From Likert scales to heat maps, family offices assess financial and personal risks. And they ask a lot of questions
If the biggest risk is not taking any risk, as Mark Zuckerberg says, probably the second biggest is failing to plan for it. Families are prone to all sorts of risk, from market downturns to messy divorces. When welcoming new clients, how does a family office measure, assess and plan to mitigate potential perils?
For Prime Quadrant in Toronto, “part of the risk assessment is making sure that we as a firm really understand what the family’s needs are, but also that the client’s expectations are aligned with what they’re engaging with us for,” says Nancy Marshall, the firm’s head of Family Office Services.
Threat analysis for the client and firm
Prime Quadrant uses a prioritization questionnaire with its prospects.
“It’s a Likert scale that goes through what is most or least important to you,” Marshall says. There is also a forced ranking exercise that might ask, for example: Which is most important to you: accessing the best managers globally, increasing your returns or reducing your administrative burden?
A third tool is the “napkin exercise,” which is so named “because our CEO used to do it literally on a napkin,” she continues. “We review several different areas of your life – involvement in the community, spirituality, investments – and use a one-to-ten scale to show where you are now and where you would like to be.”
One of the biggest risks to an individual or a couple is divorce. By order of magnitude, that’s a major risk. – TOM MCCULLOUGH, NORTHWOOD FAMILY OFFICE
Prime Quadrant keeps as close an eye on risk to the firm itself as it does to client vulnerabilities. A risk matrix is used to identify all risks in its operations – client acquisitions, for example – and point out mitigation strategies and the likelihood of those risks occurring, Marshall explains.
“Then we talk about what consequences they would have for the firm. We tally it, give it a risk scale and watch where it’s trending. We review that monthly, and it’s reviewed quarterly with our board,” she says.
The firm also uses a heat map to illustrate risk that codes each threat as green, yellow, orange or red.
Liability in cases of litigation
As president and estate planning advisor of her own firm, Cindy David Financial Group Ltd. in Vancouver, Cindy David is likewise acutely aware of the potential for danger – either to the new clients or to the firm – that can arise from lack of foresight.
Life insurance policies, for instance, serve as a prudent hedge against unforeseen difficulties, but they can pose their own hazards.
David tells of a colleague from another firm who was brought in to assist an accounting firm and its client in dealing with a difficult insurance situation. Because the insurance policy was not adequate to cover needed expenses, the case has now gone to litigation, and the advisor is facing liability.
“If you become agent-of-record on an existing policy, there’s risk,” David says. “How much do you really want to dive in to fix a situation like that, even if you’re the best person to fix it? If you step in as an advisor in a policy that’s failing, you’re not washing your hands of the risk of liability.”
When bringing new clients on board, David’s firm meets with them in one or more intensive sessions designed to gather information and lay the groundwork for a common understanding of the relationship.
“After I do a normal fact-find, then we leave them with a consulting checklist,” she says. “After the first meeting, the client understands what I need, and why.”
This process helps determine what’s needed: “If there are strained relationships, often you need a family counsellor. If you have a really great lawyer advising on how to set up a will, those decisions will not set up fights down the road. We’re having conversations to try to prevent any worst-case situations from happening.”
David also uses an engagement agreement that defines the clients’ obligations to fully impart pertinent information as it evolves and to act on advice rendered.
Balancing assets and liabilities
Financial risk is top-of-mind for Tom McCullough, chairman and CEO of Northwood Family Office in Toronto. He notes that it takes many forms, from “the ravages of inflation” to family breakups, fraud and cybercrime.
“We think of it as a balance sheet: assets and liabilities,” he says. “Debts are liabilities, but so is planned spending.”
In assessing a new client’s situation, Northwood considers three types of risk:
- Risk requirement, or the amount of risk needed to meet one’s goals.
- Risk tolerance, the level of comfort with potential setbacks.
- Risk capacity, which is the ability to handle a loss, “not emotionally, but financially,” says McCullough.
“Financial risk capacity is measurable, so we do a lot of work around risk capacity,” he says. Normally, the client portfolio manager or relationship manager would manage this process. After considering all the potential threats, “our goal is to increase the probability of them getting to their goal to as close to 100 percent as possible, so a part of our risk assessment is to draw the scenario,” McCullough explains.
“You make certain assumptions about rate of return, years of life, spending, then ask: What if you spend more? What if you live 20 years longer than you expect? What if markets drop by 40 percent and never rebound – which has never happened. It gives them two goalposts between which they can kick the ball.”
Unlike finances, some types of risk cannot be measured numerically. For instance, “one of the biggest risks to an individual or a couple is divorce. By order of magnitude, that’s a major risk in a family,” he says. “That’s a risk people would want to mitigate; one way would be with prenuptial or cohabitation arrangements for children.”
Another risk worth considering is illiquidity, which can be severe, even for wealthy people, whose money may be tied up in a business or real estate. These investments matter little “if you have to cover four kids going to university for four years in the U.S.,” says McCullough.
“You have to match your short- and long-term goals to assets and liability,” he says, “and the types of asset have to match the types of liability.”
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