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.
Good morning, welcome to our third quarter call. Joining me this morning is Dan Amos, Chairman and CEO, Kriss Cloninger, President and CFO, Paul Amos, President of Aflac and Chief Operating Officer, U.S. Operations, Ken Janke, Executive Vice President and Deputy Chief Financial Officer, Eric Kirsch, Executive Vice President and Global Chief Investment Officer, Tohru Tonoike, President and Chief Operating Officer of Aflac Japan, is joining us today from Tokyo. Before we begin, 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 are 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 could materially impact our results.
I'll turn the program over to Dan, who will begin this morning with some comments about the quarter and our operations in Japan and the U.S. I will then follow up with a few financial highlights for the quarter and the first nine months, we will be glad to take your questions. Dan?
Thank you, Robin, good morning, everyone. Let me begin with a review of Aflac Japan, our largest earnings contributor. We were again pleased with Aflac Japan's strong financial performance and phenomenal sales momentum that continued into the third quarter. Following two years of tremendous sales growth, new annualized premiums sales rose 31.7% to JPY 55.7 billion in the third quarter. These results significantly surpassed our expectations again and marked the fifth straight quarter of record sales production. For the first nine months of the year, Aflac Japan's total annualized premium sales in JPY rose 43.4%. Record sales growth, combined with continued strong persistency, contributed to Aflac Japan's double-digit increase in premium income for the third quarter. Premium income increased 10.7% to JPY 346 billion. Revenue growth was also strong in the quarter, rising 10% to JPY 404 billion.
Pre-tax earnings were JPY 78 billion, down 1.4%, and for the nine months, pre-tax earnings were JPY 238 billion, up 1.4%. The bank channel generated JPY 26.9 billion in sales, which represented an increase of 85.3% over the third quarter of 2011. The bank channel accounted for 48.6% of Aflac Japan's total new sales in the quarter. From a product perspective, WAYS, our unique hybrid whole life product, continued as our top seller in the third quarter, generating an increase of 108% over 2011, and accounted for 50% of the total third-quarter sales. Our sales management team has done an excellent job ensuring the transition from five-pay WAYS to 10-pay WAYS has gone smoothly through all distribution channels. Sales of 10-pay WAYS in the quarter was much stronger than we originally anticipated.
Sales for the medical care category was also strong, rising 11.7% in the third quarter and benefiting from July's introduction of the revised non-standard medical product. Given the current low interest rate environment, we continue to employ strategies to enhance the profitability of our child endowment and WAYS products. In the third quarter, all distribution channels stopped selling five-pay WAYS. Beginning this week, we lowered the interest rate credit from 1% to 0.5% for discounted advanced premium or DAP. This credit essentially increases the total premium paid. The profitability of WAYS and child endowment will be enhanced in April of 2013, when we lower the assumed interest rate for new product pricing. Considering Aflac Japan's very strong sales results for the nine months, we think sales could be challenged for the remainder of the year.
We anticipate the additional sales growth hurdles in the fourth quarter will come from consumers' response to a lower credit given for the DAP. As a result, we expect sales to be in the range of flat to up 15% for the quarter. Taking all that into account, we now expect 2012 Aflac Japan sales to rise 30%-35% year-over-year. Let me say that even before the fourth quarter began, my mind had already shifted to 2013 and the challenges we face following five straight quarters of record-breaking sales results. I want to point out that the bank channel represents a larger portion of our business, so projecting future sales results becomes more challenging. We won't gain insight into 2013 bank sales strategies until closer to the start of Japan's fiscal year, which starts April 1st.
Although marketing plans for Aflac Japan are being finalized for 2013, we already see some challenges on the horizon. We know that Aflac's brand is strong throughout Japan, and this enhances the appeal for our products. For the last two years, as all of you know, our sales has been spectacular due to the WAYS and child endowment products, particularly through banks. During that time, investment yields have been lower, thus putting pressure on the profitability of these products. As I said earlier, we started implementing adjustments to improve profitability, including the reduction in DAP that went into effect early this week. In 2013, with the rate increase going into effect on new policies due to lower assumed interest rates, I think you're likely to see sales slow down, but generate higher profitability, which would create higher profit margins for Aflac Japan going forward.
Now let me turn to the U.S. operations. From a financial perspective, Aflac U.S. continued to perform very well this year. Although new sales growth has been constrained, our top-line growth has been consistently strong through the year, in large part reflecting an improved persistency with each quarter. We believe there are a couple of reasons for this improvement. First, with the economic uncertainty over the last several years, workers have been reluctant to switch jobs, and people are more likely to keep the benefits they currently have. Secondly, we've enhanced communication with the policyholders at important touchpoints, and we know this has resulted in better policy retention. I also think we've done a good job in managing the U.S. operation, including budgets and people resources. Our benefit and expense ratios are lower than a year ago, resulting in stronger pre-tax operating earnings.
Aflac U.S. revenues grew 5.2% for the quarter and 5.2% for the first nine months. Pre-tax earnings were up 21.5% for the quarter and 11.5% for the first nine months. Premium income increased 5.2% for the quarter and 5.3% for the first nine months. Aflac U.S. annualized premium sales declined 1.5% for the quarter. For the nine months of the year, sales growth was positive, with total new annualized premium sales rising 1.5%. We continue to see the economic landscape in the U.S. as challenging, especially for small business segment, where more than 90% of our products are sold. Although the most recent government data shows that unemployment rates improved slightly, small business continue to hold back on hiring. The National Federation of Independent Business, which focuses on small business owners, reported this month that fewer jobs were created in September than the two previous months.
The percentage of small business owners who are planning to create new jobs in the future is historically at a weak level. We have continued to make structural changes to our marketing and sales area to maximize our future growth. While these changes have been more disruptive in the short term than we originally anticipated, we believe this will enhance our long-term results. With the election less than two weeks away, many business owners are reluctant to make changes in their benefit programs until there's greater clarity in the U.S. economic outlook. With the uncertainty and nine months of results, I think it's likely that Aflac sales for 2012 will be roughly flat. Having updated you on our operations, let me give you some details related to our global investment division.
For the last several years, our primary focus has been on investment risk management while investing our significant cash flows in assets of relatively higher quality and liquidity. As you know, we've made considerable progress in proactively de-risking our portfolio over the last four years to enhance the strength of our balance sheet. In the process, we've significantly reduced our exposure to perpetual securities, peripheral European sovereign debt, and financials, especially in Europe. In fact, we reduced our exposure in these categories by $1.4 billion during the quarter and $3.8 billion year to date, which further improved the overall quality of the portfolio. Impairments were relatively small in the quarter. The European market still represents an area of potential risk, and we remain cautious. I am convinced we're much better positioned to accommodate that volatility as a result of the de-risking efforts.
As we have stated for many years, our greatest investment challenge has been to invest Aflac's significant cash flows at reasonable investment yields. Our recently employed U.S. corporate bond program has been effective means of enhancing our new money yields in Japan. You'll recall that our initial objective was to invest JPY 200 billion or about $2.5 billion in U.S. dollar-denominated, publicly traded corporate bonds and then hedge the currency risk. We completed that pilot program in the third quarter and are very pleased with the results it generated. In the third quarter, the new money yield on the corporate bond program was 3.6%. Aflac Japan's total new money yield for the quarter was 2.76%. These yields do not reflect hedging costs for the program, which was 41 basis points.
Based on the success of this program and market conditions, we plan to invest two-thirds of Aflac Japan's fourth quarter cash flow. This successful investment program allows Aflac Japan to surpass our budgeted new money yield for 2012 of 2.05%. It also enhances the profitability of our more interest-sensitive products and benefits next year's investment income growth. Finally, I'm pleased with the continued progress in the transformation of our global investment division. We continue to grow our investment team, build new infrastructure support, develop new investment strategies with the elements of our recently completed strategic asset allocation project. We believe these efforts will improve the risk-return profile for our balance sheet and further our objective as a world-class investment operation. Now I'll turn to Aflac's consolidated financial performance. Operating earnings per diluted share were better than expected, rising 7.3% to $1.77 for the quarter.
There was no impact from foreign currency in the third quarter. It's important to note that even without a lower effective tax rate, operating earnings per share would've been right in line with our objective and guidance. For the nine months, operating earnings per diluted share rose 5% before the effect of the Japanese yen. Net earnings in the third quarter of 2012 included after-tax realized investment gains of $186 million or $0.39 per diluted share, compared with after-tax losses of $34 million or $0.08 per diluted share in the third quarter of 2011. I'm pleased the investment strategies we've implemented have improved the quality of the investment portfolio and benefited the bottom line. I'm also pleased that our capital ratios remain strong, which demonstrates our commitment to maintaining financial strength and flexibility.
Although we've not yet finalized our statutory financial statements, we estimate that the RBC ratio was between 575 and 600 at the end of September. We expect Aflac Japan's solvency margin ratio remain at the high end or above our 500 to 600 target. Given the strength of our capital ratios and our parent company's liquidity, we believe we can allocate up to $100 million toward the purchase of our shares in the fourth quarter. Purchasing shares later this quarter won't have much impact on 2012 earnings per share growth, but it will benefit us in 2013. I'll also stress that we've been prudent, and any decision we make will certainly take into account challenges within the macroeconomic environment, especially as it relates to Europe. As we have frequently discussed, profit repatriation remains a primary source for funding share repurchase.
You may remember from our second quarter call and the Tokyo analyst meeting that we expect profit repatriation to be around JPY 65 billion for 2013. We still believe that's a reasonable estimate, assuming that we have no additional investment losses that would reduce Aflac Japan's operating income. Next year's profit repatriation could provide us with significant amount of capital that could be deployed for share repurchase. I was very pleased that the board of directors approved a 6.1% increase in the quarterly cash dividend effective with the fourth quarter payment. This marks the 30th consecutive year we've increased cash dividend to the shareholders. We continue to believe that we are well-positioned to achieve our stated earnings objectives of 3%-6% increase in operating earnings per diluted share, excluding the impact of foreign currency. In the second quarter, we had guided toward the low end of the range.
Reflecting the lower annual effective tax rate, we now expect operating earnings for 2012 to be better. If the JPY averages 80 to the USD for the last three months of the year, we expect reported operating earnings for the fourth quarter to be in the range of $1.46-$1.51 per diluted share. Under the same exchange rate assumptions, we expect the full year operating earnings to be $6.58-$6.63 per diluted share, which would be roughly a 4%-5% increase on a currency-neutral basis. We believe this is reasonable and achievable. Importantly, we continue to believe that 2013's operating earnings per share will increase 4%-7% on a currency-neutral basis. In addition to operating earnings growth, we also focused on producing industry-leading return on equities. On an operating basis, the third quarter ROE was 25.2%.
For 2012 and 2013, we continue to believe it's reasonable to see operating ROE in the area of 22%-26%. We remain focused on our vision of being the leading provider of voluntary insurance in the U.S. and the number one provider of supplemental insurance in Japan. In both segments, I am confident in our brand, the fundamental needs of our products, and more importantly, the success of Aflac. Overall, I believe we had the best quarter since 2008. Robin?
Thank you, Dan. Let me start with a few financial highlights, first with Japan. Beginning with the top line in JPY terms, revenues were up 10.0% for the quarter, which is the first time we've had double-digit growth in revenues since 1997. Investment income was up 3.7%, and the persistency rate improved in the quarter. The annualized rate, including annuities for the first nine months of 2011, was 94.8%, compared with 94.4% a year ago. In terms of operating ratios for the quarter, the benefit ratio to total premiums increased over last year as a result of the impact of first sector products, primarily the WAYS product. It was 73.1% in the quarter compared to 70.0% a year ago.
The expense ratio for the quarter was 18.1%, down from 18.8% in the third quarter of 2011, reflecting lower commission costs associated with strong sales of first sector products, primarily WAYS. Reflecting the higher benefit ratio, the pre-tax profit margin decreased from 21.6% to 19.3% in the quarter. Pre-tax earnings decreased 1.4% in yen terms for the quarter. Let me turn to Aflac U.S. Total revenues rose 5.2% for the quarter. The persistency rate continued to improve in the quarter. Annualized rate for the nine months was a record 76.9%, up from 75.9% a year ago. In looking at the operating ratios for the quarter, the benefit ratio to total premiums decreased over last year, going from 56.8% in the quarter compared to 59.1% a year ago. The lower benefit ratio for the quarter is largely the result of lower paid and incurred claims experienced during the quarter.
The operating expense ratio decreased slightly, going from 31.5% a year ago to 31.2%. Benefiting from lower benefits and expense ratios, the profit margin expanded to 18.4% compared to 16.0% a year ago. As a result, pre-tax operating earnings increased 21.5% for the quarter. Let me turn to investment activity for the quarter, starting with Aflac Japan. For the third quarter, approximately JPY 2.5 billion of new cash flow was invested in the corporate bond program for a gross yield of 3.6% and a hedge cost of 41 basis points. The yield net of hedge cost was 3.19%. For the quarter, total new money cash flow invested in Japan was JPY 5.2 billion. The gross total new money yield for that cash flow was 2.76%. The yield for the total new money net of hedging was 2.56%. That gives you the hedging cost for the total portfolio of 20 basis points.
The weighted average duration of the forward contracts executed this quarter is five months and range from three to six months. During the quarter, approximately 55% of the corporate bond purchases have a maturity of eight to 10 years, and 45% have a maturity of 18 to 30 years. Approximately 44% of new cash flow was invested in JGBs in the quarter for an average yield of 1.72%. The portfolio yield at the end of the quarter was 2.8%, down 26 basis points from the end of June and 58 basis points lower than a year ago. According to Bloomberg, 20-year JGBs during the quarter were 78 basis points, a six basis points decrease from June. Additionally, to enhance our investment income this quarter, we executed on a six-month securities lending program involving approximately JPY 6.5 billion of assets from the Japan portfolio. All of these assets were JGBs.
Let me turn to U.S. investments. The new money yield for the quarter was 3.94%, a decline of 43 basis points from June 30th and 183 basis points from a year ago. The yield on the portfolio at the end of September was 6.51%, down eight basis points from the second quarter and 21 basis points from a year ago. Turning to some other items in the quarter, non-insurance interest expense in the third quarter was $45 million, compared to $44 million a year ago. Total company pre-tax operating margins decreased, reflecting the increase of the benefit ratio in Japan caused by increased sales of the ordinary line of business. Parent company and other expenses increased only slightly from $14 million to $15 million in the third quarter.
In this quarter, the company revised its estimate of the full year effective tax rate, resulting in an increase of operating earnings of $17.5 million, or $0.04 per diluted share. The company also recognized a tax benefit of $29.5 million or $0.06 per share, primarily from a favorable outcome of a routine tax exam for the years 2008 and 2009. The total impact of these items was $47 million or $0.10 per diluted share. Going forward, we expect the effective tax rate for the remainder of the year and 2013 to be somewhere between the range of 34.0%-34.5%, assuming FSA earned premium is flat year-over-year. The pre-tax margin went from 19.4% to 18.2%, and on an operating basis, the tax rate was 31.3% compared to 32.6% a year ago. Net earnings per diluted share for the quarter were $2.16 compared to $1.57 in 2011.
Let me comment on our earnings outlook for 2012. As you heard, we raised our outlook for 2012 to increase operating earnings per diluted share. If operating earnings per share increase between 3% and 6% in the fourth quarter, and the JPY averages 80 for the remainder of the year, we would expect operating EPS to be between $1.46 and $1.51. That compares with current First Call estimates of $1.53. This estimate reflects our plan to substantially increase IT expenses and expenditures related to marketing and advertising in the fourth quarter. Additionally, if you back out the $0.10 operating earnings benefited from the tax items during the quarter, reported operating earnings per diluted share were $1.67, which would be right in line with our guidance, as Dan said.
Using the same foreign currency assumption, we would expect full year operating earnings to be somewhere in the range of $6.58-$6.63 per diluted share. We're going to be glad to take your questions. To be fair to everybody, please limit yourself to one question and only one follow-up that relates to your initial question. We're ready to begin, please.
We're ready to begin the question and answer session. If you would like to ask a question, please press *1 on your touch tone phone. To withdraw your request, press *2. Our first question comes from Nigel Dally of Morgan Stanley.
Great. Thanks, and good morning, everyone. My question is on capital. With the JPY 65 billion repatriation estimate, are you expecting to retain any of that capital in your U.S. sub, or should all of that make its way to the parent? Also, you discussed an initiative to monetize some of the Deferred Tax Assets in the U.S. that you may invest today. Can we also get an update as to where you stand on that initiative? Thanks.
Yeah, Nigel, this is Ken. Right now, as we mentioned, the JPY 65 billion we still believe is a reasonable estimate for next year's profit repatriation. We currently anticipate returning to our normal dividend policy for Aflac U.S. up to the parent company to support the quarterly cash dividend payment and other parent company obligations. In terms of funding the share repurchase activities that we've anticipate for 2013, I think the combination and our ability to further dividend upstream, plus the liquidity that we have on hand would enable us to do that. We were sitting at approximately $950 million of cash at the parent company level at the end of September. After dividend payments and the $100 million of repatriation in the fourth quarter, excuse me, repurchase in the fourth quarter, we'll probably be around $785 million of cash at the end of the year.
As far as the DTAs go, we have generated gains this year. Unfortunately, the gains that we've generated have gone against the taxable losses that we've incurred as part of the de-risking activities and selling assets at a loss. We're still looking at actually a couple strategies that we think will help address the DTA issue going forward, but we still have a little more work to do on those.
Okay, great. Thanks, Ken.
Our next question is from Jeff Schuman of KBW.
Thanks. Good morning. I was wondering if you could update us on the current marginal profitability of WAYS, you've changed the rate on DAP, you've implemented the new money strategy, you've discontinued five-pay WAYS. There's several things going on there that should enhance the marginal profitability, I was wondering if you give us a read there, please.
It definitely has. I'm going to get Kriss to cover that.
Okay. Jeff, I'd kind of lead you back to what we reviewed at the Analyst Meeting in September in Tokyo. The information we laid out on the presentation at that time showed what the impact on profitability would be on the current core products with current core product pricing, if we were able to achieve an increase in, say, interest assumption on invested assets from, say, 2% to 2.25% or 2.5%. Those charts showed that at 2% interest new money, we'd have a profit margin on WAYS that range from 8%-12%. If we achieved an increase to 2.25% new money, we'd expect that margin to go up to 13%-17%. If we could get 2.5%, we'd go up to 17%-21% expected profit as a percent of premium over the life of the contract.
With the new investment program, we've had some real positive impact on our ability to enhance new money yields. That being said, for the short term, some of that increase in new money yields is going to be offset, and I mentioned this in Tokyo again to try to moderate the excitement a little bit. Some of that increase in new money yields got to fund the increase in investment expenses for personnel and infrastructure, et cetera, associated with the new investment team. That'll dampen things for, say, six months to a year a bit. It is a long-term improvement in profitability. That'll be important. Now, we did, October 22nd, decrease the credited interest rate on the discounted advanced premium from 1% to 0.5%. That basically gives us an extra 50 basis points on the funds held under that program.
The funds held under that program basically represent half the total premium ever collected on the contract, because we collect total premiums due during the contract on day one. Just for example, on the 10 pay WAYS, we'd collect the first full 10 premiums. We would apply the first premium to the policy the day we collected it. On balance, we'd have nine premiums on deposit for the next nine years. On average, we'd have four and a half premiums on deposit at an extra 50 basis points, which gives us roughly an extra 2.25% of premium profit over the life of that particular contract. Things are headed in the right direction, is all I can tell you.
In April, we'll have the-
You'll have the potential repricing when the standard interest rates decline to 1%, and we'll definitely have repricing activity at that time. We'll try to watch what competition's doing. We don't want to give ourselves a competitive disadvantage in the market. I believe that clearly, the premium rate changes associated with the decline in the assumed valuation interest rate in Japan for reserves will tend to increase premium rates, and that'll take effect April 1, 2013.
I want to make one comment about our sales force. I am so impressed with Aflac Japan's sales force, especially the bank channel, to adapt to these things, to say, "Uh-uh, we're not going to take profit margins at these ranges. We want higher profit margins, and we're stopping five-pay WAYS. We're doing discount advanced premium." Of course, the sidebar is, what a great job our investment team has come up with the higher interest rates. Then also in April, we're going to see these things. It has been a wonderful job on Tohru's part and that management team for what they've done to adapt, because this is a change. We never used to have to do like this, and now we're going to vary it to make sure we make our profits and do the things we need to do.
Okay. That's all helpful. Obviously, the new money rate piece is kind of a moving target dynamically, but kind of all in at this point, it sounds like maybe current margins are more kind of mid-teens up from more like 10% earlier. Is that kind of a fair read currently?
They're headed in that direction.
Okay. Thank you.
They're there before.
Investment
before the investment expenses. They're there now.
Right.
Okay, great. Thank you.
Our next question comes from Jimmy Bhullar of JPMC.
Hi, good morning. I had a question on the Japan new money yield. Obviously, it picked up a decent amount. I think it was around 1.97% last quarter, 2.76% in Japan this quarter. Assuming a stable environment from here, what's your expectation for the new money yield? Obviously, you're still shifting your investment allocation, and that should help. Credit spreads have come in as well over the past few months. Just either more specific or just directionally, do you expect it to improve from here or decline a little bit?
This is Eric.
Hi, good morning. If the market stays stable in terms of current interest rates in the U.S. and Japan, spread levels around where they are, on an absolute basis, we would expect our yields to go up because as we've disclosed, our plans right now, subject to market conditions, are to invest about two-thirds of fourth quarter cash flow in a similarly structured corporate bond program hedged back to JPY. Because the proportion of our new money would go to that program, based on current market conditions, the yield would go up versus last quarter, whose, of course, yield had gone up from the prior quarter because we're investing one-third in that corporate program. By and large, we would expect it to go up. Current forecast would be about, and this is after hedging costs of around 2.60% or so.
Again, market rates can change, spreads can change. That's just a rough estimate based on what we know today.
Okay. Thank you.
Our next question is from Mark Finkelstein of Evercore Partners.
Good morning. I want to talk about just the core kind of cancer medical sales in Japan. Sales were down about 3% to 4% year-over-year, flattish sequentially. You did have the product introduction of Gentle EVER, which usually does provide some form of a sales surge. I guess I'm just curious about what is the outlook for sales in those products, and can you give some background or color on the competitive landscape? Thank you.
Tohru, do you want to take that? Do you want me to? How you want to do this?
Okay, yeah, I'll take that. Yes, you are right. Our sales of the cancer and the medical combined has declined during the third quarter a little bit. This is better than the second quarter, you may have noticed. The second quarter, it was down by 8.7%. The third quarter was down by 3.6%. This increase is because of the very good sales of the new Gentle EVER, which we introduced this quarter. With the very strong sales of this new product, and also that we are planning to introduce some promotion measures in the coming fourth quarter to enhance the sales of both cancer and medical. We are rather hopeful that we'll see the better sales of these two products combined in the fourth quarter.
Gentle EVER accounted for 30% of EVER sales in the quarter.
Okay. I guess my follow-up would be, you're expecting sales to be flat to up 15% in Japan. Is there any color you can give specifically on kind of the cancer medical component, and whether you expect that to be up, flattish? What's the outlook?
Laurel?
Yes. I think I cannot give you the specific numbers as to our expected sales of the cancer and the medical combined. We are trying to move that sales up to the flat or hopefully positive in the fourth quarter. It depends on how successful our promotion would be.
I want to remind you that one thing that gives you a harder picture to follow is just remembering that WAYS is nine times more than the price of the medical products, and even endowment is three times more. The number of policy sales look better. Remember that our cancer product is 20% cheaper than it was because the changes we had in it. Actual policy sales look a little better than the premium sales numbers do.
Right. Okay. All right, thank you.
Our next question comes from Suneet Kamath of UBS.
Thanks, good morning. Just had a question, I guess, for Eric on the new investment strategy. I think the way that you described it in Tokyo was, I'll simplify it, a bit of a trade-off between greater liquidity versus a higher rollover risk in terms of the hedges. I guess I'm just curious, given that you're investing so far, 10 years plus, are you worried about this rollover risk on these currency forwards that are much shorter in duration?
The way I would phrase it is, it's a matter of risk management and a matter of having a macro view of the economy, short-term interest rates. It is something that we have to look at very carefully, and there are a variety of different hedging strategies we can employ over time. Today, am I worried? No, I think there's very little risk from a macro perspective that U.S. interest rates go up anytime or that Japan short-term interest rates change. Over the long term, those dynamics will change, and we will adjust our hedging strategies appropriately. As you recollect, in Japan, we talked about over time using forwards, cross-currency swaps. We could use longer rolling forwards. I'd also keep in mind that when we employ these strategies, we stress test them against our capital ratios. We take a number of factors into account.
I'd also say over time, we may not always buy corporates hedge. We may buy other asset classes that are JPY-denominated, et cetera. It is absolutely something that's important, but it's another risk factor amongst many. You'll see our program continue to develop and become more sophisticated as the amount of assets we deploy in it continue to grow.
Got it. I guess my follow-up is just in terms of the accounting for this. I think you're taking the mark-to-market of the hedge through net income. Presumably, we might see some more volatility in realized investment gains and losses. I just want to make sure that that is an accurate statement. I guess related, how does this impact your statutory results in terms of cash flow testing? Again, you're getting this cash that's in USD, and you're hedging the JPY. When you do your cash flow testing, how are you sort of factoring in potential changes in cost of hedges and those sorts of things? Thanks.
I'll start out with it. The accounting that we will be utilizing, consistent with GAAP, will take the change in the fair value of the hedges through net realized gains and losses. The cost of the hedging will be reflected in that line item of the financial statement. That being said, that'll be the accounting presentation. The economic evaluation of the profitability of the business, in my mind, will have to be net of the anticipated cost and the actual cost of the hedging. I don't want you to get confused to say, "Well, these guys aren't looking at the economics. They're looking at the accounting." I'm not going to worry about geography when I'm evaluating economic profitability. I'll just say that.
We'll have to reflect the potential implication of the hedging activities in our cash flow analysis that we use for both the actuarial evaluation of reserve adequacy on both U.S. statutory and on an FSA reporting basis. That'll involve using the same type of stochastic processes we currently use in evaluating cash flow adequacy and the like. All that will be baked into the normal cash flow testing process we go through effective this year-end.
Suneet, I'd add just a couple things on that. This is Ken. First, I think one of the ways you can think about this, and the way that we're hedging using forwards as opposed to cross-currency swaps, is that this is somewhat similar to the reverse currency securities you'll recall that we had purchased for many years. Meaning that we're not hedging the coupon. We're collecting the coupons in USD, and we'll have the flexibility to either reinvest in USD or convert those coupons to JPY and reinvest in JPY. What we're really hedging is the balance sheet risk so that the book value of those securities or market value don't fluctuate with currency changes. They'll fluctuate with credit changes, interest rate changes, but we're protecting it from currency changes. The reason we're doing that is really because of the solvency margin ratio in Japan.
Interestingly enough, the treatment of these securities on an FSA basis is actually favorable compared with buying straight JPY-denominated privately issued securities that we used to buy.
Understood. I get the focus on the economics, just based on what Kriss was saying about the cost of the hedges being below the line. Aren't you effectively overstating your operating earnings if you're getting the benefit of the strategy through net investment income, but you're carrying the cost of the hedge below the line?
Well, again, we're not hedging the coupons. We're hedging the balance sheet really, not the coupons. Again, to your point, and as we discussed, when we think about a value, to the extent that these securities are going to support policy liabilities in particular ways, we think economically, and when we run our cash flow testing internally, we're going to consider the cost of the hedge.
Let me just say, we recognize what the GAAP reporting requirements are, but we are also recognizing that operating earnings, as we define them, are a non-GAAP financial measure. We may have some internal discussions about what the most appropriate presentation of hedging costs in relation to operating earnings is. For the current year, we've chosen not to change anything. We may have some internal discussions, and we'll let you know what our conclusions are.
Suneet, as we talked last night, we are looking with next quarter. The amount was not very meaningful this quarter, but breaking out those different derivatives by line item also so you can see exactly what the number was.
Okay. Thank you very much.
Our next question comes from John Nadel of Sterne, Agee.
Hi, good morning, everybody. I'm curious for a little bit more detail perhaps on the securities lending program that you've initiated. I understand you guys mentioned it's a JPY 6.5 billion program, and you're lending entirely JGBs. I was just wondering what you're buying with the cash collateral. Any duration mismatch you might be taking since it's such a short-term program, I think you mentioned six months. What pickup in yield that's providing.
Yeah. The collateral is actually matched from a maturity standpoint, so it's very short duration. It's also backed in JGBs. It's a very small pickup. My recollection is around maybe 10 basis points or so on. 30 or so, I'm sorry. 30 or so on the whole program. This is an opportunity for us. As you know, we've got a lot of JGBs, and a good portion of those sit in held-to-maturity. When we have opportunities to enhance income by not really taking on much more risk, that's just extra gravy, if you will, for us. This was a good opportunity, and we're able to utilize those HTM JGBs in this fashion.
Just a quick follow-up. I'm not sure if I followed. What are you buying with the proceeds, Eric?
Basically short-term JGBs.
Okay.
With the collateral.
Okay. Just, I don't want to belabor the point too much on the currency hedging. Just a quick question as to how much capacity do you think is out there? How big can your U.S. corporates investing, swapping into yen, how big can that program get over time?
Sure. Well, let me take that from two ways. As you recollect, and I went over this in Japan, we did a strategic asset allocation program with Goldman Sachs. From an asset allocation perspective, and this program looked over a three-year rolling period. Over the next three years, we could see the U.S. corporate program being, and this assumes growth of our balance sheet, being up to about 20% or 25% of total assets. From the standpoint of capacity of the forwards markets, that's really not an issue. The currency forwards market is the most liquid, one of the largest markets in the world. There's more than adequate capacity. Of course, we also have to manage our counterparty risk.
In that regard, as you may recollect, we've initiated this program with three Japan mega banks as counterparties, but we're expanding our use of ISDA so we can expand the list of counterparties as the program grows. If there would be any limit, it would just be the credit quality of our counterparties. We don't see that as being a problem over the next three years as the program grows, as long as we continue to grow our list of counterparties.
If I could just sneak one last one in real quick. Any interest in allocating investment dollars into high yield or below investment-grade securities. I noticed the impact, the pickup in below investment grade this quarter, it seems like that was all downgrade driven. Anything you can provide there?
Sure. A couple of things on that. That's correct. Anything that shows up as an increase in BIG was because of downgrades. Again, tying back to the asset allocation strategy, high yield would be an asset class that is part of our asset allocation strategy. That would be buying the true high yield asset class as opposed to downgrades. In the short term, we're not planning on allocating to that asset class. As you recollect, we're still building our team and capability. We anticipate having that capability mid-year next year, we'll still have to make the decision tactically. We'll look at spreads in that market, whether or not it's a good time to allocate money to high yield. Over time, the answer is yes. When exactly we would do it, that'll be based on market conditions.
One other thing, just to mention for clarity, going back to the hedging. The cost right now of our hedging, which as Dan mentioned, was 41 basis points. That is a very low cost, which has primarily been driven by the low U.S. interest rates and low Japan interest rates. We don't expect that cost to stay that low forever. We know historically it's been higher. We're at a low point in cost, but it also makes it attractive to use these types of forwards at the same time. Over time, these costs will increase from an investment perspective. We're always going to look at all of our investment alternatives, and we'll look at them net of hedging costs versus JGBs versus high yield or other asset classes. It'll be a dynamic decision over time based on market conditions.
I think it's worth pointing out that those hedging costs most likely will increase versus decrease over time, given that they're at all-time lows.
Is it fair to say that in the historical periods when those hedging costs are higher, that new money yields are also higher?
Not necessarily.
Okay
The hedging cost for forwards is based on short-term rate differentials.
Okay.
We don't go out and buy short-term paper. We buy longer-term paper, 10 to 30 years. It really depends on the shape of the yield curve. We could be in an environment where short-term rates in the U.S. go up. That would cause the cost of the hedges to go up, but the long end of the yield curve may not go up. There's not necessarily a correlation between those two things.
I think it's reasonable to say that we've been looking at hedging costs being 1% versus 41. If it doesn't make sense at 1%, we're not looking at it at all.
Understood. Thank you very much.
Our next question comes from Ryan Krueger of Dowling & Partners.
Hey, good morning. I was curious, now that you've successfully completed the initial dollar-denominated program, have you given any further consideration to extending this to some of your existing available for sale JGB holdings? Correct me if I'm wrong, but it seems like if you were to do this, it would create a number of desired outcomes, which I think would include increasing returns on the existing portfolio, as well as creating some gains in Japan that I would think would increase your profit repatriation potential. I was just curious if you had some updated thoughts on that.
Sure. Over time, yes, we would consider all of our assets that are available for sale and say, is there a better opportunity for them, whether it's JGBs or something else. Of course, we have to consider liquidity and duration and capital ratios when we do that. Relative to gains, we did, as you already know, manage during the quarter because we were sitting on large gains in our AFS JGBs. We did realize some of those gains as we tried to proactively manage our gains and losses. Nevertheless, we reinvested into JGBs, primarily because during the quarter we had put a cap in the third quarter on how much we were going to put into the corporate bond program. We were already targeted to be at that cap.
As we look at the fourth quarter, we have a pretty good target for the amount of corporates, that's a healthy target and a healthy dose of higher yields for the program. We don't feel compelled right now that we need to make that swap. That's available to us depending on market conditions, which we could do at some point in time. That'll be a relative value decision. Right now we're pretty happy with the amount of money we're going to target in the fourth quarter. We don't see a need to target even more.
I don't know if Eric would totally agree with this, but let me just throw it out. That is that from my perspective, we wouldn't allocate 75% of the cash flow of any quarter to this corporate bond program on a long-term basis. The way I look at it is we're repositioning a part of the current portfolio as part of that 75%. Even though we're not liquidating it, but let's just say new money wise, we're putting 30% in to the new program, another 45% we're converting to corporates is kind of in lieu of doing gains and losses, et cetera, and putting it in there. As we just build the blocks, in my mind, I kind of look at it like we are repositioning part of the current portfolio away from JGBs, even though it's all new money.
Yeah. No, I think that's an excellent point because as you all know, prior to the initiation of this program, if I could put it in these terms, we over-allocated to JGBs because we didn't really have many alternatives based on our old investment strategy since we had stopped buying private placements almost entirely. In essence, we over-allocated to JGBs at the beginning of the year. Now that we have the flexibility to do the corporate program, there's just a higher percentage going in there as a way to fine-tune the overall allocations. To Kriss's point as well, as we continue to build out our capabilities, again, go back to the Japan presentation, I put on the board different asset classes we will buy over time.
You should expect to see, and I think it'll probably start to even out second part of next year, certainly into 2014, where we'll be buying some JGBs, some investment-grade corporate hedge, some emerging markets, high yield, including some alternatives on the board. You'll see it even out over time, but right now you're seeing those adjustments be disproportionate, in essence, because of the high amount of JGBs earlier this year.
Okay, that's very helpful. Thank you.
Our next question is from Steven Schwartz of Raymond James.
Something completely different, if Paul is still around. You asked Paul the guidance that Dan alluded to for the fourth quarter, which suggests flat. Dan also referenced some disruption in distribution. I'm assuming that Dan is talking about what you're trying to do in the large group market. I was hoping maybe you could fill that out and tell us what's going on there.
Sure. As Dan mentioned, as I've mentioned, my goal is to manage this business for the long term, not just for the short term. While 13 weeks of business is important, I'm really trying to manage our growth for not only 2012, but 2013, 2014, and beyond. In this past summer, the disruption that Dan's talking about is the combination of our sales and marketing strategy departments all into one, bringing in external leadership to help run sales, and then making sure our field force understands exactly what we're trying to do. Less so about any disruption from the broker market and what specifically is happening in the broker market. In terms of sales, we have seen, as we've stepped into fourth quarter enrollments, specifically with our small accounts, more of a decline in sentiment and purchasing than we originally expected.
When we came out in a recent release, and even Kriss's comments at the FAB in Tokyo, we commented that we thought we would be still within the range. The recent decline has to do with what we expect sales to be based on what we're seeing come out of our small business enrollments that Dan directly highlighted, between small business sentiment as well as what we believe is apprehension around the election taxes and a multitude of other items by small business owners. As I've said all along, we continue to build out our broker strategy to be a hedge against any negative downturn in small business and our ability to write business there. While that market continues to grow and grow well for us, we are still seeing great success within our broker market and broker growth.
At this point, the size of our field force and our core market, which continues to be our key focus, is so grossly proportionally larger that just any downturn in that small business market, especially in the fourth quarter, will have a negative effect on our ability to produce sales increases. Overall, I'm very optimistic for the long term. We're putting in an incredible training program beginning in January. I think we're doing all the right things from a management standpoint to make sure that long-term sales go well. In the short term, we are seeing the adverse effect of both the economy as well as apprehension in the small business market.
Okay. If I may, when we see fourth quarter results, while we're going to see your basic business down, we will see large group up year-over-year?
I'm not focusing it on group versus individual. I'm focusing it on broker versus our core field force.
Okay, yeah. Fine. Broker versus core.
The reason I do that is I'm platform agnostic. Whether an account chooses group products or individual products makes no difference to me. What I am trying to do is manage our distinct distribution channels. One thing I do want to point out, too, is we've seen great success with our field force partnering with brokers to actually help them enroll their accounts. I am very happy with our ability to succeed there. Yes, I do expect to see continued growth in the broker market. I expect to see some struggles within our career market. As I said, based on the training program and the things we're putting in place, I expect us to be able to move forward in a positive manner throughout 2013 and beyond.
Okay. I've heard some things. Are you guys looking at the individual market before? I'm talking about the true individual market here, selling to individuals as individuals. There's been some thought that supplemental health products could really, really shoot up in 2014 and beyond due to Obamacare. Wondering if that's something you might look at.
No, we've always had direct products. In fact, we've offered direct pricing in the U.S. for many years. Our agents have always found that the ability to sell at the work site not only provides us a better actuarial risk, but it provides the ability for the agent to be more productive because they can sell to a larger volume of people in a shorter period of time. As well as I think Americans in general are used to purchasing their products. Be able to move forward in a positive manner throughout 2013 and beyond.
Okay. I've heard some things. Are you guys looking at the individual market before? I'm talking about the true individual market here, selling to individuals as individuals. There's been some thought that supplemental health products could really shoot up in 2014 and beyond due to Obamacare. Wondering if that's something you might look at.
No, we've always had direct products. In fact, we've offered direct pricing in the U.S. for many years. On the training program and the things we're putting in place, I expect us to be able to move forward in a positive manner throughout 2013 and beyond.
Okay. I've heard some things. Are you guys looking at the individual market before? I'm talking about the true individual market here, selling to individuals as individuals. There's been some thought that supplemental health products could really shoot up in 2014 and beyond due to Obamacare. Wondering if that's something you might look at.
No, we've always had direct products. In fact, we've offered direct pricing in the United States for many years. Our agents have always found that the ability to sell at the work site not only provides us a better actuarial risk, but it provides the ability for the agent to be more productive because they can sell to a larger volume of people in a shorter period of time. I think Americans in general are used to purchasing their products at the work site. That said, we do expect the combination of both Obamacare, PPACA, whatever you want to call it, as well as the millennial generation being 50% of the workforce by 2016 to have some impact on how people choose to purchase insurance.
Yes, it's my job as well as our sales and marketing team to make sure that we're staying ahead and looking at all possible alternatives. We still believe, Steven, that the best market for us is the work site, businesses with 100 employees or less, and all of the other alternatives, including the broker market as well as the direct market, represent places for us to get incremental growth. Again, for us, we want to focus in on America's smallest businesses and the opportunity for us to be successful there.
Okay. Thank you, Paul.
We're at the top of the hour. We'll take one more question, please.
Thank you. Our final question comes from Tom Gallagher of Credit Suisse.
Hi. Ken, I just wanted to come back to you on something you had mentioned before, I think in response to Nigel's question. If the plan going forward here is that dividends from the U.S. is going to fund the common dividend, and you're still on track with the $800 million or so in terms of U.S. dollars repatriation coming from Japan, is it fair to say all or the vast majority of that would go toward a buyback? Is that the right way to think about that for 2013?
Well, a couple things. Number one, we've said that we anticipate funding our share repurchase activities with profit repatriation. The JPY 65 billion translates into a little over $800 million. We would expect to have more dividend capacity on a U.S. statutory basis next year than we had this year, just given where we are with realized investment losses on a statutory basis. As we think about next year, again, we want to maintain some prudence, and we're going to be very cognizant of the world around us and if additional losses emerge. Assuming that we have a relatively benign environment, thinking that we can buy somewhere within that, we indicated $300 million-$900 million in Kr iss's speech in May. We'd be at the high end of the range if we felt comfortable deploying all of that.
Yes, that would be available if we felt it was the right thing to do. Again, in the meantime, we have ample liquidity at the parent company. You'll recall that we did not dividend from the life company to the parent company at all this year. We really relied on parent company liquidity to meet our corporate needs.
Okay. That's very clear. Thanks. Then just a follow-up for Kriss on the Japan margins. 17%-21% pre-tax margins on WAYS if you get a 2.5% new money yield. Kriss, those are without the price increases, either the October or the planned one for next year?
Yeah, that's right. They'd be order of magnitude 8%-10% higher under repricing.
Okay. Then I know you'd mentioned the 6-12 month negative impact of the spend on the new investment structure. If I think about that range that you've given out, and I look at the 19.3 margin that you had this quarter, fair to say that if Eric keeps getting what he's getting, that we're actually going to start to see a reversal in margins go up here, or certainly not going down? I just want to get some context. Then as a follow-up, why is it only a 6-12 month spend? I thought most of the costs were going to be ongoing. Or is there some big one-time element?
No, the cost will be ongoing, Tom. What I'm saying is that if I look at the incremental yield on the amount we invested, say, for the first six months of the program
Say I get an extra 100 basis points on JPY 5 billion-JPY 6 billion. That's JPY 50 million-JPY 60 million. That probably meets or exceeds the cost of the build-out. The JPY 50 million-JPY 60 million of additional investment income on the investments we made over the last three months and the next three months are probably sufficient to fund the going forward, the extra infrastructure, personnel costs, et cetera. In my mind, the way I'm compartmentalizing it, I'm saying, well, if I don't count any additional profit associated with the first six months of investment now or going forward, then I've covered the total cost of the program and the P&L. Any incremental yield I get after the first six months is going to go to the bottom line, et cetera.
That may not be the way you or anybody else thinks about it, but that's the way I've compartmentalized it. I will point out, though, that the current margin is right in the middle of the range that I gave you at the FAB in May. All the ratios are in line with those numbers I gave you. I'll say that the expense ratio for the third quarter was at the low end of the range. The benefit ratio was at the high end of the range, but we had a lot of WAYS sales in the third quarter, in the second quarter. I might anticipate that those would've been a little higher. Year-to-date, though, we're right in the middle of things. 2012 year-to-date, the margin's 20.1%, and I had estimated a range in margin of 18.5%-20.5%.
Actually, that's way above the middle of the range of 19.5%. I'm comfortable with the numbers we've quoted you, and the margins are moving in the right direction. I'm just trying to be conservative in saying, don't get too excited, overly excited. I've got some additional costs to cover out of these additional incremental yields. Don't just expect EPS to explode in the next three months. Over the next year, yeah, I think it's going to really help us, and going forward, it's going to help us a lot. That plus the repricing, plus the other marketing adjustments we've made in our product strategy. Dan, did you want to comment?
Yeah. The only thing I would say is that if you take where we are today and look at where we were a year ago, it's a totally different way of looking at what's going on. We are in a position where every day profits, margins, and profits are going up. I think we're well-positioned to have a great fourth quarter and 2013. I couldn't be more excited about the future and what's really been an ability of our company to withstand what went on with the financial crisis and now move forward and really see some growth going ahead.
That's helpful. Thanks, guys.
Okay. Thank you. We're going to close it down now. If anybody wants to call with any further questions, Thomas McDaniel, my colleague, and I will be in the office, and we'll be glad to take your calls. Thank you all again for joining us today. Bye-bye.
This concludes today's presentation. Thank you for your participation. You may now disconnect.