UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
(Mark One)
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2011
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number: 001-07434
Aflac Incorporated
(Exact name of registrant as specified in its charter)
Georgia | 58-1167100 | |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) | |
1932 Wynnton Road, Columbus, Georgia | 31999 | |
(Address of principal executive offices) | (ZIP Code) |
706.323.3431
(Registrants telephone number, including area code)
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. þ Yes ¨ No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). þ Yes ¨ No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
Large accelerated filer þ | Accelerated filer ¨ | |
Non-accelerated filer ¨ (Do not check if a smaller reporting company) | Smaller reporting company ¨ |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ¨ Yes þ No
Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest practicable date.
Class | July 28, 2011 | |||
Common Stock, $.10 Par Value | 467,160,513 shares |
Aflac Incorporated and Subsidiaries
Quarterly Report on Form 10-Q
For the Quarter Ended June 30, 2011
Table of Contents
Items other than those listed above are omitted because they are not required or are not applicable.
i
Review by Independent Registered Public Accounting Firm
The June 30, 2011, and 2010, consolidated financial statements included in this filing have been reviewed by KPMG LLP, an independent registered public accounting firm, in accordance with established professional standards and procedures for such a review.
The report of KPMG LLP commenting upon its review is included on the following page.
1
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders
Aflac Incorporated:
We have reviewed the consolidated balance sheet of Aflac Incorporated and subsidiaries (the Company) as of June 30, 2011, and the related consolidated statements of earnings and comprehensive income (loss) for the three-month and six-month periods ended June 30, 2011 and 2010, and the consolidated statements of shareholders equity and cash flows for the six-month periods ended June 30, 2011 and 2010. These consolidated financial statements are the responsibility of the Companys management.
We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should be made to the consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.
We have previously audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Aflac Incorporated and subsidiaries as of December 31, 2010, and the related consolidated statements of earnings, shareholders equity, cash flows and comprehensive income (loss) for the year then ended (not presented herein); and in our report dated February 25, 2011, we expressed an unqualified opinion on those consolidated financial statements. Our report refers to a change in the method of evaluating the consolidation of variable interest entities (VIEs) and qualified special purpose entities (QSPEs) in 2010 and a change in the method of evaluating other-than-temporary impairments of debt securities in 2009. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2010, is fairly stated in all material respects, in relation to the consolidated balance sheet from which it has been derived.
Atlanta, Georgia |
August 5, 2011 |
2
Aflac Incorporated and Subsidiaries
Consolidated Statements of Earnings
Three Months Ended June 30, |
Six Months Ended June 30, |
|||||||||||||||
(In millions, except for share and per-share amounts - Unaudited) | 2011 | 2010 | 2011 | 2010 | ||||||||||||
Revenues: |
||||||||||||||||
Premiums, principally supplemental health insurance |
$ | 4,956 | $ | 4,333 | $ | 9,828 | $ 8,681 | |||||||||
Net investment income |
784 | 727 | 1,579 | 1,453 | ||||||||||||
Realized investment gains (losses): |
||||||||||||||||
Other-than-temporary impairment losses realized |
(528 | ) | 0 | (933 | ) | (42) | ||||||||||
Sales and redemptions |
(182 | ) | 14 | (326 | ) | (7) | ||||||||||
Derivative and other gains (losses) |
42 | (103 | ) | 12 | (86) | |||||||||||
Total realized investment gains (losses) |
(668 | ) | (89 | ) | (1,247 | ) | (135) | |||||||||
Other income |
16 | 9 | 44 | 45 | ||||||||||||
Total revenues |
5,088 | 4,980 | 10,204 | 10,044 | ||||||||||||
Benefits and expenses: |
||||||||||||||||
Benefits and claims |
3,310 | 2,885 | 6,532 | 5,741 | ||||||||||||
Acquisition and operating expenses: |
||||||||||||||||
Amortization of deferred policy acquisition costs |
264 | 229 | 542 | 509 | ||||||||||||
Insurance commissions |
427 | 398 | 849 | 801 | ||||||||||||
Insurance expenses |
543 | 508 | 1,051 | 988 | ||||||||||||
Interest expense |
46 | 33 | 92 | 66 | ||||||||||||
Other operating expenses |
45 | 38 | 86 | 76 | ||||||||||||
Total acquisition and operating expenses |
1,325 | 1,206 | 2,620 | 2,440 | ||||||||||||
Total benefits and expenses |
4,635 | 4,091 | 9,152 | 8,181 | ||||||||||||
Earnings before income taxes |
453 | 889 | 1,052 | 1,863 | ||||||||||||
Income taxes |
173 | 308 | 378 | 646 | ||||||||||||
Net earnings |
$ | 280 | $ | 581 | $ | 674 | $ | 1,217 | ||||||||
Net earnings per share: |
||||||||||||||||
Basic |
$ | .60 | $ | 1.24 | $ | 1.44 | $ | 2.60 | ||||||||
Diluted |
.60 | 1.23 | 1.43 | 2.58 | ||||||||||||
Weighted-average outstanding common shares used in computing earnings per share (In thousands): |
||||||||||||||||
Basic |
466,498 | 468,824 | 467,317 | 468,377 | ||||||||||||
Diluted |
469,752 | 472,539 | 470,990 | 472,497 | ||||||||||||
Cash dividends per share |
$ | .30 | $ | .28 | $ | .60 | $ | .56 | ||||||||
See the accompanying Notes to the Consolidated Financial Statements.
3
Aflac Incorporated and Subsidiaries
Consolidated Balance Sheets
(In millions) | June 30, 2011 (Unaudited) |
December 31, 2010 |
||||||
Assets: |
||||||||
Investments and cash: |
||||||||
Securities available for sale, at fair value: |
||||||||
Fixed maturities (amortized cost $46,415 in 2011 and $43,133 in 2010) |
$ 47,380 | $ 43,100 | ||||||
Fixed maturities - consolidated variable interest entities (amortized cost $4,853 in 2011 and $4,969 in 2010) |
5,126 | 5,255 | ||||||
Perpetual securities (amortized cost $5,627 in 2011 and $6,209 in 2010) |
5,559 | 5,974 | ||||||
Perpetual securities - consolidated variable interest entities (amortized cost $1,632 in 2011 and $1,618 in 2010) |
1,544 | 1,538 | ||||||
Equity securities (cost $21 in 2011 and $22 in 2010) |
23 | 23 | ||||||
Securities held to maturity, at amortized cost: |
||||||||
Fixed maturities (fair value $31,405 in 2011 and $29,899 in 2010) |
31,289 | 29,470 | ||||||
Fixed maturities - consolidated variable interest entities (fair value $577 in 2011 and $570 in 2010) |
619 | 614 | ||||||
Other investments |
153 | 135 | ||||||
Cash and cash equivalents |
1,291 | 2,121 | ||||||
Total investments and cash |
92,984 | 88,230 | ||||||
Receivables |
879 | 661 | ||||||
Accrued investment income |
739 | 738 | ||||||
Deferred policy acquisition costs |
10,028 | 9,734 | ||||||
Property and equipment, at cost less accumulated depreciation |
611 | 620 | ||||||
Other |
991 (1) | 1,056(1) | ||||||
Total assets |
$ | 106,232 | $ | 101,039 | ||||
(1) | Includes $495 in 2011 and $564 in 2010 of derivatives from consolidated variable interest entities |
See the accompanying Notes to the Consolidated Financial Statements.
(continued)
4
Aflac Incorporated and Subsidiaries
Consolidated Balance Sheets (continued)
(In millions, except for share and per-share amounts) | June 30, 2011 (Unaudited) |
December 31, 2010 | ||||||||
Liabilities and shareholders equity: |
||||||||||
Liabilities: |
||||||||||
Policy liabilities: |
||||||||||
Future policy benefits |
$ 74,472 | $ 72,103 | ||||||||
Unpaid policy claims |
3,855 | 3,719 | ||||||||
Unearned premiums |
1,306 | 1,197 | ||||||||
Other policyholders funds |
6,733 | 5,437 | ||||||||
Total policy liabilities |
86,366 | 82,456 | ||||||||
Notes payable |
3,048 | 3,038 | ||||||||
Income taxes |
2,186 | 1,969 | ||||||||
Payables for return of cash collateral on loaned securities |
338 | 191 | ||||||||
Other |
2,313(2) | 2,329(2) | ||||||||
Commitments and contingent liabilities (Note 10) |
||||||||||
Total liabilities |
94,251 | 89,983 | ||||||||
Shareholders equity: |
||||||||||
Common stock of $.10 par value. In thousands: authorized 1,900,000 shares in 2011 and 2010; issued 663,412 shares in 2011 and 662,660 shares in 2010 |
66 | 66 | ||||||||
Additional paid-in capital |
1,372 | 1,320 | ||||||||
Retained earnings |
14,587 | 14,194 | ||||||||
Accumulated other comprehensive income (loss): |
||||||||||
Unrealized foreign currency translation gains |
914 | 926 | ||||||||
Unrealized gains (losses) on investment securities: |
||||||||||
Unrealized gains (losses) on securities not other-than-temporarily |
752 | 36 | ||||||||
Unrealized gains (losses) on other-than-temporarily impaired securities |
0 | (3) | ||||||||
Unrealized gains (losses) on derivatives |
6 | 31 | ||||||||
Pension liability adjustment |
(125) | (128) | ||||||||
Treasury stock, at average cost |
(5,591) | (5,386) | ||||||||
Total shareholders equity |
11,981 | 11,056 | ||||||||
Total liabilities and shareholders equity |
$ 106,232 | $ 101,039 | ||||||||
(2) | Includes $584 in 2011 and $741 in 2010 of derivatives from consolidated variable interest entities |
See the accompanying Notes to the Consolidated Financial Statements.
5
Aflac Incorporated and Subsidiaries
Consolidated Statements of Shareholders Equity
Six Months Ended June 30, | ||||||||
(In millions - Unaudited) | 2011 | 2010 | ||||||
Common stock: |
||||||||
Balance, beginning of period |
$ | 66 | $ | 66 | ||||
Balance, end of period |
66 | 66 | ||||||
Additional paid-in capital: |
||||||||
Balance, beginning of period |
1,320 | 1,228 | ||||||
Exercise of stock options |
15 | 32 | ||||||
Share-based compensation |
18 | 17 | ||||||
Gain (loss) on treasury stock reissued |
19 | (6) | ||||||
Balance, end of period |
1,372 | 1,271 | ||||||
Retained earnings: |
||||||||
Balance, beginning of period |
14,194 | 12,410 | ||||||
Cumulative effect of change in accounting principle, net of income taxes |
0 | (25) | ||||||
Net earnings |
674 | 1,217 | ||||||
Dividends to shareholders |
(281) | (262) | ||||||
Balance, end of period |
14,587 | 13,340 | ||||||
Accumulated other comprehensive income (loss): |
||||||||
Balance, beginning of period |
862 | 29 | ||||||
Unrealized foreign currency translation gains (losses) during period, net of income taxes: |
||||||||
Cumulative effect of change in accounting principle, net of income taxes |
0 | (320) | ||||||
Change in unrealized foreign currency translation gains (losses) during period, net of income taxes |
(12) | 143 | ||||||
Unrealized gains (losses) on investment securities during period, net of income taxes and reclassification adjustments: |
||||||||
Cumulative effect of change in accounting principle, net of income taxes |
0 | 180 | ||||||
Change in unrealized gains (losses) on investment securities not other-than-temporarily impaired, net of income taxes |
716 | 587 | ||||||
Change in unrealized gains (losses) on other-than-temporarily impaired investment securities, net of income taxes |
3 | 10 | ||||||
Unrealized gains (losses) on derivatives during period, net of income taxes |
(25) | (1) | ||||||
Pension liability adjustment during period, net of income taxes |
3 | 1 | ||||||
Balance, end of period |
1,547 | 629 | ||||||
Treasury stock: |
||||||||
Balance, beginning of period |
(5,386) | (5,316) | ||||||
Purchases of treasury stock |
(231) | (5) | ||||||
Cost of shares issued |
26 | 45 | ||||||
Balance, end of period |
(5,591) | (5,276) | ||||||
Total shareholders equity |
$ | 11,981 | $ | 10,030 | ||||
See the accompanying Notes to the Consolidated Financial Statements.
6
Aflac Incorporated and Subsidiaries
Consolidated Statements of Cash Flows
Six Months Ended June 30, | ||||||||
(In millions - Unaudited) | 2011 | 2010 | ||||||
Cash flows from operating activities: |
||||||||
Net earnings |
$ | 674 | $ 1,217 | |||||
Adjustments to reconcile net earnings to net cash provided by operating activities: |
||||||||
Change in receivables and advance premiums |
926 | 423 | ||||||
Increase in deferred policy acquisition costs |
(225) | (164) | ||||||
Increase in policy liabilities |
1,922 | 1,473 | ||||||
Change in income tax liabilities |
(82) | 181 | ||||||
Realized investment (gains) losses |
1,247 | 135 | ||||||
Other, net |
(84) | (242) | ||||||
Net cash provided (used) by operating activities |
4,378 | 3,023 | ||||||
Cash flows from investing activities: |
||||||||
Proceeds from investments sold or matured: |
||||||||
Securities available for sale: |
||||||||
Fixed maturities sold |
1,767 | 1,055 | ||||||
Fixed maturities matured or called |
775 | 312 | ||||||
Perpetual securities sold |
226 | 582 | ||||||
Perpetual securities matured or called |
61 | 0 | ||||||
Equity securities sold |
0 | 328 | ||||||
Securities held to maturity: |
||||||||
Fixed maturities matured or called |
325 | 2 | ||||||
Costs of investments acquired: |
||||||||
Securities available for sale: |
||||||||
Fixed maturities acquired |
(4,822) | (4,606) | ||||||
Equity securities acquired |
0 | (330) | ||||||
Securities held to maturity: |
||||||||
Fixed maturities acquired |
(3,484) | (642) | ||||||
Cash received as collateral on loaned securities, net |
147 | 134 | ||||||
Other, net |
(29) | (11) | ||||||
Net cash provided (used) by investing activities |
$ | (5,034) | $ | (3,176) |
See the accompanying Notes to the Consolidated Financial Statements.
(continued)
7
Aflac Incorporated and Subsidiaries
Consolidated Statements of Cash Flows (continued)
Six Months Ended June 30, | ||||||||
(In millions - Unaudited) | 2011 | 2010 | ||||||
Cash flows from financing activities: |
||||||||
Purchases of treasury stock |
$ (222) | $ (5) | ||||||
Principal payments under debt obligations |
(1) | (2) | ||||||
Dividends paid to shareholders |
(260) | (262) | ||||||
Change in investment-type contracts, net |
275 | 191 | ||||||
Treasury stock reissued |
26 | 36 | ||||||
Other, net |
7 | 35 | ||||||
Net cash provided (used) by financing activities |
(175) | (7) | ||||||
Effect of exchange rate changes on cash and cash equivalents |
1 | 21 | ||||||
Net change in cash and cash equivalents |
(830) | (139) | ||||||
Cash and cash equivalents, beginning of period |
2,121 | 2,323 | ||||||
Cash and cash equivalents, end of period |
$ 1,291 | $2,184 | ||||||
Supplemental disclosures of cash flow information: |
||||||||
Income taxes paid |
$ 460 | $ 532 | ||||||
Interest paid |
72 | 52 | ||||||
Impairment losses included in realized investment losses |
933 | 42 | ||||||
Noncash financing activities: |
||||||||
Capitalized lease obligations |
1 | 1 | ||||||
Treasury stock issued for: |
||||||||
Shareholder dividend reinvestment |
21 | 0 | ||||||
Share-based compensation grants |
2 | 3 | ||||||
See the accompanying Notes to the Consolidated Financial Statements.
8
Aflac Incorporated and Subsidiaries
Consolidated Statements of Comprehensive Income (Loss)
Three Months Ended June 30, |
Six Months Ended June 30, |
|||||||||||||||
(In millions - Unaudited) | 2011 | 2010 | 2011 | 2010 | ||||||||||||
Net earnings |
$ 280 | $ 581 | $ 674 | $ 1,217 | ||||||||||||
Other comprehensive income (loss) before income taxes: |
||||||||||||||||
Unrealized foreign currency translation gains (losses) during period |
(82) | 61 | (86) | 43 | ||||||||||||
Unrealized gains (losses) on investment securities: |
||||||||||||||||
Unrealized holding gains (losses) on investment securities during period |
473 | 555 | (136) | 878 | ||||||||||||
Reclassification adjustment for realized (gains) losses on investment securities included in net earnings |
716 | (14) | 1,243 | 49 | ||||||||||||
Unrealized gains (losses) on derivatives during period |
17 | 8 | (38) | (2) | ||||||||||||
Pension liability adjustment during period |
0 | 0 | 4 | 2 | ||||||||||||
Total other comprehensive income (loss) before income taxes |
1,124 | 610 | 987 | 970 | ||||||||||||
Income tax expense (benefit) related to items of other comprehensive income (loss) |
292 | 74 | 302 | 230 | ||||||||||||
Other comprehensive income (loss), net of income taxes |
832 | 536 | 685 | 740 | ||||||||||||
Total comprehensive income (loss) |
$ 1,112 | $ 1,117 | $ 1,359 | $ 1,957 | ||||||||||||
See the accompanying Notes to the Consolidated Financial Statements.
9
Aflac Incorporated and Subsidiaries
Notes to the Consolidated Financial Statements
(Interim period data Unaudited)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of Business
Aflac Incorporated (the Parent Company) and its subsidiaries (collectively, the Company) primarily sell supplemental health and life insurance in the United States and Japan. The Companys insurance business is marketed and administered through American Family Life Assurance Company of Columbus (Aflac), which operates in the United States (Aflac U.S.) and as a branch in Japan (Aflac Japan). Most of Aflacs policies are individually underwritten and marketed through independent agents. Aflac U.S. markets and administers group products through Continental American Insurance Company (CAIC). Our insurance operations in the United States and our branch in Japan service the two markets for our insurance business. Aflac Japans revenues, including realized gains and losses on its investment portfolio, accounted for 73% and 75% of the Companys total revenues in the six-month periods ended June 30, 2011, and 2010, respectively. The percentage of the Companys total assets attributable to Aflac Japan was 87% and 86% at June 30, 2011, and December 31, 2010, respectively.
Basis of Presentation
We prepare our financial statements in accordance with U.S. generally accepted accounting principles (GAAP). These principles are established primarily by the Financial Accounting Standards Board (FASB). In these Notes to the Consolidated Financial Statements, references to GAAP issued by the FASB are derived from the FASB Accounting Standards CodificationTM (ASC). The preparation of financial statements in conformity with GAAP requires us to make estimates when recording transactions resulting from business operations based on currently available information. The most significant items on our balance sheet that involve a greater degree of accounting estimates and actuarial determinations subject to changes in the future are the valuation of investments, deferred policy acquisition costs, liabilities for future policy benefits and unpaid policy claims, and income taxes. These accounting estimates and actuarial determinations are sensitive to market conditions, investment yields, mortality, morbidity, commission and other acquisition expenses, and terminations by policyholders. As additional information becomes available, or actual amounts are determinable, the recorded estimates will be revised and reflected in operating results. Although some variability is inherent in these estimates, we believe the amounts provided are adequate.
The unaudited consolidated financial statements include the accounts of the Parent Company, its subsidiaries and those entities required to be consolidated under applicable accounting standards. All material intercompany accounts and transactions have been eliminated.
In the opinion of management, the accompanying unaudited consolidated financial statements of the Company contain all adjustments, consisting of normal recurring accruals, which are necessary to fairly present the consolidated balance sheets as of June 30, 2011, and December 31, 2010, the consolidated statements of earnings and comprehensive income (loss) for the three- and six-month periods ended June 30, 2011, and 2010, and the consolidated statements of shareholders equity and cash flows for the six-month periods ended June 30, 2011, and 2010. Results of operations for interim periods are not necessarily indicative of results for the entire year. As a result, these financial statements should be read in conjunction with the financial statements and notes thereto included in our annual report to shareholders for the year ended December 31, 2010.
Significant Accounting Policies
We have refined the explanation of our accounting policies for the translation of foreign currencies and income taxes. All other categories of significant accounting policies remain unchanged from our annual report to shareholders for the year ended December 31, 2010.
Translation of Foreign Currencies: The functional currency of Aflac Japans insurance operations is the Japanese yen. We translate our yen-denominated financial statement accounts into U.S. dollars as follows. Assets and liabilities are translated at end-of-period exchange rates. Realized gains and losses on security transactions are translated at the exchange rate on the trade date of each transaction. Other revenues, expenses and cash flows are translated using average exchange rates for the period. The resulting currency translation adjustments are reported in accumulated other comprehensive income. We include in earnings the realized currency exchange gains and losses resulting from transactions.
10
Aflac Japan maintains an investment portfolio of dollar-denominated securities on behalf of Aflac U.S., which serves as an economic currency hedge of a portion of our investment in Aflac Japan. The functional currency for these investments is the U.S. dollar. The related investment income and realized/unrealized investment gains and losses are also denominated in U.S. dollars. Since the functional currency of Aflac Japans dollar-denominated portfolio is the U.S. dollar, there is no translation adjustment to record in other comprehensive income for these investments when the yen/dollar exchange rate changes. However, the foreign exchange gains and losses related to this portfolio are taxable in Japan and the U.S. when the securities mature or are sold. Until maturity or sale, deferred tax expense or benefit associated with the foreign exchange gains or losses are recognized in the income tax expense on other comprehensive income.
We have designated the yen-denominated Uridashi and Samurai notes and yen-denominated loans issued by the Parent Company as a hedge of our investment in Aflac Japan. Outstanding principal and related accrued interest on these items are translated into U.S. dollars at end-of-period exchange rates. Currency translation adjustments are recorded through other comprehensive income and are included in accumulated other comprehensive income.
Income Taxes: Income tax provisions are generally based on pretax earnings reported for financial statement purposes, which differ from those amounts used in preparing our income tax returns. Deferred income taxes are recognized for temporary differences between the financial reporting basis and income tax basis of assets and liabilities, based on enacted tax laws and statutory tax rates applicable to the periods in which we expect the temporary differences to reverse. We record deferred tax assets for tax positions taken based on our assessment of whether the tax position is more likely than not to be sustained upon examination by taxing authorities. A valuation allowance is established for deferred tax assets when it is more likely than not that an amount will not be realized.
As discussed in the Translation of Foreign Currencies section above, Aflac Japan maintains a dollar-denominated investment portfolio on behalf of Aflac U.S. While there are no translation effects to record in other comprehensive income, the deferred tax expense or benefit associated with foreign exchange gains or losses on the portfolio is recognized in other comprehensive income until the securities mature or are sold. Total income tax expense (benefit) related to items of other comprehensive income (loss) included a tax benefit of $112.4 million and $117.8 million during the three-month periods ended June 30, 2011 and 2010, respectively, for this dollar-denominated portfolio. Excluding these amounts from total taxes on other comprehensive income would result in an effective income tax rate on pretax other comprehensive income (loss) of 36.0% and 31.5% in the three-month periods ended June 30, 2011 and 2010, respectively. Total income tax expense (benefit) related to items of other comprehensive income (loss) included a tax benefit of $50.4 million and $95.3 million during the six-month periods ended June 30, 2011 and 2010, respectively, for this dollar-denominated portfolio. Excluding these amounts from total taxes on other comprehensive income would result in an effective income tax rate on pretax other comprehensive income (loss) of 35.7% and 33.5% in the six-month periods ended June 30, 2011 and 2010, respectively.
New Accounting Pronouncements
Recently Adopted Accounting Pronouncements
Fair value measurements and disclosures: In January 2010, the FASB issued amended accounting guidance on fair value disclosures. This guidance requires the activity in fair value hierarchy Level 3 for purchases, sales, issuances, and settlements to be reported on a gross, rather than net, basis. We adopted this guidance as of January 1, 2011. The adoption did not have an impact on our financial position or results of operations.
Accounting for variable interest entities and transfers of financial assets: In June 2009, the FASB issued amended guidance on accounting for variable interest entities (VIEs) and transfers of financial assets. As discussed above, this guidance defines new criteria for determining the primary beneficiary of a VIE; increases the frequency of required reassessments to determine whether a company is the primary beneficiary of a VIE; eliminates the exemption for the consolidation of qualified special purpose entities (QSPEs); establishes conditions for reporting a transfer of a portion of a financial asset as a sale; modifies the financial asset derecognition criteria; and requires additional disclosures. We adopted the provisions of this guidance on January 1, 2010 as a cumulative effect of change in accounting principle. We were required to consolidate certain of the VIEs with which we are currently involved. We were not required to deconsolidate any VIEs on January 1, 2010.
Upon the initial consolidation of the VIEs on January 1, 2010, the assets, liabilities, and noncontrolling interests of the VIEs were recorded at their carrying values, which is the amounts at which the assets, liabilities, and noncontrolling interests would have been carried in the consolidated financial statements when we first met the conditions to be the primary beneficiary. For any of the VIEs that were required to be consolidated, we also considered whether any of the derivatives in these structures qualified on January 1, 2010, as a cash flow hedge of the changes in cash flows attributable to foreign currency and/or interest rate risk. Certain of the swaps did not qualify for hedge accounting since the swap had a
11
fair value on January 1, 2010. Other swaps did not qualify for hedge accounting since they increased, rather than reduced, cash flow risk.
For additional information concerning our investments in VIEs and derivatives, see Notes 3 and 4, respectively.
Accounting Pronouncements Pending Adoption
Presentation of comprehensive income: In June 2011, the FASB issued guidance to amend the presentation of comprehensive income. The amendments require that all non-owner changes in stockholders equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The amendment also requires reclassification adjustments for items that are reclassified from other comprehensive income to net income to be presented in the statements where the components of net income and the components of other comprehensive income are presented. This guidance is effective for interim and annual periods beginning after December 15, 2011. We do not expect the adoption of this guidance to have any impact on our financial position or results of operations.
Fair value measurements and disclosures: In May 2011, the FASB issued guidance to amend the fair value measurement and disclosure requirements. Most of the amendments are clarifications of the FASBs intent about the application of existing fair value measurement and disclosure requirements. Other amendments change a particular principle or requirement for measuring fair value or disclosing information about fair value measurements. The new fair value measurement disclosures include additional quantitative and qualitative disclosures for Level 3 measurements, including a qualitative sensitivity analysis of fair value to changes in unobservable inputs, and categorization by fair value hierarchy level for items for which the fair value is only disclosed. This guidance is effective for interim and annual periods beginning after December 15, 2011. We are currently evaluating the impact of adopting this guidance on our financial position and results of operations.
Accounting for costs associated with acquiring or renewing insurance contracts: In October 2010, the FASB issued amended accounting guidance on accounting for costs associated with acquiring or renewing insurance contracts. Only incremental direct costs associated with the successful acquisition of a new or renewal contract may be capitalized. The amendment also prohibits capitalizing direct-response advertising costs unless they meet certain criteria. This guidance is effective for interim and annual periods beginning after December 15, 2011. We are currently evaluating the impact of adopting this guidance on our financial position and results of operations.
Recent accounting guidance not discussed above is not applicable or did not have an impact on our business.
For additional information on new accounting pronouncements and recent accounting guidance and their impact, if any, on our financial position or results of operations, see Note 1 of the Notes to the Consolidated Financial Statements in our annual report to shareholders for the year ended December 31, 2010.
2. BUSINESS SEGMENT INFORMATION
The Company consists of two reportable insurance business segments: Aflac Japan and Aflac U.S., both of which sell supplemental health and life insurance. Operating business segments that are not individually reportable are included in the Other business segments category.
We do not allocate corporate overhead expenses to business segments. We evaluate and manage our business segments using a financial performance measure called pretax operating earnings. Our definition of operating earnings excludes the following items from net earnings on an after-tax basis: realized investment gains/losses (securities transactions, impairments, and the impact of derivative and hedging activities) and nonrecurring items. We then exclude income taxes related to operations to arrive at pretax operating earnings. Information regarding operations by segment follows:
12
Three Months Ended June 30, |
Six Months Ended June 30, |
|||||||||||||||
(In millions) | 2011 | 2010 | 2011 | 2010 | ||||||||||||
Revenues: |
||||||||||||||||
Aflac Japan: |
||||||||||||||||
Earned premiums |
$ | 3,770 | $ | 3,186 | $ | 7,472 | $ | 6,393 | ||||||||
Net investment income |
636 | 593 | 1,285 | 1,186 | ||||||||||||
Other income |
5 | (1) | 25 | 26 | ||||||||||||
Total Aflac Japan |
4,411 | 3,778 | 8,782 | 7,605 | ||||||||||||
Aflac U.S.: |
||||||||||||||||
Earned premiums |
1,186 | 1,147 | 2,356 | 2,289 | ||||||||||||
Net investment income |
148 | 135 | 291 | 267 | ||||||||||||
Other income |
3 | 3 | 6 | 5 | ||||||||||||
Total Aflac U.S. |
1,337 | 1,285 | 2,653 | 2,561 | ||||||||||||
Other business segments |
13 | 11 | 28 | 23 | ||||||||||||
Total business segment revenues |
5,761 | 5,074 | 11,463 | 10,189 | ||||||||||||
Realized investment gains (losses) |
(668) | (89) | (1,247) | (135) | ||||||||||||
Corporate |
60 | 49 | 121 | 101 | ||||||||||||
Intercompany eliminations |
(65) | (54) | (133) | (111) | ||||||||||||
Total revenues |
$ | 5,088 | $ | 4,980 | $ | 10,204 | $ | 10,044 | ||||||||
Three Months Ended June 30, |
Six Months Ended June 30, |
|||||||||||||||
(In millions) | 2011 | 2010 | 2011 | 2010 | ||||||||||||
Pretax earnings: |
||||||||||||||||
Aflac Japan |
$ | 931 | $ | 798 | $ | 1,911 | $ | 1,619 | ||||||||
Aflac U.S. |
246 | 227 | 499 | 471 | ||||||||||||
Other business segments |
0 | (1) | 0 | (2) | ||||||||||||
Total business segment pretax operating earnings |
1,177 | 1,024 | 2,410 | 2,088 | ||||||||||||
Interest expense, noninsurance operations |
(41) | (31) | (82) | (63) | ||||||||||||
Corporate and eliminations |
(15) | (15) | (29) | (27) | ||||||||||||
Pretax operating earnings |
1,121 | 978 | 2,299 | 1,998 | ||||||||||||
Realized investment gains (losses) |
(668) | (89) | (1,247) | (135) | ||||||||||||
Total earnings before income taxes |
$ | 453 | $ | 889 | $ | 1,052 | $ | 1,863 | ||||||||
Income taxes applicable to pretax operating earnings |
$ | 388 | $ | 339 | $ | 795 | $ | 693 | ||||||||
Effect of foreign currency translation on operating earnings |
51 | 12 | 99 | 33 | ||||||||||||
13
Assets were as follows:
(In millions) |
June 30, 2011 |
December 31, 2010 |
||||||
Assets: |
||||||||
Aflac Japan |
$ | 92,290 | $ | 87,061 | ||||
Aflac U.S. |
13,208 | 13,095 | ||||||
Other business segments |
162 | 155 | ||||||
Total business segment assets |
105,660 | 100,311 | ||||||
Corporate |
14,950 | 14,047 | ||||||
Intercompany eliminations |
(14,378 | ) | (13,319 | ) | ||||
Total assets |
$ | 106,232 | $ | 101,039 | ||||
14
3. INVESTMENTS
Investment Holdings
The amortized cost for our investments in debt and perpetual securities, the cost for equity securities and the fair values of these investments are shown in the following tables.
June 30, 2011 | ||||||||||||||||
(In millions) | Cost or Amortized Cost |
Gross Unrealized Gains |
Gross Unrealized Losses |
Fair Value |
||||||||||||
Securities available for sale, carried at fair value: |
||||||||||||||||
Fixed maturities: |
||||||||||||||||
Yen-denominated: |
||||||||||||||||
Japan government and agencies |
$ | 17,436 | $ | 556 | $ | 12 | $ | 17,980 | ||||||||
Mortgage- and asset-backed securities |
923 | 32 | 5 | 950 | ||||||||||||
Public utilities |
2,575 | 71 | 117 | 2,529 | ||||||||||||
Sovereign and supranational |
1,721 | 119 | 19 | 1,821 | ||||||||||||
Banks/financial institutions |
4,766 | 134 | 410 | 4,490 | ||||||||||||
Other corporate |
5,860 | 154 | 485 | 5,529 | ||||||||||||
Total yen-denominated |
33,281 | 1,066 | 1,048 | 33,299 | ||||||||||||
Dollar-denominated: |
||||||||||||||||
U.S. government and agencies |
1,816 | 71 | 0 | 1,887 | ||||||||||||
Municipalities |
1,027 | 19 | 21 | 1,025 | ||||||||||||
Mortgage- and asset-backed securities(1) |
451 | 98 | 1 | 548 | ||||||||||||
Collateralized debt obligations |
4 | 0 | 0 | 4 | ||||||||||||
Public utilities |
2,824 | 266 | 35 | 3,055 | ||||||||||||
Sovereign and supranational |
392 | 67 | 3 | 456 | ||||||||||||
Banks/financial institutions |
3,298 | 180 | 52 | 3,426 | ||||||||||||
Other corporate |
8,175 | 700 | 69 | 8,806 | ||||||||||||
Total dollar-denominated |
17,987 | 1,401 | 181 | 19,207 | ||||||||||||
Total fixed maturities |
51,268 | 2,467 | 1,229 | 52,506 | ||||||||||||
Perpetual securities: |
||||||||||||||||
Yen-denominated: |
||||||||||||||||
Banks/financial institutions |
6,570 | 200 | 374 | 6,396 | ||||||||||||
Other corporate |
332 | 25 | 0 | 357 | ||||||||||||
Dollar-denominated: |
||||||||||||||||
Banks/financial institutions |
357 | 16 | 23 | 350 | ||||||||||||
Total perpetual securities |
7,259 | 241 | 397 | 7,103 | ||||||||||||
Equity securities |
21 | 4 | 2 | 23 | ||||||||||||
Total securities available for sale |
$ | 58,548 | $ | 2,712 | $ | 1,628 | $ | 59,632 | ||||||||
(1) | Includes less than $1 million of other-than-temporary non-credit-related losses |
15
June 30, 2011 | ||||||||||||||||
(In millions) | Cost or Amortized Cost |
Gross Unrealized Gains |
Gross Unrealized Losses |
Fair Value |
||||||||||||
Securities held to maturity, carried at amortized cost: |
||||||||||||||||
Fixed maturities: |
||||||||||||||||
Yen-denominated: |
||||||||||||||||
Japan government and agencies |
$ | 3,216 | $ | 70 | $ | 4 | $ | 3,282 | ||||||||
Municipalities |
535 | 19 | 4 | 550 | ||||||||||||
Mortgage- and asset-backed securities |
136 | 4 | 0 | 140 | ||||||||||||
Public utilities |
6,396 | 260 | 127 | 6,529 | ||||||||||||
Sovereign and supranational |
4,173 | 198 | 89 | 4,282 | ||||||||||||
Banks/financial institutions |
12,303 | 211 | 589 | 11,925 | ||||||||||||
Other corporate |
5,149 | 214 | 89 | 5,274 | ||||||||||||
Total yen-denominated |
31,908 | 976 | 902 | 31,982 | ||||||||||||
Total securities held to maturity |
$ | 31,908 | $ | 976 | $ | 902 | $ | 31,982 | ||||||||
16
December 31, 2010 | ||||||||||||||||
(In millions) | Cost or Amortized Cost |
Gross Unrealized Gains |
Gross Unrealized Losses |
Fair Value |
||||||||||||
Securities available for sale, carried at fair value: |
||||||||||||||||
Fixed maturities: |
||||||||||||||||
Yen-denominated: |
||||||||||||||||
Japan government and agencies |
$ | 16,607 | $ | 584 | $ | 14 | $ | 17,177 | ||||||||
Mortgage- and asset-backed securities |
1,224 | 35 | 15 | 1,244 | ||||||||||||
Public utilities |
2,554 | 117 | 80 | 2,591 | ||||||||||||
Sovereign and supranational |
903 | 47 | 12 | 938 | ||||||||||||
Banks/financial institutions |
5,927 | 152 | 1,177 | 4,902 | ||||||||||||
Other corporate |
5,733 | 136 | 457 | 5,412 | ||||||||||||
Total yen-denominated |
32,948 | 1,071 | 1,755 | 32,264 | ||||||||||||
Dollar-denominated: |
||||||||||||||||
U.S. government and agencies |
32 | 4 | 0 | 36 | ||||||||||||
Municipalities |
1,006 | 9 | 42 | 973 | ||||||||||||
Mortgage- and asset-backed securities(1) |
485 | 90 | 13 | 562 | ||||||||||||
Collateralized debt obligations |
5 | 0 | 0 | 5 | ||||||||||||
Public utilities |
2,568 | 246 | 36 | 2,778 | ||||||||||||
Sovereign and supranational |
395 | 63 | 2 | 456 | ||||||||||||
Banks/financial institutions |
3,496 | 143 | 108 | 3,531 | ||||||||||||
Other corporate |
7,167 | 662 | 79 | 7,750 | ||||||||||||
Total dollar-denominated |
15,154 | 1,217 | 280 | 16,091 | ||||||||||||
Total fixed maturities |
48,102 | 2,288 | 2,035 | 48,355 | ||||||||||||
Perpetual securities: |
||||||||||||||||
Yen-denominated: |
||||||||||||||||
Banks/financial institutions |
7,080 | 172 | 533 | 6,719 | ||||||||||||
Other corporate |
328 | 15 | 0 | 343 | ||||||||||||
Dollar-denominated: |
||||||||||||||||
Banks/financial institutions |
419 | 61 | 30 | 450 | ||||||||||||
Total perpetual securities |
7,827 | 248 | 563 | 7,512 | ||||||||||||
Equity securities |
22 | 3 | 2 | 23 | ||||||||||||
Total securities available for sale |
$ | 55,951 | $ | 2,539 | $ | 2,600 | $ | 55,890 | ||||||||
(1) | Includes $4 of other-than-temporary non-credit-related losses |
17
December 31, 2010 | ||||||||||||||||
(In millions) | Cost or Amortized Cost |
Gross Unrealized Gains |
Gross Unrealized Losses |
Fair Value |
||||||||||||
Securities held to maturity, carried at amortized cost: |
||||||||||||||||
Fixed maturities: |
||||||||||||||||
Yen-denominated: |
||||||||||||||||
Japan government and agencies |
$ | 344 | $ | 4 | $ | 4 | $ | 344 | ||||||||
Municipalities |
407 | 18 | 2 | 423 | ||||||||||||
Mortgage- and asset-backed securities |
146 | 5 | 0 | 151 | ||||||||||||
Public utilities |
6,339 | 326 | 120 | 6,545 | ||||||||||||
Sovereign and supranational |
4,951 | 305 | 65 | 5,191 | ||||||||||||
Banks/financial institutions |
12,618 | 216 | 526 | 12,308 | ||||||||||||
Other corporate |
5,279 | 274 | 46 | 5,507 | ||||||||||||
Total yen-denominated |
30,084 | 1,148 | 763 | 30,469 | ||||||||||||
Total securities held to maturity |
$ | 30,084 | $ | 1,148 | $ | 763 | $ | 30,469 | ||||||||
The methods of determining the fair values of our investments in debt securities, perpetual securities and equity securities are described in Note 5.
Included in the available-for-sale fixed maturities portfolio are securities with embedded derivatives for which we have elected the fair value option. These securities were recorded at a fair value of $637 million at June 30, 2011, compared with $619 million at December 31, 2010. We recognized in earnings investment gains of $9 million and $12 million during the three- and six-month periods ended June 30, 2011, respectively, compared with less than $1 million of losses during the three- and six-month periods ended June 30, 2010, for the changes in fair value of these securities, which excludes the effects of foreign currency translation and additional fair value option elections.
During the second quarter of 2011, we did not reclassify any investments from the held-to-maturity portfolio to the available-for-sale portfolio. During the first quarter of 2011, we reclassified eight investments from the held-to-maturity portfolio to the available-for-sale portfolio as a result of significant declines in the issuers credit worthiness. At the time of the transfer, the securities had an aggregate amortized cost of $1.6 billion and an aggregate unrealized loss of $270 million. The securities transferred in the first quarter of 2011 included our investments in the Republic of Tunisia that had an aggregate amortized cost of $769 million and four securities associated with financial institutions in Portugal and Ireland with an aggregate amortized cost of $631 million. See the Investment Concentration section below for a discussion of these financial institutions in Portugal and Ireland.
During the second quarter of 2010, we reclassified four investments from the held-to-maturity portfolio to the available-for-sale portfolio as a result of significant downgrades of the issuers credit rating. At the time of transfer, the securities had an aggregate amortized cost of $1.2 billion and an aggregate unrealized loss of $665 million. We did not reclassify any investments from the held-to-maturity portfolio to the available-for-sale portfolio during the first quarter of 2010.
18
Contractual and Economic Maturities
The contractual maturities of our investments in fixed maturities at June 30, 2011, were as follows:
Aflac Japan | Aflac U.S. | |||||||||||||||
(In millions) | Amortized Cost |
Fair Value |
Amortized Cost |
Fair Value |
||||||||||||
Available for sale: |
||||||||||||||||
Due in one year or less |
$ | 1,515 | $ | 1,558 | $ | 56 | $ | 57 | ||||||||
Due after one year through five years |
3,755 | 3,964 | 255 | 287 | ||||||||||||
Due after five years through 10 years |
3,697 | 3,951 | 936 | 1,076 | ||||||||||||
Due after 10 years |
32,370 | 32,378 | 7,199 | 7,619 | ||||||||||||
Mortgage- and asset-backed securities |
1,327 | 1,441 | 47 | 56 | ||||||||||||
Total fixed maturities available for sale |
$ | 42,664 | $ | 43,292 | $ | 8,493 | $ | 9,095 | ||||||||
Held to maturity: |
||||||||||||||||
Due in one year or less |
$ | 714 | $ | 724 | $ | 0 | $ | 0 | ||||||||
Due after one year through five years |
1,172 | 1,265 | 0 | 0 | ||||||||||||
Due after five years through 10 years |
3,103 | 3,439 | 0 | 0 | ||||||||||||
Due after 10 years |
26,782 | 26,413 | 0 | 0 | ||||||||||||
Mortgage- and asset-backed securities |
137 | 141 | 0 | 0 | ||||||||||||
Total fixed maturities held to maturity |
$ | 31,908 | $ | 31,982 | $ | 0 | $ | 0 | ||||||||
At June 30, 2011, the Parent Company had a portfolio of investment-grade available-for-sale fixed-maturity securities totaling $111 million at amortized cost and $119 million at fair value, which is not included in the table above.
Expected maturities may differ from contractual maturities because some issuers have the right to call or prepay obligations with or without call or prepayment penalties.
The majority of our perpetual securities are subordinated to other debt obligations of the issuer, but rank higher than the issuers equity securities. Perpetual securities have characteristics of both debt and equity investments, along with unique features that create economic maturity dates for the securities. Although perpetual securities have no contractual maturity date, they have stated interest coupons that were fixed at their issuance and subsequently change to a floating short-term interest rate of 125 to more than 300 basis points above an appropriate market index, generally by the 25th year after issuance, thereby creating an economic maturity date. The economic maturities of our investments in perpetual securities, which were all reported as available for sale at June 30, 2011, were as follows:
Aflac Japan | Aflac U.S. | |||||||||||||||
(In millions) | Amortized Cost |
Fair Value |
Amortized Cost |
Fair Value |
||||||||||||
Due in one year or less |
$ | 435 | $ | 497 | $ | 0 | $ | 0 | ||||||||
Due after one year through five years |
1,498 | 1,555 | 5 | 5 | ||||||||||||
Due after five years through 10 years |
838 | 881 | 0 | 0 | ||||||||||||
Due after 10 years |
4,311 | 3,992 | 172 | 173 | ||||||||||||
Total perpetual securities available for sale |
$ | 7,082 | $ | 6,925 | $ | 177 | $ | 178 | ||||||||
Investment Concentrations
Our investment discipline begins with a top-down approach for each investment opportunity we consider. Consistent with that approach, we first approve each country in which we invest. In our approach to sovereign analysis, we consider the political, legal and financial context of the sovereign entity in which an issuer is domiciled and operates. Next we approve the issuers industry sector, including such factors as the stability of results and the importance of the sector to the overall economy. Specific credit names within approved countries and industry sectors are evaluated for their market position and specific strengths and potential weaknesses. Structures in which we invest are chosen for specific portfolio management purposes, including asset/liability management, portfolio diversification and net investment income.
19
Banks and Financial Institutions
Our largest investment industry sector concentration is banks and financial institutions. Within the countries we approve for investment opportunities, we primarily invest in financial institutions that are strategically crucial to each approved countrys economy. The bank and financial institution sector is a highly regulated industry and plays a strategic role in the global economy. We achieve some degree of diversification in the bank and financial institution sector through a geographically diverse universe of credit exposures. Within this sector, the more significant concentration of our credit risk by geographic region or country of issuer at June 30, 2011, based on amortized cost, was: Europe, excluding the United Kingdom (43%); United States (21%); United Kingdom (8%); Japan (8%); and other (20%).
Our total investments in the bank and financial institution sector, including those classified as perpetual securities, were as follows:
June 30, 2011 | December 31, 2010 | |||||||||||
Total Investments in Banks and Financial Institutions Sector (in millions) |
Percentage of Total Investment Portfolio |
Total Investments in Banks and Financial Institutions Sector (in millions) |
Percentage of Total Investment Portfolio | |||||||||
Debt Securities: |
||||||||||||
Amortized cost |
$ | 20,367 | 22 % | $ | 22,041 | 26 % | ||||||
Fair value |
19,841 | 22 | 20,741 | 24 | ||||||||
Perpetual Securities: |
||||||||||||
Upper Tier II: |
||||||||||||
Amortized cost |
$ | 4,426 | 5 % | $ | 4,957 | 6 % | ||||||
Fair value |
4,432 | 5 | 4,748 | 5 | ||||||||
Tier I: |
||||||||||||
Amortized cost |
2,501 | 3 | 2,542 | 3 | ||||||||
Fair value |
2,314 | 2 | 2,421 | 3 | ||||||||
Total: |
||||||||||||
Amortized cost |
$ | 27,294 | 30 % | $ | 29,540 | 35 % | ||||||
Fair value |
26,587 | 29 | 27,910 | 32 | ||||||||
Investments in Greece, Ireland, Italy, Portugal and Spain
Our investment exposure to sovereign debt and financial institutions in Greece, Ireland, Italy, Portugal and Spain was as follows:
June 30, 2011 | December 31, 2010 | |||||||||||||||
(In millions) | Amortized Cost |
Fair Value |
Amortized Cost |
Fair Value |
||||||||||||
Sovereign and supranational: |
||||||||||||||||
Italy |
$ | 310 | $ | 304 | $ | 307 | $ | 306 | ||||||||
Spain |
737 | 768 | 730 | 782 | ||||||||||||
Total |
$ | 1,047 | $ | 1,072 | $ | 1,037 | $ | 1,088 | ||||||||
Banks and financial institutions: |
||||||||||||||||
Greece |
$ | 0 | $ | 0 | $ | 1,152 | $ | 391 | ||||||||
Ireland |
525 | 379 | 710 | 659 | ||||||||||||
Italy |
186 | 182 | 184 | 183 | ||||||||||||
Portugal |
282 | 282 | 859 | 770 | ||||||||||||
Spain |
531 | 499 | 526 | 503 | ||||||||||||
Total |
$ | 1,524 | (1) | $ | 1,342 | $ | 3,431 | (1) | $ | 2,506 | ||||||
(1) | Represents 6% in 2011 and 12% in 2010 of total investments in the banks and financial institutions sector, and 1% in 2011 and 4% in 2010 of total investments in debt and perpetual securities |
20
Ireland
During the second quarter of 2011, we sold our holdings in Irish Life and Permanent PLC, which were below-investment-grade perpetual securities that had previously been impaired, at a pretax loss of $74 million ($48 million after-tax). This followed the sale of another of our impaired below-investment-grade Irish financial institution securities in the first quarter of 2011 at a $2 million pretax gain. As of June 30, 2011, senior securities included in the table above issued by an Irish financial institution with amortized cost and fair value totaling $248 million and $139 million, respectively, were rated below investment grade. We believe that these unrealized losses are linked more to Irelands systemic problems rather than issuer-specific credit factors. The Irish government has stated that it does not support burden-sharing for senior debt holdings such as ours. This Irish bank is current on its obligation to us, and we believe it has the ability to meet its obligations to us. In addition, as of June 30, 2011, we had the intent to hold this investment to recovery in value. As a result, we did not recognize an other-than-temporary impairment for this investment as of June 30, 2011.
Greece
During the second quarter of 2010, our investments in Greek financial institutions, Alpha Bank, EFG Eurobank Ergasias, and National Bank of Greece (NBG), all of which were Lower Tier II subordinated debt, were downgraded to below investment grade. As a result of the downgrades, we reclassified these investments from held to maturity to available for sale. At that time, we believed the downgrade of the Greek banks was largely related to the problems of the Greek government and its poor fiscal management, rather than the banks specific credit profiles. The three Greek bank issuers that comprised our Greek financial institution holdings had, on average, Tier I capital ratios higher than their peers in other troubled European sovereigns. Their capital was at a level that we felt could sustain deterioration in assets and operations that accompany economic conditions, such as those that the Greek economy was encountering in 2010 and those expected in the next few years. All three Greek banks had sufficient capital under the stress testing applied by the Committee of European Banking Supervisors (CEBS) in July 2010. However, the problems of the Greek government and related ratings downgrades have caused a decline in the confidence of depositors and capital market participants in the Greek banking system. As a result, the banks have significantly relied upon the European Central Bank (ECB) for liquidity via posting of collateral, which tends to be in the form of Greek Government Bonds (GGBs) or debt guaranteed by the sovereign. As of December 31, 2010, all of the Greek banks were current on their obligations to us. While these financial institutions have significant investments in GGBs, as of December 31, 2010, we believed that these institutions would be solvent even if there were a future restructuring of GGBs and they would have the ability to meet their obligations to us. In addition, as of December 31, 2010, we had the intent to hold these investments to recovery in value. As a result, we did not recognize an other-than-temporary impairment for these investments as of December 31, 2010.
Subsequent to December 31, 2010, Greece remained under pressure, which has also continued to weigh on the Greek banks. Skepticism over the rigor of the capital stress tests applied by the CEBS in July 2010 grew, especially as further problems have developed in the capital of the Irish banks. On February 18, 2011, NBG announced its proposal for a friendly merger with Alpha Bank, but Alpha Bank rejected this proposal. However, this proposal highlighted risks that accompany consolidation among the top three banks in Greece. While the proposal could have created a national champion in Greek banking, it also would have concentrated ownership of GGBs in the combined entity and formed a very low-rated entity among our top ten largest investment holdings. Two rating agencies downgraded the Greek banks subsequent to downgrading the sovereign during the first quarter of 2011 (on January 17, 2011, and March 9, 2011). In the latter action, the rating agency lowered the ratings indicative of the banks intrinsic financial strength due to the persistent pressure on liquidity, asset quality and material exposure to GGBs. In light of the above increased risks and, in particular, the March 9, 2011 downgrade, we no longer supported our previous intent to hold our Greek bank investments to recovery in value. In March 2011, we sold our investment in Alpha Bank and recognized an investment loss of $177 million ($115 million after-tax). In the first quarter of 2011, we recognized other-than-temporary impairment losses of $397 million ($258 million after-tax) for the remaining two Greek bank holdings. In the second quarter of 2011, we sold our investment in EFG Eurobank Ergasias for $2 million more than its recorded impaired value, and we sold our remaining Greek bank investment, NBG, for $47 million less than its recorded impaired value.
Portugal
As of December 31, 2010 and the end of first quarter 2011, the issuers of our Portuguese bank and financial investments, Banco BPI S.A., Caixa Geral de Depositos S.A., and Banco Espirito Santo S.A., were current on their obligations to us, were profitable and had adequate Tier I capital ratios. During the first quarter of 2011, these investments were downgraded to below-investment-grade. However, at that time we believed that these ratings and the unrealized loss position of the investments were the result of the fiscal problems in the Eurozone region rather than the banks specific credit profiles. We believed that Portugals financial institutions were stronger than their other Eurozone peers and had not required much state support. It was challenging to separate the difficulties of the sovereign from the banks since the banks sources of liquidity are limited due to the financial situation of the sovereign. We believed the government of Portugal had exercised
21
more prudent fiscal policies and was in a better financial situation than some of its other Eurozone peers. However, on May 16, 2011 when the European Union officially announced a fiscal support package for Portugal, there was an increase in risk that Portugal could experience a stressed economic environment similar to that experienced in Greece and Ireland. We believed the terms of this fiscal support package could result in liquidity constraints on the banks and there could be a need for the banks to improve their liquidity and core capital. Such a situation could negatively impact our Lower Tier II securities and our ability to recover full principal and interest. Due to the reasonably possible risk that our Portuguese bank holdings could suffer further negative declines, we no longer supported our previous intent to hold our Portuguese bank investments to recovery in value and concluded that we would take steps to reduce our exposure in the region. In the second quarter of 2011, we sold our investment in Banco BPI, S.A. at a loss of $99 million ($64 million after-tax), and we recognized other-than-temporary impairment losses of $112 million ($73 million after-tax) and $163 million ($106 million after-tax) on our investments in Caixa Geral de Depositos S.A. and Banco Espirito Santo S.A., respectively.
With the exception of the securities discussed above, all other securities included in the table above were rated investment grade as of June 30, 2011.
Derisking
During the three- and six-month periods ended June 30, 2011, we pursued strategic investment activities to lower the risk profile of our investment portfolio. Our primary focus was on reducing our exposure to peripheral Eurozone investments (discussed in the preceding section), certain perpetual securities, and investments in certain banks or financial institutions. As a result of these derisking activities, we have no direct investment exposure in Greece, only senior indebtedness in Ireland, and materially lower exposure to Portuguese investments. Additional derisking activities have resulted in a reduction in exposure to some of our largest concentrated investment positions. See further details in the Realized Investment Gains and Losses section below.
Realized Investment Gains and Losses
Information regarding pretax realized gains and losses from investments is as follows:
22
Three Months Ended June 30, |
Six Months Ended June 30, |
|||||||||||||||
(In millions) | 2011 | 2010 | 2011 | 2010 | ||||||||||||
Realized investment gains (losses) on securities: |
||||||||||||||||
Debt securities: |
||||||||||||||||
Available for sale: |
||||||||||||||||
Gross gains from sales |
$ | 10 | $ | 0 | $ | 36 | $ | 51 | ||||||||
Gross losses from sales |
(132 | ) | (110 | ) | (319 | ) | (190 | ) | ||||||||
Net gains (losses) from redemptions |
(1 | ) | 1 | 6 | 1 | |||||||||||
Other-than-temporary impairment losses |
(344 | ) | 0 | (748 | ) | 0 | ||||||||||
Total debt securities |
(467 | ) | (109 | ) | (1,025 | ) | (138 | ) | ||||||||
Perpetual securities: |
||||||||||||||||
Available for sale: |
||||||||||||||||
Gross gains from sales |
48 | 125 | 54 | 133 | ||||||||||||
Gross losses from sales |
(107 | ) | 0 | (109 | ) | 0 | ||||||||||
Other-than-temporary impairment losses |
(184 | ) | 0 | (184 | ) | (41 | ) | |||||||||
Total perpetual securities |
(243 | ) | 125 | (239 | ) | 92 | ||||||||||
Equity securities: |
||||||||||||||||
Gross losses from sales |
0 | (2 | ) | 0 | (2 | ) | ||||||||||
Other-than-temporary impairment losses |
0 | 0 | (1 | ) | (1 | ) | ||||||||||
Total equity securities |
0 | (2 | ) | (1 | ) | (3 | ) | |||||||||
Other assets: |
||||||||||||||||
Derivative gains (losses) |
(25 | ) | (103 | ) | (55 | ) | (86 | ) | ||||||||
Other |
67 | 0 | 73 | 0 | ||||||||||||
Total other assets |
42 | (103 | ) | 18 | (86 | ) | ||||||||||
Total realized investment gains (losses) |
$ | (668 | ) | $ | (89 | ) | $ | (1,247 | ) | $ | (135 | ) | ||||
During the three- and six-month periods ended June 30, 2011, net investment losses from the sales of securities and recognized impairments were primarily a result of an implemented plan to reduce the risk exposure in our investment portfolio coupled with the continued decline in the credit worthiness of issuers of certain investments. See the Investment Concentrations section above for more information. A valuation allowance of $19 million was recorded in the second quarter of 2011 related to the deferred tax assets associated with our realized investment losses.
During the three- and six-month periods ended June 30, 2010, net investment losses from securities sold or redeemed occurred in the normal course of business.
Other-than-temporary Impairment
The fair value of our debt and perpetual security investments fluctuates based on changes in credit spreads in the global financial markets. Credit spreads are most impacted by market rates of interest, the general and specific credit environment and global market liquidity. We believe that fluctuations in the fair value of our investment securities related to changes in credit spreads have little bearing on whether our investment is ultimately recoverable. Generally, we consider such declines in fair value to be temporary even in situations where an investment remains in an unrealized loss position for a year or more.
However, in the course of our credit review process, we may determine that it is unlikely that we will recover our investment in an issuer due to factors specific to an individual issuer, as opposed to general changes in global credit spreads. In this event, we consider such a decline in the investments fair value, to the extent below the investments cost or amortized cost, to be an other-than-temporary impairment of the investment and write the investment down to its fair value. The determination of whether an impairment is other than temporary is subjective and involves the consideration of various factors and circumstances, which includes but is not limited to the following:
| issuer financial condition, including profitability and cash flows |
| credit status of the issuer |
| the issuers specific and general competitive environment |
| published reports |
23
| general economic environment |
| regulatory, legislative and political environment |
| the severity of the decline in fair value |
| the length of time the fair value is below cost |
| other factors as may become available from time to time |
In addition to the usual investment risk associated with a debt instrument, our perpetual security holdings may be subject to the risk of nationalization of their issuers in connection with capital injections from an issuers sovereign government. We cannot be assured that such capital support will extend to all levels of an issuers capital structure. In addition, certain governments or regulators may consider imposing interest and principal payment restrictions on issuers of hybrid securities to preserve cash and build capital. In addition to the cash flow impact that additional deferrals would have on our portfolio, such deferrals could result in ratings downgrades of the affected securities, which in turn could impair the fair value of the securities and increase our regulatory capital requirements. We take factors such as these into account in our credit review process.
Another factor we consider in determining whether an impairment is other than temporary is an evaluation of our intent or requirement to sell the security prior to recovery of its amortized cost. We perform ongoing analyses of our liquidity needs, which includes cash flow testing of our policy liabilities, debt maturities, projected dividend payments and other cash flow and liquidity needs. Our cash flow testing includes extensive duration matching of our investment portfolio and policy liabilities. Based on our analyses, we have concluded that we have sufficient excess cash flows to meet our liquidity needs without liquidating any of our investments prior to their maturity. In addition, provided that our credit review process results in a conclusion that we will collect all of our cash flows and recover our investment in an issuer and the investment is within our target investment risk exposure limits, we generally do not sell investments prior to their maturity.
The majority of our investments are evaluated for other-than-temporary impairment using our debt impairment model. Our debt impairment model focuses on the ultimate collection of the cash flows from our investments. Our investments in perpetual securities that are rated below investment grade are evaluated for other-than-temporary impairment under our equity impairment model. Our equity impairment model focuses on the severity of a securitys decline in fair value coupled with the length of time the fair value of the security has been below amortized cost.
The following table details our pretax other-than-temporary impairment losses by investment category.
Three Months Ended June 30, |
Six Months Ended June 30, |
|||||||||||||||
(In millions) | 2011 | 2010 | 2011 | 2010 | ||||||||||||
Perpetual securities |
$ | 184 | $ | 0 | $ | 184 | $ | 41 | ||||||||
Corporate bonds |
343 | 0 | 740 | 0 | ||||||||||||
Mortgage- and asset-backed securities |
1 | 0 | 7 | 0 | ||||||||||||
Municipalities |
0 | 0 | 1 | 0 | ||||||||||||
Equity securities |
0 | 0 | 1 | 1 | ||||||||||||
Total other-than-temporary impairment losses realized |
$ | 528 | $ | 0 | $ | 933 | $ | 42 | ||||||||
We apply the debt security impairment model to our perpetual securities provided there has been no evidence of deterioration in credit of the issuer, such as a downgrade of the rating of a perpetual security to below investment grade. Subsequent to our initial investment, the perpetual securities of four issuers we own had been downgraded to below investment grade as of June 30, 2011. As a result of these downgrades, we were required to evaluate these securities for other-than-temporary impairment using the equity security impairment model rather than the debt security impairment model. Use of the equity security model limits the forecasted recovery period that can be used in the impairment evaluation and, accordingly, affects both the recognition and measurement of other-than-temporary impairment losses. We did not recognize any other-than-temporary impairment losses for perpetual securities from evaluation under our equity impairment model during the three- and six-month periods ended June 30, 2011. However, we recognized an other-than-temporary impairment loss of $184 million ($120 million after-tax) on perpetual securities during the three- and six-month periods ended June 30, 2011 due to further deterioration in the issuers creditworthiness. We recognized other-than-temporary impairment losses for perpetual securities from evaluation under our equity impairment model of $41 million ($27 million after-tax) during the six-month period ended June 30, 2010, however none of those impairment losses were recognized in the three-month period ended June 30, 2010.
Certain of our mortgage- and asset-backed securities had other-than-temporary impairments recognized prior to 2010 that had credit-related and non-credit-related components. The following table summarizes cumulative credit-related impairment losses on the securities still held at the end of the reporting period, for which other-than-temporary losses have been recognized and only the amount related to credit loss was recognized in earnings.
24
Three Months Ended June 30, |
Six Months Ended June 30, |
|||||||||||||||
(In millions) | 2011 | 2010 | 2011 | 2010 | ||||||||||||
Cumulative credit loss impairments, beginning of period |
$ | 4 | $ | 23 | $ | 13 | $ | 24 | ||||||||
Securities sold during period |
0 | (10) | (9) | (11) | ||||||||||||
Cumulative credit loss impairments, end of period |
$ | 4 | $ | 13 | $ | 4 | $ | 13 | ||||||||
Unrealized Investment Gains and Losses
Effect on Shareholders Equity
The net effect on shareholders equity of unrealized gains and losses from investment securities was as follows:
(In millions) | June 30, 2011 |
December 31, 2010 |
||||||
Unrealized gains (losses) on securities available for sale |
$ | 1,084 | $ | (61) | ||||
Unamortized unrealized gains on securities transferred to held to maturity |
98 | 135 | ||||||
Deferred income taxes |
(430 | ) | (41) | |||||
Shareholders equity, unrealized gains (losses) on investment securities |
$ | 752 | $ | 33 | ||||
Gross Unrealized Loss Aging
The following tables show the fair value and gross unrealized losses, including the portion of other-than-temporary impairment recognized in accumulated other comprehensive income, of our available-for-sale and held-to-maturity investments, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position.
25
June 30, 2011 | ||||||||||||||||||||||||
Total | Less than 12 months | 12 months or longer | ||||||||||||||||||||||
(In millions) | Fair Value |
Unrealized Losses |
Fair Value |
Unrealized Losses |
Fair Value |
Unrealized Losses |
||||||||||||||||||
Fixed maturities: |
||||||||||||||||||||||||
Japan government and agencies: |
||||||||||||||||||||||||
Yen-denominated |
$ | 1,590 | $ | 16 | $ | 1,590 | $ | 16 | $ | 0 | $ | 0 | ||||||||||||
Municipalities: |
||||||||||||||||||||||||
Dollar-denominated |
405 | 21 | 365 | 9 | 40 | 12 | ||||||||||||||||||
Yen-denominated |
58 | 4 | 0 | 0 | 58 | 4 | ||||||||||||||||||
Mortgage- and asset- backed securities: |
||||||||||||||||||||||||
Dollar-denominated |
20 | 1 | 5 | 0 | 15 | 1 | ||||||||||||||||||
Yen-denominated |
154 | 5 | 12 | 1 | 142 | 4 | ||||||||||||||||||
Public utilities: |
||||||||||||||||||||||||
Dollar-denominated |
636 | 35 | 585 | 28 | 51 | 7 | ||||||||||||||||||
Yen-denominated |
4,340 | 244 | 1,886 | 42 | 2,454 | 202 | ||||||||||||||||||
Sovereign and supranational: |
||||||||||||||||||||||||
Dollar-denominated |
62 | 3 | 29 | 1 | 33 | 2 | ||||||||||||||||||
Yen-denominated |
2,115 | 108 | 968 | 16 | 1,147 | 92 | ||||||||||||||||||
Banks/financial institutions: |
||||||||||||||||||||||||
Dollar-denominated |
1,074 | 52 | 535 | 15 | 539 | 37 | ||||||||||||||||||
Yen-denominated |
9,517 | 999 | 1,111 | 29 | 8,406 | 970 | ||||||||||||||||||
Other corporate: |
||||||||||||||||||||||||
Dollar-denominated |
1,882 | 69 | 1,512 | 43 | 370 | 26 | ||||||||||||||||||
Yen-denominated |
4,739 | 574 | 1,248 | 53 | 3,491 | 521 | ||||||||||||||||||
Total fixed maturities |
26,592 | 2,131 | 9,846 | 253 | 16,746 | 1,878 | ||||||||||||||||||
Perpetual securities: |
||||||||||||||||||||||||
Dollar-denominated |
210 | 23 | 117 | 3 | 93 | 20 | ||||||||||||||||||
Yen-denominated |
3,096 | 374 | 482 | 21 | 2,614 | 353 | ||||||||||||||||||
Total perpetual securities |
3,306 | 397 | 599 | 24 | 2,707 | 373 | ||||||||||||||||||
Equity securities |
8 | 2 | 6 | 1 | 2 | 1 | ||||||||||||||||||
Total |
$ | 29,906 | $ | 2,530 | $ | 10,451 | $ | 278 | $ | 19,455 | $ | 2,252 | ||||||||||||
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December 31, 2010 | ||||||||||||||||||||||||
Total | Less than 12 months | 12 months or longer | ||||||||||||||||||||||
(In millions) | Fair Value |
Unrealized Losses |
Fair Value |
Unrealized Losses |
Fair Value |
Unrealized Losses |
||||||||||||||||||
Fixed maturities: |
||||||||||||||||||||||||
Japan government and agencies: |
||||||||||||||||||||||||
Yen-denominated |
$ | 1,634 | $ | 18 | $ | 1,634 | $ | 18 | $ | 0 | $ | 0 | ||||||||||||
Municipalities: |
||||||||||||||||||||||||
Dollar-denominated |
682 | 42 | 632 | 28 | 50 | 14 | ||||||||||||||||||
Yen-denominated |
59 | 2 | 0 | 0 | 59 | 2 | ||||||||||||||||||
Mortgage- and asset- backed securities: |
||||||||||||||||||||||||
Dollar-denominated |
78 | 13 | 20 | 0 | 58 | 13 | ||||||||||||||||||
Yen-denominated |
415 | 15 | 415 | 15 | 0 | 0 | ||||||||||||||||||
Public utilities: |
||||||||||||||||||||||||
Dollar-denominated |
556 | 36 | 498 | 28 | 58 | 8 | ||||||||||||||||||
Yen-denominated |
2,877 | 200 | 766 | 47 | 2,111 | 153 | ||||||||||||||||||
Sovereign and supranational: |
||||||||||||||||||||||||
Dollar-denominated |
45 | 2 | 12 | 0 | 33 | 2 | ||||||||||||||||||
Yen-denominated |
1,579 | 77 | 428 | 1 | 1,151 | 76 | ||||||||||||||||||
Banks/financial institutions: |
||||||||||||||||||||||||
Dollar-denominated |
1,484 | 108 | 753 | 22 | 731 | 86 | ||||||||||||||||||
Yen-denominated |
10,609 | 1,703 | 1,506 | 40 | 9,103 | 1,663 | ||||||||||||||||||
Other corporate: |
||||||||||||||||||||||||
Dollar-denominated |
1,741 | 79 | 1,456 | 52 | 285 | 27 | ||||||||||||||||||
Yen-denominated |
4,503 | 503 | 507 | 45 | 3,996 | 458 | ||||||||||||||||||
Total fixed maturities |
26,262 | 2,798 | 8,627 | 296 | 17,635 | 2,502 | ||||||||||||||||||
Perpetual securities: |
||||||||||||||||||||||||
Dollar-denominated |
208 | 30 | 149 | 19 | 59 | 11 | ||||||||||||||||||
Yen-denominated |
4,171 | 533 | 1,793 | 119 | 2,378 | 414 | ||||||||||||||||||
Total perpetual securities |
4,379 | 563 | 1,942 | 138 | 2,437 | 425 | ||||||||||||||||||
Equity securities |
13 | 2 | 13 | 1 | 0 | 1 | ||||||||||||||||||
Total |
$ | 30,654 | $ | 3,363 | $ | 10,582 | $ | 435 | $ | 20,072 | $ | 2,928 | ||||||||||||
Analysis of Securities in Unrealized Loss Positions
The unrealized losses on our investments have been primarily related to changes in interest rates, foreign exchange rates or the widening of credit spreads rather than specific issuer credit-related events. In addition, because we do not intend to sell and do not believe it is likely that we will be required to sell these investments before a recovery of fair value to amortized cost, we do not consider any of these investments to be other-than-temporarily impaired as of and for the six-month period ended June 30, 2011. The following summarizes our evaluation of investment categories with significant unrealized losses and securities that were rated below investment grade. All other investment categories with securities in an unrealized loss position that are not specifically discussed below were composed of investment grade fixed maturities.
27
Municipalities and Mortgage- and Asset-Backed Securities
As of June 30, 2011, 71% of the unrealized losses on investment securities in the municipalities sector and 70% of the unrealized losses on investment securities in the mortgage- and asset-backed securities sector were related to investments that were investment grade, compared with 82% and 54%, respectively, at December 31, 2010. We have determined that the majority of the unrealized losses on the investments in these sectors were caused by widening credit spreads. However, we have determined that the ability of the issuers to service our investments has not been compromised. Unrealized gains or losses related to prevailing interest rate environments are impacted by the remaining time to maturity of an investment. Assuming no credit-related factors develop, as investments near maturity the unrealized gains or losses can be expected to diminish.
Public Utilities
As of June 30, 2011, 95% of the unrealized losses on investments in the public utilities sector were related to investments that were investment grade, compared with 100% at December 31, 2010. For any credit-related declines in fair value, we perform a more focused review of the related issuers credit ratings, financial statements and other available financial data, timeliness of payment, competitive environment and any other significant data related to the issuer. From those reviews, we evaluate the issuers continued ability to service our investments. We have determined that the majority of the unrealized losses on the investments in the public utilities sector was caused by a decline in creditworthiness of a couple issuers in this sector. Also impacting the unrealized losses in the public utilities sector was widening credit spreads. Based on our credit analysis, we believe that our investments in this sector have the ability to service their obligations to us.
Bank and Financial Institution Investments
The following table shows the composition of our investments in an unrealized loss position in the bank and financial institution sector by fixed-maturity securities and perpetual securities. The table reflects those securities in that sector that were in an unrealized loss position as a percentage of our total investment portfolio in an unrealized loss position and their respective unrealized losses as a percentage of total unrealized losses.
June 30, 2011 | December 31, 2010 | |||||||
Percentage of Total Investments in an Unrealized Loss Position |
Percentage of Total Unrealized Losses |
Percentage of Total Investments in an Unrealized Loss Position |
Percentage of Total Unrealized Losses | |||||
Fixed maturities |
35 % | 41 % | 39 % | 54 % | ||||
Perpetual securities: |
||||||||
Upper Tier II |
5 | 6 | 9 | 10 | ||||
Tier I |
6 | 10 | 5 | 7 | ||||
Total perpetual securities |
11 | 16 | 14 | 17 | ||||
Total |
46 % | 57 % | 53 % | 71 % | ||||
As of June 30, 2011, 78% of the $1.4 billion in unrealized losses on investments in the bank and financial institution sector, including perpetual securities, were related to investments that were investment grade, compared with 53% at December 31, 2010. This improvement is primarily due to the recognition of other-than-temporary impairments and sales of bank and financial institution securities during the first six months of 2011. Of the $13.9 billion in investments, at fair value, in the bank and financial institution sector in an unrealized loss position at June 30, 2011, only $.8 billion ($.3 billion in unrealized losses) were below investment grade. Two investments comprised nearly 83% of the $.3 billion unrealized loss. The remaining investments that comprised the unrealized loss were divided among eight issuers with average unrealized losses per investment of less than $7 million. We conduct our own independent credit analysis for investments in the bank and financial sector. Our assessment includes analysis of financial information, as well as consultation with the issuers from time to time. Based on our credit analysis, we have determined that the majority of the unrealized losses on the investments in this sector were caused by widening credit spreads, the downturn in the global economic environment and, to a lesser extent, changes in foreign exchange rates. Unrealized gains or losses related to prevailing interest rate environments are impacted by the remaining time to maturity of an investment. Assuming no credit-related factors develop, as investments near maturity, the unrealized gains or losses can be expected to diminish. Based on our credit analysis, we believe that our investments in this sector have the ability to service their obligations to us.
Other Corporate Investments
As of June 30, 2011, 61% of the unrealized losses on investments in the other corporate sector were related to investments that were investment grade, compared with 51% at December 31, 2010. For any credit-related declines in market
28
value, we perform a more focused review of the related issuers credit ratings, financial statements and other available financial data, timeliness of payment, competitive environment and any other significant data related to the issuer. From those reviews, we evaluate the issuers continued ability to service our investments. We have determined that the majority of the unrealized losses on the investments in the other corporate sector was caused by widening credit spreads. Also impacting the unrealized losses in this sector is the decline in creditworthiness of certain issuers in the other corporate sector. Based on our credit analysis, we believe that our investments in this sector have the ability to service their obligation to us.
Perpetual Securities
At June 30, 2011, 93% of the unrealized losses on investments in perpetual securities were related to investments that were investment grade, compared with 83% at December 31, 2010. This improvement is primarily a result of the recognition of other-than-temporary impairments and sales of perpetual securities during the second quarter of 2011. The majority of our investments in Upper Tier II and Tier I perpetual securities were in highly rated global financial institutions. Upper Tier II securities have more debt-like characteristics than Tier I securities and are senior to Tier I securities, preferred stock, and common equity of the issuer. Conversely, Tier I securities have more equity-like characteristics, but are senior to the common equity of the issuer. They may also be senior to certain preferred shares, depending on the individual security, the issuers capital structure and the regulatory jurisdiction of the issuer.
Details of our holdings of perpetual securities were as follows:
Perpetual Securities
June 30, 2011 | December 31, 2010 | |||||||||||||||||||||||||
(In millions) | Credit Rating |
Amortized Cost |
Fair Value |
Unrealized Gain (Loss) |
Amortized Cost |
Fair Value |
Unrealized Gain (Loss) |
|||||||||||||||||||
Upper Tier II: |
||||||||||||||||||||||||||
AA | $ | 192 | $ | 204 | $ | 12 | $ | 190 | $ | 201 | $ | 11 | ||||||||||||||
A | 3,247 | 3,260 | 13 | 3,279 | 3,250 | (29 | ) | |||||||||||||||||||
BBB | 1,051 | 1,057 | 6 | 1,274 | 1,164 | (110 | ) | |||||||||||||||||||
BB or lower | 268 | 268 | 0 | 542 | 476 | (66 | ) | |||||||||||||||||||
Total Upper Tier II |
4,758 | 4,789 | 31 | 5,285 | 5,091 | (194 | ) | |||||||||||||||||||
Tier I: |
||||||||||||||||||||||||||
A | 601 | 524 | (77 | ) | 632 | 568 | (64 | ) | ||||||||||||||||||
BBB | 1,531 | 1,446 | (85 | ) | 1,386 | 1,296 | (90 | ) | ||||||||||||||||||
BB or lower | 369 | 344 | (25 | ) | 524 | 557 | 33 | |||||||||||||||||||
Total Tier I |
2,501 | 2,314 | (187 | ) | 2,542 | 2,421 | (121 | ) | ||||||||||||||||||
Total |
$ | 7,259 | $ | 7,103 | $ | (156 | ) | $ | 7,827 | $ | 7,512 | $ | (315 | ) | ||||||||||||
As discussed previously in the Investments Concentration section, a component of our efforts during the first half of 2011 to reduce risk in our investment portfolio included sales of certain investments in perpetual securities. With the exception of the Icelandic bank securities that we completely impaired in 2008, all of the perpetual securities we own were not in default on interest and principal payments at June 30, 2011. During the three-month period ended June 30, 2011, we wrote-off accrued interest income and stopped accruing further interest income for the Dexia S.A. Upper Tier II perpetual securities which have a deferred coupon and were impaired in the second quarter of 2011. Based on amortized cost as of June 30, 2011, the geographic breakdown of our perpetual securities by issuer was as follows: European countries, excluding the United Kingdom, (70%); the United Kingdom (10%); Japan (14%); and other (6%). To determine any credit-related declines in fair value, we perform a more focused review of the related issuers credit ratings, financial statements and other available financial data, timeliness of payment, competitive environment and any other significant data related to the issuer. From those reviews, we evaluate the issuers continued ability to service our investment.
We have determined that the majority of our unrealized losses in the perpetual security category has been principally due to widening credit spreads, largely as the result of the contraction of liquidity in the capital markets. However, there was some credit tightening in the first six months of 2011 that improved our net unrealized loss position. Based on our reviews, we concluded that the ability of the issuers to service our investment has not been compromised by these factors. Unrealized gains or losses related to prevailing interest rate environments are impacted by the remaining time to maturity of an investment. Assuming no credit-related factors develop, as the investments near economic maturity, the unrealized gains or losses can be expected to diminish. Based on our credit analyses, we believe that our investments in this sector have the ability to service their obligation to us.
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Variable Interest Entities (VIEs)
As discussed in Note 1, effective January 1, 2010, we have consolidated all of the components of each former QSPE investment, including a fixed-maturity or perpetual investment and a corresponding derivative transaction. Our risk of loss over the life of each investment is limited to the amount of our original investment. In addition, new criteria for determining the primary beneficiary of a VIE that was effective January 1, 2010, resulted in the consolidation of additional VIE investments. The following table details our investments in VIEs.
Investments in Variable Interest Entities
June 30, 2011 | December 31, 2010 | |||||||||||||||
(In millions) | Amortized Cost |
Fair Value |
Amortized Cost |
Fair Value |
||||||||||||
VIEs: |
||||||||||||||||
Consolidated: |
||||||||||||||||
Total VIEs consolidated |
$ | 7,104 | $ | 7,247 | $ | 7,201 | $ | 7,363 | ||||||||
Not consolidated: |
||||||||||||||||
CDOs |
4 | 4 | 5 | 5 | ||||||||||||
Other |
13,044 | 13,191 | 13,914 | 13,214 | ||||||||||||
Total VIEs not consolidated |
13,048 | 13,195 | 13,919 | 13,219 | ||||||||||||
Total VIEs |
$ | 20,152 | $ | 20,442 | $ | 21,120 | $ | 20,582 | ||||||||
As a condition to our involvement or investment in a VIE, we enter into certain protective rights and covenants that preclude changes in the structure of the VIE that would alter the creditworthiness of our investment or our beneficial interest in the VIE.
Our involvement with all of the VIEs in which we have an interest is passive in nature, and we are not the arranger of these entities. Except as relates to our review and evaluation of the structure of these VIEs in the normal course of our investment decision-making process, we have not been involved in establishing these entities. Further, we have not been nor are we required to purchase the securities issued in the future by any of these VIEs.
Our ownership interest in the VIEs is limited to holding the obligations issued by them. All of the VIEs in which we invest are static with respect to funding and have no ongoing forms of funding after the initial funding date. We have no direct or contingent obligations to fund the limited activities of these VIEs, nor do we have any direct or indirect financial guarantees related to the limited activities of these VIEs. We have not provided any assistance or any other type of financing support to any of the VIEs we invest in, nor do we have any intention to do so in the future. The weighted-average lives of our notes are very similar to the underlying collateral held by these VIEs where applicable.
Our risk of loss related to our interests in any of our VIEs is limited to our investment in the debt securities issued by them.
VIEs-Consolidated
We are substantively the only investor in the consolidated VIEs listed in the table above. As the sole investor in these VIEs, we have the power to direct the activities of a variable interest entity that most significantly impact the entitys economic performance and are therefore considered to be the primary beneficiary of the VIEs that we consolidate. We also participate in substantially all of the variability created by these VIEs. The activities of these VIEs are limited to holding debt and perpetual securities and interest rate, foreign currency, and/or credit default swaps (CDSs), as appropriate, and utilizing the cash flows from these securities to service our investment. Neither we nor any of our creditors are able to obtain the underlying collateral of the VIEs unless there is an event of default or other specified event. For those VIEs that contain a swap, we are not a direct counterparty to the swap contracts and have no control over them. Our loss exposure to these VIEs is limited to our original investment. Our consolidated VIEs do not rely on outside or ongoing sources of funding to support their activities beyond the underlying collateral and swap contracts, if applicable. With the exception of our investment in senior secured bank loans through a unit trust structure that we began investing in during the second quarter of 2011, the underlying collateral assets and funding of our consolidated VIEs are generally static in nature and the underlying collateral and the reference corporate entities covered by any CDS contracts are all investment grade at the time of issuance.
We are exposed to credit losses within any consolidated collateralized debt obligations (CDOs) that could result in principal losses to our investments. We have mitigated our risk of credit loss through the structure of the VIE,
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which contractually requires the subordinated tranches within these VIEs to absorb the majority of the expected losses from the underlying credit default swaps. We currently own only senior CDO tranches. Based on our statistical analysis models, each of these VIEs can sustain a reasonable number of defaults in the underlying reference corporate entities in the CDSs with no loss to our investment.
VIEs-Not Consolidated
With the exception of one CDO investment, the VIEs that we are not required to consolidate are investments that are limited to loans in the form of debt obligations from the VIEs that are irrevocably and unconditionally guaranteed by their corporate parents. These VIEs are the primary financing vehicles used by their corporate sponsors to raise financing in the international capital markets. The variable interests created by these VIEs are principally or solely a result of the debt instruments issued by them. We do not have the power to direct the activities that most significantly impact the entitys economic performance, nor do we have (1) the obligation to absorb losses of the entity or (2) the right to receive benefits from the entity. As such, we are not the primary beneficiary of these VIEs and are therefore not required to consolidate them. These VIE investments are comprised of securities from 167 separate issuers which have an average credit rating of A.
Securities Lending
We lend fixed-maturity securities to financial institutions in short-term security-lending transactions. These short-term security-lending arrangements increase investment income with minimal risk. Our security lending policy requires that the fair value of the securities and/or unrestricted cash received as collateral be 102% or more of the fair value of the loaned securities. The following table presents our security loans outstanding and the corresponding collateral held:
(In millions) | June 30, 2011 |
December 31, 2010 |
||||||
Security loans outstanding, fair value |
$ | 328 | $ | 186 | ||||
Cash collateral on loaned securities |
338 | 191 | ||||||
All security lending agreements are callable by us at any time.
4. DERIVATIVE INSTRUMENTS
We do not use derivative financial instruments for trading purposes, nor do we engage in leveraged derivative transactions. The majority of our freestanding derivatives are interest rate, foreign currency and credit default swaps that are associated with investments in special-purpose entities, including VIEs where we are the primary beneficiary. The remaining derivatives are interest rate swaps associated with our variable interest rate yen-denominated debt.
Derivative Types
Interest rate and credit default swaps involve the periodic exchange of cash flows with other parties, at specified intervals, calculated using agreed upon rates or other financial variables and notional principal amounts. Generally, no cash or principal payments are exchanged at the inception of the contract. Typically, at the time a swap is entered into, the cash flow streams exchanged by the counterparties are equal in value. Interest rate swaps are primarily used to convert interest receipts on floating-rate fixed-maturity securities contracts to fixed rates. These derivatives are predominantly used to better match cash receipts from assets with cash disbursements required to fund liabilities.
Credit default swaps are used to assume credit risk related to an individual security or an index. These contracts entitle the consolidated VIE to receive a periodic fee in exchange for an obligation to compensate the derivative counterparty should the referenced security issuers experience a credit event, as defined in the contract. The consolidated VIE is also exposed to credit risk due to embedded derivatives associated with credit-linked notes.
Foreign currency swaps exchange an initial principal amount in two currencies, agreeing to re-exchange the currencies at a future date, at an agreed upon exchange rate. There may also be a periodic exchange of payments at specified intervals based on the agreed upon rates and notional amounts. Foreign currency swaps are used primarily in the consolidated VIEs in our Aflac Japan portfolio to convert foreign denominated cash flows to yen, the functional currency of Aflac Japan, in order to minimize cash flow fluctuations.
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Credit Risk Assumed through Derivatives
Our exposure to credit risk in the event of nonperformance by counterparties to our interest rate swaps associated with our variable interest rate Uridashi notes as of June 30, 2011, was immaterial. For the interest rate, foreign currency, and credit default swaps associated with our VIE investments for which we are the primary beneficiary, we do not bear the risk of loss for counterparty default. We are not a direct counterparty to those contracts.
As a result of consolidation of certain VIE investments on January 1, 2010, we began recognizing related credit default swaps that assume credit risk from an asset pool. Those consolidated VIEs will receive periodic payments based on an agreed upon rate and notional amount and will only make a payment by delivery of associated collateral, which consists of highly rated asset-backed securities, if there is a credit event. A credit event payment will typically be equal to the notional value of the swap contract less the value of the referenced obligations. A credit event is generally defined as a default on contractually obligated interest or principal payments or bankruptcy of the referenced entity. The credit default swaps in which the consolidated VIE assumes credit risk primarily reference investment grade baskets. The diversified portfolios of corporate issuers are established within sector concentration limits.
The following tables present the maximum potential risk, fair value, weighted-average years to maturity, and underlying referenced credit obligation type for credit default swaps.
June 30, 2011 | ||||||||||||||||||||||||||||||||||||||||
Less than one year |
One to three years |
Three to five years |
Five to ten years |
Total | ||||||||||||||||||||||||||||||||||||
(In millions) | Maximum potential risk |
Estimated fair value |
Maximum potential risk |
Estimated fair value |
Maximum potential risk |
Estimated fair value |
Maximum potential risk |
Estimated fair value |
Maximum potential risk |
Estimated fair value |
||||||||||||||||||||||||||||||
Index exposure: |
|
|||||||||||||||||||||||||||||||||||||||
Corporate bonds |
$ | 0 | $ | 0 | $ | 0 | $ | 0 | $ | (141 | ) | $ | (11 | ) | $ | (418 | ) | $ | (242 | ) | $ | (559 | ) | $ | (253 | ) | ||||||||||||||
December 31, 2010 | ||||||||||||||||||||||||||||||||||||||||
Less than one year |
One to three years |
Three to five years |
Five to ten years |
Total | ||||||||||||||||||||||||||||||||||||
(In millions) | Maximum potential risk |
Estimated fair value |
Maximum potential risk |
Estimated fair value |
Maximum potential risk |
Estimated fair value |
Maximum potential risk |
Estimated fair value |
Maximum potential risk |
Estimated fair value |
||||||||||||||||||||||||||||||
Index exposure: |
|
|||||||||||||||||||||||||||||||||||||||
Corporate bonds |
$ | 0 | $ | 0 | $ | 0 | $ | 0 | $ | (340 | ) | $ | (118 | ) | $ | (416 | ) | $ | (225 | ) | $ | (756 | ) | $ | (343 | ) | ||||||||||||||
Derivative Balance Sheet Classification
The tables below summarize the balance sheet classification of our derivative fair value amounts, as well as the gross asset and liability fair value amounts. The fair value amounts presented do not include income accruals. The notional amount of derivative contracts represents the basis upon which pay or receive amounts are calculated. Notional amounts are not reflective of credit risk.
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June 30, 2011 | ||||||||||||||||
(In millions) | Net Derivatives | Asset Derivatives |
Liability Derivatives |
|||||||||||||
Hedge Designation/ Derivative Type | Notional Amount |
Fair Value | Fair Value | Fair Value | ||||||||||||
Cash flow hedges: |
||||||||||||||||
Interest rate swaps |
$ | 248 | $ | (1) | $ | 0 | $ | (1) | ||||||||
Foreign currency swaps |
575 | 71 | 94 | (23) | ||||||||||||
Total cash flow hedges |
823 | 70 | 94 | (24) | ||||||||||||
Non-qualifying strategies: |
||||||||||||||||
Interest rate swaps |
546 | 121 | 125 | (4) | ||||||||||||
Foreign currency swaps |
3,927 | (27) | 276 | (303) | ||||||||||||
Credit default swaps |
559 | (253) | 0 | (253) | ||||||||||||
Total non-qualifying strategies |
5,032 | (159) | 401 | (560) | ||||||||||||
Total cash flow hedges and non-qualifying strategies |
$ | 5,855 | $ | (89) | $ | 495 | $ | (584) | ||||||||
Balance Sheet Location |
||||||||||||||||
Other assets |
$ | 2,267 | $ | 495 | $ | 495 | $ | 0 | ||||||||
Other liabilities |
3,588 | (584) | 0 | (584) | ||||||||||||
Total derivatives |
$ | 5,855 | $ | (89) | $ | 495 | $ | (584) | ||||||||
December 31, 2010 | ||||||||||||||||
(In millions) | Net Derivatives | Asset Derivatives |
Liability Derivatives |
|||||||||||||
Hedge Designation/ Derivative Type | Notional Amount |
Fair Value | Fair Value | Fair Value | ||||||||||||
Cash flow hedges: |
||||||||||||||||
Interest rate swaps |
$ | 245 | $ | (2) | $ | 0 | $ | (2) | ||||||||
Foreign currency swaps |
615 | 170 | 180 | (10) | ||||||||||||
Total cash flow hedges |
860 | 168 | 180 | (12) | ||||||||||||
Non-qualifying strategies: |
||||||||||||||||
Interest rate swaps |
743 | 56 | 124 | (68) | ||||||||||||
Foreign currency swaps |
3,815 | (58) | 260 | (318) | ||||||||||||
Credit default swaps |
756 | (343) | 0 | (343) | ||||||||||||
Total non-qualifying strategies |
5,314 | (345) | 384 | (729) | ||||||||||||
Total cash flow hedges and non-qualifying strategies |
$ | 6,174 | $ | (177) | $ | 564 | $ | (741) | ||||||||
Balance Sheet Location |
||||||||||||||||
Other assets |
$ | 2,364 | $ | 564 | $ | 564 | $ | 0 | ||||||||
Other liabilities |
3,810 | (741 | ) | 0 | (741 | ) | ||||||||||
Total derivatives |
$ | 6,174 | $ | (177 | ) | $ | 564 | $ | (741 | ) | ||||||
Hedging
Certain of our consolidated VIEs have interest rate and/or foreign currency swaps that qualify for hedge accounting treatment. For those that have qualified, we have designated the derivative as a hedge of the variability in cash flows of a forecasted transaction or of amounts to be received or paid related to a recognized asset (cash flow hedge). We expect to continue this hedging activity for a weighted-average period of approximately 25 years. The remaining derivatives in our consolidated VIEs that have not qualified for hedge accounting have been designated as held for other investment purposes (non-qualifying strategies).
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We have interest rate swap agreements related to our 20 billion yen variable interest rate Uridashi notes that will mature in September 2011 and our 5.5 billion yen variable interest rate Samurai notes that we issued subsequent to the end of the second quarter in July 2011 (see Note 6). By entering into these contracts, we swapped the variable interest rate to a fixed interest rate of 1.52% for the Uridashi notes and 1.475% for the Samurai notes. We have designated these interest rate swaps as a hedge of the variability in our interest cash flows associated with the respective variable interest rate notes. The notional amounts and terms of the swaps match the principal amount and terms of the corresponding variable interest rate notes, and the swaps had no value at inception. Changes in the fair value of the swap contracts are recorded in other comprehensive income so long as the hedge is deemed effective. Should any portion of the hedge be deemed ineffective, that value would be reported in net earnings.
Hedge Documentation and Effectiveness Testing
To qualify for hedge accounting treatment, a derivative must be highly effective in mitigating the designated changes in cash flow of the hedged item. At hedge inception, we formally document all relationships between hedging instruments and hedged items, as well as our risk-management objective and strategy for undertaking each hedge transaction. The documentation process includes linking derivatives that are designated as cash flow hedges to specific assets or liabilities on the statement of financial position or to specific forecasted transactions and defining the effectiveness and ineffectiveness testing methods to be used. At the hedges inception and on an ongoing quarterly basis, we also formally assess whether the derivatives that are used in hedging transactions have been and are expected to continue to be highly effective in offsetting changes in cash flows of hedged items. Hedge effectiveness is assessed using qualitative and quantitative methods. Qualitative methods may include the comparison of critical terms of the derivative to the hedged item. Quantitative methods include regression or other statistical analysis of changes in cash flows associated with the hedge relationship. Hedge ineffectiveness of the hedge relationships is measured each reporting period using the Hypothetical Derivative Method.
For derivative instruments that are designated and qualify as cash flow hedges, the effective portion of the gain or loss on the derivative is reported as a component of other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Gains and losses on the derivative representing hedge ineffectiveness are recognized in current earnings as a component of realized investment gains (losses). All components of each derivatives gain or loss were included in the assessment of hedge effectiveness.
Discontinuance of Hedge Accounting
We discontinue hedge accounting prospectively when (1) it is determined that the derivative is no longer highly effective in offsetting changes in the cash flows of a hedged item; (2) the derivative is de-designated as a hedging instrument; or (3) the derivative expires or is sold, terminated or exercised.
When hedge accounting is discontinued on a cash-flow hedge, including those where the derivative is sold, terminated or exercised, amounts previously deferred in other comprehensive income are reclassified into earnings when earnings are impacted by the cash flow of the hedged item.
Cash Flow Hedges
The following tables present the components of the gain or loss on derivatives that qualify as cash flow hedges:
Derivatives in Cash Flow Hedging Relationships
(In millions) | Gain (Loss) Recognized in Other Comprehensive Income on Derivative (Effective Portion) |
Net Realized Investment Gains (Losses) Recognized in Income on Derivative (Ineffective Portion) |
||||||||||||||
Three Months Ended June 30, 2011 |
Six Months Ended June 30, 2011 |
Three Months Ended June 30, 2011 |
Six Months Ended June 30, 2011 |
|||||||||||||
Interest rate swaps |
$ | 0 | $ | 1 | $ | 0 | $ | 0 | ||||||||
Foreign currency swaps |
17 | (39 | ) | 2 | (2 | ) | ||||||||||
Total |
$ | 17 | $ | (38 | ) | $ | 2 | $ | (2 | ) | ||||||
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Derivatives in Cash Flow Hedging Relationships
(In millions) | Gain (Loss) Recognized in Other Comprehensive Income on Derivative (Effective Portion) |
Net Realized Investment Gains (Losses) Recognized in Income on Derivative (Ineffective Portion) |
||||||||||||||
Three Months Ended June 30, 2010 |
Six Months Ended June 30, 2010 |
Three Months Ended June 30, 2010 |
Six Months Ended June 30, 2010 |
|||||||||||||
Interest rate swaps |
$ | 0 | $ | 1 | $ | 0 | $ | 0 | ||||||||
Foreign currency swaps |
8 | (3 | ) | 3 | 0 | |||||||||||
Total |
$ | 8 | $ | (2 | ) | $ | 3 | $ | 0 | |||||||