Quatloos! by Adkisson Consulting LLC -- Fraud Risk Management and Financial Frauds and Scams Revealed, including: Pure Trusts, Constitutional Trusts, Bank Debentures, Roll Programs, Tax Protestors, Melchizedek, New Utopia, Variable Annuities, Life Insurance, Investment Fraud, and much more!

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Financial Risk ManagementFraud Risk Management

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The Business of Insurance

To understand how an insurance company is susceptible to fraud, you must first understand what an insurance company is and how it makes money.

An insurance company is a bank. Policyholders “loan” money to the insurance company by way of paying premiums. The bank pays back the policyholders by way of paying claims.

The first profit goal of the insurance company is to benefit from the time value of the money held from when the premiums are received until the claims are paid, also known as the “investment income on reserves”.

The second profit goal of the insurance company is to benefit, if possible, by charging premiums in excess of the claims paid, also known as “underwriting profits.”

Between the two, the investment income is much more important. An insurance company can reasonably expect to average between 8% to 12% or better annually on its investment returns. No insurance company can expect to approach these profit spreads on its typical underwriting activity – except for certain niche areas of particularly lucrative insurance (e.g., credit disability insurance).

Particularly in times where property values are appreciating and the financial markets are doing well, insurance companies may offer insurance at premium rates which are lower than the amount of claims they expect to pay. This is essentially a “loss leader” function designed to obtain cash that can be invested at high rates of return, and is why insurance is cheap during economic good times.

Conversely, when property values are stagnant or depreciating, and the financial markets are doing poorly, the insurance company cannot afford to lose money on its underwriting function. This is why insurance becomes expensive during economic bad times.

So, the core function of an insurance company is investing. The primary fraud threat to insurance companies is investment fraud, and not, as one might expect, fraudulent claims (though certainly fraudulent claims can have a significant impact upon the insurance company’s net profitability).

Fraud Is Not A Competitive Issue

Fraud is an industry issue, and not a competitive issue between companies. A ring of scam artists that hits one insurance company is likely to hit another and another until they are either caught or give up their scheme. Cooperation between insurance companies is necessary not only to benefit the target company immediately, but also to deter or eliminate future fraud risks.

Intrinsic Fraud

Intrinsic fraud is internal to the insurance company, meaning that the perpetrator of the fraud is “inside” the insurance company, and presumably in a position to doctor books and records, etc., to cover up the fraud. Intrinsic fraud includes conduct that involves an outside co-conspirator.

Intrinsic fraud is the most difficult fraud to detect or prevent, namely because the perpetrator is not likely to even begin the fraud unless he or she is reasonably certain that the fraud will never even be suspected.

Investment Fraud

As mentioned, the real profit engine of any insurance company is its investment return. Internal investment fraud is relatively easy to perpetrate, insofar as it is difficult to determine exactly what an insurance company should have earned on its investment income during the year.

Performance Skimming

Should the insurance company have earned 10.19% or 13.82% or 16.27% this year? Should it have outperformed the S&P500 Index by 3%? or should it have held its own against the S&P500 Index? or should it have been 4% under the Index?

If an investment officer is able to shave 0.2% per year off of a company which invests $1 billion in assets, that’s $2 million per year!

Skimming assets takes a certain degree of sophistication, but is almost impossible to detect. Red Flags include:

  • Investments into “start-up” and “pre-IPO” and other venture capital investments (the investment officer may be selling the shares).

  • Investments into the publicly-traded stock of thinly-capitalized entities (the investment officer may be “pumping” the share price of the stock and selling into the position).

  • Significant losses in options and derivatives trading (the investment officer may be on the other side of the transaction).

Preventative mechanisms include the use of an outside investment advisor (but would the “wolf be guarding the henhouse”? See below), the use of investment committees, and implementation of long-term “buy and hold” investment strategies.

Investment Advisor Kickbacks

Insurance companies generate large fees to financial advisors, meaning that the latter have tremendous incentives to keep the insurance company’s investment officer happy. Consideration can quickly go from lunch to large payoffs.

Red Flags include:

  • A “too close” relationship between the investment officer and the financial advisor.

  • Large volume of trading (may indicate “churning”).

  • Large losses (even in times of economic downturns – indicates there was no financial risk management plan in place, see below).

  • Failure to diversify among financial advisors, or weighting investments too heavily amongst a few financial advisors.

Excessive Risk

This is a form of “soft fraud” and is very difficult to identify. Essentially, the investment officer to justify her job or to generate bonuses, will take excessive investment risks in an attempt to generate larger returns. If the bets go badly, the investment officer may then attempt to disguise the losses and make even riskier bets in an attempt to make up the past losses. Also, excessive short term gains may signal a long-term potentially negative position (such as where one raises income by selling options).

Barings Bank, a 400 year-old institution, was in several months financially wiped out by the conduct of a young Singapore derivatives trader, Nick Leeson, who managed to hide over $2 billion in losses before he finally fled Singapore and went into hiding. Though there was no evidence that Leeson benefited on the side from his trading activities, he was certainly motivated by the large bonuses offered by the bank for extraordinary investment returns.

Red flags include:

  • Failure to implement or follow a detailed financial risk management plan.

  • Excessive trading in options or derivatives.

  • Excessive profits, combined with trading in options or derivatives.

  • Bonus structures tied to investment returns.

Reinsurance Fraud

The intrinsic form of reinsurance fraud involves the procurement of reinsurance above its fair market value, in anticipation of the purchasing agent of the insurance company receiving a kickback.

The difficulty in identifying this form of fraud is that reinsurance contracts are often bid on an individual basis, and the fair market value of a reinsurance contract is difficult to determine.

Extrinsic Fraud

Bogus Claims

For an insurance company, the most common form of extrinsic fraud is the typical “bogus” or inflated insurance claim. This form of insurance fraud has been amply treated elsewhere, as is the subject of industry study, etc. Perhaps the best source to keep up with the news of such frauds is the free  daily newsletter of the Fraud Defense Network, available at http://www.fraudnews.com/

In addition to bogus claims, insurance companies face the potential of fraudulent claims being asserted by repair contractors.

Attorney Overbilling

Insurance defense firms typically have a vested interest in seeing that litigation is as costly as possible. Implicit collusion between defense firms and plaintiff firms is rampant, yet is nearly impossible to discover or prove. Litigation audit firms, and flat-fee billing helps to contain these costs.

Reinsurance Fraud

Fraud by undercapitalized or bogus reinsurance companies is a significant problem. The author was involved in litigation in the early 1990’s against a series of Belgian reinsurance companies that accepted large premiums, but then declared bankruptcy when significant claims arose. Each of the reinsurance companies was little more than a “Pyramid” or “Ponzi” scheme, paying claims only out of current premiums with no setting aside of reserves. In one of the cases, the reinsurance company was capitalized by deeds to a college in Nebraska which was never built.

Investment Fraud

As noted, insurance companies are really banks, or investment companies that seek to make their profits primarily from investing their money. As such, insurance companies, like any other investor, are at risk of investment fraud.

Investment Advisor Fraud

The high-profile case of Marvin Frankel, an investment advisor who embezzled more than $100 million in funds from several insurance companies, and then fled the U.S., is not an anomaly. Investment advisors bilk their clients, including such “sophisticated” institutional investors as insurance companies, out of billions of dollars annually.

Investment Scams

Bank Debentures/Prime Bank Scams – These offer crazily-high interest rates, say 20% per week, and purport to be based on programs that make arbitrage profits on billion-dollar notes that benefit humanitarian projects. Nonetheless, these transactions appear to be well documented, and typically rely on forged documents from a major bank, and typically also forged ICC documents. The scam artists will attempt to set up the transaction so that it appears that there is no risk to the victim, and that the money will safely be held in a major bank somewhere. In truth, the account is either a “correspondent account” with a bogus offshore bank, or the scam artists will have forged “Letter of Credit” documents allowing them take the money out of the account.

Example: In 1999, the City of Oceanside, California, nearly fell prey to a Prime Bank Scam for $100 million dollars; thwarted at the last second by refusal of the 70-year old city treasurer to sign the wire transfer documents.

Offshore Investment Scams. – The old saying “Sunny Climes Are For Shady People” is not too far off the mark. The offshore world exists for one illegal purpose or another, whether it is laundering the proceeds of narcotics trafficking, hiding money from tax collectors, or bilking investors out of dollars.

Example: Officers of the Cayman branch of Bank of Bermuda (a reputable offshore bank) induced clients of the bank (including several insurance companies) to invest in “Cash-4-Titles” and related mutual funds. Ostensibly, Cash-4-Titles made lucrative profits offering “note lot” consumer loans in Florida, but in fact was little more than a massive Ponzi scheme that ultimately defrauded investors of hundreds of millions of dollars.

Derivatives Fraud – Insurance companies probably lose as much or more money to derivatives fraud than any other source. The problems with derivative instruments include that they come in zillions of variations, many of which are hard to figure out, and they are often impossible to price with any accuracy. Indeed, the most successful derivatives traders typically utilize supercomputers with custom software that calculates a target range for each and every derivative instrument then being traded, and seeks to prey on pricing inefficiencies.

Derivatives Fraud is primarily selling a derivatives instrument to the insurance company, which instrument the broker-dealer knows is incorrectly priced, but it can also include selling an instrument which has hidden “downside” potential.

Investment Risk Fraud – Investors can also be defrauded by financial advisors who take on excessive “Beta” (investment risk) in the hopes of higher returns and therefore higher personal compensation.







From the publishers of Quatloos! comes
The Adkisson Analysis
Critical analysis of contemporary risk management
and asset protection issues.

And visit our friends

Attorney Bob Sommer's
The Tax Prophet

Investigative Reporter David Marchant's

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