INSURANCE PRODUCTS: CHALLENGES FOR THE FUTURE Keynote Address by Barry P. Barbash, Director Division of Investment Management U.S. Securities and Exchange Commission 14th Annual Advanced ALI-ABA Conference on Life Insurance Company Products Washington, D.C. November 7, 1996 Introduction Thank you, Paul, for your kind introduction. This is a time of great promise for the variable insurance industry. Assets dedicated to variable annuities and variable life insurance have experienced tremendous growth -- from $63 billion at the end of 1992 to almost $230 billion this past June.1 Innovative products are being developed, and new distribution channels are being used. Recent legislation has rationalized the regulation of variable insurance and leveled the playing field. This is also a time of great challenge for the industry and for those of us who shoulder responsibility for the legal aspects of the business -- for you, as members of the private bar, steering a rapidly growing industry through the shoals of legal compliance and, hopefully, contributing to a satisfied and loyal customer base -- and for us, at the Commission, carrying out our mandate to protect investors. My remarks today will focus on the challenges of the coming years -- your challenges and our challenges. Challenges will be presented at every step of the way from developing products to selling those products to servicing the holders of those products. New products will need to be introduced at a lightning pace as competition continues to intensify in the financial service business. The industry's challenge will be to balance the need for quick responses with the goal of providing well-conceived products suited to clients' financial needs. The major changes occurring today in the distribution of financial services will also present significant challenges for the industry. Innovative distribution channels will be used increasingly as part of the industry's effort to compete effectively with other financial service providers. Each distribution channel will need to operate in a manner that inspires satisfaction among customers. Educating prospective clients about its products will remain an important challenge for the industry. The prospectuses and other materials the industry provides can and should play an important role in selling products and services-- but only if those materials are crafted so that they can be understood by, and are useful to, investors. Perhaps the most underrated but most important challenge facing the industry today is initiating and maintaining compliance and control systems that can keep pace with new product designs, novel distribution methods, and resulting sales and servicing obligations. Our challenge -- through all phases of product design, sale, and servicing -- will be to provide for strong investor protection while accommodating innovation that, if all works well, will be good for investors and good for the industry. I. Product Development Variable insurance products compete not just with each other, but with the broad array of financial instruments available in the market, from fixed insurance to mutual funds to bank certificates of deposit to stocks and bonds. For years, the insurance industry has lamented that variable products were square pegs forced into the round hole regulatory scheme of the Investment Company Act of 1940. The regulatory mismatch, the industry argued, stifled innovative product design and hindered competition with mutual funds and banks. In passing the National Securities Markets Improvement Act of 1996, the Congress adopted the Commission staff's long-standing recommendation to address these concerns by fundamentally changing the way in which variable insurance is regulated under the 1940 Act. No longer are variable insurance contracts to be regulated under the 1940 Act's arcane periodic payment plan certificate rules, applied on a case-by-case basis. Instead, under the 1996 Act, aggregate charges under variable insurance contracts are required to be reasonable, and insurers are required to so state in registration statements. The 1996 Act gives the Commission explicit authority to adopt rules establishing guidelines for determining reasonableness. The changes made in the regulation of variable insurance present the industry with a tremendous opportunity to innovate and offer customers novel and competitively-priced products. The industry's challenge will be to ensure that flexibility in pricing does not simply lead to more costly products. Our challenge will be to monitor the industry's use of the flexibility it has been given. If abuses develop, we will step in, but we hope that will not be necessary. The challenges faced by the industry in product design do not end with pricing. They also include meeting customer needs. Two products that are emerging on the variable insurance scene -- funds of funds and equity index annuities -- pose particular challenges for the industry and the Commission. A. Fund of Funds Variable insurance is fairly complex in design and charge structure. Its degree of complexity has only been greater in recent years as many insurance companies have sought to increase the number of investment options available to contract holders. To help those holders who may have difficulty assessing their investment options, some companies have proposed to offer asset allocation programs through fund of funds arrangements. The desire to help contract holders is commendable, but it will put the insurance industry to a significant test. In the best of worlds, adding fund of funds arrangements to the variable insurance mix would simplify investment decisions. In the worst of worlds, it could threaten to make variable products -- and certainly the documents that describe them -- incomprehensible. Failure to meet the test of clarity will only undermine the goal of meeting customer needs. Dealing with fund of funds arrangements in the variable insurance context will also put us to the test. The 1996 Act clarified the Commission's authority to grant exemptive relief from the 1940 Act's percentage limitations applicable to fund of funds arrangements. We expect that, in an effort to provide the most flexible asset allocation programs, mutual fund companies and insurance companies alike will seek relief from those limitations. Our challenge will be to respond expeditiously to these exemptive requests in a manner that balances the need to protect investors with the goal of promoting innovation. We will make every effort to meet the challenge. B. Equity Index Annuities The hottest insurance product today may well be equity index annuities. A recent report indicated that the number of these products offered has increased from a mere two last year to more than a dozen today, with more on the way.2 The attraction of these products is apparent -- they offer downside protection with the ability to participate in upside market returns. The challenge raised by equity index annuities for the Commission is clear; we need to educate ourselves about them as rapidly as possible so that we can determine whether we believe they are securities or a form of insurance. Analysis of the issue is fact-intensive and depends on the features of each annuity, so there is not necessarily an easy one-size-fits-all answer. As we move forward, we will be looking at a number of factors -- the guarantees provided by the insurer, the nature of the investment risk borne by both the contract holders and the insurer, and the manner in which the annuities are marketed. We encourage the industry to assist us in analyzing these factors. A more important challenge for the industry will be to educate potential holders sufficiently about the benefits and potential pitfalls of equity index annuities. Everything we read suggests that these annuities are designed particularly for individuals who have not before ventured into the world of the equity markets and who may not understand the vagaries of the market. The lack of familiarity with the market is likely to be made worse by the complicated nature of these annuities, which are characterized by different indexing methods, participation rates, cap rates, surrender charges, and vesting schedules. The test for insurers offering equity index annuities will be not only to explain these products well enough to sell them, but also well enough so that purchasers don't have any unpleasant surprises down the road. II. Alternative Distribution Networks Insurance products have traditionally been distributed through commissioned, career agents. In recent years, though, insurers have increasingly turned to alternative distribution channels, and this trend is likely to continue. Two of the new channels, banks and the Internet, present opportunities and challenges. A. Banks Banks potentially offer a variety of ingredients critical for making sales: wide-reaching distribution systems; credibility with, and convenience for, consumers; and computer and payment systems expertise. The insurance industry already faces the challenge of explaining to customers that variable products don't come with traditional insurance guarantees. If those products are distributed through banks, the industry will face the additional challenge of overcoming the presumption in the minds of many that every instrument bought through a bank is a federally insured deposit. B. The Internet Nothing would seem to have a greater potential effect on the way in which financial instruments are offered and sold now, and in the future, than the Internet. The Commission has recognized this potential and has taken decisive steps to allow it to be realized while at the same time guarding against potential abuses. In two interpretive releases published over the last 13 months, the Commission indicated its views as to how participants in the securities business can fulfill their obligations under the federal securities laws through electronic media. To ensure that the industry does indeed meet these obligations and that electronic media are not used to take advantage of investors, the Commission staff has instituted a program of regularly surfing the Net looking for questionable conduct. We anticipate that some of our surfing will lead to enforcement actions over time. As use of the Internet for securities transactions increases, you can expect to see continued close involvement on our part in all of the issues that arise. Selling through the Internet raises many challenging issues that insurers will need to address. Should agents be permitted to communicate with prospective and current contract owners electronically? If so, to what type of home office supervision will these communications be subject? What protections will be afforded to information provided to insurers by their clients over the Internet? These are but a few of today's electronic-related questions. Tomorrow will surely bring more. III. Disclosure A central theme of the Commission during the recent past is that all participants in the investment management business must step forward and seek to communicate better with clients and customers. Some insurers have taken that step and have worked to simplify their prospectuses, and we applaud those efforts. But many prospectuses for variable contracts remain overly technical, generally murky and difficult to follow. We have committed, and continue to commit, to work with all investment management industry participants, including insurance companies, that want to improve their prospectuses. Better, clearer prospectuses can pay dividends to insurance companies in the form of more effective client marketing, particularly as the industry moves to a wider variety of distribution channels. Clarity in disclosure may well result in other important benefits to insurance companies. Survey research we have undertaken to date in connection with fund profiles and improved prospectuses suggests, among other things, that not only investors, but selling agents, strongly support improved disclosure documents. The agents surveyed told us that they themselves find improved materials easier to understand, helping them to do a more effective job of dealing with their customers. As you know, earlier this year we gave the green light to experimental use of a variable annuity "profile." We are beginning to see greater use of the profile, and we are optimistic that the pilot program will give us a better basis upon which to undertake improvement of variable annuity disclosure generally. IV. Compliance Establishing and maintaining good compliance procedures is an ongoing challenge for all investment industry participants. After all, compliance is boring and it means dealing with auditors and lawyers. Good compliance is also not free and costs can detract from performance. But, like medicine, it's good for the patient. Good procedures will certainly smooth an insurance company's interactions with our exam staff and should help to prevent interactions with our enforcement staff. Perhaps most importantly, though, good procedures make good business sense by helping to establish a satisfied and loyal customer base. A. Internal Control and Compliance Systems For internal control and compliance systems to work well in the variable insurance business, the technology that supports those systems must fit the needs of the business. Systems designed for use with traditional annuities or life insurance may need to be upgraded or replaced so that the special features of variable products can be efficiently and accurately handled. A continual review of systems is particularly important in light of the tremendous growth in the variable contracts business. Recordkeeping and bookkeeping systems should be capable of handling the volume of transactions that accompanies this level of growth. B. Compliance Culture Upgraded technology alone will not ensure that an insurance company's business is run in compliance with applicable laws and in a manner that will result in satisfied customers. Even the most technologically sophisticated system will not be sufficient to get an insurer where it needs to be in terms of compliance. Technology should be viewed as one tool of an organization with a corporate culture that is committed to compliance and vigilant in its attention to sales practices. Regrettably, the reputation of the insurance industry has suffered significantly of late from allegations of rather widespread sales practice problems. Much attention is being paid in the press to so-called "1035 exchanges" and whether they are in the best interest of contractholders. You know the effect that the negative public perception created by news of this nature can have on an insurer's ability to market its products and services. Management, with your help, is responsible for creating a corporate culture of responsibility and compliance. To avoid market conduct problems, an insurer needs to create a corporate culture that encourages appropriate conduct and targets problem areas, no matter what sales volumes are being achieved. Concrete steps an insurer can take include: ù recognizing agents who create the highest levels of customer satisfaction; ù prohibiting pressure from being placed on agents to push particular products; and ù demonstrating a willingness to discipline or fire those who fail to observe high standards, even if those individuals are "big producers." C. Compensation Practices Review of compensation practices is an integral part of a commitment to a compliance culture. Two years ago a committee on compensation practices, including representatives of the securities industry, investors and academia, was formed at the request of Chairman Levitt in response to concerns about conflicts of interest in the retail brokerage business. In a report published last year, the committee found that industry "best practices" were characterized by, among other things, compensation policies designed to align the interests of all three parties in the brokerage relationship -- the client, the registered representative, and the brokerage firm -- and to encourage long-term relationships among them. All of these elements can and should be adopted for use in the variable insurance business. Compensation practices can after all be a concrete mechanism to back up a corporate culture of compliance. They can serve as the "carrot" to reinforce good market conduct. Compensation practices are high up on the regulatory agenda, as the Commission considers comments on the NASD's proposed amendments to its rules on this topic. But, apart from any regulatory requirements, insurers should take the initiative to determine whether their compensation practices are likely to foster good sales practices and satisfied, long-term customers. D. Examinations Ensuring good compliance in the variable insurance area is a challenge not only for the industry, but also for the Commission. Our exam staff will continue to focus much time and attention on sales practices. We will be looking carefully at situations when contract holders own multiple policies or have made 1035 exchanges -- verifying that churning has not occurred. And, we will continue to take a hard look at internal control and compliance systems. Conclusion You are part of an industry that has seen very good fortune over the past several years. It is a time of great growth and promise for the variable products industry. And, by necessity, it is a time of great challenge for the industry and for you. One of Chairman Levitt's favorite quotes is a statement once made by President John Kennedy: "The time to repair the roof [the President said] is when the sun is shining." They continue to be wise words for us all. Thank you. _______________________________ 1 Figures exclude CREF assets. 2 The Equity Index Product Advisory from Financial Distributors, Inc.