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'Mixed and Shared Funding' by Mutual Funds Supporting Variable Insurance Product Separate Accounts

January 1, 1998

Reprinted with permission. Published in
The Investment Lawyer, Vol. 5, No. 1 January 1998
©1996 Aspen Law & Business, A Division of Aspen Publishers, Inc. (www.aspenpub.com).

In recent years, variable annuity contracts have become among the hottest selling investment products being offered by brokers, financial planners and insurance agents. In their wake, variable life insurance contracts have also experienced significant sales growth. Variable annuity contracts (VA contracts) and, to a lesser degree, variable life insurance contracts (VLI contracts) have become popular as asset accumulation vehicles because of their insurance features which generally include: tax-free earnings on invested contract values, death benefits upon the death of the owner or other insured person, and various life contingent annuity payout options. Assets are accumulated under VA contracts and VLI contracts (together, variable contracts) by indirectly investing the contract's cash value or contract value in mutual funds. Therefore the contract value of variable contracts fluctuates with the performance of the mutual fund(s) in which such contract value is invested (an underlying fund or insurance fund).(1)

Years ago, most insurance funds were created and managed by life insurance companies that offered variable contracts. In almost all cases, these funds were only available as investment options under contracts issued by the insurance company that managed the fund. During the mid-1980s, however, mutual fund organizations began creating insurance funds for use as investment options under variable contracts issued by different insurance companies. Often these insurance funds were replicas or "clones" of popular mutual funds offered in the retail marketplace by the same organization. Unfortunately, for tax reasons (discussed below), contract values of most variable contracts can not be invested in mutual funds offered to the general public. This article provides highlights of several important issues arising under the Investment Company Act of 1940 (1940 Act) for insurance funds that offer shares to separate accounts of unaffiliated insurance companies as well as related contractual arrangements between these funds and insurance companies.

Variable Contracts and Life Insurance Company Separate Accounts

Life Insurance Company Separate Accounts

Life insurance companies issue variable contracts through entities called separate accounts. Separate accounts are not separate companies or legal entities, but rather are segregated asset accounts where both the assets and liabilities of certain specified contracts are insulated from the insurer's other business.(2) When an insurance company issues a variable contract, the contract value is placed in a separate account and the company's obligations under the contract (e.g., the obligation to pay a death benefit in certain circumstances) must be paid from the account's assets.(3) Separate accounts supporting VA contracts (VA accounts) and VLI contracts (VLI accounts) are investment companies and are usually registered as such under the 1940 Act.(4)

Most VA accounts and VLI accounts invest in shares of underlying funds, and if registered as investment companies, are registered as unit investment trusts. Typically, such separate accounts are divided into several subaccounts, each of which holds shares of a specific underlying fund. Variable contracts also typically permit the owner to transfer contract value between and among a number of subaccounts thereby making available indirectly a number of insurance funds as investment options under the contract. VA and VLI accounts also may hold portfolio securities directly, but such accounts are only rarely used for registered variable contracts.(5)

Mixed Funding, Shared Funding, and Extended Mixed Funding

Although most VA accounts and VLI accounts cannot hold shares of mutual funds that are available to the general public, they can hold shares of insurance funds if such funds only support various types of VA accounts, VLI accounts, and qualified pension and retirement plans (qualified plans). In other words, insurance funds can offer shares to various types of VA accounts, VLI accounts, and qualified plans without endangering the tax status of such accounts or plans or of the variable contracts issued through such accounts.

The use of a common underlying fund as an investment medium for both VLI accounts and VA accounts of the same insurance company, or of two insurance companies that are affiliated persons of each other, is generally known as "mixed funding." The use of a common underlying fund as an investment medium for VLI accounts and/or VA accounts of two or more unaffiliated insurance companies is generally known as "shared funding." The use of a common underlying fund as an investment medium for VLI accounts, VA accounts, and qualified plans is often known as "extended mixed funding" or "enhanced mixed funding."

Federal Tax Law Restrictions Applicable to Separate Accounts And Insurance Funds

The Internal Revenue Code of 1986 (Code) provides for the tax-free "inside build-up" of life insurance and annuity contracts to facilitate bona fide insurance arrangements. Both Congress and the Internal Revenue Service have for tax policy reasons limited the circumstances in which non-qualified variable contracts (i.e., variable contracts not issued in connection with retirement plans receiving favorable federal income tax treatment) are entitled to the inside build-up tax benefit. In particular, the use of insurance contracts to wrap" otherwise taxable investments has been curbed by two significant limitations: Code section 817(h), enacted by Congress in 1984, and the "investor control" rulings issued by the IRS.

Section 817(h) imposes certain diversification standards on the assets held by insurance companies to support variable contracts. It provides that variable contracts will not be treated as annuity contracts or life insurance contracts for any period (or any subsequent period) for which the assets supporting them are not adequately diversified. Because underlying funds indirectly support variable contracts, Treasury Department regulations set forth specific diversification requirements for such funds.(6) The regulations generally provide that, in order to meet the diversification requirements, all shares of the underlying fund must be held by separate accounts of insurance companies. Notwithstanding this, the regulations contain several exceptions that permit trustees of qualified pension and retirement plans, insurance company general accounts, and investment managers to hold underlying fund shares without adversely affecting the "adequately diversified" status of the fund.(7) The diversification requirements of Section 817(h), in effect, limit most VA accounts and VLI accounts to holding shares of insurance funds and not shares of mutual funds that are available to the general public.

The IRS originally addressed the ownership of assets supporting variable contracts during the late 1970s and early 1980s in a series of ruling issued in response to the spread of so-called "wrap-around" annuities (i.e., deferred VA contracts used to confer tax deferral or an otherwise currently taxable portfolio of investments or mutual fund shares).(8) In these rulings, the IRS took the position that where the owner of a variable contract retains the right to control the investment of the assets in a VA account or a VLI account, the contract owner, not the insurance company, should be treated as the owner of the assets for federal income tax purposes, and is therefore subject to federal income taxation on income attributable to those assets. In other words, in the IRS's view, the owner of a variable contract cannot exercise control over the investment of underlying assets without losing the tax advantage that annuity and life insurance contracts usually offer. This doctrine is generally referred to as "investor control". The IRS's position with regard to investor control is not based on any specific provision of the Code, but rather on general principles of tax law that have been articulated by the courts. There is one court decision that specifically supports this IRS position. (Christoffersen v. United States, 749 F.2d 513 (8th Cir. 1984.)

The most far-reaching of these rulings concerned situations where assets supporting a VA contract consisted of shares of a single publicly available mutual fund (public fund), or situations where the contract owner had the right to allocated the VA account assets among five subaccounts holding shares of different publicly available mutual funds.(9) The IRS concluded that, in these situations, the purchase of the VA contract was substantially, identical to the direct purchase by the contract owner of the mutual fund shares, and the contract owner should therefore be treated as the owner of the mutual fund shares for federal income tax purposes and should be subject to current income tax on the earnings of the assets. On the other hand, where shares of a mutual fund where not sold directly to the general public but were available only through the purchase of a VA contract, the IRS concluded that the insurance company, not the contract owner, was the owner of the mutual fund shares for federal income tax purposes. As a result, VA and VLI accounts only invest in insurance funds and insurance funds only sell shares to their investments manager, VA accounts, VLI accounts, general accounts of insurance companies, and qualified plans.

SEC Restrictions on VLI Accounts

VA accounts and VLI accounts that are registered as investment companies are each governed by several rules under the 1940 Act. For the most part, these rules provide exemptions from the 1940 Act or rules thereunder that are either necessary or useful for the operation of VA or VLI accounts or for the sale or administration of VA contracts or VLI contracts.(10) As described in more detail below, VLI contracts and VLI accounts are governed by either Rule 6e-2 or 6e-3(T).(11) With regard to VLI accounts registered as unit investment trusts, both rules limit important exemptions to VLI accounts that only hold shares of certain types of underlying funds.(12)

Rules 6e-2(b)(15) permits VLI accounts offering scheduled premium VLI contracts to only hold shares of an insurance fund that offers its shares exclusively to VLI accounts of one or more affiliated insurance companies, and then, only where scheduled premium VLI contracts are issued through such VLI accounts. Therefore, Rule 6e-2 does not permit a scheduled premium VLI account to invest in shares of an underlying fund that serves as an investment vehicle for mixed funding, extended mixed funding or shared funding.(13)

Rules 6e-3(T)(b)(15) permits VLI accounts offering flexible premium VLI contracts to only hold shares of an insurance fund that offers its shares exclusively to VLI accounts (through which either scheduled premium or flexible premium VLI contracts are issued), VA accounts or the general accounts of one or more affiliated insurance companies.(14) Therefore, Rule 6e-3(T) does not permit a flexible premium VLI account to invest in shares of an underlying fund that serves as an investment vehicle for extended mixed funding or shared funding.

The origin of these exclusivity restrictions is somewhat obscure, but generally they evolved from the Securities and Exchange Commission's (SEC) concern about possible conflicts between the interests of owners of VLI contracts indirectly invested in an insurance fund and other investors in such a fund. For example, when Rule 6e-(2) was first adopted in 1976, no tax laws constraints existed to prevent VLI accounts from holding shares of public funds. The SEC appears to have had some concern that owners of VLI contracts indirectly invested in a public fund would have different investment motivations than members of the general public invested in a public fund. For example, the federal tax treatment of income and capital gains distributions from a fund would have been different for VLI contract owners than it would have been for most other shareholders. Similarly, potential conflicts are even possible today between the interests of VLI contract owners and other investors in insurance funds (as permitted by tax law) such as owners of VA contracts. For example, the diversification regulations under Section 817(h) are somewhat different for VLI accounts and VA accounts and this could conceivably cause owners of VLI contracts to desire a different investment strategy for an insurance fund than is desired by owners of VA contracts.

Exemptions from the SECExclusivity Restrictions

Fortunately for the mutual fund and insurance industries, serious conflicts have not arisen between the interests of VLI contract owners and other investors in insurance-funds.(15) For this and other reasons, the SEC has granted exemptions from the exclusivity provisions of Rules 6e-2 and 6e-3(T) to the extent necessary to permit mixed funding, shared funding and extended mixed funding. The exemptions are subject to a number of significant conditions designed to ensure that potential material conflicts between the interests of VLI contract owners and other investors are identified and resolved in a manner that does not disadvantage any class of investors.(16) For example, the trustees of an insurance fund must monitor the fund's operations for the appearance of any material conflicts of interest among or between the interests of owners of VA contracts, owners of VLI contracts and qualified plan participants and determine what action, if any, should be taken in response to such conflicts. Similarly, the fund's investment adviser, insurance companies with VA or VLI accounts holding fund shares and trustees (or other fiduciaries) of qualified plans, must each monitor their own operations and those of the fund for the purpose of identifying such conflicts and must report any such conflict (or the potential for such a conflict) to the fund's board. The insurance companies must accept responsibility for taking whatever action is necessary to remedy such a conflict as it adversely affects owners of its variable contracts in an insurance fund and qualified plan fiduciaries must accept responsibility for doing the same for participants in their plans. Often, different conditions apply to the insurance fund, its investment adviser, insurance companies with VLI accounts holding fund shares and qualified plans holding fund shares.

Although it is the VLI accounts and their insurance company sponsors and principal underwriters that must rely on the exemptions, most exemptions to permit mixed funding, shared funding and extended mixed funding are obtained on a class basis by mutual fund complexes. The class is typically defined as all VLI accounts and their insurance company sponsors and principal underwriters that may in the future invest in shares of any existing or future insurance fund in the complex.(17) In order to tie as yet unknown or unidentified VLI accounts and their affiliates to the rest of the conditions recited in the application, applications of this type contain the additional condition that each insurance company having a VLI account that holds shares of an insurance fund and certain qualified plans that hold such shares must enter into a participation agreement with the fund before purchasing such shares. The participation agreement must bind the insurance company or qualified plan to all of the other conditions recited in the application.

To the extent that such conditions apply to participating insurance companies or qualified plans rather than the applicants themselves, it is unclear what consequences would follow from one or more conditions not being met as to a particular insurer or plan. For example, could the exemptions be denied to some or all VLI accounts (and their depositors and principal underwriters) invested in an underlying fund if an unaffiliated insurer or plan invested in the same fund failed to comply with the conditions or the terms of its participation agreement? Some observers, including, informally, the SEC staff, have suggested that the applicants might have a duty to enforce the provisions of each participation agreement.

Participation Agreements

Participation agreements between insurance funds and insurance companies began in the mid- 1980s simply as vehicles to obligate the insurance company to comply with the conditions of a class exemption for mixed funding and shared funding. Over the years, however, participation agreements have evolved to encompass a wide variety of issues arising between insurance funds (and their affiliates) and insurance companies (and, with the advent of extended mixed funding in 1989, between insurance funds and qualified plans) in the purchase and redemption of fund shares. In large part, this is because the relationships between insurance funds and separate accounts (and, to a lesser extent, qualified plans) are really joint ventures to distribute variable contracts and gather insurance fund assets.

Typically, participation agreements include provisions covering the following: (1) the availability of insurance fund shares to an insurance company or qualified plan; (2) representations and warranties by each party; (3) regulatory compliance obligations of each party; (4) sale and administration of variable contracts; (5) allocation of expenses between the parties; (6) mechanisms for identifying, resolving and reporting conflicts of interest among or between investors in the fund; (7) indemnifications; (8) the ongoing relationship between the parties; and (9) termination of the agreement.

Several of these items are often the subject of a considerable amount of bargaining. For example, the provisions governing the availability of insurance fund shares typically articulate the basis upon which shares may be purchased or redeemed, including the mechanics of purchases and redemptions, computation of net asset values for the fund and a VA account, VLI account or qualified plan, resolution of pricing errors, dividend distributions and reinvestment, and limitations on other investors in the fund. Provisions regarding compliance with regulatory requirements also are often complex and include such matters as compliance with tax diversification requirements and other portfolio restrictions, compliance with the conditions of exemptive orders, voting of insurance fund shares, prior review by each party of the other's registration statements and sales literature, handling of investor complaints and litigation, and cooperation in connection with examinations and other activities of regulators. In short, participation agreements (and ancillary agreements referenced by participation agreements) these days define the entire joint venture relationship between an insurance fund and its affiliates and insurance companies and qualified plans that purchase the funds's shares.

Conclusion

At a time when variable contracts and qualified plans have become one of the primary growth sources of mutual fund assets, most fund organizations have established insurance funds and entered into joint ventures with the purveyors of these asset accumulation vehicles in order to expand or maintain their position in the marketplace. It appears likely that this trend will continue for the foreseeable future. In light of the overlapping federal securities, federal tax and state insurance laws and regulations governing insurance funds, variable contracts and qualified plans, we can expect such joint ventures to continue to generate new and challenging legal issues.

NOTES

1. For this reason, variable contracts are securities and, except where an exemption is available, are registered under the Securities Act of 1933 (Securities Act).

2. Separate accounts are established pursuant to state insurance laws. For a detailed discussion of the legal aspects of variable contracts separate accounts See, Roth, Krawczyk and Goldstein, Reorganizing Insurance Company Separate Accounts Under Federal Securities Laws, 46 The Business Lawyer 537 (1991).

3. Although several different VA contracts may be issued through a single VA account and several different VLI contracts may be issued through a single VLI account, VA contracts and VLI contracts may not be issued through the same separate account.

4. VA accounts and VLI accounts are sometimes not registered as investment companies in reliance upon the exclusions from the definition of an investment company in Sections 3(c)(1), 3(c)(7) or 3(c)(11) of the 1940 Act. Likewise, interests in such unregistered separate accounts issued in the form of variable annuity contracts or variable life insurance contracts are usually offered and sold in reliance upon the exemption from the registration requirements of the Securities Act contained in Section 3(a)(2) or 4(2) of that Act.

5. Such separate accounts are registered as open-end management investment companies under the 1940 Act.

6. Treas. Reg. 1.817-5.

7. Treas. Reg. 1.817-5(f)(3)(iii). The phrase "trustee of a qualified pension or retirement plan" has been interpreted by the IRS to include plans or arrangements established under the following Code sections: an annuity plan described in Section 403(a), an annuity contract described in Section 403(b) (including a custody account described in Section 403(b)(7)), an individual retirement account described in Section 408(a), an individual retirement account described in Section 408(b), a simplified employee pension described in Section 408(k), and a plan described in Section 501(c)(18). Rev. Rul. 94-62.

8. See Rev. Rul. 77-85, 1977-I, C.B. 12; Rev. Rul 80-274, 1980-2 C.B. 27; Rev. Rul. 81-225, 1981-2 C.B. 13.

9. Rev. Rul. 81-225.

10. Technically, the exemptions apply to the VA account or VLI account as well as to the insurance company that sponsors it and the principal underwriter of the variable contracts issued through it.

11. Rule 6e-2 governs scheduled premium VLI contracts and VLI accounts through which such contracts are issued while Rule 6e-3(T) governs flexible premium VLI contracts and VLI accounts through which such contracts are issued.

12. See subparagraph (b)(15) of both Rule 6e-2 and Rule 6e-3(T) which provide exemptions from Sections 9(a), 13(a), 15(a) and 15(b) of the Act.

13. Rule 6e-2 also does not permit a scheduled premium VLI account to invest in shares of an underlying fund that sells seed money shares to the general account of an insurance company.

14. The exemptions provided by Rule 6e-3(T)(b)(15) also would generally be available if a non-insurance company affiliate of an insurance fund (such as an investment adviser) holds "seed money" shares of the fund, provided that such person is an affiliated person of one or more of the affiliated insurance companies. See Metropolitan Tower Life Insurance Company et. al. (June 13, 1983).

15. As with all mutual funds, insurance funds sometimes entail small inequities among or between different classes of shareholders. For example, insurance funds do not have to pay Rule 24(f)-2 fees in connection with shares sold to registered VA accounts and VLI accounts, but they do not have to pay such fees in connection with shares sold to their investment adviser(s) or insurance company general accounts or to unregistered separate accounts. Owners of variable contracts issued through registered accounts therefore bear an expense that they would not have to bear if the fund did not sell shares to other types of investors. Obviously, however, the additional assets from such other investors more than makes up for the additional expense in most cases.

16. See eg. Goldman, Sachs & Co. et. al. Inv. Co. Act. Rel. No. 22995 (Jan. 8, 1998) (notice) File No. 812-10794.

17. Id.

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