I’m reading up for a two day workshop at an fine institution I discovered a few years ago called Cranlana. Named after the Myer Family’s mansion in Toorak where it is housed it’s a (small ‘l’) liberal talk shop which holds ‘colloquiums’ at which various topics are discussed. I did a week long one there many years ago and it really is something to be locked up with a bunch of interesting people to talk in a structured way about serious things. I really enjoyed it.In any event one of the readings for this session – which is on Business, ethics and society – is from the HIH Royal Commission Report. A lot of lawyers fancy themselves with a pen in hand and try not to waste the chance when it comes along. Tony Morris QC in Queeensland did waste his chance with overly histrionic behaviour which saw him bundled aside by other lawyers for bias.
When I was at the PC, I took great pains with a couple of pages of legal/economic reasoning on design protection – fancying that I was Lord Acton in Donoghue v. Stevenson.
In any event I hadn’t read the report before but Justice Owen was intent on showing himself to be a bit of a wordsmith and I think he did quite a good job which you can read at greater length here. Some worthwhile extracts over the fold.
The failure of HIH – a critical assessment
‘Beware the ides of March.’ The soothsayer’s words have become synonymous with unheeded warnings since they were penned by Shakespeare some 400 years ago. Caesar’s response¢â¬â`He is a dreamer; let us leave him: pass’¢â¬âis 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¢â¬âthe 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 corporate context
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 inept management. Indeed, an attitude of apparent indifference to, or deliberate disregard 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
Insurance is a vital element of modern society. It is one of the means whereby the consequences of injury to person or property and the risk of incurring liability to others can be spread. The object is to lighten the burden of loss to individuals and groups in the community. When an insurer fails, the loss lies where it falls. The collapse of HIH has reverberated throughout the community, with consequences of the most serious kind.
Harm to individuals
Individual cases of personal hardship emerged almost immediately after the collapse and continue 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 earnings to an income protection insurance policy developed a brain tumour in 1996. Unable to work, he and his family survived on the monthly cheques that came from HIH under the policy. In February 2001 the monthly cheque was dishonoured on presentation; his policy is now worthless. His spouse was forced to approach Centrelink 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 all face a wait of up to 10 years before receiving what the liquidator has predicted will be a ‘very poor’ payment.
Retirees who invested their superannuation or life savings in HIH shares to fund their 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 its liquidation, HIH encouraged him to settle the claim out of court for $90 000. The subsequent collapse of the insurer left the business owner liable for the payout.
Thousands of holders of professional indemnity, public liability, home warranty and travel insurance policies have found themselves uninsured for claims made by or against 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 payments.
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 wrought.
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¢â¬âa fixture in the Western Australian calendar for decades¢â¬âwas 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 community that by the end of February 2003 the Commonwealth Government had already paid out $195 million through the government-funded HIH Claims Support Scheme. 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 has brought about proposals for legislative reform of tort law, which¢â¬âwithout entering the debate about the overall desirability of the proposals¢â¬âmust 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 implemented 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 changes on individuals who are denied full (or any) recompense for a loss they have suffered.
A collapse of this magnitude must inevitably shake public confidence in the insurance industry and in the regulatory system’s ability to carry out its protective role properly. The Australian general insurance market is not particularly large by global standards. 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 their consequences, most are relatively self-contained. Some collapses, though, cause the public to question the integrity of the market system itself. The failure of HIH was an event of that nature.
Reasons for the failure: a broad perspective
How did it happen? The insurance market is undoubtedly cyclical. The second half of the 1990s was a period of poor global market conditions for commercial insurance, and HIH was not the only insurer to collapse. Nevertheless, market conditions provide neither an excuse nor an explanation for HIH’s predicament: most insurers weathered the storm.
In a collapse 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 sums of money must have been spirited away to the dungeons of financial institutions, in so¢â¬âcalled safe havens.
HIH is not a case where wholesale fraud or embezzlement abounded. Most of the instances of possible malfeasance were borne of a misconceived desire to paper over the ever-widening cracks that were appearing in the edifice that was HIH.
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¢â¬âreserving’ or ‘under¢â¬âprovisioning’. This, in my view, is the primary reason for HIH failing¢â¬âand not only failing but doing so in such an egregious way.
Why was there such serious under¢â¬âreserving 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¢â¬âand hence the reasons for the failure¢â¬âare 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¢â¬âfated commitment in 1996 to re¢â¬âenter 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¢â¬âas well as FAI, both before and after its acquisition by HIH¢â¬âwere afflicted by chronic under¢â¬âreserving 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 of HIH’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¢â¬âsometimes overt but often unstated¢â¬âthat 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¢â¬âwhich led directly to the poor decision making¢â¬âcan be summarised succinctly. There was blind faith in a leadership that was ill¢â¬âequipped 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 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 of HIH’) 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¢â¬âfor example, the chapters dealing with provisioning, reinsurance and the overseas operations¢â¬âis 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¢â¬âis 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.
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¢â¬âparticularly at tertiary level¢â¬âshould 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.