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Optimal Auditing with Scoring: Theory and Application to Insurance Fraud

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Author Info

  • Georges Dionne

    ()
    (Canada Research Chair in Risk Management, HEC Montreal, Montreal, Quebec H3T 2A7, Canada)

  • Florence Giuliano

    ()
    (Department of Economics, Paris X University, 92001 Paris, France)

  • Pierre Picard

    ()
    (Department of Economics, Ecole Polytechnique, 91128 Palaiseau, France)

Abstract

This article makes a bridge between the theory of optimal auditing and the scoring methodology in an asymmetric information setting. Our application is meant for insurance claims fraud, but it can be applied to many other activities that use the scoring approach. Fraud signals are classified based on the degree to which they reveal an increasing probability of fraud. We show that the optimal auditing strategy takes the form of a "red flags strategy," which consists in referring claims to a special investigative unit (SIU) when certain fraud indicators are observed. The auditing policy acts as a deterrence device, and we explain why it requires the commitment of the insurer and how it should affect the incentives of SIU staffs. The characterization of the optimal auditing strategy is robust to some degree of signal manipulation by defrauders as well as to the imperfect information of defrauders about the audit frequency. The model is calibrated with data from a large European insurance company. We show that it is possible to improve our results by separating different groups of insureds with different moral costs of fraud. Finally, our results indicate how the deterrence effect of the audit scheme can be taken into account and how it affects the optimal auditing strategy.

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File URL: http://dx.doi.org/10.1287/mnsc.1080.0905
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Bibliographic Info

Article provided by INFORMS in its journal Management Science.

Volume (Year): 55 (2009)
Issue (Month): 1 (January)
Pages: 58-70

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Handle: RePEc:inm:ormnsc:v:55:y:2009:i:1:p:58-70

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Keywords: audit; scoring; insurance fraud; red flags strategy; fraud indicators; suspicion index; moral cost of fraud; deterrence effect; signal manipulation;

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References

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  1. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report, Federal Reserve Bank of Minneapolis 45, Federal Reserve Bank of Minneapolis.
  2. Dionne, Georges & Artis, Manuel & Guillen, Montserrat, 1996. "Count data models for a credit scoring system," Journal of Empirical Finance, Elsevier, Elsevier, vol. 3(3), pages 303-325, September.
  3. Dionne, G., 2000. "The Empirical Measure of Information Problems with Emphasis on Insurance Fraud," Ecole des Hautes Etudes Commerciales de Montreal- 00-04, Ecole des Hautes Etudes Commerciales de Montreal-Chaire de gestion des risques..
  4. Picard, P., 1996. "On the design of Optimal Insurance Policies Under Manipulation of Audit Cost," Papers 9620, Paris X - Nanterre, U.F.R. de Sc. Ec. Gest. Maths Infor..
  5. Picard, Pierre, 1996. "Auditing claims in the insurance market with fraud: The credibility issue," Journal of Public Economics, Elsevier, vol. 63(1), pages 27-56, December.
  6. John Knowles & Nicola Persico & Petra Todd, 1999. "Racial Bias in Motor Vehicle Searches: Theory and Evidence," NBER Working Papers 7449, National Bureau of Economic Research, Inc.
  7. Nahum D. Melumad & Dilip Mookherjee, 1989. "Delegation as Commitment: The Case of Income Tax Audits," RAND Journal of Economics, The RAND Corporation, vol. 20(2), pages 139-163, Summer.
  8. Dionne, G. & Gagne, R., 2000. "Replacement Cost Endorsement and Opportunitic Fraud in Automobile Insurance," Ecole des Hautes Etudes Commerciales de Montreal- 00-01, Ecole des Hautes Etudes Commerciales de Montreal-Chaire de gestion des risques..
  9. Mookherjee, Dilip & Png, Ivan, 1989. "Optimal Auditing, Insurance, and Redistribution," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 104(2), pages 399-415, May.
  10. El Bachir Belhadji & George Dionne & Faouzi Tarkhani, 2000. "A Model for the Detection of Insurance Fraud*," The Geneva Papers on Risk and Insurance - Issues and Practice, Palgrave Macmillan, vol. 25(4), pages 517-538, October.
  11. Peter Ove Christensen, 2002. "Accounting Policies in Agencies with Moral Hazard and Renegotiation," Journal of Accounting Research, Wiley Blackwell, vol. 40(4), pages 1071-1090, 09.
  12. Dionne, G. & St-Michel, P. & Gibbens, A., 1993. "An Economic Analysis of Insurance Fraud," Cahiers de recherche, Centre interuniversitaire de recherche en économie quantitative, CIREQ 93010, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
  13. Nicola Persico, 2002. "Racial Profiling, Fairness, and Effectiveness of Policing," American Economic Review, American Economic Association, vol. 92(5), pages 1472-1497, December.
  14. Beneish, Messod D., 1997. "Detecting GAAP violation: implications for assessing earnings management among firms with extreme financial performance," Journal of Accounting and Public Policy, Elsevier, Elsevier, vol. 16(3), pages 271-309.
  15. Georges Dionne & Robert Gagné, 2001. "Deductible Contracts Against Fraudulent Claims: Evidence From Automobile Insurance," The Review of Economics and Statistics, MIT Press, vol. 83(2), pages 290-301, May.
  16. Crocker, Keith J & Tennyson, Sharon, 2002. "Insurance Fraud and Optimal Claims Settlement Strategies," Journal of Law and Economics, University of Chicago Press, vol. 45(2), pages 469-507, October.
  17. M. Martin Boyer, 2004. "Overcompensation as a Partial Solution to Commitment and Renegotiation Problems: The Case of "Ex Post" Moral Hazard," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 71(4), pages 559-582.
  18. Townsend, Robert M., 1988. "Information constrained insurance : The revelation principle extended," Journal of Monetary Economics, Elsevier, vol. 21(2-3), pages 411-450.
  19. Kofman, Fred & Lawarree, Jacques, 1993. "Collusion in Hierarchical Agency," Econometrica, Econometric Society, Econometric Society, vol. 61(3), pages 629-56, May.
  20. Gale, Douglas & Hellwig, Martin, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Wiley Blackwell, vol. 52(4), pages 647-63, October.
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Citations

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Cited by:
  1. Georges Dionne & Kili C. Wang, 2011. "Does Opportunistic Fraud in Automobile theft Insurance Fluctuate with the Business Cycle ?," Cahiers de recherche 1121, CIRPEE.
  2. Jean-Marc Bourgeon & Pierre Picard, 2012. "Fraudulent Claims and Nitpicky Insurers," Working Papers hal-00675106, HAL.
  3. Lang, Matthias & Wambach, Achim, 2013. "The fog of fraud – Mitigating fraud by strategic ambiguity," Games and Economic Behavior, Elsevier, vol. 81(C), pages 255-275.
  4. Samohyl, Robert, 2012. "Audits and logistic regression, deciding what really matters in service processes: a case study of a government funding agency for research grants," MPRA Paper 41557, University Library of Munich, Germany.
  5. Pierre Picard, 2012. "Economic Analysis of Insurance Fraud," Working Papers hal-00725561, HAL.
  6. Georges Dionne & Kili Wang, 2013. "Does insurance fraud in automobile theft insurance fluctuate with the business cycle?," Journal of Risk and Uncertainty, Springer, vol. 47(1), pages 67-92, August.
  7. Georges Dionne, 2012. "The Empirical Measure of Information Problems with Emphasis on Insurance Fraud and Dynamic Data," Cahiers de recherche 1233, CIRPEE.
  8. Dominic Spengler, 2012. "Endogenising Detection in an Asymmetric Penalties Corruption Game," Discussion Papers 12/20, Department of Economics, University of York.

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