CORPORATE FAILURE OF HIH INSURANCE

By

Parth Paliwal (352) & Krishna Mittal (335)

COMPANY BACKGROUND AND ORIGIN

• HIH Insurance was founded in 1968 by Ray Williams and Michael Payne and at this time it was known as “ M W Payne Underwriting Agency Pty Ltd “

• It was acquired in 1971 by British company CE Heath PLC and Ray Williams was appointed to the board of CE Heath PLC.

• In May 1996, CE Heath International Holdings changed its name to HIH Winterthur.

• Through 1997 and 1998, HIH Winterthur acquired a large number of companies both in Australia and globally, including Colonial Ltd General Insurance's operations in Australia and New Zealand, Solart in Argentina and Great States Insurance Co in the United States.

• Most notably, HIH acquired the large Australian counterpart FAI Insurance, whose chief executive Rodney Adler became a director of HIH in 1999.

• Winterthur Swiss sold its 51% share in HIH Winterthur to the public and HIH changed its name to HIH Insurance Ltd.

THE (Sudden) COLLAPSE

• The March 2001 collapse of HIH Insurance sent shockwaves through the Australian business community. The country’s second-largest employer, HIH was at the tail-end of a major acquisition spree. With an estimated $8.1bn asset base at the end of 2000, HIH was widely perceived as an extremely robust and reliable company…

• However, private internal reports had begun to demonstrate that the company’s debt leverage and insurance liabilities were so high that there was a real risk of insolvency.

• Ultimately, in early 2001 the company’s precarious financial situation became untenable and HIH endured the largest corporate collapse in Australian history, going down with losses of more than $5bn. With the company continuing to function purely so as to service old claims, with no new business being taken on board.

MASSIVE COMMUNITY IMPACT• The impact on retail policyholders, in particular, was dramatic

• Professional groups, community groups, small business owners, homeowners and injured individuals were left stranded with unpaid claims for :

• Professional indemnity

• Public liability

• Home warranty

• Accident & disability

• Travel

• “ The failure of HIH caused widespread distress, loss, uncertainty and cost to the taxpayer. The repercussions will echo through the economy and community for years to come “

--- Mark Westfield

ROYAL COMMISSION

• Federal Government announced that it would establish a Royal Commission to examine aspects of the company’s collapse.

• Headed by Justice Neville John Owen, the commission formed a new non-profit company called HCS (HIH Claims Support Pty Ltd) to process the government support package for HIH policyholders in hardship.

THE REAL STORY• Many of HIH's business difficulties can be primarily due to it’s aggressive expanded

business strategies. Over a decade, HIH created more than 200 subsidiaries, and the business covers almost all insurance business segments, domestically and globally.

• It either entered the insurance market that is already overcrowded and competitive by offering lower insurance premium (California, US), or chose a sector that it did not fully understand which lead to business issues and legal risks (London, UK).

• HIH acquired some troubled insurance business with too high price during its rapid growth period in 1990s.

• The most controversial acquisition is $ 300 Million to buy FAI from Rodney Adler, who later became a member of HIH's board of director. FAI was later revealed only to be worth $100 Million.

• “ It was likely at the time of the HIH takeover of FAI that both were commercially insolvent, although they gave the impression to the outside world of being financially strong in HIH's case, or, in FAI's situation, troubled but viable ... Williams was putting two weak corporations together to form a potentially weaker combined entity “

• HIH also had many fundamental problems, such as underpricing and reserve problem.

• It offered insurance with very low price, but failure to set aside enough capital to cover it’s future liability.

• According to press reports, HIH's actuarial adviser had warned HIH's risk management concern a year before company collapse. However, instead of adding extra capital, HIH chose to buy reinsurance to lay off its risk. It was proved as a wrong decision when all the reinsurance cover ran out.

• Further more, the HIH's failure is not only attributed to the business strategy and fundamental problem, but also includes additional issues like false reports, reckless management, fraud, greed and self-dealing.

• Stock market manipulation

• Disseminating false information

• Sydney businessman Brad Cooper was sentenced in the Supreme Court on 23 June 2006, after a jury found him guilty on 13 charges, relating to bribes he paid a senior HIH official to push through false claims in the months before the insurer's collapse.

• It was found that three of HIH's board members in 2000 are previously employed by Arthur Andersen, who is the external auditor of HIH. It raised huge issues for the reliance of the information provided by company and their auditors.

10

Lack of independence for non-executive

director

Dominance of Ray Williams, the CEO of

HIH

Lack of independent information resources

Inadequate risk management

FLAWS

AS THE ROYAL INVESTIGATION REPORT OF HIH DISCLOSED, THERE ARE SOME FLAWED ASPECTS REGARDING HIH

CORPORATE GOVERNANCE PRACTICE

Lack of independence for non-executive director from the management

• Justin Gardener, member of audit committee, used to be the auditor of FAI in 1980’s and FAI was sold to HIH in 1998. This takeover transaction was regarded as the one of main causes for the later failure of HIH Company as HIH has to pay huge cost for the acquisition of FAI. Undue diligence for investigation work and misjudgment of the financial perspective of FAI contribute to this awful transaction. Justin Gardener must be put in the place where his independence was questioned due to his conflict of interest. Rodney Stephen Adler, the member of investment committee in charge of the transaction also got suspect in regard to the independence because the situation should have been better had he paid due diligence.

Dominance of Ray Williams, as the CEO of HIH

• Ray Williams had an illusion that HIH is his own belongings not the shareholders and he no doubt deserves to override the board. Unfortunately the board of directors fails to refrain him from doing so, and conversely indulges him to run the company dominantly. For example, there were no clearly defined limits on the authority of CEO in some vitally important areas within HIH.

• Dominant, unfettered CEO made HIH become an entrepreneurially run company which was actually controlled by the senior manager and to run primarily in the interest of the senior managers rather than in the interest of stakeholders.

• The existence of a dominant CEO is a known big threat to the function of the corporate governance model and increases the company’s risk of departing from the interest of stakeholders and going into corporate excess.

Inadequate risk management • Given the nature of insurance company, the risk management

plays a vital role in the operation of the company.

• Although the board has set a investment committee to appreciate the risk of investment and set investment guidelines on currency and property dealings, the fact of three major investment failure mentioned above provides ample evidence that the risk management of HIH has not yet been well shaped and performed

• Directors are negligent in terms of analyzing the strategy for investment decisions and appreciating the risk in relation to the investment with adequate appropriate information sources, “risk management failure was just part of the bizarre management style that sent HIH down the toilet”.

Lack of independent information resources for NEDs to fulfill their responsibilities • For the company as large as HIH, It is not feasible and economical for the

non-executive directors to collect and process the information necessary for them to fulfill their directors’ responsibility by themselves, Hence the non-executive directors’ fulfillment of their responsibility have to be compromised because they have no choice but to depend on the accounting system organized and directed by the management.

• There was no finance director included in the board and Ray Williams, the chief executive, dominated the management and accounting information provision.

• Due to the seemingly defect in the independence of the non-executive directors who composed the audit committee, the function effect of the audit committee deserved to be doubted. Accordingly, the non-executive director can hardly fulfill their responsibility with independent information resources.

Conclusion

In the case of HIH, not with standing the corporate governance model “on paper” looks pretty well, the actual practice of corporate governance is proved to be flawed. The inadequacy of the corporate governance practice always implies the high inherent risk of the company at overall level and might lead to corporate excesses.

Thank You