Equity-indexed life and annuity products ("EIPs") represent a form of insurance contract with both guaranteed and equity-linked features; EIPs typically provide a measure of "participation" in equity returns, but also include some form of interest and/or principal guarantees. The location of a particular EIP on the insurance/securities "spectrum" will depend upon its specific features. It may be viewed as a "fixed" product that provides a controlled element of variable return, or as "variable" product that provides substantial guaranteed elements. Viewed from either perspective, these products raise interesting securities regulatory issues.
I. Federal Securities Law: The Exempt Route
A. Overview of the Product Concept
1. Equity Participation. EIPs generally provide an account and/or cash value that depends to some degree on equity returns of a specified index (for example, the return of the Standard & Poor's 500 Index, or "S&P 500"). An EIP can be distinguished from a traditional variable annuity or variable life insurance product; an EIP "controls" a contract owner's equity participation to some extent by providing account and/or cash value guarantees, and by applying an indexing formula that does not provide a direct "pass through" of index "performance."
2. Guarantees. EIPs may guarantee principal or principal plus some minimum level of credited interest upon surrender. Credited interest in excess of the minimum rate typically reflects the indexing inherent in the contract. State nonforfeiture laws for individual life insurance products raise an interesting and difficult set of issues for EIPs.
3. General vs. Separate Account. Most EIPs have, to date, been written primarily through the general account of the issuing insurer, although interest in 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 below at II.B.2.e. for a discussion of the no-action letter.
4. "Categories" of Indexing Formulae. EIP indexing formulae fall into a number of categories, including (but not limited to) the following:
a. Look-Back or "High Water Mark". Under a look-back formula, indexed excess interest is determined by "looking back" over the course of a period to one or more "high water" index levels. Example: The indexed excess 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 use some averaging technique.
b. 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 use some averaging technique.
c. 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.
d. 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.
e. 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 level at specified 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 an index to EIP values (and do not take into account reinvested dividends in determining the value of the index). 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.
5. Indexing Feature Components. 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-type products.
a. Indexing Formulae Build in a "Participation Rate," and Are Generally Subject to "Caps" and Floors". EIPs typically have "terms" (of at least one year in length) during which certain components of the indexing formula are guaranteed not to change. Among these components is a "participation rate" -- a percentage applied to the comparison of values described above. For example, if under an annually-measured ratchet formula, the increase in the index from the beginning of the year to the end of the year is 100, a participation rate of 75% would result in an index increase of 75 (before taking into account any other applicable components of the indexing formula). Also among these components are a "cap" and a "floor" -- upside and downside limits, respectively, on the indexed interest rate credited.
b. Indexed Excess Interest May Be Subject to a "Spread". Some excess index-interest formulae provide for the deduction of a basis-point "spread" after the percentage increase in the index has been calculated. 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 200 basis points, then the index excess interest rate would be 8% for that year.
c. 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 participation rates, vesting percentages are fixed in advance and do not vary with an variation in the index.
d. EIPs Provide for Different Frequencies and Durations of Indexed Interest Crediting. As noted above, some EIP designs provide for the 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. The annual crediting of excess interest arguably shifts less risk to an EIP owner. Some EIPs provide for only one excess interest credit. For example, an EIP may have only one indexed "term"; following the end of the indexed term, the EIP provides 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 certain "interim" dates, such as contract surrender, annuitization, or payment of a death benefit.
e. 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 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 tend to be short term, such as over a period of one to six months.
6. Additional Bells and Whistles Begin to Appear. In addition to developing a variety of indexing formulae, insurers have also begun building additional "bells and whistles" into EIP products.
a. Facilitating Multiple Premium Payments. The initial "wave" of EIP designs provided for the payment of a single premium. Insurers have evidenced increasing interest in developing products that provide for the payment of multiple premiums. Application of indexing formulae under flexible premium EIPs, under which each premium may be subject to a different term length, participation rate, cap, and floor, may present contract drafting and administrative systems challenges.
b. Adding EIP Options to "Combination" Contracts. Insurers have also begun exploring the addition of EIP "options" under contracts that provide for other premium allocation options -- such as variable annuities, MVA contracts, and other fixed annuity contracts. Depending upon the type of options with which an EIP option is "paired," marketing issues may be raised.
c. Designing EIPs that Permit Selection from Multiple Indices. An EIP design could permit the EIP owner to select the index to be referred to in calculating indexed excess interest from among a number of available indexes set forth in the contract. Providing for this type of index selection may also raise marketing issues.
B. Determining the Status of an EIP Under Section 3(a)(8) of the 1933 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 its indexing feature and interest crediting mechanics, as well as 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 SEC, to be insurance or annuities, or more closely resembles contracts found by courts or regulators to be securities. The industry (and courts and regulators) have, of course, a well-established framework for approaching (ii) above -- the application of authorities interpreting the scope of Section 3(a)(8) of the 1933 Act.
1. The Section 3(a)(8) Exemption for Insurance and Annuity Contracts. Section 3(a)(8) of the 1933 Act exempts from the 1933 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.
2. 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.
H.R. Rep. No. 85, 73d Cong., 1st Sess. 15 (1933).
C. Early 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 changing needs of consumers, 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 1933 Act.
1. True Variable Annuity Contracts, With "Total" Pass-Through of Equity Performance, are Securities. In SEC v. VALIC, 359 U.S. 65 (1959) ("VALIC"), the U.S. Supreme Court held that a variable annuity that places all the investment risk under the contract on the annuitant (and none on the issuer) is not insurance, but a security. The Court stated that without a "true underwriting of risks," and without a "floor" of value guaranteed by the issuer, annuities cannot be insurance: "[f]or in common understanding, 'insurance' involves a guarantee that at least some fraction of the benefit will be payable in fixed amounts." 359 U.S. at 71. The Court also stated that the assumption by an issuer of some level of mortality risk is not of itself sufficient to bring a variable annuity within Section 3(a)(8).
EIP Comment. In light of the guarantees required by state nonforfeiture law, EIPs do provide a "floor" of value. EIP contract values resulting from indexing and interest crediting provisions also reflect the assumption by the insurer of certain significant investment risks -- not all investment risk under the contract is shifted to the contract owner. Accordingly, an EIP can quickly be distinguished from the VALIC variable annuity contracts found by the Supreme Court to be securities.
2. An Annuity with "Insufficient" Guarantees and Pitched as an Investment Is a Security. In SEC v. United Benefit Life Insurance Company, 387 U.S. 202 (1967), the U.S. Supreme Court was again called upon to determine the status of a hybrid annuity contract, a "Flexible Fund Annuity," under the federal securities laws. The Court determined that it was appropriate to analyze accumulation and annuity phases of the contract separately, and focused its analysis on the accumulation phase.
a. The Guarantees Under the Contract. The Flexible Fund Annuity entitled its purchaser, at all times before maturity, to all or part of his proportionate share of the "Flexible Fund" account, which was maintained by the insurer "separately" from its other funds. The purchaser was also entitled to an alternative cash value measured by a percentage of his net premiums which gradually increased from 50% of that sum in the first year, to 100% after ten years. At maturity, the purchaser could elect to receive the cash value of his contract, measured either by his interest in the Flexible Fund, or by the net premium guarantee, whichever was larger.
b. The Guarantee Was Not Sufficient to Create "Insurance." The Court stated that it "had little difficulty" in concluding that the accumulation portion of the Flexible Fund Annuity did not fall within the insurance exemption of Section 3(a)(8). 387 U.S. 210-11. The Court noted that "[t]he insurer is obligated to produce no more than the guaranteed minimum at maturity, and this amount is substantially less than that guaranteed by the same premiums in a conventional deferred annuity contract." 387 U.S. at 208 (footnotes omitted). The Court stated:
"Flexible Fund" arrangements required special modifications of state law, and are 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. And while the guarantee of cash value based on net premiums reduces substantially the investment risk of the contract holder, the assumption of an investment risk cannot by itself create an insurance provision under the federal definition. The basic difference between a contract which to some degree is insured and a contract of insurance must be recognized.
387 U.S. at 211 (note and citation omitted; emphasis added).
c. The Court's Focus on Marketing. In finding it "equally clear" that the accumulation phase of the Flexible Fund Annuity constituted an "investment contract," the Court cited SEC v. Joiner Leasing Corp., 320 U.S. 344, 352-53 ("Joiner"): "The test . . . is what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect." The Court noted that contracts like the Flexible Fund Annuity offered important competition to mutual funds, and "are pitched to the same consumer interest in growth through professionally managed investment. It seems eminently fair that a purchaser of such a plan be afforded the same advantages of disclosure which inure to a mutual fund purchaser under §5 of the Securities Act." 387 U.S. at 211.
EIP Comment - Guaranteed Minimum. The contracts in issue in United Benefit can be distinguished from EIPs. EIPs typically provide a guaranteed minimum surrender value at least equal to the minimum nonforfeiture value applicable to traditional single premium deferred annuities -- substantially in excess of that provided in United Benefit (50% of net premiums in year 1, increasing to 100% of net premiums in year 10). The Court specifically noted that the Flexible Fund Annuity provided a guaranteed minimum "substantially less than that guaranteed by the same premiums in a conventional deferred annuity contract." 387 U.S. at 208. In addition, one factor that led the United Benefit court to conclude that the annuity at issue was a security was that, in substance, "the insurer promise[d] to serve as an investment agency and allow the contractholder to share in its investment experience." (1) An EIP's use of an external index in accordance with a predetermined fixed formula contradicts the notion that an insurance company is serving as an investment agency or supplying investment advice.
EIP Comment - Marketing. The United Benefit case is also the first in a series of Section 3(a)(8) authorities that underscore the importance of how a contract is marketed to an analysis of the contract's status under the federal securities laws. An unregistered EIP must be marketed as a contract of insurance, and not as a variable contract which is to some degree insured. Unlike the United Benefit contract, where equity return was dependent on a "professionally managed investment," a typical EIP credits excess interest that is linked to (but determined only in part by reference to) an equity index, which is, of course, unmanaged. Nonetheless, because the excess interest rate is determined in part by "equity returns," subtle distinctions may play a significant role in determining whether the marketing of an EIP passes muster under Section 3(a)(8).
D. The SEC Provides More Specific Regulatory Guidance -- the Rule 151 Safe Harbor Under Section 3(a)(8). In 1986, the SEC promulgated Rule 151, a "safe harbor." 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." SEC Release No. 33-6645 (May 29, 1986) (emphasis added) (adopting Rule 151).
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:
a. 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 nonunitized 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.)
b. For the life of the contract, the insurer
(1) Guarantees the principal amount of purchase payments and interest previously credited thereto, less any deduction (without regard to its timing) for sales, administrative or other expenses or charges (however, contracts with market-value adjustment features may not rely on the rule); and
(2) Credits 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; and
c. The insurer guarantees that the rate of any interest to be credited in excess of the rate described in (2)(b) above will not be modified more frequently than once per year.
(1) Increases in excess rates are permitted, provided that the new increased rate is not subject to reduction for a further one-year period.
(2) "Three-tier" contracts and contracts that allow a reduction in the excess interest rate before a one-year period has run are excluded from the rule. Release 6645 notes that "With each additional adjustment to the rate of return credited to the value accumulated under the contract, the obligations of the insurer are measured less in fixed-dollar terms and the investor shares to a greater extent the investment experience of the company" (emphasis added).
(3) The use of an external index to determine excess interest rates is permitted, 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.
Release 6645 (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.
3. The Contract Cannot Be Marketed Primarily As An Investment. Notwithstanding the objections of many commenters on Rule 151 as proposed, the SEC retained a "marketing" test as part of the safe harbor. Release 6645 notes that in United Benefit, the insurer advertised its product by "emphasizing the possibility of investment return and the experience of United's management in professional investing," and observed that "[t]he Supreme Court found this activity to be highly relevant in concluding that the contract did not fall within the insurance exclusion of section 3(a)(8) of the  Act" (citations omitted).
a. 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 . . . " (citation omitted).
b. The release states that
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.
EIP Comment. 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 1933 Act.
E. More Recent Judicial Interpretations.
On several occasions following the United Benefit decision, U.S. circuit and district courts have examined annuities and life insurance contracts in the context of securities fraud claims brought by purchasers of such contracts. In evaluating the legal status of EIPs, it is important to analyze them not only under the seminal Supreme Court cases and Rule 151, but also under a number of subsequent cases that provide additional gloss on the guarantees that may be viewed by courts as necessary to fall within the scope of Section 3(a)(8).
1. Olpin and the Determination of "Bonus Fund" Values. The first of the cases following United Benefit is Olpin v. Ideal National Insurance Co., 419 F.2d 1250 (10th Cir. 1969) ("Olpin"). In Olpin, the Tenth Circuit considered whether certain endorsements to life insurance policies were securities because the endorsements provided for a payment on death or after a specified period from a "bonus fund." The insurer would allocate a specified amount to the "bonus fund" (at least $1.00 but not more than $2.00, as determined by Ideal's Board of Directors, for each $1,000 in life insurance in force under certain policies), and credit a set interest rate to such amounts.
a. The Tenth Circuit concluded that the endorsements were not securities, because the insurer was obligated to pay an amount that could be mathematically calculated (a share of the allocated amounts plus 2-1/2 percent annual interest) regardless of the investment performance of amounts the insurer set aside to fund its obligation, and that therefore the insurer bore the entire investment risk. The court also noted that, aside from the investment experience of Ideal indirectly affecting the specified amount allocated to the "bonus fund," holders of policies with the endorsement in question "had no interest in and in nowise were affected by investment gains or investment losses by Ideal or its predecessors, except losses so great that they would threaten the solvency of Ideal or its predecessors." (2)
b. Interestingly, the amount payable under the "bonus fund" endorsement appeared to have been determined in part by two factors not calculated until the time of payment: the number of "units" in the policy to which the endorsement was attached; and the aggregate of the number of "units" in all the policies bearing the endorsement. (3)
EIP Comment. A given EIP's reliance upon Section 3(a)(8) -- in spite of the partially retrospective nature of its excess interest rate calculation -- may be supported by the Olpin case, in light of the apparently partially "retrospective" nature of the factors used to determine the value of the "bonus fund" that was found not to be a security. However, the subsequent Home Life case more directly -- and negatively -- discusses retrospective interest rates.
2. Otto v. VALIC: The Frequency with Which Excess Interest Can be Changed. In Otto v. Variable Annuity Life Insurance Company, 814 F.2d 1127 (7th Cir. 1986), on an interlocutory appeal the Seventh Circuit Court of Appeals ultimately reversed a lower court decision that a "fixed" annuity contract issued through the general account of VALIC was within the scope of Section 3(a)(8). The contract included (i) a principal guarantee; (ii) a guaranteed interest rate of 4% for the first ten years, and 3-1/2% thereafter; and (iii) discretionary excess interest.
a. Initially, the Seventh Circuit affirmed the lower court's finding that the contract did not constitute a security, stating that VALIC's fixed annuity satisfied each of the conditions of Rule 151. In so doing, the court stated that under the "banding" method of crediting interest used by VALIC, "VALIC in effect guarantees the excess interest rate on every deposit for the life of the annuity contract." 814 F.2d at 1134.
b. VALIC subsequently filed a motion to modify the court's initial opinion, asserting that it had the "right to alter, at its unfettered discretion, the interest "bands" paid on past contributions." 814 F.2d at 1140. In light of VALIC's "newly asserted right to alter past interest bands," the court held that VALIC's fixed annuity contract was a security. 814 F.2d at 1141. The court stated:
A claimed right to change established excess interest rates and to eliminate excess interest payments entirely at any time surely tends to shift the investment risk from VALIC to the plan participant. . . . The SEC in adopting Rule 151 rejected VALIC's view that guaranteeing a low minimum interest rate is a sufficient assumption of the investment risk by the insurance company. . . . We find that on the facts of this case the minimum interest rates guaranteed under VALIC's fixed annuity plan, although they are somewhat in excess of those required by Rule 151, alone do not place the investment risk on VALIC sufficiently to exempt the plan from the federal securities laws.
814 F.2d at 1141-42 (emphasis in the original).
c. The Supreme Court declined to hear the case on appeal. 486 U.S. 1026 (1988). Following additional procedural motions, in November 1995, a jury trial was held on two counts involving federal securities fraud and common law fraud. On December 19, 1995, the jury found in favor of VALIC on all counts and the case was dismissed. In January 1996, Otto filed a motion for a new trial which was denied in April 1996.
EIP Comment EIP designs generally do not give an insurer carteblanche to change excess interest rates. Under the typical EIP design, the formula for determining excess interest rates is determined in advance and guaranteed in advance for a subsequent term at least equal to one policy year, and usually equal to five or more policy years, in duration. This feature in and of itself distinguishes the typical EIP from the contracts in issue in Otto. In addition, EIP excess interest is usually, but not always, credited no more frequently than at the end of each policy year. (Under certain designs, excess interest is credited only at the end of a term.) The Otto court's reversal of its original opinion that the annuities were entitled to rely on Section 3(a)(8) appears to have been based upon the court's realization that the insurer could eliminate excess interest payments at any time.
3. The SEC Disputes the Otto Court's Reasoning. In the Otto v. VALIC case, VALIC petitioned the U.S. Supreme Court for a writ of certiorari, seeking a review of the Seventh Circuit's decision. The U.S. Solicitor General submitted an amicus brief that was signed by, and also expressed the views of, the SEC.
a. The SEC Reasserts the "Safe Harbor" Status of Rule 151. Calling the Seventh Circuit's reasoning "unclear," the brief states that
The court's opinion on rehearing indicates that the court believed VALIC's fixed annuity failed to qualify as an "annuity contract" solely because the fixed annuity did not satisfy one element of the test set forth in the Commission's Rule 151 -- i.e., that the excess-interest rate be guaranteed for at least one year. If that was the court's reasoning, it was mistaken. . . . As a safe harbor, Rule 151 does not express the Commission's views on the outer limits of the [Section 3(a)(8)] exemption.
Amicus Brief at 6.
b. The SEC Takes Issue with the Otto Court's Analysis of VALIC's Contract. The brief takes the position that the status of VALIC's annuity contract under Section 3(a)(8) should be determined not only by reference to Rule 151, but also to the Supreme Court's earlier decisions in VALIC and United Benefit. Observing that under these cases, as well as relevant SEC pronouncements, "it is clear that the assumption of substantial "investment risk" by the insurance company is one crucial factor . . . ", the brief goes on to state that "VALIC assumed substantial investment risk under the fixed-annuity contract sold to Otto." Amicus Brief at 6-7.
(1) Under the contract, VALIC guaranteed return of principal, return of previously credited interest, and a guaranteed interest rate for the life of the contract of at least 3-1/2 or 4%. Values did not vary with a separate account. Excess rates could, however, be reduced or eliminated at VALIC's discretion.
(2) The brief states that "Nonetheless, we believe that VALIC bore sufficient investment risk under the contract to meet the investment risk criterion of Section 3(a)(8)." Amicus Brief at 8.
EIP Comment. Most EIPs are well-positioned to demonstrate that the insurer retains more investment risk under an EIP than under the contract in issue in Otto; thus, the Amicus Brief can be read as providing fairly strong support for viewing many EIPs as within the scope of Section 3(a)(8).
4. Peoria Union and More Guidance on Insufficient Guarantees. In Peoria Union Stock Yards Co. v. Penn Mutual Life Insurance Co. ("Peoria Union"), (4) the Seventh Circuit considered an appeal from the dismissal of a complaint alleging that a "group deposit administration contract" used as the funding vehicle for a pension plan was a security. The contract provided for plan contributions to be deposited in a deposit account, and guaranteed a minimum fixed interest rate only on deposits made during the first three years of the contract (declining from 7-1/2 to 3-1/2 percent over the period these contributions were on deposit), with no interest guarantees on deposits made after the first three years.
a. Comparing the Penn Mutual contract to United Benefit's annuity, the Seventh Circuit found that the Penn Mutual contract -- like the United Benefit annuity -- guaranteed a minimum value at maturity, but a low minimum, and that the Penn Mutual contract's guarantees were non-existent after the third contract year.
b. The Peoria Union court concluded that the Penn Mutual contract was an "investment contract" subject to the federal securities laws.
EIP Comment. EIPs can be contrasted with the contracts issued by Penn Mutual. The Peoria Union court determined that the insurer did not assume sufficient investment risk to be entitled to rely on the Section 3(a)(8) exclusion when the Penn Mutual product failed to provide any guarantee of interest after the third year of the product's life, and did not provide the significant interest rate guarantees provided by most EIPs. (5)
5. Home Life: Marketing is Not in the Eyes of the Beholder; and Retrospective Rates. In Associates in Adolescent Psychiatry v. Home Life Insurance Company of New York, 729 F. Supp. 1162 (N.D. Ill. 1989), aff'd, 941 F.2d 561 (7th Cir. 1991), the court granted Home Life's motions for summary judgment on claims that a Home Life Flexible Annuity and a Pension Series Whole Life contract were securities. The court found that the annuity contracts fell within Rule 151, in light of their features and marketing. These contract guaranteed principal and a minimum interest rate of at least 4%; in addition, they provided that current interest rates credited to amounts on deposit would be guaranteed for one year.
a. In interpreting Otto v. VALIC, the court stated that "It seems clear that an annuity contract which allows the insurer to alter the rate of excess interest on past contributions at any time will be deemed a security under Otto." 729 F. Supp. at 1173.
b. With respect to marketing, the court stated that "[T]he public perception of the [annuity contract] does not control the question whether it was marketed primarily as an investment. Rule 151 does not ask how the public perceives the insurance product; it merely asks how the insurer promoted it." 729 F. Supp. at 1175.
c. In addition, the court noted that plaintiffs "point[ed] to Home Life's sales literature for the annuity contract, cull[ed] isolated passages referring to the investment aspect of the [contract] (including the desirability of the excess interest as a way of taking advantage of fluctuating interest rates), and argue[d] that these show that [the contract] was marketed primarily as an investment." The court nonetheless concluded that the sales literature did not, when read as a whole, promote the annuity contract primarily as an investment. 729 F. Supp. at 1174.
EIP Comment - Marketing. The marketing challenge presented by EIPs under Section 3(a)(8) merit attention, given the linkage of excess interest rates to an equity (i.e., security-based) index. The Home Life lower court opinion supports the notion that by carefully preparing, and closely supervising, the marketing campaign for an EIP, insurers can exercise a significant degree of control over the legal "characterization" of EIP marketing. An insurer should not be obligated to ensure that prospects do not view the product as an investment; rather, the insurer is obligated to market the product as insurance.
EIP Comment - Retroactivity. The Seventh Circuit's Home Life decision is significant for EIPs. The court suggested that the retroactive crediting of excess interest increases purchaser investment risk to the extent that the purchaser does not know in advance the exact rate of excess interest that will be credited to contract value for the coming term. In Home Life, the Seventh Circuit found this rationale persuasive; the prospective announcement of annual interest rates minimized the contract owner's investment risk precisely because the owner would know in advance the rate of return to be earned on the contract. If the rate was unsatisfactory, the purchaser was "free under the terms of the contract to take its money and go elsewhere." (6) Most EIP designs to date cannot claim to determine interest rates prospectively. However, EIPs generally provide for other types of investment risks -- including those relating the indexing formula, fixed in advance; and various interest crediting mechanisms (including "step ups" of minimum guaranteed values) -- remaining with the insurance company.
6. Berent v. Kemper Again Calls Into Question the Safe Harbor Status of Rule 151. In Berent v. Kemper Corporation, 780 F. Supp. 431 (E.D. Mich. 1991), aff'd 973 F.2d 1291 (6th Cir. 1992), the lower court found that certain single premium whole life insurance policies did not constitute securities. The policies credited current interest at a rate "guaranteed one policy year at a time...," and guaranteed to be no lower than 4.5%. Sales brochures for the policies stated that "The interest rates we apply to your policy reflect our own earning experience . . . ." 780 F. Supp. at 436 and 441. The court's opinion is notable in a number of respects, including the following:
a. In its opinion, the court stated that "SEC Rule 151 . . . sets forth the requirements for exemption of insurance contracts under Section 3(a)(8)." 780 F. Supp. at 441. This language indicates that the court viewed Rule 151 not as a safe harbor, but as a rule defining the limits of Section 3(a)(8).
b. The Kemper court also evaluated the investment risk assumed by Kemper by reference to Rule 151. The court found that the Kemper policies met all four conditions. First, net premiums under the policies were invested in Kemper's general account, not in a separate account. (7) Second, principal and interest were guaranteed under the policies. Third, the relevant minimum interest rates (4% and 4.5%) exceeded the 3% minimum of the Michigan and NAIC non-forfeiture requirement for annuities. Fourth, excess interest rates under the policies were guaranteed for a full contract year.
c. Drawing heavily upon the Home Life opinion discussed above, the court also found that the policies in question were marketed "primarily as insurance . . . ." 780 F. Supp. at 443. The court noted that sales brochures for the policies clearly emphasized "the insurance protection of the policies -- that they are paid up with a single premium, and provide death benefit protection and estate planning advantages." 780 F. Supp. at 443.
EIP Comment. The status of an EIP as an annuity contract falling within the scope of Section 3(a)(8) is not bolstered by faulty judicial interpretations (such as Kemper) suggesting that the boundaries of Rule 151 are coterminous with the boundaries of Section 3(a)(8). Kemper can, however, be read as supporting the notion that the crediting of guaranteed interest in excess of the minimum nonforfeiture rate may be helpful from a Section 3(a)(8) perspective.
F. Recent SEC Activity.
1. From time to time over the past several years, the SEC staff has informally inquired about the status under Section 3(a)(8) of certain life insurance or annuity contracts that have come to its attention. However, no formal enforcement actions under Section 3(a)(8) relating to annuity or insurance contracts have been reported since Otto v. VALIC.
2. In the early 1990's, the life insurance industry sought to have Section 3(a)(8) modified to clarify that the exemption covered contracts similar to the one at issue in Otto v. VALIC. It explored the possibility of a legislative amendment with the SEC staff. However, neither the SEC staff nor the industry have taken any further action to seek to clarify the scope of Section 3(a)(8).
3. SEC Concept Release:The SEC Staff has met with a number of industry representatives to discuss EIPs, and is in the process of preparing a "concept release" soliciting additional input on the securities issues associated with these products. Ms. Susan Nash, Assistant Director of the Division of Investment Management ("IM") and the head of the SEC Office of Insurance Product has stated that the concept release will not contain any interpretations or policy positions. It is expected that the release will raise questions and ask for industry comments on the legal status of EIPs. Currently, the concept release has been submitted by IM to the entire Commission for review. Ms. Nash recently indicated that the Commission might well issue the release within the next two months.
G. Analysis of the Product Concept. The status of a particular EIP under Section 3(a)(8) or Rule 151 depends on the product's specific features and how they are marketed. If reliance is placed on Section 3(a)(8) or Rule 151, then the EIP must be a "contract of insurance," and not an investment contract "which to some degree is insured."
1. Why EIP Issuers Have Not Relied Upon the Rule 151 Safe Harbor. Life insurance contracts technically cannot rely on the Rule 151 safe harbor, which is only available to annuity contracts. However, the SEC 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. Nonetheless, EIP designs generally do not fall within the safe harbor of Rule 151.
a. Insulated Separate Accounts. If the EIP is funded through a legally insulated unitized separate account, the safe harbor would be unavailable.
b. Insurer Assuming Investment Risk. In order to rely on the safe harbor, an EIP must satisfy all prongs of the "investment risk" test set forth in Rule 151.
(1) The EIP must, for the life of the contract, guarantee principal and return of previously credited interest (less charges specified in Rule 151); and must credit a specified interest rate (at least equal to the applicable nonforfeiture rate) to net payments and interest credited to net payments.
(2) Any excess interest credited under the contract, including indexed excess interest, cannot change more frequently than once per year.
(3) Although the language of the Rule does not speak directly to indexed contracts, Release 6645 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.) 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) may 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 "cap" or "floor," are determined at the beginning of a term, and guaranteed for the duration of the term.
c. Cannot be Marketed Primarily as an Investment. Rule 151 clearly does not preclude contracts with indexed interest rates from satisfying the marketing test. By the same token, there is nothing to suggest that the SEC was contemplating equity indices when it adopted Rule 151.
2. Status of EIPs under Section 3(a)(8). As stated above, the rationale underlying the conditions of Rule 151 are relevant to any Section 3(a)(8) determination. Factors that may be particularly relevant in determining whether an EIP falls within Section 3(a)(8) are as follows:
a. Guarantees of Principal. Without a continuous guarantee of principal (less applicable sales and administrative charges), there would be significant questions whether an EIP would qualify as an insurance contract within the meaning of Section 3(a)(8). For example, an EIP with a market-value adjustment feature that invaded principal would likely be beyond the scope of the Section 3(a)(8) exemption. (See Release 6645 at text accompanying note 19.)
b. Guarantees of Minimum Level of Credited Interest. The answers to the following questions likely would be very important in a Section 3(a)(8) analysis:
(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 and administrative charges) guaranteed upon any surrender?
(4) How frequently is an excess indexed interest rate determined or determinable under the product?
(5) To what extent does the indexing feature shift investment risk to the contract owner? This may depend, among other things, on the duration of terms; the existence and level of any "floor" on indexed excess interest; and the type and particular components of the formulaic "measure" of changes in the index (i.e., point-to-point, look-back or "law-water"; Asian or cliquet; the use of participation rate or margin; "vesting," and/or averaging, features; etc.).
c. Marketing the EIP. Is the EIP being marketed as a contract of insurance, or as a contract which is to some degree insured? Unlike the United Benefit contract, where the equity return was dependent on a "professionally managed investment," a typical EIP credits excess interest that is linked to an equity index, which is, of course, unmanaged. Nonetheless, because the excess interest rate is determined in part by "equity returns," subtle distinctions (and the predilections of judicial and regulatory forums) may play a significant role in determining whether the marketing of an EIP passes muster under Section 3(a)(8).
(1) Excessive emphasis on an EIP's participation in an index could lead to a serious risk that the EIP could be found to be a security.
(2) EIP marketing that supports reliance on Section 3(a)(8):
" emphasizes insurance benefits and features (such as death benefit and annuitization options), and highlights the EIP's intended purpose -- a vehicle for retirement savings;
" emphasizes the EIP's guarantees, including the guaranteed interest rates; and
" refers to the relevant index as a factor that in part determines the "excess" interest rate, and that may provide the potential for higher interest rates over the long term; and not as a vehicle for participating in stock market returns or gains or growth.
(3) EIP marketing that may not provide support for reliance on Section 3(a)(8):
" unduly emphasizes investment terms such as "investment performance," "investment returns," "maximizing returns," "Wall Street," or the "stock market";
" characterizes the EIP's indexing feature as a means of providing participation in the relevant index, or in the equity or stock markets; or
" emphasizes similarities to variable annuities, mutual funds, or other investments.
EIP Comment. The extent to which the courts are called upon to examine EIPs under the federal securities laws will depend in large measure on the "quality" of EIP marketing and the level of purchaser understanding of these products. The SEC has made it clear that if an insurer is not relying on Rule 151, the insurer has responsibility for determining the status of its contracts under Section 3(a)(8).
d. Use of a Separate Account. Is the EIP issued through an insulated, unitized separate account? If so, courts and/or regulators may find it difficult to distinguish the EIP from a variable contract with some form of guarantee -- suggesting that the registration route outlined below may be appropriate.
II. Federal Securities Law: The Registration Route
A. Registration History - the Product Concept. Over the years, a few insurance companies and other issuers have developed equity-oriented securities which are to some degree "insured": for example, managed separate accounts with "principal" guarantees of one form or another, or with minimum performance guarantees measured over a specified time period. Such products have been built on a registered security "chassis."
B. The SEC Regulatory Framework for Registration.
1. Securities Act of 1933.
a. Registration. Securities that are not issued through a pooled investment vehicle that is an "investment company" (for example, annuity contracts that fall outside the scope of Section 3(a)(8) and are issued through an insurer's general account) are generally initially registered under the 1933 Act on Form S-1. Securities issued by mutual funds are registered under the 1933 Act on Form N-1A, and variable contract securities issued through separate accounts are registered on Form N-3 or Form N-4 (variable annuities), or Form S-6 (variable life insurance). Stock companies and their subsidiaries generally must include audited financial statements in their registration statements that conform to generally accepted accounting principles. If not otherwise prepared, this can entail a significant additional cost.
Registration statements are reviewed and commented upon by the SEC Staff; as a general rule of thumb, a filing may become "effective" 4 to 6 months after the initial SEC filing is made.
(1) Filings on Form S-1 include disclosure focusing on the terms of the security being offered, and on the issuer of the registered security -- and require disclosure regarding: the insurance company general account, its operations, management of the company, a Management Discussion and Analysis, certain details of management compensation and pension arrangements, audited financial statements, etc. Although registration of a general account product on Form S-1 carries with it the consequences noted above, unlike variable contracts subject to the 1940 Act, the SEC does not regulate the design of registered "fixed" life insurance contracts.
(2) Filings on Form S-6 include disclosure focusing on the terms of the security being offered, and on the investment company issuing the registered security -- the mutual fund or the separate account. Because the foundation for "insured" equity products is a registered security "chassis," issuers of such products proceed down the route of 1933 Act registration for the mutual fund or variable contract security that is the "foundation" for the product. While registration of the equity product "chassis" and its issuer may be assumed in the development of such products, the presence of a "guarantee" of some type triggers an additional question -- what is the status of the guarantee under the 1933 Act?
(3) In the case of mutual fund or managed separate account securities with some form of guarantee, the guarantee may result from specialized portfolio management techniques (for example, the use of a combined equity/zero coupon bond strategy, or of sophisticated futures or options as hedges against market declines). In such cases, the "guarantee" is in effect no more than a representation from the fund manager that its specialized management techniques minimize or eliminate downside risk. While such a representation may raise unique disclosure issues, this form of built-in "guarantee" likely does not constitute a separate security required to be registered under the 1933 Act.
(4) Alternatively, a principal or performance guarantee may consist of an obligation that is separable from the registered security. A guarantee of a security is, itself, a security. See Section 2(1) of the 1933 Act, defining "security." The guarantee itself may, however, be independently exempt from registration under the 1933 Act (for example, if it is financial guaranty insurance or a bank "letter of credit"). Again, while such a guarantee may raise disclosure issues, this form of guarantee does not constitute a "security" that is required to be registered under the 1933 Act.
(5) A principal or performance guarantee may also be backed by the issuer of the registered security, or by an affiliate.
(a) If the issuer of a registered security is also providing a form of guarantee that is not itself independently exempt from registration, then 1933 Act registration of the guarantee would appear to be necessary. An argument can be made, however, that the registration statement for the registered security also serves, in effect, as the registration statement for the guarantee.
(b) On the other hand, if the "issuer" of the non-exempt guarantee is not the same entity as the issuer of registered equity product (for example, the investment adviser of a "guaranteed" mutual fund, or the underwriter of the "guaranteed" separate account product), it is unclear whether the registration of the separable guarantee can be appropriately "piggy-backed" onto the registration of the equity product.
Such guarantees may also raise additional regulatory issues under the 1940 Act. In any event, the financial statements of the issuer of the guarantee would likely need to be included in SEC registration materials. (Sales of such "guarantees," which are not issued by the issuer of the registered mutual fund shares or insurance contracts, may also raise NASD licensing issues.)
(6) Registration under the 1933 Act of either a general account- or a separate account-issued security involves costs (preparation of a registration statement, prospectus, and filing fees), and triggers potential liability under Sections 11 and 12 of the 1933 Act for misleading disclosure materials, as well as periodic reporting obligations for the issuer of registered securities.
(7) Registered securities also may only be sold through registered representatives of licensed broker-dealers.
(8) Sales loads and other charges deducted in connection with sales of registered mutual funds and variable contracts are limited by the 1940 Act and rules of the SEC, and by the National Association of Securities Dealers, Inc. ("NASD").
b. EIPs Registered Under the 1933 Act. To date, several registration statements on Form S-1 for annuity contracts including equity-indexed allocation options have been filed with the SEC. These include the filings by Keyport Life Insurance Company (File Nos. 333-01783 and 333-13609) and by Valley Forge Life Insurance Company (File No. 333-02093). (In addition, certain registered variable annuity contracts have included unregistered indexed options.)
c. Prospectus Delivery and Marketing Materials. At or prior to the time of sale, the purchaser of a registered security must receive a prospectus that meets the requirements of Sections 5 and 10 of the 1933 Act. In addition, marketing materials for registered securities are strictly regulated by the SEC and the NASD. Specialized rules and guidelines apply to marketing materials for mutual funds and variable contracts. Advertisements for registered fixed annuities are severely limited; more flexibility is available for materials accompanied or preceded by the fixed product prospectus.
d. Anti-Fraud Liability. Purchases and sales of registered securities (and securities that are exempt from 1933 Act registration under a "private placement" exemption) are nonetheless subject to the anti-fraud rules of the Securities Exchange Act of 1934, as amended (the "1934 Act") -- specifically, Rule 10b-5. 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.
e. Advantages of 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:
(1) Requirement for audited financial statements; and
(2) Requirement for management's discussion and analysis.
2. Investment Company Act of 1940.
a. Registration of the Fund or Separate Account. If a mutual fund or a separate account is making an offering of securities subject to registration under the 1933 Act, then the pooled investment vehicle issuing the securities must be registered under the 1940 Act. Mutual funds are registered under the 1940 Act on Form N-1A. Separate accounts are registered on Form N-3 (managed variable annuity separate accounts) or Form N-4 (unit investment trust variable annuity separate accounts) or Form N-8B-2 (variable life insurance separate accounts). (1933 Act and 1940 Act registrations are combined for mutual funds and variable annuities, but are separate for variable life insurance.)
(1) If a registered "insured" equity product is issued through a pooled investment vehicle such as a mutual fund or a separate account, registration of the vehicle under the 1940 Act is also triggered.
(2) If a separate charge is to be assessed against separate account assets to compensate the insurer or some third party for the costs associated with the investment guarantee, then special SEC exemptive relief may be necessary in order to deduct the charge.
b. Limitations on Charges. The 1940 Act and applicable NASD rules place limits on the charges that may be deducted in connection with variable life insurance policies issued through a registered separate account. For variable contracts, charges are subject to an overall "reasonableness" limit under the 1940 Act. The NASD further limits flexible premium variable annuity sales charges to 8.5% of premiums. (See NASD Conduct Rule 2820.)
c. Regulation of Operations and Processing. Applicable SEC regulations under the 1940 Act impose many substantive requirements on the operations of mutual funds and separate accounts. For example, purchase and sale transactions generally must be processed at the share price or unit value "next calculated" after a purchase or redemption request is received in good order. (See Rule 22c-1 under the 1940 Act.) Redemption payments must be made within seven days (see Section 22(e) of the 1940 Act), and retail mutual fund transactions are generally subject to the more stringent processing requirements of the SEC's "T+3" rule (see Rule 15c6-1 under the 1934 Act).
d. Recordkeeping and Reporting. Registered mutual funds and separate accounts are subject to detailed recordkeeping and reporting requirements under Section 31 and Section 30 of the 1940 Act.
e. EIPs and "Insulated" Separate Accounts. In January 1997, Valley Forge Life Insurance Company obtained a no-action letter regarding an "insulated" "non-unitized" separate account established in connection with SEC-registered equity indexed annuity options ("Contract") with a market value adjustment. (8) The SEC Staff agreed not to recommend enforcement action if the Contract provides for legal insulation of the separate account without registration of the separate account under the 1940 Act, provided that:
(1) The Contract owner allocating premium or account value to the separate account is entitled to Contact benefits that are determined based on a mathematical formula established at the time the Contract is issued (or subsequent terms begin). The mathematical formula is based in part on (i) a market index that is established and guaranteed in advance, and (ii) changes in guaranteed interest rates applicable to the guaranteed interest rate options. Neither the rate of index-linked excess interest nor adjustments based on changes in guaranteed interest rates are affected by the investment experience of the separate account.
(2) Valley Forge is obligated to pay all amount due to Contract owners allocating premium or account value to the separate account without regard to the value of the separate account's assets, and Valley Forge retains all profits and bears all losses from the separate account operations.
(3) Valley Forge is obligated under state law to maintain separate account assets with a market value at least equal to reserves and other contract liabilities related to the separate account and immediately to transfer to the separate account sufficient assets to remedy any shortfall. Valley Forge represents that the value of the assets in the separate account will at all times at least equal the amount of the separate account's reserves and other contract liabilities.
(4) Whenever the value of the separate account's assets exceeds the value of its reserves and other contract liabilities, state law permits Valley Forge to transfer the surplus to its general account, and the Contract owner allocating premium and account value to the separate account has no claim upon or interest in such transferred assets, except as such assets are part of Valley Forge's general account.
(5) Valley Forge establishes and proposes to provide for legal insulation of the separate account for business purposes unrelated to any attempt to pass through investment experience of the separate account.
(6) Valley Forge will take steps to ensure that its marketing program and materials refer to the separate account as a pool of assets that provide an additional measure of assurance that Contract owners allocating premium and account value to the separate account will receive full payment and not as an investment vehicle in whose performance such Contract owners will have any interest.
3. Securities Exchange Act of 1934.
a. Sales through a Registered Broker-Dealer. As noted above, 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.
(1) Broker-dealers are subject to substantive regulation by the SEC (with a particular emphasis on financial oversight and reporting) and the NASD (with a particular emphasis on supervisory procedures, fair dealing and sales practices).
(2) 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.
b. Anti-Fraud Rules. As noted above, purchases and sales of registered securities (and "privately placed" securities) are subject to the anti-fraud rules of the 1934 Act (Rule 10b-5).
c. Periodic Reporting. Insurers issuing securities registered under the 1933 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.
III. Evolving State Regulatory Developments -- National Association of Insurance Commissioners ("NAIC") Activities
A. Committee Activity
1. In December 1996, the NAIC's Life Insurance (A) Committee requested the formation of an Equity Linked Products Working Group. That suggestion was rejected at subsequent NAIC meetings.
2. On February 6, 1997, the NAIC's Life and Health Actuarial (Technical) Task Force asked the American Academy of Actuaries to undertake a study of equity indexed products ("EIPs") with the goal of suggesting new NAIC model regulations and changes to existing models by December 1997. The AAA was asked to undertake "a thorough study of all aspects of equity-indexed products" focusing on "nonforfeiture, valuation and investments supporting the products," and to prepare quarterly reports on its activities.
3. The NAIC's Life Disclosure Working Group of the Life Insurance (A) Committee has undertaken a study of equity indexed annuities ("EIAs") to determine if separate or additional disclosure regulations are needed with regard to EIAs. Reportedly, the NAIC is concerned as to whether insurers are adequately explaining to customers the product features (both guaranteed and non-guaranteed) and the risks associated with EIAs.
4. Orlando NAIC Meetings in February 1997: The "Foley Guidelines": Tom Foley of the North Dakota Insurance Department distributed a draft "Indexed Products -- Disclosure Guidelines" at the February 1997 NAIC's Life Disclosure Working Group of the Life Insurance (A) Committee in Orlando. The proposed guidelines would have required insurers writing indexed products to determine the "annual earnings rate" for those products over each seven year period that the applicable index has been in existence for the last thirty years. (The company would use actual month-end values of the index to determine the product's earning rate.) Once determined, annual earnings rates would be "ranked" from high to low and illustrations of each of the highest, lowest and average annual earning rate would be developed.
The proposal stressed that it was critical that the illustration format be product design neutral. However, industry comments on the proposal indicated that contracts with a seven year high-water mark or annual look-back design would be disadvantaged by the proposal. In addition, the industry commented that it was unclear how life products, products with multiple terms, flexible premium products and products with multiple indexes would be illustrated.
5. Chicago NAIC Meetings in June 1997: Revised Foley Bulletin
Mr. Foley distributed a revised draft North Dakota bulletin outlining minimum requirements for EIPs. The revised proposal would not have required historic illustrations of EIAs. However, hypothetical illustrations and a chart comparing the cash surrender value for the EIA with the results of a one-year treasury bill and the S&P total return index would have been required for EIAs. Equity indexed life products would have been required to comply with the requirements of the Life Insurance Illustrations Model Regulation. Comment letters on the draft bulletin were submitted to Mr. Foley by, among others, the American Council on Life Insurance and the American Academy of Actuaries Equity Indexed Product Task Force.
6. Kansas City Interim Meeting in August 1997: Final North Dakota Bulletin. At the interim meeting of the Life Disclosure Working Group held in Kansas City, Mr. Foley distributed North Dakota Bulletin 97-2 regarding "Indexed Annuity and Life Products," adopted August 1, 1997. A copy of the Bulletin is attached as Exhibit 1.
B. Coordinated Industry Response to the Life Disclosure Working Group
Charlotte Liptak of Transamerica Occidental Life Insurance Company chairs the Technical Resources Advisers ("TRA") to the Life Disclosure Working Group. On May 23, 1997, she submitted a report to the Life Disclosure Working Group on behalf of the TRA. The TRA includes a broad spectrum of interested persons, including attorneys from insurance companies and private law firms; actuaries from insurance companies and consulting firms; representatives of the ACLI , NALP and AAA; marketing and sales representatives; and insurance company compliance personnel.
Between the Orlando NAIC meetings in February 1997 and the June Chicago NAIC meetings, the TRA held numerous conference calls and meetings to discuss the viability and effectiveness of various disclosure concepts for EIPs and their ramifications. The May 1997 TRA Report summarizes those discussions as follows:
1. Fixed EIA disclosure requirements should come within and follow the overall regulation for other fixed annuities as much as possible. However, because of the variety of EIA products and levels of complexity, different types of disclosure may be more appropriate for some products than for other. While it is important that consumers have a good explanation of how EIAs operate and realistic expectations about performance, it is the TRA's position that no one standardized method of disclosure can fulfill all disclosure needs for all products designs. Therefore, the TRA recommends that different "layers" and types of disclosure be permitted for EIAs.
2. The first layer of disclosure proposed by the TRA would be a Buyers Guide containing an overview of EIAs and the features that make them unique from other fixed annuities. Rather than a required piece to be delivered at a certain point in time, the TRA envisions the Buyers Guide as a high level educational piece that state insurance departments, insurance companies and producers could distribute to consumers not familiar with EIAs. The Buyers Guide would help consumers familiarize themselves with the kinds of choices available in different product designs and the trade-offs associated with different features that are available.
3. The next layer of disclosure would be specific to the particular product being considered by the consumer. Three types of disclosure make up this layer. One of the three types of disclosure would be required with every EIA sale.
a. Narrative only: This document would include disclosure required for traditional fixed annuities. In additions, the elements specific to an EIA would be disclosed, including:
(1) a statement that the product is an equity indexed annuity;
(2) identification of the index;
(3) an explanation of how the index affects the EIA;
(4) the duration of the term during which index-linked interest applies and the length of the renewal window;
(5) a statement that the product is not a purchase of a security;
(6) a explanation of the minimum guaranteed value;
(7) an explanation of the indexing method;
(8) an explanation of any guaranteed and nonguaranteed features, such as rates, caps, floors, etc.
b. Narrative with nonpersonalized mathematical examples of how the product design works: This document would be short and would include the required narrative disclosure along with some numeric/graphic display of how values are determined. The premium amounts used would be hypothetical and the examples would be required to show one term period or five years, whichever is longer. The examples would include product specific features; one example would be required to show minimum guaranteed value.
c. Personalized illustrations including narrative explanation. This document would include a narrative explanatory section, including concepts mentioned in a. above. The term "illustration" in this context has the same meaning as in the Life Illustration Model Regulation. Because the "illustration" section of the Annuity Disclosure Regulation has not yet been drafted, the TRA's discussion of this item was very preliminary, with consensus that illustrations should be allowed, but not required, on a sale by sale basis, and that some guidelines would be necessary.
C. Proposed Balancing Language of the American Academy of Actuaries
1. The Interim Report of the Equity Indexed Products Task Force of the American Academy of Actuaries dated June 5, 1997 (the "Interim Report") contained:
a. A detailed description of equity indexed products;
b. A specific proposal for guidelines regulators can use in developing new model regulations addressing the marketing and disclosure of equity indexed products; and
c. An extensive analysis of several reserving methodologies for equity indexed products.
2. The Interim Report recommended that any marketing materials that contains language regarding nonguaranteed elements provide consumers with a balanced view of the policy provisions inherent in the equity indexed design.
3. The purpose of the balancing language is to ensure that both the negatives and the positives of product features are described to consumers.
4. The Interim Report contains the following examples of balancing language:
a. To the extent that the index methodology uses averaging and it is advertised that protection is provided against downturns, it must also be disclosed that the method does not give full credit for an upturn.
b. To the extent that the index methodology is based on multiple factors, then it must also be disclosed that comparisons of a single factor can be misleading.
c. To the extent that any year to year index increases or volatility (hypothetical or historical) are disclosed, then it must also be disclosed that the performance is no indication as to future performance.
d. To the extent that the index excludes dividends, such a fact should be disclosed.
e. To the extent that early termination or the exercise of withdrawal rights may result in the loss of some or all the benefits of any increases in the Index, this must be disclosed.
f. To the extent that the marketing materials includes statement like "participate in the upside of the Index" or "participate in the upside without risk" then it must also be disclosed that there is a downside risk which can go to the guaranteed minimum level.
5. The Interim Report made the following recommendations regarding the disclosure of contract benefits and values:
a. It suggested that disclosure regarding equity indexed products comply with the proposed NAIC Annuity Disclosure Model Regulation (as revised at the April 30, 1997 Interim Meeting of the NAIC Life Disclosure Working Group).
b. It recommended that applicants be given a Disclosure Document which includes a description of:
(1) The guaranteed and nonguaranteed elements of the contract, and their limitations, if any, and an explanation of how they operate.
c. It recommended that disclosure of "total amounts" (i.e. illustrations) of nonguaranteed elements be optional. It further recommended that if shown:
(1) Illustrations of "total amounts" be narrative or tabular, under single or multiple scenario(s) (e.g., historical, hypothetical, level, fluctuating) and under any index;
(2) The disclosure may be shown generically or may be personalized to the applicant so long as it is fully identified as to the method used; and
(3) Any projection used must be such that the implications of going beyond the initial term of the product design are clearly disclosed to the consumer.
To date, the analysis of whether a given EIP design triggers registration under the 1933 Act (or the 1940 Act) has implicitly focused on the "chassis" on which the product has been built. If the starting point for product design is a general account (or nonunitized separate account) contract that has principal and interest guarantees that form a foundation for exempt status under Section 3(a)(8), then registration has generally not been pursued. If the starting point for product design is a variable contract, with guarantees built thereon, then registration has been viewed as appropriate. As the industry continues to develop EIP products that satisfy investors' desire for market-linked "performance" and for a measure of security, these traditional distinctions are likely to become increasingly blurred; and the evaluation of the status of EIP products under the 1933 Act (and of their issuers under the 1940 Act) is likely to become increasingly challenging.
Meanwhile, the states and the NAIC are actively developing a wide range of regulations for EIPs. Such regulations deal with the unique issues relating to disclosure, market conduct, product design, company solvency and reporting raised by these innovative products.
1. United Benefit, 387 U.S. at 208 (emphasis added).
2. Olpin, 419 F.2d at 1262.
3. Id. at 1262-63.
4. 698 F.2d 320 (7th Cir. 1983).
6. Home Life, 941 F.2d at 567.
7. In this connection, the court noted that contracts supported by general account assets which the insurer segments for that purpose still satisfy this provision of the Rule.
8. The Contracts also included guaranteed interest rate options that were supported by a legally insulated non-unitized separate account that was similar, in all material respects, to the legally insulated separate account of the Equitable Life Assurance Society of the United States, with respect to which an SEC no-action position under the 1940 Act has also been issued. SeeThe Equitable Life Assurance Soc'y of the U.S., SEC No-Action Letter (Dec. 22, 1995).