Cincinnati Financial: This Dividend King Remains Well-Equipped To Reward Shareholders

This Dividend King Remains Well-Equipped To Reward Shareholders

Executive Summary

Many investors ran away from Cincinnati Financial Corp. (CINF) at the peak of the COVID-19 crisis. They feared that the claims experience would increase significantly due to the non-exclusion of pandemic risk from commercial policies. In addition, the company was more exposed to the equity market than its peers, which had a more conservative approach in terms of the strategic allocation of the investment portfolio.

In other words, it was a double whammy. The company’s investment portfolio was seeing its market value eroded, while its insurance portfolio had every reason to fear the economic consequences of COVID-19.

With the hope of a vaccine in the near future, investors have returned to insurance stocks. Is the future brighter for this Dividend Aristocrat?

A Challenging Year In Terms Of Profitability

In November, Cincinnati Financial reported its quarterly results. Net income for Q3 2020 was $484 million, more than double that of 2019 for the same period.

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Source: Company’s Latest 10-Q

However, for the first nine months of the year, Cincinnati Financial posted a positive result of only $167 million, compared with the company’s after-tax income of nearly $1.4 billion in 2019 for the same period.

The primary reason for the decline is related to the insurance portfolio. With a combined ratio of 101.8 percent for the first nine months of the year, the company generated an underwriting loss of $68 million, compared with an underwriting gain of $222 million last year for the same period.

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Source: Company’s Latest 10-Q

Two events are to blame: first, the COVID-19, which caused a slowdown in premium growth and an expected increase in claims experience in some business lines.

Second, an increase in costs related to natural disasters. In the first nine months of the year, Cincinnati Financial recorded $611 million in losses related to natural events, mainly in the Midwest. Natural catastrophes had a negative impact of 14.4 percentage points on the combined ratio.

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Source: Company’s Latest 10-Q

Let’s suppose the situation normalizes during the fourth quarter. Under this scenario, the Q4 combined ratio is expected to be between 95 and 97%, with net earned premiums of around $1.3 billion or an underwriting profit of $39-51.5 million.

Given the Q4 results for 2018 and 2019, we could even hope for better, but I think investors should remain cautious. In total, the FY2020 technical profit is expected to be between $7 million and $19 million. As a reminder, the technical result in 2019 and 2018 was $341 million and $186 million, respectively. While this year is not expected to be the most memorable year in Cincinnati Financial’s history, the insurance company should remain profitable in 2020.

Equity market volatility in 2020: Cincinnati Financial’s Emotional Roller Coaster for Investors

It should be noted that Cincinnati Financial is historically more exposed to the equity market than its peers. At the end of September 2020, the company held $7.9 billion in stocks while its bond portfolio was valued at just over $12 billion.

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Source: Investor Presentation

In other words, equities accounted for almost 40% of the company’s asset allocation.

By comparison, for Chubb (CB) and Travelers (TRV), equities represented 2.7% and 4.4% of their financial portfolio, respectively. This overexposure to the equity market is a double-edged sword. As a result of new accounting standards implemented in 2018, shares must be valued at market value, and unrealized capital gains/losses observed during the period must be reported in the income statement.

In other words, when the valuation of Cincinnati’s stock portfolio increases, its P&L is directly impacted, inflating its net income. In the event of a stock market crash, Cincinnati is penalized as its assets shrink, and the company must record unrealized capital losses in its P&L, mechanically lowering its quarterly earnings.

Due to the stock market crash that occurred after the explosion of COVID-19 cases worldwide, the Q1 2020 results have been significantly impacted. Fortunately, the stock markets rebounded in Q2 and Q3, with Cincinnati Financial benefiting from this renewed euphoria.

Cincinnati Financial Remains Well-Equipped for a Return to Favor from Investors

I think Cincinnati Financial has a lot of strengths to prove that it is back.

I’ve already mentioned his financial portfolio, which should help generate recurring income despite the stock market ups and downs, such as crashes or panic among institutional or individual investors.

Another point is its specialty insurance portfolio. In 2020, this is the only segment of Cincinnati Financial’s portfolio that was profitable in the first nine months of the year. With a combined 9M2020 ratio of 92.5%, the specialty segment certainly generated lower underwriting gains than in the same period a year ago.

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Source: Company’s Latest 10-Q

However, this segment managed to generate recurring technical profits, allowing the company to smooth out the other segments’ losses.

Another potential asset is the London-based subsidiary, acquired in 2018 from Munich Re. MSP Underwriting (rebranded as Cincinnati Global) had a long track record of success, earning an underwriting profit in 20 out of the last 24 years. Although Cincinnati Global’s earnings contribution is currently small, it might grow over the next years. In November 2020, the company has announced the London-based underwriter will begin writing two new business lines: Contingency and Specie.

Contingency insurance covers film and entertainment risks. A Specie portfolio includes coverage for theft or loss of high-value portable property, including fine art, jewelry, gold bullion, and cash in transit.

Both markets are niche and man-tailored segments, which require high expertise. Furthermore, art and entertainment risks are decorrelated to catastrophic hazards such as tornadoes or earthquakes.

The Biggest Risk So Far: The Business Interruption Cases

Currently, the most significant risk to Cincinnati Financial remains the “business interruption” claims.

Last October, a North Carolina judge ruled that Cincinnati should compensate restaurants that had seen their sales plummet due to lockdown. In November, the company filed its notice of appeal of the trial court’s decision to the Court of Appeals of North Carolina.

Besides, courts’ prevailing view across the country has been that an economic loss alone doesn’t qualify as direct physical damage or loss to property, which is the trigger for business interruption coverage. Hence, investors could expect that the impact of COVID-19 would be lower on the insurer’s claim activity, but should keep in mind that the loss ratio should deteriorate in the future if some courts rule against Cincinnati Financial.

Be Patient, Collect Your Dividend and Wait For Brighter Prospects

Cincinnati Financial has increased its dividend with no interruption for the last six decades. Management seems proud of this record that few other U.S. companies have managed to match or beat. In my opinion, all measures will be taken – even the most difficult ones – to maintain this status. The management team is also aware that the EPS metric is artificially boosted by unrealized capital gains, and remains focused on premium growth and operational performance (a combined ratio of between 95% and 100% over the long term).

The next announcement regarding the dividend increase should occur at the beginning of January. Given previous dividend increases and the current situation, a slightly lower increase of around 4-5% can be expected. A pleasant surprise is not to be excluded, but once again, caution is called for.

Buy Now?

Currently priced at 1.3x book value, I see a 15% upside potential.

ChartData by YCharts

Nonetheless, I will not currently invest in Cincinnati Financial, although it has undeniable assets: a strike force linked to its equity portfolio, a willingness to develop in niche markets, low correlation to climatic events, and a disciplined approach in terms of capital redistribution.

The reason for not investing in Cincinnati Financial is straightforward: I already have plenty of insurers in my portfolio and don’t want to increase my portfolio’s exposure to non-life insurers. If I did so, I would like to have a safety margin higher than 15%.

One Last Word

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Credit: SeekingAlpha

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