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‘Suitability and Appropriateness’ Policies in India

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As we move towards a financial market with increasing product complexity, information disclosures alone will not lead to improved customer outcomes. We believe that the core of consumer protection is the principle of ‘Suitability’ – where the onus of advice or sale of financial services lies with the provider. Continuing on our series of posts on Consumer Protection, in this post we look at how regulators in India have been thinking about client appropriateness and suitability of financial products.

IRDA – Suitability Index for recommending insurance products

IRDA has recently introduced guidelines for the development and implementation of a Suitability Index – Prospect Product Matrix by insurance companies. These guidelines are intended to help direct sales personnel, brokers and agents to recommend products based on the need and suitability of customers. These guidelines are currently applicable to all life insurance policies (Traditional, ULIPs, Pension and Health) sold as individual policies.

According to the draft guidelines, an agent will have to obtain the consumer’s suitability information before recommending a policy through the proposed ‘proposal-cum-need analysis’ form. Suitability information means information that is reasonably appropriate to determine the suitability of a recommendation, including age, Annual Income, Financial resources used for funding the purchase of the life insurance product, Intended use of the life insurance product, Financial objectives with time horizon, Existing assets including investment and life insurance holdings, Liquidity needs, Liquid net worth, Tax status, Risk tolerance etc. At present, basic information is collected after the customer has decided to buy an insurance policy. The proposed ‘Proposal-cum-Needs analysis’ form is more detailed and will need to be filled up before any policy is recommended.

Next section of the form documents the needs of the customer – Life needs (Example: Living expenses, Education) and also Insurance, savings, investment and pension needs. Based on the information collected in the form and with the aid of the Prospect-Product Matrix, the agent will recommend products and a suitable cover.

The Prospect Product Matrix will indicate the “suitable” products for a customer on the basis of Life stage (Single, Married, Married with children, Married with grown-up children or Retirement) Generic need (Protection (Life), Protection (Health), Goal based savings for wealth creation, Investment, Income) and Income segment of the customer (Mass, Mass affluent or HNI).For example: A married person with grown up children will need goal based savings products, investments and health cover more than life protection products. So the matrix will indicate 100% suitability of products intended for goal based savings, investments and health cover. The insurer will then recommend appropriate products from its portfolio for this purpose.

RBI-Suitability and Appropriateness of derivative products

The importance of suitability and appropriateness of policies for market-makers in their offering of derivate products to customers have also been emphasised by Reserve Bank of India. In August 2011, RBI issued revisions to its 2007 Comprehensive Guidelines on Derivatives to address issues of suitability and appropriateness. It encourages market-makers to offer derivative products in general and structured products in particular only to those users who understand the nature of the risk inherent in these transactions. It is imperative that the products being offered are consistent with users’ risk appetite. It requires market makers to carry out proper due diligence to check user appropriateness and suitability of products before offering derivative products.

While undertaking derivative transactions a market-maker should:

  • Analyse the expected impact of the proposed derivatives transaction on the user
  • Ensure that the terms of the contract are clear and assess whether the user is capable of understanding the terms of the contract and of fulfilling its obligations under the contract
  • Inform the customer of its opinion, where the market-maker considers that a proposed derivatives transaction is inappropriate for a customer. If the customer nonetheless wishes to proceed, the market-maker should document its analysis and its discussions with the customer in its files
  • Ensure the terms of the contract are properly documented, disclosing the inherent risks in the proposed transaction to the customer in the form of a Risk Disclosure Statement which should include a detailed scenario analysis (both positive and negative) and payouts in quantitative terms under different combination of underlying market variables such as interest rates and currency rates, etc., assumptions made for the scenario analysis and obtaining a written acknowledgement from the counterparty for having read and understood the Risk Disclosure Statement

Responsibility of ‘Customer Appropriateness and Suitability’ review is on the market-maker.

SEBI– Suitability of Mutual Funds based on risk-profiling

A SEBI circular for Mutual Funds also talks of the principle of suitability, stating that distributors of Mutual Fund schemes/funds are required to follow the principle of appropriateness of products sold to its customers.

The circular categorises customer relationship and transactions as:

a. Advisory – where a distributor represents to offer advice while distributing the product, it will be subject to the principle of ‘appropriateness’ of products to a customer.
b. Execution Only – in case of transactions that are not booked as ‘advisory’, it shall still require:

– If the distributor has information to believe that the transaction is not appropriate for the customer, a written communication must be made to the investor regarding the unsuitability of the product.

– A customer confirmation to the effect that the transaction is ‘execution only’ notwithstanding the advice of in-appropriateness from that distributor be obtained prior to the execution of the transaction.

– That on all such ‘execution only’ transactions, the customer is not required to pay the distributor anything other than the standard flat transaction charge.

Mutual Fund distributors must conduct a risk profiling of their clients and advice products that are suitable to their clients’ risk appetite. If an investor wishes to purchase a fund that is not appropriate to his declared risk appetite, the advisor must get a disclaimer signed off by the investor that he is aware that this fund is not recommended for his risk appetite but that he is buying it on his own decision.

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One Response

  1. For suitability of sale in financial services to have teeth, the provider must be held liable for sale of “unsuitable” products, say life insurance sold to a retired individual, on a backward looking basis. Otherwise, the suitability exercise will become like disclosure, in equilibrium.

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