Fraudulent Claims and Nitpicky Insurers

Insurance fraud is a major source of inefficiency in insurance markets. A self-justification of fraudulent behavior is that insurers are bad payers who start nitpicking if an opportunity arises, even in circum- stances where the good-faith of policyholders is not in dispute. We relate this nitpicking activity to the inability of insurers to commit to their auditing strategy. Reducing the indemnity payments acts as an incentive device for the insurer since auditing is profitable even if the claim is not fraudulent. We show that optimal indemnity cuts are bounded above and that nitpicking remains optimal even if it induces adverse effects on policyholders' moral standards.