Suitability is a perennial issue in financial services. It’s based on a presumably elementary and unobjectionable concept: that advisors shouldn’t sell a product to anyone who doesn’t have a need for it and whose financial resources and risk profile make buying such a product inappropriate.
Yet in violation of common sense — and business ethics — advisors in the past have made millions selling annuities to people who were unlikely to survive the product’s surrender period. And securities-licensed reps continued to sell highly speculative offerings to conservative clients who had no clue about the high-risk securities they were buying.
Gross abuses such as these led to the development of the National Association of Insurance Commissioners (NAIC)Suitability in Annuity Transactions Model Regulation and its subsequent adoption in a majority of states. Plus, FINRA cracked down on securities suitability violations with its FINRA Rule 2111.
End of problem? Hardly. The North American Securities Administrators Association (NASAA) recently released areport suggesting advisors are dropping the ball when it comes to documenting the discussions they have with prospects about risk tolerance, goals, needs, and financial status. “It just … blows our minds that we still see the No. 1 books and records issue (being) client suitability documentation,” Michael Huggs, director of the Mississippi Securities division and head of NASAA’s Investment Advisor Operations committee, told InsuranceNewsNet.
Unless advisors do this, they won’t have a leg to stand on if a client files a complaint or errors-and-omissions insurance claim in the future. Without profiling data, advisors won’t be able to prove the product they sold was appropriate. Since investment advisors and presumably insurance- and securities-licensed professionals are still having trouble with documenting suitability, perhaps it’s time for the industry to redouble its efforts to sell only suitable products to its customers.
To that end, here’s a quick refresher on basic suitability concepts. In this article, we’ll focus on insurance (primarily, annuity) pointers. In the next two articles, we’ll provide guidance on investment advisor and then securities broker suitability.
1. What is suitability?
It’s the process of assuring that clients buy a life insurance or annuity product for the appropriate reasons. That means they fully understand its features, benefits, conditions, and limitations. This doesn’t happen automatically or easily. It requires an advisor to diligently uncover client information and preferences and to apply professional analysis and judgment. It also requires a structured approach for uncovering, documenting, and saving client information so that it can be easily recalled in the event of a future dispute.
2. Why is suitability important?
Suitability is crucial because it ensures that every product sold is consistent with customer needs, resources, and risk profile. It also builds a strong relationship between customers and their advisors and insurance companies, not just today, but for decades to come. It also prevents customer complaints and errors-and-omissions insurance claims, reduces the likelihood of regulator inquiries and sanctions, and enhances the industry’s overall reputation with the public.
3. What is the suitability determination process?
At its highest level, this process typically involves five distinct steps:
• Reviewing the prospect’s income and expenses, net worth, and liquidity.
• Knowing the person’s short- and long-term goals, especially the prospect’s potential needs and plans to withdraw funds from the product in the future.
• Discussing the prospect’s appetite for risk.
• Determining the person’s marginal tax rate.
• Being clear on the prospect’s life stage and the stability of his or her income stream.
4. What type of suitability documentation is required?
As discussed earlier, it’s important to record information about the client’s situation, resources, appetite for risk, as well as specific comparisons between an existing client product and a proposed replacement. Most companies require or prefer that advisors use their suitability form, but they may allow the use of a homegrown form if it collects the same data.
5. How long should suitability records be retained?
It’s a good idea to retain suitability worksheets and other documents related to product analyses and client discussions for at least 10 years. But check state rules because some require even longer holding periods in certain cases.
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6. What specific suitability red flags are companies and regulators looking for?
There are nine major ones, involving cases where the customer:
• Will retire prior to the termination of the surrender-charge period. This may increase the person’s need and desire to withdraw funds that trigger a surrender charge.
• Is in a 15% federal tax bracket or less. This suggests the product’s tax-deferral feature may be of limited benefit.
• Has little or no investment or financial experience. This means the person may have little capacity to understand the product’s features, benefits, and suitability, perhaps resulting in a future complaint.
• Has limited disposable income, say $2,000 or less per month or is bringing in less money than he or she is spending. This again increases the likelihood of withdrawing funds prematurely and incurring an unexpected surrender penalty.
• Has limited liquid assets, again increasing the possibility of getting hit with a surrender penalty.
• Has an aggressive or moderately aggressive risk tolerance, but still wishes to purchase the product.
• Has replaced a similar product in the recent past, which may lead to another replacement in the near future.
• Is expecting to use purchase bonuses to offset surrender fees in the case of a replacement. But person must be aware that bonuses may be retracted if the new product is surrendered early, thereby creating additional costs.
• Has conflicting plans for accessing money. For example, the person plans to receive a distribution in a manner that conflicts with how he or she wants to receive that distribution.
7. In short, when might a life or annuity product be unsuitable for a given prospect?
Here are seven common examples:
• The product has a surrender charge penalty longer than the person’s life expectancy.
• The purchase of the product ties up too much liquid assets.
• The purchase is funded with the proceeds of a loan or reverse mortgage.
• The person wants to purchase the product with someone else’s money.
• The prospect doesn’t understand the features, benefits, and limitations of the purchased product.
• The person wants to replace an existing product with one that has essentially the same features and benefits.
• The proposed replacement will generate more charges and fees than produce financial benefits for the insured.
Granted, the above information is only a high-level overview of this crucial topic. To drill down, tap your insurance company compliance department as well as the compliance staff of your FMO. The important thing is to make it your business to recommend suitable products to your clients. This will make it much less likely that your new business gets hung up in a compliance or suitability review, thereby speeding commission payments. And it greatly reduces the chance of having to deal with regulator inquiries. Most importantly, it helps to prevent errors-and-omissions insuranceclaims and other black marks on your record. Good luck!
Harry J. Lew is Chief Content Officer of EOforLess. For more information on affordable errors and omissions insurance for low-risk insurance, investment, and real estate professionals, please visit E&OforLess.com. For information on ethical sales practices, please visit the National Ethics Association’s Ethics Center.
• See also: Advertising compliance guidelines: 25 ways to avoid nasty outcomes