Good morning, everybody. Welcome to Goldman Sachs' Financial Services Conference. I'm very happy to have with me today, Aflac's President and CEO, Fred Crawford, and CFO, Max Brodén. Before we kick off, I do need to read a quick disclaimer disclosure. Please reference the disclosures posted below, which are required in public appearances about Goldman Sachs' relationships with companies that we discuss. With that out of the way, one other housekeeping item, if you have any questions, there's a button at the bottom of your screen where you can submit any questions, which we will try to get to. With that, Fred, Max, thanks for joining us this morning.
Thank you.
Aflac hosted its financial analyst briefing a few weeks ago. There was a lot of material there. Thought maybe we could start with one aspect that I think you started off with, Fred, which was the growth initiatives in the U.S. I think what you had said was that there is a considerable growth opportunity in the U.S., but that you can't approach the market in the same way you have in the past while expecting different results. Maybe we can start with that and hear a little more about the different initiatives you're taking today versus in the past.
Sure. First of all, thank you, Yaron, and Goldman Sachs for inviting us this morning. Max and I appreciate it, and we enjoy attending the conference each year. To your question, first of all, stepping back on the entirety of Aflac, while we have a number of initiatives going on in Japan to support and defend their level of penetration and market share, clearly Japan is in a more maturity cycle given the sheer penetration rates and our market share and dynamics around their economy. As a result, Japan's throwing off a significant amount of free cash flow, as you would expect a mature insurance company to do.
We have been pivoting that cash flow back into the U.S. for also distribution, of course, dividend and repurchase, but also with an intent to invest more aggressively in the U.S. platform because we really do believe with a far less penetrated market, our brand recognition, our distribution reach, that there's some real opportunities to capitalize on. A couple of the shifts that we've made in the U.S., and this is what I refer to by we can't expect the same result by doing the same thing, is we've really moved first more forcefully into a direct-to-consumer model playing off of our brand. We have been somewhat by accident in the direct-to-consumer marketplace because people see our brand over the years, they'll phone up Aflac directly, and we have been moving them off into a third-party call center to process those leads, and sell business.
That worked, but it wasn't really focused on, it wasn't concentrated on, and we decided a couple of years ago to start the process of really building out a comprehensive state-of-the-art shopping experience for a full digital end-to-end. There was another reason for that pivot, and that is the growth of the gig economy. As we see more and more employees, I think we're upwards of 25 million workers in the U.S. are in a gig-type economic condition where they don't have that traditional employer-employee relationship. We wanted to capitalize on that growth rate, and the best way to do that, of course, is through the phone or digital experience with those types of workers. There was a couple of reasons why we did a more pronounced pivot, committing about $125 million over three years to build out D2C and be much more serious about it.
We think with our brand, we will attract natural traffic to that site and sell business. The other pivot, and different approach was moving into the employer-paid marketplace and on what we would call the first page of the benefit experience. Both those comments are important. Moving to the first page of benefits, meaning those benefits that are more important and more critical to employees than supplemental-type products or voluntary products is very important. The other shift to understand for Aflac is it's moving into employer-paid versus purely voluntary. We're already, of course, the leader in small business voluntary and group voluntary business, but we had yet to go into network dental and vision and true group life and disability.
We made a decision that building it from scratch would not make sense because we don't have the expertise and experience and base operations to handle a network dental and vision PPO-style product, nor do we have the true group life and disability, and particularly the advanced claims platforms that are required in that business. We also had a decision to make on whether to outright acquire some of the larger players as they were coming to market. There's been a lot of transactions. Ultimately, we felt as if that was first a seller's market. These were very richly priced properties. For us, there's going to be a level of build required no matter what, because our strength, we get stronger, particularly as we come down middle market and down market, and most of those properties are focused on upmarket.
We decided to take a buy-to-build strategy where we would buy the expertise, the platform, the administration, the technology, and very much the expertise of the individuals that have industry expertise in those areas, many years of industry expertise. We would buy that, bring that in, and fuel it through Aflac distribution and brand. That led to the Argus transaction, which is really a TPA that supports PPO-style dental and vision for Medicare and Medicaid. We like that property because there's very high tolerances required to be successful in that industry from an operating perspective because you have to adhere to the very strict standards and quality standards of Medicare in particular.
We thought by buying that property, it gives us an immediate jump start on operations, administration, and network management that we did not have as a company, and now we could fuel it by filing dental and vision product. We have been piloting dental and vision in about 10 states in 2020, and now in 2021, we roll it out to all the states, and we've made great progress through the regulatory community, and we're ready to go in 2021. The Zurich deal made a ton of sense, not just because of true group life and disability, which is something that we don't do, but it made a lot of sense because we're finding more and more bundling taking place where consultants and their customers are bundling true group and voluntary product.
Interestingly, one of the most common bundling approaches is true group life and disability and network dental and vision. If you plan to grow dynamically in network dental and vision, you really need to have a good, mature, state-of-the-art true group life disability and absence management platform. Fortunately, Zurich had spent about four years developing from scratch a state-of-the-art platform with all of the advancements that the market was asking for, and it allowed us to jump in midstream in their building plan to take over effectively the reins, bring it into Aflac, not really make any dramatic shifts to the strategy because Zurich's strategy is very similar to our strategy, and now just breathe life into it through Aflac's ability to bring voluntary into the picture as well.
That direct-to-consumer shift, that employer-paid first page of benefit shift, those are the two major moves that I was referring to when I said, "Look, we can't do things the same way and expect a different result.
Got it. That's helpful. If we stick to the direct-to-consumer shift for a second, I think one of the reasons that Aflac historically had gone through the work site was you got a very different risk profile through the work site. How do you maintain that risk profile when you do move into direct-to-consumer?
Yeah, it's a very good question. Actually, we're often asked either what took you so long or frankly, before the pandemic, why wouldn't you take advantage of your brand and be in the direct-to-consumer? I mentioned earlier, one of the big motivations was watching the emergence of the gig economy. The other dynamic was absolutely being careful about adverse selection. When you're in the supplemental health business, it stands to reason that if you think about people that are waking up in the morning and thinking about supplemental health insurance, it stands to reason that there is a reason that they're waking up in the morning and thinking about the need for supplemental health insurance, meaning there might very well be preexisting conditions or other dynamics that have created more of an awareness or higher risk in the eyes of the consumer.
As a result, quite frankly, you have to be realistic about your ability to, in fact, manage that and price that in. It will still be the case that generally speaking, it is more economic to buy in the work site because, like many group-oriented products, you benefit from the spread of that risk and control of that risk in the pricing of the product. You have to price the product in a way to recognize the fact that there is a level of adverse selection on the path to having more and more policyholders under that umbrella. The other thing that you do is you are very, very sophisticated in data management and using that data to not only track the risk and understand the risk, but also target the types of consumers that provide you a better spread of the risk.
There's no problem with taking in adverse selection as long as over time there's a balanced pool of risk. Even in the work site, when people click on our products, there is that risk of within the work site cocoon adverse selection. What we found is that there's a broader population of individual that click on the yes tab, if you will, to buy our products, and it creates a nice spread of risk. We can create that same atmosphere in direct-to-consumer as long as we're wise about mining the data and mining the targeting of clients with our ads and with gathering traffic into our site. Data management is very critical. The last thing we do is you file your products.
Part of what's taken time direct-to-consumer is we had to refile our cancer, hospital, and accident, which are the three main products we're offering direct. We had to refile them in the U.S. Why would we have to do that? Because we styled them to be digitally sold, meaning we bracket a lot of the features in the products so that we can go in and make adjustments based on the data feedback loop to pricing and other characteristics of the product if we see the data telling us something different about the trends in underwriting results. This is not uncommon. This is not a unique Aflac dynamic. You see a number of companies that will do the same thing, even on life insurance. It allows us to react more quickly to the data feedback loop to manage that risk.
A long-winded way of answering a very simple question, which is you realize that you will have adverse selection when you structure the product and price the product.
Got it. As you think about that and the realization that you need data to price more accurately and learn from it, would the strategic goal then be to grow as quickly as possible in order to collect as much data as possible and thereby improve quickly? Or would it be to take a very slow and prudent approach to learn as you go before you really hit the pedal?
That's right. I think by definition, to be quite candid with you, it will be a slow and pragmatic approach. I say that because irrespective of how aggressive you choose to be, it is going to be a slower ramp-up of this business. The other thing I would tell you is, remember when I said that we have been doing this by accident for several years, and we'll do in the range of $20 million, sometimes as much as $25 million in sales direct-to-consumer by just being a brand with a 1-800 number. We actually have been able to do quite a bit of back testing on the data and characteristics of the products that have been sold direct-to-consumer in the old-fashioned way, people just calling on their own.
It's told us that we've actually done a very good job naturally based on that national brand recognition of having a broader way of risk. We actually haven't seen a deterioration in underwriting results on those small pools of policies. We've actually been able to gather a fairly good amount of data already on the performance of the products direct-to-consumer. The slow gradual build is precisely to be careful as we build this. That is the plan, Yaron.
Okay. We have these new initiatives. I think at the investor meeting, you talked about maybe about $1 billion of revenues coming in from them by 2025, 2027. What about the existing products and distribution? Where do you see premiums in those lines over that period?
Yeah. Let me make a comment on a different kind of question in the path to answering your question, that is one thing with the traditional business that we have on our books, this would go for Japan and the U.S. too, but particularly in the U.S., is we are watching very carefully near term navigating the pandemic. One thing we talked about at our analyst briefing, horizon one, two, and three initiatives, I do want to make sure that investors and listeners understand that there is a very real horizon one that we're watching carefully, that's of course the pandemic. Given the face-to-face nature of our business in the U.S., the small business nature of our business in the U.S., and even in Japan, it being much more of a face-to-face sales dynamic.
In fact, digital sale of insurance in Japan really has never really gotten off the ground in any material way in Japan. It is a face-to-face sales environment across a number of industries. Because of that, we have to watch the pandemic very carefully. We are now clearly into a, whether you call it a second wave or a third wave, it is a significant wave in the U.S. You're seeing a much more modest version of that in Japan. I would say in Japan, that navigation is easier to understand. There may be some implications to the virus picking up steam, but as long as Japan doesn't enact a state of emergency or a prefecture by prefecture state of emergency, we would expect to see a level of improvement over time and are continuing on that path.
When you turn to the U.S., we have to be very careful right now because we have California going back into a lockdown approach. You have New York talking about it. Obviously, cases are significant. While we're not seeing anything come through the claims dynamics of any great concern, we're being very cautious on that front. We're also being very cautious on sales and sales expectations over the next couple quarters. We do think the vaccine will make a difference. We do think that both in Japan and the U.S. for a number of reasons, the back half of the year is particularly more promising than the first half of the year. I think that's a natural inclination. We are being cautious on our results as we watch things unfold with the virus.
When it comes to the base business in the U.S., we would expect, before we entered into the pandemic, we had kind of a steady two-ish percent increase in earned premium from our base voluntary small business platform sold through agents. We had a higher growth rate on group business, but together around a 2% and change type earned premium growth rate. Remembering it's from a very large base. These are very inexpensive policies, and we do $6 billion of it a year in the U.S. Also remember that you're talking about a 21%-22% lapse rate in these products, particularly around the small business sale environment. With those types of lapse rates, you're well into the year in terms of sales before you actually are incrementally adding to policies under administration and incremental premium growth.
As a result, we would expect post-pandemic, and as we bring back some steam into the agent atmosphere, that we will gain back to the level of sales that we enjoyed pre-pandemic. It will take a little bit of time to recovery after the pandemic. There'll probably be more of a pronounced increase followed by a slow trend of increase over time. That's essentially what we've put into our projections. Coupled with that, we're focused on retention. Retention is a big issue in the U.S., unlike Japan, and we'd like to bring retention back, as we said at FAB, to the 80% retention rates, which would be about a 100 to 200 basis point improvement in retention. Every one percentage point improvement in retention is around $60 million of revenue to the company. On a compounded basis over time, that could make a big difference.
We would expect recovery of the core business back to pre-pandemic levels over time, and added on to that, a renewed focus on retention.
Okay. With the new initiatives and the focus on both inorganic growth and investment in platform for organic growth, how does that impact the traditional capital deployment of the company? Where I think investors have grown used, accustomed to seeing have the dividend increase year-over-year, very strong buyback initiative. Do those get somewhat impacted by investment in other equities?
I'll ask Max to comment.
Yeah.
Thank you, Fred. We have the starting point is that we have very strong capital ratios in all of our operating subsidiaries. At FAB, we announced that we would expect an increased level of dividends coming to the holding company from our operating subsidiaries over the next three-year period. That also translates into increased capital deployment, and we've guided towards $8 billion to $9 billion for the three-year period, 2020 to 2022. This increased deployment, it's a function of the improved free cash flow generation. It's very important that we take a balanced approach in terms of how much is being deployed into dividends, how much is deployed into share repurchase, how much is being deployed into inorganic growth. We take a very simple approach to it. We will deploy capital to where we see the best long-term IRRs, that we can deploy that capital at.
That is really what's guiding us in terms of where we deploy the capital. Now, I would like to stress that all of this capital deployment and all of the subsidiary dividends is after investments into our platforms that Fred primarily talked about earlier in order to drive organic growth for the company. Needless to say, we have increased our dividend for 38 years in a row. We intend to continue to increase the dividend. That is something that's very important to the company. I would say that we almost view that as a fixed expense, more or less. This is not something that's variable, we would expect that to continue. Over time, we would expect to see continued increase in total capital deployment. Obviously with that, we will then allocate capital to where we see the best IRRs.
Okay. If we switch gears a second to Japan, because we focused mostly on U.S. initiatives until now. At FAB, you were talking about JPY 80 billion-JPY 90 billion of sales target by 2025. From my perspective, from an outsider view, it is difficult to measure that number not knowing how much of an impact Japan Post has in there. Are we talking about 2020 levels? Are we talking about 2019 levels? If we are talking about 2020 Japan Post sales, the JPY 80 billion-JPY 90 billion target seems aggressive. If we are talking about 2019 or maybe a bit earlier levels, we could come to a different conclusion. Can you offer any additional color on that?
Absolutely. I can, you are right to point it out. We tried to answer that question during FAB, it may have been certainly not as clear as maybe we could have made it. Realize that when it comes to projections on Japan Post, that our window into the preciseness of the recovery and the distribution game plan of Japan Post is still rather limited. We have met as executive teams, myself personally, Dan, with the CEO and executive team of Japan Post, together with Charles Lake, who is a member of the Japan Post board and our chairman, and Koide-san, our president of Aflac Japan. We have a great deal of confidence in the new management team. We have a great deal of confidence in their ability to recover from this event that took place pre-pandemic. Right now, they are on what is often referred to as an apology tour.
They are actually out making apologies and re-engaging the relationship with over 9 million policyholders, which takes time. It is literally a personal phone call connection and discussion to both apologize and set the relationship straight and really also set up for future product sales and future account relationships. They are in that process. Our expectation is that process will take at least through this fiscal year in Japan, which ends March 31st, may continue after that, we are not certain. Our sense is that Japan Post is eager to get back out there with business as usual, operating as normal, certainly as part of their fiscal year 2021, which begins April 1st.
Reading through the public statements and press conferences that Japan Post has had and our conferences with our internal executive dialogue with Japan Post, we have loosely suggested, if you will, that recovery in the Japan Post system is a second half of 2021 issue in our view. We will have to monitor conditions and monitor what Japan Post says and outlines along the way. That is what we have assumed in terms of our sales projections. There would be somewhat of a step function, if you will, increase in the amount of sales, realizing right now there is very little sold through Japan Post. Even though we are not technically shut down because we were not part of the issues that were exposed. They have, for all practical purposes, pointed all their distribution towards working with existing policyholders to right the wrongs, if you will.
That's been their focus, and we want them focused on that. We're going from a base of near zero, there would be a step function and then a linear path to recovery. What we've assumed over the five-year period of time is that that recovery does not recover to the levels of pre-pandemic. It recovers in a linear fashion, but not quite to the levels of 2018-2019, for example. Realize, in those years, you also had a new, fresh cancer product that really spiked sales for a period of time. We are coming more below that, okay, really in an attempt to be conservative. We think over a five-year period of time, that's very conservative, particularly because both companies are obviously committed and incentivized.
Remember, Japan Post obviously owns 7% of Aflac. For the same reason you're asking the question is the same reasons investors are very focused on Japan Post recovery and what that means for our valuation. We are all motivated to drive this back to pre-pandemic levels. From a projection standpoint, we remain conservative while seeing improvement below the levels of that pre-pandemic time period, just to be conservative.
Okay. Before I jump to the next question, just a reminder to the audience, if you have any questions, there is a box at the bottom of the screen where you can submit the questions. One other dynamic we're seeing in Japan is some pressure on net premiums earned from the limited pay products.
Yeah.
They think they've kind of hit the limit. Can you maybe remind investors why that is, that we're seeing that pressure point today, how much longer we expect that to continue, and what the economic impact is? If I understand correctly, it's actually probably pretty good for the company to see the limited pay product hit in maturity.
Yeah. Well, thank you for asking the question first. The reduction in premium that you see, remember, that is on a GAAP reported basis. Paid-up policies on a GAAP basis, once that policy is paid up, you're no longer recording premium through your GAAP financial statements. However, that is not impacting profitability as dramatically because we have booked a deferred profit liability that allows the profitability of the product over the life of the product to continue to be recognized on a GAAP basis. That's why you may see revenue coming down more pronounced. You may see it impact some of our ratios, for example, an expense ratio, which has bounced up against revenue.
When you get to the bottom line or the pre-tax profit margin, you'll notice in Japan, we still call for very healthy pre-tax profit margins, and in fact, very stable pre-tax profit margins despite the drop in revenue. That's because, yes, we are managing expenses more aggressively in Japan. We plan to take about JPY 15 billion out of expenses over the five-year timeframe. It's also because we have that deferred profit liability that supports the profit margins despite revenue moving down more aggressively. That will continue because it's largely a first sector dynamic, and we have shut down the sale of first sector. When you shut down the sale of new limited pay product and just let it run off, the paid-up will be more pronounced.
You're seeing upwards of a 10% reduction in first sector savings premium, for example, on a GAAP basis, and that leads to a 2%-3% decline in overall revenue. When you go to the third sector, that's really where the economic value is created. First sector savings has decent economic value. It covers our cost of capital, but it's not nearly as rich and productive as the third sector business we have, which is cancer and medical. Our mission in Japan for now, since 2016 and the Bank of Japan's negative interest rate decision, has been to work down first sector savings because with interest rates now and into the future, that's not a profitable or economic area to concentrate on, and to build up third sector where we have a leading market share and much better economic value.
That together with first sector protection, which is traditional life insurance, that also has a good return. That's been our strategy. As a result, we would expect to get third sector back to that 1%-2% or so earned premium growth rate, recognizing this is off a very large base of premium, and recover that as Japan Post recovers, as we introduce new product, which starts next year, and we build that back. As you move through the next five years, you will start to see that first sector savings will start to plateau a bit in terms of its reduction on a GAAP basis, and third sector earned premium will start to grow, and you will level out a little bit of the revenue stress. For a period of time, the paid-up policies is actually the majority of the reduction in premium.
For example, first sector policies in force are only leaving at around a 1%. In other words, they're lapsing at about a 1% rate, yet premium is coming down at a 10% rate. The policies remain on our books, the economics remain on our books, but the GAAP revenue recognition is more accelerated down, and we have to talk about that because it plays into some of our ratios.
Got it. Max, this next one's probably for you. If I look at the RBC ratio, about 550% today, I think, versus a near-term target of 500%, longer-term target of maybe 400%. Can you walk us through, one, what long-term means or what over time means? How long it will take to get to the 400% target, one. Two, if you have a target that's significantly lower than the 500% the target you're at today, why do you need an extra buffer on top of that to get to 550 in this environment, when it seems like there's still a huge buffer there between 500 and 400?
Yeah. Your question is very valid, and my answer is really, it's because of the environment that we are in right now. We are primarily a morbidity company in the middle of the worst pandemic that we've seen since the Spanish flu. In that kind of operating environment, even though we have not seen any significant impacts on our profitability in terms of spike in benefit ratios, et cetera, to date, we still operate in a fairly uncertain environment. Also the potential impacts it could have on the asset side of the balance sheet. Given that backdrop, we also went out and raised a lot of cash in capital in March this year when we raised $1.54 billion through two senior debt transactions. What that did was it bolstered all the capital and liquidity at the holding company.
That gave us the flexibility and opportunity to be more flexible in terms of how we manage our capital base at the subsidiary level. Right now we're running high at the subsidiary level. We're also running high at the holding company level. This is the buffer that you referred to. When we get out to a more normal economic environment, and we see that the risks to both the assets and the liability side of the balance sheet are on a more normal level, that's when we really can move our capital ratio in the U.S., so primarily our RBC ratio in the operating subsidiary, Aflac Columbus, closer down to something like 400%. How long will that take? I put 2025 on the slide at FAB.
Hopefully, it's much sooner than that, I would say that what will really dictate it will be the economic environment and the economic uncertainty around us. At the point when we feel comfortable with the economic outlook and that the risks to the balance sheet is fairly low, we will start to draw that down towards 400%. I would say that right now we have significant amounts of capital and liquidity at the holding company. We are using that. You've seen us step up our share repurchase. You've seen us guide towards increased deployment into dividends as well, and total deployment over the next three years. Given that we have all this capital at the holding company, we can then be more flexible.
Right now, we don't need to force capital up to the holding company in order to pay it out, because we already have enough capital there. In this case, actually, it makes more sense to, for a short period of time, operate with a little bit higher RBC ratio because you can earn a higher net investment income on the capital sitting at the subsidiary level than at the holding company. Because at the holding company, you have a different investments that you can make. You go much more short-term, liquid, et cetera. You then have lower NII. In the very near term, it's a tactical decision to actually hold a little bit more capital inside of the operating subsidiary.
Yaron, I might add just some perspective from a different angle. This year, when I took over this new position of President and Chief Operating Officer, I sat down with Dan, we initiated an enterprise-wide strategic planning process that really focused in on two major efforts, which is growth, which we know is a big challenge for a company that has reached maturity in our two countries that we operate in. Then also efficiency, because we know also as you move towards maturity as a company, you now need to really be particularly careful about your expense dynamics and efficiency dynamics. Meanwhile, we're all in the industry trying to continue to advance the ball on technology and digital efforts. So we went into an exhaustive strategic planning process that ended around the August timeframe.
It coupled into our financial projection process, which we do each and every year. We married up those financial projections to that five-year strategic planning process. The idea was we would then go to the board of directors, which we did, and review all of that material and talk about the efforts and investment required, and then go to our analyst briefing a few weeks ago and talk publicly about the nature of that strategic plan and financial. One of the things I want to impress upon you is we know that when we're sitting down with our investors, we're asking for you to trust a number of things.
Number one, trust that we're capable of navigating through this pandemic in a way that doesn't damage the franchise over the long run, and also secures the financial position of the company such that we can continue to distribute money back to our shareholders, while at the same time investing in the platform. We also know that we're showing you elevated expense ratios as we pivot and build these new areas of growth for the company. That includes all the issues that we talked about in the U.S. that we're driving new growth efforts in, which are naturally going to be losing money or thin margin until they reach a level of scale. We need to invest in those.
We also have certain long-term efficiency metrics that require early days investment for long-term payoffs, such as the paperless project in Japan and other initiatives, particularly the group platform technology and having that ready to be a one group Aflac face off against the customer, offering true group life and disability, network dental and vision, and leading group voluntary products. All of those investments will, in the short run, elevate your expense ratio. As a result, we purposely went to our analyst briefing to say "Well, what are we solving for when we get out to 2025?" Realize a few things. We're not done at 2025. In fact, you'll notice a number of the growth areas, dental and vision and group, we are calling for a five to seven-year growth rate, and that's because we're not done growing at 2025.
Also important, back to capital, was a 17% increase in the dividend. Your board of directors would not reflect on that strategic plan and financial plan and approve and feel comfortable with a jump, an interperiod jump in the dividend increase and continued pledge to increase, if not confident in your ability to turn that corner and produce economics with all of these investments we're making. I want to reiterate, the dividend was not just a technical dividend payout or yield exercise. It was putting money behind the effort to pivot the company and put it in a better growth position over the long term.
Thank you. That was actually a great summary, I think, with which I think we have to end. This was very helpful. Thank you both for your time and for your thoughts.
Great. Well, thank you very much for inviting us.
Thank you.
Thank you.
Take care.
Take care.