Factors That Led to the Collapse of HIH Insurance - Case Study Example

HIH CASE STUDY By Student’s Name Code + Name of Course Professor/Tutor Institution City/State Date HIH Case Study By June 200, HIH insurance was a competitive general insurer in Australia with a high net worth. The company would later be placed into provisional liquidation nine months later with debts approximated between 3.6 and 5.3 billion dollars. The failure in the company is attributed to poor corporate governance, failings in auditing and regulation as well as poor decisions made by its management. Factors That Led To the Collapse of HIH The investigations by the Royal commission into the demise of HIH discovered that the business and accounting factors as well as auditors played part in the collapse. The business aspects comprised of over-charged corporate extravagance and corporate acquisitions (Buchanan, Arnold & Nail 2003, p.199). The corporate governance was founded on the company’s culture, which affirmed that expenditure money and the idea that the HIH group was going against the policy of minimum solvency requirements established by the prudential moderator, the Insurance act and APRA. Aggressive Accounting Practices The accounting blunders comprised of insufficient provisions placed on improperly priced previous claims and insurance claims on policies. The improperly priced claims on policies resulted into an under-estimation of the existing and later insurance premiums for particular classes of industries as well as claim category. Regrettably, the HIH group’s corporate audit committee failed to evaluate the repercussions of these activities (Westfield 2003, p.24). The adoption of antagonistic accounting measures, existing fraud by the management, an incomplete take over process, and poor audit practices eventually led to failure at the HIH. The investigations by the Royal Commission recognized that the HIH group undertook vigorous accounting practices beginning early 1992. A report by Young and Ernst undertaken for CIC holdings was found to have under-reserved by 41 million dollars and understated liabilities by 18 million dollars (Buchanan, Arnold & Nail 2003, p.211). Much of this amount comprises a prudential margin. The necessity for a prudential margin is important for the operations of any insurance company. The CEO of Heath disagreed with the requirement for a prudential margin under the HIH merger. The merger later on resulted into an accounting treatment of reserves, which culminated in alterations for assets in the balance sheet. The company’s auditors knew of this activity but still failed to report to the management (Owen 2003, p. 17). The suggestions made were that the dominant culture at the HIH might have undermined an inquest by the authority. Moreover, there were 288 million dollars in the state’s securities, which HIH pledged as Westpac bank’s letters of credit security being used for the insurer’s capital syndicate at Lords. HIH used the assets committed to Westpac in solvency calculations in order to conceal its insolvency. Takeover and Due Diligence Most of the difficulties experienced by the HIH may be associated with its aggressive strategies on acquisition as well as the development of fewer than 250 subsidiaries (Westfield 2003, p. 25). The firm’sacquisition of FAI insurance that occurred in 1998 was controversial. Alder Rodney (HIH board of director then) offset his own insurance firm that was majority-owned for 300 million dollars to HIH. HIH’s cash flow necessitated that the firm borrows in order to support the acquisition. In this purchase, there were assurances made by Alder without board consultations, but rather by relying on FAI’s presently finished accounts. FAI’s assets were grossly overvalued resulting in a premium that was more than the exact value paid to get control (Owen 2003, p. 27). One of FAI’s advisor revised the valuation of the insurer from 200 million dollars to 20 million dollars without notifying the HIH group and this greatly affected the financial situation of HIH. The result was that the HIH was compelled to write off its reserves in FAI to a value of 400 million dollars by September 2000 (Owen 2003, p. 17). Management Excesses As the HIH advanced towards its collapse, its management was blamed for using the finances of the company to live off lavishly. Personal expenditures were made on the firm’s credit cards, extreme tipping at restaurants, extravagant travel expenses, and generous corporate gifts were the proof to inappropriate activities (Westfield 2003, 27). Conduct of the HIH Management The management of the HIH acted both unethically and illegally. It was illegal for Ray Williams, the Company CEO to disagree with the necessity for a prudential margin. Therefore, the HIH management entirely implemented thepolicy of under-reserve policy in line with the anticipated future claims (Clarke & Oliver 2003, p.16). Failure by the HIH management to follow the regulation ofthe Australian PrudentialRegulation Authority was against the provisions for setting the prudential margin. This resulted into an underwriting performance, which grew worse. It is unusual forgeneral insurers to incur losses onunderwriting at any given period. However, for a company like HIH, making continuous losses for successive durations on underwriting is regarded as a pattern of operational failure. Moreover, the company acted unethically by failing to use its funds prudently apart from the underwriting activity. The use of money taken from the shareholders, creditors, and policyholders was misappropriated (Mardjono 2005, p.272). The investigations by the Royal commission into the demise of HIH discovered that the business and accounting factors, as well as auditors played part in the collapse. The business aspects comprised of over-charged corporate extravagance and corporate acquisitions. Lack of independent sources of information resources for the NED denied them a chance to fulfil their responsibilities. It is unethical and not feasible for a company of HIH’s calibre as well as its non-executive directors to gather and process the information essential for them to achieve their directors’ accountability by themselves. Therefore, the non-executive directors’ accomplishment of theirresponsibility was compromised because they failed to use adequate accountingsystem that was well organized and directed (Clarke & Oliver 2003, p.17). Undoubtedly, these actions representinherent risks in the firm’s systems of corporate governance. The company should have sought compensation arrangements that comprise a financedirector into the firm’s board to ensure that the proper and direct flow of information to the non-executive directors. The company should have also ensured that its audit committee operate effectively and independently to instil faith in the audited accounting information for the non-executive directors. Judging from this, HIH appears to have fallen short of these requirements (Westfield 2003, p.30). It was wrong for the management to fail to include its finance director in the board. Moreover, the CEO Ray Williams dominated theaccounting and management information provision. The conduct of the management rendered defects into the independence and autonomy of the non-executive directors who comprised the audit committee. Accordingly, the non-executive director found it difficult to fulfil their duties with suitable information resources. In the 1990s, the Australian insurers experienced many challenges in the business environment. Many insurance firms had to change their strategies. During this period, HIH placed undue reliance on reinsurance to attain its future debts and started high-risk insurance services. The risky services of the HIH in FAI were managementdecisions that should have pointed at the problems with the company’s direction (Mardjono 2005, p. 274). The management of the HIH also contravened the "minimum solvency provision imposed by section 29 of the 1973 Insurance Act. The provision necessitates that the worth of the insurer's assets should at all times surpass the value of its liabilities by not below the greater of 20 %, $2 millionof yearly premium income or 15 % of unresolved claims provisions (Costello 2003, p.6). Section 295 of the Corporations Act,requires that the directors give their opinion as to if there are valid grounds to consider that at the date of the director’s declaration, the entity will be solvent. If not, they should desist from issuing their financial reports on going-concern grounds. The management at the HIH failed to raise any alarms as to whether the group’s financial reports should be providedon a going-concern foundation, which may specifyif the company’s solvency was improperly investigated. Additionally, HIH group’s management adopted a "group enterprise viewpoint" when demonstrating its regulatory solvency situation. The firm treated insurance subsidiaries as if they comprised a singular corporate entity and "netted-off" associated company liabilities and assets in several APRA yearly returns (Westfield & Mitchell 2010, p.112). This led to the auditor’s failure to recognize the hypothetical insolvency of some subsidiaries. Therefore, the HIH management acted both unethically and illegally. Responsible parties for the Demise of HIH The Auditors Role Arthur Anderson concluded the HIH’s external audits from 1971 until its collapse in 2001. They may have been a reason for the collapse of the company or its costly delay. Their influence to the situation is regarded in different perspectives such as their activities on the audit, their autonomy, and the level to which board management and practices may have played part in the collapse (Buchanan, Arnold & Nail 2003, p. 220). It would appear that a competent and prudent audit would have exposed several aggressive practices at the HIH. For instance, calculations of the prudential margin should have shown a feeble reserve scenario- a crucial area for any insurance company. Being observant to the management’s lavish lifestyles and scrutinizing samples of many expenses may have as well identified questionable misappropriations conducted under the firm’s name (McCarthy 2001, p.110). By examining the correspondence of the client’s, such as their credit letters, the auditors should have identified the pledged securities used in the APRA’s report. Even if the ramifications for these activities were missed, FAI’s main takeover and the explicit associated party implications should have raised concern to auditors associated with the firm’s financial position. The process of planning also appeared deprived of care because of the engagement. As part of the process of audit, a risk assessment is to be conducted by the auditors to establish the plan and structure of the audit. Arthur Anderson evaluated the HIH and reckoned it as ahigh-risk client because of its vigorous accounting practices and the challenges witnessed in the past in line with resolve of issues with the management of HIH. Despite this realization, Anderson maintained the HIH group as an audit customer. Despite of HIH being regarded as a maximum risk customer, no management risk plans were made by the engagement team and thus, not approved or reviewed by the top management team at Anderson. Lastly, the auditors arrived at wrong conclusions. Arthur Anderson signed HIH’s yearly report stating that it was a concern with $939 million net assets. Upon HIH’s collapse nine month later, with a debt of 5.3 billion dollars, Anderson used forecasts and reports by the HIH management without gathering sufficient proof to reach to their conclusion. The liquidator missed the documentation highlighting the reasons for launching HIH as a growing concern. This proves that Anderson provided inadequate working papers to prove that the audit really occurred (Westfield & Mitchell 2010, p.122). Anderson relationship with the customer was not laudable. By liquidation time, three former partners of Arthur Anderson who had conducted work on the HIH financial audit comprised HIH’s board of directors. The chairperson was Geoffrey Cohen, the CEO was Dominic Fodera while Gardener Justin was a non-executive director. The Royal Commission intimated that valid proof exists to establish that a close association formed between the parties and that this association advanced to the point that could threaten the assurance team’s independence as well as particular auditors(McCarthy 2001, p.111). Such associations would presently be in serious contravention of most conduct codes including Professional Statement F1 that applies to all Chartered Accountants operating in Australia. The Board of Directors There was an apparent absence of independence between the auditors and board of directors, which indicates that what mattered to HIH, may not necessarily have been a top priority. Anderson’s failure to give adequate working papers or to collect substantive evidence to strengthen their discoveries raise concerns regarding the eminence of the audit they undertook. Corporate processes missed outespecially with respect to right practices on corporate governance. Whereas HIH developed an audit committee, they still seemed to use it ineffectively (Abeysekera 2005, p.71). There was an open breech of autonomy within the committee. The chairman Geoffrey Cohen was also the chair for the auditing committee. Audit engagement team members failed to meet with the audit committee of HIH making it hard to be reasonably autonomous of management (Haines 2007, p.523). Therefore, it may have made it harder to discuss the questionable choices of the management. Failure by the HIH management to follow the regulation of the Australian Prudential Regulation Authority was against the provisions for setting the prudential margin. This resulted into an underwriting performance worsening the tribulations of the HIH. Arthur Anderson’s Contribution in the case There has been proof to intimate that Anderson’s autonomy lacked in the high-pressure association between the directors of HIH and Anderson’s audit team. A counsel to the HIH, Mr. Martin implies that the audits philosophy of independence, competence, and judgement may have been undermined as they took to finish their work under fiscal and time constraints. He posited that the management of HIH refused to increase the sum of audit fees payable to Anderson. Anderson pursued to minimize the quantity of work on the HIH audit (Westfield & Mitchell 2010, p. 125). A noteworthy independence issue also emerged in Arthur Anderson’s payment to the HIH chairman for consultancy fees. The fees totalled $190,887 over a period of nine years, and added the use of an office and secretary attached to Anderson (Abeysekera 2005, p.72). On top of the wilful wrongdoings, these charges were not revealed to the other board members in the annual general meetings. The complex and close relationship between the HIH chairman and the auditors raise more questions that impact this case. Lastly, it should also be pointed that Anderson provided both non-audit and audit services to HIH. Provision of audit and non-audit services to customersis permitted under given situations. However, there are ethical challenges in ensuring that auditors independence is upheld (Haines 2007, 522). It becomes a question of the possibility of an auditor providing an independent standpoint on the financial reports when they are implicated in the case however their participation may be, in directing the customer towards making those statements (Westfield & Mitchell 2010, p.124). The issue is the delivery of Arthur Anderson’s non-audit services while he acted to protect the shareholder’s interests to whom they are indebted a care duty. According to the Royal Commission, HIH’s collapse was not because of embezzlement or fraud, but rather the outcome of trials to write over the spaces generated by overpriced acquisitions (Westfield 2003, p.12). Whereas the misstatements and the management they had established resulted to the charge towards HIH’s collapse, Arthur Anderson’s contribution seemed to be significant. Reference List Abeysekera, I 2005, ‘Accounting: in crisis or ascendancy?’ Accounting History, vol. 10, no. 3, pp. 71-87. Buchanan, B, Arnold, T & Nail, L 2003, ‘Beware the Ides of March: The Collapse of HIH Insurance,’ Social Responsibility: Corporate Governance Issues, vol. 1, pp. 199-221. Clarke, F, Dean, G&Oliver, K2003. Corporate Collapse: Accounting, Regulatory and Ethical Failure, Revised Edition.Cambridge University Press. Costello, P 2003, ‘Report on the HIH Royal Commission.’press release, vol. 16, pp. 1-30. Haines, F 2007. Crime? What Crime? Tales of the Collapse of HIH. Springer US. Mardjono, A 2005, ‘A tale of corporate governance: lessons why firms fail. Managerial Auditing Journal, vol. 20, no. 3, pp. 272-283. McCarthy, G 2001, ‘The HIH Royal Commission and the tangled web of truth.’Australian Journal of Public Administration, Vol. 60, no. 3, pp. 110-112. Owen, J 2003. Report of the HIH Royal Commission. Commonwealth of Australia, Canberra. Westfield, M& Mitchell, M 2010. HIH: the inside story of Australia's biggest corporate collapse. Bolinda audio. Westfield, M2003, ‘Why did HIH collapse?’CA Charter, vol. 74, no. 3, pp. 24-29. Read More