Exactly what is ‘capacity for loss’?

It has long been the case that advisers must identify each client’s attitude to risk when making a personal recommendation. In order to satisfy this requirement, firms either create their own questionnaire, or else will use a third party ‘risk profiling tool’, which is a posh way of saying … questionnaire!

In recent years, advisers have also had an obligation to identify each client’s capacity for loss. This aspect is usually dealt with by tacking a few questions on to the end of the risk questionnaire. This often appears to be almost an afterthought and we do see some risk profilers that do not obviously address capacity for loss at all so raising the question of how advisers using those tools meet the regulatory requirement in this respect.

The profilers that do attempt to address capacity for loss either attribute a numerical score to this aspect – e.g. 3 out of 5 – or else factor it into the overall risk rating, moderating the client’s risk score in some manner, although the mathematical logic behind this is not always clear. So, the output from these tools is usually in the format of a score, e.g. ‘3’, or a label, e.g. ‘Medium’. This type of output is consistent with the score format of  output from most ATR tools but is probably not very meaningful or helpful to advisers in deciding what solutions would be suitable for that client. Firms should have a process that maps a client’s risk profile score against a risk rated portfolio or fund(s) but we have never seen a process that maps the client’s capacity for loss.

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Our View

A financial matter of fact? 

So what is an adviser supposed to do with a capacity for loss rating of say ‘3’ or ‘medium’? Well, you could ignore it and address capacity for loss in a more meaningful way! And that should involve having a sound understanding of the client’s likely income / expenditure position over the relevant period of time, i.e. when the investment will be accessed to provide capital sums or a regular income to support the client’s required standard of living.

In a recent blog we suggested that, while attitude to risk is a subjective concept, capacity for loss is a financial matter of fact. Let us examine that in a bit more detail.

Two FCA sources are relevant …

  1. COBS 9.2* Assessing Suitability;
  2. FG 11-05* Assessing suitability: Establishing the risk a customer is willing and able to take.

(* see links in the action section below)

The key phrase here is ‘willing and able’. By any plain English interpretation, willing is about the customer’s opinions, views and feelings in relation to investment risk. By definition, these are subjective and, despite every risk tool out there attempting (understandably) to turn this subjectivity into a number on a scale, the fact remains that willingness to take a degree of risk ultimately exists only in the customer’s head.

On the other hand, ability exists as an objectively measurable fact regardless of what the customer thinks or feels. Whether (s)he comes at the top, middle or bottom of the ATR scale does not change the fact that an X% drop in capital value (which the customer might be willing to take) would reduce available income below the level necessary to fund expenditure, requiring withdrawals of capital, so further exacerbating the problem.

This is surely what the FCA means when they define Capacity for loss in a footnote to FG11-05 … 

‘By ‘capacity for loss’ we refer to the customer’s ability to absorb falls in the value of their investment. If any loss of capital would have a materially detrimental effect on their standard of living, this should be taken into account in assessing the risk that they are able to take.’

In COBS 9.2.2R, Capacity for loss is referred to as follows …

 … (advisers) ‘have a reasonable basis for believing … that the specific transaction to be recommended, or entered into in the course of managing … is such that he is able financially to bear any related investment risks consistent with his investment objectives.’

FG 11-05 uses the expression ‘the risk a customer is willing and able to take’ as a shorthand description of these elements of COBS 9.2.2.R. 

Now, the adverse impact of the X% drop in value mentioned above could be softened by a number of other factors. These include …

  1. the client’s willingness to spend some of the capital value, either regularly or from time to time, to meet ongoing expenditure;
  2. the client’s willingness and ability to reduce outgoings, even if only temporarily;
  3. the degree to which other assets or sources of income contribute to the client’s expenditure needs.

So the black and white scenario described above will, inevitably, include a few shades of grey for some clients. However, ultimately, capacity for loss, i.e. whether the client can or cannot absorb the loss without ‘material detriment’ to his/her standard of living remains an objective and quantifiable fact.

Action Required By You

  • Have a look at what the FCA says …
  • COBS 9.2
    FG 11-05
  • Review the process you currently use to identify the risk that your clients are willing and able to take;
  • Ensure that it actually addresses capacity for loss and includes gaining a sound understanding of the client’s income / expenditure position over the relevant period of time;
  • Look for an objectively quantifiable capacity for loss amount or range (although the range should not be too wide);
  • If your current capacity for loss is on a scale (e.g. 1 to 5 or low to high), ensure that you have a mapping process to convert the scale into a quantifiable amount and to use this to moderate the client’s overall risk profile appropriately;

  • Ask yourself – “is the output meaningful?”

ATEB clients should speak with their account manager as necessary; otherwise contact ATEB here to find out how we can help.

About the Author

Steve is an ATEB Director and has a deep understanding of all matter regulatory, built up over his 30 years + in the industry. With a training background and a technical brain, he overseas numerous complex projects and client implementation work.

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