Economics of insurance fraud

The economics of Insurance fraud in graphs

I worked in the Insurance industry for many years. From time to time, we heard someone got caught doing something to defraud the company (usually auto insurance fraud). Since the penalty was pretty high I  would ask why would any rational person do it. If they were so clever they could use their talents in more productive ways. Can economics explain why?

Was it a matter of cost accounting, that is the opportunity cost of going to prison and forgoing earnings potential in the job market would be outweighed by potential earnings from committing insurance fraud?  Or is it a matter of simple utility, that is someone is trying to significantly increase their happiness (utility) but outsmarting an insurance company?

Here are some quick graphs I put together to try to explain the rationale of the individual and the insurance company.

This is, of course, a simple chart but it tells an interesting story. I believe economic graphs are always almost obvious, but they do give insight into why people do what they do, especially when you look a the shape of the curve or the elasticity. After a certain penalty like ten years or even 5 years, the curve starts to get very steep. Who would want to spend five years of their life behind bars no matter what the payout? Of course, we all have different indifference curves but I would not.

There is also a huge moral factor. For example, most people’s curves would be a vertical line up the y-axis as there is no price for coming moral wrong. Most people might bend the rules in their personal interactions perhaps but to consciously try to cheat is only a few people. However, during the financial crisis, some people change as they are desperate.

I think insurance companies most effective prevention is both fear and better methods for detecting fraud. Trying to lobby for increased penalties is harder.

Payout – Penalty for insurance fraud y-axis starting point

Note that there are some low levels of fraud that basically represent no risk (very low) for a penalty. This is why the curve starts at a higher level than zero. I have seen insurance companies pay 8,000 dollars even when the fraud was suspected or known, it was a lawyer or cost thing, it was not worth paying the lawyer and agents to pursue the case as it is often very difficult to prove fraud clearly. Many scams are very clever.

I would say for anything under 1,000 it would not be pursued but anything over 1,000 dollars they might investigate and over 5,000 they will do a check and over 10,000 they will look at it, for auto insurance fraud and pursue it if they suspected wrong.

However, for P&C or property and causality with homes, boats, etc there is a different level as well as with life insurance which has a bigger payout.

I, of course, believe all fraud is wrong and should not be done at any level for moral reasons and do you want to really go to jail, for some money. If you need to make money fast there are better legal ways. Some people, underestimate the long-term cost of the penalty if they get caught, such as a police record. With economics, I think you can analysis a lot of interesting things. I certainly did not do this topic justice but it is only an example of economic analysis applied to a particular case, that is a financial crime.