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From Adviser Guide: Updated Risk profiling

Q: What are the FSA’s risk assessment requirements?

The FSA remains concerned about the high number of unsuitable investment sales it sees in the pension and investment market.

By Emma Ann Hughes | Published Apr 18, 2012 | comments

The FSA’s Assessing Suitability paper is a must read for advisers and identifies some hot-topics that advisers should consider when assessing attitude to risk.

* How robust is your process for assessing the risk a customer is willing and able to take, including their capacity for loss?

* Does your process appropriately interpret responses to questions or does it attribute inappropriate weight to certain answers?

* Do all parts of your process pass the ‘clear, fair and not misleading’ test – especially questions and risk descriptors?

* Do you have a robust process for ensuring investment selections are suitable that considers customer’s objectives and financial situation as well as their knowledge and experience?

* Do you understand the nature and risks of the products or assets you have selected for customers?

* Have you sufficiently engaged the customer in the suitability assessment process?

According to Paul Resnik, co-founder of FinaMetrica, the FSA’s view is that the industry-standard approach to risk profiling, which is to use a portfolio-picker questionnaire, is no longer acceptable.

Mr Resnik said: “These short cut quizzes conflate information about parameters that should be considered independently into a single score that leads directly to a portfolio recommendation.”

* A recurring concern in the guidance is that firms fail to adequately assess capacity for risk as well as attitude to risk. Vaughan Jenkins, director of Bluerock Consulting, said: “Risk capacity is not only about withstanding a capital loss but also the potential effects on income.

“The FSA will be looking for this to be covered in suitability assessments but in such a way that information is not conflated to produce muddled outputs (for example, jumbling risk capacity, investment horizon and attitude to risk incoherently).”

* Risk questionnaires need to be easy to understand and unambiguous (both in terms of the questions and the answers provided).

Firms will also need to consider whether they require multiple attitudes to risk (in relation to specific goals, for example) or a single overall attitude to risk profile.

* Terminology regarding levels of risk needs to be reviewed and changed if necessary.

Mr Jenkins said: “Terms around reasonable or moderate risk were a particular cause for concern, and profiling tools must cater for loss averse customers.

“Several recommended model portfolios we have seen do not actually map back to those clients stating that they do not want to place any capital at risk.”

* The FSA suggests descriptions should clearly quantify the level of risk.

Mr Jenkins said: “This may seem to conflict with its warning that the profiling process should not assume an unreasonable level of mathematical ability.”

Good practice examples provided include the use of simple diagrammatic representations of relative risk.

The FSA warns against relying solely on volatility as a proxy for risk.

Firms must also take into account inflation risk, liquidity risk; the impact of interest rate changes and a lack of diversification.

* While automated tools and model portfolios have become more common place, firms must match their profiling and recommendations together in a robust system.

* Advisers (and providers) are required to understand the underlying assumptions and mechanisms in the tools that they use.

Mr Jenkins said: “This is a significant challenge for even large bancassurers let alone small IFAs as understanding the assumptions and inner workings of Monte Carlo simulations is very complex.

“Life offices have tended to rely upon actuarial consultants to validate both their asset allocation models and the relationship to suitable fund choices.

“The line of sight from attitude to risk to model portfolio through to specific product recommendation is at the centre of the FSA’s concerns.”

Firms are required to monitor changes in attitude to risk over time and should analyse the risk profiles being derived relative to expectations for the customer base.

There must be a feedback loop to ensure suitability and recalibrated processes if required.

* The FSA guidance does recognise the customer’s attitude towards risk and capacity to sustain loss may be incompatible with the customer’s needs and objectives.

Mr Jenkins said: “The key point here is to clearly define the gap; the consequences of this and to record how the customer may have come to accept a different level of risk as a result of this analysis.”

* Mr Resnik, co-founder of FinaMetrica, said: “Provided advisers can demonstrate that they act to ensure clients are able to make informed decisions then clients are responsible to the extent that the adviser has: 1) properly informed the client about strategic alternatives,

2) allowed the client to make a free choice between those alternatives,

3) recommended/selected only products/services that are fit for the alternative’s purpose, and properly implemented the recommendation/selection.”

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