Fraud in the Insurance Industry How it Can Impact Your Agency

A MarshBerry Publication Volume XXIX, Issue 4 APRIL 2013 Authored by Molly McCarthy, Senior Consultant 440.392.6584 email: Molly.McCarthy@MarshBerry.com Fraud in the Insurance Industry How it Can Impact Your Agency Occupational Fraud: The use of one s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization s resources or assets. 1 Why is this relevant to you? According to a study performed by the Association of Certified Fraud Examiners ( ACFE ) 2 : Occupational fraud is a significant threat to small businesses because they typically employ fewer anti-fraud controls The insurance industry made up 5.7% of 2012 reported fraud cases with a median loss of $95,000 Most occupational fraudsters are first-time offenders with clean employment histories What is fraud? Fraud is classified into three primary categories: 2 1. Asset Misappropriation: Occurs when an employee steals or misuses an organization s resources (e.g., theft of company cash, false billing schemes or inflated expense reports) 2. Corruption: Occurs when an employee misuses their influence in a business transaction in a way that violates their duty to the employer in order to gain a direct or indirect benefit (e.g., bribery) 3. Financial Statement Fraud: Occurs when an employee intentionally causes a misstatement or omission of material information in the organization s financial reports (e.g., recording fictitious revenues, understating reported expenses, etc.) Asset misappropriation is the greatest risk to agency owners which can occur via the blatant theft of cash or fraudulent disbursement of cash. In general, theft of cash has a lower risk of occurrence in an insurance agency due to the nature of the business, which in most agencies involves minimal direct cash transactions. However, those agencies that bill customers directly and remit payment to the carriers will be at a greater risk to this type of fraud. Figure 1 2012 Fraud Cases Reported by Industry % Cases Banking and Financial Services 16.7% Government and Public Administration 10.3% Manufacturing 10.1% Health Care 6.7% Education 6.4% Retail 6.1% Insurance 5.7% Services (Professional) 4.0% Religious, Charitable or Social Services 3.9% Services (Other) 3.5% Other 26.6% Total 100% [A] Several cases involved multiple schemes. The most relevant schemes to agencies involve fraudulent disbursement, specifically those schemes that include billing, expense reimbursement, check tampering, and payroll. Billing Schemes Billing schemes occur when a person causes the employer to issue a payment by submitting invoices for fictitious goods or services, inflated invoices or invoices for personal purchases. Examples include creating phony vendors or creating phony invoices from a legitimate vendor. 1 Report to the Nations on Occupational Fraud and Abuse 2012 Global Fraud 2 Ibid. APRIL 2013 themarshberryletter 1

Segregation of duties: Know who has signature authority (i.e., who has the right to approve payments and at what dollar thresholds) Know and restrict who has access and edit rights to your master vendor list (i.e., who has the ability to add new vendors) Understand accounts payable approval process (i.e., do you have minimum dollar thresholds that require invoice approval in place) Understand process for fielding customer and/or vendor complaints for non-payment (i.e., who handles these complaints) Review master vendor list on a periodic and random basis and investigate anomalies, such as: Unfamiliar vendors Identical vendor entries with different billing information: Vendor 1: Marsh, Berry & Co, Inc. 4420 Sherwin Rd, Willoughby, OH 44094 Vendor 2: Marsh, Berry & Co, Inc. 1450 Wood Rd, Chicago, IL 60622 Variation of vendor entries: Vendor 1: Marsh, Berry & Co, Inc. 4420 Sherwin Rd, Willoughby, OH 44094 Vendor 2: Marsh Berry & Co 123 ABC Rd, Cleveland, OH 44094 Expense Reimbursement Schemes Expense Reimbursement schemes occur when an employee makes a claim for reimbursement of fictitious or inflated business expenses. Examples include filing a fraudulent expense report claiming personal travel, non-existent meals, excessive mileage, etc. Have a formal, written expense reimbursement policy Understand the expense report review process (i.e., who performs the review, what documentation is required, etc.) Review expense reimbursement trends by employee for spikes or anomalies on a periodic and random basis Lead by example Check Tampering Schemes Check tampering occurs when a person steals the employer s funds by intercepting, forging, or altering a check drawn on one of the organization s bank accounts. Examples include stealing blank company checks or stealing outgoing checks and depositing into personal account. Figure 2 2012 Fraud Cases Reported in the Insurance Industry Schemes # Cases % Cases Billing 24 30.8% Corruption 21 26.9% Check Tampering 13 16.7% Skimming 12 15.4% Expense Reimbursement 7 9.0% Non-Cash 6 7.7% Cash Larceny 5 6.4% Payroll 3 3.8% Cash on Hand 3 3.8% Financial Statement Fraud 2 2.6% Register Disbursements 0 0.0% # of Reported Cases* 78 100% *Several cases involved multiple schemes. Segregation of duties: Keep company blank checks in locked space with restricted access Know who has signature authority (i.e., who has the right to approve payments and at what dollar thresholds?) Review the bank statement and returned checks every month Review check register on a periodic and random basis for out of sequence or missing checks Review Accounts Receivable Days Outstanding report and Bad Debt Expense Report on a periodic and random basis and investigate anomalies Payroll Schemes Payroll schemes occur when an employee causes the employer to issue a payment by making false claims for compensation. Examples include claims of overtime hours not worked or adding ghost employees on the payroll. Review master employee list on a periodic and random basis and investigate anomalies, such as: Unfamiliar employees Duplicate address entries for different employees Employees no longer employed by the agency Unexpected overtime hours by employee 2 APRIL 2013 themarshberryletter1

Types of Asset Misappropriation Category Description Examples Theft of Cash Receipts Skimming Cash Larceny Fraudulent Disbursements Billing Expense Reimbursement Check Tampering Payroll Any scheme in which cash is stolen from an organization before it is recorded on the organization's books Any scheme in which cash is stolen from an organization after it is recorded on the organization's books Any scheme in which a person causes his or her employer to issue a payment by submitting invoices for fictitious goods or services, inflated invoices or invoices for personal purchases Any scheme in which an employee makes a claim for reimbursement of fictitious or inflated business expenses Any scheme in which a person steals their employer's funds by intercepting, forging or altering a check drawn on one of the organization's bank accounts Any scheme in which an employee causes their employer to issue a payment by making false claims for compensation Employee accepts payment from a customer, but does not record the sale and instead pockets the money Employee steals cash and checks from daily receipts before they can be deposited in the bank Employee creates a shell company and bills employer for services not actually rendered (i.e., phony vendor) Employee purchases personal items and submits an invoice to employer for payment Employee files fraudulent expense report, claiming personal travel, nonexistent meals, etc. Employee steals blank company checks and makes them out to themselves or an accomplice Employee steals an outgoing check to a vendor and deposits it into their own bank account Employee claims overtime for hours not worked Employee adds ghost employee to the payroll Other Asset Misappropriation Cash on Hand Non-Cash Any scheme in which the perpetrator misappropriates cash kept on hand at the victim organization's premises Any scheme in which an employee steals or misuses non-cash assets of the victim organization Employee steals cash from a company vault Employee steals inventory from a warehouse or storeroom Employee steals or misuses confidential customer financial information Figure 3 Compare master employee list to vendor list on a periodic and random basis and investigate anomalies, such as: Identical billing information for vendor and an employee Employee: John Doe 123 ABC Rd, Cleveland, OH 44094 Vendor: Staples 123 ABC Rd, Cleveland, OH 44094 Who commits fraud? The typical fraudster is: Male 3 36 to 45 years old Has a college degree or higher Never been punished or terminated by an employer for a fraud-related offense Never been convicted of a fraud-related offense Employed by the company between one to five years Source: Report to the Nations on Occupational Fraud and Abuse 2012 Global Fraud Study, Association of Certified Fraud Examiners. According to the ACFE, the majority of frauds in the U.S. are committed by individuals working in one of the following departments: accounting, operations, customer service, purchasing, executive/upper management, and sales. Why do employees commit fraud? There are four components, when combined, instigate fraudulent behavior: 1. Pressure: Perceived pressure can be internal or external pressures. Examples inside the workplace include pressure to meet key performance metrics (e.g., new business goals, compensation incentives), whereas examples outside the workplace include personal debts, greed, drug abuse, etc. 2. Opportunity: Perceived opportunities are circumstances that allow an employee to commit fraud, such as weak internal controls, complacency by management, remote management, etc. 3. Rationalization: Rationalization is the frame of mind that allows the perpetrator to justify their actions, such as the belief they are under paid, underappreciated, etc. 4. Capability: Capability includes the knowledge of the systems and processes as well as the skills required to commit the fraud. 3 Ratio varies greatly depending on region, Canada and the United States had insignificant variance between male and female perpetrators. APRIL 2013 themarshberryletter 3

Position of Perpetrator Frequency 2012 U.S. Based Reported Fraud Cases Position of Perpetrator Median Loss 2012 U.S. Based Reported Fraud Cases Figure 4 Figure 5 Now what? Fraud is prevalent. It is estimated that the typical organization loses an estimated 5% of their revenues to fraud each year. The cost of fraud can be damaging financially to your brand and employee morale. One of the most important things you can do is understand your vulnerabilities. Due to limited resources smaller businesses are more susceptible to fraud. However that does not mean there are not controls you can put in place to mitigate your risk: Know your business you know your business best. Make it a priority to understand the roles and responsibilities of your employees in departments susceptible to fraud (e.g., accounting and operations). Know your risks you may not have enough staff in your agency to facilitate segregating all critical duties. However, in understanding where your weaknesses are you can provide better monitoring. For example, if you are unable to divide the responsibilities for vendor setup, vendor maintenance and cash disbursements among different individuals, adding a layer of management review will help mitigate your risk. Mitigate your risks don t assume it can t happen to you. Figure 6 2012 Detection Method of Victim Organization Small Business (<100 Employees) % Cases Tip 36.1% Management Review 14.0% By Accident 12.8% Internal Audit 9.9% Document Exam 7.0% Account Reconciliation 5.3% External Audit 4.8% Notified by Police 4.3% Confession 2.4% Surveillance/Monitoring 1.9% Other 1.0% IT Controls 0.5% Securities offered through MarshBerry Capital, Inc., Member FINRA and SIPC, and an affiliate of Marsh, Berry & Company, Inc. 4420 Sherwin Road, Willoughby, Ohio 44094. Except where otherwise indicated, the information provided is based on matters as they exist as of the date of preparation. Past performance is not necessarily indicative of future results. MarshBerry Capital, Inc. does not provide tax or legal advice and these professionals should be consulted separately.

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