The Tort System "Lottery" and Insurance Fraud

John Cummins and Sharon Tennyson

Center for Financial Institutions Working Papers from Wharton School Center for Financial Institutions, University of Pennsylvania

Abstract: The paper focuses on the effects of claimant behavior, especially fraudulent claiming, in determining liability insurance costs. The theoretical perspective underlying the analysis is that the ease of filing a claim and the net potential payoff affect individuals' incentives to file claims. Compensating claims via the liability system thus may increase incentives to file, because the payoff from a successful claim typically includes compensation not only for reported economic losses, but for pain and suffering.

Liability claims fraud in the automobile insurance market are analyzed within an equilibrium model, in which the level of fraud is determined by both the incentives of individuals to file fraudulent claims and the degree of fraud resistance by insurers. The consumer decision process regarding the filing of a fraudulent claim is modeled as participation in a lottery.

The optimal level of fraud control is that which minimizes the firm's total costs of fraud. The model yields predictions about the equilibrium level of fraudulent claiming in the market. The proportion of insured individuals filing a bodily injury liability claim relative to those injured in accidents depends on the characteristics of the insured population, features of the liability com-pensation system, and the efforts of insurers to deny fraudulent claims.

The authors' findings suggest that geographical variations in premium rates may be significantly related to fraudulent claiming behavior. The analysis highlights the fact that the incentive for bodily injury liability fraud stems primarily from the possibility of receiving pain and suffering awards. This suggests that appropriate reforms in accident compensation systems may be an effective means to reduce auto insurance premiums.

Date: 1993-09
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