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Aflac Maintained at Neutral

CI AFL

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We have reiterated our ‘Neutral’ recommendation on Aflac Inc. (AFL - Analyst Report) based on its strong Japanese operations, healthy capital ratios, efficient capital management and a modest improvement in the fair value of investments. However, we remain cautious about the weakness in U.S. sales, currency and interest rate risks and rising expenses.

Aflac’s strong brand name and solid business model enabled it to improve earnings faster than the other life and health insurers. Moreover, the company is a leading insurer in Japan in terms of individual policies in force. Aflac continues to strengthen its Japanese operations and premium income through new product introductions, new agent recruitments, intensified training, payroll account growth, targeted advertising, and faster claim payments and cash benefits. Revenues from Japan accounted for 74% of the company’s total revenue in the first nine months of 2012 and 83% in 2011.

Despite the challenging economic conditions that have marred the insurance industry both in Japan and the U.S., Aflac continues to enjoy a fairly liquid position. The company’s investments and cash position of $124.2 billion, at the end of the first nine months of 2012, has increased steadily from $103.5 billion in 2011, $88.2 billion in 2010, $73.2 billion in 2009, $68.6 billion in 2008 and $57.1 billion in 2007, thereby providing ample operating leverage and flexibility to the balance sheet.

A strong balance sheet along with minimized risk exposure and a modest solvency ratio also help Aflac in maintaining an efficient capital deployment strategy. The company regularly increases its dividend and has also resumed its share buyback program, which was shelved in 2008, at the peak of the financial crisis.

However, Aflac remains affected by the intense economic volatility, the continued fluctuation of the yen against the dollar, changes in interest rates, changes in credit spreads and defaults, market liquidity and declines in equity price. Further, fluctuations in the yen/dollar exchange rate have a significant impact on the comprehensive income and risk-based capital ratio of the company as a significant portion of Aflac’s business is in Japan.

Moreover, Aflac’s expenses continue to grow, thereby significantly negating top-line growth and contracting margins. In addition, the company’s exposure to the European and Japanese financial institutions, hybrid securities, below-investment-grade debt and perpetual securities is resulting in statutory investment losses and lower reinvestment yields, thereby escalating the financial and capital risks.

The ongoing market volatility, which has created a sense of caution on both macro and micro levels, has led to low demand, recent healthcare reforms and reduced client activity. Based on this, Aflac U.S. has been experiencing sluggish life insurance sales. Moreover, the company’s insurance brokerage distribution initiative has been incapable of any significant growth generation, given the poor recruitment and inadequate training infrastructure.

Overall, we believe that a stable economy in the long run will gather momentum and negate interest and currency risks, thereby providing more profitable investment opportunities for Aflac. The company carries a Zacks #3 Rank (Hold). One of the company’s peers, Cigna Corp. (CI - Analyst Report) carries a Zacks #2 Rank (Buy).

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