Loyalty Liability and Small Business: Answers From an Expert

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By: Wise Marketer Staff |

Posted on September 8, 2020

What follows is an interview with Len Llaguno, Founder & Managing Partner of Kyros Insights. Len has established himself as the go-to-guy for anything in the loyalty finance and loyalty liability realm. In this interview, we discuss point expiration and how small businesses should handle their loyalty liability. Plus if you didn't know, at his foundation, Len is an actuary. We ask Len how he ended up in loyalty and how his actuarial background has provided him with unique skills and tools when evaluating loyalty programs.

Wise Marketer (WM): Many loyalty program managers are making changes so that points never expire. We've heard anecdotally that there is no long-term impact on accumulated loyalty liability. What’s your take?

Len Llaguno (LL): There will definitely be an impact on loyalty program liability.

You probably suspect that eliminating expirations doesn’t have a big impact because United Airlines didn’t report much of a change in their breakage rate after they eliminated their rules. At year end 2018 they reported a breakage rate of 14.5%. At year end 2019 they reported a breakage rate of 14%.

I don’t have line of sight into what they are doing, so it’s hard know exactly how they arrived at these numbers. They did bring the breakage rate down from 18% in 2017, so perhaps they already had a conservatism in their liability that they are able to unwind with the change in expiration policy.

Scenario testing the financial impacts of program changes is one of the big things we do for our customers. Lately we’ve done a lot of this expiration scenario testing, and everything we’ve seen would suggest to us that the breakage rate should decrease if you eliminate expiration.

Here’s what we find:

If you are eliminating the expiration policy, it’s reasonable to expect that you’ll now see more points eventually redeem that would have otherwise expired. Exactly how large of an increase this causes in the liability is going to be a function of your current expiration policy and the engagement level of your members.

For example, if your current expiration policy is quite restrictive (e.g., points expire 12 months from when they are earned), you’ll likely see a large increase in the liability. If your current expiration policy is more generous (e.g., points expire after 36 months of inactivity), you won’t see as large of an impact.

The other dimension is the engagement level of your customers. If your customers that are currently expiring their points are completely unengaged, you probably won’t see much of an increase in the liability since many of the points that expired under the current rules will simply go unused under the new policy.

WM: We all know that no good business decision was ever made by just looking at costs and looking at the impact on liability and redemption costs is only half the picture. We've spoken about Customer Lifetime Value (CLV) in the past (Deep-dive into our 3-part series about Loyalty Finance) — can you elaborate on how CLV is a better way to evaluate the cost/benefit trade-offs?

LL: The impact on CLV can be broken down into two components:

  • A one-time cost impact due to the increase in liability for points issued in the past
  • An on-going impact for all future activity (i.e., the expected future profit from members, which we call EFP - It’s simply the future part of CLV.)

Relaxing expiration rules does generally drive increases in in EFP to a certain point, since keeping points in members accounts is an effective mechanism to keep people coming back at a higher rate and for a longer period.

We see that the impact on EFP varies by member. The most engaged members won’t change that much since the expiration rule never really affected them to begin with. The least engaged members won’t redeem their points either way, so they aren’t affected much either (there may be some improvement, but that’s not what’s driving the results). The middle of the pack is where you see the most improvement.

Whether or not the improvement in EFP offsets the one-time impact due to the restatement of the liability depends on the program. If the increase is not enough to immediately offset the one-time impact, the difference will likely be recouped eventually as you acquire new members with improved CLVs over the current state.

With all that said, relaxing expiration rules doesn’t always show improved CLV. If the program is already very rich, every additional increase in the URR could drive a large increase in costs that is hard to recoup through improved retention.

WM: For small businesses (SMBs) with a loyalty program, how do you make a decision on how to let points expire or not?

LL: CLV is the most useful metric to help with this decision. Scenario testing the optimal expiration policy for your membership that drives the best CLV is the ideal way to make this decision.

However, this is hard to do without the right expertise and actuarial training that SMBs might lack. As a shortcut, an analysis of competitor programs is a good start to ensure the optics of your program’s benefits aren’t uncompetitive with your peers.

WM: For SMBs, do you recommend expiring points to reduce the loyalty liability load?

LL: If you have good breakage models, the expiration policy becomes less and less important for managing the balance sheet since your models can accurately predict points that will never get redeemed (i.e., points held by members that have effectively “expired” and will never come back). Even if you have a lot of points outstanding, you may not have a large liability since your model will assign a near zero probability of redemption to points held by these “expired” members.

In general, I would recommend that SMBs develop sophisticated breakage models and implement lenient inactivity-based expiration policies. The models will de-risk your CFO’s liability management concerns, and provide an expiration policy that is lax enough to maximize CLV, but also acts as an incentive for loyalty program members to keep coming back.

WM: What's the most important thing to consider when approaching loyalty liability?

LL: Liability is not a bad thing.

It’s a common perception that liability is bad, but it really isn’t. Having points in members’ accounts is a good incentive mechanism for members to keep coming back. So, in this sense, the liability is an investment in members that should be optimized rather than a cost that should be minimized.

A lot of programs are really missing the opportunity to optimize the ROI they are getting on this investment simply because it’s not viewed as an investment by key stakeholders.

One of the main things we try to do for our customers is change perspectives from liability as a cost to liability as an investment.

WM: You may be the only known actuary in loyalty. When you were studying to become an actuary, did you ever think you would end up in loyalty?

LL: Definitely not!

For those who are not familiar with the profession, most actuaries work in the insurance or pension industry, so working with loyalty programs is a very specialized area for an actuary to focus on. The stereotype is that we are the people that predict when you are going to die. It is morbid, but super important if you are trying to price a life insurance policy or value a pension liability.

It turns out that toolbox is also super helpful for solving problems for loyalty programs.

I don’t think there is any other actuary who has been so intensely focused on loyalty programs for so long. I’ve been doing actuarial work solely for loyalty program for nearly a decade. There are other actuaries that dabble in this space, but they are primarily insurance actuaries who sometimes work with loyalty programs.

This laser focus in one area for such a prolonged time means we have gone through more trial and error cycles to figure out what works and what doesn’t than anyone else. We’ve leveraged this hard-earned knowledge to build the world’s best (and perhaps only) actuarial platform specifically for loyalty programs.

WM: How has your actuarial background contributed to your success in loyalty?

LL: The first way it is helped is with auditors. The professional actuarial credentials allow us to write formal actuarial opinions that are helpful to get auditor approval on the program liability. Auditor reviews can be a big pain for companies that are not sophisticated with their liability management and can turn into a huge financial headache if you cannot get auditors to sign off. Having a trusted actuary backing the liability can go a long way to de-risking this concern for the CFO.

Second, the actuarial toolbox is all about predicting over long horizons and then knowing how to use those predictions to manage risk and inform business decisions.

All loyalty programs have at least two long-term prediction problems (i.e., actuarial problems):

  1. Predicting Redemption Costs: A program is issuing points today but will not know the true cost of those points for years. How does a program manager make smart decisions today when they do not know their single largest expense?
  2. Predicting Customer Lifetime Value (CLV): Too many people see loyalty as a cost center, because they see a massive liability on the balance sheet, but not the improved long-term future profit stream you’re getting in return. CLV puts the liability in the appropriate context, helping to show that the liability is an investment to optimize rather than a cost to minimize.

These aren’t the most exciting and headline-catching problems facing loyalty programs. But they are nonetheless very important to loyalty program finances plus the overall health of the program.

The ability to predict over long horizons is key to solving these problems. The long-term nature of our work is what sets actuaries apart from other analytics professional. When you combine this with over a decade of accumulated loyalty business acumen, a deep understanding of the accounting regulations, and our proprietary technology, you get a unique mix of capabilities that allows us to solve these problems better than anyone else.