AFLAC: Its Ducks Are Not In A Row

The hit from Parmalat bond holdings raises questions about its investing style

Despite its out-of-the-way perch in rural Columbus, Ga., a small Southern town better known for textile mills and the massive Fort Benning military base, AFLAC Inc. (AFL ) has been a financial dynamo. Over the past decade, the health insurer, with $11.3 billion in revenues, has been the envy of the insurance industry. That has been due to its success in Japan, where years ago it persuaded the government to allow it to sell supplemental cancer insurance to a health-obsessed populace, and more recently to a surge in its historically slow U.S. business, thanks to the jokey TV ads featuring a dyspeptic duck.

Indeed, since 1992, operating income has more than tripled to an expected $968 million in 2003 -- a performance that earned it the No. 41 slot on the BusinessWeek 50 ranking of top-performing companies.

But suddenly, things aren't all ducky at AFLAC. In mid-December, the conservatively run company stunned Wall Street with the news that it held $428 million in bonds from the scandal-ridden Italian dairy giant, Parmalat. That was nearly a quarter of the Parmalat bonds held by all U.S. insurers. The upshot: AFLAC took a $257 million loss that will slash fourth-quarter earnings.

GROWING WORRIES. While AFLAC insists the Parmalat blunder was a one-off event, it raised new questions about the company's investment practices. None of the bond rating agencies downgraded the insurer or flagged it for a possible future downgrade, and it remains one of the better-capitalized in the industry. Still, analysts worry that AFLAC could be sitting on other Parmalat-size positions in shaky companies -- especially in Japan, where it generates 75% of operating income and holds 78% of its investment portfolio. "We have more concern going forward over their investment philosophies regarding concentration of risk," cautions Shellie A. Stoddard, a credit analyst at Standard & Poor's Ratings Services.

What's worse, the Parmalat news comes amid growing worries on Wall Street about a slowdown in AFLAC's U.S. business, which focuses on signing up small-business employees for supplemental accident and medical coverage. While total U.S. revenues rose 16.3%, to $2.2 billion, through the first nine months of 2003 on the strength of investment gains and its existing book of business, sales of new policies rose just 4.5%, to $783 million. And AFLAC has signaled that new sales in the fourth quarter will be flat -- a sharp comedown from the 28% growth in new policyholders it enjoyed as recently as three years ago. Yet AFLAC now has 16,700 "producing" agents (those still actively selling policies), almost double the number in 1999. Some analysts fear that unless it manages them better, overall growth will suffer. The U.S. generates only 25% of AFLAC's operating income, but has accounted for 52% of new sales growth in recent years, as new insurers have filtered into the Japanese cancer market.

Chief Executive Officer Daniel P. Amos, along with all other AFLAC executives, declined to comment ahead of the company's Feb. 2 earnings release. But last October, Amos was resolute that the U.S. still represents a "huge and underpenetrated market" for AFLAC's supplemental products and that "it's just a matter of time" until AFLAC regains momentum here at home. He dismissed the sales slump as a short-term issue. But some AFLAC agents are worried. Many of the dozen or so interviewed by BusinessWeek complain that a number of new hires are fresh out of college with no insurance experience. They add that the company offers too little training -- and that the result is a herd of agents all calling on the same businesses. "It's like 40 people trying to chase a mouse in a 12-by-12 room, and that mouse is the client," sighs one independent agent in Lubbock, Tex. He notes that the deluge of uncoordinated sales calls has prompted some companies to refuse even to speak to AFLAC agents anymore.

The domestic turmoil, in fact, is largely why Credit Suisse First Boston (CSR ) analyst Thomas G. Gallagher lowered AFLAC's stock rating. His recent survey of about 100 of AFLAC's U.S. agents also revealed concerns over the fallout from the hiring binge. "Our sense is that there are no signs of a turnaround heading into 2004," says Gallagher, who on Jan. 5 lowered his rating on AFLAC's stock from "neutral" to "underperform." He also warned that AFLAC's shares, now at about 35, could be worth no more than 32 if annual profit growth slows from the 20% in 2003 to the 17% he expects this year -- and 15% or less subsequently.

AFLAC's answer? It is scrambling to improve its U.S. sales operations with better oversight and more rational sales territories. And it is trying to reassure investors that its investment management is sound. Chief Investment Officer Joseph W. Smith Jr. has said that unloading Parmalat bonds as soon as they were downgraded to junk status showed that "our tolerance for below-investment-grade securities has not increased." By selling at the first whiff of scandal, AFLAC saved big. It sold the bonds at 40 cents on the dollar, twice their price just days later.

Some investors are willing to give Smith the benefit of the doubt for now. After all, he reaped praise for avoiding positions in WorldCom Inc. and Enron Corp. He also steered clear of the collapsing real estate and equity investments that have laid low so many Japanese insurers. With just $62 million in investment losses since 2001, "they'd gotten through a pretty rough period unscathed," marvels James Edelman, an analyst at Dallas' Highland Capital Management LP, which holds 2.4 million AFLAC shares.

The Parmalat affair has nevertheless raised concerns about why AFLAC takes such outsize positions in its bond portfolio. AFLAC insists that such big stakes are unavoidable. It keeps a huge portion of its $38.7 billion portfolio invested in yen-denominated assets to prevent currency swings from hurting shareholder equity and AFLAC's ability to pay out claims. There are few attractive investments in Japan's deflationary economy, so AFLAC bets big when it finds one. Its choices have generally worked out, but analysts note that AFLAC is holding $1.1 billion in bonds from just two Japanese finance companies, as well as billions more where it opted to buy out entire bond issues. AFLAC also has more than $750 million in bonds, which have slipped into junk status, from companies such as Ahold, KLM Royal Dutch Airlines (KLM ), Royal & Sun Alliance Insurance Group (RSA ), and Levi Strauss. Another corporate meltdown could sap investors' faith.

Clearly, Amos and his team have their work cut out. Overseas, AFLAC is going with what it knows -- its trademark duck keeps selling insurance, even on Japanese TV. That might sell more policies there. But it may take a goose at home to keep this company flying high.

By Dean Foust, with Michael Eidam, in Atlanta and with Brian Bremner in Tokyo

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