Study Shows Insurers Underpay Claims to Discourage Fraud
ANN ARBOR—Insurance claims that are easy to falsify, such as sprain injuries or cases involving lost wages, are routinely underpaid by insurance companies to deter fraudulent or inflated claims-even at the risk of litigation, a University of Michigan Business School study shows.
"The miserly proclivities of insurers when settling claims is legendary, and occupies a place in the pantheon of business stereotypes along with the sharp horse trader and the obdurate banker," says Keith J. Crocker, professor of business economics and public policy at the U-M Business School. "And, while it may appear that a dollar saved through reduced claims payments amounts to a dollar earned, insurers engaging in a strategy of systematic underpayment of claims do so at their own peril.
"At the very least, underpayment is likely to generate administrative costs to deal with aggrieved claimants, and the most egregious shortfalls may spawn protracted episodes of litigation and can result in substantial penalties."
However, Crocker says that his findings provide convincing support for the notion that insurers use claims payment strategies designed to mitigate claimants' incentives to exaggerate losses—in other words, they underpay claims to reduce the incidence of fraud.
In a study forthcoming in the Journal of Law and Economics, Crocker and colleague Sharon Tennyson of Cornell University analyzed nearly 13,000 individual insurance claims for automobile-related injuries nationwide.
The claimants in these bodily injury liability claims were eligible for financial losses due to injury damages (medical bills, lost wages and rehabilitation expenses) and general damages (other losses associated with the injury, such as "pain and suffering"). About 75 percent of the claims involved a sprain injury, while roughly a third included a claim for lost wages.
"Automobile insurance claiming is an area where fraud is legendary, and automobile liability insurance claims are thought to be particularly prone to exaggeration due to the possibility of compensation for pain and suffering in addition to economic losses," Crocker says. "The severity of the injuries often encountered in automobile accidents, such as sprains or other soft-tissue injuries, may be inherently unverifiable, and some of the types of claims filed, such as those for lost wages, may be easily manipulated by claimants."
The researchers found that claims with low falsification costs (i.e., those claims that are easy and inexpensive for claimants to fabricate) received, on average, lower payouts in injury-related financial damages. Easy-to-detect, non-sprain claims (e.g., contusions, amputations, fractures and burns) were paid at a marginal rate of 78 cents on the dollar, while those involving harder-to-diagnose sprain injuries received about 71 cents on the margin.
Likewise, non-wage claims were compensated at a marginal rate of 80 cents on the dollar, while claims that involved wage losses (which usually require minimal documentation and can be inflated by a claimant's malingering in returning to work) paid at a marginal rate of 71 cents.
Factoring in awards for general damages (again, "pain and suffering" and other losses above and beyond injury damages), the study found that the total claims payment in cases of sprain injuries increased only $1.02 for every dollar increase in financial losses claimed, while for non-sprain claims the marginal increase in the total payment amount was $1.54. A similar pattern was observed for wage ($1.03 awarded per dollar increase in claims) and non-wage ($1.60) claims.
"Since the amount of general damages awarded is usually linked to the amount of direct financial loss experienced by the claimant, there is an incentive for claimants to exaggerate the amount of their financial loss," Crocker says. "General damage awards are often argued to be the primary motivating factor for liability claims fraud."
The researchers say that insurers can combat a great deal of fraud simply by investigating and denying claims in which the potential for deception is great. But when cases lack observable physical markers that can signal fraudulent behavior, insurers have little choice but to resort to a strategy of underpayment.
"When audits of claims cannot uncover the true loss amount, the optimal strategy of an insurer is to reduce, at the margin, the settlement payment as a function of the claimed amount, thereby mitigating the incentives facing claimants to expend resources on claims inflation," Crocker says.
"Underpayment of claims, however, may generate costs to the insurer from claims negotiations and potential litigation, and can result in civil damages if the insurer is found to have engaged in bad faith.
"As a result, insurers must balance optimally the effects of claims underpayment on reducing the incentives for falsification, on the one hand, against the costs of underpayment, on the other."
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