Variable Annuities and
Other Insurance Products
Frank A. Taylor, Esq.
Briggs and Morgan, P.A.
2200 IDS Center
80 South Eighth Street
Minneapolis, MN 55402
© Copyright, Briggs and Morgan, Professional Association, 2006-2008
Kenneth M. Cherrier, JD, FLMI
Woodbury Financial Svcs, Inc.
500 Bielenberg Dr.
Woodbury, MN 55126
Today's Agenda
• Basics on Annuities
– What are they, what features are available?
• Life Settlements
• Hot Topics in Annuities
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Sales to seniors
State enforcement actions
FINRA Suitability Rules
NAIC Proposed Rules
SEC Rule 151A
• Discussion and Q&A Session
The Big Issues
• Aging population:
– The Baby Boomers
• As a result, three issues:
– Sales of variable annuities and other
insurance products
– Seniors
– Mission creep
Variable Annuity Sales: Basic Requirements
• Reasonable basis for recommendation
– “Any – that is every – variable annuity sale should
be viewed as having been recommended. That’s our
view – and compliance should view that way, too.”
» Dennis Kosciulek, NASD remarks to Insurance
Marketplace Standards Association Best Practices
Workshop
– Replacements
• Reasonable effort to get the consumer’s
financial information
– “Reasonable to us is ‘get the information.’ We want
to see it, so you had better have it. We’ve written
up firms for not getting it.”
» Id.
Fixed Index Annuities
• Rule 151A: treat these annuities as
securities.
• Issue: Exchange of variable annuities
into indexed products
– Done by unregistered producers like
insurance agents who cannot sell variable
products unless they have a securities
license
• Issues
All tied to Seniors
“We’re concerned that scams will become
more sophisticated as investors get
older....We’re trying to anticipate the
problems and address them.”
» Id.
• Tied closely to the senior issue: “It will
be a regulatory focus for the next 25
years – until the last Boomer
drops….That’s where the money is, and
where our focus is going to be.”
» Id.
What is a Senior?
• Notice 07-43: focuses on Seniors, but
never defines it.
• Thought: A Senior is someone
approaching retirement.
Primer on Annuities
What Are Annuities?
• An insurance contract for the right to
receive a certain amount of income in
the future
• Similarities and differences with other
investment vehicles
– 401(k) plans
– IRA and Roth IRAs
• Risks and benefits of purchasing
annuities
Basic Types of Annuities
• Immediate Annuity: Provides income now
• Deferred Annuity: Savings to accumulate
before payouts begin
• Fixed: Deferred Annuity in which money
earns interest at a rate guaranteed by the
insurance company
• Variable: Deferred annuity in which money is
placed in a separate account that is invested
in stock or bond funds. This is a security
• Fixed (Equity) Indexed Annuity: Deferred
annuity in which a portion of the return is
guaranteed and a portion is determined by the
performance of a specific Index such as the
S&P 500 Composite Stock Price Index.
When should I receive income?
• Immediate distributions
– When is this appropriate?
– What are the disadvantages?
• Deferred distributions
– Accumulation v. distribution
– When is income needed?
– Any foreseeable need for the principal?
Fixed Annuities
• Guaranteed rate-of-return on principal
during accumulation phase
• Guaranteed income payments during
distribution phase
– Term of the distribution period
• Other insurance-product features
– General account of insurance company
– State guarantee funds
• Benefits and risks of Fixed Annuities
Insurance Features
• State minimum nonforfeiture rules typically
require:
– Guaranteed minimum value of fixed annuity contract
be at least 87.5% of premiums paid
– Accumulated at an annual rate of 1-3%
• Constant Maturity Rate reported by the Federal
Reserve
• Obligation of an insurance company
– Risk of loss remains with the insurance company
• Not a security Section 3(a)(8) of the Act
• McCarran-Ferguson Act: federal law shall not
be interpreted to “supersede any law enacted
by any State for the purpose of regulating the
business of insurance.”
Variable Annuities
• Securities
• SEC v. Variable Annuity Life Ins. Co. of
Am., 359 U.S. 65 (1959) and SEC v.
United Benefit Life Ins. Co., 387 U.S.
202 (1967)
• Supreme Court held that an annuity will
be treated as a “security” where the
insurance guarantees are “superficial”
or non-existent.
Variable Annuities
• Annuitant's premium payments invested in
traditional investments by the insurer (mutual
funds, stocks, bonds, money-market
instruments)
– Separate accounts
– Not the general account of the insurer
• Distribution phase
– Pre-determined, not linked to performance
– Variable, linked to investment performance
• Early withdrawal and surrender charges
• Life-insurance contract components
Fixed (Equity)-Indexed Annuities (“FIA")
• Annuity contracts where portion of return is
fixed and there is a credit based upon
performance of equity or bond index
• Rate of return is the distinguishing feature of
an FIA
– Guaranteed minimum return
– Indexed interest rate, or market index
• Indexing methods determines
interest rate
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Annual reset or ratchet method
High-water mark
Point-to-point
Index averaging
FIAs, continued
• FIA components also effect rates of
return and gains
• Participation rates: change allowed in
the index participation
• Minimum interest credit which is never
less than zero
• Spread, margin, and asset fees
• Interest-rate caps
FIAs continued
• Unlike variable annuities, 100 percent of
premiums are deposited in insurer’s general
account
• After deduction for expenses related to sale of
annuity, premiums are invested through the
general account
• General account consists of permitted
investments under state law
• High quality fixed income securities, U.S. and
governmental agency bonds and other high
quality permitted assets
– Insurance company may hedge, but not speculate
FIAs
• Insurance company must maintain net
capital under state law
• Minimum nonforfeiture rules
– Apply to fixed and FIAs, not variable
– 87.5% of initial premiums carried forward
with interest at a rate between one and
three percent
FIAs
• Liquidity Options
– Annual penalty free withdrawals of up to 10% of the
value
– Annuitization (stream of payments)
– Nursing home rider
– Terminal illness rider
– Borrowing if sold in qualified market
• Mortality
– Generally full contract is paid without deduction
– Annuitization based upon life expectancy
• No sales charge
– Sales commissions paid from insurer’s general assets
FIA Analysis
• Need to review sales material,
Statement of Understanding and state
filings to understand
• Single Premium Fixed Annuity
• Balanced Allocation Strategy
– Index Allocation
• Indexed Earnings are calculated using S&P 500,
which does not include dividends
– Declared Rate Allocation
Single Premium Fixed Annuity
• Fee ranges from 2.25% to 4%
– Sales material
• Industry standard
– Administrative fee is $30 per year
– Management fee is 100 to 150 bps
Lock-in Option
• Lock in interest or value
– Could mean lock in rate of return on S&P
• Locks in only gain
• Hypothetical:
– Contract with 75% Index and 25% fixed
– S&P up 20% after two years
• Customer “locks”
– Six years later, 4.3296% total return, or .72% per
year
• $10,000 investment would have gained $433
per year
FIAs
• Excellent savings tool
• Even out market adjustments
• $100,000 investment from October
2004 to October 2008
– $100,000 grew to $136,000
• S&P $106,000
Life Settlements
• Viaticals vs. Life Settlements
• Viatical is imminent death
– Settlement Purpose
– HIV and Magic Johnson problem
• Life Settlement
– Owner of life insurance policy sells ownership of
policy to a third party
– Big Issue: No insurable interest
– Large Fees
• Purpose: Immediate economic benefit
• Regulatory view
Life Settlements
• FINRA will regulate life settlements that
include a variable life insurance policy
• “Any sale of a security, including variable life,
has to meet FINRA rule. We recognize
commissions of this product are high – up to
45 percent. The argument is that these
transactions are great for the consumers. But
if that’s true, why [is there a 45 percent
commission]?”
– Id.
• Off cycle sweeps.
Hot Topics
Sales to Seniors
• High-pressure sales tactics
– Attorney General Lori Swanson's testimony before
Congress and the Heritage case
– April 2008 Dateline NBC "Tricks of the Trade"
investigation on annuities
• "Annuity University" – fear and anger to make the sale
• "The FDIC is insolvent; banks are not safe."
• Misleading sales tactics
– Access to investment
– Surrender-period misrepresentations
• Free Lunch Seminars
Sales to Seniors, continued
• Suitability
– Ensuring that the annuity is fully explained
to the purchaser
– The need for liquidity conflicts with the
deferral period when the purchaser has a
fixed income
– Financial and medical emergencies
– Surrender penalties
FINRA Suitability Requirements
Rules 2820 and 2821
FINRA Rule 2820
• Contract value determined by contract
or prospectus
• Prompt transmittal of payments to the
insurer from the FINRA member
• Sales agreements mandatory
– Required clauses about sales commissions
• Prompt payments on refunds
• Member compensation
FINRA Rule 2821
• NTM 96-86: NASD Regulation Reminds
Members and Associated Persons that
Sales of Variable Contracts Are Subject
to NASD Suitability Requirements
• NTM 99-35
• NTM 00-44
• Joint SEC/NASD Report on Sales of
Variable Insurance Products
• December 4, 2004: Initial Filing of
2821
FINRA Rule 2821
• Work in progress
• Applies to the purchase or exchange of
a deferred variable annuity and initial
sub-account allocations
– Sub-account allocations
• Four parts to Rule 2821
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Recommendation requirements
Principal review and approval
Supervision
Training programs
FINRA Rule 2821, continued
• Recommendation requirements
– Must inquire about the customers basic
characteristics, financial situation, and goals
• Age, income, financial needs, investment
experience, net worth, risk tolerance, etc.
– "Reasonable bases to believe that a
particular transaction is suitable"
– Suitability determination accounts for the
basic characteristics of the annuity, as
applied to the individual
– Additional considerations for Section 1035
exchanges
FINRA Rule 2821, continued
• Principal and Supervisory Obligations
– "Registered principal" approval
– Shall approve if the there is a reasonable
basis to believe the transaction is suitable
– Approval by customer
– Exemption from "promptly transmits" rule
and net-capital requirements
FINRA Rule 2821, continued
• Firm supervisory obligations
– Consistent with Rules 3010, 3012, 3013,
and 3110 and WSPs to address annuities
– Enforcement by FINRA
• Banc One Securities Corp. - $225,000 fine for
failing to require firm supervisors to consider
necessary information in suitability reviews;
$6,500 in restitution
• Training Programs
– Ensure that associated persons know about
Rule 2821's suitability requirements
– General v. Specific?
State Regulation
• The Suitability in Annuity Transactions Model Regulation
• The Insurance and Annuity Replacement Model
Regulation
• The Advertisements of Life Insurance and Annuities
Model Regulation
• State “free look” requirements
• State oversight and approval of products, including
Interstate Insurance Product Regulation Commission
• Unfair trade practice law and regulation
• Market Conduct Examinations
• Enforcement actions by state insurance regulators and
attorneys general
• ACLI
NAIC Model Suitability Guidelines
• Addresses recommendations and suitability
similar to FINRA Rule 2821
– Reasonable grounds to recommend the annuity to
the customer
• More comprehensive than FINRA Rule 2821 on
supervision
– Insurers must maintain written procedures, conduct
periodic reviews to detect and prevent violations
• Dangers for securities
– Fixed v. variable attestations
– Insurance company validations
NAIC Suitability in Annuity Transactions
Model Regulation
• Reasonable efforts to obtain:
Consumer’s financial status, tax status,
investment objectives, other useful data
• System of supervision reasonably
designed to achieve compliance, which
includes written procedures and
periodic reviews; or contracting with a
third party to review.
– An insurer…is not required to review or
provide for the review of all insurance
producer solicited transactions
Model Regulation, con’t.
• Opt-outs. No obligation is the
consumer refuses to provide
information, rejects recommendation,
or fails to provide accurate information
• Reasonable grounds for suitability
• Agent oversight
– Mandatory training
Minnesota Atty General and Calif. DOI
• Go well beyond state law
• Review procedures for sales to seniors
and deferred annuities generally
Minnesota AG and California DOI
• Detailed requirements for sale of deferred
annuities (red flags)
• $75,000 of liquid net worth
• No change in circumstances
• Premium for the annuity should not be more
than 25% of net worth
• Premium of the annuity should not be more
than four times the annual income
• Value of all annuities should not be equal to or
greater than 75% of net worth
• 75 years old
Rule 151A
• Proposed Regulations
– SEC Rule 151A would regulate some FIAs as
securities
• Very important from compliance
perspective
Proposed Rule 151A
• Section 3(a)(8) of the ’33 Act excludes
from the definition of a security and the
Act any annuity contract (optional
annuity contract) issued by an
insurance company that is subject to
supervision of a state insurance
commissioner
– Different from insurance contract
Rule seeks to eliminate exemption
• Amounts payable by the insurer under
the contract are calculated, in whole or
in part, by reference to a performance
of a security, group of securities, or
index; and
• Amounts payable by the insurance
company are more likely than not to
exceed the amounts guaranteed under
the contract
SEC Rule 151A
• Rule 151A will eliminate the exemption
for certain insurance contracts based on
two principles
– Allocation of risk between investor and
insurer
– Marketing of the annuity to the customer
• The greater the risk borne by the
consumer, and the more the annuity is
treated like an investment, the more
likely it will lose its exempt status due
to Rule 151A.
SEC Rule 151A, continued
• An annuity that would not fall under the
exemption has two characteristics:
– (1) “amounts payable by the insurance
company under the contract are calculated,
in whole or in part, by reference to the
performance of a security, including a group
of indexed securities;” and
– (2) “amounts payable by the insurance
company under the contract are more likely
than not to exceed the amounts guaranteed
by the contract.”
Rule 151A: Compliance
• Sales are through: independent agents,
captive agents, and registered representatives
– Independent agents largest channel
• They sell: traditional fixed insurance, longterm care, disability.
– Some are tax accountants
• If adopted, they have to become registered
representatives
• Subject to FINRA Rules 3030 and 3040
• Sales of insurance products are often a “red
flag”
– 25% of sales
Rule 151A: Other Issues
• Are fixed annuities securities?
– Keyed to performance of underlying securities or indexes
– Seems to fit the two prong definition
• Agents operate through FMOs
– May have to become licensed as broker-dealers
• Super net capital rules
– Exchange Act 15c3-1(c)(2)(iv)(C)
• Registration costs
– S-1 does not work (statutory accounting v. GAAP)
– SOU v. Prospectus
– 25 years for SEC to approve a registration form for
variable annuities
– Ten years to adopt From N-6 for variable life
• Other industry issues
Discussion and
Q&A Session