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AFL > SEC Filings for AFL > Form 10-Q on 5-Nov-2013All Recent SEC Filings

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Form 10-Q for AFLAC INC


5-Nov-2013

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

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 the Securities 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 with Aflac'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 in Japan

• increased derivative activities

• 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 to Aflac 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

• interruption in telecommunication, information technology and other operational systems, or a failure to maintain the security, confidentiality or privacy of sensitive data residing on such 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

• catastrophic events including, but not necessarily limited to, epidemics, pandemics, tornadoes, hurricanes, earthquakes, tsunamis, acts of terrorism and damage incidental to such events

• failure of internal controls or corporate governance policies and procedures


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 of Aflac Incorporated and its subsidiaries for the three- and nine-month periods ended September 30, 2013 and 2012. Results of operations for interim periods are not necessarily indicative of results for the entire year. As a result, the following discussion should be read in conjunction with the consolidated financial statements and notes that are included in our annual report to shareholders for the year ended December 31, 2012. 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 BUSINESS
Aflac Incorporated (the Parent Company) and its subsidiaries (collectively, the Company) primarily sell supplemental health and life insurance in the United States and Japan. The Company's insurance business is marketed and administered through American Family Life Assurance Company of Columbus (Aflac), which operates in the United States (Aflac U.S.) and as a branch in Japan (Aflac Japan). Most of Aflac's policies are individually underwritten and marketed through independent agents. Aflac U.S. markets and administers group products through Continental American Insurance Company (CAIC), branded as Aflac Group Insurance. Our insurance operations in the United States and our branch in Japan service the two markets for our insurance business.

PERFORMANCE HIGHLIGHTS
Reflecting the weaker yen/dollar exchange rate, revenues were $5.9 billion in the third quarter of 2013, compared with $6.8 billion in the third quarter of 2012. Net earnings were $702 million, or $1.50 per diluted share, compared with $1.0 billion, or $2.16 per diluted share, in the third quarter of 2012. Also reflecting the weaker yen/dollar exchange rate, revenues were $18.1 billion in the first nine months of 2013, compared with $19.0 billion in the first nine months of 2012. Net earnings were $2.5 billion, or $5.31 per diluted share, compared with $2.3 billion, or $4.87 per diluted share, for the first nine months of 2012.
Results in the third quarter of 2013 included pretax net realized investment gains of $22 million ($15 million after-tax), compared with net realized investment gains of $286 million ($186 million after-tax) in the third quarter of 2012. Net investment gains in the third quarter of 2013 included $10 million ($6 million after-tax) of other-than-temporary impairment losses; $72 million of net gains ($47 million after-tax) from the sale or redemption of securities; and $40 million of net losses ($26 million after-tax) from valuing derivatives. Results for the first nine months of 2013 included pretax net realized investment gains of $379 million ($247 million after-tax), compared with net realized investment losses of $177 million ($115 million after-tax) in the first nine months of 2012. Net investment gains in the first nine months of 2013 included $65 million ($42 million after-tax) of other-than-temporary impairment losses; $277 million of net gains ($180 million after-tax) from the sale or redemption of securities; and $167 million of net gains ($109 million after-tax) from valuing derivatives.
Shareholders' equity included a net unrealized gain on investment securities and derivatives of $135 million at September 30, 2013, compared with a net unrealized gain of $2.6 billion at December 31, 2012.
In June 2013, the Parent Company issued $700 million of senior notes through a U.S. public debt offering. We entered into cross-currency interest rate swaps to economically convert the dollar-denominated principal and interest on the senior notes we issued into yen-denominated obligations. In March 2013, the Parent Company and Aflac entered into a five-year senior unsecured revolving credit facility agreement with a syndicate of financial institutions that provides for borrowings of 50 billion yen or the equivalent of Japanese yen in U.S. dollars. For further information regarding these transactions, see Note 7 of the Notes to the Consolidated Financial Statements and the Capital Resources and Liquidity section of this MD&A.


In the first nine months of 2013, we repurchased 5.6 million shares of our common stock in the open market for $298 million under our share repurchase program.

CRITICAL ACCOUNTING ESTIMATES
We prepare our financial statements in accordance with U.S. generally accepted accounting principles (GAAP). These principles are established primarily by the Financial Accounting Standards Board (FASB). In this MD&A, references to GAAP issued by the FASB are derived from the FASB Accounting Standards Codification™ (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 of Aflac's results of operations and financial condition are those related to the valuation of investments and derivatives, deferred policy acquisition costs (DAC), liabilities for future policy benefits and 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 for which 94% of our assets and 76% of our liabilities are reported as of September 30, 2013, and thus has a direct effect on net earnings and shareholders' equity. Subsequent experience or use of other assumptions could produce significantly different results.
In the first quarter of 2013, we engaged a third party pricing vendor to value privately issued securities within our investment portfolio which were previously being valued using our discounted cash flow pricing model at December 31, 2012. For further discussion regarding this change in pricing methodology, see Note 5 of the Notes to the Consolidated Financial Statements. Other than the change in valuation methodology for certain investments as discussed above, there have been no other changes in the items that we have identified as critical accounting estimates during the nine months ended September 30, 2013. For additional information, see the Critical Accounting Estimates section of MD&A included in our annual report to shareholders for the year ended December 31, 2012.
New Accounting Pronouncements
For 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 discussion includes references to our performance measures, operating earnings and operating earnings per diluted share, that are not based on accounting principles generally accepted in the United States of America ("GAAP"). After-tax operating earnings (operating earnings) is the measure of segment profit or loss we use to evaluate segment performance and allocate resources. Consistent with GAAP accounting guidance for segment reporting, operating earnings is our measure of segment performance. Aflac believes that an analysis of operating earnings is vitally important to an understanding of our underlying profitability drivers.

Aflac defines operating earnings (a non-GAAP financial measure) as the profits derived from operations, inclusive of interest cash flows associated with notes payable, before realized investment gains and losses (securities transactions, impairments, and derivative and hedging activities) as well as nonrecurring items. Aflac's derivative activities include: foreign currency, interest rate and credit default swaps in variable interest entities that are consolidated; foreign currency swaps associated with our senior notes and subordinated debentures; foreign currency forwards used in hedging foreign exchange risk and options on interest rate swaps (or interest rate swaptions) used in hedging interest rate risk on U.S. dollar-denominated securities in Aflac Japan's portfolio; and foreign currency forwards and options used to hedge certain portions of forecasted cash flows denominated in yen. Nonrecurring items are infrequent activities that are not directly associated with the Company's insurance operations.

Our management uses operating earnings to evaluate the financial performance of Aflac's insurance operations because realized investment gains and losses (securities transactions, impairments, and derivative and hedging activities) as well as nonrecurring items, tend to be driven by general economic conditions and events or are related to infrequent activities not directly associated with our insurance operations, and therefore may obscure the underlying fundamentals and trends in Aflac's insurance operations.

The following table is a reconciliation of items impacting operating and net earnings and operating and net earnings per diluted share.


Reconciliation of Operating Earnings to Net Earnings

                          In Millions           Per Diluted Share            In Millions           Per Diluted Share
                             Three Months Ended September 30,                   Nine Months Ended September 30,
                       2013        2012          2013          2012       2013        2012          2013         2012
Operating earnings   $   687     $   831     $    1.47       $ 1.77     $ 2,236     $ 2,400     $    4.78      $ 5.12
Items impacting net
earnings,
net of tax:
Realized investment
gains
(losses):
Securities
transactions
and impairments           41         124           .09          .26         138        (185 )         .30        (.40 )
Impact of derivative
and
hedging activities:
  Hedge costs
related to
foreign currency
investments               (4 )        (2 )        (.01 )        .00         (12 )        (2 )        (.03 )       .00
  Other derivative
and
hedging activities       (22 )        64          (.05 )        .13         121          72           .26         .15
Net earnings         $   702     $ 1,017     $    1.50       $ 2.16     $ 2,483     $ 2,285     $    5.31      $ 4.87

Realized Investment Gains and Losses
Our investment strategy is to invest primarily 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 incorporates asset-liability management (ALM) to align the expected cash flows of the portfolio to the needs of the Company's liability structure. 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 the three-month period ended September 30, 2013, we realized pretax investment gains, net of losses, of $72 million ($47 million after-tax) from sales and redemptions of securities. We realized pretax investment losses of $10 million ($6 million after-tax) as a result of the recognition of other-than-temporary impairment losses on certain securities.

During the nine-month period ended September 30, 2013, we realized pretax investment gains, net of losses, of $277 million ($180 million after-tax) from sales and redemptions of securities. We realized pretax investment losses of $65 million ($42 million after-tax) as a result of the recognition of other-than-temporary impairment losses on certain securities.

During the three-month period ended September 30, 2012, we realized pretax investment gains, net of losses, of
$288 million ($187 million after-tax) from sales and redemptions of securities. These net gains primarily resulted from
sales of Japanese government bonds (JGBs) in a bond-swap program. We realized pretax investment losses of $97
million ($63 million after-tax) as a result of the recognition of other-than-temporary impairment losses.

During the nine-month period ended September 30, 2012, we realized pretax investment gains, net of losses, of
$358 million ($233 million after-tax) from sales and redemptions of securities. These gains primarily resulted from the
bond-swap program in the third quarter of 2012 as discussed above. Other gains resulted from the redemption in the
first quarter of 2012 of a previously impaired perpetual security and sales related to our plan to reduce the risk
exposure in our investment portfolio. We realized pretax investment losses of $643 million ($418 million after-tax) as a result of the recognition of other-than-temporary impairment losses. See Note 3 of the Notes to Consolidated Financial Statements for a more detailed discussion of these investment activities.


The following table details our pretax impairment losses by investment category.

                                              Three Months Ended              Nine Months Ended
                                                September 30,                   September 30,
(In millions)                                2013           2012              2013             2012
Perpetual securities                       $     0        $    27        $     0             $  243
Corporate bonds                                  3             70             41                253
Mortgage- and asset-backed securities            0              0              0                  3
Sovereign and supranational                      7              0             23                144
Equity securities                                0              0              1                  0
Total other-than-temporary impairment
losses realized                            $    10   (1)  $    97   (1)  $    65        (1)  $  643   (1)

(1) Includes $0 and $70 for the three-month periods and $0 and $365 for the nine-month periods ended September 30, 2013 and 2012, respectively, for credit-related impairments; $0 and $27 for the three-month periods and $1 and $27 for the nine-month periods ended September 30, 2013 and 2012, respectively, for impairments due to severity and duration of decline in fair value; and $10 and $0 for the three-month periods and $64 and $251 for the nine-month periods ended September 30, 2013 and 2012, respectively, from change in intent to sell securities

Impact of Derivative and Hedging Activities Our derivative activities include foreign currency swaps, credit default swaps, and interest rate swaps in VIEs that are consolidated; foreign currency forwards and interest rate swaptions on certain fixed-maturity securities; foreign currency forwards and options that hedge certain portions of forecasted cash flows denominated in yen; foreign currency interest rate swaps associated with certain of our senior notes and our subordinated debentures; and an interest rate swap associated with our variable interest rate yen-denominated debt. During the three-month period ended September 30, 2013, we realized pretax investment losses, net of gains, of $40 million ($26 million after-tax), compared with pretax investment gains, net of losses, of $95 million ($62 million after-tax) for the same period in 2012, as a result of valuing these derivatives, net of the effects of hedge accounting. During the nine-month period ended September 30, 2013, we realized pretax investment gains, net of losses, of $167 million ($109 million after-tax), compared with pretax investment gains, net of losses, of $108 million ($70 million after-tax) for the same period in 2012, as a result of valuing these derivatives, net of the effects of hedge accounting. 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. 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 have yen-denominated assets that 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.
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 period results in relation to the comparable prior period, while yen strengthening has the effect of magnifying current period results in relation to the comparable prior period. As a result, we view foreign currency translation as a financial reporting issue for Aflac and not an economic event to our Company or shareholders. Because changes in exchange rates distort the growth rates of our operations, management evaluates Aflac'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 34.3% for the three-month period ended September 30, 2013, compared with 31.3% for the same period in 2012. Our combined U.S. and Japanese effective income tax rate on pretax earnings was 34.4% for the nine-month period ended September 30,


2013, compared with 33.2% for the same period in 2012. The lower effective income tax rates for the three- and nine-month periods ended September 30, 2012 reflected the favorable outcome of a routine tax exam for the years 2008 and 2009, which reduced income tax expense by $29.5 million. Earnings Guidance
Certain items that cannot be predicted or that are outside of management's control may have a significant impact on net earnings. Therefore, in comparing period-over-period results, we also analyze operating earnings (a non-GAAP financial measure) which includes interest cash flows associated with notes payable and excludes realized investment gains and losses (securities transactions, impairments, and the impact of derivative and hedging activities) and nonrecurring items from net earnings. We also assume no impact from foreign currency translation on the Aflac Japan segment.
Our objective for 2013 is to increase operating earnings per diluted share by 4% to 7% over 2012, excluding the effect of foreign currency translation. If we achieve our objective for 2013, the following table shows the likely results for operating earnings per diluted share, including the impact of foreign currency translation using various yen/dollar exchange rate scenarios.
2013 Operating Earnings Per Diluted Share Scenarios(1)

     Weighted-Average
        Yen/Dollar                   Operating Earnings Per           % Growth
       Exchange Rate                     Diluted Share                Over 2012                Yen Impact
            79.81(2)                      $6.86 - 7.06              3.9   -  7.0   %            $   .00
            90                             6.37 - 6.57             (3.5)  -  (.5 )                 (.49 )
            95                             6.17 - 6.37             (6.5)  - (3.5 )                 (.69 )
            100                            5.99 - 6.19             (9.2)  - (6.2 )                 (.87 )


105 5.83 - 6.03 (11.7) - (8.6 ) (1.03 )

(1)Excludes realized investment gains/losses (securities transactions, impairments, and the impact of derivative and hedging activities) and nonrecurring items in 2013 and 2012
(2)Actual 2012 weighted-average exchange rate

We expect operating earnings to increase approximately 5% for the full year of 2013, before the impact of foreign currency. If the yen averages 95 to 100 to the U.S. dollar for the last three months of the year, we would expect reported operating earnings for the fourth quarter of 2013 to be in the range of $1.38 to $1.43 per diluted share. Under that scenario, we would expect full year 2013 operating earnings of $6.16 to $6.21 per diluted share.

If the yen averages 95 to 100 to the U.S. dollar for the fourth quarter of 2013 and full year 2014, we would expect 2014 operating earnings per diluted share to be in the range of $6.28 to $6.52, which is a growth rate of approximately 2% to 5% on a currency neutral basis. Our 2014 earnings per diluted share objective will benefit significantly from increased share repurchase activities, but will also be challenged by a difficult low-interest-rate environment in Japan, sizeable expenditures in both Japan and the U.S. to enhance our operational infrastructure, and an increase in Japan's consumption tax, rising from 5% to 8% starting in April 2014.

INSURANCE OPERATIONS
Aflac's insurance business consists of two segments: Aflac Japan and Aflac U.S. Aflac Japan, which operates as a branch of Aflac, 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 and interim period 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, inclusive of interest cash flows associated with notes payable and 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 in Japan, 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 . . .

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