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Royal Commission into the failure of HIH Insurance Report by the Royal Commissioner the Honourable Justice Owen, April 2003 Volume I-A corporate collapse and its lessons


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NCE

THE FAILURE OF HIH INSURANCE

Volume I

A corporate collapse and its lessons

April 2003

c ommonwealth of Australia 2003

This wo rk is copyri ght. Apart from ahy use as permitted under the Copyright Act 1968, no part may be

reproduced by any process without prior written permission from the Commonwealth avai lable from

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ational Library of Australia Cataloguing-in-Publication data:

Australia. HIH Roya l Commission.

The failure of HIH Insurance.

ISBN 0 9750678 0 X (volume I)

ISBN 0 975 0678 50 (set)

I. HIH In surance. 2. Insurance companies-Australia.

3. In su rance- Australia. 4. Business failures- Australia.

I. Title.

368.006594

Printed by National Capital Printing, Canberra

Can berra Publishing and Printing, Canberra

The HIH Royal Commission

4 April2003

The Hon Justice Owen Commissioner

His Excellency the Right Reverend Dr Peter Hollingworth AC OBE Governor-General of the Commonwealth of Australia Government House Dunrossil Drive

Yarralumla ACT 2600

Your Excellency

In accordance with the Letters Patent issued to me on 29 August 2001, as amended by Letters Patent issued on 6 February 2002, 2 May 2002 and 23 January 2003, I have inquired into and prepared a report on the reasons for and the circumstances surrounding the failure of the HIH insurance group.

I now present to you my report and return the Letters Patent.

Yours faithfully

The Hon Justice Owen

The Landmark, 345 George St, Sydney NSW Postal Address: GPO Box 4014, Sydney NSW 2001

Telephone: (02) 8270 6216 Fa csimile : (02) 9200 5444 Email: justice.owen@hihroyalcom.gov.au

Explanatory notes

The report consists of three volumes.

This first volume 'tells the story' of the failure of HIH in order to answer the question: why did HIH collapse? It also canvasses changes that are desirable if we are to minimise the risk of another failure of a large insurance company. Discussion of the evidence is kept to a minimum in this volume, but this does not mean that I

have proceeded without a close analysis of the evidence on which my findings are based.

Volumes II and III provide a detailed recitation and critical examination of the evidence.

The following notes clarify practices adopted for the preparation of the report.

References to people

As a general rule, after the first mention people are referred to simply by their family name. This has been done in the interest of efficiency: no disrespect is intended.

Companie s a nd firms

As a general rule, companies' corporate denominators-such as Limited, Pty Ltd, pic and Inc.-are omitted after the first use.

Depending on the context, a reference to 'HIH' can be to the ultimate holding company, HIH Insurance Limited, or to the entire group, meaning HIH Insurance Limited and its subsidiaries. Where it is important to distinguish and deal with the activities of a particular entity within the group, the entity is identified.

The accounting firm Arthur Andersen, which provided services to both F AI and HIH, changed its name to Andersen in March 2001. Unless the context otherwise requires, the firm is referred to simply as Andersen.

Endnotes

The notes at the end of each chapter refer to source material used in the preparation of the chapter. Many of the references are to the transcript of proceedings or to documents tendered as exhibits. A reference such as 'T3034' is to the page number of the transcript, and a reference such as ' T3 034/ 15' is to line 15 of page 3034 of

The failure ofHJH i nsurance v

the transc ript. References such as 'AND.1360.0155 ' and 'WITS.Ol62.001 at 024 par. 4.2.1' are to material tendered as exhibits; the first one here is to a document produced by Andersen and the second to paragraph 4.2.1 on the 24th page of a witness statement.

The transcript of proceedings and the exhibits are on an electronic database that was ava ilab le to all parties before the Commission. They now form part of the records of the ommission, which are held in accordance with directions issued by the Minister res ponsible for administering the Royal Commissions Act 1902.

Legisla tion

Un less otherwise noted, references to legislation are to Commonwealth legislation.

vi Explanatory notes

Contents

Explanatory notes v

The failure of HIH: a critical assessment xiii

Policy recommendations lxv

PART ONE POST-MORTEM 1

1 Understanding this report 3

1.1 The nature of a royal commission 3

1.2 The Letters Patent 4

1.3 The proceedings: evidentiary matters 16

1.4 The proceedings: procedural fairness 19

1.5 Unavoidable repetition 22

1.6 Future directions 23

2 How the inquiry was conducted 25

2.1 The planning phase 25

2.2 Funding 26

2.3 Initial operations 26

2.4 Ongoing operations 26

2.5 Access to important information 28

2.6 Information gathering 29

2.7 Relations with the liquidators, APRA and ASIC 31

2.8 Referrals 33

2.9 Legal professional privilege 33

2.10 Procedural matters 35

2.11 The public hearings 36

2.12 Hearing procedures 37

2.13 Document-management and hearing processes 39

2.14 Access by parties, the public and the media 40

2.15 Openings by counsel assisting 41

The failure of HIH Insurance vii

2. 16 Issues papers 42

2.17 Background papers 42

2. 18 Ordering of witnesses and issues 42

2. 19 Closing submissions by counsel and parties 44

2.20 The approach to future policy directions 44

2.21 Acknowledgment of the Commission team 47

PART TWO THE LIFE AND TIMES OF HIH 49

3 A brief corporate history 51

3.1 Origins 51

3.2 Float and growth 52

3.3 The F AI acquisition 56

3.4 Overseas operations 56

3.5 The final days 59

3.6 Share performance in the last years 62

3.7 The response to the collapse 62

4 The industry and regulatory context 65

4.1 The Australian insurance market 65

4.2 Market sentiment 66

4.3 The regulatory framework 73

5 Provisioning and reinsurance: general principles 79

5.1 Provisioning 79

5.2 Reinsurance 91

PART THREE DIRECTIONS FOR THE FUTURE 99

6 Corporate governance 101

6.1 The meaning of corporate governance 101

6.2 The board of directors 106

6.3 The role of shareholders 121

6.4 Officers other than directors 121

6.5 Whistleb lowing 131

6.6 Corporate governance: an epilogue 132

viii Contents

7 Financial reporting and assurance 135

7.1 Accounting standards 135

7.2 The audit function 162

7.3 The actuarial function 184

8 Regulation of general insurance 197

8.1 A short history of regulation 197

8.2 The case for prudential regulation 199

8.3 The regulatory framework 201

8.4 The corporate regulator-ASIC 204

8.5 The prudential regulator-APRA 206

8.6 Disclosure of insurers' returns of information 226

8.7 Solvency of general insurers 232

8.8 Adequacy of the Insurance Act 233

8.9 The winding up of an insurance company 245

8.10 Issues under the ASX Listing Rules 247

9 State and territory regulation 259

9.1 State and territory regulation 260

9.2 Overlap between Commonwealth, state and territory regulation 262

9.3 State and territory monopolies 266

9.4 Prudential regulation of State insurance 268

9.5 Price controls 269

9.6 Cooperation between governments 269

10 Taxation and general insurance 273

10.1 Current tax arrangements 273

10.2 The incidence of taxation 275

10.3 The impact of sales and turnover taxes 276

10.4 Other tax matters 280

11 A policyholder support scheme 289

11.1 Policyholder protection in the wake of the collapse ofHIH 290

11.2 Policyholder priority arrangements 291

11.3 The case for a policyholder support scheme 292

11.4 The design of such a scheme 295

11.5 Conclusion 301

The failure of HIH Insurance ix

Appendix A Terms of reference 305

Appendix B Parties 308

Appendix C Witnesses 310

Appendix D Policy submitters 316

Appendix E Operational statistics 318

Appendi x F The Commission team 319

ppendix G Offence provisions: an outline 321

Appendix H Correspondence from the public 331

Glossary 332

Abbreviations 343

X

Contents

VOLUME II

12 The Winterthur years

13 Unprofitable international operations

14 The impact of the F AI acquisition

15 Under-provisioning for claims

16 Use of whole-of-account reinsurance

1 7 The demise of HIH

VOLUME III

18 The inadequacy of management information

19 Regulatory solvency

20 The effect of incorrect accounting

21 The audit function

22 Home Security International: a case study

23 Other aspects of the governance of HIH

24 The regulators

Th e failure ofHIH Insurance xi

The failure of HIH: a critical -assessment

'Beware the ides ofMarch.' The soothsayer's words have become synonymous with unheeded warnings since they were penned by Shakespeare some 400 years ago. Caesar's response-'He is a dreamer; let us leave him: pass'-is less well known but equally apposite. These words sum up the life and times of HIH, and they

resonated eerily throughout the inquiries I made.

On 15 March 2001 the major companies in the HIH Insurance group were placed in provisional liquidation. The provisional liquidators were appointed, the magnitude of the HIH group' s obligations began to emerge, and the journey towards oblivion proceeded. Formal winding-up orders were made on 27 August 2001-the corporate

equivalent of death. By then the deficiency of the group was estimated to be between $3.6 billion and $5 .3 billion. If the ultimate shortfall is anywhere near the upper end of that range, the collapse of HIH will be the largest corporate failure Australia has endured to date.

But the shambling journey towards oblivion began a long time before March 2001.

A c orporate cont ext

Corporate regulation in Australia in the late 1990s and into the present decade was replete with mechanisms designed to detect danger signs and promote the financial health and longevity of commercial entities. The law imposes duties and responsibilities on corporate officers and others such as auditors to ensure that problems that may adversely affect the solvency of a commercial entity are detected at an early stage. When problems of this nature are detected, corporate officers have a responsibility to take action. In the case of a company such as HIH, the corporate officers must inform the regulators and the public of the company's true financial position. The law also confers on regulators significant powers to act on the information that is provided and to obtain other information to protect the public interest.

Despite these mechanisms, the corporate officers, auditors and regulators of HIH failed to see, remedy or report what should have been obvious. And some of those who were in or close to the management of the group ignored or, worse, concealed the true state of the group's steadily deteriorating financial position.

The governance of a public company should be about stewardship. Those in control have a duty to act in the best interests of the company. They must use the company's resources productively. They must understand that those resources are not personal property. The last years of HIH were marked by poor leadership and

The failure of HIH Insurance xiii

in ept management. Indeed, an attitude of apparent indifference to, or deliberate di sregard of, the company' s underlying problems pervades the affairs of the group.

Those responsible for the stewardship of HIH ignored the warning signs at their own, the group's and the public' s peril. The culture of apparent indifference or deliberate disregard on the part of those responsible for the well-being of the company set in train a series of events that culminated in a calamity of monumental

proportions.

A far-reaching calamity

In surance is a vital element of modem society. It is one of the means whereby the co nsequ ences of injury to person or property and the risk of incurring liability to oth ers can be spread. The object is to lighten the burden of loss to individuals and group s in the community. When an insurer fails, the loss li es where it falls . The coll apse of HIH has reverberated throughout the community, with consequences of

the most serious kind.

Harm to individuals

Indi vidual cases of personal hardship emerged almost immediately after the collapse and contin ue to emerge. They will probably keep emerging well into the future.

A 50-year-old school principal who had contributed a portion of his weekly ea rnings to an income protection insurance policy developed a brain tumour in 1996. Unabl e to work, he and his family survived on the monthly cheques that came fro m HTH under the policy. In February 2001 the monthly cheque was dishonoured on presentation; his policy is now worthless. His spouse was forced to approach

entrelink in an effort to obtain a disability support pension.

About 200 permanently disabled people no longer receive their regular payments from HIH . These people have joined other unsecured creditors and policyholders, and they a ll face a wait of up to 10 years before receiving what the liquidator has predi cted wi ll be a 'very poor' payrnent.

Reti rees who invested their superannuation or life savings in HIH shares to fund th eir retirement have been left with nothing. A person who owned a small business and was insured with HIH became embroiled in a legal dispute. Just weeks before it liquidation, HIH encouraged him to settle the claim out of court for $90 000. The

ub equent coll apse of the insurer left the business owner liable for the payout.

Thousand s of holders ofprofessional indemnity, public liability, home warranty and travel in surance policies have found themselves uninsured for claims made by or aga in st them. A family whose HIH-insured home was destroyed in a fire was forced to live in the burnt shell of the house after HIH defaulted on their caravan rental pay ments.

xiv Th e failure ofHIH: a critical assessment

As with most corporate collapses, the employees of HIH were also dealt a bitter blow: one morning in March 2001 about 1000 of them woke to find themselves unemployed; hundreds of others lost their jobs in the ensuing months.

Some of those people will by now have received compensation under the government funded HIH Claims Support Scheme, however that scheme was necessarily limited in scope and operation. These are just a few examples of the personal hardship the failure of HIH has wrough{

Community distress

The general community has been caught up in the aftermath. The ramifications of the failure have been felt throughout many local industries. The same can be said of organisations in the arts and entertainment and in sport and recreation. Some non­ profit organisations have been forced to shut down businesses as a result of the

collapse.

A local theatre had to close its doors, with the loss of 70 jobs, because it did not receive sponsorship funds that had been promised by HIH. Sport and recreation centres, including local festivals and amusement parks, have been forced out of business, either because they have been unable to find alternative insurance or

because they are no longer able to afford the spiralling costs of premiums.

The annual St Patrick's Day parade through the streets of Fremantle-a fixture in the Western Australian calendar for decades-was almost abandoned in 2002 because the public liability insurance premium was prohibitive. At the last minute a local agency stepped in to fund the cover. In an era of scarce resources, those funds

will be sorely missed in the furtherance of welfare and social justice.

As a result of a court judgment, a rural local authority in Western Australia has been left exposed to a liability estimated at $6 million because of a fire that started in its rubbish tip and devastated surrounding farms. The local authority's lead insurer at the time was HIH. Those who suffered loss or damage to property and all ratepayers in the district are victims of the collapse. Other local authorities are similarly vulnerable.

Consequences for the public

HIH was one of Australia's biggest home-building market insurers. Its collapse left the building industry in turmoil. Home owners were left without compulsory home warranty insurance; the owners of residential dwellings have found that cover for defective building work has vanished; builders are unable to operate because they cannot obtain builders' warranty insurance. The cost to the building and construction industry alone has forced state governments to spend millions of dollars of public money to prevent further damage to the industry.

There are thousands of other cases of personal and community hardship, each one no less devastating for those affected by it. Such have been the losses to the

The failure of HIH Insurance XV

com munity that by the end of February 2003 the Commonwealth Government had already paid out $ 195 million through the government-funded HIH Claims Support cheme. By that time 11 400 applications had been received; of these, some 5850 had been approved, wholly or in part. The full cost of this scheme is yet to be determined.

There are other ramifications that, although less direct, are nonetheless real. Whether it is characterised as a symptom or a cause, the failure of HIH has contributed to what has become known as the 'public liability insurance crisis'. This ha s brought about proposals for legislative reform of tort law, which-without entering the debate about the overall desirability of the proposals- must inevitably

bring about pain, inconvenience and perhaps injustice to some individuals. The process of change is tortuous, and the states and territories have differing views about how change should be implemented. Caps on damages awards, contraction of limitation periods, and moves towards proportionate liability have either been

imp lemented or are imminent in some jurisdictions. There is a strong argument that the public interest calls for change. But this does not lessen the impact of the cha nges on individuals who are denied full (or any) recompense for a loss they have su ffered .

A collapse of this magnitude must inevitably shake public confidence in the in urance industry and in the regulatory system's ability to carry out its protective ro le properly. The Australian general insurance market is not particularly large by global sta ndards. It needs stability, and it assumes that supervisory and regulatory

functions will operate to that end. There will always be corporate failures but, in terms of the ir consequences, most are relatively self-contained. Some collapses, though, cause the public to question the integrity of the market system itself. The fai lure of HIH was an event of that nature.

Reasons for the failure: a b road perspective

How did it happen? The insurance market is undoubtedly cyclical. The second half of th e 1990s was a period of poor global market conditions for commercial . I

msurance, and HIH was not the only insurer to collapse. Nevertheless, market conditions provide neither an excuse nor an explanation for HIH's predicament: mo t insurers weathered the storm.

In a co llapse of this type it would not be unnatural for an outside observer to suspect that the central players must have been fraudsters. They might also suspect that large su ms of money must have been spirited away to the dungeons of financial in titutions , in so-called safe havens.

HI H is not a case where wholesale fraud or embezzlement abounded. Most of the in stances 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.

xvi Th e failure ofHJH: a critical assessmen t

Where did the money go? Some of it was wasted by extravagance, largesse, paying too much for businesses acquired, and questionable transactions. There were some trading losses. But in the main the money was never there. The deficiency of several billion dollars has arisen because claims arising from insured events in previous years were far greater than the company had provided for. Past claims on policies that had not been properly priced had to be met out of present income. This was a

spiral that could not continue indefinitely. In the language of the industry, the failure to provide adequately for future claims is called 'under-reserving' or 'under-provisioning'. This, in my view, is the primary reason for HIH failing- and not only failing but doing so in such an egregious way.

Why was there such serious under-reserving and why were the risks not properly priced? The answer here is that HIH was mismanaged. The factors contributing to the mismanagement of the group--and hence the reasons for the failure-are many, varied and complex. They are also interrelated. They are epitomised by a lack of

attention to detail, a lack of accountability for performance, and a lack of integrity in the company's internal processes and systems. Combined, these features led to a series of business decisions that were poorly conceived and even more poorly executed.

Among such decisions were the ill-fated commitment in 1996 to re-enter the US market (HIH having extricated itself at a profit in 1994); the expansion of the UK operations in about 1997 into previously 'uncharted territory'; and the unwise acquisition of FAI Insurances Ltd in 1998. Not surprisingly, the US and UK

operations-as well as F AI, both before and after its acquisition by HIH-were afflicted by chronic under-reserving that all but destroyed the entities or branches concerned.

The poor decision making continued until the very end. It culminated in September 2000, when HIH sold 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 ofHIH's decline and led directly to the decision on 15 March 2001 to place the company in provisional liquidation.

A cause for serious concern arises from the group's corporate culture. By 'corporate culture' I mean the charism or personality-sometimes overt but often unstated­ that guides the decision-making process at all levels of an organisation. In the case of HIH, the culture that developed was inimical to sound management practices. It resulted in decision making that fell well short of the required standards.

The problematic aspects of the corporate culture of HIH-which led directly to the poor decision making--can be summarised succinctly. There was blind faith in a leadership that was ill-equipped for the task. There was insufficient ability and independence of mind in and associated with the organisation to see what had to be done and what had to be stopped or avoided. Risks were not properly identified and managed. Unpleasant information was hidden, filtered or sanitised. And there was a lack of sceptical questioning and analysis when and where it mattered.

The failure ofHJH Insurance xvii

A brief financial perspective

Before I elaborate on my concerns about corporate culture, the financial position and performance of the group warrants mention. By 15 March 2001 the group could not pay its debts as they fell due; in other words, it was insoivent. This may sound trite, but a commercial entity such as HIH-which existed primarily to offer

financia l services to the public and to generate a return for its shareholders- must remain solvent or it cannot trade. If it does not trade it cannot fulfil either of those objectives.

The financial fortunes of the group were in serious decline from at least 1 January 1998 , although the accounting techniques the group used served to disguise to some extent the full import of the decline. It was not until 2000 that the market began to ex press serious disquiet about the group's fortunes. From mid-2000 some journalists

were writing stories generally critical of HIH. Unlike the soothsayers of Caesar's time, they did not have to consult the oracles to ascertain the bad news; it came from a source inside the company- possibly at board level. This is a small indication of just how dysfunctional the management of the company was. Nevertheless, even

during that period some brokers and analysts were looking on the group with favour.

Time has permitted an in-depth analysis only of the HIH group's accounts as at 30 June 1999 and 30 June 2000. Despite this limitation, analysis of the group suggests that serious problems existed in the years preceding 1999. The analysis in the fo llowing paragraphs takes as its base the accounts as at 31 December 1997. Moving forward from that date, there are several measures, admittedly simplistic, that demonstrate starkly the deterioration in the financial fortunes of the group during the last three or so years of its existence.

Profits and losses

In each of the years ending 31 December from 1995 to 1997 the group reported an operating profit after extraordinary items and income tax that was higher than in the preceding year. For 31 December 1997 the figure was $61.8 million. For the I 8 months to 30 June 1999 there was a loss of $21.2 million. In the year ending 30 June 2000 the group returned to profit, but only to the extent of $18.4 million. It

is my opinion that, were it not for questionable accounting treatment of some transactions, the loss in 1999 would have been greater and the profit in 2000 would have been a loss. In both 1999 and 2000 the company declared a dividend but in doing so exhausted its store of retained profits.

Underwriting performance It is not unusual for a general insurer to make a loss on underwriting. This is not fatal if returns on other aspects ofthe business, such as investment of policyholders' and shareholders' funds, are positive. But underwriting is the core aspect of a general insurer's operations and its performance requires close scrutiny.

xviii Th e failure of HIH: a critical assess men/

An analysis of the performance of HIH's underwriting business shows a similar pattern of deterioration.

In the year ending 31 December 1997 HIH made an underwriting loss of $33.8 million on net premium earned of $1233.5 million. In the 18 months to 30 June 1999 (making a pro rata adjustment to reduce it notionally to a 12-month period) the underwriting loss was $73 million against a net earned premium of

$1550 million. The comparative figures for the year ending 30 June 2000 are $103.5 million and $1995.4 million respectively. In other words, between 1997 and 1999 (notionally adjusting the latter to reduce it to a 12-month period) the underwriting loss more than doubled while the net earned premium rose by 25 per

cent. If the comparison is made between 1997 and 2000 the underwriting loss increased threefold and yet net earned premium increased by 61 per cent.

On 12 September 2000 Andersen, HIH's auditor, made a presentation to the HIH audit committee. Included in the presentation was a schedule showing trends in core underwriting performance in the various accounting periods between December 1998 and June 2000. The schedule provides a telling demonstration of the extent to

which the reported core underwriting loss was diminished by increasing use of one-off entries such as increments to goodwill and recoveries under reinsurance contracts. In the 12 months to December 1999, one-off adjustments reduced the underwriting loss by $157 million; in the year ending 30 June 2000 they reduced the

loss by $360 million. In other words, without those one-off entries the underwriting loss would have been much worse, and the situation was deteriorating.

Reliance on intangibles Another feature of the financial trend was the increasing reliance on intangible assets to support shareholders' equity. The net tangible asset backing per share, as reported in the published accounts ofHIH, was $1.39 at 31 December 1997; it had declined to 33 cents by 30 June 2000. Somewhat curiously, the net tangible asset backing was calculated by treating only goodwill and management rights as intangibles. It also reflects the position before diluting for the effect of convertible and converting notes.

In addition to goodwill and management rights, HIH had in its balance sheet future income tax benefits and deferred information technology costs and deferred acquisition costs. I do not think there can be any real argument that future income tax benefits and deferred information technology costs are tangibles. There is, however, doubt whether deferred acquisition costs- while answering the euphemistic description 'soft assets'- fall into the same category. They are omitted from the calculation that follows.

As at 31 December 1997 total shareholders' equity stood at $560 million, of which 23 per cent was represented by goodwill, future income tax benefits and deferred IT costs. By 30 June 1999 intangibles had increased to 60 per cent of total shareholders' equity. In the accounts to 30 June 2000 the total shareholders' equity was $939 million, but this relied on intangible assets of $703 million, or 75 per cent

The failure of HIH In surance xix

of total shareholders' equity. Goodwill represented 50 per cent of HIH's shareholders funds as at 30 June 2000. By way of comparison, QBE and NRMA (two comparable Australian insurance companies) had a ratio of goodwill to shareholders funds of 4.9 per cent and 0.4 per cent respectively.

This is not to say that reliance on intangibles is illegitimate. But the trend is disturbing for at least two reasons. First, the value to be attributed to intangibles is often a matter of judgment and is particularly susceptible to error- witting or unwitting; in the accounting practices of HIH goodwill became something of a repository for the unpleasant and unwanted consequences of poor business judgment. Second, when times get tough it is difficult to convert intangibles to cash;

as other sources of cash disappear, the intrinsic value of intangibles is seriously called into question.

Mismanagement: a failure of culture

I move now to consider the corporate culture of the group and how it fits with the broad statement that HIH was mismanaged. There is probably no better example of what I mean than failure of risk identification and risk management within the group.

Risk identification and risk management

An experienced Australian company director recently commented that if a director could not articulate the strategy of the company he or she should not be on the board.Z I share that view, and I consider that this is an area in which the governance of HIH was deficient.

Strategy and the board At board level, there was little, if any, analysis of the future strategy of the company. Indeed, the company's strategy was not documented and it is quite apparent to me that a member of the board would have had difficulty identifying any grand design. If the HIH board discussed strategy at all, it was in the context of an annual budget meeting. But budget sessions are generally about numbers, and there

is no indication that the board seriously grasped the opportunity to analyse the direction in which the company was heading.

Generally speaking, it is for management, rather than the board, to propose strategy. This is not an impediment to the board taking the initiative in an appropriate case. But management is best able to dedicate time to strategic thinking and is likely to have greater industry knowledge and experience. Nevertheless, it is the board's responsibility to understand, test and endorse the company's strategy. In monitoring performance, the board needs to measure management proposals by reference to the endorsed strategy, with any deviation in practice being challenged and explained. This is what the HIH board failed to do.

XX Th e failure ofH!H: a critical assessment

A plan may have existed in the mind of the chief executive. In his evidence Williams said that all of Australia's commercial insurers were under enormous pressure throughout the 1990s. The pressure was primarily a consequence of weak global market conditions for commercial insurance, which translated into inadequate

premium rates locally. Each local insurer responded differently. Some wrote business locally at cheaper rates. Others sought to compete in complex and difficult international reinsurance markets. Williams said that HIH responded with a strategy based on seeking greater exposure to the more profitable domestic personal lines

and also with some diversification offshore, principally in the United Kingdom and the United States. He also said that, without a massive capital base to withstand the cyclical downturns, insurers need consistent profitability to maintain strong balance sheets and to deliver a satisfactory return on capital.

I accept that it was a difficult commercial environment. I accept most of the other things that Williams said in that part of his evidence. Where I take a different view from that which is implicit in Williams's evidence is whether the 'strategy' was properly analysed and thought through, whether it was tested and understood by the

board, and whether it was put into effect with adequate and proper attention to detail. The problem is Williams's perspective was never clearly expressed to the board. As one director conceded, if he had been asked to commit to writing what the long-term strategy was he would have had difficulty doing so; the other directors

struggled when asked to identify strategic directions. The chairman of the board maintained that HIH's strategy was international growth and diversification. But the formulation of strategy requires more than just a broad statement of the intended result. Further, the board must regularly review and test the strategy's

appropriateness, and it must monitor and assess whether the strategy is being achieved and, if so, to what extent. According to the chairman of the board, it appears the same 'strategy' existed from at least 1995 and was never subjected to rigorous analysis to gauge its continuing suitability in a changing environment.

A long-term strategy or plan was never submitted formally to the board for critical analysis. Nor did one emerge or evolve informally. In the absence of a framework within which investment and other decisions could be evaluated, the growth of the group was opportunistic and lacking in direction.

There is a related problem. A board that does not understand the strategy may not appreciate the risks. And if it does not appreciate the risks it will probably not ask the right questions to ensure that the strategy is properly executed. This occurred in the governance of HIH. Sometimes questions simply were not posed; on other occasions the right questions were asked but the assessment of the responses was flawed. The absence of a well-understood strategy compounds the difficulties that arise in opportunistic development. The failure of operations in the United Kingdom and the United States and the acquisition ofF AI provide ample evidence of this.

The way the group managed its entry into and expansion in overseas markets was extremely imprudent and ultimately very costly. It involved bad decision making and a lack of business judgment in circumstances of adverse insurance market

Th e failure of HIH Insurance xxi

conditions. Similarly, the decision to acquire F AI was impetuous and based on completely inadequate information.

A failure: the UK operations HIH' s UK branch was established in mid-1993 and began underwriting in September of that year. The HIH board minutes for the first half of 1993 do not disclose any consideration by the board of whether the opening of a branch in the United Kingdom was compatible with HIH's broader strategy. And there is no evidence that the board contributed to the development of a business plan for the new branch. This apparent complacency about the group entering unfamiliar territory-the UK insurance market-is worrying.

Initially, the business written by the UK operations consisted of public liability and professional indemnity and some inwards treaty business. The operations were a success in their first year. These lines of business were expanded in 1995: the UK chief executive decided to move into areas of business in which the underwriters had little experience or expertise. From that time on, the losses began to flow.

The main losses occurred in the underwriting of whole-of-account excess-of-loss marine reinsurance and film financing. 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 cover- without terrorism exclusions-to an Israeli insurer.

It would appear that the UK branch failed to institute suitable underwriting guidelines and controls. The controls that did exist were inadequate to limit underwriting activity to less risky lines of business. The writing of the four lines of business just noted demonstrates the UK branch's willingness to underwrite cover in areas where the underwriters had insufficient, or no, experience. The combination of a lack of underwriting controls and a lack of relevant experience and familiarity in those particular lines of business was a formula for financial disaster.

It seems there was no appreciation of the risks associated with expanding the lines of business written by the UK operations beyond the expertise of the underwriters. The situation was exacerbated by the lack of a reporting structure that would allow others in the organisation to know what business was being written and the risks being assumed. Further, once problems emerged, there was no process for redressing them and stemming the consequent losses. Poor-quality management information and inadequate accounting systems impaired the Australian management's ability to monitor and control the UK operations effectively.

This is a different aspect of the risk-identification and -management problem because it occurs at the operational leyel, rather than the governance level. It nevertheless demonstrates systemic failure. The losses in the United Kingdom may amount to as much as $1.7 billion.

xxii Th e failure of HIH: a critical assessment

A second failure: the US operations The story of the US operations is not dissimilar to that of the UK operations. In 1994- in anticipation of legislative changes that it was thought would cause premium rates to fall- HIH sold its workers compensation business in California on

favourable terms. In late 1996 it began negotiating to reacquire the business, by then known as CareAmerica.

The decision to consider re-entering the US market was made largely on the basis of anecdotal evidence and reports from some of the CareAmerica executives that, two years after deregulation, the bottom of the market had been reached. The prognosis of the market was the fundamental consideration for HIH in determining whether to proceed with the repurchase. By 13 December 1996, when the board decided to proceed with the transaction, no attempt had been made to obtain the results of empirical research on that subject or otherwise to verify the assertions made.

The reacquisition was subject to limited due diligence. No comprehensive actuarial analysi s was sought by HIH, so the adequacy of CareAmerica' s reserves was not assessed. The review of CareAmerica' s profit forecast involved no more than testing the mathematical accuracy of the model on which it was based. The assumptions on

which the model relied- for example, the expectation of improved market conditions- were not tested for reasonableness.

The board finalised the reacquisition on 3 January 1997. Full due diligence had not been performed-contrary to the advice of HIH ' s financial adviser- and no indemnity was sought against any potential deterioration in CareAmerica' s level of reserves. The board simply accepted, without analysis, management's assertions that

re-entry into the US market would prove profitable and resolved to proceed with the transaction. There was a complete failure to appreciate the level of risk involved.

As it turned out, the re-entry into the US market was a debacle : the anticipated profits never emerged and market conditions deteriorated. In October 2000 the US operation was placed in run-off. It is estimated that the foray cost the group about $620 million.

A third failure: the F AI acquisition In September 1998 HIH announced a takeover offer for the issued share capital of F AI. The group had been interested in acquiring a strategic shareholding in, or possibly taking over, F AI since at least early 1993 . From 1995 HIH and its financial advisers kept F AI and the possibility of an acquisition under regular review . The advice to HIH always was that there would need to be a due diligence investigation ofF AI before any acquisition could proceed. But all attempts to carry out such an

investigation were rebuffed by FAI's chief executive officer, Rodney Adler. In February 1998 discussions lapsed.

In September 1998 negotiations were renewed. The HIH board met to discuss the acquisition on the evening of 22 September. It was ultimately resolved that the takeover bid should proceed. The notice of meeting had been circulated earlier that day and, because of the lateness of the notice, five of the 12 directors were not

Th e failure of HIH Insurance xxiii

present at the meeting. They were overseas and had no notice of the meeting at all. In fact, only three directors were present in person; the remaining four participated by video. Those participating by video may not have had copies of all relevant documentation-including the report prepared by HIH's financial advisers. The

meeting was told that there were other parties interested in acquiring a shareholding in F AI, and it was in that context that the meeting proceeded urgently to consider the acquisition.

There remained substantial financial uncertainties for HIH in contemplating the takeover. There was a dearth of information available to HIH at the time, and when the matter was raised with Adler he refused to allow due diligence. The directors decided to proceed in any event. A careful and considered assessment of the true worth and future prospects ofF AI, or any combined entity, was not possible in the circumstances. HIH proceeded with the takeover solely on the basis of its assessment of publicly available information. What was not apparent from that public information was the excessive under-reserving of FAI's long-tail business. HIH itself had provisioning problems: the compounding effect of the F AI shortfall would prove disastrous.

Against this background, the HIH directors' decision to approve the takeover­ reached after scant consideration, in a very short time frame, and with insufficient preparatory and investigative work-was unwise. The directors failed to consider fully the risks that the takeover posed to HIH. There had been a suggestion of competition with another potential bidder, but this was not a justification for

ignoring due process. I say this recognising the difficulty of persuading a takeover target to open its books to a suitor who is also a competitor.

The acquisition of the F AI retail lines was beneficial to HIH and, on balance, HIH achieved reasonable results from the realisation of non-insurance assets acquired from F AI. But the group was not equipped to handle the unexpected losses that arose from serious-and undisclosed- under-reserving in F AI' s long-tail portfolios. As at 30 June 2000 HIH had recognised more than $530 million of these losses. They were either taken to goodwill or purportedly covered by reinsurance.

On the available evidence, my estimate is that the cost to HIH of the F AI acquisition was about $590 million.

The harbinger of doom: the Allianzjoint venture The transaction that, in retrospect, hastened the inevitable demise of the HIH group was the Allianz joint venture, which was negotiated in the second half of 2000 and came into effect on 1 January 2001. It involved the sale of HIH's profitable retail

lines- most of which had come from the FAI acquisition- into a joint venture with Allianz Australia Limited. The arrangements agreed between HIH and Allianz ultimately caused HIH to experience an insurmountable cash flow crisis in early 2001 and largely dictated the timing ofHIH's collapse.

xxiv Th e failure of HIH: a critical assessment

Somewhat bewilderingly, no one in management or at board level called for or did a full and accurate analysis of the likely cash flow implications of the transaction before HIH entered into the joint venture in September 2000.

I can see why the joint-venture proposal might have appeared attractive to HIH. It was seen as providing the group with a form of restructure that would resolve a number of concerns that had arisen during 2000. The proportion of intangibles in the group's balance sheet was high-including a large carrying value of goodwill as

a result of the F AI acquisition. Proposed reforms to insurance licensing regulations would effectively require HIH to convert a significant amount of its intangible assets into tangible assets. The Allianz joint venture offered HIH that opportunity. It would also provide HIH with a $200 million cash injection, that being the sum payable by Allianz 'up front ' for the purchase ofHIH's retail lines.

A closer examination of the joint-venture arrangements reveals, however, that the benefits to HIH would be outweighed by the severe cash flow consequences it would experience. The arrangements envisaged that a trust would be set up to ensure that the joint venture had sufficient funds to cover claims. Premium income

to which HIH was entitled was to be paid directly into the trust and profits would be distributed from the trust on a quarterly basis- but only after an actuarial assessment confirmed that the trust funds were sufficient.

The impact on HIH's cash flow was twofold. First, the group was required to contribute a significant amount of assets and cash-about $500 million- to the trust at the outset. As it turned out, the group was unable to cobble together that amount, and the $200 million payable by Allianz to HIH as part of the purchase price had to

be used. Second, HIH was cut off from its main premium income flow-about $1 billion a year-until the completion of the first actuarial assessment, which would probably be five months or so after the start of the joint venture.

The Allianz proposal first came before the board on 5 September 2000. A joint venture of HIH' s retail insurance business was not something that had previously been raised or canvassed at board level. Yet by this time, quite extraordinarily, management had been pursuing several restructuring options for some months; various offers had been received and negotiations with interested parties were well under way. Incredibly, without board approval an information memorandum had already been distributed, in July 2000, to a number of parties. Indeed, the existence of the information memorandum was not made known to some board members until the meeting of 5 September 2000. It is strange that most members of the board appeared unconcerned by management's pursuit of such a profound change in HIH ' s strategic direction without first having been informed.

The Allianz joint venture was presented to the board as one of four restructure proposals. A basic overview was provided in respect of each of the four options. A week later, on 12 September 2000, the board met again and- in a mere 75 minutes- resolved to proceed with the Allianz proposal. This was wholly

inadequate for the proper ventilation of the complex affairs associated with the transaction. The information before the board lacked any careful analysis of the

Th e failure of HIH Insurance XXV

JOint venture and its implications for the future operations of HIH. The trust provisions and their potential adverse effect on cash flow were either completely overlooked or not properly appreciated. The board's focus appears to have been on the short-term benefits of the restructure. They were also keen to announce to the market what it considered a 'value-enhancing strategy' on presentation of HIH's very poor end-of-year results the following day.

The board's lack of understanding of the transaction-as a result of inadequate information and the oppressive time constraints-meant that the directors were incapable of fully understanding the risks involved. This failure to identify and understand the risks meant that the right questions were not asked. And so the ruinous cash flow consequences were not properly appreciated until it was too late.

In the months immediately following the signing of the joint-venture documents, HIH's management started examining in detail the trust arrangements that were to be in operation by 1 January 2001. It emerged that HIH would be required to contribute about $500 million to the trust. By November 2000, management realised that the $200 million purchase price-initially envisaged as an 'up front' payment by Allianz-would have to be used as part of the trust funds. In tum, management began to realise that cash flow difficulties would result from the transaction because HIH would be deprived of its main premium income. These matters appear to have been raised at board level at about this time, albeit with little emphasis on their significance. So it was, then, that most of the non-executive directors, and some of the executive directors, did not have a clear understanding of these matters until early January 2001.

After the joint venture came into effect, HIH remained saddled with a deteriorating claims experience from the portfolios it had retained. At the same time it was deprived of the cash flow from premiums from the retail lines committed to the joint venture and about $500 million of its assets and cash were 'locked' in the trust. And it could not expect to receive a distribution from the trust until at least May 200 I.

Thus it was that HIH was unable to gain access to the capital injection it needed to survive in the short term. The result was predictable: it ran out of cash. Within I 0 weeks of the start of the joint venture, HIH was placed in provisional liquidation.

Mismanagement: a particular outlook

Problems of corporate culture and deficiencies in management extend well beyond risk identification and control. They manifest themselves in the very heart of an organisation and the way it is run.

A private company approach As early as I995 an independent due diligence report described HIH as a 'company which has not yet made a complete transition from an entrepreneurially run company influenced strongly by senior management, and from which senior management benefits significantly, to that of an ASX listed company run primarily

xxvi Th e failure of HIH: a crilica/ assess men/

in the interests of shareholders'. In my view, this remained true for the remainder of the company's life.

For example, company funds were used to pay for personal taxation advice to certain senior executives, including executive directors. The cost of the advice was not a recognised element of the salaries provided to the recipients of the advice. In addition, the fact that the company was paying for it was not disclosed to the board or to the shareholders.

Another example is that from time to time the chief executive's personal funds were transferred into HIH UK's bank account. He would subsequently receive equivalent funds from HIH in Australia. The reason for using the corporate banking facilities remains largely unexplained. Intermingling of personal and company funds is

undesirable. Furthermore, it was not disclosed to the board.

These are not, in themselves, particularly serious matters. I mention them only as illustrations of an approach that I perceive to have existed within HIH.

Dominant personalities The business was established by Raymond Williams and Michael Payne in 1968. George Sturesteps and Terence Cassidy joined the company in 1969 and 1970 respectively. Payne was the chief executive of the UK operations until ill-health curtailed his activities in late 1997. He became chairman of the main UK entity in

1999; he was an executive director of the holding company from 1992 until June 1998 and a non-executive director from July 1998 until September 2000. Sturesteps and Cassidy remained in very senior management positions until September 2000 and March 2001 respectively. They both left the board in September 2000.

Williams was, in reality, chief executive from the inception of the business until he stepped aside in October 2000. No one rivalled him in terms of authority or influence. Even as his business judgment faltered in the second half of the 1990s he remained unchallenged. No one else in senior management was equipped to grasp what was happening and to bring about a change of direction for the group. There was a lack of accountability among senior management and the board of directors, and there was a singular failure to assess performance in the context of deteriorating financial results.

The hand and influence of Williams were paramount. In itself, there is nothing inherently wrong with a strong and forceful influence guiding the affairs of a corporation. Indeed, in Australian corporate life there have been many examples of successful businesses built in such a way. But in the modem commercial context such influence must be subject to the countervailing effect of close review, debate and questioning. This appears to have been a commodity in short supply at HIH.

I gained the impression that the general approach of the board and of senior management was unduly deferential. No doubt it was in most cases subconscious, and it would come as a surprise to some of those involved that an outside observer would hold such a view.

Th e failure ofHIH Insurance xxvii

I have no doubt that Payne, Sturesteps and Cassidy were competent insurance managers and that they had earned the respect and loyalty of Williams over a long period. Between them, they had an immense store of knowledge about the business. They should have been in a position to act as a counterfoil to Williams, but I am not convinced they did so. They were, after all, directors and executives of a public

listed company that was embarking on rapid growth in a volatile market. Williams's loyalty to them was readily apparent.

Winterthur: in and out Williams' s influence can be seen in two aspects of the dealings with Winterthur Swiss Insurance Company, a giant in the global insurance market and a company with a strong reputation and credit rating.

HIH perceived that there would be advantages in forging links with an entity such as Winterthur. In 1995, as a result of the merger between HIH and Winterthur' s Australian subsidiary, Winterthur came to hold 50 per cent of the ordinary shares in HIH but did not have board control. Winterthur believed it had an understanding with Williams that HIH would concentrate its operations in Australia and Asia and not expand in areas such as the United States (where Winterthur was active) or the United Kingdom (a market Winterthur regarded as commercially unattractive). Williams did not accept that the arrangement was as clear as the Swiss considered it to be . In any event, despite Winterthur's protestations, HIH expanded its operations in the United States and the United Kingdom. These were ventures in which Williams's influence was material. They were disasters.

In 1998 Winterthur decided to quit its holding in HIH. It would have preferred to do so by a trade sale-that is, a sale to a single entity, but Williams was opposed to such a move and did little to assist. A trade sale would have required the approval of shareholders other than Winterthur, and that approval was not likely to be forthcoming without board support. The sale was effected by a public offer foiiowing an institutional book-build. The result for HIH was a share register without a financiaiiy strong shareholder similar to Winterthur. The change was to the detriment of HIH because the market no longer had the confidence engendered

by the association with a financially strong shareholder of global repute.

Mismanagement: under-provisioning

It is beyond doubt that the biggest single cause of HIH's collapse was, as I have said, the failure to provide properly for future claims.

The provision for outstanding claims is the biggest single item on the liabilities side of a general in surer' s balance sheet and is of particular significance because the level of reserves plays an important role in the pricing of risk. For HIH, the provision for outstanding claims represented about 50 per cent of liabilities: I think the inability to price risk properly was a serious problem.

xxviii The failure of HIH: a critical assessment

Time permitted the Commission a close examination only of the accounts for 1999 and 2000. But it is very apparent that under-provisioning and the causes of it had existed for many years.

Under-provisioning: systemic problems Outstanding claims provisions are of fundamental importance to the financial well­ being of a general insurer and hence to its policyholders. The directors said they were aware of the importance of the provisions, but I am not convinced they understood their full significance. In terms of stewardship, this was a particularly

important function vested in the directors.

Both the directors and management were been found wanting in this regard. By their failure to come to grips with what I regard as the most critical aspect of HIH's financial statements, the directors passed up an opportunity to identify and deal with looming problems that proved, in the end, to be the company's undoing. Geoffrey Cohen, Charles Abbott, Rodney Adler, Justin Gardener, Alexander Gorrie, Neville Head and Robert Stitt, all of whom were non-executive directors from time to time during the period 1997 to 2001, must share some responsibility for this situation. So too must the executive directors-Williams, Cassidy, Payne, Sturesteps, Dominic Fodera and Randolph Wein.

In setting the figure for reserves, the board relied on reports by independent actuaries and on the assessment of those reports by the auditors. The actuarially based reserves were set using assumptions for factors such as discount rates and claims-handling costs. Small changes in the assumptions could have made a major

difference to the bottom-line result. Yet at no time were the actuaries' reports, or even a summary of them, tabled at meetings of the audit committee or the board. Nor was an actuary ever asked to attend a meeting to explain his or her report or answer questions. Any significant discussion of the assumptions on which the

actuaries' recommendations were based was uncommon. There was no real understanding of the way the auditors dealt with the actuaries' reports or of the extent to which, if at all, the auditors reached an independent opinion as to the appropriate level of reserves.

Another aspect of the way in which claims reserves were set is, I think, illustrative of systemic failure. Between 1997 and 2000 (and perhaps before) the auditors did what they described as an 'analytical review' and came up with 'high', 'low' and 'likely' reserves figures. The purpose was to see whether the figure proposed by

management was within the auditors' materiality tolerance (3 per cent) of the ' likely' estimate. In the presentations to the audit committee (and thus to the board) the auditors included the 'low' and 'high' figures but not the 'likely' figure.

The explanation for not including the 'likely' figure was that the auditors' testing process did not engender sufficient confidence for it to be put forward as a point estimate. There was a similar lack of confidence in the reliability of the 'low' figure , but it was included-even though the auditors knew that the directors would place

reliance on the 'low' figure to see where the reserves management proposed to book

The failure ofHIH Insurance xxix

sat in the range. There is no evidence that the directors ever asked what the 'likely' figure was. Nor were they ever told. Nor did they ask how the 'low' figure measured up to the point estimate. In fact, there were occasions when the ' low' figure was more than 3 per cent below the point estimate, but this was not disclosed to the directors.

The level of under-provisioning Lest it be thought I have placed too much emphasis on under-provisioning, it is worth de scribing briefly what I found about the level of shortfalls. It is , of course, not an exact science, and the figures will change over time as experience turns estimates into reality. But on the basis of work done by Richard Wilkinson (an actuary engaged by the liquidators) and expert actuarial advice obtained by the Commission I believe the position to be as follows .

As at 31 December 2000 HIH estimated its provisions for outstanding claims (on a going-concern basis) as $3 .1 billion. Wilkinson opined that as at 15 March 2001 , assessed on a going-concern basis, the value of the outstanding claims liabilities was $5 billion. It follows- disregarding any discrepancy that may be attributable to the different dates of valuation used by HIH and Wilkinson-that the HIH group ' s outstanding claims were undervalued by $1.9 billion. If a different approach is taken and the estimate is made on a break-up basis, which assumes the company is no longer a going concern and thus does not allow for any discounting of the estimate, the figure rises to $2.6 billion. If a prudential margin (which for present purposes can be described as a safety margin) is added, the figure rises to $4.3 billion.

I make two points about this. First, the provision for outstanding claims disclosed in the accounts to 30 June 2000 was $4.4 billion; this is without a prudential margin. Even allowing for the time difference between 30 June 2000 and 15 March 2001, a difference of $1.9 billion in a base figure of $4.4 billion is conspicuous. Second, the

liquidators have estimated the net asset deficiency of the HIH group as between $3 .6 billion and $5 .3 billion. Quite obviously, under-provisioning of between $2.6 billion and $4.3 billion has made a material contribution to that deficiency.

The use and abuse of reinsurance

Reinsurance, as traditionally understood, is a mechanism whereby an insurer transfers part of the risk it has assumed on behalf of its policyholders. It is widely used by general insurers to manage underwriting and financial risk. One purpose of reinsurance is to transfer the risk of future adverse developments in relation to claims. It is thus important when the level of outstanding claims provisions and other factors affecting an insurer's financial statements are being considered.

During the inquiry, questions emerged about the use of alternative risk-transfer products-often called financial reinsurance. Traditional reinsurance is primarily directed at the transfer of risk. On the other hand, financial insurance (of the type employed by F AI and HIH) is more like a deposit arrangement, which, whether or not it is accompanied by risk transfer, is primarily directed at the appearance of th e

XXX Th e failure of HIH: a critical assessment

balance sheet. Reinsurance is a legitimate and, when properly used, effective mechanism for insurers to augment their capital base. There is, however, a place for financial reinsurance, properly used, as well as for traditional reinsurance: nothing in this report should be taken as indicating the contrary. I do , however, have real concerns about the use- or, more accurately, the abuse-of reinsurance and its susceptibility to manipulation.

Two troublesome F AI contracts HIH was not alone when it came to severe under-reserving problems. As I noted, F AI also suffered from a seriously deficient level of reserves in relation to a number of its lines ofbusiness. Few individuals within FAI had been aware ofthis when the

problem emerged in late 1997. Management looked to reinsurance as a means of solving-or at least deferring- the problem. The objective was to use reinsurance to offset any increase in reserves on the balance sheet with a corresponding recovery under a reinsurance contract. The arrangements were structured so as to achieve an accounting treatment that would allow the company to defer to later years expensing the premium paid to obtain the recoveries. Thus it was thought that increases in reserves could be staged over a number of years.

There is a problem with this approach. It would be possible under the accounting standards only if the reinsurance contract provided for a 'transfer of risk' from the reinsured to the reinsurer. In 1998 F AI negotiated with reinsurers arrangements that were structured in such a way as to give the appearance of a transfer of risk when in fact there was none.

A wide array of practices was employed to achieve these ends, among them the use of side letters setting out arrangements that negated the transfer of risk, the backdating of documents, the inclusion of sections of cover not intended to be called upon, and the use of 'triggers' for additional cover that were unrealistic. The word

'audacious ' springs to mind.

The effect of these arrangements was that the extent of F AI' s under-reserving problems was concealed. The contracts were also vehicles for the overstatement of FAI's reported operating profit before tax for the year ending 30 June 1998. FAI reported an $8 million pre-tax operating profit instead of a significant loss . That

undoubtedly made it a more attractive takeover prospect for HIH. It also left HIH with a severe financial headache after the acquisition. Partly to cure this malady but also to counteract its own under-provisioning ills, HIH negotiated other financial remsurance.

An HIH reinsurance case study A reinsurance arrangement entered into between HIH and a reinsurer in August 1999 provides a unique case study that reveals much about what went wrong with this company.

On 25 August 1999 HIH entered into so-called reinsurance arrangements with the reinsurer. The arrangements were documented in two reinsurance binders and in

The failure ofHIH Insurance xxxi

separate agreements relating to some letters of credit and a trust. In addition, there were between the parties understandings that were recorded in correspondence but not included in any of the formal documents.

The substance of the arrangements was that companies within the HIH group would pay $200 million and five annual instalments of $11 million each into a fund. HIH could make claims up to a maximum of $550 million, but the reinsurer did not have to pay out until September 2009 at the earliest. HIH was responsible for the costs and expenses of the fund's investment and for managing the investments within guidelines agreed with the reinsurer. But payment of claims under the binders was to come from the fund, not from the reinsurer. HIH was obliged to top up the fund to ensure that it was sufficient to meet the claims.

Considered alone, the reinsurance binders created the impression that the reinsurer was responsible for establishing, maintaining and reporting on the managed fund . They also created the impression that the reinsurer carried the risk that the managed fund would not grow at a sufficient rate to meet claims by HIH. Under the letter-of­ credit agreement, however, the risk that appeared on the face of the slips to be borne by the reinsurer was transferred to HIH.

In its accounts for 30 June 1999 HIH booked a profit of some $92.4 million in relation to these reinsurance arrangements. But the contract was not entered into until 25 August 1999. For accounting purposes, it was treated as a true reinsurance arrangement. It was not true reinsurance. In any event, the booking of recoveries under it as at 30 June 1999 was not justified under the relevant accounting standard.

Management and the executive directors were aware of the circumstances surrounding this arrangement. When the auditors came to make their presentation to the audit committee there was reference to the arrangement and to the profit booked under it. But neither the contracts nor the additional documents affecting them were tabled, and none of the non-executive directors who gave evidence could recall any specific discussion about it.

Accordingly, neither the characterisation of the arrangement as true reinsurance nor the problems raised by the date the contract was entered into were addressed by the audit committee or the board. Had the transaction not been accounted for as true reinsurance, HIH's reported operating profit before tax and extraordinary items of $52 million would have become a loss of $40 million. This would have deteriorated by a further $50 million when losses on extraordinary items were taken into account.

Management accounted for recoveries and premiums under the contract on the basis that it was true reinsurance. The auditors concurred with this approach. The auditors were not shown or told about the additional arrangements. Had they been, it is unlikely that they would have approved the accounting treatment advocated by management. The auditors were, however, aware that the arrangements had not been entered into before 30 June 1999.

xxxii Th e failure ofHIH: a critical assessment

Other reinsurance arrangements Reinsurance arrangements were to serve a similar purpose in the profit-and-loss account as at 30 June 2000. During that year the company had entered into a contract with another reinsurer. I do not cavil with the characterisation of th is arrangement as true reinsurance. But the treatment afforded it in the 30 June 2000 accounts was predicated on the assumption that the contract would continue to exist for a long time. There is evidence that at one stage management believed the contract would be commuted within two to five years and that the external actuary had serious doubts about its long-term efficacy. None of this was di sclosed to the auditors. Had it been, they might not have approved the booking of an after-tax profit of $84 million under the contract. In that event the reported profit of $18.4 million would have been a loss of $66 million or thereabouts.

Another problematic reinsurance arrangement involved HIH's UK branch. Over a number of years it bought reinsurance policies from a European reinsurer. At the same time a subsidiary of the HIH group, CJC 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 UK branch to report lower taxable income in the United Kingdom and CIC to report higher income in

Australia. In later years the arrangement had the effect of allowing the UK branch to improve its balance sheet solvency for regulatory purposes in the UK.

The substance of the transaction is that risk was transferred from the UK branch to CIC. Had that been done openly- without an intermediary- the reinsurance policy could not have been counted as an eligible asset in the UK regulator' s assessment of the solvency of the UK branch. The risks associated with such an arrangement were

borne out when the reinsurer disputed liability under the policies following the collapse of the HIH group.

Corporate governance: a poor role m odel

I am becoming less and less comfortable with the phrase ' corporate govemance'­ not because of its content but because it has been so widely used that it may become meaningless. There is a danger it will be recited as a mantra, without regard to its real import. If that happens, the tendency will be for those who have to pay regard to

it to develop a 'tick the box' mentality. The attitude might be, 'Yes, we have a state­ of-the-art corporate governance model; yes, it is committed to writing; and, yes, the company secretary has checked that each item is in place and has included a statement to that effect in the annual report. Therefore there could be no problem in

the corporation' .

Corporate governance- as properly understood-describes the framework of rules, relationships, systems and processes within and by which authority is exercised and controlled in corporations. Understood in this way, the expression 'corporate governance' embraces not only the models or systems themselves but also the

practices by which that exercise and control of authority is in fact effected.

Th e failure ofHIH Insurance xxxiii

HIH had a corporate governance model. The directors said so in the annual reports. But there is little, if any, evidence that the board periodically assessed the company' s corporate governance practices to ensure that they were, and continued to be, suited to the changing environment in which the company operated. For example, what might have been adequate for a group that was primarily Australian-based, as it was in 1996, might not have been so as the overseas operations burgeoned in subsequent years. The danger of this practice is that, among other things, it can lead to the 'tick the box' approach just mentioned. There is little point in having a corporate governance model if the directors fail to examine periodically its practical effectiveness.

Earlier I have made some broad comments about the HIH board' s failure to understand long-term strategy. That went to the heart of corporate governance. Apart from that general observation, however, some specific matters arose during the inquiry that do not reflect well on the way HIH was managed.

A lack of process

An odd feature of the way HIH was organised was the relative dearth of clearly defined and recorded policies or guidelines. There may have been some, but they did not deal with areas essential to the proper running of such a large organisation In any case, where they did exist they were often ignored.

In some instances there were guidelines, such as those applying to underwriting practices. 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' . For example, the HIH procedures prohibited 'fronting' without with high-level management approval.

Fronting is a practice whereby a company issues policies under an arrangement where another company accepts lOOper cent of the risk and the issuer acts solely for a fee . Through its Adelaide office, HIH issued policies underwriting film finance in circumstances where it was fronting for a reinsurer not licensed to write business of that type. The practice went unchecked for some time and substantial losses are

likely to flow from it.

There is another illustration of serious disregard of published guidelines. In August 2000 APRA conducted a credit-risk management visit at HIH. After the visit it wrote to Williams to inform him of its main observations. The letter noted that HIH's investment strategy was 'based on the premise that the group ' s business risk arising from underwriting performance and its reinsurance policies should not be compounded by the investment risk'. It then referred to HIH' s investment guidelines and expressed this conclusion:

xxxiv

The investment guidelines include various iimits and exclusions imposed on the main asset classes including authorisation for any new acquisitions.

The failure of HIH: a critical assessment

It is clear from our visit that following the acquisition of F AI, many investments exceed Board approved guidelines and limits and have done so continuously.

APRA expressed the opinion that HIH's investment- and credit- risk management processes were inadequate in terms of identification, analysis and evaluation of the risks arising from the investment portfolio. I saw no evidence to persuade me that APRA was mistaken in this aspect of its assessment ofHIH's activities.

Li mits of authority

There were no clearly defined limits on the authority of the chief executive in areas such as investments, corporate donations, gifts, and staff emoluments. In some of these areas the system was out of control but the board did not appreciate it. Nor did the board have a well-understood policy on matters that would be reserved to itself. Apart from obvious things- such as financial statements and approvals for large

transactions- matters seem to have come forward at the discretion of the chief executive.

Within HIH management there does not appear to have been any clearly defined statement of duties or limits on authority. The chief executive had many discretions- for example, in connection with corporate donations- that were practically unfettered.

The confusion of roles was most marked as the company lurched towards its demise. Top management was restructured from 12 October 2000. Williams stepped aside as chief executive but remained on the board until 15 December 2000. Dominic Fodera, who had been chief financial officer and a member of the board, resigned as a director and became chief operating officer. In essence, he was to fill

the gap pending the appointment of a new chief executive. This occurred on 15 December 2000, when Randolph Wein took up the position. Yet no one thought to define the roles that Williams and Fodera were to play. In effect, Williams continued on with much the same authority, ill-defined as it was, as he had always

had .

A lack of in dependent critical analysis

I formed the view that the board had such a degree of respect for management that the recommendations of management were assumed to have been carefully thought out and therefore to be correct. The board was heavily dependent on the advice of senior management: there were very few occasions when the board either rejected or

materially changed a proposal put forward by management.

The board's independence was compromised by the influence of management in relation to its deliberations. I do not doubt that from time to time things were debated. There was at least one instance- the Allianz transaction- where a director asked that management carry out further analysis of proposals that had been put

before the board. But the fact that debate occurred does not necessarily mean the

Th e failure ofHIH Insurance XXXV

independence and rigour of analysis that is required of a board was practised. Generally speaking, the board was too ready to accept what management was saying without testing the matter by appropriate analysis.

A small but telling example concerns the way the board approached remuneration reviews for senior executives. The board' s human resources committee met annually. Its terms of reference required it to review, among other things, the remuneration of various officers and employees. Decisions about the performance and remuneration of senior officers were principally made by the chief executive, who, whilst not a committee member, attended all meetings by invitation. It appears that the committee did not make proposals on its own initiative, nor did it ever reject a proposal made by the chief executive.

By March 1998 the human resources committee had resolved to recommend to the board that the requirement to review senior officers against key position objectives be deleted from its terms of reference. The recorded rationale for this resolution was that the chief executive had made it known to senior officers what was expected of them. The board complied, and from that time there were no benchmarks against which the committee could measure the performance of senior officers. This ensured that the chief executive held the balance of power in relation to performance evaluation of senior officers.

By March 1999 the review of staff remuneration and allocation of bonuses among senior management was at the sole discretion of the chief executive. No guidelines existed to ensure that the levels of salary increases or bonuses were appropriate. This abrogation by the human resources committee of one of its central functions was inappropriate and rendered the committee of little practical use or importance.

There was only the most perfunctory review of the performance of the chief executive. It was carried out by the chairman, without any proper process. The human resources committee approved increases in the chief executive's salary, either without external advice or without heeding advice that had been obtained. The committee never demanded that the chief executive demonstrate how his achievements had measured up to the corporate objective of achieving value for shareholders.

Recognition and resolution of conflicts of interest

I was left wondering whether the board as a whole really understood what was involved in the concept of a conflict of interest and the critical importance it holds in corporate governance. Some members may have grasped the theory, but when the activities of the board are examined in detail the position is not at all clear. It seems that from time to time there were disputes even about whether a board member

should absent himself during discussion of a particular matter. Some members remained present when, on any objective view, their private interests were clearly at issue in a way that might be quite different from the interests of the company.

xxxvi The failure ofHIH: a critical assessment

There were similar problems associated with related-party transactions. One director considered his personal interests were so well known that in some instances he did not have to declare an interest in a transaction to which the company was also a party. In the case of another director, the fact of the interest was disclosed but the paucity of the information provided would have made it vety difficult for the other members of the board to decide whether it was in the interests of the company to permit the transaction in question to proceed.

How did these problems arise? The answer is that the board did not focus on this critical subject and did not have procedures to enable it readily to identify and resolve such issues. A chair has primary responsibility in this area. But Geoffrey Cohen, the chairman of HIH, said that he did not have any particular role to play in identifying circumstances that posed a conflict of interest. He did say, however, that

he knew the secretary was receiving from directors reports about their other interests and tabling them. He thought it was the responsibility of each of the directors to declare any conflict of interest they may have had.

The absence of disclosure by board members did not in itself permit the chairman to assume there was no conflict of interest in a transaction. Nor is disclosure a matter exclusively for the director concerned. The situation just described illustrates the chairman's abdication of responsibility for taking the lead in securing full disclosure by all directors. A voidance of conflicts goes directly to the integrity of the board's processes.

Cohen is not solely to blame. The board should have recognised it as a problem and moved on its own initiative to install a proper system. Related-party transactions were common in the life of HIH, and HIH was not immune to the problems that almost always attend them. The board should have ensured that proper procedures

had been implemented for identifying and resolving problems related to conflict of interest. It did not do so.

The role of the chair

Overall, my conclusion is that Cohen was an ineffective chairman. His lack of attention to identifying conflicts of interest has just been discussed. There are other matters that lead to this conclusion.

Failure to bring the chief executive to account Cohen seemed reluctant to act on matters that should have caused him concern, especially if he knew he would not have the support of the chief executive. For example, he did not bring Williams to account when Williams bypassed the board in

distributing the information memorandum in what was to become the Allianz transaction. He also took no steps to ensure that non-executive directors' concerns about governance were dealt with in a proper manner at board level.

The failure of HIH Insurance xxxvii

Dealing with concerns Concerns about the governance of HIH were raised separately by two directors, Gardener and Head, in May 1999.

Gardener was concerned that the board was not dealing appropriately with a number of important strategic considerations and was dealing only with issues brought to its attention by management. He prepared, for discussion with Williams, an analysis of matters that covered the desired attitudes of the board; matters to be reviewed with management, including HIH's vision, purpose and strategy; oversight of management performance; and accountability. He met Williams to discuss his concerns, but it was apparent to him that Williams did not intend to take action in response to his concerns.

Head wrote to Cohen to express his unease about HIH ' s corporate governance procedures. He questioned whether critical issues were being fully discussed and whether the board was being provided with all the information necessary for informed debate.

In June 1999 Williams called a meeting of non-executive directors to see if directors other than Gardener and Head were similarly concerned. Cohen was present at the meeting. Later in June, Head met Cohen and Williams to discuss his letter. Cohen was surprised to receive the letter from Head. The problems Head raised were never considered at a full board meeting. Cohen suggested to Williams that one way of allaying Head's concern might be to hold strategy meetings, at which strategic matters could be presented to the board. Williams did not embrace that idea and it lapsed.

Head's concerns were astute and well-reasoned, and Cohen should have acted on them. On the basis of what was then known, Cohen should have realised the emerging difficulties were serious. But he was not prepared to raise at board level matters that did not have Williams's imprimatur. Indeed his evidence was that, although he believed strategy meetings were appropriate, he did not take the matter any further because Williams did not welcome the idea. That attitude displays a misconception ofhis role and duties as chairman of the board.

The reaction to Head' s letter and the subsequent meeting was at least part of the reason why Head resigned from the board in August 1999. As for Gardener, I gained the impression that he concluded that his suggestions were not going to be acted on and he did not pursue them or raise them again. This was an opportunity lost to HIH, which should have grasped it and reviewed its entire management and directorial philosophy. The chairman should have seen to it that the opportunity was grasped.

Control of the agenda As chairman, Cohen had a general responsibility to oversee the functioning of th e board and to ensure that all matters properly to be considered by the board were in fact brought before it. Crucial to this responsibility was control of the agenda.

xxxviii Th e failure of HIH: a critical assessmenr

The agenda for each meeting was prepared by the company secretary, according to a standard form, and forwarded to Cohen for approval. Occasionally, Cohen would contact the company secretary and ask him to include a particular item or items. The agenda would then be forwarded to Williams for comment; it appears that other board members did not contribute. The agenda became pro forma and was not a living tool for organising and shaping consideration and review.

Some directors conceded in evidence that the agendas were not adequate to canvass the matters that should have been dealt with at board meetings. They tended to be formulaic and procedural in nature, bringing forward items of concern to management but little from outside that source. As chairman, Cohen should have ensured that all important matters were put on the agenda, so that board members had ample opportunity to contribute their views.

The agenda for the board was controlled by management and not by the board. This does not properly reflect the true nature and scope of a board's role; nor is it consistent with a board's responsibilities. That is undesirable.

Provision of information to the board

During the inquiry there arose many instances that caused me great concern about the information flow to the board. There were occasions when there were material omissions from information given to the board, to the point where the information provided was misleading. Directors can do little if they are misled. But the question that arises is whether appropriate checks and balances were in place to minimise

both the risk of that happening and its effect if it did occur.

In any event, management is part of the overall corporate governance structure. To the extent that there was a breakdown in the systems by which information was furnished to the board, it reflects on the corporate governance ofthe company.

The principal source of information about the group's performance was a quarterly financial report. That report was prepared by the financial services division after it had obtained information from 15 divisional managing directors in Australia and internationally. It contained a summary of the quarter's results and any issues to be

brought to the board's attention. Bill Howard (general manager of the financial services division) was responsible for producing the draft. The first review of the draft was made by Dominic Fodera (initially chief finance officer and later finance director). Following that, the report would be circulated to Williams, Cassidy and John Clarke for their comment. Once Williams had finished the final review, the

report would be finalised and sent to the board about a week before the board meeting.

Clarke was HIH's public affairs manager. I am surprised that he should have had a role in reviewing the financial report to be provided to the directors. My surprise is not assuaged by the explanation given in evidence that Clarke was involved because he helped the executive directors prepare material to be presented to insurance

analysts and major shareholders after the group announced its results. There is

The failure of HIH Insurance xxxix

nothing exceptional in that, but it does not explain why there would be public relations input to the source material that went before the board.

As noted, it does not seem that Cohen had any major involvement in the process for determining what information would be presented to the board. To a large extent, the non-executive directors were dependent on management for what they were told. The failure to present to the board the full arrangements concerning the reinsurance transactions described earlier and the fronting of high-risk film finance business are but two of many examples.

In a normal year there were four board meetings plus an annual budget meeting. Other meetings were held to approve individual transactions. My impression is that the board focused on the quarterly financial reviews and on the results from the perspective of financial performance. Apart from individual transactions, the board received little information about broader business matters.

On other occasions, although some information was presented to the board, it was not presented in such a way as to indicate its significance. Again, there are many examples, but two suffice here. One is the failure to advise the board that the due diligence that was expected to be carried out before the reacquisition of the US operations had not in fact been carried out to the extent anticipated. The other concerns the cash flow consequences of the Allianz transaction and the fact that the $200 million sale price was to go into trust.

It seems that the board placed implicit faith in management's ability to highlight significant matters for the board's attention. The financial reports were not excessively long documents. They emphasised current performance by describing the amount of premium written and earned, current underwriting losses, core earnings and core earnings ratios. They did not focus upon the reliability of the provisions, which of course would have a direct effect on those earnings and ratios.

These are good illustrations of how the process of information provision broke down. Some of them also illustrate a failure of process by the main board members. To the extent that the board papers summarised the affairs of subsidiaries, the main board members could have called for the board papers of those subsidiaries. In particular, if he were to have conducted a rigorous review of the information provided to the board, the chairman should have performed at least periodic reviews of the board papers (or other materials) of the subsidiaries to be satisfied that the summaries provided to the main board were adequate.

From the directors' perspective, this highlights the need for the chair to consider how to satisfy himself or herself that the supply of information to the board is appropriate and for the board itself to consider whether the process is optimal.

Whilst the board, and in particular the chairman, should have done more to focus on the adequacy of the information provided, management, too, should have done more to bring matters of concern to the board's attention. It did not.

xl Th e failure ofHIH: a critical assessment

Another aspect of the passing of information within HIH warrants mention. There were instances of manipulation of financial information. At various times this contributed to the board, the auditors or the Australian Prudential Regulation Authority being misled. On some occasions HIH employees who might be described as 'middle management' were involved, to varying degrees, in the manipulation. It was a frustration during the inquiry that many witnesses played down their own responsibility in these events-for reasons that are perhaps obvious. The point that needs to be made is that if these employees assumed as little responsibility as they asserted for the incidents in which they were involved, that was wrong. People in middle management who are charged with the primary practical responsibility for regulatory disclosure should not approach their task as mere functionaries. They

should not prepare for others documents that they would not, if required, be prepared to sign themselves.

Towards the finishing line

The life and times ofHIH in its last three-and-half months provides some interesting insights into the group's governance.

In late November 2000 Ernst & Young, at the behest of Westpac, delivered to the HIH directors a draft report that included comments on HIH's parlous cash flow position. The directors were told that the group's position was ' delicately poised'. They were also told that Ernst & Young had not concluded that the HIH group or any company within the group was insolvent. Such a statement should, nevertheless,

have given no real comfort to the directors. It was clear from the terms of the draft report that Ernst & Young had serious doubts about the solvency of the companies within the group but that further work was necessary before any meaningful conclusions could be expressed on that subject. The board failed to direct that such work be done urgently.

During November, December and January work continued on cash flow projections. Some of the projections showed there would be a cash deficit by the end of March 2001. The Allianz joint venture's implications for cash flow became more widely appreciated: HIH simply could not afford to allocate the $500 million it was

required to place in the trust without severe consequences for its operating cash flow.

In order to alleviate the cash flow problems a decision was taken to delay payments to or on behalf of HIH policyholders. From then on policyholders and general creditors suffered long delays in receiving their dues; many never received payment. APRA became involved when a policyholder complained about the delay. Talks continued throughout January and February 2001. Work on the half-year results to

31 December 2000 was continuing. It was becoming clear the loss would be very large. Because the company could not tell the market what the loss would be, HIH shares were suspended from trading. The cash flow problems showed no sign of abating. Indeed, they were escalating.

The failure ofHIH Insurance xli

Against that background there occurred an incident that I find quite startling. At a meeting of the board's human resources committee on 26 February 2001 it was resolved to recommend to the board retrospective increases in directors' fees. The board approved the recommendation on that day. As it turned out, there were no adverse consequences from the decision because no payments were made under the new arrangements. But, given what the directors knew about the cash flow difficulties the company was experiencing, quite how the question of fee increases came to be considered at all-let alone approved-is a mystery to me .

On I March 2001 APRA served notices calling on HIH to show cause why an inspector should not be appointed to the three authorised insurers under s. 52 of the Insurance Act 1973. HIH engaged KPMG to carry out a solvency review. At an audit committee meeting held on 13 March 2001 the auditor reported that 'going

concern was an issue' and that the half-year accounts might have to be qualified. On 14 March 200 I KPMG advised W ein and Abbott that HIH was at best marginally solvent and that they would recommend to the directors the following day that the company be placed in provisional liquidation. That happened.

The dash for cash

The lack of control and direction and the failure to appreciate the basic responsibilities of those concerned with the governance of the corporation are epitomised by the unseemly 'dash for cash' that occurred in the days leading up to 15 March 200 I. In the dying days of the corporation, millions of dollars flowed to a favoured few, some of whom-directors, senior managers, advisers, and so on­ were in privileged positions.

The accounts of HIH: substance or gloss?

This brings me squarely to the accounts of HIH and the way in which the corporate culture contributed to the preparation and presentation of accounting statements that did not accurately reflect the financial condition of the group.

The accounts of HIH

It is a truism that a company prospers in the market only if it is financially viable and likely to attract support. The market can assess the financial well-being of a company only by using the information the company publishes. The integrity of financial reporting is fundamental to the system. So how did HIH fare in thi s regard?

The accounting function At the outset I need to say something about how I view the accounting process.

Why do corporations prepare accounts at all? Leaving to one side taxati on considerations, accounts are prepared so that those with an interest in the financial

xlii The f ailure ofH!H: a critical assessmenl

affairs and condition of the entity-whether that interest be proprietorial, regulatory or transactional- are truly and fairly informed as to the entity's financial state. The process by which accounts come to be finalised is relatively simple. Management assembles the information and prepares the accounts. The auditors opine as to their truth, fairness and compliance with relevant accounting standards. But they are the accounts of the company, and the final decision on whether they accurately reflect the financial state of the organisation rests with the directors, not with management or the auditors.

This is not to downplay the role of management or the auditors. It would be facile to suggest that in a company as large as HIH the directors were not entitled to expect that management would assemble, analyse and present the information in a way that complied with statutory and ethical obligations. Of course, the board was entitled to

rely on the professional competence and standing of the auditors and to give due weight to the report they provided. But, the board-the ultimate decision maker­ could rely on management and the auditors only if it was satisfied that the accounts had been derived from systems that were likely to produce accurate returns after diligent search and inquiry into relevant and material matters.

The integrity of information sources It goes without saying that the reliability of the accounts depends on the integrity of the information on which they are based. I doubt the accuracy of much of HIH's accounting and other records. Some of the systems the company had for collecting and reporting management information left much to be desired. The lack of reliable

information meant that those who directed and managed the company's affairs were often flying blind. Worse, there was a filtering of information such that, on occasions, bad news reached the board only if it could not be avoided. I have already commented that there were occasions on which the board was misled.

Accurate information systems are a vital part of a viable insurance business. Without reliable financial data on liability for claims, an insurer faces the danger of underpricing its products and so trading unprofitably over an extended period. Similarly, information systems must be capable of producing material that will allow the board and management to assess properly the company' s financial

position and performance and to detect any deterioration on a regular basis.

The HIH accounting systems

I am far from satisfied that the accounting systems and procedures adopted by HIH were appropriate to the circumstances of the organisation. HIH was a complex group and its accounting systems focused attention at a group level. But the licences to operate the insurance businesses were conferred on individual subsidiary entities, not on the parent company or the group. No management accounts were prepared for the licensed entities. Instead, the accounting information was prepared according to divisions of business type, rather than by reference to entities, and was then consolidated at group level.

Th e failure of HIH Insurance xliii

There was then a process of disaggregation back to entities. Time and time again this process failed. The result was that the returns of licensed entities prepared for submission to the regulator were often wrong- sometimes materially so . Management should have recognised the deficiencies and moved to remedy them. But the board was also at fault: it should have satisfied itself that the systems were appropriate for the type of operation that HIH was conducting.

A problem: GEN+ In 1997 HIH developed a new electronic financial system called GEN+. At first GEN+ was introduced to the Queensland operations; it was later implemented in New South Wales and Victoria. The new system was plagued by serious and continuing problems, among them an inability to produce debtors' statements, to process correct premiums for financial endorsements, and to produce sufficient management reports for the business. Difficulties were also experienced in the processing of data, so that a significant backlog of historical transactions soon developed. The integrity of the financial data produced by GEN+ was accordingly questionable, in terms of both accuracy and completeness. As a consequence the ability of management and the board to operate HIH's businesses was significantly

impaired.

Another problem: reconciliations Similarly, the credibility of the information recorded in HIH's general ledger was compromised by problems with HIH's reconciliations extending over a long period. A project aimed at rectifying these problems was embarked upon in September 1996 and most balance sheet reconciliations were brought up to date. Yet the problems persisted because there was simply no formal process for regular, comprehensive reconciliation of all HIH's accounts. Following pressure from HIH's auditors, considerable efforts were again expended in early 2000 to complete outstanding reconciliations. But a number of unreconciled accounts remained at the date of provisional liquidation, some containing transactions dating back to 1995.

A third problem: budgets Meanwhile, HIH consistently failed to meet its budgetary targets from 1997 onwards. The budget process is an important tool for managing expenditure and assessing performance. The continuing failure to meet budget targets represented a serious breakdown in HIH's internal financial controls. It also suggested that senior management was setting aggressive or overly optimistic budget forecasts for HIH's operating divisions. Surprisingly, it seems there was no process whereby deviations from budget were clearly identified and reflected on. The substantial departure of expenditure from budget suggests that the board failed to monitor the expenditure of the executive directors and failed to ensure that proper controls existed in relation to such expenditure.

There is no evidence, for example, that at the annual budget meetings, or at an y other time, the directors considered the performance of ' actual to budget' in preceding account periods in order to assess the efficacy of the budgets or th e

xliv Th e f ailure of HIH: a critical assessment

budgetary processes. Nor did they seek explanations for the over-runs in executive office expenditure.

Budgetary control as a strategic planning tool was thus rendered completely ineffective. And the board members' reliance on budgets to exercise financial control over the actions of executive management was entirely misplaced.

The audit committee

In modem corporate governance models, great emphasis is placed on the role of the audit committee. Within the HIH structure the decision-making process in relation to financial matters was effectively delegated by the board to the audit committee. The terms of reference of the audit committee and the minutes of its meetings suggest that the committee concentrated almost entirely on matters bearing directly on the accounts and the numbers contained in them. In some companies the audit committee fulfils an allied and equally important function-that of risk

identification and assessment. Other companies have a separate committee for that purpose. Either mechanism seems to have been absent altogether from the HIH governance structures.

The way the committee was constituted In my view, the way the HIH audit committee was constituted detracted from its ability to function effectively. An audit committee should operate independently of management. In other words, it should, where possible, be the domain of the non-executive directors. This is not how the audit committee of HIH operated. Regardless of the committee's appointed membership, all directors were invited to attend the committee meetings and customarily did so. In the last few years of the company's existence there were four executive directors and two other directors who were or had recently been in senior management roles in overseas branches.

Interaction between management and auditors The auditors and management met before audit committee meetings to discuss contentious matters. That is not objectionable. But there were very few occasions when the non-executive directors met the auditors in the absence of management. I think the ability to meet in this way is a necessary part of the process whereby the

board ascertains whether it can safely rely on what management is telling it. The non-executive directors are likely to learn more about what the auditors really think and about ' line-ball' judgments if management is not present.

This is not to advocate clandestine meetings at which personal grievances and prejudices can be aired with impunity. I think, however, HIH would have been better served had organised, regular discussions between the auditors and the non-executive directors been entrenched in the deliberative processes. As I said, this did not happen. On one celebrated occasion, early in 1999, the auditors did meet with two of the non-executive directors because they were not satisfied that the

,,

The failure of HIH Insurance xlv

audit committee properly understood messages they were trying to impart. The chief executive took umbrage. There was no similar contact thereafter.

The evidence suggests that the audit committee rarely, if ever, preferred the auditors over management when the two differed in relation to something. Cohen had been an auditor before retiring from private practice and was a member of the audit committee throughout his time on the board and its chairman from August 1999. He testified that he did not read the auditors' presentations to the committee in their entirety, He said he perused them and read parts. His main concern was whether the auditors had satisfied themselves sufficiently to give an unqualified audit certificate. But the audit certificate is simply a by-product of the audit process. It does not obviate the need for the board to probe the issues carefully and thoroughly.

I have already mentioned the directors' approach to the setting of reserves for future claims. The audit committee was the first 'port of call' in the process by which the directors approved the level of provisions for future claims. The failings of the board, as already canvassed, apply equally to the audit committee. It simply did not ask the right questions.

All in all, it seems that management and the board failed in their primary responsibilities in relation to the accounts of the company. The auditors failed to detect the manifest deficiencies in the way the accounts were prepared and presented. They, too, must accept some of the responsibility.

Aggressive accounting practices

Users of HIH's accounts may not have understood it at the time but in 1999 and 2000-the years to which primary attention was given in the inquiry- the financial statements were distorted by questionable entries, heavy reliance on one-off end-of­ year transactions, and aggressive accounting practices.

Indeed, on more than one occasion independent commentators observed that the management of HIH was apt to use 'aggressive' accounting practices. This is a euphemism for accounting treatment that strains the letter of an accounting standard as far as possible and that may or may not comply with the policy underlying that standard.

In each year from 1997 to 2000 the auditors noted that HIH management tended to rely on one-off year-end transactions that affected profit. They also consistently regarded HIH as a maximum-risk audit client. Leaving to one side for the moment the role of the auditors, there was in my view a failure of the board properly to consider and redress the consequences of management' s use of aggressive accounting practices and one-off entries. What follows is an example of what I regard as an aggressive accounting practice.

The HIH group had incurred significant income tax losses for the years ending 30 June 1999 and 30 June 2000. Despite those losses, the group continued to record as an asset in its financial statements the full value of the future income tax benefits

xlvi Th e f ailure of HIH: a critical assessment

associated with those income tax losses, as well as future income tax benefits associated with timing differences. The financial statements as at 30 June 1999 showed future income tax benefits resulting from timing differences at $145 million and those resulting from tax losses at $27 million, a total of $172 million. The comparative figures for 30 June 2000 are $91 million, $13 7 million and $228 million respectively.

The relevant Australian accounting standard is AASB 1020 'Accounting for income tax (tax-effect accounting)'. The commentary to the standard makes it clear that, where a company incurs a tax loss, significant doubts must arise about the company's ability to realise the related future income tax benefit in subsequent periods. It goes on to say that in those circumstances-and unless realisation of the

benefit is virtually certain-it is imprudent to bring to account as an asset the future income tax benefit attributable to the tax loss. The commentary also notes that in such a case the test of 'virtual certainty' will be met only in rare and exceptional cases.

In the light of that accounting regime, HIH's recogmtwn of future income tax benefits in the face of the losses it was incurring can only be described as 'aggressive'.

Put bluntly, HIH management recognised that the group was underperforming at a level that could not be sustained. But it failed adequately to respond to the underlying causes of poor performance. Instead, it used and relied on questionable transactions giving rise to doubtful accounting entries, which disguised the seriousness of the situation and the consequences of leaving it unchecked. The process was fatally flawed.

Questions of solvency

Many who have been affected by the collapse ofHIH will be asking three questions: For how long before March 2001 had the company been insolvent? Who knew about it? And why did they not do anything to stop HIH trading? These are questions I cannot answer. But there are several points I can deal with and they may

be instructive.

Commercial solvency

Assuming that reference to 'HIH' is to the HIH group, to ask when HIH first became insolvent is to ask the wrong question. This is because insolvency has a particular meaning under the Corporations Law and a 'group' does not become insolvent: individual companies do. Certainly, the financial health of the entire group is relevant to the status of individual companies within it because, in normal circumstances, there would be mutual reliance, so that one member of the group would expect others to provide support in times of travail. But attention must still be

paid to the individual entities, not just to the conglomerate. I

The failure of HIH Insurance xlvii

Insolvency must be assessed according to the definition in s. 95A of the Corporations Law-namely, that the company is unable to pay all its debts as and when they become due and payable. In this inquiry that test has been referred to as 'commercial insolvency', to distinguish it from the question of whether, as an authorised entity, the company met the solvency ratios under the Insurance Act 1973.

Assessment of the commercial insolvency of an insurance company under the Corporations Law can be complex and difficult for a number of reasons, among them the uncertain nature of an insurer's liabilities. These liabilities often relate to future events and are subject to contingencies, including the outcome of future

litigation. Nonetheless they are booked as liabilities. The concept of insolvency under the Corporations Law and its application to general insurers is discussed in detail in the Commission's Background Paper no. 14 'The assessment of the insolvency of a general insurer'. I do not propose to repeat what is said there.

One thing is clear. The companies in the HIH group are being wound up in insolvency. It is safe to assume that as at 15 March 2001 all relevant companies in the group were insolvent: no one contended to the contrary. But, in the light of the difficulties just referred to, I have made no definite findings as to a particular date or dates before 15 March 2001 at which HIH became insolvent. Having said that, if the accounts had included the adjustments I believe should have been made, the state of HIH' s shareholders' funds at 30 June 1999 was parlous and there was a deficiency of shareholders' funds as at 30 June 2000. I am not able to conclude whether that translates to commercial insolvency at any particular date.

Insolvent trading

Each of the HIH directors was subject to the insolvent trading provisions of the Corporations Law, which impose civil penalty and, in some circumstances, criminal liability on directors of companies that incur debts while the company is insolvent.

For a director to be held liable for insolvent trading, it must first be established that the company was insolvent at the time the debt was incurred. It must then be established that the director had reasonable grounds to suspect that the company was insolvent.

In deciding whether a director had engaged in insolvent trading, the first step would be to identify the corporate entity that incurred the debt or debts in question; in the case of HIH, that entity is very likely to have been a subsidiary rather than the holding company. Next, it would be necessary to identify the directors of the entity concerned; in the HIH structure many of the subsidiaries had on their boards a combination of some holding company directors and some members of management. It would then be necessary to decide whether that subsidiary was insolvent.

If the debt were incurred by a subsidiary whose solvency (as a stand-alone entity) was suspect, the directors would very probably claim they relied on, and were

xlviii The failure of HJH: a critical assessment

entitled to rely on, support from other companies in the group. This, in turn, would necessitate an examination of the state of knowledge of each director of that subsidiary as to the financial state of the group. That state of knowledge would then determine the reasonableness of the reliance the director placed on the likelihood of support from other members of the group.

In the absence of evidence about specific debts incurred by specific entities, and without evidence of the state of knowledge of the directors of the entity concerned, no such finding could be made.

These difficulties became apparent at an early stage in the inquiry, so the question of the timing of the insolvency was not a focus of attention. With that in mind, little evidence was elicited that would enable any meaningful consideration to be given to the question whether particular directors had, at particular dates, reasonable grounds to suspect the insolvency of particular companies. As appears from Chapter 17, the preponderance of evidence (so far as it went) is that, although solvency had been

raised as a concern in December 2000, the question of insolvency did not come to a head until 14 March 2001. The directors then took prompt action to have the company placed in provisional liquidation: they did so on 15 March 2001.

Regulatory solvency

Another type of solvency is relevant in the context of HIH. For prudential purposes, authorised insurers are required to comply with the conditions imposed by s. 29 of the Insurance Act 1973. This includes the requirement to maintain a prescribed excess of assets over liabilities- called the 'minimum solvency requirement'. It

requires that the value of the insurer's assets at all times exceed the amount of its liabilities by not less than the greater of $2 million, 20 per cent of annual premium income, or 15 per cent of outstanding claims provisions.

Prudential insolvency does not equate to commercial insolvency. In the normal course, it is to be expected that a company would fall below the minimum solvency requirement before it would become commercially insolvent.

An authorised insurer is required to lodge quarterly returns and yearly accounts with APRA, and the yearly accounts must be audited. Among the required information is a statement of assets and liabilities, having regard to the minimum solvency requirement.

Section 30(1) of the Act provides that some assets may not be counted for the purpose of the minimum solvency calculation-including an asset 'charged for the benefit of a person other than the body corporate to the extent that it is so charged'.

HIH had three authorised insurers: HIH Casualty and General Insurance Ltd, CIC Insurance Ltd and F AI General Insurance Co. Ltd. On the evidence tendered to the Commission, all three companies were, on the face of the quarterly returns, below the minimum solvency requirements at one or more balance dates before March

200 I. The regulator took no action in relation to these breaches.

Th e failure of HIH Insuran ce xlix

For at least some of the returns the position was actually worse than had been disclosed. HIH had failed to disclose accurately and adequately in the returns the true financial position of the entities concerned. Two examples demonstrate this.

Pledged assets

In 1998 HIH acquired Cotesworth Capital Limited in order to gain entry to the Lloyd's market in the United Kingdom. Following the acquisition, arrangements were made for letters of credit to be issued to support the obligations of the Cotesworth syndicates. The letters of credit were secured by indemnities from companies within the HIH group, including the authorised insurers, supported to an extent by cash deposits or securities owned by the authorised insurers. The effect of those arrangements was that the cash deposits or securities were 'charged for the

benefit of a person other than the body corporate' within the meaning of s. 30( 1 )(c) of the Insurance Act, with the result that the authorised insurers were not entitled to count those assets for the purposes of the minimum solvency calculation.

Those assets were not excluded from the available assets in any of the returns lodged with APRA after that date. Had they been excluded, at least two of the authorised insurers concerned would have failed the minimum solvency requirements.

Netting-off related company balances When the returns lodged with APRA by the authorised insurers are compared with the statutory financial reports lodged with the Australian Securities and Investments Commission in 1999 and 2000, it is clear that in some instances related company liabilities and receivables have been set off against one another in the APRA returns. Under s. 30 of the Insurance Act related body assets are permitted to be

included in the minimum solvency calculation only if they are approved by APRA. By setting off related company liabilities and receivables, the authorised insurers understated their non-approved related body assets, with the result that net assets were overstated by the same amount.

The effect of the set-off was that on the face of the returns lodged with APRA the authorised insurers appeared to meet the minimum solvency requirement. According to the information in the statutory financial report, however, there had been no set­ off.

An explanation proffered in evidence as to how this situation might have come about is that journal entries may have been passed to give effect to the set-off. There was no evidence that the journal entries were passed before balance date (the explanation went on), so they must, if they existed, have been done after the statutory financial statements had been prepared and lodged but before the APRA returns were compiled. ·

That explanation-which I did not accept--causes me to add a comment about netting-off generally. Inter-company indebtedness is not merely notional, and it should not be treated as such in the preparation of financial statements and statutory

The failure of HIH: a critical assessment

returns. The law does not permit debtor and creditor balances to be set off against one another in the absence of a legally recognised right of set-off. If, as I suspect, there evolved within HIH a practice which disregarded that fundamental proposition, that practice is to be condemned.

This matter probably extends beyond general insurers. There is more to netting-off within a group than merely 'tidying up' the balance sheet. The problems may not be as evident where there are class orders or cross-guarantees within a group but, as a general rule, third parties deal with particular entities, not with a group. In the process of netting-off, regard must be had to the effect, if any, that the assumption or discharge of liabilities- which is a concomitant of the process-could have on the interests of third parties.

The regulators

APRA

Responsibility for the supervision of authorised general insurers under the Insurance Act 1973 was vested in the Insurance and Superannuation Commission until July 1998; since then it has been vested in the Australian Prudential Regulatory Authority.

In March 1997 government received the report of the Financial System Inquiry (known as the Wallis report). It recommended that an integrated regulator be created for the prudential supervision of all financial institutions, including banks, building societies, credit unions, superannuation funds, friendly societies, life insurers and general insurers. This recommendation was accepted and implemented. On 1 July

1998 APRA was created through a merger of the ISC and that part of the Reserve Bank that had been responsible for supervision of the banking industry.

In relation to general insurance, the ISC handed over files and responsibilities to APRA. There was a 'settling-in phase' while the board and executives of APRA considered a suitable organisational and operational structure. In the course of these considerations APRA took at least two significant decisions. First, it decided to adopt an integrated model, so that a branch or group would have responsibility for a

number of institutions allocated to it on the basis of size and complexity, rather than along industry lines. The second decision- which seems to have been taken by government rather than APRA-was to establish operations in Sydney, rather than Canberra, where the ISC had been centred. It took until August 1999 for these arrangements to be implemented, whereupon what has become known as 'new APRA' came into being.

APRA's performance in supervising HIH was not good. It missed many warning signs, was slow to act, and made misjudgments about some vital matters. But two things need to be said.

The failure ofHJH Insurance li

First, APRA did not cause or contribute to the collapse of HIH; nor could it have taken steps to prevent the failure of the company. A regulator cannot be expected to provide a guarantee that no company under its supervision will ever fail.

Second, APRA faced several handicaps in its supervision of the HIH group as a direct result of the implementation of the new regime. In particular, in APRA's early days, the move to full integration and its relocation from Canberra to Sydney created many managerial distractions for senior executives. The move also resulted

in high .levels of staff attrition and led to the loss of specialist general insurance skills. As a result of the far-reaching and fundamental nature of the reforms, the supervisory regime was in varying degrees of transition throughout the period from 1 July 1998 to 15 March 2001.

During 2001 APRA commissioned an internationally recognised regulator, John Palmer, to assess its performance in the supervision of HIH. Palmer prepared a report and it was tendered in evidence to the Commission. I have placed great weight on that report and I acknowledge the candid and open way that APRA has dealt with both it and the Commission. In giving oral evidence, Palmer said that, given the handicaps APRA faced , it would have been a miracle if it had managed quickly to identifY and act on the problems confronting HIH. But Palmer was also critical of many aspects of APRA's approach, both generally and in specific instances. I have formed much the same view.

The systemic hindrances with which APRA was burdened go some way to explaining how and why it failed to supervise HIH adequately. But numerous questions are left unanswered. In many instances-even taking account of the constraints it was under- APRA did not react appropriately. In late 1999 it was aware that HIH was spending a great deal of money on its reinsurance programme. By early 2000 it suspected that the underlying motivation for that programme was

'profit smoothing'. As the year went on, HIH's share price continued to decline and negative media speculation about the group's financial well-being intensified. In mid-July 2000 APRA received a damning document entitled 'HIH Insurance due diligence' from an anonymous former employee of HIH. Later that month APRA met with a number of HIH officers: the meeting brought to light some troubling signs in connection with HIH's capital adequacy.

By 20 September 2000 APRA was on notice that HIH was potentially overstating its statutory solvency position by including pledged assets in the solvency calculation of its licensed insurers. Within weeks APRA had realised that HIH was also overstating its statutory solvency by means of a netting-off process and incorrect reporting of its related body assets. At around this time APRA also learnt of the serious deterioration in HIH's UK and US businesses. But, in spite of the mounting evidence ofHIH's problems, APRA did comparatively little in response. It grappled poorly with the information in its possession, either failing to recognise its significance or failing to analyse it thoroughly. It lacked commitment in enforcing

in its requests for further information and explanations from HIH. It did not

Iii Th e failure ofHJH: a critical assessment

recogmse the senousness of the situation until it was too late for effective intervention.

Early in December 2000 APRA received a copy of the Ernst & Young report that was mentioned earlier. Later in December the officer to whom the report was delivered perused it. He passed it to his superior. That officer did not read it until late February 2001. He immediately recognised its significance but by then it was too late.

It must also be noted that HIH' s disclosure of information to APRA was not what it should have been. I have already described the prudential solvency regime. The returns to APRA for the quarter ending 30 September 1999 were prepared on what the author described as a 'back of the envelope' basis. Adjustments were made to reduce outstanding claims liabilities and to effect a 'notional transfer' of

semi-government bonds and unit trusts between companies in the group. These adjustments were made because it was realised that without them two of the three licensed insurers concerned would have failed the solvency tests. The returns to APRA, as compiled and lodged, did not reflect what was in the general ledgers, trial

balances and other accounting records of the entities concerned. In other words, APRA was misled.

There were other instances of APRA being given incorrect or misleading information. The matter of the pledged assets is an example. The failure of a regulated entity to deal in a frank and open way with the regulator is to be regretted and it must make the supervisory task very difficult. On the other hand, that is one of the reasons for having a system of regulation. The regulator must develop a regulatory culture that will enable it to cope.

An APRA officer proffered the view that it would have been necessary to intervene as early as mid-1999 to have made any meaningful difference to the outcome for policyholders of HIH. I can see the force in that argument. I acknowledge, too, that it would be speculative to talk of what would have happened had intervention

occurred in, say, November 2000. It would certainly have placed in jeopardy the Allianz joint venture. Policyholders whose business was transferred to the joint venture may therefore be better off. But the fact remains that HIH was still writing business in the months following November 2000. People who took out policies in that period paid good money for cover of doubtful, if any, value.

In July 2002 a new regime for the prudential supervision of general insurers came into force. It is a marked improvement on the system that was in place during the life of HIH. APRA is to be given credit for the development and implementation both of the legislation and of the prudential standards under which the new regime operates. More will be needed, though. If it is to engender in the public confidence that it is well placed to rectify the shortcomings that were identified during the

inquiry, APRA will have to demonstrate that the requisite change has occurred in its operational structures, its understanding of its powers under the legislation, and its basic approach to prudential supervision.

The failure ofH!H Insurance I iii

Other regulatory bodies

The general insurance industry is subject to regulation at a number of levels, administered by a number of bodies. As explained, APRA, which is a Commonwealth body, bears responsibility for prudential regulation. In addition, there is some state and territory regulation in specialised areas of general insurance such as compulsory third party insurance, workers compensation and builders warranty insurance. At a broader level, ASIC administers those provisions of the Corporations Law dealing with the conduct and disclosure obligations of financial service providers, including general insurers.

State regulators

Of the state regulators, only the Motor Accidents Authority of New South Wales and the Motor Accident Insurance Commission of Queensland had significant contact with HIH. In the months preceding its collapse they engaged in detailed consideration of matters arising from the HIH- Allianz joint venture. Of particular concern to the two bodies, respectively, was the sale of HIH's New South Wales and Queensland compulsory third party lines of business. The conditions of sale posed a direct and substantial risk to MAA and MAIC if the HIH group became insolvent.

In contrast to APRA, MAA and MAIC were quick to realise that the Allianz joint venture threatened HIH's ongoing financial viability. Indeed, by November 2000 MAA and MAIC were each contemplating the possibility of appointing an inspector (which they did on 6 March 2001). Ultimately, however, they were heavily reliant on APRA as the 'lead regulator', in terms of both access to information and implementation of initiatives. As it turned out, MAA and MAIC were hindered by APRA's inaction.

ASIC Similarly, ASIC limited its involvement in HIH's affairs because of a perception that APRA was responsible for and was in fact closely and effectively monitoring the situation. ASIC considered it had little direct responsibility in relation to prudential regulation of insurers: that was APRA's role. I am not sure that I agree with this view of the allocation of functions between ASIC and APRA, but I cannot fault ASIC for assuming that position. It was a view that APRA shared.

ASIC gave attention to negative media commentary in the latter half of 2000 and acted on persistent concerns about the adequacy of HIH's market disclosure by starting a formal investigation on 26 February 2001. It pursued various further actions in the days leading up to HIH's provisional liquidation.

liv Th e failure of HIH: a critical assessment

External advisers

In an environment of this kind the task of external advisers such as auditors, accountants, lawyers, investment bankers and other financial consultants is not easy. This is especially so when the advisers cannot rely on full and frank disclosure of necessary information.

Those to whom HIH owed obligations-shareholders, policyholders, creditors, regulators, and so on-were entitled to expect that the external advisers would demonstrate independence from management and exercise their professional skill in a way best suited to helping the company act as it should. There are areas in which the conduct of individual external advisers fell short of what was required in the circumstances.

But what they and the other external advisers did or failed to do can properly be described as a factor that influenced the course of events. Generally speaking, the community is entitled to be disappointed that in at least some respects the external advisers and the key regulator failed to use their professional skills and statutory powers to better effect.

The auditors Auditors play a vital role in the financial reporting process. This is particularly so with companies such as HIH because their true financial position and performance is a matter of national economic significance. A properly conducted audit should allow users of the company's financial report-including regulators, shareholders, policyholders, lenders and other creditors-to rely on the accounts with a degree of confidence. The audit process should be designed to provide the company and users of its accounts with early notice of potential risks affecting the company's short- or

long-term viability.

It is sometimes suggested that whenever a company fails its auditor must have been at fault. I do not subscribe to that theory. It is correct neither in principle nor practice. The work performed by the auditor must be carefully analysed, having regard to all the circumstances of the audit process. In the case of Andersen, those circumstances include the fact that on some occasions and in relation to material matters they were misled.

During the course of the inquiry, a select number of specific accounting matters dealt with by Andersen in the course of the 1999 and 2000 audits were examined in detail. In relation to some of them I found that Andersen did not obtain sufficient audit evidence to support its conclusions. In many instances I found that adjustments ought to have been made to the accounts in relation to matters that were the subject of inquiry.

I then had to try to find out why these defects occurred. Two specific questions arose: Was Andersen's independence compromised? And was Andersen's methodology fundamentally flawed?

The failure ofHIH Insurance lv

Independence That an auditor must be independent both in fact and in appearance is fundamental to an effective audit. The concept of 'appearance' of independence is similar to the well-known adage that justice must not only be done but be seen to be done. If the appearance of independence is affected this can undermine the confidence that a user of the accounts may attach to the audit opinion.

One such matter in the case of HIH was the presence of three former Andersen partners on its board. One of them was the chairman and the recipient of continuing benefits from Andersen, including fees from a consultancy arrangement. Another noteworthy matter was the removal from the HIH audit of the long-standing engagement partner in 1999, following his decision to meet with some of the non-executive directors of HIH in the absence of management. The pressure on the Andersen partners to maximise their fees from non-audit work-giving rise to a potential conflict with their audit obligations-was also a cause for concern. In my view, the combined effect of these features of the relationship between Andersen

and HIH gave rise (or would give rise to those aware of the relevant facts) to a perception that Andersen was not independent of HIH. Nevertheless, a close analysis of the conduct of the 1999 and 2000 audits reveals no reason to conclude that Andersen's independence was in fact compromised.

The audit methodology Andersen had in operation a formal system of quality control and procedures that governed its audit work. It required conformity with standards and policies that were consistent with authoritative auditing standards. On the whole, its general approach to the HIH audit in 1999 and 2000 complied with that system. There were, however, a few aspects of Andersen's methodology that troubled me.

One area of concern was the manner in which Andersen relied on the valuations of HIH's consulting actuary, David Slee, in the conduct of its audit. As noted, the largest single item on the balance sheet of a general insurer is the provision it sets aside for payment of future claims. That item is based on actuarial valuations. Andersen did not have any actuarial expertise, and nor did it retain such expertise to assist it as part of the audit process. It therefore relied heavily on Slee's work to confirm the credibility of the provision for outstanding claims.

In these circumstances it was incumbent on Andersen to take steps to satisfY itself as to Slee's competence, integrity and objectivity. It also needed to obtain an understanding of the assumptions and methods Slee used and to consider whether they were reasonable, based on Andersen's knowledge of the business and the results of other procedures performed. This is not to suggest that Slee's work was questionable; it is to say that Andersen was required to satisfY itself that Slee's work was beyond reproach before relying on .it so heavily.

Andersen and Slee had no direct meetings or contact during either the 1999 audit or the 2000 audit. Andersen never sought to obtain a full understanding of the extent and nature of all the work carried out by Slee for HIH and of Slee's relationship and dealings with the various management personnel in HIH. Andersen generally relied

I vi The failure of HIH: a critical assessment

on extracts from six-monthly reports Slee prepared in respect of individual portfolios and the group outstanding claims provision, which it received befo re the finalisation of the year-end accounts. In most instances the complete reports were not delivered until after the completion of the audit. Generally speaking, the extracts provided scant detail as to Slee' s methodology and assumptions.

The new prudential regulations that came into force on 1 July 2002 have codifie d some aspects of the relationship between auditor and actuary, and greater communication than occurred between Andersen and Slee is now likely to occur. Given the importance of outstanding claims provisions, that is a good th ing.

The efficacy of the audits Users of financial statements have varying expectations of the audit certificate. In my view, Andersen' s approach to the audit in 1999 and 2000 was insuffic iently rigorous to engender in users confidence as to the reliability of HIH's financial statements. This detracted from the users ' ability to appreciate full y HIH's true financial position.

Other advisers

The consulting actuary As with any general insurer, the role of the consulting actuary was vital. The board and management of HIH placed considerable reliance on Slee' s work. So, too, did the auditors, to varying degrees, as mentioned. In relation to the estimates of claims reserves in particular portfolios, there were individual instances of work carried out

by Slee (and his employees) producing results that were less than optimal. In some instances, Slee's use of data and choice of methodologies was not conducive to bringing about- and did not bring about-a satisfactory result.

During the course of the Commission' s inquiry questions were raised as to whether Slee ' s independence had been (unwittingly) compromised by his relationship with HIH, so that he could not properly carry out his functions. Individual errors do not, of themselves, connote a lack of independence. Overall, I was not convinced that

Slee was so compromised.

The lawyers HIH approached various legal advisers from time to time to provide guidance on particular matters. There were occasions when the legal advice given fell short of what one would expect in the circumstances. One such occasion involved the

provision of advice in a situation where the potential for a conflict of interest was obvious. Another entailed advice that sought to explain how to effect an arrangement in a way that would 'get around' certain provisions of the Corporations Law that otherwise prohibited the arrangement. It is also disappointing that lawyers were among those involved in what I call the ' dash for cash' in the days leading up

to 15 March 2001.

In vestment bankers and other finan cial consultants HIH sought ongoing advice and support from investment bankers and other financial consultants. In particular, these advisers were consulted about decisions

Th e fa ilure of HIH Insurance I vii

involving acquisitions, sales and restructuring. They would often explore a range of options for effecting a certain transaction. On occasion, the level of fees they were entitled to charge varied according to the option. It seemed to me that this had the potential to compromise the advice they were required to give about the merits of each option. Nevertheless, I was not able to conclude that, in relation to any

particular transaction, the advice had actually been compromised.

In some instances the fees charged to HIH were very high in relation to transactions that in the end proved not to be beneficial to the group. In one instance the financial adviser sought to downplay the significance of its role by describing it as 'purely executionary'. I am not sure what that means. If it means no more than ensuring that all of 'paperwork' was in order then the amount of fees levelled in respect of th e transaction seems difficult to justify.

Individual conduct

The terms of reference directed me to inquire into and report on the reasons for and the circumstances surrounding the failure of HIH. This is what I have referred to as the 'core instruction'. I regarded this as by far the most important aspect of the inquiry. Most of the findings I have made go to the core instruction and, in particular, to the circumstances surrounding the failure.

In identifying the reasons for and circumstances surrounding the failure I have come across acts and omissions that might amount to a contravention of the law. The terms of reference directed me, if that should occur, to report on it and recommend whether or not the possible contravention should be referred to an agency. I have complied with that direction, but I regard it as subordinate to the core instruction.

I conducted this inquiry in a manner that was as open and transparent as possible. I did so for two reasons. The first concerns the principle of open justice. The other is because this Commission was established at least in part to help restore public confidence in an important sector of industry and in the market generally. I felt that an open and transparent inquiry was the best way to make that contribution. But open inquiries come at a cost- the potential to affect reputation. The competing

interests are not always easy to balance.

During the course of the inquiry aspects of the proceedings were given widespread publicity. Matters were raised that had potential to affect the reputation of individuals, sometimes in a serious way. I made it clear that what occurred during the hearings had nothing to do with findings. Only I could make findings and I have now done so. They are presented in the body of this report.

It has not been possible to deal with , every one of the myriad matters that arose during the hearings and that could affect the reputation of individuals.

Had I analysed each such matter and ruled formally on it, this report would have become so long that it would very probably have lost its utility. In addition, I might

I viii Th e failure of H!H: a critical assessment

have overlooked some matters and thereby possibly compounded the hurt by leaving some, and not others, apparently unresolved. There are two reasons for this. First, the sheer number of matters that accumulated over the 14 months of the hearings meant that, even by careful search, it was extremely difficult to identify all contentious matters. Second, there may have been some matters that I considered to be benign without appreciating the depth of feeling harboured by the individual concerned.

The findings presented in this report represent the entirety of the findings that are, or could be regarded as, adverse to the interests or reputations of an individual or entity. If, during the course of the hearings, publicity was given to an allegation against or about a person or company and there is no express finding against that

individual or entity in the report, then it is to be taken that I have made no such finding . This is the case regardless of what may have been written or said about the person or company, in evidence, in submissions or in publicity about the proceedings. Where there is no finding in this report against the person or company, the reputation of that person or company emerges entirely free of any adverse

implications. It must be seen and judged accordingly.

What of the future?

A vital part of the work of this Commission has been its deliberations on the future. Everything that can be done should be done to minimise the risk of a collapse of the severity of the HIH failure happening again.

A number of recommendations are made to that end. The changes proposed are not particularly radical but in my opinion they are important and will make a meaningful contribution to the restoration of public confidence in the market. They build on changes that have already been made or are in progress. I can draw out some broad themes that have guided my thinking.

The regulation of insurers

General insurance is a complex product beset by uncertamtJes. Because of the vagaries, it is a minefield for the uninitiated. Strong and efficient external regulation is both justified and necessary. Much has been done to effect change in the prudential regulation of general insurers through the introduction in July 2002 of the

General Insurance Reform Act 2001 and the prudential standards promulgated by APRA under it. They are a vast improvement on the system that applied while HIH existed. But there is a great deal more to be done to minimise the risks.

Strangely, there is no fixed definition of the term 'insurance' and thus of suppliers of 'insurance-type' products who are amenable to supervision. For example, some medical indemnity arrangements are discretionary in nature and do not fit within the current understanding of the term 'insurance' under the Insurance Act 1973. This is

the subject of proposed legislation. Foreign underwriters, who are not subject to

The failure ofHIH Insurance lix

regulation by APRA, can offer products to Australian consumers through intermediaries such as agents and brokers who are situated here. But the purchasers of those products do not have the protection the regulatory system provides. In my opinion, the definition of ' insurance' should be as wide as the constitutional limits will allow, so that, so far as is possible, suppliers of insurance-type products and foreign underwriters come within the purview of APRA.

Because of the complexity of the industry- especially in relation to the estimation of its 01,.1tstanding claims liabilities- it is very difficult for consumers to make informed decisions about the financial strength of insurers. One way to limit these difficulties is to require greater disclosure of information. This is not just disclosure for disclosure's sake. It will be a catalyst for the regulator, analysts and others with experience to understand better the import of the information and so inform the public and detect weaknesses at an earlier stage.

Many overseas countries have policyholder protection schemes that are designed to lessen the impact on individuals of the collapse of an insurer. The Commonwealth Government established a scheme of that nature in the wake of HIH's failure. This may increase the expectation among consumers that, were the situation to recur, the government would step in again. Some fundamental questions have to be answered and, in my view, now is the time to do it. Is there a moral hazard in allowing consumers to make decisions (perhaps based solely on price) safe in the knowledge that if the insurer were to fail they would not suffer? Should the taxpayer bear the risk of another failure or should it be borne by the industry? I believe that the competing interest can be balanced and that a permanent scheme should be

introduced. The policy questions will then have been resolved. If a collapse were to happen in the future , the effects could be mitigated relatively quickly.

APRA's governance structures are not optimal for an organisation of its type. It has a board that is in some respect similar to the boards of commercial entities. I do not think this is necessary. Control-and with it responsibility-should rest with a small full-time executive. This would make APRA more efficient and better able to discharge the responsibilities it has.

Structural reform affecting the industry

Some general insurance activities are subject to regulation purely by APRA. Other insurance-for example, workers compensation and compulsory third party motor vehicle-is the province of the states and territories. There is a degree of overlap in regulation; this is inefficient and adds to the cost of insurance. Individual state and territory levies and imposts also add to the cost. These inefficiencies can and should

be reduced.

..

lx Th e failure of H!H: a critical assessment

Accounting considerations

Users of financial statements expect the accounts to give a true and fair view of the state of the company in question. After all, that is the prescription of the Corporations Act. HIH's accounts did not give a true and fair view of the group's situation.

Australia has joined the move to develop and adopt international accounting standards. I have no difficulty with that as a principle. Matters disclosed during the inquiry led me to conclude, however, that there were serious deficiencies in some of the accounting standards applicable to general insurers. I do not think remedying these deficiencies can await the adoption of international standards.

Once again, disclosure looms large in relation to accounting matters. There are many respects in which the confidence users of financial statements can have in accounts would be increased by greater disclosure. An example is the scope of audit. Audit is required by statute, but not all audits are conducted according to the same methodology and with the same depth of inquiry. The financial statements are those of the company, not the auditors. The directors need to understand that the audit opinion is not a commodity to be bought at the cheapest possible price. It is an assurance mechanism. It is in the interests of the directors, as much as anyone else, to get the most from the audit process.

There is a related issue. The scope of audit ought to be disclosed in plain English, so that the consumer can assess the degree of reliance to be placed on the audit opmton.

The government has before it recommendations to change the audit regime in the Corporation Act, in the form of the rather oddly named 'CLERP 9' proposals, which deal with matters such as auditor independence and the relationship between directors, management and auditors through, for example, audit committees of the

board. In my view, there are ways the CLERP 9 proposals can be refined to afford better protection to all participants. Once again, disclosure is the key, so that there is a process that is both open and accountable.

Management and control of corporations

That brings me once again to the subject of the governance of companies-a topic of intense debate in the commercial community and, for that matter, the wider community. Among the areas that I think warrant attention are the need for truly independent judgment at board level, periodic testing of the practical effectiveness

of a company's governance models, and greater disclosure of information about the way a company ts run.

There is also an allied matter. The directors are accountable for their actions. Those at other levels of the decision-making process within companies and on whom the directors rely should also be accountable. The law may have to be changed to achieve that.

The failure ofHJH Insurance I xi

The Royal Commission: a personal perspective

I have been working solidly on this inquiry for more than 18 months. I hope no one will begrudge me a few personal observations.

The two most important questions I had to consider were what I have called the 'core instruction' in the terms of reference ('the reasons for and the circumstances surrounding the failure ofHIH') and paragraph (e) (recommendations for change so as to improve the system of regulation). The terms of reference also required me to give attention to what might loosely be described as finger pointing and the apportionment of blame.

At first glance, it may seem that a far greater proportion of the report is devoted to blame than to dealing with the core instruction and paragraph (e). But much of what is contained in Volumes II and III- for example, the chapters dealing with provisioning, reinsurance and the overseas operations- is essential for a full understanding of the conclusions reached in relation to the core instruction. Matters of blame flow from those findings; they do not precede them.

I found that in relation to specific incidents there might have been a contravention of the law. I did this without enthusiasm. It is not for me to judge whether this Commission has faithfully served the public interest and whether it has fulfilled the expectations the public had of it. To the extent that I am permitted to form a view, it will not be influenced in the slightest by the number of prosecutions (if any) that flow and the severity of the penalties (if any) that are imposed. If this report is seen to provide a plausible explanation for the collapse of HIH and to offer sound guidance as to ways of lessening the chances of another such event occurring, I will be content.

I hope that readers of the report will not become preoccupied with blame and that attention will not be diverted from the primary messages. How the failure of HIH came about and what should be done to diminish the likelihood of such a calamity occurring in the future are at the heart of this report.

From time to time as I listened to the evidence about specific transactions or decisions, I found myself asking rhetorically: did anyone stand back and ask themselves the simple question-is this right? This was by no means the first time I have been prone to similar musings. But I think the question gives rise to serious thoughts.

We live in a dirigiste age. Each year there is a dramatic increase in the size of the statute books. Almost every facet of life is governed by rules, regulations, proclamations, orders, guidance notes, codes of conduct, and so on, prescribed by governments or recognised agencies. The courts, through the common law, add to the plethora of rules to which we must have regard.

lxii The failure of HIH: a critical assessment

There is no doubt that regulation is necessary: peace, order and good government could not be achieved without it. But it would be a shame if the prescription of corporate governance models and standards of conduct for corporate officers became the beginning, the middle and the end of the decision-making process.

Right and wrong are moral concepts, and morality does not exist in a vacuum. I think all those who participate in the direction and management of public companies, as well as their professional advisers, need to identify and examine what they regard as the basic moral underpinning of their system of values. They must then apply those tenets in the decision-making process. The education system­

particularly at tertiary level-should take seriously the responsibility it has to inculcate in students a sense of ethical method.

In an ideal world the protagonists would begin the process by asking: is this right? That would be the first question, rather than: how far can the prescriptive dictates be stretched? The end of the process must, of course, be in accord with the prescriptive dictates, but it will have been informed by a consideration of whether it is morally right. In corporate decision making, as elsewhere, we should at least aim for an ideal world.

As I have said, 'corporate governance' is becoming something of a mantra. Unless care is taken, the word 'ethics' will follow suit.

I note the sad passing, during the course of the inquiry, of Brian Woodley, a respected journalist who was covering the Commission at the time of his death. It was also sad that in October 2002, after he had given evidence, Randolph Wein died in an accident. I am uncomfortable about the criticisms I have made of W ein in this report, but the story ofHIH would not have been complete without them.

I am very grateful to the Commission staff and counsel and solicitors assisting for their tireless and expert help during the term of the inquiry. It is trite to say that without their contribution this report would never have been completed, but their willingness and dedication went beyond what I had a right to expect. I am also grateful to the legal practitioners and other representatives of witnesses and parties who, in often difficult circumstances, acted professionally and with patience.

A final comment

By March 2001 the pressures on HIH that had been building over the years could no longer be contained or controlled. There was a huge implosion. The end, when it came, was sudden and spectacular. The fact that the principal players were not prepared for it compounded the gravity of the consequences. But that is the end of the story: I return now to the beginning.

The failure of HIH Insurance lxiii

lxiv

Other examples are Reliance Insurance Company in the United States, Markham General Insurance Company in Canada, and Chester Street Insurance Holdings Ltd in the United Kingdom.

This is a comment by Don Argus, as reported in The Weekend Australian, 5-6 October 2002.

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Th e failure ofHIH: a critical assessment

Policy recommendations

In Part Three I deal with important matters affecting the regulation and prudential supervision of the general insurance industry. I have made recommendations that have implications for business activity and for the community generally. What follows is a list of the recommendations.

Corporate governance

I recommend that the disclosure and other requirements of the Corporations Act 2001, the relevant accounting standards and the Australian Stock Exchange Listing Rules that relate to directors' remuneration be reviewed as a matter of priority, to ensure that together they achieve clear and

comprehensive disclosure of all remuneration or other benefits paid to directors in whatever form.

2 I recommend that the Corporations Act 2001 be amended to repeal the existing legislative provisions relating to the definition of the extended classes of personnel upon whom duties are imposed by the Act and to substitute instead a definition that is clear, simple and certain of application.

The definition would focus on the function performed by the relevant person- not the classification of their legal relationship to the corporate entity-and avoid expressions such as 'employee' in favour of a functional orientation.

The definition would then form the basis of a regime having the following features:

• All the general duties imposed by Chapter 2D of the Corporations Act should be imposed on directors, secretaries and the wider class of personnel encompassed within the functional definition.

• The duties imposed by ss . 182(1 ), 183(1) and 184(2) of the Act should be imposed on all persons performing functions for and on behalf of corporations, whether employees or suppliers of services under contract.

• The liabilities created by s. 1309 of the Act should be imposed on all persons and not be restricted to a limited class of management personnel.

• The classes of personnel prohibited from acting dishonestly in connection with the performance or satisfaction of any obligation imposed on the company by any written law should be extended.

Th e failure of HIH Insurance lxv

financial reporting a nd assurance

3 I recommend that the Commonwealth Government broaden the membership of the Australian Accounting Standards Board to include people with business or professional backgrounds beyond the accounting profession.

4 I recommend that Australia participate fully in the development of

international accounting standards and pursue the adoption of high-quality, consistent and readily understood accounting standards.

5 I recommend that, in adopting international standards, Australia reserve the right to require more stringent standards that are not inconsistent with the relevant international standards. These would generally relate to disclosure requirements.

6 I recommend that the Australian Accounting Standards Board alter the Urgent Issues Group or create a separate group that is able promptly to issue binding rulings on important and urgent matters concerning the interpretation and application of the accounting standards.

The board should extend the constitution of the Urgent Issues Group or the separate group beyond accounting professionals and include lawyers and users of financial statements.

7 I recommend that the professional accounting bodies develop guidelines to encourage their members to consult independent third parties or the Urgent Issues Group when there is disagreement with the management of compames concerning the interpretation or application of accounting standards.

8 I recommend that the Australian Accounting Standards Board amend accounting standard AASB 1023 to include the following:

lxvi

• a definition of insurance that includes the requirement for a material transfer of insurance risk

• a requirement that insurance liabilities be valued at a level of

sufficiency of at least 75 per cent, as required by APRA' s prudential standards. Companies should be explicitly permitted to set prudential margins in excess of 75 per cent if the company' s board considers that appropriately reflects a true and fair view of the financial position of the insurer

• a requirement that entities disclose in their financial statements

the valuation of their insurance liabilities at a central estimate

a 7 5 per cent level of sufficiency

the margin ultimately adopted by the entity

Policy recommendations

• a requirement that premium revenue and insurance liabilities be recognised on the commencement of a contract of insurance. This will require the recognition of premium liabilities

• a requirement that, in estimating the present value of liabilities, future cash flows be discounted using a risk-free rate similar to that required by the prudential standards

• a requirement that companies subject to the standard disclose a 10-year claims-development table that includes past estimates of claims on an undiscounted basis as well as the actual costs of settling claims. This information should be provided both net and gross of reinsurance.

9 I recommend that all standards of independence of auditors in Australia, including those contained in legislation and professional standards such as Professional Statement F 1, be consistent with the standard of independence defined as follows:

• An auditor is not independent with respect to an audit client if the auditor might be impaired-or a reasonable person with full knowledge of all relevant facts and circumstances might apprehend that the auditor might be impaired- in the auditor' s exercise of objective and impartial judgment on all matters arising out of the auditor's engagement.

• A reference to an auditor includes both an individual auditor and an audit firm. In determining whether an auditor or an audit firm is independent, all relevant circumstances should be considered, including all pre-existing relationships between the auditor, the audit firm and the audit client, including its management and directors.

10 I recommend that the Corporations Act 2001 should be amended to require the board to provide a statement in the annual report that identifies all non­ audit services provided by the audit firm and the fees applicable to each item of work and explains why those non-audit services do not compromise audit independence.

11 I recommend that, in implementing the CLERP 9 proposal for restrictions on employment relationships between an auditor and the audit client, the amendments provide for the following:

• a mandatory period of four years following resignation from an audit firm before a former partner who was directly involved in the audit of a client can become a director of the client or take a senior management position with the client. This restriction should be extended to include key senior audit personnel

• an extension of the restriction to a former partner who was not directly involved in the audit of a client. In my opinion, the current proposed period of two years would be appropriate for such a partner

The failure of HIH Insurance lxvii

• a prohibition on any more than one former partner of an audit firm, at any time, being a director of or taking a senior management position with the client

These restrictions should be enforceable against both the audit firm and the relevant former partner or senior audit team member.

12 I recommend that, in implementing the CLERP 9 proposal for rotation of audit personnel, the requirement for rotation of the lead engagement partner and review partner be extended to key senior audit personnel.

13 I recommend that the Corporations Act 2001 be amended to require the disclosure in audit reports of the following:

• the impact of the position taken by the reporting entity where alternative accounting treatments are reasonably open from the reading of an accounting standard and the difference between those accounting treatments is material

• the significant matters arising in the audit process.

The Corporations Act should be amended to require audit reports to be presented in plain English and to require the inclusion of an operating and financial review as part of an annual report, which would be the subject of audit.

14 I recommend that the Corporations Act 2001 be amended to require public listed companies to include a brief, plain English summary of the nature and scope of the audit services provided by their auditor each year.

15 I recommend that both the Australian Prudential Regulation Authority and the Institute of Actuaries of Australia introduce compulsory certification of the completeness and accuracy of data.

16 I recommend that the Institute of Actuaries of Australia and the Australian Prudential Regulation Authority introduce a requirement for more detailed disclosure of the exercise, incidence and impact of subjective judgment and departure from historical experience.

17 I recommend that the Australian Prudential Regulation Authority extend the qualifications of the approved actuary to require that they not be an employee or partner of the organisation to which the approved auditor belongs.

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lxviii Policy recommendations

Regulation of general insurance

18 I recommend that the Australian Prudential Regulation Authority Act 1998 be amended to replace APRA' s non-executive board with an executive group. This group would comprise the chief executive officer and two or three executive commissioners and would carry the responsibility, and account to government, for the operation and performance of APRA.

19 I recommend that the Australian Prudential Regulation Authority Act 1998 be amended to provide the chief executive with the power to establish an advisory board.

20 I recommend that the direct involvement of representatives of the Australian Securities and Investments Commission and the Reserve Bank of Australia in the governance of the Australian Prudential Regulation Authority be discontinued. This will require amendment of the Australian Prudential Regulation Authority Act 1998.

21 I recommend that the Australian Prudential Regulation Authority chief executive instigate, as a matter of urgency, a review of APRA's organisational structure. The object of the review should be to achieve a workable and effective balance between accountability for and knowledge of particular financial services on one hand and cross-sectoral functional skills and perspective on the other. In particular, the review should consider

the creation of a specialist team to take primary responsibility for the supervision of general insurers.

The review should report to APRA's board with recommendations on APRA's appropriate internal structure, given its responsibilities across the deposit-taking, insurance and superannuation sectors. The board should publicly respond to its recommendations.

22 I recommend that the Commonwealth Government consider removing the requirement for the Treasurer's agreement to operational decisions involving APRA's prudential oversight of general insurers.

23 I recommend that, given the inconsistencies between the Insurance Act 1973 and the Banking Act 1959, the Commonwealth Government review the current legislative provisions for merit review of APRA's decisions for the purposes of ensuring consistency.

24 I recommend that the Australian Prudential Regulation Authority implement a programme to build the skills of staff involved in the supervision of general insurers. This should involve a review of its human resource management policies to assess APRA's competitiveness in the financial

services sector labour market. The review should take account of the adequacy of remuneration, training and career structures as well as other steps to increase APRA's attractiveness as an employer.

Th e failure ofHIH Insurance lxix

25 I recommend that the Commonwealth Government adopt a three-year rolling funding arrangement to set the Australian Prudential Regulation Authority' s budget.

26 I recommend that the Australian Prudential Regulation Authority develop a more sceptical, questioning and, where necessary, aggressive approach to its prudential supervision of general insurers. Consultation, inquiry and constructive dialogue should be balanced by firmness in its requirements and a preparedness to enforce compliance with applicable standards. In particular, APRA should take a firm approach to ensuring regulated entities ' timely compliance in the lodging of returns and the provision of information.

27 I recommend that the Australian Prudential Regulation Authority continue to develop and review processes, guidelines and training to assist its staff in considering the appropriate approach to take towards supervised entities in different situations.

28 I recommend that the Australian Prudential Regulation Authority develop systems to encourage its staff and management continually to question their assumptions, views and conclusions about the financial viability of supervised entities, particularly on the receipt of new information about an entity.

29 I recommend that the Australian Prudential Regulation Authority develop an internal system for tracking all relevant information concerning regulated entities.

30 I recommend that the Australian Prudential Regulation Authority develop mechanisms for investigating the reinsurance arrangements of authorised general insurers on a random but frequent basis.

31 I recommend that the effectiveness of the current memorandum of understanding between the Australian Prudential Regulation Authority and the Australian Securities and Investments Commission be reviewed.

The processes for liaison, coordination and exchange of information between APRA and ASIC should be reviewed on a regular basis. To facilitate the exchange of information, the Commonwealth Government should make a regulation specifying ASIC for the purposes of s. 56(5)(a) the Australian Prudential Regulation Authority Act 1998.

32 I recommend that matters relating to the coordination of Commonwealth regulation affecting the insprance industry be the province of the Commonwealth Treasury.

33 I recommend that coordination of the matters related to the regulation of the insurance industry be addressed through the proposed ministerial council.

lxx Policy recommendations

34 I recommend that authorised insurers be required to make greater disclosure of information about their financial position. In particular, all financial and statistical information general insurers currently provide to the Australian Prudential Regulation Authority in their regular returns should be made public.

35 I recommend that information that enables external users to make an informed assessment of an insurer's outstanding claims provisions and reinsurance arrangements be published by the insurer or the Australian Prudential Regulation Authority. APRA should develop reporting returns for insurers that would enable this to occur if existing returns are

insufficient.

In particular, general insurers should publish:

• material equivalent to the 'schedule P' loss-development data published in the United States

• a summary of the approved actuary's valuation of the outstanding claims liabilities, including the methodologies and assumptions underlying that valuation.

36 I recommend that insurers be required to make greater disclosure of qualitative information relating to their risk- and reinsurance-management strategies. Other qualitative information- where the prospect of disclosure may affect the quality of information provided to companies- need not be disclosed.

37 I recommend that the Australian Prudential Regulation Authority identifY and make known the kinds of regulatory activities that in its view should be disclosed publicly (whether or not the insurer in question is a listed company) and should specify the process by which such disclosure should occur.

38 I recommend that, as a matter of high priority, the Australian Prudential Regulation Authority develop and promulgate a standard for the effective regulation of authorised insurers that operate as part of a corporate group.

The proposed prudential standard on corporate groups should include a minimum capital requirement at the group level as well as the authorised entity level.

39 I recommend that the Australian Prudential Regulation Authority monitor the financial condition of corporate groups, including those with foreign operations. Pending the development of the proposed prudential standard on supervision of corporate groups, APRA should use existing powers to require groups to provide any information it considers necessary to perform this role.

Th e failure of HIH Insurance lxxi

40 I recommend that the Australian Prudential Regulation Authority take steps to ensure that it effectively exchanges with relevant foreign regulators information and intelligence on the operations of Australian insurers with international operations.

41 I recommend that the Australian Prudential Regulation Authority modify the prudential standards to require the annual production by an authorised general insurer's approved actuary of a report on the overall financial condition of the insurer.

42 I recommend that the Commonwealth Government amend the Insurance Act I973 to extend prudential regulation to all discretionary insurance-like products-to the extent that it is possible to do so within constitutional limits.

43 I recommend that s. 462(3) of the Corporations Act 2001 be amended so that the Australian Prudential Regulation Authority may apply to wind up a company that is an authorised insurer if any of the criteria specified in s. 52(l)(aa), (ab) or (a) of the Insurance Act 1973 are met.

44 I recommend that s. 461 of the Corporations Act 2001 be amended to specify that the interests of policyholders are interests to which the court should have regard in deciding whether to make a winding-up order.

45 I recommend that the Australian Stock Exchange amend Listing Rule 3.1 to require-or publish a guidance note making it clear-that price-sensitive announcements have the approval of either the board or a delegate of the board subject to ratification by the board.

46 I recommend that the Australian Stock Exchange amend the Listing Rules to prohibit 'blacklisting' -defined as exclusion of a person or organisation from briefings by a company or a pattern of such exclusion in the face of negative reports on the company by those analysts over a specific period.

47 I recommend that the Australian Stock Exchange clarify Listing Rule 11 .1, so that it applies to any significant change in the business or assets of a listed company, whether it be by acquisition, disposal, amalgamation or otherwise. I further recoinmend that the ASX amend the Listing Rules to define 'significant change' , so that it encompasses financial and geographic factors as well as the nature and scale of the company' s business.

48 I recommend that the Australian Stock Exchange amend Listing Rule 11 .2, so that it applies to any disposal of the whole or substantially the whole of the assets or operations of a company.

lxxii Policy recommendations

State and territ ory regulation

49 I recommend that the states and territories not undertake any prudential regulation of general insurance. The Australian Prudential Regulation Authority should be the sole prudential regulator in this field.

If such regulation is to continue, state and territory governments should ensure that it is consistent with the requirements of the Insurance Act I 9 7 3. This is a matter that might properly be referred to the proposed ministerial council.

50 I recommend that, to the extent that states and territories continue to involve themselves in prudential regulation, the Australian Prudential Regulation Authority should share all information relating to the prudential regulation of relevant general insurers with relevant state and territory bodies.

The states and territories should provide APRA with all relevant information that may concern the financial condition of relevant general insurers. This exchange of information should proceed through memorandums of understanding between APRA and each relevant state and territory body.

APRA and the state and territory instrumentalities should review applicable secrecy provisions and where necessary seek legislative action to ensure they do not inhibit the free flow of information between APRA and the instrumentalities relevant to the prudential regulation of general insurers.

51 I recommend that the states and territories implement a process designed to reduce inconsistencies in their statutory schemes. This is a task that would appropriately be overseen by the proposed ministerial council.

52 I recommend that state and territory governments apply relevant prudential requirements to government insurers and statutory fund schemes. This is a matter that would appropriately be overseen by the proposed ministerial council.

53 I recommend that the states and territories consider allowing greater price flexibility in their statutory schemes. This is a matter that would be appropriate for consideration by the proposed ministerial council.

54 I recommend that the Commonwealth Government move to identify or establish a ministerial council or like arrangement to provide a ready and regular forum for the discussion and resolution by the Commonwealth and the states and territories of matters relevant to general insurance-and perhaps to other financial services.

The failure of H/H Insurance lxxiii

The ministerial council (or other similar body) should consider measures to:

• avoid duplication in the prudential regulation of general insurers

• remove regulatory inconsistencies

• achieve a consistent approach to the prudent management of state and territory monopolies.

It could also play a part in:

• moves to introduce greater price flexibility in statutory schemes

• the introduction of a policyholder support scheme

• the removal of anomalies in the taxation arrangements applicable to general insurers.

Taxation and general insurance

55 I recommend that state and territory governments abolish stamp duty on general insurance products. It would be appropriate for this process to be coordinated through the proposed ministerial council with responsibility for general insurance.

56 I recommend that those states that have not already done so abolish fire services levies on insurers.

57 I recommend that state and territory governments exclude the cost of the GST for the purposes of calculating stamp duties or any other state or territory levies that are imposed on insurance premiums.

58 I recommend that governments avoid imposing on insurers levies and other taxes that cannot be passed on to policyholders.

59 I recommend that the Commonwealth Government review the current requirements of the Income Tax Assessment Act 1936 with a view to changing the Act to bring it into alignment with the modified accounting standards I propose.

60 I recommend that the Commonwealth Government amend the income tax regime to encourage the creation and use of catastrophe reserves. Contributions to catastrophe reserves would be tax deductible. Releases from the reserve would be assessable for tax.

lxxiv Policy recommendations

A policyholder support scheme

61 I recommend that the Commonwealth Government introduce a systematic scheme to support the policyholders of insurance companies in the event of the failure of any such company.

Th e failure of HIH Insurance lxxv

Part One Post-mortem

,.

1 Understanding this report

The HIH Royal Commission was established by Letters Patent issued by the Governor-General at the instigation of the executive government on 29 August 2001. The Letters Patent were subsequently amended on 6 February 2002, 2 May 2002 and 23 January 2003.

In the Letters Patent 'HIH' is defined to mean HIH Insurance Limited and related bodies corporate and related entities (within the meaning of the Corporations Act 2001) without limitation in time.

This chapter discusses general matters associated with interpretation and tem1inology. It begins with a brief examination of the nature of a royal commission, then moves to the Letters Patent and the interpretation of the terms of reference. The proceedings are discussed in terms of the evidence (including its admissibility and the referral question) and the concept of procedural fairness. Finally, the matter of offences and the question of future policy directions are briefly canvassed.

1.1 The nature of a royal commission

The Letters Patent were issued under the authority of the Royal Commissions Act 1902. Section lA ofthe Act empowers the Governor-General to issue to any person a commission authorising that person to inquire into and report on any matter that is specified in the Letters Patent and that concerns the peace, order and good government of the Commonwealth of Australia or any public purpose or any power of the Commonwealth.

A royal commission is an administrative and inquisitorial process. It is not a judicial process. Although the way in which royal commissioners conduct their inquiries often appears similar to court proceedings, a royal commission is not a trial between parties and a royal commissioner is not a judge resolving disputes between litigants. Fundamentally, the role of the commissioner is to investigate and report on those matters coming within the scope of the terms of reference. In doing this, the commissioner must reach conclusions of fact. Neither the conclusions of fact nor the recommendations arising out of them have a binding effect on the parties affected, the entities or agencies that might have the power to act on the recommendations, or the government to which the report is presented.

A royal commission has various coercive powers, and it usually has available to it the expertise of specialists in areas to which the inquiry is directed; in the case of this Commission, the very considerable forensic skills of experienced lawyers, accountants, actuaries and others were deployed to scrutinise the circumstances of a

The failure of HIH Insurance 3

corporate collapse of colossal proportions. Royal commissions have a particular ability to delve beneath the surface and explore and expose matters that otherwise might not readily come to light. They also have the capacity to marshal evidence and other material in such way as to assist those whose responsibility it is to consider future action. There is thus a continuing public benefit from the work royal commissions do.

1.2 The Letters Patent

1.2.1 The terms of reference

The Letters Patent set out the matters subject to inquiry and reporting; these matters are commonly referred to as the 'terms of reference' . A royal commissioner is empowered to inquire into and report on only those matters that come within the terms of reference, so a proper understanding ofthe terms of reference is critical.

The core instruction the Commission has been given is set out in the introductory paragraph of the terms of reference: ' ... to inquire into [and report on] the reasons for and the circumstances surrounding the failure of HIH prior to the appointment of the provisional liquidators on 15 March 2001 '. The terms of reference go on, in a series of itemised paragraphs, to set out specific matters to which the Commission should pay attention. These can be summarised as follows:

(a) whether, and if so the extent to which, decisions or actions of HIH or any person contributed to the failure of HIH or involved or contributed to undesirable corporate governance practices

(b) whether those decisions or actions might have constituted a breach of any law of the Commonwealth, a state or a territory and, if so, whether the question of criminal or other legal proceedings should be referred to the relevant agency

(c) the appropriateness of the manner in which powers were exercised and responsibilities and obligations discharged under Commonwealth laws

(d) the appropriateness of the manner in which powers were exercised and responsibilities and obligations discharged under state or territory laws.

In a further paragraph, designated (e), the Commission is set the task of inquiring into and reporting on the adequacy and appropriateness of arrangements for the regulation and prudential supervision of general insurance at the Commonwealth and state and territory levels, taking into account Commonwealth arrangements before and after the Financial System Inquiry reforms and different state and territory statutory insurance and tax regimes. The Commission is responsible for recommending changes to the regulatory regime, as it sees fit.

Appendix A shows the Commission's full terms of reference.

4 Understanding this report

1.2.2 The core instruction

The words 'the reasons for and the circumstances surrounding the failure of HIH' in the introductory paragraph of the terms of reference are of primary significance. The Commission's power to inquire and report is constrained only by the import of those words and by the scope and purpose of the Act. The extent of the instruction given

in the introductory paragraph is not to be constrained by the five itemised paragraphs that follow. This interpretation of the terms of reference is reinforced by the fact that the itemised material is preceded by the words 'in particular'.

Although the words 'the reasons for ... the failure of HIH' warrant little comment, it would be wrong to limit them to importing what lawyers call the ' but for' test of causation, which is a test, although not the sole test, the courts apply to attribute legal responsibility for a result. At the risk of oversimplifying the matter, at law a person's fault is a cause of another's harm if such harm would not have occurred

without it. The reasons for a corporate collapse can be many, varied and complex: they were in this case. They may accumulate one on another: they did in this case. Something can be a 'reason for' the failure even though there is a respectable argument that by itself it did not cause the failure. It depends on a judgment about the relative seriousness of the condition and the impact it had on the confluence of factors that are seen as constituting the reasons for the failure.

The expression 'circumstances surrounding the failure of HIH' does require some attention. It is not just another way of referring to the 'reasons for' the failure. It has its own meaning, referring to a broader framework of events and conditions that are associated with the collapse but that differ from the reasons for the collapse. One consequence of this is that some relevant matters that cannot be described (whether alone or in combination with other things) as a reason for the failure are nonetheless appropriate matters for inquiry and reporting because they shed light on the events

that occurred.

It is often said that a corporation does not collapse overnight. Generally, the conditions that eventually lead to the collapse have been developing and accumulating over time. Thus it is, for example, that deficiencies in management systems, personnel or techniques that are not evident in good times can become

evident when a corporation's commercial or financial conditions deteriorate. Similarly, the real purpose or effect of a transaction or a particular entry or series of entries in the books of account may not become apparent until some time after the event. When examining a corporate collapse, it is necessary to understand the true financial position of the entity at various times-not just at the moment of its demise.

To explain how and why things were done immediately before and after the demise and to understand the corporation's true financial position at a particular date, it may be necessary to go back and investigate earlier events and conditions. If those events or conditions reflect on or aid an understanding of matters closer to the time of the

failure, they might properly be described as 'circumstances surrounding the failure'.

Th e failure ofHIH Insurance 5

This is so even if they are not, additionally, reasons for the collapse in the sense outlined here.

This is not to say that the Commission's inquiry knows no bounds. The terms of reference contain an express limitation-that matters the subject of investigation should have occurred 'prior to the appointment of the provisional liquidators on 15 March 2001 '. This explains why the Commission has not been concerned to investigate the conduct of the provisional liquidation or the liquidation or the actions of the regulators after 15 March 200 1---except to the extent that they explained or evidenced conditions applying at that date. A further limitation that emerges concerns the construction of the terms of reference as a whole. There should be a logical connection between the event or matter being considered and either the reasons for or the circumstances surrounding the failure of HIH. It is not possible to define more closely what is meant by 'connection' in this regard. It cannot be decided in a vacuum; it must be judged according to the context in which

it arises.

The expression 'circumstances surrounding the failure' is important for another reason too. Most readers of the reports of royal commissions and similar inquiries understand the tetm 'adverse finding'. But not every finding or conclusion is necessarily adverse in the sense that the term is understood. This is especially the case with many of the findings and conclusions relating to the circumstances surrounding the failure ofHIH.

To make sense of the entire story, it was necessary for the Commission to follow through on chains of events and to comment on matters that might appear to be peripheral to a critical issue but that, in context, cannot be ignored. Thus, conclusions have been reached and findings reported on matters that are a part of the chain or that might be seen as peripheral. Some of these findings are phrased in such a way as to express or imply criticism; at times this has been unavoidable. Many of them are not expressed as either possible contraventions of the law or even undesirable corporate governance practices. I nonetheless regard them as findings that are necessary in order to explain properly the circumstances surrounding HIH's failure. I know that even implicit criticism can affect the reputation of a person or entity and in that sense might be regarded as an adverse finding . I trust the reader will understand that there are within the report findings of different types and with differing consequences. The findings should be considered accordingly.

The importance of understanding these fundamental propositions cannot be over­ emphasised.

Other important questions of interpretation relate to the itemised paragraphs in the terms of reference. This does not meap that these paragraphs are more important than the core instruction-on the contrary. Much of what has already been said about a connection with the reasons for or circumstances surrounding the failure of HIH applies equally to the construction of the itemised paragraphs, particularly paragraphs (a) and (b).

6 Understanding this report

1.2.3 Decisions or actions contributing to the failure

Paragraph (a) of the terms of reference requires the Commission to determine whether decisions or actions of HIH and persons related to it contributed to the failure of HIH.

There is no warrant for interpreting the words 'contributed to' as if they meant 'caused' in the 'but for' sense just discussed. Philosophers and lawyers approach the concept of 'cause' from entirely different perspectives. 1 The former tend to regard anything that contributes to a result as being a cause; the courts select only some of them as causative for legal purposes. The Shorter Oxford Dictionary defines

'contribute' as 'play a part in achieving a result'. This broader non-legal interpretation has been applied to 'contributed to' here.

There is another thing. The phrase ' contributed to' appears in paragraph (a) of the terms of reference. A decision or action may have some logical connection to the core instruction-that is, to the reasons for or the circumstances surrounding the failure of HIH-without necessarily having contributed to the failure as envisaged

in paragraph (a).

Some parties submitted that a particular finding ought not be made because the event or incident to which it relates did not itself cause or contribute to the collapse of HIH. For the reasons already given, an event or incident ought not be viewed in isolation; when considered in a broader context, it might have sufficient connection with, for example, the core instruction to justify attention.

Paragraph (a) also requires examination of 'the extent to which' decisions or actions contributed to HIH's failure. This is another aspect of the value judgment that must be made. If the connection is so distant or remote that it ceases to illuminate or explain matters proximate to the demise of the corporation, it may in any event and as a matter of judgment be an inappropriate subject on which to make a finding.

1.2.4 Undesirable corporate governance practices

Paragraph (a)(ii) of the terms of reference raises the question of whether decisions or actions of HIH or the individuals concerned involved or contributed to undesirable corporate governance practices. The terms of reference do not define 'undesirable corporate governance practices'; what follows is an explanation of how the phrase has been interpreted and applied in this report.

For the purposes of the terms of reference, it is sufficient to say that 'corporate governance' refers to the control of corporations and to systems of oversight and the accountability of those in control. Corporate governance is not limited to the legal controls established under the corporations and other legislation or under the general

law: it goes beyond this to include accountability- not only in terms of legal restraint but also in terms of self-regulation and the norms of so-called best 0 2

practice.

The failure ofHJH Insurance 7

Many publications describe corporate governance in terms that emphasise the structures, systems and processes in existence to ensure that an entity is properly directed and controlled. This led some parties to submit to the general effect that use of the expression ' corporate governance' in the terms of reference is limited to the model that HIH had (or should have had) in operation, rather than to individual instances in which the system of superintendence and accountability is said to have failed.

For several reasons, this is too narrow a reading of the terms of reference. First, in the context in which it appears, the expression 'corporate governance' is associated with decisions or actions of HIH or of various identified classes of individuals. Were it directed simply to the corporate governance model- that is, the systems, structures or processes- it would have been sufficient to refer only to HIH the corporate entity.

Second, the expression used is not simply 'corporate governance ' : it is 'corporate governance practices'. The Concise Oxford Dictionary defines 'practice' as 'the actual application or use of a plan or method as opposed to theories relating to it ' . This is wider than the corporate governance model itself and extends to the way in which actual experience demonstrates that the model achieved or failed to achieve the objectives for which it had been installed.

Third, paragraph (a)(ii) refers to decisions or actions of individuals that 'involved or contributed' to undesirable corporate governance practices. It is difficult to give meaning to the word 'contributed' in this regard if the entire concept is limited to the models and structures and excludes the way the processes operated as a matter of experience.

Fourth, it is difficult to see how a meaningful assessment of systems or controls could be made without identifying particular instances in which they failed and the reasons for their failure.

Finally, paragraph (a)(ii) gives an example of what might be an undesirable corporate governance practice- namely, failure to make disclosure of the financial position of HIH. It would be surprising if undesirable corporate governance were limited to the disclosure systems and guidelines the company had instructed the relevant officers to adopt and did not extend to the question of whether those processes were in fact followed in practice.

Other submissions to the inquiry placed emphasis on the word 'control' in the definition. They suggested, for example, that only a director, officer, employee or auditor could be involved in corporate governance and that as a consequence an external adviser who was not in a position of authority could never have the necessary element of control and thus could never be so involved.

Whether or not this is strictly correct (in the sense of involvement), paragraph (a)(ii) extends to someone who 'contributes to' undesirable corporate governance practices. Having regard to the complexity of the affairs of a large public listed

8 Understanding this report

general insurance company such as HIH, among the people who are involved in or contribute to the corporate governance practices of the company may be (depending on the circumstances) not only senior management, the board, employees and auditors but also advisers such as actuaries, lawyers, and financial experts. Much will depend on the adviser's influence on the practice under consideration.

It was also submitted that 'corporate governance' was included in the terms of reference to provide a framework against which recommendations could be made for regulatory change, rather than as a justification for making findings about individual breaches of corporate governance standards. I think this is incorrect. In the context in which the expression appears-paragraph (a)-it is meant to be

looked at in the same light as those matters encompassed within paragraph (a)(i). It has a connection with the core instruction.

In summary, in the terms of reference the expression 'corporate governance' refers to any conduct or activity-whether in accordance with legal requirements, the self­ regulatory practices of a company, or otherwise-that informs or affects the exercise of control of corporate authority within or by the company. It includes management of the corporation's affairs so as to comply with external legal and regulatory obligations. Further, the expression 'corporate governance practices' goes beyond a description of the model implemented to ensure oversight and the accountability of those in control of the corporation or of relevant activities: it

incorporates practical implementation ofthe processes.

The next question is whether the corporate governance practices engaged in by or in relation to HIH were undesirable. The ordinary meaning of the word 'undesirable' is wide. The Shorter Oxford English Dictionary defines it as, among other things, something not wanted because it is harmful, objectionable or unpleasant.

In determining whether a corporate governance practice is undesirable, I have applied the ordinary meaning of the word to the context in which the question arises. Regulatory standards, industry-accepted practices and analogous principles of law have been the guide, but I have not placed artificial limitations on the plain, ordinary meaning of the word. Each instance has been assessed on its merits. What

may be undesirable in one set of circumstances may not be so in another. I have looked objectively at the circumstances and decided whether, according to principle, the conduct in question ought to be characterised as an undesirable corporate governance practice.

Findings of undesirable corporate governance practice have been made in relation to generic shortcomings in systems or processes and to individual instances of failure to conform to a stated standard or principle.

The failure ofH!H Insurance 9

1.2.5 A breach of the law

Paragraph (b) of the terms of reference refers to 'a breach of any law of the Commonwealth, a State or a Territory'. What is intended by the use of the word 'law ' in this context? My initial thinking was that it encompassed any law, written or unwritten

3 , but that was wrong. I have interpreted paragraph (b) as referring to

conduct that might be a breach of a written law and could be the subject of a referral to an agency.

I have made no finding that there might have been a breach of an unwritten law, such as a breach of a common law or equitable duty. From time to time it was necessary to make individual findings that could be an element in such a cause of action, but no comment is made on a cause of action itself.

This is not to say that a finding of a breach of a common law or equitable duty would necessarily be outside the terms of reference. It could come within the core instruction- namely, a reason for or circumstance surrounding the failure. But I do not think the public interest requires me to reach conclusions on matters that more properly belong in the civil jurisdiction of the courts. They are essentially matters for others to decide should the occasion arise.

Criminal and civil proceedings had already been initiated in relation to some matters that are the subject of this inquiry. I took this into account when deciding whether, and if so to what extent, I should make findings and the way findings should be expressed. The initiation of proceedings has to some extent constrained the ambit of this report. The findings and conclusions expressed here cannot be taken as determinations of civil liability any more than they can be of criminalliability.4

1.2.6 Conduct that might constitute a breach of the law

Paragraph (b) of the terms of reference also refers to conduct that 'might' constitute a breach of the law. The question is whether I have the power to make specific findings as to whether, for example, a civil cause of action or a breach of the criminal law has been made out on the evidence. Whatever might be the strict answer to that question, the terms of reference do not specifically require me to make findings of the kind identified. I am not required to decide whether there has been a breach of the law, and I have not done so. The terms of reference require me to determine whether there might have been a breach of the law.

There are several reasons for following that course. First, a finding in those terms would not be binding on or enforceable against anybody. It could become binding or enforceable only as a consequence of subsequent proceedings before or actions by other bodies. For example, a finding that the law has been breached is of no effect until it has been made by a court 'of competent jurisdiction.

Second, specific findings of that type could give rise to the serious risk of inconsistency with subsequent findings by courts or other bodies whose task it is to make binding and enforceable determinations in these areas. The rules of evidence

10 Understanding th is report

would apply in any subsequent proceedings; they do not apply in this inquiry. The practices and procedures in the courts before which proceedings might subsequently come will be quite different from those adopted in the inquiry and include additional evidentiary and other safeguards. For these reasons alone, the inquiry's findings of fact may not necessarily be the same as those that a court would make. This explains why, when expressing conclusions that there might have been a breach of the law, I use phrases such as 'If, as I have found ... ' or, after referring to intermediate findings, 'On this basis ... '

Third, an expression by me of a concluded view could prejudice any subsequent proceedings. This is especially so because the evidence adduced in the later proceedings may differ from that presented to the inquiry. Section 1.3 deals in more detail with evidentiary matters.

Thus, a finding that a person might have breached the law in a particular respect does not carry with it a finding that the person is guilty of a criminal offence or is liable to a civil penalty. If those charged with responsibility for considering the Royal Commission's findings deem it appropriate to initiate proceedings, it will be up to the relevant court to determine the guilt or civil liability of the person concerned.

In the submissions of some of the parties there was a suggestion that I should be satisfied either beyond reasonable doubt or on the balance of probabilities before concluding that there might have been a breach of the law. This would be contrary to the plain meaning of the terms of reference. For example, if I were to pronounce

myself satisfied beyond reasonable doubt that certain conduct satisfied all of the elements of a particular criminal offence, I would in effect be saying there had been-not that there might have been-such a breach.

There is a further reason for declining to make findings of criminal (or, for that matter, civil) liability. A court makes legally binding determinations and because of that it will not make a finding unless it is satisfied to a specific standard. My determinations are not legally binding and there is no specific standard to which I must be persuaded before making a finding that there might have been a breach of

the law.

The use of the word 'might' (rather than, for example, 'may') in paragraph (b) is significant. As a matter of language, 'may' suggests a serious possibility and 'might' a more remote possibility5; it is a lower threshold. This distinction has been recognised in the authorities.6 Further, some parties argue that the words 'may' and

'might' are often used interchangeably. Given the gravity of the matters before me, I did not reduce the level of persuasion on account of the use of the word 'might'. It does, however, reinforce the proposition that it is not my role to find that impugned conduct actually contravenes the law. It follows that the threshold is still short of

that required by the criminal or civil standards of proof. Talking in terms of civil or criminal standards of proof-that is, the 'balance of probabilities' or 'beyond reasonable doubt' -is not appropriate: the use of 'might' suggests possibilities (albeit real ones) rather than probabilities. Nor is it appropriate to use tests that are

The failure of HIH Insurance 11

applied in, for example, committal hearings and applications for leave to appeal or for interlocutory injunctions.

Accordingly, phrases with which lawyers are generally familiar-such as 'a prima facie case', 'an arguable case' or 'a serious issue to be tried' are not apt to describe the intellectual process demanded by the making of findings following an inquiry of this type. In any event, I am reminded of the passage in A v Hayden 7 where Dawson I warned against being misled by overly strict application of verbal formulas.

I assessed each matter by looking at the evidence conscientiously and dispassionately and, where there were competing hypotheses, weighing them against the background of all available and relevant material. I then employed a process of inductive reasoning to make findings of fact and draw inferences that are rationally based although not binding in the sense that they do not give rise to legally enforceable rights and obligations. The purpose of this process was to see whether there was sufficient evidence to warrant consideration of the question of future proceedings. Having completed that process, I formed conclusions-in accordance with the language of the terms of reference-about whether there might have been a breach of the law.

Even though it is not part of my role to see whether the facts so found would justify a conclusion measured against either the criminal or civil standard of proof, I have not acted flippantly or according to whim. I approached the task from the viewpoint that the result must be intellectually sustainable and must be tempered by restraint. To the forefront of my thinking was the passage in the judgment of Dixon J in Briginshaw v Briginshaw8:

The seriousness of an allegation made, the inherent unlikelihood of an occurrence of a given description, or the gravity of the consequences flowing from a particular finding are considerations which must affect the answer to the question whether the issue has been proved.

As the High Court made clear in Neat Holdings Pty Ltd v Karajan Pty Ltc!, there are only two legal standards of proof, and Briginshaw does not establish a third. The approach enunciated in the authorities reflects the conventional perception that members of our society do not ordinarily engage in fraudulent or criminal conduct. Thus, the more serious the allegation the greater the caution needed in deciding whether to make any particular finding. In this instance the relevant findings are those that are necessary to allow me to report whether there might have been a breach of the law.

In looking at each suggested breach of the law, I bore in mind the public interest in alleging illegal activity against an individual only in cases where the circumstances justified it. I was also mindful of the individual' s private interest in the protection of reputation. In carrying out the task I took the following steps:

12 Understanding this report

• considered all elements of the law said to have been breached

• reviewed the evidence, as adduced in the course of the Commission's hearings, relevant to each element

• determined whether there is logically probative material on each element that might be accepted

• took into account factors that might influence the possibility that each element could be established in a court.

Only after giving conscientious and dispassionate attention to all these matters did I conclude that there might have been a breach of the law.

I do not describe exhaustively the reasoning process in relation to each matter for which I found there might have been a breach of the law. This is particularly the case in connection with a law that contains a mental element. An example is a provision that requires a person to act honestly: a lack of honesty is not usually able to be established otherwise than by inference from objective facts that have been found. I saw it as my task to make findings of fact from which an inference might be drawn, rather than to chase down the nuances of the reasoning process leading to a relevant inference. That might later be the task of a court if it is asked to make

binding determinations.

There are two main reasons for not disclosing the entirety of my reasoning process when I indicate there might have been a breach of the law. First, it would increase the danger of me intruding into areas that are the province of the trier of fact if proceedings are instituted. Second, had I explained my rationale in full, this report would have become unmanageably large.

Appendix G identifies and provides general comments on specific provisions of relevant statutes. This obviates the need to repeat the terms of the section or its import each time it appears in the discussion of particular events.

1.2.7 Referral for futu re proceedings

Paragraph (b) of the terms of reference suggests that if I were to conclude that there might have been a breach of the law I should also consider referral of the question of criminal or other legal proceedings to a relevant agency.

At various places in this report, fo llowing an adverse finding, there is a comment to the effect that the question of criminal or other proceedings should be referred to a relevant agency. What does this mean? It is not a recommendation that the relevant agency institute proceedings. It does not mean I formed the view that there is a 'sure

fire' case against the person or entity concerned. It means there is sufficient evidence to warrant the agency's consideration of whether or not to initiate proceedings.

The failure of HIH Insurance 13

There are at least two scenarios where this has arisen. First, there are some areas for which the Commission unearthed sufficient material to suggest there might have been a breach of the law but for which further front-line investigation of particular matters is necessary before it might be determined whether proceedings are likely to be successful. For example, the Commission's ability to conduct investigations, aided by its coercive powers, outside Australia was limited, but an agency might have mutual assistance arrangements with other countries or agencies that would assist an investigation beyond the geographical limits of Australia. In such a situation it might be appropriate for the agency to build on the material garnered by the Commission and conduct further investigations so as to assess whether proceedings are warranted.

Second, this report contains many findings that there might have been a breach of the law. They are not rated in any order of significance. No agency has unlimited resources, and the court system does not have an infinite capacity to deal with cases. Each agency will no doubt consider the findings and conclusions in this report, but it will have to do so in accordance with the guidelines it has developed, and in some instances published, concerning the criteria against which to decide whether or not to initiate proceedings. In the course of that exercise, the agency will no doubt take into account a range of discretionary considerations and matters such as admissibility of evidence that have not been pressed before the Commission.

It is important not to usurp the agencies' powers and responsibilities. But the Commission has its own public interest responsibilities and, once again, there is a public interest element here. As noted, neither the agencies nor the court system have unlimited resources. There is a public interest in the agencies not being distracted by referrals that would result in proceedings with no realistic prospect of success. I was mindful of the private interests of individuals in not being subj ected to inquiries, investigations and the threat of proceedings that are not in the public interest. I acted with restraint. This explains why on some occasions, even though I was satisfied there might have been a breach of the law, I refrained from referring the matter to an agency to consider whether proceedings should be initiated.

There are two limbs to paragraph (b) of the terms of reference. I looked first at whether there might have been a breach of the law. When I decided that question in the affirmative I went on to consider whether the matter should be referred to an agency. In doing so, I took into account the following, among other things:

• the relative seriousness of the conduct in the context of the failure of HIH

• the role and involvement of the person concerned in the management and failure ofHIH

• what factors- including the availability of admissible evidence- might impinge on the likelihood (without determining the question) of the agency being able to establish the referred matter to the criminal or civil standard, as the case may be

• whether any personal or peculiar factors called for special consideration

14 Understanding this report

• the public interest in, and regulatory effect of, a successful action.

Once again, the entirety of the reasoning process that led me to make a referral is not described in detail in the report: to have done so would have made the report unmanageably large.

During the closing submissions two particular aspects associated with referral to agencies arose. They are dealt with here in a general way.

Sections 13, 15 and 17 of the Insurance Act 1973 empower the Australian Prudential Regulation Authority to impose conditions on the authorisation granted to an entity to carry on insurance business in Australia, to revoke an authorisation previously granted, or to require an entity to assign its liabilities so as to enable

revocation. Section 27 gives APRA power to direct that an authorised entity remove a director or senior manager from the position she or he holds. In some instances I was invited to refer matters to APRA for it to consider whether to exercise those powers.

I decided not to make any referrals of that kind. There was no material before me to indicate when and how-in relation to other potential proceedings arising from the conduct said to justify the regulator's attention-APRA might approach the suggested exercise of its powers. Nor was there any material touching on the impact a revocation of an authorisation might have on the broader commercial community and on the public generally. No argument was put concerning the impact on an

individual of possible action under s. 27 of the Act before the completion of other potential proceedings.

APRA is surely aware of the extent of its powers. It wiii be able to consider the findings presented in this report and the material on which they are based. The absence of referrals should not be taken as any indication that I took a view, one way or the other, about the appropriateness of the possible exercise of powers.

The second aspect associated with referral concerns referral of the conduct of a member of a profession to a relevant disciplinary tribunal. In my opinion, a power to refer does not arise simply from paragraph (b) of the terms of reference. Both the Royal Commissions Act 1902 and the Letters Patent direct me to inquire and report:

a power to refer is a natural concomitant of the power to report.

In some instances a disciplinary tribunal has a legislative underpinning; the tribunal that oversees the conduct of legal practitioners is an example. In other instances the powers of a tribunal spring not from a statutory scheme but as a matter of a contract between a professional body and its members; an example of this is the Institute of Actuaries of Australia.

As a matter of discretion, rather than of power, I decided not to make referrals of that kind. I think it neither necessary nor desirable. The tribunals are able to act according to their own constitutions; they will be in a position to make what they will of the evidence and findings reported here; and they are perfectly well

positioned to form their own views on particular matters. In addition, some things

Th e failure ofHIH Insurance 15

relevant to the decision-making processes of the tribunals have not been the subject of evidence or submissions to this inquiry.

1.2.8 Appropriate exercise of powers

Paragraphs (c) and (d) of the terms of reference call for an examination of the appropriateness of the manner in which powers were exercised and responsibilities and obligations were discharged under Commonwealth and state and territory laws. Interpreted in its broadest sense, this could include, for example, the appropriateness of the discharge by a company director of responsibilities under the Trade Practices Act or the Fair Trading Act of a state. Because that conduct would be covered by paragraph (a) or (b), I did not interpret paragraphs (c) and (d) in that way. Instead, I took them as referring to the powers and responsibilities of the regulatory agencies.

1.3 The procee dings: evidentiary matters

1.3.1 The meaning of evidence

The Royal Commissions Act 1902 contains many references to 'evidence', but the rules of evidence that govern court proceedings do not apply in the context of a royal commission. Accordingly- and save for certain contextual exceptions 10-when the Act refers to 'evidence' it is not contemplating evidence as defined by the body of jurisprudence built up at common law and by statute as part of the rules of procedure used by courts in the resolution of disputes and in the broader public function of law enforcement. 'Evidence' as referred to in the Act must be understood in a less technical sense-as meaning information used to establish facts.

1.3.2 Ad miss ibility an d the investigative process

Section lA of the Royal Commissions Act 1902 and this Commission's Letters Patent make it clear there are two aspects of, or phases in, the work of a commission. One is the inquiry and the other is the report. It cannot have been the intention of the legislature that a commission would be permitted, during its inquiry phase, to receive material that would be inadmissible in legal proceedings and yet not be entitled to take that material into account when formulating and reporting its findings.

During the inquiry phase, this Commission received some material that might not have been admissible in legal proceedings. The main areas in which this occurred were as follows:

• the reception of hearsay testimony

16 Understanding this rep ort

• the relaxation of the so-called best evidence rule, which sometimes prohibits the reception of secondary evidence of the contents of a document

• a similar relaxation of the rule that sometimes restricts the circumstances m which a person can give evidence of his or her state of mind or intention

• the reception of testimony that is, in essence, a conclusion as to either a fact or a legal proposition

• the tender of documents other than through their author or someone who has adopted their contents or through some statutory process such as that applying to business records. Many of the documents tendered to the Commission would probably qualify as business records.

Another evidentiary matter is of great importance. Section 6DD of the Act provides that-with the exception of proceedings for an offence against the Act- a statement or disclosure made by a person in the course of giving evidence before a commission is not admissible against a natural person in any civil or criminal proceedings in a court. The same applies to the production of a document or other thing by a person pursuant to a summons, requirement or notice. It follows, for example, that an admission or concession made by a witness in oral testimony

before a commission would not be admissible against that witness in subsequent court proceedings.

Although entities and individuals who were likely to be able to assist the Commission in its inquiries were given leave to appear and were referred to as 'parties', there were no parties in the strict sense. Nor were there pleadings or defined issues. While many of the parties and witnesses were represented by counsel, no objections were taken to the reception of evidence on the basis, for example, that it was hearsay. This alone made the application 0f strict evidentiary rules difficult, if not inappropriate. In the adversarial system the trier of fact can rely on the representatives of parties to bring to his or her attention evidentiary problems

as they arise. I did not have that advantage. In no way is this a criticism of counsel assisting or of the representatives of the parties. The nature ofthe inquiry simply did not require or permit it.

1.3.3 Admissibility and findings

This is not to say that I ignored the principles lying behind the legal rules of evidence. Those principles are intrinsic to the inductive reasoning process that is at the heart of decision making in this context. I did, however, have to apply them in a practical common-sense way by looking closely at the probative value of individual

items of evidence, the reception of which might be regarded as contrary to the rules.

This is especially so in relation to hearsay and to expressions of opinion or conclusion in a non-expert context. Wherever possible, I tried to identify potential evidentiary problems and to take them into account. Again using hearsay as an example, where hearsay was identified I considered it carefully and gave it the

The failure of HIH Insurance 17

weight I thought it deserved. In some instances I thought the evidence so lacking in reliability that I disregarded it-not simply because it was characterised as hearsay but because its probative value was minimal.

1.3.4 The referral question

Evidentiary matters are also relevant to the referral question. As noted, it is up to those with the power to launch proceedings to consider the findings and decide whether litigation is appropriate. It may be, for instance, that I had regard to evidence that would be inadmissible in later proceedings on the assumption that the admissibility problems could be resolved. This has particular significance when the implications of s. 6DD of the Royal Commissions Act are considered. Subsequent events may render that assumption invalid. Those with the power to initiate proceedings may decide that the evidentiary problems are incapable of resolution. If that were so, there would be no litigation before a court of competent jurisdiction and no binding and enforceable determination of the matter with which a royal commission's finding deals.

Nevertheless, it would be wrong to assume that any evidence gathered by a royal commission cannot be used in any court proceeding, either civil or criminal, against the individual who gave the evidence. Nor is it the case that the agencies will be obliged, effectively, to start the investigation from 'square one'. The proper construction of s. 6DD of the Act leads to the following conclusions:

• Under the Act there are no constraints on either the use of the testimony of or the production of documents by a person in proceedings brought against another person.

• Although there are direct-use immunities established under s. 6DD of the Act, there are no derivative-use immunities.

• The privileges against self-incrimination and self-exposure to a penalty are not available to corporations; it follows that the immunities found in s. 6DD are similarly unavailable.

• While the use of immunities in s. 6DD make the fact of production of documents to a commission inadmissible in civil or criminal proceedings brought against the natural person who produced the documents, they do not render the documents themselves inadmissible against that person, or any other person.

18 Understanding this report

1.4 The proceedings: procedural fairness

1.4.1 The co nte nt of the procedural fairness rule

Despite the fact that my findings are neither binding on nor enforceable against a party affected by them, there can be little doubt that the rules of procedural fairness apply to an inquiry of this nature. I proceeded on that basis.

But the way in which procedural fairness is to be afforded is not itself an absolute. It involves the adoption of fair procedures that are appropriate to the circumstances of the particular case (Kioa v West11 ). The rules can vary from case to case, even though each case might be conducted before the same tribunal or person (National

Companies and Securities Commission v News Corporation Limited12 ). If they can vary from case to case, why could they not vary within a case, according to the circumstances applicable to an individual person or issue? In the context of this Commission, I respectfully agree with the comment of Roger Gyles QC (as he then was), the Royal Commissioner into Productivity in the Building Industry in New

South Wales 13 :

I can say that I do not accept that in this type of inquiry an adverse finding is the equivalent of a finding of disputed fact, of any criticism of a party, or of the exposure of evidence or material which might reflect badly on a person. Nor do I accept that a warning must be given of all poss ible ramifications of each piece of evidence before it can be referred to in the Report. I do agree that a party should not be confronted for the first time

in the Report with a true adverse finding upon a totally new point or issue which it could not have reasonably anticipated. I do not accept that this anticipation can only come from an express statement or warning by the Commissioner or Counsel Assisting.

1.4.2 The rule in the context of this Commission

The Commission sat for over 200 days to take evidence and it heard oral testimony from 128 witnesses. The transcript (excluding closing submissions) extends over 18 600 pages; after closing submissions had been taken the transcript stood at 19 598 pages. The evidence is also to be found in 305 written witness statements and approximately 31 7 000 electronic documentary images.

The rules of procedural fairness do not require that, at the time when the evidence is given, the witness receive prior notice of every proposition, every question and every document that might be put against them or that might be contrary to their interests. In the case of this Commission, that would have been a practical

impossibility: this was a dynamic inquiry in which new issues and new material were constantly emerging.

Nonetheless, I consider that the requirements of procedural fairness were satisfied. In this report no one will be confronted for the first time with a true adverse finding on a new point or a matter that could not reasonably have been anticipated; in other words, no one was ' left in the dark' about the risk of such a finding. I also consider

The failure of HIH Insurance 19

that all affected people were given a reasonable opportunity to put before me matters of significance to the fact-finding exercise. No one was deprived of a reasonable opportunity to adduce material of probative value which, had it been before me, might have dissuaded me from making a particular finding.

There are numerous ways in which the rules of procedural fairness were put into practice in this inquiry. At the beginning of each phase of the hearings counsel assisting made an opening statement, sometimes extending over several days, during which documents were tendered and the main concerns and questions for inquiry were outlined. This was, of course, an investigative procedure, so the opening statements did not delineate the issues in the way an opening would in a criminal or civil trial. Nonetheless, the statements served to place on the public record- and before anyone likely to be affected-as many of the material issues as were then known. In some instances the opening statements were supported by background or issues papers intended to serve a similar purpose.

During cross-examination by counsel assisting, every effort was made to identify and put to witnesses facts , documents and propositions that might lead to an adverse finding. In a situation where new documents and new pieces of information were being received daily throughout the term of the inquiry, it was a practical impossibility to ensure that every witness saw every item of evidence that might affect them. Nevertheless, some witnesses were recalled for that purpose.

Most witnesses were represented by counsel. The few who came unrepresented did so by choice, not because they were denied the right to representation. Each witness had the opportunity to present evidence-in-chief. Most did so by way of written statement, although in some cases evidence-in-chief was led orally. After cross­ examination by counsel assisting and by the representatives of other parties, re-examination was permitted. As the hearings progressed a practice developed whereby a witness was permitted to confer with their legal representatives and adduce further evidence in the nature of re-examination by written statement.

Parties who applied for and were given leave to appear were also permitted to apply for leave to cross-examine other witnesses. I do not recall any instance in which leave was refused. Sometimes I set time limits on cross-examination, but there were few such occasions and the limit was usually set in accordance with the estimate given by the cross-examiner.

Witnesses were also given the opportunity to seek leave to lodge supplementary written statements in answer to evidence given by other witnesses. Many witnesses took advantage of this. Again, I do not recall any instance in which leave was refused.

All of the hearings to take evidence were conducted in public, and the transcript of each day's proceedings was published on the Commission' s website. Parties who had been granted leave to appear, and some others by special arrangement, had access to an electronic database containing all of the documents that were tendered and the transcript. In many instances documents were placed on the database in the

20 Understanding this report

days before they were formally tendered. Parties therefore had early access to documents, subject to confidentiality restraints.

The closing submissions of counsel assisting were comprehensive. Counsel assisting identified what they believed to be possible adverse findings against a person or entity. Most of the submissions were made available in written form to the parties affected on 13 December 2002. Counsel assisting then addressed the submissions in the week beginning 13 January 2003. In December 2002 an arrangement was made whereby any party could lodge a written submission in response to counsel assisting's submissions and could apply for leave to make an oral submission. No written submission lodged by a party was rejected, although some had small portions masked in a way that did not detract from the intent of the document. Every application for leave to deliver an oral submission was acceded to.

The parties delivered their oral submissions between 17 and 30 January 2003 . It was possible to accommodate each party' s preferred dates and estimated times for oral submissions. The arrangements included a provision that a party would lodge their written submission no less than two business days before the start of the oral address. Parties who did not apply for leave to deliver an oral address and stated they would rely on a written submission were required to lodge that document by 22 January 2003. In other words- and acknowledging the timing difficulties

resulting from the Christmas -New Year break-the parties had at least one month to prepare their responses.

Just before counsel assisting began their oral addresses I made a statement to the effect that I regarded the closing submissions as part of the mechanism for affording procedural fairness. I asked that any party who believed they had been denied procedural fairness raise the matter in submissions- not by vague resort to

statements of principle but by squarely pointing out the issue i!l which the denial was thought to have arisen and why, if that were the case, the difficulty could not then be resolved.

One party sought to have a matter re-opened by lodging additional witness statements. The witnesses concerned were recalled for cross-examination on 1 0 and 21 January 2003 . During oral closing addresses another party sought to have another matter re-opened. This request was accommodated on 4 February 2003. No other party sought to have further hearings to deal with a perceived lack of procedural

fairness.

One particular concern noted by a number of parties warrants comment. Some complained that what might be called 'the ultimate question' was raised for the first time in closing submissions and had not been put to a witness when oral evidence was being taken. An example is conduct in which dishonesty is an element and that

might be a contravention of a law. The complaint was that it should have been put to the witness that the conduct in question was dishonest. In my opinion, the rules of procedural fairness do not go as far as that. There is a difference between a failure to put the ultimate question (which is not objectionable) and a failure to raise with the witness an essential part of the factual basis on which a conclusion is said to be

The failure of HIH Insurance 21

based. In the latter case there may be a problem. Whether it is properly characterised as a question of procedural fairness or simply a consequence of an incomplete evidentiary base from which to make a finding, it is something to which I gave close attention.

In some instances I accepted an argument that the matter in question was raised for the first time in closing submissions and that, in the circumstances, the prejudice to the party or witness concerned could not adequately be redressed. In those instances I declined to make the finding. In other instances the party left the complaint at a general level and did not put additional material before the Commission or say why

it did not do so. In this circumstance I took the complaint into account and made an assessment on a case-by-case basis. There were other occasions when the party or witness confronted the issue directly and used the process of closing submissions to put additional material before the Commission: I took account of that material and, again, in some instances declined to make the finding.

In their closing submissions counsel assisting listed a large number of adverse findings that they considered were open on the evidence. I did not make all the findings identified as possible by counsel assisting. Nor did I make any finding not raised by counsel assisting-and therefore one of which the affected party was not aware. On some occasions I did, however, make a finding that is less serious than that argued for by counsel assisting but that arises from the same factual base.

By virtue of the thoroughness of these processes, I was satisfied that parties affected by the Commission's findings were afforded procedural fairness.

The body of the report does not deal specifically with each claim by a party that in a particular situation they did not have the benefit of procedural fairness. On some occasions there is specific reference to this, but the general comments here will answer many of the questions raised.

1.5 Unavoidable repetition

There is in the report repetition of details of documents and events. This was unavoidable if I were to describe thoroughly the circumstances surrounding and the reasons for the failure of HIH. It became obvious during the early stages of the inquiry that it would not be possible to treat issues as if they were discrete and self­ contained: people, events and documents continually crossed over from one matter to another. This became even more obvious during the hearings, and it is reflected in the report.

22 Understanding this report

1.6 Future directions

This first volume of this report also presents the Commission's views and recommendations . in relation to a number of matters associated with future directions in areas of policy, insurance regulation and corporate governance. In large part this is a response to the instruction in paragraph (e) of the terms of reference to make recommendations for change to the system of prudential regulation of general insurers. The inquiry occasioned by the core instruction also prompted observations on other aspects of corporate governance. Inevitably, consideration of all these matters led to recommendations that extend beyond the general insurance industry to a much broader sector of the commercial community.

Throughout the term of the Commission's inquiry, other inquiries, investigations, research and less formal consultations were occurring in relation to these matters. Generally speaking, the recommendations put forward in this report were formulated on the basis of the Commission's consideration of the evidence before it;

inevitably, though, it did on occasion resort to wider experiences and knowledge of commercial operations.

10

II

12

13

See, for example, Timbu Kolian v The Queen ( 1968) 119 CLR 4 7 per Windeyer J at [24].

Farrar, J 2001, Corporate Governance in Australia and New Zealand, Oxford University Press, Melbourne, p. 3.

See Practice Note 6, 9 December 2002. In relation to the matters raised in this paragraph, I took into account the dicta in Canada (Attorney-General) v Canada (Commission of Inquiry on th e Blood System) [1997] 3 SCR 440, particularly at paragraphs 35, 38 to 40, 52 to 54, 57, 62 and 63 ; also

Cooke v Goodhew (1989) 91 ALR 447 per Wilcox J (at 451 - 2). The Macquarie Dictionary suggests that 'may' expresses uncertainty while 'might' expresses strong uncertainty. See F v National Crime Authority (1998) 154 ALR 471 at 479.

(1984) 56 ALR 73 at 79.

(1938) 60 CLR 336 at 362.

(1992) 67 ALJR 170 at 2.

See, for example, ss. 6DD, 7C, 7D and 16 .

(1985) 159 CLR 550 at 585 .

(I 984) 156 CLR 296 at 312. Royal Commission into Productivity in the Building Industry in New South Wales 1992, Report, (RV Gyles, Royal Commissioner), RCPBI, Sydney, p. ix .

The failure of HIH Insurance 23

2 How the inquiry was conducted

In formal terms a royal commission is a creature of executive government, at whose instigation it is appointed and to whom its report is in the end directed. It is also funded by government and is accountable through the executive for its use of public money. Notwithstanding these realities, however, the notion of independence lies at the heart of a royal commission: the public expectation is that a royal commission will be independent in its conduct. This applies to all royal commissions and is especially the case when, as with this inquiry, the royal commissioner is a judge.

I certainly saw my commission as requiring me to inquire into the matters referred to me free of direction from government or other quarters and to apply to the matters on which I was called to make findings or recommendations my own judgment­ and my judgment alone. And that is how the inquiry was in fact conducted. I engaged counsel assisting and others of my choosing to support me in my task. Under my overall direction they pursued investigations with a view to the broad public interest and prepared and presented evidence relevant to the fact-finding phase of the inquiry. They also assisted with research and the formulation of approaches relevant to future policy directions. In the end, though, the conclusions

presented in this report are those that I have reached.

2.1 The planning phase

On 18 June 2001 the Prime Minister announced the proposed establishment of the Royal Commission and that it would begin operations from 1 September 2001. Initial planning was done by officers of the Department of the Prime Minister and Cabinet, the Department of Finance and Administration and the Attorney-General's Department, in consultation with me. A preliminary assessment was made of the services that would probably be needed for the purposes of the inquiry. The Commission Secretary was engaged to undertake the executive role and some administrative staff were made available. Steps were taken to engage lawyers to

assist. A hearing room was needed but, after having inquired of courts and tribunals, it was apparent that it would not be practicable to use an existing facility. Premises that would allow for the construction of a hearing room, as well as meeting office needs, were leased in Sydney. The Commission opened its doors on 3 September 200 1.

Th e failure of HIH Insurance 25

2.2 Funding

Initial funding was provided from the resources of the Department of Finance and Administration (later reimbursed from the Commission's budget). Subsequently, the Commission was granted a budget of $29.9 million, which was increased to $39.7 million when the reporting date was extended from 30 June 2002 to 28 February 2003; no increase was sought for the later extension of the reporting date to 4 April 2003, and I am confident that final expenditure will come in under budget. The Attorney-General's Department received separate funding to administer financial assistance (in accordance with government guidelines) for the legal and related costs of people appearing before the Commission. Applications for assistance were dealt with by the department, not the Commission.

2.3 Initial operations

It became clear very early in the Commission's operations that electronic document­ management and other technology would be essential if the inquiry were to be conducted efficiently. In the three months to 3 December 2001, an electronic hearing room was designed and built, a contract for information technology and communications support was finalised, and the technology was installed. Before the information and communications system was introduced an interim system was used, with assistance from the Australian Government Solicitor and the Department of Finance and Administration.

While the infrastructure was being developed and installed, a team to assist the Commission was assembled and the inquiry began. The Commission entered into a range of other contracts for the engagement of staff and the provision of other services.

2.4 Ongoing operations

The team assisting the Commissioner consisted of lawyers, accountants, information technology specialists, secretariat staff, and other specialists brought in as necessary. The number of team members varied over the term of the Commission, but the maximum size was close to seventy. Most members of the team were engaged on contract, some on a part-time or casual basis; no more than four members at any time were seconded from the Australian Public Service.

2.4.1 The investigative team

To assist with the inquiry, three senior counsel and four junior counsel (one for only a few months, until her appointment to the Supreme Court of Victoria) were engaged, together with solicitors fro m the Australian Government So licitor's office and from the firm of Fisher Jeffries. On average, there were about 19 lawyers on the

26 How the inquiry was conducted

team. Deloitte Touche Tohmatsu and Trowbridge Consulting were engaged to provide accounting and actuarial assistance; the number of people from those firms fluctuated, depending on needs. Paralegal staff from e.Law Australia provided support, particularly in document management.

It quickly became evident that the Commission's inquiries would traverse a wide range of complex matters, many of them interrelated. It was not practicable therefore for separate teams to operate discretely in preparing and presenting evidence on particular topics. Nor was it possible to organise teams solely by reference to witnesses or organisations. It was considered that a number of witnesses- including HIH directors and executives and the auditors- would probably be able to give evidence relevant to a range of matters. This proved to be the case.

As a result, lawyers were allocated to small groups; each group dealt with a patticular topic or witness, and each lawyer participated in several groups. This arrangement ensured that each group was made up of team members who had detailed knowledge of related topics or witnesses and allowed for a cohesive, targeted approach to the Commission' s investigations. It also promoted flexibility by allowing those assisting to prepare different topics in parallel and to continue with the preparation of topics at the same time as evidence was being presented in hearings. This meant that as each phase of hearings concluded it was generally possible to move straight to the next phase, without a break.

2.4.2 Information technology

The hearing room, which was equipped with advanced technology and electronic facilities, proved well suited to the task. Documentary evidence was imaged and projected on parties' computer monitors. This enabled the Commission, the parties and their representatives to manage a huge volume of evidentiary material with little

interruption. Members of the public had access to the proceedings through seating in the hearing room and in an adjacent viewing room with full audiovisual facilities . Documentary evidence was also projected on screens in the hearing room, so that members of the public could see it. Media representatives had their own working

room, including monitors with real-time transcript as well as audiovisual coverage.

Among the technology the Commission used were document-management software, a website, a video feed of proceedings to staff desktops, transcript-analysis software, database-search software, and real-time transcript for recording the proceedings. The real-time transcript was available on desktops in the hearing room and the Commission office and was accessible to parties and other authorised observers (including the media) through the internet.

Th e failure of HIH Insurance 27

2.5 Access to important information

By the time the Commission was established the affairs of HIH were already the subject of multiple investigations. First, the provisional liquidators had begun their inquiries; their purpose was to establish an estimate of outstanding claims liabilities as well as identify claims that might be available for the benefit of creditors. Second, the Australian Prudential Regulation Authority had appointed an inspector pursuant to s. 52(2)(d) of the Insurance Act 1973 to investigate the affairs of companies within the HIH group. Third, the Australian Securities and Investments Commission had started its own investigations into a number of aspects of the collapse.

The inspector appointed by APRA had already required the provisional liquidators and other parties such as Andersen to produce large volumes of material. ASIC had also either seized or had produced to it large volumes of material, often from the same sources. The categories of documents sought by the inspector and ASIC overlapped to a significant extent.

The overlap in these processes and in the documents required led to evidentiary difficulties for the agencies and for those who were required to produce documents to them. For example, ASIC was concerned that the fact that original documents were being produced to the inspector might give rise to evidentiary difficulties in its use of those documents in any proceedings it might later commence. On the other hand, the inspector found that some of the later notices he issued overlapped with notices issued by ASIC and that a considerable number of his requests, particularly those to the liquidators, were unfulfilled at the time he came to write his report.' The inspector gave evidence to the Royal Commission that this was in part because of the parallel investigation being conducted by ASIC. That investigation had resulted in ASIC's seizure of a large quantity of HIH documents that had been specifically collated by the liquidators for the purpose of production to the inspector in answer to a notice issued by him.

The difficulties arising from the parallel investigations by the inspector and ASIC in turn gave rise to difficulties for the Commission. For example, when the Commission tried to obtain documents from the liquidators, it became clear that HIH's records were incomplete because documents had already been produced to APRA and ASIC. At least in the early months, ASIC had not completed its copying of documents for return to the liquidators- no doubt because of the very large volume of documents it had obtained.

A further difficulty lay in the fact that ASIC was still in the process of coding and cataloguing the documents for the purposes of its electronic document-management system. As a consequence, it was . not in a position to know precisely what documents it had or where particular documents or categories of documents could be located within the materials produced by or taken from HIH. Further, while documents were being coded they were not available for copying to the Commission.

28 Ho w the inquiry was conducted

Another problem stemmed from the fact that the liquidators were producing documents to both ASIC and APRA at around the same time but, apparently, did not or were not always able to take a complete copy of the documents being produced. The successive production to APRA and ASIC that occurred was not always a complete set. In due course, as the Commission obtained documents from each of HIH, ASIC and APRA, it often received the same sets of documents but in different states of completeness.

The Commission was unable to obtain from any source a complete set of HIH's board papers and minutes. To overcome this problem, Commission staff, with the assistance of HIH's company secretary, had to reconstruct a set as best they could. This process and the associated difficulties are described in detail in the statement of Frederick Lo.

2

The Commission's inability to gain access to such basic corporate records significantly impeded its progress in the early months. On the other hand, it was of considerable benefit to the Commission's early work that APRA was able to produce quickly, in fully compatible electronic format, a large volume of the documents it had obtained.

The incompatibility of ASIC's electronic document-management system with the system used by the Commission also gave rise to difficulties, although this problem did diminish with time. The Commission initially considered adopting the ASIC system, but it concluded that the Ringtail system was more directly suited to the Commission's needs, as well as being readily available and familiar to firms representing parties before the Commission.

The Commission did gain some benefit from taking early steps to secure relevant records. Overall, however, the way documents had been dealt with by various parties-including the fragmentation of critical records- made it more difficult fo r the Commission to reconstruct the affairs ofHIH.

2.6 Information gathering

The Commission initially sought the production of documents through summonses issued pursuant to s. 2 of the Royal Commissions Act 1902 as it then stood. Subsection 2( 1) of the Act provided that 'a member of a Commission may summon a person to appear before the Commission at a hearing to give evidence and to produce such documents or other things (if any) as are referred to in the summons'. The ambiguity as to whether this power allowed the Commissioner to issue a summons requiring only the production of documents was clarified by the Royal Commissions and Other Legislation Amendment Act 2001. An amendment to

s. 2 made it clear that a member of a commission could summons a person to appear before the commission either to give evidence or to produce documents or to do both. Further, the new s. 2(3A) empowered a member of a commission, by written notice, to require a person to produce a document or thing to a person specified in the notice. Thereafter in order to obtain documents the Commission principally used

The failure of HIH Insurance 29

notices to produce. During the term of the Commission some 45 summonses requiring the production of documents and 411 notices to produce were served.

As a result of its evidence-gathering processes, the Commission had produced to it approximately one million documents in electronic or hard-copy form, representing many millions of pages of material. It also obtained back-up tapes from the information technology systems that HIH, F AI and APRA had used; it is estimated that tapes contained around 43 million documents. Over 10 700 electronic mailboxes were identified, and a decision had to be made about which of them were to be restored. By the completion of the inquiry 2803 documents had been selected and loaded onto the Commission's internal document-management database. This gives some idea of the dimensions of the task of searching through the back-up tapes.

Because of questions of privilege, as well as the many commercial interests that were potentially affected, managing the production of documents was a drawn-out, time-consuming process. Reference to the difficulties encountered by the Commission can be found in the transcript of proceedings on 4 October 2001 , involving the return of summonses for a number of parties and entities.

On that occasion several parties expressed concern about ASIC's production of documents, in answer to a Commission summons, before those parties had the opportunity to review documents they had earlier produced to ASIC and that were likely to be produced by ASIC in answer to the Commission's summons. The specific concern related to the possible production by ASIC of documents over which a party might wish to assert legal professional privilege. A similar difficulty arose in respect of the Commission's summons to the inspector appointed by APRA. Resolution of this matter took considerable time- particularly in relation to the

liquidators because ASIC and the inspector had obtained such a volume of material from them. The need to manage questions of privilege and confidentiality continued throughout the term of the Commission.

Finally, the Commission encountered myriad difficulties in relation to the production of documents by Andersen. As the auditor of both F AI and HIH, Andersen was a major repository of relevant documentation, so in mid-October 2001 the Commission issued a summons to it. The response to this summons gave ri se to extensive correspondence and meetings spanning many months.

The matters rai sed were complicated and, beyond outlining three examples, do not warrant description here. In the first example, Andersen indicated that for the later HIH audit years (1998 and following) the only practical form in which documents could be produced was electronic. This was because with the Andersen audit software it was not possible to print hard copies of electronically stored documents. These documents were produced to the Commission in February 2002.

The second example concerned the incomplete state of copies of documents that related to some of the relevant earlier audit years and that Andersen had retain ed following production of documents to ASIC. Some of these audit years were critical

30 How the inquiry was conducted

to the early phases of the Commission's hearings-for instance, the 1998 FAI audit. Because Andersen did not have in its possession complete copies of these documents, the Commission had to arrange for them to be imaged by ASIC and then produced to the . Commission. Substantial production of these files was not completed by ASIC until late March 2002; production of all of the 1998 F AI audit documents was not completed until early May 2002.

Third, the Commission encountered further difficulties when it sought production of HIH-related documents from Andersen in the United Kingdom and the United States. Initially, the Commission sought the assistance of Andersen in Australia, but it was told that the overseas operations of Andersen were separate firms and the Commission should deal with those firms directly or through their lawyers. The Commission's approach to Andersen in the United Kingdom met with the response

that the firm and the partners involved would not be of assistance. Its inquiries of Andersen in the United States were also unsuccessful: it was directed to Andersen Legal, from which it received no response. In addition, the Commission was unable to obtain records from Andersen in Hong Kong: that firm stated that it could not comply with the Commission's requests for documents because of the impact of

local ordinances.

Since the Commission could not exercise its powers of compulsion outside Australia, the lack of cooperation from Andersen in the United Kingdom and the United States and the apparent inability of Andersen in Hong Kong to comply with the Commission's requests significantly curtailed the Commission's ability to

investigate thoroughly matters related to HIH in those jurisdictions.

As a final comment, the problems with the process of production by Andersen were exacerbated by changes in Andersen's legal representation after the Andersen partnership ceased to trade as such in Australia around May 2002. The legal firm that usually represented Andersen in appearances before the Commission took over from another firm responsibility for advising Andersen on the production of documents. This inevitably complicated communications.

2. 7 Relations w ith the liquidators, APRA and ASIC

The liquidators, APRA and ASIC all had an involvement in the events the Commission inquired into and provided evidence to it. At the same time, because of their respective roles and their holdings of relevant records, the Commission was anxious to maintain effective working relations with them.

2.7.1 The liquidators

Early in the inquiry Commission staff had a number of meetings with one of the liquidators, Tony McGrath, other members of his firm and the liquidators' solicitors. The initial focus was on the resolution of day-to-day matters such as the production of documents and the preparation of statements. More structured liaison

The failure of HIH Insurance 31

arrangements followed, with fairly regular meetings. On 5 November 2001 the New South Wales Supreme Court issued to the liquidators a general direction relating to cooperation with the Commission. 3 In addition, a nominated KPMG staff member acted in a liaison role, facilitating the provision of responses to numerous requests for financial and other information that necessitated input from staff employed in different areas of HIH.

The Commission was mindful that the liquidators were parties before it and represented interests that were likely to be affected by its inquiries. Communication with the liquidators generally occurred through their solicitors.

2.7.2 APRA and ASIC

The Commission's relations with APRA and ASIC developed against the background that both those agencies continued to exercise their regulatory functions while the Commission's investigations were proceeding. In the case of APRA, this was particularly so while its inspector carried out his review; in the case of ASIC, its own investigations continued throughout the term of the Commission.

The Royal Commissions and Other Legislation Amendment Act was enacted in this context. Among other changes, it enables a royal commission to communicate information and furnish evidence relating to a contravention of the law to responsible individuals or authorities (such as ASIC), regardless of whether the contravention may give rise to a criminal, civil or administrative penalty. It also amends the Australian Securities and Investments Commission Act 2001 to allow ASIC to disclose information voluntarily to a royal commission. Additionally, the Australian Prudential Regulation Authority Regulations were amended to specifY the HIH Royal Commission as an agency for the purposes of s. 56(5)(a) of the Australian Prudential Regulation Authority Act 1988; this had the effect of releasing

the Commission from the prohibitions in s. 56 that generally prevent APRA officers from disclosing protected information for purposes other than the APRA Act.

In recognition of the possible overlaps between their respective investigations, in November 2001 the Commission and ASIC signed a protocol for cooperation. The protocol established arrangements for cooperation and the exchange of information, to allow for more efficient and effective conduct of both the Commission' s inquiry and ASIC's continuing investigations. In particular, these arrangements sought to avoid duplication in the Commission' s inquiry and ASIC's investigations and any adverse impact on any civil or criminal proceeding that might arise out of ASIC's investigations. Representatives of the two organisations attended regular liaison meetings.

An example of the benefits derived from this cooperative approach is the assistance ASIC provided in arranging for the US Securities Exchange Commission to assist the Royal Commission with some of its inquiries in that jurisdiction- including to the extent of the SEC exercising its powers to take evidence from witnesses.

32 How the inquiry was conducted

The Royal Commission was mindful that both APRA and ASIC were also parties before it, and dealings with both agencies in that regard were conducted through their respective solicitors.

2.8 Referrals

Section 6P of the Royal Commissions Act authorises a commission to communicate to appropriate authorities information that relates or may relate to a contravention of a law or to evidence of a contravention of a law of the Commonwealth, a state or a territory. The Commission exercised that power on several occasions. Before any such referral, the individuals or entities affected by it were given the opportunity to make submissions.

2.9 Legal professional privilege

Questions relating to legal professional privilege loomed large during the inquiry.

Here it is useful to look first at the way other privileges are dealt with in the context of a royal commission. It is clear from s. 6A of the Royal Commissions Act that the privileges against self-incrimination and self-exposure to a penalty are partially abrogated: in response to a summons or notice to produce a document or other thing to a commission, it is not a reasonable excuse to refuse or fail do so on the grounds that the production might tend to incriminate the person or expose them to a penalty.

In recognition of the need to maintain a balance between enhancing a royal commission's ability to obtain information (which the abrogation does) and preserving the underlying values that support the privileges, s. 6DD establishes direct-use immunities. These immunities are not absolute, but in the case of the production of documents or other things they mean that the fact of production in

response to a summons or notice is not admissible in evidence against an individual in civil or criminal proceedings. The abrogation of the privileges under s. 6AA is only partial. Those privileges remain available to anyone who has been charged with an offence or against whom proceedings have been initiated that mi ght lead to the person being liable to a penalty.

It is not so clear whether a claim for legal professional privilege will constitute a reasonable excuse against production in answer to a commission summons or notice. Unlike the privileges against self-incrimination and self-exposure to a penalty, legal professional privilege is not specifically dealt with by the Act. On first

consideration it may seem odd that, although individuals may not avail themselves of the privileges against self-incrimination or self-exposure to a penalty, they may rely on legal professional privilege to withhold documents from production. It might be observed, however, that this is the position that now pertains in relation to the

production of documents to the Australian Competition and Consumer Commission under s. 155 of the Trade Practices Act 1974. 4

Th e failure of HIH Insurance 33

It is well accepted that statutory provisions are not to be construed as abrogating important common law privileges-such as legal professional privilege- in the absence of clear words or a necessary implication to that effect. It remains an unresolved matter of construction whether the provisions of the Royal Commissions Act 1902 necessarily imply the abrogation, or perhaps partial abrogation, of legal professional privilege. The Commission did not consider it necessary to resolve the question of construction or to rule formally on any claims for legal professional privilege. In the event, either claims were not pressed or the Commission did not require production of documents or parts of documents over which a claim for legal professional privilege had been made.

This is not to say that the uncertainties surrounding the privilege did not affect the operations of the Commission. One consequence of this approach was that there was a continuing need to respond to and try to manage those claims for legal professional privilege that were made. Many such claims were made, the greatest number being made on behalf of the liquidators. The difficulties were most evident where the Commission required the production of very large volumes of material­ for example, computer hard drives. There was a possibility of delay if the producing party wished to review all the material to be produced in order to identify any claims for legal professional privilege. In some cases, this would have involved the review of many thousands of documents.

One instance of this concerned a notice the Commission served on the liquidators in early 2002, effectively calling for the production of all documents relating to the operations of HIH between 1 January 1995 and 15 March 2001. This broad notice was designed to limit the need for a series of specific notices of the kind that had been issued previously. It was agreed with the liquidators that it would be sufficient compliance if they retained the material in question but made it available to the Commission as required. Further, with a view to obviating the need for the liquidators to review each document prior to production-but without compromising any legal professional privilege that might be available to them- the Commission agreed that it would not disclose the contents of any documents that might give rise to a claim for legal professional privilege without notifying the liquidators beforehand.

In response to the Commission's notice in early 2002, the liquidators applied to the Supreme Comi of New South Wales for a direction under s. 579(3) of the Corporations Act 2001 that the liquidators would be justified in giving the Commission access to records caught by the notice to produce without having taken steps to test whether production of particular documents might be resisted on the basis of legal professional privilege. The court initially declined to give the direction sought. 5 However, following revisions to the arrangements, whereby the Commission agreed it would return to the liquidators any documents identified as potentially being the subject of a legal professional privilege claim, Barrett J made a direction that the liquidators were justified in giving the Commission access to the documents. 6 His Honour's conclusion was that the arrangements that had been

34 How the inquiry was condu cted

proposed would substantially reduce the risk of waiver of legal professional privilege by the liquidators.

As a consequence of the doubt over whether legal professional privilege is available in the context of a royal commission, large amounts of time were devoted to dealing with the associated questions that arose. Accordingly, if it is the legislature's intention that legal professional privilege should not be available as a reasonable excuse against the production of documents in answer to royal commission processes, it is desirable that the Act be amended to make this explicit.

If that course were to be followed consideration would also need to be given to whether any immunity should attach to the fact of production of documents that would otherwise be protected by legal professional privilege. In particular, a question would arise whether the direct-use immunity contained in s. 6DD would apply in relation to the production of documents that otherwise might be the subject of a claim for legal professional privilege and, if so, the extent to which that

immunity might provide protection against an argument that the fact of production to a commission would give rise to a waiver of such privilege. I also note that the direct-use immunities provided for in s. 6DD as currently framed apply only in favour of natural persons-presumably in recognition of the fact that the privileges against self-incrimination and self-exposure to a penalty do not extend to corporations.

Legal professional privilege is a fundamental common law right. I make no recommendation that it be abrogated. However, given the considerable difficulties to which legal professional privilege gives rise in the conduct of an inquiry such as this one, the operation of the privilege in the context of a royal commission is a

policy matter that needs to be examined and resolved.

2.10 Procedural matters

It did not prove necessary for the Commission to hold many directions hearings: procedural matters were largely dealt with by direct written communication between the Commission and parties and through practice directions.

In September 2001 the Commission placed notices in the national press, inviting individuals and entities interested in becoming parties to the inquiry proceedings to apply for leave. Thirty-six such applications were received in response. I dealt with these applications at a preliminary hearing on 19 September 2001: leave to appear

was granted to 35 individuals or entities; five applications were adjourned; five applications were declined; and one application was withdrawn prior to the directions hearing. Of the five applications that were adjourned, only one was subsequently renewed, as a result of which leave was then granted. The Commission received 27 further applications for leave to appear (including the renewed

application just referred to). These applications were all granted, bringing to 52 the total number of parties appearing before the Commission.

The failure ofHIH Insurance 35

In each case, leave to appear was granted only in relation to matters in which the party concerned had a substantial and legitimate interest. Parties were required to seek further leave to cross-examine witnesses, tender evidence and present submissions.

Additionally, in the early days-before the enactment of the provision that obviated the need to do so-a number of short hearings were convened for the return of summonses. Aside from dealing with a small number of discrete applications relating to claims for confidentiality and the like, the only other directions hearing dealt with applications for leave to make submissions in reply to the submissions of counsel assisting and the allocation of times for the making of oral closing submissions.

Nine practice notes were issued. These were made available through the Commission's website and covered a range of procedural matters-preparation and receipt of evidence from witnesses, access to databases, arrangements for the commencement and conduct of hearings, cross-examination of witnesses and access to documents, and applications to lead further evidence. Three practice notes dealt with the arrangements for closing submissions. A guidance note was issued on the construction of the terms of reference and other related matters.

On four occasions formal reasons for ruling were issued. The first of these dealt with an application for a non-publication order; these reasons are confidential and have not been published. The second ruling dealt with an application that only one counsel assisting be permitted to examine any particular witness. The third concerned the continuation of a non-publication order in respect of a witness statement. The fourth related to an application by certain media interests for the revocation of a non-publication order made in respect of a passage of evidence given by a witness.

In addition to those and other rulings I made during the course of the hearings, I also issued 142 formal orders. The bulk of these were made towards the end of the Commission's inquiries and dealt with the tender of additional documents and written submissions. Others were made granting leave to appear or prohibiting the publication of particular documents.

By order made on 21 November 2001 I established a general confidentiality regime that, in summary, stipulated that, before their tender, documents provided to parties or other individuals were not to be disclosed or used for purposes other than in connection with the proceedings of the Commission.

2.11 The public hearings

One reason for the establishment of this Commission was to help restore public confidence in the financial system and, in particular, the general insurance sector. With this in mind-and in any event bearing in mind the importance of the concept of open justice-! acknowledged the public interest in an open proceeding where

36 How the inquiry was conducted

the process of inquiry was transparent. Throughout the 203 days on which evidence was taken and (with minor exceptions) the further time allotted to applications and closing submissions, I did not find it necessary to exclude members of the public (including the media) from hearings. On one occasion an application by the liquidators for a wide-ranging confidentiality order on documents produced by them was heard in closed session, so that the content of the documents could be discussed if that were necessary; the application was not successful. The oral closing submissions of one party were taken in closed session; this was because of a timing problem, and the transcript was made public a few days later.

In all, the Commission sat on 228 days, excluding directions hearings and returns of summonses before December 2001. Following the general opening on 3 December 2001 , sittings proceeded with few breaks through to January 2003 . Standard sitting hours were 9.30 am to 4.30 pm, with a break for lunch and brief breaks at mid­ morning and mid-afternoon. On a number of occasions the Commission sat for extended hours-for example, to meet a witness's convenience.

From time to time I made orders prohibiting the publication of documents or parts of the transcript; in almost all cases this was to preserve the commercial confidentiality of matters that were the subject of claims made by or against the liquidators. Failure to suppress this material could have had adverse consequences for creditors, wi thout adding in any material way to the store of public knowledge.

In public hearings the Commission heard from 126 witnesses, some of whom appeared mo re than once. In addition, 75 people presented written statements and the Commission decided it was not necessary for them to give oral evidence. Parties had the opportunity to request that people who presented written statements attend for cross-examination. Whenever such a request was made it was granted. Many

witnesses came from interstate; some came from overseas. The majority of witnesses made themselves readily available to the Commission and, as far as was practicable, hearing ti mes were arranged to suit the convenience of witnesses and their counsel. It was not always possible to accommodate the requests of parties but,

in the main, satisfactory arrangements were reached. A few people were unwilling to assist the Commission and were beyond the reach of its coercive powers. In some instances that has given rise to comment.

2 .12 Hearing procedures

2.12.1 Written statements

At the outset I informed the parties that I expected the majority, if not all, of the evidence to be presented by witnesses to be received in writing by means of written witness statements. I also expected, as far as possible, witness statements to be circulated in advance to parties and people whose interests might be affected.

7

The

reason for encouraging the preparation of witness statements was that I considered it would make the taking of oral evidence more efficient and would allow interested

The failure of HIH Insurance 37

parties to receive prior notice of evidence to be given. Although the original intention was that witness statements prepared by parties would be delivered to the Commission at least 14 days before the day on which the witness was to be called, perhaps inevitably that timetable was not met. At times this placed significant pressure on the conduct of the hearings. Nevertheless, the practice did result in a substantial shortening of the hearing time required for the receipt of evidence. Witness statements were generally provided to parties through the CourtBook database (see Section 2.13), as were the documents expected to be relevant to a witness 's evidence.

2.12.2 Leading of evidence

In recognition of the inquisitorial nature of the Commission's proceedings, all witnesses were called by counsel assisting. Counsel assisting did not, however, lead all witnesses' evidence-in-chief. If a witness was represented or was connected with a party who was represented, counsel for the witness or party was given leave to lead the evidence from the witness. This was done usually by adopting the witness ' s written statement where one had been provided. Often, the witness's statement was supplemented. Counsel assisting were then able to ask questions of the witness. After that, other parties could cross-examine if given leave on the basis of having a sufficient interest; on no occasion was such leave withheld. Counsel assisting were then able to examine the witness further and after that counsel for the witness were entitled to re-exarnine. 8

I subsequently saw the need to announce that, as a general rule, parties who wished to cross-examine must be ready to do so as soon as the evidence had been led and that, in the interest of the efficient conduct of its hearings, the Commission could not defer its sittings while parties prepared for the cross-examination of witnesses. 9 On occasion it became necessary to depart from that general rule, but it did form the basis on which the cross-examination of witnesses occurred and this aided the efficient conduct of the hearings.

A limited number of witnesses declined to provide written statements and instead had their evidence-in-chief led at length by their counsel. This was an inefficient method of taking evidence, and in due course I advised parties that I did not consider I was obliged to allow witnesses' oral evidence-in -chief to be adduced by their counsel. My view, which was communicated to the parties, was that it would be consistent with the requirements of procedural fairness for a witness to begin giving evidence by way of cross-examination by counsel assisting, with the witness ' s counsel being able to re-examine at the conclusion of cross-examination only with leave. 10 As matters transpired, it did not become necessary to depart from the earlier practice of allowing witnesses to have their evidence-in-chief led by their own counsel.

38 How the inquiry was conducted

2.12.3 Cross-examination

In Practice Note 4 I made the point that I would use a number of investigative methods , only one of which would be the taking of oral evidence. I noted that, while this might include cross-examination, that would be the case only if such cross­ examination would help me ascertain the facts on which to base my report. As a consequence, Practice Note 4 emphasised that, although cross-examination might play a part in affording people procedural fairness, it did not follow that it constituted the only opportunity to be heard. For this reason, I took the view that repetitive questioning of witnesses would not assist me and ought to be avoided. The hearings were conducted on this basis and, in particular, the order of cross­ examination for each witness was determined with this in mind.

2.13 Document-management and hearing processes

To carry out its task, the Commission had to obtain from various sources a very large volume of documentation and Commission lawyers and consultants had to analyse that material. Relevant material then needed to be made available to parties and formally presented during the hearings.

To meet these needs, the Commission adopted the Ringtail suite of products to support both an internal document-management database, known as CaseBook, as well as databases, known as the CourtBook databases, that would be made available to parties in the hearing room and through remote access. This technology has been widely used in other inquiries and in complex litigation. CourtBook had also been developed to support an electronic hearing room environment; a feature of the

system was its integrated real-time transcript function .

CaseBook was the main internal working database, and much of the evidence obtained by the Commission was placed there, along with relevant internally generated material. Although a significant amount of documentation was produced to the Commission in Ringtail-compatible electronic format, the Commission also received a very large number of documents in hard-copy form. These documents had to be imaged for incorporation in the CaseBook database. The Commission used an internally developed document-coding system for this purpose; the system was also used for the CourtBook databases. CaseBook was the largest of the Commission's databases: it grew to hold over 1 600 000 pages of imaged documents. Commission staff were assisted in their analytical tasks by the search and sorting capabilities of CaseBook.

Ultimately, four principal CourtBook databases were established. Two of them were essential for dealing with parties and conducting the hearings. The first of these was the main LAN CourtBook database, which was available to parties in the hearing room; the second was Parties' CourtBook, which essentially replicated the contents of the LAN CourtBook but was made available to parties through the internet so as

to facilitate access outside hearing hours. The other two databases were Observers' CourtBook, which was available through the internet to media and other observers,

The failure ofHIH Insurance 39

and Observers' Submissions CourtBook, which was available through the internet to media and some other observers in the later stages of the inquiry. These databases contained a limited selection of tendered documents from the main CourtBook databases.

The arrangements for access to the LAN CourtBook, Parties' CourtBook, Observers' CourtBook and the Commission's website were set out in Practice Note 2, issued on 15 November 2001. Access to both the LAN CourtBook and Parties' · CourtBook was restricted to people granted log-on access by the Commission. These arrangements were incorporated in the confidentiality regime that was implemented on 21 November 2001.

The CourtBook database allowed the Commission to make documents available to parties, in most instances in advance of tender. Documents could be organised into different folders dealing with particular topics, and documents referred to in witness statements could be hyperlinked; material could also be masked when necessary­ for example, for reasons of confidentiality. Ultimately, CourtBook also became the means whereby submissions were made available to parties and other potentially affected people.

Adoption of these arrangements meant that the number of hard copies of documents was significantly reduced and the dissemination of information was easier. Use of the technology greatly contributed to the fair and efficient conduct of the Commission's hearings. All those participating in the hearings seemed to embrace the use of this technology.

Although use of the CourtBook databases meant that a considerable amount of sensitive material was made available to parties and others with log-on access, to my knowledge there were no instances of any 'leaks' occurring as a result of the dissemination of information by means of CourtBook. The two instances in which there was an apparent leak of material the Commission had provided to parties or witnesses did not involve CourtBook.

2.14 Access by parties, the public and the media

The Commission was always aware that there would be a strong public interest in its inquiry and the outcome. Accordingly, proceedings were open to the public and the Commission's website was used to enable a wider public to follow proceedings. Among the information published on the website were details of the hearings, lists of parties and witnesses, background papers, witness statements, transcripts, and submissions dealing with policy matters.

In the hearing room, parties and their representatives had 50 desk spaces with modem ports and 26 computers. They had access there to the CourtBook databases and real-time transcript and in their offices through the internet. Private meeting rooms were available adjacent to the hearing room. The Commission's information

40 How the inquiry was conducted

technology contractor offered continuing techn ical support for parties and other external users of Commissi on databases.

The media room was also equipped with technology to allow electronic sound recording of the hearings. As a general rule, no video or other images of witnesses were permitted inside the building and, apart from a brief period on the opening day, there was no visual recording of the hearings by the media. I did make a ruling that the media could have access to a video recording of witnesses at the hearing if they first obtained the consent of the individual concerned; I am not aware whether there were instances in which consent was sought. In the eve nt, no access was granted to the Commission ' s video record of the proceedings.

Many media representatives sought and were granted access to Observers' CourtBook and Observers' Submissions CourtBook.

2.1 5 Openings by counsel assisting

In order to provide context for the evidence adduced before me, the practice was adopted of having counsel assisting provide an opening on each topic before the relevant evidence was put forward. Additionally, a general opening was made on 3 December 2001 , before the first witness was called.

Because the Commission's hearings were in support of an administrative inquiry, the nature of the openings by counsel assisting was quite different from the type of opening address that is presented in a trial. A trial involves the determination of rights and obligations, so, in making its opening address, a party is required to put clearly and unequivocally the propositions of fact and law that it will ask the court to accept. In this way the opening helps to define and confine the scope of the case

the party wi ll be allowed to put. In contrast, the purpose of the openings in the proceedings before me was to introduce each topic in general terms and outline the relevant documentary background as then known, thus providing some preliminary context for the examination of witnesses.

The openings also served to allow counsel assisting to nominate particular matters of probable inquiry. This facilitated the provision of procedural fairness to those whose interests might be affected by the Commission' s inquiry into a particular topic. As counsel assisting explained at the start of the general opening, his task on that occasion was merely ' to try to identify some of the questions, not provide any of the answers'.

Because the hearings were part of a broader investigative process, it would not have been possible for counsel assisting to be definitive in these topic openings. It was always probable- and indeed proved to be the case- that over time issues would emerge that had not been fore seen at the start of the inquiry. In some instances, evidence that came to the Commission's attention cast earlier evidence in a different

light.

The failure ofHIH Insurance 41

The topic openings by counsel provided a firm framework for the hearings. This was helpful to me and would also have been of assistance to affected parties and to the wider public following the proceedings.

2.16 Issues papers

With some topics, the oral openings were supplemented by issues papers that were made available through CourtBook and linked to relevant underlying documents. As with the oral openings, these papers offered the benefit of alerting parties to matters that were under consideration by counsel assisting and were thus likely to be the subject of evidence during the hearings on a topic.

2.17 Background papers

The Commission was mindful that the corporate structure of the HIH group was complex and that many aspects of the general insurance sector within which the group operated would probably not be familiar to the wider public. Accordingly, a series of background papers was prepared by or for the Commission to assist the parties, the media, and others with an interest in the proceedings.

Commission staff prepared several papers providing corporate and background information relevant to the HIH group, as well as a chronology of key events. A glossary of common insurance and reinsurance terms was also prepared. Other papers covered a variety of subjects-directors' duties and other obligations under the Corporations Act; the business and financial reports of general insurers; the general principles of establishing outstanding claims provisions; and assessment of the insolvency of a general insurance company.

The Insurance Council of Australia prepared for the Commission a paper providing a profile of the general insurance industry in Australia as well as others on Commonwealth regulation of general insurance, state and territory statutory insurance regimes, and taxes and charges on general insurance. It also prepared papers on reinsurance and on insurance education and training in Australia.

All of the background papers were made available through the Commission' s website.

2.18 Ordering of witnesses and issues

There are limits to how far the of a large inquiry can be determined in

advance. Its course cannot be predicted with certainty. The logic of the Commission's hearings evolved over time, having regard to the identification of matters by those assisting me and the time frame over which the investigations developed.

42 Ho w the inquiry was conducted

The logical starting point was to hear evidence from Tony McGrath, one of the joint liquidators of HIH in Australia, and from Tom Riddell, one of the provisional liquidators of the UK companies. Both witnesses detailed the progress of their liquidations, including the realisation of assets and the quantification of liabilities. In relation to the latter, evidence was also taken early on from Richard Wilkinson, an actuary and UK partner of KPMG. Wilkinson was questioned about his actuarial assessments of the HIH group's claims reserves, as prepared for McGrath and Riddell. These assessments are known as the phase I and phase II reports.

The other witness called to provide general background was the inspector appointed by APRA, David Lombe, a partner with Deloitte Touche Tohmatsu. Lombe had presented his report to APRA in September 2001 and APRA produced the report to the Commission in October 2001. One of the purposes ofLombe's inspection was to determine the reasons for the collapse of HIH. Because of the constraints on his

inspection, however, his report was no more than a preliminary assessment and his conclusions were qualified to that extent. Nevertheless, they provided a useful road map for the Commission's own inquiries.

Because of the very tight time frame within which I was at that time required to report, counsel assisting then decided to proceed with two discrete topics that they felt could be prepared and presented relatively quickly. The first concerned the review of the HIH group's financial viability, which Ernst & Young had carried out

in late 2000 and early 2001.

The next topic- which proved to be of central significance to the overall inquiry­ concerned certain reinsurance contracts entered into by HIH and by F AI prior to its acquisition by HIH. Although complex, the evidence relating to these contracts was able to be prepared as a relatively discrete topic. This enabled the hearings in this connection to get under way relatively early, while investigations proceeded elsewhere. Further, the potential financial consequences arising from the accounting treatment of these contracts-and the possibility that the need to enter into them signified underlying financial difficulties-meant that the topic was an appropriate one for detailed inquiry and oral evidence.

Exploration of the reinsurance contracts necessarily raised for consideration the question of the adequacy of the claims provisions ofF AI and HIH. The Commission moved to the question of whether, at the time of its acquisition by HIH, F AI had failed to retain adequate provisions in respect of outstanding claims liabilities. Using that chronological cue, evidence was then taken about the events and circumstances surrounding the takeover ofFAl by HIH.

The next phase of the inquiry concerned the central, but less easily defined, area of the general management and conduct of the affairs of HIH. This phase of the hearings canvassed a range of transactions that occurred in the years preceding the collapse as well as some important accounting and actuarial concerns. Other matters

relevant to the governance of the group were also explored. Evidence was taken from HIH directors and managers, external advisers who were involved in some of the more significant transactions, and other witnesses who were involved in

The failure of H/H Insurance 43

transactions of interest. This phase occupied the largest block of the Commission's hearings. The Commission then turned its attention to the role played by Andersen as the auditor of both F AI and HIH.

The final phase of the hearings concerned regulatory oversight of HIH. Evidence was called from employees of APRA and an expert acting on behalf of APRA, as well as from employees of ASIC, the Motor Accidents Authority of New South Wales, the Motor Accident Insurance Commission of Queensland, and the Australian Stock Exchange.

2.19 Closing submissions by counsel and parties

Following the conclusion of evidence, counsel assisting were directed to lodge comprehensive written submissions; they also made brief oral submissions. Parties were given leave to lodge a written submission in reply and, where it was sought, to make oral submissions. I also allowed counsel assisting to file brief submissions in reply to the parties, and the parties were given leave to file replies to matters raised in other parties' submissions. The role closing submissions played in assuring procedural fairness to parties and other affected participants is noted in

Section 1.4.2.

2.20 The approach to future policy directions

2.20.1 The inquiry's scope

At the outset of the inquiry I emphasised the importance I attached to the contribution the Commission could make to the direction of future policy. A large part of the inquiry was necessarily directed to the past- to what had gone wrong and why-but the Commission always had in mind the need and the opportunity it had to put forward recommendations and views to help shape regulation and governance in the future.

The Commission was specifically required by its terms of reference to inquire into the adequacy and appropriateness of arrangements for the regulation and prudential supervision of general insurance-at the state and territory level as well as the Commonwealth level. In correspondence before the Commission was formally established, the Prime Minister informed the states and territories of the proposed terms of reference and received from them assurances of cooperation with the

mqmry.

When considering regulatory matters, the Commission was required to take into account its findings in relation to the reasons for and the circumstances surrounding the failure of HIH. It was also called on to have regard to other relevant matters, including:

44 How the inquiry was conducted

(i) Commonwealth arrangements before and after the Financial System Inquiry reforms; and

(ii) different State and Territory statutory insurance and tax regimes.

The Commission's starting point in looking at general insurance regulation and supervision was its investigation of the failure of HIH and the picture this case study provided of how the regulatory system had worked in practice. In the context of the Commission's overall task, it was not feasible to examine every aspect of the current regulatory arrangements. Rather, the Commission focused on those aspects that came under the spotlight in the course of the inquiry-in particular, the prudential side of regulation. In doing this, account had to be taken of changes that have been made since HIH failed, both in the area of prudential standards and in the approach of the regulators. The system has not been standing still, and APRA and other participants in the regulatory framework deserve credit for initiatives taken to

improve the system during the term of the Commission.

The Commission also benefited from dialogue with the regulators and other interested parties and carefully examined various issues and proposals submitted by interested individuals and organisations. Reference is made to those issues and proposals in various parts of this report. Where I felt able to make a contribution on the basis of relevant knowledge and experience, I responded by way of recommendation or observation.

Beyond the regulation of general insurance, the inquiry into the failure of HIH also raised in stark outline broader questions of corporate governance, ones that extend beyond the general insurance sector to the wider commercial community. In these broader areas of governance, the inquiry again provided a rich case study that threw light on some very topical questions. A number of these questions are currently very alive in terms of public debate and are or have been the subject of specific inquiries or proposals by government or other bodies. Having regard to the state of public debate on relevant issues, where I saw an opportunity to put forward relevant recommendations or observations I did so. These views were shaped by the HIH case study as we ll as by consultation with interested bodies and individuals.

2.20.2 The deliberative process

The findings and recommendations in policy areas draw on the case study of the failure of HIH. The Commission sought to identifY the factors that contributed to the failure and to propose remedies to reduce the chance that such circumstances might recur-or, at least, escape detection in the future.

Throughout the inquiry into the fai lure of HIH, parallel inquiries, research and consultations were carried out in order to identifY and clarifY questions relating to the direction of future policy and to help formulate and test proposals in this area.

The Commission also called by advertisement for submissions on policy matters; it received responses from a range of individuals and organisations. A series of consultations was held with interested parties 11 , dealing with matters covered in

The failure ofHIH Insurance 45

their submissions and other aspects of general insurance, regulation and corporate governance. The Commission also held a public hearing at which members of the public were invited to make oral submissions on policy-related matters.

It was not possible to accommodate all the matters raised in this way: they were broad and varied in nature. Instead, I focused on issues where-having regard to the terms of reference and matters that came to light during the inquiry-! felt able to make a contribution. I acknowledge with appreciation the valuable contribution of all those who provided information, views and perspectives in this regard.

2.20.3 Ordering the topics

Chapter 6 focuses on general questions that are relevant to the governance of corporations-a subject that has had a high profile in recent debates. The discussion is not restricted to corporations engaged in general insurance: although it is primarily directed to corporations in the commercial sector, some of the principles discussed may well extend beyond that sector.

Financial reporting and assurance are dealt with in Chapter 7, which covers particular aspects of accounting, auditing and related assurance mechanisms. Some of the recommendations are specific to the general insurance industry, but others have implications for financial reporting more generally. Where relevant, reference is made to issues covered in the CLERP 9 discussion paper released by the Commonwealth Government in September 2002.

The framework of regulation applicable to general insurance at the Commonwealth level is the subject of Chapter 8; this includes the prudential and corporate regulations administered by APRA and ASIC. Chapter 9 covers questions relating to state and territory governments' regulation of general insurers.

Chapter 10 discusses some aspects of taxation, at both the Commonwealth and the state and territory levels, that raise questions relevant to the well-being of the general insurance sector. Finally, in Chapter 11 consideration is given to the possible introduction of a scheme to support policyholders in the event of the collapse of a licensed insurer.

46 How the inquiry was conducted

2.21 Acknowledgment of the Commission team

I could not have carried out this inquiry without the enormous assistance I received from the team of people engaged for the task in various professional, technical and administrative capacities. They came from all over Australia and from elsewhere; few of them had known each other before. They worked as a team. Appendix F lists their names.

I value and appreciate the contribution of everyone who played a part. I pay tribute to the great skill, judgment, energy and diligence-and the willing spirit- that members of the team brought to the task. They should share any credit for the outcome of the inquiry; any shortcomings should remain to my account.

9

10

II

CORE.0 15.001. WITS.0012.001; the assistance provided by Loin this respect is acknowledged.

Re HIH Insurance Ltd (2001) 39 ACSR 645.

The Daniels Corporation International Pty Ltd v Australian Competition and Consumer Commission [2002] HCA 49 (7 November 2002).

HIH Insurance Limited [2002] NSWSC 231 .

HIH Insurance Limited [2002] NSWSC 243.

Practice Notes 1 and 3.

Practice Note 3.

Practice Note 4.

T7920 to T7921. Appendix D lists the people and organisations that presented submissions in relation to future policy.

The failure of HIH Insurance 47

Part Two The life and times of

HIH

3 A brief corporate history

What follows is a very brief account of the history of HIH and the changing nature of its business operations in the years leading up to its liquidation. Most of the developments discussed here are dealt with much more expansively in Volumes II and II of this report.

3.1 Origins

The origins of HIH can be traced back to 1968, when Ray Williams and Michael Payne incorporated MW Payne Liability Agencies Pty Ltd to underwrite insurance business in Australia as an agency for two Lloyd's of London syndicates. Williams and Payne were directors of the company and Williams was chief executive officer. The following year George Sturesteps joined as a claims manager, and in 1972 Terence Cassidy was employed in an accounting role.

The company' s main business was the writing of workers compensation insurance in the Victorian market. This operation was successful, and in 1970 the company expanded into Tasmania (and subsequently into other states). In 1971 MW Payne Liability Agencies Pty Ltd was acquired by CE Heath plc, a public listed company based in the United Kingdom, and for the next 15 years the company was known as CE Heath Underwriting Agencies Pty Ltd. Williams continued as a director and chief executive and in 1980 was also appointed to the board of CE Heath plc.

Until the mid-1980s the company's sole business-workers compensation­ continued to expand. In 1985 and 1986, however, legislative changes to workers compensation insurance in Victoria and South Australia significantly reduced business in those states. In response, the company decided to diversify its underwriting into other insurance classes, among them property, commercial, and professional liability. It also decided to expand offshore-first in Hong Kong, where

its initial focus was reinsurance; then in California, where it concentrated on workers compensation.

By 1989 CE Heath Underwriting Agencies had become CE Heath International Holdings Limited, with Williams as principal executive. 1

As part of a 1989

restructure, CE Heath acquired the Australian business from CE Heath pic. Under this restructure, 90 per cent of the shares in CE Heath were retained by CE Heath plc and the remaining 10 per cent by the Australian management, including Williams.

There were also board changes. Robert Stitt and Neville Head were appointed non­ executive directors of CE Heath in January 1992, and Geoffrey Cohen, a former

The failure of HIH Insurance 51

senior partner at Andersen, became chairman. In addition to Williams, the other directors immediately before January 1992 were Peter Presland, Ross Eade, Cassidy and Sturesteps. In February 1992 Eade resigned as a director but continued as an executive.

3.2 Float and growth

Following a due diligence process conducted by Andersen, the company was listed on the Australian Stock Exchange in June 1992. It became a public listed general insurer. About 45 per cent of the issued capital was held by the public, 44 per cent by the UK-based CE Heath pic, and 11 per cent by the local CE Heath directors. A total of 167 million shares were issued following the float, of which about

19.2 million were held by three directors- Williams, with 12.8 million, and Cassidy and Sturesteps, with just over 3 million each. There was no immediate change of directors, although Payne joined the board later in 1992.

Expansion into the United Kingdom was a priority of the newly floated company. Operations started in August 1993, under the direction of Payne, who had been formally appointed on 1 July that year as the chief executive of a newly established subsidiary, Heath International Holdings (UK) Limited.

Until 1995 CE Heath's core business was in so-called long-tail classes of insurance. In Australia the company focused on workers compensation, public liability and professional indemnity; in California the concentration was on workers compensation; and in the United Kingdom the focus was public liability and professional indemnity.

3.2.1 The CIC acquisition

After 1995 the company embarked on a period of rapid growth: Table 3.1 illustrates this well. The growth was achieved primarily through acquisitions, which in turn brought significant changes in the company's investment and business strategies. The first big acquisition was the CIC Insurance group-for $154.2 million. The negotiations that led to the acquisition were initiated in 1993 by Colin Richardson of Hambros Corporate Finance, the Australian branch of Hambros Bank Ltd, which in tum held a substantial stake in CE Heath pic. Hambros had acted for CE Heath pic in the float of CE Heath, and over the years Richardson was involved in many of HIH's major transactions. The CIC negotiations initially foundered but were revived in 1994.

52 A brief corporate history

Table 3.1 HIH Insurance: reported contributions to total assets, 1994 to 2000

(A$ million)

Year to December 18 months Year to

Geographical to June June

area 19942 19953 19964 19975 19996 2000 7

Australia 1 016.5 2 340.8 2 647.7 2 861.4 6 034.88 6 008.3

United Kingdom 62.8 111.3 132.4 377.9 625.0 949.0

United States 17.7 39.1 106.3 502.6 733.9 762.5

New Zealand 68.3 125.1 135.0 153.7 205.6 310.3

Asia 35.7 49.0 95.0 78.0 92.2 246.8

Argentina 10.5 13.1 33.9 50.2

Total 1 201.0 2 665.3 3126.9 3 986.7 7 725.4 9 8 327.1

.. Not applicable.

CIC and CE Heath carried out due diligence on each other. In May 1995 Ernst & Young and Blake Dawson Waldron looked at CE Heath, and Hambros, Andersen, Minter Ellison and David Slee (an actuary associated with CE Heath) looked at CIC. The subsequent report on CIC was signed off by Dominic Fodera, an Andersen partner. The Insurance and Superannuation Commission approved the purchase the

same month. Despite concerns voiced in the reports on both parties, the acquisition was completed in June 1995.

The move was attractive to CE Heath: it would lift the company's earnings and establish it as a major force in the Australian insurance industry; it also would provide it with a platform for future growth in Europe. Table 3.2 shows HIH's reported revenue growth from 1994 to 2000.

Table 3.2 HIH Insurance: reported contributions to consolidated revenue, 1994 to 2000

(A$ million)

Year to December 18 months Year to

Geographical to June June

area 199410 199511 199612 199713 199914 2000 15

Australia 633.9 1 015.8 1 501.3 1 676.3 3 197.316 2 441.1

United Kingdom 30.1 90.4 113.5 266.2 664 .2 1 016.9

United States 79.8 83.7 114.4 244.9 736.4 488.8

New Zealand 25.9 51.7 68.1 88.0 187.7 286.0

Asia 12.3 27.3 46.8 59.9 150.3 197.8

Argentina 4.2 7.8 42.0 45.7

Total 782 .0 1 268.9 1 848.3 2 343.1 4 977.9 17 4 476.3

.. Not applicable .

The failure ofHJH Insurance 53

The acquisition changed the size, nature and ownership of the CE Heath business. There were three parts to the transaction:

• First, CIC Holdings sold CIC Insurance Limited to CE Heath. CIC Holdings, which subsequently changed its name to Winterthur Holdings Australia Limited, was a majority-owned subsidiary of a Swiss insurer, Winterthur Swiss Insurance Company.

• Second, the acquisition of ere Insurance was funded by CE Heath ISSUing shares to Winterthur Australia.

• Third, the parent company of CE Heath, CE Heath pic, sold its entire shareholding in CE Heath to Winterthur Australia.

A short time later Williams sold a portion of his own shareholding. With the additional shares obtained from Williams (3 per cent of the capital), Winterthur Australia became entitled to 51 per cent of the shares in CE Heath.

3.2.2 Winterthur's arrival

The effect of these transactions was that by 13 July 1995 Winterthur became the majority shareholder of CE Heath. Despite this, Winterthur agreed not to take control of the board, although it did retain the option. It chose instead to nominate only three members to join the existing seven directors. The three were Erwin Heri, Willi Schurpf and Randolph Wein.

Throughout this period CE Heath was audited by Andersen, as it had been since 1973. In June 1995 Fodera, until then the auditor ofCE Heath, was appointed group finance director of the company. In May 1997 he became a director. There were other board changes, too, as a result of Winterthur's arrival. In July 1995 Presland resigned, and in August Charles Abbott and Alexander Gorrie, previously directors of ere, were appointed as alternate directors (and non-executive directors in their own right in 1997).

In May 1996 the company changed its name to HIH Winterthur International Holdings Limited. It was to become the second largest general insurance underwriter in the Australian market.

The company moved to strengthen its position in the Australian market in May 1997 by acquiring the general insurance operations of Colonial Mutual General Insurance Company Limited in Australia and New Zealand. The objective was to allow HIH Winterthur to position itself as the market leader in the provision of general insurance through banks and other financial institutions. As a result of the purchase, HIH Winterthur and Colonial Mutua1 entered an agreement whereby all Colonial Mutual's insurance products would be underwritten by HIH Winterthur. Second, HIH Winterthur acquired Colonial Mutual General Insurance Company (NZ) Limited, giving it exclusive distribution of general insurance products in New Zealand and a springboard for further business there.

54 A brief corporate hist01y

At this po int there was an important development affecting the company's ownership. In August 1997 HIH Winterthur's principal shareholder, Winterthur, announced a proposed merger with Credit Suisse. The board of HIH Winterthur expressed concern that the merger might adversely affect its relationship with Winterthur-in particular, in terms of board control, the regulatory consequences in Australia, and the group's capacity to continue to expand overseas. Nevertheless, the merger of Winterthur and Credit Suisse was finalised early in 1998, creating a major global company. Following a review of all the enlarged Credit Suisse Winterthur group's operations- and in view of Winterthur's concerns about the

management and direction of HIH-it was decided that the merged entity would focus on being a global financial services provider.

3.2.3 Winterthur's exit

As a result of this changed focus, in January 1998 discussions occurred between Winterthur and HIH Winterthur concerning the possible sale of the Swiss company's 51 per cent shareholding. The Swiss company made its position public in July, when it announced that it proposed to sell all its shareholding in HIH Winterthur by way of a public offering. In the event, the offer- at a final price of $2.58-was fully subscribed and the sale was completed by August 1998. In October HIH Winterthur changed its name to HIH Insurance Ltd.

During 1998 there were further board changes at HIH. With Winterthur's sell-down, Schurpf and Heri resigned in April and October respectively, although Wein continued as a director. In December Justin Gardener, a former managing partner of Andersen, joined the board. Gardener had been the audit partner on CE Heath from

1973 to 1989 and the concurring partner on the audits in 1990 to 1994 and again in 1996 and 1997.

The disposal of Winterthur's holding by way of a public offering profoundly changed HIH's shareholder base. In December 1997 there were 323 277 221 HIH shares on issue, held by 5265 shareholders, 3750 of whom held less than 5000 shares. In comparison, by October 2000 there were 4 71 849 820 shares on issue, held by 29 973 shareholders, with around 18 000, or 60 per cent, holding fewer than 5000 shares.

Another change was also evident following the Winterthur sale. This was the relatively small and declining institutional shareholder base. In March 1998 HIH ' s top 20 shareholders held about 83 per cent of all issued shares; by September 1999 the figure had fallen to 53 per cent and by October 2000 it was just 38 per cent.

The failure of HIH Insurance 55

3.3 The FAI acquisition

As far back as 1995 HIH had viewed F AI Insurance as a possible acquisition, in keeping with its ambition to secure a major share of the Australian general insurance market. Some analysis of F AI and discussion about a takeover took place through Hambros, but in early 1998 these activities lapsed. The reasons were twofold-the difficulty in conducting any satisfactory due diligence ofF AI; and a reluctance to sell on the part of interests associated with Rodney Adler, the company's major shareholder.

In September 1998, however, the Adler interests changed their mind: a willing buyer was now joined by a willing seller. The negotiations were brief. On 22 September 1998 the board of what was still (for a few more weeks) HIH Winterthur resolved to launch a takeover bid for F AI. The next day Adler offered approximately 15 per cent of FAI's capital (owned by a family company) for sale through the stock exchange at 75 cents per share. In the month preceding 23 September F AI shares had traded in the range of 42 to 53 cents. HIH acquired the 15 per cent stake at 75 cents and later that day announced a takeover bid for all the remaining issued capital ofF AI.

The takeover offer-of one HIH share for every three F AI shares or one HIH share plus $2.25 cash for every six F AI shares-was not subject to any formal due diligence investigations into F AI. There was no such process. The takeover progressed and by early 1999, for a total consideration of about $300 million, F AI had become a wholly owned subsidiary of HIH. In April 1999 Adler was appointed to the HIH board and was also engaged as a consultant.

3.4 Overseas operations

As noted, from the mid-1980s CE Heath gradually expanded its underwriting classes and began to move into overseas markets. It first entered the Asian region in 1986, acquiring a small Hong Kong reinsurer, and the following year it began operations in New Zealand. From the mid-1990s relatively small operations­ initially in workers compensation but later in more general lines- were either expanded or acquired in Hong Kong, Hawaii, Argentina, China, Thailand, Malaysia and the Philippines. The United States and the United Kingdom, however, were the main focus of overseas interest.

3.4.1 US operations

CE Heath entered the US market in 1 by acquiring the California-based Falcon Insurance Company. This company had ceased to underwrite in the United States but had a Californian workers compensation licence and other state licences through which CE Heath began operating. Renamed CE Heath Compensation and Liability Insurance Company, or Heath Cal, it subsequently added marine underwriting to its business.

56 A brief corporate his toty

By the early 1990s Heath Cal was reporting rapid growth and expansion. But concern about legislative changes in California persuaded the board to sell Heath Cal in 1994 for $118.6 million. This contributed to CE Heath booking a profit of $24.5 million in the year to 31 December 1994, while still retaining some of its marine business on the West Coast.

The sale of Heath Cal did not end the group ' s aspirations in the US market. In 1997 HIH Winterthur (formerly CE Heath) re-entered the market by repurchasing Heath Cal, itself now known as CareAmerica Compensation and Liability Insurance Company. The price was $79.3 million, a substantial discount on the 1994 sale price. Even so, the acquisition had been opposed by Winterthur, HIH Winterthur's majority shareholder.

After the acquisition CareAmerica was renamed HIH America and the new entity moved to expand its operations and products in the United States. Ultimately, there­ entry into the US market proved costly: by November 2000 all remaining business there had been put into run-off.

3.4.2 UK operations

The UK experience was to prove even more unprofitable than the US one. When HIH (UK) Limited first entered the market in 1993 it did not have the necessary licences to write business in the United Kingdom. Instead, business was done in the name of HIH Casualty and General Insurance Ltd, which was registered as a foreign company in the United Kingdom and was authorised to write insurance and

reinsurance there as a branch operation of the Australian company. HIH C&G held its interests in the United Kingdom through its wholly owned subsidiary, HIH European Holding Company Limited. HIH European owned the service company, HIH (UK), which provided the premises and employees used to conduct the business of the UK branch of HIH C&G. All business written before April 1994 required approval from the Australian office.

From the start of the UK operations both Williams and Sturesteps were directors of both HIH European and HIH (UK); Payne was chairman of HIH European and executive director of HIH (UK). Although the principal entity through which business was written in the United Kingdom between 1994 and 1999 was the UK

branch ofHIH C&G, control ofthe UK business was exercised through a mixture of board meetings of HIH European and HIH (UK). Senior executives of the Australian company regularly attended.

In April 1994 a full licence was granted to HIH (UK) and from then on there was no need to seek approval from the Australian underwriting management. From about November 1994 the activities of the UK branch were expanded to include underwriting a broad mix of global insurance- such as reinsurance business, marine, property, travel and personal accident, professional indemnity, catastrophe,

contingency, film finance and political risk.

The failure ofHIH Insurance 57

Emerging problems

The UK operations were successful at first, but problems had emerged by mid-1996 and persisted throughout 1997. In July 1996, soon after Winterthur's arrival, the Winterthur internal auditors expressed concern about the manner in which the London office was conducting its business. In particular, the auditors identified problems in provisioning data, the lack of a consistent underwriting approach and coherent business philosophy in relation to inwards reinsurance, and the insufficiency and poor quality of the financial information. In August Winterthur expressed further concerns about reinsurance being placed with companies that did not satisfY Swiss prudential requirements.

Notwithstanding these concerns, Williams proposed further expansion of the UK business through the acquisition of the locally licensed River Thames Insurance Company Limited. At least one of the aims was to strengthen HIH (UK) by drawing on River Thames ' s business network and expertise. Winterthur opposed the deal and it did not proceed, although some key personnel were taken on from River Thames.

Bad news kept coming. In October 1996 Payne wrote to Williams and Fodera, alerting them to a PricewaterhouseCoopers review of the UK inwards treaty book. The PWC report was critical of the underwriting by HIH (UK), of Payne's style of management, and of the lack of adequate controls. It warned that unless the account could be properly controlled it would have to be closed down or placed into run-off. Another audit report reviewing the inwards treaty reinsurance portfolio identified the company's Charman underwriting portfolio on the Lloyd's market as a problem area where business had expanded without the appropriate infrastructure and management controls.

In May 1997 the UK Department of Trade and Industry stepped in and asked for a detailed risk profile of the UK branch operations. An internal HIH (UK) report identified problems with the marine operations and significant losses arising out of the Charman line of business. In October of that year problems in the level of reserving in the UK operations were identified by PWC in a report highlighting significant differences between the recommended and actual carried reserve levels. Then, in November, an internal audit review concluded that the accounting operations and financial integrity of the UK branch were in an unacceptable state. The review identified several problems-in particular, flaws in accounting procedures and significant losses arising from Charman.

In November 1997 Payne suffered a stroke; it was not until March 1998 that he returned to work, and then it was in a non-executive capacity. In July 1998 he resigned as chief executive of HIH (UK) and was replaced by Harvey Simons. Payne became non-executive chairman. Although problems were evident in the UK operations, the Australian directors continued to focus on further expansion.

The Cotesworth acquisition Throughout 1997 operations in the United Kingdom were extended to include underwriting of the film finance business- a move later regretted. Another, much

58 A brief corporate history

bigger, project was a decision to acquire the Cotesworth Group Limited, which, through a subsidiary, was the managing agent of four active Lloyd's syndicates, three of which wrote marine insurance. The acquisition was completed in December 1998. Under the deal HIH (as it had become) provided the collateral for one of the Cotesworth companies to borrow money to invest in one of the Lloyd's syndicates. This was in line with one of the aims of the acquisition-namely, to create HIH's own corporate syndicate within the Lloyd's market in the United Kingdom. This would enable the company eventually to write international insurance and reinsurance business through the Lloyd's licences.

Poor results continued, however. The contribution of the UK operation to the deterioration of HIH' s reserves as at 31 December 1998 was assessed as approximately $300 million. The following year serious concerns surfaced m relation to substantial under-reserving in both HIH (UK) and Cotesworth.

In January 1999, as a result of its acquisition of FAI, HIH became further exposed to losses in the UK market through earlier operations there by three F AI subsidiaries. The losses could not be sustained and in September 1999 HIH (UK) was put into run-off. Some casualty, political risk and trade credit business continued for a further year, but most new business thereafter was written through

Cotesworth.

3.5 The final days

The ambitious growth strategy adopted by HIH had a serious impact on the company's financial position (see Table 3.3). The 1998-99 annual report showed a substantial increase in the value of reported total assets and liabilities, but it also noted that these increases had occurred in a commercial environment characterised by weak premium rate returns, volatile investments, and a series of significant losses

in overseas businesses. HIH reported an end-of-financial-year loss for the first time in its history.

Table 3.3 HIH Insurance: reported contributions to operating profit before income tax

(A$ million)

Year to December 18 months Year to

Geographical to June June

area 199418 199519 199620 199721 199922 2000 23

Australia 11 .5 57.6 77 .3 67.9 78.4 152.5

United Kingdom 1.5 7.5 7.2 7.2 (21.7) (48.7)

United States 7.9 (2 .6) (5.9) 9.4 (20.5) (45 .4)

New Zealand (0. 7) 9.0 8.8 9.5 17.4 7.2

Asia (1.4) 1.6 4.8 (2.4) (5.4) (11.9)

Argentina (1 '1) (1.1) 3.8 2.2

Total 18.8 73.1 91 '1 90.5 52 .0 55.9

.. Not applicable .

Th e failure ofHIH In surance 59

During 2000 HIH reported a significant deterioration in its profitability and capital base. The share price suffered accordingly. Market difficulties in both the United Kingdom and the United States, as well as the losses resulting from the acquisition of FAI, were seen as contributing factors. The group's financial deterioration had by now become the subject of public scrutiny, through both the media and stockbrokers' reports. There were several negative reports relating to the company's management-in particular, the management style of Williams-as well as HIH's

business and investment practices.

In late 1999 and early 2000 the Australian Prudential Regulation Authority (which had succeeded the Insurance and Superannuation Commission as the industry regulator from 1 July 1998) released drafts of proposed new prudential regulations. It was apparent to HIH management that, with its existing capital structure, it would not be easy for the licensed insurers to meet these new requirements. In response, HIH curtailed its growth strategy and announced a series of transactions with established insurers. These were designed to provide substantial cash injections and consequent increases in cash reserves. As it turned out, this did not happen.

3.5.1 The Allianz joint venture

The first of the Allianz transactions was announced on 13 September 2000. HIH entered a joint-venture arrangement with Allianz Australia Insurance Limited, to come into effect on 1 January 2001. Under the joint venture HIH was to transfer a substantial part of its business-primarily its personal lines and compulsory third party insurance products-to an unincorporated joint venture for a payment of $200 million. Allianz would hold a 51 per cent interest, HIH the rest. There were put and call options.

The announcement was accompanied by the disclosure that HIH's preliminary final result for the year to 30 June 2000 was a $42 .1 million operating profit after tax but before abnormal items. The market was not impressed. HIH's Standard & Poor's credit rating of A- was placed on 'Credit Watch: negative', and over the next few days HIH' s share price fell from 99 cents to 53 cents. It never recovered.

The second defensive manoeuvre occurred in November 2000, after Standard & Poor's downgraded the rating of most HIH entities. HIH entered into a managing general agency agreement with Gerling Australia Insurance Company to benefit from that company' s strong credit standing. It had been envisaged this agreement would progress to a joint venture, but negotiations lapsed.

Rather than shore up HIH's position, the market generally reacted with scepticism. It judged the transactions to be temporary relief that would ultimately deprive HIH of its profitable lines of business. Throughout this period there was also growing public and market disquiet about two other matters. One was the constitution of the board, which was seen to have too many executive members; the other was Williams ' s performance.

60 A brief corporate history

Both Head and Gorrie had resigned from the board in late 1999. On 12 September 2000 Sturesteps and Payne also resigned, although Sturesteps continued as an employee. A month later, Cassidy and Fodera resigned as directors but they too continued as employees-Fodera being chief operating officer. On the same day Williams stood aside as chief executive and announced that he, too, would resign as a director when the position of chief executive was filled. As it happened, he continued to play a role in HIH until January 2001.

But the board changes did not stem the concern. In late October 2000 Westpac, HIH's principal banker, called on the company to appoint Ernst & Young to review its financial position. Ernst & Young's draft report, presented to HIH a month later, said that the financial position of the company was 'delicately poised'. 24

Williams resigned from the board on 15 December 2000, following Wein's appointment that day as the new chief executive.

3.5.2 Th e QBE joint venture

From mid-January 2001 speculation about HIH's financial position gathered pace­ more so after 9 February, when the company announced that its interim result to 31 December 2000 was likely to be a loss. This prompted Standard & Poor's to further downgrade five ofHIH's core operating entities.

Trading in HIH shares was temporarily suspended on 22 February. Adler resigned from the board on 26 February and on the same day ASIC started a formal investigation after being told the company's interim result was an after-adjustment loss of $378 million. HIH shares were again suspended from trading on 1 March 2001, by which time they had fallen to as low as 17 .5 cents. On the same day APRA

issued notices requiring HIH to ' show cause' why inspectors should not be appointed under the Insurance Act /973. HIH was given until15 March to respond.

HIH entered a joint venture with QBE Insurance Ltd-whereby QBE in effect obtained 60 per cent of all HIH's corporate insurance-on 6 March 2001. QBE also gained management control of the new joint venture. On the following day HIH exercised its put option in relation to its 49 per cent interest in the earlier joint venture with Allianz. This effectively sold off its interest in all its former lines of retail business in the Allianz joint venture.

On 6 March 2001 HIH formally appointed KMPG to undertake a review of its financial position. In the light of the results of that review the HIH board resolved on 15 March 2001 to appoint a provisional liquidator. Later that day the Supreme Court ofNew South Wales made the requisite orders. Similar measures were taken

during the following weeks to cover HIH's remaining overseas entities.

On 27 August 2001 a further court order placed HIH and 17 companies in the group in official liquidation and appointed KPMG partners Anthony McGrath and Alexander Macintosh as joint liquidators.

The failure of HIH Insurance 61

3.6 Share performance in the last years

As far as shareholders were concerned, HIH's share price had peaked at $3.70 in July 1997. It then fell steadily over the ensuing 12 months, to $2.80. There were further falls to around $2.20 immediately following Winterthur's sale of its 51 per cent shareholding at $2.58 per share in August 1998. Thereafter, with the exception of three brief occasions, the share price continued to fall until the company's collapse. The three exceptions involved the following:

• the completion of the FAI takeover in February 1999, when the share price rose from $2.14 to $2.30

• the sale of Oceanic Coal in July 1999, when the share price rose from $1.67 to $2.05

• the reported sale of the St Moritz Hotel in New York in November 2000, when the share price rose from $0.31 to $0.42.

HIH continued to pay dividends through the last years of its operation-13 cents (fully franked) in 1996, 15 cents (franked to 75 per cent) in 1997, 16 cents (franked to 50 per cent) in 1998, 12 cents (fully franked) in 1999, and 6 cents (fully franked) in 2000.

Taking account of both dividends and share price movements, HIH shareholders lost, on a compounding basis, around 20 per cent of their investment in each of 1997-98 and 1998-99. In 1999-2000 they lost a further 40 per cent. They completely lost their investment when HIH collapsed.

3. 7 The response to the collapse

HIH's provisional liquidation had widespread and calamitous consequences for policyholders-in addition to the loss and hurt suffered by shareholders, other creditors and employees. The effects spread quickly through the community. By the end of March 2001 the provisional liquidators made it clear there would be long delays for HIH policyholders seeking to have claims honoured. Even then, it was unlikely they would be paid in full. The liquidators' most recent estimate of the net asset deficiencies of the HIH group, as at 15 March 200 1, is a shortfall of between $3.6 billion and $5.3 billion.

Commonwealth, state and territory governments immediately came under pressure to provide assistance, and within weeks this was forthcoming. The states and territories undertook to meet most outstanding HIH builders warranty and compulsory third party claims. Best estimates at 30 September 2002 were that total payouts for these lines could ultimately amount to about $1.444 billion, based on the following break-up: New South Wales, $902.6 million; Queensland, $453.4 million; Victoria, $78.2 million; Western Australia, $6.4 million; South Australia,

62 A brief corporare hisiOI)I

$2.2 million; the Australian Capital Territory, $0.7 million; and Tasmania, $0.4 million.

On 17 May 2001 the Commonwealth announced its own scheme to help cases of 'genuine hardship ' . The centrepiece was the formation of a non-profit, insurance industry- run company, HIH Claims Support Pty Ltd, to distribute the $640 million allocated by the Commonwealth to meet claims other than for workers compensation and builders warranty. The company began operating on 1 July 2001. As at the end of February 2003, the scheme had received more than 11 400 applications and had made payments on behalf of some 5850 eligible claimants, for a total of approximately $195 million. Most claims arising from household, property, commercial and motor vehicle policies have been paid. The majority of outstanding claims are from long-tail policies, including public liability and professional indemnity.

All figures quoted in this chapter will probably be revised from time to time as the liquidation continues and as further actuarial reviews are carried out on behalf of the liquidators. HIH Claims Support's distribution services were offered to the state and territories for their aid packages. Four days after unveiling its assistance package, the Commonwealth announced that this royal commission would be established to

inquire into the reasons for and the circumstances surrounding the HIH collapse.

4

6

10

I I

12

13

14

15

16

17

Although the acronym HIH can be traced back to this name, the company did not formally change its name to include the acronym until May 1996.

CIV.001.614 at 681.

CIV.001.614 at 681.

CIV.001.690 at 755.

CIV.001.764 at 829.

CIV.001.838 at 913.

CIV.001.926 at 968. This is recorded as $A6360.5 million in the 2000 annual report: CIV.001.926 at 968.

This is recorded as $A8051.1 million in the 2000 annual report: CIV.001.926 at 968 .

CIV.001.614 at 681.

CIV.001.614 at 681.

CIV.OO 1.690 at 755 .

CIV.001.764 at 829 .

CIV.001.838 at 913.

CIV.001 .926 at 968 . This is recorded as A$2908.0 million in the 2000 annual report: CIV.001.926 at 96 8.

This is recorded as A$4688 .6 million in the 2000 annual report: CIV.001.926 at 968 .

The failure of HIH In surance 63

18

CIV.001.614 at 681. 19 CIV.001.614 at 681. 20

CIV.001.690 at 755 . 21 CIV.001.764 at 829. 22

CIV.001.838 at 913 . 23 CIV.001.926 at 968 . 24

CORE.Ol6.001.

64 A brief corporate history

4 The industry and regulatory context

Insurance is a cyclical business in Australia- just as it is elsewhere in the world. In 2000 the Australian general insurance industry had for several years been in a trough, caused by a combination of soft rates, unfortunate claims experiences, and disappointing returns on investments. These circumstances were reflected in market sentiment towards the industry, and HIH in particular.

The regulatory framework within which HIH operated in the period leading up to its failure in March 2001 had a number of shortcomings, some of which have since been resolved.

4.1 The Australian insurance market

In the year to December 2000 the top 20 insurers in Australia accounted for approximately 88 per cent of gross industry premium. The top five insurance groups listed on the Australian Stock Exchange at the time were NRMA Insurance, HIH Casualty and General Insurance, AMP General Insurance, Suncorp General Insurance, and QBE Insurance. In terms of gross premium, these five companies accounted for 44 per cent of the Australian general insurance market. Other main participants in the market were subsidiaries of foreign general insurers, among them Royal and Sun Alliance, CGU Insurance, ING-Mercantile Mutual, Allianz, and Zurich Australian Insurance.

As at December 2000, 161 private sector insurers and reinsurers licensed by the Australian Prudential Regulation Authority were writing general insurance business in Australia. 1 The general insurance industry employed approximately 55 000 people, as well as the agents and brokers who play a part in the industry.

Some general insurers deal through intermediaries; others are direct underwriters and deal directly with clients. About 975 registered insurance brokers- with a combined annual turnover of over $6 billion- service the industry.

The Insurance Council of Australia has estimated that over a typical 12-month period the general insurance industry issues around 38 million policies and receives 4 million claims. On average, the industry pays out $54 million in claims each working day. 2

In 2000 gross premium revenue was $19.6 billion- an increase of 6.8 per cent on the previous year's $18.4 billion. Claims incurred fell by 11.2 per cent, from $20.6 billion to $18.3 billion. After adjusting for reinsurance and other recoveries, claims expense and underwriting expense, the net underwriting result for the entire

Th e failure of HI H Insurance 65

general insurance industry improved from a loss of $2.9 billion in 1999 to a loss of $1.5 billion in 2000.

On a global basis, in 2000 Australia represented 2 per cent of the international market and was ranked 11th largest in the world and second only to Japan in the Asia- Pacific region.

4.2 Market sentiment

4.2.1 Industry conditions

By the mid-1990s the general insurance cycle in Australia was close to its peak. Total after-tax profit reported by listed general insurers in the year to 30 June 1996 was 80 per cent higher than for the preceding financial year. On the stock market, the insurance index outperformed the all ordinaries index and the banking index in that year.

Thereafter the cycle turned down. Low interest rates and a reduction in investment returns, coupled with a general cut in premium rates because of competition, hit the sector' s profitability. By the end of 1998 profit falls and some losses were being reported across the sector. The situation was aggravated by unusually large losses on underwriting: in the year ended December 1998 the industry reported its highest ever underwriting loss- nearly 40 per cent higher than any underwriting result in the previous 20 years. 3

This downturn in the cycle led to a consolidation in the industry: insurers merged in a bid to secure market share and extract economies of scale. It was estimated that in 1997 ten insurers accounted for 65 per cent of the Australian market, but by the end of 1998 that market share was held by five companies. 4

Competition became even more stiff because the traditional boundaries between banking and insurance were disappearing. In addition, advances in technology brought big changes across the whole financial services sector.

Other longer term concerns were also emerging. Reviews by some industry commentators drew attention tci escalating claims in long-tail classes that in some instances were not adequately reserved. These commentators estimated that by December 1998 public liability insurance was under-reserved by between $500 million and $1 billion; it was also thought that the workers compensation and professional liability classes were under-reserved.

5

This period of structural change and poor insurance returns coincided with publicity and concern about the difficulties of three big local reinsurers- GIO Australia Holdings Limited, New Cap Re, and Reinsurance Corporation Australia Limited. In the event, New Cap Re and REAC collapsed in 1999 and 2000 respectively.

66 Th e industry and regulatOty context

4.2.2 Sentiment towards HIH

In the assessments of market analysts and the media, HIH fared relatively well until early 1998. Thereafter sentiment was mixed until the second half of 2000, when it became more negative overall.

Figure 4.1 shows the movement in HIH's share price from the time of listing on the Australian Stock Exchange, in June 1992, until the company's suspension in late February 2001.

Figure 4.1

$2.50

$2 .00

HIH: share price, June 1992 to February 20016

$1 .50 +--­

$1.00

The way analysts and the media viewed HIH during its later years is outlined in this section. This is not to be judgmental with the benefit of hindsight; rather, it is in recognition of the significance of contemporaneous analysis, based on what is known or available at the time, of the way the market works in practice. Close observers' analysis and views can influence the perceptions and expectations of

investors, policyholders and others who deal with a company as well as those of regulators and other bodies with an interest in the company's affairs.

Winterthur's announcement in July 1998 that it was selling its majority holding in HIH jolted what had until then been a generally favourable, if cautious, market view of HIH. The analysts were divided in their opinions about the sale announcement. Prudential-Bache Securities and Deutsche Bank Research, for example, advised

their clients to sell their HIH shares, a position PruBache had consistently adopted since January. In contrast, Ord Minnett and ABN AMRO advised their clients to hold onto their shares, while the recommendation of Macquarie Equities and JB Were was to buy. The Age newspaper summed up the position by quoting an

Th e failure ofHJH Insurance 67

unnamed analyst: 'Rarely do you get such a dichotomy of opinion on a stock between analysts. It makes it really hard for the fund managers to decide what to do '.7

The release in September 1998 of HIH's relatively poor first-half results, and then the announcement of the bid for F AI three weeks later, further polarised opinion. For example, ABN AMRO said,

.Whil st we see the acquisition as positive, we recognise the scrip component of the bid following the sell down of Winterthur's shareholding will need to be digested by the market in the short term. More medium term, HIH will represent an attractive large cap investment

.. . We recommend Hold, with potential for upgrade on acquisition completion.8

On the other hand, Deutsche was not impressed:

We have downgraded our recommendation on HIH ... The acquisition reinforces our operational concerns regarding HIH particularly management's aggressive pursuit of top line growth . While we recognise the importance of scale in general insurance, in our view HIH have a poor track record at translating top line growth into shareholder value and we doubt this will change with the F AI acquisition since F AI has struggled for years to provide a decent return to shareholders. 9

These reports came after HIH confirmed on 4 September 1998 that it had refused some share analysts entry to a company presentation because they disagreed with management's assessment of the company. Australian Associated Press reported an HIH spokesman as saying, 'We have limited scope. We can't invite the whole market to a presentation and there are some people it is just not worth asking' .

10 The

three firms affected were PruBache, Ord Minnett and Deutsche.

When the acquisition ofFAl was completed, Standard & Poor' s downgraded HIH's credit rating from A to A- and at the same time upgraded F AI from BBB- to A-. In its report dated 22 January 1999 Standard & Poor' s said,

The rating action on HIH reflects an overall dilution of its group financial strength as a result of the acquisition of F AI, a lower rated entity of substantial size . . . Operational risk has increased post-merger, as management moves to integrate the F AI book of business and extract cost efficiencies and synergy benefits for shareholders ... The ratings outlook for HIH and F AI is stable, although operating performance should

. . h d' II Improve m t e me mm term ...

Table 4.1 shows the Standard & Poor' s rating of HIH from 17 February 1997 to 15 March 2001.

..

68 Th e industry and regulatory context

Table 4.1 The Standard & Poor's rating of HIH, February 1997 to March 200112

Date

17 February 1997

15 August 1997

27 February 1998

24 September 1998

22 January 1999

22 August 2000

13 September 2000

2 November 2000 26 February 2001

15 March 2001

Rating

AA­

AA-A: credit watch developing

A: credit watch negative

A-: off credit watch A-: credit watch developing A-: credit watch negative BBB+: credit watch negative

BBB-B: lowered and withdrawn

Despite the Standard & Poor's downgrade, most analysts looked with a degree of optimism on the enlarged company's prospects following the FAI takeover. ABN AMRO, JB Were and Merrill Lynch recommended that their clients buy HIH shares; Macquarie, Credit Suisse First Boston and Ord Minnett opted for 'hold' recommendations.

An article in the Australian Financial Review on 26 March 1999, under the heading 'New-look for HIH gets the nod from analysts', said, among other things,

HIH Insurance's earnings potential has received an upward re-rating from stockbroking analysts. The stock is tipped to outperform many of its industry peers as benefits from its $300 million F AI acquisition are realised . . . Analysts said merger-related cost savings, increased distribution and the prospect of improving investment markets could fuel a 30 per cent recovery of HIH's share price over the next year. Shaw

Stockbroking, Warburg Dillon Read and Macquarie Equities Limited all expect HIH to outperform in the long term ... Full-year profit estimates for 1999-2000 range as high as $75 million, while 2000-2001 forecasts range as high as $90 million. 13

By mid-1999 a more cautious tone was evident throughout the market as concerns emerged about HIH's profit for 1998- 99. When a profit result below expectations was confirmed on 25 August, the media coverage was critical. Under the heading 'HIH bleeds $21m of red ink', the Australian Financial Review reported, 'HIH

Insurance plunged into the red for the first time as a listed company yesterday, blaming the Government's GST and costs from its FAI merger for a dismal $21.2 million loss ' .14

The analysts were divided. ABN AMRO and JB Were maintained their 'buy' recommendation. Others were more cautious, among them Credit Suisse First Boston, which recommended that clients lighten their holding of HIH shares:

Assuming there may have been an element of 'wiping the slate clean' in this result, the future prospects of the group may be relatively brighter. However, this needs to be balanced against a tightening solvency position

The failure ofHJH Insurance 69

(especially as HIH does not carry prudential margins), falling compulsory third party rates in Australia, continued tough market conditions in the California workers compensation and London markets and a continuing adverse macro environment for the sector. 15

Deutsche was much more blunt:

The pre abnormal, post tax result came in 17 per cent below our expectations and the dividend also disappointed. Whilst the result itself was not a total disaster, in our view, the FAI acquisition has proven to be just that, with the $300 million price tag being largely wiped out by the

need for claims reserve strengthening. We retain our underperform recommendation, continuing to be concerned by management's poor track record in translating top line growth into shareholder value and the group's relatively weak capital position (solvency 41 per cent). 16

This burst of negative sentiment largely dissipated in the ensuing months. By the end of October 1999 Ord Minnett, for example, had upgraded its recommendation to shareholders to 'accumulate', noting that an extension of HIH's alliance with the National Australia Bank had increased confidence in the stock:

However, recently the share price has remained under pressure given [the company' s] poor result, concerns over Y2K, its removal from the ASX I 00 and concerns over a scrip overhang. Despite these issues we believe the market has overreacted and ignored the likely improvement in HIH's future earnings profile. 17

This more positive attitude towards HIH on the part of analysts and the media was augmented when HIH revealed on 25 January 2000 that it expected an improvement in results for the six months to 30 December 1999. The upbeat sentiment was reinforced when in March 2000 the company formally announced a profit of $40.2 million for the period. ABN AMRO, Ord Minnett and JB Were recommended that their clients buy HIH, while Macquarie and Credit Suisse First Boston

recommended that their clients hold their shares. Merrill Lynch advised its clients that there were 'signs of an improvement, but not yet enough to change our [neutral] view'. 18 Deutsche remained sceptical and reiterated the reservations it had outlined in its mid-1999 report.

Media coverage was positive. The Australian, for example, noted on 3 March 2000 that HIH had 'ridden its F AI takeover to more than double first half earnings and sees further improvements as premium rate rises start to bite'. The report went on:

HIH has managed down its expenses and claims costs relative to premium income almost to break even, at the same time as increasing revenue from the F AI acquisition and premium increases. Australian insurance companies have tended to lose money on the business of insurance but

more than make up the shortfall 'on returns from investment of premium income. 19

Reporting the half-year result, the Australian Financial Review opened its report thus: 'HIH Insurance has climbed out of the doldrums, erasing the losses of last financial year and overcoming the troubles of the sector' ? 0

Three days later, in

70 ·The industry and regulatory context

another article headed 'Fund managers place HIH at top of their fav oured list', th e paper said,

HIH Insurance is the fund managers' choice stock following the general industry reporting period which finished last week. The company's share price has tumbled in recent months but a strong performance during the six months to the end of December, alongside a takeover premium, suggests HIH may tum out to be a profitable investment ... Macquari e Investments Management's Mr Stuart Turner nominated HIH as the company with the most upside. ' People have totally under estimated

management. They had a good result,' he said. ' People are al so over­ estimating the amount of non-core assets they have on their books. ' 21

This period of generaily favourable media coverage of HIH was to end more or le ss permanently from late May 2000, coinciding with a sharp fail in the price of HIH shares. On 26 May The Australian published a damaging assessment of the company under the headline 'Flailing HIH has only itself to blame'. The article began,

Ray Williams finds his HIH Insurance once again out of favour in the market as the group struggles to convince investors it has a strategy against a backdrop of a darkening earnings outlook.

HIH, however, must bear the additional burden of being perceived to be poorly run by an entrenched management team led by Williams. It has also failed to extract the potential synergies from its three acquisitions since it listed as CE Heath in 1992 and is still suffering from the over-payment for F AI Insurance early last year.

HIH also uses a controversial policy of using retrocession to protect its underwriting exposures rather than the more accepted method of maintaining a prudential margin of about 10 per cent above provis ion s. It is regarded as under-provisioned as a result. 22

Four days later, another report in The Australian asserted that HIH had rebuffed two possible buyers for the company. Under the heading 'No one buys HIH bid silence', the report began,

As HIH shares hit a new low yesterday of $1.14, shareholders will draw little consolation from knowing that bancassurance group Suncorp­ Metway offered $1.70 a share in an approach to the underwriter's senior management six weeks ago.

The Queenslanders will be relieved now that HIH chief executive Ray Williams sent them on their way. They had the temerity to make the offer conditional on a full due diligence investigation ofHIH .

. . . Shareholders will be even more aggrieved to learn that the giant US underwriter Liberty Mutual approached HIH two years ago with an offer of $2.40. Williams sent the Americans on their way too because they also wanted to have a good look at the HIH books.

No doubt shareholders would have been keen to accept either of these exploratory offers had they been given the chance, but they were not told.

Th e failure ofHJH Insurance 71

... HIH is now in trouble, certainly in the minds of the market and the insurance industry. 23

A similar line was taken in another article the following day. HIH issued a statement denying the substance of the report and stated that it had referred the articles to its lawyers.

From this point until the collapse of the company in March 2001, media coverage of HIH was generally negative. Market analysts continued at first to be divided in their views. Coinciding with a small rally in the share price in early June, Ord Minnett, for example, reiterated its 'accumulate' recomrnendation .Z4 But, as the focus turned to the full-year result, others were less sanguine. The Australian Financial Review reported on 11 July 2000 that both UBS Warburg and Salomon Smith Barney had downgraded their recommendations: 'It appears that the rate increases that were so enthusiastically spoken about at the first half result have failed to materialise', the UBS Warburg spokesman was quoted as saying. The Salomon Smith Barney spokesman was reported as saying, 'While the stock now appears extremely cheap, we believe HIH has greater than average investment risk'.25

Credit Suisse First Boston was more hesitant in its report to clients on 13 July 2000, maintaining its 'hold' recommendation:

The company's offshore operations (with the exception of New Zealand) continue to limit significant performance improvements for the company ... Positively, HIH management's recent focus on diversifying its business lines via acquisition have delivered a more desirable business mix ... We believe management's transparent approach in cleaning up the F AI book is positive and it appears that the company is ready to enter a new phase of organically driven growth.26

Two developments in August and September appeared to tip the scales against HIH in the eyes of most analysts: the full-year results for 1999-2000 were well below expectations; rumours emerged that HIH was looking for a partner for its general insurance business.

On 13 September 2000- after the shares had been suspended from trading for a day prior to the announcement of the Allianz deal and the annual result- Standard & Poor's revised its credit watch on HIH to 'negative'. Media reaction to the Allianz joint venture was highly critical. A report in The Sydney Morning Herald of

14 September, under the headline 'Forced deal hits HIH shares', began,

HIH Insurance's shares slumped more than 17 per cent yesterday after the company was forced to cede control of its Australian retail general insurance operations to Germany's Allianz in an effort to restore its ailing balance sheet and meet tougher regulations?

7

The Australian Financial Review reported the HIH news under the headline 'Deal buys time for insurer as it sells best part of the business' . A second article in the same edition ended by quoting an unnamed market analyst as saying, 'This is the tip ofthe iceberg. This business is haemorrhaging'.28

72 Th e industry and regulatory context

On the same day both Credit Suisse First Boston and Ord Minnett downgraded their assessment of HIH shares. 29 The flow of negative media stories continued, as did the slide in HIH shares. On 12 October 2000 Williams resigned as chief executive and foreshadowed his departure from the HIH board. The Australian, the Sydn ey Morning Herald and the Australian Financial Review, whose syndicated reports dominated the national news coverage of the story, all emphasised that HIH was

now in deep trouble.

But at least one market analyst, Ord Minnett, upgraded its recommendation from 'hold' to 'accumulate'-albeit briefly-on the strength of Williams's resignation: 'Yesterday's 21 per cent rebound in HIH's battered share price highlights the positive market reaction to the departure of Williams and the Board

restructuring ... ', its report said. 'A changed management and board is a step in the right direction, however HIH is far from out of the woods' .30 This would appear to be the last upgraded recommendation on HIH shares by any of the market analysts. It was reduced to 'hold' on 6 November and further reduced to 'lighten' on

20 November.

JB Were, one of the more consistent supporters of the stock, had removed its 'buy' recommendation after the company's 13 September announcement of the Allianz joint venture and the poor annual result. From about the end of 2000 until HIH's collapse in March 2001 market analysts and investors progressively withdrew any

remaining support for the company.

4 .3 The regulatory framework

Private sector general insurers are regulated under the Insurance Act 1973. Organisations wishing to provide general insurance products in Australia are required to meet certain minimum standards of solvency, behaviour and corporate structure in order to be and remain licensed by the Commonwealth prudential supervisor. At the time HIH failed, in March 200 I, the minimum solvency standards required general insurers to have total assets exceeding total liabilities by not less than $2 million, 20 per cent of net premium income, or 15 per cent of net outstanding claims, whichever was the greatest. In addition, reinsurance arrangements had to be approved by the prudential regulator.

For insurers incorporated in Australia, these tests had to be met on both an 'inside Australia' and a global basis. Branches of foreign insurers were required to meet the tests as they applied to their Australian business.

Until 1998 the prudential regulator was the Insurance and Superannuation Commission, whose responsibilities included the licensing and supervision of general insurers. The Insurance Act provided the ISC with various licensing and investigative powers, along with the ability, in certain circumstances, to give

insurers directions in defined areas of their operations. The ISC was also responsible for advising government on prudential and other matters related to the insurance

The failure ofH!H Insurance 73

sector, such as disclosure standards and market conduct. It was also responsible for handling consumer complaints and for the licensing of insurance agents and brokers.

In 1998, in response to the report of the Financial System Inquiry-the Wallis report-the Commonwealth established the Australian Prudential Regulation Authority to be the sole body responsible for the prudential regulation of entities providing deposit-taking, general insurance, life insurance and superannuation services . in Australia. APRA began operations on I July 1998 and took over the prudential supervisory roles previously handled by the Reserve Bank of Australia and the ISC. In late 1998, APRA's head office was established in Sydney. Responsibility for state- and territory-regulated deposit-taking institutions (such as building societies and credit unions) was transferred to APRA on 1 July 1999.

APRA was established by the Australian Prudential Regulation Authority Act 1998 as an independent statutory authority with a governing board. It is responsible for the prudential regulation of financial institutions and for developing policy to be applied in performing that role. The Act requires APRA to balance the objectives of promoting financial safety and efficiency, competition, contestability and competitive neutrality.

4.3.1 Changes to the regulatory regime

A review carried out by the ISC in 1995 (and carried forward by APRA and the Commonwealth government) led to the passage on 19 September 2001 of the General Insurance Reform Act, which brought marked changes to the prudential regulatory regime applying to general insurers. The new regime came into effect on

1 July 2002. Among the more important changes were the following:

• an increase from $2 million to $5 million in the minimum capital requirement for general insurers

• the introduction of risk-weighted capital solvency requirements such that high­ risk activities would need to be supported by more capital

• the imposition of a conservative insurance liability valuation standard, including the requirement for a prudential margin. Previously, general insurers followed accounting standard AASB 1023 and provisioning practices varied

• a requirement that the board of each insurer approve an appropriate, formal reinsurance-management strategy. The previous requirement for formal approval of reinsurance arrangements by the regulator was dropped

• a general tightening of corporate governance and other management requirements-such as the requirement for insurers to adopt formal risk and other management strategies and more stringent 'fit and proper person' tests for directors, senior managers, auditors and actuaries

• for auditors and actuaries, the imposition of greater controls and requirements.

7 4 The industry and regulatory contexl

4.3.2 The Corporations Law

A national system of law and regulation for corporations and the securities market was introduced by the Commonwealth, with effect from 1991; it replaced the previous cooperative Commonwealth-state scheme and arrangements. The new Corporations Law regulated the operation and market conduct of corporate entities, and the Australian Securities Commission was established with regulatory powers.

The Corporations Law- now the Corporations Act 2001 - underwent a number of amendments during the 1990s, as a result of various review processes. Following the Wallis report, the corporate regulator, the Australian Securities Commission, became the Australian Securities and Investments Commission as from 1 July 1998 and was given additional responsibility for the consumer protection-related functions of the ISC and the Australian Payments System Council (a non-statutory

body responsible for advising the Treasurer on the development of the payments system).

ASIC is an independent statutory agency headed by an executive commission of up to eight members, although it normally operates with three members. It is required under its legislation to monitor and promote market integrity and consumer protection across the financial system. It is also responsible for the registration of auditors and liquidators and the regulation of financial services organisations and professionals who deal in and provide advice on investments, superannuation,

insurance, and deposit-taking and credit services.

4.3.3 Th e Au stralian Stock Exchange

The Australian Stock Exchange supervises companies (including private general insurers) that are listed on the exchange. Listed companies are required to comply with the ASX Listing Rules, which have statutory authority. The ASX has a particular focus on the disclosure practices of listed entities, including through the continuous disclosure regime. These arrangements are designed to ensure that the market is well informed and efficient. The ASX does not have a role in policing statutory financial reporting or accounting standards.

4.3.4 Accounting and auditing standards

The Corporations Act lays down financial reporting requirements for companies; one such requirement concerns compliance with relevant accounting standards in the preparation of financial statements. The purpose of the accounting standards is to ensure that companies report financial information that is accurate, reliable and comparable (both between companies and over time) so that, among other things, people and organisations can assess the performance and financial position of the

reporting entity. Responsibility for the development and promulgation of accounting standards lies with the Australian Accounting Standards Board.

The Corporations Act stipulates that companies must keep financial records that allow true and fair financial statements to be prepared and audited. The financial

The failure of HIH Insurance 75

statements must comply with accounting standards and give a true and fair view of the financial position and performance of the entity.

The Act also imposes on most companies a requirement to have their financial statements audited by a registered auditor. This process involves the examination of records or financial accounts-to determine their accuracy and whether they comply with relevant standards and give a true and fair view of the financial position of the company. Auditing standards are set by the Auditing and Assurance Standards Board, which is supported by the Australian Accounting Research Foundation, a private sector body established in 1996 by CPA Australia and the Institute of Chartered Accountants in Australia. Unlike the accounting standards, auditing

standards do not have the force of law.

4.3.5 Actuarial standards

In almost all cases the primary liability of a general insurer is its outstanding claims provision. Broadly speaking, this provision is an estimate of the cost of the outstanding claims that an insurer is liable to meet under existing contracts. The accuracy or otherwise of the estimate can have a significant effect on an insurer's reported profit; it is also important for use in pricing and designing insurance products.

Before 1 July 2002 general insurers were not required to use an actuary to estimate the outstanding claims provision, although it was becoming a common practice. From that date, however, using the services of an approved actuary has been mandatory, unless an insurer is granted an exemption by APRA.

Under APRA's prudential standards, the approved actuary is generally expected to be a member of the Institute of Actuaries Australia (a private professional body of actuaries) or a similar professional body. The standards also impose a professional responsibility on the approved actuary to provide advice that complies with the institute's professional standards. The institute has issued professional standard PS 300 'Actuarial reports and advice on general insurance technical liabilities', which its members are expected to meet in calculating the outstanding claims provision and other technical liabilities of an insurer.

4.3.6 State and territory regulation

In addition to Commonwealth legislation, all state and territory governments operate statutory insurance arrangements-for example, requiring relevant people and organisations to take out compulsory third party motor vehicle insurance, builders warranty insurance, and workers comf>ensation. Insurance is provided under these schemes through a mix of state-owned and -operated insurers and private general

msurers.

In some cases where insurance is provided through a private general insurer, a state or territory government will maintain some form of prudential regulation to provide

76 Th e industry and regulatory context

its own assurance that the insurer remains able to meet its obligations to its statutory policyholders. This regulation is additional to APRA's supervision. Further, where private general insurers provide statutory insurance, state and territory government bodies usually regulate or license those insurers in relation to contract conditions, coverage, reporting and pricing.

Chapter 8 of this report discusses the regulation of general insurance in terms of future policy directions. Chapter 24 discusses the role of the regulators in connection with the failure of HIH.

4

6

9

10

II

12

13

This excludes companies providing only life or health insurance. CORE.041.001. SBB.020.404 001. PURE.0004.188.

SBB.020.404 00 l. Australian Stock Exchange. PURE 0001.330. SBA.070.733 001. PURE 0004.173. PURE.OOO 1.318. PURE.0004.200 PURE.0004.002 at 252; SBA.227.028_00l.

PURE.OOO 1.184. 14 PURE.0001.189. IS

PURE.0009.015. 16 PUR£.0004.204. 17

PUR£.0002.077. 18 PUR£.0012.077. 19

PURE.OOO 1.060. 20 PURE.0001.161. 21

PURE.0001.105. 22 PURE.0001.061. 23

PUR£.0001.062. 24 PURE 0002.114. 25

PURE.OOO 1.00 1. 26 PUR£.0009.009. 27

PURE.0001.035. 28 PURE.0001.119 and PURE.0001.120. 29

PURE 0009.006 and PURE.0002.121. 30 PURE.0002.127.

The failure ofHJH Insurance 77

5 Provisioning and reinsurance: general principles

The provision for outstanding claims is a critical aspect of the accounts of any general insurer. In most instances-and certainly in the accounts of HIH- the allowance for outstanding claims is the largest single item on the liabilities side of the balance sheet. It is critically important to the financial condition of an entity; it also has a direct impact on the level of profit or loss declared in the revenue statements.

The way HIH estimated and accounted for its outstanding claims was a primary reason for the company's failure, so it is important to look at the general principles relating to the provision for such claims. Much of Section 5.1 is based on a 19 March 2002 report prepared by Estelle Pearson. 1

In Australia insurers must prepare at least three different sets of accounts. One set is commonly called the 'statutory accounts' and is governed primarily by the Corporations Act 2001 and the Australian accounting standards. The second set is designed to satisfy the obligations insurers have under the prudential regulatory framework-that is, the Insurance Act 1973 and the prudential standards issued under it. Insurers must also comply with the requirements of taxation legislation. The accounting and reporting obligations differ for each set of accounts.

This chapter also sets out some general principles on the subject of reinsurance; this is because reinsurance is widely used by general insurers to manage underwriting and financial risk. One purpose of reinsurance is to transfer the risk of future adverse developments in relation to claims. Reinsurance is thus important when the level of outstanding claims provisions and other matters affecting the financial statements of an insurer are being considered.

5.1 Provisioning

The language of insurance and accounting in the area of provisioning tends to be confusing because the terms 'reserves', 'liabilities' and 'provisions' are often used interchangeably.

There is, however, a distinction between outstanding claims liabilities, or OCL, and outstanding claims provisions, or OCP. The 'liability' is the unknown actual value of outstanding claims; because it is unknown, it must be estimated. The 'provision' is the amount set aside in the accounts to cover the liability. The distinction is

recognised in the applicable accounting and actuarial standards, but usage varies,

The failure ofHIH Insurance 79

often without regard to that technical distinction. In general, this report observes the distinction between OCL and OCP, although because the terms were used interchangeably in the evidence to the Commission and in documents available to it there are numerous departures from the general rule.

An estimate of the OCL is an estimate of the sum needed to settle all claims that have been incurred but that, for whatever reason, have not yet been paid. It arises because there are delays in notifYing claims to insurers and in settling claims.

In insurance and accounting language, the words 'provision' and 'reserves' are often, but not always, used interchangeably. 'Reserve' is apt to describe an allocation made from after-tax profits not distributed to the owners but set aside for particular or general purposes. In the insurance industry, however, it may refer to a number of things:

• the provision made on the balance sheet for the OCL

• depending on the context, an actuarial estimate of the OCL to a particular level of sufficiency

• depending on the context, estimates recorded in the general ledger for either known claims (case reserves) or known claims and unreported claims.

When insurers speak of 'strengthening reserves' they may mean correcting an earlier underestimate of their outstanding claims liabilities. Again, because the term 'reserves' was often used in the evidence presented to the Commission to describe what is, strictly speaking, an OCL or an OCP, this report is replete with similar references.

5.1.1 The components and significance of outstanding claims provisions

There are four identifiable components of outstanding claims provisions:

• Reported outstanding losses. This refers to claims that have been reported to the insurer but which have not been finalised by the reporting date. An example is a personal injury claim awaiting litigation. The liability will generally be included in the insurer's case estimates (see Section 5.1.2).

• Incurred but not reported claims. IBNR is used to resolve the problem that arises when an event has occurred and will give rise to a claim but the claim has not been notified or reported to the insurer by the reporting date. An example is a claim involving a latent disease such as asbestosis, where there is often a long delay between the occurrence or · the event giving rise to the claim and the manifestation of the loss resulting in a claim being notified. There can also be a significant IBNR in short-tail classes: this might occur, for example, if a major event such as a hai lstorm were to happen just before the reporting date. The IBNR liability can only be estimated using statistical methods.

80 Provisioning and reinsurance: general principles

• Incurred but not enough reported losses. IBNER is concerned with the development of case estimates on reported claims and means that initial case estimates are often insufficient. For example, a long-tail claim might be affected by inflation:

• Claims-administration expenses. This is an amount representing the insurer's unallocated or indirect costs in settling or managing the claim. The allocated claims settlement expenses (for example, legal costs) are normally contained in case estimates, IBNR and IBNER amounts.

Each of these elements-and therefore the total OCP figure-can only be an estimate. It is not a hard figure and so is essentially a matter of judgment. Nonetheless, it is important that the amount allocated to the balance sheet as a provision for outstanding claims is substantially correct; there are at least three reasons for this.

First, an increase or decrease in the OCP from one reporting period to another is an expense item deducted from revenue or an addition to revenue in the matching process underlying periodic profit measurement. If the provision is understated, profit will be overstated; if the provision is overstated, profit will be understated. A small percentage variation in the OCP (because it is usually such a large figure) can have a major impact on the level of profit or loss.

Second, under-provisioning can overstate solvency in the balance sheet; that is, if provisions are understated this can give a misleading impression of the value of shareholders' funds and threaten the solvency of the insurer.

The third area of significance lies in the influence OCP has on premium setting. Because claims are the largest cost item for an insurer, they are an important element in the pricing of risk. If outstanding claims estimates cannot be developed with reasonable accuracy, any consequent underpricing (resulting from inaccurate forecasting of the costs of claims) may not become apparent until the under­ provisioning has been identified. This will not occur until the estimates are revised, and by then it may be too late to make any meaningful change to the pricing structure.

The vital importance of the OCP in the structure of a general insurer is evidenced by the fact that it is recognised in the legislation governing the prudential regulation of the industry. The Insurance Act 1973 was radically amended with effect from 1 July 2002. The amendments and the prudential standards issued under the Act have had a major impact on actuarial practice and the way general insurers approach accounting matters, including OCP. It is necessary here, however, to describe the conditions that applied before the amendments and the introduction of the new prudential

standards because the events with which the Commission is concerned happened under the old legislative regime.

The failure of HIH Insurance 81

The unamended Act dealt with provisions in several sections. Section 31 provided, relevantly:

(2) For the purposes of this Act, a body corporate carrying an

insurance business shall make in its accounts provision in respect of liabilities.

(3) For the purposes of this Act, [the Australian Prudential

Regulation Authority] may, at any time, if it thinks fit, by notice in writing, direct that the body corporate shall . . . make in its accounts provision, or further provision [of a specified amount or of an amount determined in a specified manner] in respect of liabilities.

It did not, however, specify either the range of liabilities for which provision must be made-for example, unearned premium, unexpired risk, and outstanding claims--or the methods companies must use to derive such estimates.

Under s. 48 of the Act, the Australian Prudential Regulation Authority could require that an authorised company have an independent actuarial evaluation of its OCP conducted and that a copy of any such independent report be provided directly to APRA.

All authorised insurers must at all times maintain mm1mum solvency margins. Before 1 July 2002 the relevant statutory provision was s. 29(b ), which provided that APRA might authorise a body corporate to carry on an insurance business on condition that the value of its assets at all times exceeded the amount of its liabilities by not less than the greater of:

• $2 million

• 20 per cent of its premium income during the preceding financial year

or

• 15 per cent of its outstanding claims provisions.

The combination of s. 44 and Regulation 11 of the Insurance Regulations required an insurer to lodge with APRA accounts and returns that disclosed, among other things, a statement of the provision made for claims and the cost of meeting those claims.

5.1.2 Measuring outstanding claims provisions

There are many ways an insurer can assess its liabilities for claims that will arise in the future.

Insurers generally establish case estimates for claims that are reported. The amount included in the estimate will be assessed by the claims manager on the basis of technical knowledge, experience and legal advice. The case estimate can change during the term of a claim as further information becomes known. Although the

82 Provisioning and reinsurance: general principles

primary purpose of case estimates is to assist in claims management, they are an important resource for the evaluation ofOCP.

The case estimates method is generally satisfactory for short-tail classes, where the claim is settled quickly and the amount of the claim is usually clear-cut. It may also be suitable if there is potential for a significant disparity between the size of claims-such as in the professional indemnity and public liability portfolios. The accuracy of case estimates in respect of those portfolios is most important from an actuarial perspective.

Case estimates are generally established and maintained by claims managers, who may have no actuarial qualifications or experience. In the past couple of decades the ro le of actuaries in the setting of OCP has increased markedly. Case estimates are established on individual claims, taking into account the specific circumstances and

information of the claim. But an actuary seeks to estimate the total outstanding claims liability on a portfolio-wide basis. In doing so, he or she (unlike the claims manager) will make allowance for IBNR, IBNER, future claims inflation, discounting and claims-administration expenses.

A number of different actuarial methods exist. The actuary's choice of a method or methods will depend on the type and size of the portfolio and the quality and availability of the data. All methods have in common the fact that aggregate data are used, rather than information on individual claims. The methods also have in common at least two other characteristics: first, they attempt to find a consistent claims run-off pattern that has applied in the past; second, they apply that pattern, with adjustments for anticipated future changes, to estimate the run-off of claims that have been incurred but remain outstanding.

Actuarial methods do not guarantee a correct estimate of the outstanding claims liability. The results are dependent on the actuary's interpretation of the trends evident in past experience and assumptions made about future experience. Past consistency in claims trends can be abruptly disturbed and the actual outcome of the

outstanding claims liability will reflect any changes in trends.

Whatever actuarial methods are used, explicit assumptions need to be made about certain aspects of the claims experience-for example, the number of IBNR claims reported, the level of claim payments made and the level of future inflation, all of which are based on examination of past claims experience. In this way, the appropriateness of the assumptions can be checked each year and adjustments made as necessary.

Another feature common to actuarial methods is that they rely on the existence of a 'critical mass' of past data. The data are compiled in so-called triangular format, whereby the experience of past accident periods is compiled at each development period up to the current one.

The failure ofH!H Insurance 83

There is no standard or mandated actuarial method, although several-such as chain ladder, payments per claim incurred, payments per claim finalised, projected case estimates and Bomhuetter-Ferguson-are commonly used in the industry. 2

5.1.3 Central estimates and prudential margins

Before I July 2002-and thus during the period relevant to the Commission's work- a general insurer could choose to calculate its OCP using a central estimate or by applying a prudential margin. The central estimate is the mean of the distribution of possible outcomes; in other words, it is the figure that has an equal chance of being right or wrong. Or, put slightly differently, it is the figure that has a 50 per cent chance of being sufficient and a 50 per cent chance of being insufficient to accord with future claims experience.

If, however, the insurer chooses to calculate its OCP using a percentile that is higher than 50 per cent, the difference between the central estimate and the figure so calculated is called the 'prudential margin' . The rationale behind using a prudential margin is that there is inherent uncettainty in making an estimate of liabilities for outstanding claims; it is a more cautious approach.

If a prudential margin is applied it has an effect on both the balance sheet and the profit-and-loss statement. In relation to the former, it simply increases the OCP and therefore reduces net assets. In contrast, inclusion of a prudential margin will have no effect on the profit-and-loss statement because ultimately the profit or loss on any class of business will depend on what premium income was received, what was earned on that revenue, what expenses were incurred, and what was paid on claims. It will, however, have a timing effect by delaying the recognition or emergence of profit and, as a consequence; the availability of funds from which dividends can be paid. This reduces the chance that dividends might have been declared and paid in earlier years when experience in subsequent years demonstrates that the estimates of outstanding claims were insufficient.

In a regulatory regime where a prudential margin is not mandatory, an insurer, having once made additional provision, can in a later year release the margin in whole or in part. The release . would have an immediate impact by reducing liabilities in the balance sheet and by increasing profit or decreasing loss in the revenue statements.

With some rare exceptions in particular portfolios and branches, HIH (and F AI before it) reserved to the central estimate and did not apply a prudential margin. Where prudential margins had been used they were released in the years leading up to the demise of the company.

84 Provisioning and reinsurance: general principles

5.1.4 Relevant accounting and actuarial standards

AASB 1023 is the approved accounting standard for the financial reporting of general insurance activities. In various parts of this report much is said about this standard, most of it not complimentary. This section deals only with those aspects of the standard that cover OCP.

Under paragraph 5 of AASB 1023, an insurer's provision for outstanding claims must be recognised as a liability as soon as it is identified. It must be measured as the discounted present value at the balance date of projected future payments on outstanding claims. In arriving at a figure for OCP, an insurer is required to include allowances for IBNR, IBNER, future direct claims-settlement costs, and future

indirect claims-settlement costs. It must also take into account the impact of future inflation on settlement costs. Estimates of IBNR, IBNER and settlement costs are to be based on past claims experience.

In relation to discounting, paragraph 5.3 requires the use of a discount rate that is the market-determined risk-adjusted rate of return appropriate to the insurer. (Discounting is discussed in Section 5.1.5.)

The accounting standard also has something to say about the way OCP and reinsurance interact. Reinsurance is a process whereby a second insurer, in consideration of a premium, agrees to indemnify a first insurer against a risk insured by the first insurer in favour of an insured. General insurers often take out

reinsurance to protect against adverse development of OCP. By virtue of paragraphs 7.1 and 10.6 of AASB 1023 , however, the insurer is required to account for both OCP and reinsurance recoveries on a gross basis. It is not permitted to set off the recovery under the reinsurance arrangement (an asset) against the OCP (a

liability) and thereby reflect in the balance sheet a lower level of liabilities. This is so even though the net effect on the 'bottom line' might be the same. The rationale (as reflected in paragraph 7 .1.3) seems to be that it will help a reader of the financial statements to form a view as to the extent and effectiveness of the reinsurance arrangements.

The effect of the accounting disclosures required by AASB 1023 is that at each balance date an insurer must have a projection of the undiscounted amount of claim payments in future years in respect of outstanding claims at the balance date. This projection is required both gross and net of reinsurance and other recoveries, and it must be adjusted to allow for the discounting of projected claim payments to present values.

AASB 1023 does not require that OCP be calculated by an actuary; nor does it directly address the question of whether prudential margins can or should be included in balance sheet provisions for outstanding claims. The evidence before the Commission suggested that it was common in Australia for outstanding claims provisions to include a prudential margin. No witness suggested that prudential

margins were not allowable under AASB 1023.

The failure of HIH Insurance 85

Nonetheless, if AASB I 023 is to be interpreted in accordance with Statement of Accounting Concepts 43, considerable doubt arises about whether it permits-let alone requires-the inclusion of a prudential margin. The definition of' liabilities' in AASB I 023 is 'future sacrifices of economic benefits that the entity is presently obliged to make to other entities as a result of past transactions or other past events'.

SAC 4 provides (in paragraph 65) that a liability should be recognised in the statement of financial position when and only when:

• it is probable that the future sacrifice of economic benefits will be required

and

• the amount ofthe liability can be measured reliably.

The commentary attached to this statement (paragraph 67) says that the term 'probable' means that the chance of the future sacrifice of economic benefits being required is more likely rather than less likely.

To the extent that there is a margin over an estimate that is considered to have an equal chance of being sufficient or insufficient, it cannot be said that there is a 'probability' that a future sacrifice of economic benefits will be required to satisfy an existing obligation. Even without regard to SAC 4, it is difficult to classify a prudential margin as a provision for a liability, as defined. Rather, it is a provision to reflect the uncertainty in the valuation. Nothing in AASB 1023 says that the uncertainty in the valuation is something that should or can be valued and included as a liability.

This is a deficiency in AASB I023; it is discussed further in Chapter 7. It is a deficiency that has been largely, and perhaps wisely, ignored-as evidenced by the widespread practice of general insurers including a prudential margin.

It should be noted that schedule 2J of the Income Tax Assessment Act 1936 provides that a provision for outstanding claims will be tax deductible regardless of whether it includes a prudential margin.

Since May I994 the actuary's role in setting the OCP has been governed by a professional standard issued by the Institute of Actuaries of Australia and designated PS 300. The standard applies to actuaries making an estimate of the outstanding claims liabilities of a general insurer and providing advice on the balance-sheet or tax provision to be set aside to meet the liability. It describes in general terms the process the actuary must follow in carrying out the valuation. Paragraph I6 of the standard describes nine steps an actuary should take. The standard also specifies the items the liability estimate must include- that is ,

inflation, discounting and claims-administration expenses-but it is not prescriptive in terms of the valuation model or the specific assumptions to be adopted.

86 Provis ion ing and reinsurance: general principles

Under paragraph 6 of the standard the actuary is obliged to include an allowance for the present value of the insurer's internal costs of administering and settling claims. Paragraph 3 7 is also relevant:

Appropriate allowance for the future costs of administering and settling claims (in addition to those included in payments on individual claims) should be made having regard for the insurer's level of expenses, organisational structure and future administrative development. The complexity of the approach used to determine the allowance should be commensurate with the materiality of the amount of the allowance.

The actuary is required, where possible, to make a central estimate of the outstanding claims liability. But paragraphs 45 and 46 of the standard note that it is usually desirable to apply a prudential margin because of the uncertainty inherent in making an estimate of the outstanding claims liability. It is thus a matter of judgment whether and to what extent a prudential margin should be applied. Matters

such the actuary's confidence in the valuation approach and assumptions, the quality and depth of historical data, statistical fluctuations affecting ultimate claim costs, and actual outcomes of past provisions are specified as relevant considerations.

That said, the standard makes it clear that it is the directors of the entity- not the actuary- who have ultimate responsibility for the size of the provision and whether to reserve to the central estimate or adopt a prudential margin. In addition, paragraphs 4 7 and 48 make it clear that the actuary must not recommend or support a provision that is less than the central estimate or is excessive.

My doubt about whether AASB 1023 , when read with SAC 4, permits the inclusion of a prudential margin does not affect the responsibility of directors to assess whether the insurer has sufficient capital to protect the company and its policyholders against an inadequate OCP and to assess the risks of inadequacy.

5.1.5 Specific elements within OCP

Superimposed inflation The concept of economic inflation is well known: it is reflected in our everyday experience of rising prices for the goods and services we buy and in the rising costs of labour. But there is another type of inflation-called 'superimposed' or 'social'

inflation-that sits on top of economic inflation in its application to the liabilities of a general insurer.

Particularly with long-tail claims, there might be a delay of many years between the occurrence of an event, its notification and the settlement of the claim. During that period the liability the insurer must eventually meet will be subject to an evolving environment, which could affect the amount to be paid. Circumstances such as court

awards becoming more generous, changes to the law, and medical or other recoverable costs appreciating at a rate in excess of economic inflation could add significantly to the amount needed to settle the claim. This is superimposed

The failure of HIH Insurance 87

inflation. It is recognised in paragraph 33 of PS 300, and an actuary is required to take it into account. It is also recognised in paragraph 5.1.2 of AASB 1023.

Discounting of claims

For statutory and regulatory accounting purposes, both outstanding claims and reinsurance recoveries must be discounted to reflect net present value. This requirement stems from the view that the liability for outstanding claims ought to reflect the amount that, if set aside at the reporting date, would accumulate so as to enable the insurer to pay the amount of the claims as they fall due.

As noted, discounting is required by paragraph 5.3 of AASB 1023 and the discount rate is to be selected by reference to market-determined risk-adjusted rates of return appropriate to the insurer. AASB 1023 states that the estimated rates being earned on existing assets may be indicative of market-determined risk-adjusted rates of return appropriate to the insurer. Estimated rates of return must reflect the expected investment performance for the period to settlement on the amount of funds needed to meet claims liabilities as they fall due. The Australian Accounting Standards Board advised the Commission that discounting by an amount that is expected to be earned up to the time the insurer must meet claims and related costs can be considered appropriate. 4 The question of its appropriateness is discussed in Chapter 7.

PS 300 also has something to say on the subject. Paragraph 35 provides that an actuary should use the risk-free rate of return as a starting point for determining the appropriate discount rate. If the actuary does not, the reason for adopting a higher or lower rate should be explained. In paragraph 13 , a 'risk-free rate of return ' is defined as the expected rate of return on a matched portfolio of investments with minimal risk.

PS 300 also refers the reader to accounting guidance release AAG 13 , entitled 'Determining of interest rates for measuring certain liabilities at present value'. The release's starting point is much the same as that of the accounting standard. The release notes, however, that if a discount rate based on the anticipated rate of return cannot be reliably determined, the rates can be determined by making one of two assumptions:

• that the assets set aside to settle liabilities as they fall due are high-quality, essentially risk-free securities

• that the liabilities could be discounted at a rate applicable to such securities. Such a rate might be determined by reference to the rate attaching to Commonwealth Government- guaranteed securities; if so, the rate should be that applicable to securities that match as closely as possible the term to maturity of the related liability.

It is of note that the requirement to discount to net present value does not apply in other jurisdictions in which HIH operated- for example, the United States and the United Kingdom. Of course, the provisions of branches or operations in

88 Pro visioning and reinsurance: general principles

jurisdictions other than Australia had to be discounted before being included in the consolidated accounts of HIH. It was the practice of the HIH actuary to use a single rate to discount outstanding claims figures, whatever their jurisdictional origin.

Future claims-handling costs Future claims-handling costs typically include items such as internal claims­ handling department salaries, property costs and other operating costs; it also includes a proportion of human resources, central management, finance, and information technology costs relating to claims handling.

The wording of paragraph 37 of PS 300 suggests that future claims-handling costs should be based on the actual experience of the entity concerned, rather than, for example, on an assessment of what a third party might charge the entity if the claims-administration function were to be contracted out on a run-off basis.

The significance of assumptions on specific elements People with responsibility for estimating the OCP must make assumptions or judgments about individual items; the inflation rate, the discount rate and future claims-handling costs are three such instances. Because the OCP is usually such a

large figure, small variations in the assumptions can have a significant impact on the end result.

5.1.6 The actuary and the auditor

It has become common practice in Australia for general insurers to have actuaries as full-time members of staff and also to engage external actuaries as consultants. This was the case with HIH, and with F AI before it.

There is no statutory obligation of independence applying to an actuary. However, both internal and external actuaries should operate in accordance with the code of conduct issued by the Institute of Actuaries of Australia, which provides, among other things, that all actuarial advice must be unbiased. Any constraints on the

independence of the advice must be disclosed to the recipient of that advice. Guidance note no. 1 to the code explains why:

The ability to provide advice which is independent is fundamental to the public's regard for any profession . It follows that for an Actuary in a particular situation to describe the advice offered as independent, the Actuary must be free, and must be seen to be free, of any influence of constraint which might affect the advice ... An employed Actuary must consider carefully the extent to which advice offered can properly be

claimed as independent or solely in the client's interests.

The relationship between actuaries and auditors in circumstances such as those pertaining to HIH is governed by auditing standard AUS 524, entitled 'The auditor's use of the work of an actuary and the actuary's use of the work of an auditor in connection with preparation and audit of a financial report'. Actuarial guidance note

no. 551 is in identical form. They were prepared jointly by the Auditing Standards

The failure ofH!H Insurance 89

Board and the Institute of Actuaries and have been operative for reporting periods beginning on or after 1 July 1996.

AUS 524 uses the terminology of the 'reporting professional ' (being the auditor or actuary, as the case may be, who is using the work of the other) and the 'specialist professional' (being the auditor or actuary, as the case may be, whose work is being used by the other). In paragraphs 9 and 10 the responsibilities of the actuary and auditor are explained in the following terms:

The preparation and presentation of a financial report of an entity is the responsibility of the governing body. The representations contained in the financial report may include amounts determined by the actuary or based upon actuarial valuations. Circumstances may arise where the actuary may have a responsibility to express an opinion about the appropriateness of such amounts. In such circumstances, the actuary would consider whether to use the work of the auditor with respect to the accuracy and

completeness of the. data used to determine the amounts. In this situation, the actuary acts as the reporting professional and the auditor acts as the specialist professional.

The auditor is responsible for forming and expressing an opinion on a financial report. When a financial report includes amounts determined by, or based upon the work of the actuary, the auditor would consider using the work of the actuary as audit evidence. In this situation, the auditor acts as the reporting professional and the actuary acts as the specialist professional.

Paragraphs 12 and 13 of AUS 524 deal with communication between the actuary and the auditor; they are to this effect:

When determining the basis for using the specialist professional's work, the reporting professional should communicate with the specialist professional to establish an understanding of the work to be performed by each professional and of the nature and extent of reliance to be placed by each professional on the work of the other .. .

The reporting professional and the specialist professional should disclose to each other, in confidence:

(a) Information requested as being relevant to the work of the professional making the request; and

(b) Information the disclosure of which, in the opinion of the

professional making the disclosure, is necessary for a proper understanding by the other professional of the work undertaken by the professional making the disclosure.

Paragraphs 17 and 19 stipulate that, when planning to use the work of the specialist professional, the reporting professional should assess the professional competence, integrity and objectivity of the specialist professional. The reporting professional should also assess the appropriateness of the specialist professional's work (paragraph 27).

90 Provisioning and reinsurance: general principles

Under paragraph 28 of AUS 524, responsibility for determining the appropriateness and reasonableness of assumptions and methods used and their application is placed with the specialist professional. Although not having the same expertise as the specialist professional, the reporting professional needs to gain an understanding of the assumptions and methods used and to determine whether they are reasonable, based on his or her knowledge of the business and the results of the other procedures performed. In situations where the amounts to be included in the

financial report are based on the work of the specialist professional but have been finalised with further input from the governing body, the reporting professional needs to determine the reasonableness of that input.

5 .2 Reinsura nce

Reinsurance, as traditionally understood, is a mechanism whereby an insurer transfers part of the risk it has undertaken on behalf of its policyholders. Before 1 July 2002 an Australian insurer's reinsurance arrangements had to be approved by APRA (or its predecessor, the Insurance and Superannuation Commission).

There are many types of traditional reinsurance products. Facultative reinsurance is similar to direct insurance in that it involves case-by-case insurance by the ceding insurer to the reinsurer of a particular risk or risks. The ceding insurer selects the risks to be reinsured and the reinsurer decides whether to accept the risks. Under policies called ' facultative/obligatory reinsurance', the ceding insurer selects the risks to be reinsured and the reinsurer is obliged to accept all cessions made within the limits specified in the agreement.

More commonly, traditional reinsurance is placed using treaties under which an agreed share of specified risks for entire business lines is ceded to the reinsurer and the reinsurer is bound to accept what is ceded. The ceding insurer may be required to cede and the reinsurer to accept risks of a particular kind, or some action might be

required on the part of the reinsured (the ceding insurer) to bind the reinsurer to the particular risk.

What is more important for the purposes of the discussion here, however, is the distinction between proportional and non-proportional reinsurance. For proportional reinsurance, premiums and losses are shared in a defined proportion: both parties will have essentially the same loss experience before expenses. In contrast, non­ proportional reinsurance typically provides cover up to an agreed limit above a

particular retention point; it might provide cover for particular risks or for particular classes of risks. Excess-of-loss or stop-loss reinsurance is typically non­ proportional: the reinsurer and the reinsured agree that the reinsurer will pay for losses exceeding a particular amount or exceeding a specified loss ratio (the ratio of claims to premium), up to an agreed limit.

The failure of HIH Insurance 91

According to the Insurance Council of Australia, it is common practice for traditional reinsurance arrangements to be subject to performance-related adjustments, including profit commissions and reinstatement premiums. 5 It and other parties emphasised that the arrangements between an insurer and its reinsurers are typically of long standing and that, although premiums and cover are the subject of periodic negotiation and reflect market conditions, in the longer term the pricing can be expected to be such that it will provide the reinsurers with earnings commensurate with the capital risk they have taken on.

5.2.1 AASB 1023: main features

As noted in Section 5 .1.4, AASB 1023 is the standard that applies to the financial reporting of general insurance activities. The term 'general insurance activities' is not defined but is described in the following terms in the commentary to the standard:

There are various types of insurance. This standard deals with general insurance (including general reinsurance). General insurance provides protection for a specified period against specified losses resulting from the occurrence of specified types of events that may occur. Such events

include theft or storms resulting in property loss or damage, work related and motor vehicle accidents resulting in injury, and fires or floods resulting in interruptions to business. For certain amounts of premium, the insurer undertakes to accept, either wholly or in part, from the insured the risks of sustaining specified losses arising from such events within the specified period. For many types of insurance business, such as fire and fire-related risks, this specified period is usually one year. For other types of insurance business the specified period relates specifically to the underlying risk, which may be a period less than one year (for example, marine cargo insurance), or a period of many years (for example, mortgage insurance).

The main features of the standard are summarised thus in the commentary:

• Premiums must be recognised from the attachment date and be measured over the period of insurance in a pattern that accords with the incidence of risk.

• A liability for outstanding claims must be recognised for direct and inwards reinsurance business and be measured as the present value of expected future payments.

• Investments that are integral to an entity' s general insurance activities must be measured at net market value, and changes in the measured amounts must be recognised as revenues or expenses in the financial years in which those changes occur.

In relation to ceding insurers' accounting for reinsurance policies, the standard provides (in paragraph 1 0.6) that claims recoveries receivable from reinsurers and other recoveries receivable must be recognised as assets where the amount to be recovered can be reliably measured. Recoveries receivable must be measured as the

92 Provisioning and reinsurance: general principles

present value of the expected future receipts. Recoveries receivable from reinsurers may not be set off against the liability for outstanding claims that gave rise to the reinsurance recovery. 6

It is of note that recoveries receivable from reinsurers in the future need to be inflated and discounted in the same manner as the liability for outstanding claims. 7

5.2.2 AASB 1023: the pattern of reinsurance services

Paragraph 7 .l of AASB 1023 provides, 'Premium ceded to reinsurers must be recognised by the direct insurer as outwards reinsurance premium expense in accordance with the pattern of reinsurance service ... ' In relation to this requirement, the commentary provides that, for proportional reinsurance, the recognition of premium expense in accordance with the pattern of reinsurance service would normally be consistent with the pattern of risk of the underlying direct insurance policies. It goes on to say that, for non-proportional reinsurance, the expense would normally be recognised over the period of the reinsurance arrangement. 8 The standard does not, however, say how, in the case of non­ proportional reinsurance, the pattern of reinsurance service is to be determined. It appears from the submission of the Australian Accounting Standards Board that no guidance has been provided to either the insurance industry or the accounting profession on this question.9

Some guidance for interpreting paragraph 7.1 can be obtained from paragraph 4.3 of the standard, which deals with the recognition of premium revenue by a direct insurer. 10 Paragraph 4.2 provides that, over the period of insurance, premium revenue must be recognised in accordance with the pattern of the incidence of ri sk or, where the result will not be materially different, evenly over the period of the policy (for direct insurance) or period of indemnity (for reinsurance). Premium

revenue is to be recognised from the date on which the insurer accepts the risk from the insured-as soon as its amount can be reliably measured (paragraph 4.1 ).

Recourse to paragraph 4.2 suggests that the 'pattern of reinsurance service' referred to in paragraph 7 .l means the pattern of incidence of risk accepted by the reinsurer. It is not, however, otherwise helpful in elucidating the many problems that emerged during the course of the Commission's hearings as to the proper interpretation of

paragraph 7 .1.

5.2.3 Alternative risk-transfer products

Those difficulties of interpretation, as they emerged in the Commission's hearings, were associated with the entry by F AI and by HIH into policies that have been variously described as non-traditional reinsurance, financial reinsurance, finite risk reinsurance, or alternative risk-transfer products. These products are better described than defined and are tailored to cover specific requirements of the reinsured.

Submissions to the Commission emphasised that the market provided a spectrum of risk-management products to general insurers- ranging from traditional reinsurance products dealing with insurance risk to purely funding products such as debt

Th e failure ofHIH Insurance 93

facilities. In between, there has emerged in the last decade or so a range of products, some of which contain an element of risk transfer (which may be mitigated in various ways) and may cover not only insurance liabilities but also general asset risk exposures. These products can be directed to protecting key balance sheet ratios and stabilising revenue and profit. 1 1

In this regard, three particular questions emerged during the course of the Commission's hearings:

• In the case of non-traditional reinsurance, how should it be decided whether the contract ought to be accounted for as reinsurance under AASB 1023, as distinct from being accounted for as a deposit arrangement?

• Could funding or deposit arrangements and risk-transfer arrangements m a single policy be unbundled and accounted for separately?

• How should the reinsurance premium payable under the long-term contract be expensed, having regard to the reinsurance recoveries that were booked?

Relevant to these questions is the principle embodied in AASB 1001 , clause 4.1 , and the commentary thereto. This requires accounting policies to be selected and applied in a manner that ensures that the resulting financial information will satisfy the concepts of relevance and reliability. The commentary explains that, to satisfy those concepts, it is necessary that the substance, rather than the form, of the transaction be reported on where substance and form differ. Determining the substance of the transaction involves identifying all of its aspects and implications and considering the expectations and motivations of each of the parties before entering into the transaction. 12

The concept of risk transfer · According to AASB 1023 , for a transaction to be accounted for as insurance or reinsurance there must be a transfer of risk to the insurer or reinsurer, as the case might be. It does not, however, describe, either qualitatively or quantitatively, what degree of risk transfer is required. This led one party to the Commission to contend that if there is any risk transfer, however slight, the contract can properly be accounted for as reinsurance.

Nevertheless, there was general acceptance among those who gave evidence before the Commission that to qualify for accounting under AASB l 023 there had to be a more than minimal risk transfer. The extent of risk transfer was described in various terms as 'sufficient', 'significant' or 'material'. Greg Couttas, an experienced accountant retained by the Commission to provide expert evidence, said that, in the absence of specific guidance within existing Australian accounting standards, guidance could be drawn from the US Statement of Financial Accounting Standards F AS 113 'Accounting and reporting for reinsurance of short-duration and long­ duration contracts' , issued by the Financial Accounting Standards Board and effective for financial years beginning after 15 December 1992. Paragraph 9 of that standard requires that the reinsurer assume significant insurance risk under the

94 Provisioning and reinsurance: general principles

reinsured portions of the underlying insurance contracts and that it be reasonably possible that the reinsurer will realise a significant loss from the transaction. The standard then provides particular rules in relation to the assessment of whether significant insurance risk could have been assumed and requires that the prospect of a significant loss be assessed by comparing the present value of all cash flows between the ceding insurer and the reinsurer under reasonably possible outcomes.13

Donald Findlater, an experienced accountant practising in the area of accounting for general insurers, told the Commission that it was generally accepted in the insurance industry that the concept of transfer of risk involves a conclusion that there is a material transfer of risk and that in his view AASB 1023 was to be interpreted accordingly. Guidance could be obtained, he said, from other accounting standards such as AASB 1001 and AASB 1038, which provide further advice on what transfer of risk is. 14

The Commission therefore proceeded on the basis that in the insurance industry and among actuaries and insurance auditors it was accepted practice for contracts of reinsurance to be accounted for in accordance with AASB 1023 only if they contained a sufficient or material transfer of risk. I am satisfied that this approach is

in accordance with AASB 1023.

The evidence shows that, in considering the sufficiency of risk transfer, practitioners would take into account not only the chance of the insured event occurring and giving rise to a claim under the policy (the underwriting risk) but also the chance that the claim might arise and the reinsurance become payable in any year of the policy- for example, the first or third or fifth (timing risk). Additionally, practitioners would take into account whether the contract was wholly or partly retrospective.

Multi-faceted arrangements In relation to the second question, the Australian Accounting Standards Board advised the Commission that there is a presumption in AASB 1023 that a contract is either an insurance contract or it is not, although it also said that if 'other elements' are present in a contract there could be a basis for unbundling the contract into its

insurance and non-insurance elements and treating the non-insurance element in accordance with the general requirements for financial instruments. 15

There can be little doubt that in some cases unbundling may be required to give effect to the economic substance of the transaction. For example, in the case of one transaction where premiums were not to be paid but were to be put on deposit and set off against recoveries that were not to be paid for many years, the Commission found that, even though the transaction as it appeared from the face of the contract would have been reinsurance, that component of it, in substance, was not.

The failure ofHIH Insurance 95

Expensing of premiums in accordance with recoveries The third, and perhaps the most difficult, question that arose during the Commission's hearings in connection with AASB 1023 concerns the meaning of the phrase in clause 7.1 to the effect that premium should be expensed in accordance with the pattern of reinsurance service.

In its submission the Institute of Actuaries described how that phrase could operate in cases of traditional reinsurance, where risk is not uniform over the term of the policy. 16. Examples it gave are catastrophe reinsurance, where there is a seasonal pattern to major risks such as storm; crop insurance, where there is a similar

seasonal pattern of risk; and reinsurance covering all policies issued in a year, where the reinsurer's risk rises over the year as policies are issued and falls over the next year as they expire. In cases of financial or finite-risk reinsurance involving multi­ year contracts, however, the expression has been difficult to interpret. In 1994 the Insurance and Superannuation Commission urged that accounting standards and practice be developed to match the approach it said it would apply when considering

such arrangements. 17 That was not done and ambiguities remain.

In its submission, Swiss Re told the Royal Commission it had observed-in many cases but not all-that premiums appeared to be expensed as the higher of:

• in line with payment

• in line with exposure-that is , with decreasing exposure, more of the total premium should be expensed early in the contract

• in line with actual claims experience- that is, if claims are high initially, such that a high proportion of the total limit is used up, the same portion of total premiums is expensed in the period that gave rise to the claims. 18

Andersen submitted that, for non-proportional reinsurance, so long as benefits may properly be regarded as remaining available under the arrangement, premium may be expensed over the life of the arrangement. 19 The submission seemed to assume that recognising premium expense over the period of the reinsurance arrangement meant expensing the premium on a straight-line basis or in accordance with the obligation to pay.

In some cases it was suggested that if the reinsurance contract provided cover that was 'linear' - for example, cover over five years for losses in excess of a loss ratio of x per cent occurring in any of those years, subject to an aggregate limit-the premium could be expensed according to the time for payment, regardless of how much of the available recoveries was taken up in the first year of the contract. Others suggested that for a multi-year contract the premium to be expensed in the first year should at least bear the same proportion to the total premium payable under the contract as the recovery that was booked bore to the total available recoveries. Yet others suggested that when the contract was entered into there should be an assessment of the initially anticipated recoveries; the premium should then be expensed in accordance with that anticipation, such that from year to year

96 Provisioning and reinsurance: general principles

premium is expensed in the same pattern. Still others proposed that at each balance date there should be an assessment of future cash flows, both from the ceding insurer to the reinsurer and from the reinsurer to the ceding insurer, in order to come to a view as to the likely result of the contract over its entire life.

These questions are dealt with in more detail in Section 16.3.6. For current purposes it is enough to note the ambiguity of AASB I 023-an ambiguity that is open to exploitation purportedly to justify, in the early years of the arrangement, the booking of recoveries that exceed the premiums expensed. This ambiguity can be resolved only by applying what might be subjective views about what expense is appropriate to give a true and fair view of the economic substance of the transaction and its value to the ceding insurer, endeavouring to match recoveries and expenses.

6

9

10

II

12

13

14

15

16

17

18

19

WITS.0054.001 . WITS.0054.00 1 at 010 to 012 provides a brief description of each of these methods .

Compliance with SAC 4 is not mandatory.

CMC0.0048.001 at 016.

CORE.055.001 at 008. See commentary at paragraph 10 .6.2 of AASB 1023 .

See commentary at paragraph 10.6.3 of AASB 1023.

Paragraph 7 .1. 5.

CMC0.0048.001 at 010. Paragraph 7.2 makes it applicable to the recognition of inwards reinsurance premium revenue by the accepting reinsurer. See, for example, the background paper on reinsurance submitted by the Insurance Council of Australia (COR£.055.00 1 at 006 to 008) and the submission of Swiss Re (CMC0.0042.003 at 009 to 0010 and appendixes A and B).

Paragraphs 4. 1.8 to 4.1 . 11 .

ACCS.0001.080 at 083 to 084. AASB I 038 applies to accounting for life insurance, and the associated commentary shows that there must be a material transfer of risk for a reinsurance contract to be accounted for as reinsurance (paragraph 7.2.1)-see T4736/8 to T4736/27 .

CMC0.0048.00 1 at 010. CMC0.0044.008 at 029.

CORE.032.076 at 077 .

CMC0.0042.003 at 028.

SUBP.OOI8.001 at 024.

The failure ofHIH Insurance 97

Part Three Directions for the future

6 Corporate governance

A plethora of writings on the subject of corporate governance has emerged in recent years. Public interest in the subject has increased markedly in the wake of corporate failures here and overseas. I may not have anything particularly novel to say about corporate governance. But I believe I can contribute to the debate by assessing the performance of HIH in the area of corporate governance and relating that assessment to some of the recent pronouncements.

My focus is upon the governance of public listed companies. It is futile to attempt to offer a prescription for all companies. An approach that is effective for a large public company with international operations would not be appropriate for a small company controlled by an individual or a small group. However some of the principles addressed here may have wider application.

My thinking is informed by the considerable body of evidence I heard about the way HIH was governed in its last years. That case study was essentially a negative one in terms of governance; systems were flawed and mistakes were made. Yet it would be a mistake, I believe, to dismiss the case of HIH as simply a corporate aberration. There was at least a semblance of standard governance mechanisms at work. By and large the people who were involved were not inherently bad or in some way set upon being part of a corporate disaster. HIH is a reminder, if one is

needed, that a drastic fall from corporate grace can occur if those in charge lose their way.

6.1 The meaning of corporate governance

While numerous renditions of the term can be found in the literature, many of them useful, corporate governance is not a term of art. At its broadest, the governance of corporate entities comprehends the framework of rules, relationships, systems and processes wi thin and by which authority is exercised and controlled in corporations. It includes the practices by which that exercise and control of authority is in fact effected.

The relevant rules include applicable laws of the land as well as the internal rules of a corporation. The relationships include those between the shareholders or owners and the directors who oversee the affairs of the corporation on their behalf, between the directors and those who manage the affairs of the corporation and carry out its

business, and within the ranks of management, as well as between the corporation and others to whom it must account, such as regulators. The systems and processes may be formal or informal and may deal with such matters as delegations of

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authority, performance measures, assurance mechanisms, reporting requirements and accountabilities.

The term corporate governance has a descriptive content, in the sense of denoting a simple statement of a governance model that is in place. It is also commonly used in an aspirational sense, by way of holding out a model which practice should seek to emulate. Reference can be made in this regard to various statements of corporate governance principles or guidelines on good corporate governance practice, some purely hortatory, others more prescriptive, that have been published or promulgated in recent years.

Of all of the writings on the subject a document emanating from the United Kingdom and commonly known as the Cadbury report' stands out for the clarity with which it enunciates general principles.

In the Cad bury report there .is a Code of Best Practice. I do not propose to go to the Code itself. What is interesting is the report's enunciation of the principles on which the code is based. The primary focus is financial reporting but the statements of principle have a broader application. The report said:

The principles on which the Code is based are those of openness, integrity and accountability. They go together. Openness on the part of companies, within the limits set by their competitive position, is the basis for the confidence which needs to exist between business and all those who have a stake in its success. An open approach to the disclosure of information contributes to the efficient working of the market economy, prompts boards to take effective action and allows shareholders and others to scrutinise companies more thoroughly.

Integrity means both straightforward dealing and completeness. What is required of financial reporting is that it should be honest and that it should present a balanced picture of the state of the company' s affairs. The integrity of the reports depends on the integrity of those who prepare and present them.

Boards of directors are accountable to their shareholders and both have to play their part in making that accountability effective. Boards of directors need to do so through the quality of the information which they provide to shareholders, and the shareholders through their willingness to exercise their responsibilities as owners. 2

These statements of general principle can be applied to the corporate governance of HIH. It is first necessary to identify the class or classes of 'those who have a stake in the company's success'. The answer is they include the policyholders, general creditors, employees, shareholders and the regulators. In a more indirect (but no less

important) sense they include members of the public who may rely on the fact that the potential liability of a person to them is supported by the existence of insurance.

The business of HIH was primarily about the management of risk. The company had an obligation to see that the risk it assumed when it issued a contract of insurance would be met if and when a genuine claim was made by a policyholder. It had an obligation to manage those risks and its investment portfolio so that the interests of

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creditors, employees and shareholders would not be prejudiced. And it had obligations of disclosure to enable the regulator to carry out its statutory functions.

Viewed at a high level, corporate governance is all about accountability and stewardship. The funds and assets that a corporation collects are to be held and grown for the ultimate benefit of those who have a stake in the success of the business. Those in whom responsibility is vested to control and direct the business have stewardship of those funds and are accountable for them. One critical objective of a system of corporate governance is to ensure that those people hold the confidence of those having a stake in the success of a business.

The engendering of confidence gives context to the search for a benchmark against which the exercise of judgment can be measured. A corporate governance practice can be assessed by asking how it would affect the degree of confidence that the class who have an interest in the company's success would repose in those persons who carry out the practice. It can be put in a slightly different way: what would the former class sensibly expect of the persons responsible for putting the practice into effect? If the way in which the practice was or was not carried out (as the case may

be) falls materially short of the sensible expectation of the class, it would not engender confidence and would be undesirable.

6.1.1 The organs of governance

A corporation is a legal entity separate and apart from its directors and shareholders. It can only act through the intervention of the human condition. The classic statement of this principle is to be found in Lennard's Carrying Co Ltd v Asiatic Petroleum Co Ltd [ 1915] AC 705 where Lord Haldane said at 713:

My Lords, a corporation is an abstraction. It has no mind of its own any more than it has a body of its own; its active and directing will must consequently be sought in the person of somebody who is really the directing mind and will of the corporation, the very ego and centre of the personality of the corporation.

So it is then that there are various organs that influence the decision-making processes of a corporation and which are involved in corporate governance.

Obviously, primary governance responsibility lies with the board of directors. In formal terms the directors are appointed by, and are accountable to, the body of shareholders. The board will usually be constituted (and in the case of HIH was constituted) by a chair, executive directors and non-executive directors. I will have

more to say about each of them.

The role of the shareholders is to exercise the powers that are reposed in them by the Corporations Act and the constitution of the corporation. The perceived wisdom is, I think, that shareholders play a passive role as the objects of corporate governance rather than an active role as part of it. But that is a different issue and one I do not propose to pursue in any great detail. However, I will say that there is little in the

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evidence to suggest that the shareholders of HIH asserted themselves, notwithstanding its indifferent performance.

It is difficult to define with precision the part that employees play in corporate governance. It will depend on the extent to which the employee is involved in or can influence the decision-making process. Senior management is more likely to have such a role. But in large corporations or complex groups it may be that employees further down the corporate hierarchy have a decision-making function that involves elements of control of the process. There is a danger in the current emphasis on the role and responsibilities of boards of directors. It may cause to be overlooked the reality of the necessarily greater part that executives and other employees play in the day-to-day running of many corporate businesses. In Section 6.4 I deal with the current legal provisions imposing duties on persons other than directors and make some recommendations for the reform of those provisions.

Auditors play a significant role in corporate governance. This is not surprising given the emphasis placed on integrity and on the need for financial reporting that is honest and that presents a balanced picture of the state of the company's affairs. Again, I refer to the Cadbury report:

The annual audit is one of the cornerstones of corporate governance ... the audit provides an external and objective check on the way in which the financial statements have been prepared and presented, and it is an essential part of the checks and balances required. The question is not whether there should be an audit, but how to ensure its objectivity and effectiveness. 3

Further support for this position is to be found in a background comment to a revision of AUS 710 'Communication with management on matters arising from an audit' :

While corporate governance clearly remains the responsibility of the governing body, the auditor may be able to assist the governing body to attain its objectives through timely communication of matters arising from the financial report audit.

It is, I think, placing too narrow a construction on the term corporate governance (so far as it relates to the audit) to say tbat it only applies to procedures put in place by the company for the review by the company of the scope and quality of the audit. In an appropriate case the way in which the audit work was carried out and communicated to the company might be so regarded. For example, a particular audit activity might be so intimately connected with the openness, integrity and accountability with which the financial state of the company is ascertained and presented that it can properly be said to be part of corporate governance.

6.1.2 Promotion of good governance

There is continuing debate about the existence or otherwise of a correlation between good corporate governance and successful performance. Good governance processes are likely in my view to create an environment that is conducive to success. It does

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not follow that those who have good governance processes will perform well or be immune from failure. Risk exists to some extent at the heart of any business . Risks are taken in the search for rewards. No system of corporate governance can prevent mistakes or shield companies and their stakeholders from the consequences of error. Corporate failures will occur. However, good governance practices help to focus those in charge of a company on the very purpose of their corporate activity and the direction oftheir business and enable them to identify emerging problems early.

I think that any attempt to impose governance systems or structures that are overly prescriptive or specific is fraught with danger. By its very nature corporate governance is not something where 'one size fits all ' . Even with companies within a class, such as public listed companies, their capital base, risk profile, corporate history, business activity and management and personnel arrangements will be varied. It would be impracticable and undesirable to attempt to place them all within a single straitjacket of structures and processes. A degree of flexibility and an acceptance that systems can and should be modified to suit the particular attributes and needs of each company is necessary if the objectives of improved corporate governance are to be achieved.

Another danger with an overly prescriptive approach to systems and structures is that it may unwittingly encourage a superficial or 'tick the box' approach to the achievement of governance objectives.

Systems and structures can provide an environment conducive to good corporate governance practices, but at the end of the day it is the acts or omissions of the people charged with relevant responsibilities that will determine whether governance objectives are in fact achieved. For example, the identification of the background, skills and expertise of the people who walk into the board room is a good start, but it is what they do when they get there that is critical.

That is why I suggest later that the actual performance of the governance mechanisms should be reviewed from time to time by reference to benchmarks and performance indicators fashioned to suit the needs and risks of the company. It is also why other observations I make in this chapter should not be construed as an attempt to prescribe or mandate inflexible systems and structures. They are rather a guide to what individually-tailored systems and structures should strive to achieve.

6.1. 3 Govern ance models

There is a demand for more transparency by companies about their governance processes. This is accompanied by a demand for a more prescriptive approach to so-called best practice. In general this trend is healthy and is to be welcomed. It should not however be overdone.

It follows that while I see the move to corporate governance guidelines and benchmarks as worthwhile, I place much more store on an understanding of and fidelity to underlying principles than I do on adherence to the form of recommended corporate governance structures and processes.

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Boards and managements that are focused on the use of corporate resources for the benefit of their shareholders and others with an interest, other than their own benefit, in effective management of risk, accurate and reliable financial reporting and proper disclosure are well on the way to good corporate governance.

I note that the Australian Stock Exchange Corporate Governance Council has published its principles of good corporate governance and best practice recommendations. The Council has followed the UK approach of providing a set of reference points for the best practice aspirations of listed companies rather than imposing the prescription of new listing rules. I consider that the 'comply or explain' philosophy does have the advantages of flexibility and discretion identified by the Council.

Nonetheless the effectiveness of corporate best practice models in themselves is limited. Those companies with an ethical culture are likely to adopt appropriate corporate governance practices, while those where this culture is lacking are more likely to continue to adopt an idiosyncratic or expedient approach. Those in charge of a company should turn their minds to the effectiveness of their governance model

in practice, and not content themselves with the mechanisms. It is yet another instance where substance is to be preferred to form.

There is also a danger that strict adherence to a published best practice model will lead to its becoming as blunt an instrument for the achievement of the aspirational aims of corporate governance as legislation can be. It would be unfortunate and counterproductive if users of the annual report and financial statements of companies were themselves to adopt the 'tick the box' approach and not acknowledge the existence of reasoned exceptions to a recommended best practice. Market participants need to embrace the corporate best practice model in the spirit

in which it is put forward and to acknowledge that adherence is but a means to a goal. Best practice models are designed to promote growth and encourage investment in a disciplined and accountable way. They are not intended to discourage the taking of risk by the imposition of new requirements with which companies must comply if they are to be considered eligible candidates for public capital.

HIH did not have a system whereby the board or senior executives would periodically assess the practical effectiveness of its governance model. There is limited utility in describing in general terms in an annual report how the company adheres to high standards of corporate governance.

6.2 The board of directors

The board is the principal mechanism of governance in listed as well as other corporations. The shareholders, as owners of the company, elect the directors to oversee the operation and performance of the business on their behalf. The directors are accountable to the shareholders.

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The Cadbury report4 stresses the unitary nature of a board. It is commonly made up of a combination of executive directors, who bring to bear their intimate knowledge of the business, and non-executive members who bring to the board a broader view of the company's activities. They must work together and bring to bear their collective ability to provide both the leadership and the checks and balances that corporate governance demands. Although some directors may have particular responsibilities for which they are accountable to the board, it is for the board collectively to ensure that it is meeting its obligations.

There are many ways in which the fundamental role of the board has been described in the literature. The essential role of the board includes setting the company' s strategic aims, providing leadership to put them into effect, supervising the management of the business and reporting to shareholders on their stewardship. 5 The board must also ensure that the corporation has in place the necessary controls over its activities and, of equal importance, ensure that the controls are working. 6 The appointment of a chief executive officer and the continued review of his or her

performance and, through the chief executive, of management, is in large part a reflection of these obligations.

There are numerous other writings on the subject. Almost all of them include among the essential functions of a board the determination of strategic and tactical directions, the management of the agenda, ensuring accountability and establishing and monitoring policies and practices introduced to ensure compliance with obligations. 7

It is neither desirable nor practicable for the board of a large corporation to involve itself in matters of day-to-day management. But the board is ultimately responsible for the proper governance of the corporation. Accordingly, it must decide where the lines of authority lie. The board should set clearly defined delegations of authority to the chief executive and have a well-understood policy on matters that are reserved to it.

There is a potential for conflict between the interests of shareholders and management. If left unchecked, there is a risk that management may act in pursuit of self interest or without appropriate care and diligence, to the detriment of the corporation. Most corporate governance models recognise the board as the key mechanism for ensuring that management acts always in the interests of the

corporation. The role of non-executive directors in monitoring and guiding the behaviour of executives is integral in this regard.

The importance of the board' s duty to monitor was explained by Thomas J. in the New Zealand case of Dairy Containers Ltd v NZI Bank Ltd in the following terms:

It is because of the separation of ownership from management in corporate theory and practice that directors are appointed to manage the company in the absence of the owners. The directors may delegate powers and functions using the term in a broad sense but they cannot delegate the

management function itself. Executives in running the day-to-day business of the company are exercising delegated powers. It is to be borne in mind

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always that they are delegated and not original powers, and that they are therefore subject to the ultimate responsibility of the directors for the oversight of the company. 8

Under the Corporations Act 2001 companies are required to include in their annual report prescribed matters such as the entity's compliance with environmental regulation. For some companies the environment is central to their operations. In other companies, such considerations are peripheral to their business. It should not be thought that matters of corporate governance, which affect all companies equally, are of less significance than matters which are so required by statute to be addressed. Just as the annual report is the occasion for the company to give a financial account of itself, so too is it the occasion for the board to give an account to the shareholders of its stewardship of the company by reference to the matters I have mentioned.

6.2.1 The chair

The role of the chair is not clearly articulated in Australian law but is left largely to the constitution and practices of each corporation. However, there are indications that some clearer legal content to the title and role of the chair is beginning to emerge or, perhaps more accurately, is beginning to crystallise.9 Commentary and case law make it clear that the chair's role and responsibilities are different from and often greater than those of the other directors. The Cadbury report described the chair's role as follows:

Chairmen are primarily responsible for the working of the board, for its balance of membership subject to board and shareholders' approval, for ensuring that all relevant issues are on the agenda, and for ensuring that all directors, executive and non-executive alike, are enabled and encouraged to play their full part in its activities. 10

I would add that the chair has what is commonly referred to as a mentoring role in relation to the chief executive. The chair should be available as a sounding board, should encourage and where necessary provide a check. The chair also has a responsibility to see that the board keeps its own role and performance under review and does not fall into a mode of' going through the motions'.

The chair's role does not bring with it 'dictatorial power'. 11 Instead, it brings with it 'additional rights and duties and additional opportunities' which may affect the content of the role and warrant the imposition of higher standards and duties in order to ensure board effectiveness and prevent the exploitation of those additional opportunities. 12

The chair must have extensive involvement with the chief executive in order to be appropriately familiar with what is happening in the company. This is a critical factor in the governance of companies in contemporary commerce. Some publications characterise the relationship by referring to a 'strong' or 'weak' chair and a 'strong' or 'weak' chief executive and various combinations of that characterisation. Some combinations are quite obviously less desirable than others.

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Whatever the characterisation, the chair must retain sufficient detachment and avoid excessive interference with day-to-day operations which are the preserve of management and not non-executive directors. Conversely, the chair must be ready, willing and able to intervene decisively as and when necessary. The important role of the chair in keeping close to and in effect mentoring the chief executive was referred to earlier.

The chair should have the steering hand on the proceedings of the board. During the deliberations of the board, the chair must ensure that the views of all directors are heard and not stifled by the conduct of others. This can be promoted by the chair's control of any who impede the full and frank exchange of views. He or she must ensure that board meetings achieve the purposes for which they are intended. They should provide an open forum at which executives report and directors discuss with candour the company's position, performance and prospects. The chair needs to ensure that this is not done in a fashion which discourages the frank disclosure of bad news, doubts or fears.

The Cadbury report recommended that the chair' s role should not be filled by a current or previous chief executive officer. 13 The rationale for the recommendation is that, if the roles are combined, a significant power would be concentrated in one person bringing with it opportunities for exploitation. I am generally supportive of the view that the roles of chief executive officer and chair are better kept separate. This provides a useful check upon the exercise of power. But I stress the need for flexibility. The way should be left open for the roles to be combined if a persuasive case can be articulated and communicated to the shareholders.

6. 2.2 The executive directors

There is little controversy about the role of executive directors. Generally speaking they will have a much greater awareness of the day-to-day operations of the business. They play a management role according to the position they hold and the authorities that go with that position or which are delegated to them. They have a

specific ob ligation to inform the board of matters within their knowledge but which might not otherwise be known and which might be material to the board's consideration of re levant issues.

Executive directors must look beyond their executive duties and accept their full share of the responsibilities as board members for the governance of the organisation. 14

6.2 .3 The no n-executive directors

The distinctive role of non-executive directors stems from the fact that they are not involved directly in the day-to-day running of the corporation. Accordingly they bring or should bring a broader perspective to the company's activities. More significantly, they exercise (or should exercise) independent judgment over the

company's strategy, performance, resources and standards of conduct. This is not to

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downplay the role of the executive directors. They have a more detailed knowledge of the management and operations of the corporation.

The authors of the Cadbury report point out that non-executive directors have two particularly important functions based on their independence from management. The first is in reviewing the performance of the board and of the executive. Non­ executive directors should address this aspect of their responsibilities carefully and should ensure that the chair is aware of their views. 15 The second is to take the lead where potential conflicts of interest arise. 16 The Cadbury report also stresses that the essential quality that non-executive directors should bring to the board is independence of judgment. 17

It is incumbent on non-executive directors to understand the nature of the company's business regardless of their own particular expertise or experiences. They need to attain a working grasp of the essential drivers of the business, the competitive environment and the nature of the risks to be managed. In this way, they will be equipped to carry out a role of critical and constructive inquiry, review and support.

To assist directors in this regard it is desirable for listed companies to provide familiarisation or other training for new directors in particular. The word 'training' is apt to mislead. I do not suggest that directors (new or old) should be sent to a corporate equivalent of kindergarten and exposed to the joys of Company Law 101. But more formal programmes can be instructive to impart knowledge of the business, its risks and its goals drawing on sources from outside as well as within the company.

6.2.4 Reliance

One particular matter arose in the inquiry that is relevant to the position of non­ executive directors. When giving evidence it was a constant refrain from the HIH directors that they relied, and were entitled to rely, on management and external advisers and should not be held responsible for any deficiencies in the information so obtained.

Reliance is a difficult issue. The traditional view has always been that senior management runs the business, while the board ensures that it is being run appropriately and effectively. In the process it is generally accepted that the board and senior management are entitled to delegate their powers and to rely on others' advice in carrying out their duties. This has been recognised in Australian case law. In AWA v Daniels 18, Rogers CJ in Equity acknowledged that it is part of corporate life that the board cannot manage the day-to-day operations of a large company and that this function must be delegated to management. But the question that arises is the limits if any on the power of delegation and, perhaps more importantly, of reliance.

In Daniels v Anderson 19 the court, at first glance, appeared to place very stringent limitations on the notion of reliance and delegation. But I do not think this is a

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correct reading of the decision. In any event the legislature has specifically recognised the power of delegation. 20 I think Daniels v Anderson and other authorities establish the general proposition that directors can rely on information supplied by others provided the reliance is reasonable in all the circumstances. There are many factors that will be taken into account in deciding whether reliance

is reasonable. They include, but are not limited to:

• the nature of the functions delegated or in respect of which the information was given21

• the nature of the transaction or event to which the information relates and, in particular, the risk that it involves22

• the relationship between the director and the provider of the information.23

But, to my mind, the most important factor in deciding whether reliance is reasonable is the extent to which the director has made inquiries concerning the matter. As Clarke JA put it in Daniels v Anderson24 , the courts have recognised that at law more is required of a director than supine indifference. The legislature requires both diligence and action. At the very least a director has a duty to be

informed as to the company's activities and financial position and a duty to make mqumes.

There are two aspects to this. First, the facts of the particular episode may indicate the director was, or should have been, put on notice that inquiry was necessary. Second, if the director reposes trust in someone a question might arise as to what, if any, inquiries the director made to warrant the degree of trust so exhibited. In many instances, especially with reliance on management or external advisers whose services are repeatedly engaged, this will be a systemic issue.

Section 189 of the Corporations Law demonstrates that this is the proper approach to reliance.25 It provides that reliance is taken to be reasonable if, among other things, the director made an independent assessment of the information or advice, having regard to matters specified in s. 189(b )(ii).

6.2.5 Composition

The governance structure of an Australian company typically comprises a unitary board including a combination of non-executive and executive directors. This stands in contrast to the dual board system prescribed for listed companies in some other jurisdictions (for example Germany). The dual board system comprises a

management board and a separate supervisory board. The former is responsible for managing the enterprise. The latter appoints, supervises and advises the members of the management board and is involved in decisions which are of strategic importance to the enterprise.

Nothing has come to my attention during the course of the Commission to suggest that Australia should discard the unitary board structure.

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Reports on corporate governance in Australia, the United Kingdom and the United States have all emphasised the importance of choosing an effective board to lead and control a company's business. 26 I agree. But consistently with my views that adherence to an appropriate corporate governance model will not by itself guarantee the success of the corporation, so too I believe that too much attention can be directed to the desired characteristics of the board and not enough to the more difficult and important question whether the board is working effectively together­ not only to comply with the plethora of laws and 'best practices' that exist, but also to get on with its most important job of leading a viable, profitable and efficient corporation.

6.2.6 Independence

The weight of current opinion is that it is desirable to have a maJonty of independent directors on a public company board. The board of HIH had several ' independent' directors but this provided little protection against the folly of management. I am not convinced that a mandatory requirement for boards to have majority of non-executive directors is either necessary or desirable. In most cases it will be desirable (assuming the non-executive directors are truly independent) but flexibility ought to be maintained to enable corporations to be structured in a way that best suits their circumstances. Nonetheless, the trend in the prescription of codes of conduct seems to assume the premise. My recommendations have been developed accordingly.

Mandating a greater level of independence has emerged as a strong theme in reports on corporate governance. The presence of independence is regarded as the primary mechanism by which corporate governance can protect against the whims and faults of management.

Definition of independence Of course, all of this raises the question what is meant by 'independence'. Perhaps all that can be said with assurance is that independence significantly reduces the prospect that performance will be inhibited by considerations other than the best

interests of the company as a whole. This will be so because an independent director can bring to bear upon the issues confronting the company a mind that is not materially influenced by other considerations. An independent director needs to be engaged with the company-in terms of being an inside participant-but free of impediment to the exercise of objectivity of judgment.

This, it seems to me, is the key to understanding the real import of the notion of independence. It is customary to spec>.k of 'independent directors' but I think this gives the wrong emphasis. What is required is independent judgment. The distinction is subtle but important.

Not all non-executive directors can be regarded as independent although I have noticed a regrettable tendency for these terms to be used as if they are

interchangeable. They are not. Some non-executive directors may have material

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interests in or be connected to the company in other ways, for example if they are an employee or director of a significant supplier to the corporation. The non-executive directors on the board of HIH included three former partners of the auditors. One of the lawyers on the board was a significant supplier of consulting services to HIH and a consultant to a law firm engaged by HIH. His remuneration from that firm

included a commission for work referred. I will address this arrangement later. For present purposes it is sufficient to note my view that such arrangements raise serious questions about independence.

The ASX Corporate Governance Council has defined an independent director as one who is independent of management and free from any business or other relationship that could materially interfere with-or could reasonably be perceived to materially interfere with the director's ability to act in the best interest of the company. In addition, the Council identifies a number of specific circumstances which preclude a

non-executive director from being considered as independent. These matters include substantial shareholdings, employment, being a professional adviser to the company, contractual arrangements with the company and length of service as a director.

I agree that it is appropriate to give guidance as to the circumstances which need to be considered in determining independence and I have considered HIH's board against some of those measures in Chapter 23. However, neither the matters raised during the Commission nor my experience generally qualifies me to say whether all of the matters listed would necessarily deprive a person of independence. I am again concerned that an attempt to be unduly prescriptive might impose undesirable rigidity, and distract attention from the critical issue of freedom from possible influences, many of which may be subtle and not susceptible to a 'check-list' approach.

For example, it is not immediately clear to me why a substantial shareholding in the company should be regarded as compromising independence. Such a shareholding may provide greater incentive to bring the interests of the company to bear. On the other hand, the fact that a director has a close personal association with the chief

executive may be destructive of independence, but is very difficult to assess objectively or on a 'check-list' basis. The critical question, it seems to me, is not so much whether, on objective criteria, the individual is 'independent' but rather whether he or she is subjectively capable of exercising independent judgment.

I consider that there is a need for non-executive directors to appreciate their distinctive role to review the performance of management and to take the lead where potential conflicts of interest and duty arise. I also consider that the benefits of good corporate governance identified earlier are more likely to be achieved if the non­

executive directors are both independent and seen to be independent.

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6.2.7 Conflicts of interest

During the course of the inquiry, a number of instances of possible conflicts of interest involving directors were identified and investigated. HIH had no system in place to ensure that conflicts of interests were identified and resolved by the board. In large measure the chairman left it to individual directors to declare conflicts of

interest. His role was passive.

The fact that directors are fiduciaries means they have heightened obligations to avoid situations where their personal interests might conflict with their duties to protect and advance the interests of the company. As Lord Herschell said27 :

It is an inflexible rule of a court of equity that a person in a fiduciary position, such as the respondents, is not, unless otherwise expressly provided, entitled to make a profit; he is not allowed to put himself in a position where his interest and duty conflict. It does not appear to me that this rule is, as has been said, founded upon principles of moral ity. I regard it rather as based on the consideration that, human nature being what it is , there is a danger, in such circumstances, of the person holding a fiduciary position being swayed by interest rather than duty, and thus prejudicing those whom he was bound to protect.

Although that comment was made over 100 years ago it remains true today. The lackadaisical approach to conflicts of interest of some members of the HIH board encouraged this culture to spread through various sections of the management of the company. This was inimical to good corporate governance. The board and in particular the chairman should have taken the lead in ensuring that all situations which might involve or give rise to a conflict of interest were fully disclosed and ventilated so that none of the other directors could be under any misapprehension concerning the relevant circumstances. The disclosure should have included precisely what gave rise to the potential for conflict, what was the nature of the conflicting interest or the conflict of interest and duty and how material or remote the potential was for conflict.

It is not appropriate to prescribe a precise formula for dealing with this topic. It will depend on the circumstances. Directors should be open and frank with one another on this as on all issues concerning the board.

In Chapter 23 I discuss the consultancy arrangement between an HIH director and the law firm of which he was formerly a partner. The director' s role was to market the firm and his remuneration was based in part upon the fees that the firm earned from work introduced. The director concerned denied there was anything inappropriate in the arrangement and pointed to the disclosure in the annual report. I found that the level of disclosure insufficient. Even if it were disclosed full y, that would not address adequately the problems inherent in such an arrangement.

In my view, in such an arrangement the director places himself in the position where his interest in his remuneration pursuant to the consultancy conflicts with his duty to act solely in the interests of the company. Directors of public companies should make decisions as to where their company's legal work is referred free from any

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bias or influence other than what is in the best interests of the company. Consultancy arrangements such as the one in question offend this principle and so should be avoided by public companies and their directors. This applies to all areas in which the company seeks professional and like services, not just to legal services.

Proportion of independent directors

As noted above, there is a view emerging in relevant reports and codes of practice that the board should comprise a majority of independent non-executive directors. While I acknowledge the force of this view, I do not recommend that this composition should be mandated by law. Rather I consider that this should form part of a model code to which public companies should adhere unless they articulate sound reason why such a structure is inappropriate to their own situation. In this way potential investors will be under no misapprehension concerning the matter. At

the same time flexibility will be preserved.

6.2. 8 Remuneration-non-executive directors

There is an inherent tension in a board' s role in determining its own remuneration. Directors should be properly rewarded for their efforts but it is hard to avoid a perception of self-serving. While non-executive directors can and should bring an independent judgment to bear on the remuneration of executives, including executive directors, there is an obvious difficulty with their own remuneration. The ASX Listing Rules require shareholder approval of an aggregate monetary cap within which directors can determine their own remuneration. Beyond that the approach of the Corporations Act is to require disclosure of the remuneration that is

in fact paid to each director.

The remuneration of non-executive directors should be dealt with in accordance with the principles of openness, integrity and accountability. Directors' remuneration is a matter of interest to shareholders. It must not be excessive but it needs to be sufficient to attract directors with the appropriate background and experience and to have regard to the time and commitment necessary to fulfil their roles.

Retirement benefits paid to directors have received prominence in recent times. The reasonableness of any provision for retirement benefits for non-executive directors needs to be considered as part of their overall remuneration. The basis upon which those payments will be calculated should be disclosed in advance. It is undesirable that any retirement benefits for non-executive directors should be structured in such

a way as to provide an incentive for a non-executive director to remain on a board for an extended period. This could serve to encourage an incumbent to remain on the board when that may not be in the best interests of the company.

In the light of my inquiry I have concerns about the adequacy and efficacy of the disclosure and other requirements of the Corporations Act, relevant accounting standards and the ASX Listing Rules that deal with the remuneration of directors.

Th e failure of HIH Insurance 115

There are varying definitions of remuneration and instances of ambiguity or inconsistency in the relevant provisions.

In the inquiry I heard evidence about the payment of substantial consultancy fees to two non-executive directors. Arrangements of that kind, while not necessarily undesirable, do raise questions as to the continuing independent or non-executive standing of a director. But of particular concern is that those arrangements were not disclosed in a meaningful way. Regardless of the propriety of those particular arrangements and the way they were treated, there should be no doubt in the relevant regulations that payments or other benefits of whatever kind to directors must be fully and clearly disclosed.

Recommendation 1

I recommend that the disclosure and other requirements of the Corporations Act 2001, the relevant accounting standards and the Australian Stock Exchange Listing Rules that relate to directors'

remuneration be reviewed as a matter of priority, to ensure that together they achieve clear and

comprehensive disclosure of all remuneration or other benefits paid to directors in whatever form.

6.2.9 Remuneration-executive directors and officers

The remuneration of senior executives, whether or not they are directors, has also become a contentious issue. The scale of remuneration and also retirement benefits in some cases seems obscene to many in the community and gives rise to understandable outrage where there is a gap between apparent performance and the magnitude of the payment.

Engagement of the services of a chief executive, and through the chief executive an appropriate management team capable of successfully running a company's business, is one of the most important tasks of a board. Obviously a board has to be prepared to offer competitive remuneration in order to attract the right people. This does not relieve the board of the need to act responsibly, drawing on appropriate advice, in determining or reviewing executive remuneration arrangements.

The introduction in recent years of requirements for the disclosure of senior executive remuneration may have had a consequence that I suspect was unintended. Greater transparency regarding remuneration seems to have stimulated more competition in the market-place for senior executives with an element of catch-up or

'follow the leader' creeping in.

Be that as it may, the setting of executive remuneration is a core part of the stewardship role of a board. Shareholders are entitled to expect non-executive directors to play an active role, especially so far as the remuneration of the chief executive and any executive directors is concerned, and to exercise their own judgment. They should not allow themselves to be in a position where they are

reliant in effect on the advice of those who stand to benefit. They should concern themselves with and supervise the way in which any external advice is obtained on matters affecting the remuneration of executive management. It would not be

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practicable in my view to require directors to obtain shareholder approval for senior executive remuneration packages. In the end the engagement of a chief executive has to be at the discretion of those who are responsible for the conduct of a company's business. But it may not be enough, given the importance of this aspect of stewardship, for disclosure to shareholders to be confined to disclosure of actual remuneration paid after the event. There is a case for requiring boards to disclose to shareholders, at the time commitments are entered or reviewed, the elements of the remuneration arrangements of the most senior executives including aspects that deal with incentives or benefits on termination.

The creation by a board of a remuneration committee to consider matters of this kind may be useful, especially if it facilitates their consideration by the non­ executive directors. But again I mention the need for flexibility . There is not much point in demanding that a company with three directors should have a separate (or

any) remuneration committee. In the end the board itself has to take responsibility for decisions.

How remuneration is structured, including such matters as incentive payments, is generally not a matter for prescription provided that proper disclosure is made. Directors should have very much in mind the ways in which particular arrangements may skew behaviour and satisfy themselves that there is alignment with the continuing interests of the company and its shareholders.

6.2.10 Board succession

While the election of directors is formally a matter for shareholders, as a practical matter the board itself has the initiative and makes appointments subject to shareholder vote at the following annual general meeting.

Part of the board' s responsibility therefore is to keep its own composition and effectiveness under review. The chair should take the lead in this process and ensure that there are regular opportunities for review and consideration, whether through a formally constituted nomination committee or otherwise. This is an area where

boards may find it of assistance to engage external advice, either in reviewing the continuing suitability of the board's mix of skills and experience to the requirements of the company or in identifying suitably qualified candidates for appointment.

Given the nature of their role, non-executive directors should be selected with impartiality. The selection should be on the basis of merit and not through any form of patronage. The matter should not be left to the chief executive officer.

It has been recommended in a number of reports and codes of practice that boards should form nomination committees, ideally comprising a majority of independent directors, whose functions are both to propose new nominees and advise the board on the required attributes of new directors.

In many instances a board may find it useful to have a formal nomination committee to assist it. In my view however the commitment of the board to objective review

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and selection processes is far more important than the form m which its deliberations are carried forward.

Non-executive directors may lose something of their independent edge if their tenure is too long. A healthy board will seek a balance between turnover of individuals, with the injection of new ideas and perspective, and continuity and stability. The balance may vary according to the company' s circumstances.

I do not see it as appropriate to dictate a maximum term for non-executive directors. There should however be no expectation that non-executive directors are 'permanent' appointments. A healthy board should inculcate an understanding of the desirability of managed turnover, and that the company's needs may change over time, without reflection on those who leave a board to make way for others.

6.2.11 Performance review

A process by which a board reviews its own performance as well as the effectiveness of its processes should be part and parcel of a board cycle of reviews of the company and its business. This is a matter in which the chair should take a lead and in which an informed outsider may be able usefully to contribute. The review should include detailed consideration of the effectiveness of the current corporate governance model. Any ways in which it has failed or could work better should be addressed.

In reviewing its own governance practices, a board should bear in mind that corporate governance is a means to an end and not an end in itself. The end which good governance serves is the advancement of the company as a whole, for the benefit of its shareholders and the wider community. Success in that endeavour cannot be measured merely by reference to principles of governance, but in the wider context of the company's performance as a business enterprise-its profits, efficiency, viability, innovation and so on. These are the goals at which good corporate governance should be directed. Progress towards those goals should be a key part of any board review.

In much the same way as the board must review the performance of executives, it is desirable that a board develop a practice by which the performance and contribution of individual board members cari be reviewed in a constructive way. This involves an element of peer review, again possibly with external assistance. The process should be guided by the chair. In relation to the chair, performance review should be handled by another experienced non-executive director designated for the purpose. There is no room, on the board of a public listed company, for any suggestion that the performance of a director once appointed is above review.

6.2.12 Interaction between board and management

The effectiveness of interaction between the board, in particular the non-executive directors, and management is central to good governance. The chair's own

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relationship with the chief executive should set the tone for this. In a healthy company relations will be straightforward and open, with the board supportive of management's efforts where it can. But this all presupposes trust and confidence in the information and advice that is provided and in management' s responsiveness to requests for information or explanation. Where trust breaks down, change is likely to be called for.

Directors have a responsibility to request more information where necessary to fulfil their duties. They cannot simply rely upon the information presented by management.

Moreover, by taking an active responsibility for the agenda, the chair can ensure that management brings forward on a regular or periodic basis reports or other information on material aspects of the company's business and performance.

6.2.13 Corporate donations

The board and management of a company have a good deal of discretion as to how they use the company's funds so long as they act reasonably in the interests of the company. Beyond normal business expenditure, companies not uncommonly make donations to charitable or philanthropic causes or other discretionary contributions including to political parties.

While there is nothing inherently wrong with any of this, 1t IS an area where a board's stewardship responsibilities call for deliberation on how a payment will serve the company's interests and appropriate accountability to shareholders on whose behalf that discretion has been exercised.

The appropriate controls and approval of donations was an issue which arose with HIH. The board of HIH appeared to exert no meaningful control over the amount or direction of the not inconsiderable donations made by the company over the years. There may have been a corporate interest underlying the donations but if so it was

not articulated. Credit for the company was not usually sought for having made the donations and there was little if any disclosure of details of the company's magnanimity to the board let alone to shareholders.

In discretionary areas of this kind there is a possibility of abuse. The principles in accordance with which donations are made call for consideration at board as well as management level together with appropriate disclosure.

Warren Buffet, chairperson of Berkshire Hathaway Inc, once said:

Just as I wouldn ' t want you to implement your personal judgments by writing checks on my bank account for charities of your choice, I feel it inappropriate to write checks on your corporate 'bank account' for the charities of my choice.28

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A similar sentiment was expressed more recently by Sir Gerard Brennan:

There are sound reasons of policy for imposing a limitation on directors' powers to donate corporate assets. Investors, whose charitable inclinations are diverse, do not authorise directors to dispose of corporate assets to charitable objects of the directors' choice. The choice should remain with the individual investor when he or she obtains his or her share of the distributed profits. From the moral viewpoint, there is no virtue in a directors ' resolution to dispose of corporate assets to a charitable object. Virtue consists in the of what is one's own, not in the giving of

assets that belong to another. 9

However laudable the object of the donation, discretionary payments of this kind from the funds of shareholders should be undertaken in a transparent and justifiable way with full regard to the interests of the shareholders. Companies should develop their own guidelines for the disclosure of their arrangements for the stewardship of corporate donations. Guidelines should cover the disclosure to shareholders of donations made to charitable, philanthropic, political or other discretionary objects together with a statement of the rationale for those payments.

6.2.14 Control of executive expenses

The board of HIH failed to exercise appropriate supervision over expenses incurred by executive directors and management over a lengthy period. A comment was made in a due diligence report in 1995 that HIH had not made a complete transition from an entrepreneurial company influenced strongly by senior management, and from which senior management benefited significantly, to that of an ASX listed company run primarily in the interests of shareholders. This remained true throughout its life.

This is another aspect of stewardship where, although expenditure may not be all that material in relative terms, there is a need for supervision and accountability. This is not an area where I need to go into detail beyond saying that processes for authorisation, accountability and disclosure should be clear. No one should be in a position of self-authorisation of expenditure without a process for subsequent disclosure or review.

Boards should promote a corporate culture that stresses discipline. By failing to exercise control over a chief executive or others a board permits an undisciplined approach to corporate expenditure throughout the organisation. A board cannot expect a more disciplined approach by management than it imposes upon executive directors. There is also a need for a system of checks and balances which entrenches the openness, integrity and accountability with respect to the use of corporate resources. No one, including the chief executive, should have unfettered discretion to make use of the company's resources.

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6.3 The role of shareholders

Shareholder apathy can play a part in undesirable corporate governance. If shareholders as owners are unwilling or unable to exercise their powers or make themselves heard, directors and management will lack guidance or constraint from those whose interests they are supposed to serve. Shareholders have an interest in seeing that a board is properly constituted and in holding it to account for the company' s performance.

There is an opportunity for institutions and especially managed funds to take a lead. Managed funds , through which the investments of numerous sometimes small investors are pooled, should be encouraged to undertake analysis of the performance and governance of the companies in which they invest. They should make their views known to those companies and exercise voting rights for the people on whose

behalf they have invested. A proactive stance, together with a report to their investors on whether and if so how they have exercised their votes would be consistent with their responsibilities. Otherwise this is an area where legislation may be considered in the future along the lines of legislation applicable to pension funds

in the United States.

There may be practical difficulties in managed funds carrying out meaningful assessments of the performance and governance of all the companies in which they invest. There may be many hundreds of investments. But just as corporations must avoid a 'tick the box' approach to corporate governance, so too should investors avoid analysing corporations by rote.

Advances in information technology and the emphasis on continuous disclosure have made it possible for companies and shareholders to communicate on a continuing basis with less emphasis than in the past on the annual meeting.

6.4 Offic ers other t han directors

Reference was made earlier to the role of management as a component of a company's governance systems. It is customary in such discussions to focus upon the role of senior or executive level management. But elsewhere in this report I have remarked upon the significant role played by HIH employees who would be

described as 'middle management' in practices that I have found to be undesirable. As I remark elsewhere, I have been frustrated by the disinclination of those persons to accept responsibility in relation to such practices. The uncertain state of the law in this area has been a source of difficulty in my assessment of those cases where there might have been a breach of the law that might be referred for further

consideration by relevant authorities.

Because of the complex corporate structure of the HIH group, many of the senior executives were in fact directors of subsidiary companies within the group. However, this proved to be of limited significance in the identification of the legal

Th e failure ofHIH Insurance 121

duties to which they were subject because the acts and omissions which were in question were not, in the main, undertaken by them in their capacity as directors of subsidiary companies.

I have therefore had occasion to review the current legal regime governing the duties imposed upon persons other than directors. These issues seem to me to be of considerable significance, because it is clear that in larger companies many significant decisions are made by management without reference to the board. It follows that any legal regime for the enforcement of corporate governance standards which does not extend to the acts or omissions of at least some levels of management is unlikely to be wholly effective.

The evidence I have heard also suggests that 1t IS common for management decisions to be made on a collective or collegiate basis, or at least after interaction with other managers. There is therefore an opportunity for the law significantly to influence the mind-set or culture of those managers, and reinforce their obligations to the company and its shareholders.

In considering the current legal regime pertammg to the duties imposed upon persons in corporate roles other than directors, I have identified four issues which merit attention from the perspective of appropriate policy direction for the future . Those issues are:

• the correction of what appear to me to be anomalies in the current legislative structure pertaining to directors' duties

• the identification of which other officers ought be subject to some or all of the legal duties imposed upon directors

• the identification of what duties should be imposed upon the class or classes of officers other than directors

• clarification of the duties owed by officers serving a corporate group.

6.4.1 Anomalies in the existing legislation

In order to explain what I consider to be some anomalies in the existing legislative provisions relating to the duties imposed upon officers of corporations other than directors it is necessary to set out briefly the history of those provisions.

The law prior to March 2000 Prior to the CLERP amendments which came into effect in March 2000 the Corporations Law identified two classes of personnel: 'executive officer' and ' officer'.

122 Corporate governance

Executive officer was defined as follows:

In relation to:

(a) a body corporate; or

(b) an entity within the meaning of Parts 3.6 and 3.7;

means a person by whatever name called and whether or not a director of the body or entity, who is concerned, or takes part, in the management of the body or entity.

The expression 'officer' was defined by s. 82A, also by reference to either a body corporate or an entity within the meaning of Parts 3.6 and 3.7 and, significantly, included 'employees'.

Prior to March 2000 the general duties imposed upon personnel acting on behalf of corporate entities were those imposed by s. 232. That section contained its own definition of 'officer' which by s. 232(1) meant, amongst other things, 'director, secretary or executive officer' . Thus, for the purposes of the section, the word

'officer' included the statutory office holders, such as directors or secretaries, and also persons who were 'concerned, or took part, in the management' of the corporate entity. Because all the duties imposed by s. 232 were imposed upon 'officers' as defined by that section, for the purposes of those duties no distinction was drawn between directors, secretaries or those who were concerned, or took part

in , the management of the entity. In addition, one of the duties imposed by the section, namely the duty not to make improper use of position to gain advantage or cause detriment to the corporation, was imposed upon both officers (as defined) and employees, with the result that that duty applied to all personnel employed by the

corporate entity, whether engaged in management functions or not.

It is also necessary to note that the duties imposed by s. 232 were imposed in respect of 'a corporation' whereas, as I have pointed out, both 'executive officer' and 'officer' were defined by reference to 'a body corporate' or an entity within the meaning of Parts 3.6 and 3.7. However, it seems that nothing was thought to tum upon this distinction, because s. 57 A defined 'corporation' to include any body corporate. 'Body corporate' was in tum defined ins. 9 in an inclusive rather than an

exclusive way.

The identification of the class of persons who fell within the definition of ' executive officer' was considered by Ormiston J. in Commiss ioner for Corporate Affairs v Bracht. 30 In that case his Honour considered what was meant by the expression 'management' in the definition of 'executive officer' and concluded that it should be

regarded as encompassing:

Activities which involved policy and decision making, relating to the business affairs of a corporation, affecting the corporation as a whole or a substantial part of that corporation, to the extent that the consequences of

the formation of those policies or the making of those decisions may have some significant bearing on the financial standing of the corporation or the conduct of its affairs. 3 1

Th e failure ofHJH insurance 123

Ormiston J. then went on to consider the meaning to be given to the expressions ' concerned in' and 'takes part in' and concluded that the former had a significantly wider ambit of operation than the latter, but nevertheless still required an involvement of some kind in the decision-making processes of the corporation. His Honour expressed the view that the degree of involvement had to be 'more than passing' and not merely clerical or administrative. On the other hand, in his Honour's view, it was not necessary that the person concerned have ultimate control. The provision of advice to management, participation in decision-making processes and the execution of decisions going beyond the mere carrying out of directions as an employee would, in his Honour's opinion, be sufficient to lead to the conclusion that the relevant person was 'concerned in' management.

6.4.2 The CLERP amendments

The CLERP amendments which took effect in March 2000 resulted from a review designed to simplifY the Corporations Law and make it more certain. Regrettably, as a result of what appears to me to have been an oversight, in the area currently under consideration the amendments appear to have had precisely the opposite effect.

The definition of 'executive officer' was retained in s. 9 of the Corporations Law, but the definition of 'officer' in that section was amended to delete reference to s. 82A and instead to insert a definition of 'officer of a corporation' to mean, amongst other things, a director, a secretary, and a person:

(i) who makes or participates in making, decisions that effect the whole, or a substantial part, of the business of the corporation;

(ii) who has the capacity to effect significantly the corporation's financial standing; or

(iii) in accordance with whose instructions or wishes the directors of the corporation are accustomed to act . ..

The third limb of the definition is the traditional formulation of the class of person often referred to as the 'shadow' director and is not germane to the present issue.

It seems from the extrinsic material, including the parliamentary debates, that the first two limbs of the definition were intended to represent a statutory codification of the decision of Ormiston J. in Bracht. If that is so, it seems to me that the amendment did not achieve that objective. Although some of the terminology is reminiscent of the language used by Ormiston J., the failure to include a person

' concerned in' management, which was considered by his Honour to have had a significant effect in expanding the scope of operation of the definition of 'executive officer', was a material omission.

It seems to me that the deletion of that expansive terminology had the effect that the class of persons to whom the definition 'officer of a corporation' applied was significantly smaller than the class of persons embraced by the definition of 'executive officer'. Further, in relation to the suggestion that this definition was

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intended to embody, in statutory terms, the decision of Ormiston J., it seems curious that the legislature would retain the definition of 'executive officer' in much the same terms, given that it was that definition, after all, to which the decision of Ormiston J. was addressed.

The confusion created by the location of two similar but distinct definitions of classes of personnel within s. 9 was compounded by the retention of s. 82A, which defines 'officer' in relation to a body corporate or an entity coming within Parts 3.6 and 3. 7 in a broader way again, including all 'employees'.

If the retention of s. 82A was intended, it suggests that some distinction was intended to be drawn between the circumstance in which the word 'officer' was used in relation to a body corporate or entity within the meaning of Parts 3.6 or 3. 7, as compared with the word 'officer' used in relation to a corporation. However,

because s. 57 A was also retained the expression 'corporation' includes 'a body corporate' thus producing the somewhat anomalous consequence that the phrase 'officer of a corporation' embraces a significantly smaller class than the word 'officer' when used in relation to a body corporate, notwithstanding that all bodies corporate are 'corporations' .

Further, the definitional restructure appears to have had some consequences that were unintended, or if they were intended, appear to me to be undesirable. For example, the liabilities in s. 1309 of the Corporations Law in relation to the provision of false or misleading information to directors and auditors are imposed upon 'an officer of a corporation'. Prior to the CLERP amendments those liabilities would have extended to all employees, because of the extended definition contained

in s. 82A. It seems however that because the very phrase 'officer of a corporation' used in s. 1309 is that now defined by s. 9, the only persons now subject to the liabilities imposed by the section (other than directors or secretaries and so on) are those who make or participate in making decisions that affect the whole or a

substantial part of the business of the corporation or who have the capacity significantly to affect the corporation's financial standing.

For my part, I can see no reason why the legislature would have intended to narrow the class of persons upon whom the liabilities created by s. 1309 were imposed. If an employee provides information to a director or auditor which he or she knows to be false or misleading, I can see no reason why they should not be held to have contravened the law. However, as I construe the current legislation (the

Corporations Act 2001 being in essentially the same terms as the Corporations Law after the CLERP amendments) such persons will only be found to have contravened the law if they occupy a relatively senior position in the management structure as required by the current definition of 'officer of a corporation'.

Further, the sections of the Corporations Law following the CLERP amendments (and the Corporations Act 2001) which impose general duties upon officers of corporations, namely ss. 180-184, also use the expression 'officer of a corporation' and therefore presumably invoke the somewhat narrower definition of that phrase

contained within s. 9. As I shall point out shortly, some of those duties are imposed

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also upon 'employees', but a number of the duties are only applied to the narrower class of personnel. Again, it seems to me to be somewhat unlikely that the legislature would have intended to restrict the class of persons upon whom the general duties were to be imposed when enacting ss. 180-184.

The law governing the imposition of duties upon persons who act for or on behalf of corporate entities should be clear, simple, and as far as reasonably possible, certain of application. In my opinion the current law does not meet these objectives. The three definitions-'executive officer', 'officer of a corporation' and 'officer'-are confusing and seem to have the anomalous results set out above. I recommend that the legislative structure be reviewed with a view to achieving the objectives of clarity, simplicity and certainty of application. After considering the other issues which appear to arise in this general area, I will make some suggestions as to how those objectives might be achieved.

6.4.3 Individuals subject to general duties

Both before and after the CLERP amendments it was accepted that there is a class of personnel upon whom the general duties of directors should also be imposed. For reasons outlined above, it seems that prior to March 2000 that class was wider than it currently is. For my part I cannot identify any sound policy reason for narrowing the class of persons upon whom those general duties are imposed. It seems to me, based upon my consideration of the evidence received in the course of this inquiry, that the general objectives of the Corporations Act 2001 would be more readily achieved if those duties were cast upon a broader range of persons.

In my opinion, that class should not distinguish between employees and non-employees. Instead, it. should be functionally defined. That is because it is increasingly common for a wide range of corporate functions to be performed by consultants or other contractors who are not strictly 'employees'. In my opinion it is the performance of the relevant function that should attract the legal duty, not the precise legal relationship between the person performing that function and the relevant corporate entity. The definition which applied prior to the CLERP amendments- namely, that which embraced a person who ' is concerned, or takes part, in the management of the relevant entity' - seems to be appropriate. It should be sufficient to distinguish between those who are at the more senior levels of the organisational structure, and who should be subject to the general legal duties imposed upon directors, and those at a lower level, more properly described as functionaries, who should not be subject to all the general duties imposed upon directors.

It is perhaps sufficient if I record the observation that, whatever terminology is used in the relevant provision, it should be calculated to embrace a class of senior personnel engaged in management functions broader in operation and appl ication than that embraced by the current definition of 'officer of a corporation' and which is, as far as possible, clear and certain of application. A useful model in this regard is that found in the Commonwealth Authorities and Companies Act 1997. That Act

126 Co rporate governance

essentially imposes the general duties imposed by ss.l80-184 of the Corporations Act upon directors and officers of Commonwealth authorities and companies. By s. 5 of that Act, any person who 'is concerned in, or takes part in, the management of an authority is an 'officer' for the purposes of the liabilities imposed.

6.4.4 Person s su bject to duties

As already indicated, prior to March 2000 the general duties imposed by s. 232 were imposed upon directors, secretaries, and executive officers and, in addition, the duty not to make improper use of position was imposed upon all employees. Amongst the general duties imposed by s. 232 was the duty to 'act honestly in the exercise of his or her powers or in the discharge of the duties of his or her office'.

Since March 2000 the general duties imposed by ss. 180-184 have been imposed upon the somewhat narrower class of ' officer of a corporation' 32, except that the duties imposed by ss. 182(1 ), 183(1) and 184(2) are also imposed upon 'employees' . Those duties are, respectively, the duty not to use their position improperly to gain an advantage for themselves or someone else or cause detriment to the corporation, the duty not to use improperly information obtained through their

position to gain an advantage for themselves or someone else or cause detriment to the corporation, and the duty not to use their position dishonestly with the intention of gaining advantage for themselves or causing detriment to the corporation or recklessly as to those consequences.

There is another apparent anomaly in that s. 182( I) alone of these sections refers to a class of persons being 'a director, secretary, other officer or employee'. The reference to 'secretary' seems entirely superfluous, as the term 'officer' includes both director and secretary (s. 9). It is also curious that a distinction is superficially made between s. 182 on the one hand, and ss . 183 and 184 on the other, in relation to this express reference to secretaries, but without any apparent difference m

substantive effect, because of the definition to which reference has been made.

The classes of general duty which have been chosen by the legislature to be applied to the widest class of personnel seem to me to be appropriate, but I would offer the following comments.

First, by defining the wider class of personnel by reference to the word 'employee' , consultants or independent contractors are excluded, notwithstanding that they may in fact be performing functions very analogous to those performed by employees. As suggested above, it seems that function rather than contractual classification is a

more appropriate criterion for definition in this area.

The second observation I make is that, by contrast to the position which applied prior to March 2000, dishonesty only results in contravention of the law by the extended class of personnel if their actions have the additional element of being undertaken with the intent of gaining an advantage for themselves or someone else

or causing detriment to the corporation or recklessly in relation to those consequences. By contrast, prior to March 2000, any act of dishonesty in the

The failure of HIH Insurance 127

exercise of powers or the discharge of the duties of office constituted a contravention of s. 232 of the Law.

This narrowing of the prohibition has had practical consequences in my consideration of the evidence adduced in the inquiry. It has been particularly relevant where persons acting for or on behalf of the relevant corporate entity have, for example, taken steps which resulted in falsification of the corporation's accounts or the returns lodged with relevant regulatory authorities. In some of those instances it would be difficult to conclude that the actions were taken for the purpose of gaining an advantage for the person concerned or someone else, or causing detriment to the corporation- rather, the actions were taken for the purpose of misleading those who might act in reliance upon the accounts or relevant regulatory return. This consequence was particularly significant having regard to the narrowing of the ambit of operation of s. 1309 occasioned by the legislative definitional anomaly to which I have already referred.

In the case of information provided or returns lodged in fulfilment of obligations imposed other than by the Corporations legislation, such as the returns lodged with APRA pursuant to the Insurance Act 1973 , often the specific penalty provisions in that legislation had no application because they are limited to penalising a signatory who knew the information to be false, whereas the person who knew the information to be false was the person who prepared the document, not the signatory.

On the other hand, I can see some force in the observation that the statutory duty imposed prior to March 2000 was too broad and all embracing, extending to all activities undertaken in the exercise of powers or the discharge of the duties of office.

It seems to me that an appropriate balance between the broad ambit of operation of the law prior to March 2000, and its unduly narrow operation now, would be a legislative provision which operated by reference to the performance of obligations imposed either by the Corporations Act 2001 or some other statutory provision. Such a legislative provision would catch, for example, the preparation of accounts which are required to be maintained by the Corporations Act 2001 , and the lodgment of returns to regulatory authorities required by other legislative provisions-such as the Insurance Act, or the Australian Prudential Regulation Authority Act 1998. If the obligations imposed by those statutory provisions are

performed dishonestly, it seems to me that whoever undertakes those dishonest acts should be liable for a contravention of the law, whatever their classification or function within the corporate organisation.

This would necessitate the introduetion into the Corporations Act 2001 of a provision which would prohibit any person from acting dishonestly in connection with the performance or satisfaction of any obligation imposed upon a corporation under either the Corporations Act 2001 or any other written law. The objective of a provision of this type is to make it clear to people at various levels of management

128 Corporate governance

and not just directors and senior managers that they will be held to account for their part in dishonest conduct by or on behalf of a company.

I have given consideration to the possible generality and lack of imprecision in the use of the word ·'dishonest' as the touchstone for liability. However, the word is in common and regular legal use and has now evolved a meaning which is well known to the law and which has been the subject of considerable judicial enunciation and explanation. It therefore seems to me to be an appropriate criterion fo r the

imposition of liability. The word has been the subject of statutory definition and, while this is essentially a matter for the parliamentary drafter, I incline to the view that its meaning established at common law is quite adequate.

6.4.5 Duties owed to individual group companies

A further difficulty with the current provisions concerns their application to corporate groups. The reality of modem public companies is that they are managed and controlled at a group level. As with HIH, the group structure can be complex with executives often employed by a subsidiary once or twice removed from the

main listed entity. With some of the transactions I inquired into, a consideration of the separate legal existence of a subsidiary arose almost as an afterthought as the relevant transaction was being finally documented. Serious issues could arise (and did during the inquiry) under the current legislation as to whether the executive in question, who was neither employed by the company that became a party to the transaction and who had never previously made any particular decision concerning that individual company, nevertheless owed it the duties specified in ss . 180- 184. A further question is whether their actions were capable of constituting a breach of th e duties they might owe to the company employing them, or perhaps to the ultimate

holding company of the group. I consider that the question of what duties are owed to what entities is an important issue which needs to be clarified. The answer is not simple because of the possibility of competing duties owed to different companies. To some extent the recommendation I have made with respect to the adoption ofthe criterion of function rather than employment relationship may alleviate this problem

if adopted, but any review of the legislation should bear this issue in mind.

Th e failure of HI H Insurance 129

Recommendation 2

I recommend that the Corporations Act 2001 be amended to repeal the existing legislative provisions relating to the definition of the extended classes of personnel upon whom duties are

imposed by the Act and to substitute instead a definition that is clear, simple and certain of

application .

The definition would focus on the function performed by the relevant person-not the classification

of their legal relationship to the corporate entity-and avoid expressions such as 'employee' in favour of a functional orientation.

The definition would then form the basis of a regime having the following features:

• All the general duties imposed by Chapter 20 of the Corporations Act should be imposed on directors, secretaries and the wider class of personnel encompassed within the functional

definition.

• The duties imposed by ss. 182(1), 183(1) and 184(2) of the Act should be imposed on all persons performing functions for and on behalf of corporations, whether employees or suppliers

of services under contract.

• The liabilities created by s. 1309 of the Act should be imposed on all persons and not be restricted to a limited class of management personnel.

• The classes of personnel prohibited from acting dishonestly in connection with the performance or satisfaction of any obligation imposed on the company by any written law should be

extended .

Those provisions of the Act which impose more specific duties upon classes of personnel should be reviewed for the purpose of ensuring they are consistent with this general approach. In addition, consideration should be given to clarifying the law relating to the duties owed by personnel performing functions on behalf of corporate groups.

In making these recommendations I have not overlooked the provisions of the Corporations Act which extend liability to those 'involved' in a contravention of the Act (as defined by s. 79 of the Act), and which therefore can have the effect of extending liability for a contravention beyond those primarily responsible, thus embracing persons other than 'officers'. However, the possible application of those provisions seems to me to be an imperfect solution to the policy provisions I have addressed for at least two reasons.

The first is that a person can only be liable as an accessory through such provisions if a contravention has been committed by a principal offender. But the not uncommon situation thrown up by the· evidence I have received is the circumstance in which the relevant 'officer' has not contravened the Act because he or she lacked knowledge of the facts giving rise to the contravention, although those facts were within the knowledge of some person lower in the hierarchy who was aware of the course of action to be taken by the relevant officer. In that circumstance, as there is

130 Corporate governance

no principal contravention, there can be no extended liability to any person 'involved'.

The second reason I consider these provisions to be an inadequate solution to these policy issues is that they lack the educative and informative benefits which flow from the imposition of a direct liability upon a class of persons in clear and unequivocal terms.

I have not overlooked the fact that a consequence of the implementation of these recommendations would be the expansion of the range of persons potentially liable to civil penalty, and in the case of the proposed general provision relating to dishonest dealing, criminal proceedings. However, it is my view that the protection of the public interest justifies the imposition of these liabilities upon persons who contravene duties aptly imposed upon executives at a senior level, or who act dishonestly in the discharge of a statutory duty or obligation.

6.5 Whistleblowing

Submissions were received to the effect that corporate insiders who without authority pass on information to regulators or others about possible malfeasance­ so-called whistleblowers- are a valuable source of information and should be encouraged.

The whistleblowing phenomenon raises issues for corporate governance as well as for regulatory regimes. Those responsible for the governance of a company should have an interest in inculcating within the company a culture and processes that enable instances of questionable conduct to be brought to attention outside normal reporting lines without fear of retribution. The problem is more difficult of course where the culture of a company is less benign and the only option for a concerned employee is to communicate the concern outside the company.

The General Insurance Reform Act 2001 has already introduced several whistleblowing protections and obligations for certain officers of general insurers . Section 49A of the Insurance Act requires auditors and actuaries to report to APRA if they believe that:

• the insurer is insolvent or at significant risk of insolvency

• the insurer has failed to comply with the prudential standards promulgated by APRA

• the insurer has failed to comply with a requirement of the Insurance Act, the Financial Sector (Collection of Data) Act 2001

or

The failure ofHJH Insurance 131

• an existing or proposed state of affairs may materially prejudice the interests of the insurer' s policyholders.

In addition to these obligations, s. 49C of the Insurance Act provides an indemnity to a person who, in good faith, provides information to APRA under these requirements of the Act. Further, s. 49D of the Insurance Act states that an individual is not excused from the requirement to give information on the grounds that it rpay be self-incriminating, although such information is generally not available to be used against the individual in a legal proceeding.

There is a question whether obligations and or protections of that kind could usefully be expanded to include other senior managers of general insurers. The provi sions that relate to auditors and actuaries are explicable by reason of their special roles with insurers. If the provisions were extended to other officers of insurers it seems to me that consideration would need to be given to the position of corporate officers more generally, and to their provision of information to other regulators as well as APRA.

Whistleblowing raises tricky issues. There is a tension between a corporate officer' s duty to act in good faith towards the company (although that duty may be affected where there is corporate malfeasance) and any public interest in disclosure to a regulator. An officer may feel further constrained if he or she is relevantly subject to express obligations of confidentiality.

Careful thought would have to be given to any proposal to impose on corporate officers generally positive whistleblowing-type obligations. Short of that, the case for offering protections where someone in good faith takes that course has some attraction. I have not however had the opportunity to consider the issue in this wider context and I make no reconimendation.

6.6 Corporate governance: an epilogue

A reader will observe that I have made only two formal recommendations in this chapter. One is that the Corporations Act and the ASX Listing Rules be amended to force appropriate disclosure of executive remuneration. The other is to make sense of, and to extend, what is currently an unnecessarily restrictive and difficult legislative regime applying to the duties of company personnel.

The absence of recommendations about corporate governance models is quite deliberate. On 31 March 2003 the Corporate Governance Council of the ASX released its recommendations on 'Principles of good corporate governance and be st practice'. I have not had the opportunity to study the recommendations in any detail. No doubt there will be prolonged debate about them. The council's

recommendations set out in some detail the content of a model that the council sees as 'best practice'. It will take time to assess the content and to gauge what impact the principles have on corporate life.

132 Corporate governance

I am not so much concerned with the content of a corporate governance model as with the culture of the organisation to which it attaches. This is where the evidence I heard about HIH disclosed market shortcomings. There were defects in HIH's model but I suspect that HIH would have measured up reasonably well if its corporate governance system were checked off (as a paper exercise) against most of the codes I have seen. F AI certainly would have done so.

For me, the key to good corporate governance lies in substance, not form. It is about the way the directors of a company create and develop a model to fit the circumstances of that company and then test it periodically for its practical effectiveness. It is about the directors taking control of a regime they have established and for which they are responsible. These concepts do not lend themselves easily to specification in something such as a code of best practice. That

is why I have not made any formal recommendations.

One thing is clear, though. Whatever the model, the public must know about it and about how it is operating in practice. Disclosure should be a central feature of any corporate governance regime. Shareholders, potential shareholders and the wider public are entitled to real, meaningful detail about the way the directors say they are carrying out their stewardship role. The annual report and, in these times, the company's website are important forums for disclosure.

Directors who take the fundamental notions of openness, integrity and accountability seriously and who bear in mind matters of the sort discussed in this chapter will be well on the way to good corporate governance.

Cad bury report-Committee on the Financial Aspects of Corporate Governance Report, 1992, Professional Publishing Ltd, London.

Cadbury report, op cit., pars 3.2, 3.3 and 3.4.

ibid. , par. 5.1

ibid., par. 4.2 and following.

ibid., par. 2.5.

ibid., par. 1.8. Francis, I 1997, Future Direction- The Power of the Competitive Board, Pearson Professional (Australia) Pty Ltd, Melbourne, p 78 ; Bosch, J 1993, Corporate Practices and Conduct, 2nd edn, Information Australia, Melbourne, pp 9- 11; Hampel, R 1998,

'The Hampel report on corporate governance' , Company and Securities Law Journal , Vol. 16, pp.408-13 .

(1995) ACLC 3211 at 3222.

ASIC v Rich [2003] NSWSC 85 .

The failure ofHIH Insurance 133

10

II

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

29

30

31

32

134

Cadbury report par. 4.7.

Wishart v Henneberry (1962) 3 FLR 171 at 173 Spicer CJ, Dunphy and Joske JJ.

Woolworths v Kelly (1991) 4 ACSR 431 at 445; ASIC v Rich [2003] NSWSC 85.

Cad bury report Code of Best Practice 1.2.

ibid., par. 4.8.

ibid., par. 4.5.

ibid., par. 4.6.

ibid ., pars 4.11 and 4.12.

(1992) 7 ACSR 759.

(1995) 37 NSWLR 438.

Corporations Laws. 198D (now s. 198D of the Corporations Act 200I).

Re City Equitable Fire Insurance Co Ltd [1925] Ch 407 at 428-29.

Permanent Building Society (in liq) v Wheeler (1993) 11 WAR 187. Biala Pty Ltd v Mallina Holdings Ltd (1994) 13 WAR 124.

(1995) NSWLR 438 at 492. Section 189 is repeated in the Corporations Act 200 I.

See for example the IFSA Guidelines, Guideline 2, Cad bury report par. 4.1, 4.2, Cad bury Code of Best Practice 1.1, Higgs report Suggested Revised Code 1.

Bray v Ford (1896) AC 44 at 51-52 Buffet, Berkshire Hathaway Inc, Shareholder-Designated Contributions, 1981.

Hon Sir Gerard Brennan, 'Law, Values and Charity,' (2002) 76 Australian Law Journal 492 at 497.

(1989) VR 821.

At 830.

As defined by s. 9.

..

Corporate governance

7 Financial reporting and assurance

Financial reports that provide accurate, timely and comparable financial information about the underlying financial position and performance of a business are an important element of the effective operation of a modem economy. Such information allows investors and creditors to make informed decisions which assist the efficient flow of capital to its most productive uses.

Financial reports are mandated by the Corporations Act 2001 and should reflect the application and interpretation of accounting standards. The overriding requirements of the Corporations Act are that financial reports must comply with the accounting standards and present a 'true and fair' view of the financial position and performance of the entity.

The preparation of financial reports has two main elements: first, the application and interpretation of the accounting standards pertaining to those reports (Section 7.1) and second, the assurance that those reports are true and fair. These requirements are the responsibility of the board of the company with the assistance of the auditor.

The role of the auditor is considered in Section 7.2.

Under the Insurance Act 1973 most insurers are now required to use the services of an actuary to provide advice on, amongst other things, the valuation of the insurer' s outstanding claims provisions. Given the central role that provisioning plays in the business of a general insurer, the valuation of OCP is critical in providing accurate

financial statements. The role of the actuary is addressed in Section 7.3.

7.1 Accounting standards

In Australia accounting standards are set by the Australian Accounting Standards Board. The AASB is overseen by the Financial Reporting Council. The FRC is responsible for determining the broad strategic direction of the AASB and for advising the government on the setting of accounting standards and on

developments in international accounting standards. The FRC does not influence the AASB 's technical deliberations or the content of particular accounting standards.

The FRC is also responsible for appointing part-time members to the AASB. The full-time chair of the AASB is appointed by the Treasurer. The AASB is largely comprised of accountants and accounting specialists.

The AASB is funded in part by appropriations by the Commonwealth ($1.5 million in 200 1-02), state and territory governments ($0.5 million in 200 1-02) and the accounting bodies ($0.75 million) and the Australian Stock Exchange

Th e failure of HIH Insurance 135

($0.06 million). The AASB also seeks funding contributions from large listed companies in Australia.

The primary objective of the AASB is to improve the quality of general purpose financial reports in Australia. The AASB also has an objective of harmonising Australian accounting standards with international standards. The Commonwealth Government has recently announced that entities subject to the Corporations Act will be required to comply with international accounting standards from I January 2005.

The development of accounting standards in Australia is a consultative process. In broad terms, the process involves the publication of exposure drafts by the AASB following discussion with a consultative group drawn from a wide cross-section of interest groups in the private, public and not-for-profit sectors. The AASB encourages comments from interested people and organisations on exposure drafts. These comments are taken into account when the AASB finalises accounting standards.

Accounting standards have the force of law under the Corporations Act. Entities subject to the Act are required to comply with accounting standards issued by the AASB.

Evidence emerged during the Commission that the interpretation of certain key accounting standards (including, for example, AASB 1002 'Events occurring after reporting date', AASB 1013 'Accounting for goodwill' and AASB 1023 'Financial reporting of general insurance activities') was not straightforward. Often this simply reflected an incorrect application of a relatively clear standard. At other times, however, the meaning of the standard was not as clear as it could be.

Some hold the view that the problems that have been identified by this inquiry might reflect difficulties in financial reporting more broadly. Professors Dean, Clarke and Wolnizer, argued, for example that:

... the nature and scope of the financial reporting mechanisms in place to regulate corporate affairs are flawed ... In particular we submit that the regu lation in respect to financial information regarding the wealth and progress of public companies is defective in design, inept in

implementation, and the source of inherently misleading data. 1

One reason why some accounting standards lack clarity is because the current consultative process of standard setting may involve compromise and inconsistency. Another reason might be the origins of the standards, which started out as guidelines rather than delegated legislation. In my view, poorly-worded standards that are subject to wide or inconsistent interpretation are incompatible with a system that gives them the force of law as the present standards have under the Corporations Act.

As such, I consider that the accounting standard setters, the AASB and the International Accounting Standards Board, need to pay close attention to clarity and ease of interpretation of standards as they are developed. I understand, for example,

136 Financial reporting and assurance

that when drafting new standards, the AASB is now looking to draw on legal drafting experience. This should be encouraged. Indeed, given that accounting standards are in effect delegated legislation and are of critical importance the utilisation of specialist legal assistance is imperative.

I also consider that wider participation in the standard-setting process would be beneficial. At present the AASB is largely made up of accounting professionals. Inclusion of people with other business or professional backgrounds would bring a broader perspective to bear on the principles and issues at stake. As noted above, the FRC has some role in shaping the AASB's agenda. But it has limited if any direct

involvement in the actual formulation of standards. Broadening the membership of the AASB could help develop clearer and more robust standards. The preparation of accounting standards is too important to be left solely to accountants, just as the preparation of legislation is too important to be left solely to lawyers.

Recommendation 3

I recommend that the Commonwealth Government broaden the membership of the Australian Accounting Standards Board to include people with business or professional backgrounds beyond the accounting profession .

7.1.1 International accounting standards

As noted above, the government has stated that Australia will adopt international accounting standards from 1 January 2005 for entities subject to the Corporations Act 2001 . The decision to adopt international standards will mean that Australia will have less flexibility in developing standards that apply domestically. But it will

likely increase comparability of financial reports across countries and may make Australia more attractive to international capital investment.

Recommendation 4

I recommend that Australia participate fully in the development of international accounting standards and pursue the adoption of high-quality, consistent and readily understood accounting

standards.

The full implications of the government's decision to adopt international standards have not yet emerged. Adopting international standards may entail the application of those standards without amendment or addition. Or it may involve adopting the standards with some alteration for Australian conditions. In my view the standards adopted should reflect the full requirements of the international standards but

Australia should reserve the right to extend the standards in certain areas (without affecting their application), for example in areas of disclosure.

The failure ofHIH In surance 137

Recommendation 5

I recommend that, in adopting international standards, Australia reserve the right to require more stringent standards that are not inconsistent with the relevant international standards. These would generally relate to disclosure requirements.

There may also be instances where the interpretation and application of a standard may require clarification. Arguably, this should be achieved through changes to the standards themselves. But such changes may take some time to implement. As such, there may be a need for an Australian body to interpret the international standards in particular instances.

7.1.2 Interpreting accounting standards

A fundamental issue that arose in this inquiry was the interpretation and application of several Australian accounting standards. The misinterpretation of the standards and of the requirement of the Corporations Law to present financial statements that were 'true and fair' allowed HIH to publish financial statements that did not truly or fairly represent the financial position or performance of the HIH group.

Under s. 297 of the Corporations Act, annual financial statements and notes must give a true and fair view of the financial position and performance of an entity. This section does not affect the obligation imposed under s. 296 whereby a company's financial report must comply with accounting standards. If the financial statements and notes prepared in accordance with accounting standards would not give a true and fair view, additional information must be included in the notes to the financial statements under s. 295(3)(c) of the Act.

There has been some debate about whether the requirement to present a true and fair view should have primacy over the requirement to comply with the standards. The Corporations Act simply requires that both requirements be met. The obligations under the Act were recently summarised in a submission by Mark Leibler to the review of independent auditing by the Joint Committee on Public Accounts and Audit:

138

Nowhere in the [Corporations] Act is there a suggestion that accounting standards are to be treated as having primacy over 'a true and fair view'. The fact that differences between them are to be reconciled, in the case of 'a true and fair view', by way of a note to the financial statements, does not in any way suggest that 'a true and fair view' is to be treated as being in some way secondary to compliance with accounting standards.

There is no legal basis for the argument that compliance with accounting standards equates to 'a true and fair view'. On the contrary, the statutory framework specifically contemplates that accounting standards may not give 'a true and fair view'. Indeed, in one sense, looking at the financial

report as a whole, it seems clear that the Act contemplates a 'true and fair view' override, albeit that the override is by way of a note rather than being included in the body of the accounts. 2

Financial reporting and assurance

I take the same view. It may be that because the accounting standards have the force of law those who are responsible for the preparation of accounts have, over time, effectively forgotten about the 'true and fair view' requirement. This may seem strange in view of the fact that both the directors' declaration and the audit opinion contain clear reference to the words. If, as I suspect, preparers of accounts have forgotten the significance of true and fair view, they ought to be reminded.

Following its review, the JCPAA made a recommendation3 that the Corporations Act be amended by replacing the current footnote to s. 297 requiring that financial statements give a true and fair view with a separate section. In my view, this approach will clarify the effect of the Act and is worthwhile.

As the current requirements of the Corporations Act acknowledge, there will inevitably be circumstances where the correct application of the accounting standards is contentious. Fundamentally the accounting for a transaction should reflect the economic substance of that transaction. This approach is reflected m clause 4.1.8 of AASB 1001 'Accounting policies':

For financial information to satisfY both the relevance and reliability concepts, it is necessary that the substance rather than the form of a transaction or other event be reported where substance and form differ.

Problems concerning the interpretation of accounting standards need to be addressed by both compliance and the standards themselves to reduce the scope for misinterpretation or abuse.

Compliance with the accounting standards

The resolution of urgent financial reporting issues is presently the domain of the AASB through the work of the Urgent Issues Group.

The role of the UIG, which is a committee of the AASB, is to provide timely guidance on urgent financial reporting issues. Accounting standard AASB 1001/AAS 6 'Accounting policies' states that accounting policies to be applied to many transactions or other events are specified in accounting standards, other authoritative pronouncements of the AASB or UIG consensus views.

In my view, the UIG is the appropriate body to resolve important issues regarding the interpretation and application of the accounting standards in particular instances. For example, there were some concerns relating to the correct application of AASB 1023 to particular transactions entered into by HIH. If they had been dealt with by the UIG, a more appropriate application of the standard may have occurred.

Under its current charter, the UIG is arguably not equipped to address financial reporting concerns in a timely and efficient way.

The UIG is comprised of 15 part-time, unpaid members. It meets as required and attendance by all UIG members is expected. The UIG will not reach a view that conflicts with or changes either the accounting standards or statements of accounting concepts or an issue that is currently being addressed by the AASB . In

Th e failure ofHIH Insurance 139

addition, the AASB has the right to veto UIG consensus vi ews. The UIG will also inform the AASB of any emerging issues that indicate inadequacies in the accounting standards or statements of accounting concepts.

To be accepted as a consensus view, at least 11 members of the UIG must vote in favour of and no more than three members vote against the treatment proposed. In addition, except when otherwise determined by the chair, the UIG must reach a consensus view within three meetings or the issue is deleted from the UIG agenda. Such unresolved issues are passed back to the AASB for consideration.

Issues are raised for the UIG's consideration either by UIG members or observers or other persons in writing to the chair of the UIG. All new issues are considered by the UIG agenda committee comprising the UIG chair and two members of the UIG. The agenda committee determines whether an issue should be included on the UIG agenda.

In short, the UIG comprises a relatively large group of people and is structured to consider issues brought before it in a considered and comprehensive fashion.

I consider that matters of the interpretation and application of the accounting standards would be more effectively resolved by a smaller more focused group than the UIG. Perhaps a sub-committee of the larger group can fulfil that role. This smaller group should not be limited to accounting professionals. It should include a larger representation of the users of financial reports (such as analysts and shareholders) and lawyers to provide appropriate legal and other advice.

The UIG's charter should be changed to ensure that where issues of the interpretation of the accounting standards are brought before it, they are resolved in a more timely fashion. In undertaking its function, the UIG should be required, for example, to issue interim but binding statements on the interpretation of accounting standards. Such statements should stand until they are confirmed or overturned by the AASB.

Recommendation 6

I recommend that the Australian Accounting Standards Boardalter the Urgent Issues Group or create a separate group that is able promptly to issue binding rulings on important and urgent

matters concerning the interpretation and application of the accounting standards.

The board should extend the constitution of the Urgent Issues Group or the separate group

beyond accounting professionals and include lawyers and users of financial statements .

Obviously the UIG can only resolve questions of the interpretation of the accounting standards where issues are brought before it. At present, disputes between auditors and companies over the correct interpretation and application of accounting standards are usually resolved between the auditors and companies themselves. In the case of HIH, such issues were always 'resolved' by adopting the view of management which, on occasion, promoted an incorrect accounting

140 Financial reporting and assurance

treatment. This is clearly undesirable. One solution to this problem is to improve the effectiveness of the audit function. This is addressed in Section 7.2 .

On occasion however there are genuine disagreements between auditors and the management of a company as to the correct application of an accounting standard. In these instances, auditors should be able to consult professional bodies such as the UIG. Encouraging auditors to take such action is, I believe, a responsibility of the

professional accounting bodies and should be achieved through appropriate guidelines.

It is important that recourse to the UIG remains the exception rather than the rule. The UIG should not be seen as a forum where all disputes between auditors and companies are resolved. The framing of guidelines for auditors should reflect the need to strike an appropriate balance in this area. This might be achieved by encouraging auditors, in the first instance, to consult with another accounting firm to provide advice on a particular matter of interpretation. Where disagreements cannot

be resolved in this way, recourse to the UIG might then be pursued.

Recommendation 7

I recommend that the professional accounting bodies develop guidelines to encourage their members to consult independent third parties or the Urgent Issues Group when there is

disagreement with the management of companies concerning the interpretation or application of

accounting standards.

7.1.3 Improving AASB 1023

A major issue relating to the regulation of general insurance is the appropriate accounting treatment of insurance transactions. In Australia, the financial reporting of general insurance transactions is regulated by accounting standard AASB 1023 'Financial reporting of general insurance activities'.

Accurate financial information is particularly important in the case of a general insurer because insurance business involves significant uncertainties and risks that often have a major effect on the profitability and solvency of the insurer. Financial information that accurately reflects the position of an insurer is important both for shareholders and creditors, particularly policyholders, given their interest in the continued ability of the insurer to meet all valid claims as they arise.

Accurate financial information is even more important in cases of long-tail insurance where the payment of claims may occur some years after premium income has been received. In the absence of such information it is possible that a general insurer dealing in long-tail classes of business could be technically insolvent (in the

sense that its true liabilities exceed its assets) but remain operational for a significant period of time because of the timing of receipts and payments in the business. This occurred in the case of HIH.

The failure ofHJH Insurance 141

In this context it is worthwhile to consider whether the current accounting standard for insurance transactions is appropriate and, if not, what improvements might be made. The current arrangements for accounting standard AASB I 023 are outlined in the Commission's Background Paper No. 12.

In summary, AASB I023 takes a 'deferral and matching' approach to the reporting of the financial information of general insurance transactions. That is , the recognition of premium revenue is deferred and matched to the recognition of claims liabilities. AASB I 023 also requires that liabilities be estimated based on the present value of the expected future cash flows associated with the claims. This ensures that liabilities are measured on a consistent basis to insurance assets, which are valued at present market prices.

International approaches According to the AASB4 , Australia is only one of three jurisdictions to have an accounting standard relating specifically to the general insurance industry. The United States has Statement 60 'Accounting and reporting by insurance enterprises' and New Zealand has FRS-35 'Financial reporting of general insurance activities', which is based on AASB I023. The United Kingdom has a statement of recommended practice prepared by the Association of British Insurers which is recognised by the UK's Accounting Standards Board but it does not have the status of a standard.

The approaches taken in both the US standard and the UK statement of recommended practice are similar to that of AASB I023. There are some differences, however. In both the United States and United Kingdom, discounting is generally not permitted in calculating the present value of expected future cash flows associated with settling claims. This has the effect of building an implicit prudential margin in valuing claims liabilities, especially in cases of long-tail

msurance.

Like AASB 1023, the US and UK approaches do not permit the use of an explicit prudential margin, although in the United Kingdom a degree of caution is required to be used in setting provisions to ensure that the cost of highly uncertain events is not understated. The only other major difference is that the US standard requires the recognition of a premium deficiency if the sum of expected claim costs and claim adjustment expenses, expected dividends to policyholders, unamortised acquisition costs and maintenance costs exceeds related unearned premiums.

Weaknesses in AASB 1023 An important factor contributing to the failure of HIH was inaccurate reporting of financial information, particularly the ·valuation of outstanding claims provisions. This inaccurate reporting was caused partly by HIH officers and auditors misinterpreting the requirements and application of the existing accounting standards. But it was also caused by deficiencies in those standards. I believe that these deficiencies, which are discussed below, should be addressed by changing the requirements of AASB I023.

142 Financial reporting and assurance

The deficiencies in AASB 1023 are well illustrated by the accounting treatment given to a reinsurance contract entered into by HIH with a reinsurer and booked in the December 1997 accounts. This matter is dealt with in some detail in Section 16.3.5. The evidence led in relation to this contract demonstrated that there were several plausible interpretations of clause 7.1 ofAASB 1023.

Valuing insurance liabilities The largest liability of a general insurer is its liability for outstanding claims. Clause 5.1 of AASB 1023 requires that the liability for outstanding claims be recognised in respect of both direct business and inwards reinsurance business and be measured as the present value of the expected future payments. Clause 5.2 provides that the expected future payments must include amounts in relation to unpaid reported claims, claims incurred but not reported, adjustments in light of most recently available information for claims development and claims incurred but not enough reported, and costs that the insurer expects to incur in settling these claims.

'Liabilities' are defined in AASB 1023 to mean:

Future sacrifices of economic benefits that the entity is presently obliged to make to other entities as a result of past transactions or other past events.

Statement of Accounting Concepts 4 provides (at paragraph 65) that a liability should be recognised in the statement of financial position when and only when:

• it is probable that the future sacrifice of economic benefits will be required

• the amount of the liability can be measured reliably.

The commentary to this statement (at paragraph 67) says that the word 'probable' means that the chance of the future sacrifice of economic benefits being required is more likely rather than less likely.

Apart from what I regard as an almost meaningless comparison which is implied by the expression 'more likely rather than less likely', the application of these principles to the recognition of outstanding claims liabilities of general insurers is fraught with difficulty. How can a general insurer reliably measure the amount of

liabilities that it is probable (that is, more likely than not) that it has to policyholders for claims which have been incurred but which have not been reported, and therefore of which it has no knowledge? Is it necessary before any provision is made for such liabilities that in respect of each such claim there is a probability that the

insurer will be required to pay the claim and the amount thereof can be reliably measured?

As the Institute of Actuaries observed in its submissions, in the case of insurance most of the events considered, looked at individually, have probabilities of occurring of much less than 50 per cent. If the only claims liabilities recognised by an insurer were for reported claims this would result in massive under-reporting of

liabilities for those classes where lengthy reporting delays are common and substantial under-reporting in other classes. 5 As those submissions point out, the

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problem is partially addressed by accounting for liabilities in the aggregate, particularly by portfolio, rather than by requiring that each individual liability be identified and be considered probable.

The Institute submitted that the wording of the 'probable' test in SAC 4 allowed a loophole which should be closed. I agree that the standard should be clarified to ensure that it is not necessary to assess each individual claim liability as being probable and capable of reliable measurement before it can be recognised.

I am concerned in this respect by the language used in Chapter 2 of the International Standards Advisory Council's draft statement of principles (DSOP). It was summarised in the 'Project summary' prepared by the International Accounting Standards Board for its November 2002 meeting as follows:

16 . Insurance assets and insurance liabilities are assets and liabilities arising under an insurance contract. An insurer ... would recognise:

(b) an insurance liability when, and only when, it has contractual obligations under an insurance contract that result in a liability.

I agree with the general thrust of Chapter 2 of the DSOP which favours an asset and liability measurement approach rather than the approach of deferring and matching costs and revenue. However, neither the current AASB 1023, nor principle 2.2 of the DSOP, give appropriate attention to how the uncertain claims liabilities of general insurers should be recognised and valued. In this context the Institute of Actuaries submits that insurance is stochastic, whereas accounting is deterministic. In other words, to measure a general insurer's claims liabilities is to measure different ranges of uncertainty. The concept of accounting, however, which underlies the SAC 4, and principle 2.2 of the !SAC's DSOP, assumes that liabilities have largely known and fixed values.

Thus, principle 2.2 of the !SAC's DSOP, which is reflected in the paragraph I have quoted, states that an insurer should recognise and measure each of its liabilities to its policyholders individually. It uses the singular: 'an insurance liability'. If this principle were read literally, at least in conjunction with the present SAC 4, it would result in a massive under-reporting of claims liabilities. It would be inconsistent with actuarial practice and the industry's practice as to how claims liabilities are

reported. It would make no allowance for unknown claims.

In my view the accounting standards should require an insurer to determine the expected value of its outstanding claims liabilities not by reference to its liabilities to individual policyholders but by each. class of business.

At any reporting date the true value of the liability of an insurer for outstanding claims which have been incurred to that date is uncertain. There is a range of possible values. The estimate of the value of an insurer's liabilities that is considered to have a 50 per cent chance of being sufficient is known as the central estimate. It is common industry practice for insurers to add a prudential margin to

144 Financial reporting and assurance

the central estimate in determining its outstanding claims liabilities. Actuarial Standard PS300 defines a prudential margin as an amount by which the provision set aside in the accounts for outstanding claims liabilities is greater than the actuarial central estimate of the liabilities ' due to the inherent uncertainty in the detem1ination of the actuarial central estimate' .6 The Commission, with the assistance of the Insurance Council of Australia, sought information from a number of Australian general insurers as to the use made by them of prudential margins. Responses were received from seven insurers. All but one claimed to use prudential margins in the provision made for outstanding claims liabilities.

The Prudential Standard GSP21 0 requires that the valuation of outstanding claims liabilities, for each class of business, must comprise a central estimate at the value of those liabilities and risk margins that relate to the inherent uncertainty of the central estimate value. 7 The risk margin is required to ensure that the outstanding claims liability has a 75 per cent chance of sufficiency. It is to be not less than one half of the coefficient of variation of the insurance distributions.

There is a conflict between industry practice and Prudential Standard GSP21 0 on the one hand and the requirements of AASB 1023, when read with SAC 4, on the other. (See Chapter 5 for a further discussion of the general principles of provisioning). To the extent that there is a margin over the central estimate, it cannot be said that there is a 'probability' that a future sacrifice of economic benefits will

be required to satisfy an existing obligation. There is nothing in AASB 1023 which says that a prudential margin, which works to reduce the uncertainty in the valuation of the OCL, can or should be valued and included as a liability. Yet the inclusion of that margin may profoundly affect the financial position of the insurer. One of the submissions, when referring to a statement made by HIH that its claims reserving process was underpinned by an actuarial review of future long-tail claims liabilities and historical data, said:

It suggests that an ' actuarial review ... ' removes the uncertainty in the central estimate of the mean . Even if [this] were true then not including a security margin represents the antithesis of the fundamental statistical principle of insurance. It is well known that if you charge the (true) mean cost, it is statistically certain that you will eventually go bankrupt due to the process variability. But in practice you don't even know the mean cost precisely, so you need to allow for that uncertainty too ... 8 [emphasis in original]

In similar vein, an actuary retained by HIH reported to HIH that:

It is a well established law of insurance that one cannot sustain indefinitely reserving on a 50 per cent probability basis, unless one has excess capital to bum.

Even if it were possible to derive a central estimate of an insurer's liabilities which had no uncertainty in it, the mean of all the possible values of an insurer's claims liabilities will almost certainly not represent the true amount which the insurer will have to pay to settle its existing liabilities. Capital in excess of the provision for

outstanding claims (if the latter is assessed as a central estimate) is, on that account,

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excess capital which as a matter of prudence (or prudential regulation) an insurer should keep to ensure it can meet claims. Capital in excess of the central estimate will almost certainly be required from time to time to meet the existing claims.

Fair value measurement International Accounting Standards define fair value as 'the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arms length transaction'. In paragraph 3.4 of the DSOP the fair value of a liability was described 'as the amount that the enterprise would have to pay a third party at the balance sheet date to take over the liability.' The IASC proposed that while lAS 39 is still in place insurance liabilities and insurance assets should be measured at 'entity- specific value, being the present value of the costs that the

insurer will incur in settling the liability with policy holders in accordance with its contractual terms over the life of the liability ' . The IASC further proposed that if a successor standard to lAS 39 introduced fair value measurement for the substantial majority of financial assets and liabilities, the IASB should consider introducing fair value measurement for all insurance liabilities and insurance assets.

The definition of 'fair value' in the international accounting standards is adopted in AASB 1033 for the valuing of assets and liabilities comprised in financial instruments, subject to those values being determined by an actual or hypothetical market. There seems to me to be a regrettable confusion about what the definition means. To repeat, paragraph 3.4 of the !SAC's DSOP says:

Fair value is the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arms length transaction. In particular, the fair value of a liability is the amount that the enterprise would have to pay a third party at the balance sheet date to take over the liability.

The second sentence is not a particular of the first.

What a liability can be settled for depends upon what the obligee would agree to accept in discharge of the obligation. What a person will pay to have their liabilities taken over will depend on what payment a third party will require to indemnify the obligor against its liability. Except with the authority of statute, an obligor cannot transfer a liability without the consent of the obligee.

It seems to me that it is this confusion about what the ' fair value' of the liability means which explains the debate as to whether the obligor's (that is , the insurer' s) own credit standing would affect the fair value of its liabilities.

The Insurance Contracts (Phase H)-Project Summary observed in paragraph 19 that:

146

The DSOP describes entity-specific value as the value of an asset or liabilities to the enterprise that holds it. As in various IASC standards, fair value is 'the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arms-length

Financial reporting and assurance

transaction'. Entity-specific value differs from fair value in the following respects:

(c) the entity-specific value of an insurance liability would not reflect the insurer's own credit standing. The Joint Working Group on Financial Instruments proposed in December 2000 that the fair value of financial liabilities would reflect the credit risk in the liability. Although this seems to be a logical extension of fair

value, the former IASC Steering Committee had concerns about the practical implications of this approach and most commentators on the 1999 Insurance Issues Paper were strongly opposed to this idea.

The notion that the credit standing of an insurer should affect the value of its liabilities is a logical extension of the notion of fair value only if that is the amount for which the insurer's liabilities could be settled, rather than taken over.

There is and can be no market for the settlement of liabilities of an msurer. Necessarily, the only participants in the settlement of liabilities could be the insurer and its policyholders or their assignees.

The idea that a true and fair view of the value of HIH's liabilities to its

policyholders could be obtained by asking what knowledgeable and willing parties (that is HIH and its policyholders) would pay to settle those liabilities is to my mind bizarre. If the policyholders would rationally accept $0.20 in the dollar because HIH is insolvent, does that mean that HIH should report its liabilities as being a fifth of what they actually are? The proposition has only to be stated to be rejected.

As set out below, I also have no confidence in the notion that the fair value of liabilities can be based upon what, in an hypothetical market, 3omeone will pay to 'take over those liabilities.'

But before considering that question, I should emphasise my disquiet that what appear to be contradictory notions of the 'fair value' of a liability (that is both the settlement value and what someone would pay to 'take them over') should be set out in the same definition as if they meant the same thing.

In my opinion, liabilities should not be valued according to the definition of ' fair value' contained in the various lAS standards and in AASB 1033 as 'the amount for which a liability could be settled between knowledgeable and willing parties in an arms' length transaction'.

In the rest of this chapter, I treat the concept of 'fair value' of liabilities as referring to what knowledgeable and willing parties would pay and require for a third party to 'take over' those liabilities. As I have said, this is apparently how the concept was understood by the IASC in its DSOP.

In a policy paper published in March 2001 entitled 'Prudential Supervision of General Insurance' APRA commented that it remained of the view that in the

The failure ofHIH Insurance 147

absence of clear accounting standards on 'fair value', a mandated risk margin was necessary to ensure sufficient objective, reliable and consistent valuation of insurance liabilities. It characterised the 75th percentile as an arbitrary proxy for ' fair value' and said that in APRA's view its simplicity more than off set any potential drawback from its general application. APRA went on to say that:

Once the accounting standards are updated to produce a more meaningful and rigorous means of establishing the fair value of a portfolio with insurance liabilities, APRA will look to incorporate these within its Prudential Standards.

The reason why the prudential margin might be seen as a 'proxy' for a 'fair value' measurement of liabilities appears to be that if a third party were to take over an insurer's claims liabilities, it would exact as part of its price both a profit margin and an amount to protect itself against any underestimate of the liabilities. That may be true. However, it is not necessary, and may not be desirable, to postulate a hypothetical 'transfer' of liabilities to a third party to justify providing for the cost of uncertainty.

An objection to valuing liabilities at a so-called market value is that there is no market for the transfer of liabilities. In the absence of statutory authority, it is not possible for an insurer to transfer the liabilities it has to its policyholders without their consent. Although it is theoretically possible to obtain a complete indemnity in respect of an insurer's claims liabilities, and in that sense for a third party to 'take over' liabilities, there is no developed market for the buying of such indemnities. Whilst accounting for assets according to their market values provides a logical reference point for valuing those assets, as the market represents how the company could realise its assets for cash, the same is not true of valuing liabilities. Thus a

'fair value' approach to the valuing of claims liabilities would require the construction of models and the making of assumptions which would build in the insurer's (or its adviser's) own expectations and assumptions.

It is also a matter of concern that there is little focus in the debate on the 'fair value' measurement of liabilities upon the potential for an insurer to manipulate its outstanding claims provision if the insurer were allowed or required to postulate what a hypothetical party might pay to take over its· liabilities. Unless appropriate safeguards are incorporated into the standard, a general insurer may value its claims

liabilities by reference to what a hypothetical third party wou ld pay to 'take them over' and make provision for an amount which was less than its central estimate, and therefore less than what it estimated it would have to pay to settle its claims. That could be so for a number of reasons.

For example, the insurer might custQmarily not insist on strict compliance by its insureds with conditions precedent to the making of a claim, or might adopt a more lenient approach to the assessment and payment of claims than the hypothetical third party. The insurer may be under constraints, to which the hypothetical third party would not be subject, such as to preserve its reputation and market share or as a result of political or media pressure on the insurer. One could also postulate a

148 Financial reporting and assurance

hypothetical third party who would use cheaper and more efficient processes for handling and settling claims than those available to the insurer. Management who believed that the actuary's central estimate was too conservative might postulate that the hypothetical third party would also take that view.

These possibilities are not fanciful. One aspect of the claims liabilities for which an insurer must provide is its future indirect claims settlement costs. From 1998 HIH required its actuary to prepare the valuation of liabilities using an allowance across the board of 2 per cent for future claims handling costs. This was a lower percentage than the actuary had previously adopted. HIH did not seek to justify that lower

percentage by an analysis of its actual claims handling expenses. Instead it obtained a quote from a third party as to what that party would charge HIH to handle the settlement ofHIH's claims liabilities, although it was never intended that the claims handling function would be transferred to that party. This approach would seem to accord with a 'fair value' measurement of this part of the claims liabilities, by referring to a hypothetical and willing acquirer. The third party's quote was affected by a number of matters, including savings which would be available to it from the centralisation of the claims handling but which did not reflect how HIH itself had in the past handled, or proposed to handle, its claims. There was evidence before the Commission that this approach resulted in a substantial underprovision for claims

liabilities. There would also be scope for a third party, knowing that it would not in fact be taking over an insurer's liabilities, to under-quote the price it would demand to do so.

I therefore see no theoretical or practical advantage in the 'fair valuation' (meaning a value based on an hypothetical third party transaction) of an insurer's liabilities.

Risk margins The IASC recommended that the value of insurance liabilities (and assets), whether determined as the 'entity-specific value' or the 'fair value', should always reflect risk and uncertainty (Principle 5.1). This is correct in principle but is not presently allowed for under AASB 1023. The IASC recommended that both diversifiable and undiversifiable risk should be reflected in the value of the liabilities (Principle 5.4). This was qualified by describing the classification of different risks as comprising:

• model risk (the risk that the insurer has chosen an incorrect model of future cash flows)

• parameter risk (the risk of error in the application of information about an underlying probability distribution)

• process risk (the risk of unavoidable random statistical fluctuations that will occur even if the model chosen is totally accurate and the estimate of the parameters of the distribution under the model is correct).

In paragraph 5.10 the IASC said that to avoid undue subjectivity it was appropriate to exclude adjustments for model risk and parameter risk unless there is persuasive evidence that enables an insurer to quantify them by reference to observable market

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data. The IASC concluded that, so far as possible, estimates of liabilities should use observable market data to reflect the market's risk preferences using a consistent methodology over time. The data it proposed included prices for financial instruments with similar risk characteristics (to the liabilities being valued), current market insurance premiums, current market reinsurance premiums, and recent market prices for portfolio transfers. The IASC went on to say that 'in many cases' such data may need adjustment if it reflects transactions or instruments that differ in some, possibly material, respects from the insurance liability being measured. The IASC proposed that the reflection of overall risk preferences 'in the market' should be adopted because this creates comparability between different enterprises. It reports information using a reasonably common benchmark based on the degree of risk aversion present in the market as a whole (paragraph 5.24).

The IASC acknowledged that inferences about the market's risk preferences will inevitably be subjective. That must be true and it compromises the attempt to avoid subjectivity by recourse to so-called market data. One might ask how a value would be placed upon the uncertainty of the estimate of HIH's liability portfolio. According to the DSOP, the data from which the market's risk preferences may be inferred could include:

• prices for financial instruments with similar risk characteristics-although it is hard to bring to mind a financial instrument with risk characteristics similar to the liability portfolio

• current market insurance premiums-but insurance premiums price the perceived risks assumed under the policies in question. They do not contain a separate allowance for the uncertainty in the estimate of liability

• current market reinsurance premiums-the premium charged by reinsurers to provide unlimited excess-of-loss cover above the insurer' s (reinsured's) central estimate would provide good evidence of the value (or cost) of the uncertainty of the central estimate. However, at least in Australia, there is no observable

'market data' of the premiums which would be charged. The evidence before the Commission suggests, as would naturally be expected, that reinsurers offering such reinsurance make their own analysis of the portfolio in pricing the risk of the claims liabilities exceeding the insurer' s central estimate before settling on an appropriate premium for a limited amount of cover. It is not obvious how that process can yield a 'market' reinsurance premium for unlimited cover over a central estimate of a portfolio which has not been reviewed by a reinsurer. It is highly unlikely that any reinsurer would offer unlimited stop loss cover. It would also be necessary to take into account the creditworthiness of the reinsurer ) n being satisfied as to a quoted premium. Moreover, there would be a substantial risk that the true premium could be disguised, particularly if it were not proposed that unlimited stop-loss cover on the portfolio in fact be taken

• recent market prices for portfolio transfers- this assumes that there is such a market. It assumes that the market is for comparable portfolios. It assumes it

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would be possible to identify how much of a price charged by a third party to acquire a comparable loss portfolio was attributable to the uncertainty of the estimate of its liabilities. None of those assumptions can be made in Australia. The IASC's proposals to be useful would require the existence of a market of a depth and transparency that does not exist in Australia.

The IASC noted what was then APRA's proposal of a 75 per cent confidence level for general insurers. The DSOP said that it did not propose such a benchmark as it would be arbitrary. In one sense it is true that the 75 per cent confidence level is arbitrary. But it does have the merit of providing consistency and comparability to the extent insurers provide adequate data and the actuaries use consistent methodologies appropriate to the portfolio being valued.

Accordingly the position seems to be:

• uncertainty of the central estimate has a cost

• an appropriate allowance for uncertainty (risk margin) is required not only to impose implicit solvency or capital adequacy reserves, but to fairly reflect the cost to the insurer of the uncertainty in the amotlnt of its claims liabilities

• such an allowance cannot presently be obtained from observable market data

• valuing liabilities by reference to an hypothetical transaction with a third party is unlikely to yield a more accurate provision for the insurer's actual liabilities

• any allowance for uncertainty, if it is to be applied consistently, must therefore be arbitrary. But if no allowance is made the insurer's accounts will not truly and fairly reflect its financial position

• there is general support for aligning AASB 1023 with the prudential standards

• the basis for the estimate of liabilities can and should be explained by a note to the accounts.

These considerations suggest that AASB 1023 should be amended to require the provision for outstanding claims to be made in accordance with the prudential standards (specifically GPS 210 'Liability valuation for general insurers'), with a note explaining that the provision is an estimate which is considered to have at least

a 7 5 per cent chance of being sufficient, and if any higher prudential margin is used, explaining it.

In coming to this conclusion, I recognise that this approach may be seen as inconsistent with the view that in the absence of an appropriate fair value approach, estimating the insurance liabilities of an entity at a 75 per cent level of sufficiency is unlikely to represent a 'true and fair' representation of the financial position of that

entity. For example, in its submission, the AALC concludes that:

The most appropriate margin for risk and uncertainty to be included in the outstanding claims and premium liabi lities should be set on a market based model. The 75 per cent probability of sufficiency required by GPS 210 is

The failure ofHJH insurance 151

restrictive and may not reflect a reasonable market based value allowance for the risk characteristics of a particular insurer. 9

Some may further argue that in being unable adequately to calculate an appropriate fair value of the risk and uncertainty associated with insurance liabilities, a central estimate of the present value of the expected future cash flows required to settle claims should be used instead. This view would have it that any margin for risk and

uncertainty over and above the central estimate should be treated as capital rather than a liability.

In forming my view as to the appropriate approach to take in the valuation of insurance liabilities I have been cognisant of this view. For the reasons outlined above, however, I consider that valuing insurance liabilities on a central estimate would not truly and fairly represent the financial position of a general insurer. Some value must be made for risk and uncertainty and, in the absence of an adequate fair value approach to such valuations, I am of the view that including a pre-determined margin to represent the value of risk and uncertainty in the accounting standards is the best compromise. Given the desirability of maintaining consistency between the accounting and prudential standards, I believe that the margin adopted by APRA is the most appropriate for this purpose.

Recognition of revenue and liabilities As noted above, AASB 1023 requires insurers to recognise premium revenue (and reinsurance expenses) in accordance with the pattern of insurance risk under relevant contracts. While the standard does provide guidance as to the interpretation of the statement 'in accordance with the pattern of the incidence of risk', it nevertheless allows entities to manipulate the timing of the recognition of premiums. If an entity considered that an insurance (or reinsurance) policy permitted it to recognise all premiums (or reinsurance recoveries) yet delay the recognition of liabilities (or reinsurance premium expenses) th en this could result in the recognition of profit being brought forward artificially in the early period of such a contract.

It should be noted that while such an approach is arguably not consistent with the intent of AASB 1023, the approach of the prudential standards in requiring the immediate recognition of premium revenue and liabilities would disallow this treatment entirely.

In this regard, APRA argued in its submission that:

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The prospective accounting approach that the concept of premium liabilities requires has another important benefit- it prevents some of the accounting practices that the Royal Commission has uncovered that allowed financial reinsurance to be used to distort reported profitability. By bringing to account in the current period all future obligations and expected claims under a policy (be it direct insurance or reinsurance), an insurer will no longer be permitted to recognise up-front benefits while at the same time deferring future costs. (Indeed, it could be argued that this should not have been permitted under existing accounting standards, but

Financial reporting and assurance

the new accountin? framework should remove any discretion that is currently available). 0

It is correct to say that the evidence before the Commission disclosed some undesirable accounting treatments having the effect mentioned in the APRA submission. The accounting standards should not sanction treatment of that nature.

Definition of insurance As part of its project to develop an international accounting standard for general insurance activities, the IASB's Insurance Contracts Advisory Committee has suggested that a definition of an insurance contract be included in the proposed

international standard for the financial reporting of general insurance activities. The definition of an insurance contract proposed by the IASB's Insurance Steering Committee is:

A contract under which one party (the insurer) accepts an insurance risk by agreeing with another party (the policyholder) to make payment if a specified uncertain future event (the insured event) adversely affects the policyholder or other beneficiary. 11

Similarly, I consider that inserting an appropriate definition into AASB 1023 is desirable. It would provide guidance on the appropriate classification of insurance contracts and financing transactions for accounting purposes. Financing transactions, which may include the various forms of financial and finite reinsurance transactions that were used by HIH, should be reported under AASB 1033

'Presentation and disclosure of financial instruments'.

A key difference between insurance and a financing transaction is the issue of risk transfer. In my view, an appropriate definition of insurance should recognise that in order for a transaction to be defined as an insurance transaction it must involve a material transfer of insurance risk.

Discounting AASB 1023 presently requires that insurance liabilities be measured as the present value of expected future costs related to those liabilities. This requires that expected future payments be discounted. As noted in clause 5 .1.1 of AASB 1023, the rationale for this requirement is that 'the liability for outstanding claims ought to

reflect the amount which, if set aside as at the reporting date, would accumulate so as to enable the insurer to pay the amounts of claims as they fall due'.

Most foreign jurisdictions do not allow the discounting of expected future costs re lated to claims liabilities for general insurers, although the requirement to discount future cash flows is being introduced in some jurisdictions, such as Canada. The approach taken by the International Accounting Standards Board appears to be

heading in the direction of requiring such cash flows be discounted. The appropriate discounting of cash flows associated with insurance liabilities is consistent with an approach that values assets at market values. For these reasons, it is appropriate that AASB 1023 continues to require that expected future cash flows related to insurance

liabilities be discounted.

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Clause 5.3 of AASB 1023 states that 'the di scount rate or rates must be determined by reference to market-determined risk-adjusted rates of return appropriate to the insurer'. Clause 5.4 of AASB 1023 elaborates by noting that 'the rates earned on existing assets may be indicative of market-determined risk-adjusted rates of return appropriate to the insurer'. The standard does not explain what is meant by the expresswn 'market-determined risk-adjusted rates of return appropriate to the

insurer' .

In its submission the AASB stated that:

The notion underlying the market-determined risk-adjusted discount rate is that the liability for outstanding claims should be the amount an insurer would need to have today to meet existing claims and related costs . Since many of these costs need not be met until some time hence, discounting by an amount that is expected to be earned in the meantime can be considered appropriate.12

One consequence of this approach is that insurers that invest in high-risk/high-return classes of assets are able to discount their insurance liabilities at a higher rate than a more conservative insurer. This is a perverse outcome. The insurer who invests in higher risk assets with higher returns is allowed to adopt a lower provision for claims than a more conservative insurer would make for the same claims. AASB

1023 may therefore provide an inappropriate incentive for insurers to invest in higher risk assets than may be otherwise justified.

Higher risk investments are associated with higher returns primarily because they are associated with a higher risk of loss. The expected rate of return from such asset classes is on average therefore likely to be closer to a risk-free rate over the longer­ term once these risks are taken into account, but no guidance is given as to what the expression means and how discount rates should be adjusted for risk. Present rates of return on existing assets are therefore unlikely to be an accurate proxy for long­ term market-determined risk-adjusted rates of return.

It should be noted that the prudential standards require that insurers discount the expected future payments related to their insurance liabilities using a risk-free rate of an instrument (for example, a Commonwealth bond) of equivalent duration to the liability.

AASB 1023 could therefore be modified to require that insurance liabilities are discounted in a similar manner to that required by the prudential standards- that is , by using a risk-free (Commonwealth) bond rate of similar duration to the timing of the insurance liability being discounted.

In this regard, APRA in its submission argued that:

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GPS 210 also seeks to reduce the flexibility in valuation techniques by mandating that the discounting of future liabilities is to occur at the risk­ free rate (ie the government bond rate). While there are conceptual arguments why other discount rates might be superior (eg the rate of return

on the insurer's investment portfolio) , we believe that, as a practical matter, the value of an insurer's liabi lities is typically independent of the

Financial reporting and assurance

value of the underlying assets. For this reason, a discount rate that is observable, market-based and objective is most appropriate. The choice of the Government bond rate provides a degree of transparency and consistency that outweighs the benefits of other options. 13

The AALC, however, took the view that the accounting standard should not be prescriptive in terms of discount rates:

The accounting standard should not be overly prescriptive in terms of specific discount rates, but specify that a fair value discount rate should be adopted .

The most appropriate . . . discount rates . . . should be set by reference to professional guidance external to the formal accounting standard. 14

Nevertheless, the AALC also argued that:

... the discount rate adopted for the vast majority of Australian general insurance liabilities underwritten by solvent and licensed Australian insurers, should fall within the relative narrow range of:

'Risk free' market discount rates on equivalent sovereign securities (i.e. Government bond rates); to

Market discount rates on high grade equivalent duration corporate debt securities (i.e. S&P similar) rating of A or higher) net of the market price of default risk. 1

IAAust argued for the requirement of a risk-free rate to be used for discounting under AASB 1023:

The principle changes ... which are needed to bring AASB I 023 into line with APRA Prudential Standards are ... substitution ofthe 'risk-free rate', as defined by APRA, for the less well defined ' market detennined risk adjusted rates of return appropriate to the insurer.' 16

The ICA also supports the use of a risk-free rate in AASB 1023:

ICA considers that risk free rates should be used as the basis for discounting insurance Jiabilities. 17

The effect of underpricing As described above, AASB 1023 takes a 'deferral and matching' approach to the recognition and measurement of premium revenue and claims liabilities. This approach requires insurers to raise an unearned premium provision as a liability for the amount of premium they have received but not yet earned at the reporting date.

One consequence of this approach is that if an insurer prices its policies below cost, the unearned premium provision, by definition, will underestimate the claims liabilities arising from events that occur after the reporting date under existing policies. AASB 1023 requires that where this occurs, an insurer must write-down its

deferred acquisition costs. But this may be inadequate to address the shortfall in liabilities, particularly in light of the commentary to clause 10.5 of AASB 1023. The commentary states that 'the carrying amount of deferred acquisition costs will need

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to be written down to recoverable amount where this is less than the deferred costs, based on an assessment of the aggregate portfolio of insurance business written', not where that is so for a particular class or classes of business. This means that if an insurer underprices its products by an amount of more than its deferred acquisitions costs, the financial statements will provide an overly optimistic picture of its financial position. Writing down deferred acquisition costs where an insurer underprices its products is also not a conceptually satisfactory approach. It would be preferable either to recognise a separate shortfall in the unearned premium provision or value liabilities separately from premiums altogether.

This problem does not arise under the prudential standards because the standards require that all insurance liabilities, including those relating to events that are expected to occur after the reporting date under existing policies (or premium liabilities) be estimated. AASB 1023 may therefore provide an incentive for insurers to underprice their products, at least from the perspective of the financial reports.

As argued by APRA:

In a market where significant under-pricing can often occur as insurers seek to maintain or build market share, we believe [the approach taken by AASB 1 023] can significantly understate the potential liabilities of the insurer. GPS 210, by requiring an actuarial assessment of future potential claims, avoids this problem by immediately bringing to account any apparent under-pricing, ie an insurer that under-prices will need to bring to account the income, and the up-front recognition of future claims, in the current accounting period (rather than the loss to be deferred into future periods when the actual claims emerge). 8

Inconsistencies between AASB 1023 and APRA 's prudential standards As noted above there are many differences between the prudential standards and AASB 1023. While the standards are obviously designed to address different objectives, inconsistencies between in the standards are likely to add to costs and confusion amongst insurance companies and the users of their financial reports.

Several organisations argued in submissions that the approach taken in the prudential standards is superior to that of the accounting standards, at least from a prudential perspective.

According to APRA, for example:

... the new Prudential Standard-GPS 210 'Liability valuation for general insurers'-seeks to deal with many of the weaknesses that we perceive, from a prudential perspective, in AASB 1 023. 19

APRA also argued that:

156

... notwithstanding the need to continue to work to improve the ability of actuaries to perform their important duties, we believe the GPS 210 is a significant improvement on the requirements of AASB 1023, and should materially strengthen the consistency, reliability and transparency of insurance liability valuation from a prudential perspective. 20

Financial reporting and assurance

The Australian Accountants and Actuaries Liaison Committee argued that:

. . . in general terms, AALC considers that the financial statements under AASB I 023 and GPS 210 should be prepared on a consistent basis with GPS 210 to minimise differences in financial reporting frameworks. However, we consider that the liabilities should be determined on a 'fair value ' or other market based model. 21

The Australian Accounting Standards Board argued that:

. . . it is desirable that the AASB and APRA reporting requirements be harmonised to the extent feasible to help minimise costs of reporting by the industry. However, the AASB sets accounting standards for general purpose financial reporting and its role is not to automatically change in response to changes in regulatory reporting by APRA .Z2

The Australian Institute of Actuaries argued that:

The IAAust believes that a net present value approach should be imported into the Australian general insurance accounting standard, AASB 1023 and into general insurance taxation law. 23

Finally, the Insurance Council of Australia argued that:

AASB, in conjunction with APRA and ASIC, should revise AASB 1023 to ensure consistency of methodology with the new prudential standards for general insurance. This will reduce reporting costs and confusion and improve the transparency of insurance reports. 24

The ICA has also argued that:

ICA considers that GPS 210 is adequate for the purposes of prescribing the basis of insurance (premium and claims) liability valuations for regulatory purposes.25

In summary, there appears to be strong support amongst the insurance industry and relevant accounting bodies to align AASB 1023 as far as possible with APRA' s prudential standards. There also appears to be a view that the prudential standards offer a superior measurement basis to that of AASB 1023 and should therefore be the preferred basis of measurement.

Disclosure One of the most important factors in assessing the overall solvency of a general insurer is the accuracy of the estimate of its outstanding claims provisions. One way of achieving this outcome is significantly to increase the amount of disclosure relating to provisioning practices of the insurer. In this regard, I make a number of

recommendations for the greater disclosure of financial and other information by general insurers. It is also worth considering, however, whether specific requirements related to the disclosure of claims provisions should be included in the annual financial report.

When AASB 1023 was introduced in 1990 it required insurers to disclose details on the accuracy of previous estimates of claims through the publication of a ten-year

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net claims development table. This requirement was removed from the standard in 1996 because 'some general insurers and users of their financial reports considered [it] too complex and not particularly useful for analysing the financial position and performance of general insurers'. 26

At least part of the reason that the tables were considered to be too complex was because they presented information on a discounted basis and so changes in an insurer's estimates of its outstanding claims liabilities resulted from changes m discount rates as well as changes in the underlying expected cost of claims.

The aim of releasing information included in a claims development table is to enable users of a financial report to assess the accuracy of past claims estimates. In particular, such tables should shed light on whether a company's past estimates of the cost of future claims liabilities contained a systematic bias underestimating the cost of claims. Such a past bias may indicate that the company's estimate of its future claims liabilities may also be subject to bias.

I consider that the AASB should reintroduce a requirement to disclose details of a ten-year development table in AASB 1023. To address some of the complexities of the previous arrangements that led to the removal of this requirement from AASB 1023 in 1996, the information in the claims development table should be provided on an undiscounted rather than discounted basis. In addition, insurers should be required to present claims development information both net and gross of expected reinsurance recoveries.

The direction of the international accounting standards As noted above, the Australian government and the Financial Reporting Council have announced that Austr(llia will adopt International Accounting Standards from 1 January 2005.

There is presently no agreed international accounting standard for insurance transactions, although an early (incomplete) standard is expected to be promulgated in 2004 with a complete standard following some time later, possibly by 2007. While an international accounting standard has not yet been set, the international standards settings bodies have had a project under way since 1997 and it is well developed.

The work of international standard setting bodies thus far indicates that the standard eventually adopted by the IASB will differ from AASB 1023. Indeed, in many respects it will match the model proposed under APRA's prudential standards. The main areas of difference between the current direction of the international standard (as embodied in the IASC 1999 DSOP) and AASB 1023 are:

• the DSOP would require the immediate recognition of premium revenue and claims liabilities on the commencement of a contract of insurance, whereas AASB 1023 requires that premium revenue and liabilities be recognised in accordance with the pattern of insurance risk under the contract

158 Financial reporting and assurance

• the DSOP would require future cash flows to be discounted using a risk-free discount rate rather than the risk-adjusted market rate required by AASB 1023

• the DSOP would not permit overstatement of insurance liabilities to impose implicit solvency or capital adequacy requirements, but it would require an adjustment for risk and uncertainty. AASB 1023 is generally interpreted to allow neither a margin for prudence nor one for risk and uncertainty. APRA' s prudential standards require an in-built prudential margin based on insurance

liabilities being valued at a 75 per cent level of sufficiency.

No submissions speculated on the direction of the international accounting standards, although the AASB argued that:

.. . it would be inappropriate to fundamentally change the requirements of AASB I 023 in the short run only to possibly change them fundamentally once again in harmonising with the IASB. It was considered that this would be likely to create confusion among users and pre parers of financial reports. 27

This argument, while valid, depends on the implementation date of the international accounting standard for insurance transactions. In this regard, it is noteworthy that the introduction of accounting standards has generally lagged proposed timetables. Even if the IASB meets its proposed timetable, it is likely that a complete

international accounting standard for insurance transactions will not be in place until 2007. This means that Australia may have to depend on AASB 1023 for at least another four years, although changes will presumably be made by Phase I of the international accounting standards project on insurance accounting.

The current direction of the international accounting standards for insurance transactions appears to suggest that AASB 1023 will eventually face substantial changes. Early adoption of likely approaches taken in the proposed international standard may aid insurers in complying with the international standards when they are eventually adopted.

Th e failure of HIH Insurance 159

Recommendation 8

I recommend that the Australian Accounting Standards Board amend accounting standard AASB 1023 to include the following:

• a definition of insurance that includes the requirement for a material transfer of insurance risk

• a requirement that insurance liabilities be valued at a level of sufficiency of at least 75 per cent, as required by APRA's prudential standards. Companies should be explicitly permitted to set

prudential margins in excess of 75 per cent if the company's board considers that appropriately

reflects a true and fair view of the financial position of the insurer

• a requirement that entities disclose in their financial statements

the valuation of their insurance liabilities at a central estimate

a 75 per cent level of sufficiency

the margin ultimately adopted by the entity

• a requirement that premium revenue and insurance liabilities be recognised on the commencement of a contract of insurance. This will require the recognition of premium liabilities

• a requirement that, in estimating the present value of liabilities, future cash flows be discounted using a risk-free rate similar to that required by the prudential standards

• a requirement that companies subject to the standard disclose a 10-year claims-development table that includes past estimates of claims on an undiscounted basis as well as the actual

costs of settling claims. This information should be provided both net and gross of reinsurance.

These changes should be adopted as soon as is practical and in advance of the adoption of an international accounting standard for insurance. While the eventual adoption of an international standard may override AASB 1023, Australian authorities should actively encourage the IASB to adopt the approach to accounting for general insurance activities that I have recommended.

The changes that I have recommended will also require some consequential changes to the income taxation treatment of general insurance transactions. This issue is discussed in Chapter 10.

7 .1.4 Other accounting standards

In the case of HIH there were several other accounting standards that, in my view, were misinterpreted or misapplied. These related to the treatment of reinsurance contracts (specifically the Swiss Re and Hannover contracts), the treatment of certain reinsurance contracts entered into after the end of a reporting period and the treatment of the issue of preference shares in F AI. Details on these transactions are provided in Sections 16.2, 16.3 and 23.9.

Of these examples, the accounting for the issue of preference shares in F AI and the treatment of events that occurred after the end of the reporting period, occurred because of a misapplication of accounting standard AASB 1002 'Events occurring

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after reporting date'. I consider that this standard is clear and does not require amendment. This issue is discussed further in Section 23.9.

While I consider that the accounting treatment of the Swiss Re and Hannover contracts also represented a misinterpretation of AASB I 023, the changes I have recommended to AASB 1023 in Section 7.1 above should reduce the chance of similar abuse in future.

I also consider that AASB 1 013 'Accounting for goodwill' contains ambiguity and may lead to an incorrect treatment of goodwill in the financial statements of relevant entities.

The amount of goodwill recognised by HIH as an asset in respect of the F AI acquisition was $275 million as at 30 June 1999. Whilst goodwill is defined in AASB I 013 in rather conceptual terms as future benefits from unidentifiable assets28 , in practice goodwill is customarily measured simply as a residual figure, calculated as the excess of the cost of acquisition ($300 million) over FAI's net assets at acquisition ($25 million). 29 By 30 June 2000, the amount of goodwill had

increased to $438 million in consequence of a series of further adjustments which reduced F AI' s net assets at acquisition.

Clause 5.8 of AASB 1013 stated as follows:

To the extent that the cost of acquisition incurred by the entity exceeds the fair value of the identifiable net assets acquired but the difference does not constitute goodwill, such difference must be recognised immediately as an expense in the profit and loss account.

In my opinion, the provisions of AASB 1013 discussed above gave rise to the following difficulties in its application:

• There was no specific guidance as to how an assessment may be undertaken to establish that the amount of excess of the cost of acquisition over net assets at the date of acquisition represented future benefits from unidentifiable assets.

• There tended to be an increased emphasis upon the measurement of the residual amount said to represent goodwill and a decreased emphasis upon a consideration of the manner in which the future benefits from unidentifiable assets may be realised.

Further, with respect to AASB 1013, in Section 21.5.7 below I have discussed the differing interpretations with respect to clause 7.1 of that standard.

I am not proposing any changes to AASB 1013 however because the AASB has recently released an exposure draft of proposed amendments to lAS 38 Intangible Assets which is likely to lead to significant changes in the treatment of goodwill.

The failure of HIH Insurance 161

7.2 The audit function

It is the responsibility of the directors of a company to produce accounts that are in accordance with the requirements of the Corporations Act 2001. The financial reports prepared by the directors must be in accordance with accounting standards (s. 296) and must present a true and fair view of the financial position and performance of the company (s. 297).

The financial reporting system is underpinned in the case of public and large private companies by a requirement that their accounts be audited by a registered auditor. A company has to obtain from its auditor a report to shareholders on whether its financial report is in accordance with those requirements of the Corporations Act.

While the auditor's services are normally procured by a company's board or management, the appointment of the auditor is a matter for the annual general meeting. 30 Once appointed the auditor holds office until death, removal or resignation from office. 31 An auditor can be removed by resolution of the company in general meeting32or can resign as auditor of the company with the consent of ASIC. 33

As a practical matter great store is placed by directors, as well as by shareholders, creditors and others with an interest in the financial position of a company, in the fact that its accounts have been audited. The fact remains however that a company's financial report is the responsibility of the directors by whom it is signed and presented.

The point of an audit is to provide independent assurance of the integrity of the way in which the company has reported. It follows that shareholders in particular have an interest in the proper functioning of the audit process as it provides them with comfort in making investment decisions. This element of assurance is of course also relevant to the directors themselves, so far as they rely on management in the preparation of the accounts as well as to others with an interest.

Recent high-profile corporate collapses, including that of HIH, have given rise to public concerns about the efficacy of the audit function, as well as about other aspects of the financial reporting system. These concerns in tum have led to a series of reports and proposals for changes in this area.

In September 2002 the Commonwealth Government issued a chapter of its Corporate Law Economic Reform Program entitled 'Corporate disclosure­ Strengthening the Financial Reporting Framework'. CLERP 9, as it is known, set out a series of reform proposals with a view to achieving further improvement in audit regulation and the wider corporate disclosure framework. An earlier report to the Minister for Financial Services · and Regulation entitled 'Independence of Australian Company Auditors. Review of Current Australian Requirements and Proposals for Reform' by Professor Ian Ramsay in October 2001 was followed by Report 391 of the Joint Standing Committee on Public Accounts and Audit 'Review oflndependent Auditing by Registered Company Auditors' in August 2002.

162 Financial reporting and assurance

My inquiry into the failure of HIH necessarily dealt with HIH' s audit process and the role of its auditor. Drawing on that experience as well as other developments I turn to policy questions relevant to the audit function.

7.2.1 Auditor independence

Auditor independence is a critical element going to the credibility and reliability of an auditor's reports. 34 Audited financial statements play a key role promoting the efficiency of capital markets and the independent auditor constitutes the principal external check on the integrity of financial statements?5 The Ramsay report

recognised the following four functions of an independent audit in relation to capital market efficiency36 :

• adding value to financial statements

• adding value to the capital markets by enhancing the credibility of financial statements

• enhancing the effectiveness of the capital markets in allocating valuable resources by improving the decisions ofusers of financial statements

• assisting to lower the cost of capital to those using audited financial statements by reducing information risk.

In addition to the above functions noted in the Ramsay report, an independent audit contributes to capital market efficiency by enhancing the consistency and comparability of reported financial information in Australia.

It is widely accepted that the auditor must be, and be seen to be, free of any interest which is incompatible with objectivity.37 There must be public confidence in the auditor for an audit to fulfil its functions.

The responsibility of auditors to maintain independence in the carrying out of their function was stated by the US Supreme Court:

The independent public accountant performing this special function owes allegiance to the corporation's creditors and stockholders, as well as the investing public. This public watchdog function demands that the accountant maintain total independence from the client at all times and requires complete fid elity to the public trust. 38

In the absence of a competently and independently performed audit, there is increased risk to the efficiency of capital markets. There is a danger that the audit report will lure users into a false sense of security that there has been an independent scrutiny of the financial report when there has not.

While auditors perform a statutory function, the work is generally carried out by private professional services firms. Although it is the shareholders to whom the audit report is addressed, and it is the shareholders who usually appoint and remove the auditor, it is management who have the day-to-day interaction with the auditor.

Th e f ailure ofHJH Insurance 163

The processes of appointment and removal of an auditor will generally follow the recommendations of management.

CLERP 9 noted these factors may lead to apparent conflicts for auditors:

• the audit function has a significant public interest element, yet auditors are paid by the entity they are overseeing (management)

• there. is a personal relationship between auditor and client

• audit partners, managers and staff may have career and financial incentives to comply with audit client wishes on the presentation of financial reports

• lower level audit staff may have career and financial incentives to acquiesce in audit partner wishes

• audit staff may see themselves more as business consultants

• audit firms rely on non-audit services for their revenue and profit growth

• corporate clients may view audit as a dead compliance cost and want to capitalise on the knowledge of audit firm professionals.39

CLERP 9 stated that the difficulties which arise from these matters are that:

• only company management has di rect fee payment, contract and personal contact relationships with the auditor

• other incentives such as regulatory penalties, professional rules, the protection of auditor reputation, and personal career development may in some cases not be as strong as those relationships

• this can lead to market perceptions of auditors acting for profit rather than the pub lie interest. 40

Regulation of audit independence

The current regulation of audit independence derives from :

• the Corporations Act 2001

• professional standards and guidance issued by the professional accounting bodies.

The relevant requirements of the Corporations Act are concerned with such matters as indebtedness and employment relationships between a company and its auditor. 41 These provisions are directed to indicia of independence.

The standards and guidance issued by the professional accounting bodies are more comprehensive. The enforcement of these requirements is generally undertaken by the professional bodies themselves.

164 Financial reporting and assurance

Reform proposals

Various definitions and tests of audit independence have been proposed in the current round of reform proposals including by the Ramsay report and the JSCP AA report.

Paragraph 10 of Professional Statement F1 'Professional Independence' issued by the Institute of Chartered Accountants and CPA Australia states:

In determining whether a member in public practice is or is not seen to be free of any interest which is incompatible with objectivity, the criterion should be whether a reasonable person, having knowledge of the relevant facts and taking into account the conduct of the member and the member's behaviour under the circumstances, could conclude that the member has placed himself or herself in a position where his or her objectivity would or could be impaired. [emphasis added]

In contrast, the definition of independence contained in paragraph 14 of Professional Statement F1 is:

(a) Independence of mind-the state of mind that permits the provision of an opinion without being affected by influences that compromise professional judgment, allowing an individual to act with integrity, and exercise objectivity and professional scepticism; and

(b) Independence in appearance-the avoidance of facts and circumstances that are so significant a reasonable and informed third party, having knowledge of all relevant information, including any safeguards applied, would reasonably conclude a firm's, or a member of the firm's , integrity, objectivity or

professional scepticism had been compromised. [emphasis added]

The two definitions contained within Professional Statement F 1 are inconsistent. It can be seen that the definition in paragraph 14 contains a test that requires a higher standard of certainty as to the compromise of independence than does the test in paragraph 10.

In CLERP 9 the Commonwealth Government put forward a proposal to amend the Corporations Act to include a general statement of principle requiring the independence of auditors: 42

The general statement of principle will also establish a general standard of independence that an auditor is not independent with respect to an audit client if the auditor is not, or a reasonable person with full knowledge of all relevant facts and circumstances would conclude that the auditor is not, capable of exercising objective and impartial judgment on all issues encompassed within the auditor's engagement. In determining whether an auditor is independent all relevant circumstances should be considered,

includinf all relationships between the auditor and audit client. [emphasis added] 4

CLERP 9 further proposed that the law be amended to require the auditor to make an annual declaration, addressed to the board of directors, that the auditor has

The failure of HJH insurance 165

maintained independence in accordance with the Corporations Act and the rules of the professional accounting bodies. 44

Difficulties with CLERP 9 proposals

In my opinion, there are certain difficulties inherent in the standard of independence proposed in CLERP 9. The proposed standard of independence requires the independence of 'the auditor'. It will be important to clarify in the Corporations Act that the requirement of audit independence applies equally to both individual auditors and their firm (if any). Since both the individual auditor and the firm sign the audit report45 , it follows that both should be required to be, and be seen to be, independent. There may be some circumstances where one is independent, but the other is not. For example, I have discussed in Chapter 21 the change of the HIH audit engagement partner in 1999. Despite my conclusion that the circumstances surrounding that change gave rise to the perception that Andersen was not

independent, I drew no such conclusion in relation to the new engagement partner's actual independence as a result of his appointment.

The proposed standard of independence in CLERP 9 imposes a high standard of certainty of the lack of independence by requiring that a reasonable person would conclude that the auditor is not independent. That test appears to require a higher degree of satisfaction than is required in civil proceedings. In my opinion, the high standard adopted in the CLERP 9 proposals does not pay sufficient regard to the

importance of auditors being seen to be exercising impartial and objective judgment. For reasons that are discussed below, I consider that the importance of audit independence is such that the test should be stated in terms of might rather than would. Neither CLERP 9, the Ramsay report nor SEC Rule 210-01 (upon which the proposed definition is based) provide any explanation for or discussion of the high standard of the proposed definition. I am proposing an alternative standard of audit

independence which deals with the difficulties I perceive in the CLERP 9 proposals.

Matters for an audit independence standard In framing an alternative standard of audit independence, there is a particular need to consider: the difficulty of identifying any actual breach of independence; the manner in which the auditor undertakes his or her task; the interaction between the company, users of the financial reports and regulatory bodies; and the relationship an auditor has with management.

Inadequate independence on the part of an auditor will usually be difficult to discern. Suspicions might be excited but definite conclusions could be drawn only in extreme circumstances. Rarely would an auditor deliberately or even consciously compromise their independence. More often, as was the case with HIH, the auditor will deny that their independence was in any way compromised, even where an objective consideration might point to the opposite conclusion. Rarely will there be unequivocal evidence that conclusively establishes for example a connection between influence exerted by management upon the auditor and the provision by the

166 Financial reporting and assurance

auditor of an unqualified audit opinion. The existence of such a connection from a range of surrounding circumstances can usually only be inferred.

The difficulties associated with identifying a compromise of audit independence are inherent in the nature of the audit process. Most of the decisions of an auditor are made behind closed doors, either internally within the audit firm or in conjunction with management. In the case of HIH only selected matters were taken to the audit committee because Andersen and HIH management often resolved issues before the audit committee meetings. Users of the financial statements are not aware of the reasons for the auditor's decisions nor the extent to which the auditor has relied on management representations. Nor are users of the financial statements aware of any

pressure which might have been exerted on the auditor by management, such as obtaining an opinion from another audit firm on a technical issue which supports management's view that a judgmental or controversial item accords with accounting standards. Such an initiative by management may leave the auditor feeling constrained to accept that opinion and put aside his or her own opinion on the issue as being merely a difference of professional judgment.

In addition, the form of the audit certificate is largely standard and does not provide any reasoned analysis of the basis for the opinion expressed. Adopting the words of Brooking J in the Phosphate Co-operative Co of Australia Ltd. v Shears (No.3) case (which considered the independence of a report required to be prepared by an

independent expert) '[t]he calm, reflective air of the report in no way suggests its long period of gestation or the travail which accompanied its birth'.

The users of the financial statements are not privy to the information that is received by the auditor or the process by which the auditor exercises skill and judgment to reach conclusions on that information. The company, users of the financial reports and regulatory bodies place significant reliance upon the integrity of auditors. Auditors have an obligation to ensure that they are, and are seen to be, maintaining

high standards of honesty and probity, acting in the interests of the shareholders of the company to whom they are reporting and exercising independence of mind to ensure that financial reports provide a true and fair view of the financial position and performance of the company.

Absent independence, shareholders, creditors and other users of the financial statements can have no assurance or comfort as to the truth or fairness of the financial report of the economic entity with which they deal. Such assurance adds value to capital market efficiency because it enhances the credibility of financial

statements. It is in those circumstances that the perception that an auditor is independent takes on greater importance.

The primary purpose of the audit is to provide an independent and objective review of the company's financial statements. Corporate resources are expended on an audit for that purpose. An independent and objective audit, conducted with an appropriate degree of professional scepticism, is required. Management, in

particular senior management, might have a natural interest in presenting the results of the company in the most favourable light and having the auditors sign off on that

The failure of HIH Insurance 167

form of presentation. That interest of management can give rise to tension in the performance of an independent and objective review. In these circumstances, if the auditor is under pressure to conform with management's expectations, the rationale for the expenditure of corporate resources upon audit may be undermined. Where personal relationships between the auditor and management undermine professional independence and objectivity in any way, good corporate governance is imperilled.

In light of the above, it is critical that the auditor should be seen to be exercising impartial and objective judgment in addition to the actual exercise of that impartial and objective judgment. Any standard of audit independence must reflect this requirement.

Further, the difficulties referred to in discerning any actual lack of independence, coupled with a reluctance on the part of auditors to confront their own lack of independence, supports the introduction of an objective standard of independence. The CLERP 9 proposals acknowledge the need for such an objective standard.

Other models for dealing with conflict The issue of audit independence does not normally arise in the course of litigation. Where an audit is undertaken incompetently it is often said that a lack of independence adds nothing to what is otherwise a complete cause of action based upon a breach of duty. Where an audit is not undertaken incompetently, a lack of

independence will not cause any loss of itself.

There are many situations where the law imposes obligations upon people who face conflicts between their interests and their duties. In determining what I consider to be an appropriate standard of audit independence I have had regard to certain of those situations, namely the imposition of fiduciary obligations, the independence of directors, requirements in respect of related party transactions, and disqualification of members of the judiciary on the grounds of bias or apprehended bias, which are discussed below.

Fiduciary obligations The primary elements of a fiduciary relationship are that:

• the fiduciary has undertaken to act in the interests of another

• that undertaking gives to the fiduciary the power to affect the interests of the other party

• the person to whom the fiduciary duty is owed is vulnerable to the fiduciary's abuse of his or her position. 46

The vulnerability of one party to the ' other party with power or discretion was emphasised by Dawson J in Hospital Products Ltd v United States Surgical Corp:

168

There is, however, the notion underlying all the cases of fiduciary obligation that inherent in the nature of the relationship itself is a position of disadvantage or vulnerability on the part of one of the parties which

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causes him to place reliance on the other and requires the protection of equ ity acting upon the conscience of that other. 47

Vulnerable in this context does not mean intrinsic weakness but rather disadvantage due to the superior knowledge or power of the trusted party.48 A fiduciary relationship exists where one party is in a position of reliance upon the other because of the nature of the relationship.49

It has been said that there are three purposes of the law of fiduciary obligations, namely:

• the maintenance of high standards of honesty and propriety by those who are under a duty to act in the interests of others

• the confiscation of gains arising from the abuse of a relationship of trust

• the protection of one person's reasonable expectations that the other will act in her or his interests, and not in pursuance of a contrary self-interest or conflicting duty.50

The fiduciary has a duty to account to the person to whom the fiduciary obligation is owed for any benefit or gain:

• which has been obtained or received in circumstances where a conflict or significant possibility of conflict existed between the fiduciary's duty and their personal interest in the pursuit or possible receipt of such a benefit or gain

• w hi ch was obtained or received by use or by reason of the fiduciary's position or by reason of opportunity or knowledge resulting from the position. 51

As Lord Herschell stated in Bray v Forcf2 in relation to the conflict between duty and interest:

It is an inflexible rule of a Court of Equity that a person in a fiduciary position is not, unless expressly otherwise provided, entitled to make a profit; he is not allowed to put himself in a position where his interest and duty conflict. It does not appear to me that this rule is founded upon principles of morality. I regard it rather as based on the consideration that

human nature being what it is , there is a danger, in such circumstances, of the person holding a fiduciary position being swayed by interest rather than duty, and thu s prejudicing those whom he was bound to protect.

Several tests have been proposed to determine whether a fiduciary has a conflict of interest, including whether there is a 'real sensible possibility of conflict' 53 , or a 'significant possibility of conflict' between duty and interest. 54

Directors In addition to the fiduciary obligations of a director discussed above, directors also have a statutory obligation to avoid conflicts of interest and duty.

Th e failure of HIH Insurance 169

Related Parties Chapter 2E of the Corporations Act requires that transactions between a public company and any related party55 that give a financial benefit to the related party on other than arm's length terms be approved by the company's shareholders. The purpose of the chapter is to protect the interests of a public company's shareholders as a whole, by requiring shareholder approval for giving financial benefits to related parties that could endanger those interests. 56

In order · for shareholders to make an informed decision about the related party transaction, the company is required to distribute an explanatory statement which sets out certain specified information. 57

Judicial bias The test laid down by the High Court to determine whether a judge is disqualified by reason of the appearance of bias is whether a fair-minded lay observer might reasonably apprehend that the judge might not bring an impartial and unprejudiced mind to the resolution of the question the judge is required to decide. 58

The majority of the High Court stated:

That test has been adopted, in preference to a differently expressed test that has been applied in England, for the reason that it gives due recognition to the fundamental principle that justice must both be done, and be seen to be done. It is based upon the need for public confidence in the administration of justice. 'If fair-minded people reasonably apprehend or suspect that the tribunal has prejudged the case, they cannot have confidence in the decision.' The hypothetical reasonable observer of the judge's conduct is postulated in order to emphasise that the test is

objective, is founded in the need for public confidence in the judiciary, and is not based purely upon the assessment of some judges of the capacity or performance of their colleagues. 59

The parties to the litigation in question can waive an objection on the ground of bias, even where it is a question of the public apprehension of bias. 60

ASX Corporate Governance Co uncil-Test for independent directors By way of comparison, the ASX Corporate Governance Council has defined an independent director as one who is independent of management and free from any business or other relationship that could materially interfere with, or could reasonably be perceived to materially interfere with, the director's ability to act in the best interests of the company.

Proposed standard of audit independence I have concluded that a general stand;ud of independence for auditors should be adapted from the test laid down to determine whether a judge is disqualified by reason of the appearance of bias. While judges and auditors perform different functions there is a common element. Both functions involve an exercise of judgment which results in the public expression of an important opinion which is

capable of affecting society widely.

170 Financial reporting and assurance

Just as the requirement that a judge be seen to be free from bias is based on a need for public confidence in the administration of justice61, the requirement that an auditor be seen to be independent is based on a need for public confidence in the credibility and reliability of reported financial information. 62

Recommendation 9

I recommend that all standards of independence of auditors in Australia , including those contained in legislation and professional standards such as Professional Statement F1, be consistent with the

standard of independence defined as follows:

• An auditor is not independent with respect to an audit client if the auditor might be impaired-or a reasonable person with full knowledge of all relevant facts and circumstances might apprehend that the auditor might be impaired-in the auditor's exercise of objective and

impartial judgment on all matters arising out of the auditor's engagement.

• A reference to an auditor includes both an individual auditor and an audit firm . In determining whether an auditor or an audit firm is independent, all relevant circumstances should be considered, including all pre-existing relationships between the auditor, the audit firm and the

audit client, including its management and directors.

7.2.2 Audit independence-non-audit work

The subject of audit independence is both important and difficult. Nowhere is this more so than in considering the degree to which audit firms should be able to provide non-audit services to an audit client.

Proposal six of CLERP 9 dealt with the performance of non-audit work:

The Government supports the immediate application of Professional Statement F I on Professional Independence, which forms part of the Joint Code of Professional Conduct of the ICAA and CPAA.

• Statement F l is based on the independence standard adopted by the International Federation of Accountants. It requires auditors to identify and evaluate threats to independence and apply safeguards to reduce any threats to an acceptable level.

• Where the provision of non-audit services to an audit client poses a threat that cannot be reduced to an acceptable level, statement F I prohibits the provision of that service.63

The standard of independence that I have proposed should, if accepted, be adopted in professional standards such as Professional Statement Fl.

Proposal seven of CLERP 9 stated further:

The Government will implement a series of measures to deal with non­ audit services. It will:

• amend the law to require mandatory disclosure in the annual report of fees paid for the categories of non-audit services provided;

The failure ofHIH Insurance 171

• amend the law to require a statement in the annual report of whether the audit committee is satisfied that the provision of non-audit services is compatible with auditor independence. This disclosure would include an explanation as to why the following non-audit services referred to in Professional Statement F 1, if contracted, do not compromise audit independence:

preparing accounting records and fi nancial statements of the audit client;

valuation services;

internal audit services;

IT systems services ;

temporary staff assignments ;

litigation support services;

legal services;

recruitment of senior management for the audit client; and

corporate finance and similar activities. 64

The authors of the CLERP 9 report recommended against a blanket prohibition on the provision of non-audit services by an audit firm. The arguments in favour of that stance include the following:

• a prohibition on the provision of non-audit services to audit clients may result in increased audit costs as costs cannot be spread across business lines. It may also lead to severe difficulty for major listed clients seeking competitive non-audit services, particularly in Australia with its high level concentration in audit and non-audit services

• a prohibition on the provision of non-audit services to audit clients may lead to the development of separate incorporated entities for non-audit services, with no real separation in substance

• a prohibition on the provision of non-audit services to audit clients may result in the inclusion of some non-au.dit services in audit engagement contracts and the dominance of form over substance on independence issues

• there is no solid evidence of any specific link between audit failures and the provision of non-audit services, and non-audit services have been provided by audit firms to their clients for many years

• many non-audit services are both in the public interest and beneficial to audit effectiveness. For example, a company may seek the assistance of its auditors to correct control weaknesses identified during the audit

• audit firms increasingly need specialists such as information technology specialists to provide critical audit support. Attracting and retaining these

172 Financial reporting and assurance

specialists, and motivating them to provide direct audit support, may be hampered if they were to be prohibited from providing non-audit services to clients.

In announcing the CLERP 9 proposals the government said:

The Government does not agree with the view that a blanket prohibition should be imposed on all non-audit services to audit clients. The Government agrees with the force of the argument in the Ramsay report that this would place Australia out of step with the position in every other developed capital market. Even the harder legislative stance that has been adopted in the new corporate governance legislation in the United States does not contemplate the imposition of a blanket prohibition in relation to all non -audit services. The UK Co-ordinating Group on Audit and Accounting Issues has stated in its Interim Report of July 2002 that it does

not favour a blanket ban on the provision of non-audit services.

The provision of non-audit services has serious ramifications for the perception, and possibly also the actuality of independence. In my view there is a respectable argument in favour of a blanket prohibition notwithstanding the propositions advanced in favour of a more benign regime. I do not pause to develop those arguments because, in the end, I have decided against recommending a blanket prohibition. There are two reasons.

First, I take the statement set out above to be a reflection of a considered government policy that, in this area at least, it would be unwise for Australia to be 'out of step with the position in every other developed capital market' . If that is the case individual reforms ought not fragment that policy. Second, this inquiry did not examine the possible market implications of a blanket prohibition. It is not difficult to see how an outright ban could result, at least initially, in some disruption as firms supplying non-audit services to their audit clients withdraw from one or other service. The longer term effects are more difficult to determine. There must also be at least a possibility that competition in the provision of audit services may decline.

Without a thorough examination of the practical effects that a blanket prohibition would have on the marketplace I do not feel able to make a recommendation. The remainder of the discussion in this section has to be seen against those general comments.

In my opinion, the provtston of non-audit services for audit clients rmses two significant issues in the context of audit independence:

• the impact upon independence when, as a necessary part of the statutory audit, the auditor comes to review non-audit work that has been performed by the auditor or by the auditor's firm. This situation is inconsistent with the exercise of impartial and objective judgment

• the pressure upon audit personnel to procure non-audit work by maintaining a strong relationship with management. Again, this situation is inconsistent with the exercise of impartial and objective judgment. CLERP 9 identified that non­ audit services usually account for more than half of an audit firm ' s revenue and

The failure of HIH In surance 173

that audit firm projections show non-audit services are the engme for their business growth. 65

Proposal seven of CLERP 9 addressed the first of these issues.

As set out above, CLERP 9 proposed that audit committees should state annually that they are satisfied that the provision of certain non-audit services is compatible with audit independence. I agree that the audit committee is best placed to make that statement. However, on the basis that audit independence necessarily impacts upon the credibility and reliability of financial information reported by the entity, I consider that there are obligations on all directors to understand the nature and extent of all services provided by the audit firm engaged by the entity and to assess the impact of those services upon audit independence.

I note that the proposed disclosure requirement in CLERP 9 is based upon a categorisation of non-audit services and that, with respect to specific categories of non-audit services, it is proposed that the audit committee must state annually why provision of those services does not compromise audit independence. In my opinion such categorisation is likely to give rise to difficulties. For example, provision of non-audit services categorised as 'taxation' is unlikely to assist a user of financial reports as to the effect of non-audit work on independence. Strategic tax advice is inherently more likely to compromise audit independence than tax compliance services due to its impact upon income tax balances subject to the statutory audit.

The provision of tax advice by Andersen raised one issue that was considered in the inquiry. It is discussed in Section 16.2.15 and I will not repeat what I have there said. The tax arm of Andersen knew certain features of the arrangement while the audit arm did not. Those features were material to the audit. It is a matter of speculation whether the auditors would or might have discovered the existence of the documents had the tax advice been given by a third party and had the Andersen audit team inquired of the third party as part of the process.

In my opinion the audit committee should provide a statement in the annual report identifying all non-audit services provided by the audit firm and the fees applicable to each item and provide an explanation why these non-audit services do not compromise audit independence.

There is recognition in CLERP 9 of the pressure upon audit personnel to procure non-audit work by maintaining a strong relationship with management:

174

Systems of compensation within audit firms may not give adequate weight to performing the audit function and may in fact adversely impact audit effectiveness. Success in marketing an audit firm's consulting services is often a significant factor in firms' compensation systems. The skills that make one successful in marketing non-audit services to management are not generally consistent with the professional demands on an auditor to be persistently sceptical, cautious and questioning in regard to management's financial representations, thereby creating a tension counter-productive to audit excellence. 66

Financial reporting and assurance

The potential compromise to independence that such pressure entails is not addressed by the CLERP 9 proposals for disclosure of non-audit work. Professional Statement F 1 does not directly address such point either.

As discussed in Chapter 21, at the time of the 1999 and 2000 audits of HIH the performance of Andersen audit personnel was evaluated (and in turn their remuneration and career progression was determined) by reference to various 'cornerstones', one of which was their success in facilitating the use by their audit clients of Andersen's non-audit services. One of the engagement partners said that if he was called upon to exercise independence and professional scepticism by resisting management's proposals, that may well have adversely affected his ability to sell or promote the supply of non-audit services to HIH. It would follow that he would fail on one of the 'cornerstones' on which his career and remuneration were determined.

In my opinion, such a performance evaluation process might give rise to a reasonable apprehension that audit partners would prefer the maintenance of their relationship with management over their professional obligations and, as such, they might be impaired in the exercise of objective and impartial judgment.

It follows that performance evaluation criteria of this sort should form no part ofthe evaluation of audit partners and personnel. Such criteria provide an incentive to use the audit for ulterior purposes, such as professional advancement, by selling non­ audit services to audit clients. This is a matter which should be addressed by the audit firms themselves and by the professional accounting bodies.

Recommendation 10

I recommend that the Corporations Act 2001 should be amended to require the board to provide a statement in the annual report that identifies all non-audit services provided by the audit firm and the fees applicable to each item of work and explains why those non-audit services do not

compromise audit independence.

In my view, performance evaluation criteria that include facilitating the audit clients' use of non-audit services of the audit firm compromise audit independence and should not apply in respect of audit partners and personnel. Use of a performance evaluation process of this kind should amount to professional

misconduct by the audit firm and be subject to the disciplinary regime of the professional accounting bodies.

The failure of HJH Insurance 175

7.2.3 Audit independence-employment associations

Proposal four of CLERP 9 was that:

The Government will amend the law to strengthen restnctJons on emp loyment relationships between an auditor and the audit client.

• This will include a mandatory period of two years following resignation from an audit firm before a former partner who was directly involved in the audit of a client can become a director of the client or take a position with the client involving responsibility for fundamental management decisions. 67 [emphasis added]

The issue of former partners of the auditor being appointed to the board of, or otherwise employed by, an audit client arose directly in the case of HIH and is discussed in Chapter 21. Three former partners of Andersen were appointed to the board of HIH. One was appointed as the chair of the board and appointed to the audit committee 17 months after his retirement from Andersen. Another joined HIH as the chief financial officer the day after he resigned from Andersen, where he had been the engagement partner on the HIH audit. A third former partner was appointed to the board of HIH approximately five months after his retirement from Andersen, where he had played a significant role in the audit of HIH for twenty-five years.

Analysts and the financial press highlighted these associations of Andersen with HIH and Andersen's independence was questioned publicly. The extent to which the perceived credibility and reliability of the published financial reports of HIH was impaired cannot be measured accurately.

As di scussed in Chapter 21 , I consider that those circumstances resulted in the perception that Andersen were not independent of HIH. One of the primary reasons for my conclusion was that the cumulative effect of three former partners on the HIH board affected the perception that Andersen's independence had been compromised more than the presence of one former partner would have done. I note that CLERP 9 did not address that situation. I consider that it is appropriate to limit the number of former partners who can be appointed as a director of an audit client or to senior management positions to one.

Further, in my opinion, the proposed mandatory 'waiting period' of two years might not be sufficient to arrest a reasonable apprehension that former partners retain an influence over members of the audit team. This is particularly so if those with whom they may have worked for a number of years (and in respect of whom they may

have acted as mentor) are members of the audit team. In my opinion, an appropriate 'waiting period' would be four years.

I note that one former partner was never ' directly involved ' in the HIH audit whilst he was a partner of Andersen, and so would not be caught by the restriction envisaged by CLERP 9. I consider that having as a director a former partner who was not a member of the audit team might still lead to a reasonable apprehension that an audit firm is not independent. That perception would be enhanced by the

176 Financial rep orting and assurance

knowledge that a partnership involves the carrymg on of business together for profit.

I note that the restriction proposed by CLERP 9 applies only to former members (that is partners) of an audit firm. I consider that the employment by an audit client of other key senior personnel in the audit team might also lead to the compromise of the independence of the audit firm, or at least the perception of such a compromise. This is because of the close re lationships they are likely to have forged with other members of the audit team. Those relationships increase the possibility of management being able to exert influence over the auditor. Serious consideration should be given to expanding the restriction to key seni or audit personnel.

It should be noted that Professional Statement F l recognises the situations above as presenting a 'familiari ty threat' to independence. 68 Within the framework of Professional Statement F 1 such threats must be identified and the significance of those threats mu st be evaluated . Where the threats are other than clearly

insignificant, safeguards must be identi fi ed and applied to eli minate the threats or reduce them to an acceptable level such that independence is not compromised.69 Notwithstanding Professional State FI, the government has proposed a more prescriptive approach to deal ing with such a threat.

Finally, I consider that the restrictions should be enforceable against both the audit fi rm and the relevant fo rmer partner or key audit team member. Accordi ngly, the restriction should be included amongst the other circumstances in which a director cannot be appointed to the board 70 and an audi tor cannot accept an audit engagement. 71

Recommendation 11

I recommend that, in implementing the CLERP 9 proposal for restrictions on employment relationsh ips between an auditor and the audit client, the amendments provide for the following :

• a mandatory period of four years following resignation from an audit firm before a former partner who was directly involved in the audit of a client can become a director of the client or take a senior management position with the client. This restriction should be extended to

include key senior audit personnel

• an extension of the restriction to a former partner who was not directly involved in the audit of a client. In my opinion , the current proposed period of two years would be appropriate for such a

partner

• a prohibition on any more than one former partner of an audit firm , at any time , being a director of or taking a senior management position with the client

These restrictions should be enforceable against both the audit firm and the relevant former partner or senior audit team member.

Th e failure of HIH Insurance 177

CLERP 9 stated that its proposal 'attempted to achieve an appropriate balance between promoting auditor independence and not unduly impeding audit professionals joining companies and bringing with them valuable financial expertise'.

72 The recommendation set out above does not inhibit professionals from joining companies other than those audited by their former audit firm. Accordingly, I regard the proposal as achieving an appropriate balance, having regard to the

paramount importance of audit independence and the evidence in relation to the impact on perceived audit independence of the presence of former Andersen partners on the board of HIH.

I note that the CLERP 9 proposal referred to a senior management position in terms of a 'position with the client involving responsibility for fundamental management decisions'. An officer is defined in similar terms under the Corporations Act. I have discussed the difficulties inherent in defining an officer in Chapter 6. I recommend that the restrictions upon former partners (and if applicable key senior audit personnel) be expressed in the terms of whatever definition is ultimately adopted in respect of an 'officer' for the purposes of the Corporations Act.

7 .2.4 Rotation of audit personnel and firms

Proposal nine of CLERP 9 stated:

The Government will make audit partner rotation compulsory after five years.

• The new requirement will apply to the lead engagement partner and the review partner. To maintain continuity of knowledge, the appointment of these partners could be staggered. 73

In evaluating the appropriateness of that proposal in light of the HIH experience, two factors must be considered, namely the rotation of audit personnel and the rotation of audit firms.

Audit personnel I note that the CLERP proposal would only apply to the 'lead engagement partner and the review partner'. I consider that a longstanding involvement of key senior personnel in the audit team with an audit client might also lead to the compromise of the independence of the audit firm, or at least the perception of such a compromise. There is a risk that such key senior audit personnel may become too sympathetic to a client's interests, particularly if their long-term career aspirations become linked to their continued material role in the conduct of the audit. Those relationships increase the possibility of management being able to exert undue influence over the auditor.

Again, Professional Statement F 1 recognises such a situation creates a possible 'familiarity threat' to independence. 74 Notwithstanding Professional Statement F 1, the government has proposed a more proscriptive approach to dealing with such a

178 Financial reporting and assurance

threat. I consider that the requirement of compulsory rotation every five years should be extended to key senior audit personnel.

Audit firms

One aspect of the question of Andersen's independence of HIH was the length and closeness of their relationship. In particular, Andersen had been HIH's auditor since 1971. In that time, HIH had become one of the Sydney audit practice's most significant clients. That situation would not have been affected by the CLERP 9 proposal.

The length of a relationship between auditor or audit firm and client presents clear risks with respect to audit independence. An auditor must not become subject to potential compromise of their objective and impartial judgment by reason of a long­ standing relationship with management or a tendency to prefer a particular

accounting position because of a previous commitment to that position.

There is a potential tendency of an auditor to refrain from questioning a particular accounting position because of a previous commitment to that position. This may not be cured by the rotation of audit personnel alone. New audit personnel from the same audit firm as the previous audit personnel may feel a sense of loyalty to their firm, partners and colleagues. This may be motivated at least in part by remuneration, professional advancement and a shared professional indemnity

liability amongst partners. And it might result in the new audit personnel being less likely to report concerns about previous audits to the client and more likely to adhere to positions communicated to the client by the previous audit personnel.

If nothing else, the long-standing appointment of an audit firm might adversely affect the perception of the audit firm's independence, since the public will not be informed about, or may be sceptical of, the efficacy of internal rotation of personnel.

I must have regard however to the realities of the market for professional services in Australia. CLERP 9 noted that companies face a restricted pool of audit firms with experience in auditing listed companies. Where one of the major audit firms is providing non-audit services to a company, the pool of possible providers of audit services may be even more limited. Choice would be further restricted if a company did not wish to contract audit services from a firm that audited a major competitor.

75

On balance, the implementation of other measures put forward in CLERP 9 and by me on audit independence (in particular the standard of independence discussed above) would mitigate threats to independence to such a degree that the rotation of audit firms could be seen as a measure of lesser importance. I am also concerned as to the impact of implementing such a measure in what is currently a limited market of professional services firms in addition to the other measures.

If the other proposals were not to be implemented, the risks to independence arising from longstanding relationships with clients are such that I would recommend that serious consideration be given to the mandatory rotation of audit firms .

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Recommendation 12

I recommend that, in implementing the CLERP 9 proposal for rotation of audit personnel , the requirement for rotation of the lead engagement partner and review partner be extended to key senior audit personnel.

7.2.5 Audit committees

There is a discussion of the principles relevant to the effective operation of an audit committee in Chapter 23. My findings relevant to the function of the HIH audit committee are found in that chapter and Chapter 21 .

The Ramsay report concluded that having an audit committee alone is not sufficient. It is essential that the audit committee have th e necessary attributes to enable it to function as an effective corporate governance mechanism. 76 I entirely agree.

As of 1 January 2003 , the ASX amended its Listing Rules to require an audit committee for the top 500 listed entities by market capitalisation. 77 These requirements apply to the first financial year of the entity commencing after 1 January 2003 , which for most entities will be the year ended 30 June 2004.

The Listing Rules provide that the composition, operation and responsibility of the audit committee must comply with the best practice recommendations set by the ASX Corporate Governance Council. Those best practice recommendations were released on 31 March 2003. The requirement for an audit committee is mandatory. To the extent that there are departures from the other recommendations, those departures must be explained in the company ' s annual report.78

I have not been able fully to consider the recommendations and related guidance notes. But they deal with a number of the deficiencies which I have noted elsewhere in this report with respect to the HIH audit committee. In particular:

• The recommendations call for audit committees to be constituted by non­ executive directors and to have a majority of independent directors. The related guidance encourages companies to move towards an audit committee comprising solely independent directors.

• The recommendations provide for an independent chairperson who is not chair of the board.

• The recommendations call for a formal operating charter. Guidance provides that the audit committee should be given the necessary power and resources to meet its charter, which includes rights of access to management and to auditors without management present and rights to seek explanations and additional information.

• A guidance note provides that the audit committee's report to the board should include an assessment of the performance and independence of the external auditors.

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There are however two points relevant to the effective operation of audit committees. The question of independence with respect to an audit committee is usually concerned with the relationship of its members with management. In the case of HIH, an issue arose as to the independence of the audit committee from the external auditors due to the presence of ex-Andersen partners as members of the audit committee. The best practice recommendations should clarify that the audit committee is required to be independent of both management and the external auditors to ensure that the audit committee's assessment of the performance and the independence of the external auditors is, and is seen to be, effective.

The system of reporting to the board should allow sufficient time for the audit committee adequately to consider the operating results of the entity and its financial position prior to being reported to shareholders and the public.

In Chapter 6 I have made general observations about the dangers which attend attempts to be overly prescriptive in the area of corporate governance, and the vital need regularly to assess the actual performance of key corporate governance mechanisms. Those comments apply with equal force to audit committees.

7.2.6 Audit reports

CLERP 9 identified concerns as to the content and presentation of audit reports. Information identified for possible inclusion in audit reports included:

• internal audit processes

• risk management

• corporate governance processes

• the quality of forward-looking data

• the validity of measures of management performance

• critical accounting policies

• non-financial data such as environmental and social responsibility reports

• the effect on the financial statements of changing critical accounting assumptions. 79

Such disclosures are said to improve shareholder, regulator and investor understanding of the real financial position of the reporting entity, make better use of skills and positions of auditors and increase confidence in financial statements.80 CLERP 9 did not however make any proposals with respect to the content of audit

reports.

I support the general proposition that audit reports should provide more information to enable a better understanding of an entity's financial position.

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In particular, where alternative accounting treatments are reasonably open from the reading of an accounting standard and the difference between those accounting treatments is material, the impact of the position taken by the reporting entity should be explained in the audit report.

For example, additional pre-acquisition claims deterioration that had been identified as a result of management or actuarial reviews resulted in a substantial increase in the amount of goodwill brought to account in respect of the acquisition of F AI at 30 June 2000. This treatment was said to be in accordance with mandatory accounting standards. Evidence before the Commission suggested that on an alternative and appropriate view of the same accounting standards the deterioration should have been recognised as an expense for the year ended 30 June 2000, which would have resulted in HIH reporting substantial operating losses.

In addition, I am of the opinion that an audit report ought to provide commentary upon other significant matters arising in the statutory audit process. 81 The current standard form unqualified audit report sets out a scope section followed by the audit opinion. In my opinion, an understanding of the significant matters dealt with by the auditor in arriving at the opinion would enhance the functionality of the audit report. Items that I would expect to be included in such a commentary are:

• material one-off transactions entered into on or about reporting date

• the material effect of events occurring after reporting date reflected m the financial report.

It is imperative that all matters to be disclosed in the audit report are expressed in plain English, comprehensible to readers who lack accounting qualifications.

A further approach was recommended in the UK Company Law Review. This approach required public and large private companies to publish an operating and financial review as a part of their annual report. The review would contain such information as the directors decide is necessary to obtain an understanding of the business. It would include details of the company's performance, plans, opportunities, corporate governance and management risks. The Company Law Review recommended that the auditor should review the operating and financial review. I am of the opinion that such a document, which would be the subject of audit, would significantly assist in addressing the short-comings of audited accounts presented in accordance with the historical cost convention and other standards which can impede the utility of the accounts as a transparent assessment of the financial progress of the company. Such an approach would enhance the increased audit report disclosure which I have discussed above,

CLERP 9 notes that many submissions were received from audit firms and professional bodies expressing a willingness to provide more information in the audit report. However, this was on the basis there is liability reform to protect them from ' unwarranted litigation' .82

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The JSCP AA report acknowledged that broader commentary in audit reports had the potential to expose auditors to legal action where their comments have a negative impact on share prices and the value of companies. It was also suggested that any proposal for an expansion in the scope of audit reporting could not be reasonably addressed in the light of the present unlimited liability situation. 83

It is difficult to see why expanded audit reporting has been linked to the issue of audit liability in this way. It is not suggested that the inclusion of additional matters in the audit report would require the application of a higher duties of skill or care in the conduct of the audit. Further, in presenting audit reports, auditors are generally

not liable to third parties who rely on the financial reports to make investment or other financial decisions, even if the likelihood of such reliance is foreseeable or known to the auditors. 84 To the extent that there are aspects of the audit work which, if made out, could give rise to liability, there would be nothing unwarranted about any litigation arising. It is inappropriate to trade off expanded audit reporting with

issues of audit liability.

Recommendation 13

I recommend that the Corporations Act 2001 be amended to require the disclosure in audit reports of the following:

• the impact of the position taken by the reporting entity where alternative accounting treatments are reasonably open from the reading of an accounting standard and the difference between

those accounting treatments is material

• the significant matters arising in the audit process.

The Corporations Act should be amended to require audit reports to be presented in plain English

and to require the inclusion of an operating and financial review as part of an annual report, which

would be the subject of audit.

7.2.7 The scope of the audit and the audit expectation gap

In recent years there has been considerable debate about the nature and scope of audit services and the so-called 'audit expectation gap', namely the difference between what auditors actually do when they conduct an audit and what shareholders and others think auditors do, or should do, in conducting the audit.

My experience (confirmed by the evidence before the Commission) has been that audit reports are uninformative about the nature and scope of the audit services performed by the auditor. The terms of a standard audit report are quite formulaic and would not assist a reader to understand the nature or scope of the audit.

I consider that the best way to narrow, possibly to close, the audit expectation gap would be to summarise briefly in plain English in the annual report the nature and scope of the audit services provided. The summary could be included in the body of the audit opinion itself or in another section of the annual report describing the

audit. This would also enable listed public companies and readers of their annual

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reports to compare the nature and scope of the audit services provided to them with those provided to other companies. This would promote efficiency and competition in the market for audit services.

Recommendation 14

I recommend that the Corporations Act 2001 be amended to require public listed companies to include a brief, plain English summary of the nature and scope of the audit services provided by

their auditor each year.

7.3 The actuarial function

7 .3.1 Role of the actuary

Actuaries play an important role in the management and financial reporting of general insurers. In particular, they play an important role in estimating the outstanding claims liabilities of a general insurer. Although inevitably an estimate, accuracy insofar as it is possible in relation to the OCL, is critical to the financial well-being of an insurer.

The actuarial profession is supported by the Institute of Actuaries of Australia. The IAAust provides recognition, professional guidance, support and training for actuaries. It sets minimum qualifications for recognition as an actuary. It has also published a code of conduct for actuaries generally, and professional standards in relation to the work of actuaries within specific fields. In relation to general

insurance, an actuary' s work is subject to Professional Standard PS 300, Actuarial Reports and Advice and General Insurance Technical Liabilities. A number of the specific provisions ofPS 300 have been considered in Chapters 5 and 15.

Prior to the collapse of HIH the actuary had no formal or statutory role in the regulatory framework of the general insurance industry. It was left to the individual general insurer to determine:

• whether (and if so to what extent) it sought or relied upon actuarial advice

• the terms of retainer (including instructions as to assumptions to be made in the valuation exercise) of any actuary retained to provide advice

• to whom that advice was disclosed.

As will become apparent from a reading of Chapter 15 , this approach was problematic and on occasions undermined the utility of actuarial assistance.

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A number of the problems which arose in the case of HIH have been addressed by the APRA Prudential Standards which became operative on 1 July 2002. I will commence with a brief consideration of some of the relevant provisions of those standards before addressing some concerns which remain. The following consideration of those prudential standards is limited to the aspects dealing with the actuarial function. A more general consideration of the prudential standards is in Chapter 8.

7 .3.2 The APRA prudential standards

In addition to amendments to the Insurance Act 1973 which give actuaries a formal regulatory status, Prudential Standards GPS 210, Liability Valuation for General Insurers, and GPS 220, Risk Management for General Insurers, deal extensively with the role and responsibilities of actuaries. APRA has also published a series of guidance notes to these prudential standards. Of particular note in this context are GGN 210.1, Actuarial Opinions and Reports on General Insurance Liabilities, and GGN 220.1, Governance.

The Insurance Act contains a requirement (subject to limited exemptions) that general insurers appoint an approved actuary, and have this appointment approved by APRA. 85 The primary function of the approved actuary is to provide the board of a general insurer with written advice on the valuation of its insurance liabilities to ensure the board is adequately informed. The approved actuary must provide this advice at a 75 per cent probability of sufficiency. Ultimately it remains for the board to determine the appropriate provision in the insurer's accounts. But where the board decides not to accept the approved actuary's advice, this must be disclosed to APRA and in the insurer's accounts.

The prudential standards and guidance notes then deal with a number of further matters of significance to the actuarial function. These matters can be separated into those relating to the role of the approved actuary (including the actuary's qualifications, independence and relationship with the other organs of a general

insurer) and those relating to the approach to the valuation of the insurer's insurance liabilities.

The role of the approved actuary GPS 220 requires that the approved actuary be a fit and proper person. 86 It requires, amongst other things, that the actuary:

• has appropriate formal qualifications and is a member of a suitable professional bodl7

• has no actual or potential conflicts of interest that are likely to influence their ability to carry out their role and functions with appropriate probity and competence.88 As part of the approval process, the actuary must disclose to APRA details of their pecuniary interests in the insurer, including details of the remuneration which they or their firm receive from the insurer

89

Th e failure ofHIH In surance 185

• is not the chief executive officer or director of the insurer or a related body corporate90

• is not the approved auditor. 91 This is said to reflect the importance of the two positions of approved actuary and approved auditor, and to demonstrate independence and avoid potential conflicts of interest.

From Chapter 15 it is apparent that neither the board nor the auditors gave any detailed consideration to the independence of HIH's consulting actuary. These provisions should assist in formalising the consideration which ought to be given to the fitness and propriety of the actuary, including his or her independence.

The prudential standards represent a fundamental change in the obligations and relationships between the approved actuary, the insurer and APRA. Under the new regime the approved actuary must prepare a report on the value of the insurer' s insurance liabilities (in accordance with GPS 210, discussed below). This report must be supplied to the insurer' s board, and must be submitted by the insurer to APRA with its yearly accounts. 92 This may be contrasted with the very limited circulation of the reports ofHIH's consulting actuary.

It remains the responsibility of the board to determine the appropriate valuation of the insurance liabilities. However, as I have mentioned, where the board decides not to accept the approved actuary's advice, this must be disclosed to APRA and detailed in the insurer' s published financial accounts. 93 Again, this is a welcome reform in that it will ensure that the actuary ' s advice is given the serious consideration it requires. Justification will be needed for any departure from that advice.

Guidance Note GGN 210.1 acknowledges that the relationships between the board, management, auditors, internal actuaries and consulting actuaries can be very complex. It provides that it is the responsibility of the approved actuary to clarify the relationship between these parties for the purpose of preparing advice on the value of the insurer' s insurance liabilities. The extent to which the actuary obtains information from, or relies upon work undertaken by, others must be disclosed in the report. 94 It also provides that it is the role of the approved actuary to make clear that he or she may require access to , and information from, management, underwriters, other employees of the company and the company's auditors. The approved actuary however retains full responsibility for their advice and reports, and must therefore be satisfied as to the validity of the information provided to them, and work carried out for them. 95

The Insurance Act requires that an insurer make arrangements to enable the approved actuary to carry out their function. This includes ensuring the actuary has access to all relevant data and people within the insurer which the actuary reasonably believes is necessary to fulfil their obligations.96

186 Financial reporting and assurance

In Chapter 15 I recorded my surprise at the lack of direct communication between HIH's actuary and auditors. HIH's actuary made some efforts to establish a channel of communication, but his offers were not taken up by those within HIH responsible for providing him with instructions. I would expect the above provisions to go some way towards resolving this difficulty.

Guidance note CGN 220.1 paragraph 15 requires the audit committee to invite both the approved auditor and the approved actuary to meetings of the committee. This will overcome a major deficiency that I detected in the functioning of the HIH audit committee, namely that the actuary never attended a committee meeting. It will also provide a forum for the auditor and actuary to meet and engage in dialogue. It is a welcome reform and a vast improvement on the previous system.

These requirements should also go some way to addressing some of the breakdowns in the flow of provisioning information and data which I have considered in Chapter 15. While responsibility is placed upon the actuary to ensure the adequacy of the information, the company is also obliged to comply with the actuary's reasonable requests for access to information and personnel. The actuary should no

longer be constrained by his or her individual terms of retainer.

I note that in addition to preparing the regular valuation reports, the approved actuary may be required to provide other information to APRA upon request by APRA. 97 He or she may also initiate meetings with the insurer and APRA, or just with APRA. 98 Finally, the approved actuary must report to APRA any instances

identified where prudential requirements may be breached or policyholders' interests may be threatened.99

The valuation of insurance liabilities I have mentioned that the new prudential regime requires that the board of a general insurer obtain a report from an approved actuary in relation to the valuation of its insurance liabilities. Prudential Standard GPS 210 establishes a set of principles for the consistent measurement and reporting of the insurance liabilities.

In providing his or her report on the insurance liabilities, the approved actuary has a legal responsibility to provide advice that complies with the Insurance Act and Prudential Standard GPS 210, and a professional responsibility to provide advice that complies with the Guidance Notes and the professional standards of the IAAust. These responsibilities override any responsibility as an employee of, or consultant

to , the insurer. 100

Insurance liabilities are defined as including both the insurer's outstanding claims liabilities (an estimate of future payments on all claims incurred prior to the calculation date, whether or not reported) and premium liabilities (an estimate of future claim payments arising from future events insured under existing policies, assessed on a prospective basis). 101 The valuation report must include central estimates of the OCL and the premiums liabilities, and risk margins that relate to the

inherent uncertainty in each of these central estimate values. The risk margins should be established on a basis that is intended to provide a 75 per cent probability

Th e failure ofHIH Insurance 187

of sufficiency.102 The value of the insurance liabilities is the sum of the two central estimates and risk margins. 103 The actuary should provide central estimates and risk margins shown separately for each class of business. 104

Earlier in this chapter I have considered the desirability of the inclusion of a risk or prudential margin within an insurer's outstanding claims provision. But regardless of the merits of this proposal, I regard the requirement that the board of an insurer obtain actuarial advice in relation to the level of uncertainty in the central estimate as a welcome reform. Without this advice directors are disadvantaged in determining how and whether this risk is being adequately dealt with, whether through a prudential margin, a reinsurance programme, a capital surplus or otherwise.

The value of the insurance liabilities must be discounted. 105 I have referred earlier in this chapter (and in Chapter 15) to the problems which have arisen in the interpretation of the requirement under AASB 1023 that the insurance liabilities be discounted at a market-determined risk-adjusted rate of return. This has encouraged discounting at a rate of return which it is expected the insurer might earn on its assets. This approach was described in the expert actuarial evidence during the Commission as aggressive. When taken to its logical extreme, it can lead to perverse consequences with risk-taking insurers able to achieve a larger discount on their OCL. In the case of HIH, the actuary was asked to assume a particular discount rate for each of his valuations, and those rates were generally in excess of the rate of return on risk-free securities of a term matching the mean term ofHIH' s OCL.

Under the new prudential regime, the actuary's dilemma in this respect is resolved. GPS 210 recognises that the value of an insurer' s liabilities is typically independent of the value of the underlying assets, and that for this reason a discount rate that is observable, market-based and objective is more appropriate. 106 It provides that the rate to be used in discounting future claim payments fo r a class of business is the gross redemption yield of a portfolio of sovereign risk securities with a similar expected payment profile to the insurance liabilities for that class (for example Commonwealth Government securities for Australian dollar liabilities).107

Guidance Note GGN 210.1 deals with a number of matters relating both to the content of the valuation report to be provided by the approved actuary and the methodologies to be adopted in carrying out the valuation. The guidance note is intended to provide interim guidance pending release by the IAAust of its own professional standards and guidance notes. I note that some consequential amendments have already been made toPS 300.

The guidance note deals, for example, with future claims handling costs. It states that the allowance for FCHC should ·be made after a consideration of historical levels of costs, organisational structure, internal and outsourced functions and future administrative developments. 108 Not only does the guidance note make clear the need to have regard to the insurer's likely actual costs, it places an onus on the actuary to consider the above matters.

188 Financial reporting and assurance

The new prudential regime also places a greater onus on the actuary in terms of satisfying him or herself as to the reasonableness of any estimates supplied by the insurer 109 , and to consider the insurer's reinsurance arrangements. 110

Each of the matters referred to in the previous two paragraphs are the subject of some consideration in Chapter 15. An approach which allows an insurer to instruct an actuary to make assumptions about these matters, without the actuary being given an opportunity to test the appropriateness of these assumptions, is problematic. The

new prudential regime clarifies the actuary's obligations, and limits the insurer' s ability to subject the actuary' s advice to some of the constraints to which HIH's actuary was subjected.

Summary In my view the new prudential regime represents a substantial improvement upon the regime in place during HIH's time. It recognises the crucial role which actuaries play in the accurate valuation of what will ordinarily be the largest single item on the insurer's balance sheet. It both ensures that actuarial advice is obtained and considered, and clarifies the relationship between the actuary, the insurer (including

its board, management and employees), the auditors and APRA.

I note that those who made submissions in relation prudential regime broadly supported the measures relating to the actuarial function.

7 .3.3 Other potential reforms

A number of further suggested reforms were referred to in both the evidence and submissions before the Commission. I will consider briefly some of what I regard as the more meritorious suggestions.

Data certificates In Chapter 15 I have outlined a number of the data problems which confronted HIH's consulting actuary. The new prudential standards go some way towards addressing the concerns I identified. I have already mentioned the obligation upon an actuary to identify the data he or she needs, and the obligation of the insurer to provide access to that data. This enhances the ability of the actuary to demand better or additional data from the insurer. There are further more detailed provisions dealing with the actuary's obligations in relation to data.

111

They provide, for

example, that it is an actuary's responsibility to ensure that the data used gives an appropriate basis for estimating the insurance liabilities. This is said to include exposure data and claims experience data where the other data is not sufficient to reduce uncertainty to an acceptable level. They also provide that an actuary should

take reasonable steps to verify the consistency, completeness and accuracy of the data collated against the insurer' s financial records. The actuary should identify in his report the degree to which reliance has been placed upon data supplied by the company and the testing of that data by the auditors, and comment upon the

limitations these matters place upon the actuary's confidence.

Th e failure of HIH Insurance 189

These measures will no doubt assist in reducing the incidence of the breakdowns in the flow of provisioning information and data of the kind which I have found occurred in the case of HIH. But in my view it would be worth considering whether the reforms might be taken further. For example, Richard Wilkinson (an actuary from the London office of KPMG) referred in his evidence to a practice in the United Kingdom of obtaining data certificates from management of the insurer. While such certificates will not guarantee the accuracy or completeness of the data supplied to the actuaries, in my view they are likely to focus the minds of management. Although there is always a risk of a 'box-ticking' mentality, nevertheless the process of completing the certificates (and in particular identifying the person who takes responsibility for the data in signing the certificate) is likely to underscore the importance of ensuring the accuracy and completeness of the data supplied to the actuary.

Recommendation 15

I recommend that both the Australian Prudential Regulation Authority and the Institute of Actuaries of Australia introduce compulsory certification of the completeness and accuracy of data.

Peer review The IAAust submitted that it was desirable that the approved actuary's annual report on the valuation of the insurer's insurance liabilities be subject to independent review by another actuary. 112 It was further submitted that in view of the dominant influence of the claim and premium provisions on an insurer's solvency and profitability, it was not possible for the auditor to form a soundly based view of its accounts without actuarial input. The IAAust added that where the auditor had access to actuarial advice within the same firm, it was natural for an independent review to take place within the audit process. Its understanding was that this was normal audit practice in the general insurance industry.

In my view, peer review will often be a worthwhile exercise. In the case ofHIH, the auditor's review of the company's provisions did not involve any actuarial input. The review would have been improved by that input. But I can also envisage situations where a formal requirement of peer review would be an unnecessary impost which would be costly and productive of delay. Thus while I would encourage insurers and their auditors to consider carefully the need for actuarial

input in the review of the actuarial advice (or particular aspects of that advice) received by the company, I am not inclined to recommend that a formal process of peer review of the actuary's report be made mandatory.

Actuarial methodologies Responsibility for the selection of an' appropriate valuation model or methodology lies with the actuary. As I have mentioned, Guidance Note GGN 210.1 provides some guidance.

190 Financial reporting and assurance

I do not propose to consider the relative merits of the various methodologies of which I have become aware during the course of the Commission. However, I do wish to make some more general observations. They arise in part at least from the submissions of Dr Ben Zehnwirth, who was critical of the methodologies adopted by a number of actuaries, including those advising HIH. In essence his criticisms were directed towards the over reliance upon subjective judgment (for example, in determining an appropriate allowance for future claims inflation) at the expense of reliance upon properly constructed probabilistic models and analysis of the trends and variability found in historical experience.

The actuarial science is still developing. It may well be that over time a greater consensus is reached as to the merits of particular methodologies and models for particular types of insurance business. But it seems to me that there will inevitably remain a need for the exercise of subjective judgment on the part of the actuary. To me the concern is not so much with the existence of subjective judgment as with the

identification of the judgments that have been made and their impact upon the valuation.

From my consideration of HIH's actuarial valuations in Chapter 15 it is clear they involved a significant level of subjective judgment- for example, in selecting rates of superimposed inflation which were inconsistent with the historical experience, and in making assumptions about the impact of particular changes in the business being written. HIH's actuary referred often to the past experience for particular lines of HIH business not being a useful indicator of the future. But often I found it difficult from a reading of the actuarial reports to discern precisely what subjective judgments had been made, let alone the impact of those judgments upon the

valuation outcome.

In my view the usefulness of the actuarial advice provided to general insurers would be enhanced by clear disclosure of the existence and impact of such judgments and departures from historical experience. The resulting transparency of the actuarial advice should assist readers (including the board, auditors and APRA) m

identifying, testing and assessing the appropriateness of such judgments.

Recommendation 16

I recommend that the Institute of Actuaries of Australia and the Australian Prudential Regulation Authority introduce a requirement for more detailed disclosure of the exercise, incidence and

impact of subjective judgment and departure from historical experience.

Independence of actuary and auditor Under the new prudential regime, the approved actuary may be an employee of the insurer (but not the chief executive or a director). The approved actuary may not be the approved auditor, but there is nothing to prevent the approved actuary being an

employee or partner of the same organisation as the approved auditor of the insurer.

Th e failure of HIH Insurance 191

IAAu t addressed the e matter in it ubmi ion .1u It upported the

appropriatene of permitting the appro ed actuary to be an employee of the in urer on the ba is that the experience of it member a that an actuary who i an

employee of the company concern d i often better placed to undertake a d tailed analysi and valuation of that company ' in urance Iiabilitie than an actuary external to the company. It added that th former often ha a more detailed understanding than the latter of the natur of th company in urance contract and

liabilities.

The IAAu t however wa of the view that the appro d actuary hould not be an employee or partner of the arne organi at ion a th appro d auditor of the in urer. It submitted that if the appro ed actuary and approved auditor were employees of the same organisation, th nece ary degree of indep ndence of the e rol from each other might not be achieved.

I see some force in the e ubmi ion . They are con i t nt not only with the new requirement that the approved actuary not b the appro ed auditor but al o with my view in relation to the scop of rvice to be pr vided by auditor . In addre ing this concern, car hould b tak n to n ure that the approv d auditor and approved actuary are independent of each other whether they are from the arne or diffi rent but related firms.

Recommendation 17

I recommend that the Australian Prudential Regulation Authority extend the qualifications of the approved actuary to require that they not be an employee or partner of the organisation to which

the approved auditor belongs .

192

CMC0.0047.001 at 002.

Submi sion by Mr Mark Leibler to the Joint Committee on Public ccounts and udit review of independent auditing by regi t red company auditor (July 2002). pa g 6.

Recommendation 6, Joint ommittee on Public ccount and udit re iew of independent auditing by register d company auditor (July 2002).

CMC0.0048.00 I at 005 .

CMC0.0044.00 at 019.

P 300 par 47 and 4 .

GP 210 par 5 and 9.

Dr Ben Zehnwirth, CMC0.0037.295 at 309.

Financial reporting and assurance

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

29

30

3 1

32

33

34

35

36

37

38

39

40

CMC0.0057.001 at 014. CMC0.0056.001 at 018 to 019. Minutes of the Standards Advisory Committee on Insurance Contracts (Ph ase I), Hon g Kong, November 2002.

CMC0.0048.001 at 016.

CMC0.0056.001 at 018.

CMC0.0057.001 at 014.

CMC0.0057.001 at 013 .

CMC0.0044.008 at 023 . CMC0.0049.004 at 035 .

CMC0.0056.001 at 018.

CMC0.0056.001 at 017 .

CMC0.0056.001 at 019. CMC0.0057 .00 1. CMC0.0048.001 at 006.

CMC0.0044.008 at 011 . CMC0.0049.004 at 012 .

CMC0.0049.004 at 026.

AASB 1023 , Financial Reporting of General Insurance Activities, background to reVISIOn .

CMC0.0048.001 at 006. AASB I 013 par. 13 .1.

AASB 1013 par. 5.7.

Corporations Act 200!, ss. 327(1), (2) and (3) .

Corporations Act 2001 , s. 327(4).

Corporations Act 2001 , s. 329(1 ).

Corporations Act 2001, s. 329(5).

CLERP 9 at 4.2 page 42.

CLERP 9 at 4.2 page 42.

I Ramsay, 'Independence of Australian Company Auditors. Review of Current Australian Requirements and Proposals for Reform. Report to the Minister for Financial Services and Regulation' (2001) at par. 4.02 page 20. See Professional Statement F 1 'Professional Independence' issued by the Institute of Chartered Accountants and CPA Australia at par. 10.

United States v Arthur Young, 465 US 805 , 817- 818 (1984).

CLERP 9 at 3.3.1 page 33 .

CLERP 9 at 3.3 page 34 .

Th e failure ofHIH Insurance 193

41

42

43

44

45

46

47

48

49

50

51

52

53

54

55

56

Corporations Act 2001.

CLERP 9 at 4.6.3 page 46.

CLERP 9 at 4.6.3 page 46.

CLERP 9 at 4.6.3 page 47.

See Corporations Act 2001 s. 324(10).

Hospital Products Ltd v United States Surgical Corp (1984) 156 CLR 41 at 97 (Mason J).

Hospital Products Ltd v United States Surgical Corp (1984) 156 CLR 41 at 142 (Dawson J).

Canson Enterprises v Boughton & Co (1991) 85 DLR (4th) 129 at !55 (McLachlin J).

Hospital Products Ltd v United States Surgical Corp (I 984) 156 CLR 41 at 141 (Dawson J).

Parkinson The Principles of Equity (I 996) at 362.

Chan v Zacharia (1984) 154 CLR 178 at 199 (Deane J).

Bray v Ford [1896] AC 44 at 5 I to 52 (Herschell LJ).

Boardman v Phipps [ 1967] 2 AC 46 at 124 (Upjohn LJ); Queensland Mines Ltd v Hudson (1978) 18 ALR 1 at 3 (Privy Council).

Chan v Zacharia ( 1984) 154 CLR 178 at 198 to 199 (Deane J). ' Related party' is defined in section 228 of the Corporations Act 2001.

Corporations Act 2001, s. 207. 57 Corporations Act 2001, s. 219. 58

Johnson v Johnson (2000) 201 CLR 488 at 493 (Gleeson CJ, Gaudron, McHugh, Gummow and Hayne JJ). 59 Johnson v Johnson (2000) 201 CLR 488 at 493 (Gleeson CJ, Gaudron, McHugh,

Gummow and Hayne JJ). 60 Vakuata v Kelly (1989) 167 CLR 568 at 577 (Dawson J). 61

62

63

64

65

66

67

68

69

194

Johnson v Johnson (2000) 201 CLR 488 at 493 (Gleeson CJ, Gaudron, McHugh, Gummow and Hayne JJ).

see I Ramsay, 'Independence of Australian Company Auditors. Review of Current Australian Requirements and Proposals for Reform. Report to the Minister for Financial Services and Regulation' (200l)at 4.01 and 4.02 page 20

CLERP 9 at 4.9.3 page 68.

CLERP 9 at 4.9.3 page 69.

CLERP 9 at 3.1 page 29.

CLERP 9 at 4.9.1 page 64.

CLERP 9 at 4.7.3 page 49.

Professional Statement F 1, Appendix I· par. I .26.

Professional Statement F1 , Appendix I par. 1.10.

Financial reporling and assurance

70

71

72

73

74

75

76

77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

98

Corporations Act 2001 s. 20 lB.

Corporations Act 2001 s. 324.

CLERP 9 at4.7.3 page 51.

CLERP 9 at 4.11.3 page 83 .

Professional Statement Fl, Appendix 1 par. 1.26.

CLERP 9 at 3.1 page 29 .

CLERP 9 at4.10.1 pages 75 to 76.

Listing Rules 1.1 (Condition 13) and 12.7.

Listing Rule 4.10.3.

CLERP 9 at 3.4.1 pages 35 to 37.

CLERP 9 at 3.4.1 pages 35 to 37.

see JSCPAA report at par. 4.118 page 117. CLERP 9 at 3.4.1 pages 35 to 37 .

JSCPAA report pars 4.122 and 4.123 page 118.

Esanda Finance Corporation Limited v Peat Marwick Hungerfords ( 1997) 188 CLR 241 ; see Greinke ' Auditors' Liability to Third Parties: The View of the High Court' (1997) 15 C&SLJ 309 at 312.

Insurance Act ss. 39 and 40.

GPS 220 par. 2.

GPS 220 par. 8.

GPS 220 par. 6.

GN 220.1 par. 22.

GPS 220 par. 6.

GPS 220 par. 10 .

GPS 220 par. 30; Insurance Act, s. 9.

GPS 210 par. 4.

GGN 210.1 par. 5.

GGN 210.1 par. 6.

Insurance Act, s. 49K; GPS 220 pars 31 to 32.

GPS 220 par. 30; Insurance Act, s. 9.

GPS 220 par. 34. 99 GGN 220.1 pars 35 to 40 . 100

GGN 210.1 par. 7. 101 GPS 210 pars 6 and 7. 102

GPS 210 par. 1 0. The risk margin should be not less than one half of the coefficient of variation for the insurance liabilities, which in the case of highly skewed insurance

The failure of HIH In surance 195

distributions, may require greater than 75 per cent level of sufficiency - GPS 210 par. 11. 103 GPS 210 par. 9. 104

GPS 2!0 par. 13 . 105 GPS210par.19. 106

GPS210par.29. 107 GPS 210 par. 30. 108

GGN 210.1 par. 39 . 109 See, for example, GGN 210.1 par. 40, which makes it clear that the actuary is responsible for ensuring the valuation process and estimates are reasonable. 110

GPS 210 pars 37 to 41 ; GGN 210.1 pars 23 to 24 . 111 GGN 210.1 pars 11 to 16 . 112

CMC0.0044.008 at 015 . 11 3 CMC0.0044.008 at 014 to 015 .

,,

196 Financial reporting and assurance

8 Regu lation of general insurance

Arrangements for the regulation and prudential superv1s10n of general insurance have undergone marked changes in recent years. Some of those changes took effect in the last years ofHIH and others following its collapse.

In reviewing the adequacy and appropriateness of these arrangements I saw my role as essentially to identify any weaknesses in the existing regulatory landscape in light of the stresses and experience that arose from HIH and its failure .

General insurers are subject to the corporate and social regulatory regime that applies to incorporated businesses generally. This includes the legislative regimes of the Corporations Act 2001, the Trade Practices Act 1974, state fair trading legislation and, for public listed companies, the requirements of the Listing Rules of the Australian Stock Exchange.

General insurers are also subject to a range of industry specific regulations at Commonwealth, state and territory levels. These regulations subject insurers to prudential supervision. They also deal with aspects of market conduct and consumer protection and the workings of various statutory insurance schemes which operate in each state and territory.

Prudential regulation seeks to reduce the likelihood that regulated entities will fail and be unable to meet contractual commitments to those with whom they deal. Governments around the world have over many years imposed prudential controls in the financial services sector. The main focus has generally fallen on the banking and deposit-taking sector because of the critical role that sector plays in a modem

market economy. General insurance has traditionally faced less intensive supervision than the banking sector and has only been prudentially regulated in Australia since 1973. The effectiveness of the prudential regulation of general insurers was a principal focus of attention in my inquiry into the failure of HIH.

8.1 A short history of regulation

8. 1.1 Corporate regulation

The law relevant to corporations and the secuntJes markets was largely a state responsibility before 1990. In that year the Commonwealth, the states and the territories agreed that the Corporations Act 1989 would form the basis for future corporate regulation, through the Corporations Law, and that the states and territories would apply it through their own legislation. A national body, the

Australian Securities Commission, was created to administer the law. Constitutional

Th e failure ofHIH Insurance 197

difficulties arose with the Corporations Law. These were resolved in 2001 when all the states and territories agreed to refer responsibility for corporate law to the Commonwealth. This resulted in the enactment of the Corporations Act 2001 m July 2001.

In the meantime, corporate law had undergone a number of reviews and reforms under the Corporate Law Economic Reform Program. The Corporate Law Economic Reform Program Act 1999 (the CLERP Act) introduced substantial changes to corporate law.

The Corporations Act primarily regulates the legal structure, form and conduct of corporations. It is administered by the Australian Securities and Investments Commission. ASIC assumed responsibility for corporate regulation from the former Australian Securities Commission in 1998. ASIC also has responsibility for regulating consumer protection and market integrity for the banking, insurance and superannuation sectors.

8.1.2 Prudential regulation

General insurers are regulated under the Insurance Act 1973. Prior to the enactment of the Insurance Act, companies wishing to conduct general insurance business were only required to lodge a deposit of $200 000 with the Commonwealth Treasurer under the Insurance (Deposits) Act 1932. The introduction of the Insurance Act in

1973 was prompted by the failure of 16 general insurers in the preceding three years. The Act imposed prudential requirements on general insurers. These included requirements for insurers to hold a minimum level of capital and have adequate reinsurance cover. A specialist agency, the Insurance Commissioner's Office, was created to supervise general insurers under the Act. This agency subsequently evolved into the Insurance and Superannuation Commission in the 1980s with the addition of responsibility for the supervision of the superannuation sector.

In 1996 the Commonwealth Government commissioned the Financial System Inquiry to undertake a major review of the regulatory framework for the financial services sector to ensure its continued effectiveness and efficiency. The report of that inquiry (the Wallis report) made a number of recommendations that had significant implications for the structure of the system of financial regulation in Australia, including for general insurance. The Commonwealth Government accepted many of those recommendations. The main change affecting general insurers was the creation of a single prudential regulator with responsibility for prudential supervision of the entire financial services sector-the Australian Prudential Regulation Authority-which commenced operations on 1 July 1998.

On commencement APRA assumed responsibility for the prudential supervision of deposit-taking institutions previously regulated by the Reserve Bank of Australia, and general insurance, life insurance and superannuation entities. Previously, the financial supervision of the banking industry was the responsibility of the Reserve Bank of Australia. The supervision of other deposit-taking institutions (such as

198 Regulation of general insurance

building soc1et1es and credit unions) was the responsibility of the Australian Financial Institutions Commission and associated state supervisory authorities. APRA assumed AFIC's responsibilities on 22 August 1999.

In addition to prudential regulation, the Insurance and Superannuation Commission was also responsible for consumer protection and the regulation of market conduct of the general insurance industry. This function was transferred to ASIC from 1 July 1998.

Beyond the creation of APRA, the Wallis report did not recommend specific changes to the way general insurance was to be prudentially regulated. Independent of the Wallis report the Insurance and Superannuation Commission had commenced a project in 1995 to consider the adequacy of the prudential regulatory framework with respect to general insurance. This process was carried forward by APRA and the Commonwealth Government. It culminated in the passage of the General Insurance Reform Act 2001. This Act introduced a number of significant changes

which came into effect on 1 July 2002. They are discussed further in Section 8.8.

8.2 The case for prudential regulation

Government intervention in the marketplace is usually justified on the grounds of risk of market failure. As the Wallis report stated:

The general case for regulation is founded in market failure . This occurs when factors are present that prevent efficient market outcomes. 1

A key requirement for efficient market outcomes is what is often described as ' perfect information'. Perfect information allows consumers and producers to make decisions based on their own preferences and circumstances and should lead to efficient outcomes in the absence of other market failures . In the case of general

insurance a consumer is attempting to lay off or reduce risk of loss by passing it on to an insurer for the price of the premium. An important part of the purchasing decision should include an assessment of the likelihood that the insurance provider will remain solvent and able to meet a possible future claim.

It is to be expected that a rational and well-informed consumer would consider both the risk that an insurance company will be unable to meet a future claim and other factors such as the cost and coverage of insurance offered. A risk-averse consumer may purchase insurance from an insurer which has a low risk of failure. Consumers who are not so concerned about risk may be willing to buy insurance from a higher

risk company if, for example, its cover were offered at a cheaper rate. But information about the financial strength of individual insurers is not readily available.

In any event better disclosure and more accurate financial reporting may not assist less informed consumers assess the risk that a particular insurer will fail. The result is that many consumers are likely to choose their insurance provider on other

Th e failure of HIH Insurance 199

grounds-such as price, coverage, claims management or marketing. This is understandable given the cost and difficulty in making an accurate judgment of the financial strength of a particular insurer.

Apart from the difficulty in assessing the risk of an insurer failing, consumers may also face a significant loss should their insurer be unable to meet legitimate future claims. Taken together, these reasons provide the main basis for the prudential regulation of general insurance.

8.2.1 Contagion

A key reason used to justify prudential regulation of banking is the threat of contagion and systemic risk. This argument is based on the possibility that the failure of a large bank may have serious implications for other sectors of the economy. The collapse of one bank may weaken the entire banking system by reducing consumer confidence and diminishing the availability of credit.

Contagion is less relevant in the insurance industry. The failure of HIH did, however, impose significant costs on other sectors. For example, the building industry was seriously affected when HIH collapsed as builders found it difficult to find warranty insurance cover for projects in some states. This was at least partly the result of the dominance of parts of the builders warranty market by HIH. A market with a larger number of providers may be better able to cope with the failure of one provider than a market dominated by one company.

Nevertheless, the possibility that the collapse of an insurer may lead to costs in other sectors of the economy is a justification for prudential regulation, particularly given the increasing dominance of the Australian market by a few large insurers.

8.2.2 Third party risks

Another reason for the prudential regulation of general insurers is their role in providing protection for third party risks such as workers compensation, compulsory third party personal injury and product liability insurance. The third party who is protected by insurance does not have a direct relationship with the insurer providing the cover and has little, if any, say in the choice of insurer. Prudential regulation is warranted as an added protection for this important group.

In short, the failure of a large insurer can impose significant social costs on the community.

200 Regulation of general insurance

8.3 The regulatory framework

APRA and ASIC have responsibilities and interests that to some extent overlap in the area of financial services including general insurance. In its submission APRA outlined the relevant responsibilities of ASIC and APRA as follows:

• At the broadest level, corporate activity in Australia can be divided into three classes of entity:

Commercial (ie non-financial) entities;

Non-prudentially-regulated financial entities; and

Prudentially-regulated financial entities

• The activities of all corporate entities in Australia are governed by the Corporations Act 2001. This determines the fundamental corporate requirements that exist for all companies, and applies regardless of which of the above classes they exist within .. . ASIC is responsible for the oversight of the Corporations Act 2001 .. .

• Beyond these requirements that apply to all corporate activity, ASIC also has certain consumer protection responsibilities that apply to all financial entities (whether they are prudentially regulated or not) ...

• APRA is responsible for the prudential regulation of a sub-set of financial entities. These institutions-deposit-takers, insurance companies and superannuation funds-are financial entities that the Government, as a matter of public policy, views as warranting an additional layer of regulation over and above that provided by ASIC across the corporate and financial sector more generally ...

• As a general proposition APRA's prudential regulation is designed to promote stability and soundness within the financial entities it supervises . . . To characterise the difference between APRA and ASIC in what is perhaps an oversimplified manner:

ASIC permits financial entities to offer financial products provided they adequately disclose their financial position to consumers. At the same time, ASIC supervises prudentially­ regulated financial entities in exactly the same manner as it supervises other corporations of the same kind under the

Co rporations Act 2001.

APRA requires that prudentially-regulated financi al entities maintain a minimum level of financial soundness. 2

Given the overlap in their responsibilities in respect of prudentially regulated companies, the allocation of responsibilities, structure and interaction between ASIC and APRA is relevant to the overall effectiveness of the system of corporate and prudential regulation.

The failure ofHIH Insurance 201

The structure of the regulators

At an international level, two models have emerged for the interaction of prudential and corporate regulation . These are the two-agency model adopted in Australia, where the prudential regulator is separate from the companies and securities regulator; and the single agency model where corporate and prudential regulation is the responsibility of a single agency. Australia, Canada and more recently the Netherlands have adopted the two-agency model. In the United Kingdom, Japan, South Korea, Germany, Austria and Ireland corporate and prudential regulation is the responsibility of a single agency. In the United States, state governments are responsible for the prudential regulation of general insurance while, at the federal level, the Securities and Exchange Commission is responsible for regulation of the securities markets.

In a single agency model all financial services regulation is provided under one roof. Regulated entities need only deal with one rather than two regulators. Potentially, a single agency may also lead to improved coordination of prudential and corporate regulation, benefit from economies of scale and a reduction in duplication and the risk of regulatory gaps. A single regulator may also be able to offer a more holistic view of a financial institution.

The arguments for a two-agency structure largely relate to the differentiation of roles and the increased focus of objectives. A regulator with well-defined and well­ understood objectives and lines of accountability may be more effective than one with wider and possibly competing objectives. This argument partly rests on the fact that larger, more complex organisations with a range of responsibilities may be less efficient and may become overly bureaucratic and unresponsive. They may also be more difficult to manage effectively.

In recommending the creation of separate agenc1es for prudential and corporate regulation, the Wallis report stated:

The Inquiry, while recommending measures to ensure close cooperation and coordination among the financial regulatory agencies, has not favoured their amalgamation into a single agency or mega-regulator. The reasons for preferring separate, coordinated agencies to a mega-regulator are:

• it should be expected, and accepted, that agencies formed for the separate purposes of the APRC, CFSC and PSB will function best with their own distinct cultures;

• at this stage in the history of our financial system and regulatory arrangements, fusion of these agencies' functions and approaches would be premature;

• a single regulator with all of these functions might become

excessively powerful; and

• these functions may be too extensive to be combined in one agency with full efficiency.3

202 Regulation of general insurance

The Senate Select Committee on Superannuation and Financial Services also considered the question of merging APRA and ASIC:

The Committee is aware that in the United Kingdom, the Financial Services Authority is the sole financial services regulator. The Committee considers that while such a single regulatory model has some merit for consideration in Australia, the system of having two regulators is generally operating effectively.4

Issues relating to the overlap between ASIC and APRA, and the relationship between them in regard to the regulation of general insurers have caused me some concern. My attention has necessarily been directed to general insurance and the questions that are raised may or may not extend to the other prudentially regulated

market sectors of banking and superannuation.

Arguments were put in submissions and in the course of consultations about the merits of the two-agency approach. I did not find these arguments entirely persuasive. What might be described as the traditional approach is based on a supposed inherent tension between a corporate regulator, whose emphasis is on enforcement of the law, and a prudential regulator where the emphasis is likely to be on early detection of financial weakness and remedial action behind the scenes. In respect of general insurance I consider that regulation based on behind the scenes

intervention is now less justifiable in an environment where public policy increasingly mandates disclosure by corporate entities. The position may be different with regulation of banks and other deposit takers.

In any event, to the extent that the emphasis of corporate and prudential regulation may differ, those differences must be acknowledged and managed whether it is done within one agency or by coordination of the activities of separate agencies.

I am mindful that the industry has been through a period of material changes. The creation of a single agency at this stage would involve further dislocation and transition costs and risk when there is a need for the regulators to get on with their tasks. The creation of APRA itself led to some disruption in the area of prudential regulation. While a merger of APRA and ASIC would probably involve lower

transitional costs than was the case with the creation of APRA, there would inevitably be costs and some dislocation.

In the end the question of whether corporate and prudential regulation should be undertaken by a single agency or the present two-agency approach is a matter of judgment. I do not see that the creation of a single regulator, through a merger of APRA and ASIC, would necessarily address the problems identified in the inquiry

and hence I do not recommend this course of action.

On this aspect the priority at this relatively early stage of the current regulatory regime must be to attain greater clarity as to the respective roles and responsibilities of APRA and ASIC in relation to general insurers.

The failure of HIH Insurance 203

8.4 The corporate regulator-ASIC

ASIC ts responsible for administration of the law relating to corporations and financial markets under, in particular, the Corporations Act 2001 and for certain consumer protection matters that concern financial service providers including insurers.

One of the duties imposed on directors under the Corporations Act is to ensure that a company does not trade while insolvent. It follows that the solvency of companies, including financial service providers, falls within the general purview of ASIC. ASIC is also specifically charged with the protection of consumers of financial products. On its face this responsibility may also extend to the solvency of those

entities. The most serious threat posed to a consumer of a financial service is the insolvency of the provider before it has discharged its obligations to the consumer. This is certainly the case with insurance.

As a practical matter, given that ASIC is responsible for over one million companies5, it could not be expected that it would give the same kind attention to the ongoing solvency of companies as might be expected of APRA which regulates around 4000 entities.6 ASIC is ultimately responsible for certain issues relating to the winding-up of companies, and in many cases this will be after interested parties have identified that an entity is in financial difficulties. ASIC is presently developing a programme of monitoring insolvent trading by companies. This represents a practical extension of its role in this area. However ASIC does not believe that it has a major role in respect of the financial stability of companies in general, or financial service providers, including insurers, in particular.

A question arises as to whether ASIC's consumer protection responsibilities give it an additional interest in the financial health of financial service providers. In its closing submission ASIC argued that:

204

Broadly, ASIC regulates the following conduct:

• unconscionable conduct;

• misleading and deceptive conduct;

• false or misleading representations;

• the manner in which certain financial services are offered;

• harassment or coercion;

• financial services disclosures; and

• the dispute resolution schemes and compensation obligations of financial services licensees. ·

There is nothing in either the ASIC Act or the Corporations Act which justifies the submission that ASIC's consumer protection jurisdiction extends to ensuring that "the claims of policyholders will be paid in the ordinary course of business." ASIC's consumer protection responsibilities

Regulation of general insurance

towards policyholders and payment of their claims anses only in connection with the matters listed above. 7

I can accept that ASIC should not be expected to give the same kind of attention to the financial viability of regulated financial institutions as is expected of APRA. To require otherwise would involve costly and inefficient duplication of prudential supervision. I am troubled, however, by the apparent suggestion that in relation to

insurers and other prudentially regulated companies, ASIC should stand back and leave the field of solvency to APRA.

ASIC does have responsibilities in regard to solvent trading by companies generally. In the light of this, and given its consumer protection role in the financial services sector, ASIC must accept some responsibility for, and be prepared to take some action in regard to, the solvency of insurers. The fact that an entity regulated under

the Corporations Act is also prudentially regulated does not mean that ASIC need not concern itself with the entity's financial health. ASIC should continue to administer the corporate Jaw and concern itself with the consumer protection aspect of insurance, including any issues which may arise in those contexts about an

insurer's solvency. To suggest otherwise would detract from the objective of subjecting insurers to additional regulatory attention by reason of the special risks associated with failure of an insurer.

Put in blunt terms, ASIC should administer the Corporations Act and APRA should administer the Insurance Act. ASIC should be required to do no more and no less than carry out its statutory responsibilities. APRA should do likewise. Where this may lead into areas which overlap it behoves both agencies to recognise that overlap and to take steps, including by effective communication between them, to ensure that the public interest is served.

8.4.1 Corporate surveillance

In Chapter 24 of the report it is noted that ASIC conducted a surveillance programme of the accounts of some listed companies. This programme had a limited focus and companies' accounts were selected for review at random. The accounts of FAI and HIH for June 1998 and December 1998 respectively were examined under the programme but no regulatory issues were uncovered in respect of either company. ASIC is now pursuing this programme in what appears to be a more expansive fashion than that which applied in 1998. I think it is worth making a brief comment on what I consider should be important elements of such a programme.

The balancing of cost and benefit is likely to dictate that an accounts surveillance programme be conducted in respect of a limited number of companies at any one time. While random selection of companies may serve some purpose, a more strategic method of selection is preferable. Selection of companies might be based

on specific accounting or other issues that come to ASIC ' s attention. I note that in July 2002 ASIC announced it was examining accounting abuses of the types uncovered in the United States in recent times, focusing on capitalised and deferred expenses, recognition of revenue and recognition of controlled entities and

The failure of HIH Insurance 205

assets. Criteria for selection can also usefully be based on particular industries; for example, ASIC pursued disclosure and accounting issues affecting the 'dot.com' and 'new economy' stocks in 1999 and 2000.

An accounts surveillance programme should monitor public information and commentary that is relevant to financial report presentation. In Chapter 24 I refer to the fact that media and market analysts were critical of the accounting treatment that HIH adopted in respect of the Allianz transaction. This is an example of an important accounting matter-accounting for goodwill-having been raised publicly. Publicity of this type might cause a surveillance programme to examine the accounts of the company concerned.

Where particular issues are detected in respect of a company the programme should trigger a more detailed investigation. This may require the company's accounts to be reviewed again in subsequent accounting periods.

Any concerns about solvency that arise from an examination of a company's accounts should result in close review. It follows from my views about the respective roles of ASIC and APRA that if a significant going concern or solvency issue arose in respect of the accounts of a prudentially regulated company, then ASIC should itself be prepared to pursue the matter. This should occur in consultation with APRA.

8.5 The prudential regulator-APRA

Under the Insurance Act APRA has important responsibilities for the protection of the interests of policyholders through the prudential regulation of general insurers. I deal in Chapter 24 with APRA 's performance in relation to HIH including its fa ilure to identify, as early as it should have, the emergence of problems which led to HIH's failure .

While shortcomings were evident in its handling of HIH, APRA should be given credit for its role in the development and introduction of the new prudential standards that came into effect on 1 July 2002 . Those standards caused a marked improvement in the previous system and they have generally been well received. I also acknowledge the constructive and open way in which APRA approached this inquiry and its preparedness to put forward views and to engage in dialogue on policy questions for the future. There are also welcome signs in APRA' s public statements of an intent to address outstanding issues in a more aggressive and questioning manner.

There are aspects of APRA that still need to be remedied if it is effectively to carry out its responsibilities in relation to general insurance. These matters go the governance of APRA, its organisation and resources and its approach to prudential regulation. In dealing with these matters I make it clear that, in accordance with the terms of reference, my inquiry has been limited to APRA' s role in relation to general insurance, The recommendations that I make may well have implications for

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APRA's role with life insurers, banks and other deposit takers and superannuation. But they are not based on any views of APRA's performance in relation to those sectors.

8.5.1 Governance

Under the Australian Prudential Regulation Authority Act 1998 APRA is overseen by a board of largely part-time non-executive members appointed by the Treasurer. The board is presently comprised of a number of people with expertise in the various industries regulated by APRA, although they do not formally represent the interests of those industries. Section 19 of the APRA Act requires that the board include a representative from ASIC and two from the Reserve Bank of Australia, one of whom must be either the governor or deputy governor of the RBA. The board ' s primary functions, as set out in s. 17, are to:

• determine APRA ' s policies (including goals, priorities, strategies and administrative policies)

• ensure that APRA performs its functions properly, efficiently and effectively

• ensure that APRA's operations are conducted having regard to its purpose as stated in s. 8 of the APRA Act.

Section 36 of the APRA Act states that the chief executive has the duties that the board determines. But the board does not appoint the chief executive; that is a matter for the Treasurer.

The APRA Act provides the board with the power to do anything that is necessary or convenient to be done for or in connection with the performance of its functions (s. 18). The board may also delegate some of its functions to a board member (including the chief executive) or member of the staff (s. 20).

APRA is subject to the Commonwealth Authorities and Companies Act 1997. In particular this Act places duties on board members of Commonwealth authorities to :

• exercise powers with the degree of care and diligence that a reasonable person would exercise in that position (s. 22(1)). A person will be taken to have met the requirement under s. 22( I) if in respect of business judgments he or she makes the judgment in good faith for a proper purpose; does not have a material interest in the subject matter of the judgment; informs himself or herself about the subject matter to the extent reasonably appropriate; and rationally believes the judgment is in the best interests of the Commonwealth authority (s. 22(2))

• act in good faith in the best interests of the relevant authority and for a proper purpose (s. 23)

• not improperly use their position to gain an advantage for himself or herself or another person or to cause detriment to the authority or to another person (s. 24)

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• not improperly use information obtained in undertaking their role to gain advantage for himself or herself or another person or to cause detriment to the authority or another person (s. 25).

These duties are comparable to those imposed on directors under the Corporations Act.

APRA's governance arrangements largely follow the recommendations of the Wallis report. I note, however, that the Wallis report recommended that APRA's chief executive be directly responsible for enforcement actions and not be required to act in those matters under board direction. The Wallis report also recommended that APRA's chief executive be a statutory officer appointed on the nomination of the Treasurer.

The board as constituted has the powers and responsibilities of a governance board rather than the advisory model that the Wallis report appears to have had in mind. Nevertheless, the appointment of the chief executive, which is one of the key responsibilities of a governing board, is not the responsibility of APRA's board. This places the board in a potentially invidious position.

In principle, governance arrangements should ensure that the allocation of responsibility for a function is clear and coincides with the accountability for the performance of that function. The relevant person or body should be set clear and appropriate objectives and be held responsible for meeting those objectives. In APRA's case there is some dissonance and lack of clarity.

The imposition of a governance board between the chief executive and the Treasurer has the potential to cloud the line of accountability, especially as it is the board and not the Treasurer that sets the duties of the chief executive.

The chief executive is answerable to the board-although it does not appoint him or her-as well as to the Treasurer. At the same time, the board carries responsibility for the performance of APRA but does not appoint the person who runs the organisation on its behalf.

While individuals of the kind who are appointed to APRA's board would no doubt be able to play a valuable advisory role-including acting as a commercial sounding board-there is a question as to the utility of non-executive board input into how a regulatory body such as APRA carries out its statutory role.

My preferred model would vest responsibility for the performance of APRA's functions in a small full-time executive comprising a chief executive and two or three commissioners appointed by the government. This model, akin to the way ASIC is governed, would provide more clarity in and definition of lines of accountability.

The model of a small full-time executive would allow some flexibility in working arrangements with scope for collegial decision making as well as some allocation of functional or sectoral responsibilities among commissioners.

208 Regulation of general insurance

There would no longer be a need for APRA to have a governing board. It would be desirable that APRA's chief executive should be given the power to create an advisory board or boards to provide advice on matters such as prudential standards and other policy or commercial advice.

I am aware of the review currently being conducted by John Uhrig of governance arrangements for Commonwealth statutory authorities and office holders. It will be necessary to consider my views on this subject in the light of the outcome of that rev1ew.

Recommendation 18

I recommend that the Australian Prudential Regulation Authority Act 1998 be amended to replace APRA's non-executive board with an executive group. This group would comprise the chief

executive officer and two or three executive commissioners and would carry the responsibility, and account to government, for the operation and performance of APRA.

Recommendation 19

I recommend that the Australian Prudential Regulation Authority Act 1998 be amended to provide the chief executive with the power to establish an advisory board.

RBA and ASIC representation The Wallis report recommended that 'the financial regulatory agencies should have substantial board cross-representation to encourage cooperation and foster a common perspective about the needs and dynamics of the financial system' .8

In the event, APRA has a representative of ASIC and two representatives of RBA on its board. There is no reciprocal representative of APRA on the other agencies.

While the aim of promoting cooperation and a broader perspective was laudable, the concept of the representation of agencies at board level was, I believe, misconceived. On the basis of this inquiry I have reservations too about its utility in practice. Requiring a person who is responsible for running one regulatory agency to become involved in the governance of another agency can only tend to cloud and

complicate his or her focus. In my view the APRA model also places the chief executive of APRA in a difficult position. Not only does the chief executive have to account to a board, as well as the Treasurer, but there is a co-agency executive assessing conduct.

There is also a risk that the participation of RBA and ASIC representatives on the APRA board may impede as much as improve coordination between the agencies at working level. There was some indication in the evidence I heard that staff may have assumed that necessary exchange of information would be occurring at board

level obviating the need for communication at a working level.

Effective coordination of activities and exchange of information between relevant agencies should be part of the operational responsibility of those who run the

The failure ofHIH Insurance 209

agencies. This should be developed through regular formal and informal mechanisms involving agency staff at various levels. At a broader level, a mechanism such as the Council of Financial Regulators, which has representation from the Treasury as well as the agencies, would seem to me to be a more appropriate forum for the strategic consideration of issues affecting the financial services sector.

Recommendation 20

I recommend that the direct involvement of representatives of the Australian Securities and Investments Commission and the Reserve Bank of Australia in the governance of the Australian

Prudential Regulation Authority be discontinued. This will require amendment of the Australian

Prudential Regulation Authority Act 1998.

8.5.2 Organisation

Early in its life APRA resolved to implement a fully integrated internal organisational structure. Under this approach each organisational unit within APRA has responsibilities for the supervision of banks, general insurers, life insurers and superannuation funds. As noted in the report commissioned by APRA from John Palmer:

Unlike most other integrated Regulators which have retained some degree of institutional specialisation in their supervisory activities, APRA decided to move to a fully integrated model. Divisions would be responsible for the supervision of all types of institutions. 9

In effect APRA took a strategic objective of the Wallis report- to locate responsibility for the prudential regulation of relevant industry sectors in the one body-and carried it a step further. In part this appears to have been informed by an expectation of a likely increase in the conglomeration of financial services providers. APRA's board was also looking to achieve, through sharp organisational change, the development of a new and more coherent culture in place of the differing cultures of the bodies and people subsumed into APRA.

The aim of APRA's integrated approach was to improve communication and interaction between its organisational units with different functional responsibilities. This approach could also have improved operational flexibility, efficiency and consistency of supervisory practices across organisational units as well as commonality in approach to industry sectors. APRA's objectives were laudable, as was the desire to achieve early cultural change. But in my view the approach adopted by APRA was overly ambitious. The APRA board underestimated the problems inherent in an integrated approach. It was a time of great organisational change and there was a loss of staff in the general insurance division. APRA committed itself to a course that required all of its organisational units to develop expertise, skills and knowledge spanning the deposit-taking, superannuation, life and general insurance sectors. I cannot imagine that the financial services industry generally would have a great number of people with knowledge and skills spanning

210 Regulation of general insurance

all of those sectors. For a regulator, the task of inculcating that breadth of knowledge and skills across its staff was formidable.

The implementation of an integrated approach also carries the risk of diverting management's attention away from emerging concerns and of confusing lines of accountability and responsibility. By trying to make each member of staff an expert in all fields, accountability of particular units and individuals for specific matters can be lessened.

Having said all this, I acknowledge that the way in which an agency is organised internally is very much a matter for those who are charged with the responsibility for running the body. APRA has announced or taken steps to modify its organisational structure in an effort to rectify the position. It may be that it needs to go further.

Recommendation 21

I recommend that the Australian Prudential Regulation Authority chief executive instigate, as a matter of urgency, a review of APRA's organisational structure. The object of the review should be

to achieve a workable and effective balance between accountability for and knowledge of particular

financial services on one hand and cross-sectoral functional skills and perspective on the other. In particular, the review should consider the creation of a specialist team to take primary responsibility for the supervision of general insurers.

The review should report to APRA's board with recommendations on APRA's appropriate internal

structure, given its responsibilities across the deposit-taking, insurance and superannuation sectors . The board should publicly respond to its recommendations.

8.5.3 Powers

The capability of a prudential supervisor depends in part on its legislative power to require disclosure of information and to investigate the affairs of regulated entities. It must also have power, where necessary, to direct the activities of supervised entities in pursuit of the supervisor's objective of protecting policyholders and

customers. The core principles of the International Association of Insurance Supervisors include a recommendation that the insurance supervisor should have 'adequate powers ... to perform its functions and exercise its powers' . 10

Broadly speaking, APRA has power under the Insurance Act:

• to grant and revoke authorisation to carry on insurance business

• to determine prudential standards that general insurers are required to meet (prudential standards are disallowable instruments)

• to require a general insurer to appoint an independent actuary to investigate the insurer's outstanding claims provisions

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• to direct an insurer to provide in its accounts a specified amount for the value of an asset or liability

• to require information from an insurer

• to direct an insurer not to dispose of assets

• to order an independent investigation into an insurer

• following the commencement of an independent investigation, to direct an insurer with regard to the disposal of assets, to prohibit it from issuing insurance policies, to make reinsurance arrangements, to increase (to the extent that the insurer is able) its paid up capital and to order changes to financial statements.

APRA submitted that its powers, while significantly improved since 1 July 2002 should be enhanced in these areas:

• enforcement, including a consistent penalty framework

• independence in decision making

• the definition of insurance business.

I deal with enforcement immediately below, the question of independence m Section 8.5.4 and the definition of insurance business in Section 8.8.4.

Beyond these three areas I consider that APRA's powers are adequate for the performance of its functions with respect to the prudential regulation of general msurers.

APRA has a review of its legislative powers under way with a view to improving consistency across the deposit taking, insurance and superannuation sectors. This process could lead to proposals for APRA' s powers to be grouped in the APRA Act rather than in the various pieces of industry specific legislation. I see this review as worthwhile, with a view to greater clarity as well as consistency.

8.5.4 Independence of APRA decisions

Decisions made by APRA under the Insurance Act may be subject to external scrutiny on several formal levels.

Some powers can only be exercised with the agreement of the Treasurer. While some of these powers may involve matters of broad public interest 11 , most are operational in nature and relate to aspects of APRA's prudential oversight of general insurers. 12

Decisions made under a number of APRA's present legislative powers are subject to review on the merits by the Administrative Appeals Tribunal. 13 Review on the merits is the process whereby a person or body other than the original decision maker reconsiders the facts, law and policy aspects of the original decision and determines what the correct and preferable decision is.

21 2 Regulation of general insurance

Decisions made by APRA under the Insurance Act are also subject to judicial review, for example by the Federal Court under the Administrative Decisions (Judicial Review) Act 1977. In contrast to merits review, judicial review involves a court reviewing a decision to determine whether the decision maker made a legal error, for example by not following required procedure or by misconstruing the scope of the power being exercised. Judicial review does not involve a reconsideration of the merits of a particular decision.

The Wallis report recommended that APRA be independent of executive government. 14 It considered that it would be impractical, inefficient and unnecessary for the Treasurer to retain a direct role in licensing and other decision making with respect to supervised institutions. In addition, the Wallis report suggested that decisions made by APRA on prudential grounds should not be subject to

administrative or other review. This recommendation was not embraced by government.

APRA submitted that prudential decisions affecting authorised entities should not be reviewable or require the Treasurer's agreement or approval. APRA accepted that decisions which it makes affecting individuals should continue to be subject to external review. In this context APRA's reference to review was a reference to

merits review.

Treas urer's agreement APRA is accountable to the Treasurer for the carrying out of its functions. APRA submitted however that:

we do not accept that this is most efficiently or effectively achieved by interposing the Treasurer into day-to-day supervisory decisions. 15

APRA went on to note that the interposition of the Treasurer may have been appropriate when the Insurance and Superannuation Commission was responsible for prudential supervision, as it was part of the Public Service 16 but it is not appropriate with the APRA model of a statutory authority with an independent

board. I think this observation has force regardless of the role of the board in APRA's governance. It is further strengthened when the Treasurer' s role in approving APRA decisions relevant to insurance supervision is contrasted with the lack of such a role in relation to banking supervision.

The Treasurer's written approval is required, for example, before APRA can revoke an authorisation to carry on insurance business in Australia. 17 On the other hand, APRA can revoke an authorisation to carry on banking business in Australia without seeking the Treasurer's approval. 18 There is no policy reason that I can discern for

the differentiation between banking and insurance in this regard. The Explanatory Memorandum for the Financial Sector Reform (Policy and Transitional Provisions) Bill 1998, which introduced the package of reforms implemented following the Wallis report, simply noted that the process of licensing approved deposit-taking

institutions (including banks) was to be streamlined. It noted that APRA was to be responsible for licensing and that the Treasurer would no longer have a role.

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It seems to me that the approval of the Treasurer should be required only in instances where there may be a significant public interest at stake. Prudential supervisory decisions may have a significant impact on insurers, some of which are important commercial entities in the context of the Australian economy. That is also the case with banks, but under the Banking Act prudential decisions are not subject to the Treasurer's approval. In any event, quite apart from the approval process, APRA is obliged to notify the Treasurer if it considers that any body regulated by it is in financial difficulty. 19

The purpose for which APRA was established is stated in s. 8 of the APRA Act as follows:

APRA is established for the purpose of regulating bodies in the financial sector in accordance with other laws of the Commonwealth that provide for prudential regulation or for retirement income standards, and for developing the policy to be applied in performing that regulatory role.

In providing this regulation and developing this policy, APRA is to balance the objectives of financial safety and efficiency, competition, contestability and competitive neutrality.

This suggests that APRA is to have primary responsibility for prudential regulation. The Commonwealth submission recognised that the financial sector regulators, including APRA, should be independent but accountable:

Accountability for the operational or day-to-day supervision of financial institutions and markets lies with the regulators. So as to effectively perform their role, the regulators are given substantial operational independence of Government in administering legislation and in dealinff with particular cases in prudential supervision or conduct and disclosure. 2

APRA carries out its responsibilities as a Commonwealth body and should be accountable for its performance through the Treasurer, being the minister with the relevant portfolio responsibility. Nevertheless, the interposition of the Treasurer in day-to-day prudential decisions about general insurers appears to me to be unnecessary. It also runs the risk of blurring the lines of accountability for those decisions.

The provisions requiring the Treasurer's approval of decisions should be reviewed having regard to the position which applies under the Banking Act 1959 and other relevant legislation governing APRA's supervisory responsibilities across the financial services sector. The review should balance the need for effective accountability by APRA through the Treasurer for the performance of its functions and the use of its resources against the general desirability of autonomy in its execution of operational powers.

214 Regulation of general insurance

Recommendation 22

I recommend that the Commonwealth Government consider removing the requirement for the Treasurer's agreement to operational decisions involving APRA's prudential oversight of general insurers.

Review on the merits

There is a stark difference in the availability of merits review under the Insurance Act and the Banking Act. No decisions under the Banking Act are reviewable in the AAT, although proposed amendments contained in the Financial Sector Legislation Amendment Bill (No. 2) 2002 would make some decisions reviewable. 21 APRA

submitted that prudential decisions under the Insurance Act relating to entities should not be subject to merits review. It argued that:

Particularly in instances where speed is of the essence, it is important that a recalcitrant institution is not able to use appeal mechanisms to frustrate the actions of the supervisor trying to protect the interests of

policyholders? 2

APRA derived support for this contention by reference to a report issued by the Administrative Review Council in July 1999. The Council recommended that financial decisions with a significant public interest element should not be subject to

merits review. 23 APRA contended that the availability of merits review for decisions under the Insurance Act may result in delay and frustrate the actions of the regulator in trying to protect the interests of policyholders. The ARC report sets out principles developed by the ARC in advising the Attorney-General on the classes of decisions that should be subject to merits review. The report identified financial decisions with a significant public interest element as being of a class which might properly

be exempted from merits review. It describes these as typically involving the evaluation of complex and competing facts and policies going beyond mere fact finding following consultation with expert bodies or participants and which would be expected to have a significant impact on the market and on national and

international investor confidence. It observed that they will also involve a high level of political accountability.

The ARC noted that excluding decisions from merits review on this basis is rare and that, even where it may be appropriate, it favoured giving a relevant minister the discretion to issue a certificate on a case-by-case basis to exclude merits review of particular decisions rather than excluding them generally. The report gave as an example of a class of decision properly exempted on this basis the power to approve a body corporate as a stock exchange. It does not appear to me that the classes of decision about which APRA is concerned fall within this exception.

The most likely example of the risk that merits review could frustrate supervisory action by APRA is where an insurer seeks review by the AA T of a decision under s. 62 of the Insurance Act. Section 62 empowers APRA to make directions, such as that an insurer is not to issue or renew policies in a certain class or at all, where it

Th e failure of HIH Insurance 215

appears to APRA that an insurer is or is about to become unable to meet its liabilities. If the insurer were to obtain from the AA T a stay of a decision to impose directions it could continue to issue policies. This might lead to greater losses for the company and less likelihood that it would be able to meet all its obligations to policyholders if it were to become insolvent. A stay application in these circumstances would present difficulties. But I expect that the balance of convenience would tend against a stay being granted if the AA T were to be satisfied that the insurer's financial position was so precarious that it represented an unacceptable risk for future policyholders.

I note that for listed companies both the making of a direction under s. 62 and the granting of a stay would almost certainly require disclosure under the Australian Stock Exchange Listing Rules. The position would be the same for unlisted insurers if APRA put in place enhanced disclosure requirements as proposed in this report. Disclosure of these matters would also operate to minimise the risk to future policyholders.

APRA also contended that the possibility of external review may produce excessive caution on the part of supervisory staff to take prompt and decisive action for fear that a decision may be overturned by a reviewing body. This argument is not persuasive and does not justify the removal of external review. The prospect of such review should not discourage APRA from making soundly based regulatory

interventions. Rather, it should promote better decision making.

The public importance which may attach to APRA's decisions and their potential impact on a diverse range of interests suggest that merits review should continue to be available. On the other hand, the complexity which may be involved in the underlying issues does raise the question whether review by a generalist tribunal such as the AAT is appropriate, particularly when judicial review is avai lable. Of course judicial review does not involve review of the merits of a decision. The ARC has taken the view that the mere fact that a decision maker is an expert or the decision involves specialised expertise is not a sufficient basis to exclude merits review. The ARC report points out that, if necessary, experts may be appointed to the tribunal.

There is little evidence that the availability of merits review has been utilised by insurers to frustrate regulatory action by APRA or its predecessor. Review on the merits is a fundamental feature of the system of administrative law at the Commonwealth level. Exemptions from such review should not be granted lightly and certainly not in the absence of clear reasons for doing so.

In support of its submission, APRA noted that Principle 1 of the Insurance Core Principles of the International Association of Insurance Supervisors states that a prudential supervisor needs to be 'operationally independent and accountable in the exercising of its functions and powers.' I do not see external review as being inconsistent with that principle. Merits review and judicial review are both important elements of administrative law and apply broadly across the entire

216 Regulation of general insurance

spectrum of Commonwealth decision making. A fundamental purpose of both is to ensure and promote better decision making.

Accordingly, I do not recommend that there be any general move away from merits review of decisions under the Insurance Act. However, I am troubled by the apparent inconsistency between the Insurance Act and the Banking Act in this regard particularly as to the availability of review of prudential decisions concerning entities. As with the question of ministerial approval of decisions, I can discern no clear policy basis for this differentiation.

There is need for review. This review should have regard to the position which applies under the Banking Act and other relevant legislation governing APRA 's supervisory responsibilities across the financial services sector. This recommendation should not be taken as an indication that I favour the removal of

merits review from the Insurance Act.

Recommendation 23

I recommend that, given the inconsistencies between the Insurance Act 1973 and the Banking Act 1959, the Commonwealth Government review the current legislative provisions for merit review of

APRA's decisions for the purposes of ensuring consistency.

8.5.5 APRA's skills, expertise and resources

Specialist expertise A prudential regulator needs a blend of technical, industry and supervisory skills and experience among its staff at all levels. It also needs among its staff a good measure of commercial knowledge and understanding. Some of these skills are highly specialised and require significant investment in terms of formal qualification, on-the-job training and exposure to experience. Remuneration and career structures need to be attractive. It is inherently difficult for a public sector regulator to compete with relevant parts of the private sector and in some respects this is even more the case with financial services. The challenge for a body such as APRA is to develop appropriate strategies for the recruitment and development of quality staff. It needs to be seen as a professional and effective organisation performing a valuable role and being able to provide experience that is satisfying

and that will enhance career prospects.

Lack of relevant general insurance expertise in APRA was a factor in its failure adequately to supervise HIH. As outlined in Chapter 24, APRA staff- especially those in middle and upper levels-failed fully to appreciate risk factors and signs of distress in HIH. Particular problems arose in the assessment of risks relating to technical factors- such as provisioning for claims and in the treatment and value of particular reinsurance arrangements. These problems require the application of

specialist expertise and experience.

The failure of HIH Insurance 217

A consistent theme in submissions was that APRA has insufficient specialist expertise for the supervision of general insurance. This may in part be a result of APRA ' s loss of staff with general insurance supervisory experience at the time of the move to Sydney.

Effective prudential supervision demands technical skills such as a knowledge and understanding of accounting processes, relevant legislation and so on; an ability to analyse and interpret financial information; effective interpersonal skills; and a high level of judgment and experience in assessing risks and dealing with regulated businesses.

It is not easy to find these skills to the level required in a single individual. APRA needs to take special care to develop skills in its front-line supervisory staff. Skill can be nurtured through mentoring and other means, as well as a real and demonstrated appreciation of the importance of compliance techniques by middle and upper management. Staff with an interest in prudential supervision are more likely to be attracted to APRA if they see that relevant roles are rewarded and valued by senior management.

In terms of its culture, my impression is that APRA, at least in its early years, did not place enough emphasis on its front-line prudential supervisory role and on the need to develop the skills of its staff for that purpose. This objective appears to have been given a lower priority than the establishment of the new organisation and policy work to enhance the legislation and related prudential controls. It is important that APRA, in moving ahead, works to ensure that supervisory and enforcement roles are rewarded and encouraged as well as policy and other roles.

APRA's efforts to develop a staff complement with the necessary qualities and experience to perform its functions effectively will demand development of existing staff, hiring individuals with experience in the general insurance industry and others with regulatory skills and experience.

Remuneration An obvious factor in attracting and retammg appropriately skilled staff is the competitiveness of remuneration and employment conditions. When created, APRA engaged consultants to assist in the development of new remuneration arrangements. The consultants recommended that APRA base its overall remuneration target at levels equating with the 25th percentile of the general business marketplace. This recommendation was based on the standards of the public service more broadly and also reflected the fact that working in APRA included non-remuneration based benefits, such as stability of employment, job security and career path .Z

4

By way of

comparison I understand that Canada's prudential regulator has adopted a target average remuneration at the 75th percentile of the financial sector labour market.

The 25th percentile of the general business market is not sufficient to attract the calibre of staff needed to work in a demanding supervisory role. APRA's supervisory staff deal on a day-by-day basis with staff of regulated financial institutions who; in all probability, receive significantly greater remuneration in

218 Regulation of general insurance

roles that require similar levels of expertise and experience. There is a question also whether the supposed benefits of security of employment in the public sector are as significant as they once were. The public sector has moved towards private sector like performance assessment and dismissal procedures for underperformance. The 25th percentile for the general Australian business marketplace is also likely to underestimate the salary differentials in a market like Sydney where APRA' s central office is based. APRA will need to look at more competitive remuneration arrangements if it is to attract and retain good staff, operating as it does in the Sydney market and close to financial services firms that are potential competitors for quality and qualified employees.

Recommendation 24

I recommend that the Australian Prudential Regulation Authority implement a programme to build the skills of staff involved in the supervision of general insurers. This should involve a review of its human resource management policies to assess APRA's competitiveness in the financial services sector labour market. The review should take account of the adequacy of remuneration, training and career structures as well as other steps to increase APRA's attractiveness as an employer.

The possible need for remuneration increases in some areas of APRA raises the issue of the appropriate resourcing for APRA. The Commission has not reviewed the resourcing of APRA in any depth and cannot therefore comment directly on the appropriate size of APRA' s budget.

I note that APRA has significant flexibility within its overall budget to meet priorities as it sees fit. APRA should take full advantage of this flexibility in order to meet the cost of providing more competitive remuneration to attract and retain employees with the necessary skills and experience. Should APRA be unable to

meet this cost from within its existing budget, the question of additional funding would need to be raised urgently.

Budget setting processes APRA's budget is determined through the Commonwealth budget process and involves an annual review of APRA's resource requirements. The present approach involves an annual round of consultations and negotiations between APRA, Treasury and the Department of Finance and Administration to establish APRA' s annual budget allocation. The government then liaises with representatives from the banking, insurance and superannuation industries in setting the appropriate levy

rates to raise the cost of funding APRA. This process involves a large commitment of time and effort by staff of APRA and the departments to set the budget for an agency which, when fully established and operating normally, should function on a relatively consistent funding level from year to year.

Consideration should be given to alternative approaches which may be simpler and less resource intensive. A rolling three-year funding arrangement would serve the purpose.

Th e failure ofHIH Insuran ce 219

Recommendation 25

I recommend that the Commonwealth Government adopt a three-year rolling funding arrangement to set the Australian Prudential Regulation Authority's budget.

8.5.6 APRA's approach to prudential supervi sion

The consultative approach

As far as I can gather, APRA's general approach to the prudential supervision of general insurers has largely been what might be characterised as a consultative one. This appears to be a continuation of the approach of the former ISC. The underlying notion is that a company that is facing financial problems should be given the opportunity to be 'nursed back to health'. That is no bad thing in itself. This approach was highlighted in the Palmer report. Palmer quoted an internal APRA memorandum:

Our objective should be to get the institution/group to upgrade its practices and standards so that our preconditions are met. This would most likely involve a very regular visit/liaison program. We might also consider the need to conduct a full scope visit, where it may be possible to leverage off the model that is developed by Specialised Institutions Division for that type of institution. As a last resort, enforcement action may be required. 25

[emphasis added]

There is a danger however that over reliance on consultation and encouragement by a regulator and a lack of commitment to demand compliance with prescribed standards will impair overall effectiveness. A perception of weakness on the part of a regulator in itself will likely weaken their influence and diminish the regard paid to the standards by regulated bodies.

Another aspect of the consultative approach to prudential regulation of insurers is that it is generally carried out discreetly so as not to give rise to concern in the market. There is the potential that market awareness of regulatory intervention will exacerbate the problems being experienced by the company in question. The analogy of a 'run' on a bank is oft quoted. On this basis, discretion by a prudential regulator in the way it intervenes with a company so as to minimise the risk of premature market upset is to be commended. But there is also a risk that any delay

in taking necessary action while a company is given an opportunity to address its problems may lead to greater losses for policyholders and other creditors. It may be the case that earlier and more rigorous intervention by the regulator to wind up the institution would have resulted in lower losses for policyholders.

In any event, the scope for the discreet approach traditionally favoured by some prudential r:egulators has become somewhat constrained by the large emphasis now placed on disclosure in corporate regulation. For public listed companies, continuous disclosure of material developments to the market has become a comer

stone of public policy. APRA will need to be very careful that, in any non-public

220 Regulation of general insurance

intervention with a company under financial pressure, it does not become implicated in any failure by the company to keep the market appropriately informed.

This issue ultimately is one of judgment on the part of the prudential regulator. In many instances this judgment will be finely balanced. In the case of HIH, as I have canvassed in Chapter 24, APRA did not effectively deal with this question until very late.

There have been signs that APRA is moving to take a more forceful approach with greater preparedness to resort to enforcement in appropriate cases. This should be encouraged. APRA should also be willing to use its formal investigatory powers to underpin its inquiries.

Recommendation 26

I recommend that the Australian Prudential Regulation Authority develop a more sceptical, questioning and, where necessary , aggressive approach to its prudential supervision of general insurers. Consultation , inquiry and constructive dialogue should be balanced by firmness in its requirements and a preparedness to enforce compliance with applicable standards. In particular, APRA should take a firm approach to ensuring regulated entities' timely compliance in the lodging of returns and the provision of information .

Guidelines for intervention While intervention in the affairs of a regulated entity generally involves questions of judgment, consistency would require that APRA should have formal internal guidelines in this area. APRA does have such guidelines.

They should allow a sufficient degree of flexibility for APRA to address the concerns that arise in different situations. A 'one size fits all' approach is not likely to be effective in dealing with issues of prudential supervision.

Recommendation 27

I recommend that the Australian Prudential Regulation Authority continue to develop and review processes, guidelines and training to assist its staff in considering the appropriate approach to take towards supervised entities in different situations.

Prudential supervision systems Another element of effective prudential supervision is the systems that are put in place to identify, monitor and respond to emerging concerns. In supervising HIH, APRA ignored or downplayed signs that suggested HIH was under financial stress. This was at least partly due to a lack of a systematic approach to supervision and

risk-rating processes. Without rigorous systems and a sceptical approach, regulatory staff may be reluctant to change their views about the financial position of a company, notwithstanding information suggesting that the position may be otherwise.

The failure of HIH Insurance 221

APRA has taken steps to develop a new risk-rating framework called the probability and impact rating system. In addition, APRA is developing a supervisory oversight and response system which is designed to bring high-risk or high-impact entities to the earlier attention of senior management; ensure appropriate supervisory strategies are implemented in a timely manner, and provide mechanisms for tracking compliance (or otherwise) with those supervisory strategies.

While I have not reviewed the efficacy of these systems, APRA should continue to improve its processes for identifYing and recording emerging information related to authorised entities and continue to improve and test-risk rating processes. As far as possible APRA should ensure that each significant new piece of information concerning a regulated entity is recorded and used in updating its view on the financial viability of the entity concerned.

Recommendation 28

I recommend that the Australian Prudential Regulation Authority develop systems to encourage its staff and management continually to question their assumptions, views and conclusions about the financial viability of supervised entities, particularly on the receipt of new information about an

entity.

Market intelligence

APRA should also ensure that its systems do not rely solely on the information disclosed to it in the financial returns from insurers. APRA should make intelligent use of other sources of information. These other sources may include market intelligence, financial reports and other filings with ASIC or the ASX, press reports, on-site visits and information that comes to hand from whistleblowers.

Recommendation 29

I recommend that the Australian Prudential Regulation Authority develop an internal system for tracking all relevant information concerning regulated entities.

The Palmer report recommended that there should be a reasonable degree of APRA senior management involvement in important supervisory and institution-specific decisions. Decisions relating to prudential supervision involve judgment and expertise. In some cases they will call for greater experience as well as the acceptance of responsibility at a higher level. APRA should develop guidelines for the involvement of senior management in such decisions. Involvement of this kind should be based on both the importance and the risk relating to specific cases, with flexibility allowing judgment to be applied. Such processes should also call for some review by senior staff, perhaps on a random basis, of companies that are categorised as low-risk in order to confirm that APRA's risk-rating methodologies are sound.

222 Regulation of g eneral insurance

Supervision of reinsurance arrangements Reinsurance is an important area of the operations of a general insurer. Reinsurance pools risk amongst reinsuring companies and spreads the costs of catastrophes. It also effectively involves gaining access to off-balance sheet capital-insurers can write more business without increasing their level of capital while still maintaining a financially prudent operation.

The importance of reinsurance has been recognised since the introduction of the Insurance Act in 1973. From then until the introduction of the most recent reforms, APRA and its predecessors were required to approve all reinsurance arrangements proposed by authorised general insurers. The recent reforms to the Insurance Act saw a significant change in the way reinsurance arrangements are to be supervised by APRA. As noted in APRA's submission:

The shift in the style of prudential supervision implied by the new supervisory regime introduced in July 2002 is probably most obvious in the area of reinsurance. APRA is shifting its supervision from a transaction-focussed, return-based regime to a regime which emphasises that the primary responsibility for establishing and managing reinsurance arrangements rests with the insurer's Board of Directors. APRA's energies

will be more productively deployed reviewing the reinsurance strategies adopted by insurers, and building its capacity to undertake more intensive analysis and inquiry, including of individual transactions, when complex issues and concerns arise. 26

The prudential standards now require that authorised insurers must establish processes for regularly reviewing the insurer's compliance with its reinsurance management strategy.

This approach aims to make the most efficient use of APRA's resources by selectively targeting areas of concern. Its effectiveness however relies on the ability to identify and fully investigate areas of concern. In many instances this may be relatively straightforward, particularly where matters may affect the whole industry.

It may be more difficult for APRA to identify and respond in instances where particular companies do not have adequate reinsurance cover or misrepresent the reinsurance cover that they do have.

An approach requiring APRA to assess and approve all reinsurance arrangements is unlikely to be cost effective and should not be pursued. But greater efforts should be made to monitor this aspect of insurance operations. This could, for example, include APRA undertaking random or targeted investigations of an insurer's reinsurance arrangements to ensure that they are consistent with the requirements of the prudential regime. This process could be combined with regular on-site visits.

In a process like this APRA should inquire about, and closely supervise, financial reinsurance (also called finite reinsurance or alternative risk transfer). That should extend to investigating whether reinsurers have accounted for the impact of such contracts in accordance with the prudential and accounting standards and ensuring that any related agreements have been considered by the actuary valuing the

The failure of H!H1nsurance 223

affected cash flows. APRA should consider the use of its investigative powers to require the production of documents and the examination of certain persons and to carry out 'spot checks' of both insurers and reinsurers. For example, APRA should also carry out 'spot checks' of insurers' financial statements for large increases in reinsurance recoveries relative to reinsurance expenses involving financial reinsurance contracts. Where anomalies occur, this should prompt APRA to make more specific inquiries.

Action of this kind by APRA would not relieve an insurer's board of the primary responsibility for the management of that insurer's reinsurance programme.

Recommendation 30

I recommend that the Australian Prudential Regulation Authority develop mechanisms for investigating the reinsurance arrangements of authorised general insurers on a random but

frequent basis .

8.5.7 Cooperation with ASIC

In relation to prudentially regulated companies, the roles of APRA and ASIC are complementary; they are not mutually exclusive. Their interests and activities will at times overlap. Sensible coordination of relevant activities and exchange of information of possible interest to the other should not be discretionary. It should be

built into their respective operating procedures as an imperative.

The commitment by both APRA and ASIC to cooperation and full and open exchange of information needs to be reinforced. Communications and exchanges should be undertaken in a systematic way (through both formal and informal means) and based on clear protocols. This may call for attention in the context of the Council of Financial Regulators. To facilitate the exchange of information, the government should make a regulation specifying ASIC for the purposes of s. 56(5)(a). It is noted that s. 127 of the Australian Securities and Investment Commission Act 2001 enables ASIC to provide information to APRA.

APRA and ASIC should also explore ways to inculcate effective working relations. Initiatives might include such things as joint representation on site visits and staff exchange programmes.

224 Regulation of general insurance

Recommendation 31

I recommend that the effectiveness of the current memorandum of understanding between the Australian Prudential Regulation Authority and the Australian Securities and Investments Commission be reviewed .

The processes for liaison, coordination and exchange of information between APRA and ASIC

should be reviewed on a regular basis. To facilitate the exchange of information, the

Commonwealth Government should make a regulation specifying ASIC for the purposes of

s. 56(5)(a) the Australian Prudential Regulation Authority Act 1998.

8.5.8 APRA as lead regulator

The Insurance Council of Australia referred in its submissions to the need for more effective coordination of regulatory issues that affect the general insurance sector. It proposed that APRA should take the role of a 'lead regulator' to assist in coordination and provide a first point of contact for the industry.

In similar vein, the Senate Select Committee on Superannuation and Financial Services recommended that:

An Office of Regulatory and Consumer Affairs be established within APRA to act as a first point of call for consumers and others unsure of which regulator to approach regarding a particular issue. 27

The concerns reflected by these proposals are understandable given the number of agencies whose responsibilities and activities affect general insurance. I am sympathetic to the ICA's proposal. Given that APRA does not have responsibilities in relation to other relevant Commonwealth agencies I do not see it as being open to APRA unilaterally to assume a lead role of the kind suggested. This is a matter that

should be considered by the Council of Financial Regulators as far as coordination of Commonwealth agencies in their relations with the general insurance sector is concerned. There should be a forum and a clear point of contact- whether the Treasury or a nominated regulator- to facilitate the airing and discussion of issues that cut across the industry and regulatory responsibilities.

As discussed in Chapter 9 there is also the need for coordination between Commonwealth and state and territory bodies in relation to the regulation of general insurance. I propose a ministerial council to undertake this role.

Recommendation 32

I recommend that matters relating to the coordination of Commonwealth regulation affecting the insurance industry be the province of the Commonwealth Treasury.

Recommendation 33

I recommend that coordination of the matters related to the regulation of the insurance industry be addressed through the proposed ministerial council.

The failure of HIH Insurance 225

8.6 Disclosure of insurers' returns of information

The public disclosure of pertinent information by a company is an important way of improving market responsiveness and of encouraging accountable corporate behaviour. In prudentially regulated industries such disclosure can be useful to the prudential supervisor. While greater transparency by itself would not prevent corporate collapses, it would impose a degree of market discipline on directors and executives in regard to corporate performance and the way in which they conduct themselves.

A number of submissions noted that, generally speaking, general insurers in Australia were not subject to the same disclosure requirements that operate in foreign markets, particularly in the United States and the United Kingdom?8 There is a range of information about the performance and operations of general insurers that should be considered for release to the market.

General insurers who are listed on the Australian Stock Exchange are already subject to the ASX's continuous disclosure regime. This requires a company to release any information that may materially affect its share price subject to certain exceptions relating to commercially sensitive and other confidential information. Listed companies are also required to publish periodic reports containing various financial and non-financial information. General insurers are also required to make industry-specific disclosures in financial statements in accordance with clause 11 of Australian Accounting Standard AASB 1023 'Financial reporting of general insurance activities' .

There is however a significant amount of financial and non-financial information prepared by general insurers and available to APRA that is not released to the public. This includes information of a financial, statistical and qualitative nature in statutory reports prepared under the requirements of the Insurance Act as well as

information relating to risk management, reinsurance strategies, actuarial reports and so on.

In the past, APRA published statistical and financial information relating to insurance companies on an aggregate basis. It released limited information on a company-by-company basis. This has generally been -high-level data available from profit and loss and balance sheet statements of insurance companies. As at 31 March 2003, statistics about individual authorised insurers available from the APRA website contain no information for periods after December 2001.

Some submissions sought, for reasons of commercial confidentiality, to limit the amount of information provided to APRA that might be released to the public. Others supported greater disclosure. Swiss Re for example said:

226

In a number of jurisdictions including the United States and the United Kingdom, insurers are required to publish information on past claims payments that is sufficient to all ow 'outsiders' to broadly assess the quality of reserves. This has long been resisted by the industry in Australia which views data as a way of supplying information of a competitive nature.

Regulation of general insurance

Whilst understanding the competitive issues, Swiss Re believes the mandatory publication of information would benefit the longer-term interests of the industry and the wider community. 29

The position in Australia until now has been that much of the information that has been provided to the prudential supervisor has been treated on a confidential basis and has been subject to secrecy provisions. Given the increasing reliance on disclosure as a market mechanism and the disclosure of similar information in the United States and the United Kingdom, the current position is no longer appropriate.

As has been noted, one of the major justifications for the prudential regulation of general insurers is that policyholders may have difficulty in making reasonably accurate assessments of the risk that an insurer will become insolvent at some point in the future and will therefore be unable to meet the potential cost of a future claim. Part of the difficulty that consumers have encountered in making a reasonable judgment of the likely future financial viability of a general insurer is in gaining

access to relevant information. Greater disclosure would help to overcome this problem. In particular it would provide better information for analysts, ratings agencies, the media and others whose reports help to inform investors, consumers and others.

Another advantage of requiring general insurers to disclose more information is that it would make the work of the prudential regulator more visible and contestable. Informed market commentators and analysts could provide an alternative view to that of the regulator.

Greater visibility and contestability of information in this area may also act to encourage the regulator to reconsider relevant issues that it might otherwise have dismissed as unimportant. Strict secrecy requirements such as are currently found in s. 56 of the APRA Act can protect the regulator from having outsiders (even state or other Commonwealth authorities) challenge its performance as much as they protect the commercial considerations of business.

Moreover, more comprehensive information about general insurers will provide the industry itself as well as regulators and others with an interest with a better understanding of the Australian insurance market.

Recommendation 34

I recommend that authorised insurers be required to make greater disclosure of information about their financial position. In particular, all financial and statistical information general insurers currently provide to the Australian Prudential Regulation Authority in their regular returns should be made public.

The argument is put forward by some that the information provided to APRA includes commercially sensitive information which should remain confidential. It is not clear in what respects this is the case. If all insurers were placed on an equal footing and required to disclose the same information competitive sensitivities

The failure of HIH Insurance 227

would be lessened. Further, concerns may abate as the market becomes more accustomed to greater disclosure.

Important areas for greater disclosure Two types of information are particularly important in assessing the financial condition of an insurance company. These relate to the accuracy of an insurer's outstanding claims provisions and its reinsurance arrangements. Inaccurate estimation and reporting of these matters played a major role in the failure of HIH. Measures to improve their accuracy should therefore be encouraged.

Swiss Re discussed both of these issues in its submission:

Swiss Re believes that a lack of transparency destroys shareholder value because the market will discount what it does not understand. For insurance companies, there are two key areas on non-transparency:

• Reserving-the setting of reserves for future claims is subjective and this will always be the case. Changes in assumptions can have a large impact on a company's reported position and generally it is very hard to tell whether a company is appropriately reserved--either under or over; and,

• reinsurance-the reinsurance programmes of many companies have evolved over a number of years. It is common for insurance companies to have series of reinsurance contracts, each of which is split between many reinsurers of varying credit quality. Understanding the true financial position of an insurance company is difficult because the overall effect is, at best, opaque. 30

Swiss Re recommended that insurers should be required to publish information on past claims payments that is sufficient to allow outsiders to assess the quality of reserves. Swiss Re also recommended that insurers should be required to publish a reinsurance resume including broad details of key programmes together with limits and terms of coverage and the names of reinsurers.

In regard to outstanding claims provisions, Dr Zehnwirth suggested that APRA should adopt the US model of collating what is referred to as 'schedule P' loss development data (triangulations) and other relevant data on a yearly basis for each line of business for each company.

31

..

228 Regulation of general insurance

Recommendation 35

I recommend that information that enables external users to make an informed assessment of an insurer's outstanding claims provisions and reinsurance arrangements be published by the insurer

or the Australian · Prudential Regulation Authority. APRA should develop reporting returns for

insurers that would enable this to occur if existing returns are insufficient.

In particular, general insurers should publish:

• material equivalent to the 'schedule P' loss-development data published in the United States

• a summary of the approved actuary's valuation of the outstanding claims liabilities, including the methodologies and assumptions underlying that valuation.

In Chapter 7 I have recommended that AASB 1 023 be modified to require that general insurers include in their financial reports claims development tables over an extended period. These tables had been required under AASB 1023 until 1996. Public disclosure of the information in these tables and the information in my previous recommendation should assist the market in assessing the accuracy and reliability of a general insurer's historical and current provisions for its outstanding claims. The recommendation that the methodology and assumptions of the approved actuary be disclosed only in summary form should enable the general insurer to maintain the confidentiality of its provisions for individual claims or groups of claims. But it would enable analysts and users of financial statements generally to have a better understanding of the basis upon which the valuation was made, and therefore assess its reliability.

Another important element of general insurance business is the management of risk. As part of the new prudential standards, insurers are required to prepare various risk management reports, primarily for the benefit of the board of the insurer. These are designed to help the insurer monitor, control and put in place strategies to address the various risks that the insurer faces. These reports would provide useful additional information on the quality of the management of the company.

From time to time the board or management of a company may commission other research or advice from actuaries, auditors or other experts for internal management purposes. Requiring qualitative information of this nature to be released to the market may act to discourage the provision of honest and forthright advice or

discourage companies from commissioning such work and hence impede management effectiveness.

Recommendation 36

I recommend that insurers be required to make greater disclosure of qualitative information relating to their risk- and reinsurance-management strategies. Other qualitative information-where the

prospect of disclosure may affect the quality of information provided to companies-need not be disclosed .

The failure ofHIH Insurance 229

Disclosure of APRA 's enforcement actions There is a question whether regulatory action taken by APRA in relation to a supervised insurer should be disclosed. Such action may be an indicator of possible financial difficulties which threaten the interests of policyholders and others with an interest in the financial strength of the insurer.

A related question is whether the obligations for listed companies to disclose material information under the ASX Listing Rules requires the disclosure of regulatory action by APRA. Under the Insurance Act, APRA may take a number of actions in the course of prudentially supervising a general insurer. These include requesting information, serving notice of intention to appoint an inspector, appointing an inspector, directing that a general insurer take specified action and revoking a general insurer's authorisation to conduct its business.

Where regulatory action by APRA would cause a reasonable person to expect that the action would have a material affect on the price or value of the insurance companies securities, this will trigger the continuous disclosure requirement of ASX Listing Rule 3.1. Under these circumstances the company would have to inform ASX (and thereby the market) immediately unless the exceptions to rule 3.1 apply. These are that a reasonable person would not expect the information to be disclosed (3 .1 A.l ); and that the information is confidential and ASX has not formed the view that the information has ceased to be confidential (3.1A.2); and that one or more other conditions apply as described in rule 3.1A.3, namely that it would be a breach of the law to disclose the information or the information concerns an incomplete proposal or negotiation, or comprises matters of supposition, or is generated for

internal management, or is a trade secret.

One example of regulatory action by APRA that almost certainly would be considered material for the purposes of invoking Listing Rule 3.1 would be if an inspector were appointed by APRA under s. 52 of the Insurance Act or APRA had initiated an investigation. I do not believe that any of the exceptions in rule 3.1A would apply in this situation. The environment in which listed companies now operate favours disclosure as the rule rather than the exception and this is reflected in the structure of the Listing Rules. I do not believe a reasonable person would expect that material regulatory action taken by APRA should not be the subject of immediate disclosure and so the exception in rule 3.1A.l would not arise.

I also do not see that such steps by APRA are inherently confidential. Non­ disclosure on this basis should only occur if the ASX has formed the view that the information remains confidential as contemplated by rule 3.1A.2. Further, the fact of supervisory action taken by APRA cannot be a matter of supposition and does not

involve material generated for internal management in terms of rule 3.1A.3. No trade secret is involved. '

In my view rule 3.1 would also be activated if APRA served a notice under s. 52 to show cause why an inspector should not be appointed or an investigation commenced. I say this because the service of a notice under s. 52 is a material

230 Regulation of general insurance

regulatory step based on criteria which include that it appears to APRA that the insurer 'is, or is likely to become, unable to meet its liabilities'. In most if not all cases, I consider that the service of such a notice on an insurer would require it to notifY ASX under rule 3.1 and that no exception under rule 3.1A would apply.

It might be argued that it is in the best interests of policyholders for an insurer not to disclose APRA's supervisory actions. This argument is based on the view that disclosure of the fact that a prudential regulator is concerned about the financial health of an insurer might, by alarming policyholders and others, deepen or increase the company's financial difficulties. This argument may have some merit in the case of a bank, where a 'run' may involve broader systemic risks, but it has less relevance for an insurer. Moreover given that the case for the prudential regulation of general insurers is based on the difficulty policyholders have in assessing the financial position of an insurer, it is difficult to sustain an argument that disclosure of the fact of significant regulatory intervention may itself harm policyholders. In any event, as I explained earlier, a decision to serve a notice under s. 52 can only be

made on the basis of significant circumstances which will themselves require disclosure.

Greater disclosure of APRA's significant supervisory actions would help to create a more informed and efficient market. It would also place a greater discipline on insurers to implement financially sound practices so as to avoid the risk of regulatory intervention with consequential adverse publicity.

I consider that listed general insurers would have an obligation under ASX Listing Rule 3.1 to inform the market of any material regulatory action by APRA. Materiality in this regard would include APRA's appointment of an investigator, and in most cases the service of a notice under s. 52, as well as the issuing of directions or the revocation of a licence. On the other hand, actions by APRA such as a request for information, or a more casual inquiry, would not likely meet the

requirement for disclosure under Listing Rule 3.1.

The ASX Listing Rules do not, of course, apply to non-listed entities. While the Listing Rules are designed for the benefit of investors, the rules as to continuous disclosure also benefit the long-term interests of policyholders and other creditors. There is no reason why such benefits should not also be extended to the policyholders and creditors of non-listed insurers. This could be achieved either by APRA announcing its own material regulatory interventions or by requiring disclosure by non-listed companies as part of the prudential regulatory system.

Thus, whether a licensed insurer is subject to the ASX Listing Rule or not, there should be disclosure of material regulatory action by APRA. It may be that APRA should consider what particular action under the Insurance Act should require disclosure either by itself or by the insurer concerned.

The failure of HIH Insurance 231

Recommendation 37

I recommend that the Australian Prudential Regulation Authority identify and make known the kinds of regulatory activities that in its view should be disclosed publicly (whether or not the insurer

in question is a listed company) and should specify the process by which such disclosure should

occur.

It might be suggested that a risk of requiring such disclosure is that APRA may be less likely to take necessary steps to supervise an entity. APRA might seek to avoid the further pressure on the company that publicity may cause. Where material regulatory intervention is called for such concerns should not deter necessary action. The fact that such intervention is material and significant is the reason why it should be disclosed. APRA should ensure that the consequence of disclosure does not reduce the quality of its enforcement actions. The market is less likely to over-react to disclosures of interventions if they become more regular.

8. 7 Solvency of general insurers

A solvent entity is one that is capable of meeting its financial obligations as and when they fall due. Solvency is therefore of concern to the creditors of any business. In the case of an insurance company, solvency is of particular concern for its main creditors-the policyholders- because the service provided by the insurer is based on its ability to meet its promise to cover claims as they may arise in the future. A general insurer can only meet all of its commitments if it remains solvent.

Solvency is therefore a central concern for prudential regulation.

8.7.1 Commercial solvency

The importance of solvency is recognised in the Corporations Act 200 I. It imposes a duty on the directors of companies to ensure that their company does not trade while insolvent. The Act provides a range of remedies to creditors and others to apply for an order to wind up a company on the basis of insolvency. Along with other corporate entities, general insurers are required to meet this minimum standard of what might be called 'commercial solvency' at all times.

Assessing commercial solvency is not always a straightforward task and it can be particularly difficult in the case of a general insurer because of the peculiarities of the business, particularly in cases involving long-tail insurance. A long-tail insurer undertakes to cover risks that may involve the payment of claims many years into the future. The incidence and cost of these claims may be highly uncertain, making it difficult to determine the solvency of the insurer. An assessment of solvency must take into account the likely cost of such future expected claims in order to assess a company's present financial position. The Commission's Background Paper no. 15

'The assessment of the insolvency of a general insurance company' dealt with this topic in more detail.

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8.7.2 Regulatory solvency

Given the inherent uncertainty and variability in measuring and valu ing insurance liabilities, prudent insurers recognise the need to maintain a margin of safety to meet their future debts over and above their current best estimate of their liability fo r claims. Measurement error, catastrophes and other unexpected events may lead to situations where the actual liabilities of an insurer are higher than mi ght have been expected on average.

In recognition of this point, systems of prudential regulation generally impose a more conservative test of solvency than the commercial solvency test. In Austral ia, these requirements are set out in the Insurance Act and associated prudential standards determined by APRA. In broad terms, the present arrangements (which came into effect after the failure of HIH) require that insurers value their future

liabilities with a significant margin for error and meet specified capital requirements over and above commercial solvency requirements.

A general insurer in financial difficulty would in most instances be expected to fail the Insurance Act solvency test well before failing the commercial solvency test of the Corporations Act. This provides an opportunity for steps to be taken by the prudential regulator or the company itself to prevent the insurer from becoming commercially insolvent.

8.8 Adequacy of the Insurance Act

The adequacy of the Insurance Act 1973 (as well as the effectiveness of APRA's administration of that Act) is a key element in assessing the overall effectiveness of the system for prudential regulation.

8.8.1 The objective of prudential regulation

The main objective of the prudential regulation of general insurance aims to reduce the chances that a general insurer will be unable to meet its obligations to policyholders. Section 2A of the Insurance Act states the main object of the Act as being:

.. . to protect the interests of policyholders and prospective policyholders under insurance policies . . . in ways that are consistent with the continued development of a viable, competitive and innovative insurance industry.

The reference to the interests of policyholders and prospective policyholders is appropriate. Prudential regulation is not designed to protect the interests of shareholders or other creditors, although both of those groups may gain some benefit. There may be instances where the interests of policyholders and shareholders do not coincide, and the interests of policyholders should prevail.

Generally speaking shareholders should not be unfairly disadvantaged by the prudential regulatory system, particularly by measures to ensure better disclosure.

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Cost of regulation

The stated objective of the Insurance Act includes the qualification that prudential regulation should be consistent with the 'development of a viable, competitive and innovative insurance industry'. This recognises the potential cost of prudential regulation to the industry and policyholders. An effective approach to prudential regulation requires an appreciation of the relativity of the cost to the benefits derived.

Prudential regulation, especially where it imposes minimum capital requirements as the Insurance Act does, can impose significant costs on an industry. The consequence is a direct trade-off between financial safety and cost. That cost is likely to be passed on to policyholders. The prudential standard of the general insurance industry could, for example, be increased by requiring larger amounts of surplus capital. However, such an approach would have a cost and, by making insurance less obtainable, could jeopardise the existence of a viable and competitive industry. Accordingly, a balance between prudential objectives and cost is appropriately reflected in the objective of prudential regulation.

8.8.2 Insurance Act provisions before 1 July 2002

Marked changes were made to the Insurance Act 1973 by the General Insurance Reform Act 2001, most of which came into effect on 1 July 2002. The failure ofHIH occurred under the legislation as it was prior to those amendments. Before considering the adequacy of the current arrangements, I will refer to weaknesses in the pre-existing arrangements.

Minimum capital requirements The Insurance Act imposed a mm1mum capital requirement of $2 million on insurers. Allowable total assets as defined by the Act had to exceed liabilities by at least $2 million. Larger insurers were required to hold allowable total assets that exceeded liabilities by 20 per cent of their net premium income or 15 per cent of their net outstanding claims, whichever was the greater.

The Commonwealth noted in its submission that:

These solvency requirements did not adequately take into account the types and degree of risk undertaken by a diverse range of institutions conducting a variety of insurance business. In particular, the requirements were blunt in not distinguishing between the different forms of risk to which general insurers were exposed. 32

Provisioning for claims liabilities Accounting standard AASB 1023 applied for both accounting and prudential purposes as the basis for establishing provisions for claims liabilities. These liabilities include outstanding claims provisions (OCP) and unearned premium provisions (UPP). OCP include unpaid reported claims, claims incurred but not reported and claims incurred but not enough reported and the costs associated with

234 Regulation of general insurance

settling such claims. The UPP is the proportion of the premiums received that relate to unexpired risk.

OCP and UPP make up a large proportion of the liabilities of a general insurer (typically 75 percene3) and can be subject to a significant degree of uncertainty and variability, especially in long-tail insurance.

Designed for financial reporting purposes, AASB 1023 permitted (if not required) a relatively aggressive approach to the valuation of claims liabilities. A system of prudential regulation would normally be expected to require a more conservative valuation of such liabilities.

Also under AASB l 023 insurers must recognise insurance premiums and the expensing of reinsurance costs in accordance with the pattern of risk under each contract. Uncertainty as to the meaning and application of this requirement resulted in HIH and F AI manipulating the timing of the recognition of reinsurance expenses with the result that financial statements were misleading.

Governance standards The Act also imposed relatively simple governance requirements. These included rudimentary 'fit and proper' tests for directors and auditors.

8.8.3 Insurance Act provisi ons from 1 July 2002

The General Insurance Reform Act 2001 made extensive changes to the Insurance Act, including:

• extension of the Act to cover non-operating holding compames of general msurers

• providing APRA with the power to determine prudential standards for general msurers

• extension of the 'fit and proper' tests to an insurer's directors and semor management

• a requirement to appoint an approved actuary to investigate a general insurer's liabilities

• expanding the obligations and duties of the auditors and actuaries of an general insurer.

The submissions received by the Commission generally supported these changes. The Insurance Council of Australia said:

Subject to the specific issues addressed in this submission, ICA supports the recent reforms to the prudential regulation of general insurers. 34

The failure of HIH Insurance 235

The Institute of Actuaries (IAAust) said:

The IAAust supports the direction and nature of the revised requirements and believes that, as an overall package, the revised prudential regulation framework should enhance the quality of management and financial robustness of insurers, and hence should substantially reduce the likelihood of future insurer failures . 35

The Commonwealth for its part said that:

Overall, the Commonwealth considers the significant reforms to the Insurance Act represent an appropriate response to concerns about the former framework. They can be expected to reduce the likelihood of failure of a general insurance company in the future. 36

The changes address some of the structural problems with the previous Act. The new Act provides APRA with greater flexibility and the ability to impose more appropriate capital and valuation requirements on insurers through the prudential standards. It also gives more attention to risk management and corporate governance and begins to address the position of corporate groups by introducing licensing arrangements for non-operating holding companies. The changes introduced in the General Insurance Reform Act 2001 represent a marked improvement in the framework for prudential regulation of general insurance.

Adequacy of the prudential standards One of the most important changes is the empowering of APRA to issue prudential standards. The core standards issued by APRA include a capital adequacy standard, a liability valuation standard, a reinsurance management standard and a risk management standard. The first two deal with the basic financial requirements of the prudential regulatory system. They are particularly important in assessing the overall effectiveness of the system. Changes introduced by these standards are discussed below.

Valuing insurance liabilities The prudential standard for the valuation of liabilities introduced a requirement that general insurers establish a risk margin when valuing insurance liabilities. Specifically, liabilities must be valued at a 75 per cent probability of sufficiency. The previous requirement was based on AASB 1023 which, on a strict interpretation, requires the use of a central estimate or a valuation based on a 50 per cent probability of sufficiency. Many insurers value their liabilities more

conservatively than a central estimate, although HIH was a notable example of a company that used a central estimate.

The standard also requires that insurers discount future cash flows relating to insurance liabilities using a risk free rate. AASB 1023 arguably allowed a higher discount rate, meaning that insurers could book lower amounts for outstanding claims liabilities.

Finally, in valuing liabilities the standard requires that general insurers recognise premium liabilities. These are not recognised under AASB 1023. This addresses the

236 Regulation of general insurance

potential for companies to manipulate the timing of the recognition of expenses and revenue, as occurred with certain reinsurance contracts in HIH, thus manipulating the timing of the recognition of profit.

I have recommended in Chapter 7 that AASB 1 023 be changed to reflect the improvements embodied in the new prudential standard for the valuation of insurance liabilities. In that chapter I also discuss the significance of the prudential standards to the obligations ofthe actuary and the valuation of insurance liabilities.

Capital adequacy The prudential standard on capital adequacy also changed the mm1mum capital requirements. It increased the minimum capital requirement from $2 million to $5 million and introduced a risk-based regime that requires additional capital based on the risk profile of an insurer. This standard is conceptually similar to well­ recognised international standards (promulgated by the Bank of International Settlements) for the prudential regulation of deposit-taking institutions.

Overall, the standards relating to the valuation of liabilities and capital adequacy represent a marked improvement over the previous arrangements.

It must be recognised however that any system that relies on minimum capital requirements depends on the accuracy of the regulated entity' s reported financial position. A contributing factor in the failure to identify earlier the likely collapse of HIH was misleading financial information. Had the financial position of the authorised entities been accurately reported, they would have likely failed the prudential requirements of the Act then in force well before the company's eventual

collapse.

It should also be noted that the new standards are likely to require refinement in the light of experience. The new prudential requirements under the Insurance Act should be monitored to ensure their continued effectiveness and relevance.

Improving the prudential standards Other aspects of the standards call for more urgent attention as has been acknowledged by APRA.

Corporate groups The prudential standards are largely focused on licensing and regulating insurance entities as opposed to corporate groups. This approach is based on the notion that the activities and, particularly, the assets, liabilities and capital of a business can be successfully 'ring-fenced' within a single entity without affecting the rest of the corporate group of that entity. This is explicable in formal terms because if a

licensed insurer in a group fails a policyholder will only have recourse to the assets of the insurer, not the group. However, corporate businesses which formally comprise separate entities commonly operate as a single business and, as noted in APRA's submission, 'it is extremely difficult to prevent contagion of financial problems between members of a corporate group'.

37

The failure ofHIH Insurance 237

The importance of addressing this potential gap in the regulation of general insurers was acknowledged by the Commonwealth in its submission:

.. . the development of complex company structures, including intra-group transacti ons and cross-guarantees, has demonstrated that supervision of general insurers would be more appropriately conducted on a group basis.38

APRA also noted this weakness:

. . . given the increasing trend for insurers to operate as part of a complex corporate group, and/or in a range of jurisdictions using multiple legal entities, there remains a considerable risk that adverse developments in unsupervised activities could impact on th e soundness of the Australian

insurer. 39

The General Insurance Reform Act 2001 made a first step by providing APRA with supervisory powers over non-operating holding companies. Under the Insurance Act, a non-operating holding company is a company incorporated in Australia that does not carry on a business other than a business consisting of the ownership and control of other bodies corporate including, in this case, an authorised general

msurer.

Despite this improvement in the Act the present regime, as acknowledged in APRA' s submission, still largely focuses on regulating and supervising the individual authorised entity. I am concerned that the focus of the standards on particular authorised entities may prove ineffective when dealing with the circumstances of an authorised insurer that operates within a larger corporate group.

The collapse of HIH provides a clear illustration of this problem. The strict regulatory view was that there were seven separate authorised insurers, each to be considered on an individual basis. In reality, HIH carried on business as a single group. This case study demonstrated the difficulties that a complex corporate group can pose to prudential regulation.

In theory, a regime focused on the supervtston of individual entities could prudentially regulate large and complex groups. In reality, the stresses and pressures that can emerge in such groups may simply overwhelm a regulatory system focused on stand-alone entities. Widening the focus of supervision to include corporate groups as a whole should go some way towards redressing that weakness.

In its submission, APRA stated its intention to focus on this issue:

... we believe that the next stage of reform for the prudential supervision of general insurance must include a component of consolidated supervision, including capital adequacy requirements measured on a group-wide basis.40 •

I can only emphasise the importance that should be placed on early action in thi s area. Moreover, I would encourage APRA- and this may apply to other regulators- to develop its understanding of the commercial circumstances of

238 Regulation of general insurance

corporate groups lest the formal entity arrangements blind it to the commercial realities.

When it made its submission APRA was not in a position to detail how the prudential super\rision of corporate groups including one or more general insurers would occur, although it did highlight areas for further consideration. Broadly speaking these related to:

• the application of minimum capital requirements for the group as a whole (including those operating internationally)

• limiting reinsurance exposure to parents or other entities within the group

• a range of qualitative measures such as a requirement for group-wide risk and reinsurance management strategies, and the appointment of an approved actuary and approved auditor for the entire group.

I believe that these are necessary measures to be included in a prudential standard relating to corporate groups. The primary concern is however the application of group minimum capital requirements.

A potential weakness in applying minimum capital requirements at an entity level alone was noted in the submission by the Institute of Actuaries (IAAust):

We believe that there is a potential loophole in APRA's new minimum capital requirements set out in GPS 110 and the associated guidance notes. This arises when one licensed insurer is a subsidiary of another.4 1

IAAust constructed a simple example where the capital of a subsidiary insurer could be counted twice for prudential purposes under the current standards. In this example, capital was counted once against the capital charges for the subsidiary and again against the capital charges for the holding company. To address this problem, IAAust recommended the application of a 100 per cent capital charge to the appropriate proportion of any downstream insurance company capital recognised in the holding company. I note that this problem could also be addressed by imposing a minimum group capital requirement.

Given this weakness and the potential for corporate groups in distress to transfer capital between subsidiaries, I consider that minimum capital requirements should be imposed on corporate groups that include at least one authorised general insurer operating in Australia. This may require APRA to supervise a corporate group that contains non-financial services companies. This is an unavoidable consequence of operating a business in a prudentially regulated sector. While relatively few

corporate groups in Australia appear to be involved in significant non-financial activities as well as financial services, this is an issue which the regulator should be prepared to deal with.

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Recommendation 38

I recommend that, as a matter of high priority, the Australian Prudential Regulation Authority develop and promulgate a standard for the effective regulation of authorised insurers that operate

as part of a corporate group.

The proposed prudential standard on corporate groups should include a minimum capital

requirement at the group level as well as the authorised entity level.

International operations The international operation of insurers licensed in Australia is an important aspect of this issue. As described elsewhere in this report, the HIH group had significant insurance operations in the United Kingdom, the United States and Asia. Losses in the United Kingdom and the United States were material contributing factors to the failure of the HIH group as a whole. To be effective a system of prudential regulation imposed in Australia must take account of the effect of international operations on local authorised insurers.

The measures outlined above for inclusion in a proposed prudential standard on corporate groups should also regulate the foreign operations of companies associated with authorised general insurers. A group capital requirement, for example, should encompass associated companies operating in other countries.

Addressing this issue will not be easy in practice. An Australian prudential regulator does not have the same ability to regulate the foreign operations of insurers doing business in Australia. The problem faced in regulating complex corporate groups is magnified when operations of the group are conducted in countries beyond the regulator's reach. This issue is not one that can be ignored.

The prudential standards should address the potential risks that foreign operations place on authorised general insurers underwriting business in Australia. APRA notes in its submission that:

A consolidated capital requirement for internationally-operating groups would effectively apply the Australian capital adequacy requirements to the overseas operations of Australian general insurers. 42

Such an outcome is unavoidable. Subjecting group international operations to monitoring by APRA should be seen as part of the price that companies have to pay to gain authorisation to operate a general insurance business in Australia.

I recognise that, because of the complexities involved, a prudential standard for corporate groups may take some time to develop. Given the fundamental importance of this issue APRA should monitor the financial position of relevant corporate groups in the meantime using its existing powers. This may include, for example, utilising the wide powers APRA has under s. 13 of the Insurance Act 1973 to impose conditions relating to prudential matters on the continued authorisation of msurers.

240 Regulation of general insurance

These powers should be used to require the provision of group information that may affect the solvency of Australian authorised insurers that have, or which are part of, international operations. This would include information relating to foreign subsidiaries of Australian companies and information relating to the foreign parents of Australian authorised insurers.

The proposed prudential standard relating to corporate groups may ultimately require such information be provided to APRA in the form of regular returns. APRA should also use its powers to require information in specific instances where it has concerns about a particular Australian insurer with international operations.

Recommendation 39

I recommend that the Australian Prudential Regulation Authority monitor the financial condition of corporate groups, including those with foreign operations. Pending the development of the

proposed prudential standard on supervision of corporate groups, APRA should use existing

powers to require groups to provide any information it considers necessary to perform this role.

Similar problems apply in the prudential regulation of banks that operate across international borders. APRA has addressed these problems through the supervision of corporate groups as well as individual entities. In its submission APRA notes that corporate group supervision of banking entities is made somewhat simpler because of 'the presence of international standards, for example the Capital Accord issued by the Basel Committee on Banking Supervision, which has been adopted as the basis for setting regulatory capital requirements in more than 100 countries'.

43

Internationally, the prudential regulation of the banking sector is significantly more advanced than that of the general insurance sector. Significant benefits would accrue to insurance regulators around the world if there were greater harmony in the prudential standards that applied to general insurers. Regulators in all countries

should bear this in mind when developing prudential standards.

The effective supervision of corporate groups with international operations also requires close cooperation between supervisors operating in other countries. As noted in Chapter 24, there were no guidelines or mechanisms in place within APRA to allow for liaison with overseas regulators. For example, APRA did not become aware of the problems identified by the Californian regulator in HIH's workers compensation business in that jurisdiction. APRA should address this deficiency as a matter of urgency.

Recommendation 40

I recommend that the Australian Prudential Regulation Authority take steps to ensure that it effectively exchanges with relevant foreign regulators information and intelligence on the operations of Australian insurers with international operations.

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Financial condition report Under s. 113 of the Life Insurance Act I 995, the appointed actuary of a life insurance company must prepare an annual financial condition report. This report includes a valuation of the company's policy liabilities and an assessment of whether the company has complied with relevant solvency and capital adequacy standards. General insurers face similar and arguably more volatile operating conditions than life companies yet there is no similar requirement applicable to general insurers under the current prudential standards. APRA noted in its submission that it intends to introduce such a requirement:

... we are strongly of the view that a FCR [Financial Condition Report] would be a valuable tool for management and directors, as well as APRA, by providing a complete review of the insurer's financial position. 44

A requirement for a financial condition report, similar in scope to the report required for life insurers, would be a worthwhile addition to the prudential management of general insurers.

Recommendation 41

I recommend that the Austra lian Prudential Regulation Authority modify the prudential standards to require the annual production by an authorised general insurer's approved actuary of a report on

the overall financial condi tion of the insurer.

The report should be provided to the board of the insurer and to APRA. In the normal course of events I consider that such relevant information concerning the financial strength of a general insurer should be made public. However, the publication of the financial condition report might inhibit the willingness of the approved actuary to reveal all of his or her concerns. Full and frank disclosure might be better achieved by requiring dissemination of the report only to the insurer's board and to APRA. Over time, as the preparation of the report becomes an established feature further consideration could be given to the question of wider publication of the report or an extract of it.

8.8.4 Coverage of the Act

APRA and the Insurance Council of Australia referred in submissions to a number of insurance schemes that fall outside the definition of 'insurance business'45 and therefore outside of the regulatory reach of the Insurance Act. 46 Schemes that may fall outside the scope of the Insurance Act include 'discretionary' products such as mutual schemes and insurance underwritten overseas by foreign insurers. In addition, there has long been doubt whether discretionary schemes fall within the scope of s. 51 (xiv) of the Constitution. Further, state and territory schemes are not regulated under the Insurance Act.47 These schemes are considered in Chapter 9.

Several submissions called for the definition of 'insurance business' to be expanded so that all products with insurance-like characteristics are made subject to regulation under the Insurance Act. 48

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Discretionary cover

Discretionary cover is an insurance-like product that involves no legal obligation by the provider to meet the costs of an 'insured' event. The provider of such cover merely accepts that it will, in its discretion, consider meeting such costs. It is for this reason that doubts have been raised whether discretionary cover constitutes

'insurance' for the purposes of s. 5l(xiv) of the Constitution. The generally held view has been that the concept of insurance involves an insurer assuming an obligation to pay the insured on the happening of the event which is covered and where there is risk to the insured. Under a discretionary arrangement, while the person covered carries risk, there is no obligation to pay on the part of the ' insurer' .

Most of these types of schemes have grown out of smaller mutual-type arrangements based around particular professions, such as the medical or legal profession. In these schemes, a group of professionals may jointly agree to meet the costs of certain risks that members face in the course of their professional duties. In this way, the costs of seeking appropriate insurance cover can be reduced.

The discretionary structure of such arrangements, however, avoids the application of the Insurance Act. A consequence of this is that the provider can avoid the costs of complying with the requirements of the Act. This may result in a cheaper product but leaves consumers without the Insurance Act protections.

In its submissions the New South Wales Government noted that discretionary schemes of this kind, particularly in the area of medical indemnity, have a regrettable history of under-funding and appear to have given insufficient attention to pricing risk. The potential for this would be reduced if such schemes had to meet the prudential standards. The submissions further observed however that the commercial insurance market has failed to offer coverage in some areas of professional services and that mutuals have developed to fill these gaps.

49

One approach to this issue would be to leave the regulation of discretionary cover to the market, subject to appropriate disclosure. This approach might require the consumers of discretionary cover to be warned that companies providing such products are not subject to prudential regulation, and that they may therefore be

subject to higher risk of failure. Even in the case of third party policies the insured, such as a medical practitioner holding medical indemnity cover, would be made aware that he or she may be liable in the event that a discretionary scheme failed to meet valid claims because of its insolvency.

However there are reasons to believe that consumers would be unwilling to accept the failure of a provider of discretionary cover even though they may recognise that the provider was not subject to prudential regulation. The response of medical practitioners to the recent financial difficulties of various medical defence organisations highlights the problems with discretionary insurance products.

In this regard, the Commonwealth has recently introduced the Medical Indemnity (Prudential Supervision and Product Standards) Bill 2003 which, in very broad terms, provides that medical indemnity cover is only to be provided by general

The failure ofHJH In surance 243

insurers under contracts of insurance. If enacted, this will bring all medical indemnity cover under the Insurance Act and the prudential oversight of APRA. Although it may place upward pressure on premiums for medical indemnity insurance, the extension of prudential oversight to all providers in this area makes sense. After all, the primary objective of medical indemnity insurance is to protect the interests of patients who do not have control over the choice of their practitioner' s insurer.

Holders of other forms of discretionary cover are potentially exposed to the same difficulties that holders of discretionary medical indemnity coverage have recently faced. Those entitled to claim against discretionary third party-type cover are also potentially exposed. As has already been proposed for providers of medical indemnity cover, it would be desirable for all providers of discretionary cover to be subject to prudential regulation, so far as that may be possible.

Recommendation 42

I recommend that the Commonwealth Government amend the Insurance Act 1973 to extend prudential regulation to all discretionary insurance-like products-to the extent that it is possible to

do so within constitutional limits.

The policyholder support scheme recommended in Chapter 11 would provide another means of achieving the same end. As proposed, this scheme would not cover consumers of discretionary products. Coupling this with an obligation that providers must disclose to consumers that they will not be provided with support in the event of failure may work to discourage consumers' use of such products.

Insurance underwritten offshore Insurance of risks that may arise in Australia can be underwritten offshore by foreign insurers that are not authorised under the Insurance Act. Such insurance can be purchased directly or through the medium of an Australian agent or broker. In the latter case, disclosure requirements may apply.

In many instances it might be unnecessary to regulate insurance underwritten offshore. Much of this business is likely to involve large commercial insurance contracts where the purchaser would normally be considered able to judge for itself the risks involved in the transaction. Insurance of this type would only require prudential regulation if it involved systemic risk to the Australian economy.

On the other hand, suggestions have been made, including by the media, that there is a possible gap in APRA's regulatory reach under current arrangements. It was suggested that it might be feasible for an offshore insurer, for example an insurer who has been refused authorisation by APRA on prudential grounds and moved offshore, to issue insurance policies through an agent or broker in Australia in an attempt to avoid the operation of the Insurance Act. It was recognised that various disclosure requirements might apply to the agent or broker.

244 Regulation of general insurance

Depending on the particular circumstances, it may be that an offshore insurer operating through an Australian agent or broker would still be carrying on insurance business in Australia within the meaning of ss. 9 or 10 of the Insurance Act. For example, it would be relevant whether the sale of a policy was an isolated event or part of a course of conduct involving a succession of acts. In the event the foreign

insurer was properly characterised as carrying on insurance business in Australia, they would commit an offence if they had done so without obtaining authorisation under s. 12 of the Insurance Act. This may be the case regardless of whether or not the foreign insurer is acting through an Australian agent or broker.

Where a broker or agent is involved, that entity may also have certain obligations with respect to the Insurance Act. Depending on the level of knowledge of an agent or broker, he or she may also be involved in the commission of an offence under ss. 9 or 10 of the Insurance Act by being concerned in the contravention by the offshore principal. Alternatively, an agent of an overseas insurer may be carrying on business which is incidental to the 'insurance business' of the offshore provider. In this case, the agent may be carrying on 'insurance business' within the meaning of s. 3 of the Insurance Act. If so, the agent would require authorisation under the Insurance Act

in order to conduct that incidental business. Where a broker is acting as the agent of the offshore insurer, that broker may also require authorisation under the Insurance Act for the same reasons.

The proposed policyholder support scheme outlined in Chapter 11 would provide another means of making offshore products offered by unauthorised insurers less attractive to individuals and small businesses. This scheme would not offer any protection to consumers of insurance products written offshore by unauthorised foreign insurers not regulated by the Insurance Act. This fact would need to be disclosed at the point of sale of such products.

8.9 The winding up of an insurance company

If a general insurer becomes commercially insolvent it is subject to the external administration provisions that apply to all companies under Chapter 5 of the Corporations Act. These include provisions for the winding up of an insurer on the application of its creditors and at the request ofthe company. In the case of HIH, the company itself applied to the Supreme Court of New South Wales for an order that

it be wound up provisionally. An insurer may also resolve to place itself in administration under Part 5.3A of the Corporations Act if it is insolvent or is likely to become so. Both the corporate regulator, ASIC, and the prudential regulator, APRA, also have winding up powers under the Corporations Act.

An insolvent insurer, like any insolvent company, should be administered in insolvency. APRA has power to apply for an order that an insurer be wound up under the Corporations Act. These powers are in addition to any powers that APRA may have to regulate the insurer under the Insurance Act. APRA's power under the

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Corporations Act can be exercised on broader grounds than the insurer's commercial insolvency.

Section 461 of the Corporations Act gives a court a wide power to wind up an insurer if it is ' of the opinion that it is in the interests of the public, of the members or of the creditors that the company should be wound up'. The basis of APRA' s standing to apply for such an order under s. 462(3) is limited to circumstances in which an inspector has been appointed under s. 52 of the Insurance Act and 'the company' s liabilities, worked out for the purpose of the prudential standards .. . exceed the company's assets worked out for that purpose'. Section 459P of the Corporations Act, which is based only upon commercial insolvency, gives standing to APRA as a prescribed agency to apply for the winding up of the corporation. But, like any other applicant, APRA would have to establish that the corporation was commercially insolvent.

APRA should have wide and flexible powers to apply to the court to deal with an insurer's serious financial difficulties. In determining the matter, the court should be able to have regard to the general interests of the insurer's policyholders. I consider that there should be wider powers available to APRA to apply to wind up an insurer than those under s. 462(3) of the Corporations Act.

In my view, s. 461 should be amended by adding to it a ground that APRA should also be able to apply to wind up an insurer if any of the criteria specified in s. 52(1)(aa), (ab) or (a) of the Insurance Act are met. This would permit APRA to act quickly to apply to wind up an insurer, or to wind it up provisionally, without the need for notice to be served on the insurer to appoint an inspector. This additional flexibility is necessary because there may be difficulties in some cases determining whether the insurer' s liabilities exceed its assets as required by s. 462(3)(b) of the Corporations Act. It would remain a matter for the court's discretion under s. 461 (1 )(j) of the Corporations Act whether to grant a winding up order, having regard to the interests of 'the public, of the members or of the creditors'. For completeness, I consider that the interests of policyholders should also be specified in that paragraph as being interests to which the court should have regard.

In making these recommendations, I have had regard to the judicial management model that applies under the Life Insurance Act to life insurers in financial difficulty. However I note that it has been rarely used and I consider it unlikely that such a regime would have been of assistance in the case of HIH. I am also wary of suggesting that there be a further level of administration to deal with an insurer in financial difficulty in addition to those which already apply. In that regard, I suggest that it is better to refine and extend the existing powers of APRA and the court in the way I have recommended.

·'

246 Regulation of general insurance

Recommendation 43

I recommend that s. 462(3) of the Corporations Act 2001 be amended so that the Australian Prudential Regulation Authority may apply to wind up a company that is an authorised insurer if any of the criteria specified in s. 52(1 )(aa) , (a b) or (a) of the Insurance Act 1973 are met.

Recommendation 44

I recommend that s. 461 of the Corporations Act 2001 be amended to specify that the interests of policyholders are interests to which the court should have regard in deciding whether to make a winding-up order.

8.10 Issues under the ASX Listing Rules

The inquiry into the collapse of HIH has raised a number of policy issues

concerning stock market regulation. These include the processes adopted by li sted companies to enable them to meet their continuous disclosure obligations; the meaning and application of the ASX Listing Rules which regulate significant changes in listed companies' businesses or assets; and the practice of 'blacklisting'

market analysts by listed companies.

8.10.1 Continuous disclosure

A significant feature of the history of HIH is that from at least early 1999 when HIH acquired FAI the market was not fully informed about HIH's true financial position. This occurred despite the enhanced disclosure regime under the Corporations Law and the ASX Listing Rules that required listed entities to make periodic and continuous disclosure of price sensitive information, including such information about their financial position, performance or prospects.

A review of HIH's market disclosures in and after 1999 shows that HIH rarely, if ever, disclosed information to the market that was negative, despite the gravity of its true financial position and prospects during its last two years of operation. A final example of this pattern was HIH's press release on the evening of 15 March 2001 , after the Supreme Court of New South Wales had ordered that HIH be placed in provisional liquidation. 5°

That market release stated that HIH 'had this evening received approval from the NSW Supreme Court to place the company into provisional liquidation'. It went on to state that '(l)osses from discontinued HIH United Kingdom and United States business as well as other discontinued international business written from Australia,

could no longer be sustained by the sound Australian operations'. The release purported to attribute to HIH's provisional liquidator, McGrath:

that HIH will be managing its existing liabilities and claims, but will not be writing new business. The balance sheet now will facilitate an orderly run-off but is not capable of supporting ongoing insurance business.

The failure ofHIH Insurance 247

This unduly optimistic view of HIH's financial positiOn could not have been justified on 15 March 2001. It was HIH's last act as a listed public company under the continuous disclosure regime of the Corporations Law and ASX Listing Rules.

In a sophisticated market economy like that operating in Australia, timely and reliable disclosure to the market is a mainstay of corporate regulation. It is also an important mechanism for promoting public scrutiny and for improving corporate behaviour. In the prudentially regulated financial services sector, disclosure can also be a useful tool for the prudential supervisor.

The authors ofFord's Principles of Corporations Law observe that:

(s)tarting with the enactment of the first Australian state securities industry laws early in the 1970s, Australia has developed a legislative policy on securities market regulation in which disclosure of material information is a central requirement. It is thought that mandatory disclosure is essential in the interests of both market efficiency and investor protection. The development of Australia's disclosure policy has been strongly influenced by the approach to securities market regulation in the United States. 51

In Australia the Corporate Law Reform Act 1994 was enacted under the influence of modem US market disclosure policy and in response to the significant corporate failures and abuses of the 1980s which were perceived to have contributed to the recession of the early 1990s.

The Corporate Law Reform Act amended the Corporations Law to establish a regime of enhanced disclosure involving continuous disclosure as well as periodic reporting. That regime ob liges corporations and other entities which are 'disclosing entities' (essentially all entities the securities of which are listed on a stock market) to file both half-year and annual reports, and to make timely and continuous disclosure of market sensitive information about their financial performance, position and prospects. The regime is designed to ensure that on-market trading in

securities occurs in an informed market. It requires that the market as a whole is fully informed, not selectively informed.

As the authors of Ford note, following the recent collapses of the HIH group in Australia and the Enron Energy group in the United States, there has been widespread debate on the one hand about the adequacy of the regulation of the auditing profession and on the other about the quality of financial and business

information which is provided to the securities market by public listed companies.

The debate about corporate governance and accounting standards and practices in the United States led to the enactment by the US Congress in July 2002 of the Sarbanes-Oxley Act which regulates all companies the securities of which are listed on a United States stock exchange. That Act greatly increases the powers of the US Securities and Exchange Commission to make rules requiring issuers of securities to disclose information about material changes to their financial condition or operations within two business days ofthat information materialising.

248 Regulation of general insurance

The principal statutory obligations contained in the Corporations Act 2001 require the disclosure of the following types of business and financial information about Australian public companies:

• financial records, reports and audit opinions (Chapter 2M)

• continuous disclosure to the stock market (Chapter 6CA)

• prospectus information in relation to any issue or sale of secunttes

(Chapter 6D), and product disclosure information for the sale of other financial products (Part 7.9)

• information for takeovers, including particularly the disclosure statements by bidders and targets required by ss. 636 and 638

• information about substantial shareholdings and the beneficial ownership of shareholdings in public companies (Chapter 6C).

Chapter 6CA of the Corporations Act contains the provisions requiring disclosure of certain information by a listed disclosing entity as defined under the Act. These provisions give legal effect to the ASX Listing Rules and guidance notes.

ASX Listing Rule 3.1 requires an entity to inform the ASX immediately of any information that a reasonable person would expect to have a material effect on the price or value of the entity's securities, subject to several exceptions related to confidential information under rule 3.1 A. Guidance note 8 provides assistance to listed entities in their compliance with the disclosure obligations.

Continuous disclosure is a key requirement of the listing requirements of the ASX. As noted in the ASX's submission:

It is essential that a market operates with integrity if it is to maintain the confidence of investors. Continuous disclosure is designed to ensure that the Australian market is fully informed at all times, and that no investor is disadvantaged by lack of equitable access to material information.

ASX Listing Rule 3.1 is the cornerstone of continuous disclosure and is regarded as central to the orderly conduct and integrity of the ASX market. 52

The disclosure of timely and relevant financial and commercial information about a general insurance company will not by itself prevent the collapse of such a company. It will undoubtedly impose a greater degree of market discipline upon the directors and executives of such a company to act honestly and ethically thereby allowing the market a better opportunity properly to value and thereby price the risk of doing business with the enterprise. This patently did not occur in the case of HIH.

Issues concerning the disclosure practices and processes of HIH, and ofF AI prior to its acquisition by HIH that arose in the evidence taken by the Commission cause me to make recommendations concerning board approval of company announcements.

The failure ofHIH Insurance 249

Processes of disclosure

In the course of my inquiry I took evidence and submissions from various parties about the disclosure practices of both F AI and HIH. No findings about those practices are made in this report. However, in light of the evidence given and the issues that arose, I consider that a potential weakness with the current continuous disclosure regime is the lack of authoritative guidance on the internal processes by which listed companies should identifY, articulate and release price sensitive information to the market.

Given the importance of the continuous disclosure regime, most listed entities are believed to have put in place systems to monitor and disclose information to the ASX to ensure that the entity's obligations are met. Guidance on such processes is not given in Listing Rule 3.1, although guidance note 8 was recently amended and now contains certain ASIC principles designed to improve the process of disclosure of material information. 53

As the guidance note states, the principles are not mandatory. The principles say that:

(e)ach listed company needs to exercise its own judgment and develop a disclosure regime that meets legal requirements and its own needs and circumstances.

Similarly, in an ASIC discussion paper of November 1999- 'Heard it on the Grapevine' --comments are made that:

(e)ach company needs to decide what level of autonomy the corporate disclosure manager has in making decisions about disclosure. Some boards of directors will want to have total control of decisions about lodging information with the stock other boards may wish to delegate this function to various degrees. 04

In ASIC v Rich & ors 55 , the evidence of the expert witness for ASIC, Rod Cameron, was that the duties of the chair of a public company included being:

concerned to be personally satisfied about the accuracy of public statements made on a company's behalf, and the company' s compliance with the ASX Listing Rules. 56

It seems to me that listed companies shou.ld have structured arrangements for disclosure in place that allow and require the company to meet its obligations with appropriate authority. My view is based on the importance of enhanced disclosure in corporate regulation, both periodic disclosure, which requires directors to sign-off on company accounts, and continuous disclosure of price sensitive information as it anses.

While a range of legitimate approaches may be taken to this issue, depending on the nature and size of the company concerned, I consider that there should be authoritative guidance given in the ASX Listing Rules or the guidance notes as to the nature of the processes that should apply. This would be to the effect that ASX announcements should be issued with the full authority of the company. Whether

250 Regulation of general insurance

and in what circumstances that authority is delegated by the board (for example to a committee, the chair, the chief executive or another executive) should be made explicit, together with a process for the ratification by the board of announcements made by delegation. Depending on the company and its size, price-sensitive announcements may require the approval of the whole board or a sub-committee of the board; in some cases the audit committee may be considered suitable for this purpose; in other cases it may be sufficient for the chair to approve such releases.

Any such requirement should be consistent with the obligation of the company under the Listing Rule to ensure that price-sensitive information is discussed 'immediately'. Given the importance of continuous disclosure in the modem market environment, I consider that clearer guidance about the processes of market

disclosures by public companies is desirable.

Recommendation 45

I recommend that the Australian Stock Exchange amend Listing Rule 3.1 to require-or publish a guidance note making it clear-that price-sensitive announcements have the approval of either the board or a delegate of the board subject to ratification by the board .

8.10.2 Blacklisting of analysts

Market analysts perform an important role in the dissemination of information to the market. They provide a source of assessment, comment and analysis of information disclosed by listed companies pursuant to their disclosure obligations. The role performed by analysts allows those who wish to be informed of the financial position, performance and prospects of a listed company to understand better and critically assess the information that has been released by that company.

To the extent that there is any restriction on the ability of analysts to in form themselves and comment upon information disclosed by listed companies, that is a limitation on the effectiveness of corporate disclosure. In the context of HIH, evidence was received that securities analysts with unfavourable views about HIH were inhibited, and in some cases banned altogether, from obtaining relevant

information from investment briefings by senior management of HIH. Such conduct is referred to as 'blacklisting'. The blacklisting of market analysts is in my view a serious restriction on the effectiveness of the disclosure regime. In the case of HIH, such conduct prevented access to information about HIH and its performance and prospects by analysts who were seen as critical of the company. As a result the market and the public were not as fully informed about HIH as they would otherwise have been.

I note that the ASX's Guidance Note No. 8 was recently amended to provide that ' it is not appropriate for entities to ' blacklist' or exclude analysts with the purpose of minimising or eliminating ... analysts ' . This amendment was foreshadowed in the ASX' s submission and the issue was there discussed.

57

While this is a useful

amendment to the guidance note, I consider that the issue is serious enough to merit

The failure ofHIH In surance 251

elevation to the Listing Rules so that it is capable of enforcement by the ASX. Blacklisting may be difficult to define or prevent. I consider however that where a company chooses to offer briefings to selected analysts (without making the contents of the briefing publicly available) discrimination against individuals who do not 'toe the line' has the potential to undermine the integrity of the briefing process. Such conduct has the potential to impair the existence and maintenance of a fully informed market.

The ASX by its Listing Rules should require companies who choose to offer briefing to analysts or members of the media, without timely disclosure of the content of that briefing on the company's website or otherwise to the market, to do so on the basis of an open invitation to the relevant class of people.

Recommendation 46

I recommend that the Australian Stock Exchange amend the Listing Rules to prohibit 'blackl isting'-defined as exclusion of a person or organisation from briefings by a company or a

pattern of such exclusion in the face of negative reports on the company by those analysts over a

specific period.

8.10.3 Major transactions requiring shareholder approval

Questions arose in the course of the inquiry about the circumstances in which management decisions of a listed company should require shareholder approval.

Our system of corporate governance generally vests in the board of directors the power to make decisions regarding the management and strategic direction of the company, to the exclusion of the shareholders. However shareholders do have a significant role in relation to certain important transactions.

The Corporations Act requires specific documents and information to be given to the members of companies who are called upon to vote on transactions such as share buy-backs, reductions of capital, related party transactions and schemes of arrangement. ASX Listing Rules also allow members to vote on certain transactions that effect a significant change in a listed company's assets or operations.

Chapter 11 of the ASX Listing Rules regulates significant transactions entered into by a listed entity. Listing Rule 11.1 states:

(i)f an entity proposes to make a significant change, either directly or indirectly, to the nature or scale of its activities, it must provide full details to ASX as soon as practicable. It must do so in any event before making the change.

The Listing Rules regulate such a change, including a possible requirement that the entity get the approval of its shareholders before making the change. Listing Rule 11.2 says that:

252

(i)f the significant change involves the entity disposing of its main undertaking, the entity must get the approval of holders of its ordinary

Regulation of general insurance

securities and must comply with any requirements of ASX in relation to the notice of meeting. The notice of meeting must include a voting exclusion statement. The entity must not enter into an agreement to dispose of its main undertaking unless the agreement is conditional on the entity getting that approval. Rules 11.1.1 and 11.1.3 apply.

ASX guidance note number 12 states principles to assist in understanding chapter 11 of the Rules. 58

Questions about the application of these rules arose in the context of the Allianz transation. In September 2000 HIH announced its entry into an agreement with Allianz to transfer its personal lines business into a joint venture. The substance of the ASX's view on Chapter 11 was that the Allianz transaction did not attract the application of the rules. The ASX view was that 'Listing Rule 11.1 primarily applies to a transaction involving the listed entity making an acquisition and Listing Rule

11.2 is concerned with the listed entity making a disposal' . 59 Thus the Allianz transaction was considered only in terms of rule 11.2 which involves a significant change by way of 'the entity disposing of its main undertaking'. The ASX did not consider that the Allianz transaction involved a transfer of HIH's 'main undertaking'.

The ASX considered that the expression 'main undertaking' 'means something greater than disposing of a significant asset which may involve a significant change to the company ... where following the disposal the company has either no activities or only residual activities' .60 While there was no definition of 'main undertaking' in the Rules, Luise Elsing of the ASX said it was 'quite well understood that the main

undertaking means that, without (the) undertaking, the company is left with very little' .61

In making its assessment under Rule 11.2, the ASX said it relied on HIH's announcement that, after the transaction with Allianz:

HIH is a $2.5 billion gross earned premium business ($1 .8 billion stand­ alone and $0.7 billion through the joint venture) ... As the impact of the venture with Allianz only effectively reduces HIH's Australian retail premium by around $300 million, the company retains a total grossed earned premium business of $2.5 billion.

62

The ASX concluded that on that basis there was no disposal of HIH's mam undertaking.

Listing Rule 11.1 applied to the Allianz transaction because it involved 'a significant change, either directly or indirectly, to the nature or scale of [HIH's] activities'. If that was so, the shareholders of HIH should have been informed of the details of the transaction and voted upon it.

In response to this issue, the ASX advised in its submission that the guidance note would be amended. 63 In any amendment, I consider that it should be made clear that Listing Rule 11.1 applies to any significant change, whether by way of acquisition, a disposal or an amalgamation. There should be a more particular definition of what

Th e failure of HIH Insurance 253

is a 'significant change' to make clear that it encompasses financial and geographic factors, as well as the nature and scale of the company's business. Listing Rule 11.2 should require shareholder approval for a disposal of the whole or substantially the whole of the assets or operations of a listed company. This should include a clearer definition of 'main undertaking' than that presently contained in the Listing Rules and the guidance note.

In the case of the Allianz transaction, a clarification of the Listing Rules as recommended would have required that HIH provide 'full details' to the ASX, including the effect of the change on its future potential earnings. Had that occurred, it may have caused the company and its members to focus more clearly on the financial impact of that transaction.

I note that Division 3A of the Insurance Act now requires court approval of certain transactions entered into by a general insurer. Section 17B(l) provides:

(1) No part of the insurance business of a general insurer may be:

(a) transferred to another general insurer; or

(b) amalgamated with the business of another general

insurer; except under a scheme confirmed by the Federal Court.

Section 17B(3) provides that the scheme must set out:

(a) the terms of the agreement or deed under which the

proposed transfer or amalgamation is carried out; and

(b) particulars of any other arrangements necessary to give effect to the scheme.

Policyholders and APRA are to be notified of the scheme and s. 17E allows APRA to be heard on any application for court approval. This is similar to the scheme that applies in respect of transfers or amalgamations of life insurance business under Part 9 of the Life Insurance Act 199 5.

Thus a transaction like that between HIH and Allianz would now require court approval on the application of both HIH and Allianz. I consider this to be an appropriate requirement. The fact that such a transaction now attracts particular treatment under the Insurance Act does not detract from the comments and recommendations made in respect of chapter 11 of the Listing Rules.

254 Regulation of general insurance

10

II

12

13

14

15

16

17

18

19

20

21

Recommendation 47

I recommend that the Australian Stock Exchange clarify Listing Rule 11 .1, so that it applies to any significant change in the business or assets of a listed company, whether it be by acquisition, disposal , amalgamation or otherwise. I further recommend that the ASX amend the Listing Rules

to define 'significant change' , so that it encompasses financial and geographic factors as well as

the nature and scale of the company's business.

Recommendation 48

I recommend that the Australian Stock Exchange amend Listing Rule 11.2, so that it applies to any disposal of the whole or substantially the whole of the assets or operations of a listed company.

Financial System Inquiry 1997, Final Report (S. Wallis, Chair), Australian Government Publishing Service, Canberra, p. 177.

CMC0.0071.001 at 002 to 003 . Financial System Inquiry, op. cit. , page 545.

Senate Select Committee on Superannuation and Financial Services, 2001 , Prudential supervision and consumer protection for superannuation, banking and financial services, first report, p. 14.

WITS.0251.001 at 004 par. 13 (Cameron).

APRA Annual Report 2002, p. 16.

SUBP.0006.001 at 002 pars 1.4 and 1.5.

Financial System Inquiry, op. cit., p. 536.

WITS.Ol49.001 at 057 par. 9.3.2. International Association of Insurance Supervisors, 2000, Insurance Core Principles, pp. 6- 7.

For example Insurance Act I973 s. 2l(l)(b).

For example Insurance Act I973 s. 49M.

For example In surance Act I973 ss. 12, 18 and generally, Part VI.

Financial System Inquiry, op. cit. , recommendation 33 , p. 43 .

CMC0.0056.001 at 042. The ISC was part of the Department of Treasury.

Section 15 of the Insurance Act 1973.

Section 9A of the Banking Act 1959. Section 10 of the Australian Prudential Regulation Authority Act 1998.

CMC0.0062.001 at 011 par. 1.12. That Bill proposes the introduction of a new Part VI to the Banking Act which deals with reconsi deration and review of decisions. The classes of decisions wh ich are to be

The failure of HIH Insurance 255

22

23

24

25

26

27

28

29

30

31

32

33

34

35

36

37

38

39

40

41

42

43

44

45

46

47

48

49

50

51

52

256

made reviewable are certain decisions affecting individuals. An example of a decision that would become reviewable is the disqualification of a director or senior manager under s. 21 on the grounds that they are not fit and proper.

CMC0.0056.001 at 042.

Administrative Review Council, 1999, What decisions should be subject to administrative review?, Attorney General's Department, Canberra.

WITS.0149.001 at 058 .

WITS .0149.001 at 048 par. 8.5.5.

CMC0.0056.001 at 004.

Senate Select Committee on Superannuation and Financial Services, op. cit., p. 30.

See for example CMC0.0042.003 at 012 ; CMC0.0037.295 at 312; CMC0.0056.001 at 009; CMC0.0044.008 038 .

CMC0.0042.003 at 016.

CMC0.0042.003 at 015 .

CMC0.0037.295 at 312.

CMC0.0062.001 at 022.

CMC0.0062.001 at 022.

CMC0.0049.004 at 008 .

CMC0.0044.008 at 012.

CMC0.0062.001 at 035.

CMC0.0056.001 at 035.

CMC0.0062.001 at 040.

CMC0.0056.00 l at 034.

CMC0.0056.001 at 004 . .

CMC0.0044.008 at 038.

CMC0.0056.001 at 036.

CMC0.0056.001 at 036.

CMC0.0056.001 at 046. See s. 3( 1) of the Insurance Act.

CMC0.0056.001 at 043; CMC0.0049.004 at 015.

See ss. 5, 99 and 100. See, for example, CMC0.0056.001 at 043 ; and CMC0.0049.004 at 015 .

CMC0.0068.001 at 007 pars 29 to 30.

SBB.214.081_00l; SBB.214.082_001.

11th ed, 2003 , par. l 0.01 0.

CMC0.0045.00 I at 003 to 004. ..

Regulation of general insurance

53

54

55

56

57

58

59

60

61

62

63

See Australian Stock Exchange, ' Guidance Note 8-Continuous Disclosure', January 2003, p. 14 par. 76. Australian Securities and Investment Commission, 'Heard on the grapevine', discussion paper, November 1999, p. 17 par. 39.

[2003] NSWSC 85. [2003] NSWSC 85 at par. 67. CMC0.0066.001 at 005 par. 18. WITS.0243.049. WITS.0243 .00 1 at 011 par. 34.

WITS.0243.001 at 011 to 012 par. 35 . Tl8312/9 to Tl8312/ 12. SBB.002.485 001 at 485 002. - -CMC0.0066.001 at 010.

The failure ofHIH Insurance 257

9 State and territory reg ulation

General insurers are subject to extensive regulation by state and territory governments as well as by the Commonwealth. In addition state and territory government insurers themselves provide a range of insurance services. This involvement of the states and territories gives rise to fragmentation in the Australian insurance market and adds to the complexity of that market for those who conduct business in it.

Historically, the states and territories have become involved in insurance for reasons of social policy. For example, the insuring of certain classes of risk such as workers compensation was made mandatory in all parts of Australia to ensure universal coverage of third party risks. States have also sought to influence the affordability of certain classes of insurance, such as compulsory third party insurance for owners of motor vehicles.

By underwriting insurance in some classes on a monopoly basis, some states and territories have prevented private insurers from entering those markets. The states and territories also apply many additional regulatory requirements to companies that underwrite business under mandatory schemes. These requirements vary between jurisdictions. In addition, there is regulatory overlap between the states and

territories and the Commonwealth.

Overall there is a lack of clarity and coordination regarding the operation of these various regulatory layers. The complexity and overlay of regulation imposes an additional burden on general insurers. It must also be difficult for those in the industry, and those who oversee it, to grasp the full implications of particular

interventions or measures for the health and viability of the industry as a whole. I see a need for considerable improvement in the coordination of Commonwealth, state and territory regulation of insurance together with minimisation of the gaps, overlaps and inconsistencies between these schemes. Action of this kind would enhance the viability and competitiveness of general insurance services in the Australian market.

This Commission was established by the Commonwealth Government and has no formal recognition under state or territory legislation. I recognise that I have no authority arising under legislation or the Letters Patent to make recommendations that affect matters purely within the province of states and territories.

During the inquiry I heard some evidence about the regulation of HIH by two of the state bodies. I make no criticism of those bodies in this report. I have also considered numerous submissions that deal with, among other things, matters affecting the administration of the general insurance industry by states and

The failure of HIH Insurance 259

territories. I have formed views about some matters that affect states and territories that I believe, if implemented, would enhance the system of prudential regulation generally and have a beneficial effect on insurance services.

I have decided to enunciate those views in the form of recommendations. The recommendations that affect matters purely within the province of the states and territories are framed in the same way as those addressed to the Commonwealth. This is presumptuous and I recognise that it may be regarded as infelicitous. I mean no discourtesy. I have set out the recommendations in this way in the hope that they will be of some assistance to all those who are concerned with the subject of insurance regulation.

9.1 State a nd t erritory regulation

Section 51 (xiv) of the Constitution confers power on the Commonwealth parliament to make laws with respect to:

insurance, other than State insurance; also State insurance extending beyond the limits of the State concerned.

The Commonwealth by s. 51(xxxix) also has power to makes laws with respect to matters incidental to the power invested by s. 51 (xiv). Pursuant to s. 122, the Commonwealth has plenary power to make laws for the government of territories. The Commonwealth also has power to make laws with respect to foreign corporations and trading or financial corporations formed within the limits of the Commonwealth and with respect to matters incidental to this power: ss. 51 (xx) and 51 (xxxix).

Thus the Commonwealth does not have legislative power with respect to 'State insurance' that does not extend beyond the limits of the state concerned. The Commonwealth's power with respect to territory insurance has no such limitation.

State insurance is insurance that is provided by the state acting as the underwriter, whether directly or through an agent. 1 Although the grant of power under s. 51(xiv) includes ' State insurance extending beyond the limits of the state concerned', the Commonwealth has not sought to exercise the full extent of its legislative power in enacting the Insurance Act, which expressly does not apply to such insurance.

2

The Commonwealth does not have exclusive power under s. 51(xiv) to legislate with respect to insurance other than State insurance. The states may enact legislation relating to insurance provided it is not inconsistent with Commonwealth laws: s. 109 of the Constitution. However, ss. 99 and 100 of the Insurance Act 1973 in effect preserve the ability for states and territories to have statutory schemes of insurance that might otherwise offend s. 1 09, although a private insurer carrying on insurance business pursuant to a state or territory statutory scheme must still be authorised under the Insurance Act. 3 So, in enacting the Insurance Act, the

260 State and territory regulation

Commonwealth has not sought to utilise the full extent of its legislative power under s. 5l(xiv).

The states and territories have established statutory schemes across a number of different compulsory classes of insurance. Some of these schemes involve private insurers underwriting policies of insurance in accordance with state or territory regulation. In other words, the state or territory controls the determinants within which private companies underwrite (and so bear the risk for) such insurance, but the state or territory does not itself underwrite the insurance business.

The main interest of state and territory governments in general insurance is in the lines of business that, as a matter of social policy, have been made compulsory. The most notable of these are third party motor vehicle insurance, workers compensation insurance and builders warranty insurance.

At the present time the compulsory third party schemes in Victoria, Western Australia, South Australia, Tasmania and the Northern Territory are either government underwritten or administered. A similar position applies with the workers compensation schemes in New South Wales, Victoria, Queensland and

South Australia. Those schemes that are underwritten by a state or territory operate either through direct underwriting by the state or territory or through a private insurer acting as agent. In both instances, the state or territory bears the risk. The position is more complicated where the state administers the scheme through a

managed fund, such as occurs with the New South Wales WorkCover scheme.

Private insurers underwrite compulsory CTP schemes in New South Wales, Queensland and the Australian Capital Territory. In Western Australia, Tasmania, the Australian Capital Territory and the Northern Territory private operators underwrite compulsory workers compensation insurance. The private insurers underwriting these compulsory lines must be authorised as 'general insurers' under the Insurance Act.

The states and territories impose a range of legislative conditions on private providers of statutory insurance. Such conditions relate to the scope of coverage, price controls, and the requirement for insurers to provide statistical and other information to state and territory regulators. As discussed in the next section, states and territories also engage in some limited prudential regulation.

State and territory governments also usually play a nominal defendant role when statutory insurance is provided by private insurers. The nominal defendant meets the liability involved when the actual defendant is not insured or cannot be located or in cases where a private insurer is unable to meet the costs of an insured event. This

may occur if the insurer becomes insolvent. Accordingly, state and territory governments that operate statutory schemes underwritten by private insurers have an interest in the solvency and hence in the general prudential regulation of the private insurers that write statutory business.

The failure ofHIH Insurance 261

The states and territories can also have significant impact on the cost structure of general insurers, particularly through legislative intervention in areas of tort law. Tort Jaw reform has received considerable attention recently, in large part because of the escalating cost of public and professional liability insurance cover. The submission of Insurance Australia Group dealt with the topic of tort law reform in detail and canvassed issues such as the design of a ' best practice compensation scheme'. The submission identified a number of important issues that deserve careful consideration in an appropriate forum. This topic is not directly relevant to the Commission's terms of reference, however, and is not considered further.

9.2 Overlap between Commonwealth, state and territory regulation

To a large degree the regulatory regimes of the Commonwealth and those of the states and territories have a different focus. There is however overlap in some areas.

9.2.1 Prudential regulation

The submissions received by the Commission indicate that states and territories generally do not impose prudential requirements upon private insurers involved in statutory schemes in their jurisdictions. Because private insurers must be authorised under the Insurance Act to carry on insurance business they are subject to prudential supervision by APRA. They are often involved in areas of insurance business that extend beyond those regulated by the particular state or territory. Accordingly, state and territory governments generally rely on the fact that APRA is prudentially supervising the entire business of the private insurers with which they are concerned.

The New South Wales Motor Accidents Authority and the Motor Accident Insurance Commission of Queensland appear to be the only state authorities that undertake any conspicuous degree of prudential supervision of general insurers.

Under the Motor Accident Insurance Act 1994 (Qid), one ofMAIC's functions is to establish and revise prudential standards with which licensed insurers must comply: s. lO(l)(b). In determining those standards, MAIC must have proper regard to the prudential standards that apply under Commonwealth legislation: s. 1 0(2). MAIC may only grant a licence to an insurer if it is satisfied that the applicant has sufficient financial resources to carry on business as an insurer: s. 63. A licensed insurer must file certain returns and documents with MAIC: s. 70. MAIC may appoint a qualified person to audit or inspect the records or financial position of an insurer or to carry out an actuarial investigation into the assets and liabilities of an insurer: s. 71. MAIC may also appoint a person to investigate the affairs of a licensed insurer: ss. 74 to 87.

In practice, MAIC relies on the prudential supervision carried out by APRA. MAIC maintains regular contact with APRA in order to monitor the solvency, reinsurance

262 State and territory regulation

arrangements and ongoing financial viability of insurers in its jurisdiction. MAIC observed that while in theory it could prudentially supervise the CTP component of an insurer's business, it is not empowered or resourced to supervise non-CTP insurance activities, activities undertaken outside Queensland or reinsurance matters. In contrast, APRA is able to focus on the financial health of a company as a whole. 4 Also, MAIC submitted that under the Motor Accident Insurance Act it does not have a role in ensuring that premium income will be available to meet claims or that insurers adequately provision for claims. Rather, MAIC sees this as the

responsibility of APRA. 5

MAIC indicated that it is considering a number of options to reduce the risks it faces from the potential failure of private insurers. 6 Some of the options involve elements of prudential regulation, such as the imposition of solvency 'buffers' secured by trust arrangements. A concern with this approach is that the imposition of such requirements would in effect operate to quarantine a company's assets for the purpose of CTP liabilities and may have implications in relation to a company's ability to meet the capital adequacy requirements under APRA's prudential

standards.

In New South Wales MAA has a range of powers and duties in relation to the oversight of the financial position of licensed CTP insurers. Section 5(1 )(c) of the Motor Accidents Compensation Act 1999 (NSW) provides that an object of that Act is to promote competition in the setting of premiums for third party policies, and to

provide MAA with a prudential role to ensure against market failure. MAA may impose conditions on licences such as conditions to ensure that insurance premiums for CTP are available to meet claims: ss 161 and 162. A licensed insurer must notifY MAA of its reinsurance arrangements and certain limitations apply with respect to the proportion of premiums that may be paid for reinsurance relative to gross direct premium: s. 174. A licensed insurer must also keep certain records and lodge returns with MAA: s. 176. MAA may appoint a qualified person to audit or inspect such

records, or may conduct such an audit itself, to determine the profitability of a licensed insurer: s. 177.

As with MAIC, MAA largely relies upon the prudential supervision of APRA as a means of ensuring that New South Wales CTP insurers are financially sound. It also relies on information sharing with APRA to monitor the financial health of participants in the CTP scheme. 7

The New South Wales Government submitted that it is appropriate that the mandatory state schemes continue to rely on APRA's supervision of general insurers as a means of ensuring that participants in the statutory schemes are prudentially sound. It would be a waste of time and public resources for states to engage in close prudential supervision in addition to that undertaken by APRA. The New South Wales Government also observed that the Financial System Inquiry

demonstrated that the financial services sector requires regulation at the national level. 8

The failure ofHIH Insuran ce 263

The Insurance Council of Australia submitted that APRA should be the only regulator responsible for prudential regulation so as to avoid duplication and unnecessary compliance costs. The ICA submitted that consequently APRA should be the sole authorising body for entities underwriting general insurance, including entities underwriting statutory insurance. 9

The New South Wales Government agreed that APRA should continue to be the national prudential regulator. But it said it would not support a system whereby APRA would be the sole licensing authority for insurance providers across Australia.10

I agree that states and territories should have a role in the licensing arrangements for insurers providing cover under compulsory statutory schemes. I also agree that states and territories have an interest in the financial viability of such insurers. This is particularly the case where nominal defendant schemes render the states and territories responsible for meeting the costs of valid claims in cases in which the private insurer has become insolvent and is unable to meet claimants' entitlements.

On the other hand, although the Commonwealth has chosen not to cover the field in relation to the regulation of insurance, I consider that it is neither administratively efficient nor cost-effective for state and territory agencies to be involved in prudential regulation. This is because state and territory schemes are focused upon specific classes of business. It also represents an additional cost for insurers. The imposition of additional prudential requirements by a state or territory for the protection only of policyholders in a particular statutory class may undermine APRA's ability to regulate for the benefit of policyholders of a general insurer as a whole. In this context, APRA pointed out that the actions of a state or territory regulator can impact on the entire business of the insurer, even though the interest of that regulator is on a single line of business. 11

Recommendation 49

I recommend that the states and territories not undertake any prudential regulation of general insurance. The Australian Prudential Regulation Authority should be the sole prudential regulator in this field.

If such regulation is to continue, state and territory governments should ensure that it is consistent

with the requirements of the Insurance Act 1973. This is a matter that might properly be referred to

the proposed ministerial council.

To the extent that states and territories continue to involve themselves in prudential regulation, greater cooperation and information exchange between APRA and state and territory instrumentalities will ·improve the effectiveness of prudential regulation. Where not already in place, APRA should seek to establish memorandums of understanding with state and territory instrumentalities to facilitate cooperation and the exchange of information. Existing memorandums of understanding should be reviewed to confirm their effectiveness. To further facilitate the exchange of information regarding the prudential regulation of relevant

264 State and territory regula r ion

general insurers, APRA and the state and territory instrumentalities should review whether applicable secrecy provisions give rise to inhibitions on the free flow of information, in which case appropriate amendments should be sought to address this. Where secrecy provisions contemplate the taking of further steps to facilitate the flow of information, such as making regulations or entering agreements, this should be done.

Recommendation 50

I recommend that, to the extent that states and territories continue to involve themselves in prudential regulation, the Australian Prudential Regulation Authority should share all information relating to the prudential regulation of relevant general insurers with relevant state and territory

bod ies .

The states and territories should provide APRA with all relevant information that may concern the

financial condition of relevant general insurers. This exchange of information should proceed through memorandums of understanding between APRA and each relevant state and territory

body.

APRA and the state and territory instrumentalities should review applicable secrecy provisions and

where necessary seek legislative action to ensure they do not inhibit the free flow of information

between APRA and the instrumentalities relevant to the prudential regulation of general insurers.

Effect of a policyholder support scheme In Chapter 11 I have recommended the introduction of a policyholder support scheme that ideally should assume the state and territory nominal defendant roles with respect to insolvent insurers. Should the Commonwealth adopt this

recommendation, the states and territories will have less interest and need to be involved in prudential regulation.

The New South Wales Government submitted that while a national support scheme may increase regulatory efficiency by removing some duplication, there would remain a need for claims to be managed according to the claims management rules of the relevant mandatory scheme. The submission also noted that nominal

defendant schemes serve an important function where the defendant cannot be identified or has failed to take out compulsory insurance and that it is unlikely that a national fund could replace the nominal defendant schemes altogether. 12

I agree with

this proposition.

9.2.2 Overlap amongst the various licensing regimes

The states and territories impose various licensing conditions on private insurers that underwrite statutory classes of business or manage statutory schemes. The conditions may include claims handling and reporting requirements, contractual forms and conditions and price controls. These requirements impose compliance

costs on general insurers and vary across state and territory boundaries. Where a

The failure of HIH Insurance 265

general insurer operates in a number of jurisdictions, variations of this kind give rise to additional compliance costs.

In its submission lAG advocated a consistent approach to regulation across jurisdictions so as to keep compliance costs down. lAG contended that the current patchwork of arrangements ' do essentially the same thing' and create direct and indirect compliance costs borne by consumers and the wider community. 13

Examples of indirect costs include the need to undertake staff training tailored for different jurisdictions, dispersal of expertise, fragmentation of claims data and systems duplication. One insurer estimated that the cost to it of developing a system to facilitate compliance with particular multiple jurisdictional requirements was approximately $17.5 million.

The ICA submission drew attention to the consequential exposure of the industry to a significant level of political risk; the operating rules for the industry may be subject to change at any time by up to nine govemments. 14

This is an important issue, especially given the relatively small size of our general insurance market. As a general proposition fragmentation of the Australian market is undesirable. It adds to the cost of conducting insurance business and reduces opportunities for private insurers to spread risk. There is the potential for meaningful benefits if the present regulatory inconsistencies between state and territory statutory schemes could be removed or minimised.

Recommendation 51

I recommend that the states and territories implement a process designed to reduce inconsistencies in their statutory schemes. This is a task that would appropriately be overseen by

the proposed ministerial council.

9.3 State and territory monopolies

Some states and territories directly underwrite certain statutory classes of insurance under monopoly arrangements. A state or territory monopoly is not subject to the Insurance Act or supervision by APRA. 15

The Commission received submissions to the effect that states and territories should not be involved in underwriting insurance on a monopoly basis and that such business should be open to competition.

ICA argued that private general insurers are best placed to assess, price and underwrite risk for statutory lines of insurance. 16 The arguments advanced in support of this submission included:

• governments have a tendency to underprice risk as they are not subject to the same prudential requirements as authorised general insurers. This means that funding must be supported by state or territory taxpayers

266 State and territory regulation

• excluding authorised insurers reduces the size of the Australian insurance market, thus reducing opportunities for authorised insurers to spread risk

• competition can bring benefits in terms of wider choice and lower pricing.

The broad thrust of many submissions was that state and territory monopolies operate to fragment and distort the Australian market for general insurance services. In this context, ICA submitted that the potential for economies of scale and innovative national approaches in the general insurance market is adversely affected by the involvement of state and territory governments in the underwriting of

insurance outside the requirements of the Insurance Act. This was said to be the case whether they operated on a monopoly basis or otherwise. ICA submitted that the creation of a genuine national market for lines of statutory insurance could enhance the stability of the industry by:

• increasing market size

• increasing knowledge and expertise in the line of insurance

• providing better quality claims data and consistent data collection

• providing greater incentives for insurers to fund national research and development initiatives. 17

There are several reasons why states and territories might prefer to underwrite insurance directly, rather than through the use of private providers, including:

• the desire to exercise direct control over the provision of insurance in order to achieve certain policy objectives, such as lower prices

• the desire to reduce their exposure to the risk of insolvency given that they would otherwise cover unmet obligations under nominal defendant schemes

• to take advantage of potential economies of scale, such as in administration costs, through a monopoly scheme.

The New South Wales Government submitted that while the insurance industry has pressed for private underwriting, it would be premature to adopt such a position. New South Wales is currently undertaking a comprehensive review of its WorkCover scheme (which involves private insurers managing a statutory fund for

a fee but not taking on risk) including restrictions on competition and management of the financial risk to government. 18

MAIC observed that the collapse of HIH challenges the assumption that private sector underwriting minimises risks for governments at both the state and Commonwealth level. 19

Opening the state and territory monopolies to competition would provide greater opportunities to private insurers to spread risk. It would also be consistent with national competition policy principles. On the other hand, the states and territories may have other reasons for supporting these schemes, such as reducing the price of

The failure ofHJH Insurance 267

particular insurance products. Resolving these competing benefits is essentially a matter for governments. The outcome of the New South Wales Government's review of its W orkCover scheme will be of interest in this regard.

A policyholder support scheme as proposed in Chapter 11 would not cover policyholders of insurance underwritten by state and territory governments. In contrast, policyholders of private general insurers would be covered in the event of a failure . This would include private insurers providing statutory insurance in states or territories, but only where the state or territory relinquished any nominal defendant role. If my proposal for a policyholder support scheme were to be adopted, it may provide a further reason for state and territory governments to allow their monopolies to be underwritten by private insurers on the basis that the states and territories would not bear the cost of the failure of a private insurer.

9.4 Prudential regulation of State insurance

The ICA and lAG submitted that if state and territory governments are to continue to underwrite insurance, they should be subject to APRA's prudential and reporting standards. 20 A similar view was also expressed by the Industry Commission in a 1994 report into workers compensation. 21

The New South Wales Government submitted that while the insurance industry has pressed for the application of APRA's standards to the existing WorkCover scheme, it would be premature to adopt such a position, particularly in light of the review it is currently undertaking. 22

Nevertheless, the application of appropriate prudential standards to state and territory insurers would improve their financial viability and thereby reduce risks for taxpayers. It would also make their operations more transparent and assist in the production of comparable data across relevant lines of business. Appropriate

standards could relate to the valuation of liabilities and risk and reinsurance management processes (although the relevant state or territory government might act as the reinsurer). Capital adequacy requirements could also be imposed, although this would need to involve an acknowledgment of the implicit capital backing of the relevant state or territory government.

In line with the principle of competitive neutrality it would be desirable if such prudential standards were so far as possible consistent with APRA's prudential standards.

Recommendation 52

I recommend that state and territory governments apply relevant prudential requirements to government insurers and statutory fund schemes. This is a matter that would appropriately be

overseen by the proposed ministerial council.

268 State and territory regulation

9.5 Price controls

Some states have begun allowing greater price flexibility to companies that underwrite statutory insurance. MAIC's submissions referred to a comprehensive review of the Queensland CTP scheme that was undertaken in 1999. MAIC said the review had examined the fundamentals of the scheme against the criteria of affordability and the national competition policy. As a result of the review amendments were made to the Motor Accident Insurance Act. One key initiative was the introduction of a competitive premium model that allows an insurer to determine premiums within floor and ceiling bands set by MAIC. Previously premiums were set by regulation and could not be varied by the insurer.Z 3

lAG pointed to the current model for premium setting in New South Wales CTP which, lAG believes, strikes a good balance. It involves an element of community rating, which preserves affordability and availability to all sections of the community, while allowing insurers some scope to reward good risks.24

In the context of price flexibility, APRA observed that mono-line insurers face particular difficulties if states or territories exercise uncommercial price control or otherwise interfere in underwriting-an example of interference is prohibiting the refusal of certain risks. A mono-line insurer is an insurer that provides only one line of statutory insurance in a particular state or territory. According to APRA,

uncommercial regulation by states or territories has the potential to erode profits and threaten the solvency of such insurers.Z 5 The ICA also observed that, in the case of insurers with a diversified product range, uncommercial regulation in one product line can often be cross-subsidised by other more profitable lines of business.

26

Distortions and risks of this kind should be avoided.

Any price controls imposed by states and territories on statutory insurance underwritten by private insurers should take account of the full cost of providing that insurance, including the cost of complying with APRA' s prudential standards.

Recommendation 53

I recommend that the states and territories consider allowing greater price flexibility in their statutory schemes. This is a matter that would be appropriate for consideration by the proposed

ministerial council.

9.6 Cooperation between governments

The matters discussed in this chapter, together with the emergence of serious issues relating to medical indemnity coverage and tort law reform, suggest to me that there is a need for a ready forum for the discussion and resolution at a national level of issues affecting the general insurance industry. At present there is no standing

intergovernmental arrangement that lends itself to discussion of these issues on a structured basis. The need for a forum of this type is the more acute given that

Th e failure of HJH Insurance 269

responsibility for insurance matters m vanous states and territories IS allocated across several ministerial portfolios.

An intergovernmental forum would enable issues of broad application to the industry to be discussed. I have in mind matters like the impact of price controls and overlaps in prudential regulation. It would facilitate the negotiation of these issues between governments. The Commonwealth Government should take the lead in developing an appropriate vehicle to achieve this through a ministerial council or

like arrangement. A national forum of th is kind would also help the industry or others with an interest to find a way to ventilate issues of broad concern.

The immediate objective of establishing a standing arrangement of this kind would be to consider measures to avoid duplication of prudential oversight and other regulatory inconsistencies, to oversee the move towards a more consistent and effective approach to the prudent management of state and territory monopolies and the introduction of greater price flexibility to statutory schemes.

Other matters that might be addressed through such arrangements include the policyholder support scheme proposed in Chapter 11 and taxation of general insurance in Chapter 10.

Recommendation 54

I recommend that the Commonwealth Government move to identify or establish a ministerial council or like arrangement to provide a ready and regular forum for the discussion and resolution

by the Commonwealth and the states and territories of matters relevant to general insurance-and

perhaps to other financial services.

The ministerial council (or other similar body) should consider measures to :

• avoid duplication in the prudential regulation of general insurers

• remove regulatory inconsistencies

• achieve a consistent approach to the prudent management of state and territory monopolies.

It could also play a part in:

• moves to introduce greater price flexibility in statutory schemes

• the introduction of a policyholder support scheme

• the removal of anomalies in the taxation arrangements applicable to general insurers.

·'

270 State and territory regulation

4

See Bourke v State Bank of New South Wales ( 1990) 170 CLR 276; Melbourne Corporation v The Commonwealth (194 7) 74 CLR 31 both of which deal with the banking power in s. 51 (xiii) which is in analogous terms to s. 5l(xiv); see also Australian Health Insurance Association v Esso (1993) 41 FCR 450.

Section 5(1) of the Insurance Act. Section 99(2) of the Insurance Act. CMC0.0059.030 at 034 par. 1.3. CMC0.0059.030 at 036. CMC0.0059.030 at 041. CMC0.0068.001 at 003 par. 12.

CMC0.0068.001 at 004 par. 13. CMC0.0049.004 at 079. 1 ° CMC0.0068.001 at 006 par. 24. I I

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

CMC0.0056.001 at 058. CMC0.0068.001 at 005 par. 18. CMC0.0060.001 at 037; CMC0.0060.001 at 068 . CMC0.0049.004 at 014 and 077 .

Section 51 (xiv) of the Constitution and s. 5 of the Insurance Act. CMC0.0049.004 at 076. CMC0.0049.004 at 071. CMC0.0068.001 at 007 pars 32 to 33 . CMC0.0059.030 at 039. CMC0.0060.001 at 009; CMC0.0049.004 at 010. Industry Commission ( 1994), Workers ' Compensation in Australia, page 193.

CMC0.0068.001 at 007 pars 32 to 33 . CMC0.0059.030 at 032 .

CMC0.0060.001 at 077. CMC0.0056.001 at 058. CMC0.0049.004 at 073.

The failure ofH!H Insurance 271

,.

1 0 Taxation and general insurance

In addition to generally levied taxes such as company tax, the goods and services tax and payroll tax, the general insurance sector is subject to a number of industry­ specific state and territory taxes. These include stamp duties on insurance policies; fire services levies in New South Wales, Victoria, Tasmania and, until 30 June 2003, Western Australia; and the New South Wales insurance protection tax.

The Commission was required to take into account the different state and territory tax regimes in its inquiry into the adequacy and appropriateness of arrangements for the regulation and prudential supervision of general insurance. Two principal aspects are considered here:

• the impact of taxes that are specific to the insurance sector and the detrimental effects that such taxes may have on the solvency of general insurers and the overall strength and competitiveness of the general insurance industry in Australia

• whether other recommendations made in this report- particularly those relating to the accounting and prudential standards-suggest the need for adjustments to the tax system as it applies to the general insurance industry.

Account is also taken of what might be described as 'principles of good tax policy' -such as efficiency, simplicity and equity. In particular, consideration is given to whether the general insurance industry is taxed on a basis comparable with that applying to other industries, whether taxes are uniform across the country, and

whether taxes operate in a way that discourages people from prudently managing risk through insurance or penalises those who do.

In giving consideration to these questions, it is acknowledged that taxation matters must be considered by governments in a broader fiscal and budgetary context.

1 0.1 Current tax arrangements

10.1.1 Stamp duties

All states and territories impose stamp duties on insurance policies. These duties are calculated on the total premium, including any fire services levy and the goods and services tax.

The failure ofHIH Insurance 273

10.1.2 Fire services levies

New South Wales, Victoria and Tasmania impose a fire services levy on insurers to meet most of the cost of fire brigade services. The levies are determined as a percentage of the annual budget for the fire brigades, with insurance companies paying a pro rata amount in accordance with their market share.

Queensland, South Australia and the Australian Capital Territory have abolished their fire services levies, while Western Australia is planning to do so in June 2003. Those states and territories that do not impose a fire services levy fund fire brigade services either through consolidated revenue or by levying all property owners.

10.1.3 The goods and services tax

The goods and services tax is payable at a rate of 10 per cent on general insurance premiums as well as on other goods and services. GST is applied to the premium and the fire services levy but is not applied to stamp duties. GST applies to all forms of general insurance, including statutory insurance (that is, compulsory insurance underwritten by private insurers) and insurance underwritten by the states and territories, save for workers compensation in Tasmania. GST is imposed by the Commonwealth and the revenue raised is provided to the states and territories.

10.1.4 The New South Wales insurance protection tax

Following the failure ofHIH, New South Wales introduced an insurance protection tax to cover the shortfall in compulsory third party insurance and builders warranty insurance.' The amount of tax collected from each insurer is based on the insurer' s share of total annual premiums. Insurers are prohibited from charging policyholders any amount that is directly attributable to the tax.

10.1.5 The Victorian building industry levy

To help meet HIH claims, Victoria imposed a building industry levy aimed at collecting a total of $70 million to $80 million. 2

10.1.6 The Queensland FAI-related insolvency levy

After the failure of HIH Queensland imposed a $5 per vehicle per year levy on compulsory third party premiums to cover the cost of the failure of FAI (a previously licensed CTP provider in Queensland), with the balance of the shortfall being met by the government.

10.1.7 The Tasmanian workers compensation levy

Tasmania introduced a 4 per cent levy on workers compensation policies issued to employers to help fund the cost of the collapse of HIH. Self-insurers and state government agencies are also required to pay the levy.

274 Taxation and general insuran ce

10.1.8 The Western Australian workers compensation levy

Western Australia imposed a 5 per cent levy on all workers compensation policies issued to employers on or after 25 June 2001 to help fund the cost of the collapse of HIH. The levy was reduced to 3 per cent from 1 July 2002.

10.1.9 Industry levies to fund corporate regulation

The Commonwealth imposes a levy on general insurers (and other financial services businesses) to help fund financial services regulation and in particular the operations of the Australian Prudential Regulation Authority. According to the Insurance Council of Australia, the general insurance industry was levied $8.4 million in 2001-02 as its contribution to the funding of APRA and the Australian Securities and Investments Commission; this compares with $3.7 million in 1998-99.3 The states and territories also impose a number of levies to meet the cost of regulating statutory schemes.

10.2 The incidence of tax a tion

According to a study by Deloitte Touche Tohmatsu, total taxes (including the GST) on home property insurance range from 19 per cent of the base premium in Tasmania to 45 per cent in country Victoria.4 Taxes on business property insurance range from 19 per cent in Queensland to 84 per cent in country Victoria.

In those states in which it applies, the fire services levy ranges from 16 per cent in metropolitan Victoria to 24 per cent in country Victoria. Stamp duty varies from a rate of zero on some types of statutory insurance in some states and territories to 11 per cent on certain classes of cover in South Australia.

In its submission, Insurance Australia Group noted Australian Bureau of Statistics data that taxes on insurance amounted to $2.4 billion in 2000-01, up 12.3 per cent on 1999- 2000, and accounted for 1.1 per cent of total taxes raised in Australia.

10.2.1 International comparisons

The Insurance Council of Australia submitted that taxes on general insurance in Australia are considerably higher than in similar foreign countries. 5

According to

the Deloitte Touche Tohmatsu study, the tax rate levied on household insurance was higher in all Australian states and territories than the rate levied in South Africa, Germany, France, the United Kingdom, Canada (Ontario), the United States (C alifornia), Ireland, Singapore, Hong Kong and Japan.

6

The position with

commercial fire insurance is similar.

The failure of HIH Insurance 275

10.3 The impact of sales and turnover taxes

10.3.1 Tax rates

In a 2002 paper, Geoff Carmody of Access Economics presented figures comparing tax rates on general insurance in an international context. 7 Victoria and New South Wales had the highest tax rates-over 80 per cent of the basic premium in the case of Victoria and almost 70 per cent of the basic premium in the case of New South Wales. The highest international rate referred to was in France, with taxes at 30 per cent of basic premiums. As noted, insurers are subject to a number of industry­ specific taxes, many of which take the form of sales taxes being directly levied on policies (such as occurs with most stamp duties) or turnover taxes (as is the case with fire services levies). The practical effect of these taxes is to raise the price of policies as insurers cover the cost of taxes through higher premiums.

High rates of sales and turnover taxes on insurance policies could have a detrimental effect on the solvency position of general insurers. This is because they increase the cost of policies, which could in turn reduce demand for insurance and hence the scope for insurers to pool risk. As APRA noted in its submission to the

Commission,

In very simple terms, insurance works on the principle of pooling and diversifYing risk. The more diversified an insurance portfolio becomes, the more predictable its loss characteristics will tend to be, and the more easily an insurer will be able to price, reserve and manage the business. If taxation arrangements act to discourage consumers from taking out insurance policies by making it more costly to do so, this serves to limit the extent to which the benefits from pooling and diversification can be obtained. That said, at this point we have no analysis or other evidence to suggest whether existing taxation arrangements, while potentially impacting on consumers' decisions, materially impact on the risk management capabilities of insurers. 8

Whether or not the high rates of sales and turnover taxes affect the ability of insurers in the Australian market to diversify their portfolios and so better manage risk, their direct impact is almost certainly to discourage consumers from taking out insurance. Insurance Australia Group's submission included survey data suggesting that the principal reason behind consumers and small businesses not taking out insurance is the cost of premiums. 9 The Victorian Review of Business Taxes concluded that the fire services levy in that state 'contributes too great an impost on

insurers and insured alike, leading to under insurance, self insurance or free­ riding'.10 This point has a wider resonance.

Another potential consequence of high taxes is that they may encourage consumers to seek alternative, cheaper forn1s of insurance, through either discretionary-type arrangements or insurance underwritten offshore. The consequence, in the case of insurance underwritten offshore, is that the consumer does not gain the protection of Australia's system of prudential regulation. Depending on the jurisdiction, there may be less protection from consumer protection laws. Discretionary insurance

276 Taxation and general insurance

schemes are not prudentially regulated and may therefore be subject to a higher risk of failure compared with licensed general insurers. 11

Tax theory also suggests that in many instances high tax rates can be inefficient because they impose significant economic costs on society by reducing demand and discouraging activity. In the past it may have been thought that imposing high taxes on insurance was a relatively efficient way to raise revenue. This was based on the view that demand for insurance products is relatively price-inelastic-that is, demand for insurance is not responsive to changes in price. It has been suggested that this view might be incorrect. In a submission to the Victorian Review of Business Taxes, Access Economics argued that insurance is more responsive to price changes than had been originally thought. 12 To the extent that this is the case, the high rates of sales and turnover taxes levied on insurance products are likely to

involve significant economic costs. As noted by the Victorian Review of State Business Taxes,

The conclusion of studies (by groups including the Productivity Commission, The Heads of Treasuries State Taxes Working Group, comprising representatives of all state and territory Treasuries; and Access Economics) is that stamp duties and transaction taxes are among the most

distortionary of all taxes available to the states. The Committee believes that .. . abolishing them now would nurture business activity and growth. 13

Another reason why high rates of sales and turnover taxes on insurance products should be discouraged concerns the inherent benefits to individuals, third party claimants and the community more broadly that arise from the taking out of appropriate insurance cover. Such taxes have been described as 'taxes on virtue'. This is the converse of the argument that high taxes should be imposed on products associated with high social costs-such as alcohol and tobacco. In addition, governments usually face significant pressure to compensate victims when disasters

strike. The cost of such compensation will be higher if high rates of taxation discourage people from arranging adequate insurance cover.

The potential impact on the wider community of under-insurance was demonstrated in the aftermath of the recent bushfires in Canberra and its surrounding areas. Whether due to the cost of insurance or other factors, around one-quarter of the affected households were uninsured or under-insured. The ACT Government's

response to this disaster was to make an additional grant of $5000 to each affected household without contents insurance. This is in addition to the base grant of $5000 that was provided to all those whose homes were destroyed in the fires.

These arguments lead to the conclusion that state and territory governments should abolish, or at least reduce the incidence of, sales and turnover taxes on general insurance policies-having regard to the overall social utility of insurance arrangements and the risk of dampening demand for them. At the very least,

international comparisons of tax rates suggest that overall sales and turnover taxes on general insurance products in parts of Australia are well above an optimal level.

The failure ofHIH Insurance 277

The high tax rates on general insurance products are in large part attributable to state and territory stamp duties and fire services levies. The broadly based GST is also imposed on general insurance policies. The revenue received by the states includes not only stamp duty and (in the states that impose them) fire services levies but also the proceeds of the GST, which are passed to the states and territories. In effect, a significant proportion of the total premium for each policy is paid to the states and territories through various taxes; in other words, different taxes are levied on the same narrow tax base.

Appendix B to the Insurance Council of Australia's submission suggested that the proportion of premiums on home property insurance policies for metropolitan areas that is attributable to state and territory taxes as well as GST, as at August 2002, ranged from 18.8 per cent in Tasmania to 41.4 per cent in Western Australia.14 The range in country areas is shown as 18.8 per cent in Tasmania to 50.0 per cent in Victoria. Appendix C to the ICA submission set out similar data for business property insurance. The metropolitan range is shown as 19.4 per cent in Queensland to 62.1 per cent in Victoria. The range for country areas is 19.4 per cent in Queensland to 87.6 per cent in Victoria.

As noted, GST is applied to insurance premiums and any fire services levy. Because fire services levies are not uniform across the states, GST on the same policy with the same base premium will vary between states. It will also vary from region to region within a state because the fire services levy is itself calculated as a percentage of base premiums. For example, the GST on a $1000 base premium household property policy in rural Victoria, New South Wales and the Australian Capital Territory is $124, $118 and $100 respectively. Good tax policy suggests that, as far as possible, Commonwealth taxes ought to be imposed with uniform effect across Australia. The discriminatory effect and lack of equity- not only between states and territories but, of at least equal importance, between regions within states-is obvious. It is undesirable that the application of GST to fire services levies should give rise to this result. This anomaly would be corrected if fire service levies were abolished.

The impact on the insurance sector of these various industry-specific taxes is inequitable and should be redressed. The 2001 Victorian Review of State Business Taxes similarly recommended that stamp duty on insurance products be abolished and that the fire services levy be replaced with a charge on all rateable property.

Recommendation 55

I recommend that state and territory governments abolish stamp duty on general insurance products. It would be appropriate for this process to be coordinated through the proposed

ministerial council with responsibility for general insurance.

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10.3.2 Fire services levies

As noted, New South Wales, Victoria and Tasmania impose a fire services levy on household insurance policies. The New South Wales Government argued in its submission that a ijre services levy is a fair contribution by the industry to the costs of essential emergency services that have a direct role in reducing the industry' s overalllosses. 15 However, all property owners (whether insured or not) benefit fro m fire protection services and the insurance industry generally passes the levies on to customers. This means that in the relevant states the costs of providing fi re protection services are borne disproportionately by property owners who choose to take out insurance.

Ideally, the cost of providing fire services levies should be met by all property owners. This question was also considered by the Victorian Review of State Business Taxes, which recommended,

Shifting the funding for fire services away from those who currently insure their properties to all property owners, as a separate item on local government rates notices , would achieve greater equity in supporting the fire services. 16

Recommendation 56

I recommend that those states that have not already done so abolish fire services levies on insurers.

10.3.3 Cascading taxes

What has been described as the 'cascading' application of taxes on general insurance gives rise to further anomalies. This is because the GST is levied on the basic premium, including the cost of fire services levies, and stamp duties are levied on the whole premium, including both fire services levies in those states that have them and the GST. Stamp duties could therefore be described as a ' tax on a tax on a tax' in New South Wales, Victoria and Tasmania.

This treatment lacks transparency, is inequitable, and is contrary to good tax policy. While cascading taxes may not have a significant effect on the solvency of general insurers, they do increase the cost of insurance policies. For example, Appendix C to the Insurance Council of Australia' s submission showed the effect of cascading

taxes on property insurance in rural Victoria as being 12.6 per cent of the base premium- $12.60 on a $100 policy. In this regard, the Victorian Review of State Business Taxes noted,

The abolition of stamp duties on insurance will eliminate the invidious situation of taxes being charged on other taxes, a problem that is brought into sharp relief when he fire services levy, stamp duty on insurance and GST all appear on the one bill. 17

As noted, the discriminatory effect is even more marked when comparisons are made between the cost of insurance in different regions within a state or territory.

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The tax-on-tax effect of fire services levies as a consequence of the GST calculation will be avoided if, as recommended in Section 10.3.2, the remaining fire services levies are abolished. If they are not abolished, the notional cost for fire services levies should be excluded from the calculation of GST on relevant insurance policies.

Recommendation 57

I recom.mend that state and territory governments exclude the cost of the GST for the purposes of calculating stamp duties or any other state or territory levies that are imposed on insurance premiums.

10.3.4 The New South Wales insurance protection tax

In response to the collapse of HIH, New South Wales imposed an insurance protection tax on the premium income of insurers, to compensate affected policyholders of the state's compulsory third party and home owner warranty schemes. Insurers are not permitted to pass the tax directly to policyholders. Accordingly, the tax purports to be a tax on shareholders.

I am recommending a broadly based policyholder support scheme that would be funded by imposing a levy on insurers following the failure of an insurance company: this is discussed in Chapter 11. Should this recommendation be adopted and cover the statutory insurance schemes of the states and territories, taxes such as the New South Wales insurance protection tax would not be necessary.

There are questions as to how far it is possible by legislation to prevent an insurer from passing on to policyholders the burden of an impost of this kind. To the extent that this tax has to be met by insurers and cannot be passed on, it might have the effect of reducing the size of the capital base, which might in tum reduce the financial strength of the affected insurers- a potentially undesirable outcome.

Recommendation 58

I recommend that governments avoid imposing on insurers levies and other taxes that cannot be passed on to policyholders.

10.4 Other tax matters

10.4.1 Income tax

Like other corporate entities, general insurers are subject to the Income Tax Assessment Act 1936. The current requirements for the taxation treatment of general insurance companies are specified in Schedule 21 of the Act. The schedule contains provisions relating to the income tax assessment of general insurance companies in respect of the treatment of premium income and the provision for claims liabilities.

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In addition to meeting the requirements of the Income Tax Assessment Act, general insurers must also meet the requirements of the accounting standards issued by the Australian Accounting Standards Board (principally AASB 1 023 'Financial reporting for general insurance activities') and the prudential standards issued by APRA under the Insurance Act. The requirements of these standards are discussed in Chapters 7 and 8 respectively. The treatment of premiums and claims liabilities under the Income Tax Assessment Act is largely consistent with the current requirements of AASB 1023.

The prudential standards rely, however, on a different basis of accounting. The accounting and tax systems are both based on a deferral-and-matching approach, where premium revenue is recognised in accordance with the pattern of risk under insurance contracts, which is then 'matched' with the claims liabilities under those contracts. The prudential standards, however, are based on the immediate recognition of all revenue and liabilities on the commencement of an insurance

contract.

Ideally, the requirements of the taxation, accounting and prudential standards should be consistent. Such an approach is likely to be cost-effective for insurers and would also reduce any confusion that might result from the application of different standards.

I recommend elsewhere in this report that the accounting standards be changed to bring them into closer alignment with the prudential standards. The main reason is to redress particular weaknesses in the accounting standards, but it would also reduce the inconsistencies between the accounting standards and the prudential standards.

For similar reasons, should the changes I recommend in relation to AASB 1023 be adopted, the government should consider changing the Income Tax Assessment Act 19 3 6 to reduce the inconsistencies that would arise between it and the accounting standard. These changes would be largely technical in nature and would reflect a

change from a deferral-and-matching approach to the immediate recognition of revenue and liabilities. They thus should not have a significant effect on the amount of revenue collected.

Recommendation 59

I recommend that the Commonwealth Government review the current requirements of the Income Tax Assessment Act 1936 with a view to changing the Act to bring it into alignment with the

modified accounting standards I propose.

10.4.2 Catastrophe reserves

In broad terms, a catastrophe reserve is a fund that is set aside by a company to meet future catastrophic events. For an event to be considered catastrophic, its timing or size must be highly unusual or unexpected.

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The term 'equalisation reserve' is sometimes used interchangeably with 'catastrophe reserve ' . Equalisation reserves are generally understood to be a fund that is used to cover random fluctuations in claims expenses around the expected value of claims. As a result, such reserves act to equalise or smooth earnings, taking account of fluctuations in business conditions.

In its submission, the Insurance Council of Australia recommended the introduction of tax-deductible catastrophe reserves:

Commonwealth income tax legislation should be amended to enable general insurers authorised under the Insurance Act to transfer funds to a catastrophe reserve out of pre-tax profits, and to enable general insurers to claim a tax deduction for such a transfer. 18

APRA also raised the question of catastrophe reserves in its submission:

APRA is also aware of strong industry concerns about the taxation treatment for catastrophe provisions. These are provisions set aside for catastrophes, and are over and abo ve the amounts required under AASB I 023 and GPS 210. Under current taxation arrangements, these provisions are not recognised as liabilities and, as a result, do not constitute tax deductible expenditure at the time they are created. This acts as a disincentive for insurers to conservatively provision for catastrophe events. APRA 's view is that these provisions do not meet the accounting concept of a liability but that APRA would not be averse to taxation arrangements that provided greater incentive for prudent provisioning for catastrophe events, should the Government see fit to provide such a concession. 19

It is worth considering whether encouraging the use of catastrophe reserves through some form of concessional tax treatment would improve the financial stability of general insurers and whether the benefits of introducing concessional tax treatment would outweigh its cost. In assessing this question it is necessary to examine the appropriate accounting treatment for catastrophes reserves.

Accounting treatment Broadly speaking, AASB 1023 'Financial reporting of general insurance transactions' requires that insurance liabilities be valued as the discounted expected future cash flow of the cost of settling all claimable events that have occurred at the date of reporting. As such, the full cost of catastrophes that have already occurred should be reflected in the accounts of an insurer.

AASB 1023 does not require or allow the costs of a catastrophe that has not yet occurred to be recognised as a liability. This is based on the principle that a liability should be recognised only when it is probable that the future sacrifice of economic benefits will be required as a result of past transactions or events to meet their cost and the amount of the liability can be measured reliably. A future catastrophic event does not meet either of these