Welcome to the Aflac third quarter earnings conference call. Your lines have been placed on listen-only until the question and answer session. Please be advised today's conference is being recorded. I would now like to turn the call over to Ms. Robin Wilkey, Senior Vice President of Aflac Investor and Rating Agency Relations. Ms. Wilkey, you may begin.
Thank you. Good morning. Welcome to our third quarter call. Joining us this morning is Dan Amos, Chairman and CEO, Kriss Cloninger, President and CFO, Ken Janke, Executive Vice President and Deputy CFO of Aflac Incorporated, Teresa, President of Aflac U.S., Eric Kirsch, Executive Vice President and Global Chief Investment Officer. Also joining us today from Tokyo are Paul Amos, President of Aflac, and Tohru Tonoike, President and COO of Aflac Japan. Before we start, let me remind you that some statements in the 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're prospective in nature. Actual results could differ materially from those we discuss today.
We encourage you to look at our quarterly release for some of the various risk factors that can materially impact our results. Now I'll turn the program over to Dan, who will begin this morning with some brief comments about the quarter and our operations in Japan and U.S. Then Ken will provide further details about our activities in the quarter and our EPS guidance. Dan?
Thank you, Robin. Good morning. Thank you for joining us. Let me start by saying I'm very pleased with Aflac's financial performance for the third quarter and for the first nine months of the year. I'm even more pleased that our financial strength is allowing us to deploy more capital to our shareholders. We met and in many cases exceeded our financial targets for the third quarter. Notably, with nine months under the belt, we are well-positioned to increase operating earnings per share by 3%-4% for the year before the effect of currency. At the same time, we continue to anticipate operating return on equity will be strong and exceed 20%, excluding currency. Now I'd like to comment on our operations, starting with Aflac Japan, our largest earnings contributor.
Although third sector sales were down in the quarter, we like the initial results we've seen so far in October, which are up 20%. As we previously communicated, we anticipated third sector sales for the full year will come in at the low level of the expectations of 2%-7% increase. While fourth quarter comparisons will be challenging, we continue to enhance our distribution opportunities and offer in Japan, which I believe will benefit our sales. On the distribution side, I'm very happy with the expansion of Aflac Japan's alliance with Japan Post. This strategic partnership brings together Japan Post, the largest nationwide distribution network in Japan, with Aflac Japan, the industry leader in cancer insurance.
As many of you heard at the analyst meeting in Tokyo last month, Taizo Nishimuro, President and CEO of Japan Post Holdings, announced expansion of the postal outlets selling our cancer products, effective October the first. We will move from 3,000 to 10,000 postal outlets. We also talked about their plans to increase the number of post offices selling Aflac cancer products, 20,000 by the end of 2016. I think both Aflac Japan and Japan Post can enhance their synergies by working together to provide cancer products to a large group of consumers who regularly turn to the postal outlets to help their insurance needs. Turning to products, as the pioneer of cancer insurance in Japan, I'm excited about our two newest cancer policy offerings. On October the first, Aflac Japan introduced a cancer product for the sale exclusively for Japan Post and Kampo.
This new cancer product was designed to provide essential cancer-related benefits. It also complements the insurance coverage that is available through our products that Japan Post already offers. On September the 22nd, we introduced another new cancer insurance product available for sale through all of our distribution channels. This new cancer product provides enhanced coverage, including additional outpatient benefits and treatments, multiple cancer recurrence benefits, while offering better pricing at many age groups. Turning to Aflac U.S., I'm very excited about the changes that we've made in our management infrastructure. You'll recall that following a thorough evaluation of the market and our business model, we told you that we were going to be laser-focused on implementing a number of tactical initiatives designed to improve U.S. sales, and that's exactly what we've been working on. These initiatives, which were effective October the first, are primarily geared to our sales force.
They center around competitive compensation that more closely tied to corporate goals and better performance management capabilities. We had expected short-term disruption in the third quarter as a result of these changes, but things went very smoothly, and Aflac U.S. sales were relatively flat in the quarter, just down six tenths of a percent. These new sales initiatives have generated excitement both at the career channel side and the broker side. Although it can tend to take a period of time for the sales results to follow the initiative, I can already see that we're making progress, and this tells me that we're on the right path. Last quarter, you'll remember we thought sales for the latter half of the year would be down 4% to down 8%.
With sales in the third quarter essentially being flat, we now believe sales for the second half of the year will be positive, which means sales for the full year will likely be in the range of down 2%-4%. While I'm not happy with the prospects of sales being down for the full year, I believe we're heading in the right direction, and I expect to see an increase in fourth quarter sales. We're also working on ways to extend our sales momentum in 2015. Let me just say that I feel better about the opportunities in the U.S. and Japan and our ability to effectively execute on our sales strategies over the next year. I also understand the importance of returning capital to our shareholders.
While Ken will provide you more details, I want you to know that I'm pleased with the action of the board of directors to increase the quarterly cash dividend by 5.4%, effective with the fourth quarter of 2014. This marks the 32nd consecutive year of increasing our cash dividend. I also believe we've listened to our owners and understand the importance of growing our cash dividend and our share repurchase amounts. Our capital strength has given us the confidence to increase our 2014 share repurchase objective from $1 billion to $1.25 billion of our common stock. Additionally, it is our current plan to repurchase $1.3 billion of common stock in 2015. Let me leave you with this thought. You've already heard me say that my job is a balance of interest of all stakeholders.
I think we did a good job for that this year, just as we have in the past, and I believe we're going to do it again next year by delivering on our promises to our policyholders and returning significant capital to our owners. I'll turn the program over to Ken. Ken?
Thank you, Dan, and good morning, everybody. I'd like to give you a little more background into our forecast and the assumptions we have used to set our 2015 earnings objective. First, let me begin with just a brief recap of 2014 and how that relates to the initial guidance we set for this year. You may recall that a year ago, we established a 2014 objective of increasing operating earnings per diluted share by 2%-5% on a currency-neutral basis. At that time, we identified several headwinds that influenced the establishment of our earnings guidance. Frankly, based on those headwinds and other forecasting assumptions, which tend to be conservative, we would have not been surprised if this year's full year earnings would've been toward the lower end of the 2%-5% range. As the year progressed, some favorable trends emerged.
Our benefit ratios in Japan and the U.S. have been better than expected. In addition, our consolidated operating tax rate has been lower than we initially projected. As a result of those favorable developments, we narrowed our earnings objective in July. Based on the financial performance for the first half of the year, we no longer felt the low end of the range was a reasonable expectation. However, we anticipated that benefit ratios would be higher in the second half of this year for both the U.S. and in Japan, we also expected expenses to be higher for the last six months of the year, particularly in the fourth quarter. As a result, we reset the full year earnings objective to 3%-4% in July.
Although operating earnings per diluted share excluding currency have increased 5.4% for the first nine months, we continue to believe the 3%-4% range is a likely outcome for 2014. The reason is that we still expect to see higher benefit ratios in the fourth quarter and expenses will be higher as well. That's especially the case in the U.S. as we begin to absorb the costs of the change that we made to the U.S. Market Director position. As we indicated in our press release last night, we have established an objective for 2015 of increasing operating earnings per diluted share 2%-7% on a currency neutral basis. I would first note that our earnings objective is predicated on 2014 earnings per share increasing 3%-4% before currency.
Because we express our objective as growth rate, our guidance is influenced by the rate at which we grow earnings in 2014. In short, faster growth this year somewhat challenges growth rates in the following year. For our two reporting segments, we continue to anticipate the type of operating stability that you've come to expect from our business. At Aflac Japan, we currently expect to see operating ratios that are consistent with the three-year average ratios that Kriss presented to you in May. With first sector business accounting for a higher percentage of in-force premiums in 2015, we expect to see a higher benefit ratio next year compared with this year. It will still be in the 62%-64% range we previously provided. We expect the operating expense ratio to be fairly stable to a bit lower next year.
As a result, we expect the margin for Aflac Japan to be somewhat lower than it is this year, but again, well within the stated range for our expectations. For Aflac U.S., we also expect to see operating ratios in 2015 that reflect the stable and predictable nature of our business. We are assuming that the benefit ratio will be higher next year than our full year projection for 2014. However, even with an increase in the ratio, we still expect it to be at the low end of the 50%-52% range we communicated in May. We expect the expense ratio, on the other hand, to be above our estimated range for next year. As we discussed in July, we made significant changes to the structure of our sales force, those changes impact our expenses.
I would note that we are maintaining very good budget discipline in the U.S. segment, and if not for the field force changes, our expense ratio would be at the low end of the range next year. We currently anticipate that the U.S. pre-tax profit margin will be towards the middle of the range we provided in May. I'd point out that while we have a very large block of stable and predictable business, we clearly don't have a crystal ball, and there are many assumptions we need to make when setting an earnings objective. It's always been our practice to use realistic, yet conservative assumptions. Given the conservative assumptions I just reviewed, I think a starting point for next year is to assume that operating earnings per share may grow toward the lower end of the 2%-7% range, excluding currency.
Just like 2014 and in years past, it's certainly possible that we could see earnings emerge more favorably as the year progresses. For instance, benefit ratios may not rise as much as we're currently assuming. Clearly, the ongoing challenge we faced for the last couple of years has been generating better revenue growth through new sales in both markets, as well as dealing with the low interest rate environment. As you heard from Dan, we believe the activities we're undertaking in both segments will help produce better sales in the future. Improving sales is a process, it's not an event, and the results from these activities don't happen overnight. Additionally, as you likely know, it takes time for sales to be reflected in earned premium and earnings.
In the meantime, I do want to emphasize that the underlying nature of our business remains very sound, stable, and profitable. Next, I'd like to briefly comment on our sensitivity to the yen-dollar exchange rate. Although Aflac Japan makes up about 75% of our consolidated insurance earnings, about 50% of our total company earnings come from U.S. dollar sources. As we've done in the past when we release fourth quarter earnings, we will provide you with our expected currency sensitivities to per share earnings for 2015. In the meantime, we do believe our earnings will be a bit less sensitive to the weaker JPY next year than they have been in the past. I think it's also noteworthy that our consolidated GAAP equity is not significantly exposed to foreign currency risk.
For instance, although the JPY weakened 7.4% from the end of June to the end of September, our consolidated GAAP equity, excluding unrealized investment gains, declined only 1.1%. One of our key objectives is to insulate shareholders' equity from currency fluctuations. Finally, we're very pleased that our balance sheet remains strong and that our capital ratios exceed our minimum targets. You'll recall from our comments at our analyst meeting in May and in September that we expected profit repatriation to be in the range of JPY 110 billion-JPY 150 billion for 2015. Based on our current forecast of our FSA financials and the solvency margin ratio, as well as our most recent reinsurance transaction, we now expect repatriation to be at the high end of that range.
Please remember, as we've noted in the past, that repatriation could change depending on increases in interest rates, credit spreads, a strengthening yen, or significant credit losses. We do expect significant profit repatriation in 2015. In addition, as we indicated in last night's press release, we're exploring the possibility of increasing the frequency of capital transfers from Japan to the U.S., pending the completion of our internal governance process. This will enable us to better manage liquidity in the U.S. segment and at the parent company as well. As I mentioned at our analyst meeting in September, we're currently working on a multi-year capital management plan. As a part of that plan, we are making good progress toward a retrocession agreement with a reinsurer to assume some of their risk.
Retrocession of risk to an existing Aflac entity would improve the economics of our reinsurance program by effectively lowering the cost of reinsurance for Aflac. Given our strong capital position and expected cash flows from Japan, we believe we're in a good position to return capital to our shareholders through increased dividends and share repurchase, and we look forward to producing good results for our owners in 2015. Now I'd like to turn the program back to Robin.
Thank you, Ken. Thank you, Dan. To be fair to everybody, please remember to limit your questions to one initial and one follow-up that relates to your initial questions. Now we'll be glad to start taking your questions.
Thank you. At this time, we will begin the question and answer session. To ask a question, you may please press star one on your touchtone phone. Please unmute your phone and record your first and last name clearly when prompted. To withdraw your question, please star two. Once again, if you would like to ask a question, please press star one and record your name. One moment for our first question.
Our first question is coming from Mr. Steven Schwartz from Raymond James & Associates. Your question is up at this time.
Hey, good morning, everybody. Ken, can you talk about the reinsurance agreement that you announced in this quarter, I think it was JPY 55 billion. Obviously it's smaller than the last one you did, how else does it differ from the initial deal?
Steven, it's actually very similar to the initial transaction that we executed in September of 2013. In fact, it's really an extension of that same agreement. You'll recall that what we had done is seeded the premiums and the risk related to a portion of an old block of medical business, a closed block, about a third of the hospitalization benefit. With this agreement, we simply took the percentage up to 50%. We added another 17% or so to that on the same block of business. We're currently in the process, as I mentioned, of a multi-year capital management plan. Reinsurance will clearly be a part of that plan, I think it's quite possible you'll see another transaction in 2015, perhaps more than one. In looking at that, we would be exploring other blocks of business for possible transactions.
Okay. Ken, just to follow up on that then. Is this with the same reinsurer, there's still no statutory benefit?
That's correct.
Okay, thank you.
When we go through the RFP process, we are getting quotes from multiple parties, and we'll continue to do so in the future.
Okay, great. Thanks.
Our next.
This is Kriss. Let me just comment that the statutory treatment is something that we have under consideration. It's true that in the first agreement, we did not take any statutory reserve credit, but we're examining the conditions that would be required for us to qualify for such a reserve credit in the future.
Okay, thanks, Kriss.
We haven't taken it off the table, Steven.
Okay, thanks.
Our next question comes from Nigel Dally. Your question is up at this time.
Great. Thanks, good morning. Just a couple more on the reinsurance side. Given that it's more of a capital rather than risk reduction oriented transaction, any pushbacks that you're getting from the FSA on those types of transactions going forward? Also, just a commentary on increasing the frequency of the capital transfers. Just hoping to get some additional color there as well as to what the plans are.
First with respect to communications with the FSA regarding reinsurance, we made sure that they were fully briefed on the transaction that we executed in 2013, the same was true with this transaction as well. It's a fairly straightforward, simple transaction, we make sure, quite frankly, that it's not only the FSA that's briefed, but also our lead regulator in Nebraska, the Director of Insurance there, as well as the regulator in South Carolina, for instance, as well. With respect to the capital transfer, Nigel, remind me what the-
Frequency.
The frequency. Remind me.
Yeah, just with regards to increasing the frequency, what are the changes there? Are you kind of moving towards more of a quarterly repatriation from Japan, or kind of what's the plan there?
Well, the starting point is to simply get cash more frequently on a more consistent basis. Quarterly would be ideal, again, we're working through the final governance for that right now to determine the best way to do it. Historically what we have done is we have transferred a portion of the profits that were earned in a given fiscal year for Japan, we're investigating the options for moving not only earnings on an annual basis, also moving a portion of retained earnings as well. That would be entirely dependent, as we've said before, on our view of our solvency margin ratio and our ability to protect our policy holders and also to maintain that ratio in a manner that provides an adequate buffer for risks that affect the ratio above our minimum requirement of a 500%-600% range. We are optimistic.
We do believe that we can move forward with more frequent transfers. That'll give us a much better ability to smooth out our cash flows, better manage our cash at both Aflac and Aflac Inc. when it comes to deploying capital.
That's great. Thank you.
Nigel, Kriss Cloninger again. I'm sorry to interrupt. I just want to make it clear that the reinsurance we've done between Aflac Japan and an outside reinsurer is clearly a risk transfer arrangement. Even though some of the motivation is capital management, it's not a financing agreement. It is a risk transfer agreement, there's no question about that. We don't anticipate any pushback from that perspective from any of our regulators.
Great. Got it. Thank you.
Our next question comes from Yaron Kinar. Your question is up at this time.
Good morning, everybody. Thanks for taking my question. My first question, I guess, is for Ken. I appreciate the color on the year-over-year kind of changes and headwinds and then with regards to the EPS growth target. If I strip out the share repurchase impact, I think if I look at the lower end of the target range for 2015, earnings would still be in negative territory. Even when I account for a higher benefit ratio in Japan, I guess I would have expected maybe a little bit more of abatement of previous or prior headwinds to maybe see a little more earnings growth on a dollar basis, and was hoping to get a little more color and clarity on that.
Again, what I tried to get through in that segment commentary related to the ratios, the issue that we have, frankly, is we've got to do a better job at revenue growth. You're going to see relatively low rates of revenue growth, both in Japan and the U.S. The revenue growth is muted a little bit further because of the reinsurance transactions and the ceded premium. When you look within the operating ratios that are going to influence our profitability in Japan, the business mix is pushing the ratio up a bit at Aflac Japan, because first sector is a larger portion. The expense ratio, again, should be a bit lower next year than it is this year, but it still does pressure earnings.
In the U.S., since 2011, we've had an improved benefit ratio, and it's improved much better than we had ever anticipated it would. Actually, when we entered into 2014, we didn't think the improvement would continue, and we assumed a much higher benefit ratio than we've actually experienced. We still expect it to return to some type of normalcy at some point. Again, we believe that that could begin to happen in 2015. There's additional pressure in the U.S. segment in 2015 because of the added expense related to our going from the commission-based SSE position to the salary-based market director position. When you put all that together, again, we deal with fairly conservative assumptions.
We'd rather surprise on the upside than the downside, we would see both segments this year potentially producing slight declines in operating earnings versus where we expect them to fall in 2014. The good news is that we are able, because of our capital strength, to more than compensate that with very strong capital deployment plans for the latter part of this year and next year as well. Again, hopefully, as we saw in 2014, we will see some things emerge favorably vis-à-vis our assumptions.
It'll also depend on what we earn in 2014.
Okay. I appreciate the color. My one follow-up is on third sector sales, actually for the fourth quarter. Seems like if I take kind of the run rate for medical over the last three quarters, and I take the reiterated guidance for the full year, I get to roughly a doubling of cancer sales, if I'm modeling this out correctly. I wanted to just get a sense if that is kind of roughly how I should be thinking about it, and how much of this growth comes from the Japan Post partnership as opposed to the other cancer product that you launched.
Tohru or Paul?
Tohru, you want to start, and then I'll comment?
Yes. Let me start. Yes, you are right. In order to make the 2% growth for the entire year, we will need to basically double the sales of the cancer in the fourth quarter. That's what we are feeling, that we will be able to make it. Based on that numbers, we feel pretty good about the prospect. We're making at least 2% of the entire third sector sales for the full year.
Let me just follow up and say, we knew third quarter was going to be extremely difficult. We had the August 19, 2013, launch of our EVER plan. We had also pre-announced our October 1st launch this year of our new cancer plan. We faced headwinds in the third quarter for both cancer and medical sales. We're confident that going into the fourth quarter, especially given what Dan has already announced, that we're up 20% so far this month, we feel very strongly that we'll finish within the range of 2%-7%.
How much of that growth in cancer products do you anticipate coming from Japan Post?
We cannot disclose the exact number of the sales from the Japan Post, but I can tell you that the largest part of the growth of the cancer comes from the Japan Post.
Thank you.
I can also say that we are very pleased with what's going on with Japan Post and excited about the future growth of it.
Thank you. Our next question is coming from Seth Weiss. Your question is up at this time.
The question. If we could just get a little bit of granularity in terms of some of the expenses next year. Curious if you could give any commentary on the cost of the reinsurance transaction or how much that affects gross earnings next year. Also, I believe on the last quarter you mentioned that the costs of the U.S. sales initiatives would be $0.02 in the fourth quarter, then you'd give updated guidance on what the impact would be in 2015. Perhaps if you could give us a little bit of commentary around that would be helpful as well.
First of all, I would say that we really didn't isolate the expense of the second tranche of reinsurance for 2015, because we're currently working on a retrocession agreement, again, that would effectively lower that cost. What I would say is that it was incorporated, the cost before retrocession, was incorporated into the 2%-7% range we established for next year. To the extent that we're able to successfully execute a retrocession agreement, it will help a bit on the margin of lowering the expense and enhancing earnings in 2015.
I would just add that the cost of the second tranche is proportionate to the cost of the first tranche. The economics are essentially identical. To the extent that we retrocede, the cost will either be proportionate or potentially more favorable than the direct cost.
Yeah. The second question related to the cost of the market director change, in particular. It really hasn't changed. It may be modestly better than what we had originally anticipated, but the estimates that we had communicated in July are really still on. What I will say, I'm really proud of the team in the U.S., because excluding that, our expenses were flat year-over-year, 2015 compared with 2014. You'll recall my comments that we wanted to try and find a way to mitigate as much as we could those expenses. I still think that that's possible that we could see improved expenses as next year develops. We really haven't seen any material impact or any material change.
Okay, perhaps I'm misremembering then. I had thought the commentary was $0.02 to the fourth quarter, then maybe updated guidance this quarter. It's fair to say then that net no headwind from the U.S. sales initiatives?
Yeah, maybe a little bit more, maybe closer to $0.03 a quarter in 2015. It's not terribly material. It'll also depend on how well we do on the sales side, because remember that we've added fixed costs and we're taking off variable costs, and the amount of variable costs that are removed from the income statement will depend on sales through lower commission expense. The cost in year two, the offset will be significantly higher in the second 12 months than it would be in the first when it comes to an offset to the increased fixed expense.
Okay, thanks. I'm sorry.
Nothing's really materially changed.
If I could just sneak one more in just on margins, and I understand the 2%-7% growth margins in the context of normalizing margins in both the U.S. and Japan. Is it fair to categorize 2015 as a normal margin year, or will mix shift continue to cause margins to slightly deteriorate going forward?
No, I think, again, if you look at the expectations that we laid out in May and then for Japan, reiterated in September, the margins should be very stable year-over-year. Again, really consistent with what we had communicated at prior meetings on our expectations for a three-year period.
Okay, thanks for the commentary.
Our next question comes from Mr. Jimmy Bhullar. Your question is up at this time.
Hi, good morning. Most of my questions were answered, but just on U.S. recruiting, I would've thought that trends would've gotten worse given the changes that you're making, but recruiting was up, and the agent count declined a little bit less than it had declined in previous quarters. Just wondering if you could talk a little bit more about how the restructuring's going on, and do you expect further improvement from here, or would the results get worse before they begin to improve?
Well, I'm very pleased with the results so far. I thought there would be more disruption, as I said earlier, because people just don't like change. I have to compliment our field management for understanding that we've got to pay for performance, and accepting that as being a way of life, and moving on with it. Saying that, what I see is I see the fourth quarter as being easier comps than the first quarter. I see the second quarter of next year being the easiest comp. I would anticipate us being up. I would like to be up 5% for the fourth quarter. That's my goal, but I want it to absolutely be up, but that's my goal.
I think probably the first quarter will be maybe flat to up 5%, I expect at the end of the second quarter to be up 5%. I'm counting on at least having 5% growth. I'd like to do better than that. We have a new director of sales who came from being in charge of North and South Dakota, which is our highest penetration in the country, and he is concentrating on accounts of 100 or less, which is what we've said we've got to do. He's also been working on the expansion of our
District and regional level, which ultimately will increase recruiting, I think that's what's taking place right now. There could be a little disruption that we're still unaware of as people are adjusting because it went into effect October 1. I am in contact with Teresa daily, as well as with sales daily, about keeping up with how this is going. This is a major change. In my 30 years, or 25 years as CEO, this is structurally probably the biggest change we've made to the sales force. I don't take it lightly that there could be a few more bumps, but I'm not seeing them as of today. I think it's all coming together nicely.
Thank you.
Our next question is coming from Mr. John Nadel. Mr. Nadel, your question is up at this time.
Thank you, good morning, everybody. A couple of real quick ones. Maybe for Ken, does the buyback assumption for 2015, that $1.3 billion, does that assume any benefits from incremental reinsurance transactions? If so, how much?
Not transactions in 2015, if that's what you're referring to. When you look at the transaction that we announced that took effect on October 1st, that gave us the opportunity to reevaluate the SMR and then reevaluate the capital we felt comfortable deploying for both 2014 and 2015. I'd say it's a good starting point. At this point, it does not contemplate any additional transactions per se.
Okay
that might occur in 2015.
Appreciate that. For 2015, we haven't had any real discussion about what you guys are assuming in terms of new money yields in Japan and the U.S. Obviously here in the third quarter, and I guess most of 2014, maybe I'm wrong, but the investments in Japan have been largely JGBs, and then this quarter, JGBs and U.S. Treasuries. What are you thinking about in terms of new money yields for 2015? Can we see some incremental investment in maybe credit-related assets?
Hi, this is Eric.
Hi, Eric.
A couple of comments. Good morning. First, as you look year to date of our invested cash flows, I mentioned this earlier in the year, early in the year, we did overweight JGBs because of the nature of our cash flow timing. As you look at overall cash flows now, we've put about 48% or so of our Japan cash flows into U.S. dollar assets. Of that allocation, about 60%, 65% were in U.S. credit and the rest in Treasury. The credit investments we anticipated did come online, particularly in the second half of the year or second and third quarter. They were there. Recollect, I have said in the investment-grade credit space, credit spreads are at all-time tights, and we did a fair amount of purchasing of credit back in 2012 and 2013. We lightened up this year on purpose.
We're totally fine with the fundamentals of investment credit. We think those are as strong as they've ever been, the technical spreads being so tight make them pretty expensive to buy. Having said that, as we're planning for 2015, first, it's important for me to note, let's hope the Fed raises rates and we have higher yields. We are a consumer of the macro environment, and that's going to be very challenging. We assume in our plan, we don't assume necessarily that rates will go up. We try to be conservative and come up with ranges. What we certainly want to look at going into next year is a good mixture. Obviously, we'll have some traditional JGB investments to help with yen interest rate matching and interest rate risk and duration matching. To expand not only in investment-grade credit, but other places as well.
I've said this, we've seen some disruptions in the market recently. We've seen spreads on high yield bank loans, some other asset classes start to widen out, we want to see that as a buying opportunity. As we go into 2015, we're hoping to be able to take advantage of that and start to get into some other asset classes beyond just traditional investment-grade credit. That will be a function of markets, where spreads are. We're not going to chase spread just in the interest of yield. We try to work with Kriss and Ken to have a risk-adjusted NII, net investment income budget, if you will, and give us the flexibility at the same time to take advantage of those dislocations and invest at a good point in the cycle as opposed to force that investment.
Okay, thanks for that. If I can sneak one more in, just for Kriss or Ken. Just thinking about Japan margins, I think over the last 2 years, particularly during the period of very strong paced first sector sales, particularly WAYS, there was, I guess, a 1st year, if I can characterize it that way, sort of headwind on the pre-tax margin because commission rates were high, and I guess those products were maybe a little bit more surplus strain. With first sector sales having declined, at least in terms of growth so significantly. I would have thought we would have been getting some of that back. We looked forward, is that in your guidance? Are you seeing that? Can you talk about that a little bit?
John, this is Kriss. I will say that the surplus drain affects the regulatory reporting, FSA and U.S. stat more heavily than it does U.S. GAAP, that we're primarily focused on today, just because we're allowed to defer a significant amount of the acquisition expenses. Actually, the strain, John, on the 3rd sector is almost as significant on the 3rd sector as it is on the 1st sector.
Hmm. Okay.
One reason is that the cost per policy as opposed to percent of premium are somewhat higher on the lower premium products and the first sector products have 9 to 10 times the premium that the third sector products have. There hadn't been a lot of relief, so to speak, on that in percentage terms. In absolute terms, clearly as the first sector premiums declined, the surplus drain in absolute amounts have declined, but kind of not on a relative basis. I want to go back to a previous comment that was made, and somebody mentioned a 15% margin as kind of normalized. That's a pretty low number, in my opinion, for any kind of normal margin.
Once we reprice the first sector products effective April 1st, 2013, the margins increased from, say, an expected margin over the lifetime of the product, given the net investment yields we were realizing at that time, the margins increased from about 10% to closer to 20% on the first sector products. We weren't able to sell as much product because they weren't as competitive versus other financial products in the marketplace. That affected us as well as other life companies compared to other financial products issued by other organizations. While our margins went up, our sales went down, and our overall margin is affected by the mix of business, and I pointed that out in the FAB guidance materials. I sort of said, "Okay, here it is for life insurance.
Here it is for third sector business." You've got to look at the mix that you anticipate or what we actually achieve in order to get to kind of a so-called normalized margin. I did want to make the point that the move from about a 20-plus percent profit margin we're realizing on Japan right now to a 15% on an aggregate basis would take a heck of a move, and I don't anticipate margins will decline near that fast.
Really in looking at our plan and formulating guidance to follow up on that, we're looking to maintain roughly a 20% margin both this year and next year. A little bit higher this year, perhaps 20% or just a tad lower next year. Again, consistent with what we've expressed and basically very similar to what we've seen.
Thank you very much for the responses.
Good.
Sure.
Our next question is coming from Joanne Smith. Ms. Smith, your question is up at this time.
Yes. Most of my questions have been asked and answered, but just as a follow-up to John's question on the first sector product, what is the average duration of those products? Because if I recall correctly, they either had a 10-year premium period or a seven-year. There was a five, 10, and a seven, I believe. What's the average duration? I'm just wondering when we can expect those to start running off, if it's going to be any time in our lifetime. The second question is just with respect to the U.S., and that is on now that we're about a year into ACA, are you seeing things in the market settle down a bit? Thanks.
Okay, Joanne, Kriss here. I'll take a shot at the first part and let somebody else comment on ACA. Let me say, I hope we all have long lifetimes and live to see some of the developments in these first sector products. I will point out that the durations you referred to relate to the premium payment periods, and that's the period for which surrender charges are in effect. We expect very strong persistency during the premium period, both because of the surrender charge and because of the fact that a lot of the first sector products we wrote in 2011, 2012 came with the advanced premium deposit arrangement where the people paid most of the premiums up front. We're going to see strong persistency throughout the premium period on those first sector products.
At the end of the premium period, the surrender charge goes away. On the WAYS product, the real optionality of the product kicks in not at the end of the premium period, but at an age like 60 or 65 that the policyholders elect when they buy the coverage. That's the point at which they have the option to elect to continue the product as life insurance or to claim conversion to a medical policy or to continue it as an annuity, certain type payout, or perhaps to convert to a care type product. We have some limited experience emerging on that. It's not enough yet to be credible. I will say that the tendency that I think we've seen so far is toward inertia, where people allow the coverage to continue as life insurance, which is the original form.
They do have to make an election a couple of years prior to the optionality date, and we do communicate with the policyholders regarding the option they have to elect changes to the form of their coverage. We haven't seen any adverse persistency develop at all so far, Joanne, in that regard. We anticipate that the duration of these first sector products will be pretty long.
Okay. We shouldn't be expecting them to run off anytime soon?
No, you shouldn't. Now, we've talked to you about the impact of the paid-up premiums on revenue, and we'll be talking more about that throughout 2015 as we see some of the blocks that are significant start to hit the end of the premium period in 2016. I will remind you that I've told you, we recognize profit over the term of the contract, not over the term of the premium period. What we're going to see is a continuation of the amount of profit per policy, but a significant increase in the profit as a % of revenue, because the revenue is essentially going to go away except for investment income.
Would you say that would kick in sometime around year seven or eight?
Yeah. 2016 or 2017 as far as.
Oh, okay. That long. Okay.
Yeah.
All right. Great. Thank you, Kriss.
Okay.
Joanne, just as a follow-up on that and to John before, one of the things that's influencing next year's benefit ratio, as I mentioned, was mixed toward first sector. The persistency of the first sector products has generally been quite a bit better than third sector, even though third sector is very high, and it's actually improved a little bit year-over-year, whereas the third sector has been modestly lower year-over-year. That's also influencing the mix of business and the expected benefit ratios.
Okay, thanks. Then just on the ACA?
Well, this is Teresa. You asked about confusion in the market. I think right now that the regulations are set, at least for the moment they're set, you still have employers who are having to comply, and then at the end of the year and then in 2015, you have employees that have to comply. I would not say, I wouldn't characterize the environment as one where there is no confusion. I think smaller employers are opting to public exchanges, and then it's creating gaps from a product standpoint as well, as far as the Affordable Care Act. Our opportunity is still a great opportunity from an Aflac perspective.
I think our strategic focus of the market in the less than 100 market to focus our field force there and then to grow the broker side of the market, I think our strategy is a winning strategy go forward. I feel good about that.
Okay. Thank you.
Our next question is coming from Mr. Randy Binner. Your question is up at this time.
Great. Thanks. I guess I'll just pick up there with the last commentary on Obamacare. Clearly, Aflac has a big opportunity, at least in my mind, given the brand awareness to capitalize on the exchange environment. When you all talk about U.S. sales recovering, I feel like those two things aren't linked. Is the exchange opportunity not something we should expect to help U.S. sales in 2015? Or is that part of the recovery in sales you hope for in 2015?
I think the exchange is another tool that we utilize as part of our sales process. I don't know if you recall earlier or last time we spoke, we talked about the enrollment platforms and benefit admin platforms. Many of those platforms are now being characterized as exchanges today. We've always been engaged in enrollments via these benefit enrollment platforms. Now, we have specific strategies today to engage in being on specific exchanges with large brokerage houses. Those are the activities that we're doing today that we think will help us in sales go forward in 2015.
I'll just say, we're not counting on this national healthcare plan to increase sales. I think there is the potential to do that, but I don't like to count on that. We do know that our enrollments, when they take it through our exchange, increases from 30% to about 42%. We have much better enrollment when we do that. Interestingly enough, though, those would be on the accounts of 100 or less.
They are going to go and buy it on the public exchange, which can be routed through us. One of the things I was a little worried about was, is that our agents would make so much commission on major medical, although it's a small percentage, it's a large premium. If you buy it through the government exchange, which comes through ours, it's a very low commission. That means for them to make money, they've still got to push our products and services. I think that will be very beneficial to us, and will ultimately give a good return to the policyholders, fill the gaps for them, and ultimately increase our sales.
Okay, understood. Let me, if I could, just on Japan, just another kind of top-down question on sales. Ostensibly, this new CEO of Japan Post is there to turn things around, and it seems like a spin-off/IPO process is still realistic. Do you have any update on whether or not that's going to happen for Post next year? If so, should we think of that as potentially being a tailwind for sales there? Meaning that they would have a motivation to sell more product to get more fees to get their earnings numbers up.
Well, I think any company that it can ultimately increase profits before they go public is going to enhance the shareholder value. You have to understand how private Japan Post is. We don't get any information in regard to that. Those are decisions that they make. We have a very close relationship with Taizo, who is the president, and what's going on there. We're very cautious in making any comments regarding their particular business other than to say what they have done with us and what is going on was slow at first. It has now picked up and they are doing very well now, and we're excited about 2015 and the future growth there.
We think we help fill a void with the products and the services that they offer at Japan Post, and this new product will help fill the gaps that they want that will ultimately make consumers buy it.
All right. That's perfect. Thanks.
Thank you. Our next question comes from Mr. Erik Bass. Mr. Bass, your question is up at this time.
Hi, thank you. Just hoping you could provide a little bit more detail on what's driving the stronger than expected benefits ratios year-to-date, and why you think that those should normalize next year rather than experience potentially continuing.
In Japan, even though there's been a mix shift, we have seen just pays emerge at a lower rate than we had expected as we came into the year. It's really been driven by slightly lower paid claims than we had expected. We've seen a much larger change in the ratio for Aflac U.S., and again, this is a trend that we've seen since 2011. Pays are increasing slightly. We have made some modifications to IBNR to reflect our program or our initiative of emphasizing the speed at which we pay claims, because that may stimulate claims to some degree. We've also seen, in part because of lower volumes from new sales, as well as the pace at which lapsation has occurred, even though overall persistence has been fairly stable. We're seeing a smaller increase or, in this case, declines in the change in future policy benefits.
Quite simply, the additions to U.S. reserves are growing at a slower rate than we had expected. All in all, this year especially, that's what's brought down the U.S. benefit ratio. We don't expect this to hockey stick and to shoot right back up to where it was in 2011 or 2012, but we would not be surprised if it came back to a higher level than we've experienced in 2014.
Got it. Are you seeing any differences in kind of consumer behavior in terms of either utilization of benefits or other trends?
Nothing particular, but I think we have concluded that utilization, and it's not just with our products and at our company, but utilization coming out of the very weak economy for the last few years has been lower than normal. People have not accessed the healthcare system as they did prior to the financial crisis. I think that's the overall trend that's really influenced our business in the U.S. for the last few years.
Got it. Thank you.
All right. We've reached the top of the hour, so we have time for one more quick question, please.
Thank you. Our final question will be coming from Mr. Jay Guild. Mr. Guild, your question is up at this time.
Thank you. Could you give us your updated perspective on whether you expect the Japan consumption tax increase to go through in 2015? If you look at what the impact was on sales in 2014, if you have any views on that'd be helpful as well.
I'll let perhaps Toru and/or Paul to opine on whether they think that it will go through. The proposal is that it could increase from the current level of 8% to 10% in October of 2015. For budgeting purposes and in our forecasting, we have assumed that that will occur
Effective with the fourth quarter of 2015. Paul or Toru, can you comment on what you think will go through?
Yes, this is Toru Taniike, and let me speak first, and then Paul may chime in. That issue is now being heavily discussed in the Diet, and there is no decision made at this point of time, and there is no way for us to know which is more likely. Some are in favor of the tax increase and some are not. At this point, nobody knows what would be the end result in 2015. Even if, just assuming if it happens, we do not anticipate a big impact on our sales, certainly not in the 2014 and not substantial impact on the 2015 either.
Yeah, I just want to make it clear that it's expected that Prime Minister Abe will make his final decision in December, and we really won't know anything till then. They're going through the standard process here. As Toru said, we feel that this is not going to have any form of a major impact.
Based on the increase this year, if you evaluate the trends, do you have a sense of how much of a headwind on sales it may have been for the initial consumption tax increase?
We do not see any noticeable impact on our business coming from the consumption tax increase last time.
That's what I thought. Thanks very much.
All right. Thank you for joining us this morning. If you want to follow up with any questions, please call our office and we'll be glad to do any follow-ups. Thanks very much. Bye-bye.
This does conclude today's conference. You may disconnect all audio lines at this time. Again, this does conclude today's conference. You may disconnect all audio lines at this time. Thank you.