Aflac Incorporated (AFL) Goldman Sachs 2023 US Financial Services Conference (Transcript)

Aflac Incorporated (NYSE:AFL) Goldman Sachs 2023 US Financial Services Conference December 5, 2023 2:20 PM ET

Company Participants

Max Broden – CFO

Brad Dyslin – CIO

Conference Call Participants

Taylor Scott – Goldman Sachs

Taylor Scott

So we will jump right into the next session here. First, I’d appreciate to thank Max Broden, CFO of Aflac; and Brad Dyslin, CIO of Aflac for being with us. So very much appreciate it. I’m starting off a lot of these conversations with the broad strategy update sort of question. And so I’ll do the same thing for you. I’d be interested if you could just furnish a general update on what are the strategic objectives that you’re most focused on, particularly as we think through the next year?

Max Broden

So I would start by just looking back at the period that we have been in. So — especially reflecting on it as a supplemental health insurance company going through a pandemic that — what it did overall is that it pushed down our benefit ratios both in Japan and the US. And what we generally expect going forward is a little bit of a rebound upwards of that. Part of that is just simply claims utilization coming back to more normal levels and part of it is also especially in the US and that we are filing our new products with a little bit higher benefit ratios. And we’re also refreshing both the benefits and the premiums at a slightly higher level in order to bring better value overall to consumers. So if you take that and then think about what would be the main objectives in Japan and going forward, Japan is a very stable market for us. Strong profitability, strong cash flow generation.

What we are focused on is defending our market position but then also trying to boost our sales overall in Japan. That is essentially going to come through a couple of things. So more — but advance execution from Japan Post. So getting Japan Post on track towards the level, not necessarily where they were back in 2018, but to become a more significant contributor overall to our sales. Also, we are looking to refresh our life insurance offering in 2024. And as you know, we also refreshed our medical insurance product in September of this year. This is with a particular focus on the nonexclusive channel, which is a channel that historically we haven’t been that strong in, but we now believe that we have a better offering. So that will be the general objective for Japan. In the US, I think we have a lot of focus on our internal execution. We need to really get our growth platforms to perform both better — and at a better expense level. So that in conjunction with our in-force business, a greater focus on expenses going into 2024 is going to be our main objective.

Taylor Scott

Got it. And maybe in Japan, specifically, can you talk about the outlook for sales there? You mentioned some of the products you’ve launched recently. Are you seeing enough pickup that you’re still confident in some of these longer term objectives that you all are managing to?

Max Broden

So Japan, there’s no hiding behind it. It’s a challenging market from a new business standpoint. Population is not growing, it is shrinking. We don’t necessarily have around the corner any significant changes to the co-pay structure for the government health insurance scheme that potentially would be a significant driver for demand in Japan. So we’re facing this environment of a slightly, slightly decreasing demand. When we have that, you have to sort of accept that that’s the environment that you live in. I think it’s very dangerous to sort of stretch for growth, which we could do and we could produce significantly lower margins and returns but at dramatically higher sales level. For us, we do believe that it’s a better outcome to them make sure that you hit your pricing assumptions, which historically we have and produce strong economic value creation on the sales that you are selling. Because the fact of the matter in Japan, you have very long liabilities. So when you make a sale of a product that profitability would be on the books for maybe the next 20 to 25 years. So you really need to think long and hard to make sure that you price that correctly. So that being said, I do think that it is a challenging market, especially in the medical area. And that’s an area that we probably have done the most in order to sort of sharpen our pencils and make sure that we are now having a more competitive product out there. But overall, I think it’s our targets that we have in Japan from a new business standpoint, they’re very challenging.

Taylor Scott

And on the medical product in particular that you launched recently, can you tell us a little bit more about that, what was the update that was done there?

Max Broden

So where the market has been going in Japan. So first of all, there is one distribution change, which is that more and more product is being sold through the nonexclusive channels. And if you convert that into what we would we call that in the US, we call it small brokers essentially. So we have a small shift away from traditional agency towards smaller brokers or in Japanese terms, exclusive agencies to nonexclusive agencies. When that happens, you get much more off price comparison between different products. So the premium level in yen terms matters a whole lot. And what we’ve seen in the marketplace is that more and more demand for slim down offerings in terms of the benefit base and therefore, lower premiums. We have not — our product that we have had in the marketplace has generally been at a higher price point with better coverage and more benefits. So this product offering, what we have done is that actually it slimmed it down a little bit. We even call it ever slim — ever simple is what it’s called. So we simplified a lot of the benefits but it also comes therefore at a lower premium level. And that is really to make sure that we are attracting both more of the business through the nonexclusive agencies, but then also attracting a little bit more of the more price sensitive, younger population.

Taylor Scott

Got it. When I think through the higher interest rate environment, some of your peers have talked about the benefits they’re seeing there, maybe opening up the product set a little bit, and these are maybe peers that they’re willing to do some annuities over there and so forth. Are there any interest from your standpoint and maybe going into some of those first sector products as a growth avenue?

Max Broden

So on the margin, it is correct that higher rates means that rate sensitive products appreciate life insurance, savings products, it will become a little bit more attractive on the margin. But you’re still — I would call it on the margin, it’s still difficult to really make those products to work. That being said, we started selling more of our life insurance savings offering called waste last year, and we do intend to refresh our life insurance offering in 2024, as I mentioned earlier. The reason why we now can do that is we also know that these products are very capital intensive upfront, and there’s a very significant new business strain associated with these products. And we have, since last year, a reinsurance platform established that gives us an opportunity to then hold reserves at the more economic level. So over time, I would expect that with the uphold of our reinsurance platform, we can now get the IRRs and the returns to really work on this product. That’s why we’re dipping our toes into this marketplace as well. It doesn’t mean that we are making very significant returns even with reinsurance uphold. But the fact of the matter is we’re getting adequate returns and what it also gives us the offer is to cross sell our third sector business with it. And that’s a deliberate strategy for us. So selling medical and cancer alongside a life insurance protection or a life insurance savings policy is quite attractive to us. And since we started last year, refreshed our waste product, we’re starting very — we’re getting very good attachment rates. I’m positively surprised that despite relatively low volumes that this is based on, to be honest, but the attachment rate is close to 50%, which is very encouraging.

Taylor Scott

So you mentioned the Bermuda reinsurance vehicle. I think we’re about a year out from when you initially set that up. Could you talk about this entity and the ways you’re leveraging in your business, whether it’s the new business and that angle that you just mentioned or some of the in-force box?

Max Broden

Yes, I would say that it’s important in terms of the new business strategy, but the biggest piece will remain the in-force blocks. So what we’ve done there is that we have pulled together different kind of blocks that we have of our in-force and we co-mingled them to create a good block that finds the right balance between reserve release and capital efficiency, freeing up capital in Japan versus how much capital we need to hold in Bermuda and optimizing a little bit also the asset side of the balance sheet. By doing that, we have the opportunity to release significant redundant reserves that we have in Japan. Essentially, it just pulls forward profits that we would have earned in the future. But the duration of our business in Japan is so long. So you would then have profit that would come to us over 20, 25, 30 years into the future. We can now expedite that up until today, we can release the capital. And we believe that we can then invest it at a significantly higher return than what we are doing currently in Japan.

The simple way to think about it is that this is all sort of surplus capital embedded in our reserves as they are redundant. So they earn essentially our investment yield in our general account, which today is sitting at around 2.7%. If we can reinvest that at a higher rate than 2.7%, we have improved the economic outcome overall for the company. And I’ll be very disappointed, we cannot deploy it at a higher cost of — higher return than our cost of capital, which would then mean a significant spread and uplift in the return on that capital that we would deploy. If you then multiply that over a duration of something appreciate 20 years, because that’s the duration of the business here, we’re talking about then you get to very significant economic value creation.

Taylor Scott

Got it. I’m jumping around here, but I want to touch on capital management a little bit just in tandem with [Technical Difficulty] any reasonable baseline of where RBC, your solvency margin ratio should be. Why the need to free up more from appreciate a reserve redundancy when you’ve got sort of excess equity capital also sitting there available to be deployed?

Max Broden

You are saying, I’m doing a bad job…

Taylor Scott

No, you’ve already got a lot to work with here. There’s something bigger at play…

Max Broden

Yes. The thing is that none of this — if you really, really need it, it will be difficult to do it. So you need to do it when you don’t necessarily need it. So this is all about planning for the future and create to make sure that we have a platform that can be with us for the future. So when we think about the reinsurance platform that we have established, it is not there to be around for the next year or two. Really, the benefits that I expect to get out of it is going to accumulate over the next five, 10, 15, 20, 25, 30 years from now, that’s really the intent. That’s also why we built the platform, it took quite a long time to do it. And so all of that was intentional. You’re correct by saying that we are traveling with a lot of capital and it’s a function of we were conservative going into the pandemic. The pandemic did not necessarily have the outcomes that we initially expected. Initially, we actually fear that it could be very damaging to us, because one of the largest risks that we have as a health insurance company is a global pandemic. So we actually went out and raised capital, believe it or not. But what then subsequently happened during the pandemic was that non-COVID claims coming through were dramatically lower than what we had modeled and expected, quite frankly. And that led to significant capital generation and that’s what have accumulated on our balance sheet, and that’s why the capital levels are as high as they are right now. I think that we’re going through a couple of exercises, especially in Japan right now. The shift from SMR to the ESR model that’s occurring by midyear of 2024, I would expect to have the final calibration of the FSA ESR model. Once we have that, that gives us an opportunity to really contemplate and calibrate where we want to hold our ESR ratio going forward and that gives us an opportunity to potentially also rightsize the capital that we hold inside of the insurance subsidiary.

Taylor Scott

Got it. All very helpful. And yes, I mean, having that flexibility is certainly a good situation to have. In terms of technology initiatives in Japan, my understanding is a lot of what you’re working through is just the blocking and tackling appreciate getting off paper and doing some of these things. With what’s going on in tech advancement, I mean is there an opportunity to maybe sort of skip over a step, go a bit advance with the way that you’re integrating tech into your Japanese platform?

Max Broden

Yes. I’m not a technology expert and will never claim to be. So I’d say that probably the best answer is maybe. I don’t know, but I would not — certainly not regulate it out. One of the strategies that we have on our Japanese technology platform, because you have to make decisions based on very long-term investments, that makes it very tricky, especially as it relates to technology. So what it means is that we want to make sure that we do it in building blocks, which means that if you have a very long term project, well, make sure that you break it up into digestible building blocks where you may find out that a year from now, you know what, this path we’re going down is not the right path, let’s make sure we have an off-ramp, because there’s been technology advancements. So we don’t need to walk that path, this new technology we can deploy. So let’s do that instead. And let’s — and then after two years, we have another of those checkpoints. After three years, we have another of those checkpoints. So you may model out a very long project appreciate five, six, seven years, but at the same time, you make sure that you may not accomplish all seven years, quite frankly, because there may be new technology available to you so that you take different paths. So you need to design the project accordingly.

Taylor Scott

So Brad, maybe we’ll turn to you with some investment questions here. Maybe the first one since we’re focused on Japan, let’s talk about that a little. Any investment allocation shifts that you’re making in Japan as we sort of think through higher interest rate environment and opportunities in that book?

Brad Dyslin

Yes, sure. Thank you. The short answer is no, not really. Our asset allocation is driven by our SAA, of course, our strategic asset allocation, we updated every three years or so. And the best way to think about the broad strokes of the asset allocation are we take our yen liabilities, our yen reserves and we back those with yen assets. We take our surplus, which we consider effectively a dollar liability because of our US dollar based investor base and we put that into dollar assets. That’s resulted the last couple of years in essentially all of our new money going into dollar assets. Part of that is because the dollar portfolio has a significant portion that’s very short. Our loan book turns over very quickly. So it generates reinvestment on a relatively short term basis. In the yen book, we love putting money to work in yen spread product. It’s just very difficult to find it. When we do locate it, we’re putting it to work. Just basically yen credit is the prominent form of when we can see transactions. And then, of course, we always deploy our fair share of JGBs, which are necessary for both ALM and liquidity purposes. But you shouldn’t expect any big rider left turns in the portfolio just as a result of where current rates are.

Taylor Scott

Understood. FX, it looked appreciate there were some things that were moving around in terms of your hedge strategy. So I wanted to touch on that. What — maybe remind us of the changes that were made. And then what’s the financial impact as we think through hedge costs and so forth and amortization…

Brad Dyslin

Sure. So we implemented our first hedging strategy of FX about 10 years ago. And when we started out, we were doing everything in forwards. And the strategy was to effectively take our short term floaters and convert them to a yen synthetic asset. So it was an asset replication strategy of dollar assets in Japan. Over time, we’ve morphed that strategy into more of a capital protection strategy. We’ve gone from 100% forwards to forwards and options. And then beginning in third quarter, we continued the use of options aand now within Aflac Japan are effectively 100% options to hedge our US dollars for capital purposes. The result is we’ve gone from absolute protection and conversion basically to yen on a small portion of the capital through forwards to having the entire book protected with out of the money options. We still have a little volatility in capital and our capital ratios as a result of this. But given our strong capital position and the incremental savings, which are substantial from switching to an option strategy, we think that’s a very good use of that incremental capital. And that’s what you saw get implemented in third quarter.

Taylor Scott

And just in terms of the way it’s coming into hedge costs, I mean, we saw, I think it ticked down this last quarter in terms of just what we see there. I know there’s some amortization that occurs. Is that the right level from here?

Brad Dyslin

The third quarter is a pretty good place to start thinking about run rate.

Taylor Scott

Okay, all right. So maybe let’s stick with investments for a minute, commercial mortgage loan expirations. Can you talk about how that’s been getting through the office maturities this year?

Brad Dyslin

Yes. So commercial real estate, as I’m sure everyone knows, is in a very difficult spot in the cycle right now. Fortunately, for us, our total exposure across all of our loan book, mortgage loan book, is less than 10% of our total assets. It’s about $8 billion of total mortgage holdings, about three quarters of that or just over $6 billion is in transitional real estate. Some folks know whether it’s bridge financing or credit based real estate lending. The distinction there is those are much shorter loans. Those are generally three to five year maturity, so they turn over very quickly. The good news in a market appreciate this with loans that turn over very quickly is the impetus for the catalyst for that loan initially was a sponsor of the property put in some equity capital ahead of you. So you’ve got their money in — on purchase or transaction of an asset at the time you did your loan. So you’ve got 30% to 40% of the purchase price of that asset ahead of you on a recent transaction. The bad news is you’ve got a short maturity turnover cycle. So when the liquidity is as poor as it is in the market right now, it’s very difficult for those sponsors to get alternative financing to repay your loan. So what that means for us is very quickly, we enter into some form of workout negotiations with these sponsors. And in 2023, it resulted in a very significant portion of the book being extended.

Now that’s not necessarily a problem for us to extend a loan. First of all, it’s got to be a good loan, it’s got to be a good sponsor with a good business strategize on a good asset. But we also extract additional protections in exchange for extending that loan. The most notable benefit we get is additional equity put into the project, put into the property. If they can confront our terms, we’re content to extend the loan. If those negotiations do not work out and we’re not able to extract what we think is acceptable concessions, we’re not afraid to foreclose on the property. We currently have about $600 million of our portfolio that is currently in the process of foreclosure. We’re not a loan-to-own shop. We do not aggressively make loans with the intent to take over the assets and attain equity type returns. But we are fortunate that the exposure is at a manageable level that our capital is strong enough and our liquidity is strong enough that we can take ownership of these buildings, and we have the ability to do what’s necessary to improve our recovery. That could be funding additional CapEx, that could be funding tenant improvements, leasing commissions, all of the normal stuff that has to happen when you own a property to get it leased up and ride through this cycle to the other side and attain the maximum on your recoveries.

It is a very difficult environment for commercial real estate right now. It’s a very significant headwind. So we’re fortunate that our exposures are manageable. We updated our stress assess results. This is information we posted on the Web site last night that many of you may have seen. Our watch list today is at $1.2 billion. Our stress assess shows that it’s in very severe markdowns and we have seen some of — we’ve generally seen markdowns across the real estate landscape, commercial real estate landscape of 25% to 40% across most asset types. But we’ve seen some as much as 50%, and we’ve seen in some very distressed scenarios where four sellers have been as low as 70%, 75% valuation declines on their assets. But under a 50% valuation reject, we’ve modeled under a stress scenario, which we — that is a stress case for us. It’s not our base case. Under a stress scenario, we could have a $250 million of additional accounting losses. But we think those are temporary and we do believe that our recoveries will be very strong for the reasons I mentioned. But in the meantime, we’ve got to work through this noise in what’s a very difficult market.

Max Broden

And I would just say that $250 million, that translates into roughly 10 to 20 points on our SMR, which at our latest update was north of 1,000% and probably around 10 points on our RBC ratio, which we calculate to be a little bit north of 650% right now. So overall, very manageable.

Taylor Scott

Let’s shift gears to the US business a bit. How are you seeing sales broadly looking as we head into the important year end process? And has the reemergence of face-to-face interactions improved things?

Max Broden

Yes, it has. And that’s why, generally speaking, our — both number of agents is increasing and also the business that we’re doing, where we are seeing growth. Are we seeing growth as high as we would have wanted to be? Probably not. We wish we could do a little bit better than what we’ve been doing. There’s been pockets of a little bit of weakness, especially in the group space. But overall, I think that the rebound that we wanted to see from the franchise is generally coming through.

Taylor Scott

Okay. The issue of lapse rates in the US, it seems appreciate it’s subsided from a little bit higher levels that you experienced as we came out of the pandemic. Can you talk about recent trends there, confidence that, that was sort of idiosyncratic thing that’s behind you?

Max Broden

So I mean, obviously, the US economy went through a period of very significant movement of the labor force. And that’s impacting us as a worksite player. Something that, that has sort of worked its way through the book now and we are in a more normal environment as it relates to natural lapsation. That being said, I don’t think that we have our persistency exactly where we want it to be yet. I think we certainly have room for improvement. Economically, there are significant implications by getting the persistency higher. What it means is that your benefit ratio is going to be higher. You’re going to have a better value ultimately delivered to your customers, because they can really encounter the product in a better way. Your expenses are going to be lower because you can amortize your expenses over a longer period of time. Ultimately, you’re going to have little bit lower distribution expenses. So you can read in what that means. But ultimately, keeping the customer for a little bit longer time is extremely valuable to us. And I think we’ve reached a point where the turnover of the book and the persistency overall got into a too low level overall. So that’s why I’m saying that we are not done. We need to get — deliver products to the customer that brings better value. And also, we’re doing a number of different persistency initiatives, the way we are bundling product, the way we are building in touch points with the customer to make sure that they are filing claims and get more dollars back to them that generally leads to better persistency. There are a number of ways that we can do this. And I think we’re still relatively early in that. What you’ve seen so far and I’ll be honest, I really do think that it’s predominantly a function of just the employment markets are returning to a more normal level.

Taylor Scott

So next, I wanted to see if you could update us on the employee benefits part of the US business. You sort of had this buy to build strategy there. Where we are with that hitting sort of critical mass and adding to the growth story in the US? And is inorganic still an opportunity to add on to that? Do you feel appreciate you’re at the scale you want to be in?

Max Broden

So we’re a couple of years away from getting to scale, probably about three years in that business. And once we get to scale in that business that doesn’t necessarily mean that we are at our long term profitability targets, that will take a number of years to reach that as well. The reason why is because the group life and disability is going through a number of rate cycles. So once you win a case, you price it for a certain IRR. And then on the next, when it comes up for renewal, you expect to reprice it at a higher level. And then the third rate cycle, you need to reprice it to a higher level as well. That essentially means that it takes many, many years for this business to reach target profitability. That being said, the key for us is not necessarily that block of business. We obviously want to get that to profitability, don’t get me wrong. But the reason we got into the group life and disability business was to sell more voluntary benefits. So ultimately, the goal for us is to combine and have a go-to-market strategy where we are selling both group life and disability, but also voluntary group benefits as well.

Taylor Scott

Got it.

Max Broden

We are now almost ready to get to a point where we can build that platform, which, quite frankly, we were not ready to do that yet. So once we are getting both that business to scale but then also have that product offering available to customers, that’s really when I think that those businesses are going to come together and show some better performance.

Taylor Scott

So before we get to the end, I definitely wanted to circle back on capital management and just get your thoughts on, I guess, the priorities in terms of the different ways you can deploy capital, particularly just given the favorable position, especially with some of the actions you’ve taken in Bermuda.

Max Broden

So first of all, I would say, the number one priority is deploy as much capital as you can inside of the operating entities that are meeting our return hurdles. Once you confront our return hurdles, the businesses are not constrained on capital at all, they can grow as much as they want, but they have to confront that hurdle. If you then — everything else essentially is available for moving upstream and then ultimately over time deployed. There are always timing differences of that and that is partly the reason why we travel with relatively high capital levels to make sure that we at all times have the capital available in all the different parts of the company. Where is it going to go? Well, I would say that we did a couple of inorganic deployments in 2018 and 2019 to sort of round out the product offering in the US. I feel appreciate we’re in a pretty good spot as it relates to that. Is it more to be done? Not necessarily. I think we have our hands on the businesses that we really want to be in, which means that, generally speaking, excess capital at this point is predominantly coming back to shareholders through dividends and buybacks. We — through the three quarters, we bought back $2.1 billion of our own shares and we just recently increased the dividend by 19%. So we’re taking some steps in order to return some of that excess capital back to shareholders.

Taylor Scott

Maybe just in the final minute that we have here. You spoke about the Japan regulatory environment earlier. I did want to maybe just come back to that, and we have this ESR ratio that’s coming in. I think at times when you all disclosed that, it looked pretty favorable relative to what we’ve seen from many of the domestic insurers in Japan. So what’s your positioning for those regulatory changes? Are you still in that sort of position? And maybe even to add on advance, how did the interest rate environment impact it?

Max Broden

We feel very good where we are. We think we have a very strong economic solvency ratio in Japan. And there are some tweaks and calibration still going on in the ratio, but nothing that we would expect that would significantly advance the needle. As it relates to interest rates, the vast majority of our in force block is not very interest rate sensitive. So from that standpoint, interest rates moving up or down, it does have an impact but it’s not very dramatic on our overall [liaisons].

Taylor Scott

All right. Well…

Max Broden

And by the way, I do want to say we did disclose — put some slides on our Web site with some updated sensitivity to interest rates to our ESR. So that’s on our Web site for you to find.

Taylor Scott

Great. All right. Well, thanks very much. Thank you, everybody, for being here.

Max Broden

Thank you.

Question-and-Answer Session

End of Q&A