Cherry-Pick Profitable Customers by Understanding Unfavorable Selection


Executives have valuable lessons to learn from the botched rollout of the Affordable Care Act (ACA), and not just from the pretty obvious point that you want to thoroughly test your website before going live. Website functionality issues will go away, but their existence now could contribute to a longer-term and more serious danger to ACA, a danger all businesses want to avoid.

Difficulties in purchasing insurance on Healthcare.gov will deter some people from purchasing insurance. One of the concerns is that people who are sick, and know insurance is very valuable to them, will persevere with enrollment, while relatively healthy people will be particularly put off by the hassle of the website. This could shift the risk pool of policyholders to a higher risk / cost group. Known to economists as “adverse selection”, the worst-case scenario is that it could actually kill the ACA through what is called a “death spiral”.

Just like bad risk leads to higher prices, which leads to higher risks, which leads to higher prices, etc. These companies have learned the hard way about product death spirals.

A good example of this was American Airlines’ attempt to lock out its best customers when it introduced the Airpass in 1981. Priced at $ 250,000, the Airpass offered unlimited first class travel on the airline for life. . For an additional $ 150,000, the buyer could bring a companion on any flight he took. For the most frequent of frequent flyers, it turns out that it is not that difficult to browse a few hundred thousand dollars of tickets at first-class prices. So while Airpass buyers were frequent fliers, they ended up being such frequent fliers that they saved a lot of money compared to paying for each flight. Some Airpass holders have flown so much in a month that the purchase of the tickets would have cost $ 125,000.

Bob Crandall, CEO of American for much of the Airpass life, admitted, “We originally thought this would be something companies would buy for the best employees. It soon became clear that the audience was smarter than us. “

So what did American Airlines do? They have increased the price of the Airpass. But then only the people who used it even more than the original group bought it. The cost of serving customers was increasing as quickly as the price was increasing because the customer base became more and more expensive. After several price increases reaching $ 1 million for an AAirpass, they gave in to the inevitable death spiral and stopped offering the offer.

There is a more positive side to adverse selection, however, if you can find a way to select the most profitable customers from competitors who cannot narrow their products enough. In fact, this strategy has led Capital One’s credit card business to grow from a third-rate player to a market leader.

You might know Capital One as the company with the stupid Viking commercials. But the story of Capital One, now a huge provider of credit cards and other financial services, began as a lesson in using adverse selection to its own advantage. Capital One was founded in 1988, when Richard Fairbank convinced a small regional bank to experiment with its credit card unit. At that time, just about all credit cards issued in the United States had the same interest rate on overdue balances. Annual fees were comparable between cards. Fairbank believed it could generate higher profits by matching fees and interest rates to the risk of cardholder default.

After several unsuccessful experiments, Capital One found the gold (and its competitors got stuck with the opposing selection) by offering the first balance transfer program. Capital One would pay off the person’s credit card debt and charge the new customer little or no interest for the first year (after which interest rates would rise to the market rate).

An important thing to know about the credit card industry is that the most profitable customers are those with balances who don’t default. Balance transfers, at least in 1988, attracted credit card customers that had both of these attributes. A customer wouldn’t have a balance to transfer if she didn’t have one on her credit card and wouldn’t bother to transfer a balance she didn’t intend to pay off. As a result, Capital One was able to select the most profitable clients from among the other cards. Customers who paid off their balance in full each month and those who were likely to default did not find Capital One’s balance transfers appealing. But these customers are unprofitable and other banks have been stuck with them – adverse selection at work.

There are probably some enterprising health insurers out there trying to figure out how to select the right risks that don’t bother purchasing health insurance on Healthcare.gov. But the ACA made it difficult. Rules like the individual mandate and the fact that insurers cannot base prices on pre-existing conditions are meant to specifically deter picking and prevent a death spiral. Most companies, however, are freer than health insurance companies to learn from the examples given by American Airlines and Capital One. The leaders of these companies can think strategically about how to select the most profitable customers and, at the very least, not be particularly attractive to the more expensive customers.


Martin E. Berry

Leave a Reply

Your email address will not be published.