The ‘Suitability’ Round Table: Notes and Inferences
In August 2016 the National Institute of Public Finance and Policy organised a half day round table with multi-stakeholders to unpack ‘suitability’ as a regulatory defence against mis-selling of financial products and services to households. This is a summary of the discussions and some presentations that were made.
In the financial sector, India’s regulatory defence against mis-selling rests on disclosure, financial literacy and ‘suitability’, or the proper fit of the product being sold. While there has been debate about the efficacy of disclosure and financial literacy programmes, suitability as a regulatory instrument is relatively less studied in India. Is the regulatory thought on ‘suitability’ well fleshed out? Do the market participants understand the suitability metric to implement it in their organisations? Does a consumer know when the suitability requirement has been violated? To answer some of these questions a Round Table was organised at the National Institute of Public Finance and Policy in August 2016. This is a documentation of the reasons for the Round Table, the papers presented and the common themes that emerged from the debate. I also try and pin down some key suggestions from the debate at the end of this piece.
Regulators globally have grappled with the question of how to get consumer protection right in financial products. It is a tough nut to crack because of the nature of the product, which is invisible and sometimes has a moment of truth that is 30-40 years away from the time the product decision needs to be made. It is tough because, not just customers, but regulators too find themselves a few steps behind a financial sector that has attracted the best brains (some of them literally rocket scientists) in the world to design, manufacture and market products. Disclosure of all material product and service features to the consumer and making the customer financial literate have been the two legs of regulatory thought in consumer protection. But, as the sub-prime crisis of 2008 proved, plenty of disclosures are made by the financial firms, but they are unusable by the final consumer due to the volume and language of disclosure. Financial literacy was the buzz word for a few decades in the US where it was believed that making consumers of financial products better able to choose would result in better outcomes. But as this meta study shows, financial literacy efforts are quite useless. Regulatory learning has since leaned more heavily towards ‘suitability’ as a metric to protect consumers.
Regulators increasingly say that the products sold must be ‘suitable’ to the consumer. But, what is suitability? It is the quality of being right or appropriate for a particular person, purpose, or situation. In the financial sector, a suitable product or service is one that, when sold by an intermediary, matches the retail client’s financial situation, investment objectives, level of risk tolerance, financial need, knowledge and experience. (Basel Committee on Banking Supervision, 2008). A ‘suitable’ sale moves the onus from the principle of buyer beware to seller beware. Indian regulators have looked West and adopted the terminology of suitability, with most financial sector regulators putting ‘suitable’ sales as a metric for mapping right sales.
Suitability Regulation in India
The Reserve Bank of India on December 3, 2014 released a Charter of Consumer Rights that gave consumer five basic rights. The third of these rights is the Right to Suitability, which says: “The products offered should be appropriate to the needs of the customer and based on an assessment of the customer’s financial circumstances and understanding.” Banks were supposed to implement these rights by 31 July 2015, but there is no further information about what the banks have actually done to implement these. An RBI release in February 2016 still spoke about a pending review on the implementation of the Charter. A mystery shopping exercise showed that banks were far from the ideal world of a suitability regime. In fact, far from making suitable sales, they were not even making disclosures correctly.
The insurance regulator, the Insurance Regulatory and Development Authority of India (Irdai) released draft guidelines in February 2012 where it proposed the development and implementation of a Suitability Index – Prospect Product Matrix by insurance companies. The draft defined suitability as: “.. a determination that, based upon a particular prospect’s risk profile, financial situation, investment objectives and investment experience, a product is appropriate for that prospect. This is based on the data collected under the Needs Analysis section of the standard proposal form”. Wrote Deepti Bhaskaran on this in Mint: “The product matrix will indicate products on the basis of life stage, generic need and income segment of the customer. So a single person with fewer dependants will need goal-based savings products and health cover more than pure protection products….The insurer will then spell out products tailor-made for this purpose. However, for a married person all three goals—protection, goal-based saving and health—will be 100% suitable.” This was an ambitious plan by any regulator globally to create a matrix of products that matched profiles. Given the complexity of the project, this remained a draft.
The capital market regulator, the Securities and Exchange Board of India (Sebi), other than working to make the product structure less prone to mis-selling by removing front commissions in mutual funds and capping upfronting of trail commissions to 1%, made asset management companies responsible for the acts of their agents and advisors through a circular in August 2011. The circular makes a distinction between an advisory and execution only services. On advisory the circular says: “..where a distributor represents to offer advice while distributing the product, it will be subject to the principle of ‘appropriateness’ of products to that customer category. Appropriateness is defined as selling only that product categorization that is identified as best suited for investors within a defined upper ceiling of risk appetite. No exception shall be made.” For execution only, the circular says: “The distributor has information to believe that the transaction is not appropriate for the customer, a written communication be made to the investor regarding the unsuitability of the product. The communication shall have to be duly acknowledged and accepted by investor.”
For both advisors and distributors, Sebi mandated the suitability principle. In December 2012, Sebi included mis-selling of mutual funds under its Prohibition of Fraudulent and Unfair Trade Practices Regulations, where “not taking reasonable care to ensure suitability of the scheme to the buyer” is a mis-selling offence.
The pension regulator, the Pension Fund Regulatory and Development Authority included suitability as a criterion in its draft Retirement Advisor Regulation in February 2016. A retirement advisor needs to maintain several records, one of which is the “suitability assessment” report. The business plan of a retirement advisor must also showcase the “process for risk profiling of the subscriber and for assessing suitability of advice.”
Do the suitability rules work?
Translation of broad principles of consumer protection to actual action on the ground needs more work than simple articulation of a principle by the regulator. The UK’s Financial Conduct Authority (FCA) uses detailed “guidance notes” that make it clear for the market what a certain regulatory prescription means. Indian regulators have taken the right direction by using ‘suitability’ as a metric for prevention of mis-selling, but other than putting down the requirement of ‘suitability’ there is not much else that the regulatory tool kit says on the issue. Unlike the FCA, that has detailed guidelines on what is or not suitable and how to implement it, Indian regulators are silent on the application of suitability.
If India’s regulatory defence against mis-selling rests so strongly on suitability, clearly we need to unpack the idea and initiate a debate on the building blocks of a suitability regulatory regime in India. NIPFP put together a Round Table around this theme with various stake holders including regulators, firms, academics and think tank experts to unpack the concept. The Round Table’s aim was to open up the debate on thinking about a consumer protection regime that is built on the principle of suitability in retail finance. The questions before the Round Table were:
- What is a suitability regime?
- What are the metrics of suitability?
- Is there a set of common minimum metrics of suitability in retail finance?
- How should we think about implementing suitability?
- How should we think about suitability enforcement?
- NIPFP Director Dr Rathin Roy gave opening remarks
- Five presentations to look at the issue from different angles
- Short regulator comments from RBI, PFRDA and Sebi
- Round table discussion
Bindu Ananth, Chairperson, IFMR Foundation: Suitability analysis of low-income customers.
Suitability is a process of the provider and not a guaranteed outcome for the customer. Providers should institutionalize systematic practices to ensure suitability of sales and service.
You can see the presentation here.
Main points: demand for financial products for low income households is very high. The problem is the supply and the sales process– an excessive focus on disclosure-based customer protections puts the onus on customers to develop the capacity to understand complex financial products, and providing no protection from making costly mistakes early on. Following suitability process ensures that the providers are able to take adequate measures to prevent a sale that might cause substantial harm to user.
It is important to think of suitability as a process institutionalized by the provider, rather than as a guaranteed outcome for the customer. For example, KYC is a process by which the identity of a person is validated. Some people may filter through gaps in the process, but KYC mostly establishes the basic identification metric. We need to think of suitability in a similar vein.
To successfully implement suitability, all providers need to develop some form an adequate and relevant assessment of both customers and products features. For example, life insurance is a product that is likely needed by most low-income households, but there are a small set of cases where it would not be appropriate. Providers understand insurable risk, valuation and exceptions infinitely better than the average customer. They are in the best position to lay down clear guidelines/red flags for what constitutes an appropriate/inappropriate sale based on key customer characteristics and to ensure that no policy is sold unless these basic rules are reasonably met.
All financial firms should have a board-approved policy that lays down guidelines that account for product-specific and channel-specific features, and also how compliance with these guidelines will be ensured. There are nine principal components that such a policy should cover:
- Collect accurate, updated and complete relevant information from clients.
- Assess the interaction between the products/s and client profile.
- Ensure that terms are suitable based on clients’ needs, means and goals.
- Verify client’s understanding of and consent to key features and obligations.
- Provide easy access to affordable, effective and speedy internal grievance resolution.
- Enable timely post-sale servicing in accordance with commitments made at point of sale.
- Harmonize incentives and service climate at the frontline with the due process for suitable assessment, recommendation and service.
- Regularly and comprehensively monitor and audit compliance with all aspects of the suitability policy.
- Regularly test and accredit all employees/agents in the suitability policy of the provider.
One participant disagreed on thinking of suitability as a process – said process then invariably takes priority over outcome in a bureaucratic setup.
Kapil Mehta, Co-founder Secure Now Insurance Brokers: A practitioner’s perspective on suitability
One line comment: Regulators and manufacturers push onus of suitability on buyers through poorly designed disclosures.
You can see the presentation here.
Main points: Disclosure and suitability are generally treated interchangeably and buyers given excessive, poorly organised and non-relevant information. This is confusing for buyers. For example, there are many pages of disclosure in insurance plans but data on real returns, claims ratio and meaningful caveats are hard to find. The onus of suitability is pushed onto the buyer through excessive disclosure and treating the signature on documents as proof that the buyer has assessed his own suitability. An additional issue with thinking about suitability is that it is considered at a moment in time, but circumstances may change and the need for a low cost exit needs to be there. Regulators will need to actively drive and improve the issues of suitability. Some suggestions are:
- Follow a risk-based suitability regime.
- Allow exit as reasonable cost.
- Simplify information so that buyers and sellers can determine suitability.
- Institutionalise pre-sales suitability metrics. Right now it is post-sales.
- Think of a list of products that are mostly ‘suitable’ such as a term life insurance plans.
- Think of a negative list of products that are almost always never ok such as life cover for an old person.
Biju Dominic, co-founder Final Mile Consulting: , Behavioural aspects of suitability.
Risk is a feeling and not a number, how to code it into regulation?
You can see the presentation here.
Main points: Suitability metrics are based on an assessment of risk a person can take. But reducing risk to a number ignores the evidence that behavioural economics is giving us – that we are irrational beings that often misunderstand our own motivations and regularly take actions that harm us. For example, for the rational mind, returns and risk have a direct correlation, but to the emotional mind, they are an inverse relation where the not-familiar is also more risky. Any measure of suitability will have to take into account how people ‘feel’ about risk. The communication of risk becomes very important when we think about a suitability regime.
One participant spoke of how life insurance is sold purely on appeal to emotion.
Smriti Parsheera, NIPFP: Suitability principles in the Indian Financial Code.
Under the IFC retail customers have the right to suitable advice
You can see the presentation here.
Main points: IFC has one chapter on consumer protection that recommends a non-sectoral consumer protection framework with a set of basic rights and protections for all consumers and additional protection for retail consumers. The level of protection depends on the level of knowledge, experience and expertise of the consumer, the nature and degree of risk embodied in financial product or service and the extent of consumers’ dependence on the financial service provider. Basic protections for all:
- Financial service providers must act with professional diligence.
- Protection against unfair contract terms.
- Protection against unfair conduct – misleading and abusive.
- Requirement of fair disclosure.
- Protection of personal information.
- Redress of complaints by the financial service provider.
Additional protections for retail consumers:
- Right to receive suitable advice.
- Protection from conflict of interest of advisors.
- Access to the FRA for redress of grievances.
Renuka Sane, ISI: The difficulty of suitability regulations
We should not confuse suitability with optimality – should ensure hygiene in the market and leave optimality to the market.
You can see the presentation here.
Main points: a suitability regime places the burden on the seller, it should prohibit an intentional sale with incomplete or incorrect advice. It aligns incentives of the seller with the buyer and the possibility of penalties should deter incompetence. But suitability goes further. Suitable can often mean “optimal”. This is different from the sale being just “incorrect”. A ‘suitability’ regime in a restaurant will turn every waiter into a nutritionist whereas the need is for the food to be safe and hygienic. We should restrict suitability to basic hygiene. This means we need better product design and allow to household to hire a specialist if it needs to. The specialist needs to worry about optimality. This may lead us to a world with simple and complex products, with the former not needing a ‘suitable’ sale tag. Other ideas are: smarter disclosures, tagging distributors to sales, financial literacy of distributors and board level responsibility.
The regulators at the conference were of the opinion that it is difficult to hard code suitability but the environment can be made more conducive. Regulators needs to have strict consumer protection laws, lay proper emphasis on disclosures and ensure that information that reaches the customer is not incorrect, inadequate or incomplete. They were also of the opinion that suitability falls in the grey area. What can be done for a better distribution environment is to enforce awareness, get the products right and ensure transparency. The regulators also saw merit in the need of bringing down regulatory walls and allowing distributors to cross sell.
The Round Table Discussion
The discussion ranged from participants reacting to the presentations and putting forth their own points of view on the subject. Some highlights:
- The customer is able to evaluate what she gets in an Udipi restaurant but may not be able to evaluate food in a five star hotel. A five star needs better description of the food than an Udipi restaurant. Similarly complex products need more detailing than simple products.
- From the point of view of the rural women – they find the supply side fragmented. They are looking for a solution and not more confusion among competing regulators and product types. There are also concerns on early exit. We had women signing up for a pension plan, but then when there was an emergency in the house, they wanted to withdraw. This point led to a conversation about selling a pension product to a person who has no other shorter term investment for near term needs. The issue of suitability of a pension product in isolation to all other needs of a household. Clearly, the household needs shorter term funds along with pension products.
- Suitability is a shifting goal post: what is suitable today may not be suitable tomorrow from an investor standpoint. Also we must understand that most of the distributors of financial products—for instance in the case of insurance the agents are 12th pass candidates and by the industry’s own admission are individuals who were not the brightest during school days. So to train distributors on suitability can be an intensive exercise and its compliance expensive. However technology can be actively used like what IFMR does where it collects data and on the basis of data the algorithm in the software throws up suitable or unsuitable products.
However what should be immediately done are three things which to a great extent will aid suitability of products:
1. Enforce greater disclosures. As discussed in the meeting, information overload is not desired, but customers should be made aware of the most important features of any financial product. Like returns, costs, exit load, risk profile and optimal holding period in a manner which is comparable across product classes. For instance, insurance policies declare returns in absolute terms—a customer has to calculate the rate of return—whereas fixed deposit declare a rate of interest.
2. Incentives should be according to product function. Today products that serve the same end are being sold by different companies regulated by different regulators. This leads to distribution asymmetry. Products that have higher incentive structure and a larger distribution network will be sold more. What further exacerbates the situation is the lack of disclosures and handy comparison. Distributors should be regulator agnostic and end goal sensitive.
3. Regulators should step up penal action. In insurance for instance the rules are prescriptive. This puts pressure on compliance and often the rules are flouted. Instead of making the rules very prescriptive, the regulator should focus on hygiene and health metrics of the industry. For instance, in case of life insurance, the regulator needs to keep a close eye on metrics such as persistency, lapsation, claims settlement ratio, policy complaints and efficiency of complaints redressal. These should be the hygiene enforcement tool for the regulator, insurers found in violation should be taken to task seriously.
- Suitability is not just disclosure, it is much more. Suitability is of concern not just for the retail market. In 2007-08 Crisil has classified various products as suitable for retail and institutional channels. The concept of informed choice is important.
- Disclosures need to be understood and customers usually complain when they make a loss.
- The toy industry does a good job of matching age to toy. They have labels on the toy – best suited for age 9 and below. We should think of a product labelling system in finance.
- The incentives for the financial service providers are mis-aligned. For example, the fact that a certain percentage of people will not use their credit card points is built into the profit projections. Lapse profits are built into insurance profit projections.
- The regulator should fix what are unsuitable sales.
- Draw a red line around unsuitability and focus on building institutional capacity to conduct suitability/unsuitability assessments, rather than go for optimality.
- Products are themselves not bad or wrong, it is the sales process that is wrong.
- Need to tag distributor to sale and other metrics such as lapsation.
- We need metrics including risk, liquidity and return. A list of unsuitable products according to situation.
- We need to be basic work on disclosures and incentives before we move to suitability.
- Need basic hygiene for disclosures, exit is important, board approved policy must include grievance redressal, regulators should not micromanage but must enforce the basic rules and that customer protection is being met.
Common themes for action
- First get disclosures right– this works to enable well-informed customers, consumer advocates, third party analysts, as well as frontline staff of providers themselves. This emerged as the strongest part of the conversation. This is the basic hygiene reform that is needed before we try and implement a much tougher suitability regime. The current disclosures obfuscate rather than inform. Disclosures should be clear, machine readable and must be across;
- Exit costs
- Payment schedules
- Optimal holding period
- Guaranteed return or not
- Lapsation rates
- Claims experience
A larger debate is needed to drill down to what the key pieces of disclosure need to be for each product. For example, the disclosure in a medical insurance policy will be very different than that in a mutual fund or a home loan. There is need for consensus on what needs to be disclosed at the very minimum to the consumer and in what form.
- Use incentives for the distributor to get him to do the right thing. Distributors will educate themselves when incentive to make ‘right’ sales.
- Use a combination of appropriate training, incentive re-alignment, and monitoring. The board should take responsibility for all three, including for their own staff and agents.
- Simple and complex products. Simple products have a structure that is easy to understand and are usually not unsuitable for most people. Split the market so that simple products are bought over the counter but complex products need an advisor, or a sign off from the customer. There is a contrary view from Bindu Ananth of IFMR Foundation that says: “we don’t want the market for complex products to disappear. We want the difference between simple and complex for the average customer to disappear: by stepping up the front-line providers’ capacity to understand unsuitable client profiles and incentives to act responsibly, even complex products can be suitably matched to ‘financially illiterate’ customers.”
- Create a list of unsuitable products across metrics of age, income, saving ratio and other relevant factors for each product. For each product create a list of people who should not buy that product – for example a person on rent should not be buying home insurance. Or a first time equity investor should not buy a sector fund. Or a person with no dependants need not buy life insurance cover. Build-in a dynamic feedback loop to revise and improve on this list as products and channels change.
- Create a registry of sellers so that they can be tracked.
When: August 29, 2016
Where: NIPFP, New Delhi
US Paliwal, ED, RBI
Satya Prasad, ED, PFRDA
Harini Balaji, General Manager, Sebi
Mohita S. Dahiya, Manager, Sebi
Bindu Ananth, Chair IFMR Trust
Kapil Mehta, Co-Founder, Secure Now Insurance Brokers
Biju Dominic, Founder Final Mile Consulting
Smriti Parsheera, researcher, NIPFP
Sumita Kale, Chief Economist, Indicus Foundation
Vishkha RM, MD and CEO, India First Life Insurance
Surya Bhatia, founder, Asset Managers
Sanjiv singhal, founder, Scripbox
Smita Agarwal, Director Investments, Omidyar Network
Viashnavi Prathap, researcher, IFMR
Deepti Bhaskaran, Insurance Editor, Mint
Chetna Sinha, President, Mann Deshi Bank
Sumit Bose, Vice Chairman, NIPFP
Suraj Kaeley, Group President Sales and marketing, UTI AMC
Balkrishna Kini, Dy. Chief Executive of Association of Mutual Funds
Harjeet Toor, RBL
Suyash Rai, researcher, NIPFP
Mohita Dhaiya, manager, Sebi
KP Krishnan, Secretary, Ministry of Skill Development
Renuka Sane, ISI, New Delhi
Monika Halan, NIPFP