Lambros Lambrou

Most companies understand that they must address risk to remain competitive and grow their business. However the real challenge for business lies in understanding and developing the tools and solutions necessary to succeed in the face of the ever-accelerating change and complexity of today’s risk landscape.

So said Lambros Lambrou, CEO of Aon Risk Solutions Australia, a risk management business of Aon plc (NYSE:AON) ahead of the tenth annual Aon Advanced Risk Finance Conference, which kicks off in Melbourne on 8 October. The theme of this year’s conference, “Ten Years of Risk Financing Insights”, will drive home Mr. Lambrou’s point, highlighting that risks which now appear high on many organisations’ agendas barely existed 10 years ago.

According to Mr. Lambrou the breadth and variety of risks businesses now face requires them to mitigate against a wider range of issues than ever before, from white-collar crimes to cyber risk.

Mr. Lambrou highlighted cyber risk as a significant hazard in a technology driven environment that often flies under the radar: “The potential ramifications of cyber risk, which has been described as “the asbestos of risk”, are widely underestimated, particularly here in Australia where we are demonstrably behind the curve when it comes to even a basic understanding of the issues. This applies not only when it comes to individuals’ privacy, but for the integrity of entire organisations. That includes major liability issues at the Board and Director level right through to the very real threat that cyber risk poses to undermining everyday operational capability.”

The underlying theme of the conference focuses on the importance of ‘big data’ in shaping the future of risk management and helping businesses address issues like cyber risk in a more sophisticated way.

“The risk management industry has become the poster child for resolving the vexed question of how to put big data to use, and in so doing has transitioned from being a relationship, intuition-based industry to one that is increasingly truly data driven,” said Mr. Lambrou. “As our industry plays a vital role in promoting global economic growth, we must use the data and technology available to us to evolve faster than our clients on their risk and people issues to support them in meeting the challenges in the future. This conference is an ideal forum in which to do this.”

In addition to looking at global and local insurance and reinsurance trends, the conference will examine another important economic issue: risk and people – and, more specifically, how they interrelate.

“An organisation’s people is its most valuable asset. People risk is often at the heart of our conversations with clients, and rightly so. Failing to properly mitigate against this risk will have catastrophic outcomes for any business,” said Mr. Lambrou.

The Aon Advanced Risk Finance Conference 2014 will highlight the following issues:

• Shareholder value and risk maturity – the strong correlation between a company’s risk preparedness and its financial performance
• Big data – developing tools to harness its power to make better risk management and financing decisions
• Global insurance and reinsurance markets – the effect of the flow of capital from alternative sources such as pension funds and the need to use this capital to innovate
• People risk – the so-called ‘soft science’ that hits hardest on the bottom line
• The psychology of the white-collar criminal
• The “asbestos” of today’s risk management world: cyber risk

The conference unites global specialists from Aon’s London, Chicago, Singapore, Ireland and Beijing offices to share latest industry trends and data and offer risk management and financing insights to an audience of leading Australian and multinational companies.

Conference sessions will be delivered by key Aon executives from across the world, in conjunction with some of Aon’s major clients, including Coca Cola-Amatil, Lend Lease and Tesco, along with a range of experts from academia, the insurance industry and the corporate world.

Mr. Lambrou concluded: “While organisations have a surplus of information, which is growing exponentially, they also often have a shortage of insight. Understanding that information as it relates to risk and how to mitigate it can have an extraordinary effect on the growth and bottom line fortunes of any organisation.

“Risk and insurance go hand-in-hand, but our conference agenda goes beyond the surface to drill into the hard data and trends that underpin the way every single industry should be looking at managing the countless risks they face.”

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The new appointments will all be based in Sydney and have enabled the firm to expand its offering from a traditional reinsurance broker to a holistic provider of insurance services. The added strategic advisory services include:

• Capital solutions – alternative capital raising and structuring*
• Operational solutions – cost reduction and business optimisation
• Growth solutions – market analysis including identification of acquisition opportunities
• Risk management solutions – underwriting and pricing including predictive modeling
• Human capital solutions – compensation and benefit planning as well as organisational transformation

To drive this new capability, Guy Carpenter has appointed industry expert Matthew Rose to the newly created role as Principal, Capital and Strategy. Matthew has 23 years working in the finance and insurance sector and prior to Guy Carpenter held executive roles at Suncorp, Wesfarmers Insurance and Zurich.

Guy Carpenter’s chief executive of the Pacific Region, Tony Gallagher, said Matthew’s appointment cements Guy Carpenter’s vision to develop strategies which ensure the optimal use of capital for its clients.

“As insurance companies demand more innovative reinsurance solutions, Matthew’s wealth of experience in capital advice, strategies and solutions is a huge opportunity for Guy Carpenter to better support a broader range of clients,” Mr Gallagher said.

Expanding outside traditional reinsurance

Helping clients grow their business through improved underwriting and risk selection is another key growth area for Guy Carpenter as it expands outside the traditional reinsurance broking sphere. To support this area, Tom Harvey has been appointed as a catastrophe analyst, developing models to predict the impact of bushfires, floods and other perils at individual locations in Australia and New Zealand. Prior to joining Guy Carpenter, Tom worked at a number of junior exploration mining companies and graduated from the University of Sydney with first class honours.

“The insurers most likely to produce exceptional returns in the future will be those who have the capabilities to understand their risk exposures, and price and underwrite this business successfully.  Tom’s specific expertise in developing sophisticated natural disasters models gives insurers better access to these capabilities,” he said.

Drawing from its global talent pool, Samantha Dew will be relocating to Sydney as part of an intergroup transfer from Marsh, London and will be responsible for broking casualty placements for large global clients. Valerie Badcock also joins from London and will lead the property team with her most recent role at Willis Re. Both Samantha and Valerie bring years of broking experience from the London market.

Additional hires also include Kim Collins who will be responsible for broking property placements and Teresa Aquilina who has more than 20 years of experience in property and casualty underwriting.

“We’re leveraging the expertise of employees across the world to expand our local footprint and enhance the range of services we offer clients. We believe the caliber of our staff, many having decades of insurance experience, distinguishes Guy Carpenter in a competitive local market,” said Mr Gallagher.

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Insurance industry close to full recovery after Asia-Pacific disasters.

Nearly two years on from the devastating series of natural disasters that saw floods, bushfires, earthquakes and tsunamis scar the Asia-Pacific region, the insurance and reinsurance industry is close to recovery. With the great majority of short-tail claims now settled, insurer capital is returning to regular levels and consequent capacity across a range of product lines and industries is bringing renewed opportunities for insurers and insured’s alike. Additionally, there is an increasing level of ‘alternate capital’ that is now entering the market and is prepared to operate at a far lower return on capital than traditional insurers and reinsurers.

That was the positive news greeting attendees from some of Australia’s leading business and insurance organisations at the Aon Advanced Risk Finance Conference in Melbourne last week.

According to Steve Nevett, Chairman, Pacific Region, Aon Risk Solutions, positive news for the insurance industry spells positive news for Australasian business, freeing insurers and reinsurers to invest in developing more targeted risk management solutions.

“The APAC region suffered terribly due to a string of natural disasters in 2010 and 2011. With insurer and reinsurer capital and capacity significantly depleted as a result, there was limited opportunity for innovation and development – despite the clear need for new solutions as industry risk profiles change,” explained Mr Nevett. “However the relatively clear run that we’ve had over the past two years in Australasia has helped the market find its feet and apply its growing capacity to underwriting new risks and expanding product offerings.”

In addition to examining broader global and local risk financing trends, the conference offered practical lessons in risk management techniques and strategies from leading corporations including UPS and Coca-Cola Amatil.

“A key lesson from both was that business cannot treat supply chain risk mitigation as a ‘set-and-forget’. Instead, each potential risk should be addressed in line with need and adjusted as circumstances change,” said Mr Nevett.

The UPS case study was a reminder to attendees that managing risk can be difficult for any corporation, regardless of size. From an internal perspective, best practice risk management is dependent on all the parts – people, processes and technology – working together seamlessly.

The Coca-Cola case study addressed supply chain risk management, drawing upon their experiences from the recent spate of natural disasters. It focused on how important it is for corporations to continually monitor the types of risks applicable to their individual situation so as to ensure they have appropriate protection – be it through intelligent and responsive risk management frameworks or risk transfer strategies such as insurance.

Perhaps the standout presentation was one that compared the daily risk management strategies of elite fighter pilots with those of risk management professionals in business.

Delivered by aeronautical daredevils, Afterburners Australia, it addressed the respective role of planning, briefing, execution and debriefing in any successful exercise. The key message from these expert risk-takers? That execution comprises only about 5% of success. It’s the other components that have a far greater influence.

“It’s hard to imagine a more risky occupation than being a fighter pilot, so it was of particular interest to note that planning, briefing and debriefing is their focus, over and above the flight itself. It’s a formula for success that is just as relevant to risk management professionals. And it’s our hope that much of what attendees heard and experienced at our conference will help them achieve that level of success and flawless execution.”

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Below is a summary of the report:

• For some market observers today, a so-called “Great Rotation” — a massive shift of assets out of bond portfolios and into equities – is just over the horizon.  But the Black Rock Investment Institute (BII) believes that the scenario has “major holes”—and instead is urging investors to take steps now to mitigate the inherent risks still lurking in many fixed income portfolios.
• “With muted and regionally disparate economic growth, the foundation for a sustained risk rally looks shaky,” the BII notes in a new commentary, “Forget Rotation: Think Risk Mitigation.”  What is certain, the BII believes, is that bond portfolios carry fewer diversification benefits and more risk than in the past – and more risk than many investors believe.
• “Rather than worry about the bursting of a bond bubble and/or salivate over a massive shift to equities, investors would do well to focus on these hidden risks,” the BII says.

Safety Cushions No Longer

• Fixed income portfolios have become progressively riskier, the BII notes, with the hunt for yield in an historically low yield environment compressing spreads on many credit instruments to record lows.  “Ultra low yields mean safety cushions – to what extent a bond’s income offsets a price fall due to a rise in yield — have turned into beds of nails,” the BII says.  A mere 17 basis point uptick in the 10-year US Treasury yield, for example, would wipe out a year’s worth of income.
• At the same time, the argument for a coming “Great Rotation” back into equities is flawed, the BII believes.  A resumption of robust global growth that would justify a strong move back into stocks is by no means certain.
• Also, though the Great Rotation scenario assumes that strong inflows into bond funds since early 2009 came from stocks – and will now return there — in fact these flows more likely came from money market funds.
  The bottom line for investors, the BII notes:  The interest rate risk in fixed income remains acute, and portfolio mitigation measures are in order.

What Does This Mean For Investors?

• The BII suggests that investors consider the following steps to manage potential fixed income risk:
  Uncover Risks: Recognize hidden risks in bond portfolios and consider diverging from fixed income benchmarks—or even abandoning them.
• Go Short: Shorten duration and emphasize higher yielding credit over “safe” government bonds.
  Change Gears: Markets tend to overshoot. Be ready to take advantage by rotating duration, credit sectors or asset classes.
• Focus on Income: Do not count on capital gains in bond sectors that have had a great run such as US municipal bonds. Buy them for income.
• Quality Bargains: The hunt for yield has boosted not-so-great income assets. Climb up the quality ladder for a small loss in yield.
• Buy Insurance: Volatility in most assets is very low, so options to protect against downside risks or participate in upside opportunities are cheap.
• (Bond) Pickers Welcome: Correlations between asset classes are breaking down. This puts a premium on security selection.
• Neutral Bliss: Reduce market exposure by buying favored assets and simultaneously selling short similar but less desirable securities.

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Andrew Gordon, head of BNY Mellon’s Alternative Investment Services in Asia looks at the pressures impacting the hedge fund and private equity industry and what the drivers of growth are in 2011.

“The global low interest rate environment is driving institutional investors and pension funds to seek alternative sources of returns, driving an increase in appetite for alternatives in emerging markets, especially in Asia.

“In what could perhaps be described as a relatively tougher capital raising environment for hedge funds globally, 2010 saw the continuation of a paradigm change in the industry – where large institutions, especially those in Asia, including Japan, Australia, New Zealand and India, as well as the rest of the world are focusing an increased degree of attention on hedge fund opportunities, with increasing numbers of investors making their first investments in the alternatives space in the region – and this is a trend that is expected to continue well into 2011.

“An increasing number of large institutions including sovereign wealth funds, pension funds and life insurance companies are shifting their allocations to alternatives, as they seek better returns and portfolio diversification. The majority of those who have not done so are also actively looking around to identify the right fund managers to invest with.  In addition to the funds’ investment track record, what attracts these large institutions would be the business and operational track records of fund managers and the level of transparency that they can provide to their investors in terms of day-to-day reporting.

Transparency and risk management increasingly top of institutions lists

“Global investors continue to invest time and resources in the due diligence process with hedge funds in the region, looking into non-investment aspects of the managers including corporate governance, transparency and risk management.  This trend is likely to accelerate in 2011 as a number of high profile funds folded during the first half of 2010 and a multitude of insider trading cases emerged in the latter half.

“Investors, especially large global institutions, are looking to gain increased insight into their fund managers, looking beyond the traditional aspects of performance data to get into the bottom of how sustainable the team, business and strategies are. Looking through 2011, we believe we will be seeing more robust outlook and increased capital raising activities in those Asian hedge fund managers who have invested or are willing to invest in institutionalising themselves, that is, building up the infrastructure of their business for greater transparency, corporate governance and risk management, and making sure these insights are accessible to investors.

“The global hedge fund industry is institutionalizing and this trend is moving from the U.S. and Europe rapidly into Asia. This is what we believe will eventually and effectively differentiate winners from losers in the marketplace, specifically for those smaller hedge funds from the region. Post financial crisis, global hedge funds are also reviewing their presences in Asia, with a number opening offices in Hong Kong and Singapore, competition intensifies more rapidly than ever.

Private equity expected to mirror hedge fund trends

“Many of the same investors are also active in private equity, and we see similar themes. We are talking to a number of large institutional allocators to private equity in many parts of Asia, and they are seeking help to standardise and manage the increased flow of information and data that they are increasingly demanding from their managers. As with hedge funds, they trust their mangers, but are looking for independent verification of the value that their managers are bringing to the portfolios they manage – whether a company that a private equity fund has purchased, or a listed security that a hedge fund manager has taken a position in.”

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Three new funds were added to Lonsec’s universe in 2010 – the Zurich Investments Global Property Securities Fund (Recommended), BT Global Property Securities Fund (Investment Grade) and the Resolution Capital Global Property Securities Fund (Investment Grade).

Key themes from the 2010 review

Performance dispersion

Global real estate securities rallied over the year, driven by an increase in market confidence and renewed appetite for risk. Thembi Matabiswana, the Lonsec analyst who spearheaded the review, commented, “We found that those fund managers holding high levels of cash were more likely to outperform the benchmark over the longer period.”

“Cash levels were generally in the upper ranges of permissible and historical levels which support this view.”

Lonsec accepts that higher than normal cash levels are to be expected given the possibility of increased redemption requests and the more defensive portfolio positioning of many managers. However, advisers should take care when reviewing fund performance so as not to confuse strong fund performance due to high cash levels with strong fund performance due to stock picking skill.

While absolute returns have been positive in the 12 months to 30 November 2010 (average 20.9%), over a three year time horizon performance has been poor. When comparing managers across the sector, the dispersion between performances over the longer term continues to be high.

“Over the three years to 30 November 2010, ING was the top performer. This outperformance was largely driven by the manager‟s emphasis on top-down macroeconomic variables and effective re-positioning of its portfolio to accommodate changing market cycles,” said Matabiswana.

Access to equity and debt markets

REITs continued to tap both equity and debt markets throughout 2010, representing a material increase in activity from 2009. European real-estate securities in particular experienced a significant turnaround during the third quarter, driven by improving economic data and broad anticipation of additional quantitative easing programs.

“A report prepared by Jones Lang LaSalle stated that Europe dominated cross-border investment activity over the first half of 2010,” said Matabiswana.

“The report specifies that global real-estate investment totalled US$132 billion, almost double for the same period in 2009, with more than 50% of this occurring cross-border in Europe.”

As it stands, REITs continue to enjoy far superior access to capital compared to their unlisted real-estate counterparts and are therefore well positioned both offensively and defensively as economic recovery continues to strengthen or worsen.

Currency headwinds

The Australian dollar has experienced a significant amount of volatility over the last two years. The largest fall was seen over the three months to October 2008, where the Australian dollar dropped from a high of 91 cents in July to as low as 60c. With all the funds in the review offering fully hedged products, most of them have been unable to pay distributions as a result.

This is because July 2008 saw tax law changes that required all classes of income to be included in the calculation of taxable income. This included realised currency hedge gains/losses. Realised currency losses, in some instances, reduce the level of distributions that a fund can pay, if significant enough to cause a net loss on its taxable income. Importantly, currency losses continue to be carried forward until they are completely offset by future income.

“Therefore, for most of the hedged funds, such currency losses will continue to be carried forward until they are completely offset by future income. It is therefore possible that some funds‟ future distributions may continue to be affected by previous currency losses,” said Matabiswana.

“AMP and RREEF were the exceptions as these managers have continued to pay distributions; they have done this by funding the hedging losses through the sale of stock in the portfolio.”

In fact, both approaches should result in a similar outcome and not have a material effect on total returns. Those funds that will reduce or not pay distributions will benefit by a commensurate increase in their Net Asset Value (NAV) per unit. Those funds that do pay distributions will fund this by selling down a portion of their portfolio. This will act to reduce their NAV equal to this distribution amount.
Greater conviction at the regional level, for a more active global portfolio

In the past Lonsec has criticised managers for not being active enough at a global portfolio level. Managers’ active positions relative to their benchmarks were considered too small when compared to other sectors. This continues to be the case with high fees for mid conviction “active management”.

This is particularly disappointing given the extensive investment teams and resources afforded to most “active” global property securities fund managers.

“Some managers, such as RREEF and Principal, have acknowledged this. These managers have undertaken further research at a portfolio construction level and found that in order for an active position to be significant at a global level, there would have to be sufficient flexibility to take even larger regional bets,” said Matabiswana.

“These managers have adjusted their risk management systems accordingly, as well as encouraging regional teams to take larger active positions. Lonsec continues to encourage this evolution in portfolio construction, as long as it is supported by adequate resourcing and the appropriate tools and systems.”

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Melinda Howes, CEO of The Institute, speaking at the Risk Management Institution of Australasia conference in Sydney this week, said that risk management teams can be strengthened by a diversity of skill sets from different professional backgrounds.

“We see actuaries as having different and complementary skills to other risk professionals: a different way of thinking about risk, advanced risk analysis skills and experience in dealing with boards.”

The Institute of Actuaries considers that, as a matter of best practice, there should be at at least one relevantly qualified, skilled and experienced risk management professional on the board of every insurance company (including life, general and health insurers), bank and defined benefit superannuation fund. Such a board member would have risk management skills that are recognised by a professional body. There are a number of key professional groups, including the actuarial profession, from which an enterprise risk management professional may be drawn. Actuaries’ core professional skills are in the area of financial risk management – with financial risk being by far the largest risk for the abovementioned entities. Importantly, the actuarial profession also has a global qualification in respect of Enterprise Risk Management – CERA (Certified Enterprise Risk Actuary).

“It is vitally important that risk managers have business experience, and high quality training and certification,” Ms Howes said.

“As a professional group, actuaries are supported by strong standards to ensure the quality of their analysis and advice. These skills have been recognised by the regulatory requirement for life insurers, general insurers and health insurers to appoint an actuary to advise on their financial condition and to sign off on their risk management frameworks,” Ms Howes said.

Ms Howes said Australian actuaries have worked for more than 100 years to manage the financial risks of insurers and super funds and were now extending their influence.

“The specialised modelling techniques actuaries use for financial risks are now being applied to non-financial risks such as operational risk,” she said.

“There are already a number of Chief Risk Officers of financial services organisations who are actuaries. We predict that in future many more actuaries will specialise in risk management and work as risk managers in financial services organisations and beyond.”

“An enormous amount of time and money is being spent on improving the quality of risk management in financial services businesses. The case should continue to be argued that risk management is an extremely effective and business critical value-add to management and boards, not a compliance cost,” Ms Howes concluded.

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A greater focus on ‘responsible investing’ has seen many companies becoming good corporate citizens; examples include companies that rejuvenate land they have mined or contribute to the wellbeing of communities in which they operate.

Increasing investor appetite for such companies led to the emergence of a number of funds, varying described as ‘ethical’, ‘socially responsible’ or simply ESG (which stands for environment, social and governance). Each year, Lonsec researches and rates a number of funds so categorised, to help advisers find the applicable products for their clients.

How to categorise ‘responsible’ funds

The following broad definitions are a guide:

1. Ethical: Negative screening of companies in certain industries deemed to have a harmful societal impact. Avoiding investments in bad companies is the overarching investment motivation.
2. Socially Responsible Investing (SRI): Generally negative screening of certain sectors in line with above but may also include a positive screening element seeking to include socially responsible companies. Rewarding good corporate citizens is a partial investment motivation.
3. Sustainable investing (ESG): A belief that those companies with advanced approaches to environmental, social and governance risk management will exhibit superior performance than companies with sub optimal approaches. While it is likely that these companies will tend to rank highly on corporate ethics, unlike ethical investment, financial performance is the overarching investment consideration.

Lonsec takes fund categorisation a step further, focusing on the depth of responsible investment factors incorporated into the investment process; the output of which is a light, medium or dark green rating.

These classifications are aimed to give a general indication of Lonsec’s assessment of the level of ethical / Socially Responsible Investing (SRI) / Environmental, Social and Governance (ESG) criteria applied to, and evident in, the Manager’s investment process. The classification is not intended as an investment rating or recommendation.
Lonsec categorises the funds in its Responsible Investment universe as follows:

Client considerations –not a one-size fits all

ESG and sustainable investment funds now tend to dominate the Responsible Investment sector replacing traditional ethical and SRI approaches. Broadly, the market seems to have less appetite for funds focused solely on avoiding corporate bad guys compared to those investing in sustainable companies.

Despite progress, the sector still presents challenges for those providing financial advice. Investors in this sector are broadly grouped together under a ‘Responsible Investment’ categorisation, though bring different investment motivations which can make it tricky for advisers to confidently select investment managers for clients. Importantly, Lonsec believes that with some research, responsible investment investors can relatively easily determine a more suitable investment option for their needs than provided by a mainstream equities fund. The following are suggested priority areas for consideration in discussion with clients interested in this sector:

How Green is my client? It is important to sample investors’ green motivations. While Responsible Investors are commonly linked by a motivation to take account of a broader range of factors than solely fundamental financial analysis in their investment decisions and a concern about the community impact of corporate activities, the investment motivations can vary greatly across the sector. Ethically motivated investors may be aggrieved to allocated capital to major miners such as BHP and RIO, while ESG investors may be comfortable with such holdings given those companies’ risk management practices, community engagement, workplace safety record and so forth.

Does investment team buy-in matter? The level of ESG engagement in portfolio management teams varies across the sector. Lonsec believes this aspect is an important credibility test for investment managers and most likely a central consideration for investors in these products. In general a portfolio manager who is motivated and engaged with the Responsible Investment agenda brings added focus to the fund and is an important factor in increasing alignment of interest with investors. While Lonsec is primarily interested in the investment credentials of the Manager, whether the investment team is displaying a degree of engagement with the responsible investment sector is a relevant consideration in Lonsec’s appraisal of these products. This may be evident through the inclusion of positively screened companies at the margins of the portfolio where supported by the underlying investment research. Factors such as elevated corporate commitment to the sector, evident in participation in industry forums, production of research papers and company engagement can also suggest increased motivation.

Manage performance expectations. Spend some time with clients to discuss performance expectations. The depth of ethical screen can significantly constrain the investment universe and may have a performance impact during periods when certain sectors outperform (e.g. materials). Similarly, the screen can make it challenging to obtain adequate diversification in portfolios. The inclusion of a significant weighting to small caps in some funds may alter the risk/return characteristics of funds (e.g. resulting in higher tracking error versus traditional large cap core Australian equity funds).

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Standard & Poor’s believes that, other than creating a social welfare net, the most important benefit in developing a successful pension system is the way that it can help strengthen domestic capital markets.  According to John Bailey, Managing Director Standard & Poor’s for Pacific, in many parts of Asia, undeveloped financial systems are a major weakness and prevent effective intermediation between Asia’s large savings and investment needs. In contrast, the fund flows into compulsory superannuation in Australia has provided a steady stream of investment opportunities and has provided a strong source of demand for equity securities.

“The development of Australia’s superannuation system has built up some important wealth-management skills, such as equities and fixed income analysis, funds management, trustee services, and clearing and settlement skills, that have significantly enhanced Australia competitiveness,” Mr. Bailey says. “These skills are critical building blocks in creating a strong economy, and would be a major benefit to emerging economies in Asia”.

Standard & Poor’s also believes that a strong pension system is an important means of funding infrastructure projects. “In Asia, many infrastructure projects have found it difficult to find funding from the domestic capital markets” said Mr. Bailey.  “In contrast, the Australian system has a successful track record in helping generate funding through bonds and syndicated loans for major infrastructure projects, such as utilities, toll roads, and hospitals. Infrastructure is seen as a natural fit for superannuation investment because of its predictable cash flows.”

While the report recognizes that the Australian system faces a number of challenges, it offers several key insights about developing strong social security and pension systems. “If Australia can free up its financial services sector and become more outwardly focused, there could be some significant export of financial services skills and know how into the broader region,” Mr. Bailey said.

The executive comment, “Does Australia’s Pension System Chart a Future Course For Asia?” is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. Members of the media can contact Sharon Beach for a copy.

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Table 1 below outlines the 10 most common forms of unethical conduct by financial advisers in the provision of advice to clients, as identified from the findings of these external decision makers. In many instances, as outlined in the table, this unethical conduct also constituted a breach of the minimum conduct standards expected of financial advisers under the Corporations Act 2001 (Cth).

The table provides a guide to the most common ethical risks that may be faced by AFS licensees and financial advisers in the provision of advice to consumers. It should assist licensees to identify and remove roadblocks to ethical outcomes within their organisation and build organisational resilience to ethical risk.

Table 1 demonstrates that integrity issues dominate the analysis. This includes unethical conduct associated with misleading statements about the performance, features and risks of recommended financial products or misleading statements about the business reputations of those associated with financial products or managed investment schemes (35 breaches).

In addition, using client funds for the adviser’s own purposes was a clear issue particularly prevalent in ASIC banning orders (29 breaches).

The misleading conduct identified took many forms, from misrepresenting to consumers the risk of loss of capital or guarantees associated with the investments, to actively promoting that the financial product had features it did not have. The data suggested that such conduct was often associated with other forms of unethical conduct, such as not acting in the interests of clients and failing to provide clients
with all information necessary to make informed decisions as to investment choices (22 breaches).

An analysis of the data further reveals that the misleading conduct was linked to an inadequate understanding by financial planners of the financial product itself (23 breaches), which is also indicative of a breach of the competency principle. The misleading conduct also appears to have been contributed to by a failure of the compliance systems and procedures of AFS licensees to specifically prevent the behaviour (13 breaches).

Diligence in the provision of financial advice was another ethical principle that was the subject of recurring breach. The data also suggested that financial advisers are still inadequately researching the features, characteristics and risks of the financial product they recommend. This unethical conduct included the failure to conduct appropriate and independent research into the financial product being recommended (23 breaches) and inadequate explanations and examination of the risks associated with particular investment choices (19 breaches). This leads to a lack of, or inadequate understanding of, the financial product and the commensurate inability to therefore match product to the client’s needs, circumstances and objectives (23 breaches).

Objectivity issues, such as the failure to reveal conflicts of interest or fees and commissions earned (23 breaches) and the failure to disclose information relevant to the client’s decision (22 breaches), were also prevalent in the data. It should be noted that this latter conduct also constitutes a breach of the fairness principle (a failure to provide financial planning services in a manner that is fair and reasonable) in that it
is considered unfair for an adviser not to provide clients with all relevant information they require so that they may make informed choices as to whether or not to accept the advice given.

Another pattern identified in the ASIC banning order data in particular was that misleading and deceptive conduct and the appropriation of client funds were also associated with conduct such as falsifying documents and signatures and/or discretionary dealing in financial products without the consent of the client. These matters should have been identified by the AFS licensee’s compliance systems and
procedures.

If, as suggested by the theory2 that an organisation’s ethical climate helps to determine what advisers believe constitutes ethical behaviour at work and what criteria they should use to resolve ethical issues, then the presence of this type of unethical conduct suggests that an ethical climate based on self-interest may have been prevalent in these organisations.3

The ethical principle of competency is defined as providing competent financial planning services; maintaining the necessary knowledge and skill; and being professional, efficient and responsive in all dealings. Competency breaches such as the failure to provide adequate written advice (21 breaches) that met the client’s objectives or circumstances and that had a reasonable basis (28 breaches) were prevalent in the analysis. These were surprising findings, given that these ethical obligations are also legal obligations that have been prescribed by law since 2004 (see s 945A of the Corporations Act).

Generally, this form of unethical conduct was also associated with a failure to effectively undertake an assessment of the client’s tolerance to risk and then utilise that assessment appropriately, or to match financial product recommendations to the client’s specific objectives.

The implications

One of the current themes in hot debate within the sector is that the remuneration and ownership structures of AFS organisations and the failure to manage conflicts of interest associated with those structures have contributed to unethical conduct by financial advisers.4 Conflicts of interest have previously been ranked highly as an ethical issue identified by both management and employees as affecting Australian
business.5

The theory also suggests that remuneration and reward structures are contextual factors that influenced decision making within organisations.6 No decision by an external decision maker analysed for the purposes of this study overtly identified that a financial adviser had recommended a particular investment due to the pecuniary benefits that flowed to the adviser as a result. However, failures to disclose fees and commissions adequately, and the conflicts of interest associated with the receipt of these pecuniary benefits, were forms of unethical conduct identified by the analysis (23 breaches).

In addition, the systemic nature of some of the unethical conduct by financial advisers across numerous clients suggests motives other than the client’s interests for recommendations made. The receipt of high commissions and benefits from third parties as a result of financial product sales and recommendations to invest in financial products associated with their AFS licensee, whether or not it suited the interests of the client, were practices by financial advisers that were identified in this analysis. This was particularly so of advice to invest in managed investment schemes, although often by a representative who held authorisation to advise in one financial product only. It will be of interest to see whether the same patterns are repeated when advice associated with investments in Great Southern and Timbercorp, among others, is scrutinised as a result of legal action.

The results support the Future of Financial Advice (FOFA) reforms to ban commissions and volume-based payments from July 2012.

The data also demonstrated systemic instances of unethical conduct within AFS licensees by a number of advisers and across a number of clients. For example, the enforceable undertakings given by Patersons Securities Ltd (EU 017029204) and First Capital (EU 017029207) related to advice given to over 500 and 170 clients respectively.

Further evidence supporting this conclusion included the failure by some advisers and officers to follow internal procedures and policies (13 breaches); the failure to keep appropriate records of advice and ensure the integrity of records kept (10 breaches); and the failure of officers of the company to prevent contraventions and to protect consumers (six breaches).

It can be concluded from this data that some unethical conduct may have arisen because of systemic failures in the ethical frameworks within financial planning firms. This is a historical lesson well learnt but seemingly repeated in the sector at regular intervals. Current examples include advisory failures associated with Basis Capital and Lift Capital, as well as the collapse of the Storm Financial Group.

A message to licensees

Many of the forms of unethical conduct revealed by this research should have been identified by the AFS licensees’ risk management and compliance systems and procedures, but were not.

This suggests that the identification of ethical risks associated with the provision of financial advisory services is a difficult task which is not always appropriately undertaken.

The data also suggests a demonstrated failure in some advisory models and processes when advising on investments such as managed investment schemes. In most of the cases analysed, the advice to invest was simply not suitable to the particular client. The speculative nature and risks associated with the Westpoint promissory notes, for example, made them an unsuitable investment for some types of client, such as the elderly, persons from non-English speaking backgrounds, and consumers on low incomes. It is evident from the data that the current legal and ethical frameworks for financial product advice did not operate effectively to protect consumers in some instances.

The findings also raise questions as to the process currently used by some financial advisers to match financial products to the needs and objectives of clients.

Further, the complaints analysis highlights a pattern of overreliance on template statements of advice, that are not tailored to the client’s specific circumstances. A one-size-fits-all approach to the sale of financial products or strategies across client databases poses significant ethical risks. These risks are then compounded when that advice is disclosed through a statement of advice template, where only the
names and contact details of the client have been changed.

The message for compliance officers and responsible managers is as follows.

• Review your risk and ethics frameworks against the issues raised in this article, including the table showing the 10 most common ethical errors by financial advisers.
• Be alert to the overuse of template disclosure documents in the provision of advice and ensure documentation is appropriately tailored.
• Understand that financial advisers still struggle with concepts such as “reasonable basis” and “suitability” and often do not appropriately apply tolerance to risk assessments.
• Ensure that in transitioning to a fee-for-service model, your advisory divisions continue to adequately disclose all payments and soft dollar benefits received.
• Check advice to clients with special needs.

This should assist you in removing roadblocks to ethical outcomes within your organisation and in building organisational resilience to ethical risk.

FOOTNOTES

1 Source: June Smith, above note 1.
2 Martin K D and Cullen J B, “Continuities and extensions of ethical climate theory: a
meta-analytic review” (2006) 69 Journal of Business Ethics, pp 175–94.
3 Victor B, Cullen J B and Stephen C, “An ethical weather report: assessing the
organization’s ethical climate” (1989) 18(2) Organizational Dynamics, p 50.
4 Institute of Chartered Accountants in Australia (ICAA), Reinventing Financial
Planning, paper by Robert M Brown, ICAA, Sydney, March 2007, pp 1–17; D’Aloisio
T, “Regulating financial advice — current opportunities and challenges”, speech
given by the Chairman of ASIC to the Financial Planning Association of Australia
National Conference, Sydney, 28 November 2007.
5 KPMG, A View from the Top: Business Ethics and Leadership, white paper, KPMG
Advisory, KPMG in Australia, October 2005, pp 1–17.
6 Hegarty W H and Sims H P, “Some determinants of unethical decision behaviour:
an experiment” (1978) 64(3) Journal of Applied Psychology, pp 451–57

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