(AFL) Aflac Incurs Losses on Risky Investments

Yesterday, Aflac Inc. (AFL) filed a statement disclosing impairment and investment losses of about $610 million to be incurred in the second quarter of 2011.

These losses are associated with the company’s exposure to risky investments in the financial institutions of Portugal, Ireland, Greece and Spain (PIGS). The company expects to retreat from all of its risky investments in Europe by the end of this year.

The PIGS nations have been undergoing severe financial crisis since 2008 and are yet to recover from it completely. Hence, Aflac, who holds over $6.3 billion in long-term debt in these nations, has been quite eager to offload all risky investments there.

However, the company’s de-risking actions come at a time when the European governments are insisting the banks and insurance companies to actively take part in bailing out the PIGS nations from the surmounting debts. While it could be looked at through various perspectives, we believe that Aflac is keener to save its financial position before saving the nations.

Accordingly, Aflac will incur $165 million owing to a pre-tax loss on the divestment of its investments in Greece and Ireland banks and other financial institutions. Previously, the company had disclosed only $72 million of loss from these investments. With respect to the investments in banks of Portugal, Aflac estimates pre-tax impairment losses of about $445 million.

As of March 2011, Aflac had about $4.37 billion of exposure to risky investments in Portugal, Greece and Spain. This excludes the sale of its investments worth $77 million in the Allied Irish Banks.

During the first quarter of 2011, Aflac booked losses from investments, derivatives and hedging activities in PIIGS nations worth $376 million or 79 cents per share. Such impairment losses have been nibbling into the company’s earnings, which has a record of posting double-digit earnings growth.

Moreover, in order to get rid of the sour investments in Europe, Aflac has now turned to Japan, and is seeking permission to issue debt securities worth about ¥100 billion. This is an attempt to de-risk its portfolio and shift investments to a less risky zone. However, according to a news flow, Japan is buying European bailout bonds, which indicates that Aflac could be into a debt trap.

Besides, while Aflac is indulging in de-risking activities, it is moving towards investments with lesser risk and lower yields, which will further lessen investment income. Moreover, the company’s substantial exposure to European financial institutions hybrid securities, below-investment-grade debt and perpetual securities is likely to result in statutory investment losses and lower reinvestment yields, thereby escalating the financial and capital risk.

Increased losses in the investment portfolio and lower income from the variable annuity business is expected to continue to hurt the earnings at least in the near term, until the markets witness steady recovery. This is also reflected in management’s estimation of generating earnings at the lower-end of the guidance of 8–12% in 2011.

Overall, we believe that although increased catastrophe losses, exchange rate fluctuations and investment losses from European sovereign debt continue to be a concern over the next couple of quarters, Aflac has a strong earnings potential beyond 2011, which will help mitigate risks related to the constitutional capital and also enhance the company’s statutory earnings. Therefore, we recommend Aflac at Neutral, waiting for the smog to clear out.

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