Merchant Account Risk and Underwriting

Credit card processing especially for ecommerce has very complex risks and it is different for every business. There are a number of factors that can help determine the level of risk for a merchant; merchant’s longevity, industry, business model, products and services offered, financial stability and processing history are just a few to be pointed out. Risk Management guidelines and basic underwriting processes are very similar throughout the industry.

 

A Line of Credit

Risks are always present in ecommerce as merchants typically collect payments before the products or services are provided to customers. As an aid, merchants usually provide some type of quality assurance to their customers, e.g.  Products will be delivered within 5 working days, can be returned/exchanged, money back guarantee, etc. Therefore, the risk born by a Merchant Account Provider is the same as providing a line of credit.

However, when a merchant sells a product or service that they cannot or do not deliver, deliver poorly, or that is defective in some way, and the business cannot fix the situation with their own financial resources, then the Merchant Account Provider has to bear all the chargebacks, penalties, and losses. Merchant Account Providers make from very low margins in the payments industry, thus the risks are thoroughly screened and monitored closely.

 

Company longevity and financial stability

This is one of the main factors underwriters will look into when considering an application. For easier and quicker approval, merchants generally have to be experienced, good and stable financial resources, and produces good profitability. There are some merchants who like to exaggerate in their application, not knowing that they are only increasing the risk involve. For example, a new company who wants to process $1,000,000/month in credit card volume with only $10,000 in their company bank account, unprofitable businesses, high debt to equity ratio, and high deferred revenue. These factors do not prevent a merchant from getting a Merchant Account, it just elevates the risk in the application.

Besides looking at the company’s information and credentials, underwriters will also look into the principal or owner’s credit worthiness. Some providers will request a personal guaranty from business owners to prevent bad behaviour and to also safeguard themselves from any harsh penalties. This usually takes place for new businesses or businesses with very little credit history.

 

Industry

In the ecommerce business, businesses are typically categorized by their risks. The industry risk profiles have very well been identified over years or processing by millions of merchants. For example, a restaurant business is measured to be one of the lowest risk merchant industry, having  an average loss ratio of less than 1 basis point (100 basis points is equivalent to 1%). Now compare this with a high risk business like travel or gambling, the average loss ratio could be about 10 times higher compared to a restaurant business. Let’s have a look at some example business types by risk levels:

Low Risk – Restaurants, toys, books and most retailers

Medium Risk – health and beauty products, telecommunication services, tuition for schools or universities, attorneys (excluding bankruptcy), utility payments, political organizations

High Risk – Monthly memberships/subscription services, pharmacy, computer softwares, advertising services

Very difficult to underwrite – Online auctions, travel and accommodation, health or nutrition products offering guaranteed or miracle results

Typically prohibited by most providers – Debt collection agencies, firearms or weapons, bartering, prescription medication or drugs

 

Billing Method

How a merchant accepts payment from their customers can determine the level of risk of their business. Accepting payments in advance typically increases risk; the farther in advance payment is collected, the higher the risk. For example, if a merchant sells annual subscriptions and goes out of business during month 6, the merchant account provider has 6 months’ worth of financial liability. Therefore, merchant account providers would want to ensure that the merchant has financial strength before they grant the merchant an account.

Another method to reduce risk is to accept payments after the product or service has been delivered. Telco companies make a very good example for this, where they bill their customers only at the end of the month.

Some merchants also accept payments gradually. Customers will have their payment locked down and the merchant will gradually accept payments as the services are provided. Since there is no expiration date on the time the money must be used, the risk involved in this method is also low.

 

Merchant Account Provider Risk

There are many merchant account providers in the ecommerce world. There are some providers that may approve certain merchants without having proper risk assessment. On the other hand, there are some providers who are really good in determining the risk of a merchant. When a provider does not assess the risk of a merchant properly, the acquirers may flag the merchant for risk after approval, and may further revise the discount rate, charge a higher and longer reserve, and may also discontinue the account with the merchant.