Loopback Group Policy Explained

Loopback group policy are used to apply user configuration settings on the computer. The loopback policy comes to rescue when you want to apply users configuration settings to the computer irrespective of what what users are login to the particular system.There is two mode basically one is Replace and other Merge mode.  When you select replace mode in the loopback GPO, computer and user configuration configured in that OU will be applied irrespective of the which OU user belongs to and what user configuration GPO has defined in that OU. When you select Merge mode, user and computer configuration configured in the loopback GPO as well as user configuration GPO for the user belongs to the different OU will be applied. In case of conflict user configuration from the loopback GPO will win.

http://social.technet.microsoft.com/wiki/contents/articles/windows-server-understand-user-group-policy-loopback-processing-mode.aspx

Loopback policy is very effective GPO setting, but it requires proper understanding & planning,before it can be implemented in the live environment. I always believe without proper understand or something new to be tried has to go via lab testing else your production environment will become testing environment and can cause serious business loss to the clients. For testing,create a independent lab which can be either using virtual PC or VMware software. Always, test the GPO before applying to the production because reverting the changes requires time and may not be as simple as applying.

Additional references to help you better understand.

http://technet.microsoft.com/en-us/library/cc782810%28WS.10%29.aspx

http://cbfive.com/blog/post/Demystifying-Loopback-Policy-Processing.aspx

http://kudratsapaev.blogspot.in/2009/07/loopback-processing-of-group-policy.html