An actuary can improve gift card liability estimation

When looking at the unpaid claim liability of a company, estimating the liability related to outstanding gift cards can be significantly more complex than estimating other more “typical” liability exposures such as workers’ compensation, general liability, or auto liability. However, gift card liability is often analyzed without the support of any standard industry-wide methodology or the third party expertise often required by auditors for other more traditional liability items. In addition, due to the amount of data available and the varieties of consumer behavior, in-house processes can be time consuming, tedious, and unnecessarily complex.

Companies in many different industries may have exposure falling under the umbrella of gift card liability, but there’s no one-size-fits-all solution. Even the term is unique to each individual company. An airline voucher is likely to be used very differently than a gift card for gasoline. A fast-food chain may have a very different gift card use profile than a fine-dining restaurant. An amusement park may have to look at its gift card liability separately for anything purchased on site, versus those purchased externally as gifts, and further for arcade tickets. It’s important to make sure the estimation process is done in a way that accounts for the unique characteristics and intricacies of the individual company.

Terminology and characteristics

There are three crucial concepts associated with gift card consumer behavior: activation, redemption, and breakage.

• Activation refers to the date the gift card value becomes a liability or accounting transaction. This is typically the date the end consumer purchases the gift card.
• Redemption refers to the amount of the gift card that is used for a purchase. It can be thought of on a current basis, as the amount used to date, or on an ultimate basis, including any amount that will be used in the future.
• Breakage refers to the estimated amount of the gift card balance that will never be redeemed and is calculated as the Activation amount, less the Ultimate Redemption value.

Figure 1 shows a hypothetical redemption curve as a percentage of activations. Note that because of the differences in gift card liability use mentioned above, there’s no single industry-standard redemption curve that will be applicable to all programs.

Some gift cards will be redeemed relatively quickly, but some may be used at a much later date, or ultimately not used at all. We all know that drawer in the house that collects forgotten gift cards, only to be pulled out during a spring cleaning or on moving day. The redemption curve typically never reaches 100% due to those gift cards that are forgotten and never redeemed (breakage rate). The exception to this would be the existence of an expiration date, which would shorten the tail and allow for balances to be ultimately written off with certainty at a future date. However, the use of expiration dates on gift cards is illegal in many states.

In Figure 1, the curve plateaus at roughly 90% after six years. Without the presence of an expiration date it is possible for gift cards to theoretically be redeemed until the end of time. However, the value of gift cards that will ultimately be redeemed after the first several years are minimal. The point in time when this occurs can be estimated by looking at the historical gift card usage of the company. Assuming this company hypothetically has minimal redemptions beyond six years, the redemption curve implies a breakage rate of 10%. In other words, approximately 10% of activated gift cards will never be redeemed. The 10% breakage rate can then be used as support for a lower booked gift card liability during discussions with auditors.

Estimation process and actuarial methodology

A company’s historical activation and redemption data can be analyzed to determine redemption patterns based on its specific consumers’ behavior. The actuarial methods used are very similar to generally accepted reserving methods for more standard liability exposures, which helps when explaining the process to auditors for their approval. In this paper, we focus on three methods:

The results of each method are then weighed to estimate a final ultimate breakage for each activation period. Performing multiple methods and then selecting final estimates based on judgement and actuarial expertise is typical practice for standard liability reserve analyses as well.

Considerations and potential pitfalls

Each method is organized by an activation period. The most appropriate activation period to use can vary in length depending on consumer behavior and availability of data. Analyzing activations and redemptions on a yearly basis can be appropriate if consumer behavior is relatively consistent throughout the year. However, if consumer behavior varies throughout the year, performing an analysis on a quarterly or even monthly basis may be more appropriate. For example, a retailer may sell significantly more gift cards in Q4 around the holidays, with most redemptions occurring in Q1 of the following year. This pattern would be hidden if yearly activation periods were utilized.

In addition to the activation period, how to bucket the data should also be considered. For example, consumer behavior may vary by different sales and distribution channels, such as cards sold directly to the end consumer versus those sold through a third party. Or perhaps a wide range of gift card denominations are sold, prompting a shift in consumer behavior as the denomination increases.

Consumer behavior is also likely to have been impacted by the COVID-19 pandemic. Redemption rates decreased dramatically for many industries during calendar years 2020 and 2021, particularly in service industries such as restaurants and personal care. The question of whether this impact will mean gift cards will be used less overall when all is said and done, or if the redemption has simply been delayed, is an important impact to consider. Regardless, the redemption curve is unlikely to look the same as in previous activation years.

Get an actuary involved!

An actuary can help improve the estimation of gift card liability in two ways: either by reviewing in-house processes or by completing an independent full review.

With a review of the existing in-house process, an actuary can evaluate whether methodologies and assumptions are reasonable and appropriate from an actuarial standpoint. An in-house review can also evaluate efficiency and provide suggestions for areas of improvement.

An independent full actuarial review has the benefit of outsourcing tedious and time-consuming processes, and the potential for a complete program overhaul. Companies often find that the most valuable outcome of a full review is the third-party independence of the resulting estimate in the eyes of the auditor. Any conflict of interest is removed, and the actuary can communicate directly with the auditor to answer any questions as well. This frees up time of company employees, who can then focus on other tasks and goals.

Because of the actuary’s big-picture perspective, an independent full review often results in smoother results between evaluations. The actuary’s ability to look at the process with a fresh set of eyes can result in new ways to look at the process that had not been considered previously. Any simplification may also allow for more frequent, and thus responsive, results throughout the fiscal year.

Lastly, a full review has the potential to impact the bottom line on a company’s balance sheet. In-house methodologies and assumptions may not be appropriate and therefore may under- or overestimate the breakage rate. If the breakage rate is too low, the booked gift card liability may be too high, leaving money on the table that could be allocated elsewhere. If the breakage rate is too high, the booked gift card liability may be too low, leaving a company financially vulnerable. An actuarial review can help ensure a company is adequately, but not redundantly, reserved.

Conclusion

Gift card liability estimation is often an overlooked in-house process. But with the help of an actuary there is potential for a big impact to the use of company resources and the overall bottom line. Including an actuary in the review process is a great way to utilize an outside consultant to streamline processes and add confidence to company financials.