Chargeback fraud: What are chargebacks, and how can businesses prevent them?

The global rise of e-commerce as a result of the coronavirus pandemic meant more consumers shopped online than ever. But the rapid shift to e-commerce didn’t just increase online sales. It also increased criminal and friendly fraud, which increased chargeback fraud consequences for businesses.

By 2022, 66 billion transactions will produce 33 million disputes from fraud, authorization failures, processing errors, and consumer disputes, Mercator Advisory Group estimates. It’s important to note that chargebacks aren’t limited to certain industries or business sizes. They can impact a business at any time and significantly reduce revenue.

So let’s explore what a chargeback is, the types of fraud that lead to chargebacks, and the direct and hidden costs of chargebacks. Then we’ll look at chargeback fraud consequences and fraud monitoring programs, best practices for chargeback prevention, and chargeback solutions for merchants.

What are chargebacks?

A chargeback is the reversal of a credit card charge by a customer’s bank or payment processor, and it’s usually the result of a customer dispute. When a customer sees an unfamiliar charge on their credit card statement, they may call their bank to dispute the charge.

In most cases, the bank sides with the customer, refunds the charge, and processes a chargeback against the merchant. And in card-not-present (CNP) transactions, the business bears the financial impacts of repaying the customer and faces fees from the issuing bank.

A chargeback rate is a calculation of a business’s number of chargebacks against its sales volume. Businesses can divide their total chargebacks per month by their number of transactions in that month. Let’s say a business processes 1,000 transactions and experiences 50 chargebacks in a month. That business’s chargeback rate is .05%.

Number of chargebacks in a month ÷ Number of transactions in the same month = Chargeback rate

Unfortunately, there is an inevitable delay between processing a chargeback and the date of a transaction. For example, Visa divides last month’s chargebacks by this month’s transactions.

So if a business saw big sales — and normal chargebacks — in one month, those chargebacks are calculated against the next month’s sales. So the business could show an unusually high chargeback rate and incur higher fees as a result.

Types of fraud and activities that lead to chargebacks

Chargeback fraud prevention can be difficult because it’s hard to identify the type of fraud that resulted in the chargeback.

Identifying and segmenting the types of fraud that lead to chargebacks can help mitigate challenges, improve operations, and increase revenue.

The three types of fraud that lead to chargebacks are

1. Criminal fraud
2. Friendly or accidental fraud
3. Legitimate disputes

Criminal fraud occurs when bad actors use stolen credit card numbers to purchase goods and services fraudulently. Businesses that want to prevent chargebacks pre-authorization will want to reduce criminal fraud.

Friendly fraud — or accidental fraud — occurs when a customer makes a legitimate purchase but doesn’t recognize the charge on their bank statement. Not all cases of friendly fraud are accidental.

Customers commit intentional friendly fraud when they find ways to abuse company policies or keep products without paying for them.

For instance, almost 25% of consumers in Kount’s holiday shopping trends survey say they’ve bought an item, used it once, and returned it for a refund. And nearly another third say they’ve sought a refund for a gift that didn’t have a receipt.

Addressing pre-authorization criminal fraud will make it easier for businesses to address chargebacks post-authorization and prevent friendly fraud.

Legitimate disputes, while not a type of fraud, lead to chargebacks. Legitimate disputes occur when customers experience problems with merchants.

In these cases, businesses may misplace orders or make errors in order processing or shipping. Any error in the customer’s experience can lead to legitimate disputes and chargebacks.

How the dispute and chargeback process works

The dispute and chargeback process, while quick for some customers, can be lengthy and expensive for businesses, especially as compelling evidence requirements change.

Businesses can use dispute and chargeback management tools to expedite the process. Otherwise, the chargeback process follows a seven-step cycle that can take anywhere from four weeks to 90 days to complete.

1. A customer, for any number of reasons, doesn’t recognize a charge on their credit card statement. The customer contacts their issuing bank to dispute the charge.
2. The issuing bank reviews the customer’s dispute. The issuing bank may deny the claim. But it’s more likely that they’ll accept it.
3. Siding with the customer, the issuing bank takes the cost of the CNP transaction plus additional fees out of the business’s merchant account. The issuing bank refunds the customer’s money, satisfying the customer.
4. The issuing bank records the chargeback information and relays it to the business’s acquiring bank.
5. The business’s acquiring bank reviews the data and either resolves the issue or notifies the business.
6. If the acquiring bank forwards the chargeback to the business, the business can accept the chargeback or dispute it back. But it’ll have to provide evidence that the customer made a legitimate purchase. Providing evidence can be difficult if the business doesn’t have enough information to determine which type of fraud led to the customer’s dispute.
7. Evidence in hand, the acquiring bank represents the business’s chargeback dispute to the customer’s issuing bank. If the issuing bank sides with the business, it returns the transaction amount to the merchant account. If the issuing bank sides with the customer, the chargeback stands, and the business can pursue arbitration. In some cases, the issuing bank sides with the business but files a second chargeback if new information further supports the customer’s dispute.

Double-refund chargebacks defined

The chargeback and dispute process gets even lengthier when businesses experience double-refund chargebacks. Let’s say a customer doesn’t recognize a transaction due to criminal or friendly fraud. They might go to their bank and the business.

In an effort to help the customer, the business refunds their money without question. But by then, the customer’s bank has already issued a chargeback against the business and returned the customer’s money from the business’s merchant account.

In a double-refund chargeback, the business loses twice as much from the sale because the customer has been refunded twice. To correct the double-refund, the business would then have to engage in the representment process.

Unfortunately, even if a business is successful in disputing every chargeback, customer disputes can still count against them. That’s why businesses must understand how different types of fraud affect them — and their dispute and chargeback rates.

The direct and hidden costs of chargebacks

The negative effects of chargebacks are more than just the chargeback itself. Chargebacks have direct and hidden costs. To avoid losses, businesses must first understand all chargeback costs.

7 direct costs of chargebacks

1. Lost merchandise
2. Chargeback fees
3. Shipping costs
4. Potential credit card penalties
5. High transaction fees
6. Network termination
7. Operational costs

7 hidden costs of chargebacks

1. Manual reviews
2. Wasted labor
3. Lowered bank authorization rates
4. Opportunity costs
5. Customer acquisition costs
6. Brand loyalty
7. Customer friction

Businesses whose chargeback rates exceed a card brand’s defined thresholds-now-what">chargeback threshold incur additional monthly fees until they get their chargeback rate under control. Monthly penalties vary by card processor and depend on the number of consecutive months a business’s rate exceeds the threshold.

The higher the chargeback rate, the higher the fees and penalties. Excessive chargebacks can lead to the termination of a merchant account, which can force a company out of business.

Chargeback fraud consequences: Fraud and dispute monitoring programs

When businesses don’t keep their chargeback rates under the card brand thresholds, card brands place them in fraud or dispute monitoring programs. Card brands design these monitoring programs to compel merchants to reduce chargeback fraud or dispute levels.

Visa and Mastercard’s monitoring programs are the most common, and each has protocols for businesses that need to get their chargeback rates under control. In either Visa or Mastercard’s programs, businesses are subject to fees if they can’t get their fraud or chargeback rates below the thresholds.

But the biggest consequence of chargebacks and fraud for merchants is losing their account with a card brand. When that happens, the merchant can no longer accept payments from that brand, damaging both sales and customer experiences.

Visa’s Dispute Monitoring Program (VDMP) and Fraud Monitoring Program (VFMP)

By accepting Visa cards at the point of sale, merchants are responsible for controlling and preventing their own fraud incidents. Those that can’t may be subject to Visa’s monitoring programs.

Under the VDMP, Visa can monitor merchants that generate excessive disputes. The VDMP has two program timelines: the standard timeline and high-risk or excessive dispute timeline. To stay out of the VDMP, businesses must keep their dispute-to-sales rate below .9%.

Merchants in the VFMP generate an excessive level of fraud activity. They have $75,000 in fraudulent transactions or have a fraud-dollar-to-sales-dollar rate over .9%.

Visa monitors merchants in the VFMP according to the standard and high-risk or excessive timelines. Visa releases merchants from fraud monitoring programs when they don’t exceed program thresholds for three consecutive months.

Mastercard’s Excessive Chargeback Program (ECP)

Mastercard places businesses in the ECP according to their number of chargebacks and calculated basis points (i.e., the number of chargebacks in a given month divided by the number of transactions processed in the previous month).

The Mastercard monitoring program classifies businesses with over 100 chargebacks per month and 150 basis points as Excessive Chargeback Merchants (ECM). Mastercard classifies businesses with over 300 chargebacks and 300 basis points as High-Excessive Chargeback Merchants (HECM).

Businesses in either classification are subject to non-compliance assessments after their consecutive or nonconsecutive second month in the ECP. Mastercard releases businesses from the program after they’ve stayed below program thresholds for at least three months.

Mastercard’s Fraud Monitoring (EFM) program

Businesses are subject to the Excessive Fraud Merchant (EFM) program, when they meet the following criteria:

• They process at least 1,000 e-commerce Mastercard payments.
• They experience at least $50,000 in fraudulent transactions.
• They have at least 50 basis points in fraud-related chargebacks.
• They’re located in a non-regulated country, and the percentage of their clearing volume processed using 3DS is 10% or lower. Alternatively, they’re located in a regulated country, and the percentage of their clearing volume processed using 3DS is 50% or lower.

Mastercard releases businesses from the program when they don’t exceed program thresholds for at least three consecutive months. The longer a business stays in the program, the higher its fees and non-compliance assessments. Fees start at $500 in month two and can be as high as $100,000 by month 19.

Digital payments survey reveals chargeback fraud challenges

Kount’s “Digital Payments in 2021” survey revealed chargeback risk statistics that show over half of businesses said their chargeback rate has increased since March 2020. Among respondents, 47% estimate their current chargeback rate is between 0.6% and 1%.

And a third estimate their chargeback rate is at least 1.1%. Compare that to Kount's 2018 State of Chargebacks report, wherein 18% of businesses estimated their chargeback rate was between 0.6% and 1%.

The 2018 report found that businesses’ top chargeback challenges included disputing chargebacks, identifying friendly fraud, and reducing chargeback rates. But in 2021, businesses say their top challenges are all in chargeback prevention strategies.

32% of respondents say a lack of experience with chargeback prevention is their company’s top chargeback challenge. 22% say a lack of chargeback prevention strategies is their company’s top chargeback challenge. And 17% of respondents say not enough resources to dispute chargebacks is their company’s top chargeback challenge.

4 best practices for chargeback fraud prevention

Preventing chargebacks isn’t a once-a-month task or a discrete event that takes place at a single point. There are several chargeback interception catch points where businesses can take action to reduce chargebacks and avoid product losses and fees.

1. Stop criminal fraud pre-authorization

Chargeback fraud prevention isn’t just about reducing chargebacks. It’s about avoiding chargebacks altogether by stopping criminal fraud. Taking an anti-fraud approach to chargebacks is the best way to avoid chargebacks, fees, and monitoring programs.

Businesses can stop bad transactions pre-authorization with a fraud protection solution that links identity trust signals like email addresses, shipping addresses, and device IDs to verify the customer’s level of digital identity trust.

Businesses can use these fraud and trust-related signals with advanced AI and supervised and unsupervised machine learning to automate approval and decline decisions. Automating decisions can help businesses reduce manual reviews and approve more good orders.

From there, they can pair AI fraud solution with customized business policies. They can base these policies on individual risk thresholds for the most accurate risk assessment.

2. Intercept and deflect friendly fraud cases post-authorization

Businesses can avoid friendly fraud chargebacks with a solution that intercepts and deflects friendly fraud disputes. A friendly fraud solution notifies them when customers initiate disputes.

Knowing about a dispute when it happens means businesses can step in to refund purchases or communicate purchase details to customers.

In cases of friendly fraud, customers make legitimate purchases but don’t recognize them on their bank statements. Businesses can reduce unnecessary payment disputes by allowing issuing banks to request information that can help cardholders recognize unfamiliar transactions.

Plus, a friendly fraud solution can help businesses gain insights from transaction and chargeback data. This data is essential for improving risk assessment and reducing false positives.

3. Win chargeback representments

Unfortunately, 39% of shoppers initiate more disputes now than in 2020, according to a recent infographic. Businesses that want to prevent chargebacks from damaging their businesses can engage in the chargeback representment process.

To win at representment, businesses will need two things: robust data from all customer transactions and experts who can help them understand their fraud and dispute rates.

Fraud prevention solutions that integrate with or offer chargeback management services can reduce the cost of chargeback disputes. The data they provide can help businesses provide sufficient evidence to acquiring banks in representment, improving win rates.

Successful representment requires expertise that few online businesses can afford to maintain. Working with third-party providers that integrate with fraud prevention solutions can help businesses avoid chargebacks by preventing them from occurring in the first place.

4. Update business policies to avoid legitimate disputes

Customers may initiate legitimate disputes for many reasons. Maybe they didn’t receive what they ordered, received a product they weren’t expecting, couldn’t easily return a purchase for a refund, or had a bad experience with customer support. Each of these occurrences can lead to chargebacks.

Businesses can reduce legitimate disputes by assessing their refund and return policies and customer support protocols. Businesses that don’t know how these experiences are for customers should place an order, try to process a refund or return, or place a call to the service department. Doing everyday tasks that customers experience can reveal areas for improvement that can prevent legitimate disputes.

20 essential components of a complete chargeback fraud protection solution

An enterprise-level fraud solution can dramatically reduce chargebacks. But only if it includes an advanced suite of tools. Chargeback prevention is just the beginning of what a robust fraud prevention solution can accomplish.

From a global network of fraud and trust-related signals to AI-driven fraud detection, here are 20 essential components of a chargeback fraud protection solution:

1. A global network of trust and fraud-related signals
2. An advanced AI engine
3. Unsupervised machine learning
4. Supervised machine learning
5. A customizable policy engine
6. The ability to create, edit, and test business policies
7. A real-time, accurate safety score for each transaction
8. A case management hub
9. The ability to automate approve and decline decisions
10. Self-service analytics
11. Robust reporting capabilities
12. A chargeback alert solution that works with major card brands
13. A chargeback alert solution that notifies businesses when a customer initiates a dispute
14. The ability to communicate purchase details with card brands and customers
15. The ability to refund purchases from disputes quickly
16. The ability to stop the shipment of goods quickly
17. Advanced analytics tools that allow businesses to find trends and patterns in customer disputes
18. The ability to change fraud policies according to dispute data
19. Link analysis that can identify other instances of fraud
20. Multi-factor authentication protocols

Establishes identity trust for end-to-end chargeback fraud prevention

Kount’s merchant chargeback protection can reduce chargebacks dramatically while preventing fraud across the customer journey. Kount’s fraud solutions are built on the Identity Trust Global NetworkTM to uncover the true level of trust behind each interaction.

Kount’s is the largest data network of trust and fraud-related signals. It drives quick and accurate trust decisions and links signals from payments data, location data, digital identifier data, and unique customer data.

From account creation or login to loyalty points redemption and checkout, Kount’s global network analyzes billions of data points to establish real-time links between identity elements. This analysis returns identity trust decisions, approving high-trust interactions, declining high-risk interactions, and reducing chargebacks per-authorization from criminal fraud as a result.

Kount’s post-authorization chargeback protection intercepts disputes from friendly fraud-related reason codes. In some cases, merchants can act on dispute inquiries and chargeback alerts automatically from one dashboard.

Businesses can deploy Kount’s chargeback solutions based on business needs, resources, and budgets. And they can adapt it to establish policies that meet unique business needs and risk thresholds. In the end, businesses can address emerging fraud attacks, new use cases, and chargebacks from criminal and friendly fraud.