**The Space Pen**

We’ve surely all heard the old story of how, during the space race, America invested millions of dollars to develop a pen that could write in the zero gravity conditions of space while the Russian achieved the same goal using the humble pencil. Over the years much of the story has been exaggerated for the sake of its telling but its key lesson has remained the same: where there are two ways of achieving a goal, the cheapest of these methods is best.

In this story the goal was to allow astronauts to write without gravity driving the flow of ink flow through a traditional pen. It could have been achieved using an expensive pen with pressurised ink or, so the story implies, just as easily using a cheap pencil.

**Learnings for Debt Management**

If we were to apply the learnings to our debt management function, doing so would surely back-up the case for implementing a broadly inclusive self-cure strategy: that is a strategy that allows debtors a period of time in which to pro-actively repay their outstanding debt before investing the organisation’s time and money to contact them re-actively to make a direct request for that payment. Since the value of a collections recovery is the same regardless of how it is achieved, it makes sense that the method used to generate that recovery should be the cheapest effective method available. And, likewise, it makes sense that the cheapest method would be the one in which no costs are incurred.

However, by delving deeper into the history of the space pen we find that some caution is required before making that logical leap.

You see, the real story behind the space pen does not end at the same point that the anecdote does. In fact, there are two pertinent points that are seldom mentioned. Firstly, NASA had been using pencils prior to the development of the space pen and had decided they needed to be replaced. Secondly, after the introduction of space pens at NASA, the Russians also started to use them.

Why would both teams have replaced the cheaper solution with a more expensive one if both did the same job? Well it turns out that they had identified several indirect costs of pencil use; broken pieces of pencil lead can pose a risk in a zero gravity environment and the wood is flammable.

So the key lesson of the story remains true: the cheapest affective method to solve a given problem is the best method. However, the measurement of ‘cheapest’ must include all direct and indirect costs. This is true as much for a debt management function as it is for the space programme.

When designing a comprehensive self-cure strategy therefore, a lender must understand both is expected benefits and its direct and indirect costs before deciding who to include and for how long.

**Estimating the Expected Benefits of a Self-Cure Strategy**

The expected benefit of a self-cure strategy is simply the expected number of payment agreements to be achieved as a percentage of all customers in the strategy – or the probability or payment.

A standard risk based collections strategy will segment customers into a number of risk groups each of which can then be treated differently. As a natural product of this, each of these groups will have a known probability of payment based on their observed behaviour over time. But it is important to take care when using these numbers in relation to a proposed self-cure strategy.

The probabilities of payment associated with the existing risk groups inherently assume that each account will proceed through the current debt management operational strategies as before. By making that assumption invalid, you make the numbers invalid. The expected benefit of a self-cure strategy can therefore not be assumed to be equal to the currently observed probability of payment; they actual probabilities of payment will likely be significantly lower.

Therefore, early iterations of a self-cure strategy should include a number of test-and-learn experiments designed to determine the probability of payment under a self-cure strategy. A good starting point is to allow a test group a very short self-cure period – perhaps just two or three days. In many organisations this amounts to little more than de-prioritising these accounts so that the time taken to work through the rest of the accounts can serve as the self-cure period. Once the basic risk assumptions have been tested, the self-cure period can be extended – though usually to not longer than fifteen days.

It is also important to note that the probability of payment must not be measured as a single, static figure. The way it will be applied in the eventual self-cure model means that it is important to measure how the probability of payment changes over time.

Some customers in the early stages of debt management will be ‘lazy payers’, that is customers who have the will and means to meet their obligations but tend to pay late on a regular basis; their payments will likely come in the first few days after the due date. Other customers may have been without access to their normal banking channels for whatever reason; their payments may be more widely spread across the days after due date. Regardless of the exact reasons, in most portfolios the majority of self-cure payments will come in the first few days after due date and thereafter at an ever-slowing rate.

**Estimating the Costs of a Self-Cure Strategy**

If there were direct costs involved in a self-cure model, there would be a break-even point where the dropping effectiveness and the ongoing costs of the strategy would make it inefficient to continue. However, because a self-cure strategy has no such direct costs the problem needs to be looked at differently.

But, as I mentioned earlier, a valuable lesson can be learned by following the story of the space pen all the way to its real conclusion: the total cost of a solution is never its direct costs alone but also includes all of its indirect costs. In the space race, the pencil’s low direct cost was nullified by its high indirect risk costs. In debt management, a self-cure strategy’s low direct cost may also be nullified by its high indirect risk costs.

The indirect risk costs of a self-cure strategy stem from the fact that the probability of making a recovery decreases as the time to make a customer contact increases. Customers who are in arrears with one lender are likely to also have other pressing financial obligations. While the one lender may follow a self-cure strategy and hold off on a direct request for repayment, their debtor may re-prioritise their funds and pay another, more aggressive, lender instead. So, while waiting for a free self-cure payment to come in a lender is also reducing their chances of making a recovery from the next best method should it become clear at a point in the future that no such payment is likely to be forthcoming.

The cost of a self-cure strategy is therefore based on the rate at which the probability of receiving a payment from next best strategy decreases. For every day that a self-cure strategy is in force the next best strategy must start one day later and this is the key cost to bear in mind. Is one week of potential cheap recoveries from the self-cure model worth one week of opportunities lost for more expensive but more certain recoveries in the phone base collection strategy?

**Building a Self-Cure Strategy**

A self-cure strategy should be applied to all accounts for as long as they remain sufficiently likely to make a payment to compensate for the indirect costs of the self-cure strategy incurred by foregoing the opportunity to drive payments using the next best strategy.

As stated, the benefits of the strategy are equal to the probability of payment over a period of time and the costs are equal to the decrease in the probability of payment from the next best strategy over that same period.

If a customer is as likely to make a payment when they are called on day one as they are when called on day five, then there is no cost in a self-cure strategy for those first five days. Therefore, no call should be made until day six regardless of how small the probability of receiving a payment from the self-cure strategy actually is. This is because, with no costs, any recovery made is value generating and any recovery not made is value neutral.

However, if after the first five days a customer who has not been contacted begins to become less likely to make a payment when eventually called, costs start to accrue. The customer should remain in the self-cure strategy up to the point where the probability of payment from the self-cure strategy is expected to drop to a level lower than the associated drop in the probability of payment from the next best strategy.

The ideal time to move an account out of the self-cure strategy and into the next best strategy would be at the end of the period preceding the one in which this cross over of cost and benefit occurs.

*Please note that the next best strategy does actually have a direct cost. Strictly speaking, this direct cost should be added to the benefit of the self-cure strategy at each point in time. However, in the early collections stages the next best strategy is usually cheap (text messages, letters or phone calls, etc.) and so these costs are insignificant. However, if the next best strategy is expensive – legal collections or outsourcing for example – these costs could become a material consideration. For the sake of simplicity I will not include the direct cost of the next best strategy in this discussion but will in an upcoming article covering the question of when to sell a bad debt/ escalate it to legal.*

**Summary**

The cheapest method should always be used to make a recovery in debt management but, before the cheapest method can be identified, all direct and indirect cost must be understood.

I haven’t set out to discuss all the direct and indirect costs of debt management strategies here – not even all the direct and indirect costs of self-cure strategies. Rather, I have attempted to explain the most important indirect costs involved in self-cure strategies and how it can be used to identify the ideal point at which an account should be moved out of a self-cure strategy and into the first lender-driven debt management strategy.

This point will vary based on each customer’s risk profile and the effectiveness of existing debt management strategies. The probability of payment for the next best strategy will decrease faster for higher risk customers than for lower risk customers; bringing forward the ideal point of escalation. The probability of payment will fall slower for more intense collection techniques (such as legal collections) than for soft collections techniques (such as SMS) but costs also vary; the structure of an organisation’s debt management function will also move the ideal point of escalation.

Finally, you might find it strange that I didn’t talk about which clients should be included in a self-cure strategy. The reason is that, in theory, every customer should first be considered for a self-cure strategy. The important part of this statement is that I used the words ‘considered for’ not ‘included in’. Because of the mechanics of the model proposed, higher risk customers may well have an ideal point of escalation that is equal to the day they enter debt management and so, while ‘considered’ for inclusion in the self-cure strategy they won’t actually be ‘included’. At the same time, medium risk customers may be included and escalated after five days while the lowest risk customers may be included and escalated only on the fifteenth day. This will all vary with your portfolio’s make-up and so it is equally possible that no customer group will be worth leaving in a self-cure strategy for more than a day or two.