Aflac Incorporated (AFL) Earnings Call Transcript & Summary

Hi, everyone. I'm Ryan Krueger from KBW and pleased to have with me today, Max Broden, who is the CFO of Aflac. So thanks for joining us again this year, Max.

Thank you.

I thought I'd kick it off -- start discussing claims experience first in the U.S. And you've seen quite favorable claims throughout most of the pandemic in the U.S. Can you give us a little color on what you've seen and also how claims have trended in more recent months.

Yes. So our claims utilization tends to have a negative correlation to infection rates overall. So every time we see spikes in infection rates, we tend to see a drop in claims utilization. And this makes a lot of sense when you think about it. People are staying home more. They're not out and about. You get less car accidents. You get less sports accidents. People are not going for elective surgeries, less physical exams et cetera. So all the things that drive claims for us tends to go down as people stay at home more. If you look at this year, it's a great example of that. We had infection levels spike up dramatically over the Christmas, New Year time period. And then we saw, especially in the month of January, a significant drop-off in claims utilization. That started to then gradually increase somewhat in the month of February and March. But then in the second quarter, it kind of stalled and it stalled at a somewhat low level. So this is something that we did experience in 2020, and we see it in 2021 as well. So we are at a lower level than what you would generally expect. And that's why when you look at our more normalized underlying benefit ratio, it was running at 49.1% in the second quarter compared to our reported, including IBNR releases at 43.5%. So that gives you a better feel for what is the sort of core underlying rate. By the way, I would mention that in this correlation we have an element of that in Japan as well, not to the same extent, simply because infection levels are not at the same level in Japan as they are in the U.S. They have been rising more recently, but they haven't been as pronounced as they have been in the U.S.

Got it. I guess the follow-up would be, do you see much risk that at some point in time when we get past the pandemic that there could be some reversal of the favorable experience and you could actually see higher-than-normal claims due to either increased health issues from not going to the doctor or other factors like that?

So first of all, I think it's important to understand that we are generally a frequency company, i.e., what's driving our benefit ratio is frequency, not necessarily severity. There are components of severity, but in the scheme of things, it's really frequency that drives the benefit ratio. And it differs by product. So if you start with, for example, accident insurance, our largest line of business in the U.S., I doubt that you and I are going to go out and have an extra accident as we sort of normalize our behavior post pandemic just because we didn't have 1 last year. It doesn't mean we're going to have 2 the next year. So for that line of business, I do not expect that we will have any sort of over and above frequency, but rather that we just go back to where we were. The one line of business to really keep an eye on and think about is cancer insurance. So we have seen a decline in terms of claims in our cancer line of business. At the same time, we do not believe that cancer incidence rates are down. Just because people are getting COVID and we are in a pandemic does not mean that we develop -- we do not develop cancer at the same rate as we did before. So it's simply that we believe that screenings are not taking place. So we are not detecting it. And when we do eventually detect it, then it's more likely to be at a later stage. So instead of cancers being detected at Stage 0 or 1, we start taking a Stage 3 or 4. So we can have a little bit of an element in terms of severity there. The way this will manifest itself is likely to be that we could have a period of time where we would have above-trend claims coming through. That's something that we monitor closely. And we are well aware of this, we, quite frankly, expect this, and we try to run scenarios on this as well. And that is coming through in the guidance that we gave and outlook that we gave. We try to take this into consideration.

Can you give us just any rough sense of, in the U.S., how big the cancer block is relative to the overall block?

So you can look at -- think about policies in-force being a little bit lower than what the new sales contribution from cancer is.

Got it. Got it. Okay. Thanks. Maybe sticking with claims experience in Japan though. Just I guess, maybe less focused on the pandemic, but just can you discuss some of the short- and long-term benefit ratio trends that you're experiencing in Japan at this point and some of the key drivers?

So on a short-term basis, it is somewhat pandemic-related. So we see some of the same dynamics in Japan as we do in the U.S., but not to the same extent. And as I said earlier, I think it's because infection rates have been lower in Japan than in the U.S. And their whole hospital system have been operating on a more normal basis and have had seen less disruptions compared to what we see in the U.S. Therefore, it's been more normal there. The long-term trends are, we talked about this for many years, and we sound like a broken record, but it's still what's going on is that hospitalization trends and stay in hospital for certain procedures continue to be on a decline. And the reason for this is simple -- simply that there's a significant shortage of beds in Japan, and the need for health care services are increasing as the population is increasing in Japan. And these trends, we don't really see changing. We continue to see, obviously, the population aging. We don't see an increase in supply of hospital beds. And therefore, this will continue to put pressure on hospitals to shorten the stays. There's also a greater use of outpatient services as well. And you take all of this together, and it leads to favorable outcomes in terms of actual to expected on our policies, especially our cancer block of business.

Okay. if I think back several years ago, I think there was some expectation by Aflac that this was going to slow down at some point in time. But is it fair to say you haven't really seen much of a slowdown in this trend and the shorter hospital stays is kind of continuing at the same pace?

The trend is, obviously, it's not going to be as dramatic going forward as it's been in the past. And that's just simple math, you can't have that continuously. The curve is going to start to flatten out eventually. So we've seen some of that flattening and out to happen, but the trend is still on the decline. One thing I would like to point out, though, that when we priced new business, we do not price for discontinuous improvement to continue as we price for current experience when pricing new policies.

Got it. Moving to persistency. Probably when we spoke at our conference a year ago, there was definitely the thought that U.S. persistency was probably going to deteriorate due to pandemic-related conditions, but it seems like you just haven't really seen that. Can you talk about what has occurred? And then also, I know you have some other actions you've been specifically taking to try to improve persistency in the U.S.

Yes. So you didn't ask about Japan, but I do want to mention that in Japan, we see very stable persistency. It has remained in the 94% to 95% range. And so we haven't really seen any impact there from the pandemic conditions. You're right that in the U.S., as we entered the pandemic, there were clearly a lot of uncertainties how this was going to play out economically, behavior, ultimately, how claims would come in, et cetera. So as we thought about it and when we were running internal stress tests, we were definitely thinking that persistency could become an issue because of economic pressures, increased unemployment rates, et cetera. That has not played out. And clearly, that's very fortunate. Unemployment rate is at a very low level, and we have actually experienced an increase in persistency rate. In the U.S., we're currently reporting, at the end of the second quarter, persistency over 80%. Now I do want to caution because there are 2 components that have sort of pushed it up from pre-pandemic levels. We were around the 78%, and we've now moved up to slightly above 80%. There are 2 components that I would argue are onetime in nature and not necessarily something that I would expect long term. So the first is emergency orders by states. So states have put in place a no-lapse emergency order, which means that if a policyholder is not paying the premium, we are still not allowed to lapse the policy. That -- and you still have a number of states with emergency orders in place. We estimate that, that increased our June -- sorry, the second quarter persistency rate by about 60 basis points. You also have the impact of our lower sales. So lapse rates on first year policies is about twice the level of lapse rates of policies that survived the first 13 months. So that means that in years or time periods when you have significant sales increases, you tend to actually see your persistency go down. And in times with lower sales, that we are in a time period we've been in right now, persistency naturally goes up simply because of this mechanic. We estimate that in the second quarter that improved the persistency rate by about 80 basis points. So there's still some natural improvements in play going on. And there were some deliberate initiatives that we took last year, and that was in order to drive agent persistency, account persistency and ultimately, policyholder persistency. So we introduced a number of new products, value-added services to make it easier and better for agents. We also added agency loans to make sure that they could stay in business even as production levels were quite low. And we also ran wellness campaigns and notified policyholders of the wellness component of their policies so they can get some extra cash as well. And we believe that all of this all together have helped to push up our persistency. That component of the improved persistency rate, I do view as real and hopefully that should be permanent.

Got it. I mean if you were to normalize for the 2 factors that are less permanent, do you think you can do more to improve persistency over time? Or are we kind of at a pretty good level at this point?

No, I do think we can do more. And a lot of it, it is coming down to driving all these components. So the better our agents are doing, the longer they stay in business, that means that they're going to serve their accounts better. The better they serve their accounts, the more likely persistency is to go up within those accounts. When accounts get served well, the policies that are associated with that work site account stay in place for longer as well. So it is -- we're trying to improve persistency in all these 3 levels, and they're also connected. So if we do a good job of this and these are our efforts that we have a lot of initiatives implied in order to drive this long term. Because at the end of the day, acquiring a new policy costs a lot of money. There's significant customer acquisition expenses for us. So if we can rather spend a little bit of money in order to keep existing customers 0.5 year, 1 year, 2 years longer and collect those premiums, that is economically very, very attractive to us and long term should improve premium rates.

Got it. Thanks. Let's move to expenses. So you've had some pressure on expense ratios, I think from 2 things, top line pressure but also investments into new business initiatives, but then you've also taken off some offsetting actions to reduce expenses. Can you talk about where you see expense ratios headed in both the U.S. and Japan over the intermediate term when you take these things into account?

Yes. So unfortunately, a lot of things have moved against us. So lower revenues and then we also had to invest significantly in order to stand up a couple of new businesses in the U.S., like group life and disability, network dental and vision and direct-to-consumer. All of these are not fully contributing in terms of revenue generation, but we got the expenses for it. So we get hit at both the numerator and the denominator, and that has obviously led to expense ratios, especially in the U.S., that are too high. And therefore, we are attacking that both by cutting expenses and then, obviously, we strongly believe that as the new businesses come on stream and start generating revenues, we are going to get an uplift there, and that certainly should help. And in the U.S., we hope that this should start to play out already next year, with a slightly lower expense ratio than what we are running at for the full year this year. In Japan, it's more of a slow grind where it's -- I would expect our expense ratios on a GAAP basis to be fairly stable. And part of this is that from -- on a GAAP basis, we do continue to have some headwinds in terms of revenue generation because of the paid-up impact on primarily our first sector savings block. We are -- we were through the time period of the 5-year paid-up impact from the waste block, but we do have a block of business of 10-year pay products. And there, really, we're going through the paid-up impacts of that with associated revenue headwinds here in 2022, '23 and '24. That's not going to have as significant impact as the 5-year paid-up impacts were, but it's still going to be a headwind for us. So we're sort of each year sort of the starting point is that we need to cut in order to stand still and be at the same ratio, so to speak. So it's going to be a little bit challenging, but I do believe that our expense ratio should be roughly flat.

That's helpful. I'm going to shift gears a little bit on to sales. In Japan, there's like quite a number of different dynamics going on between the Japan Post, new products, pandemic. Can you talk through some of the dynamics that are impacting Japan sales at this point? And also help us think about the potential outlook for the second half of the year?

Yes. So thinking about the second half, obviously, if you start with Japan Post, they began actively selling again in the second quarter. As I'm sure you understand it, this is a significant organization. They went through a lot of change, and a lot of that change is moving to a new sales model, a new compliance model, et cetera. So to get training up and running on the sales and distribution people and also get the confidence among them, plus the confidence among consumers, it's going to take a while. And so I think that the recovery there is really going to be slow and gradual. At the same time, we're very confident that over time, Japan Post will continue to be a very significant distributor of ours. And their standing in Japanese society will continue to remain strong. If you then turn to the other distribution channels, to some extent, we are dependent on the virus environment. You have seen case counts in Japan rise that has led to a number of emergency orders, state of emergency being declared in a number of prefectures. And you may have seen us -- even yesterday, Japan extended for a number of important prefectures for us, i.e., for example, both Tokyo and Osaka extended the state of emergency until the end of the month, i.e., September 30. So all of this is making it a little bit more difficult on the margin for us to interact with consumers, because the fact of the matter is that the more confident the consumer is to interact with us on a face-to-face basis, the more sales -- the more meetings and sales we're going to generate. And we're also more efficient in terms of close rates when we do it face to face rather than virtual. So even though we do have the virtual capability in place, it is not as efficient as a face-to-face selling. So all that -- you take all of that together, and I think it still stands that we do expect the recovery in the second half, but it's going to be slow and gradual.

Thanks. You also, on the last quarter call, I think for the first time discussed plans to enter the elderly supplemental care market in Japan, which would be a new market for you. Can you give a little more detail on the product characteristics that exist in this market and also how you see the potential growth opportunity over time?

Yes. So clearly, the aging population in Japan, it leads to significant market headwinds for certain products. For something like nursing care, we see significant underlying demand. In fact, the percentage of Japanese individuals aged 75 and over is about 15% right now. But in just 10 years' time, it's expected to rise to close to 20%. So this is a market where the -- that will experience most likely significant underlying demand growth. And that's where our product is coming in where we do think that we can help filling that gap. Now I do want to make it very, very clear that nursing care in Japan is different from how products were priced in terms of the long-term care market here in the U.S., especially back in the pre-2000 sales of long-term care policies. So first of all, you have a much more extensive government long-term care program. And our product is sitting alongside that program, and we carry the same definitions that triggers care generally as the government program, which makes it sort of supplemental in nature. We also have made sure that as we price this product, we make sure that we price it for very low lapse assumptions because this is a product that inherently have been lapse-supported in not just the U.S. but in many jurisdictions around the world. We're clearly in a low interest rate environment, and we should probably when we price a product like this that tends to be long term in nature, you need to obviously price for the low interest rates to stay as well. So we feel quite good about the pricing that we can achieve on this product. And then also long term, the clear underlying demand for it. And then the third angle of it, obviously, will be that this needs to be risk managed and we risk manage it by capping payouts, make sure there's no unlimited payouts. We sit alongside the government and make sure that the interests between the government policyholders and the insurance company are aligned.

Got it. In the U.S., can you talk a little bit about how the sales recovery has differed so far between your traditional career agent channel and in the group or broker channel? And then also how sales are tracking so far this year relative to your expectations?

So the broker channel clearly have done much better than the career agency channel, and you would expect that to be the case. The career channel, this is what you should think about as going after small businesses. Generally, the target is the 3 to 99 marketplace. These sales are being conducted at the work site and face to face. Well, we were chatting just before this fireside share that both Ryan and me were actually at our work sites today for the first time in a long, long time. And that's just one example. People are generally not at the worksite. And people's confidence to transact face to face is not really there. This has been the case throughout the pandemic. And therefore, obviously, something like the career channel will be heavily impacted by that. The other thing I wanted to mention as well when it comes to career channel is recruiting. That's also been challenged. We have a model where we generally do not recruit licensed agents. We tend to go after noninsurance salespeople and we bring them in and we train them and we license them and bring them into our company. That's generally how people come into the Aflac sales and distribution network. And we have a very strong culture around this. When the pandemic hit, a lot of states did the licensing not online, but face to face, and they actually shut it down. So we have had -- in a number of places, we could not even license new recruits. So it made it really difficult for us to recruit and license and grow. And that is important in our model, which is a fairly high recruitment of agents that occur all year, and the survival rate is a little bit lower than what you will find than if you were to, for example, recruit licensed -- already licensed agents. So that means that our career model stands out a little bit compared to many other models that you see in the insurance space. And that also means that we are heavily impacted by the pandemic and probably more impacted than many other distribution channels because of that. When you move to the broker channel, it's a different story. And our broker channel have continued to chug along pretty good. Here, we're targeting large corporates that, to a greater extent, already pre-pandemic were doing enrollments virtually. As an example, I worked for a large corporate. I've enrolled virtually done that ever since I arrived at Aflac, and that's how it works. You don't necessarily sit down with an enroller face to face. So the processes and procedures in the broker channel are much easier to sort of overcome. So that's why you have gradually continued to see growth rates for the broker channel and most of the pressure we're really seeing it in the career agency channel.

Can you give an update on your -- the progress you've made so far in some of your newer growth initiatives in the U.S. in regards to group dental and vision and direct-to-consumer?

Yes. Let's take them in opposite order. So direct to consumer, this is where we were standing up a brand-new digital platform where consumers, regardless of their -- if their employer are offering Aflac or not, can gain access to Aflac policies. This was launched in the beginning of January of this year. And this is a full end-to-end digital platform that is completely new. In the beginning as we continue to sort of test it out, we restricted the flow to the direct-to-consumer website and that has gradually been lifted. So we're now seeing more and more flow coming through and the sales are gradually increasing as well as a function of that. At this point in time, it's -- in the scheme of Aflac it's still relatively small, but it's certainly building and we expect this to be meaningful over time. This is a channel we believe that more and more consumers would like to use. One thing I want to mention, though, is that obviously, from a P&L standpoint, growth in this channel is negative. So first of all, we have incurred expenses to build up the platform. And now as we start selling, we -- the acquisition expenses are not deferred, i.e., we cannot back it the same way we can do for a traditional agency-sold policy where commissions are backed because we cannot track any specific acquisition expense to a specific policy and therefore, we can't back it. So this business is likely to generate losses for a couple of years, even as it gains scale. If you turn to network dental and vision. This is coming out of the Argus acquisition, which was really a TPA that we acquired that generally serve major medical companies and did the administration for dental and vision programs. But in there, we also saw a great opportunity to use some of the capabilities that they have to grow out a national network dental and vision product. And we are doing that right now. We are now being licensed in more and more states and the network is building. So we are slowly starting to be in the market selling that product as well. I expect that to be relatively low this year, but starting next year is really when we should really see the dental product contribute more to our sales. Then it will take probably about 2 to 3 years for it to gain enough scale where it's throwing off profitability as well. If you now lastly take the group life and disability business that we acquired through a reinsurance transaction from Zurich, we're still in the building phase of that. There is an existing business. So it generates some sales, it generates some premiums, but we're still sort of growing it. We're still building connections with brokers and companies. And we're sort of still the new kid on the block. I would describe that we bought a building with a lot of the infrastructure there, but it wasn't fully decorated on the inside, and that's really what we're doing now. So we're decorating it in order to make sure that it fits with Aflac and it fits with the rest of our product portfolio because we do want it to do well on itself, but it's very important that to strengthen the sales of the other Aflac core products as well because that's really how we get this sort of 1 plus 1 to become 2, and hopefully more than that over time.

Thanks. We'll shift gears a little bit to the balance sheet. You have -- you stepped up share repurchase in recent quarters, but you still have a pretty strong excess capital position at the company. How are you thinking about that balance at this point between redeploying capital above and beyond your free cash flow versus retaining a cushion going forward?

Yes. So part of the reason why you have this very strong cash and capital position at the holding company is that in the very beginning of the pandemic, we raised $1.5 billion of capital through debt securities and we have since then kept that at the holding company. That was out of an abundance of caution, because when you go into what could have been an economic, could have been a financial crisis, you need -- more capital is very, very important. So this capital has essentially been sitting there. And fortunately, we haven't had a need to use it. Over time, I would expect that we're not going to sit with this kind of cushion at the holding company. It's a significant capital cushion. It's also a drag on our return on equity. So it's important that this gets invested wisely either through projects that can grow our business or it will be returned to shareholders through dividends and share repurchase. You said that correctly that we have stepped up our share repurchase a little bit this year. And your question, would we philosophically be willing to repurchase or deploy capital more than our sort of free cash flow generation to the holding company, and I would say that philosophically, there's no reason why we couldn't do that. Our capital position is and should always be a function of the risks and opportunities that we face. So we want to make sure that we have strong capital ratios in our operating subsidiaries, which I do think that we have today, both today and given the growth opportunities that we're seeing in the U.S., we have a high RBC ratio that can help us fund any new business strain coming from the different new initiatives that we talked about earlier. So our capital at the holding company and the cash flow that we do receive is a very strong foundation for -- continue to increase the dividend and being a strong deployer of capital back into our own stock or through other projects that can grow the franchise long term. But philosophically, it could -- does that mean that we temporarily could have deployment that is greater than the free cash flow, absolutely. And the other way around as well. So there will be times when we run lower than our free cash flow and times when we run higher than our free cash flow. But basically, we should make sure that we, over time, optimize the level of capital to the risk and the opportunity set that we see.

I guess I'll move to a topic we all will be discussing more, unfortunately, which is LDTI. I guess it seems like Aflac has directionally discussed the GAAP LDTI impacts more than most of your peers so far. So I'm curious when you might consider disclosing the quantitative impacts to the market?

Yes. We still haven't decided when to exactly come out with that. I do anticipate to advance the ball somewhat at our FAB later on this year. But in terms of the exact impacts and sensitivities, we still haven't fully decided about that. The one thing I do want to make clear though is that the LDTI implementation is a very significant overhaul of our accounting framework, and it's probably the biggest one in a long, long time for U.S. life insurance companies. This has no impact on the way we manage and run the business, and has no impact on the way we manage capital as well. So we deem any sort of movements to generally be noneconomic in nature. Now we have also been quite clear saying that the day 1 implementation could have a negative impact on our AOCI. And it's -- to make a complicated issue quite clear, I would describe it as the following. The main reason for that is our long-duration liabilities in Japan. And that means that we sold the business a long time ago. At that time, we locked in the discount rates at the interest rate levels at that point in time. And clearly, interest rate levels are now much, much lower. So when you then move to a current discount rate, for discounting those liabilities, clearly, that's going to be significantly lower, which means it leads to higher reserves, and that's going to flow through AOCI and decrease shareholders' equity. But at the same time, the offsetting impact is morbidity. That's been very favorable for us over time, but we can't add fully have that as an offsetting factor in the LDTI mentation on day 1.

I just wanted to ask one more on this, which is given your comment about, obviously, it doesn't change the economics of how you run the business. Are there alternative metrics that you're considering providing like an embedded value metric or more on free cash flow or those types of things to augment the GAAP exposures?

So it's something that is up for consideration. We clearly -- we have developed those metrics. We use those, especially VNB metrics, we use that in how we look at our new business both in Japan and the U.S., and we value distribution channels based on these product lines based on this and blocks of business based on this. So it's something that we potentially would consider. And I would argue that this is probably something that we, as an industry, are going to get together and really discuss because I think it's important that we find consistency among the different players. That's going to make it easier in the conversations that we have with you, and I think it's going to make your job a lot easier as well. So it's still to be determined, but it's definitely something that we are using internally more and more.

Great. Well, I think we are out of time. So we'll wrap it up there. Thanks a lot, Max, and to Aflac for participating and to the audience for listening. And we will end it there.

Thank you very much.

Thanks.

Appreciate it.