skynesher
skynesher
Shares of Cincinnati Financial (NASDAQ:CINF) have been an underperformer over the past year, losing about 6% of their value even as the broader market has performed well as it worked through subpar underwriting results in H1 2023. Since recommending shares as a "buy" in October, CINF has returned about 11%, which while not bad on an absolute basis, has underperformed the market's 17% return. This has been partially due to the shares' negative reaction to Q4 earnings, though much of these losses have been recovered. I continue to view shares as attractive and as offering moderate upside for long-term investors.
Seeking Alpha
In the company's fourth quarter reported on February 6th, Cincinnati earned $2.28 in adjusted EPS, which was $0.35 ahead of consensus and up 78% from last year. On a GAAP basis, it earned $7.50, but this was largely driven by the increase in the market value of its equity portfolio. CINF is relatively unique within the insurance sector for having a large equity portfolio, somewhat similar to the dramatically larger Berkshire Hathaway (BRK.B). This portfolio can generate large unrealized gains and losses, which distort GAAP results, which is why I focus on adjusted operating EPS to better gauge how the underlying insurance operation is performing.
Historically, Cincinnati has been a strong underwriter, with 12 years of a combined ratio below 100%. As a reminder, a combined ratio of 100% means that an insurance company's costs are equal to its premiums-it is running at breakeven. If an insurer has a combined ratio below 100%, it is generating an underwriting profit. CINF has consistently produced underwriting profits, with investment income on top of this, creating solid long-term returns for its investors.
In the fourth quarter, earned premiums rose by 10% to $2.06 billion, and net written premiums rose by 13%. CINF is continuing to grow its business, but inflation is a major driver of these large premium gains. The company is seeing "healthy" renewal price increases. In 2022, the insurance industry, including CINF, was negatively impacted by inflation. Because premiums tend to be set on a 12-month basis, when inflation runs faster than expected, the cost of claims has been higher than modeled. Now, insurance companies like CINF are recapturing margin and catching up to inflation by raising premiums, which should improve underwriting profits going forward. Indeed, as you can see below, insurance premium inflation is now running at the fastest pace in nearly ten years, even though overall inflation has cooled. This is because of how its 12-month contract nature causes insurance to lag other prices.
St. Louis Federal Reserve
In commercial lines, CINF's current year accident combined ratio before catastrophes was 90.7% in Q4, down from 91.1% in Q4 2022; for the full year, it was 91.6% from 93.5%. Premiums in this segment rose by 4% to $1.08 billion. This was a return to strong underwriting in the quarter and in the year in Cincinnati's primary business as underwriting issues from 2022 faded away.
Personal lines is much smaller at $560 million in earned premiums, but it is a center of growth for the company, up 26% from last year. The combined ratio fell from 95.7% in 2022 to 84.7% in Q4 2023, a really strong result as CINF scales up its operations. For the full year, the combined ratio rose by 1.2% to 100.4%, due to 3.7% of higher catastrophe losses in the first half of the year. Fortunately, Cincinnati is exiting the year on a much stronger footing.
I argued that CINF's worse-than-normal underwriting results in the first half of the year were likely an aberration, and the strong recovery in Q4 is consistent with my view of CINF as a structurally solid underwriter. On a consolidated basis, CINF's Q4 combined ratio was a strong 87.5%, down from 94.9% last year. The full year ratio was 94.9%, down by 3.2%. Thanks to this improved combined ratio, CINF generated $252 million in underwriting profits from $93 million last year.
One modest negative in the quarter was that the company has seen higher past-year losses, leaving it to increase reserves by $51 million, about $29 million from years prior to 2019. CINF has seen more "large losses," but it does not see a "material" trend in terms of future losses.
Indeed, for perspective, even with this Q4 build, for the full year, there was still $215 million of favorable prior developments. In aggregate, policies have aged better than actuarily expected, a consistent theme over the years, and I would view the Q4 increase as likely to be a one-time event, though it should continue to be monitored. I would also note this revision is quite small considering that CINF has $12.1 billion of insurance reserves.
Aside from underwriting, CINF's investment portfolio continues to perform well. Net investment income rose by 15% to $239 million. This was due to a 19% increase in investment income and a 7% increase in stock dividends. Interest accounts for about two third of investment income. It has $14.2 billion in fixed-maturity securities. Their pre-tax yield rose from 4.16% to 4.48% over the past year, aided by higher rates. With the portfolio yielding below prevailing interest rates, we should see a modest increase in investment yields over the course of the year, with a peak likely in late 2024/early 2025, assuming the Federal Reserve begins a rate-cutting cycle mid-year.
This fixed income portfolio provides CINF with the financial resources to cover insured losses with $2 billion of excess fixed income holdings relative to insured reserves. With this conversative portfolio covering its insured exposure, CINF also has $11 billion in equities, leaving it with total cash and investments of $26.26 billion. The parent company has $4.86 billion of cash and securities, with the remainder in the insurance entity. This is a fairly diverse portfolio, with Microsoft (MSFT) and Apple (AAPL) unsurprisingly among its biggest holdings. Unlike Berkshire, which makes concentrated investments and owns stand-alone business, CINF's portfolio is more S&P 500-like. Essentially, with CINF, investors own a profitable, well-run insurer with a broad-equity market exposure on top. Thanks to the strong equity market performance in 2022, it now has a $77.06 book value, which was up 14.7% from last year.
Cincinnati Financial
Looking forward, it was notable that the company is adjusting long-term targets, though this is not 2024 guidance specifically. Historically, CINF has targeted a 95-100% annual combined ratio. This target was conservative as since 2016, it has ranged from 94.3-96.1%. Reflecting this, it is now targeting to a 5-year ratio of 92-98%. That midpoint of 95% is the low-end of its previous target, but consistent with where results have been since 2016.
In essence, management has raised the bar to where it currently performs, rather than having an excessively conservative forecast. Despite raising its underwriting bar, it still targets 10-13% value creation (growth in book value, inclusive of dividends). Given the improved underwriting target, there was scope to raise this financial target, especially given the elevated interest rate environment, which is boosting investment income. Whereas management historically maintained some conservatism on its underwriting guidance, the implied investment returns now are conservative, likely to reflect the possibility the equity market performance moderates after such a large bull-run.
With the stock market already up ~6.5% year to date, that likely adds about $4 to CINF's book value vs 12/31, for a 5.2% increase. Assuming similar underwriting profits of about $250 million and investment income that should be about $1 billion, holding equities flat over the rest of the year, CINF's book value should rise a further ~$6-6.50/share, or 13%, the high-end of its target, in 2024. Of course, the stock market can move around a lot between now and year-end, moving book value up further or reducing it. Still, I view this 10-13% target as very attainable over the medium term, assuming 6+% equity returns, which is not an aggressive hurdle.
Based on this investment income and a combined ratio of about 95%, I expect CINF to earn about $6.50 in 2024, leaving shares at about 17.4x earnings. CINF's insurance operation and associated interest income has about $800-850 million in earnings power, and at 10x, that is worth $8-8.5 billion. Adding an $11 billion equity portfolio to that results in a consolidated value of about $19 billion. It has about $800 million in debt and $2 billion in fixed income securities beyond reserves, for a net value of $20-$20.5 billion, or $125-127 per share, as of year-end. With equities adding $4/share of further value year to date, fair value is closer to $130 at today's market level. With over 10% of upside, investors should stay long CINF.