Essay on Corporate Governance for Australian Organizations

Executive Summary The main objective of this paper is to explore the major significance of corporate governance in an organization. In order to explain the central idea of corporate governance, a public listed company of Australia has been selected. In this paper, HIH collapse will be discussed along with its corporate governance framework and failure. This report will clearly explain the significance of effective corporate governance in HIH Insurance. Table of Contents Executive Summary. 2 Introduction. 4 Importance of Corporate Governance. 4 Principles of Corporate Governance. 5 Corporate Governance Failure of HIH Insurance. 6 HIH Collapse. 7 Corporate Governance Failure in HIH Insurance Limited. 9 Conclusion and Recommendations. 12 References. 13 Introduction Business risk management includes various activities including corporate governance. Corporate governance basically supports the organization in meeting its objective of maximization of the shareholders wealth. Failure of corporate governance has leaded many organizations towards bankruptcy as well as affected the shareholders and concerned community. Global concern regarding corporate governance is increasing due to collapse of gigantic public listed companies. In 21st century, one of the biggest corporate failures in Australian market is collapse of HIH Insurance Limited. It has been identified that the organization has been over-optimistic in evaluating the assets. In contrast, the liabilities of the organization were extensively underestimated. HIH Insurance was liquidated in 2001 which leaded to substantial loss for the shareholders, policy holders and creditors of the organization. The major reason for the collapse of HIH insurance is the corporate governance of failure in term s of managing the risk of the organization. The entire corporate world can learn a lesson from the incident of HIH and focus on improving the corporate governance. In this paper, severity of the corporate governance is discussed in context of HIH Insurance Limited collapse (Hih.com.au, 2014). Importance of Corporate Governance Corporate governance is a system of an organization which is responsible for directing and controlling the corporate activities of the organization. Corporate governance distributes the responsibilities and authority among different individual, committee or bodies of the organization. It also designates the rules and process for making decision regarding corporate affairs. According to Fama and Jensen, Corporate governance can be described as the control over the entire operations of an organization. In other words, corporate governance is a framework of the principles and systems which guides, manages and controls the operations of an organization. The objective of corporate governance is to provide a mechanism that assists the stakeholders in exerting control over the management and organization so that their interest is catered. Effective corporate governance aims to achieve the corporate objective by enhancing the performance, improving the financial management and maintaining in tegrity of an organization. Over the past few decades corporate governance issues have received extensive attention in the public policy debates. Corporate governance is receiving greater importance as it has significant impact on the economic performance of the organization. An organization having superior quality corporate governance will assist the organization in having easy access to the capital market. The major components of corporate governance in an organization are the Board of Directors, Corporate Governance Committee, Legal framework, Organizational regulations, Business Policy, Ethical codes, Transparency and disclosure, Effective management of risk, Monitoring and Communication. Internal audit is an important tool that helps in carrying out all the corporate governance activities efficiently (Kim and Nofsinger, 2007). Principles of Corporate Governance The concept of corporate governance revolves around some basic principles. Corporate governance principles are discussed below: Every organization must respect the rights of the shareholders and enable the shareholders to exercise their rights. This requires effective communication of information which can be facilitated by motivating the shareholders to take part in the general meetings of the company. Every organization must recognize the obligations to its stakeholders (government, local community, suppliers, investor, society, employee etc) and design its business activities accordingly (Monks and Minow, 2004). The corporate governance board members must have relevant skills and knowledge about the procedure. They must understand and review various challenges regarding corporate governance. Moreover, the boards must be adequate and it has suitable level of independence as well as commitment. It is the responsibility of the organization to develop an appropriate code of conduct for its board of directors as well as executives which will be an aid in promoting the ethical decision making process in the organization. Maintenance of integrity must be basic criteria for appointing the executives and board members for corporate governance. The board of the organization is accountable to the stakeholders for its activities. It is the responsibility of the organization is to disclose and clarify the roe of the corporate governance board and management in maintaining integrity of the organization. Procedure must be adopted which will support the verification of integrity of the financial reports of the organization. All relevant information must be communicated to the investors to have a lucid and transparent idea about the activities of the business (Mallin, 2004). Corporate Governance Failure of HIH Insurance HIH Insurance Limited was one of the largest publicly listed companies in Australia. It used operate in various countries and was the second largest insurance companies of Australia. The organization was founded in 1968 and it acquired some other insurance companies. The organization has expanded and diversified globally. HIH was listed on Australian Stock Exchange (ASX). In 2001, HIH was liquidated as it failed to pay back its debt obligation. The estimated loss was 5.3 billion dollar (Austlii.edu.au, 2014). HIH Collapse The major cause of HIH collapse is failure in corporate governance. If the case is analyzed from the financial perspective it can be observed that the company encountered liquidation position as HIH Insurance was incapable of paying the claims to the policy holders. Moreover, it also failed to meet other debt obligations. The inefficient financial management of the organization has leaded to the poor cash position of HIH Insurance. This allegation against the second largest insurance of Australia is universally accepted. In order to manage the operational activities of an organization, each company needs to maintain enough cash balance. At the beginning and end of each operating cycle the company can maintain required level of cash by generating more revenue and managing it effectively. The cash position of an organization reflects the operating policy, financial policy and business activities of the organization. Moreover, there are some long term non cash transactions which influen ce the cash position of an organization. Hence, in order to identify the reason of collapse emphasis must be given on operational as well as financial activities of the organization. The insurance industry has to deal with enormous risk and every organization has high risk in terms of going concern issue. Risk in insurance industry can be mitigated by adopting appropriate strategies regarding risk pricing, investment decision and provision for outstanding claim. The risk pricing ability of an insurer can be represented by the underwriting performance of the organization. According to the investigation report presented by Royal Commission, in 1997 HIH Insurance Company had incurred underwriting loss of 33.8 million dollar. The net earnings of the company in 1997 were 1233.5 million dollars. Again the underwriting loss was estimated for 1999 and 2000. In 2000, the underwriting loss of HIH Insurance was estimated to be 103.5 million dollar for the net revenue of 1995.4 million dollar. It was observed than within the two years period (from 1997 to 1990), the estimated underwriting loss was doubled with the rise in earnings by 25%. The major reasons behind the incurre d loss are outstanding provision fro claim, recovery of reinsurance and underwriting expenditures. According to the investigation report presented by the Royal Commission, CEO of HIH Insurance Limited did not acknowledge the requirement for prudential margin. Consequently, the company had adopted as well as implemented an under-reserve policy with respect to the expected future claims. If the organization followed the regulatory Australian Prudential Regulation Authority (APRA) for setting the prudential margin, the underwriting performance of HIH Insurance would have decline which would reflect the real situation of the organization. It is frequently observed that a general insurer makes loss on the underwriting in a certain period of time. But, in case of HIH Insurance it is observed that the company is continuously encountering losses on underwriting for successive periods. Hence, it can be concluded that HIH experienced this situation due to continuous deterioration in operational activities (Findlaw.com.au, 2014). One of the most significant activities of an insurance company is managing investment activities. Money collected from the shareholders, policy holders and creditors need be invested in suitable funds so that the return is maximized. Thus the underwriting loss can be recovered by the high return achieved from investment. If the organization fails to manage its investment activities effectively it will generate negative return from investment. HIH Insurance had encountered significant loss in terms of investment. These are the major reasons for collapse of HIH Insurance apart from corporate governance issue. Corporate Governance Failure in HIH Insurance Limited One of the principle reasons for bankruptcy of HIH Insurance Limited is flawed corporate governance practice. According to Agency theory, agency cost can lead to bankruptcy of an organization. Hence, financial theories suggest that equilibrium must be maintained between the debtors and stockholders of the organization. In order to maintain the equilibrium effective corporate governance practice is considered to be an effective tool. In contrast, failure in corporate governance will lead to agency problem which is the major reason for collapse of an organization. In the annual report of HIH Insurance it had established a model for corporate governance which apparently seems to be effective for an organization. The corporate governance model outlined in the annual report of 2000 complies with the guidelines mentioned by Australian Securities Exchange (ASX). In the board level of HIH Insurance there are four major committees. Audit Committee: Audit Committee of HIH Insurance is responsible for considering the significant issues regarding the financial affairs through monitoring compliance of accounting policy, internal audit issues etc. Human Resource Committee: The Human Resource Committee of HIH Insurance was developed for reviewing the remunerations of senior executives, issues regarding the formation of board, issues related to organizational structures, development plans for employees etc. Reinsurance Committee: The responsibility of the reinsurance committee is to review the scope as well as character of the Group reinsurance policies. Investment Committee: The major responsibilities of the investment committee are consideration as well as formulation of Group asset allocation. Moreover, it determines the guidelines of investments and responsible for and reviewing the internal as well as external fund performance. According to the investigation report disclosed by Royal Commission, HIH Insurance had lot of flawed practice in Corporate Governance which leaded to major financial break down of the organization. The identified flaws regarding corporate governance are discussed below: In HIH Insurance management did not allowed the non-executive directors to work independently. There were five non-executive directors and among those two directors were former partner of an accounting firm. HIH Insurance paid them for auditing service as well as non-auditing service. Non-auditing service is the major reason for detracting the independence from the auditors and associated directors. The takeover of FAI is considered to be a major reason of failure of HIH Insurance Limited. HIH had to pay large cost for acquiring FAI. The investment committee failed to evaluate the consequence of this acquisition. The member of investment committee Rodney Stephen Alder is suspected as he could have been paid due diligence. In 2000, in order to insure the directors and executives, an entity used to pay the insurance premiums. It was recorded as liabilities but the amount and nature of the liability as not disclosed by the company. Lack of transparency leaded to corporate governance failure. Due to lack of independence of the directors, they fail to perform their job role effectively. Consequently, the corporate governance practice in HIH Insurance represented some kinked characteristics. Scarcity of clear definition and clarity of the guidelines, policies etc, lack of independence of non-executive directors and it leaded to no critical analysis of the proposals suggested by management. Thus, the corporate governance failed to identify and solve the conflict of interest in HIH Insurance Limited. Excessive dominance of the CEO, Ray Williams leaded to corporate governance failure in the organization. Due to his excellent performance and credibility he had won respect from everybody in the organization. The high ranking of the organization made him overconfident and he did not considered the interest of the shareholders. The board of directors also encouraged him to run the organization depending on the free will of Ray Williams. The existence of a dominant CEO in HIH insurance was a major reason for failure of the corporate governance. The company gradually shifted its focus from the interest of the stakeholders to their own corporate benefits. Corporate governance is an effective model for managing the risk of an organization. In case of an insurance corporation, risk management plays a vital role. The investment committee failed to perform effectively which can be reflected in three massive investment failures. It can be understood that risk management of HIH Insurance organization was not well shaped. According to Justice Neville Owen, directors were not serious while analyzing various strategies. Moreover, the investment decisions and risk were not evaluated properly. Accounting system plays a significant role in corporate governance model. In HIH Insurance Limited, the non-executive directors did not have sufficient access to the relevant information. Thus the activities for fulfilling the corporate governance standard I compromised by the non executive directors. Hence, they have to rely on the accounting system organized by the management of HIH Insurance which incorporates huge risk. As the non executive directors do not have the independent resources for information they fail to meet their responsibilities (Jiangbo, 2005). The above stated reasons are considered as the principle reason for corporate governance failure in HIH Insurance Limited. Conclusion and Recommendations From the above discussions it can be concluded that corporate governance plays a significant role in achieving the organizational goals. The failure in corporate governance had leaded to HIH collapse. Few recommendations can be made for building effective corporate governance model in Australian organizations: Every organization must lay strong foundation for managing organizational activities and oversight. The corporate governance board must be structured in such a way so that it can add value to the organization. The board must consist of more number of independent directors. Organizations must provide all relevant information to the board. Moreover, the procedure adopted for evaluating the performance of corporate governance board. Ethical, rational and responsible decisions must be made. Every corporation must have an organized approach for verifying and safeguarding the integrity of the financial reporting independently. Regular and balanced disclosure of material matters is required by the company. The rights of the shareholders must be respected. Risk management must be effective by recognizing risk properly and with the aid of internal control. The remuneration offered by a company must be fair and reasonable (www.asx.com.au, 2011). References Austlii.edu.au, (2014).Adams, Michael --- "Australian Corporate Governance: Lessons from HIH Insurance" Findlaw.com.au, (2014).The HIH legacy: Corporate governance and shareholder value. Hih.com.au, (2014).HIH Insurance - Home Page. Jiangbo, X. (2005). HIH Insurance Limited: Corporate Governance and Corporate Excesses. Kim, K. and Nofsinger, J. (2007).Corporate governance. 1st ed. Upper Saddle River, N.J.: Pearson/Prentice Hall. Mallin, C. (2004).Corporate governance. 1st ed. Oxford: Oxford University Press. Monks, R. and Minow, N. (2004).Corporate governance. 1st ed. Malden, Mass.: Blackwell Pub.