Moderator: Richard Derrig Automobile Insurers Bureau of Massachusetts Insurance Fraud Bureau of Massachusetts Martin Ellingsworth Fireman’s Fund Insurance Companies Sharon Tennyson Cornell University UNDERSTANDING INSURANCE FRAUD: THEORY AND PRACTICE Casualty Actuarial Society Annual Meeting Atlanta, GA November 13, 2001

FRAUD DEFINITION Principles  Clear and willful act  Proscribed by law  Obtaining money or value  Under false pretenses Abuse: Fails one or more Principles

INJURY FRAUD & BUILDUP CLAIMS W A Fraudulent claim is one in which there was no injury or the injury was unrelated to the accident W A Buildup claim is one in which the injury is exaggerated and/or the treatment is excessive

HOW MUCH CLAIM FRAUD?

10% Fraud

HOW MUCH CLAIM FRAUD?  Methods uSurveys (Conning, IBC, Israel, UK) uClaim Studies (AIB, Florida, Canada, Portugal, Spain) uCrime Statistics (IFB, UK)  Outcomes uGuessing:10% uAIB:Suspected 1-10% (BI) uFlorida:Suspected 10-13% (PD) uCanada:5%, 13% (PD) uSpain:22% Auto Liability

HOW MUCH FRAUD?

WHAT COMPANIES DO ABOUT FRAUD W Investigate Investigation reduces BI Claim payments by 18 percent. Additional investigation not cost-effective. Better claim selection may be cost-effective. W Negotiate Negotiation reduces BI claim payments on build-up claims by 22 percent compared to valid claims with same medicals, injuries, etc. W Litigate Litigation of bogus claims results in high number of company verdicts. When effective, claim withdrawals and closed-no-pay increase.

THEORY OF CLAIM FRAUD W Utility Maximization UTL (Fraud v. No Fraud) W Asymmetric Information Inf (Claimant/Provider v. Insurer) W Welfare Loss WFL (Detection $ v. Fraud $) _________________________________ W All Rely on Detection Probabilities

THE INSURER’S PROBLEM W Self-interested behavior of claimants W Asymmetric information W Attitudes and social norms

FRAUD FIGHTING INSTRUMENTS W Auditing (Detection Systems) W Contract Design (e.g. Deductibles) W Payment Schedules W Information and Education

ECONOMIC THEORY OF AUDITING W Insurer chooses actions to minimize total cost of fraud uTotal cost includes cost of fraud fighting W Choice of action takes into account the reaction of the insured/claimant uMinimum utility constraint W Insurer must earn a normal rate of profit uZero (economic) profit constraint

ECONOMIC THEORY OF AUDITING W Insurer chooses uInsurance premium uAuditing rule uPayment schedule (bonuses and penalties) W Taking into account uInsured’s utility from insurance and payments uCost of auditing

ECONOMIC THEORY OF AUDITING W Insured chooses uWhether to purchase insurance uWhether to exaggerate claim (if loss occurs) W Taking into account uInsurance premium and claims payments uProbability of being audited uPenalties for detected fraud

KEY RESULTS FROM THEORY W The optimal contract involves a deductible (equal to the audit threshold) W If penalties for fraud are available, random auditing is preferred

THE OPTIMAL CONTRACT 45° If verified If not verified No AuditsAudits Claim Amount Payment Amount

OPTIMAL AUDITING W Primary role of auditing is deterrence uIf insurer can “precommit” to optimal auditing strategy then all fraud eliminated W Audit claims only above some size threshold uAudit high value claims more frequently W Audit claims in areas of opportunism more frequently

OPTIMAL AUDITING No AuditsRandom Audits Claim Amount Audit probability P = 1 P < 1

CREDIBLE AUDITING W Insurer probably cannot commit to a costly auditing strategy that deters all fraud uAudit only if there is some probability of fraud detection uAudit for detection and for deterrence uAudit larger claims more frequently uAudit claims in areas of opportunism more frequently

IF AUDITING NOT EFFECTIVE W If auditing cannot detect fraud uDeductible contract is no longer optimal as it creates incentives for claim inflation uOptimal contract involves overpayment of small claims uOptimal contract involves underpayment of large claims

THE OPTIMAL CONTRACT 45° Claim Amount Payment Amount

THE IMPORTANCE OF ATTITUDES AND PERCEPTIONS W Theory of fraud assumes that claimants are opportunistic with respect to fraud uNo “moral” cost or penalty from fraud W Under self-interested behavior fraud occurs because the perceived probability of detection is low and/or the detection penalty is low

THEORY AND PRACTICE: LINKS W Theoretically optimal auditing strategies have many similarities to fraud detection systems uFocus on opportunistic claims uFocus on larger claims uBalance costs and benefits W Theory ~ general; Practice ~ specific

THEORY AND PRACTICE: LESSONS W Deterrence uFraud detection systems uInformation and education campaigns W Random auditing W Criminal prosecution W Insurance contract design

POTENTIAL VALUE OF A CLAIM DETECTION/CLASSIFICATION SYSTEM W Screening to Detect Fraud Early W Auditing of Closed Claims to Measure Fraud W Sorting to Select Efficiently among SIU Referrals W Providing Evidence to Support a Denial W Protecting against Bad-Faith

Insurance Fraud Research Register Eleventh Report July 14, 2001 Compiled by: Richard A. Derrig, Ph.D. Vice President Research Insurance Fraud Bureau of Massachusetts Searchable Database at Casualty Actuarial Society Annual Meeting Atlanta, GA Nov. 13, 2001