Start-up companies are well known for operating in the red during their early growth phases as they spend heavily on sales, marketing, and research & development to establish strong positions in their markets. Then, at some point in their success journey, they may decrease the percentage of revenue directed toward those efforts and begin to turn a profit, albeit while growing more slowly.
But in some cases even mature, long-established companies are able to rake in profitable cash when in low-growth mode. Such is often true for insurance companies. It’s very much so for Aflac, the leader in the supplemental insurance space in the world’s two largest insurance markets, the United States and Japan.
“The bad news for a mature insurance business is that the topline struggles to grow,” says Fred Crawford, Aflac’s CFO. “The good news is that when the growth rate slows, cash flow and capital generation pick up substantially.”
Speaking to the growth challenge, Crawford notes that Aflac has roughly 26 million outstanding insurance policies in Japan, about 6% of which lapse each year. The situation is even tighter in the United States: 13 million policies, with 20% to 22% of them lapsing annually. “You have to have one heck of a sales engine to keep pace with that and actually grow,” he says.
But why does slow growth stimulate profitability? It’s because of the acquisition costs for newly booked policies and the cash reserves that must be set aside in respect of potential future claims under the policies.
Those expenses are recouped from clients’ premium payments over several years. When the up-front costs decline and premium revenue from policies booked in previous, higher-growth times is strong, cash piles up.
Aflac is currently generating about $2.5 billion of excess cash flow per year, Crawford notes. About $800 million of that goes toward the company’s annual increase in its common stock dividend, which it has been providing to investors for 36 years.
As for the rest, Crawford says his investment strategy is guided by “where we can generate the greatest risk-adjusted long-term returns on that capital.”
Buying back company stock is a very low-risk way to deploy capital, the CFO notes. While the absolute return may be relatively modest, the risk-adjusted return is much higher. That makes buybacks a commonly employed investment vehicle.
At the same time, buybacks are “the basis against which other investment alternatives compete,” says Crawford, whether they’re technology investments, acquisitions, or venture capital bets.
“Share repurchase is a solid, sound investment of excess capital,” he says. “But if it’s not balanced by investing in growth, your [overall] investment return will not turn out to be what you had hoped. The stock price is not going to grow over the long term just on the back of share repurchases.”
Among Aflac’s more interesting investment vehicles is a $250 million venture capital fund. It works with Plug and Play Tech Center, among the world’s largest technology-startup incubators and accelerators, to identify new technologies worth investing in.
In particular, the company looks for digital applications that shrink “pain points,” Crawford says. For example, many people dislike the process of getting a life insurance policy application approved, which may involve seeing a doctor, submitting to tests, and giving blood and urine.
That pain point drove the venture capital fund’s investment in Lapetus Solutions, a facial recognition software company. The software does much more than recognize someone’s face; it actually can underwrite applicants for basic life insurance policies based in large part on a “selfie” the applicant snaps on his or her cell phone.
Aflac is currently testing the software, which analyzes applicants’ skin tone, eye coloring, facial lines, dark spots, and other facial features to assess how well the person is aging and his or her overall health profile.
Other insurance companies are already using the software for their small-face-amount life insurance businesses. Aflac is a small player in that market, but it invested in Lapetus “because we see a future of potential application for worksite health and life insurance, so we wanted to be part of that company’s development,” says Crawford.
Most (98%) of Aflac’s business in the United States is with employers, which offer its supplemental insurance products to employees through their benefits programs.
Conversely, in Japan, the company sells directly to individuals and families. There is a single-payer national health insurance (NHI) program for citizens and permanent residents that don’t receive coverage through employers, but it pays for only a portion of members’ health-care costs.
That helps make the market golden for Aflac. Approximately 75% of the company’s overall business comes from the Asian country. NHI pays for more and more of members’ health care needs as they age, but the payouts never reach 100% of expenditures. Most working-age Japanese adults, meanwhile, must pay a significant share of their costs, making that a good market for Aflac, too.
But demographics in the Japanese market are dynamic, even if they always shift in the same direction, given Japan’s famously aging population. “The aging population and the [corresponding] shrinkage of the workforce make growth that much more challenging,” says Crawford.
He adds, though, that there are some “natural catalysts” for Aflac’s business in Japan: For one, while the population is aging, it’s very aware of the value proposition of health insurance. Also, the Japanese government is slowly shifting more of the health-care cost burden to the population, widening the gap between what’s covered and what’s out-of-pocket.
Of course, that’s not just a Japanese phenomenon. “Undoubtedly some version of that type of pressure will be faced in the U.S. too, as we look at the affordability of health-care coverage and what employers might take on, or not take on, to fight health-care inflation,” Crawford notes. “We’ll come in and fill those gaps.”
In CFO’s conversation with Crawford, he touched on some other notable topics:
Aflac’s 2018 abandonment of quarterly guidance. The argument for frequent guidance is that the company owes its investors that degree of transparency with respect to its business and financial plan. Now, though, the company is providing only annual guidance.
Aflac’s argument against quarterly guidance is its potential to create a short-term mentality among both company management and investors.
“It’s not like there’s a group of short-term investors that just look for companies that give quarterly guidance,” Crawford says. “It’s more that it creates a dialogue with investors around the next quarter, which can suck the oxygen out of the room in terms of talking about the company’s longer-range strategies.”
He added that Aflac has experienced no negative reaction from investors or analysts over its decision to reduce guidance frequency.
The financial value of diversity. “Executives have known for a long time that there is a high correlation between strong performance and a diverse workforce,” says Crawford. “If we have 13 million policies in the U.S., we have by definition a very diverse customer population. If we’re not diverse, we’ll be less able to understand and serve them.”
Japan, he notes, is not a particularly diverse society. But one response to the country’s shrinking workforce has been an elevation of more women into companies’ senior ranks.
“The government realizes that this can support economic development and growth in Japan, and they need to do that any way they can,” the CFO says. “This thinking has emanated from the [Prime Minister Shinzō] Abe administration down into the corporate ranks.”
He adds, “Can I give you an EPS attribution for diversity? No. Are there tangible advancements and things you can reach out and grab and say, ‘if not for diversity this wouldn’t work’? The answer is yes.”
Digital transformation. Crawford doesn’t like such terms. “If I hear yet another company talking about its digital journey, I think I’m going to scream,” he says.
He says he went through a phase where he didn’t want to talk to investors about the company’s digital efforts until he fully understood them. He eventually gained that as digital teams created maps detailing each component of a customer’s interactions with Aflac, and did the same for the interactions of agents and brokers.
“In those steps are where you find the pain points,” Crawford says. “Digital is not about seeing something and thinking ‘it’s cool I can do this.’ It’s about taking something that is painful for [a stakeholder] and shrinking the pain. That’s the way to think about digital.”