(FORTUNE Small Business) – Nickie Reeves is a registered nurse who seven years ago started a small business, the Helping Angels, that provides home health-care services in Reno. Two years ago, looking for ways to attract and retain good workers, Reeves considered offering health insurance as a benefit. But as she researched the subject, Reeves, like many small business owners, was shocked by the cost--until her agent brought her a plan sponsored by a company called Employers Mutual LLC. Employers quoted a rate 50% below others. "Wow, this sounds great," Reeves recalls thinking. "My employees were really happy about it."

The Helping Angels dutifully paid the monthly premiums but soon discovered that medical claims weren't being processed. "I called the company four or five times, and each time they said, 'We'll pay them.' But they never did," says office manager Amy Buchanan. Before she knew it, Buchanan, whose son needed treatment for asthma, had run up nearly $5,000 in medical bills, and collectors were calling her day and night. "My credit rating was shot," she says.

As it turned out, there was a reason Employers Mutual wasn't paying a lot of claims: It wasn't authorized or licensed to sell health insurance in Nevada--or any other state for that matter. But that didn't stop it from "covering" some 29,000 people in all 50 states. And while the Helping Angels had indeed been duped, they were, relatively speaking, blessed. Others were going through hell because of Employers Mutual. In Denver, Zoraida Gonzales, an office worker who had paid her premiums to Employers, developed breast cancer. She soon owed $200,000. In Florida, Albert Piantodosi needed a liver transplant, which he assumed would be covered by Employers, his wife's insurer. It wasn't, and Piantodosi, who almost died waiting for the transplant, racked up $110,000 in medical expenses. Susan Matthewson, a casino worker in Nevada, developed a staph infection that led to complications requiring a lengthy hospital stay and $200,000 in charges. And then there was the case of Eddie Holland, an Alabama worker who fell ill with acute pancreatitis. He was hospitalized and later died, leaving more than $1 million in uncovered expenses.

Between March and October 2001, Employers Mutual took in some $14.75 million in premiums from hundreds of small businesses and their employees. During that time it paid out only $3 million in claims. As for the balance, the company spent millions in overhead and administration alone, much of it going to the four principals or to entities controlled by them in less-than-arm's-length transactions, according to Bette Briggs, regional director of the Office of Enforcement of the Employee Benefits Security Administration in San Francisco. Beyond that, she notes, "there's still $7.3 million we can't account for."

But those numbers are dwarfed by another figure. Employers Mutual was in business for less than a year before going under. In its wake, says Tom Dillon, its court-appointed receiver, it has left behind $54 million in unpaid medical claims. As a result Employers is the subject of a criminal investigation by four federal and two state agencies. The resources the government is willing to throw at the company are matched by the passion the case has engendered. In a recent interview, Secretary of Labor Elaine Chao, referring to Employers Mutual and similar health schemes, told FSB: "These are the most unscrupulous operators. They take advantage of people at their most vulnerable moments. It's despicable, and we will show no mercy."

It would be comforting to see employers Mutual as an isolated operation. But in recent years many entities have sold unauthorized and unlicensed health insurance to hundreds of thousands of unsuspecting consumers, most of them owners and employees of small businesses. And the number continues to grow, as does the scope of the government's inquiry. As FSB was going to press, the Department of Labor had opened 116 civil and 25 criminal investigations of fraudulent health-insurance providers like Employers Mutual, according to Chao. Meanwhile, the states have been shutting those operations as fast as they pop up. To date, Oklahoma has 60 investigations underway, while Colorado has already shut down 43 dubious plans.

"This is one of the most vicious and economically damaging scams of the past ten years," says James Quiggle, a spokesman for the Coalition Against Insurance Fraud, an advocacy group based in Washington, D.C., comprising industry, consumers, and union members. "Hundreds of thousands of small businesses and their employees have been affected in the last year and a half." By the time all the bogus plans have been uncovered and accounted for, Quiggle estimates, they could well have generated some $250 million in unpaid claims.

All this present-day damage actually has its roots in the last economic downturn. Between 1988 and 1991 similarly fraudulent health plans left behind a total of $114 million in unpaid claims, affecting nearly 400,000 people. This time the toll will be worse, says Quiggle, because "these entrepreneurs have perfected the business model. They are now able to reach more people faster and rob them of more money in a shorter time."

Adding fuel to the bonfire is what Quiggle labels a "double whammy"--a sick economy and double-digit annual increases in health-care costs. "There's a lot of anxiety among small business owners in this economy," he says. "Too many of them are willing to shed their better judgment and grasp at any deal that makes health insurance seem affordable."

Employers Mutual, like other fraudulent plans, relied on a deft mix of aggressive marketing, attractive pricing, sheer deception, and the use of legitimate cover by using licensed insurance agents to sell its policies. That combination was designed to draw in many unsuspecting small business owners quickly and raise millions in premiums from them before regulators got wind of the operation. "The sophistication of these operators is amazing," says Bob Loiseau, the court-appointed receiver of American Benefit Plans, another failed scheme, which victimized 8,000 people in Texas. "All these plans have a veneer of legitimacy that can make it very hard to distinguish them from legitimate ones." (How do you spot a bogus plan? See "Warning Signs.")

The man who created that veneer at Employers Mutual was James Lee Graf. While Graf's formal education ended when he graduated from high school, he went on to earn the equivalent of a doctorate at that sweet spot in the economy where two big and bloated industries, health care and insurance, intersect. Ben Gillard, an investigator with the Nevada Insurance Commission, has been tracking Graf for nearly two years. Gillard, a jazz trumpeter in his spare time, compares Graf to a musical genius who never learned how to read notes. "Graf learned health insurance the way Louis Armstrong learned jazz," he says. In other words, he's a natural.

According to Graf's former sister-in-law, Patti Peoples, who has known him since the early '80s, his industry apprenticeship began some 20 years ago when he handled the paperwork for four plastic surgeons in Beverly Hills. In 1986 he started Prime Care Health Network, which sold health insurance to worker groups in the Los Angeles area. The only problem was that Prime Care was "not now or ever licensed by the Insurance Commissioner as an insurer," and "it falsely represented to agents and subscribers that the health plans were underwritten by California licensed insurance companies." So said California's insurance commission in a cease-and-desist order it issued against Prime Care in October 1998. The commission also found that the company, while it had left behind some $400,000 in unpaid claims, still managed to make various payments to Graf, including "$380,000 toward an escrow account in the name of respondent Graf."

Such self-dealing was a hallmark of Graf's next venture, a complex scheme in which one company he owned, United West Coast Medical, sought to buy an insolvent HMO, Greater Pacific Health Care, in which Graf already had a 95% interest. This time the California Department of Corporations concluded that Graf's dealings amounted to "valueless transactions designed to give Greater Pacific the appearance of adequate TNE" (tangible net equity). That, in turn, would qualify Greater Pacific to provide health care legitimately in California. Despite Greater Pacific's woeful financial shape, the Department of Corporations found that it, too, diverted sizable payments to Graf or entities controlled by him. When the state's Insurance Commission shut him down once again, in August 2000, it noted a "pattern of confusion and misinformation common in Graf's business practices."

By then Graf was already ramping up to go national, incorporating Employers Mutual in Nevada in July 2000. But Graf's name did not appear on the company's incorporation papers filed with the Nevada Secretary of State. Instead, the company's officers were listed as William Kokott and Nicholas Angelos. Both men were in the construction business in California and, in a subsequent federal court hearing in Reno, acknowledged having no experience in health care. Kokott had met Graf when he did some work on Graf's house, says investigator Ben Gillard. A third officer in the company was Kari Hanson, Graf's girlfriend, with whom he lives in Canyon Lake, Calif. Despite repeated attempts, Graf, Kokott, and Angelos all refused to grant interviews for this article--in spite of phone calls, e-mail, and mail, and in Graf's case, a personal visit to his house.

From the outset, Employers Mutual LLC was designed to confuse in many ways--right down to its name. It closely mimicked the name of Employers Mutual Casualty Co., a reputable Iowa insurer that has been in business for more than 90 years. Graf similarly exploited a seam between state and federal regulations. Employers Mutual LLC claimed to be backed by the federal Employee Retirement Income Security Act, which exempts self-insured health plans from state regulation. Thus, it neither sought state licenses nor submitted compliance forms to the federal government.

In fact, Employers Mutual LLC was not Erisa-backed and was indeed subject to state regulation. But Gillard became aware of Employers only after he started hearing from consumers beset by bill collectors. By then Employers had already been doing business--collecting premiums--in Nevada for four months. Another critical claim that Employers Mutual made was that it was underwritten by large insurers with strong credit ratings. Demonstrating adequate reserves is a vital element for any company selling health-care coverage. In a January 2001 memo Kari Hanson, as Employers Mutual's director of operations, wrote to local insurance agents, assuring them that each policy "is fully funded and fully insured." She also wrote that Employers Mutual always works with the "A-rated or better insurance company; and in most states the coverage is provided through the Golden Rule Insurance Co."

After getting wind of Employers Mutual's ploy in August 2001, Golden Rule's attorney, Ronald Davis, wrote to the Alabama Insurance Commissioner, "Please be advised that Golden Rule does not have, nor has it ever had, any role whatsoever in this 'program.' " Golden Rule was not alone in having its name expropriated by Employers Mutual for marketing purposes. The company also brandished a September 2000 letter purportedly written by a senior vice president at Sun Life to Employers' president, Kokott. Among other things the letter said that, as an underwriter to Employers Mutual, "our company is willing to accept your...business." Gillard subsequently learned that the letter was written on letterhead that Sun Life had stopped using six months earlier. "That letter was a forgery," he says.

In its continued quest for legitimate cover, Employers Mutual used aggressive marketing techniques to sell its policies to local insurance agents. To make that push it engaged two middleman companies, American Benefit Society and Associated Agents of America, to sell Employers policies to reps. According to Employers Mutual's receiver, Tom Dillon, Associated received $959,574 worth of commissions on the sale of the Employers program. For Associated that amounted to 15% commissions. American Benefit declined our requests for an interview. Michael Debello, Associated's CEO, says, "We were lied to by Employers Mutual."

The promise of future commissions motivated Associated and American Benefit to generate enthusiasm among local insurance agents in the marketing seminars they conducted. Small business owners, Gillard notes, know little about the nuances of insurance, and that's why they buy it from local agents--who are licensed in part because they can distinguish legitimate from fraudulent insurance. Gillard says that while perhaps half of the agents who sold Employers Mutual policies knew they were selling bogus plans, all of them should have. In Nevada the Insurance Commission ultimately fined agents $1,000 for every Employers policy they sold. (Dillon, meanwhile, has filed a class-action lawsuit against 400 agents to recover money owed to Employers plan members.)

Employers Mutual policies were also easy to sell because they were priced well below the market--"grossly less than those rates charged by approved, legitimate insurers," according to a report by the Texas insurance commissioner. Emmet John Vaughan, a professor of insurance at the University of Iowa who reviewed the Employers case as an expert witness for the Department of Labor, noted, "Virtually all the promotional material misrepresented what the program was and how it operated. The purpose was to entice employers and employees to leave existing programs."

Judging from the premiums it raised, Employers Mutual spawned an exodus. A Department of Labor investigation found that between March and October 2001 the company took in $14,757,000 in subscriber premiums, but it paid out just $3 million in claims.

So where did the rest go? Well, the numbers just don't add up.

According to Briggs in San Francisco, the Department of Labor's investigation found that Employers Mutual's four principals compensated themselves well. Between January and August 2001, Graf, Kokott, and Angelos paid themselves $82,759, $8,900, and $11,572 in salary, respectively. Angelos's construction company received $5,166. Hanson received $107,951. Graf accepted a bonus of $150,000.

Employers Mutual also set up WRK Investments and Graf Investments--allegedly to provide investment services. But according to Briggs, the two plans, controlled by Kokott and Graf, received some $320,000 from Employers. As that money was considered "plan assets," by law it should have gone to pay claims. There is no record that this happened, says Briggs.

Employers Mutual also engaged a number of "provider networks," health-care professionals that would dispense services for which they would be reimbursed by Employers. One of them, Colombia Health Network, was headed by Hanson--who was also Employers Mutual's director of operations. The other was Western Health Network--headed by Kokott and Angelos. Between them, says Briggs, Colombia and Western received $1,050,000 from Employers Mutual. Again, she adds, there is no record that either Colombia or Western rendered any services for those fees.

With so much money being put at management's disposal, it wasn't long before it ran out. By October 2001 prescription provider Rx Prime halted service, citing the $900,000 that Employers owed it. That had direct and dire consequences for people like Gwen Carter, who had been diagnosed with multiple sclerosis in March. Her medication, which cost $1,000 a month, was suddenly not covered. "I pleaded. I went through a program for indigent people, and I'm not indigent," says Carter, who runs a weekly newspaper in Lovelock, Nev. Unable to afford the medication for three months, Carter saw her symptoms worsen. She needed three CAT scans and several lab tests. Her bill? Six thousand dollars. "That may not sound like much, but in rural Nevada that's a hell of a lot of money," says Carter. "I have very good credit. I was paranoid about losing that, so I started paying out of pocket." Carter finally found comfort when her husband's employer landed another health plan.

As state regulators began hearing similar tales of woe from consumers in late 2001, they started issuing cease-and-desist orders against the company, and in December the Department of Labor issued a temporary restraining order against Employers Mutual and appointed a receiver, Tom Dillon, to take it over. When Dillon first walked into Employers office in Glendale, Calif., he found a mess. "They just stashed in excess of 60,000 unpaid claims in file drawers," says Dillon. He estimates that Employers Mutual's unpaid claims will top out at $54 million.

James Graf lives in a large home in a gated community in Southern California called Canyon Lake. It lies an hour southeast of Los Angeles in an idyllic hilltop setting. Unannounced guests must stop at the guardhouse, as I did, present identification, and call in. A woman identifying herself as Kari Hanson answered the phone and told me that Graf was not available. Hanson called Tom Dillon a "crook," and American Benefit, which marketed Employers' policies, a "bunch of crooks." As for Graf, he was simply a "consultant to the company; he never signed a check." Hanson said she would like to tell her side, but "every time I talk to reporters, things get twisted around." Subsequent efforts to reach Graf by phone and mail went unanswered. But Peoples, Graf's former sister-in-law, describes him as "always borrowing from Peter to pay Paul." Graf was married to her sister, Karen, from 1986 to 1999--when he left her to move in with a girlfriend. Peoples claims that Graf drove a fleet of fancy cars, each registered in someone else's name. He also lived in a $1.2 million mansion, which, her sister eventually discovered, had 33 liens on it.

If that sounds outrageous, consider this: Dillon says he would be surprised if Graf ended up doing any prison time. Despite Labor Secretary Chao's strong language, "the resources of the government have shifted to chasing the Osamas of the world," notes Dillon. As for the possibility of Graf's paying a big fine resulting from a civil suit, Dillon says that seems remote, given that the assets he's dug up so far amount to $300,000. But Graf is already looking ahead, having incorporated another company in Nevada. Like his previous creations, it bears an innocuous name that may belie more complex intentions. It's called Advanced Consultants & Management.