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.

[ad#Google Adsense 336×280-IA]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).

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.

 Source: Simply Safe Dividends

Yes, Cincinnati Financial does have nearly $850 million in book debt, but the company’s debt maturity schedule is very favorable. Of the $786 million of outstanding long-term debt held at the end of 2015, none of it is due prior to 2028.

Additionally, should times get really tough, Cincinnati Financial has a $225 million revolving line of credit good through May 2019 that it can tap (only $35 million was borrowed from it at the end of 2015).

Not surprisingly, Cincinnati Financial maintains solid credit ratings from S&P (BBB+), Moody’s (A3), and Fitch (A).

Simply put, the company’s conservative balance sheet makes its dividend very secure, even when major catastrophe events occur.

In addition to its balance sheet, Cincinnati Financial’s approach to pricing risk adds strength to its dividend’s security.

Insurance companies live and die by managing risk. If insurers fail to price risk accordingly in their policies, they won’t be around for long. That doesn’t mean they can’t be great businesses, and Warren Buffett owns a number of insurers in his dividend portfolio.

Compared to some insurers, Cincinnati Financial’s underwriting process is relatively aggressive because it targets a combined ratio of 95% to 100%, which means that it expects its policies to be slightly profitable at best.

The combined ratio is the percentage of a company’s incurred losses plus all expenses per each earned premium dollar. When a combined ratio is below 100%, the company achieves an underwriting profit.

As seen below, Cincinnati Financial’s combined ratio has outperformed the industry in each of the past five years, suggesting management continues to do a superior job at managing risk.

Through the first nine months of 2016, Cincinnati Financial’s combined ratio is 94.4%. Management expects the company’s combined ratio to be 96% to 98% in the fourth quarter, including catastrophe losses.

Compared to 2011, when Cincinnati Financial’s combined ratio exceeded 109% (more on this later), the events of 2016 were a walk in the park!

Equally important, Cincinnati Financial maintains a reinsurance program that limits its losses beyond certain thresholds. This shields the business from major black swan events.

A final point that suggests Cincinnati Financial’s dividend is very secure involves a brief look at the company’s history.

Cincinnati Financial was hit with over $400 million in catastrophe losses in 2011 – nearly three times more than what the company is estimating for catastrophe losses in the fourth quarter of 2016.

The company was in a similar financial position compared to today as well. The business had $793 million of long-term debt ($827 million today) and $438 million of cash ($700 million today).

Cincinnati Financial managed to turn a profit in 2011 despite experiencing the two worst catastrophes in company history, and it went on to raise its dividend by 1.2% in August 2012.

Here’s what management said about 2011:

“When those catastrophes hit, we focused on providing our affected policyholders and agents with service and value that would support our relationships and long-term perspective on business. This approach over time has helped build the financial strength and resources to absorb $402 million of pre-tax catastrophe losses in 2011 and still end the year with exceptionally strong policyholder reserves and with balance sheets that are stronger than at year-end 2010.”

CINF’s stock declined by 25% through the first half of 2011, providing what turned out to be an excellent buying opportunity. The stock went on to triple through the end of 2016.

Great buying opportunities often arise when quality dividend stocks decline to attractive prices for reasons unrelated to their long-term futures.

Can Cincinnati Financial Increase Its Dividend?

[ad#Google Adsense 336×280-IA]While the company’s dividend remains very safe following the announced damages from catastrophe events last quarter, some investors are still wondering if dividend growth is possible.

I have no doubt that management will raise the dividend again this year, given everything we know today.

The company has increased its payout at the end of January in each of the last three years, and I expect a modest 1-2% increase to be announced in the coming weeks.

Management could delay the dividend increase to later in the year like in 2012 (the increase was announced in August), but that would surprise me given the relatively moderate extent of catastrophe damages in 2016 compared to that year.

The company’s historical dividend growth hasn’t been the fastest in the market, but it’s been enough to outpace inflation over time:

 Source: Simply Safe Dividends

Closing Thoughts on Cincinnati Financial

The latest wave of catastrophe events will impact near-term earnings but has no impact on Cincinnati Financial’s solvency or long-term outlook. The company’s strong financial position, access to lines of credit, and liquidity position it well to meet almost any unexpected obligations without jeopardizing the dividend. While dividend growth will remain low this year, I fully expect the company to extend its immaculate dividend growth streak.

Cincinnati Financial’s stock has pulled back on the news, but it still doesn’t look like a bargain trading at a forward P/E multiple in excess of 20. I would get more interested if investor sentiment continues to sour on the business, dragging the stock lower by another 10% or more. Until then, Cincinnati Financial will remain on the watch list for my Top 20 Dividend Stocks portfolio.

Brian Bollinger
Simply Safe Dividends

Simply Safe Dividends provides a monthly newsletter and a comprehensive, easy-to-use suite of online research tools to help dividend investors increase current income, make better investment decisions, and avoid risk. Whether you are looking to find safe dividend stocks for retirement, track your dividend portfolio’s income, or receive guidance on potential stocks to buy, Simply Safe Dividends has you covered. Our service is rooted in integrity and filled with objective analysis. We are your one-stop shop for safe dividend investing. Brian Bollinger, CPA, runs Simply Safe Dividends and previously worked as an equity research analyst at a multibillion-dollar investment firm. Check us out today, with your free 10-day trial (no credit card required).

Source: Simply Safe Dividends