Insurance Fraud

Author(s): Richard A. Derrig

Source: The Journal of Risk and Insurance, Vol. 69, No. 3 (Sep., 2002), pp. 271-287
Published by: American Risk and Insurance Association
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?The Journal of Risk and Insurance, 2002, Vol. 69, No. 3, 271-287

INSURANCE FRAUD
Richard A. Derrig

ABSTRACT

Insurance fraud is a major problem in the United States at the beginning of

the 21st century. It has no doubt existed wherever insurance policies are writ-
ten, taking different forms to suit the economic time and coverage available.
From the advent of "railway spine" in the 19th century to "trip and falls" and
"whiplash" in the 20th century, individuals and groups have always been
willing and able to file bogus claims. The term fraud carries the connotation
that the activity is illegal with prosecution and sanctions as the threatened
outcomes. The reality of current discourse is a much more expanded notion
of fraud that covers many unnecessary, unwanted, and opportunistic manip-
ulations of the system that fall short of criminal behavior. Those may be better
suited to civil adjudicators or legislative reformers. This survey describes the
range of these moral hazards arising from asymmetric information, especial-
ly in claiming behavior, and the steps taken to model the process and en-
hance detection and deterrence of fraud in its widest sense. The fundamental
problem for insurers coping with both fraud and systemic abuse is to de-
vise a mechanism that efficiently sorts claims into categories that require the
acquisition of additional information at a cost. The five articles published in
this issue of the Journal of Risk and Insurance advance our knowledge on sev-
eral fronts. Measurement, detection, and deterrence of fraud are advanced
through statistical models, intelligent technologies are applied to informative
databases to provide for efficient claim sorts, and strategic analysis is applied
to property-liability and health insurance situations.

INTRODUCTION

When railroads were the proverbial deep pockets in the late 19th century, organized
fakers slipped on banana peels, feigned paralysis, and extracted as much as $500
per fall from the railway companies, according to Dornstein, author of Acciden-
tally on Purpose (1996). Personal injury cases ranged from "railway spine" of the

Richard A. Derrig is vice president of research for the Insurance Fraud Bureau of Massachu-
setts and senior vice president for the Automobile Insurers Bureau of Massachusetts, Boston,
Massachusetts. The author acknowledges the production assistance of Eilish Browne and Julie
Farrell of the Automobile Insurers Bureau and the hospitality during spring semester 2002
of the Risk Management and Insurance Department of the Wharton School, University of
Pennsylvania.
271

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272 THE JOURNAL OF RISK AND INSURANCE

1870s1 to the similar "whiplash" auto claims of the 1950s, each reversing the bad
luck of accidents into the good fortune of insurance settlements. Insurance research-
ers have devoted much energy to the accommodation of insurance contracts with the
"moral hazard" of bogus and opportunistic claimants.2 Outright fraud was perceived
to be much more of a nuisance than the more pervasive exaggerated claim. In Settled
Out of Court (1970), Ross relates that "(t)he adjuster typically believes that few peo-
ple cut false claims from whole cloth, but that nearly everyone exaggerates his loss"
(p. 45).
What has happened in the past few years to make insurance fraud such a hot topic?
That is the subject of this short overview of the five major articles in this issue dedicated
solely to technical aspects of insurance fraud. This article begins by recounting some
insurance fraud milestones of the last 20 years.3 A brief discussion of parsing criminal
fraud from all other undesirable activities covered by fraud is followed by an idealized
portrayal of the claims process. The twin objectives of fraud deterrence and detection
are set in that process to highlight the importance of the integration of both in the
Tennyson and Salsas-Forn article. Major and Riedinger attack the ubiquitous problem
of systematically and strategically isolating the "interesting" claims in a database of
health care claims. A discrete choice model of claim characteristics modified to esti-
mate misclassification error in Artis et al. advances fraud measurement, specifica
the problem of undiscovered fraud. Claim features set in a database can be implic
weighted and the claim "scored" consistent with an unseen or latent variable (such
as fraud) in the algorithmic PRIDIT development of Brockett et al. Finally, alternat
scoring models that cover the landscape of current technologies (naive Bayes, neu
networks, decision trees, and others) are tested for intrinsic comparable advantag
over logistic regression in Viaene et al. The astute reader will be able to extract th
universality of these five approaches to fraud and adapt their lessons across insura
lines.

UNDERSTANDING INSURANCE FRAUD

Worldwide interest in insurance fraud, separate from moral hazard, has expanded
greatly in the past ten to 20 years.4 Growing problems with auto theft and claim frau
spawned the special investigative unit (SIU) in the United States in the 1980s (Ghe
1983). Prompted by publicity about health care fraud, specifically in Medicare, Dion
(1984) began to lay the conceptual foundation for the analysis of provider fraud
Canada. Concern was evident in the United Kingdom that fraud had become a
problem needing concerted attention in the travel, motor, home, and business covers

Railway spine was a controversial disease first described in the 1860s by a British doctor as
one with symptoms with a source in "microscopic changes to the spine that could not be
seen." Naturally, railway spine became a leading cause for personal injury compensation in
rail accidents in Britain and the United States (Dornstein, 1996, pp. 209-219).
2 See Dionne et al. (1993) for workers' compensation and Cummins and Tennyson (1996) for
automobile insurance. For an up-to-date general discussion of moral hazard in the insurance
context, see Doherty (2001), Chapter 3.
3 This trip though fraud publication history is necessarily short and incomplete. Apologies to
those making important contributions that are omitted here.
4 An annotated searchable bibliography on insurance fraud is available on the Insurance Fraud
Bureau of Massachusetts Web site at [Link]

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 INSURANCE FRAUD 273

in the late 1980s (Clarke, 1989). By the end of the 1980s, an emerging consensus on
the problem of fraud, but with wide variation in the responses, was noted for eight
industrial nations, including the United States and Canada (Clarke, 1990). Market
studies of fraud have been conducted in the United States by the Insurance Research
Council (1992, 1997), by the Insurance Bureau of Canada (Fortin and Girard, 1992;
Insurance Bureau of Canada, 1994), by the Insurance Councils of Australia (1994) and
New Zealand (1996), and by Artis et al. (1999) for the Spanish Auto Insurance Mar-
ket. Centralized associations were formed to promote solutions to the insurance fraud
problem, including the International Association of Insurance Fraud Agencies (1986),
the Coalition Against Insurance Fraud in the United States (1993), Comite Europeen
des Assurances for the European Union (1993), and the Canadian Coalition Against
Insurance Fraud (1994).

Initial systematic studies of automobile claims have been conducted in Massachu-

setts (Weisberg and Derrig, 1991, 1992), Florida (Florida Insurance Research Center,
1991), Canada (Caron and Dionne, 1999; Dionne and Belhadji, 1996), and nationally
(Insurance Research Council, 1996), establishing the characteristics and magnitude of
the auto insurance fraud problem. The Massachusetts studies have been extended to
gain more insight into the players and mechanics of insurance fraud (Derrig et al.
1994). Academic researchers began to expand the understanding of insurance fraud
in studies of auto insurance by Cummins and Tennyson (1992); workers' compensa-
tion insurance by Dionne et al. (1992) and Butler et al. (1996); health care insurance
by Sparrow (1996); and property-liability insurance in general by Picard (1994, 1996)
Economic modeling efforts followed in an attempt to promote efficient solutions in
terms of contract design and auditing strategies (Bond and Crocker, 1997; Crocker and
Tennyson, 1999; Picard, 2000; Watt, 1999, 2000). Practical models to sort out claims fo
fraud investigation began to emerge in the 1990s with database organization and selec
tion strategies (Major and Riedinger, 1992), fuzzy clustering (Derrig and Ostaszewski
1995), simple regression scoring models (Weisberg and Derrig, 1998; Brockett et al.,
1998), and probit models (Belhadji and Dionne, 1997; Belhadji et al., 2000).5
Many definitions of claim fraud are in common use. In this overview, I propose that
fraud be reserved for criminal acts, provable beyond a reasonable doubt, that violate
statutes making the willful act of obtaining money or value from an insurer under
false pretenses or material misrepresentations a crime (Derrig and Krauss, 1994). This
strict definition of fraud will not fit with the many large dollar and claim proportion
estimates of fraud so often quoted in newspaper and official industry sources.6 For
example, this definition of fraud may even be too strict to match the estimation objec-
tive of the discrete choice model applied to the Spanish auto insurance market by Artis
et al. (1999). In their study, claims are labeled as fraud when the claimant admits fraud
(undefined) and the insurer denies payment and/or cancels the policy. No criminal-
ity appears to be involved, so there is little in the way of a "cost" of being discovered
with this sort of claiming behavior, thereby increasing the economic incentives for this

5 It is highly likely that proprietary models were developed during this time frame but wer
not published.
6 In its annual report for 2000, the CAIF (2001a) produced a section called "Pin the Tail on
the Estimate." Estimates for the cost of insurance fraud ranged from a low of $18 billion by
the National Insurance Crime Bureau for property-liability fraud to a high of $96 billion by
Conning & Co. for all lines of private-market insurance.

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274 THE JOURNAL OF RISK AND INSURANCE

TABLE 1
Types of Fraud-Auto Claimant versus Workers' Compensation (WC) Claimant

Auto WC

1. Staged Accident 1. Deliberate Injury

2. Claimant Not Involved in Accident 2. Faked Injury (Multiple Claimants)
3. Duplicate Claims for Same Injury 3. Multiple Claims (Aliases)
4. Bills Submitted for Treatment Not Given 4. Fabricated Treatment

5. Real Injury, Unrelated to Accident 5. Non-Work-Related or Prior Injury

6. Fictitious Injury 6. Faked Injury (Single Claimant)
7. Misrepresentation of Wage Loss 7. Misrepresentation of Wage Loss
8. Other Material Misrepresentations 8. Other Material Misrepresentations

fraud type (Derrig and Zicko, 2002; Watt, 1999). Even with the low cost incent
Artis et al. (1999) study finds that undiscovered fraud is nearly 5 percent, com
modeled fraud to known fraud in their data set.

If fraud is to represent provable criminal behavior, then what claimant actions ar

associated with this fraud? On a simple level, insurance claim fraud is asking for pay
ment for an event that did not happen. To make this more concrete, we can look to
auto and workers' compensation insurance for parallel actions constituting fraud.7
Table 1 shows eight scenarios that all would agree to be fraud in the strictest sense.
How often do these types of events happen?

How MUCH CLAIM FRAUD Is THERE?

Despite the agreed-upon importance of measuring fraud (Dionne et al., 1993; Spar-
row, 1996), the vast array of estimates (CAIF, 2001a) attests to the imprecision of th
measurement attempts to date. According to Sparrow (1996), the health-care industr
"makes no serious attempt to measure the problem" (p. 55) and relies on the unsup-
ported 10 percent estimate provided by the Government Accounting Office. Indeed
the differences in measuring (1) criminal or hard fraud, (2) suspected criminal fraud
(3) soft fraud or systematic abuse, and (4) suspected fraud or systematic abuse are
vast. Some of those differences are generated by methodological weaknesses of th
studies. Surveys routinely ask how much fraud is there, and is it getting better o
worse, without providing working definitions or requiring any empirical backup to
the opinions solicited.8 Even expert opinions solicited in evaluating random sample
of claim files can provide suspected fraud and abuse at most as opposed to definitiv
identification.9 I suspect that orders-of-magnitude differences exist among the fou
categories spanning the fraud landscape.

7 Table 1 originally appeared in Derrig and Krauss, 1994, p. 399.

8 Of course, surveys such as the International Research Council/Insurance Services Office
[IRC/ISO] 2001 survey provide an accurate picture of the perceptions of fraud, if not frau
itself.
9 In one such sampling, four different coders provided subjective appraisals on the fraud con
tent of Massachusetts personal injury protection (PIP) and bodily injury (BI) liability claims
While each set of coders identified 5-10 percent of the claims as suspected fraud, no claim
was judged as suspected fraud by all four coders (Derrig and Ostaszewski, 1995).

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 INSURANCE FRAUD 275

TABLE 2
Fraud Measurement Example

Fraud Type IFB Data Size Percent

1. Broad Suspected Fraud Referrals 17,274 100%
2. Narrowed Suspected Fraud Accepted Referrals 6,684 39%
3. Narrowed Suspected Fraud Cases 3,349 39%
4. No Fraud Closed No-Prosecution 2,084 24%
5. Probable Fraud Refer to Prosecution 552 6%

6. Prosecuted Fraud Prosecution Complete 293 3%

7. Fraud (6) x (0.85)* 249 3%

8. Possible Fraud (7) + Prosecution Pending 119 1%

9. Fraud Estimate (7) + (8) 368 4%

Source: Insurance Fraud Bureau of

about one subject per referral.
*Approximately 85 percent of prosecuted subjects are disposed as guilty or equivalent
(Derrig and Zicko, 2002).

As an example to illustrate the wide possibilities of fraud estimates, I use data from
a ten-year, real-time experiment in Massachusetts of identifying, investigating, and
prosecuting auto and workers' compensation claim fraud. From its inception in 1991,
the Insurance Fraud Bureau of Massachusetts (IFB) solicited property-liability fraud
referrals from the industry, the government, and the public at large.1? Approximately
85 percent of the 17,274 referrals to the IFB pertained to auto and workers' compen-
sation claims. Table 2 shows the progressive weaning process from outside referral
to prosecution. It demonstrates that the ratio of suspected fraud (not abuse) by indus-
try personnel and the public to provable fraud is on the order of 25 to 1. Even if the
unsupported suspected fraud estimate of 10 percent were accurate, the true level of
criminal fraud would be less than one-half of 1 percent.

WHAT DO COMPANIES DO ABOUT FRAUD AND ABUSE?

When discussing fraud issues, one must often remember that insurance contracts be-
tween the company and the insured are agreements to pay for accidental damages
when they occur. The business of insurance is to pay claims in a timely and efficient
manner. Companies are well aware that claimants and providers may have opportu-
nities and incentives to take advantage of accidents, even fabricate or cause them to
happen, to obtain payments they might otherwise not deserve. The claim adjusting
process is in theory a narrowing of the information asymmetry (the claimant knows
exactly what happened; the company knows some of what happened) to the point that
an appropriate payment is made or the claim is denied. Adjusters routinely investigate
claims and negotiate settlements. Companies have the discretion to spend as little as
possible (overhead and routine reports only) on a claim or invest in acquiring infor-
mation (independent medical examinations, accident reconstruction, depositions) to

0 While the vast majority of referrals concerned property-liability lines, occasional referrals
were for other lines such as life and viaticals.

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276 THE JOURNAL OF RISK AND INSURANCE

TABLE 3
Fraud and Abuse: The Top
Ten Defenses

1. Adjusters
2. Computer Technology
3. Criminal Investigators
4. Data and Information

5. Experts
6. Judges
7. Lawyers
8. Legislators
9. Prosecutors

10. Special Investigators

resolve the asymmetry partially (negotiation) or fully (jury trial). This points to the
following fundamental problem: How can you sort incoming claims efficiently into
categories that require the acquisition of additional information at a cost? In the lit-
erature, this is known as costly state verification (Bond and Crocker, 1997). But these
types of decisions are made thousands of times every day. The question then becomes:
Are the sorting systems today effective at isolating fraud, isolating abuse, and isolat-
ing complicated claims from those that are easily paid? At least for auto bodily injury
liability claims in Massachusetts, the data show that reductions are taken routinely in
negotiated settlements when buildup is suspected (Weisberg et al., 1994). Claim deni-
als occur when the information, usually gathered by an SIU, supports no payment.

As for criminal fraud, the most efficient way to deal with appropriate sanctions is
centralized insurance fraud bureaus, of which there are 39 at this writing, seven of
which are for workers' compensation alone (IRC/ISO, 2001, Appendix 2; see also
CAIF, 2001b; Derrig and Zicko, 2002). They have the unique ability to connect those
with the ability to discover fraud (SIU personnel) with those who can sanction (pro-
secutors, judges). The small amount of "fraud" relative to suspected fraud and abuse
illustrated in Table 2 leads to two conclusions. First, company personnel must resolve
the vast majority of suspicious claims, with perhaps referrals to fraud bureaus and/or
regulatory authorities as an additional obligation. Second, the use of the wide defini-
tion of fraud inappropriately targets the law enforcement system as the solution when
regulatory agencies for providers and the legislated parameters of the insurance sys-
tem itself may be much more appropriate for mitigating unwanted claims and claim
payments. Table 3 identifies ten components of the fraud and abuse claim handling
system. It is instructive for the reader to rank them by their importance in fighting
fraud versus abuse; the rankings should be quite different.11

1 For example, in my opinion, prosecutors are most important (Rank 1) for deterring fraud but
least important (Rank 10) for mitigating abuse. My full ranking for the Ten Defenses (in the
alphabetical order of Table 3) for fraud are 5, 7, 3, 6, 8, 9, 10, 4, 1, and 2, and for abuse they
are 5, 4, 9, 3, 7, 8, 1, 2, 10, and 6.

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 INSURANCE FRAUD 277

FIGURE 1

Claim
Arrival DUDS

Express

Express
Claims Pre-
Data Mining

Target Claims 1

CLAIM PROCESSING
The five articles in this issue all contribute to an understanding of how the claim pro-
cessing system can be enhanced by technology. The goal is not to replace adjusters and
SIU personnel but to support their function by sharpening the information delivery
system using more appropriate data (expanded claim features) and better technolo-
gy to manipulate and deliver the data (Sparrow, 1996). Figure 1 shows the idealized
initial processing of incoming claims. When the first notice of a claim arrives, a triage
(pre-data mining) should sort arising claims into those that can be paid immediately,
called express claims here, and those that need to be further evaluated, called target
claims (Weisberg and Derrig, 1995). The remaining claims are those "duds" that never
materialize into payments, about 20 percent for PIP claims in Massachusetts.

The reason that this incoming triage is separated from the main processing is twofold.
First, it is easy to do. Figure 2 shows a set of decision criteria that typifies the simplicity
of the triage process, requiring no heavy-duty data mining operations such as those
found in Viaene et al. in this volume. Second, the presence of a large amount of the
express and dud claims, which need no additional information to resolve the claim,
will necessarily skew data mining fitting parameters as they "stretch" to accommo-
date the simple claims. The establishment of minimum criteria for investigation also
comports with costly state verification theory (Bond and Crocker, 1997). It is better to
reserve the more sophisticated techniques for the more difficult sorting problems.

Figure 3 illustrates conceptually how the target claims are potentially processed,
including the handling of fraud and abusive claims. Data mining (DM) enhancements
to the processing system are primarily valuable in delivering sorting information at
the routine adjusting stage.12 The information can range from simple routine infor-
mation (prior claims) to complicated claim type profiles (Major and Riedinger, 2002).

12 DM algorithms can also serve the more specialized sorting required within the set of claims
handled by SIU personnel. Indeed, the more sophisticated algorithms may be reserved for
SIU use, perhaps because of sensitive information and privacy concerns.

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278 THE JOURNAL OF RISK AND INSURANCE

FIGURE 2

Pre-Dat
/ Mining \
/ Simple Arising Sort \
<^ Example
~\ Auto PIP (20%) /
Expected Medical < $1 K
No Disability /

Express Paid Claim Target Claim

Once the information is in hand and the claims are sorted, those need
gation" (spend money) are identified. Ideally, investigation results in c
paid, built-up claims being negotiated (down), and suspected fraud claim
an SIU. Civil and/or criminal proceedings result when the situation war
appropriate institutional systems (such as fraud bureaus) are effective.

DEVELOPING THE CLAIM SORT

As discussed above, the fundamental problem in dealing with all claims
an effective sorting of claims into bins requiring different levels of inform
sition at a cost. At the bottom, all such claim sorting systems have the same
structure, although the details can and do vary widely. Figure 4 shows t
structure of the DM process.

One or more databases are accessed for each target claim. The databases
ulated based upon some algorithm that "scores" claims in the sense that
ing target claims are to be sorted by their "scores" into bins with assoc
Generally speaking, suspicious and complicated claims where additional
is needed appear in one collection of bins and nonsuspicious routine clai
remaining bins.13 Examples of such scoring processes are given by the
using data on fraud indicators (Brockett et al., 2002) and the probabilities of

13 Actual claim processing systems may contain more complicated layers such
reductions of upside outliers to so-called reasonable and customary levels.

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 INSURANCE FRAUD 279

FIGURE 3

( Target Claims]

r EaSY outine Adjustin~

I
Investigation

nvestigative Paid

f Build-up) Suspected
Negotiation ' Fraud SIU J

f Civil ) (Criminal)
ProceedingJ L ReferralJ

(Not Guilty- Prosecuted

Guilty

erated by the discrete choice models operating on claim characteristics (Artis et al.,
2002). Typically, the scoring output will be one-dimensional graded output along a
scale such as [-1,1] as in PRIDIT. Occasionally, the scores may be multidimensional
when more than one criterion applies,14 in which case one can make bin assignments
in multistage processes or by means of fuzzy clustering of potentially conflicting crite-
rion (Derrig and Ostaszewski, 1995). Note that the same sorting problem can occur for
claim providers, as amply demonstrated by the electronic fraud detection (EFD) sys-
tem of Major and Riedinger (2002). The development flow for a data mining process
built to score claims is idealized in Table 4.

One must start with real data on claim processing for the subject line of business. Eco-
nomic efficiency argues for acquiring that knowledge off the production line through
the analysis of random samples of claims in Step 1 of Table 4. As many relevant
dimensions of the processing should be included as possible in Step 2, including both
subjective and objective characteristics and assessments. Red flags pertinent to the
line of insurance form a starting point (Canadian Coalition Against Insurance Fraud,
1997). Additional collected or derived variables from accessible databases will most
likely help (Viaene et al., 2002). Since the data mining output is designed to assist
in the (additional) information acquisition, one must pay particular attention to th

14 One potential example would be the use of credit scores as a separate criterion not derive
from the company claim data. Another example would be some scoring of providers by the
propensity for involvement in questionable or exaggerated claims.

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280 THE JOURNAL OF RISK AND INSURANCE

FIGURE 4

/ Databases \
Scoring Functions /

Graded Outpu

v v

on-Suspicious Claims Suspicious Claims

, Routine Claims Complicated Claims

timing of the input features, with early arriving (routine) information being the most
valuable for Step 3. Steps 4-6 in Table 4 are meant to emphasize the separation of the
selection and value of the feature data themselves (Step 4), by whatever means are
chosen, from the association of the feature data with the objective of interest via the
scoring output. Expert assessment and/or historical results can provide the objective
variable for Step 5 that defines the potential extent of claim sort bins needed. Step 6
covers the difficult task of matching the modeling specification to the identification
problem at hand. Neural networks, fuzzy logic, genetic algorithms, and more can be
used singly or in tandem to manipulate the databases (Goonatilake et al., 1995; Hastie
et al., 2001). Steps 7 and 8 point out the obvious: The data mining process needs to be
validated not only in a testing mode but also in a feedback production mode (Wolf et
al., 1999). I turn next to the contributions of the articles in this issue to the idealized
claim processing flow discussed herein.

RESEARCH THIS ISSUE

All would agree that the primary goal of the information decision flow discussed
above is to both detect suspicious claims and identify the nonsuspicious claims for
rapid payment. That is the detection problem. Tennyson and Salsas-Forn elaborate
on the twin goals of detection and deterrence. They provide concrete tests of audit-
ing practices and outcomes that allow for the relative valuation of the process

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 INSURANCE FRAUD 281

TABLE 4
Claim Sorting Algorithm Development Flow

STEP 1: Sample: Systematic benchmark of a random sample of claims.

STEP 2: Features: Isolate red flags and other sorting characteristics.
STEP 3: Feature Selection: Separate features into objective and subjective; early, middle,
and late arriving; acquisition cost levels; and other practical considerations.
STEP 4: Cluster: Apply unsupervised algorithms (Kohonen, PRIDIT, fuzzy) to cluster
claims, examine for needed homogeneity.
STEP 5: Assessment: Externally classify claims according to objectives for sorting.
STEP 6: Model: Supervised models relating selected features to objectives (logistic
regression, naive Bayes, neural networks)
STEP 7: Static Testing: Model output versus expert assessment, model output versus
cluster homogeneity (PRIDIT scores) on one or more samples.
STEP 8: Dynamic Testing: Real-time operation of acceptable model, record outcomes,
repeat Steps 1-7 as needed to fine-tune model and parameters. Use PRIDIT to
show gain or loss of feature power and changing data patterns, tune investigative
proportions to optimize detection and deterrence of fraud and abuse.

toward meeting the separate detection and deterrence goals. Their research implies
that auditing outcome criteria, such as the proportion of positive outcome audits of
risk classes, can be used to tune the scoring parameter for efficient allocation of direct-
ed or random audits. The positive outcomes tested in the article are subjective (raised
doubt, refuted), which may be problematic for tuning. Perhaps a consistent measure
of claim cost reduction or savings net of cost would be better for operational purposes.

The value of reprinting the classic Major and Riedinger health claim fraud detection
article is twofold. First, the basic scientific approach to the problem of manipulat-
ing a large claim database to extract "outliers" of interest is probably more relevant
today than when the article was first written. Second, potential developers should
be encouraged that such a system design was actually implemented in a company
(Travelers) and produced results that are valid in theory and useful in practice. Their
notions of product design (EFD architecture) are similar in spirit to the development
steps of Table 4 and are essential to the final design of EFD.15 Most valuable, however,
is their discussion of frontier identification (Figure 6) as a selection criterion. While
this particular approach may not fit other modeling situations, it is highly illustrative
of the need for careful analytic choice of decision criteria that become embedded into
the model and hidden from production users.

Discrete choice models with misclassification as discussed by Artis et al. add to the
many ways of estimating fraud proportions. Their contribution not only yields an
estimate of "hidden fraud," but also provides a way of evaluating the importance of
claim features associated with fraud. They find that the discrete choice model correctly
classifies about 75 percent of claims with or without the misclassification adjustment

15 EFD is the acronym coined by Major and Riedinger for electronic fraud detection.

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282 THE JOURNAL OF RISK AND INSURANCE

(their Table 5). While percent correctly classified (PCC), or the disaggregated confusion
matrix, provides an easily interpretable evaluation criterion, both the Major and Rie-
dinger and Viaene et al. articles point to AUROC, the area under the receiver operating
curve, as the better evaluation criterion, as it shows the model specificity and sensitivi-
ty to positive and negative errors at once. The addition of the misclassification variable
in the Artis et al. final model and its additional claims "predicted" to be fraud illustrate
a fundamental principle underlying the application of these and other scoring models.
Claims with many features similar to those of fraudulent claims are (expected to be)
fraudulent. We can call it the "guilt by association" criterion. It includes the nearest
neighbors models in Viaene et al. and, indeed, most feature identification models.

Brockett et al. contribute to the evaluation and selection of appropriate feature data.
The authors prove a valuable universal theorem-namely, that feature data with re-
sponses that are monotone in a latent or hidden binary variable (like fraud) have a
unique (up-to-scale), nonlinear scoring model that separates the claims according to
the latent variable and gives a relative value to each feature that contributes to that
separation. This latter result allows for the testing of various features (Steps 2 and 3
in Table 4) to permit the use of only those feature variables that actually contribute to
effective sorting while ignoring those with weak contributions. In addition, the em-
bedded scoring model can be used to test (1) whether some alternatively developed
scoring model "fits" the data in the sense of not being too distant from the embedded
model, and (2) whether the feature data are changing over time (the embedded models
should not be too far apart).

Viaene et al. deliver four major contributions to the claim sort development problem.
First, they provide a large laundry list of potential Step 6 model specifications for
binary classification models. Logit, decision trees, nearest neighbor, neural network,
support vector machine, naive Bayes, and tree-augmented naive Bayes models with
common parameter and smoothing variations are presented in Viaene et al.'s Table 5.
Second, their results show that at least on the Massachusetts data tested, the models
per se show no advantage one over the other. While testing (Steps 7 and 8 in Table 4) is
always in order, a cost-conscious modeler may opt for the simpler and easy-to-
interpret logit model to start the claim automated sort development. Third, the
results show the superiority of the AUROC evaluation criterion (Step 7) over the PCC
criterion (compare their Table 5 and Table 6 results relative to the "majority" bench-
mark). Fourth, the feature set augmented with non-fraud indicator data provides
better results, highlighting the fact that traditional fraud indicators alone may not be
adequate and that a search for augmented features is worthwhile. Readers can now
see the sweep of the five articles in this volume and the relevance of each to the design
of a claim sort. I now turn to the future.

FUTURE RESEARCH

The five articles in this issue contribute much to the theoretical and practical aspects
of fraud detection and deterrence. As with all good research, a deeper understanding
of the process raises additional, usually more difficult, or more subtle questions. The
purpose of this final section of the insurance fraud overview is to pose some of those
additional topics for future research. This will be an admittedly biased selection con-
ditioned on the author's interest; others may note different priorities for follow-up
projects.

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 INSURANCE FRAUD 283

Data

The single most important improvement that can be made is to assemble additional
databases for production and study. Even the casual reader of these five articles will
note that three of the five use data on automobile insurance generated in studies of
Massachusetts automobile BI claims. The mere presence of additional data sets, such
as the Spanish market claims in Artis et al., provide for alternative specifications of
modeling efforts as well as tests of robustness of research results that are dependent
on the data set used (Viaene et al., 2002). Centralized data sets, perhaps assembled by
third-party vendors such as ISO, which can be accessed in the claim processing will
play a key role in the efficiency of any system of claim sorting developed. The type
of features and the quality of the reported data will determine the effectiveness of the
processing or research, as the case may be. A high priority should be to assemble a
data set for workers' compensation.16

Fraud Indicators

Determine which traditional fraud indicators carry good claim sorting information
and which augmented features best supplement or replace the fraud indicators (by
line).

Time and Place

Time and place of occurrence are objective features known early in the claim handling
flow. Tune models to take advantage of the availability of these data and test their
importance by line.

Subjective/Objective
Subjective features have the advantage of being summarized or preprocessed data
elements where the processor is a domain expert. This makes the subjective feature
a valuable way to incorporate subtle correlations that may be available to the hu-
man but not in a systematic way. Subjective features have the distinct disadvantage
of being observer-dependent and subject to wide variation of interpretation. Objec-
tive features, however, stand alone as verifiable data elements without interpreta-
tion by the processor. Showing how to replicate subjective features by equivalent, or
near-equivalent, objective features in a demonstration modeling effort would be
helpful.

Investigation Models
Build a demonstration scoring model that not only identifies sorting bins but also pro-
vides probabilities of successful investigation outcomes for each claim within each
bin.

Costly Misclassification
Compare the qualitative and quantitative outcomes of scoring models when misclass-
ification costs of false positives and false negatives are equal and unequal.

16 See Biddle, 2001.

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284 THE JOURNAL OF RISK AND INSURANCE

PRIDIT Scores

Determine the appropriate range of "permissible" supervised models in relation to the

embedded PRIDIT model for feature data that are monotone in the investigation/no
investigation latent variable. Compare that model outcome with actual investigation
decisions to determine value added. Compare PRIDIT determined valuation of fea-
tures to otherwise determined feature values, such as significance of regression coef-
ficients, in a demonstration model.

Expert Design
Determine the potential increase in scoring model efficiency by the use of expert tuning
using advanced techniques such as boosting and bagging (Hastie et al., 2001, Chapters
8 and 10).

Detection and Deterrence

Establish objective claim cost or net savings criteria as measures for valuing detection
and deterrence in the sense of Tennyson and Salsas-Forn.

Random and Targeted Audits

Determine the methods to optimize a pre-commitment policy mix for random and
targeted audits.

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