Expert Commentary

The Ethical Dilemma Caused by Fighting Fraud

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

Claims Practices
April 2006

The case resulted from a November 10, 1969, fire. The insurers, upon being informed of the fire, engaged the services of defendant P.E. Brown and Company ("Brown"). Carl Busching, a claims adjuster employed by Brown, went to the bar owned by Gruenberg, the Brass Rail, to investigate the fire and inspect the premises. While he was there, Busching stated to an arson investigator of the Los Angeles Fire Department that 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 alleged to be a direct result of the comments made by Mr. Busching to the fire arson investigator.

The insurer demanded an examination under oath of its insured who refused to testify since he was facing criminal charges. Since Mr. Gruenberg refused to appear for an examination under oath while the criminal charges were pending, the insurers denied his claim, in accordance with the law as it was then understood. He eventually defeated the criminal charges and sued the insurers for damages resulting from the claim and the charges of arson.

The California Supreme Court, creating, for the first time, a tort of bad faith in first-party claims, said:

[W]e 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.

Insurers Should Never Be the Sole Source of a Prosecution

In 2003 reports 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 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, Mr. 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. Cases against several defendants were 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.

Many of the cases were dismissed because of a lack of evidence. In an effort to round up as many defendants as possible. It appeared that the district attorney's office overreached 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 reported that lawyers for some of the defendants contend that insurance companies misled the Suffolk district attorney's office. The dismissals was evidence that the district attorney agreed.

Mr. Spota's office, as did the prosecutor who charged Mr. Gruenberg, relied on assistance from insurers and insurance anti-fraud organizations according to a story in Newsday. What both failed to do before the arrest was obtain corroborating evidence from police or prosecutor sources.

The Obligation To Report Suspected Fraud

Although insurance companies are obligated, by statute, in most states, to report suspected fraud, they can't prosecute the cases. All they can do is turn their investigation over to the prosecutor's office. Insurers are not criminal prosecutors. They have no police powers. Their experience is with insurance and insurance law, not criminal law. It is the obligation of the prosecutor to put the case into shape for a criminal trial before arresting people for fraud.

In what appeared to be a frightening admission of a failure of duty to prosecute crime South Carolina's Attorney General Henry McMaster, on March 23, 2006, during the Spring Conference held in Columbia by the Independent Insurance Agents and Brokers of South Carolina, reportedly told the brokers: "South Carolina's law enforcement officials have their hands full with violent crimes and don't have the manpower to investigate insurance fraud instances," establishing that in South Carolina, insurers are second-class victims of crime who need to act as their own police agency.

Insurance fraud cases, according to Mr. McMaster, require too much investigative work to be done by law enforcement. In a statement that should frighten all who write insurance in South Carolina, Mr. McMaster, frankly said: "If you wait for them to investigate insurance fraud, you will have a long time to wait." In his talk, Mr. McMaster reportedly appealed to insurance agents attending the meeting, and others in the state, to put together a file about alleged insurance fraud, including documents and information prosecutors can use to legally pursue a case. He said that as the state's Attorney General, he has the power to legally pursue such cases and would do so if provided with appropriate information. The Coalition Against Insurance Fraud questioned the comments and were advised that Mr. McMaster did not speak from a prepared text. The comments in the article are reported to have been slightly taken out of context.

Mr. McMaster apparently told the agents that his office did not have any investigators to assist the prosecutors so that they were reliant on other sources for their investigations. Because of that, merely reporting a fraud would not guarantee having it investigated or prosecuted. Agents are as close to knowing what is happening as anyone and if they help put a case together prior to reporting, then that would help the AG's office to move forward. Until the Coalition raised questions, Mr. McMaster's office did not even know there might be a problem with what he had said. It is our understanding that Mr. McMaster's office intends to clarify his statements.

If, as did the arson investigator in the Gruenberg case, the prosecutor relies solely on the investigation of an insurer and does no investigation of his own, 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. Regardless, immunities do not stop the insurer from being sued. The costs of defending such a suit is enormous. If the insurer accuses its own insured of a crime without adequate and believable evidence, a verdict finding that the insurer acted in 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. 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 claims—in the short run. For those who feel that a dollar given away to fraudulent plaintiffs is better than $1.01 for a successful defense, you don't understand criminals. They will just come to you 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.

The Danger of the Overzealous Fraud Investigator

More dangerous than no investigation, however, as Gruenberg has shown us, 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.
  • Implementing and monitoring internal controls including anti-fraud personnel conducted audits of basic claims files.
  • Putting 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.

Statutory and Regulatory Requirements

Insurers are faced with a dilemma: If they pursue fraud aggressively and err, they are sued by the insured. If they do not pursue fraud aggressively and establish an effective anti-fraud program, 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. One of the most stringent of such requirements is the California SIU Regulations.

The California SIU Regulations require aggressive anti-fraud activity and that every admitted insurer must conduct fraud training for all employees identified as "integral anti-fraud personnel" who include, but are not limited to:

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

Very few people employed by an insurer are not included in this list. The Regulations require the following training.

Section 2698.39 Anti-Fraud Training

Requirements for training provided by and for the SIU shall include:

  1. The insurer shall establish and maintain an ongoing anti-fraud training program, planned and conducted to develop and improve the antifraud awareness skills of the integral anti-fraud personnel.
  2. The insurer shall designate an SIU staff person to be responsible for coordinating the ongoing anti-fraud training program.
  3. The anti-fraud training program shall consist of three (3) levels:
  1. All newly-hired employees shall receive an anti-fraud orientation within ninety (90) days of commencing assigned duties. The orientation shall provide information regarding:
    1. the function and purpose of the SIU;
    2. an overview of fraud detection and referral of suspected insurance fraud to the SIU for investigation;
    3. a review of Fraud Division insurance fraud reporting requirements:
    4. an organization chart depicting the insurer's SIU; and
    5. SIU contact telephone numbers.

  2. Integral anti-fraud personnel shall receive annual antifraud in-service training, which shall include:
    1. review of the function and purpose of the SIU;
    2. introduction/review of the written procedures established by the SIU regarding the identification, documentation and referral of incidents of suspected fraud to the SIU;
    3. identification and recognition of red flags or red flag events;
    4. any changes to current procedures for identifying, documenting, and referring incidents of suspected insurance fraud to the SIU;
    5. Fraud Division insurance fraud reporting requirements; and introduction/review of existing and new, emerging insurance fraud trends.

  3. The SIU personnel shall receive continuing anti-fraud training that includes:
    1. investigative techniques;
    2. communication with the Fraud Division and authorized governmental agencies;
    3. fraud indicators;
    4. emerging fraud trends; and
    5. legal and related issues.

The Trap for Insurance Fraud Investigators

All of the training will be wasted if, however, the insurer falls into the trap created by Gruenberg. Violating the rights of an insured, falsely accusing someone of fraud, succumbing to frustration and creating evidence that is false, can be dangerous, not only to the individual employee but to the assets of the insurer. The only protection against the over zealous investigator or claims person is to properly train your anti-fraud personnel.

Before reporting a claim to public authorities the insurer must ascertain:

  • That it has gathered admissible evidence that supports the report of a suspected fraud.
  • That all of the elements of fraud can be established, that is:
  • A misrepresentation or concealment of a material fact;
  • The misrepresentation or concealment is made with knowledge of its falsity;
  • The misrepresentation or concealment is made with the intent to deceive;
  • The insurer was actually deceived; and
  • Damage resulted.

That the investigation gave as much opportunity for establishing the innocence of the insured as it does for establishing the existence of fraud.

Assistance Available

ClaimSchool, Inc. created 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 training program includes:

  • An Orientation Program For Integral Anti-Fraud Personnel
  • California Code of Regulations, Section 2698.39
  • The function and purpose of the SIU
  • Introduction/review of the written procedures established by the SIU regarding the identification, documentation, and referral of incidents of suspected fraud to the SIU
  • Identification and recognition of red flags or red flag events
  • Any changes to current procedures for identifying, documenting, and referring incidents of suspected insurance fraud to the SIU
  • Fraud Division insurance fraud reporting requirements
  • Introduction and review of existing and new, emerging insurance fraud trends
  • What Is Fraud?
  • Types of Liability Insurance Fraud
  • The red flags or indicators of insurance fraud
  • SIU Referral Liability Claims
  • Insurance Fraud Is a Crime in California
  • The Insurance Fraud Prevention Act
  • California Insurance Code 1872.5 IMMUNITY
  • Examples of Fraudulent Documents
  • 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:

  • Misrepresent the evidence available.
  • Conceal exculpatory evidence available.
  • Lie to a prosecutor or police officer.
  • Lie to an insured.
  • Lie to a claimant.
  • Make promises that cannot be kept.
  • Create false evidence.
  • Puff up weak evidence as if it is strong and reliable.
  • Act as a prosecutor by preparing the full case for the prosecutor.


The prudent fraud investigator, if it is believed that a preponderance of the evidence exists to allow denial of the claim should consult with an experienced insurance coverage attorney, an insurance knowledgeable Certified Fraud Examiner or an insurance fraud consultant. The attorney or consultant will, after an independent review of the claims and investigative file, provide one of two responses:

  1. The insurer is correct, the claim should be denied.
  2. The insurer is incorrect, the claim should be paid.

In the first instance the advice of the expert will establish that there is a genuine and well founded dispute between the insurer and the insured sufficient, in most states, to eliminate allegations of bad faith. In the second instance the claim will be paid and the insured will be satisfied.

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do 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.

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