Auditing And Assurance Services for Inherent Risk

1 —Business Risk and Inherent Risk Assessments

The business risk of HIH should be considered from a global as well as the local environment perspective. An understanding of the insurance industry and a SWOT analysis of HIH in particular would also be helpful in determining the risk associated with the company both at present as well as in the future. The major factors contributing to the losses faced by HIH may be attributed to the insurance industry in Australia which is still in its infancy. The regulations in the industry are relatively new and this results in loopholes that may be exploited by persons with the knowhow to manipulate the procedures and financial statements as can be seen from the manner in which the auditors of HIH chose to turn a blind eye to the irregularities in the country. The original Australian body in the area of insurance was the Insurance and Superannuation Commission. Following the changes introduced in the sector, this body is now a part of the APRA (Australian Prudential regulation Authority).

As a rule insurance companies are committed to dealing with risk and hence risk management is counted among the core functions of any insurance company. All insurance companies rely on their investment decision making; their risk pricing ability and the provisions for outstanding claims and reserves that help them meet all possible scenarios of risk. These three factors together help mitigate and manage risk and generate profit for the company (Jaingbo, 2010). The risk associated with insurance continues to remain high, despite the changes made in the regulations surrounding the industry due to the inherent nature of the risk in the industry as a whole.

The investment strategy at HIH works on the assumption that the risks associated with the company as part of its insurance related work should not in any manner be compounded by the risk associated with the assets of the company (International Association of Insurance Supervisors , 2006).The risk tolerance of the company is reflected in its investment portfolio. External fund managers are used by the company while selecting individual assets for investment. This allows the investment committee to concentrate on issues related to the overall asset allocation (International Association of Insurance Supervisors , 2006).

The inherent risk factors affecting HIH can be clearly seen in the financial reports of the company. The picture from a financial perspective indicated that the primary factors that lead to the liquidation of the company was the inability to pay the claims made by the insurance holders. This was attributed to the lack of provisions for settling of unpredictable claims. As a rule, insurance works on the law of averages. Thus, as the number of persons covered by a similar policy increases so does the profitability of the company since the risk is divided across a larger group of persons. This is because the claims that may be made are met easily from the large number of policies. Unfortunately, in the event of unpredictable events like natural calamities, the incidence of insurance claims would go up significantly (Jaingbo, 2010). The insurance company is therefore required by law to have the required margin called prudence margin to meet the eventuality of such an event occurring.

The investment strategy followed by the HIH was to hold a significant part of both cash and fixed interest assets. The expected cash flows of the liabilities were expected to be equal to the current cash flows of the company (International Association of Insurance Supervisors , 2006). Unfortunately, this scenario was flawed and the expected returns and cash flows did not match. This resulted in a skewed financial position and culminated in the liquidation of the insurance giant. While the company claimed that the changes in the insurance regulations and policies were the prima facto reason behind its bankruptcy, this was far from true.

HIH, in a rush to grow through mergers and takeovers, did not consider due diligence or take up the matter with the board as is the normal procedure; before making significant investments to take over other insurance firms like FIA. This resulted in depletion in the prudent margins ultimately leading to its liquidation and significant loss of investor wealth. The ineffective corporate governance, the poor risk assessment and management as well as the dubious manner in which the auditors conducted the audits are all responsible for the losses faced by HIH (Jaingbo, 2010). It can be seen that these factors have contributed significantly to the increase in the inherent risk of insurance being faced by insurance companies like HIH.

2— Legal Liability

Most shareholders and stakeholders are of the opinion that Anderson in his professional capacity should have been able to identify the problems faced by the company at the onset. In fact, many are of the opinion that the potential problems should have been identified well before they were actually faced by the company. If this action had taken place as per the safety precautions and measures already in place, the probability of the failure of the insurance giant would have been reduced significantly. In light of this scenario, the legal liabilities of Andersons as the auditors would continue despite the collapse of HIH, since they were unable to fulfil their role as the watchdog with regard to the financial health and safety of their investors (Jaingbo, 2010).

The responses of the Royal Commission that looked into the collapse of HIH are significant. They are of the opinion that poor corporate governance and non-compliance to regulatory precautions alone are responsible for the collapse and bankruptcy of HIH. The takeover of FAI was a confirmation of the strategies adopted by HIH to secure its market position as the largest insurance company in Australia (International Association of Insurance Supervisors , 2006). In the aftermath of the HIH failure, a national system of law and regulation was put in place for both security markets and corporations in the commonwealth. This measure incorporated in 1991 along with the establishment of regulatory powers for the Australian Securities Commission helped safeguard investors from the repletion of the fiasco that saw a massive erosion of investor wealth. (International Association of Insurance Supervisors , 2006).

a) Facts and findings of relevant court cases that Andersens can refer to determine the liability of the partnership:

1) Clients – HIH Claims Support Limited v. Insurance Australia Limited case no M24/2011

2) Creditors -. Wynton Stone Australia Pty Ltd (in liq) v. MWH Australia Pty Ltd case nos M158/2010; M159/2010

b) The observations by Justice Owen identify six reasons for the failure of HIH. They include the lack of money in the company to provide for future claims due to under provisioning; mismanagement of assets and company affairs; poor decision making; a corporate culture lacking in transparency and trust; the unwise acquisition of FAI; and the poor decision involved in the commitment to re-enter the markets in the United States (Blake Dawson Waldron lawyers, 2003). For negligence action to be upheld, the prosecution needs to prove that the Auditors were party to the fraud and unethical practices in HIH. The manner in which they failed to expose the aggressive accounting is also reason enough to uphold the negligence action.

3 — Ethics

a) Hiring prior members of its external audit team were a major failure on the part of HIH which should have instead taken a clean break in the aftermath of the huge losses sustained by the company. This move would have helped the company create an environment of trust among potential investors and thus help regain at least a part of the lost Goodwill of the company (International Association of Insurance Supervisors , 2006). Such a move had the potential to restore the investor faith, which would contribute to an increase in share prices, a major shot in the arm for the company. Williams, however, continues to live on false pretensions and cling to promises long broken in a bid to save face and this continues to have a negative impact on the outlook for HIH, which is still continuing its downward trajectory.

b) There are several advantages of having the same firm provide both the auditing and consulting services. The first advantage being that they are familiar with the working style of the company as well as the areas of strength and weakness. This ensures that advice given by the consultants would not clash with the working style of the company. Besides complementing their working, the auditing and consulting by the same firm would ensure that there are no vested interests dividing the company in the manner in which it operates.

c) While the long term prospects of the company continue to be good, the present scenario is a matter of major concern for all parties. The directors of the company as well as the auditors are required to provide information to the investors. Directors should not question the rules and regulations that are legally and legislatively put in place to ensure that a similar situation is avoided. Unfortunately, the directors of the company failed to fulfil their roles and obligations. This irresponsible behavior and inability to meet the needed standards is a clear example of violation of ethics expected from a business of such magnitude.

The auditors should have clearly reported the irregularities in the functioning of the firm. By issuing an audit opinion, the interests of the stakeholders would have been safeguarded. By failing to fulfil their obligations, the auditors also played along with the illusions propagated by the directors on the viability of their investments as well as the future of the company. This was also a clear cut violation of the ethical practices expected form auditors who are tasked a watchdog of the investors.

d) The primary recommendations for audit reform proposed by the Ramsay Report and CLERP include audit reforms, enforcement, continuous disclosure and rules for disclosure, financial reporting, proportionate liability, management of conflict, shareholder participation and several other miscellaneous amendments (Blake Dawson Waldron Lawyers, 2003). While the present reporting format is considered among the best in the world today; it was found to be insufficient for preventing the collapse of HIH Insurance in 2001. The proposed changes are expected to have a positive impact on the practice of auditing in the country. The reforms are expected to improve the accountability, transparency and shareholder activity(Australian Government, 2003). The role of the auditor is to add credibility to the financial statements of the company. The influences on the audit profession can be seen in areas like audit committee, audit independence, and the legal liabilities of auditors in general (Mirshekary, et al., 2005).  

CLERP was initiated to ensure that the reforms in corporate and business regulation in Australia are ongoing and continuously reviewed. As part of the reforms the auditors are expected to attend Annual General Meetings (AGM); meet a certain standard of independence and make a declaration about the same; and auditing standards would be made into legislative instruments. The auditor is now obligated to report suspected breaches in law and would be rotated every five years (Blake Dawson Waldron Lawyers, 2003). Interestingly, auditors are protected from losses incurred due to the work of another auditor or audit firm. The recommendations of the CLERP 9 are based on the recommendations of the Ramsay Report (Blake Dawson Waldron Lawyers, 2003).

References:

Australian Government, 2003. Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Bill 2003. [Online]
Available at: https://www.legislation.gov.au/Details/C2004B01549/Explanatory%20Memorandum/Text
[Accessed 31 August 2016].

Blake Dawson Waldron Lawyers, 2003. Corporate Governance Update: CLERP 9. [Online]
Available at: https://www.ashurst.com/doc.aspx?id_Content=10988
[Accessed 31 August 2016].

Blake Dawson Waldron lawyers, 2003. HIH Royal Commission Report. [Online]
Available at: https://www.ashurst.com/doc.aspx?id_Content 03543
[Accessed 31 August 2016].

International Association of Insurance Supervisors , 2006. HIH Case Study on Corporate Governance. [Online]
Available at: http://www.iaisweb.org/modules/cciais/assets/files/pdf/061004_C1-9_hih_corpgov_round01.pdf
[Accessed 31 August 2016].

Jaingbo, X., 2010. HIH Insurance Limited: Corporate Governance and Corporate Excesses. [Online]
Available at: http://www.seiofbluemountain.com/upload/product/201010/2010jjfzh05a8.pdf
[Accessed 31 August 2016].

Mirshekary, S., Yaftian, A. M. & Cross, D., 2005. Australian corporate collapse: The case of HIH Insurance. Journal of Financial Services Marketing, 9(3), pp. 249-258.

 

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