Lessons From HIH Collapse Helped Australia’s Insurers Through Current Financial Crisis

The collapse of HIH Ltd. [85891] in 2001, a forerunner to the risk management failures in last year's financial crisis affecting several international insurance groups, was one of the largest financial failures in Australia's history with immense implications for insurance management, regulation and corporate governance.

After almost a decade, the lesson learned from HIH's collapse remains relevant for the current insurance industry, which weathered one of the worst global financial crises in the past year.

"The lesson is still valid for today," said Michael Sherris, professor of actuarial studies at the University of New South Wales. In the past decades, similar problems had "repeated and repeated" again. "People just forgot about the lesson learned from the events," he noted.

"We haven't learned, maybe, as much as we still have to [now]," said Sherris in an interview. Appropriate evolution of regulatory structures and a more pro-active approach for risk management by both regulator and insurer are essential for the industry.

Lessons from the 2008 troubles of American International Group Inc. [18540] and other financial groups such as Fortis [86089] and ING Groep N.V. [85144] will lead to a range of regulatory initiatives, said John Trowbridge, executive member of the Australian Prudential Regulation Authority. These initiatives include more effective supervision on group-level activities, remuneration practices, accounting and audit standards, risk management and governance practices."We are interested today, however, in the first point: how we might supervise insurance groups more effectively," said Trowbridge in a speech last May.

"The way I propose to consider this question is by reference to the Australian system, which has its own AIG, in the name of HIH, a major Australian-based general insurer whose collapse in 2001 caused considerable financial, economic and political disruption at the time," added Trowbridge.

In Australia, the HIH collapse had brought transition to regulatory role in supervisory practice from one based on oversight of individual transactions to a systems-based approach, said Peter Costello, former treasurer of Australia's government, in a statement in 2003.

Regulatory Changes

In the wake of the HIH failure, one crucial regulatory transition was the introduction of a risk-based capital regime, similar to the Solvency II approach set to take effect in Europe in two years, said Sherris.

Even prior to the collapse of HIH in 2001, the minister for Financial Services and Regulation had already announced a major reform of the nonlife regulatory framework in Australia, with stricter standards for capital adequacy, liability valuation, reinsurance and risk management.

The risk-based capital regime had substantially lifted capital requirement for insurers. As a result, Sherris noted insurers are more serious and sensitive to enhanced regulatory requirements. This led to some small insurance companies merging with big companies due to the higher capital requirements.

APRA also brought together the supervision of banking and insurance under one roof for a stronger and more consistent approach to the financial services sector, according to Sherris.

In 2003, the HIH Royal Commission, which investigated the insurer's collapse, called for the development of "a more skeptical, questioning and where necessary, aggressive approach to its prudential supervision," and "we took that call to heart then," said John Laker, chairman of APRA. "There is no shortage of financial institutions, large and small, that have experienced APRA's tough love in the lead-up to, and during, the global financial crisis," said Laker in a speech last August. "Our risk-based supervisory approach underpinning this tough love."

Now, APRA's prudential framework is focused on contagion risk, through which adverse developments in activities conducted by a group member could affect the health of regulated insurers in the group, according to APRA's 2009 annual report. Such a scenario played out with AIG last year, when derivatives transactions in the financial unit nearly brought the group down, even though its many insurance subsidiaries were in good shape.

APRA's Trowbridge said HIH's failure highlighted the risk to insurers from contagion effects within a corporate group. This led to the adoption of a comprehensive framework for the supervision of corporate insurance groups.

The approach is to treat an insurance group as one economic entity and to apply prudential requirements to the group similar to those that apply to individual insurers with respect to capital, risk management, audit and actuarial reporting and valuation, governance, and fitness and propriety of responsible persons. The principle is to supervise insurers both on a solo and group basis, according to APRA's annual report.

The HIH Legacy

Rapid expansion, unsupervised delegation of authority, extensive and complex reinsurance arrangements, underpricing, reserve problems, false reports, reckless management, incompetence, fraud, greed and self-dealing were the factors attributing to the collapse of HIH, according to the Royal Commission's findings.

The financial deficiency of the group was estimated to be between A$3.6 billion (US$3.2 billion) and A$5.3 billion, according to the commission. The bankruptcy led to the conviction and imprisonment of a number of HIH's management members on various charges.

The nature of HIH's collapse was a technical underwriting issue, with deficient understanding of the business leading to a spectrum of failures in liability, premium price adequacy, appropriate risk reserves and responsibility to policyholders, according to Sherris.

In Australia, Sherris said insurance companies have not been greatly exposed to security investments in international markets, such as U.S. mortgage-backed securities. HIH's failure was primarily a consequence of poor underwriting in both domestic and overseas businesses.

The nature of the failure was different from the financial crunch faced by several international insurance groups in September 2008, which was more a crisis of investment risk. Nevertheless, Sherris noted the 2008 collapses happened in a similar context as an issue of risk management.

Market Impact

"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," wrote Justice Neville Owen, commissioner of the HIH Royal Commission, in its report.

As the HIH group underwrote a comprehensive lines of businesses in compulsory and noncompulsory nonlife insurance, superannuation and life insurance, the impacts were widespread, spanning from policyholders to the regulator and state governments.

As one of Australia's biggest home-building market insurers, HIH's collapse left the building industry in turmoil. Homeowners were left without compulsory home warranty insurance and builders were unable to operate because they could not obtain builders' warranty insurance.

The cost to the building and construction industry alone forced state governments to spend millions of dollars of public money to prevent further damage to the industry, said the Royal Commission.

"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," said Owen in the report in 2003. The collapse caused the public to question the integrity of the market system itself.

HIH had a wide spectrum of insurance subsidiaries, including HIH Insurance [86602], HIH Casualty and General Insurance, FAI General Insurance Co., CIC Insurance and World Marine and General Insurance, according to a report of the Australian Parliament. The group underwrote many lines of insurance in Australia, the United States and United Kingdom.

The publicly listed HIH was the second-largest insurance group in Australia prior to its collapse. After its collapse, the group's subsidiaries were placed under provisional liquidation.

The policies were taken over by several insurers including Allianz Australia Insurance [77889], NRMA Insurance [85350], QBE Insurance (Australia) [77926], Royal & Sun Alliance Australia [87883], and Dexta Corp., which was acquired by Axis Specialty Europe [83007].

The primary reason for the collapse of HIH was insolvency, or the inability to provide properly for future claims, due to "mismanagement and an inadequate response to pressure emerging in insurance markets internationally," according to Costello.

Underwriting is the core aspect of the nonlife insurer's operations and its performance requires close scrutiny, said the Royal Commission.

Prior to its collapse, HIH's underwriting loss more than doubled while net earned premiums rose 25% between 1997 and 1999. The underwriting loss increased threefold but net earned premiums jumped 61% between 1997 and 2000, according to the Royal Commission's report.

HIH had gross premium revenue of A$2.8 billion, total assets of A$8 billion, total liabilities of A$7.1 billion and net assets of A$900 million, according to the group's 2000 annual report. However, each of HIH group's Australian licensed holding companies were "clearly insolvent" and unable to pay their debts in full, according to the government report.

Improving Regulation

In Australia, the HIH's collapse had eroded consumer's confidence on insurer's risk responsibility to policyholders, which led to more initiatives on consumer protection, said Sherris. The lesson was really about an insurer's responsibility for consumers' money, he noted.

New legislation for nonlife insurers was enacted in September 2001 and new prudential standards were issued in February 2002, making insurers subject to much more robust arrangements. These reforms ensured insurers would establish appropriate systems of governance and internal controls, in addition to more transparent valuation of liabilities and risk-based capital adequacy, said Costello.

The lessons from the HIH collapse left Australia's insurance sector more confident amide last year's global financial crisis and subsequent increased regulation. Research conducted by KPMG last August found Australian insurers appeared to be unfazed by the likelihood of stiffer regulation resulting from the financial crisis.

"Our regulatory regime was enhanced and continues to evolve since the collapse of HIH in 2001, with flow-on effects positively benefiting our industry," said Brian Greig, head of insurance at KPMG. Overall, Australian insurers already operate in a well-regulated environment and do not expect further significant regulatory changes, he said in a report.

In Australia, the insurance market had not been abruptly changed by the HIH collapse. The competition is "typical" of many other insurance markets, dominated with a small number of big players, along with a large number of smaller companies offering specialized services, according to Sherris.

(By Iris Lai, Hong Kong bureau manager: [email protected])