© 2024 Alpha Spread Limited. All Rights Reserved.
www.alphaspread.com is not operated by a broker, a dealer, or a registered investment adviser. Under no circumstances does any information posted on www.alphaspread.com represent a recommendation to buy or sell a security. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. In no event shall Alpha Spread Limited be liable to any member, guest or third party for any damages of any kind arising out of the use of any content or other material published or available on www.alphaspread.com, or relating to the use of, or inability to use, www.alphaspread.com or any content, including, without limitation, any investment losses, lost profits, lost opportunity, special, incidental, indirect, consequential or punitive damages. Past performance is a poor indicator of future performance.
You don't have any saved screeners yet
Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Welcome to the Aflac Second Quarter Earnings Conference Call. Your lines have been placed on listen-only until the question-and-answer session. Please be advised today's conference is being recorded.
I would now like to turn the call over to Mr. David Young, Vice-President of Aflac Investor and Rating Agency Relations.
Good morning, and welcome to our second quarter call. This morning we will be hearing remarks from Dan Amos, Chairman and CEO of Aflac, Incorporated, about the quarter as well as our operations in Japan and the United States; then Fred Crawford, Executive Vice-President and CFO of Aflac, Incorporated, will follow with more details about our financial results, outlook and capital management. We will then open our call to questions.
Joining us this morning for Q&A are members of our executive management team in the U.S.; Teresa White, President of Aflac U.S.; Eric Kirsch, Global Chief Investment Officer; Rich Williams, Chief Distribution Officer; Al Riggieri, Global Chief Risk Officer and Chief Actuary; Max Broden, Treasurer.
We are also joined by members of our executive management team in Tokyo at Aflac Life Insurance. Charles Lake, President of Aflac International and Chairman Representative Director; Masatoshi Koide, President and Representative Director, Todd Daniels, Principal Financial Officer; and Koji Ariyoshi, Director and Head of Sales and Marketing.
Before we start, let me remind you that some statements in this 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 discuss today. We encourage you to look at our annual report on Form 10-K for some of the various risk factors that could materially impact our results. The earnings release is available on the Investors page of aflac.com, and also includes reconciliations of certain non-GAAP measures.
I'll now turn the call over to Dan.
Thank you, Dave, and good morning everyone, and thank you for joining us today.
Let me begin by saying that the second quarter 2018 established a strong first half of the year for Aflac. I am pleased that we were able to upward or revise our 2018 adjusted earnings per share outlook. Aflac Japan our largest contributor generated strong financial results. Fred will provide more details but let me just say that in yen terms, Aflac Japan's pretax profit margin was ahead of expectations both through the quarter and through the first six months.
Aflac Japan's outstanding third sector sales increase of 16% was well above our expectations. This strong results was largely due to April's introduction of our new cancer insurance products. There were a few factors that drove sales beyond our expectations for the quarter.
First, the new cancer insurance policy offered popular enhanced benefit features while carefully managing the risk profile of the product as we've done in the past. In addition, we launched a targeted promotional campaign for all this cancer - the new cancer product that incorporated television ads with the largest direct mail campaign we've ever done.
And finally we fully engaged our wide reaching distribution network. Over the last few years following our agreement with Japan post, we phased in our cancer insurance sales to postal outlets that were positioned for sales at the time. This new cancer product launch marked the first introduction that we've had access to all 20,000 plus Japan post outlets at the same time. The results there were bigger than we had anticipated. In fact this quarter reflected the highest production ever in Japan post in terms of a fee.
Our traditional agencies also had a solid performance in cancer sales and they continue to be bottled to our success. Our extensive distribution network furthers our goal to be where people want to buy insurance.
All of these factors reflected an strong cancer sales growth for both the independent corporate agencies and affiliated corporate agencies during the quarter. The quarter's results are laying the foundation for another strong year of third sector sales. We believe some of this reflects an acceleration of sales that we originally anticipated for the second half of the year recognizing the strong launch of the cancer product.
We have robust our projections and are now calling for growth rate in the low single-digit for 2018 third sector sales. Remember, we're coming off comparison to an outstanding 2017 for third sector medical sales due to last year's introduction of the new ever medical product. You will hear more about this from Ariyoshi at our financial analyst briefing in September.
Our focus of remaining our leadership position in the sale of third sector products that are less interest rate-sensitive had strong and stable margins. We will continue to refine our existing product portfolio and introduce innovative new third sector products to maintaining our market leadership.
Turning to Aflac U.S. we are pleased with our financial performance. The pretax profit margins exceeded our expectations both for the quarter and for the first half of the year. I'm also pleased with our sales results for the quarter which advanced our progress in achieving our anticipated full-year sales growth of 3% to 5%.
You'll hear more about this from Teresa and Richard at financial analyst briefing in September but we continue to expect our growth in broker sales. Our team of broker sales professionals have made great strides in successfully strengthening Aflac's relationship within the large broker community. Our partnering initiatives for True Group products is still early in development but is already starting to take up the shape.
As a result, Aflac is seeing a high rate of growth through brokers and strong sales growth in our group products. Keep in mind, Aflac is different from our peers and there is a majority of our sales comes from our independent sales agent. We are fortunate to have such a strong independent field force which is truly unique within our industry. These career sales agents are best positioned within the industry to reach and therefore succeed with the smaller employers and groups with fewer than 100 employees. Aflac independent career agents have been driving force behind Aflac's ability to dominate the smaller case market.
Recruiting remains a challenge in a strong employment marketplace. However, productivity continues to improve as our veteran agents further penetrate existing accounts and our investment in agent development gains traction. Equally important is a coordination between our powerful field force of sales agents and our growing network of broker sales professionals. It is very encouraging that our brokers look for solutions for their clients. They have found that Aflac portfolio of products helps fills those needs.
Brokers are looking for a strong brand like Aflac as they also leverage our outstanding track record of experienced and extensive fulfillment capacities. Our deal force independent agents are experts who have demonstrated their ability to accelerate growth by working with brokers and broker sales professionals. We characterize this collaboration as broker influenced business.
As we look to the remainder of 2018 we will continue to expect sales to make way towards the fourth quarter as broker and broker influenced sales are a growing part of our business.
Turning to capital deployment, Fred will provide more detail shortly. We remain committed to maintaining strong capital ratios on behalf of our bondholders, shareholders and policyholders. At the same time, we are balancing our financial strength with increasing the dividend repurchasing shares and reinvesting in our business.
We continue to anticipate that we’ll repurchase in the range of $1.1 billion to $1.4 billion of our shares in 2018. As always is the case, this assumes stable capital conditions and the absence of compelling alternatives.
Looking ahead, we believe our strong earnings growth will reflect the underlying earnings power of our insurance operations in Japan and the United States. It will also reflect our prudent approach to deploying excess capital in a way that balances the interest of all stakeholders. At the same time, we will also reflect our dedication to delivering on the promise we make to our policyholders.
I’ll conclude by saying that this has been one of the best quarters in the company's history and I'm very proud of it. I’ll continue to be excited about Aflac future growth. And now I’ll turn the program over to Fred who will cover the financial results. Fred?
Thank you, Dan.
Building on a strong start to the year our earnings results for the second quarter exceeded our expectations. While it is early in the year the strength of our performance year-to-date and stability in our margins gives us confidence, we will exceed our original guidance range for the year. We have therefore updated our currency neutral adjusted earnings guidance to a range of $3.90 to $4.06 per diluted share.
Key variables as we move through the year include continued strength in investment income, sustainability of benefit ratios in underlying claims trends and the pace of expense build as we continue to invest in the future growth and efficiencies.
For the quarter adjusted earnings of $1.07 were driven by strong pretax margins both in Japan and the U.S. Our reported results benefited modestly by a strengthening of the yen as compared to 2017 period contributing $0.01 per share to the quarter's results. Virtually all key earnings drivers performed at or above our expectations.
Japan branch conversion costs in the quarter were $40 million. We project less than 10 million in remaining costs spread over the third and fourth quarter. We have effectively wrapped up the conversion with total project cost of approximately $120 million, consistent with the low end of our forecasted range.
Turning to our Japan segment results, we reported pretax profit margin of 21.8%. Our total benefit ratio came in below our guidance range of 70% to 72%, driven by a continued shift in business mix from first sector towards third sector, positive claims trends in our cancer business and associated reserve adjustments.
Our expense ratio in Japan reverted back to the midpoint of our outlook range of 19% to 21%. The sequential increase was expected given promotional spend with the launch of our refreshed cancer product and continued build in IT modernization spend. We would expect to run towards the high end of our outlook range throughout the rest of the year.
Before moving on to the U.S. segment, as is common when introducing a new or refreshed third sector product in Japan, we typically experience elevated lapse and reissue activity as policyholders choose to upgrade their existing policies for the enhanced benefits.
In the short run and depending on the mix of policies, this can apply downward pressure on our benefit ratio as we release reserves on lapse policies and experience elevated deck amortization on the same policies.
While it is too early in the launch of our cancer product to have specific estimates on the impact, we believe this contributed to Japan's favorable benefit ratio, increased deck amortization, and provided a very modest net benefits or earnings in the quarter. We expect this impact will lessen throughout the year.
Turning to the U.S. results, our overall pretax profit margin in the quarter was 21.1%. Our total benefit ratio moved back to the midpoint of our guidance range of 51% to 53%. We have historically seen a lower first quarter benefit ratio followed by a modest increase in the second quarter, and that experience continues.
Our expense ratio in the U.S. came in below our expectations and is largely timing related. We expect accelerated spend in the second half of the year, which includes previously announced post tax reform investments. As mentioned in the first quarter, these accelerated investments will amount to approximately $0.03 per share in the second half of the year.
Overall, we continue to see the year coming in around the midpoint of our guidance range of 34% to 36%, with the second half running at the high end of the range.
Investment income performance both in Japan and the U.S. continues to deliver very strong results. The year-to-date outperformance has been driven primarily by the accelerated growth of our floating-rate portfolio, further benefiting from higher LIBOR rates, relative to our expectations coming into the year.
As we have previously commented, we elected to lock in the majority of our hedge costs for 2018, which mitigated the potential impact from higher U.S. interest rates. As hedge instruments roll off, we would expect to lose some of this relative outperformance heading into 2019.
As I discussed in the first quarter call, we continue to make progress on managing our economic exposure to the yen, while lowering enterprise wide costs associated with the Japan's U.S. dollar investment hedging.
We accomplish this by entering into an offsetting hedge position at the holding company, with the financial impact recognized in our corporate and other segment. We have built this offsetting position to approximately $1.25 billion in the quarter, contributing $7 million on a pretax basis to the quarter’s earnings.
Our strategy balance is securing Aflac's strong capital position in Japan, while lowering our enterprise exposure to a weakening yen. We will spend more time discussing this risk reduction strategy at our September financial analyst briefing in Japan.
We ended the quarter in a strong capital position. Japan's solvency margin ratio is estimated in the 950% range, this is particularly strong result recognizing our April 2nd conversion from a branch to a subsidiary reduced SMR by approximately 130 points.
As we have stated previously, we have plans in place to restore the SMR accounting impact over a three-year period. Our estimated U.S. only risk-based capital ratio at quarter end stands at roughly 850%, and includes an estimate of the full adoption of U.S. tax reform.
It is our understanding the NAIC intends on adopting the full effect of tax reform in 2018. With the impact of tax reform and dividend projections that include a drawdown of $500 million in excess capital in the second half of the year, we are projecting an RBC in the mid 600% range for year-end 2018.
We ended the quarter with just over $2 billion of capital and liquidity of the holding company. We set aside $1 billion of contingent capital, and $500 million for liquidity in support of holding company derivative positions. Despite recent increases in volatility, overall credit conditions and asset quality remains strong with very little in the way of impairments in the quarter.
Including dividends and share repurchase, we returned approximately $500 million to our shareholders in the quarter. We repurchased 6.8 million shares of our stock for $306 million in the quarter and remain tactical in our approach. We are maintaining our current outlook range for repurchase of $1.1 to $1.4 billion in 2018.
As we move into the third quarter, we plan to make a $50 million contribution to our pension fund. This contribution is larger than normal and takes advantage of a 35% corporate tax deduction if funded prior to September 15. The contribution has no implications for our capital plans and represents a sound use of excess capital.
With the conversion behind us, we are hard at work to optimize our capital and liquidity profile. We will further develop these strategies at our September financial analyst briefing.
I'll now hand the call back to David to begin our Q&A session. David?
Thank you, Fred. Now we are ready to take your questions, but first let me ask that you please limit yourself to one initial question and one related follow-up to that question to allow other participants an opportunity to ask a question. We will now take the first question.
We will now begin the question-and-answer session. The first participant to ask question is Ryan Kruger of KBW. Your line is now open.
Fred, could you help us size the potential impact of the role off of the hedges that you locked in this year as we go into next and they reset?
It certainly helped in mitigate if you will some of the rising rates. As you recall, we locked in approximately 80% of our hedge costs as we are entering into 2018 and we estimate for the full year on a pretax basis that benefits us by approximately $9 million for 2018. So that's the approximate benefits.
So it's relatively modest, but again we would note that as we roll into 2019, we'll start having a reset if you will of our hedge cost and obviously hedge cost have risen through throughout the year. Again that's offset by LIBOR benefiting us as we built down the floating rate portfolio.
And then just one other one, you mentioned prudent investment in the business I think in regard as a comment after your buyback comment for the year. As presumably the ongoing business investments don't really have much impact on your capital position that is I referred to - are you referring to things like investments and some of the insured tech companies and things along that nature?
No, not really referring to that, although we have set of sites some opportunistic money if you will to reinvest in those efforts and those efforts are going well, but they represent a relatively modest allocation of our excess capital when looking at any given year over a three-year period of time.
Really, the more important aspect of reinvestment back in the business platform both in the U.S. and Japan is that we are calling for some elevated expense ratios if you will as we move through the remainder of the year. We have been running at relatively low expense ratios in the early part of the year both in Japan and the U.S.
As you saw in the second quarter, Japan were reverted back to more what we would expect in that 20% range as an expense ratio, but the U.S. was quite low and that's largely timing related because we for natural reasons had backend loaded for example some of our tax reform investments as we formulate the plan and remain very prudent to how we allocate that money. So, some of that reinvestment is really related to expense ratio guidance and not so much a tax on our capital position or excess capital deployment.
The next question is coming from the line of John Nadel of UBS. Your line is now open.
Fred, just a question on the U.S. risk-based capital ratio. I think you had mentioned that it's around 850%, you expect it to drop down to about 650% at year-end. I think there's two drivers there, one, is the $500 million dividend that you're expecting to take out, the other is the tax impacts. Can you sort of give us a sense of the relative contributions for that 200 point decline from each?
Yes, absolutely. So, remember, the first half of tax reform was already adopted in the number that was the DTA that was adopted early. So, the tax reform impact for 2018 is really in the denominator, if you will. And that has as an impact of right around 75 points of RBC. In other words, if you were to look at our RBC before that implementation of tax reform, we would be running at or posting 925% RBC.
So, that tax reform implication had knocked it down to 850%. Now, what brings it down to 650% is that we've largely backend loaded our U.S. statutory dividend and the removal of that excess capital all takes place in the second half of the year.
In fact the removal of excess capital together with normal dividend of earnings that are produced in the U.S. entity, we are calling for upwards of just a touch over $1 billion of dividend activity up to the holding company in the second half of the year.
So, it's quite a bit backend loaded. And a lot of that had to do with making our way through the conversion and settling into our post conversion RBC estimates.
So that $1 billion of dividend is really the 200 points?
You got it. And it's a combination of statutory earnings in normal, what I would call, ordinary dividend capacity, and then the $500 million excess capital.
And then just - to circle back on persistency in Japan. I know it's nitpicky but that's ticked down a bit maybe 1 to 1.5 percentage points over the last several quarters. Is that really related to what you discussed earlier, which is the sort of shift in lab patient of old policies and for the new ones?
That's right. And particularly with cancer, because you're talking about having gone 4 years since upgrade, and so, with advancements in cancer treatment and diagnosis and then together with other beneficial features that Dan, noted in his comments. You have much more in the way of an attractive upgrade opportunity for our policyholders. Recognizing that we age down things in cancer and so it tends to be some of the more recent policies that are most susceptible to this.
And in that case what ends up happening is, yes, you'll have elevated labs activity i.e. lower persistency. You'll have sales obviously benefiting from that activity. But then when you get to our P&L, you have a bit of a lower benefit ratio as you release reserves on the policy, higher DAC and DAC amortization. And that tends to balance out for somewhat modest impact to earnings.
So, it's little less about an earnings story and more about the line items in the P&L. And I would note that it's very important to understand that. In the second quarter of last year we actually had the same dynamic, it's by coincidence but we launched our medical product in March last year.
And if you look at the trends in persistency, trends in benefit ratio, DAC amortization, you see the same phenomenon last year, 1Q to 2Q as you see this year. That's coincidental but it gives you an idea of that, that tends to happen when you first launch the product. It calms down over time, obviously.
And are you agnostic between cancer and medical sales?
I'll let Dan answer that because we talked about that. The answer is, from a profitability perspective, yes. But Dan, why don't you talk about it.
Yes, I think we are. We have always said that when the profit margins are relatively similar, then to us it doesn't matter. And agents always choose the path of least resistance. And the path of least resistance is always the newest product that's on the market.
It gives some swizzle and they can straight to it. You saw that happened last year with the EVER product. And now you're seeing it this year with the new cancer product.
So, it makes it much easier than us to try to figure out how to balance every year, which one they sell. If there was an enormous difference in profitability then that's one thing. But there isn't. So from that standpoint we feel very good about it. And it's nothing new. I mean we've been doing it since the inception of Japan, we've been working that way.
The next question is coming from the line of Nigel Dally of Morgan Stanley. Your line is now open.
I just wanted to follow on from John's question. Is it possible to, John mentioned, the portion of sales that represented the lapse then reissues activity on the new cancer product? And also just a question on accounting, when you do have a lapse and reissue, is it just a incremental premium book to the sale or is it the whole annualized premium on new policy?
Yeah, it's the overall premium, because it's really treated as literally two separate transactions, meaning -- because it's really consistent with what the consumer has decided. They've decided to lapse their policy and so you'll see that lapse accounted for and reported just as a lapse.
So, it hurts your persistency as you would expect and it's consistent with accounting. The accounting guidance on this is, if you've made material changes to the policy, particularly the benefit structure of the policy and more materially improved it, then you really account for it as a lapse and reissue.
So, that's the way it goes. The reissue then is marked and reported as a sale. And so the accounting and the way we report is consistent in that regard. And then in terms of sizing it, this is obviously been going on for many, many years. This is really always how it's been reported as a company.
We will tend to see normal lapse and reissue activity ranging in the 10% to 15% in any given period and any given year. But as I mentioned, in the period where you actually launch in that period, i.e. the quarter or perhaps a quarter or two, it will naturally be elevated upwards of 25% to 30%. And we suspect that's about the type of result we've seen this time around.
When it comes to the outright earnings impact, it's quite a bit muted. It's very dependent on the cohort of what actually lapse. Older policies, for example, which is more rare when they lapse, will release higher reserves. They often times as they're very old may have cash value associated with it, and very little DAC amortization. And so it hits the bottom line in a little more pronounced to positive way.
But because many of the policies tend to be really younger, if you will, in terms of age of the policies when they've been issued, last five years, for example, you'll have less in the way of reserve release and more in the way of DAC amortization.
So it's highly dependent on the mix of business, which is why it's difficult to estimate. We would we would estimate in this period that may be earnings benefited from ¥1 billion to ¥2 billion, in that range, so, relatively modest, and again, very similar to 2017.
But Nigel, well you've been around long time. The cancer product before this one, that was the case, and the cancer product before that when it was the case. So, it's been going on over -- across 20 years. So, it's nothing new.
The next question is coming from the line of Jimmy Bhullar of JPMorgan. Your line is now open.
First, just on the expected RBC decline because of tax reform, has that in any way changed your view of what the RBC threshold should be? I think you've mentioned 500% that being sort of an initial threshold for the RBC, just trying to assess how the lower RBC affects your plans to free the $1 billion from the U.S. conversion.
Yes, Jimmy. No impact to that. We are very comfortable, not only with the tax reform absorbed in our capital plan and drawdown of excess capital, but I would also note that we're comfortable with any potential movement related to the C1 bucket, if you will, changes that are expected in 2019.
We see neither of those events as disrupting our drawdown plans. We have settled in and expect to settle in around 500% at the end of 2019. As I've mentioned publicly, I think given the risk profile of our business as we start to print blue books and are able to analyze and report our stability, if you will, and low risk profile as U.S. only entity, we'll continue to look to see whether there's further optimization opportunity in that.
I think most observers would say that 500% RBC on the nature of our business is quite high, even for our high ratings threshold. And so, we'll work on that. But I think, when working with rating agencies and frankly thinking about our own risk management practices, it's important to start printing some of these statutory results on a U.S. only basis to make sure we have a good handle on it and can support our case.
So, we think there's room there, Jimmy, but just to answer your question, no tax reform nor the C1 changes are going to disrupt our capital plans.
And if I could ask one more just overall obviously your sales were very strong in Japan, the one negative I thought was just the medical sales continuing to shrink and I think they're sitting around the ¥6 billion quarterly range. And they’ve drifted lower steadily after you introduced the updated product last year.
So I’m assuming you had introduced a new product at some point next year, but - is this sort of a normal level of medical sales do you expect in the absence of any new products or have the sales been pressured a little bit because of the whole focus on cancer recently?
I’d like you Koji - Koide to answer the question. Koide?
[Foreign Language] Well one of the big reasons why medical sales are shrinking is because it’s been more than a year since the new medical product was launched. And then as you know we have launched a new cancer product in April and everyone is really shifting their focus to some of this product. As a result medical sales in the second quarter declined and this is something that we have assumed and this is what we have been experiencing in the past as well.
And as this medical insurance area is very competitive however we are still maintaining a number one position in new business policy number as well as AP. So please remember that we are still maintaining that number one position.
The next question is coming from the line of Humphrey Lee of Dowling & Partners. Your line is now open.
Question for Fred regarding the benefit ratio and DAC amortization impact from the lapses. I understand from a earnings is small, but like how should we think about the moving pieces in terms of the uplift – I mean the downward pressure on the benefit ratio and the uplift to DAC amortization. And then also how should we think about in the balance of the year?
Yeah I think in terms of the balance of the year, we would expect this impact to lessen as I mentioned. So it will become less distinguishable from a line item perspective and really negligible in terms of any particular earnings impact. I think an easy way to think about it Humphrey is that as I mentioned in my comments.
We would expect the benefit ratio in Japan to elevate back within the guidance range we have which is 70% to 72% and that's one way of thinking about the relative impact because that would be probably one of the features that would drive it back up.
We also have particular strong cancer claims trends don't forget we’re actually seeing just good flat net experience particularly in hospitalization trends on cancer. And that led to not only positive claims activity, but also some natural IBNR release which is somewhat mechanical as we adjust for the trends we’re seeing.
So we continue to see that development and that's a very economic if you will in terms of the benefit. Very importantly what I would say to you is that when looking at the benefit ratio overall in Japan while our guidance range is 70% to 72% we actually expect the full year to be coming in at the downside of that range that has been somewhat consistent pattern and we expect some of that to continue.
It will be more elevated than what we had in the second quarter, but still overall year will fall very close to the bottom end of that range is what we are currently projecting. So that's the way to think about it. The actual line item impact with preciseness there is more work to be done to be able to isolate that because it gets quick quite, quite technical. You're talking about really needing to isolate all the exact moving parts in the policy from particularly a lapse policy dynamic. As I mentioned the cohorts can be very sensitive as to what the impact is to the line items.
We’ll continue to do more work on that can provide more transparency, but from a bottom line perspective it's not a big material mover. And again you can kind of take both the benefit ratio guidance we've given as a little bit of the impact DAC amortization very similarly and I would again call your attention to last year's 1Q to 2Q development. You can see the same thing happening benefit ratio drifted down, when we launched the medical product in March amortization drifted up. And those are reasonable proximities of what you see on those line items.
And then on the third sector sales in the quarter so obviously there are lot of the moving pieces part of it because of the new product launch and then also kind of we having a very successful targeted promotional campaign. And then I believe there is also some pent up demand from the first quarter in anticipation of the launch. So when we think about the product is up like excluding the impact of the pent up demand from the first quarter like how would you kind of characterize the product itself kind of addressing the need of the consumer that was not available in the marketplace before this product. And how should we think about kind of the sales impact in the balance of the year?
Koide or Koji?
[Foreign Language]
Okay, I will take the question this is Koji [Foreign Language]. We have always - try to incorporate features by always thinking about what is needed by customers as well as what is going in the medical treatment area. For example this time we have implemented a specified premium waiver feature of positive care et cetera. We also have features to be able to cover broad range of customers that include new customers as well as our existing customers.
And we are also providing our product to those customers who have concerns about their health or even to cancer survivors. And particularly at this time our main feature is to add specified premium waiver feature which has been long wanted by the JP Japan Post customers. And we have also added our coverage that can be added to our existing policy holders policies and this is was very much wanted by our agencies and these have contributed two the sales this time.
I’d like to add one of thing and that is product is important here but it’s also just strong distribution channel. We are truly going to the places that people want to buy products. And then don’t forget our domination of the cancer insurance market is something that stands out worldwide that what we’ve been able to do in that market. Medical is more competitive if you go back 2001 when we deregulated the market a lot of people thought Aflac would be out of business all big competitors would put us out and instead you saw the Dai-Ichi Life sell for us.
You saw some of the other competitors get in and then pull back, you seen Japan post, you’ve seen post off – I mean the banks. I think its part distribution, but it also as those products as well but it's a one, two punch of both of them that makes it stand out.
I guess just kind of cover a little bit so like for the - almost ¥21 billion in cancer sales in the quarter. We think about some of it is probably because of the pent up demand from first quarter and the others just because of the you have a new and better product. So if we kind of bifurcate between some of the pent up demand versus the what do you expect as a more normal, quarterly sales for the cancer product, how should we think about that?
What I would say to your point if this is what you mean by pent up sales. You might recall and we've commented on this publicly that as it starts to become well understood that we’re refreshing our cancer product particularly when we filed with the FSA and we’re in motion and starting to build. You will see a natural anticipation of the new product and a pullback in some of the distribution systems as they prepare for it.
So you do have some shift from a 1Q pause to a 2Q jump out of the gate and strong sales but then as Dan had mentioned and Koji mentioned, it's natural both in medical and cancer that as the year goes on you start to see things taper from the sales perspective. So you have a little bit of acceleration of what we anticipate in the second half of the year into the second quarter and then you have exactly what you're saying a little bit of that delayed start or pent-up demand if you want to call it from 1Q to 2Q.
You can't get more about two quarters up.
The next question is coming from the line of John Barnidge of Sandle O'Neill. Your line is now open.
Given the strong first half third sector sales this year, should we start viewing the Japan segment now that we have had a product portfolio composition shift of third sector in a way from first sector as more heavily weighted towards the first half in any given year to may be balance out the U.S. increasingly 4Q '18 for sales?
I think it's a function of when we introduced new product and that is the approval based on the FSA and the minute we decide we are coming out with a new product, we wanted as quickly as we can. So we don't hold for anything. So I think that what's driving in more than anything else.
Then with the new cancer products rolled out driving strong sales, can you talk about other new products or product enhancements, please?
Japan.
Yes. That will be great.
Koide or whoever wants to do it.
[Foreign Language] In terms of new products, we'll be focusing and we have been focusing on medical and cancer and especially cancer products that we needed to develop very attractive products at appropriate timing.
And then looking at medical products because of medical area as more competitive compared with either product in much more quicker pace and we are also considering some of the products in the protection type area and we are considering them for example, one of the areas that we are currently considering - promotional area, which could be very attractive.
The next question is coming from the line of Erik Bass of Autonomous Research. Your line is now open.
In the U.S. you are seeing some nice improvement on year-over-year and agent productivity. Can you just talk about which of your initiatives have the biggest impact to date and where you still see opportunity to improve performance?
So, Erik this is Teresa. I think in the area of where we are seeing most of our improvement, its distribution expansion and all of the activities that we have around our broker tools and services. I think we have started to see the investments pay off in that area. We also have executed on product partnership and other solutions that we are bringing to the employer, which I think have helped us to provide lift on that side as well.
As to what may not be performing as well, at this point, I feel like we are operating on all cylinders, what I'm seeing is a disciplined execution on our strategy. Obviously, I'd love to have more recruits increased productivity et cetera, but we continue to see very positive movement in many of our metrics, so hopefully that will answer your question.
To follow up on one thing you mentioned. You talked about the billed out of your products including some of the partnership relationships. Can you just comment on the impact that this is having on sales?
We are seeing increase in quotes from many of our larger case brokers and actually in the mid market as well. And so we see that as a great leading indicator for sales but we’ve also seen the sales rates increase as well. Enhancements to our new cancer products has also been a part of that as well.
And now I would assume the biggest benefit from that you'd see on sales would be in the fourth quarter as well?
Yes.
The next question is coming from the line of Suneet Kamath from Citi. Your line is now open.
Wanted to talk about Japan and the annualized premiums enforced even with the strong third sector sales it looks like that number is still coming down. I know there is 5-pay way still kind of coming through, but any sense of when you think that annualized premiums enforced number will start to grow again?
Suneet I think it does take a while we are still seeing the paid up policy dynamics come through in first sector. First sector but in general has about a one little north of 1% lapse rate generally. And then the paid-up policies are running around ¥30 billion for the year and that will continue to come down, but modestly. You'll still see a level of paid-up policies not just related to 5-pay but just in general other forms of paid-up policies that we have on the books.
And then eventually there's a 10 Pay product that sold far less than the five Pay but that comes into play as well. So first sector premium in general is going to continue to be modestly down, but it's slowly starting to get overwhelmed by the growth rate of third sector particularly when we post consecutive years of third sector growth rate. And so the third sector earned premium is now about 75% of our total earned premium that's up about 200 basis points over last year this time gives you an idea the mix shift.
And that third sector premium as we said we anticipate growing in the 2% to 3% range. And we’re certainly hitting that that nicely. So you'll start to eventually turn the corner, I think for sure you're into very low growth rates once you do turn that corner just by virtue of the sheer size of our block of business and natural lapsation that takes place.
But what's really important is the embedded value if you will and profitability of that shift and mix away from first sector towards third sector is a very good development for the company over time. And you end up seeing the evidence of that in improved FSA earnings which means improved cash flow in excess capital and deployment opportunities. So we’re happy with that trend line.
And then just on the third sector sales it looks like cancer is going to carry you guys for this year I think medical was pretty strong last year. I think there was a question on this earlier but just to follow up. Is there another sort of key product launch that you guys are thinking about for 2019 to kind of overcome what’s becoming some difficult comps in '18?
Will let Japan touch on that again.
[Foreign Language] And of course for our growth it is our responsibility to really inject new product into the market in a well planned manner. So we are steadily preparing for our new product launch. However I am not able to really disclose the specifics of the product that we are thinking of.
That’s the requirement of that let’s say that not just us that act like I want Dave.
No, that’s fine just one last one just on the income support product. I think in the past you talked about maybe that product is for the third leg and the product stool in Japan cancer, medical and then income support. And I realize there has been lot of emphasis on cancer certainly this quarter, but sales there really haven't budged much in fact they are down a little bit. Is that still a product that you think has the potential to be that third stool or any thoughts around that?
I’ll answer that I’m disappointed with the sales of the product, but it is a new product it’s not a revised product like when we say okay this is a new cancer. This is new thing that’s never really been out there and what we're seeing is the Shinkin banks are being successful with it. And we think that it will grow from there. What I would say is, I'm still encouraged that there is real potential with it, but it hadn’t taken off yet and I was hoping it would be doing a little bit better.
But make no doubt about it when you're constantly introducing new products that are stable product that everyone knows about used to and it's a revised product, the new product like in the case of this one, they lose focus on it our distribution network does. So it becomes a little bit harder, but we still think it has potential is the answer, but I'm disappointed that it isn’t doing a little bit better.
The next question is coming from the line of Tom Gallagher of Evercore. Your line is now open.
This is David [inaudible] on behalf of Tom. I guess I just wanted to ask a question on this dynamic of the lapse and reissue and just get a sense for the margin or IRR on the new product versus the old. And I know it's sort of was - a bit elevated this quarter at around 30% of the sales, but you mentioned it can be anywhere from 10 to 15 in any given year. So, just wondering how that sort of overall through into results and just the margin in IRR on the new versus old?
Both medical and cancer are priced with very similar margins. So while the premium will fluctuate in terms of the nature of the benefits and features of the products, the economic IRR if you will - both the IRR, as well as profit margin is priced in a very similar range. And so this is really less about an economic issue if you will to the company. We’re relatively indifferent. We leave it up to the customer to decide what's in their best interest related to the improved benefits and structure of it.
And so we’re not motivated by necessarily economics and I would keep in mind that those economics can really go both ways depending on the age of the policy and the nature of the policy they can both contribute to GAAP profitability in a particular period, they could also take away from GAAP profitability depending on how recent the product was sold and the nature of the product. So we really don't try to model in if you will that type of activity, it's entirely a consumer driven action and what's in their best interest and we remain agnostic to the dynamic.
And then I guess shifting gears to - Fred you mentioned or you alluded to earlier on just thinking about capital structure and I think we’d mentioned the RBC ratio in the U.S. But also just looking at the leverage ratio that's pretty low under your 20% to 25% guidance range, just thinking I guess how you guys are thinking about that. And then also just capital in Japan and I guess also just an update on the ESR regime and sort of how the FSA in Japan is thinking about maybe updating the SMR towards a more Solvency II like calculation?
Yes, let me try to do a little bit of discussion on this I certainly welcome either Max or Todd also to weigh in with any thoughts, but I'll give you my overview. Let's take it one at a time. In terms of U.S., I think we’ve covered that very well. I think there is opportunity to potentially do more optimization in the U.S. but that's dependent upon really settling into our U.S. only statutory conditions. But again I think there's opportunity there, but bit more marginal as we’re bringing a lot of that excess capital down to our current plans.
When you go to Japan, we really are in a very nice capital position. SMR is very strong despite actually some widening of spreads and of course some rising interest rates particularly in the U.S. but also here just over last few days more modest increase in rates in Japan would be [OSHA] activities or comments. And so we remain in a very good SMR position.
I think in Japan the issue tends to revolve around what amount of our FSA earnings - first of all what's the trend in FSA earnings. As I mentioned it's improving because of the economic shift in our business and then what amount of those FSA earnings in any given year do we feel comfortable with moving out and into the holding company structure for deployment. And we’ll develop that more in terms of dialogue at FAB.
But right now we have a policy of 80% of FSA earnings. We moved back into the U.S., that's under the basic notion that we need to retain 20% of those earnings to support the overall growth rate and in other reinvestment activities in our Japan franchise. But what we found is that, with the runoff of first sector and the run-up in third sector, we continue to produce increasing FSA earnings and can do more with that capital over time.
So, we'll discuss more about that, but that's really the optimization issue there. When you then come to the - to answer your question on ESR, ESR - first of all, our ESR, when you incorporate an ultimate forward rate adjustment, it's still running at around north of 225%. And when rates in Japan rise a little bit, that improves from there. I would estimate - is that about right Todd you can weigh in?
Yes, that's about right. Current internal models says about 225%.
And the ultimate forward rate - my memory is that may have around 60 point or so impact to that that level. Is that about right?
Yes, that's about right.
So, it gives you an idea. But the punch line is with or without a UFR, that's an extraordinarily strong ESR, particularly as it relates to other peer companies in the industry. And that's because we're so dominated by third sector, which is a better dynamic to have under that type of solvency.
In terms of where we are with adoption, I believe we're still in field testing, and I think it's still little unclear. But Todd, or anybody in Japan, if you've got any color on that, please provide it?
Yes, the FSA kicked off another round of field testing this summer, which will be targeted to complete by the end of the year. And as far as adoption of going to an economic solvency regime, I do believe there's not going to be any movement until around 2025. The FSA is following what the IAIS is doing in their modeling and guidance. So we still have some time with SMR and further development of our SMR framework.
In terms of leverage, yes, we're running low, but remember we got kind of a booster on lowering leverage when we adjusted the deferred tax liability with tax reform, that added around $1.9 billion to our equity capitalization and that really lowered us a bit on leverage.
And so, it's not been a proactive de-levering activity on our part. It's been more of the effects of accounting adjustments related to tax reform. Now having said that, our leverage is low and our coverage is very strong, given, we borrow roughly 3.4 billion of our 5 billion in borrowings in yen.
So, we have room. I like to be somewhat tactical, if you will, in leverage capacity for opportunities and allows for absorption, should there be any other items, although we don't foresee anything.
So, we'll be looking at leverage optimization and what we may do there. I think I put that into the overall holding company, capital structure dynamic. And as we've talked about here now a couple of times, including this quarter, we're looking for ways to optimize our hedge costs in Japan through setting up mere trades at the holding company, and that serves to lower our net exposure to a weakening yen over time.
So we think there's some real economic benefits both from an earnings standpoint and risk reduction standpoint to better optimizing or utilizing the FX capital that we have at the holding company.
So, that's a bit of a flyby. Max, I don't know if there's anything you want to add from your perspective.
Just to add a little bit of color. So overall our business has a low risk profile, and we have a liability structure that is very stable and low risk as well. So you combine that with a relatively low leverage range that we are operating within, and you quickly realize that we do have significant debt capacity and we could go to a higher leverage level.
At the same time, in the post conversion phase that we are in right now, we continue to travel and want to travel with relatively low leverage and high capital. So I will put it this way, that we do have significant debt capacity but it has to be for good return projects.
We will not lever up just for the sake of it, but as we find very good projects to invest in, we do have very significant debt capacity.
Thank you. At this time, we don't have any questions on queue. I will turn the call over back to Mr. David Young.
Thank you all for joining our call this morning. Before we end, I'd like to remind you that we will be hosting a financial analyst briefing in Tokyo, on September 26. And I hope you'll join us there. Any interim, please feel free to contact our Investor and Rating Agency Relations Department for any information or questions you may have, and we look forward to speaking with you soon. Thank you.
Thank you. This concludes today's conference call. Thank you all for joining. You may disconnect at this time.