Inside Job

Gary Heaslip has recently observed a disturbing trend. In the last 18 months, his agency, Starkweather and Shepley, has handled an extraordinary number of employee dishonesty claims filed by the firm’s commercial clients. Such claims run the gamut from computer fraud and embezzlement to theft of cash and equipment.’

Not only is the volume of such claims up “the dollar amounts involved have also risen dramatically,” says Heaslip, executive vice president of the East Providence, R.I.-based independent agency. “We’re a good sized agency, the 74th largest in the country, and we think we know the primary cause for the increases. There seems to be a distinct linear relation¬ship between an increase in occupational fraud and the poor economic outlook. We’re seeing the same story play out in all types of organizations we serve, from smaller private companies and partnerships to larger professional corporations.”

Heaslip’s observations are backed up by fact. According to several studies, crimes committed against businesses by employees and third parties have risen since the recession reared more than two and a half years ago. Stressed out and fed up, unemployed or fearful of this possibility, many employees are taking out their frustrations on their employers.

The rising incidence and financial severity of crimes committed against businesses smacks into another unsettling scenario “the relatively high number of small businesses that don’t have insurance protection to address the broad range of fraud risks or the proper financial limits in their policies to absorb the related losses. “Our most recent survey on private company risk indicates that only one in four private companies buys crime insurance,” says Greg Bangs, worldwide crime, kidnap & ransom and workplace violence product manager at Chubb Group of Insurance Companies. “There apparently is a gap between these companies’ understanding of risk and their willingness to transfer it through insurance. There are a lot of uninsured companies out there, and even more that don’t have enough in insurance limits to soak up the costs.”

Fraud Runs Rampant
Chubb’s survey only addresses private companies. Yet, other studies indicate that all organizations are experiencing the same rising tide of occupational fraud and other crime-related events and losses. According to consultancy PricewaterhouseCoopers, 30% of companies worldwide experienced at least one incident of financial fraud in 2009. And key findings from the 2010 Report to the Nations on Occupational Fraud and Abuse by the Association of Certified Fraud Examiners (ACFE) indicates that organizations, on average, lose an estimated 5% of their annual revenues to fraud.

Chubb’s survey only addresses private companies. Yet, other studies indicate that all organizations are experiencing the same rising tide of occupational fraud and other crime-related events and losses. According to consultancy PricewaterhouseCoopers, 30% of companies worldwide experienced at least one incident of financial fraud in 2009. And key findings from the 2010 Report to the Nations on Occupational Fraud and Abuse by the Association of Certified Fraud Examiners (ACFE) indicates that organizations, on average, lose an estimated 5% of their annual revenues to fraud.

Nearly three out of four employees (74%) responding to a KPMG survey reported that they had personally observed or had firsthand knowledge of wrongdoing within their organizations during the previous 12 months. Nearly half of the employees (46%) reported that what they had observed “could cause a significant loss of public trust if discovered.”

The statistics compiled by ACFE, a membership organization of 55,000 anti-fraud professionals worldwide, are especially sobering. ACFE cites an average loss of $155,000 per occupational fraud for small companies with fewer than 100 employees, and an average $200,000 occupational fraud loss for companies with between 100 and 1,000 employees. “It’s quite stunning just how high these losses are, particularly for smaller companies,” says John Warren, ACFO vice president and general counsel.

Bangs says business owners must cope with a growing incidence in other crimes, such as computer fraud, fraudulent wire transfers and phishing scams by both employees and outsiders. “Small companies are not immune to phishing,” he notes. “We’ve seen several claims involving people using social engineering techniques to hack into a company’s systems to steal personal identification and password information. They then make fraudulent requests to banks pretending to be that person.”

Another common scam is creating a fictitious vendor and then setting up a bank account in that vendor’s “name.” “The “vendor’ sends a dummy invoice to the company that the fraudster pays on behalf of his or her employer,” Bangs says. “The person then takes the money from the fictitious bank account for his or her own use.”

The economic fallout of occupational fraud is steep, contributing to more than 30% of business failures, according to the U.S. Department of Commerce. For small businesses barely scraping by in the wake of the recession, the risks of demise are potentially higher. “Statistically, about half of all small businesses fail in their first five years “even without a recession,” says John Armstrong, commercial property director at Fireman’s Fund Insurance Company. “This is why small business owners must take all necessary precautions to prevent employee theft and fraud.”

Uncovering the Why Now
Such loss prevention begins with understanding why crimes against businesses happen. Spencer Timmel, client service executive at independent brokerage Hylant Group in Toledo, Ohio, agrees that the recession is fueling more occupational fraud claims. “People are increasingly desperate,” Timmel says. “They’re fearful of losing their jobs and the financial impact this would have on their families. They’re more apt then to pad their pockets, figuring they deserve something back from the organizations they’ve done so much for over the years.”

Such loss prevention begins with understanding why crimes against businesses happen. Spencer Timmel, client service executive at independent brokerage Hylant Group in Toledo, Ohio, agrees that the recession is fueling more occupational fraud claims. “People are increasingly desperate,” Timmel says. “They’re fearful of losing their jobs and the financial impact this would have on their families. They’re more apt then to pad their pockets, figuring they deserve something back from the organizations they’ve done so much for over the years.”
Another factor in the recent high claims activity is corporate belt-tightening, Timmel believes. “Many companies are taking a closer look at their risk controls in an effort to curb unnecessary costs,” he explains. “Consequently, they’re uncovering theft issues that in the past may have evaded detection.”

Warren agrees with these conclusions. “We’ve noticed that when a company’s sales are down and its profit margins are slimmer that frauds that previously were easier to hide in the books are a lot harder to conceal now,” he says. “There is little question that in tougher economic times more frauds are committed and they are easier to detect.”

To reduce the risk of occupational fraud, Armstrong counsels companies to improve their background screening of job candidates, and to be alert to employees who have a sudden, apparent devotion to work and to working late. “Strong objections to procedural changes related to financial, inventory or supply matters, and evidence of compulsive gambling, persistent borrowing or repeated requests for salary advances are other potential indicators of criminal activity,” he adds.

Close the Gap Through Coverage
Small and medium-sized businesses can pass on the financial losses of occupational fraud and other crimes to an insurance company through several types of policies. Business Owners Policies or BOPs provide a modicum of basic protections, but its no frills approach may not be right for all companies, given the sheer variety of crimes, in addition to their frequency and financial severity. “BOPs are very streamlined and cost-oriented, but a business may have greater needs than a BOP can satisfy,” says Armstrong. “This is why agents should consider package policies and standalone crime insurance coverages.”

Small and medium-sized businesses can pass on the financial losses of occupational fraud and other crimes to an insurance company through several types of policies. Business Owners Policies or BOPs provide a modicum of basic protections, but its no frills approach may not be right for all companies, given the sheer variety of crimes, in addition to their frequency and financial severity. “BOPs are very streamlined and cost-oriented, but a business may have greater needs than a BOP can satisfy,” says Armstrong. “This is why agents should consider package policies and standalone crime insurance coverages.”

Timmel does just that, routinely advising his privately-held accounts to consider more robust crime insurance protection. “BOPs tend to have limited coverages with respect to crime, with terms and conditions that are a bit narrow,” he says. “They provide basic employee theft coverages, and insurance addressing on-premises thefts by others. BOPs also insure money in transit that is stolen, the risk of someone forging a check and there is also a bit of credit card coverage. But we recommend that our clients separate out these crime coverages and tack on other things like computer fraud, false vendors, funds transfer fraud, counterfeit currency fraud and coverages picking up post-loss expenses, such as the need to hire a forensic audit firm to determine how much money was stolen.”

Heaslip pursues a similar course. “Since the advent of the new standalone forms a decade ago, our agency won’t write crime risks on a BOP anymore; we only use the new forms,” he says. “They provide a plethora of additional coverage considerations, things at first blush you wouldn’t think about, but post-loss you sure are glad you had them.”

Assessing the appropriate financial limits a commercial client will need is part art, part science, observers say. “One way is to look at the revenues of the company and assume that 5% will be the cost of fraud,” Warren says. “Then, get a limit that encompasses that amount.”

Timmel advises agents to partner with organizations like Advisen that can evaluate a client’s cash flow, number of employees and business locations, employee turnover rates and the efficacy of its internal risk controls to extrapolate an appropriate limit. “You want to benchmark the company against others to figure out the right amount of protection,” he says.

Agent Role in Risk Protection
Insurers say agents and brokers can be a valuable resource to their clients when it comes to reducing fraud risks. “We recommend breaking down a financial transaction into discrete parts and then segregating employee duties,” says Steve Balmer, vice president and crime manager at Travelers Bond & Financial Products. “This way one person isn’t controlling the entire transaction. It also makes sense to require two people to authorize the issuing of checks, purchase orders or the payment of bills.”

Insurers say agents and brokers can be a valuable resource to their clients when it comes to reducing fraud risks. “We recommend breaking down a financial transaction into discrete parts and then segregating employee duties,” says Steve Balmer, vice president and crime manager at Travelers Bond & Financial Products. “This way one person isn’t controlling the entire transaction. It also makes sense to require two people to authorize the issuing of checks, purchase orders or the payment of bills.”

Armstrong offers the following risk controls to minimize employee theft and fraud:

Use pre-numbered checks typed or written in permanent ink.
Employees with duties that do not include check preparation or distribution should reconcile the bank checking account.

Separate receiving, storekeeping and shipping functions. Complete physical inventories annually and assign them to an individual who is not responsible for inventory records.
Separate mail opening and posting functions.

Record checks and cash in appropriate registers and stamp checks for deposit only.

With the possibility of a double-dip recession still looming, the likelihood that occupational fraud and other crimes against businesses will diminish in the year ahead is small. Says Heaslip, “Now is the time to advise commercial clients of the risks they confront and the insurance protections they need.”

Banham (Russ@RussBanham.com) is an IA senior contributing writer.

The Faces of Fraud
If you’re trying to help commercial clients sniff out fraud in their ranks, look for behavioral cues. “When an employee seems to be living beyond his or her means, it could be because they are stealing from you,” says John Warren, Association of Certified Fraud Examiners vice president and general counsel. “In 43% of the fraud cases we’ve examined, we’ve noted just that. In 36% of cases, the fraudster was revealed to have been experiencing financial difficulties, which is consistent with the pressures caused by the recession. The vast majority of people who commit these crimes are not professional criminals “they’re in a financial bind, there is a way through their jobs to get hold of some quick money to relieve this pressure, and they tend to rationalize their conduct as `borrowing’ the money they took until they can pay it back.”

ACFE refers to these three elements “pressure, opportunity and rationalization “as the Fraud Triangle Theory. Other interesting ACFE tidbits “more than 80% of frauds are committed by employees in accounting, operations, sales, customer service, purchasing or upper management positions, and more than half of all frauds are committed by people between the ages of 31 and 45.
—R.B.

Look for the Big Three
The Association of Certified Fraud Examiners (ACFE) breaks down occupational fraud into three types. The first is an employee who steals from his or her employer. “Asset misappropriation “basically embezzlement or theft of inventory, cash or merchandise “is the most common and frequent crime against companies,” says John Warren, ACFE vice president and general counsel. “This represents about 85% of all cases.”

The second type of occupational fraud is corruption, a range of crimes including bid rigging, bribery, kickbacks and conflicts of interest. The third type is financial statement fraud ““cooking the books,” Warren says. “Although asset misappropriation is the most frequent occupational fraud it’s also the least costly, with cases averaging $135,000 per fraud. Financial statement fraud is the most expensive type of loss, incurring an average cost of $4.1 million per incident.”
—R.B.