Aflac’s Investment Dilemma: Can the Duck Find Some Yield?
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Aflac (NYSE: AFL) spent the last couple of years working through a pretty well chronicled set of impairments and losses tied to the European fiscal crisis. The problem stems from investments held by Aflac Japan, Aflac’s largest subsidiary and its big growth driver. Aflac is actually the largest insurer in Japan in terms of the number of policies in force, ranking fifth in premium income and sixth in total assets. Historically, Japan has been a closed market to insurers. However, Japan’s proven a lucrative market for the few international insurers like Aflac and MetLife (NYSE: MET) that have been allowed in. Unfortunately, Aflac Japan’s operational strength has been partially offset by investment losses over the last few years as Aflac unwound some of its troubled European financial sector assets.
While their operational strength afforded Aflac the opportunity to take its medicine and unload some of its riskier assets, that fix came at a cost. An unfortunate by-product of the de-risking plan was that rather than rebalancing Aflac Japan’s portfolio, de-risking actually shifted that imbalance from European securities to Japanese Government Bonds (JGBs). Both problems really stem from the same source: the exceptionally low rate environment that’s burdened Japanese investors for over a decade. Aflac’s first sin was reaching for yield in Europe. Their latest is continuing to pour cash into the safest vehicle available: JGBs. Aflac spent the last year evaluating its investment portfolio and planning a new course under new Global Chief Investment Officer Eric Kirsch. Now that the evaluations are complete, they provided some guidance on their future investment direction at their recent Tokyo analysts meeting.
With the low yields on JGBs of all duration, Aflac has to look outside the government bond market to supplement yield. Unfortunately, Japan’s corporate bond market is small and provides little opportunity for diversification, forcing Aflac to look outside Japan to boost yield. One obvious potential pool is the US corporate market. In fact, Aflac Japan has always held a small dollar-denominated investment portfolio. However, dollar denominated debt exposes the portfolio to currency exchange risk, limiting the size of that segment of the portfolio. If they were to enlarge it, it would need substantial hedging. That’s actually the primary reason that Aflac developed such a high concentration of European financial securities in the first place. European banks were willing to issue Yen-denominated securities. This was ideal at the time, since no hedging was required; the issuing banks bore all currency-related risk.
With that well run dry, Aflac was stuck with no obvious place to deploy cash flow from new premiums. Swap costs were just too high to make A-rated dollar-denominated assets worthwhile. Their cost negated any rate advantage over JGBs. Ultimately, Aflac turned to JGBs as the only reasonable alternative to deploy new money. This led to a massive accumulation of JGBs on Aflac’s books. At the end of Q2, JGBs approached $40B in fair value comprising 37.3% of Aflac’s total $107B portfolio (see Figure 1). Concentration this high in any security carries substantial risk. Aflac took steps in the past few months to reduce that portfolio imbalance by finding alternative investment strategies for new money. Two presentations this week dealt with those steps, some of which have already been implemented beginning in Q3.
Aflac brought in consultants from McKinsey & Co. and Goldman Sachs (NYSE: GS) Asset Management to review both their investment “capabilities” and portfolio. The McKinsey review of their management structure led to a number of new hires and changes in organization. Ultimately, only time can judge their success. The GSAM review on the other hand, produced some concrete recommendations that investors can better assess in the short term. GSAM identified a number of changes to enhance yield and improve the portfolio’s liquidity and balance:
- Increase global corporate fixed income, hedged back to yen
- Increase equity mix
- Increase US non-agency RMBS
- Increase Bank Loans
- Increase investment grade Emerging Market debt
- Reduce Private Placements
- Reduce JGBs
- Reduce European exposure
The major change will involve reductions in investment flow to JGBs and increased purchases of dollar-denominated corporate debt, a process that’s begun already. Aflac Japan purchased $1.9B of a planned $2.5B in approximately 50 US corporate bonds. The majority are hedged. To offset that hedging cost, Aflac broadened their target credit spectrum to include BBB issuers to enhance yield (they previously targeted only A-rated securities). They also reduced hedging costs by using forward currency futures as opposed to swaps. Long term, Aflac anticipates that global corporate bonds will reach 20-25% of the portfolio three years from now, with some of the alternatives outlined above reaching 3-5% of the total portfolio. For now, it appears that they’ll complete their $2.5B program and then pause to reevaluate the effectiveness of their hedging before proceeding with additional purchases. At the current pace, I’d expect that to occur sometime in Q4.
How effectively Aflac deploys new money in this low interest rate environment bears watching. The payment structure of a couple of very successful new first-sector life insurance products has led to very high cash flows for Aflac Japan. That money needs to be put to work effectively. Recent cash flows to investments sit at unprecedented levels, exceeding $16B last year. An additional $20B to investments is projected for 2012. That compares with an average of $6.5B over the prior four year period. How well this new team performs will be critical for success long term. For now, reducing overall exposure to JGBs should be a welcome change for investors.
JustMee01 owns shares and is short puts of AFL.The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Aflac and Goldman Sachs Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.