The Collapse Of Hih - Solvency And Audit Risk

The Collapse of HIH - Solvency and Audit Risk

Following the collapse of HIH, considerable debate, comment and speculation have arisen regarding whether and at what point HIH became insolvent. When a company is close to insolvency, the risk associated with auditing that company is considerably higher than for one that is solvent. This report investigates methods of determining insolvency, the roles of directors and auditors, and the level of audit risk associated with HIH prior to its collapse.

There is general agreement that the concept of solvency relates to having the capacity to meet debts as they fall due. An insurance company is solvent if it is able to fulfil its obligations under all contracts at any time (or at least under most circumstances). However, assessing solvency can be a challenge, as accurate estimates of the liabilities at the balance date may be difficult to determine.

Analysis of company solvency can be made from two indications: financial indications and non-financial indications. Financial indications are used to assess commercial insolvency - the company being unable to pay all its debts as and when they become due. Non-financial indications are used to assess regulatory insolvency, which occurs when the company breaks the requirements imposed by legislation, supervising regulations and other laws. Regulatory insolvency can lead to commercial insolvency .

Financial ratios, such as debt to asset ratio, current ratio and ratios calculated from the cash-flow statement can be used to determine commercial solvency, however care must be taken to ensure that that appropriate figures are used in the calculation. The HIH debt to asset ratio was 0.89 if the figures in financial reports were used; however if the PPE, deferred acquisition costs, intangibles and future tax benefits were disregarded, the ratio would be 1.01 - a warning sign of insolvency! This ratio indicates a major long-term under-provisioning situation.

Operational indicators, such as strategic direction, deficiencies in the governing body, rapid or unplanned development of business, should be considered as non-financial indicators of insolvency . During the 1990s, the business environment for Australian insurers was challenging, and insurance companies had to change strategies. During this time, HIH put undue reliance on reinsurance to meet its future debts and embarked in high-risk insurance services such as the UK film investments and marine insurance business. The risky HIH investments in FAI and operations in the United States and the United Kingdom were decisions that should have indicated problems with the group's direction. HIH also broke the "minimum solvency requirement" imposed by s. 29 of the Insurance Act 1973, which 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.

The Corporations Act, s.295 (4) requires that the directors state their opinion as to whether there are reasonable grounds to believe that the entity will be solvent at the date of the directors' declaration. If not, they should not issue the financial reports on a going-concern basis. The directors of HIH did not raise any concerns as to whether the financial reports should be issued on a going-concern basis, which may indicate that the solvency of the company was not properly investigated.

The auditors' main role in determining solvency relates to the appropriateness of management using the going concern basis in the preparation of financial reports . According to the definition of the "going concern basis" in AUS708.03, the entity is expected to be able to pay its debts as and when they fall due. The auditor must plan sufficient audit procedures to address the possibility that the going concern assumption may be subject to question, according to AUS302.09. This would include an assessment of the risk of insolvency.

The auditors' assessment of solvency may be made more difficult by the existence of cross guarantees. Cross guarantees exist where a subset of companies in the corporate group (the "closed group") guarantee the debts of each other. A regulatory-approved Deed of Cross Guarantee has existed in Australia since 1991. All subsidiaries party to a Deed of Cross Guarantee must make a solvency statement.

HIH and its subsidiary, FAI insurance had cross guarantees in place. As a result of the cross guarantee, HIH adopted a "group enterprise perspective" when attesting to its regulatory solvency position. The company treated insurance subsidiaries as if they were part of a singular corporate group and "netted-off" related company assets and liabilities in several APRA annual returns . This contributed to the fact that the auditors did not identify that some subsidiaries were potentially insolvent.

The risk that a company is insolvent is a component of audit risk, which should be taken into account by auditors. Audit risk is defined as "the risk that that the auditor will give an inappropriate audit opinion when the financial report is materially misstated". Auditors risk issuing an unqualified audit opinion on financial statements that are materially misstated or omit material transactions; therefore the procedures used in the audit must be planned according to the identified audit risk. The components of audit risk are inherent risk, control risk and detection risk.

Inherent risk is the risk that the financial statements contain a material misstatement or omission, before considering the effectiveness of the internal control