美國家庭壽險 (AFL) 2012 Q3 法說會逐字稿

Welcome to the Aflac third-quarter earnings conference call. Please be advised today's conference is being recorded. I would now like to turn the call over to Ms. Robin Wilkey, Senior Vice President of Aflac Investor and Rating Agency Relations.

Good morning, and welcome to our third quarter call. Joining me this morning is Dan Amos, Chairman and CEO, Kriss Cloninger, President and CFO, Paul Amos, President of Aflac and COO of US Operations, Ken Janke, Executive Vice President and Deputy CFO, Eric Kirsch, Executive Vice-President, Chief Global and Investment Officer, and Tohru Tonoike, President and COO of Aflac Japan is joining us today from Tokyo.

Before we begin, let me remind you that some statements in the teleconference are forward looking within the meaning of federal securities laws. Although we believe these statements are reasonable, we can give no assurance that they will prove to be accurate because they are prospective in nature. Actual results could differ materially from those we discussed today. We encourage you to look at our quarterly release for some of the various risk factors that can materially impact our results. Now I'll turn the program over to Dan who will begin this morning with some comments about the quarter and our operations in Japan and the United States. I will then follow up with a few financial highlights for the quarter in the first nine months and then we will be glad to take your questions. Dan?

Thank you, Robin. Good morning, everyone. Let me begin with a review of Aflac Japan, our largest earnings contributor. We were again pleased with Aflac Japan's strong financial performance and phenomenal sales momentum that continued into the third quarter. Following two years of tremendous sales growth, new annualized premiums, sales rose 31.7% to JPY55.7 billion in the third quarter. These results significantly surpassed our expectations again and marked the fifth straight quarter of record sales production. For the first nine months of the year, Aflac Japan's total annualized premium sales in yen rose 43.4%. Record sales growth, combined with continued strong persistency, contributed to Aflac Japan's double digit increase in premium income for the third quarter. Premium income increased 10.7% to JPY346 billion. Revenue growth was also strong in the quarter rising 10% to JPY404 billion. Pretax earnings were JPY78 billion, down 1.4% and for the nine months pretax earnings were JPY238 billion, up 1.4%.

The bank channel generated JPY26.9 billion in sales which represented an increase of 85.3% over the third quarter of 2011. The bank channel accounted for 48.6% of Aflac Japan's total new sales in the quarter. From a product perspective, WAYS, our unique hybrid whole life product, continued as our top seller in the third quarter generating an increase of 108% over 2011 and accounted for 50% of the total third quarter sales. Our sales management team has done an excellent job ensuring the transition from 5 pay WAYS to 10 pay WAYS has gone smoothly through all distribution channels. Additionally, sales of 10 pay WAYS in the quarter was much stronger than we originally anticipated. Sales for the medical category was also strong, rising 11.7% in the third quarter and benefiting from July's introduction of the revised nonstandard medical product. Given the current low interest rate environment, we continue to employ strategies to enhance the profitability of our child endowment and WAYS product. In the third quarter, all distribution channels stopped selling 5 pay WAYS.

Beginning this week, we lowered the interest rate credit from 0.5% -- from 1% to 0.5% for discounted advance premium or DAP. This credit essentially increases the total premium paid. The profitability of WAYS and child endowment will be enhanced in April of 2013 when we lower the assumed interest rate for new product pricing. Considering Aflac Japan's very strong sales results for the nine months, we think sales could be challenged for the remainder of the year. We anticipate the additional sales growth hurdles in the fourth quarter will come from consumers' response to a lower credit given for the DAP. As a result, we expect sales to be in the range of flat to up 15% for the quarter. Taking all of that into account, we now expect 2012 Aflac Japan sales to rise 30% to 35% year over year.

But let me say that even before the fourth quarter began, my mind had already shifted to 2013 and the challenges we face following five straight quarters of record breaking sales results. I want to point out that the bank channel represents a larger portion of our business so projecting future sales results becomes more challenging. Also, we won't gain insight into 2013 bank sales strategies until closer to the start of Aflac -- of Japan's fiscal year which starts April 1. Although marketing plans for Aflac Japan are being finalized for 2013, we already see some challenges on the horizon. We know that Aflac's brand is strong throughout Japan and this enhances the appeal for our products.

For the last two years, as all of you know, our sales has been spectacular due to the WAYS and child endowment products, particularly through banks. During that time, investment yields have been lower thus putting pressure on the profitability of these products. As I said earlier, we started implementing adjustments to improve profitability including the reduction in DAP that went into effect early this week. More importantly in 2013 with the rate increase going into effect on new policies due to lower assumed interest rates, I think you are likely to see sales slow down but generate higher profitability which would create higher profit margins for Aflac Japan going forward.

Now let me turn to the US operations. From a financial perspective, Aflac US continued to perform very well this year. Although new sales growth has been constrained, our top line growth has been consistently strong through the year in large part reflecting an improved persistency with each quarter. We believe there are a couple of reasons for this improvement. First, with the economic uncertainty over the last several years, workers have been reluctant to switch jobs and people are more likely to keep the benefits they currently have. Secondly, we've enhanced communication with the policy holders at important touch points and we know this has resulted in better policy retention. I also think we have done a good job in managing the US operation including budgets and people resources.

Our benefit and expense ratios are lower than a year ago, resulting in stronger pretax operating earnings. Aflac US revenues grew 5.2% for the quarter and 5.2% for the first nine months. Pretax earnings were up 21.5% for the quarter and 11.5% for the first nine months. Premium income increased 5.2% for the quarter and 5.3% for the first nine months. Aflac US annualized premium sales declined 1.5% for the quarter, however for the nine months of the year, sales growth was positive with total new annualized premium sales rising 1.5%.

We continue to see the economic landscape in the US as challenging especially for small business segment where more than 90% of our products are sold. Although the most recent government data shows that unemployment rates improved slightly, small business continue to hold back on hiring. The national federation of independent businesses, which focuses on small business owners, reported this month that fewer jobs were created in September than in the two previous months. Additionally, the percentage of small business owners who plan to create new jobs in the future is historically at a weak level.

We have continued to make structural changes to our marketing and sales area to maximize our future growth. While these changes have been more disruptive in the short term than we originally anticipated, we believe this will enhance our long-term results. With the election less than two weeks away, many business owners are reluctant to make changes in their benefit programs until there is greater clarity in the US economic outlook. With the uncertainty and nine months of results, I think it's likely that Aflac sales for 2012 will be roughly flat.

Having updated you on our operations, let me give you some details related to our global investment division. For the last several years, our primary focus has been on investment risk management while investing our significant cash flows and assets of relatively higher quality and liquidity. As you know, we made considerable progress in proactively be at risk in our portfolio over the last four years to enhance the strength of our balance sheet. In the process, we have significantly reduced our exposure to perpetual securities, peripheral European sovereign debt and financials, especially in Europe.

In fact, we reduced our exposure in these categories by $1.4 billion during the quarter and $3.8 billion year-to-date which further improved the overall quality of the portfolio. Impairments were relatively small in the quarter, however, the European market still represents an area of potential risk and we remain cautious. But I am convinced we are much better positioned to accommodate that volatility as a result of the derisking efforts. As we have stated for many years, our greatest investment challenge has been to invest Aflac's significant cash flows at reasonable investment yields. Our recently employed US corporate bond program has been effective means of enhancing our new money yields in Japan. You will recall that our initial objective was to invest JPY200 billion or about $2.5 billion in US dollar denominated publicly traded corporate bonds and then hedge the currency risk. We completed that pilot program in the third quarter and are very pleased with the results it generated. In the third quarter, the new money yield on the corporate bond program was 3.6%. Aflac Japan's total new money yield for the quarter was 2.76%.

These yields do not reflect hedging costs for the program which was 41 basis points. Based on the success of this program and market conditions, we plan to invest two-thirds of Aflac Japan's fourth quarter cash flow. This successful investment program allows Aflac Japan to surpass our budgeted new money yield for 2012 up 2.05%. It also enhances the profitability of our more interest sensitive products and benefits next year's investment income growth. Finally, I'm pleased with the continued progress in the transformation of our global investment division. We continue to grow our investment team, build new infrastructure support, develop new investment strategies with the elements of our recently completed strategic asset allocation project. We believe these efforts will include the risk return profile for our balance sheet and further our objective as a world class investment operation.

Now I will turn to Aflac's consolidated financial performance. Operating earnings per diluted share were better than expected rising 7.3% to $1.77 for the quarter. There was no impact from foreign currency in the third quarter. It's important to note that even without a lower effective tax rate, operating earnings per share would have been right in line with our objective and guidance. For the nine months, operating earnings per diluted share rose 5% before the effect of the yen. Net earnings in the third quarter of 2012 included after tax realized investment gains of $186 million or $0.39 per diluted share compared with after tax losses of $34 million or $0.08 per diluted share in the third quarter of 2011. I am pleased the investment strategies we've implemented have improved the quality of the investment portfolio and benefited the bottom line. I'm also pleased that our capital ratios remain strong which demonstrates our commitment to maintaining financial strength and flexibility. Although we have not yet finalized our statutory financial statements, we estimate that the RBC ratio was between 575% and 600% at the end of September.

We expect Aflac Japan solvency margin ratio to remain at the high end or above our 500% to 600% target. Given the strength of our capital ratios and our parent company's liquidity, we believe we can allocate up to $100 million toward the purchase of our shares in the fourth quarter. Purchasing shares later this quarter won't have much impact on 2012 earnings per share growth, but it will benefit us in 2013. I will also stress that we have been prudent and any decision we make will certainly take into account challenges within the macro-economic environment, especially as it relates to Europe. As we frequently discussed, profit repatriation remains a primary source for funding share repurchase. You may remember from our second quarter call and the Tokyo analyst meeting, that we expect profit repatriation to be around JPY65 billion for 2013. We still believe that's a reasonable estimate assuming that we have no additional investment losses that would reduce Aflac Japan's operating income. Next year's profit repatriation could provide us with significant amount of capital that could be deployed with share repurchase.

I was very pleased that the Board of Directors approved a 6.1% increase in the quarterly cash dividend effective with the fourth quarter payment. This marks the 30th consecutive year we've increased cash dividends to the shareholders. We continue to believe that we are well positioned to achieve our stated earnings objectives of 3% to 6% increase in operating earnings per diluted share excluding the impact of foreign currency. In the second quarter, we had guided toward the low end of the range. However, reflecting the lower annual effective tax rate, we now expect operating earnings for 2012 to be better. If the yen averages JPY80 to $1 for the last three months of the year, we expect reported operating earnings for the fourth quarter to be in the range of $1.46 to $1.51 per diluted share. Under the same exchange rate assumptions, we expect the full year operating earnings to be $6.58 to $6.63 per diluted share, which would be roughly a 4% to 5% increase on a currency neutral basis. We believe this is reasonable and achievable.

Importantly, we continue to believe that 2013's operating earnings per share will increase 4% to 7% on a currency neutral basis. In addition to operating earnings growth, we also focused on producing industry leading return on equities. On an operating basis, the third quarter ROE was 25.2%. For 2012 and 2013, we continue to believe it's reasonable to see operating ROE in the area of 22% to 26%. We remain focused on our vision of being the leading provider of voluntary insurance in the United States and the number one provider of supplemental insurance in Japan. In both segments, I am confident in our brand, the fundamental needs of our products, and more importantly the success of Aflac. Overall, I believe we had the best quarter since 2008. Robin?

Thank you, Dan. Now, let me start with a few financial highlights, first with Japan. Beginning with the top line in yen terms, revenues were up 10% for the quarter which is the first time we've had double digit growth in revenues since 1997. Investment income was up 3.7% and the persistency rate improved in the quarter. The annualized rate, including annuities for the first nine months of 2011, was 94.8% compared with 94.4% a year ago. In terms of operating ratios for the quarter, the benefit ratio to total premiums increased over last year as a result of the impact of first sector products, primarily the WAYS product. It was 73.1% in the quarter compared to 70% a year ago. The expense ratio for the quarter was 18.1% down from 18.8% in the third quarter of 2011 reflecting lower commission costs associated with strong sales of first sector products, primarily WAYS. Reflecting the higher benefit ratio, the pretax profit margin decreased from 21.6% to 19.3% in the quarter. Pretax earnings decreased 1.4% in yen terms for the quarter.

Now let me turn to Aflac US. Total revenues rose 5.2% for the quarter. The persistency rate continued to improve in the quarter and annualized rate for the nine months was a record 76.9%, up from 75.9% a year ago. And looking at the operating ratios for the quarter, the benefit ratio to total premiums decreased over the last year going from 56.8% in the quarter compared to 59.1% a year ago. The lower benefit ratio for the quarter is largely the result of lower paid and incurred claims experienced during the quarter. The operating expense ratio decreased slightly going from 31.5% a year ago to 31.2%. Benefiting from lower benefits and expense ratios, the profit margin expanded to 18.4% compared to 16% a year ago. As a result, pre-tax operating earnings increased 21.5% for the quarter.

Now let me turn to investment activity for the quarter starting with Aflac Japan. For the third quarter, approximately $2.5 billion of new cash flow was invested in the corporate bond program for a gross yield of 3.6% and a hedge cost of 41 basis points. The yield net of hedge costs was 3.19%. For the quarter, total new money cash flow invested in Japan was $5.2 billion. The gross total new money yield for that cash flow was 2.76%. The yield for the total new money net of hedging was 2.56%. That gives you the hedging cost for the total portfolio of 20 basis points. The weighted average duration of the forward contracts executed this quarter is five months and range from three to six months. During the quarter, approximately 55% of the corporate bond purchases have a maturity of 8 to 10 years and 45% have a maturity of 18 to 30 years.

Approximately 44% of new cash flow was invested in JGBs in the quarter for an average yield of 1.72%. The portfolio yield at the end of quarter was 2.8%, down 26 basis points from the end of June and 58 basis points lower than a year ago. According to Bloomberg, 20 year JGBs during the quarter were 78 basis points, a 6 basis points decrease from June. Additionally, to enhance our investment income, this quarter we executed on a six month securities lending program involving approximately $6.5 billion of assets from the Japan portfolio. All of these assets were JGBs.

Now let me turn to US investments. The new money yield for the quarter was 3.94%, a decline of 43 basis points from June 30 and 183 basis points from a year ago. The yield on the portfolio at the end of September was 6.51%, down 8 basis points from the second quarter and 21 basis points from a year ago. Turning to some other items in the quarter, noninsurance interest expense in the third quarter was $45 million compared to $44 million a year ago. Total company pretax operating margins decreased reflecting the increase of the benefit ratio in Japan caused by increased sales of the ordinary line of business.

Parent company and other expenses increased only slightly from $14 million to $15 million in the third quarter. Also in this quarter, the Company revised its estimate of the full year effective tax rate resulting in an increase of operating earnings of $17.5 million or $0.04 per diluted share. The company also recognized the tax benefit of $29.5 million or $0.06 per share primarily from a favorable outcome of a routine tax exam for the years 2008 and '09. The total impact of these items was $47 or $0.10 per diluted share. Going forward, we expect the effective tax rate for the remainder of the year and 2013 to be somewhere between the range of 34% to 34.5% assuming FSA earned premium is flat year over year.

The pretax margin went from 19.4% to 18.2% and on an operating basis, the tax rate was 31.3% compared to 30- -- 32.6% a year ago. Net earnings per diluted share for the quarter were $2.16 compared to $1.57 in 2011. Lastly, let me comment on our earnings outlook for '12. As you heard, we raised our outlook for '12 to increase operating earnings per diluted share. If operating earnings per share increased between 3% and 6% in the fourth quarter and the yen averages 80 for the remainder of the year, we would expect operating EPS to be between $1.46 and $1.51. That compares with current first call estimates of $1.53. This estimate reflects our plan to substantially increase IT expenses and expenditures related to marketing and advertising in the fourth quarter.

Additionally, if you back out the $0.10 operating earnings benefited from the tax items during the quarter, reported operating earnings per diluted share were $1.67 which would be right in line with our guidance, as Dan said. Using the same foreign currency assumption, we would expect full-year operating earnings to be somewhere in the range of $6.58 to $6.63 per diluted share. Now we will be glad to take your questions. To be fair to everybody, please limit yourself to one question and only one follow-up that relates to your initial question. We are ready to begin, please.

We are now ready to begin the question and answer session.

(Operator Instructions)

Nigel Dally, Morgan Stanley.

Great. Thanks and good morning, everyone. My question is on capital. With the 65 billion yen repatriation estimate, are you expecting to retain any of that capital in your US hub or should all of that make its way to the parent? Also, you discussed an initiative to monetize some of the deferred tax assets in the US that you may invest today. Can we also get an update as to where you stand on that initiative? Thanks.

Nigel, this is Ken. Right now, as we mentioned, the JPY65 billion we still believe is a reasonable estimate for next year's profit repatriation. We currently anticipate returning to our normal dividend policy for our Aflac US up to the parent company to support the quarterly cash dividend payment and other parent company obligations. In terms of funding the share repurchase activities that we've anticipate for 2013, I think the combination and our ability to further dividend upstream plus the liquidity that we have on hand would enable us to do that. We were sitting at approximately $950 million of cash at the parent company level at the end of September after dividend payments in the $100 million of repatriation in the fourth -- excuse me, repurchase in the fourth quarter will probably be around $785 million of cash at the end of the year.

As far as the DTAs go, we have generated gains this year of -- unfortunately the gains that we generated have gone against the taxable losses that we incurred as part of the derisking activities and selling assets at a loss. We are still looking at actually a couple of strategies that we think will help address the DTA issue going forward. But we still have a little more work to do on those.

Okay. Great. Thanks.

Jeff Schuman, KBW.

Thanks, good morning. I was wondering if you could update us on the current marginal profitability of WAYS because you changed the rate on DAP. You've implemented the new money strategy. You discontinued 5-pay WAYS. Several things going on there that should enhance the marginal profitability but I was wondering if you could give us a read there, please.

It definitely has. I'm going to get Kriss to cover that.

Okay. Jeff, I'd kind of lead you back to what we reviewed at the analyst meeting in September in Tokyo. The information we laid out on the presentation at that time showed what the impact on profitability would be on the current core products with current core pricing -- current core product pricing if we were able to achieve an increase in say interest assumption on invested assets from say 2% to 2.25% or 2.5%. And those charts showed that at 2% interest new money, we would have a profit margin on WAYS that range from 8% to 12%. If we achieved an increase to 2.25% new money, we would expect that margin to go up to 13% to 17%. And if we could get 2.5%, we would go up to 17% to 21% expected profit as a percent of premium over the life of the contract. So with the new investment program, we've had some real positive impact on our ability to enhance new money yields.

That being said, for the short term, some of that increase in new money yields is going to be offset. I mentioned this in Tokyo again to try to moderate the excitement a little bit. Some of that increase in new money yields got to fund the increase in investment expenses for personnel and infrastructure et cetera, associated with the new investment team and that will dampen things for say six months to a year a bit. But it is a long term improvement in profitability and that will be important. Now we did October 22 decrease the credited interest rate on the discounted advanced premium from 1% to 0.5%. That basically gives us an extra 50 basis points on the funds held under that program and the funds held under that program basically represent 50% of the total premium ever collected on the contract because we collect total premiums due during the contract on day one and just for example on the 10-pay WAYS, we would collect the first full 10 premiums. We would apply the first premium to the policy the day we collected it.

On balance, we'd have 9 premiums on deposit for the next nine years on average we would have 4.5 premiums on deposit and an extra 50 basis points which gives us roughly an extra 2.25% of premium profit over the life of that particular contract. Things are headed in the right direction is all I can tell you. And then in April, we will have the potential repricing when the standard interest rates decline to 1% and we will definitely have repricing activity at that time. We will try watch what competition is doing. We don't want to give ourselves a competitive disadvantage in the market. I believe that clearly the premium rate changes associated with the decline in the assumed valuation interest rate in Japan for reserves will tend to increase premium rates and that will take effect April 1, 2013.

And I want to make one comment about our sales force. I am so impressed with Aflac Japan sales force, especially the bank channel to adapt to these things to say no, we aren't going to take profit margins at these ranges. We want higher profit margins and we are stopping 5-pay WAYS. We are doing discounted advance premium and, of course, the side bar is what a great job our investment team has come up with a higher interest rates and then also in April we are going to see these things. It has been a wonderful job on Tohru's part and that management team for what they have done to adapt because this is a change. We never used to have to do like this and now we are going to vary it to make sure we make our profits and do the things we need to do.

Okay. That's all helpful and obviously the new money rate piece is kind of a moving target dynamically. Kind of all in at this point? It sounds like maybe current margins are more kind of mid-teens up from more like 10% earlier. Is that kind of a fair read currently?

They are headed in that direction.

Okay. Thank you.

They are there before the investment expenses. They are there now.

Right.

Okay. Great. Thank you.

Jimmie Bhullar, JPMC.

I had a question on the Japan new money yield. Obviously it picked up a decent amount. I think it was around 1.97% last quarter, 2.76% in Japan this quarter. Assuming a stable environment from here, what is your expectation for the new money yield? Obviously you are still shifting your investment allocation and that should help but credit spreads have come in as well over the past few months. So just like either more specific or just directionally, do you expect it to improve from here or decline a little bit?

If the -- this is Eric. If the market stayed stable in terms of current interest rate in the US and Japan's spread levels are around where they are. On an absolute basis we would expect our yields to go up because, as we disclosed our plans right now subject to market conditions are to invest about two-thirds of fourth quarter cash flow in a similarly structured corporate bond program hedge back to yen. So because the proportion of our new money would go to that program based on current market condition, the yield would go up versus last quarter who's of course yield had gone up from the prior quarter because we were investing one-third in that corporate program. So by and large, we would expect it to go up current forecast would be about, and this is after hedging cost of around [$2.60] or so, but again market rates can change, spreads can change. So that's just a rough estimate based on what we know today.

Okay. Thank you.

Mark Finkelstein, Evercore Partners.

Good morning. I want to talk about just the core kind of cancer medical sales in Japan. Sales were down about 3% to 4% year over year flattish sequentially. You did have the product introduction of Gentle EVER which usually does provide some form of a sales surge and I guess I'm just curious what is the outlook for sales in those products and can you give some background or color on the competitive landscape? Thank you.

Tohru, do you want to take that? Do you want me to? How do you want to do this?

I will take that. Yes. You are right. The other sales of the cancer and the medical combined has declined during the third quarter a little bit. This is better than the second quarter you may have noticed. The second quarter, it was down by 8.7%. Now the fourth quarter was down by 3.6%. This increase is because of the very good sales of the new Gentle EVER which we introduced this quarter. With the very strong sales of this new product and also that we are planning to introduce some promotion majors in the coming fourth quarter to enhance the sales of both cancer and medical. So we are rather hopeful that we would see the better sales of these two products combined in the fourth quarter.

And Gentle EVER accounted for 30% of EVER sales in the quarter.

Okay. And I guess my follow-up would be, you are expecting sales to be flat to up 15% in Japan. Is there any color you can give specifically on kind of the cancer medical component and whether you expect that to be up, flattish? What's the outlook?

Yes. I think I can't give you the specific numbers as to the -- I expect the sales of the cancer and the medical combined. We are trying to move that sales up to the flat or hopefully positively in the fourth quarter. It depends on the -- how successful our promotion would be.

I want to remind you that one thing that gives you a harder picture to follow is just remembering that WAYS is nine times more than the price of the medical product -- than the medical products and even endowment is three times more. The number of policy sales look better. Remember that our cancer product is 20% cheaper than it was because the changes we had in it. Actual policy sales look a little better than the premium sales numbers do.

Okay. All right. Thank you.

Suneet Kamath, UBS.

Good morning. Just had a question I guess for Eric on the new investment strategy. I think the way that you described it in Tokyo was simplified a bit of a tradeoff between greater liquidity versus a higher rollover risk in terms of the hedges. I guess I'm just curious given that you are investing so far, 10 years plus. Are you worried about this rollover risk on these currency forwards that are much shorter in duration?

The way I would phrase it is it's a matter of risk management and a matter of having a macro view of the economy short-term interest rates. So it is something that we have to look at very carefully and there are a variety of different hedging strategies we can employ over time. So today am I worried? No. I don't think -- I think there is very little risk from a macro perspective that US interest rates goes up any time or that Japan short term interest rates change. Over the long term, those dynamics will change and we will adjust our hedging strategies appropriately and as you recollect in Japan, we talked about over time using forwards, cross currency swaps. We could use longer rolling forwards.

I would also keep in mind that when we employ these strategies, we stress test them against our capital ratios, take a number of factors into account. I would also say over time, we may not always buy corporates hedge. We may buy other asset classes, better yen denominated, et cetera. It is absolutely something that is important but it's another risk factor amongst many and you will see our program continue to develop and become more sophisticated as the amount of assets we deploy and it continued to grow.

Got it. I guess my follow-up is just in terms of the accounting for this. I think you are taking the mark to market of the hedge through net income so presumably we might see some more volatility in realized investment gains and losses. I just want to make sure that that is an accurate statement. And then I guess related, how does this impact your statutory results in terms of cash flow testing? Again, you are getting this cash that's in dollars and you have your hedging the yen. But when you do your cash flow testing and how are you sort of factoring in potential changes in cost of hedges and those sorts of things? Thanks.

I will start out with it. The accounting that we will be utilizing consistent with GAAP will take the change in the fair value of the hedges through net realized gains and losses. And the cost of the hedging will be reflected in that line item of the financial statement. That being said, you know, that will be the accounting presentation. The economic evaluation of the profitability of the business, in my mind, will have to be net of the anticipated cost and the actual cost of the hedging. So I don't want you to get confused to say, well, these guys aren't looking at the economics. They are looking at the accounting because I'm not going to worry about geography when I'm evaluating economic profitability. I will just say that.

Now we will have to reflect the potential implication of the hedging activities in our cash flow analysis that we use for both the actuarial evaluation of reserve adequacy on both US statutory and on an FSA reporting basis and that will involve using the same type of stochastic processes that we currently use in evaluating cash flows, cash flow adequacy, and the like. All of that will be baked in to the normal cash flow testing process we go through effective this year end.

I'd add a couple of things. This is Ken. First, I think one of the ways you can think about this and the way that we were hedging using forwards as opposed to cross currency swaps is that this is somewhat similar to the reversible currency securities that you recall that we had purchased for many years meaning that we're not hedging the coupon. We're collecting the coupons in dollars and we'll have the flexibility to either reinvest in dollars or convert those coupons to yen and reinvest in yen.

What we are really hedging is the balance sheet risk so that the securities -- the book value of those securities to market value don't fluctuate with currency changes. They will fluctuate with credit changes, interest rate changes, but we're protecting it from currency changes and the reason we are doing that is really because of the solvency margin ratio in Japan. And interestingly enough, these -- the treatment of these securities on an FSA basis is actually favorable compared with buying straight yen denominated privately issued securities that we used to buy.

Understood. I get the focus on the economics but just based on what Kriss was saying the cost of the hedges being below the line, aren't you effectively overstating your operating earnings if you are getting the benefit of the strategy through net investment income but you're carrying the cost of the hedge below the line?

Well, again, we're not hedging the coupons. We are hedging the balance sheet really, not the coupons. Again, to your point and as we discussed, when we think about -- to the extent that these securities are going to support policy liabilities in particular ways, we think economically and when we run our cash flow testing internally, we are going to consider the cost of the hedge.

Let me just say, we recognize what the GAAP reporting requirements are but we are also recognizing the operating earnings as we define them or a non-GAAP financial measure. And we may have some internal discussions about what the most appropriate presentation of hedging costs in relation to operating earnings is. For the current year, we have chosen not to change anything. We may have some internal discussions and we will let you know what our conclusions are.

And Suneet, as we talked last night, we are looking with next quarter the amount was not very meaningful this quarter but breaking out those different derivatives by line item also so you can see exactly what the number was.

Okay. Thank you very much.

John Nadel, Sterne, Agee.

I'm curious for a little bit more detail perhaps on the securities lending program that you've initiated. I understand you guys mentioned it's a $6.5 billion program and you're lending entirely JGBs. I was just wondering what you are buying with the cash collateral, any duration mismatch you might be taking since it's a such short term program. I think you mentioned six months, and what pick up in yield that's providing.

The collateral is actually matched from a maturities stand-point. It's very short duration. It's also back in JGBs. It's a very small pick up. My recollection is around maybe 10 basis points or so, on 30 or so. 30 or so on the whole program. So this is an opportunity for us as you know we have got a lot of JGBs and a good portion of those sit in held to maturity. So when we have opportunities to enhance income by not really taking on much more risk, that's just extra gravy, if you will, for us. This was a good opportunity and we were able to utilize those HTM, JGBs in this fashion.

Just a quick follow-up. I'm not sure if I followed. What are you buying with the proceeds, Eric?

Basically short term JGBs.

Okay.

With the collateral.

Okay. And then just I don't want to belabor the point too much on the currency hedging. Just a quick question as to how much capacity do you think is out there? How big can your US corporates investing swapping into yen, how big can that program get over time?

Sure. Let me take that from two ways. As you recollect, and I went over this in Japan, we did the strategic asset allocation program with Goldman Sachs. And from an asset allocation perspective, and this program looked over a three year rolling period, so over the next three years, we could see the US corporate program being and this includes growth of our -- assumes growth of our balance sheet being up to about 20% to 25% of total assets. From the standpoint of capacity of the forwards markets, that's really not an issue. The currency forwards market is the most liquid largest market, one of the largest markets in the world.

So there is more than adequate capacity. Of course, we also have to manage our counter-party risk. And in that regard as you may recollect, we've initiated this program with three Japan mega banks, as counter-parties but we're expanding our use of ISDAs so we can expand the list of counter-parties as the program grows. If it would be any limit, it would just be the credit quality of our counter-parties but we don't see that as being a problem over the next three years as the program grows as long as we continue to grow our list of counter-parties.

And then if I can just sneak one last one in real quick. Any interest in allocating investment dollars into high yield or below investment grade securities? I noticed the impact, the pick up in below investment grade this quarter but it seems like that was all downgrade driven. Anything you can provide there?

Sure. Couple of things on that. That's correct. Anything that went -- that shows up as an increase in [big] was because of downgrade. Again, tying back to the asset allocation strategy, high yield would be an asset class that is part of our asset allocation strategy so that would be buying the true high yield asset classes as opposed to down grades. In the short term, we are not planning on allocating to that asset class. As you recollect, we're still building our team and capability. We anticipate having that capability mid-year next year, but then we will still have to make the decision tactically we will look at spreads in that market whether or not it's a good time to allocate money to high yield. So over time, the answer is yes. When exactly we would do it, that will be based on market conditions.

One other thing to mention for clarity going back to the hedging, the cost right now of our hedging which as Dan mentioned was 41 basis points. That's a very, very low cost which is primarily been driven by the below US interest rates and low Japan interest rates. We don't expect that cost to stay that low forever. We know historically it's been higher. So we're at a low point in cost but it also makes it attractive to use these types of forwards at the same time. So over time, these costs will increase from an investment perspective. We are always going to look at all of our investment alternatives and we'll look at them net of hedging cost versus JGBs versus high yield or other asset classes. So it will be a dynamic decision over time based on market conditions. But I think it's worth pointing out that those hedging costs most likely will increase versus decrease over time given that they are at all time lows.

Is it fair to say that in the historical periods when those hedging costs are higher that new money yields are also higher?

Not necessarily because the hedging costs for forwards is based on short term rate differentials. And we don't go out and buy short term paper. We buy longer term paper, 10 to 30 years. It really depends on the shape of the yield curve. We could be in an environment where short term rates in the US go up. That would cause the cost of the hedges to go up but the long end of the yield curve may not go up. There is not necessarily a correlation between those two things.

I think it's reasonable to say that we have been looking at hedging costs being 1% versus 41. And if it doesn't make sense at 1%, then we are not looking at it at all.

Understood. Thank you very much.

Ryan Krueger, Dowling & Partners.

Good morning. I was curious now that you've successfully completed the initial dollar denominated program, have you given any further consideration to expanding this to some of your existing available for sale JGB holdings because it seems, Eric, that you're not all that concerned about the capacity for hedges and correct me if I'm wrong, but it seems like if you were to do this it would create a number of desired outcomes which would include increasing returns on the existing portfolio as well as creating some gains in Japan I would think would increase your profit repatriation potential. So I was just curious if you had some updated thoughts on that.

Sure. Over time, yes, we would consider all of our assets that are available for sale and say is there better opportunity for them whether it's JGBs or something else. Of course, we have to consider liquidity and duration and capital ratios when we do that. Relative to gains, we did, as you already know, manage during the quarter because we weren't sitting on large gains in our AFS, JGBs. We did realize some of those gains as we tried to proactively manage our gains and losses. Nevertheless, we reinvested into JGBs primarily because during the quarter, we had put a cap in the third quarter on how much we were going to put into the corporate bond program. So we were already targeted to be at that cap.

As we look at the fourth quarter, we have a pretty good target for the amount of corporates. That's a healthy target and a healthy dose of higher yields for the program. So we don't feel compelled right now that we need to make that swap. But that's available to us depending on market conditions which we could do at some point in time and that will be a relative value decision. But right now, we're pretty happy with the amount of money we are going to target in the fourth quarter so we don't see a need to target even more.

I don't know if Eric would totally agree with this. Let me throw it out and that is that from my perspective, we wouldn't allocate 75% of the cash flow of any quarter to this corporate bond program on a long-term basis. In the way I look at it is, we are repositioning a part of the current portfolio as part of that 75%. Even though we are not liquidating it, let's just say new money-wise, we are putting 30% in to the new program and another 45% we are converting to corporates is kind of in lieu of doing gains and losses, et cetera, and putting it in there. So as we just build the blocks in my mind, I kind of look at it like we were repositioning part of the current portfolio away from a JGBs even though it's all new money.

I think that's an excellent point. Because as you all know, prior to the initiation of this program, if I could put it in these terms, we over allocated to JGBs because we didn't really have alternatives based on our old investment strategies since we had stopped buying private placements almost entirely. So in essence we over allocated to JGBs at the beginning of the year but now that we have the flexibility to do the corporate program, this is just a higher percentage going in there as a way to fine tune the overall allocations.

To Kriss' point as well, as we continue to build out our capabilities, again go back to the Japan presentation, I put on the board different asset classes we will buy over time. So you should expect to see and I think it will probably start to even out second part of next year, certainly into 2014, we will be buying some JGBs, some investment grade corporates hedge, some emerging markets, high yield, including some alternatives on the board. You will see it even out over time but right now you are seeing those adjustments be disproportionate in essence because of the high amounts of JGBs earlier this year.

Okay, that's very helpful. Thank you.

Steven Schwartz, Raymond James.

Something completely different if Paul is still around. US, Paul, the guidance that Dan alluded to for the fourth quarter would suggest flat. Dan also referenced some disruption in distribution. I'm assuming that Dan is talking about what you are trying to do in the large group market. I was hoping maybe you could fill that out and tell us what's going on there.

Sure. As Dan mentioned and as I've mentioned, my goal is to manage this business for the long-term, not just for the short-term. So while 13 weeks of business is important, I'm really trying to manage our growth for not only 2012 but '13, '14 and beyond. In this past summer, the disruption that Dan is talking about is the combination of our sales and marketing strategy departments all into one, bringing in external leadership to help run sales, and then making sure our field force understands exactly what we are trying to do. Less so about any disruption from the broker market and what specifically is happening in the broker market.

And in terms of sales, you know, we have seen as we've stepped into fourth quarter enrollments specifically with our small accounts, more of a decline in sentiment and purchasing than we originally expected. When we came out in a recent release and even Kriss' comments at the mini FAB in Tokyo, we commented that we thought we would be still within the range. The recent decline has to do with a what we expect sales to be based on what we are seeing come out of our small business enrollments that Dan directly highlighted between small business sentiment as well as what we believe is apprehension around the election, taxes, and a multitude of other items by small business owners. As I've said all along, we continue to build out our broker strategy to be a hedge against the small business, any negative downturn in small business and our ability to write business there.

While that market continues to grow and grow well for us, we are seeing -- still seeing great success with our broker market and broker growth. At this point, the size of our full force and our core market which continues to be our key focus is so grossly proportionately larger that just any downturn in that small business market, especially in the fourth quarter, will have a negative effect on our ability to produce sales increases. So overall I'm very optimistic for the long term. We're putting in an incredible training program beginning in January. I think we are doing all of the right things from a management standpoint to make sure that long term sales go well but in the short term, we are seeing the adverse effect of both the economy as well as apprehension in the small business market.

So if I may, when we see fourth quarter results, while we are going to see small -- your basic business down, we will see large group up year over year?

I'm not focusing at all on group versus individual. I'm focusing it on broker versus our core field force. And the reason I do that is I'm platform agnostic. Whether an account chooses group products or individual products makes no difference to me. What I am trying to do is manage our distinct distribution channels. One thing I do want to point out, too, is we have seen great success with our field force partnering with brokers to help them enroll in their accounts. Am I very happy with our ability to succeed there and, yes, I do expect to see continued growth in the broker market. I expect to see some struggles within our career market. But as I said, based on the training program and the things we are putting in place, I expect us to be able to move forward in a positive manner, you know, throughout '13 and beyond.

Okay. Are you guys looking -- this is -- I've heard some things. Are you looking at the individual market before? I'm talking about the true individual market here, selling to individuals as individuals. There has been some thought that supplemental health products could really, really shoot up in 2014 and beyond due to Obamacare. I was wondering if that's something you might look at.

We've always had direct products. In fact, we've offered direct pricing in the United States for many years. Our agents have always found that the ability to sell at the work site not only provides us a better actuarial risk but it provides the ability for the agent to be more productive because they can sell to a larger volume of people in a shorter period of time. As well as I think Americans in general are used to purchasing their products at the work site. That said, we do expect the combination of both Obamacare, PPACA, whatever you want to call it, as well as the millennial generation being 50% of the workforce by 2016, to have some impact on how people choose to purchase insurance.

Yes, it's my job as well as our sales and marketing team to make sure that we are staying ahead and looking at all possible alternatives but we still believe, Steven, that the best market for us is the work site, businesses with 100 employees or less, and the all of the other alternatives including the broker market as well as the direct market represent places for us to get incremental growth. Again, for us we want to focus in on America's smallest businesses and the opportunity for us to be successful there.

Okay. Thank you, Paul.

Tom Gallagher, Credit Suisse.

Hi. The -- Ken, I want to come back to you on something you had mentioned before I think in response to Nigel's question. So if the plan for going forward here is that dividends from the US is going to fund the common dividend, is it safe to assume -- and you're still on track with the $800 million or so in terms of US dollars repatriation coming from Japan. Is it fair to say all or the vast majority of that would go toward a buy back? Is that the right way to think about that for 13?

Well, I think a couple things. Number one, we've said that we anticipate funding our share repurchase activities with profit repatriation so that JPY65 billion translates into a little over $800 million. We would expect to have more dividend capacity on a US statutory basis next year than we had this year just given where we are with realized investment losses on a statutory basis. So as we think about next year, again, we want to maintain some prudence and we are going to be very cognizant of the world around us and if additional losses emerge but assuming we have a relatively benign environment, thinking that we can buy somewhere within that -- we indicated $300 million to $900 million in Kriss' speech in May, we would be at the high end of the range if we felt comfortable deploying all of that. Yes, that would be available if we felt it was the right thing to do. And again in the mean time, we have ample liquidity at the parent company. You will recall that we did not dividend from the life company to the parent company all this year. We really relied on parent company liquidity to meet our corporate needs.

Okay. That's very clear. Thanks. And to follow up for Kriss on the Japan margins. So 17% to 20%, 21% pretax margins on WAYS if you get a 2.5% new money yield. And, Kriss, those are without the price increases other the October or the planned one for next year?

Yes, that's right. They'd be, order of magnitude 8% to 10% higher under repricing.

Okay. And then I know you'd mentioned the 6 month or 6 to 12 month negative impact of the spend on the new investment structure. But if I think about that range that you have given out and I look at the 19.3% margin you had this quarter, you know, fair to say that if Eric keeps getting what he is getting, that we are actually going to start to see a reversal in margins go up here or certainly not going down. I just want to get some context and then as a follow-up. Then why is it only a 6 to 12 month spend? I thought most of the costs were going to be ongoing. Or is there some big one time element to those?

The cost will be ongoing, Tom. What I'm saying is that if I look at the incremental yield on the amount we invested, say for the first six months of the program, say I get an extra 100 basis points on $5 billion to $6 billion. That's $50 million to $60 million. That probably meets or exceeds the cost of the build outs. The $50 million to $60 million of additional investment income on the investments we made over the last three months and the next three months are probably sufficient to fund the going forward. The extra infrastructure, personnel cost, et cetera, et cetera. So in my mind, the way I'm compartmentalizing it, I'm saying well if I don't count any additional profit associated with the first six months of investment, now or going forward, then I've covered the total cost of the program and the P&L and any incremental yield I get after the first six months is going to go to the bottom line, et cetera, et cetera. That may not be the way you or anybody else thinks about it, but that's the way I've compartmentalized it.

I will point out though that the current margin is right in the middle of the range that I gave you at the FAB in May. All the ratios are in line with those numbers I gave you. I will say that the expense ratio for the third quarter was at the low end of the range. The benefit ratio is at the high end of the range but we had a lot of WAYS sales in the third quarter and in the second quarter. So I might anticipate that those would have been a little higher. Year-to-date, though, we are right in the middle of things. 2012 year-to-date, the margin's 20.1% and I estimated a range in margin of 18.5% to 20.5%. So actually that's way above the middle of the range of 19.5%. So I'm comfortable with the numbers we've quoted you. And the margins are moving in the right direction.

I'm just trying to be conservative in saying don't get too excited, overly excited. I have got some additional costs to cover out of these additional incremental yields. Don't just expect EPS to explode in the next three months. Over the next year, yes, I think it will really help us, in going forward is going help us a lot. That plus the repricing plus the other marketing adjustments we've made in our profit -- our product strategy. Dan, did you want to comment?

Only thing I would say is that if you take where we are today and look at where we were a year ago, it's a totally different way of looking at what's going on. I mean, we are in a position where everyday profits, margins, and profits are going up. And I think we are well positioned to have a great fourth quarter and 2013. I couldn't be more excited about the future. And what's really been an ability of our Company to withstand what went on with the financial crisis and now move forward and really see some growth going ahead.

Thank you.

That's helpful. Thanks, guys.

Thank you. We are going close it down now. If anybody wants to call with any further questions, Tom McDaniel, my colleague and I will be in the office and we will be glad to take your calls. And thank you all again for joining us today. Bye-bye.

This concludes today's presentation. Thank you for your participation.