Does Nitpicking On Claims Have An Adverse Effect on Policyholder Morals?

A recent topic of this blog has been the made-up insurance fraud statistics by the insurance industry, which has been discussed in Is the Insurance Industry’s Fraud Statistic Fraudulent? and Insurance Professor Jay Feinman Comments About Insurance Fraud Statistics. I have always wondered why we encounter such few allegations of policyholder fraud from insurers such as Amica, Chubb, and Lexington Preferred who charge higher premiums and compete on service rather than price. These companies do not nitpick their customers to death, and the focus is on fully paying the loss right away.

A very academic article written by economists, Fraudulent Claims and Nitpicky Insurers, caught my attention on this topic when I read its abstract:

Insurance fraud is a major source of inefficiency in insurance markets. A self-justification of fraudulent behavior is that insurers are bad payers who start nitpicking if an opportunity arises, even in circumstances where the good-faith of policyholders is not in dispute. We relate this nitpicking activity to the inability of insurers to commit to their auditing strategy. Reducing the indemnity payments acts as an incentive device for the insurer since auditing is profitable even if the claim is not fraudulent. We show that optimal indemnity cuts are bounded above and that nitpicking remains optimal even if it induces adverse effects on policyholders’ moral standards.

This bottom-line finding is not missed by most insurers because it leads to greater profits. It pays to be nitpicky even if the reaction by the customer is to induce padding and inflated claims. I am not saying either is correct, but that is the finding.

The first three paragraphs of the introduction describe the nature of the relationship and the distrust between insurers and policyholders:

Insurance fraud is widely considered to be a major source of inefficiency in insurance markets. However, although it is a recognized fact that fraud costs insurance companies billions of dollars every year, it is striking to observe how insurance defrauders often do not perceive insurance claim padding as an unethical behavior and even tend to practice some kind of self-justification. A common view among consumers holds that insurance fraud would just be the rational response to the unfair behavior of insurance companies. Consumers would tend to neutralize the psychological costs of their inappropriate behavior by considering it as the counterpart of the firms’ unfair behavior: An eye for an eye would thus be the rule of the insurance fraud game (Strutton et al., 1994, 1997; Fukukawa et al., 2007).

Perceiving unfair behavior of insurance companies is often associated with the popular view according to which insurers would be bad payers that start nitpicking if an opportunity arises. Apart from the fact that disputes are sometimes induced by the deliberate bad faith of one of the two parties, more often than not consumers’ complaints are motivated by the complexity of insurance contracts and by the difficulty to adapt oneself to (and even sometimes to figure out) all possible contingencies to which the contract may apply. It is true that insurance policies are usually very precise. They specify the various contingencies in which claims can be filed by policyholders, with exclusions and limits on payments. These clauses are often designed to lead policyholders to exert the appropriate effort when there is a risk of moral hazard. However, they also frequently allow insurers to reduce indemnity payment in circumstances where policyholders cannot be blamed for some deliberate inappropriate behavior. This may be at the origin of the feeling that the insurer legally profits from a situation where the policyholder is undoubtedly in good faith but the small print of the contract allows the insurer to deny the claim or to reduce the indemnity payment.

What is the logic of such behaviors? Why do insurers sometimes start nitpicking about claims, although the honesty of their customers is not disputed? This is a true puzzle because nitpicking induces some degree of uncertainty in the way the insurance contract is enforced, and for that reason it reduces the efficiency of the insurance coverage. Consequently, even if nitpicking is reflected in lower insurance premiums, the competition between insurers should lead them to offer the most efficient coverage and to refrain from such an apparently inefficient behavior. If nitpicking is so widespread in the insurance industry, its raison d’ˆetre must be related to insurance market mechanisms and not to the deviant behavior of some unscrupulous opportunistic insurers….

The conclusion is that nitpicking, if done correctly, reduces fraud more than it induces fraudulent behavior, and it adds to the bottom line by paying less on claims:

[N]itpicking may prove to be welfare improving in insurance markets. There are indeed (at least) two justifications for cutting down the indemnities on the basis of information collected through claims auditing: solving the ex ante moral hazard problem when perceived signals are informative on the policyholder’s effort, and improving the insurers’ ex post commitment to audit claims. When the focus is on this commitment problem, optimal nitpicking trades off the drawback of a less favorable risk sharing between insurer and insured against the efficiency gain of a lower equilibrium fraud rate. Policyholders may legitimately complain of insurers’ unfair behavior in the sense that nitpicking induces some degree of horizontal inequality. However, this behavior is the rational response to a commitment problem, and ultimately improving the credibility of the claim’s verification strategy is in the policyholders’ best interest. Nitpicking is nevertheless a second-best strategy: if insurers could make their claims monitoring perfectly credible, for instance through a reputation effect or by delegating audit to independent agents, then nitpicking would become a suboptimal strategy. In that sense, nitpicking reveals the failure of these commitment devices.

So, if everybody wants to know why we hate the way most insurance adjusters are trained in the field and why some policyholders are goaded into doing what they would not otherwise do, this is a good academic paper for study. For me, and as my mother used to say, two wrongs never make a right.

For policyholders, the lesson is clear—do not buy on price because those companies selling on price will be just as hard on price at the point of performance.

Thought For The Day

Anyone nit-picking enough to write a letter of correction to an editor doubtless deserves the error that provoked it.
—Alvin Toffler