The Ethical Dilemma Caused by Fighting Fraud

April 2004

Insurers must spend time, effort, and a great deal of money to stop fraud perpetrators from becoming wealthy off the inaction of insurers and prosecutors.

by Barry Zalma
Barry Zalma, Inc.

In 1973 an insurance adjuster, frustrated by his failure to prove that a bar owner had destroyed his bar by arson with the intent to defraud the insurer, was responsible for the creation of the tort of bad faith in first-party claims. The California Supreme Court, in Gruenberg v Aetna Insurance Co., 9 Cal 3d 566, 108 Cal Rptr 480 (1973), concluded that unfounded actions by an investigator which caused an insured to be arrested for arson required implementation of the new tort of bad faith.

The history of the case is as follows. On November 10, 1969, the insurers, upon being informed of the fire at Gruenberg's bar, engaged the services of defendant P.E. Brown and Company (Brown). Carl Busching, a claims adjuster employed by Brown, went to the bar—the Brass Rail—owned by Gruenberg, to investigate the fire and inspect the premises. While he was there, he stated to an arson investigator of the Los Angeles Fire Department that the plaintiff had excessive coverage under his fire insurance policies. Eventually the premises were locked and nothing was removed until November 14, 1969, when Busching authorized the removal of the rubble and debris.

About November 13, 1969, plaintiff was charged in a felony complaint with the crimes of arson (Pen. Code, 448a) and defrauding an insurer (Pen. Code, 548). A preliminary hearing was set for January 12, 1970. The charges against Gruenberg were probably a direct result of the comments made by Mr. Busching.

Because Mr. Gruenberg refused to appear for an examination under oath while the criminal charges were pending, the insurers denied his claim. He eventually defeated the criminal charges, offered to appear for examination under oath, and was refused because the insurer felt it had denied his claim properly. Mr. Gruenberg sued the insurers for damages resulting from the claim and the charges of arson.

Creating, for the first time in a first-party insurance claim, a tort of bad faith, the California Supreme Court said:

• We conclude that plaintiff has stated facts sufficient to constitute a cause of action in tort against defendant insurance companies for breach of their implied duty of good faith and fair dealing; that plaintiff's failure to appear at the office of the insurers' counsel in order to submit to an examination under oath and to produce certain documents, as appearing from the allegations of the complaint, is not fatal to the statement of such cause of action; and that plaintiff has stated facts sufficient for the recovery of damages for mental distress whether or not these facts constitute "extreme" or "outrageous" conduct.

New York Rules on Bad Faith

More recently reports have surfaced concerning major insurance fraud charges in New York State. Less than 6 months after Suffolk District Attorney Thomas Spota announced, with much fanfare, that his office had cracked a major auto insurance fraud ring, the investigation has ground to a halt.

The indictments of 567 defendants targeted people who allegedly staged accidents and faked injuries, as well as doctors and lawyers who allegedly profited from bilking insurance companies with phony no-fault claims. Initially, Spota said the first 85 arrests were just the “tip of the iceberg,” and blamed such fraud for this region's high auto insurance rates.

Since the highly publicized arrests, cases against several defendants have been dismissed. Many others were given dismissals on the condition that they stay out of trouble for as little as 72 hours. The prosecutor who began the investigation resigned, and lawyers familiar with the cases say many of them are weak. Other cases were dismissed because of a lack of evidence.

In an effort to round up as many defendants as possible, the district attorney's office seemed to overreach its authority. In addition, defense lawyers claimed that the district attorney's office was too quick to do the bidding of insurance companies.

The press has reported that lawyers for some of the defendants contend that insurance companies misled the Suffolk district attorney's office. Mr. Spota's office relied on assistance from insurers and insurance anti-fraud organizations according to a story in Newsday.

Insurers as Prosecutors

In most states, insurance companies are obligated, by statute, to fight fraud. But they can't prosecute the cases. All they can do is turn their investigation over to the prosecutor's office. Since insurers are not criminal prosecutors and do not have any police powers, it is the obligation of the prosecutor to put the case into shape for a criminal trial before arresting people for fraud. Casting blame on the insurers is disingenuous.

If the prosecutor relied solely on the investigation of an insurer and did no investigation of his own, as the arson investigator did in the Gruenberg case, the prosecutor will look incompetent, and the insurer will be sued for various torts including bad faith, false imprisonment, malicious prosecution, negligence, defamation, etc., when the defendants find out that the entire prosecution was based on information provided to the prosecutor by the insurer.

Of course, a good faith report to a criminal agency will be subject to immunities, but it will not stop the insurer from being sued. If the insurer accuses its own insured, the tort of bad faith will become a certainty.

Insurers must recognize they cannot rely on prosecutors to do a thorough job fighting insurance fraud. Only the insurer (the person with the biggest monetary risk if wrong) must take on the obligation to stop the crime of insurance fraud. Insurers must recognize that they are dealing with a sophisticated criminal enterprise, not teenagers stealing hubcaps. The police are not going to do the insurer's job—they don't like insurers any more than the public does.

Insurers must spend time, effort, and a great deal of money to stop the fraud perpetrators from becoming wealthy off the inaction of insurers and prosecutors. The cost of stopping the fraud may approach or even exceed the cost of paying the fraudulent bills—in the short run. Those who feel that a dollar given away to fraudulent plaintiffs is better than $1.01 for a successful defense don't understand criminals. They will just come for more next time. The best deterrent to fraudulent claims is a good and thorough investigation and a good defense. Over the long run, money will be saved.

A Good Fraud Protection Program

More dangerous than no investigation, however, as Gruenberg has shown, is the overzealous fraud investigator. The insurers must have an anti-fraud program with personnel who know insurance, insurance claims handling, insurance coverage, and criminal investigation. They must also have a robust, well-funded fraud prevention program staffed with experienced and well-trained personnel.

At a minimum, the fraud prevention program requires the following.

• An anti-fraud training program for all key claims and underwriting personnel.
• A code of conduct for dealing with suspected fraudulent claims.
• A positive environment for anti-fraud personnel.
• A program to hire, employ, and retain appropriate personnel.
• A decision to maintain a program of continuous training by anti-fraud experts of all claims and underwriting staff.
• A program to identify and measure fraud risks faced by the insurer.
• Implementation and monitoring internal controls including audits of basic claims files conducted by anti-fraud personnel.
• Use of on-staff internal auditors and Certified Fraud Examiners or contracting with external auditors and Certified Fraud Examiners.
• Using case management tools.
• Using claims databases and other tools provided by modern technology.
• Requiring all personnel—claims, underwriting, and sales—to cooperate in the anti-fraud effort.

If insurers fail to get their anti-fraud programs in order, government investigators will arrive to punish the insurer for failure to comply with anti-fraud statutes like the California Insurance Fraud Prevention Acts and Regulations enacted to enforce them. For example, California, by regulation, provides that every admitted insurer must conduct fraud training for all:

1. Claims handlers
2. Underwriters
3. Agents
4. Policy handlers
5. Call-center staff
6. Legal staff
7. Other insurer employees that perform similar duties

Very few people employed by an insurer are not included in this list. Most California insurers have done little to comply with the Regulation. The Regulations require the following training.

Exhibit 1

The Regulations also require that the admitted insurer maintain:

• [R]ecords of the anti-fraud training provided to all staff [and that it] shall be prepared at the time training is provided and be maintained and available for inspection by the Department on request. The training records shall include the title and date of the anti-fraud training course, name and title and contact information of the instructor(s), description of the course content, length of the training course, and the name and job title(s) of participating personnel.

All of the training will be wasted if, however, the insurer falls into the trap created by Gruenberg. No insurer should allow, or even consider allowing a claims handler or underwriter to:

• Violate the rights of an insured,
• Falsely accuse someone of fraud, or
• Succumb to frustration and create evidence of fraud that is false.

Such conduct can be dangerous to the insurer's bottom line. In addition the individual employee may find himself or herself a defendant of a civil or criminal action. The only protection against the overzealous investigator or claims person is to properly train and support the insurer's claims and anti-fraud personnel. (See the Fraud Investigation and Management Training Web site for a model basic training program for anti-fraud personnel to comply with the requirements of the Regulation quoted above and to provide expert assistance and trainers to the insurance industry.)

The Ethics of Insurance Fraud Investigation

An ethical fraud investigator will do a thorough and complete investigation. He or she will never accuse an insured of fraud without first obtaining sufficient information to defeat a civil case or cause a prosecutor to bring a criminal case or both. The ethical fraud investigator will never:

1. Lie to a prosecutor or police officer.
2. Lie to an insured.
3. Lie to a claimant.
4. Make promises that cannot be kept.
5. Create false evidence.
6. Puff up weak evidence as if it is strong and reliable.

Copyright © 2004, Barry Zalma, Inc.

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author’s employer or IRMI. This article does not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.