Academic journal article Journal of Risk and Insurance

Claims Auditing in Automobile Insurance: Fraud Detection and Deterrence Objectives

Academic journal article Journal of Risk and Insurance

Claims Auditing in Automobile Insurance: Fraud Detection and Deterrence Objectives

Article excerpt

ABSTRACT

Research on insurer management of opportunism in claiming has developed in two parallel literatures. One is a theoretical literature on insurance contracting that yields predictions about the nature of optimal auditing strategies for the deterrence of fraud. The other is a literature based upon statistical analysis of claims that yields empirical strategies for the detection of fraudulent claims. This article links the two literatures by providing an empirical assessment of insurers' auditing practices in relation to theoretical predictions. The analysis makes use of a data set on the disposition of more than 1,000 randomly selected automobile personal injury protection claims settled in the state of Massachusetts. The findings of the article are consistent with the use of rational auditing strategies by insurers and with the use of audits for both deterrence and detection.

INTRODUCTION

The issue of claims fraud (illegitimate claims) and buildup (exaggerated loss amounts) is a major concern among automobile insurance companies. Empirical studies have concluded that large percentages of claims appear to involve fraud or exaggeration.1 For example, studies of automobile personal injury claims in the state of Massachusetts have found that anywhere from one-quarter to three-quarters of claims show some evidence of fraud or buildup (Weisberg and Derrig, 1991, 1996). The Insurance Research Council (1996) analyzed claims from nine states and found that 21 to 36 percent of the claims involved suspected fraud or buildup.2 In all of these studies, the vast majority of suspicious claims involved potential buildup rather than outright fraud. Consistent with this concern, the focus of this article is on buildup.

In the presence of buildup, the active verification of claims through investigation or auditing is an important claims management tool. The role of auditing is recognized in both insurance theory and practice. A large theoretical literature examines the design of auditing strategies in the insurance claiming context.3 This literature derives theoretically optimal auditing strategies that minimize the total costs incurred from buildup, where the costs include both the costs of performing audits and the costs of paying built-up claims that are not detected. The key insight from theory is that the primary role of auditing in an optimally designed system is the deterrence of buildup rather than its detection.

Statistical literature aimed at designing better fraud detection systems is also growing.4 This literature focuses on the practical complexities faced by an insurer determining which claims to audit when claims differ in many characteristics. This literature provides insights into auditing for the detection of built-up claims. Auditing as a deterrent mechanism has received less attention in this literature, and audit system success is typically measured by the reduction in payment amounts on audited claims or by the number of fraudulent or built-up claims detected.

While clearly different in focus, these two approaches need not be incompatible. The theoretical literature on auditing of necessity makes a number of simplifying assumptions about the nature of claims and the information available to the insurance company, and thus yields only very general predictions about optimal auditing strategies. For example, the theory predicts that larger claims, and claims for which the potential for opportunism is greater, should be audited with a higher probability than other claims (Picard, 2000). Consistent with this, the empirically based design of fraud detection systems can be viewed as an attempt to identify those specific categories of claims that should be audited with higher probability, given complex claims characteristics and imperfect knowledge of the degree of opportunism in the claiming population.

Nonetheless, the difference in focus across the two literatures raises questions about the use and role of auditing in insurance markets. …

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