Aflac Insurance (NYSE:AFL) is trading at a multi-year low due to rising investor concern about its investment portfolio. The company, best known for its quacking duck advertisements, has a large amount of European hybrid securities, some issued by banks that are undergoing severe financial stress.

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Slow Decline
Aflac insurance survived the first part of the financial crisis in relatively good shape. The stock peaked near $68 a share in mid-2008, then settled comfortably in the $40 to $45 range while the rest of the insurance sector underwent periodic convulsions.

All that began to unravel in January, when the market began to take notice of the large amounts of hybrid securities owned by certain financial institutions. Hybrid securities are instruments that have both debt and equity characteristics.

Aflac entered 2009 trading in the mid-$40 range and started to slide slowly down. In late January, an analyst at Morgan Stanley put out a note that detailed the company's exposure to hybrid securities, in particular some issues by European banks, many of which are not in a solid financial position. Investors are concerned over whether these banks will be nationalized by their respective governments, rendering the securities worthless.

Downgraded By S&P
The next day Standard & Poor's downgraded Aflac and put the company on negative watch. The ratings agency essentially stated that for every $400 million in statutory capital that the company loses, its ratings would move down one more level. Aflac still has a fairly high rating from S&P with a financial strength rating of AA- and a debt rating of A-. (Lack of competition and potential conflicts of interest have called the value of these ratings into question; check out The Debt Ratings Debate.)

After several other analysts weighed in with similar concerns and/or downgrades of the stock, Aflac hit a low of $19.35, its lowest trade since 2000. It has since bounced back to the low $20 range.

Company Fires Back
In response, the company reported an extraordinary level of detail regarding its investment portfolio and the hybrids, which are officially known as perpetual debentures. The company offered the following information that it believes mitigates the risk to its investment portfolio:

  • 72% of the hybrids are Tier 2, which is the highest in the capital structure of the issuers.
  • The company diversified fairly well and owns 77 individual securities issued by 32 companies.
  • Ninety-two percent of the hybrids owned are rated A or AA, and all issues were current on payment. The only exceptions were the hybrids issued by several Icelandic banks that defaulted in 2008.

Largest Exposure
Aflac has the most exposure in its Tier 2 hybrid portfolio to issues from banks in the Lloyds Banking Group (NYSE:LYG), which operates under different brands including the Bank of Scotland and HBOS plc. Aflac owns securities from Lloyds with a book value of $873 million. The bank is 43% owned by the British government and has received a total of $24 billion in aid.

Other insurance companies with exposure to hybrids and other securities declining in value are Principal Financial Group (NYSE:PFG) and Protective Life (NYSE:PL). Principal Financial reported in its recent quarter that book value fell from $19.56 per share to $7.45 due to unrealized losses in its investment portfolio. Protective Life also saw investment losses in the quarter and took a realized loss of $1.02 a share. (The P/B ratio can be an easy way to determine a company's value. Learn how in Value By The Book.)

The Problem
A major part of the discrepancy between the market and the management view of the issue is based on how the securities are valued. Aflac uses a debt impairment model that apparently allows it to keep a higher value on securities – in this case an average of 90% of par. The market, in contrast, is trading them at 50% of par or even less in some cases.

Final Word
The market reaction to disclosure is another example of investor fear – a sell now, analyze later philosophy that has increased volatility for all financial stocks. It is clear that we have not heard the last on this issue for Aflac, and it will continue to roil the stock for the next year or more.