The Collapse of HIH Australian Insurance Company - Essay Example

The collapse of HIH (Australian Insurance Company) Background Though there are very few alarming news in regard to insurance business sector but when one comes across such discrepancies it really hurts. Such was the case with HIH. A publicly listed company, HIH, was once regarded as the second largest insurer in the general segment in Australia. In 1997, it acquired Colonial Mutual General Insurance and consequently went on to become the largest underwriter and that too in the Banc-assurance sector. It also took over FAI Insurance with a bid of $300 million in the year 1999. Things turned around as the company felt it had paid much higher price for FAI coupled with net profits dipped during the year. Moreover, analysts were concerned with the increase in the capital adequacy requirements in favor of the insurers. It was basically a proposal by Australian Prudential Regulatory Authority (APRA) in 2000. (A Chronology of Key Events, n.d) This was followed by selling part of domestic business to German based Allianz at about $500 million. The same year also saw the tumbling of share prices reaching to the lowest ever. Markets blamed the Allianz deal. The following year saw the most heartening part of HIH as it estimated $800 million loss and enters into a position of provisional liquidation. Both Australian Securities & Investments Commission (ASIC) and Royal Commission after analyzing the documents finally forced the company to close down its operations which marked the collapse of one of the biggest corporate ruins in Australia. (Kehl, 2001) Case Study & Analysis of various parameters Many would opine the fact that the sudden demise of such a huge insurer firm is generally due to its aggressive business strategies. It has moved on to acquire FAI and within a year or two it has again made a move to sell off its part of business to Allianz. Also another most remarkable part of the story is regarding its subsidiaries. The company recorded to have more than 200 subsidiaries world-wide. This extensive creation of subsidiaries has affected the business as a whole. With such expansion policies and an average of 26% a year of growth, the company struggled hard to find its way through as the market was experiencing enough competition especially from its overseas operations in UK and US. (HIH Insurance, 2001) Even one of the prime liquidators of HIH, Mr. McGrath also opined that the FAI Insurances were of no value when HIH bided for $295 million. (Sexton, 2009) Motive behind FAI deal making The main motive that is to be considered in acquiring FAI Insurance by HIH was to make a significant mark in the Australian insurance industry. Therefore in 1995 the company management thought for a possible acquisition. The other reasons that followed were firstly, lack of perseverance on the part of FAI to satisfactorily run and secondly reluctance on the part of Rodney Adler in order to sell off part of his stake. But however, Adler changed his mind and finally paved the way for the possible acquisition. In 1998 when Adler sold majority of his holdings in FAI Insurance, HIH had to borrow a huge sum of money in order to finance. But unfortunately the stock market had other plans. Shareholders did not support the idea. It was thought to be a worth of mere A$100 million. But however, arguments do vary from different angles of research. Some also consider that the acquisition of FAI might not be the only problem in HIH’s fall. Though it may be considered as an aggressive step towards its ultimate loss but it should not be underestimated that the adamant approach over the past 10-15 years then ultimately faltering to ruins can also pose for the reasons of decay. It is also observed in HIH Winterthur Offering Memorandum dated 13 July 1998, where the financial status of the company was clearly mentioned and some section of the intellectual stock holders opted out. But however the company saw a major development in its procedures as shares became over-subscribed. The Memorandum warned about capital adequacy of the company to meet its future liabilities and that strengthening of those remains to be an option for the company. (Zehnwirth, 2002) News agencies put up questions regarding the bid for being too huge for a company like FAI Insurance. To it Adler responded – “the price was set, definition, between consenting, intelligent parties with appropriate advisors on both sides”. (HIH Insurance, 2001) But the underlying fact that follows is HIH did not even verify and evaluate FAI’s position in the market rather estimating the recent accounts that were completed. HIH relied basically on the recent performance of the company and subsequently headed with the decision. The reason that opinions ran out in blaming the FAI insurance company was because of the fact that the troubled insurance company used finite number of products of reinsurance in order to devise its profitability to get better attraction just prior to the takeover by HIH in 1998. This was detected by the Royal Commission. It was also noticed that General Re Australia which was a subsidiary of Berkshire Hathaway owned by Warren Buffet, pumped in money marked as loan and was defined as a contract pertaining to reinsurance. This setup markedly enhanced the actualization of FAI’s accounts. The multibillionaire sold its disputable financial products, financial reinsurance, to FAI Insurances. This move was taken during the initial stages of the deal and when HIH had already finalized the deal making. (Coultan and Sexton, 2005) With little to do on its part, the company, as stated in the Memorandum, had to strengthen its reserves for the future. But it would mean that shareholder’s equity would diminish considerably in the future. May be a 20% increase in order to strengthen position would mean gross reserves mounting to around $400 million. (Zehnwirth, 2001) This would certainly be awe to company’s financial position. However this stance seems to be contradictory as the Memorandum also suggests that under provisioning can also affect the financial results. Decrease in adequacy rates, as stated by the company, reflected detrimental developments in certain areas of its long-tail portfolios that also included workers’ compensation and liability portfolios. The company had certain other major faults in its technicalities. FAI was acquired in the year 1998 which was estimated to be a loss. This portion of losses was incorporated in the accounts pertaining to June 30, 2000. But the net assets during the period revealed $952.8 million still. Simultaneously, net assets according to liquidator’s estimation showed a $5 billion dip after nine months. So in that case the acquisition had very little to do with the difference that estimated to $6 billion. In case of any further loss if incurred, that would be 1% less than the differential figure of $6 billion. Now the point that needs a careful notice is how a positive figure of $952.8 million can quickly shift to negative $5 billion within a period of nine months. So in that case, where does the figure $6 billion lie? (Zehnwirth, 2001) Implication of superimposed inflation rate Although the company used different methods for calculation but it can be said that the liquidator’s amount is estimated at $5 billion and that the true figure of the company’s net assets was just hovering around the negative zone. Again Annual Report of June, 2000 showed that the company had used 3.8% in terms of their inflation rate. It is an assumed figure that was used in order to calculate outstanding claims liabilities. That might not be a measure adopted on the basis of the company’s own experience. Similar line of businesses assume as low as 5% but 3.8% is even lower. (Zehnwirth, 2001) This is explained in the Memorandum in terms of superimposed inflation (when the rate of inflation is more than the normal economic inflation rate). HIH certainly did not perform adequate study on the aftermath issues on implication of superimposed rate of inflation. Researches have seen that wrong estimation of superimposed inflation rate would lead to strong factors of ruin, under pricing of shares and under reserving strategies. Thus for HIH on maintaining such high rate of superimposed inflation has resulted in erosion of capital reserves. It requires that the company should have strong cash flows earlier before it gets winded up abruptly. Nevertheless, various school of thoughts have opined the idea that the main reason for the decay of the company was due to the effect of the superimposed inflation rate which was neither based on genuine assessment, or factor identification or implemented on the basis of measurement of quantity of the trends that lies beneath. Deal sanctioned by APRA Though the deal with FAI seemed to be a risky venture and it was also seen to be a measure so as to reduce the risk factors of various elements at FAI but still APRA approved to move along with the proposed deal. It was a strange stance taken to by APRA much to the surprise to many. APRA did have the complete knowledge that HIH could never be able to compete with its resources and pay off its debt obligations. It had concerns over HIH’s operations in order to pay off its policy holders. Even in one of APRA-appointed auditor’s report, it was clearly mentioned about the role of APRA and the position it has been holding right from the position of the bid till HIH’s death. APRA was well informed of the poor risk management framework of the company. The report stated that during the period when FAI was in talks for the certain acquisition it had been undergoing window dressing with the use of reinsurance, valuation of assets below par and under reserving of claims. The report had the conclusion that FAI Insurance had already been into liquidation almost six months prior to its final takeover. (Mealey, 2001) It was indeed felt prior to the takeover that no such pricing strategies do exists in terms of FAI as prices were already compromised. A complete regulatory failure and role of APRA in the case Justice Owen during his investigation found no clear evidence mentioning the state of APRA or its contribution towards HIH in any form. He specifically mentioned that no proper evidences had been put forward regarding APRA in order to control the collapse or latch on to save the insurer. But APRA definitely failed to recognize the warning signals which were passed on from several directions. During the investigation several discrepancies in the administration of the Australian authority came to the forefront. There were problems in the regulatory system of APRA. Lack of resources and failed system to target the issues related to staffing coupled with accurate and specialized understanding for the purpose of restructuring were listed as the major problems for the APRA. Owen also came to know that APRA was not at all informed about crisis that lacked resources. Moreover, APRA had taken its decisions effortlessly right from the inception of the deal hoping that the company was dealing without any kind of faults on its side. It also took a confined view regarding its own strengths and abilities while measuring the depth of HIH. Justice Owen came to know that APRA was in the mood of assuming that the regulation of HIH was managed discreetly and efficiently. (Financial Regulation in Australia: Who should regulate the Regulators? 2000) It was almost late for APRA in order to test the skills and ability of HIH to make further payments. When the company showed their net assets of $1 billion in their accounts that were externally audited it was felt by APRA that the figure represented the ability of HIH to pay off its solvency requirements. Consequently, APRA perceived that it was least necessary to take stronger action against the company based on its financial position. The management of APRA did feel whether decisions taken by them on the basis of the information that were available at that moment of time were worthy. They feel it was. APRA do also admit that there decisions are mainly based on the integrity of the financial information sourced from various regulated organizations. (The HIH Collapse, 2003) And on the basis of those information it goes on to perform data construction and site verification of the larger companies. It was of-course that APRA lacked the necessary resources in order to construct details for such big organizations. On such occasions it had to depend upon the company’s managers, directors along with their actuaries and the related external and internal auditors. It was further noted that HIH in its September 2000 books it did not provide any hint to any of its disability on making payments to the policyholders those were due. The interests of the investors and the stakeholders of the company were placed under higher priority by APRA was a view among few other regulators. But APRA objected to it and that it had no such obligation in any form with respect to the investors and stakeholders. It has maintained itself on the issue of protecting the interests of the policyholders. APRA’s clarification on the issues On appointing an inspector in order to regulate and subsequently monitor the developments by exercising its right, APRA denied existence of any favorable situation to opt for an inspector. It said that there were no concrete legal procedures to appoint under the Insurance Act 1973. Secondly, there is also a notion that followed was about the fact that this situation of HIH was not at all happened within a period of 6-9 months but rather had implications back into several years. What has happened within this short tenure was merely an evaluation and serious assessment pertaining to the previously existed problems. Suggestions went around stating that a prior appointment of an inspector would also have clamed down the problems to certain extent faced by HIH. But APRA felt that appointing an inspector was not the only solution to the problem rather it acted stiffly remaining within its legal and juridical boundaries concerning the interests of the policyholders. As a matter of fact, APRA did see the solvency requirements as stated by HIH’s accounts revealed to be almost at a double. This was again reassessed in the month of January but revealed the same. But however, APRA had concerns about HIH’s position and subsequently advised the company to reassess its balance sheets and take appropriate measures for a better risk management. It also suggested the company to invigorate steps to enhance better functioning of its internal governance. In fact APRA made a healthy move by facilitating cordial arrangements with several other brands like Allianz, NRMA and QBE in order to improve the position of the policyholders. (HIH Insurance – APRA’s Role, 2001) Other alarming areas The company had also been facing tough times from its international businesses especially in the US and England. In California HIH had been making modest profits for its underwriting agencies. It had been underwriting for policies related to the Workers’ Compensation. But that too lasted till 1995. The company actually entered the market by acquiring the California based Falcon Insurance Company. Initially in the year 1990 the company reported extensive growth and expansions. But legislative differences persuaded the company to sell off for a price of $118.6 million. However, in 1997 the group again entered the US market through repurchase of the same for $79.3 million. It was a major discount from its previous sale price and was eventually opposed by Winterthur, the company’s major stakeholder. Ultimately this move proved to be costly for the company and finally in November 2000 the other businesses in the US were under put-off. (A brief corporate history of HIH, n.d) The position of the company in the UK was even more disgusting and sorrowful following the reason that during its entry into the UK market the company lacked necessary licenses in order to start off its business. It made its first entry during 1993 under the name HIH Casualty and General Insurance Ltd. Only by 1994 HIH was granted license and was allowed to make its own independent underwriting decisions. (A brief corporate history of HIH, n.d) Technical defaults revealed At the first sight the company’s UK business was a smooth one but the emergence of Winterthur in 1996 found out several loopholes in the approach of the company’s internal business. The auditor firm revealed some of the contradictory aspects of the business. It pointed out finger at the company’s system of provisioning data, inconsistent approach for underwriting, disorganized business philosophy pertaining to reinsurance and lack of depth in procuring financial information. Nevertheless, Ray had other thoughts in his store. He continued with the business by ignoring the concerns stated by Winterthur. He carried on his expansion plans through his acquisition with River Thames Insurance Company Ltd. But however the deal took place in spite of opposition from Winterthur. Unfortunately the alarming bells started to ring for HIH. (A brief corporate history of HIH, n.d) Price Water House Coopers in a statement of reviewing the status of HIH revealed some of the surprising aspects regarding management controls. It was critical in its assessment over the managerial style of the company. It warned that if a certain account cannot be managed and controlled in the best possible way it would be better closing down the operations of the account or can be placed under the section of run off. Another review of the various segments of the company revealed that HIH expanded into various divisions without proper control over its management and infrastructure. Again in 1997 PWC highlighted significant areas where it identified the differences in the level of reserves. The contradictory part lied in the differences between the recommended and the actual level. Later that year saw an internal audit firm review its financial position and came to the conclusion that the company was in an objectionable state. Mainly the problem existed in the methodologies followed by the company in its accounting procedures. The Department of Trade and Industry of UK too identified some of the problematic areas in HIH’s marine operations. In spite of the persistent problems regarding its financial integrity the company still continued with its expansion plans. (A brief corporate history of HIH, n.d) Gradually the company took itself into the grip of poor financial performance as it deteriorated. It was coupled with further losses due to failure of the acquisition of FAI. Moreover, the three subsidiaries of FAI in the UK had also been performing badly. Thus it was hard for HIH (UK) to sustain their profit making position and ultimately led itself into run-off. There were other casualties in the business like the political risk and also trade credit that followed. (A brief corporate history of HIH, n.d) The last days Thus the company’s over anxious expansion strategies began to bang hard on its financial results. The annual report of the company during the period of 1998-99 spotted substantial rise in the company’s both assets and liabilities. But subsequently it is also reported that these rises in the assets and liabilities were mainly due to poor premium returns, erratic investments and over a series of continuous and important losses in its international operations. The end of that period saw the biggest financial year loss in the history of the company. Year 2000 saw the company gradually losing its profitability and subsequently its capital base and also its share price deteriorated accordingly. Markets that were formed by the company in the US and in the UK and also conjugated losses incurred due to the acquisition of FAI, bestowed to the final loss. Inch by inch this particular situation came under the sheer scrutiny of the general public mediated by both media and stakeholders’ reports. Fingers began to point towards the company’s managerial integrity and the investment practices. (A brief corporate history of HIH, n.d) Aftermath of the collapse When Ray Williams was released from jail in 2008 after being behind the bars for almost 2 years and nine months was immediately questioned by reporters’ status of the shareholders after being misled by the company. They reported that the directors were all the more reckless and provided unreliable data to the shareholders and that they failed to maintain their identity. A great number of people along with shareholders, significant number of builders, various owners of number of homes lost huge sum of money. The time when the company collapsed it posted debt obligations of US $4.73 in the month of March 2001. (Head of Australia’s biggest corporate collapse freed from jail, 2008) Thousands of policy holders were left alone without any sort of policy cover. Moreover, the largest financial fallout has thrown lights on to the various regulatory issues round the world that still needs to cover up. It has brought to the limelight the multiple issues surrounding the financial reinsurance. (HIH collapse is a lesson from which insurers must learn, 2005) This particular corporate saga raised questions from various sections about arrangements of financial reinsurance. Justice Neville Owen, chief of the Royal Commission, remarked – “I have real concerns about the use - or, more accurately, the abuse - of reinsurance and its susceptibility to manipulation”. (HIH collapse is a lesson from which insurers must learn, 2005) Conclusion The policyholders of HIH were found to be the biggest losers in one of the biggest corporate failures. Though the government had taken up steps in rehabilitation process but there existed much difference in that is and that ought to be. The effects of the ultimate collapse began to spread among various communities and hurt the shareholders, creditors and also the employees and staffs. The result of HIH’s investigation had ushered in new laws and regulations for the insurance industries. This has been felt in the investigation of American International Group (AIG) as the US regulators felt the figures of AIG were inflated ones. This collapse had thrown light on the risks attached in under reserve. Companies tend to gather price for their investment ventures only to find them hit in the longer run when it is little to do. References 1. A brief corporate history of HIH (n.d). HIH Report. Vol. I. Retrieved on: August 14, 2009, from: http://www.oecd.org/dataoecd/24/10/19217174.pdf 2. A Chronology of Key Events (n.d). HIH Royal Commission. Retrieved on: August 14, 2009, from: http://www.hih.com.au/pdf/Chronology%20of%20Key%20Events.pdf 3. Coultan, M. and Sexton, E. (2005). Buffet targeted over sham deals with HIH. Retrieved on: August 14, 2009, from: http://www.smh.com.au/news/Business/Buffett-targeted-over-sham-deals-with-HIH/2005/04/17/1113676650582.html 4. Financial Regulation in Australia: Who should regulate the Regulators? (2000). The Free Library. Retrieved on: August 14, 2009, from: http://www.thefreelibrary.com/Financial+Regulation+In+Australia:+Who+Should+Regulate+The+Regulators%3F-a0152082848 5. Head of Australia’s biggest corporate collapse freed from jail (2008). AFP. Retrieved on: August 14, 2009, from: http://www.mywire.com/a/AFP/Head-of-Australias-biggest-corporate/5394419/?extID=10037&oliID=229&tag=mywire-article 6. HIH collapse is a lesson from which insurers must learn (2005). Strategy and Planning. Finance Week. Retrieved on: August 14, 2009, from: http://www.financeweek.co.uk/item/1338 7. HIH Insurance – APRA’s Role (2001). Media Releases. Australian Prudential Regulation Authority. Retrieved on: August 14, 2009, from: http://www.apra.gov.au/Media-Releases/01_08.cfm 8. HIH Insurance – APRA’s Role revisited (2001). Media Releases. Australian Prudential Regulation Authority. Retrieved on: August 14, 2009, from: http://www.apra.gov.au/media-releases/01_13.cfm 9. HIH Insurance (2001). An Erisk.com Case Study. Retrieved on: August 14, 2009, from: http://www.erisk.com/Learning/CaseStudies/HIHCaseStudy.pdf 10. Kehl, D. (2001). HIH Insurance Group Collapse. Retrieved on: August 14, 2009, from: http://www.aph.gov.au/library/INTGUIDE/econ/hih_insurance.htm 11. Mealey, R. (2001). More evidence of APRA’s role in HIH Collapse. Retrieved on: August 14, 2009, from: http://www.abc.net.au/pm/stories/s433527.htm 12. Sexton, E. (2009). Turnbull closer to on HIH claim. Retrieved on: August 14, 2009, from: http://www.smh.com.au/national/turnbull-closer-to-deal-on-hih-claim-20090706-daif.html 13. The HIH Collapse (2003). Report of the Royal Commission into HIH Insurance. Retrieved on: August 14, 2009, from: http://www.aph.gov.au/library/Pubs/RN/2002-03/03rn32.htm 14. Zehnwirth, B. (2001). HIH Debacle: A Global Perspective. Retrieved on: August 14, 2009, from: http://www.insureware.com/Library/HIH/HIHDebacle.pdf 15. Zehnwirth, B. (2002). FAI a red herring, not Trojan horse, in HIH disaster. Australian Financial Review. Retrieved on: August 14, 2009, from:http://www.insureware.com/Library/HIH/FAI%20a%20red%20herring.doc Read More