Fraud Detection

Article byRutan Bhattacharyya
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Fraud Detection?

Fraud detection refers to a process that involves tracking customer behavior and transactions to identify and prevent fraudulent activities. Businesses can safeguard themselves and their customers from the theft of assets, information or money by carrying out this process efficiently.

Fraud Detection

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This approach is a key element of a business’s anti-money laundering (AMP) compliance procedures and the main part of its loss prevention strategy. Organizations must depend on technological tools, techniques, policies, and analysts to efficiently carry out the process. This approach is common across insurance, medical, banking, and public sectors. Moreover, law enforcement agencies use this process.

Key Takeaways

  • Fraud detection refers to a process that involves a set of activities carried out by an organization to stop scammers or fraudsters from obtaining any asset or crucial information via false pretenses.
  • There are primarily two types of scam detection approaches. One is based on statistical data analysis, while artificial intelligence forms the basis of the other type of technique. These approaches include data mining, regression analysis, data matching, and continuous learning.
  • A noteworthy challenge of this process is that it has to evolve to keep up with the changes in scammers’ techniques.

Fraud Detection Explained

Fraud detection refers to a process that involves preventing scammers or fraudsters from acquiring assets, for example, property or money, via false means. Fraudulent activities may include cyberattacks, identity theft, money laundering, and other illegal practices. Companies use different risk management strategies and technology to prevent such activities. One must know the various steps involved in this multifaceted approach adopted by organizations to know how a fraud detection system works. Let us look at them.

  1. Data Accumulation: First, a company must gather substantial data, including customer information, transaction details, access logs, etc.
  2. Analysis Of Data: Utilizing artificial intelligence or AI-based and statistical methods, the analysis of the accumulated data occurs.
  3. Pattern Identification: This system utilizes various algorithms to spot patterns in the data that indicate fraud. Such patterns may include irregular patterns concerning accounting activity, unusual transaction volumes, or atypical access times.
  4. Predictive Modeling: The system utilizes historical data to develop models that can predict the possibility of fraud.
  5. Anomaly Detection: Such a system constantly tracks transactions and flags the ones deviating from established patterns.
  6. Triggers And Alerts: When potential fraud is detected, the scam detection system generates alerts. The configuration of such alerts can take place based on the threat’s severity.
  7. Case Management: After the fraud detection occurs, the system creates a case, which is subject to investigation. Analysts conduct a review procedure in this step and decide the suitable action.
  8. Continuous Learning: As scammers or fraudsters change their methods, the system must evolve. The machine learning models keep updating constantly with new patterns and information.
  9. Compliance And Reporting: Such a system generates reports that help understand the different fraud attempts along with the detection strategies’ effectiveness.
  10. Biometric Verification: Modern systems may have a biometric verification feature, for example, liveness detection and facial recognition. This helps ensure that the individual performing a transaction is the same person they claim they are.

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Techniques

When broadly classified, this process can be of two types. In other words, there can be two approaches. Let us look at them in detail.

#1 – Statistical Data Analysis

This technique uses various statistical operations, for example — 

  • Data Matching: In this case, the comparison of multiple data sets occurs on the basis of algorithms or programmed loops.
  • Models And Probability Distributions: This technique involves mapping different fraudulent activities related to business either with regard to probability distributions or various parameters.
  • Regression Analysis: This fraud detection method analyzes the association between at least two variables, including dependent and independent. It allows organizations to define and comprehend relationships existing between multiple fraud-related variables. This helps in making predictions regarding future fraudulent actions.

Another technique under this category is statistical parameter computation. It includes assessing various statistical parameters, such as probability distributions and performance metrics for fraud-associated data gathered when the extraction process occurs.

#2 – Artificial Intelligence-Based Approach

This approach includes the following techniques:

  • Neural Networks: Under fraud detection, neural networks carry out generalization, clustering, forecasting, and classification of information or data related to fraud. It is possible to map the predicted data against audits and financial documents.
  • Machine Learning: This method involves utilizing machine learning algorithms to spot past fraud patterns and recognize the same in transactions and activities taking place in the future.
  • Data Mining: This method allows for the segmentation and classification of data to determine correlations between data sets, helping in prevention and scam detection. This is a key element of fraud detection with regard to transactions.

Examples

Let us look at a few fraud detection examples to understand the concept better.

Example #1

Suppose ABC Company offers a payment gateway with has a robust and efficient payment detection system with multiple tools that spot indicators of fraudulent activities. Such tools accumulate user transaction and card data. Then, they map the same to past transactions. Moreover, the tools operate by blocking those users who have a history of performing fraudulent transactions. The scam detection approach involves utilizing extensive reserves comprising historical data analytics. This makes it a significantly useful system.

Example #2

Truecaller, one of the leading international platforms engaged in blocking unwanted communications and verifying contacts, completed the acquisition of Unoideo Technologies in October 2023. The Bengaluru-based organization offers TrustCheckr, a fraud detection service. This software-as-a-service or SaaS solution helps organizations verify customer information. Moreover, it assists in the identification of fraud-related risks based on digital signals and phone numbers.

The chief strategy officer and chairman of Trucaller, Nami Zarringhalam, said that the takeover adds competence and great service to their company, bringing value to all users. Moreover, it strengthens their existing enterprise offering. He believes that the combination of skills that TrusCheckr utilizes to spot scammers via external fraud signals and the internal signals of Truecaller will be extremely powerful.

Importance

One can go through the following points to understand the importance of fraud detection.

  • When carried out efficiently, this process can safeguard companies’ financial resources and prevent financial losses.
  • Fraudulent activities can lead to the disruption of business operations. As a result, costs and inefficiencies can increase. To combat this issue, businesses can conduct this process.
  • Organizations can build customer loyalty by offering protection against fraud. In other words, this process can help boost customer retention.
  • The process can allow businesses to spot and rectify weaknesses related to their internal controls. Thus, it can help prevent fraud in the future.

Additionally, this process can allow businesses to spot and rectify weaknesses related to their internal controls. This can help prevent fraud in the future.

Challenges

Some challenges associated with fraud detection systems are as follows:

  • Differentiating between fraudulent and legitimate activities is not always a straightforward task. There can be false positives, causing inconvenience.
  • Scammers or fraudsters keep refining their strategies. This requires the scam detection systems to evolve with time.
  • The substantial transaction volume can make it challenging to detect fraudulent activities.
  • Immediate response to any fraud or real-time analysis of scams can be technologically demanding and resource-intensive.

Moreover, navigating the complicated web of regulations and laws with regard to privacy and protection of data can be challenging, especially across multiple jurisdictions.

Fraud Detection vs Fraud Prevention

Many people new to the concepts of fraud prevention and detection believe that they are the same thing. However, that is not true. Both processes have completely different meaning and purpose. One can clearly understand how they differ by looking at their distinct characteristics. Hence, let us look at the key differences below.

Fraud DetectionFraud Prevention
It aims to identify frauds as they take place r shortly after.  This process’s objective is to stop fraud from taking place.
It analyzes and tracks signals of fraud. Fraud prevention executes barriers to scams or fraudulent activities. 
This process reduces the effect of fraud through prompt identification. It minimizes the possibility of fraud. 
The process focuses on reactive measures to identify and deal with fraudulent activities. It focuses on reactive measures to secure processes and systems.

Frequently Asked Questions (FAQs)

1. Is fraud detection supervised or unsupervised?

Some solutions offer tools that utilize both unsupervised and supervised machine learning models. That said, the majority of the fraud detection service providers use only supervised models. This weakens the tool’s ability to decipher data and make well-informed decisions accurately. Note that the best systems utilize both types.

2. How long does fraud detection last?

Typically, the more complicated a fraud, the more challenging the investigation. In simple cases, the detection process can be completed within a period of two days. That said, when a case involves fraud rings, investigations can carry on for months.

3. What is fraud detection and deterrence?

Fraud detection means carrying out a process to track transactions and customers’ behavior to spot and fight fraud. On the other hand, fraud deterrence is a process that involves proactively spotting and eliminating the possible causes and opportunities for fraudulent activities within an organization.

This article has been a guide to what is Fraud Detection. Here, we explain its techniques, examples, importance, challenges, and comparison with fraud prevention. You may also find some useful articles here –

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