Aflac owns land and buildings that comprise two primary campuses located in Columbus, Georgia. These campuses include buildings that serve as our worldwide headquarters and house administrative support functions for our U.S. operations. Aflac also leases administrative office space in Georgia, New York, and Nebraska. In 2005, we announced a multi-year building project for additional office space in Columbus, Georgia. The initial phase is to be completed in 2007 and will provide additional space for administrative support functions. The next phase of the expansion is anticipated to begin in mid-2007.
(1) Includes a benefit of $34 ($.07 per basic and diluted share) for the release of a valuation allowance for deferred tax assets in 2005
The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” to encourage companies to provide prospective information, so long as those informational statements are identified as forward-looking and are accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those included in the forward-looking statements. We desire to take advantage of these provisions. This report contains cautionary statements identifying important factors that could cause actual results to differ materially from those projected herein, and in any other statements made by Company officials in communications with the financial community and contained in documents filed with the Securities and Exchange Commission (SEC). Forward-looking statements are not based on historical information and relate to future operations, strategies, financial results or other developments. Furthermore, forward-looking information is subject to numerous assumptions, risks, and uncertainties. In particular, statements containing words such as “expect,” “anticipate,” “believe,” “goal,” “objective,” “may,” “should,” “estimate,” “intends,” “projects,” “will,” “assumes,” “potential,” “target,” or similar words as well as specific projections of future results, generally qualify as forward-looking. Aflac undertakes no obligation to update such forward-looking statements.
· ability to attract and retain qualified sales associates and employees
We prepare our financial statements in accordance with U.S. generally accepted accounting principles (GAAP). The preparation of financial statements in conformity with GAAP requires us to make estimates based on currently available information when recording transactions resulting from business operations. The estimates that we deem to be most critical to an understanding of Aflac’s results of operations and financial condition are those related to investments, deferred policy acquisition costs and policy liabilities. The preparation and evaluation of these critical accounting estimates involve the use of various assumptions developed from management’s analyses and judgments. The application of these critical accounting estimates determines the values at which 95% of our assets and 84% of our liabilities are reported and thus have a direct effect on net earnings and shareholders’ equity. Subsequent experience or use of other assumptions could produce significantly different results.
Aflac’s investments in debt and equity securities include both publicly issued and privately issued securities. For privately issued securities, we receive pricing data from external sources that take into account each security’s credit quality and liquidity characteristics. We also routinely review our investments that have experienced declines in fair value to determine if the decline is other than temporary. These reviews are performed with consideration of the facts and circumstances of an issuer in accordance with SEC Staff Accounting Bulletin No. 59, Accounting for Non-Current Marketable Equity Securities; Statement of Financial Accounting Standards (SFAS) No. 115,
· rating agency opinions and actions regarding the issuer’s credit standing
· adverse changes in the issuer’s economic, regulatory or political environment
Aflac’s products are generally long-duration fixed-benefit indemnity contracts. As such, our products are accounted for under the requirements of SFAS No. 60, Accounting and Reporting by Insurance Enterprises. We make estimates of certain factors that affect the profitability of our business to match expected policy benefits and deferrable acquisition costs with expected policy premiums. These assumptions include persistency, morbidity, mortality, investment yields and expenses. If actual results match the assumptions used in establishing policy liabilities and the deferral and amortization of acquisition costs, profits will emerge as a level percentage of earned premiums. However, because actual results will vary from the assumptions, profits as a percentage of earned premiums will vary from year to year.
business. While this has resulted in a higher unamortized DAC balance, the overall cost to the company has been reduced.
Deferred policy acquisition costs as a percentage of annualized premiums in force
Unpaid policy claims include those claims that have been incurred and are in the process of payment as well as an estimate of those claims that have been incurred but have not yet been reported to us. We compute unpaid policy claims on an undiscounted basis using statistical analyses of historical claims payments, adjusted for current trends and changed conditions. We update the assumptions underlying the estimate of unpaid policy claims regularly and incorporate our historical experience as well as other data that provides information regarding our outstanding liability.
Also during the fourth quarter of 2006, we transferred $85 million from Aflac Japan’s unpaid policy claims liability to its future policy benefits liability. This transfer, which was primarily related to a continued decline in current period claims caused by changes to health care delivery in Japan, had no effect on net earnings. Our 2006 claims review indicated that we experienced a continued decline in the average number of hospital days associated with the typical cancer treatment period in Japan. We believe the average number of days declined primarily due to changes in financial incentives provided to hospitals by the government-sponsored health care system in Japan to shorten the average hospital stay. However, our claims statistics also indicated that the declines in the average number of days per hospitalization are generally offset by an increase in the frequency of
During 2004, we received an issuer’s offer to redeem certain available-for-sale yen-denominated debt securities held by the Company. We accepted the issuer’s offer of $205 million and recorded a pretax loss of $23 million. This investment loss and other investment gains and losses in the normal course of business decreased 2004 pretax earnings by $12 million (after-tax, $5 million, or $.01 per diluted share).
as if we had issued yen-denominated debt of a like amount. However, the accounting treatment for cross-currency swaps is different from issuing yen-denominated Samurai and Uridashi notes. SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended (SFAS 133), requires that the change in the fair value of the interest rate component of the cross-currency swaps, which does not qualify for hedge accounting, be reflected in net earnings (other income). This change in fair value is determined by relative dollar and yen interest rates and has no cash impact on our results of operations. At maturity, the fair value will equal initial contract fair value, and the cumulative impact of gains and losses from the changes in fair value of the interest component will be zero. We have the ability and intent to retain the cross-currency swaps until their maturity. The impact from SFAS 133 includes the change in fair value of the interest rate component of the cross-currency swaps, which does not qualify for hedge accounting.
We have also issued yen-denominated Samurai and Uridashi notes. We have designated these notes as a hedge of our investment in Aflac Japan. If the value of these yen-denominated notes and the notional amounts of the cross-currency swaps exceed our investment in Aflac Japan, we would be required to recognize the foreign currency effect on the excess, or ineffective portion, in net earnings (other income). The ineffective portion would be included in the impact from SFAS 133. These hedges were effective during the three-year period ended December 31, 2006; therefore, there was no impact on net earnings.
The American Jobs Creation Act of 2004 eliminated the 90% limitation on the utilization of foreign tax credits. As a result of this tax law change, we recognized a benefit of $128 million ($.25 per diluted share) in 2004 for the release of the valuation allowance associated with certain deferred tax
We communicate earnings guidance in this report based on the growth in net earnings per diluted share. However, certain items that cannot be predicted or that are outside of management’s control may have a significant impact on actual results. Therefore, our comparison of net earnings includes certain assumptions to reflect the limitations that are inherent in projections of net earnings. In comparing year-over-year results, we exclude the effect of realized investment gains and losses, the impact from SFAS 133 and nonrecurring items. We also assume no impact from foreign currency translation on the Aflac Japan segment and the Parent Company’s yen-denominated interest expense for a given year in relation to the prior year.
Subject to the preceding assumptions, our objective for 2006 was to achieve net earnings per diluted share of at least $2.92, an increase of 15.0% over 2005 using the preceding assumptions. We reported 2006 net earnings per diluted share of $2.95. Adjusting that number for realized investment gains ($.10 per diluted share), the impact from SFAS 133 (nil per diluted share) and foreign currency translation (a loss of $.08 per diluted share), we exceeded our objective for the year.
*Excludes realized investment gains/losses, impact from SFAS 133 and nonrecurring items in 2007 and 2006
compared with 32% in 2005 and 30% in 2004. In years when the yen strengthens in relation to the dollar, translating Aflac Japan’s dollar-denominated investment income into yen lowers growth rates for net investment income, total operating revenues, and pretax operating earnings in yen terms. In years when the yen weakens, translating dollar-denominated investment income into yen magnifies growth rates for net investment income, total operating revenues, and pretax operating earnings in yen terms. On a constant currency basis, dollar-denominated investment income accounted for approximately 36% of Aflac Japan’s investment income during 2006, compared with 32% in both 2005 and 2004. The following table illustrates the effect of translating Aflac Japan’s dollar-denominated investment income and related items into yen by comparing certain segment results with those that would have been reported had yen/dollar exchange rates remained unchanged from the prior year.
The following table presents a summary of operating ratios for Aflac Japan.
The benefit ratio has declined over the past several years, reflecting the impact of newer products with lower loss ratios. We have also experienced favorable claim trends in our major product lines. We expect the benefit ratio to continue to decline in future years primarily reflecting the shift to newer products and riders. However, this decline is partially offset by the effect of low investment yields, which impacts our profit margin by reducing the spread between investment yields and required interest on policy reserves (see table and discussion on Page II-27). The operating expense ratio was higher in 2005 as a result of additional advertising expenditures and the write-off of previously capitalized systems development costs. We expect the operating expense ratio to be relatively stable
We believe the 2006 sales decline for our medical product category primarily reflected consumers’ concern over the claims-paying issues facing the industry in general. We expect this weakness will continue into 2007. However, with continued cost pressure on Japan’s health care system, we expect demand for medical products will continue to rise in the future and we remain encouraged about the outlook for the medical insurance market. Although that market is very competitive, Aflac Japan retains the distinction of being the number one seller of stand-alone medical insurance in Japan. We believe that our number one position benefits us in the marketplace. As a result, we continue to believe that the medical category will be an important part of our product portfolio.
In June 2006, we began selling a new cancer plan aimed at existing cancer insurance policyholders. This new product provides additional benefits for inpatient and outpatient care. Our
cancer life policies are also marketed by Dai-ichi Mutual Life and in June 2006, Dai-ichi Life began selling a new cancer product customized for their market. As a result, new sales from cancer insurance products were stable in 2006. We are convinced that the affordable cancer products Aflac Japan provides will continue to be an important part of our product portfolio.
We continue to expect 2007 to be a challenging year from a sales perspective and look for sales to again decline in the first half of the year, followed by modest sales increases in the second half of 2007.
At December 31, 2006, the yield on Aflac Japan’s investment portfolio, including dollar-denominated investments, was 4.14%, compared with 4.22% a year ago. See Investments and Cash on Page II-28 for additional information.
Japan’s system of compulsory public health care insurance provides medical coverage to every Japanese citizen. These public medical expenditures are covered by a combination of premiums paid by insureds and their employers, taxes, and copayments from the people who receive medical service. However, given Japan’s aging population, the resources available to these publicly funded social insurance programs have come under increasing pressure. As a result, copayments and other out-of-pocket expenses have been rising and affecting more people. In 2003, copayments were raised from 20% to 30% for most consumers and other reforms were implemented in 2006. Additional reforms are being considered. We believe higher out-of-pocket expenses will lead more consumers to purchase supplemental insurance plans. Many insurance companies have recognized the opportunities for selling supplemental medical insurance in Japan and have launched new products in recent years. However, we believe our favorable cost structure compared with other insurers makes us a very effective competitor. In addition, we believe our brand, customer service, and financial strength also benefit our market position.
The FSA adopted new mortality tables effective April 1, 2007, that will be used when developing our policy premium and reserving assumptions on newly underwritten policies. These new tables reflect recent improvements in survival rates in Japan. If our other assumptions remain unchanged, these revisions will generally lead to a decrease in policy premiums for death benefit products and an increase in premium rates for third sector products and annuities.
As disclosed in our third quarter 2006 Form 10-Q, Aflac Japan, along with the entire life insurance industry, began a review of the last five years of paid claims to determine if those claims were paid fully and accurately. In a recent notification from the FSA, the review process has been changed from a voluntary program to one that is mandatory and has been expanded to include a review of cash surrender value payments. Additionally, the FSA established a reporting deadline of April 13, 2007. We expect to complete our review of claims and cash surrender value payments and report our findings to the FSA within the time frame specified. As a result of this review, we have found some payment errors and we are correcting them. Additionally, we are using this review to identify process changes that will help ensure that payment errors such as these are not repeated. Although immaterial to our financial statements, we have recorded a liability for our estimate of the underpaid portion of those claims in our 2006 financial statements.
The percentage increases in premium income reflect the growth of premiums in force. The increases in annualized premiums in force of 10.5% in 2006, 10.0% in 2005, and 10.9% in 2004 were favorably affected by increased sales at the worksite primarily through cafeteria plans and a slight improvement in the persistency of several products. Annualized premiums in force at December 31 were $4.1 billion in 2006, compared with $3.7 billion in 2005 and $3.4 billion in 2004.
The following table presents a summary of operating ratios for Aflac U.S.
After several years of trending upward, the benefit ratio declined modestly in 2006. As a percentage of premium income, the benefit ratio was 61.0% in 2006, 61.3% in 2005, and 61.4% in 2004. We expect the benefit ratio to decline slightly in future periods due to favorable claim cost trends. The 2006 operating expense ratio reflects the write-off of remaining deferred policy acquisition costs associated with a large payroll account that terminated in the first quarter. We expect the operating expense ratio, excluding discretionary promotional expenses, to remain relatively stable in future periods. The pretax operating profit margin is expected to increase slightly in 2007.
Our financial condition has remained strong in the functional currencies of our operations during the last two years. The yen/dollar exchange rate at the end of each period is used to translate yen-denominated balance sheet items to U.S. dollars for reporting purposes. The exchange rate at December 31, 2006, was 119.11 yen to one dollar, or .9% weaker than the December 31, 2005, exchange rate of 118.07. The weaker yen decreased reported investments and cash by $357 million; total assets by $400 million; and total liabilities by $392 million, compared with the amounts that would have been reported for 2006 if the exchange rate had remained unchanged from December 31, 2005.
On a consolidated basis, we attempt to minimize the exposure of shareholders’ equity to foreign currency translation fluctuations. We accomplish this by investing a portion of Aflac Japan’s investment portfolio in dollar-denominated securities, by the Parent Company’s issuance of yen-denominated debt and by the use of cross-currency swaps (see Hedging Activities on Page II-35 for additional information). As a result, the effect of currency fluctuations on our net assets is mitigated. The dollar values of our yen-denominated net assets, which are subject to foreign currency translation fluctuations for financial reporting purposes, are summarized as follows (translated at end-of-period exchange rates) for the years ended December 31:
We are exposed to economic currency risk only when yen funds are actually converted into dollars. This primarily occurs when we repatriate funds from Aflac Japan to Aflac U.S., which is done annually. The exchange rates prevailing at the time of repatriation will differ from the exchange rates prevailing at the time the yen profits were earned. These repatriations have not been greater than 80% of Aflac Japan’s prior year earnings determined in accordance with standards established by the FSA. A portion of the repatriation may be used to service Aflac Incorporated’s yen-denominated notes payable with the remainder converted into dollars.
Changes in the interest rate environment have contributed to the unrealized gains on debt securities we own. However, we do not expect to realize a majority of these unrealized gains because we have the intent and ability to hold these securities to maturity. Likewise, should significant amounts of unrealized losses occur because of increases in market yields, we would not expect to realize these losses because we have the intent and ability to hold such securities to maturity or recovery of value. For additional information on unrealized losses on debt securities, see Note 3 of the Notes to the Consolidated Financial Statements.
*Represents yen-denominated investments for Aflac Japan that support policy obligations and therefore excludes Aflac Japan’s annuities, and dollar-denominated investments and related investment income
In response to low interest rates in the United States, we lowered our required interest assumption for newly issued products to 5.5% in 2005. In Japan, we lowered our required interest assumption for some newly issued products to 2.5% in 2005. However, the majority of Japan’s newly issued products have a required interest assumption of 3.0%. We continue to monitor the spread between our new money yield and the required interest assumption for newly issued products in both the United States and Japan and will re-evaluate those assumptions as necessary.
Over the next two years, we have yen-denominated securities that will mature with yields in excess of Aflac Japan’s current net investment yield of 3.88%. These securities total $1.1 billion at amortized cost and have an average yield of 5.80%. Currently, when debt securities we own mature, the proceeds may be reinvested at a yield below that of the interest required for the accretion of policy benefit liabilities on policies issued in earlier years. As a result, securities that mature may contribute to a decline in our overall portfolio yield. However, adding riders to our older policies has helped offset the negative investment spread. And despite negative investment spreads, adequate overall profit margins still exist in Aflac Japan’s aggregate block of business because of profits that have emerged from changes in mix of business and favorable experience from mortality, morbidity, and expenses.
*Excludes investment-grade fixed-maturity securities held by the Parent Company of $102 in 2006 and $100 in 2005.
We have investments in both publicly issued and privately issued securities. However, the status of issuance should not be viewed as an indicator of liquidity or as a limitation on the determination of fair value. The outstanding amount(s) of a particular issuance, as well as the level of activity in a particular issuance and the state of the market, including credit events and the interest rate environment, affect liquidity regardless of type of issuance. We routinely assess the fair value of all of our investments. This process includes evaluating quotations provided by outside securities pricing sources and/or compiled using data provided by external debt and equity market sources, as described more fully in Note 3 of the Notes to the Consolidated Financial Statements. The following table details investment securities by type of issuance as of December 31.
Privately issued securities accounted for 68.8% of total debt securities, at amortized cost, at December 31, 2006, compared with 66.6% at December 31, 2005. Privately issued securities held by Aflac Japan at amortized cost accounted for $31.3 billion, or 64.0%, of total debt securities at December 31, 2006, and $27.9 billion, or 61.8%, of total debt securities at December 31, 2005. Reverse-dual currency debt securities accounted for $9.7 billion, or 28.9%, of total privately issued securities at December 31, 2006, compared with $8.9 billion, or 29.6%, of total privately issued securities at December 31, 2005. Aflac Japan has invested in privately issued securities to secure higher yields than those available from Japanese government bonds. Aflac Japan’s investments in yen-denominated privately issued securities consist primarily of non-Japanese issuers and have longer maturities, thereby allowing us to improve our asset/liability matching and our overall investment returns. Most of our privately issued securities are issued under medium-term note programs and have standard documentation commensurate with credit ratings, except when internal credit analysis indicates that additional protective and/or event-risk covenants are required.
Our investment activities expose us to credit risk, which is a consequence of extending credit and/or carrying investment positions. However, we continue to adhere to prudent standards for credit quality. We accomplish this by considering our product needs and overall corporate objectives, in addition to credit risk. Our investment policy requires that all securities be rated investment grade at the time of purchase. In evaluating the initial rating, we look at the overall senior issuer rating, the explicit rating for the actual issue or the rating for the security class, and, where applicable, the appropriate designation from the Securities Valuation Office (SVO) of the National Association of Insurance Commissioners (NAIC). All of our securities have ratings from either a nationally recognized statistical rating organization or the SVO of the NAIC. In addition, we perform extensive internal credit reviews to ensure that we are consistent in applying rating criteria for all of our securities.
internal credit analysis. The distributions by credit rating of our purchases of debt securities for the years ended December 31, based on acquisition cost, were as follows:
The overall credit quality of our portfolio remained high in part because our investment policy prohibits us from purchasing below-investment-grade securities. In the event of a credit rating downgrade to below-investment-grade status, we do not automatically liquidate our position. However, if the security is in the held-to-maturity portfolio, we immediately transfer it to the available-for-sale portfolio so that the security’s fair value and its unrealized gain/loss are reflected on the balance sheet.
Once we designate a security as below investment grade, we intensify our monitoring of the issuer. We do not automatically recognize an impairment if the security’s amortized cost exceeds its fair value. Our investment management starts by reviewing its credit analysis. Included in this process are an evaluation of the issuer, its current credit posture and an assessment of the future prospects for the issuer. We then obtain fair value information from at least three independent pricing sources. Upon determining the fair value, we move our focus to an analysis of whether or not the decline in fair value, if any, is other than temporary. For securities with an amortized cost in excess of fair value, investment management then reviews the issue based on our impairment policy to determine if the investment should be impaired and/or liquidated. The assessment of whether a decline is other than
temporary requires significant management judgment and is discussed more fully in the Critical Accounting Estimates section on Page II-6. Securities classified as below investment grade as of December 31 were as follows:
Occasionally a debt security will be split rated. This occurs when one rating agency rates the security as investment grade while another rating agency rates the same security as below investment grade. Our policy is to review each issue on a case-by-case basis to determine if a split-rated security should be classified as investment grade or below investment grade. Our review includes evaluating the issuer’s credit position as well as current market pricing and other factors, such as the issuer’s or security’s inclusion on a credit rating downgrade watch list. Split-rated securities as of December 31, 2006, represented .2% of total debt securities at amortized cost and were as follows:
The following table provides details on amortized cost, fair value and unrealized gains and losses for our investments in debt securities by investment-grade status as of December 31, 2006.
The following table presents the 10 largest unrealized loss positions in our portfolio as of December 31, 2006.
The fair value of our investments in debt securities can fluctuate as a result of changes in interest rates, foreign currency exchange rates, and credit issues. Declines in fair value noted above resulted from changes in interest rates, yen/dollar exchange rates, and issuer credit status. However, we believe that it would be inappropriate to recognize impairment charges because we believe the changes in fair value are temporary. Based on our evaluation and analysis of specific issuers in accordance with our impairment policy, impairment charges recognized in each of the years in the three-year period ended December 31, 2006 were immaterial.
Realized losses on below-investment-grade securities primarily relate to the 2006 disposition of Cooper Tire & Rubber Co.
Cash, cash equivalents, and short-term investments totaled $1.2 billion, or 2.3% of total investments and cash, as of December 31, 2006, compared with $1.3 billion, or 2.6%, at December 31, 2005.
Deferred policy acquisition costs totaled $6.0 billion at December 31, 2006, an increase of $435 million, or 7.8% over 2005. The following table presents deferred policy acquisition costs by segment for the years ended December 31.
Aflac Japan’s deferred policy acquisition costs increased 6.4% (7.4% increase in yen). The weaker yen at year-end decreased reported deferred policy acquisition costs by $34 million. Deferred policy acquisition costs of Aflac U.S. increased 10.3%. The increase in deferred policy acquisition costs was primarily driven by total new annualized premium sales.
Policy liabilities totaled $45.4 billion at December 31, 2006, an increase of $3.1 billion, or 7.3% over 2005. The following table presents policy liabilities by segment for the years ending December 31.
Aflac Japan’s policy liabilities increased 6.7% (7.6% increase in yen). The weaker yen at year-end decreased reported policy liabilities by $353 million. Policy liabilities of Aflac U.S. increased 12.5%. The increase in total policy liabilities is the result of the growth and aging of our in-force business.
Aflac provides the primary sources of liquidity to the Parent Company through dividends and management fees. Aflac declared dividends to the Parent Company in the amount of $665 million in 2006, compared with $526 million in 2005 and $643 million in 2004. During 2006, Aflac paid $68 million to the Parent Company for management fees, compared with $73 million in 2005 and $33 million in 2004. The increase in management fees in 2005 resulted from a change in the allocation of expenses under the management fee agreement between Aflac and the Parent Company. The primary uses of cash by the Parent Company are shareholder dividends and our share repurchase program. The Parent Company’s sources and uses of cash are reasonably predictable and are not expected to change materially in the future.
The Parent Company also accesses debt security markets to provide additional sources of capital. Capital is primarily used to fund business expansion and capital expenditures. In 2003, we filed a Shelf Registration Statement (SRS) with Japanese regulatory authorities to issue up to 100 billion yen of Samurai notes in Japan. In July 2005, we issued 40 billion yen (approximately $360 million) of these securities with a coupon of .71% and a five-year maturity. These securities are not available to U.S. persons. The remaining 60 billion yen of the 2003 SRS expired in December 2005. As a result,
we filed a new SRS with Japanese regulatory authorities in February 2006 to issue up to 100 billion yen (approximately $840 million using the December 31, 2006, exchange rate) of Samurai notes in Japan. If issued, these securities will not be available to U.S. persons. We also filed an SRS in August 2006 with Japanese regulatory authorities to issue up to 100 billion yen (approximately $840 million using the December 31, 2006, period-end exchange rate) of Uridashi notes in Japan. In September 2006, the Parent Company issued 45 billion yen of yen-denominated Uridashi notes from this SRS. If issued, the remaining 55 billion yen of yen-denominated Uridashi notes will not be available to U.S. persons. We believe outside sources for additional debt and equity capital, if needed, will continue to be available. For additional information, see Note 7 of the Notes to the Consolidated Financial Statements.
Cash flows for Aflac U.S. and Other Operations included the January 2005 return of cash collateral from the security lending activities of Aflac U.S. at the end of 2004 (approximately $2.6 billion).
The continued long-term growth of our business may require increases in the statutory capital and surplus of our insurance operations. Aflac’s insurance operations may secure additional statutory capital through various sources, such as internally generated statutory earnings or equity contributions by the Parent Company from funds generated through debt or equity offerings. The NAIC’s risk-based capital (RBC) formula is used by insurance regulators to facilitate identification of inadequately capitalized insurance companies. The RBC formula quantifies insurance risk, business risk, asset risk and interest rate risk by weighing the types and mixtures of risks inherent in the insurer’s operations. Aflac’s RBC ratio remains high and reflects a very strong capital and surplus position. Currently, the NAIC has ongoing regulatory initiatives relating to revisions to the RBC
Payments are made from Aflac Japan to the Parent Company for management fees and to Aflac U.S. for allocated expenses and profit repatriations. During 2006, Aflac Japan paid $25 million to the Parent Company for management fees, compared with $28 million in 2005 and $24 million in 2004. Expenses allocated to Aflac Japan were $32 million in 2006, $30 million in 2005 and $26 million in 2004. During 2006, Aflac Japan repatriated profits of $442 million (50.0 billion yen) to Aflac U.S., compared with $374 million (41.2 billion yen) in 2005 and $220 million (23.9 billion yen) in 2004. Profits repatriated in 2004 were lower primarily as a result of realized investment losses recognized in 2003. For additional information on regulatory restrictions on dividends, profit repatriations and other transfers, see Note 11 of the Notes to the Consolidated Financial Statements.
In October 2006, the board of directors declared the first quarter 2007 cash dividend of $.185 per share. The dividend is payable on March 1, 2007, to shareholders of record at the close of business on February 16, 2007. In 2004, the board of directors authorized the purchase of up to 30 million shares of our common stock. In 2006, the board of directors authorized the purchase of an additional 30 million shares of our common stock. As of December 31, 2006, approximately 37 million shares were available for purchase under our share repurchase programs.
For information regarding commitments and contingent liabilities, see Note 13 of the Notes to the Consolidated Financial Statements.
$.44 per share in 2005, and $.38 per share in 2004)
Adjustments to reconcile net earnings to net cash provided by operating activities:
We have designated the yen-denominated Uridashi and Samurai notes issued by the Parent Company and the cross-currency swaps as a hedge of our investment in Aflac Japan (see the section in this note titled, “Derivatives”). Outstanding principal and related accrued interest on these items are translated into U.S. dollars at end-of-period exchange rates. Currency translation adjustments are included in accumulated other comprehensive income.
Insurance Revenue and Expense Recognition: The supplemental health and life insurance policies we issue are classified as long-duration contracts. The contract provisions generally cannot be changed or canceled during the contract period; however, we may adjust premiums for supplemental health policies issued in the United States within prescribed guidelines and with the approval of state insurance regulatory authorities.
The net unrealized gains and losses on securities available for sale, plus the unamortized unrealized gains and losses on debt securities transferred to the held-to-maturity portfolio, less related deferred income taxes, are included in accumulated other comprehensive income.
Our investments in qualifying special purpose entities (QSPEs) are accounted for as fixed-maturity or perpetual securities. All of our investments in QSPEs are held in our available-for-sale portfolio.
Policy Liabilities: Future policy benefits represent claims that may occur in the future and are computed by a net level premium method using estimated future investment yields, persistency and recognized morbidity and mortality tables modified to reflect our experience, including a provision for adverse deviation. These assumptions are generally established at the time a policy is issued.
Policyholder Protection Fund and State Guaranty Association Assessments: In Japan, the government has required the insurance industry to contribute to a policyholder protection fund. We recognize a charge for our estimated share of the industry’s obligation once it is determinable. We review the estimated liability for policyholder protection fund contributions on an annual basis and report any adjustments in Aflac Japan’s expenses.
Earnings Per Share: We compute basic earnings per share (EPS) by dividing net earnings by the weighted-average number of unrestricted shares outstanding for the period. Diluted EPS is computed by dividing net earnings by the weighted-average number of shares outstanding for the period plus the shares representing the dilutive effect of share-based awards.
New Accounting Pronouncements: In September 2006, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R) (SFAS 158). The provisions of SFAS 158 apply to all plan sponsors who offer defined benefit postretirement plans. SFAS 158 requires a plan sponsor to recognize the plan’s funded status as an asset or liability in its balance sheet, and to measure plan assets and liabilities as of the end of the sponsor’s fiscal year. It also requires an entity to recognize changes in the funded status of a defined benefit postretirement plan in comprehensive income in the year in which the changes occur. However, SFAS 158 does not change the amount of net periodic benefit cost, or expense, included in net earnings. The recognition and disclosure requirements of SFAS 158 are effective as of the end of the fiscal year ending after December 15, 2006. The measurement date provisions are effective for fiscal years ending after December 15, 2008. Earlier application of the measurement date provisions is encouraged. We adopted the recognition and measurement date provisions of this standard effective December 31, 2006. The adoption of this standard increased our pension plans’ projected benefit obligation by $64 million; and resulted in a charge to other comprehensive income of $64 million before taxes to reflect the increase in pension liabilities and an opening adjustment to retained earnings in the amount of $2 million.
accordance with SFAS No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The evaluation of a tax position in accordance with FIN 48 is a two-step process. Under the first step, the enterprise determines whether it is more-likely-than-not that a tax position will be sustained upon examination by taxing authorities. The second step is measurement, whereby a tax position that meets the more-likely-than-not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured at the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006, with earlier application encouraged. We do not expect the adoption of this interpretation to have a material effect on our financial position or results of operations.
In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments, an amendment of FASB Statements No. 133 and 140 (SFAS 155). The provisions of SFAS 155 are effective for all financial instruments acquired or issued after the beginning of the first fiscal year after September 15, 2006. Earlier adoption is permitted. SFAS 155 amends the accounting for hybrid financial instruments and eliminates the exclusion of beneficial interests in securitized financial assets from the guidance under SFAS 133. It also eliminates the prohibition on the type of derivative instruments that qualified special purpose entities may hold under SFAS 140. Furthermore, SFAS 155 clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives. In accordance with the standard’s early adoption provisions, we adopted the provisions of SFAS 155 on January 1, 2006. The adoption of this standard did not have any impact on our financial position or results of operations.
In September 2005, the Accounting Standards Executive Committee of the AICPA issued Statement of Position (SOP) 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts (SOP 05-1). SOP 05-1 provides accounting guidance on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments. SOP 05-1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006, with earlier adoption encouraged. Retrospective application of this SOP to previously issued
Securities and Exchange Commission Guidance: In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108 (SAB 108). SAB 108 addresses quantifying the financial statement effects of misstatements, specifically, how the effects of prior year uncorrected errors must be considered in quantifying misstatements in current year financial statements. Under the provisions of SAB 108, a reporting entity must quantify and evaluate errors using a balance sheet approach and an income statement approach. After considering all relevant quantitative and qualitative factors, if either approach results in a misstatement that is material, a reporting entity’s financial statements must be adjusted. SAB 108 applies to SEC registrants and is effective for fiscal years ending after November 15, 2006. In the course of evaluating balance sheet amounts in accordance with the provisions of SAB 108, we have identified the following amounts that we have adjusted for as of January 1, 2006: a tax liability in the amount of $87 million related to deferred tax asset valuation allowances that were not utilized; a tax liability in the amount of $45 million related to various provisions for taxes that were not utilized; and a litigation liability in the amount of $11 million related to provisions for various pending law suits that were not utilized. These liabilities were recorded in immaterial amounts prior to 2004 over a period ranging from 10 to 15 years. However, using the dual evaluation approach prescribed by SAB 108, correction of the above amounts would be material to current year earnings. In accordance with the provisions of SAB 108, the following amounts, net of tax where applicable, have been reflected as an opening adjustment to retained earnings as of January 1, 2006: a reduction of tax liabilities in the amount of $132 million; a reduction of litigation reserves in the amount of $11 million; and a reduction in deferred tax assets in the amount of $4 million. These three adjustments resulted in a net addition to retained earnings in the amount of $139 million.
Aflac Japan maintains a portfolio of dollar-denominated securities, which serve as an economic currency hedge of a portion of our investment in Aflac Japan. We have designated the Parent Company’s yen-denominated notes payable and cross-currency swaps as a hedge of our investment in Aflac Japan. The dollar values of our yen-denominated net assets, which are subject to foreign currency translation fluctuations for financial reporting purposes, are summarized as follows at December 31 (translated at end-of-period exchange rates):
Policyholder Protection Fund: The total liability accrued for our obligations to the Japanese life insurance policyholder fund was $175 million (20.8 billion yen) at December 31, 2006, compared with $203 million (23.9 billion yen) a year ago. The obligation is payable in semi-annual installments through 2013.
Investment exposures, which individually exceeded 10% of shareholders’ equity as of December 31, were as follows:
Privately issued securities held by Aflac Japan at amortized cost accounted for $31.3 billion, or 64.0%, of total debt securities at December 31, 2006, compared with $27.9 billion, or 61.8%, of total debt securities at December 31, 2005. Total privately issued securities, at amortized cost, accounted for $33.6 billion, or 68.8%, of our total debt securities as of December 31, 2006, compared with $30.1 billion, or 66.6%, at December 31, 2005. Of the total privately issued securities, reverse-dual currency debt securities (principal payments in yen, interest payments in dollars) accounted for $9.7 billion, or 28.9%, at amortized cost as of December 31, 2006, compared with $8.9 billion, or 29.6%, at amortized cost as of December 31, 2005.
During 2004, we received an issuer’s offer to redeem certain available-for-sale yen-denominated debt securities held by the Company. We accepted the issuer’s offer of $205 million and recorded a pretax loss of $23 million. This investment loss and other investment gains and losses in the normal course of business decreased pretax earnings by $12 million (after-tax $5 million, or $.01 per diluted share).
Fair values of debt securities and privately issued equity securities were determined using quotations provided by outside securities pricing sources and/or compiled using data provided by external debt and equity market sources. The data used in estimating fair value include credit spreads of comparably credit-rated securities and market quotations of securities with similar maturity and call structure characteristics. Fair values are then computed using standard industry models that provide pricing data based on a wide variety of inputs as noted above. The fair values provided by outside sources are reviewed internally for reasonableness. If a fair value appears unreasonable, the inputs are re-examined and the value is confirmed or revised. The fair values for publicly traded equity securities were determined using market quotations from the public exchange markets where the securities are principally traded.
The unrealized losses on our investments in government and guaranteed fixed-maturity securities, which include U.S. Treasury obligations, direct obligations of U.S. government agencies, Japan government bonds, and direct obligations of Japan government agencies were caused by changes in interest rates and/or exchange rates. The contractual cash flows of these investments are guaranteed by either the U.S. or Japanese government. Furthermore, the contractual terms of these investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investment. Because we have the ability and intent to hold these investments until a recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2006.
Included in the unrealized losses on Other corporate fixed-maturity securities is an unrealized loss of $56 million on Aflac Japan’s $201 million (24 billion yen) investment in Tollo Shipping Company S.A. Our investment is guaranteed by the issuer’s parent, Compañia Sudamericana de Vapores S.A. (CSAV). The decline in fair value of the security was primarily caused by two factors: depressed revenue due to competitive pricing pressures in the container shipping industry and weaker operating margins due to sharply increased fuel costs. The contractual terms of this investment do not permit the issuer or its parent to settle the security at a price less than the amortized cost of the investment, and give priority to repayment of our investment under certain circumstances. While CSAV’s credit rating has decreased from BBB- to BB+ (S&P), we currently believe it is probable that we will collect all amounts due according to the contractual terms of the investment. Therefore, it is expected that our investment would not be settled at a price less than the amortized cost of the investment. Because we have the intent and ability to hold this investment until a recovery of fair value, which may be maturity, we do not consider it to be other-than-temporarily impaired as of December 31, 2006.
Currently, when our debt securities mature, the proceeds may be reinvested at a yield below that of the interest required for the accretion of policy benefit liabilities on policies issued in earlier years. However, our strategy of developing and marketing riders to our older policies has helped offset the negative investment spread. In spite of the negative investment spreads, overall profit margins in Aflac Japan’s aggregate block of business are adequate because of profits that continue to emerge from changes in mix of business and favorable mortality, morbidity, and expenses.
We own subordinated perpetual debenture securities. These securities are subordinated to other debt obligations of the issuer, but rank higher than equity securities. Although these securities have no contractual maturity, the interest coupons that were fixed at issuance subsequently change to a floating short-term interest rate of 125 to 300 basis points above market rates, generally by the 25th year after issuance, thereby creating an economic maturity date. The economic maturities of our investments in perpetual debentures at December 31, 2006, were as follows:
As part of our investment activities, we own investments in qualified special purpose entities (QSPEs). At December 31, 2006, available-for-sale QSPEs totaled $2.3 billion at fair value ($2.3 billion at amortized cost, or 4.7% of total debt securities), compared with $2.2 billion at fair value ($2.3 billion at amortized cost, or 5.0% of total debt securities) at December 31, 2005. We have no equity interests in any of the QSPEs, nor do we have control over these entities. Therefore, our loss exposure is limited to the cost of our investment.
We also own yen-denominated investments in variable interest entities (VIEs) totaling $1.9 billion at fair value, ($2.0 billion at amortized cost, or 4.2% of total debt securities) at December 31, 2006. We are the primary beneficiary of VIEs totaling $1.5 billion at fair value ($1.7 billion at amortized cost)
and have consolidated our interests in these VIEs in accordance with FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities. The activities of these VIEs are limited to holding debt securities and utilizing the cash flows from the debt securities to service our investments therein. The terms of the debt securities mirror the terms of the notes held by Aflac. The consolidation of these investments does not impact our financial position or results of operations. We also have interests in VIEs that we are not required to consolidate totaling $375 million at fair value ($373 million at amortized cost) as of December 31, 2006. The loss on any of our VIE investments would be limited to its cost.
We lend fixed-maturity securities to financial institutions in short-term security lending transactions. These short-term security lending arrangements increase investment income with minimal risk. Our security lending policy requires that the fair value of the securities and/or cash received as collateral be 102% or more of the fair value of the loaned securities. At December 31, 2006, we had security loans outstanding with a fair value of $780 million, and we held cash in the amount of $807 million as collateral for these loaned securities. At December 31, 2005, we had security loans outstanding with a fair value of $605 million, and we held cash in the amount of $622 million as collateral for these loaned securities.
During 2006, we reclassified an investment from held to maturity to available for sale as a result of the issuer’s credit rating downgrade. At the date of transfer, this debt security had an amortized cost of $118 million.
During 2004, we reclassified two debt securities from held to maturity to available for sale. The first transfer resulted from the issuer’s credit rating downgrade. At the time of transfer, the debt security had an amortized cost of $118 million. Included in accumulated other comprehensive income immediately prior to the transfer was an unamortized gain of $24 million related to this security. This gain represented the remaining unamortized portion of a $32 million gain established in 2001, when we reclassified this investment from available for sale to held to maturity. The second transfer resulted from the deterioration in the issuer’s credit worthiness. At the time of transfer, this debt security had an amortized cost of $291 million.
We entered into cross-currency swaps to minimize the impact of foreign currency translation on shareholders’ equity and to reduce interest expense by converting the dollar-denominated principal and interest on the senior notes we issued into yen-denominated obligations. By entering into these cross-currency swaps, we have been able to reduce our interest rate from 6.5% in dollars to 1.67% in yen. See Note 1 for information on the accounting policy for cross-currency swaps.
The following is a reconciliation of the foreign currency component of the cross-currency swaps as included in accumulated other comprehensive income for the years ended December 31.
Interest rate component not qualifying for hedge accounting reclassified to net earnings
We are exposed to credit risk in the event of nonperformance by counterparties to our cross-currency and interest rate swaps. The counterparties to our swap agreements are U.S. and Japanese financial institutions with the following credit ratings as of December 31:
Commissions deferred as a percentage of total acquisition costs deferred were 76% in both 2006 and 2005, and 78% in 2004. Personnel, compensation and benefits as a percentage of insurance expenses were 44% in 2006, 41% in 2005 and 43% in 2004.
*Aflac Japan accounted for $33 in 2006, $77 in 2005, and $60 in 2004.
The incurred claims development related to prior years reflects favorable development in the unpaid policy claims liability previously provided for. There are no additional or return of premium considerations associated with that development.
10 billion yen and has a 10-year maturity. The third tranche totaled 20 billion yen and has a five-year maturity and a variable interest coupon of six-month yen LIBOR plus a spread. We have entered into interest rate swaps related to the 20 billion yen variable interest rate notes (see Note 4). Each tranche of Uridashi notes pays interest semiannually, may only be redeemed prior to maturity upon the occurrence of a tax event as specified in the respective bond agreement and is not available to U.S. persons. If issued, the 55 billion yen of Uridashi notes remaining under the August 2006 SRS will not be available to U.S. persons.
In 2001, 2002, and 2005, the Parent Company issued yen-denominated Samurai notes, each with five-year maturities. Each series of Samurai notes pays interest semiannually, may only be redeemed prior to maturity upon the occurrence of a tax event as specified in the respective bond agreement and is not available to U.S. persons. In June 2006, we paid in full the .87% Samurai notes issued in 2001.
The components of income tax expense (benefit) applicable to pretax earnings for the years ended December 31 were as follows:
During 2005, the valuation allowance for deferred tax assets decreased by $34 million primarily due to utilization of non-life losses. For current U.S. income tax purposes, alternative minimum tax credit carryforwards of $80 million were available at December 31, 2006.
We exclude outstanding share-based awards from the calculation of weighted-average shares used in the computation of basic earnings per share. Stock options to purchase approximately 1.8 million shares, on a weighted-average basis, as of December 31, 2006, were considered to be anti-dilutive and were excluded from the calculation of diluted earnings per share, compared with 2.5 million in 2005, and 1.1 million in 2004. The weighted-average shares used in calculating earnings per share for the years ended December 31 were as follows:
Share Repurchase Program: In 2004, the board of directors authorized the purchase of up to 30 million shares of our common stock. In 2006, the board of directors authorized the purchase of an additional 30 million shares of our common stock. As of December 31, 2006, approximately 37 million shares were available for purchase under our share repurchase programs.
The second long-term incentive compensation plan allows awards to Company employees for ISOs, NQSOs, restricted stock, restricted stock units, and stock appreciation rights. Non-employee directors are eligible for grants of NQSOs, restricted stock, and stock appreciation rights. Generally, the awards vest based upon time-based conditions or time-and-performance-based conditions. Performance-based vesting conditions generally include the attainment of goals related to Company financial performance. As of December 31, 2006, the only performance-based awards issued and outstanding were restricted stock awards. As of December 31, 2006, approximately 24 million shares were available for future grants under this plan.
Share-based awards granted to U.S.-based grantees are settled upon exercise with authorized but unissued Company stock, while those issued to Japan-based grantees are settled upon exercise with treasury shares.
We estimate the fair value of each stock option granted using the Black-Scholes-Merton multiple option approach. Expected volatility is based on historical periods generally commensurate with the estimated term of options. We use historical data to estimate option exercise and termination patterns within the model. Separate groups of employees that have similar historical exercise patterns are stratified and considered separately for valuation purposes. The expected term of options granted is derived from the output of our option model and represents the weighted-average period of time that options granted are expected to be outstanding. We base the risk-free interest rate on the Treasury note rate with a term comparable to that of the estimated term of options. The weighted-average fair value of options at their grant date was $15.28 for 2006, compared with $13.40 in 2005 and $10.66 in 2004. The following table presents the assumptions used in valuing options granted during the years ended December 31.
The following table summarizes information about stock options outstanding and exercisable at December 31, 2006.
As of December 31, 2006, total compensation cost not yet recognized in our financial statements related to restricted stock awards was $16 million, of which $7 million (305 thousand shares) was related to share-based awards with a performance-based vesting condition. We expect to recognize these amounts over a weighted-average period of approximately two years. There are no other contractual terms covering restricted stock awards once vested.
As determined on a U.S. statutory accounting basis, Aflac’s net income was $1.7 billion in 2006, $1.3 billion in 2005, and $1.2 billion in 2004. Capital and surplus was $4.2 billion at December 31, 2006, and $3.7 billion at December 31, 2005.
Net assets of the insurance subsidiaries aggregated $9.3 billion at December 31, 2006, on a GAAP basis, compared with $8.9 billion a year ago. Aflac Japan accounted for $5.7 billion, or 62.0%, of these net assets, compared with $5.5 billion, or 61.4% at December 31, 2005.
The Parent Company depends on its subsidiaries for cash flow, primarily in the form of dividends and management fees. Consolidated retained earnings in the accompanying financial statements largely represent the undistributed earnings of our insurance subsidiary. Amounts available for dividends, management fees and other payments to the Parent Company by its insurance subsidiary may fluctuate due to different accounting methods required by regulatory authorities. These payments are also subject to various regulatory restrictions and approvals related to safeguarding the interests of insurance policyholders. Our insurance subsidiary must maintain adequate risk-based capital for U.S. regulatory authorities and our Japan branch must maintain adequate solvency margins for Japanese regulatory authorities. Additionally, the maximum amount of dividends that can be paid to the Parent Company by Aflac without prior approval of Nebraska’s director of insurance is the greater of the net gain from operations, which excludes net realized investment gains, for the previous year determined under statutory accounting principles, or 10% of statutory capital and surplus as of the previous year-end. Dividends declared by Aflac during 2007 in excess of $1.6 billion would require such approval. Dividends declared by Aflac during 2006 were $665 million.
The 2004 profit repatriation was lower due to the impact on Japanese regulatory earnings from the realized investment loss on Parmalat in 2003 and our decision to leave capital in Japan in order to maintain a strong solvency margin.
On December 31, 2006, we adopted the recognition and disclosure provisions and early adopted the measurement date provisions of SFAS 158. SFAS 158 requires the recognition of the funded status (i.e., the difference between the fair value of plan assets and the projected benefit obligations) of our benefit plans in our financial statements, with a corresponding adjustment to accumulated other comprehensive income, net of tax. The adjustment to accumulated other comprehensive income at adoption represents the net unrecognized actuarial losses, unrecognized prior service costs or credits, as applicable, and the unrecognized transition asset remaining from the initial adoption of SFAS 87, all of which were previously netted against the plan’s funded status in the past under the provisions of SFAS 87. These amounts will be subsequently recognized as net periodic pension cost over future periods consistent with our historical accounting policy for amortizing such amounts. Further, the components of the benefit obligations that arise in subsequent periods and are not recognized as net periodic pension cost in the same periods will be recognized as a component of other comprehensive income. Those amounts will also be subsequently recognized as a component of net periodic pension cost as previously described. The adoption of SFAS 158 had no effect on our earnings for the year ended December 31, 2006, or for any prior period presented, and it will not affect our operating results in future periods.
We recognized a charge to opening retained earnings of $2 million net of tax and a reduction of accumulated other comprehensive income of $4 million, net of tax related to the adoption of the measurement date provisions of SFAS 158 for our U.S. pension plan. The Japanese pension plan previously used a measurement date of December 31. The impact of adopting the measurement date provisions of SFAS 158 for our other post employment benefit plans was negligible.
An actuarial gain of $1 million related to the Japanese plan arose during the year and was included in accumulated other comprehensive income; an actuarial loss of $4 million related to the U.S. plan arose during the year and was included in accumulated other comprehensive income. During 2006, $2 million of actuarial loss was amortized to expense for the Japanese plan, while $3 million was amortized to expense for the U.S. plan.
No prior service costs or credits arose during 2006 and the amounts of prior service costs and credits amortized to expense were immaterial for the year ended December 31, 2006. Amortization of actuarial losses to expense in 2007 is estimated to be $2 million for the Japanese plan and $4 million for the U.S. plan, while the amortization of prior service cost and credit is expected to be negligible.
Reconciliations of the funded status of the basic employee defined-benefit pension plans with amounts recognized in the consolidated balance sheets as of December 31 were as follows:
Equity securities held by our U.S. plan included $3 million (2% of plan assets) of Aflac Incorporated common stock at December 31, 2006, compared with $3 million (3% of plan assets) at December 31, 2005. Target asset allocations for U.S. plan assets are 55% to 60% equity securities,
35% to 40% fixed-income securities and 1% to 3% cash and cash equivalents. Target asset allocations for Japanese plan assets are 34% equity securities and 66% fixed-income securities. As discussed below, the investment strategy of our pension plans is long-term in nature. Cash and cash equivalents exceeded the target allocations for the U.S. plan in 2005 primarily as a result of third quarter employer contributions of $20 million in 2005.
In addition to the benefit obligations for funded employee plans, we also maintain unfunded supplemental retirement plans for certain officers and beneficiaries. Retirement expense for these unfunded supplemental plans was $16 million in 2006, $20 million in 2005, and $32 million in 2004. The accrued retirement liability for the unfunded supplemental retirement plans was $209 million at December 31, 2006, compared with $203 million a year ago. The assumptions used in the valuation of these plans were the same as for the funded plans.
We have entered into two outsourcing agreements with IBM. The first agreement provides mainframe computer operations and support for Aflac Japan. It began in 2006 and has a remaining term of nine years and an aggregate remaining cost of 26.0 billion yen ($218 million using the December 31, 2006, exchange rate). The second agreement provides computer server operations and support for Aflac Japan. It begins in 2007 and has a term of nine years and an aggregate cost of 31.8 billion yen ($267 million using the December 31, 2006, exchange rate).
We lease office space and equipment under various agreements that expire in various years through 2021. Future minimum lease payments due under non-cancelable operating leases at December 31, 2006, were as follows:
In 2005, we announced a multiyear building project for additional office space in Columbus, Georgia. The initial phase is to be completed in mid-2007 and is expected to cost approximately $26 million. The next phase of the expansion is anticipated to begin in mid-2007.
We are a defendant in various lawsuits considered to be in the normal course of business. Senior legal and financial management review litigation on a quarterly and annual basis. The final results of any litigation cannot be predicted with certainty. Although some of this litigation is pending in states where large punitive damages bearing little relation to the actual damages sustained by plaintiffs have been awarded in recent years, we believe the outcome of pending litigation will not have a material adverse effect on our financial position, results of operations, or cash flows.
We have audited the accompanying consolidated balance sheets of Aflac Incorporated and subsidiaries (the Company) as of December 31, 2006 and 2005, and the related consolidated statements of earnings, shareholders’ equity, cash flows, and comprehensive income for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Aflac Incorporated’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 27, 2007 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
As discussed in note 1 to the consolidated financial statements, the Company adopted the provisions of Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, as of January 1, 2006. Additionally, as discussed in notes 1 and 12 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R), as of December 31, 2006.