On March 15 March 2001 Australia’s second largest insurer, HIH collapsed with debts in excess of A$5billion. This report intends to discuss some of HIH’s business objectives and creative accounting practices that may have attributed to the collapse of the company.
HIH began operating in Australia in 1968 under the name C.E. Heath plc, an English based insurance company whose Australian operations specialised in the underwriting of workers compensation. 1968 was also the year that Ray Williams (future CEO of HIH) and good friend Michael Payne set up MW Payne Liability Agencies, a small insurance company based in Melbourne that offered workers compensation and public liability insurance (Main 2003). In 1974 the two companies merged and undertook the name C.E. Heath Underwriting and Insurance (Australia) Propriety Limited. The company led by Ray Williams was listed on the ASX as C.E. Heath International in 1992 and in 1995 C.E. Heath plc sold its remaining share of the company to Winterthur Swiss Insurance Co in a deal that also involved the acquisition of local insurer CIC (Main 2003). It was at this time that the company became known as Heath International Holdings or HIH.
HIH was comprised of over 250 companies at the time of liquidation (Main 2003), including HIH Casualty and General Insurance Limited, FAI General Insurance Company Limited (FAI), CIC Insurance Limited (CIC) and World Marine and General Insurances Limited (WMG). They provided many types of insurance in Australia, the USA, and the UK including general insurance underwriting, the operation of insurance underwriting agencies and investment funds management, while specialist areas of business included general insurance, workers’ compensation, public liability and professional indemnity insurance, and property and commercial insurance (Kehl n.d.).
In an organisation such as HIH, diverse business interests give rise to a myriad of stakeholders. In his report to the HIH royal commission Justice Neville Owen (2003) defines stakeholders as ‘those who have a stake in the company’s success.’ Owen (2003) proceeds too identify HIH’s stakeholders as policyholders, general creditors, employees, shareholders, the public and the regulators. To elaborate further Bazely, Hancock, Berry & Jarvis (2001) place stakeholders into two categories; internal stakeholders who consist of directors and managers, and external stakeholders who consist of lenders, suppliers, customers, employees, the government and the general public. At the most basic level all stakeholders require information regarding an enterprise for the purpose of planning, controlling and decision support (Bazely et al. 2001). (See table 1).
The Insurance industry operates in a cyclical business environment both in Australia and overseas. At the time of HIH’s collapse in 2001 the Australian general insurance industry had been in a depression for several years, caused by a combination of low interest rates, unfortunate claims experiences, and disappointing returns on investments (Owen 2003). The situation was described succinctly in an industry report by JP Morgan/Deloitte released in (1997) that stated ‘the harsh local conditions are best depicted by a horror story’. As a result of these conditions competition became stiff while at the same time the traditional boundaries between banking and insurance were disappearing, what’s more, advances in technology were accounting for big changes across the financial services sector (Owen 2003).
The aggressive takeover of competitors such as FAI and entry into the U.S and U.K markets are examples of HIH’s business objectives, which according to Williams (2003) were based on ‘international growth and diversification’. In his report to the royal commission, Justice Owen (2003) questions the legitimacy of the company’s business objectives stating that ‘there was little, if any analysis of the future strategy of the company’. In addition, Owen (2003) claims that any strategy that HIH had appears to have existed in the mind of Ray Williams and that his perspective was never clearly expressed to the board. The problem that arises from the absence of a well understood strategy is that the board does not understand and appreciate risks (Owen 2003). The failure of operations in the United Kingdom and the United States and the acquisition of FAI provide ample evidence of this.
In staying true to his objectives of ‘international growth and diversification’ (Williams 2003) saw the U.K market as an opportunity for HIH to broaden its’ international base (McDougall 2002). This resulted in HIH setting up its’ U.K business in 1993 offering public liability and professional indemnity insurance (Cagan 2001). Operations in the first year proved to be a success and resulted in the expansion of operations during 1997 into areas of business in which the companies underwriters had little experience or expertise (Howard 2003). Furthermore Justice Owen (2003) notably points out that the UK operations had failed to establish suitable underwriting guidelines and controls.
This combined with the lack of underwriting experience was a formula for financial disaster. In hindsight this has proven to be true as the report on the royal commission has estimated that losses in the United Kingdom may reach A$1.7 billion. The majority of these losses can be attributed too the ‘under-writing of whole account excess-of-loss marine reinsurance and film financing,’ while other substantial losses can be attributed too the ‘provision of personal accident cover to members of the Taiwanese military and of motor vehicle physical damage cover-without terrorism exclusions-to an Israeli insurer.’ (Owen 2003).
In 1997, in scenes reminiscent to those in the U.K back in 1993, HIH announced that they had re-purchased their former U.S workers compensation business CareAmerica. In a statement to shareholders Ray Williams described the conditions in the U.S market as favorable and that there was a great foundation in place for future growth (Main 2003). What he did not reveal was that U.S insurance companies did not discount their liabilities the same way that Australian insurers did, which would result in excess reserves that HIH could use to manipulate their own accounts (Main 2003).
No more than two years later Ray Williams was singing a different tune, announcing in the 1998-99 annual report that HIH would be downsizing its U.S operations due to deterioration of the U.S workers compensation market.
In 1999 the real extent of the problem was beginning to unfold. The US industry regulator told HIH’s director of international operations George Sturesteps that they believed HIH America to be under-reserved by as much as $US57 million. Reserves are essentially an allocation of after-tax profits that are set aside on the balance sheet for future insurance claims (Owen 2003). This estimate was on top of HIH’s own internal estimate that the shortfall was about $US40 million (The Mercury 2002). In an attempt to find out the true state of reserves as of March 2000, HIH hired Milliman & Robertson to conduct a full report. The report tabled by M&R found a $US55 million shortfall. These numbers were much higher than HIH’s management had anticipated so they sacked M&R and hired Towers Perrin Tillinghast to conduct a report using a different methodology. The result revealed a gap closer to $US56 million (Main 2003).
The timing of this news could not have been worse for HIH as they were about to announce their June 2000 results. Somewhere along the line though, it appears that the $US56 million shortfall had failed to be mentioned. In his statement to the royal commission Mr. Sturesteps said he did not tell the auditors or his fellow board members about the reports because ‘Mr. Williams knew’ and he did not pass the information on to the companies auditors because ‘that was not his responsibility’ (Main 2003, p.83).
On September 23, 1998, in a move that in hindsight ‘was the straw that broke the camels back’ HIH announced its takeover bid of FAI insurance with the intention of becoming Australia’s largest listed general insurer. FAI was a direct competitor of HIH and the takeover was part of HIH’s diversification and expansion strategy into the Australian market (Williams 2003). Furthermore CEO Ray Williams had identified five major benefits that HIH would achieve from the merger including: putting HIH up another level in the insurance industry; achieving substantial savings; making HIH the biggest gross premium earner in Australian general insurance; taking HIH into the direct car and home insurance market; and making HIH the biggest professional indemnity insurer in Hong Kong (Main 2003).
HIH proceeded with the takeover of FAI based on their assessment of publicly available information. (Owen 2003). A request put forward to FAI at the time for further information was denied by Rodney Adler given that FAI were negotiating with other potential buyers. Adler (2003) rightly claimed that his company did not wish its competitors to gain access to ‘sensitive commercial details’.
What was not apparent from the public information was the excessive under reserving of FAI’s long-tail business. (Owen 2003). FAI would have made a loss of around $50 million if it was not for two reinsurance deals done with General Cologne that where done as the books were closing on June 30 1998. Reinsurance essentially involves a larger insurer helping a smaller insurer to pay out policies during a rough period. The smaller insurer then pays back the money by way of a premium in the following years (Main 2003). In normal circumstances a loan is normally accounted for as a liability. Through creative accounting policies FAI’s accountants were able to take the $57 million in reinsurance policies and book it as revenue.
Main (2003) makes note that ‘some of the best auditors in Australia, and no doubt in other countries, have been talked into accepting such measures as legitimate’. These comments came under attack from federal treasurer Peter Costello (2002) who was astonished to discover that the auditors were aware of these entries and accepted them because the Australian Accounting Standards allowed it. The two reinsurance deals enabled Rodney Adler to later announce that FAI had made an $8.6 million profit in 1998, a turnaround of almost $20 million (Main 2003).
2.4 HIH accounts.
Justice Owen (2003) comments on the importance of the accounting process stating that ‘accounts are prepared so that those with an interest in the financial affairs and condition of the entity–whether that interest be proprietorial, regulatory or transactional–are truly and fairly informed as to the entity’s financial state’.
Richard White SC, Counsel for the royal commission brings attention to two entries that were of major significance in the 2000 financial statements of HIH that may have been made complex deliberately ‘in order to befuddle the reader and disguise the true substance of the transactions’ (White 2003).
The first issue concerns the writing off of any lack of value relating to the acquisition of FAI as a positive addition to the goodwill account in the balance sheet. This resulted in over A$400 million being booked on the asset side of the balance sheet from the acquisition that had cost HIH A$300 million.
Bazely et al. (2001, p.568) define goodwill as ‘the future benefits from unidentifiable assets’. Wayne Martin QC, in the royal commission elaborates further on the concept stating ‘a company can only carry goodwill in its balance sheet if it is very confident of earning that money back in the future’ (Main 2003, p.181). When asked by Wayne Martin QC in the royal commission about how HIH would earn the money back, Williams (2003) stated that ‘it was an issue that concerned the financial department’ and he furthermore pointed out that the auditors had signed off on the entry.
The second issue was the decision to enter into two reinsurance contracts during 1999 in what appears to be an attempt to lift the companies operating profits for the year. The deals were similar to those seen at FAI one year earlier in the sense that a larger insurance company, in this case Hannover Re, was to lend HIH close to A$400 million in reinsurance (Main 2003). As a result of the reinsurance contracts HIH was able to lift its profits for 1999 from A$10 million to A$102 million and for 2000 were able to turn a A$45 million loss into an A$61.9 million profit.
List of references.
Cagan, P 2001, HIH, a case study, viewed 28 Aug, 2003, < http://www.erisk.com/LearningCenter/CaseStudies/ref_case_hih.asp#STORY
Charlton, P 2003, Failing to understand the business:[1 Edition], The Courier Mail, [online], p.67, available:
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Main, A 2003, Other peoples money, Harper Collins, Sydney.
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Meigs, Meigs, Bettner & Whittington 1996, Accounting: The basis for business decision, McGraw-Hill, U.S.A.
Williams, R 2002, I may be a fool but I never lied: [1 Edition] The Australian [online], p.4, available:
http://80proquest.umi.com.ezproxy.usc.edu.au:2048/pqdweb?index=13&did=000000394897251&SrchMode=1&sid=7&Fmt=3&VInst=PROD&VType=PQD&RQT=309&VName=PQD&TS=1065144753&clientId=20906 [25 Aug, 2003]
Owen, Justice N 2003, HIH Royal Commission, viewed 1 Sept, 2003, http://www.hihroyalcom.gov.au/
Tasker, B 2002, HIH `inflated’ earnings – Deception alleged on complex contracts:[1 Edition] The Courier Mail, [online], p.27, available: http://80-proquest.umi.com.ezproxy.usc.edu.au:2048/pqdweb?index=12&did=000000397114211&SrchMode=1&sid=8&Fmt=3&VInst=PROD&VType=PQD&RQT=309&VName=PQD&TS=106