As seen below, Cincinnati Financial Corporation (NASDAQ:CINF) has also been effective at expanding its market share with agencies over time. CINF says that its net amount of agency relationships has increased by 28% since the end of 2009 and that it still only has about 11% market share of the estimated $39 billion total P&C premiums produced by currently appointed agencies, leaving plenty of room for future expansion of relationships.
Source: CINF Investor Presentation
In addition to effective distribution channels, the insurance market also requires strict compliance with regulations and substantial amounts of capital to compete. A large pool of policies and financial assets are needed for an insurer to be able to pay out claims and survive catastrophes, creating barriers to entry for new players.
While catastrophic events can strike at any time, some states are more prone to them than others. For example, California and Florida are frequently hit by earthquakes, hurricanes, and other natural disasters. One of the things we like about CINF is that it has no presence in California and a minimal presence in Florida. Most of its operations are in the Midwest, perhaps reducing its exposure to catastrophes.
Finally, the mature state of the P&C insurance market provides another advantage for CINF. When a market’s growth rate is low, new entrants have to steal market share from incumbents to gain a foothold. CINF’s policy renewal rate is between 80% and 90% most years, providing a solid base of recurring revenue that helps it keep its policy prices competitive and market share stable. Insurance is also a product that is always in demand regardless of economic cycles, which has helped CINF generate consistent results.
Key Risks
The insurance industry goes through pricing cycles, which significantly impacts its profitability. Insurance is essentially a commodity, so pricing follows supply and demand. Demand is generally stable given the non-discretionary nature of insurance, so supply is the main driver.
When insurers have a healthy pool of profits, strong capital reserves, and excess underwriting capacity, they are more apt to lower pricing to chase market share. This environment typically results from several years of minimal natural disasters and catastrophes.
After a period of catastrophes and tighter capital conditions, there is less underwriting capacity in the market as insurers look to improve their financial condition. These periods are marked by better profitability and more rational pricing. CINF must put up with this cyclicality and remain disciplined with its pricing of risk and balance sheet strength, regardless of market conditions.
Of course, unexpected catastrophes are the biggest risk faced by insurers. A “perfect storm” can wipe out smaller, less disciplined players completely. As we mentioned earlier, CINF is fairly well diversified with the states it does business in, avoids some of the riskier ones like California, and has a long operating history which adds to our confidence in its conservative underwriting process. Even still, record high catastrophe losses in 2011 caused CINF’s payout ratio to spike over 150% – you can never be too sure with insurers. A.M. Best also noted that 2013-2015 marks the first time since the early 1970s that the industry’s underwriting has been profitable in three consecutive calendar years – perhaps the next underwriting profit cycle is about to begin.
Underwriting aside, CINF does have more risk with its investment portfolio than many other insurers because it has around 30% of its portfolio in common stocks (most other insurers invest 10-20% of their portfolio in stocks). The portfolio is diversified (no stock is more than 3.6% of the portfolio) and invested in dividend growth stocks (all 50 stocks raised their dividend last year), but these investments are still more volatile than investment grade bonds.
Finally, it’s worth noting that while the insurance industry is generally slow to change, it is changing. Technology is leading to more advanced data models that are pricing risk more efficiently on a policy-by-policy basis, which will only result in more competition for accounts with the best risk profiles.
Furthermore, CINF is completely dependent on independent agencies to sell its insurance policies. According to the Independent Insurance Agents and Brokers of America, independent agencies write about 60% of overall U.S. property casualty insurance premiums today.
However, we expect more policies to be purchased online over the coming decade. Selling policies online can result in lower prices and greater profits for insurers because they do not need to pay commissions and can save labor costs as well.
Overall, CINF’s financial conservatism and long-standing customer and agency relationships help mitigate many of these concerns.
