Insurance company stock is a great way to get solid returns, especially if you buy in at a good time. Aflac (NYSE – AFL) is, right now, an excellent buy due to its recent post earnings pullback and, in our opinion, could easily be chosen over other insurance rivals like The Hartford and Berkshire Hathaway (which is quite diversified but also heavily insurance oriented).

How exactly do insurance companies make money?

Business models vary of course but insurance companies, generally speaking, all use the same set of basic principles to make their money. Their founding principle of course is to collect premiums from their customers in exchange for the promise to pay restitution if something negative happens to their property or assets. Due to this fact, most keep their collected premiums in a reserve fund so that, when the time comes for them to pony up huge amounts of cash, they’re able to do that without a problem.

The fact that most consumers don’t know is that the actual insurance premiums by themselves are not actually designed to be profitable. Just like a movie theater makes more money on their junk food than they do on the actual sale of movie tickets, an insurance company makes more money on their reserve account, and the way they invest it, not on the actual insurance premiums. If you’re wondering how the famous Warren Buffett has been so hugely successful with Berkshire Hathaway, it’s because of this very fact. Indeed, Mr. Buffett has remarked on several occasions that “our primary business is insurance”.

The true nature of Aflac.

Aflac offers a wide variety of supplemental life and health insurance policies including cancer, care, traditional life insurance, annuities and living benefit life plans. Something that most investors don’t realize is that the bulk of their earnings (nearly 80%) come from Japan rather than the United States. Indeed, they have an extensive range of channels in Japan where they sell their insurance products including over 90% of Japan’s banks and in over 1000 of their post offices, which coincidentally happen to be one of the most popular places for Japanese people to buy their insurance.

Most people who purchase Aflac’s supplemental insurance already have major medical in the United States. The reason that the average consumer gets there supplemental insurance from Aflac is that, when they have a claim, the company pays them in cash directly. In the last decade their success has been phenomenal due to their popular marketing approach, and company revenues have soared.

Aflac’s Performance and Price.

Currently Aflac’s stock is priced at 9.8 times earnings, a price well below their historic valuation multiple. When you compare them to their peers they appear to be an even better buy as, for example, The Hartford trades at a valuation comparable to Aflac but has a history of extremely shaky earnings. Berkshire Hathaway has an obvious track record of great success but that success is very costly as their shares currently trade for over 19 times what this year’s  earnings are expected to be.

What’s the reason that Aflac is priced so cheaply?

Insurance companies make money, as we said earlier, by investing their reserve funds. Thus when you have a low interest rate environment you find that returns are usually below average. Since Aflac invests in low risk investments, their yields aren’t especially high and a change of even 1 percentage point can have a huge impact on their bottom line, something that’s especially true when you have investment assets to the tune of about $116 billion.

The reason that they have had lower profit margins over the past several years is because their return on investments has gone down significantly. However, once interest rates begin to increase a similar 1 percent increase in returns will amount to approximately 1.16 billion in additional earnings for the company, an increase of about 40% over their profits this year. For that reason now may be the best time to purchase their stock before the rest of the market realizes Aflac’s huge earnings potential.

 

Filed under: Stocks for the Long Run

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