Aflac - Earnings Call - Q3 2020

Transcript

Operator (participant)

Good day everyone and welcome to Aflac third quarter 2020 earnings call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star followed by the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you. I would now like to turn the call over to your host, David Young, Vice President of Investor Relations at Aflac Incorporated. Please go ahead, sir.

David Young (VP of Investor Relations)

Thank you. Adrian, good morning and welcome to Aflac Incorporated's third quarter earnings call. As always, we have posted our earnings release and financial supplement to investors.aflac.com. This morning we will be hearing remarks about. The quarter as well as our operations. Japan and the United States amid the COVID-19 pandemic. Dan Amos, Chairman and CEO of Aflac Incorporated, will begin with an overview of our operations in Japan and the U.S. Fred Crawford, President and COO of Aflac Incorporated, will then touch briefly on conditions in the third quarter and discuss how we are navigating the pandemic, including some key initiatives. Max Broden, Executive Vice President and CFO of Aflac Incorporated, will then conclude our prepared remarks with a summary of third quarter financial results and current capital and liquidity.

Joining us this morning during the Q&A portion are members of our executive management team in the U.S., Teresa White, President of Aflac U.S., Eric Kirsch, Global Chief Investment Officer and President of Aflac Global Investments, Rich Williams, Chief Distribution Officer, Al Riggieri, Global Chief Risk Officer and Chief Actuary, June Howard, Chief Accounting Officer, and Steve Beaver, CFO of Aflac U.S. We are also joined by members. Of our executive management team in Tokyo At Aflac Life Insurance Japan. Charles Lake, Chairman and Representative Director, President of Aflac International. Masatoshi Koide, President and Representative Director, Todd Daniels, Director and CFO, and Koji Ariyoshi, Director and Head of Sales and Marketing. Before we begin, 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. As I mentioned earlier, the earnings release is available on investors.aflac.com and includes reconciliations. Of certain non-U.S. GAAP measures. I'll now hand the call over to Dan. Dan?

Dan Amos (Chairman and CEO)

Thank you, David, and good morning. Thank you for joining us. As we all know, the COVID-19 pandemic has ushered in some of the most difficult times for so many people around the globe, and we continue to pray for all those affected. I'd like to share my appreciation for our employees and sales force in Japan and the United States for their tireless work in helping our policyholders and communities impacted by the pandemic during this difficult time. It's important to note that we remain focused on doing what we do best, that is providing protective products to help consumers when they need it most. This morning I'll provide an overview of the quarter and how we performed by operating segments financially.

Aflac continues to be impacted by the pandemic but remains strong in terms of capital and liquidity. In addition, our investments are high quality, diversified and they are among the highest return on capital and lowest cost of capital in the industry. Amid the challenges of COVID-19, this quarter was also significantly impacted by the release of favorable U.S. tax regulations related to the utilization of foreign tax credits. You'll recall that our Japanese subsidiary is taxed as a U.S. domestic company for U.S. tax purposes. In the quarter we recognized a cumulative year-to-date benefit from these regulations of $202 million or $0.28 per share compared to our previous run rate. Max will provide additional details. Turning to our operations starting with Aflac Japan, the effects of COVID-19 continues noticeably impacted our results as seen in the third quarter.

With sales decreasing 32%, we continue to have around 50% of the workforce working from home in Japan and in September, traffic coming into the shops remained at 70% of pre-pandemic levels. While these sales results represent sequential improvements relative to the last quarter, the effects of the reduced face-to-face activities are evident and we continue to promote virtual sales. 2020 has also ushered in a change on the Japanese political front. Prime Minister Abe was Japan's longest-serving Prime Minister and a source of political stability with nearly eight years in office. Mr. Suga was a core member of Abe's administration leadership team serving as the Chief Cabinet Secretary. We believe Mr. Suga's administration will carry on skilled leadership.

This will continue to promote a good business environment in Japan and emphasize policies in terms of the response to the COVID-19 and economic policies. Prime Minister Suga is accelerating efforts to move forward with regulatory reforms for a post-pandemic world promoting digital transformation. In that respect, I am pleased that Aflac Japan's paperless initiative is well underway. Fred will share more, turning to. Aflac U.S., the effects of COVID-19 continue to noticeably impact our results in this segment as well, largely due to reduced face-to-face activity. Third quarter sales were down 35.7% in the U.S. We continue to feel the impact of temporary business closures and lack of access to the work site, especially among our career agents who have historically relied upon face-to-face meetings to engage our small business owners and their employees at the same time.

The fourth quarter, typically when we see strong results in the broker-driven group market, which has generally been more resilient to non-face-to-face conditions. As a result, we remain cautiously optimistic for modest sequential sales improvement for Aflac U.S. in the fourth quarter compared to the second and third quarter contingent upon the pace of the economic recovery. We are also on track to close our acquisition of Zurich's group benefits business soon, which allows us to extend our distribution reach and appeal to brokers and large employers. While having little effect on the fourth quarter, the acquisition positions us for expanded capacity as we look forward to 2021 to place Aflac in a position of strength. We know that we must balance investing in growth with an eye toward reducing expenses in the long run.

As such, we took an opportunity to offer a very generous voluntary separation package to eligible employees who expressed an interest. As a result, we have achieved an approximate 9% reduction in our U.S. and corporate workforce with expected one-time expenses of $45 million in the fourth quarter. This allowed us to thank employees for their years of faithful service and dedication as they pursue a new path or open up the next chapter. You'll recall that the U.S. benefit ratio was significantly affected by policyholders limited visits to the doctor. With this in mind, we launched a U.S. initiative early in the third quarter to remind policyholders of the value of their wellness benefits attached to their products.

The wellness benefits pays on certain routine doctor, dentist and hospitalization visits. In addition, we make sure that it pays a benefit for COVID-19 testing, the wellness initiative has been a success. We are glad we emphasize this important aspect of our policies as it reinforces how we are there for the policyholder when they need us most. This wellness campaign and the voluntary separation programs were a couple of near-term headwinds to the profit margin. However, we expect that they will serve us well as we enter 2021. To conclude our operational discussion. As I've said before, we want to be where the people want to purchase insurance that applies to both Japan and the U.S. In the past, this has meant meeting face-to-face with individuals to understand their situation, propose a solution, and close the sale. However, the pandemic clearly demonstrates the need for virtual meetings.

In other words, non-face-to-face sales to reach potential customers and provide them with the protection that they need. Therefore, we have accelerated investments to enhance the tools available to our distribution in both countries. As always, we are committed to prudent liquidity and capital management. This includes maintaining strong capital ratios on behalf of the policyholders in both the U.S. and Japan and a tactical approach to capital allocation. It goes without saying that we treasure our record of dividend growth. With the fourth quarter declaration, 2020 will mark the 38th consecutive year of dividend increases. Our dividend track record is supported by the strength of our capital and cash flows. At the same time, we have remained tactical in our approach to share repurchase, buying back $400 million of our shares in the third quarter. We have also focused on integrating the growth investments that we have made in our platform.

By doing so, we look to emerge from this period of continued position of strength and leadership. As always, we are working to achieve our earnings per share objective while also ensuring we deliver on our promise to our policyholders. We look forward to going into greater detail on our strategic growth plans and efforts to drive efficiency at the Financial Analyst Briefing conference call in a few weeks. So now I'd like to turn the. Program over to Fred.

Fred Crawford (President and COO)

Thank you, Dan. I'm going to touch briefly on conditions in the third quarter and how we're navigating the pandemic. I'll also provide an update on key initiatives in Japan and the U.S. to include our approach to managing expenses. There are currently approximately 97,000 COVID-19 cases and 1,730 deaths in all of Japan through the third quarter. Aflac Japan COVID-19 impact totaled 1,750 unique claimants with incurred claims totaling approximately JPY 550 million in the quarter and JPY 760 million year to date. In short, we are tracking well below our stress assumptions with no measurable impact from COVID-19 claims. However, reduced sales and delaying the promotion of the new cancer rider and refreshed medical product are contributing to revenue pressure. This pressure is offset somewhat by favorable persistency.

COVID-related expenses in the quarter totaled JPY 1.7 billion, which included the rollout of virtual distribution tools, employee teleworking equipment and distribution support. In the U.S., the dynamics are understandably more complex. COVID-19 case levels in the U.S. now exceed 8.5 million, with deaths nearing 230,000 through the end of the third quarter. COVID-19 claimants in the U.S. totaled 12,800, with incurred claims of approximately $23 million in the quarter and year to date, approximately $57 million. We are closely monitoring the recent surge in infections but continue to see the rate of hospitalization, length of stay in the hospital and transition to ICU trending below our expectations.

We believe this is attributed to advancements in treatment and the nature of the work site, which is generally younger and healthier population of policyholders, as Dan noted in his comments. We launched an initiative early in the third quarter to remind policyholders of their wellness benefits, which drove increased utilization. This effort involved connecting with 2.7 million accident and hospital policyholders through a combination of email and direct mail in the month of August. This impacted our benefit ratio in the period but is designed to reinforce the value proposition of our products. We have thus far seen limited impact to persistency. However, we believe this is partially attributed to state executive orders requiring premium grace periods. These executive orders are still in place in 13 states as of the end of the quarter.

In those states where the executive orders have expired, we have reduced pressure on lapse rates through proactive outreach to policyholders and employers, actively converting policyholders from payroll deduction to direct bill and notifying policyholders of their wellness benefits. Turning to key operating initiatives in both Japan and the U.S., we are balancing investments in growth while addressing our expense structure. A material driver of elevated expense ratios in Japan and the U.S. is weakness in revenue, thus the need for a balanced approach. Beginning with Japan, we are set to promote a simplified cancer rider in the fourth quarter and launching our refreshed medical product in the first quarter of 2021 rolled out in late October. We have the technology in place to pivot from face to face to virtual sales and an entirely digital customer experience.

We continue with direct mail campaigns aided by data analytics that serve to enhance the close rate. We expect the combination of product development, a recovery in pandemic conditions and our alliance with Japan Post to be important growth drivers as we make our way through 2021. We view the pandemic as a call to action on accelerating investment in our digital roadmap and related process improvement. On our second quarter call, I noted our paperless initiative across all operations in Japan. This is a three-year and roughly JPY 10 billion investment with approximately JPY 2 billion spent in the third quarter along with another JPY 3.6 billion estimated spend in the fourth quarter while elevating our 2020 expenses.

This effort will reduce the production and circulation of 80 million pieces of paper per year with run rate savings in the range of JPY 3 billion annually. As we move to the fourth quarter, we have budgeted an increase in general administration expenses over our third quarter of approximately JPY 6 billion. This includes 50% of our 2020 annual advertising spend concentrated in the quarter to raise new product awareness as well as a stepped up level of investment in the Paperless initiative. We are effectively accelerating investments in our digital platform into 2020 and 2021. Turning to the U.S., the build out of network, dental and vision remains on track. We have successfully filed our new network products in 48 states with approvals received in 37 states.

We are up and running with sales in 10 states and expect to ramp this up as we move into 2021. Our consumer markets platform remains on track with hospital accident and cancer product filings expected to be completed in early 2021. We also plan to include life insurance in 2021, recognizing that as a natural product to sell digitally empowered by the Aflac brand. Finally, we will soon close on our Zurich benefits acquisition, having successfully completed the required regulatory approvals along with efforts to improve overall persistency. These are the three largest incremental drivers to earn premium growth in the coming years.

Anticipating further pressure on near term earned premium as we move into 2021, we are addressing expenses in the U.S. with a sense of urgency. We are addressing expenses across two horizons. Horizon One is near term focused and includes a series of actions in 2020 designed to take out approximately $100 million of annualized run rate expenses as we enter 2021. This includes both the U.S. platform and corporate expenses. Early in the fourth quarter, we completed a voluntary separation plan for eligible employees which will result in a 9% reduction to our U.S. workforce. We expect to record a one time separation expense of approximately $45 million in the fourth quarter and we'll realize annualized run rate savings in the $45 million-$50 million range.

Horizon Two expense initiatives elevate near term expenses until such time the investment is complete, legacy platforms are decommissioned and business processes are adjusted. The most significant investment is in our group business and migration off an old administrative platform onto a new platform. In addition, we are completing a broader digital roadmap which includes approximately $25 million of accelerated investment in 2020, much of that investment coming in the fourth quarter. As I noted, we need to balance these expense initiatives with investment in growth. We have adopted a buy to build acquisition strategy. While a tactical and prudent use of excess capital, this is not an inexpensive effort in the early years.

These build efforts include dental and vision, direct to consumer, and group benefits, and taken together impacted our expense ratio in the third quarter by 110 basis points and are expected to impact the fourth quarter by approximately 160 basis points.

I'll conclude my comments with investment conditions. Our global investment team remains focused on asset quality monitoring, economic conditions and sourcing new investment opportunities in a low interest rate environment. Our firm view is that we will experience a check mark shaped recovery, meaning a slow road to recovery with pockets of volatility along the way. Our actions prior to the pandemic to tactically improve the risk profile of our portfolio, combined with some additional derisking earlier this year, has served us well with only modest losses on the sale of securities, impairments and loss reserve increases. These actions have also positioned the portfolio defensively should we see a second surge in the virus impact economic conditions, we continue to watch closely our middle market loan and transitional real estate portfolios.

While we have seen credit rating downgrades, our middle market loan portfolio is more resilient, consisting of first lien loans to high quality borrowers backed by strong equity sponsors. In the case of transitional real estate, our portfolio is also consisting of only first lien positions and is diversified with strong loans to value. We continue to explore ways to optimize currency hedging. Overall, no material change, but we are further refining our approach to managing the unhedged dollars in Japan. These unhedged dollars provide diversification and income benefits as well as lowering our enterprise exposure to the yen. As we look towards 2021, we will reset 2020 hedges on our floating rate portfolio and currency hedges at materially lower rates.

While we do not see this impacting net investment income to any great degree, you will see line item impacts to Japan's net investment income, hedge costs and corporate investment income. Wrapping up my comments, we are not backing off critical investments to drive long term growth and efficiency in the face of what we believe to be temporary weakness in sales results and earned premium. We will provide further detail around this when we meet for our annual financial investor conference in the coming weeks and we'll talk about the details of investments and when we expect them to turn the corner to having a positive impact on growth and profits. I'll now pass on to Max to discuss financial performance in more detail. Max?

Max Broden (EVP and CFO)

Thank you, Fred. Let me begin my comments with a review of our third quarter performance with a focus on how our core capital and earnings drivers have developed. For the third quarter, adjusted earnings per share increased 19.8% to $1.39 with no significant impact from FX in the quarter. Adjusted book value per share including foreign currency translation gains and losses grew 17.4% and the adjusted ROE excluding the foreign currency impact was a strong 16.8%. A material spread to our cost of capital.

This quarter was significantly impacted by the release of favorable U.S. tax regulations related to the utilization of foreign tax credits. As a reminder, our Japanese subsidiary is taxed as a U.S. domestic company for U.S. tax purposes. In the quarter we recognized cumulative year to date benefit from these regulations which lowered our tax rate on adjusted earnings for the quarter to 4.1%, a benefit of $0.28 versus our previous run rate.

Our tax rate for the quarter further benefited from tax credits in our solar and historic rehabilitation investments which lowered our tax expense by approximately $20 million more than in a normal quarter. In addition, variable investment income came in $6 million above our long term return expectations and together these two items boosted current quarter EPS by about $0.03 on a go forward basis and under the current U.S. corporate tax regime, we would expect our go forward tax rate on adjusted earnings to be approximately 20%.

Turning to our Japan segment, total earned premium for the quarter declined 3.3%, reflecting mainly first sector policies paid up impacts, while earned premium for the third sector products was down 1.7%. Japan's revenue trends should be considered in the light of impact of paid up policies. For example, year-over-year earned premium was down 3.3% in the quarter, while policies in force were down a little less than 1%. This disconnect masks the strength of persistency, which has been rising during the pandemic. In short, expenses related to managing our in force tend to hold steady despite the drop in reported earned premium, putting pressure on our expense ratio.

Japan's total benefit ratio came in at 71.3% for the quarter, up 130 basis points year-over-year, and the third sector benefit ratio was 61.7% up 170 basis points year-over-year. The main driver for the increase was lower lapses associated with policyholders updating their coverage given the current lower new business activity. This naturally pushes up our benefit ratio due to lower reserve releases, decreases DAC amortization, and improves reported persistency. We did experience all of this in the third quarter manifested by our persistency improving by 80 basis points year-over-year. The IBNR was also less favorable this quarter. We've seen a drop in paid claims during the pandemic, more so in our medical coverages. Our IBNR estimate has only partially reflected this drop. Given there is not much data to base an adjustment on.

We continue to monitor experience and will adjust our paid data as it gets more complete. In addition, for our cancer claims that are more than three years old, we extended the completion of claims which led to a smaller release in IBNR compared to 2019.

Our expense ratio in Japan was 21.7%, up 110 basis points year-over-year. Our paperless initiative kicked in at a higher gear as we digitized our operations and drove efficiencies from throughout the value chain to a future state with significantly reduced paper usage overall. When considering COVID-related spend, promotional spend and digital and paperless initiatives, we anticipate expense ratios in Japan to remain elevated in the 22% range for the remainder of 2020.

Net investment income declined 0.2% in yen terms despite the higher variable investment income as our yen-denominated portfolio generated lower yields due to lower call income in this quarter. The pre-tax margin for Japan in the quarter was 19.4%, impacted by both the higher benefit ratio as well as a higher expense ratio in the quarter. Turning to U.S. results, earned premium was down 2.6% due to weaker sales results. Premium persistence improved 80 basis points to 78.8% as our efforts to retain accounts and keep premium in force show early positive results. As Fred mentioned, there are still 13 states with premium grace periods in place at the end of Q3, so we are monitoring these developments closely. Our total benefit ratio came in at 48.3%, which was 80 basis points lower than Q3.

2019, we have seen a normalization of claims activity across our portfolio compared to the second quarter. In order to improve customer experience and persistency, we conducted an extensive policyholder communication campaign highlighting the embedded wellness benefit in our accident product and we encourage policyholders to utilize this benefit. We estimate this initiative drove incremental claims of approximately $14 million and impacted our benefit ratio in the range of 100 basis points over what we would normally expect, but we believe our efforts will add value for the customer and improve their experience along with improved long term persistency.

Our expense ratio in the U.S. was 37.2%, up 130 basis points year-over-year. The inclusion of Argus added 80 basis points in the quarter and a decline in revenues roughly explains the residual year-over-year impact. The impact from declining revenues has become more pronounced on our ratios in this quarter relative to prior quarters. We anticipate expense ratios in the U.S. to remain elevated in the 39% range for the full year 2020 driven by near term weakness in revenue uptick in seasonal business activity and expected inclusion of the Zurich Group benefits acquisition.

Net investment income in the U.S. was down 4.4% due to a 14 basis points contraction in portfolio yield year-over-year. Profitability in the U.S. segment remains healthy at 20.5% with a low benefit ratio as the core driver. In our corporate segment, amortized hedge income contributed $22 million on a pre-tax basis to the quarter's earnings. With an ending notional position of $5 billion. Our capital position remains strong and we ended the quarter with an SMR north of 900% in Japan and an RBC of approximately 700% in Aflac Columbus. Our RBC is temporarily boosted by delaying statutory subsidiary dividends to Q4. We still expect to end the year with an RBC in a range of 550%-600%.

Holding company liquidity stood at $3.8 billion, $1.8 billion above our minimum balance. This is down compared to earlier in the year, but reflects our decisions to delay regular Q3 subsidiary dividends to Q4 on an annual basis. We expect uninterrupted dividend flows to continue from our subsidiaries. Leverage improved to a comfortable 22.9% due to the increase in shareholders equity driven by the release of the tax valuation allowance of $1.4 billion.

While we remain cautious in terms of monitoring the pandemic, we have comfort in the strength of our capital ratios, excess capital, statutory earnings and dividend capacity, and our ability to navigate any current and future stress brought on by the pandemic or associated economic conditions. In the quarter, we repurchased $400 million of our own stock and paid dividends of $192 million. We will continue to be flexible and tactical in how we manage the balance sheet and deploy capital in order to drive strong risk adjusted return on equity with a meaningful spread to our cost of capital. Let me now turn it over to David to begin Q&A.

David Young (VP of Investor Relations)

Thank you Max. We're now ready to take your questions. But first let me ask you to please limit yourself to one initial question followed by related follow up question to allow other participants an opportunity to ask a question. Adrienne, we'll now take that first question.

Operator (participant)

Your first question comes from the line of Nigel Dally with Morgan Stanley.

Nigel Dally (Equity Analyst)

Great. Thanks and good morning everyone. My question is on expenses. You announced the U.S. Expense Reduction Initiative. Together with paperless initiatives in Japan, but you're also talking about ramping higher investments in other digital and growth initiatives. Appreciate the color for the fourth quarter, but how should we be thinking about expense ratios in 2021? Should we see some of the benefit of those initiatives flow through the bottom line or still elevated expense ratios looking forward?

Fred Crawford (President and COO)

I would, Nigel, this is Fred. I would say in general both in 2000, both in the case of the U.S. as well as Japan in 2021, you should anticipate a continuation of elevated expenses as these investments will continue at their current pace. And in fact in the U.S. we will particularly be building more proactively on the dental and vision, the consumer markets and then now adding the group benefits business. So you'll see the pace of investment improve when it comes to business as usual expenses or what we would call our general operating expenses. That's where you'll see improvement, particularly in the U.S. as we take action around staffing models, headcount and other related cost savings efforts. So it's a balancing act. We'll give more color on our expense ratios both in Japan and the U.S. at the Financial Analyst Briefing as we traditionally do.

So, I don't want to get out in front of that, but I can certainly answer your question that the pace of investment will continue to go forward, but it's really directed towards growth as well as efficiency. Remembering there's two components to the expense ratio and one of the things weighing on our expense ratios right now in Japan and the U.S. is weakness in revenue. So we've got to drive these expenses through to generate revenue improvement over time. That will be the path to victory on expense ratios ultimately.

Nigel Dally (Equity Analyst)

Very helpful. Thank you.

Operator (participant)

Your next question comes from the line of Jimmy Bhullar with J.P. Morgan Securities LLC.

Jimmy Bhullar (Equity Research Analyst)

I had a question just on the U.S. business. Obviously sales have been pretty weak recently and I'm assuming that 4Q will be a little bit better just given that a majority of the sales are broker sales. That channel doesn't seem to be. As impacted by sort of social distancing and stuff. But what's your sort of path to? An improvement in sales beyond that is because, I'm assuming, even though businesses are starting to open up, most of them are going to be reluctant to have salespeople come in and pitch products or enroll people, so what's like just a few comments on what you feel is going to drive a recovery in your sales in the U.S. beyond just sort of a? Vaccine or just normalization of social and business?

Dan Amos (Chairman and CEO)

Going to have Rich answer that?

Jimmy Bhullar (Equity Research Analyst)

Sure.

Rich Williams (CDO)

Okay. Thank you, Jimmy. You know, as Dan noted in his comments, we expect modest sequential improvement in the fourth quarter compared to the second. The third quarter. As you recall, the fourth quarter for us is more heavily weighted to broker sales, roughly about 50% of our quarter. That's where less face-to-face. Enrollment is utilized as well as larger cases. So I think those are sort of the support points to Dan's comments around modest sequential improvement. I think. Secondly, we will reserve comments around 2021 for our outlook call and Financial Analyst. Briefing and we'll look forward to that discussion then.

Dan Amos (Chairman and CEO)

Teresa, did you want to add any?

Teresa White (President)

No, I think Rich covered it. Thank you.

Jimmy Bhullar (Equity Research Analyst)

And maybe just another one on the U.S. on your persistency, can you talk? About what you've seen in terms of persistency in regions where premium grace periods have expired? Are you seeing an uptick in lapses there or not?

Teresa White (President)

Overall, thanks, Dan. Overall, we've not seen a notable increase in policy lapses given the stability and our persistency ratio, but we continue to monitor, especially with the small business side. It's important to note that, you know, small business is a large part of our in force. However, the premium is more balanced across small and large cases, so really we're not seeing what we thought we would see, but we're continuing to monitor this and we'll give more insight at the investor conference as well.

Dan Amos (Chairman and CEO)

I think the wellness benefit and our ability to pay claims for it, although it ticked up our benefit ratio, which we wanted to happen, we believe it will also have a positive impact on persistency as people realize they need the product.

Jimmy Bhullar (Equity Research Analyst)

Thanks.

Operator (participant)

The next question comes from the line of Suneet Kamath with Citi.

Suneet Kamath (Senior Research Analyst)

Thanks.Good morning. So I think you had said you expect some new products in Japan in the first quarter. So, just curious, normally when you launch a new product, we see almost an immediate pickup in sales. Just given the pandemic and how the sales dynamic has changed, should we expect the same sort of trend that we've seen historically? And will you be selling this new medical product in the Japan Post? Sorry, the cancer product in the Japan Post channel.

Dan Amos (Chairman and CEO)

[audio distortion] Koji will answer to that question.

Suneet Kamath (Senior Research Analyst)

Okay.

Koji Ariyoshi (Director and Head of Sales and Marketing)

[Foreign language]

In terms of medical insurance, as we have already started with our cancer insurance, we have implemented web-based solicitation as well as the online insurance application system from October and this will allow reduction of COVID-19 risk like having social distance.

[Foreign language]

On top of that, this medical insurance product that we plan to launch is a competitive product so we will be able to win in the competition and that way we should be able to increase our share in the medical market.

[Foreign language]

Our new product has a broad range of coverage to really be able to respond to various types of customers, for example, a lot of the customers have concerns about the three dread diseases, which we will cover further in this new product as well as short-term coverage in the medical insurance, and at the same time, those customers who really do not want to just keep on paying premium and gain nothing, we do have some no-claim bonus rider that can be added to this rider, so we should be able to respond to various needs of customers.

[Foreign language]

We would like to use this medical insurance product as sort of the engine to start our sales in 2021, and with this web virtual sales, we should be able to minimize the negative impact or the risk of COVID-19, so we'd like to really use this to harness our sales.

Suneet Kamath (Senior Research Analyst)

Okay, thanks. And then I guess for Max on the tax rate change, was any of? This related to the Trump tax cuts? I mean, accordingly, is there any risk that under a different administration this tax? Ruling that you got could be reversed?

Max Broden (EVP and CFO)

No, it's not related to the Trump tax cuts. This is related to new regulation issued by the U.S. Treasury and the IRS that came out on September 29th.

Max Broden (EVP and CFO)

Okay, thanks.

Operator (participant)

The next question comes from the line of John Barnidge with Piper Sandler.

John Barnidge (Managing Director)

How should we be thinking about the? Permanence of some of the declines in utilization in the U.S. from maybe changed. Behavior from COVID principally maybe telemedicine driving down the benefit ratio?

Dan Amos (Chairman and CEO)

I think it's still in limbo in terms of what we're absolutely sure will happen. Certainly we have seen when, let's say April, May, June. People were staying inside more. They were not going to the doctor. We saw a drop off in the claims. The idea of the wellness benefit is to get them back to a doctor twofold. One, to have utilization of the policy and therefore improve persistency, raise the loss ratio some, but also prevent people from. I mean, I have a friend whose. Wife. Was diagnosed with a stage three cancer, and if they had gone to the doctor, as they should have but couldn't because of COVID, they could have caught it much earlier. So one of the things that we're watching is to see whether or not there's a tail on this.

And that's why we're trying to encourage people to go ahead now and go back to the doctor, use these wellness benefits, get the exams you should get, and hopefully that brings down the tail on the business. So we know that it's already picking back up in terms of people going back to the doctor, but it's not back to the normal amount that it was running pre-COVID.

John Barnidge (Managing Director)

Okay. And follow up. It does. It's very helpful. The Wellness initiative that trimmed 100 basis points on the benefits ratio, has that completely played out or could there be?

Fred Crawford (President and COO)

Still more to come? We believe that there's still more to come. Sorry, Fred, go ahead. The answer is we believe that there could still be more to come there.

John Barnidge (Managing Director)

Thank you.

Operator (participant)

The next question comes from the line of Erik Bass with Autonomous Research.

Erik Bass (Equity Research Analyst)

Hi. Thank you. Do you intend to let all of? The tax benefit drop to the bottom line or do you see opportunity to either accelerate investment or adjust product pricing to boost growth?

Dan Amos (Chairman and CEO)

We obviously have multiple initiatives in place in order to drive growth as Fred outlined, and that is pushing up our expense ratio and that has been in play for the last couple of years and we see that ongoing. So generally I would characterize this benefit as dropping to bottom line.

Max Broden (EVP and CFO)

One thing I would add though, and this goes to the previous question too, about how to think about future corporate tax rate changes, is that we do have to be mindful of that. This effectively just creates an even playing field for the way in which we report our effective tax rate and cash tax payments. In other words, we are effectively paying a 21% corporate tax rate as being a U.S. taxpayer at Aflac, and so to the degree there is a change in tax law going forward will be impacted much like any other corporate taxpayer in the U.S. and so we do have to be mindful of that and we'll be watching that carefully.

Having said that, though, there's a very real benefit to us, both cash wise and effective tax rate for a period of time, including going back and grabbing some cash flows that we had previously paid out in the way of tax payments. So it's a real benefit, but one that you want to be careful about taking into the future if you believe there could be changes in the corporate tax rate going forward.

Erik Bass (Equity Research Analyst)

Thank you. And then can you talk a little bit about the recruiting and licensing backdrop for new agents?

Dan Amos (Chairman and CEO)

Rich?

Rich Williams (CDO)

Absolutely. First of all, recruiting continues to. Be a very important part of our investment and strategy going forward. We saw improvement in the third quarter. Compared to the second quarter, and we, you know, at the beginning of 2020. We implemented significant alignment from a compensation. Program to drive producer growth and to drive recruiting. And so the anticipation on recruiting for the fourth quarter as we expect to see moderate improvement compared to the second and third quarter. And then as we look to 2021. We'll clearly talk about that more at. The investor conference, but it will be a key part of our strategy.

Erik Bass (Equity Research Analyst)

Got it. Thank you.

Operator (participant)

The next question comes from the line of Humphrey Lee with Dowling & Partners.

Humphrey Lee (Head of Life Insurance and Retirement Services Research)

Good morning and thank you for taking my questions. My first question is related to the expenses in Japan. I heard that you talked about the JPY 1.7 billion for the COVID related expenses in the quarter and then also there were JPY 2 billion related to the tablet initiatives. But just looking at the sequential increase in expenses as to those two pieces only explain half of the increase. So I was just wondering what's the. Other driver for the much higher expenses in the quarter?

Max Broden (EVP and CFO)

The main driver continues to be in terms of the expense ratio is the decline in revenues, so you have the increased spending but also the function of lower revenues is impacting the expense ratio.

Humphrey Lee (Head of Life Insurance and Retirement Services Research)

I'm just referring to the notion of. General expense amount of JPY 72 billion.

Max Broden (EVP and CFO)

I think that much of that has to do with just seasonal dynamics related to direct mail spend as well as other promotional initiatives in the quarter related to, you know, as compared to last year, so I think some of it was just natural fluctuation. The two main drivers, and maybe I would add a third, are not only COVID-related expenses and the paperless initiative, but we also continue to accelerate certain digital investment in the quarter and those are the primary drivers of just an incremental increase in general operating expenses.

Humphrey Lee (Head of Life Insurance and Retirement Services Research)

Okay, and then in terms of the. Zurich acquisition in the fourth quarter, how. Should we think about the size of the premium add and then also by extension the expense impact of with that platform and also kind of what's your expectation on a full year premium? Basis. For that business?

Max Broden (EVP and CFO)

That business has been running at around, I believe, in the $75 million-$100 million annualized premium range. As you can expect, that's a lumpy business because it's largely a startup at Zurich and it tends to focus in on large accounts. But it's also a very persistent business. So there's high persistency with that business. So I would expect on an annualized basis it's in that range. So it'll have a modest impact to annual earned premium in terms of the overall P&L impact on it. As we mentioned when we announced the transaction, we would expect there to be roughly $0.05 dilution on an annualized basis related to that transaction. And that's largely because as they are still ramping up the business, their revenue is not enough to offset their cost structure because it's in a growth mode.

And so, we expect obviously and intend to continue that growth mode going forward. So that's essentially the nature of the business, it's modestly dilutive to earnings and modestly accretive to earned premium.

Humphrey Lee (Head of Life Insurance and Retirement Services Research)

Got it. Thank you.

Operator (participant)

The next question comes from the line of Andrew Kligerman with Credit Suisse.

Andrew Kligerman (Managing Director)

Hey, good morning. The first question is around the. Benefit ratio and I'm wondering as we. We're looking out in the U.S. At a 48.3%, down from 49.1% year-over-year, and then of course 44.3% quarter-over-quarter, have we reached kind of. A stable zone now? How would you expect it to trend over the course of the next several quarters?

Fred Crawford (President and COO)

Well, I mean, in general we would expect it to trend up, but really up to previous reported numbers prior to the pandemic. And that's simply because of what Dan outlined in his comments, that there'll be naturally a gradual increase in utilization but really back to normal levels and still overall favorable relative to going back in history. So you'll see a trend up. Wellness-related impacts will subside, we certainly hope, but frankly we're monitoring as you can imagine given the news COVID-related cases. But overall we would expect utilization to find its more normal levels over time. We are bringing on businesses that tend to have higher benefit ratios and lower expense ratios, network, dental, and vision for example, and then of course group benefits. So over time you'll eventually have a bit of a mixed play in our benefit ratio to be aware of.

But that's unlikely to be material over the, certainly over the next several quarters and in 2021. But you'll see that play out over time, and we'll of course be able to report that out and let you know what's influencing the benefit ratio and expense ratio.

Andrew Kligerman (Managing Director)

Earlier in the year you provided a credit stress scenario of about $680 millions of credit losses. Has that changed, improved, worsened, what's kind of the outlook there and what are you seeing into 2021?

Max Broden (EVP and CFO)

Eric, why don't you take that?

Eric Kirsch (Global Chief Investment Officer and President)

Sure thing. Thank you, Andrew. You know, naturally we continue to analyze our portfolio stress scenarios inclusive of how our portfolio actually performed over these past six months and looking forward, including assumptions about a second wave and economic and market impacts. In fact, our portfolio has performed very well through the first part of the pandemic and better than expected relative to our stress tests. In addition, as you may recollect in. The second quarter we did some marginal. De-risking and risk reduction, and there were particular names in the stress test that, in essence, were impacted or went away. Having said that, we're completing our newest stress test and intend on presenting that at this upcoming fab, so if you can be patient for about another month, you'll see some of the new results.

Andrew Kligerman (Managing Director)

Got it.Thank you.

Operator (participant)

The following question comes from the line of Tom Gallagher with Evercore ISI.

Tom Gallagher (Senior Managing Director)

Good morning. First question, Max, can you give a sense for how the cash tax benefits will compare to the reduction in the? GAAP tax rate and how we should. Think about that playing out over time?

Max Broden (EVP and CFO)

So cash taxes will always be volatile and there will be timing differences between our GAAP and our cash taxes, but over time I would expect them to have about the same impact from this change in tax regulations.

Tom Gallagher (Senior Managing Director)

Would you expect there to be a meaningful difference in the first couple of years and converge over time, or is? It's going to be, would you say. Directionally similar. With some volatility around it. If you know what I mean?

Max Broden (EVP and CFO)

Yes, it will be the latter. It will not be any material significant difference and certainly not over as long a period as a number of years. It's more the latter where we might in the short term have some timing differences, but generally speaking, we would expect our cash taxes to come down as well.

Tom Gallagher (Senior Managing Director)

Got you. And then my follow up is, can you talk just given the increase in. The benefit ratio in Japan this quarter. The 150 basis points to 200 basis points. Points, can you talk about, and I. No, you had referenced that was somewhat. Related to the slowdown in sales and the impact of lapse and reissue. Can you talk? Given that sales are likely to remain at least somewhat lower relative to historical levels, can you talk about whether you. Would still expect to see the broader. Trend of benefit ratio improving here over the next couple of years or are we likely to see that maybe go the other way?

Max Broden (EVP and CFO)

Todd, why don't you take a crack at that?

Todd Daniels (Director and CFO)

Okay. Thanks, Max. Really, when we look forward for our. Persistency and as Max alluded to, it's totally related to sales activity and about 80 basis points in the benefit ratio for the quarter is attributed to lack of what I will call lapse and reissue activity. So as we introduce product in the first quarter, I would expect that to tick up somewhat for the medical block. So I would really anticipate as we. Go through next year that you see. More of a normalized termination rate which will lead to a more normal looking benefit ratio, especially as it pertains to the policy reserve aspect of it.

Tom Gallagher (Senior Managing Director)

Gotcha, and Todd, would you still expect a. Broader trend over multiple years of improvement. In the benefit ratio?

Todd Daniels (Director and CFO)

I think as we see claims come. In our trends that we have in our cancer and medical blocks that will be reflected in the benefit ratio going forward.

Tom Gallagher (Senior Managing Director)

Okay, thanks.

Dan Amos (Chairman and CEO)

Tom. We will address some of the underlying drivers in terms of hospitalizations and. Duration of hospital stays, et cetera, at Aflac. So we'll give you a little bit more insight into that.

Tom Gallagher (Senior Managing Director)

Thank you.

David Young (VP of Investor Relations)

And that leads us to the top of the hour. Before concluding, I just wanted to remind. You know that we have combined our Financial Analyst Briefing and our 2021 outlook. Call to a special webcast event on. The morning of November 19th at 8:00 A.M. Eastern Time. For more details, please reach out to investor relations here. And we thank you all for joining. Us today and look forward to speaking. With you soon and wish you all continued good health. Thank you.

Operator (participant)

This concludes today's call. Everyone may now disconnect.