Insurance companies are a great way to achieve solid returns, especially if you get in at a good time. Aflac (NYSE:AFL) may now be a tremendous buy, especially after its recent post-earnings pullback. However, there are many other great insurers out there. Why should you choose Aflac ahead of rivals such as The Hartford and the extremely diversified (but insurance-oriented) Berkshire Hathaway?
How insurance companies make their money
Although their business models vary, insurance companies generally use the same set of basic principles to make money. What most people know is that insurance companies collect premiums on a regular basis in exchange for a promise to pay if something happens. Because of the possible need to come up with large amounts of cash, the companies keep their collected premiums in a reserve fund.
What most people don't realize is that insurance premiums aren't designed to be massively profitable by themselves. The reserve accounts of insurance companies get invested, and the return on those investments becomes the majority of the company's profit. This is how Warren Buffett has been so successful with Berkshire Hathaway. He has remarked that "our primary business is insurance," and the company's investments are mainly from the "reserve fund."
My point in discussing this will become more apparent shortly, but it is fair to assume that in a low-interest rate environment (such as the current one), insurance companies' returns are generally lower than what they would be when interest rates are high.
Aflac's true nature
Aflac offers supplemental life and health insurance policies such as cancer plans, care plans, living benefit life plans, and traditional life insurance and annuities. What many investors don't realize is that the bulk of the company's earnings (80%) comes from Japan, not the United States. Aflac's insurance products are sold through a more extensive range of channels in Japan, in more than 90% of the country's banks, and in more than 1,000 post offices (which are popular places to buy insurance in Japan).
In the U.S., the company markets its products as supplemental insurance to consumers who already have major medical insurance. The main selling point is that Aflac pays insurance claims in cash directly to the customer, unlike primary insurance. Aflac has had tremendous success with its marketing approach in both the U.S. and Japan, and the company's total revenue has soared over the past decade.
Performance and price
Now let's look at Aflac's valuation relative to where it has been in the past. Over the past several years, the company has been trading well below its historic valuation multiple and currently is priced at 9.8 times earnings.
In relation to its peers, Aflac looks like an even better bargain. The Hartford, for example, trades at a similar valuation, but the company's earnings history is extremely shaky.
Another alternative is to buy a diversified company, with extensive insurance operations, such as Berkshire Hathaway. Warren Buffett's company owns such insurers as Geico, General Re, and several others. The company uses cash from its insurance reserves to finance its investments, which have gone beyond the safe, traditional fixed-income investments of other insurance companies. However, Berkshire's track record of success comes at a steep price, with shares currently trading for more than 19 times this year's expected earnings.
So why is Aflac so cheap?
One reason Aflac is so cheap right now has to do with how insurance companies make their money by investing their reserves. In a low-interest rate environment, investment returns are subpar. The company invests in low-risk investments that don't have especially high yields, and even one percentage point can cause an enormous impact on the bottom line. This is especially true when we're talking about investment assets of around $116 billion.
Over the past several years, the company's return on its investments has declined significantly, leading to lower profit margins. Once interest rates begin to pick up, a 1% increase in investment returns could mean an additional $1.16 billion in earnings for Aflac, or about a 40% increase over this year's net profits. Now may be the time to buy before the market fully realizes Aflac's huge earings potential.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Aflac. It recommends and owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.