filings.toolsItem 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
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Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
Certain statements included in this section constitute forward-looking statements within the meaning of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements are made based on management’s current expectations and beliefs concerning future developments and their potential effects upon the Company. The Company’s actual results may differ, possibly materially, from expectations or estimates reflected in such forward-looking statements. Certain important factors that could cause actual results to differ, possibly materially, from expectations or estimates reflected in such forward-looking statements can be found in the “Risk Factors” and “Forward-Looking Statements” sections herein.
MD&A OVERVIEW
The following financial review provides a discussion of the Company’s results of operations and financial condition, as well as a summary of the Company’s critical accounting estimates. This section should be read in conjunction with Part I - Item 1. Business and the audited consolidated financial statements and accompanying notes included in Part II - Item 8. Financial Statements and Supplementary Data of this report. This MD&A is divided into the following sections:
The Company elected to omit discussion on the earliest of the three years covered by the consolidated financial statements presented in Item 8. Financial Statements and Supplementary Data. Readers should refer to Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations located in the Company's Annual Report on Form 10-K for the year ended December 31, 2019, filed on February 21, 2020, for reference to discussion of the year ended December 31, 2018, the earliest of the three years presented. Amounts reported in this MD&A may not add due to rounding.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
EXECUTIVE SUMMARY
COVID-19
The impact of the COVID-19 global pandemic on the Company continues to evolve, and its future effects remain uncertain. At the onset of the pandemic, the majority of the Company’s employees in Japan and the U.S. shifted to remote working environments, with returns to office undertaken throughout the year as warranted by local conditions. Both Aflac Japan and Aflac U.S. took measures to address employee health and safety and increase employees’ ability to develop and maintain more flexible working conditions. The Company established command centers to monitor and communicate on developments, and operations remained stable throughout the year. The Company also took prompt action at the beginning of the pandemic to strengthen its capital and liquidity position, and it continued to undertake de-risking activity in its investment portfolios and to adjust to market conditions throughout the year. Both Aflac Japan and Aflac U.S. also accelerated investments in digital initiatives to improve productivity, efficiency and customer service over the long term.
In 2020, both Aflac Japan and Aflac U.S. experienced a significant decrease in sales due to the effects of the pandemic and related government responses. Pandemic-related claims and associated reserve increases in both Japan and the U.S. have not materially impacted 2020 results and were more than offset by a reduction in claims related to routine medical needs. The pandemic’s impact on economic conditions have contributed to sales declines, pressuring premium growth rates. This, in turn, has been partially offset by lower lapse rates in the U.S. Economic conditions in the U.S. have resulted in lower interest rates having an impact on net investment income. The Company did not experience material realized losses or impairments and credit losses associated with the pandemic. The Company continues to closely monitor the effects and risks of COVID-19 to assess its impact on economic conditions in Japan and the U.S. and on the Company's business, financial condition, results of operations, liquidity and capital position. Those impacts may cause changes to estimates of future earnings, capital deployment, regulatory capital position, segment dividend payout ratios and other measures the Company provides in this MD&A.
The Company’s efforts and other developments are outlined below.
*•*Liquidity and Capital Resources
The Company entered the crisis in a strong capital and liquidity position, having maintained capital ratios in Japan and the U.S. at a level designed to absorb a degree of market volatility. To further support liquidity and capital resources, the Parent Company, in March 2020, issued four series of senior notes totaling ¥57.0 billion and, in April 2020, issued $1.0 billion in senior notes through public debt offerings under its U.S. shelf registration statement. Accordingly, as of December 31, 2020 the Company held approximately $5.1 billion in cash and cash equivalents for stress conditions, which includes the Parent Company's target minimum amount of $2.0 billion held to provide a capital buffer and liquidity support at the holding company. Even after these debt offerings, the Company’s leverage ratio remains at levels that the Company believes are adequate to maintain current ratings and leave capacity for further debt issuances. The Company has available liquidity in its unsecured revolving credit facilities of $1.0 billion and ¥100.0 billion, respectively, and currently has no borrowings under either of these facilities. In April 2020, Aflac increased its internal limit for Federal Home Loan Bank of Atlanta (FHLB) borrowings to $800 million, $300 million of which the Company has designated to be used for short-term liquidity needs of the U.S. insurance subsidiaries and subject to qualified collateral availability and other conditions. The Company has the ability to adjust cash flow management from other sources of liquidity including reinvestment cash flows and selling investments.
The Company remains committed to prudent liquidity and capital management and is taking a tactical approach to capital allocation. In terms of repurchases, the Company remains in the market and is being tactical in its approach to repurchasing its stock. The Company believes that this approach will allow it to increase or decrease repurchase activity depending on how the pandemic and market conditions evolve.
The Company is committed to maintaining a strong Aflac Japan solvency margin ratio (SMR) and Aflac U.S. risk-based capital (RBC) ratios. While the SMR is particularly sensitive to market volatility resulting from widening of credit spreads, both SMR and RBC are sensitive to credit downgrades and defaults. The Company has capital tools available to increase SMR and RBC including the reduction of subsidiary dividends paid to the Parent Company by its insurance subsidiaries and Parent Company capital contributions to insurance subsidiaries sourced through cash on hand, proceeds from debt issuances or by drawing on the revolving credit facilities noted above. For example, the Parent Company made a capital contribution of $150 million to CAIC in May 2020 and, pursuant to surplus notes, loaned $50 million to CAIC in December 2020 and $130 million to Aflac in September 2020, the latter of which was used toward the acquisition of Zurich North America's U.S. Corporate Life and
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Pensions business in November 2020. The Company also has a committed reinsurance facility in the amount of approximately ¥120 billion of reserves that could be deployed to support SMR. Additionally, Aflac Japan reduced the dividends it provides to the Parent Company in 2020 by ¥75 billion compared to initial 2020 plans. The Company intends to maintain a target minimum SMR of 500% for Aflac Japan and a target minimum RBC of approximately 400% for Aflac, consistent with the Company's risk management practices.
As a result of market volatility, the Company has made tactical adjustments to its existing foreign currency-hedging program in Aflac Japan to mitigate hedging cost and settlement risk while maintaining a strong SMR. Prior to and continuing through the pandemic, Aflac Japan has maintained a collar program on a portion of its U.S. dollar program to mitigate against more extreme moves in foreign exchange rates and therefore support SMR. In the first quarter of 2020, the Company reduced the size of the collar program by approximately $3 billion. In December 2020, the Company reduced the total size of the forward and collar programs by approximately $5 billion and purchased foreign currency options to hedge approximately $5 billion of U.S. dollar-denominated assets. While these adjustments will moderately increase the Company's exposure to SMR volatility, the Company believes that they will also reduce its exposure to pricing volatility and the related risk of negative settlements should there be a material weakening in the yen. Depending on further developments, including the possibility of further market volatility, there may be additional costs associated with maintaining the collar program. The Company is continually evaluating other adjustments, including the possibility of changing the level of hedging employed with the U.S. dollar-denominated investments. See the Liquidity and Capital Resources section of this MD&A for additional information regarding other potential sources of liquidity and capital resources.
- Investment Portfolio
The Company's investment portfolio was well-positioned entering the crisis, and the Company continues to follow its strategy of investing primarily in fixed maturity securities to generate a reliable stream of income. Fundamental credit analysis and de-risking activity in prior periods contributed to the current quality of the Company’s investments. The Company continued with de-risking activity in 2020, reducing positions in the portfolios seen as more vulnerable in the current environment. Although economic and market conditions improved in the second half of 2020, the Company remains cautious about the continued path of the recovery and the potential longer term impacts on certain sectors most vulnerable to the impacts of the pandemic. The Company continues seeking ways to improve the health of the portfolio through de-risking and other repositioning actions. Certain investments have been adversely impacted with credit rating downgrades and increased price volatility, including investments in issuers that faced an immediate and severe impact such as those in travel and lodging, leisure, non-emergency medical and energy sectors. The Company continues working with certain issuers to provide temporary relief of terms by providing payment deferrals and other modifications or waivers where the Company believes it improves its overall position. For additional information on these loan modifications, see Notes 1 and 3 of the Notes to the Consolidated Financial Statements.
Markets have stabilized from the extreme volatility seen at the outset of the crisis, although issuers continue to be affected by reduced business activity and consumer demand. Volatility in oil prices and reduction in global energy demand continue to adversely impact issuers in the energy sector. U.S. interest rates declined, and availability of new investments in certain private asset classes such as middle market loans, commercial mortgages and transitional real estate remain below pre-crisis levels. As a result, net investment income may be adversely impacted over time from lower reinvestment rates for fixed maturity investments and lower interest on floating rate assets. The Company continues to make tactical adjustments to its investment portfolios in response to the crisis, and continues to assess its investment strategy and asset allocation to identify additional tactical adjustments that may be necessary due to the continuing effects of the pandemic.
*•*Crisis Management
The Company has crisis command centers set up in Japan and the U.S. These command centers are generally utilized for any type of crisis, including natural disasters and cybersecurity events. The command centers participate in regular updates to the Company's leadership regarding developments in Japan and the U.S., including government and regulatory actions, operations, employee policies and conditions and distribution status. In addition, capital market, central bank and government stimulus updates are provided, as well as updates on cybersecurity, including with respect to the Company's remote workforce. Moreover, the Company's financial leadership group meets more frequently and has focused on the capital markets, capital and liquidity position, stress testing and any defensive actions that may be necessary as the crisis unfolds.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
*•*Aflac Japan initiatives
In February 2020, Aflac Japan began to implement actions such as working from home, staggered work hours, limitations on the number of personnel attending in-person meetings and restrictions on traveling between buildings and floors in Aflac Japan worksites. In response to the state of emergency and requests made by the Japan government in April 2020, over 70% of Aflac Japan employees were working from home as of mid-April. The state of emergency was lifted nationwide in May 2020; however, in January 2021, the state of emergency was reinstated in certain prefectures experiencing elevated rates of infection. As of December 31, 2020, Aflac Japan had approximately 50% of its workforce working remotely. Aflac Japan is evaluating return to the office measures; however, throughout the development of the pandemic in 2020, including the increase in COVID-19 cases in Japan during the fourth quarter, Aflac Japan has evaluated its operational capabilities and anticipates that the remote configuration could remain for an indefinite period of time without materially impacting operations.
Aflac Japan has announced several additional actions taken for its employees including travel restrictions and extended paid leave.
Aflac Japan remains focused on generating new business through direct mail made to existing and prospective customers. In addition, Aflac Japan is promoting digital and web-based sales to groups and introduced a new system that enables smart device-based insurance application by allowing the customer and an Aflac Japan operator to see the same screen through their smart devices. Further, in October 2020, Aflac Japan implemented a new virtual sales tool that enables online consultations and policy applications to be completed entirely online. During 2020, Aflac Japan also accelerated investments in digital and paperless initiatives designed to increase long term productivity, efficiency, customer service and business continuity. Face-to-face sales have been challenged and are having an impact on sales results. In 2020, Aflac Japan experienced a sales decline of 36.2% on a yen basis, compared to 2019, primarily due to the impact of the COVID-19 pandemic and the continuing effects of the Japan Post investigation. See the Aflac Japan Segment of this MD&A for additional information regarding sales in the Japan Post channel and the strategic alliance with Japan Post.
Aflac Japan has also followed the guidance of the FSA in terms of treating customers with care, ensuring ease and timeliness of claims payments and extended coverage for temporary medical facilities and telemedicine in certain circumstances, and waiver of interest on certain policyholder loans. In March 2020, Aflac Japan extended the grace period on premium payments for six months up to September 30, 2020 and it was re-extended to April 30, 2021 in certain cases. In January 2021, the grace period was extended to July 31, 2021 for the policyholders who live in areas under the state of emergency and in February 2021, the scope was expanded to all regions in Japan. Policyholders are required to file for relief through this extension. In April 2020, Aflac Japan announced that it will pay certain accidental death and disability benefits in the event of a death directly caused by COVID-19.
To assist with the COVID-19 pandemic, Aflac Japan has donated ¥500 million to the Japan Medical Associations and to identified municipalities where Aflac Japan has operations.
- Aflac U.S. and Corporate and Other initiatives
The Parent Company and Aflac U.S. began to implement Company mandates including restrictions on travel and in-person meetings applicable to U.S. employees beginning in February 2020 and required work from home directives across their U.S. work force in March 2020. As of December 31, 2020, approximately 95% of U.S. employees were working remotely. The Company currently anticipates that a return to the worksite for U.S. based employees of the Parent Company and Aflac U.S. will be conducted in phases beginning no sooner than the second half of 2021, subject to factors including the availability of treatments and vaccines, the return schedule of school systems and the availability of child care, the number of COVID–19 cases and the COVID–19 replication rate in areas of the U.S. where the Company has significant operations. However, Aflac U.S. anticipates that the remote configuration could remain for an indefinite period of time without materially impacting operations. The Parent Company and Aflac U.S. continue to maintain employee and worksite safety measures including travel restrictions, building access restrictions and in-person meeting restrictions.
Aflac U.S. has announced several actions taken for its employees. These include a commitment to cover the costs of COVID-19 testing and extended paid leave in certain circumstances.
Aflac U.S. is focused on supporting its agency channel, most of which are small businesses, by offering zero-interest loans and cash stipends in lieu of canceled recognition trips.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Aflac U.S. policy sales, enrollment and agent recruiting functions are highly dependent upon face-to-face interaction between independent agents and brokers with prospective and new customers and agents. Opportunities for such interaction have been significantly reduced by reactions to the pandemic, such as social distancing, shelter in place orders and work from home initiatives. In addition, licensure of newly recruited agents has been delayed in some states due to the unavailability or difficulty of temporary licenses or online training. Further, despite government stimulus measures, the long-term economic effects of the pandemic on prospective and existing customers is still largely unknown. Similar to Aflac Japan, the Aflac U.S. sales team has worked to adjust its sales approach given the reduction in face-to-face sales. Key elements to this approach include realizing sales at the worksite through an enrollment call center, video enrollment through co-browsing and self-enrollment. The traditional agent sales team is also using virtual recruiting and training through video conferencing in order to maintain or increase the recruiting pipeline. The Aflac U.S. broker sales team is focused on product enhancements due to COVID-19 as well as leveraging technology based solutions to drive enrollment. Further, during 2020 Aflac U.S. also accelerated investments in digital initiatives designed to improve long term productivity, efficiency and customer service. Aflac U.S. is in its second year of the build-out of the Consumer Markets business for the digital direct-to-consumer sale of insurance and sales made through that platform have continued to grow.
Face-to-face sales have been challenged and are having an impact on sales results. In 2020, Aflac U.S. experienced a sales decline of 30.8%, compared to 2019, reflecting the impacts of the pandemic. The Aflac U.S. benefit ratio decreased in 2020, as compared to 2019; however, the ratio began to recover in the second half of 2020, which management believes may indicate the beginning of a return to levels seen over the past several years. The Company expanded a previously piloted wellness initiative beginning in the third quarter of 2020, using digital and direct account engagement to raise awareness among policyholders as to the availability of valuable wellness benefits. The Company estimates this effort had an impact on incurred claims of approximately $19 million since September 2020.
Aflac U.S. is encouraging policyholders who are displaying COVID-19 symptoms to seek treatment and is paying wellness benefits on applicable policies for COVID-19 tests, when completed claims are submitted. Aflac U.S. is also providing coverage for treatment in temporary facilities and by telemedicine in certain circumstances.
Throughout 2020, Aflac U.S. has taken steps to comply with COVID-19-related directives issued by state regulatory authorities, including those requiring or requesting premium grace periods. As of December 31, 2020, premium grace periods remained in effect in 10 states and Puerto Rico. Although aggregate policy lapses decreased from the prior year, Aflac U.S. experienced an increase in policy lapses in the second half of 2020 in certain states where premium grace periods expired and government stimulus measures discussed below were not renewed or initiated. If the premium grace periods continue to expire in 2021, Aflac U.S. would expect an increase in lapse rates.
In September 2020, the Company announced a voluntary separation program for certain U.S. employees. The program provided eligible employees with a severance package, including twelve months of salary, the employee's targeted bonus payout for 2020 and one year of Consolidated Omnibus Budget Reconciliation Act (COBRA) or retiree medical, if eligible. Employees accepted into this program were notified in October 2020 and most transitions were completed by December 31, 2020, with a small number continuing into the first quarter of 2021. The Company recorded a one-time severance charge of $43 million in the fourth quarter of 2020 related to the program.
In 2020, the Parent Company contributed $6 million to organizations that are providing assistance for health care workers assisting with the COVID-19 pandemic.
*•*Major government initiatives
Government authorities in Japan and the U.S. have implemented several initiatives in response to the COVID-19 pandemic, including actions designed to mitigate the adverse health effects of the virus and those designed to provide broad-based relief and economic support to all aspects of the economy.
In Japan, initial emergency orders declared by the Japan government were lifted; however, emergency orders have been reinstated in certain prefectures that include Tokyo and surrounding areas experiencing elevated rates of infection.
The FSA has requested that financial service providers in Japan respond appropriately while continuing their
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
essential operations. This request includes insurance companies, which have been asked to continue essential operations such as benefits and claims payment, including policyholder loans. Moreover, following the expansion of the impact of COVID-19, the FSA requested insurance companies to consider flexible interpretation and application of insurance policy provisions and measures required for products from the standpoint of protecting policyholders. In accordance with the FSA’s request, Aflac Life Insurance Japan Ltd. implemented a measure to pay accidental death benefits and accidental serious disability benefits under its accidental death benefit rider, etc. in cases of death or specified serious disabilities from COVID-19.
In April 2020, the Cabinet of Japan approved ¥117 trillion or more than 20% of GDP in emergency stimulus measures, including various tax measures. In May 2020, the Cabinet of Japan approved a second ¥117 trillion stimulus package. The Diet passed a supplementary budget to fund the package in June 2020. The second stimulus package was intended to help small and mid-sized businesses fund leave allowances for furloughed workers and provides rent assistance for business operations.
In the U.S., initial statewide shelter in place or stay at home orders were lifted although reopening plans have been paused or reversed in certain states experiencing an increase in cases, and shelter in place orders have been reinstated in some areas.
The U.S. government took action in response to the COVID-19 pandemic by providing broad-based relief and economic support to all aspects of the economy.
The Coronavirus Aid, Relief, and Economic Security (CARES) Act, was signed into law in March 2020 and was designed to provide approximately $2 trillion in financial stimulus in the form of financial aid to individuals, businesses, nonprofits, states, and municipalities. Among other measures, the CARES Act provided for $260 billion in expanded unemployment benefits and $290 billion of direct payments to individuals, and established a $349 billion Paycheck Protection Program (PPP) providing for loans to small businesses, nonprofits, and veteran’s organizations with 500 or fewer employees. In April 2020, an additional $320 billion was allocated to the PPP, including $10 billion for administrative costs and $60 billion allocated to small lenders and community banks. In December 2020, the Consolidated Appropriations Act, 2021 (CAA) was signed into law. Among other measures, the CAA allocated an additional $284 billion to the PPP, extended the program to March 31, 2021, and provided for expanded unemployment benefits and direct payments to individuals. The CARES Act also included a five-year net operating loss (NOL) carryback, payroll tax relief and other significant provisions for businesses. Section 4013 of the CARES Act gives entities temporary relief from certain accounting and disclosure requirements for troubled debt restructurings (TDRs). The Company has applied GAAP relief with respect to certain qualifying loan modifications. See Notes 1 and 3 of Notes to the Consolidated Financial Statements for additional details.
The Federal Reserve has also taken various actions in an effort to support the economy and markets in response to heightened volatility and uncertainty. These actions include reducing by 1.5% each the rate that it charges for direct loans to banks, as well as the target for the rate banks charge each other for overnight funds (federal funds rate); initiating quantitative easing with no stated cap on purchases; committing to purchase U.S. Treasury securities, agency mortgage-backed and agency commercial mortgaged-backed securities; re-establishing the Term Asset-Backed Securities Loan Facility (TALF) originally launched in 2009, through which it will lend to holders of AA-rated asset-backed securities; and establishing facilities to support purchase of corporate bonds from large investment-grade companies.
Performance Highlights
For the full year of 2020, total revenues were down .7% to $22.1 billion, compared with $22.3 billion for the full year of 2019. Net earnings were $4.8 billion, or $6.67 per diluted share, compared with $3.3 billion, or $4.43 per diluted share, for the full year of 2019. The increase in net earnings and net earnings per diluted share in 2020 primarily reflects a $1.4 billion benefit from the release of valuation allowances on deferred foreign tax credits, which were allowed due to newly released U.S. tax regulations. The Company recorded a one-time severance charge of $43 million in the fourth quarter of 2020 related to the voluntary separation program.
Results for 2020 included pretax net investment losses of $270 million, compared with net investment losses of $135 million in 2019. Net investment losses in 2020 included $200 million of credit losses primarily driven by increases in credit losses; $169 million of net losses from certain derivative and foreign currency gains or losses; $184 million of net gains on equity securities; and $85 million of net losses from sales and redemptions.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The average yen/dollar exchange rate(1) in 2020 was 106.86, or 2.1% stronger than the rate of 109.07 in 2019.
Adjusted earnings(2) for the full year of 2020 were $3.6 billion, or $4.96 per diluted share, compared with $3.3 billion, or $4.44 per diluted share, in 2019. The stronger yen/dollar exchange rate impacted adjusted earnings per diluted share by $.04.
Total investments and cash at the December 31, 2020 were $149.8 billion, compared with $138.1 billion at December 31, 2019. In 2020, Aflac Incorporated repurchased $1.5 billion, or 37.9 million of its common shares. At December 31, 2020, the Company had 99.2 million remaining shares authorized for repurchase.
Shareholders’ equity was $33.6 billion, or $48.46 per share, at December 31, 2020, compared with $29.0 billion, or $39.84 per share, at December 31, 2019. Shareholders’ equity at December 31, 2020 included a net unrealized gain on investment securities and derivatives of $10.3 billion, compared with a net unrealized gain of $8.5 billion at December 31, 2019. Shareholders’ equity at December 31, 2020 also included an unrealized foreign currency translation loss of $1.1 billion, compared with an unrealized foreign currency translation loss of $1.6 billion at December 31, 2019. The annualized return on average shareholders’ equity in 2020 was 15.3%, driven primarily by a benefit from new tax regulations.
Shareholders’ equity excluding accumulated other comprehensive income (AOCI)(2) (adjusted book value) was $24.6 billion, or $35.56 per share at December 31, 2020, compared with $22.3 billion, or $30.74 per share, at December 31, 2019. The annualized adjusted return on equity excluding foreign currency impact(2) in 2020 was 15.0%.
(1) Yen/U.S. dollar exchange rates are based on the published MUFG Bank, Ltd. telegraphic transfer middle rate (TTM).
(2) See the Results of Operations section of this MD&A for a definition of this non-U.S. GAAP financial measure.
INDUSTRY TRENDS
The Company is impacted by financial markets, economic conditions, regulatory oversight and a variety of trends that affect the industries where it competes.
Financial and Economic Environment
The Company’s business and results of operations are materially affected by conditions in the global capital markets and the economy generally. Stressed conditions, volatility and disruptions in global capital markets, particular markets, or financial asset classes can have an adverse effect on the Company, in part because the Company has a large investment portfolio and its insurance liabilities and derivatives are sensitive to changing market factors. See Item 1A. Risk Factors for the risk factor entitled, "Difficult conditions in global capital markets and the economy, including those caused by the novel coronavirus COVID-19, could have a material adverse effect on the Company's investments, capital position, revenue, profitability, and liquidity and harm the Company's business."
Demographics
Aflac Japan
With Japan’s aging population and the rise in healthcare costs, supplemental health care insurance products remain attractive. However, due to the aging population and decline in birthrate, new opportunities for customer demographics are not as readily available. Japan’s existing customers and potential customers seek products that are easily understood, cost-effective and can be accessed through technology-enabled devices.
Aflac U.S.
Customer demographics continue to evolve and new opportunities present themselves in different customer segments such as the millennial and multicultural markets. Customer expectations and preferences are changing. Trends indicate existing customers and potential customers seek cost-effective solutions that are easily understood and can be accessed through technology-enabled devices. Additionally, income protection and the health needs of retiring baby boomers are continuing to shape the insurance industry.
Regulatory Environment
See Item 1. Business - Aflac Japan Government Regulation and Aflac U.S. Government Regulation for a discussion of regulatory developments that may impact the Company and the associated risks.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Competitive Environment
See Item 1. Business - Aflac Japan Competitive Markets and Aflac U.S. Competitive Markets for a discussion of the competitive environment and the basis on which the Company competes in each of its segments.
2021 OUTLOOK
The Company’s strategy to drive long-term shareholder value is to pursue growth through product development, distribution expansion and digital advancements to improve the customer experience.
The Company's objectives in 2021 are to navigate the COVID-19 pandemic while maintaining strong pre-tax margins in its Aflac Japan and Aflac U.S. segments, continuing to accelerate the pace of investment in its digital technology, and integrating and building upon recent acquisitions. The Company believes that its strategy of positioning itself for future growth and efficiency while defending and leveraging its market-leading position, powerful brand recognition and diverse distribution in Japan and the U.S. will provide support toward these objectives.
The Company announced a 17.9% increase in the first quarter 2021 dividend compared to the prior quarter, and it intends to maintain strong capital ratios in Aflac Japan and Aflac U.S. in support of its commitment to shareholder dividends while remaining tactical in its deployment of capital in the form of share repurchases and opportunistic investments. The Company intends to maintain a target minimum SMR of 500% for Aflac Japan and a target minimum RBC of approximately 400% for Aflac, consistent with the Company's risk management practices.
Aflac Japan Segment
In Japan, the Company anticipates that the shift in earned premium from first sector savings products to third sector cancer and medical products and first sector protection products, will continue to result in moderately lower benefit ratios in the Aflac Japan segment. The Company expects expenses to be elevated in 2021 as Aflac Japan’s investments in its paperless initiative and other digital projects are being accelerated. The Company also anticipates that benefit and expense ratios will continue to experience some level of revenue pressure due to the impact of paid up policies and reduced sales in 2020. For the 2020 through 2022 period, the Company expects a decline in Aflac Japan revenue in the range of 2.0% to 3.0% on a compound annual growth rate basis.
Aflac U.S. Segment
The Company expects the profit margins for the Aflac U.S. segment to decline in 2021 as benefit ratios stabilize, expense ratios continue to be elevated in light of investments into U.S. platforms and revenues face pressure due to the impact of the global pandemic on sales. For the 2020 through 2022 period, the Company expects Aflac U.S. revenue to range from a decline of 1.0% to a growth of 1.5% on a compound annual growth rate basis.
Corporate and Other Segment
The Company expects corporate segment results to reflect stable net investment income in 2021 compared to 2020, assuming that U.S. interest rates remain stable.
For important disclosures applicable to statements made in this 2021 Outlook, please see the Risk Factors section and the statement on Forward-Looking Information at the beginning of Item 1. Business, the Risk Factors identified in Item 1A. and Item 7. Management Discussion and Analysis.
RESULTS OF OPERATIONS
The Company earns its revenues principally from insurance premiums and investments. The Company’s operating expenses primarily consist of insurance benefits provided and reserves established for anticipated future insurance benefits, general business expenses, commissions and other costs of selling and servicing its products. Profitability for the Company depends principally on its ability to price its insurance products at a level that enables the Company to earn a margin over the costs associated with providing benefits and administering those products. Profitability also depends on, among other items, actuarial and policyholder behavior experience on insurance products, and the Company's ability to attract and retain customer assets, generate and maintain favorable investment results, effectively deploy capital and utilize tax capacity, and manage expenses.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Yen–denominated income statement accounts are translated to U.S. dollars using a weighted average Japanese yen/U.S. dollar foreign exchange rate, except realized gains and losses on security transactions which are translated at the exchange rate on the trade date of each transaction. Yen–denominated balance sheet accounts are translated to U.S. dollars using a spot Japanese yen/U.S. dollar foreign exchange rate.
The following discussion includes references to the Company's performance measures, adjusted earnings, adjusted earnings per diluted share, and amortized hedge costs/income, which are not calculated in accordance with U.S. GAAP (non-U.S. GAAP). These measures exclude items that the Company believes may obscure the underlying fundamentals and trends in the Company's insurance operations because they tend to be driven by general economic conditions and events or related to infrequent activities not directly associated with its insurance operations. The Company's management uses adjusted earnings and adjusted earnings per diluted share to evaluate the financial performance of its insurance operations on a consolidated basis, and the Company believes that a presentation of these measures is vitally important to an understanding of its underlying profitability drivers and trends of its insurance business. The Company believes that amortized hedge costs/income, which are a component of adjusted earnings, measure the periodic currency risk management costs/income related to hedging certain foreign currency exchange risks and are an important component of net investment income.
The Company defines the non-U.S. GAAP financial measures included in this filing as follows:
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Adjusted earnings are the profits derived from operations. The most comparable U.S. GAAP measure is net earnings. Adjusted earnings are adjusted revenues less benefits and adjusted expenses. The adjustments to both revenues and expenses account for certain items that cannot be predicted or that are outside management’s control. Adjusted revenues are U.S. GAAP total revenues excluding net investment gains and losses, except for amortized hedge costs/income related to foreign currency exposure management strategies and net interest cash flows from derivatives associated with certain investment strategies. Adjusted expenses are U.S. GAAP total acquisition and operating expenses including the impact of interest cash flows from derivatives associated with notes payable but excluding any nonrecurring or other items not associated with the normal course of the Company’s insurance operations and that do not reflect the Company's underlying business performance.
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Adjusted earnings per share (basic or diluted) are adjusted earnings for the period divided by the weighted average outstanding shares (basic or diluted) for the period presented. The most comparable U.S. GAAP measure is net earnings per share.
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Amortized hedge costs/income represent costs/income incurred or recognized as a result of using foreign currency-derivatives to hedge certain foreign exchange risks in the Company's Japan segment or in the Corporate and Other segment. These amortized hedge costs/income are estimated at the inception of the derivatives based on the specific terms of each contract and are recognized on a straight line basis over the term of the hedge. There is no comparable U.S. GAAP financial measure for amortized hedge costs/income.
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Adjusted earnings excluding current period foreign currency impact are computed using the average foreign currency exchange rate for the comparable prior-year period, which eliminates fluctuations driven solely by foreign currency exchange rate changes. The most comparable U.S. GAAP measure is net earnings.
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Adjusted earnings per diluted share excluding current period foreign currency impact are adjusted earnings excluding current period foreign currency impact divided by the weighted average outstanding diluted shares for the period presented. The most comparable U.S. GAAP measure is net earnings per share.
*•*U.S. dollar-denominated investment income excluding foreign currency impact is determined using the average foreign currency exchange rate for the comparable prior year period.
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Adjusted book value is the U.S. GAAP book value (representing total shareholders' equity), less AOCI as recorded on the U.S. GAAP balance sheet. The most comparable U.S. GAAP measure is total book value. The Company considers adjusted book value important as it excludes AOCI, which fluctuates due to market movements that are outside management's control.
-
Adjusted return on equity (ROE) excluding foreign currency impact is calculated using adjusted earnings excluding current period foreign currency impact divided by average shareholders’ equity, excluding AOCI. The most comparable U.S. GAAP financial measure is return on average equity as determined using net earnings and average total shareholders’ equity.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following table is a reconciliation of items impacting adjusted earnings and adjusted earnings per diluted share to the most directly comparable U.S. GAAP measures of net earnings and net earnings per diluted share, respectively, for the years ended December 31.
Reconciliation of Net Earnings to Adjusted Earnings**(1)**
| In Millions | Per Diluted Share | ||||||||||||||||||||||||||||||||||
| 2020 | 2019 | 2020 | 2019 | ||||||||||||||||||||||||||||||||
| Net earnings | $ | 4,778 | $ | 3,304 | $ | 6.67 | $ | 4.43 | |||||||||||||||||||||||||||
| Items impacting net earnings: | |||||||||||||||||||||||||||||||||||
| Net investment (gains) losses (2),(3),(4),(5) | 229 | 15 | .32 | .02 | |||||||||||||||||||||||||||||||
| Other and non-recurring (income) loss | 28 | 1 | .04 | .00 | |||||||||||||||||||||||||||||||
| Income tax (benefit) expense on items excluded from adjusted earnings | (72) | (3) | (.10) | .00 | |||||||||||||||||||||||||||||||
| Tax reform adjustment (6) | 0 | (4) | .00 | (.01) | |||||||||||||||||||||||||||||||
| Tax valuation allowance release (7) | (1,411) | 0 | (1.97) | .00 | |||||||||||||||||||||||||||||||
| Adjusted earnings | 3,552 | 3,314 | 4.96 | 4.44 | |||||||||||||||||||||||||||||||
| Current period foreign currency impact (8) | (31) | N/A | (.04) | N/A | |||||||||||||||||||||||||||||||
| Adjusted earnings excluding current period foreign currency impact | $ | 3,521 | $ | 3,314 | $ | 4.92 | $ | 4.44 |
(1) Amounts may not foot due to rounding.
(2) Amortized hedge costs of $206 in 2020 and $257 in 2019, related to certain foreign currency exposure management strategies have been reclassified from net investment gains (losses) and included in adjusted earnings as a decrease to net investment income. See "Hedge Costs/Income" discussion below for further information.
(3) Amortized hedge income of $97 in 2020 and $89 in 2019, related to certain foreign currency exposure management strategies have been reclassified from net investment gains (losses) and included in adjusted earnings as an increase to net investment income. See "Hedge Costs/Income" discussion below for further information.
(4) Net interest cash flows from derivatives associated with certain investment strategies of $12 in 2020 and $(17) in 2019 have been reclassified from net investment gains (losses) and included in adjusted earnings as a component of net investment income.
(5) A gain of $56 in 2020 and $66 in 2019 related to the interest rate component of the change in fair value of foreign currency swaps on notes payable have been reclassified from net investment gains (losses) and included in adjusted earnings as a component of interest expense.
(6) The impact of tax reform was adjusted in 2019 as a result of additional guidance released by the IRS.
(7) One-time tax benefit recognized in 2020 representing the release of valuation allowances on deferred foreign tax credits due to new tax regulations.
(8) Prior period foreign currency impact reflected as “N/A” to isolate change for current period only.
Reconciling Items
Net Investment Gains and Losses
The Company's investment strategy is to invest primarily in fixed maturity securities to provide a reliable stream of investment income, which is one of the drivers of the Company’s growth and profitability. This investment strategy incorporates asset-liability matching (ALM) to align the expected cash flows of the portfolio to the needs of the Company's liability structure. The Company does not purchase securities with the intent of generating investment gains or losses. However, investment gains and losses may be realized as a result of changes in the financial markets and the creditworthiness of specific issuers, tax planning strategies, and/or general portfolio management and rebalancing. The realization of investment gains and losses is independent of the underwriting and administration of the Company's insurance products. Net investment gains and losses include securities transactions, credit losses, derivative and foreign currency activities and changes in fair value of equity securities.
Securities Transactions, Credit Losses and Gains (Losses) on Equity Securities
Securities transactions include gains and losses from sales and redemptions of investments where the amount received is different from the amortized cost of the investment. Prior to January 1, 2020, impairments include other-than-temporary impairment losses on investment securities as well as changes in loan loss reserves for loan receivables. Effective January 1, 2020, credit losses include losses for held-to-maturity fixed maturity securities, available-for-sale fixed maturity securities, loan receivables, loan commitments and reinsurance recoverables.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Certain Derivative and Foreign Currency Gains (Losses)
The Company's derivative activities include:
-
foreign currency forwards and options used in hedging foreign exchange risk on U.S. dollar-denominated investments in Aflac Japan's portfolio
-
foreign currency forwards and options used to economically hedge certain portions of forecasted cash flows denominated in yen and hedge the Company's long term exposure to a weakening yen
-
cross-currency interest rate swaps, also referred to as foreign currency swaps, associated with certain senior notes and subordinated debentures
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foreign currency swaps that are associated with variable interest entity (VIE) bond purchase commitments, and investments in special-purpose entities, including VIEs where the Company is the primary beneficiary
-
interest rate swaps used to economically hedge interest rate fluctuations in certain variable-rate investments
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interest rate swaptions used to hedge changes in the fair value associated with interest rate fluctuations for certain U.S. dollar-denominated available-for-sale fixed-maturity securities
-
bond purchase commitments at the inception of investments in consolidated VIEs.
Gains and losses are recognized as a result of valuing these derivatives, net of the effects of hedge accounting. The Company also excludes from adjusted earnings the accounting impacts of remeasurement associated with changes in the foreign currency exchange rate. Amortized hedge costs/ income related to certain foreign currency exposure management strategies (see Amortized Hedge Cost/Income section below), and net interest cash flows from derivatives associated with certain investment strategies and notes payable are reclassified from net investment gains (losses) and included in adjusted earnings.
Amortized hedge costs/income can fluctuate based upon many factors, including the derivative notional amount, the length of time of the derivative contract, changes in both U.S. and Japan interest rates, and supply and demand for dollar funding. Amortized hedge costs and income have fluctuated in recent periods due to changes in the previously mentioned factors. For additional information regarding foreign currency hedging, refer to Hedging Activities in the Investments section of this MD&A.
For additional information regarding net investment gains and losses, including details of reported amounts for the periods presented, see Notes 3 and 4 of the Notes to the Consolidated Financial Statements.
Other and Non-recurring Items
The U.S. insurance industry has a policyholder protection system that provides funds for the policyholders of insolvent insurers. The system can result in periodic charges to the Company as a result of insolvencies/bankruptcies that occur with other companies in the life insurance industry. Some states permit member insurers to recover assessments paid through full or partial premium tax offsets. These charges neither relate to the ordinary course of the Company’s business nor reflect the Company’s underlying business performance, but result from external situations not controlled by the Company. The Company excludes any charges associated with U.S. guaranty fund assessments and the corresponding tax benefit or expense from adjusted earnings.
In Japan, the government also requires the insurance industry to contribute to a policyholder protection corporation that provides funds for the policyholders of insolvent insurers; however, these costs are calculated and administered differently than in the U.S. In Japan, these costs are not directly related to specific insolvencies or bankruptcies, but are rather a regular operational cost for an insurance company. Based on this structure, the Company does not remove the Japan policyholder protection expenses from adjusted earnings.
In 2020, other items also included integration costs related to the Company's acquisition of Zurich North America's U.S. Corporate Life and Pensions business; these costs primarily consist of expenditures for legal, accounting, consulting, integration of systems and processes and other similar services. These integration costs amounted to $13 million for the year ended December 31, 2020.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Income Taxes
The Company's combined U.S. and Japanese effective income tax rate on pretax earnings was (14.9)% in 2020 and 25.7% in 2019. In 2020, the combined effective tax rate differs from the U.S. statutory rate primarily due to the release of certain valuation allowances established on the Company's deferred foreign tax credit benefits. The release of these valuation allowances was a result of the issuance of Final and Proposed Regulations by the U.S. Treasury and Internal Revenue Service in September 2020, and resulted in a one-time income tax benefit of $1.4 billion in the third quarter of 2020. Total income taxes were $(.6) billion in 2020 and $1.1 billion in 2019. Japanese income taxes on Aflac Japan's results account for most of the Company's consolidated income tax expense.
For additional information, see Note 10 of the Notes to the Consolidated Financial Statements and the Critical Accounting Estimates - Income Taxes section of this MD&A.
The Company expects that its effective tax rate for future periods will be approximately 20%. The effective tax rate continues to be subject to future tax law changes both in the U.S. and in foreign jurisdictions. See the risk factor entitled "Tax rates applicable to the Company may change" in Part I, Item 1A. Risk Factors for more information.
Foreign Currency Translation
Aflac Japan’s premiums and a significant portion of its investment income are received in yen, and its claims and most expenses are paid in yen. Aflac Japan purchases yen-denominated assets and U.S. dollar-denominated assets, which may be hedged to yen, to support yen-denominated policy liabilities. These and other yen-denominated financial statement items are, however, translated into dollars for financial reporting purposes. The Company translates Aflac Japan’s yen-denominated income statement into dollars using the average exchange rate for the reporting period, and the Company translates its yen-denominated balance sheet using the exchange rate at the end of the period.
Due to the size of Aflac Japan, whose functional currency is the Japanese yen, fluctuations in the yen/dollar exchange rate can have a significant effect on the Company's reported results. In periods when the yen weakens, translating yen into dollars results in fewer dollars being reported. When the yen strengthens, translating yen into dollars results in more dollars being reported. Consequently, yen weakening has the effect of suppressing current period results in relation to the comparable prior period, while yen strengthening has the effect of magnifying current period results in relation to the comparable prior period. Management evaluates the Company's financial performance both including and excluding the impact of foreign currency translation to monitor, respectively, cumulative currency impacts on book value and the currency-neutral operating performance over time.
RESULTS OF OPERATIONS BY SEGMENT
U.S. GAAP financial reporting requires that a company report financial and descriptive information about operating segments in its annual and interim period financial statements. Furthermore, the Company is required to report a measure of segment profit or loss, certain revenue and expense items, and segment assets. The Company's insurance business consists of two segments: Aflac Japan and Aflac U.S. Aflac Japan is the principal contributor to consolidated earnings. Businesses that are not individually reportable, such as the Parent Company, asset management subsidiaries and business activities, including reinsurance retrocession activities are included in the Corporate and other segment. See the Item 1. Business section of this Form 10-K for a summary of each segment's products and distribution channels.
In 2020, Aflac Japan sales for protection-type first sector and third sector products decreased 36.9% and total sales decreased 36.2% on a yen basis, compared to 2019, primarily due to the impact of the COVID-19 pandemic and the continuing effects of the Japan Post investigation. Sales from Aflac U.S. were down 30.8% in 2020, as compared to 2019, due to social distancing efforts, which eliminated face-to-face sales opportunities beginning in mid-March 2020. The respective Aflac Japan and Aflac U.S. platforms and distribution partners continue to work to adapt to the new environment. The Company continues to monitor the effects of COVID-19 on its operating results and has taken several steps to mobilize its resources to ensure adequate liquidity, a strong capital position, business continuity and employee safety during this pandemic. See the Executive Summary subsection of this MD&A for additional information.
Consistent with U.S. GAAP guidance for segment reporting, pretax adjusted earnings is the Company's U.S. GAAP measure of segment performance. The Company believes that a presentation of this measure is vitally important to an understanding of the underlying profitability drivers and trends of its business. Additional performance measures used to evaluate the financial condition and performance of the Company's segments are listed below.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
-
Operating Ratios
-
Expense Ratio
-
New Annualized Premium Sales
-
New Money Yield
-
Return on Average Invested Assets
-
Average Weekly Producer
For additional information on the Company’s performance measures included in this MD&A, see the Glossary of Selected Terms found directly following Part II. Other Information. See Note 2 of the Notes to the Consolidated Financial Statements for the reconciliation of segment results to the Company's consolidated U.S. GAAP results and additional information.
AFLAC JAPAN SEGMENT
Aflac Japan Pretax Adjusted Earnings
Changes in Aflac Japan's pretax adjusted earnings and profit margins are primarily affected by morbidity, mortality, expenses, persistency and investment yields. The following table presents a summary of operating results for Aflac Japan for the years ended December 31.
Aflac Japan Summary of Operating Results
| (In millions) | 2020 | 2019 | |||||||||||||||
| Net premium income | $ | 12,670 | $ | 12,772 | |||||||||||||
| Net investment income: (1) | |||||||||||||||||
| Yen-denominated investment income | 1,296 | 1,307 | |||||||||||||||
| U.S. dollar-denominated investment income | 1,569 | 1,446 | |||||||||||||||
| Net investment income | 2,865 | 2,753 | |||||||||||||||
| Amortized hedge costs related to certain foreign currency exposure management strategies | 206 | 257 | |||||||||||||||
| Adjusted net investment income | 2,659 | 2,496 | |||||||||||||||
| Other income (loss) | 42 | 45 | |||||||||||||||
| Total adjusted revenues | 15,371 | 15,313 | |||||||||||||||
| Benefits and claims, net | 8,851 | 8,877 | |||||||||||||||
| Adjusted expenses: | |||||||||||||||||
| Amortization of deferred policy acquisition costs | 644 | 709 | |||||||||||||||
| Insurance commissions | 740 | 731 | |||||||||||||||
| Insurance and other expenses | 1,873 | 1,734 | |||||||||||||||
| Total adjusted expenses | 3,257 | 3,174 | |||||||||||||||
| Total benefits and adjusted expenses | 12,108 | 12,051 | |||||||||||||||
| Pretax adjusted earnings | $ | 3,263 | $ | 3,261 | |||||||||||||
| Weighted-average yen/dollar exchange rate | 106.86 | 109.07 |
| In Dollars | In Yen | ||||||||||||||||||||||||||||||||||
| Percentage change over previous period: | 2020 | 2019 | 2020 | 2019 | |||||||||||||||||||||||||||||||
| Net premium income | (.8) | % | .1 | % | (2.8) | % | (1.1) | % | |||||||||||||||||||||||||||
| Adjusted net investment income | 6.5 | % | 3.9 | 4.4 | % | 2.2 | |||||||||||||||||||||||||||||
| Total adjusted revenues | .4 | .7 | (1.7) | (.6) | |||||||||||||||||||||||||||||||
| Pretax adjusted earnings | .1 | % | 1.7 | (2.0) | .2 |
(1) Net interest cash flows from derivatives associated with certain investment strategies of $9 and $(17) in 2020 and 2019, respectively, have been reclassified from net investment gains (losses) and included in adjusted earnings as a component of net investment income.
In yen terms, Aflac Japan's net premium income decreased in 2020, primarily due to an anticipated decrease in first sector premiums as savings products reached premium paid-up status and constrained sales from the impact of pandemic
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
conditions. Adjusted net investment income increased in 2020 primarily due to higher income from U.S. dollar-denominated assets and lower hedge costs.
Annualized premiums in force at December 31, 2020, were ¥1.43 trillion, compared with ¥1.49 trillion in 2019. The decrease in annualized premiums in force in yen of 4.2% in 2020 and 2.5% in 2019 was driven primarily by limited-pay products reaching paid up status. Annualized premiums in force, translated into dollars at respective year-end exchange rates, were $13.8 billion in 2020 and $13.6 billion in 2019.
Aflac Japan's investment portfolios include U.S. dollar-denominated securities and reverse-dual currency securities (yen-denominated debt securities with dollar coupon payments). In years when the yen strengthens in relation to the dollar, translating Aflac Japan's U.S. dollar-denominated investment income into yen lowers growth rates for net investment income, total adjusted revenues, and pretax adjusted earnings in yen terms. In years when the yen weakens, translating U.S. dollar-denominated investment income into yen magnifies growth rates for net investment income, total adjusted revenues, and pretax adjusted earnings in yen terms.
The following table illustrates the effect of translating Aflac Japan's U.S. dollar-denominated investment income and related items into yen by comparing certain segment results with those that would have been reported had foreign currency exchange rates remained unchanged from the prior year. Amounts excluding foreign currency impact on U.S. dollar-denominated investment income were determined using the average foreign currency exchange rate for the comparable prior year period. See non-U.S. GAAP financial measures defined above.
Aflac Japan Percentage Changes Over Prior Year
(Yen Operating Results)
For the Years Ended December 31,
| Including Foreign Currency Changes | Excluding Foreign Currency Changes | ||||||||||||||||||||||||||||||||||
| 2020 | 2019 | 2020 | 2019 | ||||||||||||||||||||||||||||||||
| Adjusted net investment income | 4.4 | % | 2.2 | % | 5.7 | % | 2.9 | % | |||||||||||||||||||||||||||
| Total adjusted revenues | (1.7) | (.6) | (1.5) | (.5) | |||||||||||||||||||||||||||||||
| Pretax adjusted earnings | (2.0) | .2 | (1.0) | .7 |
The following table presents a summary of operating ratios in yen terms for Aflac Japan for the years ended December 31.
| Ratios to total adjusted revenues: | 2020 | 2019 | ||||||||||||||||||
| Benefits and claims, net | 57.6 | % | 58.0 | % | ||||||||||||||||
| Adjusted expenses: | ||||||||||||||||||||
| Amortization of deferred policy acquisition costs | 4.2 | 4.6 | ||||||||||||||||||
| Insurance commissions | 4.8 | 4.8 | ||||||||||||||||||
| Insurance and other expenses | 12.2 | 11.3 | ||||||||||||||||||
| Total adjusted expenses | 21.2 | 20.7 | ||||||||||||||||||
| Pretax adjusted earnings | 21.2 | 21.3 | ||||||||||||||||||
| Ratios to total premiums: | ||||||||||||||||||||
| Benefits and claims, net | 69.9 | % | 69.5 | % | ||||||||||||||||
| Adjusted expenses: | ||||||||||||||||||||
| Amortization of deferred policy acquisition costs | 5.1 | 5.5 |
In 2020, the benefit ratio to total premiums increased, compared to the prior year, primarily due to higher persistency, resulting in an increase in future policy benefit reserves, partially offset by the continued change in mix of first and third sector business as first sector products become paid-up. In 2020, the adjusted expense ratio increased mainly due to the decrease in total revenues and an increase in expenses related to the paperless and COVID-19 initiatives, which include the expansion of and enhancements to virtual desktops and telework terminals to support a remote workforce, partially offset by lower DAC amortization due to higher persistency. In total for 2020, the pretax adjusted profit margin decreased slightly as compared to 2019. For 2021, the Company will continue to monitor the situation with respect to COVID-19, and potential impacts on the pretax adjusted profit margin and benefit ratio.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Aflac Japan Sales
The following table presents Aflac Japan's new annualized premium sales for the years ended December 31.
| In Dollars | In Yen | ||||||||||||||||||||||||||||||||||
| (In millions of dollars and billions of yen) | 2020 | 2019 | 2020 | 2019 | |||||||||||||||||||||||||||||||
| New annualized premium sales | $ | 477 | $ | 731 | ¥ | 50.9 | ¥ | 79.7 | |||||||||||||||||||||||||||
| Increase (decrease) over prior period | (34.8) | % | (15.9) | % | (36.2) | % | (16.9) | % |
The following table details the contributions to Aflac Japan's new annualized premium sales by major insurance product for the years ended December 31.
| 2020 | 2019 | |||||||||||||||||||
| Cancer | 56.6 | % | 59.2 | % | ||||||||||||||||
| Medical | 31.2 | 31.0 | ||||||||||||||||||
| Income support | 1.0 | 1.2 | ||||||||||||||||||
| Ordinary life: | ||||||||||||||||||||
| WAYS | .7 | .5 | ||||||||||||||||||
| Child endowment | .4 | .2 | ||||||||||||||||||
| Other ordinary life (1) | 9.5 | 7.4 | ||||||||||||||||||
| Other | .6 | .5 | ||||||||||||||||||
| Total | 100.0 | % | 100.0 | % |
(1) Includes term and whole life
The foundation of Aflac Japan's product portfolio has been, and continues to be, third sector products, which include cancer, medical and income support insurance products. Aflac Japan has been focusing more on promotion of cancer and medical insurance products in this low-interest-rate environment. These products are less interest-rate sensitive and more profitable compared to first sector savings products. With continued cost pressure on Japan’s health care system, the Company expects the need for third sector products will continue to rise in the future and that the medical and cancer insurance products Aflac Japan provides will continue to be an important part of its product portfolio.
Sales of protection-type first sector and third sector products on a yen basis decreased 36.9% in 2020, compared with 2019. The decline in sales primarily reflects the impact of the COVID-19 pandemic and the continuing effects of the Japan Post investigation.
Sales of Aflac Japan cancer products in the Japan Post Group channel experienced a material decline beginning in August 2019 and continued in 2020. For additional information, see the risk factor entitled "Events related to the ongoing Japan Post investigation and other matters regarding sales of Japan Post Insurance products could negatively impact the Company’s sales and results of operations," in Part I, Item 1A. Risk Factors. Aflac Japan experienced a sharp drop-off in total sales, beginning in the second quarter of 2020 and continuing into 2021, due to the impact of the COVID-19 pandemic and continuing effects of the Japan Post investigation.
The following table details the contributions to Aflac Japan's new annualized premium sales by agency type for the years ended December 31.
| 2020 | 2019 | |||||||||||||||||||
| Independent corporate and individual | 52.3 | % | 45.7 | % | ||||||||||||||||
| Affiliated corporate (1) | 42.6 | 50.0 | ||||||||||||||||||
| Bank | 5.1 | 4.3 | ||||||||||||||||||
| Total | 100.0 | % | 100.0 | % |
(1) Includes Japan Post
In 2020, Aflac Japan recruited 48 new sales agencies. At December 31, 2020, Aflac Japan was represented by more than 8,500 sales agencies, with approximately 112,000 licensed sales associates employed by those agencies. The number of sales agencies has declined in recent years due to Aflac Japan's focus on supporting agencies with strong management frameworks, high productivity and more producing agents.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Japan Post offers Aflac's cancer insurance products in more than 20,000 postal outlets. Notwithstanding the recent reduction in sales of Aflac Japan's cancer products in the Japan Post channel, the Company believes this alliance with Japan Post has benefited and will continue to benefit its cancer insurance sales over the long term.
At December 31, 2020, Aflac Japan had agreements to sell its products at 361 banks, approximately 90% of the total number of banks in Japan.
Strategic Alliance with Japan Post Holdings
On December 19, 2018, the Parent Company and Aflac Japan entered into a Basic Agreement with Japan Post Holdings a Japanese corporation. Pursuant to the terms of the Basic Agreement, Japan Post Holdings agreed to form a capital relationship with the Parent Company, and Japan Post Holdings and Aflac Japan agreed to reconfirm existing initiatives regarding cancer insurance and to consider new joint initiatives, including leveraging digital technology in various processes, cooperation in new product development to promote customer-centric business management, cooperation in domestic and/or overseas business expansion and joint investment in third party entities and cooperation regarding asset management.
On February 28, 2019, the Parent Company entered a Shareholders Agreement with Japan Post Holdings, J&A Alliance Holdings Corporation, a Delaware corporation, solely in its capacity as trustee of J&A Alliance Trust, a New York voting trust (Trust), and General Incorporated Association J&A Alliance, a Japanese general incorporated association. Pursuant to the Shareholders Agreement, Japan Post Holdings agreed to cause the Trust to use commercially reasonable efforts to acquire, through open market or private block purchases in the U.S., beneficial ownership of approximately 7% of the Common Stock in connection with the Basic Agreement. According to a Schedule 13G/A filed by Japan Post Holdings with the SEC on January 6, 2021, the Trust had beneficially acquired 7.45% of the outstanding Common Shares as of December 31, 2020. Japan Post Holdings is the sole beneficiary of the Trust.
On May 1, 2020, the Parent Company filed a registration statement on Form S-3 that registered the sale of its common stock from time to time by J&A Alliance Holdings Corporation in its capacity as trustee of the Trust. The filing was made strictly pursuant to a contractual requirement contained in the Shareholders Agreement. Notwithstanding the contractual commitment and filing of the Form S-3, the Trust continues to be subject to a lockup period for a period expiring four years after the Trust acquired 7% of the Parent Company's outstanding shares, under the terms of the Shareholders Agreement.
The Trust has agreed not to own more than 10% of the Parent Company’s outstanding shares for a period expiring four years after the Trust acquired 7% of such shares, five years after it acquires 5% of such shares, or ten years after the Trust begins acquiring the Parent Company’s stock. After expiration of such period, the Trust has agreed not to own more than the greater of 10% of the Parent Company’s outstanding shares or such shares representing 22.5% of the voting rights in the Parent Company.
In light of the fact that the shares acquired by the Trust, like all Aflac Incorporated common shares, will be eligible for 10-for-1 voting rights after being held for 48 consecutive months, the Shareholders Agreement further provides for voting restrictions that effectively limit the trustee’s voting rights to no more than 20% of the voting rights in the Parent Company and further restrict the trustee’s voting rights with respect to certain change in control transactions. Japan Post Holdings will not have a Board seat on the Parent Company’s Board of Directors and will not have rights to control, manage or intervene in the management of the Parent Company.
As of December 31, 2019, all regulatory approvals expressly set forth in the Shareholders Agreement have been obtained. The Shareholders Agreement requires the parties to use reasonable best efforts to cooperate in connection with any ongoing regulatory matters related to or arising from the Trust’s acquisition or ownership or control of the shares of Company Common Stock, including any applications or filings in connection with a direct or indirect acquisition of control of or merger with an insurer by the Company or its affiliates. The foregoing is subject to and qualified in its entirety by reference to the full text of the Shareholders Agreement, a copy of which is attached as Exhibit 10.50 to the Company’s Quarterly Report on Form 10-Q filed April 26, 2019, and the terms of which exhibit are incorporated herein by reference.
Aflac Japan Investments
The level of investment income in yen is affected by available cash flow from operations, the timing of investing the cash flow, yields on new investments, the effect of yen/dollar exchange rates on U.S. dollar-denominated investment income, and other factors.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
As part of the Company's portfolio management and asset allocation process, Aflac Japan invests in yen and U.S. dollar-denominated investments. Yen-denominated investments primarily consist of JGBs and public and private fixed maturity securities. Aflac Japan's U.S. dollar-denominated investments include fixed maturity investments and growth assets, including public equity securities and alternative investments in limited partnerships or similar investment vehicles. Aflac Japan has been investing in both publicly-traded and privately originated U.S. dollar-denominated investment-grade and below-investment-grade fixed maturity securities and loan receivables, and has entered into foreign currency forwards and options to hedge the currency risk on the fair value of a portion of the U.S. dollar investments.
The following table details the investment purchases for Aflac Japan for the years ended December 31.
| (In millions) | 2020 | 2019 | |||||||||||||||
| Yen-denominated: | |||||||||||||||||
| Fixed maturity securities: | |||||||||||||||||
| Japan government and agencies | $ | 736 | $ | 583 | |||||||||||||
| Private placements | 574 | 1,122 | |||||||||||||||
| Other fixed maturity securities | 385 | 542 | |||||||||||||||
| Equity securities | 276 | 212 | |||||||||||||||
| Total yen-denominated | $ | 1,971 | $ | 2,459 | |||||||||||||
| U.S. dollar-denominated: | |||||||||||||||||
| Fixed maturity securities: | |||||||||||||||||
| Other fixed maturity securities | $ | 1,393 | $ | 2,767 | |||||||||||||
| Infrastructure debt | 101 | 66 | |||||||||||||||
| Collateralized loan obligations | 300 | 0 | |||||||||||||||
| Equity securities | 0 | 58 | |||||||||||||||
| Commercial mortgage and other loans: | |||||||||||||||||
| Transitional real estate loans | 688 | 1,846 | |||||||||||||||
| Commercial mortgage loans | 12 | 565 | |||||||||||||||
| Middle market loans | 2,215 | 1,442 | |||||||||||||||
| Other investments | 279 | 145 | |||||||||||||||
| Total dollar-denominated | $ | 4,988 | $ | 6,889 | |||||||||||||
| Total Aflac Japan purchases | $ | 6,959 | $ | 9,348 |
See the Investments section of this MD&A for further discussion of these investment programs, and see Notes 1, 3 and 4 of the Notes to the Consolidated Financial Statements for more information regarding loans and loan receivables.
Funds available for investment include cash flows from operations, investment income, and funds generated from maturities, redemptions, securities lending, and other securities transactions. Securities lending is also used from time to time to accelerate the availability of funds for investment. Purchases of securities from period to period are determined based on multiple objectives including appropriate portfolio diversification, the relative value of a potential investment and availability of investment opportunities, liquidity, credit and other risk factors while adhering to the Company's investment policy guidelines.
The following table presents the results of Aflac Japan's investment yields for the years ended and as of December 31.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
| 2020 | 2019 | ||||||||||||||||
| Total purchases for the period (in millions) (1) | $ | 6,680 | $ | 9,203 | |||||||||||||
| New money yield (1),(2) | 3.75 | % | 3.83 | % | |||||||||||||
| Return on average invested assets (3) | 2.38 | 2.33 | |||||||||||||||
| Portfolio book yield, including U.S. dollar-denominated investments, end of period (1) | 2.59 | % | 2.64 | % |
(1) Includes fixed maturity securities, commercial mortgage and other loans, equity securities, and excludes alternative investments in limited partnerships
(2) Reported on a gross yield basis; excludes investment expenses, external management fees, and amortized hedge costs
(3) Net of investment expenses and amortized hedge costs, year-to-date number reflected on a quarterly average basis
The decrease in the Aflac Japan new money yield in 2020 was primarily due to lower yields on floating rate asset classes.
See Notes 3, 4 and 5 of the Notes to the Consolidated Financial Statements and the Investments section of this MD&A for additional information on the Company's investments and hedging strategies.
AFLAC U.S. SEGMENT
Aflac U.S. Pretax Adjusted Earnings
Changes in Aflac U.S. pretax adjusted earnings and profit margins are primarily affected by morbidity, mortality, expenses, persistency and investment yields. The following table presents a summary of operating results for Aflac U.S. for the years ended December 31.
Aflac U.S. Summary of Operating Results
| (In millions) | 2020 | 2019 | |||||||||||||||
| Net premium income | $ | 5,758 | $ | 5,808 | |||||||||||||
| Adjusted net investment income (1) | 705 | 720 | |||||||||||||||
| Other income | 102 | 22 | |||||||||||||||
| Total adjusted revenues | 6,565 | 6,550 | |||||||||||||||
| Benefits and claims | 2,765 | 2,871 | |||||||||||||||
| Adjusted expenses: | |||||||||||||||||
| Amortization of deferred policy acquisition costs | 570 | 573 | |||||||||||||||
| Insurance commissions | 576 | 590 | |||||||||||||||
| Insurance and other expenses | 1,386 | 1,244 | |||||||||||||||
| Total adjusted expenses | 2,532 | 2,407 | |||||||||||||||
| Total benefits and adjusted expenses | 5,297 | 5,279 | |||||||||||||||
| Pretax adjusted earnings | $ | 1,268 | $ | 1,272 | |||||||||||||
| Percentage change over previous period: | |||||||||||||||||
| Net premium income | (.9) | % | 1.8 | % | |||||||||||||
| Net investment income | (2.1) | (1.0) | |||||||||||||||
| Total adjusted revenues | .2 | 1.7 | |||||||||||||||
| Pretax adjusted earnings | (.3) | (1.0) |
(1) Net interest cash flows from derivatives associated with certain investment strategies of $3 for the year ended December 31, 2020 have been reclassified from net investment gains (losses) and included in adjusted earnings as a component of net investment income.
Annualized premiums in force decreased 3.2% in 2020 and increased 1.1% in 2019. Annualized premiums in force at December 31 were $6.1 billion in 2020, compared with $6.3 billion in 2019.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following table presents a summary of operating ratios for Aflac U.S. for the years ended December 31.
| Ratios to total adjusted revenues: | 2020 | 2019 | ||||||||||||||||||
| Benefits and claims | 42.1 | % | 43.8 | % | ||||||||||||||||
| Adjusted expenses: | ||||||||||||||||||||
| Amortization of deferred policy acquisition costs | 8.7 | 8.7 | ||||||||||||||||||
| Insurance commissions | 8.8 | 9.0 | ||||||||||||||||||
| Insurance and other expenses | 21.1 | 19.0 | ||||||||||||||||||
| Total adjusted expenses | 38.6 | 36.7 | ||||||||||||||||||
| Pretax adjusted earnings | 19.3 | 19.4 | ||||||||||||||||||
| Ratios to total premiums: | ||||||||||||||||||||
| Benefits and claims | 48.0 | 49.4 | ||||||||||||||||||
| Adjusted expenses: | ||||||||||||||||||||
| Amortization of deferred policy acquisition costs | 9.9 | 9.9 |
The benefit ratio decreased in 2020, compared with 2019, reflecting reduced accidents, wellness medical visits and routine procedures due to shelter-in-place orders and heightened social distancing due to COVID-19. The adjusted expense ratio increased in 2020, compared with 2019, primarily due to anticipated spending increases reflecting ongoing investments in the U.S. platform, distribution, and customer experience, TPA related expenses from the acquisition of Argus, the Voluntary Separation Plan, and lower unit cost capitalization reflecting a decline in sales. The pretax adjusted profit margin decreased slightly in 2020 when compared with 2019, due to higher expense ratios, offset somewhat by lower benefit ratios. For 2021, the Company will continue to monitor the situation with respect to COVID-19, and potential impacts on the pretax adjusted profit margin and benefit ratio.
Aflac U.S. Sales
The following table presents Aflac's U.S. new annualized premium sales for the years ended December 31.
| (In millions) | 2020 | 2019 | ||||||||||||||||||
| New annualized premium sales | $ | 1,093 | $ | 1,580 | ||||||||||||||||
| Increase (decrease) over prior period | (30.8) | % | (1.3) | % |
The following table details the contributions to Aflac's U.S. new annualized premium sales by major insurance product category for the years ended December 31.
| 2020 | 2019 | |||||||||||||||||||
| Accident | 26.1 | % | 28.5 | % | ||||||||||||||||
| Short-term disability | 22.3 | 22.5 | ||||||||||||||||||
| Critical care (1) | 22.2 | 21.9 | ||||||||||||||||||
| Hospital indemnity | 18.0 | 16.6 | ||||||||||||||||||
| Dental/vision | 4.1 | 4.4 | ||||||||||||||||||
| Life | 7.3 | 6.1 | ||||||||||||||||||
| Total | 100.0 | % | 100.0% |
(1) Includes cancer, critical illness and hospital intensive care products
New annualized premium sales for accident insurance, the Aflac U.S. leading product category, decreased 36.6%, short-term disability sales decreased 31.5%, critical care insurance sales (including cancer insurance) decreased 30.1%, and hospital indemnity insurance sales decreased 25.2% in 2020, compared with 2019. Overall sales decreased in 2020 as well net earned premium decreased .9%. Primarily, the decline in sales for Aflac U.S. is attributable COVID-19 social distancing efforts, which limited face-to-face sales opportunities beginning in mid-March 2020. See the Executive Summary section entitled "COVID-19" of this MD&A for additional information.
In 2020, the Aflac U.S. sales forces included an average of approximately 6,500 U.S. agents, including brokers, who were actively producing business on a weekly basis. The Company believes that this average weekly producer equivalent
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
metric allows sales management to monitor progress and needs, as well as serve as a leading indicator of future production capacity.
In November 2020, the Company, through its insurance subsidiaries Aflac and Aflac New York, acquired Zurich North America’s U.S. Corporate Life and Pensions business, which consists of group life, disability and absence management products. Aflac and Aflac New York agreed to reinsure on an indemnity basis Zurich North America’s U.S. in-force group life and disability policies with annualized earned premium of over $100 million. Aflac also acquired assets needed to support the group life and disability business, along with an absence management platform.
In November 2019, the Company acquired Argus Holdings, LLC and its subsidiary Argus Dental & Vision, Inc., a benefits management organization and national network dental and vision company, which provides a platform for Aflac Dental and Vision. Argus is an addition to the Aflac U.S. segment.
Aflac U.S. Investments
The level of investment income is affected by available cash flow from operations, the timing of investing the cash flow, yields on new investments, and other factors.
As part of the Company's portfolio management and asset allocation process, Aflac U.S. invests in fixed maturity investments and growth assets, including public equity securities and alternative investments in limited partnerships. Aflac U.S. has been investing in both publicly traded and privately originated investment-grade and below-investment-grade fixed maturity securities and loan receivables.
The following table details the investment purchases for Aflac U.S. as of December 31.
| (In millions) | 2020 | 2019 | ||||||||||||||||||
| Fixed maturity securities: | ||||||||||||||||||||
| Other fixed maturity securities | $ | 573 | $ | 1,032 | ||||||||||||||||
| Infrastructure debt | 45 | 119 | ||||||||||||||||||
| Collateralized loan obligations | 150 | 0 | ||||||||||||||||||
| Equity securities | 8 | 58 | ||||||||||||||||||
| Commercial mortgage and other loans: | ||||||||||||||||||||
| Transitional real estate loans | 143 | 423 | ||||||||||||||||||
| Commercial mortgage loans | 52 | 104 | ||||||||||||||||||
| Middle market loans | 79 | 99 | ||||||||||||||||||
| Other investments | 31 | 16 | ||||||||||||||||||
| Total Aflac U.S. Purchases | $ | 1,081 | $ | 1,851 |
Funds available for investment include cash flows from operations, investment income, and funds generated from maturities, redemptions, and other securities transactions. Purchases of securities from period to period are determined based on multiple objectives, including appropriate portfolio diversification, the relative value of a potential investment and availability of investment opportunities, liquidity, credit and other risk factors while adhering to the Company's investment policy guidelines.
The following table presents the results of Aflac's U.S. investment yields for the years ended and as of December 31.
| 2020 | 2019 | |||||||||||||||||||
| Total purchases for period (in millions) (1) | $ | 1,050 | $ | 1,835 | ||||||||||||||||
| New money yield (1), (2) | 3.04 | % | 4.51 | % | ||||||||||||||||
| Return on average invested assets (3) | 4.90 | 5.07 | ||||||||||||||||||
| Portfolio book yield, end of period (1) | 5.18 | % | 5.40 | % |
(1) Includes fixed maturity securities, commercial mortgage and other loans, equity securities, and excludes alternative investments in limited partnerships
(2) Reported on a gross yield basis; excludes investment expenses and external management fees
(3) Net of investment expenses, year-to-date number reflected on a quarterly average basis
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The decrease in the Aflac U.S. new money yield for the year ended December 31, 2020 was primarily due to lower U.S. interest rates.
See Note 3 of the Notes to the Consolidated Financial Statements and the Market Risks of Financial Instruments - Credit Risk subsection of Item 7A. for more information regarding the sector concentrations of the Company's investments.
CORPORATE AND OTHER
Changes in the pretax adjusted earnings of Corporate and other are primarily affected by investment income. The following table presents a summary operating results for Corporate and other for the years ended December 31.
Corporate and Other Summary of Operating Results
| (In millions) | 2020 | 2019 | |||||||||||||||
| Premium income | $ | 194 | $ | 200 | |||||||||||||
| Net investment income | 80 | 88 | |||||||||||||||
| Amortized hedge income related to certain foreign currency management strategies | 97 | 89 | |||||||||||||||
| Adjusted net investment income | 177 | 177 | |||||||||||||||
| Other income | 13 | 15 | |||||||||||||||
| Total adjusted revenues | 384 | 393 | |||||||||||||||
| Benefits and claims, net | 180 | 194 | |||||||||||||||
| Adjusted expenses: | |||||||||||||||||
| Interest expense | 164 | 133 | |||||||||||||||
| Other adjusted expenses | 155 | 137 | |||||||||||||||
| Total adjusted expenses | 319 | 270 | |||||||||||||||
| Total benefits and adjusted expenses | 499 | 464 | |||||||||||||||
| Pretax adjusted earnings | $ | (115) | $ | (72) |
Adjusted net investment income benefited from the Company’s enterprise corporate hedging program for the years ended December 31, 2020 and 2019, respectively. Beginning in 2020, net investment income also includes the Company's portion of earnings from its strategic equity investment in an asset management company. See the Hedging Activities subsection of this MD&A for further information on the enterprise corporate hedging program. The increase in interest expense in 2020 is primarily due to the issuance of additional senior notes in the first and second quarter of 2020. See Note 9 of the Notes to the Consolidated Financial Statements for more information on these senior notes.
In October 2020, the Company entered into an agreement to purchase approximately $200 million in newly issued common stock of Trupanion, Inc., a provider of medical insurance for pets in the United States and Canada. The Company closed on approximately $60 million of this transaction in October 2020. The Company closed on the remaining approximately $140 million of this transaction in November 2020 which resulted in the Company owning approximately 9% of the outstanding common stock of Trupanion, Inc. The Company also announced that it has entered into an alliance agreement with Trupanion, Inc. to sell pet insurance on an exclusive basis in the United States, subject to certain exceptions, and to explore on an exclusive basis potential distribution opportunities for pet insurance in Japan.
INVESTMENTS
The Company’s investment strategy utilizes disciplined asset and liability management while seeking long-term risk-adjusted investment returns and the delivery of stable income within regulatory and capital objectives, and preserving shareholder value. In attempting to optimally balance these objectives, the Company seeks to maintain on behalf of Aflac Japan a diversified portfolio of yen-denominated investment assets, U.S. dollar-denominated investment portfolio hedged back to yen and a portfolio of unhedged U.S. dollar-denominated assets. As part of the Company's portfolio management and asset allocation process, Aflac U.S. invests in fixed maturity investments and growth assets, including public equity securities and alternative investments in limited partnerships. Aflac U.S. invests in both publicly traded and privately originated investment-grade and below-investment-grade fixed maturity securities and loans.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
For additional information concerning the Company's investments, see Notes 3, 4, and 5 of the Notes to the Consolidated Financial Statements.
The following tables detail investments by segment as of December 31.
Investment Securities by Segment
| 2020 | |||||||||||||||||||||||
| (In millions) | Aflac Japan | Aflac U.S. | Corporate and Other | Total | |||||||||||||||||||
| Available for sale, fixed maturity securities, at fair value | $ | 88,757 | $ | 15,133 | $ | 1,992 | $ | 105,882 | |||||||||||||||
| Held to maturity, fixed maturity securities, at amortized cost (1) | 24,464 | 0 | 0 | 24,464 | |||||||||||||||||||
| Equity securities | 674 | 66 | 543 | 1,283 | |||||||||||||||||||
| Commercial mortgage and other loans: | |||||||||||||||||||||||
| Transitional real estate loans (1) | 4,331 | 900 | 0 | 5,231 | |||||||||||||||||||
| Commercial mortgage loans (1) | 1,268 | 420 | 0 | 1,688 | |||||||||||||||||||
| Middle market loans (1) | 3,365 | 270 | 0 | 3,635 | |||||||||||||||||||
| Other investments: | |||||||||||||||||||||||
| Policy loans | 242 | 18 | 0 | 260 | |||||||||||||||||||
| Short-term investments (2) | 449 | 242 | 448 | 1,139 | |||||||||||||||||||
| Limited partnerships | 828 | 91 | 85 | 1,004 | |||||||||||||||||||
| Other | 0 | 26 | 0 | 26 | |||||||||||||||||||
| Total investments | 124,378 | 17,166 | 3,068 | 144,612 | |||||||||||||||||||
| Cash and cash equivalents | 2,001 | 785 | 2,355 | 5,141 | |||||||||||||||||||
| Total investments and cash | $ | 126,379 | $ | 17,951 | $ | 5,423 | $ | 149,753 |
(1) Net of allowance for credit losses
(2) Includes securities lending collateral
| 2019 | |||||||||||||||||||||||
| (In millions) | Aflac Japan | Aflac U.S. | Corporate and Other | Total | |||||||||||||||||||
| Available for sale, fixed maturity securities, at fair value | $ | 75,780 | $ | 13,703 | $ | 1,779 | $ | 91,262 | |||||||||||||||
| Held to maturity, fixed maturity securities, at amortized cost | 30,085 | 0 | 0 | 30,085 | |||||||||||||||||||
| Equity securities | 657 | 67 | 78 | 802 | |||||||||||||||||||
| Commercial mortgage and other loans: | |||||||||||||||||||||||
| Transitional real estate loans | 4,507 | 943 | 0 | 5,450 | |||||||||||||||||||
| Commercial mortgage loans | 1,308 | 399 | 0 | 1,707 | |||||||||||||||||||
| Middle market loans | 2,141 | 271 | 0 | 2,412 | |||||||||||||||||||
| Other investments: | |||||||||||||||||||||||
| Policy loans | 234 | 16 | 0 | 250 | |||||||||||||||||||
| Short-term investments (1) | 386 | 242 | 1 | 629 | |||||||||||||||||||
| Limited partnerships | 496 | 55 | 17 | 568 | |||||||||||||||||||
| Other | 0 | 30 | 0 | 30 | |||||||||||||||||||
| Total investments | 115,594 | 15,726 | 1,875 | 133,195 | |||||||||||||||||||
| Cash and cash equivalents | 1,674 | 417 | 2,805 | 4,896 | |||||||||||||||||||
| Total investments and cash | $ | 117,268 | $ | 16,143 | $ | 4,680 | $ | 138,091 |
(1) Includes securities lending collateral
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The ratings of the Company's securities referenced in the table below are based on the ratings designations provided by major rating organizations such as Moody's, Standard & Poor's and Fitch or, if not rated, are determined based on the Company's internal analysis of such securities. When the ratings issued by the rating agencies differ, the Company utilizes the second lowest rating when three or more rating agency ratings are available or the lowest rating when only two rating agency ratings are available.
The distributions of fixed maturity securities the Company owns, by credit rating, as of December 31 were as follows:
Composition of Fixed Maturity Securities by Credit Rating
| 2020 | 2019 | ||||||||||||||||||||||||||||||||||||||||||||||
| Amortized Cost | Fair Value | Amortized Cost | Fair Value | ||||||||||||||||||||||||||||||||||||||||||||
| AAA | 1.0 | % | .9 | % | 1.1 | % | 1.0 | % | |||||||||||||||||||||||||||||||||||||||
| AA | 4.5 | 4.6 | 4.3 | 4.4 | |||||||||||||||||||||||||||||||||||||||||||
| A | 69.3 | 69.5 | 68.6 | 69.8 | |||||||||||||||||||||||||||||||||||||||||||
| BBB | 21.9 | 21.9 | 23.1 | 22.1 | |||||||||||||||||||||||||||||||||||||||||||
| BB or lower | 3.3 | 3.1 | 2.9 | 2.7 | |||||||||||||||||||||||||||||||||||||||||||
| Total | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % |
As of December 31, 2020, the Company's direct and indirect exposure to securities in its investment portfolio that were guaranteed by third parties was immaterial both individually and in the aggregate.
The following table presents the 10 largest unrealized loss positions in the Company's portfolio as of December 31, 2020.
| (In millions) | Credit Rating | Amortized Cost | Fair Value | Unrealized Loss | |||||||||||||||||||||||||||||||||||||||||||
| Transocean Inc. | CCC | $ | 50 | $ | 16 | $ | (34) | ||||||||||||||||||||||||||||||||||||||||
| Diamond Offshore Drilling Inc. | D | 28 | 7 | (21) | |||||||||||||||||||||||||||||||||||||||||||
| KLM Royal Dutch Airlines | B | 153 | 134 | (19) | |||||||||||||||||||||||||||||||||||||||||||
| Grenke Finance PLC | BBB | 68 | 56 | (12) | |||||||||||||||||||||||||||||||||||||||||||
| Chevron Corp. | AA | 145 | 135 | (10) | |||||||||||||||||||||||||||||||||||||||||||
| Intesa Sanpaolo Spa | BBB | 151 | 141 | (10) | |||||||||||||||||||||||||||||||||||||||||||
| National Football League | A | 156 | 147 | (9) | |||||||||||||||||||||||||||||||||||||||||||
| Kommunal Landspensjonskasse (KLP) | BBB | 145 | 137 | (8) | |||||||||||||||||||||||||||||||||||||||||||
| Heathrow Funding Ltd. | BBB | 97 | 89 | (8) | |||||||||||||||||||||||||||||||||||||||||||
| Lloyds Banking Group PLC | A | 222 | 216 | (6) |
Generally, declines in fair values can be a result of changes in interest rates, yen/dollar exchange rate, and changes in net spreads driven by a broad market move or a change in the issuer's underlying credit quality. The Company believes these issuers have the ability to continue making timely payments of principal and interest, with the exception of Diamond Offshore Drilling Inc. which has declared bankruptcy. See the Unrealized Investment Gains and Losses section in Note 3 of the Notes to the Consolidated Financial Statements for further discussions of unrealized losses related to financial institutions and other corporate investments.
Below-Investment-Grade Securities
The Company's portfolio of below-investment-grade securities includes debt securities purchased while the issuer was rated investment grade plus other loans and bonds purchased as part of an allocation to that segment of the market. The following is the Company's below-investment-grade exposure.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Below-Investment-Grade Investments
| December 31, 2020 | ||||||||||||||||||||||||||||||||||||||||||||||||||
| (In millions) | Par Value | Amortized Cost (1) | Fair Value | Unrealized Gain (Loss) | ||||||||||||||||||||||||||||||||||||||||||||||
| Investcorp Capital Limited | $ | 407 | $ | 407 | $ | 459 | $ | 52 | ||||||||||||||||||||||||||||||||||||||||||
| Commerzbank | 386 | 262 | 431 | 169 | ||||||||||||||||||||||||||||||||||||||||||||||
| Pemex Project Funding Master Trust | 290 | 290 | 294 | 4 | ||||||||||||||||||||||||||||||||||||||||||||||
| KLM Royal Dutch Airlines | 193 | 153 | 134 | (19) | ||||||||||||||||||||||||||||||||||||||||||||||
| Autostrade Per Litalia Spa | 193 | 192 | 205 | 13 | ||||||||||||||||||||||||||||||||||||||||||||||
| Telecom Italia SpA | 193 | 193 | 250 | 57 | ||||||||||||||||||||||||||||||||||||||||||||||
| Barclays Bank PLC | 193 | 127 | 169 | 42 | ||||||||||||||||||||||||||||||||||||||||||||||
| Apache Corporation | 138 | 130 | 154 | 24 | ||||||||||||||||||||||||||||||||||||||||||||||
| Ovintiv Inc. | 134 | 138 | 155 | 17 | ||||||||||||||||||||||||||||||||||||||||||||||
| IKB Deutsche Industriebank AG | 126 | 56 | 89 | 33 | ||||||||||||||||||||||||||||||||||||||||||||||
| Other Issuers | 1,017 | 875 | 1,006 | 131 | ||||||||||||||||||||||||||||||||||||||||||||||
| Subtotal (2) | 3,270 | 2,823 | 3,346 | 523 | ||||||||||||||||||||||||||||||||||||||||||||||
| Senior secured bank loans | 214 | 235 | 207 | (28) | ||||||||||||||||||||||||||||||||||||||||||||||
| High yield corporate bonds | 675 | 703 | 712 | 9 | ||||||||||||||||||||||||||||||||||||||||||||||
| Middle market loans | 3,757 | 3,636 | 3,640 | 4 | ||||||||||||||||||||||||||||||||||||||||||||||
| Grand Total | $ | 7,916 | $ | 7,397 | $ | 7,905 | $ | 508 |
(1) Net of allowance for credit losses
(2) Securities initially purchased as investment grade, but have subsequently been downgraded to below investment grade
The Company invests in senior secured bank loans and middle market loans primarily to U.S. corporate borrowers, most of which have below-investment-grade ratings. The objectives of these programs include enhancing the yield on invested assets, achieving further diversification of credit risk, and mitigating the risk of rising interest rates and hedge costs through the acquisition of floating rate assets.
The Company maintains an allocation to higher yielding corporate bonds within the Aflac Japan and Aflac U.S. portfolios. Most of these securities were rated below-investment-grade at the time of purchase, but the Company also purchased several that were rated investment grade which, because of market pricing, offer yields commensurate with below-investment-grade risk profiles. The objective of this allocation was to enhance the Company's yield on invested assets and further diversify credit risk. All investments in this program must have a minimum rating at purchase of low BB using the Company's above described rating methodology and are managed by the Company's internal credit portfolio management team.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Fixed Maturity Securities by Sector
The Company maintains diversification in investments by sector to avoid concentrations to any one sector, thus managing exposure risk. The following table shows the distribution of fixed maturities by sector classification as of December 31.
| 2020 | |||||||||||||||||||||||||||||
| (In millions) | Amortized Cost (1) | Gross Unrealized Gains | Gross Unrealized Losses | Fair Value | % of Total | ||||||||||||||||||||||||
| Government and agencies | $ | 56,649 | $ | 9,822 | $ | (52) | $ | 66,419 | 48.9 | % | |||||||||||||||||||
| Municipalities | 2,855 | 668 | (7) | 3,517 | 2.5 | ||||||||||||||||||||||||
| Mortgage- and asset-backed securities | 1,009 | 35 | (6) | 1,038 | .9 | ||||||||||||||||||||||||
| Public utilities | 8,837 | 2,057 | (16) | 10,879 | 7.6 | ||||||||||||||||||||||||
| Electric | 7,131 | 1,683 | (13) | 8,803 | 6.1 | ||||||||||||||||||||||||
| Natural Gas | 318 | 63 | 0 | 381 | .3 | ||||||||||||||||||||||||
| Other | 615 | 133 | 0 | 747 | .5 | ||||||||||||||||||||||||
| Utility/Energy | 773 | 178 | (3) | 948 | .7 | ||||||||||||||||||||||||
| Sovereign and Supranational | 1,784 | 337 | (3) | 2,113 | 1.5 | ||||||||||||||||||||||||
| Banks/financial institutions | 10,525 | 1,644 | (109) | 12,062 | 9.0 | ||||||||||||||||||||||||
| Banking | 6,299 | 1,041 | (37) | 7,305 | 5.4 | ||||||||||||||||||||||||
| Insurance | 2,007 | 404 | (36) | 2,375 | 1.7 | ||||||||||||||||||||||||
| Other | 2,219 | 199 | (36) | 2,382 | 1.9 | ||||||||||||||||||||||||
| Other corporate | 34,397 | 6,143 | (288) | 40,253 | 29.6 | ||||||||||||||||||||||||
| Basic Industry | 3,309 | 720 | (15) | 4,013 | 2.9 | ||||||||||||||||||||||||
| Capital Goods | 3,388 | 566 | (20) | 3,934 | 2.9 | ||||||||||||||||||||||||
| Communications | 4,096 | 940 | (33) | 5,003 | 3.5 | ||||||||||||||||||||||||
| Consumer Cyclical | 3,159 | 573 | (29) | 3,703 | 2.7 | ||||||||||||||||||||||||
| Consumer Non-Cyclical | 7,209 | 1,256 | (44) | 8,423 | 6.2 | ||||||||||||||||||||||||
| Energy | 4,130 | 641 | (57) | 4,715 | 3.6 | ||||||||||||||||||||||||
| Other | 1,565 | 210 | (6) | 1,769 | 1.3 | ||||||||||||||||||||||||
| Technology | 3,514 | 341 | (38) | 3,816 | 3.0 | ||||||||||||||||||||||||
| Transportation | 4,027 | 896 | (46) | 4,877 | 3.5 | ||||||||||||||||||||||||
| Total fixed maturity securities | $ | 116,056 | $ | 20,706 | $ | (481) | $ | 136,281 | 100.0 | % |
(1) Net of allowance for credit losses
Securities by Type of Issuance
The Company has investments in both publicly and privately issued securities. The Company's ability to sell either type of security is a function of overall market liquidity which is impacted by, among other things, the amount of outstanding securities of a particular issuer or issuance, trading history of the issue or issuer, overall market conditions, and idiosyncratic events affecting the specific issue or issuer.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following table details investment securities by type of issuance as of December 31.
Investment Securities by Type of Issuance
| 2020 | 2019 | ||||||||||||||||||||||||||||||||||||||||||||||
| (In millions) | Amortized Cost (1) | Fair Value | Amortized Cost | Fair Value | |||||||||||||||||||||||||||||||||||||||||||
| Publicly issued securities: | |||||||||||||||||||||||||||||||||||||||||||||||
| Fixed maturity securities | $ | 95,545 | $ | 111,479 | $ | 89,625 | $ | 105,557 | |||||||||||||||||||||||||||||||||||||||
| Equity securities | 740 | 740 | 717 | 717 | |||||||||||||||||||||||||||||||||||||||||||
| Total publicly issued | 96,285 | 112,219 | 90,342 | 106,274 | |||||||||||||||||||||||||||||||||||||||||||
| Privately issued securities: (2) | |||||||||||||||||||||||||||||||||||||||||||||||
| Fixed maturity securities (3) | 20,511 | 24,802 | 19,831 | 23,299 | |||||||||||||||||||||||||||||||||||||||||||
| Equity securities | 543 | 543 | 85 | 85 | |||||||||||||||||||||||||||||||||||||||||||
| Total privately issued | 21,054 | 25,345 | 19,916 | 23,384 | |||||||||||||||||||||||||||||||||||||||||||
| Total investment securities | $ | 117,339 | $ | 137,564 | $ | 110,258 | $ | 129,658 |
(1) Net of allowance for credit losses
(2) Primarily consists of securities owned by Aflac Japan
(3) Excludes Rule 144A securities
The following table details the Company's reverse-dual currency securities as of December 31.
Reverse-Dual Currency Securities**(1)**
| (Amortized cost, in millions) | 2020 | 2019 | ||||||||||||
| Privately issued reverse-dual currency securities | $ | 5,300 | $ | 4,993 | ||||||||||
| Publicly issued collateral structured as reverse-dual currency securities | 1,775 | 1,678 | ||||||||||||
| Total reverse-dual currency securities | $ | 7,075 | $ | 6,671 | ||||||||||
| Reverse-dual currency securities as a percentage of total investment securities | 6.0 | % | 6.1 | % |
*(1)*Principal payments in yen and interest payments in dollars
Aflac Japan has a portfolio of privately issued securities to better match liability characteristics and secure higher yields than those available on Japanese government or other public corporate bonds. Aflac Japan’s investments in yen-denominated privately issued securities consist primarily of non-Japanese issuers, are rated investment grade at purchase and have longer maturities, thereby allowing the Company to improve asset/liability matching and overall investment returns. These securities are generally either privately negotiated arrangements or issued under medium-term note programs and have standard documentation commensurate with credit ratings of the issuer, except when internal credit analysis indicates that additional protective and/or event-risk covenants were required. Many of these investments have protective covenants appropriate to the specific investment. These may include a prohibition of certain activities by the borrower, maintenance of certain financial measures, and specific conditions impacting the payment of the Company's notes.
HEDGING ACTIVITIES
The Company uses derivative contracts to hedge foreign currency exchange rate risk and interest rate risk. The Company uses various strategies, including derivatives, to manage these risks. See item “7A. Quantitative and Qualitative Disclosures About Market Risk” for more information about market risk and the Company’s use of derivatives.
Derivatives are designed to reduce risk on an economic basis while minimizing the impact on financial results. The Company’s derivatives programs vary depending on the type of risk being hedged. See Note 4 of the Notes to the Consolidated Financial Statements for:
-
A description of the Company's derivatives, hedging strategies and underlying risk exposure.
-
Information about the notional amount and fair market value of the Company's derivatives.
-
The unrealized and realized gains and losses impact on adjusted earnings of derivatives in cash flow, fair value, net investments in foreign operations, or non-qualifying hedging relationships.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Foreign Currency Exchange Rate Risk Hedge Program
The Company has deployed the following hedging strategies to mitigate exposure to foreign currency exchange rate risk:
-
Aflac Japan hedges U.S. dollar-denominated investments back to yen (see Aflac Japan’s U.S. Dollar-Denominated Hedge Program below).
-
Aflac Japan maintains certain unhedged U.S. dollar-denominated securities, which serve as an economic currency hedge of a portion of the Company's investment in Aflac Japan (see Aflac Japan’s U.S. Dollar-Denominated Hedge Program below).
-
The Parent Company designates yen-denominated liabilities (notes payable and loans) as non-derivative hedging instruments and designates certain foreign currency forwards and options as derivative hedges of the Company’s net investment in Aflac Japan (see Enterprise Corporate Hedging Program below).
-
The Parent Company enters into forward and option contracts to accomplish a dual objective of hedging foreign currency exchange rate risk related to dividend payments by its subsidiary, ALIJ, and reducing enterprise-wide hedge costs. (see Enterprise Corporate Hedging Program below).
Aflac Japan’s U.S. Dollar-Denominated Hedge Program
Aflac Japan buys U.S. dollar-denominated investments, typically corporate bonds, and hedges them back to yen with foreign currency forwards and options to hedge foreign currency exchange rate risk. This economically creates yen assets that match yen liabilities during the life of the derivative and provides capital relief. The currency risk being hedged is generally based on fair value of hedged investments. The following table summarizes the U.S. dollar-denominated investments held by Aflac Japan as of December 31.
| 2020 | 2019 | ||||||||||||||||
| (In millions) | Amortized Cost (1) | Fair Value | Amortized Cost | Fair Value | |||||||||||||
| Available-for-sale securities: | |||||||||||||||||
| Fixed maturity securities (excluding bank loans) | $ | 19,249 | $ | 21,108 | $ | 18,012 | $ | 19,542 | |||||||||
| Fixed maturity securities - bank loans (floating rate) | 319 | 283 | 677 | 649 | |||||||||||||
| Equity securities | 20 | 20 | 19 | 19 | |||||||||||||
| Commercial mortgage and other loans: | |||||||||||||||||
| Transitional real estate loans (floating rate) | 4,331 | 4,298 | 4,507 | 4,543 | |||||||||||||
| Commercial mortgage loans | 1,268 | 1,365 | 1,308 | 1,319 | |||||||||||||
| Middle market loans (floating rate) | 3,365 | 3,377 | 2,141 | 2,153 | |||||||||||||
| Other investments | 828 | 828 | 496 | 496 | |||||||||||||
| Total U.S. Dollar Program | 29,380 | 31,279 | 27,160 | 28,721 | |||||||||||||
| Available-for-sale securities: | |||||||||||||||||
| Fixed maturity securities - economically converted to yen | 2,085 | 3,094 | 1,700 | 2,608 | |||||||||||||
| Total U.S. dollar-denominated investments in Aflac Japan | $ | 31,465 | $ | 34,373 | $ | 28,860 | $ | 31,329 |
(1) Net of allowance for credit losses
U.S. Dollar Program includes all U.S. dollar-denominated investments in Aflac Japan other than the investments in certain consolidated VIEs where the instrument is economically converted to yen as a result of a derivative in the consolidated VIE. Aflac Japan maintains a collar program on a portion of its US dollar program to mitigate against more extreme moves in foreign exchange and therefore support SMR. In the first quarter of 2020, the Company reduced the size of the collar program by approximately $3 billion. In December 2020, the Company reduced the total size of the forward and collar programs by approximately $5 billion and purchased foreign currency options to hedge approximately $5 billion of U.S. dollar-denominated assets. While these adjustments will moderately increase the Company's exposure to SMR volatility, the Company believes that they will also reduce its exposure to pricing volatility and the related risk of negative settlements should there be a material weakening in the yen. Depending on further developments, including the possibility of further market volatility, there may be additional costs associated with maintaining the collar program. The Company is continually evaluating other adjustments, including the possibility of changing the level of hedging employed with the U.S dollar-denominated investments.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
As of December 31, 2020, Aflac Japan had $6.4 billion outstanding notional amounts of foreign currency forwards and $13.1 billion outstanding notional amounts of foreign currency options, of which none were in-the-money, hedging the U.S. dollar-denominated investments. The fair value of Aflac Japan's unhedged U.S. dollar-denominated portfolio was $9.4 billion (excluding certain U.S. dollar-denominated assets shown in the table above as a result of consolidation that have been economically converted to yen using derivatives).
Foreign exchange derivatives used for hedging are periodically settled, which results in cash receipt or payment at maturity or early termination. The Company had net cash outflows of $21 million in 2020 and net cash outflows of $20 million in 2019, associated with the currency derivatives used for hedging Aflac Japan’s U.S. dollar-denominated investments.
Enterprise Corporate Hedging Program
The Company has designated certain yen-denominated liabilities and foreign currency forwards and options of the Parent Company as accounting hedges of its net investment in Aflac Japan. The Company's consolidated yen-denominated net asset position was partially hedged at $9.9 billion as of December 31, 2020, compared with $9.1 billion as of December 31, 2019.
The Company makes its accounting designation of net investment hedge at the beginning of each quarter. If the total of the designated Parent Company non-derivative and derivative notional is equal to or less than the Company's net investment in Aflac Japan, the hedge is deemed to be effective, and the currency exchange effect on the yen-denominated liabilities and the change in estimated fair value of the derivatives are reported in the unrealized foreign currency component of other comprehensive income. The Company's net investment hedge was effective during the years ended December 31, 2020 and 2019, respectively. For additional information on the Company's net investment hedging strategy, see Note 4 of the Notes to the Consolidated Financial Statements.
In order to economically mitigate risks associated with the enterprise-wide exposure to the yen and the level and volatility of hedge costs, the Parent Company enters into foreign exchange forward and option contracts. By buying U.S. dollars and selling yen, the Parent Company is effectively lowering its overall economic exposure to the yen, while Aflac Japan's U.S dollar exposure remains reduced as a result of Aflac Japan's U.S. dollar-denominated hedge program that economically creates yen assets. Among other objectives, this strategy is intended to offset the enterprise-wide amortized hedge costs by generating amortized hedge income. The portion of the enterprise-wide amortized hedge income contributed by this strategy was $97 million in 2020 and $89 million in 2019. This activity is reported in Corporate and Other. As this program evolves, the Company will continue to evaluate the program’s efficacy. See the Results of Operations section of this MD&A for the Company's definition of amortized hedge costs/income.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following table presents metrics related to Aflac Japan amortized hedge costs and the Parent Company amortized hedge income for the years ended December 31.
Hedge Cost/Income Metrics**(1)**
| 2020 | 2019 | ||||||||||||||||
| Aflac Japan: | |||||||||||||||||
| FX Forwards | |||||||||||||||||
| FX forward (sell USD, buy yen) notional at end of period (in billions) (2) | $6.4 | $8.8 | |||||||||||||||
| Weighted average remaining tenor (in months) (3) | 12.7 | 8.5 | |||||||||||||||
| Amortized hedge income (cost) for period (in millions) | $(197) | $(256) | |||||||||||||||
| FX Options | |||||||||||||||||
| FX option notional at the end of period (in billions) (2) | $13.1 | $9.2 | |||||||||||||||
| Weighted average remaining tenor (in months) (3) | 5.3 | 1.9 | |||||||||||||||
| Amortized hedge income (cost) for period (in millions) | $(9) | $(1) | |||||||||||||||
| Corporate and Other (Parent Company): | |||||||||||||||||
| FX Forwards | |||||||||||||||||
| FX forward (buy USD, sell yen) notional at end of period (in billions)(2) | $5.0 | $4.9 | |||||||||||||||
| Weighted average remaining tenor (in months)(3) | 12.1 | 13.7 | |||||||||||||||
| Amortized hedge income (cost) for period (in millions) | $102 | $90 | |||||||||||||||
| FX Options | |||||||||||||||||
| FX option notional at the end of period (in billions) (2) | $2.0 | $2.0 | |||||||||||||||
| Weighted average remaining tenor (in months) (3) | 7.2 | 8.4 | |||||||||||||||
| Amortized hedge income (cost) for period (in millions) | $(5) | $(1) |
(1) See the Results of Operations section of this MD&A for the Company's definition of amortized hedge costs/income.
(2) Notional is reported net of any offsetting positions within Aflac Japan or the Parent Company, respectively.
(3) Tenor based on period reporting date to settlement date
Interest Rate Risk Hedge Program
Aflac Japan and Aflac U.S. use interest rate swaps from time to time to mitigate the risk of investment income volatility for certain variable-rate investments. Additionally, to manage interest rate risk associated with its U.S. dollar-denominated investments held by Aflac Japan, from time to time the Company utilizes interest rate swaptions.
For additional discussion of the risks associated with the foreign currency exposure refer to the Currency Risk section in Item 7A., Quantitative and Qualitative Disclosures about Market Risks, and Item 1A, specifically to the Risk Factors titled “The Company is exposed to foreign currency fluctuations in the yen/dollar exchange rate“ and “Lack of availability of acceptable yen-denominated investments could adversely affect the Company's results of operations, financial position or liquidity."
See Note 4 of the Notes to the Consolidated Financial Statements for additional information on the Company's hedging activities.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
POLICY LIABILITIES
The following table presents policy liabilities by segment and in total for the years ended December 31.
| (In millions) | 2020 | 2019 | ||||||||||||
| Japan segment: | ||||||||||||||
| Future policy benefits | $ | 88,652 | $ | 81,462 | ||||||||||
| Unpaid policy claims | 3,177 | 2,879 | ||||||||||||
| Other policy liabilities | 11,299 | 11,452 | ||||||||||||
| Total Japan policy liabilities | 103,128 | 95,793 | ||||||||||||
| U.S. segment: | ||||||||||||||
| Future policy benefits | 9,674 | 9,405 | ||||||||||||
| Unpaid policy claims | 2,010 | 1,779 | ||||||||||||
| Other policy liabilities | 126 | 111 | ||||||||||||
| Total U.S. policy liabilities | 11,810 | 11,295 | ||||||||||||
| Consolidated: | ||||||||||||||
| Future policy benefits | 97,783 | 90,335 | ||||||||||||
| Unpaid policy claims | 5,187 | 4,659 | ||||||||||||
| Other policy liabilities | 11,421 | 11,560 | ||||||||||||
| Total consolidated policy liabilities (1) | $ | 114,391 | $ | 106,554 |
(1) The sum of the Japan and U.S. segments exceeds the total due to reinsurance and retrocession activity.
See Note 7 of the Notes to the Consolidated Financial Statements for additional information on the Company's policy liabilities.
BENEFIT PLANS
Aflac Japan and Aflac U.S. have various benefit plans. For additional information on the Company's Japanese and U.S. plans, see Note 14 of the Notes to the Consolidated Financial Statements.
POLICYHOLDER PROTECTION
Policyholder Protection Corporation
The Japanese insurance industry has a policyholder protection system that provides funds for the policyholders of insolvent insurers. Legislation enacted regarding the framework of the Life Insurance Policyholder Protection Corporation (LIPPC) included government fiscal measures supporting the LIPPC. In November 2016, Japan's Diet passed legislation that again extends the government's fiscal support of the LIPPC through March 2022. Effective April 2014, the annual LIPPC contribution amount for the total life industry was lowered from ¥40 billion to ¥33 billion. Aflac Japan recognized an expense of ¥1.9 billion for LIPPC assessments in each of the years ended December 31, 2020 and 2019.
Guaranty Fund Assessments
Under U.S. state guaranty association laws, certain insurance companies can be assessed (up to prescribed limits) for certain obligations to the policyholders and claimants of impaired or insolvent insurance companies that write the same line or similar lines of business. The amount of the guaranty fund assessment that an insurer is assessed is based on its proportionate share of premiums in that state. See Note 15 of the Notes to the Consolidated Financial Statements for further information on guaranty fund assessments.
OFF-BALANCE SHEET ARRANGEMENTS
See Note 3 of the Notes to the Consolidated Financial Statements for details on certain investment commitments.
As of December 31, 2020, the Company had no material letters of credit, standby letters of credit, guarantees or standby repurchase obligations. See Note 15 of the Notes to the Consolidated Financial Statements for information on material unconditional purchase obligations that are not recorded on the Company's balance sheet.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
LIQUIDITY AND CAPITAL RESOURCES
Liquidity refers to the ability to generate sufficient cash resources to meet the payment obligations of the Company. Capital refers to the long-term financial resources available to support the operations of the businesses, fund business growth and provide for an ability to withstand adverse circumstances. Financial leverage (leverage) refers to an investment strategy of using debt to increase the potential return on equity. The Company targets and actively manages liquidity, capital and leverage in the context of a number of considerations, including:
-
business investment and growth needs
-
strategic growth objectives
-
financial flexibility and obligations
-
capital support for hedging activity
-
a constantly evolving business and economic environment
-
a balanced approach to capital allocation and shareholder deployment.
The governance framework supporting liquidity, capital and leverage includes global senior management and board committees that review and approve all significant capital related decisions.
The Company's cash and cash equivalents include unrestricted cash on hand, money market instruments, and other debt instruments with a maturity of 90 days or less when purchased, all of which has minimal market, settlement or other risk exposure. The target minimum amount for the Parent Company’s cash and cash equivalents is approximately $2.0 billion to provide a capital buffer and liquidity support at the holding company. Amid the COVID-19 pandemic, the Company remains committed to prudent liquidity and capital management. At December 31, 2020, the Company held $5.1 billion in cash and cash equivalents for stress conditions, which includes the Parent Company's target minimum amount of $2.0 billion. For additional information on the Company’s liquidity and capital resources in response to COVID-19, see the Executive Summary section of this MD&A.
Aflac Japan and Aflac U.S. provide the primary sources of liquidity to the Parent Company through management fees and dividends. To maintain a strong capital position during the COVID-19 pandemic in 2020, dividends paid to the Parent Company by Aflac Japan were reduced. For additional information on the impact to subsidiary dividends paid to the Parent Company as a result of COVID-19, see the Executive Summary section of this MD&A.
The following table presents the amounts provided to the Parent Company for the years ended December 31.
Liquidity Provided by Subsidiaries to Parent Company
| (In millions) | 2020 | 2019 | ||||||||||||||||||
| Dividends declared or paid by subsidiaries | $ | 2,068 | $ | 3,466 | ||||||||||||||||
| Management fees paid by subsidiaries | 131 | 151 |
The following table details Aflac Japan remittances for the years ended December 31.
Aflac Japan Remittances
| (In millions of dollars and billions of yen) | 2020 | 2019 | ||||||||||||||||||
| Aflac Japan management fees paid to Parent Company | $ | 71 | $ | 75 | ||||||||||||||||
| Expenses allocated to Aflac Japan (in dollars) | 0 | 4 | ||||||||||||||||||
| Aflac Japan profit remittances to the Parent Company (in dollars) | 1,215 | 2,070 | ||||||||||||||||||
| Aflac Japan profit remittances to the Parent Company (in yen) | ¥ | 129.8 | ¥ | 225.2 |
The Company intends to maintain higher than historical levels of liquidity and capital at the Parent Company for stress conditions and with the goals of addressing the Company’s hedge costs and related potential need for collateral and mitigating against long-term weakening of the Japanese yen. Further, the Company plans to continue to maintain a portfolio of unhedged U.S. dollar based investments at Aflac Japan and consider whether the amount of such investments should be increased or decreased relative to the Company’s view of economic equity surplus in Aflac Japan in light of potentially rising hedge costs and other factors. See the Hedging Activity subsection in this MD&A for more information.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
In addition to cash and equivalents, the Company also maintains credit facilities, both intercompany and with external partners, and a number of other available tools to support liquidity needs on a global basis. In September 2018, the Parent Company filed a shelf registration statement with the SEC that allows the Company to issue an indefinite amount of debt securities, in one or more series, from time to time until September 2021. The Company believes outside sources for additional debt and equity capital, if needed, will continue to be available. Additionally, as of December 31, 2020, the Parent Company and Aflac had four lines of credit with third parties and seven intercompany lines of credit. For additional information, see Note 9 of the Notes to the Consolidated Financial Statements.
The primary uses of cash by the Parent Company are shareholder dividends, the repurchase of its common stock and interest on its outstanding indebtedness and operating expenses.
Major Contractual Obligations
The following table presents the estimated payments by period of the Company's major contractual obligations as of December 31, 2020. The Company translated its yen-denominated obligations using the December 31, 2020, exchange rate. Actual future payments as reported in dollars will fluctuate with changes in the yen/dollar exchange rate.
Distribution of Payments by Period
| (In millions) | Total Liability**(1)** | Total Payments | Less Than One Year | One to Three Years | Three to Five Years | After Five Years | |||||||||||||||||||||||||||||
| Future policy benefits liability (Note 7)**(2) | $ | 97,783 | $ | 256,340 | $ | 10,057 | $ | 19,724 | $ | 19,661 | $ | 206,898 | |||||||||||||||||||||||
| Unpaid policy claims liability (Note 7)**(3) | 5,187 | 5,187 | 3,343 | 1,090 | 432 | 322 | |||||||||||||||||||||||||||||
| Other policyholders' funds (Note 7)**(3) | 7,824 | 10,219 | 373 | 477 | 868 | 8,501 | |||||||||||||||||||||||||||||
| Long-term debt – principal (Note 9) | 7,745 | 7,804 | 0 | 700 | 1,320 | 5,784 | |||||||||||||||||||||||||||||
| Long-term debt – interest (Note 9) | 49 | 2,984 | 221 | 426 | 345 | 1,992 | |||||||||||||||||||||||||||||
| Cash collateral on loaned securities (Note 3) | 964 | 964 | 964 | 0 | 0 | 0 | |||||||||||||||||||||||||||||
| Operating service agreements (Note 15) | N/A | (4) | 407 | 195 | 168 | 44 | 0 | ||||||||||||||||||||||||||||
| Operating lease obligations (Note 9) | 143 | 152 | 52 | 51 | 21 | 28 | |||||||||||||||||||||||||||||
| Finance lease obligations (Note 9) | 11 | 11 | 4 | 5 | 2 | 0 | |||||||||||||||||||||||||||||
| Total contractual obligations | $ | 119,706 | $ | 284,068 | $ | 15,209 | $ | 22,641 | $ | 22,693 | $ | 223,525 |
Liabilities for unrecognized tax benefits in the amount of $19 have been excluded from the tabular disclosure above because the timing of cash payment is not reasonably estimable.
(1) Liability amounts are those reported on the consolidated balance sheet as of December 31, 2020.
(2) The estimated payments due by period reflect future estimated cash payments to be made to policyholders and others for future policy benefits. These projected cash outflows are based on assumptions for future policy persistency, mortality, morbidity, and other assumptions comparable with the Company's experience, consider future premium receipts on current policies in force, and assume market growth and interest crediting consistent with assumptions used in amortizing deferred acquisition costs. These cash outflows are undiscounted with respect to interest and, as a result, the sum of the cash outflows shown for all years in the table of $256,340 exceeds the corresponding liability amount of $97,783. The Company has made significant assumptions to determine the future estimated cash outflows related to the underlying policies and contracts. Due to the significance of the assumptions used, actual cash outflow amounts and timing will differ, possibly materially, from these estimates.
(3) Includes assumptions as to the timing of policyholders reporting claims for prior periods and the amount of those claims. Actual amounts and timing of unpaid policy claims payments may differ significantly from the estimates above.
(4) Not applicable
For more information on the Company's major contractual obligations, see the applicable Note in the Notes to the Consolidated Financial Statements as indicated in the line items in the table above.
The Company's consolidated financial statements convey its financing arrangements during the periods presented. The Company has not engaged in material intra-period short-term financings during the periods presented that are not otherwise reported in its balance sheet or disclosed therein. The Company was in compliance with all of the covenants of its notes payable and lines of credit at December 31, 2020. The Company has not entered into transactions involving the transfer of financial assets with an obligation to repurchase financial assets that have been accounted for as a sale under applicable accounting standards, including securities lending transactions. See Notes 1, 3, and 4 of the Notes to the Consolidated Financial Statements for more information on the Company's securities lending and derivative activities. With the exception of disclosed activities in those referenced footnotes and the Risk Factors entitled, "The Company is exposed to foreign currency fluctuations in the yen/dollar exchange rate" and "Lack of availability of acceptable yen-denominated investments could adversely affect the Company's results of operations, financial position or liquidity," the
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Company is not aware of a trend, demand, commitment, event or uncertainty that would likely result in its liquidity increasing or decreasing by a material amount.
Consolidated Cash Flows
The Company translates cash flows for Aflac Japan's yen-denominated items into U.S. dollars using weighted-average exchange rates. In years when the yen weakens, translating yen into dollars causes fewer dollars to be reported. When the yen strengthens, translating yen into dollars causes more dollars to be reported.
The following table summarizes consolidated cash flows by activity for the years ended December 31.
| (In millions) | 2020 | 2019 | ||||||||||||||||||
| Operating activities | $ | 5,958 | $ | 5,455 | ||||||||||||||||
| Investing activities | (4,619) | (3,171) | ||||||||||||||||||
| Financing activities | (1,115) | (1,713) | ||||||||||||||||||
| Exchange effect on cash and cash equivalents | 21 | (12) | ||||||||||||||||||
| Net change in cash and cash equivalents | $ | 245 | $ | 559 |
Operating Activities
The principal cash inflows for the Company's insurance activities come from insurance premiums and investment income. The principal cash outflows are the result of policy claims, operating expenses, income tax, as well as interest expense. As a result of policyholder aging, claims payments are expected to gradually increase over the life of a policy. Therefore, future policy benefit reserves are accumulated in the early years of a policy and are designed to help fund future claims payments.
The Company expects its future cash flows from premiums and investment portfolios to be sufficient to meet its cash needs for benefits and expenses. Consolidated cash flow from operations increased 9.2% in 2020, compared with 2019.
Investing Activities
The Company's investment objectives provide for liquidity primarily through the purchase of publicly traded investment-grade debt securities. Prudent portfolio management dictates that the Company attempts to match the duration of its assets with the duration of its liabilities. Currently, when the Company's fixed maturity securities mature, the proceeds may be reinvested at a yield below that required for the accretion of policy benefit liabilities on policies issued in earlier years. However, the long-term nature of the Company's business and its strong cash flows provide the Company with the ability to minimize the effect of mismatched durations and/or yields identified by various asset adequacy analyses. From time to time or when market opportunities arise, the Company disposes of selected fixed maturity securities that are available for sale to improve the duration matching of assets and liabilities, improve future investment yields, and/or re-balance its portfolio. As a result, dispositions before maturity can vary significantly from year to year.
As part of its overall corporate strategy, the Company has committed $400 million to Aflac Ventures, LLC (Aflac Ventures), as opportunities emerge. Aflac Ventures is a subsidiary of Aflac Global Ventures, LLC (Aflac Global Ventures) which is reported in the Corporate and Other segment. The central mission of Aflac Global Ventures is to support the organic growth and business development needs of Aflac Japan and Aflac U.S. with an emphasis on digital applications designed to improve the customer experience, gain efficiencies, and develop new markets in an effort to enhance and defend long-term shareholder value. Investments are included in equity securities or the other investments line in the consolidated balance sheets.
As part of an arrangement with FHLB, Aflac U.S. obtains low-cost funding from FHLB supported by acceptable forms of collateral pledged by Aflac U.S. In 2020, Aflac U.S. borrowed and repaid $299 million under this program. As of December 31, 2020, Aflac U.S. had outstanding borrowings of $301 million reported in its balance sheet. To further support liquidity and capital resources amid the pandemic, in April 2020, Aflac U.S. increased its internal limit for borrowings under this program to $800 million, $300 million of which the Company has designated to be used for short-term liquidity needs only and subject to qualified collateral availability and other conditions.
See Note 3 of the Notes to the Consolidated Financial Statements for details on certain investment commitments.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Financing Activities
Consolidated cash used by financing activities was $1.1 billion in 2020 and $1.7 billion in 2019.
In April 2020, the Parent Company issued $1.0 billion of senior notes through a U.S. public debt offering. The notes bear interest at a fixed rate of 3.60% per annum, payable semi-annually, and will mature in April 2030. These notes are redeemable at the Parent Company's option in whole at any time or in part from time to time at a redemption price equal to the greater of: (i) the aggregate principal amount of the notes to be redeemed or (ii) the amount equal to the sum of the present values of the remaining scheduled payments for principal of and interest on the notes to be redeemed, not including any portion of the payments of interest accrued as of such redemption date, discounted to such redemption date on a semiannual basis at the yield to maturity for a U.S. Treasury security with a maturity comparable to the remaining term of the notes, plus 45 basis points, plus in each case, accrued and unpaid interest on the principal amount of the notes to be redeemed to, but excluding, such redemption date.
In March 2020, the Parent Company issued four series of senior notes totaling ¥57.0 billion through a public debt offering under its U.S. shelf registration statement. The first series, which totaled ¥12.4 billion, bears interest at a fixed rate of .300% per annum, payable semiannually and will mature in September 2025. The second series, which totaled ¥13.3 billion, bears interest at a fixed rate of .550% per annum, payable semi-annually, and will mature in March 2030. The third series, which totaled ¥20.7 billion, bears interest at a fixed rate of .750% per annum, payable semiannually and will mature in March 2032. The fourth series, which totaled ¥10.6 billion, bears interest at a fixed rate of .830% per annum, payable semi-annually, and will mature in March 2035. These notes may only be redeemed before maturity, in whole but not in part, upon the occurrence of certain changes affecting U.S. taxation, as specified in the indenture governing the terms of the issuance.
In January 2020, the Parent Company used the net proceeds from senior notes issued in December 2019 to redeem $350 million of its 4.00% fixed-rate senior notes due February 2022.
In December 2019, the Parent Company issued four series of senior notes totaling ¥38.0 billion through a public debt offering under its U.S. shelf registration statement. The first series, which totaled ¥12.6 billion, bears interest at a fixed rate of .500% per annum, payable semi-annually, and will mature in December 2029. The second series, which totaled ¥9.3 billion, bears interest at a fixed rate of .843% per annum, payable semi-annually, and will mature in December 2031. The third series, which totaled ¥9.8 billion, bears interest at a fixed rate of .934% per annum, payable semi-annually, and will mature in December 2034. The fourth series, which totaled ¥6.3 billion, bears interest at a fixed rate of 1.122% per annum, payable semi-annually, and will mature in December 2039. These notes may only be redeemed before maturity, in whole but not in part, upon the occurrence of certain changes affecting U.S. taxation, as specified in the indenture governing the terms of the issuance.
In September 2019, the Parent Company renewed a ¥30.0 billion senior term loan facility. The first tranche of the facility, which totaled ¥5.0 billion, bears interest at a rate per annum equal to the Tokyo interbank market rate (TIBOR), or alternate TIBOR, if applicable, plus the applicable TIBOR margin and will mature in September 2026. The applicable margin ranges between .30% and .70%, depending on the Parent Company's debt ratings as of the date of determination. The second tranche, which totaled ¥25.0 billion, bears interest at a rate per annum equal to the TIBOR, or alternate TIBOR, if applicable, plus the applicable TIBOR margin and will mature in September 2029. The applicable margin ranges between .45% and 1.00%, depending on the Parent Company's debt ratings as of the date of determination.
In April 2019, ALIJ issued ¥30.0 billion (par value) of perpetual subordinated bonds. These bonds bear interest at a fixed rate of .963% per annum and then at six-month Euro Yen LIBOR plus an applicable spread on and after the day immediately following April 18, 2024. The bonds will be callable on each interest payment date on and after April 18, 2024. In November 2019, ALIJ amended the bonds to change their duration from perpetual to a stated maturity date of April 16, 2049 and to remove provisions that permitted ALIJ to defer payments of interest under certain circumstances.
See Note 9 of the Notes to the Consolidated Financial Statements for further information on the debt issuances discussed above.
The Company was in compliance with all of the covenants of its notes payable and lines of credit at December 31, 2020.
Cash returned to shareholders through treasury stock purchases and dividends was $2.3 billion in 2020, compared with $2.4 billion in 2019.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following tables present a summary of treasury stock activity during the years ended December 31.
Treasury Stock Purchased
| (In millions of dollars and thousands of shares) | 2020 | 2019 | ||||||||||||||||||
| Treasury stock purchases | $ | 1,537 | $ | 1,627 | ||||||||||||||||
| Number of shares purchased: | ||||||||||||||||||||
| Share repurchase program | 37,899 | 31,994 | ||||||||||||||||||
| Other | 542 | 592 | ||||||||||||||||||
| Total shares purchased | 38,441 | 32,586 |
Treasury Stock Issued
| (In millions of dollars and thousands of shares) | 2020 | 2019 | ||||||||||||||||||
| Stock issued from treasury: | ||||||||||||||||||||
| Cash financing | $ | 34 | $ | 49 | ||||||||||||||||
| Noncash financing | 54 | 50 | ||||||||||||||||||
| Total stock issued from treasury | $ | 88 | $ | 99 | ||||||||||||||||
| Number of shares issued | 2,393 | 2,324 |
Under share repurchase authorizations from the Company's board of directors, the Company purchased 37.9 million shares of its common stock in 2020, compared with 32.0 million shares in 2019. In August 2020, the Company's board of directors authorized the purchase of 100 million shares of its common stock. As of December 31, 2020, a remaining balance of 99.2 million shares of the Company's common stock was available for purchase under share repurchase authorizations by its board of directors. See Note 11 of the Notes to the Consolidated Financial Statements for additional information. For information on the impact of COVID-19 on the Company's share repurchase program, see the Executive Summary section of this MD&A.
Cash dividends paid to shareholders in 2020 of $1.12 per share increased 3.7% over 2019. The following table presents the dividend activity for the years ended December 31.
Dividends Paid to Shareholders
| (In millions) | 2020 | 2019 | ||||||||||||||||||
| Dividends paid in cash | $ | 769 | $ | 771 | ||||||||||||||||
| Dividends through issuance of treasury shares | 29 | 30 | ||||||||||||||||||
| Total dividends to shareholders | $ | 798 | $ | 801 |
In November 2020, the board of directors announced a 17.9% increase in the quarterly cash dividend, effective with the first quarter of 2021. The first quarter 2021 cash dividend of $.33 per share is payable on March 1, 2021, to shareholders of record at the close of business on February 17, 2021.
Regulatory Restrictions
Aflac Japan
Aflac Japan is required to meet certain financial criteria as governed by Japanese corporate law in order to provide dividends to the Parent Company. Under these criteria, dividend capacity at the Japan subsidiary is basically defined as total equity excluding common stock, accumulated other comprehensive income amounts, capital reserves (representing statutorily required amounts in Japan) but reduced for net after-tax unrealized losses on available-for-sale securities. These dividend capacity requirements are generally aligned with the SMR. Japan's FSA maintains its own solvency standard which is quantified through the SMR. Aflac Japan's SMR is sensitive to interest rate, credit spread, and foreign exchange rate changes, therefore the Company continues to evaluate alternatives for reducing this sensitivity, including the reduction of subsidiary dividends paid to the Parent Company and Parent Company capital contributions. In the event of a rapid change in market risk conditions causing SMR to decline, the Company has one senior unsecured revolving credit facility in the amount of ¥100 billion and a committed reinsurance facility in the amount of approximately ¥120 billion
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
as a capital contingency plan. Additionally, the Company could take action to enter into derivatives on unhedged U.S. dollar-denominated investments with foreign currency options or forwards. See Notes 8 and 9 of the Notes to the Consolidated Financial Statements for additional information.
The Company has already undertaken various measures to mitigate the sensitivity of Aflac Japan's SMR. For example, the Company employs policy reserve matching (PRM) investment strategies, which is a Japan-specific accounting treatment that reduces SMR interest rate sensitivity since PRM-designated investments are carried at amortized cost consistent with corresponding liabilities. In order for a PRM-designated asset to be held at amortized cost, there are certain criteria that must be maintained. The primary criterion relates to maintaining the duration of designated assets and liabilities within a specified tolerance range. If the duration difference is not maintained within the specified range without rebalancing, then a certain portion of the assets must be re-classified as available for sale and held at fair value with any associated unrealized gain or loss recorded in surplus. To rebalance, assets may need to be sold in order to maintain the duration with the specified range, resulting in realizing a gain or loss from the sale. For U.S. GAAP, PRM investments are categorized as available for sale. The Company also uses foreign currency derivatives to hedge a portion of its U.S. dollar-denominated investments. See Notes 3, 4 and 8 of the Notes to the Consolidated Financial Statements for additional information on the Company's investment strategies, hedging activities, and reinsurance, respectively.
Aflac Japan's SMR ratio remains high and reflects a strong capital and surplus position. As of December 31, 2020, Aflac Japan's SMR was 960%, compared with 1,043% at December 31, 2019. The Company is committed to maintaining strong capital levels throughout the pandemic, consistent with maintaining current insurance financial strength and credit ratings. For additional information see the Executive Summary COVID-19 section of this MD&A.
The FSA is considering the introduction of an economic value-based solvency regime based on the Insurance Capital Standards (ICS) for insurance companies in Japan. The FSA is currently conducting field testing with insurance companies in Japan for the purpose of investigating the impact of the introduction of regulations. Provisional specifications are expected to be decided in 2022, and a new capital regime to replace the current solvency regime may be introduced as early as 2025.
Aflac U.S.
A life insurance company’s statutory capital and surplus is determined according to rules prescribed by the NAIC, as modified by the insurance department in the insurance company’s state of domicile. Statutory accounting rules are different from U.S. GAAP and are intended to emphasize policyholder protection and company solvency. The continued long-term growth of the Company's business may require increases in the statutory capital and surplus of its insurance operations. The Company's insurance operations may secure additional statutory capital through various sources, such as internally generated statutory earnings, reduced dividends paid to the Parent Company, capital contributions by the Parent Company from funds generated through debt or equity offerings, or reinsurance transactions. The NAIC’s RBC formula is used by insurance regulators to help identify inadequately capitalized insurance companies. The RBC formula quantifies insurance risk, business risk, asset risk and interest rate risk by weighing the types and mixtures of risks inherent in the insurer’s operations.
The combined RBC ratio for Aflac U.S. as of December 31, 2020 was 550%. The Company calculates its combined RBC ratio to include all U.S. regulated life insurance entities as if a single combined U.S. RBC entity net of intercompany items related to capital resources and risk.
The table below presents RBC ratios for the Company’s U.S. life insurance subsidiaries as of December 31, the most recently statutory fiscal year-end for the subsidiaries for which RBC was filed. The Company intends to maintain a target minimum RBC of approximately 400% for Aflac, consistent with the Company's risk management practices.
| 2020 | ||||||||
| Aflac | 508 | % | ||||||
| CAIC | 975 | |||||||
| TOIC | 6,964 | |||||||
| Aflac New York | 1,077 |
The NAIC completed its Solvency Modernization Initiative (SMI) process relating to updating the U.S. insurance solvency regulation framework. The SMI focused on key issues such as capital requirements, governance and risk management, group supervision, reinsurance, statutory accounting and financial reporting matters. The NAIC still has some ongoing
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
initiatives related to SMI, such as monitoring the international efforts on group capital requirements as well as RBC. In 2020, the NAIC formally adopted a group capital calculation (GCC) that conceptually uses an RBC aggregation methodology for all entities within the insurance company holding system. The GCC is intended to be a regulatory tool used by regulators as a means to standardize group capital requirements. In addition, the NAIC has also proposed changes to investment risk factors for fixed maturity securities which are expected to be adopted for 2021 RBC filings. Any negative developments by the NAIC in these areas could result in increased capital requirements for the Company.
Aflac is subject to the NAIC’s Own Risk and Solvency Assessment (ORSA) reporting requirement. Through the ORSA requirements, Aflac is expected to regularly, no less than annually, conduct an ORSA to assess the adequacy of its risk management framework, and its current and projected future solvency position; internally document the process and results of the assessment; and provide a confidential high-level ORSA Summary Report annually to the lead state commissioner. In November 2020, Aflac filed its ORSA report with the Nebraska Department of Insurance.
Aflac, CAIC and TOIC are domiciled in Nebraska and are subject to its regulations. The Nebraska Department of Insurance imposes certain limitations and restrictions on payments of dividends, management fees, loans and advances to the Parent Company. Under Nebraska insurance law, prior approval of the Nebraska Department of Insurance is required for dividend distributions that exceed the greater of the net income from operations, which excludes net investment gains, for the previous year determined under statutory accounting principles, or 10% of statutory capital and surplus as of the previous year-end. Dividends declared by Aflac during 2021 in excess of $872 million would be considered extraordinary and require such approval. Similar laws apply in New York, the domiciliary jurisdiction of Aflac New York.
Privacy and Cybersecurity Governance
The Company’s Board of Directors has adopted an information security policy directing management to establish and operate a global information security program with the goals of monitoring existing and emerging threats and ensuring that the Company’s information assets and data, and the data of its customers, are appropriately protected from loss or theft. The Board has delegated oversight of the Company’s information security program to the Audit and Risk Committee. The Company’s senior officers, including its Global Security and Chief Information Security Officer, are responsible for the operation of the global information security program and communicates quarterly with the Audit and Risk Committee on the program, including with respect to the state of the program, compliance with applicable regulations, current and evolving threats, and recommendations for changes in the information security program. The global information security program also includes a cybersecurity incident response plan that is designed to provide a management framework across Company functions for a coordinated assessment and response to potential security incidents. This framework establishes a protocol to report certain incidents to the Global Security and Chief Information Security Officer and other senior officers, with the goal of timely assessing such incidents, determining applicable disclosure requirements and communicating with the Audit and Risk Committee. The incident response plan directs the executive officers to report certain incidents immediately and directly to the Lead Non-Management Director.
Other
For information regarding commitments and contingent liabilities, see Note 15 of the Notes to the Consolidated Financial Statements.
Additional Information
Investors should note that the Company announces material financial information in its SEC filings, press releases and public conference calls. In accordance with SEC guidance, the Company may also use the Investor Relations section of the Company's website (http://investors.aflac.com) to communicate with investors about the Company. It is possible that the financial and other information the Company posts there could be deemed to be material information. The information on the Company's website is not part of this document. Further, the Company's references to website URLs are intended to be inactive textual references only.
CRITICAL ACCOUNTING ESTIMATES
The Company prepares its financial statements in accordance with U.S. GAAP. These principles are established primarily by the FASB. In this MD&A, references to U.S. GAAP issued by the FASB are derived from the FASB Accounting Standards Codification™ (ASC). The preparation of financial statements in conformity with U.S. GAAP requires the Company to make estimates based on currently available information when recording transactions resulting from business operations. The estimates that the Company deems to be most critical to an understanding of Aflac’s results of operations
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
and financial condition are those related to the valuation of investments and derivatives, DAC, liabilities for future policy benefits and unpaid policy claims, and income taxes. The preparation and evaluation of these critical accounting estimates involve the use of various assumptions developed from management’s analyses and judgments. The application of these critical accounting estimates determines the values at which 94% of the Company's assets and 82% of its liabilities are reported as of December 31, 2020, and thus has a direct effect on net earnings and shareholders' equity. Subsequent experience or use of other assumptions could produce significantly different results.
Valuation of Investments, Including Derivatives, and Recognition of Current Expected Credit Losses
Aflac's investments, primarily consisting of debt and equity securities, include both publicly issued and privately issued securities. For publicly issued securities, the Company determines the fair values from quoted market prices readily available from public exchange markets and price quotes and valuations from third party pricing vendors. For the majority of privately issued securities within the Company's investment portfolio, a third party pricing vendor has developed valuation models that the Company utilizes to determine fair values. For the remaining privately issued securities, the Company uses non-binding price quotes from outside brokers. In September 2020, the Company refined its valuation model for private placements to explicitly incorporate currency basis swap adjustments (market observable data) to assumed interest rate curves where appropriate as noted in Note 5 of the Notes to the Consolidated Financial Statements.
The Company estimates the fair values of its securities on a monthly basis. The Company monitors the estimated fair values obtained from its pricing vendors and brokers for consistency from month to month, while considering current market conditions. The Company also periodically discusses with its pricing brokers and vendors the pricing techniques they use to monitor the consistency of their approach and periodically assess the appropriateness of the valuation level assigned to the values obtained from them. If a fair value appears unreasonable, the Company will re-examine the inputs and assess the reasonableness of the pricing data with the vendor. Additionally, the Company may compare the inputs to relevant market indices and other performance measurements. Based on management's analysis, the valuation is confirmed or may be revised if there is evidence of a more appropriate estimate of fair value based on available market data. The Company has performed verification of the inputs and calculations in any valuation models to confirm that the valuations represent reasonable estimates of fair value. Inputs used to value derivatives include, but are not limited to, interest rates, credit spreads, foreign currency forward and spot rates, and interest volatility.
The Company estimates an expected lifetime credit loss on investments measured at amortized cost including held-to-maturity fixed maturity securities, loan receivables and loan commitments on a quarterly basis. For the Company’s available-for-sale fixed maturity securities, the Company evaluates estimated credit losses only when the fair value of the available-for-sale fixed maturity security is below its amortized cost basis
The Company’s approach to estimating credit losses is complex and incorporates significant judgments. In addition to a security, or an asset class, or an issuer-specific credit fundamentals, it considers past events, current economic conditions and forecasts of future economic conditions. The Company's estimates are revised as conditions change and new information becomes available.
See Notes 1, 3, 4 and 5 of the Notes to the Consolidated Financial Statements for additional information.
Deferred Policy Acquisition Costs and Policy Liabilities
Insurance premiums for most of the Company's health and life policies, including cancer, accident, hospital, critical illness, dental, vision, term life, whole life, long-term care and disability, are recognized as revenue over the premium-paying periods of the contracts when due from policyholders. When revenues are reported, the related amounts of benefits and expenses are charged against such revenues, so that profits are recognized in proportion to premium revenues during the period the policies are expected to remain in force. This association is accomplished by means of annual additions to the liability for future policy benefits and the deferral and subsequent amortization of policy acquisition costs.
Premiums from the Company's products with limited-pay features, including term life, whole life, WAYS, and child endowment, are collected over a significantly shorter period than the period over which benefits are provided. Premiums for these products are recognized as revenue over the premium-paying periods of the contracts when due from policyholders. Any gross premium in excess of the net premium is deferred and recorded in earnings, such that profits are recognized in a constant relationship with insurance in force. Benefits are recorded as an expense when they are incurred. A liability for future policy benefits is recorded when premiums are recognized using the net premium method.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Deferred Policy Acquisition Costs
The calculation of DAC and the liability for future policy benefits requires the use of estimates based on sound actuarial valuation techniques. For new policy issues, the Company reviews its actuarial assumptions and deferrable acquisition costs each year and revise them when necessary to more closely reflect recent experience and studies of actual acquisition costs. For policies in force, the Company evaluates DAC by major product groupings to determine that they are recoverable from future revenues, and any amounts determined not to be recoverable are charged against net earnings. See Note 6 of the Notes to the Consolidated Financial Statements for a detail of the DAC activity for the past two years.
Policy Liabilities
The Company's policy liabilities, which are determined in accordance with applicable guidelines as defined under U.S. GAAP and Actuarial Standards of Practice, include two components that involve analysis and judgment: future policy benefits and unpaid policy claims, which accounted for 85% and 5% of total policy liabilities as of December 31, 2020, respectively.
Future policy benefits provide for claims that will occur in the future and are generally calculated as the present value of future expected benefits to be incurred less the present value of future expected net benefit premiums. The Company calculates future policy benefits based on assumptions of morbidity, mortality, persistency and interest. These assumptions are generally established at the time a policy is issued. The assumptions used in the calculations are closely related to those used in developing the gross premiums for a policy. As required by U.S. GAAP, the Company also includes a provision for adverse deviation, which is intended to accommodate adverse fluctuations in actual experience.
Unpaid policy claims include those claims that have been incurred and are in the process of payment as well as an estimate of those claims that have been incurred but have not yet been reported to the Company. The Company computes unpaid policy claims on a non-discounted basis using statistical analyses of historical claims payments, adjusted for current trends and changed conditions. The Company updates the assumptions underlying the estimate of unpaid policy claims regularly and incorporates its historical experience as well as other data that provides information regarding the Company's outstanding liability.
The Company's insurance products provide fixed-benefit amounts per occurrence that are not subject to medical-cost inflation. Furthermore, the Company's business is widely dispersed in both the U.S. and Japan. This geographic dispersion and the nature of the Company's benefit structure mitigate the risk of a significant unexpected increase in claims payments due to localized epidemics and events of a catastrophic nature. Claims incurred under Aflac's policies are generally reported and paid in a relatively short time frame. The unpaid claims liability is sensitive to morbidity assumptions, in particular, severity and frequency of claims. Severity is the ultimate size of a claim, and frequency is the number of claims incurred. The Company's claims experience is primarily related to the demographics of its policyholders.
As a part of its established financial reporting and accounting practices and controls, the Company performs detailed annual actuarial reviews of its policyholder liabilities (gross premium valuation analysis) and reflects the results of those reviews in its results of operations and financial condition as required by U.S. GAAP. For Aflac Japan, the Company’s annual reviews in 2020 and 2019 indicated no need to strengthen liabilities associated with policies in Japan. For Aflac U.S., the Company's annual reviews in 2020 and 2019 indicated no need to strengthen liabilities associated with policies in the U.S.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The table below reflects the growth of the future policy benefits liability for the years ended December 31.
Future Policy Benefits
| (In millions of dollars and billions of yen) | 2020 | 2019 | ||||||||||||||||||
| Aflac U.S. | $ | 9,674 | $ | 9,405 | ||||||||||||||||
| Growth rate | 2.9 | % | 2.9 | % | ||||||||||||||||
| Aflac Japan | $ | 88,652 | $ | 81,462 | ||||||||||||||||
| Growth rate | 8.8 | % | 4.7 | % | ||||||||||||||||
| Consolidated | $ | 97,783 | $ | 90,335 | ||||||||||||||||
| Growth rate | 8.2 | % | 4.6 | % | ||||||||||||||||
| Yen/dollar exchange rate (end of period) | 103.50 | 109.56 | ||||||||||||||||||
| Aflac Japan | ¥ | 9,176 | ¥ | 8,925 | ||||||||||||||||
| Growth rate | 2.8 | % | 3.3 | % |
The growth of the future policy benefits liability in yen for Aflac Japan and in dollars for Aflac U.S. has been due to the aging of the Company's in-force block of business and the addition of new business.
In computing the estimate of unpaid policy claims, the Company considers many factors, including the benefits and amounts available under the policy; the volume and demographics of the policies exposed to claims; and internal business practices, such as incurred date assignment and current claim administrative practices. The Company monitors these conditions closely and makes adjustments to the liability as actual experience emerges. Claim levels are generally stable from period to period; however, fluctuations in claim levels may occur. In calculating the unpaid policy claim liability, the Company does not calculate a range of estimates. The following table shows the expected sensitivity of the unpaid policy claims liability as of December 31, 2020, to changes in severity and frequency of claims.
Sensitivity of Unpaid Policy Claims Liability
| (In millions) | Total Severity | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Total Frequency | Decrease by 2% | Decrease by 1% | Unchanged | Increase by 1% | Increase by 2% | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Increase by 2% | $ | (1) | $ | 26 | $ | 54 | $ | 81 | $ | 109 | |||||||||||||||||||||||||||||||||||||||||||||||||
| Increase by 1% | (27) | 0 | 27 | 54 | 81 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Unchanged | (54) | (27) | 0 | 27 | 54 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Decrease by 1% | (80) | (54) | (27) | 0 | 26 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Decrease by 2% | (107) | (80) | (54) | (27) | (1) |
Other policy liabilities, which accounted for 10% of total policy liabilities as of December 31, 2020, consisted primarily of annuity and unearned premium reserves, and discounted advance premiums on deposit from policyholders in conjunction with their purchase of certain Aflac Japan insurance products. These advanced premiums are deferred upon collection and recognized as premium revenue over the contractual premium payment period. Advanced premiums represented 19% and 24% of the December 31, 2020 and 2019 other policy liabilities balances, respectively. See the Aflac Japan segment subsection of this MD&A for further information.
Income Taxes
Income tax provisions are generally based on pretax earnings reported for financial statement purposes, which differ from those amounts used in preparing the Company's income tax returns. Deferred income taxes are recognized for temporary differences between the financial reporting basis and income tax basis of assets and liabilities, based on enacted tax laws and statutory tax rates applicable to the periods in which the Company expects the temporary differences to reverse. The evaluation of a tax position in accordance with U.S. GAAP is a two-step process. Under the first step, the enterprise determines whether it is more likely than not that a tax position will be sustained upon examination by taxing authorities. The second step is measurement, whereby a tax position that meets the more-likely-than-not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. A valuation allowance is established for deferred tax assets when it is more likely than not that an amount will not be realized. The determination of a valuation allowance for deferred tax assets requires management to make certain judgments and assumptions.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
In evaluating the ability to recover deferred tax assets, the Company's management considers all available evidence, including taxable income in open carry back years, the existence of cumulative losses in the most recent years, forecasted earnings, future taxable income exclusive of reversing temporary differences and carryforwards, future taxable temporary difference reversals, and prudent and feasible tax planning strategies. In the event the Company determines it is not more likely than not that it will be able to realize all or part of its deferred tax assets in the future, a valuation allowance would be charged to earnings in the period such determination is made. Likewise, if it is later determined that it is more likely than not that those deferred tax assets would be realized, the previously provided valuation allowance would be reversed. Future economic conditions and market volatility, including increases in interest rates or widening credit spreads, can adversely impact the Company’s tax planning strategies and in particular the Company’s ability to utilize tax benefits on previously recognized capital losses. The Company's judgments and assumptions are subject to change given the inherent uncertainty in predicting future performance and specific industry and investment market conditions.
In September 2020, the U.S. Treasury and Internal Revenue Service issued Final and Proposed Regulations. Under the guidance of these regulations, the Company recognized a one-time income tax benefit of $1.4 billion due to the release of previously established valuation allowances related to deferred foreign tax credit benefits. The Company believes this will also reduce the effective tax rate in future periods, subject to any future changes in the U.S. tax policy.
For additional information on income tax, see Note 10 of the Notes to the Consolidated Financial Statements presented in this report.
Future Adoption of Accounting Standard for Long-Duration Insurance Contracts
In August 2018, the FASB issued ASU 2018-12, “Financial Services - Insurance, Targeted Improvements to the Accounting for Long-Duration Contracts” (The ASU). The update significantly changes how insurers account for long-duration contracts, amends existing recognition, measurement, presentation, and disclosure requirements applicable to the Company. Issues addressed in the new guidance include: 1) a requirement to review and, if there is a change, update cash flow assumptions for the liability for future policy benefits at least annually, and to update the discount rate assumption quarterly, 2) accounting for market risk benefits at fair value, 3) simplified amortization for deferred acquisition costs, and 4) enhanced financial statement presentation and disclosures.
Since the initial issuance, the FASB has deferred the ASU effective date for two years, such that the amendments are now effective for the Company for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2022. Early application of the amendments is permitted, however, the Company does not expect to early adopt the updated standard. The Company plans to use the additional time to educate investors and analysts on the adoption impact, conduct robust testing and analysis, enhance the control environment, and perform parallel financial reporting.
The Company expects that the ASU's adoption will have a significant impact on the Company’s reported financial position, results of operations, and disclosures. The Company anticipates that the requirement to update assumptions for liability for future policy benefits will have a significant impact on its results of operations, systems, processes and controls while the requirement to update the discount rate will have a significant impact on its AOCI and equity. The Company currently has no products with market risk benefits.
There are two permitted transition methods upon adoption and the Company has selected the modified retrospective transition method. Under the modified retrospective method, the opening reserve balance at the transition date (January 1, 2021, assuming January 1, 2023 adoption), would generally be the same as the closing balance before transition; however, it would be updated for changes in the discount rate required under the new guidance with the difference impacting AOCI.
The new guidance requires that discount rates used for the discounting of insurance liabilities be initially adjusted on the adoption date and subsequently at each reporting period to the market levels for the upper-medium-grade (low credit risk) fixed income instrument yields (single-A in the currency of the underlying insurance contract) reflecting the duration of the Company’s insurance liabilities. The update of the discount rate will be recognized in AOCI.
The Company expects that the impact to its reported financial statements under U.S. GAAP will be greatly influenced by the nature of the Company’s business model. Adoption of the new guidance will reflect the Company’s concentration in Japan third-sector business, in particular cancer insurance, with respect to which the duration of liabilities is materially longer than asset durations, while Japan’s aggregate block of business continues to see favorable experience from mortality, morbidity, and expenses. The long duration of the Company’s third-sector insurance liabilities in Japan coupled with limited-to-no-liquidity of the Japanese long-dated fixed-income market creates challenges in application of the market-based discount rate guidance and will require the Company to apply significant judgments in designing discount
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
rate methodologies for its Japanese third-sector liabilities. Under the modified retrospective method, the impact of a low discount rate applied to long-duration third sector liabilities is recognized at adoption, while associated favorable morbidity margins are recognized over time thus driving a pronounced timing impact to U.S. GAAP equity. In addition, with respect to the Japan segment, the Company maintains a large portfolio of assets designated as held-to-maturity (HTM) as a strategy to reduce capital (solvency margin ratio or SMR) volatility. In a low interest rate environment, such as presently exists in Japan, assets designated as HTM that were purchased in a higher interest rate environment have significant embedded gains not reflected in AOCI (HTM securities are carried at amortized cost under U.S. GAAP), which serves as an economic offset to a low discount rate applied to policy liabilities. At December 31, 2020, the Company’s HTM portfolio was $24.5 billion at amortized cost and had $5.9 billion in net unrealized gains. After adoption of ASU 2018-12, the Company also expects net earnings and net earnings per share (which were $4.8 billion and $6.67 per diluted share, respectively, in 2020) to reflect larger quarterly fluctuations due to the new requirement to update assumptions for liability for future policy benefits.
As an example of the potential impact of the new guidance, and for illustrative purposes only, under the modified retrospective method and in a low interest rate environment, the Company would expect AOCI (which was $8.9 billion at December 31, 2020) to significantly decline upon adoption and to thereafter reflect larger quarterly fluctuations due to the new requirement to adjust discount rates quarterly. Conversely, in a higher interest rate environment, the Company would expect AOCI to decline less or even increase (depending on the specifics of the interest rate environment), as well as to reflect quarterly fluctuations.
The ultimate impact on these items from the Company’s implementation of the updated standard is subject to assessments that are dependent on many variables, including but not limited to (i) how certain aspects of the new standard will be interpreted and implemented by the Company and other similar companies, such as (but not limited to) amortization of deferred acquisition costs and selection of discounting methodologies and inputs, as well as establishment of policies, processes and controls for setting, monitoring and periodically updating reserve assumptions, and (ii) changes in the interest rate environment in the US and Japan. The impact on transition under the modified retrospective method will be driven by updating discount rates that will increase reserves and lower AOCI by the corresponding amount.
The Company has created a robust governance framework and a detailed implementation plan to support timely implementation of the ASU. As part of the implementation, the Company has made significant progress on key accounting policy decisions (discount rate, cash flow assumptions, deferred acquisition costs amortization, and disclosures), and is working toward modernization of its actuarial platform to increase automation of key reporting and analytical processes and optimize a control framework around new technologies, data sourcing and maintenance solutions. The Company has also begun to incorporate into its ASU implementation project other functional areas not directly associated with U.S. GAAP reporting that nonetheless will be impacted by the accounting changes.
The Company expects that while the adoption of this new accounting guidance will affect the Company’s financial statements under U.S. GAAP, it will not impact financial statements for Aflac Japan under FSA requirements or for Aflac U.S. under applicable statutory requirements. Therefore, the Company does not expect adoption of the updated standard to impact its overall cash flows, subsidiaries’ dividend capacity or their ability to meet applicable regulatory capital standards, nor does the Company anticipate adoption to affect its existing debt covenants or strategies for capital deployment.
New Accounting Pronouncements
During the last three years, various accounting standard-setting bodies have been active in soliciting comments and issuing statements, interpretations and exposure drafts. For information on new accounting pronouncements and the impact, if any, on the Company's financial position or results of operations, see Note 1 of the Notes to the Consolidated Financial Statements.
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