In our latest "Ask a Loyalty Expert" segment, we interviewed Len Llaguno, the Founder and Managing Partner of KYROS, the world's only actuarial firm exclusively focused on loyalty programs. Len, an actuary by profession, has leveraged his extensive and rigorous training to bring a unique perspective to the loyalty program industry.

At KYROS, he uses his specialized actuarial skills to make highly accurate long-term predictions on critical metrics such as customer lifetime value, breakage, redemption rates, customer spending, and various other factors essential to the success of loyalty programs. His expertise helps businesses understand and optimize their loyalty strategies for sustained growth and customer engagement.

Actuarial science meets loyalty program liability

Part of what makes Len and KYROS so effective and successful is their use of actuarial science, an area of expertise often unnoticed by professionals outside the insurance industry. Actuarial science, however, enables long-term predictions by leveraging data to make informed estimates many years into the future. 

This skill is critical for tackling problems such as liability management and customer lifetime value, potentially saving businesses millions of dollars, as Len explains below.

Predicting over the long term is also very different from data science. Data scientists are broadly trained in analytics and predictive models, typically short-term, such as predicting who will open an email or convert on a campaign. In contrast, Len's work involves making predictions about events, like how many loyalty points will be redeemed over the next ten years, making it a very specialized class of predictions.

It's, nevertheless, difficult for most actuaries to make loyalty predictions. Loyalty and insurance differ significantly, as loyalty schemes are inherently fluid and dynamic. By definition, loyalty schemes aim to change people's behavior, requiring models that are more responsive to behavior changes and can reflect those changes in predictions.

As an actuary in loyalty, Len aims to integrate actuarial theory with modern machine learning and data science, creating a brand-new actuarial toolbox that solves loyalty-related problems.

Read on to find out how Len explains in great detail the concepts of loyalty program liability and customer lifetime value, as well as the serious consequences of not accurately addressing these issues. We also learn more about how KYROS has been supporting businesses in maximizing the benefits of their loyalty programs.

What is loyalty program liability? 

Liability is typically focused on the cost. However, as we know, no good business decision is ever made just by looking at the cost. Customer lifetime value allows us to compare the benefit component against the cost. You must understand customer lifetime value and liability to get a complete financial picture.

"No good business decision is ever made just by looking at the cost." Len Llaguno, the Founder and Managing Partner of KYROS

An easier way to think about loyalty program liability is to recognize that every time a loyalty program issues a point, that point will eventually cost the company something. It's essentially an IOU issued to the customer and has value if redeemed. Liability means that all the outstanding points that haven't expired or been redeemed cost something. The question is, how much do these points cost? That's the simplest way to frame what loyalty program liability is.

The macro-level concept is how much a company will pay for those loyalty points.

What is accruals management?

Managing accruals in a loyalty program is a crucial task that systematically tracks and manages the loyalty points, miles, or other rewards customers earn.

A robust system is essential for several reasons, starting with maintaining the program's financial health. By accurately reflecting liabilities on the balance sheet, we make everything accounted for, so tracking and processing earned awards is seamless.

Even more, compliance with accounting standards isn't just about ticking boxes – it's about promoting transparency and integrity within the program. When we adhere to these standards, we assure stakeholders about the loyalty program's reliability and fairness. This, in turn, adds to the reputation and relevance of the program, creating an opportunity for long-term success and trust for all involved.

The importance of accruals management

A well-structured accruals management system is crucial for several reasons:

The financial health of the loyalty program

Proper accruals management is essential for maintaining the financial stability of a loyalty program. By accurately tracking earned rewards, businesses can forecast liabilities and plan for future redemption costs. For example, a hotel chain can predict how many free nights might be claimed in a given year. This kind of financial foresight is instrumental for budgeting and determining the program's long-term sustainability.

Customer satisfaction

Accurate and transparent reward management is critical for customer satisfaction. When customers see that their loyalty points or miles are being reliably tracked and managed – like through an app that updates in real-time after each transaction – they're more likely to trust and engage with the loyalty program. Such trust leads to higher levels of customer loyalty and repeat interaction, which are key objectives for any loyalty program. 

Compliance with loyalty program accounting standards

Loyalty schemes often involve complex financial transactions that must adhere to accounting standards and regulations. Accruals management ensures that all rewards are accounted for consistently with these standards, minimizing the risk of financial discrepancies and regulatory issues. Compliance is a legal necessity, reinforcing the credibility and integrity of the loyalty program.

The Financial Accounting Standards Board (FASB) provides guidelines that help companies recognize and measure the liabilities and expenses associated with loyalty programs. These guidelines ensure that companies accurately report the timing and amount of reward-related transactions.

For example, under FASB's Accounting Standards Codification (ASC) 606, companies must determine the fair value of rewards and recognize this cost over the period the related revenue is recognized.

Additionally, ASC 606 requires that loyalty rewards be accounted for as a separate performance obligation. This means that the company must defer a portion of the revenue associated with the initial transaction until the customer redeems loyalty points or lets them expire. This process of revenue recognition ensures compliance with FASB standards and enhances the transparency and reliability of financial statements, reinforcing stakeholder confidence in the loyalty program's fiscal management.

Key components of accruals management

Accruals management in a loyalty program that actually works typically includes several key components:

Earned rewards tracking

Recording the loyalty points, miles, or other rewards that customers earn through various activities such as purchases, referrals, or engagement with the brand is essential. Advanced tracking systems capture these transactions in real time, providing up-to-date accrual information.

Take, for instance, a supermarket's loyalty card program. After each shopping trip, the loyalty points are automatically updated, allowing customers to see their rewards immediately. This real-time capture not only keeps customers informed but also enhances their engagement and satisfaction, making the loyalty program more effective and appreciated.

Liability management

As customers accumulate rewards, these loyalty points or miles represent a future liability for the business since customers will eventually redeem them for free or discounted goods, services, or coupons.

Proper accruals management involves forecasting these liabilities and maintaining adequate resources to fulfill them. Accurately predicting these liabilities helps the business manage its resources effectively and maintain financial stability.

Redemption patterns analysis

Understanding how and when customers redeem their rewards is essential for effective accruals management. By analyzing redemption patterns, businesses can better predict future costs and adjust their loyalty program strategies accordingly.

For instance, a fashion retailer might notice that most redemptions occur during seasonal sales and can plan inventory accordingly. This insight allows businesses to align their strategies with customer behavior, optimizing both inventory and customer satisfaction.

System integration

Integrating accruals management with other business systems, such as customer relationship management (CRM) and financial software, facilitates seamless data flow and reduces the risk of errors. Such an integration also allows for more comprehensive reporting and analysis.

A good example would be a bank that links its loyalty program with its CRM to provide personalized offers based on customer data. Such integration not only improves operational efficiency but also enhances the personalization of interactions.

Reporting and auditing

Regular reporting on the status of accrued rewards and periodic auditing of the accruals management system are essential for maintaining transparency and accuracy. 

These practices help identify any discrepancies early and guarantee that the program operates smoothly. Regular audits and reports build trust and sustain the long-term viability of the loyalty program.

How to reconcile redemption rates and engagement? 

The higher the engagement rate, the more likely customers will redeem their points. People often discuss redemption rates, which in turn drive engagement. However, as I mentioned earlier, no sound business decision is made solely by looking at costs. Focusing solely on redemption rates or liability in isolation is pointless if you're trying to make a business decision.

Instead, you need to consider costs versus trade-offs. This is where customer lifetime value becomes crucial. Our goal is to optimize this value. So, if your redemption costs are rising or you expect more points to be redeemed due to increased customer engagement, that's fine – as long as your top-line revenue increases more than your redemption costs. In other words, if your profits are growing, higher redemption costs aren't an issue.

Ultimately, we aim to optimize bottom-line profit. When businesses ask about the optimal ultimate redemption rate (URR) or if the URR should increase, they're asking the wrong question. The right question is: how are we increasing customer lifetime value? You can't answer this correctly without knowing your redemption costs and liability. Both are essential. 

Loyalty as a cost center and its implications

Customer loyalty programs shouldn't be seen as a cost center – they should be viewed as enterprise value generators. If a loyalty program is truly effective, it increases customer lifetime value by fostering loyalty and boosting future purchase frequency, leading to future profits.

Companies are valued based on their projected future profits. If a loyalty program enhances retention and thus increases future profits, it generates enterprise value. This is why I see loyalty programs as creators of enterprise value. Customer lifetime value allows for this perspective. However, many people struggle to accurately measure customer lifetime value, making it challenging to value loyalty schemes appropriately.

Finance departments typically focus on the liability aspect of loyalty programs because they must quantify liabilities and costs according to accounting regulations. There's no regulation requiring the quantification of customer lifetime value, so it is often overlooked. When only the costs are considered, loyalty schemes are viewed as cost centers.

The trick is to reframe the perspective, emphasizing customer lifetime value and future profit growth, which we refer to as member equity. If more companies could evaluate loyalty programs this way, it would be easier to recognize them as enterprise value generators.

KYROS aims to simplify these complex predictive modeling exercises, enabling our customers to understand and leverage these insights easily.

Why aren't companies focusing enough on customer lifetime value?

Most people in the loyalty space are familiar with the concept and understand it. If you ask loyalty marketing professionals, they would be open to learning more about it and how to measure it. The challenge is that they lack extensive experience because few companies use it in detail. This is because guessing each individual customer's spending and behavior over the long term is extremely difficult. Well, predicting tomorrow's actions is hard enough, let alone the next three or four years.

Some loyalty programs have millions of members, making it very challenging to create a predictive framework for each one. KYROS has developed some impressive capabilities, but it has been a journey I have been on for over a decade since 2012.

Finding individuals with the necessary skills – data science, actuarial expertise, loyalty business acumen, data engineering, finance, and accounting – is highly complicated. However, these skills are essential for making accurate customer lifetime value predictions. That's why, at KYROS, we are working to build these capabilities and package them to make it easier for loyalty programs.

How to move loyalty from cost center to profit center - methods, best practices

Under IFRS 15, the precise allocation of the transaction price to separate performance obligations within a contract is paramount. When a customer purchases a product and earns loyalty points, this creates two specific obligations:

1. Delivering the purchased product
2. Providing future goods/services upon redemption of the customer loyalty points

The transaction price, generally the purchase price, must be allocated between these separate performance obligations based on their relative stand-alone selling prices.

The most important aspect is being able to quantify member equity. For those unfamiliar with the term, member equity represents the sum of the expected profit that your members will generate in the future. Ideally, this sum should reflect the bottom-line profit. Starting from the top-line revenue, you need to subtract the costs of goods sold. 

Since we’re discussing loyalty schemes, you also have to deduct redemption costs, which are associated with the points generated by the program and come with their own costs. After subtracting the transaction price from deferred revenue, you get the gross margin.

Additionally, you must subtract operational costs such as rent, depreciation, interest, and salaries to determine your net profit. However, the focus should be on your gross margin and your ability to forecast it for the future. This forecast must account for redemption costs due to the nature of loyalty schemes. 

Accurately quantifying these redemption costs requires a deep understanding of liability, ultimate redemption rates, breakage, and similar factors. 

Consequently, the concept of expected future profit is intertwined with liability.

You have to quantify these aspects: expected future profit and then sum that up across all of your customers, which then equals member equity. That's a really powerful KPI, and you want that number to grow. The importance of this lies in the fact that companies are valued based on their future profit potential. M

ember equity measures the future profit generated, making it a predictive and forward-looking KPI. If it's increasing, it indicates that you're creating enterprise value.

This linkage is how we connect the loyalty program to enterprise value creation. It transforms the program from just a marketing tool into an enterprise value generator. So, member equity is essential for making this connection.

How can loyalty program owners mitigate liability risks associated with a loyalty program?

In the article "Loyalty program liability guide," there's an aspect of how "failure to properly factor in the impact of these material financial costs on the company's balance sheet can have an unexpected financial cost upon redemption of outstanding rewards points." 

Certainly, I'll make sure to retain the original meaning, tone, and voice:

Now, the big risk here is assuming the redemption costs. For example, you might say, "Hey, 80% of all points I issued will get redeemed." You run your business with that assumption, which is crucial in quantifying your redemption costs. So, the formula you use is your points issued in a month times your ultimate redemption rate times your cost per point, which gives you the expected cost of the points you issued in a given month. Given that redemption costs are the most considerable expense in loyalty program business models, not getting this number right is very risky.

Let's say you assume your redemption rate is 80%, and you run your business on that assumption for years. Then, one day, you realize it's actually 90%. All of a sudden, you find you've been running your business and accumulating all of these IOUs effectively. Maybe you have $100 million worth of these IOUs just sitting out there, but then you learn it should be $150 million instead. This lands you in a difficult financial position, $50 million short, with a massive hole in your balance sheet. It's not an easy situation to find yourself in, and it creates a lot of financial volatility.

That's why it's super important to accurately estimate the ultimate redemption rate and have mechanisms and processes in place to monitor that assumption. After all, an estimate is an estimate – it's never going to be perfect, so you need to have the capacity to monitor and update it as you learn more. Another issue is that most companies don't have a suitable mechanism for estimating or monitoring their ultimate redemption rate effectively, and they're not investing much into this function.

Often, these estimates are akin to someone in finance doing a back-of-the-envelope calculation, or the company outsources it to a marketing firm that does the calculation for them. These estimates are often very poorly done. They're not actuarially sound calculations, and the number can be very, very wrong. We've been in situations where companies that contact us have been doing it wrong for years, and they're off by $100 million, leading to dire financial situations. And they need to find that money somewhere.

We've also seen it the opposite way, though, where they've been overshooting the ultimate redemption rate by 50%. In that case, they're just being way too conservative. They're dampening their profit and holding themselves back. Very rarely do we actually find a company doing it well and right. And, again, fundamentally, it's because most programs don't have an actuary on staff looking at it with the right actuarial lens, so they're doing it wrong. That's a big value proposition we bring: we can come in and bring a lot of rigor to that calculation when companies don't have the internal capabilities to do it themselves.

The growing recognition of the importance of actuarial professionals in companies

Companies are coming to KYROS, and many of our conversations with them are very eye-opening. We offer them a unique perspective. Much of our work focuses on helping them understand liability and why the ultimate redemption rate is moving a certain way and on assisting them to solve their business problems. We bring a vastly different perspective, a long-term perspective around customer lifetime value. 

That's super helpful when it comes to thinking about program strategy, design, and that sort of thing. Companies are starting to appreciate this, but we're still on the fringes. I'd love, in my career, to help make actuary science more common in the loyalty world.

However, the biggest problem is that most companies don't realize they're doing it wrong. Liability isn't exactly the most exciting part of loyalty programs. Frankly, it's probably the most boring one, so the people running these programs don't really want to focus their time, energy, and resources on it, and I don't blame them. They want to focus on things like engaging with their customers, coming up with incentives and benefits, and so on.

While that's absolutely the right place to concentrate, the potential problems brewing on the financial side of a loyalty program that they may not be aware of shouldn't be ignored either. Basic education needs to be provided in the industry about the consequences of miscalculating breakage analytics, liability analytics, and member equity analytics. This is something KYROS is also trying to achieve. We have lots of educational content, videos, and ebooks available on our website, which is easily accessible to anyone who wants to learn more about the subject.

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To learn more about the things discussed in this piece, check out the KYROS website, where you’ll find a range of resources as well as KYROS Academy courses.