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Market Movers The Actuary Mix in Loyalty Programs

In this edition of Market Movers, Co-Founder and Chief Strategist Al Lalani of Annex Cloud sits down to chat with Len Llaguno, Founder and Managing Partner of KYROS Insights. Len brings a new perspective to the loyalty program discussion as an actuary who analyzes loyalty program data. This perspective shows the true value of the investment in an existing loyalty program as well as giving insight to the ROI for those that are considering adding a loyalty program for their company.

Transcript

Al Lalani:

Welcome to another discussion of Annex Cloud Market Movers, where we bring in experts and luminaries to help us through the current times. Focusing on customer retention and loyalty, today's topic is very interesting, yet very, very different than what we've done in the past, because today I have with me Len Llaguno, who is the founder and managing partner of KYROS Insights. Len, welcome to the discussion.

Len Llaguno:

Al, thanks for having me.

Al Lalani:

And the reason I think this is very interesting is you are an actuary. And in the past, we've always spoken to marketers, but you focus on loyalty programs. And so maybe you can start us off with just describing how does a role of actuary mix with the role of loyalty programs in this case?

Len Llaguno:

Yeah, for sure. It's a weird place for an actuary to be working. So for those of you who don't even know what an actuary is, and I don't blame you, most people don't, the stereotype of what an actuary does is we predict when you're going to die, which is like super morbid, but consider that's super important if you're trying to price a life insurance policy, or trying to manage a pension liability. You really need to be able to predict the entire person's lifetime or at least an expectation of that to be able to quantify those things accurately. Most actuaries work either insurance or with pensions. As you pointed out, I do not. Me and my team at KYROS we work with loyalty programs. Not a lot of actuaries working in this space.

And fundamentally, what we do as actuaries is we predict over long horizons and then we use those predictions to influence business decisions today. It's like a high level if you really abstract it, that's what actuaries are doing. And it turns out that's a really valuable skillset when you're talking to loyalty programs as well. Every single loyalty program has basically two long-term prediction problems, or in other words, actuarial problems that they need to solve for. The first is predicting redemption costs. Loyalty programs are issuing points today, but they won't actually know the cost of those points potentially for years into the future.

I did an analysis for a loyalty program where we were seeing points issued 30 years ago just now getting redeemed. It's like really, really long horizons. Now, there's a real risk here running a loyalty program with assumptions that are wrong, particularly when you have assumptions related to redemption costs where... No, redemption as you know, it's probably the single largest expense for any loyalty program business model. So there's real risk if you're running a loyalty program with the wrong assumptions around those costs. And you could be in a situation where you're unknowingly accumulating a financial burden that will eventually come due. And so loyalty programs need to derisk that for the organization. So that's actuarial problem number one.

The other actuarial problem that every single loyalty program has is trying to link the program to long-term profitability. Too many people within organizations think loyalty programs are cost centers. I'm sure you've come across that a time. And the reason is you have this gigantic liability on your balance sheet and the benefit you're getting for that comes in the form of improved retention, compounding period after period, after period into the future. So you're in a situation where you have big cost today, uncertain benefit far out into the future. And so if you really want to bring transparency to that cost benefit trade-off, you got to be able to predict over long horizons. And if you really want to be able to convert skeptics into loyalty advocates, you really got to be able to bring clarity to that trade-off. So those are fundamentally the two actuarial problems that every single loyalty program has.

Al Lalani:

Makes sense. And when we are talking to marketers in establishing these programs, one of the biggest considerations for us in addition to coming up with the customer journey and coming up with all the ways that people can earn and use the points and then all the ways that we can engage people and audiences across that customer journey, one of the biggest considerations in parts of that program is the definition of the program structure. And defining the program structure, the biggest consideration is how are we going to generate ROI to your point of these have to be profitable at the end of the day? Marketers are trained and they say, "This is how much I'm going to spend, this is how much I'm going to get."

And we have to build ROI models that depict potential future profitability of these programs. And part of that profitability metric on the cost side of the equation is obviously the vendors cost and whatever not, but there's the rewards costs or the liability, so to speak. So maybe you can speak a little bit about how and what liability is first and why should loyalty marketers care about that liability. And just talk a little bit about what we should conceptually think as marketers from a liability perspective, how you should manage it.

Len Llaguno:

Right, right. Sure. So everybody listening to this podcast belongs to a loyalty program, probably many. We've probably all redeemed and gotten some free stuff before. The question is, who's paying for all that free stuff? It's the program. The program is fitting the bill for it. Every time they issue a point to one of their members, they're basically writing a little bit of an IOU to that member saying, "I'm going to give you something." And so the way it works is the accounting standards... well, here in the United States and internationally require that you put a liability on the balance sheet basically equal to the sum of all those IOUs that you're issuing. That's basically what these liabilities represent. A lot more nuance when you really dig into the accounting standards are exactly how useful to go about doing it. But high level, that's what it is.

And a lot of people just don't realize how large these liabilities can actually be. I'm just going to look at some numbers here. American Airlines, they have a liability on their balance sheet that's worth $8.6 billion, Delta Air Lines 6.7 billion, United Airlines 5.3 billion, Marriott 5.7 billion, American Express, they're north of 8 billion as well. So these liabilities can be absolutely massive. It's not uncommon for a big global hotel chain, or frequent flyer program, online travel leisure, or even just like a big global business with tens of millions of members, have liabilities north of hundreds of millions of dollars. So that's what a liability is.

Why should a loyalty marketer care about it? I think that there's really two risks that you need to keep in mind. So there's a financial reporting risk here. So you have this gigantic liability on your balance sheet. And at that scale, there's going to be a lot of scrutiny around that number. You effectively got to convince your auditors that that number is correct and reasonable for you to be able to put it on your balance sheet. And it would be an absolute nightmare if you can't convince your auditor that that number is correct. If they force you to make a change of that, that can cause serious financial volatility that you just don't want to deal with. And so that's the reason number one is that financial reporting risk.

Reason number two is business model risk. I alluded to it a little bit earlier. Running a loyalty program with bad assumptions around redemption costs is really, really risky because you could be in a situation where you're unknowingly accumulating this financial burden. It will come due and it will disrupt the business eventually. And what happens then, you're going to get calls for devaluations, you're going to get terrible customer experience, you're going to get destroyed loyalty, you're going to be in a situation with terrible PR, you're going to be in this situation, the sort of downward spiral where things are very, very bad and almost defeats the purpose of the loyalty program altogether. And so you obviously want to try to mitigate that by making sure you have accurate assumptions today with respect to redemption costs.

Now, what's really interesting here is not a lot of loyalty programs spend a lot of effort on this despite these really material risks. They're not spending a lot of time and energy on it. And I think it makes sense why. They're people running loyalty programs. Their core competency is loyalty marketing, it's customer experience, customer engagement, customer retention, building emotional ties and relationships with customers. That's their core competency. Those are the right things they should be focusing on. Actuarial science is not their core competency. And frankly, it's boring for most people. But it's important. It's important at the end of the day. And there are real risks associated with it. So often what we end up seeing is somebody that doesn't have any actuarial training or the expertise responsible for managing an Excel spreadsheet that tries to quantify $100 million, $1 billion liability. And it just doesn't seem fair to put that pressure on an individual without the right training particularly when there's this much risk at play.

Al Lalani:

Especially now because in this time, current age, as all these companies are starting to evaluate whether they extend their statuses or extend the points for people and that sort of thing, it amplifies the challenge you're talking about because they're making some very, very big business decisions. It might sound very easy. "Hey, great. I've got my points for another six months or whatever that might be." But you're creating certain challenges within that methodology, especially if there were certain expiration rules or certain things that would obviously change the liability and the carry forward that you're doing, I guess.

Len Llaguno:

Oh, that's 100% right. And I think today, a lot of companies, these programs, they have some process in place. And I think they're under investing in it. And I think the scary part is a lot of companies don't even know that their models are potentially producing inaccurate estimates because they don't have somebody with the right actuarial training that knows how to look at the data the right way to pull out those risk factors. And so it can be a situation where, again, you're accumulating this financial burden that eventually will come due.

Al Lalani:

Yeah. And you're right. Marketers are primarily trained to think about customer experience, less about the numbers, but that's when they bring in their CFOs. The challenge of the CFO side is they're thinking of liability and saying, "Oh my God, that's just another number I got to carry on my books. I don't like it. I don't want to do this. Let's not do the loyalty program because it's going to be such a big liability." The marketers are saying, "No, no, no, this is great. It's great for customer experience." And you've got this sort of yin and yang of like figuring out what's good, what's not.

I think sometimes liability gets that negative connotation. It's like, "Oh, I've got this massive liability. It's growing. Is that a problem?" Whatever else. It would not technically be a problem if it's managed and you know when it's going to expire and you're running it accurately. So how do you think about it as you're dealing with a CFO and you're a marketer, or if you're a CFO, how do you think about making your CFO an advocate for the program if you're a marketer?

Len Llaguno:

Yeah. Well, let's break that down. I want to be really clear as much as I'm talking about these redemption costs and the risk associated with them. Liability is not a bad thing. It's a really, really good thing. If your liability is accurately stated, all that means is that you've got a really, really engaged membership that wants to redeem their points. That's awesome. And what that typically means when we do these sorts of analysis, we see this, that typically means is your members have incredible customer lifetime value. And in fact, when we look at this, we can see that members that have ultimate redemption rates, which just represents the probability of redemption. Members that have ultimate redemption rates close to 100% are 5 to 10 times more valuable than members that have ultimate redemption rates around 50%. So, yeah, what that means is they're absolutely going to cost you more in redemption. But what you're getting above and beyond in terms of profit because they keep coming back and keep coming back and keep coming back far outweighs those redemption costs. And so liability is absolutely not a bad thing. But I agree with you. A lot of people think it is a lot of people just look at liability and they see a cost. By the way, I try to think about it in a way I try to position it for our customers. Liability is actually more like an investment you're making in your customers that has a wonderful ROI. And when you shift that perspective, it allows to have a different conversation. You shift from cost minimization to value maximization. And that's the really critical part. And it's the hard part, but that's the critical part is to shift that perspective.

Al Lalani:

And from a CFO's perspective, if we're thinking about this, what kind of tools or things that we can give our CFOs where they can get a little bit more comfortable and have a little bit more of a feeling of control over this aspect, I guess?

Len Llaguno:

Yeah, yeah. So it's high level. There's basically three steps that you've got to go through to convince your CFO to convert a skeptical CFO to a loyalty advocate. Step number one is you just got to de-risk the CFO's redemption cost concerns. It's going to be very, very difficult to get the CFO or any skeptic or anybody focused on costs to think more broadly about it if they don't feel like they've got their arms wrapped around the risks. And so to be able to do that, you basically got to give them really sophisticated models that they can believe, and you got to give them experts that they can trust. So that's really step number one.

Once you've achieved that and you've de-risked the CFO's redemption cost concerns, then step number two is you got to give the CFO tools to look at value in addition to cost. You can't just quantify the cost for the CFO because if you do, then naturally, they're just going to be cost-centric. You really need to quantify the benefits that go along with those costs so that you can really look at those cost benefit trade-offs. Customer lifetime value models are really, really good for doing that. And in particular, customer lifetime value models that are really geared towards the CFO's perspective of enterprise value are really, really important to accomplish step number two.

And then once you get that far, then it's step number three, the last step, which is reinforcing the notion that liability is actually an investment to optimize rather than a cost to minimize. And the way you go about doing that basically is you never show the liability without customer lifetime value. And every single quarter, talking to your CFO and your auditors about the liability on the balance sheet, you need to be making sure that the discussion is not just about liability, but also about customer lifetime value and value creation. And in fact, that should be what goes first in the presentation. It should be we're creating this much value, the lifetimes of our customers are getting more valuable, and this is how many millions we're generating. And as a consequence, by the way, the liability is also changing. But don't forget, we're creating value at the end of the day. Flipping it on its head quite a lot.

Al Lalani:

That's great. And when we think about these loyalty programs and kind of are trying to create these programs, what point in time do you think these considerations should be done? Are they things when it's a completely brand new program, are the things that we will do at the very beginning of the program when the structure is being done, or are there considerations or things we can do once these programs are up and running? And how would you advise people when they're either starting new programs or updating their programs to insert this consideration of liability management and actuarial considerations within the program?

Len Llaguno:

Yeah. Yeah, let's break that up into the two scenarios, net new program versus changes to a program. Net new program, yeah, you absolutely want to be designing the program with liability and customer lifetime value in mind. And frankly, customer lifetime value is the number you really want to care about. And then liability just comes out of that, but you just got to manage. Yeah, it's just a little bit more difficult there because you don't have a lot of data. Unless you're a digital program or a digital company where you already track what your customers are doing, you can understand customer behavior, then yeah, you can build some sophisticated actuarial models to understand baseline behaviors and then layer on top of that what that means in terms of redemption behaviors, etc. You absolutely should be doing that.

But what I see more often than not is a lot of companies don't have that data to begin with for net new programs. And so you're doing assumptions based sort of financial models. And that's fine as well. It's all you can do when you don't have the data. When we're talking about overhauls of current programs or things along those lines, you usually do have a tremendous amount of data. And that's really, really great where now you've got a program that's been in place, you understand your members, you can segment them and understand who are the high value ones, who are the low value ones, who are the members that are really responsive to points, where points actually move the needle on their behavior. These are all really important things that fall out of the actuarial analytics that can help you be informed about new program structures and how you might want to design it with that long-term result in mind.

And then in addition, once you nailed down exactly what you want the... or maybe a couple of scenarios of the new program structure that you want to have, you can also scenario-test that. And run that through the actuarial model and say, "Okay, well, this model structure will result in this customer lifetime value in this liability, whereas this other structure will result in this customer lifetime value in this other liability. Really allows you to have this longer term economic picture by which you can then start making smart business decisions around which structure you want to go with for the new program.

Al Lalani:

Absolutely. Great. Well, Len, this is great. And as I said, I mean to everyone else, this is one of the unique discussions we've had because usually we talk about customer experience and improvement of how we can build these programs better. This time around, such an important topic within building these structures better is liability management, is managing redemption costs. And Len, this was fantastic in terms of how you brought your perspective in doing that. If people want to reach you for your support or your team's support, I assume they go to your website, which is kyrosinsights.com, or go and find you on LinkedIn, I assume. Is that the best way?

Len Llaguno:

I spend a lot of time on LinkedIn. Yep. And then the website's a great place. And I could share my email address, which is len.llaguno@kyrosinsights.comFeel free to email me there as well.

Al Lalani:

Wonderful. Well, thank you so much, Len. And for everyone else, if you want to watch more of these videos, please go to annexcloud.com/marketmovers Bye for now.

Featured Speakers

Al Lalani

Al Lalani

Co-Founder, Annex Cloud

Len Llaguno

Len Llaguno

Founder and Managing Partner, KYROS Insights

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Since 2010, Annex Cloud has provided industry leading loyalty solutions to more than 250 leading brands and retailers, including Jenni Kayne, Hewlett-Packard, Bed Bath & Beyond, e.l.f. Cosmetics, Olympus, Sugarfina, Mizuno, MacKenzie-Childs, VF Corp., with the ability to engage tens of millions of their customers one-to-one at scale.

The Annex Cloud platform provides fully integrated Customer Loyalty, Referral Marketing, and User Generated Content (UGC) solutions that seamlessly work together to optimize the customer journey and deliver a unified customer experience that is designed to accelerate revenue growth, retain valuable customers, increase average order values (AOV) and drive repeat order frequency.

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KYROS helps loyalty marketers convert their skeptical CFOs into loyalty advocates by showing them that loyalty program liabilities are investments to optimize rather than costs to minimize. KYROS is the only actuarial firm globally that solely focuses on loyalty programs. Our niche expertise and specialized focus means we’ve created the industry’s leading actuarial platform for loyalty programs to predict redemption costs and customer lifetime value. We service loyalty programs in all industries around the world.

To learn more about Kyros Insights, visit https://www.kyrosinsights.com/