AFLAC INC – 10-K – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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FORWARD-LOOKING INFORMATION
The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" to encourage companies to provide prospective information, so long as those informational statements are identified as forward-looking and are accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those included in the forward-looking statements. We desire to take advantage of these provisions. This report contains cautionary statements identifying important factors that could cause actual results to differ materially from those projected herein, and in any other statements made by Company officials in communications with the financial community and contained in documents filed with theSecurities and Exchange Commission (SEC). Forward-looking statements are not based on historical information and relate to future operations, strategies, financial results or other developments. Furthermore, forward-looking information is subject to numerous assumptions, risks and uncertainties. In particular, statements containing words such as "expect," "anticipate," "believe," "goal," "objective," "may," "should," "estimate," "intends," "projects," "will," "assumes," "potential," "target" or similar words as well as specific projections of future results, generally qualify as forward-looking.Aflac undertakes no obligation to update such forward-looking statements.
We caution readers that the following factors, in addition to other factors mentioned from time to time, could cause actual results to differ materially from those contemplated by the forward-looking statements:
• difficult conditions in global capital markets and the economy
• governmental actions for the purpose of stabilizing the financial markets
• defaults and credit downgrades of securities in our investment portfolio
• impairment of financial institutions • credit and other risks associated withAflac's investment in perpetual
securities • differing judgments applied to investment valuations
• significant valuation judgments in determination of amount of impairments
taken on our investments • limited availability of acceptable yen-denominated investments • concentration of our investments in any particular single-issuer or sector • concentration of business inJapan • ongoing changes in our industry • exposure to significant financial and capital markets risk • fluctuations in foreign currency exchange rates • significant changes in investment yield rates
• deviations in actual experience from pricing and reserving assumptions
• subsidiaries' ability to pay dividends toAflac Incorporated • changes in law or regulation by governmental authorities
• ability to attract and retain qualified sales associates and employees
• decreases in our financial strength or debt ratings
• ability to continue to develop and implement improvements in information
technology systems • changes in U.S. and/or Japanese accounting standards
• failure to comply with restrictions on patient privacy and information
security • level and outcome of litigation • ability to effectively manage key executive succession
• impact of the recent earthquake and tsunami natural disaster and related
events at the nuclear plant inJapan and their aftermath
• catastrophic events including, but not necessarily limited to, tornadoes,
hurricanes, earthquakes, tsunamis, and damage incidental to such events
• failure of internal controls or corporate governance policies and procedures
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MD&A OVERVIEW
Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to inform the reader about matters affecting the financial condition and results of operations ofAflac Incorporated and its subsidiaries for the three-year period endedDecember 31, 2011 . As a result, the following discussion should be read in conjunction with the related consolidated financial statements and notes. This MD&A is divided into the following sections: • Our Business • Performance Highlights • Critical Accounting Estimates • Results of Operations, consolidated and by segment
• Analysis of Financial Condition, including discussion of market risks of
financial instruments
• Capital Resources and Liquidity, including discussion of availability of
capital and the sources and uses of cash OUR BUSINESSAflac Incorporated (the Parent Company) and its subsidiaries (collectively, the Company) primarily sell supplemental health and life insurance inthe United States andJapan . The Company's insurance business is marketed and administered throughAmerican Family Life Assurance Company of Columbus (Aflac ), which operates inthe United States (Aflac U.S.) and as a branch inJapan (Aflac Japan ). Most ofAflac's policies are individually underwritten and marketed through independent agents. Aflac U.S. markets and administers group products throughContinental American Insurance Company (CAIC), branded asAflac Group Insurance . Our insurance operations inthe United States and our branch inJapan service the two markets for our insurance business. PERFORMANCE HIGHLIGHTS Results for 2011 benefited from the stronger yen/dollar exchange rate. Total revenues rose 6.9% to$22.2 billion , compared with$20.7 billion a year ago. Net earnings were$2.0 billion , or$4.18 per diluted share, compared with$2.3 billion , or$4.95 per diluted share, in 2010. Results for 2011 included pretax net realized investment losses of$1.6 billion ($1.0 billion after-tax), compared with net investment losses of$422 million ($274 million after-tax) in 2010. Net investment losses in 2011 consisted of$1.9 billion ($1.2 billion after-tax) of other-than-temporary impairment losses;$594 million of net gains ($386 million after-tax) from the sale or redemption of securities; and$245 million of net losses ($159 million after-tax) from valuing derivatives. Shareholders' equity atDecember 31, 2011 , included a net unrealized gain on investment securities (including derivatives) of$1.2 billion , compared with a net unrealized gain (including derivatives) of$64 million atDecember 31, 2010 . InJuly 2011 , we issued three series of Samurai notes totaling50 billion yen through a public debt offering. InSeptember 2011 , we redeemed35 billion yen (approximately$459 million using the exchange rate on the date of redemption) of our Uridashi notes upon their maturity. We repurchased 6.0 million shares of our common stock in the open market during 2011. CRITICAL ACCOUNTING ESTIMATES We prepare our financial statements in accordance with U.S. generally accepted accounting principles (GAAP). These principles are established primarily by theFinancial Accounting Standards Board (FASB). In this MD&A, references to GAAP issued by the FASB are derived from the FASB Accounting Standards CodificationTM (ASC). The preparation of financial statements in conformity with GAAP requires us to make estimates based on currently available information when recording transactions resulting from business operations. The estimates that we deem to be most critical to an understanding ofAflac's results of operations and financial condition are those related to the valuation of investments and derivatives, deferred policy acquisition costs, liabilities for future policy benefits and 31
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unpaid policy claims, and income taxes. The preparation and evaluation of these critical accounting estimates involve the use of various assumptions developed from management's analyses and judgments. The application of these critical accounting estimates determines the values at which 96% of our assets and 83% of our liabilities are reported as ofDecember 31, 2011 , and thus has a direct effect on net earnings and shareholders' equity. Subsequent experience or use of other assumptions could produce significantly different results.
Investments and Derivatives
Aflac's investments in debt, perpetual and equity securities include both publicly issued and privately issued securities. For publicly issued securities, we determine the fair values from quoted market prices readily available from public exchange markets and price quotes and valuations from third party pricing vendors. For privately issued securities, we determine the majority of the fair values using a discounted cash flow pricing model and for the remaining securities, non-binding price quotes from outside brokers. We also routinely review our investments that have experienced declines in fair value to determine if the decline is other than temporary. These reviews are performed with consideration of the facts and circumstances of an issuer in accordance with applicable accounting guidance. The identification of distressed investments, the determination of fair value if not publicly traded, and the assessment of whether a decline is other than temporary involve significant management judgment and require evaluation of factors, including but not limited to: • issuer financial condition, including profitability and cash flows • credit status of the issuer • the issuer's specific and general competitive environment • published reports • general economic environment • regulatory, legislative and political environment • the severity of the decline in fair value • the length of time the fair value is below cost
• our intent, need, or both to sell the security prior to its anticipated
recovery in value • other factors as may become available from time to time Our derivatives are primarily interest rate, foreign currency and credit default swaps that are associated with investments in special-purpose entities, including variable interest entities (VIEs) where we are the primary beneficiary. Inputs used to value derivatives include, but are not limited to, interest rates, credit spreads, foreign currency forward and spot rates, and interest volatility. Prior to the third quarter of 2011, these interest rate swaps and certain foreign currency swaps were priced by broker quotations. For our credit default swaps and certain foreign currency swaps, there were limited or no observable valuation inputs. We estimated the fair value of these instruments by obtaining broker quotes from a limited number of brokers. These brokers based their quotes on a combination of their knowledge of the current pricing environment and market conditions. In the third quarter of 2011, we changed from receiving valuations from brokers to receiving valuations from a third party pricing vendor for our derivatives.
See Notes 1, 3, 4 and 5 of the Notes to the Consolidated Financial Statements for additional information.
Deferred Policy Acquisition Costs and Policy Liabilities
Aflac's products are generally long-duration fixed-benefit indemnity contracts. We make estimates of certain factors that affect the profitability of our business to match expected policy benefits and deferrable acquisition costs with expected policy premiums. These assumptions include persistency, morbidity, mortality, investment yields and expenses. If actual results match the assumptions used in establishing policy liabilities and the deferral and amortization of acquisition costs, profits will emerge as a level percentage of earned premiums. However, because actual results will vary from the assumptions, profits as a percentage of earned premiums will vary from year to year. We measure the adequacy of our policy reserves and recoverability of deferred policy acquisition costs (DAC) annually by performing gross premium valuations on our business. Our testing indicates that our insurance liabilities are adequate and that our DAC is recoverable. 32
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Deferred Policy Acquisition Costs
Certain costs of acquiring new business are deferred and amortized over the policy's premium payment period in proportion to anticipated premium income. Future amortization of DAC is based upon our estimates of persistency, interest and future premium revenue generally established at the time of policy issuance. However, the unamortized balance of DAC reflects actual persistency. See Note 1 of the Notes to the Consolidated Financial Statements and the New Accounting Pronouncements discussion in this section of MD&A for information on changes to the accounting policy for costs associated with acquiring or renewing insurance contracts effectiveJanuary 1, 2012 . As presented in the following table, the ratio of unamortized DAC to annualized premiums in force forJapan decreased in 2011 after having an upward trend for the previous two years. This decrease was due to the lower expense ratio of the first sector products that generated high volumes of sales inJapan . The upward trend in the ratio of unamortized DAC to annualized premiums in force inJapan in 2010 and 2009 was a result of a greater proportion of our annualized premiums being under the alternative commission schedule, which pays a higher commission on first-year premiums and lower commissions on renewal premiums. This schedule is very popular with our new agents as it helps them with cash flow for personal and business needs as they build their business. While this resulted in a higher unamortized DAC balance, the overall cost to the Company was reduced. The ratio of unamortized DAC to annualized premiums in force has increased for Aflac U.S. for the last three years. The increase has been primarily driven by a greater proportion of our annualized premiums being under an accelerated commission schedule for new associates and was also impacted by the loss of a large payroll account in 2010 which had a lower ratio of unamortized DAC to annualized premiums in force. Deferred Policy Acquisition Cost Ratios Aflac Japan Aflac U.S. (In millions) 2011 2010 2009 2011 2010 2009 Deferred policy acquisition costs $ 7,733 $ 6,964 $ 5,846 $ 2,921 $ 2,770 $ 2,687 Annualized premiums in force 17,284 15,408 13,034 5,188 4,973 4,956 Deferred policy acquisition costs as a percentage of annualized premiums in force 44.7 % 45.2 % 44.9 % 56.3 % 55.7 % 54.2 % 33
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Policy Liabilities
The following table provides details of policy liabilities by segment and in total as ofDecember 31 . Policy Liabilities (In millions) 2011 2010 Japan segment: Future policy benefits $ 72,792 $ 66,023 Unpaid policy claims 2,786 2,592 Other policy liabilities 10,944 6,257 Total Japan policy liabilities $ 86,522 $ 74,872 U.S. segment: Future policy benefits $ 6,484 $ 6,078 Unpaid policy claims 1,195 1,126 Other policy liabilities 390 377 Total U.S. policy liabilities $ 8,069 $ 7,581 Consolidated: Future policy benefits $ 79,278 $ 72,103 Unpaid policy claims 3,981 3,719 Other policy liabilities 11,334 6,634 Total consolidated policy liabilities $ 94,593 $ 82,456 Our policy liabilities, which are determined in accordance with applicable guidelines as defined under GAAP and Actuarial Standards of Practice, include two components that involve analysis and judgment: future policy benefits and unpaid policy claims, which accounted for 84% and 4% of total policy liabilities as ofDecember 31, 2011 , respectively. Future policy benefits provide for claims that will occur in the future and are generally calculated as the present value of future expected benefits to be incurred less the present value of future expected net benefit premiums. We calculate future policy benefits based on assumptions of morbidity, mortality, persistency and interest. These assumptions are generally established at the time a policy is issued. The assumptions used in the calculations are closely related to those used in developing the gross premiums for a policy. As required by GAAP, we also include a provision for adverse deviation, which is intended to accommodate adverse fluctuations in actual experience. Unpaid policy claims include those claims that have been incurred and are in the process of payment as well as an estimate of those claims that have been incurred but have not yet been reported to us. We compute unpaid policy claims on a non-discounted basis using statistical analyses of historical claims payments, adjusted for current trends and changed conditions. We update the assumptions underlying the estimate of unpaid policy claims regularly and incorporate our historical experience as well as other data that provides information regarding our outstanding liability. Our insurance products provide fixed-benefit amounts per occurrence that are not subject to medical-cost inflation. Furthermore, our business is widely dispersed in boththe United States andJapan . This geographic dispersion and the nature of our benefit structure mitigate the risk of a significant unexpected increase in claims payments due to epidemics and events of a catastrophic nature. Claims incurred underAflac's policies are generally reported and paid in a relatively short time frame. The unpaid claims liability is sensitive to morbidity assumptions, in particular, severity and frequency of claims. Severity is the ultimate size of a claim, and frequency is the number of claims incurred. Our claims experience is primarily related to the demographics of our policyholders. As a part of our established financial reporting and accounting practices and controls, we perform actuarial reviews of our policyholder liabilities on an ongoing basis and reflect the results of those reviews in our results of operations and financial condition as required by GAAP. 34
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Our fourth quarter 2011 review indicated that we needed to strengthen the liability associated primarily with a closed block of cancer policies and a block of care policies inJapan , primarily due to low investment yields. We strengthened our future policy benefits liability by$123 million in 2011 as a result of this review. Our fourth quarter 2010 review indicated that we needed to strengthen the liability for a closed block of dementia policies inJapan</location>, primarily due to low investment yields. We strengthened our future policy benefits liability by $93 million in 2010 for this closed block of policies. In computing the estimate of unpaid policy claims, we consider many factors, including the benefits and amounts available under the policy; the volume and demographics of the policies exposed to claims; and internal business practices, such as incurred date assignment and current claim administrative practices. We monitor these conditions closely and make adjustments to the liability as actual experience emerges. Claim levels are generally stable from period to period; however, fluctuations in claim levels may occur. In calculating the unpaid policy claim liability, we do not calculate a range of estimates. The following table shows the expected sensitivity of the unpaid policy claims liability as ofDecember 31, 2011 , to changes in severity and frequency of claims. For the years 2009 through 2011, our assumptions changed on average by approximately 1% in total, and we believe that a variation in assumptions in a range of plus or minus 1% in total is reasonably likely to occur. Sensitivity of Unpaid Policy Claims Liability (In millions) Total Severity Decrease Decrease
Increase Increase
Total Frequency by 2% by 1% Unchanged by 1% by 2% Increase by 2% $ 0 $ 23 $ 46 $ 70 $ 93 Increase by 1% (23 ) 0 23 46 70 Unchanged (45 ) (23 ) 0 23 46 Decrease by 1% (67 ) (45 ) (23 ) 0 23 Decrease by 2% (89 ) (67 ) (45 ) (23 ) 0
The table below reflects the growth of the future policy benefits liability for the years ended
Future Policy Benefits (In millions of dollars and billions of yen) 2011 2010 2009 Aflac U.S. $ 6,484 $ 6,078 $ 5,779 Growth rate 6.7 % 5.2 % 6.2 % Aflac Japan $ 72,792 $ 66,023 $ 55,720 Growth rate 10.3 % 18.5 % 3.4 % Consolidated $ 79,278 $ 72,103 $ 61,501 Growth rate 10.0 % 17.2 % 3.7 % Yen/dollar exchange rate (end of period) 77.74 81.49 92.10 Aflac Japan (in yen) 5,659 5,380 5,132 Growth rate 5.2 % 4.8 % 4.7 % The growth of total consolidated future policy benefits liability in dollars was primarily driven by the strengthening of the yen against the U.S. dollar in 2011 and 2010; however, it was offset in 2009 by the weakening of the yen against the U.S. dollar. The growth of the future policy benefits liability in yen forAflac Japan and in dollars for Aflac U.S. has been due to the aging of our in-force block of business and the addition of new business. Other policy liabilities, which accounted for 12% of total policy liabilities as ofDecember 31, 2011 , consisted primarily of discounted advance premiums on deposit from policyholders in conjunction with their purchase of certainAflac Japan insurance products. See the Aflac Japan Segment subsection of this MD&A for further information. 35
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Income Taxes
Income tax provisions are generally based on pretax earnings reported for financial statement purposes, which differ from those amounts used in preparing our income tax returns. Deferred income taxes are recognized for temporary differences between the financial reporting basis and income tax basis of assets and liabilities, based on enacted tax laws and statutory tax rates applicable to the periods in which we expect the temporary differences to reverse. The evaluation of a tax position in accordance with GAAP is a two-step process. Under the first step, the enterprise determines whether it is more likely than not that a tax position will be sustained upon examination by taxing authorities. The second step is measurement, whereby a tax position that meets the more-likely-than-not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. A valuation allowance is established for deferred tax assets when it is more likely than not that an amount will not be realized.
See Note 9 of the Notes to the Consolidated Financial Statements for additional information.
New Accounting Pronouncements
During the last three years, various accounting standard-setting bodies have been active in soliciting comments and issuing statements, interpretations and exposure drafts. We will adopt amended accounting guidance on accounting for costs associated with acquiring or renewing insurance contracts effectiveJanuary 1, 2012 . Under the amended accounting guidance, only incremental direct costs associated with the successful acquisition of new or renewal contracts may be capitalized, and direct-response advertising costs may be capitalized under certain conditions. The guidance is effective on a prospective or retrospective basis. As of the date of adoption, approximately 70% of our deferred acquisition cost balance was related to compensation paid to third party agents for successful sales and remains deferrable under the amended accounting guidance. The remaining 30% of our deferred acquisition costs balance was evaluated for deferral under the amended accounting guidance. We estimate that the retrospective adoption of this accounting standard effectiveJanuary 1, 2012 , will result in an after-tax cumulative reduction to opening retained earnings of$400 million to $500 million , or 3.6% to 4.5% of shareholder's equity, as ofDecember 31, 2010 . We also estimate the adoption will result in an immaterial impact on net income in 2011 and 2012 and for all preceding years. For additional information on new accounting pronouncements and the impact, if any, on our financial position or results of operations, see Note 1 of the Notes to the Consolidated Financial Statements. RESULTS OF OPERATIONS
The following table is a presentation of items impacting net earnings and net earnings per diluted share for the years ended
Items Impacting Net Earnings In Millions Per Diluted Share 2011 2010 2009 2011 2010 2009 Net earnings $ 1,964 $ 2,344 $ 1,497 $ 4.18 $ 4.95 $ 3.19 Items impacting net earnings, net of tax: Realized investment gains (losses): Securities transactions and impairments (850 ) (273 ) (788 ) (1.81 ) (.58 ) (1.67 ) Impact of derivative and hedging activities (159 ) (1 ) 0 (.34 ) .00 .00 Gain on extinguishment of debt 0 0 11 .00 .00 .02 Other 0 0 (3 ) .00 .00 (.01 ) 36
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Realized Investment Gains and Losses
Our investment strategy is to invest in fixed-income securities to provide a reliable stream of investment income, which is one of the drivers of the Company's profitability. This investment strategy aligns our assets with our liability structure, which our assets support. We do not purchase securities with the intent of generating capital gains or losses. However, investment gains and losses may be realized as a result of changes in the financial markets and the creditworthiness of specific issuers, tax planning strategies, and/or general portfolio maintenance and rebalancing. The realization of investment gains and losses is independent of the underwriting and administration of our insurance products, which are the principal drivers of our profitability.
Securities Transactions and Impairments
During 2011, we realized pretax investment losses of$1.9 billion ($1.2 billion after-tax) as a result of the recognition of other-than-temporary impairment losses on certain securities. We realized pretax investment gains, net of losses, of$594 million ($386 million after-tax) from the sale of securities. The impairments and many of the sales were the result of an implemented plan to reduce the risk exposure in our investment portfolio coupled with the continued decline in the credit worthiness of certain issuers. Gains were primarily driven by the sale of U.S. Treasury strips and Japanese Government bonds (JGBs) that were part of a bond-swap program. In 2010, we realized pretax investment losses of$459 million ($298 million after-tax) as a result of the recognition of other-than-temporary impairment losses. We realized pretax investment gains, net of losses, of$38 million ($25 million after-tax) from securities sold or redeemed in the normal course of business. In 2009, we realized pretax investment losses of$1.4 billion ($884 million after-tax) as a result of the recognition of other-than-temporary impairment losses. We realized pretax investment losses of$101 million ($66 million after-tax) from the exchange of certain perpetual security investments into fixed-maturity securities. The losses were partially offset by pretax investment gains of$250 million ($162 million after-tax) that were generated primarily from a bond-swap program that took advantage of tax loss carryforwards.
See Note 3 of the Notes to the Consolidated Financial Statements for more details on these investment activities.
The following table details our pretax impairment losses by investment category for the years ended
(In millions) 2011 2010 2009 Perpetual securities $ 565 $ 160 $ 729 Corporate bonds 1,316 285 458 Collateralized debt obligations 0 0 148 Mortgage- and asset-backed securities 17 12 24 Municipalities 2 0 0 Equity securities 1 2 2 Total other-than-temporary impairment losses realized $ 1,901 (1) $ 459 (2) $ 1,361 (2)
(1) Includes
change in intent to sell securities
(2) Consisted completely of credit-related impairments
Impact of Derivative and Hedging Activities
EffectiveJanuary 1, 2010 , we adopted updated accounting guidance which resulted in the consolidation of certain VIEs in which we have an investment. Upon consolidation, the beneficial interest in these VIEs was derecognized and the underlying collateral assets (fixed-maturity securities and perpetual securities) and corresponding foreign currency, interest rate and credit default swaps were recognized. The change in value of the swaps is recorded through current period earnings, and the change in value of the available-for-sale fixed-maturity and perpetual securities associated with these swaps is recorded through other comprehensive income. We realized pretax investment losses, net of gains, of$245 million ($159 million after-tax) in 2011 and$1 million ($.7 million 37
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after-tax) in 2010 from valuing foreign currency, interest rate and credit default swaps related to our consolidated VIEs. For a description of other items that could be included in the Impact of Derivative and Hedging Activities, see the Hedging Activities subsection of MD&A and Note 4 of the accompanying Notes to the Consolidated Financial Statements.
For additional information regarding realized investment gains and losses, see Notes 3 and 4 of the Notes to the Consolidated Financial Statements.
Debt Extinguishment
We did not early extinguish any debt during 2011 or 2010. During 2009, we extinguished portions of our yen-denominated Uridashi and Samurai debt by buying the notes on the open market. We realized a total gain from extinguishment of debt of1.6 billion yen , or$17 million ($11 million after-tax), which we included in other income.
Foreign Currency Translation
Aflac Japan's premiums and most of its investment income are received in yen. Claims and expenses are paid in yen, and we primarily purchase yen-denominated assets to support yen-denominated policy liabilities. These and other yen-denominated financial statement items are translated into dollars for financial reporting purposes. We translate Aflac Japan's yen-denominated income statement into dollars using an average exchange rate for the reporting period, and we translate its yen-denominated balance sheet using the exchange rate at the end of the period. However, it is important to distinguish between translating and converting foreign currency. Except for a limited number of transactions, we do not actually convert yen into dollars. Due to the size of Aflac Japan, where our functional currency is the Japanese yen, fluctuations in the yen/dollar exchange rate can have a significant effect on our reported results. In periods when the yen weakens, translating yen into dollars results in fewer dollars being reported. When the yen strengthens, translating yen into dollars results in more dollars being reported. Consequently, yen weakening has the effect of suppressing current year results in relation to the prior year, while yen strengthening has the effect of magnifying current year results in relation to the prior year. As a result, we view foreign currency translation as a financial reporting issue forAflac and not an economic event to our Company or shareholders. Because changes in exchange rates distort the growth rates of our operations, management evaluatesAflac's financial performance excluding the impact of foreign currency translation.
Income Taxes
Our combined U.S. and Japanese effective income tax rate on pretax earnings was 34.4% in 2011, 34.6% in 2010 and 33.0% in 2009. The lower effective tax rate in 2009 primarily reflected the settlement of an examination by theInternal Revenue Service that reduced the tax liability by$24 million . Total income taxes were$1.0 billion in 2011, compared with$1.2 billion in 2010 and$738 million in 2009. Japanese income taxes on Aflac Japan's results account for most of our consolidated income tax expense. See Note 9 of the Notes to the Consolidated Financial Statements for additional information.
Earnings Guidance
We communicate earnings guidance in this report based on the growth in net earnings per diluted share. However, certain items that cannot be predicted or that are outside of management's control may have a significant impact on actual results. Therefore, our comparison of net earnings includes certain assumptions to reflect the limitations that are inherent in projections of net earnings. In comparing period-over-period results, we exclude the effect of realized investment gains and losses (securities transactions, impairments, and the impact of derivatives and hedging activities) and nonrecurring items. We also assume no impact from foreign currency translation on the Aflac Japan segment and the Parent Company's yen-denominated interest expense for a given year in relation to the prior year. Subject to the preceding assumptions, our objective for 2011 was to increase net earnings per diluted share by 8% over 2010. We reported 2011 net earnings per diluted share of$4.18 . Adjusting that number for after-tax realized investment losses ($2.15 per diluted share) and foreign currency translation (a gain of$.36 per diluted share), we met our objective for the year. 38
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Our objective for 2012 is to increase net earnings per diluted share by 2% to 5% over 2011, excluding the effect of realized investment gains and losses (securities transactions, impairments, and the impact of derivative and hedging activities), nonrecurring items, and foreign currency translation. This range reflects the impact of portfolio derisking and investing significant cash flows at low interest rates. Once the effects of our investment derisking activities and low interest rate yields on investments have been integrated into our financial results, we expect the rate of earnings growth in 2013 to improve over 2012. If we achieve our objective, the following table shows the likely results for 2012 net earnings per diluted share, including the impact of foreign currency translation using various yen/dollar exchange rate scenarios. 2012 Net Earnings Per Share (EPS) Scenarios(1) Weighted-Average Yen/Dollar Net Earnings Per % Growth Yen Impact Exchange Rate Diluted Share Over 2011 on EPS 70.00 $7.02 - 7.21 10.9 - 13.9% $.56 75.00 6.71 - 6.90 6.0 - 9.0 .25 79.73(2) 6.46 - 6.65 2.1 - 5.1 .00 80.00 6.45 - 6.64 1.9 - 4.9 (.01) 85.00 6.21 - 6.41 (1.9) - 1.1 (.25)
(1) Excludes realized investment gains/losses (securities transactions,
impairments, and the impact of derivative and hedging activities) and
nonrecurring items in 2012 and 2011
(2) Actual 2011 weighted-average exchange rate
INSURANCE OPERATIONSAflac's insurance business consists of two segments: Aflac Japan and Aflac U.S. Aflac Japan, which operates as a branch ofAflac , is the principal contributor to consolidated earnings. GAAP financial reporting requires that a company report financial and descriptive information about operating segments in its annual financial statements. Furthermore, we are required to report a measure of segment profit or loss, certain revenue and expense items, and segment assets. We measure and evaluate our insurance segments' financial performance using operating earnings on a pretax basis. We define segment operating earnings as the profits we derive from our operations before realized investment gains and losses (securities transactions, impairments, and the impact of derivative and hedging activities) and nonrecurring items. We believe that an analysis of segment pretax operating earnings is vitally important to an understanding of the underlying profitability drivers and trends of our insurance business. Furthermore, because a significant portion of our business is conducted inJapan , we believe it is equally important to understand the impact of translating Japanese yen into U.S. dollars. We evaluate our sales efforts using new annualized premium sales, an industry operating measure. New annualized premium sales, which include both new sales and the incremental increase in premiums due to conversions, represent the premiums that we would collect over a 12-month period, assuming the policies remain in force. For Aflac Japan, new annualized premium sales are determined by applications submitted during the reporting period. For Aflac U.S., new annualized premium sales are determined by applications that are issued during the reporting period. Premium income, or earned premiums, is a financial performance measure that reflects collected or due premiums that have been earned ratably on policies in force during the reporting period. 39
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AFLAC
Aflac Japan Pretax Operating Earnings
Changes in Aflac Japan's pretax operating earnings and profit margins are primarily affected by morbidity, mortality, expenses, persistency and investment yields. The following table presents a summary of operating results forAflac Japan for the years endedDecember 31 . Aflac Japan Summary of Operating Results (In millions) 2011 2010 2009 Premium income $ 15,619 $ 13,487 $ 12,178 Net investment income: Yen-denominated investment income 1,799 1,645 1,510 Dollar-denominated investment income 889 808 755 Net investment income 2,688 2,453 2,265 Other income (loss) 46 37 43 Total operating revenues 18,353 15,977 14,486 Benefits and claims 11,037 9,553 8,746 Operating expenses: Amortization of deferred policy acquisition costs 686 597 523 Insurance commissions 1,179 1,103 1,060 Insurance and other expenses 1,593 1,441 1,357 Total operating expenses 3,458 3,141 2,940 Total benefits and expenses 14,495 12,694 11,686 Pretax operating earnings(1) $ 3,858 $ 3,283 $ 2,800 Weighted-average yen/dollar exchange rate 79.73 87.69 93.49 In Dollars In Yen
Percentage change over previous year: 2011 2010 2009
2011 2010 2009 Premium income 15.8 % 10.8 % 14.1 % 5.4 % 3.8 % 3.3 % Net investment income 9.6 8.3 10.3 (.4 ) 1.6 (.1 ) Total operating revenues 14.9 10.3 13.7 4.5 3.4 3.0 Pretax operating earnings(1) 17.5 17.3 24.4 6.8 10.0 12.4
(1) See the Insurance Operations section of this MD&A for our definition of
segment operating earnings.
The percentage increases in premium income in yen reflect the growth of premiums in force. The increases in annualized premiums in force in yen of 7.0% in 2011, 4.6% in 2010 and 3.3% in 2009 reflect the high persistency of Aflac Japan's business and the sales of new policies. Annualized premiums in force atDecember 31, 2011 , were1.34 trillion yen , compared with1.26 trillion yen in 2010 and1.20 trillion yen in 2009. Annualized premiums in force, translated into dollars at respective year-end exchange rates, were$17.3 billion in 2011,$15.4 billion in 2010, and$13.0 billion in 2009. Aflac Japan maintains a portfolio of dollar-denominated and reverse-dual currency securities (yen-denominated debt securities with dollar coupon payments). Dollar-denominated investment income from these assets accounted for approximately 33% of Aflac Japan's investment income in 2011, 2010 and 2009. In years when the yen strengthens in relation to the dollar, translatingAflac Japan's dollar-denominated investment income into yen lowers growth rates for net investment income, total operating revenues, and pretax operating earnings in yen terms. In years when the yen weakens, translating dollar-denominated investment income into yen magnifies growth rates for net investment income, total operating revenues, and pretax operating earnings in yen terms. Excluding foreign currency changes from the respective prior year, dollar-denominated investment income accounted for approximately 35% of Aflac Japan's investment income during 2011, compared with 34% in 2010 and 36% in 2009. 40
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The following table illustrates the effect of translating Aflac Japan's dollar-denominated investment income and related items into yen by comparing certain segment results with those that would have been reported had yen/dollar exchange rates remained unchanged from the prior year. Aflac Japan Percentage Changes Over Prior Year (Yen Operating Results) Including Foreign Excluding Foreign Currency Changes Currency Changes(2) 2011 2010 2009 2011 2010 2009 Net investment income (.4)% 1.6% (.1)% 3.0% 3.8% 3.4% Total operating revenues 4.5 3.4 3.0 5.1 3.8 3.5 Pretax operating earnings(1) 6.8 10.0 12.4 9.3 12.1 15.1
(1) See the Insurance Operations section of this MD&A for our definition of
segment operating earnings.
(2) Amounts excluding foreign currency changes on dollar-denominated items were
determined using the same yen/dollar exchange rate for the current year as
each respective prior year.
The following table presents a summary of operating ratios in yen terms for Aflac Japan for the years ended
Ratios to total revenues: 2011 2010 2009 Benefits and claims 60.1 % 59.8 % 60.4 % Operating expenses: Amortization of deferred policy acquisition costs 3.7 3.7 3.6 Insurance commissions 6.4 6.9 7.3 Insurance and other expenses 8.8 9.0 9.4 Total operating expenses 18.9 19.6 20.3 Pretax operating earnings(1) 21.0 20.6 19.3
(1) See the Insurance Operations section of this MD&A for our definition of
segment operating earnings.
Aflac Japan's financial results for 2011 reflected a provision of3.0 billion yen , or$37 million , for claims related to the earthquake and tsunami that occurred inJapan onMarch 11, 2011 . These claims were offset by reserve releases and reinsurance of2.0 billion yen , or$25 million , resulting in a net income statement impact of1.0 billion yen , or$12 million , in 2011. The financial results also reflected.7 billion yen , or$8 million , of operating expenses in the first quarter of 2011 resulting from the earthquake and tsunami. Based on our claims experience to date and our claims estimates, we believe that our initial provision is adequate. The natural disaster and its related events have not had a material impact on our financial position or results of operations. In the past several years, the benefit ratio for our health products has been positively impacted by favorable claim trends, primarily in our cancer product line. We expect this downward claim trend to continue. However, for several years, the rate of decline in Aflac Japan's benefit ratio has moderated, due primarily to strong sales results in our ordinary products including WAYS and child endowment. These products have higher benefit ratios and lower expense ratios than our third sector products. The benefit ratio has also been impacted by the effect of low investment yields and portfolio derisking, both of which impact our profit margin by reducing the spread between investment yields and required interest on policy reserves (see table and discussion in the Interest Rate Risk subsection of this MD&A). Despite a slight increase in the benefit ratio in 2011, the decrease in the operating expense ratio resulted in an increase in the pretax operating profit margin, compared with 2010. In 2012, we expect to achieve our profit objectives through better-than-average premium growth associated with the life products and somewhat lower profit margins due to the change in business mix discussed above. 41
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Aflac Japan Sales
In 2011, Aflac Japan generated its largest annual production in its 36-year history. Our upwardly revised objective for 2011 was for sales to be flat to up 5% in yen. New annualized premium sales significantly exceeded our expectations during 2011 and rose to161.0 billion yen , an 18.6% increase compared with 2010. The following table presents Aflac Japan's new annualized premium sales for the years endedDecember 31 . In Dollars In Yen
(In millions of dollars and billions of yen) 2011 2010 2009 2011 2010 2009 New annualized premium sales
$ 2,027 $ 1,554 $ 1,310 161.0 135.8 122.3 Increase (decrease) over prior year 30.5 % 18.6 %
17.5 % 18.6 % 11.0 % 6.7 %
The following table details the contributions to new annualized premium sales by major insurance product for the years ended
2011 2010 2009 Medical 22 % 34 % 39 % Cancer 20 22 28 Ordinary life: Child endowment 17 19 9 WAYS 26 9 6 Other ordinary life 10 12 14 Other 5 4 4 Total 100 % 100 % 100 % The bank channel generated new annualized premium sales of46.5 billion yen in 2011, an increase of 133.9% over 2010. Bank channel sales generated 29% of new annualized premium sales for Aflac Japan in 2011, compared with 15% in 2010 and 6% in 2009. As the bank channel has become a larger contributor to sales,Aflac Japan has enhanced its product portfolio to better meet the needs of banks. These products include our child endowment product and WAYS, a product that we first introduced in 2006 and introduced to the bank channel in 2009. WAYS has been a primary driver of Aflac Japan's sales increase in 2011. The average premium for WAYS sold through the bank channel, the primary distribution outlet for this product, is about ten times the average premium for cancer and medical products, making it a strong contributor to revenue growth. Sales of WAYS were42.1 billion yen during 2011, an increase of 248.0% over 2010. Our profit margin on WAYS is significantly enhanced when policyholders elect to pay premiums upfront using the "discounted advance premium" option. Approximately 90% of customers at banks choose this payment option. Cancer insurance sales increased 5.8% during 2011, compared with 2010. The increase primarily reflected sales of the new base cancer policy, DAYS, which was introduced at the end ofMarch 2011 , and DAYS PLUS, which upgrades older cancer policies. The enhancements in this new base policy are a response to the changes in cancer treatment as well as our commitment to being the number one provider of cancer insurance inJapan . We are convinced that the affordable cancer products Aflac Japan provides will continue to be an important part of our product portfolio. Medical insurance sales decreased 22.7% during 2011, compared with 2010, primarily due to our traditional sales channels being focused on selling our DAYS and DAYS PLUS cancer policies. Despite the comparative sales decrease, we maintained our position as the number one seller of medical insurance policies inJapan . With continued cost pressure onJapan's health care system, we expect the need for medical products will continue to rise in the future, and we remain encouraged about the outlook for the medical insurance market. Sales of our child endowment product increased 8.3% in 2011, compared with 2010, however on a quarterly basis subsequent to the first quarter of 2011, sales of this product have either declined or remained flat compared to the comparable period in 2010. Having sold the child endowment product for more than two years, we have already made a first attempt at selling this product to the eligible target market of families with young children. We expect 42
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child endowment sales to decline in 2012 as our distribution channels remain focused on selling WAYS and our new cancer product DAYS.
AtDecember 31, 2011 , we had agreements to sell our products at 370 banks, or more than 90% of the total number of banks inJapan . We have seen sales steadily improve at many of these bank branches as training has taken place and as many banks expand their offerings ofAflac products. We believe we have significantly more banks selling our third sector insurance products than any other insurer operating inJapan . We believe our long-standing and strong relationships within the Japanese banking sector, along with our strategic preparations, have proven to be an advantage as this channel opened up for our types of products. We remain committed to selling through our traditional channels. These channels include affiliated corporate agencies, independent corporate agencies and individual agencies. In 2011, we recruited approximately 5,000 new sales agencies, an increase of 3.8% over 2010. AtDecember 31, 2011 , Aflac Japan was represented by more than 19,700 sales agencies and more than 120,700 licensed sales associates employed by those agencies. We believe that there is still a continued need for our products inJapan . We expect that our strong sales results in 2011 will create difficult comparisons in 2012. Following strong sales growth in 2010 and 2011, our objective for 2012 is for new annualized premium sales to be in the range of down 2% to down 5% inJapan . Aflac Japan Investments Growth of investment income in yen is affected by available cash flow from operations, the timing of investing the cash flow, yields on new investments, and the effect of yen/dollar exchange rates on dollar-denominated investment income. Aflac Japan has invested in privately issued securities to secure higher yields than those available on Japanese government or other public corporate bonds, while still adhering to prudent standards for credit quality. All of our privately issued securities are rated investment grade at the time of purchase. These securities are generally issued with documentation consistent with standard medium-term note programs. In addition, many of these investments have protective covenants appropriate to the specific issuer, industry and country. These covenants often require the issuer to adhere to specific financial ratios and give priority to repayment of our investment under certain circumstances. The following table presents the results of Aflac Japan's investment yields for the years endedDecember 31 . 2011 2010 2009 New money yield - yen only 2.39 % 2.39 % 2.80 % New money yield - blended 2.48 2.63 3.03 Return on average invested assets, net of investment expenses 3.18 3.48 3.65 The decrease in the Aflac Japan's blended new money yield reflects the low level of interest rates. AtDecember 31, 2011 , the yield on Aflac Japan's investment portfolio, including dollar-denominated investments, was 3.29%, compared with 3.56% a year ago. In order to address our challenge of investing inJapan's low-interest-rate environment, in 2011 and 2010, we increased the amountAflac Japan invested in higher-yielding dollar-denominated securities, including U.S. Treasury strips. We sold these U.S. Treasury strips at the end of 2011, when U.S. Treasury yields decreased, in order to realize investment gains. 43
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The following table presents the composition of total investments by sector, at amortized cost, and cash for Aflac Japan (
Composition of Portfolio by Sector 2011 2010
Debt and perpetual securities, at amortized cost:
Banks/financial institutions(1) 26.8 %
34.9 % Government and agencies 32.5 21.6 Municipalities .9 .8 Public utilities 11.8 12.8
Collateralized debt obligations .0
.1
Sovereign and supranational 6.8
7.7
Mortgage- and asset-backed securities 1.4
1.9
Other corporate(2) 18.0
18.9
Total debt and perpetual securities 98.2
98.7
Equity securities and other .2
.2
Cash and cash equivalents 1.6
1.1
Total investments and cash 100.0 % 100.0 %
(1) Includes 6.9% and 9.3% of perpetual securities at
2010, respectively.
(2) Includes .4% of perpetual securities at
Our highest sector concentrations are in government and agencies and banks and financial institution securities. In regards to banks and financial institutions, our investment discipline begins with a top-down approach. We first approve each country we invest in, and within those countries, we primarily invest in financial institutions that are strategically crucial to each country's economy. The banks and financial institutions sector is a highly regulated industry and plays a strategic role in the global economy. While this is our second largest sector concentration, we achieve some degree of diversification through a geographically diverse universe of credit exposures. See Note 3 of the Notes to the Consolidated Financial Statements and the Market Risks of Financial Instruments - Credit Risk subsection of MD&A for more information regarding the sector concentrations of our investments. Yen-denominated debt and perpetual securities accounted for 91% of Aflac Japan's total debt and perpetual securities atDecember 31, 2011 and 2010, at amortized cost. Funds available for investment include cash flows from operations, investment income, and funds generated from bond swaps, maturities and redemptions.Aflac Japan purchased debt security investments at aggregate acquisition cost of approximately2,012.0 billion yen in 2011 (approximately$25.5 billion ),790.4 billion yen in 2010 (approximately$9.1 billion ), and955.6 billion yen in 2009 (approximately$10.1 billion ). The purchases in 2011 were largely related to a bond-swap program as discussed further below. During the three-year period endedDecember 31, 2011 , there were no purchases of perpetual securities, and equity security purchases were immaterial. 44
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The following table presents the composition of debt security purchases for Aflac Japan by sector, as a percentage of acquisition cost, for the years ended
Composition of Purchases by Sector 2011 2010 2009 Debt security purchases, at cost: Banks/financial institutions 3.9 % 8.5 %
4.6 % Government and agencies 83.7 55.1 49.3 Municipalities .7 2.5 3.3 Public utilities 2.4 11.4 14.4
Sovereign and supranational .5 5.8
11.2
Mortgage- and asset-backed securities .0 2.3
1.9 Other corporate 8.8 14.4 15.3 Total 100.0 % 100.0 % 100.0 % The change in allocation of purchases from year to year is based on diversification objectives, relative value and availability of investment opportunities. The increase in purchases of securities in the government and agencies sector in 2011 was due to the investment in Japanese Government Bonds (JGBs) as part of a bond-swap program and as reinvestment of proceeds from sales of other securities. In addition, we purchased U.S. Treasury strips which were subsequently sold before the end of the year. We use specific criteria to judge the credit quality of both existing and prospective investments. Furthermore, we use several methods to monitor these criteria, including credit rating services and internal credit analysis. The ratings referenced in the two tables below are based on the ratings designations provided by the major credit rating agencies (Fitch Ratings ("Fitch"), Moody's Investors Service ("Moody's") andStandard & Poor's Ratings Services ("S&P")) or, if not rated, are assigned based on our internal analysis of such securities. For investment grade securities where the ratings assigned by the major credit agencies are not equivalent, we use the highest rating that is assigned. For a description of the ratings methodology that we use when a security is split-rated (one rating agency rates the security as investment grade while another rating agency rates the same security as below investment grade), see "Market Risks of Financial Instruments -Below-Investment-Grade and Split-Rated Securities " in the Analysis of Financial Condition section of this MD&A. The distributions by credit rating of Aflac Japan's purchases of debt securities for the years endedDecember 31 , based on acquisition cost, were as follows: Composition of Purchases by Credit Rating 2011 2010 2009 AAA 7.0 % .8 % 7.9 % AA 79.5 68.9 62.9 A 7.5 18.5 28.5 BBB 5.4 11.8 .7 BB or lower .6 .0 .0 Total 100.0 % 100.0 % 100.0 % Our purchases of securities are determined through an evaluation of attractive relative value that securities present while still meeting our investment policy guidelines for liquidity, safety and quality. The increase in purchases of AAA rated securities during 2011 was due to purchases of U.S. Treasury strips that were subsequently sold prior to the end of the year. The increase in purchases of AA rated securities during 2011 was primarily due to the purchase of JGBs as discussed above. The purchases of BB or lower rated securities during 2011 was due to a limited program that we initiated inMay 2011 to invest in senior secured bank loans to U.S. and Canadian corporate borrowers, most of which have below-investment-grade ratings. The program is managed externally by a third party firm specializing in this asset class. Its mandate requires a minimum average credit quality of BB-/Ba3, no loans rated below B/B2, and no exposure to any individual credit greater than 3% of the program's assets. The objectives of this program include enhancing the yield on invested assets, achieving further diversification of credit risk, and mitigating the risk of rising interest rates through the acquisition of floating rate assets. 45
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The distributions of debt and perpetual securities owned by Aflac Japan, by credit rating, as of
Composition of Portfolio by Credit Rating 2011 2010 Amortized Fair Amortized Fair Cost Value Cost Value AAA 2.4 % 2.5 % 3.1 % 3.4 % AA 44.3 45.5 38.3 39.4 A 29.3 29.7 34.6 35.2 BBB 18.2 17.2 17.6 17.4 BB or lower 5.8 5.1 6.4 4.6 Total 100.0 % 100.0 % 100.0 % 100.0 % The overall credit quality of Aflac Japan's investments remained high. At the end of 2011, 94.2% of Aflac Japan's debt and perpetual securities were rated investment grade, on an amortized cost basis. See Notes 3 and 5 of the Notes to the Consolidated Financial Statements and the Analysis of Financial Condition section of this MD&A for additional information on our investments.
Japanese Economy
Japan's economy experienced downward pressure in 2011 due to the effects of the earthquake and tsunami that occurred onMarch 11, 2011 . However, according to monthly reports published by the Bank of Japan in 2011, the economy showed signs of the improvement in the months following the natural disaster. Production and exports increased at a moderate pace after declining sharply following the earthquake. In addition, both housing investment and private consumption showed signs of improvement. However, The Bank of Japan'sJanuary 2012 Monthly Report of Recent Economic and Financial Developments stated that, due to effects of the slowdown in overseas economies and the appreciation of the yen, economic activity and production exports have been more or less flat as of the end of 2011. Signs of improvement are still present, as housing investment has generally increased, public investment has stopped declining, and private consumption has remained firm. The report projected thatJapan's economy is expected to gradually return to a moderate recovery path as the pace of recovery in overseas economies improves and reconstruction demand related to the tsunami and earthquake disaster gradually materializes. Exports and production are expected to remain more or less flat for the time being and increase moderately thereafter, housing investment and public investment are expected to increase gradually, and private consumption is expected to remain firm.
Japanese Regulatory Environment
Japan's Financial Services Agency (FSA) maintains a solvency standard, which is used by Japanese regulators to monitor the financial strength of insurance companies. The FSA will apply a revised method of calculating the solvency margin ratio for life insurance companies as of fiscal year-end 2011 (March 31, 2012 ) and has encouraged the disclosure of the ratio as reference information as of fiscal year-end 2010 (March 31, 2011 ). The FSA had commented that the revision would generally reduce life insurance companies' solvency margin ratios to approximately half the level of those reported under the current calculation method. As ofDecember 31, 2011 , Aflac Japan's solvency margin ratio was 985.8% using the current calculation method and, disclosed as reference information, was 547.3% under the new standards. As expected, based on the results of the calculation of the solvency margin ratio under the new standards, Aflac Japan's relative position within the industry has not materially changed. In 2005, legislation aimed at privatizingJapan's postal system (Japan Post ) was enacted into law. The privatization laws splitJapan Post into four entities that began operating inOctober 2007 . In 2007, one of these entities selected Aflac Japan as its provider of cancer insurance to be sold through its post offices, and, in 2008, we began selling cancer insurance through these post offices.Japan Post has historically been a popular place for consumers to purchase insurance products. Currently, our products are being offered in approximately 1,000 post 46
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offices. The ruling coalition is currently in discussions with the major opposition parties regarding the direction of postal reform going forward. Regardless, we believe that the Diet debate on postal reform is unlikely to change Aflac Japan's relationship with the post office company.
AFLAC U.S. SEGMENT
Aflac U.S. Pretax Operating Earnings
Changes in Aflac U.S. pretax operating earnings and profit margins are primarily affected by morbidity, mortality, expenses, persistency and investment yields. The following table presents a summary of operating results for Aflac U.S. for the years endedDecember 31 . Aflac U.S. Summary of Operating Results (In millions) 2011 2010 2009 Premium income $ 4,743 $ 4,586 $ 4,444 Net investment income 588 549 499 Other income 10 11 10 Total operating revenues 5,341 5,146 4,953 Benefits and claims 2,713 2,553 2,561 Operating expenses: Amortization of deferred policy acquisition costs 416 433 419 Insurance commissions 546 534 508 Insurance and other expenses 749 702 689 Total operating expenses 1,711 1,669 1,616 Total benefits and expenses 4,424 4,222 4,177 Pretax operating earnings(1) $ 917 $ 924 $ 776
Percentage change over previous year:
Premium income 3.4 % 3.2 % 4.0 % Net investment income 7.1 9.9 (1.1 ) Total operating revenues 3.8 3.9 3.5 Pretax operating earnings(1) (.8 ) 19.2 4.1
(1) See the Insurance Operations section of this MD&A for our definition of
segment operating earnings.
Annualized premiums in force increased 4.3% in 2011, .3% in 2010 and 3.5% in 2009. Annualized premiums in force atDecember 31 were$5.2 billion in 2011, compared with$5.0 billion in 2010 and 2009.
The following table presents a summary of operating ratios for Aflac U.S. for the years ended
Ratios to total revenues: 2011 2010
2009
Benefits and claims 50.8 % 49.6
% 51.7 %
Operating expenses:
Amortization of deferred policy acquisition costs 7.8 8.4
8.5
Insurance commissions 10.2 10.4
10.3
Insurance and other expenses 14.0 13.6
13.8
Total operating expenses 32.0 32.4
32.6
Pretax operating earnings(1) 17.2 18.0 15.7
(1) See the Insurance Operations section of this MD&A for our definition of
segment operating earnings.
In 2010, the pretax operating profit margin and benefit ratio were positively impacted by the loss of a large payroll account, which resulted in the release of the future policy benefit reserves and amortization of the deferred policy acquisition costs for policies associated with the account. As expected, our benefit ratio increased in 2011 toward more normal levels, compared with 2010. The expense ratio decreased in 2011; however, the offsetting 47
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increase in the benefit ratio resulted in a decline in the pretax operating profit margin, compared with 2010. In 2012, we expect the benefit and expense ratios and pretax operating profit margin to be similar to those experienced in 2011. Aflac U.S. Sales In 2011, Aflac U.S. generated new annualized premium sales growth of 6.8%, compared with prior year, exceeding our annual sales expectation of flat to 5% sales growth. We believe this sales improvement reflects our intense focus on supporting our field force with enhanced products, including group products, and other resources that help our sales force approach selling in the current economic environment more effectively. The following table presentsAflac's U.S. new annualized premium sales for the years endedDecember 31 . (In millions) 2011 2010 2009 New annualized premium sales $ 1,476 $ 1,382 $ 1,453 Increase (decrease) over prior year 6.8 % (4.9 )% (6.4 )%
The following table details the contributions to new annualized premium sales by major insurance product category for the years ended
2011 2010 2009 Income-loss protection: Short-term disability 18 % 17 % 18 % Life 6 6 6 Asset-loss protection: Accident 30 30 30 Critical care(1) 24 23 23 Supplemental medical: Hospital indemnity 16 18 17 Dental/vision 6 6 6 Total 100 % 100 % 100 %
(1) Includes cancer, critical illness and hospital intensive care products
New annualized premium sales for accident insurance, our leading product category, increased 5%, short-term disability sales increased 13%, critical care insurance sales (including cancer insurance) increased 11%, and hospital indemnity insurance sales decreased 6% in 2011, compared with 2010.
Our sales and marketing areas have synchronized their efforts by creating strategies that continue to benefit our sales results. In 2011, we pursued sales through "Smart Launches," which are product-specific coordinated sales marketing efforts geared toward existing accounts. These efforts, which included strategic product pushes of enhanced products including dental and short-term disability, contributed to sales for our veteran agents selling to existing accounts. As part of our U.S. sales strategy, we continue to focus on growing and enhancing the effectiveness of our U.S. sales force. Field force recruiting continued to benefit from targeted national advertising campaigns that we began inJanuary 2011 . These campaigns contributed significantly to our 10.5% increase in recruits during 2011, compared with 2010. We recruited more than 24,400 new sales associates during 2011, resulting in approximately 74,800 licensed sales associates as ofDecember 31, 2011 . In addition to expanding the size and capabilities of our traditional sales force, we are encouraged about the opportunities to broaden our distribution by pursuing and strengthening relationships with insurance brokers. Insurance brokers have been a historically underleveraged sales channel forAflac , so we have been developing relationships with brokers the past several years that complement our traditional distribution system. We have a management team experienced in broker sales, and we are supporting this initiative with streamlined products, targeted broker-specific advertising campaigns, customized enrollment technology, and competitive compensation.
Our group products sold through
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In 2011, sales fromAflac Group Insurance increased 118.1%, compared with the prior year, to$181 million , representing 12% of new annualized premium sales for Aflac U.S. Although we remain somewhat cautious in our short-term sales outlook forAflac U.S., our longer-term view has not changed. We believe the need for the products we sell remains strong, and thatthe United States provides a vast and accessible market for our products. We are taking measures to better reach potential customers through our product and distribution strategy, which includes broadening our product portfolio to include group products in addition to our traditional individually issued products. The addition of the group product platform and our growing broker initiative only serve to enhance our ability to leverage the Aflac brand to reach employees at more companies, large and small, acrossthe United States . Following the passage of health care reform in 2010, we believe employers and consumers will increasingly come to understand the need for the products we offer, just as they have inJapan . For 2012, our objective is for Aflac U.S. new annualized premium sales to increase in the range of 3% to 8%.
Aflac U.S. Investments
The following table presents the results ofAflac's U.S. investment yields for the years endedDecember 31 . 2011 2010 2009 New money yield 5.75 % 5.82 % 7.26 % Return on average invested assets, net of investment expenses 6.41 6.37 6.66 The decrease in the U.S. new money yield in 2011 reflects a low level of interest rates and tightening credit spreads. AtDecember 31, 2011 , the portfolio yield onAflac's U.S. portfolio was 6.72%, compared with 6.92% a year ago. We have investments that support$200 million of variable interest rate funding agreements issued by Aflac U.S. Because these investments do not support our core policyholder benefit obligations, the yield on these investments is not included in the Aflac U.S. portfolio yield or in the yields listed in the above table. The following table presents the composition of total investments by sector, at amortized cost, and cash for Aflac U.S. ($9.2 billion in 2011 and$9.1 billion in 2010) as ofDecember 31 . Composition of Portfolio by Sector 2011 2010
Debt and perpetual securities, at amortized cost:
Banks/financial institutions(1) 20.8 %
23.6 % Government and agencies .2 .2 Municipalities 8.0 8.3 Public utilities 17.6 16.0
Sovereign and supranational 2.4
2.0
Mortgage- and asset-backed securities .5
3.8
Other corporate 47.1
40.4
Total debt and perpetual securities 96.6
94.3
Cash and cash equivalents 3.4
5.7
Total investments and cash 100.0 % 100.0 %
(1) Includes 1.9% and 2.6% of perpetual securities at
respectively.
See Note 3 of the Notes to the Consolidated Financial Statements and the Market Risks of Financial Instruments - Credit Risk subsection of MD&A for more information regarding the sector concentrations of our investments.
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Funds available for investment include cash flows from operations, investment income, and funds generated from bond swaps, maturities and redemptions.Aflac U.S. purchased debt security investments at an aggregate acquisition cost of approximately$1.5 billion in 2011,$1.9 billion in 2010 and$1.0 billion in 2009. We purchased no perpetual or equity securities during the three-year period endedDecember 31, 2011 . The following table presents the composition of debt security purchases for Aflac U.S. by sector, as a percentage of acquisition cost, for the years endedDecember 31 . Composition of Purchases by Sector 2011 2010 2009 Debt security purchases, at cost: Banks/financial institutions 4.5 % 4.2 % 12.5 % Municipalities 12.8 19.0 33.0 Public utilities 16.6 21.6 10.1 Sovereign and supranational .0 .6 .7 Mortgage- and asset-backed securities .0 .0 3.0 Other corporate 66.1 54.6 40.7 Total 100.0 % 100.0 % 100.0 %
The change in allocation of purchases from year to year is based on diversification objectives, relative value and availability of investment opportunities.
We use specific criteria to judge the credit quality of both existing and prospective investments. Furthermore, we use several methods to monitor these criteria, including credit rating services and internal credit analysis. The ratings referenced in the two tables below are based on the ratings designations provided by the major credit rating agencies (Fitch, Moody's and S&P) or, if not rated, are assigned based on our internal analysis of such securities. For investment grade securities where the ratings assigned by the major credit agencies are not equivalent, we use the highest rating that is assigned. For a description of the ratings methodology that we use when a security is split-rated, see "Market Risks of Financial Instruments -Below-Investment-Grade and Split-Rated Securities " in the Analysis of Financial Condition section of this MD&A. The distributions by credit rating ofAflac's U.S. purchases of debt securities for the years endedDecember 31 , based on acquisition cost, were as follows: Composition of Purchases by Credit Rating 2011 2010 2009 AAA .1 % 1.6 % 4.9 % AA 12.1 21.5 17.8 A 50.5 53.6 61.4 BBB 37.3 23.3 15.9 Total 100.0 % 100.0 % 100.0 % Our purchases of securities are determined through an evaluation of attractive relative value that securities present while still meeting our investment policy guidelines for liquidity, safety and quality.
The distributions of debt and perpetual securities owned by Aflac U.S., by credit rating, as of
Composition of Portfolio by Credit Rating 2011 2010 Amortized Fair Amortized Fair Cost Value Cost Value AAA 1.4 % 1.4 % 5.2 % 5.0 % AA 11.4 11.8 12.6 12.8 A 50.7 52.5 47.4 48.0 BBB 33.1 31.5 30.5 30.1 BB or lower 3.4 2.8 4.3 4.1 Total 100.0 % 100.0 % 100.0 % 100.0 % 50
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The overall credit quality of Aflac U.S. investments remained high. At the end of 2011, 96.6% of Aflac U.S. debt and perpetual securities were rated investment grade, on an amortized cost basis. See Notes 3 and 5 of the Notes to the Consolidated Financial Statements and the Analysis of Financial Condition section of this MD&A for additional information on our investments.
U.S. Economy
Operating in the U.S. economy continues to be challenging. We generated sales growth that exceeded our expectations for 2011, but even so, ongoing low confidence levels from consumers and small businesses coupled with fewer employees at the worksite continue to pose sales challenges. Our group products and growing relationships with insurance brokers that handle the larger-case market are helping us as we expand our reach to do business with larger businesses. However, most of our business continues to revolve around small business owners and accounts with fewer than 100 employees. Small businesses, in particular, have proven to be especially vulnerable to ongoing economic weakness, and both small-business owners and their workers are anxious about the future. Workers at small businesses are holding back on increasing their spending for voluntary insurance products. Although we believe that the weakened U.S. economy has dampened our sales growth, we also believe our products remain affordable to the average American consumer. We believe that consumers' underlying need for our U.S. product line remains strong, and thatthe United States remains a sizeable and attractive market for our products.
U.S. Regulatory Environment
InMarch 2010 , PresidentBarack Obama signed the Patient Protection and Affordable Care Act (PPACA) to give Americans of all ages and income levels access to comprehensive major medical health insurance. The primary subject of the new legislation is major medical insurance; therefore, the PPACA, as enacted, does not directly affect the design of our insurance products or our sales model. Our experience withJapan's national health care environment leads us to believe that the need for our products will only increase over the coming years. InJuly 2010 ,President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act, commonly known as the Dodd-Frank Act, which, among other things, created aFinancial Stability and Oversight Council . The Council may designate by a two-thirds vote whether certain insurance companies and insurance holding companies pose a grave threat to the financial stability ofthe United States , in which case such nonbank financial companies would become subject to prudential regulation by theBoard of Governors of the U.S. Federal Reserve (the Board), including capital requirements, leverage limits, liquidity requirements and examinations. The Board may limit such company's ability to enter into merger transactions, restrict its ability to offer financial products, require it to terminate one or more activities, or impose conditions on the manner in which it conducts activities. The Dodd-Frank Act also established a Federal Insurance Office under theU.S. Treasury Department to monitor all aspects of the insurance industry and of lines of business other than certain health insurance, certain long-term care insurance and crop insurance. Traditionally, U.S. insurance companies have been regulated primarily by state insurance departments. The Dodd-Frank Act requires extensive rule-making and other future regulatory action, which in some cases will take a period of years to implement. We believe thatAflac would not likely be considered a company that would pose a systemic risk to the financial stability ofthe United States . However, at the current time, it is not possible to predict with any degree of certainty what impact, if any, the Dodd-Frank Act will have on our U.S. business, financial condition, or results of operations.
OTHER OPERATIONS
Corporate operating expenses consist primarily of personnel compensation, benefits, and facilities expenses. Corporate expenses, excluding investment income, were$74 million in 2011,$67 million in 2010 and$77 million in 2009. Investment income included in reported corporate expenses was$10 million in 2011,$11 million in 2010 and$9 million in 2009. ANALYSIS OF FINANCIAL CONDITION Our financial condition has remained strong in the functional currencies of our operations. The yen/dollar exchange rate at the end of each period is used to translate yen-denominated balance sheet items to U.S. dollars for reporting purposes. 51
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The following table demonstrates the effect of the change in the yen/dollar exchange rate by comparing select balance sheet items as reported at
Impact of Foreign Exchange on Balance Sheet Items As Exchange Net of (In millions) Reported Effect Exchange Effect
Yen/dollar exchange rate(1) 77.74 81.49 Investments and cash $ 103,462 $ 3,810 $ 99,652 Deferred policy acquisition costs 10,654 356 10,298 Total assets 117,102 4,237 112,865 Policy liabilities 94,593 3,982 90,611 Total liabilities 103,596 4,253 99,343
(1) The exchange rate at
stronger than the
Market Risks of Financial Instruments
Our investment philosophy is to maximize investment income while emphasizing liquidity, safety and quality. Our investment objective, subject to appropriate risk constraints, is to fund policyholder obligations and other liabilities in a manner that enhances shareholders' equity. We seek to achieve this objective through a diversified portfolio of fixed-income investments that reflects the characteristics of the liabilities it supports.Aflac invests primarily within the fixed income securities markets. The following table details investment securities by segment as ofDecember 31 . Investment Securities by Segment Aflac Japan Aflac U.S. (In millions) 2011 2010 2011 2010 Securities available for sale, at fair value: Fixed maturities $ 37,473 $ 39,485 $ 9,961 (1) $ 8,750 (1) Perpetual securities 6,271 7,233 168 279 Equity securities 25 23 0 0 Total available for sale 43,769 46,741 10,129 9,029 Securities held to maturity, at amortized cost: Fixed maturities 47,009 30,084 0 0 Total held to maturity 47,009 30,084 0 0 Total investment securities $ 90,778 $ 76,825 $
10,129
(1) Excludes investment-grade, available-for-sale fixed-maturity securities held
by the Parent Company of
Because we invest in fixed-income securities, our financial instruments are exposed primarily to three types of market risks: currency risk, interest rate risk and credit risk.
Currency Risk The functional currency of Aflac Japan's insurance operation is the Japanese yen. All of Aflac Japan's premiums, claims and commissions are received or paid in yen, as are most of its investment income and other expenses. While we have been investing a portion of our yen cash flow in dollar-denominated securities, most of 52
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Aflac Japan's investments, cash and liabilities are yen-denominated. When yen-denominated securities mature or are sold, the proceeds are generally reinvested in yen-denominated securities. Aflac Japan holds these yen-denominated assets to fund its yen-denominated policy obligations. In addition,
Although we generally do not convert yen into dollars, we do translate financial statement amounts from yen into dollars for financial reporting purposes. Therefore, reported amounts are affected by foreign currency fluctuations. We report unrealized foreign currency translation gains and losses in accumulated other comprehensive income. Aflac Japan maintains a portfolio of reverse-dual currency securities (yen-denominated debt securities with dollar coupon payments), which exposesAflac to changes in foreign exchange rates. This foreign currency effect is accounted for as a component of unrealized gains or losses on available-for-sale securities in accumulated other comprehensive income. When the yen strengthens against the dollar, shareholders' equity is negatively impacted and, conversely, when the yen weakens against the dollar, shareholders' equity is positively impacted. Aflac Japan invests a portion of its assets in reverse-dual currency securities to provide a higher yield than those available on Japanese government or other public corporate bonds, while still adhering to prudent standards of credit quality. The yen/dollar exchange rate would have to strengthen to approximately 46 before the yield on these instruments would equal that of a comparable yen-denominated instrument. On a consolidated basis, we attempt to minimize the exposure of shareholders' equity to foreign currency translation fluctuations. We accomplish this by investing a portion of Aflac Japan's investment portfolio in dollar-denominated securities and by the Parent Company's issuance of yen-denominated debt (for additional information, see the discussion under the Hedging Activities subsection of MD&A). As a result, the effect of currency fluctuations on our net assets is reduced. 53
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The following table demonstrates the effect of foreign currency fluctuations by presenting the dollar values of our yen-denominated assets and liabilities, and our consolidated yen-denominated net asset exposure at selected exchange rates as ofDecember 31 . Dollar Value of Yen-Denominated Assets and Liabilities at Selected Exchange Rates (In millions) 2011 2010 Yen/dollar exchange rates 62.74 77.74 (1) 92.74
66.49 81.49 (1) 96.49
Yen-denominated financial instruments: Assets: Securities available for sale: Fixed maturities $ 31,405 $ 25,345 $ 21,246 $ 35,905 $ 29,296 $ 24,742 Fixed maturities - consolidated variable interest entities 3,402 2,746 2,302 3,637 2,968 2,506 Perpetual securities 6,117 4,937 4,138 6,911 5,638 4,762 Perpetual securities - consolidated variable interest entities 1,477 1,192 999 1,745 1,424 1,203 Equity securities 24 19 16 23 19 16 Securities held to maturity: Fixed maturities 57,451 46,366 38,867 36,119 29,470 24,889 Fixed maturities - consolidated variable interest entities 797 643 539 752 614 518 Cash and cash equivalents 1,737 1,402 1,175 939 766 647 Other financial instruments 183 147 124 153 125 105 Subtotal 102,593 82,797 69,406 86,184 70,320 59,388 Liabilities: Notes payable 1,599 1,291 1,082 1,280 1,044 882 Japanese policyholder protection corporation 88 71 60 132 108 91 Subtotal 1,687 1,362 1,142 1,412 1,152 973 Net yen-denominated financial instruments 100,906 81,435 68,264 84,772 69,168 58,415 Other yen-denominated assets 11,487 9,271 7,771 10,338 8,435 7,124 Other yen-denominated liabilities 112,842 91,069 76,339 95,441 77,873 65,767 Consolidated yen-denominated net assets (liabilities) subject to foreign currency fluctuation $ (449 ) $ (363 ) $ (304 ) $ (331 ) $ (270 ) $ (228 )
(1) Actual period-end exchange rate
EffectiveJanuary 1, 2010 , we were required to consolidate certain variable interest entities (VIEs) upon the adoption of new accounting guidance. Prior to the adoption of this new accounting guidance, our beneficial interest in certain VIEs was a yen-denominated available-for-sale fixed maturity security. Upon consolidation onJanuary 1, 2010 , the original yen-denominated investment was derecognized and the underlying U.S. dollar-denominated fixed-maturity or perpetual securities and cross-currency swaps were recognized. While the combination of a U.S. dollar-denominated investment and cross-currency swap economically creates a yen-denominated investment, these investments will create foreign currency fluctuations but have no impact on our net investment hedge position. For additional information, see the Hedging Activities subsection of MD&A. Some of the consolidated VIEs in our Aflac Japan portfolio use foreign currency swaps to convert foreign denominated cash flows to yen, the functional currency of Aflac Japan, in order to minimize cash flow fluctuations. Foreign currency swaps exchange an initial principal amount in two currencies, agreeing to re-exchange the currencies at a future date, at an agreed upon exchange rate. There may also be periodic exchanges of payments at specified intervals based on the agreed upon rates and notional amounts. 54
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We are exposed to economic currency risk only when yen funds are actually converted into dollars. This primarily occurs when we repatriate yen-denominated funds from Aflac Japan to Aflac U.S., which is generally done annually. The exchange rates prevailing at the time of repatriation will differ from the exchange rates prevailing at the time the yen profits were earned. A portion of the repatriation may be used to serviceAflac Incorporated's yen-denominated notes payable with the remainder converted into dollars.
Interest Rate Risk
Our primary interest rate exposure is to the impact of changes in interest rates on the fair value of our investments in debt and perpetual securities. We use a modified duration analysis modeling approach, which measures price percentage volatility, to estimate the sensitivity of the fair values of our investments to interest rate changes on the debt and perpetual securities we own. For example, if the current duration of a debt security or perpetual security is 10, then the fair value of that security will increase by approximately 10% if market interest rates decrease by 100 basis points, assuming all other factors remain constant. Likewise, the fair value of the debt security or perpetual security will decrease by approximately 10% if market interest rates increase by 100 basis points, assuming all other factors remain constant. The estimated effect of potential increases in interest rates on the fair values of debt and perpetual securities we own, interest rate swaps, foreign currency swaps, notes payable, and our obligation to the Japanese policyholder protection corporation as ofDecember 31 follows: Sensitivity of Fair Values of Financial Instruments to Interest Rate Changes 2011 2010 +100 +100 Fair Basis Fair Basis (In millions) Value Points Value Points Assets: Debt and perpetual securities: Fixed-maturity securities: Yen-denominated $ 74,474 $ 65,219 $ 62,733 $ 55,518 Dollar-denominated 19,481 17,600 16,091 14,764 Perpetual securities: Yen-denominated 6,129 5,669 7,062 6,444 Dollar-denominated 310 291 450 411
Total debt and perpetual securities
Interest rate and foreign currency swaps $ 375 $ 212 $ 564 $ (251 ) Liabilities: Notes payable(1) $ (3,536 ) $ (3,334 ) $ (3,248 ) $ (3,060 ) Interest rate and foreign currency swaps (401 ) (563 ) (398 ) (8 ) Japanese policyholder protection corporation (71 ) (71 ) (108 ) (108 )
(1) Excludes capitalized lease obligations
There are various factors that affect the fair value of our investment in debt and perpetual securities. Included in those factors are changes in the prevailing interest rate environment, which directly affect the balance of unrealized gains or losses for a given period in relation to a prior period. Decreases in market yields generally improve the fair value of debt and perpetual securities, while increases in market yields generally have a negative impact on the fair value of our debt and perpetual securities. However, we do not expect to realize a majority of any unrealized gains or losses because we generally have the intent and ability to hold such securities until a recovery of value, which may be maturity. For additional information on unrealized losses on debt and perpetual securities, see Note 3 of the Notes to the Consolidated Financial Statements. 55
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We attempt to match the duration of our assets with the duration of our liabilities. The following table presents the approximate duration of Aflac Japan's yen-denominated assets and liabilities, along with premiums, as of
(In years) 2011
2010
Yen-denominated debt and perpetual securities 13
12
Policy benefits and related expenses to be paid in future years 14
14
Premiums to be received in future years on policies in force 10
10
The following table presents the approximate duration of Aflac U.S. dollar-denominated assets and liabilities, along with premiums, as of
(In years) 2011
2010
Dollar-denominated debt and perpetual securities 11
10
Policy benefits and related expenses to be paid in future years 7
7
Premiums to be received in future years on policies in force 6
6
The following table shows a comparison of average required interest rates for future policy benefits and investment yields, based on amortized cost, for the years endedDecember 31 . Comparison of Interest Rates for Future Policy Benefits and Investment Yields (Net of Investment Expenses) 2011 2010 2009 U.S. Japan(1) U.S. Japan(1) U.S. Japan(1) Policies issued during year: Required interest on policy reserves 4.75 % 2.25 % 5.50 % 2.39 % 5.50 % 2.51 % New money yield on investments 5.72 2.42 5.79 2.44 7.22 2.88 Policies in force at year-end: Required interest on policy reserves 5.99 4.02 6.03 4.40 6.06 4.47 Return on average invested assets 6.41 3.18 6.37 3.48 6.66 3.65
(1) Represents yen-denominated investments for Aflac Japan that support policy
obligations and therefore excludes Aflac Japan's annuity products, and
dollar-denominated investments and related investment income
We continue to monitor the spread between our new money yield and the required interest assumption for newly issued products in boththe United States andJapan and will re-evaluate those assumptions as necessary. The decline inAflac Japan's required interest rates on policy reserves from 2010 to 2011 was the result of strengthening of future policy benefit reserves primarily for a closed block of cancer policies and a block of care policies. Over the next two years, we have yen-denominated securities that will mature with yields in excess of Aflac Japan's current net investment yield of 3.02%. These securities total$3.9 billion at amortized cost and have an average yield of 4.84%. Currently, when debt and perpetual securities we own mature, the proceeds may be reinvested at a yield below that of the interest required for the accretion of policy benefit liabilities on policies issued in earlier years. However, adding riders to our older policies has helped offset negative investment spreads on these policies. Overall, adequate profit margins exist in Aflac Japan's aggregate block of business because of changes in the mix of business and favorable experience from mortality, morbidity and expenses. We entered into interest rate swap agreements related to our5.5 billion yen variable interest rate Samurai notes that we issued inJuly 2011 , and we had interest rate swap agreements related to our20 billion yen variable interest rate Uridashi notes that matured inSeptember 2011 . These agreements effectively converted the variable interest rate notes to fixed rate notes to eliminate the volatility in our interest expense. We also have interest rate swaps related to some of our consolidated VIEs. These interest rate swaps are primarily used to convert interest receipts on floating-rate fixed-maturity securities contracts to fixed rates. For further information, see Notes 4 and 8 of the Notes to the Consolidated Financial Statements. 56
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Credit Risk
Our investment activities expose us to credit risk, which is a consequence of extending credit and/or carrying investment positions. However, we continue to adhere to prudent standards for credit quality. We accomplish this by considering our product needs and overall corporate objectives, in addition to credit risk. In evaluating the initial rating, we look at the overall senior issuer rating, the explicit rating for the actual issue or the rating for the security class, and, where applicable, the appropriate designation from the Securities Valuation Office (SVO) of theNational Association of Insurance Commissioners (NAIC). All of our securities have ratings from either a nationally recognized statistical rating organization, the SVO of the NAIC, or are assigned ratings by us based on NAIC rules. In addition, we perform extensive internal credit reviews to ensure that we are consistent in applying rating criteria for all of our securities. We use specific criteria to judge the credit quality of both existing and prospective investments. Furthermore, we use several methods to monitor these criteria, including credit rating services and internal credit analysis. The ratings referenced in the two tables below are based on the ratings designations provided by the major credit rating agencies (Fitch, Moody's and S&P) or, if not rated, are assigned based on our internal analysis of such securities. For investment grade securities where the ratings assigned by the major credit agencies are not equivalent, we use the highest rating that is assigned. For a description of the ratings methodology that we use when a security is split-rated, see "Market Risks of Financial Instruments -Below-Investment-Grade and Split-Rated Securities " in the Analysis of Financial Condition section of this MD&A.
The distributions by credit rating of our purchases of debt securities for the years ended
Composition of Purchases by Credit Rating 2011 2010 2009 AAA 6.6 % 1.0 % 7.6 % AA 75.8 60.7 58.9 A 9.9 24.5 31.4 BBB 7.2 13.8 2.1 BB or lower .5 0.0 0.0 Total 100.0 % 100.0 % 100.0 % Purchases of securities from year to year are determined based on diversification objectives, relative value and availability of investment opportunities, while meeting our investment policy guidelines for liquidity, safety and quality. We did not purchase any perpetual securities during the periods presented in the table above. The increase in purchases of AAA rated securities during 2011 was due to an increase in purchases of U.S. Treasury strips that were subsequently sold prior to the end of the year to generate investment gains. The increase in purchases of AA rated securities during 2011 was primarily due to purchases of JGBs as part of a bond-swap program and for asset liability management purposes. The purchases of BB or lower rated securities during 2011 was due to a limited program that we initiated inMay 2011 to invest in senior secured bank loans to U.S. and Canadian corporate borrowers, most of which have below-investment-grade ratings. The program is managed externally by a third party firm specializing in this asset class. Its mandate requires a minimum average credit quality of BB-/Ba3, no loans rated below B/B2, and no exposure to any individual credit greater than 3% of the program's assets. The objectives of this program include enhancing the yield on invested assets, achieving further diversification of credit risk, and mitigating the risk of rising interest rates through the acquisition of floating rate assets.
The distributions of debt and perpetual securities we own, by credit rating, as of
Composition of Portfolio by Credit Rating 2011 2010 Amortized Fair Amortized Fair Cost Value Cost Value AAA 2.3 % 2.3 % 3.3 % 3.6 % AA 41.3 42.0 35.7 36.5 A 31.3 32.1 36.0 36.6 BBB 19.5 18.7 18.8 18.7 BB or lower 5.6 4.9 6.2 4.6 Total 100.0 % 100.0 % 100.0 % 100.0 % 57
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As ofDecember 31, 2011 , our direct and indirect exposure to securities in our investment portfolio that were guaranteed by third parties was immaterial both individually and in the aggregate.
Subordination Distribution
The majority of our total investments in debt and perpetual securities was senior debt atDecember 31, 2011 and 2010. We also maintained investments in subordinated financial instruments that primarily consisted of Lower Tier II, Upper Tier II, and Tier I securities, listed in order of seniority. The Lower Tier II (LTII) securities are debt instruments with fixed maturities. Our Upper Tier II (UTII) and Tier I investments consisted of debt instruments with fixed maturities and perpetual securities, which have an economic maturity as opposed to a stated maturity.
The following table shows the subordination distribution of our debt and perpetual securities as of
Subordination Distribution ofDebt and Perpetual Securities 2011 2010 Amortized Percentage Amortized Percentage (In millions) Cost of Total Cost of Total Senior notes $ 85,544 86.2 % $ 68,407 79.5 % Subordinated securities: Fixed maturities (stated maturity date): Lower Tier II 5,795 5.8 8,679 10.1 Upper Tier II 0 0.0 15 .0 Tier I(1) 555 0.6 613 .7 Surplus notes 335 0.3 335 .4 Trust preferred - non-banks 85 0.1 85 .1 Other subordinated - non-banks 51 0.1 52 .1 Total fixed maturities 6,821 6.9 9,779 11.4 Perpetual securities (economic maturity date): Upper Tier II 4,285 4.3 4,957 5.7 Tier I 2,268 2.3 2,542 3.0 Other subordinated - non-banks 344 0.3 328 .4 Total perpetual securities 6,897 6.9 7,827 9.1 Total debt and perpetual securities $ 99,262 100.0 % $ 86,013 100.0 %
(1) Includes trust preferred securities
As indicated in the table above, the percentage of our investment portfolio comprising subordinated fixed maturities and perpetual securities investments has declined due primarily to sales and impairments resulting from an implemented plan to reduce the risk exposure in our investment portfolio. See the Investment Concentrations section below for more information on these derisking activities.
Portfolio Composition
For information regarding the amortized cost for our investments in debt and perpetual securities, the cost for equity securities and the fair values of these investments, refer to Note 3 of the Notes to the Consolidated Financial Statements. Investment Concentrations
As of
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the United States ,United Kingdom andEurope spread to structured investment securities. As a result, banks and financial institutions suffered significant write-downs of asset values, which pressured banks and financial institutions to seek capital and liquidity support. National governments responded with various forms of support, ranging from guarantees on new and existing debt to significant injections of capital. In the second half of 2009, asset valuations generally improved, and banks and other institutions continued to use exchanges and tender offers to enhance their core capital. However, 2010 brought new concerns about the fiscal integrity of peripheral European sovereign nations, and in 2011, concerns about the fiscal integrity of peripheral European sovereigns persisted due to the inability of Eurozone leaders to establish an effective solution. As a result, most financial institutions in the Euro area have faced both liquidity and asset valuation pressures.Greece ,Ireland , and, most recently,Portugal were forced to accept external funding aid in various forms to meet their financial obligations, as public markets were not accessible. Nationalization and/or recapitalization, along with loss-sharing among bondholders, all remain distinct risks for financial institutions. While European politicians have become increasingly hesitant to put taxpayers at risk, with few exceptions, we believe nationalizations and burden-sharing among debt holders remain options of last resort.
See Note 3 of the Notes to the Consolidated Financial Statements for a discussion of our investment discipline and further discussion of our investment industry sector concentration in banks and financial institutions.
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Our 20 largest global investment exposures as ofDecember 31, 2011 , were as follows: Largest 20 Global Investment Positions Ratings Amortized % of (In millions) Cost Total Seniority Moody's S&P Fitch Japan National Government(1) $ 29,244 29.5 % Senior Aa3 AA- AA- Israel Electric Corp. 847 .9 Senior Baa3 BB+ - Republic of Tunisia(2) 823 .8 Senior Baa3 BBB- BBB- Republic of South Africa 785 .8 Senior A3 BBB+ BBB+ HSBC Holdings PLC 742 .8 HSBC Finance Corporation (formerly Household Finance) 643 .7 Senior A3 A AA- HSBC Bank PLC 19 .0 Upper Tier II A3 A- A+ The Hongkong &Shanghai Banking Corporation Ltd. 80 .1 Upper Tier II Aa3 - - Mizuho Financial Group Inc. 604 .6Mizuho Bank , Mizuho Finance Cayman & Aruba 604 .6 Upper Tier II A3 BBB+ - UniCredit SpA 601 .6 UniCredit Bank Austria AG 11 .0 Lower Tier II Aa3 AA+ - UniCredit Bank AG (Hypovereinsbank) 216 .2 Lower Tier II Baa2 BBB+ AUniCredit Bank AG (HVB Funding Trust I, III & VI) 374 .4 Tier I Baa3 BBB- BBB Bank of America Corp. (includes Merrill Lynch) 579 .6 Merrill Lynch & Co. Inc. 322 .3 Senior Baa1 A- A Bank of America Corp. 257 .3 Lower Tier II Baa2 BBB+ A- BNP Paribas (includes Fortis) 579 .6 BNP Paribas 129 .2 Senior Aa3 AA- A+ Fortis Bank SA-NV 321 .3 Upper Tier II A3 A- BBB+ Fortis Luxembourg Finance SA 129 .1 Upper Tier II A3 A- BBB+Bank of Tokyo-Mitsubishi UFJ Ltd. 579 .6Bank of Tokyo-Mitsubishi UFJ Ltd. (BTMU Curacao Holdings NV) 579 .6 Lower Tier II A1 A A- Erste Group Bank AG 540 .5 Erste Group Bank 116 .1 Lower Tier II A2 A- A- Erste Group Bank (Erste Finance Jersey Ltd. 3 & 5) 424 .4 Tier I Ba1 - - Investcorp SA 526 .5 Investcorp Capital Limited 526 .5 Senior Ba2 - BB+(3) Sumitomo Mitsui Financial Group Inc. 514 .5 Sumitomo Mitsui Banking Corporation 128 .1 Lower Tier II A1 A A- Sumitomo Mitsui Banking Corporation (SMBC International Finance) 386 .4 Upper Tier II A2 BBB+ - National Grid PLC 514 .5 National Grid Gas PLC 257 .2 Senior A3 A- A National Grid Electricity Transmission PLC 257 .3 Senior A3 A- A Telecom Italia SpA 514 .5 Telecom Italia Finance SA 514 .5 Senior Baa2 BBB BBB Citigroup Inc. 507 .5 Citigroup Inc (includesCitigroup Global Markets Holdings Inc.) 506 .5 Senior A3 A- A Citigroup Inc. (Citicorp) 1 .0 Lower Tier II Baa1 BBB+ A- JP Morgan Chase & Co. (including Bear Stearns) 504 .5 JPMorgan Chase & Co (includingBear Stearns Companies Inc.) 450 .5 Senior Aa3 A AA- JPMorgan Chase & Co (FNBC) 26 .0 Senior Aa1 A+ - JPMorgan Chase & Co (Bank One Corp.) 17 .0 Lower Tier II A1 A- A+ JPMorgan Chase & Co (NBD Bank) 11 .0 Lower Tier II Aa2 A A+Commonwealth Bank of Australia 502 .5Commonwealth Bank of Australia 129 .1 Lower Tier II Aa3 A- AA-Commonwealth Bank of Australia 257 .3 Upper Tier II - BBB - Bankwest 116 .1 Upper Tier II Aa3 BBB - Credit Suisee Group 495 .5 Credit Suisse Group Capital 193 .2 Upper Tier II A1 BBB BBB+ Credit Suisse Group Capital 302 .3 Tier I Baa1 BBB- BBB+ Hutchison Whampoa LTD (CKI Holdings LTD) 493 .5 Hutchison Whampoa Finance (CI) Limited 92 .1 Senior A3 A- A- HongKong Electric Finance Limited 15 .0 Senior - A+ - Cheung Kong Infrastructure Finance 386 .4 Senior - A- A- Total $ 40,492 40.8 % Total debt and perpetual securities $ 99,262 100.0 %
(1) JGBs or JGB-backed securities
(2) Deemed by the Company to be below investment grade
(3) Downgraded to BB by Fitch in
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As previously disclosed, we own long-dated debt instruments in support of our long-dated policyholder obligations. Included in our largest global investment holdings are positions that date back many years. Additionally, the concentration of certain of our holdings of individual credit exposures has grown over time through merger and consolidation activity. Beginning in 2005, we have generally limited our investment exposures to individual issuers to no more than 5% of total adjusted capital (TAC) on a statutory accounting basis, with the exception of obligations of the Japanese and U.S. governments. However, existing investment exposures that exceeded 5% of TAC at the time this guidance was adopted, or exposures that may exceed this threshold from time to time through merger and consolidation activity, are not automatically reduced through sales of the issuers' securities but rather are reduced over time consistent with our investment policy. In January andFebruary 2012 , Mizuho Financial Group Inc. announced the redemption of a total of20 billion yen ($257 million using the yen/dollar exchange rate atDecember 31, 2011 ), on an amortized cost basis, of our perpetual security holdings;10 billion yen will be redeemed onFebruary 27, 2012 , and10 billion yen will be redeemed onMarch 27, 2012 . These securities are being redeemed on their first economic maturity date.
Investments in Certain European Countries
With the periphery ofEurope garnering the attention of markets, we are disclosing our exposure toGreece ,Ireland ,Italy ,Portugal , andSpain . These countries are at the epicenter of the European debt crisis, and the developments affecting these countries in turn affect the other 12 countries inextricably linked to these five countries through their collective membership in theEconomic and Monetary Union and resultant adoption of a single common currency - the euro. The primary factor considered when determining domicile is the legal domicile of the issuer. However, other factors such as the location of a parent guarantor, the location of the company's headquarters or major business operations (including location of major assets), location of primary market (including location of revenue generation) and specific country risk publicly recognized by rating agencies can influence the assignment of the country (or geographic) risk location. When the issuer is a special financing vehicle or a branch or subsidiary of a global company, then we consider any guarantees and/or legal, regulatory and corporate relationships of the issuer relative to its ultimate parent in determining the proper assignment of country risk. 61
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Our direct investment exposure toGreece ,Ireland ,Italy ,Portugal andSpain and the related maturities of those investments as ofDecember 31 were as follows: 2011 Five to Ten One to Five Years Years After Ten Years Total Amortized Fair Amortized Fair Amortized Fair Amortized Fair (In millions) Cost Value Cost Value Cost Value Cost Value Available-for-sale securities: Ireland: Banks/financial institutions $ 0 $ 0 $ 0 $ 0 $ 287 $ 170 $ 287 $ 170 Italy: 0 Public utilities 0 0 0 0 15 14 15 14 Other corporate 0 0 0 0 399 392 399 392 Portugal: Public utilities 10 10 40 33 129 105 179 148 Spain: Sovereign 0 0 148 162 0 0 148 162 Banks/financial institutions 34 35 0 0 45 45 79 80 Public utilities 0 0 0 0 476 422 476 422 Other corporate 34 33 0 0 243 212 277 245 Held-to-maturity securities: Ireland: Banks/financial institutions 0 0 0 0 257 209 257 209 Italy: Sovereign 0 0 0 0 322 303 322 303 Banks/financial institutions 0 0 0 0 193 181 193 181 Public utilities 0 0 0 0 952 914 952 914 Other corporate 0 0 0 0 707 661 707 661 Portugal: Public utilities 0 0 129 135 0 0 129 135 Spain: Sovereign 0 0 0 0 489 470 489 470 Banks/financial institutions 0 0 0 0 450 356 450 356 Public utilities 0 0 0 0 450 447 450 447 Other corporate 0 0 0 0 257 241 257 241
Total gross and net funded exposure $ 78
317 $ 330 $ 5,671 $ 5,142 $ 6,066 $ 5,550 62
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Banks/financial institutions $ 0
0 0 0 0 219 219 219 219Italy : Public utilities 0 0 0 0 15 16 15 16 Other corporate 0 0 0 0 258 278 258 278 Portugal: Public utilities 10 11 40 37 0 0 50 48 Banks/financial institutions 92 91 0 0 368 307 460 398
Sovereign 0 0 141 159 0 0 141 159 Banks/financial institutions 34 37 0 0 63 69 97 106 Public utilities 0 0 0 0 454 418 454 418 Other corporate 31 32 0 0 234 224 265 256 Held-to-maturity securities: Ireland: Banks/financial institutions 0 0 0 0 491 440 491 440
Sovereign 0 0 0 0 307 306 307 306 Banks/financial institutions 0 0 0 0 184 183 184 183 Public utilities 0 0 0 0 908 925 908 925 Other corporate 0 0 0 0 675 661 675 661Portugal : Public utilities 0 0 123 136 123 129 246 265 Banks/ financial institutions 0 0 0 0 399 372 399 372 Other corporate 0 0 0 0 184 178 184 178 Spain: Sovereign 0 0 0 0 589 623 589 623 Banks/financial institutions 0 0 0 0 429 397 429 397 Public utilities 0 0 0 0 430 439 430 439 Other corporate 0 0 0 0 245 254 245 254 Total gross and net funded exposure $ 167 $ 171 $ 304 $ 332 $ 7,727 $ 6,829 $ 8,198 $ 7,332 We do not have any unfunded exposure in the European countries shown in the preceding table, and we have not entered into any hedges to mitigate credit risk for our funded exposure. The banks and financial institutions investments inGreece ,Ireland ,Italy ,Portugal andSpain represented 5% and 12% of total investments in the banks and financial institutions sector atDecember 31, 2011 and 2010, respectively, and 1% and 4% of total investments in debt and perpetual securities atDecember 31, 2011 and 2010, respectively. Any increases in amortized cost for these peripheral Eurozone investments in 2011 were due to the strengthening of the yen against the U.S. dollar. 63
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During the second quarter of 2010, our investments in Greek financial institutions, Alpha Bank, EFG Eurobank Ergasias, and National Bank of Greece (NBG), all of which were Lower Tier II subordinated debt, were downgraded to below investment grade. As a result of the downgrades, we reclassified these investments from held to maturity to available for sale. At that time, we believed the downgrade of the Greek banks was largely related to the problems of the Greek government and its poor fiscal management, rather than the banks' specific credit profiles. The three Greek bank issuers that comprised our Greek financial institution holdings had, on average, Tier I capital ratios higher than their peers in other troubled European sovereigns. Their capital was at a level that we felt could sustain deterioration in assets and operations that accompany economic conditions, such as those that the Greek economy was encountering in 2010 and those expected in the next few years. All three Greek banks had sufficient capital under the stress testing applied by theCommittee of European Banking Supervisors (CEBS) inJuly 2010 . However, the problems of the Greek government and related ratings downgrades have caused a decline in the confidence of depositors and capital market participants in the Greek banking system. As a result, the banks have significantly relied upon theEuropean Central Bank (ECB) for liquidity via posting of collateral, which tends to be in the form of Greek Government Bonds (GGBs) or debt guaranteed by the sovereign. As ofDecember 31, 2010 , all of the Greek banks were current on their obligations to us. While these financial institutions had significant investments in GGBs, as ofDecember 31, 2010 , we believed that these institutions would be solvent even if there were a future restructuring of GGBs and they would have the ability to meet their obligations to us. In addition, as ofDecember 31, 2010 , we had the intent to hold these investments to recovery in value. As a result, we did not recognize an other-than-temporary impairment for these investments as ofDecember 31, 2010 . Subsequent toDecember 31, 2010 ,Greece remained under pressure, which also continued to weigh on the Greek banks. Skepticism over the rigor of the capital stress test applied by the CEBS inJuly 2010 grew, as did fears of contagion asIreland accepted aEuropean Union -International Monetary Fund (EU-IMF) bailout program. OnFebruary 18, 2011 , NBG announced its proposal for a "friendly merger" with Alpha Bank, but Alpha Bank rejected this proposal. However, this proposal highlighted risks that accompany consolidation among the top three banks inGreece . While the proposal could have created a national champion in Greek banking, it also would have concentrated ownership of GGBs in the combined entity and formed a very low-rated entity among our top ten largest investment holdings. Two rating agencies downgraded the Greek banks subsequent to downgrading the sovereign during the first quarter of 2011 (onJanuary 17, 2011 , andMarch 9, 2011 ). In the latter action, the rating agency lowered the ratings indicative of the banks' intrinsic financial strength due to the persistent pressure on liquidity, asset quality and material exposure to GGBs. In light of the above increased risks and, in particular, theMarch 9, 2011 downgrade, we no longer supported our previous intent to hold our Greek bank investments to recovery in value. InMarch 2011 , we sold our investment in Alpha Bank and recognized an investment loss of$177 million ($115 million after-tax), and we recognized other-than-temporary impairment losses of$397 million ($258 million after-tax) for the remaining two Greek bank holdings. In the second quarter of 2011, we sold our investment in EFG Eurobank Ergasias for$2 million more than its recorded impaired value, and we sold our remaining Greek bank investment, NBG, for$47 million less than its recorded impaired value. At the end of 2011, we had no direct exposure toGreece .
During the second quarter of 2011, we sold our holdings in Irish Life and Permanent PLC, which were below-investment-grade perpetual securities that had previously been impaired, at a pretax loss of
As ofDecember 31, 2011 , our total direct exposure toIreland was$544 million at amortized cost, comprised of senior unsecured obligations. Senior securities issued by the Bank of Ireland with amortized costs and fair values totaling$257 million and$140 million , respectively, were rated below investment grade. We believe that these unrealized losses were more closely linked to the Irish government's aggressive approach to addressing its debt burden, which included at one point potentially imposing losses on senior debt holders of certain non-viable Irish banks. While the political risk of burden-sharing remains, it significantly subsided during the second half of 2011, as the government has shifted its focus to reducing its debt burden related to the EU/IMF program rather than disrupt the progress made in restoring stability to the Irish banking sector. This Irish bank is current on its obligation to us, and we believe it has the ability to meet its obligations to us. In addition, as ofDecember 31, 2011 , we had the intent 64
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to hold this investment to recovery in value. As a result, we did not recognize an other-than-temporary impairment for this investment as ofDecember 31, 2011 . The other senior security holdings inIreland were issued byDEPFA Bank PLC and had an amortized cost of$287 million as ofDecember 31, 2011 . DEPFA is an Irish-domiciled and licensed financial institution that is a wholly owned subsidiary ofHypo Real Estate Holding , aGermany licensed and regulated financial institution. Due to this ownership by a German parent, DEPFA has not been included in theRepublic of Ireland's bank re-structuring and capitalization plan. DEPFA has been current on its obligation to us and was rated investment grade at Baa3/BBB/BBB+ by Moody's, S&P and Fitch, respectively, as ofDecember 31, 2011 . There have been no additional ratings actions by Moody's since it downgradedIreland's foreign currency long-term debt rating from Baa3 to Ba1 onJuly 12, 2011 . Moody's affirmed its rating ofIreland onFebruary 13, 2012 . S&P placedIreland's foreign currency long-term debt rating of BBB+ on negative watch onDecember 5, 2011 and subsequently removed the watch onJanuary 13, 2012 . OnDecember 16, 2011 , Fitch placed its foreign currency long-term debt rating of BBB+ forIreland on negative watch. Fitch affirmed its rating ofIreland onJanuary 27, 2012 .
During the second half of 2011, the European sovereign crisis shifted focus fromGreece and moved to other periphery European sovereigns, includingItaly . We believe the focus onItaly has been driven by a combination of factors which, separately in a normal market environment, would have a limited impact on the fiscal profile and financing capabilities of a developed market government, likeItaly's . The factors include the EU leadership's inability to solve theGreece fiscal problem, weak economic growth, a high overall debt profile, and a lack of political will to address the government's budget. As ofDecember 31, 2011 , our total direct exposure toItaly was$2.6 billion , at amortized cost. This exposure comprised$322 million of direct investment in the sovereign ofItaly ; a senior unsecured obligation of$193 million ; and several utility and industrial companies of$967 million and$1.1 billion , respectively. We expect the operating environment will be difficult in 2012 asItaly's government implements austerity measures to reduce deficits. Meaningful economic growth will be difficult due to the aforementioned austerity measures and a contraction of bank credit. Although there has been substantial improvement in the political environment and the fiscal outlook has improved recently,Italy's economic and ratings profile is expected to remain under pressure in the short-term. Corporates, especially utilities, domiciled inItaly will continue to carry sovereign rating risk, but we expect they will continue to meet obligations due to factors including high barriers to entry, necessity of product/service, good operating cash flow, leading market positions and well-diversified product and market mix.Italy's foreign currency long-term debt rating was downgraded by Moody's from Aa2 to A2 onOctober 4, 2011 and was further downgraded one notch by Moody's to A3 onFebruary 13, 2012 . S&P placedItaly's long-term debt rating of A on negative watch onDecember 5, 2011 and subsequently downgraded the rating to BBB+ onJanuary 13, 2012 .Italy's foreign currency long-term debt rating was downgraded by Fitch from AA- to A+ onOctober 7, 2011 .Italy's rating was again placed on negative watch by Fitch onDecember 16, 2011 , and was subsequently downgraded to A- onJanuary 27, 2012 .
As of
As ofDecember 31, 2010 and the end of first quarter 2011, the issuers of our Portuguese bank and financial investments, Banco BPI S.A.,Caixa Geral de Depositos S.A. , and Banco Espirito Santo S.A., were current on their obligations to us, were profitable and had adequate Tier I capital ratios. During the first quarter of 2011, these investments were downgraded to below-investment-grade. However, at that time we believed that these ratings and the unrealized loss position of the investments were the result of the fiscal problems in the Eurozone region rather than the banks' specific credit profiles. We believed thatPortugal's financial institutions were stronger than their other Eurozone peers and had not required much state support. It was challenging to separate the difficulties of the sovereign from the banks since the banks' sources of liquidity are limited due to the financial situation of the 65
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sovereign. We believed the government ofPortugal had exercised more prudent fiscal policies and was in a better financial situation than some of its other Eurozone peers. However, onMay 16, 2011 when theEuropean Union officially announced a fiscal support package forPortugal , there was an increase in risk thatPortugal could experience a stressed economic environment similar to that experienced inGreece andIreland . We believed the terms of this fiscal support package could result in liquidity constraints on the banks and there could be a need for the banks to improve their liquidity and core capital. Such a situation could negatively impact our Lower Tier II securities and our ability to recover full principal and interest. Due to the reasonably possible risk that our Portuguese bank holdings could suffer further negative declines, we no longer supported our previous intent to hold our Portuguese bank investments to recovery in value and concluded that we would take steps to reduce our exposure in the region. In the second quarter of 2011, we sold our investment in Banco BPI, S.A. at a loss of$99 million ($64 million after-tax), and we recognized other-than-temporary impairment losses of$112 million ($73 million after-tax) and$163 million ($106 million after-tax) on our investments inCaixa Geral de Depositos S.A. and Banco Espirito Santo S.A., respectively. In the third quarter of 2011, we sold our investments inCaixa Geral de Depositos S.A. and Banco Espirito Santo S.A., our remaining Portuguese bank investments, at gains of$52 million ($34 million after-tax) and$54 million ($35 million after-tax), respectively. As ofDecember 31, 2011 , our total direct exposure toPortugal was$308 million , at amortized cost. All of this exposure is to electric utility issuers domiciled inPortugal ,Redes Energeticas Nacionas SGPS, S.A. (REN) andEnergias de Portugal SA (EDP). Our exposure to REN and EDP was$129 million and$179 million , respectively, at amortized cost. REN, an electric transmission operator, is currently rated Ba1/BBB-. As ofDecember 31, 2011 , our investment in REN was classified as below investment grade, although S&P maintains an investment grade rating. As ofDecember 31, 2011 , REN has been current on its obligations to us and we believe it has the ability to meet its obligations to us. EDP, an integrated electric utility, is currently rated Ba1/BB+/BBB+. As ofDecember 31, 2011 , our investment in EDP was classified as investment grade and was current on all its obligations to us. InDecember 2011 , a Chinese utility company,China Three Gorges , announced the acquisition of a majority stake in EDP as part ofPortugal's sale of strategic asset holdings. EDP's debt rating from Moody's had been Baa3 sinceJuly 8, 2011 , however following Moody's downgrade ofPortugal to Ba3 onFebruary 13, 2012 , EDP's debt rating was downgraded to Ba1 onFebruary 16, 2012 . S&P placed EDP's foreign issuer credit rating on credit watch negative onDecember 8, 2011 and subsequently downgraded it from BBB to BB+ onFebruary 1, 2012 . Fitch downgraded EDP to BBB+ onApril 4, 2011 and affirmed the ratings onDecember 23, 2011 . Due to the downgrade by Moody's onFebruary 16, 2012 , we will classify our investment in EDP as below investment grade effectiveFebruary 2012 . Utilities domiciled inPortugal will continue to carry sovereign rating risk and could experience difficulty in accessing capital markets because of that risk. However, we expect they will continue to meet debt obligations as a result of factors including high barriers to entry, necessity of product/service, good operating cash flow, market leading positions and well-diversified markets.
During 2011, the Euro area sovereign crisis shifted to other periphery European sovereigns, includingSpain . The factors influencing the crisis inSpain include the EU leadership's inability to solve theGreece fiscal problem, high unemployment and other social burdens, the rapid decline of its real estate/construction sector, a high fiscal deficit and a difficulty at both the federal and regional level to address the government's fiscal budget. We expect the operating environment will be difficult in 2012 asSpain's government implements austerity measures to reduce deficits at both the federal and regional level. In addition, meaningful economic growth will be difficult due to the aforementioned austerity measures and a contraction of bank credit. Greater uncertainty over their fiscal profiles could make it difficult for most regional governments inSpain to obtain reasonable financing for existing and new debt facilities. Therefore,Spain's and its regional government's economic and ratings profile is expected to remain under pressure in the short-term.
As of
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obligations of$193 million ; several Lower Tier II obligations of$336 million ; andSpain -domiciled utilities and industrials of$926 million and$534 million , respectively. In the fourth quarter of 2011, one of our sub-sovereign investments inSpain , which had an amortized cost and fair value of$123 million and$135 million atDecember 31, 2010 , respectively, was downgraded to below investment grade due to a decline in creditworthiness of the issuer. Prior to the end of the fourth quarter of 2011, we exercised our option to put this investment to the issuer at par due to the below-investment grade rating. Corporates, especially utilities, domiciled inSpain will continue to carry sovereign rating risk, but we expect they will continue to meet obligations due to some or all of the following factors including high barriers to entry, necessity of product/service, good operating cash flow, market leading positions and well-diversified product and market mix.Spain's foreign currency long-term debt rating was downgraded by Moody's from Aa2 to A1 onOctober 18, 2011 and was further downgraded two notches by Moody's to A3 onFebruary 13, 2012 . S&P placedSpain's foreign currency long-term rating of AA- on negative watch onDecember 5, 2011 and subsequently downgraded the rating to A onJanuary 13, 2012 .Spain's foreign currency long-term debt rating of AA- was placed on negative watch onDecember 16, 2011 and was subsequently downgraded to A onJanuary 27, 2012 .
As of
Monitoring and mitigating exposure
During most of 2011, we saw the Euro area sovereign crisis persist and escalate. As a result, we saw contagion risk expand from periphery Eurozone sovereign credits to also include core Eurozone sovereign credits. Apart from our direct investments in sovereign debt, we view our European financial holdings as our largest indirect exposure due to the high correlation between financials and the sovereign from both a ratings and economics perspective. Our other significant source of indirect exposure is via our investment in fixed income securities issued by integrated electric utilities and industrials domiciled in periphery Eurozone sovereigns. As ofDecember 31, 2011 , we had investments of$10.1 billion in European financials,$4.3 billion in periphery Eurozone utilities and$7.4 billion in periphery Eurozone industrials, at amortized cost. Our large and diversified exposure requires a considerable allocation of resources. In order to maintain up-to-date knowledge of conditions, we use a number of tools and resources including news reports, rating agency commentary and reports, company reports, third party research, and academic and regulator commentary. In addition, we regularly conduct teleconference and on-site interviews with executives of companies in which we have invested inEurope , rating agency analysts and Euro area regulatory officials to assist us in the monitoring and evaluation of conditions in the Euro area. Due to the persistency of this crisis and the opportunity to obtain better financial data from theEuropean Banking Authority (EBA) stress tests performed during the year, we performed a more intense and comprehensive stress test on all our financial institutional holdings. Our stress test incorporated the development of several negative events, including the restructuring of European periphery sovereigns and an overall deterioration in various capital ratios. The results of the test assisted us in identifying those credits more likely to experience a serious credit event resulting from a large restructuring event and considering implementing risk mitigation strategies, including, but not limited to, redemption, impairment, sale, or use of credit derivatives. It should be noted that the majority of our holdings are structured as private placements and therefore, other than impairment, there can be no assurance that these risk mitigation strategies would be effective or could be easily executed. Additionally, in the second half of 2011, we performed a general stress test of our entire investment portfolio based on the recurrence of conditions similar to those experienced in 2008. These conditions incorporated several events, including default of one or more of the Euro area sovereign credits, strengthening of the yen, recession inJapan ,Europe andthe United States , and a general contraction in available credit. The test contemplated both direct and indirect exposures. The results assisted us in identifying those credits more likely to experience a serious credit event in the coming quarters and possibly implementing risk mitigation strategies, including, but not limited to, redemption, impairment, sale, or use of credit derivatives. It should be noted that the majority of our holdings are structured as private placements and therefore, other than impairment, there can be no assurance that these risk mitigation strategies would be effective or could be easily executed. 67
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In addition, several of our fixed income investments issued by periphery European sub-sovereigns and periphery Eurozone domiciled utilities contain covenants that enable us to seek an early redemption of our security. The covenants contained in these instruments vary from put options that vest should the issuer be downgraded to below investment grade by a rating agency, obligations to maintain leverage below a certain level, obligations to maintain interest coverage ratios above a certain level or a combination of the above. On an amortized cost basis, as ofDecember 31, 2011 , we had$1.4 billion in securities issued by periphery sub-sovereigns and corporates containing below-investment-grade put options, of which$405 million were issued by sub-sovereign entities and$952 million were issued by corporate and utility companies. As ofDecember 31, 2011 , we had$862 million in securities issued by periphery corporate and utility companies that contained a leverage covenant, an interest coverage covenant, or a combination of both. InFebruary 2012 , Moody's announced that it will be reviewing several European banks for possible downgrades. The review is expected to be completed within 90 days. While the results of the review are not known at this time, early indications are that as much as$4.8 billion of amortized cost of our holdings are subject to these possible ratings actions.
Derisking
During 2011, we pursued strategic investment activities to lower the risk profile of our investment portfolio. Our primary focus was reducing our exposure to peripheral Eurozone banks and financial institutions and sovereign investments and perpetual securities. Our derisking activities in these categories, consisting of sales, redemptions, and impairments, are summarized as follows: Investment Derisking Activities Year Ended December 31, 2011 Balance, Realized Investment Balance, Beginning of Period Gains (Losses) End of Period Par Amortized Sales and Par Amortized (In millions) Value Cost Redemptions Impairments Value Cost Peripheral Eurozone banks/financial institutions, by country: Ireland(1) $ 1,220 $ 710 $ (72 ) $ 0 $ 544 $ 544 Greece 1,154 1,152 (222 ) (397 ) 0 0 Portugal 859 859 7 (275 ) 0 0 Peripheral Eurozone sovereign investments, by country: Spain 730 730 0 0 637 637 Perpetual securities: Dexia SA (includes Dexia BankBelgium & Dexia Overseas) $ 552 $ 448 $ 0 $ (273 ) $ 579 $ 190Royal Bank of Scotland Group PLC 58 19 28 0 0 0Lloyds Banking Group PLC(2) 33 7 18 0 0 0 Swedbank 356 299 2 0 244 185 HSBC Holdings PLC 166 155 4 (21 ) 136 99 BAWAG Capital Finance Jersey 172 120 0 (50 ) 180 77Hypo Vorarlberg Capital Finance 135 108 0 (31 ) 141 83KBL European Private Bankers S.A. (Part of KBC Group NV) 245 137 48 (24 ) 0 0 Barclays Bank PLC 310 293 0 (50 ) 322 255 Deutsche Bank AG 261 261 0 (58 ) 273 216 Nordea Bank Finland (Part of Nordea Bank AB) 123 123 0 (19 ) 129 110 Pohjola Bank PLC 123 123 0 (40 ) 129 89Irish Life and Permanent PLC 454 112 (74 ) 0 0 0
(1)
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(2) Remainder of exposure to this issuer does not consist of perpetual
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Any increases in par value or amortized cost for the peripheral Eurozone or perpetual security investments were due to the strengthening of the yen against the U.S. dollar. As a result of our investment derisking activities, we have experienced significant reductions in peripheral Eurozone, perpetual, and financial exposures on an amortized cost basis. At the start of 2008, sovereign and financial investments in peripheral Eurozone countries comprised 5.9% of total investments and cash, declining to 2.2% by the end of 2011. At the start of 2008, investments in perpetual securities comprised 14.7% of total investments and cash, declining to 6.8% by the end of 2011. At the start of 2008, investments in financial securities comprised 41.9% of total investments and cash, declining to 26.2% by the end of 2011. As a result of these derisking activities, we have no direct sovereign or financial investment exposure toGreece orPortugal , and we have only senior indebtedness inIreland . As we pursue opportunistic investment transactions, we will continue to take actions to reduce our exposure to European debt. We also focused on reducing our exposure to large concentrated positions that exceeded 10% of total adjusted capital (TAC) on a statutory accounting basis. During 2011, we reduced our exposure toIsrael Electric by$125 million , theRepublic of Tunisia by$107 million , HSBC by$108 million , Commerzbank by$283 million , and Bank of America Corp. by$97 million , on an amortized cost basis, through sales and impairments, resulting in a pretax net loss of$240 million ($156 million after-tax). In addition, maturities of certain securities further reduced our exposure to theRepublic of Tunisia by$18 million and to Commerzbank by$125 million .
See the Investment Concentrations section of Note 3 of the Notes to the Consolidated Financial Statements for additional information on our investment derisking activities.
We have investments in both publicly and privately issued securities. The outstanding amount of a particular issuance, as well as the level of activity in a particular issuance and market conditions, including credit events and the interest rate environment, affect liquidity regardless of whether it is publicly or privately issued. The following table details investment securities by type of issuance as ofDecember 31 . Investment Securities by Type of Issuance 2011 2010 Amortized Fair Amortized Fair (In millions) Cost Value Cost Value
Publicly issued securities:
Fixed maturities $ 45,475 $ 48,163 $ 31,098 $ 32,457 Perpetual securities 195 178 235 256 Equity securities 13 15 13 14 Total publicly issued 45,683 48,356 31,346 32,727
Privately issued securities:
Fixed maturities 46,890 45,792 47,088 46,367 Perpetual securities 6,702 6,261 7,592 7,256 Equity securities 9 10 9 9 Total privately issued 53,601 52,063 54,689 53,632
Total investment securities
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The following table details our privately issued investment securities as of
Privately Issued Securities (Amortized cost, in millions) 2011
2010
Privately issued securities as a percentage of total debt and perpetual securities 54.0 %
63.6 %
Privately issued securities held by Aflac Japan $ 50,819 $ 51,70 2 Privately issued securities held by Aflac Japan as a percentage of total debt and perpetual securities 51.2 % 60.1 % Reverse-Dual Currency Securities (1) (Amortized cost, in millions) 2011
2010
Privately issued reverse-dual currency securities $ 12,655 $ 12,790 Publicly issued collateral structured as reverse-dual currency securities 2,958
2,844
Total reverse-dual currency securities$ 15,613
Reverse-dual currency securities as a percentage of total debt and perpetual securities 15.7 % 18.2 %
(1) Principal payments in yen and interest payments in dollars
The decrease in privately issued securities as a percentage of total debt and perpetual securities was due primarily to sales and impairments of investments and the allocation of new investments to JGBs during 2011. Aflac Japan has invested in privately issued securities to better match liability characteristics and secure higher yields than those available on Japanese government or other public corporate bonds. Aflac Japan's investments in yen-denominated privately issued securities consist primarily of non-Japanese issuers and have longer maturities, thereby allowing us to improve our asset/liability matching and our overall investment returns. Most of our privately issued securities are issued under medium-term note programs and have standard documentation commensurate with credit ratings of the issuer, except when internal credit analysis indicates that additional protective and/or event-risk covenants are required.
Below-investment-grade debt and perpetual securities represented 5.5% of total debt and perpetual securities atDecember 31, 2011 , compared with 6.2% of total debt and perpetual securities atDecember 31, 2010 , at amortized cost. Debt and perpetual securities classified as below investment grade atDecember 31, 2011 and 2010 were generally reported as available for sale and carried at fair value. 70
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The below-investment-grade securities atDecember 31 shown in the following table were investment grade at the time of purchase and were subsequently downgraded. Below-Investment-Grade Securities (1) December 31, 2011 December 31, 2010 Par Amortized Fair Unrealized Par Amortized Fair Unrealized (In millions) Value Cost Value Gain (Loss) Value Cost Value Gain (Loss) Israel Electric Corp. $ 888 $ 847 $ 805 $ (42 ) $ * $ * $ * $ * Republic of Tunisia(2) 823 823 877 54 * * * * Dexia SA (Includes Dexia BankBelgium & Dexia Overseas)(3) 579 190 190 0 368 264 186 (78 ) Investcorp Capital Limited 526 526 441 (85 ) 504 504 337 (167 ) Erste Group Bank (ErsteFinance Jersey Ltd. 3 & 5)(3) 450 424 253 (171 ) * * * *Lloyds Banking Group PLC(4) 408 360 312 (48 ) 440 364 387 23 UPM-Kymmene 399 399 235 (164 ) 380 380 290 (90 ) Ford Motor Credit Company 386 386 388 2 368 368 374 6 CSAV (Tollo Shipping Co. S.A.) 309 130 130 0 295 295 161 (134 ) Bank of Ireland 257 257 140 (117 ) * * * * Tokyo Electric Power Co., Inc. 232 235 211 (24 ) * * * * BAWAG Capital Finance Jersey(3) 180 77 77 0 172 120 116 (4 ) IKB Deutsche Industriebank AG 167 87 87 0 160 160 104 (56 )Hypo Vorarlberg Capital Finance(3) 141 83 86 3 135 108 97 (11 ) Redes Energeticas Nacionais SGPS,S.A. 129 129 105 (24 ) * * * * Finance For Danish Industry (FIH) 129 100 100 0 123 123 104 (19 )Irish Life and Permanent PLC(3) 0 0 0 0 454 112 112 0 EFG Eurobank Ergasias 0 0 0 0 417 416 131 (285 ) NBG (National Bank of Greece) 0 0 0 0 368 368 146 (222 ) Alpha Bank 0 0 0 0 368 368 115 (253 ) Swedbank(3) * * * * 356 299 314 15 Hella KG Hueck & Co. * * * * 270 269 224 (45 )KBL European Private Bankers S.A. (Part of KBC Group NV)(3) 0 0 0 0 245 137 144 7 Allied Irish Banks PLC 0 0 0 0 245 77 77 0 Aiful Corporation 0 0 0 0 184 67 67 0Royal Bank of Scotland Group PLC(3) 0 0 0 0 58 19 42 23 Commerzbank AG (formerlyDresdner Bank AG ) (Tier 1 only) 0 0 0 0 53 55 46 (9 ) Macy's Inc. * * * * 53 58 58 0 Various Other Issuers (below$50 million in par value)(5) 394 362 330 (32 ) 386 366 326 (40 ) Total $ 6,397 $ 5,415 $ 4,767 $ (648 ) $ 6,402 $ 5,297 $ 3,958 $ (1,339 )
* Investment grade at respective reporting date
(1) Does not include senior secured bank loans in an externally managed portfolio
that were below investment grade when initially purchased
(2) Deemed by the Company to be below investment grade
(3) Perpetual security
(4) Included perpetual securities at
(5) Includes 16 different issuers in 2011 and 19 different issuers in 2010
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InMay 2011 , we initiated a limited program to invest in senior secured bank loans to U.S. and Canadian corporate borrowers, most of which have below-investment-grade ratings. The program is managed externally by a third party firm specializing in this asset class. Its mandate requires a minimum average credit quality of BB-/Ba3, no loans rated below B/B2, and no exposure to any individual credit greater than 3% of the program's assets. The objectives of this program include enhancing the yield on invested assets, achieving further diversification of credit risk, and mitigating the risk of rising interest rates through the acquisition of floating rate assets. As ofDecember 31, 2011 , our investments in this program totaled$124 million at amortized cost. Occasionally, a debt or perpetual security will be split rated. This occurs when one rating agency rates the security as investment grade while another rating agency rates the same security as below investment grade. Our policy is to review each issue on a case-by-case basis to determine if a split-rated security should be classified as investment grade or below investment grade, and to assign a credit rating based on such internal analysis. Our review includes evaluating the issuer's credit position as well as current market pricing and other factors, such as the issuer's or security's inclusion on a credit rating downgrade watch list. Split-rated securities totaled$2.7 billion as ofDecember 31, 2011 and$2.4 billion as ofDecember 31, 2010 , and represented 3% of total debt and perpetual securities, at amortized cost, atDecember 31, 2011 and 2010. The 10 largest split-rated securities as ofDecember 31, 2011 , were as follows: Split-Rated Securities Amortized Investment-Grade (In millions) Cost Status Israel Electric Corp. $ 847 Below Investment Grade SLM Corp. 416 Investment-Grade Commerzbank AG 331 Investment-Grade Bank of Ireland 257 Below Investment Grade Swedbank(1) 139 Investment-Grade Redes Energeticas Nacionais SGPS, S.A. 129 Below Investment Grade Goldman Sachs Capital I 120 Investment-Grade Dexia Overseas SA(1) 63 Below Investment Grade Sparebanken Vest(1) 60 Investment-Grade Macy's Inc. 58 Investment-Grade (1) Perpetual security
Other-than-temporary Impairment
See Note 3 of the Notes to the Consolidated Financial Statements for a discussion of our impairment policy.
Unrealized Investment Gains and Losses
The following table provides details on amortized cost, fair value and unrealized gains and losses for our investments in debt and perpetual securities by investment-grade status as of
Total Total Percentage Gross Gross Amortized Fair of Total Fair Unrealized Unrealized (In millions) Cost Value Value Gains Losses Available-for-sale securities: Investment-grade securities $ 46,719 $ 49,126
48.9 % $ 3,603 $ 1,196 Below-investment-grade securities
5,534 4,885 4.9 72 721 Held-to-maturity securities: Investment-grade securities 47,009 46,383 46.2 992 1,618 Total $ 99,262 $ 100,394 100.0 % $ 4,667 $ 3,535 72
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The following table presents an aging of debt and perpetual securities in an unrealized loss position as of
Aging of Unrealized Losses Six Months to Less 12 Months Total Total Less than Six Months than 12 Months or Longer Amortized Unrealized Amortized Unrealized Amortized Unrealized Amortized Unrealized (In millions) Cost Loss Cost Loss Cost Loss Cost Loss Available-for-sale securities: Investment-grade securities $ 11,576 $ 1,196
$ 3,106 $ 125 $ 416 $ 49 $
8,054 $ 1,022 Below-investment-grade securities 3,225 721 802 95 282 25 2,141 601 Held-to-maturity securities: Investment-grade securities 18,034 1,618 4,388 117 1,634 111 12,012 1,390 Total $ 32,835 $ 3,535 $ 8,296 $ 337 $ 2,332 $ 185 $ 22,207 $ 3,013
The following table presents a distribution of unrealized losses on debt and perpetual securities by magnitude as of
Percentage Decline From Amortized Cost Total Total Less than 20% 20% to 50% Greater than 50% Amortized Unrealized Amortized Unrealized Amortized Unrealized Amortized Unrealized (In millions) Cost Loss Cost Loss Cost Loss Cost Loss Available-for-sale securities: Investment-grade securities $ 11,576 $ 1,196
0 $ 0 Below-investment-grade securities 3,225 721 2,081 249 1,144 472 0 0 Held-to-maturity securities: Investment-grade securities 18,034 1,618 15,532 955 2,502 663 0 0 Total $ 32,835 $ 3,535 $ 27,931 $ 2,074 $ 4,904 $ 1,461 $ 0 $ 0
The following table presents the 10 largest unrealized loss positions in our portfolio as of
Credit Amortized Fair Unrealized (In millions) Rating Cost Value Loss Erste Group Bank AG (Lower Tier II & Tier I(1) ) BB $ 540 $ 369 $ (171 ) UPM-Kymmene BB 399 235 (164 ) SLM Corp. BBB 416 253 (163 ) Bank of Ireland BB 257 140 (117 )Bank of Tokyo-Mitsubishi UFJ Ltd. (BTMU Curacao Holdings N.V.) A 579 466 (113 ) Bank of America Corp. (includes Merrill Lynch) A 579 481 (98 ) Investcorp Capital Limited BB 526 441 (85 ) Deutsche Postbank AG BBB 309 231 (78 ) UniCredit SpA (includes HVB and Bank Austria) BBB 601 524 (77 ) Nordea Bank AB(1) BBB 441 368 (73 ) (1) Perpetual security 73
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Declines in fair value noted above were impacted by changes in interest rates and credit spreads, yen/dollar exchange rates, and issuer credit status. However, we believe it would be inappropriate to recognize impairment charges because we believe the changes in fair value are temporary. See the Investment Concentrations and Unrealized Investment Gains and Losses sections in Note 3 of the Notes to the Consolidated Financial Statements for further discussions of unrealized losses related toIreland , financial institutions including perpetual securities, and other corporate investments.
Investment Valuation and Cash
We estimate the fair values of our securities available for sale on a monthly basis. We monitor the estimated fair values derived from our discounted cash flow pricing model and those obtained from our custodian, pricing vendors and brokers for consistency from month to month, while considering current market conditions. We also periodically discuss with our custodian and pricing brokers and vendors the pricing techniques they use to monitor the consistency of their approach and periodically assess the appropriateness of the valuation level assigned to the values obtained from them. Due to our reliance on third-party pricing services to provide valuations on 49% of our Level 2 portfolio, we regularly discuss and review pricing methodologies with the investment custodian. We also review the custodians' Service Organization Control (SOC 1) report for the period covering the current year to gain satisfaction with the controls and control environment of the custodian.
See Note 5 of the Notes to the Consolidated Financial Statements for the fair value hierarchy classification of our securities available for sale as of
Cash and cash equivalents totaled$2.2 billion , or 2.2% of total investments and cash, as ofDecember 31, 2011 , compared with$2.1 billion , or 2.4%, atDecember 31, 2010 . For a discussion of the factors affecting our cash balance, see the Operating Activities, Investing Activities and Financing Activities sections of this MD&A.
For additional information concerning our investments, see Notes 3, 4, and 5 of the Notes to the Consolidated Financial Statements.
Deferred Policy Acquisition Costs
The following table presents deferred policy acquisition costs by segment for the years endedDecember 31 . (In millions) 2011 2010 % Change Aflac Japan $ 7,733 $ 6,964 11.0 %(1) Aflac U.S. 2,921 2,770 5.5 Total $ 10,654 $ 9,734 9.5 %
(1) Aflac Japan's deferred policy acquisition costs increased 5.9% in yen during
the year ended
The increase in deferred policy acquisition costs was primarily driven by new annualized premium sales and the strengthening of the yen against the U.S. dollar. See Note 6 of the Notes to the Consolidated Financial Statements for additional information on our deferred policy acquisition costs, and see the New Accounting Pronouncements subsection of this MD&A for a discussion of changes to the accounting policy for DAC effectiveJanuary 1, 2012 . 74
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Policy Liabilities
The following table presents policy liabilities by segment for the years endingDecember 31 . (In millions) 2011 2010 % Change Aflac Japan $ 86,522 $ 74,872 15.6 %(1) Aflac U.S. 8,069 7,581 6.4 Other 2 3 (33.3 ) Total $ 94,593 $ 82,456 14.7 %
(1) Aflac Japan's policy liabilities increased 10.2% in yen during the year ended
The increase in policy liabilities was primarily the result of growth and aging of our in-force business and the strengthening of the yen against the U.S. dollar. See Note 7 of the Notes to the Consolidated Financial Statements for additional information on our policy liabilities.
Notes Payable
Notes payable totaled$3.3 billion atDecember 31, 2011 , compared with$3.0 billion atDecember 31, 2010 . InSeptember 2011 , the Parent Company redeemed35 billion yen (approximately$459 million using the exchange rate on the date of redemption) of Uridashi notes upon their maturity. InJuly 2011 , the Parent Company issued50 billion yen of yen-denominated Samurai notes (approximately$643 million using theDecember 31, 2011 , exchange rate). The ratio of debt to total capitalization (debt plus shareholders' equity, excluding the unrealized gains and losses on investment securities and derivatives) was 21.0% as ofDecember 31, 2011 , compared with 21.7% as ofDecember 31, 2010 .
In
Benefit Plans
Aflac Japan and Aflac U.S. have various benefit plans. For additional information on our Japanese and U.S. plans, see Note 13 of the Notes to the Consolidated Financial Statements.
The Japanese insurance industry has a policyholder protection system that provides funds for the policyholders of insolvent insurers. Legislation enacted regarding the framework of theLife Insurance Policyholder Protection Corporation (LIPPC) includes government fiscal measures supporting the LIPPC throughMarch 2012 . OnDecember 27, 2011 ,Japan's FSA announced plans to enhance the stability of the LIPPC by extending the government's fiscal support of the LIPPC throughMarch 2017 . Accordingly, the FSA submitted legislation to the Diet onJanuary 27, 2012 , to extend the government's fiscal support framework.
Hedging Activities
Net Investment Hedge
Our primary exposure to be hedged is our investment in Aflac Japan, which is affected by changes in the yen/dollar exchange rate. To mitigate this exposure, we have taken the following courses of action. First, Aflac Japan maintains a portfolio of dollar-denominated securities, which serve as an economic currency hedge of a portion of our investment in Aflac Japan. The foreign exchange gains and losses related to this portfolio are taxable inJapan and the U.S. when the securities mature or are sold. Until maturity or sale, deferred tax expense or benefit associated with the foreign exchange gains or losses are recognized in other comprehensive income. Second, we have designated the majority of the Parent Company's yen-denominated liabilities (Samurai and Uridashi notes and yen-denominated loans) as a hedge of our investment in Aflac Japan. At the beginning of each quarter, we make our net investment hedge designation. If the total of our designated yen-denominated liabilities is equal to or less than 75
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our net investment in Aflac Japan, the hedge is deemed to be effective and the related exchange effect on the liabilities is reported in the unrealized foreign currency component of other comprehensive income. Should these designated yen-denominated liabilities exceed our investment in Aflac Japan, the foreign exchange effect on the portion of the liabilities that exceeds our investment in Aflac Japan would be recognized in net earnings. We estimate that if our yen-denominated liabilities exceeded our investment in Aflac Japan by10 billion yen , we would report a foreign exchange gain/loss of approximately$1 million for every 1% yen weakening/strengthening in the end-of-period yen/dollar exchange rate. Our net investment hedge was effective during the years endedDecember 31, 2011 , 2010 and 2009. We recognized an immaterial amount in net earnings for the negative foreign exchange effect on the Parent Company yen-denominated liabilities that exceeded our yen net asset position inAflac Japan in certain quarters of 2011 and 2009. As mentioned in the Notes Payable section in this MD&A, the Parent Company issued$750 million of senior notes inFebruary 2012 . We have entered into cross-currency swaps to convert the dollar-denominated principal and interest on the senior notes into yen-denominated obligations and will designate this debt obligation as part of our net investment hedge. EffectiveJanuary 1, 2010 , the yen net asset figure calculated for hedging purposes differs from the yen-denominated net asset position as discussed in the Currency Risk subsection of MD&A. As disclosed in that subsection, the consolidation of the underlying assets in certain VIEs onJanuary 1, 2010 , required that we derecognize our yen-denominated investment in the VIE and recognize the underlying U.S. dollar-denominated fixed-maturity or perpetual securities and cross-currency swaps. While these U.S. dollar investments will create foreign currency fluctuations, the combination of the U.S. dollar-denominated investment and the cross-currency swap economically creates a yen-denominated investment that qualifies for inclusion as a component of our investment in Aflac Japan. The dollar values of our yen-denominated net assets, including certain VIEs as yen-denominated investments for net investment hedging purposes as discussed above, are summarized as follows (translated at end-of-period exchange rates) for the years endedDecember 31 : (In millions) 2011
2010
Aflac Japan yen-denominated net assets $ 3,657 $
3,282
Parent Company yen-denominated net liabilities (1,258 )
(1,041 )
Consolidated yen-denominated net assets (liabilities) subject to foreign currency translation fluctuations $ 2,399 $ 2,241 Cash Flow Hedges EffectiveJanuary 1, 2010 , as a result of the adoption of new accounting guidance and the corresponding consolidation of additional VIEs, we have freestanding derivative instruments that are reported in the consolidated balance sheet at fair value and are reported in other assets and other liabilities. During 2011, we de-designated certain of the derivatives used in cash flow hedging strategies as a result of determining that these swaps would no longer be highly effective in offsetting the cash flows of the hedged item. The$7 million after-tax gain recorded in accumulated other comprehensive income for these swaps is being amortized into earnings over the expected life of the respective hedged item. The amount amortized from accumulated other comprehensive income into earnings related to these swaps was immaterial during 2011. As ofDecember 31, 2011 , a couple of the freestanding foreign currency swaps that are used within VIEs to hedge the risk arising from changes in foreign currency exchange rates still qualified for hedge accounting. See Note 4 of the Notes to the Consolidated Financial Statements for additional information. We entered into interest rate swap agreements related to our5.5 billion yen variable interest rate Samurai notes that we issued inJuly 2011 , and we had interest rate swap agreements related to our20 billion yen variable interest rate Uridashi notes that matured inSeptember 2011 . By entering into these contracts, we swapped the variable interest rates to a fixed interest rate of 1.475% for the Samurai notes and 1.52% for the Uridashi notes. We designated these interest rate swaps as a hedge of the variability in our interest cash flows associated with the respective variable interest rate notes. These hedges were effective during the three-year period endedDecember 31, 2011 . See Note 4 of the Notes to the Consolidated Financial Statements for additional information. 76
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Off-Balance Sheet Arrangements
As of
CAPITAL RESOURCES AND LIQUIDITYAflac provides the primary sources of liquidity to the Parent Company through dividends and management fees. The following table presents the amounts provided for the years endedDecember 31 : Liquidity Provided by Aflac to Parent Company (In millions) 2011 2010 2009 Dividends declared or paid by Aflac $ 282 $ 370 $ 464 Management fees paid by Aflac 230 205 124 The primary uses of cash by the Parent Company are shareholder dividends, the repurchase of its common stock and interest on its outstanding indebtedness. The Parent Company's sources and uses of cash are reasonably predictable and are not expected to change materially in the future. For additional information, see the Financing Activities subsection of this MD&A. The Parent Company also accesses debt security markets to provide additional sources of capital. InMay 2009 , we filed a shelf registration statement with theSEC that allows us to issue an indefinite amount of senior and subordinated debt, in one or more series, from time to time throughMay 2012 . As ofDecember 31, 2011 , we had issued$2.0 billion of senior notes under this registration statement, and inFebruary 2012 , we issued an additional$750 million of senior notes. InNovember 2009 , we filed a shelf registration statement with Japanese regulatory authorities that allowed us to issue up to100 billion yen of yen-denominated Samurai notes inJapan throughNovember 2011 . InJuly 2011 , the Parent Company issued50 billion yen of yen-denominated Samurai notes under this registration statement. InDecember 2011 , we filed a shelf registration statement with Japanese regulatory authorities that allows us to issue up to100 billion yen of yen-denominated Samurai notes inJapan throughJanuary 2014 . If issued, these yen-denominated Samurai notes would not be available to U.S. persons. We believe outside sources for additional debt and equity capital, if needed, will continue to be available. For additional information, see Note 8 of the Notes to the Consolidated Financial Statements.
The principal sources of cash for our insurance operations are premiums and investment income. The primary uses of cash by our insurance operations are investments, policy claims, commissions, operating expenses, income taxes and payments to the Parent Company for management fees and dividends. Both the sources and uses of cash are reasonably predictable.
When making an investment decision, our first consideration is based on product needs. Our investment objectives provide for liquidity through the purchase of investment-grade debt securities. These objectives also take into account duration matching, and because of the long-term nature of our business, we have adequate time to react to changing cash flow needs. As a result of policyholder aging, claims payments are expected to gradually increase over the life of a policy. Therefore, future policy benefit reserves are accumulated in the early years of a policy and are designed to help fund future claims payments. We expect our future cash flows from premiums and our investment portfolio to be sufficient to meet our cash needs for benefits and expenses. Our financial statements adequately convey our financing arrangements during the periods presented. We have not engaged in material intra-period short-term financings during the periods presented that are not otherwise reported in our balance sheet. We do not have any restrictive financial covenants related to our notes payable, and we were in compliance with all of the covenants of our notes payable atDecember 31, 2011 . We have not entered into transactions involving the transfer of financial assets with an obligation to repurchase financial assets that have 77
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been accounted for as a sale under applicable accounting standards, including securities lending transactions. See Notes 1 and 3 of the Notes to the Consolidated Financial Statements for more information on our securities lending activity. We do not have a known trend, demand, commitment, event or uncertainty that would reasonably result in our liquidity increasing or decreasing by a material amount. Our cash and cash equivalents include unrestricted cash on hand, money market instruments, and other debt instruments with a maturity of 90 days or less when purchased, all of which has minimal market, settlement or other risk exposure.
The following table presents the estimated payments by period of our major contractual obligations as of
Distribution of Payments by Period Less Total Total Than One to Four to After (In millions) Liability(1) Payments One Year Three Years Five Years Five Years Future policy benefits liability (Note 7) $ 79,278 $ 342,337 $ 11,022 $ 21,728 $ 21,223 $ 288,364 Unpaid policy claims liability (Note 7) 3,981 3,969 2,983 605 224 157 Long-term debt -principal (Note 8) 3,275 3,281 342 440 799 1,700 Long-term debt -interest (Note 8) 33 2,245 161 313 278 1,493 Policyholder protection corporation (Note 2) 71 71 45 26 0 0 Operating service agreements (Note 14) N/A (2) 631 160 418 53 0 Operating lease obligations (Note 14) N/A (2) 168 62 62 29 15 Capitalized lease obligations (Note 8) 10 10 3 5 1 1
Total contractual obligations $ 86,648
Liabilities for unrecognized tax benefits in the amount of
(1) Liability amounts are those reported on the consolidated balance sheet as of
December 31, 2011 . (2) Not applicable The distribution of payments for future policy benefits is an estimate of all future benefit payments for policies in force as ofDecember 31, 2011 . These projected values contain assumptions for future policy persistency, mortality and morbidity. The distribution of payments for unpaid policy claims includes assumptions as to the timing of policyholders reporting claims for prior periods and the amount of those claims. Actual amounts and timing of both future policy benefits and unpaid policy claims payments may differ significantly from the estimates above. We anticipate that the future policy benefit liability of$79.3 billion atDecember 31, 2011 , along with future net premiums and investment income, will be sufficient to fund future policy benefit payments. The distribution of payments due in less than one year for long-term debt consists of26.6 billion yen for our Samurai notes (approximately$342 million using theDecember 31, 2011 , exchange rate) that are due inJune 2012 . We issued$750 million of senior notes inFebruary 2012 and plan to use the proceeds to redeem these Samurai notes upon their maturity. For more information on our major contractual obligations, see the applicable Note in the Notes to the Consolidated Financial Statements as indicated in the line items in the table above.
Consolidated Cash Flows
We translate cash flows for Aflac Japan's yen-denominated items into U.S. dollars using weighted-average exchange rates. In years when the yen weakens, translating yen into dollars causes fewer dollars to be reported. When the yen strengthens, translating yen into dollars causes more dollars to be reported. 78
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The following table summarizes consolidated cash flows by activity for the years endedDecember 31 . (In millions) 2011 2010 2009 Operating activities $ 10,842 $ 6,989 $ 6,161 Investing activities (10,829 ) (7,432 ) (5,476 ) Financing activities 64 161 699 Exchange effect on cash and cash equivalents 51 80 (2 ) Net change in cash and cash equivalents $ 128 $ (202 ) $ 1,382 Operating Activities Consolidated cash flow from operations increased 55% in 2011, compared with 2010. The following table summarizes operating cash flows by source for the years endedDecember 31 . (In millions) 2011 2010 2009 Aflac Japan $ 10,246 $ 6,327 $ 5,177 Aflac U.S. and other operations 596 662 984 Total $ 10,842 $ 6,989 $ 6,161 The increase in Aflac Japan operating cash flows during 2011 was largely due to the receipt of discounted advance premiums from policyholders in conjunction with their purchase of certain Aflac Japan insurance products and due to the strengthening of the yen against the U.S. dollar. Aflac U.S. operating cash flows have been reduced by the payout of lump-sum return-of-premium benefits to policyholders on a closed block of U.S. cancer insurance business. These benefit payouts began in 2008 and will significantly decline in 2012 and beyond. We paid out$72 million in 2011,$104 million in 2010, and$152 million in 2009, and we anticipate paying out an additional$25 million over the next year.
Investing Activities
Operating cash flow is primarily used to purchase debt securities to meet future policy obligations. The following table summarizes investing cash flows by source for the years ended
(In millions) 2011 2010 2009 Aflac Japan $ (10,246 ) $ (6,221 ) $ (5,156 ) Aflac U.S. and other operations (583 ) (1,211 ) (320 ) Total $ (10,829 ) $ (7,432 ) $ (5,476 ) Prudent portfolio management dictates that we attempt to match the duration of our assets with the duration of our liabilities. Currently, when our debt and perpetual securities mature, the proceeds may be reinvested at a yield below that required for the accretion of policy benefit liabilities on policies issued in earlier years. However, the long-term nature of our business and our strong cash flows provide us with the ability to minimize the effect of mismatched durations and/or yields identified by various asset adequacy analyses. When market opportunities arise, we dispose of selected debt and perpetual securities that are available for sale to improve the duration matching of our assets and liabilities, improve future investment yields, and/or rebalance our portfolio. As a result, dispositions before maturity can vary significantly from year to year. Dispositions before maturity were approximately 27% of the annual average investment portfolio of debt and perpetual securities available for sale during the year endedDecember 31, 2011 , compared with 7% in 2010 and 12% in 2009. The relatively higher dispositions before maturity in 2011 were due to a bond-swap program that generated investment gains and were also the result of an asset liability management strategy. 79
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Financing Activities
Consolidated cash provided by financing activities was$64 million in 2011,$161 million in 2010, and$699 million in 2009. Cash returned to shareholders through dividends and treasury stock purchases was$860 million in 2011 and$656 million in 2010, compared with$524 million of dividends in 2009. InSeptember 2011 , we redeemed35 billion yen of our Uridashi notes upon their maturity. InJuly 2011 , the Parent Company issued50 billion yen of yen-denominated Samurai notes (approximately$643 million using theDecember 31, 2011 , exchange rate). See Note 8 of the Notes to the Consolidated Financial Statements for further information on this debt issuance. InAugust 2010 , the Parent Company issued$450 million and$300 million in senior notes that are due inAugust 2040 andAugust 2015 , respectively. InJuly 2010 , we paid$447 million to redeem39.4 billion yen of our Samurai notes upon their maturity. InDecember 2009 , the Parent Company issued$400 million in senior notes that are due inDecember 2039 , and inMay 2009 , issued$850 million in senior notes that are due inMay 2019 . InApril 2009 , we redeemed our$450 million senior notes and settled the related cross-currency, interest rate swaps that were used to convert the original dollar-denominated debt obligation into yen. InAugust 2009 , the Parent Company executed a5 billion yen loan that is due inAugust 2015 . InJuly 2009 , the Parent Company executed a10 billion yen loan that is due inJuly 2015 . During 2009, we extinguished portions of our yen-denominated Uridashi and Samurai debt by buying the notes on the open market. We paid4.4 billion yen to extinguish6.0 billion yen of debt, yielding a realized gain from extinguishment of debt of1.6 billion yen , or$17 million ($11 million after-tax), which we included in other income. InFebruary 2012 , the Parent Company issued$400 million and$350 million of senior notes that are due inFebruary 2017 andFebruary 2022 , respectively. We plan to use proceeds from this debt offering to redeem26.6 billion yen (approximately$342 million using theDecember 31, 2011 , exchange rate) of Samurai notes when they mature inJune 2012 . We have no restrictive financial covenants related to our notes payable. We were in compliance with all of the covenants of our notes payable atDecember 31, 2011 .
The following tables present a summary of treasury stock activity during the years ended
Treasury Stock Purchased (In millions of dollars and thousands of shares) 2011 2010 2009 Treasury stock purchases $ 308 $ 121 $ 10 Number of shares purchased: Open market 6,000 2,000 0 Other 182 192 264 Total shares purchased 6,182 2,192 264 Treasury Stock Issued (In millions of dollars and thousands of shares) 2011 2010 2009 Stock issued from treasury: Cash financing $ 26 $ 45 $ 17 Noncash financing 57 2 11 Total stock issued from treasury $ 83 $ 47 $ 28 Number of shares issued 1,852 1,834 1,043 80
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Beginning inFebruary 2009 when the market value of our stock fell below our weighted-average cost of treasury shares, we discontinued issuing shares from treasury and all shares purchased with dividends, as well as those shares used for internal stock award plans, were all purchased on the open market. Beginning again in 2011, these types of stock issuances, considered non-cash, were once again issued using treasury shares. Under share repurchase authorizations from our board of directors, we purchased 6.0 million shares of our common stock in the open market in 2011, compared with 2.0 million shares in 2010. During 2009, we did not purchase any shares of our common stock under our share repurchase program. See Note 10 of the Notes to the Consolidated Financial Statements for additional information. As ofDecember 31, 2011 , a remaining balance of 24.4 million shares of our common stock was available for purchase under a share repurchase authorization by our board of directors in 2008. Cash dividends paid to shareholders in 2011 of$1.23 per share increased 7.9% over 2010. The 2010 dividend paid of$1.14 per share increased 1.8% over 2009. The following table presents the dividend activity for the years endedDecember 31 . (In millions) 2011 2010 2009 Dividends paid in cash $ 552 $ 535 $ 524
Dividends declared but not paid 0 0
(131 )
Dividends through issuance of treasury shares 23 0
0
Total dividends to shareholders $ 575 $ 535
In
Regulatory Restrictions
Aflac is domiciled inNebraska and is subject to its regulations. TheNebraska insurance department imposes certain limitations and restrictions on payments of dividends, management fees, loans and advances byAflac to the Parent Company. TheNebraska insurance statutes require prior approval for dividend distributions that exceed the greater of the net income from operations, which excludes net realized investment gains, for the previous year determined under statutory accounting principles, or 10% of statutory capital and surplus as of the previous year-end. In addition, theNebraska insurance department must approve service arrangements and other transactions within the affiliated group of companies. These regulatory limitations are not expected to affect the level of management fees or dividends paid byAflac to the Parent Company. A life insurance company's statutory capital and surplus is determined according to rules prescribed by the NAIC, as modified by the insurance department in the insurance company's state of domicile. Statutory accounting rules are different from GAAP and are intended to emphasize policyholder protection and company solvency. The continued long-term growth of our business may require increases in the statutory capital and surplus of our insurance operations.Aflac's insurance operations may secure additional statutory capital through various sources, such as internally generated statutory earnings or equity contributions by the Parent Company from funds generated through debt or equity offerings. The NAIC's risk-based capital (RBC) formula is used by insurance regulators to help identify inadequately capitalized insurance companies. The RBC formula quantifies insurance risk, business risk, asset risk and interest rate risk by weighing the types and mixtures of risks inherent in the insurer's operations.Aflac's company action level RBC ratio was 493% as ofDecember 31, 2011 .Aflac's RBC ratio remains high and reflects a strong capital and surplus position. As ofDecember 31, 2011 ,Aflac's total adjusted capital exceeded the amounts to achieve a company action level RBC of 400% and 350% by$1.2 billion and$1.9 billion , respectively. See Note 12 of the Notes to the Consolidated Financial Statements for information regarding the impact of permitted practices by theNebraska Department of Insurance on our statutory capital and surplus. Currently, the NAIC has an ongoing Solvency Modernization Initiative (SMI) relating to updating the U.S. insurance solvency regulation framework. The SMI will focus on key issues such as capital requirements, governance and risk management, actuarial, and accounting matters. In addition to limitations and restrictions imposed by U.S. insurance regulators,Japan's FSA may not allow profit repatriations from Aflac Japan if the transfers would cause Aflac Japan to lack sufficient financial strength for the protection of policyholders. The FSA maintains its own solvency standard. See the Japanese Regulatory 81
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Environment subsection of this MD&A for a discussion of changes to the calculation of the solvency margin ratio. As ofDecember 31, 2011 , Aflac Japan's solvency margin ratio was 985.8% using the current calculation method, which significantly exceeded regulatory minimums, and was 547.3% under the new standards, disclosed as reference information. As expected, based on the results of the calculation of the solvency margin ratio under the new standards, our relative position within the industry has not materially changed. Given the sensitivity of the solvency margin ratio and the low interest rate environment, we increased our allocation of JGBs classified as held to maturity during the third and fourth quarters of 2011. We continue to evaluate other alternatives for reducing the sensitivity of the solvency margin ratio against interest rate changes. Payments are made from Aflac Japan to the Parent Company for management fees and to Aflac U.S. for allocated expenses and remittances of earnings. The following table details Aflac Japan remittances for the years endedDecember 31 . Aflac Japan Remittances (In millions of dollars and billions of yen) 2011
2010 2009
Aflac Japan management fees paid to Parent Company
Expenses allocated to Aflac Japan 43
37 37
Aflac Japan profit remittances to Aflac U.S. in dollars 143 317 230
Aflac Japan profit remittances to Aflac U.S. in yen 11.0 28.7 20.0
The total amount of profit remittances in 2011 was lower than that in 2010 due to realized investment losses.
For additional information on regulatory restrictions on dividends, profit repatriations and other transfers, see Note 12 of the Notes to the Consolidated Financial Statements.
Other
For information regarding commitments and contingent liabilities, see Note 14 of the Notes to the Consolidated Financial Statements.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information required by Item 7A is incorporated by reference from the Market Risks of Financial Instruments section of MD&A in Part II, Item 7, of this report.
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