Cincinnati Financial Corporation (NASDAQ:CINF)
Presentation at Nasdaq OMX 29th Investor Program
December 4, 2012 9:40 a.m. ET
Steven Johnston - President and CEO
Michael Sewell - CFO
Thanks to all of you for joining us today. We really appreciate your presence. We’re going to start with an overview of Cincinnati. The first thing we need to do, though, is cover the nondisclosure statement. Here it is. And we’re just letting you know that there could be some forward looking statements in our presentation, and we would invite you to also look to our website and our filed documents with the SEC for further details.
In terms of an overview, Cincinnati Financial was the 25th largest U.S. property and casualty insurance company. We are strong finally, rated A+ by A.M. Best. We also have a record of increasing our dividend for 52 years in a row. So not only have we paid a dividend, but we’ve increased that dividend each and every year for 52 straight years. That’s matched by only nine other publicly traded companies that we can find in the United States.
The dividend is yielding about 4%, and to put that in perspective the average dividend yield for the S&P 500 is about 2%. In the S&P 1500, there are 27 insurance companies, and the average of those 27 is 1.2%. We all know what the 10-year Treasury is at less than 2%. And the BofA Merrill Lynch Bond Index is at 3%. So our 4%, on a relative basis, is strong and I think probably even more attractive to investors is the consistency of the increases that we’ve had for the last 52 years.
We write $3.2 billion in net written premium. We’re on track on a direct basis to increase that to $5 billion. That’s our goal, $5 billion, in direct written premium for all of our lines, including life insurance, by 2015. We ended the year 2011 at $3.5 billion in direct written premium, so it’s about a 9% CAGR, and we are on target this far.
If you look at how the business is split, we write about 69% in commercial lines, another 24% in personal lines, 5% in life, and 2% in excess and surplus lines. A large part of that - and when you hear the Cincinnati story, you’ll hear it today - is our strong relationship with independent agents. An in fact, if we’ve been in an agency for five years or more, we’re number one or number two in that agency nearly 75% of the time. And that is very unique in our business.
We’re very much, at Cincinnati, focused on creating shareholder value. Our primary financial metric is the value creation ratio. And that is basically the growth in book value plus dividends. We know in our industry that stock price follows book value growth, and so we really focus on growing our book value.
There are three drivers we think, towards hitting our goal of 12-15% over the period of 2010 to 2014. And the three drivers are, one, our combined ratio. And that has to be clearly under 100%. We target for 95%. So underwriting is a big driver of creating value. Another one is our premium growth. We want to be above the industry. So far this year, we’re at 13%, and again targeting $5 billion by 2015 in direct written premium.
Investments is a very important part of the Cincinnati strategy, and you’ll hear about that more from Mike. But we invest about 26% of our portfolio in equities that pay dividends and also have a propensity to increase dividends. So the investment contribution is big. We’re up 1% so far year to date 2012, and that has been helped in a low interest environment by our equities paying and increasing their dividends. In fact, in the third quarter, the stocks that we owned increased their dividend by 17%. So those are the three drivers of creating value.
So how have we been doing? We feel that we’ve been a good long term value creator for shareholders. This slide shows several purchase dates through November 27, 2012. So just before we left home. The three bars here represented, the blue bar, Cincinnati Financial, the yellow bar, the S&P 500, and the green bar, S&P’s index of P&C stocks.
So this first set of bars here shows what we’ve done so far this year. For a purchase at year end 2011, and holding to November 27, our total shareholder return, which would include reinvestment of dividends, is up 36%. That’s versus 13.8% for the S&P 500 and 19% for S&P’s index of P&C stocks. So you can see we’ve clearly outperformed this year.
If we go back a year further, to year end 2010, you can see likewise we’re up 38%, more than double both of the indexes. Go back another year to 2009, we’re up 76.1%, again far outpacing both indexes in terms of a purchase at year end ’09 and holding until November 27.
If we go back to 2008, I didn’t want to show a clean sweeps, so at one point we were actually in second place here, but we had a strong week last week, and we’re actually outperforming both indexes from a purchase date of 2008.
And if we go longer term, go back 10 years, almost 11 years now, to a purchase date of December 31, 2001, we’re up 76.8%, outperforming both indexes. And if we go back 15 years, nearly 16 now, we’re up 243.8%, so investors have more than tripled their money in Cincinnati Financial over that period of time.
Now, the reason we put this slide up is you can see if you’re up 76.8% for a purchase date at the end of ’01, and 76.1% at the end of ’09, there wasn’t a whole lot going on during that time period. We all know that. But we like to look at things on a relative basis, and show our relative performance to other choices that investors have. And we feel our business model has produced strong shareholder value over both the short term and the long term.
Our strategy, as we mentioned, is very much an independent agency strategy. Independent agents represent several companies, not just Cincinnati, and we were formed by four independent agents back in 1951, so our roots with independent agents go deep. They’re at the center of everything that we do. We tell our customers that we are founded by agents to serve agents.
So we try to select the best independent agents. And it’s a limited number. They have a franchise value at Cincinnati. We only have appointed 1,401 independent agencies. That is a relatively small number.
And another important part of the business model is we put our people out in the field, working out of their homes, living in the communities with the independent agents. So they can go out and see the risks, participate in that binding of the coverage with the agents, and really understand what’s going on at the local level.
We also put our claims people out there, and we have a great reputation for excellent claim service. We recognize how important that is to our independent agency customers, to have excellent claims representation.
Also, our financial strength is quite strong. Our premium surplus ratio is 0.9 to 1. We had an additional $1.2 billion in cash and marketable securities at our holding company. So we have about $5.3 billion in cap equity supporting just about $3.2 billion in net written premium.
So that’s our business model, appoint just the very best independent agents, put our field people out there, working out of their homes, with the ability and the authority to make decisions, back it up with great claims service, and back it up with great financial strength. It’s worked good through every cycle since 1951, and we’re confident it will work well for the next 60 years as well.
In terms of how that’s played out, we got our start in Cincinnati, Ohio, in the Ohio area. This map shows our market share. You can see the green states would be where we’re 1% and higher. Now, only the states of Ohio and Indiana are actually higher than 2%. We’ve got 4.7% share in Ohio, and 2.7% share in Indiana. So all the rest of the green states are just between 1% and 2% share. The blue states, less than 1% share. So you can see that we have an awful lot of room to grow right in our existing territories.
Again, we have 1,401 agencies in these 39 states, and we support those with 130 territories, or 130 marketing representatives such. So they only average, each of our marketing representatives, about 11 agents each, which gives them plenty of time to visit the agents and go out and help write coverage.
Continuing to improve profitability is very important to us. Mike will show you more of the details of our profitability improvement, but in terms of what we’re doing to continue to improve profitability, we have three listed here. One would be predictive modeling. This is giving us a much more granular approach to pricing, much more accurate approach, that we can get an increase in our prices as well as make sure that we get each policy priced accurately. It also puts us in a position to monitor how we’ve done with our pricing, and to show the improvement that we’re making in our pricing.
Technology is another way that we’re improving, putting out more automated systems so that it’s easier to do business with the Cincinnati Insurance Company. That leads to growth. It also makes us more efficient, such that we can decrease staff overall. In fact, we’ve decreased our staff by 4% since 2009, but at the same time, put more people out in the field with the customers, so we’ve increased our field force by 4% over that same period of time.
We’re also concentrating on problem lines. Workers compensation would be a great example of that. Back in 2009 we very much lagged the industry in terms of our workers compensation performance. We joined together with a very well-diversified effort within the company. Every area contributed, from pricing, to underwriting, to sales, to loss control, to claims. Everyone jumped in, and we’ve actually moved from where we were a laggard to where we are ahead of the industry. And in fact, over the last seven quarters, we’re a good 30 points better than where we were back in 2010, in a profitable area. Very tough line.
Property has become more tough of late, so we’re taking the same techniques that we used to improve our workers compensation results, and we’re applying them to property. Premium growth is also very important. Here we show three of our initiatives to improve our premium growth. New agency appointments, we had 130 as a target in 2011 and actually appointed 133. So this is allowing us to grow our agency for us. And I’ll talk a little bit more about that on the next slide.
Expansion of our marketing capabilities is another area. We’ve established something that we call target markets. We’ve been a generalist through most of our history, but we’ve found with certain markets, we’ve done better than in others. So we’ve put together a good marketing program.
One example would be dentists. We’ve a good job of marketing to and insuring dentists, so we have a dentist program such that I think a big benefit would be a new producer in an agency who knows they like Cincinnati insurance, but doesn’t know exactly how to get started. We can help them get started with, say, dentists. Small colleges would be another example of one of our target markets.
We’re also growing in terms of not only the agencies that we appoint, but the operating territories. And just since 2008 we’ve entered the states of Texas, Colorado, Wyoming, Connecticut, and Oregon. We’ve expanded the number of states that we write personal lines in to seven additional states.
Also, we started up an excess and surplus lines company back in 2008. We’ve got a very unique business model there, where we have formed our own wholesaler. We call it C Super. Most of the time in the excess and surplus lines world the way it works is the excess and surplus lines carrier works with an external wholesaler, an agent, and then the end policyholder. We’re able, by having our own wholesaler, to focus just on the agents that represent Cincinnati, and I think it gives us the competitive advantage in that space.
And we’re on target to hit over $100 million in premium this year. Last year our excess and surplus lines ended the year with a combined ratio of 92.2. So just another way that we can get closer to our agents in terms of our growth strategy.
This is my final slide before I turn it over to Mike. And this shows the impact of the growth strategy. As we appoint independent agents - and I mentioned before, we become number one or number two for those agents who we’ve been in their office for five years or more - we tend to gain share at about 1% per year. Since 2008, the new agents that we have appointed in total - not with us, but in total - have written about $10 billion.
So you can see, if we can keep this same trend moving upward from $1.2 to $4.3, about 1% a year, as we appoint a book of new agencies, you can see why we’re confident about the growth, confident about hitting that $5 billion target by 2015. Profit is number one, growth is also very important to us.
So we have a good, profitable growth strategy. Again, it’s an independent agency strategy that’s worked well, that’s created value, as we showed on the stock slide, and we’re very confident in it.
And with that, I’d like to turn it over to Mr. Mike Sewell, our CFO, to cover the financial presentation. Let’s give Mike a hand.
Thank you, Steve. I’ll start off by reviewing the favorable trends in the property casualty underwriting results, and then cover investments and other financial areas.
Our combined ratio for the first nine months of 2012 reflects a steady pace of improvement, particularly before the effects of catastrophes. This slide shows a nice improvement of that trend that we believe is due in part to the initiatives such as the pricing precision efforts Steve just described to you, and we expect continued improvement.
Another important consideration is quality of earnings and balance sheet strength. Our approach to establishing loss reserves is very consistent, resulting in 23 consecutive years of reserve development that has been positive. That track record indicates that you should have confidence that our improved combined ratio is not being driven by releasing reserves prematurely.
Our use of reinsurance also strikes a prudent balance between maintaining strong capital and maximizing earnings over the long term. Profitability, growing our property casualty and life insurance segments, along with the steady contribution of our investment operation, are working together to grow our earnings and book value.
I’ll highlight investments next. First we are quite satisfied that we’ve been able to grow the investment income given the ongoing pressure of the bond portfolio yields. Rising dividend rates on common stocks and strong cash flow have driven that growth.
Net cash flow from operations is much improved from a year ago, reflecting our premium growth initiatives plus lower catastrophe losses, helping to fuel our investment portfolio. It’s on pace to exceed the level of net cash flow for 2010, and has already exceeded the full year of 2011 and through the first nine months of this year cash flow from operating activities has been $433 million.
Unrealized gains in our $12.5 billion investment portfolio have risen 29% in the first nine months of 2012 to $1.2 billion. Our portfolio reflects the principles of quality and diversification. Bonds represent nearly 3/4 of the total portfolio.
At September 30, 2012, their fair value exceeds total insurance reserves by 36%. The bond portfolio has a generally laddered maturity structure and no single corporate or municipal bond exposure exceeded 0.7% of that portfolio. 96% of the portfolio is fair value bonds are rated investment grade, with an average rating of A. Nearly three quarters of the year end municipal portfolio was insured, and 95% of those insured have underlying ratings of A- or higher.
What sets us apart from most reinsurers with respect to our investment approach is our allocation of roughly 25% of our portfolio in equity securities, consistent with our focus of creating value through the book value growth. The structure of our portfolio also provides some hedging benefits that should inflation rates increase relative to portfolios, more relatively weighted in bonds.
We actively manage our equity portfolio and seek dividend paying stocks with good growth prospects. At September 30, the two sectors with the biggest percentage point variation from the S&P 500 index were in an overweight position in the industrials, and in an underweight position in financial services. There are about 50 names in our common stock portfolio. Pepsico was our largest holding at September 30, at 4.4% of the common stock portfolio, and 1.1% of the total investment portfolio.
Steve mentioned the drivers of the value creation ratio, and I’ll highlight a few key items. The tan and orange colored bars represent the investment portfolio gains. And you can see that they were a drag on the ratio in 2007 and 2008, and then boosted the ratio as markets rebounded since then.
Over the long term, we think our equity portfolio is in an important contribution to the VCR. The average for the VCR during 2009 and 2011 was within our target range, and for 2012 we’re on track also, based on the first three quarters. Through the first three quarters, we’re at 10.1%, and we would expect our fourth quarter, which is typically our best quarter of the year, will put us into that range.
The black line represents total shareholder return for Cin Fin stock, including the benefits of both stock price changes and dividends. Over the long term, the VCR and total shareholder return are highly correlated. We pay a lot of attention to these measures, and their related performance drivers. Management incentive plans include the value creation ratio and the total shareholder return as performance measures. So our interests are aligned with shareholders. As we execute our strategic plan, we see great opportunity for the company and its shareholders.
To conclude, there are several reasons to invest in Cincinnati Financial. We have a history of successfully growing our business with a clear strategy for improving underwriting results, increasing earnings and book value over the long term. Steve explained how our strategy includes specific initiatives for improving profitability while driving premium growth.
Our record for increasing shareholder dividends is outstanding, reflecting the long term view we take on managing our business and the current dividend yield of 4% is very attractive. Our capital also remains very strong, and you can see the quality of our balance sheet. Management at Cincinnati Financial is confident about the future prospects of the company, and how that will create value for its shareholders.
So with that, I think Steve and I are prepared to take some questions.
Unidentified Audience Member
Could you talk about the trend in pricing, and maybe give us a little bit more detail about pricing precision?
Excellent question. We are seeing an increase in the pricing trend. We had gone through a soft market, where rates were going down. Starting with the third quarter last year, we started to achieve rate increases. And for each quarter since then, we have gotten just a little bit more in terms of our rate increase. And right now we’re getting overall mid single digit rate increases.
In terms of by line, workers compensation, at the low double digits, and property, at the high single digits, are leading the way in terms of the lines where we’re getting rate. But we’re also getting small single digit type rate increases in the casualty lines.
I think in terms of the segmentation, that’s very important, and I think key to the question. In past hard markets we’ve seen kind of a rising tide lifts all ships type of result, where every policy would get a rate increase. I think with the pricing precision now, there’s much more of a distribution around the rate increases, with some getting more than others. But when we average them all up, we are getting mid single digit rate increases, and we feel that’s ahead of our loss cost trend.
Unidentified Audience Member
So pricing position is just about differentiating between lines, then. Surely there’s some color about what kind of techniques, or what kind of processes you’re using.
Sure. And it is not just about line. We have rolled out predictive models in all of our lines, but it is very much a policy by policy basis, where we have many more rating variables than we would have had in the past. Take, for example, commercial automobile, where when I was starting out in the business, as a commercial auto underwriter, you had three basic rate levels. And the base class was light local service. So the rating classes had to do with the weight of the vehicle, the radius of operation, and what type of business it was.
Now we have some 23 rating variables, now that we have more data, better computing power, where we’ll pull from our own experience, loss experience, industry experience, credit experience, demographic data, build a model with 23 variables that utilizes generalized linear modeling and accounts for correlation and interaction between the rating variables. It’s much more sophisticated. So we are not a class underwriter. It’s very much on a policy by policy basis.
Unidentified Audience Member
You have increased the dividend for 52 consecutive years, which is quite amazing. But what about share buyback? Is that an area you…
We do do share buybacks. It’s part of our capital management strategy. We do put more emphasis on the dividend payment. That is where we have more of our capital management strategy headed, toward the dividend. But we have been repurchasers of our shares over time. It’s just to a lesser magnitude than the dividend.
Unidentified Audience Member
But you might change that in the future, in particular if the tax reform, as we have heard so far, could impact dividend tax going up from 15% to 40-45%.
And we will keep an eye on that. But we also want to consider, being a long dividend payer, we have paid dividends through a variety of different cycles of tax regimes. And we feel that it’s worked well in all tax regimes. And I think the rates that we focus on - and certainly I focus on - are the individual tax rates.
But also, keep in mind that a lot of investors are pension funds that don’t have the tax requirements. There are other funds that do not focus as much on the tax. So we’ll keep a close eye on it, but we feel confident in our dividend strategy through all types of cycles.
Other questions? We got two good ones to start out with.
Unidentified Audience Member
Talking about your investment portfolio, as you’ve said it’s unusual to have such a high weighting in equities. It seems extremely sensible given the environment we’re in. But you are unusual in that respect. Is there any regulatory limit to the amount of equities you can have in your portfolio? What sort of leeway do you have there?
Not only do we have the states to worry about, but of course the rating agencies. And we have 25% of our portfolio currently in equities. We do not have any current issues. If we were to grow that to, let’s say, 50%, we would have a little bit more of an issue. It’s been very nice having the investment portfolio that we do have with the lift that we have been getting in unrealized gains on the equity portfolio. Right now it’s about $1 billion in unrealized gains.
And we are investing in companies that typically, like us, have been increasing dividends over the course of time. And so where a lot of insurance companies are seeing investment income being very challenged, and maybe going down, we are losing rate like everyone else on fixed maturities, but with our investment portfolio and our equities, increasing the dividends. That has been a nice, if you will, cushion, or an offset, to decreasing interest rates. With the additional cash flow from operating activities and reinvesting that money, we’ve been actually able to grow investment income. And for the first nine months of this year, we’ve grown investment income 1%.
And I would add to that too, to also consider the financial strength of the company with the $5.3 billion in GAAP equity supporting just $3.2 billion in writings. And we do have, within our investment policy statement, a constraint that the bond portfolio will always be larger than our insurance liabilities. And I believe right now we’re comfortably above that at about 1.3x. so what we are investing in equities is up above 1.3x insurance reserves in bonds.
Good questions, but we have this clock up here that’s showing five seconds. So it would have to be a quick question, I think to take another one. But we have one at the buzzer! [laughter]
Unidentified Audience Member
I was just going to ask about the level of sovereign debt you have in your fixed income portfolio to corporate bonds.
The sovereign debt is next to nothing. We have very little to none. I think we’ve got 0.6 or something like that. It’s a very small percentage in sovereign debt. Very conservative, high-grade corporate bonds for the most part.
Well, excellent questions, and we thank you very much for your time.
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