Recurring ROE (Return on Equity) is a summary measure of recurring profitability from all business activities. Recurring income excludes One Time Items and so Recurring ROE (Return on Equity) is more persistent than ROE (Return on Equity). Moreover if One Time Items are really transitory or at least substantially less persistent than Recurring Income, Recurring Return on Equity ROE may facilitate more precise predictions of future ROE (Return on Equity) than ROE (Return on Equity) itself. Accordingly the relationship between equity value and profitability should be stronger when profitability is measured using Recurring ROE (Return on Equity) instead of ROE (Return on Equity).
One Time Items which are removed from comprehensive income available to common share holders in measuring recurring income, generally include other comprehensive income extraordinary items, income from discontinued operations, impairment charges, asset write downs, restructuring charges, realized gains and losses, and other items which are deemed to be relatively transitory, net of related income taxes. For essentially all insurers, a primary source of transitory items is realized gains and losses on investments. For PC insurers a potentially large transitory item is also included in the losses and loss expenses. In addition to the current cost of coverage, losses and loss expenses include the adjustment to the previous year balance of the loss reserve. This correction is comparatively momentary because it reflects the impact of changes in estimates.
Recurring ROE (Return on Equity) is measured as follows:
The same arguments that motivate most analysts to exclude transitory items from earnings, lead some analysts to exclude AOCI (Accumulated Other Comprehensive Income) from book value when measuring ROE (Return on Equity) or the price to book ratio. For insurers, AOCI (Accumulated Other Comprehensive Income) often cause significant volatility in ROE (Return on Equity), similar to the effect of transitory earnings items on reported income. Still excluding AOCI (Accumulated Other Comprehensive Income) is problematic for the following reason. A primary motivation for the removal of transitory earnings from reported income is that they are optional, that is management might have deliberately engaged in the transactions that generated those items. Thus, excluding transitory earnings items provides a measure of non discretionary real earnings. In contrast removing AOCI (Accumulated Other Comprehensive Income) actually makes the resulting book value discretionary. For example selling a security with unrealized gains reduces AOCI (Accumulated Other Comprehensive Income) and increases ex-AOCI book value but does not change total book value.
Another more legitimate argument for the exclusion of AOCI (Accumulated Other Comprehensive Income) from book value is that excluding AOCI (Accumulated Other Comprehensive Income) mitigates distortions caused by the mixed attributes model historical cost and fair value currently used. Specifically most insurers’ investments are classified as available for sale and reported at reasonable value with unrealized gains and losses incorporated in AOCI (Accumulated Other Comprehensive Income). In contrast, the reserves liabilities that these investments are expected to settle are generally not marked to market. Because the values of investments and reserve liabilities are positively correlated, the inclusion of unrealized investment gains and losses in AOCI (Accumulated Other Comprehensive Income) causes an artificial volatility in book value.
One Time Items which are removed from comprehensive income available to common share holders in measuring recurring income, generally include other comprehensive income extraordinary items, income from discontinued operations, impairment charges, asset write downs, restructuring charges, realized gains and losses, and other items which are deemed to be relatively transitory, net of related income taxes. For essentially all insurers, a primary source of transitory items is realized gains and losses on investments. For PC insurers a potentially large transitory item is also included in the losses and loss expenses. In addition to the current cost of coverage, losses and loss expenses include the adjustment to the previous year balance of the loss reserve. This correction is comparatively momentary because it reflects the impact of changes in estimates.
Recurring ROE (Return on Equity) is measured as follows:
Another more legitimate argument for the exclusion of AOCI (Accumulated Other Comprehensive Income) from book value is that excluding AOCI (Accumulated Other Comprehensive Income) mitigates distortions caused by the mixed attributes model historical cost and fair value currently used. Specifically most insurers’ investments are classified as available for sale and reported at reasonable value with unrealized gains and losses incorporated in AOCI (Accumulated Other Comprehensive Income). In contrast, the reserves liabilities that these investments are expected to settle are generally not marked to market. Because the values of investments and reserve liabilities are positively correlated, the inclusion of unrealized investment gains and losses in AOCI (Accumulated Other Comprehensive Income) causes an artificial volatility in book value.