Incident Response, Malware, Phishing, TDR

Optimizing fraud: Yes, there is a silver lining

Despite a sluggish economy, online shopping continues to show impressive revenue gains. Recent Forrester Research data suggests that online shopping will grow 17 percent in 2008, a far cry from what is happening in the brick-and-mortar world.

While this number points to increased interest in shopping online for both convenience and price reasons, it also highlights the growing relevance of subscriptions and other recurring revenue models as part of an online merchant's arsenal as an opportunity to grow the average customer lifetime value (ACLV).

Success invariably begets fraud, and in the case of online merchants this fraud typically takes the form of chargebacks. Fraudulent chargebacks are one of two types: true fraud, which typically occurs when a credit card or other payment method has been compromised and friendly fraud, which occurs when the legitimate cardholder decides to refute the transaction. There is significant risk to merchants who cross the one percent chargeback rate, ranging from association fines to the potential loss of their merchant account. There are a number of best practices that will allow you to effectively fight and manage chargebacks that do come into your organization:

  • Don't rely on reason codes. There are many times when the issuing bank will assign incorrect or inaccurate reason codes to a chargeback so it is important to review the cardholder's documentation to determine the real reason for their chargeback. By addressing the cardholder's real complaint, you increase your chances of success.
  • Immediately shut down accounts that have chargebacks. This is especially important if you have a recurring business. If you continue to charge the customer after a chargeback has occurred, it will be very difficult for you to continue to fight them if the customer issues another chargeback as a result of the recurring charge.
  • Dispute what you can reasonably prove.  If you have usage and transaction data related to the charge and information about the customer in your files matches the cardholder's documentation, then it is a sound business practice to dispute that charge.
  • Leverage fraud screening. To prevent chargebacks from potentially happening in the first place, think about employing a fraud screening solution. Transactions that cross your risk threshold can be credited to the customer even before they turn into chargebacks and you incur the fees associated with processing the chargeback.

    There are, however, subtleties to fighting chargebacks that are related to the characteristics of your online business. With the amount of fraud that occurs in the online world, companies are spending more and more resources around screening for fraud. The impact of this is two-fold: not only do fraudulent transactions get stopped, but inevitably valid transactions get stopped as well – the latter phenomenon is commonly referred to as “false positives.”

    In an online business that revolves around both intangible goods and a recurring billing model, there are significant implications of having false positives.  In such a business, the true value of the customer is measured by ACLV, which is the average transaction amount multiplied by the average lifetime of that customer.  In these businesses, ACLV can run in the hundreds of dollars. This can be contrasted with the cost associated with fighting a chargeback, which often is only in the tens of dollars. It therefore becomes vitally important for merchants to explicitly calculate the tradeoff decision between stopping all fraud and minimizing the number of false positives.

    A simple example should highlight this tradeoff. Assume an intangibles business that offers a subscription to its service at $10 a month and the average lifetime of a customer is 24 months. The ACLV is $240, which is the cost of any false positive since that represents the lost revenue to the merchant. If a transaction results in a chargeback, the costs to the merchant are comprised of three basic elements:

    • The internal cost of fighting the chargeback that typically ranges up to $15
    • The cost of that good, which in an intangible business is often just the cost of the bandwidth, which is typically less than a dollar; and
    • The chargeback fee, which can range from $2.50 to $10   

      Even at the high end of these estimates, the cost of the chargeback typically won't be more than $30 to $40. Thus, this merchant would want to tune its fraud screening process to eliminate obvious fraudulent charges while still ensuring that its customer acquisition pipeline is wide open via the elimination of false positives.

      There are two exceptions to this general recommendation. The first is if there is a significant social cost to the community from the person incurring the chargeback – for example, griefers in the gaming world. The other exception is if the business in question is a tangible goods merchant where the cost of goods sold is very high. In a fraudulent chargeback situation, the merchant is not only out the transaction but also the good itself. In both circumstances, there is greater incentive to stop fraudsters, even at the expense of false positives.

      With online shopping continuing to grow strongly, an appreciation of the dynamics between fraud screening, chargeback rates and false positives is critical to optimizing your business for both revenue and the ideal customer experience.

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