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U.S. Securities and Exchange Commission

Remarks Before the ALI-ABA (American Law Institute/American Bar Association) Conference on Life Insurance Company Products


Andrew J. Donohue1

Director, Division of Investment Management
U.S. Securities and Exchange Commission

Washington, D.C.
November 14, 2008


Thank you very much for that kind introduction. I would like to thank ALI-ABA for inviting me to speak at this conference.

Before I begin my remarks today, I need to remind you that my comments represent my own views and not necessarily the views of the Commission, the individual Commissioners, or my colleagues on the Commission staff.

Well, I think we can all agree it has been quite a ride over the past few months and quite an unsettling time for many if not most market participants. Let’s briefly discuss this year to date. During the third quarter of 2008, we saw the Dow Jones experience its largest point drop ever, we saw failures of some prominent financial institutions, and a money market fund “broke the buck.” These startling events occurred in the context of continuing struggles in the housing market, increases in the inflation rate as measured against the first quarter of 2008, and a jump in the unemployment rate to its highest level in five years. We witnessed continuing turmoil in the credit markets, which ultimately led to the enactment of the historic Emergency Economic Stabilization Act on October 3 of this year. Then, in the last week of October, the Dow Jones Industrial Average gained over 11%, at least partly in response to the rate cut announced by the Federal Reserve and hopes of a corresponding credit thaw. And just this week, we have seen several negative days in the market, followed by a late-session rally yesterday with the Dow closing up over 550 points. This economic climate of volatility has led to anxious investors who find themselves on a bumpy ride.

In my view, the regulatory imperative in these volatile times is to help investors navigate the bumps and turns by implementing protective measures I will metaphorically call “seat belts.” While protection is the main function of a seat belt, an ancillary benefit is to inspire confidence in the person behind the wheel, the American investor.

Of course, one of the most effective seat belts is disclosure, which we all know to be a cornerstone of SEC regulation. Another seat belt is investor education. I am not prone to waxing philosophical, but as I prepared for this talk I was reminded of one of Socrates’ most famous sayings: that the “unexamined life is not worth living.” Well, for purposes of my talk today, I am going to take some literary license and tweak that axiom to say that an unexamined financial product is not worth buying or owning, an idea that I think has been borne out by recent events. With that in mind, I would like to discuss some of the recent disclosure and education initiatives that have been advanced by the SEC and others. At the heart of these initiatives is an effort to get all market participants — those who design and issue financial products, those who market and sell them, as well as the investors who purchase them — to have in common among their respective roles, a clear focus on the potential risks as well as the benefits attending such products. Also, I would like to briefly talk about the pending rulemaking regarding indexed annuities and the companion proposal for Exchange Act relief for certain insurance contracts.


In November 2007, the Commission proposed a mutual fund disclosure reform initiative, which, if adopted as proposed, would represent an important milestone in the on-going efforts by the Commission to streamline mutual fund disclosure. I believe that the approach taken in this initiative may well result in more efficient and effective communication of the information that is essential to an informed investment decision. The Commission is scheduled to consider adoption of the disclosure reform proposal on November 19th.

The cornerstone of this reform proposal is the summary prospectus for mutual funds — a brief, plain English synopsis of key information about a fund's investment objectives and strategies, costs, and risks, with more detailed information available both in paper and in a user-friendly online format. The proposed summary prospectus would enable mutual fund investors, intermediaries, analysts and others to quickly access and use the information they need and want. Meanwhile, the full prospectus and statement of additional information would be available on line or in paper upon request for those who seek more comprehensive information. Investors and analysts accessing the more detailed disclosure documents on-line could use interactive hyperlinks to navigate easily through the layered information. With respect to variable insurance contracts, this new disclosure regime, if approved, would of course require coordination and cooperation between insurers and underlying funds, and in particular funds unaffiliated with the insurance company, in the spirit of good and effective disclosure. I could also foresee a corollary benefit to your industry, in that streamlined disclosure should assist separate account depositors with their obligations to deliver underlying fund documents.

Another aspect of the Commission’s efforts to make the mutual fund disclosure regime more user-friendly is the Commission’s mutual fund interactive data project. Last year, the Commission launched a voluntary filing program to enable funds to file the risk/return summaries from their prospectuses using an interactive data taxonomy developed by the Investment Company Institute. In June, the Commission proposed rules to require mutual funds to file the risk/return summary of their prospectuses using the interactive data format. In the proposing release, the Commission expressed its belief that requiring mutual funds to file the risk/return summary of their prospectuses in this format would enable investors, analysts, as well as the Commission staff, to capture and analyze information more quickly and at less cost than is possible using a static format. Any investor with a computer would have the ability to acquire and download interactive data that have generally been available only to intermediaries and third-party analysts. The proposed interactive data requirements would not change what is currently disclosed, but would add a requirement to include risk/return summary information in a new format as an exhibit. Investors would still have the ability to view the traditional text-based document, if they so choose. The transparency that should result from the use of interactive data should help investors with their comparative analyses.

Meanwhile, as the SEC’s summary mutual fund prospectus proposal is pending, the insurance industry, and the American Council of Life Insurers in particular, is advocating a variable annuity short-form disclosure document. The ACLI has devised a short form template that describes annuity features and costs, with input from focus groups comprising retirees, baby boomers and producers. I think this effort is a positive step that could facilitate a productive dialogue between the Division of Investment Management and the industry regarding the essential elements of any variable annuity short form disclosure document. At a minimum, I believe any such document should stand alone so that its effectiveness does not rely on information incorporated from other documents; it should disclose all the fees and charges; and it should describe the basic features of the product in clear, concise English. This is not an easy task, given the complexity of these products. However, I think it is doable and I commend the goal of this initiative.

These developments can be viewed against the backdrop of the SEC’s 21st Century Disclosure Initiative. This is an initiative that was launched by Chairman Cox in June of this year. The Initiative’s goal, as announced by Chairman Cox, is to modernize the disclosure systems so that information the Commission requires from registrants is more useful and transparent to investors, the marketplace, and the Commission, all while harnessing the conveniences and efficiencies of technology.

As a part of that Initiative, a Roundtable on Modernizing the Securities and Exchange Commission’s Disclosure System was held on October 8 to hear from voices from the field, as it were, on ways to modernize the current disclosure regime. The Roundtable was organized into two panels. The first panel explored the data, technology, and processes that companies and other filers use in satisfying their Commission disclosure obligations and the data and technology that investors use in making their investment decisions. The second panel considered how the Commission could better organize and operate its disclosure system so that companies enjoy efficiencies and investors have better access to high-quality information.

Another disclosure effort, which is in the proposal stage, is being undertaken by FINRA. Under the proposed changes to NASD Interpretive Material 2210-2, which governs FINRA’s member firm communications with the public about variable insurance products, all communications would have to “clearly identify the type of product discussed” and members would be prohibited from representing or implying that a variable insurance product is a mutual fund. The proposal also would address claims about riders as well as guarantees. Under the proposal, “communications that discuss the circumstances under which a guarantee or rider will benefit the customer must be fair and balanced considering the circumstances under which the guarantee or rider will not benefit the customer.” Additionally, the proposed rule would require “rider discussions to explain the nature of the rider, its costs and limitations and the fact that it is an optional feature of the contract.” The proposal also codifies FINRA’s staff guidance concerning comparative illustrations of the mathematical principle of tax-deferred versus taxable compounding. In proposing this rule, FINRA has taken steps to further increase investor awareness of key information on the products they are offered and the risks and benefits associated with those products.

It is often remarked that crisis can bring out the best in people. In this time of real trepidation regarding the financial markets, it is incumbent on all of us to think of ways that we can responsibly address this trepidation. I would like to briefly take note of a couple of actions that have been undertaken voluntarily by investment companies that are intended to do just that. First, a number of mutual funds have implemented new portfolio disclosure practices, pursuant to which they have disclosed their portfolio holdings on their websites more frequently than required, in an attempt to increase transparency. In connection with portfolio holdings, some funds have also used their websites to discuss their exposure to companies whose names have been in the news for their fiscal troubles. Second, a number of money market funds have also chosen to disclose on their website their participation in the Treasury Department’s Temporary Guarantee Program for money market funds. I am mentioning these efforts to encourage others to think about what voluntary disclosures on websites or otherwise might positively contribute to the mix of information available to assist investors in making informed decisions about the products in which they invest.

With a few exceptions, the SEC currently does not prescribe web site disclosure under our form requirements or otherwise. The disclosures I just identified have been undertaken at the initiative of the companies, and not in response to our rules. That said, I would note that the staff does frequently take a look at web site disclosure by investment companies. In particular, the staff’s review of financial statements of underlying funds pursuant to the Sarbanes-Oxley mandate frequently is integrated with our review of registration statements and other regulatory filings to ensure consistency and, for example, compliance by the registrant with stated investment restrictions. In that context, it makes sense for the staff to consider web site postings to complete the story, such as where portfolio holding information is posted and may provide insight into compliance with stated policies. This approach to a company’s disclosures should be viewed as a helpful resource to in-house personnel responsible for preparing disclosure documents and SEC filings.


Investor education is another important seatbelt. Investors who are empowered with information are in a better position to make smart decisions. While all investors can benefit from additional guidance, Chairman Cox has made clear that the protection of seniors is a high priority at the Commission. It is estimated that there are nearly 77 million baby boomers in the U.S. today, so the ranks of senior investors are swelling rapidly. Beginning in 2006, the Commission expanded collaborative efforts with FINRA and state securities regulators aimed at protecting seniors by providing educational programs targeted to senior investors, while also conducting focused examinations of financial services firms doing business with senior investors, and prosecuting investment scams preying on senior investors.

The Commission held its 3rd annual Seniors Summit on September 22. A primary focus of that Summit was to help older investors make difficult decisions about their finances and learn ways to protect their assets as they age. Among the topics discussed were investment management techniques in light of risks tied to longevity, inflation and underperforming markets. Investors were presented with information to consider with respect to investing. For example, withdrawal rates, diversification, income cushions and taxes were discussed. The Summit also featured presentations designed to raise seniors’ awareness of risk factors for investment fraud. The other key focus of the Seniors Summit was on how securities firms and professionals can effectively serve older investors, and the challenges that come with that responsibility.

In addition to the Seniors Summit, the SEC’s efforts to educate seniors include hosting “safe investing” seminars for seniors. The SEC also maintains a web page devoted to seniors, which includes links to useful publications and other resources. For example, seniors and others can find a “ball park estimate retirement calculator” and a “mutual fund calculator” on that page as well as generic explanations of products like variable annuities and equity-indexed annuities. Meanwhile, other regulators are actively seeking to educate investors about potential financial pitfalls, for example, in April of this year FINRA published information designed to assist the public with detecting early retirement scams.

On the technological front, in April, the Commission launched a new interactive webpage called the Mutual Fund Reader. The Reader enables investors to read, analyze, and compare the information provided by mutual funds related to fund cost, risk, investment objective, strategy and past performance using the interactive data submissions from the voluntary program, which so far have been somewhat small in number, limiting the effectiveness of this promising tool. Still, by accessing the new web page, an interested person can “test drive” the capabilities that interactive data offers, and get a sense of how useful a more complete database will be. This tool is just one in the SEC’s arsenal of investor education efforts.


I would now like to discuss indexed annuities. On June 25 of this year, the Commission proposed a new rule intended to clarify the status under the federal securities laws of indexed annuities. As stated in the proposal, individuals who purchase indexed annuities assume many of the same risks and rewards that investors assume when investing their money in mutual funds, variable annuities, and other securities. However, with few exceptions, indexed annuities historically have not been registered as securities, and, as a result, most purchasers of indexed annuities have not received the benefits of federally mandated disclosure and sales practice protections. With respect to annuities falling within the scope of the proposed rule, investors would be entitled to the seat belt of the federal securities laws, including disclosure and sales practice protections.

The proposed rule would provide a new definition of “annuity contract” that, on a prospective basis, would define a class of indexed annuities that are outside the scope of Section 3(a)(8) of the Securities Act, the exemption for annuity contracts that are subject to the supervision of state regulatory authorities. The proposed rule would provide that an annuity issued by an insurance company would not be an “annuity contract” under Section 3(a)(8) if the annuity has two characteristics. First, amounts payable by the insurance company under the contract are calculated, in whole or in part, by reference to the performance of a security, including an index of securities. Second, amounts payable by the insurance company under the contract are more likely than not to exceed the amounts guaranteed under the contract.

We have received over 4,000 comments. Supporters of the proposal agreed with the Commission that indexed annuities impose investment risk on investors, and cited sales practice abuses and other issues that they believe would be addressed by federal securities regulation. However, many of the comments argue that these contracts should be considered insurance, particularly in light of the guarantees of principal and minimum interest typically provided. Many comments also argue that state regulation of indexed annuities is effective in protecting investors, recognizing in particular the states’ role in overseeing suitability of sales and disclosure regarding annuities, as well as insurer solvency. The staff is reviewing and analyzing these and other comments. Several comments expressed concern that the rule as proposed is overbroad in its scope, so that it could be read to cover traditional fixed annuities. In the proposing release for the rule, the Commission contrasted the two types of annuities, noting that in the case of an indexed annuity the purchaser assumes substantially different risks and benefits. Notably, at the time that such a contract is purchased, the risk for the unknown, unspecified, and fluctuating securities-linked portion of the return is primarily assumed by the purchaser. If the staff makes a final rule recommendation, we would expect to make clear that traditional fixed annuities are excluded.

Last month, the Commission reopened the proposal’s comment period to give the public additional time to review the proposal. The new comment period ends this coming Monday, November 17.


In tandem with the indexed annuity rule proposal, the Commission also proposed a rule that would exempt insurance companies from reporting requirements under the Securities Exchange Act with respect to indexed annuities, so-called “market value adjustment” features and certain other securities that are issued by insurance companies and registered under the Securities Act. The proposed exemption would apply both to existing types of insurance contracts and to other contracts that may be developed in the future. To be eligible for this exemption, the securities would have to be regulated under state insurance law, the issuing insurance company and its financial condition would have to be subject to supervision and examination by a state insurance regulator, and the securities could not be publicly traded. The staff is also reviewing and analyzing these comment letters.


One kind of contract that would qualify for the exemption under the rule as proposed is what some call the “synthetic guaranteed withdrawal contract” or “synthetic annuity,” which I notice was a topic for a panel discussion yesterday. Based on that panel, you are already familiar with the basic workings of this kind of contract. I believe that the recent market turmoil and continuing volatility in the markets can be expected to increase the investing public’s interest in products that offer guaranteed income – in this case without the investor having to sacrifice liquidity by annuitizing. This makes it vitally important that prospectuses for these products be effective in explaining the benefits and risks attending them. They are complex and, as with other complex instruments, explaining them in plain English is no simple feat. I think it is important that any investor considering one of these contracts understand the significance of the limited withdrawals permitted and the asset allocation restrictions imposed, and how these affect the likelihood that the insurance company will actually make payments under the guarantee. Correspondingly, I think that suitability determinations for these contracts may be challenging for the firms selling them, but vitally important in light of their complexity. I encourage those of you who are offering, or just now developing, such contracts in your shops to be thoughtful and thorough in addressing these challenges.


In conclusion, I would like to note that at the October 8th Roundtable on Modernizing the Securities and Exchange Commission’s Disclosure System, the Chairman had the following to say, and I quote: “Today, we are continuing to build on that essential premise: that investors have a right to know the truth – and the risks – about the securities that trade in our public markets. Never in this agency’s history has this fundamental mission been more relevant, and more urgent. The current credit crisis has shown the importance of transparency to a healthy marketplace – and how costly hidden risk can be.” To the extent there are concerns with the efficacy of our disclosure system, then I say that we (and that includes you market participants) can and must address those concerns. We have the know-how to make the system better than it was before — better, stronger, and with technology faster and more efficient. If we act in concert, we can meet the challenges of enhancing investor protection in this dynamic securities market. I began my talk invoking seatbelts as a metaphor. I will come full circle by saying a seatbelt is only effective if you buckle it. Tools are only useful when they are put to use. Do we have the resolve and the wherewithal to buckle-up and drive in this unpredictable environment? I believe we do. My hope is that we can share ideas on how best to meet the challenges we face together.

Thank you very much for your attention and enjoy the rest of the conference.




Modified: 11/14/2008