Why merchants don't need to buy fraud insurance to cover everything

The discipline of fraud prevention has changed dramatically over the past five years and continues to evolve rapidly. Consequently, former truths about fraud prevention are increasingly becoming outdated myths. Legacy vendors propagate these myths to maintain relevance, but industry leaders understand the distinction and are moving forward. 

In this article, the common myth we’ll tackle is that a merchant should buy fraud insurance to cover everything -- this is typically touted in the market as a 'chargeback guarantee.' On the surface, the simplicity is appealing; the vendor is claiming to solve merchants’ fraud problems by taking liability for chargebacks, returns abuse, Item Not Received abuse, and potentially more. But the statement is very much a myth for, at the very least, five important reasons:

The economics are usually unfavorable for the merchant

There are very specific situations in which a merchant should purchase fraud insurance via a chargeback guarantee, including:

• They don’t have the internal resources to think about or own fraud prevention
• Their business is in a dispute or fraud monitoring program (with, for example, Visa)
• Their chargeback rate is above thresholds that issuers deem acceptable

In nearly every other situation, the merchant would be better with an uncovered agreement in which they themselves retain liability for fraud. The insurance cost greatly exceeds the cost of the chargebacks -- that’s how insurance vendors make money. 

It’s also worth noting that in many cases at the start of the relationship, the insurance vendor may actually charge less than the current fraud rate so there is the appearance of an immediate cost-saving. However, the economic gain deteriorates over time after the initial benefit of some optimization is factored in.

The incentives for the solution provider may not completely align with the merchant’s objectives

Fraud insurance providers assume liability for chargebacks, so their primary incentive is to minimize their risk by declining more transactions. Therefore, a merchant might see their chargeback rate decline, but so does their approval rate, costing them valuable customers and revenue. When they sign a chargeback guarantee, they are handing over control of their own fraud operations and signing over critical aspects of their customer experience. 

Fraud prevention isn’t only about reducing chargebacks; it’s about making decisions that prevent fraudsters from harming your business while ensuring legitimate customers always have a positive experience. An uncovered agreement emphasizes this balance -- between chargeback and approval rate -- to optimise a merchant’s business outcomes. While a chargeback guarantee only guarantees chargebacks, an uncovered agreement guarantees chargeback rate, approval rate, platform uptime, and decision speed.

The terms and conditions are never simple

Providers often only deliver a false sense of security. One of the loudest vendors in the market sells the simplicity of their 'Guaranteed Fraud Protection Reimbursement Policy.' The truth is not so simple. 

The terms and conditions on its website require more than a dozen conditions be met to receive reimbursement for a chargeback. The merchant must provide proof of shipment, tracking numbers, proof of address match, mapped email addresses, and more -- all within seven days, following a strict process in the vendor’s portal. There’s nothing simple about that -- which is probably why this vendor is saddled with numerous 1-star reviews from merchants whose chargeback requests have been denied.

Of course, the process could be simpler. Merchants can instead select a vendor who trusts its technology and its customers, so they don’t have to protect against chargebacks with excessive terms and conditions. The message here is simple -- businesses should look past the guarantee glitter and ensure they understand the terms and conditions (and read peer reviews) before signing any contracts.

Fraud insurance kicks the can on critical issues

Sure, shifting liability for policy abuse -- such as returns abuse and Item Not Received (INR) abuse -- offers peace of mind. But it does not solve the underlying problem. The fundamental problem is that repeat abusers are not stopped; they are allowed to continue buying from the merchant and then return items outside of policies or claim those items were never received. 

The truth is that fraudsters and policy abusers are fundamentally different and must be treated as such. The latter can be readily identified and blocked with the right technology; you can even adjust policies in real-time for repeat offenders. For example, an individual who has claimed Item Not Received in the past can purchase with a delivery signature requirement. 

By purchasing fraud insurance for an issue that is not fraud and cannot be solved using fraud mechanisms, merchants end up with an expensive policy and then an increasing decline rate. With the fundamental issue of policy abuse not addressed, the merchant will only see the fraud insurance policy get increasingly expensive over time. At some future point, should the merchant want to take on that liability, they will be inheriting a much larger problem. In summary, fraud insurance only masks policy abuse problems when you need a real solution.

Fraud insurance is NOT a sustainable business model

Chargeback guarantee companies have very publicly faced challenges from declining margins. For example, one publicly traded vendor saw margins drop from 53 percent to 46 percent year-over-year as they began insuring merchants operating in higher-risk industries.

It’s reasonable to point out that "margins are the provider’s problem; what does that have to do with me, the merchant?" Well, the merchant needs their provider to be healthy and stay in business for continuity. When facing financial pressures, the provider will need to reduce costs to maintain margins. That means less investment in customer service and success, and less investment in research and development, which slows innovation.

The bottom line is that the merchant is banking their financial stability on the health of their solution provider, so they should ensure they’re aligning themselves with a market leader that has strong fundamentals. Fraud insurance providers lack a long-term business model, and the merchant should not absorb that risk.

This myth has a lot to unpack since it is so widely trafficked. With the pros and cons of chargeback guarantees vs. uncovered agreements in mind, merchants should decide which will be more effective at helping them not only meet fraud prevention goals, but also align with their business objectives. 

Ultimately, most merchants would benefit from a provider that offers the flexibility to begin on a chargeback guarantee and eventually shift to an uncovered agreement over time, minimizing chargebacks while maximizing revenues. 

Image Credit: FuzzBones/Shutterstock

Aaron Begner is General Manager EMEA at Forter.