We'll get started. We're very excited to have Fred Crawford, CFO of Aflac, with us today. For those of you less familiar with Aflac, it's a supplemental health and life insurance provider operating in both the U.S. and Japan. The format we're going to use today is a fireside chat. We'll go straight into it. First, let me say welcome, and thanks for being here with us.
Thanks, Alex. Appreciate it. Thanks for inviting us.
Absolutely. I guess to start, maybe we'll talk about the growth avenues in Japan. If you could discuss some of the strategic shifts that have been occurring there over the past few years, new distribution partners, and how you see the third sector evolving over the next couple of years.
In terms of some of the dynamics affecting our growth rate in Japan, I would say a couple things. One is there are some underlying catalysts that we think support our business model in Japan. Most of you are familiar with the challenges of economic growth in Japan and the aging population, the aging and shrinking workforce, and those are all dynamics that certainly weigh on economic expansion. They weigh on the capital markets in Japan, interest rates and the like. In our business, those same sorts of dynamics are bringing about an aging population in Japan. With that aging population is a natural increased demand for supplemental healthcare policies, both medical and particularly cancer. The other dynamic you're seeing is that same population dynamic is also putting financial pressure on the Japanese government and the sustainability of their national healthcare system.
They are shifting more of the burden and have been shifting more of the burden onto the Japanese policyholder or Japanese citizen. That has made for greater opportunity for supplemental health coverages, like what Aflac provides. As a leader in third sector, which is essentially medical cancer-related products, that puts us in a good position to continue to grow and build the business. Having said that, though, the medical business in Japan, medical supplemental business in Japan, is very highly penetrated, in and around 70+% penetration. It's also very crowded and very competitive. Unlike the cancer business where we have, in our case, 60% market share, it is a less penetrated business, approaching, say, 40% penetration, and we see awareness picking up, and we see the demand for our products picking up.
We have been actively engaged in really a couple different strategies in Japan to try to ride this catalyst and this opportunity. One is we periodically refresh our products. Every other year, we refresh our medical product, and that stays current with the types of coverage and treatments in the system in Japan. That usually provides a catalyst to sales and a boost to sales in the year where we're refreshing the product. In the case of cancer, it's about every four years that we refresh, and that provides a good jump to the business because there's been lots of advancements in medical treatments, inpatient, outpatient in particular, advancements, and then early detection and forms of experimental treatment have become more normalized treatment for cancer. All of that means an expanded opportunity for coverage and demand for the product.
Those are the things that are sort of driving our third sector business in general. From a strategic shift standpoint, what we did do, however, is we pulled back more dramatically from first sector savings products. These would be traditional type of annuity, cash value, life insurance type policies, deposit-oriented products. That's because of not only the low interest rate, but also the reserving requirements on those products are quite strenuous. You end up really having difficulty achieving the internal rate of return you want on the products. We've priced those products accordingly, and we've seen a big pullback. That's helpful in that it positions ourselves for more economic value growth in Japan because we see much more value over the long run in our third sector core business.
Maybe you could talk a little bit about some of the investing you're doing to spur more growth. I think you talked a bit about it earlier this year at the financial analyst briefing, some of the things you're doing with digital investing, investment in distribution and so forth. Can you talk about some of those things? What are the tangible things that we can think of that are contributing to growth over the next couple of years?
Yeah. In Japan, we can't just be cancer medical cancer medical. We have to expand our product line, and we've been doing that in terms of new forms of, say, income or disability supplemental riders. We've now put renewed focus on first sector protection products, which is more morbidity products. On the digital front, we've also developed a digital product. This is a product that is a medical supplemental product, it can be purchased digitally, i.e., you can purchase and manage the product from your cell phone. Also, it's been designed around the millennial population to open up a new demographic. It is a health underwritten product, meaning it taps into biometrics, and if you maintain a healthy lifestyle, we can underwrite your health age as opposed to your actual age.
If you're 40 years old but have the health characteristics of a 35-year-old, we can underwrite you to 35. The way it works is in the form of a rebating, if you will, a refunding of your premium. You'll get premium back if you maintain those types of health statistics over time, over the life of owning the policy. It opens up a younger demographic. It creates a digital avenue to sell product. It creates natural persistency because you're now incented to not only remain healthy but hang on to this product as you remain healthy. You get rewarded, if you will, each year as you maintain your health and hang on to the policy. Because we've attracted a younger generation, we can now carry that generation into the older years when they start considering broader medical supplemental coverage, cancer coverage, disability coverage, et cetera.
We also see it as lead generation in Japan for traditional agent sold. Beyond that, in Japan, we have opened up an innovation shop in Shibuya. Shibuya is the technology center of the Tokyo area and Japan. We have a floor there, effectively, it's a portion of a floor of a building that has been retrofitted around innovation technology and more of a lab and research. There we are developing. It's where we have our venture capital investments that we make. It's where we incubate new ideas like the GAP product, which is this digital product I mentioned. In that area, we're looking for opportunities to where we can provide digital solutions to pain points in the customer experience, do a similar thing in the U.S.
The pain points for buying insurance in general, whether it be in Japan or the U.S., is what I would call a target-rich environment. It is not an easy buying situation for most clients, and even when you have the policy, it's not necessarily an easy situation for you when you go on claim and you manage and work with your insurance company. We think we're one of the best at it. Things like One Day Pay and other things make our particular franchise very good. We look for those pain points, whether it be the policyholder, the agent, the broker, and we use digital technology or digital means to close that pain point. It's as simple as that. Maybe we can eliminate the pain point. Oftentimes we can't eliminate it, we can shrink it quite dramatically through digital application.
That's everything from using optical technology, voice recognition technology, being able to do more things on your phone, be more self-service, and that's where we're making investments. In the U.S., we have a similar lab, only it's in Charlotte, North Carolina. We bought a company in Charlotte. It's not an accident. As you know, we're sitting here at a financial service conference. Charlotte is the retail headquarters for Wells Fargo, Bank of America. There's a tremendous fintech environment in that area of the country. For us, it was a nice natural location for us to house and build up some technology and digital expertise, both in company and outside the company. There we're developing our direct-to-consumer business model as well as incubating other technologies that we think can change the customer experience.
In the U.S., that customer experience is largely revolving around the small business customer experience, the agent experience, the broker experience.
I guess the next question I have for you is just around how this all translates to revenue growth. I think the revenue growth you all guided to is, I think it's actually a decline in revenue, at least in the near term. It feels like there's maybe this disconnect between how much effort's being put into the digital initiatives and the investing you're doing relative to other peers in the life insurance industry and sort of like the fruits you're bearing from it.
Yeah.
Would be interested to hear, when do you expect to really start benefiting from some of these actions you're taking?
I think if you're not known as a digital industry, technology industry, to me, it stands to reason that investors in particular would say, "When you show me the money, I'll get more encouraged." I personally think it's rational that investors and observers would say, "I want to see the fruits of these investments before I'm convinced that it can mean more dynamic growth for the company." That to me is very reasonable. We just have to stick to our knitting and invest. The thing I would say to you is the areas we think have great opportunity is, 1, we think digital delivery of our product is a new area and a dynamic opportunity both in Japan and in the U.S. We think the demand for product on that basis is maturing, and it's going to continue to mature.
The market share of digitally delivered insurance product is growing, but it's still a small part of the marketplace. What I like about our product is it is a simple product. We do not have a complex product. It's a very simple product to understand. It serves a simple purpose. It pays you cash directly. We have every opportunity to have a great customer experience and a very satisfying experience as compared to most complex forms of insurance. We sell in the U.S. at the work site, the work site is naturally demanding more technology and more customer-centric ease of doing business for their employees. We have a lot of opportunity to, I think, make inroads on the digital side as a company over time, but it's going to take time.
This is still an industry where the products are largely still sold versus bought, which means I think you're going to see a combination of true direct-to-consumer digital and agent-assisted digital platforms to deliver the product. It's all about customer ease of doing business. That's really what it's about. Now, from Aflac's perspective, something to be mindful of is, yes, we suffer from the law of large numbers and 60-plus years of success and high growth rates in the U.S. and 40-plus years of dynamic growth rates in Japan. By that, meaning when you have 26 million policies in Japan that lapse at 6% a year, you've got 13 million policies in the U.S. that lapse at north of 20% a year, you have to have one heck of a sales-generating capability to keep pace with that natural lapsation in the blocks of business.
That means your earned premium is going to be challenged to grow beyond the low single-digit type dynamic. In the U.S., we're growing in the 2%-3% range earned premium. In Japan, we're actually coming down 1% because we made the proactive decision to move away from first sector savings, which brings assets and investment risk and other things that could be challenging in Japan. Meanwhile, our third sector is growing at the 2-plus percent rate. When you have the dominant market share we have in one in four households in Japan and 460,000 small businesses that we work with in the U.S., where we're three times our next largest competitor, growing at those low single-digit levels is not a small amount of growth in actual premium, actual JPY.
If we can maintain our margins, that's a good bottom-line growth rate, particularly when you're using excess capital to buy back stock on top of that. With that maturing business model, you start throwing off a lot of cash flow. I think what's very important for us is that we need to segregate out a portion of that cash flow to make sure we're investing in that next generation of technology and digital. It's both offensive and defense. You've asked the question in an offensive way, remember, there are players out there that could look to disturb the marketplace we're in, and we want to be the ones that would get there first if there is such a technology or capability. We're playing both defense and offense with our investments, both protecting our franchise and looking to grow it.
It's going to be next horizon type growth. There's no question. It's not going to be something. We're just not the type of business model, our industry is not the type of business model where you wave a wand, and all of a sudden, sales are up dramatically. In fact, we're in an industry where if sales are up dramatically, there's an old saying, if it grows like a weed, it might be a weed. That is the situation in the insurance industry. You're going to be asking me more questions if the growth is too dynamic. What kind of business are you selling? What kind of risk are you taking? What is the underwriting of it? Have you priced it properly? Those are all questions you'll ask me, so we want to be measured and careful about it.
I guess a related question. You mentioned persistency lapses. I'd be interested if you can talk more about just some of the dynamics in Japan with lapsation and what it's done to the benefit ratio, and where you'd expect that third sector margin to trend as a result of these lapses occurring.
Number one, we enjoy very strong pre-tax profit margins both in Japan and the U.S. In Japan, our pre-tax profit margin has been hovering around 20%, which is as strong as any part of our industry, frankly, including in Japan. We have very good margins in the business. We have very stable and high-quality margins. We're a morbidity play, and so we tend not to see too much in the way of volatility in our morbidity when you've got 26 million policies outstanding in Japan and 13 million in the U.S. It's a very high quality, very stable and consistent, and strong margin we have. When you look at things like the dynamics that are at play in that, let's call it combined ratio, benefit ratio, and expense ratio. In Japan, we have high persistency, okay?
When we introduce a new product, whether it be a medical product or most recently this year, a cancer product, there'll be a level of heightened lapsation for a period of time, because you will have people that own our policies, and because of the marked improvement in the policy, new coverage capabilities, new treatments that are being covered, and other features, they often will opt to replace their old policy with a new policy. The way that works is an outright lapsation of the old policy and the sale of a new policy. On the old policy, you're releasing the reserves on that policy, which if it's an older policy, that's a benefit to your benefit ratio and your bottom line.
If it's a younger policy, you are also typically writing off the DAC or the acquisition cost that you've capitalized, which will increase your expense ratio. In years when we are offering up a new, particularly a new cancer product, where it's been four years since we've refreshed the product, and we're in sizable distribution channels like Japan Post, which is probably one of the other more dynamic strategies that has taken place in recent years, last four years or so, selling cancer insurance in 20,000 post offices. You will see a heightened level of lapse and replacement, and that will play with your benefit ratio in that year, lowering it, and it'll tick up your expense ratio. The bottom line should be either net to the positive or unaffected. That's largely what we saw this year.
A little better pre-tax profit margins because some of the business that lapsed and reissued was older cancer business, we released more reserves than we wrote off DAC. That's not an unusual dynamic, and as a result, we're expecting stable margins into 2019.
Maybe if we could switch over to the U.S. One of the things that surprised me a little bit is just following tax reform, there was some expectation that the pricing competition would maybe grow in some of the supplemental products. Benefit ratios have continued to be favorable. In the financial analyst briefing, you made comments suggesting they are more favorable than sort of how you're pricing today. How much longer would you expect them to be favorable? What are you seeing in terms of competition, in terms of pricing?
There is more competition on pricing. First of all, tax reform did not have a marked impact, in my view, on pricing competition and margins in the sense of we have not seen marked aggressiveness in the products, and I think that's because these are relatively inexpensive products that are sold in the work site through payroll deduction. It's a bit of a different dynamic than you might find with other products in terms of price elasticity. In terms of the actual margins on the product, it's a bit more competitive, as you can imagine, in the brokerage space, because you are being lined up against other products. You, in some cases, face competition from folks that are bundling, if you will, group and/or major medical with supplemental. It can be more competitive there.
Overall, still strong margin business and operating well above our cost of capital, and we have among the lowest costs of capital in the industry. Still a very good margins and very good return on capital. Haven't seen a lot of movement in pricing. Aflac being such a dominant player in the marketplace, we drive, in some respects, some of the pricing in the marketplace. We also have such great scale that we spread our expenses over a great number of policies compared to our competitors. We bring a lower expense ratio to the table, and that allows us to compete. I don't feel as if pricing pressure is the issue. One interesting thing to think about in the U.S. is there's 170 million workers in the U.S., and we do business with, as I mentioned earlier, about 450,000, 460,000 businesses in the U.S.
Those businesses employ approximately 47, 48 million of that 170 million workers in the U.S. Of that 47 million who have the ability to buy our product at any point in time because it's being offered in their workplace, not quite 8 million of them have our product. That's relatively low penetration despite our size. The reason I say that is, to me, it's not about price competition, it's about penetration. For every one piece of business I lose in the way of, say, price competition with a competitor, I have an opportunity to sell three or four or five policies by just convincing the marketplace of the value proposition of a supplemental health policy. Price is not the challenge in the U.S., it's really penetration and a recognition of the value proposition of the product so that it can expand the penetration.
In Japan, a little bit different. Cancer we feel good about. First sector protection, we stay in the game, but we're not looking to be a price leader. Medical insurance in Japan is a different dynamic. Very competitive, price competition, feature competition. We have about 16% market share, which is a leading market share, but it's much more heavily competitive. Large players involved, sophisticated players. That's where we will see some challenges in maintaining margins as we go forward as, in my view, is the medical business. We have to be creative to try to defend that.
Helpful. Maybe switching over to capital for a minute. When I look across the different potential sources of excess capital, I mean, high RBC ratio, I think relative to the risk in the U.S., strong economic solvency ratio in Japan, you have a lot of hold co cash. I think you probably have a pretty significant amount of debt capacity. All of these things combined would give you a fair amount of firepower. Is there anything that you would consider beyond just the digital investing that you've outlined that would be bigger and more transformative to the company?
Yeah, it's interesting. Let me just make a couple comments. One, we, by definition, have not been and are not an acquisitive company. It's very important for us to be in the game to understand what opportunities are in the marketplace. What people, I think, don't give enough credit to is being involved in the corporate development dynamics in Japan and the U.S. allows you to get highly educated on what dynamics are taking place in the marketplace. It gives you a better realization of where you have gaps in your strategy, and areas to improve. Every once in a while, you may in fact find a property that makes perfect sense and you want to pull the trigger on it. We don't tend to think of our business model as being in need of acquisition help.
When we look at the gaps in our strategy, there aren't too many. When you've got the leading brand in the U.S. and Japan, the deepest and widest distribution, the largest scale, and you have a broad array of products that meet all the needs of the voluntary marketplace, work site marketplace in the U.S. and supplemental marketplace in Japan, you don't stare at your business model and say, "We really lack the following and should acquire our way into it." Over and over again, what ends up happening is build ends up being as provocative as buy. The reason for it is what we tend to bring to the table is massive distribution. When we have 460,000 business clients and 26 million, one in every four household has an Aflac product in Japan, we're bringing all that access to the client.
We typically would not find it attractive to book goodwill and pay a premium for a property when we're the one that's going to bring the growth rate to the table. You just don't find it to be particularly attractive. When you switch gears on technology and digital and venture and alternative distribution methods, now it gets much more attractive because now you can apply that to all of those core competencies that we possess and really leverage the platform, do something dynamic with, and it often accelerates what otherwise is a longer road of technology. Something to keep in mind is, just to put it in perspective, all the digital investments we're talking about. If you look at our outlook call yesterday, we talked about in next year, we're going to generate between $2.7 billion and $3 billion in the year of 2019 of deployable capital.
If you remove the $ 500 million of excess capital that we're pulling out of the U.S., then you're into a $ 2.2 billion-$ 2.7 billion a year. When I look at all of our digital investments, everything from our $250 million venture capital fund, of which only roughly $ 60 million is invested, I look at the Empowered, which is our N.C., our Charlotte-based property, which I paid $35 million for, plus a $ 5 million contingency, and have about 80 people working there. The Shibuya office in Japan, which is a little office about maybe, say, twice the size of this room, that has 30 or so people in there working on innovation. You're talking about downhill with the wind. I've invested $400 million over the next several years in what I would call digital and venture driving that investment.
That's on generating $2.5 billion a year of free cash flow. This is a very small bet, if you will, in terms of capital investment for what might be the potential payoff of both dynamically shifting and enhancing your business growth and defending the franchise you have. It is just simply a no-brainer to make these types of investments from a return on capital standpoint. We have a $800 million a year common stock dividend. We're 36 years into increasing the dividend, and we plan to do that. We've been buying back our stock at high rates, and I just guided to $ 1.3 billion-$1.7 billion of stock buyback. We are delivering plenty of capital back to the shareholder while really taking a fairly minor chunk out of that to say, "You know what?
We better be on top of the digital technology and innovation side of things, given the business we're in." I think that's very prudent.
Makes a lot of sense. I guess the other thing I wanted to touch on during this conversation was just some of the upcoming accounting changes. The FASB has now issued, I guess, a new accounting regime for 1Q 2021, which is quite a ways out in the future. I think some of your products are exposed to some of the changes related to FAS 60 and some of your, I think the way the Japan business is accounted for and so forth. I'd be interested to hear any kind of color you can give us on that.
Sure.
Any differences between retrospective versus-
Yeah
methodology and your ability to do full retro, if that is the preferred method.
Yeah, I'm happy to. It's interesting when I talk to investors and outside observers, they say it's a ways off. When I talk to our internal accounting and actuarial team, it's right around the corner. That's because it is an enormous project. As you know, for all companies in our industry, it's a significant lift to adopt this change on a timely basis and do it right. We are actively engaged in doing it. I would say right out of the gate, these two big methodologies that you have to decide on, and that is retrospective versus modified retrospective, we have not made a decision on that. I would tell you that the decision framework is very similar to what you've heard from other companies.
We're no different, meaning there's a tremendous amount of work and energy required if you were to choose to go retrospective and needing to go really back into time and gather substantial information. It's a big lift, and it causes most companies to say, "Is it worth that type of an effort? And is that really where we want to spend our time and money? And does it actually deliver a better outcome for reporting our results on a go-forward basis? Is it somehow more understandable, more transparent or what have you?" I think a lot of companies are citing the direction of modified retrospective for those reasons, but we haven't made a decision. The other thing that's out there is will you early adopt?
I would tell you that I don't know where most companies are, the reason I made the comment of just around the corner when you talk about 2021 is, from our standpoint, we would not early adopt. We're more likely to adopt on the timeframe that's been dictated so far. What we are ready to talk about and able to talk about is not numbers and impact, but rather what are the areas of the P&L and the balance sheet that we are focused on. I made a comment, I think a couple of quarters ago, that it's not so much about the new accounting implementation. It's more about one set of rules and conditions being applied to very different business models in the industry and how that comes through. In our case, we have a very unique business model.
We are uniquely 70%-80% Japan, depending on how you measure it. We have a third sector concentrated business and really a morbidity business in the U.S. As a result, we are going to have a unique model when we adopt. What I would say in general is the following, that is we have very strong morbidity margins that comes through in our cash flow testing, and it comes through in our statutory earnings and FSA earnings in Japan. Very strong GAAP margins on gross premium valuation. Those strong and stable margins should still be the case under the new accounting. There'll be more volatility, but more volatility on a business model that is very stable in terms of its pure margins both in Japan and the U.S.
DAC amortization will be strung out a little bit more, that will tend to be a little lower because there are some products where we amortize the DAC quicker, and under the new adoption, it'll be spread out a little bit more. All companies will not have provisions for adverse deviation or pads that applied to the reservings they set up on new products on a GAAP basis. That will mean less reserves as you set up your products, which means a bit more margin, but a bit more volatility because you'll be unlocking those reserves each quarter. I think the other dynamic is really so-called below the line in AOCI. You're going to be applying a discount rate now to the liabilities, much like you have an unrealized gain or loss position on your assets.
You're going to have a similar type position by applying a discount rate to the liabilities. If you naturally have asset liability mismatch, which is typically the case with Japanese insurance companies because we have long duration third sector businesses, don't confuse it with annuities and long-term care and these types of businesses, but long duration third sector and a shorter duration asset portfolio, you're going to naturally have a little bit more variability in the gains and losses on the asset side versus the gains and losses on the liability. If you couple that with being a company that has a lot of held-to-maturity assets on their balance sheet where there's no gain or loss that's recorded through AOCI, you will end up with even a little more exaggeration.
I think what's going to be the case for the industry, and Aflac's no different, is that you'll see the strength you've grown accustomed to in terms of the margins and the earnings power of the company and the stability of the company. You'll see no implications to cash flow, capital generation, and capital usage. Very typical of AOCI and unrealized gains and losses on bonds, you're going to have to explain why those numbers are the way they are and why they react the way they do. What I've said to people all along is I'm convinced the new accounting is going to drive everybody towards economic value approaches. It's going to cause you to pay very careful attention to statutory results in the U.S., and in our case, statutory or FSA results in Japan.
You're going to be looking at the cash flow generation and cash flow yield of stocks. You're going to be doing that because it's going to be much more volatile on a GAAP basis, so you're going to want to see the real economic generation. That piece of it actually gets me excited because our business model is naturally a very strong economic value business model with, on a relative basis, lower volatility. That's what we're building up. It's not just the adoption of the new accounting, but the realization that we need to advance the ball on our economic transparency and metrics in light of that.
All right. Should we open it up to see if there's a question from the audience?
Happy to.
Maybe I'll give you one more. Just in light of the switch trade that you guys have put in, there's been some different asset allocations that have occurred over the last couple of years. Anything you're seeing in your asset portfolio, just in light of widening credit spreads and a bit more concern around credit? Are you seeing anything in your portfolio that gives you any pause? Any of the stuff you bought more recently, any update on how that's performing?
Interestingly, we continue to monitor carefully, frankly, older privates that we bought because they're somewhat concentrated, they're a little less liquid. We have done a lot of de-risking in that area, and we are far better positioned today than, of course, we were several years ago. We are less concerned about it, but we still watch it because of the nature of those holdings. We feel like we're in decent shape. We've actually done a fair amount of de-risking throughout the year, which doesn't bode well for net investment income as you go into 2019, because a lot of those holdings that we've de-risked were at higher coupon levels. We think it's prudent if you think there could be some credit weakness. When you say switch trades, some of what we have done is actually quite tactical that is not credit risk related.
It's actually credit improvement in that with the tax reform, we did the calculations and figured out that the after-tax return on capital allocated to munis for us was a beneficial asset class to be in. We sold out of corporates where we were fearing a widening spread and possible credit cycle and went into munis. That's unique for the insurance industry. The last time the life insurance industry went into munis was Build America Bonds, this is a bit new. We like that trade. The only other dynamic I would tell you is that we clearly have been citing towards building up loans, the loan portfolio, middle market loans, and transitional real estate. That's because it's particularly attractive for us because it's a type of U.S. security that we can hedge efficiently in Japan, so we can hold it in our Japanese portfolio.
It does expose you to LIBOR rates, which has been a helper this year recently, as you all know. That also comes, however, with rising hedge costs, we have to manage the hedge cost and LIBOR rate dynamic. What I would say is we like those loans better. One, they're accounted for as loans, so they're less volatile from an unrealized gain loss position when it comes to our SMR ratio, which is our capital ratio in Japan. The other is they tend to come with a covenant structure, and that gives you a little bit of added protection relative to, say, a traditional below investment grade bond because many of these middle market loans are BB type category bonds, sometimes lower. We'd rather be in that than be in a true below investment grade security.
Transitional real estate we favor. That's because it's more higher rated. It tends to be more BBB rated. We've got some good external managers that know what they're doing in that asset class. We have confidence in them.
All right. Well, thank you for being with us today.
Great.