Insurance Fraud and Optimal Claims Settlement Strategies
Posted: 15 May 2002
We examine the optimal claims settlement strategy for a liability insurer when claimants can permanently misrepresent their loss by engaging in costly claims falsification. In this environment claims auditing is not a possible deterrent to fraud, and the settlement strategy consists of an indemnification profile relating the insurance payment to the claimed amount of loss. The optimal indemnification profile is shown to involve systematic underpayment of claims at the margin as a means to deter loss exaggeration, with the extent of underpayment limited by expected litigation costs and potential bad faith claims. The key testable implication of the theory is that the extent of underpayment should be greater for classes of claims for which loss exaggeration is easier. Empirical analysis of insurance settlements for bodily injury liability in automobile accidents confirms this prediction. This suggests that liability insurers optimally choose claims payment strategies to mitigate claimants' incentives to exaggerate loss.
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