Welcome to the Aflac first quarter earnings conference call. Your lines have been placed on listen only until the question and answer session. Please be advised today's conference is being recorded. Now I'd like to turn the call over to Mr. David Young, Vice President of Aflac Investor and Rating Agency Relations. Sir, you may begin.
Thank you. Good morning, and welcome to our first quarter call. Joining me this morning from the U.S. are Dan Amos, Chairman and CEO, Kriss Cloninger, President of Aflac Incorporated, Paul Amos, President of Aflac, Fred Crawford, Executive Vice President and CFO of Aflac Incorporated, Teresa White, President of Aflac U.S., and Eric Kirsch, Executive Vice President and Global Chief Investment Officer. Joining us from Tokyo are Hiroshi Yamauchi, President and COO of Aflac Japan, Masatoshi Koide, Deputy President of Aflac Japan, and Koji Ariyoshi, Executive Vice President and Director of Sales and Marketing. Before we start, let me remind you that some statements in this teleconference are forward-looking within the meaning of federal securities laws. Although we believe these statements are reasonable, we can give no assurance that they will prove to be accurate because they are prospective in nature.
Actual results could differ materially from those we discuss today. We encourage you to look at our annual report on Form 10-K for some of the various risk factors that could materially impact our results. The earnings release is available on the investors page of aflac.com and also includes reconciliations of certain non-GAAP measures. I'll turn the program over to Dan, who will begin this morning with some comments about the quarter, as well as our operations in Japan and the United States. Dan?
Thank you, David. Good morning, and thank you for joining us. Let me begin by saying that the first quarter of 2017 kicked off a good start to the year for Aflac. I'll lead off by briefly highlighting two changes in the senior management you probably heard about. Earlier this month, we welcomed Max Broden to Aflac as Senior Vice President and Treasurer. We also announced earlier this week that Koide-san, Deputy President of Aflac Japan, will assume the role of President and Chief Operating Officer of Aflac Japan on July the 1st as Yamauchi-san assumes the Vice Chairman's role. Fred and Paul will comment more on this shortly, and you'll hear from Koide-san as well. We are excited to welcome them both into the new roles, and we look forward to their contributions to Aflac.
Now, turning to the results and operations, we are pleased with the company's overall performance for the first quarter. Our results are consistent with what we communicated on the December outlook call. From a segment perspective, I'll start with Aflac Japan, our largest earnings contributor. Despite the persistent low interest rate environment, Aflac Japan generated solid financial results. In yen terms, results on an operating basis were consistent with our expectations for the quarter. I'm also very pleased with Aflac Japan's better than expected third quarter sales increase of 7.6%. Production was solid across all channels, which further affirms our leading position in the third sector market. Sales in the quarter benefited from the February 20th introduction of our revised EVER and GIFT products. Results also benefited from sales of our latest third sector product called Income Support Insurance.
As you may recall, this product provides fixed benefit amounts should a policyholder be unable to work due to significant illness or injury. It was developed to supplement the disability coverage provided through Japan's Social Security system. Our Income Support Insurance targets consumers in their 20s through 40s, which is a segment of the population where we're underrepresented. Income Support Insurance has been favorably received, and we believe this product can potentially develop into a new product pillar over the long term. Turning to the first sector savings product, you'll recall that we proactively pulled products from the select channel and aggressively repriced our WAYS and child endowment products, factoring in the reality of a prolonged low interest rate environment. Aflac Japan continued to make notable progress limiting the sales of first sector savings products, reflecting a decrease of 81.3% in the quarter.
Regarding distribution channels, our traditional agencies have been and remain vital to our success. Our alliance partners has also made significant contributions to our sales results. With such an extensive distribution network that includes Japan Post 20,000 plus postal outlets selling our cancer insurance, we are furthering our goal to be where people want to buy insurance. As we look ahead, Aflac Japan's focus will remain on selling our third sector products, along with first sector protection products, both of which are less interest rate sensitive and have strong and stable margins. We will continue to refine our existing product portfolio and introduce innovative new third sector products to maintain our market leadership. As we've communicated, we view Aflac Japan's long-term compound growth rate in the third sector as being in the range of 4%-6%.
Turning to our U.S. operations, we're pleased with the financial performance and continued strength in profitability. Our financial results on an operating basis are in line with our expectations, which is particularly notable in that they are reflected in ongoing investment in our platform. We began to see our platform pay off in the form of improved persistency and customer satisfaction. A whopping 95% of our policyholders who use One Day Pay say they are likely to refer people to Aflac, which will encourage us to continue to differentiate and reinforce our strong brand and policyholder trust. Independent research continues to show there is no doubt American consumers need cash quickly, and paying claims fast and fairly sets us apart from the competition. With respect to career agent activity, we continue to focus agents on groups with fewer than 100 employees.
I believe this market is Aflac's to grow because our career sales agents are best positioned within the industry to reach and therefore succeed with these smaller employers. We're also increased our career sales agents' adoption of our Everwell enrollment platform, which in turn has increased our account penetration in our accounts with less than 100 workers. In terms of our broker activity, our team of brokers, sales professionals, has made great progress in successfully expanding Aflac's relationship with large broker community. Based on the positive results we've seen in the large broker space, we're extending our broker sales team with new roles designed to focus on the mid-broker space. While our sales increased 1.7% in the quarter is below our target of our long-term CAGR increase of 3%-5%, we believe the strategy for growth we implemented in both career and broker sales is the right one.
We also will continue to make tactical adjustments to meet our long-term growth objectives. I want to reiterate that we continue to target for the long-term compound annual growth of 3%-5% we provided on our December outlook call. Turning to our capital deployment, Fred will provide more details shortly, but let me just say that we remain committed to maintaining strong capital ratios on behalf of the stakeholders. We continue to anticipate that we'll repurchase in the range of $1.3 billion-$1.5 billion of our shares in 2017, with the majority taking place in the first half of the year. As is always the case, this assumes the stable capital conditions and the absence of any compelling alternatives. As we shared last week, last year was the 34th consecutive year in which we increased cash dividends.
Our objective remains to grow the dividend at a rate generally in line with the increase in the operating earnings per diluted share before the impact of foreign currency. You've heard me say that my job is a balance between the interest for all stakeholders. Just as we've done a good job of that in the past, I believe we're going to do it again in 2017 by delivering on our promise to our policyholder and enhancing shareholder value. I'll conclude by reiterating that I'm more excited today than I've ever been about the future of Aflac. Now I'll turn the program over to Fred. Fred?
Thank you, Dan. Our earnings results for the first quarter were in line with our expectations and consistent with guidance provided on our December outlook call. Operating EPS came in at $1.67 per diluted share. There were no items worthy of calling out in the quarter. However, there were a couple of items running through net income and outside our definition of operating earnings. We recorded a $14 million pre-tax charge associated with guarantee fund assessment on Penn Treaty, or approximately $0.02 a share after tax, and we booked approximately $6 million in pre-tax costs associated with our Japan branch conversion. The conversion remains on track, and there is no change to our original guidance on conversion costs of $120 million-$130 million pre-tax through mid-2018.
We anticipate conversion costs picking up pace in the second quarter. We will continue to disclose them as part of our quarterly reporting. Our Japan segment margins were solid in the quarter and reflect the inclusion of amortized hedge costs as part of investment income. As we have commented on over the past few years, premium weakness in the period was largely attributed to our first sector five-pay WAYS product hitting paid-up status, which alone contributed to nearly JPY 10 billion decline in first sector premium in the quarter. As a reminder, while the paid-up product impacts revenue, we have booked a deferred profit liability that amortizes into earnings and serves to largely mitigate any bottom-line impact. Benefit and expense ratios in Japan were in line with our outlook call guidance.
The decline in investment income reflects our fourth quarter switch trade, selling higher yielding bonds and investing proceeds in JGBs as we build out our floating rate portfolio with 2017 cash flows. Hedge costs were up as expected over the 2016 quarter. We have locked in over 90% of our anticipated costs in 2017. We are now on track to come in at the low end of our full year guidance range of $250 million-$270 million pre-tax. Turning to U.S. segment, Dan noted improved persistency, up nearly 1% over the previous year's quarter supporting a premium growth rate of 1.7%. Benefit ratios were solid, recognizing last year's performance was particularly favorable. Our expense ratio was at the high end of our guidance range and reflects progress on certain platform investments, including our group administrative platform and enrollment platform and related technology.
Overall, our U.S. pre-tax profit margin of 19.7% is strong by historical standards and in line with our guidance. Before commenting on capital, the first quarter was an active period of successful execution on our tactical investment strategy to build back net investment income after our 2016 switch trade stabilizing near-term hedge costs. We announced an alliance with NXT Capital to build out our middle market private debt portfolio. These assets have attractive yields. The floating rate structure is an attractive asset to hold in our Japan dollar portfolio as they are efficient to hedge. Along with allocating NXT an initial $500 million portfolio, we invested $50 million in the equity of NXT Capital look forward to developing a strategic partnership as we build this important asset class.
In addition, we lengthened the duration of our hedge program through purchasing $1.5 billion of long-dated five-year forwards have now locked in nearly 50% of hedge costs for 2018. While hedge costs have risen over the past couple of years, a flattening of the cost curve favorable market conditions offered us an opportunity to lock in future costs without pressuring 2017 net investment income. These strategies are all steps in building out a three-bucket portfolio approach to managing the U.S. dollar program in Japan. Those buckets include, first, unhedged dollar investments where capacity is guided by our view of the risk-adjusted economic value of our Japan branch capital volatility. Second, a disciplined approach to building out a short-duration floating rate loan portfolio where LIBOR-based yields are correlated to hedge costs are primarily hedged with short-dated forwards.
Finally, a diversified debt portfolio where we are actively extending the duration of our hedge instruments, reducing near-term exposure to rising hedge costs. Early execution on this strategy has reduced investment income in the short run, but once fully developed, will build back income with less volatility. Our capital ratios remain very strong. SMR is estimated to be in the mid-900% range, and RBC estimated in the 875% range at quarter end. We ended the quarter with $1.7 billion of excess liquidity at the holding company, which includes $500 million of contingency capital. Leverage remains at the low end of our policy range of 20%-25%, consistent with securing our strong ratings. Overall credit conditions and asset quality remain strong with only a modest level of impairments in the quarter. Including dividends and share repurchase, we returned approximately $773 million to our shareholders in the first quarter.
We repurchased $600 million of stock in the first quarter and are on track to repurchase between $1.3 billion-$1.5 billion for the year. This again assumes repurchase as the optimal use of excess and deployable capital. Including our common dividend, we are reaffirming our guidance of deploying $2 billion-$2.2 billion to shareholders in 2017. We announced a few weeks ago the launch of Aflac Corporate Ventures. We expect to invest approximately $100 million over the next few years in early-stage companies with focus across the insurance value chain, insurance and benefits digital innovation, and customer experience. While a modest commitment of capital, we are already actively investing in select properties in the U.S. and Japan and expect our investments will generate solid returns and contribute to Aflac's future growth. Finally, I want to reiterate our 2017 earnings guidance of $6.40-$6.65 per share on a currency-neutral basis.
Looking ahead, we remain well-positioned in terms of our core margins and capital strength, consistent with our December outlook call comments. Before we hand the call back to David for Q&A, Paul and I want to comment briefly on two notable senior management announcements that Dan referenced earlier. First, I want to welcome Max Broden to the team here at Aflac as our new Senior Vice President and Treasurer. Max is known to many of you in his previous position as Global Insurance Portfolio Manager for Nordea Bank. Max brings great experience and perspective to Aflac in optimizing our capital allocation and deployment strategies to drive long-term value. Max is responsible for treasury, corporate finance, investor and rating agency relationships, and partnering with Teresa and her team on U.S. corporate development opportunities. I'll now hand off to Paul on our Japan leadership announcement. Paul?
Thank you, Fred, and good morning. As you're probably aware from our release earlier this week, we announced that Hiroshi Yamauchi, who currently serves as Aflac Japan's President and Chief Operating Officer, will be assuming the role of Vice Chairman of Aflac Japan in July as he passes the torch of President and Chief Operating Officer of Aflac Japan to Masatoshi Koide. When someone has impacted the company as much as Yamauchi-san has impacted Aflac Japan, starting in the first recruited class of college graduates 41 years ago, when our Aflac Japan operation was in its infancy, it is astounding to consider the changes he has seen and the initiatives he's been a vital part of implementing. We will certainly continue to benefit from his support of Aflac Japan from a broader perspective as he assumes the role of Vice Chairman of Aflac Japan.
This transition also highlights one of the many major strengths, and that is Yamauchi-san's leadership and his vision for succession planning. When he assumed the role as president of Aflac Japan two years ago, his main goal was to identify and prepare a successor, and that's exactly what he's done by identifying and preparing Koide-san to be president and chief operating officer of Aflac Japan effective July 1st. Let me turn the call over to Koide-san to make a few comments.
Thank you, Paul. I'm Masatoshi Koide. Effective July 1st, I will assume the role of Aflac Japan president and chief operating officer. I would like to take a moment to introduce myself and talk a bit about how I plan to approach my role as Aflac Japan president. I started my professional career in the Japanese banking sector in 1984 and joined Aflac Japan in 1998. I first worked in investments and moved to legal and compliance. Since then, I have been working in various areas. In recent years, as executive vice president, I have been overseeing corporate planning and have worked with Dan, Paul, Charles, and Yamauchi-san to design and develop Aflac Japan's business strategy. In addition, I support Paul as the Japan owner of the overall project to convert Aflac Japan to a subsidiary.
As deputy president, I currently oversee all Aflac Japan divisions and serve as Yamauchi-san's deputy. In this context, I also have had the honor of leading the team that drafted Aflac Japan's long-term strategy, Vision 2024, which I presented at the financial analyst meeting in Tokyo last September. Vision 2024 lays out the mid to long-term direction for Aflac Japan by the end of 2024, which will mark its 50th anniversary. Against the backdrop of business environment change driven by a rapidly aging society and information technology innovation, Aflac Japan is committed continuing to create new value and growth by adapting to and embracing change. Aflac Japan is currently implementing its three-year medium term business plan under Vision 2024. From this July, it will be my responsibility as president to ensure these efforts produce sound results.
As Aflac Japan's president, I am determined to ensure that Aflac Japan continues to be the leading company that supports creating living in your own way. Thank you. I will now turn the call back over to Paul.
Thank you, Koide-san. I know Koide-san will continue to do an exceptional job in his new role as President and Chief Operating Officer. Koide-san shares Yamauchi-san's same dedication and work ethic. He has been a driving force in guiding our Japan branch conversion. Now I will turn the call back over to David, who will bring us to Q&A.
Thank you, Paul. We are ready to take your questions, first let me remind you that to be fair to everybody, please limit yourself to one initial question and only one follow-up that relates to your initial question. We will now take the first question.
Thank you. We will now begin the question and answer session of today's conference. To ask a question, please press star followed by the number one, unmute your phone and record your name clearly when prompted. To cancel your question, please press star followed by the number two. Our first question is coming from Nigel Daly with Morgan Stanley. Your line is now open.
Japan sales. Typically, in the past when you have introduced new product, sales of that product benefit, it comes at the expense of lower sales of other products. That did not seem to be the case this quarter. Medical sales benefited, cancer also remained strong. Hoping to get a little color as to what was different this quarter.
This is Paul. I'll be more than happy to answer that, Nigel. The reality is, as we've talked to you about, 13 weeks of sales are sometimes difficult to predict. In this particular case, we felt like sales had the potential to be down for multiple reasons that we mentioned on the previous call, and one of those was that our key alliance partners who primarily focus or solely focus on selling our cancer plan, we felt were going to focus on their own internal products more than they were focusing on selling Aflac products. For our benefit, that didn't solely turn out to be the case. We saw that many of our alliance partners continued to sell well, and our cancer line of business for that primary reason was propped up by those sales.
In terms of our other products, as you may have seen, the Income Support Insurance product was down slightly sequentially from quarter to quarter. Part of that had to do with the increased focus in our agency channel and traditional channel on selling our new EVER plan. We believe that the quarter results from a sales perspective exceeded our expectations. Sales of EVER launched more quickly than we anticipated. This was in part due to the launch of not only the traditional product, but also an additional two-pay and five-pay version of the product, which has similar profit characteristics to the overall. That only added about an additional 2% of sales up five versus up seven. Overall, we felt that sales for the quarter did an exceptional job.
Koji and his team performed across all channels, and we were very happy to see our alliance partners perform in the cancer line of business.
That's great. Thank you.
Our next question is coming from Jimmy Bhullar with JPMorgan. Your line is now open.
Hi, good morning. I just had a follow-up on just Japan sales. Has the growth in sales in 1Q affected your view for the rest of the year? Specifically, if you think about the new EVER product or the revised EVER that you launched in February, to what extent has it fully ramped up? Do you expect that to happen in the second quarter and provide a lift to sales in the near term?
Jimmy, thanks so much for the question. The reality is that we are not ready to make any change to our sales thoughts and future so far. First quarter did, however, exceed our expectations. It's difficult for us to tell over the remaining three quarters of the year how that will fare out. We are happy with where we stand in terms of the launch of EVER at this time. We do believe that will be a boost to our second quarter. We had already been planning for it to be a strong boost for our second quarter. We didn't, however, expect it to sell so well in March. The reality is that it's ramped up. We expect to do well. I want to be cautious just because I believe that we have tough comparisons coming later in the year.
I'm not yet ready to commit to any change in our guidance.
Okay. You had a fairly large derivative loss, I think around $92 million this quarter. Could you discuss what the drivers of that were?
Yeah, Jimmy, this is Fred. There's a few things running through that number that really are somewhat non-economic in nature. That is, we have treasury swaps on our books, which do nothing more than swap USD to JPY, and those swaps are mark-to-market. There's a portion of the swap that's actually recorded through interest expense, as you would expect, there's a mark-to-market portion. As there's movements in the JPY, you will sometimes have wide marks on those swaps. The second component is that we've been ramping up a commercial mortgage loan and middle market loan portfolio in Japan. We hedge those portfolios.
In the way the accounting works under GAAP, is you don't have the mark-to-market dynamic on those loans on our books, you do mark the hedge instruments, and that separation in the treatment between the loan approach and the derivatives will create some noise. We had some losses related to that. Again, not economic, as it's meant to be part of a long-term strategy. We also have some remeasurement that takes place. This is nothing more than U.S. dollar cash and related liquidity that's in Japan that gets remeasured, if you will, as U.S. dollar assets held in Japan. That's really the noise running through that number. It will fluctuate from period to period. Sometimes it will add to net income, sometimes take away, but largely uneconomic in nature.
Shouldn't really affect your free cash flow or dividends from the business?
That's right. That's essentially what I mean by economic. It's not having implications on free cash flow.
Okay, thank you.
Our next question is coming from Humphrey Lee with Dowling & Partners. Your line is now open.
Good morning, and thank you for taking my question. Just to follow up on the hedging costs. You mentioned that right now you're looking at towards the low end of your guidance of $250 million for the full year of 2017. Comparing the $52 million in the quarter, it seems to be still kind of below what the quarterly run rate would imply based on the low end. How should we think about the trajectory of the hedging costs for the balance of the year?
Yeah. You're right to point this out. If you recall, in the fourth quarter of last year, we recorded a little north of $60 million. In the first quarter, you're seeing that amortized level step back to 52. That's nothing more than really two basic components. One is, recall the switch trade that we executed on in roughly the November time period last year. That resulted in a move out of bonds which were hedged and into JGBs. As a result of that, we brought the notional down pretty considerably. That was a $2.5 billion U.S. dollar switch trade. That brought the notional down. Somewhat of what you're seeing in the first quarter is a natural ramping up then of the floating rate portfolio, which is starting the process of ramping up.
It won't pick up steam until we move into the second half of the year. You're going to see a natural rise in the hedge cost throughout the year as we build out that portfolio. Realize, while that is taking place, you're also seeing a rise in net investment income as we put to work the money in the floating rate investments. That's how it will move forward. The other element of it that's worth noting is that we did actually proactively bring the hedge ratio down a bit. We currently run around a $22 billion market value U.S. dollar portfolio currently. We have, as you know from our disclosures, not quite $11 billion of that hedged with forwards, about $10.7 billion.
We brought that hedge ratio down a little bit. We used the economics of bringing that down to execute on the $1.5 billion five-year forwards that we purchased. Think of it this way, on the money we saved by bringing some of the hedge ratio down, we spent that economics to extend the duration of the hedge program. It made sense from a risk management and market perspective. However, when we did buy those long-dated hedges, we got them at pretty good prices, better than we thought, because the market had cooperated on the long side, we took advantage of it. Those things are actually favoring our hedge costs and allowing us to be comfortable with the low end of the range. The buildup is more naturally going to take place as we build the portfolio.
Okay, thank you. Shifting gears just a little bit. There's some discussion about the change in mortality table in Japan. Can you talk about how that would affect your in-force business and new product pricing? Especially given my understanding that the change in the mortality table would suggest a higher pricing for the third sector products.
Yeah, I'll ask Todd to comment on developments on that front.
Yeah, thanks, Fred. For the in-force business, the change in mortality table would not have an impact. When you start selling new products, obviously that table would have to be reflected in your reserve assumptions. We would review the table relative to where we are with our current assumptions with pricing, we don't have to reflect that table with the new premiums. We will investigate it, and I think that's coming out April of 2018, so we have a little bit of time.
Based on my conversations with some of the other Japanese insurers, they talked about how because of the competition in the marketplace, it will be difficult for them to pass through some of the required price increases to the marketplace. Do you get a sense that that is kind of similar to what you're seeing over there?
I think we're still going to have to review the assumption relative to where we are with premiums and capital strain with those products. Hopefully later in the year, we would be able to comment further on it.
Okay, thank you.
Our next question is coming from Yaron Kinar with Deutsche Bank. Your line is now open.
Good morning, everybody. Just want to go back a second to third sector sales in Japan. The pressure from partnership sales did not really manifest itself as you had expected. Do you think it's something that could still pop up later in the year?
Well, as you may recall, Japan's fiscal year runs April through March. What we believed was that our partners were going to primarily focus on finishing the Japanese fiscal year with that transition. They have obviously finished the year in a different way. I mean, they sold their internal product, but also sold ours. We do believe that the sales of our two-pay product help add some benefit to the quarter and could continue to do so going into the next quarter. The reality is that as we go into the next Japan fiscal year, we've renegotiated, as we always do, with all of our partners, and we're hopeful and continue to believe that our alliance partnerships will continue to yield good results going into the next Japanese fiscal year, which began April the 1st.
Got it. I realize this framework is still a work in progress, but I think industry ESR levels actually came in quite a bit, given the low rate environment in Japan. Can you maybe give us an update on where Aflac stands there?
The last we commented on, again, the Economic Solvency Ratio, it goes by different names in Japan, but effectively that ratio was at our FAB meeting in Tokyo. You might remember at that time, I'm going to guess here, quite honestly, I don't have it in front of me, but 30-year JGBs were very low at that time. They had actually recovered a bit by the time we got to our conference, but they were still, I would say, certainly, I think sub 50 basis points, if I recall right. Today, the 30-year JGB is upwards of north of 80 basis points. I mentioned the 30-year JGB because that has an awful lot of directional impact, if you will, on how to think about these economic ratios. At that time, I had mentioned being in the 160% range as a ratio, which is quite strong.
Today, given the rates having recovered a bit in Japan, we are pretty consistently recording a ratio in and around 200%, which is quite strong. I would note that the mix of our business tends to yield a much better ratio than many that are more concentrated in first sector business. The other very important thing to remember, if you recall our comments at the conference, is that don't lose sight of the fact that's also assuming an ultimate forward rate recovery that is put into, it's really a long-dated recovery rate that's assumed in the formula, which contributes to it, but is believed to be the type of practice that would be eventually adopted. Remember, this is in testing phase. It's still a bit unclear as to the preciseness of the calculation once adopted, if adopted, and the pattern or method of adoption.
We've been tracking it, and we continue to be very healthy.
Thank you very much.
Our next question is coming from Ryan Krueger with KBW. Your line is now open.
Hi. Thanks. Good morning. Fred, on the 50% of the hedge costs locked in for 2018, could you disclose at what level of cost in basis points that is in, and then where forward hedge costs are running at this point?
I'll toss to Eric on the forward hedge costs. I don't know, Eric, if you've got anything on the cost going out into 2018. I would suspect it's approaching 190-ish basis points in that range, maybe a bit north of that.
Yeah, it's a bit north of that because in 2018, as Fred mentioned earlier, we executed on five-year forwards. When you think about the forward curve for hedge costs, those are higher going out 5 years than, say, one-year hedge costs or two-year hedge costs.
What I can share with you is based on that 50% locked in and looking at forward markets for the other 50% estimates of our cash flow, we'd be running at about 224 basis points for next year. Again, that reflects the lengthening of duration, locking in a five-year forward on those hedge costs.
Got it. Okay. Thanks. Just a quick follow-up on the excess capital. I guess the $1.7 billion of excess liquidity at the holding company, how much of the U.S. excess capital has been upstreamed at this point?
We have not. If what you're referring to is the excess capital that we would expect to unlock as part of our Japan branch conversion, we have not moved any significant portion of excess capital up to the holding company at this point. It would be a little premature to do that. We are, however, though, proactively moving what I would call excess cash flow or free cash flow generated on our U.S. property up to the holding company. We have not necessarily started into the movement of the excess capital that we expect to create mid-2018 upon conversion.
Okay, great. Thank you.
Yeah, one other thing I would say about 2018 hedge costs that is worthy of note too is recall that we are ramping up a floating rate portfolio as part of our strategy. Remember, that floating rate portfolio will be largely hedged and largely hedged with very short-dated forwards, which depending on the nature of the curve, should be less expensive. Ultimately, we will have a blended cost structure as we go into 2018. Our forecast is for rising hedge costs, and until that changes, it is good to be certainly prudent on the estimate.
Thank you. Our next question is coming from Erik Bass with Autonomous Research. Your line is now open.
Hi, thank you. This is a question for Teresa. On the fourth quarter call, you outlined a number of initiatives to boost sales and address the areas of weakness from 2016. Just hoping you could provide an update on those and which are already starting to have an impact versus which ones will kick in later in the year.
Certainly. Thank you, Eric. In the fourth quarter, I talked a little bit about four areas, and those areas were career agent sales and specifically veteran engagement. We talked about the middle market, broker sales leadership, and public sector. I'll just go through each of those. From a career agent standpoint, we're seeing better-than-expected new associate conversion to producer, which is a positive underlying metric. We're also seeing better veteran engagement, and a lot of that, we believe, is due to some of the compensation strategies that we have in place. We do see, and actually a large part of our increase for the first quarter was the veteran engagement piece of that. We do see that working for us. We talked about, again, the broker sales side, and we specifically talked about the mid-market.
We are hiring a 25% increase in our broker sales professionals. As we do that, we've already hired about 50% of that number, and we've onboarded those folks, and we're continuing our hiring up through the second quarter. We really don't expect a positive result to that until the second half of the year. That's going well for us. On the public sector side, we, I believe, talked about additional competition that we were seeing in the public sector market. We've also hired a department head over the public sector arm of the business, and we have a large book of business, public sector. We're making sure that we protect that book of business, but we're also building out strategies that are tools and services for the public sector market.
That is well on its way as well, and we expect to see results with that in the second half of the year as well.
Okay. Thank you.
Our next question is coming from Seth Weiss with Bank of America. Your line is now open.
Great. Thank you. Just to follow up on Erik's question, it sounds like there will be a lot of expense initiatives on the effort to turn around the U.S. sales channels that may yield sales in the back half of the year into 2018. How should we think about the expense ratio for the U.S. with regard to your guidance within this context here?
Yeah, this is Fred. There will be quarter to quarter some ebb and flow in the pace of expense because these are projects that will naturally move around a bit. Our guidance remains the outlook call range on expense ratio of 34%-35%. We're running a bit high, as I mentioned in my comments in the first quarter, we would expect that to moderate as we go through the year. It's the first quarter, as we move through the year, if we see some difference in that, we'll of course communicate that to all of you. As it stands right now, our plans are to be running in essentially the middle of that 34%-35% range.
Great. Thank you.
Our next question is coming from Suneet Kamath with Citi. Your line is now open.
Great, thanks. Just wanted to circle back to the U.S. again. When you first entered the broker market in the large case side of the business, you ran into this channel conflict with the career agents. As you expand the broker market into the middle market, what are you doing differently to avoid any future channel conflict in that area of the business?
I think the primary, and thanks for the question, Suneet. This is Teresa. The primary driver or the primary success measure for us is ensuring that in that market, if we have employers that have brokers, that we honor that and we work with the broker side. We have self-leadership. Our self-leadership, quite frankly, I've been very impressed with, because that leadership is working from the career side and the broker leadership side are working together to tackle this mid-market space. The strategy that was put together is really put together by those leaders. Certainly there are going to still be conflicts, but those leaders are working to manage through that conflict. A lot of what we're really trying to do is we're trying to put compensation where we want each of those channels to play.
I think we've seen some success in doing that, and so we hope to see that same success in the middle market as well.
I guess maybe a bigger picture question for the U.S. You continue to target this 3%-5% long-term sales growth. If you look over the past five years or so, I think you've only been there in that range once. I guess, at what point do you think you'll be able to get into that range on a sustainable basis?
Well, again, we actually are looking at this for the long term. We're continuing to progress toward that long-term 3%-5%. At this point, what we're doing is we're rebooting some of our strategies. We're assessing the underlying metrics, and I do believe that we're actually seeing progress toward our longer term goal. We expect to continue to progress toward that long-term CAGR.
I'd like to make a comment on that. I believe that the foundations that we're setting right now give us an opportunity, and we should be able to do that. Whether it's going to be when exactly, I'm not sure, but I know the new systems we're putting in is going to give us a big competitive advantage on the group insurance. Frankly, we've been evolving into that, as you know, over the years, and we're getting better at it. The broker strategy is beginning to work. The challenge has been much like it was in Aflac Japan. As we have shifted from just being corporate agency driven in Japan to adding the alternative distribution system, is the corporate agency is what kept us afloat for many years.
Well, our field force is still key to keeping it growing or at least flat, while these new areas, specifically broker, are growing our business. That's been the challenge. It gets closer, I feel, every year, and once it does, I think we'll see it take back off and do very well. I'm encouraged with the things we're doing.
Okay, thank you.
Our next question is coming from Tom Gallagher with Evercore. Your line is now open.
Good morning. Fred or Eric, I just wanted to make sure I understood what you guys said about the hedging costs and what that would imply, at least as an initial run rate of overall hedge costs for 2018. The 224 basis points, I'm just not sure what notional amount to compare that with because I know that's moved around a bit. Can you give us a ballpark range? Is that going to be meaningfully above the $250 million to $275 million 2017 run rate hedge cost?
A couple of things I would say, Tom. One is this sort of creeping into 2018 outlook comments around earnings and earnings drivers is a bit premature. I would suggest to you that we would hold to refine those types of comments and guidance, more specifically as we approach FAB in September and are able to outline it together with a strategy and of course the outlook call. I don't want to front run our traditional pattern of guidance. What we do plan to do, though, is build that U.S. dollar portfolio throughout the year. As I mentioned, we're running at about $22 billion now. That will build to approximately $25 billion at the end of the year. We're currently running at about a 50% hedge ratio using forwards only. Remember, we do use collars on the unhedged portion, but just forwards, which drives the cost.
We run around a 50% hedge ratio, you would expect the notional decline throughout the year to approaching between $12 billion and $13 billion, and then you start applying your cost. It's a little early to move into forecasting hedge cost ranges next year. Remember, we're disclosing this as part of our net investment income for a reason, and that is don't just isolate hedge costs. Remember, in part, they're building because we are proactively building out a floating rate portfolio that has very attractive yields. While we see some rising hedge costs, we're also building net investment income in the process, and you need to be mindful of that. We'll provide greater detail as we start to move into really 2018 comments more broadly.
That's helpful perspective, Fred, because yeah. It sounds like it's going to be against a smaller notional amount. If you just took the nominal increase in basis points, it would imply like a spike in hedge costs, it sounds like there'll be some offset. I just wanted to understand directionally that point.
Yeah. Really the best answer is just, it takes a holistic understanding of where are you going with the U.S. dollar portfolio and its mix? What is your hedge ratio philosophy and why? This is the three buckets we're talking about. Of course, execution, which includes the pricing and market pricing. That's the type of color and backdrop that we'll provide when really we start into the planning process around 2018 and can give more refinement, namely an outlook call, and some strategic color at our FAB.
Okay. Just to follow up on, there were higher incurred claims in Japan during the quarter. If you look at the mix of how the benefit ratio played out, you had lower future policy benefit reserves being put up, and you had higher incurred claims. Was there a mix shift, something going on there that you could explain?
Let me just pause one thing, before we answer that. Eric, you wanted to add something?
Yeah, I just wanted to emphasize, as Fred's mentioned, the three buckets and the build-out of the floating rate portfolio. Keep in mind the strategic reason besides liking the asset class from a credit perspective, floating rate assets are short duration. Their coupons float with LIBOR, which has a high correlation, not a perfect one, to hedge costs. As this floating rate portfolio grows, you guys will be able to see that the net margin, so the net income, gross income from the floaters less the hedge cost, becomes much more stable in our net investment income. Won't be a perfect match quarter to quarter because the floaters may reset on different dates than the hedge costs, but that's the concept. That's just important to note. While notional could inch up as the floating rate builds, net investment income will go up.
That was the exchange for the switch trade. Build that back up, but it becomes much more stable in the future.
Tom, I'm going to turn to Todd. I know the interaction you're talking about there in the way of paid claims and an FBR on the P&L this quarter. Todd, any color you are able to provide?
Yeah. I'll give you a little bit of color on that. There's normal seasonality that happens in the first quarter in the benefits in Japan with extra lapses that happen around, what I'll call retirement or leaving your employer, that happens at the end of March. You have incurred claims are going to include your cash surrender value, and when we pay that cash surrender value, we typically release the reserve associated with that policy, so you would have a lower change in FPV for the quarter.
Really it's just related to lapsation and releasing the reserve due to that.
That's correct.
Okay. Thank you.
Operator, I think we are nearing the end of the top of the hour. We probably have time for one more call. Do we have a call in line?
Yes, sir. We have one more in queue, and it is coming from John Nadel with Credit Suisse. Your line is now open.
Thanks for sneaking me in. Good morning. Maybe a question for Teresa. Just a little bit more follow-up on the U.S. I think you sort of hinted at the veteran agents having a bit better production this quarter. Can you give us a sense when you break down the one and a half or so % year-over-year growth in sales, where the real drivers were? I mean, we know it from a product perspective, it looks like the short-term disability product was the key driver, can you help us understand which of the pieces of the distribution mix drove it?
Certainly. You're right. We benefited from higher than expected short-term disability sales in Q1. The other piece of this is Everwell adoption. We also benefited from higher Everwell adoption, if you remember or recall, Everwell is our small business solution, and we get higher policy holder participation rates with Everwell versus our S&G unit. Many of our state organizations have adjusted their training. They've engaged the veterans in training of the Everwell unit. We see a lot more of our adoption of Everwell. I think we had about around 28% adoption of Everwell this quarter, and that was well above what we had anticipated that we would have. The increased productivity of those veterans.
We also had a couple of initiatives to specifically, and these were compensation initiatives where we were driving veterans to go back into some of our existing accounts to offer additional product and services. We saw success with that initiative as well. Again, if I sum them up, it would be veteran engagement and it would be technology with our Everwell unit that increased our productivity.
Maybe can you just touch on what you saw from the broker channel as well?
From the broker channel, we were relatively flat when you looked at the mid-case market and the large case market. We expected that. We expect to see a lot more from our broker side in the second half of the year.
Fred, one last one. Just on the ratio of hedged to unhedged U.S. dollar investments out of the Japanese arm. How should we think about your risk limits there? I know you're not really leaving the other 50% unhedged, but how do we think about risk limits there?
I think the way to think about it is for quite a long time, Aflac has always had a level of unhedged U.S. dollar portfolio, a long time, and it tended to be married up to the GAAP equity, if you will, that we had allocated to the Japan branch. I want to recall that traveled, say, in the $7 billion-$8 billion territory, for example, perhaps a little less than that. Nevertheless, it was always in that category. The idea of an unhedged portion, if you will, of the portfolio is frankly nothing new. Really what we're introducing is more what you're seeing from a number of companies that operate in Japan, and go down this type of a portfolio strategy, which is becoming more common. That is particularly U.S. companies that have Japanese branches or subsidiaries.
What is the economic value that's driven in that branch? The theory being that value over time comes back in dollar form. As a result, what really is an amount of unhedged that you can make an economic case for and a risk case for. As is always the case with a company that's performing very well, and as we are in Japan, your economic value tends to be quite a bit north of what you may be holding in the way of GAAP book equity. So it allows you to think more about a higher dollar amount that you can hold unhedged. Now, however, there are risk limitations to that, and the risks tend to be revolving around SMR volatility, potential FSA volatility.
You do, to some degree, depending on the collar structure, need to be thinking about carrying more capital against that type of a strategy. So you have to think about a capital-adjusted value proposition of going more unhedged. That's the way in which we think about it. There is some fairly good science and stress testing about what you can tolerate, but it's allowing us to drift up, if you will, in an amount unhedged, but protecting the outer limits of movement through collars. Hopefully that helps. That's what I mean by an economic value driven approach. Again, very importantly, it's a stressed economic value. Don't confuse it with what you might post or calculate. It's also got to be under stress conditions.
Understood. Then one last one since I'm last, I'll sneak one housekeeping item in. How much was repatriated during the quarter?
I think we repatriated a bit north of JPY 30 billion, if I recall right. Let me see if I can get that number.
Thank you
I have it handy, but let me actually, I should be able to gather if you just give me a minute. I've got it right here. JPY 31 billion year to date.
Perfect. Thank you so much.
Operator, are there any other calls in queue?
I see no questions in queue at this time, sir.
Thank you. Well, for those of you that have questions after this call, please feel free to contact our investor and rating agency relations department. We'll be happy to answer your questions and look forward to speaking with you then. Thank you.
That concludes today's conference. Thank you for your participation. You may disconnect at this time.