3.1. Community impacts
The collapse of HIH had far-reaching consequences for Australian communities and a negative impact on consumer confidence in the insurance industry. Thousands of employees working at HIH lost their jobs, tens of thousands of HIH shareholders were left holding worthless equity, and HIH policyholders were left unsure whether their insurance contracts would continue to be honoured.
Stories of personal hardship emerged almost immediately. Sick or disabled policyholders claiming on salary continuance policies with HIH stopped receiving ongoing payments (which they often relied on for day-to-day living expenses). In Queensland alone, car accident victims insured with HIH were left waiting for operations and other medical procedures worth $190 million.17 Without HIH insurance cover, the Australian Rugby Union had to cancel games across the country until replacement cover could be procured.18 Injured players were left stranded without compensation.19
|Class of business||Market share (%)|
|Compulsory third party (CTP) motor vehicle||19|
|Public and product liability||15|
Source: Australian Competition and Consumer Commission (2002)
As Australia’s dominant professional indemnity insurer, HIH’s collapse had a major effect on professional service providers. Services were suspended by many of Australia’s 150 community legal centres after their professional indemnity insurance was put under a cloud.20 Other professionals, such as accountants and engineers, were also impacted by the loss of cover. Without public liability cover, councils and not-for-profit organisations became reluctant to hold community and sporting events. In New South Wales (NSW), local councils were left with $65 million of uncovered public liability claims.
HIH was the only provider of certain niche insurance products in the Australian market. As a result, some niche policyholders were forced to look offshore for cover at higher premium rates. HIH also held substantial market shares in a number of insurance product classes. For instance, as one of the largest, if not the largest, builders’ warranty insurers, the collapse of HIH left thousands of builders without insurance cover (which was mandatory in most states and territories). Almost $2 billion of construction activity was placed on hold while builders sought replacement cover.21 For many, this was not a quick process as the few remaining builders’ warranty insurers were flooded with applications.
The number of affected policyholders would have been far higher had HIH not sold most of its personal lines and compulsory third party (CTP) businesses to Allianz Australia22 and its workers’ compensation business to NRMA Insurance, and had QBE not offered renewal policies to most of HIH’s former corporate insurance policyholders.23 In addition, after negotiating with the Liquidator of HIH, QBE acquired HIH’s travel insurance business, further reducing the number of exposed policyholders. These transactions, facilitated by APRA, resulted in the business of over 90 per cent of HIH’s estimated one million policyholders (covered by two million policies) being transferred away immediately before (to Allianz Australia and NRMA Insurance) and shortly after (to QBE) HIH’s collapse.
3.2. Insurance market pricing impacts
HIH’s collapse catalysed large premium increases in certain insurance classes, most notably in professional indemnity and public liability insurance.24 For example, the Victorian Government received representations from accountants highlighting how the diminished availability of professional indemnity insurance had driven premiums to increase by as much as 1,000 per cent in a year.25 Six tourism and heritage rail and tram societies in South Australia faced public liability insurance premium increases ranging from 55 to 900 per cent. As a result, one rail society ceased its operations, unable to afford the requisite insurance.26
A 2002 review of insurance industry market pricing by the Australian Competition and Consumer Commission (ACCC) concluded that the HIH collapse had led to large and sustained insurance premium increases.27 This was, in part, because HIH had significantly under-priced risks. After its collapse, the majority of HIH’s competitors, along with new entrants into the market, offered insurance at more sustainable rates that were markedly above those charged by HIH. This repricing occurred against the backdrop of a global ‘hardening’ in insurance markets triggered by the events of 11 September 2001 in the US, a series of large-scale natural disasters, and the bursting of the ‘dot-com’ bubble — which in turn fostered a decline in global equity markets and in the investment returns earned by insurers.28 The Government’s response to the sharp rises in premiums for certain insurance product classes is covered in Subsections 3.4.2 and 3.4.3.
3.3. HIH Royal Commission
Shortly after announcing that it would implement a support scheme to assist affected HIH policyholders (the HIH Scheme is covered in detail in Section 4), the Government established a Royal Commission ‘to inquire into the reasons for, and the circumstances surrounding, the failure of HIH prior to the appointment of the Provisional Liquidators on 15 March 2001’.29
In April 2003, Commissioner Justice Neville Owen delivered his report on the findings of the Royal Commission. Justice Owen identified a litany of failures at HIH which led to its collapse. The findings were damning (Box 1).
Box 1: Major causes of HIH’s collapse30
- Under-pricing and under-reserving
- HIH grossly underestimated its liabilities, overestimated its assets, charged premiums that were too low, and under-reserved (under-provisioned) for future claims, particularly ‘long-tail’ claims. 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.
- Corporate governance failures
- The Board of HIH was unduly influenced by, and failed to monitor the performance of, senior HIH management. It also: failed to subject management proposals to sufficient scrutiny; paid too little attention to strategic matters; failed to implement mechanisms to identify and resolve conflicts; and failed in its stewardship of HIH’s assets by not reigning in excessive expenditures, including executive remuneration and termination payments.
- The factors contributing to the mismanagement of HIH were many, varied and complex. They included: a lack of attention t
o detail; a lack of accountability for performance; and a lack of integrity in the company’s internal processes and systems. Combined, they led to a series of business decisions that were poorly conceived and executed.
- Acquisition of FAI
- HIH’s acquisition of FAI Insurance for $295 million was a poor business decision. FAI was itself in serious financial trouble, and its true value was significantly lower than the acquisition price. HIH later acknowledged that it had overpaid for FAI. Having borrowed heavily to fund the acquisition, HIH subsequently wrote off its entire investment in the company. It was later revealed that no due diligence was performed by HIH directors on the financial status of FAI.
- Ill-fated international ventures
- HIH’s UK and US operations generated combined losses estimated at around $2.4 billion. Its UK operations, initially underwriting public liability and professional indemnity insurance, branched out into areas that HIH had little experience in, including marine reinsurance and film financing. Large losses followed, and were not stemmed due to inadequate reporting systems that impaired Australian management’s ability to effectively control the UK operations. In the US, a combination of deteriorating market conditions and significant mispricing of risk led to substantial losses. Losses were also recorded in some of HIH’s other international operations.
- Inadequate auditing
- Internal auditors focused too heavily on the accounts and not enough on the poor risk management frameworks employed by HIH. Additionally, external audits which were not rigorous enough in questioning HIH’s financial position and accounting treatments and relied too heavily on HIH’s internal audit documents. In some instances, HIH’s auditors were mislead by HIH and some of its counterparties.
In addition to the factors listed in Box 1, the Royal Commission uncovered evidence of complex and questionable reinsurance arrangements31 and aggressive accounting methods used to disguise the true (precarious) financial position of HIH. It also uncovered evidence that some senior HIH personnel may have contravened corporations laws. Subsequent investigations by authorities led to charges being laid against a number of HIH directors, senior managers and associates. Convictions followed, resulting in custodial sentences and other severe sanctions.
3.4. Post-HIH collapse reforms
Justice Owen’s report delivered 61 wide-ranging policy recommendations that addressed issues impacting on the prudential, legal and regulatory regime governing the general insurance industry in Australia. They focused on: corporate governance; financial reporting; the conduct and approach of the prudential regulator, APRA; the scope of the principal piece of general insurance legislation, the Insurance Act 1973 (the ‘Insurance Act’); state and territory regulation of insurance; and taxation of general insurance products.32
The failure of HIH also spurred changes in a number of related areas, including tort law and the introduction of support schemes for medical indemnity insurance.
Five main areas of post-HIH general insurance industry reform are discussed below.
3.4.1. Prudential regulation
Changes to the legislative framework were already underway at the time of HIH’s failure, but the collapse accelerated reform, escalated its perceived importance and public profile, and caused an expansion of the focus on aspects of regulation that were viewed as requiring attention.33 Minimum entry-level capital requirements for general insurers were substantially increased. Reforms were also introduced to enable APRA to make prudential standards for general insurance. This made standard setting a faster and more flexible process and allowed the prudential regime to more easily accommodate market developments. The current regulatory framework applying to general insurance in Australia is largely the product of these reforms.
Although the Royal Commission found that APRA did not cause or contribute to the collapse of HIH, a number of shortcomings in its supervisory practices were identified.34 APRA eschewed ‘light touch’ supervision in the wake of the collapse, and it has significantly strengthened its supervisory practices since then. In APRA’s view, its most enduring contribution to the resilience of Australian financial institutions through the Global Financial Crisis (GFC) came from its ‘close touch’ efforts to promote their financial health prior to the crisis, and to deal conclusively with struggling institutions.35
The Royal Commission recommended that APRA develop ‘a more sceptical, questioning and, where necessary, aggressive approach to its prudential supervision of general insurers’.36 This recommendation referred to general insurance, but APRA took the message to heart more broadly.37 From that point, APRA increased the frequency of its on-site visits to and regular liaison and follow-up with regulated institutions, and began to engage directly with boards on matters of prudential concern.
John Laker, the recently-retired chairperson of APRA, noted in 2010 that:
Because of the forces of history and the reality of HIH, [APRA] took advantage of Australia’s benign economic environment in the early and middle years of this decade to build the foundations for a strong regulator.38
According to Jeffrey Carmichael, the inaugural chairman of APRA, Australia is living proof of the Old Regulator’s Prayer: ‘God, let there be a failure, but a small one’.39 The failure of HIH was hardly small, but HIH was certainly not large or interconnected enough to trigger a systemic crisis like that seen in other jurisdictions in the 2000s, and its failure helped to instil in APRA a supervisory culture that was a contributing factor to Australia’s strong economic performance during and after the GFC.
3.4.2. Tort law reform
In late 2001 and during 2002, a combination of forces resulted in a severe ‘hardening’ of premium rates for liability insurance in Australia. The collapse of HIH, increasing compensation payments for bodily injury, increasingly litigious community attitudes, and changes in the way courts were prepared to extend liability for negligence combined to impact heavily on the cost of insurance.40 Consumers were confronted with significant premium increases in the previously under-priced lines of public liability and professional indemnity insurance.
It was also apparent that claims costs, and in particular the cost of personal injury claims, had escalated. In the 10 years to 2002, inflation in Australia had averaged 2.5 per cent per year while awards for personal injury had increased at an average rate of 10 per cent per year. When looking at large claims, the comparison was even more startling. Between 1979 and 2001, the highest award for personal injury grew from $270,000 to $14.2 million, an increase of over 5,000 per cent.41
In insurance law, jurisdictional powers are split between the states, territories and the Commonwealth. The Federal Minister for Revenue and Assistant Treasurer thus convened a series of meetings with ministers from all jurisdictions to tackle the prob
lem. The result was a succession of changes, implemented by all jurisdictions, which can be broadly grouped into three types:42
- establishing liability — changes to the law governing decisions on liability, including contributory negligence43 and proportionate liability;
- damages — changes to the amount of damages paid to an injured person for personal injury claims or for economic claims against a professional;44 and
- claims procedures — time limits and methods for making and resolving claims, including court procedures, legal conduct and legal costs.
This extensive program of law reform in a limited timeframe was described as unprecedented in the history of Australian insurance law and, taking into account the complexity of Australia’s multiple jurisdictions, perhaps a first for the common law world. In 2006, the Government reported that there was evidence of the above reforms achieving their goal of improving the availability and affordability of public liability insurance.45
3.4.3. Medical indemnity insurance
The problems experienced in the medical indemnity insurance sector were similar to those found more broadly in professional indemnity insurance. From the mid-1990s, the sector experienced a dramatic increase in the frequency and severity of claims. HIH was a major reinsurer of United Medical Protection Limited/Australasian Medical Insurance Limited (UMP/AMIL), then Australia’s largest medical defence organisation.46 HIH’s failure, coupled with the events of 11 September 2001 and the resultant downturn in financial markets, did irreparable damage to UMP/AMIL and it was placed into provisional liquidation in May 2002.47 Doctors threatened to cease work in hospitals in response to concerns about the availability and affordability of medical indemnity insurance.48
Shortly after UMP/AMIL’s collapse, the Commonwealth Government established a number of schemes to subsidise premiums for medical practitioners in Australia and provide financial assistance to medical indemnity providers and medical practitioners for high-cost claims. These schemes were consolidated (along with a number of professional indemnity programs for midwives) into the Indemnity Insurance Fund in 2011. The total value of funds available under the Fund is $427 million over 2012-13 to 2015-16.49
In February 2014, the National Commission of Audit (NCOA) found ‘strong evidence’ that the market for medical indemnity insurance is normalising. Average premiums have fallen since 2003-04 and major firms in the medical indemnity sector have reported healthy profits.50 Recommendation 48 of the NCOA was that the Commonwealth scale back its subsidies. The Government responded to the NCOA findings on 13 May 2014, noting that reforms to medical indemnity would be considered following the 2014-15 Budget.51
3.4.4. Discretionary Mutual Funds and Direct Offshore Foreign Insurers
Discretionary cover is an insurance-like product that involves no legal obligation by the provider to meet the costs of an ‘insured’ event. At the time of the failure of HIH, doubts were raised about whether discretionary cover was subject to provisions under the Insurance Act and therefore APRA’s regulatory regime. The Royal Commission found that consumers would be unwilling to accept the failure of a provider of discretionary cover, and therefore recommended that the Insurance Act be amended to extend prudential regulation to all discretionary insurance-like products.52 Discretionary mutual funds (DMFs)53 at the time represented less than one-half of one per cent of the Australian general insurance market.54
The Royal Commission also examined the insurance of risks in Australia that were underwritten by direct offshore foreign insurers (DOFIs), today known as unauthorised foreign insurers. It found that in many instances it might be unnecessary to regulate offshore insurance, as much of this business was likely to involve large commercial contracts (where the purchaser would normally be considered able to judge for itself the risks involved in the transaction).55 On the other hand, the Royal Commission also considered suggestions that offshore insurance might constitute a ‘gap’ in APRA’s regulatory regime.56 It made no formal recommendations on this matter.
In response to the Royal Commission’s findings, the Government commissioned an independent review of DMFs and DOFIs.57 The review recommended that discretionary mutual cover be offered only as a contract of insurance under the Insurance Act,58 and that DOFIs be exempted from prudential regulation if they were domiciled in a country APRA considered to have comparable prudential regulation to Australia (subject to a market significance threshold).
In 2007, the Minister for Revenue and Assistant Treasurer announced reforms to ‘address the risk to Australian consumers and businesses from unauthorised DOFIs that are unscrupulous or that fail’.59 Any person or company wishing to undertake insurance business in Australia must now obtain an authorisation from APRA.60 The Government also decided that, in the absence of appropriate data, it would not (yet) subject DMFs to prudential regulation. However, it did legislate to require DMFs to provide detailed data on their operations to APRA.
The Minister announced that within three years of the start of the DMF data collection regime, the Government would review the data to determine whether there was a need for prudential regulation to apply to DMFs. This data collection period has been extended three times: to the end of the 2010-11 financial year; again to the end of the 2011-12 financial year; and then once more to the end of the 2012-13 financial year. At the time of writing, there has been no further progress on analysis of whether DMFs should be subject to prudential regulation.
3.4.5. Financial Claims Scheme
The Financial System Inquiry of 1997 (the ‘Wallis Inquiry’) examined the question of depositor and policyholder protection, but did not recommend an explicit protection scheme. Later, in 2003, the Royal Commission concluded that the time was right to re-examine whether there should be a safety net for holders of general insurance policies (and for third-party claimants against such policies).61 It went on to recommend that the Commonwealth ‘introduce a systematic scheme to support the policyholders of insurance companies in the event of the failure of any such company.’
At the time, policyholder support schemes were widely used in other countries. At the end of 2000, there were 21 OECD countries — including the US, the UK, Canada, Germany, France and NZ — with one or more protection schemes covering insurance companies. Without a policyholder support scheme in Australia, in the event of the failure of an APRA-auth
orised general insurer, policyholders would simply be pooled with other unsecured creditors in a wind-up process that in most cases would be complex and lengthy.62
Worries that an explicit policyholder support scheme could create moral hazard had persuaded previous Australian governments not to introduce such a scheme. However, the collapse of HIH and the establishment of the HIH Scheme had the effect of challenging the credibility of government statements that there were no implicit guarantees for policyholders. Concerns that an explicit scheme could create moral hazard became of less import if there was widespread public belief that implicit guarantees existed.63
The Government responded to the Royal Commission’s recommendation by commissioning a technical study to consider the merits of introducing an explicit guarantee for part or parts of the Australian financial system. The technical study, which reported on 26 March 2004, found that the costs and benefits of adopting a guarantee scheme appeared to be finely balanced.64
In 2005, the Council of Financial Regulators65 completed a comprehensive review of Australia’s failure and crisis management arrangements.66 The Council recommended that the government consider a compensation scheme that would apply to retail deposits in authorised deposit-taking institutions (ADIs) and the policyholder claims of life and general insurers. The Council noted that, given the lengthy nature of the wind-up process for a financial institution, it could take many months, or even years, before funds are made available for distribution. This could create financial hardship for households and businesses, generating pressure on the government to make an ad hoc response.
Three years later, at the height of the GFC, legislation was passed introducing a Financial Claims Scheme (FCS) to protect depositors of ADIs and policyholders of general (but not life) insurers in the event of an insolvency of an APRA-authorised ADI or general insurer.67 The FCS ensures that protected depositors and policyholders receive early access to funds, providing certainty and economic stability whilst the formal liquidation of a failed institution is carried out.68
17 Wenham (2001).
18 The Australian Rugby Union was able to arrange temporary replacement cover with QBE later in March 2001.
19 Dore et al. (2001).
21 Wenham (2001), op. cit.
22 The sale also included the transfer of HIH’s small business packages, rural packages and most small commercial insurances (such as commercial motor, fleet motor less than 150 vehicles, property with asset values less than $20 million, public and product liability policies with turnover less than $5 million, and marine) arranged through distributors other than international brokers. These insurance lines were covered under the joint venture established between Allianz Australia and HIH.
23 HIH’s corporate insurance policies included professional indemnity, public and product liability, directors’ and officers’ liability, group salary continuance, trade credit and builders’ warranty insurance.
24 Productivity Commission (2010), Chapter 10.
25 Dutton (2006), page 11.
26 ibid, page 8.
27 Australian Competition and Consumer Commission (2002), op. cit.
28 International Association of Insurance Supervisors (2011), page 48.
29 Howard and Hockey (2001).
30 Adapted from the findings of the HIH Royal Commission (2003), op. cit.
31 HIH entered into reinsurance arrangements where it agreed to not make claims against its reinsurers. Under these arrangements, first used by FAI and later HIH, the reinsurance was booked as an asset, even though risk was not in effect ceded to the reinsurers. FAI’s use of financial reinsurance (as such transactions are known) helped conceal its financial problems at the point HIH acquired the company.
32 Carrigan (2004).
33 ibid, page 4.
34 These shortcomings may have been exacerbated by the fact that APRA had to respond to a number of other general insurance near-failures in the years leading up to HIH’s collapse. Two other large Australian insurers, GIO and MMI, were reportedly on the brink of collapse in 1998 before they were taken over by AMP and Allianz Australia, respectively. In addition, Palmer (2002) noted that the loss of corporate memory and industry expertise in creating APRA had an inevitable short-term impact on the quality of supervision in APRA.
35 Australian Prudential Regulation Authority (2014), page 6.
36 HIH Royal Commission (2003), op. cit., Recommendation 26.
37 Australian Prudential Regulation Authority (2014), op. cit., pages 19-20.
38 Blees (2010).
39 Cornell (2009).
40 Coonan (2004), page 3. As noted in Subsection 3.2, the hardening of insurance markets more broadly was driven by a series of natural disasters and a decline in equity markets and investment returns for insurers, due to the bursting of the ‘dot-com’ bubble and the 11 September 2001 terrorist attacks.
41 ibid, page 4.
42 In addition, ministers at the ministerial meeting on insurance issues in May 2002 agreed to the ACCC monitoring costs and premiums in public liability and professional indemnity insurance on a six-monthly basis. In 2006, this practice was suspended in light of the more comprehensive data that became available from APRA’s National Claims and Policies Database (NCPD).
43 An important contribution to the reforms was a report commissioned by ministers to review the law of negligence. An expert panel, chaired by Justice David Ipp, made 61 recommendations to governments on a principled approach to reforming the law. In November 2002, ministers formally agreed on a package of reforms implementing the Ipp Review’s key recommendations.
44 For instance, professional standards legislation allows professionals to limit their liability in
exchange for risk management, compulsory insurance and other consumer protection initiatives.
45 Dutton (2006), op. cit., page 64. Similarly, in 2009, the ICA reported that it was clear the objectives of the tort law reforms had been met. In contrast, Wright (2006) argued that litigation rates generally had not increased in the period leading up to the Ipp Review and that there was no foundation for the premises underlying tort law reform as a strategy for addressing the insurance ‘crisis’.
46 Before 1 July 2003, medical indemnity protection was traditionally offered by medical defence organisations (MDOs). Cover provided by MDOs was discretionary — that is, the medical practitioner had no contractual right to be indemnified by the MDO. MDOs operated mainly along state lines and were outside APRA’s prudential framework. These arrangements changed on 1 July 2003, when the Commonwealth passed legislation to require that medical indemnity cover must be provided by an insurer authorised by APRA.
47 Toh et al. (2009), pages 11-12.
48 Coonan (2004), page 10.
49 The MIIF includes the following schemes: Exceptional Claims Scheme; Run-off Cover Scheme; High Cost Claims Scheme; Premium Support Scheme; Incurred-But-Not-Reported Indemnity Claims Scheme; Midwife Professional Indemnity (Commonwealth Contribution) Scheme; and Midwife Professional Indemnity Run-off Cover Scheme. The MIIF was established in 201 through the consolidation of a range of existing medical indemnity and professional indemnity for midwives programs. See Department of Health (2014).
50 National Commission of Audit (2014), Appendix: Volume 2, pages 118-123.
51 Hockey and Cormann (2014).
52 HIH Royal Commission (2003), op. cit., Recommendation 42.
53 A DMF may be a trust, mutual, company limited by guarantee or other structure.
54 Treasury (2005), page 28.
55 Most of the business placed with unauthorised foreign insurers, notably including professional indemnity and public liability insurance, was classified under the Corporations Act 2001 as ‘wholesale’ business. This meant that the intermediaries offering these products to consumers were not subject to the conduct and disclosure requirements introduced by the Financial Services Reform Act 2001 for ‘retail’ business.
56 HIH Royal Commission (2003), op. cit., s.8.8.4.
57 Potts (2004).
58 Unless APRA considers in the case of an individual entity that there is no residual contingent risk.
59 Dutton (2007).
60 Limited exemptions are granted for insurance business that cannot be appropriately placed in Australia.
61 HIH Royal Commission (2003), op. cit., Chapter 11.
62 With the collapse of HIH, policyholders (apart from those transferred to Allianz Australia, QBE or NRMA Insurance) would have ranked with other unsecured creditors in relation to valid policy and premium refund claims. The Provisional Liquidators announced that it was unlikely that the distribution of any available assets, either through liquidation or a Scheme of Arrangement, would occur for at least nine months. See HIH Insurance (2013b).
63 Davis and Jenkinson (2013), page 9. In addition, there is strong community expectation of government assistance in the event of the failure of a general insurer. In 2006, the Reserve Bank of Australia (RBA) commissioned a survey on public attitudes regarding what would happen if a general insurer was to fail. Around 50 per cent of respondents believed either that their policies were guaranteed by the government, or that the government would step in to protect them in the event of a failure, despite the fact that no explicit guarantee existed. See Treasury (2012), page 7.
64 Davis (2004).
65 The Council is the coordinating body for Australia’s main financial regulatory agencies. It consists of the RBA, APRA, ASIC and the Treasury.
66 Council of Financial Regulators (2005).
67 Australian Prudential Regulation Authority (n.d). Note: The FCS is entirely post-funded and is intended to have few other compliance costs for general insurers in normal circumstances.
68 To date, the FCS Policyholder Compensation Facility has been activated only once (in 2009) for a small general insurer, Australian Family Assurance Limited, which had been in run-off since 2002. See Bowen (2009).