Reference no: EM133210340

Company Overview:

The Equity Funding Life Insurance Company (EFLIC) was in the co-insurance business and had 4,000 full-time sales representatives. EFLIC would sell life insurance policies to individuals and then sell the policies to other insurance companies that assumed the related risk. The policies would be transferred to the other insurance companies but EFLIC would continue to service the policies for a fee. The premiums were collected by EFLIC and forwarded to the other insurance companies that held the policies. EFLIC would be paid 180% of the first year's premiums as a fee for the sale and service of the policy. (See Figure 2) This provided EFLIC with needed immediate cash flow to raise share value for acquisitions. EFLIC would retain 10% of future premium payments as a service fee.

The Scheme:

As a growing organization, Equity Funding was desperate to meet cash demand for expenses and to grow the organization. A scheme was concocted to create fictitious people that would purchase life insurance policies that could be sold to other insurance companies. EFLIC created a committee, "The Maple Street Gang", to create the fictitious policyholders. The paperwork to create a person required detailed information: name (used a baby naming book), address (used maps), sex, birthdate, and numerous other pieces of information required on the insurance forms. The Maple Street Gang ultimately created 64,000 fictitious people. This was close to two-thirds of EFLIC's business. As reflected in the following flowchart (Figure 2), the revenue from the policyholders created in the first year was used to inflate the financial statements and to meet the cash flow needs. The inflated financial statements kept the share value high to generate more cash from the sale of 6 stock and also, in shares-to-shares acquisitions. The high share value minimized dilution.These acquisitions were of profitable companies that made Equity Funding appear profitable. Unfortunately, part of the premiums (180%) from the second-year fictitious policyholders had to be used to pay the premiums for the first-year fictitious policyholders. Note, the fictitious policyholders are unable to pay premiums. You can see that this was in essence a great big pyramid scheme, that functioned similar to a Ponzi Scheme. The all-pervading concern of executive management was the share price. This is often the downfall of management. The insurance companies holding the policies were never suspicious since they always received their policyholder premiums through EFLIC and the lapse rate and claims rates were consistent with expectations.

The Assigned Auditors: Wolfson, Weinert, Ratoff, and Lapin (WWRL):

The external auditors on site at the client did not fully understand the business nor the computer operations used in the fraud. Two of the external audit partners were aware of the fraud and were indicted. The on-site auditors allowed the client to generate random numbers on their computer for testing of policies. Even EFLIC management could not determine the difference between the valid policies and the fake policies. The prefix of 99 was added to the policy number of all fake policies for identification. It would not have been difficult to run a sample list for the auditors that just eliminated all 99 policies. As a side note, the use of Benford's Law would have discovered this fraud. In a database of natural numbers, if you select the first digit of each number, the number "1" will appear about 30% of the time and the number "9" would appear only about 4% of the time. In the database of EFLIC policies, the 8 number "9" would have appeared first in about 70% of the policies. Remember, that about 2/3 of the policies were fictitious and started with a "9". The auditors gave the client's administrative assistant a list of claims to confirm. The auditors asked the individual to make the calls and patch the number through to the conference room where they were working when the policyholder was on the phone. The calls were actually all made to an EFLIC manager down the hall who pretended to be a policyholder. Additionally, the EFLIC managers gained access to the auditors' plans and used this information to help conceal the fraud.

Many people at Equity Funding knew about the fraud. Twenty-two people were indicted relative to the fraud. Which of the following do you think was the primary reason people did not report the fraud? Why?

Obedience to authority
Fear of reprisal
Fear of being ostracized
Maintaining their positions and benefiting