AFL AFLAC Inc

Yesterday, Aflac Inc. (AFL) witnessed a rating downgrade on its senior debt from ratings agency– Moody’s Investor Service of Moody’s Corp. (MCO) – based on continued investment risk from its investment portfolio in Europe.

Accordingly, Moody’s demoted Aflac’s senior debt to “A3” from “A2,” which reflects a negative outlook. Previously, in May this year, the rating agency had affirmed its “A2” on the senior debt along with an insurance financial strength rating of “Aa2” on its operating subsidiary– American Family Life Assurance Co. of Columbus. However, even then the outlook was maintained at negative.

The rating action is backed by the ongoing concerns over Aflac’s investment portfolio that is substantially exposed to investments in European financial institutions hybrid securities, below-investment-grade debt and perpetual securities. Primarily, the company’s investments are highly concentrated in Greece, Portugal and Ireland, all of which are facing abysmal economic downturns.

Although Aflac is busy de-risking its investment portfolio, these actions are also resulting in heavy statutory investment losses and lower reinvestment yields, thereby escalating the financial and capital risk. Besides, while Aflac is indulging in de-risking activities, it is moving toward investments with less risk and lower yields, which will further lessen investment income.

Aflac incurred about $838 million or $1.78 per share in securities transactions and impairments primarily related to de-risking activity of its European sovereign debt. This was dramatically higher compared to $33 million or 6 cents per share reported in the year-ago period.

Such significant losses are likely to have an adverse impact on its earnings and capital strength in 2011. Increasing expenses, investment impairment losses and the prevalent low rate environment have further impelled management to peg its earnings growth guidance at 8% from prior 8–12% in 2011.

On the flip side, while Aflac’s above-average investment risk appetite raises concern over the intermediate term, the company has sufficient fund sources for meeting its debt maturities in 2011. With an estimated financial leverage below 25%, Aflac enjoys a healthy risk-adjusted capital position along with reduced asset impairments.

This has also helped the company resume its share repurchase program. We believe the company should be able to buy back at the mid-point of its projection of 6–12 million shares in 2011 despite losses from the de-risking portfolio.

Although the lingering effects of the investment and catastrophes losses along with low rate environment poses ample risk on the operations of Aflac, a stable economy in the long run will gather momentum and negate the financial, interest and currency risks, thereby providing more profitable investment opportunities for the company. Hence, we maintain a Neutral recommendation on Aflac.

 
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