Afternoon, everyone. I'm Ryan Krueger from KBW. Really pleased to have Aflac with us this year, and representing the company is Max Brodén, who is their Chief Financial Officer. Just a reminder that at the bottom of your screen, there is a box that you can type in questions, should you have any, during the fireside chat. To start off, Max, I was hoping you could discuss the U.S. claims impact that you saw in the second quarter, both from COVID, as well as social distancing impacts, and how you're thinking about those two opposing forces as we head into the second half of the year.
Thank you, Ryan. If we start with the COVID impact on the U.S., we had about 5,000 claims so far in the second quarter, and we have recorded about $31 million of claims so far. About 70% of that is IBNR that we put up. It's a fairly low number in totality so far. It is interesting to note as well that about 80% of the claimants that we've seen have been short-term disability, and a fairly low claim count coming through our hospital indemnity product. At the same time, the other factor, obviously, as we mentioned, has been our, let's call it normal claims or non-COVID claims. With social distancing taking effect in the second quarter, obviously a lot of people are not going for physicals. They're not going for dental cleanings, and there's a postponement of elective surgeries, et cetera.
We obviously have seen claims activity decline, and that manifested itself in a lower benefit ratio overall in the U.S. in the second quarter, where our benefit ratio dropped year-over-year by a little bit more than 500 basis points. You've seen so far that the social distancing impact on non-COVID claims have far outweighed the impact from COVID claims. At the same time, we think as we then look into the second half, we would expect a continuation, obviously, of COVID claims to come through. At the same time, as the economy is open and you have less of a social distancing impact, you should see a normalization in the normal claims on accident products, on hospital products, et cetera.
You could even see a potential pent-up demand, so to speak, in terms of dental cleanings being postponed, that being surgeries that have been postponed as well. We don't necessarily, obviously, view the benefit ratio in the second quarter as something that we would expect to be That's far from a run rate, obviously. We would even expect that we, in the near term, could see a normalization in the benefit ratio. Temporarily, it could go up on some lines of business because of a pent-up demand in terms of if you think about people going for physicals, cleanings, et cetera.
Thanks. In Japan, your COVID claims were extremely modest in the second quarter. I know it didn't seem like social distancing really had much of an impact on medical claims there either. Can you touch on why that was?
In Japan, I think that the difference has been a little bit how the hospitals have actually operated. In Japan, we've seen that hospitals operate almost normal, and I think part of the reason why that's been the case is because of the lower spread of the virus. You have had fewer patients coming into the hospitals with COVID-19. Therefore, they didn't have to shut down as much of their normal operations. You have not seen, to the same extent, the postponement of physicals, elective surgeries, et cetera. That is really, to some extent, one of the drivers why Japan saw a more normal claims environment. The other thing I'll mention as well is, you asked correctly the question specifically on medical in Japan.
I do want to mention that obviously our large block of policies in Japan is cancer, and cancer is not taking a break from COVID. We see more normal claims activity when it comes to cancer.
Thanks. I guess moving beyond COVID claims and just thinking about the Japan benefit ratio overall. Over the intermediate term, can you talk about some of the key trends that are affecting the Japan benefit ratio? I'm thinking about certain things like hospital stays, mix shift, new business, those types of impacts.
Yeah. Obviously in Japan, a long-term driver that we have seen has been the shorter hospital stays. I'm sorry, I need to open a door for my dog. This is what happens when you work from home.
No worries at all.
Yeah.
Been there many times.
We've seen shorter hospital stays for patients whenever they've been admitted to a hospital. This has been a long-term trend. Not only is that something that obviously is driven by better medical technology, it's obviously good for patients. Because part of the benefits that we pay is per day admitted into the hospital, so that lowers the total claims that we pay on a medical policy, even a cancer policy. You've also seen, obviously, a push towards more outpatient services. That is also a trend that is beneficial to us. Overall, you've seen this driver, the underlying driver for all of this, obviously, is the greater need for hospital services and hospital beds, et cetera, because of the aging population in Japan.
At the same time, you're seeing increasing demand for hospital beds, but actually the supply of hospital beds have actually declined because you continue to have an even greater demand for nursing care homes in Japan. What the Japan government has done is to actually convert some hospitals into nursing care homes. There are strong underlying drivers for this. When we drill down and we look at what are the core underlying drivers of the improvement in the benefit ratio, this is probably the strongest driver. We've talked about this for many years, and it continues to be a very strong driver in terms of the actual to expected experience for us. When we look forward, we do not assume in our pricing that this will continue, but we obviously take recent trend into consideration for pricing of new products and new business.
Got it. I guess, given that, is it reasonable to expect over time a continued downward benefit to the benefit ratio in Japan?
If you have a continued shortening of the days in hospital per stay, then you should have a continued improved actual to expected. If that were to flatten out, then you will obviously not see that improvement anymore.
Got it. Wanted to shift to the digital investments that you've been making in both Japan and the U.S. Can you discuss those in more detail, as well as talk about to what extent that you're accelerating those investments in this type of environment?
This is something that we obviously have been working on for quite some time, what COVID has done and what the whole work from home environment has done is that it basically has accelerated the need to go digital. We as a company and we as an industry are very paper heavy. If I start with Japan in particular is very paper heavy. We have accelerated an initiative to have Aflac Japan go paperless, and this is a very important initiative, and it's a pretty significant and big initiative as well. We would estimate that the accelerated expense for this is about JPY 10 billion, but that should yield about a JPY 3 billion benefit per year in run rate reduced expenses going forward.
This is important in terms of the whole operational and customer experience, the way we can build and sell products in the future, obviously it reduces risk as well for us. Obviously, they're in an area with a lot of earthquakes, and obviously if you have paper and you shake the building around, that's not necessarily a good thing. There are many reasons why it actually made sense for us to accelerate this. In the U.S., it has been more around the sales experience. We have accelerated spend on our digital enrollment capability. We have accelerated spend on our digital onboarding in our group ecosystem. We have accelerated spend also on the self-service portal. Within the MyAflac app, we have added capabilities there to make it easier and also expanded what you can do in terms of self-service.
We also expanded and accelerated some spend on automating claims as well. If you take all of this together in the U.S., we're talking about an accelerated spend to the magnitude of about $25 million.
Got it. When you put these things together with the other impacts in the business, can you talk about how you see expense ratios in both Japan and the U.S. trending over the next few years?
Yeah. First of all, I do want to mention that our expense ratios have been increasing the last couple of years. It is partly because of the underlying business mix shift in our in-force that have pushed up the expense ratio in Japan. It's because of a greater contribution into our in-force from third sector and less from first sector business. In the U.S., it's from more group products being sold that carry a higher expense ratio and a lower benefit ratio. There are some underlying elements that have pushed up our expense ratio. Obviously, the main driver has been increased investment spend. We should continue to see that going into 2021. After that, I would expect us to have some leveling off of our expense ratio.
I do want to highlight as well that what is important here, I do like to talk about it in terms of expense ratio and not just hard expenses, because it's very much a factor of what we're doing on the revenue side. For us, it becomes important to drive both revenues and to manage expenses in order to get the expense ratio down. It will be a combination of both, where expenses needs to come down, and also that we need to generate a greater revenue growth in order to get the ratio down over time.
Got it. Thank you. I'm going to shift to premium persistency in the U.S. in particular. Can you discuss how the economic weakness we're currently experiencing is causing any changes to persistency in the U.S. so far and as you look forward over the next few quarters?
Our persistency so far at the end of the second quarter had not moved very much at all. We reported a 78.3% persistency rate for the second quarter, and that needs to be put in context of we had many states with grace periods in place, which means that we did not lapse policies even if we didn't necessarily receive premiums on time, the same way we would normally do. That means that that persistency rate at the end of the second quarter becomes somewhat inflated because of these state orders that we were not allowed to lapse the policies. This varies by state, but most states, a very significant portion, those grace periods ended on June 1st. Now, don't confuse grace periods with all of a sudden we're giving away free coverage. That's not what it's about.
It's simply that we're not canceling the policy at that point in time. It's really the only number that to some extent gets inflated here is the persistency rate. Going forward, we would expect some higher lapses to come through. It's obviously because of grace periods expiring and also the Paycheck Protection Program, that's going to lapse as well. You have less support going to small businesses. We are obviously a company that very much catered to the small business segment, we are somewhat economic sensitive from that. If you put all of this together, we would expect some weakness in terms of lapses to come through, and that should hit our persistency here in the second half.
If you go back in history and look at business reactive increases in unemployment in the past, you can go back to the last economic downturn that we had in 2008, 2009, we did see that our persistency did weaken in the range of 200 to 400 basis points, just to give you a sense for how our business has reacted in the past.
Is the primary reason for the reduction in persistency due to economic weakness, or is there also some influence from the owners of these policies not having the opportunity to interact with a salesperson to influence the renewal within the workplace as well?
The interaction with the salesperson is a fairly important one. Very often you have reminders and relationships that go out between the agents and the small businesses. For example, very often the agent helps and supports in terms of even filing claims. There's a fairly strong relationship there. There is a correlation between if you have an agency account go down, the account that an agent may have covered in the past, if that agent is no longer with the company and they're no longer servicing that company, that's now a so-called dormant account. The probability for a lapse obviously is higher under that circumstance as well.
In Japan, has there ever been much of a correlation between persistency and economic conditions?
We've seen very little impact from economic conditions to the persistency rate. There are several factors for that. The first one, obviously, being that unemployment does not tend to move a lot in Japan the same way it does in the U.S. That factor leads to better persistency. The other factor I would say is also that individuals are less economically sensitive from the standpoint of they generally have greater savings. There's not a need to the same extent to lapse the policy for economic reasons. The Japanese policyholder base arguably have a very good understanding for what the products do and the need for them, especially when it comes to cancer. There's a great reluctance to give up coverage. I'll say, the last piece has to do with the pricing of the products.
Because we price by age in Japan, that means that if you lapse the policy and ever want to buy coverage again, then you're going to come in at a higher age category in terms of pricing. It's going to be a lot more expensive for you. That's generally fairly well understood in Japan, and that obviously drives behavior and leads to better persistency.
Thanks. On the sales side, on the second quarter call, you had guided to modest improvements in Japan and U.S. sales in the second half of the year relative to the first half. As the economy continues to gradually reopen, can you talk about why you don't expect more of a significant near-term recovery in the back half of the year?
Obviously, the assumption that we're doing is that we're not back to the work site and what we're doing, the sales model that we are conducting is the model that we are communicating right now. There's one important factor in the difference between traditional face-to-face when you're in a room versus the way we are conducting this communication right now. It's a lot easier for you to say no to me when we are over the web versus when we are in a room face-to-face. Not only do we obviously get slightly less meetings with people, that means that obviously sales will be lower. Even in a particular group, we tend to have lower conversion rates than what we would when we sit face-to-face. That also plays into that commentary.
One specific factor on the U.S. side, I would say, is that our recruitment is somewhat challenged, and that is really stemming from the licensing. For us to go out and find people and recruit people in, we can certainly do that. Our problem is to then actually them to go through the state licensing process. A lot of states did actually shut down the licensing process. You can recruit existing insurance agents. You can certainly do that. Our model is more based on new recruits that weren't in this industry before. We quite frankly, had quite some difficulties getting them licensed because the states were not ready to do this remotely. That's been a challenge for us as well. All of that plays into us being somewhat more cautious in terms of how quick the recovery will take place.
In the U.S., the issues you just spoke about, it sounds like those are more related to the traditional agent force and that they potentially have somewhat less of an impact to the broker sales that occur in the fourth quarter?
That's correct.
Got it. Maybe just one last question related to this would be, if the U.S. does move to an environment where more individuals work from home over time, how's Aflac working to address that challenge? Is it through the different digital initiatives?
Yes. We're obviously moving towards what I would call a virtual sales model, where we can conduct the sales process purely virtually. We obviously already have the capability to do enrollment virtually, getting greater acceptance from employers, employees, and regulatory bodies to actually do the sales process itself on a virtual basis. The other aspect I would say to that will be that we're also building out a direct-to-consumer effort, where we can go digitally direct to consumers as well. This is obviously targeting the non-work site market, which is very significant. This will target individuals that we are not reaching today because their employer is not offering Aflac at the work site. That means that the employees that are working from home can also access us through that channel as well.
Thanks. I want to move to the investment portfolio. You had presented a stress test on the most COVID-affected areas in the portfolio in the first quarter. How is credit playing out so far relative to that stress test? To what extent are you making any changes in the portfolio as we go through the year?
The overall investment portfolio is performing well. By the end of the second quarter, I would say that we're clearly tracking favorably to the stress test. It's also very early days, and this credit cycle has not fully played out yet. We remain cautious, and we monitor everything very closely. We're far from declaring victory. The good thing for us, I would say, is that we have the capital, which brings us the flexibility to continue to execute on the investment strategies that we have put in place, we continue to obviously be governed by our strategic asset allocation, where we can make some tactical moves around it. We certainly do to try to take advantage of it.
At least we're not capital constrained, which means that it brings that flexibility to try to take advantage of whenever spreads widen out on an uneconomic basis, we can take advantage of it. The bottom line is that there's no significant sharp right or left turns in terms of investment philosophy.
I believe investment income came in a bit above your expectations in the first half of the year. Can you discuss what drove that, how does the current interest rate environment affect your outlook?
In January, we announced a strategic investment and a partnership with a middle market lender called Varagon. With them, we deployed some more capital into middle market loans, clearly this is beneficial given the high yield that these loans are achieving. That helped our NII in the first and the second quarter to run a little bit higher than what we would have previously anticipated it to run. Going forward, I would break down the portfolio more or less by currency. If you think about it from a yen standpoint, yen yields are actually higher than what they were a year ago. It sounds crazy, but we're very pleased to see a positive four basis points on the 10-year JGB right today. That relieves some pressure on the yen portfolio.
We've been in this sort of low yen yield environment for quite some time now. Keep in mind that our yen portfolio had a fairly long duration, it takes a long time. We're still in an area where there is long-term pressure on the yen yields in the portfolio. If you turn to the U.S. dollars, obviously the 10-year treasury had come down quite a bit. We're also operating right now at fairly tight credit spreads again, partly because of obviously Fed action. That leads to obviously pressure in terms of new money yields, that will over time come through in the investment portfolio. What's good for us is that we have not huge amounts in terms of new money that is being reinvested each year. The decline in average portfolio yield is a very slow and gradual decline.
You know this very well that the vast majority of our profitability is really driven off of the underwriting of the products, and we have a fairly limited amount of reserves that carry a cash surrender value, which means that overall our spread income and the sensitivity to spread income for us as a corporation is fairly low Which certainly helps in this environment.
Thanks. On the balance sheet, from a capital standpoint, you have continued to buy back stock throughout this period, but have pulled back some. Can you delve into how you're approaching share repurchase at this point?
We need to be very thoughtful in terms of how we deploy capital. We acknowledge that we are in the middle of a pandemic affecting the liability side of the balance sheet, that also have led to an economic output that is fairly challenged, we are very likely to continue to see elevated credit losses overall. Not just for Aflac, but obviously for the industry. We need to take that into consideration, our response to that has been to travel with more capital in the operating subsidiaries so that we can absorb any shocks that comes through any investment losses or increases in COVID-related claims. We also made a decision to increase the cash position at the holding company as well by issuing $1.54 billion of debt in the month of March.
What that essentially does is that it creates the flexibility for us to continue to be active repurchasing our shares. Now, we do felt that obviously in the height of the uncertainty in the second quarter, that it made sense for us to reduce the pace at what we're buying back shares. Going forward, we're going to be very tactical in terms of how we approach it. We're going to look at what our economic outlook is, what our sort of, let's call it, health outlook is, what the capital positions are of our operating subsidiaries and cash of the holding company, take all of that together, then also thinking about the different sort of deployment opportunities that we have. All of that leads to us making decisions where to allocate capital and what returns we're getting on those potential investment opportunities that we have.
That is sort of how we think about and eventually arrive at the level of share repurchase.
You mentioned the strong capital position and particularly at the holding company at this point. I believe your liquidity is about $2 billion above your target. As we do get past the pandemic and hopefully as the economy normalizes, what are the potential uses of that excess wholesale cash that you have built up?
We will address this at FAB coming up in November. I would say that historically, we used it for essentially three different paths is where our capital has gone. Starting with the dividend, it is something that is very important to us. We are a dividend aristocrat, and we intend to continue to be a dividend aristocrat. It is a great way for a CFO of Aflac to become unemployed by cutting the dividend. There is no plans to do that. We have been a very active repurchaser of our own stock, and we continue to obviously evaluate and look at that. More recently, you have seen us being a little bit more active in terms of deploying what we deem as opportunistic capital deployments. In the last 12 months, you have seen us make an investment in a dental company, Argus.
We entered into a reinsurance transaction with Zurich for employee benefits business. We took a strategic investment stake in Varagon. These are fairly small individually in terms of the capital commitment. Taken together, then it becomes a little bit more of a meaningful amount. This is how we sort of view that we want to continue to equip the company with what we deem to be significant growth opportunities for us, so that we position the company for a higher growth rate in the future.
Is that how you plan to continue to pursue any M&A in terms of more pretty small bolt-ons that add capabilities? Or would you contemplate a bit larger M&A opportunities over time?
I will always reserve the right to do whatever we think is the right thing for the company. Generally speaking, I would say that we operate in a very profitable niche market in the U.S. and in Japan. We do that quite well. We know that quite well. To venture out to most of the adjacent businesses and areas tends to be lower return on capital areas. They tend to be somewhat more competitive as well. I would say that that's not lost on us. The opportunity to deploy significant capital within our niche businesses is quite difficult Therefore, that is essentially what has led us historically towards more of deploying capital in terms of increasing dividends, share repurchase, and these sort of smaller bolt-on acquisitions.
Got it. In terms of the M&A that you have done, the bolt-on M&A in the U.S., how do you see those contributing together to the growth outlook over the next several years?
They should be meaningful contributors to our growth rates going forward. Obviously, if you look very near term, you will primarily see it in terms of sales. Over time, obviously, this will build through earned premium as well. If you take a longer-term view, so let's say over the next five years, I would expect that the bolt-on acquisitions that I just mentioned, I would expect that they will be a meaningful growth contributor to us.
Got it. In Japan, from a capital standpoint, just these are two related questions. One would be how you're thinking about the appropriate solvency margin ratio target relative to the 900% plus that you're currently at. Related to that, you have been an advocate of Japan adopting an economic solvency ratio. Where is the FSA at in considering that?
Yeah. Generally speaking, our risk appetite is to be north of 600% SMR. I would say this, that it depends a little bit where you have some of the most important factors that goes into the SMR calculation. That obviously being interest rates, credit spreads, and FX. What that means is that the optimized SMR is somewhat of a moving target. The higher unrealized gains you have, the higher that optimized SMR will be. This kind of moves around a little bit. Right now, I would say that north of 900%, given where interest rates, credit, and FX are sitting at the moment, is a very strong capital ratio that we're very, very pleased with. In terms of optimizing that, it's something that we always evaluate how to manage this, but we feel pretty good at where we are right now.
Turning to ESR, this is a very important initiative that the FSA are driving. Right now, we continue to be in field test status. The working assumption that the FSA has put out is an introduction in 2025 on the ESR capital regime. For Aflac, that is a very morbidity driven business, and we're not very much an investment risk driven business. We view this as quite positively. It brings us closer to being able to manage the balance sheet with a more economic lens, which obviously is positive. It would also bring better stability to our capital ratio in Japan, as it's not to the same extent as sensitive to especially credit spreads. That is something that can very quickly widen out, and you, from time to time, do get dislocations in credit markets. This certainly will help us.
That's part of the reason why we're very much in favor of the ESR work that the FSA are conducting.
All right. Well, we are out of time. Thanks a lot, Max and Aflac for participating, and we will wrap it up there.
Thank you very much. I appreciate the questions.
Thanks.