Identifying fraud in business interruption claims

Business income (interruption) insurance has received a lot of attention since the beginning of the pandemic due to business closures across the globe. Unfortunately for business owners (in the U.S. and most other countries), business income losses were not covered due to a virus exclusion.

The businesses forced to close or curtail their normal business operations due to COVID-19 restrictions or requirements suffered tremendous losses, which were unrecoverable under their policies. While some businesses were able to pivot and thrive during the pandemic, many had to close their doors permanently. Business owners need to pay close attention to policy language to have a clear understanding of their coverage in the event of a business interruption.

Business income coverage protects business owners, companies and employees in case of damage that results in the disruption of a business’s ability to make and earn revenue and ultimately a profit. Many covered perils such as fire, water, theft, vandalism, weather and freak accidents can easily destabilize even a thriving business. This coverage is often a saving grace when disaster strikes.

Typically, upon a loss event, the business owners will contact their insurance company or agent to notify them of the loss and seek direction, support and ultimately payment for their loss. A business income loss claim compensates business owners for lost revenue, less non-continuing expenses, from the date of the loss through to the reasonable amount of time to complete the repairs, known as the period of restoration. This is essential to the business and its employees as it provides reimbursement of employee payroll, which helps minimize financial damage to all affected. It also allows the business continuity in meeting their fixed cost obligations such as mortgage, rent, insurance and more.

While most claims including business interruption are valid and legitimate, insurance companies have to be leery that there are bad-faith actors trying to find an easy payday. While medical fraud rings have taken much of the spotlight over the years, fraud occurs within all types of claims. An estimated $308.6 billion in fraudulent claims are made every year in the U.S according to The Coalition Against Insurance Fraud.

Black’s Law Dictionary defines fraud as “a knowing misrepresentation of the truth or concealment of a material fact to induce another to act to his or her detriment.” The four major elements of fraud are: (1) false statement of a (2) material fact that is (3) willfully made with an (4) intent to deceive.

Understanding fraud and how it occurs

According to the Corporate Finance Institute, “The Fraud Triangle is a framework commonly used in auditing to explain the reason behind an individual’s decision to commit fraud.” It consists of three components that together, contribute to increasing the risk of fraud: (1) Opportunity, (2) Incentive and (3) Rationalization.

Opportunity — The perceived opportunity that the fraudster can avoid detection due to a weakness in a system.

Incentive — Personal or business financial pressure.

Rationalization — Policy deductibles or wait periods are applied to insurance claims that lower the claim amount.

There may be a tendency to justify the fraud as they are merely recouping their loss.

Fraud is not present in every business interruption claim but unsurprisingly, it does exist. Many of these claims start as legitimate losses. A business sustains damage from an event and reports the claim to its carrier. An adjuster is assigned and initiates the coverage review, and investigates the cause of loss and policy language. An inspection of the physical damage is conducted and the loss amount is estimated.

If the business suffers a loss of income due to the covered peril, typically by closing fully or partially while repairs are completed, the insurance carrier will either handle the inquiry in-house or hire a forensic accountant to gather and evaluate the company’s financial statements and then prepare a financial loss calculation to quantify the economic damage to the business. Forensic accountants are useful in detecting fraud and can help expedite the resolution of a business interruption claim.

Fraud can occur at any stage of this process in multiple forms such as intentionally causing (staging) the loss, false statements of material facts, altered financial reports, claiming more of a loss than actually sustained (padding), overstating pre-loss revenues, or understating loss-period revenues and direct or variable costs.

Types of business interruption fraud

There are several types of fraud found in business interruption claims. These include:

Exaggerating the loss — There is a legitimate loss but the business owner (policyholder) exaggerates (“pads”) the claimed amount. Ironically, the business owner often doesn’t recognize this offense as fraud and tries to rationalize the actions as covering the deductibles, or making up for actual costs they perceive they lost.

Overstating pre-loss income — This type of fraud is found in the financial statements. Reported sales are higher than actual sales in an attempt to have a higher projection of lost sales for the loss period. It is a good practice to evaluate and reconcile multiple sources of accounting and financial data. In addition to tax returns, profit and loss statements, and sales reports, the request for sales tax filings, sales invoices, bank/merchant statements and general ledgers can aid in the reconciling process.

Understating income during loss period — Intentionally shifting income/cash collection to future periods, processing transactions at other locations.

Understating expenses — In the calculation of lost gross profit, the cost of goods sold is deducted from the lost sales. Cost of goods sold is usually the largest expense, hence even slight manipulations may significantly inflate the loss amount. Understatement of other direct or variable costs, such as credit card fees and supplies, may also increase the loss amount.

The Association of Certified Fraud Examiners reported in its “Occupational Fraud 2022: A Report to the Nations,” that fraud is a global problem affecting all organizations worldwide. The 2022 study, covering 2110 real cases from 133 countries and 23 industries, found fraud caused total losses of more than $3.6 billion. The same study estimated that while financial statement fraud schemes are the least common (occurring in 9% of the cases) it is the costliest with a median loss of $593,000.

Identifying fraud

There often are red flags that help identify potential fraud in business interruption claims. While not all are sure signs of intentional fraud, some factors should be investigated:

• Claims history — Has the insured had multiple or suspicious losses in the past?
• Does the business or owner(s) have financial issues? Bankruptcy, foreclosure, divorce, etc.
• Were there recent policy revisions or limit increases?
• Quality of sourced documents — Evidence of being altered or questionable information?
• Financial statement review — Do financial statements reconcile to the tax returns?
• Does the business have significant uncollected account receivables or a high rate of receivables significantly past due? This could indicate an attempt to overstate pre-loss revenues by posting fictitious sales to account receivables.
• Do the company’s revenues reconcile to the cash ledgers? If the company is recording significantly more revenues than cash collections, this could signal the presence of fictitious revenues.
• Are the expense ratios in line with the industry? A helpful resource to verify the cost of goods sold and expense ratios (variable costs) are BizMiner Industry Financial reports. These reports provide comparisons of over 5000 industry classifications broken out in specific market areas.
• Are there other locations from where the business may be operating? Did other locations experience an increase in sales while the loss location was not operational?
• Is the business open and operating? A quick internet search may tell us if the business is open and operating. Typically, a business interruption claim is handled virtually as the forensic accountant rarely visits the loss location and relies on the adjusters and business owners for information about potentially resumed sales. It is not uncommon for a business to reopen sooner than the estimated period of restoration, either fully or partially, which may not be conveyed to the forensic accountant. A close eye should be kept on the status of the reopen date as repairs near completion. It is helpful when the field adjuster closely monitors the repair status and communicates to the forensic accountant so additional days are not paid in error.

The business owner’s demeanor is also noteworthy. When policyholders are overly aggressive in settling the claim quickly, it may not be because they just want to move on and reopen. It may indicate they don’t want too much time spent in the evaluation process as the financials may not hold up to close scrutiny. The business owners may even refuse to provide substantive documentation to support their claim and insist that the demanded amount be paid without quality sources.

When handling any claim, it is important to gather as much information about the business upon the onset of the claim. Keeping detailed notes and documenting all conversations is a great practice, as it makes it easier to identify inconsistencies should they arise.

Many conditions encourage fraud whether due to previous COVID-19 losses, an unstable economic environment, rising costs, personal financial hardship or other motives. Being aware of where the fraud is likely to present itself is a valuable tool when combatting fraudsters and preventing illicit payouts.

Having a solid understanding of financial statements, the ability to analyze and interpret the data, and recognizing red flags when present, can go a long way in protecting the claim expense ratio and a carrier’s financial health.

Tracy Santa (tracy@biloss.com) is CEO and co-founder of Business Income Loss Group, a claim preparation and forensic accounting consulting firm specializing in the evaluation and calculation of business interruption and employee dishonesty claims. Her firm services insurance carriers, independent adjusting firms, accounting advisory firms, third-party administrators, attorneys, adjusters and other claims professionals.

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