UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K |
(Mark One)
ý | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the fiscal year ended December 31, 2014
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) | |
Securities registered pursuant to Section 12(b) of the Act:
Title of each class | Name of each exchange on which registered | |
Common Stock, $.10 Par Value | New York Stock Exchange | |
Tokyo Stock Exchange | ||
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. þ Yes ¨ No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. ¨ Yes þ No
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 (Section 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ
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 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
The aggregate market value of the voting common stock held by non-affiliates of the registrant as of June 30, 2014, was $27,797,345,404.
The number of shares of the registrant’s common stock outstanding at February 17, 2015, with $.10 par value, was 438,903,157.
Documents Incorporated By Reference
Certain information contained in the Notice and Proxy Statement for the Company’s Annual Meeting of Shareholders to be held on May 4, 2015, is incorporated by reference into Part III hereof.
Aflac Incorporated
Annual Report on Form 10-K
For the Year Ended December 31, 2014
Table of Contents
Page | ||
PART I | ||
Item 1. | ||
Item 1A. | ||
Item 1B. | ||
Item 2. | ||
Item 3. | ||
Item 4. | ||
PART II | ||
Item 5. | ||
Item 6. | ||
Item 7. | ||
Item 7A. | ||
Item 8. | ||
Item 9. | ||
Item 9A. | ||
Item 9B. | ||
PART III | ||
Item 10. | ||
Item 11. | ||
Item 12. | ||
Item 13. | ||
Item 14. | ||
PART IV | ||
Item 15. | ||
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PART I
ITEM 1. BUSINESS
We prepare our financial statements in accordance with U.S. generally accepted accounting principles (GAAP). This report includes certain forward-looking information that is based on current expectations and is subject to a number of risks and uncertainties. For details on forward-looking information, see Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A), Part II, Item 7, of this report.
Aflac Incorporated qualifies as a large accelerated filer within the meaning of Exchange Act Rule 12b-2. Our Internet address is aflac.com. The information on the Company's Web site is not incorporated by reference in this annual report on Form 10-K. We make available, free of charge on our Web site, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments thereto as soon as reasonably practicable after those forms have been electronically filed with or furnished to the Securities and Exchange Commission (SEC).
General Description
Aflac Incorporated (the Parent Company) was incorporated in 1973 under the laws of the state of Georgia. Aflac Incorporated is a general business holding company and acts as a management company, overseeing the operations of its subsidiaries by providing management services and making capital available. Its principal business is supplemental health and life insurance, which is marketed and administered through its subsidiary, 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 Aflac's policies are individually underwritten and marketed through independent agents. Aflac U.S. markets and administers group products through Continental American Insurance Company (CAIC), branded as Aflac Group Insurance. Our insurance operations in the United States and our branch in Japan service the two markets for our insurance business.
Aflac offers voluntary insurance policies in Japan and the United States that provide a layer of financial protection against income and asset loss. We continue to diversify our product offerings in both Japan and the United States. Aflac Japan sells voluntary supplemental insurance products, including cancer plans, general medical indemnity plans, medical/sickness riders, care plans, living benefit life plans, ordinary life insurance plans and annuities. Aflac U.S. sells voluntary supplemental insurance products including products designed to protect individuals from depletion of assets (accident, cancer, critical illness/ care, hospital intensive care, hospital indemnity, fixed-benefit dental, and vision care plans) and loss-of-income products (life and short-term disability plans).
We are authorized to conduct insurance business in all 50 states, the District of Columbia, several U.S. territories and Japan. Aflac Japan's revenues, including realized gains and losses on its investment portfolio, accounted for 72% of the Company's total revenues in 2014, compared with 74% in 2013 and 77% in 2012. The percentage of the Company's total assets attributable to Aflac Japan was 82% at December 31, 2014, compared with 85% at December 31, 2013.
Results of Operations
For information on our results of operations and financial information by segment, see MD&A and Note 2 of the Notes to the Consolidated Financial Statements in this report.
Foreign Currency Translation
For information regarding the effect of currency fluctuations on our business, see the Foreign Currency Translation and Market Risks of Financial Instruments - Currency Risk subsections of MD&A and Notes 1 and 2 of the Notes to the Consolidated Financial Statements in this report.
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Insurance Premiums
The growth of earned premiums is directly affected by the change in premiums in force and by the change in weighted-average yen/dollar exchange rates. Consolidated earned premiums were $19.1 billion in 2014, $20.1 billion in 2013, and $22.1 billion in 2012. For additional information on the composition of earned premiums by segment, see Note 2 of the Notes to the Consolidated Financial Statements in this report. The following table presents the changes in annualized premiums in force for Aflac's insurance business for the years ended December 31.
(In millions) | 2014 | 2013 | 2012 | ||||||||
Annualized premiums in force, beginning of year | $ | 20,440 | $ | 22,689 | $ | 22,472 | |||||
New sales, including conversions | 2,513 | 2,963 | 4,129 | ||||||||
Change in unprocessed new sales | 13 | 66 | 183 | ||||||||
Premiums lapsed and surrendered | (2,146 | ) | (2,154 | ) | (2,173 | ) | |||||
Other | (29 | ) | 17 | (9 | ) | ||||||
Foreign currency translation adjustment | (1,897 | ) | (3,141 | ) | (1,913 | ) | |||||
Annualized premiums in force, end of year | $ | 18,894 | $ | 20,440 | $ | 22,689 | |||||
Insurance - Japan
We translate Aflac Japan's annualized premiums in force into dollars at the respective end-of-period exchange rates. Changes in annualized premiums in force are translated at weighted-average exchange rates. The following table presents the changes in annualized premiums in force for Aflac Japan for the years ended December 31.
In Dollars | In Yen | |||||||||||||||||||
(In millions of dollars and billions of yen) | 2014 | 2013 | 2012 | 2014 | 2013 | 2012 | ||||||||||||||
Annualized premiums in force, beginning of year | $ | 14,870 | $ | 17,238 | $ | 17,284 | 1,567 | 1,492 | 1,344 | |||||||||||
New sales, including conversions | 1,080 | 1,539 | 2,641 | 115 | 149 | 211 | ||||||||||||||
Change in unprocessed new sales | 13 | 66 | 183 | 1 | 6 | 14 | ||||||||||||||
Premiums lapsed and surrendered | (695 | ) | (717 | ) | (845 | ) | (74 | ) | (70 | ) | (68 | ) | ||||||||
Other | (145 | ) | (115 | ) | (112 | ) | (15 | ) | (10 | ) | (9 | ) | ||||||||
Foreign currency translation adjustment | (1,897 | ) | (3,141 | ) | (1,913 | ) | 0 | 0 | 0 | |||||||||||
Annualized premiums in force, end of year | $ | 13,226 | $ | 14,870 | $ | 17,238 | 1,594 | 1,567 | 1,492 | |||||||||||
For further information regarding Aflac Japan's financial results, sales and the Japanese economy, see the Aflac Japan Segment subsection of MD&A in this report.
Insurance - U.S.
The following table presents the changes in annualized premiums in force for Aflac U.S. for the years ended December 31.
(In millions) | 2014 | 2013 | 2012 | ||||||||||||||
Annualized premiums in force, beginning of year | $ | 5,570 | $ | 5,451 | $ | 5,188 | |||||||||||
New sales, including conversions | 1,433 | 1,424 | 1,488 | ||||||||||||||
Premiums lapsed | (1,451 | ) | (1,437 | ) | (1,328 | ) | |||||||||||
Other | 116 | 132 | 103 | ||||||||||||||
Annualized premiums in force, end of year | $ | 5,668 | $ | 5,570 | $ | 5,451 | |||||||||||
For further information regarding Aflac's U.S. financial results, sales and the U.S. economy, see the Aflac U.S. Segment subsection of MD&A in this report.
Insurance Products - Japan
Aflac Japan's insurance products are designed to help consumers pay for medical and nonmedical costs that are not reimbursed under Japan's national health insurance system. Changes in Japan's economy and an aging population have put increasing pressure on Japan's national health care system. As a result, more costs are being shifted to Japanese
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consumers, who in turn have become increasingly interested in insurance products that help them manage those costs. Aflac Japan has responded to this consumer need by enhancing existing products and developing new products.
Aflac Japan's product portfolio has expanded beyond traditional health-related products to include more life products. Some of the life products that we offer in Japan provide death benefits and cash surrender values. These products are available as stand-alone policies and riders. Some plans, such as our WAYS product, have features that allow policyholders to convert a portion of their life insurance to medical, nursing care, or fixed annuity benefits at a predetermined age. Our child endowment product offers a death benefit until a child reaches age 18. It also pays a lump-sum benefit at the time of the child's entry into high school, as well as an educational annuity for each of the four years during his or her college education. We believe that life insurance (first sector product) provides further opportunities for us to sell our cancer and medical insurance (third sector products) through cross-selling opportunities.
In early 2002, we introduced EVER, a stand-alone, whole-life medical product which offers a basic level of hospitalization coverage with an affordable premium. Since its initial introduction, we have expanded our suite of EVER product offerings to appeal to specific types of Japanese consumers and achieve greater market penetration. New EVER, introduced in 2009, offered enhanced surgical benefits and gender-specific premium rates. An upgrade to our New EVER product, released in January 2012, included more advanced medical treatment options than its predecessor. The most recent upgrade to our New EVER product, released in August 2013, introduced outpatient coverage prior to hospitalization and enhanced coverage for short-term hospitalization with premium levels to attract a younger generation of consumers, an area in which we are currently underpenetrated. Gentle EVER, our non-standard medical product, is designed to meet the needs of certain consumers who cannot qualify for our base EVER plan. The most recent upgrade to our Gentle EVER product, released in July 2012, includes expanded benefits and a newly attached advanced medical care rider. We continue to believe that the entire medical category will remain an important part of our product portfolio in Japan.
Aflac pioneered the cancer insurance market in Japan in 1974, and we remain the number one provider of cancer insurance today. Over the years, we’ve customized our cancer product to respond to, and anticipate, the needs of our consumers and the advances in medical treatments. The cancer insurance plans we offer in Japan provide a lump-sum benefit upon initial diagnosis of internal cancer and benefits for treatment received due to internal cancer such as fixed daily benefits for hospitalization, outpatient services and convalescent care, and surgical and terminal care benefits. In September 2014, Aflac Japan introduced New Cancer DAYS, a new cancer product which provides enhanced coverage, including outpatient treatments and multiple cancer occurrence benefits. At the same time, premiums for this product have been lowered for most ages compared to prior plans. As the number one provider of cancer insurance in Japan, we believe this product further strengthens our brand, and most importantly, provides valuable benefits to consumers who are looking for solutions to manage cancer-related costs. We are convinced that the affordable cancer products Aflac Japan provides will continue to be an important part of our product portfolio.
We also offer traditional fixed-income annuities and care policies. For additional information on Aflac Japan's products and composition of sales, see the Aflac Japan Segment subsection of MD&A in this report.
Insurance Products - U.S.
We design our U.S. insurance products to provide supplemental coverage for people who already have major medical or primary insurance coverage. Most of our U.S. policies are individually underwritten and marketed through independent agents. Additionally, we started to market and administer group insurance products in 2009.
Our individually issued policies are portable and pay benefits regardless of other insurance. Most products' benefits are paid in cash directly to policyholders; therefore, our customers have the opportunity to use this cash to help with expenses of their choosing. Our individually issued health insurance plans are typically guaranteed-renewable for the lifetime of the policyholder (to age 75 for short-term disability policies). Our group insurance policies are underwritten on a group basis and often have some element of guaranteed issue.
Aflac U.S. offers accident coverage on both an individual and group basis. These policies are designed to protect against losses resulting from accidents. The accident portion of the policy includes lump-sum benefits for accidental death, dismemberment and specific injuries as well as fixed benefits for hospital confinement. In addition, other benefits such as short-term disability are available as riders.
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Aflac U.S. offers short-term disability benefits on both an individual and group basis. In 2013, we introduced a completely redesigned group short-term disability product with enhanced benefit options and higher income replacement amounts. In 2014, this group short-term disability product was introduced in additional states, formally completing the active launch of the product to the U.S. market.
Aflac U.S. offers coverage for critical illnesses on both an individual and group basis. These policies are designed to protect against losses resulting from critical illnesses such as heart attack, stroke, or cancer. On an individually underwritten basis we offer cancer plans, critical illness/critical care plans, critical care and recovery plans (formerly called specified health event) and hospital intensive care plans. On a group basis we offer critical illness/critical care plans. In 2014, we updated our individual critical care plan to increase initial diagnosis benefits and expand coverage for additional heart conditions.
Aflac U.S. offers hospital indemnity coverage on both an individual and group basis. Our hospital indemnity products provide policyholders fixed dollar benefits triggered by hospitalization due to accident or sickness, or just sickness alone. Indemnity benefits for inpatient and outpatient surgeries, as well as various other diagnostic events, are also available. In 2014, we introduced a new lump sum rider than can be added to our individual accident, short-term disability and hospital indemnity products. The rider may not be available on all these products in all states. This rider provides a lump sum payment for a wide range of critical illness events including traumatic brain injury, Type 1 diabetes, advanced Alzheimer's disease, advanced Parkinson's disease and many more. In 2013, we introduced a new individual hospital plan, designed to provide flexible options for consumers as they deal with out of pocket expenses associated with new medical plans that have emerged with the implementation of the Affordable Care Act of 2010 (ACA). This product focuses on providing benefits triggered by a wide variety of hospital services, including emergency visits, surgeries, and diagnostics, as well as benefits relating to traditional hospital stays. In 2013, we also updated our group hospital plan which provides multiple hospital admission amounts for an employer to choose, giving the flexibility to more closely match the out of pocket expenses associated with the employer's level of major medical coverage. In addition, we added a wellness benefit to specified levels of coverage, supporting healthier habits with employees and promoting lower health plan utilization for employers.
Aflac U.S. offers fixed-benefit dental coverage on both an individual and group basis. Aflac U.S. also offers Vision NowSM, an individually issued policy which provides benefits for serious eye health conditions and loss of sight. Vision Now also includes coverage for corrective eye materials and exam benefits. Aflac U.S. offers term and whole-life policies on both an individual and group basis. In 2014, Aflac introduced a new individual life portfolio which includes a guarantee-issue individual term life policy if participation requirements are met.
For additional information on Aflac's U.S. products and composition of sales, see the Aflac U.S. Segment subsection of MD&A in this report.
Distribution - Japan
The traditional channels through which we have sold our products are independent corporate agencies, individual agencies and affiliated corporate agencies. The independent corporate agencies and individual agencies that sell our products give us better access to workers at a vast number of small businesses in Japan. Agents' activities are primarily focused on insurance sales, with customer service support provided by the Aflac Contact Center. Independent corporate agencies and individual agencies contributed 46.1% of new annualized premium sales in 2014, compared with 43.8% in 2013 and 34.7% in 2012. Affiliated corporate agencies are formed when companies establish subsidiary businesses to sell our insurance products to their employees as part of a benefit package, and then expand to sell our products to suppliers and customers. These agencies help us reach employees at large worksites, and some of them are also successful in approaching customers outside their business groups. Affiliated corporate agencies, which include Japan Post, contributed 30.0% of new annualized premium sales in 2014, compared with 23.1% in 2013 and 18.5% in 2012. During 2014, we recruited more than 900 new sales agencies. As of December 31, 2014, Aflac Japan was represented by approximately 14,500 sales agencies, with more than 121,100 licensed sales associates employed by those agencies. We believe that new agencies will continue to be attracted to Aflac Japan's high commissions, attractive products, superior customer service and strong brand image.
We have sold our products to employees of banks since our entry into Japan in 1974. However, December 2007 marked the first time it was permissible for banks to sell our type of insurance products to their customers. By the end of 2014, we had agreements with 371 banks, approximately 90% of the total number of banks in Japan, to sell our products. We believe we have significantly more banks selling our supplemental health insurance products than any of our competitors. Japanese consumers rely on banks to provide traditional bank services, and also to provide insurance
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solutions and other services. We believe our long-standing and strong relationships within the Japanese banking sector, along with our strategic preparations, have proven to be an advantage, particularly starting when this channel opened up for our products. Our partnerships throughout the banking sector provide us with a wider demographic of potential customers than we would otherwise have been able to reach, and it also allows banks to expand their product and service offerings to consumers. Banks contributed 21.5% of Aflac Japan new annualized premium sales in 2014, compared with 31.3% in 2013 and 45.6% in 2012.
Aflac Japan and Japan Post Holdings entered into a new agreement in July 2013, further expanding their partnership that was initially established in 2008 (see Regulation-Japan). At the end of June 2014, Japan Post Insurance (Kampo) received Financial Services Agency (FSA) regulatory approval to enter into an agency contract with Aflac Japan to begin distributing Aflac Japan's cancer insurance products at all of Kampo's 79 directly managed sales offices. Aflac Japan has developed a unique Aflac-branded cancer product for Japan Post and Kampo that was introduced on October 1, 2014. In the fourth quarter of 2014, the number of postal outlets selling our cancer products expanded to approximately 10,000, and Japan Post intends to further expand the number of post offices that offer Aflac's cancer products to 20,000 postal outlets by the end of first quarter 2016. We believe this alliance with Japan Post will further benefit our cancer insurance sales.
For additional information on Aflac Japan's distribution, see the Aflac Japan Segment subsection of MD&A in this report.
Distribution - U.S.
As of December 31, 2014, our U.S. sales force comprised more than 70,800 sales associates and brokers who are licensed to sell accident and health insurance. Many are also licensed to sell life insurance.
Sales associates and brokers are independent contractors and are paid commissions based on first-year and renewal premiums from their sales of insurance products. In addition to receiving commissions on personal production, district, regional, and, until September 30, 2014, state sales coordinators may also receive override commissions and incentive bonuses.
Beginning in the third quarter and continuing into the fourth quarter of 2014, Aflac U.S. implemented tactical initiatives centered around pay for performance providing competitive compensation to our sales hierarchy and positioning us to more effectively and consistently execute on the U.S. sales strategy across all states. These measures are designed to more effectively link sales management's success to Aflac's success. We enhanced compensation through an incentive bonus for the first level of our sales associate management, district sales coordinators, who are primarily responsible for selling Aflac products and training new sales associates. Additionally, to better manage our state operations, we eliminated the commission-based position of state sales coordinator and introduced the new position of market director. Effective October 1, 2014, market directors are salaried employees with the opportunity to earn sales-related bonuses. We believe this position change will enhance our performance management and better align compensation with new business results.
We concentrate on marketing our insurance products at the worksite. This method offers policies to individuals through employment, trade and other associations. Historically, our policies have been individually underwritten with premiums generally paid by the employee. Additionally, Aflac's individual policies are portable, meaning that individuals may retain their full insurance coverage upon separation from employment or such affiliation, generally at the same premium. We collect a major portion of premiums on such sales through payroll deduction or other forms of centralized billing. With our brokerage sales expansion and the acquisition of CAIC, branded as Aflac Group Insurance, we offer group voluntary insurance products desired by many large employers. These products are sold on a group basis and often have some element of guaranteed issue. Worksite marketing enables sales associates and brokers to reach a greater number of prospective policyholders and lowers distribution costs, compared with individually marketed business.
Aflac U.S. utilizes dual-channel distribution to market our insurance products to businesses of all sizes. Our career agent channel focuses on marketing Aflac to the small business market, which consists of employers with less than 100 employees. As such, we have aligned our recruiting, training, compensation, marketing and incentives for our career agents to encourage specific activity and sales of individual policies in this market. Our newest channel is the broker channel, which is a sales division of Aflac Group. The broker channel focuses on selling to the mid- and large-case market, which is comprised of employers with more than 100 employees and typically an average size of 1,000 employees or more. Since regional and national brokers have traditionally served the mid- and large-case market, the highly trained and experienced sales professionals of the broker channel are assigned a geographic market to strengthen
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relationships with the top brokers and sell Aflac products to their clients. As a result, we are represented on more than 80 benefit administration platforms, sometimes referred to as exchanges, of various brokers.
For additional information on Aflac's U.S. distribution, see the Aflac U.S. Segment subsection of MD&A in this report.
Competition - Japan
In 1974, Aflac was granted an operating license to sell life insurance in Japan, making Aflac the second non-Japanese life insurance company to gain direct access to the Japanese insurance market. Through 1981, we faced limited competition for cancer insurance policy sales. However, Japan has experienced two periods of deregulation since we entered the market. The first came in the early 1980s, when nine mid-sized insurers, including domestic and foreign companies, were allowed to sell cancer insurance products for the first time. The second period began in 2001 when all life and non-life insurers were allowed to sell stand-alone cancer and medical insurance products as well as other stand-alone health insurance products. As a result, the number of insurance companies offering stand-alone cancer and medical insurance has more than doubled since the market was deregulated in 2001. However, based on our growth of annualized premiums in force and agencies, we do not believe that our market-leading position has been significantly impacted by increased competition. Furthermore, we believe the continued development and maintenance of operating efficiencies will allow us to offer affordable products that appeal to consumers. Aflac is the largest life insurer in Japan in terms of cancer and medical policies in force. As of December 31, 2014, we exceeded 23 million individual policies in force in Japan.
Aflac has had substantial success selling cancer policies in Japan, with more than 14 million cancer policies in force as of December 31, 2014. Aflac continued to be the number one seller of cancer insurance policies in Japan throughout 2014. We believe we will remain a leading provider of cancer insurance coverage in Japan, principally due to our experience in the market, low-cost operations, expansive marketing system (see Distribution - Japan above) and product expertise.
We have also experienced substantial success selling medical insurance in Japan. While other companies have recognized the opportunities that we have seen in the medical insurance market and offered new products, we believe our products stand out for their value to consumers.
In addition to third sector products, Aflac Japan sells life insurance products such as WAYS (described in the Products section of this report). These sales are generated largely through the bank channel. The market for ordinary life products of this kind is highly competitive. We will continue to pursue the development and marketing of specialty products that meet specific needs within the general life insurance market.
Competition - U.S.
Aflac competes against several voluntary supplemental insurance carriers on a national and regional basis. We believe our policies, premium rates, and sales commissions are competitive by product type. Moreover, we believe that Aflac products are distinct from competitive offerings given our product focus (including features, benefits, and our claims service model), distribution capabilities, and brand awareness. For many companies with which we compete, voluntary supplemental insurance products are sold as a secondary business. A growing number of major medical and life insurance carriers are also entering into the voluntary supplemental insurance market. For Aflac, supplemental insurance products are our primary business and are sold via a large distribution network of independent sales associates and brokers (see Distribution - U.S. above). Aflac's advertising campaigns have increased our name awareness and understanding by consumers and businesses of the value our products provide.
Both private and publicly-traded insurers offer major medical insurance for hospitalization and medical expenses. Much of this insurance is sold on a group basis to accounts that are both fully and self-insured. The federal and state governments also pay substantial costs of medical treatment through various programs. Major medical insurance generally covers a substantial portion of the medical expenses incurred by an insured. Aflac policies are designed to provide coverage that supplements major medical insurance by paying cash directly to the policyholder to use for expenses their major medical insurance is not designed to cover. Thus, we do not compete directly with major medical insurers except those who sell supplemental insurance products as a secondary business. Any reduction of coverage, increase in employee participation costs, or increased deductibles and copayments by major medical commercial or government insurance carriers could favorably affect our business opportunities. With the implementation of the ACA, we anticipate a larger burden of the cost of care will be borne by some consumers, potentially creating a favorable impact on key markets for Aflac products. We also expect the ACA potentially will result in a more competitive landscape for Aflac, as
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major medical carriers face profitability erosion in some of their core lines of business and seek competitive entry into Aflac's supplemental product segments to offset this impact.
Investments and Investment Results
Net investment income was $3.3 billion in 2014 and 2013 and $3.5 billion in 2012. Although Aflac Japan benefited from some U.S. dollar exposure in the investment portfolio, the net impact from the weakening yen was a reduction in the reported net investment income in U.S. dollar terms for 2014 and 2013. In addition, the growth rate of net investment income has been negatively impacted by the low level of investment yields for new money in both Japan and the United States. In particular, Japan's life insurance industry has contended with low investment yields for a number of years. For information on our investments and investment results, see the Insurance Operations and Analysis of Financial Condition sections of MD&A and Notes 3, 4 and 5 of the Notes to the Consolidated Financial Statements in this report.
Regulation - Japan
The financial and business affairs of Aflac Japan are subject to examination by Japan's FSA. Aflac Japan files annual reports and financial statements for the Japanese insurance operations based on a March 31 fiscal year end, prepared in accordance with Japanese regulatory accounting practices prescribed or permitted by the FSA. Japanese regulatory basis earnings are determined using accounting principles that differ materially from U.S. GAAP. For example, under Japanese regulatory accounting practices, policy acquisition costs are expensed immediately; deferred income tax liabilities are recognized on a different basis; policy benefit and claim reserving methods and assumptions are different; the carrying value of securities transferred to held-to-maturity is different; premium income is recognized on a cash basis; different consolidation criteria apply to variable interest entities; and different accounting for reinsurance. Capital and surplus of Aflac Japan, based on Japanese regulatory accounting practices, was $5.6 billion at December 31, 2014, compared with $4.2 billion at December 31, 2013.
The FSA maintains a solvency standard, which is used by Japanese regulators to monitor the financial strength of insurance companies. As of December 31, 2014, Aflac Japan's solvency margin ratio (SMR) was 857%, compared with 777% at December 31, 2013. See the Capital Resources and Liquidity Section of MD&A for a discussion of measures we have taken to mitigate the sensitivity of Aflac Japan's SMR.
We typically repatriate a portion of Aflac Japan's accumulated earnings, as determined on a Japanese regulatory accounting basis, to Aflac U.S. provided that Aflac Japan has adequately protected policyholders' interests as measured by its SMR. The FSA may not allow profit repatriations to Aflac U.S. if the transfers would cause Aflac Japan to lack sufficient financial strength for the protection of Japanese policyholders. In the near term, we do not expect these requirements to adversely affect the funds available for profit repatriations, nor do we expect these requirements to adversely affect the funds available for payments of allocated expenses to Aflac U.S. and management fees to the Parent Company.
In 2005, legislation aimed at privatizing Japan’s postal system (Japan Post) was enacted into law. The privatization laws split Japan Post into four operating entities that began operating in October 2007. In 2007, one of these entities selected Aflac Japan as its provider of cancer insurance to be sold through its post offices, and, in 2008, we began selling cancer insurance through these post offices. Japan Post has historically been a popular place for consumers to purchase insurance products. Legislation to reform the postal system passed the Diet in April 2012 and resulted in the merger of two of the postal operating entities (the one that delivers the mail and the one that runs the post offices) on October 1, 2012. In July 2013, Aflac Japan entered into a new agreement with Japan Post Holdings to further expand the partnership that was initially established in 2008. See the Distribution-Japan section for further developments in 2014.
The Japanese insurance industry has a policyholder protection corporation that provides funds for the policyholders of insolvent insurers. For additional information regarding the policyholder protection fund, see the Policyholder Protection subsection of MD&A in this report.
In June 2013, a revision to the Financial Instruments and Exchange Act established a post-funded Orderly Resolution Regime for financial institutions to prevent a financial crisis in the event of a financial institution’s failure. This regime came into effect in March 2014 and has not had, and is not expected to have, a material impact on the Company's operations in Japan.
On January 16, 2014, Japan’s FSA issued a reporting order pursuant to the Insurance Business Law to all insurance companies, including Aflac Japan, entitled “Regarding the Rectification, etc. of Insurance Agency Employees.” Companies have been ordered to ascertain conditions on the ground regarding sales agents, facilitate the discontinuation of the
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practice of subcontracting (i.e., the use of non-employee contractors to sell insurance on behalf of insurance agencies), and report to the FSA no later than April 30, 2015. In light of the Company's current mix of distribution channels, the use of non-employee contractors is not a major channel for the Company in Japan.
As a branch of our principal insurance subsidiary, Aflac Japan is also subject to regulation and supervision in the United States (see Regulation - U.S.). For additional information regarding Aflac Japan's operations and regulations, see the Aflac Japan Segment subsection of MD&A and Notes 2 and 13 of the Notes to the Consolidated Financial Statements in this report.
Regulation - U.S.
The Parent Company and its insurance subsidiaries, Aflac (a Nebraska-domiciled insurance company), American Family Life Assurance Company of New York (Aflac New York, a New York-domiciled insurance company) and CAIC (a South Carolina-domiciled insurance company) are subject to state regulations in the United States as an insurance holding company system. Such regulations generally provide that transactions between companies within the holding company system must be fair and equitable. In addition, transfers of assets among such affiliated companies, certain dividend payments from insurance subsidiaries, and material transactions between companies within the system, including management fees, loans and advances are subject to prior notice to, or approval by, state regulatory authorities. These laws generally require, among other things, the insurance holding company and each insurance company directly owned by the holding company to register with the insurance departments of their respective domiciliary states and to furnish annually financial and other information about the operations of companies within the holding company system.
Like all U.S. insurance companies, Aflac is subject to regulation and supervision in the jurisdictions in which it does business. In general, the insurance laws of the various jurisdictions establish supervisory agencies with broad administrative powers relating to, among other things:
• | granting and revoking licenses to transact business |
• | regulating trade and claims practices |
• | licensing of insurance agents and brokers |
• | approval of policy forms and premium rates |
• | standards of solvency and maintenance of specified policy benefit reserves and minimum loss ratio requirements |
• | capital requirements |
• | limitations on dividends to shareholders |
• | the nature of and limitations on investments |
• | deposits of securities for the benefit of policyholders |
• | filing of financial statements prepared in accordance with statutory insurance accounting practices prescribed or permitted by regulatory authorities |
• | periodic examinations of the market conduct, financial, and other affairs of insurance companies |
The insurance laws of Nebraska that govern Aflac's activities provide that the acquisition or change of “control” of a domestic insurer or of any person that controls a domestic insurer cannot be consummated without the prior approval of the Nebraska Department of Insurance. A person seeking to acquire control, directly or indirectly, of a domestic insurance company or of any person controlling a domestic insurance company (in the case of Aflac, the Parent Company) must generally file with the Nebraska Department of Insurance an application for change of control containing certain information required by statute and published regulations and provide a copy to Aflac. In Nebraska, control is generally presumed to exist if any person, directly or indirectly, acquires 10% or more of an insurance company or of any other person or entity controlling the insurance company. The 10% presumption is not conclusive and control may be found to exist at less than 10%. Similar laws apply in New York and South Carolina, the domiciliary jurisdictions of the Parent Company's other insurance subsidiaries, Aflac New York and CAIC.
State insurance departments conduct periodic examinations of the books and records, financial reporting, policy filings and market conduct of insurance companies domiciled in their states, generally once every three to five years. Examinations are generally carried out in cooperation with the insurance departments of other states under guidelines promulgated by the National Association of Insurance Commissioners (NAIC). In 2013, the Nebraska insurance regulator, along with the New York insurance regulator, completed a coordinated risk-focused full scope financial examination for the four-year period and three-year period, respectively, ended December 31, 2011 for Aflac and Aflac New York as part of the normal examination process. These examinations found no material deficiencies. Also, in 2011 the South Carolina
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insurance regulator completed a risk-focused full scope financial examination for the three-year period ended December 31, 2010 for CAIC as part of the normal examination process and found no material deficiencies.
The NAIC continually reviews regulatory matters and recommends changes and revisions for adoption by state legislators and insurance departments. The NAIC uses a risk-based capital formula relating to insurance risk, business risk, asset risk and interest rate risk to facilitate identification by insurance regulators of inadequately capitalized insurance companies based upon the types and mix of risk inherent in the insurer's operations. The formulas for determining the amount of risk-based capital specify various weighting factors that are applied to financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio of a company's regulatory total adjusted capital to its authorized control level risk-based capital as defined by the NAIC. Companies below specific trigger points or ratios are classified within certain levels, each of which requires specified corrective action. The levels are company action, regulatory action, authorized control, and mandatory control. Aflac's NAIC risk-based capital ratio remains high and reflects a very strong capital and surplus position. As of December 31, 2014, based on year-end statutory accounting results, Aflac's company action level risk-based capital (RBC) ratio was 945%.
Federal legislation and administrative policies in several areas, including health care reform legislation, financial services reform legislation, securities regulation, pension regulation, privacy, tort reform legislation and taxation, can significantly and adversely affect insurance companies. Various forms of federal oversight and regulation of insurance have been passed by the U.S. Congress and signed into law by the President. For example, the ACA, federal health care reform legislation, gives the U.S. federal government direct regulatory authority over the business of health insurance. The reform includes major changes to the U.S. health care insurance marketplace. Among other changes, the reform legislation includes an individual medical insurance coverage mandate, provides for penalties on certain employers for failing to provide adequate coverage, creates health insurance exchanges, and addresses coverage and exclusions as well as medical loss ratios. The legislation also includes changes in government reimbursements and tax credits for individuals and employers and alters federal and state regulation of health insurers. These changes, directed toward major medical health insurance coverage which Aflac does not offer, have already begun and will continue to be phased in over the next several years. The major elements of the bill became effective on January 1, 2014. We believe that the ACA, as enacted, does not materially affect the design of our insurance products. However, indirect consequences of the legislation and regulations, including uncertainty related to implementation, could present challenges and/or opportunities that could potentially have an impact on our sales model, financial condition and results of operations.
In 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act, commonly known as the Dodd-Frank Act, which, among other things, created a Financial Stability Oversight Council (the Council). In April 2012, the Council released a final rule describing the general process it will follow in determining whether to designate a nonbank financial company for supervision by the Board of Governors of the U.S. Federal Reserve System (the Board). The Council may designate by a two-thirds vote whether certain nonbank financial companies, including certain insurance companies and insurance holding companies, could pose a threat to the financial stability of the United States, in which case such nonbank financial companies would become subject to prudential regulation by the Board. On April 3, 2013, the Board published a final rule that establishes the requirements for determining when a nonbank financial company is "predominantly engaged in financial activities" - a prerequisite for designation by the Council. Prudential regulation by the Board includes supervision of capital requirements, leverage limits, liquidity requirements and examinations. The Board may limit such company’s ability to enter into mergers, acquisitions and other business combination transactions, restrict its ability to offer financial products, require it to terminate one or more activities, or impose conditions on the manner in which it conducts activities. The Council designated two insurers in 2013 and an additional insurer in 2014 as a Systematically Important Financial Institution (SIFI) in 2014. On December 18, 2014, President Obama signed the Insurance Capital Standards Clarification Act into law. This legislation will clarify the Board’s authority to apply insurance-based capital standards for insurance companies subject to federal supervision. Although Aflac is a nonbank financial company predominantly engaged in financial activities as defined in the Dodd-Frank Act, we do not believe Aflac will be considered a company that poses a threat to the financial stability of the United States.
Title VII of the Dodd-Frank Act and regulations issued thereunder may have an impact on Aflac's derivative activity, including activity on behalf of Aflac Japan, in particular rules and rule proposals to require central clearing and collateral for certain types of derivatives. The five U.S. banking regulators and the U.S. Commodity Futures Trading Commission (CFTC) recently re-proposed for comment their rules regarding collateral for uncleared swaps. If adopted as proposed, such rules may result in increased collateral requirements for Aflac or impose limits on the types of collateral we are permitted to post.
The Dodd-Frank Act also established a Federal Insurance Office (FIO) under the U.S. Treasury Department to monitor all aspects of the insurance industry and of lines of business other than certain health insurance, certain long-term care
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insurance and crop insurance. Traditionally, U.S. insurance companies have been regulated primarily by state insurance departments. In December 2013, the FIO released a report entitled "How To Modernize And Improve The System Of Insurance Regulation In The United States." The report was required by the Dodd-Frank Act, and included 18 recommended areas of near-term reform for the states, including addressing capital adequacy and safety/soundness issues, reform of insurer resolution practices, and reform of marketplace regulation. The report also listed nine recommended areas for direct federal involvement in insurance regulation. Some of the recommendations outlined in the FIO report released in December 2013 have been implemented. Of the nine recommended areas for direct federal involvement in insurance regulation that are applicable to Aflac, President Obama has signed the National Association of Registered Agents and Brokers Reform Act into law in January 2015, which simplifies the agent and broker licensing process across state lines. The FIO has also engaged with the supervisory colleges to monitor financial stability and identify regulatory gaps for large national and internationally active insurers.
On December 10, 2013, five U.S. financial regulators adopted a final rule implementing the "Volcker Rule," which was created by Section 619 of the Dodd-Frank Act. The Volcker Rule generally prohibits "banking entities" from engaging in "proprietary trading" and making investments and conducting certain other activities with "private equity funds and hedge funds." The final rule became effective April 1, 2014; however, at the time the agencies released the final Volcker Rule, the Federal Reserve announced an extension of the conformance period for all banking entities until July 21, 2015. In response to industry questions regarding the final Volcker Rule, the five U.S. financial regulators, which included the Office of the Comptroller of the Currency (OCC); the Federal Reserve; the Federal Deposit Insurance Corporation (FDIC); the SEC and the U.S. CFTC, issued a clarifying interim final rule on January 14, 2014 that permits banking entities to retain interests in certain collateralized debt obligations (CDOs) backed by trust preferred securities if the CDO meets certain requirements.
On December 18, 2014, the Federal Reserve announced a second extension to the Volcker Rule conformance period, to give banking entities until July 21, 2016, to conform investments in and relationships with covered funds and foreign funds that were in place prior to December 31, 2013 (legacy covered funds). The Federal Reserve also announced its intention to act in the future to grant banking entities an additional one-year extension of the conformance period until July 21, 2017, to conform ownership interests in and relationships with these legacy covered funds. The Federal Reserve did not act to extend the conformance period for proprietary trading activities.
Nonbank financial companies such as Aflac that are not affiliated with an insured depository institution or otherwise brought within the definition of "banking entity" generally will not be subject to the Volcker Rule's prohibitions. However, the prohibitions of the Volcker Rule could impact financial markets generally, for example, through reduced liquidity in certain markets or the exiting of positions by banking entities as the end of the conformance period approaches.
The Dodd-Frank Act requires extensive rule-making and other future regulatory action, which in some cases will take a period of years to implement. However, at the current time, it is not possible to predict with any degree of certainty what impact, if any, the Dodd-Frank Act will have on our U.S. business, financial condition, or results of operations.
In September 2014, the Nebraska Department of Insurance chaired the second meeting of the Aflac Supervisory College, which included the attendance of Japan's Financial Services Agency. Consistent with international regulatory standards and supervisory best practices, the Supervisory College was established in 2013 as a forum for cooperation and communication between the Company's primary supervisors. At the second meeting, the supervisors agreed to continue to meet annually with the next meeting in 2015.
For further information concerning Aflac U.S. operations, regulation, change of control and dividend restrictions, see the Aflac U.S. Segment subsection of MD&A and Notes 2 and 13 of the Notes to the Consolidated Financial Statements in this report.
Other Operations
Our other operations include the Parent Company and a printing subsidiary. For additional information on our other operations, see the Other Operations subsection of MD&A.
Employees
As of December 31, 2014, Aflac Japan had 4,526 employees, Aflac U.S. had 4,709 employees, and our other operations, the Parent Company and printing subsidiary, had 290 employees.
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Executive Officers of the Registrant
(1)Unless specifically noted, the respective executive officer has held the occupation(s) set forth in the table for at least the last five years. Each executive officer is appointed annually by the board of directors and serves until his or her successor is chosen and qualified, or until his or her death, resignation or removal.
NAME | PRINCIPAL OCCUPATION(1) | AGE | |
Daniel P. Amos | Chairman, Aflac Incorporated and Aflac, since 2001; Chief Executive Officer, Aflac Incorporated and Aflac, since 1990 | 63 | |
Paul S. Amos II | President, Aflac, since 2007; Chief Operating Officer, U.S. Operations, Aflac, from 2006 until 2013 | 39 | |
Koji Ariyoshi | Executive Vice President, Director of Marketing and Sales, Aflac Japan, since 2012; First Senior Vice President, Director of Marketing and Sales, Aflac Japan, from 2010 until 2011 | 61 | |
Susan R. Blanck | Executive Vice President, Aflac Japan, since 2012; Executive Vice President, Corporate Actuary, Aflac, since 2011; First Senior Vice President, Aflac Japan, from 2008 until 2012; Senior Vice President, Corporate Actuary, Aflac, from 2004 until 2011 | 48 | |
Kriss Cloninger III | President, Aflac Incorporated, since 2001; Chief Financial Officer, Aflac Incorporated and Aflac, since 1992; Treasurer, Aflac Incorporated, since 2001; Executive Vice President, Aflac, since 1993 | 67 | |
June Howard | Chief Accounting Officer, Aflac Incorporated and Aflac, since 2010; Treasurer, Aflac, since 2011; Senior Vice President, Financial Services, Aflac Incorporated and Aflac, since 2010; Vice President, Financial Services, Aflac, from 2009 until 2010 | 48 | |
Kenneth S. Janke | Executive Vice President, Deputy Chief Financial Officer, Aflac Incorporated, since 2010; President, Aflac U.S., from 2013 until 2014; Senior Vice President, Investor Relations, Aflac Incorporated, from 1993 until 2010 | 56 | |
Eric M. Kirsch | Executive Vice President, Global Chief Investment Officer, Aflac, since 2012; First Senior Vice President, Global Chief Investment Officer, Aflac, from 2011 until 2012; Managing Director, Global Head of Insurance Asset Management, Goldman Sachs Asset Management, from 2007 until 2011 | 54 | |
Charles D. Lake II | President, Aflac International, since 2014; Chairman, Aflac Japan, since 2008 | 53 | |
Audrey B. Tillman | Executive Vice President, General Counsel, Aflac Incorporated and Aflac, since 2014; Executive Vice President, Corporate Services, Aflac Incorporated, from 2008 until 2014 | 50 | |
Teresa L. White | President, Aflac U.S., since 2014; Executive Vice President, Chief Operating Officer, Aflac, from 2013 until 2014; Executive Vice President, Chief Service Officer, Aflac, from 2012 until 2013; Executive Vice President, Chief Administrative Officer, Aflac, from 2008 until 2013 | 48 | |
Robin Y. Wilkey | Senior Vice President, Investor and Rating Agency Relations, Aflac Incorporated, since 2010; Vice President, Investor Relations, Aflac Incorporated, from 2003 until 2010 | 56 | |
Hiroshi Yamauchi | President, Chief Operating Officer, Aflac Japan, effective 2015; Executive Vice President, Aflac Japan, from 2012 until 2014; First Senior Vice President, Aflac Japan, from 2002 until 2011 | 63 | |
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ITEM 1A. RISK FACTORS
We face a wide range of risks, and our continued success depends on our ability to identify, prioritize and appropriately manage our enterprise risk exposures. Readers should carefully consider each of the following risks and all of the other information set forth in this Form 10-K. These risks and other factors may affect forward-looking statements, including those in this document or made by the Company elsewhere, such as in earnings release webcasts, investor conference presentations or press releases. The risks and uncertainties described herein may not be the only ones facing the Company. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may also adversely affect our business. If any of the following risks and uncertainties develop into actual events, there could be a material impact on the Company.
Difficult conditions in global capital markets and the economy could have a material adverse effect on our investments, capital position, revenue, profitability, and liquidity and harm our business.
Our results of operations are materially affected by conditions in the global capital markets and the global economy generally, including in our two primary operating markets of the United States and Japan. Weak global financial markets impact the value of our existing investment portfolio, influence opportunities for new investments, and may contribute to generally weak economic fundamentals, which can have a negative impact on our operating activities.
For the last few years, global capital markets have been severely impacted by several major events. The financial crisis that began in the latter part of 2008 saw dramatic declines in investment values and weak economic conditions as the global financial system came under extreme pressure. Although U.S. markets began recovering as early as late 2009 and 2010, Europe continued to struggle under a severely weakened banking system and investor concerns with sovereign debt levels. Following a period of unprecedented intervention by governments and central banks, including the U.S. Federal Reserve and European Central Bank (ECB), financial conditions improved from the dire conditions of the global financial crisis, global recession, and European debt crisis. Recently, global markets have experienced increased volatility due to concerns including changes in the market’s perception of global growth, additional ECB intervention, uncertainty surrounding Japan’s continued recovery amidst assorted policy changes, and sizable declines in global commodity prices including oil.
As we hold a significant amount of fixed maturity and perpetual securities issued by borrowers located in many different parts of the world, including a large portion issued by banks and financial institutions, sovereigns, and other corporate borrowers in the U.S. and Europe, our financial results are directly influenced by global financial markets. A retrenchment of the recent improvements in overall capital market health could adversely affect our financial condition, including our capital position and our overall profitability. Market volatility and recessionary pressures could result in significant realized or unrealized losses due to severe price declines driven by increases in interest rates or credit spreads, defaults in payment of principal or interest, and credit rating downgrades.
Following the election of Shinzo Abe as Prime Minister of Japan in December 2012, the new administration adopted a new set of financial measures to stimulate the Japanese economy. In a December 2014 snap-election, the ruling Liberal Democratic Party (LDP) won a landslide victory, further strengthening Mr. Abe's ability to implement economic reform and address key policy challenges. The Japanese financial markets have reacted with even lower rates on Japanese Government bonds, large increases in Japanese equity market values, and a weakening of the yen relative to the U.S. dollar, a situation that remains largely intact today.
Japan is the largest market for our products and we own substantial holdings in Japanese Government Bonds (JGBs). Government actions to stimulate the economy affect the value of our existing holdings, our reinvestment rate on new investments in JGBs or other yen denominated assets, and consumer behavior relative to our suite of products. The additional government debt from fiscal stimulus actions could contribute to a weakening of the Japan sovereign credit profile and result in further rating downgrades at the credit rating agencies. This could lead to additional volatility in Japanese capital and currency markets.
Our investment portfolio owns sizeable credit positions in many other geographic areas of the world including the Middle East, Latin America, Asia, and other emerging markets. Deterioration in their underlying economies, sovereign credit worthiness, or financial market conditions could negatively impact our financial position. We also own credit investments that result in exposure to commodity valuations, including oil, natural gas, gold, and other metals. The recent significant declines in the prices of these commodities could result in credit deterioration of our holdings and
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significant credit losses due to depressed bond valuations, defaults in payment of principal or interest, or credit rating downgrades.
Most of our investment portfolio holdings are income-producing bonds that provide a fixed level of income. Many of our investments were made at the relatively low level of interest rates prevailing the last several years. Any increase in the market yields of our holdings due to an increase in interest rates could create substantial unrealized losses in our portfolio, as discussed further in a separate risk factor in this section of the Form 10-K.
We need liquidity to pay our operating expenses, dividends on our common stock, interest on our debt and liabilities. For a further description of our liquidity needs, including maturing indebtedness, see Item 7 of this Form 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations - Capital Resources and Liquidity. In the event our current resources do not meet our needs, we may need to seek additional financing. Our access to additional funding will depend on a variety of factors such as market conditions, the general availability of credit to the financial services industry and our credit rating. We have a credit facility agreement as a capital contingency plan with a syndicate of financial institutions that provides for borrowings in the amount of 50 billion yen. This agreement provides for borrowings in Japanese yen or the equivalent of Japanese yen in U.S. dollars on a revolving basis and will expire on the earlier of March 29, 2018, or the date of termination of the commitments upon an event of default as defined in the agreement. Should investors become concerned with any of our investment holdings, including a concentration of JGBs, our access to market sources of funding could be negatively impacted. There is a possibility that lenders or debt investors may develop a negative perception of us if we incur large investment losses or if the level of our business activity decreases due to a market downturn or there are further adverse economic trends in the United States or Japan, specifically, or generally in developed markets. Similarly, our access to funds may be impaired if regulatory authorities or rating agencies take negative actions against us.
Broad economic factors such as consumer spending, business investment, government spending, the volatility and strength of the capital markets, and inflation all affect the business and economic environment and, indirectly, the amount and profitability of our business. In an economic downturn characterized by higher unemployment, lower family income, lower corporate earnings, lower business investment and lower consumer spending, the demand for financial and insurance products could be adversely affected. This adverse effect could be particularly significant for companies such as ours that distribute supplemental, discretionary insurance products primarily through the worksite in the event that economic conditions result in a decrease in the number of new hires and total employees. Adverse changes in the economy could potentially lead our customers to be less inclined to purchase supplemental insurance coverage or to decide to cancel or modify existing insurance coverage, which could adversely affect our premium revenue, results of operations and financial condition. We are unable to predict the course of the current recoveries in global financial markets or the recurrence, duration or severity of disruptions in such markets.
The effect that governmental actions for the purpose of stabilizing the financial markets will have on such markets generally, or on us specifically, is difficult to determine at this time.
In response to the severity of the global financial crisis, numerous regulatory and governmental actions were taken to address weakness in the banking system, volatility in capital market conditions, and to stimulate the global economy. In the United States, this included aggressive expansionary monetary policy actions by the Federal Reserve, including conventional measures such as reducing the Federal Funds rate to near zero, and less conventional measures such as multiple rounds of quantitative easing. The result of the actions of the Federal Reserve was to keep interest rates, as measured by the U.S. Treasury curve and other relevant market rates, at very low levels for an extended period of time in an attempt to stimulate the economy.
As the U.S. economy has continued to improve, the Federal Reserve has reduced the amount of monetary stimulus. The stimulative actions previously taken by the Federal Reserve, and the amounts involved, are unprecedented. As such, there exist considerable risks associated with the amount of monetary stimulus provided and its withdrawal. These risks could include heightened inflation, increased volatility of interest rates, significantly higher interest rates, and overall increased volatility in the fair value of investment securities. These factors could negatively impact our business by reducing the value of our existing portfolio, negatively impacting our opportunities for new investments as market volatility increases, increasing the risk of depressed bond valuations or defaults in our credit portfolio, and reducing the demand for our products should the broader economy be negatively impacted by withdrawal of monetary stimulus.
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The financial crisis also created new government regulation, including the Dodd-Frank Financial Regulatory Reform Bill for U.S. institutions. This significant legislation, intended to reduce risk of another crisis, contains multiple provisions that could impact our business as rules are finalized and implemented. This legislation could impact the value of our significant holdings in banks and other financial institutions and our ability to conduct financial and capital market transactions, and affect the general competitiveness of the U.S. financial services industry.
As the effects of the financial crisis continue to linger, other central banks around the world have followed the actions of the Federal Reserve and taken unprecedented actions. In the case of the ECB, multiple actions were taken to mitigate the European sovereign and banking crisis, and to stimulate the economies throughout the Eurozone. The Bank of Japan has undertaken monetary policy actions designed to stimulate the Japanese economy. These governmental interventions have helped create an environment of extremely low interest rates for an extended period of time. There can be no assurance as to the effect that these governmental actions, other governmental actions taken in the future, or the ceasing of these governmental actions will have on the financial markets generally, the economies in which we operate, our competitive position, or our business and financial condition.
Defaults, downgrades, widening credit spreads or other events impairing the value of the fixed maturity securities and perpetual securities in our investment portfolio may reduce our earnings.
We are subject to the risk that the issuers, guarantors, and/or counterparties of fixed maturity securities and perpetual securities we own may default on principal, interest and other payments they owe us. A significant portion of our portfolio represents an unsecured obligation of the issuer, including some that are subordinated to other debt in the issuer’s capital structure. In these cases, many factors can influence the overall creditworthiness of the issuer and ultimately its ability to service and repay our holdings. This can include changes in the global economy, the company's assets, strategy, or management, shifts in the dynamics of the industries in which they compete, their access to additional funding, and the overall health of the credit markets. Factors unique to our securities including contractual protections such as financial covenants or relative position in the issuer's capital structure also influence the value of our holdings.
Most of our holdings carry a rating by one or more of the Nationally Recognized Statistical Rating Organizations (NRSROs, or “rating agencies”). Any change in the rating agencies' approach to evaluating credit and assigning an opinion could negatively impact the fair value of our portfolio. We employ a team of credit analysts to monitor the creditworthiness of the issuers in our portfolio. Any credit-related declines in the fair value of positions held in our portfolio we believe are not temporary in nature will negatively impact our net income through impairment and other credit related losses.
We are also subject to the risk that any collateral providing credit enhancement to our positions could deteriorate. These instruments may include senior secured first lien loans and loan-backed securities such as CDOs and mortgage-backed securities (MBS), where the underlying collateral notes may default on principal, interest, or other payments, causing an adverse change in cash flows to the positions held in our investment portfolio.
Our portfolio includes holdings of perpetual securities. Most of these are issued by global banks and financial institutions. Following the financial crisis, rating agencies reviewed and, in most cases, modified the rating criteria for financial institutions. This has caused multiple downgrades of many bank and financial issuers, but perpetual securities have been more negatively impacted as their lower position in the capital structure represents relatively more risk than other more senior obligations of the issuer. Further downgrades or default of issuers of securities we own will have a negative impact on our portfolio and could reduce our earnings.
We are exposed to sovereign credit risk through instruments issued directly by governments and government entities as well as banks and other institutions that rely in part on the strength of the underlying government for their credit quality. In addition to the United States and Japan, many governments, especially in Europe, have been subject to rating downgrades due to the need for fiscal and budgetary remediation and structural reforms, reduced economic activity, and investment needed to support banks or other systematically important entities. Additional downgrades or default of our sovereign issuers will have a negative impact on our portfolio and could reduce our earnings.
In addition to our exposure to the underlying credit strength of various issuers of fixed maturity and perpetual securities, we are also exposed to credit spreads, primarily related to market pricing and variability of future cash flows associated with credit spreads. A widening of credit spreads could reduce the value of our existing portfolio and create unrealized losses on our investment portfolio. This could, however, increase the net investment income on new credit investments. Conversely, a tightening of credit spreads could increase the value of our existing portfolio and create
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unrealized gains on our investment portfolio. This could reduce the net investment income available to us on new credit investments. Increased market volatility also makes it difficult to value certain of our investment holdings (see the Critical Accounting Estimates section in Item 7, Management's Discussion and Analysis, of this Form 10-K).
For more information regarding credit risk, see the Market Risks of Financial Instruments - Credit Risk subsection of Item 7, Management's Discussion and Analysis, of this Form 10-K.
We are exposed to significant interest rate risk, which may adversely affect our results of operations, financial condition and liquidity.
We have substantial investment portfolios that support our policy liabilities. Low levels of interest rates on investments, such as those experienced specifically in Japan, the United States, and generally globally during recent years, have reduced the level of investment income earned by the Company. Our overall level of investment income will be negatively impacted if a low-interest-rate environment persists. While we generally seek to maintain a diversified portfolio of fixed-income investments that reflects the cash flow and duration characteristics of the liabilities it supports, we may not be able to fully mitigate the interest rate risk of our assets relative to our liabilities. Our exposure to interest rate risk relates primarily to the ability to invest future cash flows to support the interest rate assumption made at the time our products were priced and the related reserving assumptions were established. A rise in interest rates could improve our ability to earn higher rates of return on funds that we reinvest. Conversely, a decline in interest rates could impair our ability to earn the returns assumed in the pricing and the reserving for our products at the time they were sold and issued. Our ability to earn the returns we expect due to low interest rates may also influence our ability to develop and price attractive new products and impact our overall sales levels.
We also have exposure to interest rates related to the value of the substantial investment portfolios that support our policy liabilities. Changes in interest rates have a direct impact on the fair values of fixed securities in our investment portfolio; however, they do not have a direct impact on the related valuation of the corresponding liabilities. Prolonged periods of low interest rates, as have been experienced in recent years, heighten the risk of future increases in interest rates because of an increasing proportion of our investment portfolio includes investments that bear lower rates of return than the embedded book yield of the investment portfolio. A rise in interest rates could increase the net unrealized loss position of our debt and perpetual securities. Aflac sells insurance products in the US and Japan that provide cash surrender values. A rise in interest rates could trigger significant policy lapsation which might require the Company to sell investment assets and recognize unrealized losses. This situation is commonly referred to as disintermediation risk. Conversely, a decline in interest rates could decrease the net unrealized loss position of our debt and perpetual securities. While we generally invest our assets to match the duration and cash flow characteristics of our policy liabilities, and therefore would not expect to realize most of these gains or losses, our risk is that unforeseen events or economic conditions, such as changes in interest rates resulting from governmental monetary policies, domestic and international economic and political conditions, and other factors beyond our control, reduce the effectiveness of this strategy and either cause us to dispose of some or all of these investments prior to their maturity, or increases the risk that the issuers of these securities may default or may require impairment, which could result in our having to recognize such gains or losses.
Rising interest rates also negatively impact the solvency margin ratio since unrealized losses on the available-for-sale investment portfolio are included in the calculation. While we closely monitor the solvency margin ratio and have taken steps to reduce the sensitivity of Aflac Japan's available-for-sale portfolio to increases in interest rates, there is no assurance that these measures will be fully effective, particularly for sharp increases in interest rates.
Significant changes in interest rates could have a material adverse effect on our consolidated results of operations, financial condition or cash flows through realized losses, impairments, changes in unrealized positions, and liquidity.
For more information regarding interest rate risk, see the Interest Rate Risk subsection within the Market Risks of Financial Instruments section of MD&A in this report.
We are subject to certain risks as a result of our investments in perpetual securities.
As of December 31, 2014, we held $2.4 billion of perpetual securities, at amortized cost, which represented 2.6% of our total portfolio of debt and perpetual securities. Perpetual securities have characteristics of both debt and equity instruments. These securities do not have a stated maturity date, but generally have a stated interest coupon that was fixed at the time of issuance but then changes to a floating rate security at some predetermined date. Most perpetual securities have call features including the ability of the issuer to retire the debt at par upon the change to a floating rate
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security. Generally, the mechanics of the floating rate change were intended at the time of issuance to incent the borrower to call the instrument, having the effect of creating an expected economic maturity date. We believe many of the issuers of our perpetual securities will call the instruments upon a change in payment structure but there are no assurances the issuers will do so. While we have recently experienced calls for certain perpetual securities upon their economic maturity dates, there can be no assurance the remaining issuers will have the ability to repay the outstanding principal amount.
Perpetual securities may contain provisions allowing the borrower to defer paying interest for a time. In some cases, we have contractual provisions that stipulate any deferred interest payment accumulates for our benefit and must be paid in the future. There is no assurance such issuers will not choose to defer making payments or will be able to honor a cumulative deferral feature.
There is also a risk that the accounting for these perpetual securities could change in a manner that would have an adverse impact on the reporting for these securities. At the date of filing this Form 10-K, the SEC does not object to the use of a debt impairment model for impairment recognition of these securities as long as there is no significant deterioration in the credit condition of the perpetual securities. The debt impairment model allows the holder to consider whether or not interest and principal payments will be received in accordance with contractual terms and the holder's intent and ability to hold the perpetual security until there is a recovery in value. The equity impairment model, by contrast, looks at the length of time a security's fair value has been below its cost basis and the percentage decline to determine whether an impairment should be recorded, without consideration to the holder's intent and ability to hold the security until recovery in value. The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are also working on the financial instruments project which addresses classification and measurement, impairment and hedging. The outcome and timing of the FASB project is uncertain but could result in changes to the current accounting model for perpetual securities.
The valuation of our investments and derivatives includes methodologies, estimations and assumptions which are subject to differing interpretations and could result in changes to investment valuations that may adversely affect our results of operations or financial condition.
The vast majority of our financial instruments are subject to the fair value classification provisions under GAAP, which specifies a hierarchy of valuation techniques based on observable or unobservable inputs to valuations, and relates to our investment securities classified as available for sale in our investment portfolio, which comprised $68.3 billion (64%) of our total cash and invested assets, and our entire derivatives portfolio, comprising $802 million of derivative assets and $2.4 billion of derivative liabilities, as of December 31, 2014. In accordance with GAAP, we have categorized these securities and derivatives into a three-level hierarchy, based on the priority of the inputs to the respective valuation technique. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1). It gives the next priority to quoted prices in markets that are not active or inputs that are observable either directly or indirectly, including quoted prices for similar assets or liabilities and other inputs that can be derived principally from or corroborated by observable market data for substantially the full term of the assets or liabilities (Level 2). The lowest priority represents unobservable inputs supported by little or no market activity and that reflect the reporting entity's understanding about the assumptions that market participants would use in pricing the asset or liability (Level 3). An asset or liability's classification within the fair value hierarchy is based on the lowest level of significant input to its valuation.
At December 31, 2014, approximately 27%, 72% and 1% of our total available-for-sale securities represented Level 1, Level 2 and Level 3 securities, respectively, and approximately 87% and 13% of our total derivatives exposure were classified as Level 2 and Level 3, respectively. Financial instruments may be transferred to Level 3 from Levels 1 and 2 during periods of market disruption or illiquidity.
As such, valuations may include inputs and assumptions that are less observable or require greater estimation as well as valuation methods which are more sophisticated, thereby resulting in values which may be greater or less than the value at which the investments may be ultimately sold. Rapidly changing and unprecedented credit and equity market conditions could materially impact the valuation of securities as reported within our consolidated financial statements and the period-to-period changes in value could vary significantly.
Valuations of our derivatives fluctuate with changes in underlying market variables, such as interest rates and foreign currency exchange rates. During periods of market turbulence created by political instability, economic uncertainty, government interventions or other factors, we may experience significant changes in the volatility of our derivative valuations. Extreme market conditions can also affect the liquidity of such instruments creating marked
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differences in transaction levels and counterparty valuations. Depending on the severity and direction of the movements in its derivative valuations, the Company will face increases in the amount of collateral required to be posted with its counterparties. Liquidity stresses to the Company may also occur if the required collateral amounts increase significantly over a very short period of time. Conversely, the Company may be exposed to an increase in counterparty credit risk for short periods of time while calling collateral from its counterparties.
For further discussion on investment and derivative valuations, see Notes 1, 3, 4, and 5 of the Notes to the Consolidated Financial Statements in this report.
The determination of the amount of impairments taken on our investments is based on significant valuation judgments and could materially impact our results of operations or financial position.
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. The determination of the amount of impairments under this model is based upon our periodic evaluation and assessment of known and inherent risks associated with the respective securities. Such evaluations and assessments are revised as conditions change and new information becomes available.
An investment in a fixed maturity or perpetual security is impaired if the fair value falls below book value. We regularly review our entire investment portfolio for declines in value. For our fixed maturity and perpetual securities reported in the available-for-sale portfolio, we report the investments at fair value in the statement of financial condition and record any unrealized gain or loss in the value of the asset in accumulated other comprehensive income. For our held-to-maturity portfolio, we report the investments at amortized cost. The determination of whether an impairment in value is other than temporary is based largely on our evaluation of the issuer's creditworthiness. Our team of experienced credit professionals must apply considerable judgment in determining the likelihood of the security recovering in value while we own it. Factors that may influence this include our assessment of the issuer’s ability to continue making timely payments of interest and principal, the overall level of interest rates and credit spreads, and other factors. If we determine it is unlikely we will recover our book value of the instrument prior to our disposal of the security, we will reduce the carrying value of the security to its fair value and recognize any associated impairment loss in our consolidated statement of earnings.
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 security's decline in fair value coupled with the length of time the fair value of the security has been below amortized cost and the financial condition and near-term prospects of the issuer.
Our management updates its evaluations regularly as conditions change and as new information becomes available and reflects impairment losses in the Company's income statement when considered necessary. Furthermore, additional impairments may need to be taken in the future. Historical trends may not be indicative of future impairments.
Lack of availability of acceptable yen-denominated investments could adversely affect our results of operations, financial position or liquidity.
We attempt to match both the duration and currency of our assets with our liabilities. This is very difficult for Aflac Japan due to the lack of long-dated yen-denominated fixed income instruments.
Prior to the financial crisis of 2008, the Company was focused on investing cash flows in JGBs, which had relatively low yields, and utilizing private placement and perpetual securities to gain additional yield, extend the duration of the investment portfolio, and maintain yen exposure. The investment in private placements and perpetual securities has led to increased risks associated with illiquidity.
Starting in 2012, Aflac Japan augmented its investment strategy to include U.S. dollar-denominated securities which could then be hedged back to yen. In October 2014 and December 2014, Aflac Japan sold approximately $1.4 billion of U.S. Treasury securities and $1.0 billion of U.S. dollar-denominated investment grade corporate securities with the intention of utilizing the proceeds from the sales to fund purchases of other asset classes. Despite those sales, as of December 31, 2014, Aflac Japan held approximately $20.2 billion in U.S. dollar-denominated fixed income securities, at amortized cost, and approximately $13.1 billion of notional in foreign currency forwards and options to hedge principal currency risk. These strategies are intended to improve diversification, income yields and liquidity.
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However, these strategies have increased our exposure to U.S. interest rates and credit spreads and risks associated with derivatives. The tenors of the forwards being used are shorter than the corresponding U.S. corporate securities, which have created the economic risk associated with roll-over of the currency forwards (risk of increasing hedge costs). These risks can significantly impact the Company's consolidated results of operations, financial position or liquidity.
The concentration of our investment portfolios in any particular single-issuer or sector of the economy may have an adverse effect on our financial position or results of operations.
Negative events or developments affecting any particular single issuer, industry, group of related industries or geographic sector may have an adverse impact on a particular holding or set of holdings. We seek to minimize this risk by maintaining an appropriate level of diversification. To the extent we have concentrated positions in our investment portfolios, it could have an adverse effect on our investment portfolios and, consequently, on our results of operations and financial position. Our global investment guidelines establish concentration limits for our investment portfolios.
At December 31, 2014, approximately 39.4% of our total portfolio of debt and perpetual securities of $95.1 billion, on an amortized cost basis, was invested in the government and agencies sector, with $37.0 billion, or 38.9% of the total, consisting of investments in JGBs. In the fourth quarter of 2014, an additional rating agency downgraded JGBs from AA to A. Also at December 31, 2014, 14% of our total portfolio of debt and perpetual securities was in the bank and financial institution sector. For further details on the concentrations within our investment portfolios see the Analysis of Financial Condition section of MD&A in this report.
Our concentration of business in Japan poses risks to our operations.
Our operations in Japan, including realized gains and losses on Aflac Japan's investment portfolio, accounted for 72% of our total revenues for 2014, compared with 74% in 2013 and 77% in 2012. The Japanese operations accounted for 82% of our total assets at December 31, 2014, compared with 85% at December 31, 2013. The Bank of Japan's January 2015 Monthly Report of Recent Economic and Financial Developments stated the following about the Japanese economy. Japan's economy continues to recover moderately. Public investment has plateaued at a high level while housing investment, which continued to decline following the consumption tax hike, has recently started to bottom out. Private consumption has remained resilient due to steady improvement in employment and income. The report projected that Japan's economy is expected to recover moderately, and the effects such as those of the decline in demand following the consumption tax hike are expected to dissipate. Exports are expected to increase moderately due to the improving overseas economies. As for domestic demand, public investment is expected to flatten at a high level and subsequently begin to decline moderately. Private consumption is expected to remain resilient due to steady improvement in employment and income, and the effects of the decline in demand following the consumption tax hike are expected to dissipate gradually. Housing investment is projected to gradually regain its resilience as well.
Further, because of the concentration of our business in Japan and our need for long-dated yen-denominated assets, we have a substantial concentration of JGBs in our investment portfolio. As such we have material exposure to the Japanese economy, geo-political climate, political regime, and other elements that generally determine a country's creditworthiness. Specifically, the NRSROs have placed increased scrutiny on JGBs, which are a significant component of the Company’s overall investment portfolio. The NAIC is also considering changes to investment risk factors. Any negative developments by the NRSROs or NAIC in these areas could result in increased capital requirements for the Company.
We seek to match the investment currency and interest rate risk to our yen liabilities. The low level of interest rates available on yen securities has a negative effect on our overall net investment income. A large portion of the cash available for reinvestment each year is deployed in yen-denominated instruments and subject to the low level of yen interest rates.
Any potential deterioration in Japan's credit quality, market access, the overall economy of Japan, or Japanese market volatility could adversely impact the business of Aflac in general and specifically Aflac Japan and our related results of operations and financial condition.
Due to the size of Aflac Japan, where our functional currency is the Japanese yen, fluctuations in the yen/dollar exchange rate can have a significant effect on our reported financial position and results of operations. Aflac Japan's premiums and most of its investment income are received in yen. Claims and expenses are paid in yen, and we
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primarily purchase yen-denominated assets and dollar-denominated assets hedged to yen to support yen-denominated policy liabilities. These and other yen-denominated financial statement items are, however, translated into dollars for financial reporting purposes. Accordingly, fluctuations in the yen/dollar exchange rate can have a significant effect on our reported financial position and results of operations. In periods when the yen weakens, translating yen into dollars causes fewer dollars to be reported. When the yen strengthens, translating yen into dollars causes more dollars to be reported. Any unrealized foreign currency translation adjustments are reported in accumulated other comprehensive income. As a result, yen weakening has the effect of suppressing current year results in relation to the prior year, while yen strengthening has the effect of magnifying current year results in relation to the prior year. In addition, the weakening of the yen relative to the dollar will generally adversely affect the value of our yen-denominated investments in dollar terms. Foreign currency translation also impacts the computation of our risk-based capital ratio because Aflac Japan is consolidated in our U.S. statutory filings due to its status as a branch. Our required capital, as determined by the application of risk factors to our assets and liabilities, is proportionately more sensitive to changes in the exchange rate than our total adjusted capital. As a result, when the yen strengthens relative to the dollar, our risk-based capital ratio is suppressed. We engage in certain foreign currency hedging activities for the purpose of hedging the yen exposure to our net investment in our branch operations in Japan. These hedging activities are limited in scope and we cannot provide assurance that these activities will be effective.
Additionally, we are exposed to economic currency risk when yen cash flows are converted into dollars, resulting in an increase or decrease in our earnings when exchange gains or losses are realized. This primarily occurs when we repatriate funds from Aflac Japan to Aflac U.S., but it also has an impact when yen cash is converted to U.S. dollars for investment into U.S. dollar-denominated assets (as described above). The exchange rates prevailing at the time of repatriation may differ from the exchange rates prevailing at the time the yen profits were earned. We engage in foreign currency hedging activities to mitigate the exposure to this foreign exchange risk.
For more information regarding foreign currency risk, see the Currency Risk subsection within the Market Risks of Financial Instruments section of MD&A in this report.
A decline in the creditworthiness of other financial institutions could adversely affect us.
We have exposure to and routinely execute transactions with counterparties in the financial services industry, including broker dealers, derivative counterparties, commercial banks and other institutions.
We use derivative instruments to mitigate various risks associated with our investment portfolio, notes payable, and profit repatriation. We enter into a variety of agreements involving assorted instruments including foreign currency forward contracts, foreign currency options, foreign currency and interest rate swaps, and options on interest rate swaps (or interest rate swaptions). To provide additional alternatives to increase our overall portfolio yield while managing our overall currency risk, starting in 2012, we have invested a significant portion of the investable cash flow generated by Aflac Japan into U.S. dollar-denominated investment grade public bonds and hedged these bonds to yen through the use of currency forward and option contracts. The derivative forward and option contracts are of a shorter maturity than the hedged bonds which creates roll-over risks within the hedging program. Due to changes in market environments, there is a risk the hedges become ineffective and lose the corresponding hedge accounting treatment. At December 31, 2014, we held foreign currency forwards and options of approximately $13.1 billion notional associated with Aflac Japan's U.S. dollar-denominated investments referenced above, and we also had interest rate swaptions of approximately $2.5 billion notional associated with certain investments, foreign currency swaps of $2.7 billion notional associated with our notes payable, and foreign currency forwards of approximately $1.3 billion notional associated with profit repatriation hedges. The Company's increased use of derivatives in the past couple years has increased our financial exposure to derivative counterparties. If our counterparties fail or refuse to honor their obligations under these derivative instruments our hedges of the risks will be ineffective.
We engage in derivative transactions directly with unaffiliated third parties under International Swaps and Derivatives Association, Inc. (ISDA) agreements and other documentation. Most of the ISDA agreements we enter into also include Credit Support Annexes (CSA), which generally provide for two-way collateral postings, in certain cases at the first dollar of exposure and in other cases once various rating and exposure threshold levels are triggered. We attempt to mitigate the risk that counterparties to transactions might be unable to fulfill their contractual obligations by monitoring counterparty credit exposure and collateral value while generally requiring that collateral be posted at the outset of a transaction or that collateral be posted upon the occurrence of certain events or circumstances. In addition, a significant portion of the derivative transactions have provisions that require collateral to be posted upon a downgrade of our long-term debt ratings or give the counterparty the right to terminate the transaction upon a downgrade of Aflac’s financial strength ratings. The actual amount of collateral required to be posted to counterparties
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in the event of such downgrades, or the aggregate amount of payments that we could be required to make, depends on market conditions, the fair value of outstanding affected transactions, and other factors prevailing at and after the time of any such downgrade. If the Company is required to post collateral to support derivative contracts and/or pay cash to settle the contracts at maturity, the Company's liquidity could be strained.
Further, we have agreements with various financial institutions for the distribution of our insurance products. For example, at December 31, 2014, we had agreements with 371 banks to market Aflac's products in Japan. Sales through these banks represented 21.5% of Aflac Japan's new annualized premium sales in 2014. Any material adverse effect on these or other financial institutions could also have an adverse effect on our sales.
All of these risks could adversely impact our consolidated results of operations and financial condition.
If future policy benefits, claims or expenses exceed those anticipated in establishing premiums and reserves, our financial results would be adversely affected.
We establish and carry, as a liability, reserves based on estimates of how much will be required to pay for future benefits and claims. We calculate these reserves using various assumptions and estimates, including premiums we will receive over the assumed life of the policy; the timing, frequency and severity of the events covered by the insurance policy; and the investment returns on the assets we purchase with a portion of our net cash flow from operations. These assumptions and estimates are inherently uncertain. Accordingly, we cannot determine with precision the ultimate amounts that we will pay for, or the timing of payment of, actual benefits and claims or whether the assets supporting the policy liabilities will grow to the level we assume prior to payment of benefits or claims. If our actual experience is different from our assumptions or estimates, our reserves may prove inadequate. As a result, we would incur a charge to earnings in the period in which we determine such a shortfall exists, which could have a material adverse effect on our business, results of operations and financial condition.
As a holding company, the Parent Company depends on the ability of its subsidiaries to transfer funds to it to meet its debt service and other obligations and to pay dividends on its common stock.
The Parent Company is a holding company and has no direct operations or significant assets other than the stock of its subsidiaries. Because we conduct our operations through our operating subsidiaries, we depend on those entities for dividends and other payments to generate the funds necessary to meet our debt service and other obligations and to pay dividends on our common stock. Aflac is domiciled in Nebraska and is subject to insurance regulations that impose certain limitations and restrictions on payments of dividends, management fees, loans and advances by Aflac to the Parent Company. The Nebraska insurance statutes require prior approval for dividend distributions that exceed the greater of the net income from operations, which excludes net realized investment gains, for the previous year determined under statutory accounting principles, or 10% of statutory capital and surplus as of the previous year-end. In addition, the Nebraska insurance department must approve service arrangements and other transactions within the affiliated group of companies. In addition, the FSA may not allow profit repatriations or other transfers from Aflac Japan if they would cause Aflac Japan to lack sufficient financial strength for the protection of policyholders.
The ability of Aflac to pay dividends or make other payments to the Parent Company could also be constrained by our dependence on financial strength ratings from independent rating agencies. Our ratings from these agencies depend to a large extent on Aflac's capitalization level. Any inability of Aflac to pay dividends or make other payments to the Parent Company could have a material adverse effect on our financial condition and results of operations. There is no assurance that the earnings from, or other available assets of, our operating subsidiaries will be sufficient to make distributions to us to enable us to operate.
Our risk management policies and procedures may prove to be ineffective and leave us exposed to unidentified or unanticipated risk, which could adversely affect our businesses or result in losses.
We have developed an enterprise-wide risk management framework to mitigate risk and loss to the Company. We maintain policies, procedures and controls intended to identify, measure, monitor, report and analyze the risks to which the Company is exposed.
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However, there are inherent limitations to risk management strategies because there may exist, or develop in the future, risks that we have not appropriately anticipated or identified. If our risk management framework proves ineffective, the Company may suffer unexpected losses and could be materially adversely affected. As our businesses change and the markets in which we operate evolve, our risk management framework may not evolve at the same pace as those changes. As a result, there is a risk that new products or new business strategies may present risks that are not appropriately identified, monitored or managed. In times of market stress, unanticipated market movements or unanticipated claims experience resulting from greater than expected morbidity, mortality, longevity, or persistency, the effectiveness of our risk management strategies may be limited, resulting in losses to the Company. In addition, under difficult or less liquid market conditions, our risk management strategies may not be effective because other market participants may be using the same or similar strategies to manage risk under the same challenging market conditions. In such circumstances, it may be difficult or more expensive for the Company to mitigate risk due to the activity of such other market participants.
Many of our risk management strategies or techniques are based upon historical customer and market behavior and all such strategies and techniques are based to some degree on management’s subjective judgment. We cannot provide assurance that our risk management framework, including the underlying assumptions or strategies, will be accurate and effective.
Management of operational, legal and regulatory risks requires, among other things, policies, procedures and controls to record properly and verify a large number of transactions and events, and these policies, procedures and controls may not be fully effective. Models are utilized by our businesses and corporate areas primarily to project future cash flows associated with pricing products, calculating reserves and valuing assets, as well as in evaluating risk and determining capital requirements, among other uses. These models may not operate properly and rely on assumptions and projections that are inherently uncertain. As our businesses continue to grow and evolve, the number and complexity of models we utilize expands, increasing our exposure to error in the design, implementation or use of models, including the associated input data and assumptions.
Past or future misconduct by our employees or employees of our vendors could result in violations of law by us, regulatory sanctions and/or serious reputational or financial harm and the precautions we take to prevent and detect this activity may not be effective in all cases. There can be no assurance that controls and procedures that we employ, which are designed to monitor associates’ business decisions and prevent us from taking excessive or inappropriate risks, will be effective. We review our compensation policies and practices as part of our overall risk management program, but it is possible that our compensation policies and practices could inadvertently incentivize excessive or inappropriate risk taking. If our associates take excessive or inappropriate risks, those risks could harm our reputation and have a material adverse effect on our results of operations or financial condition.
Extensive regulation and changes in legislation can impact profitability and growth.
Aflac's insurance subsidiaries are subject to complex laws and regulations that are administered and enforced by a number of governmental authorities, including state insurance regulators, the SEC, the NAIC, the FIO, the FSA and Ministry of Finance (MOF) in Japan, the U.S. Department of Justice, state attorneys general, the U.S. Commodity Futures Trading Commission, the FIO, and the U.S. Treasury, including the Internal Revenue Service, each of which exercises a degree of interpretive latitude. In addition, proposals regarding the global regulation of insurance are under discussion. Consequently, we are subject to the risk that compliance with any particular regulator's or enforcement authority's interpretation of a legal or regulatory issue may not result in compliance with another regulator's or enforcement authority's interpretation of the same issue, particularly when compliance is judged in hindsight. There is also a risk that any particular regulator's or enforcement authority's interpretation of a legal or regulatory issue may change over time to our detriment. In addition, changes in the overall legal or regulatory environment may, even absent any particular regulator's or enforcement authority's interpretation of an issue changing, cause us to change our views regarding the actions we need to take from a legal or regulatory risk management perspective, thus necessitating changes to our practices that may, in some cases, limit our ability to grow or otherwise negatively impact the profitability of our business.
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The primary purpose of insurance company regulatory supervision is the protection of insurance policyholders, rather than investors. The extent of regulation varies, but generally is governed by state statutes in the United States and by the FSA and the MOF in Japan. These systems of supervision and regulation cover, among other things:
• | standards of establishing and setting premium rates and the approval thereof |
• | standards of minimum capital requirements and solvency margins, including risk-based capital measures |
• | restrictions on, limitations on and required approval of certain transactions between our insurance subsidiaries and their affiliates, including management fee arrangements |
• | restrictions on the nature, quality and concentration of investments |
• | restrictions on the types of terms and conditions that we can include in the insurance policies offered by our primary insurance operations |
• | limitations on the amount of dividends that insurance subsidiaries can pay or foreign profits that can be repatriated |
• | the existence and licensing status of a company under circumstances where it is not writing new or renewal business |
• | certain required methods of accounting |
• | reserves for unearned premiums, losses and other purposes |
• | assignment of residual market business and potential assessments for the provision of funds necessary for the settlement of covered claims under certain policies provided by impaired, insolvent or failed insurance companies |
• | administrative practices requirements |
• | imposition of fines and other sanctions |
Regulatory authorities periodically re-examine existing laws and regulations applicable to insurance companies and their products. Changes in these laws and regulations, or in interpretations thereof, could have a material adverse effect on our financial condition and results of operations.
Federal legislation and administrative policies in several areas, including health care reform legislation, financial services reform legislation, securities regulation, pension regulation, privacy, tort reform legislation and taxation, can significantly and adversely affect insurance companies. Various forms of federal oversight and regulation of insurance have been passed by the U.S. Congress and signed into law by the President. For example, the ACA, federal health care reform legislation, gives the U.S. federal government direct regulatory authority over the business of health insurance. The reform includes major changes to the U.S. health care insurance marketplace. Among other changes, the reform legislation includes an individual medical insurance coverage mandate, provides for penalties on certain employers for failing to provide adequate coverage, creates health insurance exchanges, and addresses coverage and exclusions as well as medical loss ratios. The legislation also includes changes in government reimbursements and tax credits for individuals and employers and alters federal and state regulation of health insurers. These changes, directed toward major medical health insurance coverage which Aflac does not offer, have already begun and will continue to be phased in over the next several years. The major elements of the bill became effective on January 1, 2014. We believe that the ACA, as enacted, does not materially affect the design of our insurance products. However, indirect consequences of the legislation and regulations could present challenges and/or opportunities that could potentially have an impact on our sales model, financial condition and results of operations.
In 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act, commonly known as the Dodd-Frank Act, which, among other things, created a Financial Stability Oversight Council. In April 2012, the Council released a final rule describing the general process it will follow in determining whether to designate a nonbank financial company for supervision by the Board of Governors of the U.S. Federal Reserve System (the Board). The Council may designate by a two-thirds vote whether certain nonbank financial companies, including certain insurance companies and insurance holding companies, could pose a threat to the financial stability of the United States, in which case such nonbank financial companies would become subject to prudential regulation by the Board. On April 3, 2013, the Board published a final rule that establishes the requirements for determining when a nonbank financial company is "predominantly engaged in financial activities" - a prerequisite for designation by the Council. Prudential regulation by the Board includes supervision of capital requirements, leverage limits, liquidity requirements and examinations. The Board may limit such company’s ability to enter into mergers, acquisitions and other business combination transactions, restrict its ability to offer financial products, require it to terminate one or more activities, or impose conditions on the manner in which it conducts activities. The Council designated two insurers in 2013 and an additional insurer in 2014 for supervision by the Board. On December 18, 2014, President Obama signed
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the Insurance Capital Standards Clarification Act into law. This legislation will clarify the Board’s authority to apply insurance-based capital standards for insurance companies subject to federal supervision. Although Aflac is a nonbank financial company predominantly engaged in financial activities as defined in the Dodd-Frank Act, we do not believe Aflac will be considered a company that poses a threat to the financial stability of the United States.
Title VII of the Dodd-Frank Act and regulations issued thereunder may have an impact on Aflac's derivative activity, including activity on behalf of Aflac Japan, in particular rules and rule proposals to require central clearing and collateral for certain types of derivatives. The five U.S. banking regulators and the U.S. Commodity Futures Trading Commission (CFTC) recently re-proposed for comment their rules regarding collateral for uncleared swaps. If adopted as proposed, such rules may result in increased collateral requirements for Aflac or impose limits on the types of collateral we are permitted to post.
The Dodd-Frank Act also established an FIO under the U.S. Treasury Department to monitor all aspects of the insurance industry and of lines of business other than certain health insurance, certain long-term care insurance and crop insurance. Traditionally, U.S. insurance companies have been regulated primarily by state insurance departments. In December 2013, the FIO released a report entitled "How To Modernize And Improve The System Of Insurance Regulation In The United States." The report was required by the Dodd-Frank Act, and included 18 recommended areas of near-term reform for the states, including addressing capital adequacy and safety/soundness issues, reform of insurer resolution practices, and reform of marketplace regulation. The report also listed nine recommended areas for direct federal involvement in insurance regulation. Some of the recommendations outlined in the FIO report released in December 2013 have been implemented. Of the nine recommended areas for direct federal involvement in insurance regulation that are applicable to Aflac, President Obama has signed the National Association of Registered Agents and Brokers Reform Act into law in January 2015, which simplifies the agent and broker licensing process across state lines. The FIO has also engaged with the supervisory colleges to monitor financial stability and identify regulatory gaps for large national and internationally active insurers.
On December 10, 2013, five U.S. financial regulators adopted a final rule implementing the "Volcker Rule," which was created by Section 619 of the Dodd-Frank Act. The Volcker Rule generally prohibits "banking entities" from engaging in "proprietary trading" and making investments and conducting certain other activities with "private equity funds and hedge funds." The final rule became effective April 1, 2014; however, at the time the agencies released the final Volcker Rule, the Federal Reserve announced an extension of the conformance period for all banking entities until July 21, 2015. In response to industry questions regarding the final Volcker Rule, the five U.S. financial regulators, which included the Office of the Comptroller of the Currency (OCC); the Federal Reserve; the Federal Deposit Insurance Corporation (FDIC); the SEC and the U.S. CFTC, issued a clarifying interim final rule on January 14, 2014 that permits banking entities to retain interests in certain CDOs backed by trust preferred securities if the CDO meets certain requirements.
On December 18, 2014, the Federal Reserve announced a second extension to the Volcker Rule conformance period, to give banking entities until July 21, 2016, to conform investments in and relationships with covered funds and foreign funds that were in place prior to December 31, 2013 (legacy covered funds). The Federal Reserve also announced its intention to act in the future to grant banking entities an additional one-year extension of the conformance period until July 21, 2017, to conform ownership interests in and relationships with these legacy covered funds. The Federal Reserve did not act to extend the conformance period for proprietary trading activities.
Nonbank financial companies such as Aflac that are not affiliated with an insured depository institution or otherwise brought within the definition of "banking entity" generally will not be subject to the Volcker Rule's prohibitions. However, the prohibitions of the Volcker Rule could impact financial markets generally, for example, through reduced liquidity in certain markets or the exiting of positions by banking entities as the end of the conformance period approaches.
The Dodd-Frank Act requires extensive rule-making and other future regulatory action, which in some cases will take a period of years to implement. However, at the current time, it is not possible to predict with any degree of certainty what impact, if any, the Dodd-Frank Act will have on our U.S. business, financial condition, or results of operations.
Changes in domestic or foreign tax laws or interpretations of such laws could increase our corporate taxes and reduce our earnings. Additionally, global budget deficits make it likely that governments’ need for additional revenue will result in future tax proposals that will increase our effective tax rate. However, it remains difficult to predict the timing and effect that future tax law changes could have on our earnings both in the United States and in foreign jurisdictions.
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Compliance with applicable laws and regulations is time consuming and personnel-intensive, and changes in these laws and regulations may materially increase our direct and indirect compliance and other expenses of doing business, thus having a material adverse effect on our financial condition and results of operations.
Sales of our products and services are dependent on our ability to attract, retain and support a network of qualified sales associates.
Our sales could be adversely affected if our sales networks deteriorate or if we do not adequately provide support, training and education for our existing network. Competition exists for sales associates with demonstrated ability. We compete with other insurers and financial institutions primarily on the basis of our products, compensation, support services and financial rating. An inability to attract and retain qualified sales associates could have a material adverse effect on sales and our results of operations and financial condition. Our sales associates are independent contractors and may sell products of our competitors. If our competitors offer products that are more attractive than ours, or pay higher commissions than we do, these sales associates may concentrate their efforts on selling our competitors' products instead of ours.
Any decrease in our financial strength or debt ratings may have an adverse effect on our competitive position.
Financial strength ratings are important factors in establishing the competitive position of insurance companies and generally have an effect on the business of insurance companies. On an ongoing basis NRSROs review the financial performance and condition of insurers and may downgrade or change the outlook on an insurer's ratings due to, for example, a change in an insurer's statutory capital; a change in a rating agency's determination of the amount of risk-adjusted capital required to maintain a particular rating; an increase in the perceived risk of an insurer's investment portfolio; a reduced confidence in management; or other considerations that may or may not be under the insurer's control. In addition to financial strength ratings, various NRSROs also publish ratings on our debt. These ratings are indicators of a debt issuer's ability to meet the terms of debt obligations in a timely manner and are important factors in our ability to access liquidity in the debt markets and other available sources. Downgrades in our credit ratings could give our derivative counterparties the right to require early termination of derivatives transactions or delivery of additional collateral, thereby adversely affecting our liquidity.
In view of the difficulties experienced in the last several years by many financial institutions, including in the insurance industry, the NRSROs have heightened the level of scrutiny that they apply to such institutions, increased the frequency and scope of their reviews, requested additional information from the companies that they rate, including additional information regarding the valuation of investment securities held, and, in certain cases, have increased the capital and other requirements employed in their models for maintenance of certain rating levels.
A downgrade in any of these ratings could have a material adverse effect on agent recruiting and retention, sales, competitiveness and the marketability of our products which could negatively impact our liquidity, operating results and financial condition. Additionally, sales through the bank channel in Japan could be adversely affected as a result of their reliance and sensitivity to ratings levels.
We cannot predict what actions rating agencies may take, or what actions we may take in response to the actions of rating agencies, which could adversely affect our business. As with other companies in the financial services industry, our ratings could be downgraded at any time and without any notice by any NRSRO.
The success of our business depends in part on effective information technology systems and on continuing to develop and implement improvements in technology.
Our business depends in large part on our technology systems for interacting with employers, policyholders, sales associates, and brokers, and our business strategy involves providing customers with easy-to-use products to meet their needs and ensuring employees have the technology in place to support those needs. Some of our information technology systems and software are older, legacy-type systems that are less efficient and require an ongoing commitment of significant resources to maintain or upgrade to current standards (including adequate business continuity procedures). We are in a continual state of upgrading and enhancing our business systems; however, these changes are always challenging in our complex integrated environment. Our success is dependent in large part on maintaining or improving the effectiveness of existing systems and continuing to develop and enhance information systems that support our business processes in a cost-efficient manner.
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Interruption in telecommunication, information technology and other operational systems, or a failure to maintain the security, confidentiality or privacy of sensitive data residing on such systems, could harm our business.
We depend heavily on our telecommunication, information technology and other operational systems and on the integrity and timeliness of data we use to run our businesses and service our customers. These systems may fail to operate properly or become disabled as a result of events or circumstances wholly or partly beyond our control. Despite our implementation of a variety of security measures, our information technology and other systems could be subject to physical or electronic break-ins, unauthorized tampering, security breaches or other cyber-attacks, resulting in a failure to maintain the security, confidentiality or privacy of sensitive data, including personal information relating to customers, or in the misappropriation of our intellectual property or proprietary information. Although the security breaches we have experienced to date have not had a material effect on our business, interruption in telecommunication, information technology and other operational systems, or a failure to maintain the security, confidentiality or privacy of sensitive data residing on such systems, whether due to actions by us or others, could delay or disrupt our ability to do business and service our customers, harm our reputation, subject us to regulatory sanctions and other claims, lead to a loss of customers and revenues and otherwise adversely affect our business.
Changes in accounting standards issued by the FASB or other standard-setting bodies may adversely affect our financial statements.
Our financial statements are subject to the application of generally accepted accounting principles in both the United States and Japan, which are periodically revised and/or expanded. Accordingly, from time to time we are required to adopt new or revised accounting standards issued by recognized authoritative bodies, including the FASB. It is possible that future accounting standards we are required to adopt could change the current accounting treatment that we apply to our consolidated financial statements and that such changes could have a material adverse effect on our results of operations and financial condition.
The FASB and IASB have announced their commitment to achieving a single set of high-quality global accounting standards. In 2010, the SEC announced a work plan, the results of which would aid the Commission in its evaluation of the impact that the use of IFRS by U.S. companies would have on the U.S. securities market. Included in this work plan is consideration of IFRS, as it exists today and after the completion of various convergence projects currently underway between U.S. and international accounting standards-setters. In 2012, the SEC issued the final report which stated that adopting IFRS would present challenges and that the majority of the U.S. capital market participants did not support adopting IFRS. However, the report also stated there was significant support for other methods of incorporating IFRS through endorsement into U.S. GAAP. The FASB and IASB are re-deliberating previously exposed proposals for the insurance contracts project that will change the way insurance liabilities are determined and reported. The FASB decided in February 2014 to focus on making targeted improvements to existing U.S. GAAP. Therefore, it appears unlikely that the FASB and IASB will achieve a converged standard relating to insurance contracts. In July 2014, the IASB issued amended guidance to International Financial Reporting Standards (IFRS) 9, Financial Instruments, including amendments to classification and measurement and the impairment model. The FASB exposed, in December 2012, similar changes to classification and measurement and the impairment model. Based upon recent deliberations, it now seems unlikely that the FASB and IASB will achieve a converged standard related to classification and measurement and impairment of financial instruments. The ultimate outcome and timing of these events including the adoption of IFRS are uncertain at this time. The adoption of IFRS and/or the effects of accounting standards changes could significantly alter the presentation of our financial position and results of operations in our financial statements.
See Note 1 of the Notes to the Consolidated Financial Statements in this report for a discussion of recent changes in accounting standards and those that are pending adoption.
If we fail to comply with restrictions on patient privacy and information security, including taking steps to ensure that our business associates who obtain access to sensitive patient information maintain its confidentiality, our reputation and business operations could be materially adversely affected.
The collection, maintenance, use, disclosure and disposal of individually identifiable data by our businesses are regulated at the international, federal and state levels. These laws and rules are subject to change by legislation or administrative or judicial interpretation. Various state laws address the use and disclosure of individually identifiable health data to the extent they are more restrictive than those contained in the privacy and security provisions in the federal Gramm-Leach-Bliley Act of 1999 (GLBA) and in the Health Insurance Portability and Accountability Act of 1996
25
(HIPAA). HIPAA also requires that we impose privacy and security requirements on our business associates (as such term is defined in the HIPAA regulations). With regard to personal information obtained from policyholders, the insured, or others, Aflac Japan is regulated in Japan by the Act on the Protection of Personal Information (APPI) and guidelines issued by FSA and other governmental authorities.
Even though we provide for appropriate protections through our contracts with business associates, we still have limited control over their actions and practices. In addition, despite the security measures we have in place to ensure compliance with applicable laws and rules, our facilities and systems, and those of our third-party providers may be vulnerable to security breaches, acts of vandalism or theft, computer viruses, misplaced or lost data, programming and/or human errors or other similar events. The U.S. Congress and many states are considering new privacy and security requirements that would apply to our business. Compliance with new privacy and security laws, requirements, and new regulations may result in cost increases due to necessary systems changes, new limitations or constraints on our business models, the development of new administrative processes, and the effects of potential noncompliance by our business associates. They also may impose further restrictions on our collection, disclosure and use of patient identifiable data that are housed in one or more of our administrative databases. Noncompliance with any privacy laws or any security breach involving the misappropriation, loss or other unauthorized disclosure of sensitive or confidential member information, whether by us or by one of our vendors, could have a material adverse effect on our business, reputation and results of operations, including: material fines and penalties; compensatory, special, punitive and statutory damages; consent orders regarding our privacy and security practices; adverse actions against our licenses to do business; and injunctive relief.
In addition, under Japanese laws and regulations, including the APPI, if a leak or loss of personal information by Aflac Japan or its business associates should occur, depending on factors such as the volume of personal data involved and the likelihood of other secondary damage, Aflac Japan may be required to file reports to the FSA; issue public releases explaining such incident to the public; or become subject to an FSA business improvement order, which could pose a risk to our reputation.
We face risks related to litigation.
We are a defendant in various lawsuits considered to be in the normal course of business. Members of our senior legal and financial management teams review litigation on a quarterly and annual basis. The final results of any litigation cannot be predicted with certainty. Although some of this litigation is pending in states where large punitive damages, bearing little relation to the actual damages sustained by plaintiffs, have been awarded in recent years, we believe the outcome of pending litigation will not have a material adverse effect on our financial position, results of operations, or cash flows. However, litigation could adversely affect us because of the costs of defending these cases, costs of settlement or judgments against us or because of changes in our operations that could result from litigation.
Managing key executive succession is critical to our success.
We would be adversely affected if we fail to adequately plan for succession of our senior management and other key executives. While we have succession plans and employment arrangements with certain key executives, these plans cannot guarantee that the services of these executives will be available to us, and our operations could be adversely affected if they are not.
Catastrophic events could adversely affect our financial condition and results of operations.
Our insurance operations are exposed to the risk of catastrophic events including, but not necessarily limited to, epidemics, pandemics, tornadoes, hurricanes, earthquakes, tsunamis, and acts of terrorism. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. Certain events such as earthquakes, tsunamis, hurricanes and man-made catastrophes could cause substantial damage or loss of life in larger areas, especially those that are heavily populated. Claims resulting from natural or man−made catastrophic events could cause substantial volatility in our financial results for any fiscal quarter or year and could materially reduce our profitability or harm our financial condition, as well as affect our ability to write new business.
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We operate in an industry that is subject to ongoing changes.
We operate in a competitive environment and in an industry that is subject to ongoing changes from market pressures brought about by customer demands, legislative reform, marketing practices and changes to health care and health insurance delivery. These factors require us to anticipate market trends and make changes to differentiate our products and services from those of our competitors. We also face the potential of competition from existing or new companies in the United States and Japan that have not historically been active in the supplemental health insurance industry. Failure to anticipate market trends and/or to differentiate our products and services can affect our ability to retain or grow profitable lines of business.
Events, including those external to our operations, could damage our reputation.
Because insurance products are intangible, we rely to a large extent on consumer trust in our business. The perception of financial weakness could create doubt regarding our ability to honor the commitments we have made to our policyholders. Maintaining our stature as a responsible corporate citizen, which helps support the strength of our unique brand, is critical to our reputation and the failure or perceived failure to do so could adversely affect us.
Changes in our discount rate, expected rate of return, life expectancy, health care cost and expected compensation increase assumptions for our pension and other postretirement benefit plans may result in increased expenses and reduce our profitability.
We determine our pension and other postretirement benefit plan costs based on assumed discount rates, expected rates of return on plan assets, life expectancy of plan participants and expected increases in compensation levels and trends in health care costs. Changes in these assumptions, including from the impact of a sustained low interest rate environment, may result in increased expenses and reduce our profitability.
We also face other risks that could adversely affect our business, results of operations or financial condition, which include:
• | any requirement to restate financial results in the event of inappropriate application of accounting principle |
• | failure to appropriately maintain controls over models used to generate significant inputs to the Company’s financial statements |
• | a significant failure of internal controls over financial reporting |
• | failure of our prevention and control systems related to employee compliance with internal policies and regulatory requirements |
• | failure of corporate governance policies and procedures |
ITEM 1B. UNRESOLVED STAFF COMMENTS
Not applicable.
ITEM 2. PROPERTIES
In the United States, Aflac owns land and buildings that comprise two primary campuses located in Columbus, Georgia. These campuses include buildings that serve as our worldwide headquarters and house administrative support and information technology functions for our U.S. operations. Aflac also owns land and office buildings in Columbia, South Carolina, which house our CAIC subsidiary. Aflac leases office space in New York that houses our Global Investment division. Aflac leases administrative office space in Georgia, South Carolina, New York, Nebraska, and in 36 additional states throughout the United States, as well as Washington, D.C. and Puerto Rico.
In Tokyo, Japan, Aflac has two primary campuses. The first campus includes a building, owned by Aflac, for the customer call center, information technology departments, and training facility. It also includes a leased property, which houses our policy administration and customer service departments. The second campus comprises leased space, which serves as our Japan branch headquarters and houses administrative and investment support functions for the Japan branch. Aflac also leases additional office space in Tokyo, along with regional offices located throughout the country.
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ITEM 3. LEGAL PROCEEDINGS
We are a defendant in various lawsuits considered to be in the normal course of business. Members of our senior legal and financial management teams review litigation on a quarterly and annual basis. The final results of any litigation cannot be predicted with certainty. Although some of this litigation is pending in states where large punitive damages, bearing little relation to the actual damages sustained by plaintiffs, have been awarded in recent years, we believe the outcome of pending litigation will not have a material adverse effect on our financial position, results of operations, or cash flows.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
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PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
PURCHASES OF EQUITY SECURITIES
Market Information
Aflac Incorporated's common stock is principally traded on the New York Stock Exchange under the symbol AFL. Our stock is also listed on the Tokyo Stock Exchange. The quarterly high and low market prices for the Company's common stock, as reported on the New York Stock Exchange for the two years ended December 31 were as follows:
Quarterly Common Stock Prices
2014 | High | Low | |||||||||
4th Quarter | $ | 62.46 | $ | 54.99 | |||||||
3rd Quarter | 64.20 | 57.70 | |||||||||
2nd Quarter | 64.47 | 60.60 | |||||||||
1st Quarter | 66.69 | 60.45 | |||||||||
2013 | High | Low | |||||||||
4th Quarter | $ | 67.62 | $ | 61.96 | |||||||
3rd Quarter | 63.63 | 56.08 | |||||||||
2nd Quarter | 58.75 | 48.54 | |||||||||
1st Quarter | 54.44 | 48.17 | |||||||||
Holders
As of February 17, 2015, there were 87,431 holders of record of the Company's common stock.
Dividends
2014 | 2013 | ||||||||||
4th Quarter | $ | .39 | $ | .37 | |||||||
3rd Quarter | .37 | .35 | |||||||||
2nd Quarter | .37 | .35 | |||||||||
1st Quarter | .37 | .35 | |||||||||
In February 2015, the board of directors declared the first quarter 2015 cash dividend of $.39 per share. The dividend is payable on March 2, 2015 to shareholders of record at the close of business on February 17, 2015. The declaration and payment of future dividends to holders of our common stock will be at the discretion of our board of directors and will depend upon many factors, including our financial condition, earnings, capital requirements of our operating subsidiaries, legal requirements, regulatory constraints and other factors as the board of directors deems relevant. There can be no assurance that we will declare and pay any additional or future dividends. For information concerning dividend restrictions, see Regulatory Restrictions in the Capital Resources and Liquidity section of MD&A and Note 13 of the Notes to the Consolidated Financial Statements presented in this report.
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Stock Performance Graph
The following graph compares the five-year performance of the Company's common stock to the Standard & Poor's 500 Index (S&P 500) and the Standard & Poor's Life and Health Insurance Index (S&P Life and Health). The Standard & Poor's Life and Health Insurance Index includes: Aflac Incorporated, Lincoln National Corporation, MetLife Inc., Principal Financial Group Inc., Prudential Financial Inc., Torchmark Corporation and Unum Group.
Performance Graphic Index
December 31,
2009 | 2010 | 2011 | 2012 | 2013 | 2014 | ||||||||||||
Aflac Incorporated | 100.00 | 124.89 | 98.27 | 124.18 | 160.09 | 150.03 | |||||||||||
S&P 500 | 100.00 | 115.06 | 117.49 | 136.30 | 180.44 | 205.14 | |||||||||||
S&P Life & Health Insurance | 100.00 | 125.25 | 99.31 | 113.80 | 186.04 | 189.67 | |||||||||||
Copyright© 2015 Standard & Poor’s, a division of The McGraw-Hill Companies Inc. All rights reserved. (www.researchdatagroup.com/S&P.htm)
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Issuer Purchases of Equity Securities
During the year ended December 31, 2014, we repurchased shares of Aflac common stock as follows:
Period | Total Number of Shares Purchased | Average Price Paid Per Share | Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs | Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs | |||||||||||||||||
January 1 - January 31 | 3,218,667 | $ | 64.24 | 3,217,000 | 45,993,020 | ||||||||||||||||
February 1 - February 28 | 3,113,966 | 62.45 | 3,008,016 | 42,985,004 | |||||||||||||||||
March 1 - March 31 | 311,944 | 64.60 | 310,000 | 42,675,004 | |||||||||||||||||
April 1 - April 30 | 20,000 | 62.73 | 20,000 | 42,655,004 | |||||||||||||||||
May 1 - May 31 | 865,548 | 62.12 | 865,000 | 41,790,004 | |||||||||||||||||
June 1 - June 30 | 723,697 | 62.37 | 722,480 | 41,067,524 | |||||||||||||||||
July 1 - July 31 | 135,969 | 60.71 | 135,000 | 40,932,524 | |||||||||||||||||
August 1 - August 31 | 683,577 | 60.04 | 682,700 | 40,249,824 | |||||||||||||||||
September 1 - September 30 | 2,112,414 | 59.66 | 2,110,700 | 38,139,124 | |||||||||||||||||
October 1 - October 31 | 700,000 | 59.81 | 700,000 | 37,439,124 | |||||||||||||||||
November 1 - November 30 | 3,570,000 | 59.32 | 3,570,000 | 33,869,124 | |||||||||||||||||
December 1 - December 31 | 4,320,676 | 59.46 | 4,319,000 | 29,550,124 | |||||||||||||||||
Total | 19,776,458 | (2) | $ | 61.05 | 19,659,896 | 29,550,124 | (1) | ||||||||||||||
(1)The total remaining shares available for purchase at December 31, 2014, consisted of 29,550,124 shares related to a 40,000,000 share repurchase authorization by the board of directors in 2013.
(2)During the year ended December 31, 2014, 116,562 shares were purchased in connection with income tax withholding obligations related to the vesting of restricted-share-based awards during the period.
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ITEM 6. SELECTED FINANCIAL DATA
Aflac Incorporated and Subsidiaries
Years Ended December 31,
(In millions, except for share and per-share amounts) | 2014 | 2013 | 2012 | 2011 | 2010 | ||||||||||||||
Revenues: | |||||||||||||||||||
Net premiums, principally supplemental health insurance | $ | 19,072 | $ | 20,135 | $ | 22,148 | $ | 20,362 | $ | 18,073 | |||||||||
Net investment income | 3,319 | 3,293 | 3,473 | 3,280 | 3,007 | ||||||||||||||
Realized investment gains (losses) | 215 | 399 | (349 | ) | (1,552 | ) | (422 | ) | |||||||||||
Other income | 122 | 112 | 92 | 81 | 74 | ||||||||||||||
Total revenues | 22,728 | 23,939 | 25,364 | 22,171 | 20,732 | ||||||||||||||
Benefits and expenses: | |||||||||||||||||||
Benefits and claims, net | 12,937 | 13,813 | 15,330 | 13,749 | 12,106 | ||||||||||||||
Expenses | 5,300 | 5,310 | 5,732 | 5,472 | 5,065 | ||||||||||||||
Total benefits and expenses | 18,237 | 19,123 | 21,062 | 19,221 | 17,171 | ||||||||||||||
Pretax earnings | 4,491 | 4,816 | 4,302 | 2,950 | 3,561 | ||||||||||||||
Income taxes | 1,540 | 1,658 | 1,436 | 1,013 | 1,233 | ||||||||||||||
Net earnings | $ | 2,951 | $ | 3,158 | $ | 2,866 | $ | 1,937 | $ | 2,328 | |||||||||
Share and Per-Share Amounts | |||||||||||||||||||
Net earnings (basic) | $ | 6.54 | $ | 6.80 | $ | 6.14 | $ | 4.16 | $ | 4.96 | |||||||||
Net earnings (diluted) | 6.50 | 6.76 | 6.11 | 4.12 | 4.92 | ||||||||||||||
Cash dividends paid | 1.50 | 1.42 | 1.34 | 1.23 | 1.14 | ||||||||||||||
Cash dividends declared | 1.50 | 1.42 | 1.34 | 1.23 | 1.14 | ||||||||||||||
Weighted-average common shares used for basic EPS (In thousands) | 451,204 | 464,502 | 466,868 | 466,519 | 469,038 | ||||||||||||||
Weighted-average common shares used for diluted EPS (In thousands) | 454,000 | 467,408 | 469,287 | 469,370 | 473,085 | ||||||||||||||
Supplemental Data | |||||||||||||||||||
Yen/dollar exchange rate at year-end (yen) | 120.55 | 105.39 | 86.58 | 77.74 | 81.49 | ||||||||||||||
Weighted-average yen/dollar exchange rate (yen) | 105.46 | 97.54 | 79.81 | 79.75 | 87.73 | ||||||||||||||
Amounts prior to 2012 have been adjusted for the adoption of accounting guidance on January 1, 2012 related to deferred policy acquisition costs.
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Aflac Incorporated and Subsidiaries
December 31,
(In millions) | 2014 | 2013 | 2012 | 2011 | 2010 | ||||||||||||||
Assets: | |||||||||||||||||||
Investments and cash | $ | 107,341 | $ | 108,459 | $ | 118,219 | $ | 103,462 | $ | 88,230 | |||||||||
Other | 12,426 | 12,848 | 12,875 | 12,775 | 12,013 | ||||||||||||||
Total assets | $ | 119,767 | $ | 121,307 | $ | 131,094 | $ | 116,237 | $ | 100,243 | |||||||||
Liabilities and shareholders’ equity: | |||||||||||||||||||
Policy liabilities | $ | 83,933 | $ | 89,402 | $ | 97,720 | $ | 94,239 | $ | 82,310 | |||||||||
Income taxes | 5,293 | 3,718 | 3,858 | 2,308 | 1,689 | ||||||||||||||
Notes payable | 5,282 | 4,897 | 4,352 | 3,285 | 3,038 | ||||||||||||||
Other liabilities | 6,912 | 8,670 | 9,186 | 3,459 | 2,666 | ||||||||||||||
Shareholders’ equity | 18,347 | 14,620 | 15,978 | 12,946 | 10,540 | ||||||||||||||
Total liabilities and shareholders’ equity | $ | 119,767 | $ | 121,307 | $ | 131,094 | $ | 116,237 | $ | 100,243 | |||||||||
Amounts prior to 2012 have been adjusted for the adoption of accounting guidance on January 1, 2012 related to deferred policy acquisition costs.
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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
FORWARD-LOOKING INFORMATION
The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” to encourage companies to provide prospective information, so long as those informational statements are identified as forward-looking and are accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those included in the forward-looking statements. We desire to take advantage of these provisions. This report contains cautionary statements identifying important factors that could cause actual results to differ materially from those projected herein, and in any other statements made by Company officials in communications with the financial community and contained in documents filed with the Securities and Exchange Commission (SEC). Forward-looking statements are not based on historical information and relate to future operations, strategies, financial results or other developments. Furthermore, forward-looking information is subject to numerous assumptions, risks and uncertainties. In particular, statements containing words such as “expect,” “anticipate,” “believe,” “goal,” “objective,” “may,” “should,” “estimate,” “intends,” “projects,” “will,” “assumes,” “potential,” “target” or similar words as well as specific projections of future results, generally qualify as forward-looking. Aflac undertakes no obligation to update such forward-looking statements.
We caution readers that the following factors, in addition to other factors mentioned from time to time, could cause actual results to differ materially from those contemplated by the forward-looking statements:
• | difficult conditions in global capital markets and the economy |
• | governmental actions for the purpose of stabilizing the financial markets |
• | defaults and credit downgrades of securities in our investment portfolio |
• | exposure to significant financial and capital markets risk |
• | fluctuations in foreign currency exchange rates |
• | significant changes in investment yield rates |
• | credit and other risks associated with Aflac's investment in perpetual securities |
• | differing judgments applied to investment valuations |
• | significant valuation judgments in determination of amount of impairments taken on our investments |
• | limited availability of acceptable yen-denominated investments |
• | concentration of our investments in any particular single-issuer or sector |
• | concentration of business in Japan |
• | decline in creditworthiness of other financial institutions |
• | deviations in actual experience from pricing and reserving assumptions |
• | subsidiaries' ability to pay dividends to Aflac Incorporated |
• | ineffective risk management policies and procedures |
• | changes in law or regulation by governmental authorities |
• | ability to attract and retain qualified sales associates and employees |
• | decreases in our financial strength or debt ratings |
• | ability to continue to develop and implement improvements in information technology systems |
• | interruption in telecommunication, information technology and other operational systems, or a failure to maintain the security, confidentiality or privacy of sensitive data residing on such systems |
• | changes in U.S. and/or Japanese accounting standards |
• | failure to comply with restrictions on patient privacy and information security |
• | level and outcome of litigation |
• | ability to effectively manage key executive succession |
• | catastrophic events including, but not necessarily limited to, epidemics, pandemics, tornadoes, hurricanes, earthquakes, tsunamis, acts of terrorism and damage incidental to such events |
• | ongoing changes in our industry |
• | events that damage our reputation |
• | increased expenses for pension and other postretirement plans |
• | failure of internal controls or corporate governance policies and procedures |
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MD&A OVERVIEW
Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to inform the reader about matters affecting the financial condition and results of operations of Aflac Incorporated and its subsidiaries for the three-year period ended December 31, 2014. As a result, the following discussion should be read in conjunction with the related consolidated financial statements and notes. This MD&A is divided into the following sections:
• | Our Business |
• | Performance Highlights |
• | Critical Accounting Estimates |
• | Results of Operations, consolidated and by segment |
• | Analysis of Financial Condition, including discussion of market risks of financial instruments |
• | Capital Resources and Liquidity, including discussion of availability of capital and the sources and uses of cash |
OUR 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 Company's 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 Aflac's policies are individually underwritten and marketed through independent agents. Aflac U.S. also markets and administers group products through Continental American Insurance Company (CAIC), branded as Aflac Group Insurance. Our insurance operations in the United States and our branch in Japan service the two markets for our insurance business.
PERFORMANCE HIGHLIGHTS
Yen-denominated income statement accounts are translated to U.S. dollars using a weighted-average Japanese yen/U.S. dollar foreign exchange rate, while yen-denominated balance sheet accounts are translated to U.S. dollars using a spot Japanese yen/U.S. dollar foreign exchange rate. The spot yen/dollar exchange rate at December 31, 2014 was 120.55, or 12.6% weaker than the December 31, 2013 spot yen/dollar exchange rate of 105.39. The weighted-average yen/dollar exchange rate for the year ended December 31, 2014 was 105.46, or 7.5% weaker than the weighted-average yen/dollar exchange rate of 97.54 for the same period in 2013.
Reflecting the weaker yen/dollar exchange rate, total revenues were down 5.1% to $22.7 billion in 2014, compared with $23.9 billion in 2013. Net earnings in 2014 were $3.0 billion, or $6.50 per diluted share, compared with $3.2 billion, or $6.76 per diluted share, in 2013.
Results for 2014 included pretax net realized investment gains of $215 million ($140 million after-tax), compared with net realized investment gains of $399 million ($259 million after-tax) in 2013. Net investment gains in 2014 consisted of $31 million ($20 million after-tax) of other-than-temporary impairment losses; $215 million of net gains ($140 million after-tax) from the sale or redemption of securities; and $31 million of net gains ($20 million after-tax) from valuing derivatives. Shareholders' equity included a net unrealized gain on investment securities and derivatives of $4.7 billion at December 31, 2014, compared with a net unrealized gain of $1.0 billion at December 31, 2013.
In November 2014, the Parent Company issued $750 million of senior notes through a U.S. public debt offering. We entered into cross-currency interest rate swaps to economically convert the dollar-denominated principal and interest on the senior notes we issued into yen-denominated obligations. In October 2014, the Parent Company and Aflac entered into a 364-day uncommitted bilateral line of credit that provides for borrowings in the amount of $100 million. For further information regarding these transactions, see Note 9 of the Notes to the Consolidated Financial Statements and the Capital Resources and Liquidity section of this MD&A.
We repurchased 19.7 million shares of our common stock in the open market for $1.2 billion under our share repurchase program in 2014, compared with 13.2 million shares repurchased in 2013.
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CRITICAL ACCOUNTING ESTIMATES
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 this MD&A, 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 based on currently available information when recording transactions resulting from business operations. The estimates that we deem to be most critical to an understanding of Aflac's results of operations and financial condition are those related to the valuation of investments and derivatives, deferred policy acquisition costs (DAC), liabilities for future policy benefits and unpaid policy claims, and income taxes. The preparation and evaluation of these critical accounting estimates involve the use of various assumptions developed from management's analyses and judgments. The application of these critical accounting estimates determines the values at which 93% of our assets and 73% of our liabilities are reported as of December 31, 2014, and thus has a direct effect on net earnings and shareholders' equity. Subsequent experience or use of other assumptions could produce significantly different results.
Investments and Derivatives
Aflac's investments in debt, perpetual and equity securities include both publicly issued and privately issued securities. For publicly issued securities, we determine the fair values from quoted market prices readily available from public exchange markets and price quotes and valuations from third party pricing vendors. For the majority of privately issued securities within our investment portfolio, a third party pricing vendor has developed valuation models to determine fair values. For the remaining privately issued securities, we use non-binding price quotes from outside brokers. We also routinely review our investments that have experienced declines in fair value to determine if the decline is other than temporary. The identification of distressed investments, the determination of fair value if not publicly traded and the assessment of whether a decline is other than temporary involve significant management judgment.
Our team of experienced credit professionals must apply considerable judgment in determining the likelihood of the security recovering in value while we own it. Factors that may influence this include our assessment of the issuer’s ability to continue making timely payments of interest and principal, the overall level of interest rates and credit spreads, and other factors. This process requires consideration of risks which can be controlled to a certain extent, such as credit risk, and risks which cannot be controlled, such as interest rate risk. Management updates its evaluations regularly and reflects impairment losses in the Company's income statement as such evaluations are revised.
Our derivative activities include foreign currency, interest rate and credit default swaps in variable interest entities (VIEs) that are consolidated; foreign currency swaps associated with certain senior notes and our subordinated debentures; foreign currency forwards and options used in hedging foreign exchange risk and options on interest rate swaps (or interest rate swaptions) used in hedging interest rate risk on U.S. dollar-denominated securities in Aflac Japan's portfolio; and foreign currency forwards and options used to hedge certain portions of forecasted cash flows denominated in yen. Inputs used to value derivatives include, but are not limited to, interest rates, credit spreads, foreign currency forward and spot rates, and interest volatility. With the exception of the derivatives associated with our VIE investments, the fair values of the derivatives referenced above are based on the amounts we would expect to receive or pay to terminate the derivatives. For derivatives associated with VIEs where we are the primary beneficiary, we receive valuations from a third party pricing vendor.
See Notes 1, 3, 4 and 5 of the Notes to the Consolidated Financial Statements for additional information.
Deferred Policy Acquisition Costs and Policy Liabilities
Aflac's products are generally long-duration fixed-benefit indemnity contracts. We make estimates of certain factors that affect the profitability of our business to match expected policy benefits and deferrable acquisition costs with expected policy premiums. These factors include persistency, morbidity, mortality, investment yields and expenses. If actual results match the assumptions used in establishing policy liabilities and the deferral and amortization of acquisition costs, profits are expected to emerge ratably over the life of the policy. However, because actual results will vary from the assumptions, profits as a percentage of earned premiums will vary from year to year.
We measure the adequacy of our policy reserves and recoverability of DAC annually by performing gross premium valuations on our business. Our testing indicates that our insurance liabilities are adequate and that our DAC is recoverable.
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Deferred Policy Acquisition Costs
Certain costs of acquiring new business are deferred and amortized over the policy's premium payment period in proportion to anticipated premium income. Future amortization of DAC is based upon our estimates of persistency, interest and future premium revenue generally established at the time of policy issuance. However, the unamortized balance of DAC reflects actual persistency. See Note 6 of the Notes to the Consolidated Financial Statements for a detail of the DAC activity for the past two years.
Policy Liabilities
The following table provides details of policy liabilities by segment and in total as of December 31.
Policy Liabilities
(In millions) | 2014 | 2013 | |||||
Japan segment: | |||||||
Future policy benefits | $ | 57,916 | $ | 61,780 | |||
Unpaid policy claims | 2,120 | 2,342 | |||||
Other policy liabilities | 14,539 | 16,180 | |||||
Total Japan policy liabilities | $ | 74,575 | $ | 80,302 | |||
U.S. segment: | |||||||
Future policy benefits | $ | 7,728 | $ | 7,354 | |||
Unpaid policy claims | 1,511 | 1,421 | |||||
Other policy liabilities | 117 | 323 | |||||
Total U.S. policy liabilities | $ | 9,356 | $ | 9,098 | |||
Consolidated: | |||||||
Future policy benefits | $ | 65,646 | $ | 69,136 | |||
Unpaid policy claims | 3,630 | 3,763 | |||||
Other policy liabilities | 14,657 | 16,503 | |||||
Total consolidated policy liabilities | $ | 83,933 | $ | 89,402 | |||
Our policy liabilities, which are determined in accordance with applicable guidelines as defined under GAAP and Actuarial Standards of Practice, include two components that involve analysis and judgment: future policy benefits and unpaid policy claims, which accounted for 78% and 4% of total policy liabilities as of December 31, 2014, respectively.
Future policy benefits provide for claims that will occur in the future and are generally calculated as the present value of future expected benefits to be incurred less the present value of future expected net benefit premiums. We calculate future policy benefits based on assumptions of morbidity, mortality, persistency and interest. These assumptions are generally established at the time a policy is issued. The assumptions used in the calculations are closely related to those used in developing the gross premiums for a policy. As required by GAAP, we also include a provision for adverse deviation, which is intended to accommodate adverse fluctuations in actual experience.
Unpaid policy claims include those claims that have been incurred and are in the process of payment as well as an estimate of those claims that have been incurred but have not yet been reported to us. We compute unpaid policy claims on a non-discounted basis using statistical analyses of historical claims payments, adjusted for current trends and changed conditions. We update the assumptions underlying the estimate of unpaid policy claims regularly and incorporate our historical experience as well as other data that provides information regarding our outstanding liability.
Our insurance products provide fixed-benefit amounts per occurrence that are not subject to medical-cost inflation. Furthermore, our business is widely dispersed in both the United States and Japan. This geographic dispersion and the nature of our benefit structure mitigate the risk of a significant unexpected increase in claims payments due to epidemics and events of a catastrophic nature. Claims incurred under Aflac's policies are generally reported and paid in a relatively short time frame. The unpaid claims liability is sensitive to morbidity assumptions, in particular, severity and frequency of claims. Severity is the ultimate size of a claim, and frequency is the number of claims incurred. Our claims experience is primarily related to the demographics of our policyholders.
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As a part of our established financial reporting and accounting practices and controls, we perform actuarial reviews of our policyholder liabilities on an ongoing basis and reflect the results of those reviews in our results of operations and financial condition as required by GAAP.
For Aflac Japan, our review in 2014 and 2013 indicated no need to strengthen liabilities associated with policies in Japan. Our review in 2012 indicated that we needed to strengthen the liability associated primarily with a block of care policies and closed block of dementia policies in Japan, primarily due to low investment yields. We strengthened our future policy benefits liability by $81 million in 2012 as a result of this review.
For Aflac U.S., our review in 2014 indicated no need to strengthen liabilities associated with policies in the United States. Our review in 2013 and 2012 indicated that we needed to strengthen the liability associated primarily with long-term care in the United States. We strengthened our future policy benefits liability by $20 million in both 2013 and 2012 as a result of this review.
The table below reflects the growth of the future policy benefits liability for the years ended December 31.
Future Policy Benefits
(In millions of dollars and billions of yen) | 2014 | 2013 | 2012 | |||||||||
Aflac U.S. | $ | 7,728 | $ | 7,354 | $ | 6,931 | ||||||
Growth rate | 5.1 | % | 6.1 | % | 6.9 | % | ||||||
Aflac Japan | $ | 57,916 | $ | 61,780 | $ | 69,530 | ||||||
Growth rate | (6.3 | )% | (11.1 | )% | (4.5 | )% | ||||||
Consolidated | $ | 65,646 | $ | 69,136 | $ | 76,463 | ||||||
Growth rate | (5.0 | )% | (9.6 | )% | (3.6 | )% | ||||||
Yen/dollar exchange rate (end of period) | 120.55 | 105.39 | 86.58 | |||||||||
Aflac Japan (in yen) | 6,982 | 6,511 | 6,020 | |||||||||
Growth rate | 7.2 | % | 8.2 | % | 6.4 | % | ||||||
As of December 31, 2014, the decrease in total consolidated future policy benefits liability in dollars was primarily driven by the weakening of the yen against the U.S. dollar, compared with December 31, 2013. The growth of the future policy benefits liability in yen for Aflac Japan and in dollars for Aflac U.S. has been due to the aging of our in-force block of business and the addition of new business.
In computing the estimate of unpaid policy claims, we consider many factors, including the benefits and amounts available under the policy; the volume and demographics of the policies exposed to claims; and internal business practices, such as incurred date assignment and current claim administrative practices. We monitor these conditions closely and make adjustments to the liability as actual experience emerges. Claim levels are generally stable from period to period; however, fluctuations in claim levels may occur. In calculating the unpaid policy claim liability, we do not calculate a range of estimates. The following table shows the expected sensitivity of the unpaid policy claims liability as of December 31, 2014, to changes in severity and frequency of claims.
Sensitivity of Unpaid Policy Claims Liability
(In millions) | Total Severity | ||||||||||||||||||||||||||||
Total Frequency | Decrease by 2% | Decrease by 1% | Unchanged | Increase by 1% | Increase by 2% | ||||||||||||||||||||||||
Increase by 2% | $ | 0 | $ | 23 | $ | 47 | $ | 70 | $ | 94 | |||||||||||||||||||
Increase by 1% | (23 | ) | 0 | 23 | 47 | 70 | |||||||||||||||||||||||
Unchanged | (46 | ) | (23 | ) | 0 | 23 | 47 | ||||||||||||||||||||||
Decrease by 1% | (68 | ) | (46 | ) | (23 | ) | 0 | 23 | |||||||||||||||||||||
Decrease by 2% | (91 | ) | (68 | ) | (46 | ) | (23 | ) | 0 | ||||||||||||||||||||
Other policy liabilities, which accounted for 18% of total policy liabilities as of December 31, 2014, consisted primarily of discounted advance premiums on deposit from policyholders in conjunction with their purchase of certain Aflac Japan insurance products. These advanced premiums are deferred upon collection and recognized as premium revenue over the contractual premium payment period. Advanced premiums represented 47% and 53% of the December 31, 2014 and
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2013 other policy liabilities balances, respectively. See the Aflac Japan segment subsection of this MD&A for further information.
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. The evaluation of a tax position in accordance with GAAP is a two-step process. Under the first step, the enterprise determines whether it is more likely than not that a tax position will be sustained upon examination by taxing authorities. The second step is measurement, whereby a tax position that meets the more-likely-than-not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. A valuation allowance is established for deferred tax assets when it is more likely than not that an amount will not be realized. The determination of a valuation allowance for deferred tax assets requires management to make certain judgments and assumptions.
In evaluating the ability to recover deferred tax assets, our management considers all available evidence, including taxable income in open carry back years, the existence of cumulative losses in the most recent years, forecasted earnings, future taxable income exclusive of reversing temporary differences and carryforwards, future taxable temporary difference reversals, and prudent and feasible tax planning strategies. In the event we determine it is not more likely than not that we will be able to realize all or part of our deferred tax assets in the future, a valuation allowance would be charged to earnings in the period such determination is made. Likewise, if it is later determined that it is more likely than not that those deferred tax assets would be realized, the previously provided valuation allowance would be reversed. Future economic conditions and market volatility, including increases in interest rates or widening credit spreads, can adversely impact the Company’s tax planning strategies and in particular the Company’s ability to utilize tax benefits on previously recognized capital losses. Our judgments and assumptions are subject to change given the inherent uncertainty in predicting future performance and specific industry and investment market conditions.
Interest rates and credit spreads in both the United States and Japan are not the only factors that impact the Company’s unrealized gain/loss position and the evaluation of a need for a valuation allowance on the Company’s deferred tax asset, but they do have a direct and significant effect on both. Based on our methodology described above for evaluating the need for a valuation allowance, we have determined that it is more likely than not that our deferred tax assets will be realized in the future, therefore we have not recorded a valuation allowance as of December 31, 2014.
See Note 10 of the Notes to the Consolidated Financial Statements for additional information.
New Accounting Pronouncements
During the last three years, various accounting standard-setting bodies have been active in soliciting comments and issuing statements, interpretations and exposure drafts. For information on new accounting pronouncements and the impact, if any, on our financial position or results of operations, see Note 1 of the Notes to the Consolidated Financial Statements.
RESULTS OF OPERATIONS
The following discussion includes references to our performance measures, operating earnings and operating earnings per diluted share, that are not based on accounting principles generally accepted in the United States of America (“GAAP”). Operating earnings is the measure of segment profit or loss we use to evaluate segment performance and allocate resources. Consistent with GAAP accounting guidance for segment reporting, operating earnings is our measure of segment performance. Aflac believes that an analysis of operating earnings is vitally important to an understanding of our underlying profitability drivers and trends of our insurance business. Furthermore, because a significant portion of our business is conducted in Japan, we believe it is equally important to understand the impact of translating Japanese yen into U.S. dollars.
Aflac defines operating earnings (a non-GAAP financial measure) as the profits derived from operations. Operating earnings includes interest cash flows associated with notes payable but excludes items that cannot be predicted or that are outside of management's control, such as realized investment gains and losses from securities transactions, impairments, and derivative and hedging activities; nonrecurring items; and other non-operating income (loss) from net earnings. Aflac's derivative activities are primarily used to hedge foreign exchange and interest rate risk in our investment portfolio as well as manage foreign exchange risk for certain notes payable and forecasted cash
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flows denominated in yen. Our management uses operating earnings to evaluate the financial performance of Aflac’s insurance operations because realized gains and losses from securities transactions, impairments, and derivative and hedging activities, as well as other and nonrecurring items, tend to be driven by general economic conditions and events or related to infrequent activities not directly associated with the Company’s insurance operations, and therefore may obscure the underlying fundamentals and trends in Aflac’s insurance operations.
The following table is a reconciliation of items impacting operating and net earnings and operating and net earnings per diluted share for the years ended December 31.
Reconciliation of Operating Earnings to Net Earnings
In Millions | Per Diluted Share | ||||||||||||||||||||||
2014 | 2013 | 2012 | 2014 | 2013 | 2012 | ||||||||||||||||||
Operating earnings | $ | 2,797 | $ | 2,887 | $ | 3,097 | $ | 6.16 | $ | 6.18 | $ | 6.60 | |||||||||||
Items impacting net earnings, net of tax: | |||||||||||||||||||||||
Realized investment gains (losses): | |||||||||||||||||||||||
Securities transactions and impairments | 119 | 41 | (326 | ) | .26 | .09 | (.69 | ) | |||||||||||||||
Impact of derivative and hedging activities: | |||||||||||||||||||||||
Hedge costs related to foreign currency investments | (24 | ) | (17 | ) | (5 | ) | (.05 | ) | (.04 | ) | (.01 | ) | |||||||||||
Other derivative and hedging activities | 16 | (1) | 229 | (1) | 105 | .03 | .49 | .22 | |||||||||||||||
Other and non-recurring income (loss) | 43 | 18 | (5 | ) | .10 | .04 | (.01 | ) | |||||||||||||||
Net earnings | $ | 2,951 | $ | 3,158 | $ | 2,866 | $ | 6.50 | $ | 6.76 | $ | 6.11 | |||||||||||
(1) Excludes a gain of $28 and $6, after tax, in 2014 and 2013, respectively, related to the interest rate component of the change in fair value of foreign currency swaps on notes payable which is classified as an operating gain when analyzing segment operations
Realized Investment Gains and Losses
Our investment strategy is to invest in fixed-income securities to provide a reliable stream of investment income, which is one of the drivers of the Company’s growth and profitability. This investment strategy incorporates asset-liability matching (ALM) to align the expected cash flows of the portfolio to the needs of the Company's liability structure. We do not purchase securities with the intent of generating capital gains or losses. However, investment gains and losses may be realized as a result of changes in the financial markets and the creditworthiness of specific issuers, tax planning strategies, and/or general portfolio management and rebalancing. The realization of investment gains and losses is independent of the underwriting and administration of our insurance products, which are the principal drivers of our profitability.
Securities Transactions and Impairments
During 2014, we realized pretax investment gains, net of losses, of $215 million ($140 million after-tax) from sales and redemptions of securities. These net gains primarily resulted from gains on sales of JGBs and our U.S. Treasury holdings, currency gains from transactions by our externally managed portfolio of U.S. dollar-denominated bank loans, and assorted other bond sales and calls. We realized pretax investment losses of $31 million ($20 million after-tax) as a result of the recognition of other-than-temporary impairment losses on certain securities.
During 2013, we realized pretax investment gains, net of losses, of $262 million ($170 million after-tax) from sales and redemptions of securities. These net gains primarily resulted from sales of Japanese Government Bonds (JGBs) as part of a portfolio repositioning exercise. We also realized modest gains from bond tender offers of several of our holdings. We realized pretax investment losses of $199 million ($129 million after-tax) as a result of the recognition of other-than-temporary impairment losses on certain securities.
During 2012, we realized pretax investment gains, net of losses, of $474 million ($309 million after-tax) from sales and redemptions of securities. These net gains primarily resulted from sales of JGBs in a bond-swap program in the third quarter of 2012 and sales resulting from our efforts to reduce risk exposure in our investment portfolio. We realized pretax investment losses of $977 million ($635 million after-tax) as a result of the recognition of other-than-temporary impairment losses on certain securities.
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See Note 3 of the Notes to the Consolidated Financial Statements for more details on these investment activities.
The following table details our pretax impairment losses by investment category for the years ended December 31.
(In millions) | 2014 | 2013 | 2012 | |||||||||
Perpetual securities | $ | 0 | $ | 70 | $ | 243 | ||||||
Corporate bonds | 31 | 102 | 345 | |||||||||
Mortgage- and asset-backed securities | 0 | 0 | 3 | |||||||||
Sovereign and supranational | 0 | 26 | 386 | |||||||||
Equity securities | 0 | 1 | 0 | |||||||||
Total other-than-temporary impairment losses realized (1) | $ | 31 | $ | 199 | $ | 977 | ||||||
(1) Includes $45 and $597 for the years ended December 31, 2013 and 2012, respectively, for credit-related impairments;
$26 and $27 for the years ended December 31, 2013 and 2012, respectively, for impairments due to severity and duration
of decline in fair value; and $31, $128 and $353 for the years ended December 31, 2014, 2013 and 2012, respectively, from change
in intent to sell securities
Impact of Derivative and Hedging Activities
Our derivative activities include foreign currency swaps, credit default swaps and interest rate swaps in VIEs that are consolidated; foreign currency forwards and options, interest rate swaptions and futures on certain fixed-maturity securities; foreign currency forwards and options that hedge certain portions of forecasted cash flows denominated in yen; and foreign currency swaps associated with certain senior notes and our subordinated debentures. During 2014, we realized pretax investment gains, net of losses, of $31 million ($20 million after-tax), compared with pretax investment gains, net of losses, of $336 million ($218 million after-tax) in 2013 and pretax investment gains, net of losses, of $154 million ($100 million after-tax) in 2012 as a result of valuing these derivatives, net of the effects of hedge accounting. For a description of other items that could be included in the Impact of Derivative and Hedging Activities, see the Hedging Activities subsection of MD&A and Note 4 of the accompanying Notes to the Consolidated Financial Statements.
For additional information regarding realized investment gains and losses, see Notes 3 and 4 of the Notes to the Consolidated Financial Statements.
Foreign Currency Translation
Aflac Japan’s premiums and most of its investment income are received in yen. Claims and expenses are paid in yen, and we have yen-denominated assets that support yen-denominated policy liabilities. These and other yen-denominated financial statement items are translated into dollars for financial reporting purposes. We translate Aflac Japan’s yen-denominated income statement into dollars using an average exchange rate for the reporting period, and we translate its yen-denominated balance sheet using the exchange rate at the end of the period.
Due to the size of Aflac Japan, where our functional currency is the Japanese yen, fluctuations in the yen/dollar exchange rate can have a significant effect on our reported results. In periods when the yen weakens, translating yen into dollars results in fewer dollars being reported. When the yen strengthens, translating yen into dollars results in more dollars being reported. Consequently, yen weakening has the effect of suppressing current period results in relation to the comparable prior period, while yen strengthening has the effect of magnifying current period results in relation to the comparable prior period. As a result, we view foreign currency translation as a financial reporting issue for Aflac and not an economic event to our Company or shareholders. Because changes in exchange rates distort the growth rates of our operations, management evaluates Aflac’s financial performance excluding the impact of foreign currency translation.
Income Taxes
Our combined U.S. and Japanese effective income tax rate on pretax earnings was 34.3% in 2014, 34.4% in 2013 and 33.4% in 2012. The lower effective income tax rate for 2012 reflected the favorable outcome of a routine tax exam for the years 2008 and 2009, which reduced income tax expense by $29.5 million. Total income taxes were $1.5 billion in 2014, compared with $1.7 billion in 2013 and $1.4 billion in 2012. Japanese income taxes on Aflac Japan's results account for most of our consolidated income tax expense. See Note 10 of the Notes to the Consolidated Financial Statements for additional information.
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Earnings Guidance
Our original objective for 2014 was to increase operating earnings per diluted share by 2% to 5% over 2013, and we revised the objective during the year to a 3% to 4% increase, excluding the effect of foreign currency translation. We reported 2014 net earnings per diluted share of $6.50. Adjusting that number for after-tax realized investment gains ($.24 per diluted share), other non-operating income ($.10 per diluted share), and foreign currency translation (an expense of $.26 per diluted share), we finished the year at the high end of our revised objective with a 3.9% increase in operating earnings per diluted share.
Earnings growth from 2014 will create tough comparisons in 2015. Our objective for 2015 is to increase operating earnings per diluted share by 2% to 7% over 2014, excluding the effect of foreign currency translation. Interest rates in both Japan and the United States are at historic lows, with cash flows to investments being lower in 2015 than in prior years. The progression of the benefit ratios in Japan and the United States, which have seen favorable trends in 2014, could also have a significant impact on our results. If we achieve our objective for 2015, the following table shows the likely results for operating earnings per diluted share, including the impact of foreign currency translation using various yen/dollar exchange rate scenarios.
2015 Operating Earnings Per Diluted Share Scenarios(1)
Weighted-Average Yen/Dollar Exchange Rate | Operating Earnings Per Diluted Share | % Growth Over 2014 | Yen Impact | ||||||||||
100 | $6.47 - 6.77 | 5.0 | - | 9.9% | $ | .18 | |||||||
105.46(2) | 6.29 - 6.59 | 2.1 | - | 7.0 | .00 | ||||||||
115 | 6.01 - 6.31 | (2.4 | ) | - | 2.4 | (.28 | ) | ||||||
125 | 5.77 - 6.07 | (6.3 | ) | - | (1.5) | (.52 | ) | ||||||
135 | 5.56 - 5.86 | (9.7 | ) | - | (4.9) | (.73 | ) | ||||||
(1)Excludes realized investment gains/losses (securities transactions, impairments, and the impact of derivative and hedging activities),
nonrecurring items, and other non-operating income (loss) in 2015 and 2014
(2)Actual 2014 weighted-average exchange rate
INSURANCE OPERATIONS
Aflac's insurance business consists of two segments: Aflac Japan and Aflac U.S. Aflac Japan, which operates as a branch of Aflac, is the principal contributor to consolidated earnings. GAAP financial reporting requires that a company report financial and descriptive information about operating segments in its annual and interim period financial statements. Furthermore, we are required to report a measure of segment profit or loss, certain revenue and expense items, and segment assets.
We evaluate our sales efforts using new annualized premium sales, an industry operating measure. New annualized premium sales, which include both new sales and the incremental increase in premiums due to conversions, represent the premiums that we would collect over a 12-month period, assuming the policies remain in force. For Aflac Japan, new annualized premium sales are determined by applications submitted during the reporting period. For Aflac U.S., new annualized premium sales are determined by applications that are issued during the reporting period. Premium income, or earned premiums, is a financial performance measure that reflects collected or due premiums that have been earned ratably on policies in force during the reporting period.
AFLAC JAPAN SEGMENT
Aflac Japan Pretax Operating Earnings
Changes in Aflac Japan's pretax operating earnings and profit margins are primarily affected by morbidity, mortality, expenses, persistency and investment yields. The following table presents a summary of operating results for Aflac Japan for the years ended December 31.
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Aflac Japan Summary of Operating Results
(In millions) | 2014 | 2013 | 2012 | ||||||||
Net premium income | $ | 13,861 | $ | 14,982 | $ | 17,151 | |||||
Net investment income: | |||||||||||
Yen-denominated investment income | 1,429 | 1,497 | 1,902 | ||||||||
Dollar-denominated investment income | 1,233 | 1,154 | 943 | ||||||||
Net investment income | 2,662 | 2,651 | 2,845 | ||||||||
Other income (loss) | 32 | 55 | 57 | ||||||||
Total operating revenues | 16,555 | 17,688 | 20,053 | ||||||||
Benefits and claims, net | 10,084 | 10,924 | 12,496 | ||||||||
Operating expenses: | |||||||||||
Amortization of deferred policy acquisition costs | 649 | 641 | 716 | ||||||||
Insurance commissions | 845 | 944 | 1,174 | ||||||||
Insurance and other expenses | 1,519 | 1,551 | 1,763 | ||||||||
Total operating expenses | 3,013 | 3,136 | 3,653 | ||||||||
Total benefits and expenses | 13,097 | 14,060 | 16,149 | ||||||||
Pretax operating earnings(1) | $ | 3,458 | $ | 3,628 | $ | 3,904 | |||||
Weighted-average yen/dollar exchange rate | 105.46 | 97.54 | 79.81 | ||||||||
In Dollars | In Yen | ||||||||||||||||
Percentage change over previous period: | 2014 | 2013 | 2012 | 2014 | 2013 | 2012 | |||||||||||
Net premium income | (7.5 | )% | (12.7 | )% | 9.8 | % | .1 | % | 6.8 | % | 9.9 | % | |||||
Net investment income | .4 | (6.8 | ) | 5.8 | 8.8 | 13.9 | 6.1 | ||||||||||
Total operating revenues | (6.4 | ) | (11.8 | ) | 9.3 | 1.3 | 7.8 | 9.4 | |||||||||
Pretax operating earnings(1) | (4.7 | ) | (7.1 | ) | 2.0 | 3.1 | 13.6 | 2.0 | |||||||||
(1)See the Insurance Operations section of this MD&A for our definition of segment operating earnings.
The relatively small change in premium income in yen for 2014 was influenced by the impact of weak first sector sales in 2014 and 2013 in addition to premiums ceded in the 2014 and 2013 reinsurance transactions. Annualized premiums in force at December 31, 2014, were 1.59 trillion yen, compared with 1.57 trillion yen in 2013 and 1.49 trillion yen in 2012. The increases in annualized premiums in force in yen of 1.7% in 2014, 5.0% in 2013 and 11.1% in 2012 reflect the sales of new policies combined with the high persistency of Aflac Japan's business. Annualized premiums in force, translated into dollars at respective year-end exchange rates, were $13.2 billion in 2014, $14.9 billion in 2013, and $17.2 billion in 2012.
Aflac Japan's investment portfolios include dollar-denominated securities and reverse-dual currency securities (yen-denominated debt securities with dollar coupon payments). Dollar-denominated investment income from these assets accounted for approximately 46% of Aflac Japan's investment income in 2014, compared with 44% in 2013 and 33% in 2012. This percentage increase in 2014 and 2013 is due to our higher allocation to U.S. dollar-denominated investments. In years when the yen strengthens in relation to the dollar, translating Aflac Japan's dollar-denominated investment income into yen lowers growth rates for net investment income, total operating revenues, and pretax operating earnings in yen terms. In years when the yen weakens, translating dollar-denominated investment income into yen magnifies growth rates for net investment income, total operating revenues, and pretax operating earnings in yen terms. Excluding foreign currency changes from the respective prior year, dollar-denominated investment income accounted for approximately 44% of Aflac Japan's investment income during 2014, compared with 39% in 2013 and 33% in 2012.
The following table illustrates the effect of translating Aflac Japan's dollar-denominated investment income and related items into yen by comparing certain segment results with those that would have been reported had yen/dollar exchange rates remained unchanged from the prior year.
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Aflac Japan Percentage Changes Over Prior Year
(Yen Operating Results)
Including Foreign Currency Changes | Excluding Foreign Currency Changes(2) | |||||||||||||||
2014 | 2013 | 2012 | 2014 | 2013 | 2012 | |||||||||||
Net investment income | 8.8 | % | 13.9 | % | 6.1 | % | 4.8 | % | 4.7 | % | 5.9 | % | ||||
Total operating revenues | 1.3 | 7.8 | 9.4 | .7 | 6.4 | 9.3 | ||||||||||
Pretax operating earnings(1) | 3.1 | 13.6 | 2.0 | .3 | 7.0 | 1.7 | ||||||||||
(1)See the Insurance Operations section of this MD&A for our definition of segment operating earnings.
(2)Amounts excluding foreign currency changes on dollar-denominated items were determined using the same yen/dollar exchange rate for the current year as each respective prior year.
The following table presents a summary of operating ratios in yen terms for Aflac Japan for the years ended December 31.
Ratios to total revenues: | 2014 | 2013 | 2012 | ||||||
Benefits and claims, net | 60.9 | % | 61.7 | % | 62.3 | % | |||
Operating expenses: | |||||||||
Amortization of deferred policy acquisition costs | 3.9 | 3.6 | 3.6 | ||||||
Insurance commissions | 5.1 | 5.3 | 5.9 | ||||||
Insurance and other expenses | 9.2 | 8.9 | 8.7 | ||||||
Total operating expenses | 18.2 | 17.8 | 18.2 | ||||||
Pretax operating earnings(1) | 20.9 | 20.5 | 19.5 | ||||||
(1)See the Insurance Operations section of this MD&A for our definition of segment operating earnings.
In 2014, the benefit ratio decreased compared with 2013, reflecting lower incurred claims which are offsetting the mix of in-force shift to first sector products. In addition, the reinsurance agreements that we entered into at the end of third quarter 2013 and the beginning of fourth quarter 2014 reduced the benefit ratio by approximately 50 basis points in 2014. The benefit ratio has also been influenced by the effect of low investment yields, which impacts our profit margin by reducing the spread between investment yields and required interest on policy reserves (see table and discussion in the Interest Rate Risk subsection of this MD&A). In 2014, the operating expense ratio increased primarily due to the change in the mix of business for new sales. In total, the pretax operating profit margin improved in 2014, compared with 2013. For 2015, we anticipate the pretax operating profit margin to be comparable with the 2013 and 2014 levels.
Aflac Japan Sales
The following table presents Aflac Japan's new annualized premium sales for the years ended December 31.
In Dollars | In Yen | |||||||||||||||||||
(In millions of dollars and billions of yen) | 2014 | 2013 | 2012 | 2014 | 2013 | 2012 | ||||||||||||||
New annualized premium sales | $ | 1,080 | $ | 1,539 | $ | 2,641 | 114.5 | 149.3 | 210.6 | |||||||||||
Increase (decrease) over prior period | (29.8 | )% | (41.7 | )% | 30.3 | % | (23.3 | )% | (29.1 | )% | 30.8 | % | ||||||||
The following table details the contributions to new annualized premium sales by major insurance product for the years ended December 31.
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2014 | 2013 | 2012 | |||||||
Medical | 31.8 | % | 27.9 | % | 17.5 | % | |||
Cancer | 30.3 | 17.0 | 13.1 | ||||||
Ordinary life: | |||||||||
Child endowment | 10.2 | 11.7 | 11.6 | ||||||
WAYS | 14.0 | 27.5 | 44.9 | ||||||
Other ordinary life | 8.3 | 10.3 | |||||||