​Fraud Sewed Up

Payroll fraud charges against two business owners illustrate the high cost of the underground economy.

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California authorities have charged two jeans company subcontractors and their accountant with workers' compensation insurance fraud, the Associated Press reports. Sisters Su​​ng Hyun Kim and Caroline Choi, who owned separate sewing companies, allegedly conspired to underreport US$78 million in payroll, which caused the loss of more than US$1 million in premiums to insurers. California insurance officials began their investigation after discovering a significant gap between the payroll amount the sisters reported to them and the amount they reported to the California Employment Development Department. Officials say the sisters also paid some employees under the table.

Lessons Learned

Workers' compensation insurance premium fraud has a significant dollar impact on the operations of insurance companies and workers themselves. Yet this amount pales in comparison to the staggering size and growth of the overall "underground economy" in the U.S. Although difficult to measure, economists estimate that as much as US$2 trillion in unreported economic activity takes place annually — double what it was in 2009. That amounted to an estimated US$500 billion in revenue losses for the U.S. government in 2013, up from US$385 billion in 2006, according to a U.S. Internal Revenue Service study.

What's behind this trend? Answers include the severity of the 2008 recession and the weakness of the recovery from it, general distrust of governments and taxation, the growth of casual work arrangements and cash wage payments in many types of jobs, immigration growth and illegal workers, and U.S. Affordable Care Act mandates to provide health insurance to employees. And, as illustrated in this story, some businesses and people commit fraud to keep more money for themselves.

Employers commit three basic types of premium fraud:

  • Underreporting of payroll occurs when a policyholder fails to accurately report its entire work staff to the insurance company, often by paying employees off the books or presenting employees as subcontractors or independent contractors rather than as actual employees.
  • Misclassification of employees occurs when a high-risk employee, such as a construction worker, is classified as a person with low-risk clerical duties, enabling the company to pay lower workers' compensation premiums.
  • Experience modification evasion occurs when a company closes, then attempts to re-emerge as a new company on paper to obtain a lower experience-modification factor — and lower premiums — but the new business is actually unchanged from the original business.

Regulators, organizations, and internal auditors can take several steps to deter or detect payroll and workers' compensation fraud:

  • Strengthen and make more consistent use of regulatory tools. Many states have insurance funds and laws that prohibit workers' compensation insurance fraud schemes and grant the states audit and punitive powers including financial restitution, penalties, and criminal prosecutions. States like California go a step further by publishing all of the pertinent information associated with the crime committed by an employer convicted of premium fraud to the state's Department of Insurance website.
  • Educate employers regarding the need for diligence, compliance, and accurate reporting. Employers must understand the implications of good reporting, such as for the classification of jobs, as well as the fact that reporting statements could be used in fraud investigations.
  • Regularly exercize the audit provisions of workers' compensation insurance policies. The standard workers' compensation insurance policy will contain a provision allowing the insurance company to audit the insured's records at its discretion. Auditors can use certain industries, geographical locations, economic circumstances, and other factors to better target potential employer fraud abuse before it takes hold. If the auditor finds potential irregularities at an early stage, with the employer's cooperation, the typical result may be a simple reassessment and correction of the premium actually owed.
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