Whilst the way to assess an individual's attitude to risk has been well researched, there is limited academic research that considers how to assess an individual's capacity for loss. This may be because, unlike risk attitude, there was little focus on the concept of capacity for loss until the Financial Services Authority (FSA) issued its guidance in 2011 entitled “Assessing suitability: Establishing the risk a customer is willing and able to take and making a suitable investment selection.”
What is capacity for loss?
Capacity for loss refers to an individual's ability to withstand a financial loss. Arguably the best definition of capacity for loss was provided by the FSA in 2011 in their guidance highlighted above when they stated: “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 their 2011 guidance the regulator was clear that risk attitude and capacity for loss should be assessed independently of each other. The reason for this is that they measure different things. Risk attitude concerns itself with the risk an individual is willing to take whereas capacity for loss considers the risk a client can afford to take.
Risk attitude is subjective and based on an individual's personal opinions. This differs to capacity for loss which is objective in nature and based on fact. While an individual's attitude to risk may not necessarily change through their life cycle (although differing objectives may have different risk attitudes), it could be contended that their capacity to bear loss may vary more as their personal circumstances change.
The key variables to consider
The available academic literature reveals a wide range of variables to consider when assessing capacity for loss and the main ones are highlighted in the table below. A greater understanding of these variables and how they impact an individual's standard of living will help create a more accurate assessment of their ability to handle loss.
Capacity for loss variables:
- Individual's age
- Investment time horizon
- Number of years before retirement (ability to make up any losses incurred)
- State of health
- Number of dependant
- Income and expenditure
- Net worth (assets less liabilities)
- Amount of savings
- Amount of debt
- Availability of funds in the event of a planned or committed expenditure in the next five years
- Amount of insurance held
The FSA's successor, the Financial Conduct Authority (FCA), operates a principles-based regulatory regime which relies on stated principles rather than a detailed set of rules. The methodology adopted to assess capacity for loss is therefore down to individual advisers and as a result open to interpretation. This has resulted in uncertainty as to the best practice that should be adopted for assessing loss capacity.
Advisory firms are obliged to satisfy themselves that they have considered, discussed and documented capacity for loss when formulating an overall investment recommendation. By doing this they will be able to satisfy themselves and their clients that the FCA investment risk regulatory requirements have been met.
Two common methods are used by advisers when assessing an individual's capacity to bear loss; cash flow modelling and or a targeted capacity for loss questions based approach. As with all things, both methods have advantages and disadvantages. The FCA has not prescribed a standardised basis for advisory firms to adopt when assessing an individual's capacity to bear loss; either option can be appropriate.
While detailed comprehensive cash flow analysis is an effective way to assist in assessing an individual's capacity to bear loss, many clients may feel that the cost and time commitment of such a service outweighs the benefits offered.
A potential gap exists in the accurate assessment of capacity for loss between those who are willing to pay for comprehensive cash flow modelling and those who are not. The use of specific capacity for loss questions, which consider the variables outlined above and are used to form the basis of discussion in this area of risk, may help to bridge this gap when assessing an individual's capacity to bear loss.
The assessment of capacity for loss is a subject that remains high on the regulator's radar. It is therefore crucial that advisers have and can demonstrate a strong, robust process for assessing an individual's capacity to bear loss.
Learn more about assessing capacity for loss
To find out more about how you can effectively assess your clients’ capacity for loss, join us at Round 2 of Bankhall’s Professional Development Days 2017, where Standard Life will present on the key things you need to know.
Click here to register your place on a date and at a location that suits you.