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Optimal Auditing for Insurance Fraud

  • Georges Dionne
  • Florence Giuliano
  • Pierre Picard

This article aims at making a bridge between the theory of optimal auditing and current procedures applied to audit files in different markets where scoring is the instrument used to implement an audit strategy. The literature has not yet developed an optimal audit policy for the scoring methodology. Our application is meant for the audit of insurance fraud but can be applied to many other activities that use the scoring approach. On the theoretical side, we show that the optimal auditing strategy takes the form of a "Red Flags Strategy" which consists in referring claims to a Special Investigation Unit (SIU) when certain fraud indicators are observed. Fraud indicators are classified based on the degree to which they reveal an increasing probability of fraud and this strategy remains optimal if the investigation policy is budget constrained. Moreover, the auditing policy acts as a deterrence device. On the empirical side, four significant results are obtained with data from a large European insurance company. First, we are able to compute a critical suspicion index for fraud, providing a threshold above which all claims must be audited. Secondly, we obtain that if the insur applies this policy, he will save more than euro22 milllion, which represents 43% of the current cost of fraudulent claims. Thirdly, we show that it is possible to improve these results by using information capable of isolating different groups of insureds with different morale 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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Paper provided by CIRPEE in its series Cahiers de recherche with number 0329.

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Date of creation: 2003
Date of revision:
Handle: RePEc:lvl:lacicr:0329
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  1. 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.
  2. 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..
  3. Townsend, Robert M., 1979. "Optimal contracts and competitive markets with costly state verification," Journal of Economic Theory, Elsevier, vol. 21(2), pages 265-293, October.
  4. Dionne, Georges & Gagne, Robert, 2002. " Replacement Cost Endorsement and Opportunistic Fraud in Automobile Insurance," Journal of Risk and Uncertainty, Springer, vol. 24(3), pages 213-30, May.
  5. Pierre André Chiappori & Bernard Salanié, 2002. "Testing Contract Theory: A Survey of Some Recent Work," CESifo Working Paper Series 738, CESifo Group Munich.
  6. Pierre Picard, 2012. "Economic Analysis of Insurance Fraud," Working Papers hal-00725561, HAL.
  7. Kofman, F. & Lawarree, J., 1990. "Collusion in Hierarchical Agency," Discussion Papers in Economics at the University of Washington 91-01, Department of Economics at the University of Washington.
  8. 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..
  9. 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.
  10. 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.
  11. repec:bla:restud:v:52:y:1985:i:4:p:647-63 is not listed on IDEAS
  12. Graetz, Michael J & Reinganum, Jennifer F & Wilde, Louis L, 1986. "The Tax Compliance Game: Toward an Interactive Theory of Law Enforcement," Journal of Law, Economics and Organization, Oxford University Press, vol. 2(1), pages 1-32, Spring.
  13. G. Dionne, 2000. "The Empirical Measure of Information Problems with Emphasis on Insurance Fraud," THEMA Working Papers 2000-20, THEMA (THéorie Economique, Modélisation et Applications), Université de Cergy-Pontoise.
  14. Townsend, Robert M., 1988. "Information constrained insurance : The revelation principle extended," Journal of Monetary Economics, Elsevier, vol. 21(2-3), pages 411-450.
  15. Montserrat Guillen & Manuel Artis, 1994. "Count Data Models For A Credit Scoring System," Risk and Insurance 9407004, EconWPA.
  16. 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.
  17. 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.
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