A.Product Concept. Equity indexed life and annuity products ("EIPs") represent a form of insurance contract that provides a platform of traditional guarantees, including interest and/or principal guarantees, while crediting excess interest based on a formula that, in part, takes into account movement in an equity index. Section II of this outline provides an overview of the product concept, of the various index formulae currently employed, and comments on how key features of EIPs distance them from variable products.
B.Unregistered Products -- the Legal Framework. To date, most of the more than 30 companies offering EIPs have decided not to register their EIP with the U.S. Securities and Exchange Commission ("Commission" or "SEC") as a security under the Securities Act of 1933 (the "Securities Act"), in reliance on the exemption from registration for insurance policies and annuity contracts available under Section 3(a)(8) of the Securities Act. Section III briefly examines Section 3(a)(8) and the safe harbor provided by Rule 151 under the Securities Act.
C.The SEC's Concept Release on EIPs. On August 20, 1997, the Commission issued a concept release requesting comments on the location of EIPs on the insurance/securities "spectrum." (1) In the release, the Commission requests detailed information on the "structure of equity index insurance products, the manner in which they are marketed, and any other matters the Commission should consider in addressing federal securities law issues raised by equity index insurance products." (2) Through a series of specific questions and informational requests, the Commission seeks comment on the allocation of investment risk between the insurer and contract owner under EIPs and the manner in which EIPs are marketed, and the impact of these factors on whether the product is entitled to the insurance exemption under Section 3(a)(8). Section IV contains a description and summary of the Concept Release and offers selected highlights from several of the responses to the Concept Release received by the SEC.
D.The Registration Route. Section V outlines the costs and benefits of SEC registration, provides an overview of the registration process for an EIP and certain securities law issues raised by EIPs. Section V then examines the no-action letter obtained by Valley Forge Life Insurance Company (Jan. 30, 1997) with regard to an "insulated" separate account established in connection with SEC-registered equity indexed annuity ("EIA") options, where the SEC staff agreed not to recommend enforcement action if the separate account was not registered as an investment company under the Investment Company Act of 1940 (the "1940 Act").
II.OVERVIEW OF THE PRODUCT CONCEPT
Growth in EIPs sales has been exponential with total industry sales by year-end 1997 estimated in the $3 to $4 billion range, (3) up from $.2 billion in year 1995. From being issued by a handful of insurers less than two years ago, EIAs are now offered by more than 30 companies with product variations numbering over 50. (4) At least five companies have launched 7 equity index life products. (5) Companies offering EIPs tend to be smaller insurance companies with surveys showing that a large percentage of EIP sales are made by general insurance agents who are not registered as broker-dealers with the National Association of Securities Dealers ("NASD"). (6)
A. Equity Index Linkage. EIPs generally provide an account and/or cash value credited with earnings that are linked to some degree to the movement of a specified index (for example, the value of the Standard & Poor's 500 Composite Stock Price Index, or "S&P 500"). An EIP can be distinguished from a variable annuity or variable life insurance product; an EIP "controls" a contract owner's equity index linkage by providing a platform of contractual guarantees, and by applying an indexing formula that does not provide a "pass through" of index "performance." Moreover, the index to be used, the formula for crediting indexed interest, and the dates on which indexed interest is calculated and credited, are established in the contract and guaranteed for the life of the contract. From a marketing standpoint, EIPs are attractive to insurers' traditional target market of conservative savers. (7)
B. Platform of Guarantees. As is the case with traditional annuities, unregistered EIAs have provided guaranteed benefits to be paid out upon annuitization, (8) death, or surrender, regardless of the investment experience of the insurer's general account (or separate account) assets. And like traditional universal life insurance products, unregistered equity indexed life products provide guaranteed benefits to be paid out upon death or surrender, regardless of the company's investment experience. These guaranteed benefits are significant, given the amount and long-term nature of the guarantees.
Upon surrender, unregistered EIPs generally guarantee principal (less contract expenses and charges) plus some minimum level of credited interest. Credited interest in excess of the minimum rate typically reflects the indexing feature inherent in the contract.
Unlike variable and market-value adjusted ("MVA") products, all unregistered EIPs have guaranteed minimum nonforfeiture values. State nonforfeiture laws for individual fixed annuities require that single premium equity index annuities guarantee the return of an amount at least equal to 90% of premium, accumulated at an annual rate of at least 3%. For flexible premium individual deferred annuities, state nonforfeiture laws require a guaranteed return of an amount equal to 65% of the net consideration for the first contract year and 87.5% of the net considerations for the second and later contract years, all accumulated at an annual interest rate of at least 3%.
Equity indexed life products have complied with state nonforfeiture laws for individual life insurance. This law is more complicated than the annuities nonforfeiture law in that the prescribed minimum values depend on the interplay of the various charges and interest rates, and therefore does not require the crediting of a specified rate of interest to net premiums and to interest credited thereon, less deductions for cost of insurance, rider costs, administrative charges and other policy expenses. The few insurers that currently are offering equity indexed life products credit interest at a minimum rate of at least 2%.
C. General vs. Separate Account. Most EIPs have, to date, been written through the general account of the issuing insurer, although interest in the use of non-unitized separate accounts, and potentially, "insulating" such separate accounts, appears to be increasing. See, for example, the registration statement on Form S-1 for a combination MVA/EIP annuity contact being issued by Valley Forge Life Insurance Company (File No. 333-02093) through an insulated separate account. Valley Forge obtained an SEC no-action letter regarding the status of the separate account under the Investment Company Act of 1940, as amended (the "1940 Act"). See Section V below for a discussion of the Valley Forge letter.
D. Categories of Indexing Formulae. EIPs credit excess interest using a formula that is based, in part, on movement in an index. EIP indexing formulae fall into a number of categories, including (but not limited to) the following:
1. Look-Back or "High Water Mark". Under a look-back formula, indexed excess interest is determined by "looking back" over the course of a term to one or more "high water" measurement points. Example: The indexed interest credited at the end of a term is determined by identifying the highest index level during the term at specified measurement points and comparing it to the index level at the beginning of a term. Typically, these measurement points are the anniversaries of the contract, but they could occur with greater frequency. Each of these measurement points could incorporate some averaging technique.
2. Low Water Mark. Under a low water mark formula, indexed excess interest reflects a comparison of the index level at the end of a term to the lowest value the index has achieved at specified measurement points during the term. Typically, these measurement points are the anniversaries of the contract, but they could occur with greater frequency. Each of these measurement points could incorporate some averaging technique.
3. Annual Reset or "Ratchet". Under an annual "ratchet" formula, indexed excess interest reflects a comparison of the index level at the end of a year to the index level at the beginning of a year. A compound ratchet applies the index-based interest rate to the current contract value at the time of crediting. A simple ratchet applies the index-based interest rate to the premium minus cumulative withdrawals at the time of crediting. So far, for administrative reasons, most equity indexed life products have used the annual reset design without bells and whistles.
4. Point to Point. Under a point to point design, indexed excess interest is determined by comparing an index level at the end of a specified period to the index level at the beginning of the period. Averaging at the end of the period may "soften" the impact of index declines on excess interest rates, but also "dulls" the impact of index increases. Today, most EIPs have either an annual ratchet or a point to point design, with fewer high water mark products on the market.
5. Ladder. Under a ladder design, indexed excess interest is credited as a portion of the percentage growth in the underlying index from the beginning of the term to the end of the term with the additional guarantee that the recognized final index value will not fall below a specified index level if the index reached that specified level at particular points during the term. One or more "rungs" of a ladder may be specified. Measurements are typically done on anniversaries, but a more frequent basis is possible.
EIP formulae do not result in the "pass-through" of the performance of either the index or the basket of stocks underlying the equity index to EIP values. The index is referred to only at specific discrete points in time in accordance with a predetermined fixed formula to calculate excess interest. And the use of the index does not take into account reinvested dividends (which means that the index value will not produce the same value as if the underlying stocks in the index were purchased and held for a similar period). Rather, the formulae each essentially create two or more index-based values that are compared to determine the starting point for the calculation of excess interest to be credited for a given period under the EIP.
E. Components of the Indexing Feature. In addition to reflecting one (or in some cases, more than one) of the basic categories of indexing formulae set forth above, an indexing feature incorporates a number of additional components that further "distance" EIPs from variable products.
1. Indexing Formulae May Build in a "Participation Rate" and May Be Subject to "Caps" and "Floors". EIPs typically have "terms" (of at least one year in length) over which indexed interest is calculated and credited to contract value in accordance with the formula stated in the contract. The index formula may include a "participation rate" that is set in advance and guaranteed for at least one year periods. A participation rate determines how much of the movement in the index, as determined under the indexing formula, will be used to calculate interest. For example, if under an annually-measured ratchet formula, the index increases by 10%, a participation rate of 75% would result in an index increase of 7.5% (before taking into account any other applicable components of the indexing formula). Among these additional components may be a "cap" and a "floor" -- upside and downside limits, respectively, on the indexed interest rate credited. Virtually all EIPs have at least a "zero" floor, so that negative interest is never credited and premium plus previously credited interest is never forfeited as a result of the application of the indexing feature.
2. Indexed Excess Interest May Be Subject to a "Margin" or "Spread". Some excess index-interest formulae include a deduction of a basis-point "spread" as part of the indexing formula. For instance, if under an annual ratchet design, the increase in the index from the beginning of the year to the end of the year is 10% and the spread is 250 basis points, then the index excess interest rate would be 7.5% for that year.
3. Indexed Excess Interest May Be Subject to a "Vesting" Feature. EIPs that credit indexed excess interest on an annual basis may include a "vesting" feature, which limits the amount of excess interest that is available for withdrawal over the course of a term. For example, after the first contract year, 40% of excess interest may be available for withdrawal; this percentage would increase by 10% each contract year until the end of a seven year term, when 100% of excess interest would be available for withdrawal. Like the index formula, vesting percentages are fixed in advance of a term and do not vary with the movement in the index.
4. EIPs Provide for Different Frequencies and Durations of Indexed Interest Crediting. As noted above, some EIP designs provide for the calculation and/or crediting of indexed excess interest at the end of each contract year; others provide for the crediting of indexed excess interest at the end of a term. Some EIPs provide for only one excess interest credit. For example, a point to point EIP may have only one indexed term; following the end of the indexed term, the EIP would provide for the crediting of excess interest at rates determined in advance by the insurer. Other EIP designs may also provide for the calculation and crediting of excess interest on specified "interim" dates, such as contract surrender, annuitization, or payment of a death benefit.
5. EIPs May Provide for Simple or Compounded Interest Over a Term. Some EIPs provide for simple, additive interest during a term, where the amount or rate of indexed excess interest is calculated each year based on the original premium and then added either each year or at the end of the term to the original premium. Other EIPs offer compound interest during a term, where indexed excess interest is calculated based on the original premium plus previously credited indexed interest. In either case, however, the base value is stepped-up at the end a term to include all indexed excess interest.
6. EIPs Provide for Different Averaging Techniques. Some EIP designs average index values over a certain period of time and with varying frequencies of measurements within the period. Daily averaging may be used for a short period of time (30 or 60 days) at the end of each term or each contract year, and sometimes at the beginning of a term. Some multi-year point-to-point EIP designs provide for averaging of monthly index values over a period of several months or several years. Certain annual ratchet designs use daily, monthly or quarterly averaging within a year to reduce the volatility of interest credited to the contract.
Due to the generally shorter index terms on equity indexed life products, averaging tends to be short term, such as over a period of one to six months.
F. Other EIP Features.In addition to an indexing formulae, insurers may offer one or more of the following features in an EIP product:
1. Multiple Premium Payments. The initial "wave" of EIP designs provided for the payment of a single premium. Some insurers now offer products that provide for the payment of multiple premiums. With flexible premium EIPs, application of the indexing formula usually involves administering all premiums under the same term length with the same participation rate, margin, cap and floor. EIP designs under which each premium may be subject to a different term length, participation rate, margin, cap, and floor, present contract drafting and administrative systems challenges.
2. Adding EIP Options to "Combination" Contracts. Insurers have begun to add EIP "options" under contracts that provide for other premium allocation options -- such as variable annuities, MVA contracts, and other fixed annuity contracts. Providian Life & Health Insurance Company (formerly National Home Life Assurance Company), for instance, has for several years offered a Five-Year Guaranteed Equity Option as a general account option to its Providian Prism Variable Annuity. (9) This product is a five year straight point to point product where 100% of accumulated value is credited with 3% interest, compounded annually. At the end of the fifth year, the company guarantees to credit additional interest in the amount equal to the amount by which (a) exceeds (b), where: (a) equals the percentage change in the S&P 500 from the first day of the five year term to the end of the term, multiplied by the amount allocated; and (b) equals the total amount of interest previously credited during the five-year term.
3. Designing EIPs that Permit Selection from Multiple Indices, Including a Composite Index. A few EIAs have been designed that permit the owner to select the index to be referred to in calculating indexed excess interest from among a number of available indices set forth in the contract. For instance, one insurer offers a choice of terms (1, 3 and 5 years) and a choice of indices (the S&P 500 Index or the Lehman's Aggregate Bond Index). Another insurer offers terms of 1, 3, 5, 7, and 9 years and a choice of the S&P 500, the S&P Midcap 400, the NASDAQ 100, and the insurer's own composite International Index.
4. Immediate EIAs. At least one company is offering an immediate EIA that permits annuity payments to be linked to an equity index. The product offers two options: (a) a level guaranteed payment amount for the duration of the contract; or (b) the potential for guaranteed payments to be "stepped-up" annually to provide for indexed growth.
III. DETERMINING THE STATUS OF AN UNREGISTERED EIP UNDER SECTION 3(a)(8) OF THE SECURITIES ACT -- PLACING AN EIP ON THE INSURANCE/SECURITIES CONTINUUM
The starting point for a securities law analysis of an EIP is an in-depth legal review of its indexing feature and interest crediting mechanics, guarantees and the EIP marketing plan. This analysis is necessary (i) to confirm the mechanical "integrity" of the policy form; and (ii) to determine whether the EIP, given the guarantees it provides and its excess interest rate features, as well as its marketing, more closely resembles contracts found by the courts, or deemed by the Commission, to be insurance or annuities, or more closely resembles contracts found by courts or regulators to be securities. While the industry (and courts and regulators) have an established framework for approaching (ii) above, through the application of authorities interpreting the scope of Section 3(a)(8) of the Securities Act, the Commission's recent Concept Release on EIPs (discussed in Section IV) places this framework under close scrutiny.
A. The Section 3(a)(8) Exemption for Insurance and Annuity Contracts. Section 3(a)(8) of the Securities Act exempts from registration under the Securities Act "[a]ny insurance or endowment policy or annuity contract or optional annuity contract, issued by a corporation subject to the supervision of the insurance commissioner, bank commissioner, or any agency or officer performing like functions of any State or Territory of the United States or the District of Columbia." Section 3(a)(8) has remained unchanged since 1933.
Section 3(a)(8) provides no definitional standards. Indeed, courts and the Commission have recognized that the line between a traditional annuity and an investment contract can be elusive, in part because all annuities are inherently investments. (10) As the Commission noted in an earlier concept release, an annuity contract "cannot always be readily characterized as 'insurance' or as a 'security' for purposes of Section 3(a)(8)." (11)
B. Section 3(a)(8) is an Exclusion, not an Exemption. The legislative history of Section 3(a)(8) states:
[Section 3(a)] (8) makes clear what is already implied in the act, namely, that insurance policies are not to be regarded as securities subject to the provisions of the act. The insurance policy and like contracts are not regarded in the commercial world as securities offered to the public for investment purposes. The entire tenor of the act would lead, even without this specific exemption, to the exclusion of insurance policies from the provisions of the act, but the specified exemption is included to make misinterpretation impossible. (12)
C. Key Judicial Decisions Applying Section 3(a)(8). As insurance policies and annuity contracts evolved with changes in the economy during the 1950s and 1960s, and the needs of consumers changed, courts and regulators first faced the challenge of determining whether certain hybrid insurance/investment contracts constituted "insurance" within the meaning of Section 3(a)(8), or securities required to be registered under the Securities Act.
The Supreme Court first considered the contours of the Section 3(a)(8) exemption in the VALIC (13) case, and held that a primary factor determining whether an annuity qualifies as insurance under Section 3(a)(8) is the degree of "investment risk-taking on the part of the company." (14) In VALIC, the Court held that a variable annuity was a security when it shifted the entire investment risk to the contract owner. (15) In the subsequent United Benefit case, the Court held that a variable contract was a security when the insurer's investment risk was minimal because the contract's guaranteed cash value was set at such a low level that the guarantee would never have been operable in the prior fifty years. (16) In both cases, the insurer was found to have assumed an insufficient degree of risk to qualify the product as insurance within the Section 3(a)(8) exemption. The key issue in an analysis, then, is whether an annuity provides "guarantees of principal and interest sufficient for the insurer to be deemed to assume the investment risk . . .." (17)
Despite judicial and regulatory precedents, the precise contours of Section 3(a)(8)'s investment risk standard remain undefined. On the securities end of the insurance-securities spectrum, the Supreme Court has held a variable contract to be a security if it provides a pass through of investment performance (18) or provides a pass through with a guarantee "substantially less than that guaranteed by the same premiums in a conventional deferred annuity contract". (19) It is important to note that neither the VALIC nor the United Benefit contract satisfied state minimum nonforfeiture laws. At the insurance end of the spectrum, the Commission, after considerable deliberation, adopted a safe harbor rule under which issuers of certain discretionary excess interest contracts are deemed to assume sufficient investment risk under Section 3(a)(8), despite any investment risk borne by owners of such contracts. However, in so doing, the Commission made clear that it did not believe that the safe harbor defined the outer boundaries of the Section 3(a)(8) exemption. (20)
D. The Commission's Rule 151 Safe Harbor Under Section 3(a)(8). In 1986, the Commission promulgated Rule 151, a "safe harbor." (21) Contracts that meet the conditions of the rule are deemed to fall within Section 3(a)(8). Contracts outside of the safe harbor may also rely directly on Section 3(a)(8); however, the "rationale underlying the conditions [of] Rule 151 is relevant to any Section 3(a)(8) determination." (22) In proposing and ultimately adopting Rule 151, the Commission provided a significant amount of detailed guidance regarding its views on the scope of Rule 151, and on the factors that are relevant to making a determination as to whether a contract falls within Section 3(a)(8). This guidance is critical to an analysis of EIPs under the Securities Act.
Life insurance contracts technically cannot rely on the Rule 151 safe harbor, which is only available to annuity contracts. However, the Commission has indicated that it is appropriate to apply the principles of Rule 151 to life insurance contracts in determining their status under the federal securities laws.
The Conditions of the Rule 151 Safe Harbor. To fall within the safe harbor, an annuity must meet the following conditions:
1. The Contract Must Be Issued by an Insurance Company. The contract must be issued by a corporation ("issuer") subject to the supervision of the insurance commissioner, bank commissioner, or any agency or officer performing like functions, of any State or Territory of the United States or the District of Columbia.
2. The Insurer Must Assume the Investment Risk. The insurer must assume the investment risk under the contract, as prescribed in the rule. The rule provides that the insurer shall be deemed to assume the investment risk under the contract if the following conditions are met.
a. Not Vary with the Investment Experience of a Separate Account. The value of the contract does not vary according to the investment experience of a separate account. A contract that provides for allocation of contributions to a non-unitized separate account not structured as a single unit operating independently of the investment experience of the insurer's general account is not precluded from relying on the rule.
EIP Comment. If the EIP is funded through the general account or through a non-unitized separate account, this condition of the safe harbor could be met. However, if the EIP is issued through an insulated, unitized separate account, courts and/or regulators may find it difficult to distinguish an EIP from a variable contract with some form of guarantee.
b. For the life of the contract, the insurer:
(1) Guarantees Principal and Interest. The insurer must guarantee principal and return of previously credited interest thereto (less charges for sales, administrative or other expenses or charges). Contracts with market-value adjustment features may not rely on the rule.
EIP Comment. A continuous guarantee of principal (less applicable sales and administrative charges and other expenses) is critical to the analysis whether an EIP would qualify as an insurance contract. For instance, an EIP with a market-value adjustment feature that invades principal would not qualify for the Rule 151 safe harbor and likely would be beyond the scope of the Section 3(a)(8) exemption. (23)
(2) Guarantees a Minimum Level of Credited Interest. The insurer must credit a specified rate of interest (at least equal to the minimum nonforfeiture interest rate for individual annuities) to net purchase payments and interest credited thereto.
EIP Comment. The answers to the following questions likely would be very important in analyzing EIPs under this prong: (1) Does the EIP guarantee that interest will be credited (and accumulate) at a rate at least equal to applicable nonforfeiture rates, for the life of the contract? (2) Is principal, plus previously credited interest, credited with minimum nonforfeiture interest for the life of the contract? (3) Is principal plus previously credited interest (less applicable sales, administrative or other expenses or charges) guaranteed upon any surrender?
c. Guarantees that the Excess Interest Rate Will Not Change More Frequently Than Annually. The insurer must guarantee that the rate of any excess interest to be credited in excess of the rate described in b.(2) above, including indexed excess interest, will not be modified more frequently than once per year. (24)
EIP Comment - Use of an External Index. Although the language of Rule 151 does not speak directly to indexed contracts, Release 6645 permits the use of an external index to determine excess interest rates, so long as the excess rate is not modified more frequently than once per year. Thus, an insurer is permitted:
to specify an index to which it will refer, no more often than annually, to determine the excess rate that it will guarantee under the contract for the next twelve-month or longer period. Once determined, the rate of excess interest credited to a particular purchase payment or to the value accumulated under the contract must remain in effect for at least the one-year time period established by the rule. Thus, while the rate of interest calculated under a particular index or formula may fluctuate upward or downward on a daily basis, the excess interest rate actually credited may not fluctuate more than once per year. (25)
EIP Comment -- Retroactivity. Release 6645 and the recent Concept Release can be read to interpret Rule 151 to cover only contracts where the actual excess interest rate (as opposed to the excess interest rate formula) is declared in advance, not in arrears. (See above quotation.) Under this interpretation, an EIP product that credits indexed excess interest at the end of a contract term or period based on an equity linked excess interest rate that is determined at the end of that period (rather than at the beginning) would not fit within the safe harbor, even if (i) each term or period is at least one year in duration; and (ii) the indexing formula, index participation rate, and any applicable "margin,""cap," or "floor," are determined in advance and guaranteed for one year.
3. The Contract Cannot Be Marketed Primarily As An Investment. Notwithstanding the objections of many commenters on proposed Rule 151, the Commission retained a "marketing" test as part of the safe harbor. Release 6645 notes that the insurer should not advertised its product by "emphasizing the possibility of investment return and the experience of United's management in professional investing." (26)
a. Insurance Appeal. The thrust of the insurer's total marketing plan for the product must be targeted to appeal to purchasers " . . . on the usual insurance basis of stability and security . . .. " (27) This does not mean that "an insurer in marketing its product cannot describe the investment nature of the contract, including its interest rate sensitivity and tax-favored status." (28)
b. A Balanced Approach. The SEC noted: "A marketing approach that fairly and accurately describes both the insurance and investment features of a particular contract, and that emphasizes the product's usefulness as a long-term insurance device for retirement or income security purposes, would undoubtedly "pass" the rule's marketing test. By way of contrast, if a contract is promoted with primary emphasis on current discretionary excess interest, and the possibility of future interest, or other investment-oriented features of the contract, that contract would likely fail the marketing test." (29)
EIP Comment. Rule 151 clearly does not preclude contracts with indexed interest rates from satisfying the marketing test. However, excessive emphasis on an EIP's "upside potential" could lead to a serious risk that the EIP could be found to be a security.
Conclusion: EIP designs generally may not fall within the safe harbor of Rule 151, for one or more reasons. However, an analysis of EIP contract features under Rule 151 "investment risk" principles, and consulting Rule 151 marketing guidance, may provide a "blueprint" for determining the level of comfort that an insurance company may have in offering an EIP without registration under the Securities Act. (30)
IV. RECENT COMMISSION ACTIVITY: EQUITY INDEX INSURANCE PRODUCTS CONCEPT RELEASE
A. Summary: On August 20, 1997, the Commission issued a concept release seeking comments on "the structure of equity index insurance products, the manner in which they are marketed, and any other matters the Commission should consider in addressing federal securities law issues raised by equity index insurance products." (31) Comments were due on January 5, 1998.
1. EIPs Characterized. In soliciting comments, the Commission characterized EIPs as products that "combine features of traditional insurance products (guaranteed minimum return) and traditional securities (return linked to equity markets)." (32) While recognizing that most EIPs have not been registered under the Securities Act, the release noted that "commentators have acknowledged that substantial uncertainty exists whether all of these products are entitled to exemption from registration." (33)
EIA contracts are described as sharing two characteristics: (i) a return based on changes in an equity index; and (ii) a guaranteed minimum return if the contract is held to maturity. Other features, such an indexing method, participation rates, vesting, margins, caps and floors are described. (34)
Comment was sought on whether all EIPs share certain features that result in all of them being covered by the insurance exemption, or not covered. The Concept Release also inquired whether there are features that distinguish those EIPs covered by the insurance exemption from those that are not. Commenters were asked to discuss the ways in which EIPs are similar to or different from traditional fixed insurance products, on the one hand, and variable insurance products, on the other.
2. Applicability of Section 3(a)(8). The Concept Release reconfirmed that the allocation of investment risk between issuer and contract owner, and marketing, are key factors to a determination of a contract's status under Section 3(a)(8). (35) The release restated the Commission's position that where the Rule 151 safe harbor is not available, the status of a contract may be analyzed by reference "to the principles discussed in Rule 151 and the accompanying releases and to judicial precedents construing Section 3(a)(8)." (36)
The Concept Release directed commenters to discuss the applicability to EIPs of the factors employed by courts and the Commission to determine whether a product is entitled to the insurance exemption. (37)
3. The Applicability of State Insurance Regulation.In discussing the first prong of Rule 151 (that the annuity be issued by a corporation subject to the supervision of a state insurance regulator), the Commission concluded that EIPs are "generally issued by companies subject to state insurance regulation, thereby appearing to meet [the] threshold requirement for insurance status" under the first element of Rule 151. (38)
The Commission sought comment regarding the status of EIPs under state law. For contracts regulated by the states as insurance, commenters were asked to "describe the provisions of state law that apply, e.g., regulation of reserves, investment restrictions, approval of contract forms, illustration requirements, market conduct standards, applicability of state insurance guaranty laws." (39)
4. The Investment Risk Allocation. With respect to investment risk, comment was requested on how investment risk is allocated between the insurer and the contract owner in EIPs. (40)
a. Contract Value Not Tied to Separate Account. The Concept Release acknowledged that EIPs typically are general account products that appear to satisfy the first condition of Rule 151's investment risk test that the value of the contract not vary according to the investment experience of a separate account. (41)
The Concept Release, however, sought comment on the general account investments used by insurers to support obligations under EIPs, and whether the nature of these investments affected the analysis of the securities status of EIPs. (42) It asked: "Should the relative levels of a contract owner's purchase payment allocated to the floor guarantee and the index-based benefit affect the status of a contract as insurance under the federal securities laws?" (43)
The release specifically questioned whether an insurer's "hedging" of its general account obligations to pay an indexed benefit results in a "pass-through" of performance from insurer to contract owner. (44)
b. Guarantee of Purchase Payments and Credited Interest. The Concept Release noted that EIAs generally guarantee 90% of premium and annual interest of 3%. Comment was sought on whether the "typical floor guarantee" for EIAs, "by itself," satisfies the investment risk requirement of Rule 151. (45) Comment also was sought regarding annuity floor guarantees other than the typical 90% floor and how the different floors affect the investment risk analysis.
Commenters were asked to address whether, and under what circumstances, the "typical 10% deduction" from purchase payments is attributable to sales, administrative, or other expenses or charges and "therefore falls within the rule's parameters." (46)
c. Specified Rate of Interest. The Concept Release observed that EIAs appear to satisfy this prong of Rule 151 by guaranteeing minimum interest of 3%, which is generally equal to the minimum rate required by state law. Commenters were asked to describe the minimum guaranteed rates on various indexed products and to analyze whether these rates satisfy the conditions of Rule 151. (47)
d. Excess Interest. The Concept Release recounted the Commission's initial reluctance to permit the use of external indices to determine excess interest rates because use of an index feature shifts "to the contract owner all of the investment risk regarding fluctuations in that rate." (48) The release described the Commission's decision in adopting Rule 151 to permit insurers to specify an index to which it would refer, no more often than annually, to determine the excess rate that it would guarantee under the contract "for the next 12-month or longer period." (49)
Comment was sought on "the Commission's expressed concern with shifting the risk of fluctuations in an index rate to a contract owner" and on "the Commission's decision to limit the benefit of Rule 151 to situations where an index is used to fix a specific excess interest rate in advance." (50)
Comment was sought on how various indexing formulas and the duration of any guarantees of "caps, floors, participation rates, margins, or other terms" affect investment risk allocation. (51)
5. Marketing. The release restated the "marketing test" from United Benefit in which the Supreme Court found a contract to be a security when it was "considered to appeal to the purchaser not on the usual insurance basis of stability and security but on the prospect of 'growth' through sound investment management." (52)
The release commented that "[t]he Commission is concerned that the nature of equity index insurance products may make it particularly difficult to market these products without primary emphasis on their investment aspects." (53) The Commission questioned whether, given their "structure and purposes," EIPs can be marketed without such primary emphasis. (54)
To assist in evaluating its concerns, the Commission requested information on how EIPs are marketed and an analysis of how the marketing factor applied to EIPs. Information about "the ability" of an insurer to train and monitor its sales force so as to ensure proper marketing was sought. Commenters were asked to identify distribution channels and discuss whether the use of a particular distribution channel affects the insurer's ability to meet the marketing test. (55)
B. Discussion. In general, the Concept Release -- while raising many questions -- does not (and was not intended to) provide "answers" or otherwise give strong signals regarding the current views of the Commission (or its staff) on the Section 3(a)(8) status of these products.
1. Historic Context. The SEC has issued concept releases relating to insurance products two times in the past twenty years. The most recent concept release was issued in 1990 and sought industry comment on, among other things, the application of Sections 26 and 27 under the Investment Company Act to variable insurance products. (56) That concept release resulted in the Division of Investment Management's 1992 study, "Protecting Investors: A Half Century of Investment Company Regulation," and set in motion a process that culminated in several new and revised rules and the new securities legislation passed last year.
Prior to that, the SEC issued a concept release in 1977 in connection with excess interest contracts, indicating that the purpose of the release was to "indicate areas of concern and request comments with respect to the manner in which [excess interest contracts] are similar to or different from traditional fixed annuity contract exempt from registration by Section 3(a)(8) of the Act." (57)
Similar in tone to the recent Concept Release on EIPs, the 1977 release expressed the SEC staff's concerns regarding the marketing of excess interest contracts: "The staff is concerned that some of these contracts are not being offered and sold as insurance or annuity contracts but rather an investment vehicles designed for the accumulation of tax-deferred funds in a manner and on a basis of representations different from traditional insurance policies and annuity contracts." (58)
The sales of excess interest contracts through broker-dealers led the staff to express its further concern that "the method of distribution of these new contracts indicates that they are regarded in the commercial world as securities offered to the public for investment purposes and are not being sold on the basis of representations similar to those attending the sale of traditional life insurance and annuities." (59)
Release 5838 also discussed the increased investment risk borne by owners of excess interest contracts: "the purchaser of an excess interest contract, as compared to one purchasing a traditional fixed annuity, is not purchasing a fixed benefit, as the amount of excess interest which will be declared is unknown. The contract holder thus bears a risk as to the difference between the low guaranteed rate of interest and the anticipated excess interest." (60)
Release 5838 led to several subsequent rule proposals and ultimately to the adoption of the Rule 151 safe harbor in May 1986 -- almost 9 years after the concept release was issued. (61)
2. Applicability of State Insurance Regulation. The Concept Release asked commenters to describe the provisions of state law that apply to EIPs, specifically "regulation of reserves, investment restrictions, approval of contract forms, illustration requirements, market conduct standards, applicability of state insurance guaranty laws." (62)
This list of state provisions appears to recognize that state insurance regulators are concerned with -- and actively regulating -- disclosure, market conduct and sales practices involved in the distribution of insurance products, and that the states' expertise is not limited to reserves and investment restrictions.
3. Hedging and Reinsurance Techniques for General Account Assets Under Scrutiny. The Concept Release suggested that the Commission is considering the possibility of taking into account, not only the allocation of investment risk as between an insurer and a contract owner, but also the extent to which an insurer retains -- or how an insurer manages -- its investment risk, in examining the securities law status of an indexed product. (63)
An insurer's skill (or lack thereof) in managing its investment risk, through its own investment strategies or through arrangements with third parties, falls squarely within the province of state regulators. While the Concept Release raises the possibility that the method of managing this risk might be relevant, the authority under the federal securities laws is unclear for "looking through" to an insurer's risk management strategies for purposes of evaluating, as part of a Section 3(a)(8) analysis, the allocation of investment risk between the issuer and the owner of a general account product.
4. Does a Minimum Guarantee that Meets Standard Nonforfeiture Law Satisfy the Investment Risk Requirement? The Commission posed the question whether a floor guarantee that meets standard nonforfeiture law, alone, should be sufficient to satisfy the investment risk prong of Rule 151. Since many traditional single premium fixed annuities impose a level of surrender and administrative charges that could lower minimum surrender values to standard nonforfeiture levels, any other position by the Commission could raise a series of tangled issues under state insurance laws governing reserves and other solvency-related regulations, and raise doubts regarding the exemption of many fixed-rate products from Securities Act registration.
5. Retroactive Crediting of Indexed Interest. The Commission requested comment on its concern that indexed products shift to the contract owner the risk of fluctuations in an index rate. The Commission also requests comment on its decision to limit the benefit of Rule 151 to situations where an index is used to fix a specific excess interest rate in advance.
As with a conventional excess interest product, an EIP sets the index-linked interest rate at specified points in time, thus significantly controlling the fluctuation in the index. But unlike an excess interest product which requires the owner to bear the risk that the declared excess-interest rate could be reduced or eliminated at the company's discretion, the indexed interest rate under an EIP must be credited in accordance with the formula set forth in the contract. If an indexed interest rate can never fall below zero, any investment risk caused by a negative fluctuation in the index is eliminated in an EIP. In other words, use of an indexed interest feature will not erode existing value.
And while the owner of an EIP bears the risk that the index will decline resulting in no indexed-linked interest being credited (however, existing values will not be eroded), the owner of an EIP has the assurance not only that minimum nonforfeiture values will be paid, but also that the index formula -- not the company's discretion -- will determine the amount of index-linked interest to be credited. The insurer bears the significant risk that it must pay out the index-linked interest regardless of the overall performance of the investments in its general account.
6. Marketing. The Commission's concerns with EIP marketing raise a number of questions, such as:
- What features of EIP marketing would be considered "investment aspects?"
- Would a marketing plan that explains the contract guarantees and the indexing features with equal prominence (64) satisfy the marketing test if the materials attempt to describe in detail how the index feature is calculated?
- Would materials designed to meet specific state insurance regulations qualify as insurance-oriented marketing?
- If an EIP marketing piece focuses on minimum guarantees and the guaranteed application of the indexing formula over the long-term, is this a sufficient appeal to stability and security?
7. Potential Ramifications for Non-EIP Products. The Commission's questions are fundamental and require careful consideration. Its ultimate position on EIPs could have consequences regarding the proper mix of insurance and securities features "in any insurance product, including an equity index insurance product" (65) that would entitle a product to exemption from registration under Section 3(a)(8) of the Securities Act.
C. Comments Received by the SEC Responding to the Concept Release.. The SEC currently has received 37 responses to the Concept Release. Respondents included the NAIC, 3 states (Florida, Oregon and New York), the National Association of Securities Dealers, Inc. ("NASD"), the Investment Company Institute ("ICI") , the American Academy of Actuaries (the "AAA"), the Committee of Annuity Insurers, the National Association for Indexed Products and 11 insurance companies. See Exhibit 1 for a complete list of the 37 respondents and the Exhibit Index for the list of attached responses.
1. NAIC. The NAIC's letter noted that its regulators have concluded after extensive study that a properly structured equity indexed annuity or life insurance policy is a fixed product and should not be subject to SEC regulation.
According to the NAIC, if an equity indexed product over-emphasizes the investment features in its marketing, or does not provide a minimum guarantee, or in some other way functions as a security, then it may be appropriate to subject that product to SEC regulation.
2. Florida. Florida has concluded that EIPs provide variable benefits or values, but without establishing a separate account. According to Florida, EIPs do not appear to qualify under Rule 151 for the exemption from Section 3(a)(8) of the 1933 Act (a comment that appears to incorrectly equate the boundaries of Rule 151 with the Section 3(a)(8) exemption). Therefore, Florida concludes, it is necessary for the SEC to take a firm stand regarding the securities status of EIPs.
3. Oregon. Oregon's comment primarily addressed the types of EIPs that, in Oregon's view, need the dual regulatory protection of state insurance and federal securities law. Oregon noted that EIPs that delay the index credit for longer than one year transfer too much investment risk to the insureds. Oregon stated its concern that such EIPs were being filed solely as insurance and lacked the additional protections of the federal securities law.
4. New York. New York is concerned that the "vanishing premium" saga not be permitted to recur. If the SEC concludes that dual federal security and state insurance departments is necessary to ensure adequate disclosure to consumers, then New York stated that it would be supportive of such an approach.
5. NASD. The NASD forcefully argued that unregistered fixed account EIPs are securities that fail virtually every test of Rule 151. The NASD argued that EIPs are complicated investments requiring clear, complete disclosure to investors that complies with federal securities laws. The NASD stated that state insurance regulatory scheme provides no substitute for federal securities law requirements regarding registration, prospectus delivery, anti-fraud protection and sale by broker-dealers who are governed by NASD Rules of Contract on suitability and supervision of sales activities.
6. ICI. The ICI argued that all EIPs fall outside the safe harbor of Rule 151 and are not entitled to rely on Section 3(a)(8) because investors, not insurers, assume the primary investment risk under EIP contracts, and because EIP contracts, by their nature, can be fairly marketed only as securities.
Because EIP contract values vary according to the investment experience of a "virtual" separate account (i.e., an external equity index), and because most insurers apply that investment experience to determine retrospectively -- not prospectively, as Rule 151 requires -- the "excess interest" to be credited to the contract, EIP are securities.
Moreover, the ICI argues, because the return from an EIP investment, subject only to minimum guarantees, depends upon the performance of the equity markets, a fair explanation of these products requires insurance agents to discuss, and indeed emphasize, the risks of equity investments.Therefore, the ICI states, purchasers of EIPs need, and entitled to, the protections of the federal securities laws before making informed investment choices between an EIP and a registered variable product or another investment alternative.
The ICI also raises the specter of subjecting general account reserves funding EIPs to "the important investor protections afforded under the Investment Company Act of 1940." The ICI cites the Harris Trust case (66) as precedent for applying "a specialized regulatory scheme to the assets of the insurer's general account."
Finally, the ICI bolsters its arguments in favor of federal securities regulation of general account EIPs by noting the "[i]nability of state insurance regulators to adequately regulate nationwide selling practices of insurers subject to their jurisdiction."
7. Committee of Annuity Insurers. The Committee argued that general account EIAs structured to guarantee minimum nonforfeiture values are important, innovative guaranteed insurance products that should fall within the Section 3(a)(8) exemption. Because EIAs involve substantial investment risk-taking by state-regulated insurers and provide a platform of traditional insurance guarantees, the Committee explained, EIAs satisfy the investment risk standards articulated in judicial precedents and therefore qualify for the insurance exclusion from federal securities regulation. The Committee's response also voiced the concern that the outcome of the SEC's examination of EIAs could have unintended consequences for other unregistered fixed annuity products.
The Committee forcefully argued that EIAs do not "pass through" index or market performance, but rather look to an index only to determined the level of excess interest above nonforfeiture rates and only at specific, discrete points in time in accordance with a formula established in advance and specified in the contract.
The Committee also expressed its view that the methods used by insurers to manage their general account investment risks -- whether hedging or reinsurance -- are matters that have been, and should continue to be, solely regulated by state insurance departments. An insurer's general account asset management techniques are simply not relevant to an examination of the securities law status of a general account product.
With respect to retroactivity, the Committee noted that while retroactivity may result in some investment risk being borne by the contract owner, that risk arguably is not materially different from the risk shifted to owners by the ability of insurers to change discretionary excess interest rates or retroactively forfeit previously credited excess interest under an MVA feature.
Finally the Committee urged the SEC to provide objective guidance to insurers marketing excess interest contract, including EIAs. The goal of such an SEC marketing interpretation would be to assist insurers achieve an accurate, fair and balanced presentation of the material investment and insurance features of any excess interest annuity, include an EIA, while remaining within the bounds of Section 3(a)(8).
8. Valley Forge/CNA. As the offerer of one of the few registered equity indexed products on the market, Valley Forge focused its comments on the potentially unfair stringent advertising restrictions that accompany federal registration of EIAs. Valley Forge asked the SEC to introduce marketing and advertising guidelines for issuers of registered EIPs. Specific suggestions for expanding Rule 134 tombstone advertisements (see below) to inform potential buyer about the key attributes and general availability of the product were made. CNA concluded that issuers of registered EIPs need to be able to rely on more permissive tombstone rules when developing advertisements so that potential investors can be better informed.
D. Next Steps: What Might the SEC Do Next? After studying the responses to the Concept Release, the SEC could take any number of possible actions, including the following:
1. No Further Action. The Commission could take no further action at this time if its questions and concerns are adequately addressed by the responses it receives to the Concept Release.
2. New Safe Harbor Rule. The Commission could, after study, propose a new safe harbor rule specifying conditions under which a particular EIP contract would be entitled to rely on the insurance exemption from registration. (67)
3. Interpretative Release. The Commission could issue an interpretative release providing a general statement of policy regarding the applicability of Rule 151 and/or Section 3(a)(8) to EIPs.
4. Industry No-Action Letter. The Office of Insurance Products of the Division of Investment Management at the SEC ("OIP") could issue an industry-wide no-action letter explaining its position on one or more aspects of EIPs. For example, it could provide guidance on marketing but not comment on investment risk issues. While the staff normally issues no-action letters only in individual situations based on specific facts, the staff has on rare occasion taken a position based upon the general characteristics and categories of a product summarized in the no-action request, not upon any particular fact situation. (68)
5. Individual No-Action Letters. Although requests for no-action relief under Section 3(a)(8) are rarely considered by the staff, (69) the director of OIP had indicated prior to the issuance of the Concept Release that no-action requests submitted in connection with the status of EIPs under Section 3(a)(8) will be taken under consideration by staff.
6. Selective Enforcement. In addition, the Commission could take selective enforcement actions against particular issuers, if it concluded that certain product designs and/or marketing were particularly troublesome.
V. THE REGISTRATION ROUTE
Over the past two years, two insurance companies have filed registration statements on Form S-1 with the Commission for three annuity contracts including equity-indexed allocation options. This section provides an overview of the registration process and costs and benefits associated with registration. It then reviews the three registered EIAs and discusses the Valley Forge no-action letter.
A. Registration Under the Securities Act. Annuity and life insurance contracts that fall outside the scope of Section 3(a)(8) and that are issued through an insurer's general account are generally initially registered under the Securities Act on Form S-1.
1. Form S-1 Requires Detailed Disclosure Regarding the Insurance Company's General Account. Filing a registration statement on
Form S-1 includes disclosure focusing on the terms of the security being offered, and on the issuer of the registered security.
The focus of the disclosure required by Form S-1 is on the insurance company, as the issuer of the EIP contract and the source of contract guarantees. The disclosure requirements of Form S-1 are derived from Regulation S-K, which also governs the disclosure that the company is required to provide in its periodic reports filed under the Securities Exchange Act of 1934, as amended ("1934 Act"). The prospectus for the contract must, in accordance with Form S-1 and Regulation S-K,
include -- among other disclosure -- the following:
a. A discussion of the general development of the insurer's business over the previous five years, and a detailed narrative description of the insurer's business "done and intended to be done." (70)
b. Selected financial data for at least the last five fiscal years of the insurance company, and management's discussion and analysis ("MD&A") of the insurance company's financial condition and results of operations (including liquidity, capital resources, and reported income). MD&A generally must address the three-year period covered by the audited general account financial statements required to be included in the prospectus (and any interim periods required to be presented). (71)
c. Detailed disclosure regarding the directors and executive officers of the insurance company, including their background, involvement in certain legal proceedings, transactions with the insurance company, and compensation. (72)
2. Securities Act Registration Requires the Registration of a Definite Amount of Securities - In Advance. Interests in EIP contracts, like interests in variable contracts and most other investment company securities, are offered on a continuous basis. However, Rule 24f-2 under the 1940 Act is not available to non-investment company registrants (such as issuers of EIP contracts). Accordingly, EIP registrants must (i) file an initial registration statement, and (ii) at that time pay Securities Act registration fees in advance (currently, at the rate of .000295 of the aggregate amount of securities to be offered) for securities to be sold during approximately the first two years of the offering. (73) The amount of securities sold must be tracked with care; and a new registration statement for such securities must be effective (and accompanying fees must have been paid) before the securities previously registered have been exhausted. Rule 429 under the Securities Act facilitates an "overlap" in registration statements (and the use of prospectuses filed in more current registration statements to provide updated annual disclosure to purchasers of EIP contracts under prior registration statements).
3. Securities Act Registration Triggers Reporting under the 1934 Act by the Insurer's General Account. The 1934 Act imposes periodic reporting requirements with respect to issuers of certain securities that are registered under the Securities Act. (See below.) (74)
4. Other Consequences of Registration. Registration under the Securities Act of course involves initial costs (preparation of an initial registration statement, prospectus, and filing fees). Other consequences of registration include:
a. Sales Through Broker-Dealers Only. Registered securities also may only be sold through registered representatives of licensed broker-dealers. (See below.)
b. Required Prospectus Delivery. At or before the time of sale/delivery of the security, the purchaser of a registered EIP must receive a prospectus that meets the requirements of Sections 5 and 10 of the Securities Act. Supplemental sales literature cannot be delivered to the applicant/purchaser unless preceded or accompanied by the prospectus.
c. Annual Update of the Prospectus. The prospectus delivered in connection with the offer and sale of an EIP must be updated at least annually -- just like prospectuses delivered in connection with the offer and sale of variable contracts and other investment company securities. (75)
d. Limitations on Advertising: Rule 134 Tombstone Ads under the Securities Act. Advertisements for registered fixed annuities are severely limited and must conform to the stringent requirements of Rule 134 under the Securities Act. According to Rule 134, an ad can contain only the name and business of the issuer, the name of the security, price, and name of underwriters. It may not contain performance data and current rate information for registered fixed annuities. Securities Act registration does not facilitate an insurer's advertising an EIP's current rate information in a manner similar to that permitted for performance advertising by investment companies under Rule 134(a)(3)(iii) and Rule 482 under the Securities Act. Contracts registered solely on Form S-1 are permitted to advertise current guaranteed annual rates provided those rates are not subject to any charges, such as a contingent deferred sales load or an MVA. (76) Under this precedent, EIPs would generally appear to be limited to advertising minimum guaranteed rates. Greater flexibility is available for materials accompanied or preceded by the product prospectus.
e. Anti-Fraud Liability. Prospectuses and marketing materials for such securities must be prepared and used by sales personnel in a manner that ensures that "material misstatements and omissions" and deceptive communications are not part of the sales process. Section 12 of the Securities Act prohibits offering securities by use of a prospectus that contains material misstatements and omissions. The remedy for a Section 12 violation can be the rescission of the contract (the purchaser can sue to recover what was paid for the EIP, plus interest, less income already paid on the security) or damages. Officers and directors who signed the registration statement are liable under Section 11 of the Securities Act for false or misleading statements and omission in the registration statement.
5. Potential Advantages of EIP Registration. The rigors of developing disclosure materials in the SEC registration process should help to minimize the risk of private litigation based on misleading or inaccurate marketing materials. In addition, if an EIP is registered, it can be marketed with greater flexibility (i.e., as an investment). Also, the fact that securities firms are accustomed to selling securities products suggests that companies offering registered products may have an advantage in signing a sales agreement with such firms over companies offering unregistered products. Finally, actions taken by the NAIC that have increased the reporting obligations of insurers generally have been drawn largely from SEC regulations applicable to public companies. Therefore, the consequences of SEC registration should not be as dramatic as they may have been a few years ago. Examples of NAIC actions include the requirements for audited financial statements and for management's discussion and analysis.
B. EIAs Registered Under the Securities Act. As noted above, three EIAs are currently registered on Form S-1 with the Commission.
1. Keyport Life Insurance Company (File Nos. 333-01783 and 333-13609). Keyport has registered two EIA products on Form S-1 -- one EIA is a group and individual single premium annuity contract with an MVA feature that could invade principal; the second is a group and individual flexible premium annuity without an MVA, but providing an indexing formula with a potentially negative floor. Under this product, negative interest may be deducted from principal under certain circumstances if the index declines or the contract is surrendered.
Each Form S-1 contains a detailed description of the contract (terms, transfers, withdrawals, death benefit, annuity options), the terms and operation of the indexed interest feature, the MVA feature, and tax issues. Extensive information about Keyport, its selected financial data, MD&A, disclosure regarding directors and executive officers, and company financial statements is also included. Appendices to the prospectus provide detailed illustrations of the indexing formula and the MVA feature.
2. Valley Forge Life Insurance Company (File No. 333-02093). Valley Forge has registered its EIA on Form S-1 and styled the product as an individual and group single premium deferred modified guaranteed annuity with an MVA feature that could invade principal. The product is an annual reset design with participation rates and caps guaranteed for the length of the term; owners can choose from among several guarantee periods, each exceeding one year. Two averaging methods are available -- a daily annual average with no cap and a point-to-last-90-day average with a cap. Free withdrawals of up to 10% are available starting year two, subject to an MVA which may be positive or negative. Surrender charges vary by guarantee period and remain level.
The Form S-1 contains detailed information regarding the contract, the separate account, the interest options available under the contract, including equity index options, and the company. Appendices to the prospectus demonstrate the operation of the MVA, provide hypothetical illustrations of the calculation of indexed interest assuming varying performance of the index, and provide graphs of index performance.
C. 1940 Act Status of "Insulated" Separate Accounts Supporting EIPs. In January 1997, Valley Forge Life Insurance Company (a CNA affiliate) obtained a no-action letter regarding its "insulated" "non-unitized" separate account established in connection with SEC-registered EIA options with an MVA. The Commission staff agreed not to recommend enforcement action if the contract provided for legal insulation of the separate account supporting the EIA options without registering the separate account under the 1940 Act, provided certain conditions were met.
The Valley Forge letter was modeled after the no-action letter obtained by The Equitable (77) in which the staff stated that it would not recommend enforcement action if Equitable's MVA contract provided for legal insulation of the separate accounts supporting Equitable's liabilities under the contracts, without registering the separate accounts under the 1940 Act.
As with Equitable, Valley Forge acknowledged that it was obligated under state law to maintain separate account assets with a market value at least equal to reserves and other contract liabilities, and immediately to transfer to the separate account sufficient assets to remedy any shortfall. Valley Forge and Equitable both represented that the value of the assets in the separate account would at all times at least equal the amount of the account's reserves and other contract liabilities.
D. Securities Exchange Act of 1934.
1. Sales through a Registered Broker-Dealer. Registered securities (and securities exempt from registration under a "private placement" analysis) must be sold through registered representatives of an SEC-registered broker-dealer that is a member firm of the NASD.
a. Broker-dealers are subject to substantive regulation by the Commission (with a particular emphasis on financial oversight and reporting) and the NASD (with a particular emphasis on supervisory procedures, fair dealing and sales practices).
b. Individuals selling securities must be NASD-licensed (Series 6 or 24 for sales of mutual funds, variable contracts, and other registered insurance or annuity contracts) through their broker-dealer firm.
2. Anti-Fraud Rules. Purchases and sales of registered securities (and securities exempt from Securities Act registration under a "private placement" exemption) are subject to the anti-fraud rules of the 1934 Act -- specifically Rule 10b-5.
3. Periodic Reporting. Insurers issuing securities registered under the Securities Act on Form S-1 become subject to the periodic reporting requirements under the 1934 Act, and therefore must file annual reports on Form 10-K, quarterly reports on Form 10-Q and, when necessary, current reports on Form 8-K.
As the Concept Release and the Valley Forge no-action letter demonstrate, the Commission has focused its attention on EIPs and has raised fundamental questions regarding the status of EIPs under the Securities Act. The Commission's evolving position on the "proper mix" of insurance and securities features with regard to EIPs could well have significant consequences for EIPs and for the broader universe of insurance products.
1. Equity Index Insurance Products, Securities Act Release No. 7438, 62 Fed. Reg. 45,359 (Aug. 27, 1997) (the "Concept Release"). Throughout this outline, Concept Release page number references are to the Concept Release as issued by the SEC.
3. See, e.g., Linda Koco, "Index Product Design, Sales Still Surging," National Underwriter, Sept. 1, 1997, at 49.
4. See, e.g., Jack Marrion, "EIA Status Report: They Number Over 50," National Underwriter, July 21, 1997, at 13.
5. See Deanne L. Osgood, "Equity Indexed Annuity: State of the Market Address," Printed Remarks at Institute for International Research, Conference on Fixed Annuities '97 (Workshop on Equity Index Annuities), Sept. 17, 1997.
6. See, e.g., James B. Smith, Jr., "Survey Shows Strong Interest in Offering EIAs," National Underwriter, Jan. 20, 1997, at 14; Jim Connolly, "Cos. Give Agents Extra Support With EIAs," National Underwriter, Sept. 1, 1997, at 23.
7. The Commission noted the appeal of EIPs to consumers of traditional insurance products: "Equity index annuities are designed to appeal to risk averse consumers who desire to participate in market increases, without sacrificing the guarantees of principal and minimum return offered in traditional fixed annuities." Concept Release at 3.
8. EIAs also contractually guarantee annuity purchase rates and annuity settlement options that usually include life contingencies. The SEC has noted the importance of such guarantees: "The guarantee of a fixed level of income, continuing for a lifetime, which cannot be changed or revoked, is perhaps the most important feature of annuities as they were known at the time the [Securities] Act was passed." Proposed Rule Interpreting Exemptive Provisions, Securities Act Release No. 5933, [1977-1978 Transfer Binder] Fed. Sec. L. Rep. (CCH)
81,598 (May 17, 1978) at 80,398 ("Release 5933").
9. See Registration Statement on Form N-4 for Providian Life and Health Insurance Company Separate Account V (File No. 33-45862).
10. Justice Brennan noted in his concurrence in S.E.C. v. VALIC, 359 U.S. 65 (1959): "The point [is] that there then [in 1933 and 1940] was a form of 'investment' known as insurance (including 'annuity contracts') which did not present very squarely the sort of problems that the Securities Act and the Investment Company Act were devised to deal with, and which were, in many details, subject to a form of state regulation of a sort which made the federal regulation even less relevant." 359 U.S. at 75.
11. Request for Comments on Reform of the Regulation of Investment Companies, Securities Act Release No. 6868, [1990 Transfer Binder] Fed. Sec. L. Rep. (CCH)
84,607 at 80,897 (June 15, 1990) ("Release 6868") (emphasis added).
12. H.R. Rep. No. 85, 73d Cong., 1st Sess. 15 (1933).
13. S.E.C. v. Variable Annuity Life Insurance Co. of America, 359 U.S. 65 (1959) ("VALIC").
14. 359 U.S. at 71.
16. S.E.C. v. United Benefit Life Insurance Company, 387 U.S. 202, 209 n.12 (1967) ("United Benefit") ("The record shows that United set its guarantee by analyzing the performance of common stocks during the first half of the 20th century and adjusting the guarantee so that it would not have become operable under any prior conditions.") In addition, the Court noted that the United Benefit contract required special modifications in state law. Id. at 211.
17. Definition of Annuity Contract or Optional Annuity Contract, Securities Act Release No. 6645, [1986-87 Transfer Binder] Fed. Sec. L. Rep. (CCH)
84,004 (May 29, 1986) at 88,128 ("Release 6645") (emphasis added).
18. VALIC, 359 U.S. at 71.
19. United Benefit, 387 U.S. at 208 (1967).
20. In adopting Rule 151, the Commission stated: "Rule 151 is merely a 'safe harbor,' not an all-inclusive definition purporting to encompass every annuity contract that falls within the section 3(a)(8) exclusion. The rule, therefore, does not attempt to identify the outer limits of section 3(a)(8) beyond which a contract, though denominated 'insurance,' is a security subject to federal regulation. Rather, the rule simply defines a class of annuities that the Commission believes is clearly entitled to rely on the section. While compliance with rule 151 will assure 'non-security status,' failure to comply with the rule would not mandate 'security status' for an annuity product. Finally, as stated in the proposing release, an insurer offering a contract that, for one reason or another, does not satisfy all of the rule's conditions may still rely directly on section 3(a)(8), albeit with no Commission assurance that the contract is covered by the section 3(a)(8) exclusion. The Commission has revised the caption of the rule to better emphasize that it is just a 'safe harbor.'" Release 6645 at 88,129 (emphasis added).
21. Release 6645 at 88,129.
22. Id. at 88,138.
23. Seeid. at text accompanying note 19.
24. As the Commission noted in proposing Rule 151, "[u]nder a traditional annuity contract, the insurer assumes the investment risk because it guarantees for the life of the contract (1) the principal amount of purchase payments made and interest credited thereto and (2) to pay a specified rate of interest." Securities Act Release No. 6558, [1984-85 Transfer Binder] Fed. Sec. L. Rep. (CCH)
83,710 at 87,159 n. 3 (Nov. 21, 1984) ("Release 6558") (proposing Rule 151)(emphasis added).
25. Release 6645 at 88,136 (emphasis added; footnotes omitted). The Commission also expressed its concern that contracts crediting indexed excess interest that adjust the rate of return actually credited more frequently than annually operate less like a traditional annuity and more like a security in that they shift to the contract owner "all of the investment risk regarding fluctuations in the indexed rate." Id.
26. Id. at 88,137 (citations omitted).
27. Release 6645 at 88,137 (citation omitted).
30. See generally Kimberly J. Smith, "Indexed UL: To Register or Not to Register?," National Underwriter, May 19, 1997, at 15 (discussing features of equity indexed life products from a Section 3(a)(8) perspective).
31. Concept Release at 1.
32. Id. at 4. Of course, courts have noted the difficulty in drawing the line between a traditional annuity and an investment contract. Justice Brennan, for instance, noted in his concurrence in VALIC, "[s]ome urge that even the traditional annuity has few 'insurance' features and is basically a form of investment.'" 359 U.S. at 81 (citations omitted). It was the traditional annuity that is the "sort of investment form that Congress was . . . willing to leave exclusively to the State Insurance Commissioners," id. at 76, primarily because "the investor in an annuity or life insurance contract [did] not become a direct sharer in the company's investment experience . . ." Id. at 78 (emphasis in original).
33. Concept Release at 4-5 (emphasis added; citations omitted).
34. Id. at 6-9.
35. Id. at 11.
37. Id. at 12.
40. Id. at 14.
42. Seeid. at 14-15.
43. Id. at 15.
45. Id. at 15.
48. Id. at 17.
50. Id. at 17-18.
51. Id. at 18.
52. Id. (citing 387 U.S. at 211.)
56. Release 6868 at 80,894-97.
57. Request for Submission of Views with Respect to the Offer and Sale of Certain Contractual Arrangements Issued by Life Insurance Companies, Securities Act Release No. 5838, [1977-78 Transfer Binder] Fed. Sec. L. Rep. (CCH)
81,217 (June 22, 1977) at 88,251 ("Release 5838").
58. Id. at 88,253.
60. Id. at 88,254.
61. See Release 5838 (concept release); Release 5933 (proposing Rule 154); Annuity Contracts and Optional Annuity Contracts; Withdrawal of Proposed Rule, Securities Act Release No. 6050, [1979 Transfer Binder] Fed. Sec. L. Rep. (CCH)
82,047 at 81,673 (Apr. 5, 1979) (withdrawing Rule 154); General Statement of Policy Regarding Exemptive Provisions Relating to Annuity and Insurance Contracts, Securities Act Release No. 6051, 1 Fed. Sec. L. Rep. (CCH)
2111 (Apr. 5, 1979) ("Release 6051"); Release 6558 (proposing Rule 151); Release 6645 (adopting Rule 151).
62. Concept Release at 12.
64. Equal prominence in this context would not necessarily mean equal space, given the unique and novel nature of the indexing formula which would require additional, supplemental explanation.
65. Concept Release at 4 (emphasis added).
66. John Hancock Mutual Life Insurance Co. V. Harris Trust & Savings Bank, 350 U.S. 86 (1993).
67. As the Commission noted when proposing Rule 151, a safe harbor rule "is not intended to define the features of all guaranteed investment contracts that presently, or in the future, may be entitled to rely on section 3(a)(8)." Release 6558 at 87,159.
68. See, e.g., American Council of Life Insurance, SEC No-Action Letter, [1977-1978 Transfer Binder] Fed. Sec. L. Rep. (CCH)
81,103 at 87,814 (Mar. 18, 1977) (life insurance companies may offer and sell guaranteed investment contracts to tax-qualified corporate pension and profit-sharing plans without compliance with the registration requirements of the Securities Act).
69. The Commission has explicitly instructed its staff to refuse to consider such requests, except "in the most compelling circumstances." Release 6558 at 87,163.
70. See Item 101(a) and 101(c) of Regulation S-K.
71. See Item 301 and Item 303(a) and (b) of Regulation S-K; with respect to the financial statements required to be included in Form S-1, see Item 11(e) of Form S-1, and generally, Articles 3, 10, and 11 of Regulation S-X. Regulation S-X requires that auditors' reports on financial statements indicate whether the financial statements have been prepared in accordance with generally accepted accounting principles. See Rule 2-02(b) of Regulation S-X. Financial statements filed for mutual life insurance companies and wholly-owned stock insurance company subsidiaries of mutual life insurance companies may be prepared in accordance with statutory accounting requirements. See Rule 7-02(b) of Regulation S-X. However, for fiscal years beginning after December 15, 1995, financial statements prepared in accordance with statutory accounting principles may not be described as prepared in conformity with generally accepted accounting principles. See FASB Interpretation No. 40 (Apr. 1993) and Statement of Financial Accounting Standards No. 120 (Jan. 1995).
72. See Items 401 and 402 of Regulation S-K.
73. See Rule 415(a)(2) under the Securities Act.
74. See generally Section 12, Section 13, and Section 15(d) of the 1934 Act.
75. See Section 10(a)(3) of the Securities Act.
76. SeeHartford Life Companies, SEC No-Action Letter (July 1, 1988).
77. SeeThe Equitable Life Assurance Soc'y of the U.S., SEC No-Action Letter (Dec. 22, 1995).