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Risks Associated with Business Investment Portfolio in Insurance Industry

Describe about the Audit and Assurance for Business Investment Portfolio.

Insurance as a business is intrinsically risky and has plenty of risks that the company needs to prudently manage in order to run the business in a profitable and sustainable manner. Some of the key risks in this regard are outlined as follows. (Gay & Simnett, 2012).

The investment portfolio that the company invest is exposed to continued market risk.

Besides, due to human errors in the business processes and operations, there are operational risks.

However, the greatest risk that the insurance business is exposed to is perhaps underwriting risk when the claims tend to exceed the premiums collected

The above risks clearly indicate that the business risks are significant but these can be mitigated if managed well using appropriate risk management, One of the key strategies to manage the underwriting risk is to apply the prudential regulation norms but HIH does not follow these and instead practices a strategy that worsens the underlying risk which is reinsurance. On top of it, the company had expanded business into segments where the losses could be potentially huge such as aviation and money could be made only if sound risk framework is in place. However, HIH’s internal working is extremely lousy and reckless. The group has embarked on acquisition without enough due diligence and thereby ended up acquiring a company which it should not and in the process inflated the pressure on the already deteriorating balance sheet. The company lacked sound risk management based on planning of adverse events and the nexus of the management with the auditor further prolonged these practices and pushed HIH towards the brink of failure.

Apparently, the business risk associated with HIH can be termed as high in wake of the arguments presented above.

The various inherent risk factors that impact the HIH at the financial level are summarised below based on the information provided in the case.

It is known that the company did not apply the prudential norms despite having exposure to high risk sectors and instead opted for reinsurance which is widely believed to further increase the risk for insurance companies. Thus, this approach enhanced the inherent risk of the business and played a key role in the group’s failure.

Acquisition of FAI Insurance

The acquisition of the above company was completed by HIH without even undergoing adequate due diligence and having enough consultations at the level of the board which is not acceptable. The end result was that the HIH group ended up paying a premium for a company they should have not even acquired as it did not make business sense for them. However, this deteriorated the financial position of the company and therefore increased the inherent risk.

Inherent Risk Factors Affecting Business Investment Portfolio

Management Auditor Nexus

It is apparent from the information presented that there was nexus operation between the management and auditor where each party was serving each other interest so as to serve their selfish interest and in the process the investors and clients ended up as the loser. This nexus prolonged the reckless policies usage at HIH and thereby enhanced the inherent risk of the company (Gay & Simnett, 2012).

Independence of the Board of Directors compromised

The company appointed three of the previous audit partners on the board which clearly had an adverse impact on the board’s neutrality and prudence and ensured that the reckless policies and imprudent risk management policies continued unabated in the company without these coming to the notice of the external stakeholders. This evidently led to the rise in the inherent risk associated with the business (Arens et. al., 2013).

2. 1) The concerned case which the auditors counsel can quote to hint at liability of the directors of the partnership firm is Equitable Life Assurance Society v Hyman [2000] case. As per the case facts, the society sold an insurance policy with two variants i.e. a guaranteed annual return rate as against the market return. The premium associated with both these was the same so that investors can choose as per their risk profile. However, it so happened that whenever it was found that the guaranteed returns exceeded the market rate of returns, then the directors deployed their discretion to cause reduction in the terminal bonuses of the guaranteed returns policyholders. This resulted in lesser returns than promised and hence the court ruled the matter in favour of aggrieved policyholders holding the directors of the firm responsible for the losses borne by clients (Swarb, 2015).

2) For avoiding the liability from the creditors, the auditors counsel can bring to notice the Therapy Partners of America Inc v. Health Providers, Inc[1998] case. In case of a declaratory judgement, it is imperative for the court to ensure, if there is any existence of controversy between the parties and if the same is justifiable or not. From this case, it can be highlighted that it is possible for the partnership frim to defend a declaratory decision and take a stance in such cases which implies that liability of creditors is to be borne by the partnership firm (Findlaw, nd).

For establishing negligence beyond any doubt, it is of utmost importance that the following three conditions need to be satisfied,

Negligence - Conditions Necessary to Establish It

It needs to be established that the defendant had a duty to care towards the plaintiff owing to the proximate relation to be tested through the neighbour test where it is seen whether the plaintiff would be impacted by the choices made by the defendant with regards to engaging or refraining from a particular activity. However, the contour of this duty to care is limited to only that danger or harm which is foreseeable by any reasonable third party in the given situation (Harvey, 2009).

Breach of Duty

The defendant owing to the duty to care is obliged to take relevant and reasonable measures to ensure that no damage is caused to the plaintiff and precautions should be taken. The level of care extended towards the plaintiff has direct relationship with the possibility of risk and the extent of damage to result from the same. However, if the defendant acts in a reckless manner and hence do not extend adequate care towards plaintiff so as to recharge his/her duty,, then breach of duty has taken place (Lindgren, 2011).

Damage

The breach of duty could cause damage to the plaintiff and this is wide in its meaning and includes not only physical or financial harm but extends in the domain of mental and emotional suffering as well. However, it is imperative to develop a causal link between the breach of duty by the defendant and the damage being suffered by the plaintiff. The recommended manner to establish the same is to prove that damage could have been prevented if the duty had not been breached (Pathinayake, 2014).

The fulfilment of all the above conditions leads to negligence being conclusively established.

3. It is apparent from the information provided that the previous audit partners have been appointed to the board. The appointment of not one but three partners from one audit firm seems extremely dubious and by any stretch of imagination no justifiable reason emerges except the strong possibility of a quid pro quo relationship between the management of HIH and Arthur Anderson audit partners. The company rewarded the auditors with hefty fees through the consulting contracts where the auditors performed their jobs by being :cooperative” and assuring by ensuring that the glaring discrepancies tend to continue without being reported in any report for the external shareholders. The current move to appoint the auditors at the board positions seems a symbolic gesture and a continued ploy of management auditor nexus where the mutual interests are served (Heeler, 2009).

Even though there are issues with the concept of auditors also being involved in consulting on account of conflict of interests, however there are some obvious advantages due to which the idea is still muted in academic and professional circles. These are summed below.

The involving of the audit company in providing consulting services to the same client results in enhanced understanding of the company’s business model coupled with potential risks. For an auditor, this information is highly valuable as the auditor also needs to critically determine the inherent risk of the business which requires a sound understanding of the underlying business. Also, the key risks and critical functions also become apparent which facilitates the process of audit planning and related formation of strategy to implement the audit work. Also, this enhanced understanding of the business is critical for the audit team with regards to application of requisite controls and procedures. Hence, the net impact of this is that there is material drop in the misrepresentation of financial statements as the audit quality witnesses an improvement (Gay & Simnett, 2012).

Consulting Services Quality Enhancement

Further, the audit services experience and information aids in the consulting process which can provide solutions that are more pragmatic and take into consideration the client’s needs. In this context, a pivotal role is granted by due consideration to the tax structures and the implications of the business decisions in this regard and ensuring tax effective solutions are proposed (Arens et. al., 2013).

c) Currently, there is a trend where the audit providers are also venturing into consulting services and engaging in cross selling to the same client. While this may be permissible by law but clearly in the wake of the recent incidents, this is an extremely unethical approach. This is because acting in a dual capacity of auditor and consultant could result in conflict of interest. This risk is even compounded when the client associate lucrative consulting contracts with the auditing flexibility displayed by the auditor in provided an unqualified audit opinion (Clout, Chappelle & Gandhi, 2013). With the investor confidence in audit services at the nadir after incidents such as Enron and HIH where the explicit involvement of auditors cannot be denied, it is imperative that the auditors should refrain from engaging in any activity that leads to suspicion in the mind of investors and other users. The practices adopted by HIH in the given case are testimony to how the dual provision of consulting and auditing can be detrimental to the investor’s interest. This could potentially enhance the agency costs and pose doom for the profession of audit in the long run as investor confidence gradually erodes (Livne, 2015).

d) The emergence of various reforms like Ramsay Report and CLERP assume importance in the wake of incidents such as HIH where it was clearly highlighted that lack of disclosures from HIH coupled with compromised independence of external auditor proved to be a nemesis for the investors (Arens et. al., 2013).

The aim of CLERP 9 was to ensure that sound corporate governance policies be framed and implemented by the companies that would lead to greater transparency. Prominent recommendations are outlined below (Clout, Chappelle & Gandhi, 2013).

Increase the amount of disclosures in the annual report of the company. In this regard, particular emphasis was given on adding incremental sections such as Director’s report and Remuneration Section which would enhance the overall information received at the end of investors.

External auditors to be rotated on a periodic basis so as to avoid collusion of the management and auditor.


On the other hand, the core focus of the Ramsay Report was to ensure external auditor independence for which the following measures were suggested (Parker, 2002).

The internal audit committee to be strengthened with greater powers and scope of functioning.

Proactive measures need to be taken to ensure that the relationship between auditor and client remains constrained.

The annual report should contain declaration with regards to auditor independence and also board independence to be issued by the board and auditor respectively.

It was suggested that a committee named as Auditor Independence Supervisory Board be put in place to ensure that independence of the auditor is not compromised.

The steps taken above if implemented with full intent could potentially prove to a game changer and enhance the overall corporate governance standards thereby lowering the agency costs and also provide a new lifeline to the auditor profession which currently is facing a looming crisis (Gay & Simnett, 2012).

References

Arens, A., Best, P., Shailer, G. & Fiedler,I. 2013. Auditing, Assurance Services and Ethics in Australia, 2nd eds., Pearson Australia, Sydney

Findlaw nd, THERAPY PARTNERS OF AMERICA INC v. HEALTH PROVIDERS INC, Findlaw Website, Available online from https://caselaw.findlaw.com/oh-court-of-appeals/1097866.html  (Accessed on September 4, 2016)

Clout, V, Chappelle, E & Gandhi, N 2013, ‘The impact of auditor independence regulations on established and emerging firms’, Accounting Research Journal Vol. 26, No. 2, pp. 88-108

Gay, G. & Simnett, R. 2012, Auditing and Assurance Services in Australia, 5th eds., McGraw-Hill Education, Sydney

Harvey, C. 2009, Foundations of Australian law. 3rd eds., Tilde University Press, Prahran, Victoria

Heeler, D 2009, Audit Principles, Risk Assessment & Effective Reporting. 4th ed., Pearson Press, Sydney

Lindgren, KE 2011, Vermeesch and Lindgren's Business Law of Australia, 12th eds., LexisNexis Publications, Sydney

Livne, G 2015, Threats to Auditor Independence and Possible Remedies, Finance Practitioner Website, Available online from https://www.financepractitioner.com/auditing-best-practice/threats-to-auditor-independence-and-possible-remedies?full. (Accessed on September 4, 2016)

Parker, C 2002. ‘Auditing at arm’s length’, CACharter, February, pp. 38-40

Pathinayake, A 2014, Commercial and Corporations Law, 2nd eds., Thomson-Reuters, Sydney

Swarb 2015, EQUITABLE LIFE ASSURANCE SOCIETY V HYMAN; HL 20 JUL 2000, Available online from https://swarb.co.uk/equitable-life-assurance-society-v-hyman-hl-20-jul-2000/ (Accessed on September 4. 2016)

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