Catastrophes such as hurricanes, tornados, and floods are never pleasant, and they can make or break insurance companies.
The year 2016 saw its fair share of disasters, including record-breaking snowfall throughout the East Coast in January, severe flooding in Louisiana, wildfires in California, and Hurricane Matthew.
Cincinnati Financial (CINF) is an insurer that has seen its fair share of disasters with an operating history stretching all the way back to 1950 (see my full thesis on the company here).
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However, investors were spooked last week when the company announced its preliminary estimate for fourth quarter catastrophe losses, which are expected to total roughly $135 million (almost half of the total amount of dividends Cincinnati Financial is expected to pay this year).
CINF’s stock fell over 6% on the news. Many dividend growth investors are wondering if Cincinnati Financial’s dividend remains safe and is able to continue growing in light of higher-than-expected catastrophe costs.
Companies cut their dividends for a number of reasons. Businesses usually slash their payouts because they have unexpectedly fallen on hard times (reducing their cash flow), have too much debt, and need to preserve cash to weather the storm.
Investors looking to learn more about dividend safety can review a table containing all of the dividend cuts from 2016 and why they happened by clicking here.
Insurance companies are unique in that their dividends can look safe until they suddenly are not. Major catastrophe events come with little to no warning and can rack up devastating losses that result in insolvency for some insurance providers.
If insurance companies fail to price risk appropriately, they can be left with insufficient reserves from which to pay claims. In fact, “under-reserving” and “mismanagement” are the two most frequently identified causes of insolvency.
Therefore, conservative income investors must be very careful if they decide to purchase shares of any insurance business. Larger, diversified insurance providers with long track records of managing risk conservatively are often the best bets.
That’s why Cincinnati Financial is a favorite pick for income investors. The company is a dividend aristocrat and a dividend king, signaling its consistent profitability. More impressively, only eight U.S. public companies can match or exceed its dividend growth streak of 56 years.
The company’s dependable dividend growth has been fueled by Cincinnati Financial’s conservatism. The business has enjoyed 27 years of favorable reserve development, meaning its realized losses were lower than its original estimates on the books.
Let’s take a closer look at Cincinnati Financial’s new catastrophe losses and if they could pose legitimate risk to the dividend.
Cincinnati Financial estimates $55 million of catastrophe losses from the wildfire in Gatlinburg, Tennessee, and $75 million to $85 million of catastrophe losses from Hurricane Matthew. Total losses will reach $130 million to $140 million.
Through the first nine months of 2016, Cincinnati Financial generated $386 million of operating income, easily covering the $229 million of dividend payments made during that time (a payout ratio of 59%).
Factoring in the $130 million to $140 million of catastrophe losses and another quarter’s worth of dividends, Cincinnati Financial’s payout ratio for 2016 will likely increase to more than 100%.
However, just because a payout ratio spikes above 100% doesn’t mean a dividend is in immediate danger.
Take a look at the chart below, which shows the company’s payout ratio based on net income (dark blue bars) and operating income (yellow bars) from 2002 through 2015.
You can see spikes above 100% in 2009 and 2011 for the payout ratio based on operating income. The company’s net income payout ratio also exceeded 100% in 2011.
During these lean years, Cincinnati Financial’s conservative balance sheet allowed it to continue paying and growing its dividend by using cash on hand and issuing debt and equity, if necessary.
Just like country singer Gary Allan’s hit song “Every Storm Runs Out of Rain,” the same is true with catastrophe events.
You can see from the chart above that Cincinnati Financial’s payout ratio has historically snapped back to sustainable levels after a rough year of catastrophe events.
But is Cincinnati Financial healthy enough today to get through the latest storm? I certainly think so.
Let’s start with the company’s balance sheet. As you can see below, Cincinnati Financial had $700 million of cash on hand entering the fourth quarter. That amount alone could cover the catastrophe event losses ($135 million) plus over a year’s worth of dividend payments.