How Will Abenomics Force This Stock to Evolve?
We expect a progressive change in this insurer's product mix and investment strategies.
Japanese investors are used to disappointment, given the economy's stagnation over the past two or three decades. The introduction of Prime Minister Shinzo Abe's economic reform plan in late 2012 represented one of the best hopes for breaking the economy out of its long-standing slump, but the situation remains fragile, complex, and highly uncertain. One thing remains clear: Given a rapidly aging (and shrinking) population in Japan, coupled with a cutback in national health-care coverage, Aflac (AFL) has a unique long-term growth opportunity as the leading provider of voluntary medical coverage. However, the impact of Abenomics and the corresponding declines in bond yields and the yen complicate this attractive picture for one of our favorite insurers, as we anticipate lower insurance sales and investment income in the near term. As a result, it is critical that investors understand how Aflac will navigate this challenging environment to fully capture the tremendous growth in front of it.
At a minimum, we believe Aflac's product and investment strategies will have to evolve. At a product level, the changes include a heavier reliance on cancer and medical policies and a corresponding reduction in the life insurance business. For Aflac's investments, we expect to see a higher allocation for U.S.-denominated bonds, versus its traditional focus on Japanese government bonds. Overall, we think Aflac offers a high-quality opportunity to play a powerful long-term secular trend in a country where strong and investable companies are few and far between. We would be avid buyers at a discount to our fair value estimate.
Japan's Unique Demographic Situation Means a Product Shift for Aflac
The situation regarding Japan's population, and its impact on the country's medical expenditures, is dire. The Japanese population peaked in 2010 at approximately 128 million and is projected to decline in the next 40 years, as the number of deaths has been exceeding the number of births. Unless birth rates improve dramatically, the population will drop to levels first seen in the 1960s, to approximately 100 million by 2015. Additionally, as a large portion of the baby boomers are now reaching retirement age, the over-65 population has surpassed 30 million, accounting for approximately 23% of the Japanese population as of the end of 2012, the highest level in the world. This over-65 population ratio is expected to reach nearly 40% by 2050, based on projections from the Statistics Bureau of Japan.
Outlook Is for Japanese Population to Shrink While Over-65 Burden Rises
The impact of this aging population on the Japanese economy cannot be understated. As a country, Japan spent approximately 9.3% of GDP (approximately $385 billion) on medical expenditures in 2011. Medical expenditures are expected to rise 14% from 2011 levels to JPY 45 trillion (approximately $440 billion) by 2015 and JPY 60 trillion (or approximately $587 billion) by 2025. The United States still spends the most on medical expenditures (17% of GDP) as of 2011, but Japan is expected to catch up in the next decade, accounting for as much as 14% of GDP.
Rising Medical Expenditures as a Percentage of GDP
To combat the many medical issues related to an aging population, Japan runs a universal health system that covers virtually all of its citizens. Employees and their families (about 60% of the population) are required to enroll in health insurance offered through their employers. The remaining 40%--unemployed, self-employed, and retired people--are covered under the health plan administered by the local municipal government. The system is funded through a combination of public and private funds.
However, with the Abe administration looking to use government spending to fund infrastructure projects under its Abenomics plan in order to revive economic growth, medical spending is likely to be a lower priority in the fiscal budget. This shift means that medical coverage will be less generous under the universal plan in the coming years. We expect medical spending to make up 18% of the budget in 2018 versus 21% today, as infrastructure spending increases to 12% from 6%.
The reduction in health benefits is a long-term and powerful secular trend that should benefit Aflac, in our view. Aflac's voluntary medical benefit products are designed to help consumers pay for medical expenses that are not reimbursed under the country's national health insurance system. Currently, out-of-pocket payments represent about 16% of total health-care expenditures. This ratio is expected to rise to about 30% by 2025, as the gap between government-funded care and consumer out-of-pocket spending widens. As a result, we expect healthy demand for voluntary medical benefit policies to drive 15% average growth for this key product line over the next few years.
Given this shift in the Japanese economic picture and the demand environment for its products, Aflac has adjusted its strategy to compensate. The government's ultra-easy-money policy led to a sharp increase in the Nikkei, which rose 57% in 2013 but has dropped 12% since the start of 2014. As a result, Japanese consumers have piled into investment trusts and shifted away from insurance products, which have traditionally been used as an investment vehicle by consumers, in part because of the saving feature included in the policy. The timing here was poor, as Aflac needed to increase pricing for its life insurance products. Specifically, the company revised the assumed interest rate used for product pricing based on the change in the reserving rate mandated by the Japanese insurance regulators. The net result was a nearly 20% increase in premium rates for the WAYS policies (a hybrid whole-life insurance product from Aflac), which significantly damped new policy sales. The company elected to pursue price increases only on WAYS policies, leaving the pricing for cancer policies and medical policies unchanged in 2013. However, given the asset-purchase program scheduled to start in 2014 and the low interest rate picture, we would not be surprised to see Aflac increase prices on its best-selling cancer policies and medical products.
Aflac's renewed focus on cancer policies and voluntary medical benefits (collectively, third-sector products) helps support the company's narrow Morningstar Economic Moat Rating. Price and product selection are not sustainable differentiators, in our view, given the ease of imitation. However, we do think a low-cost distribution network is sustainable. Aflac was one of the first to offer supplemental insurance in Japan and has since developed a fiercely loyal collection of policyholders. The company's sales method, primarily through low-cost channels such as the workplace, allows it to price its policies at rates similar to or lower than competitors' while still earning a substantial underwriting margin. Finally, as supplemental insurance is often a much smaller purchase and often deducted through policyholders' paychecks, holders are much less likely to shop around for other policies based on price. As a result, Aflac enjoys a 95% persistency rate, among the highest in the industry, and we consider it to have a strong narrow moat.
Abenomics Means That Aflac Needs to Change Its Investments, Too
Weeks after taking office in December 2012, Abe announced his plan to implement new economic policies aimed at spurring inflation and pulling Japan out of two decades of economic stagnation. Abenomics takes a three-prong approach to reinflate the economy through monetary, fiscal, and structural policies. Abe's broad goals are to boost annual GDP growth (currently 2%) and increase inflation to 2% through short-term stimulus spending, monetary easing, and reforms that will boost domestic labor markets and increase trade partnerships.
To achieve these goals, Abe is undertaking a multifaceted plan. First, his targeted fiscal policy includes a $210 billion stimulus package, of which nearly half would come in government spending with a focus on infrastructure to boost GDP toward the desired 2% target. Second, the inflation target of 2% is expected to be achieved by quantitative easing, which would buy up mostly short-term government debt in a bond-purchase program due to start in 2014. This bond-purchase program, led by the Bank of Japan, caused the yen to weaken against the U.S. dollar and Japanese government bond yields (already at historically low levels) to decline.
The resulting yen depreciation and yield decline caused by the announcement of this bond program could present many challenges for Aflac in asset allocation and investment decisions because of balance sheet, capital solvency, and capital market liquidity concerns.
First, as far as the balance sheet, 90% of Aflac's liabilities are yen-denominated, have long durations, and are generally not very interest rate sensitive. To back these liabilities, the company's investments focus on longer-duration, yen-denominated, fixed-income securities, which include mainly Japanese government bonds and other credit investments.
Second, from a capital solvency perspective, Aflac's Japan operation has a target solvency margin ratio to maintain, which also points to the use of Japanese government bonds. These bond holdings are treated as held-to-maturity securities, versus as available-for-sale securities. The difference in accounting treatment is important for the purposes of capital calculations, because held-to-maturity securities use par value whereas available-for-sale securities use fair market value.
Third, because the Japanese bond market doesn't have the depth and liquidity of the U.S. and European markets, Aflac has historically invested in non-investment-grade European privately issued securities. Now, as part of the derisking program, Aflac has decided to terminate further allocation to this type of investment and leave the existing holdings as held to maturity. In late 2012, Aflac started to allocate new money to a hedged U.S. corporate bond program, in which cash flows from U.S. corporate bonds are hedged back to the yen. This program is intended to improve overall new money yields and gain security-level liquidity. The benefits were clear, with approximately 70 basis points of improvement in new-money yields in the second half of 2012 relative to the first half.
To date, Aflac has invested approximately $9 billion (about 9% of the investment portfolio) in this program and plans to continue to invest about two thirds of Japan's new-money flows to this asset class. Considering the lack of investment alternatives, we think Aflac is taking the right step in seeking better yields in U.S. assets.
These investment decisions have led to a gradual change in asset allocation in the investment portfolio, as Aflac continues to shift its emphasis to U.S. corporate bonds and terminates further investments in European private securities. At the same time, in order to balance the risk of introducing volatility to its capital base through its holding of low-yielding Japanese government bonds, the company tries to adhere to a long-run target range of 35%-40% in its Japanese government bond allocation. U.S. bond holdings increased to 23.4% in 2013 from 15.7% in 2012, while the company's European allocation dropped in lockstep to 20.3% in 2013 from 27.6% in 2012. Aflac's Japanese government bond position declined to 37.8% in 2013 from 39.4% in 2012 and remained in its target allocation range in both years. Given the attractive yield differentials between the U.S. and Japan, we see little reason for Aflac not to continue its tactical allocation in U.S. bonds with new money.
Over time, we expect Aflac's U.S. holdings to take up a larger share of the asset allocation. Assuming Aflac continues a similar allocation policy with new money as it did in 2012 and 2013, we expect its U.S. allocation to be close to 25% by the end of 2014. We estimate that the U.S. allocation will reach 35% by 2018, as the company's European positions continue to shrink via maturities and sales. As a result, we estimate that the European allocation will represent merely 10% of the total portfolio by 2018.
How Aflac Will Change in the Coming Years
We maintain a positive long-term outlook for Aflac's Japanese business, but expect 2014 top-line growth to be modest as a result of anticipated declines in life sales, lower sales growth for third-sector products, and depressed investment yields.
We expect life insurance and WAYS production to drop another 30% in 2014 because of price increases and lower bank channel sales. We also assume a 5% increase in third-sector product sales, with margin staying at 20%. As a result, we assume an 8.5% drop in premium revenue in Japan for 2014.
We think low new-money yields continue to present headwinds for investment income. For 2014, we expect Aflac to continue to make tactical moves by increasing credit exposure to BBB bonds and geographic exposure to U.S. corporate bonds. This move could add more interest rate risk to the balance sheet and hurt the company's capital solvency ratio, but we believe the risk-adjusted returns generated from the tactical moves remain attractive. Consistent with this investment philosophy, we assume a 3% investment yield for Aflac's investment portfolio for 2014.
In our base-case scenario, we use the assumptions laid out above--an 8.5% drop in premiums from new sales in Japan in 2014 due to a lower emphasis on life insurance products and a 3% investment yield on the investment portfolio. We assume a constant exchange rate of JPY 102 per $1 over the five-year projection period. In our forecast period, we assume a 4.5% increase in third-sector product sales in year two, partly offset by a 7.5% drop in new life insurance sales. In the back end of our projection, we expect third-sector product sales to slow, as competition intensifies in the voluntary benefit market. At the same time, we believe life sales will stabilize and start to grow at 2%. Putting it together, we expect to see a continued shift in emphasis to third-sector products from life insurance products, with the third sector's share of new sales growing to 56.5% in 2018 from 51.4% in 2014. Over the same period, we expect the life insurance share to decline to 39.4% in 2018 from 42.5% in 2014. Using these assumptions, our fair value estimate is $60, which implies a price/book multiple of 2.1 based on the firm's book value excluding accumulated other comprehensive income at year-end 2013. The average return on equity over our five-year projection period is 19.6%, reflecting a 100-basis-point improvement from the average returns we have seen between 2011 and 2013 for this narrow-moat insurer.
Vincent Lui does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.