Now that the Royal Commission has ruled out fraud and embezzlement in the case of HIH, Nigel Allen examines what is left.

On 1 May this year, the US Department of Justice announced expanded charges of fraud and other criminal offences against Enron Chief Financial Officer Andrew Fastow, his wife and seven former Enron employees. Fastow was originally indicted for 78 counts of wire fraud, money laundering and conspiracy in October 2002, to which he has pleaded not guilty.

That the collapse of Enron appears largely founded on fraud is in many ways reassuring. Fraud, while wholly unacceptable, is nevertheless comprehendible, as according to the Collins Dictionary definition, it is "deliberate deception or cheating intending to gain an advantage". However, when the Royal Commission into the demise of the HIH Insurance Group stated, "HIH is not a case where wholesale fraud or embezzlement abounded", understanding the factors which culminated in the group being placed into provisional liquidation on 15 March 2001 becomes a much more tortuous affair.

HIH was the second largest general insurance company in Australia. On 27 August 2001, 25 of the 26 HIH group companies were placed into liquidation under the Corporations Act. While no exact figures are available as to the deficiency of the group (liquidator Tony McGrath is expected to announce the final figure towards the end of June), it has been estimated at between A$3.6bn and A$5.3bn. Almost one million policyholders with approximately two million policies have been affected. As of 28 February 2003, the Australian government has paid out over A$195m to policyholders through the HIH Claims Support Scheme, a government-funded body established in the immediate aftermath of the collapse with an allocated fund of A$640m. Creditors of HIH have been informed that they can expect to receive as little as 10c in the dollar, and payments may not be made until 2010.

The source of the rot
Fraud and embezzlement did not clog the arteries of HIH's financial heart, mainly because there was little real blood flow at all. A combination of poor risk pricing and substantial under-reserving, according to Royal Commissioner, Justice Neville Owen, meant that, "in the main the money was never there".

In purely practical terms, the demise of HIH was founded upon four ill-fated decisions: to re-enter the Californian workers compensation market through the re-acquisition of CareAmerica, formerly Heath Cal, an HIH-owned company previously sold to UniHealth America; to expand the UK operations into 'uncharted territory' including film financing and marine reinsurance; to acquire FAI Insurances Ltd without proper due diligence; and to implement 'Project KTB' resulting in the sale into a joint venture with Allianz Australia Ltd of HIH's most profitable lines of business. However, while trading losses were clearly catastrophic - the UK debacle alone resulted in losses totalling some A$1.7bn - the core of the problem lay in extreme mismanagement.

From Winterthur to liquidation
A prime example of the myriad cases of mismanagement is the Winterthur/HIH merger, which provides a backdrop to the events that led to HIH's downfall, and offers an insight into the corporate and management failings that plagued the group.

On 6 April 1992, HIH gained a listing on the Australian Stock Exchange as a means of acquiring new capital, but with limited success. The following year, broker CE Heath, a 44% shareholder in HIH, started to reduce its shareholding and a successor owner was sought. Negotiations were entered into with Winterthur and its subsidiary CIC. In April 1995, CIC commissioned Ernst & Young to carry out due diligence on HIH. The findings of the report revealed serious under-reserving to the tune of A$60m and also questioned the group's actuarial processes. These findings were rejected by David Slee, HIH's consulting actuary.

A central figure in negotiating the sale of CE Heath's shareholding was Raymond Williams, one of its directors. That he was also a director, Chief Executive and major shareholder of HIH did not appear to worry him. Conflict of interest was a common complaint in the history of HIH, but an ailment rarely addressed. In December 1995, following a request by Winterthur that its shareholding be increased by 2% to 51% by that year's end, which Williams claimed was to enable consolidation of the Winterthur and HIH results, he sold them six million of his own HIH shares at a much higher price than that negotiated for the sale of CE Heath's shareholding. The sale was carried out with approval from neither board nor shareholders being sought. Williams was beholden to no one.

Following the merger, Winterthur set about addressing the deficiencies revealed by the initial due diligence report into HIH and subsequent audit reports. Winterthur, while owning 51% of the HIH shares, did not seek a majority position on the HIH board, allowing Williams and his retinue to retain control. What they discovered was, "a closely knit and related club where one is either part of it or 'out'". Any attempts to alter or rearrange this 'club' structure were rebuffed. Despite its position as the main shareholder, Winterthur had little influence over company matters and little or no impact on procedures or strategy.

The use of the word 'strategy' is fairly dubious in the HIH context; according to the Commissioner, HIH's movements were rarely directed by any form of company strategy. While Williams stated that HIH operated a strategy based on "seeking greater exposure to the more profitable domestic personal lines and also some diversification offshore", this approach was never documented and is one which board members were not made aware of. Owen describes the expansion of HIH as "opportunistic and lacking in direction".

Winterthur was led to believe that further growth of HIH would be limited to Australia, a belief stemming from a fax received by Winterthur in May 1995 entitled "Gentlemen's Agreement with Raymond Williams". However, the ink on the agreement had barely dried before Williams was seeking to expand HIH's UK operations.

Winterthur raised immediate concerns about the decision and in May 1996 initiated a strategic review of all of HIH's overseas activities. The branch expanded into sectors in which the underwriters had limited experience, resulting in transactions such as providing an Israeli insurer with motor vehicle physical damage cover which lacked any terrorism exclusions. The financial impact of the UK failures was devastating, but an inadequate reporting structure allowing uncontrolled underwriting, and a lack of any meaningful supervision by those in Australia, hampered by an ineffective accounting system and poor provision of information, meant that the activities went unchecked. When the financial deficiencies did come to light, HIH directors failed to respond effectively.

The decision to re-enter the US market through the re-acquisition of CareAmerica further exacerbated Winterthur's concerns, but once again, HIH ignored the protestations of its major shareholder. On 13 December 1996, following minimal due diligence and no thorough actuarial analysis, the HIH board gave the go-ahead. To make matters worse, despite not having assessed the company's reserves, HIH did not insist on a reserve indemnity.

For two years prior to placing HIH America (which also included Great States Insurance Co) into run-off in October 2000, the board had been aware of the financial shortcomings of the US operations. The deficit was due largely to claims arising which had been severely underestimated. Once again, the board failed to take any steps to rectify the problem. The move resulted in a loss of over A$600m, a failure which Owen said resulted from three factors:

  • l inadequate assessment of the pros and cons of re-entering the Californian workers compensation market;
  • inadequate action by the boards of the subsidiaries and of HIH when losses began to emerge; and
  • the boards' failure to recognise and disclose the losses when they occurred.
  • The takeover of FAI took place towards the end of the Winterthur/HIH merger in 1998. Perceived as a means of counterbalancing long-tail lines by increasing the amount of short-tail business, it proved another costly decision from the very beginning, with HIH paying well over the odds for the company, and resulted in an overall loss of approximately A$530m. Unsurprisingly, HIH yet again failed to carry out sufficient due diligence and accounts reviews, and did not uncover FAI's massive under-reserving.

    Rodney Adler, Chief Executive of FAI, stopped HIH from carrying out due diligence. He was fully aware of the shortcomings in its reserves, but did not disclose this information to the board, based on the fact that a reinsurance arrangement was in the pipeline which he believed would rectify the situation. The resulting transaction was, in fact, a sham, with no actual risk transfer taking place. However, FAI was now in a position to report an A$8m pre-tax profit, dramatically improving the company's appeal to HIH. It is ironic that Adler's exploitation of reinsurance to conceal the financial reality of the situation - a clear factor in HIH's decision to purchase - was a ploy later employed by HIH to massage its figures.

    Winterthur finally threw in the towel and sought to sell its shares in 1998. Unable to blind itself any longer to its financial plight - despite the best efforts of management's aggressive accounting practices, misuse of reinsurance structures and restriction of information flows to conceal the fact - HIH tabled a number of restructuring proposals. In September 2000, the group entered into a joint venture with Allianz Australia Ltd, which included the sale of its retail insurance business, the most profitable lines. Proposed amendments to insurance licensing regulations influenced the deal. If enacted, the amendments would require HIH to convert the majority of its intangible assets (which totalled almost half of the group's total net assets) into tangible assets, something which the joint venture would facilitate. The agreement also called for the establishment of a claims reserve trust, requiring HIH to contribute a A$500m lump sum to cover its current claims liabilities.

    Had either board or management considered the repercussions of this move, the venture would never have been considered. HIH could ill afford to be denied access to its most profitable lines of business until the completion of an initial actuarial report and was certainly in no position to stump up A$500m. The venture came into effect on 1 January 2001 and just over two months later HIH went into provisional liquidation.

    It is impossible to detail all of HIH's failings without reproducing the 1,500-page Royal Commission in full, but in a nutshell, the group was dominated by Williams and heavily influenced by senior management. The board was malleable, apathetic and self-serving, while the Chairman, Geoffrey Cohen, was ineffectual. He consistently failed to deal with issues of conflict of interest, did not react appropriately to concerns raised by directors, and was subservient to Williams. The interests of shareholders were rarely taken into consideration. Aggressive accounting strategies were employed by management to create an impression of economic stability that did not exist, coupled with an almost blanket ban on the dissemination of financial information, even to board members. In fact, so successful was this policy that the Australian Prudential Regulatory Authority (APRA) was almost caught with its pants down when HIH collapsed. Serious questions have since been raised about APRA's mishandling of the HIH affair and its failure to respond to numerous warning signs.

    Finger-pointing exercise?
    The Royal Commission was also charged with ascertaining whether any of the actions taken by HIH, its directors, officers, auditors or advisors constituted a breach of the Corporations Law and the Crimes Act (NSW) and if so, whether they warranted further investigation by the relevant authorities, the Australian Securities and Investments Commission (ASIC) or the New South Wales Director of Public Prosecutions. A total of 56 possible breaches were highlighted and the Commissioner recommended the commencement of criminal investigations into the activities of Bill Howard, General Manager of Finance for HIH, Rodney Adler, Chief Executive of FAI, and Daniel Wilkie, Chief Operating Officer of FAI. No criminal proceedings are to be brought against Williams, although recommendations have been made to the ASIC to investigate eight possible cases for civil action.

    While this may seem like small potatoes when considered in the context of the consequences of their actions, the impact of the HIH collapse is much greater than the sum of its parts. Just as HIH sought to paper over the "ever-widening cracks", so the HIH Royal Commission has revealed a number of cracks spread across the Australian general insurance regime. Justice Owen issued a total of 61 recommendations, grouped under six headings:

  • corporate governance;
  • financial reporting and assurance;
  • regulation of general insurance;
  • state and territory regulation;
  • taxation and general insurance; and
  • a policyholder support scheme.
  • Under the heading of corporate governance, Justice Owen recommends an amendment to the Corporations Act 2001 to redefine the "extended classes of personnel upon whom duties are imposed by the Act" so as to "avoid expressions such as 'employee' in favour of a functional orientation." By imposing a more "functional" approach, widening the coverage of the Corporations Act and potentially including "middle management" and external service providers under its provisions, a number of questions have been raised concerning the potential impact for underwriters writing D&O business and the greater risk exposure that could result.

    It is of little surprise that some of the recommendations focus on the need for increased disclosure by insurers in relation to both financial statements and audit reports. To be implemented by amendments to the Corporations Act and accounting standard AASB 1023, the recommendations include a requirement that entities disclose in their financial statements the valuation of their insurance liabilities as a central estimate, a 75% level of sufficiency, and the margin ultimately adopted by the entity.

    Further still, recommendation 34 proposes that all financial and statistical information presently supplied to APRA by general insurers be made publicly accessible. A requirement that Australia implement international accounting standards is also proposed.

    While Justice Owen stated that "APRA did not cause or contribute to the collapse of HIH", nevertheless, 27 of the recommendations relate directly to its activities. Owen describes the authority's approach during its involvement with HIH as too reliant upon discussion and lacking any material guidance. In effect, what he has called for is a greater degree of backbone and the implementation of a more aggressive and cynical approach in the supervision of general insurers. To facilitate this hardening of attitude, the Commission recommends that APRA be the sole regulator of general insurance, removing any influence by ASIC or the Reserve Bank of Australia, that the non-executive board be replaced with an executive board, and that the authority be given the power to wind up a company that is an authorised insurer. Owen does, however, commend the authority for its involvement in and implementation of a new prudential regime for Australian general insurance companies, the General Insurance Reform Act 2001, involving the reauthorization of 111 general insurance companies to write new business.

    In an effort to reduce excessive premiums since the collapse, the Commission recommends that state and territory governments abolish both stamp duty on general insurance products and, where still in existence, fire service levies on insurers. It has already been suggested by the insurance industry that such steps could result in a large premium reduction. However, the response from government has not been so positive, as such tax streams act as major forms of income.

    A contributing factor in the disparate nature of Australia's insurance regime is the regulatory inconsistencies which exist between states. While the Australian government in general terms is charged with the regulation of the insurance industry, insurance afforded by a specific state or by an entity of that state is regulated by the individual state. Recommendation 54 endorses the establishment of 'a ministerial council' to act as a forum for discussion for Commonwealth, state and territory governments to iron out these inconsistencies. It also recommends that prudential regulation of general insurance not be the preserve of the states and territories, but rather be handled solely by APRA.

    The final recommendation calls for the establishment of a policyholder support scheme in the event of the failure of any insurance company. While considering the 'moral hazard' argument that providing policyholders with a safety net may make them more inclined to take on riskier transactions, Owen concludes that a scheme is still preferable. Any such scheme should be restricted to policies issued by general insurers authorised under the Insurance Act 1973.

    The legislative context
    The demise of HIH took place during a period of legislative upheaval in the Australian insurance industry. Some have concluded that APRA's failure to effectively monitor the group's decline was based on the fact that it was still finding its feet, following its relatively recent establishment under the Australian Prudential Regulation Authority Act 1998.

    APRA has undertaken massive reform of the Insurance Act 1973, which the authority claimed "had long been overtaken by the market and regulatory developments". The reforms embodied in the 2001 reform act took effect from 1 July 2002 and have introduced standards for policy liability valuations and capital adequacy. They also impose requirements on general insurers that they establish reinsurance and risk management strategies, which must be disclosed to APRA.

    The Australian government has also introduced the Corporate Law Economic Reform Program (CLERP 9) to address the regulation of the financial services sector, including the general insurance industry.

    Both insurers and policyholders are seeking reassurance in the industry which such legislative measures will hopefully provide. The response to the Royal Commission and its recommendations has been positive. It is seen as a means of reintroducing a level of confidence in a sector hard hit not only by the demise of HIH, but also by September 11 and the liability insurance crisis. It is expected that the government will take time to analyse the findings of the Commission before reacting to the recommendations. However, it is interesting to note that the government has already provided ASIC with additional funding to help its investigations into the 56 possible breaches of the Corporations Law and the Crimes Act. While Justice Owen is at pains to make clear that the purpose of the HIH Royal Commission was not to blame individuals, it would appear that the government is keen to point the finger at someone.

    By Nigel Allen

    Nigel Allen is the assistant editor of Global Reinsurance.