Form 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

[ X ]  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2010

or

[    ]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

Commission File Number:    001-07434

LOGO

Aflac Incorporated

 

(Exact name of registrant as specified in its charter)

 

Georgia   58-1167100
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification No.)
1932 Wynnton Road, Columbus, Georgia   31999
(Address of principal executive offices)   (ZIP Code)

706.323.3431

 

(Registrant’s telephone number, including area code)

 

 

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.            þ   Yes  ¨  No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).                                                                                                                                                       þ   Yes    ¨   No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer  þ      Accelerated filer  ¨
Non-accelerated filer    ¨ (Do not check if a smaller reporting company)      Smaller reporting company ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).                                                                                                                                                            ¨  Yes   þ  No

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class       May 3, 2010
Common Stock, $.10 Par Value     469,563,139 shares


Table of Contents

Aflac Incorporated and Subsidiaries

Quarterly Report on Form 10-Q

For the Quarter Ended March 31, 2010

Table of Contents

 

PART I.    FINANCIAL INFORMATION:    Page
Item 1.    Financial Statements   
   Review by Independent Registered Public Accounting Firm    1
   Report of Independent Registered Public Accounting Firm    2
   Consolidated Statements of Earnings    3
     Three Months Ended March 31, 2010, and 2009   
   Consolidated Balance Sheets    4
     March 31, 2010 and December 31, 2009   
   Consolidated Statements of Shareholders’ Equity    6
     Three Months Ended March 31, 2010, and 2009   
   Consolidated Statements of Cash Flows    7
     Three Months Ended March 31, 2010, and 2009   
   Consolidated Statements of Comprehensive Income    9
     Three Months Ended March 31, 2010, and 2009   
   Notes to the Consolidated Financial Statements    10
Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations    50
Item 3.    Quantitative and Qualitative Disclosures about Market Risk    83
Item 4.    Controls and Procedures    83
PART II.    OTHER INFORMATION:   
Item 1A.    Risk Factors    84
Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds    86
Item 6.    Exhibits    87

Items other than those listed above are omitted because they are not required or are not applicable.

 

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PART I. FINANCIAL INFORMATION

Item 1.  Financial Statements.

Review by Independent Registered Public Accounting Firm

The March 31, 2010, and 2009, consolidated financial statements included in this filing have been reviewed by KPMG LLP, an independent registered public accounting firm, in accordance with established professional standards and procedures for such a review.

The report of KPMG LLP commenting upon its review is included on the following page.

 

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Report of Independent Registered Public Accounting Firm

The Shareholders and Board of Directors of Aflac Incorporated:

We have reviewed the consolidated balance sheet of Aflac Incorporated and subsidiaries as of March 31, 2010, and the related consolidated statements of earnings, shareholders’ equity, cash flows and comprehensive income for the three-month periods ended March 31, 2010 and 2009. These consolidated financial statements are the responsibility of the Company’s management.

We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should be made to the consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the accompanying consolidated balance sheet of Aflac Incorporated and subsidiaries as of December 31, 2009, and the related consolidated statements of earnings, shareholders’ equity, cash flows and comprehensive income for the year then ended (not presented herein); and in our report dated February 26, 2010, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2009, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

 

LOGO
Atlanta, Georgia
May 7, 2010

 

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Aflac Incorporated and Subsidiaries

Consolidated Statements of Earnings

 
     Three Months Ended March 31,  
(In millions, except for share and per-share amounts - Unaudited)        2010      2009         
 

Revenues:

     

Premiums, principally supplemental health insurance

   $    4,348       $    4,115         

Net investment income

   726       688         

Realized investment gains (losses):

     

Other-than-temporary impairment losses:

     

Total other-than-temporary impairment losses

   (42)      (238)        

Other-than-temporary impairment losses recognized in other comprehensive income

   0       4         
 

Other-than-temporary impairment losses realized

   (42)      (234)        

Sales and redemptions

   (21)      225         

Derivative gains (losses)

   17       0         
 

Total realized investment gains (losses)

   (46)      (9)        

Other income

   37       24         
 

Total revenues

   5,065       4,818         
 

Benefits and expenses:

     

Benefits and claims

   2,857       2,811         

Acquisition and operating expenses:

     

Amortization of deferred policy acquisition costs

   280       250         

Insurance commissions

   403       389         

Insurance expenses

   481       457         

Interest expense

   33       8         

Other operating expenses

   37       32         
 

Total acquisition and operating expenses

   1,234       1,136         
 

Total benefits and expenses

   4,091       3,947         
 

Earnings before income taxes

   974       871         

Income taxes

   338       302         
 

Net earnings

   $        636       $        569         
 

Net earnings per share:

     

Basic

   $       1.36       $       1.22         

Diluted

   1.35       1.22         
Weighted-average outstanding common shares used in computing earnings per share (In thousands):      

Basic

   467,926       466,097         

Diluted

   472,450       467,132         
 

Cash dividends per share

   $         .28       $         .28         
 

See the accompanying Notes to the Consolidated Financial Statements.

 

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Aflac Incorporated and Subsidiaries

Consolidated Balance Sheets

(In millions)    March 31,
2010
(Unaudited)
    December 31,    
2009

Assets:

    

Investments and cash:

    

Securities available for sale, at fair value:

    

Fixed maturities (amortized cost $34,467 in 2010 and $37,633 in 2009)

   $    33,992       $    36,781 (1)         

Fixed maturities - consolidated variable interest entities (amortized cost $4,350 in 2010)

   4,443       (1)        

Perpetual securities (amortized cost $6,083 in 2010 and $7,554 in 2009)

   6,218       7,263  (1)        

Perpetual securities - consolidated variable interest entities (amortized cost $1,432 in 2010)

   1,205       (1)        

Equity securities (cost $21 in 2010 and $22 in 2009)

   24       24            

Securities held to maturity, at amortized cost:

    

Fixed maturities (fair value $25,031 in 2010 and $25,828 in 2009)

   25,861       26,687 (1)        

Fixed maturities - consolidated variable interest entities (fair value $457 in 2010)

   538       (1)        

Other investments

   106       114            

Cash and cash equivalents

   1,611       2,323            

Total investments and cash

   73,998       73,192            

Receivables

   671       764            

Accrued investment income

   654       649            

Deferred policy acquisition costs

   8,522       8,533            

Property and equipment, at cost less accumulated depreciation

   583       593            

Other

   750  (2)     375            

Total assets

   $    85,178       $    84,106            
 
(1)

Due to the prospective application of accounting guidance adopted in 2010, consolidated fixed maturity and perpetual security variable interest entities (VIEs) are only disclosed separately in 2010.

(2)

Includes $292 of derivatives from consolidated VIEs

See the accompanying Notes to the Consolidated Financial Statements.

(continued)

 

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Aflac Incorporated and Subsidiaries

Consolidated Balance Sheets (continued)

 
(In millions, except for share and per-share amounts)    March 31,
2010
(Unaudited)
    December 31,    
2009
 

Liabilities and shareholders’ equity:

    

Liabilities:

    

Policy liabilities:

    

Future policy benefits

   $    61,530       $    61,501     

Unpaid policy claims

   3,298       3,270     

Unearned premiums

   937       926     

Other policyholders’ funds

   3,739       3,548     
 

Total policy liabilities

   69,504       69,245     

Notes payable

   2,584       2,599     

Income taxes

   1,629       1,653     

Payables for return of cash collateral on loaned securities

   486       483     

Other

   1,988  (3)    1,709     

Commitments and contingent liabilities (Note 10)

    
 

Total liabilities

   76,191       75,689     
 

Shareholders’ equity:

    

Common stock of $.10 par value. In thousands: authorized 1,900,000 shares in 2010 and 2009; issued 661,799 shares in 2010 and 661,209 shares in 2009

   66       66     

Additional paid-in capital

   1,248       1,228     

Retained earnings

   12,890       12,410     

Accumulated other comprehensive income:

    

Unrealized foreign currency translation gains

   412       776     

Unrealized gains (losses) on investment securities:

    

Unrealized gains (losses) on securities not other-than-temporarily impaired

   (197)      (621)    

Unrealized gains (losses) on other-than-temporarily impaired securities

   (8)      (16)    

Unrealized gains (losses) on derivatives

   (9)      (3)    

Pension liability adjustment

   (105)      (107)    

Treasury stock, at average cost

   (5,310)      (5,316)    
 

Total shareholders’ equity

   8,987       8,417     
 

Total liabilities and shareholders’ equity

   $    85,178       $    84,106     
 
(3)

Includes $521 of derivatives from consolidated VIEs

See the accompanying Notes to the Consolidated Financial Statements.

 

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Aflac Incorporated and Subsidiaries

Consolidated Statements of Shareholders’ Equity

 
     Three Months Ended March 31,    
(In millions - Unaudited)    2010            2009        
 

Common stock:

     

Balance, beginning of period

   $            66         $            66     
 

Balance, end of period

   66         66     
 

Additional paid-in capital:

     

Balance, beginning of period

   1,228         1,184     

Exercise of stock options

   16         0     

Share-based compensation

   5         6     

Gain (loss) on treasury stock reissued

   (1)        0     
 

Balance, end of period

   1,248         1,190     
 

Retained earnings:

     

Balance, beginning of period

   12,410         11,306     

Cumulative effect of change in accounting principle, net of income taxes

   (25)        0     

Net earnings

   636         569     

Dividends to shareholders

   (131)        0     
 

Balance, end of period

   12,890         11,875     
 

Accumulated other comprehensive income:

     

Balance, beginning of period

   29         (582)    

Unrealized foreign currency translation gains (losses) during period, net of income taxes:

     

Cumulative effect of change in accounting principle, net of income taxes

   (320)        0     

Change in unrealized foreign currency translation gains (losses) during period, net of income taxes

   (44)        (255)    

Unrealized gains (losses) on investment securities during period, net of income taxes and reclassification adjustments:

     

Cumulative effect of change in accounting principle, net of income taxes

   180         0     

Change in unrealized gains (losses) on investment securities not other-than-temporarily impaired, net of income taxes

   244         (1,772)    

Change in unrealized gains (losses) on other-than-temporarily impaired investment securities, net of income taxes

   8         (3)    

Unrealized gains (losses) on derivatives during period, net of income taxes

   (6)        0     

Pension liability adjustment during period, net of income taxes

   2         4     
 

Balance, end of period

   93         (2,608)    
 

Treasury stock:

     

Balance, beginning of period

   (5,316)        (5,335)    

Purchases of treasury stock

   (4)        (2)    

Cost of shares issued

   10         13     
 

Balance, end of period

   (5,310)        (5,324)    
 

Total shareholders’ equity

   $        8,987         $        5,199     
 

See the accompanying Notes to the Consolidated Financial Statements.

 

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Aflac Incorporated and Subsidiaries

Consolidated Statements of Cash Flows

      Three Months Ended March 31,    

(In millions - Unaudited)

       2010      2009         

Cash flows from operating activities:

     

Net earnings

   $    636       $     569         

Adjustments to reconcile net earnings to net cash provided by operating activities:

     

Change in receivables and advance premiums

   235       257         

Increase in deferred policy acquisition costs

   (50)      (68)        

Increase in policy liabilities

   679       734         

Change in income tax liabilities

   (71)      187         

Realized investment (gains) losses

   46       12         

Other, net

   (197)      (42)        

Net cash provided (used) by operating activities

   1,278       1,649        

Cash flows from investing activities:

     

  Proceeds from investments sold or matured:

     

Securities available for sale:

     

      Fixed maturities sold

   712       3,575         

      Fixed maturities matured or called

   150       1,087         

      Perpetual securities sold

   54       0         

Securities held to maturity:

     

      Fixed maturities matured or called

   1       103         

  Costs of investments acquired:

     

Securities available for sale:

     

      Fixed maturities acquired

   (2,593)      (3,615)        

Securities held to maturity:

     

      Fixed maturities acquired

   (302)      (832)        

  Cash received as collateral on loaned securities, net

   7       (1,582)        

  Other, net

   2       (61)        

Net cash provided (used) by investing activities

   $(1,969)      $(1,325)        

See the accompanying Notes to the Consolidated Financial Statements.

(continued)

 

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Aflac Incorporated and Subsidiaries

Consolidated Statements of Cash Flows (continued)

 

      Three Months Ended March 31,    

(In millions - Unaudited)

       2010      2009         

Cash flows from financing activities:

     

Purchases of treasury stock

   $         (5)      $     (2)        

Principal payments under debt obligations

   (1)      (1)        

Dividends paid to shareholders

   (131)      (131)        

Change in investment-type contracts, net

   89       90         

Treasury stock reissued

   7       4         

Other, net

   18       (5)        

Net cash provided (used) by financing activities

   (23)      (45)        

Effect of exchange rate changes on cash and cash equivalents

   2       (24)        

Net change in cash and cash equivalents

   (712)      255         

Cash and cash equivalents, beginning of period

   2,323       941         

Cash and cash equivalents, end of period

   $    1,611       $1,196         
           

Supplemental disclosures of cash flow information:

     

Income taxes paid

   $       403       $   190         

Interest paid

   10       6         

Impairment losses included in realized investment losses

   42       234         

Noncash financing activities:

     

Treasury stock issued for:

     

Associate stock bonus

   0       6         

Share-based compensation grants

   2       3         
           

See the accompanying Notes to the Consolidated Financial Statements.

 

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Aflac Incorporated and Subsidiaries

Consolidated Statements of Comprehensive Income

      Three Months Ended March 31,    

(In millions - Unaudited)

       2010           2009      

Net earnings

   $    636       $       569      

Other comprehensive income (loss) before income taxes:

     

Unrealized foreign currency translation gains (losses) during period

   (18)      (109)     

Unrealized gains (losses) on investment securities:

     

Unrealized holding gains (losses) on investment securities during period

   323       (2,763)     

Reclassification adjustment for realized (gains) losses on investment securities included in net earnings

   63       12      

Unrealized gains (losses) on derivatives during period

   (10)      1      

Pension liability adjustment during period

   2       6      

Total other comprehensive income (loss) before income taxes

   360       (2,853)     

Income tax expense (benefit) related to items of other comprehensive income (loss)

   156       (827)     

Other comprehensive income (loss), net of income taxes

   204       (2,026)     

Total comprehensive income (loss)

   $    840       $  (1,457)     
           

See the accompanying Notes to the Consolidated Financial Statements.

 

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Aflac Incorporated and Subsidiaries

Notes to the Consolidated Financial Statements

(Interim period data – Unaudited)

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Description of Business

Aflac Incorporated (the Parent Company) and its subsidiaries (collectively, 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. Aflac U.S. markets and administers group products through Continental American Insurance Company (CAIC). Our insurance operations in the United States and our branch in Japan service the two markets for our insurance business. Aflac Japan’s revenues, including realized gains and losses on its investment portfolio, accounted for 74% of the Company’s total revenues in both the three-month periods ended March 31, 2010, and 2009. The percentage of the Company’s total assets attributable to Aflac Japan was 85% at both March 31, 2010, and December 31, 2009.

Basis of Presentation

We prepare our financial statements in accordance with U.S. generally accepted accounting principles (GAAP). These principles are established primarily by the Financial Accounting Standards Board (FASB). In these Notes to the Consolidated Financial Statements, references to GAAP issued by the FASB are derived from the FASB Accounting Standards CodificationTM (ASC). The preparation of financial statements in conformity with GAAP requires us to make estimates when recording transactions resulting from business operations based on currently available information. The most significant items on our balance sheet that involve a greater degree of accounting estimates and actuarial determinations subject to changes in the future are the valuation of investments, deferred policy acquisition costs, liabilities for future policy benefits and unpaid policy claims, and income taxes. These accounting estimates and actuarial determinations are sensitive to market conditions, investment yields, mortality, morbidity, commission and other acquisition expenses, and terminations by policyholders. As additional information becomes available, or actual amounts are determinable, the recorded estimates will be revised and reflected in operating results. Although some variability is inherent in these estimates, we believe the amounts provided are adequate.

The consolidated financial statements include the accounts of the Parent Company, its subsidiaries and those entities required to be consolidated under applicable accounting standards. All material intercompany accounts and transactions have been eliminated.

In the opinion of management, the accompanying unaudited consolidated financial statements of the Company contain all adjustments, consisting of normal recurring accruals, which are necessary to fairly present the consolidated balance sheets as of March 31, 2010, and December 31, 2009, and the consolidated statements of earnings, shareholders’ equity, cash flows and comprehensive income for the three-month periods ended March 31, 2010, and 2009. Results of operations for interim periods are not necessarily indicative of results for the entire year. As a result, these financial statements should be read in conjunction with the financial statements and notes thereto included in our annual report to shareholders for the year ended December 31, 2009.

Significant Accounting Policies

As a result of accounting guidance adopted subsequent to December 31, 2009, we have updated our accounting policy for investments and derivatives and hedging. All other categories of significant accounting policies remain unchanged from our annual report to shareholders for the year ended December 31, 2009.

 

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Investments:   Our debt securities consist of fixed-maturity securities, which are classified as either held to maturity or available for sale. Securities classified as held to maturity are securities that we have the ability and intent to hold to maturity or redemption and are carried at amortized cost. All other fixed-maturity debt securities, our perpetual securities and our equity securities are classified as available for sale and are carried at fair value. If the fair value is higher than the amortized cost for debt and perpetual securities, or the purchase cost for equity securities, the excess is an unrealized gain, and if lower than cost, the difference is an unrealized loss.

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 recorded through other comprehensive income and included in accumulated other comprehensive income.

Amortized cost of debt and perpetual securities is based on our purchase price adjusted for accrual of discount, or amortization of premium and recognition of impairment charges, if any. The amortized cost of debt and perpetual securities we purchase at a discount or premium will equal the 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 have investments in variable interest entities (VIEs) and qualified special purpose entities (QSPEs). In periods prior to 2010, VIEs were evaluated for consolidation based on the variable interest created by a VIE, and QSPEs were exempt from consolidation. Our investments in VIEs and QSPEs were accounted for as fixed-maturity or perpetual securities. The majority of our investments in VIEs and QSPEs were held in our available-for-sale portfolio.

Subsequent to the adoption of updated accounting guidance on VIEs and QSPEs in 2010, our accounting treatment for these investments changed. The concept of QSPEs was eliminated, and therefore, the former QSPEs are treated as normal VIEs and are evaluated for consolidation. We adopted the new criteria for evaluating VIEs for consolidation, which, instead of focusing on a quantitative approach, focuses on identifying which enterprise has the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance and (1) the obligation to absorb losses of the entity or (2) the right to receive benefits from the entity. As a result of the application of this new guidance, we are the primary beneficiary of certain VIEs. While the VIEs generally operate within a defined set of documents, there are certain powers that are retained by us that are considered significant in our conclusion that we are the primary beneficiary. These powers vary by structure but generally include the initial selection of the underlying collateral or, for collateralized debt obligations (CDOs), the reference credits to include in the structure; the ability to obtain the underlying collateral in the event of default; and the ability to appoint or dismiss key parties in the structure. In particular, our powers surrounding the underlying collateral were the most significant powers since those most significantly impact the economics of the VIE. We have no obligation to provide any continuing financial support to any of the entities in which we are the primary beneficiary. Our maximum loss is limited to our original investment. We and any of our creditors have no ability to obtain the underlying collateral, and we have no control over the instruments in the VIEs, unless there is an event of default.

For those entities where we are the primary beneficiary, the assets consolidated are fixed-maturity securities, perpetual securities and derivative instruments. The calculation method of the yields on these investments did not change as a result of adoption of the new accounting guidance.

For the collateralized mortgage obligations (CMOs) held in our fixed-maturity securities portfolio, we recognize income using a constant effective yield, which is based on anticipated prepayments and the estimated economic life of the securities. When estimates of prepayments change, the effective yield is recalculated to reflect actual payments to date and anticipated future payments. The net investment in CMO securities is adjusted to the amount that would have existed had the new effective yield been applied at the time of acquisition. This adjustment is reflected in net investment income.

We use the specific identification method to determine the gain or loss from securities transactions and report the realized gain or loss in the consolidated statements of earnings.

 

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Our credit analysts/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, among other factors, the length of time and the extent to which amortized cost exceeds fair value, the financial condition, operations, credit and liquidity posture, and future prospects of the issuer as well as our intent or need to dispose of the security prior to a recovery of its fair value to amortized cost. 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.

In periods prior to 2009, if, after monitoring and analyses, management believed that a decline in fair value was other than temporary, we adjusted the amortized cost of the security to fair value and reported a realized loss in the consolidated statements of earnings. Subsequent to the adoption of updated accounting guidance on impairments in 2009, our accounting policy changed. If, after monitoring and analyses, management believes that fair value will not recover to amortized cost prior to the disposal of the security, we recognize an other-than-temporary impairment of the security. Once a security is considered to be other-than-temporarily impaired, the impairment loss is separated into two separate components: the portion of the impairment related to credit and the portion of the impairment related to factors other than credit. We automatically recognize a charge to earnings for the credit-related portion of other-than-temporary impairments. Impairments related to factors other than credit are charged to earnings in the event we intend to sell the security prior to the recovery of its amortized cost or if it is more likely than not that we would be required to dispose of the security prior to recovery of its amortized cost; otherwise, non-credit-related other-than-temporary impairments are charged to other comprehensive income.

We lend fixed-maturity securities to financial institutions in short-term security lending transactions. These securities continue to be carried as investment assets on our balance sheet during the terms of the loans and are not reported as sales. We receive cash or other securities as collateral for such loans. For loans involving unrestricted cash collateral, the collateral is reported as an asset with a corresponding liability for the return of the collateral. For loans collateralized by securities, the collateral is not reported as an asset or liability.

For further information regarding our investments, see Note 3.

Derivatives and Hedging:  We do not use derivatives for trading purposes, nor do we engage in leveraged derivative transactions.

Freestanding derivative instruments are reported in the consolidated statements of financial position at fair value and are reported in other assets and other liabilities, with changes in value reported in earnings. These freestanding derivatives are interest rate swaps, credit default swaps (CDSs) and/or foreign currency swaps. Interest rate and foreign currency swaps are used within VIEs to hedge the risk arising from interest rate and currency exchange risk, while the CDSs are used to increase the yield and improve the diversification of the portfolio.

From time to time, we purchase certain investments that contain an embedded derivative. We assess whether this embedded derivative is clearly and closely related to the asset that serves as its host contract. If we deem that the embedded derivative’s terms are not clearly and closely related to the host contract, and a separate instrument with the same terms would qualify as a derivative instrument, the derivative is separated from that contract, held at fair value and reported with the host instrument in the consolidated statements of financial position, with changes in fair value reported in earnings.

For those relationships where we seek hedge accounting, we document all relationships between hedging instruments and hedged items, as well as our risk-management objectives for undertaking various hedge transactions. This process includes linking derivatives and nonderivatives that are designated as hedges to specific assets or liabilities on the balance sheet. We also assess, both at inception and on an ongoing basis, whether the derivatives and nonderivatives used in hedging activities are highly effective in offsetting changes in fair values or cash flows of the hedged items. The assessment of hedge effectiveness determines the accounting treatment of noncash changes in fair value.

 

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We have designated certain interest rate swaps as a hedge of the variability of the interest cash flows associated with our variable rate Uridashi notes. Changes in the fair value of these and any of our other derivatives that are designated and qualify as cash flow hedges are recorded in other comprehensive income as long as they are deemed effective. Any hedge ineffectiveness is recorded immediately in current period earnings as net realized investment gains and losses. Periodic derivative net coupon settlements are recorded in the line item of the consolidated statements of operations in which the cash flows of the hedged item are recorded. We include the fair value of these derivatives in either other assets or other liabilities on the balance sheet.

We have designated our yen-denominated Samurai and Uridashi notes and yen-denominated loans (see Note 6) as nonderivative hedges of the foreign currency exposure to our investment in Aflac Japan. At the beginning of each quarter, we make our net investment hedge designation. If the total of our designated 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 designated yen-denominated liabilities exceed our investment in Aflac Japan, the foreign exchange effect on the portion of the liabilities that exceeds our investment in Aflac Japan would be recognized in net earnings (other income). Until their expiration in April 2009, we designated our cross-currency swaps as a hedge of the foreign currency exposure of our investment in Aflac Japan. We included the fair value of the cross-currency swaps in either other assets or other liabilities on the balance sheet. We reported the changes in fair value of the foreign currency portion of our cross-currency swaps in other comprehensive income. Changes in the fair value of the interest rate component were reflected in other income in the consolidated statements of earnings.

Reclassifications: Certain reclassifications have been made to prior-year amounts to conform to current-year reporting classifications. These reclassifications had no impact on net earnings or total shareholders’ equity.

New Accounting Pronouncements

Recently Adopted Accounting Pronouncements

Fair value measurements and disclosures: In January 2010, the FASB issued amended accounting guidance on fair value disclosures. This guidance requires new disclosures about transfers in and out of fair value hierarchy Levels 1 and 2. We adopted this guidance as of January 1, 2010. The adoption did not have an impact on our financial position or results of operations.

Accounting for variable interest entities and transfers of financial assets: In June 2009, the FASB issued amended guidance on accounting for VIEs and transfers of financial assets. As discussed above, this guidance defines new criteria for determining the primary beneficiary of a VIE; increases the frequency of required reassessments to determine whether a company is the primary beneficiary of a VIE; eliminates the exemption for the consolidation of QSPEs; establishes conditions for reporting a transfer of a portion of a financial asset as a sale; modifies the financial asset derecognition criteria; and requires additional disclosures. We adopted the provisions of this guidance on January 1, 2010 prospectively. As a result, we were required to consolidate certain of the VIEs with which we are currently involved. We were not required to deconsolidate any VIEs on January 1, 2010.

Upon the initial consolidation of the VIEs on January 1, 2010, the assets, liabilities, and noncontrolling interests of the VIEs were recorded at their carrying values, which is the amounts at which the assets, liabilities, and noncontrolling interests would have been carried in the consolidated financial statements when we first met the conditions to be the primary beneficiary. For any of the VIEs that were required to be consolidated, we also considered whether any of the derivatives in these structures qualified on January 1, 2010, as a cash flow hedge of the changes in cash flows attributable to foreign currency and/or interest rate risk. Certain of the swaps did not qualify for hedge accounting since the swap had a fair value on January 1, 2010. Other swaps did not qualify for hedge accounting since they increased, rather than reduced, cash flow risk. See Note 4 for further discussion.

The impact of consolidating these VIEs as of January 1, 2010, includes three components. The first component is the valuation differences associated with the underlying securities and derivatives included in the VIE structures. Prior to the consolidation of these VIEs, we utilized a pricing model to value our beneficial interests and did not separately consider the fair value of the financial instruments included within the structures. The cumulative impact of these valuation adjustments was recorded in accumulated other comprehensive income or retained earnings depending on whether the valuation adjustment was associated with the underlying debt securities and whether the derivative qualified as a cash flow hedge.

 

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Another portion of the impact of consolidation was related to the currency translation adjustments that were previously recognized for our beneficial interests in the VIEs that were yen-denominated. Since some of the underlying assets in the VIEs are dollar-denominated, the previously recognized currency translation adjustment was reversed.

The final portion primarily relates to the fair value of CDSs included in the CDOs that had been designated as held to maturity. Under U.S. GAAP, these credit default swaps were recorded at fair value as a cumulative effect adjustment through retained earnings. The CDSs are not eligible for hedge accounting.

The following table summarizes the cumulative after-tax consolidation impact of adopting this new accounting guidance on January 1, 2010:

 

 
(In millions)   Accumulated Other
Comprehensive
Income
  Retained Earnings   Total
Shareholders’ Equity  
 

Cumulative valuation adjustments

  $     180    $        -      $     180   

Currency translation adjustments

        (320)            -          (320) 

Swaps

           -         (26)         (26)

Other

           -           1           1
 

  Total

  $    (140)   $     (25)    $    (165)  
 

For additional information concerning our investments in VIEs and derivatives, see Notes 3 and 4, respectively.

Accounting Pronouncements Pending Adoption

Fair value measurements and disclosures: In January 2010, the FASB issued amended accounting guidance on fair value disclosures. This guidance requires the activity in fair value hierarchy Level 3 for purchases, sales, issuances, and settlements to be reported on a gross, rather than net, basis. This guidance is effective for interim and annual periods beginning after December 15, 2010. We are in the process of assessing the impact of the adoption of this guidance on our financial position and results of operations.

Accounting for embedded credit derivatives: In March 2010, the FASB issued accounting guidance on embedded credit derivatives. This guidance clarifies the type of embedded credit derivative that is exempt from embedded derivative bifurcation requirements. This guidance is effective for interim periods beginning after June 15, 2010. We are in the process of assessing the impact of the adoption of this guidance on our financial position and results of operations.

Recent accounting guidance not discussed above is not applicable or did not have an impact to our business.

For additional information on new accounting pronouncements and their impact, if any, on our financial position or results of operations, see Note 1 of the Notes to the Consolidated Financial Statements in our annual report to shareholders for the year ended December 31, 2009.

 

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2. BUSINESS SEGMENT INFORMATION

The Company consists of two reportable insurance business segments: Aflac Japan and Aflac U.S., both of which sell supplemental health and life insurance.

Operating business segments that are not individually reportable are included in the “Other business segments” category. We do not allocate corporate overhead expenses to business segments. We evaluate and manage our business segments using a financial performance measure called pretax operating earnings. Our definition of operating earnings excludes the following items from net earnings on an after-tax basis: realized investment gains/losses, the impact from ASC 815 (“Derivatives and Hedging”), and nonrecurring items. We then exclude income taxes related to operations to arrive at pretax operating earnings. Information regarding operations by segment as follows:

 

 
     Three months Ended March 31,       
(In millions)    2010          2009     
 

Revenues:

       

  Aflac Japan:

       

Earned premiums

   $        3,206         $        3,012     

Net investment income

   593         560     

Other income

   28         7     
 

  Total Aflac Japan

   3,827         3,579     
 

  Aflac U.S.:

       

Earned premiums

   1,142         1,103     

Net investment income

   132         125     

Other income

   2         2     
 

  Total Aflac U.S.

   1,276         1,230     
 

Other business segments

   12         11     
 

  Total business segments

   5,115         4,820     

Realized investment gains (losses)

   (46      (9)    

Corporate

   52         35     

Intercompany eliminations

   (56      (28)    
 

  Total revenues

   $        5,065         $        4,818     
 

 

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     Three Months Ended March 31,          
(In millions)    2010           2009       
 

Pretax earnings:

       

  Aflac Japan

   $          821         $          681       

  Aflac U.S.

   244         204       

  Other business segments

   (1)        -        
 

Total business segments

   1,064         885       

  Interest expense, noninsurance operations

   (31)        (7)      

  Corporate and eliminations

   (13)        (9)      
 

Pretax operating earnings

   1,020         869       

  Realized investment gains (losses)

   (46)        (9)      

  Impact from ASC 815

   -          (5)      

  Gain on extinguishment of debt

   -          16       
 

Total earnings before income taxes

   $          974         $          871       
 

  Income taxes applicable to pretax operating earnings

   $          354         $          302       

  Effect of foreign currency translation on operating earnings

   22         41       
 

Assets were as follows:

 

 
(In millions)    March 31,
2010    
       December 31,    
2009          
 

Assets:

       

  Aflac Japan

   $      72,384         $      71,639       

  Aflac U.S.

   12,198         11,779       

  Other business segments

   145         142       
 

Total business segments

   84,727         83,560       

  Corporate

   11,616         11,261       

  Intercompany eliminations

   (11,165)        (10,715)      
 

Total assets

   $      85,178         $      84,106       
 

 

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3. INVESTMENTS

Investment Holdings

The amortized cost for our investments in debt and perpetual securities, the cost for equity securities and the fair values of these investments are shown in the following tables.

 

 
     March 31, 2010
 
(In millions)    Cost or
Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
  

  Fair

  Value

 

Securities available for sale,

  carried at fair value:

           

  Fixed maturities:

           

Yen-denominated:

           

Japan government and agencies

   $  12,308            $    375          $    123          $  12,560    

Mortgage- and asset-backed

  securities

   1,097            11          16          1,092    

Public utilities

   2,252            116          105          2,263    

Sovereign and supranational

   825            28          90          763    

Banks/financial institutions

   4,073            109          660          3,522    

Other corporate

   4,991            117          534          4,574    
 

  Total yen-denominated

   25,546            756          1,528          24,774    
 

Dollar-denominated:

           

U.S. government and agencies

   139            4          2          141    

Municipalities

   724            7          25          706    

Mortgage- and asset-backed

   securities(1)

   693            73          57          709    

Collateralized debt obligations

   2            2          -          4    

Public utilities

   1,975            165          27          2,113    

Sovereign and supranational

   368            53          7          414    

Banks/financial institutions

   3,451            109          234          3,326    

Other corporate

   5,919            435          106          6,248    
 

  Total dollar-denominated

   13,271            848          458          13,661    
 

  Total fixed maturities

   38,817            1,604          1,986          38,435    
 

  Perpetual securities:

           

Yen-denominated:

           

Banks/financial institutions

   6,808            437          552          6,693    

Other corporate

   288            30          -          318    

Dollar-denominated:

           

Banks/financial institutions

   419            41          48          412    
 

  Total perpetual securities

   7,515            508          600          7,423    
 

  Equity securities

   21            4          1          24    
 

  Total securities available for sale

   $  46,353            $  2,116          $  2,587          $  45,882    
 
(1)

Includes $12 million of other-than-temporary non-credit-related losses

 

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     March 31, 2010
 
(In millions)    Cost or
Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
  

Fair  

Value  

 

Securities held to maturity,

  carried at amortized cost:

           

  Fixed maturities:

           

Yen-denominated:

           

Japan government and agencies

   $      215          $      5         $         -        $      220     

Municipalities

   357          1         6        352     

Mortgage- and asset-backed securities

   165          2         7        160     

Public utilities

   5,395          153         154        5,394     

Sovereign and supranational

   4,203          143         160        4,186     

Banks/financial institutions

   11,655          133         1,033        10,755     

Other corporate

   4,409          135         123        4,421     
 

  Total yen-denominated

   26,399          572         1,483        25,488     
 

  Total securities held to maturity

   $  26,399          $  572         $  1,483        $  25,488     
 

 

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     December 31, 2009
 
(In millions)    Cost or
Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
  

  Fair

  Value

 

Securities available for sale,

  carried at fair value:

           

  Fixed maturities:

           

Yen-denominated:

           

Japan government and agencies

   $  11,710            $    405          $    174          $  11,941    

Mortgage- and asset-backed

  securities

   549            13          -          562    

Public utilities

   2,284            145          79          2,350    

Collateralized debt obligations

   165            97          24          238    

Sovereign and supranational

   833            28          96          765    

Banks/financial institutions

   5,248            144          784          4,608    

Other corporate

   6,401            112          714          5,799    
 

  Total yen-denominated

   27,190            944          1,871          26,263    
 

Dollar-denominated:

           

U.S. government and agencies

   221            3          7          217    

Municipalities

   519            4          28          495    

Mortgage- and asset-backed

   securities(1)

   586            9          78          517    

Collateralized debt obligations

   24            7          2          29    

Public utilities

   1,587            123          42          1,668    

Sovereign and supranational

   353            48          9          392    

Banks/financial institutions

   2,668            75          259          2,484    

Other corporate

   4,485            339          108          4,716    
 

  Total dollar-denominated

   10,443            608          533          10,518    
 

  Total fixed maturities

   37,633            1,552          2,404          36,781    
 

  Perpetual securities:

           

Yen-denominated:

           

Banks/financial institutions

   6,964            311          604          6,671    

Other corporate

   291            28          -          319    

Dollar-denominated:

           

Banks/financial institutions

   299            30          56          273    
 

  Total perpetual securities

   7,554            369          660          7,263    
 

  Equity securities

   22            4          2          24    
 

  Total securities available for sale

   $  45,209            $  1,925          $  3,066          $  44,068    
 
(1)

Includes $25 of other-than-temporary non-credit-related losses

 

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     December 31, 2009
 
(In millions)    Cost or
Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
  

Fair  

Value  

 

Securities held to maturity,

  carried at amortized cost:

           

  Fixed maturities:

           

Yen-denominated:

           

Japan government and agencies

   $      217          $     6        $         -        $      223    

Municipalities

   281          1        4        278    

Mortgage- and asset-backed securities

   167          2        6        163    

Collateralized debt obligations

   109          -        14        95    

Public utilities

   5,235          180        138        5,277    

Sovereign and supranational

   4,248          161        143        4,266    

Banks/financial institutions

   11,775          140        984        10,931    

Other corporate

   4,455          142        104        4,493    
 

  Total yen-denominated

   26,487          632        1,393        25,726    
 

Dollar-denominated:

           

Collateralized debt obligations

   200          -        98        102    
 

  Total dollar-denominated

   200          -        98        102    
 

  Total securities held to maturity

   $  26,687          $  632        $  1,491        $  25,828    
 

The methods of determining the fair values of our investments in debt securities, perpetual securities and equity securities are described in Note 5.

As discussed in Note 1, we adopted new accounting guidance for VIEs on January 1, 2010, that resulted in the consolidation of most of our investments in CDOs. As a result, these investments are no longer reported as a single investment. In addition, in conjunction with this change in accounting for VIEs, certain VIEs, totaling $309 million at amortized cost as of January 1, 2010, are no longer classified as held to maturity. The underlying collateral for these VIEs is classified as available for sale as of January 1, 2010.

During the first three months of 2010, we did not reclassify any investments from the held-to-maturity portfolio to the available-for-sale portfolio. During the first three months of 2009, we reclassified six investments from the held-to-maturity portfolio to the available-for-sale portfolio as a result of a significant decline in the issuers’ credit worthiness. At the time of transfer, the securities had an aggregate amortized cost of $497 million and an aggregate unrealized loss of $200 million.

 

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Contractual and Economic Maturities

 

The contractual maturities of our investments in fixed maturities at March 31, 2010, were as follows:

 

 
     Aflac Japan    Aflac U.S.
 
(In millions)    Amortized
Cost
   Fair
Value
   Amortized
Cost
   Fair  
Value  
 

Available for sale:

           

Due in one year or less

   $ 565    $ 572    $ 4    $             4  

Due after one year through five years

     5,339      5,753      264      297  

Due after five years through 10 years

     2,338      2,447      833      935  

Due after 10 years

     21,535      20,434      6,032      6,074  

Mortgage- and asset-backed securities

     1,330      1,390      460      412  
 

Total fixed maturities available for sale

   $ 31,107    $ 30,596    $ 7,593    $ 7,722  
 

Held to maturity:

           

Due after one year through five years

   $ 1,468    $ 1,524    $ -    $ -  

Due after five years through 10 years

     2,527      2,815      -      -  

Due after 10 years

     22,239      20,989      -      -  

Mortgage- and asset-backed securities

     165      160      -      -  
 

Total fixed maturities held to maturity

   $ 26,399    $     25,488    $ -    $ -  
 

 

At March 31, 2010, the Parent Company had a portfolio of investment-grade available-for-sale fixed-maturity securities totaling $117 million at both amortized cost and fair value, which is not included in the table above.

 

Expected maturities may differ from contractual maturities because some issuers have the right to call or prepay obligations with or without call or prepayment penalties.

 

The majority of our perpetual securities are subordinated to other debt obligations of the issuer, but rank higher than the issuer’s equity securities. Perpetual securities have characteristics of both debt and equity investments, along with unique features that create economic maturity dates for the securities. Although perpetual securities have no contractual maturity date, they have stated interest coupons that were fixed at their issuance and subsequently change to a floating short-term interest rate of 125 to more than 300 basis points above an appropriate market index, generally by the 25th year after issuance, thereby creating an economic maturity date. The economic maturities of our investments in perpetual securities, which were all reported as available for sale at March 31, 2010, were as follows:

 

 
     Aflac Japan    Aflac U.S.
 
(In millions)    Amortized
Cost
   Fair
Value
   Amortized
Cost
   Fair  
Value  
 

Due in one year or less

   $ 107    $ 109    $ -    $ -  

Due after one year through five years

     1,049      1,156      -      -  

Due after five years through 10 years

     1,608      1,748      5      5  

Due after 10 years through 15 years

     -      -      -      -  

Due after 15 years

     4,512      4,164      234      241  
 

Total perpetual securities available for sale

   $         7,276    $ 7,177    $ 239    $ 246  
 

 

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Investment Concentrations

Our investment discipline begins with a top-down approach for each investment opportunity we consider. Consistent with that approach, we first approve each country in which we invest. In our approach to sovereign analysis, we consider the political, legal and financial context of the sovereign entity in which an issuer is domiciled and operates. Next we approve the issuer’s industry sector, including such factors as the stability of results and the importance of the sector to the overall economy. Specific credit names within approved countries and industry sectors are evaluated for their market position and specific strengths and potential weaknesses. Structures in which we invest are chosen for specific portfolio management purposes, including asset/liability management, portfolio diversification and net investment income.

Our largest investment industry sector concentration is banks and financial institutions. Within the countries we approve for investment opportunities, we primarily invest in financial institutions that are strategically crucial to each approved country’s economy. The bank and financial institution sector is a highly regulated industry and plays a strategic role in the global economy. We achieve some degree of diversification in the bank and financial institution sector through a geographically diverse universe of credit exposures. Within this sector, the more significant concentration of our credit risk by geographic region or country of issuer at March 31, 2010, based on amortized cost, was: Europe, excluding the United Kingdom (49%); United States (20%); United Kingdom (8%); Japan (8%); and other (15%).

As a result of the consolidation of additional VIEs as disclosed in Note 1, $120 million in additional perpetual securities were recognized since the securities were included in the former QSPE structures.

Our total investments in the bank and financial institution sector, including those classified as perpetual securities, were as follows:

 

     March 31, 2010   December 31, 2009
     Total Investments in
Banks and Financial
Institutions Sector
(in millions)
  Percentage of
Total Investment
Portfolio
  Total Investments in
Banks and Financial
Institutions Sector
(in millions)
  Percentage of
Total Investment    
Portfolio

Debt Securities:

       

Amortized cost

          $ 19,179              26  %           $ 19,691             28  %    

Fair value

    17,603              25          18,023             26         

Perpetual Securities:

       

Upper Tier II:

       

Amortized cost

          $ 4,964                 7  %              $ 4,909                 7  %       

Fair value

    5,139              7          4,938              7         

Tier I:

       

Amortized cost

    2,263              3          2,354              3         

Fair value

    1,966              3          2,006              3         

Total:

       

Amortized cost

          $ 26,406             36  %           $ 26,954             38  %    

Fair value

    24,708              35           24,967              36          
 

 

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Realized Investment Gains and Losses

Information regarding pretax realized gains and losses from investments is as follows:

 

     Three Months Ended
March 31,
(In millions)        2010                  2009    

Realized investment gains (losses) on securities:

        

Debt securities:

        

Available for sale:

        

Gross gains from sales

   $ 51        $ 223  

Gross losses from sales

     (80)         (1) 

Net gains (losses) from redemptions

     -           1  

Impairment losses

     -           (169) 
 

Total debt securities

     (29)         54  
 

Perpetual securities:

        

Available for sale:

        

Gross gains from sales

             -  

Impairment losses

     (41)         (65) 
 

Total perpetual securities

     (33)         (65) 
 

Equity securities:

        

Impairment losses

     (1)         -  
 

Total equity securities

     (1)         -  
 

Other assets:

        

Derivatives

     17          -  

Other long-term assets

     -           2  
 

Total other assets

     17          2  
 

Total realized investment gains (losses)

   $ (46)       $ (9) 
 

During the three-month period ended March 31, 2010, we realized pretax investment losses of $42 million ($27 million after-tax) as a result of the recognition of other-than-temporary impairment losses. We also realized pretax investment losses, net of gains, of $21 million ($14 million after-tax) from securities sold or redeemed in the normal course of business. We realized pretax investment gains of $17 million ($11 million after-tax) from valuing foreign currency, interest rate and credit default swaps related to certain VIEs that were required to be consolidated following the adoption of new accounting guidance effective January 1, 2010.

During the three-month period ended March 31, 2009, we realized total pretax investment losses of $234 million ($152 million after-tax) as a result of the recognition of other-than-temporary impairment losses. We also realized pretax investment gains, net of losses, of $225 million ($146 million after-tax) from a bond–swap program that took advantage of tax loss carryforwards and from securities sold or redeemed in the normal course of business.

Other-than-temporary Impairment

The fair value of our debt and perpetual security investments fluctuates based on changes in credit spreads in the global financial markets. Credit spreads are most impacted by market rates of interest, the general and specific credit environment and global market liquidity. We believe that fluctuations in the fair value of our investment securities related to changes in credit spreads have little bearing on whether our investment is ultimately recoverable. Therefore, we consider such declines in fair value to be temporary even in situations where an investment remains in an unrealized loss position for a year or more.

 

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However, in the course of our credit review process, we may determine that it is unlikely that we will recover our investment in an issuer due to factors specific to an individual issuer, as opposed to general changes in global credit spreads. In this event, we consider such a decline in the investment’s fair value, to the extent below the investment’s cost or amortized cost, to be an other-than-temporary impairment of the investment and write the investment down to its fair value. The determination of whether an impairment is other than temporary is subjective and involves the consideration of various factors and circumstances, which includes but is not limited to the following:

 

   

issuer financial condition, including profitability and cash flows

 

   

credit status of the issuer

 

   

the issuer’s specific and general competitive environment

 

   

published reports

 

   

general economic environment

 

   

regulatory, legislative and political environment

 

   

the severity of the decline in fair value

 

   

the length of time the fair value is below cost

 

   

other factors as may become available from time to time

In addition to the usual investment risk associated with a debt instrument, our perpetual security holdings may be subject to the risk of nationalization of their issuers in connection with capital injections from an issuer’s sovereign government. We cannot be assured that such capital support will extend to all levels of an issuer’s capital structure. In addition, certain governments or regulators may consider imposing interest and principal payment restrictions on issuers of hybrid securities to preserve cash and build capital. In addition to the cash flow impact that additional deferrals would have on our portfolio, such deferrals could result in ratings downgrades of the affected securities, which in turn could impair the fair value of the securities and increase our regulatory capital requirements. We take factors such as these into account in our credit review process.

Another factor we consider in determining whether an impairment is other than temporary is an evaluation of our intent, need, or both to sell the security prior to its anticipated recovery in value. We perform ongoing analyses of our liquidity needs, which includes cash flow testing of our policy liabilities, debt maturities, projected dividend payments and other cash flow and liquidity needs. Our cash flow testing includes extensive duration matching of our investment portfolio and policy liabilities. Based on our analyses, we have concluded that we have sufficient excess cash flows to meet our liquidity needs without liquidating any of our investments prior to their maturity. In addition, provided that our credit review process results in a conclusion that we will collect all of our cash flows and recover our investment in an issuer, we generally do not sell investments prior to their maturity.

The majority of our investments are evaluated for other-than-temporary impairment using our debt impairment model. Our debt impairment model focuses on the ultimate collection of the cash flows from our investments. Our investments in perpetual securities that are rated below investment grade are evaluated for other-than-temporary impairment under our equity impairment model. Our equity impairment model focuses on the severity of a security’s decline in fair value coupled with the length of time the fair value of the security has been below amortized cost.

 

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The following table details our pretax other-than-temporary impairment losses by investment category.

 

     

    Three Months Ended    

March 31,

(In millions)        2010                      2009    

Perpetual securities

   $ 41         $ 65  

Corporate bonds

     -           50  

Collateralized debt obligations

     -           113  

Collateralized mortgage obligations

     -           6  

Equity securities

     1           -  
 

Total other-than-temporary impairments

   $ 42         $ 234  
 

We apply the debt security impairment model to our perpetual securities provided there has been no evidence of deterioration in credit of the issuer, such as a downgrade of the rating of a perpetual security to below investment grade. During the three-month period ended March 31, 2010, the perpetual securities of two issuers we own were downgraded to below investment grade. As a result of these downgrades, we were required to evaluate these securities for other-than-temporary impairment using the equity security impairment model rather than the debt security impairment model. Use of the equity security model limits the forecasted recovery period that can be used in the impairment evaluation and, accordingly, affects both the recognition and measurement of other-than-temporary impairment losses. As a result of market conditions and the extent of changes in ratings on our perpetual securities, we recognized other-than-temporary impairment losses for perpetual securities being evaluated under our equity impairment model of $41 million ($27 million after-tax) during the three-month period ended March 31, 2010, compared with $65 million ($42 million after-tax) during the three-month period ended March 31, 2009.

During our review of certain CMOs during the three-month period ended March 31, 2009, we determined that a portion of the other-than-temporary impairment of the securities was credit-related. However, we concluded a portion of the reduction in fair value below amortized cost was due to non-credit factors, which we believe we will recover. As a result, we recognized an impairment charge in earnings for credit-related declines in value of $6 million ($4 million after-tax) during the three-month period ended March 31, 2009. We recorded an unrealized loss in other comprehensive income of $4 million ($3 million after-tax) during the three-month period ended March 31, 2009, for the portion of the other-than-temporary impairment of these securities resulting from non-credit factors. We did not recognize any impairments of the CMOs in the three-month period ended March 31, 2010.

The other-than-temporary impairment losses recognized in the first three months of 2009, of which a portion was transferred to other comprehensive income, related only to the other-than-temporary impairment of certain of our investments in CMOs. The other-than-temporary impairment charges related to credit and all other factors other than credit were determined using statistical modeling techniques. The model projects expected cash flows from the underlying mortgage pools assuming various economic recession scenarios including, more significantly, geographical and regional home data, housing valuations, prepayment speeds, and economic recession statistics. The following table summarizes cumulative credit-related impairment losses on securities still held at the end of the reporting period for which other-than-temporary losses have been recognized and only the amount related to credit loss was recognized in earnings.

 

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Table of Contents
     

    Three Months Ended    

March 31,

(In millions)      2010             2009  

Cumulative credit loss impairments, beginning of period

   $ 24         $ -  

Credit losses for which an other-than-temporary impairment was not previously recognized

     -            6  

Securities sold during period

     (1)          -  
 

Cumulative credit loss impairments, end of period

   $ 23         $ 6  
 

Unrealized Investment Gains and Losses

Effect on Shareholders’ Equity

The net effect on shareholders’ equity of unrealized gains and losses from investment securities were as follows:

 

(In millions)            March 31,  
2010
           December 31,  
2009

Unrealized gains (losses) on securities available for sale

      $ (471)               $ (1,141)        

Unamortized unrealized gains on securities transferred to held to maturity

        141                  148         

Deferred income taxes

        125                  356         
 

Shareholders’ equity, net unrealized gains (losses) on investment securities

      $ (205)               $ (637)        
 

Gross Unrealized Loss Aging

The following tables show the fair value and gross unrealized losses, including the portion of other-than-temporary impairment recognized in accumulated other comprehensive income, of our available-for-sale and held-to-maturity investments, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position.

 

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     March 31, 2010
     Total   Less than 12 months   12 months or longer
(In millions)   Fair
    Value    
  Unrealized
Losses
  Fair
    Value    
  Unrealized
Losses
  Fair
    Value    
  Unrealized  
Losses  

Fixed maturities:

           

U.S. government and agencies:

           

Dollar-denominated

  $ 93   $ 2   $ 28   $ -   $ 65   $ 2  

Japan government and agencies:

           

Yen-denominated

    5,105     123     1,691     15     3,414     108  

Municipalities:

           

Dollar-denominated

    425     25     371     10     54     15  

Yen-denominated

    281     6     251     5     30     1  

Mortgage- and asset- backed securities:

           

Dollar-denominated

    266     57     51     1     215     56  

Yen-denominated

    600     23     582     16     18     7  

Public utilities:

           

Dollar-denominated

    602     27     375     11     227     16  

Yen-denominated

    3,793     259     1,131     73     2,662     186  

Sovereign and supranational:

           

Dollar-denominated

    95     7     13     -     82     7  

Yen-denominated

    2,683     250     705     18     1,978     232  

Banks/financial institutions:

           

Dollar-denominated

    1,675     234     521     31     1,154     203  

Yen-denominated

    9,971     1,693     484     108     9,487     1,585  

Other corporate:

           

Dollar-denominated

    1,810     106     1,032     35     778     71  

Yen-denominated

    4,971     657     1,069     47     3,902     610  
 

Total fixed maturities

    32,370     3,469     8,304     370     24,066     3,099  
 

Perpetual securities:

           

Dollar-denominated

    190     48     36     12     154     36  

Yen-denominated

    2,656     552     444     67     2,212     485  
 

Total perpetual securities

    2,846     600     480     79     2,366     521  
 

Equity securities

    6     1     4     -     2     1  
 

Total

  $ 35,222   $ 4,070   $ 8,788   $ 449   $ 26,434   $ 3,621  
 

 

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     December 31, 2009
     Total   Less than 12 months   12 months or longer
(In millions)   Fair
    Value    
  Unrealized
Losses
  Fair
    Value    
  Unrealized
Losses
  Fair
    Value    
  Unrealized  
Losses  

Fixed maturities:

           

U.S. government and agencies:

           

Dollar-denominated

  $ 175   $ 7   $ 112   $ 3   $ 63   $ 4  

Japan government and agencies:

           

Yen-denominated

    5,760     174     5,456     153     304     21  

Municipalities:

           

Dollar-denominated

    378     28     322     11     56     17  

Yen-denominated

    223     4     223     4     -     -  

Mortgage- and asset- backed securities:

           

Dollar-denominated

    338     78     78     3     260     75  

Yen-denominated

    54     6     35     -     19     6  

Collateralized debt obligations:(1)

           

Dollar-denominated

    117     100     -     -     117     100  

Yen-denominated

    181     38     -     -     181     38  

Public utilities:

           

Dollar-denominated

    465     42     200     10     265     32  

Yen-denominated

    3,290     217     592     37     2,698     180  

Sovereign and supranational:

           

Dollar-denominated

    92     9     43     3     49     6  

Yen-denominated

    2,331     239     948     31     1,383     208  

Banks/financial institutions:

           

Dollar-denominated

    1,325     259     305     14     1,020     245  

Yen-denominated

    10,306     1,768     807     313     9,499     1,455  

Other corporate:

           

Dollar-denominated

    1,393     108     535     13     858     95  

Yen-denominated

    6,084     818     1,643     93     4,441     725  
 

Total fixed maturities

    32,512     3,895     11,299     688     21,213     3,207  
 

Perpetual securities:

           

Dollar-denominated

    181     56     -     -     181     56  

Yen-denominated

    3,117     604     373     28     2,744     576  
 

Total perpetual securities

    3,298     660     373     28     2,925     632  
 

Equity securities

    6     2     3     1     3     1  
 

Total

  $ 35,816   $ 4,557   $ 11,675   $ 717   $ 24,141   $ 3,840  
 
(1)

Beginning January 1, 2010, these investments are consolidated and are no longer reported as a single investment.

 

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Analysis of Securities in Unrealized Loss Positions

The unrealized losses on our investments have been primarily related to changes in interest rates, foreign exchange rates or the widening of credit spreads rather than specific issuer credit-related events. In addition, because we do not intend to sell and do not believe it is likely that we will be required to sell these investments before a recovery of fair value to amortized cost, we do not consider any of these investments to be other-than-temporarily impaired as of and for the three-month period ended March 31, 2010. The following summarizes our evaluation of investment categories with significant unrealized losses and securities that were rated below investment grade. All other investment categories with securities in an unrealized loss position that are not specifically discussed below were comprised of investment grade fixed maturities.

Municipalities and Mortgage- and Asset-Backed Securities

At March 31, 2010, 71% of securities in the municipalities sector and 46% of securities in the mortgage- and asset-backed securities sector in an unrealized loss position were investment grade, compared with 74% and 39%, respectively, at the end of 2009. We have determined that the majority of the unrealized losses on the investments in these sectors were caused by widening credit spreads. However, we have determined that the ability of the issuers to service our investments has not been compromised. Unrealized gains or losses related to prevailing interest rate environments are impacted by the remaining time to maturity of an investment. Assuming no credit-related factors develop, as investments near maturity the unrealized gains or losses can be expected to diminish.

Bank and Financial Institution Investments

The following table shows the composition of our investments in an unrealized loss position in the bank and financial institution sector by fixed maturity securities and perpetual securities. The table reflects those securities in that sector that were in an unrealized loss position as a percentage of our total investment portfolio in an unrealized loss position and their respective unrealized losses as a percentage of total unrealized losses.

 

 
     March 31, 2010    December 31, 2009        
 
     Percentage of
Total Investments in
an Unrealized
Loss Position
   Percentage of
Total Unrealized
Losses
   Percentage of
Total Investments in
an Unrealized Loss
Position
   Percentage of        
Total        
Unrealized         
Losses        
 

Fixed maturities

   33  %    47  %    33  %    44  %    

Perpetual securities:

           

Upper Tier II

   4       5        5       5        

Tier I

   4       10          4       10          
 

Total perpetual securities

   8       15          9       15          
 

Total

   41  %    62  %    42  %    59  %    
 

Throughout 2008 and during the first half of 2009, banks and financial institutions suffered significant write-downs of asset values which created capital pressure. Weakness in housing sectors in the UK, U.S. and Europe, along with declines in the values of structured investment securities, were significant causes. In the second half of 2009, the valuation of these assets improved. To reduce capital pressure, banks and other financial institutions have sought to enhance their capital positions in part through exchanges and tender offers. In addition, national governments in these regions have provided support in various forms, ranging from guarantees on new and existing debt to significant injections of capital. Should capital markets deteriorate, more of these banks and financial institutions may need various forms of government support. While it does not appear to be a preferred solution, some troubled banks and financial institutions may be nationalized. Few nationalizations have occurred to date, and the governments have generally stood behind the classes of investments that we own.

 

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As of March 31, 2010, 82% of our investments in the bank and financial institution sector in an unrealized loss position was investment grade, compared with 75% at December 31, 2009. We have determined that the majority of the unrealized losses on the investments in this sector were caused by widening credit spreads, the downturn in the global economic environment and, to a lesser extent, changes in foreign exchange rates. Unrealized gains or losses related to prevailing interest rate environments are impacted by the remaining time to maturity of an investment. Assuming no credit-related factors develop, as investments near maturity, the unrealized gains or losses can be expected to diminish. Based on our credit analysis, we believe that our investments in this sector have the ability to service their obligations to us.

Other Corporate Investments

As of March 31, 2010, 52% of the securities in the other corporate sector in an unrealized loss position was investment grade, compared with 58% at December 31, 2009. For any credit-related declines in market value, we perform a more focused review of the related issuer’s credit ratings, financial statements and other available financial data, timeliness of payment, competitive environment and any other significant data related to the issuer. From those reviews, we evaluate the issuers’ continued ability to service our investments. We have determined that the majority of the unrealized losses on the investments in the other corporate sector were caused by widening credit spreads. Also impacting the unrealized losses in this sector is the decline in creditworthiness of certain issuers in the other corporate sector. Based on our credit analysis, we believe that our investments in this sector have the ability to service their obligation to us.

Perpetual Securities

At March 31, 2010, 97% of our total investments in perpetual securities in an unrealized loss position was investment grade, compared with 92% at December 31, 2009. The majority of our investments in Upper Tier II and Tier I perpetual securities were in highly-rated global financial institutions. Upper Tier II securities have more debt-like characteristics than Tier I securities and are senior to Tier I securities, preferred stock, and common equity of the issuer. Conversely, Tier I securities have more equity-like characteristics, but are senior to the common equity of the issuer. They may also be senior to certain preferred shares, depending on the individual security, the issuer’s capital structure and the regulatory jurisdiction of the issuer.

 

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Details of our holdings of perpetual securities as of March 31, 2010, were as follows:

Perpetual Securities

 
(In millions)    Credit
Rating
        Amortized
Cost
        Fair
Value
        Unrealized  
Gain (Loss)  
 

Upper Tier II:

                    
   AA       $ 177           $ 188       $   11    
   A         3,226             3,270         44    
   BBB         874             882         8    
   BB         975             1,117         142    
 

  Total Upper Tier II

           5,252             5,457         205    
 

Tier I:

                    
   A         569             447         (122)   
   BBB         1,326             1,059         (267)   
   BB or lower         368             460         92    
 

  Total Tier I

           2,263             1,966         (297)   
 

  Total

         $   7,515           $ 7,423       $   (92)   
 

With the exception of the Icelandic bank securities that we completely impaired in 2008 and our Lloyds Banking Group plc dollar-denominated Tier I perpetual securities (par value of $33 million at March 31, 2010), all of the perpetual securities we own were current on interest and principal payments at March 31, 2010. Based on amortized cost as of March 31, 2010, the geographic breakdown of our perpetual securities by issuer was as follows: European countries, excluding the United Kingdom (67%); the United Kingdom (14%); Japan (14%); and other (5%). To determine any credit-related declines in market value, we perform a more focused review of the related issuer’s credit ratings, financial statements and other available financial data, timeliness of payment, competitive environment and any other significant data related to the issuer. From those reviews, we evaluate the issuer’s continued ability to service our investment.

We have determined that the majority of our unrealized losses in the perpetual security category was principally due to widening credit spreads, largely as the result of the contraction of liquidity in the capital markets. Based on our reviews, we concluded that the ability of the issuers to service our investment has not been compromised by these factors. Unrealized gains or losses related to prevailing interest rate environments are impacted by the remaining time to maturity of an investment. Assuming no credit-related factors develop, as the investments near economic maturity, the unrealized gains or losses can be expected to diminish. Based on our credit analyses, we believe that our investments in this sector have the ability to service their obligation to us.

Qualified Special Purpose Entities (QSPEs) and Variable Interest Entities (VIEs)

As discussed in Note 1, effective January 1, 2010, we have consolidated all of the components of each former QSPE investment, including a debt or hybrid instrument and a corresponding derivative transaction (swap). In addition, new criteria for determining the primary beneficiary of a VIE that is effective January 1, 2010, has resulted in the consolidation of additional VIE investments. Under accounting guidance in effect at December 31, 2009, QSPEs were exempt from consolidation and VIEs were evaluated for consolidation using a quantitative approach.

 

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The following table details our investments in VIEs and former QSPEs.

Investments in Qualified Special Purpose Entities

and Variable Interest Entities

 

     March 31, 2010     December 31, 2009    
 
(In millions)    Amortized
Cost
    Fair
Value
    Amortized
Cost
    Fair
Value  

QSPEs:

        

Total QSPEs

   $ -      $ -      $ 4,405      $ 4,089  
 

VIEs:

        

Consolidated:

        

  Total VIEs consolidated

   $ 6,320 (1)     $ 6,105 (1)     $ 1,809      $ 1,522  
 

Not consolidated:

        

CDOs

     2        4        498        464  

Other

     9,946        9,513        727        689  

  Total VIEs not consolidated

     9,948        9,517        1,225        1,153  

  Total VIEs

   $ 16,268      $      15,622      $ 3,034      $ 2,675  
 

(1)Includes CDOs and former QSPEs consolidated beginning on January 1, 2010

QSPEs

The underlying collateral in the former QSPEs, which we began consolidating effective January 1, 2010, is structured as fixed-maturity or perpetual investments, which we have classified as available for sale. We are the only beneficial interest holder in the former QSPEs and our risk of loss over the life of these investments is limited to the amount of our original investment.

VIEs

As a condition to our involvement or investment in a VIE, we enter into certain protective rights and covenants that preclude changes in the structure of the VIE that would alter the creditworthiness of our investment or our beneficial interest in the VIE.

Our involvement with all of the VIEs in which we have an interest is passive in nature, and we are not the arranger of these entities. Except as relates to our review and evaluation of the structure of these VIEs in the normal course of our investment decision-making process, we have not been involved in establishing these entities. Further, we have not been nor are we required to purchase the securities issued in the future by any of these VIEs.

Our ownership interest in the VIEs is limited to holding the obligations issued by them. All of the VIEs in which we invest are static with respect to funding and have no ongoing forms of funding after the initial funding date. We have no direct or contingent obligations to fund the limited activities of these VIEs, nor do we have any direct or indirect financial guarantees related to the limited activities of these VIEs. We have not provided any assistance or any other type of financing support to any of the VIEs we invest in, nor do we have any intention to do so in the future. The weighted-average lives of our notes are very similar to the underlying collateral held by these VIEs where applicable.

Our risk of loss related to our interests in any of our VIEs is limited to our investment in the debt securities issued by them.

 

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VIEs-Consolidated

We are substantively the only investor in the consolidated VIEs listed in the table above. As the sole investor in these VIEs, we have the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance and are therefore considered to be the primary beneficiary of the VIEs that we consolidate. We also participate in substantially all of the variability created by these VIEs. The activities of these VIEs are limited to holding debt securities and interest rate and/or foreign currency swaps, as appropriate, and utilizing the cash flows from these securities to service our investment. Neither we nor any of our creditors are able to obtain the underlying collateral of the VIEs unless there is an event of default. Further, we are not a direct counterparty to the swap contracts and have no control over them. Our loss exposure to these VIEs is limited to our original investment.

Prior to January 1, 2010, we had interests in VIEs that we were not required to consolidate as reflected in the above table. Included in the VIEs that we did not consolidate are CDOs issued through VIEs originated by third parties. These VIEs combine highly rated underlying assets as collateral for the CDOs with CDSs to produce an investment security that consists of multiple asset tranches with varying levels of subordination within the VIE. However, subsequent to the adoption of new criteria for determining the primary beneficiary of a VIE, we have consolidated the majority of these investments effective January 1, 2010.

The underlying collateral assets and funding of these VIEs are generally static in nature. These VIEs are limited to holding the underlying collateral and CDS contracts on specific corporate entities and utilizing the cash flows from the collateral and CDS contracts to service our investment therein. The underlying collateral and the reference corporate entities covered by the CDS contracts are all investment grade at the time of issuance. These VIEs do not rely on outside or ongoing sources of funding to support their activities beyond the underlying collateral and CDS contracts. We currently own only senior CDO tranches within these VIEs.

Consistent with our other debt and perpetual securities we own, we are exposed to credit losses within these CDOs that could result in principal losses to our investments. We have mitigated our risk of credit loss through the structure of the VIE, which contractually requires the subordinated tranches within these VIEs to absorb the majority of the expected losses from the underlying credit default swaps. Based on our statistical analysis models, each of the VIEs can sustain a reasonable number of defaults in the underlying CDS pools with no loss to our investment.

VIEs-Not Consolidated

The VIEs that we are not required to consolidate are investments that are limited to loans in the form of debt obligations from the VIEs that are irrevocably and unconditionally guaranteed by their corporate parents. These VIEs are the primary financing vehicle used by their corporate sponsors to raise financing in the international capital markets. The variable interests created by these VIEs are principally or solely a result of the debt instruments issued by them. We do not have the power to direct the activities that most significantly impact the entity’s economic performance, nor do we have (1) the obligation to absorb losses of the entity or (2) the right to receive benefits from the entity. As such, we are not the primary beneficiary of these VIEs and are therefore not required to consolidate them. The increase in the amounts disclosed for VIEs not consolidated of $8.4 billion ($8.7 billion at amortized cost) at March 31, 2010, compared with December 31, 2009, was due to a change in disclosure requirements that was effective January 1, 2010.

 

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Securities Lending

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. The following table presents our security loans outstanding and the corresponding collateral held:

 

(In millions)

  

March 31,

2010

  

December 31,    

2009  

Security loans outstanding, fair value

   $    474        $    467        

Cash collateral on loaned securities

   486        483        
 

All security lending agreements are callable by us at any time.

For general information regarding our investment accounting policies, see Note 1.

 

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4.   DERIVATIVE INSTRUMENTS

We do not use derivative financial instruments for trading purposes, nor do we engage in leveraged derivative transactions. The majority of our freestanding derivatives are interest rate, foreign currency and credit default swaps that are associated with investments in special-purpose entities, including VIEs where we are the primary beneficiary. The remaining derivatives are interest rate swaps associated with our variable interest rate yen-denominated debt.

Derivative Types

Interest rate and credit default swaps involve the periodic exchange of cash flows with other parties, at specified intervals, calculated using agreed upon rates or other financial variables and notional principal amounts. Generally, no cash or principal payments are exchanged at the inception of the contract. Typically, at the time a swap is entered into, the cash flow streams exchanged by the counterparties are equal in value. Interest rate swaps are primarily used to convert interest receipts on floating-rate fixed maturity securities contracts to fixed rates. These derivatives are predominantly used to better match cash receipts from assets with cash disbursements required to fund liabilities.

Credit default swaps are used to assume credit risk related to an individual security or an index. These contracts entitle the consolidated VIE to receive a periodic fee in exchange for an obligation to compensate the derivative counterparty should the referenced security issuers experience a credit event, as defined in the contract. The consolidated VIE is also exposed to credit risk due to embedded derivatives associated with credit-linked notes.

Foreign currency swaps exchange an initial principal amount in two currencies, agreeing to re-exchange the currencies at a future date, at an agreed upon exchange rate. There may also be a periodic exchange of payments at specified intervals calculated using the agreed upon rates and exchanged principal amounts. Foreign currency swaps are used primarily in the consolidated VIEs in our Aflac Japan portfolio to convert foreign denominated cash flows related to certain investment receipts and liability payments to yen, the functional currency of Aflac Japan, in order to minimize cash flow fluctuations due to changes in non-yen currency rates.

Credit Risk Assumed through Derivatives

Our exposure to credit risk in the event of nonperformance by counterparties to our interest rate swaps associated with our variable interest rate Uridashi notes as of March 31, 2010, was immaterial. For the interest rate, foreign currency, and credit default swaps associated with our VIE investments for which we are the primary beneficiary, we do not bear the risk of loss for counterparty default. We are not a direct counterparty to those contracts.

The consolidated VIE enters into credit default swaps that assume credit risk from an asset pool in order to synthetically replicate investment transactions. The consolidated VIE will receive periodic payments based on an agreed upon rate and notional amount and will only make a payment by delivery of associated collateral, which consists of highly rated asset-backed securities, if there is a credit event. A credit event payment will typically be equal to the notional value of the swap contract less the value of the referenced obligations. A credit event is generally defined as a default on contractually obligated interest or principal payments or bankruptcy of the referenced entity. The credit default swaps in which the consolidated VIE assumes credit risk primarily reference investment grade baskets. The diversified portfolios of corporate issuers are established within sector concentration limits.

The following table presents the maximum potential risk, fair value, weighted-average years to maturity, and underlying referenced credit obligation type for credit derivatives as of March 31, 2010.

 

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Less than

one year

 

One to

three years

 

Three to

five years

 

Greater than

five years

  Total
(In millions)   Maximum
potential
Risk
  Estimated
fair value
  Maximum
potential
risk
  Estimated
fair value
  Maximum
potential
risk
  Estimated
fair value
  Maximum
potential
risk
  Estimated
fair value
  Maximum
potential
risk
  Estimated
fair value

Index exposure:

               

 

Corporate
bonds

  $ -   $ -   $ -   $ -   $ (326)   $ (93)   $ (393)   $ (198)   $ (719)   $ (291)
 

Derivative Balance Sheet Classification

The table below summarizes the balance sheet classification of the Company’s derivative fair value amounts, as well as the gross asset and liability fair value amounts. The fair value amounts presented do not include income accruals. The notional amount of derivative contracts represents the basis upon which pay or receive amounts are calculated. Notional amounts are not reflective of credit risk.

 

             Net Derivatives            Asset
    Derivatives    
   Liability
    Derivatives    
(In millions)    Notional
        Amount        
           Fair Value                    Fair Value                    Fair Value        
Hedge Designation/
Derivative Type
  

March 31,

2010

  

March 31,

2010

  

March 31,

2010

  

March 31,

2010

Cash flow hedges:

           

Interest rate swaps

         $ 215              $ (3)              $ -              $ (3)    

Foreign currency swaps

     375          86           86          -     

Total cash flow hedges

         $ 590              $ 83               $ 86              $ (3)    
 

Non-qualifying strategies:

           

Interest rate swaps

         $ 708              $ 45               $ 73              $ (28)    

Foreign currency swaps

     3,538          (66)          133          (199)    

Credit default swaps

     719          (291)          -          (291)    
 

Total non-qualifying strategies

         $ 4,965              $ (312)              $ 206              $ (518)    
 

Total cash flow hedges and non-qualifying strategies

         $ 5,555              $ (229)              $ 292              $ (521)    
 

Balance Sheet Location

                           

Other assets

         $ 1,821              $ 292               $ 292              $ -     

Other liabilities

     3,734          (521)          -          (521)    

Total derivatives

         $ 5,555              $ (229)              $ 292              $ (521)    
 

Hedging

As part of the adoption of the new accounting requirements associated with VIEs, we considered whether the interest rate and/or foreign currency swaps in the consolidated VIEs would qualify for hedge accounting treatment on January 1, 2010. For those that qualified, the Company designated the derivative on January 1, 2010, as a hedge of the variability in cash flows of a forecasted transaction or of amounts to be received or paid related to a recognized asset (“cash flow” hedge). We expect to continue this hedging activity for a weighted-average period of approximately 19 years. The remaining derivatives that did not qualify for hedge accounting were designated on January 1, 2010, as held for other investment purposes (“non-qualifying strategies”).

 

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We have interest rate swap agreements related to the 20 billion yen variable interest rate Uridashi notes (see Note 5). By entering into these contracts, we have been able to lock in the interest rate at 1.52% in yen. We have designated these interest rate swaps as a hedge of the variability in our interest cash flows associated with the variable interest rate Uridashi notes. The notional amounts and terms of the swaps match the principal amount and terms of the variable interest rate Uridashi notes. The swaps had no value at inception. Changes in the fair value of the swap contracts are recorded in other comprehensive income so long as the hedge is deemed effective. Should any portion of the hedge be deemed ineffective, that value would be reported in net earnings. This hedge was effective during the three-month periods ended March 31, 2010, and 2009, therefore there was no impact on net earnings.

Hedge Documentation and Effectiveness Testing

To qualify for hedge accounting treatment, a derivative must be highly effective in mitigating the designated changes in cash flow of the hedged item. At hedge inception, the Company formally documents all relationships between hedging instruments and hedged items, as well as its risk-management objective and strategy for undertaking each hedge transaction. The documentation process includes linking derivatives that are designated as cash flow hedges to specific assets or liabilities on the statement of financial position or to specific forecasted transactions and defining the effectiveness and ineffectiveness testing methods to be used. The Company also formally assesses both at the hedge’s inception and ongoing on a quarterly basis, whether the derivatives that are used in hedging transactions have been and are expected to continue to be highly effective in offsetting changes in cash flows of hedged items. Hedge effectiveness is assessed using qualitative and quantitative methods. Qualitative methods may include the comparison of critical terms of the derivative to the hedged item. Quantitative methods include regression or other statistical analysis of changes in cash flows associated with the hedge relationship. Hedge ineffectiveness of the hedge relationships are measured each reporting period using the “Hypothetical Derivative Method.”

For derivative instruments that are designated and qualify as cash flow hedges, the effective portion of the gain or loss on the derivative is reported as a component of other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Gains and losses on the derivative representing hedge ineffectiveness are recognized in current earnings as a component of realized gains (losses). All components of each derivative’s gain or loss were included in the assessment of hedge effectiveness.

Discontinuance of Hedge Accounting

The Company discontinues hedge accounting prospectively when (1) it is determined that the derivative is no longer highly effective in offsetting changes in the cash flows of a hedged item; (2) the derivative is de-designated as a hedging instrument; or (3) the derivative expires or is sold, terminated or exercised.

When hedge accounting is discontinued on a cash-flow hedge, including those where the derivative is sold, terminated or exercised, amounts previously deferred in other comprehensive income are reclassified into earnings when earnings are impacted by the variability of the cash flow of the hedged item.

Cash Flow Hedges

The following table presents the components of the gain or loss on derivatives that qualify as cash flow hedges:

 

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Derivatives in Cash Flow Hedging Relationships

 

(In millions)   

Gain (Loss) Recognized in

 

Other Comprehensive Income

 

on Derivative (Effective Portion)

  

Net Realized Investment Gains (Losses)

 

Recognized in Income

 

on Derivative (Ineffective Portion)

     

Three Months Ended

March 31, 2010

  

Three Months Ended

March 31, 2010

Interest rate swaps

   $                   1     $                   -  

Foreign currency swaps

                     (11)                       (3) 

Total

   $                (10)    $                 (3) 
 

There was no gain or loss reclassified from accumulated other comprehensive income into earnings related to our cash flow hedges for the three-month period ended March 31, 2010. As of March 31, 2010, the before-tax deferred net gains on derivative instruments recorded in other comprehensive income that are expected to be reclassified to earnings during the next twelve months is immaterial.

Non-qualifying Strategies

The Company’s other derivative activities in VIEs do not receive hedge accounting treatment. Changes in the fair value for these derivative instruments are reported in current period earnings as net realized investment gains (losses). The following table presents the gain or loss recognized in income on non-qualifying strategies:

Non-qualifying Strategies

Gain (Loss) Recognized within Net Realized Investment Gains (Losses)

 

(In millions)    Three Months Ended        
March 31, 2010        

Interest rate swaps

    $      (5)        

Foreign currency swaps

       4  

Credit default swaps

     21  

Total

       $      20            
 

Nonderivative Hedges

We have designated a majority of the Parent Company’s yen-denominated Samurai and Uridashi notes and yen-denominated loans (see Note 6) as nonderivative hedges of the foreign currency exposure of our investment in Aflac Japan. Our net investment hedge was effective during the three-month periods ended March 31, 2010, and 2009; therefore, there was no impact on net earnings during those periods.

For additional information on our financial instruments, see the accompanying Notes 1, 3 and 5 and Notes 1, 3 and 4 of the Notes to the Consolidated Financial Statements in our annual report to shareholders for the year ended December 31, 2009.

 

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5.  FAIR VALUE MEASUREMENTS

We determine the fair values of our debt, derivative, perpetual and privately issued equity securities primarily using three pricing approaches or techniques: quoted market prices readily available from public exchange markets, a discounted cash flow (DCF) pricing model, and price quotes we obtain from outside brokers.

Our DCF pricing model utilizes various market inputs we obtain from both active and inactive markets. The estimated fair values developed by the DCF pricing models are most sensitive to prevailing credit spreads, the level of interest rates (yields) and interest rate volatility. Credit spreads are derived based on pricing data obtained from investment brokers and take into account the current yield curve, time to maturity and subordination levels for similar securities or classes of securities. We validate the reliability of the DCF pricing models periodically by using the models to price investments for which there are quoted market prices from active and inactive markets or, in the alternative, are quoted by our custodian for the same or similar securities.

The pricing data and market quotes we obtain from 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.

In recent years, we have noted a continued reduction in the availability of pricing data from market sources. This decline is due largely to the contraction of liquidity in the global markets and a reduction in the overall number of sources to provide pricing data. As a result, we have noted that available pricing data has become more volatile. The reduction in available pricing sources coupled with the increase in price volatility has increased the degree of management judgment required in the final determination of fair values. We assess the reasonableness of the pricing data we receive by comparing it to relevant market indices and other performance measurements. The final pricing data used to determine fair values is based on management’s judgment.

Fair Value Hierarchy

GAAP specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. These two types of inputs create three valuation hierarchy levels. Level 1 valuations reflect quoted market prices for identical assets or liabilities in active markets. Level 2 valuations reflect quoted market prices for similar assets or liabilities in an active market, quoted market prices for identical or similar assets or liabilities in non-active markets or model-derived valuations in which all significant valuation inputs are observable in active markets. Level 3 valuations reflect valuations in which one or more of the significant valuation inputs are not observable in an active market. The vast majority of our financial instruments subject to the classification provisions of GAAP relate to our investment securities classified as securities available for sale in our investment portfolio. We determine the fair value of our securities available for sale using several sources or techniques based on the type and nature of the investment securities.

 

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The following tables present the fair value hierarchy levels of the Company’s assets and liabilities that are measured at fair value on a recurring basis.

 

 
     March 31, 2010
 
(In millions)    Level 1    Level 2    Level 3    Total
 

Assets:

           

Fixed maturities:

           

Government and agencies

   $   12,020    $ 681    $ -    $ 12,701  

Municipalities

     -      706      -      706  

Mortgage- and asset-backed securities

     -      1,738      63      1,801  

Public utilities

     -      3,888      488      4,376  

Collateralized debt obligations

     -      -      4      4  

Sovereign and supranational

     -      879      298      1,177  

Banks/financial institutions

     -      5,745      1,103      6,848  

Other corporate

     -      9,569      1,253      10,822  
 

Total fixed maturities

     12,020      23,206      3,209      38,435  
 

Perpetual securities:

           

Banks/financial institutions

     -      5,410      1,695      7,105  

Other corporate

     -      318      -      318  
 

Total perpetual securities

     -      5,728      1,695      7,423  
 

Equity securities

     15      -      9      24  
 

Other assets:

           

Interest rate swaps

     -      73      -      73  

Foreign currency swaps

     -      219      -      219  
 

Total other assets

     -      292      -      292  
 

  Total assets

   $   12,035    $   29,226    $ 4,913    $   46,174  
 

Liabilities:

           

Interest rate swaps

   $ -    $ 31    $ -    $ 31  

Foreign currency swaps

     -      199      -      199  

Credit default swaps

     -      -      291      291  
 

  Total liabilities

   $ -    $ 230    $ 291    $ 521  
 

 

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Table of Contents
      December 31, 2009
(In millions)    Level 1    Level 2    Level 3    Total

Assets:

           

Fixed maturities:

           

Government and agencies

   $   10,178    $   1,980    $ -    $   12,158  

Municipalities

     -      495      -      495  

Mortgage- and asset-backed securities

     -      1,017      62      1,079  

Public utilities

     35      3,486      497      4,018  

Collateralized debt obligations(1)

     -      -      267      267  

Sovereign and supranational

     -      864      293      1,157  

Banks/financial institutions

     -      5,852      1,240      7,092  

Other corporate

     13      9,254      1,248      10,515  

Total fixed maturities

     10,226      22,948      3,607      36,781  

Perpetual securities:

           

Banks/financial institutions

     -      5,503      1,441      6,944  

Other corporate

     -      319      -      319  

Total perpetual securities

     -      5,822      1,441      7,263  

Equity securities

     15      -      9      24  

  Total assets

   $   10,241    $   28,770    $   5,057    $   44,068  
 

Liabilities:

           

Interest rate swaps

   $ -    $ 3    $ -    $ 3  

  Total liabilities

   $ -    $ 3    $ -    $ 3  
 
(1)

Beginning January 1, 2010, the majority of these investments are consolidated and are no longer reported as a single investment.

Approximately 51% of our investments classified as Level 2 are valued by obtaining quoted market prices from our investment custodian. The custodian obtains price quotes from various pricing services that estimate fair values based on observable market transactions for similar investments in active markets, market transactions for the same investments in inactive markets or other observable market data where available.

The fair value of approximately 42% of our Level 2 investments is determined using our DCF pricing model. The significant valuation inputs to the DCF model are obtained from, or corroborated by, observable market sources from both active and inactive markets.

For the remaining Level 2 investments that are not quoted by our custodian and cannot be priced under the DCF pricing model, we obtain specific broker quotes from up to three outside securities brokers and generally use the average of the quotes to estimate the fair value of the securities.

We use derivative instruments to manage the risk associated with certain assets. However, the derivative instrument may not be classified with the same fair value hierarchy as the associated asset. Derivative instruments are reported in Level 2 of the fair value hierarchy.

The interest rate and foreign currency derivative instruments were priced by broker quotations using inputs that are observable in the market. Inputs used to value derivatives include, but are not limited to, interest rates, foreign currency forward and spot rates, credit spreads and correlations, and interest volatility. For any derivatives associated with any of our VIEs where we are the primary beneficiary, we are not the direct counterparty to the swap contracts. As a result, the fair value measurements provided by the broker incorporate the credit risk of the collateral associated with the VIE and counterparty credit risk. All other derivatives where we are the direct counterparty incorporate our credit risk along with counterparty credit risk in the valuation.

 

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The fair value of our interest rate swap contracts associated with our variable interest rate yen-denominated debt is based on the amount we would expect to receive or pay to terminate the swaps. The prices used to determine the value of the swaps are obtained from the respective swap counterparties and take into account current interest rates, duration, counterparty credit risk and our own credit rating.

The fixed maturities, perpetual securities and CDSs classified as Level 3 consist of securities for which there are limited or no observable valuation inputs. We estimate the fair value of these securities by obtaining broker quotes from a limited number of brokers. These brokers base their quotes on a combination of their knowledge of the current pricing environment and market flows. We consider these inputs unobservable. The equity securities classified in Level 3 are related to investments in Japanese businesses, each of which are insignificant and in the aggregate are immaterial. Because fair values for these investments are not readily available, we carry them at their original cost. We review each of these investments periodically and, in the event we determine that any are other-than-temporarily impaired, we write them down to their estimated fair value at that time.

Historically, we have not adjusted the quotes or prices we obtain from the brokers and pricing services we use.

The following tables present the changes in our available-for-sale investments and derivatives classified as Level 3.

 

     

Three Months Ended

March 31, 2010

(In millions)    Balance,
Beginning of
Period
   Effect of
Change in
Accounting
Principle (1)
   Revised
Balance,
Beginning of
Period
   Realized
Gains or
Losses
Included in
Earnings
  

Unrealized Gains
or Losses
Included

in Other
Comprehensive
Income

   Purchases,
Issuances,
Sales, and
Settlements
   Transfers
Into and/or
Out of
Level 3
   Balance,
End of
Period
  

Change in
Unrealized
Gains
(Losses)
Still

Held(2)

Fixed maturities:

                          

Mortgage- and asset- backed securities

   $ 62    $ -    $ 62     $    $    $ -    $ -    $ 63     $ -

Public utilities

     497      -      497            (9)      -      -      488       -

Collateralized debt obligations

     267      (263)                     -      -           -

Sovereign and supranational

     293      -      293                 -      -      298       -

Banks/financial institutions

     1,240      -      1,240            33       (175)      -      1,103       -

Other corporate

     1,248      -      1,248                 -      -      1,253       -

Total fixed maturities

     3,607      (263)      3,344            35       (175)      -      3,209       -

Perpetual Securities:

                          

Bank/financial institutions

     1,441      -      1,441       (17)      176       (54)      149      1,695       (25)

Total perpetual securities

     1,441      -      1,441       (17)      176       (54)      149      1,695       (25)

Equity securities

     9      -                     -      -           -

Credit default swaps

     -      (312)      (312)      21            -      -      (291)      21

Total

   $ 5,057    $ (575)    $ 4,482     $    $ 211     $ (229)    $ 149    $ 4,622     $ (4)
 

(1) Change in accounting for VIEs effective January 1, 2010. See Notes 1, 3 and 4 for additional information.

(2) Represents the amount of total gains or losses for the period, included in earnings, attributable to the change in unrealized gains (losses) relating to assets classified as Level 3 that were still held at March 31, 2010

 

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Three Months Ended

March 31, 2009

(In millions)   Balance,
Beginning
of Period
 

Realized

Gains or
Losses
Included in
Earnings

 

Unrealized
Gains
or Losses

Included

in Other
Comprehensive
Income

  Purchases,
Issuances,
Sales, and
Settlements
  Transfers
Into and/
or Out of
Level 3
  Balance,
End of
Period
  Change in
Unrealized
Gains
(Losses)
Still  Held
(1)

Fixed maturities:

             

 

Mortgage- and asset-backed securities

  $ 35   $ -     $ (1)   $ -     $ -   $ 34   $ -  

Public utilities

    502     -       (40)     -       -     462     -  

Collateralized debt obligations(2)

    19     (114)     147      -       22     74     (114)

Sovereign and supranational

    260     -       (51)     -       -     209     -  

Banks/financial institutions

    876     -       (125)     -       88     839     -  

Other corporate

    898     -       (62)     -       200     1,036     -  

Total fixed maturities

    2,590     (114)     (132)     -       310     2,654     (114)

Perpetual securities:

             

 

Banks/financial institutions

    412     -       (133)     -       357     636     -  

Total perpetual securities

    412     -       (133)     -       357     636     -  

Equity securities

    4     -       -       -       6     10     -  

Total

  $ 3,006   $ (114)   $ (265)   $ -     $ 673   $ 3,300   $ (114)
 
(1)

Represents the amount of total gains or losses for the period, included in earnings, attributable to the change in unrealized gains (losses) relating to assets classified as Level 3 that were still held at March 31, 2009

(2)

Beginning January 1, 2010, the majority of these investments are consolidated and are no longer reported as a single investment.

The inputs we receive from pricing brokers for forward exchange rates and the credit spreads for certain issuers, including liquidity risk, have become increasingly difficult for us to observe or corroborate in the markets for our investments in CDOs (prior to January 1, 2010), callable reverse-dual currency securities (RDCs), securities rated below investment grade, and to a lesser extent less liquid sinking fund securities. This has resulted in the transfer of affected fixed maturities available for sale from the Level 2 valuation category into the Level 3 valuation category.

As discussed in Notes 1 and 3, we adopted new accounting guidance on VIEs effective January 1, 2010, and as a result have consolidated certain VIE investments. Upon consolidation, the beneficial interest was derecognized and the underlying securities and derivatives were recognized. In many cases, the fair value hierarchy level differed between the original beneficial interest asset and the underlying securities that are now being recognized. In the Level 3 rollforward, we have separately disclosed the impact of consolidating these VIE investments that were previously categorized as Level 3 and now the underlying securities are Level 2. As noted in the Level 3 rollforward above, the CDSs which are separately recognized as a result of this change in accounting are reported as Level 3 investments. In addition, approximately $1.0 billion of Level 2 investments were reclassified upon the adoption of this guidance, and their underlying securities are being reported as Level 1 as of January 1, 2010.

During the first three months of 2010, we transferred investments totaling $149 million into Level 3 from Level 2 as a result of credit downgrades of the respective securities to below investment grade. During the year ended December 31, 2009, we transferred investments totaling $1.8 billion into Level 3 as a result of credit downgrades of the respective securities to below investment grade.

The significant valuation inputs that are used in the valuation process for the below-investment-grade, callable RDC and private placement investments classified as Level 3 include forward exchange rates, yen swap rates, dollar swap rates, interest rate volatilities, credit spread data on specific issuers, assumed default and default recovery rates, certain probability assumptions, and call option data.

 

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Some of these securities require the calculation of a theoretical forward exchange rate which is developed by using yen swap rates, U.S. dollar swap rates, interest rate volatilities, and spot exchange rates. The forward exchange rate is then used to convert all future dollar cash flows of the bond, where applicable, into yen cash flows. Additionally, credit spreads for the individual issuers are key valuation inputs of these securities. Finally, in pricing securities with a call option, the assumptions regarding interest rates in the U.S. and Japan are considered to be significant valuation inputs. Collectively, these valuation inputs, are included to estimate the fair values of these securities at each reporting date.

In obtaining the above valuation inputs, we have determined that certain pricing assumptions and data used by our pricing sources are becoming increasingly more difficult to validate or corroborate by the market and/or appear to be internally developed rather than observed in or corroborated by the market. The use of these unobservable valuation inputs causes more subjectivity in the valuation process for these securities and consequently, causes more volatility in their estimated fair values.

Fair Value of Financial Instruments

The carrying values and estimated fair values of the Company’s financial instruments were as follows:

 

      March 31, 2010    December 31, 2009
(In millions)    Carrying
Value
   Fair
Value
   Carrying
Value
  

Fair

Value

Assets:

           

Fixed-maturity securities

   $ 59,853    $ 59,023    $ 63,468    $ 62,609 

Fixed-maturity securities - consolidated variable interest entities

     4,981      4,900      -     

Perpetual securities

     6,218      6,218      7,263      7,263 

Perpetual securities - consolidated variable interest entities

     1,205      1,205      -     

Equity securities

     24      24      24      24 

Interest rate, foreign currency, and credit default swaps

     292      292      -     

Liabilities:

           

Notes payable (excluding capitalized leases)

     2,578      2,754      2,593      2,683 

Interest rate, foreign currency, and credit default swaps

     521      521      3     

Obligation to Japanese policyholder protection corporation

     111      111      128      128 
 

As mentioned previously, we determine the fair values of our debt, perpetual and privately issued equity securities, and our derivatives using three basic pricing approaches or techniques: quoted market prices readily available from public exchange markets, a DCF pricing model, and price quotes we obtain from outside brokers.

The fair values of notes payable with fixed interest rates were obtained from an independent financial information service. The fair value of the obligation to the Japanese policyholder protection corporation 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.

 

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The carrying amounts for cash and cash equivalents, receivables, accrued investment income, accounts payable, cash collateral and payables for security transactions approximated their fair values due to the short-term nature of these instruments. Consequently, such instruments are not included in the above table. The preceding table also excludes liabilities for future policy benefits and unpaid policy claims as these liabilities are not financial instruments as defined by GAAP.

DCF Sensitivity

Our DCF pricing model utilizes various market inputs we obtain from both active and inactive markets. The estimated fair values developed by the DCF pricing models are most sensitive to prevailing credit spreads, the level of interest rates (yields) and interest rate volatility. Management believes that under normal market conditions, a movement of 50 basis points (bps) in the key assumptions used to estimate these fair values would be reasonably likely. Therefore, we selected a uniform magnitude of movement (50 bps) and provided both upward and downward movements in the assumptions. Since the changes in fair value are relatively linear, readers of these financial statements can make their own judgments as to the movement in interest rates and the change in fair value based upon this data. The following scenarios provide a view of the sensitivity of our securities priced by our DCF pricing model.

The fair values of our available-for-sale fixed-maturity and perpetual securities valued by our DCF pricing model totaled $12.2 billion at March 31, 2010. The estimated effect of potential changes in interest rates, credit spreads and interest rate volatility on these fair values as of such date is as follows:

 

Interest Rates   Credit Spreads   Interest Rate Volatility
 Factor change   

Change in

fair value

  (in millions)  

  Factor change  

Change in

fair value

  (in millions)  

  Factor change  

Change in

fair value

  (in millions)  

      +50 bps

   $ (583)   +50 bps   $ (578)   +50 bps   $ (10)

       -50 bps

     626    -50 bps     621    -50 bps    
 

The fair values of our held-to-maturity fixed-maturity securities valued by our DCF pricing model totaled $24.0 billion at March 31, 2010. The estimated effect of potential changes in interest rates, credit spreads and interest rate volatility on these fair values as of such date is as follows:

 

Interest Rates    Credit Spreads    Interest Rate Volatility
 Factor change    Change in
fair value
  (in millions)  
   Factor change    Change in
fair value
  (in millions)  
   Factor change    Change in
fair value
  (in millions)  

      +50 bps

   $ (1,591)    +50 bps    $ (1,477)    +50 bps    $ (447)

       -50 bps

     1,648     -50 bps      1,513     -50 bps      291 
 

The two tables above illustrate the differences on the fair values of our investment portfolio among each of the inputs for interest rates, credit spreads and interest volatility. These differences are driven principally by the securities in our portfolio that have call features. These call features cause the fair values of the affected securities to react differently depending on the inputs used to price these securities.

For additional information on our investments and financial instruments, see the accompanying Notes 1, 3 and 4 and Notes 1, 3 and 4 of the Notes to the Consolidated Financial Statements in our annual report to shareholders for the year ended December 31, 2009.

 

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6. NOTES PAYABLE

A summary of notes payable follows:

 

(In millions)      March 31,  
2010
  December 31,  
2009

8.50% senior notes due May 2019

   $ 850         $ 850      

6.90% senior notes due December 2039

           396   (1)              396   (1)

Yen-denominated Uridashi notes:

    

1.52% notes due September 2011 (principal amount 15 billion yen)

     161           163      

2.26% notes due September 2016 (principal amount 8 billion yen)

     86           87      

Variable interest rate notes due September 2011 (.68% at March 2010, principal amount 20 billion yen)

     215           217      

Yen-denominated Samurai notes:

    

.71% notes due July 2010 (principal amount 39.4 billion yen)

     423           428      

1.87% notes due June 2012 (principal amount 26.6 billion yen)

     286           289      

Yen-denominated loans:

    

3.60% loan due July 2015 (principal amount 10 billion yen)

     107           109      

3.00% loan due August 2015 (principal amount 5 billion yen)

     54           54      

Capitalized lease obligations payable through 2015

     6           6      
 

Total notes payable

   $ 2,584         $ 2,599      
 

 

       (1)

$400 issuance net of a $4 underwriting discount that is being amortized over the life of the notes

We have no restrictive financial covenants related to our notes payable. We were in compliance with all of the covenants of our notes payable at March 31, 2010. No events of default or defaults occurred during the three months ended March 31, 2010.

For additional information, see Notes 4 and 7 of the Notes to the Consolidated Financial Statements in our annual report to shareholders for the year ended December 31, 2009.

 

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7. SHAREHOLDERS’ EQUITY

The following table is a reconciliation of the number of shares of the Company’s common stock for the three-month periods ended March 31.

 

(In thousands of shares)    2010           2009       

Common stock - issued:

         

Balance, beginning of period

   661,209         660,035     

Exercise of stock options and issuance of restricted shares

   590         391     

Balance, end of period

   661,799           660,426       

Treasury stock:

         

Balance, beginning of period

   192,641         193,420     

Purchases of treasury stock:

         

Open market

   -         -     

Other

   94         85     

Dispositions of treasury stock:

         

Shares issued to AFL Stock Plan

   -         (355  

Exercise of stock options

   (270      (13  

Other

   (88      (135  

Balance, end of period

   192,377           193,002       

Shares outstanding, end of period

   469,422         467,424     
 

Outstanding share-based awards are excluded from the calculation of weighted-average shares used in the computation of basic earnings per share. The following table presents the approximate number of share-based awards to purchase shares, on a weighted-average basis, that were considered to be anti-dilutive and were excluded from the calculation of diluted earnings per share for the three-month periods ended March 31.

 

(In thousands)    2010          2009      

Anti-dilutive share-based awards

   2,450       15,367   
 

As of March 31, 2010, a remaining balance of 32.4 million shares of our common stock was available for purchase under share repurchase authorizations by our board of directors. The 32.4 million shares were comprised of 2.4 million shares remaining from a board authorization in 2006 and 30.0 million shares remaining from an authorization by the board of directors in 2008.

 

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8. SHARE-BASED TRANSACTIONS

The Company has two long-term incentive compensation plans. The first plan, which expired in February 2007, is a stock option plan which allowed grants for incentive stock options (ISOs) to employees and non-qualifying stock options (NQSOs) to employees and non-employee directors. Options granted before the plan’s expiration date remain outstanding in accordance with their terms. The second long-term incentive 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. As of March 31, 2010, approximately 16.7 million shares were available for future grants under this plan, and the only performance-based awards issued and outstanding were restricted stock awards.

Share-based awards granted to U.S.-based grantees are settled with authorized but unissued Company stock, while those issued to Japan-based grantees are settled with treasury shares.

The following table provides information on stock options outstanding and exercisable at March 31, 2010.

 

     

Stock

Option

Shares

(in thousands)

  

  Weighted-Average  
Remaining

Term

(in years)

  

Aggregate
Intrinsic

Value

  (in millions)  

  

  Weighted-Average  
Exercise Price

Per Share

Outstanding

   16,777    5.4    $        270          $    38.79  

Exercisable

   12,769    4.3        213        37.82
 

We received cash from the exercise of stock options in the amount of $13.4 million during the first quarter of 2010, compared with $.4 million in the first quarter of 2009. The tax benefit realized as a result of stock option exercises and restricted stock releases was $11 million in the first quarter of 2010, compared with $2 million in the first quarter of 2009.

As of March 31, 2010, total compensation cost not yet recognized in our financial statements related to restricted-share-based awards was $32 million, of which $15 million (626 thousand shares) was related to restricted-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.

For additional information on our long-term share-based compensation plans and the types of share-based awards, see Note 10 of the Notes to the Consolidated Financial Statements included in our annual report to shareholders for the year ended December 31, 2009.

 

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9. BENEFIT PLANS

Our basic employee defined-benefit pension plans cover substantially all of our full-time employees in the United States and Japan. The components of retirement expense for the Japanese and U.S. pension plans were as follows:

 

      Three Months Ended March 31,
      2010    2009
(In millions)    Japan    U.S.    Japan      U.S.      

Components of net periodic benefit cost:

           

Service cost

   $ 3        $ 3         $    $ 2     

Interest cost

     1          3                3     

Expected return on plan assets

     (1)         (3)          (1)      (3)    

Amortization of net actuarial loss

     1          1                1     

Net periodic benefit cost

   $ 4        $ 4         $    $ 3     
 

During the three months ended March 31, 2010, Aflac Japan contributed approximately $4 million (using the March 31, 2010, exchange rate) to the Japanese pension plan, and Aflac U.S. did not make a contribution to the U.S. pension plan.

For additional information regarding our Japanese and U.S. benefit plans, see Note 12 of the Notes to the Consolidated Financial Statements in our annual report to shareholders for the year ended December 31, 2009.

10. COMMITMENTS AND CONTINGENT LIABILITIES

We are a defendant in various lawsuits considered to be in the normal course of business. Members of our senior legal and financial management teams 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.

11. SUBSEQUENT EVENTS

At March 31, 2010, we had Greek exposure of $1.3 billion, at amortized cost, available-for-sale fixed maturity investments comprised of $1.0 billion invested in Greek financial institutions and $280 million in Greek sovereign debt. Subsequent to March 31, 2010, the Greek financial institutions were downgraded to below investment grade. We continue to believe that these issuers have the ability to meet their obligations to us, and we have the intent to hold these investments to recovery in value. As a result, we have not recognized an other-than-temporary impairment for these investments as of March 31, 2010.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

FORWARD-LOOKING INFORMATION

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.

We caution readers that the following factors, in addition to other factors mentioned from time to time, could cause actual results to differ materially from those contemplated by the forward-looking statements:

 

   

difficult conditions in global capital markets and the economy

 

   

governmental actions for the purpose of stabilizing the financial markets

 

   

defaults and downgrades in certain securities in our investment portfolio

 

   

impairment of financial institutions

 

   

credit and other risks associated with Aflac’s investment in perpetual securities

 

   

differing judgments applied to investment valuations

 

   

subjective determinations of amount of impairments taken on our investments

 

   

limited availability of acceptable yen-denominated investments

 

   

concentration of our investments in any particular sector

 

   

concentration of business in Japan

 

   

ongoing changes in our industry

 

   

exposure to significant financial and capital markets risk

 

   

fluctuations in foreign currency exchange rates

 

   

significant changes in investment yield rates

 

   

deviations in actual experience from pricing and reserving assumptions

 

   

subsidiaries’ ability to pay dividends to the Parent Company

 

   

changes in law or regulation by governmental authorities

 

   

ability to attract and retain qualified sales associates and employees

 

   

decreases in our financial strength or debt ratings

 

   

ability to continue to develop and implement improvements in information technology systems

 

   

changes in U.S. and/or Japanese accounting standards

 

   

failure to comply with restrictions on patient privacy and information security

 

   

level and outcome of litigation

 

   

ability to effectively manage key executive succession

 

   

catastrophic events

 

   

failure of internal controls or corporate governance policies and procedures

 

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MD&A OVERVIEW

Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to inform the reader about matters affecting the financial condition and results of operations of Aflac Incorporated and its subsidiaries for the period from December 31, 2009, to March 31, 2010. As a result, the following discussion should be read in conjunction with the consolidated financial statements and notes that are included in our annual report to shareholders for the year ended December 31, 2009. This MD&A is divided into the following sections:

 

   

Our Business

 

   

Performance Highlights

 

   

Critical Accounting Estimates

 

   

Results of Operations, consolidated and by segment

 

   

Analysis of Financial Condition, including discussion of market risks of financial instruments

 

   

Capital Resources and Liquidity, including discussion of availability of capital and the sources and uses of cash

OUR BUSINESS

Aflac Incorporated (the Parent Company) and its subsidiaries (collectively, 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. Aflac U.S. markets and administers group products through Continental American Insurance Company (CAIC). Our insurance operations in the United States and our branch in Japan service the two markets for our insurance business.

PERFORMANCE HIGHLIGHTS

Results for the first quarter of 2010 benefited from the stronger yen. Total revenues rose 5.1% to $5.1 billion, compared with $4.8 billion in the first quarter of 2009. Net earnings were $636 million, or $1.35 per diluted share, compared with $569 million, or $1.22 per share, in the first quarter of 2009.

We experienced net realized investment losses of $46 million in the first quarter of 2010, which included the recognition of other-than-temporary impairments of $42 million. During the first quarter of 2010, we had a $478 million decrease in gross unrealized losses on our available-for-sale debt and perpetual securities due primarily to improved fair values for many categories of investment securities.

CRITICAL ACCOUNTING ESTIMATES

We prepare our financial statements in accordance with U.S. generally accepted accounting principles (GAAP). These principles are established primarily by the Financial Accounting Standards Board (FASB). In this MD&A, references to GAAP issued by the FASB are derived from the FASB Accounting Standards CodificationTM (ASC). 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 the valuation of investments, deferred policy acquisition costs, liabilities for future policy benefits and unpaid policy claims, and income taxes. 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 94% of our assets and 87% of our liabilities are reported as of March 31, 2010, and thus has a direct effect on net earnings and shareholders’ equity. Subsequent experience or use of other assumptions could produce significantly different results.

 

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There have been no changes in the items that we have identified as critical accounting estimates during the three months ended March 31, 2010. For additional information, see the Critical Accounting Estimates section of MD&A included in our annual report to shareholders for the year ended December 31, 2009.

New Accounting Pronouncements

For information on new accounting pronouncements and the impact, if any, on our financial position or results of operations, see Note 1 of the Notes to the Consolidated Financial Statements.

RESULTS OF OPERATIONS

The following table is a presentation of items impacting net earnings and net earnings per diluted share for the three-month periods ended March 31.

 

Items Impacting Net Earnings
      In Millions    Per Diluted Share
          2010            2009            2010            2009        

Net earnings

   $     636     $     569     $     1.35     $     1.22     

Items impacting net earnings, net of tax:

           

Realized investment gains (losses)

     (30)      (6)      (.06)      (.01)    

Impact from ASC 815

          (3)           (.01)    

Gain on extinguishment of debt

          10            .02     
 

Realized Investment Gains and Losses

Our investment strategy is to invest in investment-grade fixed-income securities to provide a reliable stream of investment income, which is one of the drivers of the Company’s profitability. This investment strategy aligns our assets with our liability structure, which our assets support. We do not purchase securities with the intent of generating capital gains or losses. However, investment gains and losses may be realized as a result of changes in the financial markets and the creditworthiness of specific issuers, tax planning strategies, and/or general portfolio maintenance and rebalancing. The realization of investment gains and losses is independent of the underwriting and administration of our insurance products, which are the principal drivers of our profitability.

During the three-month period ended March 31, 2010, we realized pretax investment losses of $42 million ($27 million after-tax) as a result of the recognition of other-than-temporary impairment losses. We realized pretax investment losses, net of gains, of $21 million ($14 million after-tax) from securities sold or redeemed in the normal course of business. We also realized pretax investment gains of $17 million ($11 million after-tax) from valuing foreign currency, interest rate and credit default swaps related to certain VIEs that were required to be consolidated following the adoption of new accounting guidance effective January 1, 2010.

During the three-month period ended March 31, 2009, we realized total pretax investment losses of $234 million ($152 million after-tax) as a result of the recognition of other-than-temporary impairment losses. We also realized pretax investment gains, net of losses, of $225 million ($146 million after-tax) from a bond–swap program that took advantage of tax loss carryforwards and from securities sold or redeemed in the normal course of business.

 

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The following table details our pretax impairment losses by investment category.

 

      Three Months Ended
March  31,
(In millions)        2010            2009    

Perpetual securities

   $ 41    $ 65  

Corporate bonds

     -      50  

Collateralized debt obligations

     -      113  

Collateralized mortgage obligations

     -      6  

Equity securities

     1      -  

Total other-than-temporary impairments

   $ 42    $ 234  
 

For additional information regarding realized investment gains and losses, see Notes 3 and 4 of the Notes to the Consolidated Financial Statements.

Impact from ASC 815

We had cross-currency interest rate swap agreements that economically converted our dollar-denominated senior notes, which matured in April 2009, into a yen-denominated obligation. Until April 2009, we designated the foreign currency component of these cross-currency swaps as a hedge of the foreign currency exposure of our investment in Aflac Japan. The effect of issuing fixed-rate, dollar-denominated debt and swapping it into fixed-rate, yen-denominated debt had the same economic impact on Aflac 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. ASC 815, “Derivatives and Hedging,” 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. This change in fair value was determined by relative dollar and yen interest rates and had no cash impact on our results of operations. At maturity, the fair value equaled initial contract fair value, and the cumulative impact of gains and losses from the changes in fair value of the interest component was zero.

We have issued yen-denominated Samurai and Uridashi notes and have entered into two yen-denominated loans. We have designated a majority of these notes and loans as a hedge of our investment in Aflac Japan. If the value of these designated yen-denominated liabilities exceeds our investment in Aflac Japan, we would be required to recognize the foreign currency effect on the excess in net earnings. The foreign currency gain or loss on the excess liabilities would be included in the impact from ASC 815. Our net investment hedge was effective during the three-month periods ended March 31, 2010, and 2009; therefore, there was no impact on net earnings.

We have interest rate swap agreements related to the 20 billion yen variable interest rate Uridashi notes and have designated the swap agreements as a hedge of the variability of the debt cash flows. The notional amounts and terms of the swaps match the principal amount and terms of the variable interest rate Uridashi notes, and the swaps had no value at inception. GAAP requires that the change in the fair value of the swap contracts be recorded in other comprehensive income so long as the hedge is deemed effective. Any ineffectiveness would be recognized in net earnings and would be included in the impact from ASC 815. These hedges were effective during the three-month periods ended March 31, 2010, and 2009; therefore, there was no impact on net earnings.

For additional information, see the Impact from ASC 815 subsection of MD&A and Notes 4 and 7 of the Notes to the Consolidated Financial Statements in our annual report to shareholders for the year ended December 31, 2009.

 

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Debt Extinguishment

We did not extinguish any debt during the first quarter of 2010. During the first quarter of 2009, we extinguished portions of our yen-denominated Uridashi and Samurai debt by buying the notes on the open market. We realized a total gain from extinguishment of debt of 1.5 billion yen, or $15 million ($10 million after-tax), which we included in other income.

Foreign Currency Translation

Aflac Japan’s premiums and most of its investment income are received in yen. Claims and expenses are paid in yen, and we primarily purchase yen-denominated assets to support yen-denominated policy liabilities. These and other yen-denominated financial statement items are translated into dollars for financial reporting purposes. We translate Aflac Japan’s yen-denominated income statement into dollars using an average exchange rate for the reporting period, and we translate its yen-denominated balance sheet using the exchange rate at the end of the period. However, it is important to distinguish between translating and converting foreign currency. Except for a limited number of transactions, we do not actually convert yen into dollars.

Due to the size of Aflac Japan, where our functional currency is the Japanese yen, fluctuations in the yen/dollar exchange rate can have a significant effect on our reported results. In periods when the yen weakens, translating yen into dollars results in fewer dollars being reported. When the yen strengthens, translating yen into dollars results in more dollars being reported. Consequently, yen weakening has the effect of suppressing current period results in relation to the comparable prior period, while yen strengthening has the effect of magnifying current period results in relation to the comparable prior period. As a result, we view foreign currency translation as a financial reporting issue for Aflac and not an economic event to our Company or shareholders. Because changes in exchange rates distort the growth rates of our operations, management evaluates Aflac’s financial performance excluding the impact of foreign currency translation.

Income Taxes

Our combined U.S. and Japanese effective income tax rate on pretax earnings was 34.7% for the three-month periods ended March 31, 2010, and 2009.

Earnings Guidance

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 period-over-period results, we exclude the effect of realized investment gains and losses, the impact from ASC 815 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 period in relation to the prior period.

Subject to the preceding assumptions, our objective for 2010 is to increase net earnings per diluted share by 9% to 12% over 2009. If the yen/dollar exchange rate averages 90 to 95, we would expect reported net earnings per diluted share to be in the range of $1.33 to $1.38 in the second quarter of 2010. Based on our stated objective for 2010, the following table shows the likely results for 2010 net earnings per diluted share, including the impact of foreign currency translation using various yen/dollar exchange rate scenarios.

 

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2010 Net Earnings Per Share (EPS) Scenarios(1)

    Weighted-Average

    Yen/Dollar

    Exchange Rate

   Net Earnings Per
Diluted Share
           % Growth
         Over 2009
  

Yen Impact
on EPS

  85.00

   $ 5.61  -  5.76                            15.7  -   18.8 %                   $    .33    

  90.00

      5.41  -  5.56    11.5  -   14.6            .13    

      93.49 (2)

      5.29  -  5.43    9.1  -   12.0              -    

  95.00

      5.24  -  5.38    8.0  -   10.9       (.05)   

100.00

      5.08  -  5.22    4.7  -     7.6         (.21)     

 

(1)

Excludes realized investment gains/losses, impact from ASC 815 and nonrecurring items in 2010 and 2009

(2)

Actual 2009 weighted-average exchange rate

INSURANCE OPERATIONS

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 and interim period 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 ASC 815, 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.

We evaluate our sales efforts using new annualized premium sales, an industry operating measure. Total new annualized premium sales, which include new sales and the incremental increase in premiums due to conversions, represent the premiums that we would collect over a 12-month period, assuming the policies remain in force. For Aflac Japan, total new annualized premium sales are determined by applications written during the reporting period. For Aflac U.S., total new annualized premium sales are determined by applications that are accepted during the reporting period. Premium income, or earned premiums, is a financial performance measure that reflects collected or due premiums that have been earned ratably on policies in force during the reporting period.

 

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AFLAC JAPAN SEGMENT

Aflac Japan Pretax Operating Earnings

Changes in Aflac Japan’s pretax operating earnings and profit margins are primarily affected by morbidity, mortality, expenses, persistency and investment yields. The following table presents a summary of operating results for Aflac Japan.

 

Aflac Japan Summary of Operating Results
                        Three  Months Ended March 31,    
(In millions)    2010    2009    

Premium income

   $ 3,206    $ 3,012    

Net investment income:

     

Yen-denominated investment income

     401      371    

Dollar-denominated investment income

     192      189    

Net investment income

     593      560    

Other income

     28      7    

Total operating revenues

     3,827      3,579    

Benefits and claims

     2,277      2,202    

Operating expenses:

     

Amortization of deferred policy acquisition costs

     143      124    

Insurance commissions

     271      267    

Insurance and other expenses

     315      305    

Total operating expenses

     729      696    

Total benefits and expenses

     3,006      2,898    

Pretax operating earnings(1)

   $ 821    $ 681    
 

Weighted-average yen/dollar exchange rate

     90.49      93.37    
 
      In Dollars    In Yen
Percentage change over previous period:        2010            2009             2010            2009         

Premium income

   6.5  %    16.5  %    3.3  %    3.6  %    

Net investment income

   5.8         12.9         2.5         .5         

Total operating revenues

   6.9         16.2         3.6         3.3         

Pretax operating earnings(1)

   20.5         22.9         16.8         9.3         
 
(1)

See the Insurance Operations section of this MD&A for our definition of segment operating earnings.

The percentage increases in premium income reflect the growth of premiums in force. The increases in annualized premiums in force in yen of 3.6% in the first quarter of 2010 and 3.1% for the same period of 2009 reflect the high persistency of Aflac Japan’s business and the sales of new policies. Annualized premiums in force at March 31, 2010, were 1.21 trillion yen, compared with 1.17 trillion yen a year ago. Annualized premiums in force, translated into dollars at respective period-end exchange rates, were $13.0 billion at March 31, 2010, compared with $11.9 billion a year ago.

Aflac Japan maintains a portfolio of dollar-denominated and reverse-dual currency securities (yen-denominated debt securities with dollar coupon payments). Dollar-denominated investment income from these assets accounted for approximately 32% of Aflac Japan’s investment income in the first three months of 2010, compared with 34% a year ago. In periods 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 periods 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 33% of Aflac Japan’s investment income during the first three months of 2010. 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 comparable period in the prior year.

 

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Aflac Japan Percentage Changes Over Previous Period

(Yen Operating Results)

Three Months Ended March 31,

      Including Foreign
    Currency Changes     
   Excluding Foreign
     Currency Changes(2)    
      2010    2009    2010    2009    

Net investment income

           2.5  %    .5  %          3.5  %    4.6  %    

Total operating revenues

           3.6         3.3               3.4         3.7         

Pretax operating earnings(1)

         16.8         9.3              15.7          11.2         
 
(1)

See the Insurance Operations section of this MD&A for our definition of segment operating earnings.

(2)

Amounts excluding foreign currency changes on dollar-denominated items were determined using the same yen/dollar exchange rate for the current period as the comparable period in the prior year.

The following table presents a summary of operating ratios for Aflac Japan.

 

      Three Months Ended March 31,
Ratios to total revenues:    2010    2009

Benefits and claims

   59.5  %        61.5  %    

Operating expenses:

     

   Amortization of deferred policy acquisition costs

   3.7             3.5         

   Insurance commissions

   7.1             7.5         

   Insurance and other expenses

   8.3             8.5         

Total operating expenses

   19.1             19.5         

Pretax operating earnings(1)

   21.4             19.0         
 
(1)

See the Insurance Operations section of this MD&A for our definition of segment operating earnings.

The benefit ratio has declined over the past several years, reflecting the impact of newer products and riders with lower loss ratios. We have also experienced favorable claim trends in our major product lines. We expect the improvement in the benefit ratio to continue as we shift to newer products and riders and benefit from the impact of favorable claim trends. However, this improvement 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. The operating expense ratio has decreased slightly in the first quarter of 2010, compared with the same period a year ago. We expect the operating expense ratio to remain relatively stable in 2010, compared to the prior year. Due to continued improvement in the benefit ratio, the pretax operating profit margin expanded in the three-month period ended March 31, 2010. We expect the improved benefit ratio to continue in 2010, resulting in a continued expansion of the profit margin for 2010.

 

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Aflac Japan Sales

The following table presents Aflac Japan’s total new annualized premium sales for the three-month periods ended March 31.

 

      In Dollars    In Yen
(In millions of dollars and billions of yen)      2010     2009    2010         2009     

Total new annualized premium sales

     $ 334          $ 293         30.3          27.5      

Increase (decrease) over comparable period in prior year

     14.1       11.0  %    10.0  %    (.4)  %
 

The following table details the contributions to total new annualized premium sales by major insurance product for the three-month periods ended March 31.

 

      2010             2009     

Medical

     37        34   %  

Cancer

   22           34  

Ordinary life

   35           23  

Rider MAX

   2           4  

Other

   4             5    

Total

   100        100   %  
 

Medical insurance sales increased 21.4% during the first quarter of 2010, compared with the same period a year ago. This increase in sales primarily reflected the favorable consumer response to our revised EVER product, Aflac Japan’s market-leading medical product, which was introduced in August 2009. With continued cost pressure on Japan’s health care system, we expect the need for medical products will continue to rise in the future, and we remain encouraged about the outlook for the medical insurance market.

Cancer insurance sales were impacted by our focus on our new medical product and declined 29.4% during the first quarter of 2010, compared with the same period in 2009. Despite this decrease, we are convinced that the affordable cancer products Aflac Japan provides will continue to be an important part of our product portfolio.

Ordinary life product sales increased 64.4% during the first quarter of 2010, compared with the same period a year ago. The increase in our ordinary life products was driven by a favorable consumer response to our child endowment product that we introduced at the end of first quarter 2009. We believe that traditional life insurance products, like our child endowment plan, provide opportunities for us to sell our third sector cancer and medical products. For every 10 child endowment plans that were purchased in the first quarter of 2010, we sold two additional Aflac products to the same customers.

The sales of our supplemental health insurance products through the bank channel increased 206.6% during the first quarter of 2010, compared with the same period in 2009, and represented 10% of total new sales. At March 31, 2010, we had agreements with 352 banks to sell our products. We have significantly more selling agreements with banks than any of our competitors in Japan. We believe our long-standing and strong relationships within the Japanese banking sector, along with our strategic preparations, have proven to be an advantage as this channel opened up for our products.

We remain committed to selling through our traditional channels, which allows us to reach consumers through affiliated corporate agencies, independent corporate agencies and individual agencies. During the first quarter of 2010, we recruited approximately 1,200 new sales agencies, an increase of 15.0% over the same period a year ago. At March 31, 2010, Aflac Japan was represented by more than 19,500 sales agencies, or more than 110,800 licensed sales associates employed by those agencies.

 

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We believe that there is still a strong need for our products in Japan. Our objective for 2010 is for total new annualized premium sales to be flat to up 5% in Japan.

Aflac Japan Investments

Growth of investment income in yen is affected by available cash flow from operations, the timing of investing the cash flow, 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 those available on Japanese government or other public corporate bonds, 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 documentation consistent with standard medium-term note programs. In addition, many of these investments have protective covenants appropriate to the specific issuer, industry and country. These covenants often require the issuer to adhere to specific financial ratios and give priority to repayment of our investment under certain circumstances.

The following table presents the results of Aflac Japan’s investment activities for the three-month periods ended March 31.

 

      2010                2009     

New money yield - yen only

   2.46  %       3.87  %

New money yield - blended

   2.67            4.36     

Return on average invested assets, net of investment expenses

   3.55            3.70     
 

At March 31, 2010, the yield on Aflac Japan’s investment portfolio, including dollar-denominated investments, was 3.75%, compared with 3.87% a year ago. See Notes 3 and 5 of the Notes to the Consolidated Financial Statements and the Analysis of Financial Condition section of this MD&A for additional information on our investments.

Japanese Economy

Japan’s economic conditions have shown signs of improvement due to various policy measures taken in Japan and abroad; however, improvement is expected to continue only at a moderate pace. For additional information, see the Japanese Economy subsection of MD&A in our annual report to shareholders for the year ended December 31, 2009.

Japanese Regulatory Environment

We expect that our distribution system will continue to evolve in Japan. Regulatory changes that took effect in December 2007 enable banks to sell our third sector products to their customers. Our strong brand as the leading seller of cancer and medical insurance products in Japan and our many long-term relationships within the Japan banking sector place us in a strong position to sell through this channel.

The FSA maintains a solvency standard, which is used by Japanese regulators to monitor the financial strength of insurance companies. The FSA will apply a revised method of calculating the solvency margin ratio for life insurance companies as of the fiscal year-end 2011 (March 31, 2012) and requires the disclosure of the ratio as reference information for fiscal year-end 2010 (March 31, 2011). The FSA has stated that the revision would generally reduce life insurance companies’ solvency margin ratios to approximately half the level of those reported under the current calculation method. We do not expect our relative position within the industry to materially change.

In 2005, legislation aimed at privatizing Japan’s postal system (Japan Post) was enacted into law. The privatization laws split Japan Post into four entities that began operating in October 2007. In 2007, one of these entities selected Aflac Japan as its provider of cancer insurance to be sold through post offices, and, in 2008, we began selling cancer insurance. Japan Post has historically been a popular place for consumers to purchase insurance products. Currently, our products are being offered in approximately 1,000 post offices.

A bill on Japan Post reform has been introduced to the Japanese Diet for which debate is expected to commence in mid May 2010. The current Diet session is scheduled to end in June 2010 and, it is unclear whether there will be adequate time to debate the legislation for passage during the current session. Adding to this uncertainty is the fact that the current debate on postal reform is taking place in the context of complex political dynamics in Japan wherein the coalition government led by the Democratic Party of Japan is facing a July Upper House election. While Japan Post sales are not currently a significant part of Aflac Japan’s sales, it is not possible to predict with any degree of certainty what effect this legislation, if passed, will have on Aflac Japan’s business, financial condition, or results of operations.

 

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AFLAC U.S. SEGMENT

Aflac U.S. Pretax Operating Earnings

Changes in Aflac U.S. pretax operating earnings and profit margins are primarily affected by morbidity, mortality, expenses, persistency and investment yields. The following table presents a summary of operating results for Aflac U.S.

Aflac U.S. Summary of Operating Results

      Three Months ended March 31,     
(In millions)    2010         2009     

Premium income

   $ 1,142         $ 1,103     

Net investment income

     132           125     

Other income

     2           2     

Total operating revenues

     1,276           1,230     

Benefits and claims

     580           609     

Operating expenses:

     

Amortization of deferred policy acquisition costs

     138           126     

Insurance commissions

     132           122     

Insurance and other expenses

     182           169     

   Total operating expenses

     452           417     

Total benefits and expenses

     1,032           1,026     

Pretax operating earnings(1)

   $ 244         $ 204     
 
     
Percentage change over previous period:    2010         2009     

  Premium income

     3.5  %      5.0  %

  Net investment income

     5.6           1.4     

  Total operating revenues

     3.7           4.7     

  Pretax operating earnings(1)

     19.4           7.2     
 
(1)

See the Insurance Operations section of MD&A for our definition of segment operating earnings.

Annualized premiums in force increased 2.8% in the first quarter of 2010 and 4.4% for the same period of 2009. Annualized premiums in force at March 31, 2010, were $4.9 billion, compared with $4.7 billion a year ago.

 

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The following table presents a summary of operating ratios for Aflac U.S.

 

      Three Months Ended March 31,      
Ratios to total revenues:    2010              2009       

Benefits and claims

   45.5  %      49.5  %  

Operating expenses:

       

   Amortization of deferred policy acquisition costs

   10.8           10.3       

   Insurance commissions

   10.3           9.9       

   Insurance and other expenses

   14.3             13.7       

Total operating expenses

   35.4           33.9       

Pretax operating earnings(1)

   19.1           16.6       
 
(1)

See the Insurance Operations section of this MD&A for our definition of segment operating earnings.

The benefit ratio declined and amortization of deferred policy acquisition costs increased in the first quarter of 2010, compared with the same period a year ago, due primarily to the loss of a large payroll account and the release of the related policy reserves and deferred policy acquisition costs. Although the improvement in the benefit ratio was somewhat offset by an increase in operating expenses, the pretax operating profit margin improved during the first quarter of 2010, compared with the same period a year ago. Without the benefit of the payroll account termination mentioned above, the pretax operating profit margin would have been 16.0% in the first quarter of 2010. We expect the benefit and operating expense ratios to return to more normal levels in the remaining quarters of 2010, which will result in a modestly expanded profit margin for 2010.

Aflac U.S. Sales

Weak economic conditions continued to challenge Aflac’s sales results in the United States. The following table presents Aflac’s U.S. total new annualized premium sales for the three-month periods ended March 31.

 

(In millions)    2010                 2009        

Total new annualized premium sales

   $ 316            $     351        

Increase (decrease) over comparable period in prior year

     (10.0 )  %            (.6)  %  
 

The first quarter of 2010 had five fewer production days than the first quarter of 2009, resulting in $16 million less sales comparatively. However, that impact was largely offset by $13 million of sales gained through CAIC in the first quarter of 2010.

The following table details the contributions to total new annualized premium sales by major insurance product category for the three-month periods ended March 31.

 

      2010               2009       

Accident/disability

   47  %       48  %  

Cancer

   16            18       

Hospital indemnity

   20            17       

Life

   6            7       

Fixed-benefit dental

   5            6       

Other

   6              4       

Total

   100  %       100  %  
 

Total new annualized premium sales for accident/disability insurance, our leading product category, decreased 10% and cancer insurance sales decreased 17%, while our hospital indemnity insurance sales increased 4% in the first quarter of 2010, compared with the same period a year ago.

 

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One aspect of our U.S. sales strategy is our focus on growing and improving our U.S. sales force. We remain satisfied with our progress in the ongoing expansion of our U.S. sales force. We recruited 5,900 new sales associates in the first quarter of 2010, resulting in more than 74,500 licensed sales associates at March 31, 2010. Due to record recruiting in the first quarter of 2009, recruitment of new sales associates was down sharply in the first quarter of 2010, compared with the same period a year ago. However, compared with the fourth quarter of 2009, new agent recruitment was up 6.9%.

In 2009, we implemented our new Aflac for BrokersSM initiative. Insurance brokers have been a historically underleveraged sales channel for Aflac, and we believe we can establish relationships that will complement, not compete with, our traditional distribution system. We have assembled a management team experienced in broker sales, and we are supporting this initiative with streamlined products, targeted broker-specific advertising campaigns, customized enrollment technology, and competitive compensation. Additionally, a new level of management was introduced in 2009 to deliver this initiative. Over 100 broker development coordinators have been hired to be single points of contact for brokers across the country. Broker development coordinators are responsible for building relationships with new brokers as well as strengthening relationships with our current brokers. These coordinators are assisted by a team of certified case managers whose role is to coordinate and manage the account enrollments for brokers.

Furthering our initiatives in the broker arena, we purchased CAIC in 2009. CAIC equips us with a platform for offering attractive voluntary group insurance products that are well-suited for distribution by insurance brokers at the worksite. CAIC is rated A+ (Superior) by A.M. Best. We believe that CAIC has the potential to benefit us in the U.S. market by helping us meet the product requests and needs of our field force when they pursue larger payroll accounts.

Broker sales increased 30.6% in the first quarter of 2010, compared with the same period a year ago. On a proforma basis in which CAIC sales were included in the first quarter results for both this year and last year, broker sales increased 5.9%.

We expect 2010 to be a challenging year from a sales perspective and look for sales to again decline in the second quarter of the year, followed by modest sales increases in the second half of 2010.

Aflac U.S. Investments

The following table presents the results of Aflac’s U.S. investment activities for the three-month periods ended March 31.

 

      2010         2009  

 New money yield

        5.98 %           8.67 %  

 Return on average invested assets, net of investment expenses

    6.49         6.80    
 

The decrease in the U.S. new money yield reflects tightening credit spreads. At March 31, 2010, the portfolio yield on Aflac’s U.S. portfolio was 7.06%, compared with 7.19% a year ago. See Notes 3 and 5 of the Notes to the Consolidated Financial Statements and the Analysis of Financial Condition section of this MD&A for additional information on our investments.

U.S. Economy

Operating in the U.S. economy continues to be challenging. The weak economic environment has likely had an impact on some of our policyholders, potential customers and sales associates. Although we believe that the weakened U.S. economy has been a contributing factor to slower sales growth, we also believe our products remain affordable to the average American consumer. We believe that consumers’ underlying need for our U.S. product line remains strong, and that the United States remains a sizeable and attractive market for our products.

 

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U.S. Regulatory Environment

In March 2010, President Barack Obama signed the Patient Protection and Affordable Care Act (PPACA) to give Americans of all ages and income levels access to comprehensive major medical health insurance. The primary subject of the new legislation is major medical insurance, therefore the PPACA does not directly affect the design of our insurance products nor our sales model. Our experience with Japan’s national healthcare environment leads us to believe that the need for our products will only increase over the coming years.

ANALYSIS OF FINANCIAL CONDITION

Our financial condition has remained strong in the functional currencies of our operations. 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 following table demonstrates the effect of the change in the yen/dollar exchange rate by comparing select balance sheet items as reported at March 31, 2010, with the amounts that would have been reported had the exchange rate remained unchanged from December 31, 2009.

Impact of Foreign Exchange on Balance Sheet Items

 (In millions)   

  As  

Reported

       Exchange            
    Effect      &