Aflac Inc (AFL) — Q2 2018 Earnings Call Transcript

Good morning, and welcome to our second quarter call. This morning we will be hearing remarks from Dan Amos, Chairman and CEO of Aflac, Incorporated, about the quarter as well as our operations in Japan and the United States; then Fred Crawford, Executive Vice-President and CFO of Aflac, Incorporated, will follow with more details about our financial results, outlook and capital management. We will then open our call to questions. Joining us this morning for Q&A are members of our executive management team in the U.S.; Teresa White, President of Aflac U.S.; Eric Kirsch, Global Chief Investment Officer; Rich Williams, Chief Distribution Officer; Al Riggieri, Global Chief Risk Officer and Chief Actuary; Max Broden, Treasurer. We are also joined by members of our executive management team in Tokyo at Aflac Life Insurance. Charles Lake, President of Aflac International and Chairman Representative Director; Masatoshi Koide, President and Representative Director; Todd Daniels, Principal Financial Officer; and Koji Ariyoshi, Director and Head of Sales and Marketing. Before we start, let me remind you that some statements in this teleconference are forward-looking within the meaning of federal securities laws. Although we believe these statements are reasonable, we can give no assurance that they will prove to be accurate because they are prospective in nature. Actual results could differ materially from those we discuss today. We encourage you to look at our annual report on Form 10-K for some of the various risk factors that could materially impact our results. The earnings release is available on the Investors page of aflac.com and also includes reconciliations of certain non-GAAP measures. I'll now turn the call over to Dan.

Thank you, Dave, and good morning everyone, and thank you for joining us today. Let me begin by saying that the second quarter 2018 established a strong first half of the year for Aflac. I am pleased that we were able to revise our 2018 adjusted earnings per share outlook. Aflac Japan, our largest contributor, generated strong financial results. Fred will provide more details, but let me just say that in yen terms, Aflac Japan's pretax profit margin was ahead of expectations both through the quarter and through the first six months. Aflac Japan's outstanding third sector sales increase of 16% was well above our expectations. This strong result was largely due to April's introduction of our new cancer insurance products. There were a few factors that drove sales beyond our expectations for the quarter. First, the new cancer insurance policy offered enhanced benefit features while carefully managing the risk profile of the product as we've done in the past. In addition, we launched a targeted promotional campaign for this new cancer product that incorporated television ads with the largest direct mail campaign we've ever done. And finally, we fully engaged our extensive distribution network. Over the last few years following our agreement with Japan Post, we phased in our cancer insurance sales to postal outlets positioned for sales at the time. This new cancer product launch marked the first introduction where we've had access to all 20,000 plus Japan Post outlets at the same time. The results there were bigger than we had anticipated. In fact, this quarter reflected the highest production ever in Japan Post in terms of a fee. Our traditional agencies also had solid performance in cancer sales and continue to be vital to our success. Our extensive distribution network furthers our goal to be where people want to buy insurance. All of these factors reflected strong cancer sales growth for both the independent corporate agencies and affiliated corporate agencies during the quarter. The quarter's results are laying the foundation for another strong year of third sector sales. We believe some of this reflects an acceleration of sales that we originally anticipated for the second half of the year recognizing the strong launch of the cancer product. We have revised our projections and are now calling for a growth rate in the low single digits for 2018 third sector sales. Remember, we're coming off a comparison to an outstanding 2017 for third sector medical sales due to last year's introduction of the new EVER medical product. You will hear more about this from Ariyoshi at our financial analyst briefing in September. Our focus remains on maintaining our leadership position in the sale of third sector products that are less interest rate-sensitive, with strong and stable margins. We will continue to refine our existing product portfolio and introduce innovative new third sector products to maintain our market leadership. Turning to Aflac U.S., we are pleased with our financial performance. The pretax profit margins exceeded our expectations both for the quarter and for the first half of the year. I'm also pleased with our sales results for the quarter which advanced our progress in achieving our anticipated full-year sales growth of 3% to 5%. You'll hear more about this from Teresa and Richard at the financial analyst briefing in September, but we continue to expect our growth in broker sales. Our team of broker sales professionals has made great strides in successfully strengthening Aflac's relationships within the large broker community. Our partnering initiatives for True Group products are still early in development, but are already starting to take shape. As a result, Aflac is experiencing a high rate of growth through brokers and strong sales growth in our group products. Keep in mind, Aflac is different from our peers, and a majority of our sales come from our independent sales agents. We are fortunate to have such a strong independent field force which is truly unique within our industry. These career sales agents are in the best position within the industry to reach and therefore succeed with smaller employers and groups with fewer than 100 employees. Aflac independent career agents have been the driving force behind Aflac's ability to dominate the smaller case market. Recruiting remains a challenge in a strong employment marketplace. However, productivity continues to improve as our veteran agents further penetrate existing accounts and our investment in agent development gains traction. Equally important is the coordination between our powerful field force of sales agents and our growing network of broker sales professionals. It is very encouraging that our brokers look for solutions for their clients. They have found that Aflac's portfolio of products helps fill those needs. Brokers are looking for a strong brand like Aflac as they also leverage our outstanding track record of experienced and extensive fulfillment capacities. Our independent agents are experts who have demonstrated their ability to accelerate growth by working with brokers and broker sales professionals. We characterize this collaboration as broker-influenced business. As we look to the remainder of 2018, we will continue to expect sales to ramp up towards the fourth quarter as broker and broker-influenced sales are a growing part of our business. Turning to capital deployment, Fred will provide more detail shortly. We remain committed to maintaining strong capital ratios on behalf of our bondholders, shareholders, and policyholders. At the same time, we are balancing our financial strength with increasing dividends, repurchasing shares, and reinvesting in our business. We continue to anticipate that we’ll repurchase in the range of $1.1 billion to $1.4 billion of our shares in 2018. As always is the case, this assumes stable capital conditions and the absence of compelling alternatives. Looking ahead, we believe our strong earnings growth will reflect the underlying earnings power of our insurance operations in Japan and the United States. It will also reflect our prudent approach to deploying excess capital in a way that balances the interests of all stakeholders. At the same time, we will also reflect our dedication to delivering on the promises we make to our policyholders. I’ll conclude by saying that this has been one of the best quarters in the company's history, and I'm very proud of it. I’ll continue to be excited about Aflac's future growth. And now I’ll turn the program over to Fred who will cover the financial results.

Thank you, Dan. Building on a strong start to the year, our earnings results for the second quarter exceeded our expectations. While it is early in the year, the strength of our performance year-to-date and stability in our margins gives us confidence that we will exceed our original guidance range for the year. We have therefore updated our currency-neutral adjusted earnings guidance to a range of $3.90 to $4.06 per diluted share. Key variables as we move through the year include continued strength in investment income, sustainability of benefit ratios in underlying claims trends, and the pace of expense build as we continue to invest in future growth and efficiencies. For the quarter, adjusted earnings of $1.07 were driven by strong pretax margins both in Japan and the U.S. Our reported results benefited modestly from a strengthening of the yen as compared to the 2017 period, contributing $0.01 per share to the quarter's results. Virtually all key earnings drivers performed at or above our expectations. Japan branch conversion costs in the quarter were $40 million. We project less than $10 million in remaining costs spread over the third and fourth quarters. We have effectively wrapped up the conversion with a total project cost of approximately $120 million, consistent with the low end of our forecasted range. Turning to our Japan segment results, we reported a pretax profit margin of 21.8%. Our total benefit ratio came in below our guidance range of 70% to 72%, driven by a continued shift in business mix from the first sector towards the third sector, positive claims trends in our cancer business, and associated reserve adjustments. Our expense ratio in Japan reverted back to the midpoint of our outlook range of 19% to 21%. The sequential increase was expected given promotional spending with the launch of our refreshed cancer product and continued investment in IT modernization. We would expect to run towards the high end of our outlook range throughout the rest of the year. Before moving on to the U.S. segment, as is common when introducing a new or refreshed third sector product in Japan, we typically experience elevated lapse and reissue activity as policyholders choose to upgrade their existing policies for the enhanced benefits. In the short run, and depending on the mix of policies, this can apply downward pressure on our benefit ratio as we release reserves on lapsed policies and experience elevated DAC amortization on those policies. While it is too early in the launch of our cancer product to have specific estimates on the impact, we believe this contributed to Japan's favorable benefit ratio, increased DAC amortization, and provided a very modest net benefit or earnings in the quarter. We expect this impact will lessen throughout the year. Turning to U.S. results, our overall pretax profit margin in the quarter was 21.1%. Our total benefit ratio moved back to the midpoint of our guidance range of 51% to 53%. We have historically seen a lower first-quarter benefit ratio followed by a modest increase in the second quarter, and that experience continues. Our expense ratio in the U.S. came in below our expectations and is largely timing-related. We expect accelerated spending in the second half of the year, which includes previously announced post-tax reform investments. As mentioned in the first quarter, these accelerated investments will amount to approximately $0.03 per share in the second half of the year. Overall, we continue to see the year coming in around the midpoint of our guidance range of 34% to 36%, with the second half running at the high end of the range. Investment income performance both in Japan and the U.S. continues to deliver very strong results. The year-to-date outperformance has been driven primarily by the accelerated growth of our floating-rate portfolio, further benefiting from higher LIBOR rates relative to our expectations coming into the year. As we have previously commented, we elected to lock in the majority of our hedge costs for 2018, which mitigated the potential impact from higher U.S. interest rates. As hedge instruments roll off, we would expect to lose some of this relative outperformance heading into 2019. As I discussed in the first quarter call, we continue to make progress on managing our economic exposure to the yen while lowering enterprise-wide costs associated with Japan's U.S. dollar investment hedging. We accomplish this by entering into an offsetting hedge position at the holding company, with the financial impact recognized in our corporate and other segments. We have built this offsetting position to approximately $1.25 billion in the quarter, contributing $7 million on a pretax basis to the quarter’s earnings. Our strategy balances securing Aflac's strong capital position in Japan while lowering our enterprise exposure to a weakening yen. We will spend more time discussing this risk reduction strategy at our September financial analyst briefing in Japan. We ended the quarter in a strong capital position. Japan's solvency margin ratio is estimated in the 950% range, this is a particularly strong result recognizing our April 2nd conversion from a branch to a subsidiary reduced SMR by approximately 130 points. As we have stated previously, we have plans in place to restore the SMR accounting impact over a three-year period. Our estimated U.S. only risk-based capital ratio at quarter end stands at roughly 850%, and includes an estimate of the full adoption of U.S. tax reform. It is our understanding the NAIC intends to adopt the full effect of tax reform in 2018. With the impact of tax reform and dividend projections that include a drawdown of $500 million in excess capital in the second half of the year, we are projecting an RBC in the mid-600% range for year-end 2018. We ended the quarter with just over $2 billion of capital and liquidity in the holding company. We set aside $1 billion of contingent capital, and $500 million for liquidity in support of holding company derivative positions. Despite recent increases in volatility, overall credit conditions and asset quality remain strong with very little in the way of impairments in the quarter. Including dividends and share repurchases, we returned approximately $500 million to our shareholders in the quarter. We repurchased 6.8 million shares of our stock for $306 million in the quarter and remain tactical in our approach. We are maintaining our current outlook range for repurchase of $1.1 to $1.4 billion in 2018. As we move into the third quarter, we plan to make a $50 million contribution to our pension fund. This contribution is larger than normal and takes advantage of a 35% corporate tax deduction if funded prior to September 15. The contribution has no implications for our capital plans and represents a sound use of excess capital. With the conversion behind us, we are hard at work to optimize our capital and liquidity profile. We will further develop these strategies at our September financial analyst briefing. I'll now hand the call back to David to begin our Q&A session.

Thank you, Fred. Now we are ready to take your questions, but first let me ask that you please limit yourself to one initial question and one related follow-up to that question to allow other participants an opportunity to ask a question. We will now take the first question.

Fred, could you help us size the potential impact of the roll-off of the hedges that you locked in this year as we go into next and they reset?

It certainly helped to mitigate, if you will, some of the rising rates. As you recall, we locked in approximately 80% of our hedge costs as we were entering into 2018, and we estimate for the full year on a pretax basis that benefits us by approximately $9 million for 2018. So that's the approximate benefit. So it's relatively modest, but again we would note that as we roll into 2019, we'll start having a reset of our hedge costs and, obviously, hedge costs have risen throughout the year. Again, that's offset by LIBOR benefiting us as we build down the floating rate portfolio.

And then just one other one, you mentioned prudent investment in the business I think in regard to your buyback comment for the year. As presumably the ongoing business investments don't really have much impact on your capital position. Are you referring to things like investments in some of the insurtech companies and things along that nature?

No, not really referring to that, although we have set aside some opportunistic money, if you will, to reinvest in those efforts, and those efforts are going well, but they represent a relatively modest allocation of our excess capital when looking at any given year over a three-year period of time. Really, the more important aspect of reinvestment back into the business platform both in the U.S. and Japan is that we are calling for some elevated expense ratios as we move through the remainder of the year. We have been running at relatively low expense ratios in the early part of the year both in Japan and the U.S. As you saw in the second quarter, Japan reverted back to more of what we would expect in that 20% range as an expense ratio, but the U.S. was quite low and that's largely timing-related because we naturally backloaded, for example, some of our tax reform investments as we formulate the plan and remain very prudent in how we allocate that money. So, some of that reinvestment is really related to expense ratio guidance and not so much a tax on our capital position or excess capital deployment.

Fred, just a question on the U.S. risk-based capital ratio. I think you had mentioned that it's around 850%, and you expect it to drop down to about 650% at year-end. I think there's two drivers there; one is the $500 million dividend that you're expecting to take out, the other is the tax impacts. Can you sort of give us a sense of the relative contributions to that 200-point decline from each?

Yes, absolutely. So, remember, the first half of tax reform was already adopted in the number—that was the DTA that was adopted early. So, the tax reform impact for 2018 is really in the denominator, if you will. And that has an impact of right around 75 points of RBC. In other words, if you were to look at our RBC before that implementation of tax reform, we would be running at or posting 925% RBC. So, that tax reform implication had knocked it down to 850%. Now, what brings it down to 650% is that we've largely backloaded our U.S. statutory dividend, and the removal of that excess capital all takes place in the second half of the year. In fact, the removal of excess capital together with normal dividend earnings that are produced in the U.S. entity, we are calling for upwards of just a touch over $1 billion of dividend activity up to the holding company in the second half of the year. So, it's quite a bit backloaded. And a lot of that had to do with making our way through the conversion and settling into our post-conversion RBC estimates.

So that $1 billion of dividend is really the 200 points?

You got it. And it's a combination of statutory earnings in normal, what I would call, ordinary dividend capacity, and then the $500 million excess capital.

And then just to circle back on persistency in Japan. I know it's nitpicky but that's ticked down a bit maybe 1 to 1.5 percentage points over the last several quarters. Is that really related to what you discussed earlier, which is the shift in lapsed patients of old policies and for the new ones?

That's right. And particularly with cancer, because you're talking about having gone four years since the upgrade. And so, with advancements in cancer treatment and diagnosis, and then together with other beneficial features that Dan noted in his comments, you have much more in the way of an attractive upgrade opportunity for our policyholders. Recognizing that we age down things in cancer and so it tends to be some of the more recent policies that are most susceptible to this. And in that case, what ends up happening is, yes, you'll have elevated lapse activity, i.e., lower persistency. You'll have sales obviously benefiting from that activity. But then when you get to our P&L, you have a bit of a lower benefit ratio as you release reserves on the policy, higher DAC and DAC amortization. And that tends to balance out for somewhat modest impact to earnings. So, it's a little less about an earnings story and more about the line items in the P&L. And I would note that it's very important to understand that. In the second quarter of last year, we actually had the same dynamic; it's by coincidence but we launched our medical product in March last year. And if you look at the trends in persistency, trends in benefit ratios, DAC amortization, you see the same phenomenon last year, 1Q to 2Q as you see this year. That's coincidental but it gives you an idea of that, that tends to happen when you first launch a product. It calms down over time, obviously.

And are you agnostic between cancer and medical sales?

Yes, I think we are. We have always said that when the profit margins are relatively similar, then to us it doesn't matter. Agents always choose the path of least resistance, and the path of least resistance is always the newest product that's on the market. It gives some swizzle and they can tread to it. You saw that happen last year with the EVER product. And now you're seeing it this year with the new cancer product. So, it makes it much easier for us to try to figure out how to balance every year, which one they sell. If there was an enormous difference in profitability then that's one thing. But there isn't. So from that standpoint, we feel very good about it. And it's nothing new. I mean we've been doing it since the inception of Japan, we've been working that way.

I just wanted to follow on from John's question. Is it possible to provide the portion of sales that represented the lapse and reissue activity on the new cancer product? And also just a question on accounting, when you do have a lapse and reissue, is it just an incremental premium booked to the sale or is it the whole annualized premium on the new policy?

The overall premium is treated as two separate transactions, reflecting what the consumer has chosen. When a policy lapses, it is recorded as a lapse, which negatively impacts persistency as expected and aligns with accounting standards. If there are significant changes to the policy, especially improvements to the benefit structure, it is accounted for as a lapse and reissue. The reissue is then reported as a sale, with our accounting approach being consistent in this regard. Over the years, we've consistently reported normal lapse and reissue activity in the range of 10% to 15%. However, during the launch period, this can rise to 25% to 30%, which reflects the current situation. The overall impact on earnings is muted and highly contingent on which policies lapse. Older policies, although less frequently, result in higher reserve releases due to potential cash value and minimal DAC amortization, thus affecting the bottom line more noticeably. In contrast, younger policies, particularly those issued in the last five years, tend to have less reserve release and more DAC amortization, making it challenging to estimate the impact. We estimate that earnings in this period may have benefited by around ¥1 billion to ¥2 billion, which is modest and similar to what we observed in 2017. This trend has been consistent for the past 20 years, exemplified by previous cancer products.

First, just on the expected RBC decline because of tax reform. Has that in any way changed your view of what the RBC threshold should be? I think you've mentioned 500% that being sort of an initial threshold for the RBC, just trying to assess how the lower RBC affects your plans to free the $1 billion from the U.S. conversion.

Yes, Jimmy. No impact to that. We are very comfortable, not only with the tax reform absorbed in our capital plan and drawdown of excess capital, but I would also note that we're comfortable with any potential movement related to the C1 bucket changes that are expected in 2019. We see neither of those events as disrupting our drawdown plans. We have settled in and expect to settle in around 500% at the end of 2019. As I've mentioned publicly, I think given the risk profile of our business as we start to print blue books and are able to analyze and report our stability, if you will, and low-risk profile as a U.S. only entity, we'll continue to look to see whether there's further optimization opportunity in that. I think most observers would say that 500% RBC on the nature of our business is quite high, even for our high ratings threshold. And so, we'll work on that. But to answer your question, no tax reform nor the C1 changes are going to disrupt our capital plans.

And if I could ask one more just overall obviously your sales were very strong in Japan, the one negative I thought was just the medical sales continuing to shrink, and I think they're sitting around the ¥6 billion quarterly range. And they’ve drifted lower steadily after you introduced the updated product last year. So I’m assuming you had introduced a new product at some point next year, but is this sort of a normal level of medical sales? Do you expect in the absence of any new products or have the sales been pressured a little bit because of the whole focus on cancer recently?

I’d like you Koji - Koide to answer the question. Koji?

One of the main reasons for the decline in medical sales is that it has been over a year since the release of the new medical product. We launched a new cancer product in April, and everyone is shifting their focus to that. Consequently, medical sales fell in the second quarter, which is something we anticipated based on past experiences. The medical insurance sector is quite competitive, but we are still holding the top position in terms of new business policy numbers and annual premiums. Please keep in mind that we continue to maintain that leading position.

Question for Fred regarding the benefit ratio and DAC amortization impact from the lapses. I understand from an earnings perspective it's small, but like how should we think about the moving pieces in terms of the uplift - I mean the downward pressure on the benefit ratio and the uplift to DAC amortization? And then also how should we think about in the balance of the year?

Yeah, I think in terms of the balance of the year, we would expect this impact to lessen, as I mentioned. So it will become less distinguishable from a line item perspective and really negligible in terms of any particular earnings impact. I think an easy way to think about it, Humphrey, is that as I mentioned in my comments. We would expect the benefit ratio in Japan to elevate back within the guidance range we have, which is 70% to 72%, and that's one way of thinking about the relative impact because that would be probably one of the features that would drive it back up. We also have particularly strong cancer claims trends; don't forget, we’re actually seeing just good flat net experience, particularly in hospitalization trends on cancer. And that led to not only positive claims activity, but also some natural IBNR release which is somewhat mechanical as we adjust for the trends we’re seeing. So we continue to see that development and that's very economic, if you will, in terms of the benefit. Very importantly what I would say to you is that when looking at the benefit ratio overall in Japan, while our guidance range is 70% to 72%, we actually expect the full year to be coming in at the downside of that range. That has been a somewhat consistent pattern, and we expect some of that to continue. It will be more elevated than what we had in the second quarter, but still overall the year will fall very close to the bottom end of that range, is what we are currently projecting. So that's the way to think about it. The actual line item impact with preciseness there is more work to be done to be able to isolate that because it gets quite technical. You're talking about really needing to isolate all the exact moving parts in the policy from particularly a lapse policy dynamic. As I mentioned, the cohorts can be very sensitive as to what the impact is on the line items. We’ll continue to do more work on that to provide more transparency, but from a bottom line perspective, it's not a big material mover. And again, you can kind of take both the benefit ratio guidance we've given as a little bit of the impact on DAC amortization very similarly and I would again call your attention to last year's 1Q to 2Q development. You can see the same thing happening; the benefit ratio drifted down, when we launched the medical product in March, amortization drifted up. Those are reasonable proximities of what you see on those line items.

And then on the third sector sales in the quarter, so obviously there are a lot of moving pieces. Part of it is because of the new product launch, and then also we having a very successful targeted promotional campaign. And then I believe there is also some pent-up demand from the first quarter in anticipation of the launch. So when we think about the product, excluding the impact of the pent-up demand from the first quarter, how would you kind of characterize the product itself to kind of address the needs of the consumer that was not available in the marketplace before this product? And how should we think about kind of the sales impact in the balance of the year?

Koide or Koji?

We have always focused on incorporating features that cater to customer needs and align with developments in the medical treatment field. Recently, we introduced a specific premium waiver feature that our customers have long desired. Our offerings are designed to accommodate a wide array of customers, including both new and existing ones, and we aim to support those concerned about their health, such as cancer survivors. A significant highlight of our current offerings is the addition of this specified premium waiver feature, which has been highly requested by Japan Post customers. Furthermore, we have extended coverage options that can be added to existing policyholders' plans, which our agencies have shown a strong demand for, and these enhancements have positively impacted our sales.

I’d like to add one thing, and that is that the product is important here, but it’s also just strong distribution channels. We are truly going to the places that people want to buy products. And then don’t forget our domination of the cancer insurance market is something that stands out worldwide in what we’ve been able to do in that market. Medical is more competitive; if you go back to 2001 when we deregulated the market, a lot of people thought Aflac would be out of business—all big competitors would put us out, and instead you saw Dai-Ichi Life sell for us. You saw some of the other competitors get in and then pull back; you saw Japan Post; you’ve seen post-offices—I mean the banks. I think it’s part distribution, but it also has those products as well; but it's a one-two punch of both of them that makes it stand out.

I guess just to cover a little bit, so like for the almost ¥21 billion in cancer sales in the quarter, we think about some of it is probably because of the pent-up demand from the first quarter, and the others just because you have a new and better product. So if we kind of bifurcate between some of the pent-up demand versus what do you expect as a more normal quarterly sales for the cancer product, how should we think about that?

What I would say to your point, this is what you mean by pent-up sales. You might recall, and we've commented on this publicly, that as it starts to become well understood that we’re refreshing our cancer product, particularly when we filed with the FSA and we’re in motion and starting to build, you will see a natural anticipation of the new product and a pullback in some of the distribution systems as they prepare for it. So you do have some shift from a 1Q pause to a 2Q jump out of the gate and strong sales, but then as Dan had mentioned and Koji mentioned, it's natural both in medical and cancer that, as the year goes on, you start to see things taper from the sales perspective. So you have a little bit of acceleration of what we anticipate in the second half of the year into the second quarter, and then you have exactly what you're saying, a little bit of that delayed start or pent-up demand if you want to call it from 1Q to 2Q.

You can’t get more about two quarters up.

Given the strong first half third sector sales this year, should we start viewing the Japan segment now that we have had a product portfolio composition shift of third sector in a way from first sector as more heavily weighted towards the first half in any given year to maybe balanced out with the U.S. increasingly in Q4 '18 for sales?

I think it's a function of when we introduce new products and that is the approval based on the FSA and the minute we decide we're coming out with a new product, we want it as quickly as we can. So we don't hold for anything. So I think that what's driving it more than anything else.

Then with the new cancer products rolled out driving strong sales, can you talk about other new products or product enhancements, please?

Japan.

Yes. That will be great.

Koide or whoever wants to do it.

In terms of new products, we are focusing on medical and cancer-related products and are dedicated to developing attractive offerings in a timely manner. The medical field presents more competition and advances rapidly, prompting us to evaluate products in the protection category. One area we are considering is promotions, which could be very appealing.

In the U.S., you are seeing some nice improvement on year-over-year and agent productivity. Can you just talk about which of your initiatives have the biggest impact to date and where you still see opportunity to improve performance?

So, Erik, this is Teresa. I think in the area of where we are seeing most of our improvement, it’s distribution expansion and all of the activities that we have around our broker tools and services. I think we have started to see the investments pay off in that area. We also have executed on product partnerships and other solutions that we are bringing to the employer, which I think have helped us to provide a lift on that side as well. As to what may not be performing as well, at this point, I feel like we are operating on all cylinders; what I'm seeing is a disciplined execution on our strategy. Obviously, I'd love to have more recruits, increased productivity, etc., but we continue to see very positive movement in many of our metrics, so hopefully that will answer your question.

To follow up on one thing you mentioned. You talked about the build-out of your products including some of the partnership relationships. Can you just comment on the impact that this is having on sales?

We are seeing an increase in quotes from many of our larger case brokers and actually in the mid-market as well. And so we see that as a great leading indicator for sales, but we’ve also seen sales rates increase as well. Enhancements to our new cancer products have also been a part of that.

And now I would assume the biggest benefit from that you'd see on sales would be in the fourth quarter as well?

Yes.

Wanted to talk about Japan and the annualized premiums enforced even with the strong third sector sales. It looks like that number is still coming down. I know there is 5-pay way still kind of coming through, but any sense of when you think that annualized premiums enforced number will start to grow again?

Suneet, I think it does take a while; we are still seeing the paid-up policy dynamics come through in first sector. First sector, but in general, has about a little north of 1% lapse rate generally. And then the paid-up policies are running around ¥30 billion for the year, and that will continue to come down, but modestly. You'll still see a level of paid-up policies not just related to 5-pay, but just in general other forms of paid-up policies that we have on the books. And then eventually there's a 10-pay product that sold far less than the five pay, but that comes into play as well. So, first sector premium in general is going to continue to be modestly down, but it’s slowly starting to get overwhelmed by the growth rate of third sector, particularly when we post consecutive years of third sector growth rates. And so the third sector earned premium is now about 75% of our total earned premium, that's up about 200 basis points over last year this time, gives you an idea of the mix shift. And that third sector premium, as we said, we anticipate growing in the 2% to 3% range. And we’re certainly hitting that nicely. So you'll start to eventually turn the corner, I think for sure you’re into very low growth rates once you do turn that corner just by virtue of the sheer size of our block of business and the natural lapsation that takes place. But what's really important is the embedded value, if you will, and profitability of that shift and mix away from first sector towards third sector is a very good development for the company over time. And you end up seeing the evidence of that in improved FSA earnings which means improved cash flow in excess capital and deployment opportunities. So we’re happy with that trend line.

And then just on the third sector sales, it looks like cancer is going to carry you guys for this year. I think medical was pretty strong last year. I think there was a question on this earlier, but just to follow up. Is there another sort of key product launch that you guys are thinking about for 2019 to kind of overcome what’s becoming some difficult comps in '18?

We'll let Japan touch on that again.

And for our growth, it is our responsibility to effectively introduce new products to the market in a well-planned manner. We are steadily preparing for our new product launch, but I cannot share the specific details of the product we are considering.

That’s the requirement of that. Let’s say that not just us, but Aflac.

No, that’s fine, just one last one just on the income support product. I think in the past you talked about maybe that product is for the third leg and the product stool in Japan—cancer, medical, and then income support. And I realize there has been a lot of emphasis on cancer certainly this quarter, but sales there really haven't budged much. Is that still a product that you think has the potential to be that third stool? Or any thoughts around that?

I’ll answer that. I’m disappointed with the sales of the product, but it is a new product; it’s not a revised product like when we say okay this is a new cancer. This is a new thing that’s never really been out there, and what we're seeing is the Shinkin banks are being successful with it. And we think that it will grow from there. What I would say is, I'm still encouraged that there is real potential with it, but it hadn’t taken off yet and I was hoping it would be doing a little bit better. But make no mistake about it, when you're constantly introducing new products that are stable products that everyone knows about used to, and it's a revised product, the new product like in the case of this one, they lose focus on it; our distribution network does. So it becomes a little bit harder, but we still think it has potential is the answer, but I'm disappointed that it isn’t doing a little bit better.

This is David on behalf of Tom. I guess I just wanted to ask a question on this dynamic of the lapse and reissue and just get a sense for the margin or IRR on the new product versus the old. And I know it's sort of was a bit elevated this quarter at around 30% of the sales, but you mentioned it can be anywhere from 10% to 15% in any given year. So, just wondering how that sort of overall throws into results and just the margin in IRR on the new versus old?

Both medical and cancer are priced with very similar margins. So while the premium will fluctuate in terms of the nature of the benefits and features of the products, the economic IRR, if you will—both the IRR as well as profit margin is priced in a very similar range. And so this is really less about an economic issue if you will to the company. We’re relatively indifferent. We leave it up to the customer to decide what's in their best interest related to the improved benefits and structure of it. And so we’re not motivated by necessarily economics. And I would keep in mind that those economics can really go both ways depending on the age of the policy and the nature of the policy; they can both contribute to GAAP profitability in a particular period, and they could also take away from GAAP profitability depending on how recent the product was sold and the nature of the product. So we really don't try to model in, if you will, that type of activity; it's entirely a consumer-driven action and what's in their best interest, and we remain agnostic to the dynamic.

And then I guess shifting gears to, Fred, you mentioned or you alluded to earlier on just thinking about capital structure and I think we mentioned the RBC ratio in the U.S. But also just looking at the leverage ratio that's pretty low under your 20% to 25% guidance range, just thinking I guess how you guys are thinking about that. And then also just capital in Japan, and I guess also just an update on the ESR regime and sort of how the FSA in Japan is thinking about maybe updating the SMR towards a more Solvency II like calculation?

Yes, let me discuss this a bit. I invite either Max or Todd to share their thoughts, but I'll provide my perspective. Let’s break it down. Regarding the U.S., I believe we've addressed that thoroughly. There is potential for further optimization in the U.S., but it really depends on finalizing our U.S. statutory conditions. However, I see some opportunities there, albeit more limited as we are aligning a lot of excess capital with our current plans. In Japan, we are in a strong capital position. Our SMR remains robust despite some spread widening and rising interest rates, especially in the U.S., and we’ve recently seen a modest increase in rates in Japan. Therefore, we continue to maintain a solid SMR position. The focus in Japan is on the trend of our FSA earnings. As I mentioned, this is improving due to changing economic conditions within our business. We also consider how much of those FSA earnings we’re comfortable moving to the holding company structure for deployment. Currently, we have a policy of transferring 80% of FSA earnings back to the U.S., based on the need to retain 20% to support overall growth and reinvestment activities in our Japan operations. We’ve noticed that as the first sector winds down and the third sector grows, our FSA earnings are increasing, allowing us to manage that capital more effectively over time. We’ll discuss this further, but that’s the optimization aspect we are focused on. To respond to your question on ESR, when incorporating an ultimate forward rate adjustment, our ESR is currently running at over 225%. A slight rise in rates in Japan will enhance that figure. Is that correct, Todd? You can add your input.

Yes, that's about right. Current internal models say about 225%.

And the ultimate forward rate—my memory is that may have around 60 points or so impact to that level. Is that about right?

Yes, that's about right.

So, it gives you an idea. But the punch line is, with or without a UFR, that's an extraordinarily strong ESR, particularly as it relates to other peer companies in the industry. And that's because we're so dominated by third sector, which is a better dynamic to have under that type of solvency. In terms of where we are with adoption, I believe we're still in field testing, and I think it's still a little unclear. But Todd, or anybody in Japan, if you've got any color on that, please provide it?

Yes, the FSA kicked off another round of field testing this summer, which will be targeted to complete by the end of the year. And as far as adoption of going to an economic solvency regime, I do believe there's not going to be any movement until around 2025. The FSA is following what the IAIS is doing in their modeling and guidance. So, we still have some time with SMR and further development of our SMR framework.

In terms of leverage, yes, we're running low, but remember we got kind of a boost on lowering leverage when we adjusted the deferred tax liability with tax reform, that added around $1.9 billion to our equity capitalization and that really lowered us a bit on leverage. And so, it's not been a proactive de-levering activity on our part; it's been more of the effects of accounting adjustments related to tax reform. Now having said that, our leverage is low and our coverage is very strong, given we borrow roughly $3.4 billion of our $5 billion in borrowings in yen. So, we have room. I like to be somewhat tactical, if you will, in leverage capacity for opportunities and allows for absorption, should there be any other items, although we don't foresee anything. So, we'll be looking at leverage optimization and what we may do there. I think I put that into the overall holding company capital structure dynamic. And as we've talked about here now a couple of times, including this quarter, we're looking for ways to optimize our hedge costs in Japan through setting up mere trades at the holding company, and that serves to lower our net exposure to a weakening yen over time. So, we think there's some real economic benefits both from an earnings standpoint and risk reduction standpoint to better optimizing or utilizing the FX capital that we have at the holding company. So, that's a bit of a flyby. Max, I don't know if there's anything you want to add from your perspective.

Just to add a little bit of color. So overall our business has a low risk profile, and we have a liability structure that is very stable and low risk as well. So you combine that with a relatively low leverage range that we are operating within, and you quickly realize that we do have significant debt capacity, and we could go to a higher leverage level. At the same time, in the post-conversion phase that we are in right now, we continue to travel and want to travel with relatively low leverage and high capital. So, I will put it this way: we do have significant debt capacity, but it has to be for good return projects. We will not lever up just for the sake of it, but as we find very good projects to invest in, we do have very significant debt capacity.

Thank you all for joining our call this morning. Before we end, I'd like to remind you that we will be hosting a financial analyst briefing in Tokyo on September 26. I hope you'll join us there. Any interim, please feel free to contact our Investor and Rating Agency Relations Department for any information or questions you may have, and we look forward to speaking with you soon. Thank you.