Post Mortem Zweier Australischer Versicherer

Æqui-£ibria

Post Mortem of Two Australian Insurers

HIH and FAI before a Royal Commission

(Versicherungswirtschaft Heft 13/2002, S. 1042, translated from German by the author)

Tourists travelling to Sydney in these months are not limited to the scenic view from a Harbour bridge tower, a ferry trip to Manly and seafood dinner at Doyle’s. In addition, a unique type of live-entertainment is featured which even comes for free. The post-mortem of the previously larges Australian non-life insurer is being carried out in front of the general public. A number of previously well remunerated insurance executives and brokers are placed in a rather embarrassing situation.

FAI, Larry Adler’s Long Ailing Heritage

FAI [1] was founded in 1960 as Incorporated Fire and All Risks Insurance Pty Ltd in Sydney by the Hungarian immigrant Larry (previously Laszlo) Adler. Dramatic growth was achieved through the 1960s by taking over a whole string of smaller insurers with names such as Omnibus and General Insurance Brokers.

The company primarily wrote motor- and long-tail business. Nonetheless, the property account in 1975 almost brought the company to its knees. Larry Adler had economised on per event protections and for a couple of years following the Darwin storms had to operate on the verge of bankruptcy.

Thanks to his cash flow underwriting Larry Adler was able to be a big-time investment player. Repeatedly, he participated in spectacular take-overs of non-insurers. At times there would be challenges arising out of alleged non-adherence to stock exchange take-over rules.

In 1988 Larry Adler, a diabetic, died prematurely. During the year of his death FAI featured a profit of A$ 171m and was even listed on NYSE. However, the decline had already commenced: FAI had given failed entrepreneur Alan Bond loans totalling A$ 500m and eventually had to rely on precarious collateral to get its money back (the St. Moritz Hotel in New York, a coal deposit and a former brewery site). Furthermore, there was a CHF 800m bond outstanding and claims reserves were short by some A$100m.[2]

Successor was to be the then just 29 year old son Rodney, a move his father had declared as the „step which will launch FAI into the 21st century“. [3] The son maintained public relations specialists who in the sense of court reporting regularly launched reports concerning his personal life style (purchase of new residences etc.) in the local press. He persevered with his father’s aggressive investment style but was not particularly astute as an insurer.

Under the stewardship of Rodney Adler and the not all that vigilant eyes of regulators, FAI managed to totter on for a further 10 years until the redeeming amalgamation with HIH. Rather than retiring with his family’s share of the substantial purchase price, Rodney had himself elected to the board of HIH and at times was attempting to become the new CEO. There was a A$10m loan from HIH which he took up in order to purchase further HIH shares, something the stock exchange regulators ASIC definitely did not approve of. Rodney Adler is now somewhat closer to being a „charming bankrupt“ than a „wealthy bastard“.[4]

HIH, Broker Creation and later Antipodean Venture of Winterthur

The origins of HIH go back to the setting up of an Australian underwriting agency by the name of MW Payne Underwriting Agency Pty. Ltd in 1968. This underwriting agency which had been created by Ray Williams and Michael Payne (the renowned liability underwriter at Lloyd’s) was in 1971 sold to UK broker C.E. Heath plc. In spite of the intervening nationalization of workers compensation insurance in most Australian States, what had initially been a mere underwriting agency prospered and grew into a large local industrial insurer. In mid 1992 there was a public listing and the UK parent’s share was reduced to 44%. A further 11% of the shares were held by management.

In July 1995 HIH acquired CIC Insurance Group the majority of which was in the hands of Winterthur Insurance. Simultaneously, Winterthur in several steps acquired a bit over the majority of HIH. HIH remained publicly listed and since May 1996 was called HIH Winterthur International Holdings Limited.[5]

The relationship between Winterthur and HIH management did not turn out to be as harmonious as originally expected:

Ray Williams complained the new parent entity made „absolutely nothing“ available in terms of technical support
Winterthur mistrusted the worldwide expansion ambitions of HIH, in particular with regard to the London portfolio. Somehow, Winterthur’s attempts failed to clip the wings of the rather independent-minded management and to force it to concentrate on the Australian market. [6] Winterthur’s frustration was probably a decisive element when subsequent to the Winterthur-Credit Suisse merger the word-wide activities of Winterthur were being scrutinised for their strategy conformity.[7]

On the basis of an Offering Memorandum[8] Winterthur in mid 1998 disposed of most of its shares in HIH, but apparently retained 14% and furthermore sub-ordinated debentures with a par value of A$ 65.3m.

Until the announced disposal by Winterthur, HIH was rated AA- by S&P. Given the lack of a major reputable shareholder, the rating was then reduced to single A.

The company’s development following withdrawal of Winterthur was most dynamic:

Purchase of competitor FAI, which however turned out to be a great deal more impaired than anticipated
Acquisition of Lloyd’s underwriting agency Cotesworth – just at the beginning of a 4 year London market loss phase - and deployment of appr. A$200m of own funds to support underwriting at Lloyd’s
Expensive and ultimately failed attempt to establish itself via a joint venture in the Chinese market

When the level of technical reserves was starting to be challenged, an attempt was made to sell individual portfolios at a profit, e.g. personal lines to MMI/Allianz. However, a consequence not taken into consideration was that HIH continued to be liable for the claims reserves but was cut off from the cash flow arising out of new business. Since January 2001 even HIH’s solicitors’ bills were only met with considerable delay (HIH had the reputation of being an insurer which did not like paying claims and instead had a habit of taking evasive action). On 15.3.2001 HIH finally collapsed. Court appointed liquidator is Tony McGrath of KPMG. The balance sheet deficit is said to be somewhere between A$ 4 and 5 billion. One of the critical points is the right of certain classes of insurers to have separate access to reinsurance assets, in particular with regard to facultative coverage.

Mission und Functioning of the Royal Commission

The Royal Commission[9] is presided by Justice Neville Owen. It resides in its own centrally located office floor. Typical attendance includes the chairman and a number of Counsel assisting the Commission (lawyers working for the Commission) plus up to 20 alert solicitors representing various potentially affected parties. (at an hourly fee of say A$400 this signifies hourly running costs of A$8,000 to be borne by their clients) Their clients include Arthur Andersen (external accountants to both HIH and FAI), those being questioned and also several reinsurers. Those attending have individual screens available on which incriminating documents (such as reinsurance slips) appear.

The Commission maintains its own web-site, from which the daily transcripts (usually around 100 pages) can be down-loaded. The Economist magazine lauds the high „entertainment value“ of the Commission. [10]

An example for deliberations is a financial reinsurance contract concluded by FAI on 6.5.1998 but back-dated by some 6 weeks. The contract features a side letter. All those who were involved on FAI’s sied (chairman, chief executive, finance director) featured lapses of memory, a standard answer being: „I can’t recall that, no“. Such a vague answer has the advantage of making a later perjury conviction rather difficult.

Central Issues

Topics for the Royal Commission include:

Insufficient corporate governance: It is striking that Arthur Andersen were the external auditors of both FAI and of HIH. As regards HIH, in addition the chief financial officer Dominic Fodera was previously the responsible audit partner at Arthur Andersen. Furthermore, 3 of HIH’s board members were former Arthur Andersen partners. The very close HIH-Arthur Andersen relationship is somewhat reminiscent of the Arthur Andersen-Enron relationship.[11] On the other hand, solicitors acting for Arthur Andersen are adroit at cross examining witnesses and pointing out that there must have been a number of vital issues which were not properly disclosed to Arthur Andersen.
Underwriting of long-tail business at prices far below an economical level, in particular as regards commercial liability business.
Insufficient gross reserves, potentially on the background of incomplete or erroneous communications to the reserving actuaries
Use of financial reinsurance (a product with boomerang character in order to use an Australian metaphor) in order to shroud the true state of affairs at HIH und FAI
Failure of the regulators to intervene (APRA, Australian Prudential Regulatory Authority, previously Insurance and Superannuation Commission).

Presently, the Commission is focusing on what happened at FAI, thereafter until September HIH will be the main topic of the hearings. Also the role played by regulators is still to be put into the limelight. Those involved will be given the opportunity to make concluding remarks in December. On 28.2.2002 the final report is to be handed over to the Governor General as local representative of the Queen.

Work for the Australian Courts for the Next 10 Years

The HIH collapse is likely to keep the Australian courts occupied for the next 10 years. Apart from the criminal law aspects which may arise, the following action can be envisaged:

Damages which HIH’s liquidator may demand from two triple A rated reinsurers because of their involvement in obfuscating the true state of FAI’s balance sheet. On the basis of manipulated numbers, HIH subsequently bought FAI. (this claim is said to amount to several A$100m)
Damages against Arthur Anderson who acted as external auditors of both HIH and FAI
Claims of the HIH liquidator against board members, in particular against those employed by Winterthur (who may have been subject to a hold harmless from their employer[12])
Prospectus liability of Credit Suisse arising out of the sale of Winterthur’s stake in HIH in the middle of 1998

Conclusion

The following lessons can be drawn from the present Sydney post mortem:

Even what has been looking shaky for many years (to the effect that the public has gotten used to this state of affairs) may yet still collapse some day[13]
One should not overly rely on an implicit support by a major parent company. It may just in time discretely leave the scene.
Neither the audit by a major firm of external auditors nor a rating by one of the renowned rating agencies are all that significant
Insurance company bankruptcies tend to happen at the bottom of the rating cycle. However, there are considerable incentives for the management of tottering insurers to gain a year or two by not booking gross reserves or beautifying net reserves (via financial reinsurance). If they are lucky, they will be able to discreetly address their balance sheet issues during the expected hard market years.
HIH and FAI were not isolated Australian cases. It would appear that the UK’s Independent Insurance had some common features. Who knows which other rapidly expanding and dynamic commercial lines insurer may in reality be near the abyss.

Philipp Thomas

Post Mortem of Two Australian Insurerspage 1 of 5

[1] From Cabbie to Chairman, Larry Adler and the story of FAI Insurance Group, Peter Denton, Sydney 1991 (written by a ghost writer on behalf of the Adler family geschrieben, preface by the former Australian prime minister Bob Hawke), Sydney 1991

[2] Aussage Rodney Adler am 5.6.2002, http://www.HIHroyalcom.gov.au/Documents/Transcript/Transcript_2002_06_05.pdf

[3] From Cabbie to Chairman, S. 212

[4] From Cabbie to Chairman, Heading for Chapter 9: “Better a wealthy bastard than a charming bankrupt”

[5] HIH Winterthur Offering Memorandum 13.7.1998, p. 26/27

[6] AFR, 15.7.1998, S. 48: Chanicleer, A European reprieve for HIH

[7] Media Release Winterthur/HIH Winterthur 14.7.1998

[8] HIH Winterthur Offering Memorandum 13.7.1998, Global Co-ordinator and Lead Manager: Credit Suisse First Boston

[9] virtual spectators can participate via www.HIHroyalcom.gov.au

[10] The Economist 25.5.2002 Seite 78ff: Australian Insurance, The Enron down under, The ripples from a big insurer’s collapse continue to spread

[11] other prominent former clients of Arthur Andersen were deLorean, Cendant

[12] the 1998er Prospectus on p. Vii specifically refers to 2 external board members

[13] in this context, there is a rather alarming comment by A.M.Best who estimate the reserve shortfall of US non-life insurers at US$33b for asbestos and at US$24b for environmental exposure: A.M.Best, Final Data Support A.M. Best’s Projection of A&E Reserve Shortfall, Special Report Nov. 5, 2001