The Business of
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
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
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
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
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
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
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
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.
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.
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
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
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
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
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
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
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
Red flags include:
Failure to implement or follow a
detailed financial risk management plan.
Excessive trading in options or
Excessive profits, combined with
trading in options or derivatives.
Bonus structures tied to investment
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.
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.
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
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.
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
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.
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
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
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
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
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”
– 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.