STRATEGIC DECISIONS THAT CONTRIBUTED TO THE COLLAPSE OF HIH INSURANCE

Strategic Decisions that Contributed to the Collapse of HIH Insurance The breakdown of HIH Insurance Group in 2001 is one of the major failures in Australian corporate world. Through a ramified network of subsidiaries all over the country and overseas, HIH Insurance Group was one of major players in the Australian insurance market and provided a broad range of services, including but not limited to general insurance, personal and domestic insurance, travel insurance, builders warranty insurance, sporting insurance, corporate and other policies. The government financed the investigation into the HIH Insurance Group bankruptcy, set up an emergency rescue package for those affected by the collapse, and the regulators transferred most insurance policies to other insurers. Unfortunately, these measures were not enough to indemnify nightmarish consequences of the corporate giants demise since the matter concerned losses in the amount of 5.3 billion Australian dollars. This was an inevitable result of failed strategic decisions based on overoptimistic valuations of assets and immense underestimation of the companys liabilities on the balance sheet. The main problem was that HIH Insurance accumulated a large pool of insurance policies which were offered at quite a low price without setting aside sufficient capital to cover future claims. Instead, HIH Insurance invested receipts from insurance premiums into reinsurance schemes created with other companies. This situation was largely aggravated by poor management and improper due diligence dictated by overly aggressive acquisition strategy aimed at rapid growth. As a result, HIH Insurance Group acquired a number of troubled insurance businesses at exorbitant prices. This led to the creation of a massive portfolio composed of nearly 200 subsidiaries in such a highly competitive and overcrowded market as insurance.

STRATEGIC DECISIONS THAT CONTRIBUTED TO THE COLLAPSE OF HIH INSURANCE The most questionable transaction in terms of its value and expedience was the acquisition of FAI Insurance in late 1998. To finance the purchase worth 300 million Australian dollars, HIH Insurance had to borrow heavily only to find out that share price of the acquired company suffered a threefold decrease. This proves that in its strategic decision making, HIH Insurance relied solely on figures in the financial statements reported by FAI instead of conducting a proper due diligence on the target company. The merger proposal envisioned one HIH Insurance share for every three shares of the target company or one HIH Insurance share and additionally $2.25 for every six shares of the target company. However, this offer was not subject to any kind of formal investigations into financial conditions and business operations of FAI. The deal was signed and already by early 1999 FAI had become a subsidiary of HIH Insurance Group for a total amount of approximately 300 million Australian dollars. Naturally, the acquisition of this company was burdensome to HIH Insurance as it challenged its already compromised reserving policies. The abovementioned transaction was only one in a series of unfortunate business

decisions implemented by HIH Insurance. Its international insurance operations also contributed to the collapse considerably, especially those exercised by the companys subsidiaries in the United Stated, England, China, Hong Kong, and Thailand, to name a few. For example, in California HIH Insurance managed to become a number one underwriter of workers compensation insurance by offering the lowest possible premiums. When minimum rates were abolished in 1995 triggering deregulation processes in the market, HIH Insurance failed to take a more fundamental approach to the situation in the market and viewed it as an ordinary three-year cycle. It was decided to leave the market, and come back in three years. However, HIH Insurance did not recognize that deregulation reshaped the market conditions completely, particularly that

STRATEGIC DECISIONS THAT CONTRIBUTED TO THE COLLAPSE OF HIH INSURANCE now regulators demanded insurance companies to assume more of the risk. Thus, the company

did not test the ground before its re-entrance and its capital was largely exposed to inherent risks of workers compensation insurance. Along with many other market players, HIH Insurance incurred huge losses. The situation was not better for HIH Insurance subsidiary in England. There it encountered substantial losses in the film-financing industry, which is quite a difficult sphere for doing business that requires deep understanding of all the peculiarities related to film projects. HIH Insurance was unable to fully comprehend and cover associated legal risks, and consequently suffered significant losses. Neither the company managed to reimburse the money from reinsurers who pointed to numerous insurance coverage breaches. The UK courts took the side of London-based reinsurers and rejected reimbursements to HIH Insurance. Actually, back in July 1996, the internal auditors voiced concern about the way in which the London office managed its operations. The auditors pointed to the problems in collecting market data, the lack of risk management practices, negligent underwriting approach, excessive risk taking, as well as the insufficiency and inadequacy of the analysis of available financial information. Other concerns that were expressed were connected to reinsurance schemes practiced by HIH insurance and companies that failed to meet requirements stipulated in Basel II. Regardless of these apparently burning problems, Mr. Williams, HIH Insurances CEO (will be discussed later) called for further expansion of HIH Insurances business in the UK by taking over River Thames Insurance Company Limited and Cotesworth, which held local licenses for conducting corresponding business activity (Robinson, 2003). Furthermore, PricewaterhouseCoopers identified the lack of appropriate infrastructure and management controls when it undertook review of inwards treaty book (Kehl, 2001).

STRATEGIC DECISIONS THAT CONTRIBUTED TO THE COLLAPSE OF HIH INSURANCE The joint venture deal with Allianz Australia Insurance Limited crowned a series of

strategic decisions that contributed to the demise of HIH Insurance Group. The board of directors hastily approved restructuring proposals developed by management without considering their implications for the business and appreciating inherent risks. It was decided to sell retail insurance business, and that depleted cash from HIH Insurances operations. The aggressive growth strategy pursued by HIH Insurance had a disastrous effect on the companys financial condition. The annual report for the 1998-99 financial year showed a considerable growth in the value of total assets and liabilities, but it was also mentioned that this growth had occurred in a business environment characterized by low premium rates, volatile returns, and losses incurred all over the industry. It was the first time in its history when HIH Insurance reported a year-end loss. Throughout 2000 HIH Insurance reported a substantial decrease of its profitability. The share price plummeted downwards. The situation was exacerbated by market difficulties that the company encountered both in the United States and overseas, as well as the losses resulted from the acquisition of FAI, as it was discussed earlier in the present paper. HIH Insurances financial downfall had attracted significant public attention as all the developments were reflected in the media and stockbrokers reports. Among others, there were negative statements in the address of the companys senior management, particularly the management style exercised by Mr. Williams, his failed business and investment strategies (Westfield, 2003). The question is who stood behind ineffective managerial decisions. Ray Williams occupied the post of chief executive officer from the foundation of HIH Insurance and up to his resignation in fall 2000. His rule in the company was highly dominative and he brought many of his friends on to the governing positions. This caused a lack of accountability demonstrated by

STRATEGIC DECISIONS THAT CONTRIBUTED TO THE COLLAPSE OF HIH INSURANCE upper management to the board of directors, and absence of independent investigation into business practices or at least proper assessment of the state of affairs in the company. Mr. Williams had unlimited powers in making investment and business development decisions. The board of directors never questioned these policies, and senior management implemented what was said leaving the solution of all business matters to the CEOs will. The most daunting result of ineffective corporate governance was absence of proper risk management practices which is apparently vital for any company doing business in the insurance and reinsurance industry in general. Geoffrey Cohen, the chairman of HIH Insurance, was evidently not the right person for this position. He might have fit Mr. Williams view on holding the board meetings, but he never ensured that the matters of primary concern were brought under discussion. Only the issues

raised by the management were discussed, and this approach excluded consideration of strategic issues beyond managerial control. Moreover, the board seemed to discuss only past performance of the company as the board members were provided with quarterly financial reviews and summoned four times a year. They had no clear vision of the companys strategy and in what direction it was heading; and they did not ask any questions. It is the generally accepted practice of corporate governance that the board of directors role is to approve and review a corporate strategy, monitor achieved results, and set milestones for future performance. If the CEO neither communicates his vision on business development nor identifies strategic directions, how could management prepare a long-term strategic plan and present it to the board of directors for critical analysis and endorsement? In these circumstances, all investment decisions were rather opportunistic and the company moved ahead without a direction. Additionally, there were no mechanisms to estimate the risks associated with one or

STRATEGIC DECISIONS THAT CONTRIBUTED TO THE COLLAPSE OF HIH INSURANCE another investment project or check its progress. This corporate dysfunction caused major failures of HIH Insurances operations discussed in detail in the paper above. In conjunction with apparent failures in corporate governance, non-executive directors

were blamed for not understanding the outstanding claims provisioning. However, it is one of the most crucial areas of knowledge that decision makers in the insurance company should possess as it is critical to the financial health of the entire company. The more so, it used to be a major part of the financial statements of HIH Insurance. This lack of understanding of the companys core operations meant that non-executive directors could not identify risks and cope with looming problems. Furthermore, HIH Insurance failed to establish proper practices for reserved capital. Even though this issue should be of the highest priority to the insurer, HIH Insurance based its decisions regarding the amount of reserves on the figures that appeared in the reports prepared by actuaries. These reports were neither discussed at the board meetings nor submitted to the audit committee for consideration. So, nobody checked the reliability of the figures presented by actuaries. Similarly, the board of directors never tested the recommendations suggested by senior management. There were no proper internal financial controls and consequently the company continually suffered from the failure to meet budgetary targets. However, this issue was not addressed by decision makers. Thus, budgetary control as a common tool of strategic planning was absolutely ineffective. Remarkably, HIH Insurance management resorted to the use of oneoff end of year transactions that affected profits to disguise poor underlying performance (Hutchinson, 2003). Whether the use of such aggressive accounting practices was appropriate was not considered by the board or audit committee.

STRATEGIC DECISIONS THAT CONTRIBUTED TO THE COLLAPSE OF HIH INSURANCE Another ethical dilemma spotlighted by the demise of HIH Insurance is related to the services provided by audit professionals. It was revealed that during the 1999-2000 financial year HIH Insurance paid 1.6 million Australian dollars to Arthur Andersen for consultancy fees while audit services during the same period totaled 1.7 million Australian dollars (HIH Royal Commission, 2003). The issue to be considered, however, is whether the provision of such services was ethical on Arthur Andersens part while being in the best interests of shareholders to whom they owe a duty of care (Coombes and Watson, 2000).

Arthur Andersen forwarded an argument that the fees for the non-audit services rendered to HIH Insurance were above the market average because they had developed a profound knowledge of HIH Insurances business operations over a long period of time. This allowed Arthur Andersen to see a better picture of the business activities performed by HIH Insurance, and thereby offer more customized services in a more cost-effective fashion. However, this intimate knowledge should have also enhanced the ethical obligations of Arthur Andersen to bar their client from the conflicts of interest. The Australian regulator of the insurance industry has acknowledged that the HIH Insurance case has raised topical issues to what extent it should rely on information provided by insurance and reinsurance companies and their auditors. The collapse of HIH Insurance is one in a row of large failures in the Australian insurance sector in the recent years. New rules and procedures, which came into effect in summer 2002, require the companies to implement a clearcut reinsurance strategy, build up capital reserves, embody proper risk management practices, and avoid excessive risk taking. In essence, many of these provisions were formulated well before the breakdown of HIH Insurance; if they have been enforced earlier, HIH Insurance might have not lived up to set standards and made efforts towards some improvements.

STRATEGIC DECISIONS THAT CONTRIBUTED TO THE COLLAPSE OF HIH INSURANCE

At the same time, it is fair to note that while the new standards imply that the capital held by insurance companies should be more closely related to the inherent risks, unfortunately, the reforms have failed to fully answer the concerns related to risk reporting. Bruce Ferguson, president of the Association of Risk & Insurance Managers of Australasia, commented on the situation: We need a watchdog with more teeth, and one that barks a bit more often. It is futile to have a regulatory system which is either not armed with the [timely] information the market requires or is unable to pass it to insurance buyers. The report on HIH Insurance completed by the Royal Commission has pointed to the need for immediate and profound changes in corporate governance, management, financial reporting, budgeting, and in a set of insurance-related activities. The report has given way to a series of repercussions for the audit and assurance profession as a whole with focus put on the Ramsay Report regarding the issues of auditor independence. It has also advocated greater regulation of the audit and assurance profession and recommended the introduction of amendments to the Corporations Act 2001 and the listing rules of the Australian Stock Exchange. The recommendations provided by the ASX Corporate Governance Council are numerous and detailed, and as it was said, will force many boards to spend long hours in restructuring the way they do things (ASX Corporate Governance Council, 2003). However, it is important to mention that they give a comprehensive framework for boards of directors and senior management to ensure more effective and efficient performance and improved accountability, and do not fall ineptly into the loose corporate governance practices unearthed by the Royal Commission at HIH Insurance.

STRATEGIC DECISIONS THAT CONTRIBUTED TO THE COLLAPSE OF HIH INSURANCE

References Allens Arthur Robinson (2003) HIH Report and CLERP 9, Focus: Corporate Governance, May, p.2. www.aar.com.au/pubs/pdf/ma/focgmay03.pdf. ASX Corporate Governance Council (2003) Principles of good corporate governance and best practice recommendations, March 2003, Australian Stock Exchange, Sydney. Coombes, P. and Watson, M. (2000) Three surveys on corporate governance, The McKinsey Quarterly, No.4, 74-77. HIH Royal Commission (2003) The Failure of HIH Insurance: A Corporate Collapse and its Lessons, (Mr Justice Neville Owen (commissioner), 3 vols, Commonwealth of Australia, Canberra. Hutchinson, M.R (2003) An analysis of the association between firm risk, executive share options and accounting performance: some Australian evidence, Review of Accounting and Finance, Vol.2, No.3. pp. 48-71. Kehl, David (29 November 2001) HIH Insurance Group Collapse. Parliamentary Library (Parliament of Australia). http://www.aph.gov.au/library/intguide/econ/hih_insurance.htm

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Westfield, Mark (2003). HIH: The Inside Story of Australia's Biggest Corporate Collapse. John Wiley & Sons Australia.