new product development and customer response to new products and new marketing initiatives
ineffectiveness of hedging strategies used to minimize exposure of our shareholders' equity to foreign currency translation fluctuations
This MD&A is divided into four primary sections. In the first section, we discuss our critical accounting estimates. We then follow with a discussion of the results of our operations on a consolidated basis and by segment. The third section presents an analysis of our financial condition as well as a discussion of market risks of financial instruments. We conclude by addressing the availability of capital and the sources and uses of cash in the Capital Resources and Liquidity section.
We prepare our financial statements in accordance with U.S. generally accepted accounting principles (GAAP). 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 investments, deferred policy acquisition costs and policy liabilities. 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 95% of our assets and 83% of our liabilities are reported and thus have a direct effect on net earnings and shareholders' equity. Subsequent experience or use of other assumptions could produce significantly different results.
Investments in debt and equity securities include both publicly issued and privately issued securities. For privately issued securities, we receive pricing data from external sources that take into account each security's credit quality and liquidity characteristics. 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 SEC Staff Accounting Bulletin No. 59, Accounting for Non-Current Marketable Equity Securities; SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities; and related 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:
Under the requirements of SFAS No. 60, 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 at time of policy issuance. However, the unamortized balance of DAC reflects actual persistency. As presented in the following table, the ratio of unamortized DAC to annualized premiums in force has been relatively stable for Aflac U.S. and Aflac Japan over the last three years.
In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123 (revised), Share-Based Payment (SFAS 123R). This standard amends SFAS No. 123, Accounting for Stock-Based Compensation, and supercedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. SFAS 123R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions, such as granting stock options. It requires that companies use a fair value method to value share-based awards and recognize the related compensation expense in net earnings. We adopted SFAS 123R January 1, 2005, using the modified-retrospective application method. As a result, prior-year results have been adjusted to reflect the expensing of share-based awards. See Note 9 of the Notes to the Consolidated Financial Statements for additional information.
Our investment strategy is to invest in fixed-income securities in order to provide a reliable stream of investment income, which is one of the drivers of the Company's profitability. 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. 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.
In 2005, we realized pretax gains of $262 million (after-tax, $167 million, or $.33 per diluted share). The significant realized investment gains in 2005 primarily resulted from the execution of bond swaps in the third and fourth quarters that took advantage of tax loss carryforwards. These bond swaps also improved overall portfolio credit quality and investment income.
Realized investment losses in 2003 related primarily to the sale of our investment in Parmalat at a pretax loss of $257 million. We also sold our investment in Levi Strauss at a pretax loss of $38 million. These investment losses and other investment transactions in the normal course of business decreased 2003 pretax earnings by $301 million (after-tax, $191 million, or $.37 per diluted share).
We entered into cross-currency swap agreements to effectively convert our dollar-denominated senior debt obligation, which matures in 2009, into a yen-denominated obligation (see Notes 4 and 6 of the Notes to the Consolidated Financial Statements). The effect of issuing fixed-rate, dollar-denominated debt and swapping it into fixed-rate, yen-denominated debt has the same economic impact on Aflac as if we had issued yen-denominated debt of a like amount. However, the accounting treatment for cross-currency swaps is different from issuing yen-denominated Samurai notes. SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended (SFAS 133), requires that the change in the fair value of the interest rate component of the cross-currency swap, which does not qualify for hedge accounting, be reflected in net earnings (other income). This change in fair value is determined by relative dollar and yen interest rates and has no cash impact on our results of operations. At maturity, the swaps' fair value and their initial contract fair value will be equal, and the cumulative impact of gains and losses from the changes in fair value of the interest component will be zero. We have the ability and intent to retain the cross-currency swaps until their maturity. The impact from SFAS 133 includes the change in fair value of the interest rate component of the cross-currency swaps, which does not qualify for hedge accounting.
We have also issued yen-denominated Samurai notes. We have designated 110 billion yen of these notes as a hedge of our investment in Aflac Japan. If the value of these yen-denominated notes and the cross-currency swaps exceeds our investment in Aflac Japan, we would be required to recognize the foreign currency effect on the excess, or ineffective portion, in net earnings (other income). The ineffective portion would be included in the impact from SFAS 133. These hedges were effective during the three-year period ended December 31, 2005; therefore, there was no impact on net earnings. See Notes 1 and 4 of the Notes to the Consolidated Financial Statements for additional information.
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 causes fewer dollars to be reported. When the yen strengthens, translating yen into dollars causes more dollars to be 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 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.
Our combined U.S. and Japanese effective income tax rate on pretax earnings was 33.4% in 2005, 28.6% in 2004 and 35.8% in 2003. Total income taxes were $743 million in 2005, compared with $507 million in 2004 and $430 million in 2003. The lower than normal income tax rate primarily resulted from the release of the valuation allowance for non-life losses in 2005. Our 2004 effective income tax rate and tax expense were impacted by the release of the valuation allowance for deferred tax assets discussed previously. Japanese income taxes on Aflac Japan's results accounted for most of our consolidated income tax expense. See Note 7 of the Notes to the Consolidated Financial Statements for additional information.
Subject to the preceding assumptions, our objective for 2005 was to achieve net earnings per diluted share of at least $2.56, an increase of 14.8%. Based on 2005 net earnings per diluted share of $2.92, adjusted for realized investment gains ($.33 per diluted share), the impact from SFAS 133 (a loss of $.02 per diluted share), the release of the valuation allowance for deferred tax assets (a gain of $.07 per diluted share) and foreign currency translation (a loss of $.02 per diluted share), we met our objective for the year.
Our objective for 2006 is to achieve net earnings per diluted share of at least $2.92, an increase of 15.0% over 2005 using the preceding assumptions. If we achieve this objective, the following table shows the likely results for 2006 net earnings per diluted share, including the impact of foreign currency translation using various yen/dollar exchange rate scenarios.
Our objective for 2007 had been to increase net earnings per diluted share by 13% to 16%, on the basis described above. However, based on the development of our business, we now expect net earnings per diluted share to increase by 15% to 16%, on the basis described above.
Page II-26). The operating expense ratio increased in 2005 as a result of additional advertising expenditures and the write-off of previously capitalized systems development costs. We expect the operating expense ratio to be relatively stable in 2006 as we continue our investment in systems development. Due to improvement in the benefit ratio, the pretax operating profit margin expanded to 14.5% in 2005. We expect a modest expansion in the profit margin in 2006 and 2007.
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 32% of Aflac Japan's investment income in 2005, compared with 30% in 2004 and 29% in 2003. In years when the yen strengthens in relation to the dollar, translating Aflac 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. The following table illustrates the effect of translating Aflac Japan's dollar-denominated investment income and related items by comparing certain segment results with those that would have been reported had yen/dollar exchange rates remained unchanged from the prior year.
For 2005, sales increased 5.1% in yen, which was in line with our objective of 5% to 10% growth for the year. We saw strong sales results in our stand-alone medical product category and from cancer life sales through Dai-ichi Mutual Life. However, as expected, sales continued to be affected by sharp declines in Rider MAX sales. The following table presents Aflac Japan's total new annualized premium sales for the years ended December 31.
Our medical products, which include our EVER product line, sustained strong sales growth in 2005. With continued cost pressure on Japan's health care system, we expect demand for medical products will continue to rise in the future and we remain encouraged about the outlook for the medical insurance market. Although that market is very competitive, Aflac Japan retains the distinction of being the number one seller of stand-alone medical insurance in Japan. We believe that our number one status provides us with a distinct advantage in the marketplace. As a result, we continue to believe that the medical category will be an important part of our product portfolio.
Cancer life sales benefited from a new product introduction in 2005, as well as our program that converted payroll policies to a direct-billing mode. Our cancer life policies are also marketed by Dai-ichi Mutual Life. In 2005, Dai-ichi Life's sales of our cancer life product increased to 277,700 policies, compared with 244,400 in 2004 and 305,600 in 2003. Dai-ichi Life sales of our cancer life policies accounted for 8% of total new annualized premium sales in 2005, compared with 7% in 2004 and 10% in 2003.
We continued to focus on the growth of our distribution system in Japan. During 2005, the number of licensed sales associates rose 14.6% to approximately 81,700, compared with 71,400 at December 31, 2004. The growth of licensed sales associates resulted primarily from individual agency recruitment. In 2005, we recruited 4,388 agencies, compared with our goal of 4,400 agencies. We believe that new agencies and sales associates will continue to be attracted to Aflac Japan's high commissions, superior products, customer service and brand image. Furthermore, we believe that these new agencies and associates will enable us to further expand our reach in the Japanese market.
The percentage increases in premium income reflect the growth of premiums in force. The increases in annualized premiums in force of 10.0% in 2005, 10.9% in 2004, and 13.8% in 2003 were favorably affected by increased sales at the worksite primarily through cafeteria plans and a slight improvement in the persistency of several products. Annualized premiums in force at December 31 were $3.7 billion in 2005, $3.4 billion in 2004, and $3.0 billion in 2003.
We were pleased with the sales results of Aflac U.S. For 2005, sales increased 6.1%, which met our objective of 3% to 8% growth for the year. Our accident/disability and cancer expense products were again the primary contributors to sales. The following table presents Aflac's U.S. total new annualized premium sales for the years ended December 31.
One aspect of our growth strategy is the continued enhancement of our product line. Based on consumer feedback, we revised our dental product in November 2004. We also introduced Vision Now, an innovative vision care product, in July 2005. The following table details the contributions to total new annualized premium sales by major product category for the years ended December 31.
The following table compares the results of Aflac's U.S. investment activities.
The returns on average invested assets for Aflac U.S. in 2005 and 2004 were reduced by higher-than-usual securities lending at the end of 2004. Excluding loaned securities, and the related investment income earned from our security lending program, the adjusted return was 7.12% in 2005 and 7.22% in 2004. In 2003, securities lending did not have a material effect on the return on average invested assets. See Investments and Cash on
Corporate operating expenses consist primarily of personnel compensation, benefits, and facilities expenses. Corporate expenses, excluding investment income, were $56 million in 2005, $67 million in 2004 and $51 million in 2003. Investment income included in reported corporate expenses was $14 million in 2005, and $5 million in both 2004 and 2003. The increase in the 2004 corporate expenses was primarily the result of increased expenses associated with our retirement obligations.
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. Furthermore, most of 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, Aflac Incorporated has yen-denominated notes payable and cross-currency swaps related to its dollar-denominated senior notes.
Page II-35 for additional information). As a result, the effect of currency fluctuations on our net assets is mitigated. At December 31, consolidated yen-denominated net assets subject to foreign currency fluctuation were $781 million in 2005 and $735 million in 2004. Aflac Japan's yen-denominated net assets were $2.2 billion at both December 31, 2005 and 2004. Aflac Incorporated's yen-denominated net liabilities were $1.4 billion at December 31, 2005, and $1.5 billion at December 31, 2004. 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 of December 31.
We are exposed to economic currency risk only when yen funds are actually converted into dollars. This primarily occurs when we transfer funds from Aflac Japan to Aflac U.S., which is done annually. The exchange rates prevailing at the time of transfer will differ from the exchange rates prevailing at the time the yen profits were earned. These repatriations have not been greater than 80% of Aflac Japan's prior-year FSA-based earnings. A portion of the repatriation may be used to service Aflac Incorporated's yen-denominated notes payable with the remainder converted into dollars.
Changes in the interest rate environment have contributed to the unrealized gains on debt securities we own. However, we do not expect to realize a majority of these unrealized gains because we have the intent and ability to hold these securities to maturity. Likewise, should significant amounts of unrealized losses occur because of increases in market yields, we would not expect to realize these losses because we have the intent and ability to hold such securities to maturity. For additional information on unrealized losses on debt securities, see Note 3 of the Notes to the Consolidated Financial Statements.
In response to low interest rates in the United States, we lowered our required interest assumption for newly issued products to 5.50% in 2005. In Japan, we also lowered our required interest assumption for some newly issued products to 2.50%. However, the majority of Japan's newly issued products have a required interest assumption of 3.00%. We continue to monitor the spread between our new money yield and the required interest assumption for newly issued products in both the United States and Japan and will re-evaluate those assumptions as necessary.
The decrease in investments during 2005 reflected the effect of a weaker yen/dollar exchange rate partially offset by the substantial cash flows in the functional currencies of our operations. See Capital Resources and Liquidity on
Total privately issued securities accounted for 66.6%, at amortized cost, of total debt securities as of December 31, 2005, compared with 64.7% at December 31, 2004. Privately issued securities held by Aflac Japan at amortized cost accounted for $27.9 billion, or 61.8%, and $27.0 billion, or 60.1%, of total debt securities at December 31, 2005 and 2004, respectively. Reverse-dual currency debt securities accounted for $8.9 billion, or 29.6%, of total privately issued securities as of December 31, 2005, compared with $7.8 billion, or 26.8%, at December 31, 2004. Aflac Japan has invested in privately issued securities to secure higher yields than those available from Japanese government 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, except when internal credit analysis indicates that additional protective and/or event-risk covenants are required.
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. All of our securities have ratings from either a nationally recognized statistical rating organization or the SVO of the NAIC. The distributions by credit rating of our purchases of debt securities for the years ended December 31, based on acquisition cost, were as follows:
The distributions of debt securities we own, by credit rating, were as follows:
Once we designate a security as below investment grade, we intensify our monitoring of the issuer. We do not automatically recognize an impairment for the difference between fair value and amortized cost. Our investment management starts by reviewing its credit analysis. Included in this process are an evaluation of the issuer, its current credit posture and an assessment of the future prospects for the issuer. We then obtain fair value information from at least three independent pricing sources. Upon determining the fair value, we move our focus to an analysis of whether or not the decline in fair value, if any, is other than temporary. For securities with an amortized cost in excess of fair value, investment management then reviews the issue based on our impairment policy to determine if the investment should be impaired and/or liquidated. The assessment of whether a decline is other than temporary requires significant management judgment and is discussed more fully in the Critical Accounting Estimates section on
Page II-6. Securities classified as below investment grade as of December 31 were as follows:
Occasionally a debt 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. 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 as of December 31, 2005, represented .7% of total debt securities at amortized cost and were as follows:
The following table provides details on amortized cost, fair value and unrealized gains and losses for our investments in debt securities by investment-grade status as of December 31, 2005.
For a presentation of values and unrealized gains and losses for our investments in debt and equity securities as of December 31, 2005, see Note 3 of the Notes to the Consolidated Financial Statements.
The following table presents an aging of securities in an unrealized loss position as of December 31, 2005.
The fair value of our investments in debt securities can fluctuate as a result of changes in interest rates, foreign currency exchange rates, and credit issues. Declines in fair value noted above resulted from changes in interest rates, yen/dollar exchange rates, and issuer credit status. However, we believe that it would be inappropriate to recognize impairment charges because we believe the changes in fair value are temporary. Impairment charges were immaterial in each of the years in the three-year period ended December 31, 2005.
Realized losses on debt securities by investment-grade status were as follows for the year ended December 31, 2005.
As part of our investment activities, we have investments in variable interest entities (VIEs) and qualifying special purpose entities (QSPEs). See Note 3 of the Notes to the Consolidated Financial Statements for additional information.
Deferred policy acquisition costs totaled $5.6 billion at December 31, 2005, a decrease of $5 million, or .1% over 2004. The following table presents deferred policy acquisition costs by segment for the years ended December 31.
The Parent Company has issued yen-denominated Samurai notes in Japan. In June 2001, we issued 40 billion yen (approximately $333 million); in July 2002, we issued 30 billion yen (approximately $254 million); and in July 2005, we issued 40 billion yen (approximately $360 million). Each of these issuances has a five-year maturity. Proceeds were used for various corporate purposes. In October 2005, we used 30 billion yen of the July 2005 Samurai proceeds to pay in full the 1.55% Samurai notes issued in 2000.
In April 1999, the Parent Company issued $450 million of senior notes with a 10-year maturity. Proceeds were used for various corporate purposes. We entered into cross-currency swaps that effectively convert the dollar-denominated principal and interest of these notes into yen-denominated obligations. See Notes 1 and 4 of the Notes to the Consolidated Financial Statements for additional information on the cross-currency swaps.
The Japanese insurance industry has a policyholder protection system that provides funds for the policyholders of insolvent insurers. In 2002, the members of the Life Insurance Policyholder Protection Corporation (LIPPC) approved the Financial Services Agency's proposal, which required the industry to contribute additional funds to the policyholder protection fund. In 2005, legislation was enacted extending the LIPPC framework, which included government fiscal measures supporting the LIPPC through March 2009. These new measures do not contemplate additional industry assessments through March 2009 absent an event requiring LIPPC funds. The likelihood and timing of future assessments, if any, cannot be determined at this time.
The following table presents the estimated payments by period of our major contractual obligations as of December 31, 2005. We translated our yen-denominated obligations using the December 31, 2005, exchange rate. Actual future payments as reported in dollars will fluctuate with changes in the yen/dollar exchange rate.
The 2005 dividend of $.44 per share increased 15.8% over 2004. The 2004 dividend of $.38 per share increased 26.7% over 2003. Dividend payments by year were as follows:
Aflac is domiciled in Nebraska and is subject to its regulations. The Nebraska insurance department imposes certain limitations and restrictions on payments of dividends, management fees, loans and advances by Aflac to the Parent Company. The Nebraska insurance statutes require prior approval for dividend distributions that exceed the greater of the net gain 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, the Nebraska insurance department must approve service arrangements and other transactions within the affiliated group. These regulatory limitations are not expected to affect the level of management fees or dividends paid by Aflac 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.
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. In 2005, expenses allocated to Aflac Japan were $30 million, $26 million in 2004 and $22 million in 2003. During 2005, Aflac Japan also remitted profits of $374 million (41.2 billion yen) to Aflac U.S., compared with $220 million (23.9 billion yen) in 2004 and $385 million (45.6 billion yen) in 2003. Profits remitted in 2004 were lower primarily as a result of realized investment losses recognized in 2003. For additional information on regulatory restrictions on dividends, profit transfers and other remittances, see Note 10 of the Notes to the Consolidated Financial Statements.
In February 2006, the board of directors declared the first quarter cash dividend of $.13 per share. The dividend is payable on March 1, 2006, to shareholders of record at the close of business on February 17, 2006. In 2004, the board of directors authorized the purchase of up to 30 million shares of our common stock. As of December 31, 2005, approximately 17 million shares were available for purchase under our share repurchase program. In February 2006, the board of directors authorized the purchase of an additional 30 million shares.
Basis of Presentation: 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). The preparation of financial statements in conformity with GAAP requires us to make estimates when recording transactions resulting from business operations based on currently available information. The most significant items on our balance sheet that involve a greater degree of accounting estimates and actuarial determinations subject to changes in the future are the valuation of investments, deferred policy acquisition costs, and liabilities for future policy benefits and unpaid policy claims. These accounting estimates and actuarial determinations are sensitive to market conditions, investment yields, mortality, morbidity, commission and other acquisition expenses, and terminations by policyholders. As additional information becomes available, or actual amounts are determinable, the recorded estimates will be revised and reflected in operating results. Although some variability is inherent in these estimates, we believe the amounts provided are adequate.
Translation of Foreign Currencies: The functional currency of Aflac Japan's insurance operations is the Japanese yen. We translate our yen-denominated financial statement accounts into U.S. dollars as follows. Assets and liabilities are translated at end-of-period exchange rates. Realized gains and losses on security transactions are translated at the exchange rate on the trade date of each transaction. Other revenues, expenses and cash flows are translated using average exchange rates for the year. The resulting currency translation adjustments are reported in accumulated other comprehensive income. We include in earnings the realized currency exchange gains and losses resulting from transactions. Realized currency exchange gains and losses were immaterial during the three-year period ended December 31, 2005.
Investments: Our debt securities include fixed-maturity securities and perpetual debentures, which are classified as either held to maturity or available for sale. Securities classified as held to maturity are securities that we have the ability and intent to hold to maturity or redemption and are carried at amortized cost. All other debt securities and our equity securities are classified as available for sale and are carried at fair value. If the fair value is higher than the amortized cost for debt securities, or the purchase cost for equity securities, the excess is an unrealized gain, and if lower than cost, the difference is an unrealized loss.
Policy Liabilities: Future policy benefits represent claims that may occur in the future and are computed by a net level premium method using estimated future investment yields, persistency and recognized morbidity and mortality tables modified to reflect our experience, including a provision for adverse deviation. These assumptions are established at the time a policy is issued.
Earnings Per Share: We compute basic earnings per share (EPS) by dividing net earnings by the weighted-average number of shares outstanding for the period. Diluted EPS is computed by dividing net earnings by the weighted-average number of shares outstanding for the period plus the shares representing the dilutive effect of share-based awards.
Adjustments and Reclassifications: Certain adjustments have been made to prior-year balances and results of operations to reflect the adoption of SFAS 123R. Additionally, certain reclassifications have been made to prior-year amounts to conform to current-year reporting classifications. These reclassifications had no impact on net earnings or total shareholders' equity.
Operating business segments that are not individually reportable are included in the "Other business segments" category. We do not allocate corporate overhead expenses to business segments. We evaluate and manage our business segments using a financial performance measure called pretax operating earnings. Our definition of operating earnings as presented in this report excludes the following items from net earnings on an after-tax basis: realized investment gains/losses, the impact from SFAS 133, and nonrecurring items. We then exclude income taxes related to operations to arrive at pretax operating earnings. Information regarding operations by segment for the years ended December 31 follows:
Depreciation and amortization expenses, which are included in insurance expenses in the consolidated statements of earnings, were as follows for the years ended December 31:
Remittances from Aflac Japan: Aflac Japan makes payments to the Parent Company for management fees and to Aflac U.S. for allocated expenses and remittances of earnings. Information on remittances for each of the years ended December 31 is shown below. See Note 10 for information concerning restrictions on remittances from Aflac Japan.
Policyholder Protection Fund: The total liability accrued for our obligations to the Japanese life insurance policyholder fund was $203 million (23.9 billion yen) at December 31, 2005, compared with $254 million (26.5 billion yen) a year ago. The obligation is payable in semi-annual installments through 2013.
At December 31, 2005, we owned below-investment-grade debt securities in the amount of $1.1 billion at amortized cost ($886 million at fair value), or 2.3% of total debt securities, compared with $807 million at amortized cost ($740 million at fair value), or 1.8% of total debt securities a year ago. Each of the below-investment-grade securities was investment grade at the time of purchase and was subsequently downgraded by credit rating agencies. These securities are held in the available-for-sale portfolio.
As of December 31, 2005, $131 million, at fair value, of Aflac Japan's debt securities had been pledged to Japan's policyholder protection fund. At December 31, 2005, debt securities with a fair value of $13 million were on deposit with regulatory authorities in the United States and Japan. We retain ownership of all securities on deposit and receive the related investment income.
During the third quarter of 2004, we received an issuer's offer to redeem certain available-for-sale yen-denominated debt securities held by the Company. We accepted the issuer's offer of $205 million and recorded a pretax loss of $23 million. This investment loss and other investment gains and losses in the normal course of business decreased pretax earnings by $12 million (after-tax $5 million, or $.01 per diluted share).
The fair values and unrealized losses for debt and equity securities in a continuous unrealized loss position as of December 31, 2004, were as follows:
As part of our investment activities, we own investments in qualified special purpose entities (QSPEs). At December 31, 2005, available-for-sale QSPEs totaled $2.2 billion at fair value ($2.3 billion at amortized cost, or 5.0% of total debt securities), compared with $1.4 billion at fair value ($1.4 billion at amortized cost, or 3.0% of total debt securities) at December 31, 2004. We have no equity interests in any of the QSPEs, nor do we have control over these entities. Therefore, our loss exposure is limited to the cost of our investment.
The carrying amounts for cash and cash equivalents, receivables, accrued investment income, accounts payable, cash collateral and payables for security transactions approximated their fair values due to the short-term nature of these instruments. Consequently, such instruments are not included in the above table. The preceding table also excludes liabilities for future policy benefits and unpaid policy claims as these liabilities are not financial instruments as defined by GAAP.
We have outstanding cross-currency swap agreements related to the $450 million senior notes (see Note 6). We have designated the foreign currency component of these cross-currency swaps as a hedge of the foreign currency exposure of our investment in Aflac Japan. The notional amounts and terms of the swaps match the principal amount and terms of the senior notes.
We are exposed to credit risk in the event of nonperformance by counterparties to these contracts. The counterparties to our swap agreements are U.S. and Japanese financial institutions with the following credit ratings as of December 31:
In 2000, 2001 and 2002, the Parent Company issued yen-denominated Samurai notes, each of which had five-year maturities. In July 2005, the Parent Company issued an additional series of yen-denominated Samurai notes totaling 40 billion yen. In October 2005, we used 30 billion yen of the July 2005 Samurai proceeds to pay in full the 1.55% Samurai notes issued in 2000. Each series of Samurai notes may only be redeemed prior to maturity upon the occurrence of a tax event as specified in the respective bond agreement and are not available to U.S. residents or entities.
Changes in unrealized foreign currency translation gains/losses included deferred income tax expense of $122 million in 2005, compared with deferred income tax benefits of $31 million in 2004 and $111 million in 2003.
The American Jobs Creation Act of 2004 eliminated the 90% limitation on the utilization of foreign tax credits. As a result of this tax law change, we recognized a benefit of $128 million ($.25 per diluted share) for the release of the valuation allowance associated with certain deferred tax assets.
We exclude outstanding share-based awards from the calculation of weighted-average shares used in the computation of basic earnings per share. Stock options to purchase approximately 2.5 million shares as of December 31, 2005 were considered to be anti-dilutive and were excluded from the calculation of diluted earnings per share, compared with 1.1 million in 2004 and .3 million in 2003. The weighted-average shares used in calculating earnings per share for the years ended December 31 were as follows:
Long-Term Incentive Plans: The Company has two long-term incentive compensation plans. The first is a stock option plan, which allows grants for both incentive stock options (ISOs) and non-qualifying stock options (NQSOs) to employees and NQSOs to non-employee directors. The options have a term of 10 years and generally vest after three years. The strike price of options granted under this plan is equal to the fair market value at the date of grant. At December 31, 2005, 2.3 million shares were available for future grants under this plan.
The second long-term incentive compensation plan allows awards to Company employees for ISOs, NQSOs, restricted stock, restricted stock units, and stock appreciation rights. Non-employee directors are eligible for grants of NQSOs, stock appreciation rights, and restricted stock. Generally, the awards vest based upon time-based conditions or time-and-performance-based conditions. Performance-based vesting conditions generally include the attainment of goals related to Company financial performance. As of December 31, 2005, the only performance-based awards issued and outstanding were restricted stock awards. Awards granted under this plan during 2004 were not material. At December 31, 2005, approximately 24.6 million shares were available for future grants under this plan.
The following table presents the expense recognized in the following items as a result of applying the provisions of SFAS 123R for the periods ended December 31.
Net assets of the insurance subsidiaries aggregated $8.9 billion at December 31, 2005, on a GAAP basis, compared with $8.8 billion a year ago. Aflac Japan accounted for $5.5 billion, or 61.4%, of these net assets, compared with $5.4 billion, or 61.0% at December 31, 2004.
Capital and surplus (unaudited) of Aflac Japan, based on Japanese statutory accounting practices, aggregated $2.8 billion at December 31, 2005, and $2.9 billion at December 31, 2004. Japanese statutory accounting practices differ in many respects from U.S. GAAP. Under Japanese statutory accounting practices, premium income is recognized on a cash basis, policy acquisition costs are charged off immediately, policy benefit and claim reserving methods and assumptions are different, policyholder protection fund obligations are not accrued, and deferred income tax liabilities are recognized on a different basis.
The Parent Company depends on its subsidiaries for cash flow, primarily in the form of dividends and management fees. Consolidated retained earnings in the accompanying financial statements largely represent the undistributed earnings of our insurance subsidiary. Amounts available for dividends, management fees and other payments to the Parent Company by its insurance subsidiary may fluctuate due to different accounting methods required by regulatory authorities. These payments are also subject to various regulatory restrictions and approvals related to safeguarding the interests of insurance policyholders. Our insurance subsidiary must maintain adequate risk-based capital for U.S. regulatory authorities and our Japan branch must maintain adequate solvency margins for Japanese regulatory authorities. Additionally, the maximum amount of dividends that can be paid to the Parent Company by Aflac without prior approval of Nebraska's director of insurance is the greater of the net gain 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. Dividends declared by Aflac during 2006 in excess of $1.2 billion would require such approval. Dividends declared by Aflac during 2005 were $526 million.
The 2004 profit repatriation was lower due to the impact on Japanese regulatory earnings from the Parmalat loss that was realized in the fourth quarter of 2003 and our decision to leave capital in Japan in order to maintain a strong solvency margin.
Our basic employee defined-benefit pension plans cover substantially all of our full-time employees in the United States and Japan. At December 31, 2005, other liabilities included a liability for both plans in the amount of $65 million, compared with $60 million a year ago. The under-funded status of the plans was primarily attributable to steadily increasing pension benefit obligations. We plan to make contributions of $20 million to both the Japanese and U.S. plans in 2006 to continue to improve their funded status.
Stock Bonus Plan: Aflac U.S. maintains a stock bonus plan for eligible U.S. sales associates. Plan participants receive shares of Aflac Incorporated common stock based on their new annualized premium sales and their first-year persistency of substantially all new insurance policies. The cost of this plan, which is included in deferred policy acquisition costs, amounted to $37 million in 2005, $35 million in 2004, and $32 million in 2003.
We lease office space and equipment under various agreements that expire in various years through 2019. Future minimum lease payments due under non-cancelable operating leases at December 31, 2005, were as follows:
We have entered into an outsourcing agreement with IBM to provide mainframe computer operations and support for our Japanese operations. The agreement has a term of 10 years with an aggregate cost of 28.2 billion yen ($239 million using the December 31, 2005, exchange rate).
We have audited the accompanying consolidated balance sheets of Aflac Incorporated and subsidiaries (the Company) as of December 31, 2005 and 2004, and the related consolidated statements of earnings, shareholders' equity, cash flows, and comprehensive income for each of the years in the three-year period ended December 31, 2005. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Aflac Incorporated's internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 28, 2006 expressed an unqualified opinion on management's assessment of, and the effective operation of, internal control over financial reporting.