Aflac: Excellent Management Offers 50% Upside

In 1974, Aflac Inc. (NYSE: AFL) was the second supplemental life insurance provider to enter the Japanese market was characterized with high government regulation. Subsequently, we witnessed two periods of deregulation, one in the 1980s and another in the 2000s. Thereafter, the market became highly competitive with over 19 providers in the late 1980s itself; nonetheless, Aflac Japan remained on the forefront of this industry. Now, Aflac Japan still accounts for over two thirds of Aflacs total revenue steam despite efforts to gain market share in the U.S. market. Aflac primarily operates in two major markets (U.S. and Japan) and generated over $18.5 billion net premiums during fiscal 2017, up from $13 billion a decade ago. The company almost exclusively invests in fixed-income securities with almost half of its invested concentrated in Japanese Government Bonds.

A Little Bit About Insurance

While insurance companies typically attempt to differentiate themselves through advertisement, insurance is fundamentally a commodity as consumers, we look for the lowest possible price and rarely much more. For this reason, the industry is highly competitive, meaning most firms operate at marginal levels of profitability. When the industry as a whole is experiencing high profitability, inevitably firms begin to increase volume and drive rates back down into a loss. While an insurance policy is an impalpable good, the industry still suffers from the ravages of oversupply.

Under normal circumstances, the insurance industry as a whole typically operates under an underwriting loss. That is, premiums written typically do not cover benefits given and other operating expenses. What makes insurance companies profitable is the investment income earned over the life of a policy; if a company exhibits exception capital allocation skills, even a large underwriting loss can be mitigated through prudent investing. Because of the extraordinary role of capital allocation in the success of insurance companies, the person in charge of the investment portfolio is arguably the most important variable when appraising an insurance company.

When an insurance policy is written, payment is received upfront while benefits are deferred. Especially in the case of life insurance, benefits may be deferred for 20-30 years or not paid at all. During this period, the insurance company has a pool of investable premiums which should (ideally) cover the firms underwriting loss and produce a profit. We call this pool of funds float. As one can imagine, a company cannot invest these funds as it wishes after all, its not free money and must eventually be paid. Therefore, a company must maintain sufficient liquidity to prevent insolvency in the case that many policies become due at once. Of course, a company ought to be diligent in underwriting to prevent systematic risk, but a low probability is still a possibility and a firm must be prepared for it.

If float is not free, then what is its cost? To answer this, we return to the underwriting loss. Many actuaries will underwrite policies that they know will produce a loss simply due the investable funds these policies will generate. In other words, losses are incurred for the sake of increasing float. Thus, we can view a companys underwriting loss as the cost of float. In business, there is no free lunch. However, this scenario is beneficial if and only if the cost of float is less than the cost of obtaining other types of financing (i.e. debt or equity financing). This is a rare occurrence. For reference, both MetLife and Prudential both incurred a cost of float of over 5% in 2017 compared to the yield of the 10-year U.S. Treasury bond of ~3%. If an insurance company can consistently grow float at a low-cost relative to U.S. Treasury yields, then we have found ourselves a gem.

Aflacs Float

Aflac, however, does not suffer from this affliction. In fact, most recently, AFLs cost of float has been less than 0%, that is, people pay Aflac to hold their money. The following chart illustrates this. Float is defined as policy liability which is defined as future policy benefits plus unpaid premiums and unearned premiums less deferred policy acquisition costs and other prepaid expenses.

Average Float vs. Underwriting performance over time

Aflac has never had to pay more than 2% for its investable float, and most recently, it has been paid to invest $90 billion while also accruing all the benefits from these investments (about a 5% yield). Nevertheless, all of this amount is recorded as a liability under GAAP rules; in reality, every dollar that is expected to be paid in benefits tomorrow is replaced with a dollar today. The true economic liability of this float, therefore, is far less than the amount written on the books. Instead, this pool of investable funds should be thought of as a revolving credit facility that is obtained at no cost. Most importantly, AFL has demonstrated a consistent trend of decreasing its cost of float from ~2% in 1997 to -1% today, and for half of the period presented, float has been obtained for free plus some.

If we take the average float from 1997-2002 and compare that to the average float from 2012-2017, it has grown from $22.6 billion to almost $82 billion for an average growth rate of ~6.5% per annum. If we assume a growth rate of 3% going forward, over the next five years, AFL will generate a float of about $104 billion. At a 1% profit (keeping in mind combined ratio has been declining over time), our underwriting profit would be on the order of $1.4 billion, or around $500 million incremental cash flows ($1.4 billion minus ~$900 million current underwriting profit) at absolutely no cost. It seems as if the market is missing this extremely useful competitive advantage surrounding Aflac, not to mention its propensity to produce cost-less earnings through a marginal increase in investment yields.

Unrealized Investment Gains

Under GAAP accounting, only realized investment gains are recording in a companys income statement. For example, if a company owns $1 billion in securities that appreciate to $2 billion, this accretion will not be accounted for in the income statement should the company not sell the securities. However, in terms of economic value, unrealized gains are equal in statue to realized gains. This discrepancy between what the company reports and what it really earned becomes very large when you have over $100 billion in securities.

Of course, unrealized gains are by their nature erratic. That is, if we were to add them to reported earnings, we would get very lumpy figures. In addition, future unrealized gains are, in part, dependent on the actions taken by portfolio managers today (if a company sells a security today, future gains are obviously not recorded anywhere). Despite these shortcomings, adding unrealized gains and losses to the reported earnings does provide a useful proxy to what the company couldve produced in any given year. If unrealized gains and losses more or less equal, adding them to reported earnings will not change a thing. No harm, no foul. However, if an investment consistently appreciates or depreciates in value, the company not selling the security can shroud an otherwise higher or lower earnings figure. The following table attempts to create a real investment income by incorporating realized with unrealized gains and losses:

Overall, there is a significant difference on the order of $700 million. If we add these new figures to underwriting profit, we obtain a larger pre-tax earnings figure.

This result suggests a fair value for AFL on the order of $50 billion (~10X pre-tax income). This is, of course, assuming no growth. If we assume underwriting profit and investment income to increase by 3% every year (same as the float), then the intrinsic value of Aflac may be closer to $60 billion. And while I do not like (nor think I can accurately) making macroeconomic projections, this investment will fare well given a rise in interest rates, which corresponds to a rise in investment yields.

Disclosure: I am/we are long AFL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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