Your IndustryJun 18 2015

Regulator’s risk assessment requirements

twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Search supported by

The paper is a must read for advisers and identifies some hot topics that advisers should consider when assessing attitude to risk. These include:

• 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; and

• have you sufficiently engaged the customer in the suitability assessment process.

The key point to take away from the regulator’s comments on this subject are that the investment outcome delivered by an adviser’s risk assessment should meet the suitability rules.

In addition, Paul Resnik, co-founder of FinaMetrica, says the regulator has stated that advisers need to be aware of the risk tools they use and are aware of any weakness that they may have.

The tools should therefore be used as part of a compliant investment advice process. He says the regulator wants clients who are advised to make informed decisions regarding investments.

They also want advisers to make informed decisions in the selection of the questionnaires/tools they use, he adds.

To conform to the regulator’s requirements, Mr Resnik says advisers need to be clear on the following key areas:

• ensure the questionnaire/tool they select is fit for purpose;

• understand how to use the questionnaire/tool as part of a compliant investment suitability advice process;

• knowledge of the benefits and the shortcomings of the questionnaires/tools they use; and

• have in place processes to compensate for those weaknesses.

Independence issues

When selecting a risk profiling tool, independence is a key issue regarding risk tool design and development, according to Mr Resnik.

Anecdotally, Mr Resnik says many product providers’ risk tolerance tools have been specifically configured for the provider products and funds. He says the issue of independence with regards to the questionnaire/tool provider is therefore an important factor.

This includes independence regarding freedom from ownership conflicts; allowing focus and specialisation in the area of risk tolerance without fear of tailoring of questions and reporting leading to ‘preferred’ portfolio recommendations.

Mr Resnik says independence usually comes at a price.

He says: “A good rule-of-thumb is if an adviser is paying a fee for the use of a questionnaire/tool then this can be a sign of independence; if the questionnaire/tool is free to the adviser, then the commercial motive of the tool must lie elsewhere in the process and the tool will not be independent of cross-subsidy or transparent.”

Technical questions

In addition Mr Resnik says it is important to get access to the technical manual which will highlight the technical details including the testing and development process - this should be transparently written and demonstrate good academic underpinnings.

A good risk tolerance test will be relatively easy to understand and answer, he adds. It must also have been developed on sound scientific principles in order to ensure the validity and reliability of its results, Mr Resnik points out.

The starting point is a pool of potential questions. The trialing process these must go through will identify which questions work (statistically) and which do not, he adds.

The questions that are effective in a questionnaire are not necessarily those most suitable for an interview, he points out. A good risk tolerance system will also allow treatment of couples separately as it is common for couples to have different risk tolerances - sometimes significantly different.

Mr Resnik adds that in most cases, they will know which is the more risk tolerant of the two but usually not the magnitude or detail of the difference.

“Therefore it is recommended that couples each complete a separate questionnaire so that the differences can be identified more precisely.

“Armed with this knowledge, a couple is far better placed to decide how to manage the difference. Identifying couple mismatches is a great way to demonstrably add value as an adviser by helping a couple resolve the mismatch.

“It also often leads to very interesting communications. You will find that some couples will spend time at home talking about their ‘feelings’ on the issue, which is great way to help your clients feel part of the planning process.

“So a system that allows for easy comparison of a couples risk tolerance is essential.”

Behavioural factors

Vaughan Jenkins, financial services expert at PA Consulting Group, says the tool should have the sensitivity to tap into qualitative and behavioural factors as well as the consumers risk capacity and investment time horizon.

The profile may also be tuned to the specific objective in mind rather than a blanket attitude to risk and return, he adds.

Mr Jenkins says the selection process should therefore demonstrate that due diligence has taken place regarding the integrity of the tool and the provider; the scientific basis that it is built upon and the outcomes for relevant customer cohorts.