One of the most significant risks an insurer faces today is therisk of fraud. According to the December, 2012 Forrester Researchreport “Prevent Insurance Crime with the Four Cornerstones of Better FraudManagement” (the “Forrester Report”), the FBIestimates that non-healthcare insurance fraud costs the industry atleast $40 billion annually. The resulting average higher insurancepremium by household is at least $700 annually.

Insurance industry estimates generally put fraud at about 10percent of the P&C industry's incurred losses and lossadjustment expenses each year. With respect to healthcare fraud,the Government Accountability Office estimates that improperMedicare payments alone amount to at least $17 billion annually,and some estimates of healthcare fraud overall are cited to be inexcess of $500 billion.

Many insurers have begun to highlight claim fraud risk on theirenterprise risk management (ERM) “Top Risk” lists. A deeper lookinto the statistics reveals claim fraud carries a triple threat—thepotential for high frequency, high severity of loss, andsignificant reputational impact. It's not surprising, then, thatclaims fraud gets attention and resources. In fact, many statesrequire insurers to monitor and report suspected instances offraud. However, within ERM programs, risk professionals must lookat the potential for internal and external fraud in all departmentsand functional areas. Is fraud risk in all areas being sufficientlyassessed? How can fraud management be most improved?

What is Insurance Fraud?

The California Department of Insurance (CDI) defines fraud asoccurring “when someone knowingly lies to obtain some benefit oradvantage to which they are not otherwise entitled, or someoneknowingly denies some benefit that is due and to which someone elseis entitled.” Fraud may be perpetrated by an individual as anopportunistic response to an event or environment, such as alegitimate claim or unprotected process that the individualexploits. Alternatively, it may be conducted in an organized andsystemic manner by professional crime rings. These organized unitsmay view insurance fraud as potentially just as lucrative as othercrimes such as drug dealing, while carrying less punitive penaltieswith slower prosecution.

Nearly half of all states require insurers to file a fraud plan,form a program to combat fraud, or create an investigation unit todetect and report fraudulent activities. Insurance Fraud may beprosecuted as a crime in all states, though some states onlycriminalize specifically enumerated types, such as workercompensation or automobile claim fraud.

Fighting fraud is often an uphill battle, and the legal costs ofprosecution are high. The reality is insurers bite the bullet inmany cases and pay questionable claims. As a result, the effort andexpense of implementing specific controls and systems which preventor improve the chances of early detection of fraud can have asignificant impact on the company's bottom line.

Fraud Risk in Claims

Many state insurance department websites, such as the onemanaged by the CDI, provide information about fraud trends.California's site outlines some of the most commonly investigatedclaim-related insurance fraud:

Automobile Collision. Includes staged accidentscaused by swerving, sudden stops, backing out of a driveway orparking space, or the striking or faking a “hit and run” of apedestrian involved in the scheme. Accidents can be orchestrated byorganized crime rings and may involve unscrupulous attorneys,doctors or medical providers.

Personal and Commercial Premises and Auto PropertyDamage: Involves damage from an alleged accident that isexaggerated, non-existent, or pre-existing. Other examples includetheft, arson, vandalism and alleged lost property in transit.

Medical/Health and Workers' Compensation: Someexamples include suspicious slip/fall claims, inflated medicalfacility or provider billing, disability claims pending while theclaimant receives continual benefits and/or vocational benefits,and identity theft for obtaining medical services.

Life: Involves questionable circumstancessurrounding a reported death, staged deaths and cases of falseidentity. Other examples include claims with suspicious or falsepolicy application statements, such as denial of known medicalconditions.

Claims fraud tends to increase substantially after a naturaldisaster. In November of 2012, insurers alerted many homeowners tostorm-chasing contractors trying to make slipshod repairs orexploit the confusion after Superstorm Sandy and steal constructiondeposits. In the wake of Hurricane Katrina, many insurersencountered questionable claims submitted for complete roofreplacements, after they had settled initial claim for simple roofrepairs.

Other Insurance Fraud

The underwriting process itself may be the source of insurancefraud. Premium fraud may include misrepresentation ornon-disclosures, either by the insured, or in some cases, by theagent or broker. Undervaluing total worth and contents of propertyis common to both personal and commercial property lines. Othertactics include understating estimated payroll, which impactsretrospectively rated policies, or intentionally misclassifyingworkers, as discovered in fraud inquiries into workers compensationclaims.

In auto lines, a small but systemic fraud is the misstatement ofauto garage locations. In March, Sen. Diane Savino of New Yorkannounced that constituents were calling her office to reportneighbors who were illegally registering their cars out of state tosave money on auto insurance. It is estimated that more than one in10 vehicles owned by New York motorists are registeredout-of-state, according to the advocacy group New Yorkers Stand Against InsuranceFraud. Such auto-insurance fraud cost New York motorists morethan $200 million in 2010, according to the Insurance Information Institute.

Agents or brokers are frequently investigated for premium theft,the improper comingling of accounts, or for improperly backdatingpolicies prior to the date of a loss. Other third-party vendors mayalso present an increased risk for fraud. TPAs, claims handlers ormanaging general agents, for example, may have separate physicaloffices with their own corporate culture, managementaccountabilities, policies and procedures and accounting systems.These situations present unique challenges that often fall beyondthe control of even the most vigilant supervising carrier.

Internal Fraud

In addition to external fraud, an overlooked and under-reportedtype of fraud is internal fraud by employees. Direct theft, briberyand employee kickbacks may be more difficult than claim fraud todetect in some cases. Operating under the dangerous assumption that“it doesn't happen here with our employees,” somecompanies may not maintain the same tight controls over theinternal environment as they do with external party transactions.Additionally, insurers may think it is too difficult to detectinternal fraud through audits or reviewing transactions on theirlegacy systems.

In part two, we'll examine how to improve fraudrisk management with ERM techniques.