GUIDE TO ANNUITIES AND
ETHICAL MARKETING PRACTICES
(2015 Edition)
Researched and Written by:
Edward J. Barrett
CFP, ChFC, CLU, CEBS, RPA, CRPS, CRPC
Disclaimer
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ABOUT THE AUTHOR
Edward J. Barrett CFP®, ChFC®, CLU, CEBS®, RPA, CRPS, CRPC®, began his career in
the financial and insurance services back in 1978 with IDS Financial Services, becoming a
leading financial advisor and top district sales manager in Boston, Massachusetts. In 1986,
Mr. Barrett joined Merrill Lynch in Boston as an estate and business-planning specialist
working with over 400 financial advisors and their clients throughout the New England
region assisting in the sale of insurance products.
In 1992, after leaving Merrill Lynch and moving to Florida, Mr. Barrett founded The Barrett
Companies Inc., Broker Educational Sales & Training Inc., Wealth Preservation Planning
Associates and The Life Settlement Advisory Group Inc.
Mr. Barrett is a qualifying member of the Million Dollar Round Table, Qualifying
Member Court of the Table® and Top of the Table® producer. He holds the Certified
Financial Planner designation CFP®, Chartered Financial Consultant (ChFC), Chartered
Life Underwriter (CLU), Certified Employee Benefit Specialist (CEBS), Retirement
Planning Associate (RPA), Chartered Retirement Planning Counselor (CRPC) and the
Chartered Retirement Plans Specialist (CRPS).
About EJB Financial Press
EJB Financial Press, Inc. (www.ejbfinpress.com) was founded in 2004, by Mr. Barrett to
provide advanced educational and training manuals approved for correspondence continuing
education credits for insurance agents, financial advisors, accountants and attorneys
throughout the country.
About Broker Educational Sales & Training Inc.
Broker Educational Sales & Training Inc. (BEST) is a nationally approved provider of
continuing education and advanced training programs to the mutual fund, insurance and
financial services industry.
For more information visit our website at: www.bestonlinecourses.com or call us at
800-345-5669.
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Table of Contents
ABOUT THE AUTHOR .................................................................................................. 3 SECTION I GUIDE TO ANNUITIES ........................................................................ 15 CHAPTER 1 INTRODUCTION ................................................................................ 17 Overview ........................................................................................................................... 17 Learning Objectives .......................................................................................................... 17 Annuity Defined................................................................................................................ 17 History of Annuities .......................................................................................................... 18 Annuities in the U.S ................................................................................................... 19 U.S. Individual Annuity Sales ................................................................................... 20 Annuity Buyers ................................................................................................................. 21 Primary Uses of Annuities ................................................................................................ 21 Annuity Outlook ............................................................................................................... 22 Chapter 1 Review Questions ........................................................................................... 23 CHAPTER 2 CLASSIFICATION OF ANNUITIES ................................................ 25 Overview ........................................................................................................................... 25 Learning Objectives .......................................................................................................... 25 Classification of Annuities................................................................................................ 25 Purchase Option ................................................................................................................ 26 Single Premium ......................................................................................................... 26 Periodic (Flexible) Payment ...................................................................................... 26 Date Benefit Payments Begin ........................................................................................... 26 Deferred Annuities..................................................................................................... 27 Immediate Annuities .................................................................................................. 28 Deferred Income Annuity .......................................................................................... 29 Investment Options ........................................................................................................... 30 Fixed Annuity ............................................................................................................ 30 Variable Annuity ....................................................................................................... 30 Sales of Annuities ...................................................................................................... 31 Payout Options .................................................................................................................. 31 Chapter 2 Review Questions ........................................................................................... 34 CHAPTER 3 FIXED ANNUITIES ........................................................................... 35 Overview ........................................................................................................................... 35 Learning Objectives .......................................................................................................... 35 Advantages of Fixed Annuities......................................................................................... 35 Disadvantages of Fixed Annuities .................................................................................... 36 Fixed Annuity Fees and Expenses .................................................................................... 36 Contract Charge ......................................................................................................... 36 Interest Spread ........................................................................................................... 36 Surrender Charges ..................................................................................................... 36 Fixed Annuity Sales .......................................................................................................... 37 Types of Fixed Annuities .................................................................................................. 37 Crediting Rates of Interest ................................................................................................ 38 Non-forfeiture Interest Rate ....................................................................................... 39 Current Rate of Interest ............................................................................................. 39 5
Portfolio Rate ............................................................................................................. 39 New Money Rate ....................................................................................................... 40 Calculating the Rate ................................................................................................... 41 Interest Rate Trends ................................................................................................... 42 Interest Rate Projections ............................................................................................ 42 Bonus Annuities......................................................................................................... 42 Two-Tiered Annuities ................................................................................................ 43 Fixed Annuitization: Calculating Fixed Annuity Payments ............................................ 43 Chapter 3 Review Questions ........................................................................................... 44 CHAPTER 4 VARIABLE ANNUITIES................................................................... 45 Overview ........................................................................................................................... 45 Learning Objectives .......................................................................................................... 45 VA Defined ....................................................................................................................... 46 The VA Market .......................................................................................................... 46 VA Product Features.................................................................................................. 48 Separate Accounts ............................................................................................................. 48 Investment Options .................................................................................................... 48 Accumulation Units ................................................................................................... 49 VA Charges and Fees........................................................................................................ 50 Mortality and Expense (M&E) Charge...................................................................... 51 Management (Fund Expense) Fees ............................................................................ 51 Contract (Account) Maintenance Fees ...................................................................... 52 Summary of Above Fees ........................................................................................... 52 Surrender Fees ........................................................................................................... 53 VA Sales Charges ...................................................................................................... 53 Premium Tax ..................................................................................................................... 54 Investment Features .......................................................................................................... 55 Dollar Cost Averaging ............................................................................................... 55 Enhanced Dollar Cost Averaging .............................................................................. 56 Fund Transfers ........................................................................................................... 56 Asset Allocation......................................................................................................... 57 Asset Rebalancing ..................................................................................................... 57 Guaranteed Minimum Death Benefit ................................................................................ 57 Enhanced GMDB Features ........................................................................................ 58 Initial Purchase Payment with Interest or Rising Floor ............................................. 58 Contract Anniversary, Or “Ratchet” .......................................................................... 59 Reset Option .............................................................................................................. 59 Enhanced Earnings Benefits ...................................................................................... 59 Guaranteed Living Benefit (GLB) Riders......................................................................... 59 Types of GLB Riders ................................................................................................. 60 Guaranteed Minimum Income Benefit (GMIB) ............................................................... 60 GMIB Features and Benefits ..................................................................................... 60 GMIB Caveats ........................................................................................................... 61 GMIB Client Suitability ............................................................................................ 62 Guaranteed Minimum Account Balance (GMAB) ........................................................... 62 GMAB Example ........................................................................................................ 62 6
GMAB Caveats .......................................................................................................... 62 GMAB Client Suitability ........................................................................................... 63 Guaranteed Minimum Withdrawal Benefit (GMWB) ...................................................... 63 GMWB Example ....................................................................................................... 63 GMWB Caveats ......................................................................................................... 63 GMWB Client Suitability .......................................................................................... 64 Guaranteed Minimum Withdrawal Benefit for Lifetime .................................................. 64 GMWBL Features and Benefits ................................................................................ 65 GMWBL Client Suitability........................................................................................ 65 Treatment of Withdrawals from GLB Riders ................................................................... 66 Dollar-for-Dollar........................................................................................................ 66 Pro-Rata ..................................................................................................................... 66 Variable Annuitization: Calculating Variable Annuity Income Payouts ......................... 66 Annuity Units............................................................................................................. 67 Assumed Interest Rate (AIR)..................................................................................... 68 VA Regulation under the Federal Securities Laws ........................................................... 69 Securities Act of 1933 ............................................................................................... 69 Securities Act of 1934 ............................................................................................... 70 Investment Company Act of 1940 ............................................................................. 70 Regulation of Fees and Charges ................................................................................ 71 Outlook for Variable Annuities ........................................................................................ 71 Chapter 4 Review Questions ........................................................................................... 73 CHAPTER 5 INDEX ANNUITIES ........................................................................... 75 Overview ........................................................................................................................... 75 Learning Objectives .......................................................................................................... 75 Index Annuity Defined ..................................................................................................... 75 Index Annuity Market ....................................................................................................... 76 Profile of an IA Buyer....................................................................................................... 77 IA Basic Terms and Provisions......................................................................................... 77 Tied Index .................................................................................................................. 77 Index (Term) Period .................................................................................................. 78 Participation Rate....................................................................................................... 78 Spreads or Margins .................................................................................................... 79 Cap Rate..................................................................................................................... 80 No-Loss Provision ..................................................................................................... 81 Guaranteed Minimum Account Value ....................................................................... 81 Liquidity .................................................................................................................... 81 Fees and Expenses ..................................................................................................... 82 Surrender Charges ..................................................................................................... 82 Interest Calculation .................................................................................................... 83 Exclusion of Dividends.............................................................................................. 83 Index-Linked Interest Crediting Methods ......................................................................... 83 Annual Reset (Ratchet) Method ................................................................................ 84 High-Water Mark Method ......................................................................................... 85 Point-to-Point Method ............................................................................................... 85 Interest Crediting Method Comparison ..................................................................... 88 7
Averaging .................................................................................................................. 89 Other Interest Crediting Methods ..................................................................................... 89 Multiple (Blended) Indices ........................................................................................ 89 Monthly Cap (Monthly Point-to-Point) ..................................................................... 90 Binary, Non-Negative (Trigger) Annual Reset ......................................................... 90 Bond-Linked Interest with Base ................................................................................ 90 Hurdle ........................................................................................................................ 90 Annual Fixed Rate with Equity Component .............................................................. 91 Rainbow Method ....................................................................................................... 91 Index Annuity Waivers and Riders ................................................................................... 93 Types of Riders .......................................................................................................... 93 IA’s with Bonuses ............................................................................................................. 94 Regulation of IA’s............................................................................................................. 94 FINRA Investor Alerts .............................................................................................. 95 Chapter 5 Review Questions ........................................................................................... 96 CHAPTER 6 ANNUITY TAX LAWS ...................................................................... 97 Overview ........................................................................................................................... 97 Learning Objectives .......................................................................................................... 97 Background ....................................................................................................................... 97 Annuity Defined for Tax Purposes ................................................................................... 98 Premiums .......................................................................................................................... 98 Qualified Premiums ................................................................................................... 98 Nonqualified Premiums ............................................................................................. 98 IRC § 72: Tax-Deferral .................................................................................................... 99 The Power of Tax-Deferred Compounding ............................................................... 99 IRC § 72(a) General Rules for Annuities ................................................................ 100 IRC § 72(b): Exclusion Ratio Rule ......................................................................... 100 IRC § 72(c)(4): Annuity Starting Date ................................................................... 101 IRC § 72(e): Lifetime Distributions ....................................................................... 102 IRC § 72(e)(4)(A): Loans and Assignments ........................................................... 102 IRC § 72(e)(4)(c): Gift of the Annuity Contract .................................................... 103 IRC § 72(e)(5)(E) Gain in the Contract .................................................................. 103 IRC §72(e)(11)(A)(ii) Aggregation Rules .............................................................. 103 IRC § 72(t)(1): Additional 10% Penalty Tax on Early Distribution ...................... 104 IRC § 72(q)(1): Premature Distribution 10% Penalty Tax ..................................... 105 IRC § 72(s): Death Distribution Rules at Death of the Holder............................... 106 IRC § 72(u): Non-Natural Person Rule .................................................................. 108 IRC § 72(u)(4): Defines an Immediate Annuity ..................................................... 109 IRC Section 165: Claiming a Loss................................................................................. 109 IRC Section 7702B(e)(1) ................................................................................................ 110 IRC § 1035: Tax-Free Exchanges .................................................................................. 111 IRC § 1035 Requirements ....................................................................................... 111 Partial IRC § 1035 Exchanges ................................................................................. 111 Revenue Ruling 2003-76 ......................................................................................... 113 IRS Revenue Procedure 2008-24 .................................................................................... 114 The New IRC Section 1035(a)(4) ............................................................................ 114 8
Partial Annuitization of NQ Annuity Contracts ...................................................... 114 Inherited Annuity 1035 Exchange (PLR 201330016) ............................................. 115 IRC § 2039: Estate Tax Inclusion .................................................................................. 116 IRC § 691(c) Income in Respect of a Decedent (IRD) ................................................... 117 Calculating the IRD Deduction ............................................................................... 118 Annuities inside Qualified Retirement Plans .................................................................. 118 Congressional Mandate ........................................................................................... 119 Annuities in an IRA ................................................................................................. 119 Advantages of Annuities inside a Qualified Retirement Plan ................................. 120 RMD Rule Requirements on Variable Annuity Contracts ............................................. 122 Actuarial Present Value Defined ............................................................................. 122 RMD Calculation under the New Rules .................................................................. 122 Safe Harbor Rules .................................................................................................... 123 Example: Calculating RMD under New Rules ....................................................... 123 Qualifying Longevity Contracts (QLAC) ....................................................................... 124 Disclaimers With Regards to Tax and Legal Issues ....................................................... 125 Chapter 6 Review Questions ......................................................................................... 127 CHAPTER 7 PARTIES TO THE CONTRACT ................................................... 129 Overview ......................................................................................................................... 129 Learning Objectives ........................................................................................................ 129 Background ..................................................................................................................... 129 The Contract Owner ........................................................................................................ 130 Rights of the Owner ................................................................................................. 130 Changing the Annuitant ........................................................................................... 130 Duration of Ownership ............................................................................................ 130 Purchaser, Others as Owner ..................................................................................... 131 Taxation of Owner ................................................................................................... 131 Death of Owner: Required Distribution ................................................................. 131 Spousal Exception ................................................................................................... 132 The Annuitant ................................................................................................................. 132 A Natural Person...................................................................................................... 132 Role of the Annuitant............................................................................................... 132 Naming Joint Annuitants/Co-Annuitants ................................................................ 132 Taxation of Annuitant .............................................................................................. 133 Death of Annuitant .................................................................................................. 133 The Beneficiary ............................................................................................................... 134 Death Benefit ........................................................................................................... 134 Whose Death Triggers the Death Benefit ................................................................ 134 Changing the Beneficiary ........................................................................................ 135 Designated Beneficiary ............................................................................................ 135 Spouse or Children as Beneficiaries ........................................................................ 135 Non-Natural Person as Beneficiary ......................................................................... 135 Multiple Beneficiaries ............................................................................................. 135 Taxation of Beneficiary ........................................................................................... 135 Death of Beneficiary ................................................................................................ 136 The Insurer ...................................................................................................................... 137 9
Collecting and Investing the Premium .................................................................... 137 Paying the Guaranteed Death Benefit...................................................................... 137 Paying the Guaranteed Income Option .................................................................... 137 Insurance Rating Services ............................................................................................... 138 A.M. Best ................................................................................................................. 138 Moody’s ................................................................................................................... 138 Duff & Phelps .......................................................................................................... 139 Standard & Poor’s.................................................................................................... 139 Weiss Research ........................................................................................................ 140 State Guaranty Associations ........................................................................................... 141 Coverage .................................................................................................................. 141 Member Assessments .............................................................................................. 142 Chapter 7 Review Questions ......................................................................................... 143 CHAPTER 8 ANNUITY CONTRACT STRUCTURE ......................................... 145 Overview ......................................................................................................................... 145 Learning Objectives ........................................................................................................ 145 Background ..................................................................................................................... 145 Structuring the Contract .................................................................................................. 146 Annuity Contract Forms ................................................................................................. 146 Owner-Driven .......................................................................................................... 147 Annuitant-Driven Contract ...................................................................................... 147 Joint Annuitants/Co-Annuitants...................................................................................... 147 Contingent Annuitants ............................................................................................. 148 The Death Benefit ........................................................................................................... 148 Death after the Annuity Starting Date ............................................................................ 149 Chapter 8 Review Questions ......................................................................................... 170 SECTION II ETHICAL MARKETING PRACTICES .......................................... 171 CHAPTER 9 ETHICS .............................................................................................. 173 Overview ......................................................................................................................... 173 Learning Objectives ........................................................................................................ 173 Ethics Defined ................................................................................................................. 173 Why is Ethics Important?................................................................................................ 174 Identifying What Is Not Ethics ................................................................................ 175 Why Identifying Ethical Standards is Hard .................................................................... 175 Making Ethical Decisions ............................................................................................... 177 The Four-Way Test .................................................................................................. 178 The Golden Rule ............................................................................................................. 179 The Ten “Ethical Hazard Approaching” Signs ............................................................... 181 Everyday Ethics .............................................................................................................. 181 Ethics Self Examination .................................................................................................. 182 General Ethical Principles to Live By and Work By ...................................................... 183 Honesty .................................................................................................................... 183 Integrity.................................................................................................................... 184 Reliability (Promise-Keeping) ................................................................................. 185 Responsibility .......................................................................................................... 185 Caring ...................................................................................................................... 185 10
Selflessness .............................................................................................................. 186 Courage .................................................................................................................... 186 Excellence ................................................................................................................ 187 Chapter 9 Review Questions ......................................................................................... 188 CHAPTER 10 ETHICS AND THE INSURANCE INDUSTRY .......................... 189 Overview ......................................................................................................................... 189 Learning Objectives ........................................................................................................ 189 Insurance Defined ........................................................................................................... 189 The Role and History of Insurance ................................................................................. 190 History of Insurance ................................................................................................ 190 The Importance of Trust in the Insurance Industry ........................................................ 191 Outlook for Ethics in the Insurance Industry .................................................................. 193 Ethical Responsibilities of the Insurance Producer ........................................................ 194 Insurance Producer’s Ethical Responsibilities to the Insurer .................................. 195 Insurance Producer’s Ethical Responsibility to Insured/Policy Owner ................... 196 Insurance Producer’s Ethical Responsibilities to the State...................................... 196 Insurer’s Responsibility to the Insurance Producer ........................................................ 197 The Employment Agreement ................................................................................... 197 The Insurer’s Obligation of Compensation ............................................................. 197 Indemnification of Producer .................................................................................... 197 Potential Liabilities of Insurance Producers/Errors and Omissions (E&O) Exposure
................................................................................................................................. 198 Agency Law Principles ................................................................................................... 198 Presumption of Agency ........................................................................................... 199 Power of Authority ......................................................................................................... 199 Express Authority .................................................................................................... 199 Implied (Lingering) Authority ................................................................................. 199 Apparent Authority .................................................................................................. 200 Waiver and Estoppel ................................................................................................ 200 Categories of Insurance Producers.................................................................................. 200 Life and Health Producers (Agents) ........................................................................ 201 Property and Casualty Agents ................................................................................. 201 Brokers ..................................................................................................................... 201 Solicitors .................................................................................................................. 202 Insurance Consultants .............................................................................................. 202 Captive Agents vs. Independent Agents ......................................................................... 202 Independent Agents ................................................................................................. 203 Insurance Producers as a Professional ............................................................................ 203 Chapter 10 Review Questions ....................................................................................... 204 CHAPTER 11 REGULATION OF THE INSURANCE INDUSTRY ................. 205 Overview ......................................................................................................................... 205 Learning Objectives ........................................................................................................ 205 Background ..................................................................................................................... 205 Paul vs. Virginia ...................................................................................................... 206 South-Eastern Underwriters Association (SEUA)................................................... 206 McCarran-Fergusson Act......................................................................................... 207 11
State Regulation of the Insurance Industry ..................................................................... 207 Structure of the State Regulatory Framework ......................................................... 207 The Role of the State Legislators............................................................................. 208 State Insurance Departments ................................................................................... 209 Insurance Commissioner ......................................................................................... 209 The Role of the NAIC ..................................................................................................... 210 NAIC Model Laws .................................................................................................. 210 The Purpose and Structure of Insurance Regulation....................................................... 211 Insurer Licensing ..................................................................................................... 211 Producer Licensing .................................................................................................. 212 Product Regulation .................................................................................................. 212 Financial Regulation ................................................................................................ 213 Market Regulation ................................................................................................... 214 Consumer Services .................................................................................................. 214 Federal Legislation.......................................................................................................... 215 Employment Retirement Income Security Act of 1974 (ERISA) ........................... 215 Fair Crediting Reporting Act ................................................................................... 215 HIPAA ..................................................................................................................... 216 The Financial Services Modernization Act of 1999 ................................................ 218 The Wall Street Reform and Consumer Protection Act of 2010 ............................. 218 The Future of Insurance Regulation ............................................................................... 218 Chapter 11 Review Questions ......................................................................................... 221 CHAPTER 12 UNFAIR MARKETING PRACTICES ......................................... 223 Overview ......................................................................................................................... 223 Learning Objectives ........................................................................................................ 223 Background ..................................................................................................................... 223 Purpose of the Act ................................................................................................... 224 Misrepresentation ............................................................................................................ 224 Fraud ............................................................................................................................... 224 Altering Applications ...................................................................................................... 224 Premium Theft ................................................................................................................ 225 False or Misleading Advertising ..................................................................................... 225 Defamation ...................................................................................................................... 225 Boycott, Coercion, Intimidation ..................................................................................... 226 Twisting .......................................................................................................................... 226 Churning ......................................................................................................................... 226 Discrimination................................................................................................................. 226 Rebating .......................................................................................................................... 226 Use of Senior Specific Certifications and Designations ................................................. 227 Annuity Disclosure Model Regulation ........................................................................... 228 Fixed and Index Annuities ....................................................................................... 229 Variable Annuities ................................................................................................... 229 Recordkeeping ......................................................................................................... 230 Annuity Suitability Model Regulation ............................................................................ 230 Senior Protection in Annuity Transactions Model Regulation ................................ 230 2006 Suitability Model ............................................................................................ 230 12
2010 NAIC Suitability in Annuity Transactions Model Regulation .............................. 231 Determining Suitability ........................................................................................... 232 Systems of Supervision and Training ...................................................................... 233 FINRA Compliance ................................................................................................. 234 The Wall Street Reform and Consumer Protection Act of 2010 ............................. 235 FINRA/SEC Suitability Regulations .............................................................................. 237 FINRA Rule 2821 .................................................................................................... 237 FINRA Rule 2330 .................................................................................................... 239 FINRA Rule 2111 .................................................................................................... 240 FINRA Rule 2090: Know Your Customer .............................................................. 240 SEC Approves Consolidated FINRA Rules ............................................................ 241 Recent FINRA Disciplinary Action......................................................................... 241 Benefits of Maintaining Suitability Standards ................................................................ 242 Avoid Market Conduct Trouble............................................................................... 242 Increased Client Satisfaction ................................................................................... 242 A Win-Win-Win Solution........................................................................................ 243 Chapter 12 Review Questions ....................................................................................... 244 CHAPTER 13 CODES OF ETHICS....................................................................... 245 Overview ......................................................................................................................... 245 Learning Objectives ........................................................................................................ 245 Code of Ethics Defined ................................................................................................... 245 Code of Conduct Defined ............................................................................................... 246 Reasons for a Code of Ethics .......................................................................................... 246 Developing a Code of Ethics .......................................................................................... 247 Live By a Code of Ethics ................................................................................................ 248 Samples of Codes of Ethics ............................................................................................ 248 National Association of Insurance and Financial Advisors (NAIFA) ..................... 249 National Association of Health Underwriters (NAHU) .......................................... 250 The Society of Financial Services Professionals ..................................................... 250 The Certified Financial Planners Board of Standards, Inc. (CFP®) ....................... 257 The Society of Certified Senior Advisors (CSA) .................................................... 260 American Institute for Chartered Property and Casualty Underwriters .................. 261 Million Dollar Round Table (MDRT) ..................................................................... 263 Chapter 13 Review Questions ........................................................................................ 265 CHAPTER 14 ANTI-MONEY LAUNDERING .................................................... 267 Overview ......................................................................................................................... 267 Learning Objectives ........................................................................................................ 267 Stages of Money Laundering .......................................................................................... 267 Federal Regulation in the U.S. ........................................................................................ 268 The Money Laundering Control Act of 1986 .......................................................... 268 The Bank Secrecy Act of 1970 ................................................................................ 268 USA Patriot Act of 2001.......................................................................................... 269 The New Anti-Money Laundering Rules ....................................................................... 270 AML Training for Insurance Producers .................................................................. 271 Covered Products Pursuant to the Rule ................................................................... 272 Indicators of Insurance Money Laundering Schemes ............................................. 272 13
Role of the Insurance Producer Agent ............................................................................ 274 Chapter 14 Review Questions ....................................................................................... 275 CHAPTER REVIEW ANSWERS.............................................................................. 277 CONFIDENTIAL FEEDBACK .................................................................................. 279 14
SECTION I
GUIDE TO ANNUITIES
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CHAPTER 1
INTRODUCTION
Overview
Many financial professionals think of the annuity as a modern day investment. However,
annuities were in use long before the Internal Revenue Code was enacted. The creation
of annuities was not tax driven; it was driven by our need for security in an uncertain
world. It was, and is, driven by our need for the insurance features that the annuity
contract provides. The principal insurance role of annuities is to indemnify individuals
against the risk of outliving their resources.
In this chapter, we will define the annuity and review the historical uses of the annuity.
In addition, we will examine the role of annuities in the U.S., their sales, who purchases
the annuity and the reasons for the purchase of an annuity. At the end of the chapter, we
will examine the future outlook for annuities.
Learning Objectives
Upon completion of this chapter, you will be able to:





Identify how an annuity is defined;
Demonstrate the mathematical concept of an annuity
Explain how annuities have been used throughout history;
Explain the reasons why people purchase annuities today; and
Understand the outlook for the future of annuities.
Annuity Defined
In general terms, an annuity is a mathematical concept that is quite simple in its most
basic application. Start with a lump sum of money, pay it out in equal installments over a
period of time until the original fund is exhausted, and you have an annuity. Expressed
differently, an annuity is simply a vehicle for liquidating a sum of money.
But of course, in practice, the concept is a lot more complex. An important factor
missing from above is interest. The sum of money that has not yet been paid out is
earning interest, and that interest is also passed on to the income recipient (the
“annuitant”).
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Anyone can provide an annuity as long as they can calculate the payment based upon
three factors:



A sum of money
Length of payout period, and
An assumed interest rate
However, there is one important element absent from this simple definition of an annuity,
and it is the one distinguishing factor that separates insurance companies from all other
financial institutions. While anyone can set up an annuity and pay income for a stated
period of time, only an insurance company can do so and guarantee income for the life of
the annuitant.
The insurance companies, with their unique experience with mortality tables, are able to
provide an extra factor into the standard annuity calculation, a survivorship factor. The
survivorship factor provides insurers with the means to guarantee annuity payments for
life, regardless of how long that life lasts.
Don’t get confused between an annuity and a life insurance contract. Annuities are not
life insurance contracts. Even though it can be said that an annuity is a mirror image of a
life insurance contract—they look alike but are actually exact opposites. Life insurance
is concerned with how soon one will die; life annuities are concerned with how long one
will live.
But did you know that annuities existed long before the existing of insurance companies.
As you will see, annuities have a long and illustrious history going back thousands of
years. In fact, annuities can actually trace their origins back to Roman times.
History of Annuities
There is some evidence that shows that one of the first life annuity ever purchased (or
invested), would have been around 1700 BCE. According to research by Moshe
Molevsky, he uncovered evidence that a life annuity was purchased by a prince ruling the
region of Sint in the Middle Kingdom (1100-1700 BCE). The annuitant’s name was
Price Hepdefal, but little else is known about the annuity itself, in what units it was paid
for and whether it ended up being a good investment for him.
Around the sixth century BCE, within the Old Testament, 2 Kings 25:30 makes reference
to the (life) annuity that was granted to Jehoiakim, king of Judah, by the king of Babylon
upon on his release from prison. By the second and third centuries CE, life annuities
became quite popular in Rome, where mutual aid societies of the Roman legions granted
them to soldiers who retired from military service at age 46. In addition, it has been
reported that during that time ancient Roman contracts known as annua (or “annual
stipends”) promised an individual a stream of payments for a fixed term, or possibly for
life, in return for an up-front payment. Such contracts were apparently offered by
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speculators who dealt in marine and other lines of insurance. A Roman, Domitius
Ulpianus, compiled the first recorded life table for the purpose of computing the estate
value of annuities that a decedent might have purchased on the lives of his survivors.
During the 17th century, governments in several nations, including England and Holland,
sold annuities in lieu of government bonds, to pay for massive, on-going battles with
neighboring countries. The governments received capital in return for a promise of
lifetime payouts to the annuitants. The governments would then create a “tontine”,
promising to pay for an extended period of time if citizens would purchase shares today.
The United Kingdom, locked in many wars with France, started one of the first group
annuity contracts called the State of Tontine of 1693. Participants in these early
government annuities would purchase a share of the Tontine for ₤100 from the UK
Government. In return, the owner of the share received an annuity during the lifetime of
their nominated person (often a child). As each nominee died, the annuity for the
remaining proprietors gradually became larger and larger. This growth and division of
wealth would continue until there were no nominees left. Proprietors could assign their
annuities to other parties by deed or will, or they passed on at death to the next of kin.
Annuities in the U.S
In the United States, annuities made their first mark in America during the 18th century.
In 1759, Pennsylvania chartered the Corporation for the Relief of Poor and Distressed
Presbyterian Ministers and Distressed Widows and Children of Ministers. It provided
survivorship annuities for the families of ministers. Ministers would contribute to the
fund, in exchange for lifetime payments. In Philadelphia in 1812, the Pennsylvania
Company for Insurance on Lives and Granting Annuities was founded. It offered life
insurance and annuities to the general public and was the forerunner of modern stock
insurance companies. The Pennsylvania Company for Insurance on Lives and Granting
Annuities was the very first American company to offer annuities to the general public.
Annuities constituted a small share of the U.S. insurance market until the 1930s, when
two developments contributed to their growth. First, concerns about the stability of the
financial system drove investors to products offered by insurance companies, which were
perceived to be stable institutions that could make the payouts that annuities promised.
Flexible payment deferred annuities, which permit investors to save and accumulate
assets as well as draw down principal, grew rapidly in this period. Second, the group
annuity market for corporate pension plans began to develop in the 1930s.
The entire country was experiencing a new emphasis saving for a “rainy day.” The New
Deal Program introduced by President Franklin D. Roosevelt (FDR) unveiled several
programs that encouraged individuals to save for their own retirement. Annuities
benefited from this new-found savings enthusiasm.
By today’s standard, the first modern-day annuities were quite simple. These contracts
guaranteed a return of principal, and offered a fixed rate of return from the insurance
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company during the accumulation period (Fixed Annuity—see Chapter 3 for a full
discussion of Fixed Annuities). When it was time to withdraw from the annuity, you
could choose a fixed income for life, or payments over a set number of years. There were
few bells and whistles to choose from.
That all changed beginning in 1952, when the first variable annuity was created by the
College Retirement Equities Fund (CREF) to supplement a fixed-dollar annuity in
financing retirement pensions for teachers. Variable annuities credited interest based on
the performance of separate accounts inside the annuity. Variable annuity owners could
choose what type of accounts they wanted to use, and often received modest guarantees
from the issuer, in exchange for greater risks they (the owner) assumed. This type of
annuity was then made available to any individual, when the Variable Life Insurance
Company (VALIC) in 1960, began to market its own nonqualified variable annuity (See
Chapter 4 for a full discussion of Variable Annuities). It was the variable annuity that
boosted the popularity of annuities. Then in 1994, Keyport Life Insurance Company
introduced a new type of a fixed annuity called an index annuity (see Chapter 5 for a full
discussion of Index Annuities). And the rest is history.
U.S. Individual Annuity Sales
According to the Life Insurance Marketing Research Association (LIMRA), for full year
2014, total U.S. Individual Annuity sales were $235.8 billion, a 3 percent increase over
2013. Assets under management in annuities reached a record-high of nearly $2.7 trillion
(see Table 1.1).
Table 1.1
Total U. S. Individual Annuity Sales and Assets
2000 – 2014 (billions)
Year
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Sales
$190.0
187.6
218.3
218.0
221.0
217.0
238.0
257.0
265.0
235.0
222.0
238.0
219.0
230.0
235.8
Assets
$1,279
1,237
1,217
1,484
1,633
1,751
1,916
2,028
1,707
2,009
2,035
2,220
2,454
2,589
2,730ͤ
Source: LIMRA Secure Retirement Institute, U.S. Individual Annuities Survey
(based on data from 60 companies, representing 96 percent of total sales, March 2015).
20
Annuity Buyers
In a survey conducted by LIMRA, more than three-quarters of recent annuity buyers are
satisfied with their purchase of an annuity. LIMRA published this finding in a summary
of results from a survey of 1,200 consumers age 40 or over who purchased retail deferred
annuities within the past three years. The study was conducted in the third quarter of
2011.
Nearly 9 in 10 buyers of traditional fixed annuities are happy with their purchase, new
research reveals. The survey reveals that 86% of traditional fixed annuity buyers are
satisfied with their deferred annuity purchase. Likewise, most buyers are variable
annuities (75%) and indexed annuities (83%) are also satisfied with the purchases, the
survey reveals.
LIMRA observes that, of those who are satisfied, two-thirds of the VA households (61%
for indexed and half for traditional fixed) own two or more annuities. The study also
discloses that five of six deferred annuity buyers would recommend an annuity to their
friends or family.
Primary Uses of Annuities
The top reason consumers give for buying an annuity is to supplement their Social
Security or pension income. The second most popular reason is to accumulate assets for
retirement; this is especially true for individuals under age 60 (see Table 1.2).
Receiving guaranteed lifetime income is also a concern, especially for buyers aged 60
and older, the survey says. Annuity buyers’ single most important financial objective is to
have enough money to last their and/or their spouse’s lifetime.
Table 1.2
Intended Uses for Annuities
55%
Accumulate assets for retirement
32%
30%
Cover basic living expenses in retirement
25%
21%
Leave as an inheritance
Pay for emergencies only
Provide temporay income until…
17%
8%
5%
4%
3%
Source LIMRA Study, The “Deferred Annuity Buyer Attitudes and Behaviors” 2012
21
Annuity Outlook
Over the past few years, we saw some companies have slowed down or eliminated new
annuity sales, for various reasons. Many thought these departures would mark the
beginning of the end for the annuity market. Instead, it has created opportunities for
other companies to attract new customers and expand their holdings in one of the safest
investment options available today. We have seen an influx of private equity firms
entering the annuity market, specifically by purchasing interests in fixed-indexed
companies, as well as variable annuity blocks. Additionally, companies are innovating
with new products that are less capital-intensive, which may increase the capacity at
certain companies. The prognosis for 2015 and beyond shows increased investment in
annuities and new players in the marketplace.
22
Chapter 1
Review Questions
1. What is the principal insurance role of annuities?
(
(
(
(
) A. Indemnify individuals against market declines
) B. Indemnify individuals against the risk of dying too soon
) C. Indemnify individuals against the risk of outliving their resources
) D. Indemnify individuals against interest rate risk
2. What is the name of the extra factor that insurance companies can provide with the
means to guarantee annuity payments for life, regardless of how long that life lasts?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
Survivorship factor
Gross interest factor
Annuity factor
Morbidity factor
3. In 1952, the first variable annuity was created by:
(
(
(
(
) A. The Romans
) B. College Retirement Equities Fund (CREF)
) C. Presbyterian ministers
) D. Variable Annuity Life Insurance Company (VALIC)
4. In 1960, the first non-qualified annuity was issued by:
(
(
(
(
) A. The Pennsylvania Company for Insurance on Lives and Granting Annuities
) B. The Teachers Insurance Association of America (TIAA)
) C. Variable Life Insurance Company (VALIC)
) D. College Retirement Equities Fund (CREF)
5. According to the Life Insurance Marketing Research Association (LIMRA), which of
the following is the major reason why an individual purchases an annuity?
(
(
(
(
) A. Pay for LTC premiums
) B. Pay for emergencies only
) C. Leave an inheritance
) D. Supplement Social Security or pension income
23
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24
CHAPTER 2
CLASSIFICATION OF ANNUITIES
Overview
Annuities can be categorized along many dimensions. In this chapter we will examine
the various ways annuities are classified. It also describes the age-old problems that
annuities attempt to solve and explains how annuities have been used over the years.
Finally, the chapter discusses how important annuities are to our society today.
Learning Objectives
Upon completion of this chapter, you will be able to:





Identify the various classifications of annuity contracts.
Demonstrate an understanding of the differences between a deferred annuity and
an immediate annuity;
Distinguish between an immediate annuity and a deferred income annuity;
Recognize the key elements of a variable annuity and fixed annuity; and
Identify the various payout options of an annuity in the distribution phase
Classification of Annuities
Annuities are flexible in that there are a number of classifications (options) available to
the purchaser (contract holder/owner) that will enable him or her to structure and design
the product to best suit his or her needs. Those options are:




Purchase Option
Date Benefit Payments Begin
Investment Options
Payout Options
Let’s review each of these classifications in greater detail beginning with the purchase
option.
25
Purchase Option
An annuity begins with a sum of money, called principal. Annuity principal is created
(or funded) in one of two ways; immediately with a single premium or over time with a
series of flexible premiums.
Single Premium
A single premium annuity is basically just what the name implies; an annuity that is
funded with a single, lump-sum premium, in which case the principal is created
immediately. Usually, this lump sum is fairly large.
Periodic (Flexible) Payment
But not everyone has a large lump sum with which to purchase an annuity. Annuities can
be funded through a series of periodic premiums that, over time, will amass an amount
large enough to buy a significant annuity benefit. At one time, it was common for
insurers to require that periodic annuity premiums be fixed and level, much like insurance
premiums. Today, it is more common to allow contract owner’s flexibility as to allowing
premiums of any size (within certain minimums and maximums, such as none less than
$25 or more than $1,000,000) and at virtually any frequency.
Date Benefit Payments Begin
The annuity is the only investment vehicle that has two phases based upon when the
income payment begins. The phases are:


Deferred (Accumulation Phase); or
Immediate. (Pay-out/Distribution Phase)
The main difference between deferred and immediate annuities is when annuity payments
begin. Every annuity has a scheduled maturity or annuitization date (usually age 90 or
age 95), which is the point the accumulated annuity funds are converted to the payout
mode and benefit payments to the annuitant are to begin.
According to LIMRA SRI, total sales of deferred annuities in 2014 were $218.0 billion
and immediate (income) annuities totaled $17.8 billion, (which includes $9.7 billion of
immediate annuities, $2.7 billion of deferred income annuities and $5.4 billion of
structured settlements).
26
Table 2.1
Annuity Industry Total U.S. Sales
Deferred vs. Immediate Annuities
2000 - 2014 ($ billions)
YEAR
DEFERRED
IMMEDIATE
TOTAL
2000
$ 181.1
$ 8.8
$189.9
2001
175.0
10.3
185.3
2002
208.6
11.3
219.9
2003
207.5
8.3
215.8
2004
209.2
11.6
220.8
2005
204.9
11.5
216.4
2006
226.3
12.4
238.7
2007
243.8
13.0
256.8
2008
250.6
14.4
265.0
2009
225.4
13.2
238.6
2010
209.0
13.5
221.3
2011
227.1
13.2
240.3
2012
207.0
12.7
219.7
2013
216.0
14.1
230.1
2014
218.0
17.8
235.8
Source: LIMRA Secure Retirement Institute, U.S. Individual Annuities Survey
(based on data from 60 companies, representing 96 percent of total sales, March 2015).
Deferred Annuities
Deferred annuities are designed for long-term accumulation and can provide income
payments at some specified future date. A deferred annuity can be funded with either
periodic payments, commonly called flexible premium deferred annuities (FPDAs), or
funded with a single premium, in which case they’re called single premium deferred
annuities, or SPDAs. While a deferred annuity has the potential of providing a
guaranteed lifetime income at some point in the future, the current emphasis in a deferred
annuity is on accumulating funds rather than liquidating funds. An advantage that
deferred annuities have over many other long-term savings vehicles is that there are no
taxes (tax-deferral) paid on the accumulated earnings in an annuity until withdrawals are
made.
27
Immediate Annuities
An immediate annuity is designed primarily to pay income benefit payments one period
after purchase of the annuity. Since most immediate annuities make monthly payments,
an immediate annuity would typically pay its first payment one month (30 days) from the
purchase date. If, however, a client needs an annual income, the first payment will begin
one year from the purchase date. Thus, an immediate annuity has a relatively short
accumulation period. As you might guess immediate annuities can only be purchased
with a single premium payment and are often called single-premium immediate annuities,
or SPIA’s. The SPIA is the simplest individual annuity contract. In return for a single
premium payment, the annuitant receives a guaranteed stream of future payments that
begin immediately. These types of annuities cannot simultaneously accept periodic
funding payments by the owner and pay out income until the annuitant dies (a simple life
annuity), or when both the annuitant and a co-annuitant, such as a spouse, have died (a
joint life survivorship annuity). A simple life annuity is primarily designed to insure
annuitants against outliving their resources; a joint life survivorship annuity addresses
this risk and also provides retirement income for dependents. The average age of a SPIA
buyer is 73.
A once-snubbed annuity product—the immediate income annuity—appears to be gaining
a foothold in the broad annuity marketplace and in the practices of advisors who serve the
boomer and retirement income markets. According to LIMRA SRI, immediate income
annuity sales jumped 17 percent in 2014; totaling $9.7 billion (see Table 2.2).
Table 2.2
Total Sales of Immediate Annuities
2000 – 2014 ($ billions)
YEAR
VARIABLE
FIXED
TOTAL
2000
$ 0.6
$ 8.0
$ 8.6
2001
0.6
9.6
10.2
2002
0.5
10.7
11.2
2003
0.5
4.8
5.3
2004
0.4
6.1
6.5
2005
0.6
6.3
6.9
2006
0.8
6.3
7.1
2007
0.3
6.7
7.0
2008
0.4
8.6
9.0
2009
0.1
7.5
7.6
2010
0.1
7.6
7.7
28
2011
0.1
8.1
8.1
2012
0.1
7.7
7.7
2013
0.1
8.3
8.4
2014
0.1
9.6
9.7
Source: Morningstar Inc. and LIMRA International, March 2015.
Not including $5.3 of Structured Settlements.
Deferred Income Annuity
In recent years, a new form of retirement income annuity solution has been gaining
visibility: Deferred Income Annuity (DIA), also known as the longevity annuity.
According to LIMRA, deferred income annuities experienced record growth in 2014,
reaching $2.7 billion. This was 22 percent higher than sales in 2013. Like immediate
annuities, DIA’s suffered from falling interest rates in the fourth quarter. DIA sales were
$680 million in the fourth quarter 2014, 4 percent lower than fourth quarter 2013 results.
A "cousin" to the more familiar immediate annuity discussed above, the goal of the DIA
is similar - to provide income for life - but the payments do not begin until years (or even
decades) after the purchase. As such, these "deferred income annuities" can provide
significantly larger payments when they do begin - e.g., at age 85 - in light of both the
compounded interest and the mortality credits that would accrue over the intervening
time period.
Example: A couple both age 65, purchase a $100,000 DIA contract and stipulate that
payments will not begin until they reach age 85. However, the couple does reach age
85, payments of $2,656.20 will commence and be payable for as long as either
remains alive. Notably, the trade-off here is rather “extreme” – if the couple dies
anytime between now and age 85 (assuming both pass away), the $100,000 is lost.
However, if they merely live half way through age 88, they will have recovered their
entire principal, and from there will continue to receive $31,874.40/year thereafter, a
significant payoff for “just” $100,000 today.
Of course, the payout rates will vary depending on the starting age. If the 65-year-old
couple begins payments at age 75 instead of 85, the monthly payments are only
$934.18/month, instead of $2,656.20. The couple could also purchase a single premium
immediate annuity (SPIA) at age 65 with payments that start immediately, but the
payouts would only be $478.91/month. Thus, in essence, by introducing a 10-year
waiting period, the payments more than double; by waiting 20 years, the payments more
than quintuple! And if the couple starts even earlier, the payments are greater; a longevity
annuity purchased for $100,000 at age 55 with payments that don’t begin until age 85
receive a whopping $4,054.10/month ($48,649.20/year!) if at least one of them remains
alive to receive the payments! Alternatively, the couple could include a return-ofpremium death benefit (to the extent the original $100,000 is not recovered in annuity
payments, it is paid out at the second death to the beneficiary), which would drop the
29
payments to a still-significant $3,690.30/month. (Quotes are from Cannex, as of
7/8/2014)
In essence, the concept of the DIA is to truly hedge against longevity; while the couple
may receive limited payments if they don’t survive, the payments are very significant
relative to the starting principal if they do live long enough; in fact, the payments can be
so “leveraged” against mortality that the couple doesn’t actually need to set aside very
much in their 50s and 60s to fully “hedge” against living beyond age 85 (which also
makes it easier to invest for retirement when the time horizon is known and fixed to just
cover between now and age 85!).
In theory, a longevity annuity could be purchased with after-tax dollars (a non-qualified
annuity), or within a retirement account. After all, the reality is that for many people, the
bulk of their retirement savings is currently held within retirement accounts, and if there’s
a goal to use a longevity annuity to hedge against long life, those are the dollars to use!
Unfortunately, though, there’s a major problem with holding a longevity annuity inside of
a retirement account: how do you have a contract that doesn’t begin payments until age
85 held within an account that has required minimum distributions (RMDs) beginning at
age 70 ½!
We’ll that was settled when the IRS issued final regulations (T.D. 9673) that now permits
participants of IRAs and 401(a) qualified retirement plans, 403(b) plans and eligible
governmental 457 plans to purchase a “Qualified Longevity Annuity Contracts
(QLACs),” using a certain amount of their account balance, without having these
amounts count for calculating required minimum distributions (RMDs).
Investment Options
An annuity can be classified by two types of investment options. They are:


Fixed and
Variable
Fixed Annuity
A fixed annuity is an insurance contract in which the insurance company guarantees both
the earnings and principal (See Chapter 3 for a full discussion of fixed annuities).
Variable Annuity
A variable annuity, on the other hand, is an insurance contract where the contract holder
decides how to invest the money invested in sub-accounts (essentially mutual funds)
offered within the annuity. The value of the sub-accounts depends on the performance of
the funds chosen. The most popular type of annuity sold is the variable annuity (see
Chapter 4 for a full discussion of Variable Annuities).
30
Sales of Annuities
Table 2.3 illustrates the total U.S. Sales of Annuities between Variable Annuities and
Fixed Annuities. As you can see for the full year 2014, VA total sales fell 4 percent in
2014, totaling $140.1 billion. This represents the lowest annual VA sales since 2009. On
the other side, Fixed Annuity (FA) sales were $95.7 billion in 2014, improving 13
percent compared with 2013.
Table 2.3
Annuity Industry Total U.S. Sales
Variable vs. Fixed 2000 - 2014 ($ billions)
Year
Variable
Fixed
Total
2000
$ 137.3
$ 52.7
$190.0
2001
113.3
74.3
187.6
2002
115.0
103.3
218.3
2003
126.4
84.1
215.8
2004
133.0
88.0
221.0
2005
137.0
80.0
217.0
2006
160.0
78.0
238.0
2007
184.0
73.0
257.0
2008
156.0
109.0
265.0
2009
128.0
111.0
239.0
2010
140.0
82.0
222.0
2011
158.0
80.0
238.0
2012
147.0
72.0
219.0
2013
145.0
85.0
230.0
2014
140.1
95.7
235.8
Source: LIMRA Secure Retirement Institute, U.S. Individual Annuities Survey
(based on data from 60 companies, representing 96 percent of total sales, March 2015).
Payout Options
Another way to classify an annuity is the payout option chosen. Once an annuity matures
and its accumulated fund is converted to an income stream, a payout schedule is
established (see Table 2.4). There are a number of annuity payout options available:
31


Straight (Single) Life Income Option. A straight life income option (often called a
life annuity or single life annuity) pays the annuitant a guaranteed income for his
or her lifetime. This is the purest form of life annuitization. The straight life
income option pays out a higher amount of income than any other life with period
certain or a joint and survivor option, but they might not be higher than other
options (such as cash refund, installment refund, or pure period certain). At the
annuitant death, no further payments are made to anyone. If the annuitant dies
before the annuity fund (i.e., the principal) is depleted, the balance, in effect, is
“forfeited” to the insurer. It is used to provide payments to other annuitants who
live beyond the point where the income they receive equals their annuity
principal.
 Cash Refund Option. A cash refund option provides a guaranteed income to the
annuitant for life and if the annuitant dies before the annuity fund (i.e., the
principal) is depleted, a lump-sum cash payment of the remainder is made to the
annuitant’s beneficiary. Thus, the beneficiary receives an amount equal to the
beginning annuity fund less the amount of income already paid to the deceased
annuitant.
 Installment Refund Option. Like the cash refund, the installment refund option
guarantees that the total annuity fund will be paid to the annuitant or to his or her
beneficiary. The difference is that under the installment option, the fund
remaining at the annuitant’s death is paid to the beneficiary in the form of
continued annuity payments, not as a single lump sum.
 Life with Period Certain Option. Also known as the life income with term certain
option, this payout approach is designed to pay the annuitant an income for life,
but guarantees a definite minimum period of payments. For an example, if an
individual has a ten-year period certain annuity, and receives monthly payments
for six years before dying, his or her beneficiary will receive the same payments
for four more years. Of course, if the annuitant died after receiving monthly
annuity payments for ten or more years, his or her beneficiary would receive
nothing from the annuity.
 Joint and Full Survivor Option. The joint and full survivor option provides for
payment of the annuity to two people. If either person dies, the same income
payments continue to the survivor for life. When the surviving annuitant dies, no
further payments are made to anyone. There are other joint arrangements offered
by many companies:
o Joint and Two-Thirds Survivor. This is the same as the above arrangement,
except that the survivor’s income is reduced to two-thirds of the original joint
income.
o Joint and One-Half Survivor. This is the same as the above arrangement
except that the survivor’s income is reduced to one-half of the original joint
income.
Period Certain. The period certain option is not based on life contingency; instead it
guarantees benefit payments for a certain period of time, such as 5, 10, 15, or 20
years, whether or not the annuitant is living. At the end of the specified term,
payments cease.
32
Table 2.4 illustrates the comparison of the monthly settlement cash flow options for a
Male and Female age 65 with $100,000 purchase payment and income begins one month
after purchase date (as of February 9, 2015). As you can see the single life income with
no payments to beneficiaries pays out the highest amount of income at $550 for a male
and $512 for a female per month. Notice as well, the 5-year period certain payment of
$1,703, a payment of both principal and interest of 20.44%.
Table 2.4
Comparison of Monthly Settlement Options
Cash
Flow
Female
Estimated
Monthly
Income
Cash
Flow
$550
6.60%
$512
6.14%
Single life w/10 years certain
$508
6.10%
$505
6.06%
Single life w/20 years certain
$483
5.80%
$512
6.14%
Single Life w/Installment Refund
$502
6.02%
$482
5.78%
Income Payment Options
Single life
beneficiaries
income
no
payments
Income Payment Options
Male
Estimated
Monthly
Income
to
Estimated Monthly
Income
Cash Flow
Joint Life 100% Survivor (no payments to
beneficiaries)
$454
5.45%
Joint Life 100% Survivor (10 year certain)
$452
5.42%
5-Year Period Certain
$1,703
20.44%
10-Year Period Certain
$915
10.98%
Source: http://www.immediateannuities.com/; Date 2-9-2015. Cash flow –monthly income times twelve divided by
the deposit amount. Cash flow percentage is significantly higher than the internal rate credited to the premium.
Contract options dramatically change the pay-out on an IA, as shown by the projected monthly payout on a $100,000
annuity purchased by a hypothetical 65-y.o. M/F.
33
Chapter 2
Review Questions
1. What is the most popular type of annuity sold?
(
(
(
(
2.
)
)
)
)
A.
B.
C.
D.
Fixed Annuity
Deferred Annuity
Immediate Annuity
Variable Annuity
Which of the following types of annuities is basically a single premium deferred
annuity with an income annuity component?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
Fixed Annuity
Deferred Annuity
Immediate Annuity
Deferred Income Annuity
3. What is the average age of a SPIA buyer?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
55
73
60
63
4. Which type of annuity will begin to make annuity payments one month after
the purchase payment?
(
(
(
(
) A. Index Annuity
) B. Period Certain Annuity
) C. Single Premium Immediate Annuity
) D. Deferred Income Annuity
5. Which annuity payout option is the purest form of life annuitization?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
Straight (single) life income
Joint and survivor
Life with 10 years certain
Life with 20 years certain
34
CHAPTER 3
FIXED ANNUITIES
Overview
Fixed annuities place the investment risk on the insurer. One of the major features of a
“fixed” annuity is safety of principal and also safety in that the rate of return is certain.
Over the past several years, we have seen the sales of fixed annuities decline drastically
due to the overall low interest rate in the financial markets. However, as interest rates
begin to tick up, we certainly are seeing an insurgence of interest in fixed annuities with
both deferred and income payout annuities.
In this chapter, we will examine the basic advantages and disadvantages of fixed
annuities, the sales of fixed annuities as well as the various types of fixed annuities. We
will also examine how fixed annuities are credited with interest payments.
Learning Objectives
Upon completion of this chapter, you will be able to:






Identify the advantages and disadvantages of fixed annuities;
Identify the various expenses of a fixed annuity;
Explain the various types of fixed annuities;
Explain the various interest crediting methods of fixed annuities;
Demonstrate differences between portfolio rate and new money rate; and
Demonstrate the payout options of a fixed annuity.
Advantages of Fixed Annuities
One of the major features of a “fixed” annuity is safety. Safety of principal and also
safety in that the rate of return is certain. The fixed aspect of the annuity also offers
safety in that the annuity holder does not take on responsibility for making any decisions
about where or in what amount the funds in his or her annuity should be invested. This is
in contrast to a variable annuity in which the annuity holder does take on this type of
responsibility.
Premiums made to a fixed annuity are invested in the insurance companies’ general
account. The company then invests the premiums it receives in a manner that will allow
35
it to credit the rates it has stated it will pay. The interest rate chosen by the insurance
company during the first year is meant to be competitive with rates currently offered on
other financial vehicles.
Disadvantages of Fixed Annuities
Like everything else in life, even though fixed annuities offer several advantages, they
also have their disadvantages. Probably the most significant disadvantage is that by
locking in the fixed annuity’s fixed rate of interest, the policyholder might lose out on
any potentially greater gains that could be realized if the same funds were invested in the
stock market.
A second potential disadvantage of the fixed annuity involves the fact that the benefit
payout amount will be a fixed amount. While this fixed payout amount will be viewed
by some annuity holders as a decided advantage, others will realize that, over time, the
fixed benefit amount will lose ground against inflation with the potential reduction of
spending power over time. For example, at an inflation rate of 3 percent per year, the real
value of annuity payouts in the first year of an annuity liquidation period is more than
twice that of the name nominal payout 24 years later. At an inflation rate of 4 percent,
the purchasing power of the fixed monthly payment would be halved in only 18 years.
Fixed Annuity Fees and Expenses
Fixed annuity fees and expenses generally cover the insurance company's administrative
expenses, the cost of offering the annuitization guarantee and profits to the insurance
company and sales agent.
Contract Charge
The rate quoted is the rate paid. Some fixed annuities may assess an annual contract fee,
typically around $30 to $40.
Interest Spread
Just like other investments fixed annuities have fees and expenses. Most fees and
expenses of a fixed annuity are factored into the stated annual percentage rate (APR) the
investor is quoted, this is known as the interest spread.
Surrender Charges
Most fixed annuity contracts impose a contract surrender charge on partial and full
surrenders from the contract for a period of time after the annuity is purchased. This
surrender charge is intended to discourage annuity holders from surrendering the contract
36
and to allow the insurance company to recover its costs if the contract does not remain in
force over a specific period of time.
Fixed Annuity Sales
According to LIMRA SRI, total U.S Fixed Annuity sales increased 13 percent in 2014,
totaling $95.7 billion (see Table 3.1).
Table 3.1
Fixed Annuity Sales and Assets, 2000 - 2014 ($ billions)
YEAR
TOTAL SALES
NET ASSETS
2000
$ 52.7
$ 322
2001
74.3
351
2002
103.3
421
2003
84.1
490
2004
86.7
497
2005
77.0
520
2006
74.0
519
2007
66.6
511
2008
106.7
556
2009
104.3
620
2010
82.0
659
2011
81.0
675
2012
72.0
692
2013
85.0
715
2014
95.7
745ͤ
Source: LIMRA Secure Retirement Institute, U.S. Individual Annuities Survey
(based on data from 60 companies, representing 96 percent of total sales, March 2015).
Types of Fixed Annuities
The basic types of deferred fixed annuities can be broken down into the following
categories. They are:

Book value deferred annuity products earn a fixed rate for a guaranteed period.
The surrender value is based on the annuity’s purchase value plus a credited
interest, net of any charges. Book value products are the predominant fixed
annuity type sold in banks.
37


Market value adjusted annuities are similar to book value deferred annuities but
the surrender value is subject to a market value adjustment based on interest rate
changes.
Index annuities guarantee that a certain rate of interest will be credited to
premiums paid but also provide additional credited amount based on the
performance of a specified market index (such as the S&P 500®).
Types of immediate (fixed income) annuities:


Structured settlement annuities are used to provide ongoing payments to an
injured party in a lawsuit.
Single premium immediate annuities (SPIA’s) are usually purchased with a lump
sum and payments begin immediately (usually within 30 days) or within one year
after the annuity is purchased.
As reported by LIMRA SRI, total sales of fixed annuities in 2014 increased by 14 percent
to total $95.7 billion, as compared to $84.4 billion in 2013. Market value-adjusted
products increased 15 percent in 2014, totaling $8.6 billion in sales as compared to $7.5
billion in 2013. In addition, indexed annuities grew by 23 percent, totaling $48.2 billion,
compared to $39.3 billion in 2013. However, book value annuities decreased 3 percent,
from $21.8 billion in 2013 to $21.1 billion in 2014.
Table 3.2
Fixed Annuity Industry Estimates (billions)
TYPE
YTD SALES
2014
YTD Sales
2013
Pct. Chg.
2014/2013
Fixed-rate deferred
Book value
Market value adjusted
Indexed
Fixed deferred
Deferred income
Fixed immediate
Structured settlements
$29.7
21.1
8.6
48.2
77.9
2.7
9.7
5.8
$29.3
21.8
7.5
39.3
68.6
2.2
8.3
5.3
1%
-3%
15%
23%
14%
22%
17%
3%
Total Fixed
$95.7
$84.4
13%
Source: LIMRA Secure Retirement Institute, U.S. Individual Annuities Survey
(based on data from 60 companies, representing 96 percent of total sales, March 2015).
Crediting Rates of Interest
As discussed earlier, typically a fixed annuity contract will offer two interest rates: a
guaranteed rate and a current rate. The guaranteed rate is the minimum rate that will be
credited to funds in the annuity contract regardless of how low the current rate sinks or
how poorly the issuing insurance company fares with its investment returns. A typical
guaranteed interest rate is between 1.5% and 3%.
38
Non-forfeiture Interest Rate
In 2003, the National Association of Insurance Commissioners (NAIC) adopted a new
annuity Standard Non-forfeiture Law (SNFL) that ties the minimum interest rate that
must be paid by fixed annuities to current yields. Prior to this, the state-mandated
minimum interest rate was 3% in most states. During times of extremely low interest
rates, this made profitably crediting an interest rate above 3% difficult and sometimes
impossible. As a result, many companies had no choice but to pull specific products or
interest rate guarantee periods from the market.
With the new law, the rate floats between 1% and 3%. The standard does not become
effective until adopted by individual states, but almost all states now have enacted one of
two types of relief—either in the form of a 1.5% minimum guaranteed interest rate, or a
rate that moves with prevailing interest rates.
Current Rate of Interest
The current interest rate (excess rate) varies with the insurance company’s returns on its
investment program. Some annuity contracts revise the current rate on a monthly basis;
others change the current interest rate only one time each year. The overall current
interest rate credit to a fixed annuity is normally 1 percent to 3 percent higher than bank
CDs and money markets.
Once the interest rate on an annuity contract has been set, there remains at least one other
item to understand regarding the method in which the interest will be credited to the
funds placed in the annuity. This item is the method of interest rate crediting that the
insurance company will apply to the specific annuity contract. Generally, there are two
methods of crediting interest:


Portfolio (average) rate method, and
New money rate method.
Portfolio Rate
The portfolio (average) rate method credits policyholders with a composite of interest
that reflects the company’s earnings on its entire portfolio of investments during the year
in question. During periods of rising interest rates, the interest credited to the “new”
contribution received during the year will be heavily influenced by the interest earned on
investments attributable to “old” contributions those received and invested 5, 10, 15 or
more years earlier. The interest credited will therefore be stabilized.
To illustrate this method under both a rising and declining interest trend (see Illustration
3.3). Under the steadily increasing trend, the contribution made in year 1 earns 3.0%, all
funds in the account (new or old) in year 2 earn 4.0%, and all funds in the account during
year 3 earn 5.0%.
39
Illustration 3.3
Illustrative Comparison of Increasing and Decreasing Portfolio Rates
Increasing Rates
Year
One
Two
Three
Year 1
3%
Year 2
4%
4%
Year 3
5%
5%
5%
Decreasing Rates
One
Two
Three
5%
4%
4%
3%
3%
3%
New Money Rate
Under the new money rate (sometime referred to as the “banding approach”, or
investment year method of crediting interest), the contributions made by all contract
holders in any given period are banded together and credited with a rate of interest
consistent with the actual yield that such funds obtained during the period. Thus, even
though a company’s average return on all money may be only 5% in a given period, the
contributions made by all participants during the current period may be credited with the
5.0% if the company was able to make new investments that, on average, returned in
excess 5.0% interest. Moreover, the interest rate credited on those contributions should
continue to earn 5.0% until the monies are reinvested. After reinvestment, the interest on
these contributions will change and the rate credited to contributions banded in the
following period could be higher or lower.
Under a trend of increasing interest, and assuming monies are reinvested every year, an
investment in year 1 earns 5.0% (the new money rate for that year) and then earns 5.25%
in the second year and 5.50% in the third year (see Illustration 3.4). An investment in
year 2 earns 6.0% (the new money rate for that year) and then earns 6.00% in the second
year and 6.25% in the third year. Finally, an investment in year 3 earns 7.0%.
40
Illustration 3.4
Illustrative Comparison of Increasing and Decreasing Portfolio Rates
Increasing Rates
Year
One
Two
Three
Year 1
5.00%
Year 2
5.25%
6.00%
Year 3
5.50%
6.25%
7.00%
Decreasing Rates
One
Two
Three
5.00%
4.50%
4.00%
4.50%
4.00%
3.00%
Note: The higher rates were used for the new money rate illustration. That is because the
portfolio rate includes the return on investments made in earlier years at lower rates.
The illustrations points out three things. First and most important, it is deceptive to
compare the current interest rate between two companies using different approaches.
Second, the new money rate method is advantageous to the participant when interest rates
are increasing. Third, in a declining interest rate period, the portfolio method has merit.
Another consideration in analyzing the products of tax-deferred annuity companies that
use the new money approach is how funds are treated when a participant makes a partial
withdrawal of funds. There are three approaches that are used: LIFO, FIFO and HIFO.
“Last-In, First Out” (LIFO) means that the sum withdrawn will be taken from the most
recent contribution band. “First In, First Out” (FIFO) means that the sum withdrawn will
be taken from the earliest contribution band. “Highest In, First Out” (HIFO) means that
the sum withdrawn will be taken from the band that is being credited with the highest
interest rate.
Keep in mind that, although interest rates are very important, they are but one of several
items to be considered when selecting a fixed annuity.
Calculating the Rate
Whether the portfolio rate or the new money rate method is used, there are several
approaches used to arrive at the actual numerical rate to be credited. A common approach
is to credit a rate (or rates, in the case of the new money rate method) that reflects the
company’s earnings on its entire portfolio of investments during the year in question.
Another approach would be to use an expected rate of return on the accumulations.
41
Interest Rate Trends
In valuing the rate of interest credited (rate of return) on their investments, a number of
insurance companies have moved from the calendar year to a quarterly approach. Some
have even adopted techniques for valuing the return on a daily basis. The objective of
such a move is twofold:


The insurance company can move quickly if it believes the spread between the
rate of return actually being earned on its investment and the rate credited to the
contract is moving in a direction disadvantageous to its best interests, and
Competitive position in the marketplace can be maintained, especially when
interest rates increase sharply.
Interest Rate Projections
Most companies’ sales literature will show projections for the guaranteed interest rate,
however, these types of data provide little, if any, information to help select an annuity.
Since projected values are hypothetical, their use as an instrument of prediction is
significantly flawed. Only when a company has established a trend of consistently high
historical current interest rates do projections of future accumulations become significant.
Bonus Annuities
Some insurance companies declare a “bonus” rate of interest that will be paid on top of a
current or “base” rate offered on an annuity contract. This bonus is designed to attract
new business to the insurance company. The bonus amount offered by many insurance
companies can range from one percent to five percent of the original single premium
payment. For example, if an applicant purchases an annuity with a single premium of
$100,000, and the extra credit sign-up bonus is 5 percent, the account value will be
$105,000. Some insurers may credit the bonus with the initial premium payment and or
may credit the premium payments made within the first year of the annuity contract.
Under some annuity contracts, the insurer will take back all bonus payments made to the
annuity holder within the prior year or some other specified date, if the annuity holder
makes a withdrawal, if a death benefit is paid to the annuity holder’s beneficiaries upon
the annuitant’s death, or in other circumstances.
Though this feature is attractive, there might be some hidden costs. Some companies
charge extra fees and/or extend surrender periods. Some contracts may impose higher
mortality and expense (M&E) charges, while others may impose a separate fee
specifically to pay for the bonus feature. As the advisor, it is your responsibility to
understand these costs and fully disclose to the purchaser of an annuity.
42
Two-Tiered Annuities
A two-tiered annuity is basically a dual-fund, dual-interest rate contract. The two funds
are the accumulation account and the surrender value. There is a permanent increasing
surrender charge.
The interest rate offered is a relatively high interest rate, but only if the owner holds the
contract for a certain number of years and then must annuitize the contract. If the annuity
is surrendered at any point prior to the contract period, the interest credited to the contract
is recalculated from the contract’s inception using a lower tier of interest rates.
The higher tier of rates is designed to reward annuitization and to make the product more
attractive than competing annuities, the lower tier of rates generally makes the contract
very unattractive compared to other alternatives. And the interest penalty applies under
some contracts even if the annuity is surrendered due to the death of the owner. This type
of fixed annuity contract has come under scrutiny by state insurance departments in how
they are marketed and sold especially to seniors.
Fixed Annuitization: Calculating Fixed Annuity Payments
Another aspect of the fixed annuity that is “fixed” is the amount of the benefit that will be
paid out when the contract is annuitized. Fixed annuity payments are determined by
insurance company annuity tables that give the first payment value per $1,000, which
depends on:




The age of the annuitant,
The sex of the annuitant,
The payout options chosen, and
Deductions for expenses.
Thus, if an annuitant has $100,000 in his/her account, and the value is $5 per $1,000, then
the first payment will be $500. For a fixed annuity, this will be the value of all
subsequent payments. This would be true whether the insurance company’s investment
returns are better or worse.
43
Chapter 3
Review Questions
1. In a fixed annuity, who assumes the investment risk?
(
(
(
(
) A. Owner
) B. Annuitant
) C. Insurance company
) D. Beneficiary
2. Which of the following is an advantage of investing in a fixed annuity?
(
(
(
(
) A. Safety of principal
) B. Protection against inflation
) C. Returns tied to the stock market
) D. Invest in sub-accounts
3. What type of fixed annuity’s account value is subject to a market value adjustment
based on interest rate changes?
(
(
(
(
) A. Bonus Annuity
) B. Two-tiered Annuity
) C. Index Annuity
) D. Market Value Adjusted Annuity
4. Which type of interest rate crediting method reflects the company’s earnings on its
entire portfolio during the year of crediting?
(
(
(
(
) A. Old Money Rate
) B. Portfolio Rate
) C. New Money Rate
) D. Current Money Rate
5. Which method is used when taking a withdrawal from an annuity from funds recently
contributed?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
HILO
LIFO
HIFO
FIFO
44
CHAPTER 4
VARIABLE ANNUITIES
Overview
Variable annuities (VA’s) are commonly called "mutual funds with an insurance
wrapper". In an all-in-one package sold by an insurance company, a variable annuity
combines the characteristics of a fixed annuity with the benefits of owning mutual funds.
They are one class of annuity products, designed to reduce the risk of inflationary erosion
of real benefit payments.
The VA is one of the most rapidly growing insurance products of the last two decades.
They offer the opportunity to link payouts to the returns on an underlying asset portfolio.
But they also have the potential for the contract holder of the annuity to lose principal due
to market corrections.
In this chapter, we will define a variable annuity, review the history of the VA market,
and discuss the VA features and benefits. It will also review the various VA investment
options, the VA guaranteed minimum death benefits (GMDBs) and the enhanced
GMDBs, as well as the guaranteed living benefit (GLB) riders. At the end of the chapter,
we will examine VA annuitization, as well as VA regulation and, discuss the future
outlook for VA’s.
Learning Objectives
Upon completion of this chapter, you will be able to:







Define a variable annuity and explain the history of the VA;
Determine the various features and benefits of the VA;
Identify the various investment options in a VA;
Identify the fees and expenses within a VA;
Differentiate between the various enhanced guaranteed minimum death benefits
and riders;
Differentiate between the various guaranteed living benefit riders; and
Explain the regulation of the VA.
45
VA Defined
A variable annuity (VA) is a long-term tax-deferred contract between an investor
(contract owner/holder) and an insurance company, under which the insurer agrees to
make periodic payments, either immediately or at some time in the future. A VA is
structured to have both an investment component and an insurance element. A VA offers
a range of investment options, known as sub-accounts (discussed below). Opposite a
fixed annuity, it is the investor (contract owner/holder) who assumes all of the investment
risk.
The VA Market
Variable annuities were introduced in the United States by the Teachers Insurance and
Annuities Association-College Retirement Equities Fund (TIAA-CREF) in 1952. The
first variable annuities were qualified annuities that were used to fund pension
arrangements.
VA’s grew slowly during the next three decades—in part because of the need to obtain
regulatory approval for these products from many state insurance departments. Because
variable annuities are usually backed by assets, such as corporate stocks, that do not
guarantee a fixed minimal payout, the reserves that back these policies are maintained in
separate accounts from the other policy reserves of the life insurance companies. Other
than TIAA-CREF no other insurance company had issued a variable annuity policy as of
1960, primarily because state laws prohibited insurers from supplying a new class of
products backed by common stock assets that were segregated from the insurer’s other
assets. In addition, the 1959 Supreme Court ruling that the VA fell under joint
jurisdiction of the Securities and Exchange Commission (SEC) and the state level
insurance regulations department made it even more difficult to develop a VA.
However, all that changed when financial planner John D. Marsh conceived a variable
annuity that would be available to the general public. Mr. Marsh began his quest in 1955
when he and a group of associates established the Variable Annuity Life Insurance
Company (VALIC). However, it wasn’t until May 13, 1960, that the first commercial
variable annuity prospectus became available in the United States, and, with it, the first
insurance company separate account. And the rest is history.
The slow growth experienced in the 1950’s and 1960’s had been reversed. VA’s have
now become one of the most popular investment products offered by insurers. The
attractions of tax-deferred growth, guarantees and a broad range of investment choices
made VA’s one of the fastest growing products in the insurance industry.
U.S. VA gross sales had been increasing steadily from 2001 to 2007. By 2005, VA gross
sales had rebounded virtually to 2000 levels (a historic high). In 2007, U.S. VA gross
sales totaled $182.2 billion, again the highest in history.
46
Then in 2008, the financial market crisis led to a downturn in VA sales. Total gross VA
sales in 2008 were $154.8 billion, representing a 15 percent decrease in sales from 2007.
VA sales also showed a further decline in 2009, with sales of $125.0 billion, representing
a 19 percent decrease from 2008 sales.
Beginning in 2010 thru 2011, we saw the economy recover and demand for VA products
with guaranteed living benefit riders surged. VA gross sales increased 13 percent in 2011
to $159.3 billion from 2010 sales of $140.5 billion. Total VA assets at the end of 2011
were nearly $1.6 trillion.
However, since 2012, we have seen a trend that VA sales are no longer tracking with the
equities market. Despite extraordinary growth in the equities market we have seen three
years of negative growth in VA sales, from $159. 3 billion in 2010 to $140.1 billion in
2014 (see Table 4.1).
Table 4.1
U. S. Sales of Variable Annuities and Net Assets 2000 - 2014 ($ billions)
YEAR
TOTAL SALES
ASSETS
2000
$ 137.3
$ 956
2001
113.3
888
2002
115.0
796
2003
126.4
999
2004
129.7
1,136
2005
133.1
1,231
2006
157.3
1,397
2007
182.2
1,517
2008
154.8
1,151
2009
125.0
1,389
2010
140.5
1,561
2011
159.3
1,593
2012
147.4
1,762
2013
145.4
2,008
2014
140.1
2,130
Source: LIMRA Secure Retirement Institute, U.S. Individual Annuities Survey
(based on data from 60 companies, representing 96 percent of total sales, March 2015).
47
Total VA sales in 2014, were down 4 percent to $140.1 billion from $145.4 billion in
2013.
VA Product Features
Just as there are characteristics of the fixed annuity that are consistent from product to
product, as discussed in Chapter 3, so too there are certain features shared by all variable
annuities. Let’s begin our discussion with some of the basic features of the variable
annuity and then, we will review the optional protection benefits (riders) that are used to
design the new versions of the VA product.
Separate Accounts
The variable annuity is characterized by a separate account (also known as sub-accounts)
that holds all of the variable account options. The separate account receives its name
because it is not part of the general account assets of the insurance company. Instead
they are investment fund options or sub-account that make-up the variable annuity.
Actually, the separate account is maintained solely for the purpose of making investments
for the contract owner. This transfers the risk from the insurer to the contract owner.
The separate accounts are not insured (guaranteed) by the insurance company, except in
the event of the owner or annuitant’s death. Account values will fluctuate, depending
specifically on the performance of the underlying investment of the separate account. All
profits and losses, minus fees, are passed along to the contract owner. In the event the
insurance company becomes insolvent, separate accounts are not attachable by the
insurer’s creditors and are normally distributed immediately to the contract owners. A
wide variety of funds are available to the contract owner in the separate account.
Investment Options
As mentioned above, in a variable annuity, investment choices are offered through subaccounts, which invest in a selection of funds, similar to mutual funds that are sold to the
public. The value of the funds will fluctuate over time, and the variable annuity’s return
is based on the investment performance of these funds. Variable annuities have, on
average, 49 sub-accounts.
A variable annuity contract will generally permit the contract owner to choose from a
range of funds (asset classes) with different investment objectives and strategies. The
basic asset classes include:





Money market fund
Equity
Fixed accounts
Balanced
Bonds
48

Alternative Investments
Premiums allocated to the guaranteed (fixed) account option are guaranteed against
investment risk and are credited with a guaranteed fixed rate of interest. However,
insurance companies may calculate the fixed rate payable differently (based on either the
portfolio rate or new money rate as discussed in Chapter 3).
Under some variable annuity contracts, the various sub-accounts are managed by the
insurance company (single management), while others are often managed by different
investment advisors (multi-managers), who may or may not be affiliated with the
insurance company. In fact, a number of well-known mutual fund companies offer funds
that serve as investment options for variable annuities.
Recently, a growing number of insurers have added a number of new sub-accounts that
will use alternative investments and dynamic asset allocation strategies to the investment
options available to VA investors. Since 2012, insurers added 102 VA sub-accounts that
use alternative strategies which include: currencies, long-short, market neutral and
precious metals, according to Morningstar Inc. That’s up from 63 new additions in 2011.
In fact, in a recent survey by one of the leading VA insurers, they reported that more than
nine out of 10 advisers expect to increase their use of alternative asset classes over the
next year. Among those advisors who anticipate an increase, more than half said they
would increase their use of alternatives by 15 percent or more in the next 12 months.
Nearly a third will boost their use of alternatives by 20 percent or more. Of the small
percentage of advisors who have not used alternative assets classes to date, more than 90
percent say they are now considering using them.
The major goal of using these types of alternative sub-accounts: real estate holdings,
hedge funds, commodities and the like, in the pursuit of diversification is to allow
investors to have tactical management strategies without suffering the tax consequences
of frequent trading. It would allow small investors to have access to alternatives that
otherwise would be available only to more affluent investors. And most importantly will
provide the tax efficiency (tax-deferral).
Accumulation Units
Once invested into the sub-account, the amount invested is then converted into
accumulation units. The use of accumulation units is simply an accounting measure to
determine a contract owner’s interest in the separate account during the accumulation
period of a deferred annuity.
Not all purchase payments (gross payments) made by a contract owner goes toward the
purchase of accumulation units. Before units can be purchased, the various charges and
fees (discussed later in this chapter) are deducted. The money to buy accumulation units
is then the net purchase payment.
49
The number of units, which the net payment will buy, depends upon the value of an
accumulation unit at that time. This value is determined periodically, usually daily. At
the risk of oversimplification, the value of one accumulation unit is reached by dividing
the value of the separate account by the number of accumulation units outstanding.
As the contract owner continues to buy accumulation units, these are added to those
already purchased. The dollar value of all the units owned by the contract owner equal
the number of units the contract owner owns times the value one accumulation unit.
The following example illustrates how this works out in practice:



Initial Value of Accumulation Unit on 01/01
Monthly Premium Payment
Initial Number of Units Purchased
= $5
= $100
= 20
Subsequent
Accumulation
Unit
Values
Number of
Units Purchased
01/01
$5.00
20.00
02/01
5.05
19.80
03/01
4.87
20.53
04/01
4.94
20.24
05/01
4.99
20.04
06/01
5.12
19.53
At the end of the six-month period, the annuity holder would have a total of 120.14
accumulation units. As stated above, the value of these units will continue to fluctuate
according to the unit’s market value. With each premium payment, the annuity owner
adds to the total accumulation units. The accumulation unit price will probably continue
to fluctuate. When the annuity matures, the annuity owner will have been credited with a
specified number of accumulation units.
The only exception to this process/equation is the money market account whose net asset
value is maintained on a constant dollar basis, where one dollar buys one unit. The
money market account credits a stated interest rate that changes as the underlying assets
of the money market changes.
VA Charges and Fees
The charges and fees levied under variable annuity contracts, while somewhat similar to
those charged by fixed annuity contracts, are subject to a greater degree of regulation due
to the fact that variable annuities are considered to be securities. (Remember: charges and
50
fees must be disclosed in the annuity’s prospectus). With a variable annuity, the fees are
calculated on either an annual basis and/or an asset basis.


Annual fees are fixed expenses that are deducted from the contract and average
about $35 to $50 a year. (Many contracts waive the annual fee at certain account
values, for example $50,000.)
Asset-based fees are percentages of the total value of the annuity, deducted on a
regular basis, usually daily, monthly, or annually. All owners of the same
contract pay the same percentage of their assets in these fees, but different dollar
amounts.
Mortality and Expense (M&E) Charge
The asset-based mortality and expense risk fee, also called the M&E charge, on all
variable annuity contracts pays for three things:



The guaranteed death benefit,
The option of a lifetime of income,
The assurance of fixed insurance costs including the M&E fee itself, which are
guaranteed (frozen) for the life of the contract.
In most cases, the fee is subtracted proportionately from each of the variable portfolios
that funds are invested in. According to Morningstar data, the average annual mortality
and expense charge was 1.27% in 2014.
Management (Fund Expense) Fees
The asset-based management fees (fund expenses) that are paid to the sub-account
manager for managing sub-account assets are debited from the annuity unit value and are
reflected in the investment return. These fees are described in the prospectus, and are
sometimes broken down into an investment advisory fee and an operating expense fee.
They’re often aggregated under the management fees (fund expenses) heading.
Because of the large amounts of assets under management, insurance and investment
companies are able to offer economies of scale, or competitive fee schedules, to their
customers. While operating fees vary amongst contracts, they can vary quite
dramatically, based primarily on the way the portfolio invests. For example, fees on index
portfolios tend to be significantly lower than the norm because the management costs are
lower. On the other hand, fees on foreign equity portfolios or those requiring extensive
research and management tend to be higher. These fee structures tend to be fairly
consistent from contract to contract. They’re also comparable to, but generally lower
than, the management fees you pay as part of a mutual fund investment. Remember to
compare apples to apples: in this case, similar equities to equities sub-accounts and
similar bonds to bonds sub-accounts.
51
Contract (Account) Maintenance Fees
A yearly contract (account) maintenance fee is commonly assessed to cover the
administrative expenses associated with the variable annuity contract. This charge
(usually a flat dollar amount), which covers the cost of issuing the contract and providing
administrative services, is usually applied at each contract anniversary date and upon a
surrender of the contract. The annual flat dollar fee ranges from $25 to $50 dollars.
Most insurers waive this fee if the contract value is greater than a certain amount (usually
$50,000 to $100,000) depending upon the contract.
The average Administrative and Distribution Fee in 2014, as calculated by Morningstar,
remained at 0.28%.
Summary of Above Fees
Based on its averages for Mortality and Expense Risk Charge, Administrative Fees,
Annual Records Maintenance Fees and Total Fund Expense Averages, Morningstar
calculated the Total Weighted Average Expenses for the year of 2014 was 2.51%.
According to Morningstar, the average annual expense ratio for publicly available equity
mutual funds was 1.25%, while the typical bond fund charges 1%. The comparable
figures show for underlying funds in variable annuities was 0.96%—0.29% lower. These
figures show that the lower expense ratio of underlying funds in some VA’s may actually
offset part of the additional insurance charges and suggest that, on average, the actual
cost differential of the two products is about 1.19% (see Table 4.2).
Table 4.2
Mutual Funds vs. VA Expense Comparison 2014
Mutual Funds
Fund Expense
M&E
Administrative charges
Distribution
Total
Difference
Variable Annuities
1.25%
0.96%
1.27%
0.19%
0.09%
2.51%
1.25%
1.26%
Source: Morningstar and LIMRA International June 2014.
Why are the average expense ratios for publicly available mutual funds higher than those
of underlying funds in variable annuity sub-accounts? The difference may be attributable
to several factors, but a primary reason is the additional handling and administrative
expenses incurred by mutual funds that are sold to the public. These mutual funds have
thousands of individual shareholders, and each shareholder has an investment account
that must be administered by the fund or another service provider. In the case of variable
annuities, however, most of these functions are handled by the insurance company and
are reflected in the insurance and administrative charges. The insurance company is, in
effect, one “account holder” of the underlying mutual fund.
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The potential for variable annuity underlying fund expense ratios to be lower than
publicly available mutual funds is an important factor to keep in mind when considering
whether to invest in a variable annuity. By choosing carefully and comparing the costs of
the investment funds in a variable annuity to those of publicly available mutual funds, the
additional cost of the variable annuity may be partially offset by the cost savings offered
by the annuity sub-accounts. The point to remember is this—although there will be
charges for the valuable insurance features of a variable annuity, depending on the
product selected and the underlying investment options offered, the total cost differential
between the variable annuity and publicly available mutual funds may be less than one
might think.
Surrender Fees
Variable annuity contracts also have a charge, or surrender fee, when an owner
withdraws part or all of their annuity contract value during the early years of the contract.
These surrender fees are usually calculated as a percentage of the amount of the
withdrawal and generally decline each year until the fee disappears, typically seven years
after the purchase. With some contracts, the surrender fee period begins with the
purchase of the contract. With others, a new surrender fee period begins with each new
purchase payment.
Surrender fees serve several purposes. First, they make people think of their long-term
retirement account. The fee also benefits the insurance company issuing the contract,
since the charge can help to offset any losses it may incur in the liquidating holdings or
changing investment strategy to pay out the cash. In addition, since the company has
significant up-front costs in issuing the contract and is expecting to receive asset-based
fees or interest margins over a period of years, the surrender fees cover this loss of
income that results when the annuity is surrendered.
Remember, many annuities let the owner withdraw a certain percentage, generally up to
10%, from either the premiums paid into the contract, while other contracts may allow
the withdrawal from the total net surrender value of the annuity, without. As you can
imagine, the amount available to be withdrawn can be significantly different depending
on which contract is purchased.
VA Sales Charges
A number of insurers offer their VA contracts with various charge structures to meet
different investor needs. The following are the most common:

A-share: VA’s have up-front sales charges instead of surrender charges. Sales
charges are calculated as a percentage of each premium payment. A-share VA’s
offer breakpoint pricing, which means up-front sales charges decrease depending
on the cumulative amount of purchase payments that have been made. In
addition, assets that a contract owner has in other products in the company’s
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





product line may be recognized in the cumulative payment amount used to
determine the breakpoint pricing. A-share contracts often have lower ongoing
M&E annual fees than annuities with surrender charges.
B-share: Most VA contracts are B-share products. They are offered with no
initial sales charge, but cancellation of the contract during the early years may
trigger a surrender charge. These charges typically range from 5-7% of the
premium in the first policy year, and subsequently decline to zero.
C-share: No surrender charge variable annuities, offer full liquidity to clients at
any time, without any up front or surrender charges (although tax penalties may
apply to withdrawals prior to age 59½). There are ongoing M&E and
administrative fees, however, which may be higher.
Class I (No Load): No front load or contingent deferred sales charge and M&E
less than 1%.
L-share: Have no up-front sales charges. They typically have relatively short
surrender charge periods, such as three or four years, but may have higher
ongoing M&E and administrative charges.
O-share: Front load spread out over x years and contingent deferred sales charge,
both determined by a breakpoint-based reducing schedule.
X-share: X-Share variable annuity contracts credit an additional amount to the
contract value, which is calculated as a percentage of purchase payments added to
the contract at or subsequent to contract issue. This category does not include
contracts that credit additional amounts to the contract value after a designated
period, sometimes referred to as “persistency bonuses.” There are ongoing M&E
and administrative fees, which tend to be higher than B-Share contracts.
According to Morningstar Inc., B-shares were the most popular type of surrender charge
based on VA Share Class Distribution (Non-Group New Sales) for year-end 2014.
Surrender charges underscore the long-term nature of the annuity product. As long as
contract owners remain committed to accumulating money for retirement through their
variable annuity, they generally will not incur these charges. A number of insurers have
begun to offer other types of charge structures to meet different investor needs.
Premium Tax
A few states impose premium taxes on variable annuity purchases. These taxes range
from 0.50% - 5.0% depending on the state of residence but in most cases do not exceed
5% (see Table 4.3).
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Table 4.3
States Charging a Premium Tax on Annuities
State
California
Maine
Nevada
South
Dakota
Virgin
Islands
West
Virginia
Wyoming
Qualified
Funds
Taxed Upfront
Qualified
Funds
Taxed @
Annuitization
2.35%
2.00%
3.50%
NQ-Funds
Taxed Upfront
NQ-Funds
Taxed @
Annuitization
0.50%
1.25%
5.00%
1.00%
5.00%
1.00%
1.00%
Investment Features
A variable annuity offers a wide range of investment options for the contract holder
(owner) to invest their premiums in various sub-accounts. To assist the contract holder in
their investment strategies the VA contract also offers various investment features such as
dollar cost averaging, fund transfers, asset allocation strategies and automatic portfolio
(asset) rebalancing.
Dollar Cost Averaging
Dollar cost averaging may reduce an individual’s concern about making an investment at
the “wrong” time. Investors sometimes delay the purchase of a security whose price has
been rising rapidly because they feel that it may be due for a correction. Meanwhile the
price continues to rise and they lose the good investment opportunity. They may also
delay the purchase of a security whose price has been falling because they fear it may be
in a long-term downward trend.
Dollar cost averaging alleviates this problem. With dollar cost averaging, an individual
invests the same flat dollar amount in the same securities at regular intervals over a
period of time, regardless of whether the price of the securities is rising or falling.

If the price of the security rises, the investor cannot purchase as many units of
that security for the same flat dollar amount. However, the value of the
investment as a whole will have risen. And if the price of the security later falls,
the fewer units purchased at the higher price will not drag down the total return
on the investment as much as if a large lump sum had been invested at the higher
price.
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
If the price falls, the value of the investment also falls, but the investor is able to
purchase more units of those securities. If the price of the units later rises, the
larger number of units purchased at the lower price will more quickly offset the
loss in value caused by the earlier decline.
Dollar cost averaging does not offer a guarantee of gain or a guarantee against loss, but
over time it helps to average out the highs and lows in the security’s price. This frees the
investor from the anxiety of trying to predict the long-and short-term price swings that, in
many cases, can fool even the most experienced investor.
With all that said, there are several financial experts who argue that DCA does not work.
In an article in the October 2006, “Journal of Financial Planning”, John G. Greenhut,
Ph.D., writes that:
“…the behavior of stock volatility, which has given rise through illustrations to the
widespread belief that dollar-cost averaging, allows more shares to be bought over
time than would occur through a lump-sum investment. We have exposed that
illustration as a mathematical illusion, based on arithmetic changes in a denominator
leading to disproportionate changes in the fraction.”
Enhanced Dollar Cost Averaging
Enhanced dollar-cost-averaging (EDCA) follows the traditional DCA very closely but
allows for a slight change. The EDCA strategy invests a fixed additional amount after a
down month, and reduces the investment by a fixed amount after an up month. Note:
Due to the current interest rate environment a number of insurers have decided to
discontinue the EDCA in their VA contracts.
Fund Transfers
A variable annuity will allow the annuity contract holder to transfer funds from one subaccount to another (subject to some restrictions) tax-free. This flexibility to reposition
investments under the umbrella of the variable annuity offers the annuity holder the
opportunity to change his or her investment focus. It also allows an annuity holder to
change the level of risk that he/she is willing to accept. However, most contracts do have
some limitations on transfers. They are:



May limit the frequency of transfers by stipulating that they must be separated by
a certain interval, such as seven or thirty days.
There may be a minimum dollar amount or percentage of sub-account value that
is being transferred, and a minimum dollar amount or percentage of value that
must remain in the sub-account.
Some contracts limit the number of transfers that may be made each year. Some
contracts have no limits, but reserve the company’s right to charge a fee.
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
Because fixed account guarantees are supported by investments that may have to
be liquidated at a loss to accommodate a transfer, limits on the timing and amount
of transfers from the fixed account are common.
Asset Allocation
Asset allocation involves the use of a number of different investment options, each of
which plays a role in meeting the contract holder’s overall financial goals. It also
involves adjusting the percentage of assets devoted to each investment option to increase
the chances that the contract holder’s goals will continue to be met as circumstances
change.
The essence of asset allocation is to establish a mix of investments to match a contract
holder’s financial objectives and risk profile, and to change that mix as expectations
change in regard to the returns available in each class of investments. Some contracts
offer asset allocation services which will move the owner’s money according to a
professional asset manager’s assessment of the outlook for stocks, bonds, interest rates,
and so on. Under some other contracts, this is established by allowing the money
manager to make the appropriate transfers in the owner’s sub-accounts. Other contracts
offer an asset allocation sub-account in which the money manager changes the mix of
various investments on an on-going basis in an attempt to achieve the next favorable
return.
Asset Rebalancing
Asset rebalancing is a technique used by many portfolio managers to reduce risk and
improve a portfolio’s overall return. It involves making security trades at certain intervals
in order to bring the asset mix back into line with the allocations originally determined
for the portfolio. In effect, the portions of the portfolio that have performed the best are
reduced so that additional assets can be purchased for the portions of the portfolio that
have performed the worst.
There are no guarantees, of course, that automatic asset rebalancing will improve a
contract holder’s return, nor does automatic asset allocation provide any assurances
against the chance that the value of the securities underlying the investment option may
fall.
Guaranteed Minimum Death Benefit
A common feature of variable annuities is the death benefit. The contractual payout of
the death benefit varies by contract. The death benefit is generally payable as a lump sum
payment or as an annuity payment. Variable annuity contracts have traditionally offered a
guaranteed minimum death benefit (GMDB) during the accumulation phase that is
generally equal to the greater of:
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

The contract value or
Premium payments less prior withdrawals.
The GMDB gives the contract owners the confidence to invest in the stock market, which
is important in order to keep pace with inflation, since we know that their family will be
protected against financial loss in the event of an untimely death.
Enhanced GMDB Features
Over the past ten years, many insurers have offered enhanced GMDB riders. Some type
of enhanced death benefit is now available with most variable annuity contracts. There
are four types of enhanced GMDB riders. They are:




Initial Purchase Payment with Interest or Rising Floor (Roll-up)
Contract Anniversary (Market Anniversary Value) or Ratchet
Reset Option
Enhanced Earnings Benefit
These different types of enhanced GMDBs are riders to the contract and will have
additional associated charges. The charges could be applied to the contract value or
benefit base. Generally, these optional death benefit riders can only be elected at issue if
the owner(s)/annuitant(s) are within the age specifications as set forth in the contract rider
and prospectus and are irrevocable once elected.
Let’s review each of these enhanced guaranteed minimum death benefits in greater detail.
Initial Purchase Payment with Interest or Rising Floor
Some insurers offer rising floor or rollup GMDBs that is equal to the greater of:


The standard GMDB, or
The purchase payments accumulated at a specified annual rate (5% - 7%) up
to a specified age and adjusted for any withdrawals.
Note: By stepping up the increasing GMDB to the Account Value may start over a new
surrender charge period.
Example: Mr. Jones purchased a $100,000 variable annuity with a surrender charge
of 5 years. Over the years Mr. Jones owned the contract, his account value jumped
around from $150,000 to $250,000. At the end of the five years, Mr. Jones’ surrender
charges had expired and the value of his account was $200,000. At that time, Mr.
Jones locks in his step-up death benefit to the account value of $200,000. In
exchange, the insurer restarts another 5-year surrender charge penalty schedule.
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Of course, these types of increasing death benefits do not last forever. Most contracts
call for the suspension of the increasing death benefit at ages from age 75 to age 85,
depending on the contract.
In some cases, a ratchet and a rising floor may be available within the same contract.
Some contracts offer a choice of a ratchet or a rising floor.
Contract Anniversary, Or “Ratchet”
Some insurance companies offer ratchet GMDBs that are equal to the greater of:



The contract value
Premium payments less prior withdrawals
The contract value on a specified prior date
This is essentially a discrete look-back option—the death benefit equals to the larger of
the amount invested or the ratcheted account value. More precisely, the death benefit
guarantee only moves up at the beginning of every ratchet period. The specified date
could be a prior contract anniversary date such as the contract anniversary date at the end
of every seven-year period, every anniversary date or even more often. A ratchet GMDB
locks in the contract’s gains on each of the specified prior dates.
Reset Option
Here, the GMDB can be adjusted (moved up or down) at the beginning of every reset
period. The frequency of the resetting interval ranges from once a year to once every five
years.
Enhanced Earnings Benefits
Some insurers offer enhanced earnings benefits (EEB), which provide a separate death
benefit that can be used, for example, to pay the taxes on any gains in the contract. With
this feature, beneficiaries will receive not only the death benefit amount, but also an
additional amount, which is usually equal to a percentage of earnings.
Guaranteed Living Benefit (GLB) Riders
The introduction of “guaranteed living benefit” riders (GLBs) back in the late 1990s
conceptually filled a void in the investment spectrum that had been identified by
academic research decades earlier. Beginning in the 1960’s economists puzzled over
why retirees, the most risk-averse segment of the population, have historically eschewed
converting their defined benefit pension and 401(k) plan savings into guaranteed lifetime
annuity payments in favor of far riskier self-directed investment choices.
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However, with the arrival of GLB riders attached to VA contracts, they now offered
retirees (and those approaching retirement) a guaranteed lifetime income solution with
the potential to let them have their figurative cake and eat it too. At the heart of these
GLB riders is the concept of “deferred annuitization,” a financial engineering innovation
that allows VA contract owners (holders) to invest in an underlying portfolio of risky
assets for capital appreciation while retaining the right to receive a guaranteed lifetime
income stream, from the benefit base, if the investments and/or the overall markets
perform poorly and are exhausted through systematic withdrawals (assuming rider terms
and conditions are met). Conversely, if the underlying investments perform well, the
contract holders retain complete control over the asset (contract value) during their
lifetimes and, upon death, the named beneficiaries receive the remaining assets.
It is important to remember that a VA’s guaranteed living benefit withdrawal benefit is
calculated using a separate metric known as the “benefit base,” which is distinct from its
contract value. A VA’s benefit base will typically grow at a fixed rate known as a “rollup rate” during the accumulation phase unless strong performance propels the contract
value above the benefit base on a specified date. In that scenario, the benefit base will
reset higher to the contract value. Today, many VA’s have a rollup that range from 4
percent to 6.5 percent, based on the annuitant age. A VA’s benefit base typically will not
decline regardless of what happens to the contract value, which is how the market
protection feature works. Thus, once a benefit base is reset higher, those gains a locked
in. This is what’s known as a “high-water mark” provisions.
Types of GLB Riders
GLB riders attached to a VA can be offered as one of the following:




Guaranteed Minimum Income Benefits (GMIB),
Guaranteed Minimum Accumulation Benefits (GMAB),
Guaranteed Minimum Withdrawal Benefits (GMWB), and
Guaranteed Minimum Withdrawal Benefit for Lifetime (GMWBL).
Guaranteed Minimum Income Benefit (GMIB)
The GMIB was the first living benefit rider that hit the market back in 1996. What it’s
designed to do is guarantee the client (contract holder/annuitant) a future income stream.
The VA-GMIB has two values: a Contract Value and an Income Benefit Base. The
GMIB payment will be based on the Income Benefit Base and the annuitization factor.
GMIB Features and Benefits
One of the important features of the VA—GMIB rider is how the income credit
accumulates. With the GMIB rider, the income credit accumulation can continue
whether or not the client (annuity holder/owner) makes a withdrawal. This is different
60
than most GMWBs/GMWBLs contracts, where the credit accumulation stops once you
commence withdrawals (discussed below).
For Example: If the accumulation rate of the GMIB is 5%, then you can take any
amount up to 5%. Whatever you don’t take out continues to accumulate in the
Income Benefit.
Credit accumulation ends when the age limit (usually age 85/91) is reached or when
annuitization occurs.
Another important feature of the GMIB is annuitization. When your client purchases a
GMIB rider, their future annuity rates are stated in the prospectus. These rates are
generally lower than the life annuity rates in the open market. It does this via its income
base or bases. Today, GMIBs may have both a roll-up base, which increases annually
from 4-5 percent depending on the insurance company, and a second income base that
steps up to the account (contract) value, typically annually.
GMIBs also have a waiting period in which the benefit cannot be exercised. This period
ranges from five to ten years depending on the insurance company and benefit.
Something to keep in mind is that some insurance companies will require your client to
restart the waiting period if you lock in a new value for the step-up base.
GMIBs are available at contract issue, provided the oldest annuitant is not over the age
specified in the rider and the prospectus at issue (usually, ages 70 or 78). GMIBs are
irrevocable, optional living benefits that provide a safety net for retirement assets in the
form of a guaranteed minimum income stream—no matter how the underlying annuity
investments performs as long as no withdrawals are taken.
To receive the income benefits from the rider the client must annuitize the contract under
the terms of the contract. Note: The guaranteed payout rates with the GMIB are based on
conservative actuarial factors and are currently less favorable than the current payout
rates used to convert contract values to annuitization income. In other words, there is a
“haircut” on the GMIB annuity actuarial factors.
GMIB Caveats
The following are some of the caveats of the GMIB rider:





A set waiting period (usually 7-10 years)
Maximum age required for annuitization age 80 - 91.
May require Asset Allocation /Immunization strategies
To benefit greatly the difference between the guaranteed amount and the actual
account value must be substantial
Must annuitize the contract with the insurer
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GMIB Client Suitability
The following would be individuals who the guaranteed minimum income benefit rider
may be suitable:



Client looking for a lifetime income stream and wants to maximize security above
all other considerations.
Individual plans to annuitize their contract.
Owner/annuitant cannot be over a specified age set forth in the contract.
Guaranteed Minimum Account Balance (GMAB)
The GMAB rider offers a guarantee of principal while remaining invested in the market
after a specific waiting period usually five to ten years. Be aware that there may be
conditions and restrictions on this benefit. Most variable annuities using the GMAB come
with prepackaged asset allocation models into which you place the premiums invested in
the contract by the contract holder. Today, many insurers now offer access to a wider
range of investment options so that your client can design a strategy specific to their
needs and timelines. Some contracts now offer target maturity date funds in their
portfolios, making the job that much easier.
What’s important with this feature is that the benefit base is a walk away amount. Your
client does not need to annuitize the contract.
GMAB Example
A client invests $100,000 in a variable annuity with a GMAB feature. After 10 years the
contract holder has taken no withdrawals and the market value has dropped to ½ of its
original value, or $50,000. With the GMAB rider, the account is returned back to the
benefit base of $100,000, the original principal, and because no withdrawals were taken
during the 10-year period the contract holder could then surrender the contract and
receive $100,000.
GMAB Caveats
The following are some of the caveats of the GMAB rider:




Some GMAB contracts mandate that all assets be allocated in specified
investment options (asset allocation models) to access the benefits.
Some contracts allow the insurer to change the client’s allocation at their
discretion and the client has no control over the investment choices.
At the end of the waiting period, the benefit may be exercised, expired, or
renewed, depending on terms of the contract.
If the benefit is not exercised or renewed, the guaranteed amount will be subject
to market risk and may lose value.
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
If benefit is renewed it will start a new waiting period.
GMAB Client Suitability
The following would be individuals who the guaranteed minimum accumulation benefit
rider may be suitable:



Clients who are seeking protection against unpredictable markets.
Clients who have a number of years before they will need the money, and
Clients who are not seeking a death benefit or looking to convert their contract to
income (annuitize).
Guaranteed Minimum Withdrawal Benefit (GMWB)
The GMWB rider was the second type of GLB, it evolved in 2002 in response to some of
the limitations posed by the GMIB, especially during bull markets. The idea behind the
GMWB is to allow the contract holder to withdraw a maximum percentage of their total
investment each year for a set number of years, regardless of market performance, until
recovery of 100% of the investment. The insurer can be defined as a rider that guarantees
a fixed percentage–generally 5% (some contracts may be higher) of the annuity
premiums can be withdrawn annually for a specified period of time until the entire
amount of paid premiums have been withdrawn, regardless of market performance and
without annuitizing the annuity.
GMWB Example
A client invested $100,000 into a variable annuity with a GMWB with a 5% systematic
withdrawal; the contract holder could withdraw $5,000 per year for 20 years regardless of
market performance. If the contract holder’s account value went to zero before the 20
years were up, the contract holder would continue to receive the $5,000 for the remainder
of the 20-year benefit period. You calculate the benefit period by taking the benefit base
and dividing it by the percentage of the dollar-for-dollar withdrawal. Here in our
example, a 5% dollar-for-dollar withdrawal would give the client a benefit period of 20
years.
GMWB Caveats
The following are some of the caveats of the GMWB rider:


Owner/annuitant cannot be over a specified age (usually age 70 or 75) as set forth
in the contract rider.
Generally, with the GMWB there are no lifetime income guarantees (no longevity
insurance). However, as we will discuss later, there are some new contracts that
have come to market that have lifetime guarantees known as GMWBL.
63



Withdrawals lower the benefit base on a dollar for dollar basis up to a certain
level (usually 5-7%). Any excess amount withdrawn will be treated on a pro-rata
basis which will decrease greatly the benefit base (also there may be additional
surrender charges).
Any withdrawals from the GMWB are taxed under the LIFO method—last in–
first out method—resulting in all interest/earnings must come out of the contract
first and will be taxable.
If used for a 72(t) Series of Substantial Equal Periodic Payments (SOSEPP) or
held in a qualified plan and/or IRA and required minimum distributions (RMDs)
are needed, the amount that may be distributed may be greater than the
withdrawal amount allowed in the contract and this may disrupt the rider
guarantees.
Example: If a client, who is in their 80s and is required to take an RMD of
6% and only is allowed a systematic withdrawal of 5% from the contract, then
there will be a problem. Note: Some contracts have become “RMD friendly”
and they will allow the distribution to be greater than the contract withdrawal
in order to meet these requirements without any charges.
Some people believe you can take the withdrawals for a period of time and
then annuitize based on their premium. That is not the case. You can annuitize
the feature, but it is based on the income base, not the premium. If the income
base is exhausted, there is no annuitization benefit.
GMWB Client Suitability
Best suited for clients who are looking for current income and would like to remain
invested in the market - clients who prefer a “safety net” (portfolio insurance) if the
market goes down.
Guaranteed Minimum Withdrawal Benefit for Lifetime
As discussed above, the earlier GMWB riders covered only a certain term, usually 17-20
years. GWMBs did not provide longevity insurance. All that changed in 2004, with the
Guaranteed Minimum Withdrawal Benefit for Lifetime (GMWBL).
The GMWBL rider attached to variable annuities provides two market values that will
fluctuate similar to a mutual fund (similar to GMIB discussed above): The Contract
Value and the Income Benefit Base. The Income Benefit Base’s value does not fluctuate
with market conditions, but it is used to calculate the income payments. When you first
purchase a GMWBL rider, both the Contract Value and the Income Benefit Base are the
same, i.e. your initial premium. Even if the contract value goes down to zero in adverse
markets, annual payments continue for life of the contract, based on the Income Benefit
Base.
64
GMWBL Features and Benefits
There are several important features and benefits of GMWBL rider. They are:




Guaranteed pay: Most contracts pay, for life, 5% of the Income Benefit Base
each year. Some contracts may pay higher. For example, if your client purchases
a VA with the GMWBL rider with $100,000 at age 65, he/she is guaranteed to
receive at least $5,000 each year for the rest of his or her life (longevity
insurance), regardless of how his or her investments perform (portfolio
insurance).
Step-Up Reset: If the portfolio does well and the contract value exceeds the
Income Benefit Base, then the Income Benefit Base is reset higher, equal to the
contract value. Most contracts allow for an annual reset. Many insurers put a
time limit on step-up resets, such as 30 years from the initial contract date, or until
age 80 or 85.
Income Credit: If your client buys a VA- with the GMWBL rider prior to needing
income, then an income credit may be added to the Income Benefit Base annually,
usually 5%. A higher Income Benefit Base pays a higher guaranteed income
when it starts. For example, the insurer might agree to pay 5.0% at age 55. But if
you wait until age 70 to begin taking income, the insurer might increase to 6.0%.
At age 80, it could be 7%. If there is a step-up reset that increases the Income
Benefit Base by more than the income credit amount in that year, then no income
credit is added. There is usually a time or an age limit on income credit.
Other Benefits: The same benefits that are available for a regular variable annuity
also apply to a VA—GMWBL; such as death benefits, principal protection, and
conversion to a life annuity. Keep in mind that these benefits, or riders, differ
from contract to contract, and usually come with additional costs.
Jim Otar, in his book: “Unveiling The Retirement Myth: An Advanced Retirement
Planning based on Market History,” writes about the VA—GMWBL “as one of the most
versatile income classes in an advisors toolbox. They convert longevity and market risks
into inflation risk. They go a long way in minimizing the “fear” for the retiree.”
Note: The annuity starting date on most annuity contracts is age 95. Most insurance
companies will force the individual to annuitize the contract at that point in time. Some
contracts may pay out the larger of: the annuitization factor or the withdrawal benefit
amount.
GMWBL Client Suitability
For Example: Rebecca is 65 years old and a recent widow. She has $700,000 to last her
for the rest of her life. She wants an equity-based investment that will guarantee her a
minimum of $35,000 a year starting immediately with a chance for that income to
increase (but not decrease) should the stock market move up. Rebecca also wants to
know that:
65




Her stream of income will last for her entire lifetime, even if she should live to
well over age 100;
If she dies prematurely, any remaining account value will be paid out to
beneficiaries;
She won’t have to annuitize;
She has the option to withdraw against the account balance at any time.
For Rebecca’s $700,000 investment, a VA with the GMWBL rider may be suitable.
Treatment of Withdrawals from GLB Riders
Let’s review the two different treatments of withdrawals and how they affect the income
base of the guaranteed living benefit chosen.
Dollar-for-Dollar
The first and simplest is a dollar-for-dollar withdrawal, in which the base is simply
reduced by the same amount as the withdrawal.
For Example: With a dollar-for-dollar withdrawal an account value of $100,000
and an income base of $200,000, a withdrawal of $10,000 from the account value
will lower the income base to $190,000 ($200,000 - $10,000).
Pro-Rata
The second type of withdrawal, pro-rata, is a little more difficult to calculate. The
income is reduced on a proportionate basis in relation to the current account value when
the withdrawal is taken.
Example: Using the same scenario as above, with a $100,000 account value and
a $200,000 benefit base, this time when we withdraw the $10,000 we have to look
to the current account value to calculate the reduction in the benefit base. The
$10,000 represents 10 percent of the account value, or $10,000 divided by
$100,000. We then reduce the income base a proportionate amount of the 10
percent, or $20,000. This is simply 10 percent of the $200,000 income base. We
end up with an income base of $180,000.
Variable Annuitization: Calculating Variable Annuity Income
Payouts
Annuitization is one of the least utilized and often misunderstood options of a variable
annuity contract. The annuity contract holder may elect to allocate all or part of the value
of the contract to either the fixed account and/or the separate account.
66
Allocations to the fixed account will provide annuity payments on a fixed basis; amounts
allocated to the separate account will provide annuity payments on a variable basis
reflecting the investment performance of the underlying sub-account.
To understand why and how the income payout amount will vary under the variable
payout option, it is necessary to understand the two important concepts:


“Annuity units” and
“Assumed interest rate” (AIR)
Annuity Units
An annuity unit is a unit of measure used to determine the value of each income payment
made under the variable annuity option. How the value of one unit is calculated is a
fairly complex process involving certain assumptions about investment returns. It is
probably sufficient to understand that the amount of each month’s variable annuity
income payout is equal to the number of annuity units owned by the contract holder in
each investment account multiplied by the value of one annuity unit for that investment
account.
Example: Let’s assume that on January 1, the date the annuitant retires, he or she has
collected a total of 10,000 accumulation units. Assume further that at that time the
10,000 units have a market value of $50,000.
Using the above process, the insurance company then converts the annuitant’s 10,000
accumulation units to 100 annuity units.
On the first payment, each annuity unit is worth $10. If the annuitant chooses the fixed
payment option, the $1,000 monthly payment, as listed in the example below as of
January 1, would remain constant for the balance of the payout period.
Assume that the annuitant chooses a variable payout; in that case, a six-month projection
of monthly payments would be as follows:
Date
Annuity
Unit Value
Monthly Payment
to Annuitant
01/01
$10.00
$1,000
02/01
10.17
1,017
03/01
9.73
973
04/01
9.89
989
05/01
10.11
1,011
06/01
10.57
1,057
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The major benefit of using the variable accounts during the annuitization phase of a
variable annuity is that it gives the annuity contract holder the opportunity for his/her
income payment amounts to increase sufficiently so that they may keep up with inflation.
However, as shown above there is the risk that the income payment may also decrease.
To accommodate those clients who are concerned with that risk, many insurers allow the
annuity contract holder to place a portion of the accumulation value in the guaranteed
general account and thus receive a fixed income payment (fixed annuitization) and place
the remainder of the accumulation value into a separate investment account (variable
annuitization) and receive a variable benefit amount from these funds.
Assumed Interest Rate (AIR)
The selection of the assumed interest rate (AIR) is unique to a variable annuity and
requires a high degree of knowledge about the subject. The AIR is the most significant
component in the conversion factor for a variable annuity. A poor decision could result
in receiving less than the maximum possible benefit. All variable annuities require an
AIR as the basis for the initial and subsequent payments.
Also, the AIR will have a significant impact on the initial payment level and on the
pattern of subsequent payments. Many contracts allow the annuity contract holder to
select the interest rate to be assumed (AIR) in calculating the initial payment level. Other
companies only offer one AIR. A higher AIR produces a larger initial payment than a
lower AIR.
Since the AIR is an assumption and not a guarantee, subsequent payments will vary
according to the relationship between actual investment performance and the selected
AIR. If actual investment returns are exactly to the AIR, then the payment amount will
not change. If actual investment returns are greater than the AIR, then the payment
amount will increase. If investment returns are less than the AIR, payments will
decrease.
A higher AIR means not only that the initial payment level will be higher, but also that
subsequent payments will increase more slowly or decline more quickly than payments
determined with a lower AIR. If the annuity contract holder lived long enough and had
two annuities alike except for the AIR, the payments based upon two different AIRs
would eventually cross, and the payments based upon the higher AIR would thereafter
always be less than those based upon the lower AIR.
Typically, the payment patterns of a high AIR and a low AIR will cross after eight or
nine years of payments; however, the total payments received will not be equal until after
about 14 or 15 years of payments. In other words, an annuity contract holder who lives
less than 15 years would receive more annuity benefits under a higher AIR than under a
lower AIR; conversely, an annuity contract holder who lives more than 15 years would
receive more annuity benefits under a lower AIR than under a higher AIR. Favorable
investment performance will result in an increase under all AIRs.
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Here is an example of the impact of the AIR on payment levels: Monthly payments
under alternative AIRs based on a 6 percent actual investment return and a $10k annuity
purchase at age 65 would mean $100 at year five. On a basis of 3 percent actual
investment return at age 65 would be $91 at year five. The monthly payment for a 9
percent actual investment return at age 65 would increase to $108 at year five.
VA Regulation under the Federal Securities Laws
Besides being governed by the state regulatory framework, variable annuities as
securities are regulated under federal securities laws. The primary federal securities that
regulate variable annuities and the separate accounts through which they are issued are:



Securities Act of 1933 (1933Act),
Securities Act of 1934 (1934 Act), and
Investment Company Act of 1940.
The Securities Exchange Commission (SEC) administers these acts.
Securities Act of 1933
The Securities Act of 1933 sets out three very important rules:


Registration of Contracts. Because variable annuities are securities, they must be
registered with the SEC under the 1933 Act before they can be offered to the
public (with two exceptions noted below). The SEC staff reviews and comments
on registration statements, which usually must be amended in response to staff
comments before they will be declared effective. (The SEC does not, however,
approve or disapprove of any securities, including variable annuities and does not
pass on the accuracy or adequacy of any prospectus.) A “post effective”
amendment updating the variable annuities registration statement generally must
be filed at least annually. The first registration exception is for annuity contracts
that are issued in connection with certain qualified plans such as 401(k) plans.
The second exception is for “privately offered” annuities, which are contracts
that, among other things, are not offered to the general public. Even with these
exceptions, however, issuers and others involved in marketing non-registered
variable annuities, remain subject to the anti-fraud provisions of the 1933 Act.
Prospectus Delivery. When someone purchases a registered non-qualified
variable annuity he or she receives a prospectus. These prospectuses are updated
regularly. Separate prospectuses describe underlying investment options—the
funds to which the annuity holder may allocate his or her investments. This can
result in the annuity holder receiving numerous prospectuses. However, the SEC
recently adopted a rule permitting fund “profiles” which are shorter, user friendly
summary prospectuses, to be given to the prospective purchaser. The SEC also
permits limited use of variable annuity profiles.
69

Disclosure of Fees and Expenses. Variable annuity prospectuses contain fee
tables that list the amounts of each contract and underlying fund charges. These
amounts are expressed in dollar amounts or percentages of the contract value or
fund assets so purchasers will know what they will pay if they buy the contract.
In addition, variable annuity prospectuses contain numerical examples showing in
dollar amounts per $1,000, what the annuity holder would pay for the contract and
each portfolio of the fund over 1-, 3-, 5-, and 10-year periods.
o For example, the ABC VA prospectus could have a tabular example
showing total expenses on a $1,000 investment in the contract allocated to
the stock fund to be $78, $106, $126, and $208, for the 1-, 3-, 5-, and 10
year periods, respectively, following the purchase. These examples
assume a 5% return and that the contract is surrendered at the end of the
relevant period.
Additional examples are required that assume that the investor does not surrender
the contract. This format shows the effect of any surrender charge.
Securities Act of 1934
The 1934 Act generally requires variable annuities to be distributed through registered
broker-dealer firms and their registered representatives. Broker-dealers and their
representatives are subject to extensive operational and financial rules that cover
minimum net capital requirements, reporting, record keeping, supervision, advertising,
and sales activities.
In addition to the broker-dealer regulatory framework established by the 1934 Act,
registered broker-dealer firms that sell variable annuities also must be members of the
NASD. The NASD is a self-regulatory organization overseen by the SEC. It has an
extensive body of rules with which broker-dealers must comply. For example,
examinations are required; fingerprints must be provided; and numerous supervisory,
suitability, advertising, record keeping, and reporting rules apply.
Note: As of July 2007, the NASD, with the consolidation of the member regulation,
enforcement and arbitration functions of the New York Stock Exchange, will now be
called the Financial Industry Regulatory Authority (FINRA).
A 1934 Act rule requires broker-dealers to send confirmation statements to annuity
holders after each purchase and sales transaction made involving a variable annuity
contract. In addition, insurance companies send annuity holders periodic account
statements showing a beginning balance, transactions during the period, and an ending
balance so that the annuity holder will have a record of all activity in his or her contract.
Investment Company Act of 1940
The 1940 Act imposes an extensive federal regulatory structure on investment
companies, including separate accounts and underlying funds. Note: Some separate
70
accounts and funds however, such as those used in connection with tax-qualified
retirement plans, are not subject to the 1940 Act. For example, the Act governs how
variable annuities and shares of underlying funds are issued and redeemed. There are
also corporate governance requirements and prohibitions against self-dealing.
Each separate account regulated under the 1940 Act must file a report on its operations
annually with the SEC. In addition, an annual and semi-annual report containing
information about the underlying mutual funds that serve as investment options for the
variable annuities must be sent to annuity holders. In some cases, these reports also
contain information on the variable annuities themselves.
The SEC inspects variable annuity separate account operations regularly. The SEC also
inspects various locations, such as broker-dealer offices, from which variable annuities
are sold. Recommendations are made and any deficiencies are noted. If the situation is
serious enough, it is referred to the SEC’s enforcement division.
Regulation of Fees and Charges
Currently, the SEC does not regulate individual variable annuity fees and charges.
However, the 1940 Act makes it unlawful for any registered separate account funding
variable annuity contracts, or for the sponsoring insurance company, to sell any such
contract unless the fees and charges deducted under the contract are, in aggregate,
reasonable in relation to the services rendered, the expenses expected to be incurred, and
the risks assumed by the insurance company. The insurer must represent in the annuity
contract’s registration statement that the fees and charges are reasonable.
Outlook for Variable Annuities
The fact that several major insurers exited from the annuity business should tell us all we
need to know about the health and viability of the industry heading into 2015. If only it
were that simple, since the industry, like the product itself, is a bit more complicated.
The industry has dealt with several issues in recent years: hedging issues, suitability, 77
million baby boomers going into retirement, the living benefit “arms race” and also, let’s
not forget the worst global financial crisis in the history of the world.
In fact, the insurance industry’s exposure to variable annuities that are in the money,
where the account value is smaller than the guaranteed living benefit base, continues to
shrink. In 2011, life insurers had $721.3 billion in assets under management tied to VA’s
with these features, while benefit bases were worth $823.4 billion. That leaves the
industry under water on these benefits by $102.1 billion, according to Morningstar.
During the crisis in 2008, insurers were underwater on these benefits by $253.7 billion.
In 2006, the halcyon days prior to the downturn and the living benefits arms race, carriers
were only underwater by $3 million.
71
As the markets return to normalcy, the appetite for variable annuities is poised for a
comeback, which will perhaps outshine the growth of the past decade. The reason for
this optimistic outlook is that many investors continue to face volatile financial markets,
dwindling pensions and a money-strapped Social Security system that may be incapable
of providing the income they need for a secure and, very likely, extended retirement.
Given the various challenges in retirement funding within today’s risk-averse investment
climate, the VA, coupled with an appropriately diversified portfolio, can serve as an
important retirement-income solution.
In the end, VA providers with the best risk management capabilities should emerge from
the current crisis in a stronger position with solid products that continue to play a critical
role in meeting retirement needs. There are compelling reasons to believe that a surge in
demand is just over the horizon. And insurers who persist in refining their products and
hedging programs should be in the best position to exploit it.
Ultimately, investors (especially baby boomers) will continue to seek ways to allocate a
portion of their portfolio to the kind of guaranteed, lifelong income their parents enjoyed
via their company pensions. As these investors intensify the search for defined benefitlike retirement alternatives, VA’s may increasingly be seen as a vehicle of choice, given
their role in portfolio diversification and providing a potential source of stable income.
In addition, with the increasing income tax rates and the new IRC Section 1411
(Medicare Surtax) of 3.8% many investors will be seeking the basic benefits of plain tax
deferral. We have seen a number of insurers that have come to market with specific VA
products to meet this demand.
LIMRA estimates that VA sales should grow to $162 billion by 2018.
72
Chapter 4
Review Questions
1. In a variable annuity who assumes all of the risk in the sub-accounts?
(
(
(
(
) A. Contract holder (owner)
) B. Insurance Company
) C. Investment Company
) D. Management Company
2. Mortality and Expense (M&E) charges in a variable annuity pays for all of the
following fees and charges EXCEPT:
(
(
(
(
) A. Guaranteed death benefit
) B. Investment Management fees
) C. The option of a lifetime of income
) D. The assurance of fixed insurance costs
3. What is the measure used in a variable annuity to determine the contract owner’s
interest in the separate account during the accumulation phase?
(
(
(
(
) A. Annuity unit
) B. Assumed interest rate
) C. Net asset value
) D. Accumulation unit
4. Which of the following provides a separate death benefit that can be used to pay taxes
on gains in the contract?
(
(
(
(
) A. GMAB
) B. GWSIP
) C. Enhanced Earnings Benefit
) D. GMIB
5. Which of the following is the most significant component in the conversion factor for
a variable annuity?
(
(
(
(
) A. Net asset value
) B. Accumulation unit
) C. Annuity unit value
) D. Assumed interest rate
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74
CHAPTER 5
INDEX ANNUITIES
Overview
The IA is designed for safety of principal with returns linked to upside market
performance. Since their inception back in 1994, there have been numerous articles
written about the positives as well as the negatives of Index Annuities (IA’s). But one
thing is certain, sales of IA’s has vastly increased every year since 1996.
In this chapter, we will define an Index Annuity (IA), review the IA market and history,
the various terms and provisions specific to an IA, and the regulatory issues of IA’s.
Learning Objectives
Upon completion of this chapter, you will be able to:






How to define an Index Annuity;
Determine a consumer profile that would be suitable for an Index Annuity;
Demonstrate an understand the various moving parts of the Index Annuity;
Identify the various interest linked interest crediting methods;
Understand the various IA Waivers and Riders; and
Recognize the role of state insurance departments in the regulation of IA’s.
Index Annuity Defined
Fundamentally, an Index Annuity (IA) is a type of fixed annuity whose ultimate rate of
return is a function of the appreciation in an external market index, with a guaranteed
minimum return. As such, IA’s provide their owners with the potential for larger interest
credits—based on growth in the equities market—than what might be paid on traditional
fixed-rate annuities, while avoiding the downside risk that accompanies the direct
investing in equities. The external market index used in IA’s is almost always the
Standard & Poor’s 500 Composite Stock Price Index (i.e., S&P 500), although one of
several other recognized market indices might also be used.
The fundamental concept that underlies all IA’s is a fairly simple one; interest credits are
tied to an external market index. However, as will be seen later, achieving a full
understanding of IA product design is not a simple task, due partly to the proliferation of
product designs and interest-crediting structures that currently exist in the marketplace.
75
Although introduced in the U.S. market more than a decade ago, IA product design is still
evolving. New products, containing one or more new features or offering variations on
one or more “old” features, are introduced into the marketplace on a relatively frequent
basis. Furthermore, a number of contract features affect the financial performance of
IA’s, not just the change in the external market index.
The major features, or components, of IA product design are described later in this
chapter. However, it is important to note here that for many contract features the insurer
has a variety of options from which to choose in designing an IA product. As a result, the
current IA marketplace contains hundreds of variations in IA product design. Many
insurers have multiple IA products, each one designed to address a differing set of
customer needs and objectives.
Index Annuity Market
The origin of IA’s in the U.S. is generally traced back to 1995 when Keyport Life
Insurance Company began selling its “Key Index” product that year. The first IA was
purchased February 15, 1995 by a 60 year old from Massachusetts. Over the next five
years the original $21,000 premium placed in a Keyport Key Index annuity grew to
$51,779. The IA era had begun. These products have garnered a lot of excitement in the
annuity marketplace and, simultaneously, have achieved record industry sales in a
relatively short period of time. However, IA’s, as well as certain sales and marketing
practices, are also currently the subject of controversy and criticism.
In 1997, IA sales were $3 billion, a mere blip on the annuities marketplace. Fast forward
17 years and IA’s racked up $48.2 billion in sales by the end of 2014, and comprise 50
percent of all fixed annuity sales, according to data compiled by Advantage Compendium
(see Table 5.1).
Table 5.1
Sales Index Annuities 2000 – 2014 ($ billions)
Year
Total
IA Assets
Total
IA Sales
Sales as a % of
Total FA Sales
2000
$19
$5.5
10%
2001
25
6.8
9
2002
35
11.8
11
2003
47
11.3
14
2004
71
21.1
24
2005
93
26.8
35
2006
103
25.1
34
76
2007
125
25.0
38
2008
138
26.7
25
2009
157
29.5
28
2010
185
32.4
43
2011
205
32.2
44
2012
225
33.9
47
2013
257
39.3
51
2014
365
48.2
50
Source: LIMRA Secure Retirement Institute, U.S. Individual Annuities Survey
(based on data from 60 companies, representing 96 percent of total sales, March 2015).
Profile of an IA Buyer
Who would be a typical IA buyer? IA’s are designed for people that are averse to risk.
The type of person whom, if given a choice between an investment that has an equal
chance of doubling in a year or losing 20% of its value versus an investment that will
make 6%, will always choose the low risk/low return alternative. Certificate of deposit
and traditional fixed annuity buyers fit this profile. IA’s can be used to overcome this
aversion to risk by providing the potential for higher returns than traditional savings
vehicles without market risk to principal.
It is important to remember that an IA should never be used in comparison with a VA or
any other type of equity investment.
Next, let’s review some of the various terms and provisions of an IA.
IA Basic Terms and Provisions
If there is one major complaint about IA’s, it is that there are too many moving parts,
terms and provisions, to understand. For an example, in 2013 there were 51 insurance
companies offering index annuities with over 27 variations according to Advantage
Compendium. Let’s now review some of the basic terms and provisions that are part of
an index annuity.
Tied Index
Each and every IA contract ties the actual interest-crediting rate, in excess of the
guaranteed rate, to an external market index. Different IA products may use varying
indices. Some IA’s allow the contract owner to allocate individual portions of the
premium between two or more indices and may also permit a portion of the premium to
77
be allocated to a fixed interest rate option within the IA contract. In these instances
owners are usually allowed to change their allocations annually on policy anniversary
dates.
The majority of IA products are based on the S&P 500 Composite Stock Price Index (or
simply, S&P 500). In theory, however, any market index that tracks the performance of a
specific collection of securities, a segment of a securities market, or the entire market
could be used. While many, if not most, IA contracts specify a single index, some IA
products permit purchasers to choose one or more indices from a group of prescribed
indices. This latter category of IA’s frequently permits the contract holder to change
from one external index to another at one or more times during the term of the contract.
In addition to the S&P 500, other market indices used by some IA’s include the DJIA, the
Barclay Indexes, Nasdaq 100, Mid-Cap 400, Russell 2000, some contracts allow an
interest rate benchmark strategy tied to the 3-Month London Inter-Bank Offered Rate
(LIBOR), and a number of contracts also allow a fixed interest rate strategy. Of course,
different indices pose varying levels of risk to the IA purchaser. To illustrate, an interestcrediting rate tied to the S&P 500, on average, would be expected to vary from one
period to the next to a lesser extent than in interest-crediting rate tied to the Nasdaq 100.
Market indices other than the S&P 500 are currently offered by approximately one-fourth
of the IA carriers. At present time, however, approximately 95 percent of sales are for
S&P 500 indexed products, with very little money flowing into any of the other indices.
Index (Term) Period
The index (term) period of an index annuity is defined as the length of time that index
interest credits are linked to the particular index used in the contract. The “initial” index
period must be listed on the contract data page. Index periods vary from contract to
contract, and can be as short as one year and as long as twelve years. Using a shorter
index period limits the percentage of index growth that the client can receive as an index
interest credit when compared with the percentage of longer index periods.
Participation Rate
The indexed-link interest rate credited to an IA’s accumulation value invariably is lower
than the full gain in the tied index over the duration of the interest-crediting period. This
is usually accomplished in one or more of the following ways:



By applying a “participation rate” to the total index gain
By deducting a state percentage, or “yield or spread,” from the otherwise
calculated interest-crediting rate; and/or
By placing a ceiling or cap on the interest-crediting rate.
An IA’s participation rate is multiplied by the gain in the tied index in determining the
index-linked interest that will be credited to the IA’s accumulation value. Participation
rates can be anywhere from 45% to 100%. Some variations in this and other IA contracts
78
incorporate two participation rates, with a higher rate applied to the initial index gain and
a somewhat lower rate applied to any additional gains.
Participation rates cannot be compared among products without also considering the
indexing crediting method used (discussed below). To add to some of the confusion, a
contract with a 100% participation rate does not necessarily produce a greater index
benefit than a contract with an 85% participation rate. Some contracts that may offer a
100% participation rate may have a cap or a spread.
Spreads or Margins
The spread or margin, also referred to as an administrative fee, is another way of
determining the interest rate for the year or for the index period. Instead of multiplying
by a participation rate, some index annuities simply deduct a spread or margin from the
growth of the index as measured by the particular indexing method chosen by the issuing
company.
Example: If the calculated change in the index is 7.75%, the contract might
specify that 2.25% will be subtracted from the rate to determine the interest
credited. In this example, the rate would be 5.50% (7.75% - 2.25% = 5.50%). In
this example the insurer subtracts the percentage only if the change in the index
produces a positive interest rate.
Note: Spreads and margins can be issued in the contract as either guaranteed or nonguaranteed.
Some index annuities may use a hybrid approach with the use of a participation rate and
also deduct a spread or margin. Typically, these methods have higher participation rates
and then utilize the spread or margin as the main working calculation element. Why
would a company choose both of these methods? There are two main reasons:


First, it allows the insurance company to express a very high participation rate
compared with designs in which do not add a spread or margin. At first glance,
the higher participation rate can attract interest in the product and produce a
marketing advantage.
The second reason has to do with pricing. When the company is able to
incorporate two different interest rate determiners into its pricing, it has more
flexibility in dealing with market changes that occur during the index period.
Caution: Some index annuities allow the insurance company to change participation
rates, cap rates, or spread/asset/margin fees either annually or at the start of the next
contract term. If an insurer subsequently lowers the participation rate or cap rate or
increases the spread/asset/margin fee, this could adversely affect the return on the
contract. As the insurance producer/financial advisor, you must read your contracts
carefully to see if it allows the insurer to change these features.
79
Cap Rate
Many IA’s specify an interest rate cap, or ceiling rate, that establishes an upper limit on
the amount of index-linked interest that will be credited to the accumulation value. The
cap may be expressed as a monthly limit (e.g., 1.5%), an annual limit (e.g., 5%) or as a
ceiling on the total amount of index-linked interest credited over the entire contract term
(e.g., 30%). A review of the www.indexannuity.org website shows a large number of
annual interest rate caps between 2.5% to as high as 5%, inclusive. Some insurers show a
monthly cap of 1.20% to as high as 2.35% and quarterly caps between 1.1% and 2.3% (as
of 1/05/2015).
When permitted by state law, insurers typically reserve the right, by contract, to change
the size (up or down) of their participation rats, yield spreads and interest rate caps,
subject to some guaranteed amount (a minimum or “floor” for participation rates and
interest rate caps, and a maximum in the case of yield spreads). Such changes (in
percentages) usually can be made only once a year on the contract’s anniversary date and
remain in effect for the entirety of the next policy year. Since they may be subject to
change by the insurer, participation rates, yield spreads and interest rate caps frequently
are referred to as moving parts. It should be noted that, when more than one of these
features is included in a specific IA contract, only one of the provisions is subject to
change and the other provisions are fixed throughout the duration of the contract.
Example: If the issuing insurer reserves the right to change the participations
rate, any yield spread and/or interest rate cap included in the IA will be
guaranteed for the life of the contract.
These contract provisions, used individually or in tandem with each other, play a
significant role in determining the ultimate amount of index-linked interest that will be
credited under a specific interest-crediting structure. As we will discuss shortly, the three
approaches affect the financial performance of the IA’s in slightly different ways.
However, they all serve a common purpose and, to that extent, the three separate types of
“moving parts” are somewhat interchangeable with each other.
It is important to remember, that interest rate caps are applied after the interest
calculation is made and the participation rate applied or the spread or margin is deducted.
The cap is the last element applied before the index interest rate for the year or the index
period is determined.
Example: Let us assume that a particular index annuity has a 75 percent
participation rate and a 3 percent annual cap. Assuming that for a given year (or
for the entire index period) the indexing method produces an index growth of 5.5
percent, the 75 percent participation rate will result in a net of 4.125 percent (75 x
5.50). However, with the cap of 3 percent, the client receives an index interest rate
of only 3 percent.
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In the first half of 2014, more insurers have introduced un-capped crediting strategies that
utilize volatility-controlled indices to manage the risk
No-Loss Provision
The no-loss provision in an IA, means that once a premium payment has been made or
interest has been credited to the account, the account value will never decrease below that
amount. This provides safety against the volatility of the index (S&P 500).
Guaranteed Minimum Account Value
In order for the IA to be classified as a fixed annuity it must comply with the Guaranteed
Minimum Account Value (GMAV) rules specified in the Standard Non-Forfeiture Law
for Individual Annuities. Pertaining to fixed annuities, Section 4 states that they:
“provide for a guaranteed minimum account value at all times no less than 90
percent of the single premium amount compounded by interest of no less than 3
percent per year.”
For a declared fixed rate annuity the insurance companies base their GMAVs on 100
percent of the single premium amount compounded at 3 percent per year. This means that
after the first policy year, the declared fixed rate annuity buyer will never receive an
annual statement where the GMAV is less than the single premium amount, unless a
withdrawal has been made.
However, with an index annuity its value at any point in time is the greater of a
guaranteed floor value or an accumulation value less a surrender charge. Under the new
non-forfeiture regulation, the guaranteed floor is 87.5 percent of premium compounded at
a value based on the 5-year treasury yield (no less than 1 percent, usually no greater than
3 percent). So then, it is possible to see a guaranteed minimum account value of less than
the single premium amount on the policy statement. This is not necessarily a bad thing.
However, it is different from what is customary with most fixed rate annuities. That fact
may cause a concern for your client who is looking to purchase an equity index annuity
and will need to be explained.
Liquidity
Generally a 10% withdrawal is allowed annually without surrender penalty and some FIA
contracts offer more standard withdrawal provisions. (Some contracts allow 15%
annually.) Reminder: Most articles analyzing appropriate withdrawal rates for retirees
range in the 4-6% range annually, depending upon various methods of thought. This
being said, a 10% withdrawal privilege should not be an issue for most retirees and
individuals.
Nearly all IA’s provide a full surrender value upon death of the owner or annuitant. Many
IA issuers offer full surrender for nursing home stays, extended hospital visits and
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terminal illness. Several carriers offer full surrender for unemployment if under 65 years
of age. IA opponents commonly cite surrender fees in some older IA products that were
marketed that were as long as 15 -20 years and fees as high as 20% in the earlier years of
surrender, as an issue.
But, proponents of IA’s claim that, if you review the various free withdrawal privileges
and based on the appropriate range of annual withdrawals, most individuals who
purchase an IA will not encounter a penalty except through their choice. Second,
surrender fees are required by state insurance regulators in order for policies to be
qualified for sale. The existence of surrender fees helps an insurer recapture up-font costs
on products that were designed to be held for several years, and protects persisting
policies from the imposition of extra costs by those who choose to surrender early. Third,
the idea that securities do not have penalties is not only flawed but simply not accurate.
Even if the actual mutual fund one is holding does not assess surrender charges, it is
subject to annual management fees and market risk. Furthermore, they claim, IA’s
provide a guaranteed minimum return along with principal preservation which mutual
funds and other similar investments do not provide.
Fees and Expenses
Unlike mutual funds, an IA does not deduct sales charges, management fees or 12b-1
marketing fees. Instead, the insurance company uses a small amount from the underlying
portfolio which lowers participation rates in the market index to cover administrative
costs and commissions to agents. Because the IA provides policy crediting rate formulae
and periodic annuity owner reports net of any fees and management expenses, it does not
separately disclose them.
Surrender Charges
All IA’s charge a penalty if the policy is surrendered, cashed-in, prior to the end of the
surrender period. Depending on the policy purchased, surrender periods vary in length
from one to eighteen years, and penalties can be as high as 25 percent of the initial
premium (although very high penalties are usually offset by a “premium bonus”.) Keep
in mind; it is usually because of the high up-front bonuses that result in the very high
surrender charge schedules.
A typical surrender charge is expressed either as a percentage of the accumulated value of
the IA or as a percentage of the original premium. Although IA principal is protected
from market risk, most index annuities would return less than the original premium if
surrendered too early. Surrender penalties do not usually apply if the policy is paid out, if
the policy is annuitized, or due to death of the owner (all deferred annuities issued after
January 18, 1985 must pay out upon the death of the owner).
A number of IA contracts do not state a specific surrender charge, but instead base the net
surrender value on the minimum guaranteed value. Although this calculation may not be
called a surrender charge, it has the same effect.
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Example: If the minimum guaranteed surrender value is based on 3 percent
interest compounded on 90 percent of the premium, then the cash received upon
surrender would be 90% during the first contract year, 92.7 percent during the
second, 95.5 percent during the third and 98.3 percent during the fourth year.
This is really a de facto declining penalty of 10%, 7.3%, 4.5% and 1.7% for the
first four years of the IA contract.
Interest Calculation
The way an insurance company calculates interest (compounding or simple) earned
during the term of the index annuity can make a big difference in the amount credited to
the annuity. Some index annuities pay simple interest during the term of the annuity.
Because there is no compounding of interest, the return credited will be lower. While the
annuity may earn less from simple interest, it may have other features more beneficial to
the client, such as a higher participation rate.
Exclusion of Dividends
Depending on the index used, stock dividends may or may not be included in the index’s
value. For example, the S&P 500® is a price index and only considers the prices of
stocks. It does not recognize any dividends paid on those stocks. Since the annuity is not
being credited dividends, it will not earn as much as if invested directly in the market.
Index-Linked Interest Crediting Methods
One of the most important features in determining the actual interest received on an IA
contract is the crediting method used to measure the amount of change in the underlying
index. The three most common methods are:



Annual Reset (Ratcheting) Method
High Water Mark Method
Point-to-Point Method
In addition, several variations exist within these three common methods creating several
dozen different approaches to measuring index gains. While the following discussion is
extensive, it is not intended to be an exhaustive treatment of all methods for measuring
index gains as many of these methods account for only a very small percentage of totalindustry wide IA sales.
Let’s discuss each of these in greater detail beginning with the Annual Reset.
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Annual Reset (Ratchet) Method
The annual reset, aka, the ratcheting method; the interest is determined by comparing the
index value at the end of the contract year with the index value at the beginning of the
contact year. Interest is added each year for the term of the contract. In years where
gains in the tied index are negative, a “0” is recorded. Consequently, while there can be
“flat” years—with no index gains—under annual reset IA’s, it is impossible to have a
“down” year. Accumulation values will either grow or remain steady from one year to
the next, regardless of the amount of volatility in the underlying market index.
Positive gains are divided by the index value at the beginning of the year to determine a
percentage amount. Depending on the specific IA contract, this percentage may be
reduced by a participation rate less than 100 percent, a yield spread and/or a cap in
determining the index-linked interest-crediting rate. The index-linked rate multiplied by
the beginning-of-year accumulation value generates the dollar amount of index-linked
interest for the year. Once interest is credited to the accumulation value, it is locked-in
and the accumulation value will never decrease from that level regardless of the future
performance of the tied index.
The annual crediting of interest and the corresponding protection against market declines
in future years is a primary reason underlying the popularity of annual reset (ratcheting)
IA’s. Once locked-in, index-linked interest gains can never be lost due to a subsequent
downturn in the tied index. A related advantage is that the annual locked-in interest
credits provide the purchaser with periodic “progress reports” of the IA’s financial
performance. The accumulation value at any point in time can serve as a partial predictor
of what the total financial gain might be at the end of the contract term.
Let’s review an example: Let’s assume that an individual purchased an Annual Reset IA
with a four-year surrender period. Further assume that the tied market index declines
from a beginning value of 1000 to 800 at the end of the first contract year. In this case, no
interest is credited to the accumulation value in the first year. However, the index value
at the beginning of the second year is reset at 800 and any growth in the index during the
second year will be measured from this lower amount. If the tied index increases again to
1000 at the end of the second year, the index gain is 25 percent for this year. Let’s now
assume that this exact pattern is repeated in years three and four. Under this scenario,
zero gain will be recorded in the third year since the index declined in value from 1000 to
800. And, another 25 percent gain will be recorded in the fourth year since the
beginning-of-year index value was reset to 800, and the index value at the end of the
fourth year is assumed to have reached 1000 again. In summary, the index gains for this
four-year Annual Reset IA are:




Year 1 = 0%
Year 2 = 25%
Year 3 = 0%
Year 4 = 25%
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Assuming a $1,000 initial premium, a participation rate of 0.60 and annual compounding
of interest, the accumulation value at the end of the four-years is $1,322.50.62. In
contrast, if this IA were either a Point-to-Point or High Water Mark product, there would
be no index-linked interest credits since:


There was no gain in the index between the beginning and ending dates of the
term, and
The index value never exceeded the index value at the date of purchase.
Next, let’s review the first successful index interest crediting method—High-Water Mark.
High-Water Mark Method
The High-Water Mark method calculates the interest crediting method is recorded at
various points in time during the term of the contract. Typically, the annual anniversary
is used as the reference points. Interest is added at the end of the contract period and is
based on the difference between the highest index value and the beginning index value.
Both approaches incorporate a multi-year index term. However, IA’s using a High Water
mark approach generally credit index-linked interest each time a new index “high” is
reached. The High Water Mark method is also sometimes referred to as the “no regret”
or “term-high” design. It is also known as the “look-back” method since, at the end of the
index term, the insurer and the purchaser look back over the entire term to identify the
peak value of the index.
The advantage of the high-water mark method is that a customer may receive a higher
amount of interest than other methods if the index reaches a high point towards the
beginning or middle of the contract, then falls at the end of the contract term. However,
the disadvantages are that this method sometimes comes with a cap and a lower
participation rate than other methods. In addition, some contracts state that if the
annuitant surrenders the contract before the end of the term, then the interest is forfeited.
Point-to-Point Method
The final method, Point-to-Point , measures the change in the tied market index between
two discrete points in time, such as the beginning and the ending dates of the contract
term, usually greater than one year or two years. Similar to the high-water mark method
discussed above. The beginning point is usually the purchase date of the IA contract and
the ending point is typically the end of the multi-year index term. If there is a decrease in
the market index between the beginning and end points, the change is recorded as zero.
Point-to-point is the simplest approach to measuring index gain over the life of the
contract and, possibly, also the easiest for insurance producers and financial advisors to
explain to prospective IA purchasers. Under this design no index-linked interest is
credited prior to the end of the index term. Unlike what typically occurs with traditional
fixed-rate annuities and many other types of interest-bearing products, interest is not
calculated and credited annually (or more frequently) under a Pont-to-Point IA product.
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This approach is sometimes referred to as the European method since recognizing the
index gain only at the end of the index term is characteristic of options trading that occurs
in many European equities markets. European options can be exercised (or recognized”)
only on their expiration date and not at any earlier time. This is in direct contrast to the
typical American stock option where the option can be exercised at any time up to, and
including, the expiration date. For obvious reasons, the Point-to-Point is also known as
the “term –end point,” “end of term,” “term point-to-point,” or “long-term point-to-point”
design.
The first step in determining the amount of index-linked interest to be credited to the IA’s
accumulation value is to subtract the beginning index value from the endpoint value. If
the result is negative (i.e., the market index declined in value from the beginning to the
end of the index term), it is recorded as zero and the IA’s accumulation value is credited
with the minimum guaranteed return.
Positive index gains are divided by the beginning index value to arrive at a percentage
gain. The percentage gain is then multiplied by a participation rate. The product of these
two numbers is then multiplied by the amount of money invested in the contract (i.e.,
premiums plus any bonuses) and then added to this principal amount to arrive at the
contract’s accumulation value. At the end of the index term, the contract owner is
entitled to the larger of the accumulation value and the guaranteed minimum value.
A potential, yet significant, drawback to purchasers of IA’s incorporating the traditional
Point-to-Point structure results from the fact that the index-linked interest-credit depends
on a single index value—the value at the end of the index term. All other index values
throughout the term of the contract are completely irrelevant under this design (other than
the beginning index value, of course). This situation may not be troublesome to IA
purchasers so long as the index trend is generally upward throughout the contract term or
the index value, while experiencing several “ups” and “downs,” is significantly higher at
the end of the contract term than at the beginning. However, a pattern of equity returns
that leads to generally higher index values over time, followed by a sudden and
significant decline in the external index in the last few days, weeks or months just prior to
the end of the index term may lead to significant disappointment on the part of contract
owners in the financial performance of their EIA.
To address this concern, most EIA’s using the Point-to-Point method incorporate an
averaging process into the design of the interest-crediting mechanism. Commonly
referred to as the Asian-end, or average-end, design, this interest crediting method
calculates the ending index value as the average of a series of index values—typically
daily, weekly or monthly values occurring during the last year of the index term. To
illustrate, the ending index value might be defined as the average of the index values on
the last business day of each month for the 12 months prior to the end of the term.
Alternatively, the ending index value might be computed as the average of the index
values over the last few days, few weeks, or the last three months in the last year of the
index term. Of course, other averaging possibilities exist.
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The index gain is computed as the difference between the “average” ending index value
and the index value at the time the IA was issued. Clearly, the Asian-end variation is
designed to mitigate the negative effects on the contract’s financial performance that
otherwise would result from a significant decline or a series of declines in the tied index
during the last few days, weeks or months of the index term. One might expect that an
EIA purchaser who is risk averse would prefer an Asian-end averaging method or even
an entirely different structure, e.g., Annual Reset, to the traditional Point-to-Point method
for crediting index-linked interest. The Point-to-Point design (with or without averaging)
may be preferred, however, since it is “less costly” to the insurer due to lower option
prices and, as a result, typically provides for greater index participation in comparison
with Annual Reset methods.
In addition to the traditional and Asian-end designs, a third Point-to-Point (i.e., term-end
point) approach to measuring gain in the external index is the Term Yield Spread
indexing method. This type of structure:




Computes the total index gain for the entire term;
Converts the total gain into an annualized compounded rate of return;
Subtracts a yield spread from the annual rate of return; and then
Recalculates the total index gain for the entire term by compounding the “net”
annualized rate.
To illustrate, assume that the tied external index increased from a beginning index value
of 1000 to an index value of 1800 at the end of a six-year term. This 80 percent total gain
is equal to an annualized compounded rate of return of 10.3 percent (rounded to the
nearest tenth of one percent). Assuming an annual yield spread of 1.8 percent, the net
annualized rate equals 8.5 percent. The total index gain credited to the policy’s
accumulation value is equal to 8.5 percent compounded over six years, or 63.1 percent
(rounded).
Under Point-to-Point designs, significant increases in index values during the early or
middle years of the contract term will not automatically result in large index-linked
interest credits. At the point where it really matters, when index gains are measured and
index-linked interest is credited to the IA’s accumulation value, many or all of these early
gains could vanish prior to the end of the index term. Consequently, purchasers of Pointto-Point IA’s are unable to measure or otherwise ascertain the periodic growth in their
accumulation values. This can be a significant drawback since the typical Point-to-Point
IA has an index term of five, seven, 10 years or longer. The absence of periodic indexlinked interest credits increases the uncertainty as to the values—both current and
future—that should be placed on this asset as part of an overall financial plan. This can
pose serious planning issues if the IA comprises a significant portion of the individual’s
total financial portfolio.
Another potentially significant disadvantage of the Point-to-Point approach concerns the
period—frequently the entire index term—during which surrender charges are imposed.
Since any index-linked interest earnings under the Point-to-Point method are credited to
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the contract’s accumulation value only at the end of the index term, the purchaser is
generally not entitled to any index-linked interest credits whatsoever if the IA is cashedin prior to the end of the surrender-charge period. Most likely, in this instance, the
contract owner will be entitled to a return of premiums paid plus any guaranteed interest
less the surrender penalties, subject to the guaranteed minimum value “floor.” It is
possible that surrender charges will exceed any guaranteed interest credits, thereby
creating a financial loss to the IA purchaser.
Interest Crediting Method Comparison
The three index annuity crediting methods discussed above seem similar, however, the
index-linked interest that is paid on an annuity will heavily depend on which method is
used for the particular policy. Therefore, it is important that investors weigh the pros and
cons of each method and choose the one best suited to current market trends.
Table 5.2 shows the various tradeoffs to get features a client may want in an IA. This
means that the IA he/she may choose may also have some features they don’t want.
Table 5.2
Advantages and Disadvantages of Different Indexing Methods
Interest Crediting
Method
Annual Reset
High-Water Mark
Advantages
Disadvantages
Since the interest earned is "locked
in" annually and the index value is
"reset" at the end of each year, future
decreases in the index will not affect
the interest you have already earned.
Therefore, your annuity using the
annual reset method may credit more
interest than annuities using other
methods when the index fluctuates
up and down often during the term.
This design is more likely than
others to give you access to indexlinked interest before the term ends.
Since interest is calculated using the
highest value of the index on a
contract anniversary during the term,
this design may credit higher interest
than some other designs if the index
reaches a high point early or in the
middle of the term, then drops off at
the end of the term.
The IA’s participation rate may
change each year and generally
will be lower than that of other
indexing methods. Also, an
annual reset design may use a
cap or averaging to limit the total
amount of interest that can be
earned each year by the contract.
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Interest is not credited until the
end of the term. In some IA’s, if
the contract is surrendered before
the end of the term, the contract
may not get index-linked interest
for that term. In other IA’s, the
contract may receive indexlinked interest, based on the
highest anniversary value to date
and the IA’s vesting schedule.
Also, contracts with this design
may have a lower participation
rate than IA’s using other
designs or may use a cap to limit
the total amount of interest the
Point-to-Point
Since interest cannot be calculated
before the end of the term, use of this
design may permit a higher
participation rate than annuities
using other designs.
contract may earn.
Since interest is not credited until
the end of the term, typically six
or seven years, you may not be
able to get the index-linked
interest until the end of the term.
Averaging
An IA may use an average of an index’s value rather than the actual value of the index on
a specified date (as discussed with the three various interest crediting methods above).
The index average may be taken at the beginning, the end or throughout the entire term of
the contract.
Today, the majority of IA contracts sold today are structured with annual reset designs
(discussed below) that average index values to determine the index movement.
Averaging at the beginning of a term protects the client from buying their annuity at a
high point, which would reduce the amount of interest earned. Averaging at the end of
the term protects against severe declines in the index and losing index-linked interest as a
result. On the other hand, averaging may reduce the amount of indexed-linked interest
earned when the index rises either near the start or at the end of the term.
It is important that you and your client understand that a 100% index participation rate,
when applied to a contract using averaging, will never credit precisely the same return
reported for that index in the financial section of the newspaper. Occasionally it may be
higher, but usually it will be lower.
Other Interest Crediting Methods
The annual reset method and the point to point method discussed above represent the
bulk of the IA sales. Most of the IA’s sold use some degree of averaging, a significant
number of IA’s apply ceilings or caps on maximum interest credited, and whether a
participation or yield spread is used often depends on the marketing climate. Design
structures are often combined. Several annual reset structures use averaging of index
values, have a cap, and either use a participation rate or a yield spread. There are several
other crediting methods used.
Multiple (Blended) Indices
The multiple indices method, as it name implies adds up returns from different indices
and applies a participation rate to the overall index gain or loss. The IA performance
over multiple years uses a percentage of the gains or losses of the different indices.
Note: This is not a rainbow method (described below) because the allocation of the
indices is fixed and does not change based on index performance.
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Monthly Cap (Monthly Point-to-Point)
The monthly cap calculates gains losses of the index on a monthly basis, adds up the
monthly figures, and the final number is the interest credited for the period; the period’s
interest can never be less than zero. The maximum monthly gain recognized is subject to
a cap., but monthly losses are not subject to a cap. This method is also called monthly
point-to-point, the difference between this method and an annual point-to-point is that the
values are not locked each month.
Assuming a 2% cap, a “best case” scenario would be where the index increases 2% each
month for 12 months, producing a 24% interest for the year. On the flip side, a “worst
case” scenario would be if the index were to increase, say, 35% over eleven months, but
then decline 25% in the twelfth month. The maximum possible gain for the eleven
months would be 22% (2 x 11), which would be offset by the 25% decline in the 12th
month resulting in zero gain, even though the index would have increased by 14% for the
year.
Binary, Non-Negative (Trigger) Annual Reset
This design method will pay a stated interest rate if the index does not go down. The
insurer will declare that the “trigger” rate for the coming year is 5. If the index does not
end lower a year from now the trigger method will credit 5% interest. Whether the index
goes up 1% or 90% the trigger method will credit 5%. Even if the index ends up exactly
where it started, posting neither gain nor loss for the previous twelve months, the trigger
method will credit 5%.
Bond-Linked Interest with Base
Don’t get confused, although there are a few IA’s offering a bond index, or a bond index
in addition to equity choices, that is not what we are describing. This crediting method
links interest crediting to U.S. Treasury Notes. If the T-note rate is higher at contract
anniversary, the IA renewal rate is credited with a like increase. If the T-note rate is
lower in subsequent years, the IA rate goes down the same amount, but the IA rate can
never be less than the initial rate.
Hurdle
With this method, the IA is credited with the gain above the floor (the hurdle), but
nothing below. For example, say the current participation rate is 50% above a floor of
5%. If the index increased 10% next year the IA would credit 2.5% (10% - 5% = 5% x
50%). But, if the index increased 45% the IA would credit 20% (45% - 5% = 40% x
50%).
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Annual Fixed Rate with Equity Component
There a couple of IA’s that credit a fixed rate to a portion of the premium with the
remainder participates in the index. A yield spread or asset fee is then deducted from the
total. Net gains are credited as interest and net losses are treated as zero interest earned.
Another method, known as the balanced allocation method, uses a fixed rate component
(the range of rates depends on the interest rate environment) and also a term end point
part that participates in positive index movements over a four, five or six year period.
The higher the fixed interest rate selected, the lower the participation rate applied to the
index. At the end of the period, gains from the fixed rate and index-linked components
are combined and credited. An annualized asset fee (yield spread) may be deducted from
the combined return.
The “equity kicker” or “balanced” structure might look at a six year time period and offer
a couple of options. For example, one option may be to allocate 50% into a fixed account
paying, let’s say 3% and the remaining 50% would provide a 100% participation rate on
any gains in the index from start to end of the six year period. Another option might
allocate 20% into a fixed account paying 3% and the remaining 80% would provide a
100% participation rate on any gains in the index from start to end of the six year period;
however, a 2% yield spread would be deducted from the combined annualized gain
before net interest was credited.
Example: Let’s suppose that the index has increased from 100 to 150 (50%) in
six years, and that the 4% fixed rate gain, compounded over six years is 26.5%.
What is the return under these two balanced method options?
Since the yield spread was not deducted from the 50/50 allocation the total gain
remains 38.3% for the six year period and that translates into an annualized return
of 5.5%, while the 80/20 allocation produced a total gain of 29.7% (after
application of the yield spread) for an annualized return of 4.4%.
In this example the better choice would have been putting half of the premium
into the fixed rate. When would the 80/20 allocation have won? If the index had
gone up more than 87% the total net yield, even after the 2% yield spread, would
have been higher than the yield on the 80/20 allocation.
Rainbow Method
The latest trend in the IA market is a new type of crediting method, commonly referred to
as a “rainbow method”. It is an option basket whose best-performing indices are
weighted more heavily than those that perform less well. It is always a “look back”
because the money is allocated based on the rankings of the performance after the period
is over. Not all allocation methods are rainbows. Theoretically, the rainbow method can
be used on any of the methods we have discussed. However, it is used mainly with the
monthly averaging and annual point-to-point strategies. Note: A couple of insurers IA
products credit interest based on the blended performance of multiple indices, but the
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specific index allocation is fixed at the beginning of each year so they are not rainbow
methods.
Here’s how it works: The IA contract offers a choice of 2 or more indices on a single
crediting method during a term. This is different from traditional IA products which
typically offer only one index per crediting method during the term. (Note: In the
rainbow products, the contract currently credits their interest in anywhere from 1-3
years.)
The so-called rainbow products now on the market tend to credit interest by using one of
the following two approaches.

In the first approach, the contract applies a stated percentage weighting to each
index; these percentages stay the same over the stated term of the crediting
method. Potential indexed gains will be credited based on those weightings at the
end of the crediting period, in view of each index’s performance.
Example: An insurer offers indices A, B, and C on a monthly averaging
crediting method in an index annuity with a 3-year period. Index A will
receive a weighting of 40% over the 3-year period; Index B will receive a
weighting of 35%; and Index C will receive a weighting of 25%. The
carrier then deducts a spread from any potential indexed gains at the end
of the term, and then applies the remainder to policy’s account value.

The second approach, after the end of the crediting period, the insurer does a
look-back on the performance of the indices. Then, it ranks the best performing
indices for that term. From that ranking, the carrier applies a stated percentage per
index, and then credits any potential index interest accordingly. (These
calculations can vary; some will use participation rates, while others may use caps
or spreads.)
Example: An insurer offers indices A, B, and C on an annual point-topoint crediting method on an index annuity with a 1-year term. The best
performing index over the one-year period gets 75% weighting in the
crediting calculation; the next-best performing index gets 25% weighting;
and the least-best performing index gets zero credit. The carrier then
applies a participation rate to any potential indexed gains to determine the
amount to credit to the policy.
Many agents are drawn to the appeal of a “we’ll give you the best performing index”
approach. Besides the S& P 500, the Nasdaq and the Dow Jones, many carriers allow a
number of international indices such as, The DJ Euro Stoxx 50, the FTSE 100, Heng
Seng and the Nikkei 225. Most recently one insurer has added a commodity index using
the S&P GSCI Index from Standard & Poor’s, New York.
92
Naysayers who have argued about lack of diversification in the IA product line may now
have difficulty finding an argument not to recommend these fixed products.
Index Annuity Waivers and Riders
Index annuity contracts offer a number of waivers and riders for policy owners to enjoy
and use at their discretion. Before we discuss the various waivers and riders, let’s
differentiate between a waiver and a rider.
A waiver allows the policy owner to withdraw funds from the IA without incurring a
surrender charge. There are no additional charges for a waiver. On the other hand, a
rider is an extra feature that can be added to an IA and there are additional costs.
Types of Riders
Most IA contracts offer the following riders:



Death Benefit Rider: Most IA’s may provide a rider that acts like a life insurance
benefit. (Note: Annuity death benefits to heirs have a different tax status than life
insurance benefits which pass to beneficiaries’ tax free.) If the policy owner dies
before he/she collects the full value of the annuity, the rider pays to their heirs the
amount invested plus interest or the market value of the funds minus whatever the
policy owner has collected in payouts.
Long-Term Care Rider: A Long-Term Care rider provides long term care
insurance in addition to a steady stream of income. The 2006 Pension Protection
act now allows for withdrawals from an annuity or life insurance policy with a
long term care rider to be tax free to the individual for qualified long term care
expenses (discussed further in Chapter 5). Note: This only applies to nonqualified
contracts.
Guaranteed Lifetime Withdrawal Benefit Riders (GLWB): GLWBs have grown in
prominence, but they have also become more complex. More than 40 companies
now offer the GLWB rider with their IA’s. According to LIMRA, a GLWB was
available on 87 percent of IA’s sold in 2014 and 72 percent of policyholders
purchased this rider. It is important to remember every GLWB is different. Some
offer rollups with simple interest, when most pay compound interest on their
rollups (and no, double-digit simple interest is not always greater than single-digit
compound interest). Some GLWB riders do not have an explicit cost where
others charge as much as 0.95 percent annually. Some have a charge that is
calculated on the benefit base value of the GLWB, where a few have charges that
are calculated on the lower account value of the contract (remember, charges
based on the benefit base always cost more because the Benefit Base is always
higher). Some have bonuses on the benefit base value, where most do not. Some
have greater withdrawal percentages than others. A few IA contracts provided
inflation adjusted withdrawals (or withdrawals that will increase by a stated
percentage each year).
93
IA’s with Bonuses
For IA’s, the most common type of bonuses are:


Income account bonuses; or
Premium bonuses
Income account bonuses are added to the amount from which future guaranteed lifetime
withdrawals will be made. These bonuses were less frequently offered in 2013 than in
prior years. Premium bonuses (usually a percentage of the initial purchase amount) are
added to the annuity’s accumulation (cash) value. Along with the GMWB rider,
premium bonuses have become a main feature used to promote IA’s. Some companies
offered these bonuses with a vesting schedule, entitling owners to an increasing
percentage of the bonus over time. Fixed rate annuities sometimes offer premium
bonuses as well. But interest rate bonuses are more frequent. These bonuses make the
initial credited rate more attractive. In 2014, they were most often offered on contracts
with credited rates that can change annually during the surrender charge period.
Two other bonus types were less frequently offered in 2014. They were:


Persistency bonuses reward owners for keeping their annuity for a specified
period.
Annuitization bonuses reward owners who convert their deferred annuity
contract into an income annuity.
But remember the saying, “there is no free lunch.” Typically when an insurance
company offers bonuses, the surrender charges in the annuity are greater and for a longer
period of time. Your job, as the financial professional, is to understand those charges, as
well as to disclose and explain them to your clients prior to them purchasing a fixed index
annuity.
Regulation of IA’s
As was discussed earlier, over the years, IA’s have been subjected to increasing
regulatory scrutiny. Back in August, 2005, the then National Association of Security
Dealers (NASD), now known as the Financial Industry Regulatory Authority (FINRA)
issued Notice to Members 05-50, which detailed the responsibility of member firms for
supervising sales of unregistered index annuities, in which the Notice referred to as
Equity Index Annuities (EIA’s). The Notice began with a section titled “Investor
Protection Issues Presented By Equity-Indexed Annuities”, and noted, in the opening
sentence, the following, “EIA’s are complex investments”. After detailing some of the
complexities of these products, the Notice declared that, “NASD is concerned about the
manner in which associates [persons or individuals engaged in the sales of securities,
including “Registered Representatives”, in NASD member firms] are marketing and
94
selling unregistered EIA’s, and the absence of adequate supervision of these sales
practices”. In other words, the NASD was sufficiently concerned that registered
representatives of NASD member firms, over which it had regulatory authority, might
have been marketing these unregistered products (over which it did not have authority) in
ways that “could confuse or mislead investors”. “Moreover”, it continued, “because of
the products complexity, some associated persons might have difficulty understanding all
the features of the product and determining the extent to which those features meet the
need of the customer”.
In Section 3 of the Notice entitled “Supervision under Rule 3030 and Rule 3040, the
Notice outlined the supervisory methods that it deemed necessary for NASD member
firms to implement with regard to equity index annuities. It began by acknowledging that
many B-Ds treat the sale of unregistered EIA’s as “outside business activities”, beyond
the reach of their supervision. It declared that:
“A broker-dealer runs certain risks in applying Rule 3030 to the sale of an
unregistered EIA on the assumption that the product is not a security. As a result,
if a particular EIA did not qualify for the exemption, a firm might incorrectly treat
the EIA transaction as an outside business activity under Rule 3030 rather than a
private securities transaction under Rule 3040 and thereby fail to supervise sales
of the product as required by NASD rules”.
This was the justification used by the NASD in 05-50 to why B-Ds should require their
registered representatives to submit all index annuity business through them.
However, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010,
with the work of Iowa Senator Harkin, changed all that and removed the uncertainty of
IA’s by preserving them as fixed insurance products and not as a security. In order to
meet this requirement under the Act, the IA must satisfy the standard non-forfeiture laws
and be issued by an insurer that is either from a state that has adopted the NAIC Annuity
Suitability rules or the company itself has implemented practices contained in the annuity
suitability rules.
FINRA Investor Alerts
FINRA has put out an Investor Alert Title: Equity Index Annuities—A Complex Choice.
You can view the alert at:
http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/AnnuitiesAndInsurance/p0
10614
95
Chapter 5
Review Questions
1. In what year was the “Key Index” Annuity sold?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
1974
1995
2001
1984
2. What is the term for the index-link interest rate credited to an IA’s accumulation
value?
(
(
(
(
) A. Participation Rate
) B. Spread
) C. Cap Rate
) D. Margin
3. The spread or margin is also referred to as:
(
(
(
(
) A. Participation Rate
) B. Spread
) C. Administrative Fee
) D. Index Period
4. What is the interest crediting method that compares two discrete points in time,
such as the beginning and ending dates of the IA contract term?
(
(
(
(
) A. Annual reset (Ratchet)
) B. High water
) C. Point-to-point
) D. Interest averaging
5. What is the interest-crediting method in an IA contract that is also known as the lookback period?
(
(
(
(
) A. Point-to-point method
) B. Annual reset method
) C. Ratchet method
) D. High water mark method
96
CHAPTER 6
ANNUITY TAX LAWS
Overview
Federal tax law has traditionally encouraged the use of annuities by affording them
favorable tax treatment, including deferral of any income from the accumulation phase to
the distribution (payout) phase.
In this chapter, we will examine the basic tax laws under IRC § 72 which affect mostly
nonqualified annuities. It will also review the benefit of purchasing an annuity inside a
qualified retirement plan and/or IRA, as well as the required minimum distribution rules,
and the tax rules pertaining to Qualified Longevity Annuity Contracts (QLACs).
Learning Objectives
Upon completion of this chapter, you will be able to:







Associate the appropriate federal tax treatment of annuities;
Demonstrate the benefits of tax deferral;
Demonstrate and understanding of the IRC Section 72(s) rules
Differentiate the various tax rules pertaining to IRC Section 1035;
Apply the tax rules of IRC Section 691(c) Income in Respect of a Decedent;
Identify the advantages of placing an annuity in a qualified retirement plan or an
IRA; and
Distinguish the benefits of a Qualified Longevity Annuity Contact (QLAC).
Background
Over the past fifteen or twenty years, there has been a dramatic change in the traditional
picture. With the advent of the variable annuity, policyholders came to enjoy the same
broad array of investment choices as mutual fund investors. This made the annuity very
attractive to anyone who wanted these types of investments but did not want to pay tax
currently on the interest, dividends and capital gains that they generate. Thus annuities
became popular as a tax-favored investment and were marketed and sold to investors who
had little or no interest in ever using them for retirement income.
However, as annuity sales skyrocketed, Congress realized that the tax benefits intended to
encourage retirement savings were also threatening to create a new tax-sheltered
97
investment industry. Beginning with the Tax Equity and Fiscal Responsibility Act of 1982
(“TEFRA”) and continuing in a series of laws throughout the 1980s, Congress has
narrowed the favorable tax treatment of annuities to re-emphasize its original purpose of
encouraging retirement savings (one obvious example: the 10% “penalty” tax on income
withdrawn before age 59½). Keeping this theme in mind is useful as the insurance
producer/financial advisor attempt to understand the technical and seemingly disjointed
special rules of annuity taxation discussed in this chapter. Let’s first begin by defining
an annuity for tax purposes.
Annuity Defined for Tax Purposes
As was discussed in Chapter 1, an annuity contract is an insurance policy that promises
the periodic payment of a sum of money for a term of years (a term certain annuity), for
the life of an individual or the joint lives of several individuals (a life annuity), or both.
How an annuity is viewed, however, depends upon the context in which it is considered.
For instance, annuities have been described differently for federal securities law, banking,
law, and tax law purposes. However, for federal tax purposes, we will focus on IRC § 72,
which is the principal Code provisions governing the taxation of annuity contracts.
Premiums
Premiums paid into an annuity for federal tax purposes can be classified as either:


Qualified; or
Nonqualified
Qualified Premiums
A qualified annuity is purchased as part of, or in conjunction with, an employer provided
retirement plan or an individual retirement arrangement (such as an Individual
Retirement Annuity or as part of a 401(a) qualified plan. If certain requirements are
satisfied, contributions made to qualified annuities may be wholly or partially deductible
from the taxable income of the individual or employer making contributions. Premiums
(contributions) to a qualified plan are limited by IRS code and follow different tax rules
as compared to nonqualified premiums.
Nonqualified Premiums
A nonqualified annuity is not part of an employer provided retirement program and may
be purchased by any individual or entity. Contributions to nonqualified annuities are
made with after-tax dollars and are not deductible from gross income for income tax
purposes. Premium contributions to a non-qualified annuity are only limited by the
insurance company.
98
Note: Most of the discussion about annuity taxation in this chapter will involve
nonqualified annuity contracts.
IRC § 72: Tax-Deferral
Dividends, interest, and capital gains credited to an annuity are not taxed until they are
withdrawn. This is true as long as the annuity meets certain requirements of IRC § 72
and the owner of the annuity is a natural person. In other words, earnings are taxdeferred and reinvested to help accumulate assets for retirement. Because of this feature,
money may be transferred from one investment option to another inside a variable
annuity without incurring a tax liability. This is not true for taxable investments, where
moving funds from one investment vehicle to another, such as from one portfolio of a
mutual fund to another portfolio of that fund will be treated as a sale and any gains will
be taxed.
The Power of Tax-Deferred Compounding
The secret to growing one’s investments is its compounding rate. The higher it is, the
faster the investment grows. But that’s only half the story. Increasing the compounding
rate from 6% to 8% will produce more than that 33% increase in the investment over the
years (see Table 6.1). That’s the magic! And that’s why tax-deferred investments are
such an advantage. Let’s take a look at some results…
Table 6.1
Percent Greater Accumulation for
8% over 6% Compound Rates of $10,000
Year
6%
8%
% more
5
10
15
20
25
30
13,382
17,908
23,966
32,071
42,919
67,435
14,693
21,589
31,722
46,610
68,485
100,627
10%
21%
32%
45%
60%
75%
Taxable accounts are those that generate interest or dividend earnings that are subject to
annual taxation. If one’s investment return is 10% and their income tax bracket is 28%,
then 28% of that 10% (i.e. 2.8%) of that investment return is lost to taxation. This leaves
only 7.2% (rather than the full 10%) as the compounding rate of that investment. Since
tax-deferred accounts suspend yearly taxation of such earnings, which would leave the
10% investment return as the compounding rate. Recognizing taxation’s effect on
compound rates, we’re interested now in how much higher an earnings rate must a
taxable account have to match the growth of a lower earnings tax-deferred account. And
this depends also on the tax bracket of the investor.
99
Table 6.2 shows what taxable earnings rate (i.e. subject to yearly taxation) a taxpayer
must receive to achieve a compounding rate equal to the tax-deferred earnings rate based
on the tax bracket those taxable earnings are taxed at.
Table 6.2
Taxable Earnings Needed to
Compound Equally to Tax-Deferred Earning
10%
Tax-Deferred
Earnings
8%
7%
6%
5%
4%
8.89%
7.78%
6.67%
5.56%
4.44%
Federal Income Tax
15%
25%
28%
33%
35%
Equivalent Taxable Earnings at Each Tax Bracket
9.41%
8.24%
7.06%
5.58%
4.71%
10.67%
9.33%
8.00%
6.67%
5.33%
11.11%
9.72%
8.33%
6.94%
5.56%
11.94%
10.41%
8.96%
7.46%
5.97%
12.31%
10.77%
9.23%
7.69%
6.15%
IRC § 72(a) General Rules for Annuities
IRC § 72(a)(1) provides that gross income includes any amount received as an annuity
(whether for a period certain or during one or more lives) under an annuity, endowment,
or life insurance contract.
IRC § 72(b): Exclusion Ratio Rule
Annuities have historically been purchased to provide a stream of income over a period
of years. Annuitization allows the owner of the contract to receive income over his or her
life expectancy. In order to determine how the payments will be taxed, an exclusion ratio
(which may be expressed as a fraction or as a percentage) must be established. This
exclusion ratio is applied to each annuity payment to find the portion of the payment that
is excludable from gross income for the year received. [IRC § 72(b)(1).]
For annuities with a starting date after December 31, 1986, the exclusion ratio applies to
payments received until the payment in which the investment in the contract is fully
recovered. In that payment, the amount excludable is limited to the balance of the unrecovered investment. Payments received thereafter are fully includable in income [IRC
§ 72(b)(2)]. For annuity starting dates before January 1, 1987, the exclusion ratio applies
to all payments received throughout the entire payment period, even if the annuitant has
received his or her investment. For those contracts, it would be possible for a long-lived
annuitant to receive tax-free amounts, which in the aggregate exceed his or her
investment in the contract.

Fixed Annuity Exclusion Ratio: With a fixed annuity, the exclusion ratio is
established by (1) dividing the premiums paid for the contract (investment in the
100
contract IRC § 72(c)) by the expected return, as determined by IRS tables IRC §
72(c)(3), and (2) multiplying the payment by such ratio.
Example: Assuming that the investment in the contract is $12,650 and
expected return is $16,000, the exclusion ratio is $12,650/$16,000, or
79.1%. If the monthly payment is $100, the portion to be excluded from
gross income is $79.10 (79.1% of $100), and the balance of the payment is
included in the gross income. If 12 such monthly payments are received
during the taxable year, the total amount to be excluded for the year is
$949.20 (12 x $79.10), and the amount to be included is $250.80 ($1,200 $949.20).

Variable Annuity Exclusion Ratio: With a variable annuity, since the expected
return cannot be predicted, the exclusion ratio is computed by dividing the
premiums paid for the contract by the number of years payments are expected to
be made. If payments are to be made for a fixed number of years without regard
to life expectancy, the divisor is the fixed number of years. If, payments are to be
made for a single life, the divisor is the appropriate life expectancy multiple
(Treas. Reg. § 1.72-2(b)(3)) whichever is applicable (depending on when the
investment in the contract was made) of the IRS Tables.
Example: Assume that Mr. Jones, a 65-year-old male elects a life annuity
and his investment in the contract was $100,000. Assume further that he
has elected to receive annual variable annuity payments and the payment
for the first year is $8,000 (since payments are variable, they will vary
each year thereafter). Applicable IRS Tables indicate that such a person is
expected to live 21 years. One hundred thousand dollars divided by 21 is
$4,762, which is the portion of each annuity payment that is excluded
from tax. During the first year, $4,762 of the $8,000 will be excluded
from income and $3,228 will be included. The $4,762 is excluded each
year until the total investment in the contract has been received. Note:
Once the total investment in the contract has been received any remaining
payments will be 100% taxable.
IRC § 72(c)(4): Annuity Starting Date
The exclusion ratio for taxing annuity payments under a particular contract is determined
as of the annuity starting date. This is the “first day of the first period for which an
amount is received as an annuity. For example, suppose that a person purchases an
immediate annuity on August 1st providing monthly payments beginning September 1st
(the first payment is for the one-month period beginning August 1st). Hence, the annuity
starting date is 8/1.
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IRC § 72(e): Lifetime Distributions
Partial surrenders and withdrawals (distributions not part of a series of payments under an
annuity payout option) are considered “amounts not received as an annuity” [IRC § 72
(e)]. The taxation on such distributions depends on when the contract was issued.
If the deferred annuity was issued before August 14, 1982, it gets “FIFO” tax treatment—
first in, first out—and the withdrawals are not taxable until the contract holder has
withdrawn the entire investment in the contract. If the contract was issued after August
13, 1982, it gets “LIFO” tax treatment—last in, first out—and all distributions are taxed
as ordinary income to the extent that there is still undistributed gain.
Two clarifications:


A deferred annuity issued before August 14, 1982 gets “FIFO” treatment only
with respect to distributions allocable to contributions made before that date.
A pre-August 14, 1982 contract that was exchanged under IRC § 1035 for another
annuity issued after August 14, 1982 will generally be grandfathered and only
“FIFO” taxation of withdrawals
Let’s review an example of a withdrawal from an annuity contract after August 13, 1982:
Bob, who is age 50 and in a 35% federal income tax bracket, purchases a variable
annuity contract. The initial deposit is $100,000, all allocated to a growth fund
sub-account. Three years later the contract has an accumulated value of $114,000
and a surrender value of $108,000. Bob withdraws $10,000 as a down payment
for a vacation home. Since the cash value ($114,000) exceeds the investment
($100,000) by $14,000, the entire $10,000 is taxed as ordinary income, costing
Bob $3,500 of tax ($10,000 x 35%).
Note: All income from an annuity contract is ordinary income and none capital gain, even
if the increase in the annuity’s value is entirely due to capital gains in the underlying
investment sub-account. Also the policy’s surrender charge of $6,000 is disregarded for
purposes of determining the amount that is taxable on a partial withdrawal.
IRC § 72(e)(4)(A): Loans and Assignments
Most nonqualified annuity contracts do not offer the option of taking a loan against the
annuity values. This is probably due largely to the fact that any amount received as a
loan under a contract entered into after August 13, 1982 is taxable to the extent that the
cash value of the contract immediately before the loan exceeds the investment in the
contract.
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IRC § 72(e)(4)(c): Gift of the Annuity Contract
If the contract owner (the “Donor”) makes a gift of an annuity contract issued after April
22, 1987 under which the cash surrender value is greater than his or her investment in the
contract, then the Donor must include the difference as ordinary income in the year of the
gift. This rule does not apply if the transfer is made between spouses or former spouses
as part of a divorce settlement. Gift taxes may also apply.
Any amount that a donor includes in income under this rule (basis adjustment) is added to
the “investment in the contract” for purposes of figuring the income tax consequences of
future distributions.
If the cash surrender value of an annuity contract issued prior to April 23, 1987 at the
time of the gift, exceeds the donor’s cost basis, and the donee subsequently surrenders the
contract, the donor must report as taxable income the “gain” existing at the time of the
gift. In other words, the donor is taxed on the difference between the premiums he or she
paid and the cash surrender value of the contract at the time of the gift. The balance of
the gain, if any, is taxed to the donee.
IRC § 72(e)(5)(E) Gain in the Contract
Generally, an annuity contract provides that if the annuitant dies before the annuity
starting date (annuitization), the beneficiary will be paid as a death benefit the amount of
premium paid or the accumulation value of the contract. The gain, if any, is taxable as
ordinary income. The death benefit under an annuity contract does not qualify for tax
exemption under IRC § 101(a) as life insurance proceeds payable by reason of insured’s
death. Gain is measured by subtracting:


Total gross premiums from
The death benefit plus aggregate dividends and any other amounts that have been
received under the contract, which was excluded from gross income.
IRC §72(e)(11)(A)(ii) Aggregation Rules
All contracts issued by the same company to the same policyholder during any calendar
year will be treated as one contract for purposes of computing taxable distributions.
Example: Client A purchases five non-qualified deferred annuity policies in
2011 from ABC Life Insurance Company. For planning purposes, the client
names a different beneficiary on each policy, thinking (wrongly) that this will
avoid the aggregation rule. To make things simple, let’s assume the investment in
each is $50,000. Further, let’s assume that two years later each policy has grown
in value to be worth $60,000. Sometime after, Client A requests a distribution of
$40,000 from one of the contracts purchased two years prior. The investment (tax
cost basis) in each is $50,000, interest earnings in each policy at the time of
withdrawal is $10,000, for a total gain of $50,000 in the five policies. Because
103
the five polices are owned by the same owner and were purchased within the
same calendar year from the same company, the values are aggregated to
determine the amount of gain considered distributed when a withdrawal is
requested. Since the withdrawal of $40,000 is less than the total gain in the five
policies, the entire withdrawal is considered taxable. While the full amount was
removed from a single contract, under the aggregation rules, the gain is
determined on a global (aggregated) basis. Individual policy basis and gain
tracking is effectively ignored.
Exceptions to the Aggregation Rules:




Annuitized contracts
Immediate annuities
Distributions required on death of owner
Contracts issued prior to 10/21/88
Note: If a pre-10/21/88 contract is subsequently exchanged or transferred, the new
contract becomes subject to aggregation.
IRC § 72(t)(1): Additional 10% Penalty Tax on Early Distribution
IRC § 72(t)(1) imposes an additional tax on premature distributions from “qualified”
annuity contracts (e.g., an IRC § 403(b) annuity contract or an IRC § 408 individual
retirement annuity) that is similar to the penalty tax imposed by § 72(q). IRC §
72(t)(2)(A)(iv) also provides that the additional tax does not apply to a series of
substantially equal periodic payments and IRC § 72(t)(4) sets forth a recapture rule
similar to the rule of 72(q)(3).
IRS Notice 89-25 provides guidance regarding the imposition of the additional tax on
distributions from qualified employee plans, § 403(b) annuity contracts, and individual
retirement annuities (IRAs). Notice 89-25 sets forth three methods for determining
whether payments to individuals from their IRAs or from their qualified retirement plans
constitute a series of substantially equal periodic payments for purposes of IRC §
72(t)(2)(A)(iv). The three methods are:

The Required Minimum Distribution Method: Under the required minimum
distribution method, the annual payment for each year is determined by dividing
the account balance for that year by the number from the chosen life expectancy
table for that year. With this method, the account balance, the number from the
chosen life expectancy table (see Rev. Rul. 2002-62 § 2.02(a) (life expectancy
tables)) and the resulting annual payments are re-determined for each year. If this
method is chosen, no modification in the series of substantially equal periodic
payments will be deemed to occur, even if the amount of payments changes from
year to year, provided there is not a change to another method of determining the
payments.
104


The Fixed Amortization Method. Under the fixed amortization method, the annual
payment for each year is determined by amortizing in level amounts the account
balance over a specified number of years determined by using the chosen life
expectancy table and the chosen interest rate (see Rev. Rul. 2002-62 § 2.02(a)
interest rates). With this method, the account balance, the number from the
chosen life expectancy table and the resulting annual payment are determined
once for the first distribution year and the annual payment is the same amount
each succeeding year.
The Fixed Annuitization Method. Under the fixed annuitization method, the
annual payment for each year is determined by dividing the account balance by an
annuity factor that is the present value of an annuity of $1 per year beginning at
the taxpayer’s age and continuing for the life of the taxpayer (or joint lives of the
taxpayer and beneficiary). The annuity factor is derived using the mortality table
in Appendix B to Rev. Rul. 2002-62 and using the chosen interest rate. With this
method, the account balance, the annuity factor, the chosen interest rate and the
resulting annual payment are determined once for the first distribution year and
the annual payment is the same in each succeeding year.
Prior to 2002, Notice 89-25 provided that the additional IRC § 72(t)(1) tax would be
imposed if (i) at any time before attaining age 59½ a taxpayer changed the distribution
method to a method that does not qualify for the exception, or (ii) the taxpayer changed
the distribution method within the five years after the receipt of the first payment. Rev.
Rul. 2002-62 modified notice 89-25 by providing two exceptions to this rule.


First, an individual is not subject to the IRC § 72(t)(1) additional tax if (i) the
payments are not substantially equal because the assets in the IRA (or individuals
account plan) are exhausted, and (ii) the individual followed one of the prescribed
methods of determining whether payments are substantially equal periodic
payments.
Second, an individual who begins receiving distributions in a year using either the
fixed amortization or fixed annuitization method may switch to the minimum
distribution method for the year of the switch, and all subsequent years, and the
change will not be treated as a modification within the meaning of IRC § 72(t)(4).
Any subsequent change, however, will be a modification for purposes within the
meaning of IRC 72 § (t)(4).
IRC § 72(q)(1): Premature Distribution 10% Penalty Tax
IRC § 72(q)(1) imposes a penalty tax on certain premature or early distributions under a
nonqualified annuity contract equal to 10 percent of the amount that is includible in gross
income. The penalty tax is imposed on premature distributions received prior to the
taxpayer’s attaining age 59½ from nonqualified annuity contracts issued after January 18,
1985. The penalty does not apply to any part of a distribution that is tax free, such as
amounts that represent a return of principal (cost basis) or that were rolled over to another
retirement plan. The penalty tax will not be imposed, however, if the distribution
satisfies one of the exceptions set forth in IRC § 72(q)(2). IRC § 72 (q)(2)(D) provides
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that a distribution will not be subject to the penalty tax if it is “part of a series of
substantially equal periodic payments (SOSEPP) made at least annually for the life (or
life expectancy) or the joint lives (or joint life expectancies) of such taxpayer and his
designated beneficiary.” If the payments are subsequently modified, IRC § 72(q)(3)
generally requires a taxpayer to take into account the penalty tax, plus interest, that would
have been imposed if IRC § 72(q)(2)(D) had not applied to the prior distribution.
The penalty tax will also not apply to the following distributions from a nonqualified
annuity contract:




From a deferred annuity contract to the extent allocable to investment in the
contract before August 14, 1982,
From a deferred annuity contract under a qualified personal injury settlement,
From a deferred annuity contract purchased by an employer upon termination
of a qualified employee plan or qualified employee annuity plan and held by
the employer until the employee separates from service, or
From an immediate annuity contract (a single premium contract providing
substantially equal annuity payments that start within one year from the date
of purchase and are paid at least annually).
The IRS and Treasury believe that, when the provisions of IRC § 72 are intended to
address different concerns with respect to the treatment of qualified and nonqualified
annuities, it is appropriate to apply those provisions in a different manner. However, if
the provisions of IRC § 72 are designed to achieve the same purpose whether or not the
annuity is qualified or non-qualified, it is appropriate to apply that provision in the same
manner to both qualified and non-qualified annuities.
IRC § 72(s): Death Distribution Rules at Death of the Holder
Section 72(s)(1), which was added to the Internal Revenue Code effective for contracts
issued after January 18, 1985, states that a contract will not be treated as an annuity
contract under IRC § 72 and subtitle A purposes (meaning it would not be eligible for tax
deferral) unless it provides the following:


If, “any holder of such contract” dies on or after the annuity starting date and
before the entire interest in the contract has been distributed, the remaining
portion must be distributed at least as rapidly as under the method of distributions
being used as of the date of the holder’s death; and
If, “any holder of such contract” dies before the annuity starting date, the entire
interest must be distributed within five years after the death of the holder.
Note: It is especially important to note that IRC § 72(s) focuses on “the holder.” The
“holder” has been interpreted to mean the owner of the contract. As you will see in our
later discussion, in many cases, the owner will also be the “annuitant” under the contract.
This can lead to some tricky planning and technical issues.
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To reiterate, if the holder dies before annuitization has begun, the general rule is that the
contract proceeds must be distributed within five years of the holder’s death. This rule is
to prevent deferral of income on the gains in an annuity contract by passing ownership
from person to another person without taxation occurring. However, there are exceptions
to this rule, under IRC § 72(s)(2) and (3), which provides two important exceptions:
The first exception, under IRC § 72(s)(2), states that if:



Any portion of the holder’s interest is payable to or for the benefit of a
“designated beneficiary,”
That portion will be distributed over the life of such designated beneficiary (or
over a period not extending beyond the life expectancy of such beneficiary);
Distributions of that portion begin no later than one year after the holder’s death,
then, for purposes of the one-year rule under IRC § 72(s)(1), that portion will be
treated as fully distributed on the day the distributions begin.
In other words, the death distribution rules will be satisfied by a payout over the life or
life expectancy of the designated beneficiary as long as the payout begins within one year
of the holder’s death.
The second exception, under IRC § 72(s)(3), states that:
“If, the designated beneficiary is the holder’s surviving spouse, then IRC §
72(s)(1) is to be applied by treating the spouse, as the holder of the contract.”
In other words, since the spouse, as holder, would be alive, there would be no required
distribution as a result of the original holder’s death.
As noted, the required distribution rules apply when the holder dies. If the holder of the
contract is not an individual, IRC § 72(s)(6)(A) provides that the primary annuitant is to
be treated as the holder of the contract, meaning the death of the annuitant will trigger
the required distribution rules. The term “primary annuitant” is defined in IRC § 72
(s)(6)(B) as “the individual, the events in the life of whom are of primary importance in
affecting the timing or amount of the payout under the contract.”
IRC § 72(s)(7) states that when the holder is not an individual, and thus the death benefit
of the primary annuitant would trigger the required distribution rules, any change in the
primary annuitant is treated as the death of the holder.
Finally, there are certain annuity contracts that are not subject to the required distribution
rules of IRC § 72(s). Specifically, IRC § 72(s)(5) makes IRC § 72(s) inapplicable to the
following:


Annuity contracts provided under qualified plans covered by IRC § 401(a) or
qualified annuity plans covered by IRC § 403(a),
Annuity contracts described in IRC § 403(b),
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

Annuity contracts that are individual retirement annuities or provided under
individual retirement accounts or annuities, or
Annuity contracts that are qualified funding assets.
Note: Annuity contracts provided under qualified plans, such as 401(a), 403(b)
IRAs, etc. are subject to the required distribution rules of IRC 401 (a)(9)(6) rather
than IRC § 72(s).
IRC § 72(u): Non-Natural Person Rule
Prior to 1986, the interest earned inside the annuity was tax deferred no matter who or
what entity owned the annuity. However in 1986, Congress passed The Tax Reform Act of
1986, to prevent corporations and other “non-natural persons’ from taking advantage of
the tax deferral of an annuity.
If an annuity contract is owned by a “non-natural person” (an entity),” i.e., a corporation,
and contributions are made to that contract after February 28, 1986 the earnings on those
contributions are not eligible for tax-deferral in most cases. Thus, such an entity is taxed
each year on the change in the net surrender value of the contract, issued after February
28, 1986, minus premiums paid during the year. Congress enacted this requirement (IRC
§ 72(u)) to ensure that the tax deferral granted by annuities is used primarily as a vehicle
for individuals’ retirement savings.
However, under IRC § 72(u)(3), there are some types of annuities to which this rule,
which is often referred to as the “non-natural person rule” does not apply. These include
any annuity contract that is:





Acquired by a person’s estate at the persons’ death;
Held under a qualified retirement plan, a Tax Sheltered Annuity (TSA), or an
Individual Retirement Arrangement (IRA);
Purchased by an employer upon the termination of a qualified retirement plan or
TSA program and held by the employer until all amounts under the contract are
distributed to the employee for whom the contract was purchased or to his or her
beneficiary;
An immediate annuity (an annuity which is purchased with a single premium and
begins payments within a year); and
A qualified funding asset (an annuity contract issued by a licensed insurance
company which is purchased to fund a payment for damages resulting from
personal physical injury or sickness).
Under IRC § 72(u)(1), an annuity contract held by a trust or other entity as agent for a
natural person is considered held by a natural person. In Private Letter Rule (PLR)
9204014 and 9204010, a trust that owned an annuity contract which was to be distributed,
prior to its annuity date, to the trust’s beneficiary, a natural person, was considered to
hold the annuity contract holding “as an agent” not clearly required for a natural person
(see PLRs 199933033 (May 25,1999) & 199905015 (Nov. 5, 1998)). Further, a bank
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holding an annuity contract used to fund a pre-need funeral arrangement as trustee was
considered to hold an annuity contract as an agent for a natural person, where the trust
constituted a grantor trust (PLR 9120024).
IRC § 72(u)(4): Defines an Immediate Annuity
Internal Revenue Code Section 72(u)(4) defines an immediate annuity as an annuity
purchased with a single premium or annuity consideration, with an annuity starting date
no later than one year from the date of purchase and providing for a series of substantially
equal periodic payments to be made no less than once a year during the annuity period.
IRC Section 165: Claiming a Loss
A loss deduction can be claimed only if the loss is incurred in connection with the
taxpayer’s trade or business or in a transaction entered into for profit [IRC §165].
Generally, the purchase of a personal annuity contract is considered a transaction entered
into for profit. Consequently, if a taxpayer sustains a loss upon surrender of a refund
annuity contract, he/she may claim a deduction for the loss regardless of whether he/she
purchased the contract in connection with his/her trade or business or as a personal
investment. The big question is: How does the taxpayer take the deduction and what is
the amount of the deduction?
Example: Sara invested $100,000 in a variable annuity a few years back. The value of
the annuity is now $80,000. Sara is told that if she cashes out the annuity, she'll have to
pay a surrender charge of $5,000, leaving her with a total of $75,000. Given all of this,
Sara decides to pull the plug, and the annuity company sends her a check for $75,000.
Sara lost $25,000 in real dollars -- and that's the amount she can deduct on her tax return.
Remember that a deductible loss is realized only if the annuity is completely cashed out
or otherwise surrendered. Note: If you conduct a 1035 exchange, any gain or loss on the
prior annuity will simply be transferred into the new annuity, and there’ll be neither
income nor deductions to report on the exchange.
There is one silver lining to Sara’s misfortune: She won't have to pay a penalty tax of
10% on any of the $75,000 distributed to her when she cashed out the annuity, even if
she's not yet age 59½. The penalty applies only to gains on income when an annuity is
cashed out. Since Sara actually lost money from her initial investment, she's spared the
tax hit.
You might think that Sara’s $25,000 is a capital loss, to be reported on Schedule D with
other investment losses, but that's not quite the case. The IRS has clearly ruled that losses
like these are ordinary losses, not investment losses. And it gets even trickier when you
look at where on the tax return to report the loss.
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Some say (more conservative approach) that the loss should be treated as a miscellaneous
itemized deduction that is not subject to the 2% floor on miscellaneous itemized
deductions. Others, say it is a miscellaneous itemized deduction subject to the 2% floor.
So if you have high AGI -- let's assume that Sara's is $150,000, with no other
miscellaneous itemized deductions – the actual deduction will be limited to less than the
loss. In this case, Sara's 2% works out to $3,000. Subtracting that from the $25,000 she
lost in the annuity, she can only deduct $22,000.
It can get worse: Large miscellaneous itemized deductions can wreak havoc with the
alternative minimum tax (AMT). So claiming the loss as a miscellaneous itemized
deduction is a tough route no matter what. (And if you don't itemize deductions, you'll be
subject to the 2% hit and the standard deduction.)
A more aggressive approach is the recommendation to take the loss using IRS Form
4797, and then move that IRS Form 4797 number directly to the front of the tax return
under "other gains or losses." This method lets you deduct the full loss without that 2%
bite. Additionally, you'll have no AMT issues, and the loss will help to reduce your AGI,
which might help in many other ways.
Note: In the 2007 edition of IRS Publication 575, page 20 (Pension and Annuity
Income), the IRS says that a loss under a variable annuity is treated as a miscellaneous
itemized deduction subject to the 2% floor.
As the insurance producer/financial advisor, I would highly recommend that you consult
your clients’ tax attorney to let him or her determine how much risk the client is willing
to assume when preparing their tax return. If you'd like to read what little authority there
is on this issue, visit the IRS website and check out Revenue Ruling (Rev. Rul.) 61-201
and 72-193.
IRC Section 7702B(e)(1)
The Pension Protection Act of 2006, signed into law on August 17th, 2006 and effective
2010, allows life insurance and annuity companies to offer long-term care riders on top of
regular policies. It also provides that internal charges against the values in annuities and
permanent life insurance policies used to pay long-term care insurance premiums aren’t
taxed.
Section 844 of the PPA of 2006 was intended to expand accessibility to tax-favored longterm care insurance by providing the ability for life insurance and annuity contracts to
add long-term care insurance riders and use the cash value to cover the cost of long-term
care insurance premiums without incurring taxable distributions, effective after 2009.
The new law broadens the provisions for Code Section 1035 tax-free exchanges to allow
for exchange of life and annuity policies into long-term care insurance contracts
(discussed below).
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IRC § 1035: Tax-Free Exchanges
Tax-free exchanges of annuity contracts play an important role in the annuity business. In
order to appreciate their importance, consider that tax-free exchanges are like refinancing
in the mortgage business. Just as homeowners are often looking for competitive interest
rates, annuity owners are often looking for new product features and competitive returns.
Annuity owners generally can exchange their annuity contract for a new contract, taxfree. There are several reasons why an annuity holder may want to be interested in such
an exchange. They may be:




The solvency of the insurance company that issued the existing contract.
The interest rates currently being offered are higher than current contract.
The new contract may have substantially better features and benefits.
Desire for better guarantees and or investment options.
IRC § 1035 Requirements
However, to assure the tax-free exchange the agent must make sure that the exchange
meets certain IRS requirements. Some of the requirements are:



The insured (or annuitant) on the new contract must be the same as on the old
one.
The owner on the new policy must also be the same as the owner on the old one.
“Basis” (or investment in the contract) is carried over from the old contract to the
new one.
Generally, IRC § 1035 provides that the following exchanges may be made without
current income taxation:





An annuity contract for another annuity contract;
A life insurance policy for an annuity;
An endowment contract for an annuity contract;
A life insurance contract for another life insurance contract;
An endowment contract for an endowment contract, which will begin making
payments no later than payments would have commenced under the old contract.
Note: The Pension Protection Act (PPA) of 2006 expanded the scope of IRC § 1035 to
include tax-free exchanges of qualified long-term care (LTC) contracts. Under Provision
824, it will also cover LTC provided as part of, or a rider to a life or annuity contract.
This will become applicable to exchanges occurring after 12/31/09.
Partial IRC § 1035 Exchanges
As discussed above, Internal Revenue Code (“IRC”) §1035(a)(3) permits taxpayers to
transfer an annuity contract, life insurance or endowment policy from one insurance
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company to another insurance company without recognizing a taxable event. IRC §1035
has always permitted taxpayers to execute tax-free exchanges of entire contracts or
policies; however, the Code and its accompanying regulations had never addressed the
tax treatment of partial IRC § 1035 exchanges. Consequently, insurance and annuity
companies have been processing 1035 exchanges of entire insurance and annuity
contracts for over 17 years but, due to the lack of guidance from the Internal Revenue
Service (“IRS”), they have been reluctant to allow contract owners to enter into an
exchange of anything less than an entire contract.
The first indication that the IRS was considering changing its position regarding partial
IRC § 1035 exchanges came in 1998 when the Tax Court ruled in favor of a taxpayer
who had exchanged a portion of an annuity contract from one company to another
(Conway v. Commissioner, 111 T.C. 350 (1998), acq., 1999-2 C.B. xvi). In Conway, the
petitioner asked the Tax Court to recognize the transfer of a portion of an annuity
contract from one insurance company to another as a tax-free exchange under IRC
§1035(a). The IRS did not challenge the Tax Court’s favorable ruling, but rather issued
an “Action on Decision.” In the “Action on Decision” the IRS indicated that they would
not challenge the facts of the case, however they would continue to challenge similar
transactions by taxpayers who entered into these partial 1035 exchanges for the purpose
of avoiding taxes and penalties under IRC §72.
The IRS’s concern regarding the use of partial 1035 exchanges for the purpose of
avoiding taxes and penalties arises because of potential abuse in the treatment of the cost
basis between the original and the new contract. For example, when a contract owner
enters into a 1035 exchange of an entire contract, the insurance company surrendering the
contract and transferring the cash surrender value is responsible for providing the
receiving company with the cost basis (premiums deposited) and gain (any amount above
the original premium(s)) information on the original contract. The receiving company
relies on the accuracy of that information in order to properly report the taxable portions
of any future distributions on Form 1099R. The transmission of this information is not
difficult when the entire contract is being exchanged. However, when only a portion of a
contract is being exchanged, the question arises as to what is being transferred. Basis or
gain? If the owner were to transfer all the gain to the new contract and leave the entire
cost basis in the original contract, he could take distributions from the original contract
and thus avoid paying any tax on the distributions. The aggregation rule (discussed
above) would not apply. Of course, if the IRS did not allow partial 1035 exchanges, the
contract would distribute gain first, which is taxable at ordinary income rates.
After Conway, the majority of annuity companies still did not permit partial 1035
exchanges, citing the IRS’s warning and its lack of guidance on how to treat the annuity
cost basis. Nonetheless, Conway was seen by some as an opening, after which some
annuity companies did begin to allow contract owners to enter into partial tax-free
exchanges of their annuity contracts. With no guidance, however, there was very little
consistency within the industry regarding how partial 1035 exchanges were processed. As
a result, some companies allowed contract owners to exchange a portion of their annuity
contract on a LIFO (last in first out) basis, while other companies allowed partial
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exchanges on a pro rata basis (the portion exchanged is reduced equally between cost
basis and gain). Inconsistencies in the processing of partial 1035 exchanges were due not
only to the lack of guidance from the IRS but to companies’ systems and technological
constraints.
Revenue Ruling 2003-76
On July 8, 2003, the Department of the Treasury and the IRS issued Revenue Ruling
2003-76. This revenue ruling addressed the issue of partial 1035 exchanges of annuity
contracts and outlined how such transactions would be considered valid tax-free
exchanges. Specifically, the revenue ruling indicated that a taxpayer could transfer a
portion of the cash surrender value within an annuity contract to another annuity contract
at another company without realizing a taxable event on the amount transferred.
Furthermore, the revenue ruling provided guidance with respect to the treatment of cost
basis, stating that the portion of the cash surrender value exchanged should be reduced
ratably between the cost basis and gain of the original contract. This concept is illustrated
below.
CONTRACT A
Contract A’s value before partial 1035 exchange
Cost basis before partial 1035 exchange (50%)
Gain before partial 1035 exchange (50%)
Partial 1035 exchange amount
$100,000
50,000
50,000
$ 60,000
Contract A’s new value after partial 1035 exchange
Cost basis after partial 1035 exchange (50%)
Gain after partial 1035 exchange (50%)
$ 40,000
20,000
20,000
CONTRACT B
Contract B’s value after partial 1035 exchange
Cost basis after partial 1035 exchange (50%)
Gain after partial 1035 exchange (50%)
$ 60,000
30,000
30,000
To supplement the revenue ruling, the Treasury and IRS also issued Notice 2003-51,
which stated that the IRS would consider issuing regulations to deter taxpayers from
entering into partial 1035 exchanges for the purpose of avoiding taxes. For example, the
IRS indicated that it might propose a rule that would require any surrender or distribution
from either the original contract or the newly issued contract that occurs within 24
months of the partial 1035 exchange to be treated as if the two contracts were one for tax
reporting purposes. In addition, the IRS would likely create “safe harbor” exceptions for
certain withdrawals within the 24-month period, such as withdrawals due to disability or
divorce, or substantially equal periodic payments under IRC 72(q).
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In summary, Revenue Ruling 2003-76 and Notice 2003-51 certainly provided the
industry with much needed guidance regarding partial 1035 exchanges. However, more
guidance may still be required, especially if and when regulations are published. For
example, if the 24-month distribution rule is enacted, how will companies track
distributions from contracts held at different companies? Will there be additional tax
reporting requirements? Who will determine if a “safe harbor” exception is met? What
tax reporting requirements will be imposed on companies for “safe harbor” distributions?
Notwithstanding these questions, the issuance of Revenue Ruling 2003-76 and Notice
2003-51 has dramatically changed the way annuity companies can do business. Most
companies will likely be updating their systems and procedures in order to provide partial
1035 exchanges. As in any other business, annuity companies are always looking for
ways to differentiate themselves. For now, those companies that can accommodate
partial 1035 exchanges efficiently and accurately will certainly have a competitive
advantage.
IRS Revenue Procedure 2008-24
The IRS has changed the way it treats annuity withdrawals that follow a partial exchange
of assets from one annuity to another. Under Revenue Procedure 2008-24, the IRS will
reduce the period it considers when deciding whether a taxpayer made a partial exchange
to avoid taxes on withdrawals to 12 months, from 24 months under IRS Revenue
Procedure 2003-51 (discussed above).
In addition to shortening the exchange review period, the IRS also removed the
requirement relating to the taxpayer’s motives for making the partial annuity exchange.
The New IRC Section 1035(a)(4)
IRC Section 1035, providing for tax-free exchanges of insurance and annuity contracts, is
expanded to allow a life insurance, endowment, or annuity contract to be exchanged for a
qualified long-term care insurance policy (QLCI).
The new IRC Section also allows a qualified long-term care insurance policy to be
exchanged for another long-term care policy. In addition, under the new IRC Sections
1035(b)(2) and (3), an exchange to or from a life insurance or annuity contract that has a
long-term care insurance rider to a policy that does not have such a rider will still be
treated as like-kind property for exchange purposes.
Partial Annuitization of NQ Annuity Contracts
Under H.R. 5297, the Small Business Jobs Act of 2010, signed into law by President
Obama, Section 2113 provides for a partial annuitization provision for nonqualified
contracts. The new provision, under IRC § 72(a)(2), which became effective January 1,
2011, will allow a portion of an annuity, endowment or life insurance contract that is not
part of a qualified retirement plan may be annuitized, while the balance is not annuitized,
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provided that the annuitization period is for 10 years or more, or is for the lives of one or
more individuals.
If any amount is received as an annuity for a period of 10 years or more, or for the lives
of one or more individuals, under any portion of an annuity, endowment or life insurance
contract, then that portion of the contract is treated as a separate contract for income tax
purposes. The investment in the contract is allocated on a pro rata basis between each
portion of the contract from which amounts are received as an annuity and the portion of
the contract from which amounts are not received as an annuity.
This should simplify the process for nonqualified deferred annuity owners to annuitize a
portion of their annuity contract while allowing the remaining amount to grow taxdeferred. Currently, as discussed above, annuity owners can partially annuitize their
contracts through a complex process that involves exchanging their annuity contract for
two and then annuitizing one of the new contracts. The partial annuitization provision
will allow the individual (annuitant) to receive annuity payments from a portion of their
contract in one step.
Inherited Annuity 1035 Exchange (PLR 201330016)
In Private Letter Ruling (PLR) 201330016 , the Internal Revenue Service granted the
beneficiary of a series of several fixed and variable non-qualified inherited annuities to
complete a 1035 exchange of those contracts into a new variable annuity to gain access to
more appealing investment returns. In the IRS' viewpoint, the beneficiary-as-inheritor
had sufficient ownership and control of the inherited annuity to allow the exchange, and
permitted the exchange to occur, as long as the technical requirements for the 1035
exchange were honored, and the beneficiary committed to taking post-death distributions
from the new annuity at least as rapidly as were occurring under the old contract.
Historically, annuity companies have not permitted beneficiaries to complete 1035
exchanges of inherited annuities (at least in the case of non-qualified annuities; for
inherited annuities held inside of retirement accounts, post-death transfers were generally
permitted under the existing rules for direct transfers of inherited IRAs). For better or for
worse, the non-qualified annuity contract that was originally owned was the one the
beneficiary was stuck with, as it wasn't clear how the "owner" of an annuity could
exchange to a new contract when the (original) owner was deceased. This inability to
exchange an annuity contract after the death of the original owner was especially
problematic if the beneficiary ended out tied to an annuity company with a weak or
declining credit rating. More commonly, it was a challenge simply because the
investment choices of the original owner's annuity often didn't align with how the
beneficiary wished to invest, especially in circumstances where the beneficiary inherited
a fixed annuity but wanted to invest in equities for growth (i.e., wished that he/she had
inherited a variable annuity instead).
Yet in reviewing the historical legislative guidance from Congress and subsequent rulings
from the IRS on 1035 exchanges, the IRS in PLR 201330016 acknowledged that in
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reality, the beneficiary of an inherited annuity does effectively become the new owner,
that the guidance on how to complete a 1035 exchange can be applied accordingly (as
long as the ownership doesn't change, and the funds are transferred directly from the old
company to the new company), and as a result that a 1035 exchange should be
permissible.
The key point of emphasis in the IRS' ruling was simply that the terms of the new
contract must ensure that distributions will continue in compliance with IRC § 72(s)(1),
which stipulates the rules for required minimum distributions over the life expectancy of
the beneficiary (or subject to the 5-year rule) after death of the original owner. In other
words, as long as the 1035 exchange by the beneficiary isn't done in a manner to
circumvent the post-death distribution rules, and is simply a change of contract and
investments with the same (beneficiary) owner maintained, that the exchange of the
inherited annuity is permissible.
Don’t forget to keep in mind that ultimately a private letter ruling applies only to the
individual who applied for the ruling; technically, the IRS is not bound to follow this
ruling, and its prescriptions for postmortem 1035 exchanges of inherited annuities by
beneficiaries are certainly not required to be followed by today's annuity companies.
Nonetheless, there's little reason to expect that the IRS would not continue to follow the
ruling, at least for exchanges that occur within the faith and intent of the rules (a properly
executed 1035 exchange where the new contract continues to make distributions at least
as rapidly as the prior contract). Companies that wish to honor the guidance in the ruling
will likely establish "standard" inherited annuity 1035 exchange forms that conform to
the requirements acknowledged in the PLR (including contractual provisions that annuity
ownership cannot be transferred, that new contributions cannot be made, and that
distributions must occur at least as rapidly as prescribed under IRC § 72(s) for the
original decedent's annuity contract).
The bottom line, though, is simply this: for beneficiaries of inherited annuities who were
unhappy with the annuity contracts and companies to which they were tied - because it's
what the decedent owned when he/she passed away - a new world of flexibility looks to
be opening up for those who follow the 1035 exchange guidance.
IRC § 2039: Estate Tax Inclusion
Basically, the value of an annuity contract is included in the deceased contract owner’s
gross estate. [IRC § 2039.] The value of the contract is determined by federal estate tax
valuation rules. When the annuity is owned jointly, the amount included in each owner’s
estate depends on the marital status of the joint owners. If the joint owners are not
married, or if they are married but the surviving spouse is not a U.S. Citizen, the value is
included in the estate to the extent of the owner’s proportional contribution to the contract
purchase.
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However, when an annuity is jointly owned by a married couple, one-half of the
annuity’s value is included in the estate of each spouse. This treatment means that estate
tax treatment for annuities is different from its treatment of life insurance. In a life
insurance policy, it does not matter who paid the premium on a policy. With annuities,
payments define the tax treatment at death.
The value of the contract is defined as accumulated cash value when the death occurs
before payments begin. When death occurs after payments have started, contract value is
defined as the present, or commuted, value of remaining contract payments. This contract
value can also be defined as the single premium amount that could buy the balance of
benefits available in the contract. The insurer that issued the contract supplies this figure.
Note that in terms of estate taxes, it does not matter how the survivor benefits are paid.
They may be paid as a lump sum, as an annuity, in “period certain” installments, or in
fixed amount installments. The present value of the remaining annuity payments is
included in the gross estate, proportionate to the amount purchased with funds of the
decedent.
For tax year 2015, based on the Tax Relief, Unemployment Insurance Reauthorization,
and Job Creation Act (TRA 2010), signed into law by President Obama on December 17,
2010, the federal estate tax, gift tax and the generation skipping transfer will be set at a
maximum tax rate of 40% with a $5,430,000 exemption, up from $5,340,000 in 2014
with the same tax rate. The Act also provides the following provisions:


Inherited amounts will receive a full step-up in basis.
Any unused exemption by one deceased spouse is portable to the second spouse’s
estate. The executor of the first spouse must actively elect this option on an estate
tax return, even if there is no liability owed.
IRC § 691(c) Income in Respect of a Decedent (IRD)
The IRD deduction [IRC 691(c)] is one of the oldest provisions in the tax code, dating
back to the early 1940’s. With so many baby boomers inheriting larger retirement plans
(including nonqualified annuities and IRAs) more people are in a position to qualify for
this deduction than ever before. But they may not receive it due to their ignorance of its
existence, which is why it is very important for the advisor to understand IRD and to be
able to help their clients take advantage of this deduction.
Treasury regulations define “income in respect of a decedent” (IRD) as “those amounts to
which a decedent was entitled as gross income but which were not properly includible in
computing his taxable income for the taxable year ending with the date of death or for a
previous taxable year under the method of accounting employed by the decedent” (Treas.
Regs. § 1.691(a)-1(b)). So, with this definition and IRC § 691, we are left to identify and
administer assets that, upon the owner’s death, will produce an immediate ordinary
income tax liability to the recipient of the asset.
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The death benefit of an annuity contract received upon the death of the owner/annuitant is
income in respect of a decedent to the extent that the death benefit amount exceeds the
basis in the annuity contract. The IRD deduction is a way for the beneficiaries to offset
the effect of the double taxation (estate taxation and income taxation) that comes with
inheriting assets such as a nonqualified annuity. Note: The deduction only applies to
federal income and federal estate taxes.
The IRD deduction is much more valuable than most other itemized deductions because
it is not eroded by the 2 percent of adjusted gross income (AGI) limitation nor is it even
subject to the dreaded alternative minimum tax (AMT). By not checking to see if your
clients can qualify for this deduction could end up costing them as much as 60 to 70
percent of the inherited annuity.
Calculating the IRD Deduction
To calculate the IRD you need to take the following steps:





Step 1. Take the federal estate tax amount from page one of IRS Form 706.
Step 2. Calculate the estate tax again without including any of the IRD items
in the estate (Note: subtract out the cost basis of the annuity).
Step 3. Subtract the estate tax in Step 2 from the estate tax in Step 1. The
result is the total amount of the IRD deduction.
Step 4. Divide the amount from Step 3 by the amount of the Annuity value
minus the cost basis. This will give you the percentage of the deduction the
client will be able to claim.
Step 5. Multiply the amount of the distribution (if any) by the percentage
from Step 4 to get the deduction amount for the year.
Note: There is no place on the IRS forms to guide your clients through the IRD
calculation. Without your guidance your client is more likely to miss this important tax
opportunity. You should educate your clients on what IRD is and encourage them to
speak to their tax accountant and/or attorney to help calculate the deduction.
Annuities inside Qualified Retirement Plans
A major “suitability” controversy in the financial world has been the placing of an
annuity inside a qualified retirement plan, especially a deferred variable annuity. Critics
charge that since both annuities and qualified retirement plans offer income tax-deferral,
putting an annuity in a qualified retirement plan is redundant and inappropriate. They
also charge that the annuity is more costly and that additional costs will reduce the
overall performance over the long run. And finally, they contend that government
regulations and ethical guidelines militate against placing an annuity into qualified
retirement plans.
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This concept has received much negative attention in recent years—ranging from class
action lawsuits, to FINRA arbitrations, to critical press, even to FINRA and SEC
commentary – all questioning the appropriateness of using annuities within qualified
retirement plans.
However, fixed and variable annuities have been used extensively as funding vehicles for
qualified retirement programs for many years. This is due to the favorable design of
these products, which provides not only professional investment management of
retirement assets, but also incorporates important insurance protections of assets and a
future stream of guaranteed lifetime income.
Congressional Mandate
The history of variable annuities in qualified retirement plans is strong and clear, with the
basis formed by Congress through statutory provisions (Sections) in the Internal Revenue
Code (“IRC”) of 1986. Let’s review some of those specific provisions:





IRC § 401 – Qualified Pensions, Profit Sharing and Stock Bonus Plans. IRC §
401(f) – Annuity Contract shall be treated as Qualified Trust.
IRC § 403(a) – Qualified Annuity Plan.
IRC § 403(b) – Annuity purchased by IRC § 501(c)(3) organization or public
school.
IRC § 408 (b) – Individual Retirement Annuity.
IRC § 457 – Plans established for state and local government employees, funded
with annuities.
It seems quite clear from this legislation that annuities have been recognized by the U.S.
Congress to be a legitimate funding vehicle for qualified plans. It should also be noted
Congress provided specifically for annuity investments in tax-qualified plans well before
the Internal Revenue Code of 1954 was enacted, funding these programs with fixed
annuities at the time.
By using variable annuities as the investment within these tax-qualified retirement plans,
regulators at both FINRA and the SEC have recognized that the disclosure with regard to
the variable annuity benefits, risks and costs must be complete, and the investment must
meet the suitability criteria applicable to the customer’s situation.
Annuities in an IRA
Individuals may also open a Traditional IRA and or a Roth IRA with an annuity provider
and build an annuity-based plan. With this plan, the IRA stands for Individual
Retirement Annuity (IRC § 408(b)). An individual retirement annuity operates much like
a traditional individual retirement account. The main difference is that an individual
retirement annuity involves purchasing an annuity contract or an endowment contract
from an insurance company. An endowment contract is an annuity that also provides life
insurance protection.
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An individual retirement annuity must be issued in the name of the owner. The owner or
the owner’s surviving beneficiaries are the only ones who can receive benefits or
payments from the annuity. The annuity contract must also meet the following
requirements:






The owner’s interest in the annuity contract must be non-forfeitable (i.e., fully
vested).
The contract must provide that the owner cannot transfer any portion of it to any
person other than the issuer (i.e., the insurance company).
The contract must allow for flexible premiums so that if the owner’s
compensation changes, the amount of the payments can also change.
Yearly contributions cannot exceed $5,500 for 2015, or if age 50 or older, a total
of $6,500 (includes $1,000 catch-up contribution).
Any refunds of premiums can only be used to pay for future premiums or to buy
more benefits before the end of the calendar year after the year the refund is
received.
Distributions from the annuity must begin to be made by April 1 of the year
following the year the owner reaches age 70½ (if not, 50% penalty).
Advantages of Annuities inside a Qualified Retirement Plan
Some of the advantages of owning a variable annuity inside a qualified retirement plan
and/or IRA that may debunk those critics are the following:


Investment Portfolio Choice. Variable annuities typically offer a number of
investment portfolios so that your client can choose those that are best suited to
match their goals and tolerance for risk. Most variable annuities also offer a
guaranteed fixed rate of return, which can be valuable for some plan participants.
(Note: Some of the fixed rate portfolios may be subject to a market value
adjustment). Today, most variable annuities offer guaranteed living benefit riders
to protect the annuity owner from the volatility in the market with “portfolio
insurance”.
Guaranteed Death Benefit. Variable annuities often guarantee the owner that
regardless of what happens to the underlying funds held in his or her annuity,
their beneficiary would receive the greater of the market value of the annuity at
death, or the net value of contributions paid into the annuity. Several annuity
issuers pay a death benefit that automatically adjusts or ratchet upward every few
years (at an additional cost). Other issuers allow a variable annuity owner to
purchase a death benefit that is guaranteed to increase in value each year at a set
rate (at an additional cost). These guaranteed death benefits ensure that the
owner’s beneficiaries will always receive at minimum, proceeds that will exceed
net contributions made by the annuity owner. In fact, FINRA has held that the
death benefit offered by variable annuities may be an appropriate reason for
placing a variable annuity inside a qualified plan.
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




Guarantees of Income for Life. Annuities provide the guarantee of income
payments for the life of an individual or the joint life of two individuals, no matter
how long the individuals live. With people living longer lives, this annuitization
guarantee of income payments that cannot be outlived is increasingly important as
individual’s fear of running out of money during their lifetimes. With the variable
annuity people are buying “longevity insurance.” Also, with variable
annuitization it provides an added benefit of basing lifetime payments on a
portfolio of equity investments, which may provide an important hedge against
inflation. In combination with a fixed annuity, a portion of the regular payments
can be a guaranteed fixed dollar amount, with the balance providing the
opportunity for growth through variable payments.
Guaranteed Living Benefits. Guaranteed living benefits, optional riders on a
growing number of variable annuities, create a variety of guarantees for investors
while they are still living, as opposed to a variable annuity standard death benefit,
which are really only guarantees for the investor’s beneficiaries. The growth of
living benefits during the bear market years defined their success. Today,
variable annuities with guaranteed living benefits are becoming the norm, rather
than the exception.
Guarantee of Annuity Purchase Rates (Annuitization). Annuity contracts also
provide minimum annuitization payments for any given amount applied through
contractually guaranteed initial annuity purchase rates. These minimum purchase
rates are guaranteed at the time the contract is initiated and continue in force for
the life of the contract, no matter what the changes are in economic conditions,
life expectancies, interest rate climate, etc. At the time of inception, the
individual knows the very minimum rate, which could be paid upon annuitization
at any time in the future, with the opportunity for higher payments based upon
conditions when payments commence. The variable annuity’s annuitization
benefit has been cited by industry regulators as appropriate reason for placing a
variable annuity in a qualified plan.
Expense Guarantee. Most variable annuity contracts guarantee that the mortality
and expense risk charges and administrative fees within the contract will never be
increased for as long as the contract is owned by the individual. It seems evident
that this guaranteed lock on contract expenses is very meaningful over a 30 – 40
year period, which is typical of contract ownership, particularly when one
considers how account and administrative fees have increased over recent years
for other financial service products.
Building/Replacing a Defined Benefit Plan. Over the past few years there has
been numerous reports talking about the changing retirement landscape and how
retirees in the 21st century will need to build their own retirement plans. A new
acronym has been developed: YoYo plans. Which stands for: You’re On Your
Own. Gone are the days when an employee could depend upon their employer
(defined benefit plans) and the government (social security) to retire for the
“golden years.” For many new retirees, the largest retirement plan they may own
may be their 401(k) plan. This defined contribution plan does not guarantee the
income for life that a defined benefit plan would. Then it would seem logical that
the opportunity would present itself for many of these retirees to rollover their
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qualified plan (401(k)) into an IRA and inside the IRA purchase an annuity. The
annuity would accomplish all that a defined benefit plan would: Guaranteed
income for life of the annuitant and/or his or her beneficiary.
These important guarantees provide real protection and benefits to the participant-owners
who own an annuity inside a qualified plan and/or IRA. The tax deferral in the annuity is
a matter of law—it is not a benefit provided by the insurance company, and there is no
fee or charge for tax deferral.
RMD Rule Requirements on Variable Annuity Contracts
For RMD calculation purposes the entire interest of an individual’s qualified assets in
their qualified retirement account or certain self-directed qualified annuity is the sum of
all their individual assets held within their qualified retirement account or self-directed
qualified annuity as of December 31 of a given year. To determine the RMD for a
qualified retirement account or self-directed qualified annuity for a given year, the total
account value or contract interest for self-directed annuities is then divided by the
owner’s life expectancy using the appropriate IRS tables as provided in the Treasury
Regulations.
The new rules require that the actuarial present value of additional benefits, must be
combined with the actual account value of the contract to determine the “entire interest.”
Previously, if a deferred annuity was held as an asset in a qualified account or as a selfdirected IRA annuity, only the contract value of the annuity was used to determine the
“entire interest” for RMD purposes.
Actuarial Present Value Defined
The actuarial present value (APV) is determined by projecting the actuarial value of the
guaranteed benefit provided under the contract into the future and then estimating its
present value. In determining this value, companies may consider what the benefit will
be worth in the future and how likely it is that the benefit will become payable, taking
into account the likelihood of various occurrences such as death and contract surrender
value. This likely future value is then discounted at a reasonable rate of interest at the
present value.
RMD Calculation under the New Rules
To determine a contract’s value for RMD calculation purposes, the amount derived from
the calculation of the actuarial present value of any guaranteed benefit is added to the
December 31 account value of the previous year. This value is then divided by the
owner’s life expectancy using the appropriate IRS tables. The resulting number is the
RMD for the year.
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Safe Harbor Rules
There is a safe harbor under the rules. This safe harbor provision states that an additional
benefit under a deferred annuity contract can be disregarded for purposes of determining
the actuarial present value requirement if it fits at least one of two circumstances:


When the only additional benefit is a death benefit that does not exceed the
premiums paid less the amount of prior withdrawals (Return of Premium GMDB),
or
When withdrawals impact benefits of a pro-rata basis and the actuarial present
value of all “guaranteed benefits” under the contract do not exceed 20% of the
contract value.
Example: Calculating RMD under New Rules
Detailed below is a hypothetical example of how the APV may be determined for a
qualified annuity contract with a guaranteed minimum death benefit (GMDB) and
guaranteed minimum income benefit (GMIB). This example is based on assumptions
that a hypothetical company may deem reasonable. Other annuity issuers may determine
different values based on the assumptions they have selected. Note: Under the Workers
Retirement Employer’s Rescue Act of 2008, RMDs for 2009 are not required.

GMDB Example 1: Assume the Owner (who is also the Annuitant) is 75 years
old with a variable annuity with a pro-rata Maximum Anniversary Value (MAV)
GMDB. On December 31, 2010, the annuity contract value is $500,000 and the
MAV GMDB is $1,000,000.
o Step 1: Using the life expectancy tables prescribed by the IRS, the RMD
factor for a 75-year old is 22.9. To determine the client’s RMD for this
contract prior to determining an actuarial present value calculation for the
GMDB, divide the annuity contract value by the RMD factor: $500,000 /
22.9 = $21,834.
o Step 2: To calculate the actuarial present value of the GMDB, an
insurance company must reflect the net amount at risk (i.e. the difference
between the contract value and GMDB) and the maximum age through
which such a benefit may be paid.
Let’s assume the following: The Company requires annuitization at age
95; the Company assumes the net market performance for this product is
6.5% and a discount rate of 5.0% is appropriate to reflect the time value of
money. Based on these hypothetical assumptions, an actuarial present
value of the $1,000,000 MAV GMDB would be $65,519.
o Step 3: Next determine whether the actuarial present value of the GMDB
falls within he “safe harbor” prescribed by the rules. To calculate this
value, divide the actuarial present value of the GMDB by the annuity
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contract value: $65,519 / $500,000 = 13.1%. Since this value is less than
20% and the MAV GMDB design is pro-rata, there would be no impact on
the previously RMD of $21,834 (Step 1).

As previously noted, the “safe harbor” does not apply to benefits that are
adjusted on a dollar-for-dollar basis for withdrawals. Based on the
assumptions above, if a 75 year old owner had a dollar-for-dollar MAV
GMDB design, the RMD would be increased as follows: ($500,000 +
$65,519) / 22.9 = $24,695. This RMD is 13.1% INCREASE over the
previously calculated RMD of $21,834.
GMDB Example 2: Using the same assumptions described above, suppose the
annuity contract value is $400,000.
o Step 1: Determine the client’s RMD for this contract prior to determining
an actuarial present value calculation for the GMDB by dividing the
annuity contract value by the RMD factor: $400,000 / 22.9 = $17,467
o Step 2: The actuarial present value of the $1,000,000 MAV GMDB is now
$104,317.
o Step 3: Determine whether the actuarial present value of the GMDB falls
within the “safe harbor” set by the new rules. To make this determination,
divide the actuarial present value of the GMDB by the annuity contract
value to get: $104,317 / $400,000 = 26.1%.
Here is the actuarial present value does not fall within the “safe harbor.”
o Step 4: Determine the RMD for this contract by adding the actuarial
present value of the GMDB to the annuity contract value and divide it
by the RMD factor to get the RMD for the year—($4000,000 +
$104,317) / 22.9 = $22,023.
As previously outlined in Step 1, under the old rules the RMD for a client
in this scenario would have been: $400,000 / 22.9 = $17,467. This new
RMD is a 26.1% INCREASE over the old RMD.
Qualifying Longevity Contracts (QLAC)
The insurance industry received a July 4th gift from the Internal Revenue Service in the
form of a new regulation released on July 1, 2014. This regulation makes it possible to
place IRA and pension plan investments into fixed annuities. This will enable the IRA
holder or plan participant to avoid the minimum distribution rules that apply after age 70
½ to the extent that IRA or plan assets are held under such vehicles. The maximum
amount that can be invested in such fixed annuities under an IRA or pension will be the
lesser of $125,000 or 25% of the value of the pension or IRA account as of the time of
the investment. Basically, the value of such contracts will not be considered to be assets
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of the IRA or pension for purposes of the minimum distribution rules until the owner is
age 85.
These rules will also allow QLACs to be held under 403(b), and 457(b) plans, but not
under defined benefit plans or Roth IRAs.
Under the regulations, these annuity contracts will not be variable or equity indexed
annuities, even if they offer a guaranteed minimum rate of return, unless or until
explicitly approved by the Internal Revenue Service. Instead, the products available will
be ones with a fixed rate of return, life payment, or other similar contract that can be
expected to guarantee a minimum rate of return, and to actually credit a slightly higher
rate of return in the same manner that many whole life insurance products now offer.
The preamble to the new regulations point out that variable and equity indexed annuities
with contractual guarantees provide an unpredictable level of income to the holder, and
they are inconsistent with the purpose of the new regulation.
A typical arrangement would be that a taxpayer would invest $125,000 (the maximum
that can be invested is the lesser of 25% of the value of the qualified account at the time
of the investment or $125,000) into a deferred income annuity contract that would payout upon the earlier of the death of the account holder or planned participant or ratably
from ages 85-90.
Example: If a 65 year old male wants to receive monthly income of $1,000 from
his IRA after the age of 80, put $47,920 into an annuity contract under his IRA,
and the value of the annuity contract would not be subject to the Required
Minimum Distribution rules on the value of his IRA until reaching age 80. The
contract could allow access to receive payments earlier, if and when needed,
based upon the terms of the contract.
The new regulations require that payments from a QLAC must begin to be made by age
85. Therefore, if a 65 year old man wants to receive $1,000 a month for life beginning at
age 85, he would only have to put $26,634 into a QLAC contract, and would receive a
guaranteed payment for life beginning at age 85.
In both of the above arrangements there is a death benefit, as is permitted under the new
regulations, which will provide that if the account holder dies before receiving payments
equal to the amount invested, then the deficit amount will be paid into the IRA (typically
without interest) shortly after death, or payments might continue for the lifetime of a
surviving spouse who could roll the annuity over to his or her own IRA and continue to
have the benefit of payment rights.
Disclaimers With Regards to Tax and Legal Issues
As the insurance producer/financial advisor, you should make every effort to assure the
client that they you are not giving tax or legal advice. Review disclaimers below:
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


If, an insurance professional/financial advisor offers to sell to a client any life
insurance or annuity product, the life agent shall advise the client or the client’s
agent in writing that the sale or liquidation of this product may have tax
consequences.
As the insurance professional/financial advisor you must disclose that the client
may consult independent legal counsel for financial advice before buying, selling
or liquidating any assets being solicited or offered for sale.
This course is not intended to provide advice with issues surrounding income and
estate taxation of annuities. If expert tax assistance is required, insurance
professional/financial advisor shall advise client to consult with other
professionals.
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Chapter 6
Review Questions
1. What is the principal IRC § (section) governing the tax-deferral of annuity contracts?
(
(
(
(
) A. IRC § 401(a)
) B. IRC § 408
) C. IRC § 408 A
) D. IRC § 72
2. Which legislation passed by Congress prevented corporations and other “nonnatural persons” from taking advantage of the tax-deferral of an annuity?
(
(
(
(
) A. Employment Retirement Income Security Act of 1974
) B. Tax Reform Act of 1986
) C. Economic Growth Tax Relief Reconciliation Act of 2001
) D. Tax Equity and Fiscal Responsibility Act of 1982
3. All of the following would be considered IRC § 1035 tax-free exchanges EXCEPT:
(
(
(
(
)
)
)
)
A.
B.
C.
D.
Annuity to an annuity
Life to life
Annuity to life
Life to an annuity
4. Under IRC Section 72(s)(1), if the owner dies after annuitization, but before the entire
interest in the contract has been distributed, the beneficiary must:
( )
A. Distribute at least as rapidly as under the method of distribution in effect at
time of death.
( ) B. Distribute remaining balance of annuity over five years.
( ) C. Take an immediate distribution of the full value remaining within one year.
( ) D. Take distribution over his or her life expectancy immediately upon the death
of the owner.
5. Generally, under IRC Section 72(s)(1), if the owner of an annuity contract dies prior
to annuitization of the contract, the entire amount of the contract must be distributed
in how many years?
(
(
(
(
) A. Within seven years
) B. Within one year
) C. Within five years
) D. Immediately
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CHAPTER 7
PARTIES TO THE CONTRACT
Overview
In order to properly structure the annuity contract it is important that the insurance
producer/financial advisor have an understanding of the various parties to an annuity
contract. Different than most contracts that may have only two parties, the annuity
contract has four.
In this chapter, we will examine the various parties to the annuity contract, their rights
and roles. It will also review the various insurance rating services and the State Guaranty
Associations.
Learning Objectives
Upon completion of this chapter, you will be able to:



Identify the roles and rights of the four parties to an annuity contract;
Distinguish the various insurance rating agencies and their methods of ratings;
and
Identify the role and the responsibilities of the State Guarantee Associations.
Background
An annuity is a contract between an annuity (contract) owner and an insurance company.
However, while most other types of contracts involve only two parties, an annuity
contract involves more because the contract rights and benefits are measured by the life
of a third party who is called the annuitant. In many cases the owner and the annuitant
are the same person. In addition, because disbursement of annuity values can occur after
the death of the contract owner or annuitant, another party is usually named in the
contract, a beneficiary.
Next, let’s examine the rights and benefits of each of the parties to an annuity contract in
greater detail, beginning with the contract owner.
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The Contract Owner
The contract owner is the individual who purchasers the annuity. As the owner of the
contract, the individual is given certain rights.
Rights of the Owner
The annuity contract gives the owner of the contract certain key rights. While the
annuitant is living, the contract owner generally has the power to do the following:








Name the annuitant.
State and change the annuity starting date.
Choose (and change, prior to the annuity starting date) the payout option.
Name and change the beneficiary.
Request and receive the proceeds of a partial or full surrender.
Initiate and change the status of a systematic withdrawal.
Assign or otherwise transfer ownership of the contract to other parties.
Amend the contract with the issuing company’s consent.
Changing the Annuitant
Note that “change the annuitant” was not included in our general list of rights. Some
annuity contracts specifically give the owner the right to change the annuitant and some
do not. If the owner of the contract is a not a natural person, a change of annuitant is
treated as the death of an owner for income tax purposes, which means that certain
distributions are required to be made from the contract. Therefore, even if the contract
specifically allows the owner to change the annuitant, care should be taken in naming the
annuitant when the owner is a non-natural person in order to avoid the possibility that
unfavorable tax consequences may be incurred if a change of annuitant is later desired.
Duration of Ownership
As noted earlier, when we introduced the general list of owner’s rights with the clause
“while the annuitant is living,” under some annuities, the owner’s rights in the contract
cease to exist when the annuitant dies. One of two things can happen; either the value of
the annuity is paid to the beneficiary or the beneficiary becomes the new owner.
This is fine where the owner and the annuitant are the same person. But care must be
taken in those situations where the owner and the annuitant are different parties.
Under some contracts, the owner’s rights do not automatically cease when the annuitant
dies. If the owner is not the annuitant and the annuitant dies first, some contracts provide
that the owner automatically becomes the annuitant. Other contracts provide for a period
of time in which the owner can name a new annuitant, after which, if a new annuitant is
not named, the owner becomes the new annuitant. Still other contracts provide for a
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contingent owner to assume ownership of the contract in the event the original owner dies
before the annuitant.
Purchaser, Others as Owner
In most cases the purchaser of the contract names himself or herself as owner. However,
sometimes the purchaser names another party, such as a trust, as owner. For example,
trust ownership may be used when the purchaser wishes to make a gift to a minor.
Certain forms of trust ownership may shift income and estate taxation of the benefits of
the contract away from the purchaser. However, the purchaser may be liable for gift
taxes on the value of the annuity and/or the premiums paid on it.
In any case, by giving up ownership of the contract, the purchaser also gives up all
contractual rights to control the annuity. A purchaser could name a trust as owner and
still retain control over the trust, but such a trust would not shift income or estate tax
away from the purchaser. Purchasers should consult tax and legal counsel before giving
ownership of an annuity to anyone other than himself or herself.
Taxation of Owner
In general, it is the owner of the annuity who is taxed on any amounts disbursed from the
annuity during the annuitant’s lifetime. This is true even if someone else is receiving
annuity benefit payments: naming another person as annuitant does not shift tax liability
away from the owner. Only a gift or other transfer of ownership can do that. However,
you should note that under some contracts, once the contract is annuitized, the annuitant
automatically would become the owner. This change of owner may have tax
consequences to the old owner.
Remember that, with certain exceptions, if the owner of the annuity is not a natural
person, the annuity does not provide income tax-deferral on accumulations. The major
exceptions to the nonqualified person rule are a trust acting as agent for a natural person,
a qualified plan, or the estate of the deceased owner.
Death of Owner: Required Distribution
Federal tax law requires that certain distributions be made from an annuity in the event
that any owner of the contract dies. If the owner of the contract is not a natural person then the annuitant will be considered the owner - and a change of annuitant is treated the
same as the death of an owner for tax purposes.
Required distributions are as follows:

If an owner dies after the annuity starting date, any remaining payments that are
due under the annuity must continue to be made at least as quickly as payments
were being made prior to the death of the owner.
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
If an owner dies before the annuity starting date, the entire value of the annuity
must either be distributed within five years of the date of such owner’s death, or
the value of the annuity must be annuitized within one year of the date of such
owner’s death.
Spousal Exception
There is an exception to the rule requiring distributions in the event of an owner’s death.
If, the beneficiary of the annuity is the surviving spouse of the deceased owner, then the
surviving spouse is permitted to become the owner. Distributions will not be required
until the surviving spouse’s subsequent death (See IRC § 72s(3) in Chapter 6).
The Annuitant
Many annuity contracts define the annuitant as the individual who is designated to
receive income benefits, under the contract. However, under some contracts, as well as
in the tax law, the annuitant is the individual whose life is of primary importance in
affecting the timing or amount of the payout under the contract. In other words, the
annuitant’s life is the measuring life in the contract.
A Natural Person
The annuitant must be an individual (or in the case of joint annuitants, two individuals).
If a trust, a corporation or other non-natural person were the annuitant, there would be no
natural life by which to measure the benefits of the contract.
Role of the Annuitant
The role of the annuitant as the measuring life under an annuity contract is similar to the
role of the insured under a life insurance policy. Just as it is the insured’s age in which
determines the premium rates for a life insurance policy, it is the annuitant’s age in which
determines the benefits payable under an annuity contract. And just as it is the insured’s
death in which triggers the payment of benefits under a life insurance policy, it is the
attainment of a given age on the part of the annuitant that triggers the annuity starting
date under an annuity. And just as the insured is usually also the owner of a life
insurance policy, the annuitant is usually also the owner of an annuity, though there are
exceptions, as we have discussed previously.
Naming Joint Annuitants/Co-Annuitants
Some contracts allow the owner to name joint or co-annuitants. However, having joint
annuitants to a deferred annuity may unnecessarily increase the risk that unwanted
changes would be made to the contract prior to the annuity starting date. This is because
the risk of death for either two people is higher than the risk of death for one person.
Under some contracts, the value of the annuity would be paid immediately to the
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beneficiary. Under others, the owner could change the annuitant designation. But if the
owner is not an individual, this change would be treated the same for tax purposes as a
death of an owner, triggering required distribution from the contract.
The increased risk of naming joint annuitants may be unnecessary because even if only
one annuitant is named under a deferred annuity contract, a joint-and-survivor income
option can be chosen at the annuity starting date. If a guaranteed lifetime income stream
over the lives of two individuals is desired, this objective can be achieved without
naming joint annuitants during the accumulation (deferral) period.
Taxation of Annuitant
As mentioned earlier, it is generally the owner rather than the annuitant who is taxed on
annuity payments. If the owner and the annuitant are the same person, of course, it is the
owner/annuitant who is taxed.
However, even if the owner and the annuitant are different persons, it is still with
reference to the annuitant’s life that the exclusion ratio (IRC § 72(b)—discussed in
Chapter 6) for the payment is calculated.
As a reminder, some annuity contracts provide that the annuitant will become the owner
of the contract after the annuity starting date. In that case, the annuitant, as owner, would
become liable for the tax on the income-taxable portion of those payments earned after
the annuity starting date. Earnings before annuity starting date should be taxed to old
owner on the annuity starting date or as distributions are made after the annuity starting
date.
Death of Annuitant
The death of the annuitant can cause some major changes to the contract or in some cases
even the cessation of the contract, because the annuitant is the measuring life under the
contract. We’ve already discussed above the possible effects of the annuitant’s death
prior to the annuity starting date. Under an annuitant-driven contract, when the annuitant
dies, the guaranteed death benefit is paid and the contract ceases.
Under an owner-driven contract, the annuity remains in force if the annuitant dies. The
owner must name a new annuitant, or the contract may specify that the owner also
becomes the annuitant. If there is a contingent annuitant, then the contingent annuitant
becomes the annuitant; the owner typically may not name a new contingent annuitant.
However, if it is a contingent annuitant who dies, not the primary annuitant, the owner
may simply name a new contingent annuitant.
If the annuitant dies after the annuity starting date, the income option under which
annuity payments are being made controls what happens next. Under a “life only”
income option, payments cease. Under a “period certain” or “refund” payment option,
the balance of any remaining guaranteed payments will be made to the beneficiary.
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Under a joint and survivor payment option, payments will continue to the surviving
annuitant for the remainder of his or her life.
The Beneficiary
The beneficiary is the person designated under the contract to receive any payments that
may be due upon the death of the owner (owner driven contracts) or annuitant (annuitant
driven contracts).
Death Benefit
The death benefit payable to the beneficiary of a deferred annuity prior to the annuity
starting date is usually equal to the greater of either:


The total premium paid for the annuity to date, minus any withdrawals, or
The current accumulated value of the annuity fund.
For variable annuities, this protects the beneficiary in case of declines in the financial
markets. Under some variable annuities, the current accumulated value of the annuity
fund may be increased by crediting interest at the guaranteed rate.
Generally, no surrender charges or market value adjustments are applied in determining
the amount of a deferred annuity’s death benefit.
Today, most variable annuities offer “stepped-up” death benefit features or “resets” under
which gains achieved in the separate account investment options may be preserved for
the purpose of calculating the death benefit even if the accumulated value later drops.
The stepped-up death benefit is generally calculated with reference to the highest
accumulated value recorded at certain intervals—for example, every third or every fifth
policy anniversary. The stepped-up death benefit may also include any premiums paid
(minus any withdrawals taken) since that time. Reminder: Step up may impose higher
charges.
Whose Death Triggers the Death Benefit
A similarity between a life insurance contract and an annuity contract is that death is the
event in which triggers the payment of benefits to the beneficiary. However, with a life
insurance contract, the benefit is paid at the death of the insured. With an annuity, the
payment of the death benefit is triggered upon the death of the owner (owner-driven
contracts) and may also be triggered by the death of the annuitant (annuitant-driven
contracts), depending on how the pertinent provisions in the contract are worded. If the
owner and the annuitant are the same person, this potential complexity does not come
into play.
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Remember that, regardless of the type of contract, the value of the contract must be
distributed or annuitized if an owner dies. This forced distribution is not the same as a
guaranteed death benefit.
Changing the Beneficiary
Most annuities reserve the contract owner’s right to change the beneficiary at any time
during the annuitant’s life. However, some contracts, give the owner the option of
naming a permanent, or irrevocable, beneficiary. If an irrevocable beneficiary is named,
the beneficiary designation can later be changed only with the beneficiary’s consent.
Designated Beneficiary
The term “designated beneficiary” is defined in Section 72(s)(4) to mean “any individual
designated a beneficiary by the holder of the contract.”
Spouse or Children as Beneficiaries
In most cases, the beneficiary is the owner’s spouse so that the spousal exception (See
Chapter 6--IRC § 72(s)(3)) to the required distribution rules can be used to continue the
contract in the event of the owner’s death. Sometimes it is appropriate for the owner to
name his or her child or children as beneficiaries. If a beneficiary is a minor child, the
owner should have a will and name a guardian to receive the benefits on the child‘s
behalf. Otherwise, the child’s lack of legal competence will likely cause the insurer to
delay paying the benefits until the court names a guardian.
Non-Natural Person as Beneficiary
In some cases, it may be appropriate to name a trust or estate beneficiary under an
annuity—a beneficiary need not be a natural person. If the proceeds are paid to a nonnatural person as a required distribution upon the owner’s death prior to the annuity
starting date, proceeds must be distributed within five years—the annuitization option
will not be available, since the beneficiary is not a natural person.
Multiple Beneficiaries
An annuity contract can have more than one beneficiary. Most annuities provide that if
more than one beneficiary is named, equal shares will be paid out to each named
beneficiary unless a specific percentage is mandated.
Taxation of Beneficiary
With an annuity-driven contract, upon the annuitant’s death, the beneficiary becomes
liable for income tax on any gain paid out of the contract, if Owner and Annuitant is the
same person. If, Owner is still alive, amounts earned before Annuitant’s death are
taxable to Owner.
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Also, in some cases, the beneficiary may become liable for the 10% penalty tax on
premature distributions. This is because of the way the definition of the “premature
distributions” is written in the tax law for annuities purchased on a nonqualified basis.
For annuities purchased on a nonqualified basis:


The definition of a premature distribution is written with reference to the
taxpayer’s age. Upon the death of the annuitant, to the extent the beneficiary
becomes the taxpayer rather than the owner, the beneficiary’s age must be used
to determine whether a penalty is due.
In addition, the distribution-at-death exception to the definition of “premature
distribution” refers to the death of the contract owner or to the annuitant only if
the owner is not a natural person. If the owner and annuitant are different
persons and the owner is a natural person, the distribution-at-death exception
does not apply at the death of the annuitant.
Therefore, if an annuity is purchased on a nonqualified basis and the owner of the annuity
is a natural person and is not the annuitant; the annuitant’s beneficiary will be liable for
the 10% penalty tax if he or she receives taxable death proceeds from the annuity when
he or she is under age 59½.
The situation is not as unlikely as it may sound. Most annuities are purchased on a
nonqualified basis, and if the husband of a married couple is the purchaser, he is likely to
name himself owner. However, it is also common for a married couple to assume that the
husband will die before the wife, since men have a shorter average life expectancy than
women, so the owner may name his spouse as annuitant. And since it is assumed that the
husband will have already died by the time the wife dies, the couple’s child or children
may be named beneficiary.
However, as we have already discussed, depending on the provisions in the contract, if
the wife dies first, the husband’s ownership rights may cease and the value of the annuity
may be paid to the children. The surviving husband-owner will have to pay income tax
on any gain existing in the contract at the time of the wife’s death. If the husband is
under age 59½, they’ll be liable for the 10% penalty tax as well as regular income tax on
any future income paid out of the contract.
Better results can be obtained by having either the husband or wife as both owner and
annuitant, and naming the other spouse beneficiary. Then regardless of who dies first,
the spousal exception is available to continue the contract without income tax
consequences. The children can be named as contingent beneficiaries in the event of a
common disaster involving both the husband and wife (See examples in Chapter 8).
Death of Beneficiary
The death of the beneficiary does not affect the contract itself. If death of the beneficiary
occurs prior to the death of the owner or annuitant, the owner could name a new
beneficiary or if one was named in the contract, the contingent beneficiary, would
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become the primary beneficiary. However, if the beneficiary dies before the owner or
annuitant and a new beneficiary is not named, benefits may end up being paid to the
owner’s or annuitant’s estate.
The Insurer
The insurance company that issues the annuity contract assumes a number of financial
and fiduciary obligations to the owner, the annuitant, the beneficiary, and to the agent
who sold the contract. Depending on the type of annuity contract, such as Individual
Retirement Annuities (IRAs), Tax-Sheltered Annuities (TSAs), and annuities issued in
connection with qualified retirement plans, those financial and fiduciary obligations will
differ especially from a nonqualified annuity. It is important to be aware of these
differences even though many insurance companies use the same single annuity contract
form for nonqualified as well as qualified retirement plan purposes.
Collecting and Investing the Premium
In its simplest form, it is the insurance company that issues an annuity contract, collects
the premium, and then promises to invest the premiums collected responsibly and then
credit interest to the funds placed in the annuity. How the premium payments are
invested and how much, if any, control the owner retains over the investment decisions
affecting his or her funds varies depending upon which type of annuity is purchased.
Some annuities provide variable annuitization.
Paying the Guaranteed Death Benefit
In addition to investing the owner’s premium payments and crediting funds with interest,
the issuing insurance company of the annuity also promises to pay the guaranteed death
benefit in the contract, as determined in the provisions of the contract, at the death of the
owner and/or the annuitant prior to annuitization of the contract.
Paying the Guaranteed Income Option
As discussed earlier, an annuity has one basic purpose—to provide a series of payments
over a period of time. It is the responsibility and the financial obligation of the insurance
company who issues the annuity contract to set aside reserves and to invest those reserves
conservatively to meet the future obligations of those guaranteed income payments to its
policyholders. By fulfilling these contractual obligations, the insurance company meets
the objective of the annuity –to avoid the annuity owner from outliving his or her
financial means.
While it may seem at first glance that an annuity contract issued by one company is just
the same as a contract issued by any other company, the truth is that annuity contracts do
differ from one company to the next.
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Insurance Rating Services
The financial strength and investment philosophy of the insurance company should be
one of the crucial steps in evaluating one insurance company over another. The
purchaser and the agent selling the contract should be knowledgeable about and
comfortable with this information.
To assist in this evaluation of the financial strength, several “rating” services are
available and, indeed are used extensively by agents and consumers alike. For many
years, the A.M. Best Company was the only company in the insurance company rating
service business. Four other major financial rating companies now provide a similar
service: Moody’s, Standard & Poor’s, Duff and Phelps, and Weiss Research. Each of
these companies provides extensive reports on company operations and related statistics
as well as letter rating classifications. In addition, the National Association of Insurance
Commission (NAIC) has developed the Insurance Regulatory Information System (IRIS)
to assist state insurance departments in overseeing the financial condition of insurance
companies.
A.M. Best
The A.M. Best Company is perhaps the best known of all the insurance rating companies.
It has been rating insurance companies for over 85 years and provides full ratings for the
largest number of insurance companies among the rating agencies. It charges a fee for a
company to be included in its rating service. A.M. Best publishes over 50 different
information products about insurance companies and the insurance industry. One such
report, Best’s Insurance Reports, provides a one-year assessment of each company’s
financial situation and Best’s letter ratings. The objective of Best’s rating system is to
provide an opinion concerning a company’s ability to meet its contractual obligations by
reviewing the factors, which can impact a company’s performance. The letter ratings are
intended to categorize each company with respect to its claims paying ability. The letter
ratings range from A++ to F. Some companies are not rated because of their relative
newness in the market. A listing of the A.M. Best Company rating categories is
presented in Table 7.1.
Moody’s
Moody’s Investors Service founded in 1909, rates the financial strength of a variety of
investment vehicles and institutions, including corporate bonds, preferred stock, shortterm debt, mutual funds and insurance companies. Moody’s assigns “financial strength
ratings” to insurance companies, which range from Aaa (the highest) to C (the lowest). A
listing of Moody’s rating categories is included in Table 7.1.
Moody charges a substantial fee to insurance companies who want to be included in their
ratings. As a result of this high fee, Moody rates a limited self-selected universe of
companies who would probably not decide to be rated if they did not expect high ratings
in the first place. Differences in the numerical ranking order of Best and Moody’s (e.g.
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the highest ranking from one company versus the third highest ranking from another)
should be a red flag indicating that the company’s financials should be given especially
close review.
Duff & Phelps
Duff & Phelps Credit Rating Company rates the “claims paying ability” of insurance
companies. Duff & Phelps categorizes companies from AAA (the highest rating) to DD
(the lowest rating). A listing of Duff & Phelps rating categories is included in Table 7.1
Similar to Moody’s; Duff & Phelps charges insurance companies substantial fees to be
included in their rating service. However, if a relative ranking differs from the ranking
provided by Best or Moody’s, it should be an indication that the agent should look more
closely at other indicators of the company’s financial condition.
Standard & Poor’s
Standard and Poor’s Corporation (S & P) now provides two types of rating services for
insurance companies. First, is a rating of an insurance company’s “claims paying
ability.” Similar to Moody’s and Duff and Phelps, S&P charges companies substantial
fees to be included in this claims-paying ability rating service. S&P rates companies
from AAA (highest) to R (lowest). A listing of S&Ps rating categories is included in
Table 7.1.
As with A.M. Best, Moody’s and Duff & Phelps’, it appears that basically only the better
companies are willing to pay the substantial fee to be included in S&Ps rating listings.
The relatively high ratings may also reflect the fact that companies are permitted to
withdraw from the S&P listing if they find the S&P rating unacceptable.
In addition, S&P provides a system of “qualified solvency ratings” for insurance
companies. In contrast with the claims-paying ability rating service that requires the
cooperation of the insurance company’s management and access to proprietary company
information, the qualified solvency rating is a mechanical rating system based solely on
public information from financial statements filed with state regulators. Qualified
solvency ratings are issued for each company that is in the NAIC database of public
filings for insurance companies and that does not have an S&P claims paying ability
rating.
The qualified solvency rating system was developed in order to provide some financial
stability rankings to the public for companies that do not choose to pay to be listed in the
claims-paying ability rating service. Companies are assigned to one of three broad
categories:



BBBq—above average
BBq—Average
Bq—Below average
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Although S&P admits that their assessments are limited by the lack of the “inside”
information they use to make their claims-paying ability ratings, they consider insurers
rated BBBq to be candidates for claims-paying ability ratings in the secure range.
Weiss Research
Weiss Research is a relatively newcomer to insurance company ratings. They have their
own proprietary rating system that, in contrast with the other services, is almost
exclusively dependent on publicly available information. Weiss Research does not charge
any fees to insurance companies to be rated.
Included in Weiss’s statistical analysis is a measure of how well each insurer would fare,
given their financial position today, in “average” and “severe” recessions. Companies
with considerable “liquidity” and low-risk investments are rated higher than companies
with less-liquidity or less-secure investments that might have to drop a weak product line
or upgrade the quality of financial assets to weather a financial crisis. A listing of Weiss
rating categories is included in Table 7.1.
In general, Weiss ratings have been much more severe than those of the other rating
services. They have tended to rate insurers lower, sometimes much more so, than their
competitors. The Weiss ratings tend to look like a typical academic bell curve. Only a
small portion earns an A or B rating, reflecting “excellent” or “good” financial health.
The largest portion of the companies rated fall into the C (average/fair) range. Unlike the
same grade from the other rating services, a C from Weiss may not be that bad a grade.
The last portion of companies rated get D (weak), E (very weak), or F (failed) grades.
The companies that get a B+ or better grade earn a spot on Weiss’ list of companies that
are recommended for safety.
The Weiss ratings appear to be much more conservative than the ratings given by the
other rating services; as a result it would seem that companies with high ratings from
Weiss are the most secure companies. However, Weiss uses less information in making
its rankings than the other services. In addition, it does not consider the quality and
history of management to avoid financial crisis when overall economic conditions turn
bad.
Table 7.1
Scales in Use by Financial Rating Services
Firm
Scale, Highest to Lowest
A.M. Best
A++, A+, A, A-, B++, B+, B, B-, C++, C+, C, C-, D, E, F
Moody’s
Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3, Ba1, Ba2,
Ba3, B1, B2, B3, Caa1, Caa2, Ca3, C1, C2, C3
AAA, AA+. AA, AA-, A+, A, A-,BBB+, BBB, BBB-, BB+,
BB, BB-, B+, B, B-, CCC, CC, D
A+, A, A-, B+, B, B-, C+, C, C-, D+, D, D-, E+, E, E-, F+, F, F-
S&P and Duff and Phelps;
Weiss Research
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State Guaranty Associations
For almost 40 years America’s life and health insurance guaranty associations have
protected policyholders when they need it most. Located in every state as well as the
District of Columbia and Puerto Rico, guaranty associations provide a financial safety net
for consumers if their insurance company fails.
Life and health insurance guaranty associations are organized under state law to provide
certain protections to state residents who own or are beneficiaries of policies issued by a
life or health insurance company that has been ordered liquidated by a court.
Generally, individual or group life and health insurance policies and individual annuity
contracts issued by the guaranty association’s member insurers are covered by guaranty
associations.
Coverage
The state guaranty fund does not cover any portion of a policy which investment risk is
borne by the individual, and they may or may not cover guaranteed investment contracts
or unallocated annuity contracts purchased by retirement plans. Every state (plus Puerto
Rico) provides $100,000 in withdrawal and guaranteed cash values for all other annuities
(California provides 80 percent of the present value, up to a maximum of $100,000).
Thirteen states (and one district) have higher limits:






$100,000 (or $250,000 for IRAs) in Virginia
$130,000 (adjusted for inflation) in Minnesota
$200,000 in Utah
$250,000 in Iowa
$300,000 in Arkansas, D.C., North Carolina, Oklahoma, Pennsylvania, South
Carolina and Wisconsin
$500,000 in Connecticut, New York and Washington
Guaranty associations limit protection to residents of their own state, and policyholders
and beneficiaries are covered if the failed insurer was licensed their state of residence.
Policyholders who reside in states where the insolvent insurer was not licensed are
covered, in most cases, by the guaranty association of the insolvent insurer’s state of
domicile.
According to the National Organization of Life and Health Insurance Guaranty
Associations (http://www.nolhga.com), since their inception, state guaranty associations
have:


Provided protection to more than 2.3 million policyholders.
Guaranteed more than $21.2 billion in coverage benefits.
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
Contributed more than $5.2 billion to ensure that policyholders received their
benefits.
Member Assessments
When a state determines that an insurer is insolvent, and there is a shortfall of funds
needed to meet the obligation to policyholders, the remaining member insurers doing
business in a particular state are assessed a share of the amount required to meet the
claims of resident policyholders.
The amount member insurers are assessed is based on the amount of premiums they
collect in that state on the kind of business for which benefits are required.
Fixed annuity values up to state guaranty funds limits have always been protected when
an insurer failed, although it can take time, often years, before the values are paid out.
Every state guaranty fund covers at least $100,000 of cash value in the event of carrier
insolvency.
A great source of information is the National Organization of Life and Health Insurance
Guaranty Associations (NOLHGA, 13873 Park Center Road, Suite 329, Herndon, VA
22071). http://www.nolhga.com/factsandfigures/main.cfm/location/stateinfo.
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Chapter 7
Review Questions
1. The parties to a nonqualified annuity contract are:
( )
( )
A. The third party administrator, the annuitant, the owner, and the beneficiary
B. The pension plan trustee, the annuitant, the owner, the insurance company
and the beneficiary
( ) C. The owner, the annuitant, the beneficiary, and the insurance company
( ) D. The owner, the annuitant, the tax partner, the beneficiary and the insurance
company.
2. Generally, all of the following are basic of an annuity contract EXCEPT:
(
(
(
(
) A. Name or change the beneficiary
) B. Request a withdrawal
) C. State and change the annuity starting date
) D. Change the annuitant
3. The contract rights and benefits to an annuity are measured on whose life?
(
(
(
(
) A. Beneficiary
) B. Annuitant
) C. Owner
) D. Contingent owner
4. What happens at the death of the annuitant during the accumulation phase in an
annuitant-driven contract?
(
(
(
(
) A. Contract continues with the owner as the annuitant
) B. Contract owner names a new annuitant
) C. Contract ceases to exist and is paid out to the beneficiary
) D. Contract ceases to exist and is paid out to the owner
5. What is the basic purpose of an annuity?
(
(
(
(
) A. Provide a series of payments over a period of time.
) B. Tax-free income
) C. Provide a lump-sum payment to lottery winners
) D. Safety of principal
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CHAPTER 8
ANNUITY CONTRACT STRUCTURE
Overview
There is more to the sales process than just having a purchaser sign an application to buy
an annuity. Deciding whom to name as the owner, annuitant, and beneficiary of an
annuity is commonly referred to as “structuring the contract.” The problem with
improper structuring is that it may cause unwanted tax bills and cause the improper
distribution of the annuity proceeds. It is important to remember to always structure an
annuity in a way that results in the least amount of negative tax and penalties upon payout
of the death benefit.
In this chapter we will examine how to properly structure an annuity contract. It will also
examine several contract structure examples.
Learning Objectives
Upon completion of this chapter, you will be able to:






Identify the importance of proper annuity contract structure;
Distinguish between an Owner-driven vs. Annuitant-driven contract;
Recognize the importance of simple vs. complex contract structure;
Apply the rules for proper annuity structure for spousal election;
Apply the rules for proper annuity structuring when a trust is named the
beneficiary; and
Apply the rules for properly annuity structuring when neither a spouse nor a trust
is named beneficiary.
Background
As the insurance professional (agent), it is your responsibility to help your client
understand the different types of annuity contracts (full disclosure) and how to properly
structure the contract to meet the needs and financial goals of the client.
The most critical point for agents to remember about annuity contracts is that they are
ALL DIFFERENT! There are some tax laws and IRS regulations that apply equally to
all annuity contracts, but annuities differ from company to company because they may
have different contract provisions.
145
If a contract is improperly structured the result may cause unwanted income, gift and
possibly estate tax consequences to the purchaser and his or her beneficiaries. To avoid
these consequences, it is vital the insurance professional (agent) know the annuity
contracts they are selling.
Structuring the Contract
When structuring an annuity contract it is probably best to keep it simple by naming the
same individual as both owner and annuitant. If that individual dies, any remaining
annuity value is paid to the beneficiary. This simple structure generally assures that the
benefits of the contract flow to the parties that the purchaser intended.
However, there may be times when a contract must have a more complex structure. Such
a situation may call for the annuitant to be someone other than the owner of the annuity.
In such cases, you must take care to ensure that various contingencies do not have
unintended consequences.
Example: Let’s say that Bill is the owner of a deferred annuity that is still in the
accumulation (deferral) phase. His wife Paula is the annuitant, and their son Dan
is the beneficiary. If Paula dies while Bill is still alive, would Bill want the value
of the annuity to be paid immediately to Dan or kept under Bill’s control?
You must know the answer to that question in order to structure the contract properly.
You must understand the variations in the annuity contract language.
Annuity Contract Forms
Annuities can be divided into two contract forms. They are:


Owner-Driven (OD) contracts; and
Annuitant-Driven (AD) contracts.
By “driven” we mean that certain actions occur upon death that are beyond the control of
the named parties to the contract, unless proper structuring is done regarding who owns,
who is an annuitant, and who is a beneficiary to the contract. These structuring issues
must be understood and addressed before investing in an annuity. The first thing that the
insurance producer/financial advisor must understand is the type of annuity contract
being used to make the investment and then proceed cautiously from there. Is it an OD
or an AD?
Note: Annuity contracts must display on Page 1 of the prospectus whether the contract is
an owner-driven or an annuitant-driven contract.
146
Let’s examine in greater detail the differences between Owner-Driven vs. AnnuitantDriven annuity contracts.
Owner-Driven
Owner-driven (OD) contracts pay a death benefit upon the death of the contract owner
(who may not be the primary annuitant). This would likely lead a person to conclude that
any given deferred annuity contract is either one or the other. That would make sense, but
it’s not the case.
If the annuitant in an owner-driven contract dies, the owner can become the annuitant and
enjoy the income. Alternatively, the owner can name a new annuitant and the contract
continues unchanged.
Annuitant-Driven Contract
With an Annuitant-Driven contract, the owners can usually be changed. It is contract
specific as to whether an annuitant can be changed once the contract is issued. Also, the
contract will pay out upon the death of either owners or annuitants. In an AD contract, if
the annuitant dies, there must be a distribution immediately to the beneficiary, and the
contract will cease to exist. For this reason, most insurance producers/financial advisors
should keep annuity structures as simple and clean as possible, which, in most cases,
means avoiding joint owners and annuitants. In the case of spouses, naming anyone other
than the surviving spouse as primary beneficiary should be avoided, or if done, a lot of
caution should be used.
Joint Annuitants/Co-Annuitants
There are some special rules that apply to contracts with joint or co-annuitants. With an
owner-driven contract, if one of the joint annuitants dies (as long as he or she were not
also an owner), the contract could continue. Generally, no new annuitant is named in this
situation.
But under an annuitant-driven contract, if one of the joint annuitants dies, some contracts
may state that no distribution is made until the death of the second joint annuitant (see
Examples No. 20, 21, 22). Companies have the option of designing their product using
either provision. Again, this underscores the importance of knowing the language of the
contract you are selling. You must be careful to explain to your client exactly when a
death benefit may be paid, and when it will not, especially if your contract specifies that
the death benefit is not paid until the death of the joint annuitant.
It may help to recall here what was covered previously regarding joint annuitants. If the
contract calls for the payment of an enhanced death benefit at the death of the first joint
annuitant (co-annuitant) to die, remember that the risk of death for either of two
annuitants is higher than the risk of death for one. You must be sure that your client
147
understands this risk. If the contract calls for payment only at the second-to-die, you
must make sure that the owner does not expect a death benefit payment when the first
annuitant dies. But if the owner’s goal is simply to have a guaranteed lifetime income
stream over the lives of two individuals, this can be achieved without naming joint
annuitants (co-annuitants). Even if only one annuitant is named, a joint-and survivor
income option can still be chosen at the annuity starting date.
Contingent Annuitants
With either an owner-driven or an annuitant-driven contract, when a contingent annuitant
is named in the contract and either the primary annuitant or the contingent annuitant dies
(assuming the annuitant was not also the owner), generally no distribution is made to the
primary beneficiary. Otherwise there would have been no reason to name a contingent
annuitant in the first place. It is common practice that, when a contingent annuitant dies,
the owner may simply name a new contingent annuitant. If the primary annuitant dies,
the contingent annuitant succeeds as primary; the owner may or may not name a new
contingent annuitant, depending on the provisions in the contract.
The Death Benefit
As was discussed in Chapter 6, there are different types of death benefits that can be paid
out under an annuity contract:



The standard guaranteed death benefit is generally the greater of the current value
of the account or the total amount of deposits paid into the contract, minus any
withdrawals.
An enhanced death benefit, an important feature of many variable annuity
contracts, may provide for some guaranteed percentage increase in the contract
value over time for the purpose of calculating the death benefit. Or the death
benefit may be stepped up or “reset” on each anniversary date to the account’s
highest value over the period, thus preserving any gains in the account for the
death benefit even if the actual value of the account later drops. Depending upon
the contract, this periodic step-up or reset may stop when the owner reaches a
specified age.
A third type of distribution is not really a “death benefit” although it may be
confused with one. This is the distribution of the current value of the contract that
is required by law if any owner of an annuity dies.
How and whether the enhanced or guaranteed death benefit will be paid out depends
upon the provisions in each different contract. The enhanced death benefit might be paid
only on the death of the annuitant, only on the death of the owner, or it could be paid if
either party dies; it all depends upon the contract provisions of the annuity.
148
Death after the Annuity Starting Date
Recall that, when death occurs after the annuity starting date (annuitization), then:



If the owner dies (assuming he or she is not also the annuitant), any remaining
payments due under the annuity must be made at least as quickly as payments
were being made before the death of the owner.
If the annuitant dies, the income option under the contract determines whether and
how any remaining payments are made. Under a straight life annuity, payments
cease. Under a joint-and-survivor option, payments will continue to the survivor
annuitant for the rest of his or her life. Under period certain or refund options,
any remaining payments will be made to the beneficiary.
If the beneficiary dies, the contract as such is not affected. Generally a new
beneficiary should be named.
Most of the following examples are annuitant-driven contracts (see Example # 11 for an
example of an owner-driven contract). The enhanced death benefit is paid only upon the
death of the annuitant, not the owner. The fact that the annuitant is often also the owner
of the contract does not change the death benefit paid. This enhanced death benefit is not
the same as the forced distribution explained earlier.
149
I.
WHEN SPOUSAL ELECTION IS ALLOWED
Example 1: A typical structure: husband is the owner/annuitant, wife the
beneficiary. Use this structure when the owner wants the spouse to receive the
proceeds if he or she dies. A child or children could be named the contingent
beneficiary to receive the proceeds in case both parents died simultaneously. If
the owner wants children to receive the proceeds at his or her death, the children
should be named as primary beneficiary, but the right of spousal continuation will
be lost.
Owner Annuitant Beneficiary 1st Death
H
H
W
H
Contract
Disposition
Wife can:
1) Take lump
sum,
2) Defer
distribution for
up to 5 years,
3) Annuitize
within one
year.
Federal
Federal Federal
Income Tax Estate Tax Gift Tax
None
Contract
If contract
Value
continued,
taxes remain included in
H's estate.
deferred.
(Included in
gross
If contract is
not continued, estate, not
income taxed taxable
estate.
to W as
This
received.
qualifies
for
(Taxed
as
OR
the marital
ordinary
deduction).
income).
4) Continue
contract
Special
becoming
marital
owner &
deduction
annuitant.
rules apply
Name a new
if wife was
beneficiary.
not a U.S.
Citizen.
Annuitant-Driven: In this arrangement, the death benefit is triggered at the death of the
husband who is both the owner and annuitant.
150
I.
WHEN SPOUSAL ELECTION IS ALLOWED
Example 2: This arrangement allows the surviving spouse to become owner
following annuity owner’s death.
Owner Annuitant
H
W
Contract
Beneficiary 1st Death Disposition
Survivor can:
Survivor of
H
1) Take lump
H and W
sum,
2) Defer
distribution
for up to 5
years,
3) Annuitize
within 1 year
Federal
Income
Tax
If contract
continued,
taxes
remain
deferred.
Federal
Federal
Estate Tax Gift Tax
None
Value of
contract is
included in
husband’s
gross
estate, but
If contract qualifies for
marital
is not
continued, deduction,
assuming
income
taxed to spouse is a
OR
Wife as U.S. citizen.
4) Continue received.
.
(Taxed as
contract.
(The survivor ordinary
income).
becomes
Owner and
Annuitant).
(If the
beneficiary
continues the
contract, a
new
beneficiary
would have
to be
named.)
Annuitant-Driven: Again, in this arrangement, the death benefit is triggered at the
death of the husband who is the owner while the wife is the annuitant and the beneficiary.
151
I.
WHEN SPOUSAL ELECTION IS ALLOWED
Example 3: Joint-ownership annuity. Naming the surviving owner as
beneficiary allows the surviving spouse to become owner following the death of
either spouse. If someone other than the surviving joint owner is named as
beneficiary, then the spousal election to continue the contract will be lost,
regardless of the fact that the spouses are joint owners.
These are examples of the way in which an annuity contract should be set up if
you want your surviving spouse to become the owner at your death.
Owner Annuitant Beneficiary 1st Death
H and
H
SJO
H or W
W
Contract
Federal
Disposition
Income Tax
If contract is
SJO can:
1) Take lump not continued,
then deferred
sum,
income is
2) Defer
taxed to
distribution for
beneficiary
up to 5 years,
3) Annuitize (i.e., the SJO)
within one year as received.
(Taxed as
ordinary
OR
income).
4) Continue
contract. (SJO
becomes Owner
and Annuitant).
(If the
beneficiary
continues the
contract, a new
beneficiary
would have to
be named).
Federal
Federal
Estate Tax
Gift Tax
One half of
None
contract value
included in estate
of first to die.
(Included in
gross estate, not
taxable estate.
This qualifies for
the marital
deduction).
Assuming Wife is
a U.S. Citizen.
Note: This
provision is
contractual and
not a federal
income tax
requirement.
Annuitant-Driven: In this arrangement, the death benefit will be triggered at the death
of either the Husband or Wife. When naming both spouses as joint owners and joint
beneficiary. At either, the husbands’ or the wife’s death, the surviving owner can
continue the contract.
152
I.
WHEN SPOUSAL ELECTION IS ALLOWED
Example 4: The trust is assumed to be a revocable trust with husband as grantor.
Contract
Owner Annuitant Beneficiary 1st Death Disposition
Wife can:
T
H
W
H
Federal
Federal Estate Federal
Income Tax
Tax
Gift Tax
If contract Contract Value None
continued,
included in
1) Take lump taxes remain Husband’s
deferred.
gross estate,
sum,
but qualifies for
If not, income the marital
2) Defer
deduction,
distribution for taxed as
assuming
ordinary
up to 5 years,
spouse is a
income to
U.S. citizen.
Wife as
3) Annuitize
received.
within one
.
year.
OR
4) Continue
contract
becoming
owner &
annuitant.
Name a new
beneficiary.
Note: This
provision is
contractual
and not a
federal income
tax
requirement.
Annuitant-Driven: In this arrangement, the husband is the grantor of the revocable trust
and is also named as the annuitant. At the husband’s death, the beneficiary who is the
surviving spouse will have the right to continue the contract.
153
II.
WHEN SPOUSAL ELECTION IS NOT AVAILABLE
Example 5: When the beneficiary dies, rather than the owner/annuitant, the
contract is not affected. The ownership remains unchanged. No death benefit is
paid.
Owner Annuitant
H
H
Federal
Contract
Income
Tax
Beneficiary 1st Death Disposition
Contract
W
W
remains intact;
new
None
beneficiary
should be
named.
Federal
Estate
Tax
Federal
Gift Tax
None
None
Owner-Driven and/or Annuitant-Driven
Example 6: The following arrangement is NOT recommended. Since the
husband was both the owner and beneficiary of the contract, a better arrangement
would have been for the husband to have named his wife as contingent
beneficiary. For example: Husband if living, otherwise wife. Then if the husband
died, the assets would not be moved into the estate, and the wife would be able to
continue the contract. In order to continue the contract, the beneficiary must be
the deceased owner’s spouse.
Owner Annuitant
H
W
Beneficiary
1st Death
H
H
Contract
Disposition
H's estate
can:
1)Take lump
sum OR
2) Defer
distribution for
up to 5 years.
Federal
Income
Tax
Federal
Estate
Tax
Deferred Contract
income
value
taxed to included in
H's estate H's estate.
as
received.
(Taxed as
ordinary
income).
Federal
Gift Tax
None
Annuitant-Driven: In this arrangement, the husband is both the owner and the
beneficiary. At his death, the assets of the annuity would not be transferred directly
to the surviving spouse, but to the deceased’s estate. The surviving spouse would
lose the benefit of spousal continuation.
154
II. WHEN SPOUSAL ELECTION IS NOT AVAILABLE
Example 7: The following arrangement is NOT recommended. The Beneficiary
is someone other than the husband or wife; it could be their child or children
(Party X). In order to continue the contract, the beneficiary must be the deceased
owner’s spouse. With this structure, the beneficiary receives the proceeds if
either the owner or the annuitant dies.
Owner Annuitant
H
W
Beneficiary
1st
Death
Party X
W
Contract
Disposition
Federal
Federal
Income Tax Estate
Tax
Deferred
Beneficiary
income
can:
taxed as
1) Take lump
ordinary in
sum,
year of
2) Defer
distribution for wife’s death.
If H is
up to 5 years
under 59½,
OR
he may
3) Annuitize
within one year. have to pay
the 10%
penalty tax
Note: This
provision is on any gain
which
contractual and
not a federal existed until
spouse’s
income tax
death*
requirement.
None
Federal
Gift Tax
Upon
wife’s
death,
husband
potentially
made a
taxable gift
to
beneficiary
of the full
contract
value on
date of
death.
Beneficiary
is taxed on
all future
income and
if under
59½, is
liable for
n
such
Annuitant-Driven: * Some tax authorities hold that, in this case the beneficiary rather
than the owner is liable for all income taxes on the proceeds.
155
II. WHEN SPOUSAL ELECTION IS NOT AVAILABLE
Example 8: In this situation, the annuitant is someone other than the husband or
wife. To qualify for the spousal election, the beneficiary must be the deceased
owner’s spouse. In this case, if the annuitant dies, the owner is not deceased, so
the spousal election is not available.
Owner
H
Annuitant
X
Beneficiary
W
1st
Death
X
Federal
Income
Federal
Tax
Estate Tax
None. Not
Deferred
included in
income
annuitant’s
taxed as
estate.
ordinary
income to
2) Defer
Assumes that
wife as
distribution for
annuitant is
up to 5 years, received.
U.S. Citizen.
If wife is
3) Annuitize
under 59½,
within one
she may
year.
have to pay
the 10%
penalty tax.
Contract
Disposition
W can:
1) Take lump
sum,
Husband is
not taxed
on income
due to the
fact that
this is a
transfer to
his spouse
(see IRC §
1041).
Annuitant-Driven
156
Federal Gift
Tax
Amount to a
gift from
Husband to
wife.
Assuming
Wife is a
U.S. Citizen,
it qualifies
for the
marital
deduction.
II.
WHEN SPOUSAL ELECTION IS NOT AVAILABLE
Example 9: This is the same structure as that of Situation No. 2 earlier. If the
wife-annuitant dies, the husband does not qualify to continue the contract as the
spouse of the deceased owner. However, if this was an owner-driven contract and
the wife-annuitant died, the contract would continue. The husband could either
become the annuitant or name a new annuitant.
Contract
Federal
Federal
Owner Annuitant Beneficiary 1st Death Disposition Income Tax Estate Tax
None
Deferred
Husband can:
H
W
H/W
W
income
1) Take lump
taxed as
sum,
ordinary
2) Defer
distribution for income to
up to 5 years Husband as
received.
OR
3) Annuitize
within one year If Husband
Note: This is under age
provision is 59½, he may
contractual and have to pay
the 10%
not a federal
penalty tax
income tax
as well.
requirement.
Federal
Gift
Tax
None
Annuitant-Driven: In this arrangement, at the wife’s death, who is also the annuitant, the death benefit would be forced to be taken
by the contract provisions. Spousal election would be lost because of the death of the annuitant.
Contract
Federal
Federal
Owner Annuitant Beneficiary 1st Death Disposition Income Tax Estate Tax
None
None
Wife may elect
to
continue
the
H
W
H/W
H
contract.
Federal
Gift
Tax
None
See case No. 2
Note: This
provision is
contractual and
not a federal
income tax
requirement.
Annuitant-Driven: In this arrangement, which is similar to arrangement 2, at the death
of the husband who is also the owner, the wife may elect to continue the contract.
157
II.
WHEN SPOUSAL ELECTION IS NOT AVAILABLE
Example 10: In this situation, if the wife dies, the husband may not continue the
contract. The contingent beneficiary will receive the proceeds of the contract.
However, if the husband dies, spousal election to continue the contract is possible,
since the wife would be the deceased owner’s spouse and primary beneficiary.
Note: Provisions of the contract not a requirement of IRC § 72(a) when Wife
dies. First reason, Husband is owner and he has not died. IRC § 72(s) requires
distribution only upon owner’s death.
1st
Owner Annuitant Beneficiary Death
H
W
W
W
Contingent
Beneficiary
X
Contract
Federal
Federal
Disposition
Income Tax Estate Tax
Deferred
X can:
None
1) Take lump sum, income taxed
as ordinary
2) Defer distribution income to
for up to 5 years. husband in
year of wife’s
death. If
OR
husband is
3) Annuitize within under age
59½ he may
one year for a
period no longer have to pay
than the contingent 10% penalty
tax on any
beneficiary’s life
gain, which
expectancy.
existed until
spouse's
Note: This
death.
provision is
contractual and not
a federal income Beneficiary is
tax requirement. taxed on all
future income
and if under
59½, is liable
for 10%
penalty on
such
amounts.
Federal
Gift Tax
Upon wife’s
death,
husband
potentially
made a
taxable gift
to
contingent
beneficiary
of the full
contract
value on
date of
death.
Contingent
beneficiary
may be
entitled to
IRC § 691(c)
deduction.
Annuitant-Driven: In this arrangement, the annuitant and the beneficiary is the wife.
158
At her death, the proceeds of the contract would be paid to the contingent beneficiary,
who is not the husband. The husband, who is the owner, would not be able to continue
the contract. The contract must be paid out under the contract provisions.
II.
WHEN SPOUSAL ELECTION IS NOT AVAILABLE
Example 11: This is an example of an owner-driven contract. If the Annuitant
dies, there is no distribution and the contract continues. If owner dies, there is a
distribution and spousal election is not available.
Federal
Federal Federal
Contract
Income
Estate
Gift
Owner Annuitant Beneficiary 1st Death Disposition
Tax
Tax
Tax
Contract
None
None
None
H
W
X
W
continues;
Child
husband/owner
may become
the annuitant
or, depending
on the contract,
may name
another
annuitant.
Deferred Value of None
Child can:
H
W
X
H
income contract is
Child
1) Take lump taxed as included in
ordinary husband’s
sum,
income to
gross
child as
2) Defer
estate.
distribution for received.
up to 5 years
Child may
be entitled
OR
to IRC §
3) Annuitize
691(c)
within one
deduction
year.
Owner-Driven: In the first arrangement, at the death of the wife who is the annuitant
would not force the distribution of the contract. The owner, who is the husband can name
a new annuitant and continue the contract. However, in the second arrangement, upon
the death of the husband, who is the owner, a death benefit distribution would be paid to
the beneficiary, the child. Under contract provisions the policy cannot continue for the
surviving spouse who is the annuitant and not the beneficiary.
159
III. ANNUITIES INVOLVING TRUSTS
Example 12: In these cases, the trust is a grantor trust, with the husband the
grantor. At the owner’s death, the trust receives the proceeds and manages or
distributes the proceeds according to the trust agreement. Note: Again 72 (s) does
not require distribution in this situation. Assume trust becomes owner upon
Wife’s death. IRC § 72 (e)(4)(c) should apply & Federal income tax treatment
would be the same as Example 10.
Contract
Federal
Federal
Federal
Owner Annuitant Beneficiary 1st Death Disposition
Income Tax
Estate Tax Gift Tax
Deferred
Contract value None
1) Take lump
H
W
T
H
income taxed included in H’s
sum,
as ordinary
estate.
or
income to trust
2) Defer
distribution for as received.
up to 5 years.
At Husband’s
death, trust
ceased to be a
grantor trust
and becomes
an irrevocable
trust.
Not in W's
None
Deferred
1) Take lump
H
W
T
W
estate.
income taxed
sum,
to H in year of
2) Defer
distribution for W’s death or
over
up to 5 years
annuitization
OR
3) Annuitize period. If under
within one year. 59½, may be
subject to 10%
penalty.
Note: This
(Taxed as
provision is
ordinary
contractual and
income).
not a federal
income tax
requirement.
Annuitant-Driven
160
III. ANNUITIES INVOLVING TRUSTS
Example 13: Assume the trust is a grantor trust, with the husband the grantor.
The same trust is both the owner and beneficiary. This structure may be useful to
clients who have been advised to handle the ownership of assets including their
annuities, by means of a trust. Note: Need to be careful here, in Grantor trust
situations, insurer needs to know who grantor is because the grantor is the owner
of annuity for tax purposes and their death will trigger IRC 72 (s) not annuitant’s
if a different person.
Owner Annuitant Beneficiary 1st Death
T
H
T
H
Contract
Disposition
Trust can:
Federal
Federal
Federal
Income Tax
Estate Tax Gift Tax
None
Because
Deferred
income taxed husband is the
grantor of
1) Take lump sum as ordinary
income to trust, the value
may be
trust as
OR
included in
received.
Husband’s
2) Defer
estate.
distribution for up A 10% penalty
to 5 years.
would apply if
the grantor of Not all grantor
trusts require
trust were
inclusion in
someone
other than the gross estate of
grantor.
husband.
IRC§ 691
may be
available
Annuitant-Driven: Note: In this example Husband is the owner for tax purposes, not
the trust because the grantor Trust is treated as the owner of the assets held by the trust
for tax purposes.
161
III. ANNUITIES INVOLVING TRUSTS
Example 14: In this case, the owner and beneficiary are NOT the same trust.
Both trusts are grantor trusts.
Owner Annuitant
T
H
Federal
Contract
Income
Federal Federal
Beneficiary 1st Death Disposition
Tax
Estate Tax Gift Tax
Deferred If husband May apply
Trust can:
T
H
on funding
is the
income
1) Take lump
taxed as grantor of if grantor
sum
trust is
ordinary the owner
OR
income to trust, then irrevocable
2) Defer
value of
distribution for trust as
the
up to 5 years. received.
contract
3) Annuitize
within one If contract is may be
continued, included in
year.
income Husband’s
4) If
estate.
taxes
beneficiary
remain
trust is a
grantor trust deferred.
where the
IRC § 691
wife is the
(c)
grantor, then
the wife may deduction
may be
continue the
available.
contract.
Annuitant-Driven
162
III. ANNUITIES INVOLVING TRUSTS
Example 15: In this case, the trust is a grantor trust. If the wife dies, the child
will receive the proceeds of the contract.
Federal Federal
Federal
Estate
Gift
Owner Annuitant Beneficiary 1st Death
Income Tax
Tax
Tax
None. Not None
Deferred
T
W
X
W
income taxed in wife’s
Child
estate.
as ordinary
1) Take lump
income to
sum
child, in the
OR
year of the
2) Defer
distribution for wife’s death or
over
up to 5 years.
annuitization
3) Take
period.
distributions over
his or her life
If child is
expectancy.
under age 59
½, he or she
may be
subject to
10% penalty
tax.
Contract
Disposition
Child can:
Annuitant-Driven
Example 16: This structure can be used when a client wants an irrevocable
Charitable Remainder Trust (CRT) to own the contract and receive the proceeds.
The income beneficiary of the trust should be the annuitant. At the death of the
annuitant, the proceeds will be paid to the CRT and then be distributed to the
charity according to the trust document.
1st
Death
Owner Annuitant Beneficiary
X
T
Annuitant
T
Recipient
of income
from CRT
Contract
Disposition
CRT can:
Federal
Income Tax
CRT is taxexempt.
1) Take lump
Income is
sum
taxable at
OR
distribution
2) Defer
under CRT
distribution for up tax rules.
to 5 years.
Annuitant-Driven
163
Federal
Estate Federal
Tax
Gift Tax
None
None
IV. GIFT OF AN ANNUITY CONTRACT
Example 17: These are the tax implications when the owner makes a gift of the
annuity contract. The example is the common structure where husband is both
owner and annuitant, with the wife the beneficiary.
Owner
H
Annuitant
H
Beneficiary
X
Contract
Disposition
Gift to W
W
W
H
Gift to H
H
H
W
W
W
H
Federal
Income
Federal
Federal
Tax
Estate Tax
Gift Tax
None. There
None
Qualifies for the
is no income
unlimited marital
tax due on
deduction
gifts to a
assuming
spouse.
donee/spouse is
a U.S. citizen.
IRC § 1041
Same as
above
None
Same as above.
Gift to
Owner/donor
someone other taxed on gain
than spouse. at time of gift
(cash
surrendervalue basis).
May be
subject to
penalty tax if
under age
59½.
None
Donor has made
a gift equal to the
cash surrender
value of annuity.
Donee’s basis is
equal to the cash
surrender value
of the annuity at
the time of the
gift.
Gift to
someone other
than spouse
None
Same as above
Same as
above
Owner –Driven or Annuitant-Driven
164
V. ANNUITIES WHERE PARTIES ARE NEITHER
SPOUSES NOR TRUSTS
Example 18: The two parties, “X” and “Y,” are not meant to be gender-specific.
They could be either male or female, but they are not husband and wife.
.
Owner Annuitant
X
X
X
X
Contract
Beneficiary 1st Death Disposition
1) Take lump
Y
X
sum,
2) defer
distribution for
up to 5 years,
or
3) annuitize
within one
year.
Y
Y
Contract
remains
intact, but a
new
beneficiary
should be
named.
Annuitant-Driven
165
Federal
Income
Federal Federal
Tax
Estate Tax Gift Tax
None
Deferred Contract
value
income
taxed to Y included in
X’s estate.
as
received.
(Taxed as
ordinary
income).
May be
entitled to
IRC 691(c)
deduction.
None
None
None
V.
ANNUITIES WHERE PARTIES ARE NEITHER
SPOUSES NOR TRUSTS
Example 19: Two parties, “X” and “Y,” are not meant to be gender-specific.
They could be either male or female, but they are not husband and wife.
Owner Annuitant Beneficiary 1st Death
X
Y
X
X
X
Y
X
Y
Contract
Disposition
Federal
Income Tax
Federal Federal
Estate Gift Tax
Tax
X’s estate can:
Deferred
Contract
None
1) Take lump sum, income taxed
value
OR
as ordinary included in
2) Defer
income to X’s X’s gross
distribution for up
estate as
estate.
to 5 years.
received.
IRC 691(c)
deduction
may be
available.
None.
Deferred
Value of
income is
contract is
taxed as
1) Take lump sum
not
ordinary
2) Defer
distribution for up income to X included in
“Y’s”
as received.
to 5 years,
estate.
OR
3) Annuitize within If X is under
59½, he or
one year.
she may have
Contract not IRC § to pay 10%
penalty tax.
72 (s) driven
requirements.
X can:
Annuitant-Driven
166
None
VI. JOINT OWNERS AND/OR JOINT ANNUITANTS
Example 20: In this case, husband and wife are joint annuitants. Caution: Some
annuitant-driven contracts pay the enhanced death benefit only at the second
annuitant’s death. In this example, when the husband dies, who is also the owner,
IRS rules force a distribution to the beneficiary. It may mean no enhanced death
benefit is paid. Once again the importance of knowing your contracts!
Contract
Federal
Joint
1st Death
Disposition
Income Tax
Owner Annuitants Beneficiary
Child can:
Deferred
H
H/W
X
Husband dies,
income
Child
or Husband and 1) Take lump sum, taxed as
Wife die
ordinary
simultaneously.
OR
income to
child as
2) Defer distribution received.
for up to 5 years
IRC 691(c)
3) Annuitize within deduction
one year.
may be
available.
H
H/W
X
Child
W
Contract continues;
husband is still the
owner and
annuitant because
contract pays out
death benefit only
upon death of 2nd
joint annuitant.
Owner has not died
so IRC § 72(s) is
not implicated in
this situation.
Owner-Driven or Annuitant-Driven
167
None
Federal Federal
Estate
Gift
Tax
Tax
Contract None
value
included in
husband’s
gross
estate.
None.
None
VI. JOINT OWNERS AND/OR JOINT ANNUITANTS
Example 21: In this case, husband and wife are both joint owners and joint
annuitants. If either dies, the beneficiary will receive the entire value of the
contract, but will be taxed on just half of the earnings because only ½ of the
contract is distributed by contract terms.
Joint
Joint
Owners Annuitants Beneficiary
H and W H and W
X
Child
1st
Death
Either
H or W
dies
Contract
Disposition
Child can:
1) Take lump
sum,
OR
2) Defer
distribution for
up to 5 years
3) Annuitize
within one
year.
H and W
H and W
X
Child
H and W
Die
simultaneously
Child can:
Same as
above
Federal
Federal
Federal
Income Tax Estate Tax Gift Tax
Decedents Assuming Survivor’s
surviving share is a
deferred
income taxed spouse is a taxable gift.
U.S.
as ordinary
income to Citizen 1/2
of the
child as
contract
received.
value is
IRC 691(c)
deduction included in
decedent’s
may be
gross
available.
estate.
Survivor’s
deferred
income taxed
as ordinary
income to
him or her in
year of death.
Joint owners’
respective
shares of
income
correspond to
their
respective
shares of
premium
payments.
Deferred
Deceased
None
income taxed spouses’
as ordinary shares of
income to
value of
child as
contract
received
are
IRC 691(c) included in
deduction
each of
may be
their
available.
estates.
Owner-Driven or Annuitant-Driven
168
VI. JOINT OWNERS AND/OR JOINT ANNUITANTS
Example 22: Wife and child are joint annuitants when owner/beneficiary
husband dies. This arrangement is not recommended.
Joint
Owner Annuitants
H
Wife and
Child
Beneficiary
H
1st
Death
H dies
Contract
Disposition
Contract
Husband’s estate
Deferred
value
can:
income taxed
as ordinary included in
1) Take lump sum, income to husband’s
gross
husband’s
estate.
OR
estate as
received.
2) Defer distribution
for up to 5 years.
May be
available
IRC 691(c)
deduction.
Owner-Driven or Annuitant-Driven
169
Federal
Federal Federal
Income Tax Estate Tax Gift Tax
None
Chapter 8
Review Questions
1. Deciding whom to name as the owner, annuitant and the beneficiary of an annuity
contract is commonly called what?
(
(
(
(
) A. Taxation structure
) B. Contract structure
) C. Annuitization structure
) D. Annuity classification
2. What is the most critical point for an agent to remember about annuity contracts?
(
(
(
(
) A. They are impossible to understand
) B. They are all easy to understand
) C. They are all different
) D. They are all created equal
3. When structuring an annuity contract it is probably best to:
(
(
(
(
) A. Keep it simple
) B. Keep it complex
) C. Name the trust as the annuitant
) D. Name the estate as beneficiary
4. Under an annuitant-driven (AD) contract the death benefit would be paid at whose
death?
(
(
(
(
) A. Death of the owner only
) B. Death of the beneficiary only
) C. Death of either the annuitant and/or owner
) D. Death of the contingent beneficiary only
5. Which of the following statement is true about the “enhanced death benefit” feature
available in some variable annuity contracts?
(
(
(
(
) A. It is paid upon the death of the annuitant only
) B. It is paid upon the death of the contract owner only.
) C. It is paid according to the provisions of the contract
) D. None of the above
170
SECTION II
ETHICAL MARKETING PRACTICES
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CHAPTER 9
ETHICS
Overview
Today, an increasing amount of States now require insurance producers and brokers to be
tested as part of their continuing education requirement in the area of ethics. The purpose
of this is twofold. One, licensed professionals are held to a higher level of legal
responsibility to the general public and more specifically to their clients. Two, by
standardizing ethics practices the insurance producer (agent) will run into less risk of
unethical practice suits by the general public.
In this chapter, we will define what ethics is and is not. It will also examine the
importance of ethics in every-day life, and how to develop standards to assist us in
making ethical decisions.
Learning Objectives
Upon completion of this chapter, you will be able to:







Define ethics;
Demonstrate the importance of ethics;
Determine what is not ethics;
Distinguish between the five different ethical standards;
Identifying the various methods for exploring ethical dilemmas and identifying
ethical courses of action;
Apply the Golden Rule in you day to day activities; and.
Demonstrate the general ethical standards in which to live by and work by.
Ethics Defined
Ethics is the branch of study dealing with what is the proper course of action for man. It
answers the question “What do I do?” It is the study of right or wrong in human
endeavors. At a more fundamental level it is a method by which we categorize our
values and pursue them.
The study of ethics can be traced back to the Greeks, who attempted to categorize fallible
human behavior against divine ideals. Our word ethics is derived from two Greek
antecedents:
173


“ethikos”, or correct social behavior; and
“ethos”, or character.
Today, if you were to search for a definition of ethics in a dictionary you’ll find that
ethics is defined as:


Ethics (n.1) “The science of human duty’s; the body of rules of duty drawn from
this science; a particular system of principles and rules concerning duty, whether
true or false; rules of practice in respect to a single class of human actions; as
political or social ethics; medical ethics.” (Webster (1913) Dictionary)
Ethics (used with sing. verb or pl. verb): “The study of the general nature of
morals and of the specific moral choice to be made by a person; moral
philosophy. The rules of standards governing the conduct of a person or the
members of a profession.” (American Heritage Dictionary)
According to the Josephson Institute ethics is defined as:
“Standards of Conduct that indicate how one should behave based on moral
duties and values.”
So then, ethics refers to principles that define behavior as right, good and proper. Such
principles do not always dictate a single “moral” course of action, but provide a means of
evaluating and deciding among competing options. Ethics is not just what is imposed by
law, not just what is defined in a company policy, not just what is written into a code.
Ethics is more than what is expected by civilized society. Ethics rises above each and all,
of those standards. Ethics is the choice to do what is right, not because it is required or
expected but because it is RIGHT. That requires making sometimes hard decisions. But
therein is ethics.
Why is Ethics Important?
Ethics is so important because it is a requirement for human life. It is the means of
deciding a course of action. Without it, your actions, not just as an insurance producer
but in everyday life, would be random and aimless. There would be no way to work
towards a goal because there would be no way to pick between a limitless numbers of
goals. Even with an ethical standard, we may be unable to pursue our goals with the
possibility of success. To the degree which a rational ethical standard is taken we are
able to correctly organize our goals and actions to accomplish our most important values.
Any flaw in our ethics will reduce our ability to be successful in our endeavors.
Taking this course and other courses on ethics will, hopefully, help insurance producers
make the right decision when they find themselves in ambiguous, confusing and
otherwise difficult situations, such as situations that present a conflict of interest or
situations that may be perfectly legal but not necessarily ethical. Such situations are so
174
common that many clients say ethical behavior is the number one characteristic they want
in their insurance producer. Strong ethical behavior is an invaluable characteristic to an
insurance producer’s success. Ethical insurance producers immediately gain the trust,
respect, and loyalty of their clients. Such clients provide additional business and valuable
referrals.
Ethical behavior is a key ingredient to the success of every insurance producer and to the
insurance industry as a whole.
Identifying What Is Not Ethics
It is also important to identify what ethics is NOT:





Ethics is not the same as feelings. Feelings provide important information for our
ethical choices. Some people have highly developed habits that make them feel
bad when they do something wrong, but many people feel good even though they
are doing something wrong. And often our feelings will tell us it is
uncomfortable to do the right thing if it is hard.
Ethics is not religion. Many people are not religious, but ethics applies to
everyone. Most religions do advocate high ethical standards but sometimes do
not address all the types of problems we face.
Ethics is not following the law. A good system of law does incorporate many
ethical standards, but law can deviate from what is ethical. Law can become
ethically corrupt, as some totalitarian regimes have made it. Law can be a
function of power alone and designed to serve the interests of narrow groups.
Law may have a difficult time designing or enforcing standards in some important
areas, and may be slow to address new problems.
Ethics is not following culturally accepted norms. Some cultures are quite ethical,
but others become corrupt -or blind to certain ethical concerns (as the United
States was to slavery before the Civil War). "When in Rome, do as the Romans
do" is not a satisfactory ethical standard.
Ethics is not science. Social and natural science can provide important data to
help us make better ethical choices, but science alone cannot define ethically
sound behaviors. Science may provide an explanation for human nature, but
ethics provides reasons for how humans ought to act. Just because something is
scientifically or technologically possible, it may not be ethical to do it.
Why Identifying Ethical Standards is Hard
There are two fundamental problems in identifying the ethical standards we are to follow:


On what do we base our ethical standards?
How do those standards get applied to specific situations we face?
175
If our ethics are not based on feelings, religion, law, accepted social practice, or science,
what are they based on? Many philosophers and ethicists have helped us answer this
critical question. They have suggested at least five different sources of ethical standards
we should use. They are:





The Utilitarian Approach. Some ethicists emphasize that the ethical action is the
one that provides the most good or does the least harm, or, to put it another way,
produces the greatest balance of good over harm. The ethical corporate action,
then, is the one that produces the greatest good and does the least harm for all
who are affected-customers, employees, shareholders, the community, and the
environment. The utilitarian approach deals with consequences; it tries both to
increase the good done and to reduce the harm done.
The Rights Approach. Other philosophers and ethicists suggest that the ethical
action is the one that best protects and respects the moral rights of those affected.
This approach starts from the belief that humans have a naturally endowed selfworth and right to freedom of choice. The list of moral rights includes the right to
choose one’s life path, to be told the truth, to not be injured, to a degree of
privacy, and so on. This is widely debated. Some argue that non-humans have
rights, as well. Also, it is often said that rights imply duties; in particular, the duty
to respect others' rights.
The Fairness or Justice Approach. Aristotle and other Greek philosophers have
contributed the idea that all equals should be treated equally. Today we use this
idea to say that ethical actions treat all human beings equally-or if unequally, then
fairly based on some standard that is defensible. We pay people more based on
their harder work or the greater amount that they contribute to an organization,
and say that is fair.
The Common Good Approach. The Greek philosophers have also contributed the
notion that community is a good in itself and our actions should have a positive
contribution. This approach suggests that the interlocking relationships of society
are the basis of ethical reasoning and that respect and compassion for all others,
especially the vulnerable, are requirements of such reasoning. This approach also
calls attention to the common conditions that are important to the welfare of
everyone. This may be a system of laws, effective police and fire departments,
health care, a public educational system, or even public recreational areas.
The Virtue Approach. A very ancient approach to ethics is that ethical actions
ought to be consistent with certain ideal virtues that provide for the full
development of our humanity. These virtues are dispositions and habits that
enable us to act according to the highest potential of our character and on behalf
of values like truth and beauty. Honesty, courage, compassion, generosity,
tolerance, love, fidelity, integrity, fairness, self-control, and prudence are all
examples of virtues. Virtue ethics asks of any action, "What kind of person will I
become if I do this?" or "Is this action consistent with my acting at my best?"
Each of the above approaches helps us determine what standards of behavior can be
considered ethical. There are still problems to be solved, however.
176
The first problem is that we may not agree on the content of some of these specific
approaches. We may not all agree to the same set of human and civil rights. We may not
agree on what constitutes the common good. We may not even agree on what is a good
and what is a harm.
The second problem is that the different approaches may not all answer the question
"What is ethical?" in the same way. Nonetheless, each approach gives us important
information with which to determine what is ethical in a particular circumstance. And
much more often than not, the different approaches do lead to similar answers.
Making Ethical Decisions
As an insurance producer/financial advisor, you are constantly put on the spot to make
ethical decisions. So, how do you know if the decision you are about to make is ethical?
According to the Markkula Center for Applied Ethics at Santa Clara University
(www.scu/edu/ethics-center/), making good ethical decisions requires a trained sensitivity
to ethical issues and a practiced method for exploring the ethical aspects of a decision and
weighing the considerations that should impact our choice of a course of action. Having
a method for ethical decision making is absolutely essential. When practiced regularly,
the method becomes so familiar that we work through it automatically without consulting
the specific steps.
The more novel and difficult the ethical choice we face, the more we need to rely on
discussion and dialogue with others about the dilemma. Only by careful exploration of
the problem, aided by the insights and different perspectives of others, can we make good
ethical choices in such situations. Here is a framework recommended by the Markkula
Center for Applied Ethics that can be a useful method for exploring ethical dilemmas and
identifying ethical courses of action.



Recognize an Ethical Issue.
o Could this decision or situation be damaging to someone or to some
group? Does this decision involve a choice between a good and bad
alternative, or perhaps between two "goods" or between two "bads"?
o Is this issue about more than what is legal or what is most efficient? If so,
how?
Get the Facts.
o What are the relevant facts of the case? What facts are not known? Can I
learn more about the situation? Do I know enough to make a decision?
o What individuals and groups have an important stake in the outcome? Are
some concerns more important? Why?
o What are the options for acting? Have all the relevant persons and groups
been consulted? Have I identified creative options?
Evaluate Alternative Actions. Evaluate the options by asking the following
questions:
177


o Which option will produce the most good and do the least harm? (The
Utilitarian Approach)
o Which option best respects the rights of all who have a stake? (The Rights
Approach)
o Which option treats people equally or proportionately? (The Justice
Approach)
o Which option best serves the community as a whole, not just some
members? (The Common Good Approach)
o Which option leads me to act as the sort of person I want to be? (The
Virtue Approach)
Make a Decision and Test It
o Considering all these approaches, which option best addresses the
situation?
o If I told someone I respect which option I have chosen, what would they
say?
Act and Reflect on the Outcome
o How can my decision be implemented with the greatest care and attention
to the concerns of all stakeholders?’
o How did my decision turn out and what have I learned from this specific
situation?
Let me share with you another ethical guide you should consider using when making
ethical decisions, it’s called—“The Four-Way Test”.
The Four-Way Test
The 4-Way Test was designed by businessman Herbert J. Taylor in 1932 as a foundation
to use for ethical decision making. The Rotary International adopted the test in the
1940’s. Since that time, the test has been introduced in schools, governments and
businesses worldwide, as a yardstick for principle-based living. Ask yourself the
following:




First: Is it the TRUTH?
Second: Is it FAIR to all concerned?
Third: Will it build GOODWILL & BETTER FRIENDSHIP?
Fourth: Will it be BENEFICIAL to all concerned?
The Four-Way Test can serve us as a trusted ethical guide. Through it, you are pointed to
the ethics of principle. Through it you are pointed to the ethics of practicality. But as
responsible, insurance producers, you are trusted to recognize the differences. You are
expected to apply both principle and practicality in an ethically mature way.
It is not enough that you ASK the four questions. It is not enough that you make a
decision based on some ONE of the questions. The Four-Way Test is not only your call
to lofty principles and to beneficial practicality – it is your challenge to combine them in
ethically responsible decisions and actions.
178
Next let’s review probably the most famous ethical principle: The Golden Rule.
The Golden Rule
The most famous ethical principle is the golden rule, which states
“Do unto others as you would have them do to you.”
Known as “the golden rule,” this rule implies that an ethical person is concerned not only
with themselves but also with the well-being of others. This principle describes a
"reciprocal", or "two-way", relationship between one's self and others that involves both
sides equally, and in a mutual fashion. This entails always being honest, keeping
promises, and respecting people and property.
The Golden Rule has a history that long predates the term "Golden Rule", or "Golden
law", as it was called from the 1670s in England and Europe. As a concept of "the ethic
of reciprocity," it has its roots in a wide range of world cultures, and is a standard way
that different cultures use to resolve conflicts. It has a long history, and a great number
of prominent religious figures and philosophers have restated its reciprocal, "two-way"
nature in various ways (not limited to the above forms).
This principle can be explained from the perspective of psychology, philosophy,
sociology and religion.



Psychologically, it involves a person empathizing with others. Philosophically, it
involves a person perceiving their neighbor as also an “I” or “self.”
Sociologically, this principle is applicable between individuals, between groups,
and also between individuals and groups. (For example, a person living by this
rule treats all people with consideration, not just members of his or her in-group.)
Religions figure prominently in the history of this concept.
The golden rule is endorsed by all the great world religions; Jesus, Hillel, and Confucius
used it to summarize their ethical teachings (see Table 9.1). And for many centuries the
idea has been influential among people of very diverse cultures. These facts suggest that
the golden rule may be an important moral truth.
All versions and forms of the proverbial Golden Rule have one aspect in common: they
all demand that people treat others in a manner in which they themselves would like to be
treated.
179
Table 9.1
“Ethic of Reciprocity” Passages from Various Religions
Religion
Bahá'í Faith
Brahmanism
Buddhism:
Christianity
Confucianism
Ancient Egyptian
Hinduism
Islam
Jainism:
Judaism
Taoism
Passage
"Ascribe not to any soul that which thou wouldst not have ascribed to
thee, and say not that which thou doest not." "Blessed is he who
preferreth his brother before himself." Baha'u'llah
"This is the sum of Dharma [duty]: Do naught unto others which would
cause you pain if done to you". Mahabharata, 5:1517 "
"...a state that is not pleasing or delightful to me, how could I inflict that
upon another?" Samyutta NIkaya v. 353 Hurt not others in ways that
you yourself would find hurtful." Udana-Varga 5:18
"Therefore all things whatsoever ye would that men should do to you,
do ye even so to them: for this is the law and the prophets." Matthew
7:12, King James Version.
"And as ye would that men should do to you, do ye also to them
likewise." Luke 6:31, King James Version.
"...and don't do what you hate...", Gospel of Thomas 6. The Gospel of
Thomas is one of about 40 gospels that circulated among the early
Christian movement, but which never made it into the Christian
Scriptures (New Testament).
"Do not do to others what you do not want them to do to you" Analects
15:23
"Tse-kung asked, 'Is there one word that can serve as a principle of
conduct for life?' Confucius replied, 'It is the word 'shu' -- reciprocity.
Do not impose on others what you yourself do not desire.'" Doctrine of
the Mean 13.3
"Try your best to treat others as you would wish to be treated yourself,
and you will find that this is the shortest way to benevolence." Mencius
VII.A.
"Do for one who may do for you, that you may cause him thus to do."
The Tale of the Eloquent Peasant, 109 - 110 Translated by R.B.
Parkinson. The original dates to circa 1800 BCE and may be the earliest
version of the Epic of Reciprocity ever written.
“This is the sum of duty: do not do to others what would cause pain if
done to you.” Mahabharata 5:1517
"None of you [truly] believes until he wishes for his brother what he
wishes for himself." Number 13 of Imam "Al-Nawawi's Forty Hadiths."
"Therefore, neither does he [a sage] cause violence to others nor does he
make others do so." Acarangasutra 5.101-2.
"In happiness and suffering, in joy and grief, we should regard all
creatures as we regard our own self." Lord Mahavira, 24th Tirthankara
"A man should wander about treating all creatures as he himself would
be treated. "Sutrakritanga 1.11.33
"...thou shalt love thy neighbor as thyself.", Leviticus 19:18
"What is hateful to you, do not to your fellow man. This is the law: all
the rest is commentary." Talmud, Shabbat 31a.
"And what you hate, do not do to any one." Tobit 4:15
“Regard your neighbor’s gain as your gain, and your neighbor’s loss as
your own loss.” Tai Shang Kan Yin P’ien
"To those who are good to me, I am good; to those who are not good to
me, I am also good. Thus all get to be good."
180
Zoroastrianism
"That nature alone is good which refrains from doing to another
whatsoever is not good for itself." Dadisten-I-dinik, 94,5
"Whatever is disagreeable to yourself do not do unto others." Shayastna-Shayast 13:29
Next, let’s review the ten “Ethical Hazard Approaching” signs that have been developed
by the Josephson Institute of Ethics to help individuals gauge their ethical decision
making and 5-questions to ask yourself every day.
The Ten “Ethical Hazard Approaching” Signs
Michael Josephson, founder of the Josephson Institute Center for Business Ethics,
highlights ten common rationalizations for unethical acts that serve as “ethical hazard
approaching” signs. Each of the ten rationalizations contains additional contextual
information that someone believes outweighs the initial gut feeling that the action is
unethical.
Beware when someone says:










It may seem unethical…but it is legal and permissible.
It may seem unethical…but it is necessary.
It may seem unethical…but i6t is just part of the job.
It may seem unethical…but it is all for a good cause.
It may seem unethical…but I am just doing it for you.
It may seem unethical…but I am just fighting fire with fire.
It may seem unethical…but it doesn’t hurt anyone.
It may seem unethical…but everyone else is doing it.
It may seem unethical…but I don’t gain personally.
It may seem unethical…but I’ve got it coming.
Everyday Ethics
Thomas Shanks, S.J., Ph.D., Executive Director of the Markkula Center for Applied
Ethics, recommends that everyone ask themselves these five questions at the end of the
day.
o
o
o
o
o
Did I practice any virtues (e.g., integrity, honesty, compassion)?
Did I do more good than harm?
Did I treat others with dignity and respect?
Was I fair and just?
Was my community better because I was in it? Was I better because I was in my
community?
181
Ethics Self Examination
The adage, “an ounce of prevention is worth a pound of cure” applies well to market
conduct and compliance. To meet one’s compliance responsibilities effectively and
efficiently, compliance and market conduct activities need to be an integral part of an
insurance producer’s/financial advisor’s operation and should not be a “tacked on”
afterthought. A good way to integrate compliance and market conduct responsibilities
into your normal business routine is to build compliance related activities into your plans
so that they get accomplished along with everything else. Here are some specific tips in
building compliance into your plans:
Determine your annual goals — incorporate compliance into your overall business goals.
To identify what your important compliance goals may be, consider the following:







Review compliance audit results for the last two or three years. What areas did
auditors focus on for further development? Were there barriers to being prepared
for the audit and how could they have been avoided?
Review compliance issues that may have arisen in the previous year. For example,
what company procedures created frustration and confusions for you or your
administrative staff?
Assess whether there are any compliance or market conduct issues that need to be
considered with products that will be sold in the coming year.
What are the continuing education requirements of the states in which you hold a
license and what is the timing for meeting these requirements?
Consider the markets you work in and whether there are compliance risks in those
markets?
Develop plans for achieving your goals. If you plan to facilitate a seminar, be sure
to include the need to obtain approved seminar materials in a timely manner. Or,
plan on hiring a new administrative associate, build into the plan the necessary
compliance training that he or she will need.
Create a compliance calendar — this can be a valuable tool for managing
compliance activities, due dates, and responsibilities and serve as a reminder of
key due dates. Some activities that should be listed on a compliance calendar
include:
o Removing old sales materials
o Updating manuals and procedures
o Preparing for company audits
o Attending local industry association meetings
o Attending required training programs
o Reviewing changes in laws and regulations using information
communicated by companies
o Meeting continuing education requirements
By making compliance part of your overall plan, it is more likely that you will implement
your compliance goals and reap the benefits of having them in place.
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General Ethical Principles to Live By and Work By
Here is a list of general ethical principles that a professional insurance producer should
live by and work by every day.
Honesty
There is no more fundamental ethical value than honesty. Honesty is a cornerstone of
ethical behavior, for it means “telling the truth.” Someone who is honest takes care not to
deceive others, either by what they say or what they fail to say. For example, if an
insurance producer told a prospect that a product had a 6% guaranteed return, we
wouldn’t consider that insurance producer honest if the 6% return was guaranteed for
only one year and the insurance producer didn’t make the one-year limit on the guarantee
period clear to the prospect. The statement may have been accurate as far as it went, but
the agent withheld a material fact which would likely result in a misunderstanding on the
part of the prospect. Honesty requires telling the whole truth.
Earl Nightingale once considered the issue of honesty, and then he said:
“Every time you do something less than honest, you‘re throwing a boomerang.
How far it will travel no one knows. How great or small a circle it will travel only
time will tell. But it will eventually, it must finally, it will inevitably, come around
behind you and deliver a blow to you.”
According to Josephson Institute, “…honesty is a broader concept than many may
realize. It involves both communications and conduct.”
Honesty in communication is expressing the truth as best we know it and not conveying
it in a way likely to mislead or deceive. There are three dimensions:



Truthfulness. Truthfulness is presenting the facts to the best of our knowledge.
Intent is the crucial distinction between truthfulness and truth itself. Being
wrong is not the same thing as lying, although honest mistakes can still damage
trust insofar as they may show sloppy judgment.
Sincerity. Sincerity is genuineness, being without trickery or duplicity. It
precludes all acts, including half-truths, out-of-context statements, and even
silence, that are intended to create beliefs or leave impressions that are untrue or
misleading.
Candor. In relationships involving legitimate expectations of trust, honesty
may also require candor, forthrightness and frankness, imposing the obligation
to volunteer information that another person needs to know.
Honesty in conduct is playing by the rules, without stealing, cheating, fraud, subterfuge
and other trickery. Cheating is a particularly foul form of dishonesty because one not
only seeks to deceive but to take advantage of those who are not cheating. It’s a two-for:
a violation of both trust and fairness.
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Honesty has connotations beyond mere communication to all types of action. Honesty
means being fair as well as truthful. Honesty means making sure others receive what they
are entitled to and not accepting things to which one is not entitled. Clients pay for an
objective evaluation of their life insurance needs, for an objective recommendation about
what will best meet their needs, and for ongoing service to assure that their needs are
continually met, and they should get nothing less.
“No man for any considerable period can wear one face to
himself, and another to the multitude without finally getting
bewildered as to which may be true.”
Nathanial Hawthorne
Being honest is essential to creating the kind of trust in the insurance producer-client
relationship that allows consumers to make an affirmative buying decision. Consumers
aren’t going to buy life insurance from an insurance producer they think has been
dishonest with them, nor will they refer that insurance producer to other people they
know. Would you? At the same time, consumers are eager to work with insurance
producers whom they know have made a competent evaluation of their life insurance
needs and an objective recommendation regarding how they should meet those needs. In
addition, insurance producers who handle themselves in an honest and professional
manner have no trouble obtaining referrals to other high quality prospects.
Integrity
Integrity is similar to honesty, but integrity carries with it the connotation of being
incorruptible no matter what the temptation to be dishonest. The word integrity comes
from the same Latin root as “integer” or whole number. Like a whole number, an
insurance producer of integrity is undivided and complete. This means that the ethical
person acts according to his or her beliefs, not according to expediency. The ethical
insurance producer is also consistent. There is no difference in the way he or she makes
decisions from situation to situation; their principles don’t vary at work or at home, in
public or alone. An insurance producer who has integrity does the right thing regardless
of the consequences.
“One man cannot do right in one department of life whilst he is
occupied in doing wrong in any other department. Life is one
indivisible whole.”
Mahatma Gandhi
Some people only want to be honest as long as it doesn’t cost them too much. The price
these people are willing to pay varies. For example, some might be willing to risk losing
a small sale, but not a large one, for the sake of being honest. Some might be willing to
risk losing any size sale, but not their job.
The higher degrees of honesty may be more commendable, but the highest degree of
honesty and the most commendable, is being willing to risk anything and everything for
the sake of being honest. That’s integrity.
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Reliability (Promise-Keeping)
When we make promises or other commitments that create a legitimate basis for another
person to rely upon us, we undertake special moral duties. We accept the responsibility
of making all reasonable efforts to fulfill our commitments. When we make promises to
our clients it is an important aspect of trustworthiness, it is important to:


Avoid bad-faith excuses. Interpret your promises fairly and honestly. Don’t try
to rationalize non-compliance.
Avoid unwise commitments. Before making a promise consider carefully
whether you are likely to keep it. Think about unknown or future events that
could make it difficult, undesirable or impossible. Sometimes, all an insurance
producer can promise is to do their best.
Responsibility
To be responsible is to be reliable and trustworthy. This is an essential element in the
ethic of an insurance producer because, as we have said before, the insurance business is
built on trust. The insurance producer possesses specialized knowledge of needs and
products, which is not easily accessible to the average consumer. As a result, clients must
rely on insurance producers for their professional expertise. Insurance producers have an
ethical obligation to accept and fulfill their responsibilities to the best of their abilities.
When we are responsible we are in charge of our choices and thus, our lives. A
responsible insurance producer knows that they are held accountable for what he or she
does. It also means that the insurance producer recognizes that their actions matter and
that they are morally on the hook for the consequences. Our capacity to reason and our
freedom to choose make us morally autonomous and, therefore, answerable for whether
we honor or degrade the ethical principles that give life meaning and purpose.
An ethical insurance producer shows responsibility by being accountable, pursuing
excellence and exercising self-restraint.
Caring
If you existed alone in the universe, there would be no need for ethics and your heart
could be cold, hard stone. Caring is the heart of ethics and ethical decision making. It is
scarcely possible to be truly ethical and yet unconcerned with the welfare of others. That
is because ethics is ultimately about good relations with people.
Caring is the motivation behind the work of the insurance producer. No amount of
money or recognition is reward enough for the challenges that insurance producers must
face day after day and year after year in their careers. The real payoff is knowing that
they’ve helped people get their financial houses in order: that there will be cash and
income to help keep a surviving family in their own world if a breadwinner should die
prematurely, that a business can keep its doors open and continue to provide jobs and
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services to the community when an owner is taken out of the picture, that individuals will
have resources upon which they can count for the rest of their lives after they retire.
Caring is also the guide that enables insurance producers to act in their clients’ best
interests. If an insurance producer cares about their clients, they will do for their clients
what they would do for themselves if they were in the clients’ situation. Remember the
golden rule – do unto others as you would have them do unto you.
Selflessness
Selflessness is the opposite of selfishness. Selfishness is a concern only with oneself and
a disregard for others. After what we’ve said about caring, you should readily see that the
life insurance business is no place for the selfish. Insurance producers have to put others
first. But because the purpose of the insurance business is to be of service to others,
insurance producers succeed the most by putting others first. By directly serving others’
best interests, they indirectly serve their own interests.
Selflessness also has a connotation of being generous, of giving more than the minimum
required by any situation. Successful insurance producers find that the more they give to
their clients, the more their clients give back to them.
Courage
It takes courage to be ethical. The right thing may always be the best thing in the long
term, but in the short term there may be a price to pay. To be ethical, individuals may
find that they have to stand up to a customer, or to an esteemed colleague, or to a
superior, or even to their families who don’t want to risk the material loss that hewing to
the ethical line might bring. It takes courage to stand up to those persons, whose
expectations we are ordinarily eager to meet.
However, all the good intentions in the world don’t amount to anything unless one acts
on one’s principles. Courage is the quality that converts ethical intention into ethical
action.
On the positive side, courage is a universally admired trait. When individuals
demonstrate that they have the courage to stand up for principle, they win the respect of
their peers, their superiors, their customers, and their family. Individuals who at first feel
alone when faced with an ethical situation requiring courage often end up finding a great
deal of support for having done the right thing.
One situation that takes courage for an insurance producer is declining to work with an
individual with whom the producer feels he or she could not establish a mutually
beneficial professional relationship. For example, an insurance producer may be
introduced to a prospect that doesn’t value ethical behavior. It’s hard to turn down the
possibility of making a sale, but insurance producers must keep in mind that clients are
likely to provide referrals to other people like themselves. Better to give up one sale than
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to try to build a career out of ethically compromised actions. It’s easier and more
profitable for insurance producers to work with ethical people who will appreciate the
value of their services as well as their ethical orientation, and who will refer them to more
people whose values they share.
Excellence
Excellence is the quality of being outstanding. To excel, to be the best one can be,
certainly requires ethical behavior.
Gains obtained through unethical actions are lost eventually, and along with them
reputation, self-esteem, trust, and perhaps the means of making one’s livelihood are also
lost. On the other hand, the ethical individual builds success on solid ground. Gains
obtained in an ethical manner compound themselves through the respect and confidence
of customers and colleagues, and through the energizing effect of self-esteem.
In the insurance business, ethical behavior and excellence go hand in hand. As we
discussed earlier, studies have shown that individuals who value ethical behavior are
generally more successful in their careers than individuals who do not value ethical
behavior.
Knowing that they have helped their clients is the motivation behind the work of all
ethical life insurance producers/financial advisors.
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Chapter 9
Review Questions
1. Ethics answers the question?
(
(
(
(
) A. Who am I?
) B. What do I get?
) C. What do I do?
) D. What are the consequences?
2. The study of ethics began with the:
(
(
(
(
) A. Greeks
) B. Italians
) C. Turks
) D. Spaniards
3. Ethics is the branch of study dealing with:
(
(
(
(
) A. Deciding who is responsible for one’s decisions
) B. The proper course of action for man
) C. Being responsible
) D. Being Irresponsible
4. Which of the following sources of ethical standards is the one that provides the most
good or does the least harm, or, to put it another way, produces the greatest balance of
good over harm?
(
(
(
(
) A.
) B.
) C.
) D.
The Utilitarian Approach
The Right Approach
The Fairness Approach
The Virtue Approach
5. Which of the following is a key ingredient to the success of an insurance producer?
(
(
(
(
) A. Unethical sales practices
) B. Sales to unsuitable clients
) C. Ethical behavior
) D. Generating sales without considering the needs of the client
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CHAPTER 10
ETHICS AND THE INSURANCE INDUSTRY
Overview
As an industry, we need to refocus our attention to our ethical responsibilities. It’s
unfortunate that unethical acts of a relatively few individuals cast a shadow on the
majority of insurance producers who have always conducted themselves according to the
highest ethical standards. The many ethical insurance producers are the people to whom
the insurance industry owes its success, and they deserve some credit.
However, the reality is, there will always be a few “bad apples,” as there will be in any
industry. But we can’t let that be an excuse for complacency. It is important that all
insurance producers understand the ethical dimensions of some of the issues our industry
faces. The goal of ethics education is to create a win-win environment for all parties who
hold a stake in the continuing success of the insurance industry: the insurer and their
employees, insurance producers, policyowners, beneficiaries, the general public, and state
and federal regulators.
In this chapter we will review the history of insurance, the role that insurance plays, and
discuss the most fundamental principle of the insurance industry: trust. It will also
examine the ethical responsibilities of the insurance producer and the insurer.
Learning Objectives
Upon completion of this chapter, you will be able to:




Distinguish the role and importance of insurance to consumers;
Recognize the importance of trust in the insurance industry;
Apply the ethical responsibilities of the insurance producer; and
Identify the ethical responsibilities of the insurer to the insurance producer and to
the consumer.
Let’s first define what insurance is.
Insurance Defined
Insurance is a social device for spreading the chance of financial loss among a large
number of people. By purchasing insurance, a person shares risk with a group of others,
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reducing the individual potential for disastrous financial consequences. Insurance is a
financial asset that helps to reduce those adverse consequences (risks).



Financial definition: A financial arrangement for redistributing the costs of
unexpected losses.
Legal definition: A contractual arrangement whereby one party agrees to
compensate another party for losses.
Bell’s Definition: An economic device whereby insured’s transfer potentially
large uncertain financial risks to the insured group (usually through an insurance
company) in exchange for a relatively small certain payment (the premium).
The Role and History of Insurance
Insurance plays a major role in the lives of most people in the United States. Every day,
all of us face various risks; such as the risk of unemployment, disability, sickness,
premature death, damage or loss of our property, and even living too long. These risks
evolve from uncertainty which result in personal financial loss. Risk is the possibility
that a loss might occur and is one of the reasons that people purchase insurance.
History of Insurance
Insurance originated back in the 13th century with ship owners who wanted to insure their
ships and cargo against the loss at sea. These ship owners met at coffee houses to
transact business with groups of wealthy individuals willing to insure property against
potential loss. The leading coffee house eventually became Lloyd’s of London in the 17th
century. Fire insurance was first offered in the 16th century. In the United States, the
first fire insurance company was started in 1752 by Benjamin Franklin, and was known
as the Philadelphia Contributionship for the Insurance of Houses from Loss by Fire.
The insurance company receives relatively small amounts of money, referred to as
premium, from each of the large number of people buying insurance. A large uncertain
loss is exchanged for a specific small amount of premium.
The agreement between the insurer and the insured, the person covered by the insurance,
is established in a legal document referred to as a contract of insurance or a policy. The
insurer promises to pay the insured according to the term of the policy if a loss occurs.
Loss is defined as reduction in the value of an asset. To be paid for a loss, the insured
must notify the insurer by making a claim. The claim is a “demand” for payment of the
insurance benefits to the person named in the policy.
The costs and benefits of insurance to society are obvious. Due to the sharing, or
pooling, of a large number of similar risks, insurance coverage is available to most
individuals for a reasonably affordable premium. When losses occur, insurance helps
individuals to maintain their customary standard of living, which helps the whole
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economy. Insurance is the device that allows individuals and society in general to
recover from unexpected losses.
It is because of this unique role of insurance that it is more important for the insurance
industry to maintain a high ethical standard.
The Importance of Trust in the Insurance Industry
The basic insurance product is an uncertain promise that the insurer may never be called
upon to fulfill. The value of the promise is based on the trust of the policyholder in the
insurer. Without trust, insurance cannot perform its proper function as a risk
management device for companies and individuals.
No industry depends more on trust than the insurance industry, and this trust comes from
a series of events in which ethical values are demonstrated. For instance, a life insurance
policy might provide coverage for decades, although it’s only a piece of paper. That
piece of paper, however, commands a series of premium payments totaling thousands of
dollars over many years. The same piece of paper, in return, promises a large payment
sometime in the future. Trust is a fundamental principle of insurance.
“To be trusted is a greater compliment than to be loved”
George MacDonald
However, year after year, consumers have rated insurance companies as one of the lowest
industries when it comes to trust. In fact it is well documented that the level of trust in
the financial and insurance services industry remains unchanged and relatively low. For
example, The 2014 Edelman Trust Barometer rates the financial/insurance services at the
bottom of the table of trusted industries, well below even sectors such as energy,
pharmaceuticals and brewing and spirits. According to the Edelman Trust barometer, the
best that can be said is that the level of trust has increased slightly – but by just 1% on
average globally over the past year. Clearly, financial institutions face a huge task to
convince the world that they are changing and establishing some integrity in their
operations.
Only 48% of people globally trust financial services, according to the Edelman Trust
Barometer 2014 – a global survey of attitudes to banks, insurers, other financial
institutions and other industries. New York based public relations firm Edelman has been
surveying attitudes to business in general since 2000, but only began looking at financial
services as a separate group in 2011. Since then, trust in the sector has risen from 46% to
48%, but stagnated there. This compares with 79% who trust the technology sector (up
2% since 2013), 75% who trust consumer electronics manufacturing (also up 2% since
2013) and 70% who trust the automotive sector (up 1%). Interestingly, the industry that
vies most often with financial services for bottom place is the media (i.e. Figure 10.1).
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Figure 10.1
Trust In Industries
Technology
Consumer electronics manufacturing
Automobile
Food and beverage
Consumer packaged goods
Entertainment
Brewing and spirits
Telecommunications
Consumer health companies
Energy
Pharmaceiticals
Chemicals
Media
Banks
Financial services
79%
75%
70%
66%
65%
65%
64%
63%
60%
59%
59%
55%
51%
51%
50%
Source: Edelman Trust Barometer for 2014; January 2014;
http://www.edelman.com/assets/uploads/2014/05/Spotlight-Trust-V2.pdf
There is some divergence across the sector. Banks, credit cards and payments are trusted
by 52%, whereas insurance scores 47% and financial advisory and asset management
languish at 46% (see Figure 10.2).
Figure 10.2
Trust In Financial Services Industries
52%
52%
48%
Financial services
industry
47%
Banks
Credit
cards/payments
Insurance
Source: Source: Edelman Trust Barometer for 2014; January 2014;
http://www.edelman.com/assets/uploads/2014/05/Spotlight-Trust-V2.pdf
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46%
Financial
advisory/asset
management
Since 1997, in every Gallup poll entitled Honesty/Ethics, consumers have consistently
ranked insurance salespersons and insurance companies among the lowest in terms of
perceived honesty and ethical standards. Figure 10.3 illustrates the most recent Gallup
Poll (2014) that rates the insurance salesperson with only 15% of the people surveyed
listed the insurance salesperson at very high or high to be ethical and honest.
Figure 10.3
Gallup Profession Survey
% Very High/High Nurses
Grade school teachers
Medical doctors
Police Officers
Clergy
Judges
Auto mechanics
Bankers
Business executives
Lawyers
Insurance salesperson
Car salespeople
Members of Congress
Lobbyists
80%
70%
65%
54%
46%
45%
29%
23%
22%
21%
15%
8%
7%
6%
Source: Gallup Survey Honesty/Ethics Profession (December 2014)
http://www.gallup.com/poll/1654/honesty-ethics-professions.aspx
David Callahan in his book, The Cheating Culture, writes
“…the fall of trust in the United States over the past forty years has long been
discussed and debated. It is a well-known fact that Americans trust nearly every
institution less than we used to. We are less trusting of government, less trusting
of the media, less trusting of religious institutions, and less trusting of lawyers
and other professions.”
Outlook for Ethics in the Insurance Industry
Let’s face it, the consumer’s attitudes towards insurance are changing, and their
expectations are rising. Regulatory changes point to the need for a new mind-set in
conduct and culture by both insurance producers and insurers. In an insurance market in
a changing world, it will be down to the insurance producer acting professionally to
confront the issues and challenges to ensure that trust and confidence is aligned with the
traditional strengths of the insurance market.
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As an industry, we need to refocus our attention to our ethical responsibilities. It’s
unfortunate that unethical acts of a relatively few individuals cast a shadow on the
majority of insurance producers who have always conducted themselves according to the
highest ethical standards. The many ethical insurance producers are the people to whom
the life insurance industry owes its success, and they deserve some credit. It can be very
discouraging when instead of getting it, they are painted with the same broad-brush as a
few “bad apples.” Here are a few ideas that professional insurance producers should
keep in mind.



Researchers suggest that ethical sales behavior can lead to more client trust and
that insurance producers who engage in customer-oriented behavior are more
likely to have long term satisfied customers and are less likely to engage in
unethical activities. (Legace, Dahlstrom and Gassenheimer 1991 Journal of
Personal Selling and Sales Management)
The consequences of unethical behavior are particularly unpleasant for those who
engage in it. Penalties often involve loss of one’s license, fines and civil liability
for monetary damages, in addition to personal disgrace. Unethical people do get
caught. And even if there are a few who don’t, it’s not worth the risk.
So what’s the bottom line on being ethical? For ethical people, self-respect (being
able to look into the mirror and like what you see) is more important than any
reward someone else could offer. That fact doesn’t change even when unethical
people seem to benefit from their behavior or when ethical behavior goes
unrecognized. Ethical people do the right thing just because it’s the right thing to
do.
The reality is, there will always be a few “bad apples” in the life insurance business, as
there will be in any industry. But we can’t let that be an excuse for complacency.
Courses like this one are part of an effort to make the life insurance industry’s implicit
commitment to ethics more explicit. Even persons who are not inclined toward unethical
behavior can benefit from understanding the ethical dimensions of some of the issues our
industry faces. Once again, it is important to remember, the goal of ethics education is to
create a win-win environment for all parties who hold a stake in the continuing success of
the life insurance industry: the insurer and their employees, insurance producers,
policyowners, beneficiaries, the general public, and state and federal regulators.
Next, let’s examine some of the ethical responsibilities that are squarely placed on the
shoulders of the insurance producer.
Ethical Responsibilities of the Insurance Producer
There are three areas of ethical responsibility for an insurance producer:

Responsibility to the Insurer. Responsibilities to the agent's insurer are covered
under the concept of agency. The agent owes his or her insurer the duties of good
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

faith, honesty and loyalty. The agent's day-to-day activities are a direct reflection
of the insurer's “image” within the community.
Responsibility to the Insured/Policy Owner. Responsibilities to policy owners
require the agent to meet the needs of the client, provide quality service, maintain
loyalty, confidentiality, timely submission of applications and prompt policy
delivery. Responsibilities to the public require the agent to maintain the highest
level of professional conduct and integrity in all public contact in order to
maintain a strong positive image of the industry.
Responsibility to the State. Responsibilities to the state require the agent to
adhere to the ethical standards mandated by his or her state.
Let’s review each of these ethical responsibilities in greater detail.
Insurance Producer’s Ethical Responsibilities to the Insurer
The insurance producer's contract or agency agreement with the insurer will specify the
producer’s (agent's) duties and responsibilities to the principal. In all insurance
transactions, the insurance producer’s responsibility is to act in accordance with the
agency contract and thus for the benefit of the insurer. If the insurance producer is in
violation of the agency agreement, then he or she may be held personally liable to the
insurer for breach of contract.
An insurance producer has a duty to act with a degree of care that a reasonable person
would exercise under similar circumstances. This prudent person rule is to protect the
insurer and the insured from unreasonable insurance transactions on the part of the
insurance producer (agent).
In accordance with the insurance producer’s fiduciary obligation to the insurer and his or
her agency agreement, the insurance producer has a responsibility of accounting for all
property, including money that comes into his or her possession. The insurance producer
must not embezzle or commingle these funds.
As part of the insurance producer’s working relationship with the insurer, it is important
that pertinent information be disclosed to the insurer, particularly with regard to
underwriting and risk selection. If the insurance producer knows of anything adverse
concerning the risk to be insured, it is his or her responsibility to provide this information
to the insurer. To withhold important underwriting information could adversely affect
the insurer's risk selection process. In accordance with agency law, information given to
the insurance producer is the same as providing the information to the insurer.
It is the insurance producer's responsibility to obtain necessary information from the
insurance applicant and to accurately complete the application for insurance. A signed
and witnessed copy of the application becomes part of the legal contract of insurance
between the insured and the insurer.
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Finally, the insurance producer has a responsibility to deliver the insurance policy to the
insured and collect any premium that might be due at the time of delivery. The insurance
producer must be prepared to provide the insured with an explanation of some of the
policy's principal benefits and provisions. If the policy is issued with any changes or
amendments, the insurance producer will also be required to explain these changes and
obtain the insured’s signature acknowledging receipt of these amendments.
Insurance Producer’s Ethical Responsibility to Insured/Policy Owner
An insurance producer has a fiduciary duty to just about any person or organization that
he or she comes into contact with as part of the day-to-day business of transacting
insurance. By definition, a fiduciary is a person in a position of financial trust. Thus,
attorneys, accountants, trust officers, and insurance producers (agents) are all considered
fiduciaries.
As a fiduciary, the insurance producer has an obligation to act in the best interest of the
insured (policy owner). The insurance producer must be knowledgeable about the
features and provisions of various insurance policies and the use of these insurance
contracts. The insurance producer must be able to explain the important features of these
policies to the insured. The insurance producer must recognize the importance of dealing
with the general public's financial needs and problems and offer solutions to these
problems through the purchase of insurance products.
As a fiduciary, the insurance producer must collect and account for any premiums
collected as part of the insurance transaction. It is the insurance producer’s duty to make
certain that these premiums are submitted to the insurer promptly. Failure to submit
premiums to the insurer, or putting these funds to one's own personal use, is a violation of
the insurance producer’s fiduciary duties and possibly an act of embezzlement.
The insured’s premiums must be kept separate from the insurance producer’s personal
funds. Failure to do this can result in commingling—mixing personal funds with the
insured or insurer's funds.
Insurance Producer’s Ethical Responsibilities to the State
Since states regulate the insurance industry, you as a licensed insurance producer are
required to meet the state’s rules, regulations and legislation to protect the consumer.
States through an Insurance Commissioner or Director oversee the marketing activities of
insurance producers as a licensed insurance producer, you are required to have a license
in the state (s) you are conducting business in and as a licensed agent in that state(s), you
are required to meet the ethical conduct as set forth in the state’s Insurance Code and
abide by the state’s administrative code as set forth by the state department of insurance.
Next, let’s review the insurer’s ethical responsibility to the insurance producer
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Insurer’s Responsibility to the Insurance Producer
Because the insurer (the principal) is obligated and responsible for the actions of his or
her insurance producers (agents) it is imperative that the insurer chooses individuals of
the highest caliber of ethical conduct.
The obligation of both the insurer and the producer are spelled out in an employment
agreement. The insurer has three major duties to the producer:



Employment
Compensation
Indemnification
The Employment Agreement
The employment agreement covers the following elements:





Length of time
Minimum production standards
Lines of business that may be written
Method of compensation
Insurer’s recourse for non-performance
The Insurer’s Obligation of Compensation
In exchange for representation the insurer compensates the producer based on the terms
of the employment agreement. Compensation is broken down depending on the nature of
the business and whether it is new business or renewal business. The most common
breakdown is as follows:



Different rates for different lines of insurance
Higher rate of commission on new business
Lower rate of commission on renewal business
Due to this type of structure sometimes producers may shift policyholders from one
company to another company at renewal time. An ethical producer must never do this at
the expense of the client.
Indemnification of Producer
Unless the producer is found guilty of breach of duty or lacking in due diligence, the
insurer indemnifies the producer from all costs and claims made against him or her in the
carrying out of his or her agency relationship with the insurer.
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Potential Liabilities of Insurance Producers/Errors and Omissions
(E&O) Exposure
Errors and omissions (E&O) insurance is needed by professionals who give advice to
their clients. It covers negligence, error, or omission by the insurer or producer who is the
insurer's representative. E&O policies protect producers from financial losses they may
suffer if insured’s sue to recover for their financial loss due to a producer giving them
incorrect advice (error) or not informing them of an important issue (omission). Because
a producer's office is very busy, he or she must take special care to follow strict
procedures in regard to taking applications, explaining coverage, collecting premiums,
submitting changes to policies upon an insured’s request, and preparing claim forms. Any
error or omission could result in losing a client and could lead to a lawsuit. All E&O
insurance policies have certain basic characteristics in common:




The policy covers only losses due to negligence, error, or omission. For example,
the agent who fails to tell a client that his or her purchase of a new policy means
that waiting periods have to be met again can be sued for this omission if the
event previously covered occurs and the insured finds that he or she is not
currently covered.
The policy usually has a high deductible, such as $500 or $1,000. The high
deductible provides an added incentive for a producer to reduce his or her errors.
The coverage may be written with both a limit per claim, and a limit for all claims
during the policy period.
Except for obvious exclusions, like a producer committing unfair trade practices,
the policy has few other exclusions.
Agency Law Principles
An understanding of the law of agency is important because an insurance company, like
other companies, must act through agents.
Agency is a relationship in which one person is authorized to represent and act for
another person or for a corporation. Although a corporation is a legal "person," it cannot
act for itself, so it must act through agents. An agent is a person authorized to act on
behalf of another person, who is called the principal. In the field of insurance, the
principal is the insurance company and the insurance producer is the agent. When one is
empowered to act as an agent for a principal, he or she is legally assumed to be the
principal in matters covered by the grant of agency. Contracts made by the agent are the
contracts of the principal. Payment to the agent, within the scope of his or her authority,
is payment to the principal. The knowledge of the agent is assumed to be the knowledge
of the principal.
The two fundamental principles of an agency relationship are power and authority and
the high standards of conduct expected of the agent as a fiduciary
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Presumption of Agency
If a company supplies an individual with forms and other materials (signs and evidences
of authority) that make it appear that he or she is an agent of the company, a court will
likely hold that a presumption of agency exists. The company is then bound by the acts
of this individual regardless of whether he or she has been given this authority. The
agent’s ethical behavior is of utmost concern in carrying out the principal’s instructions.
Power of Authority
An insurance producer (agent) has one of three types of authority. They are:



Express Authority
Implied Authority
Apparent Authority
Let’s review each of these in greater detail.
Express Authority
Express Authority is an explicit, definite agreement. It is the authority the principal gives
the insurance producer as set forth in his or her contract.
Implied (Lingering) Authority
Implied authority is not expressly granted under an agency contract, but it is actual
authority that the insurance producer has to transact the principal's business in accordance
with general business practices.
For Example: If an insurance producer’s contract does not give him or her
express authority of collecting and submitting the premium, but the insurance
producer does on a regular basis, and the company accepts the premium, the
insurance producer is said to have implied authority.
Lingering implied authority means that the insurance producer carries "signs or evidences
of authority." By having these evidences of authority, an insurance producer who is no
longer under contract to an insurer could mislead applicants or insured’s. When the
agency relationship between insurance producer and company has been terminated, the
company will try, or should try, to get back all the materials it supplied to the former
insurance producer, including sales materials.
On the other hand, the public cannot assume that an individual is a producer agent merely
because he or she says so. The insurance producer must carry the credentials (for
example, the insurance producer’s license and appointment) and company documents
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(such as applications and rate books) that represent him or her as being an insurance
producer for an insurance company.
Apparent Authority
Apparent authority is the authority the agent seems to have because of certain actions
undertaken on his or her part. This action may mislead applicants or insured’s, leading
them to believe that the agent has authority that he or she does not, in fact, have. The
principal adds to this impression by acting in a manner that reinforces the impression of
authority. For instance, an agent's contract usually does not grant him the authority to
reinstate a lapsed policy by accepting past due premiums. If, in the past, the company has
allowed the agent to accept late premiums for that purpose, a court would probably hold
that the policy owner had the right to assume that the agent's acceptance of premiums was
within the scope of his or her authority.
Waiver and Estoppel
The legal doctrines of waiver and estoppel are directly related to the responsibilities of
insurance producers. An insurer may, by waiver, lose the right of making certain
defenses that it might otherwise have available.


Waiver is defined as the intentional and voluntary giving up of a known right. An
insurance company may waive its right to cancel a policy for nonpayment by
accepting late payments.
Estoppel means that a party may be precluded by his or her acts of conduct from
asserting a right that would act to the detriment of the other party, when the other
party has relied upon the conduct of the first party and has acted upon it. An
insurer may waive a right, and then after the policy owner has relied upon the
waiver and acted upon it, the insurer will be estopped from asserting the right.
Waiver and estoppel often occur together, but they are separate and distinct doctrines.
The insurance producer must be alert in his or her words, actions, and advice to avoid
mistakenly waiving the rights of the insurance company. As a representative of the
company the insurance producer’s knowledge and actions may be deemed to be
knowledge and actions of the company.
Categories of Insurance Producers
Insurance producers are not only categorized by their function in the industry, but also by
the line of insurance they sell. They can be categorized and licensed as:




Life and Health Agents
Property and Casualty Agents
Brokers
Solicitors
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
Insurance Consultants
Note: Every state requires that individuals who sell insurance have a license (resident or
non-resident) from the state in which they conduct business in.
Life and Health Producers (Agents)
Generally, life and health producers (agents) represent the insurer to the consumer with
respect to the sale of life and health insurance products. The insurance producer (agent)
is appointed by the insurer and usually the agent’s authority to represent the insurer is
specified in the agency agreement between them, which is a working agreement between
the insurance producer (agent) and the insurer. Life and health insurance producers
(agents) generally do not have the authority to issue or modify insurance contracts.
Customarily, life and health insurance producers (agents) are authorized to solicit,
receive, and forward applications for the contracts written by their companies. The
insurance producer (agent) may receive the first premium due with the application, but
usually not subsequent premiums, except in industrial life insurance. The insurance
company approves and issues the contract after receiving the application and premium
from the applicant through the insurance producer (agent). The insurance producer
(agent) cannot bind coverage. This means that an insurance producer (agent) cannot
commit to providing insurance coverage on behalf of the insurance company.
Property and Casualty Agents
Insurance producers (agents) appointed by property and liability insurance companies
generally are granted more authority. These agents may bind or commit their companies
by oral or written agreement. They sometimes inspect risks for the insurance company
and collect premiums due. They may be authorized to issue many types of insurance
contracts from their own offices.
Brokers
In contrast to the agent-client relationship in which the agent represents the insurer to the
purchaser, a broker legally represents the insured and acts as an independent contractor
on behalf of his or her principal, the insured.
The broker’s role is to seek out the best he or she can find for his or her client, the
insured, and represents that client’s best interest. Although the broker receives
compensation from the insurer the amount of compensation should not become an ethical
issue by serving his or her needs ahead of his or her principal’s needs. However, recent
scandals on “bid rigging” with several large insurance brokers has brought
unquestionable concerns about the role and ethics of those brokers and the industry as a
whole.
Brokers must be licensed just like agents and generally their routine activities and
functions are similar to that of agents. Brokers solicit applications for insurance, may
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collect the initial premium and deliver policies. Brokers do not have the authority to bind
coverage.
Similar to an insurance producer (agent) who has certain ethical obligations to both the
insurer and the insured, a broker also has obligations to the insurer even though his or her
client is the insured. These obligations include:





Disclosure of all pertinent information
Carrying out obligations in a professional and diligent manner
Seeking out quality business
Competing fairly and ethically
Acting promptly and diligently
Note: Some states do not license brokers, such as the State of Florida.
Solicitors
A solicitor is a salesperson who works for an agent or a broker. This working
relationship is most common in the property and casualty insurance field. Most often the
solicitor will be licensed as a solicitor. Depending on the state, the solicitor may obtain
an agents or broker’s license. Solicitors normally have a working agreement with an
agent or broker. In accordance with this agreement, the solicitor’s primary functions are
to solicit insurance, collect initial premiums and deliver policies. Solicitors cannot bind
coverage.
Insurance Consultants
A very small group of insurance professionals call themselves consultants. Consultants
are not paid by commission for the sales of insurance policies. Instead, they work strictly
for the benefit of insured’s, and are paid a fee by the insured’s they represent.
Captive Agents vs. Independent Agents
A captive agent is one who has signed an exclusive contract with one or more insurers.
The captive agent must represent the interest of those insurers as their fiduciary in the
highest and most reputable manner.
It would be unethical for a captive agent to represent more than one insurance company
selling the same or similar policies. The insurer owns and maintains control of all
accounts serviced by the captive agent and in return the captive agent is paid a salary and
or commissions.
The captive agent has an obligation to disclose to the insurer his or her interest in any
similar business or service that he or she renders regardless of whether he or she receives
compensation. It is then up to the principal to determine if there exists a conflict of
interest.
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Independent Agents
Independent agents (producers) most often represent numerous companies and are paid
on a commission basis. An independent agent owns all of his or her clients and will shop
with various insurance companies to find the best product at the most economical price
for the client.
However, because independent agents must often meet sales targets set by insurance
companies to maintain their writing ability with that insurance company, the ethical
issues this type of agent often faces, is the dilemma of getting the best deal for his or her
client, verses meeting his or her target levels, or perhaps receiving the highest
commission (conflict of interest).
To avoid these conflicts and potential ethical violations, the independent agent must
follow the guidelines set forth for dual agency. Under these guidelines the independent
agent represents:


His or her client only during the process of helping the client select the insurance
plan best suited to the client’s needs. It is up to the independent agent to see that
the insurance policy is written properly to meet the client’s needs and intent.
The insurance company when the insurance is being applied for and when it is in
the underwriting process, in record keeping, in claims settlement or other insurer
related activities.
Dual agency when practiced ethically can serve both the insurer and the client without
conflict.
Insurance Producers as a Professional
Insurance producers, including this producer, have long sought to distinguish ourselves as
professionals on a plane with law, medicine and education. A professional is defined as a
person in an occupation requiring an advanced level of training, knowledge, or skill.
Professionals enjoy rights commensurate with their skills, but they also have higher
responsibilities in caring for others because of the title of professional.
Do you consider yourself to be a professional?
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Chapter 10
Review Questions
1. Insurance originated back in what century with ship owners who wanted to insure
their ships and cargo against the loss at sea?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
18th Century
15th Century
19th Century
13th Century
2. Which of the following is to protect the insurer and the insured from unreasonable
insurance transactions on the part of the insurance producer (agent)?
(
(
(
(
) A. One person one contract rule
) B. Dual agency rule
) C. Prudent Person Rule
) D. The Golden Rule
3. The agent’s authority to represent the insurer is specified in the:
(
(
(
(
) A. The insurance contract
) B. The compensation agreement
) C. The agency agreement
) D. The solicitation agreement
4. Which category of producer is granted more authority and is able to bind or commit
their companies by oral and written agreement?
(
(
(
(
) A. Insurance broker
) B. Property and casualty agents
) C. Life and health agents
) D. Insurance consultants
5. Which of the following statements about an “independent agent” is FALSE?
(
(
(
(
) A. An independent agent must follow the dual agency rule
) B. An independent agent represents only one insurer
) C. An independent agent owns his clients
) D. An independent agent is paid on a commission basis
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CHAPTER 11
REGULATION OF THE INSURANCE INDUSTRY
Overview
Insurance is a highly regulated industry. It is regulated to protect the public interest and
to make sure insurance is available on an equitable basis. Regulation of the insurance
industry is undertaken from several perspectives and is divided among a number of
authorities.
In this chapter, we will examine the history of the regulation of the insurance industry
between the federal and state governments, and review the purposes for regulation. It
will also examine the role of the National Association of Insurance Commissioners
(NAIC) and examine several pieces of federal legislation affecting the insurance industry.
Learning Objectives
Upon completion of this chapter, you will be able to:




Distinguish between the role of the federal government vs. state government in
the regulation of the insurance industry;
Identify the state government structure for the regulation of the insurance
companies doing business within their states;
Identify the role of the state insurance departments in the regulation of insurance;
and
Define the role of the National Association of Insurance Commissioners in the
regulation of the insurance industry.
Background
Benjamin Franklin helped found the insurance industry in the United States in 1752 with
the Philadelphia Contributionship for the Insurance of Houses from Loss by Fire. Back
then the Commerce Clause of the United States Constitution, Article I, section 8, clause
3, provided that:
“Congress shall have power…to regulate Commerce…among the several states.”
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And, it would seem that, because most insurance companies in many states, insurance
sales is interstate commerce, and, therefore, subject to the jurisdiction of the federal
government. So, this clause gave the Federal government the power to regulate insurance
as a means to oversee those areas not covered by state regulation of the industry.
However, in 1868, the Supreme Court first found, in the case of Paul v. Virginia, that
insurance was not interstate commerce, and, thus, the states had the right to regulate
insurance.
Paul vs. Virginia
In Paul v. Virginia (75 US 168 (1869), the U.S. Supreme Court upheld a Virginia statute
requiring out-of-state insurers and their agents to obtain a license before conducting
business within the state. The Court held that insurance was not commerce within the
meaning of the Commerce Clause, and therefore, states held exclusive regulatory
authority over the business of insurance.
For 75 years following the Paul decision, state authority over insurance regulation was
unquestioned. The states created a vast and pervasive network of laws, regulations,
taxes, and cooperative accounting practices.
South-Eastern Underwriters Association (SEUA)
In 1944, the Supreme Court reviewed its decision in Paul in United States v. SouthEastern Underwriters Association (322 U.S. 5433 (1944)).
The South-Eastern
Underwriters Association, a rate making organization, was charged with restraining
commerce in violation of the Sherman Antitrust Act by fixing and enforcing arbitrary and
noncompetitive premium rates. The Supreme Court rejected South-Eastern’s claim that
the Sherman Anti-Trust Act did not apply because, under Paul, insurance is not
commerce. The Court reversed its holdings in Paul and ruled that insurance is commerce,
and when transacted across state lines, it is interstate commerce subject to federal law,
including the Sherman Antitrust Act. As a result of (Paul), the constitutionality of all
states statutes regulating the insurance business was called into question and a state of
confusion reigned. Congress, unlike the states, had passed no laws specifically regulating
the business of insurance.
However, changing the entire industry was not that easy. Bureaucracies and insurance
companies had developed an understanding—some would say cozy relationship. The
states already had many rules and regulations governing insurance, whereas the federal
government had virtually none. Furthermore, it raised the possibility that the states did
not have the right to tax insurance.
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McCarran-Fergusson Act
In response to the SEUA decision, the federal government passed the McCarronFerguson Act in 1945 (this Act is also known as Public Law 15 (Chapter 20, 59 Stat. 33,
1945, codified in 15 U.S.C. 1011-15). The Act stipulated that it was in the public interest
to have the states regulate insurance, and that the insurance industry would not be subject
to federal antitrust laws if it was regulated by state law.
The Act granted states the power to regulate the business of insurance, removing all
Commerce Clause limitations on the states’ authority in this area. Congress’ authority to
delegate this power to the states under the Commerce Clause was upheld by the Supreme
Court in the 1946 case of Prudential Ins. Co. v. Benjamin.
However, a provision in the McCarran-Ferguson Act would permit the federal
government to resume control over the regulation of the business of insurance if state
regulation becomes inadequate. The McCarran-Ferguson Act allows Congress to enact
legislation invalidating, impairing, or superseding state law, if the legislation
“specifically relates to the business of insurance (15 U.S.C. 1012 (b)).
State Regulation of the Insurance Industry
The primary state insurance regulatory functions remain as they have been since the
enactment of McCarran-Ferguson. This allows the states to perform solvency oversight
of the U.S. insurance industry and to regulate insurer and insurance producers behavior in
the marketplace.
Structure of the State Regulatory Framework
The regulatory framework is not confined to insurance departments but extends to
all levels and branches of state government (See Figure 11.1). The major authorities in
the current regulatory system are:




The executive branch at the state level;
State legislatures;
The courts; and
State insurance departments.
The body of laws at the state level is called the Insurance Code. State regulation consists
of Statutes, and rules and regulations. Statutes are the body of law developed by the
Legislature branch of government. They outline, in general terms, the duties of the
Commissioner and the activities of the Insurance Department. Rules and regulations are
developed by the Insurance Department to expand upon statutory requirements and carry
out legislative intent.
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Figure 11.1
The Typical Organizational Structure of an Insurance Department
Governor’s
Office
Insurance
Commissioner
State
Legislature
Licensing
And
Education
Insurance
Department
Consumer
Affairs
Administration
Accounting
And
Auditing
The Role of the State Legislators
State legislators are the public policymakers that establish set broad policy for the
regulation of insurance by enacting legislation providing the regulatory framework under
which insurance regulators operate. They establish laws which grant regulatory authority
to regulators and oversee state insurance departments and approve regulatory budgets.
State insurance departments employ 11,600 regulatory personnel (2013 figures).
Increases in staff and enhanced automation have allowed regulators to substantially boost
the quality and effectiveness of their financial oversight of insurers and expand consumer
protection activities.
The state legislature establishes the insurance department, enacts insurance laws and
approves the regulatory budget. Insurance departments are part of the state executive
branch, either as a stand-alone agency or as a division within a larger department.
Commissioners must often utilize the courts to help enforce regulatory actions, and the
courts in turn, may restrict regulatory action. The insurance department in a given state
must coordinate with other state insurance departments in regulating multistate insurers
and rely on the NAIC for advice as well as some support services. The federal
government overlays this entire structure, currently delegating most regulatory
responsibilities to the states, while retaining an oversight role and intervening in specific
areas.
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State Insurance Departments
The Insurance Code of each state authorizes the establishment of an Insurance
Department to administer and carry out the insurance laws. State insurance departments
handle the daily affairs of the insurance industry, and spread more specialized
administrative rules for the industry that has the force of law.
Insurance Commissioner
In each state, a public official will head the Insurance Department—the title of the
official will be the Commissioner, Superintendent, or Director of Insurance. The title
differs from state-to-state.
However, a majority of the states use the title
“Commissioner.” State Insurance Commissioners can be either an elected official (no
less than 12 states, two of those states being those most populous in the nation), or be
duly appointed by their elected governors. In all cases, the public official in charge of the
Insurance Department has broad powers to supervise and regulate the insurance affairs
within the state.
The insurance laws of the state usually confer upon the Commissioner all of the
following powers and duties:









To conduct investigations and examinations
To make reasonable rules and regulations
To hire employees, and examiners, and delegate any power, duty, or function to
such persons
To examine the accounts, records, documents, and transactions of any insurer,
agent or broker
To subpoena witnesses and administer oaths in order to further any examination,
investigation, or hearing on insurance matters
To issue orders and notices on decisions made or matters pending
To impose penalties for violations of the Insurance Code, including but not
limited to fines, suspension or revocations of license and Certificate of Authority,
and requesting that the Attorney General prosecute a violator
To approve insurance policy forms sold within the state
To approve rates and rate increases for regulated lines of insurance
Insurance commissioners in every state belong to the National Association of Insurance
Commissioners (NAIC). The NAIC reviews industry regulations and drafts model laws
and policy forms for the states. Even though the NAIC has no legal authority, the states
generally adopt their suggestions.
One of the state Insurance Commissioner’s duties is to handle customer complaints and
generally has a staff for this purpose. The commissioner’s office will typically relay the
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complaint to the insurer and request a response by a certain date. If the insurer’s response
is unsatisfactory, the commissioner may direct a course of action.
The Role of the NAIC
The National Association of Insurance Commissioners (NAIC), established in 1871, is
the U.S. standard-setting and regulatory support organization created and governed by the
chief insurance regulators from the 50 states, the District of Columbia and five U.S.
territories.
The NAIC functions as an advisory body and service provider for state insurance
departments although without legal authority as a group, it imposes a strong influence in
the area of the industry’s self-regulation. The NAIC is the organization that has done the
most to standardize law between the states. Although the wording, and sometimes the
provisions themselves differ from state to state, for the most part the differences are only
slight as each state attempts to follow, in essence, the wording of the “model laws”
established by the NAIC.
NAIC Model Laws
The NAIC generally meets quarterly to conduct its affairs. Activities are conducted
through committees, subcommittees, task forces and working groups staffed by state
insurance regulators and their staffs with final action taken by the NAIC members as a
whole. The NAIC has its own staff that supports the activities of the state insurance
regulators. A listing of committees and committee charges (current assignments)
together with information on current activities is available on the website of the NAIC –
www.naic.org (select “Committees and Activities”). The NAIC publishes minutes of its
meetings in the form of the NAIC Proceedings, which are available for purchase from the
NAIC.
One of the key activities of the NAIC is the adoption of model laws and regulations, and
amendments thereto. These model laws and are recommended for each state to enact
(through their state legislatures) or promulgate (as regulations to the extent they may be
promulgated by a state insurance regulator).
The NAIC publishes a multiple-volume set of model laws and regulations titled “Model
Laws, Regulations and Guidelines” which collects all current model laws and regulations.
Each model law or regulation includes:


The text of the model law or regulation together with its history (citing to the
NAIC Proceedings),
A listing of states that have enacted the model or a related law, and its citation,
and
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
Usually a history of the model law or regulation prepared by the NAIC staff.
To review a list of the NAIC Model Laws, regulations and guidelines you can go to:
http://www.naic.org/documents/committees_models_table_of_contents.pdf
The Purpose and Structure of Insurance Regulation
The fundamental reason for government regulation of insurance is to protect American
consumers. Insurance is more heavily regulated than other types of business because of
the complexity of the insurance contracts, the lack of sufficient information for insurance
consumers to adequately shop for prices and adequacy of coverage and because insurance
contracts are generally contracts of adhesion. Conceptually insurance regulation is very
simple. The public wants two things from insurance regulators. They want solvent
insurers who are financially able to make good on the promises they have made and they
want insurers to treat policyholders and claimants fairly. All regulatory functions will
fall under either solvency regulation or market regulation to meet these two objectives.
State insurance regulatory systems are accessible and accountable to the public and
sensitive to local social and economic conditions. State regulation has proven that it
effectively protects consumers and ensures that promises made by insurers are kept.
Insurance regulation is structured around several key functions, including insurer
licensing, producer licensing, product regulation, market conduct, financial regulation
and consumer services.
Let’s review each of these key functions in greater detail.
Insurer Licensing
State laws require insurers and insurance-related businesses to be licensed before selling
their products or services. Currently, there are approximately 7,800 insurers in the
United States. All U.S. insurers are subject to regulation in their state of domicile and in
the other states where they are licensed to sell insurance. Insurers who fail to comply with
regulatory requirements are subject to license suspension or revocation, and states may
exact fines for regulatory violations. In 2010, there were 342 companies that had their
licenses suspended or revoked. The NAIC’s Uniform Certificate of Authority
Application (UCAA), an insurer licensing facilitation system, helps states expedite the
review process of a new company license. In addition, an NAIC database has been
developed to facilitate information sharing on acquisition and merger filings. These
databases assist insurance regulators by creating a streamlined and more cost efficient
regulatory process.
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Producer Licensing
Insurance agents and brokers, also known as producers, must be licensed to sell insurance
and must comply with various state laws and regulations governing their activities.
Currently, more than two million individuals are licensed to provide insurance services in
the United States. State insurance departments oversee producer activities in order to
protect insurance consumer interests in insurance transactions.
The states administer continuing education programs to ensure that agents meet high
professional standards. Producers who fail to comply with regulatory requirements are
subject to fines and license suspension or revocation. In 2010, roughly 5,000 insurance
producers had their licenses suspended or revoked. Fines exceeded $25 million and over
$50 million was returned to rightful owners. When insurance producers operate in
multiple jurisdictions, states must coordinate their efforts to track producers and prevent
violations. Special databases are maintained by the NAIC to assist the states in this
effort. The National Insurance Producer Registry (NIPR)—a non-profit affiliate of the
NAIC—was established to develop and operate a national repository for producer
licensing information.
Product Regulation
State regulators protect consumers by ensuring that insurance policy provisions comply
with state law, are reasonable and fair, and do not contain major gaps in coverage that
might be misunderstood by consumers and leave them unprotected. The nature of the
regulatory reviews of rates, rating rules and policy forms varies somewhat among the
states depending on their laws and regulations.
For personal property-casualty lines, about half of the states require insurers to file rates
and to receive prior approval before rate or policy form filings go into effect. With the
exception of workers’ compensation and medical malpractice, commercial propertycasualty lines in many states are subject to a competitive rating approach. Under such a
system, regulators typically retain authority to disapprove rates if they find that
competition is not working.
Rates for life insurance and annuity products generally are not subject to regulatory
approval, although regulators may seek to ensure that policy benefits are commensurate
with the premiums charged.
Historically, many states subjected health insurance rates to prior approval—with some
states using a “file and use” system or no provisions for review. The recently adopted
Affordable Care Act has changed the landscape for health insurance. All states now must
review health insurance rates before they go into effect. Health insurance rates are also
subject to review by the Department of Health and Human Services if the rate change is
deemed to be “unreasonable.” Improvements are also included addressing the way in
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which consumers shop for health insurance. Health insurance exchanges are being
developed and there is much focus of transparency of consumer information.
State insurance regulators, in the early 1990s, developed SERFF (System for Electronic
Rate and Form Filings). The intent was to provide a cost-effective method for handling
insurance policy rate and form filings between regulators and insurance companies. The
SERFF system is designed to enable companies to send and states to receive, comment
on, and approve or reject insurance industry rate and form filings. It has added incredible
operational efficiencies that enhanced speed to market for rate and policy form filings. In
2010, over 565,000 filings were processed through SERFF.
Insurance regulators have also been innovative in addressing speed to market concerns of
insurers desiring the ability to make a single filing that applies in multiple jurisdictions.
The Interstate Insurance product Regulation Compact (Compact) is an important
modernization initiative that benefits state insurance regulators, consumers and the
insurance industry. The Compact enhances the efficiency and effectiveness of the way
insurance products are filed, reviewed and approved allowing consumers to have faster
access to competitive insurance products in an ever-changing marketplace. The Compact
promotes uniformity through application of national product standards embedded with
strong consumer protections.
The Compact established a multi-state public entity, the Interstate Insurance Product
Regulation Commission (IIPRC) which serves as an instrumentality of the Member
States. The IIPRC serves as a central point of electronic filing for certain insurance
products, including life insurance, annuities, disability income and long-term care
insurance to develop uniform product standards, affording a high level of protection to
purchasers of asset protection insurance products. The IIPRC uses the SERFF filing
network for its communications between the 44 participating jurisdictions (43 states and
Puerto Rico), representing approximately two-thirds of the premium volume nationwide,
and the insurers using the system for flings.
Financial Regulation
Financial regulation provides crucial safeguards for America’s insurance consumers. The
states maintain at the NAIC the world’s largest insurance financial database, which
provides a 15- year history of annual and quarterly filings on 5,200 insurance companies.
Periodic financial examinations occur on a scheduled basis. State financial examiners
investigate an insurer’s accounting methods, procedures and financial statement
presentation. These exams verify and validate what is presented in the insurer’s annual
statement to ascertain whether the insurer is in sound financial standing. When an
examination of financial records shows the company to be financially impaired, the state
insurance department takes control of the insurer. Aggressively working with financially
troubled companies is a critical part of the regulator’s role. In the event the insurer must
be liquidated or becomes insolvent, the states maintain a system of financial guaranty
funds that cover most of consumers’ losses.
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State financial regulators are subject to a peer review through an accreditation process.
To achieve accreditation, an insurance department is required to undergo a
comprehensive review by an independent review team every five years to ensure the
department continues to meet baseline financial solvency oversight standards. The
accreditation standards require state insurance departments to have adequate statutory and
administrative authority to regulate an insurer's corporate and financial affairs, as well as
the necessary talent and resources to carry out that authority.
Market Regulation
Market regulation attempts to ensure consumers are charged fair and reasonable
insurance prices, have access to beneficial and compliant insurance products and insurers
operate in ways that are legal and fair to consumers. With improved cooperation among
states and uniform market conduct examinations where uniformity is needed, regulators
hope to ensure continued quality consumer protection at the state level. Traditional
market conduct examinations occur on a routine basis, but also can be triggered by
complaints against an insurer. These exams review producer licensing issues,
complaints, types of products sold by insurers and producers, producer sales practices,
compliance with filed rating plans, claims handling and other market-related aspects of
an insurer’s operation. When violations are found, the insurance department makes
recommendations to improve the insurer’s operations and to bring the company into
compliance with state law. In addition, an insurer or insurance producer may be subject to
civil penalties or license suspension or revocation.
Insurance regulators, through the NAIC, began the Market Conduct Annual Statement
(MCAS) in 2002 with the goal of collecting uniform market conduct related data. The
MCAS provides market regulators with information not otherwise available for their
market analysis initiatives. It promotes uniform analysis by applying consistent
measurements and comparisons between insurers. MCAS has always been a
collaboration of regulators, industry and consumers who recognize the benefits of
monitoring, benchmarking, analyzing, and regulating the market conduct of insurance
companies. Through this teamwork, MCAS has grown from eight states collecting only
Life and Annuity information to nearly all states collecting Property and Casualty data, as
well as Life and Annuity information.
Consumer Services
The single most significant challenge for state insurance regulators is to be vigilant in the
protection of consumers, especially in light of the changes taking place in the financial
services marketplace. State insurance regulators have established toll- free hotlines,
Internet Web sites and special consumer services units to receive and handle complaints
against insurers and insurance producers. The state insurance regulators also have
launched an interactive tool to allow consumers to research company complaint and
financial data using the NAIC Web site. Called the Consumer Information Source (at
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https://eapps.naic.org/cis/), this web-based tool allows consumers to file a complaint,
report suspected fraud and access key financial and market regulatory information about
insurers.
During 2010 (latest data available), state insurance departments handled over 2.1 million
consumer inquiries and over 300,000 formal consumer complaints. As needed, state
insurance departments worked together with claimants, policyholders and insurers to
resolve disputes. In addition, many states sponsor consumer education seminars and
provide consumer brochures on a variety of insurance topics. Many states publish rate
comparison guides to help consumers get the best value when they purchase insurance.
Federal Legislation
Below are several pieces of federal regulations that have been passed to protect
consumers when purchasing insurance.
Employment Retirement Income Security Act of 1974 (ERISA)
The Employee Retirement Income Security Act (29 U.S.C. Section 1001 seq.), also
known as ERISA, passed by Congress and signed into law by President Gerald Ford back
in 1974, is a complex body of federal statutory law that, in general, deals with matters
relating to both employee pension benefit plans and employer sponsored health and
welfare benefit plans.
The purpose of ERISA was to set consistent nationwide standards of protection for
employer pension, health care and other employee benefit plans from mismanagement
and fraud.
Fair Crediting Reporting Act
In 1970, the federal government passed the Fair Credit Reporting Act, or FCRA, with the
intent of protecting individual’s right to privacy. When an application is submitted to a
life or health insurance company, a consumer reporting agency is hired to obtain personal
information about the applicant to be used in the underwriting evaluation. FCRA
established procedures for the collection and disclosure of information obtained on
consumers through investigation and credit reports; it seeks to ensure fairness with regard
to confidentiality, accuracy and disclosure. The FCRA is quite extensive. Included in it
are the following important requirements pertaining to insurers:

Applicants must be notified (usually within three days) that the report has been
requested. The insurer must also notify the applicant that he or she can request
disclosure of the nature and scope of the investigation. If the applicant requests
such disclosure, the insurer must provide a summary within five days of the
request.
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



The consumer must be provided with the names of all people contacted during the
preceding six months for purposes of the report. People contacted who are
associated with the consumer’s place of employment must be identified as far
back as two years.
If, based on inspection or consumer report, the insurance rejects an application;
the company must provide the applicant with the name and address of the
consumer reporting agency that supplied the report.
If requested by the applicant, the consumer reporting agency—not the insurance
company—must disclose the nature and substance of all information (except
medical) contained in the consumer’s file. Note that the file may be more
extensive than the actual report that was provided to the insurer. The Fair
Crediting Reporting Act does not give consumers the right to see the actual report,
although most reporting agencies do routinely provide copies of the report, if
requested.
If the applicant disagrees with information in the file, he or she can file a
statement giving his or her opinion on the issue.
HIPAA
As financial advisors with life and health licenses, we are exposed to and trusted with
personal medical information from the clients we work with. It has always been good
business practice to view this type of information as confidential. In 1996, however, the
federal government passed The Health Insurance Portability and Accountability Act
(HIPAA), which provides specific rules for how an insurance producers/financial
advisors must protect personal medical information.
Who is required to comply with HIPAA?



Covered Entities – A Covered Entity includes health plans, health care clearing
houses and most health care providers. (Includes employer group health plans)
Business Associates – A Business Associate includes a business or an individual
who works with a Covered Entity and creates, uses, receives or discloses
protected health information.
Employer and Other Sponsors of Group Health Plans – Includes all employers
that receive protected health information as well as other organizations that
sponsor group health plans, e.g., a union plan.
HIPAA defines as any individually identifiable health information that is created or
received by a health care provider, health plan, employer or health care clearinghouse.
(PHI includes a person’s name and address.) HIPAA requires that a group health plan
does not disclose this information except for the following permitted or required
disclosures:

To the individual.
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



To carry out treatment, payment or health care operations.
With a valid authorization.
Under limited circumstances, when the individual has the opportunity to agree or
object to the use or disclosure.
For defined “public good function” and for very limited “marketing” purposes.
Disclosure of protected health information to business associates, with satisfactory
assurance that the business associate will adequately safeguard the information.
Required Disclosures



To individuals seeking to access their protected information.
To individuals seeking an accounting of disclosures of their protected health
information.
When required by the secretary of HHS to investigate or determine the health
plan’s compliance with the regulation.
Business Associates – as life and health agents, we fall under the definition of a “Business
Associate,” consequently, we are required to enter into a “BA” contract with the health
plans with which we work. These contracts are required to have the following
provisions:












Establish the permitted uses and disclosures of protected health information.
Provide that the business associate will not use or further disclose the information
other than as allowed under the contract or required by law.
Provide that the business associate will use appropriate safeguards to prevent the
unauthorized disclosure of information.
Require the business associate to report to the health plan any unauthorized uses
or disclosures of the information.
Ensure that agents or subcontractors to whom the business associate discloses
protected health information agree to these same restrictions.
Provide that the business associate will make protected health information
available for inspection.
Establish the permitted uses and disclosures of protected health information.
Provide that the business associate will not use or further disclose the information
other than as allowed under the contract or required by law.
Provide that the business associate will use appropriate safeguards to prevent the
unauthorized disclosure of information.
Establish the permitted uses and disclosures of protected health information.
Provide that the business associate will not use or further disclose the information
other than as allowed under the contract or required by law.
Provide that the business associate will use appropriate safeguards to prevent the
unauthorized disclosure of information.
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The Financial Services Modernization Act of 1999
The Financial Services Modernization Act of 1999, also known as the Gramm-LeachBliley Act, established a comprehensive regulatory framework to permit affiliations
among banks, securities firms and insurance companies by repealing the Depression Era
Glass-Steagall Act. The Gramm-Leach-Bliley Act once again affirmed that states should
regulate the business of insurance by declaring that the McCarran-Ferguson Act remained
in effect. However, Congress also called for state reform to allow insurance companies
to compete more effectively in the newly integrated financial service marketplace and to
respond with innovation and flexibility to evermore demanding consumer needs. It
established the concept of functional regulation where each functional regulator is
responsible for regulation of its functional area.
The Wall Street Reform and Consumer Protection Act of 2010
The Wall Street Reform and Consumer Protection Act of 2010, better known as the
Dodd-Frank Wall Street Reform Act once again had an impact on state insurance
regulation. While primarily banking and securities reform legislation, Dodd-Frank did
create the Federal Insurance Office (FIO) under Title V, Section 502, as an information
gatherer to inform Congress on insurance matters. In addition, under Title IX; Section
989J of the Act (also known as the Harkin Amendment), it contains a provision that
limits the ability of the U.S. Securities Exchange Commission (SEC) to classify indexed
annuities and other insurance products as securities.
The provision states that an insurance product, annuity product or endowment product
with a value that does not vary according to the performance of a separate account is an
insurance product, as long as the product meets or exceeds nonforfeiture and suitability
criteria set by the NAIC.
Starting in 2013, a product eligible for Section 989J protection must be issued by an
insurer in a state of domicile that adopts any new NAIC suitability rules within 5 years of
the rules being established.
To review the whole document of the Act visit:
www.sec.gov.about/laws/wallstreetreform-cpa.pdf
The Future of Insurance Regulation
While states dominate the regulation of insurance industry, since the great recession of
2008-2009, with the federal bailout of one of America’s largest insurance conglomerates
along with the failure of a host of its bond insurers, there has been an increase of
concerns that the insurance industry is not necessarily a stable, staid keeper of our rainy
day funds.
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It is important to remember that today, insurance is a global business, with huge firms
writing not just life and home insurance policies, but also entering into more exotic lines
of business. Most notoriously, the industry regularly uses credit default swaps, which
have proved to be capable of exposing those firms to the vicissitudes of international
finance and the risk of insolvency.
But the American insurance regulation system has long been focused on the local market
and the protection of policy holders, instead of the global market and the stability of
insurance firms. To the extent that state insurance commissioners focus on the solvency
of insurers, they do so from a consumer protection perspective. That means they consider
whether firms are likely to be able to pay out on their policies, rather than on the effect
that they have on the financial system as a whole.
Some financial experts claim that the financial crisis shows that American insurance
supervision is focused on the wrong problems. In fact, under Section 313(p) of Title 31
of the United States Code, as codified by the Dodd-Frank Wall Street Reform and
Consumer Protection Act, it required the Federal Insurance Office to conduct a study on
how to modernize and improve the system of insurance regulation in the United States.
After nearly two years of delay, the U.S. Department of the Treasury’s Federal Insurance
Office (FIO) released its report, on how to modernize and improve the system of
insurance regulation in the United States. The FIO report concluded that in some
circumstances, policy goals of uniformity, efficiency, and consumer protection make
continued federal involvement necessary to improve insurance regulation. The report
states:
“…should the states fail to accomplish necessary modernization reforms in the
near term, Congress should strongly consider direct federal involvement.”
However, in a softer note the report emphasizes that insurance regulation in the United
States is best left to a hybrid mode, where both state and federal regulatory bodies play
complementary roles.
“The business of insurance involves offering many products that are tailored for
and delivered at a local level. For the most part, effective delivery of the product
will require local knowledge and relationships, and local regulation. Moreover,
establishing a new federal agency to regulate all or a part of the $7.3 trillion
insurance sector would be a significant undertaken.”
To review the complete report of the FIO recommendations visit:
http://www.treasury.gov/initiatives/fio/reports-andnotices/Documents/How%20to%20Modernize%20and%20Improve%20the%20System%
20of%20Insurance%20Regulation%20in%20the%20United%20States.pdf
219
Certainly the future role of states in the insurance regulatory arena is in question. There
is no doubt that there are serious barriers to coordination among the states which prohibit
them from being effective regulators on certain issues. In addition, because of the
predominance of nationwide operations, there are potential externalities that can be
remedied by a federal approach to regulation (like CE and state licensing requirements).
To be fair, there are also potential problems with federal regulation that need to be
addressed. State regulation does protect the industry from bad regulation in the sense that
if a state were to make a serious error regarding regulation, the negative effects of the
error will likely be most felt in the state with the “bad” regulation. In contrast, a mistake
at the federal level hurts the entire industry nationwide. Further, merely copying state
regulation without thinking about the merits of the regulation is also inefficient.
So, whatever your feelings are with regards to the regulation of insurance industry it will
probably continue on the current path of a “hybrid” approach consisting of both state and
federal regulation. Stay tuned!
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Chapter 11
Review Questions
1. Which of the following court decisions held that insurance is not commerce and is
therefore not subject to regulation by the federal government?
(
(
(
(
) A. Paul v. Virginia
) B. United States v. South-Eastern Underwriters Assoc.
) C. Prudential Ins. Co. v. Benjamin
) D. None of the above
2. Most regulation of the insurance industry is conducted at what level?
(
(
(
(
) A. Federal
) B. State
) C. Self-regulation
) D. NAIC
3. The body of laws regulating the insurance industry at the state level is called:
(
(
(
(
) A.
) B.
) C.
) D.
State statutes
Administrative Rules
Insurance Code
State Constitution
4. Which court case reversed the decision in Paul v. Virginia and ruled that insurance
transacted across state lines is interstate commerce subject to federal law?
(
(
(
(
) A. McCarran-Ferguson
) B. ERISA
) C. U.S. v. South-Eastern Underwriters Association
) D. Prudential Insurance Co. v. Benjamin
5. Which Section of the Dodd-Frank Wall Street Reform Act contains a provision that
limits the ability of the SEC to classify indexed annuities and other insurance products
as securities?
(
(
(
(
) A. Section 152
) B. Section 502
) C. Section 412
) D. Section 989J
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CHAPTER 12
UNFAIR MARKETING PRACTICES
Overview
Most states have laws that prohibit insurers from engaging in “unfair trade practices.”
The NAIC Unfair Trade practices Act was one of the first NAIC model laws, having been
adopted in 1947 shortly after enactment of the McCarran-Ferguson Act in 1945.
In this chapter, we will examine several unfair trade practices that have been developed
by the NAIC in their enforcement of ethical practices in the insurance industry. It will
also review several other Model laws issued by the NAIC that have become part of many
state’s insurance code to protect consumers from unfair marketing practices conducted by
unethical insurance producers. In addition, the chapter will also review the FINRA/SEC
suitability laws.
Learning Objectives
Upon completions of this chapter, you will be able to:






Demonstrate an understanding of the Unfair Marketing Practices;
Identify when to use and not to use specific Certifications and Designations;
Recognize the key elements of the Annuity Disclosure Rules;
Demonstrate when a sale of an annuity may be unsuitable;
Apply the 2010 Annuity Suitability Model Regulation in the sale of annuities; and
Identify the FINRA/SEC suitability rules.
Background
Each state regulates the ethical conduct of insurance producers by creating rules,
regulations and legislation (statutes) that become part of the state’s Insurance Code that is
set forth to protect the consumer.
The Unfair Marketing Practices Act was created by the National Association of Insurance
Commissioners (NAIC) back in the 1940’s and since then has been amended (2004) and
expanded. The Act is divided into two parts—Unfair Marketing Practices and Unfair
Claims Practices. In each state, statutes define and prohibit certain marketing practices
and claims practices, which are unfair, unethical, misleading and deceptive.
223
Purpose of the Act
The purpose of this Act:
“… is to regulate trade practices in the business of insurance in accordance with
the intent of Congress as expressed in the Act of Congress of March 9, 1945
(Public Law 15, 79th Congress) and the Gramm-Leach-Bliley Act (Public Law
106-102, 106th Congress), by defining or providing for the determination of, all
such practices in this state that constitute unfair methods of completion or unfair
or deceptive acts or practices and by prohibiting the trade practices so defined or
determined. Nothing herein shall be construed to create or imply a private cause
of action for a violation of this Act.”
Let’s review several of these unfair marketing practices beginning with
misrepresentation.
Misrepresentation
“Misrepresentation” is simply a false statement of fact; that is a lie. For many insurance
agents, the biggest market conduct danger they may face is making a misrepresentation
during a sales presentation. Sometimes, it is the result of over-enthusiasm of “selling”
the benefits of a policy too strongly. It may also be the result of a willingness to stretch
the advantages of a particular product and sidestep the disadvantages. While on the other
hand, providing vague or elusive responses is just as serious a form of misrepresentation
as is deliberately lying about a policy’s features and benefits or expected performance.
Fraud
If an insurance agent intentionally misrepresents any information in an insurance
transaction, he or she is guilty of “fraud.” An insurance agent found guilty of fraud may
be subject to fines and/or imprisonment as well as the possible loss of their license to sell
insurance as well as public disgrace.
Altering Applications
“Altering applications”, for any purpose, is not permitted. It is illegal and insurance
agents must not engage in altering applications.
In the past, applications have been altered for a number of fraudulent reasons, such as to:

Change underwriting information to get a more favorable premium rate, or
224


Switch the type of coverage applied for, or
Add additional zeroes to the amount of coverage applied for.
Premium Theft
Of all the prohibited activities, “premium theft” ranks among the worst offense an
insurance agent can commit. In addition to the outright theft of the premium money,
failure to turn over a premium on a policy prevents the policy from going into effect. The
consumer believes he or she is insured, but in fact, the application was never submitted to
the insurance company. These situations are quickly discovered if any inquiry is made
by the prospective insured or the insurance company.
Premium theft is rigorously punished by every state Insurance Department.
False or Misleading Advertising
The potential for “false (deceptive) advertising” or promotion by insurance companies
and or insurance agents alike is significant and the consequences to the consumer can be
grave. Accordingly, all states regulate insurance advertising.
The NAIC has created a model regulation more specifically directed at advertising—the
Rules Governing Advertising of Life Insurance. This model regulation, which so far has
been adopted by more than 31 states, defines advertising and attempts to address those
actions that have caused the most problems in the industry. It also mandates the proper
identification of insurance agents and companies, a system of control over its
advertisement, a description of the type of policy advertised, and the disclosure of graded
or modified benefits over time and so forth.
Recently, several states have passed specific legislation (For example in California, two
bills were passed by the legislators, SB 620 and SB 618) for regulating advertising to
seniors age 65 and older.
Defamation
“Defamation” is any false maliciously critical or derogatory communication written or
oral—that injures another’s reputation, fame or character. Without the element of
communication there can be no defamation. Both insurance agents and insurers can be
defamed. Unethical insurance agents participate in defamation by spreading rumors or
falsehoods about the character of a competing insurance agent or the financial condition
of another insurer.
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Boycott, Coercion, Intimidation
“Boycott, coercion and intimidation” are unethical trade practices, which attempt to limit
or restrain trade in the sale of insurance. No person or company has the right or the
power to force, coerce or intimidate any person into purchasing insurance from a specific
insurance agent or insurer.
Twisting
“Twisting” is the unethical act of inducing a client to lapse, surrender or terminate an
existing insurance product solely for the purpose of selling another policy with another
insurer without regard to the possible disadvantages to the policy owner. By definition,
twisting involves some kind of misrepresentation by the insurance agent to convince the
policy owner to switch insurers. The key word in the definition of “twisting” is
“inducement”. Twisting is illegal and should not be confused with replacement, which is
legal if done in accordance with specific state laws.
Churning
Related to twisting is “churning”. If an insurance agent induces a prospect/client to
replace a policy with a new policy with the same insurer and if the replacement is not in
the client’s best interest, the insurance agent is guilty of churning. In cases involving
churning, there is no demonstrated benefit to the policy owner with the new policy or
contract. Churning is unethical and illegal.
Discrimination
“Discrimination” is both illegal and unethical in accordance with state and federal laws.
From an insurer’s perspective, it is unlawful to permit discrimination between individuals
of the same class and life expectancy regarding life insurance rates, dividends or other
policy benefits. It is unlawful to discriminate because of age in the issuance of and rates
for automobile insurance. It is unethical and illegal to permit or cause discrimination due
to race, creed, color or national origin regarding the issuance or the rates charged for
insurance.
Rebating
Splitting a commission or paying a client for his or her business is considered
“rebating." Rebating occurs if the buyer of an insurance policy receives any part of the
insurance agent's commission or anything else of significant value as an inducement to
226
purchase the insurance product being sold by the insurance agent. Rebating is illegal in
all but two states:


California (Rules regarding unfair practices are outlined in CA Assembly Bill 689
specific to annuity sales and suitability to seniors, and in CIC 790-790.15 for all
insurance transactions); and
Florida (Rules specific to the allowance of rebating are found in the 2012 Florida
Statues, Title XXXVII, Section 626.572).
However, most insurers forbid their insurance agents to rebate even in jurisdictions where
it is legal. It is acceptable to provide gifts of nominal value (pens, calendars, coffee mugs,
etc.) to prospects and clients when those gifts are given regardless of whether or not you
make a sale. If you provide a nominal gift, you must provide it to everyone you
approach.
Use of Senior Specific Certifications and Designations
The NAIC membership gave its final approval (Fall Meeting-September 2008) on the
Model Regulation on the Use of Senior-Specific Certifications and Professional
Designations in the Sale of Life Insurance and Annuities (Model Regulation 278). The
new model follows the approach for regulating senior-specific designations taken in the
model rule adopted on April 1, 2008 by the North American Securities Administrators
Association (NASDSA).
Both models are designed to stop the use of misleading senior-specific designations by
establishing a standard of whether the use of a particular designation indicates or implies,
in a way that misleads the consumer, that the agent has special certification or training in
advising seniors. Neither model references specific designations; rather, individual
designations will be measured against this standard. The models establish what is
essentially a safe harbor for designations that:


Are not primarily sales/marketing oriented and
Are issued/accredited by the American National Standards Institute, the National
Commission for Certifying Agencies, or an institution of higher education.
The models also expressly prohibit the use of designations that have not been legitimately
earned, that are nonexistent, or that misrepresent a level of expertise of education that
does not exist.
The NAIC Model applies to the sale of insurance-related products. Under Section 5 A(1)
of the Model Act it states:
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“It is unfair and deceptive act of practice in the business of insurance for an
insurance producer to use a senior-specific certification or professional
designation that indicates or implies in such a way as to mislead a purchaser or
prospective purchaser that insurance producer has special certification or
training in advising or servicing seniors in connection with the solicitation, sale
or purchase of a life insurance or annuity product or in the provision of advice as
to the value of or the advisability of purchasing or selling a life insurance or
annuity product, either directly or indirectly through publications or writings, or
by issuing or promulgating analyses or reports related to a life insurance or
annuity product.”
The prohibited use of senior-specific certifications or professional designations includes,
but is not limited to, the following:



Use of a certification or professional designation by an insurance agent who has
not actually earned or is otherwise ineligible to use such certification or
designation;
Use of a nonexistent or self-conferred certification or professional designation;
use of a certification or professional designation that indicates or implies a level
of occupational qualifications obtained through education, training or experience
that the insurance agent using the certification or designation does not have; and
Use of a certification or professional designation that was obtained from a
certifying or designating organization that:
o Is primarily engaged in the business of instruction in sales or marketing;
o Does not have reasonable standards or procedures for assuring the
competency of its certificants or designees;
o Does not have reasonable standards or procedures for monitoring and
disciplining its certificants or designees for improper or unethical conduct;
or
o Does not have reasonable continuing education requirements for its
certificants or designees in order to maintain the certificate or designation.
Annuity Disclosure Model Regulation
On August 3, 2011, the NAIC Life Insurance and Annuities (A) Committee adopted
revisions to the Annuity Disclosure Model Regulation, Model 245 ("Annuity Disclosure
Model" or "Model"). The revised Annuity Disclosure Model continues to require that
consumers be provided a Buyer's Guide and a disclosure document. The revised Annuity
Disclosure Model applies to fixed annuities, index annuities and variable annuities.
228
Fixed and Index Annuities
The most substantive change to the Annuity Disclosure Model is the addition of the
standards for fixed and fixed indexed annuity illustrations. New Section 6 applies to an
"illustration," which is defined to mean "a personalized presentation or depiction
prepared for and provided to an individual consumer that includes non-guaranteed
elements of an annuity contract over a period of years." In addition to setting forth the
parameters for non-guaranteed and guaranteed elements of illustrated values and the
manner of presentation of such values, the new illustration standards require:



A narrative summary (unless the information is provided at the same time in a
disclosure document).
A numeric summary.
If the annuity contains a market value adjustment ("MVA"), a narrative
explanation of the MVA, a demonstration of the MVA under at least one positive
and one negative scenario, and actual MVA floors and ceilings.
New Section 6 includes additional specific requirements for a fixed indexed annuity
illustration. These requirements include illustrating the nonguaranteed values for three
different scenarios:



The last continuous 10 calendar years.
A continuous 10 calendar year period out of the last 20 that would produce the
least index value growth.
A continuous 10 calendar year period out of the last 20 that would produce the
most index value growth.
If any index has not been in existence for at least 10 calendar years, then that index may
not be illustrated.
The Model also was revised to include additional disclosure items for fixed indexed
annuities.
Variable Annuities
Previously, the Annuity Disclosure Model did not apply to the sale of registered variable
annuities. The Model was revised to require the following be delivered in connection
with a sale of a registered variable annuity:


A Buyer's Guide.
After January 1, 2014, a disclosure document, unless prior to such date, the SEC
adopts a summary prospectus rule or FINRA approves for use a simplified
disclosure form applicable to variable annuities.
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Variable annuity illustrations, however, are not subject to the revised Annuity Disclosure
Model's new standards for illustrations.
The Annuity Disclosure Model was revised to include a new exception from the Model
for non-registered variable annuities issued exclusively to accredited investors or
qualified purchasers.
Recordkeeping
The Model was revised to include a requirement to maintain or make available to the
insurance regulatory authorities records of the information collected from the consumer
and other information provided in the disclosure statement (including illustrations).
Annuity Suitability Model Regulation
The National Association of Insurance Commissioners (NAIC) has taken specific actions.
Dating back to 2000, these actions require both insurance producers and insurers selling
annuities to take affirmative steps to ensure the suitability of the annuity for the
consumer. Below, we will review the history of several Model Regulations passed by the
NAIC to protect consumers when purchasing both fixed and/or variable annuities.
Senior Protection in Annuity Transactions Model Regulation
In 2000, the NAIC adopted a white paper calling for the development of suitability
standards for non-registered products similar to those existed for some time under the
Securities and Exchange Commission (SEC) for registered products (discussed below).
The result of the white paper was a working group of the NAIC under the Life Insurance
and Annuities Committee that drafted a model setting suitability standards for all life
insurance and annuity products.
The NAIC Life Insurance and Annuity Committee decided to focus first on the area that
had been identified as subject to the greatest abuse: the inappropriate sales of annuities to
persons age 65 and over. The resulting Senior Protection in Annuity Transactions Model
Regulation (“Suitability Model”) was adopted by the NAIC in 2003. This Model
Regulation was another tool that regulators could use to protect consumers from
inappropriate sales practices in addition to the NAIC’s Annuity Disclosure Model
Regulation.
2006 Suitability Model
Then in 2006, still concerned about the abusive and unsuitable sales of both life insurance
and annuity products not just to seniors, the NAIC membership overwhelmingly adopted
revisions to the “Suitability Model” to have its requirements apply to all consumers
regardless of age.
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The amended “Suitability Model” imposes certain duties and responsibilities on insurers
and insurance agents regarding the suitability of a sale or exchange of an annuity to a
consumer. Specifically, in recommending to a consumer the purchase of an annuity or
the exchange of an annuity, the insurance agent, or the insurer if no agent is involved,
must have “reasonable grounds” for believing that the recommendation is suitable for the
consumer. This is based on facts disclosed by the consumer as to his or her investments
and other insurance products and as to his or her financial situation and needs. To
ascertain the product’s suitability, prior to the execution of a purchase or exchange of the
recommended annuity, the insurance agent, or insurer if no agent is involved, must make
all reasonable efforts to obtain information concerning:




Consumer’s financial status;
Consumer’s tax status;
Consumer’s investment objectives, and
Any other information used or considered to be reasonable in making the
recommendation to the consumer.
However, since fixed annuities are not considered securities, they are regulated only by
state departments of insurance and traditionally were not subject to the same suitability
requirements as variable annuities. In March 2010, the NAIC took action to recommend
model regulations to bring all annuities in line with existing securities regulations
governing variable annuity transactions with The 2010 NAIC Suitability in Annuity
Transactions Model Regulation.
2010 NAIC Suitability in Annuity Transactions Model Regulation
In 2010, the NAIC again amended the “Suitability Model” with the 2010 Suitability in
Annuity Transactions Model Regulation. The purpose of this Model Regulation was to
set standards and procedures for suitable annuity recommendations for purchase and
exchanges of an annuity (both fixed and variable), and requires insurers to establish a
supervisory system.
Specifically, this Model Regulation was adopted to:



Require insurance producers to have reasonable grounds for believing that the
recommendation to by an annuity is suitable for the consumer;
Establish a regulatory framework that holds insurers responsible for ensuring that
annuity transactions are suitable (based on the criteria discussed below), whether
or not the insurer contracts with a third party to supervise or monitor the
recommendations made in the marketing and sale of annuities.
Require that agents be trained on the provisions of annuities in general, and the
specific products they are selling.
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
Where feasible and rational, to make suitability standards consistent (a safeharbor) with the suitability standards imposed by the Financial Industry
Regulatory Authority (FINRA).
Determining Suitability
As discussed above, the 2006 version of the NAIC Model Regulation required that, prior
to recommending an annuity, an insurance producer or an insurer must make reasonable
efforts to obtain information about the consumer's financial status, tax status, and
investment objectives, as well as other information that could be used in making a
recommendation to the consumer.
However, the newly revised 2010 NAIC Model Regulation, Section 6, imposes a
substantially higher benchmark for determining the "suitability" of all types of annuities,
closely approximating FINRA standards applicable to variable annuity sales.
First, the 2010 Model Regulation requires that the insurance agent have "reasonable
grounds" to believe that the annuity recommendation is suitable for the consumer. This
suitability determination is to be made from "suitability information" disclosed by the
consumer about his investments and other insurance products and his financial situation
and needs. Such "suitability information" consists of 12 different factors, including the
consumer's intended use of the annuity, financial time horizon, existing assets, liquidity
needs, liquid net worth, and risk tolerance.
These suitability factors are clearly more expansive than the few listed in the 2006
version of the Model Regulation. They are:












Age;
Annual income;
Financial situation and needs, including the financial resources used for the
funding of the annuity;
Financial objectives;
Financial experience;
Intended use of the annuity;
Financial time horizon;
Existing assets, including investment and life insurance holdings;
Liquidity needs;
Liquid net worth;
Risk tolerance; and
Tax status.
Note: California added a 13th factor: Whether or not the consumer has a reverse
mortgage.
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Second, duties of insurers and of the insurance agent must also have a "reasonable basis"
to believe that the annuity as a whole, its unique features, and the transaction itself are in
the best interests of, and can be understood by, the consumer. Specifically, Under Section
6A, the insurance agent, or the insurer where no agent is involved, shall have reasonable
grounds for believing that the recommendation is suitable for the consumer on the basis
of the facts disclosed by the consumer as to his or her investments and other insurance
products and as to his or her financial situation and needs, including the consumer’s
suitability information, and that there is a reasonable basis to believe all of the following:




The consumer is reasonably informed of the annuity's features;
The consumer will benefit from certain features of the annuity, such as taxdeferred growth, annuitization, or a death or living benefit;
The particular transaction, the annuity as a whole, the underlying sub-accounts,
and any riders and similar product enhancements are suitable for the particular
consumer; and
As applicable, the exchange or replacement is suitable, considering surrender
charges, increased fees, benefits from product enhancements and improvements,
and other exchanges or replacements within the preceding 36 months.
Both the 2006 and 2010 versions of the Model Regulation limit the agents' obligations to
the consumer where the consumer refuses to provide complete or accurate suitability
information or enters into an annuity transaction that expressly is not recommended.
Section 6D of the 2010 Model Regulation states that neither an agent nor an insurer has
any obligation to a consumer under the provisions of this regulation if:




No recommendation is made;
The consumer provided materially inaccurate information which led to an
unsuitable recommendation;
A consumer fails to provide relevant suitability information and the transaction is
not recommended of an insurance agent.
However, an insurer’s issuance of an annuity is to be reasonable under all
circumstances actually known to the insurer, even if the situations listed above
apply.
Systems of Supervision and Training
The 2010 Model Regulation, Section 6F, now provides additional guidance for
establishing effective supervisory procedures.
Under the newly amended Model Regulation, insurance agents must make a record of
any annuity recommendation and obtain a consumer signed statement if the consumer
refuses to provide the required suitability information or decides to purchase an annuity
not based on a recommendation.
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In addition, prior to the issuance of an annuity contract, the insurer (or a third party with
whom the insurer has contracted) must review annuity recommendations to ensure that
there is a reasonable basis to believe the transaction is suitable. This may be
accomplished by a screening system that would identify selected transactions for
additional scrutiny.
The insurer also will be required to maintain reasonable procedures to detect
recommendations that are not suitable, including confirming consumer suitability
information, conducting customer surveys and interviews, sending confirmation letters
and establishing internal monitoring programs.
Finally, the 2010 Model Regulation mandates that insurers train their insurance agents on
the new suitability requirements and on the products themselves. Section 7A requires the
insurance agent to have adequate product training, prior to soliciting an annuity product.
In addition, Section 7B requires a one-time, minimum four (4) credit hour general
annuity training course offered by an insurance-department approved educational
provider and approved by an insurance department in accordance with applicable
insurance education training laws or regulations. For this mandated course, the provider
may not train in sales or marketing techniques or product specific information.
Section 7B (3) outlines the minimum required topics for this program of instruction,
which can be offered in the classroom or via an insurance department approved self-study
method. If an insurance agent is licensed with a life insurance line of authority prior to
the effective date of the regulation, there is a six month grace period to comply with the
training requirements; insurance agents who obtain the life authority on or after the
effective date of the regulation must complete the training prior to the sale of an annuity
product.
FINRA Compliance
It should be noted that under Section 6H of the Model Regulation's safe harbor provision,
sales of annuities already in compliance with FINRA rules will comply with the new
NAIC suitability regulation as well. Broker-Dealers may subject fixed annuity sales to
FINRA suitability and supervision rules; and sales made in compliance with such rules
would also qualify as complying with the NAIC suitability regulation. However, since,
FINRA does not have authority to enforce its rules on the sale of fixed annuities, brokerdealers supervising fixed annuity sales may be subject to more intensive insurance
examination than for the sale of security insurance products. Representatives of a brokerdealer, who are not required by the broker-dealer to comply with the FINRA
requirements on the sale of fixed annuities, will have to comply with the insurance
suitability regulation adopted by the state. In any case, insurers are responsible for any
unsuitable annuity transactions no matter what suitability regulation or rule is applied by
a broker-dealer.
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The Wall Street Reform and Consumer Protection Act of 2010
As was discussed in Chapter 11, under Section 989J of the Wall Street Reform and
Consumer Protection Act of 2010 (also known as the Harkin Amendment), it called for
all states to adopt and enforce the NAIC 2010 Suitability in Annuities Transaction Model
Regulation (Model Act 275. In addition, the Federal Insurance Office (FIO), which was
created by the Act, also calls on the states to adopt the NAIC Model Act 275. The
annuity suitability recommendation appears in the “marketplace oversight” section. It
runs only 650 words, but annuity professionals will be perusing those words very
carefully. The report states:
“The suitability of an annuity purchase should not be dependent upon the state in
which the consumer resides,”
Reading between the lines, the underlying message is that this is no time for footdragging. All states need to adopt and implement the NAIC suitability model ASAP. If
all states aren’t on board fairly soon, the feds might step in. According to the 71-page
report:
“Given the importance of national suitability standards for consumers
considering or purchasing annuities, states should adopt the Model Suitability
Regulation. In the event that national uniformity is not achieved in the near term,
federal action may become necessary.”
The last statement – that “federal action may be necessary” – will no doubt stir up a
certain amount of industry murmuring. That is because, according to various published
reports, many states have already adopted one version or another of the annuity suitability
model developed by NAIC. “So why even bring this up?” some professionals will ask.
Apparently, this has to do with the lack of uniformity among those regulations. As was
discussed above, the NAIC has adopted three versions of its suitability model over the
years. The 2003 version applies to sales involving senior buyers. The 2006 version
updates the model to apply to consumers of all ages. And the 2010 model substantially
strengthens the standards (by clarifying insurer compliance and producer education
requirements, for example).
To bolster its case, the FIO researchers point out that the Dodd-Frank Act has two sets of
provisions that incorporate this suitability model.

One set of provisions essentially involves voluntary adoption. Here, the act
provides “incentives” for state regulators to enact national suitability standards.
These include grants for which states can apply to support efforts “to enhance the
protection of seniors from misleading and fraudulent sales of financial products,”
the researchers say. The catch is, in order to obtain the grants, the states must
meet certain requirements, including a requirement to “adopt suitability standards
that meet or exceed” those in the model regulation. They could choose not to
adopt the standards, but then they won’t qualify for the grants.
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
The second set of provisions moves closer to being an indirect requirement. Here,
Dodd-Frank includes a direction to the Securities and Exchange Commission that
involves both the suitability model and regulation of indexed annuities. This is
the so-called Harkin Amendment, and it exempts indexed annuities from
securities regulation. To get the exemption, an indexed annuity must meet certain
standards. One of the standards is that the annuity must be issued in a state that
has adopted the suitability model or be issued by an insurer whose nationwide
practices meet or exceed the suitability model standards.
Currently, only thirty-five states have adopted the 2010 version (See Table 12.1), with
more on the way. But the other states adopted the earlier versions or, in a few cases, they
have entirely different suitability approaches in effect.
NAIC has put on a big push to spur the remaining states to adopt the 2010 version. But
states handle NAIC model adoption in different ways and in accordance with their own
laws. That means state adoption of this particular model, as with most models, has
occurred over a period of years, not months.
Relative to that point, the FIO’s call for the states to achieve uniformity in the “near
term” will be another source of concern. Annuity professionals and state regulators will
ponder what “near term” means in this context. Within a few months? A year? Five
years? When?
Table 12.1
States Adopted 2010 NAIC Suitability Model
Date
Effective
Regulation
AK
CA
10/16/11
9/29/03
1/1/12
4/1/11
MN
ND
2013 MN H.F. 791
H.B. 116 Section 4
6/1/13
8/1/11
NE
L.B. 887
7/19/12
2/18/12
NJ
6/24/11
OH
FL
SB 166
6/14/13
OK
HI
Act 108
1/1/12
OR
IA
Iowa Administrative Rule
191-15.72
Illinois Code
Section 3120.69(c)(4)
HB 1486
HB1015
K.A.R. 40-2-14A
1/1/11
RI
10/7/11
SC
N.J.A.C.
11:4-59A.3
Ohio Admin. code
Rule 3901-6-13
Administrative Code
Title 365:25-3-21
OAR 836-071-0180
to 0250
RI Insurance
Regulation 12.6
South Carolina
Regulation 69-29
2/4/13
DC
3 AAC 26.110
SB620 Section 1749.8 AB
1416 and AB 689
3 CCR 702-4
Regulation 4-1-11
CT Ins. Regulations
Sections 38a-432a-1-8
DC Rule 8404.1-11
1/1/12
SD
S.B. 32
7/1/12
6/1/13
TX
HB 2277
9/1/10
CO
CT
IL
IN
KS
State
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Regulation
Date
Effective
State
7/1/11
7/14/10
7/1/11
6/1/11
9/25/11
HB 2154F
KY
806 KAR 9:220
Section 5
1/1/12
WA
LA
H.B. 1177
8/15/12
WI
MD
COMAR 31.09.12.07
10/31/11
WV
MI
Senate Bill 467
Section 4160
WAC 284-17-265
Section 628.347
Wisconsin Statutes
Title 114
Legislative Rule 11B
3/29/12
5/1/11
7/1/11
6/1/13
Source: NAIC; As of September 2014, the following states have not adopted the 2010 Suitability Model: AL, AZ, AR,
DE, GA, MA, ME, MO, MY, NV, NM, NC, PA, TN, VT, and VA.
FINRA/SEC Suitability Regulations
The Financial Industry Regulatory Authority (FINRA), previously known as the National
Association of Security Dealers (NASD), is an independent self-regulatory organization
charged with regulating the securities industry, including sellers of variable annuities.
FINRA has issued several investor alerts on the topic of variable annuities and has issued
a number of Rules pertaining to the sale and suitability of variable annuities (discussed
below).
FINRA Rule 2821
Based on the findings of a joint report “Examinations Findings Regarding Broker-Dealer
Sales of Variable Insurance Products” (Joint Report) which identified “weak practices”
regarding the suitability of variable annuity sales practices for investors and the lack of
adequate disclosure of the risks, fees and tax consequences, FINRA published Rule 2821.
FINRA Rule 2821 imposed stringent sales practice standards and supervisory
requirements on the sale of variable annuities by its members. The Rule set forth
disclosure and information-gathering responsibilities regarding the sale of deferred
variable annuities, as well as supervisory requirements to increase disclosure and sales
force training.
The key requirements of the rule include:

Suitability (Rule 2821(b)): Requires that no recommendation shall be made
unless reasonable efforts have been made to obtain, at a minimum, information
concerning the customer’s:
o Age,
o Annual income,
o Financial situation and needs,
o Investment experience,
o Investment objectives,
o Intended use of the deferred variable annuity,
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o
o
o
o
o
o
Investment time horizon,
Existing investment and life insurance holdings,
Liquidity needs,
Liquid net worth,
Risk tolerance, and
Tax status.
Under the new rules, the insurance agent/registered representative would be required to
ascertain the following key pieces of information from the client:


Has the client been informed of the unique features of the variable annuity?
Does the client have a long-term objective?
o Is the annuity and its underlying sub-accounts the right match for the
particular client?
Once the suitability requirements are reviewed, the insurance agent/registered
representative would need to sign off on their validity. At the end of the day, the
insurance agent/registered representative should be able to answer yes to the above
checklist of suitability guidelines.

Disclosure: The member firm or its representative would be required to provide
the client with a current prospectus and a separate, brief, “plain English” risk
disclosure document highlighting the main features of the particular variable
annuity transaction. Those features would include:
o Liquidity issues, such as potential surrender charges and IRS penalties;
o Sales charges;
o Fees (including mortality and administrative fees, investment advisory
fees and charges for riders or special features);
o Federal tax treatment for variable annuities;
o Any applicable state and local government premium taxes, and
o Market risk.
The risk disclosure document would be required to inform the client whether a “free
look” period applies to the variable annuity contract, during which the client could
terminate the contract without paying any surrender charges and receive a refund of his or
her purchase payments.

Principal Review (Rule 2821 (c)): Requires that a registered principal must
review and sign off on suitability and disclosure requirements, no later than seven
(7) business day following the date when a firm’s office of supervisory
jurisdiction (OSJ) receives a complete an correct application package. The
registered principal will be required to retrace the suitability requirements that the
writing agent addressed, including:
o What is the client’s age and liquidity need?
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o Does the amount of money exceed a specific percentage of the client’s net
worth or more than a set dollar amount?
o Does the transaction involve an exchange or replacement?
o Is the purchase of the VA for a tax-qualified retirement account?
If a transaction has an exchange or replacement clause, the registered principal
would need to review and approve a separate exchange or replacement document.
Justification for the FINRA’s new rules, according to the agency, is that the
principal review requirements ultimately give the client the ability to review,
complete and execute an application for a VA in a quick one-step process.

Training (Rule 2821 (e)): Registered firms would be required to develop and
document specific training policies or programs designed to ensure that registered
representatives and registered principals comply with the rule’s requirements and
that they understand the unique features of deferred variable annuities.
The Security Exchange Commission (SEC), after years of review and discussion,
approved Rule 2821 on September 7, 2007 with an effective date of May 5, 2008.
The SEC made the following changes to Rule 2821:



The rules application applies to the purchase or exchange (not sale or surrender)
of a deferred variable annuity and the initial subaccount allocations.
The rule does not apply to reallocations of sub-accounts made or to funds paid
after the initial purchase or exchange of a deferred variable annuity. Note: There
are other FINRA rules, however, that are applicable to such transactions. For
instance, FINRA’s general suitability rule (FINRA Rule 2310) continues to apply
to any recommendations to reallocate sub-accounts or to sell a deferred variable
annuity. FINRA Rule 2821 applies to the use of deferred variable annuities to
fund IRAs, but not to deferred variable annuities sold to certain tax-qualified,
employer-sponsored retirement or benefit plans, unless a member firm makes a
recommendation to an individual plan participant, in which case the rule would
apply to that recommendation.
“The new rule applies to sales to all investors and not just to seniors.
The SEC published the order approving the new rules in Release Number 34-56375,
which relates to File Number SR-NASD-2004-183.
FINRA Rule 2330
January 2010, FINRA consolidated Rule 2821 on deferred variable annuities into FINRA
Rule 2330. The consolidated rule establishes sales practice standards regarding
recommended purchases and exchanges of deferred variable annuities. All of the rule’s
provisions became applicable as of February 8, 2010. The rule has the following six
main sections:
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





General considerations, such as the rule’s applicability;
Recommendation requirements, including suitability and disclosure obligations;
Principal review and approval obligations;
Requirements for establishing and maintaining supervisory procedures;
Training obligations; and
Supplementary material that addresses a variety of issues ranging from the
handling of customer funds and checks to information gathering and sharing.
FINRA Rule 2111
As part of the process to develop a new consolidated rulebook (the Consolidated FINRA
Rulebook), Regulatory Notice 09-25, calls for the elimination of FINRA Rule 2310 to be
consolidated with the new FINRA Rule 2111 (“Suitability Rule”). The modified rule
would codify various interpretations regarding the scope of the suitability rule, clarify the
information to be gathered and used as part of a suitability analysis and create a clear
exemption for recommended transactions involving institutional customers, subject to
specified conditions.


Scope of FINRA Rule 2111: FINRA Rule 2111 will explicitly apply suitability
obligations to a recommended transaction or investment strategy involving a
security or securities. In this regard, the Rule would codify longstanding SEC and
FINRA decisions and other interpretations stating that FINRA Rule 2111 covers
both recommended securities and strategies. FINRA also proposes to codify in
one place the discussions of the three main suitability obligations (reasonable
basis, customer specific and quantitative), which are currently located in various
IMs following FINRA Rule 2310.
Information Gathering Regarding the Proposed Suitability Rule: FINRA Rule
2111 contains a number of minor changes regarding the gathering and use of
information as part of the suitability analysis. For instance, the information that
must be analyzed in determining whether a recommendation is suitable would
include not only information disclosed by the member firm’s or associated
person’s reasonable efforts to obtain it, but also information about the customer
that is “known by the member or associated person.” The Rule also requires
members or associated persons to make reasonable efforts to obtain more
information than is explicitly required by FINRA Rule 2310 (age, investment
experience, investment time horizon, liquidity needs and risk tolerance).
FINRA Rule 2090: Know Your Customer
FINRA Rule 2090, will also transfer into the Consolidated FINRA Rulebook a modified
version of NTSE Rule 405(1) requiring firms to use due diligence to know their
customers and eliminate the NYSE version and its related supplementary material and
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rule interpretation. The Rule would eliminate paragraphs (2) and (3) of NYSE Rule 405
and their related supplementary materials and rule interpretations as duplicative of NASD
provisions that FINRA has proposed (or will be proposing) to be transferred into the
Consolidated FINRA Rulebook. For instance, NYSE Rule 405(2) (Supervision of
Accounts) is duplicative of NASD Rule 3110 (c )(1)(C )(Customer Account Information)
and 3011 (Anti Money Laundering Compliance Program) and, to a certain extent, the
proposed modified version of NYSE Rule 405(1), discussed below.
FINRA Rule 2090, know-your-customer obligation, captures the main ethical standard of
NYSE Rule 405(1). Firms would be required to use due diligence, in regard to the
opening and maintenance of every account, to know the essential facts concerning every
customer (including the customer’s financial profile and investment objectives or policy).
This information may be used to aid the firm in all aspects of the customer/broker
relationship, including, among other things, determining whether to approve the account,
where to assign the account, whether to extend margin (and the extent thereof) and
whether the customer has the financial ability to pay for transactions. The obligation
arises at the beginning of the customer/broker relationship and does not depend on
whether a recommendation has been made.
SEC Approves Consolidated FINRA Rules
The SEC approved FINRA’s proposal (Regulatory Notice 09-25) to adopt rules
governing know-your-customer (FINRA Rule 2090) and suitability (FINRA Rule 2111)
obligations for the consolidated FINRA rulebook. The new rules are based in part on and
replace provisions in the NASD and NYSE rules and are discussed below.
Recent FINRA Disciplinary Action
You may be asking yourself why we have so much regulation. This recent FINRA
disciplinary action may give you the answer. In a recent case (7/2014) two registered
representatives recommended and effected unsuitable VA transactions for their
customers, causing their customers to pay unnecessary surrender fees on VA’s that had
only been held for two to three years, and incurring longer surrender periods on new
VA’s.
FINRA’s facts and figures give a good sense of the seriousness of the conduct. One of
the brokers switched 140 customers who held 214 fixed or variable annuities to a VA
issued by an unaffiliated third-party insurance company, costing the customers
approximately $208,000 in unnecessary surrender penalties and earning the broker
$380,235 in commissions. The other broker switched 66 customers who held 87 fixed or
variable annuities to the same unaffiliated VA, costing the customers approximately
$155,173 in unnecessary surrender penalties and earning the broker $196,684 in
commissions. As a result of each replacement transaction, the customer incurred a new
surrender period.
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It gets worse. FINRA found that the brokers employed a “one size fits all” investment
strategy, notwithstanding the diversity of their customer base. Although the customers
were between the ages of 27 and 73, some were working and some were retire, and they
had varied net worth’s and income, the brokers classified all of their customers as having
the same risk tolerance and primary investment objectives. In addition, the brokers
switched substantially all of their customers into the same VA, the same rider, and the
same asset allocation investment fund option.
Next, let’s discuss another major suitability controversy: placing an annuity inside a
qualified retirement plan.
Benefits of Maintaining Suitability Standards
The benefits of maintaining suitability standards are the following:



Avoid market conduct trouble.
Increased customer satisfaction and trust.
A Win-Win-Win Solution.
Avoid Market Conduct Trouble
As insurance professionals, when we prepared for our licensing exams, we read
extensively about proper market conduct and the types of sales practices that could put
our licenses in jeopardy. Every state Insurance Department has passed an Unfair Trade
Practices Act that has laid out the types of unfair trade practices that can be costly and
even put our careers in danger.
Increased Client Satisfaction
Paying attention to suitability will not just keep you on the right side of market
compliance regulations it will also improve your business.
Let’s face it, without satisfied clients, insurance professional/financial advisors, cannot
stay in business. That’s why it’s so important to take steps to ensure that clients are
satisfied with the products that you present to them and purchase from you. Applying
suitability standards to the recommendations you make will increase client satisfaction
because clients will know you are helping them reach their financial goals and objectives.
To borrow from an advertisement from a popular men and women’s clothing store, “An
educated consumer is the best consumer.”
Remember that a satisfied client becomes a lifetime client and will more than likely
purchase more than one product from you. In addition, fully satisfied clients will feel
242
more comfortable in giving you referrals of other friends and family, and that will expand
your business even further.
A Win-Win-Win Solution
Everyone wins when insurance producers and financial advisors make suitable
recommendations. The insurance companies win, because lapse rates will fall, meaning
that the business you worked so hard to put on the books will stay on the books. Renewal
rates will improve. As an insurance producer/financial advisor you will win because
building a long-term client relationship helps lock out the competition and gives you the
inside track on meeting your clients’ other financial needs as they arise in the future.
Most importantly, the clients win because they end up with products and services they
need and receive full value for what they’ve paid for while meeting their financial goals.
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Chapter 12
Review Questions
1. In what year was the original Unfair Marketing Practices Act created by the NAIC?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
1940
1955
1960
1980
2. What is the biggest market conduct danger an insurance agent may face during a
sales presentation?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
Rebating
Fraud
Misrepresentation
False advertising
3. The 2010 NAIC Model Regulation requires "suitability information" that consists of at
least how many different factors?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
Four
Six
Twelve
Fifteen
4. Which of the following NAIC Model regulations adopted revisions to the Annuity
Disclosure Model Regulation?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
Model 275
Model 245
Model 278
Model 570
5. Section 989J of the Wall Street Reform and Consumer Protection Act of 2010 is also
known as the:
(
(
(
(
) A. Reid Amendment
) B. McConnell Amendment
) C. Dodd-Frank Amendment
) D. Harkin Amendment
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CHAPTER 13
CODES OF ETHICS
Overview
A “Code of Ethics” provides guidance beyond what is a legal or regulated practice. A
code of ethics describes broad ethical aspirations that reinforce a moral consensus, rather
than just one person’s opinion, and legitimizes dialogue about ethical issues when
challenging situations arise.
In this chapter, we will define a Code of Ethics, differentiate between a Code of Ethics
and a Code of Conduct and provide reasons why companies develop codes of ethics and
how they are developed. It will also examine several codes of ethics that have been
developed by leading insurance and financial organizations.
Learning Objectives
Upon completion of this chapter, you will be able to:
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Identify the differences between a Code of Ethics v. Code of Conduct;
Recognize the reasons for a Code of Ethics;
Identify the guidelines for developing a Code of Ethics; and
Apply the Code of Ethics from several major Insurance and Financial
Organizations
Code of Ethics Defined
A Code of Ethics often conveys organizational values, a commitment to standards, and
communicates a set of ideas. In practice, code of ethics is used interchangeably with code
of conduct.
In Section 406 (c), the Sarbanes-Oxley Act defines “code of ethics” as such standards as
are reasonably necessary to promote:
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Honest and ethical conduct, including the ethical handling of actual or apparent
conflicts of interest between personal and professional relationships;
Full, fair, accurate, timely and understandable disclosure in the periodic reports
required to be filed by the insurer; and
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
Compliance with applicable governmental rules and regulations.
Code of Conduct Defined
Code of conduct specifies actions and code of ethics are general guides to decisions
about those actions. The following steps are employed to develop a code of conduct:
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Identify key behaviors needed to adhere to the ethical values proclaimed in the
code of ethics, including ethical values derived from review of key laws and
regulations, ethical behaviors needed in your product or service area, behaviors to
address current issues in the workplace, and behaviors needed to reach strategic
goals.
Include wording that indicates that all members of the organization are expected
to conform to the behaviors specified in the code of conduct.
Obtain review from key members of the organization.
Announce and distribute the code of conduct.
Include examples of topics typically addressed by code of conduct, such as:
o Illegal drugs
o Reliability
o Confidentiality
o Not accepting personal gifts from clients as a result of company role
o Avoiding sexual or racial discrimination
o Avoiding conflicts of interest
o Complying with laws and regulations
o Not using the organization's property for personal use
o Reporting illegal or questionable activities
Reasons for a Code of Ethics
There are three major reasons why professions develop a code of ethics (or code of
conduct). They are:
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To regulate members’ behavior — to inform them of expected behavior; to
remind them that ethical behavior overrides many other considerations; to remind
them of personal responsibility.
To hold members accountable — to provide bases for judging in cases of breach;
to help address situations where conflicting views of what is right are possible.
To present profession to society — to state its ethical bases, reassure stakeholders,
and give them a basis for evaluating professionals.
A code of ethics generally describes the highest values to which a company or industry
aspires to operate. It contains the “thou shalt’s”. A code of ethics specifies the ethical
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rules of operation. It is the ‘thou shalt not’s. More than 76% of companies surveyed by
The Conference Board, a leading business membership organization, have a code of
ethics.
Some business ethicists disagree that codes have any value. Usually they explain that too
much focus is put on the codes themselves, and that codes themselves are not influential
in managing ethics in the workplace. Many ethicists note that it is the developing and
continuing dialogue around the codes values that is most important. Occasionally,
members of an organization react to codes with suspicion, believing that values are like
“motherhood and apple pie” and codes are for window dressing. But, when managing a
complex issue, especially in a crisis, having a code is critical. Some organizations update
and continue to develop their code of ethics in challenge meetings. They ask each
individual “do we still believe this?’ and, if fine tuning is needed, the codes are amended.
In most cases, only minor points are fine-tuned — the values underlying the code are not
amended.
Developing a Code of Ethics
There are some guidelines employed by most organizations when developing a code of
ethics:
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Relevant laws and regulations are reviewed—this ensures the organization is not
breaking any relevant laws or regulations.
Values which produce the top three or four traits of a highly ethical and successful
service or product in the industry are reviewed—Objectivity, confidentiality,
accuracy, etc. Values are identified that produce behaviors that exhibit these traits.
Values needed to address current issues in the industry are identified—
descriptions of major issues in the workplace or industry are collected. Then
descriptions of the behaviors that produce those issues are defined and reviewed
for those which are ethical in nature, e.g., issues in regard to respect, fairness and
honesty. The behaviors that are needed to resolve these issues are defined, and
the values that generate these preferred behaviors are listed. There may be values
included that some people would not deem as moral or ethical values, (teambuilding, promptness, etc.), but these special values may add utility to a code of
ethics.
Evaluate the industry’s SWOT—Strengths, Weaknesses, Opportunities and
Threats. Determine what behaviors are needed to build on strengths, shore up
weaknesses, take advantage of opportunities and guard against threats.
Top ethical values that might be prized by the consumer are considered-for
example, the expectations of clients and customers, underwriters, agencies, the
community, etc.
The top five to ten ethical values which are high priorities in the industry are
collected examples of ethical values might include some of the following:
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Trustworthiness: honesty, integrity, promise keeping, and loyalty.
Respect: autonomy, privacy, dignity, courtesy, tolerance, acceptance.
Responsibility: accountability, pursuit of excellence.
Caring: compassion, consideration, giving, sharing, kindness, loving.
Justice and fairness: procedural fairness, impartiality, consistency, equity,
equality, due process.
o Civic virtue and citizenship: law abiding, community service, protection
of business environment.
o
o
o
o
o
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Behaviors are associated with values—critics of codes of ethics assert the codes
may seem vacuous because many only list ethical values but do not clarify these
values by associating examples of behaviors.
Input from members of the industry is solicited—ideas and input from as many
leaders of the industry as possible are included.
The code is reviewed regularly - the most important aspect of the code of ethics is
in its development; the code should be reviewed every year for relevance.
Continued dialogue and reflection around ethical values produces ethical
sensitivity and consensus.
Goals are refined – it is not possible to include in a code of ethics for every
possible ethical dilemma that might arise. The goal is to focus on top ethical
values needed in the organization and avoid potential ethical dilemmas that seem
most likely to occur.
Live By a Code of Ethics
One good way to establish, maintain, or enhance our ethical standards is to review and
live by a code of ethics. Practicing high ethics is the job of everyone in our industry.
The code of ethics developed by professional associations applies general ethical
concepts to the specific types of activities in which those professionals engage. In the
insurance and financial services business, codes of ethics have been developed by a
number of organizations. To provide a standard for ethical conduct, we will devote the
final chapter to a sampling of some of those codes of ethics.
Samples of Codes of Ethics
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National Association of Insurance and Financial Advisors
National Association of Health Underwriters
Certified Financial Planners Board of Standards, Inc.
The Society of Certified Senior Advisors
American Society of Certified Property and Casualty Underwriters
The Million Dollar Round Table
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Read through all of these sample codes carefully. In them you will find expressed many
of the ethical principles we have discussed in this course. As powerful encapsulated
statements of the more detailed discussions we have covered in previous chapters, these
codes of ethics will serve to consolidate your knowledge of ethical concepts and enhance
the positive effect of your training efforts.
National Association of Insurance and Financial Advisors (NAIFA)
The National Association of Insurance and Financial Advisors (NAIFA) is a national
nonprofit organization representing the interests of more than 70,000 insurance and
financial advisors nationwide, through its federation of over 900 state and local
associations. Founded in 1890 as the National Association of Life Underwriters, NAIFA
is the nation’s largest financial services membership association. Its mission is to
advocate for a positive legislative and regulatory environment, enhance business and
professional skills, and promote the ethical conduct of our members.
NAIFA corporate offices are located in Falls Church, Virginia. If you seek additional
information, contact member services Toll Free at 877-TO-NAIFA or email at
membersupport@naifa.org.
Code of Ethics: Preamble
Those engaged in offering insurance and other related financial services occupy the
unique position of liaison between the purchasers and the suppliers of insurance and
closely related financial products. Inherent in this role is the combination of professional
duty to the client and to the company as well. Ethical balance is required to avoid any
conflict between these two obligations.
Therefore, I Believe It To Be My Responsibility:
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To hold my profession in high esteem and strive to enhance its prestige.
To fulfill the needs of my clients to the best of my ability.
To maintain my clients’ confidences.
To render exemplary service to my clients and their beneficiaries.
To adhere to professional standards of conduct in helping my clients to protect insurable
obligations and attain their financial security objectives.
To present accurately and honestly all facts essential to my clients’ decisions.
To perfect my skills and increase my knowledge through continuing education.
To conduct my business in such a way that my example might help raise the professional
standards of those in my profession.
To keep informed with respect to applicable laws and regulations and to observe them in
the practice of my profession.
To cooperate with others whose services are constructively related to meeting the needs
of my clients.
Reprinted with permission of the National Association of Life and Financial Advisors.
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National Association of Health Underwriters (NAHU)
The National Association of Health Underwriters (NAHU) founded back in 1930, is a
trade association that represents 20,000 health insurance producers and employee benefit
specialists nationally. More information about NAHU can be found on their website
www.nahu.org.
NAHU members embrace a strict code of ethics and constantly seek to improve their
knowledge of health, insurance regulations and products through continuous education.
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To hold the selling, service and administration of health insurance and related
products and services as a professional and public trust and do all in my power to
maintain its prestige.
To keep paramount the needs of those whom I serve.
To respect my clients’ trust in me, and to never do anything which would betray
their trust or confidence.
To give all service possible when service is needed.
To present policies factually and accurately, providing all information necessary
for the issuance of sound insurance coverage to the public I serve.
To use no advertising which I know may be false or misleading.
To consider the sale, service and administration of health insurance and related
products and services as a career, to know and abide by the laws of any
jurisdiction Federal and State in which I practice and seek constantly to increase
my knowledge and improve my ability to meet the needs of my clients.
To be fair and just to my competitors, and to engage in no practices which may
reflect unfavorably on myself, or my industry.
To treat prospects, clients and companies fairly by submitting applications which
reveal all available information pertinent to underwriting a policy.
To extend honest and professional conduct to my clients, associates, fellow agents
and brokers, and the company or companies whose products I represent.
Reprinted with permission of the National Association of Health Underwriters
The Society of Financial Services Professionals
The Society of Financial Service Professionals is over 75 years old with over 22,000
members in over 200 Chapters in all 50 states, Puerto Rico, Canada and Singapore.
Founded in 1928 by the first graduates of The American College, its mission is to
promote professionalism among its members through the highest quality continuing
education and the maintenance of high ethical standards and conduct. While many of its
members have earned a designation or degree from The American College, the Society is
a separate and independent organization.
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Society members are credentialed financial service professionals who provide financial
planning, estate planning, retirement counseling, asset management and other services
and products to their clients. Members reflect a great diversity of financial practitioners
from fee-only financial planners, estate planning attorneys and accountants, to asset
managers, employee benefits specialists and life insurance agents.
The Society is the only professional organization in the industry that requires its members
to be credentialed or actively pursuing one of these widely-recognized financial service
designations or degrees: CEBS®, CFA®, CFP®, ChFC, CLF, CLU, CPA, CTFA, JD
(licensed), MSFS, MSM, REBC & RHU. More information about the Society of
Financial Services Professionals can be found on their website: www.financialpro.org.
Code of Professional Responsibility: Preamble
The Society of Financial Service Professionals is dedicated to setting and promoting
standards of excellence for professionals in financial services. In fulfillment of this
mission, the Society’s Board of Directors has adopted this Code of Professional
Responsibility. All Society members are automatically bound by its provisions.
The ultimate goal of enacting the Code is to serve the public interest. The path to
fulfilling the goal is the fostering of professionalism in financial services. A profession
has been defined in the writings of Solomon S. Huebner as possessing four essential
traits:
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
Knowledge or expertise
Service to others
Working with other professionals to enhance the practice and reputation
of one who is a member
Self-regulation
Through its Code of Professional Responsibility, the Society strives to improve the level
of ethical behavior among its members by articulating standards that are aspirational in
nature, that is, by identifying the lofty, altruistic ideals that define a true profession, and
by delineating and enforcing minimum standards of ethical conduct.
This Code of Professional Responsibility has its origin in the code of ethics of the
American Society of CLU & ChFC, the predecessor organization of the Society of
Financial Service Professionals. The members of the Society created and adopted a code
of ethics in 1961. With a name change in the fall of 1998, and a broadened membership
constituency, it became appropriate to create this new Code of Professional
Responsibility.
The Society acknowledges the diversity of its membership…from those that serve the
public directly, as advisers, to those that serve indirectly through companies, educational
organizations, and the like. Whatever role he or she plays within the financial services
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industry, it is the responsibility of each Society member to understand and adhere to the
Code of Professional Responsibility.
From time to time, a Society member may be unclear about the ethical implications of a
given course of action. In such cases, a Society member may request an advisory opinion
from the Society; or may seek confidential advice through the Society’s Ethics
Information Line. Advisory opinions will be unpublished and specific to the inquiring
member. However, there may be instances in which the subject matter of the advisory
opinion has broad, general application and in such cases, at its discretion, the Society
may choose to publish a given opinion for the benefit of all members, preserving the
anonymity of those involved.
An alleged violation of the Society’s Code of Professional Responsibility will result in an
enforcement action, carried out in accordance with the Disciplinary Procedures. The
procedures ensure that any member charged with ethical misconduct is afforded
appropriate due process. The procedures also provide for appropriate sanctions, such as
reprimand, censure, and revocation of membership, should a member be found to have
acted in violation of the Code.
True enforcement of ethical behavior must come from the personal conscience of each
individual, rather than external forces. Nevertheless, as an organization that promotes its
members’ education and expertise to the consumer, the Society believes it is essential that
it act in an enforcement capacity.
CANON 1. Fairness
A member shall perform services in a manner that respects the interests of all those
he/she serves, including clients, principals, partners, employees, and employers. A
member shall disclose conflicts of interests in providing such services.
Fairness requires that a professional treat others as he/she would wish to be treated if in
the other’s position. A professional also strives to avoid unfairness by inflicting no
unnecessary harm on others and, when possible, shielding others from harm.
RULES
R1.1 A member shall not engage in behavior involving concealment or misrepresentation
of material facts.
R1.2 A member shall respect the rights of others.
R1.3 A member shall disclose to the client all information material to the professional
relationship, including, but not limited to, all actual or potential conflicts of interest. In a
conflict of interest situation, the interest of the client must be paramount.
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R1.4 A member shall give proper respect to any relationship that may exist between the
member and the companies he or she represents.
R1.5 A member shall make and/or implement only recommendations that are appropriate
for the client and consistent with the client’s goals.
R1.6 In the rendering of professional services to a client, a member has the duty to
maintain the type and degree of professional independence that (a) is required of
practitioners in the member’s occupation, or (b) is otherwise in the public interest, given
the specific nature of the service being rendered.
CANON 2: Competence
A member shall continually improve his/her professional knowledge, skill, and
competence.
Professionalism starts with technical competence. The knowledge and skills held by a
professional are of a high level, difficult to attain, and, therefore, not held by the general
public. Competence not only includes the initial acquisition of this specialized knowledge
and skill, but also requires continued learning and practice.
RULES
R2.1 A member shall maintain and advance his/her knowledge in all areas of financial
service in which he/she is engaged and shall participate in continuing education programs
throughout his/her career.
R2.2 A member shall refrain from giving advice in areas beyond the member’s own
expertise.
CANON 3: Confidentiality
A member shall respect the confidentiality of any information entrusted to, or obtained in
the course of, the member’s business or professional activities.
A financial service professional often gains access to client records and company
information of a sensitive nature. Each Society member must maintain the highest level
of confidentiality with regard to this information.
RULES
R3.1 A member shall respect and safeguard the confidentiality of sensitive client
information obtained in the course of professional activities. A member shall not divulge
such information without specific consent of the client, unless disclosure of such
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information is required by law or necessary in order to discharge legitimate professional
duties.
R3.2 A member shall respect and safeguard the confidentiality of sensitive
company/employer information obtained in the course of professional activities. A
member shall not divulge such information without specific consent, unless disclosure of
such information is required by law or necessary in order to discharge legitimate
professional duties.
R3.3 A member must ensure that confidentiality practices are established and maintained
by staff members so that breaches of confidence are not the result of intentional or
unintentional acts or omissions.
CANON 4: Integrity
A member shall provide professional services with integrity and shall place the client’s
interest above his/her own.
Integrity involves honesty and trust. A professional’s honesty and candor should not be
subordinate to personal gain or advantage. To be dishonest with others is to use them for
one’s own purposes.
RULES
R4.1 A member shall avoid any conduct or activity that would cause unnecessary harm to
others by:
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
Any act or omission of a dishonest, deceitful, or fraudulent nature.
Pursuit of financial gain or other personal benefits that would interfere with the
exercise of sound professional judgments and skills.
R4.2 A member shall establish and maintain dignified and honorable relationships with
those he/she serves, with fellow practitioners, and with members of other professions.
R4.3 A member shall embrace and adhere to the spirit and letter of laws and regulations
governing his/her business and professional activities. See also Rule 6.1.
R4.4 A member shall be truthful and candid in his/her professional communications with
existing and prospective clients, and with the general public.
R4.5. A member shall refrain from using an approved Society designation, degree, or
credential in a false or misleading manner.
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CANON 5: Diligence
A member shall act with patience, timeliness, and consistency in the fulfillment of his/her
professional duties.
A professional works diligently. Knowledge and skill alone are not adequate. A
professional must apply these attributes in a prompt and thorough manner in the service
of others.
RULES
R5.1 A member shall act with competence and consistency in promptly discharging
his/her responsibilities to clients, employers, principals, purchasers, and other users of the
member’s services.
R5.2 A member shall make recommendations to clients, whether in writing or orally,
only after sufficient professional evaluation and understanding of the client’s needs and
goals. A member shall support any such recommendations with appropriate research and
documentation.
R5.3 A member shall properly supervise subordinates with regard to their role in the
delivery of financial services, and shall not condone conduct in violation of the ethical
standards set forth in this Code of Professional Responsibility.
CANON 6: Professionalism
A member shall assist in raising professional standards in the financial services industry.
A member’s conduct in all matters shall reflect credit upon the financial services
profession. A member has an obligation to cooperate with Society members, and other
financial service professionals, to enhance and maintain the profession’s public image
and to work together to improve the quality of services rendered.
RULES
R6.1 A member has the duty to know and abide by the local, state, and national laws and
regulations and all legal limitations pertaining to the member’s professional activities.
R6.2 A member shall support the development, improvement, and enforcement of such
laws, regulations, and codes of ethical conduct that foster respect for the financial service
professional and benefit the public.
R6.3 A member shall show respect for other financial service professionals and related
occupational groups by engaging in fair and honorable competitive practices; collegiality
among members shall not impede enforcement of this Code.
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R6.4 A member shall cooperate with regulatory authorities regarding investigations of
any alleged violation of laws or regulations by a financial service professional.
CANON 7: Self-Regulation
A member shall assist in maintaining the integrity of the Society’s Code of Professional
Responsibility and of the professional credentials held by all Society members.
Every professional has a responsibility to regulate itself. As such, every Society member
holds a duty of abiding by his/her professional code of ethics. In addition, Society
members have a duty to facilitate the enforcement of this Code of Professional
Responsibility.
RULES
R7.1 A member has the duty to know and abide by all rules of ethical and professional
conduct prescribed in this Code of Professional Responsibility.
R7.2 A member shall not sponsor as a candidate for Society membership any person
known by the member to engage in business or professional practices that violate the
rules of this Code of Professional Responsibility.
R7.3. A member shall not directly or indirectly condone any act by another member
prohibited by this Code of Professional Responsibility.
R7.4 A member shall immediately notify the Society if he/she is found in violation of any
code of ethics to which he or she is subject and shall forward details to the Society.
R7.5 A member shall immediately notify the Society of any revocation or suspension of
his/her license by a state or federal licensing or regulatory agency and forward details to
the Society.
R7.6 A member possessing unprivileged information concerning an alleged violation of
this Code of Professional Responsibility shall report such information to the appropriate
enforcement authority empowered by the Society to investigate or act upon the alleged
violation.
R7.7 A member shall report promptly to the Society any information concerning the
unauthorized use of an approved Society designation, degree, or credential.
Reprinted with permission from the Society of Financial Service Professionals.
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The Certified Financial Planners Board of Standards, Inc. (CFP®)
Code of Ethics
The Code of Ethics consists of the seven Principles. These Principles of the Code
establish the individual CFP Board designee’s responsibilities to the public, to clients, to
colleagues, employers and to the profession. They apply to all CFP Board designees and
provide guidance to them in the performance of their professional services.
Principle 1: Integrity.
The first principle is Integrity, which refers to candor, honesty, and trust. The code states:
“A CFP Board designee shall offer and provide professional services with
integrity. CFP Board designee is placed by clients in positions of trust and
confidence. The ultimate source of public trust is the CFP Board designee’s
personal integrity. In deciding what is right and just, a CFP Board designee
should rely on his or her integrity as the appropriate touchstone. Integrity
demands honesty and candor that must not be subordinated to personal gain and
advantage. Within the characteristics of integrity, allowance can be made for
legitimate difference of opinion; but integrity cannot co-exist with deceit or
subordination of one’s principles. Integrity requires the CFP Board designee to
observe not only the letter but also the spirit of the Code.”
In terms of actions that violate the principle of integrity, the allegations of
misrepresentation are the most common client complaint heard by the CFP Board’s
Board of Professional Review (BOPR). For example, promised a better return than
actually received, did not make sure they understood the risks of a recommendation,
failed to explain the tax consequences of a recommendation or did not disclose the fees
associated with a recommendation.
To avoid these allegations CFP Board designees should take the steps necessary to ensure
that clients fully understand all aspects of a recommendation. It certainly is not enough to
simply give a client a prospectus and have them sign a disclosure statement.
Principle 2: Objectivity
The second principle is Objectivity, which refers to intellectual honesty, impartiality and
states:
“A CFP Board designee shall be objective in providing professional services to
clients. Objectivity is an essential quality for any professional. Regardless of the
particular service rendered or the capacity in which a CFP Board designee
functions, a CFP Board designee should protect the integrity of his or her work,
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maintain objectivity, and avoid subordination of his or her judgment that would
be in violation of this Code.”
Objectivity also means exercising reasonable and prudent professional judgment and
acting the interests of clients. The most common client complaint the BOPR has related
to the principle of objectivity is that the planner did not provide the care and attention the
client expected. Pulling together adequate procedures to communicate with the clients on
a regular basis can go a long way to avoiding this complaint.
Principle 3: Competence
The third principle is Competence. This principle describes the need to attain and
maintain professional skills and to recognize professional limitations and states:
“A CFP Board designee shall provide services to clients competently and
maintain the necessary knowledge and skill to continue to do so in those areas in
which the CFP Board designee is engaged. One is competent only when one has
attained and maintained an adequate level of knowledge and skill, and applies
that knowledge effectively in providing services to clients. Competence also
includes the wisdom to recognize the limitations of that knowledge and when
consultation or client referral is appropriate.
“A CFP Board designee, by virtue of having earned the CFP® designation, is
deemed to be qualified to practice financial planning. However, in addition to
assimilating the common body of knowledge required and acquiring the necessary
experience for designation, a CFP Board designee shall make a continuing
commitment to learning and professional improvement”
The most common client complaint the BOPR has related to the principle of competence
is when the planners try to do too much. As stated before, it’s important for CFP Board
designee to recognize their limitations and have procedures in place for referring clients
to other competent professionals when appropriate.
Principle 4: Fairness
The fourth principle is Fairness. This principle directs CFP Board designee to perform
services that are fair and reasonable to clients, principles, partners, and employers. It also
discusses disclosing any possible conflict(s) of interest and states:
“A CFP Board designee shall perform professional services in a manner that is
fair and reasonable to clients, principals, partners and employers, and shall
disclose conflict(s) of interest in providing such services. Fairness requires
impartiality, intellectual honesty, and disclosure of conflicts(s) of interest. It
involves a subordination of one’s own feelings, prejudices, and desires so as to
achieve a proper balance of conflicting interests. Fairness is treating others in the
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same fashion that you would want to be treated and is an essential trait of any
profession.”
The Golden Rule: “Do unto others as you would have them do unto you.” This rule
implies that an ethical person is concerned not only with themselves but also with the
well-being of others
Principle 5: Confidentiality
The fifth principle is Confidentiality which covers the proper disclosure of information
concerning clients, co-owners, and employers and states that:
“A CFP Board designee shall not disclose any confidential client information
without the specific consent of the client unless in response to proper legal
process, to defend against charges of wrongdoing by the CFP Board designee or
in connection with a civil dispute between the CFP Board designee and client.”
A CFP Board designee must safeguard the confidentiality of client information to
develop a relationship based on personal trust.
Principle 6: Professionalism
The sixth principle is Professionalism. This principle explains how our professional
conduct reflects upon our profession and states:
“A CFP Board designee’s conduct in all matters shall reflect credit upon the
profession. A CFP Board designee shall behave in a manner that maintains the
good reputation of the profession and its ability to serve the public interest. A
CFP Board designee shall avoid activities that adversely affect the quality of his
or her professional advice.
“This principle focuses on a CFP Board designee’s conduct as it reflects on the CFP
certification marks and the financial planning profession,” explains Margaret Brock,
Director of Profession Review at CFP Board.
Under the principle of professional, CFP Board designees must abide by all applicable
laws, rules and regulations of governmental agencies or authorities. Certain actions, such
as criminal conviction or professional suspension, must be reported to CFP Board within
10 days (see Art. 12.2 CFP Board’s Disciplinary Rules and Procedures). Often actions,
for example, a client arbitrage or NASD investigation must be disclosed during the
certification application or renewal process, although the designee has the option of
reporting earlier.
259
Also under the principles of professionalism, CFP Board designees must report any
violations of the Code of Ethics by another designee to both the CFP Board and other
appropriate regulatory bodies.
Principle 7: Diligence
The seventh and final principle is Diligence, which informs us that services to clients
must be performed in a prompt and thorough manner and also states:
“A CFP Board designee shall act diligently in providing professional services.
Diligence is the provisions of services in a prompt and thorough manner.
Diligence also includes proper planning for and supervision of the rendering of
professional services.”
Placing a client in a variable annuity when the client has no need of a death benefit is an
example of a case the CFP Board might hear that centers on the issue of suitability.
The requirement of diligence extends to supervisory activities as well. For example, if a
CFP Board designee supervises an individual whose actions are in conflict with the Code
of Ethics, the CFP Board designee could be held in violation of the Code of Ethics
whether or not the subordinate is a CFP Board designee.
The Society of Certified Senior Advisors (CSA)
Code of Professional Responsibility
1. To conduct your business according to high standards of honesty and fairness and
to render that service to your clients that, in some circumstances, you would apply
or demand yourself.
2. To provide competent and consumer-focused sales and service.
3. To engage in active and fair competition
4. To provide fair and expeditious handling of client business, complaints and
disputes.
5. To provide your clients with advertising and sales materials that have a clear
purpose and an honest and fair content.
6. To maintain your competency through continuing education. Being competent
means having the skills, knowledge, commitment, and attitude to do a
professional job as a senior advisor.
Reprinted with permission from the CSA Board of Standards
260
American Institute for Chartered Property and Casualty Underwriters
Founded in 1944, the CPCU Society’s mission is to “meet the career development needs
of a diverse membership of professionals who have earned the Chartered Property
Casualty Underwriters (CPCU) designation, so that they may serve others in a competent
and ethical manner.”
CPCUs who join the Society take their commitment to ethical behavior one step further
by agreeing to be bound to an enforceable Code of Ethics and pledging the CPCU
Society Creed. CPCUs also join the Society to take advantage of continuing education,
networking, and other skill development opportunities, such as leadership training, public
speaking, job enhancement, change management, and career building. CPCUs also work
to spread the message about the value of the CPCU designation to the industry and the
public through consumer education efforts and campaigns. Members may also interact on
a local level by joining one of 154 chapters, or network with other CPCUs who share
their same area of professional expertise by joining one of 14 special interest sections.
Located in Malvern, Pennsylvania, a suburb of Philadelphia, the CPCU Society is
governed by volunteer leadership, including a board of 36 governors, five executive
committee members, and two ex officio members. Staff resources include more than 30
association professionals in the areas of administration, communications and marketing
services, continuing education, finance, meeting services, member and professional
services, and the member resource center. For more information visit their website
www.cpcusociety.org
Code of Professional Ethics: Canons and Rules
CANON 1
CPCU’s Should Endeavor at All Times to Place the Public Interest Above Their Own.
Rules of Professional Conduct
R1.1 A CPCU has a duty to understand and abide by all Rules of conduct, which are
prescribed in the Code of Professional Ethics of the American Institute.
R1.2 A CPCU shall not advocate, sanction, participate in, cause to be accomplished,
otherwise carry out through another, or condone any act which the CPCU is prohibited
from performing by the Rules of this Code.
CANON 2
CPCU’s Should Seek Continually to Maintain and Improve Their Professional
Knowledge, Skills, and Competence.
261
Rules of Professional Conduct
R2.1 A CPCU shall keep informed on those technical matters that are essential to the
maintenance of the CPCU’s professional competence in insurance, risk, management, or
related fields.
CANON 3
CPCU’s Should Obey All Laws and Regulations, and Should Avoid Any Conduct or
Activity Which Would Cause Unjust Harm to Others.
Rules of Professional Conduct
R3.1 In the conduct of business or professional activities, a CPCU shall not engage in
any act or omission of a dishonest, deceitful, or fraudulent nature.
R3.2 A CPCU shall not allow the pursuit of financial gain or other personal benefit to
interfere with the exercise of sound professional judgment and skills.
R3.3 A CPCU will be subject to disciplinary action for the violations of any law or
regulation, to the extent that such violation suggests the likelihood of professional
misconduct in the future.
CANON 4
CPCU’s Should Be Diligent in the Performance of Their Occupational Duties and Should
Continually Strive To Improve the Functioning of the Insurance Mechanism.
Rules of Professional Conduct
R4.1 A CPCU shall competently and consistently discharge his or her occupational
duties.
R4.2 A CPCU shall support efforts to effect such improvements in claims settlement,
contract design, investment, marketing, pricing, reinsurance, safety engineering,
underwriting, and other insurance operations as will both inure to the benefit of the public
and improve the overall efficiency with which the insurance mechanism functions.
CANON 5
CPCUs Should Assist in Maintaining and Raising Professional Standards in the Insurance
Business.
262
Rules of Professional Conduct
R5. 1 A CPCU shall support personnel policies and practices which will attract qualified
individuals to the insurance business, provide them with ample and equal opportunities
for advancement, and encourage them to aspire to the highest levels of professional
competence and achievement.
R5.2 A CPCU shall encourage and assist qualified individuals who wish to pursue CPCU
or other studies, which will enhance their professional competence.
R5.3 A CPCU shall support the development, improvement, and enforcement of such
laws, regulations, and codes as will foster competence and ethical conduct on the part of
all insurance practitioners and inure to the benefit of the public.
R5.4 A CPCU shall not withhold information or assistance officially requested by
appropriate regulatory authorities who are investigating or prosecuting any alleged
violation of the laws or regulations governing the qualifications or conduct of insurance
practitioners.
CANON 6
CPCU’s Should Strive to Establish and Maintain Dignified and Honorable Relationships
with Those Whom They Serve, with Fellow Insurance Practitioners, and with Members
of Other Professions.
Rules of Professional Conduct
R6.1 A CPCU shall keep informed on the legal limitations imposed upon the scope of his
or her professional activities.
R6.2 A CPCU shall not disclose to another person any confidential information entrusted
to, or obtained by, the CPCU in the course of the CPCU’s business or professional
activities, unless a disclosure of such information is required by law or is made to a
person who necessarily must have the information in order to discharge legitimate
occupational or professional duties.
Million Dollar Round Table (MDRT)
The Million Dollar Round Table is an organization whose members qualify for inclusion
by meeting certain production and persistency objectives over the course of the year.
Considered to be among the most prestigious of life insurance sales organizations, the
MDRT is headquartered in Park Ridge, Illinois.
263
Code of Ethics
Members of the Million Dollar Round Table should be ever mindful that complete
compliance with and observance of the Code of Ethics of the Million Dollar Round Table
shall serve to promote the highest quality standards of membership. These standards will
be beneficial to the public and the life insurance industry; and its related financial
products. Therefore, members and provisional applicants shall:
1. Always place the best interests of their clients above their own direct or indirect
interests.
2. Maintain the highest standards of professional competence and give the best
possible advice to clients by seeking to maintain and improve professional
knowledge, skills, and competence.
3. Hold in the strictest confidence, and consider as privileged, all business and
personal information pertaining to their clients’ affairs.
4. Make full and adequate disclosures of all facts necessary to enable their clients to
make informed decisions.
5. Maintain personal conduct which will reflect favorably on the life insurance
industry and the Million Dollar Round Table.
6. Determine that any replacement of a life insurance or financial product must be
beneficial for the client.
7. Abide by and conform to all provisions of the laws and regulations in the
jurisdictions in which they do business.
© 1991 Million Dollar Round Table, reprinted with permission.
264
Chapter 13
Review Questions
1. Which of the following statements about a Code of Ethics is FALSE?
(
(
(
(
) A. Code of Ethics generally describes penalties for noncompliance
) B. Code of Ethics often conveys organizational values
) C. Code of Ethics is used interchangeably with Code of Conduct
) D. Code of Ethics specify the ethical rules of operation
2. Which of the following are reasons why professionals develop a Code of Ethics?
(
(
(
(
) A. To regulate members behavior
) B. To hold members accountable
) C. To present profession to society
) D. All of the above
3. Code of Ethics is interchangeable with:
(
(
(
(
) A. Code of Honor
) B. Code of Conduct
) C. Code of Compliance
) D. Code of Respect
4. Which professional organization in the insurance industry requires their members to
be credentialed?
(
(
(
(
) A. Society of Financial Service Professionals
) B. American Society of Certified Property and Casualty Underwriters
) C. Certified Financial Planners Board of Standards, Inc.
) D. National Association of Health Underwriters
5. Which professional organization’s Code of Ethics consists of seven Principles?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
American Society of Certified Property and Casualty Underwriters
Certified Financial Planners Board of Standards, Inc.
Society of Financial Service Professionals
National Association of Health Underwriters
265
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266
CHAPTER 14
ANTI-MONEY LAUNDERING
Overview
Money laundering is the conversion of property that is the proceeds of either all crimes or
certain designated crimes into money or property that has the appearance of being
legitimately obtained, to hide the true nature and origin of the money.
In this chapter, we will examine the three stages of money laundering, identify the federal
regulations pertaining to anti-money laundering, as well as the various insurance products
that are subject to these regulations. It will also review the role and responsibilities of the
insurance producer in carrying out these anti-money laundering rules.
Learning Objectives
Upon completion of this chapter, you will be able to:




Identify the various stages of money laundering;
Demonstrate an understanding of the various federal regulations pertaining to
anti-money laundering;
Recognize the role of the insurance producer in following the federal anti-money
laundering regulations; and
Identify the various insurance products that are covered under the anti-money
laundering.
Stages of Money Laundering
Money laundering is generally said to have three stages, which may, at times, overlap.
The three stages are:

Placement: Placement is the stage in which the proceeds from criminal activities
are introduced into the financial system. This occurs, for example, when a person
opens an account. It is probably easiest to detect money laundering at the
placement stage, which is one reason why it is so vital to perform your customer
identification procedures effectively, and to make a diligent effort to know your
customer. It is also at the placement stage that most (but not all) of the
government-required reports come into plan, as we will see later in the chapter.
267


Structuring, the practice of breaking up one large cash transaction into two or
more smaller transactions for the specific purpose of evading a reporting or record
keeping requirement, is particularly important at the placement stage.
Layering: Layering is the process of obscuring the origin of the ill-received funds
through a complex web of financial transactions for the purpose of obstructing
any attempt to trace the funds. This stage can involve multiple wire transfers,
conversion of cash into securities, or the purchase of legitimate businesses.
Detection can be more difficult at this stage, and depends largely upon the
diligence of personnel in knowing the customer and being alert to activity that is
aberrational or that makes no sense given the information on file about the
customer. Ongoing monitoring is essential for distributing out money laundering
at this stage, and a system for reporting suspicious activities is required.
Integration: Integration is the final stage in which an apparently legitimate
transaction is used to disburse the now-laundered funds back to the criminal. This
stage can involve, for example, redemption of mutual fund shares or selling shares
of equity securities.
Federal Regulation in the U.S.
The federal government has enacted laws designed to make the money laundering
process more difficult. Such laws criminalize the act of money laundering (Money
Laundering Control Act) and establish reporting requirements for certain types of
currency transactions and suspicious activity (Bank Secrecy Act).
The Money Laundering Control Act of 1986
The Money Laundering Control Act is codified at 18 USC 1956, 1957 and, under certain
circumstances, makes it a federal felony to spend, save, transport, or transmit proceeds of
criminal activity.
The Bank Secrecy Act of 1970
The Bank Secrecy Act of 1970 (BSA) is codified at 31 USC 5311-5330 and gives the
Secretary of the U.S. Treasury Department broad powers to implement anti-money
laundering regulations on financial institutions, and such regulations are implemented by
the Treasury Secretary through 31 CFR 103. The authority of the Secretary to administer
Title II of the BSA has been delegated to the Director of Financial Crimes Enforcement
Network (FinCEN).
The BSA requires banks and other financial institutions to file “currency transaction
reports” and “suspicious activity reports” (SARs) with the Treasury Department upon
performing certain transactions. “Financial institutions” are defined at 31 USC 5312,
which does explicitly include “insurance companies.”
268
Under the law, an SAR is triggered if the dollar amount involves at least $5,000 in funds
or other assets and the institution knows, suspects, or has reason to suspect that the
transaction involves:



Funds derived from illegal activity;
Attempts to evade any requirements under the Bank Secrecy Act; or
No apparent business or lawful purpose or is not the sort of transaction in which
the particular customer would normally be expected to be engaged in.
The SAR should be filed no later than 30 calendar days after the date of initial detection
by the institution of facts that may form the basis for filing a SAR. If no suspect was
identified on the date of the detection of the incident requiring the filing, an institution
may delay their filing for an additional 30 calendar days to identify a suspect. In no case
can an institution delay filing an SAR by more than 60 days after the date of initial
detection of a reportable transaction. Finally, if the situation requires immediate
attention, the institution is expected to notify appropriate law enforcement by telephone
in addition to filing a SAR. Violations for noncompliance have been known to range as
high as $2 million!
USA Patriot Act of 2001
The Uniting and Strengthening America by Providing Appropriate Tools Required to
Intercept and Obstruct Terrorism (USA PATRIOT) was enacted by President Bush on
October 26, 2001. This law was introduced in the USA a few months after September
11, 2001 and was a direct response to issues raised by money laundering and terrorist
financing with respect to the bombing of the World Trade Center in New York. The
objective of this law was to strengthen our nation’s ability to combat terrorism and
prevent and detect money-laundering activities.
Title III of the Act contains several new anti-money laundering provisions that affect
financial institutions and affect insurance companies and insurance regulators. The
Treasury Secretary has the authority to impose these provisions on financial institutions,
and since the definition of financial institutions includes insurance companies, these
provisions are also imposed on insurance companies unless exempted through regulation.
The applicable sections are as follows:

Section 314(b)-Financial Sharing of Information—Section 314(b) provides
financial institutions with the ability to share information with one another, under
a safe harbor that offers protections from liability, in order to better identify and
report potential money laundering or terrorist activities. 314(b) is a voluntary
program, and FinCen strongly encourages information sharing through Section
314(b). For additional information go to:
http://www.fincen.gov/statutes_regs/patriot/pdf/314bfactsheet.pdf
269


Section 326 – Customer Identification - Section 326 of the Act amends the
BSA to require that Treasury issue regulations setting forth minimum standards
for financial institutions regarding the identity of their customers in connection
with the purchase of a policy or contract of insurance. This program must set
forth customer identity verification and documentation procedures, as well as
procedures the insurer will employ to notify its customers about this requirement
and determine whether the customer appears on government lists of known or
suspected terrorists or terrorist organizations. Note: FinCEN has not yet issued
Customer Identification Program—known as CIP—Regulations for insurers.
Section 352 – Establishing Anti-Money Laundering Programs - Section 352
of the Act requires the establishment of an anti-money laundering program,
including, at a minimum:
o The development of internal policies, procedures, and controls; these
should be appropriate for the level of risk of money laundering identified.
o The designation of a compliance officer; the officer should have
appropriate training and background to execute their responsibilities. In
addition, the compliance officer should have access to senior management.
o An ongoing employee training program; a training program should match
training to the employees’ roles in the organization and their job functions.
The training program should be provided as often as necessary to address
gaps created by movement of employees within the organization and
turnover.
o An independent audit functions to test the programs. The independent
audit function does not require engaging outside consultants. Internal staff
that is independent of those developing and executing the anti-money
laundering program may conduct the audit.
Anti-money laundering programs are not anticipated to be “one size fits all.” Rather, it is
expected that they will be developed using a risk-based approach. Development of an
anti-money laundering program should begin with identification of those areas, processes
and programs that are susceptible to money laundering activities. The practices and
procedures implemented under the program should reflect the risks of money laundering
given the entity’s products, methods of distribution, contact with customers and forms of
customer payment and deposits.
The New Anti-Money Laundering Rules
Under the terms of the final rules, the obligation to establish an anti-money laundering
program applies to an insurance company, and not its agents or brokers. Nevertheless,
because insurance agents and brokers are an integral part of the insurance industry due to
their direct contact with customers, the final rule requires each insurance company to
establish and implement policies, procedures, and internal controls reasonably designed
to integrate its agents and brokers into its anti-money laundering program and to monitor
their compliance with its program.
270
An insurance company’s anti-money laundering program also must include procedures
for obtaining all relevant customer-related information necessary for an effective
program, either from its agents and brokers or from other sources.
The new rules impose a direct obligation only on insurance companies and not their
agents and brokers, for a number of reasons:



First, whether an insurance company sells its products directly or through agents,
Congress felt that it is appropriate to place on the insurance company, which
develops and bears the risks of its products, the responsibility for guarding against
such products being used to launder unlawfully derived funds or to finance
terrorist acts.
Second, insurance companies, due to their much larger size relative to that of their
numerous agents and brokers, are better able to bear the costs of compliance
connected with the sale of their products.
Finally, numerous insurers already have in place compliance programs and best
practices guidelines for their agents and brokers to prevent and detect fraud.
Insurance agents and brokers will play an important role in the effective operation of an
insurance company’s anti-money laundering program. By not placing an independent
regulatory obligation on agents and brokers, Congress did not intend to minimize their
role. In fact, they intend to assess the effectiveness of the rule on an ongoing basis. If it
appears that the effectiveness of the rule is being undermined by the failure of agents and
brokers to cooperate with their insurance company principles, they will consider
proposing appropriate amendments to the rule. They also expect that an insurance
company, when faced with a non-compliant agent or broker, will take the necessary
actions to secure such compliance, including, when appropriate, terminating its business
relationship with such agent or broker.
AML Training for Insurance Producers
The final rule gives an insurance company the flexibility of directly training its insurance
producers. Alternatively, an insurance company may satisfy its training obligation by
verifying that its insurance producers have received the training required by the rule from
another insurance company or from a competent third party (such as this course) with
respect to the covered products offered by the company. In essence, it is left to the
discretion of an insurance company to determine whether the training of its insurance
producers by another party is adequate.
Note: The Federal Government does not certify, license, or otherwise prospectively
approve training programs.
271
Covered Products Pursuant to the Rule
For purposes of the final insurance company rule, the term “covered product” is defined
to mean:



A permanent life insurance policy, other than a group life insurance policy;
An annuity contract, other than a group annuity contract; and
Any other insurance product with cash value or investment features.
The definition incorporates a functional approach, and encompasses any insurance
product having the same kinds of features that make permanent life insurance and annuity
products more at risk of being used for money laundering (e.g., having a cash value or
investment feature). To the extent that term life insurance, property and casualty
insurance, health insurance, and other kinds of insurance do not exhibit these features,
they are not products covered by the rule.
Because they pose a lower risk for money laundering, the following products are not
defined as “covered products” in the final rule:



Group insurance products.
Products offered by charitable organizations, e.g. charitable annuities,
term (including credit) life, property, casualty, health, or title insurance
reinsurance and retrocession contracts.
Contracts of indemnity and structured settlements (including workers’
compensation payments) are not within the definition of “covered products” for
purposes of the final rule.
Indicators of Insurance Money Laundering Schemes
The following examples are possible indicators of a suspicious transaction and may give
cause for an insurance agent to alert his/her insurer to file a Suspicious Activity Report:





Application for a policy from a potential client in a distant place where a
comparable policy could be provided “closer to home”;
Application for business outside the policyholder’s normal pattern of business.
Introduction by an agent/intermediary in an unregulated or loosely regulated
jurisdiction or where organized criminal activities (e.g., drug trafficking or
terrorist activity) or corruption are prevalent;
Any want of information or delay in the provision of information to enable
verification to be completed;
An atypical incidence of pre-payment of insurance premiums;
The client accepts very unfavorable conditions unrelated to his or her health or
age;
272




















The transaction involves use and payment of a performance bond resulting in a
cross border payment (wire transfer) and, or, the first (or single) premium is paid
from a bank account outside the country;
Large fund flows through non-resident accounts with brokerage firms;
Insurance policies with premiums that exceed the client’s apparent means;
The client requests an insurance product that has no discernible purpose and is
reluctant to divulge the reason for the investment;
Insurance policies with values that appear to be inconsistent with the client’s
insurance needs;
The client conducts a transaction that results in a conspicuous increase of
investment contributions;
Any transaction involving an undisclosed party;
Early termination of a product, especially at a loss, or where cash was tendered
and/or the refund check is to a third party;
A transfer of the benefit of a product to an apparently unrelated third party;
A change of the designated beneficiaries (especially if this can be achieved
without knowledge or consent of the insurer and/or the right to payment could be
transferred simply by signing an endorsement on the policy);
Substitution, during the life of an insurance contract, of the ultimate beneficiary
with a person without any apparent connection with the policyholder;
Requests for a large purchase of a lump sum contract where the policyholder has
usually made small, regular payments;
Attempts to use a third party check to make a proposed purchase of a policy;
The applicant for insurance business attempts to use cash to complete a proposed
transaction when this type of business transaction would normally be handled by
checks or other payment instruments;
The applicant for insurance business requests to make a lump sum payment by a
wire transfer or with foreign currency;
The applicant for insurance business is reluctant to provide normal information
when applying for a policy, providing minimal or fictitious information or,
provides information that is difficult or expensive for the institution to verify;
The applicant for insurance business appears to have policies with several
institutions;
The applicant for insurance business purchases policies in amounts considered
beyond the customer’s apparent means;
The applicant for insurance business established a large insurance policy and
within a short time period cancels the policy, requests the return of the cash value
payable to a third party;
The applicant for insurance business wants to borrow the maximum cash value of
a single premium policy, soon after paying for the policy.
273
Role of the Insurance Producer Agent
While it’s true that new insurance regulations do not require insurance producer’s to
establish anti-money laundering programs or to report suspicious transactions
themselves; it is also clear that those insurance producer’s will have an important role to
play in insurance companies’ anti-money laundering programs because they have direct
contact with customers and are thus often in the best position to gather information and
detect suspicious activity.
Insurance companies and their distribution partners must collaborate in preventing money
laundering. The new rules required life insurance companies to integrate insurance
producers and brokers into their anti-money laundering programs and to monitor their
insurance producers and brokers compliance with their AML programs.
The preamble to the rules states that if efforts to integrate agents/brokers into insurance
company’s AML programs are ineffective, Fin CEN (the U.S. Treasury) may reconsider
its decision and then require insurance producer’s and brokers to establish their own
programs.
In other words, if you as an insurance producer and/or broker do not cooperate, the
Treasury may require additional reporting at a later point in time for not cooperating.
And, violations for not following the rules could be severe and costly.
274
Chapter 14
Review Questions
1. The three stages of money laundering are described as layering, integration, and:
(
(
(
(
) A. Protection
) B. Inactivation
) C. Intervention
) D. Placement
2. The SAR should be filed no later than how many days after the date of initial
detection ?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
7 days
20 days
30 days
180 days
3. What is the dollar amount that triggers a suspicious activity report (SAR)?
(
(
(
(
)
)
)
)
A.
B.
C.
D.
$2,000
$5,000
$10,000
$100,000
4. Under the Bank Secrecy Act, whose obligation is it to identify and report suspicious
transactions to FinCEN?
(
(
(
(
) A. Agents
) B. Brokers
) C. Concerned citizens
) D. Insurance companies
5. Which of the following would be considered a “covered” product?
(
(
(
(
) A. A permanent life insurance policy
) B. A term insurance policy
) C. A group life policy
) D. A structured settlement
275
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276
CHAPTER REVIEW
ANSWERS
Chapter 1
Chapter 2
Chapter 3
Chapter 4
1.
2.
3.
4.
5.
1.
2.
3.
4.
5.
1.
2.
3.
4.
5.
1.
2.
3.
4.
5.
C
A
B
C
D
D
D
B
C
A
C
A
D
B
B
A
B
D
C
D
Chapter 5
Chapter 6
Chapter 7
Chapter 8
1.
2.
3.
4.
5.
1.
2.
3.
4.
5.
1.
2.
3.
4.
5.
1.
2.
3.
4.
5.
B
A
C
C
D
Chapter 9
1.
2.
3.
4.
5.
C
A
B
A
C
Chapter 13
1.
2.
3.
4.
5.
A
D
B
A
B
D
B
C
A
C
Chapter 10
1.
2.
3.
4.
5.
C
D
B
C
A
Chapter 11
D
C
C
B
B
1.
2.
3.
4.
5.
Chapter 14
.
1. D
2. C
3. B
4. D
5. A
277
A
B
C
C
D
B
C
A
C
C
Chapter 12
1.
2.
3.
4.
5.
A
C
C
B
D
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278
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