Major life changes may be a trigger to review protection. But, writes Adam Higgs, investor clients should also be prepared.
Over the past few years, risk profiling has moved from assessing the investment client's attitude to risk via a questionnaire only, to a process where the client's preference for risk is combined with other wider financial issues to assess not only the risk they are willing to take but also the level of risk they are able to take.
With the FCA placing increased focus on measuring clients' ability to sustain losses as part of this, it is surprising that many advisers are not considering the clients' protection needs as part of the process. After all, we are discussing the subject of risk, aren't we?
Risk profiling process
Ensuring that the client has adequate protection in place is a crucial element of the risk profiling process, which will broadly consider three main elements of the client's situation, all on the face of it investment focused.
Risk tolerance is the level of risk the client is willing to take, capacity for loss considers the amount of risk they are able to take, and risk required looks at what level of risk they would need to take in order to meet their goal.
Tools can make it easier to assess risk tolerance and risk required. A robust attitude to risk questionnaire will give the adviser the client's risk tolerance, while a stochastic projection of different asset allocations will show the level of risk the client might be required to take to meet their goal.
Capacity for loss, on the other hand, will require the adviser to make an assessment of the client's current situation and their ability to absorb losses without having a detrimental effect on their financial wellbeing. It is in this assessment that the clients protection needs should be a key consideration.
Most capacity for loss assessments focus on what emergency funds are in place, or the amount of expendable income the client may have that could be used to lessen the impact of a loss.
What we often do not consider is the effect on the client's ability to meet their goal if something other than an investment loss has a major impact on the client's life.
What would be the impact on the client if they were taken ill and unable to work? If there is no cover in place, would the client need to use their investments to replace their income?
Equally, what would happen if the clients spouse was taken ill with a critical illness and therefore unable to look after the children? Again, without critical illness cover the client might look to their investments to either fund childcare or supplement their income while they took time off to care for them.
Both scenarios would have a detrimental effect on the client's financial wellbeing and ability to meet their goals. Considering the issue further, should the discussions really be left at life-based protection products when a lack of general insurance could have a similar impact on the client's finances? What would happen if the client's house burned down and there was no home and contents cover, for example?
Cash flow modelling
Although many advisers may not provide general insurance services, this is still something that should be documented and considered as part of the risk profiling process and could provide referral opportunities.
An increasingly popular method of assessing a client's capacity for loss is cash flow modelling as the interactive graphs allow the adviser to model ‘what if' scenarios, such as investment loss, and demonstrate the effects of these on the client's ability to meet their goal.
Using a similar method, you could model the effects of the client losing their income due to ill health or their spouse dying prematurely and therefore the loss of their earnings. Modelling these scenarios could help you understand whether protection should be considered, as well as the investment itself.
Protection as a wider picture
It is easy for protection needs to be dismissed out of hand by the client if approached in isolation, but if presented as part of a wider financial picture the justification can be far clearer.
Consumers focus frequently on investments, without fully recognising the importance of protection. Cash flow modelling can be a powerful tool to represent risks graphically that the client might not have foreseen but that can be addressed economically using protection products.
Whatever your particular risk profiling process is, it will undoubtedly look to ensure that the investment strategy recommended can not only help the client achieve their goal, but do so within the limits of their tolerance and capacity for financial loss. If the level of protection the client has in place is not considered and fully documented, can we really say that we have achieved this?
Adam Higgs is head of research - adviser services at F&TRC
