The Collapse of HIH as Regulatory Failure - Case Study Example

The Collapse of HIH: A Case of Regulatory Failure Student’s Name Institution The Collapse of HIH as a Case of Regulatory Failure Introduction to the HIH Collapse The failure of HIH began in March 15, 2001 when it was put under provisional liquidation for its inability to settle its debts, which were estimated to be about $5.5 billion. Before its collapse, HIH was rated the second largest insurance company in Australia. As a result, its failure was regarded as the biggest financial collapse in the Australian corporate history (Vinten, 2005). The collapse of HIH not only had a negative effect on the Australian economy, but also affected the country’s social status. Many people, including the stakeholders, policy holders, general creditors, and employees among others, were greatly affected by the collapse of HIH Insurance (Westfield, 2003). The main factor that is blamed for the collapse of HIH is regulatory failure. This failure is known to have led to the continuing financial depression, apparent high risk areas, and poor corporate governance practices. It is unclear why the stakeholders, the general credits and the policy holders were not issued with any warning regarding the deteriorating financial capability of HIH, even after the company had been placed under provisional liquidation in March 15, 2001 (Westfield, 2003). It is believed that after the provisional liquidation, the company took at least one year before it eventually collapsed. This was enough time to inform the stakeholders about the financial status of the company so they could make informed decisions (Vinten, 2005). Anderson Accounting Firm, the then main auditor and external adviser of HIH, is also to blame for the collapse of the insurance company. The accounting firm is said to have failed in its duty as the main watchdog of the stakeholders who invested their resources in HIH (Vinten, 2005). Andersen’s malpractices in relation to how it audited the records of HIH in 1999 and 2000 were pointed out by Honourable Justice Owen, the chairperson in the Royal Commission that was set up to investigate the collapse of the insurance company. Justice Owen categorically stated that Anderson’s conclusions were misleading since the firm did not obtain enough evidence during their 1999/2000 audits of HIH’s financial accounts (Bailey, 2003). This paper analyzes the regulatory failure caused by the poor corporate governance and misuse of power, which in turn, resulted into the collapse of HIH. The paper addresses the kind of white collar crimes involved in the HIH case. The white collar crimes that led to the collapse of HIH include inferior risk management, malpractices of Andersen Accounting Firm, and poor corporate governance. The Failure of the HIH The main cause of HIH’s collapse can be well understood through financial and regulatory perspectives. The company is said to have been put in the liquidation position due to its inability to settle its financial debts, which had accumulated to huge amounts. The company was totally unable to meet the claims of its policy holders and other creditors. This obviously was caused by the poor resource management, which resulted into the poor cash status that the company was in at that time it became bankrupt (Westfield, 2003). In business principle and practices, the main goal of companies such as HIH is to make more cash than the initial capital it began with. A company is supposed to make more money in the long run. The cash is considered as the starting and the end point and therefore, the cash position of a company at any given time is a reflection of the impact of financial and operational policies and activities (Mardjono, 2005). The financial and operational activities have been used in several occasions to explain the causes of the insolvent status of various insurance companies that have collapsed. Following this perception, the collapse of HIH can be linked to operational and financial activities as much as it is linked to the cash position of the company during the time it went insolvent (Kehl, 2001). Hypothetically, insurance practices involve insurance companies committing to help other companies and individuals deal with risks. In the process of committing to deal with the risks, the insurance companies put themselves at a higher risk position than the companies and individuals they safeguard. Insurance practices are based on three principles: sound investment decision, risk pricing ability, and the policy for reservation of the outstanding claims provision (Mardjono, 2005). The two principles, the outstanding claims provision and risk pricing, apply directly to the case of HIH. The risk pricing ability is based on the insurer’s underwriting performance, which is the most important factor in relation to the practices of an insurance company. HIH’s problems began with the shortcoming in its underwriting performance and risk pricing ability (Kehl, 2001). This is evident from the findings of the HIH Royal commission that was set to investigate the collapse of HIH Insurance. For instance, the commission found out that the HIH suffered an underwriting loss of about $34 against $1234 total premiums earned in the year ended December 31, 1997. The company continued to make more underwriting losses in the following years. In the year ended June 30, 2000, the losses were $103.5 against premiums of $1995. Between 1997 and 2000, the HIH premiums rose by about 15% while the underwriting losses more than doubled within the same period (Bailey, 2003). Another cause of the HIH collapse is the inferior investment ability of the company’s management. The management of the company could have set poor protocols for investing the money collected from the stakeholders, policy holders and the general creditors. In many occasions, the effect of underwriting losses in an insurance company can be offset by good returns on investment. However, if the investment is based on a long-term contract that involves a significant amount of money, the situation may be tricky to control (Kehl, 2001). The poor investment criteria of the funds collected from the stakeholders and policy holders occurred in the case of HIH. According to the Royal Commission findings, HIH failed in almost all the places where it had invested significant amounts of money (Mardjono, 2005). The first investment failure that HIH suffered was in the United Kingdom where the company lost close to $1.8 billion in its operations in the country. The second place where the company had a major financial blow was in the United States where the company lost more than $620 million in its operations in various states. Unlike the first two investment losses, which could be considered as bad luck, the third loss was purely as a result of the HIH management’s poor skills of investment. The management decided to complete the acquisition of FAI in 1998 despite the warning from experts against the move. At the end, HIH incurred a loss of close to $535 million as a result of undisclosed-under-reserving information about the acquisition process and the contracts that FAI had entered into prior to the acquisition (Bailey, 2003). White Collar Crime and Regulatory Failure in HIH’s Collapse The main white collar crime in the HIH case became evident as a result of the flawed practices of the company’s corporate governance. There are theories that can be used to explain the importance of corporate governance in preventing a company from cases of bankruptcy. The first theory, the theory of agency, asserts that the main cause of corporation bankruptcy emerges from the agency cost issues caused by fallouts between debtors, managers, and proprietors of the company (Allan, 2006). The mainstream financial theory is another hypothesis that seeks to explain how a company can be placed in the liquidation position as a result of bad corporate governance. The latter theory requires that a balance between the debtors and stakeholders be struck and maintained on a dynamic basis. This is important at ensuring that destruction of debtors’ interests is prevented; such an impairment of interest can adversely affect the interests of the stakeholders. This balance can only be achieved in a company by setting up an effective corporate governance system (Allan, 2006). According to the information provided about the HIH management system, the company’s corporate governance system was well structured. For instance, the board of directors in HIH consisted of two executive directors, assisted by five non-executive directors (Allan, 2006). The problem within HIH’s corporate governance began when the non-executive directors decided to take active positions, such as serving in the remuneration committee within the company’s management. According to the Australian Stock Exchange (ASX) guidelines, this involvement of the non-executive directors was unacceptable and it made the HIH’s corporate governance have serious flaws (Bailey, 2003). Inappropriate Risk Management The inadequate ways of managing risks employed by HIH were its first major regulatory failure that led to its collapse. The presence of appropriate ways for managing risks in an insurance company plays a great role in its management. It is fair to note that the board of directors of HIH had an investment committee whose mandate was to deal with issues related to investment procedures and investment risks (Feetham & Amos, 2012). However, the failure of HIH’s investments in the three locations is a clear indication that the committee was incompetent or that the members of the committee might have used their power inappropriately to make unfair personal gains. According to the findings of the Royal Commission, the HIH directors were negligent in carrying out their responsibilities and over-exercised their powers, which contributed to the collapse of the company (ASIC, 2003). Inadequacy of Independent Information Resources Establishing information resources for use by non-executive directors are the second regulatory measure that was put in place to deal with unforeseen cases of bankruptcy in HIH. The practice that the HIH non-executive directors carried out was against the companies’ act. The directors would collect and process the information meant for use by them on their own. This act was neither feasible nor economical; the act of these directors was questionable as this meant that the directors would entirely rely on the accounting and auditing model formulated by the company’s management team (Feetham & Amos, 2012). The lack of independent information resources for use by the non-executive directors can be seen as an inherent risk of the management system. However, the corporate governance of HIH tried to make up for the hitch in the company’s management system. Firstly, the management made the stakeholders and policy holders believe that the audit committee was allowed to function independently to enhance HIH’s effectiveness (ASIC, 2003). This would certainly make the non-executive directors have confidence in the audited accounting data processed by the committee. Secondly, the management showed the public that there was a finance director in the BOD who would adequately inform the non-executive directors on all the accounting-related information (Clarke, Dean, & Oliver, 2003). As it turned out, none of the above measures to ensure independency of the information used by the non-executive directors were installed in the HIH management system. According to the findings of the Royal Commission, HIH did not have a finance director in its management system as expected. Instead, Ray Williams, the chief executive officer, took over all the responsibilities of managing the accounts (Clarke, Dean, & Oliver, 2003). The findings also indicated that the influence of the non-executive directors on the audit committee contributed a lot to the collapse of HIH. As a result, the non-executive directors were unable to carry out their duties since there was no independent audit information to rely on (ASIC, 2003). Interference of Non-Executive Directors on the Management It was discovered that the non-executive directors had great influence on the HIH management system. Firstly, it emerged that two of the non-executive directors, Robert Stitt and Charles Abbott, were former stakeholders of Andersen Accounting Firm, the main firm that audited and advised HIH on accounting issues. The main issue that is questionable in the whole scenario is how Andersen more than doubled the fees it charged HIH after the two directors joined the company. For instance, Andersen used to charge about $7 million as auditing fee before the appointment of the two directors. This amount rose to $1.7 million in 2000; it was clear that the two non-directors influenced the change (Bailey, 2003). The second issue is linked to the failure of the management to disclose the necessary information when insuring its directors and Justin Gardner’s problem of conflict of interest. In 2000, the management of HIH decided to insure the directors against any liability incurred by the company. However, the HIH management did not disclose some of the crucial information, such as the amount of premium payable, which is required in such cases. This was definitely a plot to defraud the company (ASIC, 2003). In addition, Justin Gardner, who was appointed as a member of the audit committee, was actually one of the main auditors at FAI before the company was taken by HIH. It is believed that Justine, in most cases, was faced by the problem of conflict of interest and the loss that HIH incurred in the acquisition of FAI, was to a large extent his fault (Bailey, 2003). Rodney Adler’s Misuse of Power Rodney Adler was also a non-executive director and an active member of the investment committee at the HIH insurance company. He led the acquisition of FAI in 1998, and like other directors of HIH, he used his power to make shoddy deals from where he got numerous selfish gains. Adler was guilty of close to four white collar crimes; firstly, he obtained money by giving false information about the company to the public. Secondly, he carried out his duties dishonestly; by lying to the public that the shares of the HIH were undervalued, he was able to obtain money from the shareholders. He also lied to the public that he personally bought the shares of HIH in June, 2000. Lastly, Adler wrongfully advised HIH to invest huge amounts of money in Business Thinking Systems (BTS). It is particularly wrong for Adler to convince HIH to invest in BTS since Adler was a partner to BTS (Elias, 2003). CEO’s Dominance over HIH’s Management The problem of dominance of Ray Williams, the CEO of HIH, began from an illusion that he was the founder of the insurance company. Although this illusion should have stopped after the company was listed as a corporation, Williams continued to maintain the same feeling. He put himself above the BOD and almost single-handedly designed the management system for running HIH. As a result, the board of directors failed to design the limits on the authority of the CEO and Williams took the advantage of the situation by managing HIH like an entrepreneurially run company. The CEO ran the company according to the senior managers’ interests and forgot about the shareholders. This, together with other factors, changed the company into corporate excess after disregarding the interests of the shareholders (Feetham & Amos, 2012). Conclusion HIH’s collapse is a case of regulatory failure caused by a weak system of corporate governance. The financial problems of HIH began when the company could not adequately settle its debts as well as the claims of its policy holders. One of the major causes of the problem was poorly planned expansion criteria. The second problem was the company’s failures in most of its investments. Lastly, the poor corporate governance together with an incompetent CEO and directors, also contributed to the collapse of the insurance company. There are various measures that could have been put in place to prevent the collapse of HIH. Firstly, the management of HIH should have been more cautious when planning to expand the operations of the company into other locations and markets. It is a proper practice to try to expand a business by venturing into other markets to boost the firm’s sales and cover its liabilities. However, the expansion comes with several challenges among them capturing new markets that the company knows very little about. HIH, while expanding, did not have any mechanisms put in place to deal with any eventualities that might have arisen from the expansion process. The management of the company should at least have set aside some money to pay policy holders in case the expansion failed. Secondly, the company should have designed limits of authority of the CEO to make him work together with the board of directors, managers and the shareholders. Lack of such limits resulted in the chief executive officer and the non-executive directors misusing their powers and in some cases, using them to benefit themselves. Adler and other directors’ attempts to fix the financial crisis in the short-term only worsened the situation. If HIH had put an effective management system and the correct regulatory measures in place, the collapse of the insurance company could have been prevented. References Allan, G. (2006). The HIH collapse: A costly catalyst for reform. Deakin Law Review, 11(2), 137-159. ASIC. (2003). Current corporate governance issues an ASIC perspective. Retrieved February 11, 2013, from http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/nt_bus&prof_women_corp_g ov190903.pdf/$file/nt_bus&prof_women_corp_gov190903.pdf%20on%20the%2006.04. 2010 Bailey, B. (2003). Report of the Royal Commission into HIH Insurance. Retrieved February 11, 2013, from http://www.aph.gov.au/library/Pubs/RN/2002- 03/03rn32.htm%20on%20the%2007.04.2010 Clarke, F., Dean, G., & Oliver, K. (2003). Corporate collapse: Accounting, regulatory and ethical failure. Cambridge: Cambridge University Press. Elias, D. (2003). Adler guilty on 4 charges. Retrieved February 11, 2013, from http://www.theage.com.au/news/National/Adler-guilty-on-4- charges%20/2005/%2002/16/%201108500154731.html%20on%20the%2003.04.2010 Feetham, N., & Amos, R. (2012). A guide to insurance: Combining governance, compliance and regulation. London: Spiramus Press. Kehl, D. (2001). HIH Insurance Group collapse. Retrieved February 11, 2013, from http://www.aph.gov.au/library/INTGUIDE/econ/hih_insurance.htm Mardjono, A. (2005). A tale of corporate governance: Lessons why firms fail. Managerial Auditing Journal, 20(3), 272-283. Vinten, G. (2005). Financial regulation. Bradford: Emerald Group Publishing. Westfield, M. (2003). HIH: The inside story of Australia’s biggest corporate collapse. Sydney, NSW: John Wiley & Sons. Read More