Reference no: EM131046626

Story HIH was one of Australia's biggest home-building market insurers selling home warranty insurance and builders' warranty insurance. Raymond Williams and Michael Payne established the business in 1968. Despite Australian regulation designed to detect solvency problems at an early stage,"the corporate officers, auditors and regulators of HIH failed to see, remedy or report what should have been obvious." Poor leadership, inept management, and indifference to company problems marked the last years of HIH. Those involved in HIH management ignored or concealed the true state of the company's steadily deteriorating financial position, which lead by 2001 to the largest corporate failure in Australian history. (HIH Royal Commission 2003) The problematic aspects of the corporate culture of HIH were caused by a number of factors. One was blind faith in a leadership that was ill-equipped for the task. Risks were not properly identified and managed. Unpleasant information was hidden, filtered or sanitized. Finally, there was no skeptical questioning and analysis.

Underwriting Losses

The main reason for HIH's financial decline was several billion dollars in underwriting losses based on claims arising from insured events in previous years. Past claims on policies that had not been properly priced had to be met out of present income, i.e. a deficiency resulted from "under-reserving" or "under-provisioning." The reserves were based on reports of independent actuaries and the assessment of those reports by the auditors. Actuaries were never called in before the Board of Directors to describe the report. From as far back as 1997 their underwriting losses increased dramatically. In the year ending December 31, 1997 HIH made an underwriting loss of $33.8 million on net premium earned of $1,233.5 million. The comparative figures for the year ending June 30 2000 are $103.5 million and $1,995.4 million respectively. Between 1997 and 1999 the underwriting loss was up 206 percent while the net earned premium rose by only 25 percent. The reported underwriting losses were high, but without several one-off entries they would have been much worse. On September 12, 2000 Andersen, HIH's auditor, made a presentation to the HIH audit committee. They said that in the 12 months to December 1999, oneoff adjustments reduced the underwriting loss by $157 million; and at June 30, 2000 they reduced the loss by $360 million.

Reliance on intangibles

Another feature of the financial trend was the increasing reliance on intangible assets to support shareholders' equity. In addition to goodwill and management rights, HIH had on its balance sheet future income tax benefits, deferred information technology costs, and deferred acquisition costs. Goodwill alone represented 50 percent of HIH's shareholders funds. By way of comparison, QBE and NRMA (two comparable Australian insurance companies) had a ratio of goodwill to shareholders funds of 4.9 percent and 0.4 percent respectively.

Acquisitions

At board level, there was little, if any, analysis of the future strategy of the company. Indeed, the company's strategy was not documented. As one director conceded, if he had been asked to commit to writing what the long-term strategy was he would have had difficulty doing so. Examples of this lack of strategy were the acquisition of a UK branch (where losses amounted to $1.7 billion), reacquisition of US operations (causing losses of $620 million), and a joint venture with Alliance Australia Limited. The most disastrous business transaction involved joint venture arrangements agreed between HIH and Allianz which ultimately caused HIH to experience an insurmountable cash flow crisis in early 2001 and largely dictated the timing of HIH's collapse. In addition to the transfer of HIH's most profitable retail lines to the joint venture, HIH was required to contribute $200 million received for the retail lines plus an additional $300 in cash and assets to a trust to cover claims. All premium income (about $1 billion) was paid into the trust, and HIH was not allowed access to the funds until an actuarial assessment, about five months after the transfer. The agreement to proceed with the Allianz proposal took a mere 75 minutes of the board of director's meeting. The trust provisions and their potential adverse effect on cash flow were either completely overlooked or not properly appreciated.

Corporate Governance Model

The corporate governance model at HIH was deficient in a number of ways. There was a dearth of clearly defined and recorded policies or guidelines. There were no clearly defined limits on the authority of the chief executive in areas such as investments, corporate donations, gifts, and staff emoluments. The board did not have a well-understood policy on matters that would be reserved to itself, but depended on the chief executive. In addition, it was heavily dependent on the advice of senior management. There were very few occasions when the board either rejected or materially changed a proposal put forward by management. The board was reluctant to disclose related-party transactions. The Chairman of the board gave board agendas to the CEO, but not to the board members, for comments.

Discussion Questions

¦ What were the warning signs of financial decline that the auditors should have addressed in their procedures?

¦ Describe why assessment of the corporate governance model is important to the audit?

¦ What types of strategies and actions could the board of directors initiate which could have changed the outcome?