Welcome to the Aflac 2018 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.
Thank you. Good morning. Welcome to our 2018 Outlook call. Joining me this morning from the U.S. are Dan Amos, Chairman and CEO, Kriss Cloninger , President of Aflac Incorporated, Fred Crawford, Executive Vice President and CFO of Aflac Incorporated, Teresa White, President of Aflac U.S., Eric Kirsch, Executive Vice President and Global Chief Investment Officer, and Todd Daniels, Executive Vice President, Global Chief Risk Officer and Chief Actuary. Also joining us from Tokyo this morning are Charles Lake, President of Aflac International and Chairman of Aflac Japan, Masatoshi Koide, President and COO of Aflac Japan, and Koji Ariyoshi, Executive Vice President and Director 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.com, as well as the slides for today's presentation and include reconciliations of certain non-GAAP measures. 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 and value creation. Teresa will give an update on the U.S. strategic focus and outlook, followed by Koide-san, who will provide the strategic focus for our Aflac Japan operations and outlook.
Fred will follow with comments about our 2018 financial outlook and capital management. Dan?
Thank you, Dave. Good morning, and thank you for joining us today as we share with you our outlook for 2018. 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. This has propelled our successful development of strategic points of leverage in both Japan and the U.S. that we will use to grow and drive shareholder value. Our industry-leading market share and scale in both Japan and the U.S. drive our administrative efficiencies. This allows us to offer affordable valued coverage to our customers, along with competitive compensation to our distributors. At the same time, it drives value for our shareholders. Building on the leading position in both countries will help position us for future growth.
As a product innovator, we have experienced remarkable success leveraging the strength of Aflac's recognized and powerful brand to drive sales. About nine out of 10 people in both the U.S. and Japan recognize the Aflac brand. Our brand is a combination of many elements, with the most visible being the Aflac Duck. However, it's also made up of the trust we build through our relationships with businesses, policyholders, and consumers. With this backdrop, we are very proud to be the leaders in voluntary insurance at the worksite in the U.S. and in Japan. We also insure one out of four households. In Japan and the U.S., Aflac's established brand continues to serve as an effective door opener. With a strong brand people know and trust, individuals and businesses are more receptive to hearing about Aflac's products can provide value for them.
As just one example in the U.S., One Day Pay, our industry-leading claims initiative, allows us to process, approve, and pay eligible claims in just one day. Our policyholders and consumers continue to tell us how our commitment to paying claims fast through One Day Pay underscores Aflac's integrity and commitment to deliver on our promise faster than ever. Having diverse and productive distribution channels is a strategic point of leverage and a vital component of our growth strategy in Japan and the U.S. As such, this is an area where we focused a great deal of our efforts. Our goal is to have a presence in all the outlets where consumers in both countries want to make their insurance purchasing decisions. We offer innovative products and high-quality customized service to provide businesses and their employees with affordable solutions that help protect their financial well-being.
We've established a strong capital position with stable earnings and strong cash flows. Our capital ratios demonstrate our commitment to maintaining robust capital levels and flexibility on behalf of our policyholders, bondholders, and shareholders. We also regularly assess our capital adequacy to ensure we remain strong even under extreme economic scenarios. As a result, we hold among the highest financial strength ratings in the industry. Finally, we recognize the need to balance earnings growth with prudent risk management and containing volatility during a period of difficult investment conditions. These points of leverage are long in making and driven from years of investment and strong performance. To be clear, our mission and management challenge is to take advantage of these core franchise strengths to grow the business and our entire enterprise value.
Before I hand the call off to Teresa, I want to take a moment to go over our strategic focus in 2018. Related to Japan branch conversion to a subsidiary, we are on budget with the conversion and approvals are moving forward according to plan. In fact, just this morning, we received a series of key approvals from Japan's Financial Services Agency. This means we are currently on track to meet our midyear 2018 timing objective and may complete the conversion as early as April the 1st. The conversion forms a key to the sustainable growth by bringing enhanced business development flexibility and reduced strategic risk, a consistent regulatory framework aligned with global standards, and improved transparency of cash flows and capital, all of which will be advantageous to all of our stakeholders.
With respect to growth, we are focused on delivering innovative and relevant products in both Japan and the U.S. We also continue to look for ways to expand our distribution, especially in the U.S., where our new chief distribution officer will develop new growth initiatives and continued development and alignment of our current distribution strategies. We continue to evaluate and invest in digital applications and ventures with the aim of improving our customer experience and seeding new growth opportunities. We are focused on maximizing efficiencies by continuing our investment in our IT infrastructure to achieve improved productivity and improve long-term expense ratios. Finally, as it relates to our financial strength, Fred will provide a more detailed outlook, but we are committed to maintaining stable margins and allocating our capital to drive higher returns.
You will see this in both our investment strategy and our decisions surrounding business mix in Japan. We remain committed to returning capital to our shareholders in the form of dividend and repurchase. We also recognize that smart investment in our platform is also critical to grow earned premium and drive efficiencies, which ultimately will impact the bottom line. That investment will continue into 2018 and beyond. Teresa and Koide-san will cover this in my comments shortly. These areas of focus are viewed through the lens of strong leadership and governance. I believe we have the right leaders in the right place at the right time. This will continue to guide and propel our strong governance principles and approach. Now let me turn the program over to Teresa, who will discuss the U.S. Teresa?
Thank you, Dan. I'd like to begin by sharing some key highlights of what we're observing in the U.S. market, a market we believe holds great opportunity and is capable of supporting significant growth, provided we execute. The competitive landscape continues to expand and cause short-term industry disruption. However, competition is driving greater awareness and innovation that we believe will yield expansion of the marketplace over the long run. The need to meet varying customer preferences requires investment and transformation that allows the consumer to access our products on their own terms. There are also clear growth catalysts presented in today's market. With the evolving political climate and increasing media coverage of healthcare, the timing is right to leverage employers' heightened interest and awareness around benefits.
The availability of data-driven technology can help us to get closer to the potential buyer and better respond to the newer generation of consumer. These factors are indicators of strong positive outlook for the voluntary markets. With this as a backdrop, we believe Aflac's benefits will not only continue to remain relevant in this environment, but that the need for them is stronger than ever. Aflac's brand recognition, distribution strength, and unique solutions are competitive advantages in the market. Our 2018 strategic playbook capitalizes on these advantages and will continue to focus on growth, efficiency, and customer experience. Driving growth will include further strengthening our core distribution of sales agents and brokers while building new opportunities to meet the needs of an evolving marketplace.
In 2018, we'll continue to focus on that mid-case market, where regional benefits brokers are demonstrating an interest in our enrollment solutions and voluntary benefits expertise. We'll also expand our producer base through strategic partnerships, which opens new avenues for American workers to access Aflac. Simply put, we want to be where consumers want to buy insurance. From a product perspective, we will continue expansion of our portfolio with long-term and short-term disability. You'll recall we expanded our life portfolio in 2017 with whole, universal, and term life products by partnering with other insurers with expertise in these areas. These true group products provide increased lift in our sales of the core products that we offer in a way that minimizes risk to Aflac. At the same time, they help us to increase our quote activity and case wins by offering the simple, comprehensive solutions that employers need.
Over the last couple of years, we've also been investing in technology with two primary objectives, enhancing customer experience and increasing operational efficiency. From a customer experience perspective, Aflac is responding to the new breed of customer that expects ease, choice, and simplicity. Technologies like enterprise enrollment provide a holistic view of benefits with major medical, voluntary, and value-add, creating a consultative shopping experience for consumers that's transparent and easy to understand. In 2018, we're leveraging digital tools such as decision support tools and call center capabilities to further enhance the Aflac enrollment experience. One-Day Pay provides the ease and simplicity of filing claims while meeting the need of getting claims paid quickly. One-Day Pay has already improved our customer experience. This year, we expect to pay 2.1 million claims in one day.
In 2018, we plan to continue to leverage One-Day Pay by introducing new mobile capabilities that will further empower our policyholders. Now, being an incumbent in today's market, we must invest in our core platforms, especially if we want to leverage digital properties of the future and drive operational efficiency. In 2018, we will leverage Empowered as our digital center of excellence. As you recall, this is a company that we purchased in 2015 and is the developer of our Everwell platform. In addition, we will continue our investment in our core operations to reduce our cost structure and enable ease and agility with third-party integrations. As I mentioned at our investor day in September, these investments will increase our expense ratio in the near term while lowering our expense ratio longer term.
We believe we have the right strategy in play, ultimately, our growth and customer experience objectives will drive strong sales and improve persistency while our efficiency objectives will support lower expense ratios in the long term and strong profit margins. With that, in 2018, we anticipate new annualized premium growth in the range of 3%-5%, in addition to a 2%-3% growth in earned premium. Thank you. Now let me turn the call over to Koide.
Thank you, Teresa. I will discuss Aflac Japan's competitive market environment, our 2018 strategic playbook, and provide a growth outlook for 2018. Regarding the competitive environment, market player consolidation has led to fewer, stronger market players. As such, competition has intensified, especially in the medical market, where numerous products have been released. That said, life insurance providers see growing opportunity in the service sector, where Aflac Japan is the hands-down leader as new and in-force annualized premium or AP continues to rise as shown on the slide. We expect these trends to continue in 2018. It is therefore critical that we invest in our platform to both defend and expand upon our leading position. Aflac Japan's growth strategy continues to focus on developing innovative products in response to ever-changing customer needs and medical advancements, and on enhancement distribution channels.
For 2018, there are four elements of this strategy I would like to highlight. That is promoting Aflac Japan's third sector products. As Aflac Japan moves forward with conversion to a Japan subsidiary, we are carefully considering the rollout of new products and divisions. Though I am not able to comment on the details, we plan to introduce new and refreshed products following Aflac Japan's conversion to a subsidiary. We will also continue to grow Income Support Insurance by increasing awareness of this new category and focusing on those concerned about disability, home ownership, and the like. Second is further strengthening Aflac Japan's distribution initiatives. In 2018, Aflac Japan's strategic alliances will continue to strengthen and evolve, especially with partners including Japan Post, where our ongoing sales training programs take further root. For Aflac Japan's traditional channels, our nationwide model sales office initiative is almost complete.
The initiative is aimed at enhancing sales agent productivity and further strengthening selected high-market potential agencies. While not expected to impact sales in 2018, we will be actively investing in alternative distribution capabilities for future growth. Third is the strategic placement of protection type first sector products. As you know, Aflac Japan has substantially reduced sales of saving type first sector products. At the same time, we will continue to sell protection type first sector products to provide our exclusive agency channel with a more comprehensive product portfolio to continue cross-sell with third sector products. Finally is our ongoing effort to enhance operational efficiencies. As noted during the financial analyst briefing in September, Aflac Japan is fundamentally re-examining its processes and operations, where strengthening procurement and purchase capabilities. In 2018, Aflac Japan will focus on cost structures by leveraging efficiency improvements and information technology.
Smartphone claims applications and voice recognition systems are just two such items we have recently adopted, and we are implementing other projects, including robotics, in various fields of our operations. Aflac Japan will redirect a portion of the generated savings back into the organization for future further efficiency. Aflac Japan will continue to focus on driving long-term sales growth. We will face difficult sales comparisons in the near term, but we believe the previously mentioned strategies will enable us to achieve our long-term growth goals. Also, as noted during our third quarter earnings call, first quarter 2018 sales are expected to decline as compared to the first quarter of 2017, which benefited from our refreshed medical product launch. However, we do anticipate improved third sector sales in the second half of 2018 following introduction of a new third sector product.
We expect to recover in the second half of 2018, but our overall sales results are expected to be modestly down to flat when compared to a very strong 2017. That said, over the past several years, we have increased our third sector annual sales from the mid JPY 60 billion range in 2012 to approximately JPY 85 billion today. That's good business with strong margins and leading market share. We have done so while maintaining very high persistency rates. As illustrated by earned premium, this production engine generates meaningful economic value each year, and this indicates long-term value. Against this backdrop, third sector earned premium is expected to continue its steady growth in the 2%-3% range, reflecting Aflac's stable sales and high persistency in Japan.
In closing, I'm excited about 2018 and confident that Aflac is implementing a nimble, robust product and distribution strategy needed to continue leading the third sector insurance market in Japan. Thank you. I will turn it over to Fred to discuss Aflac's financial outlook.
Thank you, Koide-san. Before providing details on our financial forecast, let me start with a few comments on corporate tax reform. Tax reform is still fluid and evolving as it makes its way through the House and Senate process, and potentially onto the president. While there is greater visibility into the potential tax bill, at this time it is still premature to provide estimates on potential financial impact. We've not incorporated tax reform into our 2018 financial plan and guidance. We are focused primarily on the tax treatment of reserves, deferred acquisition costs, and any changes to territorial tax rules, given our Japan franchise and recognizing we remain a branch for tax purposes. Overall, lowering of corporate tax rates is expected to be a long-term positive to capital formation and cash flows.
While we believe our U.S. RBC would be negatively impacted upon adoption, it would recover over a few years, and we see no material impact to our U.S. capital drawdown plan. Turning to the key drivers of our financial outlook. In Japan, we continue to shift capital away from lower return, asset-leveraged, first sector savings products towards our higher return third sector business. This shift emerges over time in the form of improved FSA earnings and cash flow. It naturally pressures GAAP revenue and earnings as we transition. Overall, margins in both our Japan and U.S. segments remain strong as we continue to experience favorable benefit ratios and underlying claims trends. 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.
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. Finally, in a year of material legal structure transition in Japan, we are actively managing and seeking to optimize the intersection of investment, capital, and liquidity strategies. I'd like to provide greater detail on the assumptions underlying our 2018 core insurance earnings drivers in Japan and the U.S. Focusing first on Japan, we are managing our way through the peak period for limited pay products, mainly five pay WAYS, reaching paid-up status in 2017. This headwind will continue in 2018, negatively impacting earned premium by approximately JPY 36 billion and contributing to a roughly 1.5% overall reduction in premium.
As Koide-san mentioned, we expect third sector earned premium to grow at a steady rate of 2% to 3%. With the distribution of earned premium shifting towards third sector and a lower benefit ratio relative to first sector products, this is expected to lower our reported benefit ratio by approximately 40 basis points in 2018 as compared to 2017. We expect benefit ratios in our core lines of cancer and medical to remain strong, with claims trends continuing to benefit from fundamental changes in Japan's healthcare system. We continue to invest in IT and administration with near-term efficiencies gained from process improvements reinvested back into our platform. We have an active product development pipeline, including investment in digital solutions. We expect near-term expense ratios to be elevated, and we have increased our projected range. Profit margins remain generally consistent with recent performance.
Turning to the U.S., earned premium is expected to grow at around 2%, assuming we continue to achieve our sales targets and reflecting recent improvements in persistency. We think trends in healthcare utilization and hospitalization will continue in the near term as consumers struggle to afford higher deductibles and co-pays. Our expense ratio will be elevated as we have been actively investing in our U.S. IT and digital platforms. It's also worth noting that our capital management plans in the U.S. impact net investment income in the segment. Profit margins in the U.S. are expected to be strong, but modestly lower as compared to our 2017 performance. Turning to investment strategy, Japan net investment income is expected to increase by nearly JPY 3 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 JPY fixed income investments continue as a headwind, but is more than offset by the gradual build in our U.S. dollar portfolio. Hedge costs in 2018 are projected to stay relatively neutral versus 2017. We continue to lower our hedge ratio while at the same time lengthening the average duration at modestly higher pricing. The larger floating rate portfolio will allow for increased use of shorter duration forwards for hedging, and we will continue to increase the duration of the forwards backing longer U.S. fixed income investments. Our objectives include closing the duration gap for greater stability in investment income, reducing our hedge ratio reflecting our view of long-term and stressed economic value in Japan, while balancing SMR and FSA earnings volatility and managing costs.
As mentioned earlier, net investment income for the 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. Turning to our near-term capital outlook, in the third quarter, SMR is in excess of 1,000%, and RBC on a consolidated basis in the mid 800% range. Our SMR ratio is sensitive to market fluctuations and is elevated by unrealized gains in our AFS portfolio. We tend to focus on the quality of our SMR without unrealized gains and losses, which is currently in the 800% range.
As we discussed during our September FAB conference, 2018 is a year of transition, and we believe it prudent to carry a level of excess capital and liquidity throughout the year, then looking to optimize once settled in. We are repositioning excess capital in the U.S. to Japan in support of lowering our U.S. dollar portfolio hedge ratio and continue on our U.S.-only RBC drawdown path. In our execution of this strategy, we will reduce Japan repatriation in 2018 by JPY 60 billion, and then spend down excess capital moved out of the U.S. entity to support a stable level of deployment. We expect 2018 repurchase to be in the range of $1.1 billion-$1.4 billion, the wider range allowing us to be more tactical in our deployment strategy as opportunities emerge to invest in growth or other strategic investments. As is always the case, this assumes stable capital conditions.
Leverage will remain around the midpoint of our 20%-25% policy range. Our holding company liquidity is expected to travel in the range of $1.5 billion-$2 billion in 2018, remembering that we now hold a minimum of $1 billion as contingent capital with additional funds for day-to-day liquidity. Concluding with our view of earnings per share, we are projecting a range for 2018 operating EPS of $6.65-$6.95 per share, assuming a foreign exchange rate of JPY 112 to the dollar. This excludes the cost of our branch conversion, which are expected to accelerate in the next few quarters. When looking at our currency-neutral EPS estimates for 2018 and normalizing for certain tax and reserve benefits identified throughout 2017, the range equates to approximately a 2% increase. We view this as a solid plan when considering incremental investments into our Japan and U.S.
digital growth in IT platforms totaling $0.15 to $0.20 a share, and a balanced approach to capital deployment. Our plan does assume a continuation of favorable claims trends in Japan and in the U.S. and associated reserve adjustments somewhat consistent with our experience in 2017. Our financial playbook for creating value is straightforward. Defend the attractive margins in our core supplemental health business, allocate capital to stable businesses that earn comfortably above our cost of capital, and invest to drive eventual top-line growth and improve efficiencies. Finally, in this year of transition, we continue to balance maintaining strong capital ratios with returning capital to our shareholders. I'll now turn the call back to David to take us into Q&A. David?
Thank you, Fred. Before we take your questions, let me remind you that to be fair to everybody, please limit yourself to one initial question and then a follow-up that relates to that initial question. We will now take the first question.
Thank you, speakers. We will now begin the question and answer session. The first question is coming from the line of Mr. Jimmy Bhullar of J.P. Morgan. Your line is now open.
Thanks. Hi, good morning. First, I just had a question on long-term EPS growth potential. I think you're indicating about 2% EPS growth this year, and there are obviously headwinds related to investment in the business that you're talking about, but there's also a little bit of a tailwind from drawing down the U.S. RBC. To what extent do you feel this is reflective of your long-term EPS growth potential? As you look beyond 2018, do you expect EPS growth to pick up, or should it be close to where you're expecting it to be next year?
Thank you, Jimmy. As you know, we don't tend to give what I would call long-range EPS targets, per se, but from a general statement, our near-term EPS is weighed down by a couple of natural things. Most notably is the reinvestment back into the platform. I call out, for example, this particular year, roughly $0.15-$0.20 of impact related to investments in both Japan and the U.S. I, by the way, would break that down as roughly JPY 7 billion of incremental investment in IT and digital platform in Japan and around $35 million-$40 million pre-tax in the U.S. This is really backing the statements of Teresa and Koide-san. That type of investment in the platform is extremely important. It is what is going to eventually yield both defending and growing our business going forward, and with that, earning strength.
The other dynamic that is starting to take hold is you are indeed seeing a bit of a shift or turning now gradually, very gradually, of investment income in Japan. We still face headwinds related to the reinvestment of higher coupon maturities and calls, largely in these old private placements that are quite sizable when they mature. There's still a headwind there. Obviously, as you've seen, spreads have tightened up quite a bit, reinvestment rates are pressured by spreads being tight. Having said that, it's starting to slow and starting to turn. For example, you're seeing some pickup even after hedge costs in net investment income this year. We have some things that represent tailwinds, if you will, to earnings growth as we move forward.
That earnings growth is only going to come if we execute and invest back in our platform and take advantage of the core points of leverage that Dan outlined in his comments. A little bit of near-term weakness was certainly the idea and was certainly the goal, if you will, of long-term improvement in growth rates and EPS.
Okay. If I could ask just one more on the buyback range. I think this year especially, you did more in the first half, and you're slated to do a little bit less in the second half. You mentioned tactical as you talked about buybacks. What are going to be the factors that influence, one, the timing of your buybacks, and second, if you fall at the high end or the low end of the range?
Yeah. Let's first discuss timing. You're absolutely right. We have historically had a pattern of more of a front-end loading, if you will, of repurchase, and we have not assumed that in this plan. We've assumed just a balanced and smooth approach to repurchase over the course of the year. We're not benefiting, if you will, from any, what I would characterize as acceleration from a plan assumption standpoint. What would cause us to change our views would really be the view of it being opportunistic, if you will, from a timing perspective to put our capital in that direction. We always have that ability to do it, but we have not assumed that in the plan. My guidance on that would be you should assume a somewhat smooth approach to repurchase throughout this year, unlike previous years.
In terms of what would influence the bottom end and the top end of the range, it would largely be essentially the alternatives, if you will, for the use of our excess capital. To be very clear, I have $1.1 billion-$1.4 billion of repurchase guidance for 2018. If you recall our FAB comments in September, through the course of 2017, 2018, and 2019, we're projecting upwards of $3.5 billion or $3.6 billion of repurchase. To be very clear, we view the buying of our stock as a good long-term investment. Having said that, in order to make that a good long-term investment, we need to be allocating our capital towards growth rates and investments that defend our margins and manage efficiencies.
Those are the types of decisions we're making, and fundamentally, that's what's going to really give rise to being on the low or the high end of that range.
Okay. Thank you.
Thank you. The next question is coming from the line of Humphrey Lee of Dowling & Partners. Your line is open.
Good morning, and thank you for taking my question. Just a question regarding the impact of the branch conversion and the sales to the new product introduction in Japan. Based on the prepared remarks, we could see the conversion to be completed as early as April 1st. Would that accelerate your plan in terms of rolling out new products? Instead of happening in the second half, we could see actually your product launch in the second quarter if you were able to complete the conversion earlier?
Yeah, this is Dan. I'm going to let Koide-san answer that.
This is Koide from Aflac Japan.
Hello?
In terms of the new product launch for 2018, we are thinking of launching it immediately after the conversion. We are hoping to launch the new product in the early timing of the second quarter.
Okay. Got it. I think it got cut off a little bit, but I think I get the most of it. A follow-up question on the distribution in Japan. I think Koide-san talked about potential kind of alternative distribution strategy in Japan. Just to kind of get a sense, are you talking about digital distribution or actually working with an alternative distribution partner? Like, for example, Dai-ichi recently launched a partnership with Matsumoto Kiyoshi. Is that something that you would look into in terms of as a strategic distribution partner?
This is Aflac Japan, Koide again. Right now we are considering digital platform, and therefore we are making investments into a digital platform.
What about the potential partnership with another kind of brick-and-mortar company?
I'll answer that. We are constantly looking for ways to get to the consumer wherever they're located. Yes, we would be looking at that. We have nothing on the horizon at this particular point. Our concentration, we believe, in today's environment is the digital platform to make sure the younger people, through cell phones, we're able to reach. We have looked at that. Certainly as you've seen with Dai-ichi Life, Daido Life, and also with Japan Post, we are constantly looking for partners, and there are a few potentials out there that we've had some discussions, but there's nothing on the horizon that we would announce at this particular time.
Understood. Thank you.
Thank you. The next question is coming from the line of Nigel Dally of Morgan Stanley. Your line is now open.
Great. Thank you, and good morning. The higher investments into IT and operations, you've been making those investments in those areas for several years, and as you mentioned, it'll continue into 2018. Beyond 2018, should we expect those investments to trail off? It's been a multi-year initiative. Just hoping to get some color as to how long these investments will continue.
The answer is yes, you should expect those to tail off. I would say for a number of years in Japan, we have been making those investments, and those investments have been, in fact, yielding savings, but we've been effectively recycling, if you will, those savings and efficiencies back into further advancing the IT model. This really is a strategy to try to maintain margins and profitability as we move along. In the U.S., however, it's been a bit more of a recent level of activity and therefore more accelerated, and that's in part why in the U.S. you see a bit more of a pronounced impact to expense ratio and bottom-line margins as opposed to Japan, which has remained relatively stable. In both cases, they will eventually wind down and start to yield better results.
This really, frankly, goes back to some of my comments at the FAB conference, where we're talking about work underway to achieve long-term run rate expense ratios that are improved from their current elevated levels. At FAB, you might recall, I talked about a five-year plan, if you will, over the course of the next five years to drive our expense ratios down towards the midpoint of Japan's expense ratio guidance, that guidance being 19%-21% or rather 18%-20%. We want to try to drive it down towards the midpoint of that range. In the U.S., our comments were to drive down towards the low end of the expense ratio range of 33%-35%.
This is a long-term plan, and just like any expense ratio, it obviously relies as much on revenue and revenue growth as it does on executing on the expense side. It's clearly a challenging objective over time, but these investments are in fact expected to stabilize and start to reduce in terms of expense ratio pressure and therefore yield together with growth, improved expense ratios, and defense of our margins.
That's great. Thanks, Fred.
Thank you. The next question is coming from the line of Erik Bass of Autonomous Research. Your line is now open.
Hi, thank you. Fred, can you talk about some of the things that you're looking at that would fall into the opportunistic capital deployment bucket, and how much of this capital has already been sort of earmarked or allocated and factored into your guidance?
I think there's a couple ways to think about. Let's first address the first part of your question, opportunities. First, what are we doing already? Well, what we're already doing is building out our venture investments. As you know we have announced a $100 million venture capital fund. We've made to date, both in Japan and the U.S., eight investments totaling approximately $25 million, to give you an idea of the capital committed thus far. We would expect over the course of the next couple of years to put that $100 million in total to work. That's one area. The second area of opportunities is similar in that it evolves around what I would characterize as digital opportunities, technology investment opportunities, and possibly digital and technology that relate to distribution expansion or alternative distribution. That tends to be the categories that we find most interesting.
It tends not to be what I would call traditional insurance-related opportunities because, with our scale, the depth and breadth of our product, we tend not to find those necessarily additive to our value. It tends to be hovered around technology, digital distribution expansion, and those types of investments. By definition, that is not always the case, but it tends to be smaller in nature, thus it doesn't disrupt entirely our capital plan and deployment plan. That's not always guaranteed, but it tends to be the types of things that we're looking at and find interest in. Meanwhile, organically, we're investing in our digital platform in Japan, which includes new product development and new product delivery. Then in U.S., you might recall that two years ago, we acquired a company called Empowered Benefits in Charlotte.
That acquisition was approximately $35 million-$40 million in size, but we have been adding to that platform as essentially a digital hub as well as also an incubation site for venture investments. We've been actively building out that platform, and that represents actually a good portion of the incremental $35 million-$40 million I mentioned earlier in the U.S. Those are the types of things we're looking at opportunistically. In terms of sizing it, one way to size the opportunity fund, if you want to call it that, would be the difference between the low point and the high point of our share repurchase range. That would suggest something in the neighborhood of $300 million. I would tell you that we're generating capital a bit over and above that level. We've got the capability of investing more if necessary.
We'll make those decisions according to where we see the best returns for our shareholders.
Just to be clear, we've had a lot of discussions about this. Our first priority is share repurchase because that's the safest and the thing that we like to do, but we've also got to be prepared for the future. It is changing rapidly, and some of the things that we're adding too, we feel like have been good investments and will help us for long-term growth.
Thank you. One other question. Fred, you mentioned the RBC ratio impact of tax reform, and obviously the initial decline makes sense as it's largely mechanical. I was curious about your view that the ratio would recover over time. Is that just as simple as that you would have higher statutory earnings, but you would pay a similar kind of level of free cash flow to the holding company as you do currently, so you would build capital?
That's right. That's a fair way of assuming it. Based on the modeling we've done, of course, tax reform is fluid, we have to continue to kind of watch it. Based on what we understand of the treatment of just simply a lower corporate tax rate or a lower tax rate in general, that you would tend to have around a 15% impact to your RBC. What do I mean by that? If you're running at 1,000 RBC on a U.S.-only basis, you would have an impact approaching 150 points. If you're running at a 500% RBC, the impact would be approaching 75 points. We would expect to recover that over a roughly two to three-year period in the way of capital formation from the higher cash flows or statutory earnings with the lower corporate tax rate. That's essentially the very basic math.
All in, it recovers very quickly, it really does not disrupt any of our near-term capital plans.
Got it. That's helpful. Your overall free cash flow to the holding company is the same. I guess the percentage relative to your GAAP earnings would be a little bit lower.
I think that's right. Yep.
Okay. Thank you.
Thank you. The next question is coming from the line of Mr. Thomas Gallagher of Evercore ISI. Your line is now open.
Good morning. Fred, just a follow-up on capital return. In terms of the $1.8 billion to $2.1 billion, does that include the deployment of $500 million of excess? If so, does that tell us that JGAAP earnings are trending lower here in terms of sort of driving the outlook? Can you talk a little bit about what's happening to the Japan earnings side, the dividend flow coming out of there for now?
Yeah. Let me just start with the first premise of your question, and that is you have to separate the deployment estimate, which is the $1.8 billion to $2.1 billion, from what I would call capital generation in the company. Capital generation tends to be, as we've said at FAB, free cash flow generation between $1.6 billion and $1.8 billion. On top of that would be the $500 million of excess capital. That is your capital generation engine as a company. It travels a bit north of this deployment level. That's primarily because, as I mentioned in my comments, we're carrying a level of excess capital and liquidity into this year of transition. We want to get through this year, settle into our new corporate structure and new cash flow rules of engagement, and then optimize. Optimize the capital structure and optimize cash flow.
It's really just being prudent during a time of transition. You have to separate capital generation from the deployment guidance that we have here. They're modestly different. In terms of FSA earnings, as I mentioned in my comments, by pulling back on first sector savings and continuing to grow third sector, we're seeing better results in our FSA earnings. In the near term, they tend to be increasing at around the 3%-5% range. The reason why that's a little bit lower is because we are investing so actively in the Japan platform, as I mentioned earlier. Over time, we would expect that to pick up. You have to set everything else equal. Obviously, FSA earnings can be subject to market volatility.
Setting aside market volatility and impairment dynamics, we would expect a steady, roughly mid-single-digit build in FSA earnings over time, and that's the free cash flow I mentioned.
Fred, the visibility on FSA earnings is still pretty good, and you see that more as a tailwind relative to, we'll say, Japan earnings as they're reflected on a GAAP basis. You think that they should improve on a relative basis based on that trend?
That's right.
Okay.
I focus primarily on that FSA earnings build because that's really a sign of your strategy yielding economic value creation and capital generation, and we're seeing good signs there.
Okay, I just want to get a better sense for the NII. I think the 1% increase in Japan is certainly a pretty good outcome, just considering where interest rates are in Japan. I know there's a mix issue with the shift into the USD portfolio that's driving it. As you think about the next several years, do you think we can remain flattish even if rates remain where they are in Japan? If rates remain where they are in Japan, will that reinvestment headwind catch up to you at some point?
I'll ask Eric to comment on that.
Sure, Tom. Obviously, in a way, that's a forecasting question. I would frame it to you more than just where Japan rates are, because remember now, the portfolio is well-diversified. Yen rates will impact us with reinvestment into JGBs, other yen products, particularly as we think about ALM. We now have a dollar portfolio, and with the buildup of the floating rate securities, besides the attractive new money yields we're getting, those will float in the future.
It's more than just yen rates. It's also what will dollar rates do, particularly at the short end with respect to LIBOR, and that will also correlate with hedge costs. Finally, we have initiated our growth portfolio, the alternatives like private equity and real estate. Those will obviously be variable income, so there could be some volatility. By and large, we would expect over the next few years to get positive contributions there. When you add all of that up, we certainly cannot predict what rates will do in the future. To your premise, if they stayed relatively flat, we would expect a small growth rate over the next few years to NII. We model that regularly, but obviously it's going to be very dependent. We're diversified, and that's what I want to stress.
Even if Japan yields were to go down, it's possible U.S. yields go up, variable income goes up, and those could be tailwinds against any headwinds.
Thanks, Eric. How big is the floating rate portfolio again right now?
Right now it's about $6 billion, it'll grow to probably about eight or nine by the end of next year.
Okay, thanks.
Thank you. The next question is coming from the line of Suneet Kamath of Citi. Your line is now open.
Thanks. Good morning. Just wanted to go back to tax reform. If the tax rate does go to 20%, can you just talk about the impact on your GAAP tax rate? I know your tax statements will be a little different, but on a GAAP basis, what happens to the tax rate?
Yes. Obviously, we are, as I mentioned, a branch for tax purposes. We are a U.S. taxpayer. Japan's corporate tax rate is 28%. As a result, if you were to lower the corporate tax rate to 20%, our effective tax rate remains in the 26% territory by virtue of Japan's higher corporate tax rate under that scenario. I might also note that because we're a U.S. taxpayer, and have been a branch for tax purposes, we don't have any effect, if you will, related to things like one-time repatriation tax benefits and so forth. We have been and continue to be paying taxes on our earnings in Japan, and the repatriation associated with it.
Got it. For Teresa, in your outlook slide, you talked about disruptive forces in the U.S., I just wanted to drill into that a little bit just to understand. Are these the sort of the traditional things that we're used to thinking about, other insurance companies moving into supplemental? Are you talking about some sources of competition that we're traditionally have not seen?
I think that you've got it characterized correctly. It's the traditional true group players moving into the voluntary market, it's a push for many of these digital properties moving into the insurance market as well. We're not just competing on product, we're also competing on a digital platform as well.
Got it. Just lastly for you also, Teresa, in terms of persistency, we've seen a nice move over the past several years into the high 70s for the U.S. Any thoughts on where you think or you'd like to see that go, given some of the initiatives that you talked about?
Well, in our plan for 2018, our goal is to hold it steady. We're at the highest levels we've been in a while, our plan is to hold it steady. I will say this, as we continue to bring in new technology that allows us to be more efficient, you can expect that then it also will reduce the manual nature of some of the activities that we do, which will reduce errors. From an operational efficiency standpoint, I do believe that we still have room to improve our persistency, especially when we know that some of the loss in the premium that we get is because of an error that we'll make or our employees will make. At the end of the day, I think that there's still room, our plan is basically aligned with keeping it steady.
Let me say one thing about persistency is that I want to give kudos to our U.S. and what they've done, because you can improve persistency by riding or keeping sick old people and knocking your loss ratio through the roof. You've got to figure out how to bring the young people on with the older, sicker people to make sure it's balanced as you do it. We've been able to do that. It's not just about persistency, it's about the combination of the two. I just want to make note that they've done an excellent job of that, and I'm very pleased with it.
Hi, this is Eric again. I'm sorry. I just want to correct an answer I gave to Tom. The floating rate assets at the end of this year is expected to be $2.7 billion, and at the end of next year, about $5.5 billion. Just to correct that. I mixed up some numbers there.
I guess to end my point is that as we improve our service, we will improve our persistency. I believe that.
Okay. Thanks, Teresa.
Thank you. The next question is coming from the line of Ryan Krueger of KBW. Your line is now open.
Hi. Thanks. Good morning. Just one quick one for Fred Crawford. Can you give us a sense of how much NII the U.S. to the corporate segment as we think about the corporate segment into next year?
I think what we're doing there, Ryan Krueger, is that we're attempting to select and shift, as much as possible, the dividend of actual securities up to the U.S. We can only do this within practical limits, if you will because obviously that capital at the holding company, while it is of a slightly more permanent nature, it needs to be somewhat ready capital. We're doing that in an attempt to preserve as much NII for the organization as we can. I'm going to give you a very round number, but it's approximately correct. We're trying to preserve around $25 million or so of annualized NII up at the holding company. That's roughly in line with what we would hope to do. I would tell you that that's going to require very specific selection of securities and transfer.
I would suggest it's a bit range bound around that number.
Okay, thanks. One more on tax reform. In terms of the lower RBC ratio expectation, at this point in time, do you believe you will need to rebuild the RBC ratio back up to what it was before as a result of tax changes? Do you think it's possible rating agencies change their view of what the appropriate RBC is post-tax reform?
Yeah, it's a great question. No doubt a question that's on the minds of my peers, CFOs across the industry. Fundamentally, you would expect there to be somewhat of a reset. We have a lot of moving parts on RBC, as it turns out. We've got the tax reform moving parts. We also have some C1 asset charges that are being adjusted here in the near term. We've got what I would call industry-wide adjustments of RBC taking place now, both potentially tax and C1. We'll have to see how all that plays out. Right now, our view is you assume effectively no change in the mind frame of a rating agency, if you will, relative to their standards for RBC and your ratings. That may evolve. That may evolve as we move forward. I mentioned a couple of times optimization. U.S.
RBC is a point of optimization for this company, and I think there's opportunity there over time. Japan SMR and with it, FSA earnings volatility, hedge ratio, that's another area of optimization model for the company. Finally, at the holding company, we're carrying a fairly good amount of contingent capital and liquidity, and we want to seek to optimize that. I would say beyond RBC, we're going to be looking at those three major buckets for how we best dial it in to be the most effective for our shareholders, while at the same time maintaining our industry-leading ratings.
Okay. Thanks, Fred.
Thank you. The next question is coming from the line of Alex Scott of Goldman Sachs. Your line is now open.
Hi. Thanks for taking the question. I guess on the holding company liquidity and contingent capital, it looks like that's expected to grow well above, I guess the billion-dollar minimum that you guys, I think increased from $500 million at the FAB. Just wondering about how you think about the amount of excess on the other side of coming out of the branch conversion. Maybe between that and debt capacity, how much do you think is there to optimize when you're on the other side of that?
Yeah. In terms of debt capacity, if you make the assumption that we're traveling by and large in the mid-range of our 20%-25% leverage, I'm going to round for you and say we comfortably have about $1 billion of what I would call debt capacity available to us if necessary or if we desire and optimize. I would tell you that leverage for this company is somewhat constrained, if you will, in the sense that we always have to have one eye towards the free cash flow dynamics in Japan, and with that, frankly, the SMR ratio, which can be quite volatile. That requires us to remain at arguably a lower level of leverage than our business model could afford. We certainly could afford more leverage, but that's a tricky dynamic. That's the leverage statement.
In terms of holding company liquidity, the billion-dollar minimum is really pure contingent capital. That is, we need actual capital in the system on a short-term basis, and we have that ability to invest that money. Beyond that, we have natural liquidity needs, and the largest liquidity need we have at the holding company, particularly after conversion, is the fact that we hold certain derivatives at the holding company. This would include swaps on our debt from USD to JPY, and also repatriation hedges that we have in place. As a result, we have to be always on the ready to not only receive, but also post collateral for those derivatives. We tend to carry a fairly good amount of excess liquidity just to make sure that we obviously don't have any adverse conditions related to the posting of collateral.
We do a heck of a lot of stress testing around that. In that dynamic of contingent capital and contingent liquidity, that's in fact where there's optimization opportunities. If we look at the capitalization in Japan and the U.S., and then we put on top of that contingent capital, we have opportunity to say, what's that really right amount to dial in based on stress testing once we settle into our new structure? Same goes with derivatives. As we look at repatriation hedging strategies, as we issue more debt in actual JPY, as we have recently, as opposed to USD and swapping it, that gives rise to the potential to optimize the level of standby liquidity we have at the holding company. I'm going into greater detail with you, but this is what I mean when I say optimization opportunity. Now's not the time.
We need to settle into this new structure, then move forward.
Understood. Maybe just one on Japan. The SMR that you guys are reflecting here, does that already include the 750, I guess, buffer that was going to be put in there for the USD investments? Or is that SMR coming down sort of-
I guess, incremental to the 750 that I guess would be positive?
Yeah. The more precise level of capital retention in Japan that is planned is JPY 60 billion of planned retention of capital. For example, our actual repatriation estimate, if you will, combination repatriation and dividend for 2018, is approximately JPY 80 billion. That is down JPY 60 billion representing the retention in Japan. Okay. That equates to about $550 million, depending on the conversion rate you want to use. What happens is, in the SMR ratio, there's a level of accrual that takes place based on your plans for dividend and dividend expectations, or in this case, repatriation. In other words, there is, in fact, an element of that planned JPY 60 billion retention that is in the SMR ratio. It's part of the contribution to it being higher. Frankly, the biggest contribution is the AFS portfolio in unrealized gains.
Okay, thanks.
Thank you. At this time, speakers, we don't have any questions on queue. I will now turn the call over back to Mr. David Young.
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