As a recent article published in The Telegraph demonstrates, risk can be a highly subjective component of any investment.
The basis of the majority of claims made against independent financial advisors (IFAs) seems to be that they mis-sold to clients because they failed to adhere to the client’s risk profile. But what do we mean by risk and is the term applied generically across the financial services industry?
When I studied complex systems for my degree there was a pretty straightforward starting point; understand the impact of a failure and the probability of it occurring and you can start to understand the risks.
Impact
Premium Bonds are regarded as one of the lowest risk investments because your capital remains intact even if you never win a prize. At the other end of the spectrum, entire investments can be lost when a Hedge Fund goes bust. The impact of failing to win a prize is clearly far less worrying than losing everything put into an investment.
So when the Financial Services Regulator encouraged consumers to take action against IFAs for mis-selling the EEA Life Settlements shares and branded them as high risk, where did EEA sit on the scale? Well given that the fund was based on life insurance policies that the US Government obliges insurers to make available for a secondary market, and the policies were underwritten by some of the world’s largest insurance corporations, the capital amounts invested should have been secure. In fact the only erosion in the value of capital was the amount of premiums paid and the management fees taken once each policy was purchased. Both of these factors were predictable but in this respect the investment could not be described as quite as low risk as, for example, Premium Bonds. But then very few investments are.
The risk with EEA Life Settlements shares was overwhelmingly about the magnitude of gains once premiums and fees were deducted and not about the loss of the underlying policy values. Not Premium Bonds, but certainly on the low risk side of scale as opposed to Hedge Funds or more speculative investments.
Probability
Even if the consequences of a fund failing are low, we rightly also consider the probability of that occurring. None of us would place our savings in a fund that was highly likely to fail. Although for many there may be an increasing desire to find safety by placing our savings in low or zero growth funds in order to avoid the uncertainty of financial markets.
To understand the probability of a failure, we were taught to study those factors which influence an entity, both in its immediate and extended environment. We would then conduct a detailed risk analysis. In the case of EEA Life Settlements, the probability of the fund crashing was extremely low because almost all the factors in its environment were detached (it was sold as uncorrelated because the performance of stock, currency or commodity markets had no impact on the fund). Life Insurance corporations might have failed to meet their obligations but the risk of this occurring would be no greater than large banks or even governments defaulting – it happens, but it’s thankfully rare and if we judged all investments exposed to this risk as high, every investment under the sun would be in that category.
The only real risk in EEA Life Settlements related to the magnitude of any gains with a very small risk of capital depletion if every policy holder outlived the life expectancy analysis (carried out by qualified physicians) by a considerable margin. Even if the fund had been badly managed, the underlying policies represented a rock solid asset.
In November 2011, it was accurate to describe EEA Life Settlements as low risk.
But then in November 2011 nobody could have predicted what would happen next.
The analogy that springs to mind is of a pedestrian crossing the road. There’s a risk which is largely determined by the traffic on the road and the common sense of the pedestrian, but we rely upon traffic controllers to mitigate that risk by implementing safeguards. What you don’t expect is a traffic control helicopter to target the pedestrian and deliberately land on top of him or her.
You could argue about whether the EEA Life Settlement fund was in a quiet country lane or the high street but prior to November 2011, when the traffic helicopter of the FSA landed on the fund, it was safe – it was certainly low risk.
It’s unfortunate for those who would like to take action against their IFA for mis-selling (as a consequence of risk) but the only thing that changed the risk status of the EEA Life Settlements Fund was the action of the FSA – the traffic police. The action of the regulator exclusively and retrospectively transformed the fund from low to high risk.
Another analogy; worrying lending decisions are discovered at 3 or 4 small banks. The regulator declares the banking sector to be on the verge of a solvency crisis; a run on all banks follows forcing the doors to close and access to all cash denied. Would it be reasonable to brand Barclays, HSBC or NatWest as high risk before this intervention? In the Life Settlements industry, EEA was the largest fund operating in the UK and one of, if not the, largest in the world.
At least we know that if the banks fail, tax payers will bail them, or if the FCA makes reckless comments about the insurance sector, millions of pounds will be spent on independent reports and officials will be too embarrassed to accept their bonuses.
What is the risk, I wonder, of our new administration doing the right thing for ordinary savers?
Action Group For Life Settlement Fund Investors 