Newsletter 53 - October 2009 / FSA Annex

Structured Investment Products

This Annex summarises the standards, as set out in our report, against which we assessed whether firms were giving suitable advice for structured investment products.

Analysis of customers’ needs and circumstances – liquidity and investment timescale
As part of the suitability assessment, advisers must consider the customer’s finances and personal circumstances (COBS 9.2.1R (2), COBS 9.2.2R, also COBS 2.1.1R(1)). The factors that we expect advisers to consider include, but are not limited to, the following:

• whether the customer has sufficient emergency funds;
  
• the customer’s timescale for investment;
  
• whether the customer has a potential need for liquid capital during the period of investment and, if so, whether capital has been set aside for this purpose;
  
• if the investment is designed to provide a set return on a set date to meet a future need for money but the contract has the potential to mature early, what this may mean for re-planning, re-investment, and, hence, potential additional expense for the customer;
  
• whether the customer has any existing liabilities that may best be repaid before considering investment; and
  
• the implications of recommending a fixed-term product that cannot be cashed in according to market sentiment.

Attitude to investment risk
In order to give suitable advice, advisers must recommend products which match the customer’s attitude to investment risk (COBS 2.1.1R(1), COBS 9.2.1R(2), and COBS 9.2.2R). Structured investment products are complex and include different features which contribute to the risk profile of the product. Advisers need to consider these features to ensure they recommend a suitable product taking account of the customer’s risk profile, investment objectives and financial needs and circumstances.

We take the view that structured investment products are unsuitable for customers who do not want to take any risk with their capital or have no capacity for loss.

Having established that a customer is willing to take investment risk, the suitability factors that we expect advisers to consider when recommending structured investment products include, but are not limited to, the following:

• the risk of capital loss upon maturity;
  
• the likelihood of different investment outcomes (e.g. the likelihood that the product will provide the maximum quoted return);
  
• counterparty risk: we consider that advisers should have regard to the financial strength of the underlying counterparties and whether this is appropriate given the customer’s attitude to risk. However, we consider the due diligence it was reasonable for advisers to apply on the financial strength of the counterparty changed after Lehman’s collapse:
  
  • We have not applied the benefit of hindsight to the period before Lehman’s insolvency (in September 2008). Where a customer was willing to take counterparty risk we believe that it was not reasonable to expect advisers to distinguish between the financial strength of different counterparties that were rated A or above in this period.
    
  • From September 2008, given the failure of an investment grade counterparty, we expect advisers to have undertaken a higher level of due diligence when recommending products with counterparty risk, and to consider more carefully how this may relate to customers’ attitudes to risk. This due diligence should include:
    
    • consideration of the number of counterparties underlying a single structured product;
      
    • the location of the counterparties (e.g. UK-based, offshore etc); and
      
    • the relative financial strength of counterparties.
• the suitability of additional product features such as early kick-out;
  
• the risk profile of the underlying investment indices and implications of a
• product linked to more than one index;
  
• any level of gearing in the product;
  
• the investment risk given the term of the product with particular regard to
• the customer’s investment objectives including:
  
  • the effect of inflation over the investment term; and
    
  • whether the investment term is sufficiently long for the underlying investment to achieve the expected returns.

   

Concentration risk
Advisers should consider both product and portfolio concentration risk:

• product concentration – the suitability of the level of investment recommended for a single product relative to the customer’s other savings and investments; and
  
• portfolio concentration – the suitability of the total proportion of a customer’s savings and investments portfolio invested in a single product type (i.e. structured products).This requires an adviser to consider, and take account of, a customer’s capacity for loss as well as their attitude to risk (COBS 9.2.1R(2), COBS 9.2.2R, also COBS 2.1.1R(1)).

Taxation
The advice should take account of the customer’s tax situation including the effect of income tax, capital gains tax and, where applicable, age allowances and married couples’ allowance (COBS 9.2.1R(2)(b)).

Systems and controls for delivering suitable advice (SYSC 3.1 & 3.2)

Product features
Prior to Lehman’s insolvency, a firm should have considered the features of each structured investment product sold and consequently, how appropriate they were for certain groups of customers. This includes undertaking sufficient research over and above providers’ marketing material, for example, to determine the risks of specific product features highlighted above (see section ‘Attitude to Investment Risk’) and how these matched different customer risk profiles. Research should have sought to identify who the underlying counterparties were and considered their financial strength (in so far as whether they were investment grade). The firm’s attitude to risk profiling methodology should have accurately determined each customer’s attitude to risk to ensure advisers recommended suitable products.
As indicated above (see section ‘Attitude to Investment Risk’), post-Lehmans’ collapse, we expect firms to have been applying higher levels of research and due diligence, particularly around the counterparty risk elements of structured products, to include, for example, the number of counterparties, their location and their relative financial strength, and assessing how these features may impact upon the suitability of individual products for different types of customers.

Management Information (MI)
A firm should have appropriate MI to monitor and review structured products advice to enable it to act upon risks and issues and ensure the fair treatment of their customers. This includes identifying good and poor outcomes for consumers and developing key performance indicators to measure performance against these.

Advisers’ understanding of structured products
Advisers should have a sound understanding of how structured products work and the key risks of these products.

Monitoring and oversight arrangements
The firm should employ appropriate monitoring and oversight arrangements to ensure advisers provide suitable advice on structured products. Monitoring should focus on customer outcomes, the specific risks of structured products and the suitability of the advice. It should not be solely process focused.

Risk disclosure
The firm’s communications with customers – including its suitability reports - should communicate the risks of investing in structured products in a way that is fair, clear and not misleading. This includes explaining to the customer the nature of counterparty risk and the possibility that, in the event of the failure of a counterparty, their capital could be lost.

Changes since the Lehman Brothers’ insolvency
The firm should have reacted appropriately to market conditions and reviewed whether its advice framework and procedures was, and is, fit for purpose. The firm should have made the necessary changes to enhance its framework, where necessary, for providing advice on structured products.