The Art of Deception
Sydney Morning Herald
April 16, 2005
Posted December 19, 2005
Some insurers have taken unacceptable risks to prop up profits, write Elisabeth Sexton and Lisa Murray.
Justice James Wood takes a dim view of people who publish misleading annual reports. When he sentenced former HIH boss Ray Williams on Friday, the chief judge in common law said the offence involved "serious criminality".
"[It] risks undermining the public confidence in published accounts, that is essential for the orderly conduct of financial markets," he said.
Williams will go to jail for at least two years and nine months, subject to a foreshadowed appeal.
The term should send a powerful message to others in business.
It's rare to see a chief executive heading to Silverwater jail. More ominously, there are many signs that Williams is not the only executive to have been tempted by the same method of falsifying accounts.
Five, six, seven years after the doctoring took place, prosecuting authorities and those left out of pocket finally are coming to grips with a scandal extensively investigated by the royal commission three years ago. It now appears the practice has spread well beyond HIH and its subsidiary FAI.
Known as the misuse of "financial reinsurance", the issue recently exploded on Wall Street where New York Attorney-General Eliot Spitzer has turned his crusading zeal to it. It has flared again in Australia with a fresh regulatory crackdown.
On March 28, Spitzer claimed the scalp of Hank Greenberg, who quit after running America's largest insurer, American International Group, for 37 years, as the company acknowledged it had "improperly" accounted for a $US500 million contract.
Spitzer said: "The evidence is overwhelming that these were transactions created for the purpose of deceiving the market. We call that fraud. It is deceptive. It is wrong. It is illegal."
AIG bought the contract from a company called General Reinsurance, a subsidiary of the much-admired investment company Berkshire Hathaway.
On Monday, the legendary chairman of Berkshire, Warren Buffett, suffered the indignity of giving evidence to state and federal investigators in New York about the contract AIG bought from General Re.
Berkshire has also quietly repaid $82 million to the HIH liquidator, a sum which equates to money FAI deposited with two Berkshire subsidiaries as part of controversial financial reinsurance arrangements.
On Thursday, a more serious fate befell the Australian arm of General Re when an official inspector with wide-ranging powers was appointed to investigate its conduct.
The inspector, insurance expert Estelle Pearson, has access to all of the company's books and records and can compel company insiders and external parties such as auditors and clients to answer questions on oath. The penalty for refusal to co-operate is three months' jail.
The Australian Prudential Regulation Authority has armed Pearson with these powers to get to the bottom of General Re's marketing of financial reinsurance.
A spokesman for General Re's local arm said on Thursday the reinsurer would continue to "co-operate fully" with APRA.
The regulator welcomed this statement, but has clearly not been persuaded by General Re that it has cleaned up its act since 2002, when several of its senior executives endured stints in the witness box at the HIH royal commission.
General Re's name landed on the front pages when a former executive, Andrew Allison, gave evidence that the FAI deal was not a one-off.
In a dramatic development, commissioner Neville Owen asked Allison to write on a piece of paper the names of other insurers who had bought suspect policies from General Re, and then imposed a confidentiality order.
Allison described being berated by his boss for telling a staff seminar the way General Re "was doing financial reinsurance" in the late 1990s was not allowed by the regulator.
Just how widespread the practice was in Australia remains a hot topic of speculation.
FAI bought two policies, one from General Re and another from another Berkshire subsidiary, National Indemnity.
Four other controversial contracts are now on the public record.
HIH (which got into the game after it bought FAI and uncovered its deals) bought one from Hannover Re. It was that deal that landed Williams in prison.
Specialist reinsurer New Cap Re bought one from General Re, shortly before it went into liquidation in 1998.
GIO was saved from collapse by being taken over by AMP shortly before its reinsurance arm reported a $789 million loss in 1999. It too was negotiating a policy relating to these losses with a subsidiary of Munich Re shortly before the takeover.
The most recent case to come to light involves a solvent company: Zurich Financial Services Australia.
APRA is on the brink of taking enforcement action against Zurich in relation to a policy it bought from General Re in 2000.
On Thursday, APRA said Pearson's appointment as inspector to General Re followed its "investigation in 2004 of certain financial reinsurance practices in Australia".
This suggests its crackdown on General Re was not so much sparked by the now well-picked-over insurance collapses of several years ago, but by a concern that dubious practices have been employed by companies and executives still operating.
Industry sources say financial reinsurance is uncommon today. This is partly due to the bad publicity and regulatory action. But it is more because the industry is benefiting from the best conditions in over 30 years.
Financial reinsurance is defended as a legitimate means of managing the impact of the peaks and troughs of the insurance cycle on company results. The problem arises in the way it is treated in the accounts.
However, it is notable that insurers only ever seem interested in using financial reinsurance in bad times.
After the alarm caused by Allison's evidence, APRA sent a letter to all local insurance companies asking them to confess to any financial reinsurance transactions with questionable accounting treatment.
Insurance industry sources say many contracts were unwound or accounts adjusted when insurers owned up.
To book reinsurance recoveries as income, there needs to be a genuine transfer of risk from the insurer to the reinsurer. If instead the aim is to smooth the insurer's earnings with no risk transfer, it should be accounted for what it is: a long-term deposit arrangement.
One company which said it had no suspect transactions was Zurich.
The regulator is said to have been furious in March last year when a Zurich staffer quietly alerted APRA about a 2000 contract with General Re uncovered by its compliance department.
APRA immediately began an investigation, followed soon after by a separate one by the corporate regulator. The Australian Securities and Investments Commission's probe is understood to focus on Zurich's published accounts and whether executives misled the board.
Last June, APRA announced an inspector was examining Zurich. Three weeks later, the chief executive, John Butler, who had been head of the general insurance arm in 2000, quit the company. Others followed. Zurich said in August that "none of the officers involved in the establishment of the arrangements in 2000 is still with the Zurich group in Australia".
The contract is believed to have boosted Zurich's 2000 profit by $60 million but the impact has since been reversed.
Zurich reported last month that its financial statements for the years 2000 to 2003 contained "errors". It said the financial impact of those errors would be contained in its 2004 results.
Full details of how Zurich accounted for the policy are yet to come to light, but a common characteristic of misused financial reinsurance contracts is that they offer an immediate boost to profits at the expense of losses in later years.
Investigators have been told the contract was written after the Swiss parent company refused to top up the claims reserves of the local arm.
Like all its rivals in the industry, Zurich was battling a low point in the insurance cycle in the late 1990s but is now enjoying better times.
"Zurich is financially sound and we are exceeding our capital requirements," said Rob White, the company's spokesman in Australia. "There's no question about our solvency."
The 2004 accounts were "still on schedule for release" this month, he said.
The Swiss parent company has already released its consolidated accounts which include a $US140 million charge following an internal review of its accounting for reinsurance arrangements.
The annual report disclosed that some business units purchased reinsurance from third parties, which in turn passed the risk back to other Zurich business units. When asked how much of the charge related to Australia, Daniel Hofmann, a spokesman for the parent company, said: "I don't want to speculate. There is a number of complex transactions that were conducted. Some of them are now unwound, some of them have been commuted."
It seems unlikely that any investor or policy holder will lose money because of the Zurich transaction.
But others have not been so fortunate.
In 1998, a group of sophisticated investors paid $80 million for notes convertible into shares in a company listed on the Australian Stock Exchange called New Cap Reinsurance. Two months later, New Cap collapsed and they lost the lot.
The investors are trying to recover their money in a NSW Supreme Court action, which will be heard in August.
The liquidator, John Gibbons from accounting firm Ernst & Young, has alleged that there was a "dishonest and fraudulent design" to falsify the accounts included in the prospectus for the notes.
The culprit was a contract which New Cap bought from General Re.
Gibbons has settled a civil case against General Re on confidential terms.
In a judgment last year, Justice Peter Young said Gibbons alleged that there were two "legs" to the contract, but only one was disclosed in the accounts.
The balance sheet "included as an asset the monies that would flow through to the company under Leg One whilst [under Leg Two] there were repayment offsets which were certain to arise which would eliminate it."
Gibbons claimed that if the true position had been described in the accounts, New Cap would have been unable to write new business and would "inevitably" have gone into an orderly wind-down before the new capital was raised.
Another example also came to light well before the HIH collapse. Australia's largest life insurer, AMP, became a laughing stock when it tried to buy a similar dominance of the general insurance industry by taking over GIO.
It succeeded in 1999, and stunned the market by reporting later that year that GIO's reinsurance arm had incurred an annual loss of $789 million. GIO's takeover defence documents had predicted a reinsurance profit of $80 million.
ASIC has taken civil action against three GIO reinsurance executives, Geoffrey Vines, Frank Robertson and Timothy Fox. The three, who have denied the claims, are waiting for judgment to be handed down.
The regulator's case alleges that Vines and Fox improperly negotiated a financial reinsurance transaction with American Re, a subsidiary of industry leader Munich Re.
ASIC says the contract was designed to avoid disclosing losses caused by Hurricane Georges until after the AMP takeover.
The transaction was rejected by the GIO's due diligence committee and the external auditors, but it cost GIO $489,000 to exit it.
ASIC is seeking civil penalties and banning orders.
ASIC's action against Williams was a much tougher criminal charge. He pleaded guilty to knowing that HIH's 1999 published profit of $102 million was misleading, because it was overstated by $92 million thanks to a contract purchased from Hannover Re.
Handing down sentence on Friday, Justice Wood said: "The arrangement, which went under the euphemism of 'financial reinsurance', did no more than involve a notional transfer of the risk which HIH had accrued, and retained, subject to shifting the time for payment.
"In truth, the arrangement should have been treated [in the accounts] as involving a capital transaction because HIH was providing the funds from which the supposed reinsurance would be paid, without any transfer of the risk."
HIH got into the financial reinsurance game after it took over FAI in 1998. It uncovered two contracts which obliged it, as the new owner, to continue paying premiums to General Re and National Indemnity. The so-called benefits of these policies had been booked shortly before the takeover when FAI reported an annual profit of $9 million.
The HIH royal commissioner, Neville Owen, concluded that the real result was a $49 million loss.
Three FAI executives, Daniel Wilkie, Tim Mainprize and Stephen Burroughs, face trial later this year on ASIC charges that they concealed the true nature of the General Re contract from FAI's auditors.
Last year, the prosecuting authorities granted indemnities from self-incrimination to three General Re executives who have agreed to give evidence against the FAI trio. The protection was granted to Geoff Barnum, Andrew Smith and Lindsay Self.
These three, along with three colleagues, were all disqualified from holding senior positions in the insurance industry by APRA last year. All are appealing against the disqualifications, which related to the FAI transaction.
In the meantime, HIH liquidator Tony McGrath of McGrathNicol+Partners is trying to extract money from the reinsurer for those left out of pocket by Australia's largest corporate collapse.
McGrath has filed a substantial damages claim in the NSW Supreme Court alleging that General Re engaged in deceptive conduct that helped FAI falsify its accounts and that this deception was a cause in the collapse of HIH.
McGrath has not publicly disclosed the sum he is seeking in damages, but has made no secret of the fact that General Re is one of his biggest targets in retrieving money for creditors.
The HIH royal commissioner said a conservative calculation of how much HIH lost by making the poor decision to purchase FAI was $591 million.
McGrath received a cheque for $27.2 million from General Re last May. This did not include any recompense for damages, but was the amount FAI had on deposit with General Re as part of the reinsurance arrangements.
Creditors have also retrieved funds from the vendor of FAI's second controversial policy, National Indemnity.
On December 16 last year, the Nebraska company transferred $55.1 million into FAI's bank account, an amount equal to the sum FAI still had on deposit with National Indemnity at the time it collapsed.
A spokesman for McGrath Nicol said this week all matters relating to the payment were subject to a confidentiality agreement.
NSW Supreme Court records show that last May McGrath started a civil suit against National Indemnity to unwind a so-called "uncommercial transaction".
Unlike its sister company General Re, National Indemnity has no corporate presence in Australia.
But Justice Reg Barrett allowed the case to proceed after accepting evidence from a US lawyer, Richard P. Garden jnr.
Garden told the judge he had properly served papers on the defendant, "a Nebraska corporation in good standing".
It was a bit of an understatement. Since 1940, National Indemnity Company has grown into one of the most successful insurance companies in America.
Buffett said last month that if his company had not taken over National Indemnity in 1967, "Berkshire would be lucky to be worth half of what it is today."
Based on the Berkshire share price, that puts a value of $US67 billion ($87 billion) on the insurer.
Understandably, Buffett has been a consistent admirer of National Indemnity and its senior management. He often singles out for praise its head of reinsurance, Ajit Jain.
"Ajit's value to Berkshire is enormous," Buffett told shareholders in a letter on March 5.
When Buffett faces questions from the floor at his annual "Woodstock for capitalists" shareholder gathering in Omaha next month, he might wish that Jain had not been exposed in the HIH royal commission as personally annotating the 1998 contract with FAI.
He might also wonder whether buying General Re in 1998 was such a good idea.