Resistance (to Fraud) is Futile∗

This paper studies a static principal-agent model of insurance fraud using a costly state verification approach. In an economy where there are two types of agents, the Truths, who always report the true state of the world, and the Dares, who dare misreport the true state of the world, I show that no separating contract exists. The optimal pooling contract can then be divided into two parts. For a proportion of Dares (ξ) smaller than some ξ∗, the agents’ expected utility decreases as the proportion of Dares (ξ) increases. For a proportion greater than ξ∗, the agents ’ expected utility is independent of the exact proportion of Dares. In both cases the fixed punishment inflicted to Dares found to have committed fraud has no impact on the optimal contract. Investment in prevention is always beneficial if ξ < ξ∗. On the other hand, when ξ> ξ∗, investment in prevention may have no impact on fraud, depending on prevention technology and the initial proportion of Dares