The risk in miss-selling financial products
01 June 2012 | Magazine Archives FAnews & FAnuus | Features / Profiles | Wessel Oosthuizen, University of the Free State
Regulation about Fit and Proper Requirements for Financial Services Providers, Conflict of Interest and the pending Treating Customers Fairly regime, are aimed at eliminating unethical practices from the financial advice space. Miss-selling is among the practices most scorned by industry stakeholders!
Miss-selling is broadly defined as the ethically questionable practice of misrepresenting or misleading a client about the characteristics of a financial services product in an attempt to clinch a sale. The victims of this flawed advice process are left with policies or investments wholly unsuited to their needs.
Is your advice suitable?
One can also define miss-selling as the failure by an advisor to give appropriate and suitable advice, thereby placing both advisor and client at risk. The importance of "suitability of advice” is highlighted by its inclusion in the FAIS General Code of Conduct.
A recent consultation report by The International Organization of Securities Commissions (IOSCO) indicates that suitability of financial recommendations is a universal problem that will form part of regulatory discussions and decisions in the future.
Ignoring regulatory requirements
Despite regulation, court cases and determinations on the importance of suitable advice, many advisors fail to take the requirement seriously.
Why is miss-selling so prevalent in the pro-consumer age? We can identify four principle reasons why client’s end up with unsuitable products, including:
1. A lack of knowledge of the advisor’s ongoing liabilities and obligations to the client;
2. A lack of understanding the client’s goals and needs, and to a lesser extent risk tolerance;
3. A lack of knowledge of the product and its potential to impact the client’s financial situation adversely; and
4. The advisor’s external obligations or motivation for personal gain, which result in an unsustainable conflict of interest, thereby compromising the duty of care owed to the client purchasing the product.
It is no surprise that many miss-selling events are traced back to product providers offering excessive commission structures. A number of cases emerged from the recent collapse of one of the country’s most popular property syndications, for example.
Dealing with loss
When advisors consider a client’s attitude to risk they consider concepts such as risk preference and appetite for loss, but fail to take note of important factors such as their client’s capacity for loss (can they afford to lose the money), experience and knowledge.
Advisors rely on questionnaires and other assessment tools to determine their client’s attitude to risk (risk tolerance). They then flesh out these results with asset-allocation tools and model portfolios before making investment recommendations.
The problem is if these tools become the primary influence in making an investment decision, then it is inevitable there will be a lack of appropriate consideration of the client’s other needs and circumstances. We cannot assume a client is willing to take the risk of capital loss, without discussing whether our assumption is correct, for example.
Getting to grips with risk
We cannot make product recommendations unless we have established whether the client has the necessary experience and knowledge to understand both the risk involved in the recommended product and the risks associated with the ongoing management of their portfolio.
The collection of information on the source and extent of the client’s regular income, his assets (including liquid assets, investments and real property) and his regular financial commitments are factors vital for establishing product suitability, even in a case where advice on a single need is given.
Information regarding a client’s knowledge and experience is just as important and cannot be ignored. This information includes:
1. The types of service, transaction and designated investments with which the client is familiar;
2. The nature, volume and frequency of the client’s transactions in designated investments and the period over which they have been carried out; and
3. The level of education, profession or relevant former profession of the client.
Matching product to risk
A robust process that ensures that all relevant suitability factors are taken into account will lead to recommendations that are suitable. These recommendations will then translate into suitable investment selections that meet the client’s investment objectives within their respective risk tolerance!
