In Tokyo, Japan, Aflac has two primary campuses. The first campus includes a building that Aflac owns that serves as customer service center. The second campus comprises leased space, which serves as our Japan branch headquarters and houses administrative support functions for the Japan branch. Aflac also leases additional office space in Tokyo, along with regional offices located throughout the country.
(3) Includes a charge of $26 ($.05 per basic and diluted share) for the policyholder protection fund in 2002 in Japan
· new product development and customer response to new products and new marketing initiatives
· changes in U.S. and/or Japanese tax laws or accounting requirements
Aflac Incorporated (the Parent Company) and its subsidiaries (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. Our insurance operations in the United States and our branch in Japan service the two markets for our insurance business.
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-year period ended December 31, 2006. As a result, the following discussion should be read in conjunction with the related consolidated financial statements and notes.
· percentage decline in value and the length of time during which the decline has occurred
· adverse changes in the issuer’s availability of production resources, revenue sources and technological conditions
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 generally established at the 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. over the last three years. The ratio of unamortized DAC to annualized premiums in force has shown a slight upward trend for Aflac Japan for the last three years. This trend is a result of a greater proportion of our annualized premiums being under the alternative commission schedule, which pays a higher commission on first-year premiums and lower commissions on renewal premiums. This schedule is very popular with our new agents as it helps them with cash flow for personal and business needs as they build their
Our policy liabilities, which are determined in accordance with SFAS No. 60 and Actuarial Standards of Practice, include two primary components: future policy benefits and unpaid policy claims, which accounted for 90% and 5% of total policy liabilities as of December 31, 2006, respectively.
Future policy benefits provide for claims that will occur in the future and are generally calculated as the present value of future expected benefits to be incurred less the present value of future expected net benefit premiums. We calculate future policy benefits based on assumptions of morbidity, mortality, persistency and interest. These assumptions are generally established at the time a policy
is issued. The assumptions used in the calculations are closely related to those used in developing the gross premiums for a policy. As required by GAAP, we also include a provision for adverse deviation, which is intended to accommodate adverse fluctuations in actual experience.
Our insurance products provide fixed-benefit amounts that are not subject to medical-cost inflation. Furthermore, our business is widely dispersed in both the United States and Japan. This geographic dispersion and the nature of our benefit structure mitigate the risk of a significant unexpected increase in claims payments due to epidemics and events of a catastrophic nature. Claims incurred under Aflac’s policies are generally reported and paid in a relatively short time frame. The unpaid claims liability is sensitive to morbidity assumptions, in particular, severity and frequency of claims. Severity is the ultimate size of a claim, and frequency is the number of claims incurred. Our claims experience is primarily related to the demographics of our policyholders.
hospitalizations associated with the treatment of cancer. This shift reduced current period claims, and future period claims are anticipated to increase by similar amounts.
In computing the estimate of unpaid policy claims, we consider many factors, including the benefits and amounts available under the policy; the volume and demographics of the policies exposed to claims; and internal business practices, such as incurred date assignment and current claim administrative practices. We monitor these conditions closely and make adjustments to the liability as actual experience emerges. Claim levels are generally stable from period to period; however, fluctuations in claim levels may occur. In calculating the unpaid policy claim liability, we do not calculate a range of estimates. The following table shows the expected sensitivity of the unpaid policy claims liability as of December 31, 2006, to changes in severity and frequency of claims. For the years 2004 through 2006, and before the effect of the fourth quarter 2006 adjustments noted above, our assumptions changed on average by approximately 1% in total, and we believe that a variation in assumptions in a range of plus or minus 1% in total is reasonably likely to occur.
Our investment strategy is to invest in fixed-income securities to provide a reliable stream of investment income, which is one of the drivers of the Company’s profitability. 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.
In 2006, we realized pretax gains of $79 million (after-tax, $51 million, or $.10 per diluted share) primarily as a result of bond swaps and the liquidation of equity securities held by Aflac U.S. In 2005, we realized pretax gains of $262 million (after-tax, $167 million, or $.33 per diluted share) primarily as a result of bond swaps. We began our bond-swap program in the second half of 2005 and concluded it in the first half of 2006. These bond swaps took advantage of tax loss carryforwards and also resulted in an improvement in overall portfolio credit quality and investment income.
During the third quarter of 2006, we entered into interest rate swap agreements related to the 20 billion yen variable interest rate Uridashi notes (see Notes 4 and 7 of the Notes to the Consolidated Financial Statements). By entering into these contracts, we have been able to lock in the interest rate at 1.52% in yen. We have designated these interest rate swaps as a hedge of the variability in our interest cash flows associated with the variable interest rate Uridashi notes. The notional amounts and terms of the swaps match the principal amount and terms of the variable interest rate Uridashi notes, and the swaps had no value at inception. SFAS 133 requires that the change in the fair value of the swap contracts be recorded in other comprehensive income so long as the hedge is deemed effective. Any ineffectiveness is recognized in net earnings (other income). The impact from SFAS 133 would include any ineffectiveness associated with these interest rate swaps. The fair value of these swaps and related changes in fair value were immaterial during the year ended December 31, 2006. See Notes 1 and 4 of the Notes to the Consolidated Financial Statements for additional information.
assets. The 2005 and 2004 tax benefits are included as reductions to income tax expense in the consolidated statements of earnings.
During 2004, we concluded the process of returning the substitutional portion of Aflac Japan’s pension plan to the Japanese government as allowed by the Japan Pension Insurance Law. We recognized a one-time gain (other income) as the result of this transfer to the Japanese government in the amount of $6 million (after-tax, $3 million, or $.01 per diluted share) in 2004.
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.
Our combined U.S. and Japanese effective income tax rate on pretax earnings was 34.5% in 2006, 33.4% in 2005, and 28.6% in 2004. Total income taxes were $781 million in 2006, compared with $743 million in 2005 and $507 million in 2004. Japanese income taxes on Aflac Japan’s results account for most of our consolidated income tax expense. Our 2005 income tax rate was lower than normal primarily as a result of the release of the valuation allowance for non-life losses discussed previously. Our 2004 income tax rate and tax expense were also lower than normal as a result of the release of the valuation allowance for deferred tax assets discussed previously. See Note 8 of the Notes to the Consolidated Financial Statements for additional information.
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
We evaluate our sales efforts using new annualized premium sales, an industry operating measure. Total new annualized premium sales, which include new sales and the incremental increase in premiums due to conversions, represent the premiums that we would collect over a 12-month period, assuming the policies remain in force. Premium income, or earned premiums, is a financial performance measure that reflects collected or due premiums that have been earned ratably on policies in force during the reporting period.
Changes in Aflac Japan’s pretax operating earnings and profit margins are primarily affected by morbidity, mortality, expenses, persistency, and investment yields. The following table presents a summary of operating results for Aflac Japan.
The percentage increases in premium income reflect the growth of premiums in force. The increases in annualized premiums in force in yen of 5.4% in 2006 and 6.8% in both 2005 and 2004, reflect the high persistency of Aflac Japan’s business and the sales of new policies. Annualized premiums in force at December 31, 2006, were 1.08 trillion yen, compared with 1.03 trillion yen in 2005 and 961.9 billion yen in 2004. Annualized premiums in force, translated into dollars at respective year-end exchange rates, were $9.1 billion in 2006, $8.7 billion in 2005 and $9.2 billion in 2004.
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 37% of Aflac Japan’s investment income in 2006,
in 2007. Due to improvement in the benefit ratio, the pretax operating profit margin expanded to 15.8% in 2006. We expect continued expansion in the profit margin in 2007.
Aflac Japan’s total new annualized premium sales declined 8.8% in 2006. The sales decline primarily reflected industry-wide weakness in the market for stand-alone medical insurance as well as continued declines in the sale of Rider MAX. The following table presents Aflac Japan’s total new annualized premium sales for the years ended December 31.
Aflac Japan’s sales mix has been shifting during the last few years. The following table details the contributions to total new annualized premium sales by major product for the years ended December 31.
Recent events indicate that Japan’s economy has begun to recover. The Bank of Japan’s January 2007 Monthly Report of Recent Economic & Financial Developments stated that Japan’s economy is expanding moderately, noting increases in exports and capital expenditures and moderate increases in household income, private consumption and housing investment, all against the backdrop of high corporate profits and expansion of overseas economies. The report did note a downward trend related to public investment and projected the trend to continue. However, it also included an expectation that the economy would continue to expand moderately, supported by expectations of increasing exports and domestic private demand. Nevertheless, the time required for a full economic recovery remains uncertain.
Additionally, the FSA has implemented a new rule for third sector product reserving. The new reserving rule will be implemented in the Japanese fiscal year starting April 1, 2007. Under the new rule, we are required to conduct stress testing of our reserves using a prescribed method that incorporates actual incidence rates. The results of the tests and their relation to our reserves determine whether reserve strengthening is required. We do not anticipate that the new reserving requirements will have a material impact on our FSA-based financial statements or our pricing.
For 2006, total new annualized premium sales increased 13.1%, which exceeded our objective of 8% to 12% growth for the year. These record sales results were due, in part, to the re-enrollment of a large payroll account. 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.
Our objective for 2007 is to increase total new annualized premium sales by 6% to 10%.
The following table details the contributions to total new annualized premium sales by major product category for the years ended December 31.
One aspect of our growth strategy is the continued enhancement of our product line. During the third quarter of 2006, we launched revised specified health event and intensive care plans. In 2007 we will introduce an innovative care policy that provides benefits to help offset costs associated with caring for dependents as a result of their accident or illness.
Another aspect of our growth strategy is our focus on growing and improving our U.S. sales force, and we were encouraged to see continued expansion in 2006. Although we did not set a specific recruiting target for 2006, we continued to emphasize recruiting as a means for growing our producer base. We recruited more than 26,000 new associates during 2006, which was 7.8% higher than 2005. At December 31, 2006, Aflac U.S. was represented by more than 68,300 licensed sales associates, which was 8.5% higher than a year ago. Our primary focus has been on increasing producing sales associates. We believe that we can achieve better producer growth through more effective and standardized training for our sales associates and sales management. On an average weekly basis, the number of producing associates rose 6.4% in 2006 to approximately 10,300, compared with a year ago. As previously disclosed, our focus has shifted from average monthly producers to average weekly producers as both a reporting and management metric. This shift provides for a more active management of our sales associates and allows our sales management to monitor progress and needs on a real-time basis.
At December 31, 2006, the portfolio yield on Aflac’s U.S. portfolio was 7.15%, compared with 7.24% a year ago. See Investments and Cash on Page II-28 for additional information.
Corporate operating expenses consist primarily of personnel compensation, benefits, and facilities expenses. Corporate expenses, excluding investment income, were $57 million in 2006, $56 million in 2005, and $67 million in 2004. Investment income included in reported corporate expenses was $16 million in 2006, $14 million in 2005, and $5 million in 2004. Corporate expenses in 2004 were higher than normal primarily as a 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.
Our investment philosophy is to maximize investment income while emphasizing liquidity, safety and quality. Our investment objective, subject to appropriate risk constraints, is to fund policyholder obligations and other liabilities in a manner that enhances shareholders’ equity. We seek to achieve this objective through a diversified portfolio of fixed-income investments that reflects the characteristics of the liabilities it supports. Aflac invests primarily within the debt securities markets.
Realized losses on debt securities were as follows for the year ended December 31, 2006:
Notes payable totaled $1.4 billion at both December 31, 2006 and 2005. The ratio of debt to total capitalization (debt plus shareholders’ equity, excluding the unrealized gains and losses on investment securities) was 17.2% as of December 31, 2006, compared with 18.8% a year ago. See Note 7 of the Notes to the Consolidated Financial Statements for additional information.
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 increased the industry’s obligation 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.
Aflac has limited hedging activities. Our primary exposure to be hedged is our investment in Aflac Japan, which is affected by changes in the yen/dollar exchange rate. To mitigate this exposure, we have taken the following courses of action. First, Aflac Japan owns dollar-denominated securities, which serve as an economic currency hedge of a portion of our investment in Aflac Japan. Second, we have designated the Parent Company’s yen-denominated liabilities (Samurai and Uridashi notes payable and cross-currency swaps) as a hedge of our investment in Aflac Japan. If the total of these
During the third quarter of 2006, we entered into interest rate swap agreements related to the 20 billion yen variable interest rate Uridashi notes. By entering into these contracts, we have been able to lock in our interest rate at 1.52% in yen. We have designated these interest rate swaps as a hedge of the variability in our interest cash flows associated with the variable interest rate Uridashi notes. The notional amounts and terms of the swaps match the principal amount and terms of the variable interest rate Uridashi notes, and the swaps had no value at inception. Changes in the fair value of the swap contracts are recorded in other comprehensive income. The fair value of these swaps and related changes in fair value were immaterial during the year ended December 31, 2006.
As of December 31, 2006, we had no material unconditional purchase obligations that were not recorded on the balance sheet. Additionally, we had no material letters of credit, standby letters of credit, guarantees or standby repurchase obligations.
The following table presents the estimated payments by period of our major contractual obligations as of December 31, 2006. We translated our yen-denominated obligations using the December 31, 2006, exchange rate. Actual future payments as reported in dollars will fluctuate with changes in the yen/dollar exchange rate.
*Liability amounts are those reported on the consolidated balance sheet as of December 31, 2006.
The distribution of payments for future policy benefits is an estimate of all future benefit payments for policies in force as of December 31, 2006. These projected values contain assumptions for future policy persistency, mortality and morbidity. The distribution of payments for unpaid policy claims includes assumptions as to the timing of policyholders reporting claims for prior periods and the amount of those claims. Actual amounts and timing of both future policy benefits and unpaid policy claims payments may differ significantly from the estimates above. We anticipate that the future policy benefit liability of $40.8 billion at December 31, 2006, along with future net premiums and investment income, will be sufficient to fund future policy benefit payments.
Consolidated cash flow from operations was $4.4 billion in both 2006 and 2005, and $4.5 billion in 2004. The following table summarizes operating cash flows by source for the years ended December 31.
The decrease in Aflac Japan cash flows was due primarily to an increase in income tax payments in 2006 as a result of realized gains related to our bond-swap program.
Prudent portfolio management dictates that we attempt to match the duration of our assets with the duration of our liabilities. Currently, when debt securities we own mature, the proceeds may be reinvested at a yield below that required for the accretion of policy benefit liabilities on policies issued in earlier years. However, the long-term nature of our business and our strong cash flows provide us with the ability to minimize the effect of mismatched durations and/or yields identified by various asset adequacy analyses. When market opportunities arise, we dispose of selected debt securities that are available for sale to improve the duration matching of our assets and liabilities and/or improve future investment yields. As a result, dispositions before maturity can vary significantly from year to year. Dispositions before maturity were approximately 7% of the annual average investment portfolio of debt securities available for sale during the year ended December 31, 2006, compared with 11% in 2005 and 5% in 2004. The increase of dispositions before maturity in 2006 and 2005 primarily resulted from the bond swaps we executed from the third quarter of 2005 through the second quarter of 2006.
Consolidated cash used by financing activities was $434 million in 2006, $196 million in 2005 and $313 million in 2004. In September 2006, we received $382 million in connection with the Parent Company’s issuance of yen-denominated Uridashi notes. In June 2006, the Parent Company paid $355 million in connection with the maturity of the 2001 Samurai notes. In October 2005, we paid $261 million in connection with the maturity of the 2000 Samurai notes. In July 2005, the Parent Company received $360 million from its issuance of yen-denominated Samurai notes. Cash provided by investment-type contracts was $217 million in 2006, compared with $257 million in 2005 and $220 million in 2004.
Cash dividends paid in 2006 of $.55 per share increased 25.0% over 2005. The 2005 dividend of $.44 per share increased 15.8% over 2004. The following table presents the sources of dividends to shareholders for the years ended December 31.
Aflac is rated AA by both Standard & Poor’s and Fitch Ratings and Aa2 (Excellent) by Moody’s for financial strength. A.M. Best assigned Aflac an A+ (Superior) rating for financial strength and operating performance. Aflac Incorporated’s senior debt, Samurai notes, and Uridashi notes are rated A by Standard & Poor’s, A+ by Fitch Ratings, and A2 by Moody’s.
Income tax expense (benefit) related to items of other comprehensive income (loss)
Description of Business: Aflac Incorporated (the Parent Company) and its subsidiaries (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. Our insurance operations in the United States and our branch in Japan service the two markets for our insurance business. Aflac Japan accounted for 72% of the Company’s total revenues in 2006, 74% in 2005 and 75% in 2004, and 82% of total assets at both December 31, 2006 and 2005.
Our credit analysts and credit research personnel routinely monitor and evaluate the difference between the amortized cost and fair value of our investments. Additionally, credit analysis and/or credit rating issues related to specific investments may trigger more intensive monitoring to determine if a decline in fair value is other than temporary. For investments with a fair value below amortized cost, the process includes evaluating the length of time and the extent to which amortized cost exceeds fair value, the prospects and financial condition of the issuer, and our evaluation for a potential recovery in fair value, among other factors. This process is not exact and requires consideration of risks such as credit risk, which to a certain extent can be controlled, and interest rate risk, which cannot be controlled. Therefore, if an investment’s amortized cost exceeds its fair value solely due to changes in interest rates, impairment may not be appropriate. If, after monitoring and analyses, management believes that a decline in fair value is other than temporary, we adjust the amortized cost of the security and report a realized loss in the consolidated statements of earnings.
Derivatives: We have limited activity with derivative financial instruments. We do not use them for trading purposes, nor do we engage in leveraged derivative transactions. At December 31, 2006, our only outstanding derivative contracts were interest rate swaps related to our 20 billion yen variable interest rate Uridashi notes and cross-currency swaps related to our $450 million senior notes (see Notes 4 and 7).
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value under GAAP, and expands disclosures about fair value measurements. This standard applies to other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, SFAS 157 does not require any new fair value measurements. Where applicable, this standard simplifies and codifies related guidance within GAAP. SFAS 157 is effective for fiscal years beginning after November 15, 2007, with earlier application encouraged under limited circumstances. We do not expect the adoption of this standard to have a material effect on our financial position or results of operations.
In June 2006, the FASB issued FASB Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109. The provisions of FIN 48 clarify the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in
financial statements is not permitted. The adoption of this standard is not expected to have a significant impact on our financial position or results of operations.
In December 2004, the 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 establishes the accounting for grants of share-based awards in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or transactions that may be settled by the issuance of those equity instruments. SFAS 123R requires that companies use a fair value method to value share-based awards and recognize the related compensation expense in net earnings. The provisions of SFAS 123R, as amended by the Securities and Exchange Commission, were effective as of the beginning of the first fiscal year after June 15, 2005, although earlier application was encouraged. In accordance with the standard’s early adoption provisions, we began accounting for share-based awards using the modified-retrospective application method effective January 1, 2005.
*Includes charges of $46 in 2005 and $26 in 2004 related to the write-down of previously capitalized systems development costs for Aflac Japan’s administration system.
Yen-Translation Effects: The following table shows the yen/dollar exchange rates used for or during the periods ended December 31. Exchange effects were calculated using the same yen/dollar exchange rate for the current year as for each respective prior year.
Transfers of funds from Aflac Japan: Aflac Japan makes payments to the Parent Company for management fees and to Aflac U.S. for allocated expenses and profit repatriations. Information on transfers for each of the years ended December 31 is shown below. See Note 11 for information concerning restrictions on transfers from Aflac Japan.
Receivables: Receivables consisted primarily of monthly insurance premiums due from individual policyholders or their employers for payroll deduction of premiums. At December 31, 2006, $221 million, or 41.4% of total receivables, were related to Aflac Japan’s operations, compared with $192 million, or 40.0%, at December 31, 2005.
**For this issuer, we own more than one security with different ratings.
As of December 31, 2006, $91 million, at fair value, of Aflac Japan’s debt securities had been pledged to Japan’s policyholder protection fund. At December 31, 2006, 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.
The following table shows the gross unrealized losses and fair value of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2006.
The unrealized losses on the other investment categories in the preceding table were caused by changes in interest rates, yen/dollar exchange rates, and/or increased credit spreads. For credit related declines in market value, we begin a more focused review of the related issuer including more significantly, issuer credit ratings, issuer financial statements and other available financial data, timeliness of payment and issuer competitive environment. From those reviews, we evaluate the issuer's continued ability to service our investment. If, based on our reviews, we determine that the issuer has the ability to continue to service our investment; we conclude that the investment is temporarily impaired. Because we have the ability and intent to hold these investments until a recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2006.
The following table shows the gross unrealized losses and fair value of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2005.
The net effect on shareholders’ equity of unrealized gains and losses from investment securities at December 31 was as follows:
The contractual maturities of our investments in fixed maturities at December 31, 2006, were as follows:
The Parent Company has a portfolio of investment-grade available-for-sale fixed-maturity securities totaling $103 million at amortized cost and $102 million at fair value, which is not included in the table above.
During 2005, we reclassified an investment from held to maturity to available for sale as a result of the issuer’s credit rating downgrade. This debt security had an amortized cost of $254 million at the date of transfer.
The methods of determining the fair values of our investments in debt and equity securities are described in Note 3. The fair values of notes payable with fixed interest rates were obtained from an independent financial information service. The fair values of our cross-currency swaps are the expected amounts that we would receive or pay to terminate the swaps, taking into account current interest rates, foreign currency rates and the current creditworthiness of the swap counterparties. The fair value of the Japanese policyholder protection fund is our estimated share of the industry’s obligation calculated on a pro rata basis by projecting our percentage of the industry’s premiums and reserves and applying that percentage to the total industry obligation payable in future years.
The components of the fair value of the cross-currency swaps were reflected as an asset or (liability) in the balance sheet as of December 31 as follows:
We have entered into interest rate swap agreements related to the 20 billion yen variable interest rate Uridashi notes (see Note 7). By entering into these contracts, we have been able to lock in the interest rate at 1.52% in yen. We have designated these interest rate swaps as a hedge of the variability in our interest cash flows associated with the variable interest rate Uridashi notes. The notional amounts and terms of the swaps match the principal amount and terms of the variable interest rate Uridashi notes. The swaps had no value at inception. Changes in the fair value of the swap contracts are recorded in other comprehensive income. The fair value of these swaps and related changes in fair value were immaterial during the year ended December 31, 2006.
Deferred Policy Acquisition Costs and Insurance Expenses: Consolidated policy acquisition costs deferred were $1.05 billion in 2006, compared with $1.00 billion in 2005, and $962 million in 2004. The following table presents a rollforward of deferred policy acquisition costs by segment for the years ended December 31.
Other amortization expense in 2005 and 2004 included the write-down of previously capitalized systems development costs for Aflac Japan’s administration system ($46 million before taxes in 2005 and $26 million before taxes in 2004).
Our policy liabilities primarily include future policy benefits and unpaid policy claims, which accounted for 90% and 5% of total policy liabilities at December 31, 2006, respectively. We regularly review the adequacy of our policy liabilities in total and by component. The liability for future policy benefits as of December 31 consisted of the following:
The weighted-average interest rates reflected in the consolidated statements of earnings for future policy benefits for Japanese policies were 4.7% in 2006, 4.8% in 2005, and 4.9% in 2004; and for U.S. policies, 6.3% in 2006 and 6.4% in 2005 and 2004.
In August 2006, the Parent Company filed a Shelf Registration Statement (SRS) with Japanese regulatory authorities to issue up to 100 billion yen of yen-denominated Uridashi notes in Japan. In September 2006, the Parent Company issued three tranches of Uridashi notes totaling 45 billion yen. The first tranche totaled 15 billion yen and has a five-year maturity. The second tranche totaled
For our yen-denominated loans, the principal amount as stated in dollar terms will fluctuate from period to period due to changes in the yen/dollar exchange rate. We have designated all of our yen-denominated notes payable as a hedge of the foreign currency exposure of our investment in Aflac Japan. We have also designated the interest rate swaps on our variable interest rate Uridashi notes as a hedge of the variability in our interest cash flows associated with these notes.
The SRS we filed with Japanese regulatory authorities in 2003 expired in December 2005. As a result, the Parent Company filed a new SRS with Japanese regulatory authorities in February 2006 to issue up to 100 billion yen of yen-denominated Samurai notes in Japan. If issued, these securities will not be available to U.S. persons.
The aggregate contractual maturities of notes payable during each of the years after December 31, 2006, are as follows:
We were in compliance with all of the covenants of our notes payable at December 31, 2006. No events of default or defaults occurred during 2006 and 2005.
Changes in unrealized foreign currency translation gains/losses included deferred income tax expense of $11 million in 2006, compared with deferred income tax expense of $122 million in 2005 and deferred income tax benefit of $31 million in 2004.
We received regulatory approval for a change in the allocation of expenses under the management fee agreement between Aflac and the Parent Company in 2005. This enabled the Parent Company to fully utilize its tax-basis, non-life operating losses and therefore release the valuation allowance on the associated deferred tax assets, resulting in a benefit of $34 million ($.07 per diluted share) in 2005.
Voting Rights: In accordance with the Parent Company’s articles of incorporation, shares of common stock are generally entitled to one vote per share until they have been held by the same beneficial owner for a continuous period of 48 months, at which time they become entitled to 10 votes per share.
The Company has two long-term incentive compensation plans. The first is a stock option plan, which allows grants for incentive stock options (ISOs) to employees and non-qualifying stock options (NQSOs) to employees and 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 of a share of our common stock at the date of grant. At December 31, 2006, approximately 26 thousand shares were available for future grants under this plan.
As of December 31, 2006, the aggregate intrinsic value of stock options outstanding was $333 million, with a weighted-average remaining term of 5.4 years. The aggregate intrinsic value of stock options exercisable at that same date was $317 million, with a weighted-average remaining term of 4.5 years. The total intrinsic value of stock options exercised during the year ended December 31, 2006, was $62 million, compared with $114 million in 2005 and $57 million in 2004. We received cash from the exercise of stock options in the amount of $38 million in 2006, compared with $49 million in 2005 and $32 million in 2004. The tax benefit realized as a result of stock option exercises was $19 million in 2006 and $37 million in 2005. Due to the effect of the valuation allowance in 2004, the tax benefit realized from stock option exercises was immaterial (see Note 8).
Reconciliations of Aflac’s net assets on a GAAP basis to capital and surplus determined on a U.S. statutory accounting basis as of December 31 were as follows:
Aflac Japan must report its results of operations and financial position to the Japanese Financial Services Agency (FSA) on a Japanese regulatory accounting basis as prescribed by the FSA. Capital and surplus (unaudited) of Aflac Japan, based on Japanese regulatory accounting practices, aggregated $2.6 billion at December 31, 2006, and $2.8 billion at December 31, 2005. Japanese regulatory accounting practices differ in many respects from U.S. GAAP. Under Japanese regulatory accounting practices, policy acquisition costs are charged off immediately; deferred income tax liabilities are recognized on a different basis; policy benefit and claim reserving methods and assumptions are different; the carrying value of securities transferred to held to maturity is different; policyholder protection fund obligations are not accrued; and premium income is recognized on a cash basis.
A portion of Aflac Japan earnings, as determined on a Japanese regulatory accounting basis, can be repatriated each year to Aflac U.S. after complying with solvency margin provisions and satisfying various conditions imposed by Japanese regulatory authorities for protecting policyholders. Profit repatriations to the United States can fluctuate due to changes in the amounts of Japanese regulatory earnings. Among other items, factors affecting regulatory earnings include Japanese regulatory accounting practices and fluctuations in currency translation of Aflac Japan’s dollar-denominated investments and related investment income into yen. Profits repatriated by Aflac Japan to Aflac U.S. were as follows for the years ended December 31:
Our basic employee defined-benefit pension plans cover substantially all of our full-time employees in the United States and Japan. At December 31, 2006, other liabilities included a liability for both plans in the amount of $102 million, compared with $65 million a year ago. The increase in the pension liability is due principally to the adoption of SFAS 158. We plan to make contributions of $20 million to the U.S. plan and $13 million to the Japanese plan in 2007 to continue to improve their funded status.
The incremental effects of adopting the provisions of SFAS 158 on our consolidated balance sheets, statements of shareholders’ equity and statements of comprehensive income at
December 31, 2006 are presented in the following table. Had we not adopted SFAS 158 at December 31, 2006, we would have recognized an additional minimum liability under the provisions of SFAS 87. The effect of recognizing the additional minimum liability is included in the table below in the column labeled “Prior to Application of SFAS 158.”
The investment objective of our U.S. and Japanese plans is to preserve the purchasing power of the plan’s assets and earn a reasonable inflation adjusted rate of return over the long term. Furthermore, we seek to accomplish these objectives in a manner that allows for the adequate funding of plan benefits and expenses. In order to achieve these objectives, our goal is to maintain a conservative, well-diversified and balanced portfolio of high-quality equity, fixed-income and money market securities. As a part of our strategy, we have established strict policies covering quality, type and concentration of investment securities. For our U.S. plan, these policies prohibit investments in precious metals, limited partnerships, venture capital, and direct investments in real estate. We are also prohibited from trading on margin. For our Japanese plan, these policies include limitations on investments in derivatives including futures, options and swaps, and low-liquidity investments such as real estate, venture capital investments, and privately issued securities.
We monitor the U.S. plan’s performance over a three- to five-year period utilizing shorter time frame performance measures to identify trends. We review investment performance and compliance with stated investment policies and practices on a quarterly basis. The specific investment objectives for the U.S. pension plan are: to exceed a composite of asset class target returns, weighted according to the plan’s target asset allocation; and to outperform the median fund from a universe of similarly managed corporate pension funds. Both objectives are measured over a rolling five-year period. We monitor the Japanese plan’s performance and compliance with stated investment policies and practices on a quarterly basis.
During 2005, the Japanese plan was amended. As a result of this amendment, participant salary and future salary increases are not factors in determining pension benefit cost or the related pension benefit obligation and accumulated benefit obligation.
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 $40 million in 2006, $37 million in 2005, and $35 million in 2004.
We have also entered into an outsourcing agreement with Accenture to provide application maintenance and development services for our Japanese operation. The agreement has a term of seven years with an aggregate cost of 5.3 billion yen ($45 million using the December 31, 2006, exchange rate).
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Aflac Incorporated and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.