The collapse of HIH Insurance

Origins: a marine underwriting agency

HIH began in 1968 as a marine underwriting agency, formed out of two earlier insurance businesses — Fire and All Risks Insurance, and the insurance operations of National Consolidated. For its first two decades it was a mid-sized participant in a heavily regulated domestic market, writing general insurance through brokers and agents rather than directly to the public.

That period matters to the story for a reason that is easy to miss. General insurance is a business of estimation. An insurer collects a premium today and pays a claim at some unknown point in the future, for an amount that is not yet known. Between those two events sits a liability — the outstanding claims reserve — that is essentially a professional estimate of what the company expects to pay out. The whole business rests on the quality of that estimate.

Through the 1970s and 1980s HIH expanded by acquisition, and acquisitions in insurance bring a specific complication: when you buy a portfolio of policies, you also buy the obligation to pay claims on them, and you inherit whatever the previous owner believed those claims would cost. If that belief was optimistic, the true cost surfaces later, in your accounts.

The growth years and the acquisitions

Through the 1990s HIH pursued scale aggressively. It listed on the Australian Securities Exchange in 1992 and used its shares as currency for expansion, both in Australia and overseas. By the late 1990s it described itself as one of the largest general insurers in the country, with operations in the United Kingdom, the United States and Asia.

The pattern that recurs across the decade is a widening gap between the size of the business and the strength of its reserves. Size grew through purchase. The reserves attached to the purchased business, and the adequacy of the group's own reserving, are the questions that later occupied investigators.

There is a structural feature of insurance accounting that makes this hard to see from outside, and it is worth understanding because it applies to every insurer whose accounts you might read. Money set aside for future claims sits on the balance sheet as a liability. Increase that liability, and profit falls — immediately and visibly. Reduce it, and profit rises. A company under pressure to report growth therefore faces a temptation that does not exist in most industries: the estimate is genuinely uncertain, and within the range of defensible estimates, the choice materially changes the reported result.

The FAI acquisition

The pivotal transaction came in 1998, when HIH acquired FAI Insurance. The acquisition was pursued against competition from a rival bidder and was completed at a price that was criticised at the time and investigated afterwards. In the years that followed, it became apparent that the claims liabilities HIH had acquired with FAI were larger than had been recognised in the transaction.

This is the point at which the archive's interest lies, and it is not really about the personalities involved. It is about a mechanical difficulty in the acquisition process itself. When one insurer buys another, the buyer must form a view about the seller's outstanding claims. The seller has an incentive to present those claims favourably — its own reported profits depend on the same estimates. The buyer, wanting the deal, may accept that view. Two years later, the difference between the estimate and reality lands in the buyer's accounts.

An acquiring company is required to disclose the consideration paid, the assets and liabilities acquired, and the effect on its own financial position. Those disclosures exist in the public record, and reading them in sequence — the acquisition announcement, the annual report for that year, and the annual reports for the two following years — shows the gap opening up.

The collapse, month by month

The end came quickly, and the public record of it is unusually complete because the failure triggered both a Royal Commission and extensive litigation.

The reported deficiency — the gap between what the company owed and what it had — ran into the billions of dollars. The precise figure depended on how claims were ultimately settled, which took years. Policyholders, small businesses and shareholders bore the consequences, and public confidence in the general insurance market was damaged in a way that took a decade to repair.

The failure was not detected early because the number that would have revealed it — the adequacy of the claims reserve — is the one number in an insurer's accounts that cannot be verified from outside the company.

What the Royal Commission found

The Royal Commission's report is a public document and remains the most detailed account of the failure. Its findings addressed several distinct areas, and it is worth separating them because they represent different types of failure.

• Reserving and accounting. The inquiry examined whether the company's provisions for outstanding claims were adequate and whether accounting treatments — including the treatment of deferred acquisition costs and the recognition of income — had the effect of overstating the group's financial position.
• The FAI acquisition. The inquiry examined the due diligence conducted before the acquisition and the basis on which FAI's liabilities were assessed.
• Governance. The inquiry examined the operation of the board, the flow of information to directors, and the adequacy of the company's risk management and internal reporting.
• Audit. The inquiry examined the role of the auditor, and its recommendations contributed to significant changes in Australian audit regulation and independence requirements.
• Regulation. The inquiry examined the effectiveness of the then regulator, APRA, and Australian Prudential Regulation Authority's capacity to intervene before a failure of this kind.

Criminal and civil proceedings followed. Several former directors and officers faced prosecution or civil penalty proceedings, with outcomes that varied considerably between individuals. Our purpose here is not to recount those proceedings in detail — they are a matter of public record and a reader interested in them should go to the judgments themselves. The archive's interest is in what the failure revealed about the documents a company publishes.

Why insurance reserves are the hardest number to check

This is the transferable lesson, and it applies to any insurer a reader might study, not just HIH.

Most figures in a set of financial statements can be verified against something outside the company. Revenue can be checked against invoices and cash receipts. Cash balances can be confirmed with a bank. Inventory can be counted, however imperfectly. Property can be valued against market evidence.

Outstanding claims cannot be verified by anyone outside the company, because they concern events that have not yet happened. The company estimates what it will pay. An actuary tests the estimate against historical patterns. The auditor reviews the method. But the eventual number is unknowable at the time, and the range of defensible estimates is wide.

That means an insurer's reported profit is, to a significant degree, a function of a management estimate. Three questions follow, and they are answerable from the published accounts:

1. Did the estimate change? A weakening of prior-year reserves — sometimes called a reserve strengthening — is disclosed. Repeated weakening across several years suggests earlier estimates were optimistic.
2. How does the reserve compare to premium income? The ratio of outstanding claims to annual premium is comparable across insurers and across years within one insurer. A ratio that drifts below peers deserves an explanation.
3. What do the notes say about assumptions? The discount rate, inflation assumptions and claims development patterns are described in the notes. A change in assumption is a change in reported profit, and it is disclosed.

None of these questions requires hindsight. Each is answered by documents published years before the failure.

What the archive takes from this

HIH is in this archive because it is the clearest Australian example of a specific problem: a company whose reported numbers depended on estimates that only management could make, and whose disclosure obligations were satisfied while those estimates were, in hindsight, badly wrong.

Three things stand out, and none of them are about predicting a collapse.

First, disclosure is not the same as clarity. HIH published annual reports, disclosed its acquisitions, and described its accounting policies. The information existed. What it did not do was make the risk visible in a form a non-specialist could act on. That is a general problem with financial reporting, and it is why the ability to read a set of accounts — rather than merely obtain one — is the skill this archive exists to build.

Second, estimates are where the judgement lives. In every set of financial statements there are a small number of figures that are genuinely uncertain: claims reserves, impairment of goodwill, provisions for doubtful debts, the useful life of an asset. These are the figures where management discretion has the largest effect on reported profit. Everything else in the accounts is comparatively mechanical.

Third, regulation follows failure, not the reverse. Nearly every significant strengthening of Australian corporate disclosure and audit regulation in the last quarter-century traces to a specific collapse — HIH among them, alongside others. The rules a company operates under today exist because of what happened in cases like this one.

Sources

1. HIH Royal Commission, The Failure of HIH Insurance, report of the Royal Commission chaired by the Hon. Justice Neville Owen, April 2003. Available through the Australian Government's public records.
2. HIH Insurance Limited, annual reports and financial statements, 1998–2000, lodged with the Australian Securities Exchange.
3. Australian Prudential Regulation Authority, public statements and submissions concerning HIH Insurance, 2001–2003.
4. Judgments of the Supreme Court of New South Wales, including ASIC v Adler [2002] NSWSC 171, which concerned related-party transactions connected to the FAI acquisition.
5. Australian Securities and Investments Commission, public registers, for the corporate history and status of the entities concerned.