Sunday, 26 August 2012

The Beauty of Creative Accounting

The Beauty of Creative Accounting

When an organisation is confronted with a situation that could be misunderstood by shareholders, customers or voters it is essential that the organisation manage the release of that information in a manner that minimises the risk of an overreaction from those shareholders, customers or voters.

The New Zealand Government was recently challenged by this very dilemma. New Zealand’s second most populous City was devasted by the most damaging (per capita) natural disaster in the history of the OECD. Occurring during the depths of the Global Financial Crisis it would have been especially imprudent for the Government to respond with the usual excesses of socialistic generosity towards disadvantaged residential property investors that are characteristic of left wing governments such as Japan and the United States of America under George W. Bush. Such profligate use of taxpayer funds would have placed the New Zealand Governments AA+ credit rating at unacceptable risk. However, with an election looming the Government had to gie the impression of being compassionate and generous whilst actually acting with great fiscal prudence.

New Zealand’s statutory requirement for Government’s to produce “no surprises” budgets means that when the current government commits future governments to spend money those future liabilities must be included in the current accounts as though all of the future commitment had been spent in the current financial year. By contrast, revenues may only be included in the year in which they are actually receipted.

To this end it has indeed been fortuitous that the Government has been operating a natural disaster insurance scheme, the EQC. By adding the liabilities of the Government’s insurer to the Government’s account whilst excluding the insurers invested reserves was able to exaggerate both the Government’s financial assistance and the earthquake’s impact on the Government’s accounts. Thus the 2010/2011 Budget had to include EQC’s claims liability of $3.3bn but could not include any reference to the fact that the EQC held $6bn in reserves to cover these costs as these reserves held in investments, which cannot be counted as revenue until the investments are converted into cash.

Furthermore, the Government estimated that it would face costs of $2.2bn but allowed a contingency for a further $3.3bn of costs to be subsequently identified, thus creating a future liability of up to $5.5bn.  However, this liability would be significantly offset by charging GST on the rebuild of Christchurch but under the “no surprises” accounting regime this revenue cannot be included in the Government accounts until it is actually receipted. Thus the earthquake’s impact on the Government’s accounts was able to reported as a deficit of $8.8bn whereas the actual impact on the Government’s accounts at the end of the reconstruction of Christchurch would actually be between a surplus of $700m and a deficit of $2.2bn.

Thus the Government was able to tell voters that the earthquakes were seriously hurting the nation whilst receiving a generous response from central government, without having to tell lies and with the confidence that the international credit ratings would check the full facts and assess the Governments credit rating based on the longterm fiscal impact.

A year later and the circumstances have become even more convenient for keeping socialist voters satisfied without offending fiscally prudent voters. Independent loss assessors have concluded that EQC’s claims exposure could exceed EQC’s reserves and reinsurance cover by up to $1.5bn. Fortunately, the total estimated cost of reconstructing Christchurch has also increased resulting in a $1.5bn increase in GST levied on the reconstruction. If the EQC loss assessment is pessimistic then the Government could achieve a surplus of $2.2bn. But its maximum deficit would still be $2.2bn.

Unfortunately the summary account released for the $5.5bn Canterbury Earthquake Recovery Fund in Budget 2011/12 indicates that almost $2bn of the unallocated funds have now been mysteriously allocated. Board documents available from the New Zealand Transport Agency reveal that at least $500m of the “other costs” is for road repairs even though traffic using Christchurch City Council owned roads pays sufficient in fuel taxes and road user charges to the Government to meet the road repair costs without requiring taxpayer assistance. Discussion of the following table from Budget 2011/12 with insurance brokers and property developers has led to universal bemusement at the incompetence of Government departments when dealing with skilled negotiators from insurance companies and property development companies and a general consensus that CERA is spending three times more than is reasonable on this EQC de-risking exercise.

Monday, 20 August 2012

New Zealanders are keen investors in real estate. With no capital gains tax or inheritance tax, home ownership is seen as a safe form of investment with high returns.

The Canterbury earthquakes have presented the New Zealand Government with a nightmare scenario. Most home ownership investment is funded by bank mortgages. Banks will only provide mortgages if the homes are comprehensively insured. When insurance companies are hit with events that cost decades of premium receipts they are inclined to exit that particular marketplace, as briefly happened in the wake of Hurricane Andrew and the Northridge earthquake. With comprehensive insurance no longer available banks would have had to withdraw from the mortgage markets triggering a collapse in property prices throughout the nation. Despite the fact that this is a risk that property investors should have factored into their decision making the New Zealand Government refused to let the invisible hand deliver an appropriate market solution. With an election looming the Government set out to de-risk the nation’s property insurance portfolio through a process of Government compulsory acquisition of private property in what were deemed to be the most high risk locations.

Investing in real estate, as with any other investment strategy, requires the investor to weigh up the potential for gaining or losing money and to happily accept the consequences of those choices.
However, property investing is not entirely risk free. Floods, landslides, fire and earthquakes can damage houses and land. These risks can be shared with other property investors through the mechanism of property insurance.

Due to the fact that building up reserves sufficient to cope with events less common than 1-in-30 years would attract unwanted attention from asset stripping corporate raiders most insurance companies rely on purchasing re-insurance to ensure that they are able to meet their obligations to policy holders in the unlikely event of a low frequency but highly damaging circumstance occurring. To provide an additional incentive to re-insurers the New Zealand Government has, since 1942, operated a Government guaranteed natural disaster insurance scheme for land and houses, relieving the insurance industry of substantial disaster risk exposure.

One consequence of this approach, and the absence of any catastrophically damaging natural disasters since the Masterton earthquakes of 1942, has been the inclusion by most insurance companies of comprehensive disaster insurance into household insurance policies at minimal additional premium and with minimal excesses.

Unfortunately the recent Canterbury earthquakes could have dealt a savage blow to profits in the insurance industry in New Zealand. Not only is the proportion of housing stock destroyed or severely damaged the highest ever recorded anywhere in the OECD, but this is also true for the proportion of commercial buildings and public buildings damaged or destroyed. Rubbing salt into the insurance industry’s wounds is the fact that New Zealand also has the highest proportion of properties insured for natural disaster damage. Consequently, it was necessary for the re-insurers to reassess their exposure to New Zealand, as indeed had been deemed necessary after Hurricane Andrew and the Northridge earthquake in the United States. Consequently, it was beholden on the New Zealand Government to take extraordinary measures to preserve the equity of homeowners by significantly de-risking the Government’s natural disaster insurance scheme, resisting calls for regulation of premiums and excesses, removing insurance companies from the oversight of the Commerce Commission, requiring the Insurance Ombudsman to take a business-as-usual approach to dispute resolutions between policy holders and insurance companies, and refraining from engaging the Crown Law Office to negotiate insurance payouts on properties purchased by CERA in the residential Red Zones.

Whilst it is clearly reprehensible that the New Zealand Government has recklessly interfered in with the functional ability of the free market, some credit must be given, however reluctantly, for the New Zealand Government’s pragmatic approach to balancing the competing interests of property investors and insurance company investors and resisting the temptation to open the floodgates to a dependency inducing deficit financed socialist spending spree response of the types we have witnessed in the wake of Hurricane Katrina, the Queensland floods, the Japanese Tsunami and innumerable Turkish and Italian earthquakes.