HIH Debacle: A Litany of Ineptitude

Further, the New South Wales Court of Appeal last week upheld civil charges and penalties against former HIH Director Rodney Adler and former HIH Chief Executive Officer Ray Williams, (except on one count for Mr. Adler.) For breaching their duties as directors, Mr. Adler and Mr. Williams have been ordered to pay compensation equaling nearly A$8 million (US$5.4 million), in addition to penalties. They also are banned from acting as directors20 years for Mr. Adler and 10 years for Mr. Williams. Mr. Adler is also facing criminal charges, according to a statement from the ASIC.

According to the HIH Royal Commission report, HIH does not demonstrate a case of wholesale fraud or embezzlement.

"Most of the instances of possible malfeasance were borne of a misconceived desire to paper over the ever-widening cracks that were appearing in the edifice that was HIH," the report said.

The report said the inability to price risk properly and chronic under-reserving were major contributors to the companys failure and its financial deficiency of as much as A$5.3 billion (US$3.6 billion), which led liquidators to step in on March 2001.

Although on Dec. 31, 2000, HIH estimated its provisions for outstanding claims were A$3.1 billion (US$2.1 billion), it was later estimated that the outstanding claims were undervalued by as much as A$4.3 billion (US$2.9 billion).

There was "a lack of attention to detail, a lack of accountability for performance, and a lack of integrity in the companys internal processes and systems," which led to a series of bad business decisions, the report said.

"There was blind faith in a leadership that was ill-equipped for the task," the report said, as well as insufficient independent oversight.

Further, the report said, the board failed to assess the companys corporate governance practices to ensure they were suited to the changing environment in which the company operated.

Some of the business decisions listed by the report include:

A decision in 1996 to re-enter the U.S. market.

"In 1994in anticipation of legislative changes that it was thought would cause premium rates to fallHIH sold its workers compensation business in California on favorable terms," the report said.

In January 1997, HIH reacquired the business, by then known as CareAmerica, because management believed anecdotal evidence and reports from CareAmerica executives that the bottom of the market had been reached, the report indicated.

The reacquisition, however, was subject to limited due diligence, the adequacy of CareAmericas reserves was not assessed, and no indemnity was sought against the potential deterioration of reserves, the report said.

"In October 2000, the U.K. operation was placed in run-off. It is estimated that the foray cost the group about [A$620 million or US$420.1 million]."

The expansion in 1997 of U.K. operations into areas of business in which the underwriters had little experience or expertise.

"The main losses occurred in the underwriting of whole-of-account excess-of-loss marine reinsurance and film financing," the report said. "Among other instances of dismal outcomes were the provision of personal accident cover to members of the Taiwanese military and of motor vehicle physical damage coverwithout terrorism exclusionsto an Israeli insurer."

In 1998, the company acquired the Cotesworth Group Limited, which was a managing agent of four Lloyds syndicates, which also had reserving problems.

The report said the situation in the U.K. operations "was exacerbated by the lack of a reporting structure that would allow others in the organization to know what business was being written and the risks being assumed." The report said that losses in the United Kingdom may reach A$1.7 billion (US$1.2 billion).

The unwise acquisition of FAI Insurance Ltd. in 1998.

HIH had been interested in acquiring a holding in or possibly taking over FAI since about 1993, but FAIs chief executive officer, Rodney Adler, rebuffed attempts to carry out due diligence, the report said. After discussions lapsed in February 1998, negotiations were renewed in September 1998, the report said. HIH directors decided to proceed with the takeover despite Mr. Adlers continued refusal to allow due diligence, the report said.

"HIH proceeded with the takeover solely on the basis of its assessment of publicly available information," the report said, which did not reveal the excessive, and undisclosed, under-reserving of FAIs long-tail business. The report estimated that the cost to HIH of the FAI acquisition was about A$590 million (US$399.7 million).

The sale in January 2001 of most of its profitable lines of business to a joint venture with Allianz Australia Limited.

"The negative cash flow aspects of this venture hastened the rate of HIHs decline and led directly to the decision" to bring in the liquidators.

The use of financial reinsurance, traditional reinsurance and questionable accounting techniques to hide, filter or sanitize "unpleasant information"in other words, to reduce losses.

Financial reinsurance was used by FAI to conceal the extent of the companys under-reserving problems, the report said.

"The contracts were also vehicles for the overstatement of FAIs reported operating profit before tax for the year ending June 30, 1998," the report added. "FAI reported an $8 million pre-tax operating profit instead of a significant loss," which made it a more attractive takeover prospect for HIH.

Side agreements for the financial reinsurance cover meant it turned the reinsurance policy into a disguised loan rather than a true reinsurance policy, explained Michael Vine, director of Standard & Poors in Melbourne, Australia.

To redress FAIs financial problems as well as its own under-reserving, HIH negotiated other financial reinsurance in August 1999. As a result, in its June 30, 1999, accounts, "HIH booked a profit of some A$92.4 million [US$62.6 million] in relation to these reinsurance arrangements, but the contract was not entered into until August 25, 1999," the report said.

For accounting purposes, it was treated as true reinsurance, although that was not the case and the booking of recoveries at June 30, 1999, was not justified under accounting standards, the Royal Commission report said.

"Had the transaction not been accounted for as true reinsurance, HIHs reported operating profit before tax and extraordinary items of $52 million would have become of loss of $40 million" (or a US$35.2 million profit and US$27.1 million loss, respectively).

Although other arrangements were indeed true reinsurance, the report said their treatment by the company helped to put its balance sheet in a better position.

For example, HIHs U.K. branch had bought reinsurance policies from a European reinsurer for a number of years, the report said. "At the same time, a subsidiary of the HIH group, CIC Insurance Limited, issued policies to the reinsurer on identical terms. In relation to the 1993, 1994 and 1995 underwriting years, the arrangement had the effect of allowing the U.K. branch to report lower taxable income in the United Kingdom and CIC to report higher income in Australia."

In later years, the report continued, the arrangement helped the U.K. branch improve its balance sheet solvency for U.K. regulatory purposes.

A relative dearth of clearly defined and recorded policies or guidelines to assure proper corporate governance. And where they did exist, they were often ignored.

"The presence of written instructions does not guarantee there will not be departures, and the system of checks and balances HIH had in operation failed to detect and stop what might be termed rogue underwriting," the report said.

For example, although the company prohibited fronting without high-level management approval, one office issued policies underwriting film finance where it was fronting for a reinsurer not licensed to write that type of business. "The practice went unchecked for some time and substantial losses are likely to flow from it."

A lack of independent critical analysis.

The board had a high level of respect for management, heavily dependent on the advice of senior management, and assumed that managements recommendations were carefully thought out and, therefore, were correct, the report said.

Indeed, there were few occasions when the board rejected or changed a management proposal, the report added. "[I]t is the boards responsibility to understand, test and endorse the companys strategy," the report said, which the HIH board failed to do.

Reproduced from National Underwriter Edition, July 14, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved. Copyright in this article as an independent work may be held by the author.