Aflac owns land and buildings (approximately 870,000 square feet) 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 Tokyo, Japan, Aflac owns an administrative office building and a training facility. 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," 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.
deviations in actual experience from pricing and reserving assumptions including, but not limited to, morbidity, mortality, persistency, expenses, and investment yields
We measure the adequacy of our policy reserves and recoverability of deferred policy acquisition costs (DAC) annually by performing gross premium valuations on our business. Our testing indicates that our insurance liabilities are adequate and that our DAC is recoverable.
Our policy liabilities, which are determined in accordance with SFAS No. 60 and Actuarial Standards of Practice, include two primary components: future policy benefits and unpaid policy claims, which accounted for 89% and 6% of total policy liabilities as of December 31, 2005, respectively.
Future policy benefits provide for claims that will occur in the future and are generally calculated as the present value of future expected benefits to be incurred less the present value of future expected net benefit premiums. We calculate future policy benefits based on assumptions of morbidity, mortality, persistency and interest. These assumptions are established at the time a policy is issued. The assumptions used in the calculations are closely related to those used in developing the gross premiums for a policy. As required by GAAP, we also include a provision for adverse deviation, which is intended to accommodate adverse fluctuations in actual experience.
Claims incurred under Aflac's policies are generally reported and paid in a relatively short time frame. They are sensitive to frequency and severity of claims. They are not, however, subject to medical cost inflation because benefits are based on a fixed indemnity. Our claims experience is primarily related to the demographics of our policyholders.
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. However, if current period claims were to change by 1%, we would expect the unpaid policy claim liability to change by approximately $19 million.
During the last three years, various accounting standard-setting bodies have been active in soliciting comments and issuing statements, interpretations and exposure drafts on issues, including equity-based compensation, pensions, variable interest entities, special purpose entities, derivatives, intangible assets and business combinations.
During the third quarter of 2004, we received an issuer's offer to redeem certain available-for-sale yen-denominated debt securities held by the Company. We accepted the issuer's offer of $205 million and recorded a pretax loss of $23 million. This investment loss and other investment gains and losses in the normal course of business decreased 2004 pretax earnings by $12 million (after-tax, $5 million, or $.01 per diluted share).
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 assets. The 2005 and 2004 tax benefits are included as reductions to income tax expense in the consolidated statement of earnings.
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.
Aflac's insurance business consists of two segments: Aflac Japan and Aflac U.S. Aflac Japan, which operates as a branch of Aflac, is the principal contributor to consolidated earnings. GAAP financial reporting requires that a company report financial and descriptive information about operating segments in its annual financial statements. Furthermore, we are required to report a measure of segment profit or loss, certain revenue and expense items, and segment assets. We measure and evaluate our insurance segments' financial performance using operating earnings on a pretax basis. We define segment operating earnings as the profits we derive from our operations before realized investment gains and losses, the impact from SFAS 133, and nonrecurring items. We believe that an analysis of segment pretax operating earnings is vitally important to an understanding of the underlying profitability drivers and trends of our insurance business. Furthermore, because a significant portion of our business is conducted in Japan, we believe it is equally important to understand the impact of translating Japanese yen into U.S. dollars.
The percentage increases in premium income reflect the growth of premiums in force. The increases in annualized premiums in force in yen of 6.8% in 2005, 6.8% in 2004, and 7.9% in 2003, reflect the high persistency of Aflac Japan's business and the sales of new policies. Annualized premiums in force at December 31, 2005, were 1.03 trillion yen, compared with 961.9 billion yen in 2004, and 900.3 billion yen in 2003. Annualized premiums in force, translated into dollars at respective year-end exchange rates, were $8.7 billion in 2005, $9.2 billion in 2004, and $8.4 billion in 2003.
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 effects of low investment yields, which affect our profit margin by reducing the spread between investment yields and required interest on policy reserves (see table and discussion on
Aflac Japan's sales mix has been shifting during the last few years. The following table details the contributions to total new annualized premium sales by major product for the years ended December 31.
As we have disclosed previously, we expect Rider MAX conversions and sales to continue to decline in future periods. Conversion activity accounted for approximately 17% of total Rider MAX sales in 2005, compared with 25% in 2004 and 24% in 2003. For policy conversions, new annualized premium sales include only the incremental annualized premium amount over the original term policy. We expect that conversions will continue to decline in future periods.
For 2006, we expect to generate solid sales growth from our medical products. However, we anticipate that lower Rider MAX sales and weaker conversions will continue to restrain sales growth. As a result, our objective for 2006 is to increase total new annualized premium sales in yen by 5% to 8%.
Growth of investment income in yen is affected by available cash flow from operations, yields on new investments, and the effect of yen/dollar exchange rates on dollar-denominated investment income. Aflac Japan has invested in privately issued securities to secure higher yields than Japanese government or other corporate bonds would have provided, while still adhering to prudent standards for credit quality. All of our privately issued securities are rated investment grade at the time of purchase. These securities are generally issued with standard documentation for medium-term note programs and have appropriate covenants.
The following table compares the results of Aflac Japan's investment activities.
Recent events indicate that Japan's economy has begun to recover. The Bank of Japan's January 2006 Monthly Report of Recent Economic & Financial Developments indicates continued increases in exports, an upward trend in industrial production, and continued increases in capital expenditures and household income. The same report also expressed the Bank of Japan's opinion that the economy is expected to continue a steady recovery trend. This opinion is based on expectations of increases in domestic private demand and exports, while issues such as excess corporate debt are dissipating. Nevertheless, the time required for a full economic recovery remains uncertain.
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 and as a result, copayments have been rising and affecting more people. In 2003, copayments were raised from 20% to 30% and additional reforms are being considered for 2006 and 2008. We believe the trend of higher copayments will lead more consumers to purchase supplemental insurance plans. Many insurance companies have recognized the opportunities for selling supplemental 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 benefit ratio has increased slightly over the past several years, primarily due to the impact of declining investment yields on the growth of our investment income. As a percentage of premium income, the benefit ratio has been fairly stable at 61.3% in 2005, 61.4% in 2004 and 61.1% in 2003. We expect the benefit ratio to decline slightly in future periods due to favorable claim cost trends. We also expect the operating expense ratio, excluding discretionary promotional expenses, to remain relatively stable. The pretax operating profit margin is expected to improve modestly in 2006.
Overall, the financial effect from hurricanes in 2005 was not material. In early September, we announced that we were allowing a 90-day grace period for premium payments in the hurricane-affected areas as defined by the Federal Emergency Management Agency. Additionally, the insurance departments in Louisiana, Mississippi and Alabama have mandated various grace periods for the affected areas, some of which extended into early 2006. In 2005, we saw a modest increase in policy terminations in the areas impacted by the hurricanes. However, these additional terminations did not have a material impact on our financial results.
Our objective for 2006 is to increase total new annualized premium sales by 8% to 12%.
We recruited more than 24,200 new associates during 2005, which was 8% higher than 2004 and in line with our expectation of a 5% to 10% increase for the year. Aflac U.S. was represented by more than 63,000 licensed sales associates in 2005, or 7% higher than a year ago.
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, 2005, was 118.07 yen to one dollar, or 11.7% weaker than the December 31, 2004, exchange rate of 104.21. The weaker yen decreased reported investments and cash by $5.1 billion, total assets by $5.7 billion, and total liabilities by $5.6 billion, compared with the amounts that would have been reported for 2005 if the exchange rate had remained unchanged from December 31, 2004.
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
We attempt to match the duration of our assets with the duration of our liabilities. For Aflac Japan, the duration of policy benefits and related expenses to be paid in future years is longer than that of the related invested assets due to the unavailability of acceptable long-duration yen-denominated securities. The following table presents the approximate duration of our yen-denominated assets and liabilities, along with premiums, as of December 31.
Over the next two years, we have several yen-denominated securities that will mature with yields in excess of Aflac Japan's current net investment yield of 3.92%. These securities total $640 million at amortized cost and have an average yield of 5.91%. These maturities will contribute to a continued decline in our overall portfolio yield. 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. 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.
Aflac invests primarily within the debt securities markets. 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). In addition, we perform extensive internal credit reviews to ensure that we are consistent in applying rating criteria for all of our securities. The following table details investment securities by segment as of December 31.
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 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.
The increase in below-investment-grade securities primarily resulted from credit rating downgrades of the securities of two U.S. issuers. 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.
The following table presents a distribution of unrealized losses by magnitude as of December 31, 2005.
Cash, cash equivalents, and short-term investments totaled $1.3 billion, or 2.6% of total investments and cash, as of December 31, 2005, compared with $3.8 billion, or 7.3%, at December 31, 2004. The decrease, compared with a year ago, was due to the return of cash collateral in early 2005 ($2.6 billion) associated with a higher level of loaned securities at December 31, 2004.
For additional information concerning investments and fair values, including information on the maturities of our investments in fixed maturities and perpetual debentures presented by segment at amortized cost and fair value, see Notes 3 and 4 of the Notes to the Consolidated Financial Statements.
Policy liabilities totaled $42.3 billion at December 31, 2005, a decrease of $1.2 billion, or 2.8% over 2004. The following table presents policy liabilities by segment for the years ending December 31.
Aflac Japan's policy liabilities decreased 4.6% (8.1% increase in yen). The weaker yen at year-end decreased reported policy liabilities by $5.0 billion. At December 31, 2005, policy liabilities of Aflac U.S. increased 13.7%. The increase in policy liabilities is the result of the growth and aging of our in-force business.
The ratio of debt to total capitalization (debt plus shareholders' equity, excluding the unrealized gains and losses on investment securities) was 18.8% as of December 31, 2005, compared with 21.7% a year ago.
We use short-term security lending arrangements to increase investment income with minimal risk. For further information regarding such arrangements, see Note 3 of the Notes to the Consolidated Financial Statements.
Aflac U.S. and Aflac Japan have various benefit plans. For additional information on our U.S. and Japanese plans, see Note 11 of the Notes to the Consolidated Financial Statements.
Aflac has limited hedging activities. Our primary exposure to be hedged is our investment in Aflac Japan, which is affected by changes in the yen/dollar exchange rate. In order to mitigate this exposure, we have taken the following courses of action. First, Aflac Japan owns dollar-denominated securities, which serve as an economic currency hedge of a portion of our investment in Aflac Japan. Second, we have designated the Parent Company's yen-denominated liabilities (Samurai notes payable and cross-currency swaps) as a hedge of our investment in Aflac Japan. If the total of these yen-denominated liabilities is equal to or less than our net investment in Aflac Japan, the hedge is deemed to be effective and the related exchange effect is reported in the unrealized foreign currency component of other comprehensive income. Should these yen-denominated liabilities exceed our investment in Aflac Japan, the portion of the hedge that exceeds our investment in Aflac Japan would be deemed ineffective. As required by SFAS No. 133, we would then recognize the foreign exchange effect on the ineffective portion in net earnings (other income). We estimate that if the ineffective portion was $100 million, we would report a foreign exchange gain/loss of approximately $1 million for every one yen weakening/strengthening in the end-of-period yen/dollar exchange rate. At December 31, 2005, and 2004, our hedge was effective with yen-denominated assets exceeding yen-denominated liabilities by 92.3 billion yen and 76.6 billion yen, respectively. In 2005, we chose not to increase our hedge for the increase in our yen-denominated net asset position.
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 $526 million in 2005, compared with $643 million in 2004 and $408 million in 2003. During 2005, Aflac paid $73 million to the Parent Company for management fees, compared with $33 million in 2004 and $37 million in 2003. The increase in management fees in 2005 resulted from the previously discussed 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, capital expenditures and our share repurchase program. In 2003, we filed a Shelf Registration Statement 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 or entities. The remaining 60 billion yen of the 2003 Shelf Registration Statement expired in December 2005. As a result, in February 2006 we filed a new Shelf Registration Statement with Japanese regulatory authorities to issue up to 100 billion yen (approximately $847 million using the December 31, 2005, exchange rate) of Samurai notes in Japan. If issued, these securities will not be available to U.S. persons or entities. We believe outside sources for additional debt and equity capital, if needed, will continue to be available.
The distribution of payments for future policy benefits is an estimate of all future benefit payments for policies in force as of December 31, 2005. These projected values contain assumptions for future policy persistency, mortality and morbidity. The distribution of payments for unpaid policy claims includes assumptions as to the timing of policyholders reporting claims for prior periods and the amount of those claims. Actual amounts and timing of both future policy benefits and unpaid policy claims payments may differ significantly from the estimates above. We anticipate that the future policy benefit liability of $37.9 billion at December 31, 2005, along with future net premiums and investment income, will be sufficient to fund future policy benefit payments.
We translate cash flows for Aflac Japan's yen-denominated items into U.S. dollars using weighted-average exchange rates. In years when the yen weakens, translating yen into dollars causes fewer dollars to be reported. When the yen strengthens, translating yen into dollars causes more dollars to be reported. The following table summarizes consolidated cash flows by activity for the years ended December 31.
In 2005 consolidated cash flow from operations decreased 1.4% to $4.4 billion, compared with $4.5 billion in 2004 and $3.4 billion in 2003. The following table summarizes operating cash flows by source for the years ended December 31.
The increase in Aflac Japan cash flows in 2004 was primarily attributable to the growth of our business, lower cash surrender values as a result of improved policy persistency, and the stronger yen.
Prudent portfolio management dictates that we attempt to match the duration of our assets with the duration of our liabilities. For Aflac Japan, the duration of policy benefits and related expenses to be paid in future years is longer than that of the related invested assets due to the unavailability of acceptable long-duration yen-denominated securities. Currently, when debt securities we own mature, the proceeds may be reinvested at a yield below that required for the accretion of policy benefit liabilities on policies issued in earlier years. However, the long-term nature of our business and our strong cash flows provides us with the ability to minimize the effect of mismatched durations and/or yields identified by various asset adequacy analyses. When market opportunities arise, we dispose of selected debt securities that are available for sale to improve the duration matching of our assets and liabilities and/or improve future investment yields. As a result, dispositions before maturity can vary significantly from year to year. Dispositions before maturity were 11% of the annual average investment portfolio of debt securities available for sale during the year ended December 31, 2005, compared with 5% in 2004 and 7% in 2003. The increase in dispositions before maturity primarily resulted from the bond swaps we executed in the third and fourth quarters of 2005.
Consolidated cash used by financing activities was $196 million in 2005, $313 million in 2004 and $298 million in 2003. In 2005, we received net proceeds of $360 million in connection with the issuance of Samurai notes due in 2010 and paid in full the 2000 Samurai notes at their maturity. Cash provided by investment-type contracts increased to $257 million in 2005, compared with $220 million in 2004 and $159 million in 2003.
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 formula as well as numerous initiatives covering insurance products, investments, and other actuarial and accounting matters. We believe that we will continue to maintain a strong RBC ratio and statutory capital and surplus position in future periods.
In addition to restrictions by U.S. insurance regulators, Japan's FSA may not allow transfers of funds 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. Aflac Japan's solvency margin ratio significantly exceeds regulatory minimums.
For information regarding commitments and contingent liabilities, see Notes 11 and 12 of the Notes to the Consolidated Financial Statements.
Description of Business: Aflac Incorporated (the Parent Company) and its subsidiaries (the Company) primarily sell supplemental health and life insurance in the United States and Japan. The Company's insurance business is marketed and administered through American Family Life Assurance Company of Columbus (Aflac), which operates in the United States (Aflac U.S.) and as a branch in Japan (Aflac Japan). Most of Aflac's policies are individually underwritten and marketed through independent agents. Our insurance operations in the United States and our branch in Japan service the two markets for our insurance business. Aflac Japan accounted for 74% of the Company's total revenues in 2005, 75% in 2004 and 74% in 2003, and 82% of total assets at December 31, 2005, compared with 80% a year ago.
Aflac Japan maintains an investment portfolio of dollar-denominated securities on behalf of Aflac U.S. The functional currency for these investments is the U.S. dollar. The related investment income and realized/unrealized investment gains and losses are also denominated in U.S. dollars.
We have designated the yen-denominated 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 premiums for health and life policies are recognized ratably as earned income over the premium payment periods of the policies. 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.
Amortized cost of debt securities is based on our purchase price adjusted for accrual of discount, or amortization of premium. The amortized cost of debt securities we purchase at a discount will equal the face or par value at maturity. Debt securities that we purchase at a premium will have an amortized cost equal to face or par value at maturity or the call date, if applicable. Interest is reported as income when earned and is adjusted for amortization of any premium or discount.
We do not consolidate our investments in qualifying special purpose entities (QSPEs), rather we recognize these investments as fixed-maturity or perpetual securities. All of our investments in QSPEs are held in our available-for-sale portfolio.
Our portfolio managers and credit research personnel routinely monitor and evaluate the difference between the amortized cost and fair value of our investments. Additionally, credit analysis and/or credit rating issues related to specific investments may trigger more intensive monitoring to determine if a decline in fair value is other than temporary. For investments with a fair value below amortized cost, the process includes evaluating the length of time and the extent to which amortized cost exceeds fair value, the prospects and financial condition of the issuer, and our evaluation for a potential recovery in fair value, among other factors. This process is not exact and requires consideration of risks such as credit risk, which to a certain extent can be controlled, and interest rate risk, which cannot be controlled. Therefore, if an investment's amortized cost exceeds its fair value solely due to changes in interest rates, impairment may not be appropriate. If, after monitoring and analyses, management believes that a decline in fair value is other than temporary, we adjust the amortized cost of the security and report a realized loss in the consolidated statements of earnings.
Derivatives: We have limited activity with derivative financial instruments. We do not use them for trading purposes, nor do we engage in leveraged derivative transactions. At December 31, 2005, our only outstanding derivative contracts were cross-currency swaps related to our $450 million senior notes (see Notes 4 and 6).
New Accounting Pronouncements: In December 2004, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 123 (revised), Share-Based Payment (SFAS 123R). This standard amends SFAS No. 123, Accounting for Stock-Based Compensation, and supercedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. SFAS 123R establishes the accounting for grants of share-based awards in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity's equity instruments or transactions that may be settled by the issuance of those equity instruments. SFAS 123R requires that companies use a fair value method to value share-based awards and recognize the related compensation expense in net earnings. The provisions of SFAS 123R, as amended by the Securities and Exchange Commission, are effective as of the beginning of the first fiscal year after June 15, 2005, although earlier application is encouraged. In accordance with the standard's early adoption provisions, we began accounting for share-based awards using the modified-retrospective application method effective January 1, 2005. Prior-year results have been adjusted to reflect the expensing of share-based awards in accordance with this new standard (see Note 9).
In November 2005, the FASB issued Staff Position Number FAS 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (FSP 115-1). FSP 115-1 addresses the determination as to when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. It also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in FSP 115-1 amends FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, and was effective January 1, 2006. We do not expect the adoption of this staff position to have a material effect 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 financial statements is not permitted. We are currently evaluating the impact of this SOP on our accounting for internal replacements.
Recently, various accounting standard-setting bodies have been active, issuing a number of accounting pronouncements with various effective dates. These pronouncements, which were not discussed above, do not have a material effect on our financial position or results of operations.
The costs of buildings, furniture and equipment are depreciated principally on a straight-line basis over their estimated useful lives (maximum of 45 years for buildings and 10 years for furniture and equipment). Expenditures for maintenance and repairs are expensed as incurred; expenditures for betterments are capitalized and depreciated. Classes of property and equipment as of December 31 were as follows:
The increases in amortization expense in 2005 and 2004 were primarily attributable to the write-down of previously capitalized systems development costs for Aflac Japan's administration system ($46 million before taxes in 2005 and $26 million before taxes in 2004).
Receivables consisted primarily of monthly insurance premiums due from individual policyholders or their employers for payroll deduction of premiums. At December 31, 2005, $192 million, or 40.0% of total receivables, were related to Aflac Japan's operations, compared with $183 million, or 43.9%, at December 31, 2004.
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 $27.9 billion, or 61.8%, and $27.0 billion, or 60.1%, of total debt securities at December 31, 2005 and 2004, respectively. Total privately issued securities, at amortized cost, accounted for $30.1 billion, or 66.6%, of our total debt securities as of December 31, 2005, compared with $29.1 billion, or 64.7%, at December 31, 2004. Of the total privately issued securities, reverse-dual currency debt securities (principal payments in yen, interest payments in dollars) accounted for $8.9 billion, or 29.6%, and $7.8 billion, or 26.8%, at amortized cost as of December 31, 2005 and 2004, respectively.
Information regarding realized and unrealized gains and losses from investments for the years ended December 31 follows:
In 2005, we realized pretax gains of $262 million (after-tax $167 million, or $.33 per diluted share) primarily as a result of the execution of bond swaps.
Realized investment losses in 2003 related primarily to the sale of our investment in Parmalat at a pretax loss of $257 million. We also sold our investment in Levi Strauss in 2003 at a pretax loss of $38 million. These investment losses and other investment transactions in the normal course of business decreased pretax earnings by $301 million (after-tax, $191 million or $.37 per diluted share).
The fair values and unrealized losses for debt and equity securities in a continuous unrealized loss position as of December 31, 2005, were as follows:
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 displayed 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 and we have the ability and intent to hold until recovery of value.
We attempt to match the duration of our assets with the duration of our liabilities. For Aflac Japan, the duration of policy benefits and related expenses to be paid in future years is longer than that of the related investment assets due to the unavailability of acceptable long-duration yen-denominated securities. The following table presents the approximate duration of our yen-denominated assets and liabilities, along with premiums, as of December 31.
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.
The contractual maturities of our investments in fixed maturities at December 31, 2005, were as follows:
The Parent Company has a portfolio of investment-grade fixed-maturity securities totaling $100 million at amortized cost and fair value, which is not included in the table above.
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, 2005, were as follows:
We also own yen-denominated investments in variable interest entities (VIEs) totaling $1.8 billion at fair value, ($1.9 billion at amortized cost, or 4.2% of total debt securities) at December 31, 2005. We have concluded that we are the primary beneficiary of VIEs totaling $1.6 billion at fair value ($1.7 billion at amortized cost) and we 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 proceeds 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 $226 million at fair value ($220 million at amortized cost) as of December 31, 2005. The notes representing our interests in these VIEs are reported as fixed-maturity securities on the balance sheet. The loss on any of our VIE investments would be limited to its cost.
During 2005, we reclassified an investment from held to maturity to available for sale as a result of the issuer's credit rating downgrade. This debt security had an amortized cost of $254 million at the date of transfer.
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 significant deterioration in the issuer's credit worthiness. At the time of transfer, this debt security had an amortized cost of $291 million.
The methods of determining the fair values of our investments in debt and equity securities are described in Note 3. The fair values of notes payable with fixed interest rates were obtained from an independent financial information service. The fair values of our cross-currency swaps are the expected amounts that we would receive or pay to terminate the swaps, taking into account current interest rates, foreign currency rates and the current creditworthiness of the swap counterparties. The fair value of the Japanese policyholder protection fund is our estimated share of the industry's obligation calculated on a pro rata basis by projecting our percentage of the industry's premiums and reserves and applying that percentage to the total industry obligation payable in future years.
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 expense from 6.5% in dollars to 1.67% in yen. See Note 1 for information on the accounting policy for cross-currency swaps.
We have also designated our yen-denominated Samurai notes (see Note 6) as hedges of the foreign currency exposure of our investment in Aflac Japan.
Our policy liabilities primarily include future policy benefits and unpaid policy claims, which accounted for 89% and 6% of total policy liabilities at December 31, 2005, respectively. We regularly review the adequacy of our policy liabilities in total and by component. The liability for future policy benefits as of December 31 consisted of the following:
The weighted-average interest rates reflected in the consolidated statements of earnings for future policy benefits for Japanese policies were 4.8% in 2005, and 4.9% in both 2004 and 2003; and for U.S. policies, 6.4% in 2005, 2004 and 2003.
For our yen-denominated loans, the principal amount as stated in dollar terms will fluctuate from period to period due to changes in the yen/dollar exchange rate. We have designated 110 billion yen of our yen-denominated notes payable as a hedge of the foreign currency exposure of our investment in Aflac Japan.
The Shelf Registration Statement we filed with Japanese regulatory authorities in 2003 expired in December 2005. As a result, the Parent Company filed a new Shelf Registration Statement with Japanese regulatory authorities in February 2006 to issue up to 100 billion yen of yen-denominated Samurai notes in Japan. If issued, these securities will not be available to U.S. persons or entities.
In 1999, we issued $450 million of senior notes. These notes are redeemable at our option at any time with a redemption price equal to the principal amount of the notes being redeemed plus a make-whole premium. We have entered into cross-currency swaps related to these notes (see Note 4).
We were in compliance with all of the covenants of our notes payable at December 31, 2005. No events of default or defaults occurred during 2005 and 2004.
Share Repurchase Program: In 2004, the board of directors authorized the purchase of up to 30 million shares of our common stock. As of December 31, 2005, approximately 17 million shares were available for purchase under our share repurchase program. In February 2006, the board of directors authorized the purchase of an additional 30 million shares.
We adopted SFAS 123R to account for share-based awards effective January 1, 2005. In accordance with the modified-retrospective application method, we have adjusted previously reported results to reflect the effect of expensing share-based awards. The cumulative adjustment associated with adoption decreased our tax liability $2 million, increased additional paid-in capital $148 million and decreased retained earnings $146 million as of December 31, 2002.
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 $13.40 for 2005, compared with $10.66 in 2004 and $10.27 in 2003. 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 at December 31, 2005.
As of December 31, 2005, the aggregate intrinsic value of stock options outstanding was $383 million, with a weighted-average remaining term of 5.5 years. The aggregate intrinsic value of stock options exercisable at that same date was $332 million, with a weighted-average remaining term of 4.6 years. The total intrinsic value of stock options exercised during the year ended December 31, 2005, was $114 million, compared with $57 million in 2004 and $102 million in 2003. We received cash from the exercise of stock options in the amount of $49 million in 2005, compared with $32 million in 2004 and $30 million in 2003. The tax benefit realized as a result of stock option exercises was $37 million in 2005. Due to the effect of the valuation allowances in 2004 and 2003, the tax benefit realized from stock option exercises was immaterial (see Note 7).
The following table summarizes restricted stock activity during the years ended December 31.
As of December 31, 2005, total compensation cost not yet recognized in our financial statements related to restricted stock awards was $8 million, of which $4 million (151,000 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. Awards of two thousand shares of restricted stock were granted in 2004. No restricted stock was granted in 2003.
As determined on a U.S. statutory accounting basis, Aflac's net income was $1.3 billion in 2005, $1.2 billion in 2004, and $742 million in 2003. Capital and surplus was $3.7 billion and $2.8 billion at December 31, 2005 and 2004, respectively.
Reconciliations of Aflac's net assets on a GAAP basis to capital and surplus determined on a U.S. statutory accounting basis as of December 31 were as follows:
A portion of Aflac Japan earnings, as determined on a Japanese statutory accounting basis, can be remitted each year to Aflac U.S. after complying with solvency margin provisions and satisfying various conditions imposed by Japanese regulatory authorities for protecting policyholders. Profit remittances to the United States can fluctuate due to changes in the amounts of Japanese regulatory earnings. Among other items, factors affecting regulatory earnings include Japanese regulatory accounting practices and fluctuations in currency translation of Aflac Japan's dollar-denominated investments into yen. Profits remitted by Aflac Japan to Aflac U.S. were as follows for the years ended December 31:
The valuation date for our U.S. plan is September 30 and December 31 for our Japanese plan. 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 (3% of plan assets) of Aflac Incorporated common stock at December 31, 2005, compared with $2 million (3% of plan assets) at December 31, 2004. Target asset allocations for U.S. plan assets are 55% to 60% equity securities, 35% to 40% fixed-income securities and 5% to 10% 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 are long-term in nature. Cash and cash equivalents exceeded the target allocations for the U.S. plan in 2005 and 2004 primarily as a result of third quarter employer contributions of $20 million in 2005 and $15 million in 2004.
The investment objective of our U.S. and Japanese plans is to preserve the purchasing power of the plan's assets and earn a reasonable inflation adjusted rate of return over the long term. Furthermore, we seek to accomplish these objectives in a manner that allows for the adequate funding of plan benefits and expenses. In order to achieve these objectives, our goal is to maintain a conservative, well-diversified and balanced portfolio of high quality equity, fixed-income and money market securities. As a part of our strategy, we have established strict policies covering investment security quality, type and concentration. For our U.S. plan, these policies prohibit investments in derivatives, precious metals, limited partnerships, real estate, venture capital, futures contracts, and foreign securities. We are also prohibited from trading on margin. For our Japanese plan, these policies include limitations on investments in derivatives including futures, options and swaps, and low-liquidity investments such as real estate, venture capital investments, and privately issued securities.
We monitor the U.S. plan's performance over a three- to five-year period utilizing shorter time frame performance measures to identify trends. We review investment performance and compliance with stated investment policies and practices on a quarterly basis. The specific three- to five-year investment objectives for the U.S. pension plan are to earn a total rate of return on equity securities that exceeds the rate of return for the Standard & Poor's 500 stock index and to earn a total rate of return on fixed-income securities that exceeds the Merrill Lynch one- to 10-year investment grade government/corporate bond index. We monitor the Japanese plan's performance and compliance with stated investment policies and practices on a quarterly basis.
Prior to 2004, our Japanese pension plan had two distinct components: the corporate portion and the substitutional portion. The corporate portion, which the Company still maintains, is based on a plan established by Aflac Japan. The substitutional portion, which was transferred to the Japanese government in 2004, is based on the pay-related part of old-age pension benefits prescribed by the Japan Welfare Pension Insurance Law. In connection with the transfer, we recognized a pretax gain of $6 million (after-tax, $3 million, or $.01 per diluted share) in the first quarter of 2004. This gain was composed of a settlement loss and related increase in the accrued pension liability in the amount of $17 million for the release of unrecognized losses related to the substitutional plan; a reduction in pension expense and related adjustment to the accrued pension liability in the amount of $15 million for the release of the accrued pension cost related to the substitutional plan; and a subsidy from the Japanese government in the amount of $9 million (other income) in connection with the completion of the transfer process.
During 2005, the Japanese plan was amended. Subsequent to amendment, participant salary and future salary increases will no longer be a factor in determining pension benefit cost or the related pension benefit obligation and accumulated benefit obligation.
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 $23 million in 2005, $35 million in 2004, and $21 million in 2003. The accrued retirement liability for the unfunded supplemental retirement plans was $224 million at December 31, 2005, compared with $223 million a year ago. The assumptions used in the valuation of these plans were the same as for the funded plans.
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 is expected to cost between $23 million and $25 million.
We are a defendant in various lawsuits considered to be in the normal course of business. 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 against other companies, including insurers, in recent years. Although the final results of any litigation cannot be predicted with certainty, we believe the outcome of pending litigation will not have a material adverse effect on our financial position, results of operations, or cash flows.
As discussed in notes 1 and 9 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, to account for stock options and other share-based transactions, effective January 1, 2005.