Auditing HIH Disaster - Essay Example

AUDITING HIH DISASTER Started in 1960s, HIH Insurance Ltd had been in general insurance business enjoying a celebrity status among the corporates of Australia with international presence .It became a listed company in early 1990s. Its premium income in 1999 was A$ 2 billion and was known for its aggressive pricing to win business and was specializing in volatile liability classes. (Tucci) A major occurrence in July 1998 went unnoticed when the Swiss Insurer parted with its 51.1% stake in HIH to the investors just when the newly formed Australian Prudential Regulation Authority (APRA) took charge of regulating the insurance industry in Australia. In spite of major events which took place in succession in the HIH, some thing was lurking behind. By January 1999, the HIH acquired FAI insurance for A$ 300 million which later turned out be worth onlyA$100 million though the external audit of Arthur Andersen for the year 2000 did not make any issue of it. On the other hand the company was lauded to be worth A$ 939 million. Soon after in September, it sold half of its profitable retail general insurance business for cash liquidity and as a result its share prices fell down from A$ 1.05 to A$ 0.45 when the company announced losses. Yet the regulatory authority did not think fit to inspect the accounts as it relied on the external audit report had painted a healthy picture. This was followed by the resignation of the CEO founder of the company for 30+ years, with a compensation of A$ 5 million in December 2000. As the company had not filled its December statements, when they became overdue by February 2001, the regulator APRA was concerned for the first time. Meanwhile on 27 February Australian Securities & Investments Commission (ASIC) took the initiative by suspending HIH's share trading soon followed by the APRA's fire fighting act of transferring the company's risk portfolio to other insurance companies to the extent possible. On 15 March 2001 HIH declared provisional liquidation with Government agencies covering some of its obligations which might cost the tax payer about A$ 1 billion to bail out policy holders. On 16 March, finally APRA started inspection of the HIH affairs. Government of Australia lost no time to set up an independent Royal Commission by August 2001 as already announced in May 2001 to investigate into the failure of the company. It took 6 months for the liquidator to arrive at the losses as between A$ 3.6 billion and A$ 5.3 billion. It has been stated that not only the settlement of policies and the company's creditors could not be made in full but also it would take ten years for disbursement which might be in the ratio of 1: 0.5. This was how the second largest Australian insurer's corporate bubble burst representing the biggest collapse in the corporate history of Australia to date. The whole imbroglio was attributed to poor management by under pricing of policies and overestimation of its assets mostly non tangible rather than frauds. Soon after the company's fall, the premium market shot up steeply. While the APRA conceded that it was because of not provisioning the company with sufficient capital to cover its risks for quite a number of years that this had happened, the Australian Prime Minister had to rebut the public accusations that political donations siphoned off the company's resources. (Sungard Banc ware Erisk). Actually the company had indulged in acquisition spree of more than 200 subsidiaries which only made the company's size unwieldy in an already overcrowded and competitive insurance market though the acquisitions accounted for 26% premium growth per annum for a decade. Most controversial of all was the acquisition of FAI insurance for A$ 300 million which was worth hardly A$ 100 million and that too the company had borrowed money for the settlement. Rodney Adler the major stock holder of FAI who also became a member of HIH Board however clarified "that the purchase price of his company was too high by stating that the price was set, by definition, between consenting, intelligent parties with appropriate advisors on both sides. It has emerged that HIH did not conduct due diligence on FAI, and instead relied on FAIs recently completed accounts. APRA approved the deal, even though it regarded FAI as a relatively risky venture, perhaps because it saw the deal as reducing the risk of any problems at FAI" (Sungard Banc ware Erisk). Besides the HIH's international operations particularly in U.S. and England were also not healthy. For instance in California where HIH was a leading underwriter of Workmen's Compensation insurance which was very profitable till 1995 later became very much competitive when a legislation brought the workers compensation insurance under non-tariff thus removing the minimum floor prices. Though the company believed in 3-year-cycle period and left the market, it re-entered California market after 3 years which only worsened the market for HIH along with its fellow insurers there in California. It is said that the company also lost in England heavily in 90s in its professional indemnity and public liability businesses. At the time, the Lloyds also had lost heavily. The HIH also had insured film-financing in which it incurred high profile losses by paying out claims to failed businesses with the hope of getting reinsurance from its reinsures namely New Hampshire Insurance Co and American International Group who had also incurred heavy losses in the same sector and hence could not pay. They maintained "HIH should not have paid the claim because it could have asserted various coverage breaches. The UK courts sided with the reinsurers and ruled that HIH had not been obliged to pay out on the film claims and, consequently, was not entitled to reinsurer reimbursements. HIH lost hundreds of millions of dollars from its film finance insurance business."( Sungard Banc ware Erisk) What are the risk factors are as could be inferred from the financial results of HIH for the year 1999 & 2000 Inherent risk factors that might not justify the company being certified as a going concern as per AUS 708. "Going concern basis means the accounts basis whereby in the preparation of financial report the reporting entity is viewed as a going concern: that is, the entity is expected to (@) be able to pay its debts as and when they fall due; and (b) continue in operation without any intention or necessity to liquidate or otherwise wind up its operations" ( AUS 708) General Insurance Highlights for the period from 1 July 1999 to 30 June 2000paints a very dismal picture for Private insurers in Australia which strengthens the following risks in the HIH report under review. It says" Private sector general insurers reported a $668 million decrease in aggregate after tax profits. After tax profit decreased from -$304 million to -$972 million, in part due to the decrease in general insurance losses from -$365 million to -$1 billion and the underwriting loss on business inside and outside Australia". The following risk factors have been drawn from the power point presentation of JohnTucci, Senior Mamager and Actuary- Asia General Insurance -courtesy Trowbridge Deloitte A high-performing firm should have an ROCE (Return on Capital Employed) of 15% to 20%. For the year under report HIH Insurance(Australia)( herein after"the company') has a ROCE % 0.94 only, as per DU PONT ANALYSIS1. Needles to say it is seriously below the threshold range and only indicates that the company is not making efficient use of its assets. The company's profitability and activity should be in the level of 10% and above 2 respectively as a bench mark levels, though it will differ from industry to industry. In the company's case, profitability to premium revenue ratio and performance in activity 1.23 and 0.76 respectively. The company has a weighted cost of borrowing (WCB) of 6.87 % which is higher than ROCE indicative of the company's inability meet its debt obligations if this trend continues. ROE (return on equity) is a measure of company's ability to generate a return on share holders 'funds. In the year under review, it is just 2.68% Hence it is a not sufficient return share holders' funds. Premium revenue growth is -9.80 which is a fall from last year's level. Profit performance for the company is worse than 75% of its peers in the following areas. Gross profit margin on premium revenue Gross profit return on total assets Gross profit return on total capital employed Cash flow performance Operating cash flow of the company for the period under review is at the rate of 0.01 in relation to sales. This means that there was 0.01 dollars of cash for every dollar of sales which could be used for repayment of debt, capital expenditure and dividends. Significant volatile long tail liability classes No financial due diligence undertaken- relied on public information Hasty decision to buy HIH-notice of board meeting circulated on the day of decision and only 3 to 12 directors present industry rumors that HIH was in trouble "The ambitious growth strategy adopted by HIH had a serious impact on the company's financial position (see Table 3.3). The 1998-99 annual report showed a substantial increase in the value of reported total assets and liabilities, but it also noted that these increases had occurred in a commercial environment characterised by weak premium rate returns, volatile investments, and a series of significant losses in overseas businesses. HIH reported an end-offinancial- year loss for the first time in its history." Table 3.3 HIH Insurance: reported contributions to operating profit before income tax (A$ million)( from pages 51 to 64 of volume I of the HIH report) The above state of affairs strongly indicates presence of inherent risk factors stated above In 2000 strong indications that the company was under-reserved for liabilities and funded by significant "goodwill" in balance sheet. It is quite likely that good will amount represents hidden loss which may open up a Pandora's Box when thoroughly probed. In a bid to raise cash, directors sell "short tail" business through a joint venture with Allianz Allainz proposal presented at board meeting and agreed in 75 minutes Major cash flow crisis ensued Liquidation deficiency identified as upto A$ 5.3 billion Under provision of reserves A$ 2.4 billion U.K. operations A$ 1.7 billion loss U.S.operation A$ 0.6 billion loss FAI acquisition A$ 0.6 billion loss Major under-provisioning on the back of claims on unprofitably written business Dubious reinsurance contracts Quality of assets 75% of net assets were intangibles 50% was good will Danger of Collapse due to chronic under provisioning Mismanagement, ineffective board Conflict of interest- flawed understanding Blind faith in leadership of company Poor identification of risks and excessive filtering of information-ineffective board Losses from business with Lloyd's, London should be A$40 million and not $9 million The net assets should be reduced by A$ 100 million and not A$ 57 million There is reasonable suspicion of Company's insolvency but not able to assert for want of financial details of company's subsidiaries outside Australia (Auditor General Victoria) The insurer financial strength ratings on the core operating units of HIH Insurance Ltd. (HIH) have been lowered from "BBB-" to "B" by Standard & Poor's. HIH is comprised of the following companies: HIH Casualty and General Ins. Ltd.; CIC Insurance Ltd. (including New Zealand branch); FAI General Ins. Co. Ltd.; HIH Insurance (Asia) Ltd.; and HIH WorkAble Ltd. Concurrently, the counterparty credit ratings on these entities were changed from "BBB-" to "B." S&P had previously lowered the ratings on HIH in November 2000 and again in February 2001, placing them on CreditWatch negative. The most recent rating action withdrew the ratings from CreditWatch, which was done at the request of HIH management. S&P said that it expects HIH to report a significant loss and that the negative outlook is a reflection of significant uncertainty regarding HIH's capacity to meet obligations due to recent adverse business conditions.(insurance journal Mar 20001) The "A-" ratings assigned to HIH's New Zealand operations are unchanged. Those companies are HIH Casualty and General Insurance (N.Z.) Ltd. The above inherent risk factors have been identified in strict adherence of embodied in AUS 708 by meeting with the directors, company's bankers, through Bank confirmation requests (AGS 1002), market reports of the company, industrial trends as reported in the media and respective Govt agencies. Besides AUS 402 which establishes standards and provides guidance to the auditor in obtaining understanding of the entity and its environment and assessing the risks of material misstatement in a financial report audit.(AUS 402) Other sources of information to arrive at the above are last year's audited financial statements and APRA returns, last years' working papers, minutes of meting of the board of directors and various correspondence with regulatory authorities and Bankers and leading creditors. It has also been verified whether opening balances are the same and whether they contain misstatements that may affect materially the current period' audit report and whether there is consistency in the company's accounting policies and any changes have been accounted for and disclosed. Overall assessment of the inherent risk of HIH. How this assessment will have an impact on the planning of audit procedures The overall assessment of risk can be said without doubt that the company is leading to disastrous results warranting audit procedures on liquidation basis but for the unclear financial results of the subsidiaries of the company outside Australia. And some of the key indicators for risks of materials misstatements contained in Appendix 2 of AUS 402 present in HIH Ltd for the period under review, will have an impact on audit procedures being modified - Weaknesses in internal control, especially those not addressed by management. - Inquiries into the entity's operations or financial results by regulatory or government bodies. - Past misstatements, history of errors or a significant amount of adjustments at period end. - Significant amount of non-routine or non-systematic transactions including intercompany transactions and large revenue transactions at period end. - Transactions that are recorded based on management's intent, for example, debt refinancing, assets to be sold and classification of marketable securities. - Accounting measurements that involve complex processes. - Events or transactions that involve significant measurement uncertainty, including accounting estimates. - Pending litigation and contingent liabilities, for example, sales warranties, financial guarantees and environmental remediation. There are no independent non-executive directors on HIH Board. The report shows that of the four non-executive directors, Gardner and Cohen were both former partners of the present auditors while Abbot and Stitt are both involved in providing legal services to the company. The company's board is dominated by founders and relatives of founders , with potential conflicts of interests and loyalties to the company history and reputation. These issues may have colored their judgment. The company had two founders on the board and also Adler, the son of the founder of FAI, one of the core HIH businesses. There is not a single independent director on the audit committee. While in 72 % of the top 100 companies, separate nomination and remuneration committees are established as per the guidelines of Investment and financial services association, HIH has combined the two committees. (Leung, Cooper) And since there are many items of inherent risk factors stated above which can be likened to the to some of the examples in Appendix 2 of AUS 708 for going concern problems, an audit report as per appendix 4 of AUS 708 modified regarding the going concern basis is called for.. Significant uncertainty exists adequately disclosed in the financial report. Besides there are no significant mitigating factors that could be inferred from the financial report furnished thus warranting modified audit report on going concern basis REFERENCES Auditor General Victoria, Autumn 2003 AUS 402, Understanding the entity and its environment and assessing the risks of material misstatement http://www.auasb.gov.au/docs/AUS_402.pdf accessed on 05 May 2006 AUS 708 , Accounting Standards AAS6/AASB 1001 "Accounting Policies" http:// http://www.auasb.gov.au/docs/AUS708_07-02.pdf acceesed on 05 May 2006 Insurance Journal, March 26 2001> Ratingshttp://www.insurancejournal.com/news/accessed on 05 May 2006 Leung Philomena Barry Cooper, RMIT University, Victoria, Australia "Mad Hatter's Corporate Tea Party, accessed on 05 May 2006 Sungard Bancware Eriskhttp://www.erisk.com/Learning/CaseStudies/HIHInsurance accessed on 30 April 2006 Tucci John, Senior Manager and Actuary, Asia General Insurance, in 6th Conference of Actuaries, Trowbridge Deloitte Power point presentation Read More