We'll get started. First, thanks for joining me this morning. I've got Fred Crawford, CFO, soon to be COO, and Max Brodén, Deputy CFO, soon to be CFO. Appreciate you guys being here.
Thank you.
Last week on your 2020 outlook call, and earlier this year at the financial analyst briefing, you spoke about investing in the business for growth. This has been characterized as a three-pronged approach that includes buy-to-build M&A, core new business incubation, and venture capital investing. I'd like to kick it off just for the discussion of these strategies, and particularly where you feel you have a clear line of sight on opportunities that'll translate to revenue and earnings growth.
Sure, let me just start by saying that as a mature company in our particular segment of the industry in Japan and the U.S., and by mature meaning 25 million policies in Japan and 13 million policies in the U.S., and number 1 market share, there's a natural challenge that a company like us faces, and that is top-line growth. Fortunately, the quality of the business that's been put on the books over many, many years is very high quality, so it's throwing off significant capital. We're now in a stage where we're shifting a portion of that excess capital to reinvest in the business for growth, that's what's behind these drivers.
One thing I do want to make sure we're clear on is that the blocking and tackling on a day-to-day basis of product development and productivity improvements and natural competitive moves to gain share remains, and that continues to be job one. The examples that you have raised, Alex, are really where you now start to deploy incremental capital towards essentially non-organic growth initiatives. Clearly the one that has the cleanest line of sight is the buy-to-build strategy. From an acquisition standpoint, we're a fairly clear story. We don't typically find value in large-scale transformative acquisitions. The main reason for that is when you bring our brand and our scale and our distribution depth and breadth, there's not a heck of a lot of value we tend to see in paying goodwill, if you will, or a premium for a property.
We tend to be the one looking to breathe a growth rate into whatever the property is. We do lack certain domain expertise, and in the U.S., that's particularly around what we would call the first page of the benefit enrollment platform. That would be network dental and vision, True Group Life, and True Group Disability. Those would be the primary areas that we would seek to leverage. We call that the first page because as all of you sit down each year and enroll in your benefits, it tends to be on the, quote-unquote, first page of what you're enrolling, along with major med and 401K, et cetera. Our products tend to land on the second page of the enrollment, and as a result, we suffer with getting penetration in the accounts we go after. Our choice is to buy-to-build.
Let's get the domain expertise, most recently buying Argus for dental and vision network capabilities, and then we will bring the clients to it. One very unique nature of Aflac to always keep in mind is we have, in the U.S., 470,000 businesses we do business with, but 400,000 of those clients have 100 or less employees. If you think about the world of the first page of benefit enrollment, it tends to be driven by brokers and driven in the large case or medium case, i.e., employees of 500 and up, 1,000 and up, where we have built the company in the U.S. on small businesses.
When I say that, you can see why we would naturally be more a buy-to-build, because I'm not interested necessarily in paying a big premium and a large purchase price to have an upmarket company, because I ultimately need to bring it down market to make a difference for our franchise. We see most of the growth rate in buy-to-build, and that is in dental and vision right now. We are interested in True Group Life and Disability. Then on the other end of the scale is consumer markets, which is more the incubation. Incubation meaning the direct-to-consumer sale of insurance.
That actually leads into my next question. I was interested just in the project that was, I think, announced around the financial analyst briefing last year to go direct-to-consumer. We'd just like to hear where that stands. You talked a little bit more about it last week. What does the timeline look like? How much growth potential do you think that could have?
We have a direct-to-consumer initiative in the U.S. We also have one in Japan. Max actually led the charge on our investment in Singapore Life, which is a direct-to-consumer platform in Southeast Asia. It's allowed us to have sort of a global vantage point on D2C. A couple truisms about direct-to-consumer that you will realize very quickly is the conversion rates are very low, and the way to think about the economics of this business are the marketing cost to annualized premium you generate. That is the formula that drives return on capital and IRR. While the marketing cost will tend to be less in direct-to-consumer, as you would expect versus an agent-driven model, the conversion rates are extremely low, down around 1%.
No matter what company you talk to in the life space and the health space, with very few exceptions, those conversion rates tend to hover around 1%. The way in which companies are now taking advantage of those platforms is through lead generation, moving it back into making their traditional agency channels more productive. Right now, that's what we're working on in the U.S. is direct-to-consumer build, but with the idea of leveraging the data to also create lead generation to take advantage of, frankly, the company's brand in the U.S. and Japan. One comment I would make is you're going to find us moving slow. It's not because we're slow, it's because there's a very unique nature to our product that you have to understand.
Imagine for a moment, people universally waking up in the morning and saying, "I'm going to go online shopping for supplemental health insurance." You have to think to yourself, what might be the drivers of a population that's looking for that kind of a product? In other words, what I'm telling you is adverse selection is a huge risk in our line of business. You want to measure three times and cut once and be very careful and calculated. We know how to do this, but because of that dynamic, it's going to be gradual. It's sort of a good news, bad news. The bad news is that makes direct-to-consumer a little more difficult and tricky to build. The good news is it makes direct-to-consumer less of a threat to our core business model.
Maybe if I switch gears over to Japan specifically. It was mentioned last week that there won't be as many product launches in Japan in 2020, and that 2021 would be a more productive year. Can you discuss what's the dynamic that's causing this, and what would you be looking to do in 2021 in terms of updates?
Well, we tend to run a cycle of every two years or so, we in some way refresh or update our medical product. It's typically on roughly a three- to four-year cycle for the cancer product. That has been our pattern over the years, and that's not necessarily a policy move on our part. It's really more that tends to be the cadence of advancements in medicine, advancements in treatment, a need to remain competitive in the marketplace because it's a crowded marketplace, particularly on the medical side. You'll tend to find that cadence.
More recently, you've seen some of the product development slow only because we've gone to a rider strategy where that policy, particularly on the medical side, can remain in place, and through adding riders to the policy, the policyholder gets the upgrade or has the ability to upgrade their current coverage without lapsing an old policy and buying a new one. That has slowed what we would call the sales, because it ends up being a rider addition. It is also much more efficient because it costs a lot of money to generate and build a product and launch the product as a company our size in Japan. That's been the dynamic. What I mentioned on the outlook call is that we are going to be providing a more simplified cancer product, if you will.
The treatment is simplified, that will be done in 2020, and that will help on the cancer side to refresh that dynamic. You would expect the normal cadence on medical treatment from there on out. I would expect medical would follow in the next year as one area to address. We do look beyond medical and cancer, of course. We tend to side towards riders on things like disability and nursing care because it's an easier sale in our process. We do look to expand, but that's primarily through rider additions.
I want to add that you're going to see us utilize more of a rider strategy going forward because, like Fred mentioned, the cost of putting a refreshed product on our systems costs quite a lot of money. Putting a new rider on it is a lot easier. You have less of a cost as you implement this sort of new product or this new coverage. A consumer can achieve essentially the same coverage through just adding one or two riders versus a full new refreshed product. You also then do not necessarily pay out the same commission levels that you generally do for a full new product if you lapse an old and you buy a new one. The commission on the rider is significantly lower. For us to deliver that product to the consumer is cheaper as well.
The return on capital for us is significantly better in a rider strategy versus a full refreshed product strategy.
Maybe next on Japan Post. Can you provide a general update on this distribution channel? There's been a focus on the sales, and I think you guys guided to 20%-30% down 2020 sales. If you could just talk about what's going on there in terms of correcting it. What does the timeline look like for a more normalized distribution channel?
Based on our dialogue with Japan Post, they are, not surprisingly, heavily focused on taking the appropriate corrective action necessary to make sure their policyholders are treated properly and fairly. That's what is consuming their time right now. As we mentioned on our outlook call, they anticipate being largely through that process as they end the year and perhaps into early next year, they expect to be back to business starting next year. Our view is from a sales perspective, and to square it for you, we're projecting about JPY 12 billion-JPY 13 billion of sales in 2019 in Japan Post, down 20%-30% from that is our current planning estimate. This is not something we've agreed to with Japan Post. This is not based on some sort of ground-up analysis, which would normally be the case.
This is simply a placeholder to have some estimate of premium flows into the year. It's strictly a number for planning purposes. Based on our conversation with them, we would expect to have a slow start to the year in 2020, then see more recovery in the latter part or the second half of 2020. That's our anticipation. That's how we folded the pattern of sales into our planning. Again, according to Japan Post, they are certainly hopeful to get back to business in 2020. That's their goal, but right now they're very focused on addressing the issues.
Okay. I guess, sticking with Japan Post for a minute, in 2018, you announced a deepened partnership with them on a number of fronts. Two of the items that were mentioned were product development and the potential to invest in joint ventures, and I think it was mentioned, potentially in different geographies. There's been some distraction since then. I'd just be interested to hear, how is the planning phase of that going, and has it changed the timeline at all?
Yeah. Very candidly, the planning process stalled out for all practical purposes during this period of Japan Post looking inward and working on their issues. That's a natural thing, and it's straightforward that that would happen, and we want to allow them space to address those issues because frankly, from a long-term perspective, that's the most important thing for us in the relationship. I think when they talk about getting back to business in 2020, and we talk about the expectations of getting back to business in 2020, that includes working on the alliance. In the interim, we've done a few things. They're quite tiny, but we've made some joint venture capital investments together.
We have a venture capital fund of about JPY 400 million, which includes making investments in Japan, and we've had a couple of opportunities where both Japan Post and Aflac in Japan see opportunity in a particular investment. There has been some working relationship that's gone on, but the key points that most investors are interested in is the degree to which there's product development that takes place with Japan Post going forward, and possibly other larger scale strategic investments. Those things have been put on pause for a while, but again, we would expect and hope that we get back to conversation and dialogue in 2020.
Got it. Maybe in Japan, on just some benefit ratios, they've continued to trend quite favorably for a number of years, and I think there's a series of factors. I'd just be interested to hear about what's been driving it more recently. Is it really just a continuation of hospital day stayed? How much is the mix shift contributing, and how powerful is that when it comes to sort of the annual downward trajectory of that?
The primary shift has been mix. The primary move in the benefit ratio has been the mix shift really in recent years. The third sector standalone loss ratios have in fact held favorable and trended marginally positive. That includes also reserve releases on cancer blocks as we see more and more actual to expected favorable results in claims activity. That follows the trends in the business with medical advancements. That is a relatively minor contribution to the overall aggregate benefit ratio coming down. The main has been product shift.
What I want to really remind people of is that same shift in product that moves the benefit ratio down, meaning as more of your in-force moves from first sector life insurance to the much more active claims paying, expense driven third sector business, you have natural lower benefit ratio in third sector and higher expense ratio because of the more frequent claims activities and so forth. One thing to keep in mind is that you do indeed have downward pressure on benefit ratio, but realize you have a bit of upward pressure on expense ratio. If you notice, you see very little impact to our pre-tax profit margin. It's really just the nature of the mix of business. Don't get overly excited about a lower benefit ratio because remember there's some offset in expense ratio.
Get more excited about the fact that this is very high embedded value economic business and much better over the long run than first sector savings business given the low interest rate environment.
All right. The next one's on the asset side of things in Japan. New money yields and the portfolio yield in Japan have held up quite well, and part of it's driven by the U.S. dollar denominated investment program. I think this program's expected to reach $28 billion, while the hedge ratio is also coming down a little bit in 2020. How do you think about the limits of what you can do here? How big can you take it, and how low do you think you can take the hedge ratio?
There's investment strategy that dictates the allocation to U.S. dollars, and that we would characterize as our strategic asset allocation. The limitations around capital management, which is a significant part of what Max currently does and will continue to do on the CFO side. Maybe I'll have you give some color, Max, from your perspective, but keep in mind those two things, NII and capital management play into this.
Yeah. The SAA will dictate how much, to some extent, we would like from an investment standpoint when we create the efficient frontier. When we look at the efficient frontier, we do have more capacity in order to increase our U.S. dollar exposure in the Japanese general account. At the same time, that consumes capital. That also then overlays with a return on capital calculation because the additional capital will need to get a good return on that as well. The more U.S. dollars we hold There is an exponential capital requirement for that because we're putting on more credit risk exposure, et cetera. That drives up our capital requirements, so that becomes a constraint. The third piece is how much U.S. dollar exposure do we want overall, not just in Japan, but also when we take the enterprise lens.
How much U.S. dollar exposure do we want associated with our Japan franchise as an enterprise? That's also a constraint. It's sort of these three and the interplay of those that sort of guides us how much U.S. dollar exposure we would want within our Japanese business. We do think that we have room to grow that further from where we are today, but we are in a fairly good position where we are.
Got it. One thing that we think more technically about is the amount of unhedged dollars in Japan. I say that because the amount of unhedged dollars, don't forget, as a shareholder in Aflac, yes, there's increased net investment income from a U.S. dollar portfolio versus investing in yen, but there's also a protection component for you, and that is an unhedged dollar in Japan essentially protects you against a weakening yen on the economic value you own in Japan. 70% of our economics are in Japan, and our market cap, as you know, is up around $39 billion. You can do the math on how much of a value you own in Japan when you buy a share of our stock. We want to protect that value against a weakening yen, and holding a level of unhedged dollars in Japan helps protect you.
It's a form of hedge, and we think an awful lot about that. The flip side to that, though, is when we do too much of that, you have FSA earnings and SMR volatility, capital volatility in Japan, and that acts as a governor. Max and I and Eric Kirsch, we tend to think with the broad lens of NII, capital management, risk management. It takes all three to develop your strategy around U.S. dollars. It's not just an NII. It's a mistake to think of it as strictly a strategy because, of course, low interest rate in Japan. It's not that simple. It's providing multitude of benefits as a shareholder.
Next on the regulatory environment, could you provide a brief update on what you're seeing there in terms of economic solvency ratios, fiduciary standards, if there's anything else that's notable going on?
Well, primarily, we do see some development in terms of economic solvency ratio. Just to recap that the FSA in Japan are currently field testing an ESR ratio. You should think about this ratio as not too different from a Solvency II framework, essentially. We do believe that this is very good for the industry. It aligns the economics with the capital ratios in a better way than the current SMR regime. We view this as quite favorably. We report out on a regular basis what our ratios are. At FAB in September, we indicated that at that point in time, our ESR ratio was in the range of 115%-130% without a UFR.
If you include a UFR, that would add about 80 points to that ratio, that takes you up to 195%-210%, which is a very healthy level of ESR. Keep in mind that since then, the JGBs have increased in rates since then, creating a tailwind to that ratio as well. When we look at the field testing being conducted, we feel quite comfortable with the levels that we are at. As a reminder, this is not expected to be implemented until 2025. We would anticipate to be in a field test environment for quite some time.
Got it. Maybe we can pivot over to the U.S. You talked a little bit about the focus on getting to the first page of the open enrollment. I know you're at the smaller end of the market as well. How much competition are you facing in trying to do that? I know some of the bigger companies have talked about going down market. I don't know if they're going all the way down to some of the smaller groups that you're focused on, would be interested to hear.
Yeah, that's really it, Alex, in the sense that when you're talking about the, as I mentioned earlier, 400,000 clients that are in the small business category, that is a less crowded, a less spreadsheeted, as you would say, environment. We have a very unique business model to get to it. The 8,000 average weekly producers and 20,000 active licensed agents that write business periodically throughout the year in the U.S. is a very unique army of agents that focus on small businesses. That was really the formation of Aflac in the U.S. 65 years ago, it continues to be a machine that should be respected and understood in the marketplace. It's a very difficult agent force to grow, quite frankly, it tends to be the unique economic model necessary to address that type of the market efficiently.
When you go down in those markets, it's less competitive. As soon as you pop up into the broker-driven markets, particularly in the 1,000 and up employee level, you're now getting very competitive very quickly. Probably the biggest competition that we see is what I would call the bundling approach that takes place in the market. Think of it this way, there's 2 types of bundlers in the market. One is the large major medical players that often bundle with things that are of a network nature, like dental and vision. Okay. They are looking to include voluntary product where necessary to support their returns and support and build out their relationships. The other bundlers in the market are the true group players, True Group Life and Disability that are looking to bundle with voluntary product, quite frankly, because it carries a higher return.
There's no secret that the returns that Aflac generates in the U.S., both IRR and pre-tax profit margin, are significantly better than both network dental and vision and true group life and disability. The downside is that the penetration really lacks. What we are trying to do is come onto the first page and look for opportunities to restyle that, to bring it down market and make it available for our agents, because that has multiple lift associated with it, the so-called halo effect. One is we see a lot more employees. On average, things like dental and vision will have 80% penetration in the employee base. True group life and disability will have 50%-60% penetration. Our products struggle to get to 15%-20% penetration. Give you an idea.
If we can see more employees and get the Aflac product in front of more employees, we have opportunity to upsell and cross-sell the voluntary products to make a good return out of it. That's really our goal. We don't get too squeezed on competition because the brokerage market is paid to find the best of class. What they will tell you is when it comes to the voluntary product, Aflac is still a recognized name, a brand that is loved. Customer service and One Day Pay are great advantages that we bring to the market. A broker tends to recommend Aflac on the voluntary side and move away from bundling.
Oftentimes, the head of HR of a large company wants to save and needs to save money, the reality is they look to bundle from time to time, that's where the competition comes in.
The fourth Q's become a pretty important quarter in terms of sales because of seasonality and so forth. Producer counts are down a little bit, I think, recently. I'd just be interested to hear how fourth Q is shaping up in the U.S. in terms of sales and the impact that you're seeing from producer counts.
Yeah, I think it's shaping up to be somewhat traditional in its pattern, meaning that not only is it the fourth quarter that is the larger quarter for us in the U.S., but it's literally the final weeks of the year. In fact, at this point in time in the year, it's not uncommon for us to be getting effectively daily updates on how things are tracking. That's because of the simple timing of the brokerage market and renewal of large group cases in particular. What makes it a very difficult fourth quarter to predict is that it can really ebb and flow by a percentage point or two, even on a big case that you may win or not win, lose in the final stages. We would expect that pattern of late in the year pick up relative to the trend throughout the year.
The fourth quarter as compared to last year's fourth quarter, that's a bit trickier. There's no question that the average weekly producer count in the traditional market, the non-group market, okay? That has struggled and continues to struggle with a decline in average weekly producers. That decline, by the way, is largely driven by economic conditions where it's more difficult to attract people to the platform and retain people. To get to average weekly producer means that you have a regular status of generating week in and week out product for Aflac. That takes training and time, and it's difficult to retain agents when a strong economy offers a non-commission-based stable level of income and benefits. It becomes more difficult. We're starting to work on that through recruiting and retention practices, adding things like dental and vision.
We just recently refreshed our life insurance products, are all designed to help these agents make a living, make more of a living, and have a little more staying power. One thing to keep in mind is when we move to the first page, as we mentioned on enrollment, we're also giving these agents more ammunition to sell and make a living. It starts to support the retention of your agent force along with the retention of policies.
Just like sales are tilted towards the fourth quarter, so is expenses, because keep in mind that our premiums and our revenues, they run fairly equal throughout the year, while our expenses, i.e., commissions, particularly in the U.S. With these higher sales volumes comes higher commission payouts and other expenses associated with that activity. Not all of that is being DAC'd. Therefore, we tend to seasonally run a higher expense ratio in the fourth quarter. In addition to that, we also tend to have higher project spend. That's consultants, et cetera, that tend to have the billing come in in the fourth quarter more than in other quarters of the year. For those reasons, we tend to have a higher expense ratio in the fourth quarter as well.
This might be my last question before I open it up to the audience, just to give you guys a head start here if you're thinking through questions. I guess, maybe next on GAAP accounting and the Long-Duration Targeted Improvements. You've offered up a little bit more than a lot of your peers in terms of the impact, which is appreciated. I guess, could you talk a little bit about what is it about these asymmetries with the hold-to-maturity and the morbidity margin not being released that's really driving those conclusions? Maybe if you could talk a little bit about cash flow and the cash flow capacity, because it seems like all this is just going to drive us further towards that as the main metric, really.
Yeah, maybe I'll make a few comments on the accounting just relative to our business model, then Max can comment on the cash flows and those dynamics. Just in general The FASB, they are after the right intent, meaning transparency into how the company performs in terms of loss ratios and the like, and seeing that run through the financials. The FASB didn't wake up and say, "Let's do it this way for companies that have 70% of their business in Japan and 13 million cancer policies outstanding." It's a one-size-fits-all application to the accounting, each business model in the industry is going to have slightly different outcomes when applying it.
In our particular case, if you think about having a large Japanese business and you think about having 60% market share in the cancer market with 13 million policies outstanding, the cancer product is a natural product that has the majority of its profitability driven by morbidity profits and has relatively low interest rate exposure. Okay. The low interest rates and the natural ALM disconnect, because ALM is not really as sensitive a dynamic in a morbidity product, that is getting accelerated up and booked in AOCI as an accelerated loss. Future loss is accelerated and discounted in the future by applying a low discount rate to the liabilities. What's not getting brought up and accelerated into the balance sheet is the morbidity margin. That gets taken over time.
What I've been telling investors is, look, when you finally see our financial statements, you're going to see a negative number in the current low interest rate environment in AOCI, that, to some degree, is real in the sense that there is indeed a lower interest rate environment than when we originally booked the product. It is overwhelmed by morbidity profits, you'll see that in a net premium ratio that will contribute more earnings. Unfortunately, I'm taking that morbidity margin over time, I'm accelerating in AOCI, okay, the forward view of the losses. What exaggerates it is that I have JPY 30 billion of assets held in HTM. Why do I have it held to maturity? Because then it's less volatile for my SMR ratio.
That held-to- maturity gains, the gains in that portfolio, are not showing up in my AOCI, so I don't have a gain offset on the discount rate applied to liabilities. The key here is that we have to explain how our business model, okay, results in a certain outcome on GAAP, reconcile that through non-GAAP measures, and then move forward with the real economics of the business, which is cash flow.
The cash flow answer is actually really easy because there is no impact. There's no impact on our statutory capital ratio in the U.S. or our capital ratios in Japan. That makes it a relatively simple story. I think that in the communication that we have with all of you, we more and more are going to talk about measures like cash flow, like value of new business, IRRs, cash payback periods, et cetera, because that is really what's going to bridge the gap. There will be volatility introduced, and it's important, I think, that we as a company stay focused on the economics of the business. We need obviously to understand and report all the GAAP numbers, and so do you, but also that in this conversation, that there is going to be an increased focus on cash and economics.
We may have just time for one question if there's anybody that's got one. All right. Well, with that, I'll leave it there. Thank you very much for joining us.
Thank you all. Thank you.