a game theory approach to anti-fraud legislation in chinas social insurance funds

8/3/2019 A Game Theory Approach to Anti-Fraud Legislation in Chinas Social Insurance Funds

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A Game Theory Approach to Anti-fraud Legislation inChinas Social Insurance Funds

Journal: Journal of Pension Economics and Finance

Manuscript ID: Draft

Manuscript Type: Research Paper

Keywords: Game Theory, Mixed Strategy, Social Insurance Funds, Anti-fraud

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A Game Theory Approach to Anti-fraud Legislation in Chinas Social Insurance Funds

Hu, Jiye*

Draft with known errors; January 23, 2011PLEASE DO NOT CITE OR CIRCULATE

Abstract

Social insurance fraud is a worldwide phenomenon, the deterrence of which is one of the most

important tasks for governments and social insurance agencies. This essay develops a mixed strategy game

model of regulators and of those subjected to regulation (regulatees) in the disbursal of social insurance

benefits, and establishes each sides best strategies during the process. Based on Chinas civil law, criminal

law and social insurance law, and using the results of mixed strategy Nash Equilibrium analysis, it is

possible to conclude that punishment should be specified by law and regulations when regulatees are

guilty of malpractice; that regulators should pursue low-cost offsite regulation; and that the rules for

rewards and punishments according to work efficiency should be strictly adhered to. Game Theory

analysis shows that legislative suggestions should be applied to laws and regulations, such as social

insurance funds supervision and management regulation, and social insurance antifraud regulation.

Key words: Game Theory, Mixed Strategy, Social Insurance Funds, Anti-fraud

*Associate Professor of Law, Research Fellow in Center for Law and Economics, China University of

Political Science and Law. Email: [email protected] essay is a periodical achievement of Chinese National Social Sciences Fund program Legislative

Research of Social Insurance Funds Regulation (Grant number 09BFX053). For helpful suggestionsand discussions, I am grateful to John Armour, Mark Button, Gordon Clark, Grayson Clarke, Jim Gee, Yu-wei Hu, Zhichao Lin, Tao Xi, and Guangdong Xu. At the same time, Id like to thank graduate studentsparticipation on my Game theory and the Law course. Of course, Im responsible for any fault and errorsin this essay.

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1. Introduction and Literature

Social insurance fraud is a general problem all over the world, both in developed and developing

countries. The UK Fraud Act 2006 of introduced a new offence of fraud which can be committed in three

ways: by false representation, by failing to disclose, and by abuse of a position of trust.1

In UK, although

pension fund fraud has been relatively rare, its impact on individuals in these rare cases can be significant

(Myners, 2001).

Recent research by Levi and Burrows (2008) has conservatively estimated the extent of

fraud at 14 billion per annum. A more recent report has indicated that fraud costs the UK over 30 billion

a year, in which the Department for Work and Pensions loses 1.1 billion through benefit fraud.2

In the US, the conventional wisdom is that as much as 10 percent of total spending on health care is lost

to fraud, waste, and abuse, approximately $115 billion a year (Hyman, 2002). According to the US

Attorney General Eric Holder, health care fraud remains a significant problem, costing the public and

private sectors more than $60 billion each year.3

In China, violation of social insurance funds management law is happening increasingly with the rapid

enlargement of funds scale, with the astonishing case of the Shanghai social security funds in 2006 serving

as a prime example.4

Since then, the public, scholars and legislatures have reached a consensus that

relevant laws should be enacted as soon as possible, which could supervise the social insurance fundscollection, management and distribution. The newly adopted Social Insurance Law prescribes in general

terms that the state takes strict supervision on social insurance funds, and sets up a specific chapter to

rule the funds, but there remains a lack of effective measures in anti-fraud. According to our site survey

on social insurance funds legislation in 18 provinces across China, social insurance fraud exists in all of

the provinces, and occurs at every stage - from collection to payment. Some entities and individuals

practice fraud by taking advantage of leaks in social insurance business, leading to a loss in social

insurance funds.5

Prevention of the worldwide fraud in social insurance field is an enormous task for regulators. Which

elements are important in the deterrence of fraud will demonstrate the direction of their endeavors.

Regulators denounce fraud, and scheme managers promise to attack fraud, while there are no interest

groups arguing in favor of fraud (except some fraudsters in private). Some economics scholars used the

principal-agency model to describe the relationship between auditor and auditee. Melumad and

Mookherjee (1988) showed that the principal might implement any optimal random audit strategy by

delegating responsibility for audits to an independent auditor, and committing instead to a simple incentive

contract for this auditor. Mookherjee and Png (1989) specified an objective function and showed that the

audit strategy should always be probabilistic, in addition to establishing some monotonicity properties of

the reporting strategy.

Some scholars attempted to solve the problem from the view of law. Hyman (2001) distinguished

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between raw fraud and other fraud-related problems: when dealing with raw fraud, an aggressive fraud

control regime is absolutely essential. The regulator should begin the hard work of establishing what we

actually want to accomplish, and design and anti-fraud system for ensuring compliance accordingly.

Button and Brooks (2009) suggested the government could develop an anti-fraud culture by two strategies:

staff awareness training and screening procedures were explored in depth.

As the regulator and regulatee are in opposing positions, in the same way that the policeman and the

thief, or the auditor and the audited are, some scholars use Game Theory to describe the procedure of

regulation or auditing, and to investigate a better way to deter fraud.

Game Theory is a theory which tries to explain human behavior through mathematical techniques.

Game Theory has been applied successfully in some research areas like biology, psychology, and behavior

analysis. Currently, its core principle is not only utilized in nearly all aspects of economic activity, but has

also been introduced in a wide range of classic economics textbooks. Nobel Prize laureate Myerson (1999)

believed that formulation of the Nash equilibrium has had a fundamental and pervasive impact on

economics and social sciences, which is comparable to that of discovery of the DNA double helix in the

biological sciences.

According to the general hypothesis of Game Theory, players are all rational economic individuals, who

thus aim to maximize their profits under certain constraints. Individual utility function relies not only on

the choice of oneself, but also on ones antagonist. In other words, an individuals best choice functionally

is decided by his antagonists choices. No matter what people decide, what they do is consistent with

certain fundamental principles, including strict dominance strategy (Baird et al, 1998). A rational

economic person will maximize expected utility function after choosing a strictly dominant strategy (Cho

and Kreps, 1987). The true meaning of rationality is that people will choose the best countermeasure

considering what his antagonists potential decision is. Otherwise, they would have no motivation to react

when rivals keep still, just like a chess game ends with stalemate. Nash Equilibrium is one of the best ways

to maximize legal effect; otherwise expected efficiency is not easy to achieve. From the point view of

microeconomics, in a certain legal relationship, the power that affects a partys behavior comes from both

sides. As a result, it is more precise to define peoples behavior as countermeasures than as reactions under

legal rules. Meanwhile, no other instruments are better than game theory in analyzing non-market systems

and imperfectly competitive markets, such as law. Thats why game theory is becoming the leading

analyzing formula in law and economics. (Wei, 2002)

Some scholars use Game Theory as a tool to solve problems in the analysis of regulation and audit.

Morton (1993) established his own Game Theory model and found that only a costly audit can directly

verify the report and impose penalties when fraud is discovered. The optimal audit policy was therefore

found to be to take a stratified random audit; and a common prior review practice is analytical review,

which seeks to gauge the reasonableness of the report in light of prior information. Mortons results show

the auditors strategy to be both probabilistic and contingent. The owner decides to audit with a positiveprobability or not to audit at all. Cushing (1999) has employed a well-known prisoners dilemma game to



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model an audit context. Compared to other authors who constructed mathematically complex games to

model a specific audit issue or set of issues, the advantage of Cushings model is its intuitiveness and

understandability to those less familiar with more mathematical or rigorous Game Theory applications.

Coate et al (2002) built up a chicken game model to describe client-auditor financial reporting and audit

effort strategies. By modelling the client decision to misstate or not misstate financial statements, and the

auditor decision to provide or not provide the effort to detect misstatements, the authors found that if the

client is ethical but not competent, failed audits and over auditing become unavoidable.

Game theorys method is to simplify a situation by describing it in terms of players, actions, payoffs,

after which the players strategic interactions can be described. Whether used explicitly or implicitly, this

is a highly useful approach to law (Rasmusen, 2008). This essay aims to apply Game Theory to in an

analysis of legal problems concerning social insurance funds anti-fraud in China. Considering weakness of

research on social security funds anti-fraud theory, the questions are: which elements are more important

in anti-fraud regulation? How do various interest groups maximize their benefit during enacting process?

From microeconomic point of view, and based on interest groups game strategies, how can opportunism

of both regulator and regulatee are eliminated?

The rest of the essay is organized as follows. Section 2 establishes the mixed strategy game model

which, by simplifying the regulator and regulatee into two parties, calculates the optimal probability of

action for each side. Section 3 surveys how the game model translates to the real world, and established

the regulatory application of the model. Section 4 based on the above analysis, reviews legal elaboration

and amendment, and proposes suggestions to the legislation of anti-fraud in social insurance funds of

China. Finally, conclusions are presented in section 5.

2. A Game Theory Model of Anti-fraud

Practically, social premium collection is the first step to building social insurance funds. As a result,

collection regulation is of crucial importance; otherwise, its almost impossible to establish a well-

functioning social security system. In fact, collection is conducted by local tax bureaus in most areas of

China. The collection procedures for social insurance premiums and taxes are similar; as such, the tax

examination model suggested by Zhang (1996) can be borrowed to develop a regulation model of social

insurance premium collection.

Another important process is the distribution of benefit payment. Pension benefits are often falsely

claimed by relatives after the pensioner has died; and fraud offences are even more common in cases of

medical insurance, such as using ones Medicare account to pay others medical fee, or buying cosmetics

and daily necessities using a medical insurance card.6

Even though the Interim Regulations on the

Collection of Social Insurance Premiums andRegulations on the Auditing of Social Insurance Premiums

have been issued to regulate fraud offences, the lack of systematic legal support makes it difficult toexpose frauds; and a many of pension and Medicare fraudsters have not been caught.



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Analyzing parties relationship under Game Theory in social insurance benefit claims, we should build a

model which has two sides: Regulator (G) and Regulatee (P). As basic rationality is an innate human trait,

we assume Regulator and Regulatee both are rational economic individuals. The goals of the Regulator are

to detect fraudsters and to punish them; the goals of Regulatee are to maximize their utility, by falsely

claiming as much as possible under conditions of weak supervision. Therefore, the game between them

can be constructed as follows: there are two strategies available to the regulatee: fraud or not; and two

available to the regulator: audit or not. Game players make their decisions all based on common

knowledge and information they share, then the game begins.

Let us begin with both Regulator and Regulatee chooses not to fraud/audit, with the result that the

Regulatee receives ordinary benefits, while the Regulator gains ordinary reputations; neither of them gets

unexpected extra benefit or loss. We quantify the payoffs as 0 for both of them.

The second combination of strategies is that the regulator does nothing when the Regulatee commits

frauds. As a result, the Regulatee receives payoffs of Extra (illegal) Income (E), while regulator receives

payoffs of losing Reputation (R). Reputation here involves higher honour, promotion, and respect from the

public.

The third combination of strategies is when the Regulatee commits fraud, and the Regulator audits them,

as a result of which the Regulatee must be detected. In this case, regulatees Extra (illegal) Income (E) is

confiscated, and they receive a payoff of net income loss through a Fine (F), which is larger then E in real

world. Meanwhile, the Regulator needs to pay the audit Cost (C), which covers auditors fees, materials,

time loss, and so on. In addition, Regulator is rewarded with a Bonus (B) for their excellent work; hence

total received payoff of benefit for the regulator is B-C. An assumption here is B-C -R, or B+RC,

showing that for Regulator, the aggregate value of Reputation and a Bonus is more important than audit

Cost. This is a fundamental assumption: when considering his own reputation and the potential for a bonus,

the Regulator wont avoid his responsibilities; in other words, once fraud can be ascertained, the Regulator

definitely will act to meet the demands of his duty.

The fourth and final combination of strategies is that Regulator spends audit Cost (C), but no fraud is

committed. Therefore, there is no Bonus (B) for the Regulator; and consequently he receives a payoff of

C, while the payoff received by the Regulatee is 0.

Here the elements of E, R, F, C and B are all positive.

The game matrix below shows the different benefits to Regulator and Regulatee described above. The

data in the left panel of each column represents regulators gain, while data in the right panel is regulatees

gain. Vertical arrows indicate the dominant strategy for the Regulator; horizontal ones indicate the

dominant strategy for Regulatee. Here represents the audit probability for the regulator: 1- represents

non-audit probability; represents fraud probability of the Regulatee, and 1- represents non-fraud.



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Regulatee (P)

Fraud() None-fraud(1-)

Audit

()

B-C, -F -C, 0Regulator

(G)

Non-audit

(1-)

-R, E 0 , 0

Figure 1 Game between regulatee and regulator

In this game there is not a pure-strategy of Nash Equilibrium, as in the famous game of Prisoners

Dilemma; instead, it is more like a game of policeman and thief. The Regulator could be considered the

policeman, and the Regulatee as the thief. Once the Regulatee chooses to fraud, the best strategy for the

regulator obviously is to audit, in which case they perfectly undertake their job duty despite the cost paid.

On the contrary, when the Regulator takes measures of auditing, the best choice for Regulatee is not to

commit fraud. In this case, the Regulator will be prone to non-audit, because when the Regulatees

behavior is legitimate, they complete their duty without any payment.

From the game matrix, it can be assumed the Regulatees highest payoff comes from an undetected

fraud, which is E. The Regulatees lowest payoff comes from a detected fraud, which is -F. The Regulatee

wishes to attempt a fraud only when it will not be detected and non-fraud only when the Regulator

performs non-audit. The Regulators highest payoff is when the Regulatee commits fraud and he detects it,

which results in B-C. The Regulators lowest payoff is -R, occurs when there is an audit failure that the

Regulatees undetected fraud.

However, Regulatee will never give up the chance to defraud when they understand that Regulator is

negligent in auditing. For that reason, we cant predict the result of this game, because no automatic

equilibrated strategy combination exists in such a game. It is a one-shot game of coin toss, just like

Mortons (1993) random game. Whats crucial for both sides are keeping their own individual strategy

confidentially, making decisions randomly, and the decisions one made cant be viewed by the other side.

Practically speaking, the Regulator randomly checks claims by certain probability, and the Regulatee

defrauds by tracking the Regulators probability of auditing. The key issue is calculating the probabilities

at which a mixed strategy Nash Equilibrium will be reached, i.e., the optimum value of probabilities and

.

Assuming the regulatees probability of fraud is , the expected payoff for Regulator auditing (in the

upper line) or not (in the under line) are, respectively:



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In the upper line:(1, ) ( - ) (- )(1- ) -G B C C B C = + =

(1)

In the under line:(0, ) - 0(1- ) -G R R = + =

(2)

According to the basic assumption that Regulatee does his best to escape from auditing, * maybe the

optimum probability of fraud at which he can get maximal payoff. Then the Regulator expected benefits

are the same no matter how he audits or not. Given that (1)=(2), we can calculate the optimum probability

of

*

*C

B R

+=

3

We can illustrate the above result on the following chart:

Figure 2 The regulator payoff varying from regulatees fraud probability

From the drawing we can see: when Regulatees fraud probability is 0, or non-fraud, the Regulators

payoff is -C; when regulatees false probability is 1, or definitely fraud, the Regulators payoff is B+RC.

The line CB+R-C cross the X axis at *, i.e. *

indicate the intersect, which is the Regulatees

optimum fraud probability. If the Regulators audit cost C decreases to C, the line CB+R-C will

mean move to CB+R-C. Then decreases, which means Regulatees optimum false probability

become reduction when the regulators audit cost decrease.

Similarly, we can calculate the Regulators optimum audit probability. Given probability of auditing ,

Regulatees expected benefits with fraud (in the left column) or not (in the right column) are, respectively:

0

1

-C

B+R-C

*C

B+R-C

B+R-C

X: Regulatees fraud probability

Y: Regulators payoff

C

C



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In the left column:( ,1) (- ) (1- ) - ( )G F E E E F = + = +

(4)

In the right column:( ,0) 0 0(1- ) 0G = + =

(5)

Assuming that (4) = (5), we can calculate the optimum value of probability in auditing:

*E

E F

+=

(6)

We can illustrate the above result on the following drawing:

Figure 3 The Regulatees payoff varying from Regulators audit probability

From Figure 3, we can conclude that when the Regulators audit probability is 0, (non-audit), the

Regulatees payoff is E; and when the Regulators audit probability is 1, (must audit), the regulatees

payoff is F. The line EF cross the X axis on *, i.e. *

indicate the intersect, which is the Regulators

optimum audit probability. If the Regulatees punishment F increases to F, the line EF will move to EF.

Then decreases, which means that the Regulators optimum audit probability reduces when fines for

Regulatees detected committing fraud increase.

Based on separate analyses with mixed strategy on both sides above, we can establish the mixed

strategy of Nash equilibrium in this game is:

*E

E F

+=

*

CB R

+

=

This means, unlike Mortons (1993) random audit, the probability of a Regulator audit isE

E F+ ; and

01

E

F

*

E

F

F

X: Regulators audit probability

Y: Regulatees payoff



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the probability of a Regulatee committing fraud is

CB R+ accordingly.

For the Regulatee, illegal profit of fraud is E and loss F after being detected represents power of law

execution. The relationship between E and F is an important element for the Regulatee. The constraints

assumed here are common in the literature on the economics of crime (Becker 1968 and Stigler 1970),

namely that the punishment must fit the crime, or that the loss that can be imposed on the Regulatee is

some increasing function of the size of the fraud. Linear penalties are the most plausible approximation of

the outcome of a complex and uncertain judicial process. So obviously, when E >F, Regulatee will choose

to violate the law because punishment is minimal, even if the fraud is detected. Only if enforcement of

fines F is much stronger than offensive profits E, will the Regulatee choose to obey the law, therefore the

stronger legal power F is, the lower probability that offences will happen and auditing be taken. If F>>E,

we can get that * 0.5EE F +=


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doubt that analyzing models provides us with effective ways to solve practical problems.

A. Fortify Legal Executive Power and Reduce the Temptation of FraudSocial insurance premium collection is the accumulation of social insurance funds, while benefits

disbursement is the spending of them, and they are both important for the purposes of safeguarding funds.

Illegal excess benefits drive Regulatees to violate law. According to Becker (1968), the optimal amount of

enforcement is dependent on the cost of catching and convicting fraudsters, the nature of the punishments,

and the responses of fraudsters to changes in enforcement. It means an independent decision maker weighs

the costs and benefits of a criminal act, choosing to commit the crime only when the expected gain

exceeds the expected cost of punishment. The truth is that the potential fraudster does not dare to break the

law when strict punishment is in place. They can weigh illegal benefits and legal repercussions before

action.

The model also demonstrated that maintaining normal claims order not only depends upon enforcing

legal power F, but also on reducing illegal profits as much as possible. Only by these methods can we

prevent Regulatees from filing false claims. Therefore, we need to consummate a social insurance legal

system, leaving no loopholes for fraudsters.

The current situation of social insurance funds is that it lacks any superior norms as a framework, and

there are no charges related to social insurance in Criminal Law. It is difficult for regulators to convict or

sentence fraudsters. Actually, the maximum fine for a Regulatee has just been set at RMB 20,000(or

US$3,000) inInterim Regulations on the Collection and Payment of Social Insurance Premiums.8

Against

the background of rapid economic development in China, this amount is so little to most Regulatees, that

violations are effectively encouraged. For that reason, setting fines in proportion to the amount defrauded

must be as a principle when laws are enacted or amended. Consequently, opportunity costs become high

enough to stop Regulatees from committing offences.

B. Choosing Off-site Supervision by the Reason of Lower CostAccording to the game model, we know that auditing costs significantly affect offence probability: the

higher auditing cost, the higher probability of offences. This suggests that reducing auditing costs is the

best measure to deal with premium evasion and frauds. On-site auditing costs more because human

resources, materials, and time are added to the process. The off-site auditing measures principle are

reasonable enough to be borrowed in the Law of the Peoples Republic of China on Regulation and

Supervision over the Banking Industry.9 At the local governmental level, Beijing Local Taxation Bureau

has applied an internet audit system to personal income tax, comparing, analyzing and examining tax

application materials using specific computer procedures, so that tax evasions by withholding payers and

tax payers can be detected and informed promptly.

Its valuable for China to borrow successful regulation and execution experiences of other countries. As

a statutory agency, Centrelink of Australia mainly uses off-site auditing, specifically, applying technology

of data matching with the cooperation of tax bureaus and security exchange commission to checkstockholders records (including all directors and top twenty shareholders), to find out social insurance



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contribution, collecting, and benefits claims by analyzing their revenues, assets declarations, and cross

registered stockholding records. Once mismatches are found among these data, further cross examinations

on Regulatees tax declarations will be taken to detect potential problems. At the same time, the Regulator

also examines health care data by further data matching, to detect excess use of medical resources and

deceptions. During 2005 and 2006, Centrelink detected 28,114 cases of over payment, and recovered

funds equivalent to AUS$135 million, representing a Cost-Benefit Ratio is 1:9.3.10

Mixed strategy Game Theory analysis and experiences both home and abroad show that off-site

auditing can cut down regulatory costs. This is why off-site auditing should be taken as the leading

instrument in social insurance funds regulation.

C. Solving the Problem of Paradox in RegulationIts harmful for social insurance funds operations when offences of contribution payers and Regulatees

escape detection and punishment, which will encourage fraudsters in other areas, thereby jeopardizing the

whole social system. In this case, the losses of honor and profits are incurred by both the government and

the Regulator, and the only way to reduce this loss is to detect and punish offences in time. However, the

Regulator also takes the risk of being punished for slack regulation as a result of corruption.

Many factors affect the evaluation of Regulators auditing and detection procedures. As a result, it is

important for Regulators to build perfect incentive and restraint mechanisms through legislation,

rewarding the good and punishing the bad. In UK for example, the NHS Counter Fraud and Security

Management Service proved that fraud had been reduced 60% by introducing more stringent checks. An

example of such a check is that pharmacists are required to ask people for proof that they are entitled to

free prescriptions, and a 70 reward is offered to pharmacists who spot fraudulent claims.11

According to the above game model, we find that the higher Bonus (B) for Regulators who detect

offences, the more valuable their own reputation R, and the lower the probability that offences will be

committed. One example of that is Hong Kongs Independent Commission Against Corruption (ICAC). It

has strongly deterred external attempts to manipulate civil servants, and has contributed greatly to the

enforcement of government regulations (Harris, 1988). The ICAC has won the publics trust, and

established an excellent reputation, so it fulfills the result very well in this game theory model.

There are also conflicts between the temptation of illegal profits and rule enforcement for Regulator. In

general, detecting violations is the duty of Regulator. However, many serious offences escape punishment

in reality, and worse still, these offences are often hiding behind the authorities. Regulators must balance

the benefits for themselves before deciding how to deal with offences. As rational economic individuals,

extremely severe punishment for misconduct probably discourages regulations and encourages offences.

This presents another problem, which is who regulates the Regulator? The newly adopted Social

Insurance Law provides unique a clause of regulation by congress, which is more independent than

government, thus solving the problem to some degree.12

4. Legal Elaboration and Amendment of the Model



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The model in this essay builds on an assumption of static Game Theory, i.e. only two sides in the game:

one side is Regulator, and the other is Regulatee. This is much simpler than what happens in real world.

Since information between realistic game players is not symmetrical, incomplete information games are

much more common in reality. Therefore modifications need to be made to this model. Meanwhile,

current Chinese laws have established punishments for serious fraud offences, which can be adopted by

social insurance regulation legislation, allowing it to elaborate Game Theory more precisely from the point

of law.

A. Modification of the Model and the Review of Rational Economic AssumptionThe proposed model is a single and static one; but in reality, dynamic games take place between one

Regulator and multiple beneficiaries. Because once a kind of strategy is taken by a single Regulatee to

fight one single Regulator, other beneficiaries take this into account and moderate it by adjusting it to their

individual circumstances. Even though dynamic Game Theory repeats superficially, players behaviors

and results may be different. This is because during this process, both sides make their decisions with

changing benefits judgments. An example is if a fraudster successfully escapes detection and punishment,

copycats follow him, and fraud spreads rapidly. This is the so called Broken Window Theory by

American political scientist Wilson and criminologist Kelling: if a window is broken intentionally, and not

repaired in time, it actually allows others to break more and cause bigger, more lasting problems.13

We can

apply this in our case, if one offence Regulatee is punished on time, the other potential fraud beneficiaries

will be deterred. Consequently, repeated games are much more complex than simple aggregations of basic

games, and it is essential to consider the process as whole. Each game without any definite end can be

modeled as an infinite repeated game.

Repeated Game Theory indicates that if game players are not living only at the moment, then they

think more about future. They will value their reputations more when the discount factor is big enough.

That means todays RMB100 will be worth at least RMB60, rather than null. Because funds are being

collected and distributed every day, repeated game theory is closer to reality, which means it is very

important for any party to develop its reputation. Hong Kongs ICAC plays an important role in the field

of anti-fraud and corruption only because it has built up a sound reputation through its year after year

working process. Its reputation has taken shape through its professional investigations that uncover

evidence of how fraud has been undertaken, through the application of sanctions if fraud is found, and

through the broader effectiveness of the sanctions were permitted.

Generally speaking, the reputation of a Regulator as strict enforcers can make the beneficiaries to obey

the law and beneficiaries with lasting good records can be rewarded with fewer inspections and

interruptions from regulators. Looking back into the history, we found that almost all laws were based on

repeated games. Legal systems delineate boundaries for human behavior. So social insurance regulation

should encourage strict auditing and observation, punish opportunism of both sides, and preventcontribution evasion and frauds.



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Its necessary to correct the premise of Game Theory rational economic men. Selten, a Nobel Prize

winner, has devoted himself to create dynamic game theorys basissub-game perfect Nash Equilibrium.

He put forwarded that traditional economics is what was called mainstream economics in past 50 years

before the World War II. Before that time, rational assumptions were made much less than right now.

Later, the model produced from super rational assumption is kind of immature rationalism.14

This clearly shows that the rational economic men assumption of this model must be updated. Both

sides of the game may take their actions irrationally, and the probability in this model is just an

approximation under strict hypothesis, and must be carefully adopted by legislation. For example, the

strength of peer group pressure is also a factor, i.e. the extent to which the honest majority is mobilized

and vocal in their view that fraud is wrong. Even if it is rational to undertake fraud on the basis of Game

Theory, wider social pressure that it is unacceptable (this works particularly in healthcare and social

insurance, where there is a direct negative impact on the quality of life for some) can lead many not to do

it. This is consistent with Button and Brooks (2009) which suggested the government can develop anti-

fraud culture. Given the size of the problem of fraud in government, the fruits of anti-fraud culture may

well lead to greater resources been released to provide government services.

B. An Elaborate of the ModelAfter thirty years reform and opening up, Chinas economy is now the second largest in the world after

the United States. The universal increases in living standards that have elevated hundreds of millions from

absolute poverty. With the economy developing, Chinas current multi-pillar pension system (established

in the 1990s) was supposed to introduce individual accounts to top up the basic pension, but it has not

been completed due to problems in implementation (including fraud). With further execution of social

security, the social insurance funds collection, operation, and payment are becoming increasingly

complicated because of the large amount of money involved. Since the operation procedure of social

insurance funds is complex, the risk points increase naturally.

Social insurance fraud was not viewed easily as a purely criminal matter in China. During the collection

process, entities hide collection bases, initial times, and employees numbers; and distort employees ID

deliberately to escape contribution. False claims are more common phenomena in the payment process. In

some cases, benefits continue to be claimed after death of the beneficiaries (typically by their relatives);

false claims and collusions are even more widely observed concerning medical insurance.

According to current laws in China, fraud in this model has violated laws like General Principles of the

Civil Law and Contract Law. Related provisions in The General Principles of the Civil Law are: civil

dispositions made by fraudulence shall be null and void, for example, those performed by a person

against his true intentions as a result of cheating, coercion or exploitation of his unfavorable position by

the other party, those that performed through malicious collusion are detrimental to the interest of the state,

a collective or a third party, those that violate the law or the public interest.15

The Supreme Peoples

Court defines fraudulence injudicial interpretations as follows: when a person relates a false situation toanother intentionally, or intentionally hides the real situation, leading the other party to perform against his

http://dj.iciba.com/judicial/http://dj.iciba.com/judicial/


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true intentions as a result of cheating, shall be defined as fraud.16

Obviously, intention is an

indispensable component affirmed by both theory and the interpretation of the Supreme Court. Negative

acts, especially silent behavior, may not always be fraud, except that where notification is duty to a person

according to laws, transaction habits or honest principles, in which case, keeping silence is fraud because it

constitutes hiding the truth. If pensioners relatives keep receiving benefits after the receptors death, it is a

fraudulence defined by hiding the real situation intentionally.

According to the newly adopted Social Insurance Law, social insurance agencies duties are to provide

social insurance services, to register and keep social insurance records, and to pay social insurance benefits;

while the only way for them to prevent fraud relies on developing business, financial, security and risk

management system.17

In fact, social insurance agencies in China belong to the kind of public institutions

without enforcement power; which leads to inaction in relation to fraud except in the case ofContract Law,

where they have the right to request the peoples court or an arbitration institution to modify or revoke the

fraud commission.18

The government does not manage this process itself, its brand-new for the

government to build powerful, professional, and public participation mechanics. For these reasons, the

Regulator in this model is purely conceptual, and cant be treated as identical to either social insurance

agencies or government departments. Meanwhile, all parties are well aware of this information, and the

chances for beneficiaries to take advantage of this flaw increase dramatically.

It can be found from the model that self-interested parties make their decisions based on opportunism

and they absolutely choose to fraud. The power of law is to close the loophole by indispensable

painstaking supervision legislation.

C. The Reference Viewpoint of Criminal Law and Tax LawBesides civil law, we can also learn corresponding supervising legislative principles from tax law for

the similar reason of compulsion. In the model, F represents the fine for frauds, which could be identified

as tax evasion defined in article 63 and 64 ofLaw on the Administration of Taxation Collection. By the

approval of the seventh amendments to the Criminal Law of the PRC in Feb. 2009, crime of tax

evasion was amended to cover a broader range of offences: A taxpayer who fails to pay or underpays the

amount of tax payable by means of forging, concealing, or filling a false tax declaration, shall be

sentenced to be deemed to have committed tax evasion.19

There is no specific crime for social insurance contribution evasion and fraud in Criminal Law, but

declaration and measurement of the penalty related to crime of fraud and crime against tax collection and

management could be borrowed as references. The Relative article in Criminal Law is: A person who,

under any of the following circumstances, conducts swindling activities of insurance: (1) An insurance

policy holder intentionally fabricates the object of insurance to defraud the insurance money; (2) An

insurance policy holder, insurant or a regulatee fabricates false reasons for or exaggerate the degree of loss

on an insurance accident which has happened to defraud the insurance money.20

However, swindling

activities of insurance refers to commercial insurance, which is based on the common principle of thelaw of large numbers. These articles are very valuable to social insurance anti-fraud. In addition, Article



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266 of Criminal Law defines the crime of swindling public and personal assets as a person who swindles

a relatively huge amount of public or private property for illegal encroachment.

Considering all of the above points, it is rudimental for Criminal Law to embrace social insurance fraud

crime. From a legislative perspective, since no formal social security law has been enacted, social

insurance funds supervision departments enforcement is hindered due to a lack of legal system. Zhou and

Lang (2001) advised for the enactment of a legal explanation or amendment of Criminal Law so as to

build and develop social insurance funds criminal protection system. A further study by Chen and Cheng

(2006) put forward the idea of adding social security fraud into Criminal Law, on the grounds of

improving the social security legal system, and raising judicial supervision effectiveness.

When comparing social insurance fraud to ordinary fraud, we found that a unique outcome of social

insurance fraud is that its victims are other social insurance participants, which means that damages

involve majority of mass people in society. For this reason, it would be more precise to add social

insurance fraud crime directly into Criminal Law. In this way, a benchmark for further anti-fraud

legislation will be established, especially for the stage of social insurance contribution collection. Game

Theory examines punishment mechanisms under the assumption of a perfect legal system (meaning the

value of F in formula is uncertain), in fact, there are no social insurance fraud crimes in Criminal Law for

which the value of F is undetermined. It is urgent to specify relative crimes in law in order to build

deterrents against fraudulent beneficiaries and to decrease the probability of violations.

In order to prevent fraud in social security, especially in contribution collection and payment, the State

Council, previously the Labor and Social Security Ministry, issued Interim Regulations on Collection and

Payment of Social Insurance Premiums, Social Security Contribution Collecting Inspect and Audit Rules,

Social Security Audit Rules as well as other administrative rules and department regulations, for the

propose of reinforcing social insurance funds audit. But when conducting audit work in reality, obstacles

in social insurance anti-fraud exist in the following forms.

Firstly, the lack of laws and regulations limit execution of anti-fraud procedures. Even though some

relevant social insurance regulations have been issued in the last decades, the emergence of a complete

social insurance legal system is still far away. The newly adopted Social Insurance Law has only a

framework for anti-fraud, which makes fixing newborn problems like fraud in the context of the law

difficult, especially in the scope of local governments daily work. Furthermore, articles of anti-fraud

borrowed from Criminal Law and Contract Law dont match situations exactly.

Secondly, regulations for different social insurance jurisdictions are not uniform. Anti-fraud is important

for social insurance regulation, however, so far a social insurance regulation system still hasnt emerged

due to the wide dispersal of contributions of different social insurance types. Generally speaking, anti-

fraud procedures for social insurance contribution collection and payment are operated by social insurance

agencies, but what usually happens in reality is collusion: external fraud is hardly ever achieved without

facilitation provided by employees of the relevant agencies. Anti-fraud should be executed by a specificsocial insurance funds regulation bureau, so that management and supervision are separated from each



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other.

The third obstacle is the imperfection of internal control systems, which decreases the ability Regulators

to prevent social insurance fraud. An internal control system is a means of self-regulation by social

insurance agencies. Obviously, a well-functioning internal control system plays an important role in social

insurance regulation, as well as being a key factor in preventing various risks. Even though some advanced

agencies have been carrying out internal control measures, most agencies still ignore the importance of

internal control. As a result, collusion happens frequently and makes investigation more difficult.

Current civil law, tax law, and criminal law have established a legal basis for anti-fraud for social

insurance funds, but it still needs further development. An ordinary and acceptable international

convention in this area is a light fraud isnt a criminal fraud. In 2003 in Sweden, 244,000

decisions were made concerning tax surcharges, but only 470 persons were fined, sent

to prison, put on probation or given suspended sentences for offences against the Tax

Fraud Act.21

Considering the legislation and amendment tendencies in China, legislators consider and

give more weight to Regulatees attitudes and damage outcomes. For instance, the Seventh Amendment to

Criminal Law rules: A person, who has received administrative punishments for tax evasion, shall be

exempted from criminal liability. This is used to recover tax losses and cultivate tax consciousness, and

adjust to international tendency on dealing with commercial crimes.

5. Concluding Remarks

Chinas Social Insurance Law has now been adopted by the Congress and was put into force from 1

July 2011. It takes up the highest level in social insurance funds supervision legal field. Currently what we

need to do is to focus on newly emerged problems and cases in social insurance fraud field, and solve

them case by case. In practice, we can borrow relative articles in The General Principles of the Civil

Law, Law on the Management of Tax Revenue Collection and the latest version of Criminal Law, build

up an implementation system by using laws and regulations under current legal system. Taking into

account the microeconomic analysis of game partys violation probability; practical laws, regulations, and

rules might be enacted more effectively, protecting social insurance funds more efficiently. Based on what

has been mentioned above, relative legislative consultation concerning Regulation on Social Insurance

Funds Supervision and Management and Social Insurance Anti-Fraud Regulation is necessary in the

future.

In the game model we know that the fraud punishment F is one of the most important elements in

determining the probability of fraud being committed, so a better strategy for future amendments to

Criminal Law could be to borrow current crimes like the crime of tax evasion and the crime of

insurance swindling, to introduce a crime of social insurance contribution evasion and crime of socialinsurance fraud, which could eventually form strong powerful deterrents against committing social



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insurance fraud. Additionally, reinforcing supervision of Regulators, and severely punishing corruption

and malpractice are also helpful strategies in shaping independent, effective, and un-biased Regulators.

The conclusion drawn from analyzing the game model is that auditing cost varies positively in relation

to the probability of violation. Therefore, decreasing costs is the key to lowering violation probability.

Experiences of domestic local tax auditing and Australian Centrelink show that most illegal actions can be

detected by modern internet technology and data-matching technology, reducing auditing cost

significantly by achieving off-site auditing. We may also consult off-site auditing rules in the Law of

Regulation and Supervision over the Banking Industry, insisting on off-site supervision as the leading

work principle. By means of a social insurance information management system based on current Gold

Insurance Project, authorities would be capable of discovering, analyzing and evaluating supervisees

situations, lowering cost effectively, and conducting on-site auditing pertinently, eventually cutting downprobability of offences.

The Regulators reputation is another key point we can draw through the game model. An independent,

incorruptible, and outstanding Regulator will be the best deterrent against social insurance fraud. We can

learn from the independent UK Pensions Regulator, Hong Kong ICAC and China Security Regulatory

Committee, and reconstruct the current social regulatory systems used in these cases. But the building of a

reputation is not an easy task, and represents a long term effort.



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Remarks

1UK, the Fraud Act 2006, CHAPTER 35, This Act provides for, criminal liability for fraud and obtaining

services dishonestly. [8th November 2006], No.2, 3, 4.2

See Helen Pows report, Fraud costs the UK 30bn a year, 22 January 2010, the money marketings

website at: http://www.moneymarketing.co.uk/politics/fraud-costs-the-uk-%C2%A330bn-a-

year/1005404.article

3The first National Summit on Health Care Fraud, Health Care Fraud Costs U.S. More Than $60 Billion

Annually: DOJ(Department of Justice), January 28 2010, CCCH Internet Research NetWorks website at:

http://hr.cch.com/news/benefits/021210.asp

4The 2006 Shanghai case is one of the worst scandals concerning social insurance funds in China. Chen

Liangyu, secretary of the Shanghai Municipal Committee of Communist Party of China, was sacked for

his involvement in a social security fund scandal. Zhu Junyi, director of the Shanghai Municipal Bureau of

Labour and Social Security, was stripped of his post in August 2006. The 55-year-old city official is

suspected of misconduct involving a 3.2 billion yuan (400 million dollars) loan of social security funds to

a private toll road operator. See report of Xinhua news agency at:

http://news.xinhuanet.com/english/2006-09/25/content_5134994.htm

5From 2007-2010, sponsored by the Carter Center of the former US President Jimmy Carter, and

organized by the author and the center for law and economics of China University of Political Science and

Law; a group of teachers and students conducted a site survey on social insurance funds legislations in 18

provinces across China. The sites include Beijing, Shanghai, Heilongjiang, Liaoning, Jilin, Hebei, Inner

Mongolia, Ningxia, Shanxi, Shaanxi, Henan, Hunan, Chongqing, Sichuan, Jiangsu, Guangdong, Guangxi,

and Zhejiang.

6This kind of case is commonly observed nationwide. For example, the Medical Insurance Centre in

Anhui Province detected 92 false claim cases in the first quarter of 2005, in which more than 300,000

RMB was involved. See He, Cong, So many false claims strongly indicate the loopholes of medical

insurance mechanism, Peoples Daily, Jul 28th, 2005. Additionally, correspondent Xia Yousheng of East

Today Sep 10th, 2007, reported that Zhongjing Drugstore, Shangcheng Road Branch sells cosmetics

illegally by stealing medical insurance, while involved illegal money was up to 11162.88 RMB.

7 Social Insurance Law of China section 87: whoever commits fraud of social insurance funds payment



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by using forged or altered certificates or any of other means, the department in charge of social insurance

administration shall order he/she returns the benefits, imposes a fine at an amount equivalent to two to five

times the amount of involved money.

8Interim Regulations on Collection and Payment of Social Insurance Premiums, Article 24: If a unit

paying premiums violates relevant financial, accounting or statistics laws or administrative regulations or

relevant State regulations, or forges, alters or intentionally destroy relevant account books or documents,

or fails to keep accounts, thereby making it impossible to determine the base number for the collection and

payment of social insurance premiums, it shall not only be subjected to administrative penalties,

disciplinary punishment and/or criminal prosecution in accordance with the provisions of the relevant laws

and administrative regulations, but it shall also make payment in accordance with Article 10 of these

Regulations. If it delays payment, the administrative department of labor security or the tax authority shall

decide to impose a late-payment fine in accordance with Article 13 of these Regulations and impose a fine

of not less than 5,000 yuan and not more than 20,000 yuan on the person in charge who are directly

responsible and other directly responsible persons.

9 The Law of the People's Republic of China on Regulation and Supervision Over the Banking Industry,

Article 23: The banking regulatory authority shall conduct off-site supervision of the business operations

and risk profile of the financial institutions of the banking industry, for which it shall establish an

information system to analyze and assess the risk profile of such institutions.

10

Centrelink and the Data-matching Agency, Australian Government, Data-matching Program Reporton Progress 2004-2007, Reported by Carolyn Hogg, Acting Chief Executive Officer,20 October 2009.

11BBC news: Prescription fraud cut by 60%. Last Updated Wednesday, 18 February, 2004. See Website

at: http://news.bbc.co.uk/1/hi/health/3499017.stm

12 Social Insurance Law of China section 76: All of the various levels of the people's congress Standing

Committee debriefs the same levels government on the income and expenses to social insurance funds,

the work managing, investing and superintending results of the review, through organizing the inspection

of law enforcement and implementation etc, to exercises supervision on the government authority to rule

by law.

13Wilson, James Q. and George L. Kelling, Broken Windows, The Atlantic, Issue of March 1982.

14From Correspondent Cui, Keliangs interview, Reinhard Selten: the key problem of Chinese economic

is real estate bubble, China Economic Times, 8 Nov., 2009.

15 General Principles of the Civil Law of the PRC, Article 58: Civil acts in the following categories shall

be null and void: (1) those performed by a person without capacity for civil conduct; (2) those that

according to law may not be independently performed by a person with limited capacity for civil conduct;

(3) hose performed by a person against his true intentions as a result of cheating, coercion or exploitation

of his unfavorable position by the other party; (4) those that performed through malicious collusion are

detrimental to the interest of the state, a collective or a third party; (5) those that violate the law or the

public interest; (6) economic contracts that violate the state's mandatory plans; and (7) those that



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performed under the guise of legitimate acts conceal illegitimate purposes. Civil acts that are null and void

shall not be legally binding from the very beginning.

16 The Supreme Peoples Court, Remarks on Execution of The General Principles of the Civil Law of

the PRC (Interim), issued 2 Apr., 1988, article 68.

17 Social Insurance Law, Article 8: Social insurance agency provides social insurance services,

responsible for social insurance registration, participants benefits recording, and social insurance benefits

paying. Article 73: Social insurance agency shall build and improve business, financial, security and risk

management systems.

18Contract Law, Article 54 section 2: If a contract is concluded by one party against the other party's

true intentions through the use of fraud, coercion or exploitation of the other party's unfavorable position,

the injured party shall have the right to request the people's court or an arbitration institution to modify or

revoke it. Where a party requests for modification, the people's court or the arbitration institution may not

revoke the contract.

19In newly amended Criminal Law, Article 201: A taxpayer who fails to pay or underpays the amount

of tax payable by means of forging, altering, concealing or destroying accounting books or vouchers for

the accounts without approval, or overstating expenses or omitting or understating incomes in accounting

books, or refusing to fill a tax declaration after notification by the tax authority, or filling a false tax

declaration, shall be sentenced to fixed-term imprisonment of not more than three years or criminal

detention and concurrently to a fine of not less than one time and not more than five times the amount oftax evaded if the amount of tax evaded amounts to not less than 10% and not more than 30% of the

amount of tax payable and the amount of tax evaded is not less than 10,000 RMB and not more than

100,000 RMB or if he commits tax evasion again after having been twice subjected to administrative

sanctions by the tax authority for tax evasion; and if the amount of tax evaded amounts to not less than

30% of the tax payable and the amount of tax evaded is not less than 100,000 RMB, to fixed-term

imprisonment of not less than three years and not more than seven years and concurrently to a fine of not

less than one time and not more than five times the amount of tax evaded.

20Criminal Law, Article 198: 3. An insurance policy holder, insurant or a beneficiary fabricates an

insurance accident which never happens to defraud the insurance money; 4. An insurance policy holder or

insurant intentionally causes an insurance accident with property loss to defraud the insurance money; or 5.

An insurance policy holder or a beneficiary intentionally causes death, injury, disability or disease of the

insurant to defraud the insurance money.

21See: Taxes in Sweden 2004, An English summary of Tax Statistical Yearbook of Sweden, Swedish

Tax Agency, December 2004.


a game theory approach to anti-fraud legislation in chinas social insurance funds

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