Cincinnati Financial: A Potential COVID-19 Casualty

Summary

• If courts rule Cincinnati's business interruption policies must pay for the COVID-19 situation, the stock may have little value.
• Weakening trading momentum suggests a tough road may lie ahead for common equity investors.
• Listing the stock as an Avoid, Sell, or Short idea is a caution-based approach, measured against thousands of safer investment choices.

Cincinnati Financial (NASDAQ:CINF) is a diversified insurer, with a focus on commercial property & casualty coverage and policies. Cincinnati’s biggest operating dilemma is its potential exposure to billions in business interruption insurance claims from the COVID-19 business shutdown ordered by U.S. and state government agencies.

Image Source: Company Website

While the company does not have a specific exclusion for pandemics in its written policies, like some other issuers, management believes they can skirt major business interruption payouts as “property damage” or “loss to property” is a written requirement for policyholders. CEO Steven Johnston explained this rationale in the latest conference call with analysts. Nevertheless, investors are starting to believe judges and jury trials will classify a loss to property to include the lost use of property from government-mandated closure. With 63% of premiums from commercial and excess/surplus lines generally in 2019 (including 37% of premiums derived from basic commercial property & casualty policies), Cincinnati could have one of the biggest insurance company exposures to COVID-19 claims.

Page 109 of the 10-K lists a potential claims amount of roughly $1 billion on its regular property & casualty policies, given a once every 250-year catastrophe in a single city. On top of that, the company is involved in the reinsurance market. Page 30 of the 10-K describes potential losses of $180 million in a once every 250-year hurricane event from this unit, using standardized industry catastrophe models. I have personally explained the economic losses from the coronavirus as similar to a natural disaster like a hurricane, but on a scale of 10 or even 100 times, hitting cities all over the planet. Using this line of reasoning, if legal claims and arguments on business interruption fail for Cincinnati, the hit could be enormous.

Business interruption payouts will likely be litigated in the courts for years. Cincinnati will have to pay expensive legal costs upfront at a minimum, and perhaps even be forced to pay record amounts of capital and equity into 2021-22 if the coronavirus interruption is ruled an insured event. Interestingly, in the March 10-Q filing released last week, management added COVID-19-related risks to an expansive disclosure now including about 40 bullet lines in its Safe Harbor statement to investors explaining the unpredictable road ahead including potential write-downs and charge-offs from:

• Effects of the COVID-19 pandemic that could affect results for reasons such as:

◦ Securities market disruption or volatility and related effects such as decreased economic activity that affect the company’s investment portfolio and book value

◦ An unusually high level of claims in our insurance or reinsurance operations that increase litigation-related expenses

◦ An unusually high level of insurance losses, including risk of legislation or court decisions extending business interruption insurance to require coverage when there was no direct physical damage or loss to property

◦ Decreased premium revenue and cash flow from disruption to our distribution channel of independent agents, consumer self-isolation, travel limitations, business restrictions and decreased economic activity

◦ Inability of our workforce to perform necessary business functions

The good news is Cincinnati held strong credit ratings of A to A+ going into the coronavirus mess. Below are the major ratings on February 24, listed in the 10-K annual filing for fiscal 2019. The company was already holding $17.5 billion in investments and $6.1 billion in loss reserves for other expected claims before coronavirus issues at the end of March.

Image Source: Company 10-K Filing

Then COVID-19 showed up. Adding insult to the potential of major covered policy injury, bond and equity prices have tanked in 2020. The money needed to make covered payouts is dwindling, and fast. Cincinnati Financial reported a $1.7 billion quarterly investment loss for March (about 10% of investment assets), from the initial recessionary decline in Wall Street asset values. With just $8 billion in shareholders' equity remaining, a resumption of bear market trends in financial assets could combine with required policy payouts to dramatically impair company worth by the end of the year. At least that’s what the stock quote seems worried about.

Technical Breakdown On Friday

On the chart below, you can see the sharp downdraft in Cincinnati last week. On Friday, the stock reached a new 52-week low. At $61 a share, the equity capitalization is around $10 billion, slightly above its March book value of $8 billion. The mid-April peak around $85 a share in hindsight was a great area to sell or short the stock, coinciding with the green circle of the normalized Relative Strength Index (RSI) reading. All told, plenty of downside remains if the company is liable for billions or even tens of billions in business interruption claims.

The red arrow on the chart is pointing to the truly weak Negative Volume Index (NVI) indicator. Since early March, around $95 a share, few buyers have appeared on falling volume days. The lack of buyers on weakness is a standout condition vs. other S&P 500 companies that have recovered 30% in price from March lows. Corroborating the horrible NVI and price selling trend, the On Balance Volume (OBV) line marked with a blue arrow reversed from an uptrend to a severe downtrend in February. The past week has witnessed the sharpest OBV drop of 2020.

The slide in Cincinnati Financial shares during 2020 has pushed its performance into a badly lagging position vs. peer blue-chip insurance companies. Below I have drawn price charts between three months and one year of its worsening loss picture against the overall Financial Select SPDR ETF (XLF), Travelers (TRV), Chubb (CB), Allstate (ALL) and Berkshire Hathaway (BRK.A) (BRK.B). Cincinnati’s relative weakness may be screaming something is wrong.

Final Thoughts

Could the Cincinnati Financial stock price stabilize or reverse higher? Sure, if the virus does not come back later in the year and courts rule its business interruption insurance really isn’t business interruption insurance.

But things can always get worse on the coronavirus front. National testing shows just 5% of the U.S. population has antibodies to the virus, killing 65,000 individuals. In other words, 95% of America has yet to be infected or directly affected by its fury. I can logically and mathematically argue the reopening of our country in May will immediately lead to another large spike in viral activity, with new lock-downs and stay-at-home orders by June. A University of Pennsylvania study released Sunday estimates a 5-fold increase in deaths the next two months from reopening local businesses and relaxing distancing guidelines.

We do not have the testing capacity or will of society to contain and track the virus like the success stories in South Korea, Taiwan or Hong Kong. What if U.S. stock and bond markets collapse well beneath the March lows, and the Federal Reserve fails to stop a depression. I know it’s upsetting to think about. But we are in a war with an invisible enemy that doesn’t care where we’ve been in the fight. The CDC and NIH are warning of a new wave to come in the fall. What if the business interruption mess is just starting, and Cincinnati has to pay tens of thousands of claims up to the maximum dollar amount of each policy contract?

Warren Buffett explained a truly bearish take on the economy and COVID-19 effect on his businesses at the Berkshire annual meeting on Saturday. He stated $140 billion in cash may be needed to keep the company afloat, hinting at needed capital reserves for potential business interruption insurance and reinsurance claims. And he is considered one of the biggest bulls on America and U.S. stocks!

If you invested through the Great Recession in 2007-09, you understand financial stocks under the gun can fall all the way to zero, or close to it. Stocks that appeared to be safe investments during good times, turned into train wrecks when the economy soured. Cincinnati could be one of the highest risk investments in early May, if courts require business interruption claim payments later in the year.

If you decide to sell short securities, keep in mind a borrowed position involves a greater degree of risk than simple long purchases. An investor can lose more than initially invested, so high levels of diversification are recommended. A variety of longs and shorts held together in a hedged portfolio design is the best way to lower the risk any single position will ruin your performance. Don’t be afraid to limit your losses at 15-20% with a stop-loss order on your short trade.

Please consider this article a first step in your research process, if interested in selling or shorting Cincinnati Financial. As always, please consult with a registered and experienced investment advisor before making any trade.

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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in CINF over 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.

This writing is for informational purposes only. All opinions expressed herein are not investment recommendations, and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity and is not a registered investment advisor. The author recommends investors consult a qualified investment advisor before making any trade. This article is not an investment research report, but an opinion written at a point in time. The author's opinions expressed herein address only a small cross-section of data related to an investment in securities mentioned. Any analysis presented is based on incomplete information, and is limited in scope and accuracy. The information and data in this article are obtained from sources believed to be reliable, but their accuracy and completeness are not guaranteed. Any and all opinions, estimates, and conclusions are based on the author's best judgment at the time of publication, and are subject to change without notice. Past performance is no guarantee of future returns.

Comments

[Frank Risalvato]

Physical damage = physical damage. Period. If aliens land and circle the city of Indianapolis, placing it under siege, and none of your customers can enter your business, you don't need specific "alien siege exclusion" language. You still have your physical warehouse or store standing.

[reapwell]

@150emerson
If you believe "Mr. Market tells more to the story", than what did Mr. Market tell you on March 23, and what did Mr. Market tell you the 30+ days thereafter? The answer is an exuberance of behavior fueled by current suppositions directing cash flows. CINF is high quality, well capitalized, and a top Dividend King on the list. The Insurance Contract will speak for itself in the midst of all the fluff.

[150emerson]

The CEO can say whatever he wants to say and the lawyers can say the same thing BUT Mr. Market is telling you there is a lot more to the story than what the CINF lawyers say. The fact it is so underperforming other insurance stocks the last few weeks says there is a skunk under the porch.
Analysts have slashed their revenue forecasts and the short sellers are circling the wagons.

[aochamp]

@Paul Franke: Hey Paul, a heads-up for you: Pandemics are not covered under business interruption insurance policies since there is no direct PHYSICAL loss to the property.

[cplui]

Aloha Paul - I love your line "courts rule its business interruption insurance really isn’t business interruption insurance". If the courts rule in the insurance company's favor, isn't that deceptive practices? Comes to the point where you need to hire a lawyer to read the fine print of what is truly covered and not. In general, the reason why folks don't like insurance companies, no problem in taking your premiums but give you a hard time in paying out claims. Take care and stay safe!

[Art-V]

Thanks for writeup!

However why not mention Chubb in this context? . As looked through their transcript.

"Secondly, the insurance industry, for the most part, except for those customers who discreetly purchased it, BI insurance doesn’t cover COVID-19. It covers and requires direct physical loss to a property. And the regulators who’ve approved these forms, because we’re highly regulated, confirm that themselves that it’s not contemplated. Now, lawyers and the trial bar will attempt to torture the language on standard industry forms and try to prove something exists that actually doesn’t exist and try to twist the intent when the intent is very clear and the industry will fight this tooth and nail."

So they seem to follow similar contracts. Except they actually having those businesses paying up for the extra coverage. And there they have to pay claim of course. I would just assume premium paid would been much higher if such cover would be part of policy from beginning.

[Current$ea]

So here is what the CEO actually said on the earnings call about liability due to pandemic business disruption the earning call:

“Virtually, all of our commercial property policies do not provide coverage for business interruption claims unless there is direct physical damage or loss to property. Because the virus does not produce direct physical damage or loss to property, no coverage exists for this peril, rendering an exclusion unnecessary. For this reason, most of our standard market commercial property policies in states where we actively write business do not contain a specific exclusion for COVID-19. ”

There is also risk to explicit wording in contracts, e.g., when was it declared a pandemic, is the term “pandemic” a legal term or “term of art”.

[InsuranceShark]

Interesting; no virus exclusion what were they thinking? Even if they come out of this alive - Not good underwriters and wouldn't touch them. It's easy to grow an insurance or reinsurance company - anyone can do it. But grow it profitably with prudent underwriting, that's the value creation I'm looking for.

[ARG1]

Shark there was an exclusion of nonphysical damage which would exclude virus epidemic. Legally there would be no grounds to make a claim unless there was physical damage loss to property.