HGIC Harleysville Grp. Inc. (MM)

We are downgrading our recommendation on the shares of Cincinnati Financial Corp. (CINF) to Underperform from Neutral following the wider-than-expected operating loss reported by the company in second quarter 2011 owing to huge catastrophe losses.

Moreover, the Commercial Lines segment will likely remain somewhat weak due to the sluggish economy, although the decline in business is moderating gradually.

The top-line growth at Cincinnati Financial has been slow for the past five years, with 5-year compounded annual growth rate of negative 0.7%. The decline was completely due to weak markets and economic pressures. The lingering effects of the soft insurance market pricing are expected to affect growth rates and earned premium levels in 2011 or perhaps later, depending on when insurance market conditions improve.

These conditions continue to weaken loss ratios and hamper near-term profitability. The Commercial Lines, which accounted for 73% of 2010 net written premiums, is still experiencing a very strong competition in the market, along with pricing decline in low single digits and reduced insured exposure levels that include negative effects on audit premium.

However, net written premiums dropped 26 million or 1% in 2010, which is quite an improvement from the 6% decline in 2009. We expect the segment to remain somewhat weak until the fragile economy strengthens significantly.

Investment income is an important component of Cincinnati Financial’s revenues and net income. The company has experienced investment portfolio problems owing to equity investments, which formed a significant portion of its investment portfolio.

Though the portfolio has been diversified to reduce equity concentration (26.4% of the total portfolio as of December 31, 2010), it is equity-heavy relative to its peers, thus imparting equity-market-related volatility. Moreover, low yield for investment options is expected to continue, thereby limiting any investment income growth.

Though Cincinnati has undertaken several growth initiatives (new agency appointments and entering new states, technology investments, etc), these measures are yet to reach their full contribution to earnings. Thus, the company might not see advantages of these investments for several years.

Cincinnati’s geographic concentration ties its performance to business, economic, environmental and regulatory conditions in certain states. Although the company markets its property casualty insurance products in 37 states, its business is significantly concentrated in the Midwest region, which is susceptible to catastrophes. As such, the company’s operations are vulnerable to catastrophe losses, imparting volatility to earnings.

In its other business segments – Personal, Excess and Surplus, and Life business– Cincinnati is seeing moderating trends. Its homeowners line within the Personal Line segment is witnessing an improvement in new business levels and strong retention levels, as well as rate increases.

The Personal auto lines is also witnessing high retention, along with rate hikes albeit in low single digits. The company’s investments in pricing precision and technology are positively impacting the personal lines segments, thus helping to produce an improved loss ratio as well as premium growth in that area. Going forward, with an improvement in the personal insurance market, the company will see increased premium growth.

Cincinnati’s Life Insurance earned premiums also grew in the second quarter as did profit. The Life Insurance segment remains an important contributor to operating results and helps compensate the variable results from the company’s property and casualty operations.

Cincinnati’s Excess and Surplus lines is also performing well. Despite a soft market environment, the segment has been able to achieve rate increases for nine consecutive months.

Strong capital levels, consistent dividend increases, and stable share buybacks, will hold earnings in the near term. However, we believe that the top-line growth will remain suppressed as the slow economic recovery continue to limit a larger base of insured exposures, causing lower premium growth.

Cincinnati is carrying a Zacks #5 Rank, indicating downward pressure on the shares over the near term. It competes with Harleysville Group Inc. (HGIC )  and Selective Insurance Group Inc. (SIGI ) , both of which have significant market presence in Midwestern United States.

 
CINCINNATI FINL (CINF): Free Stock Analysis Report
 
HARLEYSVILLE GP (HGIC): Free Stock Analysis Report
 
SELECT INS GRP (SIGI): Free Stock Analysis Report
 
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