Welcome to the Aflac 2019 Outlook Conference Call. Your lines have been placed on listen only until the question and answer session. Please be advised today's conference is being recorded. I would now like to turn the call over to Mr. David Young, Vice President of Aflac Investor and Rating Agency Relations.
Good morning. Welcome to our 2019 Outlook Call. Joining us this morning during the Q&A portion are members of our executive management team in the U.S. Dan Amos, Chairman and CEO, Fred Crawford, CFO of Aflac Incorporated, Teresa White, President of Aflac U.S., Eric Kirsch, Global Chief Investment Officer, Rich Williams, Chief Distribution Officer, Al Riggieri, Global Chief Risk Officer and Chief Actuary, and Max Brodén, Treasurer. We are also joined by members of our executive management team in Tokyo at Aflac Life Insurance Japan, Charles Lake, Chairman, Representative Director, and President of Aflac International, Masatoshi Koide, President and Representative Director, Todd Daniels, Director and Principal Financial Officer, Koji Ariyoshi, Director and Head of Sales and Marketing. Before we start, let me remind you that some statements in this teleconference are forward-looking within the meaning of federal securities laws.
Although we believe these statements are reasonable, we can give no assurance that they will prove to be accurate because they are prospective in nature. Actual results could differ materially from those we discuss today. We encourage you to look at our annual report on Form 10-K for some of the various risk factors that could materially impact our results. The earnings release is available on the investors page of Aflac's website at investors.aflac.com, as well as slides for today's presentations, and includes reconciliations of certain non-GAAP measures. Now, I'll turn the program over to Dan, who will begin this morning with some high-level comments and outline the company's strategic focus, value creation, and operational outlook. Fred will follow with comments about our 2019 financial outlook and capital management. Dan?
Thank you, David. Good morning. Thank you for joining us today. At Aflac, we've always managed our business for the long term while remaining laser-focused on meeting our financial objectives. At the same time, we continue to work on enhancing our customer service and growing our book of business. Over time, our approach has led to the development of our strategic strengths in both Japan and the U.S. that we have leveraged to grow and drive shareholder value. One of the more evident strengths is Aflac's well-recognized and strong brand, which many people most commonly associate with the Aflac duck. While about nine out of 10 people in both the United States and Japan recognize the Aflac brand, it's also a name that people have come to trust over the decades.
As such, individuals and businesses are more receptive to hearing about Aflac's innovative products can do to provide value to them. Excuse me. Our well-established brand continues to serve as a very effective door opener. Along with Aflac's strong brand, we look to leverage our diverse and productive distribution channels. In Japan and the U.S., we focused a great deal of our efforts on having a presence where consumers want to make their insurance purchasing decisions. We will continue to enhance the productivity of our current channels while exploring distribution expansion opportunities. We offer innovative products and high-quality customized service to provide our customers an affordable solution that help protect their financial well-being.
It was our innovative spirit that led to the groundbreaking One Day Pay initiative in the U.S. to process, approve, and pay eligible claims in just one day gets cash in the hands of the policyholders fast. One Day Pay stands out as an example of how we place the customer first and has benefited customer satisfaction, increased referral opportunities, and differentiated us from our competitors. Most importantly, One Day Pay symbolizes how we look to transform not only our company but the industry. Over the past two months, I've spent quality time at innovative hubs in Charlotte, North Carolina, and Shibuya, Japan. At both locations, I've received a comprehensive update and engaged with members of our innovation and digital team. I am energized about the initiatives we have under development.
I'm also realistic that not all the initiatives will be commercially successful, but that is part of the process of developing exciting new paths of growth. At the same time, I want to make sure that we're driving digital innovation in the market we dominate and keeping pace with the evolving customer expectations and rapidly industry changes. All of these strengths have combined to our industry-leading market share and scale in both Japan and the U.S., which allows us to offer affordable valued coverage to our customers and competitive compensation to our distributors. We are very proud to be the leaders in voluntary insurance sales at the work site in the U.S. and to insure one out of four households in Japan, thus we look to build upon our leading position in both countries.
Ultimately, these strengths have allowed us to establish appropriately strong capital positions and consistently deliver stable earnings and strong cash flows to drive value for our shareholders. These points of leverage are the product of years of disciplined approach. To be clear, our mission and management challenge is to further leverage these core franchise strengths to grow the business and our enterprise value in 2019 and beyond. For 2019, we continue to focus on delivering profitable growth in both Japan and the United States through our core products by enhancing our distribution, including digital direct initiatives. As such, we continue to evaluate and invest in digital applications and ventures with the aim of improving customer experience and seeding new growth opportunities. We will continue to focus on maximizing efficiencies through the investment in our IT infrastructure with the goal of enhancing productivity and improving long-term expense ratios.
As always, we remain committed to maintaining stable margins and allocating our capital to drive higher returns. You will continue to see this in both our investment strategy and our decisions to emphasize third sector and first sector protection rather than saving products in Japan. We remain committed to returning capital to our shareholders in the form of dividends and share repurchase. We also recognize that smart investment in our platform is critical to grow earned premium and drive efficiencies, while ultimately will impact the bottom line. That investment will continue into 2019 and beyond. These areas of focus are steered by strong leadership and governance. I believe we have the right leaders in place who will continue to guide and propel our operations moving forward. Looking at the near-term growth initiatives, we are pushing sales growth by focusing on three key market opportunities in the U.S.
First, for the small business market, we continue to focus on growing the under-penetrated market with the strength of our agency distribution team. Second, we are expanding our reach into the broker market, especially through local and regional brokers. Third, we will improve the servicing of our existing accounts to drive increased participation and persistency. We're also investing in digital transformation of our current platform to improve our customer experience. To that, we are leveraging our U.S. venture investments for commercial partnerships to accelerate our digital innovation. In 2019, we will consider installing a new platform that supports our strategy to drive agent-assisted sales and digital distribution. This platform will enhance the overall customer experience and make it easier for our distribution teams to sell. We will leverage this platform with our current product set and innovative new-to-market products to meet challenging customer needs.
As we look to 2019, we anticipate growth in new sales premium to be stable within the range of the 3%-5% increase. We continue to expect sales to be skewed towards the fourth quarter, influenced by increased distribution of broker sales. As we execute on our strategy, we anticipate stable premium persistency to lead to earned premium growth of 2%-3%. We have initiatives underway to address persistency, and we believe there is opportunity over the long run.
Turning to Aflac Japan, we continue to focus on enhancing the value of our core third sector franchise through the following initiatives: refreshing our existing product to keep pace with medical advancements, utilizing riders of our core medical product that recognize Japan's aging population, like lump sum nursing care coverage, launching innovative products like our recent health promotion medical insurance that underwrites to your health age and offers recovery of premium when you maintain certain health biometrics. This product is digitally distributed and administered. Finally, being patient as new products like our income protection product take hold as one of the few high-quality disability products in the market in Japan. Our third sector franchise is complemented by the sales of our first sector protection products. While we don't lead with first sector protection sales, they complement our third sector line of products very well and have similar profitability.
From that profitability perspective, we tend to be agnostic when it comes to selling cancer, medical, or first sectors protection insurance. In 2019, we have initiatives in place to work toward higher policy retention, which allows profitability to emerge as we maintain the business. Long term, we will continue to leverage our innovative labs and Shibuya strategic partnership and Aflac's digital health platforms to develop new innovative products solutions that appeal to customers and revolve around Aflac's cancer and medical. Turning to Aflac Japan sales, Aflac Japan's new marketing campaign will focus on first sector protection products and riders to attach to medical policies. Aflac Japan sales face challenging comparisons given the success of our new cancer product launch in 2018. This launch was supported by the alliance partners who sell only Aflac's cancer insurance.
As a result, we expect third sector and first sector protection sales combined to decline in the low single-digit range. Recognizing the impact of medical and cancer new product launches on a given year sales results, it's important to focus on the long-term growth. Over the past five years, and in the face of competition, we've grown our third sector annual sales platform from the mid JPY 60 billion range to nearly JPY 90 billion annually. With respect to earned premium, we expect to see a slight decrease in Japan's total earned premium, mainly due to first sector savings products reaching paid-up status. Most importantly, we expect to see growth of combined net earned premium of third sector and first sector protection products continue to grow in the 2% range, which will be driven by the third sector policies.
Before turning the call over to Fred, it goes without saying that we treasure our 36 years of consecutive dividend growth. I continue to believe that the absence of more compelling alternatives, dividend and share repurchase are the most attractive means of deploying AFS capital, and those are the primary avenues we will continue to pursue. At the same time, we will reinvest in our business to enhance organic growth. Ultimately, we believe this is a more sustainable approach to business that will continue to increase shareholder value. By staying disciplined and focused on what we do best, I believe we will continue to generate results that build long-term shareholder value. Now I'll turn the program over to Fred. Fred?
Thank you, Dan. Let me start by highlighting the key drivers of our 2019 financial outlook. Overall margins in both our Japan and U.S. segments remain strong as we continue to experience favorable benefit ratios and underlying claims trends. Consistent with Dan's comments, digital growth and IT initiatives are expected to elevate expenses in the near term, but we are confident will result in improved operating efficiencies and future growth opportunities. Our investment strategy is designed to drive stable returns while managing capital volatility. We continue to navigate a challenging rate environment in Japan by evolving the U.S. dollar portfolio asset mix and associated hedging to achieve consistent results. Having completed a year of significant legal structure transition in Japan, we continue to make progress on our capital optimization efforts and anticipate a step-up in deployable capital fueling our dividend growth and a build in repurchase capacity and opportunistic capital.
A common theme running throughout our business strategy and investment decisions is a focus on defending and building economic value while being mindful that we have experienced several years of favorable market conditions, which will ultimately slow and reinforce the benefits of our defensive business model. I'd like to provide greater detail on the assumptions underlying our 2019 core insurance earnings drivers in Japan and the U.S. Focusing first on Japan, while overall premium continues to decline, largely due to first sector policies becoming paid up, we expect third sector earned premium to grow at a steady rate in the 2% range. The distribution of earned premium continues to shift towards third sector, which will lower our reported benefit ratio as compared to 2018.
We expect benefit ratios in our core lines of cancer and medical to remain strong with claims trends benefiting from fundamental changes in Japan's healthcare system. We continue to invest in digital and IT administration with near-term efficiencies gained from the process improvements reinvested back into our platform. In addition, we have an active product development pipeline in 2019, an ongoing investment in digital solutions, as Dan noted. Together with a modest decline in overall revenue, we therefore expect near-term expense ratios to be elevated. Overall, profit margins remain generally consistent with our full-year forecast for 2018. Turning to the U.S., earned premium is expected to grow around 2%-3%. Growth in our group business is gradually shifting the mix of earned premium away from more persistent cancer business towards individual and group short-term disability, accident, and hospitalization policies.
Premium mix has a gradual impact on our ratios, with group, in particular, having a lower benefit ratio and higher expense ratio driven largely by lower persistency. While more stable in recent years, we believe trends in healthcare utilization and hospitalization will continue. Our expense ratio will be elevated as we have been actively investing in our U.S. IT and digital and distribution platforms. Our capital management plans in the U.S. naturally represent a headwind to net investment income in the segment. Overall, profit margins are expected to remain generally consistent with our forecast for 2018. Turning to the investment strategy, Japan net investment income is expected to increase by nearly JPY 2 billion. The build of the U.S. floating rate portfolio is positively influencing our projected new money rate in Japan.
Reinvestment of higher yielding called and maturing yen fixed income investments continue as a headwind, but is more than offset by the gradual build in our U.S. dollar portfolio. With current costs of new hedges above 3% and excess capital in Japan, we continue to lower our hedge ratio, which we expect to be 35% by the end of January. This strategy delivers a sensible return on excess capital and reduces our enterprise exposure to a weakening yen. Consistent with our tactical approach to managing hedge costs and our current view that costs are likely to rise in 2019, we have locked in approximately 80% of 2019 hedge costs. Our current forecast is a range of $250 million-$270 million in hedge costs for 2019.
We execute on this strategy consistent with our tactical approach to grouping our U.S. dollar portfolio according to hedged floating rate investments, fixed rate and hedged traditional bond investments, and unhedged U.S. dollar investments. We have completed a review and refreshed our strategic asset allocation. While representing modest adjustments overall, the new strategic asset allocation will guide our new money allocations for the next few years. Adjustments worthy of calling out include placing more portfolio weighting on U.S. dollar floating rate investments and certain U.S. dollar growth in alternative assets such as private equity. We anticipate a lower allocation to JGB and overall yen fixed income assets. The global investments team will continue to tactically navigate credit and interest rate markets, which will influence the pace and growth of any particular asset class.
As mentioned earlier, net investment income for Aflac U.S. will naturally decline, reflecting the reduction in assets backing our RBC drawdown strategy. From an overall Aflac investment income perspective, there is a modest shift in income from our Aflac U.S. segment to the corporate segment, until such time the excess capital is deployed. As Max covered at this year's financial analyst briefing in Japan, we are actively addressing two meaningful risks to the long-term economic valuation of our enterprise, the exposure to the yen and volatility of hedge costs. At the holding company, we have launched an effort to reduce both of these risks. As you know, in Japan, we buy U.S. dollar corporate bonds and hedge them back to yen to synthetically create yen assets relative to the yen liabilities. This also provides significant Japan capital relief and attractive returns.
At the holding company, we have entered into forward contracts which offset a portion of the hedge costs for Aflac Japan. By buying U.S. dollar and selling yen, the opposite trade enter into in Japan, we are effectively lowering our overall economic exposure to the yen, while the Japan balance sheet continues to hold a synthetic yen asset for capital stability. The GAAP accounting impacts on net earnings and non-GAAP adjusted earnings would be similar, but in offsetting directions. Ultimately, this reduces our risk of hedge cost volatility when looking at consolidated adjusted earnings, reduces GAAP net income volatility, and reduces the yen exposure on an economic basis enterprise-wide. There is a limit to this strategy, given capital and liquidity constraints. We are taking a measured approach to building the program to include both internal and external review.
Currently, the program is approximately $2.5 billion, and we expect to build modestly throughout 2019. We have forecasted a contribution of $60 million to $80 million to pre-tax earnings recorded as part of the corporate segment for 2019. This compares to an estimate of $30 million pre-tax for 2018. We expect to expand our disclosures in our statistical supplement to assist investors in understanding the program's quarterly development. I mentioned during our 2018 financial analyst briefing that as we head towards the adoption of new accounting standards, this will only increase the importance of understanding regulatory earnings as the basis of cash flow and development of economic value. In Japan, FSA earnings power remains strong as we have pulled back from capital and reserve intensive first sector savings products. Earnings are supported by strong benefit ratios and stable investment income.
Our U.S. statutory earnings are growing and are supported by earned premium growth and strong benefit ratios. Going forward, there will be greater visibility into our U.S. only statutory earnings, which improves the transparency of cash flow generation. Of note, in our earnings projections, we have embedded an estimate for impairments and realized losses. This represented by the shaded section on the bars. While based somewhat on a bottoms-up view of the portfolio, this is simply a practical placeholder we use for overall three-year planning cycle and not a specific view of estimated losses in 2019 or 2020. Our SMR ratio is sensitive to market fluctuations and is elevated by unrealized gains in our AFS portfolio. Holding all market conditions stable, we expect SMR to remain in the 950% range for 2019, and RBC will be drawn down to the 525% range.
Of note, our 2019 RBC estimate includes both the full implementation of tax reform and an estimate of the implementation of C1 capital charges. As we discussed during last year's outlook call, 2018 marked a year of transition, and we felt it prudent to carry a higher level of excess capital and liquidity throughout the year. 2019 is a year of executing on our optimization plans, which includes increasing our subsidiary dividend policy up to 100% of both FSA earnings and U.S. statutory income. We will continue with our plans to move $500 million of excess capital out of the U.S. insurance entities. We therefore expect 2019 repurchase to be in the range of $1.3 billion-$1.7 billion, the range allowing us to be more tactical in our deployment strategy. As is always the case, this assumes stable capital conditions in the absence of compelling alternatives.
Leverage will remain around the midpoint of our 20%-25% policy range. Along with a successful JPY debt offering, we refinanced a piece of our U.S. debt in October. We are tactically leveraging our strong ratings, favorable spreads, and access to Japan's debt markets to secure our low cost of debt and extend maturities. We expect holding company liquidity to approach $3.5 billion by the end of 2019, which includes a minimum $1 billion capital buffer and now $1 billion of liquidity support for derivatives activity. We have adjusted our liquidity policy to support our holding company strategy to reduce enterprise hedge costs with ample liquidity to manage collateral posting and settlements on associated forwards under stressed foreign exchange assumptions.
Our deployable capital is robust and growing, but it's worth noting this is after our first priority of investing in our business model in the form of product development, distribution expansion, digital innovation, IT transformation, and capital and support of our general account strategic asset allocation. In short, regulatory earnings are stable and growing, core ratios remain solid, and cash flow is building, allowing us to balance investment in our profitable business model while delivering meaningful capital back to shareholders. Concluding with our view of earnings per share, we are projecting a range for 2019 of adjusted EPS of $4.10-$4.30 per share, assuming a foreign exchange rate of 110 JPY to the dollar. When looking at our currency neutral EPS estimates for 2019 and normalizing for certain tax items identified in 2018, the range equates to approximately a 3% increase.
We view this as a solid earnings plan when considering incremental investments in our Japan and U.S. digital growth platforms and a balanced approach to capital deployment. Our plan does assume a continuation of favorable claims trends in Japan and the U.S. and associated reserve adjustments consistent with our experience in 2018. Our financial playbook for creating value is straightforward. Defend the attractive margins in our core supplemental health business, invest to drive eventual top-line growth, and improve efficiencies. Finally, we continue to balance maintaining strong capital ratios with returning capital to our shareholders. I'll turn the call back to David now to take us to Q&A. David?
Thank you, Fred. We're now ready to take your questions. First let me ask that you please limit yourself to one initial question followed by a related follow-up to allow other participants an opportunity to ask a question. Operator, we'll now take the first question.
Thank you. The first question is from Humphrey Lee of Dowling & Partners. You may now ask your question.
Good morning. Thank you for taking my questions. Just looking at the slide that shows the FSA earnings, there seems to be some decline from 2019 to 2020. I was just wondering what would be the driver for that decline?
Yes. There's just really a primary issue going on there, and it has less to do with the decline and more to do with the jump in FSA earnings in 2019. Remember, we're talking fiscal year. These numbers are March ending 2019. The jump for March ending 2019 is actually related somewhat to the introduction of our new cancer product and some of the lapse and reissue activity, which has the effect of lowering your reserves and boosting your FSA earnings. That, coupled with very little in the way of impairments and losses, has coupled to generate a very strong jump in FSA earnings for the year. We are expecting, from a projection standpoint, a modest decline as we would see that activity slow down for 2020 fiscal year ending. Note, of course, that we have a placeholder of impairment and losses.
I think we allocate roughly $150 million in dollar terms of impairments and losses to Japan. That'll give you an idea of that shaded area. That, of course, may happen, may not happen, may be higher, may be lower. Overall, on a scale basis, remember, this is really not a particularly large drop in FSA earnings. It remains very strong.
Understood. Staying with Japan, I think in the slide that you show the net investment income projection, the 2018, you were expecting ¥260 billion. If I think about for the first nine months, you're already close to ¥200 billion. The implied ¥60 billion in net investment income in Japan would seem to be the lowest quarterly number for 2018. Is that a function of that callable and mature private that you mentioned earlier, or how should we think about the lower fourth quarter net investment income?
We'd have to take a harder look at that, Humphrey, just to check the numbers. I would say a few things, though, and that is we have been gradually de-risking the portfolio throughout the year, meaning selling out of, particularly when we have opportunities to sell out of higher yielding privates where we have concentrated exposure. That may be catching up a little bit to some of the NII trends. You also have some rolling of hedge costs into a higher hedge cost environment, although fairly modest. I would say we would need to double check your numbers to make sure we're seeing the same sort of trends you are.
As we head into the year, while we are expecting an increase in overall NII, we're happy with that in the sense that it's in the face of some de-risking, it's in the face of some gradually rising hedge costs, and then having to work against replacing maturing and callable higher yielding privates. I think Eric can add his comments, but one thing that's very important to understand is we're seeing some signs of being cautious and careful around credit markets. We're wanting to make sure that on balance, we remain defensive.
Yep. The only thing I'd add to that, but as Fred said, we would need to check the accounting numbers. As you all recollect, with respect to the build-out of our dollar program and the floating rate assets, we were very successful, particularly in the first quarter of 2018, in accelerating some of that build-out as well as in the second quarter. Most likely, since those are higher yielding assets, the first and second quarter, and perhaps a bit in the third quarter, reflected a bump up in our NII. In the fourth quarter, it's a little less deployment in those asset classes. To be specific, we'd have to check the numbers.
Yeah. Right now on the surface, Humphrey, we're not quite seeing the drop that you're noting, but what we'll do is reconcile later, and if we need to clarify, we will.
Okay. Thank you.
Thank you. Next question is from Suneet Kamath of Citi. Your line is now open.
Thanks. Just to start on capital, the share buyback guidance of $1.3 billion-$1.7 billion, that's a decently wide range. What would it take to get to the lower end of that range? Is that sort of contemplating a period of economic stress and credit losses, or is there something else there?
Suneet, we have a fairly good opportunistic bucket there. Opportunistic can certainly be on the offense, opportunistic can also be on the defense if we were to face an early cycle, if you will, credit cycle and the like. I don't see the early stages of a credit cycle impacting our deployment plans. Really, the range there is tactical in the sense of as compared to other opportunities to invest our capital, we want to have a range to be tactical. That is tactical up, meaning increasing to the higher end of our range if repurchase argues strongly for the capital. It also comes down to the lower end of the range, based primarily on alternative opportunities for that capital. We have a range.
It's about $400 million, as you can see, a little bit wider than last year, really just to send the signal that we would expect to be tactical. When we talked to our investors, they were very clear that they like repurchase. Do we. It's an attractive return and has been a very attractive return for the company. They also want us to be very practical and tactical about it as well because it's a sizable use of capital.
Okay. Just to pivot to Japan sales, I guess for Dan. It seems like the third sector sales outlook for next year obviously contemplates strong results this year. Are we getting closer to the point where we'll start to see consistent growth in the third sector on an annual basis? Is it one of these situations where we're just always going to be dealing with a comps issue, so maybe every other year will be a tougher year for growth as you start to introduce new products?
Let me let Koji and Aflac Japan answer that. I'll follow up if you'd like.
In terms of the third sector outlook, we have been increasing our AP since 2013. It was JPY 67.1 at the time of 2013, in 2016 we were at around JPY 88 billion. Particularly in 2018, we are projecting that we would record the highest ever cancer sales. That means that we will have to compare in 2019 against this very high 2018. In terms of the medical insurance, the product cycle in medical is becoming shorter and shorter, we are planning to launch a new product in 2019. We also believe that because our alliance channel does not sell medical insurance, although we are launching a new product in medical in 2018, it will not match up with the increase in cancer in 2018.
Although we do believe that 2019 will be a tough comparison against 2018, we do have plans from 2020 and beyond for new products, as well as improving productivity of our agency channels. In terms of increasing the productivity of our agency channel, what we are doing is using a digital tool to show our customers what kind of coverage that our customers are missing, and we can propose. Also we are also conducting trainings for our exclusive agencies or agencies that are very much exclusive to Aflac and to improve their productivity in sales. That's all from me.
What I would add is, you're correct as the business has continued to grow, the more difficult it is to achieve the objectives. We still see a growth opportunity. 19 is a little unusual in that it's going to be a year when we launch riders to attach to the medical products, which means we don't have a major product like we've had in other years. That cycle that Koji was talking about is getting shorter and shorter. I'm still encouraged and believe we still see growth from our existing relationship with partners as well as our field force itself and what they're performing with our individual and corporate agencies.
Thanks, Dan.
Sure.
Thank you. Next question is from Jimmy Bhullar of J.P. Morgan. Your line is now open.
Hi, good morning. Fred, I had a question on expense ratio. You mentioned it's going to be elevated because of digital related spending. Should we assume that, given how the business is evolving that this level of spending is ongoing, or is it above what you'd expect as normal, and should we expect the expense ratio to moderate in the next, let's say, two to three years?
Yeah. Let's break it down into Japan and the U.S., and then I'll answer your question in terms of timeline. In terms of Japan, we have been for quite a while now investing in our IT platform, but we have been achieving savings and reinvesting those savings back into the IT platform. Incrementally, expenses are going up in Japan. Budgeted expenses are going up in Japan in the range of JPY 5 billion-JPY 7 billion, and some of that is related to the digital initiatives and innovation initiatives that we've launched in Japan. I think it's also important, though, to note when looking at the Japan expense ratio, that some of that increase is really related to revenue decline in the face of that increased investment. We are seeing budgeted expenses go up a little bit.
We're seeing revenue come down a little bit, and that creates a little bit of elevated Japan expense ratio, but not a substantial delta in the amount of expense. In the U.S., you have really two things going on with the expense ratio. Of course, you have growing revenue in the U.S., that's a helper. There's two items that are pressuring expenses. One actually is a rise in DAC amortization unrelated to our investments, and that rise in DAC amortization is simply a result of selling more group business. Group business tends to have lower persistency, you're amortizing your DAC more quickly. As that becomes more a portion of our business, you'll see a little bit of elevated DAC year-over-year. Now remember, that comes with a lower benefit ratio, so it tends not to penalize us on the pre-tax profit margin.
From a budgetable expense standpoint in the U.S., we are absolutely pushing the pedal and have been for a couple of years now on IT transformation and digital. We're seeing, for example, our incremental expense 2018 to projected 2019 on budgeted expenses go up approximately $60 million. That's roughly a one percentage point increase in the expense ratio just related to the delta in IT transformation and digital advancement. We obviously expect that to pay off over time in the way of increased premium flows and efficiencies, to bring that expense ratio down. I think in terms of the timeline, I think you can go back to our long-term projections, and that is both in Japan and the U.S., we're targeting lower expense ratios come 2022.
We've given you some idea of those forecasts at our FAB call around the 20% range in Japan and then 33%-34% range in the U.S. by 2022. That gives you an idea of the timeline we're on for continued spend.
You mentioned the credit markets in response to a few questions. What are your views on where we are sort of in the credit cycle, and is your team making any changes in allocations of securities by asset class or by rating?
I'll toss to Eric, who can give you a much better answer on that question. Eric, why don't you answer?
Thank you, Fred. Good question. We've been watching the credit markets carefully, in particular over the last year because our sense was probably sometime later 2019 into 2020, we would see a shift in the cycle. Of course, we don't expect to get that exactly right, but broadly. We also felt, more or less a year ago, that credit spreads were just so tight, it was really difficult to find relative value. We're not necessarily surprised right now in the credit markets with widening out of spreads, more sensitivity to the leverage loan market. Relative to our own allocations, we have been doing more private market transactions where we're negotiating covenants and terms to our liking. We've allocated a fair amount to things like transitional real estate, which are more investment-grade, with some allocation to middle-market loans, but based on strong credit underwriting.
At the same time, we've been pruning where it makes sense in our credit portfolio with an eye towards one to two years from now if the credit market changes. Some of the particular holdings we may have, say, in the triple B sector or even below investment grade, we prefer to lighten up today. We've done this year about just around JPY 1 billion of various de-risking, I'll call it, of some of the older private placements. South Africa would be a good example. We sold a portion of that. Catalonia credits that we feel could have some volatility if the credit cycle changes. We think our portfolio is well-positioned for the future through the good diversification, the credit work that we've done over the last few years.
I'll also say, I think we're very well-positioned defensively, but we're also in a good position to play offense as well. Remember, if credit spreads do widen out in certain asset classes, our capital is strong, and our asset allocation plans provide that flexibility. Those could be opportunities, too, as the portfolio is well-positioned moving into the change of the credit cycle that might happen or may not.
Thank you.
Thank you. Next question is from Erik Bass of Autonomous Research. Your line is now open.
Hi, thank you. I wanted to follow up on Suneet's question about Japan sales. You've talked about a long-term target of 4%-6% growth, and realized you've certainly done that over the past five years, but that was with the help of bringing on Japan Post. Then for 2018, you're targeting low single digits growth, even with the benefit of a very successful new cancer product. Then 2019, expect low single digits decline. I guess what needs to happen to be able to consistently achieve that 4%-6% target?
Koji?
In terms of cancer insurance, because we have a large volume or large block of in-force.
Hello?
Cancellations.
Sorry.
As I mentioned earlier in 2018, since we had a boost in cancer sales, we had the largest third sector AP in the past 10 years for in 2018. Our outlook for 2019 is that since we have to go against this very high number in 2018, it will be a tough year. As I mentioned, although we will be launching a new medical product, but because our alliance channel does not sell medical insurance, we are not expecting to see such a high growth as with cancer. Although we've been talking about the CAGR of 4%-6% for the past few years, by looking at just next year alone, we will be just slightly under 4%, around 3.9%. As I mentioned before, towards 2020 or in 2020, we will be launching more new products, and we will also be improving agency productivity.
As a result, we will be back in that range.
One thing, Eric, this is Fred, that I would say just to bring some perspective is don't lose sight of the fact that since in 2013, the third sector franchise of the company was producing about JPY 65 billion, JPY 67 billion, give or take. Actually, JPY 67 billion in third sector sales. That same franchise is now producing routinely JPY 85+ billion in third sector sales. Any given year with the timing of new product launch, there'll be ups and downs, and comparables will be tough or easy depending on the year.
Overall, what the team in Japan is focused on, and Dan and I are focused on, is that constant consistency of upgrading your products, refreshing it for medical advances and changing demographics, introducing new product where we think we have opportunity, and then expanding distribution to new demographics through, say, digital product, for example, which we've introduced this year and we hope to build. So
It's going to be an accumulation of a lot of things that year-over-year will cause fluctuation. Don't lose sight that someone might ask, "Boy, how have you so consistently increased the growth rate over the last several years in Japan as opposed to the other way around?" We actually are quite happy with the growth rate, year-over-year, there'll be some volatility.
Got it. No, I appreciate that. I guess that was sort of the thrust of my question is that you've grown a lot over the past few years, so your base is a lot higher, and a lot of that came from bringing on a very large distribution partner. Is the 4%-6% still a realistic target to think about long term, given that you've reset the base meaningfully higher?
Well, it's certainly tougher. There's no question about that. As you heard from Koji, he still believes there's the potential for that to go going forward. That would be my comment at this particular time. I think what Fred said covered it real well about how we're going to continue to grow it going forward.
Got it. Thank you.
It's worth noting the right-hand side of the slide, which is earned premium. One other thing, that right-hand side of the sales slide that has earned premium is very illustrative. It shows you the change in mix between first sector and third sector. It highlights that we're trying to move the dial on first sector protection, which is more a mortality-based product. It shows that earned premium is growing pretty steadily, which that's really a sign of economic value growth. The reducing gray bars are products or in-force products that carry less in the way of economic value in our view, due to interest rate sensitivities and asset-intensive and reserve-intensive product. When we think of growth, we do think of sales, of course, we think of earned premium, but we also think of building the economic value in the company.
You should take that from the slide.
Thank you. The next question is from John Nadel of UBS. Your line is now open.
Good morning. I have two questions. One, Fred, I think it's slide 15 in your deck, that's the enterprise hedge costs reducing FX exposure.
Maybe I missed it in your remarks, could you explain to us what the line that says forecasted impact to Adjusted Earnings of $60 million-$80 million, what does that mean?
Yes. What that is, what we would expect, first of all, by the end of the year, in fact, actually currently as we speak, we have a notional amount of hedges at the holding company of about $2.5 billion, we would expect on average, the weighted average, if you will, of that notional amount of offsetting hedges at the holding company to be in the range of $3 billion. That $3 billion, if you will, of average notional hedges at the holding company has offsetting earnings or has an earnings component to it that offsets the hedge costs in Japan. When you effectively attribute the same methodology we use for hedge costs in Japan to these hedge instruments in the U.S. at the holding company, that generates $60 million-$80 million of pre-tax profitability at the corporate level.
You will see that profit line emerge in the Corporate and Other segment of our financials. That's what we've been doing for the last three quarters. As I mentioned, that number was $30 million pre-tax in 2018, now we expect it to rise to $60 million-$80 million as we build the program. Again, remember, the real simple way to think about it is we're entering into forwards of an opposite economic characteristic. The way I simplistically think about it is I could, in theory, go out any day and I can sell both those positions and generate equal economics on either side. All we're trying to do is reflect that reality in our income statement, or in this case, our Adjusted Earnings. This is the methodology in which we're doing it because we're entering into separate transactions at both legal entities, Japan K.K.
and the U.S. holding company.
Got it. That's helpful. Sorry, it's really more my bad for not keeping up with you in the prepared remarks. Sorry.
That's okay. It's a newer strategy that we developed and is still maturing. We want to be as helpful as we can in the disclosure to understand it because you do have to wrap your head around the economics and understand how we're best portraying those economics in our reported adjusted earnings.
Thanks for that. The second question, it may be a little bit more of a follow-up to Jimmy's question, I'm not sure. As we think about the elevated spending levels in the relatively near term, how can we think about the pace of that spending when we look out over time? Is there an opportunity for margin, whether it's in the U.S. or Japan or both, is there an opportunity for margin, pre-tax operating margin to expand beyond 2019? I'm really talking about more than just favorable underwriting results or something like that.
I would tell you, John, and others listening that in our financial planning process where we pay particularly careful attention to the three-year financial plan for 2019, 2020, and 2021, and then in certain areas we expand that to a five-year forecast, particularly as it relates to expense ratio since we have a long-term target. We continue to see strong pre-tax profit margins, and the trends remain largely the same as what you're seeing the last couple of years, and that is what we may be leaking out in the way of an expense ratio, either due to elevated DAC amortization due to persistency or proactive investment in our platform to drive premium growth, we are gaining in the benefit ratio.
Much of that is mix of business related, but it's helping us really defend the pre-tax profit margin, and gives an opportunity for defense and expansion over time if we can do a good job in executing on the expense side. Having said that, whenever you see a declining benefit ratio, you also have an opportunity to look at whether or not there's ways in which to leverage that benefit ratio to grow the business. Meaning product design, product pricing, and other strategies, particularly around retention. Much of a low benefit ratio has to do with lower persistency, and in the U.S. in particular, we would like to see the persistency come up, particularly on the group side, but across the board. We have lapse rates that range from 20%-25%, depending on the nature of the product. We'd like to see that do better.
When that does better, you naturally see a climbing benefit ratio and a reducing expense ratio because DAC amortization is strung out more. We think we have opportunity in our pre-tax profit margins to reinvest back in the business model to drive growth, and that's really what we're focused on. We can do that while maintaining the strong margins we've been recording.
Got you. Very helpful. If I could sneak one last one in. Any early indications on fourth quarter for the U.S. in terms of sales, given how critical a quarter it is at this point, given the mix shift?
No, not at this particular point. It all comes in the last 5 weeks of every quarter now, and it's too hard to tell. I am encouraged by the reports I've been getting and the enthusiasm. Don't go take that as it's made, because I've been enthused before. Let's just wait and see. I think we've got the right people in the right place, and I'm encouraged by the management team and what they're doing.
Thanks, Dan.
Thank you. The next question is from Tom Gallagher of Evercore. Your line is now open.
Good morning. Just from looking at the slides on Japan sales, if I isolate third sector versus first sector protection and separate them, it looks like third sector sales are going to decline by more than the low single digit, maybe more like 5%-10%. I don't know if you can quantify that in terms of third sector specifically for 2019.
Generally, our sales plan for the year, it has a range. It's essentially low single digit decline, both for third sector only and when combined with third sector and first sector protection.
Can you split out just third sector, though? I know historically you guys have made a big point of emphasis between first and third.
Yeah, it's not significant. The difference between the two is not that significant at this particular point.
Got you.
low single digit both ways.
Remember, you'll be a little more range bound when you're projecting. Some of that is a range, Tom, as opposed to a point estimate. The point estimate is low single digits. There's a range around that where we may do better, we may do worse, but the point estimates are low single digits for both categories.
Got you. Then, because it does look like there's a bit of a mix shift here going on between first sector protection are expected to get a bit stronger, third sector a bit weaker, at least just from eyeballing the graphs here. Can you comment a bit more about what's going on with this first sector protection? Is that a far better margin than the old ways products that were sold? Maybe compare and contrast a bit of what's happening there.
Yes, it absolutely is. In fact, we've created that column in a protection category versus a savings category to make it easier for you to follow. The protection runs the same profit margin as does the cancer or does the medical. As I said earlier in my comments, we're agnostic in terms of which way it's sold and how it's sold, and we believe that there's an opportunity for us to tack on some additional business there according to our research from our people. It's more meeting the consumer's needs is what's driving this to a great degree. We'll have to wait and see, but we don't want to lose focus on what's built the company, which is the third sector. We're being very cautious about it.
At the same time, Koji feels like, and so does his team, that it's worth us considering that and riding it, and as long as it has the same profit margin, we don't care.
Got you.
Okay, let me add a comment. This is Koji.
Well, this first sector protection type is a type of product that we can sell together with third sector or on top of third sector. It's not like we are changing the product mix altogether. It's more like we are selling first sector protection on top of third sector or together with third sector. By doing so, we are also able to maintain the sales of third sector products. As Dan mentioned, our focus or our core products are third sector, but we are selling these first sector protection products on top of the third sector products. It's not like we are totally changing our product mix.
Thank you. I will now hand the call back to Mr. David Young.
Thank you. Thank you all for joining us for our call this morning. Before we end the call today, I'd like to remind everyone of our upcoming fourth quarter earnings release on January 31st, followed by a teleconference on February 1st. In the interim, please feel free to contact our investor and rating agency relations department with any questions. We look forward to speaking with you soon. Thank you.
Thank you. That concludes today's conference. Thank you for participating. You may now disconnect.