In Tokyo, Japan, Aflac has three primary campuses. The first campus includes a building, owned by Aflac, for the customer call center, the claims department, information technology departments, and training facility. It also includes a leased property, which houses our policy administration and customer service departments. The second campus comprises leased space, which serves as Aflac Japan's headquarters and houses administrative and investment support
functions for the Japan branch. The third campus comprises leased space for the information technology departments. Aflac also leases additional office space in Tokyo, along with regional offices located throughout the country.
The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” to encourage companies to provide prospective information, so long as those informational statements are identified as forward-looking and are accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those included in the forward-looking statements. We desire to take advantage of these provisions. This report contains cautionary statements identifying important factors that could cause actual results to differ materially from those projected herein, and in any other statements made by Company officials in communications with the financial community and contained in documents filed with the Securities and Exchange Commission (SEC). Forward-looking statements are not based on historical information and relate to future operations, strategies, financial results or other developments. Furthermore, forward-looking information is subject to numerous assumptions, risks and uncertainties. In particular, statements containing words such as “expect,” “anticipate,” “believe,” “goal,” “objective,” “may,” “should,” “estimate,” “intends,” “projects,” “will,” “assumes,” “potential,” “target”, "outlook" or similar words as well as specific projections of future results, generally qualify as forward-looking. Aflac undertakes no obligation to update such forward-looking statements.
failure to execute or implement the conversion of the Japan branch conversion to a legal subsidiary
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, 2016. As a result, the following discussion should be read in conjunction with the related consolidated financial statements and notes. This MD&A is divided into the following sections:
For more information on our business, see Business, Part I, Item 1 of this report.
Reflecting the stronger yen/dollar exchange rate, total revenues increased 8.1% to $22.6 billion in 2016, compared with $20.9 billion in 2015. Net earnings in 2016 were $2.7 billion, or $6.42 per diluted share, compared with $2.5 billion, or $5.85 per diluted share, in 2015.
Results for 2016 included pretax net realized investment losses of $123 million ($80 million after-tax), compared with net realized investment gains of $140 million ($91 million after-tax) in 2015. Net investment losses in 2016 consisted of $215 million of net gains ($140 million after-tax) from the sale or redemption of securities; $83 million ($54 million after-tax) of other-than-temporary impairment losses; and $255 million of net losses ($166 million after-tax) from valuing derivatives.
Shareholders' equity included a net unrealized gain on investment securities and derivatives of $4.8 billion at December 31, 2016, compared with a net unrealized gain of $3.0 billion at December 31, 2015.
In December 2016, the Parent Company completed a tender offer in which it extinguished $176 million principal of its 6.90% senior notes due 2039 and $193 million principal of its 6.45% senior notes due 2040. The pretax loss due to the early redemption of these notes was $137 million.
In September 2016, the Parent Company issued $700 million of senior notes through a U.S. public debt offering and also entered into a 5.0 billion yen loan and a 25.0 billion yen loan. In September 2016, we extinguished 8.0 billion yen of 2.26% fixed rate Uridashi notes upon their maturity and in July 2016, we extinguished 15.8 billion yen of 1.84% fixed rate Samurai notes upon their maturity.
We repurchased 21.6 million shares of our common stock in the open market for $1.4 billion under our share repurchase program in 2016, compared with 21.2 million shares repurchased in 2015.
Aflac's investments, primarily consisting of debt, perpetual and equity securities, include both publicly issued and privately issued securities. For publicly issued securities, we determine the fair values from quoted market prices readily available from public exchange markets and price quotes and valuations from third party pricing vendors. For the majority of privately issued securities within our investment portfolio, a third party pricing vendor has developed valuation models that we utilize to determine fair values. For the remaining privately issued securities, we use non-binding price quotes from outside brokers.
We also routinely review our investments that have experienced declines in fair value to determine if the decline is other than temporary. 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. We must apply considerable judgment in determining the likelihood of the security recovering in value while we own it. Factors that may influence this include our assessment of the issuer’s ability to continue making timely payments of interest and principal, the overall level of interest rates and credit spreads, and other factors. This process requires consideration of risks, which can be controlled to a certain extent, such as credit risk, and risks which cannot be controlled, such as interest rate risk. Management updates its evaluations regularly and reflects impairment losses in the Company's net earnings or other comprehensive income, depending on the nature of the loss, as such evaluations are revised.
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, 2016, to changes in severity and frequency of claims.
Other policy liabilities, which accounted for 15% of total policy liabilities as of December 31, 2016, consisted primarily of discounted advance premiums on deposit from policyholders in conjunction with their purchase of certain Aflac Japan insurance products. These advanced premiums are deferred upon collection and recognized as premium revenue over the contractual premium payment period. Advanced premiums represented 38% and 43% of the December 31, 2016 and 2015 other policy liabilities balances, respectively. See the Aflac Japan segment subsection of this MD&A for further information.
The following table is a reconciliation of items impacting operating earnings, net earnings, operating earnings per diluted share, and net earnings per diluted share to the most directly comparable U.S. GAAP measures for the years ended December 31.
(1) Prior year amounts have been reclassified to reflect the change in methodology of calculating the hedge costs related to foreign currency investments. See "Hedge Costs" discussion below for further discussion.
(2) Excludes a gain of $85 in both 2016 and 2015 and $44 in 2014 related to the interest rate component of the change in fair value of foreign currency swaps on notes payable which is classified as an operating gain when analyzing segment operations
(5) Amounts excluding current period foreign currency impact are computed using the average yen/dollar exchange rate for the comparable prior-year period, which eliminates dollar-based fluctuations driven solely from currency rate changes.
During 2014, we realized pretax investment gains, net of losses, of $215 million ($140 million after-tax) from sales and redemptions of securities. These net gains primarily resulted from gains on sales of JGBs and our U.S. Treasury holdings, currency gains from transactions by our externally managed portfolio of U.S. dollar-denominated bank loans, and assorted
other bond sales and calls. We realized pretax investment losses of $31 million ($20 million after-tax) as a result of the recognition of other-than-temporary impairment losses on certain securities.
Our derivative instruments include foreign currency swaps and credit default swaps held in consolidated VIEs; foreign currency forwards and options, interest rate swaptions and futures on certain fixed-maturity securities; foreign currency forwards and options that economically hedge certain portions of forecasted cash flows denominated in yen; and foreign currency swaps associated with certain senior notes and our subordinated debentures. During 2016, we realized pretax investment losses, net of gains, of $255 million, compared with pretax investment losses, net of gains, of $10 million in 2015 and pretax investment gains, net of losses, of $31 million in 2014 as a result of valuing these derivatives, net of the effects of hedge accounting. For a description of other items that could be included in the Impact of Derivative and Hedging Activities, see the Hedging Activities subsection of MD&A and Note 4 of the accompanying Notes to the Consolidated Financial Statements.
Due to the size of Aflac Japan, where our functional currency is the Japanese yen, fluctuations in the yen/dollar exchange rate can have a significant effect on our reported results. In periods when the yen weakens, translating yen into dollars results in fewer dollars being reported. When the yen strengthens, translating yen into dollars results in more dollars being reported. Consequently, yen weakening has the effect of suppressing current period results in relation to the comparable prior period, while yen strengthening has the effect of magnifying current period results in relation to the comparable prior period. As a result, we view foreign currency translation as a financial reporting issue for Aflac rather than an economic event to our Company or shareholders.
We believe that our efforts will continue our prudent strategies for capital deployment, as well as our ongoing commitment to customer service, product innovation and distribution enhancement.
Annualized premiums in force at December 31, 2016, were 1.61 trillion yen, compared with 1.62 trillion yen in 2015 and 1.59 trillion yen in 2014. The decrease in annualized premiums in force in yen of .7% in 2016 reflects the net effect of sales of new policies combined with limited-pay policies becoming paid-up and the persistency of Aflac Japan’s business.
The increases in annualized premiums in force in yen of 1.5% in 2015 and 1.7% in 2014 reflect the sales of new policies combined with the high persistency of Aflac Japan's business. Annualized premiums in force, translated into dollars at respective year-end exchange rates, were $13.8 billion in 2016, $13.4 billion in 2015, and $13.2 billion in 2014.
(2)Amounts excluding foreign currency impact on U.S. dollar-denominated items (a non-U.S. GAAP measure) were determined using the same yen/dollar exchange rate for the current year as each respective prior year.
Cancer insurance sales on a yen basis were up 8.5% in 2016, compared with 2015. Aflac Japan enhanced its medical insurance product with new riders in June 2015. This revision provides better protection against critical diseases such as cancer, heart attack and stroke. Our 2016 sales results also benefited from the launch of a new Income Support Insurance product in mid-July. This product provides fixed-benefit amounts in the event that a policyholder is unable to work due to significant illness or injury and was developed to supplement the disability coverage within Japan’s social security system. This product targets young to middle-aged consumers, and by focusing our efforts on this demographic, we believe we are building relationships that lay the groundwork for the sale of our cancer and medical insurance later in life to the Income Support policyholders. With continued cost pressure on Japan’s health care system, we expect the need for third sector products will continue to rise in the future, and we remain convinced that the medical and cancer insurance products Aflac Japan provides will continue to be an important part of our product portfolio.
Japan Post has expanded the number of post offices that offer Aflac's cancer insurance products from 10,000 in the fourth quarter of 2014 to more than 20,000 postal outlets as of July 2015. We believe this alliance with Japan Post has and will further benefit our cancer insurance sales.
In June 2013, a revision to the Financial Instruments and Exchange Act established a post-funded Orderly Resolution Regime for financial institutions to prevent a financial crisis in the event of a financial institution’s failure. This regime came into effect in March 2014 and has not had, and is not expected to have, a material impact on the Company's operations in Japan.
Starting in 2015, Aflac Japan added investments in dividend-focused yen-denominated publicly traded equity securities, including investments in exchange traded funds (ETFs) holding Japan real estate investment trusts. In 2016, Aflac Japan invested $258 million in yen-denominated publicly traded equity securities, which are classified as available for sale and carried on the balance sheet at fair value.
Funds available for investment include cash flows from operations, investment income, and funds generated from maturities, redemptions, securities lending, and other securities transactions. Securities lending is also used from time to time to accelerate the availability of funds for investment. Purchases of securities from period to period are determined based on multiple objectives including appropriate portfolio diversification, the relative value of a potential investment and availability of investment opportunities, liquidity, credit and other risk factors while adhering to our investment policy guidelines. Aflac Japan purchased debt security investments at an aggregate acquisition cost of approximately 1.0 trillion yen in 2016 (approximately $9.1 billion), 663.6 billion yen in 2015 (approximately $5.5 billion) and 1.0 trillion yen in 2014 (approximately $10.0 billion).
(2) Includes fixed maturities and perpetual securities, loan receivables, and equities
On January 1, 2016, the company revised its definition of purchases to include the reinvestment of proceeds related to unplanned sale activity. New purchases include all purchases related to fixed maturities and perpetuals, loan receivables, and equities. Securities lending/repurchase agreement activity and capital contributions to alternatives are excluded. The definition of new money yield has also been revised to reflect this change. Yields for equities are based on the assumed dividend yield at the time of purchase. Historical amounts have been revised to reflect the new definitions.
The following table presents the composition of total investments by sector, at cost or amortized cost, and cash for Aflac Japan ($91.9 billion in 2016 and $85.1 billion in 2015) as of December 31.
(1)Includes 1.4% and 1.9% of perpetual securities at December 31, 2016 and 2015, respectively
The overall credit quality of Aflac Japan's investments remained high. At the end of 2016, 94.8% of Aflac Japan's debt and perpetual securities were rated investment grade, on an amortized cost basis.
Annualized premiums in force increased 2.4% in 2016, 1.6% in 2015 and 1.8% in 2014. Annualized premiums in force at December 31 were $5.9 billion in 2016, compared with $5.8 billion in 2015 and $5.7 billion in 2014.
In 2016, our traditional U.S. sales forces included more than 9,000 U.S. associates who were actively producing business on a weekly basis. We believe that the average weekly producer equivalent metric allows our sales management to monitor progress and needs. In 2016, sales through employers with less than 100 workers were relatively flat. In 2017, we will continue to focus our career sales agents on selling to this segment.
Our products provide cash benefits that can be used to help with increasing out-of-pocket medical expenses, help cover household costs, or protect against income and asset loss. Our group products and relationships with insurance brokers that handle the larger-case market are helping us as we expand our reach selling to larger businesses. We are regularly evaluating the marketplace to identify opportunities to bring the most relevant, cost-effective products to our customers. We believe the need for our products remains very strong, and we continue to work on enhancing our distribution capabilities to access employers of all sizes, including initiatives that benefit our field force and the broker community. At the same time, we are seeking opportunities to leverage our brand strength and attractive product portfolio in the evolving health care environment.
The Affordable Care Act (ACA), federal health care reform legislation, is intended to give Americans of all ages and income levels access to comprehensive major medical health insurance and gave the U.S. federal government direct regulatory authority over the business of health insurance. The reform included major changes to the U.S. health care insurance marketplace. Among other changes, the reform legislation included an individual medical insurance coverage mandate, provided for penalties on certain employers for failing to provide adequate coverage, created health insurance exchanges, and addressed coverage and exclusions as well as medical loss ratios. It also imposed an excise tax on certain high cost plans, known as the “Cadillac tax,” that is currently scheduled to begin in 2020. The legislation also included changes in government reimbursements and tax credits for individuals and employers and alters federal and state regulation of health insurers. At this time it is unclear whether implementation of the ACA will continue. While the ACA was enacted in 2010, the major elements of the law became effective on January 1, 2014. We believe that the ACA, as enacted, does not require material changes in the design of our insurance products. However, indirect consequences of the legislation and regulations could present challenges and/or opportunities that could potentially have an impact on our sales model, financial condition and results of operations.
Penn Treaty Network Company and its subsidiary American Network Insurance Company (collectively referred to as Penn Treaty) is a financially distressed long-term care insurance company, with no affiliation to us. Penn Treaty was placed in rehabilitation on January 6, 2009, and remained in rehabilitation as of December 31, 2016. Under state laws, health insurers will be assessed a share of the guarantee funds needed to protect Penn Treaty’s policyholders. This charge will be funded over several years and the cash will be largely recovered through premium tax credits over time. Current accounting practice only allows this charge to be recognized when a final court order of liquidation is declared, a condition that had not been met as of December 31, 2016. We expect to accrue a charge of between $10 million and $20 million, in future periods, for our portion of the assessment.
Historically, Aflac U.S. has invested primarily in investment grade corporate bonds. In 2015, as part of the Company's portfolio management and asset allocation process, Aflac U.S. purchased high yield corporate bonds and senior secured middle market loan receivables and initiated a senior secured commercial mortgage loan investment program. In addition, in the fourth quarter of 2016, Aflac U.S. initiated an infrastructure debt program. In 2016, Aflac U.S. invested $18 million in high yield corporate bonds; $207 million in middle market loan receivables, of which $41 million was unfunded; $111 million in commercial mortgage loans; and $2 million in infrastructure debt. As of December 31, 2016, the Company had $303 million in outstanding commitments to fund potential future loan originations related to the middle market loan investment program. This commitment is contingent upon the availability of middle market loans that meet underwriting criteria. See Notes 1 and 3 of the Notes to the Consolidated Financial Statements for more information regarding loans and loans receivables.
Funds available for investment include cash flows from operations, investment income, and funds generated from maturities, redemptions, and other securities transactions. Purchases of securities from period to period are determined based on multiple objectives, including appropriate portfolio diversification, the relative value of a potential investment and availability of investment opportunities, liquidity, credit and other risk factors while adhering to our investment policy guidelines. Aflac U.S. purchased debt, equity, and loan receivable investments at an aggregate acquisition cost of approximately $1.1 billion in 2016, compared with $900 million in 2015 and $1.0 billion in 2014.
The decrease in the Aflac U.S. new money yield in 2016 was primarily due to lower U.S. interest rates during much of the investment period.
The following table presents the composition of total investments by sector, at cost or amortized cost, and cash for Aflac U.S. ($14.1 billion in 2016 and $13.7 billion in 2015) as of December 31.
Corporate operating expenses consist primarily of personnel compensation, benefits, reinsurance retrocession activities, and facilities expenses. Corporate expenses, excluding investment and retrocession income, were $141 million in 2016, $90 million in 2015 and $91 million in 2014. Investment income included in reported corporate expenses was $18 million in 2016, $22 million in 2015 and $13 million in 2014, and net retrocession income was $7 million in 2016 and 2015.
The following table demonstrates the effect of the change in the yen/dollar exchange rate by comparing select balance sheet items as reported at December 31, 2016, with the amounts that would have been reported had the exchange rate remained unchanged from December 31, 2015.
(2)The exchange rate at December 31, 2016, was 116.49 yen to one dollar, or 3.5% stronger than the December 31, 2015, exchange rate of 120.61.
(1)Excludes available-for-sale fixed-maturity securities held by the Parent Company and other business segments of $607 in 2016 and$523 in 2015.
Other investments primarily consisted of loan receivables that are recorded at amortized cost on the acquisition date and are carried at adjusted amortized cost. The adjusted amortized cost of the loan receivables reflects allowances for expected incurred losses estimated based on past events and current economic conditions as of each reporting date. See the Loans and Loan Receivables section in Note 3 of the Notes to the Consolidated Financial Statements for further discussion of these investments.
As of December 31, 2016, our direct and indirect exposure to securities in our investment portfolio that were guaranteed by third parties was immaterial both individually and in the aggregate.
Aflac Japan has a portfolio of privately issued securities to better match liability characteristics and secure higher yields than those available on Japanese government or other public corporate bonds. Aflac Japan’s investments in yen-denominated privately issued securities consist primarily of non-Japanese issuers, are rated investment grade at purchase and have longer maturities, thereby allowing us to improve our asset/liability matching and our overall investment returns. These securities are generally either privately negotiated arrangements or issued under medium-term note programs and have standard documentation commensurate with credit ratings of the issuer, except when internal credit analysis indicates that additional protective and/or event-risk covenants were required. Many of these investments
have protective covenants appropriate to the specific investment. These may include a prohibition of certain activities by the borrower, maintenance of certain financial measures, and specific conditions impacting the payment of our notes.
We use specific criteria to judge the credit quality of both existing and prospective investments. The ratings referenced in the tables below are based on the ratings designations provided by the major credit rating agencies (Moody's, S&P, and Fitch) or, if not rated, are determined based on our internal credit analysis of such securities. When the ratings issued by the rating agencies differ, we utilize the second lowest rating, regardless of how many of the three rating agencies actually rated the instrument. Split-rated securities are those where the ratings are not equivalent and one or more of the ratings is investment grade and one or more is below investment grade. For these split-rated securities, if there are only two ratings assigned by the credit rating agencies, we take the lower below-investment-grade rating. If there are three ratings assigned, and two of the three are below investment grade, we consider it a below-investment-grade security. If there are three ratings and two are investment grade, we consider it an investment grade security unless our evaluation and assessment shows a below-investment-grade rating is warranted despite two of the three rating agencies rating it investment grade.
Our portfolio of below-investment-grade securities includes debt securities purchased while the issuer was rated investment grade plus other loans and bonds purchased as part of an allocation to that segment of the market. The following is our below-investment-grade exposure in accordance with the above described rating methodology as of December 31.
(1) Excludes middle market loan portfolio which are primarily identified as below investment grade
(3) Includes 13 issuers in 2016 and 15 issuers in 2015
(5) Includes 197 issuers in 2016 and 201 in 2015; all issuers below $40 million in par value
(6) Includes 62 issuers in 2016 and 57 issuers in 2015; all issuers below $25 million in par value
Excluding the senior secured bank loans and certain high yield corporate bonds discussed above that were rated below investment grade when initially purchased, below-investment-grade debt and perpetual securities represented 2.8% of total debt and perpetual securities at December 31, 2016, compared with 3.1% at December 31, 2015, on an amortized cost basis. Debt and perpetual securities classified as below investment grade at December 31, 2016 and 2015 were generally reported as available for sale and carried at fair value.
We own debt of various European issuers including corporate and government-related borrowers. Most European countries have seen improvement in their economies since the European debt crisis which has helped stabilized credit quality among European issuers. To support sustainable economic growth, the ECB in 2015 launched a quantitative easing (QE) stimulus program that was recently extended to December 2017, with reduced purchases to start in April 2017.
We continue to monitor the European situation closely. Additionally, some of our European fixed-maturity investments contain covenants that we believe mitigate our risk. These may include put options that allow us to return our holdings to the issuer at a predetermined price, usually par, should the issuer be downgraded to below investment grade by a rating agency. Additionally, these covenants may include restrictions on the ability of the issuer to incur additional debt, sell assets, or provide collateral for indebtedness. As of December 31, 2016, all of the European issuers in our portfolios were current on their obligations to us, and we believe they have the ability to meet their obligations to us.
As a result of the significant decline in oil prices, which began in the fourth quarter of 2014, there has been heightened attention to certain investments in the various energy sub-sectors related to the oil and gas industry. Although prices have recovered somewhat from the lows, the sector continues to operate in a period of lower prices and increased volatility. Our portfolio includes holdings diversified across multiple sub-sectors of the oil and gas industry, spread among multiple geographies. The following tables show the breakout of our exposure to the oil and gas industry as of December 31.
As of December 31, 2016, the weighted-average rating of our total fixed maturity energy exposure is BBB, and 88% of our exposure to the oil and gas industry was investment grade, compared to 93% at December 31, 2015. Further declines in oil and gas prices, unexpected increases in supply, or other company specific situations could lead to additional negative ratings activity from the public rating agencies for energy credit issuers. We do not currently expect our investments in the energy sector to have a material impact on our results of operations.
The yen net asset figure calculated for hedging purposes differs from the yen-denominated net asset position as discussed in the Currency Risk subsection of MD&A. As disclosed in that subsection, the consolidation of the underlying assets in certain VIEs requires that we derecognize our yen-denominated investment in the VIE and recognize the
Notes payable totaled $5.4 billion at December 31, 2016, compared with $5.0 billion at December 31, 2015.
Subsequent to December 31, 2016, in January 2017 the Parent Company issued 60.0 billion yen of senior notes through a U.S. public debt offering. The notes bear interest at a fixed rate of .932% per annum, payable semi-annually, and have a 10-year maturity. These notes may only be redeemed before maturity, in whole but not in part, upon the occurrence of certain changes affecting U.S. taxation, as specified in the indenture governing the terms of the issuance.
The primary uses of cash by the Parent Company are shareholder dividends, the repurchase of its common stock and interest on its outstanding indebtedness and operating expenses. The Parent Company's sources and uses of cash are reasonably predictable and are not expected to change materially in the future. For additional information, see the Financing Activities subsection of this MD&A.
The Parent Company also accesses debt security markets to provide additional sources of capital. In August 2016, we filed a shelf registration statement with Japanese regulatory authorities that allows us to conduct public offerings of bonds in Japan, including yen-denominated Samurai notes, up to 200 billion yen or its equivalent through August 2018. The shelf registration statement is for possible public offerings in Japan, but the bonds issued under the shelf may be transferred by the bondholders to U.S. persons in compliance with U.S. law. We filed a shelf registration statement with the SEC in May 2015 that allows us to issue an indefinite amount of senior and subordinated debt, in one or more series, from time to time until May 2018. We believe outside sources for additional debt and equity capital, if needed, will continue to be available. For additional information, see Note 9 of the Notes to the Consolidated Financial Statements.
As a result of policyholder aging, claims payments are expected to gradually increase over the life of a policy. Therefore, future policy benefit reserves are accumulated in the early years of a policy and are designed to help fund future claims payments. We expect our future cash flows from premiums and our investment portfolio to be sufficient to meet our cash needs for benefits and expenses.
are terminated pursuant to an event of default, as such term is defined in the credit agreement. The credit facility requires compliance with certain financial covenants on a quarterly basis. As of December 31, 2016, we did not have any borrowings outstanding under our 100.0 billion yen revolving credit agreement.
(1)Liability amounts are those reported on the consolidated balance sheet as of December 31, 2016.
Consolidated cash flow from operations decreased 11.6% in 2016, compared with 2015. The following table summarizes operating cash flows by source for the years ended December 31.
The level of Aflac Japan operating cash flows during 2016 and 2015 was impacted by a decline in the sales of products such as WAYS, which resulted in a reduced amount of cash received from discounted advance premiums. We do not expect this trend to continue in 2017.
Operating cash flow is primarily used to purchase investments to meet future policy obligations. The following table summarizes investing cash flows by source for the years ended December 31.
Prudent portfolio management dictates that we attempt to match the duration of our assets with the duration of our liabilities. Currently, when our fixed-maturity securities and perpetual securities mature, the proceeds may be reinvested at a yield below that required for the accretion of policy benefit liabilities on policies issued in earlier years. However, the long-term nature of our business and our strong cash flows provide us with the ability to minimize the effect of mismatched durations and/or yields identified by various asset adequacy analyses. When needed or when market opportunities arise, we dispose of selected fixed-maturity and perpetual securities that are available for sale to improve the duration matching of our assets and liabilities, improve future investment yields, and/or re-balance our portfolio. 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 fixed maturities and perpetual securities available for sale during the year ended December 31, 2016, compared with 5% in 2015 and 6% in 2014.
In September 2016, the Parent Company entered into two series of senior unsecured term loan facilities totaling 30.0 billion yen. The first series, which totaled 5.0 billion yen, bears an interest rate per annum equal to the TIBOR, or alternate TIBOR, if applicable, plus the applicable TIBOR margin. The applicable margin ranges between .20% and .60%, depending on the Parent Company's debt ratings as of the date of determination. The second series, which totaled 25.0 billion yen, bears an interest rate per annum equal to TIBOR, or alternate TIBOR, if applicable, plus the applicable TIBOR margin. The applicable margin ranges between .35% and .75%, depending on the Parent Company's debt ratings as of the date of determination.
In March 2015, the Parent Company issued two series of senior notes totaling $1.0 billion through a U.S. public debt offering. The first series, which totaled $550 million, bears interest at a fixed rate of 2.40% per annum, payable semi-annually, and has a five-year maturity. The second series, which totaled $450 million, bears interest at a fixed rate of 3.25% per annum, payable semi-annually, and has a ten-year maturity. We have entered into cross-currency swaps that convert the U.S. dollar-denominated principal and interest on the senior notes into yen-denominated obligations which
results in lower nominal net interest rates on the debt. By entering into these cross-currency swaps, we economically converted our $550 million liability into a 67.0 billion yen liability and reduced the interest rate on this debt from 2.40% in dollars to .24% in yen, and we economically converted our $450 million liability into a 55.0 billion yen liability and reduced the interest rate on this debt from 3.25% in dollars to .82% in yen. In April 2015, the Parent Company used $1.0 billion of fixed-rate senior notes that were issued in March 2015 to redeem all of our $850 million 8.50% fixed-rate senior notes due May 2019 and to pay a portion of the corresponding $230 million make-whole premium due to the investors of these notes.
Cash returned to shareholders through dividends and treasury stock purchases was $2.1 billion in 2016, compared with $2.0 billion in 2015 and $1.9 billion in 2014.
See our preceding discussion in this Capital Resources and Liquidity section of MD&A regarding the 364-day uncommitted bilateral line of credit entered into by the Parent Company and Aflac in October 2016 in the amount of $100 million; the three-year senior unsecured revolving credit facility agreements entered into by the Parent Company in March 2016 in the amount of 100 billion yen; the five-year senior unsecured revolving credit facility agreement entered into by the Parent Company and Aflac in September 2015 in the amount of 55 billion yen; and the $50 million uncommitted bilateral line of credit entered into by the Parent Company and Aflac in February 2015. As of December 31, 2016, no borrowings were outstanding under these lines of credit.
We were in compliance with all of the covenants of our notes payable and lines of credit at December 31, 2016.
Under share repurchase authorizations from our board of directors, we purchased 21.6 million shares of our common stock in the open market in 2016, compared with 21.2 million shares in 2015 and 19.7 million shares in 2014. In August 2015, Aflac's board of directors authorized the purchase of an additional 40 million shares of its common stock. As of December 31, 2016, a remaining balance of 26.8 million shares of our common stock was available for purchase under share repurchase authorizations by our board of directors. We currently plan to purchase $1.3 billion to $1.5 billion of our common stock in 2017, front-end loaded in the first half of the year. See Note 11 of the Notes to the Consolidated Financial Statements for additional information.
In January 2017, the board of directors declared the first quarter 2017 cash dividend of $.43 per share. The dividend is payable on March 1, 2017, to shareholders of record at the close of business on February 15, 2017.
Aflac is subject to the NAIC’s Own Risk and Solvency Assessment (ORSA), effective January 1, 2015. Through the ORSA requirements, Aflac is expected to regularly, no less than annually, conduct an ORSA to assess the adequacy of its risk management framework, and its current and estimated projected future solvency position; internally document the process and results of the assessment; and provide a confidential high-level ORSA Summary Report annually to the lead state commissioner if the insurer is a member of an insurance group. In November 2016, Aflac filed its ORSA report with the Nebraska Department of Insurance.
In addition to limitations and restrictions imposed by U.S. insurance regulators, Japan’s FSA may not allow profit repatriations from Aflac Japan if the transfers would cause Aflac Japan to lack sufficient financial strength for the protection of policyholders. The FSA maintains its own solvency standard which is quantified through the SMR. Aflac
In the fourth quarter of 2014, we began to increase the frequency of capital transfers from Japan to the United States to better manage cash flow. This capital repatriation is reflected in Aflac Japan's SMR.
For information regarding commitments and contingent liabilities, see Note 15 of the Notes to the Consolidated Financial Statements.
In our opinion, Aflac Incorporated maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Aflac Incorporated and subsidiaries as of December 31, 2016 and 2015, and the related consolidated statements of earnings, comprehensive income (loss), shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2016, and our report dated February 24, 2017 expressed an unqualified opinion on those consolidated financial statements.
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, 2016 and 2015, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Aflac Incorporated's internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 24, 2017, expressed an unqualified opinion on the effectiveness of the Company's internal control over financial reporting.
(1) Includes $819 in 2016 of loan receivables from consolidated variable interest entities
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 period. 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 foreign currency transactions.
Insurance premiums for most of the Company's health and life policies, including cancer, accident, hospital, critical illness, dental, vision, term life, whole life, long-term care and disability, are recognized as revenue over the premium-paying periods of the contracts when due from policyholders. When revenues are reported, the related amounts of benefits and expenses are charged against such revenues, so that profits are recognized in proportion to premium revenues during the period the policies are expected to remain in force. This association is accomplished by means of annual additions to the liability for future policy benefits and the deferral and subsequent amortization of policy acquisition costs.
The calculation of deferred policy acquisition costs (DAC) and the liability for future policy benefits requires the use of estimates based on sound actuarial valuation techniques. For new policy issues, we review our actuarial assumptions and deferrable acquisition costs each year and revise them when necessary to more closely reflect recent experience and studies of actual acquisition costs. For policies in force, we evaluate DAC by major product groupings to determine that they are recoverable from future revenues, and any amounts determined not to be recoverable are charged against net earnings. We have not had any material charges to earnings for DAC that was determined not to be recoverable in any of the years presented in this Form 10-K.
We have investments in variable interest entities (VIEs). Criteria for evaluating VIEs for consolidation focuses on identifying which enterprise has the power to direct the activities of a variable interest entity that most significantly impact the entity's economic performance and (1) the obligation to absorb losses of the entity or (2) the right to receive benefits from the entity. We are the primary beneficiary of certain VIEs, and therefore consolidate these entities in our financial statements. While the VIEs generally operate within a defined set of documents, there are certain powers that are retained by us that are considered significant in our conclusion that we are the primary beneficiary. These powers vary by structure but generally include the initial selection of the underlying collateral or, for collateralized debt obligations (CDOs), the reference credits to include in the structure; the ability to obtain the underlying collateral in the event of default; and the ability to appoint or dismiss key parties in the structure. In particular, our powers surrounding the underlying collateral were considered to be the most significant powers since those most significantly impact the economics of the VIE. We have no obligation to provide any continuing financial support to any of the entities in which we are the primary beneficiary. Our maximum loss is limited to our original investment. Neither we nor any of our creditors have the ability to
Other investments include policy loans, middle market loans, commercial mortgage loans, and other short-term investments with maturities of one year or less, but greater than 90 days, at the time of purchase. We invest in middle market loans through participation rights, and commercial mortgage loans that are accounted for as loan receivables and recorded at amortized cost on the acquisition date. Since we have the intent and ability to hold these loan receivables for the foreseeable future or until they mature, they are considered held for investment and are carried at adjusted amortized cost in the other investments line on our consolidated balance sheets. The adjusted amortized cost of the loan receivables reflects allowances for expected incurred losses estimated based on past events and current economic conditions as of each reporting date. Other short-term investments are stated at amortized cost, which approximates estimated fair value.
Derivatives and Hedging: Freestanding derivative instruments are reported in the consolidated balance sheet at fair value and are reported in other assets and other liabilities, with changes in value reported in earnings and/or other comprehensive income. These freestanding derivatives are interest rate swaps, foreign currency swaps, credit default swaps (CDSs), foreign currency forwards, foreign currency options, and options on interest rate swaps (or interest rate swaptions). Interest rate and foreign currency swaps are used within VIEs to hedge the risk arising from interest rate and currency exchange risk, while the CDSs are used to increase the yield and improve the diversification of the portfolio. Foreign currency forwards and options are used in hedging foreign exchange risk on U.S. dollar-denominated investments in Aflac Japan's portfolio. Foreign currency forwards and options are used to hedge certain portions of forecasted cash flows denominated in yen. Interest rate swaps are used to hedge the variability of interest cash flows associated with our variable interest rate notes. Cross-currency interest rate swaps, also referred to as foreign currency swaps, are used to economically convert certain U.S. dollar-denominated note obligations into yen-denominated principal and interest obligations. Interest rate swaptions have been used to hedge interest rate risk for certain U.S. dollar-denominated available-for-sale securities. We do not use derivatives for trading purposes, nor do we engage in leveraged derivative transactions.
We have designated the majority of the Parent Company's yen-denominated liabilities (notes payable and yen-denominated loans) as non-derivative hedges and designated certain derivatives as hedges of the foreign currency exposure to our investment in Aflac Japan. At the beginning of each quarter, we make our net investment hedge designation. If the total of the designated Parent Company non-derivative and derivatives notional is equal to or less than
our net investment in Aflac Japan, the hedge is deemed to be effective, and the exchange effect on the yen-denominated liabilities and the change in estimated fair value of the derivatives are reported in the unrealized foreign currency component of other comprehensive income. Should these designated net investment hedge positions exceed our net investment in Aflac Japan, the foreign exchange effect on the portion that exceeds our investment in Aflac Japan would be recognized in current earnings within derivative and other gains (losses).
If a derivative is not designated as an accounting hedge or its use in managing risk does not qualify for hedge accounting, changes in the estimated fair value of the derivative are generally reported within derivative and other gains(losses), which is a component of realized investment gains (losses). The fluctuations in estimated fair value of derivatives that have not been designated for hedge accounting can result in volatility in net earnings.
For assessing hedge effectiveness of cash flow hedges, qualitative methods may include the comparison of critical terms of the derivative to the hedged item, and quantitative methods may include regression or other statistical analysis of changes in cash flows associated with the hedge relationship. Hedge ineffectiveness of the hedge relationships on our VIE cash flow hedges is measured each reporting period using the “Hypothetical Derivative Method.” For derivative instruments that are designated and qualify as cash flow hedges, the effective portion of the gain or loss on the derivative is reported as a component of other comprehensive income (loss) and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Gains and losses on the derivative representing hedge ineffectiveness are recognized in current earnings within derivative and other gains (losses). All components of each derivative's gain or loss are included in the assessment of hedge effectiveness.
Unpaid policy claims are estimates computed on an undiscounted basis using statistical analyses of historical claims experience adjusted for current trends and changed conditions. The ultimate liability may vary significantly from such estimates. We regularly adjust these estimates as new claims experience emerges and reflect the changes in operating results in the year such adjustments are made.
Business Combinations - Simplifying the Accounting for Measurement-Period Adjustments: In September 2015, the FASB issued guidance requiring that an acquirer recognize adjustments to estimated amounts that are identified during the measurement period in the reporting period in which the adjustments are determined. In the same period’s financial statements, the acquirer is required to record income effects of the adjustments as if the accounting had been completed at the acquisition date. The acquirer is also required to present separately on the face of the income statement or disclose in the notes the portion of the amount recorded in current-period earnings by line item that would have been recorded in previous reporting periods if the adjustment to the estimated amounts had been recognized as of the acquisition date. We adopted this guidance as of January 1, 2016. The adoption of this guidance did not have a significant impact on our financial position, results of operations, or disclosures.
Financial Services - Insurance - Disclosures about Short-Duration Contracts: In May 2015, the FASB issued updated guidance requiring enhanced disclosures by all insurance entities that issue short-duration contracts. The amendments require insurance entities to disclose for annual reporting periods information about the liability for unpaid claims and claim adjustment expenses. The amendments also require insurance entities to disclose information about significant changes in methodologies and assumptions used to calculate the liability for unpaid claims and claim adjustment expenses. In addition, the amendments require insurance entities to disclose for annual and interim reporting periods a roll-forward of the liability for unpaid claims and claim adjustment expenses. For health insurance claims, the amendments require the disclosure of the total of incurred-but-not-reported liabilities and expected development on reported claims included in the liability for unpaid claims and claim adjustment expenses. We adopted this guidance as of December 31, 2016, and have no insurance contracts classified as short-duration. The adoption of this guidance did not have a significant impact on our disclosures.
Fair Value Measurement - Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent): In May 2015, the FASB issued updated guidance that removes the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the net asset value per share practical expedient. The amendments also remove the requirement to make certain disclosures for all investments that are eligible to be measured at fair value using the net asset value per share practical expedient. Rather, those disclosures are limited to investments for which the entity has elected to measure the fair value using that practical expedient. We adopted this guidance as of January 1, 2016. The adoption of this guidance did not have a significant impact on our disclosures.
Interest - Imputation of Interest - Simplifying the Presentation of Debt Issuance Costs: In April 2015, the FASB issued updated guidance to simplify presentation of debt issuance costs. The updated guidance requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The recognition and measurement guidance for debt issuance costs are not affected by this amendment. In August 2015, the FASB issued updated Securities and Exchange Commission (SEC) Staff guidance pertaining to the presentation of debt issuance costs related to line-of-credit arrangements. The guidance states that an entity may defer and present debt issuance costs as an asset, subsequently amortizing the deferred debt issuance costs ratably over the term of the line-of-credit arrangement, regardless of whether there are any outstanding borrowings on the line-of-credit arrangement. We retrospectively adopted this guidance as of January 1, 2016. The retrospective adoption of this accounting standard resulted in a $40 million reduction to notes payable and other assets as of December 31, 2015, the earliest balance sheet date presented in the period of adoption, but did not have a significant impact on our financial position, results of operations, or disclosures.
Receivables - Troubled Debt Restructurings by Creditors - Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure: In January 2014, the FASB issued updated guidance for troubled debt restructurings clarifying when an in substance repossession or foreclosure occurs, and when a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage
Intangibles - Goodwill and Other - Simplifying the Test for Goodwill Impairment: In January 2017, the FASB issued amendments simplifying the subsequent measurement of goodwill. An entity, under this update, is no longer required to perform a hypothetical purchase price allocation to measure goodwill impairment. Instead, the entity should perform its annual or interim goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. The amendments are effective for public business entities that are U.S. SEC filers for annual or any interim goodwill impairment tests in fiscal years beginning after Dec. 15, 2019. Early adoption is permitted for any goodwill impairment tests performed on testing dates after January 1, 2017. We do not expect the adoption of this guidance to have a significant impact on our financial position, results of operations, or disclosures.
Business Combinations - Clarifying the Definition of a Business: In January 2017, the FASB issued amendments clarifying when a set of assets and activities is a business. The amendments provide a screen to determine when a set of assets and activities is not a business. The amendments are effective for public business entities beginning after December 15, 2017, including interim periods within those periods. We do not expect the adoption of this guidance to have a significant impact on our financial position, results of operations, or disclosures.
Statement of Cash Flows - Restricted Cash: In November 2016, the FASB issued amendments requiring that a statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. The amendments are effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted. We do not expect the adoption of this guidance to have a significant impact on our financial position, results of operations, or disclosures.
Income Taxes - Intra-Entity Transfers of Assets Other Than Inventory: In October 2016, the FASB issued amendments that require an entity to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs. The amendments are effective for public business entities for annual reporting periods beginning after December 15, 2017, including interim reporting periods within those annual reporting periods. Early adoption is permitted. We are evaluating the impact of adoption of this guidance on our financial position, results of operations, or disclosures.
Consolidation - Interests Held through Related Parties That Are under Common Control: In October 2016, the FASB issued amendments which clarify the consolidation guidance on how a reporting entity that is the single decision maker of a VIE should treat indirect interests in the entity held through related parties that are under common control with the reporting entity when determining whether it is the primary beneficiary of that VIE. The amendments are effective for public business entities for fiscal years beginning after December 15, 2016, including interim periods within those fiscal
The amendment also requires all excess tax benefits and tax deficiencies (including tax benefits of dividends on share-based payment awards) to be recognized as income tax expense or benefit in the income statement. The guidance requires modified retrospective transition for settlements on all outstanding awards (both historical and future) that did not give rise to an excess benefit to be recorded through retained earnings on a cumulative-effect basis. We estimate that the adoption of these amendments in the guidance will not have a significant impact on our financial position, results of operations, or disclosures.
Additionally, the amendment requires that the minimum statutory tax withholding for all outstanding liability awards be reclassified at the date of adoption to equity (assuming equity classification results from the guidance change), and record a cumulative-effect adjustment to equity on a modified retrospective basis. We estimate that the adoption of these amendments in the guidance will not have a significant impact on our financial position, results of operations, or disclosures.
The guidance requires certain reclassifications of balances on the statement of cash flows to or from operating and financing activities. The reclassification guidance will not have a significant impact on our statement of cash flows.
The amendment allows an entity to elect whether to use estimates of forfeitures, or to account for forfeitures as they occur, using modified retrospective application. We estimate that the election and adoption of this amendment in the guidance will not have a significant impact on our financial position, results of operations, or disclosures.
Investments - Equity Method and Joint Ventures - Simplifying the Transition to the Equity Method of Accounting: In March 2016, the FASB issued amendments which eliminate the requirement that when an investment qualifies for use of the equity method as a result of an increase in the level of ownership interest or degree of influence, an investor must adjust the investment, results of operations, and retained earnings retroactively on a step-by-step basis as if the equity method had been in effect during all previous periods that the investment had been held. Per the amendments, upon qualifying for the equity method of accounting, no retroactive adjustment of the investment is required. The amendments also require that an entity that has an available-for-sale equity security that becomes qualified for the equity method of accounting recognize through earnings the unrealized holding gain or loss in accumulated other comprehensive income at the date the investment becomes qualified for use of the equity method. The amendments are effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. The amendments should be applied prospectively upon their effective date to increases in the level of ownership interest or degree of influence that result in the adoption of the equity method. Early adoption is permitted. We have evaluated the adoption of this guidance and do not expect the guidance to have a significant impact on our financial position, results of operations, or disclosures.
Leases: In February 2016, the FASB issued updated guidance for accounting for leases. Per the amendments, lessees will be required to recognize all leases on the balance sheet, with the exception of short-term leases. A lease liability will be recorded for the obligation of a lessee to make lease payments arising from a lease. A right-of-use asset, will be recorded which represents the lessee’s right to use, or to control the use of, a specified asset for a lease term. Under the new guidance, lessor accounting is largely unchanged. The amendments are effective for public companies for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. We have identified certain operating leases in scope of this guidance to include office space and equipment leases (See Note 15 for current balances of leases in scope). The leases within scope of this guidance will increase our right-of-use assets recorded on our financial position, however we estimate leases within scope of the guidance to represent less than 1% of our total assets as of December 31, 2016. We estimate that the adoption of this guidance will not have a significant impact on our financial position, results of operations and disclosures.
We do not allocate corporate overhead expenses to business segments. Consistent with U.S. GAAP accounting guidance for segment reporting, we evaluate and manage our business segments using a financial performance measure called pretax operating earnings. Our definition of operating earnings includes interest cash flows associated with notes payable and excludes the following items from net earnings on an after-tax basis: realized investment gains/losses (securities transactions, impairments, and the impact of derivative and hedging activities), nonrecurring items and other non-operating income (loss). 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:
Prior year amounts have been adjusted for the adoption of the accounting guidance on January 1, 2016 related to debt issuance costs.
For those VIEs other than certain unit trust structures, our involvement is passive in nature. We are not, nor have we been, required to purchase any securities issued in the future by these VIEs.
Our ownership interest in VIEs is limited to holding the obligations issued by them. We have no direct or contingent obligations to fund the limited activities of these VIEs, nor do we have any direct or indirect financial guarantees related to the limited activities of these VIEs. We have not provided any assistance or any other type of financing support to any of the VIEs we invest in, nor do we have any intention to do so in the future. For those VIEs in which we hold debt obligations, the weighted-average lives of our notes are very similar to the underlying collateral held by these VIEs where applicable.
We are substantively the only investor in the consolidated VIEs listed in the table above. As the sole investor in these VIEs, we have the power to direct the activities of the variable interest entity that most significantly impact the entity's economic performance and are therefore considered to be the primary beneficiary of the VIEs that we consolidate. We also participate in substantially all of the variability created by these VIEs. The activities of these VIEs are limited to holding invested assets and foreign currency, and/or CDS, as appropriate, and utilizing the cash flows from these securities to service our investment. Neither we nor any of our creditors are able to obtain the underlying collateral of the VIEs unless there is an event of default or other specified event. For those VIEs that contain a swap, we are not a direct counterparty to the swap contracts and have no control over them. Our loss exposure to these VIEs is limited to our
original investment. Our consolidated VIEs do not rely on outside or ongoing sources of funding to support their activities beyond the underlying collateral and swap contracts, if applicable. With the exception of our investments in unit trust structures, the underlying collateral assets and funding of our consolidated VIEs are generally static in nature and the underlying collateral and the reference corporate entities covered by any CDS contracts were all investment grade at the time of issuance.
We invest through unit trust structures in yen-denominated public equity securities, U.S. dollar-denominated public equity securities, bank loans, commercial mortgage loans, and middle market loans in which we are the only investor, requiring us to consolidate these trusts under U.S. GAAP. The yen-denominated and U.S. dollar-denominated equity securities are classified as available-for-sale in the financial statements. As of December 31, 2016, the amortized cost and fair value of these equity securities was $972 million and $1.0 billion, compared with amortized cost and fair value of $363 million as of December 31, 2015. The bank loans are classified as available-for-sale fixed-maturity securities in the financial statements. As of December 31, 2016, the amortized cost and fair value of our bank loan investments was $2.0 billion and $1.9 billion, respectively, compared with an amortized cost and fair value of $1.4 billion as of December 31, 2015. The commercial mortgage loans, all of which were purchased in 2016, are classified as held for investment and reflected in other investments on the consolidated balance sheets. As of December 31, 2016, the amortized cost of these loans, net of loan loss reserves, was $745 million. The middle market loans, which were purchased in 2016, are classified as held for investment and reflected in other investments on the consolidated balance sheets. As of December 31, 2016, the amortized cost of these loans, net of loan loss reserves, was $74 million.
As of December 31, 2016, we had commitments of $779 million to fund potential future loan originations related to this investment program, inclusive of loans held in unit trust structures. These commitments are contingent upon the availability of middle market loans that meet our underwriting criteria.
In 2016, we began funding investments in commercial mortgage loans. As of December 31, 2016, the amortized cost of these investments, net of loan loss reserves and inclusive of those loans held in unit trust structures as discussed above, was $855 million. We had no loans that were past due in regards to principal and/or interest payments, and we held no loans that were on nonaccrual status or considered impaired as of December 31, 2016. Our commercial mortgage loan allowance for losses was immaterial as of December 31, 2016. We had no troubled debt restructurings during the year ended December 31, 2016.
As of December 31, 2016, we had $19 million in outstanding commitments to fund commercial mortgage loans, inclusive of loans held in unit trust structures. These commitments are contingent on the final underwriting and due diligence to be performed.
(1) These securities are pledged as collateral under our U.S. securities lending program and can be called at our discretion; therefore, they are classified as Overnight and Continuous.
Foreign currency forwards and options are executed for the Aflac Japan segment in order to hedge the currency risk on the carrying value of certain U.S. dollar-denominated investments. The maturities of these forwards and options are typically two years or less. In forward transactions, Aflac Japan agrees with another party to buy a fixed amount of yen and sell a corresponding amount of U.S. dollars at a specified future date. Aflac Japan also executes foreign currency option transactions in a collar strategy, where Aflac Japan agrees with another party to simultaneously purchase a fixed amount of U.S. dollar put options and sell U.S. dollar call options. The combination of these two actions results in no net premium being paid (i.e. a costless or zero-cost collar). The foreign currency forwards and options are used in fair value hedging relationships to mitigate the foreign exchange risk associated with U.S. dollar-denominated investments supporting yen-denominated liabilities.
Interest rate swaps involve the periodic exchange of cash flows with other parties, at specified intervals, calculated using agreed upon rates or other financial variables and notional principal amounts. Typically, at the time a swap is entered into, the cash flow streams exchanged by the counterparties are equal in value. No cash or principal payments are exchanged at the inception of the contract. Interest rate swaps are primarily used to convert interest receipts on floating-rate fixed-maturity securities contracts to fixed rates. These derivatives are predominantly used to better match cash receipts from assets with cash disbursements required to fund liabilities.
Periodically, we may enter into other derivative transactions depending on general economic conditions.
The derivative notional amount increased from 2015 to 2016 primarily due to an increase in non-qualifying strategies. The increase in non-qualifying strategies related to entering into longer duration foreign currency forwards designated as fair value hedges that resulted in the dedesignation of existing foreign currency forwards. We also entered into offsetting foreign currency forwards for the remaining term of the foreign currency forwards that were dedesignated, both of which are included in the notional amounts presented for non-qualifying strategies.
We designate and account for certain foreign currency forwards and options as fair value hedges when they meet the requirements for hedge accounting. These foreign currency forwards and options hedge the foreign currency exposure of certain U.S. dollar-denominated investments. We recognize gains and losses on these derivatives and the related hedged items in current earnings within derivative and other gains (losses). The change in the fair value of the foreign currency forwards related to the changes in the difference between the spot rate and the forward price is excluded from the assessment of hedge effectiveness. The change in fair value of the foreign currency option related to the time value of the option is excluded from the assessment of hedge effectiveness.
Our primary exposure to be hedged is our net investment in Aflac Japan, which is affected by changes in the yen/dollar exchange rate. To mitigate this exposure, we have designated the Parent Company's yen-denominated liabilities (see Note 9) as non-derivative hedges and designated foreign currency forwards and options as derivative hedges of the foreign currency exposure of our net investment in Aflac Japan.
Our net investment hedge was effective for the years ended December 31, 2016, 2015 and 2014.
In the fourth quarter of 2016, we began using foreign exchange forwards to mitigate the currency risk of our U.S. dollar-denominated middle market loan portfolio held within the Aflac Japan segment. As of December 31, 2016, the outstanding derivative notional amounts associated with these U.S. dollar-denominated middle market loans was approximately $109 million. In the third quarter of 2016, we began using foreign exchange forwards to mitigate the currency risk of our U.S. dollar-denominated commercial loan portfolio held within the Aflac Japan segment. As of December 31, 2016, the outstanding derivative notional amounts associated with these U.S. dollar-denominated commercial mortgage loans was approximately $710 million. We have not elected to apply hedge accounting for these middle market loans and commercial mortgage loans. The change in fair value of the foreign exchange forwards and the foreign currency remeasurement of the middle market loans and commercial mortgage loans are each recorded through current period earnings, and generally offset each other.
derivative instruments recorded in accumulated other comprehensive income that are expected to be reclassified to earnings during the next twelve months were immaterial.
We engage in derivative transactions directly with unaffiliated third parties under International Swaps and Derivatives Association, Inc. (ISDA) agreements and other documentation. Most of the ISDA agreements also include Credit Support Annexes (CSAs) provisions, which generally provide for two-way collateral postings at the first dollar of exposure. We mitigate the risk that counterparties to transactions might be unable to fulfill their contractual obligations by monitoring counterparty credit exposure and collateral value while generally requiring that collateral be posted at the outset of the transaction. In addition, a significant portion of the derivative transactions have provisions that give the counterparty the right to terminate the transaction upon a downgrade of Aflac’s financial strength rating. The actual amount of payments that we could be required to make, depends on market conditions, the fair value of outstanding affected transactions, and other factors prevailing at and after the time of the downgrade.
Amounts have been adjusted for the adoption of accounting guidance on January 1, 2016 related to debt issuance costs.
U.S. GAAP requires disclosure of the fair value of certain financial instruments including those that are not carried at fair value. The carrying amounts for cash and cash equivalents, other investments (excluding loan receivables), receivables, accrued investment income, accounts payable, cash collateral and payables for security transactions approximated their fair values due to the nature of these instruments. Liabilities for future policy benefits and unpaid policy claims are not financial instruments as defined by U.S. GAAP.
The fair values of the foreign currency forwards, options, and interest rate swaptions associated with certain investments; the foreign currency forwards and options used to hedge foreign exchange risk from our net investment in Aflac Japan and economically hedge certain portions of forecasted cash flows denominated in yen; and the foreign currency swaps associated with certain senior notes and our subordinated debentures are based on the amounts we would expect to receive or pay. The determination of the fair value of these derivatives is based on observable market inputs, therefore they are classified as Level 2.
For derivatives associated with VIEs where we are the primary beneficiary, we are not the direct counterparty to the swap contracts. As a result, the fair value measurements incorporate the credit risk of the collateral associated with the VIE. We receive valuations from a third party pricing vendor for these derivatives. Based on an analysis of these derivatives and a review of the methodology employed by the pricing vendor, we determined that due to the long duration of these swaps and the need to extrapolate from short-term observable data to derive and measure long-term inputs, certain inputs, assumptions and judgments are required to value future cash flows that cannot be corroborated by current
The largest component of the other policyholders' funds liability is our annuity line of business in Aflac Japan. Our annuities have fixed benefits and premiums. For this product, we estimated the fair value to be equal to the cash surrender value. This is analogous to the value paid to policyholders on the valuation date if they were to surrender their policy. We periodically check the cash value against discounted cash flow projections for reasonableness. We consider our inputs for this valuation to be unobservable and have accordingly classified this valuation as Level 3.
The fair values of our publicly issued notes payable classified as Level 3 were obtained from a limited number of independent brokers. These brokers base their quotes on a combination of their knowledge of the current pricing environment and market conditions. We consider these inputs to be unobservable. The fair values of our yen-denominated loans approximate their carrying values.
(d) N/A represents securities where we receive unadjusted broker quotes and for which there is no transparency into the providers' valuation techniques or unobservable inputs.
In circumstances where our valuation model price is overridden because it implies a value that is not consistent with current market conditions, we will solicit bids from a limited number of brokers. We also receive unadjusted prices from brokers for our mortgage and asset-backed securities. These quotes are non-binding but are reflective of valuation best estimates at that particular point in time. Offered quotes are an unobservable input in the determination of fair value of mortgage- and asset-backed securities, certain banks/financial institutions, certain other corporate, and equity securities investments.
The CDO tranche in our portfolio is a senior mezzanine tranche and, due to the low level of credit support for this type of tranche, exhibits equity-like behavior. As a result, an increase in recovery rates tends to cause its value to decrease.
Consolidated policy acquisition costs deferred were $1.4 billion in 2016, compared with $1.3 billion in 2015 and 2014. The following table presents a rollforward of deferred policy acquisition costs by segment for the years ended December 31.
Personnel, compensation and benefit expenses as a percentage of insurance expenses were 53% in 2016, compared with 52% in 2015 and 2014. Advertising expense, which is included in insurance expenses in the consolidated statements of earnings, was as follows for the years ended December 31:
As of December 31, 2016 and 2015, unearned premiums consisted primarily of discounted advance premiums on deposit. Discounted advance premiums are premiums on deposit from policyholders in conjunction with their purchase of certain Aflac Japan limited-pay insurance products. These advanced premiums are deferred upon collection and recognized as premium revenue over the contractual premium payment period. These advanced premiums represented 76% of the December 31, 2016 and 77% of the December 31, 2015 unearned premiums balances.
As of December 31, 2016 and 2015, the largest component of the other policyholders' funds liability is our annuity line of business in Aflac Japan. Our annuities have fixed benefits and premiums. These annuities represented 98% of both the December 31, 2016 and 2015 other policyholders' funds liability.
For our reinsurance transactions to date, we have recorded a deferred profit liability related to the reinsurance transactions. The remaining deferred profit liability of $870 million, as of December 31, 2016, included in future policy benefits in the consolidated balance sheet, is being amortized into income over the expected lives of the policies. We also have recorded a reinsurance recoverable for reinsurance transactions, which is included in other assets in the consolidated balance sheet and had a remaining balance of $860 million and $805 million as of December 31, 2016 and 2015, respectively. The increase in the reinsurance recoverable balance was driven by two aggregating factors: yen strengthening and the growth in reserves related to the business that has been reinsured as the policies age. The spot yen/dollar exchange rate strengthened by approximately 4% and ceded reserves increased approximately 3% from December 31, 2015 to December 31, 2016.
These reinsurance transactions are indemnity reinsurance that do not relieve us from our obligations to policyholders. In the event that the reinsurer is unable to meet their obligations, we remain liable for the reinsured claims.
annually, and has a five-year maturity. The second series, which totaled $450 million, bears interest at a fixed rate of 3.25% per annum, payable semi-annually, and has a 10-year maturity. We have entered into cross-currency swaps that convert the U.S. dollar-denominated principal and interest on the senior notes into yen-denominated obligations which results in lower nominal net interest rates on the debt. By entering into these cross-currency swaps, we economically converted our $550 million liability into a 67.0 billion yen liability and reduced the interest rate on this debt from 2.40% in dollars to .24% in yen, and we economically converted our $450 million liability into a 55.0 billion yen liability and reduced the interest rate on this debt from 3.25% in dollars to .82% in yen.
dollars to 2.07% in yen. In July 2012, the Parent Company issued $250 million of senior notes that are an addition to the original first series of senior notes issued in February 2012. These notes have a five-year maturity and a fixed rate of 2.65% per annum, payable semiannually.
In 2010 and 2009, we issued senior notes through U.S. public debt offerings; the details of these notes are as follows. In August 2010, we issued $450 million of senior notes that have a 30-year maturity. In December 2009, we issued $400 million of senior notes that have a 30-year maturity. These senior notes pay interest semiannually and are redeemable at our option in whole at any time or in part from time to time at a redemption price equal to the greater of: (i) the principal amount of the notes or (ii) the present value of the remaining scheduled payments of principal and interest to be redeemed, discounted to the redemption date, plus accrued and unpaid interest.
The Parent Company and Aflac have a five-year senior unsecured revolving credit facility agreement with a syndicate of financial institutions that provides for borrowings of up to 55.0 billion yen or the equivalent of yen in U.S. dollars on a revolving basis. This credit agreement provides for borrowings in Japanese yen or the equivalent of Japanese yen in U.S. dollars on a revolving basis. Borrowings bear interest at a rate per annum equal to, at our option, either (a) a eurocurrency rate determined by reference to the LIBOR for the interest period relevant to such borrowing adjusted for certain additional costs or (b) a base rate determined by reference to the highest of (1) the federal funds effective rate plus ½ of 1%, (2) the rate of interest for such day announced by Mizuho Bank, Ltd. as its prime rate and (3) the eurocurrency rate for an interest period of one month plus 1.00%, in each case plus an applicable margin. The applicable margin ranges between .79% and 1.275% for eurocurrency rate borrowings and 0.0% and .275% for base rate borrowings, depending on the Parent Company’s debt ratings as of the date of determination. In addition, the Parent Company and Aflac are required to pay a facility fee on the commitments ranging between .085% and .225%, also based on the Parent Company’s debt ratings as of the date of determination. Borrowings under the amended and restated credit facility may be used for general corporate purposes, including a capital contingency plan for the operations of the Parent Company and Aflac. The amended and restated credit facility requires compliance with certain financial covenants on a quarterly basis and will expire on the earlier of (a) September 18, 2020, or (b) the date the commitments are terminated pursuant to an event of default, as such term is defined in the credit agreement. As of December 31, 2016, we did not have any borrowings outstanding under our 55.0 billion yen revolving credit agreement.
Based upon a review of the Company's anticipated future taxable income, and including all other available evidence, both positive and negative, the Company's management has concluded that it is more likely than not that the net deferred tax assets will be realized.
Under U.S. income tax rules, only 35% of non-life operating losses can be offset against life insurance taxable income each year. For current U.S. income tax purposes, there were no unused operating loss carryforwards available to offset against future taxable income. The Company has capital loss carryforwards of $9 million available to offset capital gains which expire in 2021.
Included in the balance of the liability for unrecognized tax benefits at December 31, 2016, are $293 million of tax positions for which the ultimate deductibility is highly certain, but for which there is uncertainty about the timing of such deductibility, compared with $261 million at December 31, 2015. Because of the impact of deferred tax accounting, other than interest and penalties, the disallowance of the shorter deductibility period would not affect the annual effective tax rate, but would accelerate the payment of cash to the taxing authority to an earlier period. The Company has accrued approximately $1 million as of December 31, 2016, for permanent uncertainties, which if reversed would not have a material effect on the annual effective rate.
The Company recognizes accrued interest and penalties related to unrecognized tax benefits in income tax expense. We recognized approximately $13 million in interest and penalties in 2016, compared with $11 million in 2015 and 2014. The Company has accrued approximately $26 million for the payment of interest and penalties as of December 31, 2016, compared with $22 million a year ago.
As of December 31, 2016, there were no material uncertain tax positions for which the total amounts of unrecognized tax benefits will significantly increase or decrease within the next 12 months.
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
As of December 31, 2016, total compensation cost not yet recognized in our financial statements related to restricted stock awards was $33 million, of which $10 million (953 thousand shares) was related to restricted stock awards with a performance-based vesting condition. We expect to recognize these amounts over a weighted-average period of approximately 1.0 years. There are no other contractual terms covering restricted stock awards once vested.
Aflac entered into a reinsurance agreement effective March 31, 2015 with a then unauthorized reinsurer. The effective date of this agreement predated the effective date of Nebraska's Amended Credit for Reinsurance statute (44-416) allowing certified reinsurers and also predated the subsequent approval of the agreement's assuming reinsurer as a Certified Reinsurer, which occurred on August 30, 2015 and December 24, 2015, respectively. Aflac has obtained a permitted practice to recognize this treaty and counterparty as Certified Reinsurer for the purpose of determining the collateral required to receive reinsurance reserve credit.
As of December 31, 2016, Aflac's capital and surplus significantly exceeded the required company action level capital and surplus of $1.3 billion. As determined on a U.S. statutory accounting basis, Aflac's net income was $2.8 billion in 2016, $2.3 billion in 2015 and $2.4 billion in 2014.
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 of the Japan branch, based on Japanese regulatory accounting practices, was $5.6 billion at December 31, 2016, compared with $4.7 billion at December 31, 2015. Japanese regulatory accounting practices differ in many respects from U.S. GAAP. Under Japanese regulatory accounting practices, policy acquisition costs are expensed immediately; policy benefit and claim reserving methods and assumptions are different; premium income is recognized on a cash basis; different consolidation criteria apply to VIEs; reinsurance is recognized on a different basis; and investments can have a separate accounting classification and treatment referred to as policy reserve matching bonds (PRM).
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 income from operations, which excludes net realized investment gains, for the previous year determined under statutory accounting principles, or 10% of statutory capital and surplus as of the previous year-end. Dividends declared by Aflac during 2017 in excess of $2.8 billion would require such approval. Aflac declared dividends of $2.0 billion during 2016.
Pension and other postretirement benefit expenses, included in acquisition and operating expenses in the consolidated statements of earnings for the years ended December 31, included the following components:
The investment objective of our Japanese and U.S. funded defined benefit 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 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. 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.
The fair values of our pension plan investments categorized as Level 1, consisting of mutual funds and common stock, are based on quoted market prices for identical securities traded in active markets that are readily and regularly available to us. The fair values of our pension plan investments classified as Level 2 are based on quoted prices for similar assets in markets that are not active, other inputs that are observable, such as interest rates, yield curves, volatilities, prepayment speeds, loss severities, credit risks, and default rates, or other market-corroborated inputs.
The 401(k) contributions by the Company, included in acquisition and operating expenses in the consolidated statements of earnings, were $11 million in 2016, $9 million in 2015 and $7 million in 2014. The plan trustee held approximately one million shares of our common stock for plan participants at December 31, 2016.
We have two outsourcing agreements with information technology and data services companies to provide application maintenance and development services for our Japanese operation. The first agreement has a remaining term of three years with an aggregate remaining cost of 6.1 billion yen ($53 million using the December 31, 2016, exchange rate). The second agreement has a remaining term of one year with an aggregate remaining cost of 740 million yen ($6 million using the December 31, 2016, exchange rate).
We lease office space and equipment under agreements that expire in various years through 2026. Future minimum lease payments due under non-cancelable operating leases at December 31, 2016, were as follows: