthcare system. We continue to invest in digital and IT administration with near-term efficiencies gained from the processed improvements reinvested back into our platform.
In addition, we have an active product development pipeline in 2019, and ongoing investment in digital solutions, as Dan noted. Together with a modest decline in overall revenue, we therefore expect near-term expense ratios to be elevated. Overall, profit margins remain generally consistent with our full-year forecast for 2018.
Turning to the U.S., earned premium is expected to grow around 2% to 3%. Growth in our group business is gradually shifting the mix of earned premium away from more persistent cancer business towards individual and group short-term disability, accident and hospitalization policies. Premium mix has a gradual impact on our ratios with group in particular having a lower benefit ratio and higher expense ratio, driven largely by lower persistency. While more stable in recent years, we believe trends in healthcare utilization and hospitalization will continue. Our expense ratio will be elevated as we have been actively investing in our U.S. IT and digital and distribution platforms. Our capital management plans in the U.S. naturally represent a headwind to net investment income in the segment. Overall, profit margins are expected to remain generally consistent with our forecast for 2018.
Turning then to the investment strategy. Japan net investment income is expected to increase by nearly ¥2 billion. The build of the U.S. floating rate portfolio is positively influencing our projected new money rate in Japan. Reinvestment of higher-yielding called and maturing yen fixed income investments continue as a headwind but is more than offset by the gradual build in our U.S. dollar portfolio.
With current cost of new hedges above 3% and excess capital in Japan, we continue to lower our hedge ratio, which we expect to be 35% by the end of January. This strategy delivers a sensible return on excess capital and reduces our enterprise exposure to a weakening yen. Consistent with our tactical approach to managing hedge costs and our current view that costs are likely to rise in 2019, we have locked in approximately 80% of 2019 hedge cash costs. Our current forecast is a range of $250 million to $270 million in hedge costs for 2019.
We execute on the strategy consistent with our tactical approach to grouping our U.S. dollar portfolio according to hedged floating rate investments, fixed rate and hedged traditional bond investments and unhedged U.S. dollar investments.
We have completed a review and refreshed our strategic asset allocation. While representing modest adjustments overall, the new strategic asset allocation will guide our new money allocations for the next few years. Adjustments worthy of calling out include placing more portfolio weighting on U.S. dollar floating rate investments and certain U.S. dollar growth and alternative assets such as private equity. We anticipate a lower allocation to JGB and overall yen fixed income assets.
The global investments team will continue to tactically navigate credit and interest rate markets, which will influence the pace and growth of any particular asset class. As mentioned earlier, net investment income for Aflac U.S. will naturally decline, reflecting a reduction in assets backing our RBC drawdown strategy. From an overall Aflac investment income perspective, there is a modest shift in income from our Aflac U.S. segment to the corporate segment, until such time, the excess capital is deployed.
As Max covered at this year's financial Analyst Briefing in Japan, we are actively addressing two meaningful risks to the long-term economic valuation of our enterprise, the exposure to the yen and volatility of hedge costs. As the holding company, we have launched an effort to reduce both of these risks.
As you know, in Japan, we buy U.S. dollar corporate bonds, and hedge them back to yen to synthetically create yen assets relative to the yen liabilities. This also provides significant Japan capital relief and attractive returns. At the holding company, we have entered into forward contracts which offset a portion of the hedge costs for Aflac Japan. By buying U.S. dollar and selling yen, the opposite trades enter into in Japan, we are effectively lowering our overall economic exposure to the yen, while the Japan balance sheet continues the hold the synthetic yen asset for capital stability. The GAAP accounting impacts on net earnings and non-GAAP adjusted earnings would be similar but in offsetting directions. Ultimately, this reduces our risk of hedge cost volatility when looking at consolidated adjusted earnings, reduces GAAP net income volatility and reduces the yen exposure on an economic basis, enterprise-wide. There is a limit to this strategy, given capital and liquidity constraints. We are taking a measured approach to building a program to include both internal and external review. Currently, the program is approximately 2.5 billion and we expect to build modestly throughout 2019. We have forecasted a contribution of $60 million to $80 million to pretax earnings recorded as part of the corporate segment for 2019. This compares to an estimate of $30 million pretax for 2018.
We expect to expand our disclosures in our statistical supplement to assist investors in understanding the program’s quarterly development. I mentioned during our 2018 financial analyst briefing that as we head towards the adoption of new accounting standards, this will only increase the importance of understanding regulatory earnings as the basis of cash flow and deployment of economic value -- development of economic value.
In Japan, FSA earnings power remains strong as we have pulled back from capital and reserve intensive first sector savings products. Earnings are supported by strong benefit ratios and stable investment income. Our U.S. statutory earnings are growing and are supported by earned premium growth and strong benefit ratios. Going forward, there will be greater visibility into our U.S.-only statutory earnings, which improves the transparency of cash flow generation.
Of note, in our earnings projections, we have embedded an estimate for impairments and realized losses, this represent -- represented by the shaded section on the bars. While based somewhat on the bottoms up view of the portfolio, this is simply a practical placeholder we use for overall three-year planning cycle and not specific -- as specific view of estimating losses in 2019 or 2020. Our SMR ratio is sensitive to market fluctuations and is elevated by unrealized gains in our AFS portfolio. Holding all markets conditions stable, we expect SMR to remain in the 950% range for 2019 and RBC will be drawn down to the 525% range. Of note, our 2019 RBC estimate includes both, the full implementation of tax reform and an estimate of the implementation of C-1 capital charges.
As we discussed during last year’s outlook call, 2018 marked a year of transition, and we felt it prudent to carry a higher level of excess capital and liquidity throughout the year. 2019 is a year of executing on our optimization plans, which includes increasing our subsidiary dividend policy up to 100% of both FSA earnings and U.S. statutory income. We will continue with our plans to move $500 million of excess capital out of the U.S. insurance entities. We therefore expect 2019 repurchase to be in the range of $1.3 billion to $1.7 billion, the range allowing us to be more tactical in our deployment strategy. As is always the case, this assumes stable capital conditions in the absence of compelling alternates. Leverage will remain around the midpoint of our 20% to 25% policy range. Along with a successful yen debt offering, we refinanced a piece of our U.S. debt in October. We are tactically leveraging our strong ratings, favorable spreads and access to Japan’s debt markets to secure our low cost of debt and extend maturities.
We expect holding company liquidity to approach $3.5 billion by the end of 2019, which includes a minimum $1 billion capital buffer and now $1 billion of liquidity support for derivatives activity. We have adjusted our liquidity policy to support our holding company strategy to reduce enterprise hedge costs with ample liquidity to manage collateral posting and settlements on associated forwards under stressed foreign exchange assumptions.
Our deployable capital is robust and growing. But it’s worth noting, this is after our first priority of investing in our business model in the form of product development, distribution expansion, digital innovation, IT transformation, and capital and support of our general account strategic asset allocation. In short, regulatory earnings are stable and growing; core ratios remain solid; and cash flow is building, allowing us to balance investments in our profitable business model, while delivering meaningful capital back to shareholders.
Concluding with our view of earnings per share, we are projecting a range for 2019 of adjusted EPS of $4.10 to $4.30 per share, assuming a foreign exchange rate of 110 yen to the dollar. When looking at our currency neutral EPS estimates for 2019 and normalizing for certain tax items identified in 2018, the range equates to approximately a 3% increase. We do this as a solid earnings plan when considering incremental investments in our Japan and U.S. digital growth platforms and a balanced approach to capital deployment.
Our plan does assume a continuation of favorable claims trends in Japan and the U.S. and associated reserve adjustments, consistent with our experience in 2018. Our financial playbook for creating value is straight forward, defend the attractive margins in our core supplemental health business, invest to drive eventual top-line growth, and improve efficiencies. Finally, we continue to balance maintaining strong capital ratios with returning capital to our shareholders.
I’ll turn the call back to David now to take us to Q&A. David?
Thank you, Fred. We’re now ready to take your questions, but let me ask you that you please limit yourself to one initial question followed by a related follow-up to allow other participants an opportunity to ask a question. Operator, we will now take the first question.
Thank you. The first question is from Humphrey Lee of Dowling & Partners. You may now ask you question.
Good morning and thank you for taking my questions. Just looking at the slide that shows the FSA earnings, there seems to be some decline from 2019 to 2020. I was just wondering what would be the driver for that decline.
Yes. There is just really a primary issue going on there, and it has less to do with a decline and more to do with the jump in FSA earnings in 2019. Remember, these are -- we’re talking fiscal year and so, these numbers are March ending 2019. The jump from March ending 2019 is actually related somewhat to the introduction of our new cancer product and some of the lapse in reissue activity which has the effect of lowering your reserves and boosting your FSA earnings. That coupled with very little in the way of impairments and losses has coupled to generate a very strong jump in FSA earnings for the year. So, we are expecting, from a projection standpoint, a modest decline as we see that activity slow down for 2020 fiscal year ending. And then, note, of course, that we have a placeholder of impairments and losses. I think we allocated roughly $150 million in dollar terms of impairments and losses to Japan; that will give you an idea that shaded area. That of course may happen, may not happen, maybe higher, maybe lower. But overall, on a scale basis, remember, this is really not a particularly large drop in FSA earnings; it remains very strong.
Staying with Japan, seeing the slide that you show the net investment income projection, the 2018, you are expecting ¥260 billion. If I think about for the first nine months, you are already close to ¥200 billion. So, the implied ¥60 billion in net investment income in Japan seems to be the lowest quarterly number for 2018. Is that a function of that callable and mature privates that you mentioned earlier or how should I think about the lower fourth quarter net investment income?
We’d have to take a harder look at that Humphrey, just to check the numbers. I would say a few things though, and that is, we have been gradually derisking the portfolio throughout the year, meaning selling out of particularly when we have opportunity to sell out of higher-yielding privates where we have concentrated exposure and that may be catching up a little bit to some of the NII trends. You also have some rolling of hedge costs into a higher hedge cost environment, although fairly modest. I would say we would need to double check your numbers to make sure we’re seeing the same sort of trends you are. But certainly, as we head into the year, while we are expecting an increase in overall NII, that is -- we're happy with that, in the sense that it’s in the face of some derisking, it's in the face of some gradually raising hedge costs, and then having to work against replacing maturing and callable higher-yielding privates. I think Eric can add his comments. But one thing is very, very important to understand is we’re seeing some signs of being cautious and careful around credit markets, and we’re wanting to make sure that on balance, we remain defensive.
The only thing I would add to that -- but as Fred said, we would need to check the accounting numbers. As you all recollect with respect to the build out of our dollar program and the floating rate assets, we were very successful, particularly in the first quarter of 2018 in accelerating some of that build out, as well as in the second quarter. So, most likely, sine those are higher yielding assets, the and second quarter and perhaps a bit in the third quarter reflected a bump-up in our NII in the fourth quarter; so, little less deployment in those asset classes. But, to be specific, we have to check the numbers.
Yes. Right now, in the surface, Humphrey, we’re not quite seeing the drop that you’re noting. But what we’ll do is reconcile later, and if we need to clarify, we will.
Okay. Thank you.
Thank you. The next question is from Suneet Kamath of Citi. Your line is now open.
Thanks. Just to start on capital, the share buyback guidance of $1.3 billion to $1.7 billion. That’s a decently wide range. What would it take to get to the lower end of that range? Is that sort of contemplating sort of economic stress and credit losses, or is it something else there?
Suneet, we have a fairly good opportunistic bucket there, and opportunistic can certainly be on the offense, but opportunistic, and also be on the defense, if we were to face an early cycle, if you will, credit cycle and the like. So, I don’t see the early stages of a credit cycle impacting our deployment plans. Really, the range there is tactical in a sense of as compared to other opportunities to invest our capital. We want to have a range to be tactical. That is tactical up, meaning increasing to the higher end of our range, if that -- if repurchases are used strongly for the capital and it also comes down to the lower end of the range but based primarily on alternative opportunities for that capital.
So, we want to -- we have a range; it’s about $400 million, as you can see, a little bit lighter than last year, but really just to send the signal that we would expect to be tactical. When we talk to our investors, they are very clear that they like repurchase, so do we. It’s an attractive return and has been a very attractive return for the Company, but they also want us to be very practical and tactical about it is well, because it’s a sizable use of capital.
Okay. And then just to pivot to Japan sales, I guess for Dan. It seems like the third sector sales outlook for next year obviously contemplates strong results this year. But, are we getting closer to the point where we’ll start to see consistent growth in the third sector kind of on annual basis or is it one of these situations where we’re just always going to be dealing with comps issues, maybe every other year will be a tougher year for growth as you start to introduce new products?
I think, let me let Koji, and Aflac Japan answer that, and then I’ll follow up, if you like.
Unidentified Company Representative
In terms of the third sector outlook, we have been increasing our AP [ph] since 2013; it was 67.1 at the time of 2013; and in 2016, we went around 88 billion.
And for 2018, we have -- we are projecting that we record the highest ever cancer sales. And as a result -- and so that means, that we will have to compare in 2019 against very high 2018.
And in terms of medical insurance, we -- the product cycle in medical is becoming shorter and shorter, and we are planning to launch a new product in 2019.
And we also believe that because our alliance channel does not medical insurance, although we are launching a new product in medical in 2019, it will not match up with the increase in cancer in 2018.
And although we do believe that 2019 will be a tough comparison against 2018, we do have plans as for 2020 and beyond for new products, as well as improving productivity of our agency channel.
And in terms of increasing the productivity of our agency channel, what we are doing is using a digital tool to show our customers what kind of coverage that our customers are missing, and we can propose.
And also, we are also conducting trainings for our exclusive agencies or agencies that are very much exclusive to Aflac, and to improve their productivity in sales. And that’s all for me.
What I would add is, you’re correct and as the businesses continue to grow, the more difficult it is to achieve the objectives. But we still see growth opportunity. 2019 is a little unusual and that -- it’s going to be a year when we launch riders to attach to the medical products, which means we don’t have a major product like we had in other years. But that cycle that Koji was talking about is getting shorter and shorter. But, I’m still encouraged and believe we still see growth from our existing relationship with partners as well as our deal force itself and what they’re performing with our individual and corporate agencies.
Thank you. Next question is from Jimmy Bhullar of JP Morgan. Your line is now open.
So, Fred, I had a question on expense ratio. And you mentioned it’s going to be elevated because of digital related spending? Should we assume that given all the businesses evolving that this level of spending is ongoing or would you -- is it above what you’d expect as normal and should we expect the expense ratio to moderate in next let’s say 2 to 3 years?
So, let’s break it down into Japan and the U.S., and then I’ll answer your question in terms of timeline. In terms of Japan, we have been, for quite a while now, investing in our IT platform, but we have been achieving savings and reinvesting those savings back into the IT platform. Incrementally, expenses are going up in Japan, budgeted expenses are going up in Japan in the range of ¥5 billion to ¥7 billion, and some of that is related to the digital initiatives and innovation initiatives that we’ve launched in Japan. I think, it’s also important though to know when looking at the Japan expense ratio, that some of that increase is really related to revenue decline in the face of that increased investment. So, we’re seeing budgeted expenses go up a little bit, but we’re seeing revenue come down a little bit, and that creates a little bit of elevated Japan expense ratio but not a substantial delta in the amount of expense.
In the U.S you have really two things going on with the expense ratio. Of course, you have growing revenue in the U.S., and so that's a helper. But there is two items that are pressuring expenses, one actually is a rise in DAC amortization, unrelated to our investments, and that rising DAC amortization is simply a result of selling more group business. Group business tends to have lower persistency, and so you’re amortizing your DAC more quickly. And as that becomes more a portion of our business, you will see a little bit of elevated DAC year-over-year. Now, remember, that comes with a lower benefit ratio, so it tends not to penalize us on the pretax profit margin. From a budgetable expense stand point in the U.S., we are absolutely pushing the paddle and have been for a couple years now in IT transformation in digital. We’re seeing for example, our incremental expense 2018 to projected 2019 on budgeted expenses go up approximately $60 million. That's roughly a one-percentage-point increase in the expense ratio just related to the delta and IT transformation and digital advancement. We obviously expect that to pay off over time in a way of increased premium flows and efficiencies to bring that expense ratio down.
I think, in terms of the timeline, I think you can go back to our long-term projections, and that is both in Japan and the U.S., we’re targeting lower expense ratios come 2022. We've given you some idea of those forecasts at our FAB call around 20% range in Japan and then 33% to 34% range in the U.S. by 2022. So, that gives you an idea of the timeline we’re on for continued spend.
And you mentioned the credit markets in response of your questions. What are your views on where we are sort of in the new credit cycle, and is your deal [ph] making any changes in allocations of securities by asset class or by rating?
I will toss to Eric; he can give you a much better answer on that question. So, Eric?
Thank you, Fred. Good question. We've been watching the credit markets carefully, in particular over the last year, because our sense was probably sometime later ‘19 into ‘20, we would see a shift in the cycle. Of course, we don’t expect to get that exactly right, but broadly. And we also felt more or less a year ago that credit spreads were just so tight, it was really difficult to find relative value. So, we’re not necessarily surprised right now in the credit markets with widening out of spreads, more sensitivity to the leverage loan market.
Relative to our own allocations, we have been doing more private market transactions where we’re negotiating covenants and terms to our liking. We’ve allocated fair amounts of things like transitional real estate which are more investment grade with some allocations to middle market loans, but based on strong credit underwriting. At the same time, we've been pruning where it makes sense in our credit portfolio with an eye towards one to two years from now, if the credit market changes, some of the particular holdings we may have, say in the BBB sector or even below investment grade. We prefer to lighten up today. And we’ve done this year about just around $1 billion of various derisking, I will call it, of some of the older private placements, South Africa would be a good example. We sold a portion of that Catalunya credit that we felt, could have some volatility of the credit cycle changes. So, we think our portfolio is well-positioned for the future, because of good diversification, the credit work that we’ve done over the last few years. And I’ll also say, I think we’re very well-positioned to defensively, but we’re also in a good position to play offense as well. Remember, credit spreads do widen out in certain asset classes. Our capital is strong and our asset allocation plans provide that flexibility. So, those could be opportunities too, as the portfolio is well-positioned moving into the change into the credit cycle that might happen or may not.
Thank you. Next question is from Erik Bass of Autonomous Research. Your line is now open.
Hi. Thank you. I wanted to follow up on Suneet’s question about Japan sales. And you talked about a long-term target of 4% to 6% growth and I realize you’ve certainly done that over the past five years, but that was with the help of bringing on Japan post. And then, I think for 2018 you’re targeting low single digits growth, again, with the benefit of very successful new cancer product, and then 2019 expect to low single digits decline. I guess, what needs to happen to be able to consistently achieve that 4% to 6% target?
Unidentified Company Representative
Well in terms of capital issuance, because we have a large volume or large block of [technical difficulty]
Unidentified Company Representative
Unidentified Company Representative
As I mentioned earlier, in 2018, since we had a boost in cancer sales, we had a largest third sector AP [ph] in the past 10 years in 2018.
And so, our outlook for 2019 is that since we have to go against this very high number in 2018, it will be a tough year.
And as I mentioned, although we will be launching a new medical product, but because of alliance channel does not sell medical insurance, we will not be able to -- we are not expecting to see such a high growth as with cancer.
And although we’ve encountered the CAGR of 4% to 6% for the past few years, by looking at just next year alone, we will be just slightly under 4%, around 3.9%.
But, as I mentioned before, in 2020, we will be launching more new products and we will also be improving agency productivity. As a result, we will be back in that range.
One thing, Erik, this is Fred, that I would say, just to bring some perspective, is don’t lose sight of the fact that since in 2013, the third sector franchise of the Company was producing about ¥65 billion, ¥ 67 billion give or take, actually ¥67 billion in third sector sales, and that same franchise is now producing routinely ¥85 billion plus in third sector sales. And so, any given year with the timing of new product launch, there’ll be ups and downs, and comparables will be tough or easy depending on the year. But overall, what the team in Japan is focused on and Dan and I are focused on is that constant consistency of upgrading your products, refreshing it for medical advances and changing demographics, introducing new product where we think we have opportunity, and then expanding distribution to new demographics through say digital product, for example, which we’ve introduced this year and we hope to build. So, it’s going to be accumulation of a lot of things that year-over-year will cause fluctuation, but don’t lose sight that someone might ask, how have you so consistently increased the growth rate over the last several years in Japan, as opposed to the other way around. We actually are quite happy with the growth rate, but year-over-year will be some volatility.
Got it? I appreciate that. I guess that was sort of the thrust of my questions that you’ve grown a lot over the past few years that your base is a lot higher. And a lot of that came from bringing on a very large distribution partner. So, is the 4% to 6% still a realistic target to think about long-term, given that you’ve reset the base meaningfully higher?
Well, it’s certainly tougher. So, there’s no question about that. But, as you heard from, Koji, he still believes there is a substantial for that to go going forward. So that would be my comment at this particular time. But, I think what Fred said, covered it real well, about how we’re going to continue to grow with going forward.
Got it. Thank you.
It’s worth noting, the right hand side of the slide, which is earned premium. So, one other thing that we’re -- that right hand side of the sales slide that has earned premium is very illustrative. It shows to the changing mix between first sector and third sector. It highlights that we’re trying to move the dial in first sector protection, which is more mortality based product. But, it shows that earned premium is growing pretty steadily, which -- that’s really a sign of economic value growth, and the reducing grade bars are products, or enforced products that carry less in a way of economic value in our view due to interest rate sensitivities and asset intensive and reserve intensive product. So, when we think of growth, we do think of sales of course, we think of earned premium, but we also think of building the economic value in the Company. And you should take that from the slide.
The next question is from John Nadel of UBS. Your line is now open.
Good morning. I have two questions. One, Fred, I think it’s slide 15 in your deck that the enterprise hedge costs reducing FX exposure. Maybe I missed it in your remarks, but could you just -- could you explain to us what the line that says forecasted impact to adjusted earnings of $60 million to $80 million -- what does that mean?
Yes. So, what that is, is that what we would expect -- first of all, by the end of the year, in fact, actually currently as we speak, we have a notional amount of hedges at the holding company of about 2.5 billion, and we would expect on average, the weighted average, if you will, of that notional amount of offsetting hedges at the holding company to be in the range of 3 billion. That 3 billion, if you will, of average notional hedges at the holding company, has a offsetting earnings or has an earnings component to it that offsets the hedge costs in Japan. And so, when you effectively attribute the same methodology we use for hedge costs in Japan to these hedge instruments in the U.S. at the holding company that generates $60 million to $80 million of pretax profitability at the corporate level. So, you will see that profit line emerge in the corporate and other segment of our financials. That’s what we've been doing for the last three quarters. As I mentioned, that number was $30 million pretax in 2018 and now we expect it to rise to $60 million to $80 million as we build program.
And again, remember, the simple way to think about it is we’re entering into forwards of an opposite economic characteristic. And the way I simplistically think about it is I could in theory, go out any day, and I can sell both those positions and generate equal economics on either side. And all we’re trying to do is reflect that reality in our income statement or in this case, our adjusted earnings. And this is the methodology in which we’re doing it because we’re entering into separate transactions at both legal entities, Japan KK and the U.S. holding company.
Got it. That’s helpful. Sorry, it is really more my bad for not keeping up with you in the prepared remarks.
That’s okay. It’s a newer strategy that we developed and is still maturing. And so, we want to be as helpful as we can in the disclosures to understand it, because you do have to wrap your head around the economics and understand how we’re best portraying those economics in our reported adjusted earnings.
Thanks for that. And then the second question. It may be a little bit more of a follow-up to Jimmy’s question. I'm not sure. But, as we think about the elevated spending levels in the relatively near term, how can we think about the pace of that spending when we look out over time. I mean, is there an opportunity for margin -- whether it's in the U.S. or Japan or both, is there an opportunity for margin, pretax operating margin to expand beyond 2019? And I’m really talking about more than just favorable underwriting results or something like that.
I would tell you, John, and others listening, that in our financial planning process where we pay particularly careful attention to the three-year financial plan for ‘19, ‘20 and ‘21, and then in certain areas, we expand that to a five-year forecast, particularly as it relates to expense ratio, since we have a long-term target, we continue to see strong pretax profit margin. And the trends remain largely the same as what you’re seeing last couple years. And that is what we may be leaking out in the way of an expense ratio, either due to elevated DAC amortization due to persistency or proactive investment in our platform to drive premium growth, we are gaining the benefit ratio. Much of that is mix of business related, but it's helping us really defend the pretax profit margin and gives an opportunity for defense and expansion over time, if we can do a good job in executing on the expense side. Now, having said that, whenever you see a declining benefit ratio, you also have an opportunity to look at whether or not there is ways in which to leverage that benefit ratio to grow the business, meaning product design, product pricing, and other strategies, particularly around retention. So, much of a low benefit ratio has to do with lower persistency. And in the U.S. in particular, we would like to see the persistency come up, particularly on the group side, but across the board. We have last rates -- range from 20% to 25% depending on the nature of the product, and we’d like to see that do better. And when that does better, you naturally see a climbing benefit ratio and a reducing expense ratio, because DAC amortization is strong out more.
So, we think we have opportunity in our pre-tax profit margins to reinvest back in the business model to drive growth, and that’s really what we’re focused on. But we can do that while maintaining the strong margins we’ve been recording.
Got you. Very helpful. And, if I can sneak one last one in. Any early indications on fourth quarter for the U.S. in terms of sales, given how critical a quarter it is at this point, given the mix shift?
No, not at this particular point. It all comes in the last five weeks of every quarter now. And it’s too large to tell. But, I’m encouraged by the reports I’ve been getting and the enthusiasm, but don’t go take that it is made, because I have been enthused before. So, let’s just wait and see. But I think we’ve got the right people in the right place, and I’m encourage by the management team and what they’re doing.
Thank you. The next question is from Tom Gallagher of Evercore. Your line is now open.
Good morning. Just from looking at the slides on Japan sales, if I isolate third sector versus first sector protection and separate them, it looks like third sector sales are going to decline by more than the low single-digit, maybe more like 5% to 10%. Can you -- I don’t know if you can quantify that in terms of third sector specifically for 2019?
Generally our sales plan for the year, I mean it has a range, but it’s essentially low single-digit decline, both for third sector only and when combined with third sector and first sector protection.
Can you split out just third sector though, because I know historically you guys have a made a big points of emphasis…
Yes, it’s not significant. The difference between the two is not that significant at this particular point. So, it was single-digit both ways.
Remember, you’ll be a little more range-bound when you’re projecting. So, some of that is a range time as opposed to a point estimate. So, the point estimate is low single digits. There is a range around that where we may do better, we may do worse, but the point estimates are low single digits for both categories.
Got you. And then, because it does look like there is a bit mix shift here going on between first sector protection are expected to be get a bit stronger, third sector a bit weaker, at least just my bowing the graphs. Can you comment a bit more about what’s going on with this first sector protection? And, is that a far better margin than the old ways products that were sold, maybe compare and contrast a bit of what’s happening there?
Yes. It absolutely is. In fact, we created that column, protection category versus the savings category to make it easier for you to follow. Because the protection runs the same profit margin as does the cancer or does the medical. So, as I said earlier in my comments, we’re agnostic in terms of, which way it’s sold and how that’s sold. And we believe that there’s an opportunity for us to tackle on some additional business there, according to our research from our people. So, it’s more meeting the consumers’ needs is what’s driving this to a great degree. And so, we’ll have to wait and see, but we don’t want to lose focus on what’s built the Company, which is the third sector. So, we’re being very cautious about it. But at the same time, Koji feels like and so does his time that it’s worth us considering that and riding it; and as long as it has the same profit margin, we don’t care.
Okay. Let me add a comment, this is Koji.
Well, this first sector protection type is a type of product that we can sell together with third sector or on top of third sector. So, it’s not like we’re changing the product mix altogether. It’s more like, we are selling first sector protection on top of third sector or together with third sector. By doing so, we are also able to maintain the sales of third sector products. So, as I mentioned, our focus or our core products are third sector, but we are selling the first sector protection products on top of the third sector products. So, it’s not like we are totally changing our product mix.
Thank you. I will now hand the call back to Mr. David Young.
Thank you. And thank you all for joining us for our call this morning. Before we end the call today, I’d like to remind everyone of our upcoming fourth quarter earnings release on January 31st followed by teleconference on February 1st. In the interim, please feel free to contact our Investor and Rating Agency Relations department with any questions, and we look forward to speaking with you soon. Thank you.
Thank you. That concludes today’s conference. Thank you for participating. You may now disconnect.