Underpaying claims discourages fraud.
"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," said Keith J. Crocker, professor of business economics and public policy at the university. "And, while it may appear that a dollar saved through reduced claim 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."
The study, scheduled to appear in the Journal of Law and Economics, analyzed nearly 13,000 individual insurance claims for automobile-related injuries nationwide. The claimants were eligible for financial losses due to injury damages (medical bills, lost wages, and rehabilitation expenses) and general damages (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.
Crocker and colleague Sharon Tennyson, of Cornell University, 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. Non-wage claims were compensated at a 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) were paid at 71 cents.
Factoring in awards for general damages, the study found that the total claim 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 losses," Crocker said. "General damage awards are often argued to be the primary motivating factor for liability claim fraud."
Insurers could combat a great deal of fraud simply by investigating and denying claims in which the potential for deception is great, the research suggests. However, when cases lack observable physical markers that can signal fraudulent behavior, insurers have little choice but to resort to a strategy of underpayment. "As a result," said Crocker, "insurers must balance optimally the effects of claim underpayment on reducing the incentives for falsification, on the one hand, against the costs of underpayment, on the other."