SIU TO THE RESCUE
Due to the frequency and cost of fraud, insurers have dedicated teams of experts devoted to identifying and combating insurance fraud. The first line of defense are claims professionals who take the First Notice of Loss (FNOL) and those that are assigned to adjust the reported claim. Claims adjusters receive basic training[42] from the National Insurance Crime Bureau (NICB) on how to identify potential warning signs and how to properly handle a questionable claim. Carriers have well documented procedures for their claims personnel on when and how to make a referral to their internal Special Investigations Unit (SIU) which consists of highly trained specialists, often with a background in law enforcement, to handle questionable claims. Questionable claims are reported by member carriers to NICB, and this non-profit also provides access to a litany of resources that can assist SIU teams in their work.
Depending on the circumstances, a questionable claim may be withdrawn by the policyholder or claimant to avoid further adverse action. Sometimes, a policy will be voided (essentially hitting the “undo” button and acting as if the policy never existed) or is cancelled by the insurer mid-term or non-renewed. If insurance fraud can be proven, a referral will be made to law enforcement for further investigation and possible arrests and prosecution. One of the biggest challenges with insurance fraud is that it competes for prioritization of limited law enforcement and prosecutorial resources that could be spent on other crimes. Insurance fraud is often considered a “victimless” crime because the fraud is perpetrated against an insurance carrier, which is often a large corporation with hundreds of millions or even billions of dollars in capital and loss reserves (also known as “deep pockets”). Bottom line: the cost of fraud is paid for by every single one of the insurer’s policyholders in the form of higher premiums and adds up quickly to billions of dollars that do not directly benefit insureds.
In addition to SIU teams and partners like NICB and local law enforcement personnel, there are additional tools to combat insurance fraud. Predictive algorithms, artificial intelligence and machine learning can spot patterns and trends in massive amounts of data that might be indicators of fraud that humans can’t see easily or might overlook. The ability of these tools to leverage disparate data sources such as unstructured data, images and text, is particularly powerful. Some innovative insurtech startups are also trying to leverage social science to help create bonds between insureds through peer-to-peer arrangements. Perhaps most famously, the insurtech startup Lemonade promises to donate any proceeds that remain after covering their costs (including a provision for profit) and claims to charity in hopes that customers who might consider inflating their claims or otherwise committing insurance fraud will think twice about doing so and reducing the amount available for a charitable cause.
A RATE OF INTEGRITY
The concept of rate integrity is more subtle than insurance fraud itself but can add up to significant costs for policyholders. In a nutshell, actuaries and underwriters devise a rating plan that is dependent on a number of factors which all together form the basis for the insurance premium that is charged. Some of these factors are easier to manipulate than others, and it is in that manipulation that rate integrity becomes an issue. For example, it is more difficult to manipulate rating factors such as age and gender (although not impossible), the make and model of the vehicle being insured, or the property address being insured. Other variables are easier, such as the number of miles an insured drives annually if self-reported by the insured. There are some ways to verify this based on odometer readings, but it can become expensive to validate these factors. Another example is the square footage of a home; it might be represented differently on the original building permit and tax records, not to mention real estate listings. Does it include a finished basement or the apartment above the attached garage? What about whether the home has an actively monitored alarm or the apartment complex has sprinklers?
Auto insurance in particular is a ripe target for premium leakage which costs insurers $29 billion annually according to Verisk.[43] Verisk describes the issue of premium leakage from an insurer’s perspective like this: too costly to ignore, too expensive to address, and too risky for relationships.
According to Verisk’s 2016 Auto Insurance Premium Leakage Survey, 80% of respondents were at least “moderately concerned” with auto premium leakage. Major sources of premium leakage are:
Source: Verisk
One of the biggest sticking points between carriers and insureds is adding a youthful driver to an auto policy. Most auto policies allow for permissive users: if I lend my car to my buddy Tony, and he gets into an accident, my policy covers the resulting claim because Tony is a licensed driver that I permitted to use my vehicle. For teenager drivers within a household, the cost of adding them to the family’s auto policy can cause sticker shock (and no wonder, as teenager drivers statistically are far more likely to be involved in an auto accident than their parents). So parents have an incentive to delay adding their teenagers to their auto policies as long as they can. Families run the risk of not having proper insurance coverage when they do not disclose a youthful driver and add them to their auto policy, but often times a teenager involved in an accident when driving will be covered as a permissive user. If a household can be covered for an auto accident caused by their teenager driver without having to pay the large increase in policy premium by adding them as a driver to their auto policy, that creates a strong financial incentive to be less-than-fully transparent with the insurer.
According to a 2017 NerdWallet poll, 1 in 10 Americans reported providing false information when purchasing auto insurance. Some common forms of false information included:
•40% reported lower mileage than they actually drive annually
•27% reported omitting a driver
•20% reported lying about how the vehicle was being used
•10% gave a wrong zip code, claimed the car was garaged when it was not, and improperly claimed a discount they did not qualify for
Not only do some of these variables rely on the insured’s accurate self-reporting of their data, but often agents provide bogus information in their applications in order to “engineer” a lower premium for their customer to try to win their business. Some are intentional misrepresentations, but often these are innocent mistakes. What type of siding does your home have? What type of roof shingles - architectural or 3-tab? Many customers (and therefore their agents) simply do not know all of the relevant information that is requested as part of the application process that is used in rating and underwriting. The use of public records and third-party data providers has certainly helped insurers obtain more accurate and reliable information over the past 20-30 years (not to mention reduced the time needed to obtain a quote). However, even these sources are not infallible.
The costs associated with improperly classifying risks through manipulation (whether intentional or an honest mistake) generally do not add to the overall costs for insurers, but they do cause some policyholders to pay less than they should in premiums based on their risk factors. This means that others are paying more than their “fair” share of the costs in the form of higher premiums. The reverse is true as well: a misclassified risk that, if properly classified, warrants a lower premium will cause some policyholders to pay more than they “should” pay. The difference, of course, is that no one knowingly misrepresents their risk in order to pay a higher premium, but some do knowingly misrepresent their risk to pay a lower premium.
What are the consequences of intentionally misrepresenting your risk in order to pay a lower premium? There is a potential that you will not be covered for a loss, but the far more likely outcome is that your premium will be adjusted, and you will pay a rate more commensurate with your risk going forward. (You might have your past premiums adjusted but generally only back to the start of the current policy term.) In other words, in that vast majority of cases the incentives to “cheat” a bit by misrepresenting one or more
risk factors in order to “earn” a lower rate are fairly strong, the likelihood of being discovered are low, and the consequences are fairly benign.
BACK TO THE (FRAUDULENT) FUTURE
So what can insurers do to combat insurance fraud? According to a 2016 survey by the Coalition Against Insurance Fraud, 61% of insurers who responded believed that suspected fraud had increased to some degree. However, virtually all insurers in the same survey reported using some type of anti-fraud technology.
•90% who are using antifraud technology use red flags and business rules to identify potential fraud
•50% of survey respondents reported using predictive modeling to combat fraud
•76% identified detecting claims fraud as the primary focus of their antifraud technology
While new technologies offer the promise of helping to reduce the occurrence and cost of insurance fraud and improve rate integrity, there is another side to technological improvements: new sources of fraud. For new product lines such as cyber insurance, there will likely be creative minds that find ways to thwart the controls that are put into place and commit new forms of insurance fraud. Additionally, as insurers looks to leverage technology to improve customer experiences in streamlined processes such as one-touch or zero-touch claims, there will undoubtedly be new ways to cheat the system and commit fraud. The accelerating pace of technological change creates almost unimaginable possibilities from a carrier’s perspective. Carriers spend a lot of time thinking about how to combat fraud and put controls in place to limit the opportunities, but it is hard to proactively think of all of the myriad ways to cause havoc in a giant and complex insurance ecosystem. Insurers and law enforcement have to hone the ability to be a “rapid reaction” enterprise to combat threats such as money laundering, cyber attacks and other crimes that can drive up the cost of insurance for all policyholders.
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CHAPTER 6 - DRAINING THE (CASH) SWAMP
LIQUIDITY DOWN THE DRAIN
When you live paycheck to paycheck as over 75% of Americans say they do, and over half of us save less than $100 per month,[44] anything that depletes your cash reserves is a big deal. Building an emergency fund that covers 3 to 6 months of expenses is an important step that many financial advisors recommend to their clients. A recent study by Bankrate showed that 1 in 3 Americans experienced a major unexpected expense in the past year, yet less than 40% of Americans have $1,000 in savings to cover such emergencies.[45] Holding on to precious cash is important for the vast majority of us. Economists refer to the ability to turn assets into cash as liquidity, and businesses carefully monitor not just profits to judge the health of their organization but also cash flow. The ability to hold cash and tap into financial resources of some variety when an unexpected emergency occurs is critically important for billions of people throughout the world.
Many of the largest monthly costs for most households, such as rent or mortgage loans, auto loans and student loans, the cash paid by consumers is for servicing of debt. These debts are the result of borrowing a larger amount of money in order to purchase a major asset (a car or truck, an apartment or house, an undergraduate and/or graduate college education) that a consumer immediately benefits from without needing to fully pay 100% upfront in cash for that asset (or use of the asset in the case of rent or a leased vehicle.) Other expenses do require payment up front, such as utilities, but they also provide a large tangible benefit that is consumed daily. People don’t often think about the bills they pay to keep the lights on, the heat or cooling going and the water running but if you were faced with the decision not to pay these utility bills and lose those services, it would be a big deal. If you don’t pay your electric and gas bill on time, you could lose heat or cooling in your home. If your water gets shut off because you are unable to pay the bill, you’ll have a hard time taking a shower or washing dishes. Unfortunately, many people in financial need are faced with these exceedingly difficult decisions.
By contrast, insurance requires full payment monthly (or sometimes a larger down payment or full payment in advance) before the policy comes into effect. However, because most policy terms go by with no insurance claims, this known payment is made for a contingency - that a covered loss might occur during the policy term - that usually does not occur. Put another way, the consumer does not receive immediate, tangible benefits with insurance products (other than being able to provide proof of insurance if required) in return for their outflow of cash. While insurance premiums can sometimes be paid with a credit card, the relatively large cost of insurance monthly quickly adds up if the credit card is not paid in full, which incurs interest charges and drives up the overall cost of insurance. Regardless of whether the insurance is paid from cash or with a credit card that payments must then be made on, the constant outflow of cash is a burden to consumers over and above the outright cost of the product.
LET ME HOLD ONTO THAT FOR YOU
From one perspective, insurance is one of the most massive appropriations of income that consumers have. In any given policy period, if only 5-10% of the risk pool have claims that are paid by the carrier, the remaining 90-95% saw no tangible value - other than proving they had it to meet compulsory requirements - from their “investment” of paying insurance premiums. I’d argue that the only appropriation of hard-earned money that is larger in size and scope are taxes. Similar to taxes, consumers only partially benefit directly from the resulting “spend” on insurance premiums. Under the tax system, everyone pays taxes in some form or fashion whether it be in the form of sales tax, income tax, property tax - or all three. However, the benefits derived from those taxes are not proportional. In other words, there are winners and losers: some people pay more in taxes than the economic benefits they receive from government spending, while others clearly receive more economic benefits from the spending funded by taxes than they pay into the system. Insurance is no different: everyone who has a policy pays into the system - some more than others - and some receive greater economic value in return because of the claims they had that were paid and others receive less economic benefit. The largest difference is that with taxes, in the long run every person will receive a reasonable (if not proportional) amount of tangible benefits from paying taxes, while this is often not necessarily case for insurance.
Does insurance provide risk-averse consumers “peace of mind,” or is it a big waste of money? Historically, the insurance industry attempted to sell the peace of mind argument. The reality is that the money spent on insurance premiums with no corresponding return often feels like a waste of money to consumers. Relative to the monthly budget of a typical household, insurance is expensive. For the vast majority of people, on an annual basis, insurance premiums represent several hundreds or even thousands of dollars being paid for no tangible value in return. A recent analysis by the insurance search engine The Zebra found that the average auto insurance premium in the United States was $1,427 annually, up 20% from 2011. This average varied greatly by state with Michigan as the most expensive state ($2,610), and North Carolina being the cheapest ($865).[46] A similar study compiled by HowMuch.net based on data from Insurance.com for annual home insurance premiums found an even wider spread among states with Hawaii being the cheapest at $703, and Florida the most expensive at $6,892. (Vermont was the 2nd cheapest state at $1,033 so in all states except Hawaii the annual cost is over $1,000.)[47]
Is this really the most efficient use of this capital? If we look at insurance policyholders from an investor’s lens, you are taking valuable cash in hand on a regular basis and investing that money in the equivalent of speculative junk bonds: investments that have a low probability of paying off handsomely (if you have a claim) and a high probability of yielding no return on that investment. Worse than earning no return from an investor’s standpoint is losing principal as well. No financial adviser worth their salt would recommend such an investing strategy for all but the most wealthy and sophisticated investor, one that has a high enough risk toleran
ce to afford to lose their capital. Yet this is exactly how the P&C insurance market works! The only redeeming quality is that the “insurance asset” is not correlated with other financial markets: it “pays” only when the investor (policyholder) has an auto accident, leaking water heater, wind damage from a hurricane, etc. In other words, the investor (policyholder) gains some asset diversification that provides downside protection in some scenarios with a large likelihood in any given year that the asset (policy) will end up being worthless.
GIVE ME SOME CREDIT
Think of some alternatives to insurance: take credit cards for example. Credit cards general charge a high interest rate, but many consumers are willing (if not happy) to pay these higher interest rates for the convenience and flexibility of a credit card. How much do consumers love credit cards? It is estimated by the New York Federal Reserve that over 450,000,000 are currently in circulation, and the Federal Reserve estimates that there is over $780 billion in outstanding debt on credit cards. The average consumer in the U.S. holds 4 credit cards, and they are popular even with the 45% of cardholders that pay off their balance every month due to their flexibility.[48]
The End of Insurance as We Know It Page 7