Aflac (AFL) is a well-known insurance company that has proven to be a very reliable dividend payer over the years. The company has increased its dividend for 33 consecutive years and has plenty of room for continued dividend growth.

The insurance business has many attractive characteristics, but AFL’s high exposure to Japan has served as a meaningful headwind over the past few years. The stock currently trades at less than 10x forward earnings, and we hold the stock in our Top 20 Dividend Stocks portfolio.

Aflac Business Overview

AFL is the number one provider of individual voluntary insurance products at the worksite in the U.S. and protects one in four households in Japan. AFL provides insurance to more than 50 million people worldwide and was founded in 1955.

AFL’s insurance operations generate cash in two ways – policy premiums and investment income. Policy premiums are the company’s primary source of cash flow and are generated from policy renewals and new policies issued.

In Japan, AFL’s key product lines are life insurance and supplemental insurance products such as cancer and medical insurance. In the U.S., AFL’s product line includes income-loss protection (e.g. disability, life), supplemental medical (e.g. dental, vision), and asset-loss protection (e.g. accident, cancer, critical illness). AFL pays cash benefits to policyholders when they get sick or hurt, helping them replace lost income from missed work and asset losses.

AFL also invests its premiums to earn additional income and offer policyholders more competitive premiums and benefits. Investments are matched with AFL’s policy liabilities by both duration and currency.

By geography, AFL generated 72% of its revenue in Japan during 2014. The rest of AFL’s business is in the U.S.

Business Analysis

AFL’s primary competitive advantages are derived from the company’s brand recognition, leading market share, distribution channels, financial strength, and conservative approach to risk management.

The company has operated in the U.S. for 60 years and in Japan for 40 years, building up significant brand equity. Management estimates that about 9 out of 10 people in Japan and the U.S. recognize AFL’s brand. The Aflac Duck was introduced in the U.S. and Japan in 2000 and 2003, respectively, and has further benefited AFL’s recognition.

AFL’s business actions over the years have also positioned the company favorably with consumers. For example, the company introduced its One Day Pay claims initiative in the U.S. in February 2015. One Day Pay focuses on the speed of claims payments and means that AFL processes, approves, and pays a claim in just one day, helping lift policyholders’ financial burden quickly.

Getting cash in the hands of policyholders faster than anyone else is very important because they are experiencing a very difficult time of their life. AFL expects to reach over 2 million people with One Day Pay in 2015 and believes that 70% of its policyholders can use One Day Pay for their claims. Actions like these further build up AFL’s brand reputation.

While many insurance markets are fragmented, large players like AFL have meaningfully advantages over their smaller counterparts. Since insurance products are very similar in nature from one supplier to the next, competitors must try to differentiate on quality of service, brand recognition, and financial strength. We already touched on AFL’s strong brand recognition and service, but the company’s sheer size also plays to its advantage.

AFL has built up a strong reputation and massive distribution networks over many decades. With such a large base of premium policies mostly being renewed each year, AFL has the scale to keep its premiums very competitively priced (AFL is the lowest cost provider in many instances) and offer compelling benefits to policyholders that smaller rivals cannot match.

Beyond scale, channel networks, and brand recognition, AFL’s actuarial expertise is another key advantage. For at least the last 10 years, AFL’s annual cash flow from policy premiums has exceeded the policy benefits the company has paid out. In other words, AFL’s actuaries have done an excellent job assessing and pricing risk accordingly. This keeps AFL’s costs very competitive and frees up more funds to be invested for additional income.

It would take new competitors many years and cost a fortune to replicate AFL’s distribution network, brand strength, and actuarial expertise.

Key Risks

While AFL has plenty of staying power, the business faces several challenges. Like all other insurance businesses, AFL runs the risk of mispricing its policies or facing a “black swan” event that forces it to pay out more policy benefits than expected. There’s nothing we can really do about this other than look at management’s track record, which has been excellent (policy premiums have exceeded benefit payouts for at least the last 10 years).

Insurance markets can also go through cycles of increased pricing pressure and competition. However, AFL is typically the lowest cost provider and has the financial strength and brand recognition to outlast almost all of its competitors. With a favorite holding period of “forever,” we are less concerned with this risk impacting AFL’s long-term earnings potential.

The bigger issue with AFL is Japan, where the company generated over 70% of its sales last year. The Japanese yen has declined by 30% since 2012, causing fewer dollars to be reported on AFL’s financial statements.

Furthermore, about 39% of AFL’s total portfolio of debt and perpetual securities was invested in Japanese Government Bonds (JGBs) as of 12/31/14. JGBs have extremely low interest rates and have significantly limited AFL’s investment income, which is expected to decline by 1-2% in Japan in 2016.

Since 2012, AFL has been working to improve the return and risk profile of its Japanese investment portfolio. The company also hired a new Chief Investment Officer of Aflac Japan, which will hopefully help the portfolio’s long-term returns as it attempts to move into investments outside of JGBs.

Japan’s economy faces several challenges that could cause foreign exchange and interest rate headwinds to persist. The country’s economy recently dipped into a technical recession, its population is aging, birth rates are declining, and medical treatment costs are increasing. The Japanese government is undertaking actions to try and stimulate the economy, which could have unintended consequences on Japan’s sovereign credit profile and create more volatility in Japanese capital and currency markets.

S&P and Fitch actually cut their credit ratings of Japan by one level earlier this year, citing little chance of the government’s strategy turning around the poor outlook for economic growth and inflation over the next few years.

It’s challenging to forecast how these factors could impact AFL’s earnings from Japan, but we believe AFL’s conservatism and the stock’s depressed multiple help mitigate this risk. The company will also continue seeking organic growth opportunities via channel network expansion, potential new products, and maybe even new geographies one day.

Dividend Analysis

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. AFL’s long-term dividend and fundamental data charts can all be seen by clicking here.

Aflac  Dividend Safety Score

Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and

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